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Slovenia's rules

The richest of the EU's new Central European members may be on a glide path to the euro, but it needs to sharpen its competitive edge.

Alpina stands as a prime example of the industrial prowess of Slovenia, the most developed of the European Union's new Central and Eastern European members. The Ziri-based company, which makes shoes and sports footwear, has captured one third of the global market for cross-country ski boots, a reflection of the importance of skiing in this Alpine country. Slovenia's EU membership, however, offers little immediate benefit to Alpina, which already exports the bulk of its boots to Western Europe, particularly Scandinavia. Instead, chief executive Andraz Kopac is preoccupied by the threat from the east -- namely, intense competition from shoemakers in Asia. To meet that threat, Kopac is moving some of his own production eastward, to lower-cost footwear plants in Bosnia and Romania. He also is expanding the company's retail network by adding new stores in Bosnia, Bulgaria, Croatia and Serbia, hoping to benefit from a consumer boom as these countries raise their standards of living toward Western levels.

"There are some pluses and some minuses with the EU, but even more important is the Far East story," says Kopac. "The competition is tough, and every year it is worse and worse."

Stories like Kopa c's are common in Slovenia. This small country of 2 million people boasts by far the highest standard of living of any of the new Central European members of the EU, with a per-capita GDP that is 77 percent of the EU average, ahead of Portugal and only narrowly behind Greece. Slovenia possessed the cream of the former Yugoslavia's industrial base when it boldly, and almost bloodlessly, declared independence in 1991 -- an event that triggered nearly a decade of civil war in the rest of the Balkans. The country's manufacturers, ranging from consumer-goods companies like Alpina to makers of pharmaceuticals and machinery, have exploited their position at the crossroads of Europe, nestled amid Austria, Croatia, Hungary and Italy, to develop markets to the west and east. Slovenia celebrated its successful economic transition in March by becoming the first Central European nation to formally graduate from the World Bank's lending programs; its income levels now place it among the developed countries.

Prosperity brings its own challenges, though. The stagnation of key export markets like Germany and France caused Slovenia's growth rate to slow to a pedestrian 2.3 percent last year, the lowest among the accession countries of Central Europe. One by-product of success, relatively high wages, makes the country increasingly less competitive compared with other Central and Eastern European states. Foreign investment has lagged behind that in many other accession countries because of the government's reluctance to let industry, particularly banking and insurance, pass into foreign control. As a result, the risk for Slovenia is that the country could start to look more like its sluggish neighbors to the west than the dynamic, faster-growing nations to the east.

The center-left government of Prime Minister Anton Rop has a two-pronged strategy for meeting the economic challenge. First, Rop wants to lock in the country's economic stability by adopting the euro as soon as possible, most likely in 2007. Slovenia comfortably meets the deficit and debt criteria for euro membership, thanks to a decade of conservative fiscal policy, while government-enforced wage restraint has helped bring inflation close to EU levels.

"We think only macroeconomic stability gives you growth on a long-term basis. It's better to grow a bit more slowly but grow every year," says Finance Minister Dusan Mramor. "From this point of view, the euro, which requires macroeconomic stability, is just a continuation of what we were doing so far."

The government also is drawing up a ten-year economic plan that aims to improve growth to an annual rate of 5 percent by trimming the size of government while increasing spending in specific areas, notably education, research and development and investment in infrastructure.

"The challenge is very straightforward," Prime Minister Rop tells Institutional Investor. "We cannot base our economy on low-value-added production. That's something that is impossible in Slovenia because we are too developed; we have too high wages. We can find a solution only through a higher level of competitiveness, a higher level of education and higher expenditure on research and investment."

Rop's ability to implement his strategy, however, may be in doubt. The political consensus that has marked Slovenia for most of its independence shows signs of breaking down: The governing coalition of Rop's Liberal Democracy of Slovenia party and the United List of Social Democrats suffered a significant defeat in the June elections for the European Parliament, winning just three seats, compared with four for the conservative opposition Slovenian Democratic Party and its ally, New Slovenia. The poor result followed the defection of the Slovene People's Party from the government in April.

Opposition leaders say the country would benefit from a change of direction now that it has achieved its overriding goal of EU membership. "We need a new consensus on economic policy," declares Andrej Bajuk, a University of California, Berkeley­trained economist and the deputy leader of New Slovenia, which aligns itself with Europe's Christian Democratic parties. "Slovenia was like Austria and northern Italy in the early 20th century. The question is, why are we not at the level of Austria or northern Italy today? We can do much better if we truly open up to the market system without any reservations about foreign investment."

