Mitja Gaspari: Adoption of the Euro – a Sign of the Economic Integration with the Most Developed Countries 1

CONTENTS

EDITORIAL Mitja Gaspari: Adoption of the euro – a sign of the economic integration with the most developed countries 1

ON THE ROAD TO CONVERGENCE

Ivan Ribnikar: Bank of Slovenia on the road to the Eurosystem 3 Damjan Kozamernik: Achieving price stability in ERM II and after euro adoption 10 Velimir Bole: Short-term fiscal risks and economic policy measures 20 Monika Kirbiš: Relation between EU budget and Slovenian budget 28

Božo Jašovič and Boštjan Jazbec: Interest rates after ERM II entry 35

Marko Košak and Tomaž Košak: Impact of ERM II participation on Slovenia’s banking sector 42

Franjo Štiblar: Financial groups and conglomerates in Slovenia under impact of euro 50

PAYMENT SYSTEMS

Matevž Pirnat: Convergence of payment systems in Slovenia and the EU 57

INTERNAT IONAL FINANCIAL REPORTING S T A N D A R D S

Sonja Anadolli: The influence of IFRS on banks balance sheet and capital 65

FOR EIGN EXPERI ENCE AND INSTITUTIONAL VIEWS

Filip Keereman: Towards the euro: an institutional view on convergence in the recently acceded Member States 71 Jens Thomsen: Experience of Danish credit institutions in ERM II 78 Andres Sutt: Estonia’s preparations for joining the euro area 83

STATISTICAL APPENDIX

Matjaž Noč: Selected macroeconomic and banking indicators 89 EDITORIAL

Adoption of the euro – a sign of the economic integration with the most developed countries Mitja Gaspari *

aving wrapped up the process of macroeconomic and structural adjustments that took a decade or so, Slovenia reached the level of development where the door leading into the new economic environment opened widely. The accession to the Europe- an Union has confirmed the capability of the Slovenian economy to cope with competitive pressures on the playing ground alongside more developed countries without turning its back on the positive elements of its social environment. Slovenia’s firm foothold in the level playing ground coupled with commitment to preserve the dignity of social security for economically less privileged segments of society, puts us in a pole position for further integration of our economy into the European area and the H adoption of the euro in the final stage as a sign of the full economic alliance with the club of the most developed countries in Europe. The economic imperative of the adoption of the euro opens a series of important questions both for the economic policy makers and businesspersons and social partners in general. If stripped of quality economic growth feeding on the adequate appropriation and employment policy, the single currency could turn out to be an objective without any real content. This explains why reinforcing a sustainable level of the macroeconomic stability is essential for us (low rate of inflation, balanced payments, relatively low unemployment rate, controlled low fiscal deficit) by fostering dynamic growth of the economy (increasing labour productivity, aligning the social security system with economic possibilities, curbing monopolies in the public economic sector, and the increase of the role of the economising in the public services area). For that we need properly harmonised economic policies and social partners capable of down- playing current interests for the sake of future positive results. With this in mind, the entry into ERM II and the beginning of the process to adopt the euro are seen as an important turning point that demands fine-tuned economic policy and does not provide any room for feet-dragging when the necessary structural reforms are at stake. Stable low inflation will no longer be largely a result of successful monetary policy, but ever more of a government capable of adjusting itself to the restrictions of the external environment (single currency, stronger competition, pending liabilities for aging population). As seen from the picture of economic growth and development among the members of the euro group, the consequences of lame co-ordination of policies and delaying reforms may be large already over a relatively short time. It is even truer for small open economies where internal demand is not a long-term solution to the problems of sluggish growth. Flexibility, efficiency and social cohesion are the advantages, which enable living within euro zone to demonstrate those advantages an * Mitja Gaspari, M. Sc., optimum currency area is supposed to have. On the other hand, it is merely an opportu- Governor of the Bank of Slovenia nity – will it evolve into reality depends on the ability of each and every economy.

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ON THE ROAD TO CONVERGENCE

UDK 336.711(497.4):339.738:061.1EU Bank of Slovenia on the road to the Eurosystem Ivan Ribnikar *

With the entry into the eaving aside challenges or problems of replacing the Eurosystem approaching, the Bank of Slovenia tolar with the euro, the general public might be less in- should decrease its stock of euro-denominated bills. terested in changes the Bank of Slovenia has to make in The Bank of Slovenia should abolish them before the adoption of the euro as order to assure smooth transition to the Eurosystem. they have already fulﬁlled L their task. However, the Among the Maastricht criteria, inflation convergence may for Bank of Slovenia cannot set a similar objective for Slovenia be the most important and at the same time most diffi- the tolar denominated bills. The decrease in the cult test to pass together with the exchange rate at which the stock of tolar denominated bills should be as large as tolar will be converted to euro (conversion rate). No hike in the possible for the Bank of Slovenia to be still able to nominal the tolar value vis-à-vis the euro to meet the inflation monetise it. When doing so, the Bank of Slovenia criterion would be appropriate due its adverse effects on Sloveni- must not allow a decrease in the nominal euro an companies. Whatever changes the Bank of Slovenia has in exchange rate. Those tolar denominated bills and store will be limited to redefining its relationship with banks as bank deposits, which the Bank of Slovenia will retire and pay back only after its most important clients. adoption of the euro, should be paid with the The Bank of Slovenia bills are the first issue addressed in Bank of Slovenia’s assets currently kept as this paper. The central bank does not use bills denominated in international monetary reserves with banks in foreign currency to steer monetary policy; hence they are redun- euro area countries. Liabilities and claims dant on its balance sheet and should be phased out. Consequent- towards the Eurosystem come about because of ly, banks must find alternative liquid investment and it has to be payment imbalances among countries or their denominated in foreign currency. As long as banks do not come central banks. Costs of these debts are such that up with another type of investment, they will stick to foreign cur- it would probably not be good if the Bank of rency bills issued by the central bank. On the other hand, bills Slovenia incurred them also because it has not reduced its stock of bills as denominated in tolars are used to conduct monetary policy; much as possible before the adoption of euro. For hence their phasing-out would not be so problem-free. The first this reason it would be sensible that the Bank of part of the paper focuses on changes in the relationship between Slovenia pays back its liabilities towards banks the Bank of Slovenia and banks from the perspective of tolar-de- in such a way, which does not increase banks’ nominated BS bills. reserves with the Bank of Slovenia. * Dr. Ivan Ribnikar, full professor, Faculty of Economics, University of Ljubljana

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In the second part, we analyse a plating the phasing out of tolar-de- place a portion of the matured ones, simplified balance sheet of a national nominated BS bills is not that straight- it would have to find another way of central bank (NCB) in the Eurosystem forward. Let us next examine different withdrawing excess liquidity from to provide an explanation for pay- strategies and limitations in reducing banks, which has been created by ment imbalances, say between the outstanding stock of tolar-denomi- the monetisation of the tolar-denomi- Slovenia and the other euro area nated BS bills. nated BS bills. One option would be countries. These imbalances will be From the technical perspective the selling foreign currency to banks. even larger if the Bank of Slovenia re- Bank of Slovenia will be reducing the However, this would mean that the deems most of its bills from banks (by stock of tolar denominated SB bills by Bank of Slovenia is changing the ex- crediting their accounts with the Bank monetising them at maturity. The size change rate policy, i.e. it does not of Slovenia) only after the introduction of this operation will correspond to maintain the euro exchange rate with- of the euro. The consequences of pay- the required size of the increase in in the standard band around the cen- ment imbalances are of interest to the the base money. By monetising the tral rate, which was set on 28 June topic of this paper: should the Bank of bills we mean that the Bank of 2004, but allows the euro exchange Slovenia retire as much of its bills as Slovenia will pay tolars to banks and rate to drop. possible before the introduction of the therefore increase their liquidity. This Since this is not a plausible sce- euro? We should be particularly wary will reduce the stock of BS bills on the nario, the net reduction of BS tolar of how the payment deficit of the liabilities side of the Bank of Slovenia bills stock is in a way a dependent country or clients of domestic banks is variable. The Bank of Slovenia should presented, and what costs are in store not set a firm objective how to reduce for financing such payment deficits this stock (it can do so for foreign-cur- among the countries of the euro area. By issuing rency bills), since this reduction Therefore, we will examine payment should be a dependent variable or a imbalances between regions in gener- residual. As it is nevertheless impor- al. We will analyse this issue (a) in the tolar- tant how fast and to what extent the context of former Yugoslavia, (b) in Bank of Slovenia will be reducing the the case where the ECB directly denominated stock of tolar bills, it is essential to played a role of the bank of banks in identify all elements of this reduction. the euro area, and (c) the case with bills, Bank First and most important is the bal- the ECB as the central bank of nation- ance of payments at the time when al central banks (NCBs). the Bank of Slovenia will be reducing of Slovenia the stock of its tolar bills. There are TOLAR-DENOMINATED BS BILLS three possible scenarios regarding withdraws the Bank of Slovenia interventions in In contrast to BS bills denominated the foreign exchange market to keep in foreign currency, which can be rel- the euro exchange rate in the stand- atively easily abolished, this is not the from banks ard band around its central parity of case with tolar denominated BS bills, SIT 239.64. These three scenarios which are issued by the Bank of excessive are: (1) the Bank of Slovenia must buy Slovenia in the process of conducting foreign currency, (2) the Bank of monetary policy. The Bank of autonomous Slovenia does not need to intervene Slovenia issues tolar denominated in the foreign-exchange market, and bills to withdraw from banks the ex- (3) the Bank of Slovenia must sell for- cessive »autonomous« liquidity. By liquidity. eign currency. Moreover, the issue is »autonomous« we do not mean to not only whether to buy or sell foreign imply that it is beyond the scope of currency but also the scope of these the Bank of Slovenia. This liquidity balance sheet and on the assets side operations. Consequently, there will does not stem from conducting mone- of the balance sheet of commercial be not only three but an infinite tary policy and as such it is autono- banks. However, as indicated earlier, number of balances of payments, and mous. It stems from the Bank of the size of this operation should not thus an infinite number of scenarios Slovenia buying foreign currency, i.e. exceed the required increase in the and limitations for the central bank to from conducting exchange rate policy base money. If at a certain point of reduce the stock of bills denominated and not monetary policy. Let us as- time this was not be the case, i.e. the in tolar without influencing the nomi- sume that we can draw a distinct line amount of matured bills exceeds the nal euro exchange rate. Figure 1 between monetary and exchange required increase in the base money, shows all possible balance of pay- rate policy. Once the Bank of the Bank of Slovenia would need to ments scenarios. This figure has al- Slovenia cannot issue tolar-denomi- issue new bills. In such a case, the net ready been used in a slightly different nated bills anymore, it will be limited decrease in the stock of BS bills context in two different papers in buying foreign currency from would be correspondingly smaller (Ribnikar, 2004 and Ribnikar and banks. As this will still be important than the amount of matured bills, i.e. Košak, 2004a). until the adoption of the euro, or at the amount which the Bank of To come back to interventions in least until the tolar-euro parity has Slovenia paid to the banks. If the the foreign exchange market, we been irrevocably fixed – which will Bank of Slovenia does not want to or should remember that a central bank happen somewhat earlier, contem- is not allowed to issue new bills to re- could buy foreign currency without

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sterilisation within the scope of possi- Figure 1: The largest possible decrease (expressed as the required ble monetisation, i.e. possible in- increase in the base money) of the stock of BS bills (line ZZ) as a function of balance of payments (PND and ZBZ) with a constant nominal crease in the base money. The Bank euro exchange rate of Slovenia has intervened in this manner quite often. There have been hardly any other means of increasing the Legend: PND – required purchase of foreign currency quantity of the base money. On the assets side of the Bank of Slovenia PPD – required sale balance sheet, there is almost exclu- of foreign currency sively foreign currency as the corre- ZBZ – desired decrease sponding entry to the base money. in the stock of BS bills When we discuss purchases and sales of foreign currency by the Bank of Slovenia, we will be referring to all such operations – sterilisation and non-sterilisation. In addition, we will not discuss cases where the Bank of Slovenia would need to conduct sterilisation by selling foreign currency, because the Bank of Slovenia can easily replace the withdrawn quantity of the base money by compensatory buying of domestic assets. The Bank of Slovenia might have some difficulties finding adequate domestic assets because of the small treasury bills market, but there are other very good assets available – for instance BS bills. Other elements, besides the differ- tisation. ZZ line depicts the largest compensatory withdrawal of the in- ent balance of payment scenarios, possible relative decrease in the stock creased quantity of the base money which will influence the process of re- of BS bills as a function of the re- by selling foreign currency (euros). duction of the stock of tolar-denomi- quired the Bank of Slovenia interven- This would lead to a decrease in the nated BS bills, will be the required in- tions in the foreign exchange market, euro exchange rate. Therefore, the re- crease in the base money and the de- with the assumption of an unchanged duction of the stock of BS bills with sired reduction of the stock of tolar- euro exchange rate. Combinations their monetisation at maturity is not denominated BS bills on the liabilities above or to the right of the ZZ line compatible with keeping the euro ex- side of the Bank of Slovenia balance are not feasible without a decrease in change rate unchanged. sheet. Figure 1 shows the desired re- the nominal euro exchange rate. The shaded area in Figure 1 show duction of the stock of tolar denomi- If the Bank of Slovenia did not in- possible reduction of the stock of BS nated BS bills (ZBZ) and the required tervene in the foreign exchange mar- bills without changing (decreasing) scope of the Bank of Slovenia inter- ket, the largest possible reduction of the euro exchange rate. It this case ventions in the foreign exchange mar- the stock of BS bills would be equal to the Bank of Slovenia – by performing ket (PND shows the required purchas- the required increase in the base sterilising purchases of foreign curren- es of foreign currency, and PPD the money quantity (point A). The largest cy (they show as the stock of BS bills required sales), relative to the size of possible reduction of the stock of BS on the liability side of the Bank of the potential increase in the base bills is smaller if the Bank of Slovenia Slovenia balance sheet before the be- money. The required scope of foreign has to purchase foreign currency (for ginning of their reduction and aboli- exchange purchases includes both example point B). However, the larg- tion) – did not only temporarily post- sterilisation and non-sterilisation oper- est possible reduction of the stock of pone the necessary real appreciation ations. Therefore, in Figure 1 there BS bills can be larger if the Bank of of the national currency but prevented can only be two variables, ZBZ on Slovenia has to sell foreign currency, it. The prevention of the real appreci- the horizontal axis and PND or PPD as for example shown by point C. At ation of the tolar could merely be a on the vertical axis. points D and E, the largest possible consequence of the fact that in a All combinations of the Bank of reduction of the stock of BS bills is longer period of time – due to the Slovenia interventions in the foreign larger for the horizontal distance from sterilising purchases of foreign curren- exchange market (vertical axis) and these two points to the ZZ line. A re- cy by the Bank of Slovenia – the nec- the desired reduction of the stock of duction of the BS bills stock as shown essary real appreciation of tolar and BS bills (horizontal axis) in the shad- by point F is not feasible without a de- its actual real appreciation, i.e. the ed (grey) area are possible without a crease in the nominal euro exchange appreciation in the absence of sterilis- change in the euro exchange rate. rate. In this case the Bank of Slovenia ing interventions by the Bank of We can also say that the required would wish to monetise its bills for the Slovenia, would cancel out. It could size of foreign currency purchases by distance between point F and the y- also be a consequence of the fact the Bank of Slovenia does not exceed axis. To accomplish this, the Bank of that in a longer period of time the ini- the possible or potential size of mone- Slovenia would need to perform a tial sterilising purchases of foreign

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currency transform into non-sterilising long-term deposits held by banks at count. Within a country or a mone- ones. The required increase in the the Bank of Slovenia), we first have a tary area banks are not forbidden to base money is for instance significant- look at a simplified balance sheet of hold current accounts at each other. ly larger in the period of two years a NCB, e.g. the Bank of Slovenia as Probably the same holds for the Bank that of one month. Thus, what cannot part of the Eurosystem (Figure 2). On of Slovenia, which will at least for be monetised in one month can be the right hand side there are two cat- some time keep its holdings with euro monetised in a longer time period – egories, euro currency (B), and hold- area banks – these holdings are the for example in two years. In this case ings of banks with the Bank of Bank of Slovenia’s international re- the sterilisation only extends the dura- Slovenia, which roughly corresponds serves until the introduction of the tion of the monetisation (purchase) of to the mandatory reserves of banks or euro. Banks will likely be able to proc- foreign currency – of course monetisa- credit institutions (R). For the time ess a credit transfer abroad for a cli- tion within the scope of the possible being, we leave aside category T, ent also against these holdings with increase in the base money. which we will explain later. For now, banks in the euro area. Similarly, the The closer we are to point 0 in let us assume T is a part of category Bank of Slovenia will be able to pay Figure 1, i.e. the smaller the required R. Corresponding categories on the matured bills or bank deposits against relative decrease in the stock of BS left hand side of the balance sheet, its holdings with euro area banks. bills, the more room for manoeuvre which have to be equal in size to cat- Today it is not necessary (and it there is for the central bank. The Bank egories B and R (in our case R+T), are does not make sense either) that of Slovenia could be net purchasing the liquidity deficit (M) and the net fi- banks in Slovenia hold (current) ac- foreign currency, and at the same nancial assets (F). Category M is counts with each other for the pur- time it could be reducing the stock of mainly NCB claims to the ECB in the pose of settling payments for their cli- its bills, so that the size of monetisa- context of monetary policy instru- ents. It is sufficient that they hold an tion does not exceed the possible or ments. Net financial assets (F) equal- account with the Bank of Slovenia. feasible amount. From the central ises both sides of the NCB balance Correspondingly, it will probably not bank’s perspective it would be opti- sheet. In general the net liquidity defi- make sense to hold accounts with mal to have the required increase in cit is smaller than the sum of currency other euro area banks. But they will base money as large as possible, and in circulation (B) and bank reserves keep account with banks outside the the required reduction in the stock of (R), thus F are net financial assets. euro area. its bills as small as possible. As to the For our analysis the key part of the With respect to payments within latter, to have as small as possible balance sheet is the category »net the euro area, there are two stages, stock of its bills when it commences intra-Eurosystem liabilities (or claims) but the mechanism is different from the phasing-out of these bills, it would resulting from TARGET transactions«. the one used for payments within a suit the Bank of Slovenia. We will label it with T. country. When a client pays a client The key message of Figure 1 is At adoption of the euro, Slovenian of a bank in another euro area coun- that the Bank of Slovenia has to limit banks will still have their operational try, his assets on the (transaction) ac- its ambitions to reduce the stock of foreign currency reserves on accounts count with his bank are reduced. The the tolar-denominated bills. The Bank with banks in the euro area. Most current account (reserves) that his of Slovenia has to bring them to and likely they will not immediately trans- bank holds with the NBC is reduced, contain them in the shaded area of fer these holdings to the Bank of as well. Because the ECB is not the Figure 1. It is certain that the last BS Slovenia in exchange for reserves at central bank of national central tolar bills will be retired only after the the Bank of Slovenia’s current ac- banks, assets of the NCB with the Bank of Slovenia has become a part ECB of the country of the paying cli- of the Eurosystem. They will be paid Figure 2: Simplified balance ent are not reduced, while at the out in euro, similar to bank deposits sheet when the Bank of Slovenia same time assets of the NCB with the with the Bank of Slovenia which is a part of the Eurosystem ECB of the receiving client are not in- where created when banks invested creased. This would be the case in a proceeds from matured BS bills into Assets Liabilities three-tier system, which will be dis- these deposits. However, the amount cussed at the end of the paper. of these holdings should only be The ECB is not the third tier. equal to the amount that cannot be Together with the NCBs it constitutes monetised (Figure 1). In the rest of the the Eurosystem. In the case above, paper we will show why it is best for paying client bank’s reserves with the banks and the Bank of Slovenia that Bank of Slovenia (assuming it is a the central bank reduces the stock of Slovenian bank) are reduced, but the its bills as much as possible. Bank of Slovenia’s reserve assets are not reduced, as it would be the case SIMPLIFIED BALANCE SHEET if the ECB were the bank of central OF A NATIONAL CENTRAL banks. Instead, liabilities towards the BANK OF THE EUROSYSTEM Eurosystem on the balance sheet of the Bank of Slovenia increase corre- To see why it is optimal for the spondingly, i.e. this change is record- Bank of Slovenia – from a cost per- ed under »Other claims within the spective – to enter the Eurosystem Eurosystem (net)«. The size of the with as little bills as possible (and/or Bank of Slovenia balance sheet does

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not change. In case of a payment fer. If payments are performed via the liabilities towards the Eurosystem, be- from abroad, both bank reserves with Bank of Slovenia, then there an addi- cause of the payment deficit, would the Bank of Slovenia and the Bank of tional stage of transaction, but neither increase (T). These increased liabili- Slovenia claims towards the a transfer of reserve assets nor a de- ties come at a cost. The Bank of Eurosystem increase. The Bank of cline in claims on the Eurosystem takes Slovenia must pay interest to other Slovenia balance sheet increases for place. Is Liabilities towards the NCBs, which have surpluses, at the the amount of the payment from Eurosystem and consequently towards ECB interest rate. abroad. As payments go in both di- the other NCBs increase. The econom- rections, i.e. to and from abroad, the ic intuition of both cases is the same. THE COST OF PAYMENT net position is important. With a neg- Moreover, this is the same as if there DEFICIT FINANCING ative net position, reserves of banks were a three-tier system and there decrease and in the Bank of Slovenia were a transfer of reserve assets. The Bank of Slovenia will be balance sheet liabilities towards the This can become important when, obliged to pay into the pool, where Eurosystem increase. With a positive upon entry into the Eurosystem, the the monetary surpluses of the net position, reserves of banks in- Bank of Slovenia will have to redeem Eurosystem are collected, all realised crease and, for the same amount, the the remaining bills. If the Bank of gains from category M, as well as the Bank of Slovenia claims towards the Slovenia were to redeem the remain- average return from earmarked assets Eurosystem increase. ing BS bills and bank deposits by of the Eurosystem for investments (F). In the case of imbalances in pay- The only deduction from these payments among countries there is no ments into the common pool is pay- transfer of reserve assets among ments that the Bank of Slovenia trans- NCBs, but there are claims and liabili- Within fers to banks as interest accrued on ties. The size of the balance sheet of their reserves and overnight deposits the NCB with a deficit remains un- with the Bank of Slovenia. Because changed, but the size of the balance a country or a category T is on the right hand side sheet of the NCB with a surplus in- of the Bank of Slovenia balance creases. The only change in the con- monetary area, sheet, it would actually need to pay solidated balance sheet of both NCBs even more. is the decrease in reserves of the When a NCB records a deficit of NBC with the deficit, and the increase banks are payments with other central banks, on – for the same amount – of reserves the liabilities side of its balance sheet of the NBC with the surplus. This is allowed to have bank reserves decrease and liabilities the only change that can happen. towards the Eurosystem increase by Banks can have current accounts the same amount (T in Figure 2). Bank with banks in other euro area coun- accounts with reserves with other NCBs increase on tries. This will be the case, for in- the liabilities side, while on the assets stance, at the time of the introduction each other. side category T appears. of the euro. Let us assume that banks NCB, which has T on the right keep these accounts for some time hand side of its balance sheet, pays and do not increase their holdings transferring money from its (current) interest at the ECB seven-day lending- with the Bank of Slovenia by this accounts with banks abroad to (cur- to-banks interest rate, which is the amount. If with these assets banks fi- rent) accounts of Slovenian banks main refinancing facility. These inter- nanced the payment deficit, then there with banks abroad, then this would ests go to those NCBs that have T on would be no changes in the Bank of decrease the part of the Bank of the left side of the balance sheet. Slovenia balance sheet. If they trans- Slovenia balance sheet which we Hence, these interests do not go di- ferred their assets from foreign banks have labelled II (Ribnikar, 2001). rectly into the pool. The basis for in- to the Bank of Slovenia and then fi- Banks could use these holdings with terests that flow into the pool is the nanced the payment deficit, then first foreign banks, which they would get size of the balance sheet. NCB with T reserves on the liabilities side of the after the Bank of Slovenia has paid on the right hand side pays interests Bank of Slovenia balance sheet would back BS bills and deposits with the on the net financial assets (F). increase, as well as assets held with Bank of Slovenia, to invest in foreign Category F on the assets side of the foreign banks. When banks use this securities. A lending boom appears balance sheet is namely larger when money for investments in foreign secu- unlikely, since over a short period of there is T on the right hand side of the rities, for example, reserves with the time such a large increase in custom- balance sheet. NCB pays interest at Bank of Slovenia decline. Liabilities to- er lending would be impossible. In the average interest rate for the ear- wards the Eurosystem increase by the this case there would be no other marked assets of the Eurosystem. Let same amount. changes but a decrease in the size of us assume this rate is 2.5 %. NCB In the first case, when domestic the Bank of Slovenia balance sheet. If with T on the right hand side does not banks pay by debiting their holdings the Bank of Slovenia paid money for pay 2.5 % on top of 2 % which it with banks in other euro area coun- its matured bills to banks’ accounts pays to other NCBs and which do not tries, they do not transfer reserve as- with the Bank of Slovenia (R) and go directly to the pool. It pays only sets to foreign banks but they de- banks invested this money in foreign the difference, in our case 0.5 %. crease claims towards foreign banks, securities, then bank reserves with the Therefore, the cost of financing of the which is equivalent to the assets trans- Bank of Slovenia would decrease and payment deficit is 2.5 %.

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The size of the balance sheet of a banks BS bills and bank deposits, among euro area countries. The size NCB, which has T on the left hand which it will not have paid before the of the balance sheet of a NCB, which side of its balance sheet, increases. adoption of euro, from its assets, i.e. has a payment deficit with other euro This NBC receives interest from former foreign reserves in euro area area countries, remains unchanged. NCBs, which have T on the right countries, to banks’ accounts in euro Its bank reserves decline, and on the hand side. The NCB might need to area countries. In this case bank re- liabilities side of its balance sheet lia- pay a part of this interest for possibly serves with the Bank of Slovenia (R), bilities towards the Eurosystem in- larger bank reserves and other bank which would later transform into T, do crease. Balance sheet of a NCB with deposits kept with it. All the rest goes not increase. Consequently, figures a payment surplus increases. Reserves into the pool. Thus, from the income posted on the central bank’s balance on the liabilities side of the bank in- perspective this NCB is in the same sheet do not go up. crease, as do claims on the position as it would be if it had T Eurosystem on the assets side. equal to zero. PAYMENT IMBALANCES Let us imagine that the ECB were If a NCB with T on the right hand the only central bank. All banks side were paying interest at 2.5 % di- It is a technical characteristic of would have their current account rectly into the pool, then this would monetary arrangements, which can and/or reserve accounts with it. not change anything for this bank, but have a significant impact on the con- Moreover, the ECB could be the cen- all the other NCBs with T on the left sequences on payment imbalances tral bank of national central banks, hand side would be worse off. among different countries, i.e. surplus- i.e. we would have a three-tier central Namely, they would have a larger es of payments into one country or banking system. Before briefly exam- balance sheet (for the size of T) and surplus of payments from this country, ining this scenario, let us first analyse hence a larger basis for payments which these surpluses ultimately get the monetary set-up in the former into the pool. If this problem were to paid with different money. It can be Yugoslavia, which was characterised be solved by these banks not paying the money of the same country, but it by the »regionally closed banks«. into the pool for the size of category is still different money because it is T, then the total amount paid into the high-powered money (base money or Clients of one bank pool by NCBs with T on the right money of the central bank), in contrast represent the territory hand side would be divided among to money used for payment within a or region of one money all NCBs according to their share in country. In general these are assets, ECB’s capital. This would be wrong which are used – at lease in a relative A characteristic of the monetary because interest would not go to sense – for the ultimate settlement system in the former Yugoslavia NCBs through which the payment def- (ECB Monthly Bulletin, 2001). When (Ribnikar, 1988) was that the pay- icit is financed. The larger the pay- disusing monetary-technical character- ment imbalances among banks, ment deficits and surpluses, the more istics of monetary arrangements, we which geographically covered one or money would flow into the pool. It is do not imply that they cause most more counties, had similar features because of this that interest paid on T problems. The key problem remains than imbalances among countries. In do not go into the pool but is paid reasons for payment imbalances, this sense we have a kind of narrow- within the Eurosystem to other NCBs. which can grow even more difficult if est territory of one money. This is the The principle is that a NCB partici- accompanied with technical problems territory or region of clients of one pates in the ECB profit according to related to the monetary arrangement. bank and its deposit money. its share in the ECB’s capital, regard- If we were on the gold standard To elaborate on this, let us assume less of its payments into the pool. and were using only gold coins for that clients of each bank belong to a Since by definition the Bank of payments, then no technical problems geographically limited or closed re- Slovenia cannot have risky invest- discussed above would exist. It would gion, and that there is only one bank ments, it is unlikely that it could earn be similar if we had a paper standard per region. Banks are obliged to hold more on investments F than the aver- but only one currency to serve as partial reserves for deposits, which age yield on earmarked assets. means of payment. All payments may or may not constitute the deposit Therefore, its earnings would be mea- would be made in this currency, simi- money. On the assets side of their gre unless it got rid of its legacy as a lar to gold coins with gold standard. balance sheets banks carry loans to matter of urgency. This and the free- Deposit money (of banks) would not clients but no money market securi- dom of investment for a large part of be used, unless fully backed by re- ties, e.g. treasury bills. The smaller bank assets is an important reason serves. As such, this would not be »an the bank, the larger its exposure to fore the Bank of Slovenia to complete- independent« money and we would assets volatility and consequently to ly abolish its foreign-currency bills by only have one money. This would also fluctuations of its reserves and liquidi- end-2006, and we shown that it mean that there were no monies of ty. Assets volatility means that at should not be a problem. banks or countries, but only one times assets can increase but then Furthermore, it should abolish tolar money for the whole world. This again they can decrease. If these bills, as well as bank deposits with money would have the same power changes follow each other quickly, the Bank of Slovenia, which have re- all over. Finally, there would be no then liquidity can be maintained by placed tolar denominated bills, to the difference between money as a banks holding larger reserves or by largest possible extent. For tolar de- means of payments and money as the central bank interventions. nominated bills the restriction or limi- ultimate asset. A different situation arises if the tation shown in Figure 1 still holds. We have already examined con- outflow from a bank is not caused by The Bank of Slovenia should pay to sequences of payment imbalances short-term or daily volatility of assets.

8 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

Because the bank has no generalised respect to payments abroad. IMF would issue the definite (final) claims, i.e. financial instruments, Payments to other banks were hin- money or »bancor«, which central which are due to the rating of the dered, which consequently encour- banks would use for settlements debtor, for example the government, aged trade among clients of one (Machlup, 1966). widely accepted, it cannot replace its bank. This was labelled as »regional In this case NCBs would keep liquidity with proceeds from selling limitation or closure«. The transfer of their reserves with the ECB. Their generalised claims. The bank has to financial assets among regions and function would be analogous to re- adjust by reducing loans to clients. as such among individual banks took serves kept by banks. NCBs would The reason that a payment of one place via the central bank and the not have monetary sovereignty. They bank’s client to anther bank’s client federal budget. would be limited in issuing base does not increase the money of the We can conclude that generally money because they would need to second client for exactly the same accepted financial assets must exist ensure convertibility of the base amount as the first client has paid, but within a currency area in order to money to the money of the ECB. Their that is also forces the first bank to re- avoid problems with payments within position vis-à-vis the ECB would be duce loans to its clients, lies firstly in this area. In the former Yugoslavia no the same as that of banks towards partial reserves for the deposit money such financial assets existed. As a their NCBs today. and bank deposits in general. If the consequence, problems, typical for a The monetary system of euro area reserve ratio were 100 %, the only currency area, arose within regions of countries is a two-stage system. But in consequence of the above transaction individual banks or, similarly, among the case of payment deficits there is would be that the first client would clients of individual banks. Hence, no transfer of financial assets among have less and the second client would this situation can be seen as having NCBs. Instead, liabilities and claims have more money. It would be the as many monies or currency areas as among them increase and decrease. normal situation (Yeager, 1976). With there were banks. Perhaps it is easier to understand this partial reserves, this is not the case. arrangement if we are aware of alter- Others, whose only link with the pay- natives, which may be interesting but ECB as the only ing client is that they hold accounts are more or less unrealistic. with same bank, also feel the conse- central bank quences. With the second bank, the If all euro area states had a fully REFERENCES: opposite is the case, i.e. the bank can centralised central banking system, 1. ECB Monthly Bulletin, 2001, “Towards a increase loans to its clients. But this is all credit institutions would keep ac- uniform level of retail payments in the euro by no means a comforting fact for cli- area”, February. counts directly with the ECB. This ents of the first bank, which has re- would also include keeping accounts 2. Ingram, J. C., 1959, “State and Regional duced its loan activity. The fact that Payments Mechanisms”, Quarterly Journal of with ECB’s subsidiaries, i.e. former other clients felt the consequences ap- Economics, No. 4. NCBs. In such a case payment prob- plied to the banking system of the 3. Machlup, F., 1966, “International lems would not show at the NCB former Yugoslavia. Monetary Economics”, George Allen & level, which would be ECB’s subsidi- Unwin, London. If banks kept 100 % reserves for aries. Rather they would show at indi- the deposit money (or bank deposits), 4. Ribnikar, I., 1988, “Financiranje privrede vidual banks and it would be very i države i teritorialna zatvorenost privrede or if all financial assets were accept- important that generally accepted i banaka”, Ekonomist, Zagreb, No. 2. ed across the country, then there financial assets existed in countries 5. Ribnikar, I, 2001, “The origin and would be no problems of the kind de- of the euro area. Banks would need development of Slovenia’s monetary system”, scribed above. Because reserves to keep a part of their investments in Bančni vestnik, Vol. 50, No. 5, pp. 71-76. were partial and there were no gener- these financial assets. Smaller banks 6. Ribnikar, I., 2004, “Novčani sustav ally and widely accepted financial as- would need to keep more of these Slovenije: blagajnički zapisi Banke Slovenije sets, the consequences of payment (BS) do sada i pred ulazak u EMU”, V: assets. deficits among regions were similar to Lovrinović, I. & Vidučić, Lj. (eds.). Suvremena payment deficits among countries. ﬁnancijska pitanja i izazovi razvitka hrvatskog ﬁnancijskog sektora. Split: We could even argue that we did not ECB as the central bank Ekonomski fakultet, pp. 211-221. have only one money but as many of NCBs 7. Ribnikar, I. & Košak, T., 2004a, monies as there were banks. “Monetary system and monetary policy”. There is analogy between the Another alternative to the system V: Mrak, M, Rojec, M. & Silva – Jáuregui, C. process of finding a balance of pay- introduced on 1 January 1999 would (eds.). Slovenia: from Yugoslavia to the ment equilibrium after the Second be a three-stage bank and/or mone- European Union. Washington: The World Bank, pp. 150-170. World War and the process on the tary system. For example, this is level of a bank, i.e. in the region cov- Keynes’ idea of the IMF being the 8. Yeager, L. B., 1976, “International Monetary Relations: Theories, History and ered or dominated by a bank. The central bank of other central banks or Policy”, 2nd Edition, Harper & Row main elements were restrictions with a “clearing union” of central banks. Publishers.

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UDK 336.748.1:338.5(497.4) Achieving price stability in ERM II and after euro adoption

Damjan Kozamernik *

This paper analyses risks lovenia completed its disinflation process in 2005. The in meeting the Maastricht price stability criterion, inflation rate has reached and even fallen below its nat- and the plausible inflation environment ural level that is a level in line with the long-term stabili- after Slovenia adopts the euro. It is argued that ty of the tolar. Reaching a sustainable low level of infla- although the natural inflation rate in a stable S tion allowed a decision for the next logical step in macroeconom- exchange rate environment probably lies between 2.5 % and ic policy: stabilising the nominal tolar exchange rate within ERM 3.5 %, the projected reference value of the II and focusing economic policy on the earliest possible adoption price stability criterion, currently much lower, is of the euro. The sustainability of the low inflation was ensured likely to be met in the first half of 2006. This is by the soundness of the disinflation process, during which the mostly due to the negative output gap principal macroeconomic equilibria, in particular the current ac- producing downward pressures on prices and count and the general government budget balance, were main- labour costs. Another asset for Slovenia is the tained. Imbalances might have brought about only a temporary joint programme for the ERM II entry and fall in inflation, and might cause reverse inflation shocks or adoption of the euro. It was put in place at the would temporarily slow down economic growth and real conver- end of 2003, and provides a useful and gence. At the end of 2003 the Bank of Slovenia and the Sloveni- sensible framework for macroeconomic policy an government adopted the programme for ERM II entry and management in the context of a stable adoption of the euro, which set out a sound framework for exer- nominal exchange rate and after the adoption of cising macroeconomic policy under the conditions of a stable the euro. The most significant risk in meeting nominal exchange rate, i.e. the conditions that will be in place the criterion is the high volatility of world oil after the euro is adopted. The adoption of the euro is tied to the prices, which for structural reasons is fulfilment of the convergence criteria, with Slovenia not yet hav- transmitted more strongly to inflation in Slovenia ing met the price stability criterion. than in most of the eurozone economies. The The purpose of this article is to evaluate the inflation risks other significant risk is credit-driven demand in meeting the Maastricht price stability criterion and the infla- shock, if there is a need for domestic interest rates tion risks following the adoption of the euro. To this end there is to be cut significantly at the advent of the euro first a brief examination of indicators of inflationary pressures adoption. * Damjan Kozamernik is the director of the Analysis and Research Department of the Bank of Slovenia. The views expressed by the author do not necessarily correspond to those of the Board of the Bank of Slovenia.

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and the effects of the principal macr- the risks, and the responses of eco- tion of the euro, an effective and oeconomic factors on inflation trends. nomic policy in the event of these prompt response by fiscal policy to A simple estimate shows the probable risks being realised. From today’s asymmetric cycles in aggregate de- natural inflation rate, i.e. the inflation point of view, the largest risk is pre- mand with an anti-cyclic adjustment rate in line with long-term macroeco- sented by movements of the oil prices, in economic activity will remain of nomic equilibria and a stable nominal with structural factors meaning that a key importance. exchange rate. In the context of the rise would be transmitted more strong- The rest of the article consists of current and projected trends in macr- ly to domestic prices than in the ma- three sections and an appendix. The oeconomic factors, this allows for the jority of the eurozone members. second section summarises the infla- postulation of the likely future medium- Another major risk is linked to a re- tion and disinflation factors in term inflation trend and for appropri- versal in the cycle, which could cause Slovenia, and examines the probable ate adjustments in macroeconomic a further fall in interest rate as the natural inflation rate under a fixed policy if this transgresses the limits of time for adopting the euro approach- nominal exchange rate. The third sec- meeting the price stability criterion. In es. The fall in interest rates in 2004 tion examines the risks in the process the longer term it is necessary to make already contributed to significant of meeting the price stability criterion the appropriate choice of macroeco- growth in lending and a rise in do- and the possible responses of macr- nomic policy with regard to the sourc- mestic demand, while the output gap oeconomic policy. The final section es of inflation to maintain price stabili- halved last year. Even after the adop- outlines the macroeconomic environ- ty also in the future. ment after the adoption of the euro. Given the probable projections of The appendix gives a simplified cal- inflation factors, the Maastricht price culation of the long-term equilibria stability criterion will be met in the Throughout that determine the level of prices and first half of 2006. Even though esti- form the basis for analysis of cost fac- mates of natural inflation range from tors of inflation. 2.5% to 3.5%, which exceeds the the past period projected reference value of the price THE DISINFLATION PROCESS stability criterion, it is the current and curbing AND THE NATURAL projected trends in inflation factors INFLATION RATE that form the grounds for this assess- inflation has ment. The main reason for predicting Analysis of inflation factors in the that the criterion will be met is that past is of use in the areas discussed the output gap is still negative, i.e. been hindered by this article. An interpretation of economic activity remains behind po- the effect of various macroeconomic tential output, which adds to the pres- by fiscal factors on the movement of inflation sure for a fall in inflation and for and their variation over time is given, slower growth in labour costs. An ad- pressures, and the responses of economic policy ditional factor that could also help in and their own effect on inflation are meeting the criterion is the pro- evaluated. gramme as the framework for coordi- taxes and nating macroeconomic policy between the Bank of Slovenia and the The disinﬂation trend government under the conditions administered and macroeconomic factors when monetary policy must be orient- of inﬂation ed towards maintaining exchange prices hikes. Slovenia experienced a trend of rate stability. The programme defines falling inflation in the period from monetary independence to 1999, and Figure 1: Macroeconomic equilibria were maintained then following inflation shocks in that year the disinflation trend was re- stored at the end of 2000. The reversal of the trend in 1999, the only time when the cyclical inflation trend rose for four consecutive quarters (see shading on figure), was caused by a simultaneous combination of strong inflation shocks, namely the cost and demand effects of the introduction of VAT, a sharp rise in the oil price on world markets, and an upturn in the business cycle. The Bank of Slovenia estimates that the introduction of VAT had a direct impact on inflation of 2.5 to 3 percentage points, while the rise in the oil price on world markets

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had approximately the same impact.1 propriately restrictive until the begin- contributed to the narrowing of the However, there was also a more per- ning of 2004 with the exception of the output gap after 2000. In 2000, out- sistent rise in inflation because of ex- first quarter of 2002, when the rise in put was still in excess of potential out- cess aggregate demand, with the VAT again brought an increase in in- put, but in the first half of 2001 the largest excess over potential supply in flation.4 The moderately restrictive output gap became negative and ac- the short period since independence monetary policy gradually curbed ex- celerated the fall in inflation. coming at the end of 1999.2 Other cess domestic demand, while slower Inflationary pressures from cost factors that added to the persistence growth in the rest of the world also factors are shown as the difference of inflation in the period after the inflation shocks arose were wage in- Figure 2: Disinflation trend creases, partly under the influence of indexation, the delay in the response by monetary policy and the depreciation of the real tolar exchange rate. Throughout this period the decline in inflation was restricted by inflationary pressures of a fiscal nature, a rise in taxation and increases in administered prices. Nevertheless the moderately restrictive monetary policy gradually curbed the demand pressures on inflation and brought back the disinflation trend, and inflation fell from 10% to less than 3% at the end of 2003. In 1999 and 2000 monetary policy was formally expansive, as illustrated by the movement of real interest Figure 3: Output gap rates. The low and even negative real interest rates were caused by the inflation shock, not a decline in nominal interest rates. In principle there is no need to raise interest rates during supply shocks, but the Bank of Slovenia was probably late in responding to the reversal in the aggregate demand cycle.3 As is apparent in the Bank of Slovenia Annual Report for 1999, during that year the central bank had not yet identified the reversal in the cycle, even though in 1999 it already react- ed by raising nominal interest rates. Real interest rates were positive until the end of 2000, and then were ap-

1 Bank of Slovenia Annual Report for 2000. 2 In Figure 3, in the calculation of the output gap, potential output is expressed as a trend Figure 4: Bank of Slovenia interest rate with a linearly declining rate of growth, in line with the process of real convergence. 3 The optimal monetary policy allows a fall in real interest rates during supply-side inflation shocks by accommodating such shocks with no change in nominal interest rates. For an illustration of the optimal response by monetary policy in a modern theoretical macroeconomic model, see Clarida, Gali and Gertler (1999). 4 The level of interest rates that ensures that monetary policy is appropriately restrictive is open to question. The interest rate was actually even slightly higher (by 1.2 percentage points, 0.2 percentage points, 0.9 percentage points and 0.9 percentage points in 2000 to 2003) if the other short-term bills used by the Bank of Slovenia to withdraw excess money from circulation are taken into consideration. In addition, the actual real interest rate was also higher if expectations of falling inflation are taken into consideration in place of the current inflation rate.

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between the estimated equilibrium to inflation by increases in tax rates case if the transmission of the inflation level of prices with regard to the nom- and by excessive rises in administered caused in this manner to wages, and inal level of labour costs and the nom- prices, which represent an increase in then back to inflation via labour inal effective tolar exchange rate.5 inflation with regard to the neutral in- costs, is taken into consideration. In The real equilibria illustrated roughly flation state. In terms of direct taxes a 2003, there was a clear effort to limit represent the real unit labour costs neutral inflation state entails the ab- the creation of such inflationary pres- and the real effective tolar exchange sence of any increase in levels of di- sures, and even though they were still rate, with equilibrium established rect taxes or excise duties that compa- inflationary, they had significantly less when the indicator is zero. A price nies build into prices because they in- impact on limiting the fall in inflation. level in excess of the equilibrium price crease (marginal) costs.8 Administered The effects on inflation are com- level (when the indicator is positive) prices encourage inflation when their pletely in line with the prevailing eco- means that the factor is working to re- rate of growth exceeds the rate of nomic theory and practice, are not duce inflation, and vice-versa. The growth in free prices, but to measure one-dimensional, and vary over time. level of nominal labour costs, with re- the effect on inflation it is necessary Persistent cycles of aggregate demand gard to the equilibrium on the labour to give the acceleration in inflation in cause discrepancies between supply market, applied downward pressure administered prices the weighting that and demand, and give rise to the out- on inflation throughout the period in it has in the price index. The impulses put gap, which is reflected in prices question. The exception was the ex- from factors under the control of fiscal and in inflation. These pressurise la- tremely high wage growth in the early policy were extremely high in the pe- bour costs, which are the main factor nineties and the slight inflation devia- riod examined. Because fiscal factors in the price level in the long term. A tion in 2000 and 2001. There were were inflationary (positive values), policy to successfully ensure that there much greater deviations away from this demanded restrictiveness of other is a falling inflation trend must above equilibrium in the real effective ex- factors and monetary policy in order all maintain a falling trend in nominal change rate. This points to weaker to maintain the disinflation trend. labour costs. The exchange rate has a adjustments in prices to deviations These types of shocks, which mone- relatively minor impact on inflation, as away from equilibrium. The real effec- tary policy is unable to neutralise in long as it is not transmitted to labour tive tolar exchange rate mostly appre- the short term, are one of the princi- costs. Monetary policy effectively ciated prior to 1999 and depreciated pal reasons for the slowdown in the maintained a falling inflation trend by after 2000, which allowed the exter- fall in inflation. This is even more the placing long-term controls on money nal equilibrium to be re-established.6 Figure 5: Cost factors of inflation The nominal exchange rate was actually inflationary in this period, but the relatively weak transmission to prices clearly did not hinder the re-emergence of the disinflation trend.7 By the time Slovenia joined ERM II the real effective exchange rate was in balance, slightly appreciated owing to the weak dollar, and in line with the sustainable external equilibrium. Clearly asymmetric, the fiscal policy inflation sources have in the last period systematically produced pressures on inflation increases. The table illustrates the estimated impulse given

5 A description of simplified estimates of long- term equilibria is given in the appendix. 6 The impact of the real exchange rate on the current account is clear. A formal estimate of the Table 1: Fiscal effects on inflation real equilibrium exchange rate in the context of ERM II entry was made by Genorio and 2000 2001 2002 2003 2004 Kozamernik (2004). * 7 If the transmission of the exchange rate to taxes 2.07 1.77 0.57 0.34 prices had been rapid and complete, for VAT 0.00 0.72 0.05 0.00 example in less than one year, then the tolar depreciation of almost 5% in 2000 should have energy 1.96 0.84 0.23 0.00 caused inflation hike of 5 percentage points in 2001. But instead of rising from 10% to 15%, other 0.11 0.21 0.28 0.34 inflation fell to just over 7%. There is no doubt, however, that the exchange rate made no administered prices** 2.07 0.74 0.56 –0.07 1.06 contribution to the reversal in inflation in 1999, as the real exchange rate was in balance at that oil 1.47 –0.96 0.23 –0.02 0.86 time. 8 The possibility of substitution is not considered non-oil 0.60 0.22 0.33 –0.05 0.20 in the deployed method, since VAT affects all prices, while with excise duties it is mostly a Notes: matter of products with a minimal level of * Value of the tax revenue increase over the value of the tax base in the national accounts. substitution (petroleum products, cigarettes, Computations ARC. alcohol). ** Excess over free prices, corrected for the weights. Computations ARC.

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in circulation, and in the medium term Figure 6: Natural inflation rate by adjusting interest rates and exert- ing an influence on the output gap, and indirectly on labour costs.

What natural inﬂation rate can be anticipated in the future?

The natural or equilibrium inflation rate is the inflation rate where all inflation factors are in equilibrium. The current inflation rate fluctuates around it as a reaction to various inflation shocks, as outlined above. Under the conditions of a stable nominal exchange rate, or under the conditions of monetary union with an economic community of sufficient size to make inflation independent of domestic inflation, the natural inflation rate is long-term growth in the nominal ex- rate is a theme of effective manage- uniquely defined, and reflects long- change rate, while for illustration of ment of macroeconomic policy.12 term inflation abroad and the equilib- the past the trend in the nominal ex- rium processes of real convergence. change rate is assessed using filter- MEETING THE PRICE ing.10 The long-term trend in real la- There is a considerable consensus STABILITY CRITERION among Slovenian economists about bour costs (productivity) is also as- the reasonable value of natural infla- sessed.11 Substituting in the system of The problem for Slovenia, as it is tion rate in Slovenia. The process of equations in the appendix gives the for the majority of the new member real convergence is causing slightly long-term equilibrium price index and states that have to adopt the euro, is higher inflation in the domestic econo- the natural annual inflation rate as the my, for in correspondence to the need rise in the index with regard to the 12 In Figure 6 it is worth pausing and asking to catch up in terms of productivity, level four quarters before. The natural whether everything above this inflation rate is there is also a process of catching up inflation rate estimated in this manner the result of exchange rate policy: did the is shown in Figure 6, and is always exchange rate dynamic in recent years cause with foreign prices, which are gener- (for example) 70% of inflation, where 70% ally at a higher level. Estimates of this within the band in line with the pre- represents the difference between the actual type of Balassa-Samuelson effects, liminary estimates. and natural inflation rates under a fixed The inflation rate fluctuates around exchange rate? The answer is, of course, no. It expressed as the surplus over inflation is obvious that all inflation shocks (other than in the wealthiest countries in the mon- its long-term equilibrium with regard the exchange rate) would be transmitted to etary union, range from 1 to 1.5 per- to the state of inflation factors, while inflation at least temporarily. If the demand shock were the most significant, inflation could 9 centage points. Assuming a long- the stabilisation of the exchange rate have risen more than it did, as monetary policy term inflation rate in these countries alone is insufficient to effectively stabi- would not be able to raise interest rates as of between 1.5% and 2%, which is lise inflation in the short term and me- appropriate to maintain a fixed exchange rate. dium term. Figure 6 shows the year- Figure 6 could also give rise to deliberations in the ECB target, then the natural infla- favour of earlier fixing of the exchange rate: the tion rate would be between 2.5% and on-year inflation rate in Slovenia in exchange rate could have been fixed much 3.5%, inside the band shown in the last 11 years as the deviation from earlier (years earlier), with the risk of real costs to the economy (appreciation, external Figure 6. Comparable countries such the year-on-year rate of growth in the imbalances, financial crises, etc.), but now as Greece, Portugal and Spain all nominal effective exchange rate trend: inflation would be fluctuating much less around it therefore includes the trend of real its natural rate – in Figure 6 it is clear that on recorded inflation between 2.5% and average inflation is much closer to its natural 4% recently. appreciation and an indicator of the rate at the end of the period than before. Such Another estimate of the natural in- trend in foreign inflation. Variations in deliberation regarding inflation at the end of the period could be said to hold true (although the flation rate can be obtained from the inflation around the natural inflation effectiveness of a policy that guarantees the equilibria on the labour market and in rate can be huge and long lasting. same results at greater cost could be The fluctuations in the first period are questioned), but it is necessary to point out that the real exchange rate, formalised in a stable real exchange rate, adjusted to the the appendix, which determine the linked to the first period of disinflation, needs of real appreciation, is to a great extent level of prices in the long term. then they partly stabilise, although re- a side effect of the Bank of Slovenia’s monetary maining significant. Similar fluctua- policy, namely its managed float of the nominal Factors that clarify the long-term level tolar exchange rate. If the real exchange rate of prices are replaced with their long- tions in inflation of up to 7 percentage were stabilised as the side effect of the Bank of term trends. A stable nominal ex- points were also recorded by coun- Slovenia policy, it would not necessarily be stable without this policy. In other words, a change rate, trivially, means zero tries with a fixed nominal exchange trend that in recent years was strongly rate and similar inflation shocks (e.g. correlated with the inflation rate, and therefore 9 Jazbec (2001), Žumer (2002) and Kozamernik the Baltic states) and countries with a with inflation shocks, owing to the needs of monetary policy, has been subtracted from the (2003). significantly more restrictive exchange 10 inflation rate. The question is whether the The standard Hodrick-Prescott filter with a variability in Figure 6 would remain the same or λ rate policy in recent times (Hungary, smoothing parameter of = 1600 is used. would be reduced if the Bank of Slovenia had 11 In this calculation employment is endogenous Slovakia). Preventing major fluctua- introduced any other exchange rate trend, for with regard to growth in labour costs. tions in inflation around its natural example a fixed exchange rate.

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that the natural inflation rate exceeds recent times labour costs have been An additional factor that could the current and projected reference low in respect of prices, which has contribute to meeting the criterion is a value of the price stability criterion. applied downward pressure on infla- gradual increase in the restrictiveness Under these circumstances the stabili- tion. The real exchange rate is practi- of monetary policy abroad. By main- sation of the exchange rate itself hin- cally at equilibrium and is not having taining interest rates at the upper limit ders the adoption of the euro, as in- any significant effects on inflation. still allowed by the maintenance of flation tends to move outside the area A commonly cited anti-inflation exchange rate stability, the Bank of of meeting the criterion unless the real factor is the cooperation between the Slovenia aims to restrain further falls exchange rate is appreciated. Of Bank of Slovenia and the government in interest rates. Further falls in inter- course, inflation can be temporarily within the programme for ERM II entry est rates could additionally accelerate lower owing to a macroeconomic en- and adoption of the euro. This pro- lending activity, which is already vironment that acts to reduce infla- gramme represents a sound basis for high. If aggregate demand continues tion. If macroeconomic trends are not credible monetary policy action to grow as quickly as it did in 2004, in line with an inflation rate below the under the regime of the stable nomi- the output gap would rapidly close, equilibrium level, then more restrictive nal tolar exchange rate and after the and this would reduce the possibility economic policy is necessary in order adoption of the euro. It defines the of a further fall in inflation. Potential to meet the price stability criterion. priorities and responsibilities of the rises in foreign interest rates, the ECB two institutions, and clarifies the pos- rate in particular, would allow for A macroeconomic environment smaller cuts in domestic interest rates in line with meeting when they are equalised prior to the the price stability criterion Natural adoption of the euro. In the economic forecasts pub- Risks in meeting the price lished in the most recent Bank of stability criterion Slovenia Monetary Policy Report, it is or equilibrium anticipated that the price stability cri- Forecasts are only an estimate of terion will be met in the first half of inflation rate the most likely scenario. The 2006.13 These forecasts are based on Monetary Policy Report also exam- the projected macroeconomic trends implies that ines various scenarios that could lead and economic policy. to inflation rising above its anticipat- The main reason for continuing the ed level. Because expectations are fall in inflation below its natural rate all inflation that the inflation criterion will be met remains the negative output gap. at the edge of the area of fulfilment, Aggregate demand remaining behind factors even a small deviation in the direction potential supply applies downward of higher prices in the realisation of pressure on inflation. The excess level the macroeconomic environment rep- of potential supply additionally limits are balanced. resents a risk. Of course, any devia- the use of production factors and ap- tion in economic policy from that plies downward pressure on labour planned in the programme, in particu- costs. Slower growth in labour costs sibilities for responding effectively in lar loosening of policies under gov- allows a further reduction in price the event of the various shocks to ernment control, would represent an rises. Moderation in wage growth which the Slovenian economy could extra risk. Some risks are examined was also underpinned by the wage be subjected in the future. A sensibly separately. agreements between the social part- and clearly organised framework for A commonly cited risk is a rise in ners, which envisage growth in real monetary policy action is undoubted- oil prices. Oil shocks can be strongly wages remaining behind growth in ly a beneficial instrument for meeting reflected in temporary rises in infla- productivity.14 As seen in Figure 5, in economic targets. tion, as the price of liquid fuels is a direct component of the price index. Figure 7: Forecast of meeting the price stability criterion Its actual weighting in the index is relatively small, but changes in the oil price can be extremely large and the final effect on the price index can be significant. It is also necessary to consider the indirect effect via transmission, particularly if nominal wages are adjusted to higher prices and higher labour costs have an additional impact on inflation. In Slovenia the

13 Monetary Policy Report, April 2005. 14 Incidentally, remaining behind productivity in real terms brings about a real fall in labour costs and facilitates a positive employment trend. The process can be sustainable and desirable in the long-term, if the level of employment is too low.

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effect on prices is relatively large in tional accelerating effect on wages in level of prices is illustrated stylistically comparison with the countries most the private sector. in Figure 8, together with the effect likely to be included in the calcula- on the price stability criterion. The ef- tion of the reference value of the Potential responses by fect on the criterion is slower, as it in- price stability criterion, because the volves the one-year average of year- economic policy weighting given to liquid fuels is on-year inflation rates, and amounts greater and with excise duties at the Monetary policy focused on the to about one-fifth of the change in minimum level allowed by the EU the stabilisation of the nominal exchange the exchange rate after one year. In world price accounts for a larger pro- rate can no longer respond inde- order to lower the criterion by 0.6 to portion of the cost to the consumer. pendently if projected inflation leaves 1 percentage points, it would be nec- The effect of the price is symmetrical: the area in which the inflation criteri- essary to revalue the central rate by if oil prices on the world market are on is met. In principle the Bank of between 3% and 5%.17 Although it is lower than assumed, domestic infla- Slovenia could try to stem inflation probably possible to achieve a suffi- tion will fall more than the reference via real appreciation of the tolar or a cient lowering of the criterion through value of the criterion. central rate revaluation, but in reality a sufficiently aggressive revaluation, A decline in (real) interest rates only the government-controlled re- the incomplete transmission to prices could further accelerate lending, sponses defined in the programme in the short term and the medium spending and aggregate demand, are reasonable. term would cause significant real ap- and slow down or even reverse the preciation and a decline in the com- falling inflation trend. The fall in (real) petitiveness of the domestic economy. interest rates in 2004 contributed to These would remain after the adop- the extremely high lending growth, Further tion of the euro, and could threaten which strongly promoted domestic de- the external equilibria. Changing the mand and brought economic growth central rate in ERM II is theoretically to the highest level recorded in recent interest rate possible, and revaluation can be car- years. Economic growth exceeded ried out unilaterally, but it is not in growth in potential supply, and the cuts could 16 output gap therefore shrank. A credit A substantially faster pass-through of nominal exchange rate changes to domestic prices is boom brought about by further cuts in additionally estimated in Coricelli, Jazbec and Masten interest rates could speed up the clos- (2004). The estimated shorter period of price adjustment may probably be due to the ing of the output gap, which would omission of the main factors that determine limit the possibility of further falls in in- accelerate inflation persistence (labor costs and output flation without the intervention of mac- gap), while short-run estimates are additionally biased by omission of other important roeconomic policy. It is the case, how- lending activity, determinants of inflation like fiscal effects and ever, that economic growth slowed oil prices. Also, it is incorrect to interpret the slightly in the last two quarters and CJM results in a way that the shown impulse- which is response functions bring evidence of a perfect the estimated output gap remained at exchange rate pass-through to price level, approximately –1% of GDP. From this which is the only way a long-run equilibrium relationship consistent with economic theory (a point of view the economic growth already high. perfect pass-through in levels implies a perfect forecast for this year (just below 4%) pass-through in differences while the opposite is might be on the optimistic side, while not necessarily true). Because integrals of response functions for inflation and exchange the inflation forecast might therefore The possibility of revaluing the rate dynamics are not equal, inflation (Slovenia) be seen as a conservative. central exchange rate with the aim of systematically exceeds the exchange rate dynamics (immediate response to an Faster growth in labour costs than meeting the price stability criterion is appreciation shock is even a substantial forecast would significantly and limited in practice.15 A revaluation increase in inflation!) until the system converges quickly raise inflation above the fore- would in principle lower import pric- to equilibrium. Therefore after exchange rate appreciation prices in the new equilibrium fall cast level. The ARC model forecasts es and apply pressure for a fall in less than the exchange rate. This implies an show that a rise of 1 percentage prices partly or entirely tied to the ex- imperfect exchange rate pass-through to prices, real appreciation and a loss in competitiveness. point in annual wage growth would change rate. In the second phase this Problems with CJM estimates are even more lead to an increase in the inflation pressure for a fall in prices would apparent in countries where estimated rate of 0.2 percentage points this gradually be transmitted to other exchange rate and inflation dynamics are not the same in the new equilibrium. Price level year and 0.4 percentage points in prices via the re-establishment of the systematically diverges from the exchange rate 2006. Faster wage growth could in relative relationships between prices level in the new equilibrium and therefore and via the re-emergence of equilibri- nominal shock generates an on-going real particular occur if economic growth is appreciation, in sharp contradiction with the better than forecast. Faster public sec- um in real wages. The forecasts of prevailing economic theory and evidence. tor wage growth would have an addi- Žumer (2003) and the IMF (2004) Statistical relationships in CJM are thus hardly showing any plausible causal relationship and the ARC model forecasts all indi- between prices (inflation) and exchange rate 15 A temporary appreciation of the exchange cate the first phase to be relatively (exchange rate dynamics). rate with a depreciation and return to parity in a very short time frame would probably not rapid, with a 20% to 30% change in 17 These calculations can be a very thankless have a significant effect on prices and has the exchange rate within a year, and task. On one hand, if the revaluation is fully therefore not been considered as an option. The credible, price adjustment could be faster. On projected exchange rate including prices the subsequent transmission to be rel- the other hand, an effect producing a fall in (partly) tied to foreign currencies is not changed atively slow at between 10% and prices is mostly estimated as being slower than if the central bank does not show credible 15% p.a.16 Such a transmission of a an effect that leads to price increases. In intentions of making a permanent change in the addition the simulation was carried out under central rate. change in the exchange rate to the the assumption of unchanged interest rates.

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Figure 8: Reaction functions for inflation and inflation criterion sary to envisage sufficient budget reserves for there to be no threat to meeting the Maastricht fiscal criterion in the future and no danger of breaching the Stability and Growth Pact. Under conditions of high economic growth, when tax revenues are high, it is therefore necessary to cre- ate such reserves and appropriately cut the budget deficit.20

MACROECONOMIC POLICY AND INFLATION AFTER THE ADOPTION OF THE EURO

By way of conclusion, the analysis and views given in this article are for- keeping with the very purpose of quickly be transmitted to wages in the mulated into a deliberation of macr- ERM II. Participation in ERM II is in private sector, particularly in areas oeconomic policy and inflation after essence conceived as a verification with weaker competition, where high- the adoption of the euro. After the of the sustainability of the central er labour costs can be compensated euro is adopted inflation in the mem- rate, where the exchange rate must for by price increases, and the crea- bers of the eurozone becomes a mat- reflect external equilibrium sustaina- tion of inflationary pressures. ter for the ECB, and formal fulfilment ble in the long-term, which is one of Through adjustments in public of the price stability criterion is no the substantive criteria for adopting spending, fiscal policy can have an longer required. Inflation in Slovenia the euro.18 Of course the adoption of impact on aggregate demand and will fluctuate around its natural rate a foreign currency with a re-appreci- economic activity, and thus an effect with regard to the inflation shocks ated tolar would not be in the interest on inflation via the output gap. In that occur in the future, and the of the domestic economy either. A re- order to illustrate the manoeuvring capacity of economic policy to stem valuation of the central exchange space for a restrictive fiscal policy, these shocks and not to cause them rate targeted at meeting the inflation Figure 8 shows the effect on inflation itself. criterion would entail a disproportion- and the inflation criterion of a cut in The country will not be without a ately high cost to the economy with government expenditure that would monetary policy: it will have the regard to the inflation benefits.19 balance the budget. ARC model fore- ECB’s monetary policy. If the econom- The arsenal of government-control- casts show that such an effect would ic cycles are synchronized with the led measures is relatively comprehen- be significant within one year and majority of the eurozone members, sive: administered prices policy, limits that this level of restriction would the ECB policy will also be optimal on tax and excise duty increases, probably ensure that the criterion for Slovenia. There are grounds for anti-cyclical planning of public spend- is met even if certain risks were relative optimism regarding synchroni- ing and public sector incomes policy. realised. The simulated adjustment zation in the economic cycle; the ma- The administered prices policy has in fiscal policy is considerable (a cut jority of research points to a consider- recently been in line with the in expenditure of 2% of GDP is able level of coordination on the part programme, with overall inflation in assumed), but is not outside the scope administered prices not in excess of of adjustments made by countries with 18 ECB, Convergence Report 2004. inflation in free prices. It would be similar needs for restrictiveness (e.g. 19 The very mention of shifts in the central possible to tighten up this policy, and Denmark). exchange rate as a genuine possibility for meeting inflation targets is hated by central give it an anti-inflation effect, but Several arguments point to the bankers. If the foreign exchange market expects there is a real danger that it would be need for greater restrictiveness in a revaluation, it can adopt a speculative position (capital inflows). When the central unsustainable in the medium term; if general government spending. bank is unable to balance these, it is forced to the restraint on administered prices Successfully meeting the price stabili- cut interest rates, and this would increase the were to be out of line with the actual ty criterion will be of great signifi- expansiveness of monetary policy. Thus there can be no expectation of a revaluation as a cost factors in these sectors, inflation cance in confirming the effectiveness realistic option for meeting the price stability would merely be shifted to the future. of the framework for economic policy criterion. Policy is also restrictive in terms of ad- action set out in the programme, and 20 In principle, meeting the criterion is also possible even if the reference value is justing tax rates and excise duties, the establishment of the central rate exceeded, on the basis of assessments of the and the projected effect on inflation as a nominal anchor for inflationary sustainability of nominal and real convergence. this year is minimal (0.1 percentage expectations. This measure is also It is primarily a matter of a long-term balance in public finances and the external equilibria. In points according to the ARC forecast). logical in terms of time and sustaina- the light of a qualitative assessment of the The public sector wage policy has re- ble in the long term, if the government sustainability of the macroeconomic equilibria, a credible response by fiscal policy, even if it cently been restrictive, and year-on- wishes to gradually (or rapidly) cut fails to meet its target in the short time frame year growth in wages was actually the proportion of the economy that it available, would strongly improve the negative at certain times last year. accounts for. And finally, for the (negotiating) conditions for adopting the euro. Reliance on charity and a failure to take Excessive wage growth (per employ- needs of an anti-cyclical macroeco- measures would worsen the (negotiating) ee) in the public sector could very nomic policy in the future it is neces- conditions.