The emerging debate about the country's direction is a departure from the remarkable stability that has characterized Slovene politics since independence. In contrast to countries like the Czech Republic, Hungary and Poland, which have experienced lurches in policy since the end of communism, Slovenia has been controlled by Rop's center-left LDS party for all but six months since 1992.

Janez Drnovsek helped lead Slovenia to independence and served as prime minister for almost a decade before being elected president in 2002 and handing the prime minister's job to Rop. Central bank governor Mitja Gaspari served as Finance minister from 1992 to 2000. Throughout the transition period the government maintained a uniquely Slovene policy that combined fairly high levels of government spending with a low deficit, and it cautiously liberalized its markets. Growth was steady if unspectacular, and the lack of sudden policy shifts allowed the country to build its prosperity.

"That continuity makes a big difference," says Roger Grawe, a World Bank director for Central Europe. "Economic policymakers were conservative in terms of fiscal and macroeconomic management."

The political climate has become much more fluid lately. Not only did the opposition score well in last month's European parliamentary elections, but some politicians are testing the waters for new alliances. Milan Kuçan, a founder of the LDS and the first president of independent Slovenia, has launched a group named Forum 21 to explore new policy options, while Foreign Minister Dimitrij Rupel has announced his intention of joining with opposition figures in the Assembly for the Republic, a vaguely defined, cross-party gathering that aims to recreate the sort of mass popular movements that arose in many Central European countries after the fall of communism.

"The long period of LDS rule is behind us. There is obviously a desire for new ideas," says Jurij Giacomelli, publisher of the business daily Finance. Just where this desire will lead is anyone's guess. The risk is that parties will pander to growing populist tendencies, encouraging nationalism and endangering economic progress. In April, Slovene voters overwhelmingly rejected a law passed by Parliament that would have restored citizenship to some 18,000 people from other former Yugoslav republics who were stripped of it shortly after independence. The opposition Slovenian Democratic Party led the campaign for a "no" vote in the referendum. Giacomelli, for one, was disturbed by the referendum: "That is not something that Slovenia can be proud of."

Whatever their differences, politicians across the spectrum agree on certain fundamentals, and chief among them is the euro. Slovenia meets most of the economic criteria for adopting the single currency, with a projected budget deficit of about 1.7 percent of GDP this year and debt of about 27 percent of GDP. Inflation, which exceeded 2,000 percent at the start of the country's independence, has fallen dramatically: It was 3.8 percent in May, compared with an average of 2.5 percent in the 12-nation euro area, while rates on government bonds have converged with the low rates prevailing in the euro zone.

"We are now already in the environment of the euro," explains Andrej Rant, the Bank of Slovenia vice governor who is leading preparations for the transition to the euro.

The trick for policymakers will be to maintain downward pressure on inflation after linking the exchange rate of the Slovene tolar to the euro. Slovenia -- along with Estonia and Lithuania -- entered the EU's exchange-rate mechanism late last month, pegging the tolar at a rate of 239.64 to the euro. Under EU rules countries need to keep their exchange rates steady for two years before they can adopt the euro.

A stable exchange rate should help Slovene interest rates fall toward euro-zone levels. But credit growth is expanding at a rate of 19 percent a year, increasing the risk that excessive bank lending could fuel an inflationary boom, as the International Monetary Fund cautioned in its recent assessment of the country's policies.

The government hopes to ward off the threat with an incomes policy, approved by business and unions earlier this year, that will limit pay increases to 1 percentage point below the level of productivity increases. The government also has tightened its budget to offset the impact of EU membership, which, by eliminating most customs duties and requiring increases in spending to match EU aid, will raise the deficit by almost a quarter point of GDP this year and nearly half a point in 2005.

"We did everything possible to have a restrictive fiscal policy," says Finance Minister Mramor. He will have to clamp down harder in coming years, however. The government aims to eliminate its structural budget deficit -- the part that doesn't reflect the business cycle -- over the next four years.

The Bank of Slovenia, which in recent years has maintained relatively high real interest rates to dampen inflation and moderate the impact of capital flows, acknowledges that managing the economy will be tricky given the exchange-rate mechanism. "Fiscal policy by definition is less flexible in the short term than monetary policy," says the central bank's Rant. "Two years is a long time, and there are elections." These, of course, tend to increase pressure for greater public spending.

Rant is optimistic, though, that the authorities can smoothly steer Slovenia to the euro. The central bank is preparing to require banks to practice so-called dynamic provisioning, which involves setting aside a steady level of bad-loan provisions in good economic times as well as bad. Such a change should help moderate the current growth of credit, he says.