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of Slovenia in the movement of aggre- tied to fiscal policy that is shocks that which the common monetary policy gate demand, but less in terms of sup- would no longer occur if economic cannot respond. An excessive in- ply-side shocks.21 Here it is probably policy were managed correctly. crease in domestic spending, for ex- a matter primarily of inflation shocks The largest problem is therefore ample, that could bring about a posi- an asymmetric shock that occurs sole- tive output gap and faster wage 21 See joint programme for ERM II entry and the research cited therein. ly in the domestic environment and to growth would be reflected in an infla-

APPENDIX: A SIMPLE ILLUSTRATION OF LONG-TERM EQUILIBRIA Cost or supply-side inflationary pressures, here limit- the domestic level of prices as a weighted average of ed in the long term to labour costs and the exchange domestic and foreign cost factors, where weightings sum- rate, are shown as a deviation in the level of prices from ming to 1 ensure the homogeneity in nominal factors. their long-term (equilibrium) state in terms of these cost The estimated equilibrium relationships have two con- factors. A price level behind the level determined by the sequences for interpreting long-term price dynamics. cost factors causes an adjustment upwards and acceler- First, the model is a priori set up to imply complete trans- ates inflation. If the cost factors are low with regard to mission of the nominal exchange rate and/or nominal the current level of prices, market mechanisms apply costs to prices in the long term, provided all nominal vari- downward pressure, and inflation falls. It is not always ables are adjusted so that the real equilibrium remains simple to estimate where the equilibrium that marks the unchanged. Together with the first-order homogeneity boundary between upwards and downwards pressure among the nominal factors that make up prices, this en- on inflation lies, as the real equilibrium varies with time. sures that the model has nominal neutrality in the long To analyse cost factors it is therefore handy (and indeed term. Second, and proceeding from the estimates and not necessary) to make use of structural estimates that repre- from the a priori specification of the equations, control- sent a long-term real equilibrium on the labour market ling the growth of nominal labour costs is of key impor- and an exchange rate adjusted to the long-term appre- tance to controlling inflation in the long term. This is illus- ciation trend that is a component of the equilibrium trated by the weighting given to labour costs in the long- process of real convergence. term cointegrated vector for prices, which is almost three The equilibria are specified as cointegrated vectors times the weighting for the nominal exchange rate. This is in standard econometric models: of course of no surprise, as labour costs alone represent on average approximately 70 % of companies’ total costs.2 In addition labour costs are also included in the real equilibrium exchange rate, which limits real appreciation in rapidly growing countries, where high unemployment limits growth in labour costs. The key therefore is for macroeconomic policy to ensure that long-term growth in labour costs is in line with productivity, or a falling trend where lcost is the nominal level of labour costs per em- in growth in nominal labour costs as a tool of the disinfla- ployee, p is the level of prices, y is real GDP, l is employ- tion process. The equations show that in an environment ment, e is the nominal effective exchange rate, and ppiW of a fixed nominal exchange rate (monetary union), ex- is the foreign producer price index. All the variables are cessive growth in domestic cost factors will be seen in a logarithmic and seasonally adjusted. All three equations rise in inflation and a fall in employment. The nominal are estimated simultaneously as a system, using the neutrality of the exchange rate is not guaranteed (com- method of minimum squares for the period from the first plete transmission of the exchange rate to prices), as the quarter of 1993 to the final quarter of 2004. equilibrium on the labour market adjusts itself.3 Equation (1) describes the long-term equilibrium on Inflationary pressures are shown in Figure 5 as price the labour market, where real labour costs per employ- levels deviating from the long-term level determined by ee are in the long term the same as real output per em- cost factors. Positive deviations represent an excessive ployee, with an adjustment that for an increase in em- price level and a downward pressure on inflation from the ployment real labour costs must decrease. The second factor in question, while negative deviations represent a equation represents the equilibrium real exchange rate price level that is too low and an upward pressure on in- as a linear simplification of Harrod-Balassa-Samuelson flation. The overall pressure on prices is the weighted rela- effects;1 the long-term differences between price levels tion of the two cost factors as estimated in equation (3). in different countries are a consequence of differences in the relative productivity between the tradable (T) and 1 See for example Obstfeld and Rogoff (1996). non-tradable (N) sectors: P = PT f(prodN/prodT). 2 Jongen (2004). Assuming that ppiW represents tradable prices (PT) that 3 The same results in estimating the long-term relationships in structural econometric models were shown by Žumer (2004) and the IMF (2004). in the long term are the same at home and abroad, and The estimated weightings given to labour costs in the two studies were that f (.) corresponds approximately to the linear func- 0.83 and 0.76, while those given to the exchange rate were 0.17 tion of productivity or real labour costs, taking logs (import prices) and 0.35 (the IMF does not assume a priori homogeneity). Of course it is necessary to treat all the estimates with an gives equation (2). Equation (1) can be used to describe appropriate degree of scepticism (and add long-term diagnostic tests the equilibrium level of prices p in relation to nominal la- for estimates that are not problematic). If the assessment period is shortened to the period since 1995, the weighting given to labour costs bour costs, and equation (2) describes them in relation in the ﬁnal equation rises to 90.06%, nine times that given to the to the nominal exchange rate. Equation (3) represents exchange rate.

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tion rate higher than abroad, and ductivity. All macroeconomic imbal- REFERENCES: would lead to a decline in competi- ances will be balanced out on the la- 1. Bank of Slovenia (2000), Bank of tiveness. It is only with the economic bour market, as there is actually no Slovenia Annual Report for 1999. slowdown that follows a decline in longer any flexibility in monetary poli- 2. Bank of Slovenia (2001), Bank of Slovenia competitiveness that prices usually cy or exchange rate policy. If wages Annual Report for 2000. fall back to the equilibrium level. If are not sufficiently flexible, and fail to 3. Bank of Slovenia (2005), Monetary Policy prices and labour costs proved diffi- mitigate the effects of (asymmetric) Report, April 2005. cult to adjust downwards, the infla- shocks on companies, then the com- 4. Bank of Slovenia and Government of the tion cycle described can sometimes petitiveness of companies will de- Republic of Slovenia (2003), Programme for lead to a very long period of slow cline, leading to job losses. ERM II Entry and Adoption of the Euro. economic growth. Of course the re- The programme for the adoption 5. ECB (2004), Convergence Report 2004. verse cycle is also possible, with de- of the euro is probably the best basis 6. Clarida R, Gali J, Gertler M (1999), The flationary pressures and slow eco- for macroeconomic policy action Science of Monetary Policy: A New Keynesian Perspective, Journal of Economic nomic growth. The burden of prevent- even after the euro is introduced. The Literature 37. ing such asymmetric cycles, both in- product of a wide economic and po- 7. Coricelli, F., Jazbec B., Masten I. (2004), flationary and deflationary, must now litical consensus, it is a very useful Exchange Rate Pass-Through in Acceding fall to fiscal policy, through appropri- document, and probably one of Countries: The Role of Exchange Rate ate adjustments in government spend- Slovenia’s most significant compara- Regimes, Economics Working Papers ing. Currently the most dangerous tive advantages. The central ex- ECO2004/16, European University Institute. asymmetric shock is a possible fur- change rate must become an effec- 8. Genorio H, Kozamernik D (2004), FEER ther fall in interest rates when the tive anchor on inflationary expecta- Estimates – the Slovenian Case, Surveys and Analyses, July 2004. euro is adopted. At that time nominal tions as soon as possible. The key to interest rates will be equalised with this is for macroeconomic policy to 9. IMF (2004), Republic of Slovenia: Selected Issues and Statistical Appendix. those in the eurozone and will proba- be credible in preventing inflationary bly be lower than at present, unless cycles, which demands that macr- 10. Jazbec B (2002), Model of Exchange Rate Determination in Transition Economies, then ECB raises its interest rates. This oeconomic policy also counteracts in- Working Paper of the Faculty of Economics could give rise to a new lending flationary cycles even as they arise. 118, University of Ljubljana. cycle, and excess demand would put Sound macroeconomic policy can 11. Jongen ELW (2004), An Analysis of Past pressure on inflation and cause a de- contribute to the stabilisation of infla- and Future GDP Growth in Slovenia, IMAD cline in competitiveness. Economic tion by stabilising inflationary expec- Working Paper No. 3. policy must prepare for an appropri- tations in line with the central ex- 12. Kozamernik D (2003), Long-Run Growth ate response or preventive action. change rate. Stabilising inflationary and Price Convergence, Surveys and Reliance on monetary union as the expectations lowers the degree to Analyses, July 2003. sole macroeconomic price stabiliser which inflation responds to shocks, 13. Obstfeld M, Rogoff K (1996), would sooner or later prove to be thanks to the expectation that an ap- Foundations of International Macroeconomics, MIT Press. naive and harmful. propriate reaction from macroeco- The success of macroeconomic nomic policy will actually counteract 14. Žumer T (2002), Estimation of the Balassa-Samuelson Effect in Slovenia, policy is already conditioned by the the inflation shocks. Macroeconomic Surveys and Analyses, September 2002. level of agreement between the social policy thereby contributes to price 15. Žumer T (2004), Modelling Prices and partners. Wage growth and labour stability and lowers the adjustment Wages in Slovenia Based on the Supply costs must be subject to growth in pro- costs to the economy. Side, Surveys and Analyses, July 2004.

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UDK 336.1/.5(497.4):339.738:061.1EU Short-term fiscal risks and economic policy measures Velimir Bole *

A decrease in the tax fter entering the euro area, supervising the fiscal administration efficiency after entering EU, as well stance will become main policy makers’ task, as they as the increased tax competition in the EU, will be committed to following the numerical rules set will prove to be the most significant short-term by the Stability and Growth Pact. Changes in the fiscal risks for the general government tax Astance caused by EU integration will therefore have visible revenues. The optimal economic policy response effects on policy measures. to the increased tax competition and falling After Slovenia adopts the euro, reduced tax administration efficiency of the tax administration would be efficiency, especially in administering domestic taxes on goods lower labour taxation (abolishing payroll tax), and services, and increased tax competition in the EU could de- and simplified corporate income tax (all tax teriorate fiscal stance. Potential consequences of the anticipated incentives have to be suppressed). decline in tax administration performance and the effects of tax Economic policy must neutralize decrease in the competition on the fiscal stance could be determined only vague- tax revenue by reducing general government ly. Possible policy makers’ measures to neutralize such effects spending and not by increasing domestic taxes are, therefore, also not apparent. The present paper will try to on goods and services. A higher taxation of the unveil some of those indeterminacies. consumption (VAT and excise) would be In the following, the paper consists of three parts. In the acceptable only in the case of an increase in the next section, an illustration of the anticipated reduction in the consumption taxation in the euro countries or at general government revenue is given. The third section touches least in the neighbouring euro countries. some plausible tax system changes necessary to neutralize drop in the revenues, while the fourth sections outlines the possibilities of the general government spending restructuring. The paper ends with a summary of the main conclusions.

RISKS TO THE GENERAL GOVERNMENT REVENUES

Taxation – size and structure The relative size of the tax revenue in the EU is generally higher than in Slovenia (with tax revenue of approximately 38%

* Velimir Bole, Economic Institute of School of Law, Ljubljana

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of GDP). A comparison with the less tering domestic taxes on goods and Higher levels of VAT efficiency re- developed EU economies (Spain, Por- services. The border customs control sulted not only from the integrated tugal, and Greece) and the two most lost a great deal of its fiscal function. nature of the information on taxable dynamic smaller EU economies (Ire- Therefore, information on transactions transactions, but also from the lower land and Finland) is of the greatest burdened by the value added tax efficiency of the capital market.4 interest. The data reveal that Portu- cannot be fully integrated any more, Since EU integration, tax administer- gal, Spain and Greece have smaller as it is only partially available to the ing could decrease also because tax revenue. While out of the compet- tax administration. Significant correc- of an increase in the capital market itive faster-growing economies, Ire- tions to the 2004 imports and exports efficiency; after entering the euro land shows a significantly lower tax data made in 2005 illustrate, for ex- area this effect could be even revenue (31% of GDP) and Finland, ample, the possible scale of a decline greater. on the other hand, significantly high- in the available information on the ex- VAT revenue shortfall in 2004 er tax revenues (at approximately port and import transactions. was caused by shifts in timing. 47% of GDP) than Slovenia. Of the The previous high level of the effi- Namely, the timing of taxing goods remaining EU economies, only in ciency in the tax administering and, imported from the EU was changed Great Britain the volume of tax reve- therefore, the potential tax revenue at EU accession, while small correc- nue is slightly lower. decline in the first few years of EU tions in legislation shifted also timing The noticeable difference of membership, can be illustrated by a of refunds. Both timing changes influ- Slovenia’s effective tax structure, enced only cash flow of the VAT reve- when compared to the EU and espe- nue. In 2005 and 2006, however, cially the OECD economies, is the solvency of the tax revenue could de- above-average taxation of labour, a In the second teriorate also, because of the men- slightly higher consumption taxes and tioned potential drop in the tax ad- a significantly lower taxes on capital ministering efficiency. income. half of 1990s, The lower bound for possible drop In the second half of the 1990s, in the tax revenue can be estimated consumption was effectively taxed at effective tax by taking into account the efficiency the rate of 24%, labour income at of the most efficient tax administra- 43% and capital income at 24%. Due on consumption tions in EU. However, only countries to inappropriate specification of the with similar VAT system have to be personal income tax in comparison used as a reference. Namely, VAT with the corporate tax burden, there was around system with several nonzero tax rates were large discrepancies between could reduce efficiency of the tax ad- the capital taxation for the corporate 24%, on labour ministering far more than, for exam- sector and the capital taxation of the ple, single rate VAT. Therefore, only sole proprietors. Except for the capi- countries with one non-standard tax tal income taxes, the effective tax 43% and on rate were taken into account at esti- rates in Slovenia, heuristically speak- mating the lower bound for possible ing, measure up to those in Nordic capital 24%. drop in the VAT revenue. countries, while the pattern of the ef- The average VAT collection effi- fective tax structure is closest to that ciency in the corresponding EU coun- in France.1 sizable differences in the value added tries amounts to 0.405% of GDP per After 1999, only consumption tax- tax revenue collected in the EU and unit of standard tax rate.5 Drop in the ation changed considerably; namely, in Slovenia before joining the EU. efficiency of administering domestic the sales tax was replaced by value In Slovenia, the tax revenue per each taxes on goods and services, could added tax and excises. The change point of the standard VAT rate exceed- therefore reach up to 2% of GDP. The increased consumption taxation by ed 0.5% of GDP, while in the EU on anticipated deterioration in the VAT approximately 7.6%. Effective tax rate average it reached a mere 0.36% of administration efficiency, caused only for the consumption taxation therefore GDP.2 A detailed analysis shows that by new information flow obstacles, increased to almost 26%. not only VAT tax collection effective- 1 Reducing nonneutrality generated ness in Slovenia (prior to EU integra- See Bole (1999), where the same methodology for estimating effective tax by the tax system would require (cete- tion) was 40% higher than in the EU structure is used as in Mendoza et al (1994). ris paribus), a significant reduction in on average, but even in Germany 2 Despite the common practice of measuring taxing the labour income, an increase and Luxembourg efficiency of adminis- VAT administration by yield (in GDP percentage) per standard tax rate unit (VAT/ in the capital income taxation and the tering VAT was 15% lower than in GDP/standard rate), the comparison can only same or slightly reduced taxation of Slovenia, although last two countries be valid if the specification and other tax consumption. are superior to other EU countries in parameters (except rates) are similar between the economies in question. Since Slovenia tax efficiency. Efficiency of VAT tax implemented EU VAT specifications, the Declining efficiency administering in Slovenia was higher comparison of tax collection practices between even in comparison to the EU coun- the EU and Slovenia is reasonable. of the tax administration 3 tries having only one VAT rate See IMF (2002). 4 3 The growth in capital market efficiency After EU entry, the efficiency of (Denmark and Estonia), despite the increases the possibility of tax evasion; see the Slovenia’s tax administration start- fact that administering a single rate Stiglitz (1998) for example. ed to decline, particularly in adminis- VAT tends to be far more effective! 5 See, for example, IMF (2002).

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amounts to approximately 0.5% to “financed” by the EU structural funds. There are also other arguments 1% of GDP.6 Knowing the EU treatment of state against an increase in the taxation of Actual decreasing in the tax ad- aid, it is obvious that even a minimum consumption. ministration efficiency towards new amount of tax coordination would be An increase in the taxation of con- equilibrium tax revenue will, however, more than welcome, if full tax harmo- sumption would mean a supply shock be gradual. Actual dynamics of the nisation cannot be achieved.10 for prices, which could immediately tax evasion increase and, therefore, Nevertheless, so far the EU has done influence inflation. The effect of the in- the time path of a decline in the tax very little to coordinate this field. Its creased taxation of consumption is revenue cannot be estimated with the endeavours to date are summarised not only faster, but also in the cumula- available empirical evidence. in the Code of Conduct adopted by tive terms usually also greater than Smaller access to information the European Commission in 1996. the effect of changing direct taxa- on taxable transactions and the in- These rules stopped discriminatory tion.12 Since no change in the ex- creased efficiency of the capital mar- tax action (such as lower tax rates for change rate central parity can be ex- ket will probably decrease also effi- non-residents) only if “explicitly” pected either during the ERM II peri- ciency of administering the corporate being used as a type of state aid.11 od or after adoption of the euro, a income tax. Especially because of the The EU enlargement in 2004 has supply shock caused by an increase way in which tax investment incen- intensified tax competition. Some of in the domestic taxes on goods and tives are implemented in the new law the newcomers have very low corpo- service, could noticeably change rela- promulgated in 2004. According to rate tax rates despite the fact that tive prices (tradable vs. none-tradable the new law eligibility for tax (invest- they are, like Ireland, net EU fund re- goods). ment) incentives is, namely, deter- cipients. If, in addition, tax correction is lim- mined outside of the tax administra- An increase in the tax competition ited to increasing just one VAT rate tion (in special agency) that could in- for taxes with a mobile base, especial- (for example, the lower rate), or to increase biasedness towards higher tax ly the lowering of corporate tax, decreasing only excises, the variability investment incentives. creases the tax revenue of other EU of relative prices would increase fur- economies, as it drains their tax base. ther. This would push inflationary ex- Increased tax competition Furthermore, tax competition reduces pectation up and stretch the process the relative size of the operating sur- of subduing inflation.13 During the 1990s, EU countries plus, and hence the competitive It is well known that VAT with one witnessed an increase in the tax com- strength (and therefore investment and non-zero tax rate is a better solution petition for taxes with a mobile tax employment) of other EU economies. than (revenue adjusted) VAT with sev- base; a process was led by Ireland. Since Slovenia’s tax structure is al- eral non-zero tax rates. Single rate As a significant EU transfer recipient ready strongly biased towards high namely facilitates greater efficiency in (between 4% and 7% of GDP), it was labour taxation and low capital in- tax administration, because in such a in position to significantly lower its come taxes, tax competition could system there are no taxpayers (except taxation of corporate profits for for- prove particularly harmful for exporters), which receive net refunds. eign enterprises (in the first phase, to Slovenia, as capital income tax reduc- Net refunded taxpayers are, namely, as low as 10%). Even though the tax tions would only increase noneutrali- the main cause of lower efficiency in credit was formally tied to certain ties of the tax system. administering VAT. Using available ev- conditions,7 these were so “soft” that idence on taxable transactions, it is any multinational could take advan- POSSIBLE TAX SYSTEM far more difficult to track (gross) transactions of net refunded taxpayers, tage of them. The reduced corporate CORRECTIONS tax rate led to a massive increase in due to the status of “border” products foreign direct investment in Ireland; Risks in the increasing 6 approximately 40% of all US FDI in consumption tax Assuming that the efficiency in value added tax collection practice will drop to the level of the EU was channelled to Ireland dur- the corporate income tax efficiency. See Bole ing that period. Fiscal policy could respond on the (2002). The EU has been unable to find consequences of the afore-mentioned 7 It was limited to enterprises manufacturing any institutional means to curb this risks threatening tax revenue by chang- industrial goods or corresponding services, have a listing on one of the EU stock exchanges, rise in the tax competition, even ing (increasing) other taxes or by re- etc. See Figura (2002) though it was largely the result of EU ducing general government spending. 8 Adjusting Ireland’s steep growth for mentioned structural funding.8 The likelihood of Should economic policy try to off- EU transfers, makes its growth rates far less spectacular, between 2% and 5%; See Figura corporate income tax harmonisation set the shortfall in the tax revenue (2002) or, at the very least, an agreement on with an increase in the labour income 9 See, for example, Figura (2002). minimum corporate income taxation is taxation, major distortions in the tax 10 See, for example, Plichon (1999). very low, as consent would be need- system would be only amplified. 11 The Code of Conduct contains five tax ed from every EU Member State, al- Similar argument could be used interventions that violate Article 87 of the EU. though such an agreement was made also for domestic taxes on goods and All apply to the differential treatment of the specific groups of taxpayers. See Figura for VAT, as a response to the threat of services. Current taxation of consump- (2002). 9 the tax competition. tion is, namely, already high, so fur- 12 See the comparison of direct and indirect The opportunity costs of the tax ther increase of domestic taxes on taxes, ECB (2005) competition between EU Member goods and services would only in- 13 Effects of the tax rates changes on inflation are well illustrated by the inflation performance States are similar to those of the state crease existing distortions generated of the Slovenian economy after 2000. See Bole aid, especially if tax competition is by the tax system. and Mramor (2005).

22 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

(compare, for example, taxing food tion performance and long-term therefore, increase already existing and food preparation) and (artificial) macroeconomic performances.17 In nonneutralitiy (biasedness) of the tax subsidiary production units that are Slovenia, economic policy must adjust system. refunded in net terms.14 consumption taxation changes to the Comparison with less developed, Despite the advantages of a single changes of the same taxation (domes- or high growth EU countries shows tax rate, the opportunity costs of a uni- tic taxes on goods and services) in that high gross labour costs are the lateral VAT rate changes (independent the euro area countries, or at least main reason for the low net business of VAT changes in the other euro area to the corresponding changes in its surplus (per unit of output), despite economies), after exchange rate cen- neighbouring countries. Slovenia the fact that value added (per unit of tral parity is already fixed, could be should not venture into this segment of output) is relatively high in Slovenia.18 large, especially after entering euro the tax system alone. Decreasing labour income taxa- area. In the economy, that faced signif- tion would neutralize the tax competi- icant reduction of room for policy ma- A decrease tion effects more efficiently than de- noeuvre, one-sided changes in taxing creasing the corporate taxation. A de- in the labour taxation consumption, could lead to an asym- crease in the tax rate for taxing profits metric supply shock that could jeop- As already mentioned, compari- to a mere 6.5% would, for example, ardize achievement of inflation target son of Slovenia and EU (and whole give the same fiscal stimulus as abol- as well as long-term growth perform- OECD) countries shows that labour in- ishing payroll tax, as an increase in ance of the economy. Any unilateral the business net surplus would be ap- acceleration of price growth would de- proximately the same. There is, name- crease the long-term competitive mar- ly, no difference in the revenue of gin of its tradable sector; in the case If consequences both taxes (in 2004, each brought of opening EU services market, the roughly 2% of GDP). At the same non-tradable sector would suffer also. time, a decrease in the payroll tax After setting exchange rate central of tax would additionally (!) reduce also the parity and, especially, after entering relative price of labour. Abolishing euro area both, abolishing the lower competition payroll tax would, therefore, have tax rate and increasing the standard much higher effect on the employment tax rate could have significant macr- are to be than an (revenue) equivalent decrease oeconomic opportunity costs. in the corporate income taxation.19 VAT tax rates in neighbouring It should be mentioned also, that a countries are particularly important neutralised, radical decrease in the corporate in- for the non-tradable sectors’ competi- come taxation (by cutting tax rate, for tiveness (especially for tourism). The payroll tax example, to 6.5%) would increase tax standard VAT rate is lower in Italy burden on labour to over six times the (19%), the same in Austria (20%), tax burden put on the corporate in- somewhat higher in Croatia (22%) should be come. That could become questiona- and much higher in Hungary (25%).15 ble as a potential form of discriminato- Apart from Croatia, all neighbouring abolished. ry state aid, though Article 87 of the countries also have lower VAT rates. EU Treaty has not gone this far yet. Since present differences in the tax rates are not high, increasing the tax come taxation is very high and capi- Necessary tax system rates could affect the competitive po- tal income taxation too low, in sition of important service sectors in Slovenia. Economic policy, therefore, changes – guidelines Slovenia, especially the day tourism should neutralize effects of increased (shuttle trade) sector. An increase of tax competition (and potential drop in Due to increased tax competition the lower tax rate could prove deadly tax revenue) by taking into account and useless efforts in reaching mini- for this economic sector, as hotel and also main already present noneutrali- mum tax system harmonization in the restaurant service prices would signifi- ties in the tax system. That is, econom- EU (similar to that achieved at the cantly increase. Such deterioration in ic policy should decrease high labour 14 competitiveness of enterprises from income taxation, and not (low) capital See Bole (1997). 15 this sector could jeopardize especial- income taxation! See, for example, IMF (2002). 16 A size of a decrease in daily tourism ly daily tourism in the bordering re- Several arguments speak for a de- (migration) and deterioration in the gions!16 crease in the labour income taxation performances of hotels and restaurants in Abolishing lower rate and simplifi- (for example reducing payroll tax) bordering regions after the introduction of double pricing of gasoline in Italy, should be a cation of VAT would also call for and against a decrease in the corpo- clear warning of possible effects of increasing changes in the special VAT treatment ration income tax. in the consumption taxation. of farmers. That could further exacer- The capital income taxation is low 17 On necessary changes of economic policy parameters before policy makers’ degrees of bate their competitive position, al- (in comparison with other developed freedom are reduced, see Bole and Mramor ready significantly damaged after en- economies in the EU and OECD), es- (2005). tering EU. pecially if compared in relative terms 18 See, for example, Bole and Mramor (2005). After entering ERM II, increase in of the labour income tax. Decrease of 19 This is why tax incentives in corporate income the consumption taxation is therefore the corporation income tax (as a part tax should be terminated and increased tax revenue used for payroll tax cuts; see, for inappropriate, as it could harm infla- of capital income taxation) would, example, in Bole (2003).

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value added tax), and taking into ac- could cause a long-term fiscal stance Possible spending reductions count existing nonneutralities in the deterioration as well as the deteriora- Potential public spending reduc- Slovenian tax system, policy makers tion of other macroeconomic per- tion “degrees of freedom” are illus- have to neutralize effects of the tax formances.22 trated on the Table 1. The table shows competition by lowering dominant dis- Since the value added tax reve- the economic structure of the public tortion in the tax system, namely the nue will probably decrease after en- spending. Spending is given in per- high labour taxation. tering EU by over 1% of GDP in the centages of GDP, for Slovenia, some Payroll tax elimination is the most process of normalization of the tax of the most or least developed econo- appropriate step in neutralizing the administration efficiency, cyclically mies in EU, and for the most dynamic tax competition consequences; it adjusted public spending should be EU economies. namely lowers labour tax burden and cut. If the increased EU tax competi- Heuristically speaking, economic simultaneously increases the net busi- tion would be neutralized by abolish- structure of the public spending given ness surplus. ing payroll tax, tax revenue would in the table could be used for crude Main characteristics of the corpo- decrease by an additional 2% of benchmarking of the public spending rate income taxation must remain un- GDP. General government spending in Slovenia. Differences in the econom- changed. But to enable easier and should be, therefore, decreased to ic structure items could be caused by more efficient administering of the approximately 40% of GDP (cash different portfolios of public services tax, exemptions and tax incentives flow basis). offered by the specific countries, or by should be eliminated, and the proce- A drop of the tax revenue by 3%– different public service production effi- dure for determining business-related 4% of GDP in the period of two to ciency. In principle, the optimal “tech- costs simplified. Tax exemptions and three years would need significant nology” for public service production tax incentives, namely, impede admin- cut of public spending already in the is, namely, available to all countries. istering the corporate income tax. At very short-term period. Only an au- For a leaner state, the first step the same time they do not have statis- tonomous decrease in the tax reve- has to be identification of the ineffi- tically detectable effect on the invest- nue (independent of any cut in tax cient segments of the public spend- ment and employment, although cor- rates) could namely increase fiscal ing. We will show, that only reduction responding distortionary differences deficit to over 3% of GDP. Because of of the inefficiencies in the public between sectors (for example, labour- the necessary cut in the public spend- spending would not be enough to intensive versus capital-intensive) and ing, segments of the general govern- neutralize tax revenue drop caused between old and new enterprises are ment spending should be identified, by assumed tax system restructuring. quite large.20 where either spending efficiency is Therefore, the public service portfolio, The tax rate changes for the do- lower than on average, or “marginal offered by the general government, mestic taxes on goods and services utility” of the public spending (meas- should be restructured (supply of serv- have to be adjusted to the changes of ured by the policy maker’s goal func- ices reduced) also. the same taxes in the other countries tion) is lower. of euro area, or at least to the corre- When identifying public spending 20 Because of the constitutional court decision, sponding tax changes in the neigh- segments appropriate for reduction, that investments abroad are also eligible for tax bouring euro countries. it is necessary to take into account incentive, the reasonables of tax incentives is reduced even further. It is worth mentioning, that the also constraints determined by the 21 Possible tax reduction effects could be payroll tax termination would not nec- public services “supply function”. That illustrated by the labour cost dynamics in the essarily have a considerable or auto- is, the size of the individual public last year and a half, when increased competitive pressure and intensiﬁed matic effect on the increased activity spending segments which could en- deterioration in the performance of the labour and (or) employment. It is, namely, danger the supply of corresponding intensive sectors didn’t halt rising of wages and questionable, how much of the elimi- public services, as well as the size of salaries signiﬁcantly above nominal product dynamics. nated tax burden would be offset by cross-subsidizing between different 22 21 For example, supply shock to prices, due to a wage and salary increases. spending balances of the general reversed tax rate increase, a decrease in state government. credibility, etc. POTENTIAL CHANGES Table 1: Economic structure of public spending (2002) IN THE PUBLIC SPENDING Total general Spending for Salaries and government Interest Transfers Investments goods and What to change in the wages spending structure spending services Ireland 33.26 1.38 8.30 9.81 4.33 9.43 Due to the tax system restructuring Finland 50.12 2.20 13.53 18.69 2.87 12.81 (tax rates reduction), a decrease in Denmark 55.80 3.67 17.65 18.94 1.75 13.87 the tax revenue must follow rather Sweden 58.31 3.17 16.29 20.65 3.26 14.92 than precede corresponding public Germany 48.51 3.09 7.94 27.14 1.62 8.70 spending reduction. In the opposite Greece 46.81 6.23 12.02 16.43 3.77 8.33 case (for example, due to political blocking of the necessary govern- Spain 39.93 2.84 10.34 15.03 3.38 8.33 ment spending reduction, or because Portugal 45.94 3.02 15.39 14.83 3.39 9.29 of an inappropriate estimation of the Slovenia 42.17 1.60 9.68 18.77 4.06 7.85 necessary spending reduction, etc.) Source: OECD, 2004, “General Government Accounts”, Vol. 4; SURS, “Statistical the restructuring of the tax system Yearbook”; own calculations.

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The public sector spending in higher. But the variability in the gener- fers indicate that these could not be Slovenia is relatively low compared to al government investments is low caused by differences in the produc- the average of euro area states among countries. Public sector invest- tion efficiencies or differences in the shown in the Table. Only Ireland ments in Slovenia are, for example, “production” technology. Large differ- shows lower general government higher than in the next (highest) five ences in the volume of transfers have spending (33.3% of GDP in 2002). countries by less than 0.8% of GDP. If to result from very diverse portfolios The size of the general government the general government investments in of transfers, between economies. That spending in Slovenia is lower also in both dynamic EU economies (Finland portfolios of transfers considerably comparison with the less developed and Ireland) and in the least devel- differ between EU countries docu- countries in EU. oped EU economies (Greece, Spain ments already the structure of the In Slovenia, all items of the gener- and Portugal) indicate “necessary” transfers. al government spending, except trans- size of investments in the less devel- In Slovenia, (direct) transfers in- fers, are closest to the corresponding oped EU economies targeting fast clude transfers to the business sector items of the general government growth, then we could conclude, that (approximately 1.3% of GDP) and spending in Ireland. Namely, general by cutting public investments it would transfers to the households (approxi- government spending for interest, not be possible to reduce general mately 17.4% of GDP). Because state wages and salaries, investments and government spending by more than aid has to be reduced after entering current purchases of goods and serv- 1% of GDP. EU, transfers to the business sector ices in Slovenia are very similar to present the second item of the public those in Ireland, and, at the same spending, appropriate for noticeable time, substantially different from corre- reductions. sponding expenditures items in other Changed There are three crucial questions EU countries, including the least de- regarding cutting transfers to the veloped ones: Spain, Greece and households. First, how much transfers Portugal indexation could be shrunk only by improving ef- Figures in the table show, that pol- ficiency? Second, which transfers icy makers in Slovenia do not have of pension stand out the most compared to the any room for cutting current purchas- reference countries? And third, what es of goods and services. In Slovenia, benefits will is the amount of cross financing (sub- this item is substantially lower than in sidizing) between individual transfers all mentioned EU countries, despite to households? the fact that the corresponding public level off If the public spending has to be service portfolio is similar in all coun- reduced, transfers which are not part tries and that (up to date) public serv- the pension of the social safety net (other direct ice production “technology” is acces- transfers) have to be first candidate sible to all member countries. The size for cutting.24 These transfers have, of the spending for goods and servic- reform effect in namely, the smallest effect on the de- es is small compared also to other cline in social protection of the lowest (non-EU) OECD countries. Since cur- two-years’ time. income quantiles of population and, rent purchases of goods and services therefore, on the potential poverty are low already on average, purchas- rise. These transfers increased after es of goods and services in some dis- By far the biggest differences the exogenous transition phase came aggregates of the general govern- among the presented EU economies to an end (after 1996). They replaced ment could be already exposed to are in the transfer expenditures. “transition” transfers, which were dangerous rationing.23 Slovenia, with 18.8% of GDP, is at the used for alleviating the consequences Due to the low level of country very top of those countries with the of the economic restructuring during debt, the amount of paid interest in biggest transfers (together with the “transition depression” phase. Slovenia is small. From the above- Sweden, Denmark and Finland); only These transfers represented approxi- mentioned EU countries, interest ex- Germany displays higher transfers. mately 2% of GDP in 2004. penditures are lower only in Ireland. Slovenia exceeds all the reference Since other direct transfers are Wage and salary expenditures are economies: less developed econo- also part of the social safety net, it is, also below average; still, in some mies by at least 2.5% of GDP to at however, necessary to analyze the countries wage expenditures are most 4% of GDP, and the most dy- structure of the whole portfolio of so- lower than in Slovenia; for example in namic ones by 9% of GDP at most cial transfers supplied by the govern- Ireland and Germany. Besides, it is and at least 0.1% of GDP. ment. Besides, it is necessary to ana- impossible to evaluate possible conse- It seems, that only the transfers lyze whole social protection segment, quences of the new law on wages in spending differences between that is all social transfer expenditures the public sector. But, since the law Slovenia and other EU developed (all social benefits) and not only di- anticipates large structural changes, countries are high enough to absorb 23 Partial empirical evidence indicates that there is high possibility that it will in- a decrease in public spending neces- rationing of the current purchases of goods and crease also the total wage bill. sary to offset reduction in the tax rev- services is already present in Tax Administration In Slovenia, investment expendi- enue of the analysed size. and health sector. 24 This, for example, pertains to special veteran tures are high if compared with refer- Large differences between EU transfers, some family size beneﬁts, sick ence countries, only in Ireland are countries regarding the size of trans- allowances, etc.

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rect government transfers to the When social transfers expendi- Comparing the size of the unem- households. The latter differ from all tures reduction is discussed not only ployment social transfers and the un- social transfer by not encompassing the volume but also the structure of employment rate it is obvious, that the public services, financed indirect- the social transfer expenditures is im- cover of possible risky business oper- ly by the general government (for, ex- portant. The question is, how much ations that could end in the loss of ample health care), as well as non- the structure of the social transfers is jobs is very low. In Slovenia, there is public social transfers. “biased”, taking into account the level almost 50% lower unemployment pro- of Slovenia development and the goal tection than in the country with the Social transfer function of the economic policy. That lowest cover in the EU (Finland). In is, by how much are specific social the fast growing economies, large expenditures transfers in Slovenia higher (in terms enough (but short-term) transfers for In Slovenia, social transfer expen- of GDP) than in the referent EU coun- the unemployed increase readiness of ditures slightly lag behind correspond- tries? the market players for more aggres- ing average social transfer expendi- Structure of the social transfer port- sive business operations and stronger tures in the EU. However, social trans- folio for some EU members is outlined competition on the market.29 fers are better targeted in Slovenia in Table 2. In Slovenia, age transfers Healthcare social transfers are than in the EU. (pensions) and unemployment trans- also high in Slovenia; they are higher Social transfer expenditures (in- fers stand out if compared with the than in the both highly competitive cluding private schemes) amount to presented EU countries. Pensions are economies.30 However, correct com- approximately 26.6% of GDP, in substantially higher than in the most parison demands two modifications Slovenia. The average social transfer EU countries, although demographic in the presented figures. When com- expenditures in the EU are higher, differences are small. Actually, pen- paring social transfers (following the around 27.3%. But above-mentioned sions in Slovenia are as high as in the Eurostat methodology), expenditures reference economies from the EU (less first EU quintile. Unemployment trans- for voluntary supplementary health in- developed or high competitive one) fers are significantly lower than in the surance are also taken into account. If have lower social transfers than most EU countries. that part of the social protection ex- Slovenia. In the less developed EU Although age transfers are al- penditures is eliminated (because they members, the social transfer expendi- ready high, total public spending for are, for example, “socially poorly tar- tures vary between 20% and 26% of this purpose is even higher. But the geted”),31 healthcare benefits in GDP (Portugal 22.7%, Spain 20.1% difference is hidden by cross subsidiz- Slovenia are narrowed to the public and Greece 26.4%); highly competi- ing between different segments of the expenditures on health. For compari- tive, small EU economies also have public spending. The most important son, the last column in the table 2 lower social transfers than Slovenia cross subsidizing (around 1% of GDP) presents the public healthcare expen- (Ireland 14.1%, Finland 25.2%).25 is taking place between health and ditures (in% of GDP) for the same With the exception of the “miscel- pension spending balance.28 It is group of countries: for Slovenia, for laneous transfers” (sick and maternity worth mentioning that age transfers highly competitive small EU econo- leave, salary compensation, birth as- restructuring, which was launched mies and for the EU economies with sistance and some other social securi- with parametric pension reform in high expenditures on the social pro- ty transfers), in Slovenia social trans- 1999, have decreased age transfers tection.32 fers are well targeted. On average, (pension expenditures) by approxi- To make comparison with other each social transfer unit (in% of GDP) mately 0.6% of GDP until 2004. That countries fair, in Slovenia sick allow- lowers poverty by 2.26 percentage is slightly more than half of the neces- ances must also be omitted from the points, while the same effect of the sary reduction, to neutralize above- public health expenditures (because social transfers in the EU only mentioned hidden burden of the data for other countries are prepared amounts to 0.92 percentage points.26 healthcare balance. However, a on the OECD methodology). Adjusted We can conclude that an increase wrong policy makers’ decision to peg figures on the public health expendi- in the efficiency of the social transfer pensions to wages, launched in tures are presented in the last column implementation cannot noticeably de- 2005, put a halt to such a restructur- of table 2. Data for Slovenia are for crease public spending.27 Analysed ing of the pension expenditures bal- 2002. decrease in the tax revenue, there- ance. Even worse, such government 25 See Abramovici (2003) fore, cannot be neutralized mainly decision will wipe out also already achieved pension expenditures reduc- 26 See Dennis and Guio (2003); own through increasing efficiency of the calculations tions in the span of two years. social transfer implementation! 27As it is, for example, expected from comparison of different social transfers of Table 2: Social Transfers in 2000 (% of GDP) individual beneﬁciaries (crossing of the corresponding databases). Unemployment Health Pensions Disability Family Health-public 28 See, for example, Bole (1998) or Bole Ireland 1.4 5.8 3.6 0.7 1.8 4.7 (2004). 29 Finland 2.5 6.0 9.0 3.5 3.1 5.0 Stiglitz lecture in Ljubljana. 30 Denmark 3.0 5.8 11.0 3.5 3.8 6.9 See Dennis and Guio (2003);own calculations Sweden 2.1 8.7 12.5 3.8 3.5 7.1 31 This is due to the complementarity of the Slovenia 1.1 8.2 12.0 2.4 2.4 5.6 public and private ﬁnancing of the healthcare protection. See “The Health Reform,” 2003, Germany 2.5 8.3 12.4 2.3 3.1 7.9 Ministry of Health Source: Bole (2004). 32 See OECD (2003).

26 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

It is obvious that, comparing with healthcare quality services as is pro- Parametric pension reform in Slovenia, the public health expendi- vided in both of the smallest highly 1999 enabled a slow, but tolerable tures are noticeably higher in competitive EU economies. Sick al- and sustainable, dynamic of the age Germany and also in Denmark and lowances are therefore another im- transfer normalization, for approxi- Sweden. Seven EU countries (besides portant cross-subsidizing item which mately 0.2% of GDP per year. The Finland and Ireland, which are given (inappropriately) burdens the health change in the pegging of the pen- in the table, also, for Austria, expenditures balance.33 sions made in 2005 will reverse the Luxemburg and the Netherlands) dynamics of normalization, in two have lower public healthcare expen- SUMMARY years reform effects will be wiped ditures than Slovenia. out. To enable at least rough compari- A decrease in the tax administra- son of such healthcare public expen- tion efficiency after entering EU, as REFERENCES: ditures efficiency (the quality of ap- well as the increased tax competition 1. Abramovici,G., (2003), “The social propriate healthcare services), it is in the EU, will prove to be the most protection in Europe”, Statistics in focus, Eurostat. necessary to take into account the significant short-term risks for the gen- fact that part of healthcare expendi- eral government tax revenues. The op- 2. Bole V., 1997, “Value added tax – one or tures is independent of the country timal economic policy response to the more rates? (in Slovene), GG, December, 23–44. economic development. In Slovenia, increased tax competition and falling such expenditures (for drugs and efficiency of the tax administration 3. Bole V., 1998, “Fiscal stance of the medical instruments) amounted to ap- general government and pension system” (in would be lower labour taxation (abol- Slovene), GG, June, 23–39. proximately 1.1% of GDP, in 2003. ishing payroll tax), and simplified cor- The development of Slovenia (meas- porate income tax (all tax incentives 4. Bole V., 1999, “Structure of the tax system ured by GDP/pc) is approximately EU accession” (in Slovene), GG, September, have to be suppressed). 25–44. (28/11=) 2.54 times lower than that Economic policy must neutralize 5. Bole V., 2002, “Potential Difﬁculties in the of Finland or Ireland. The volume of decrease in the tax revenue by reduc- the public healthcare expenditures in Administration of VAT at the Accession to the ing general government spending and EU”, www.eipf.si. Slovenia, that could be correctly used not by increasing domestic taxes on 6. Bole V., 2003, “Corporate income tax; in comparison of the efficiency of goods and services. A higher taxation public healthcare expenditures with analysis of investment incentives efﬁciency” of the consumption (VAT and excise) (in Slovene), GG, November, 25–60. the reference countries is, therefore, would be acceptable only in the case (5.6)2/(1.1*2.54+4.5)=4.3%. 7. Bole V., 2004, “Fiscal risks at entering of an increase in the consumption tax- euro and the general government The comparable volume of the ation in the euro countries or at least restructuring” (in Slovene), www.eipf.si. public healthcare expenditures is in the neighbouring euro countries. somewhat (by 0.3% or 0.7% of GDP) 8. Bole V. and D. Mramor, 2005, “Landing Economic policy will not be able Phase: Lessons from Slovenia”, will be lower than that in Ireland or Finland. to neutralize decrease in the tax reve- published in Medium-Sized Firms and Heuristically speaking, we can say, nue merely by increasing the efficien- Economic Growth, (ed. J. Prašnikar), Nova Science Publishers, 45–63. that in the case of the same efficiency cy of the public spending. It will be than in the reference countries, the necessary to cut actual level of the 9. Dennis I. and A.Guio, 2003,”poverty and public healthcare expenditures in public services. There is some room social exclusion in the EU after Laeken-part 1”, Statistics in focus, Eurostat Slovenia enables approximately 7%- for cutting general government spend- 16% lower healthcare quality than is ing at investments. But the bulk of the 10. Figura P., 2002, “European Union Tax Rate Harmony: an Unattainable and supplied by the most dynamic (small) public spending cutting would have to EU economies. Detrimental Goal”, New Eng. Journal of be made on transfers, to the business International and Comparative Law, Vol. 8, Since the volume of the sick allow- sector and households. 127–156. ances amounts to 13% of the public An increase in the social transfer healthcare expenditures, the public fi- 11. Gonzales-Paramo J.M., 2005, “Taxation, allocation efficiency (“database tax reform and monetary policy”,www.ecb.int. nancing of the healthcare services is crossings”) will not result in noticeable that much lower than the appropriate 12. IMF, 2002, »Republic of Slovenia; savings. It would be necessary to re- Strenghtening the VAT«, IMF. fiscal (tax) burden. To put it in other duce volume of the transfers. Apart words, if all the funds collected from 13. OECD, 2003, “Health at a glance”, from pensions, the smallest impact on OECD. the mandatory (public) health insur- the deterioration of the social protec- 14. Plichon C., 1999, “European tax ance had been used for the health- tion would have a reduction in other care service financing, the public harmonization”, Conjuncture, February, direct transfers that are not part of the 10–15. funds would have enabled (at the base social safety net. These transfers same spending efficiency) the same 15. Stiglitz J.E., 1988, “The General Theory accounted for approximately 2% of of Tax Avoidance”, National Tax Journal, 38, 33 See, for example, Bole (2004). GDP in 2004. 325–337.

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UDK 336.121:339.923:061.1EU:336.121(497.4) Relation between EU budget and Slovenian budget Monika Kirbiš *

When a country joins the s a full member of the EU, Slovenia pays monthly EU, budgetary cash flow mechanisms between the contribution to the EU budget from her own resources, EU budget (as the central subject) and national and receives compensations, payments for agriculture, budgets are established. Member States pay etc. from the EU budget. The greatest problem both for monthly contributions from their own resources Athe liquidity and general government budget position is the time into the EU budget, and on the other hand, they inconsistency between outflows and inflows of European funds. receive funds for the implementation of While the dynamics of contributions to the EU budget is set out common European policies. However, this system of payments has by European legislation (Council Regulation No 1150/2000 and some disadvantages, for instance the time 2028/2004) the dynamics of the majority of payments from the inconsistency between outflows to and inflows EU budget depends on the absorption capacity of each Member from the EU budget, high additional payments from State. In the first year of EU membership Slovenia’s absorption own resources at the beginning of a budgetary of European funds was below the forecasted amount. Therefore, year, etc. which may pose an additional burden on the net budgetary position fell short of expectations. the Member States’ budgets. The European This paper is divided into four parts. In the first part, we Commission tries to decrease this burden by look into some basic features of the EU budget, i.e. its structure, paying compensations during the first years of size and fundamental principles. The second part presents the EU membership. In 2004, Slovenia contributions to the EU budget, including some exceptions. We received SIT 3.4 billion more than it had contrib- also investigate the problem of paying interest on delays for uted to the EU budget. The net budgetary posi- payments to the EU budget. In the third part, we discuss the tion was positive but fell short of expectations. dynamics of transfers from the EU budget to the Slovenian Some European funds remained unused, mainly budget. Finally, the fourth part shows the net budgetary position because of low administrative absorption capac- of Slovenia for a 3-year period between 2004 and 2006. ity of Slovenia. Basic characteristics of the eu budget The EU budget differs from that of national governments’ in three fundamental aspects: it is more tightly regulated, it is

* Monika Kirbiš, M.Sc., Ministry of Finance of the Republic of Slovenia - The Treasury. Opinions and views expressed by the author are not necessarily those of the institution where the writer of this paper works.

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much smaller, and the pattern of Table 1: Budgetary cash flows between national budgets of member revenue and expenditure is completely countries and the EU budget between 2004 and 2006 different. The structure of European EU BUDGET REVENUE EU BUDGET EXPENDITURE budgetary cash flows is shown in OWN RESOURCES: 1. Agricultural policy (market related expend- Table 1.1 1. The VAT-based resources iture, direct aids, rural development) The size of the EU budget can 2. The GNI-based resources 2. Structural and cohesion policy (four struc- be seen from Figures 1–3. Figure 1 3. Traditional own resources tural funds: the European Regional shows total budgetary expenditure of – customs duties Development Fund, the European Social – antidumping and other product im- Fund, the European Agricultural Guidance all Member States, outflows of the EU port duties from third countries and Guarantee Fund, the Financial Instrument budget and EU’s GDP in the period – levies on agricultural products im- for Fisheries Guidance; cohesion fund) 1986-2002. Despite its political import from third countries 3. Internal policies (e.g. Schengen border in portance, the EU budget is quite mod- – levies on sugar, isoglucose and in- Slovenia) est in size. This seems reasonable uline (sugar levies) 4. External actions 4. United Kingdom correction (also 5. Administration since it does not include expenditure UK rebate) 6. Reserves for public services, social security 7. Pre-accession aid (for new Member States) OTHER REVENUE: proceeds form – SAPARD and sovereignty (Mrak and Rant, taxation on the salaries, wages and – ISPA 2004). Furthermore, loans may not allowances of EU staff, interests and – PHARE be taken to cover the EU budget defi- repayments, income from fines 8. Compensations (cash flow lump-sums, 2 cit. While the expenditure of the na- LOANS budgetary compensations) tional budgets represents nearly half Source: General Budget of the European Union for the Financial Year 2004 – The of EU’s GDP the outflows of the EU Figures (2004) budget represent only about 1% of EU’s GDP. Figure 1: EU-15 GDP and budgetary expenditure of the Member States As can be seen from Figure 2, and the EU between 1986 and 2002 (in billion EUR) only five national budgets were smaller than the EU budget in 2002, while the others were substantially larger, especially the German budget.3 Slovenian budget is comparable to the budget of Luxemburg and is approximately seven times smaller than the EU budget. In most EU Member States budgetary expenditure represents 40-50% of their GDP. The exceptions are Sweden and Denmark with the highest share of budgetary expenditure in GDP (nearly 60% of GDP) and Ireland with the lowest share (34% of GDP) (Figure 3). In Slovenia the budgetary expend- Source: Newcronos, Allocation of Operating Expenditure by Member State (1999–2003), iture represents approximately 43% Doménech (2004) and Ureel (2004). of GDP, which is the same as in Luxemburg. Figure 2: Budgetary expenditure in 2002 (in billion EUR)

1 For detailed presentation of the structure and the features of budgetary cash flows in the EU see Voje and Kirbiš (2003) and Kirbiš (2005). 2 Ackrill (1998) writes about the so-called balanced budget rule, which defines that operative expenditure (funds for agriculture, structural and cohesion policy, internal policies and compensations) shall not exceed total revenue of the EU budget in any year. Although the EU has the ability to borrow funds through, for example, the European Investment Bank, it cannot use this facility for deficit financing. 3 In 2004, the EU budget amounted to EUR 109.1 billion in commitment appropriations and to EUR 97.5 billion in payment appropriations. It represented 0.98% of EU’s GNI. Commitment appropriations are expenditure items identified in year 2004 when expenditure will be made in year 2004 and in the following years; the cost of programmes which last more than one year are also included. Payment appropriations are expenditure items identified in year 2004 when the expenditure is made in year 2004. The rule of the balanced budget applies only to Source: Newcronos, Allocation of Operating Expenditure by Member State (1999–2003), appropriations for payment. Doménech (2004) and Ureel (2004).

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The EU budget is governed by the – The principle of unity means that redeploy appropriations within the following fundamental principles all the EU’s revenue and expenditure budget adopted or call in additional (Griese, 1998; Ardy, 2001): must be brought together in a single resources. – The annuality principle means budget document. – The principle of universality is that the budget is adopted only for – The principle of equilibrium (also based on two rules: the rule of non- a period of one year, although the the principle of balance – see Note 2 assignment, which states that budget- financial perspective lasts longer and 3) requires estimated revenue for ary revenue may not be allocated to (seven years at the moment).4 a financial year to be equal to the ap- particular items of expenditure, and – Specification of expenditure propriations for payment of that par- the gross budget principle which means that each appropriation must ticular year. No funds may be bor- states that all revenue and expendi- have a given purpose and be as- rowed to cover a budget deficit. It is ture must be entered in the budget in signed to a specific objective in order possible that small deficits and sur- full without any adjustment against to prevent any confusion between ap- pluses might emerge but these are not each other. propriations, at both the authorisation allowed to cumulate. A surplus is en- and the execution stage, and thus to tered as revenue in the following Payments from the slovenian ensure that the budget as established year’s budget and any unforeseen ad- budget into the eu budget is quite unambiguous, and that it is ditional expenditure incurred in the executed in accordance with the course of the year must be financed Slovenia makes monthly entries of wishes of the budgetary authority. by an amending budget, which will the own resources to the Commission’s account opened at the Bank of Figure 3: The share of budgetary expenditure in GDP in 2002 (in%) Slovenia. Own resources may only be entered in Slovenian tolars and have the following dynamism: – VAT-based and GNI-based resources and UK correction are entered in the Commission’s account on a monthly basis, in twelfths, on the first working day of each month.5 Slovenia entered own resources for the first time on 3 May 2004; – entry of the traditional own resources in the Commission’s account shall be made at the latest on the first working day following the 19th day of the second month following the month during which the entitlement was established. Slovenia’s entry was recorded for the first time on 20 July Source: Newcronos, Allocation of Operating Expenditure by Member State (1999-2003) 2004. and Doménech (2004). For the specific needs of paying Figure 4: Monthly EU-15 budget cashflow – revenue (in million EUR) EAGGF Guarantee Section expenditure, pursuant to Regulation (EEC) No 1765/92 and depending on the

4 The duration of the next financial perspective will still be seven years (2007-2013). Afterwards, the Commission proposes to move towards duration of five years for better alignment with the duration of the mandates of the Commission and the European Parliament. Most Member States disagree with this proposal and want to preserve financial perspectives for duration of 7 years. 5 Since the EU budget is adopted in euros, the Commission converts twelfths into tolars. The exchange rate used for own resources is the one of the last day of quotation of the year, as published in the Official Journal of the European Communities, for the monthly call-ups of twelfths from February to December of the following year and the rate of the first day of quotation following 15 December for the January call-up. Therefore, the twelfth for January 2005 was converted into tolars at the exchange rate of 16 December 2004 (1 EUR = 239.78 SIT) and all other twelfths for 2005 at the exchange rate of 31 December 2004 (1 EUR = 239.76 SIT). Contributions (eights) for the period from May to December 2004 were converted at the Source: Administrative Conditions in the Area of the European Communities’ Own exchange rate of 31 December 2003 (1 EUR = Resources – Answers to Frequently Asked Questions (2003). 236.7 SIT).

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Community’s cash position, Member means that the difference between contribution from own resources to States may be invited by the common funds and cash requirements the EU budget (Table 2). Commission to bring forward by one is shared among the Member States or two months in the first quarter of according to their shares in planned Interest on delayed payments the financial year the entry of one- budgetary revenues. In addition, due twelfth or a fraction of one-twelfth of to earlier entries, commitments in the Because of the unfavourable li- the amounts in the budget for VAT following months are adequately re- quidity position of the national budget and GNI resources (Council duced. This view is supported by or other reasons, a Member State Regulation No 2028/2004). Figure 4, which shows monthly cash may become unable to enter own re- Individual quarterly entries should not flows of the EU budget for the period sources in the Commission’s account exceed the planned budget. 2000–2002. Payments are always in due time. In this case the Member With the wisdom of hindsight, the the highest at the beginning of a year, State has to pay interest according to assumption about early pre-payments particularly in January, whereas in the Council Regulation No from own resources is sound, because the middle of a year (in July, August 2028/2004. in order to finance the Common and/or September) they are usually In the case of Member States be- Agricultural Policy (CAP), the extremely low. longing to the EMU, the interest rate Commission is likely to need more re- Slovenia had to make additional shall be equal to the rate as pub- sources than the available amount on payments to the EU budget in the first lished in the Official Journal of the its account at the beginning of a fiscal months of 2005, which had an unfa- European Union, C series which the year. The Commission frequently in- vourable effect on the national budg- European Central Bank applied to its vites the Member States to enter addi- et’s liquidity. This was especially refinancing operations, on the first tional money from VAT or GNI re- problematic in January when we had day of the month in which the due sources in January or February (not to pay a whole amount for January date fell, increased by two percent- more than five twelfths in the first and February and also half of the age points. This rate shall be in- three months), taking into considera- contribution for March. However, in creased by 0.25 of a percentage tion payment appropriations and the the first quarter of 2005, Slovenia point for each month of delay. The in- Community’s cash position. This paid about one third of its annual creased rate shall be applied to the entire period of delay. Table 2: Payments from own resources in the first quarter of 2005 (in million SIT) In the case of Member States not belonging to the EMU, the interest rate shall be equal to the rate applied on the first day of the month in question by the national central banks for their main refinancing operations, increased by two percentage points, or, for the Member States for which the central bank’s rate is not available, the most equivalent rate applied on the first day of the month in question on the Member State’s money market, increased by two percentage points. Note: Monthly plan = one-twelfth of the yearly amount estimated in the Slovenian budget for 2005. This rate shall be increased by 0.25 Source: Budget of the RS for the Year 2005 (2003) and Ministry of Finance of the RS. of a percentage point for each month of delay. The increased rate shall be Table 3: Interest rates on delays for Member States not belonging applied to the entire period of the to the EMU delay. Table 3 shows the interest rates used in calculating interest on delays for states not belonging to the EMU. The lowest interest rate, which is practically the same as the refinancing interest rate of the European Central Bank, can be found in Sweden and Czech Republic (2%), and is the highest in Hungary (7.75%). With the interest rate of 3.5% Slovenia ranks among the top countries in terms of relatively high delay interest rate – in April 2005, nineteen EU Member States had a lower interest rate than Slovenia. Voje and Kirbiš (2003) stress that if Slovenia had belonged to the EMU Source: Central Banks of the EU Member States (2005). in 2004, the rate of interest charged

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on its outstanding duties would have executing the state budget (compen- new Member States. Compensations been approximately 20% lower than sations) and to other sub-accounts are paid in twelfths, usually on the it is at present. Nevertheless, no late (other funds) within the single treasury first working day of a month. payments interest has been paid so account.6 These sub-accounts belong The first such inflow to the state far since all entries of the own re- to the Republic of Slovenia and not to budget was realised on 29 April sources in the EU budget have been the Commission like own resources 2004, despite the fact that it was made at the scale and under the account held at the central bank. planned for 3 May 2004, at the terms set out by the Commission. Transfers are made in euros. same time as the entry of the twelfths Among the payments from the EU in the EU budget. It should be pointed Payments from the eu budget budget, only cash-flow lump sums and out that in order to manage the liquid- into the Slovenian budget budgetary compensations have a ity of the budget, it is necessary to known scale and time frame and aim make and receive payments on the The Commission transfers to ease the accession to the EU and planned day. By taking into account European funds to a sub-account for decrease the financial burden for the the planned budgetary cash flows the state treasury manages the liquidity of Table 4: Budgetary cash flows between the Slovenian the national budget (borrows money and the EU budget in 2004 (in million SIT) or places surplus money in money markets). This means that, in terms of liquidity, it would be better if payments of compensations to the state budget were made on the agreed day, that is, on the first working day of the month.7 The extent and dynamics of all other inflows are highly unpredicta- ble, which causes some problems in planning and managing the liquidity of the national budget.

6 The single treasury account is managed by the Bank of Slovenia and its sub-accounts by the Public Payments Administration of the Republic of Slovenia. For more information about the system of European accounts see Voje in Kirbiš (2004) and Kirbiš (2005). 7 The Commission usually makes payments for compensations in advance, because some countries may otherwise experience liquidity problems and may not be able to fulﬁl their obligations towards the EU budget in due time.

Note: Payments of compensations to the state budget were usually made before the agreed date (except those for June) – also in December 2004, when we received compensations for January 2005. Pre-accession aid amounted to SIT 10.9 billion (Phare: SIT 6.2 billion, Sapard: SIT 2.8 billion, Ispa: SIT 1.9 billion). Source: Kirbiš (2005).

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Slovenia’s net less than expected. Payments from the depends on the absorption capacity budgetary position VAT and GNI resources were lower, of each Member State. in the period 2004-2006 since the delegation of the Republic he EU-10 may have some prob- of Slovenia reached an agreement lems with administrative and financial It was planned that Slovenia’s con- about lowering the GNI base for absorption capacity of the European tribution to the EU budget would 2004 at the Advisory Committee on funds.8 In line with EU legislation, ab- amount to SIT 45 billion in 2004 (of Own Resources (ACOR). sorption of European funds is based which SIT 6.6 billion from VAT re- In 2005 and 2006, contributions on refunds, which means that the sources, SIT 31.3 billion from GNI re- to the EU budget will gradually in- Member States make advance pay- source, SIT 3.5 billion for the UK cor- crease. In 2005 and 2006, outflows ments from their domestic budgets to rection and SIT 3.6 billion from the are likely to amount to SIT 76.3 billion finance certain activities and receive traditional own resources), while its and SIT 79.7 billion, respectively. The refunds from the EU budget (ex-post entitlement from the EU budget was structure of outflows will probably re- reimbursement of incurred expenses). expected to add up to SIT 65 billion. main unchanged through the whole The time mismatch between contribu- Had these assumptions become reali- period, with GNI as the most impor- tions to the EU budget and incoming ty, Slovenia’s net budgetary position tant source to tap (Figure 5). transfers depends mainly on the would have been nearly SIT 20 billion Payments from the EU budget dur- Commission’s and Member States’ (Table 4). ing the period 2005–2006 will be control procedures, which usually However, Slovenia received in higher than in 2004. In 2005 and take a long time to be completed. 2004 only SIT 3.4 billion more than it 2006, the inflows are likely to total 8 Three specific definitions of absorption had contributed to the EU budget. The SIT 91.4 billion and SIT 93.6 billion, capacity can be found in Horvat (2004) and net budgetary position was worse respectively. Šumpíková, Pavel and Klazar (2004): than expected, mainly due to lower By taking into account these as- 1. Macroeconomic absorption capacity can be defined and measured in terms of GDP levels to inflows from the EU budget – we re- sumptions, Slovenia’s net budgetary structural funds allocated. The upper limit for the ceived only SIT 44 billion of inflows. position in 2005 and 2006 would be absorption of structural and cohesion funds is At this point we have to stress that the around SIT 15 billion. However, in the generally set at 4% of the respective Member State’s GDP. situation would have been different light of the payments made in 2004, 2. Administrative absorption capacity, which had there been no compensations we should ask ourselves if these fore- can be defined as the ability and skills of and pre-accession aid, which repre- casts are still realistic. We should central, regional and local authorities to prepare acceptable plans, programmes, and sented 86% of all inflows. In that case stress that both compensations and projects in due time, to decide on programmes Slovenia would have become a net pre-accession aid are to decrease and projects, to arrange co-ordination among contributor to the EU budget in the over the next couple of years, whereas the principal partners, to cope with the vast amount of administrative and reporting work very first year after the accession. all other inflows are likely to increase. required by the Commission, and to finance and Until now we have not received any The main problem among future supervise implementation properly, avoiding money from the structural and cohe- payments from the EU budget will fraud as much as possible. 3. Financial absorption capacity, which means sion funds and that could affect our probably still represent funds for struc- the ability to co-finance EU-supported position when negotiating the new tural and cohesion policy. The programmes and projects, to plan and financial perspective (2007–2013). Member States receive these funds to guarantee these national contributions in multi- annual budgets, and to collect these However, Slovenia contributed in finance projects approved by the contributions from several partners (public and 2004 to the EU budget SIT 4 billion Commission. The extent of the funds private), interested in a programme or project.