Investors appear to have little doubt about Slovenia's euro ambitions, having already pushed interest rates there to match those in the euro area -- the first time this has happened in any of the accession countries. Eight-year government bonds traded last month at a yield of 4.15 percent, two basis points below comparable German government bonds. "If the government continues its stability-oriented economic policy, the introduction of the euro in 2007 is within reach," says Walter Pudschedl, an economist at Bank Austria Creditanstalt.

Slovenia's politicians see their country as a bridge between Western and Eastern Europe, particularly the Balkans. Mramor hosted finance ministers of the former Yugoslav republics at the Slovene resort of Bled early last month to offer lessons on how to open up their economies and adopt European regulatory standards in preparation for seeking to join the EU. The country claimed a major success at the EU summit in Brussels late last month when the bloc's leaders formally agreed to open membership negotiations with Croatia.

"What is important is that the EU give a very strong signal to these countries that they have a future in the EU," Mramor says. "These countries see us as a role model. If you introduce a market economy, if you open up -- if you look outwards and not inwards -- that makes a big difference."

The private sector has already jumped on the Balkan bandwagon. The country experienced a modest net outflow of foreign direct investment last year -- an unprecedented development in Central Europe -- as Slovene companies like Alpina stepped up investments in countries further east.

Mercator, the country's largest retailer, with a 42 percent share of the domestic market, is investing E150 million ($180 million) this year to build five shopping malls in Bosnia, Croatia and Serbia. The company aims to generate 50 percent of its revenues in those countries in coming years, compared with just 16 percent currently. "All other countries in the former Yugoslavia look at Slovenia as a model they can follow," says the group's chief executive, Zoran Jankovic.

The country's access to Eastern markets was a major reason why Swiss pharmaceuticals company Novartis paid Sf1.2 billion ($774 million) to acquire Slovene generic drugmaker Lek Pharmaceuticals in 2002. Lek provided 40 percent of the revenue growth at Sandoz, Novartis's generic division, last year and overnight made Sandoz the fifth-largest drug company in Russia, where it previously was a minor presence. Lek opened a E70 million plant in the Polish city of Lodz in May and plans to manufacture in Russia.

To maintain these export successes, Slovenia needs to improve its competitive edge at home. The country has slipped nine places to 45th in the overall-competitiveness rankings compiled by Lausanne, Switzerland­based business school IMD International.

Slovenia is trying to improve its competitiveness. Finance Minister Mramor has cut payroll taxes over the past two years, especially for low-paid workers, and increased the budget for education and training by 20 percent this year in a bid to help steer the economy toward higher-value production and services. "We have to move labor from industries that are reducing in size to industries that are increasing in size," he explains.

The key to success, in Slovenia as in other accession countries, lies with foreign investment. The country has lagged behind many Central European states, attracting a total $1,700 per person in foreign direct investment between 1989 and 2002, the latest year for which figures are available. Slovenia ranked the same as Slovakia and trailed well behind Hungary ($2,253) and the Czech Republic ($3,554).

Even that data flatters Slovenia: Fully half of all foreign direct investment came into the country in 2002, most of it resulting from Novartis's acquisition of Lek and Belgium-based KBC Bank's E435 million purchase of a 34 percent stake in Nova Ljubljanska Banka, the country's largest bank. Only a third of Slovenia's banking industry is in foreign hands, whereas countries like Poland have sold the majority of their banks to foreign companies.

KBC is satisfied with its investment in Nova Ljubljanska and has taken effective management control without any hindrance from the state or domestic institutions, each of which own roughly a third of the bank, says André Bergen, who oversees KBC's investments in Central Europe. KBC plans to take full control of the bank when its standstill agreement with the government not to raise its stake expires in 2006.

"Foreign ownership is an issue everywhere, including France, Belgium and Germany," says Bergen. "I don't see it as a factor unique to Slovenia."

Mramor, however, declines to commit himself publicly to an eventual sale of the remainder of Nova Ljubljanska and praises the current arrangement. "It's a combination of domestic ownership and state ownership and foreign ownership, which is probably the best combination," he says.

The government also is proceeding cautiously toward the privatization of the country's largest insurance company, Triglav Insurance Co., which controls half of the domestic market. The Economics Ministry has set a loose 2005 target for privatizing the company, which it hopes will form the basis of a domestic financial services champion. Progress is similarly slow in the sale of Telekom Slovenije, also scheduled for sometime around 2005. The government is first building an alternative telecoms network, using two state-owned highway and railway companies; it insists this is a necessary precondition for successful liberalization.

"The experience of other countries shows that if there is not an introduction of competition along with privatization, the result is even worse," says Mramor. "What you want to get is low prices and good quality. You don't get that with a monopoly."