Figure 5: Expected budgetary cash flows between the Slovenian and the EU budget in 2005 and 2006 (in million SIT)

Note: There is a great possibility that inﬂows shown in italics (market related expenditure, rural development, structural funds, cohesion fund) are not paid in full or in due time. Source: Pre-accession Economic Programme (2003).

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Summary and conclusions these changes might be difficult, at 11. Council Regulation (EC, Euratom) No least in the short-run. In spite of that, 1150/2000 of 22 May 2000 Implementing Decision 94/728/EC, Euratom on the As regards Slovenia, membership the budget proposal for the next finan- of the EU has posed an additional System of the Communities’ Own Resources cial perspective is aimed mainly at the (Official Journal of the European burden on the budget. In 2004, its development, since its priority is to Communities, 2000/L 130/1). net budgetary position was positive, achieve a higher economic growth 12. Council Regulation (EC, Euratom) but worse than expected. According and employment in the EU. The EU No 2028/2004 of 16 November 2004 to the plan Slovenia should remain a should become an effective and equal amending Regulation (EC, Euratom) net receiver of EU funds also in this partner to the rest of the world. No 1150/2000 implementing Decision and the next year. Since Slovenia is 94/728/EC, Euratom on the system of the In addition to changes among Communities’ own resources (Official one of the most developed newcom- transfers from the EU budget, the Journal of the European Communities, ers to the EU and given the fact that Commission also proposes some 2004/L 352/1). pre-accession aid and compensations changes of the own resources system, 13. Doménech Rafael. http://iei.uv.es/ will be reduced over the following i.e. the introduction of some new ~rdomenec/EUbudget/EUbudget.html [cit.: years, we can assume that in the next taxes. Three main candidates as tax- 14.3.2004]. financial perspective (2007-2013), it based own resources are the national 14. Euro Exchange Rates (Official Journal of will not be an easy task for Slovenia VAT, the corporate income tax and the European Communities, 2004/C 1/03). to achieve a favourable position as in the energy tax. In addition, the 15. Euro Exchange Rates (Official Journal the first period. That would only be Commission proposes the replace- of the European Communities, 2004/C possible in the case of very successful ment of the UK rebate by a general- 312/01). negotiations with the Commission, ised correction mechanism, which 16. Euro Exchange Rates (Official Journal of high absorption of EU funds, by get- would be triggered in all Member the European Communities, 2005/C 1/02). ting more money to realize main pri- States beyond a certain threshold, ex- 17. General Budget of the European Union orities of the EU for this period (for in- pressed as a percentage of each for the Financial Year 2004 – The Figures. stance research and development) Brussels: European Commission, 2004. state’s GNI. 23 p. and by increasing funds for internal While the reform of the European policies (Schengen facilities). Taking 18. Griese Antonia: Die Finanzierung der payments system might be very ex- Europäischen Union – Bestandsaufnahme into account the fact that more coun- pensive and depends on the political und Ausblick. Europarecht, Bonn, 1998, 4, tries will be entitled to the same scale will and negotiations with the p. 462-477. of EU funds, whether Slovenia re- Member States, it is simply impossible 19. Horvat Andrej: Absorption Problems in mains a net receiver from the EU to predict when and to what extent all the EU Structural Funds – Some Aspects budget or not, is difficult to answer these changes will be realized. Regarding Administrative Absorption with certainty. Capacity in the Czech Republic, Estonia, The EU as a whole will also have Hungary, Slovakia and Slovenia. Ljubljana: BIBLIOGRAPHY AND SOURCES: National Agency for Regional Development to cope with some challenges over the 1. Ackrill Robert: The European Union Budget, of Slovenia, 2004. 35 p. forthcoming years. One of the most the Importance of the Balanced Budget Rule 20. Internal data and publications of the important challenges is its further en- and the Future of the Rule under Economic Ministry of Finance of the Republic of largement to the east. There are five and Monetary Union. Leicester: Centre for Slovenia. European Economic Studies, 1998. 25 p. more countries queuing for the EU 21. Kirbiš Monika: Javnofinančni denarni membership and they could be eligi- 2. Administrative Conditions in the Area of tokovi v Evropski uniji in likvidnost ble as early as in the period 2007- the European Communities’ Own Resources – državnega proračuna. Master’s thesis. 2013: Bulgaria and Romania as the Answers to Frequently Asked Questions. Ljubljana: Faculty of Economics, 2005. Brussels: European Commission, 2003. 51 p. forerunners with Croatia, Macedonia 93 p. and Turkey following in their footsteps. 3. Allocation of 1998 EU Operating 22. Mrak Mojmir, Rant Vasja: Vsebinski Expenditure by Member State. Brussels: Undoubtedly, that will be an addition- izzivi razširjene EU in nova finančna European Commission, 1999. 97 p. perspektiva. Bančni vestnik, Ljubljana al drain on the EU-25 budget. Since 4. Allocation of 1999 EU Operating 53(2004), 5, p. 117-125. the differences in the level of develop- Expenditure by Member State. Brussels: 23. Newcronos – Eurostat’s database. ment between the Member States are European Commission, 2000. 125 p. already big, some new ideas and 24. Pre-accession Economic Programme. 5. Allocation of 2000 EU Operating Ljubljana: Government of the Republic of propositions have been voiced about Expenditure by Member State. Brussels: Slovenia, 2003. 68 p. the EU budget restructuring. While in European Commission, 2001. 126 p. 25. Šumpíková Markéta, Pavel Jan, Klazar the previous financial packages ex- 6. Allocation of 2001 EU Operating Stanislav: EU Funds: Absorption Capacity penditure on agriculture accounted for Expenditure by Member State. Brussels: and Effectiveness of Their Use, with Focus on more than half of the budget, it should European Commission, 2002. 129 p. Regional Level in the Czech Republic. not be the case in the forthcoming pe- 7. Allocation of 2002 EU Operating Prague: Grant Agency of the Czech Republic, 2004. 14 p. riod as the payments will be gradually Expenditure by Member State. Brussels: European Commission, 2003. 130 p. reduced and allocated to new, more 26. Ureel Johan: lecture notes, 2004. market-oriented activities (especially 8. Ardy Brian: The EU Budget and EMU. 27. Voje Jerica, Kirbiš Monika: Denarni London: European Institute, 2001. 28 p. rural development). There are also tokovi v Evropski uniji in likvidnost some ideas about a complete abolish- 9. Budget of the Republic of Slovenia for the proračuna. Bančni vestnik, Ljubljana, Year 2005 (Official Gazette of the Republic 52(2003), 12, p. 2-8. ment of direct aids to large farmers. of Slovenia, No 130/2003). However, since the EU faces pressure 28. Voje Jerica, Kirbiš Monika: Račun 10. Central Banks of the EU Member States. Evropske komisije za nakazila sredstev iz from strong agriculture lobbies and http://www.centralbanking.co.uk/links/ lastnih virov. Bančni vestnik, Ljubljana Member States’ national interests, [cit.: 14.04.2005]. 53(2004), 4, p. 10-14.

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UDK 336.711(497.4):336.781:339.738:061.1EU Interest rates after ERM II entry Božo Jašovič and Boštjan Jazbec *

Following entry into ERM ess than two months after the EU accession, Slovenia II the monetary policy focuses on exchange rate joined the European exchange rates mechanism (ERM stability while interest rate policy remains II), a mandatory phase before the euro adoption. It is a subordinated to exchange rate policy. Therefore, in framework for the exchange rate regimes of those order to ensure macroeconomic stability LMember States that have not yet introduced the euro as their and continuation of the disinflation trend, fiscal currency. ERM II participation reduces monetary policy and revenues policies will have to either prevent or autonomy and at the same time is the test of the capacity for respond to shocks hitting the economy. For the appropriate functioning of other macroeconomic policies for monetary policy the room for the manoeuvre is ensuring price stability and maintaining macroeconomic limited to the risk premium yet tolerated by equilibrium. Fiscal and revenue policies supported by long-term the market which reflects the currency and the structural policies are seen as crucial to the process. country risk. In addition to that, the transmission During the stay in ERM II, the Bank of Slovenia focuses on mechanism of monetary policy is further impaired exchange rate stability; hence it tailors its measures to meet this by the fact that the degree of euroisation in goal. On the other hand, other macroeconomic risks lurk on the economy is increasing. The process of further road to the euro adoption (e.g. inflation risk) threatening the nominal and real convergence will successful introduction of the single currency. To respond undoubtedly enhance the competitive position of appropriately to such risks and to prevent any inflation shocks is financial institutions and provide the ground for of key importance. However, when it comes to assuring exchange sustainable economic growth in a catching up rate stability, monetary policy has little influence on inflation, process. while interest rate policy is subordinated to exchange rate stability and thereby its care over channelling mid-term inflation movements is encroached upon. For that reason a precondition for entering ERM II was the introduction of a program for the alignment of economic policies, where the government binds itself, that the fiscal policy will support the preservation of price stability.1 In the second part of the paper we will try to find out,

* Božo Jašovič, M.Sc., and Boštjan Jazbec,Ph D, Members of the Governing Board of the Bank of Slovenia 1 Report on Monetary Policy. Bank of Slovenia, April 2005.

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where the boundaries of the monetary est rates predominantly connected to however, the cause-effect connections policy in the time of stay in ERM II lie, changes in the ECB interest rates. can be extremely numerous and as a and what is its reach in the time prior Concerning the future changes in the rule functioning very differently under to the introduction of a single risk premium itself we can according different circumstances. Generally currency. Convergence of the interest to past experience also conclude that speaking, it holds true that the inter- rates adaptation after entering ERM II it will decrease as we are approach- est rates on the money market influ- will be presented in more detail and ing the introduction of the euro and ence the credit and deposit interest some possible dangers prior to the at the moment of introduction also ul- rates, the expected changes in inter- final introduction of the euro warned timately disappear. Domestic interest est rates influence the long-term mar- against. Special attention will be rates can therefore differ from the ket interest rates, and all together in- dedicated to the consequences of the ECB interest rates only for the size fluences the other economy variables, increased competition pressures on thus defined risk premium. The inter- such as the prices of bonds and the Slovenian financial market. est rates policy that would deflect shares (equity prises) and real estate from the boundaries described would prices, exchange rates, saving and Monetary Policy sooner or later endanger the ex- spending, investment decisions and Transmission Mechanism change rate stability. last but not least aggregate economic We may wonder whether by activity and the price level or infla- The participation in ERM II has means of steering the nominal interest tion. Thereby it is necessary to point brought a number of changes in the out that the above-described chain of principles of the workings in mone- cause-effect connections does not tary policy and exchange rate policy. work only through changes in interest The activity of the central bank in a By adopting rates, but to a relevant extent also way that ensures the maximum ex- through expectations. central bank, change rate stability superficially re- which enjoys a high rate of credibility sembles the fixed rate regime. Even if euro we are concerning the ensuring of price sta- exchange rate stability becomes a bility, can exercise a fairly direct in- partial and operative aim of the mon- also going to fluence on the expectations of eco- etary policy, that does not offer a nomic agents concerning the future guarantee of its unconditional de- adopt common inflation and thereby their decisions fence of the narrow band, but only when determining prices, salaries the limit values of the standard band and other market variables. +/– 15%. In this light we can classify monetary It is an extremely difficult task to the ERM II inside the classification of define precisely the monetary trans- exchange rate regimes as a target policy managed mission channels. The process is usu- zone regime.2 The exchange rates ally extremely complex and the policy in such cases cannot be entire- cause-effect chain works with delays ly independent, but is to a large ex- by ECB. and decreasing strength. Also other tend subordinated to the achievement shocks that the economy is continually of the desired external value of the subject to can influence the same vari- tolar. An attempt to achieve the inner rates during the stay in ERM II mone- ables as the monetary policy does, balance through the changes in do- tary policy has some room for ma- and even further obscure the cause-ef- mestic interest rates would result in noeuvre.3 fect correlations. Even the empirical an increased inflow/outflow of inter- Taking into consideration all of the models, which try to identify and est-elastic financial flows and as a above we can start asking ourselves quantify the respective channels of final consequence a pressure on ex- whether such a limited change in in- transmission mechanisms, can only change rates. The key interest rate for terest rates can have a discernable in- partially explain the complex mone- the withdrawal of base money in fluence at all? Or, to put it in other tary transmission. The numerous em- Slovenia is therefore the same as the words, how strongly can channels of pirical experiments have in common ECB (euro area) interest rate, in- monetary transmission work in the cir- especially one thing – they are prov- creased by the risk premium, which cumstances described? ing the neutrality of the monetary pol- reflects the perception of the investors The monetary policy transmission icy in the long run: its influence on the concerning partial in foreign curren- begins with the changes in the inter- aggregate product is only temporary, cy risks. The key issue is, how high est rates on the operations carried whereas the impact on the prices is the risk premium can be and what out by the central bank. Considering permanent (ECB, 2004). The size and changes we can expect? An analyti- the fact that the central bank is a mo- dynamics of the influences of mone- cal answer would exceed the scope nopoly institution, issuing base tary policy on other economic varia- of this paper, so only an intuitive money, it is by definition independent bles are however differing from standpoint is offered here (Jašovič, in the determining of interest rates for model to model, which reflects a high 2004): if on the foreign exchange its instruments, through which it degree of uncertainty concerning the market stability prevails, then the sends/places money into circulation, given level of interest rates includes a or withdraws it from circulation (ECB, 2 For more information see Ribnikar (2004). premium, expected from the side of 2004). Its interest rates have a most 3 Danish central bank, with its long participation direct influence on the money market in ERM II, frequently changes interest rates of market participants and are therefore her own operations in order to ensure price and the future changes in domestic inter- interest rates, and from there on, exchange rate stability .

36 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

pinpointing of the exact qualities of Through the key interest rates the the market participants. Thereby it is transmission mechanisms. Especially signals are transmitted to the market worth mentioning that the key interest due to the fact that the impulses of the through the interest transmission chan- rates of the Bank of Slovenia that ex- monetary policy work with delays nel, which influences the behaviour of ercise the strongest influence on other and with a decreasing strength, and that simultaneously the same econom- Figure 1: Movements in the 60-day tolar bill, ic variables are subject to also other short-term credits and deposits influences (shocks), must the monetary policy when ensuring the price stability be oriented mid-term wise. Namely, an excessive short-term activ- ism could introduce an even stronger variability into the functioning of the economy.

Movements of Some Interest Rates before and after Entering into ERM II

In the following part we will through comparison of the temporal series of some interest rates try to establish whether the data show the possibility of existence of an interest- rate channel of monetary transmission. In regard to this, it has to be em- Source: Bank of Slovenia phasized that we will not try to prove the cause-effect relationship empiri- Figure 2: The movements of the refinancing interest rate and SIONIA cally, but merely show the fluctuation of different interest rates in a shorter time frame, which can serve only as a confirmation of the assumption about the correlation between the market interest rates and the central bank ones. The Bank of Slovenia had been gradually decreasing the key nominal interest rates (see Figure 1) in accordance with the disinflation trend and through reducing the level of depreciation of the tolar, which was closing the gap between domestic and foreign interest rates, even prior to the ERM II entry. The monetary policy had through the channelling of the real interest rates influenced aggregate activity and mid mid-term inflation dynamics.4

4 Monetary Policy Report. Bank of Slovenia, April 2005. Source: Bank of Slovenia

Table 1: Changes in some Key Interest Rates of the Bank of Slovenia for 2004 and 2005

7.4. 9. 1. 6. 2. 5. 3. 18. 3. 2. 4. 7. 5. 4. 6. 17. 6. 28. 6. 2. 7. 23.12. 2005 Lombard Loan 7.00 6.75 6.25 5.75 5.50 5.00 Foreign Currency Bill Repo, 7 days Repurchase facility for Foreign Currency, 7 days 2.75 2.50 2.25 2.00 1.75 1.50 1.00 1.25 1.50 Reselling Facility for Foreign Currency, 7 days 1.50 1.00 0.75 0.50 0.25 1.00 Refinancing interest rate 4.75 4.50 4.25 4.00 3.75 3.50 3.00 3.25 3.50 Overnight deposit 2.75 2.50 2.25 60- Day Tolar Bill 5.75 5.50 5.25 4.75 4.50 4.25 4.00 270-Day Tolar Bill 6.50 6.25 5.75 5.50 5.00 4.75 4.50 4.25 Source: Bank of Slovenia

BV 7-8/2005 37 ON THE ROAD TO CONVERGENCE

interest rates are the refinancing inter- the tolar. Interest rates for foreign currency as soon as possible already est rate, according to which banks rency credits are predominantly regu- alone incites a greater proportion of can acquire liquidity from the central lated by foreign markets and are the borrowing in euros and also the eu- bank, and the interest rate of 60-day result of the functioning of transmis- roization process itself. The data for tolar bill, with which the Bank of sion mechanisms of other central past periods show a tendentious in- Slovenia withdraws money from the banks. The possible differences be- crease of the foreign currency credit circulation. Taking into consideration tween domestic and foreign ex- share, which in year 2004 exceeded the fact that the money market in change rates depict among the rest 77% of the credits, granted to non-fi- Slovenia is in structural surplus central foreign currency and country risks nance companies in that year. At the bank has to withdraw money predom- and last but not least also the costs of population crediting the tendency is inantly from the circulation, which ap- transition from foreign to domestic similar, only that the share of credits pears as the result of autonomous for- currency and vice versa, in cases granted in foreign currency in the past eign currency transactions between when residents run into debt in for- year was lower than with companies. respective banks and the Bank of eign currency. The independence of the mone- Slovenia, is the interest rate of the 60- The Bank of Slovenia with its inter- tary policy of the Bank of Slovenia is day tolar bill one of the more impor- est rate policy and hence cannot influ- defined by 2 determinants: First, the tant ones for market participants: the ence the terms of borrowing in for- space for the independent changing data for the last 9 quartiles show that eign currencies. Thereby we can ask of interest rates is practically limited the above-mentioned interest rate to the size of the’ premium’ reflecting serves as a benchmark for determin- the difference between domestic and ing credit and deposit interest rates , foreign interest rates, still accepted by which can be seen from the series , In comparison the market. Secondly, the power of shown in Figure 1. Banks in Slovenia monetary transmission is even further are to a much larger extent kept busy impaired by the increasing level of by the issue of investing surplus liquid- with eurozone europeization and the decrease in the ity, rather than with the issue of ac- area under the influence of the do- quiring the necessary liquidity for the interest rates, mestic monetary politics. financing of their investments. Even By adopting the euro we are also more direct is the transmission of the tolar interest going to adopt common monetary central bank interest rates on the policy, which is under the compe- money market that then further influ- tence of the ECB. As a precondition ence other interest rates. For the illus- rates are for the entry, Slovenian economy tration of this view in Figure 2, we must also structurally resemble to a have compared the refinancing inter- still higher sufficient degree the economies of est rate–an interest rate, according to the existing members of the EMU. which banks can acquire a temporary Therefore we must in this time fulfil liquidity from at the central bank, with by one to two the monetary and fiscal Maastricht interest rate for uninsured interbank criteria and, apart from that, prove credits overnight– SIONIA. Periodical percentage convergence through a two-year par- deflections of the above-mentioned in- ticipation in ERM II. However, the ful- terest rate downward typically occur points. filment of Maastricht criteria does not at the end of the periods of the oblig- yet mean our alignment with the atory reserve maintenance, when European average in a way for all banks are facing excessive liquidity. ourselves about the scope of the resi- the measures of the ECB – which at Otherwise also this interest rate fluctu- dents’ borrowings in tolars that is determining the uniform monetary ates similarly to the refinancing inter- about that segment of the credit mar- policy takes decisions on the basis of est rate, determined by the Bank of ket that the influence of the domestic average values of macroeconomic Slovenia. interest transmission can at least po- aggregates of EMU-will be entirely When observing the movement of tentially reach. suitable to structural particularities of SIONIA we can towards the end of The residents’ borrowing in foreign our economy. To put it in other the observed period notice even a currencies is on the increase and is words, the common monetary policy slight tendency in its increase, which the result of numerous factors one of cannot be entirely effective if the av- is connected to structural adjustment the most relevant among which is the erage conditions on the European of the foreign currency repurchase fa- difference between domestic and for- money market will not correspond cility price (in December and April), eign interest rates, which in the eyes with Slovenian ones. The suitability which also resulted in an increase in of the residents exceeds the accepta- and effectiveness of mutual monetary refinancing interest rate.5 ble ‘premium’. Another reason for the policy, generally speaking, depends Considering the data shown, on frequency of borrowing in foreign cur- 5 The purpose of the structural adjustment of the the basis of which it is possible to rency is the fact that it offers to com- foreign currency repurchase facility prices was conclude about the functioning of in- panies that realize the majority of to make the effective price of temporary tolar liquidity , acquired by banks at the Bank of terest rate transmission in Slovenia, their revenue on foreign markets, a Slovenia,become similar to the 60-day tolar bil we have not put a special emphasis natural hedge against the currency interest ratel. Efective price of temporary tolar on the fact that the Bank of Slovenia liquidity equals the EURIBOR iterest rate, risk. Last but not least, the determina- increased by proﬁt margin and foreign currency can only influence the interest rates of tion to adopt the euro as a single cur- repurchase facility price.

38 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

upon the fulfilling of three conditions will also after the adoption of the euro term, as they can in contrary case en- (Jazbec and Masten, 2004). The first in Slovenia signify lower real interest danger the financial position of some of those conditions is the coordina- rates in the countries with faster eco- banks at the moment of adopting the tion of the direction of the changes in nomic growth and higher inflation lev- euro. In a specific way activity in interest rates with the business cycles els. In Slovenia, however, after enter- Slovenian banking space resembles of respective economics. Second, the ing into ERM II foreign exchange rate the processes in other economies in changes in THE ECB interest rates mechanism, two processes have start- transition, when especially foreign have to be adequately high in order ed: first, the migration of savings and banks are establishing their position to have the foreseen macroeconomic borrowing in tolars into euros, and on local markets. In this way they indi- effects. That can be achieved only if second, an aggressive cutting of inter- rectly and directly increased their ac- the transmission mechanisms of mon- est rates on euro-denominated instru- tion effectiveness of domestic banks etary politics between the economies ments, which in specific segments of and financial institutions, which is hap- are similar. The third condition for the the market led to lower than average pening in Slovenia as well. suitability and efficiency of mutual interest rates even below the EMU av- In comparison to euro exchange monetary policy is an effective influ- erage. The accelerated euroization of rates, the tolar exchange rates are ence of fiscal policy on aggregate the Slovenian financial market is ex- still lower by one to two percentage demand. The fulfilment of this condi- pected and will to a great extent even points. This difference to a large ex- tion serves in the first place as an aid enable an easier introduction of euro tent reflects the interest rates policy with the reduction of possible prob- that the Bank of Slovenia has been lems with uncoordination of the trans- carrying out since the ERM II entry. mission mechanisms of the ECB mon- Irrespective of the great involvement etary policy within the respective Mostly of Slovenian economy into the Member States. Generally speaking European financial market, and at we can say that Slovenian economy least formally complete capital mobili- is fulfilling all three conditions, which foreign-owned ty, it is evident after a year’s stay in means that we can since the time of ERM II that the differences between entering into ERM II recognize some banks are euro and tolar interest rates on the processes that help increase the con- Slovenian financial market reflect a vergence coordination of Slovenian in the market bigger share risk of Slovenian econo- economy with the European average. my. As already mentioned, this can Consequently, the processes of the be on one hand a consequence of the nominal interest rates convergence with lower transitional history of Slovenian econ- are of particular interest, and along- omy, whereas on the other hand this side other requirements the participa- interest rates. difference is determined by a number tion in ERM II brings, will be shaped of factors, among which we can un- by competitive pressures on the finan- doubtedly include the small size of cial market. in January 2007. The processes of in- economy and its relatively weak inter- creased euroization took place also in national recognition. Despite all that, The convergence other present members of the euro however, the difference in interest area and as such represent in the first rates will, until the final adoption of of nominal interest rates place rational expectations of the eco- euro, decrease and finally disappear The changes in nominal interest nomic subjects, who through the use when he tolar is no longer our curren- rates in Slovenia had in the past not of the euro safeguard their claims and cy. On the basis of the experience of been coordinated with the changes in liabilities. At the same time they repre- other countries, whereby we are in EMU members. This is not really sur- sent a faith in the bearers of economic the first place thinking about Greece, prising, as Slovenia had a transitional- policy to carry out all of the processes who adopted euro later than the orig- ly specific movement of economic and fulfil the measures, required for inal eleven members of the euro area, growth and inflation. Entering the EU the adoption of euro. Whereas the in- we can expect a further decrease in and EMU was supposed to accelerate creased euroization represents an ex- the lowering of the tolar interest rates further coordination of business cycles pected response of the economy, the in the second half of the next year at of European and Slovenian economies decrease in euro interest rates on the the latest, when we know for sure and an even higher level of financial other hand is to a large extent the re- when the adoption of euro is possi- integration of Slovenian economy with sult of the competitive struggle of ble. Because of the process of the in- the European. An important question banks in the direction of the increase crease in euroization of Slovenian regarding the common monetary poli- in market shares. From the view of the economy, the decrease in the tolar in- cy of EMU is above all the suitability customers and the economy the lower terest rates will be merely a technical of the general level of the interest interest rates are by all means a wel- procedure, with no great impact upon rates, which will be determined by come change in convergence process the leading and carrying out of mone- THE ECB. Together with other new Slovenian economy, but the excessive tary policy before the final adoption Member States, Slovenia will for some increase in market shares of some of euro. years be achieving higher average banks on the account of lower interest In spite of the general decrease in levels of economic growth. Therefore rates negatively influence the financial interest rates and their convergence the uniform nominal exchange rates, stability frame in Slovenia. Fortunately with the euro area levels, we can still determined for the entire EMU area these processes can be only short- observe in Slovenia relatively higher

BV 7-8/2005 39 ON THE ROAD TO CONVERGENCE

interest rates for housing loans. Those corporate loans and housing loans. market. Namely, the lower interest are higher as well on granted tolar– On the right-hand side the interest rates on the market are offered pre- as well as euro– loans and to a great rates are denominated in tolars, dominantly by foreign-owned banks. extend depict the problems of the whereas on the left side the interest The difference in behaviour between Slovenian real-estate market. In spite rates on loans, granted in euros, are Slovenian and foreign banks can be of all that we can also concerning in- shown. determined also according to the terests on housing loans expect a fur- However, the movement in the av- branch loan structure or segmental ther convergence on the level with the erage interest rates illustrated in customers, financed by banks in one in the euro area. Figure 3 illus- Figure 3 does not reveal that an im- Slovenia. Slovenian banks have in trates customer loans interest rates, portant activity on Slovenian financial comparison to other banks in Slovenia

Figure 3: The comparison of Slovenian and euro area loan interest rates

Source: Indicators of Monetary Politics, Bank of Slovenia, May 2005

40 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

on average a higher credit exposure EMU. In this case entering into EMU Considering the fact that the opera- to industries, whose products are con- has contributed to a faster real conver- tive goal in the activity of Bank of sumer cyclical goods (car industry, gence through faster adaptation of fi- Slovenia is the ensuring of a stable tourism and leisure, and transport), nancial markets and financial institu- exchange rate, it is almost running out which increases the sensitivity of tions. Taking into account the rapidity of space to change its interest rates, banks to credit risk according to the factors of the influence of the single which would enable it to influence the phase of the economy cycle.6 Over a monetary policy we can conclude that mid-term inflation dynamics. All of its longer period of time therefore the be- in Slovenia7 this influence will be rela- room for the manoeuvre was de- havioural pattern of the foreign banks tively fast as a result of the small part creased for the size of the market pre- represents the possibility of an in- of non-banking financing of the econ- mium, which reflects the difference creased dependence of Slovenian omy and, above all, because of the between the domestic and foreign in- economy from financial mediation short-term structure of the financial terest rates, still tolerated by the mar- and services, offered by foreign banks market. From this point of view the sta- ket. On the presumption that this pre- in Slovenia. We can speak about bilization effect of the change in ECB mium is going to gradually disappear competitive pressures that foreign interest rates can be favourable. What as well, and entirely disappear at the banks are exercising in a wish to in- could be problematic, however, is the time of the introduction of euro, it is crease their market shares, where possible small efficiency of changes more than obvious that the burden of Slovenian banks can hardly follow. stemming from the shallowness of ensuring price stability in this time From the macroeconomic point of Slovenian financial mediation and the falls on other macroeconomic poli- view the above-mentioned processes lack in long-term bonds. Be that as it cies, whereas Bank of Slovenia with of nominal and real convergence and may, in EMU we can expect a rapid its interest policy predominantly influ- increasing the competitiveness among convergence of the transmission mech- ences expectations only, and to a providers of financial services positive- anisms predominantly out of two rea- lesser extent financial parameters di- ly influence the maintenance of condi- sons. First, entering the EMU is the rectly. This holds true even more if we tions for a higher economic growth most important factor of financial inte- are aware of the fact that the chan- and the processes of catching up the gration, as the domestic financial insti- nels of monetary transmission are level of development of Slovenian tutions will have to cope with the com- being even further weakened by an economy with European average. petitors from the entire single currency increased level of euroization, which area. And second, inside the EMU is reducing those segments of finan- What to Expect only one institution is responsible for cial system which the domestic mone- after Adoption of the Euro? the monetary policy, which will have tary policy could at all influence. an influence on the increase of the en- The source of potential dangers dogenous of changes in the instru- BIBLIOGRAPHY AND SOURCES: and with them connected negative ef- ments of monetary policy. Through fects of the unbalance between the that the role of other economy policies 1. Crespo-Cuaresma, J., Egert, B., and Reiniger, T. Interest Rate Pass-Through in processes of nominal and real conver- in the mechanism of adaptation to the gence on national economies after the New EU Member States: The Case of the possible asymmetric Shocks in EMU Czech Republic, Hungary and Poland. The adoption of euro can occur as a result will increase. In Slovenia after enter- William Davidson Institute Working Paper of asimetricity in the activity of trans- ing into the ERM II the financial mar- No. 671, May 2004. mission mechanism of the ECB mone- ket has started to deepen, above all in 2. Jašovič Božo. 2004. ERM II – Učinki in tary politics. Asymetricity occurs when the first place because of a greater prve izkušnje. Priloga k zborniku: Dnevi the change in the common ECB inter- competition among financial institu- slovenskih bančnikov. Združenje bank Slovenije, Maribor, November 2004. est rate, due to the structural charac- tions and greater offer of alternative teristics of the economy, stemming in saving forms, which became topical 3. Jazbec B., Masten, I. Učinki vstopanja this case especially from the differenc- also due to certain institutional chang- Slovenije v območje evra na slovenski bančno-ﬁnančni sektor za gospodarsko rast. es between financial markets develop- es (interest taxation, interest rate con- ments, works with a different speed V: BORAK, Neven (ur.). Novi bančni vergence, the building of additional standardi in ERM II : [zbornik]. Ljubljana: and strength in a country that is struc- pension insurance pillars). On the Zveza ekonomistov Slovenije, 2004, pp. 45- turally not coordinated with the EU av- basis of empirical studies in econo- 58. erage. Entry into the euro-zone can mies, comparable to our (Crespo- 4. Pavlič Damijan, J., Jazbec, B., Majcen, B., therefore cause in an economy with a Cuaresma et al., 2004; Tieman, Polanec, S., Masten, I., Jaklič, M., in Cotič structurally less developed financial 2004) we can conclude that the intro- Svetina., A., Ocena makro in mikro market that the changes in ECB inter- ekonomskih učinkov vstopa Slovenije v duction of the euro will further acceler- Evropsko unijo, GZS, Ljubljana, May 2003. est rate do not have a strong enough ate the processes of the convergence and stabilization effect. The empirical 5. Poročilo o denarni politiki. Banka adaptation of Slovenian banking-fi- Slovenije, Ljubljana, April 2005. studies from the period prior to the nancing sector, which will increase EMU showed a great heterogeneity the efficiency of transmission mecha- 6. Ribnikar Ivan, 2004. Režimi deviznega tečaja “izginjajoče sredine”. Bančni vestnik, among the EU Member States, which nism monetary policy of the ECB. had been reduced after entering the letnik 53, številka 9, Ljubljana, 2004. 7. The monetary policy of ECB. European 6 The problematics of credit risks is in more Conclusion central bank, Frankfurt, 2004. detail presented in the Report on Financial 8. Tieman, A. Interest Rate Pass-Through in stability for 2004, Bank of Slovenia. The independence of the mone- 7 For more on the costs and beneﬁts of the Romania and Other Central European Slovenian entry into the EU, see Pavlič Damijan tary policy is within the working Economies. IMF Working Paper No. 211. et. All (2003). frame of ERM II highly impaired. November 2004.