Support for that cautious approach to liberalization and foreign investment runs deep in Slovenia. This is not surprising given the strength of nationalist feeling in such a young country. "We didn't sell all the best companies to foreign investors. I think that's to our advantage," says Mercator's Jankovic. "To me, it's important to know who the owner of a company is and where the profits go."

But if Slovenia wants to build on its prosperity and achieve the same living standards as its Western European partners, the country will have to open itself up more. Says the World Bank's Grawe, "Over time they're going to need the resources and management perspectives that foreign investors will bring."


Slovenia's Rop: Building bridges to the East and West

An economist by training, Prime Minister Anton Rop has had a hand in every step of Slovenia's transition from a breakaway state of the former Yugoslavia to the most highly developed new European Union member from Central Europe. He worked on privatization in the Economics Ministry in the early 1990s, then served as Labor and Finance minister before rising to the premiership two years ago. He talked with Institutional Investor European Editor Tom Buerkle during a break in the EU summit meeting in Brussels last month.

Institutional Investor: Slovenia has a unique history in coming out of a failed federation. I wonder if, seeing the difficulties of reaching consensus among 25 nations in the European Union, you have any worries that your country is trading one failed federation for another, with its own political difficulties?

Rop: I would not say so. We have our experiences from the former Yugoslavia, in which we didn't have the same political system, we didn't have democracy. We know how hard it is to reach a compromise. Usually, you are not satisfied. You have to pay a price for that.

We are quite realistic about the European Union. What's important for us is that we have gone through a very important process of transition. We have changed our economy, changed our society, changed our way of thinking and attitudes to everyday life. That's the biggest achievement and gain.

There are different visions of the EU: more centralized and more decentralized. Given your history, how would you like to see the European Union develop?

It's not so simple to say we want to have a very centralized or decentralized European Union. You just have to find the optimum. In some fields, such as agriculture, rural development and environmental policy, it's very important to have an efficient European Union. In other fields I think it's very important to have decentralized concepts, to allow member states to run their own policy -- in the field of social policy, the welfare state and also partially in taxation. It's important to allow members to run their own policies to be competitive, to find their own way of life.

You've talked often of a bridge role for Slovenia between Western Europe and Central and Southeastern Europe. What do you mean by that? What role can Slovenia play?

Slovenia is the only country from the former Yugoslavia that is in the European Union. We went through the convergence process; we had quite rich experiences in how to change society and the economy to get in the European Union. We believe that we can help all other countries in the region. We would like to offer them our experiences, our success, but also our mistakes. That's why we decided to establish in Slovenia an enlargement center for the region.

Slovenia has enjoyed remarkable political consistency. You haven't had the left-right lurches of many Central European countries. Do the recent changes in the coalition, with the defection of the Slovene People's Party and the results of the European Parliament election, which showed gains for the opposition, suggest some kind of fracturing of the political consensus in Slovenia?

I would not say so. This is quite normal what happened. We saw a little movement toward the right, but participation was very low. We believe we can be the strongest party after the next elections, but this is not so easy because the Liberal Democratic Party has been in power for the past ten years, and it's hard to keep power for that long.

The conservative opposition complains about the government's gradualism, its cautiousness in opening up to foreign investment, and says you need to fully open up to have a faster growth rate. How do you respond to that?

That's not true. If you compare economic growth in Slovenia with other accession countries, you find that only one country has had higher cumulative growth than Slovenia since 1993: Poland. At the same time, you know there is instability in Poland, public deficits and unemployment -- you cannot compare Poland with Slovenia. The fact is, we have quite stable economic growth and the lowest unemployment rate. We really have achieved a lot. That's why we have such a stable government and a stable political environment.

You have by far the highest standard of living of the Central European accession countries. A number of companies have competitive concerns. How do you see this challenge of maintaining competitiveness?

The challenge is very straightforward. It's very clear that we cannot base our economy on low-value-added production. That is impossible in Slovenia because we are too developed, we have too high wages. We can find a solution only in a higher level of competition, of competitiveness, a higher level of education and spending on research and investment. That's it.

You've set a target of adopting the euro by 2007. Why is that so important?

We did an analysis of the Slovenian economy together with the central bank. The conclusion was that we have proper macroeconomic stability in all fields of the economy: wages, inflation, the deficit, interest rates. This equilibrium is such that it is the proper moment to enter the exchange-rate mechanism. The only challenge we had at the end of last year was inflation, really. This year we expect inflation to be about 3.3 percent to 3.6 percent, depending on the price of oil. So we believe now we have a proper macroeconomic equilibrium, with the lowest possible risk.