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UDK 336.71:339.738:061.1EU Impact of ERM II participation on Slovenia's banking sector

Marko Košak and Tomaž Košak *

Slovenia, Estonia and ll new Member States that joined the EU on 1 May Slovenia were the first among the new EU 2004 have the obligation to adopt the single currency Member States that decided to enter ERM II. as soon as they fulfil all the convergence criteria. The Slovenia’s formal participation in ERM II economic criteria have been precisely determined and created some uncertainties for banks A also publicly known in advance, however no one of the new associated with the implementation of the fixed foreign exchange Member States was given a prices date for the implementation rate regime. After a year in ERM II we can see that of the single currency. Shortly after the enlargement Estonia, the formal ERM II entry did not have any Lithuania and Slovenia showed a strong interest in an early euro significant shocking impacts for banks. adoption. All three countries applied for ERM II membership just However, it has been evident already for few shortly after the accession date and on 28 June 2004 they en- recent years that some institutional changes and tered ERM II. It hardly came as a surprise, although the decision different economic conditions, related to the of Estonia and Lithuania was been less questioned than the EU membership and expected future adoption decision of Slovenia. Namely, Estonia and Lithuania set up their of the euro, have had some impact on banking respective currency boards before applying for ERM II member- operations. ship, which technically meant that they already had a fixed exchange-rate regime in place – ERM II key characteristic. Thus for Estonia and Lithuania the situation in their foreign exchange markets and financial markets did not change in June 2004, whereas for Slovenia ERM II entry resulted in the implementation of the de facto fixed exchange rate and the reaction of the financial markets to this change was ambiguous. Especially in the case of Slovenian ERM II entry there was also a certain degree of uncertainty regarding the reactions of the banking sector, although on the other hand it was very likely that banks have had anticipated the impact of ERM II entry on their operations well in advance. This paper aims to analyse

* Marko Košak, University of Ljubljana, Faculty of Economics, Tomaž Košak, Bank of Slovenia, Financial Stability Department

42 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

banking operations in the period fol- The Personal Income Tax Act concern goes to two possible direct lowing June 2004 and to examine to (ZDoh-1, Official Gazette of the effects in the Slovenian banking sec- what extent being part of ERM II has Republic of Slovenia No. 54/2004 tor. First, due to relatively high per- affected Slovenia’s banking sector. and amendments) has ended the priv- sonal income tax rates in Slovenia Some indications of likely further devel- ileged status of the interest income, there is a serious concern that interest opments in banking industry are also which has been tax-exempt income taxation could trigger the outflow of briefly described. ever since Slovenia’s independence. savings to banks in neighbouring After the introductory part, the Special tax treatment of interest in- Austria. Savings transfer could be paper examines the main characteris- come was often criticised especially stimulated by a considerable tax rate tics of the economic environment and by the advocates of the more promi- differential, since for many Slovenian 2004’s key institutional changes. Sec- nent role of the capital market in the taxpayers the applied marginal rates tion three outlines Slovenia’s banking savings intermediation in the econo- are considerably higher than the with- environment. Section four gives de- my. The new Corporate Profit Tax Act holding tax rate that applies to non- tails of the elements of the banking (ZDDPO-1, Official Gazette of the residential depositors in Austria. sector earnings structure, section five Republic of Slovenia No. 40/2002 Namely, in Austria as well as in looks into the process of stepping up and amendments), which, under cer- Belgium and Luxembourg the imple- nominal interest rates convergence, tain circumstances, lay a heavier tax mentation of the EU directive on taxa- and section six highlights the changes burden on the shoulders of Slovenian tion of savings income (2003/48/EC) in the banking sector’s balance sheet is subject to a transition period, which structure. Section seven describes the means that all three countries are currency structure of banking opera- going to implement a special with- tions and section eight examines ex- Interest margin holding tax for non-residential deposi- posure to interest rate and credit risk. tors. Fortunately Slovenian legislator Section nine briefly compares bank- has built into the law a provision on ing operations in Slovenia, Estonia calculated gradually increasing tax base, which and Lithuania after the ERM II entry. actually eliminated the threat of sav- Section ten summarises the findings on aggregate ings’ flight to Austria due to tax rate and conclusions. differential. Potentially deposits in total assets Slovenian banking sector could be at- The environment tracted to Austrian banks only at the in which banks operate end of Slovenia’s transition, but only of Slovenian for the depositors in the highest in- Banking operations in 2004 were come brackets and relatively high in- affected by a number of economic terest income. Second, it could be factors that existed even before banks was that the implemented interest income Slovenia’s membership of the EU and taxation would impact the current ma- ERM II. Both institutional changes 2.68% last year. turity structure of savings, since capi- (memberships) have only intensified tal gains made on investments with the mainstream economic develop- maturities longer than three years are ments. Slovenia’s economy grew in banks by levying a withholding tax treated as tax free, whereas interest 2004 at the rate of 4.6% and infla- on interest payments to non-residents. income from deposits is taxed regard- tion rate fell to 3.2% (2003: 2.3% The question is to what extent such less of maturity. In both cases the con- and 4.6%, respectively). The balance tax solutions deteriorate the relative cerns are based on the calculation of of payment in remained on track in competitiveness of the domestic banks the effective tax rates that apply to 2004. Current account b-o-p deficit both in comparison with other seg- tax payers. expanded from –0.4% to –0.9% of ments of the financial system and in While the real effects of interest in- GDP and was accompanied by an comparison with foreign banks or come taxation are yet to be seen and ebb in net financial inflow dropping their subsidiaries. their effects will become tangible at from 0.6% to 0.4% of GDP. The same The bottom line is that that the the end of 2005, the effects of the applies to stepping up the process of changes in tax legislation will have a new corporation taxation provisions nominal convergence of interest rates spillover effect on the cost of bank have already driven the legislator to started already in the second half of funding. That is very likely to be the make some changes (e.g. the aboli- 2002 or two years before Slovenia’s case with customer deposits as well tion of the provisions with retroactive EU accession: as with non-deposit funding. The lat- effect). The overall impact of the new In addition, significant changes in ter especially could affect the compet- law on the banking industry is similar tax legislation were promulgated in itiveness of banks, depending on their to the effect of the law on personal in- 2004. The innovations enacted in the ownership structure. come tax – it directly raises the cost of Personal Income Tax Act and the The announcement of levying a non-deposit borrowings from abroad, Corporate Profit Tax Act are not di- tax on income from interest accrued by introducing a 25% withholding tax rectly related to Slovenia’s ERM II on deposits probably had some ad- on interest payments to non-residents, entry, some provisions will inevitably verse effects even before the imple- which is unlikely to be transferred to affect some lines of banking business mentation of the new law in January foreign creditors. By implementing this and intensify effects typically attribut- 2005 as reflected in sluggish deposit type of taxation the government has ed to the EU and ERM II membership. growth rates. However, the greatest not only raised the cost of the most

BV 7-8/2005 43 ON THE ROAD TO CONVERGENCE

prominent source of funding in 2004 Bank proﬁtability But the improved pre-tax profit of but also caused potential tax discrimi- and income structure the banking sector was not only a re- nation between banks on the basis of sult of a rise in non-interest income their ownership structure. Die to the The above-mentioned economic but also a result of lower operating implementation of the directive on a developments and institutional chang- costs (in real terms) of the banks and common system of taxation applica- es have been directly reflected in almost unchanged level of provisions ble to interest and royalty payments bank profitability in 2004. The bank- if compared to 2003. The cost effi- made between associated companies ing system profit in 2004 improved ciency improvement can be also at- of different Member States more than the year before. It was a tributed to the intensified competition (2003/49/EC), the taxation must not change for 17.4% to SIT 56.1 billion, in the credit market. This was banks be applied to associated companies while in 2003 the pre-tax profit in- were able to achieve 17.4% profit (banks) operating within the EU. Thus creased by a meagre 3.4%. The ex- growth, while at the same time their all banks in Slovenia with access to planation for such a strong profit gross income grew only by 5.7%. In funding from their associated compa- growth cannot be found in net inter- comparing cost efficiency improve- nies in other EU Member States enjoy est income growth, as one might ex- ments, foreign-owned banks turned tax exemption and borrow abroad at pect due to the posted credit activity out to be less successful than banks in adequately lower cost. growth, but in the improvement of the domestic ownership. The former in- net non-interest income. Banks man- creased their cost by more than 10% Openness of the banking aged to increase significantly net in- and the latter by only 0.9%. Greater market come from trading and forex opera- cost efficiency in the banking sector tions. The latter grew by more than was also reflected in the improved The number of banks in Slovenian 55% and at end-2004 accounting for cost-to-income ratio, which has banking sector has not changed sub- 12.5% of total gross income. This changed from 62.5% in 2003 to stantially in 2004. There were 18 contributed to the increased share of 61.3% in the first quarter of 2005. A banks and two branches of foreign net non-interest income in total gross general trend of improving cost effi- banks operating in Slovenia at income of the banking sector, so non- ciency has been in last few years also yearend 2004, whereas most of the interest income was 40.8% of gross detected in banking sectors of the old savings and loan undertakings were income – quite close to the structure EU Member States (EU-15), where in acquired by one of the smaller do- typical of the EU banking sector aver- 2003 the average cost-to-income mestic banks. The expectations that age. However, the significantly big- ratio decreased by more than 3% the Slovenia’s membership in the EU ger share of net income from trading (Report on EU banking sector stabili- and consequent application of single and forex operations has to be taken ty, 2004). On the other hand the banking licence could trigger a mas- “with a grain of salt”, since it was cost-to-income ratio in the new sive opening of foreign banks’ mostly a result of favourable capital Member States even increased in branches and transformation of exist- market conditions in the first half 2003 by roughly 3%, indicating a de- ing foreign-owned banks in branches, of 2004. For this reason one can teriorating average cost efficiency in has not been realised. Till the end expect also a larger fluctuations in the EU-10 banking sectors. March 2005 only one additional bank earnings and greater sensitivity Net interest income generated by branch of foreign bank was estab- of the net non-interest income to the the banking sector decreased by lished, while all previously existing conditions prevailing on the capital 1.7% in 2004 and totalled SIT143.2 foreign-owned banks have kept their market. billion, which was consequently re- independent status. Table 1: Income statement structure in Slovenian banking sector Parent banks from Austria, Italy and France probably did not decide Share in gross income y-to-y growth rates to change the status of their subsidiar- 2002 2003 2004 2002 2003 2004 ies in Slovenia because of the still ex- Net interest income 63.9 63.6 59.2 23.7 1.6 -1.7 isting differences in legal system and institutional set-up. Despite intensified Net commissions 24.0 24.0 25.5 30.0 1.8 12.2 harmonisation and convergence of Net trading and forex 9.5 8.5 12.5 1.9 -8.1 55.3 the banking legislative framework oper. there still exist important differences Other net incomes 2.6 3.9 2.9 -214.3 52.6 -21.8 that directly impact bank operations Gross income 100 100 100 29.6 2.0 5.7 in different national banking markets Gross income within the EU. One may wonder if 224.4 228.9 242.0 in SIT billion some foreign banks have come to Slovenia just to get a foothold in its Operating costs 59.7 62.5 60.8 18.6 6.9 2.8 banking market. Another sign of such – Labour costs 29.5 31.5 31.7 24.4 8.8 6.4 thinking could be found in a large Net provisions -19.8 -16.6 -16.0 -0.7 -14.5 2.0 number of notifications for a temporary licence. Until the end of March Profit before taxes 20.5 20.9 23.2 197.9 3.8 17.4 2005, about 82 banks from the EU Taxes 7.4 7.2 8.0 22.0 -0.6 17.7 have notified Bank of Slovenia of their intention to temporary direct conduct Profit after taxes 13.1 13.7 15.2 1432.1 6.2 17.3 of business in Slovenia. Source: Bank of Slovenia, Financial stability report for 2004

44 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

flected in lower net interest margin Figure 1: Credit and deposit interest rates and inflation rates calculated on interest-earning assets. in percentages Over the period of one year, net interest margin fell by 40bp to 2.8%. The downward trend persisted in the first quarter of 2005, when net interest margin was further reduced by 20bp to 2.6%. Nevertheless, the net interest margin of Slovenian banks remained 1.2 percentage points above the average net interest margin of EU banks in 2003. Namely the declining trend of net interest margins in European banking has been to a large extent also a reflection of recently low interest rate levels. The average net interest margin (calculated on total assets) was 1.38% in the EU-15 in 2003. Specifically, the figure for the group of large banks was on average even smaller (1.22%), whereas for the group of small banks significantly Source: Bank of Slovenia, Financial stability report for 2004 larger (2.54%). Taking into the account that on average Slovenian the proportion of long-term deposits loans in total assets is completely com- banks are small banking undertakings in total non-bank deposits decreased parable to the average share in EU-15 from the EU perspective, then the av- by 1.8 percentage points to 7.7% in banking sectors, where customer erage net interest margin does not de- the period from 2002 to the end of loans on average represented 51% of viate significantly from the figures 2004. At the same time the share of total assets at the year end 2003, posted by comparable banks in the sight deposits increased by 2.7 per- whereas in the group of small banks old EU Member States. Average net centage points to 35% of total non- this share was by 57.4% even some- interest margin calculated on the bank deposits. what higher (EU banking sector stabil- banking sector total assets was ity, 2004). Very aggressive efforts for 2.68% in 2004. The changing structure the enlargement of markets shares in credit market were to a large extent of the banking sector’s also a result of declining net interest Nominal convergence balance sheet margins. This way banks were able to of interest rates The main factors stimulating the avoid a deterioration of their profita- The process of nominal conver- boom in lending since mid-2003 bility ratios: ROE and ROA. The ag- gence of interest rates gained momen- were: plunging interest rates, fixed gressive market penetration strategy tum in 2003 and the first half of exchange rate since Slovenia’s ERM II was observed especially with foreign- 2004 and has not lost breath since. entry, vigorous economic growth, and owned banks, which managed to in- Bank interest rates on loans and ad- increasing domestic consumption. crease their market share by 2.5 per- vances have been cut faster than the Customer lending rose at the rate of centage points, reaching 23.5% of rates at which interest accrues on de- 16.3% at the annual level already at total customer loans at the end of 1 posits. Therefore, the average interest the year-end 2003, gained additional 2004. For comparison: the market rate spread was further trimmed by 4.0 percentage points in 2004 notch- share of foreign banks, measured by 30bp to 2.6 percentage points in ing 19.8% at year-end and rising fur- total assets represented only 20.1% of 2004. Intensive cutting of deposit in- ther in 2005. With over 21% rise, the banking sector. terest rates eventually slowed down lending to households enjoyed the The explanation why the foreign- but not before the second half of stronger growth under the due from owned banks have been more suc- 2004, when interest rates for some customers item in comparison with cessful in cutting a bigger slice of the maturities became ex post negative in 20% pencilled in by corporate loans. Slovenian banking market may be real terms. That was partly also a Housing loans 32% yearly growth rate their easier and more favourable ac- consequence of Bank of Slovenia in- at the end of 2004 encountered the cess to foreign funding, mostly by bor- tervention, which stabilised 60-day strongest growth among loans to rowing from their parent banks. tolar bill rates at 4.0% level. households and trend was even con- However, also domestic banks man- The nominal convergence of inter- tinued in the first quarter of 2005 aged to increase the share of foreign est rates has been accompanied with when housing loans reached record funding in 2004, so the proportion of an inverted yield curve in the deposit 37% yearly growth rate. Consequently foreign funding increased from 14% market. The yield curve shape was the proportion of loans to non-bank 1 For more information on the changing structure basically the same also in the money sectors has in only one year increased of the credit market in terms of size and market. By inverting the yield curve by 3.7 percentage points and ownership of the banks, please see »Financial stability report for 2004« prepared by the banks only stimulated the process of achieved 54% of banking sector’s Financial Stability Department of the Bank of maturity shortening for deposits. So total assets. This share of customer Slovenia (Bank of Slovenia, June 2004).

BV 7-8/2005 45 ON THE ROAD TO CONVERGENCE

Table 2: Balance sheet structure of the banking sector and subsets of foreign-owned and domestic banks

All banks Domestic banks Foreign owned banks 2002 2003 2004 2002 2003 2004 2002 2003 2004 Total assets in SIT billion 4557 5057 5645 3788 4103 4519 769 954 1136 Assets 100 100 100 100 100 100 100 100 100 Cash 3.2 2.8 2.5 3.1 2.8 2.5 3.6 2.8 2.4 Bank loans 8.4 6.8 8.9 7.8 6.1 8.4 11.0 9.9 10.5 Non-bank loans 47.9 50.2 53.9 46.1 48.8 51.4 56.9 56.1 63.0 Loans to corpor. sector 29.8 33.6 36.4 28.7 33.5 35.9 35.0 34.1 38.0 Loans to households 12.4 12.5 13.6 12.0 11.8 12.3 14.3 15.3 18.4 Loans to government 4.7 2.8 2.5 4.3 2.1 1.8 6.8 5.8 5.4 Loans to nonresidents 1.0 1.3 1.4 1.0 1.4 1.4 0.8 1.0 1.2 Securities 34.0 34.0 29.1 36.2 35.7 31.2 22.8 26.8 20.4 Short-term securities 21.1 20.9 14.2 21.4 20.3 14.2 19.7 23.4 14.0 Long-term securities 12.8 13.1 14.9 14.8 15.4 17.0 3.1 3.4 6.4 Equity holdings 1.5 1.6 1.5 1.8 1.9 1.8 0.3 0.2 0.2 Other assets 5.1 4.6 4.1 5.1 4.7 4.6 5.4 4.2 3.6 Liabilities 100 100 100 100 100 100 100 100 100 Bank deposits 12.8 16.6 19.3 10.6 12.4 13.8 23.7 34.5 40.6 Non-bank deposits 69.1 65.1 62.4 70.6 68.1 66.2 61.9 52.4 46.7 Securities 3.9 4.3 4.0 4.3 4.9 4.8 2.0 1.5 0.8 Provisions 2.0 2.0 2.1 2.1 2.1 2.2 1.7 1.7 1.7 Subordinated debt 1.5 1.9 2.5 1.6 2.1 2.8 1.1 1.1 1.6 Equity capital 8.3 8.3 8.2 8.5 8.5 7.6 7.8 7.4 7.0 Other liabilities 2.3 1.8 1.5 2.4 1.9 2.6 1.8 1.4 1.6 Source: Bank of Slovenia

Table 3: Annual loan growth rates in percent, broken down by sectors and bank ownership

All banks Domestic banks Banks in frgn. ownersh. 2002 2003 2004 2002 2003 2004 2002 2003 2004 Loans to non-bank sector 14.0 16.3 19.8 11.8 14.8 16.0 23.9 22.3 33.6 Loans to corporate customers 11.5 25.2 20.9 10.6 26.2 18.0 15.7 20.8 32.6 Loans to households 8.1 11.7 21.5 6.0 6.5 14.9 18.0 33.0 43.0 Source: Bank of Slovenia to 18% of total assets and was the The loan structure by segments of premiums. It is measured by a rate most important part of inter-bank lia- borrowers has not changed much differential between a Slovenian gov- bilities. The increasing importance of after Slovenia’s ERM II entry. Typically ernment Eurobond and a comparable foreign funding can be attributed to foreign-owned banks managed to German government bond and it ex- the effect of lowering country risk, achieve higher growth rates of cus- ceeded 60bp at end-2002. Since which is elaborated latter in this tomer loans than banks in domestic then, the country risk premium has paper, and to the lower currency risk, ownership over the last few years. been shrinking and since mid-2004 it whish was a direct consequence of The only exception was 2003 when has been around 20bp. The interna- the ERM II entry. Despite these effects domestic banks succeeded in increas- tional rating agencies improved the intensity of foreign funding re- ing corporate loans more than their Slovenia’s rating on the eve of its mains higher with foreign-owned foreign-owned counterparts. The loan ERM II entry. Since those significant banks than with banks in domestic growth rate differential between for- changes in sovereign rating either ownership. So the inter-bank liabilities eign-owned and domestic banks has through the risk premium reduction or in foreign-owned banks increased by increased even more in 2004, be- through upgrading credit rating, there 5.7 percentage points to 40.6% of cause of the already mentioned for- have been no big changes. total assets, which was significantly eign funding under more favourable An important factor driving banks more that the share of inter-bank lia- conditions of the foreign-owned to borrow abroad has also a sluggish bilities with banks in domestic owner- banks. The latter were especially suc- growth of non-bank deposits, which ship. Nevertheless the growth rates of cessful in increasing lending to house- have really fallen behind credit inter-bank liabilities at domestic banks holds – up by 43%. growth. Due to a permanent trend of were still high – in 2004 about 39%, As already mentioned the in- lowering interest rates and strength- which was less than in 2003 when creased borrowing from abroad can ened domestic spending the deposit the growth rate reached 50% at the be to a large extent attributed also to growth rate dropped to only 7% year- annual level. continuous trimming of country risk ly at the year end 2004, which was

46 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

continuation of the low growth rates So in 2004 the asset liability man- 45% p.a. and their share in total loans from previous years. Additionally de- agement of banks has moved away to corporate sector reached 45.1%, posit growth rates lost momentum also from active management of assets, up from 38% a year earlier. The share because of the anticipated taxation of which was relevant in the 2000 – of loans in foreign currency hit the interest income in 2005 and scarce 2002 period, determined by intensi- rock bottom in 1997, when these knowledge about the real effect of the fied capital influx, to more active loans accounted for 13% of total newly implemented taxation. All these management of bank liabilities. The loans. Since then the share has been reasons have resulted in the share of change was necessary due to the increasing gradually all the time. non-bank deposits in total assets of modest growth of domestic deposits The pace at which loans to house- the banking sector falling by 3.0 per- and because of the additional accu- holds denominated in foreign curren- centage points to 62.4% of total as- mulation of capital, necessary for cy accelerated in 2004, although sets in 2004, whereas the share of maintaining sufficient solvency. there is plenty of room for improve- household deposits fell by a moderate ment. It can be attributed to a quite 1.0 percentage point to 41.5% of total Currency structure of the late removal of barriers to household assets. For the banks in foreign owner- borrowing in foreign currency from banks’ balance sheet ship the reduction of the share of non- banks. Last restrictions were lifted in bank deposits in their total assets was The fixed exchange rate and the autumn 2003, when the proportion of even larger, so the share dropped by closing interest rate differential have lending denominated in foreign cur- 5.7 percentage points to only 47% of rency was less than 1.0% of total total assets. loans to households. In the first quar- The improving credit activity has ter of 2005 the share of forex loans been accompanied with a decreasing The principal rose to 5%. proportion of securities in total assets. Total foreign-currency assets The share of securities was reduced gained 2.1 percentage points in from 34% to still high 29.1% of total source 2004 notching 35.5% of total assets, assets in 2004. Tolar bills issued by while on the other hand the growth of the Bank of Slovenia represented that of booming total liabilities denominated in foreign part of the securities portfolio that was currency was even faster: up 3.3 per- contracted the most, mostly due to foreign- centage points to just below 38% of central bank’s decision to discontinue total assets as a result of bank cross- its 270-days tolar bills and replace border borrowing. The increase in them by long-term deposit facility of- exchange household deposits in foreign curren- fered by Bank of Slovenia. At the cy of 1.0 percentage point in 2004 same time the central bank also decid- funding is bank should also be taken into account. ed to gradually diminish the mandato- A relatively quick expansion of ry subscription of bills denominated in cross-border assets and liabilities denominated in foreign currency, which has been one foreign currency in 2004 partly stim- of the liquidity ladder requirements. ulated by Slovenia’s ERM II entry is Consequently, banks replaced bills borrowing. probably the most obvious structural with more profitable and still highly change in the balance sheet of the liquid investments. All methodological banking sector year-on-year. These changes related to the fulfilment of the caused a quick growth of the propor- structural changes had an adverse liquidity ratio requirements actually tion of the forex loans to corporate cli- effect on the performance of the helped to prevent further deterioration ents and individuals in 2004. Forex banks with a limited access to cross- of liquidity ladder ratios for both ma- loans to the corporate sector grew by border borrowing under favourable turity segments, from 0 to 30 days and from 0 to 180 days, in mid-2004. Table 4: Currency structure of the banking sector balance sheet in percentage The process of Slovenian accession to the EU triggered in Slovenian 2002 2003 2004 banks similar structural changes as al- in SIT in forex in SIT in forex in SIT in forex ready experienced by Portugal and Assets 67.0 33.0 66.6 33.4 64.5 35.5 Greece, two countries at a similar development stage as Slovenia, when Loans to banks 19.8 80.2 18.3 81.7 39.2 60.8 they were in the middle of the acces- Loans to 75.7 24.3 71.2 28.8 65.8 34.2 sion process. The intensified credit ac- nonbanking sector tivity coupled with enhanced credit Securities 59.3 40.7 62.7 37.3 62.4 37.6 demand in Slovenia, was just like in Liabilities 66.1 33.9 65.4 34.6 62.1 37.9 Portugal and Greece financed from two sources (T. Košak, 2004): Banking liabilities 29.8 70.2 31.9 68.1 24.5 75.5 1. by borrowing abroad, which Non-banking 66.4 33.6 66.7 33.3 65.5 34.5 was relatively more important funding liabilities source for foreign-owned banks, and Debt securities 97.3 2.7 97.7 2.3 98.3 1.7 2. by divesting securities and equity holdings. Source: Bank of Slovenia, Financial stability report for 2004

BV 7-8/2005 47 ON THE ROAD TO CONVERGENCE

terms through associated companies Figure 2: Changes in average adjustment periods since the interest margin on foreign for credit and deposit rates funding was lower than on tolar funding.

Exposure to interest rate and credit risk

Beside the changing currency structure, banks were also facing changing maturity structure in 2004. It was a direct consequence of deposits’ maturity shortening and increasing average maturity of customer loans. Because of a faster growth of long- term loans – they grew by 27% and outpaced significantly short-term loans that grew at 14% rate – the pro- Source: Bank of Slovenia, Financial stability report for 2004 portions of long-term and short-term lending to customers were matched. Table 5: The segmentation of classified assets The process of deposit maturity shortening together with the process of Proportion of rating segment as% of classified assets loan maturity lengthening caused a Bad loans A B C D E growing mismatch between average (D-E) interest rate adjustment period on the 2002 80.3 12.8 3.1 1.7 2.2 3.9 asset side and average interest rate adjustment period on the liabilities 2003 80.9 12.6 2.9 1.7 2.0 3.7 side. This mismatch increased from 2004 81.8 12.7 2.5 1.4 1.6 3.0 four months at end-2003 to six Source: Bank of Slovenia months at end-2004. The exposure to interest rate risk has been increasing where assets increased by 1.6 per- Similarity of circumstances since 2002, when the indexation centage points to 81.8% at the end of in three new ERM II members practice was abandoned. This unfa- 2004. The proportion of sub-stand- vourable trend may be reversed or at ard assets graded from “B” to “E” fell Estonia, Lithuania and Slovenia least mitigated by a relatively quick in the range from 10bp to 60bp over were the first new Member States to increase of new variable-rate loans. the same period. A proportion of apply for ERM II membership. The The proportion of variable rate loans loans, assigned the worst credit rat- ERM II entry had no direct dramatic already exceeded 54% this year ings “C” and “D”, fell from 3.9% at effects for banking sectors neither in (Bank of Slovenia, 2005). end–2002 to 3.0% at the end– Slovenia nor in Estonia and Lithuania. Contrary to the interest rate risk 2004. Recent relatively good credit The credit activity has been inten- situation, credit risk exposure of the ratings have been a result of high sified also in Estonia and Lithuania in banking sector did not deteriorate in economic growth, low interest rates last few years. The indebtedness of 2004. Nevertheless, we should take and falling inflation rates. In case of the Estonian non-financial sector grew into account that favourable credit any deterioration of general econom- by almost 32% p.a. in the second half scoring could be also a result of the ic situation the percentage of default- of 2004, while the indebtedness favourable economic conditions and ed claims would be increased very growth rates at end–2002 and in business optimism stemming from quickly. Based on some indicators 2003 resisted at the level of 25% of Slovenia’s joining the EU. Namely, de- presented in the Financial Stability yearly growth. A large proportion of spite the high credit growth and low- Report for 2004, we could find some this growth had its origin in growth ering proportion of securities in evidence on pro-cyclical credit activi- rates of household loans, although the banks’ portfolios, which has caused ty of the banking sector, which indi- growth of the latter was reduced from an increase in classified assets of cates a relatively high sensitivity of 45% yearly in mid–2003 to 41% p.a. 18%, banks’ specific provisions in- the quality of the bank portfolio to in the last quarter of 2004. On the creased by only 4.3%. The “provi- the current economic cycle (M. and other hand the indebtedness of the sions-classified-assets” ratio has dete- T. Košak, 2004). corporate sector has been increasing riorated by 70bp to 5.2% in only one A similar process of more optimis- throughout the year 2004, which has year. The same ratio has deteriorated tic estimation of credit risk exposures been reflected in growth rates of cor- more for banks in foreign ownership and consequent deterioration of the porate loans. They grew by 18% p.a. than for domestic banks. provisions-to-risky-assets ratio can be at the beginning of 2004 and accel- Banks have been rather optimistic detected also in other banking sectors erated to more than 28% p.a. at the when assessing their credit risk expo- of the EU (ECB, 2004). So Slovenia’s end– 2004. In Lithuania credit growth sures. The greatest increase in the accession to the EU cannot be exclu- rates were even somewhat higher, proportion of assets over the last two sively blamed for the over-optimistic since bank loans to non-bank sector years has been in the group A, assessment of credit exposure. were increased by 39% in 2004. A

48 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

large proportion of this growth may the banking sectors performance ra- 43% growth rate and domestic banks be attributed to the growth of forex tios, as well as in the structure of their only 15% growth rate in 2004. If in loans, which grew at 48% p.a. in operations. this year the revision of the law on 2004. In Lithuania the highest growth A strongest direct effect associat- corporate income taxation is not rates were also recorded for loans to ed with the entry into the EU and going to occur, the taxation of interest households – in the first half of 2004 ERM II was the convergence of inter- payments to non-residents will further about 60%. In any case we need to est rates, which lowers the cost of make borrowing abroad more expen- keep in mind that these growth rates funding and at the same time also the sive firs of all for banks in domestic are not sustainable in the long run credit cost. Intensified interbank com- ownership. Consequently the relative and were realised mostly because of petition for market shares has low- market position of banks in domestic the low starting levels of the credit ag- ered interest rates, which was reflect- ownership could deteriorate. gregates in banking sector. So the ed in the decreased net interest mar- In the future a gradual slowdown first signs of credit growth slow down gin. The latter dropped down to 2.6% of credit growth rates can be expect- may be observed in the case of in the beginning of 2005. Diminishing ed, especially for household loans. Lithuania, where the highest credit net interest earnings of banks, forced At same time the proportion of for- growth rate in banking sector was re- them to intensify their efforts for high- eign-currency loans, especially those corded in 2003. er net non-interest earnings and lower denominated in euros, is expected to Of course high credit growth rates costs. These effects were materialised increase. It is very likely that the proc- were accompanies by adequately in strong improvement of net income ess of »euroisation« is going to inten- high growth rates of bank liabilities. from trading and forex activity, which sify first within the banking sector and In this respect some differences be- also mirrored more favourable market will eventually spread to the rest of tween banking sectors in three coun- conditions, and in the decrease of the the economy. tries can be detected. While high cost-to-income ratio of the banking credit growth rates in Slovenian and sector to 61% in the beginning of SOURCES: Estonian banking were funded by 2005. 1. ECB: Financial stability review, ECB, borrowing abroad, especially from Changes in the structure of finan- Frankfurt, December 2004. parental banks, banks in Lithuania still cial intermediation have been clearly 2. Košak M. in Košak T.: Simulacija učinkov managed to fund their credit growth demonstrated in almost 20% yearly uvedbe dinamičnih rezervacij v slovenskem bančnem sektorju; Economic and Business largely by domestic deposits. So in growth of customer loans in 2004. Review, Vol 6, 2004. 2003 and 2004, deposits in Among them the growth of housing 3. Košak T. in Jašovič B.: Trendna gibanja v Lithuanian banks increased by 26%, loans was with 32% rate the fastest. strukturi bančnega sektorja Slovenije; Bančni and 30%, respectively. Such high An important source of the accelerat- vestnik, Ljubljana, Letnik 53., št. 6, junij growth rates may be difficult to sus- ed growth rates was foreign funding 2004. tain in the long run, since the poten- and securities’ and equity holdings’ di- 4. Banka Slovenije: Poročilo o ﬁnančni tials for deposit growth are limited, to vestiture. The non-bank deposits were stabilnosti za leto 2004; Banka Slovenije, June 2005. some extent also because of the inten- enhanced by modest 7% p.a. only. 5. Deželan S. in Košak M.: Razvoj enotnega sified cross-border borrowing. Foreign funding proved to be an ad- evropskega trga ﬁnančnih storitev in učinki vantageous source of financing for za Slovenijo. V Raziskovalna dejavnost ter Conclusions foreign-owned banks primarily, since inovacije, konkurenčnost in družbena those banks had access to such finan- odgovornost podjetij. (Ur. J. Prašnikar), Slovenian formal ERM II entry at cial sources at their parent banks. Ljubljana, Časnik Finance, 2004. end-June 2004 did not have any radi- Advantageous funding terms were re- 6. ECB: Convergence Report 2004, ECB, Frankfurt, 2004. cal consequences for banking opera- flected in strong credit growths at- 7. ECB: Banking structures in the new EU tions. Slovenian banking sector has tained by foreign-owned banks. The Member States. ECB, Frankfurt, January been exposed to changing environ- most outstanding category of loans by 2005. ment for several years, and all those growth rates were household loans, 8. ECB: EU banking sector stability. ECB, changes have been reflected also in where foreign-owned banks recorded Frankfurt, November 2004.

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UDK 336.7:368/369(497.4):339.738(4) Financial groups and conglomerates in Slovenia under impact of euro Franjo Štiblar *

Slovenia’s financial sector lovenia’s EMU membership i.e. introduction of the euro is in is still in the process of restructuring. While EU expected in 2007. Neither the changeover not the prepa- membership did have important impact on the rations for it through ERM II participation (the waiting position of its institutions, future EMU membership room for the EMU) does not have distinctive effect on fi- and preparation for it (ERM II regime) will have Snancial conglomerates in Slovenia. The introduction of the euro less importance. Many financial groups were is predominantly a technical question (a procedure how to do it) already created during transformation of the with the fulfilment of Maastricth macroeconomic criteria as a financial sector in Slovenia, but only one or precondition. The technical procedure to introduce the euro is two qualify presently as financial conglomerates. similar for all financial institutions, regardless of their institu- Further integration is expected in the future, tional form (banks, insurance companies, institutions of capital although due to high criteria for financial market, their groups or conglomerates). Fulfilment of five macr- conglomerate and concern for market oeconomic Maastricths criteria (budget deficit and public debt, competition will prevent their explosion in small inflation, interest rate and exchange rate) is above all a matter country like Slovenia. of macroeconomic policy and, again, implications of their fulfilment touch all financial (and real) micro entities in the same way, regardless of their specific institutional form. The new Slovenian legislation on financial conglomerates is in the pipeline and the bill transposes solutions from the EU directive into internal legislation. The first comments of the team preparing the new law are that only one or two financial undertakings would fulfil the strict conditions from the directive and qualify as financial conglomerates in Slovenia. They are the financial group of Triglav insurance company, and potentially KD Investments financial group. On the other hand, even the largest financial group in Slovenia, Nova Ljubljanska banka group, does not qualify as a financial conglomerate, because the market share of its parent company, Nova Ljubljanska banka, does not

* Dr. Franjo Štiblar, Dean of the Law School in Ljubljana and Scientiﬁc Councillor of the Economic Institute of the Law School.

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exceed 40% of the banking market, ates. It decreases capital by 5–10%, least two of the activities of banking as required under the financial con- while diversification effect (saving (collecting customer deposits in order glomerates directive. capital) is the largest at level 1. to grant loans and invest in securi- The existence of several financial As an alternative to the above two ties), insurance (to underwrite and groups in Slovenia, which do not qual- approaches financial conglomerates cover the risks of their customers) and ify as financial conglomerates, tells a are adopting economic capital as a securities (invest assets of their clients different story. Real sector conglomer- common currency for risk measure- on the capital market in securities). In ates do not qualify in the light of the ment internally (defines the need for the U.S. one entity in the group to be restrictions laid down in financial con- capital for all risk factors in probabil- defined as a financial conglomerate glomerate directives. Real sector con- istic terms at a common point in a loss has to be a bank. glomerates are not specifically regu- or value distribution). Financial con- Group is a set of undertakings, lated in the EU, while regulation of fi- glomerates are creating centralized consisting foremost of a parent under- nancial groups, particularly within risk and capital management units. taking and its subsidiaries as defined banking, insurance and capital mar- Special problem are non-regulated in Directive on consolidated ac- ket institutions, is laid down in sepa- subsidiaries within financial conglom- counts. rate legislation for each of these sec- erate (financial or commercial). To define a scope for cross-secto- tors (banking directives, insurance di- The proposed external mutually ral activity there should be at least rectives, capital market institutions di- reinforcing regulatory mechanism two financial sectors involved (one rectives). There are many such finan- of them insurance), sector should cial groups in Slovenia, which include have more than 10% in group total in their group members from all three balance sheet and solvency require- sub-sectors of financial sector and, Slovenia ment, but should not be smaller than sometimes, also enterprises from the €6 billion. real sector. They will be presented There are several differences next with connections described. is preparing among three main financial sub-sec- This is probably the first time that tors (table 1). financial conglomerates and even a new law While banking is associated with financial groups are identified in higher systemic risk, it is vulnerable Slovenia. For that reason, the list is on financial to crisis of confidence (reputation), not complete, but represents initial has a central role in the economy, effort. and a high degree of inter-connec- This paper consists of the theory, conglomerates. tion through interbank market and EU legislation, EU evidence of creat- payment systems, in the insurance ing financial conglomerates, and an sector and securities trading supervi- empirical overview of situation in can be synthesized in a “3+1” pillar sors are more focused on consumer Slovenia’s financial sector regarding framework: rule-based first pillar, su- and investor protection. groups and conglomerates. pervision-based second pillar, market-based approaches (similar to Motives for the establishment THEORY Basel II and planned Solvency II) of ﬁnancial conglomeration and, in addition, legal-based ap- Market forces (globalisation, con- proach as legal firewalls as fourth pil- 1. Cost and revenue synergies solidation, deregulation) are fuelling lar. Three pillars are related to 3 ag- Include scale efficiency (same the growth of large, multi-line finan- gregates of risk given above. product at larger scale achieving the cial conglomerates. But early legisla- In aggregation effect of risk pro- size of minimum average total costs: tion treated risk and capital of enti- file regulators and clients stress capi- delivery methods and financial engi- ties in financial conglomerates as in- tal versus risk, while shareholders of neering tools) and scope efficiency dependent silo, which has at least company and policyholder stress re- (multiple products using same distri- three main limitations: in aggrega- turn versus risk. Lower correlation be- bution channels and the same cus- tion, incompleteness and inconsisten- tween risk factors enables diversifica- tomer database). cy. The special problem is to aggre- tion benefits that means less capital 2. Diversification gate risk across diverse business lines to cover all risks. Typical correlations Company reduces volatility of its at the three levels, defined in a build- are: 0.8 between market/ALM risk cash flow, which reduces need for ing block approach: and credit risk and 0.4 between op- external finance thus reducing the Level 1 – aggregates standalone erational risk and credit risk. It is probability of financial distress and risk within single risk factor over N clear that risk of the whole cannot be avoiding additional costs. policyholders, greater than the sum of the parts. 3. Agency reasons (versus princi- Level 2 – aggregates risk across (Oliver, Wyman, 2001). pal) different risk factors within a single By mergers and acquisitions man- business line, Deﬁnition agers want to achieve personal goals Level 3 – aggregates risk over dif- in empire building, or in protection of ferent business lines (bank, insurance, Financial conglomerate is group employees against insolvency risks investment entity). of entities whose primary business is with diversification. Thus, managers Cross-business diversification of financial and whose regulated entities shelter themselves from the market risk is unique to financial conglomer- engage to a significant extent in at discipline and governance mecha-

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Table 1: Differences among three main financial sub – sectors Capital adequacy is calculated separately for banks and investment Criterion Bank Insurance Securities companies (requirement determined Assets loans, interbank, investment portfolio receivables secured, on the basis of institution risk weight- assets, securities fin. instruments ed assets) and insurer’s overall busi- Liabilities deposits, interbank technical provisions payables to ness volume as a risk proxy (includ- liabilities customers ing claims and premiums for non-life, Distribution channel branch agent, broker financial intermediary mathematical provisions and capital Time horizon intermediate long (life), long- short at risk for life). Measuring the finan- short (non-life) cial conglomerate capital means Main risks credit, funding, underwriting, market, liquidity liquidity investment comparing the aggregate of different sectoral requirements with the sum of Transfer mechanism securitization, reinsurance OTC derivatives derivatives the group-wide capital, adjusted to Capital/provisions both more provisions more capital eliminate double counting. Three use methods are proposed in directive for Supervisory Concern systemic risk, protecting investor protection, calculation of capital: protecting policyholders systemic risk, market – the accounting consolidation depositors method: uses consolidated accounts Supervisory Tools capital requirements capital requirements capital requirements of the financial conglomerate, restrictions on adequate tech. asset segregation – deduction and aggregation activities sound provisions record keeping method: the sum of the own funds of policies, procedures investment, operational controls reinsurance rules each entity in the group is calculated, id needed with a correction for Source: Sterzynski, 2005 double counting. Then, the solvency nism and increase their skills, making 2. Parent-subsidiary: parent and requirement for each entity and the them more valuable for the company. subsidiary are separately capitalized book value are added together. There are several risks involved in (bank-insurance) Available own funds have to be at creation of a financial conglomerate: 3. Holding company: holding least as high as the requirement; – regulatory arbitrage (double company concentrates common – the book value method: internal gearing by using the same capital by group functions and is without own transactions between entities in finan- more entities, excessive leveraging by operational activity, which is execut- cial conglomerate are eliminated to using debt by a parent company and ed in several subsidiaries, among obtain consolidated book value. down-streaming proceeds), which there is no capital relation); or: – contagion (one group entity diffi- it can be several holding companies Organizational requirements culty via loans, capital holdings, guar- (for banks, insurances undertakings) for financial conglomerates antees and cross default provisions interconnected by holding company spills over to others, effect of misbe- on top and controlling subsidiaries They should cover: haviour of one group entity on other), 4. Horizontal group: unified man- – risk management: determines – moral hazard (non-regulated en- agement has shared representatives policy and terms of risks assumed, tity tries to get access to bank’s safe- in several entities, which are inter- capital adequacy and the integration ty net, conglomerate becomes too linked by capital. of risk monitoring system; big to fail, group entities may expect – internal control mechanism: it is help from other group entities at the Supervision of financial adequate mechanism to identify and financial distress), conglomerates measure the material risks incurred – lack of transparency (too big and appropriately related to the conglomerate, non-transparent inter- Regulated entities can have a funds to these risks; action between groups of entities), form of a stand-alone (solo basis), – “fit and proper requirements”: – conflict of interests (sharing the homogeneous financial group (in one requested for all financial conglomer- information about consumers within financial sector) or financial conglom- ates as they are usually managed on the whole financial conglomerate), erates. But, mixed activity group can top-down basis. – abuse of economic power in the includes financial conglomerate and Supervisors of financial conglom- market (too big market concentration holding of industrial or commercial erate are: one coordinator and sev- leads to less competition and thus firms. Mixed financial service group eral co-operators to exercise supple- less efficient financial system overall, provides a heterogeneous (mixed) ac- mentary supervision at the level of fi- with less innovations. tivity and for it applies regulation of nancial conglomerate. Decisions to financial services directive. Super- be undertaken include: identification Models for financial vision framework includes joint forum of financial conglomerate, technical conglomerates of international organizations of in- decisions on reporting capital ade- surance, banking supervisors and se- quacy, risk concentration, intra-group 1. Integrated model: services are curities commission transactions, coordination and gath- offered by one and the same entity Specific regulatory and supervi- ering information about financial (for instance universal banking in- sory issues to control financial conglomerate, supervisory review cludes commercial and investment conglomerate in the EU are the and assessment of the financial banking under one roof) following: conglomerate financial situation and

52 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

taking enforcement measures when balance sheet total of the group, its monization of regulation. In Annex 3 needed. each financial sector entity exceeds methods to calculate capital adequa- There are regulatory and supervi- 10% of total financial sector balance cy and technical application of the sory structures dealing with the finan- sheet or solvency requirement and provisions on intra-group transactions cial conglomerate at the EU and na- the balance sheet of the smallest fi- and risk concentration are given. tional level. While each of the finan- nancial sector in the group exceeds cial sectors have its own level 2 and €6 million. The criterion for identify- THE DEVELOPMENT level 3 committees (according to ing financial conglomerate is quite OF CROSS-SECTORAL CAPITAL Lamfalussy), financial conglomerates high, so that only few groups can be LINKAGES IN THE EU have the European Financial defined as financial conglomerates Conglomerates Committee. Dealing as this means additional restrictions Financial conglomerates are born with the supervision of financial con- on them regarding capital adequacy usually through mergers and acquisi- glomerates opens again dilemma of (Art. 6), risk concentration (Art. 7) tions. That leads to bankassurance or having supervision integration for all and intra-group transactions (Art. 8) assurfinance. In the EU the following financial sectors or not. Supervision and requires from such entities risk volume of mergers and acquisitions integrated in one institution has its management process and internal were completed in 1990–2003 peri- advantages (economy of scale and control mechanism (Art. 9). od according to Thomson Financial: scope, efficiency for supervised Supplementary supervision is facilitat- In comparison, in the USA during entities, lower risk of regulatory same period domestic acquisitions arbitrage) but also disadvantages with insurer as acquirer were much (conflicting supervisory objectives, higher than in the EU, with bank as more scope for moral hazard and Regulatory and acquirer much lower than in the EU. collusive behaviour), slower decision Non-domestic M&A were much making process due to organization- smaller in the US than in the EU. al diseconomies in integrated super- supervisory Critical question with regard to fi- visory authority. Around half of EU nancial conglomerates is their impact Member States have one integrated structures are on market concentration (and thus supervisory authority. competition). The USA has different supervision in place at EU Thus, for instance, among 30 of financial conglomerates than the members of CEA in the non-life insur- EU. In EU compared to the USA finan- ance market concentration K5 de- cial conglomerate is not so much bank level and in clined in Slovenia from 100% to 94% oriented, it is possible to have finan- in 1992 and 2002, respectively (sec- cial conglomerate without bank and Member States. ond largest). In the life insurance mar- market is more regulated and liberal. ket concentration in Slovenia also declined from 99% to 88% in 1992 and EU REGULATION ed by nomination of coordinator of fi- 2002, respectively (7th largest). nancial conglomerate supplementary The largest M&A bank-insurer Directive on supplementary super- supervision, which co-ordinates su- deals in the EU during the 1990- vision of credit institutions, insurance pervision, collects information (Art. 2003 period were: undertakings and investment firms in 11, 12). Special solutions are given – Allianz-Dresdner Bank (2001: a financial conglomerate was adopt- for the case parent company of finan- 22.3 billion euros), ed in December 2002, published on cial conglomerate is in non-EU mem- – Lloyds-Scottish Widows Funds 11 February, 2003, to be transposed ber country. Financial Conglomerates (2000: 12.0 billion euros) by August 2004 to Member States Committee was established to sup- – Fortis – General de Bank (1998: legislation and to be implemented in port the Commission in supervision. 10.5 billion euros). 2005. Chapter I it gives objective The existing directives for banking, and definitions. A financial conglom- insurance and capital market institu- FINANCIAL SECTOR IN erate is a financial group which con- tions should be amended so that reg- SLOVENIA AND INTRODUCTION sists of at least one bank/investment ulatory arbitrage is not possible. By OF THE EURO company and one insurance under- 11 August 2007, the Commission taking, where parent company has at shall submit to the Financial Plan of Introduction of The euro least 20% participation (share, voting Conglomerates Committee report on was adopted by the Bank of Slovenia rights) in subsidiary, where financial Member States practices, and, if nec- and endorsed by the Government entities/institutions exceed 40% of essary, on the need for further har- (the latest plan from January 2005).

Table 2: Value of M&A with credit institutions and insurance undertakings 1990–2003 (billion €) TARGET Domestic Intra EU Outside EU Total ACQUIRER Bank Insurer Bank Insurer Bank Insurer Bank Insurer Bank 446 41 75 4 60 5 581 50 Insurer 52 115 20 37 4 73 77 226 Source: Thomson Financial

BV 7-8/2005 53 ON THE ROAD TO CONVERGENCE

Table 3: Major bankassurance Table 4: Financial institutions pany Triglav group) qualifies at this groups in the EU-15 are currently in Slovenia moment as financial conglomerate, (By total consolidated assets; in billions of euros): 1. Banking: 18 banks plus one branch while another candidate for it could (Kaertner Sparkasse): be investment company KD. But, there 1. Deutsche Bank GE 917.7 Market share are many financial groups in Slovenia: 2. Allianz GE 911.9 Bank by assets Banking 3. BNP Paribas FR 825.3 (end-2003) 1. Among banks: the largest fi- 4. HSBC Holdings UK 778.6 1. NLB 34.6% nancial group in Slovenia is Nova 5. ING Group NL 705.1 2. NKBM 10.8% Ljubljanska banka group (with total 6. ABN AMRO NL 597.4 3. Abanka Vipa 8.6% assets over 10 billion euros). It consists of the parent bank and: 7. Royal Bank of Scotland UK 590.0 4. SKB 7.7% – Three companies in Slovenia 8. Barclays UK 573.5 5. Banka Celje 6.4% – 10 financial institutions in 9. Credit Agricole FR 563.3 6. Banka Koper 6.1% Slovenia and three financial institu- 10. Societe Generale FR 512.5 7. Gorenjska banka 4.9% tions abroad, 8. BA CA 4.5% – four “daughter” banks in The material deals mainly with techni- 9. Krekova Banka Reiffeisen 2.5% Slovenia and 10 bank subsidiaries cal issues of introduction of the euro: 10. Probanka 2.0% abroad; general framework, legal framework, 11. PBS (now part of NKBM) 2.0% 2. Nova Kreditna banka Maribor and criteria of good practice. All pro- group with 8 investment companies, 12. Hypo Alpe Adria 1.7% cedures required during introduction one insurance company and 2 banks are the same for all financial entities/ 13. Banka Domžale 1.5% in its group, institutions, practically for all business 14. Volksbank 1.4% 3. Abanka with four financial enti- entities. No special requirements are 15. Deželna banka 1.3% ties/institutions in the group, set for financial conglomerates 16. Koroška banka 1.3% 4. Bank Austria CA Ljubljana is among them. Regulation of financial 17. Factor banka 1.1% subsidiary of BA-CA Vienna, conglomerates was more important 18. Kaertner Sparkasse 0.9% 5. Banka Celje has one subsidiary issue when Slovenia entered the EU and equity holdings in two financial 19. Banka Zasavje 0.9% in May 2004, as the entire body of institutions; 20. SIB (now liquidated) 0.4% the acquis had to be adopted by 6. Banka Koper is majority owned then. However, legislation to adopt fi- Source: Mladina, 2005 by an Italian bank and has an open- nancial conglomerates directive is 2. Insurance: 13 insurance companies ended mutual pension fund; still only in a very early preparatory plus 2 reinsurance companies 7. Gorenjska banka is majority phase, despite the fact that Slovenia (Sava Re and Triglav Re): owner of five financial and commer- has already been EU Member State Market Share cial companies plus has equity hold- for over a year. (by gross Insurance Company ings in 15 other financial and non-fi- Regardless of minor specific im- premium nancial institutions. in 2004) pact of introduction of the euro on fi- 8. Hypo Alpe Adria Bank 1. Triglav 43.1% nancial groups and conglomerates, it Ljubljana: is owned by Austrian paris worthwhile to identify and present 2. Vzajemna 17.6% ent bank and has two financial enti- them in one place, probable for the 3. Zavarovalnica Maribor 3.6% ties/institutions in ownership, first time. 4. Adriatic 9.7% 9. Probanka financial group has 5. Slovenica 5% parent bank, which controls five Financial institutions 6. Tilia 3.2% other financial entities/institutions; in Slovenia 7. Merkur 2.4% 10. Raiffeisen Krekova banka is 8. Generali 1.9% part of RIB Raiffeisen Concern from Slovenia is between developed 9. Grawe 1.9% Austria; and developing countries regarding 11. SKB is owned 100% by 10. NLB Vita 1.5% the level of development of financial Societe generale financial conglom- 11. ARAG 0.01% sector. In three financial sub-sectors erate (France) and has three financial in Slovenia there are following institu- 12. Triglav Zdravstvena 0.01% companies in its group. tions: 13. Krekova zavarovalnica 0.00% 12. Volksbank Ljubljana is a sub- Half of capital in banks and one Source: Mladina 2005 sidiary of Austrian parent bank with third in insurance undertakings is for- 3. Institutions of capital market equity holdings in two financial enti- eign–owned, while the share of for- – 17 management companies (largest KD ties/institutions in Slovenia; eigner shareholders in capital of insti- Investments with a 44.3% market share Other six banks do not form finan- in 2005) with: tutions of capital market remains cial group or information on them is below 20%. – 11 special managed investment not readily available. companies Insurance – 40 mutual funds (largest Galileo with Financial conglomerates and a 27.4% market share) 1. Insurance company Triglav: has ﬁnancial groups in Slovenia – 5 mutual pension funds management four insurance companies abroad, companies, with 6 mutual pension one at home; one management com- Due to very strict definition only funds pany, one reinsurance company and one financial group (Insurance com- – 29 stock broker companies. one pension fund.

54 BV 7-8/2005 ON THE ROAD TO CONVERGENCE

2. Reinsurance company Sava Capital market criteria for financial conglomerate Shares in four insurance compa- The largest group is KD investment and concern for market competition nies at home, one abroad, one invest- group. There is also Aktiva group and will prevent their explosion in small ment company at home. some other smaller financial groups country like Slovenia. 3. Insurance company Maribor: with institution of capital market as shares in one management company, controlling entity. REFERENCES AND SOURCES OF DATA: one pension fund, two insurance 1. Banka Slovenije: Načrt uvedbe eura (Plan of Introduction of the euro), Ljubljana, agencies and two non-financial CONCLUDING REMARKS January 2005. undertakings 2. Data on Slovene Financial Sector on 4. Slovenica insurance company Slovenia’s financial sector in is still Web, June 2005. merged with Adriatic insurance in the process of restructuring. While 3. Directive on supplementary supervision company. EU membership did have important of credit institutions, insurance undertakings and investment firms in a financial 5. Generali insurance company impact on the position of its institu- conglomerate, 2002/83/EC, Spring 2005. Ljubljana: subsidiary of Generali tions, future EMU membership and 4. Mladina, priloga o finančnem sektorju insurance company Vienna, preparation for it (ERM II regime) will Slovenije, Ljubljana, 25.4.2005. 6. Grawe insurance company, have less importance. Many financial 5. Oliver, Wyman and Co: Study on the risk Maribor: subsidiary of Grazer groups were already created during profile and capital adequacy of financial Wechselseitige insurance company transformation of the financial sector conglomerates, London, February 2001. Austria. in Slovenia, but only one or two quali- 6. Sterzynski M.: Definition of financial conglomerates, Ljubljana, Spring 2005. Other insurance companies do fy presently as financial conglomer- 7. Sterzynski M.: Development of cross- not quality as financial groups or ates. Further integration is expected sectoral capital linkages in the EU, information is not available. in the future, although due to high mimeograph Ljubljana, Spring 2005.

BV 7-8/2005 55

PAYMENT SYSTEMS

UDK 336.717(497.4):339.738:061.1EU Convergence of payment systems in Slovenia and the EU Matevž Pirnat *

By replacing the national y replacing the national currency by the euro on the tar- currency by the euro on the target date of 2007, get date of 2007, Slovenia will become a part of the Slovenia will become a part of the euro area and euro area and a part of the emerging single euro pay- a part of the emerging single euro payments ments area. The Slovenian banking sector has been wor- area. The Slovenian banking sector has been Bking for months on the preparations for the timely implementa- working for months on the preparations for the tion of business, organisational, technological and other adjust- timely implementation of business, organisational, ments dictated by the introduction of the new currency. The in- technological and other adjustments dictated by tensity of changes upon the euro adoption will not be the same the introduction of the new currency. The inten- in all lines of business, but payment transfers will be hard hit – sity of changes upon the euro adoption will not be both providers and users of payments services will have to face the same in all lines of business, but payment these changes. transfers will be hard hit – both providers and users of payments serv- Introduction ices will have to face these changes. Let us start by mentioning the changes in the conditions of economic operations which will be caused by being fully com- pliant with the EU legislation1, as well as the adjustments of processes, (payment) infrastructure or payment systems – here the first important steps have been already taken. The fact is that the payments systems convergence is not a single act to be realised by entering the euro area, but a process which will continue well after joining EMU due to the fact that today the single euro payments area is far from being in place. It is like boarding a moving train whose terminal station has not been named yet. Although over the past few years much has been written about the European payment transfers due to the intensity of

* Matevž Pirnat, BEc, advisor of the director, NLB d.d, Ljubljana 1 Particularly the regulation concerning cross-border payments and the directive about a new legal framework for payments on the internal market, which is being prepared.

BV 7-8/2005 57 PAYMENT SYSTEMS

changes, and the domestic expert quirements in regard to information for the European Payments Council public monitors these processes with providers of payment services (i.e. mi- (EPC). vivid interest (especially after Slove- nimal standards for customer informa- The EPC is the most important deci- nia’s accession to the EU), this paper tion about prices and the time needed sion-making body of the European focuses on the changes of particular to carry out payments) and the terms banking sector for payment transfers, relevance to our integration into the or principles of cost sharing for carr- as well as the most representative par- euro area. ying out cross-border payments within ticipant in discussions with the Euro- the EU or the single economic area. pean regulators. With the EU enlarge- Transforming the European Despite effort to facilitate cross- ment, the new Member States got the border payment services, the intensity opportunity to participate in the EPC; payment transfers and forming of changes in the European banking it thus now consists of 64 members the single euro payments area sector did not satisfy the European from 27 countries.7 In September With the euro changeover on the Commission, especially because 2004, the Bank Association of Slove- 1 January 1999, the single currency banks continued to charge substan- nia became a member of the EPC. area within the European Monetary tially higher fees than for domestic Four task forces work within the Union became a reality, while the sin- payments in euro. EPC, they cover individual payment in- gle euro payments area is still not in The discontent with the situation re- struments or fields, which are defined place. The European payment trans- sulted in the adoption of the Directive as essential, namely: fers are fragmented into national pay- – electronic credit transfers, ment transfers based on different pro- – electronic direct debits, cedures, conventions, standards and – credit card transactions, and regulations. For domestic euro pay- It is like – cash transactions. ments,2 i.e. euro payments within na- Two additional groups were estab- tional borders, countries use various boarding lished to support these four basic task payment infrastructures that differ forces, namely: from those used for cross-border pay- – the support group for opera- ments.3 a moving train tions, infrastructure, technology and The latter is significantly less effec- standards; and tive in regard to costs, the required whose terminal – the subgroup for legal matters. 8 time to carry out payments, and the the EPC in its programme for the quality, i.e. reliability or frequency of realisation of SEPA set itself the task 9 errors. station to provide frameworks for establis- The fact that the European pay- hing suitable pan-European infrastruc- ment systems are so different and the has not been ture until 2008, this infrastructure will absence of appropriate or efficient provide consumers and companies pan-European infrastructure have named yet. with the same level of services as been identified among the main ob- exists in the domestic payment trans- stacles for establishing the single euro fers, for 2010 the transformation of payments area. national payment schemes into pan- on cross-border payments in euro5, This unsatisfactory state of affairs European is planned, this will estab- according to which banks have to lish the single euro payments environ- has forced the regulators, i.e. the Eu- carry out cross-border payments in ropean Commission and the Euro- euro within the EU at the prices for 5 The Regulation no. 2560/2001 of the Euro- pean Central Bank (ECB), as well as the equivalent euro payments in their pean Parliament and the Council of the EU on the European banking industry, to domestic payment transfers. cross-border payments. The regulation concerns search for satisfactory solutions which low value payments – up to € 12,500, yet such payments must meet some additional criteria, would provide the users of payment namely that the originator provides IBAN of the services with highly efficient (price- SEPA and the European pay- beneficiary and the BIC of his bank, which ment environment would enable the providers of payment services competitive, fast and reliable) credit automated processing or Straight Through transfer in euro as a basis for smooth Processing (STP). After 1 January the limit will Parallel with the activities of the re- flow of goods, services and capital rise to €50,000. gulators and in response to Directive 6 within the internal market. European Banking Federation (EBF), European on cross-border payments in euro, Savings Banks Group (ESBG), European Asso- Before the euro was introduced, Di- ciation of Cooperative Banks (EACB) the European banking sector began rective on cross-border assignments 7 European Payment Council: Annual Report searching or designing solutions for was adopted4. It laid down uniform re- 2004 establishing the single euro payments 8 European Payments Council: Roadmap 2004- 2010 2 In the countries members of the EMU about area, which was named SEPA (Single 99% of all payment transactions within national Euro Payments Area) and defined as 9 The role of the EPC is not to develop the infra- systems, i.e. as domestic payment transfers, are the area “in which citizens and com- structure independently and appear as, for carried out in euros. Source: Bundesverband example, the owner or operator of certain Deutscher Banken, Der europaeische Zahlungs- panies will be able to carry out pay- payment systems, but to establish framework(s), verkehr im Wandel ments as easily and at the same pri- i.e. rules or standards, which individual system must follow and meet in order to be acknowled- 3 Cross-border payments are payments in euro ces as in their domestic environment”. ged as pan-European. The essence of these made by the originator in one EU member state frameworks is also that they still foster competi- to a beneficiary in another EU member state. In order to realise SEPA, 43 of the largest European banks and three Euro- tion in this field, which is a condition for further 4 Directive 97/5 EC of the European Parliament improving payment services and the efficiency 6 and of the Council of 27 January 1997. pean banking associations founded of their providers.

58 BV 7-8/2005 PAYMENT SYSTEMS

ment. Each of the principal task forces settlement (RTGS) systems managed ment account at the European Central will design appropriate solutions for by national central banks,11 the pay- Bank). In addition to this, the volume their respective fields, these solutions ment system of the European Central and value of transactions settled by will have to derive from the best prac- Bank (Euro Payment Mechanism, this system are considerably lower tice in individual national environ- EPM) and technical infrastructure,12 than those settled by the system ments – they will have to be friendly functionalities and procedures. The TARGET.19 to the users of payment services. participants send their payment in- The fragmentation of the European The EPC has no legislative power, structions into their domestic RTGS payment environment prevails prima- so the success of its endeavours de- (according to the formats valid in rily in the field of low value payments. pends above all on the commitment of their countries), while national banks Domestic payment systems are much its members or the national environ- exchange them in a single/uniform more efficient since they allow higher ments in the EU to reach the set goals message format.13 degrees of automation in payment or realise the decisions it makes. This The system TARGET, the most im- processing than the payment transfers means the so-called principle of self- portant European system for high through current accounts which banks regulation, which is intended to show value euro payments, enables settle- used for cross-border payments, and that the European banking sector is ment of domestic payments (within na- this produced a considerable discre- capable to independently design two- tional RTGS), as well as cross-border pancy between the conditions which fold solutions that on one hand provi- payments. The monthly number of banks offered their clients for dome- de increasing benefits for the users of transactions is sometimes higher than stic euro payments and those for payment services (who are guiding 6 million14 – their value exceeds cross-border payments. the decisions of the regulators), and 40,000 billion euros. Domestic pay- Prices of cross-border payments are on the other hand rational and ments prevail in the structure of the were several times higher than that least inconvenient for the banking sec- settled payments, they represent al- of domestic payments, it took several tor itself. most 76% of the total number of tran- days to settle payments, while In connection with this, the EPC sactions in 2004, while their percenta- reliability and security of cross- has established a system of reporting ge of the total value is slightly lower, border payments was considerably to monitor the realisation of its deci- namely 67%. lower.20 sions and conventions in national envi- In 2002 the ECB responded to ronments, as well as to keep the Euro- deficiencies15 of the existing system 10 According to the Regulation ES 2560/2001, pean regulators informed. by making a decision to design a low value payments are those up to 12,500 euros. To distinguish high and low value pay- new system, the so-called TARGET2, ments, the terms ﬁnancial (as a rule of high value) and commercial transactions are also European payment systems which would be based on a single common platform, i.e. on a single used. or infrastructure 11 The participants in RTGS have opened settle- RTGS, to replace the interconnected ment accounts at these banks. When discussing the European national RTGS systems (these will be 12 This includes the components and telecommu- payment systems or infrastructure, abolished). The key role in the pro- nication network for exchanging information in ject of implementing TARGET2 was real time which link national RTGS systems and one should distinguish between the the payment system of ECB. taken on by the central banks of Fran- systems by which high-value euro pay- 13 The linking component is based on the net- ments (Grossbetragszahlunsverkehr or ce, Germany and Italy, which distribu- work SWIFTNet. TARGET supports messages of Individualzahlunsgsverkehr) are ted individual assignments among the types MT103 and MT 103+, MT198 and MT 202. made, and the low value payments themselves.16 The common platform 14 Source: European Central Bank website systems10 (mass-payments, Massenzah- is planned to start operating on 15 Among them is the variability of the existing lungsverkehr). 1 January 2007, the central banks national RTGS incorporated into TARGET and A prominent system in the first are to accept it gradually, first the the difﬁculties with incorporating new ones. group is TARGET – the system that was three banks mentioned above, and 16 The project is managed and coordinated by the Central Bank of France, providing hardware developed and is managed by the Eu- then, by the end of the year, the and communication technology is the assign- ropean Central Bank (ECB). It was in- remaining banks. ment of the Central Bank of Italy, while the troduced on 4 January 1999 and it The system EURO 1, which started provision of software is assigned to the Central Bank of Germany. coincided with the third phase of the operating also on 4 January 1999, 17 EBA or European Banking Association. The European Economic and Monetary was designed as a supplement and system is managed by the company EBA Clea- Union (the euro changeover). In order also as a competitor of the system ring Company S.A. in Paris to ensure uniform monetary policy or TARGET. The owner of the system 18 EURO1 supports the following types of messages: MT102, MT103, MT104, MT 202, MT204 the implementation of its measures, a EURO 1 is the European Banking As- and MT400. 17 pan-European payment system that sociation (EBA) The purpose of de- 19 The last year’s average monthly volume of enables fast and reliable transfers of li- signing a system, which includes 70 transactions was 3.5 million, while their total quidity had to be established. TARGET banks, was to provide efficient, reliab- average monthly value reached 3,677 billion euros. is thus a real time gross settlement le and price-competitive infrastructure 20 Bundesverband deutscher Banken, Der eurosystem, which requires only seconds for settling high value euro payments. paeische Zahlungsverkehr im Wandel. The for final settlement of individual high This system, like TARGET, is based on average fee for a domestic euro payment was 18 from 0 to 3 euros, while the fee for a cross- value payments between European cre- SWIFT infrastructure, the essential border payment was from 2 to 20 euros. The dit institutions, as well as for all opera- difference between them is that pay- average time for settling a domestic payment tions of the ECB’s monetary policy. ments are settled once a day and on was from 1 to 3 days, and from 2 to 6 days for a cross-border payment. The frequency of errors Its structure is decentralised, it con- the net base (net positions are settled in domestic payments was from 0 to 0.1%, sists of 15 national real time gross at the end of a day through the settle- 0.5% in cross-border payments.

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European banks relatively soon dis- increasing volume of transactions and Slovenian payment systems covered that they would have to offer consequent cutting of costs per tran- converging with the European cross-border euro payments to consu- saction, we can expect STEP2 to be- systems mers and companies at the same con- come a strong competitor for national ditions as domestic payments, so they payment systems also in the field of The payment transfers reform star- began searching for solutions and de- domestic euro payments. ted in Slovenia already in 1994. Pay- signing models21 to provide appropria- If we summarise what has been ment transfers were thus no longer the te pan-European infrastructure or an said so far, we can point out the domain of a state agency (Agency of pan-European clearing house which following: the Republic of Slovenia for Pay- would enable higher standardisation – The key actors in the European ments), but of banks, and this requi- or automation in payment processing, payments environment are: the Euro- red the designing of two new appro- thus cutting the costs and shortening pean banking sector organised within priate payment systems, namely: the time required for cross-border sett- the European Payments Council with – system for high value payments lements. In 2000 EBA introduced the all its task forces and support groups, RTGS (Real Time Gross Settlement)); system STEP1, which enables settling and the regulatory authorities – the and of individual low value cross-border European Commission, the European – system for low value payments payments. This system is used prima- Parliament and the European Central GCS (giro clearing system). rily by those credit institutions (banks) Bank. All Slovenian banks and two sa- which meet the criteria22 for participa- vings banks are included in these two ting in EURO1, the membership in this systems established in 2002, while system is used as an “entrance ticket” the Central Securities Clearing Corpo- for the system STEP2. Bank ration (KDD), a depository clearing STEP2 is a pan-European payment company, participates also in RTGS. system established in April 2003, Both RTGS and GCS are mana- which on the basis of a standardised of Slovenia acts ged by the Bank of Slovenia with format23 process24 a large number of which the participants have opened low-value payments (bulk payments) as a settlement settlement accounts. The Bank of Slo- a day after the payment is entered venia also acts as a settlement agent into the system (D+1); this enables agent for the participants, at the same time the participants to automatically pro- it oversees the procedures of the parti- cess the payments (STP), thus lowe- cipants in relation to the operation of ring the costs of processing. STEP2 for providers both systems. was due to these characteristics ack- The RTGS system settles all high- nowledged (recognised) as the pay- of payment value payments, i.e. is payments of at ment system, which came closer to least two million tolars,26 and all ur- what required the concept of a pan- gent payments. The system provides European clearinghouse. The EPC services. immediate individual settlement of and also the ECB on the basis of this payments, yet only to the amount co- made the demand (the so-called Re- vered by the balance on the settle- ceiver Capability) that through all – Characteristic for the European ment account opened with the Bank banks in the EU should be accessible payment infrastructure are systems for of Slovenia. through this system, including the settling high-value payments and low- 21 Designed were five basic models, which differ banks of the new Member States. value payments. The former predomi- in the degree of centralisation and the extent to Banks can enter STEP2 as direct or in- nantly rely on the system TARGET, es- which they preserve the heterogeneity of structu- direct participants. Two solutions ap- tablished and managed by the ECB, res. Each has certain advantages and shortco- mings. For more, see Bundesverband Deutscher peared in connection with the indi- the system that will be because of its Banken, Der europaeische Zahlungsverkehr im rect mode, namely: limitations replaced by the system Wandel. – entering the system through a TARGET2; and the system EURO1, de- 22 One of the most important criteria for EURO correspondent bank (a direct partici- veloped by the banking sector (priva- 1 participation is the size of the bank wishing to enter the system - its capital have to be at least pant in the system which plays the te banks) and managed by the Euro- €1.25 bn. Source: EBA website. pean Banking Association (EBA). role of a settlement agent) at which a 23 STEP2, like other discussed systems, is based bank have opened an account – In the field of bulk payments, cha- on the network and standards SWIFT, and – entering through the national racterised by being predominantly car- supports the following types of messages: 25 MT102, MT103+ and MT 202. Payment messa- central bank, which enables acces- ried out within national borders and by ges, which are entered into this system, must sing the system through the so-called usually highly efficient yet considerably always include the recipient’s international bank single entry point. variegated payment systems (regula- account number (IBAN) and the bank identifier code of the beneficiary (BIC). At the moment only cross-border tion, practices, standards), two system 24 Gross positions of participants in STEP2 are credit transfers are processed by the were developed after the introduction settled by the system EURO1. The same holds system STEP2, yet plans exist for the of the euro, they are managed, like true for the system STEP1. inclusion of debit and credit card pay- EURO1, by EBA; these systems are 25 Such solution was for example offered by the ments, and cheques. Plans are in STEP1 and STEP2, the latter is closest central banks of Germany and Austria, as well as Slovenia’s central bank. place also for faster settlement of pay- to the concept of an pan-European 26 ments by the system, i.e. in the same clearing house (PEACH – Pan-Euro- The decision on the management of the RTGS system, (Official Gazette of the Republic of day. From what has been said, the pean Automated Clearing House). Slovenia, no. 65/02).

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In the GCS net positions of the which the participants in the system30 this way, except those in foreign ow- members are settled 5 times a day have to take into account. nership, which have entered the (5 settlement cross-sections). The sett- We can conclude, on the basis of system through their parent banks lement is carried out by the RTGS the described characteristics of the abroad.34 system. To ensure the settlement and payment systems in Slovenia, that the Establishing the single entry point the finality of payments, a settlement Slovenian banks are provided with ef- and entering into the system STEP2 in guarantee scheme has been establis- ficient infrastructure for settling dome- November 2004 met on time the re- hed – for the case when a bank can- stic payments based on SWIFT stan- quirement made by the ECB concer- not settle its net debit position. Accor- dards31 (for RTGS and GCS) which ning accessibility of all banks through dingly, each participating bank has enables a very high level of proces- this system, the Slovenian banking sec- to maintain the balance on the settle- sing automation. tor was thus already before the intro- ment account that corresponds to the The situation in the field of foreign duction of the euro granted favourab- extent of its share in the guarantee, payment transfers or cross-border pay- le access to the infrastructure which the latter is calculated monthly by the ments in euro is quite different, since enables a way of processing cross- Bank of Slovenia.27 banks for the most part use interbank border euro payments much more effi- Both RTGS and GCS are based on connections established by current ac- ciently than the correspondent way of SWIFT standards. counts (this was the case also with all carrying out payment transfers. This The GCS supports the message low value payments in euro until the fact is even more significant because format MT 103+ with the use of IBAN entry into STEP2), which is in regard the Slovenian banks will upon ente- and BIC, which enables the participa- to costs and the time required to settle ring EMU and adopting the euro have ting banks 99% automated proces- payments considerably less efficient to equalise the prices (fees) for cross- sing of payments. The Bank of Slove- way of payment transfers. border low value payments with the nia designed the special network BS- prices for equivalent domestic pay- net to forward payments into GCS Integrating into ments – these are considerably lower, and to communicate with the partici- so banks will simply not be able to af- the European payment systems pants in the system, while the partici- ford less efficient processing of such pants have to provide appropriate The described issues in regard to payments.35 hardware and software to connect to the transformation of the European 27 For more, see the Bank of Slovenia: Rules of the system. payment environment or the formation GCS Operation Besides the said two payment of the single euro payments area 28 Other systems in Slovenia do not include all systems managed by the Bank of Slo- (SEPA) became topical for the Slove- banks, they are of local character and thus not venia, we should mention28 also the nian banking sector when Slovenia discussed. Control Centre. It operates within the The term new payment instruments are special joined the EU and with the plans to deposit order, special money order, standing limited liability company Bankart and adopt the euro as domestic currency. order, direct authorisation and direct debit is based as a computer service dea- In accordance with the already entry. ling with electronic exchange and pro- mentioned requirement made by the 29 The term new payment instruments are special deposit order, special money order, stan- cessing of data on new payment in- EPC and ECB in regard to accessibi- ding order, direct authorisation and direct debit struments (NPI).29 It was founded by lity of the new Member States through entry. banks and savings banks, members of the system STEP2 by the end of 2004, 30 The document Bankart: the Instructions and the Banking Association of Slovenia, Standards for Exchanging Data through the the banks in Slovenia had first to face Control Centre (April 2005) defines in detail in order to unify and rationalise ope- the dilemma about how to enter the members’ entry into the system, submission of rating of these instruments among the pan-European system of low-value data into the Control Centre and their processing, and the standards applied with individual participants of the payment system. payments. types of instruments These instruments cover either bulk Two options were presented: 31 This is not always the case with the low value payments for the same recipient or as- – the STEP2 entry as a direct parti- payments systems in the EU members because signments of the same assignor to the cipant; this proved to cause high national standards are often used. 32 accounts of several originators. The 32 These costs were related primarily to the costs , which were not justified by membership of STEP1, which was the condition participants of the system are banks the expected volume of payments sett- for the direct membership in STEP2 (direct and companies (the latter can submit led by this system; membership of EURO1 was due to the criteria concerning the required extent of members’ the data to the Control Centre directly – entering the system indirectly capital assets out of the question anyway), and or through a bank). The Control Cen- through a direct member of the to the necessary investment into IT or adjust- tre performs the following functions: system abroad, i.e. a correspondent ments. 33 accepting data from the participants, The existing infrastructure was used for com- bank; this arose the question of pre- munication between the Bank of Slovenia and classifying data and preparing them serving the bank’s autonomy in carr- the banks members of the common entry point – for the participants, statistical monito- ying out payment transfers. the infrastructure BSnet, which is used for the giro clearing system, this substantially influen- ring of operations, recording data The solution for these questions ced the costs of investments. Besides, the tariff and processing reclamations, while and dilemmas came with the decision of the Bank of Slovenia for a payment order the flow of funds goes without Ban- of the Bank of Slovenia to provide the submitted through the common entry point is very competitive. kart (the settlement). The data entered Slovenian banks with equal or neutral 34 For more about entering into STEP2 through 33 into the system are processed once or and cost-effective access to the the single entry point, see S. Anko: Vključevanje several times a day, depending on system by joining STEP2 directly and slovenskega bančnega sektorja v enotno območ- je plačil v evrih, Bančni vestnik 2005/1-2 the type of an instrument, each type by establishing the so-called single 35 As already mentioned, these are the so-called of an instrument has a pertaining stan- entry point. Most Slovenian banks regulated cross-border payments, defined by dard or structure of data record have decided to join the system in the Regulation ES 2560/2001.

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The problem of cross-border pay- other hand it represents the best ses, besides the said new payment in- ments in euro was thus efficiently sol- basis for the transition to TARGET2, if struments, also credit card and ATM ved by entering into STEP2, while the it is established before the adoption payments. The idea that Bankart question concerning high value cross- of the euro. should in future become the clearing border payments remains, since these Integrating into the European pay- house is increasingly frequent in the payments are still settled through cor- ment systems (dictated also by the Eu- Slovenian banking sector, this would respondent relations. These payments ropean regulators) raises the question require appropriate agreement as a rule appear on the basis of finan- of the future of the domestic payment among the banks which founded or cial transactions whose number is con- systems and the prospective position own it in order to harmonize their inte- siderably lower than the number of of the Slovenian banks in the field of rests concerning the types of services low value payments, yet they are providing payment services. (settlements) transacted within this more important because of the value The discussion so far makes it house. A sine qua non for future deve- they represent. clear that the RTGS system will beco- lopment of the company into the clea- Similarly as with low value pay- me redundant upon entering ringhouse is of course also fulfilling all ments, the Bank of Slovenia also took TARGET2 since domestic high value requirements set or dictated by the the initiative in this field by formula- payments will be settled by the com- Bank of Slovenia as a regulator. As in ting the strategy for entering TARGET, mon TARGET2 platform as efficiently case of GCS, the future of this system which should be realised when the as within RTGS. will be essentially determined by the euro is adopted at the latest. Because realisation of the project SEPA, by the of the requirement made by the ECB solutions developed by the European concerning the mandatory members- banking sector within the EPC.38 hip in TARGET when adopting the Entry When discussing the convergence euro and the uncertainty whether the to the European payment systems we system TARGET2 will be actually es- must mention also the cooperation or tablished at the time when Slovenia into European the inclusion of the Slovenian banking enters EMU, two possible options for sector in the EPC. The Slovenian ban- entering emerge: payments king sector became a member of the – the Bank of Slovenia and com- EPC last year through the Banking As- mercial banks directly enter the systems brings sociation of Slovenia. The members- system TARGET2, which will accor- hip in the EPC enabled the participa- ding to the plans start operating on tion in decision-making and, what is the day Slovenia enters EMU that is Slovenian more important, offered the possibility on 1 January 2007, this is the best- to directly monitor the solutions deve- case scenario; banks new loped within that institution. The Slove- – entering the system TARGET nian banks with the membership of through one of the existing national the EPC accepted the obligation to RTGS systems. This means entering by opportunities realise its decision according to the the so-called remote participation, principle of self-regulation and work which enables the use of all functiona- and challenges. towards establishing the Single Euro lities of the host system, and requires Payments Area – SEPA. The Slovenian the least possible extent of adjust- banks have already taken the first ments in the host bank and the guest The future of GCS will be marked steps in this direction – most of them central bank.36 by the realisation of the project SEPA, have acceded to the CREDEURO and The ECB allows the latter option which plans the transition from natio- ICP Conventions (Interbank Conven- even before the euro is adopted; con- nal payment infrastructures to pan-Eu- tion of Payments), which the EPC sequently the Bank of Slovenia plans ropean for 2010. GCS is in regard to adopted in regard to the regulated to enter the system with other Slove- the level of automation (the applica- payments. The first convention requi- nian banks through the German tion of SWIFT standards, IBAN, BIC), component of the existing system the frequency of settlements within a 36 For more, see S.Anko: ibidem TARGET, i.e. the system RTGS+, in day and, last but not least, the price 37 The comparison between STEP2 and GCS case TARGET will have to be entered (fee) per transaction a modern and shows that payments entered into STEP2 are settled on the next working day, while in GCS before TARGET2 is designed. The very efficient payment system. The they are settled on the day of entering and ﬁve decision was made because of the system STEP2 (its upgrade) or some times a day. The price (fee) for a payment importance of this system (the largest entered into the system STEP2 is 0.095 euro for other new system aspiring to be a direct participants on condition the number of a share of transactions), the favourable pan-European infrastructure in the member’s payments is at least 500 per day, price per transaction and the similari- field of low value payments will thus otherwise the price is higher, while in GCS the price (fee) for an individual payment is only 5 ties with the Slovenian RTGS (format have to offer at least the same if not Slovenian tolars or about 0.02 euro. Source: of payments, the simplest connecting better conditions37 if the existing volu- Decision on changing the Decision on the tariff of systems). Such solution on one me of payments now settled by GCS for charging fees for services provided by the Bank of Slovenia (Ofﬁcial Gazette of the Repub- hand makes it possible to use all is to be redirected and taken over. lic of Slovenia, no. 4/2004). TARGET’s advantages concerning Especially interesting question of 38 Those solutions which are being prepared by instant settlement of high value the future development of the Control the task force for direct debit entries and the task force for credit card transactions are of cross-border euro payments even Centre managed by the limited liabi- particular importance from the perspective of before the euro is adopted, on the lity company Bankart, which proces- Bankart.

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res the banks to ensure the settlement have despite the increasing use of hin a bank. These decisions will es- of payments (i.e. from receiving an cheaper channels found out that the sentially define the productivity and order to authorising the beneficiary’s costs of payment transfers fall slower profitability of their payment transfers account) in three days at the most, than the pertaining income.40 This services. while ICP regulates mutual charging experience is also an important mes- In the conclusion we could say of costs among the banks, which parti- sage for the Slovenian banks, which that by entering into EMU or by adop- cipate in transacting of such pay- have so far not faced the fall in inco- ting the euro as the domestic cur- ments. me from payment transfers. rency the Slovenian banks, which are The European banks responded from the European perspective small New challenges to these challenges primarily in two or medium banks, enter a new period for the Slovenian banks ways: in which competition will be even kee- – by increasing or at least preser- ner. They will thus have to follow de- The adoption of the euro and the ving the level of income on the basis velopmental trends and changes even pending integration into the European of the increased volume of payment more actively, understand their impli- payment systems or the single euro transfers, this is characteristic prima- cations for their own operation and payments area bring new opportuni- rily of bigger banks; and make appropriate adjustments as fast ties and challenges for the Slovenian – by cutting the costs of proces- as possible, at the same time they will banks. By entering into STEP2 and sing per unit on the basis of consolida- have to search for possibilities to TARGET (2) the banks have already ting volumes (co-sourcing)41 or elimina- offer new services (with value added) started to use or will be able to use ting of processing (outsourcing), this in order to improve or at least preser- the infrastructure, which is conside- is characteristic for medium-sized and ve their competitiveness. Ensuring rably more efficient than the corres- small banks. highly rational use of limited resour- pondent network, this present them The last two concepts may repre- ces in the activities at the national with the chance to thoroughly over- sent an interesting strategic option level and especially at the micro 39 haul or rationalise the account net- also for the Slovenian banks because level will be essential, since the new work at foreign banks in the EU. they diminish or obviate the need for conditions will no longer permit low This infrastructure offers the oppor- regular investments, as well as becau- cost-effectiveness. tunity to essentially improve the level se in the following years the move- of automation of cross-border payment of future costs will be conside- BIBLIOGRAPHY AND SOURCES: ments processing, banks should at the rably affected by the investments in 1. Anko: Vključevanje slovenskega bančne- same time provide appropriate inter- new technologies needed also for es- nal organisational and technological ga sektorja v enotno območje plačil v evrih, tablishing SEPA. Bančni vestnik 2005/1–2. adjustments. The question here is From what has been written we whether it is reasonable to preserve 2. Banka Slovenije: Pravila delovanja siste- can divide the future tasks of the Slo- ma Žiro Kliring. the division between the domestic venian banking sector in the field of and foreign payment transfers once 3. Bankart: Navodila in standardi za izme- payment transfers into two main njavo podatkov prek zbirnega centra, April the euro is adopted. groups, namely: 2005. The lodestar for these changes or – tasks at the macro or national decisions, which banks will realise in 4. Bundesverband deutscher Banken, Der eu- level, among them are the short-term ropaeische Zahlungsverkehr im Wandel, the field of payment transfers, must be successful integration into TARGET, June 2003. rationalisation of procedures (proces- the establishment of a national pro- 5. European Payment Council: Annual Report sing) and cost cutting, even more so gramme for realising SEPA and the de- 2004, March 2005. in the light of the Regulation on cross- cision about the future clearing house 6. European Payment Council: Roadmap border payments in euro. The latter and its formation in accordance with 2004-2010, December 2004 and other inter- has according to the experiences of SEPA standards; nal papers of the the EPC. the EMU members left the banks wit- – tasks on the micro level, these 7. Regulation No. 2560/2001 of the Euro- hout a chunk of income. The banks will have to be carried out in order to pean Parliament and European Council on position each individual bank in the cross-border payments, 19 December 2001. 39 Preserving and maintaining of a large current account network entails locked-up liquidity to new conditions. All banks will have 8. European Commission, Proposal of directi- provide the necessary balance on individual to design (redefine) and implement ve New legislative framework for single mar- accounts, appropriate monitoring procedures ket payments, V 5.0, December 2004. etc. which can burden banks with substantial their strategies for payment transfers costs. However, the current account network or to define the market segment on 9. The Boston Consulting Group: Global Pay- ments 2003, The Payments Puzzle, Putting preserving the accounts in individual banks is which they will focus, the types of ser- often a condition for transacting other interbank The Pieces Together, 2003. businesses, e.g. treasury transactions or acqui- vices or instruments they will develop, ring sources of reﬁnancing, thus any closing of and the infrastructure they will use; 10. Sklep o spremembi sklepa o tariﬁ, po ka- accounts requires a deliberated decision. teri se zaračunavajo nadomestila za storitve, the guiding principle here will be the ki jih opravlja Banka Slovenije (Ur.l. RS, 40 For more, see The Boston Consulting Group: Global Payments 2003, The Payments Puzzle. provision of high or complete automa- št. 4/2004). 41 Examples are small cooperative banks in tion (straight-through processing or 11. Sklep o upravljanju sistema bruto porav- Germany. See The Boston Consulting Group. STP) of payments processing also wit- nave v realnem času, (Ur.list RS, št. 65/02).

BV 7-8/2005 63

INTERNATIONAL FINANCIAL REPORTING STANDARDS

UDK 366.71:657.36/.37:006:061.1EU The influence of IFRS on banks balance sheet and capital Sonja Anadolli *

As laid down by the n line with the Regulation (EC) No. 1606/2002, adopted by Regulation of the European Parliament the European Parliament on 19 July 2002, all banks, which and of the Council, as from 1 January 2005, prepare consolidated accounts and are listed on a regulat- all publicly traded companies shall prepare ed stock exchange, shall apply International Financial their consolidated ﬁnancial statements IReporting Standards (IFRS) as from 1 January 2005. Any in accordance with International Financial amendments to IFRS will be followed by amendments to the Reporting Standards (IFRS). The main Regulation. differences between IFRS and Slovenian Accounting The Companies Act is the main document in Slovenia gov- Standards arise from IAS 32 – Financial instruments erning the application of IFRS. In addition to the entities listed – Disclosure and Presentation and IAS 39 – in the Regulation, the Act also requires the following companies Financial instruments – Recognition and to prepare their annual accounts in conformity with IFRS: Measurement. With the formal start of the IFRS 1. banks, which present their financial statements in line reporting, the release of some provisions and with IFRS for the first time for the financial year stipulated by recognition at fair value of securities held-for- the Bank of Slovenia, but not later than for 2007; trading and derivatives will have the greatest 2. insurance companies, and impact on increasing assets and capital. 3. other companies, if so decided by the company’s annual Key words: International Financial Reporting general meeting of shareholders, but at least for the period of Standards (IFRS), Slovenian Accounting five years. Standards (SAS), banks, impairment, risks, In February 2005, the Governing Board of the Bank of ﬁnancial instruments Slovenia adopted the regulation requiring banks and savings banks to prepare their annual accounts in line with IFRS for the first time for the financial year starting on 1 January 2006. The transition to IFRS will lead to changes in accounting practices and when applied for the first time, it will have a one-off effect on bank results. The Governing Board of the Bank of Slovenia has decided in favour of 2006 as the formal start of IFRS reporting rather than

* Sonja Anadolli, Certiﬁed Auditor, Deputy Director of the Bank Association of Slovenia

BV 7-8/2005 65 INTERNATIONAL FINANCIAL REPORTING STANDARDS

2007 when the euro adoption and measured as the difference between time of the duration of the legal rela- implementation of the Basel II stand- the asset’s carrying amount and the tionship from which the bank expo- ards should take place. In addition, present value of the estimated future sure arises, the bank has to closely the amendments to Slovenian Ac- cash flows discounted at the finan- follow the performance of the debt- counting Standards (SAS) in line cial asset’s original effective interest or and the quality of collateral for with international standards are also rate. The carrying amount of the its financial assets. The assets are scheduled to be in place as from the asset shall be reduced either directly classified from A to E on the basis of beginning of 2006. or through use of an allowance ac- assessment and valuation of debt- Just like the savings resulting count. The amount of impairment or’s ability to settle obligations to- from the introduction of the euro are loss shall be recognised directly in wards the bank at maturity. It estab- expected to exceed the one-off costs the income statement. lishes between 1 and 100 % of pro- of the changeover to the shared cur- The impairment of the individual- visions immediately upon the ap- rency, the implementation of IFRS as ly significant financial assets can be proval of the loan, regardless of the a basis for financial reporting will valued individually, whilst the collec- quality of collateral. lead to a more homogenous busi- tive assessments can be made for The positive effects associated ness environment contributing to less important assets. A bank joins with the IFRS implementation in the greater transparency and lower op- assets together in a group on the area of loss provisioning will mostly erating costs. basis of similar characteristics and arise from: – taking into account collateral THE EFFECTS OF IFRS which reduces the scope of provi- IMPLEMENTATION sions, which is not permitted under ON BANKS’ BALANCE SHEETS Release the current regulations; – reversal of provisions for gener- Upon the transition from SAS of provisions al banking risks and partly for coun- and the Bank of Slovenia regula- try risks; tions to IFRS, the Slovenian banks – changed method of calculating may expect substantial changes to and measuring provisions for assets which will be their balance sheets arising from: individually assessed, and securities – partial reversal of provisions Reversed provisions for assets classified in the low-risk A group. International Accounting and derivatives Under IFRS, it will no longer be Standard (IAS) 39 lays down that possible to establish provisions for specific provisions i.e. impairments at market value future losses. Impairment will only of financial assets are only recog- be possible in the case of the prov- nised if a bank concludes that there will have able deterioration of the situation, is objective evidence that a financial i.e. for the events still underway or asset or a group of financial assets the events which have already oc- is impaired. If any such evidence ex- the biggest curred before the day of assessment ists, the bank has to determine the and will affect the quality of the amount of any impairment loss. The positive effect portfolio. The results in income impairment is caused by one ore statement will reflect much more evi- more events, which take place after dently the current economic situa- the initial measurement of the finan- on equity tion and reduce the soundness of cial assets and affect(s) the estimat- the banking system, but they will ed future cash flows from the im- capital. also provide the shareholders with paired assets. The losses arising a fairer market value of shares, with from the expected future events do no hidden profits or losses on finan- not affect the impairment of assets thus assesses the impairment of the cial statements. However, these even though the probability of their whole group. No individually as- accounting guidelines might also occurrence is very high. sessed assets for which the amount increase operational risk, as the The decision to make adjust- of loss has already been determined desire for “balancing” yields may ments may also be significantly influ- may be included in the collective as- lead to other forms of creative enced by rapid changes in technolo- sessment. When the financial situa- accounting. gy, political and economic situation tion or the circumstances improve, on the market and in regulations, the previously recognised impair- Recognising the effects which cause the investment in finan- ment loss is reversed through profit of valuation in income cial instrument not to be repaid. and loss. statement and not directly If there is objective evidence that In accordance with the central in capital en impairment loss on loans and re- bank regulations, impairments are ceivables or other financial assets currently determined on the basis of Under SAS, a gain on securities carried at amortised cost has been the regulatory amount of provisions held for trading and derivatives (if incurred, the amount of the loss is for each individual group. For the according to the bank’s accounting

66 BV 7-8/2005 INTERNATIONAL FINANCIAL REPORTING STANDARDS

policy these rules are applied) shall is included either in the revaluation the contractual rights to receive cash be recognised in revaluation re- reserves related to long-term finan- flows from the financial asset have serves. In accordance with IFRS, a cial investments or the company expired; or there has been a trans- gain on these securities is recog- may decide to increase its financial fer of the financial asset under dif- nised through profit and loss. The revenues by the revaluation effect. ferent terms. If the transfer does not differences arising from securities Investments in associates not in- result in derecognition because the held for trading and derivatives will cluded in consolidated financial bank has retained substantially all increase banks’ retained profits and statements are recognised in sepa- the risks and rewards of ownership enable a more realistic operational rate financial statements by apply- of the transferred assets, the entity risk management. In line with SAS, ing the cost method. In accordance shall continue to recognise the trans- the positive effects respect pruden- with IFRS, the capital method can ferred asset in its entirety and shall tial principle, which, however, dis- still be applied to banks’ investment recognise a financial liability for the torts banks’ results and the valuation s in subsidiaries and associated consideration received. of derivative financial instruments companies included in consolidated SAS do not refer to these opera- held for trading in particular. financial statements. However, in tions directly, but the Bank of The change, after which the ef- the financial statements of the par- Slovenia in its special clarifications fects of a gain on available-for-sale ent bank, investments in subsidiaries requires repurchase agreementsto financial assets will no longer be and associated companies have to be treated as derivatives. This will recognised through profit and loss lead to reallocation of transactions but in capital, will slightly reduce to the assets side of the balance the effects of reversing impairment sheet. or increasing retained profits. Corporate The implementation of IFRS will Nevertheless, the positive effects of also bring about some reallocations valuation will prevail and increase Profit Act or some merging of items, which banks’ retained profits. will not materially affect the finan- remains silent cial statements. The biggest differ- Additional liabilities ence between IFRS and SAS exist in related to staff costs the income statement. Under IFRS, about tax profit or loss from financial opera- IFRS require recognition of liabili- tions have to be broken down into: ties for employee benefits, which treatment – loss or profit from securities are known in advance. They include held for trading, e.g. the severance payments and ju- – loss or profit from securities bilee awards. The costs are calculat- of effects held to maturity, and ed by actuaries. Under SAS, staff – loss or profit from foreign cur- costs are recognised only after the to appear rency trading. event takes place and not in ad- Another difference is also recog- vance. The time distinction can only on bank nition of capital reduced by the be made for the payments, which bought back own (treasury) shares appear unevenly during the business or stakes. The capital is reduced by year, e.g. holiday bonus; therefore, balance sheets the purchase value of treasury any additional staff costs will reduce shares. This might lead to a differ- retained profits referred to above. at transition. ence in valuation, because under The resulting additional costs are SAS treasury shares are considered not recognised as eligible costs financial investments valued accord- under current tax legislation. ing to the regulatory rules. Under be accounted for either at cost, or IFRS, minority interests are present- Changed valuation in accordance with IAS 39. IFRS ed as a component of equity capi- of capital investments thus strengthens the fair value prin- tal, whilst in accordance with SAS, in subsidiaries ciple for all financial assets and lia- they posted under liabilities. and associated companies bilities. This might lead to differences in accounting for investments be- Effect on capital In line with SAS, the parent com- tween IFRS and SAS in separate fi- and capital adequacy pany valuates in its financial state- nancial statements of the parent ments long-term investments in equi- bank. Releasing of provisions and valu- ty capital of subsidiaries and association of securities held for trading ated companies by using the equity Derecognition and derivatives will have the most capital method, i.e. the carrying of ﬁnancial assets positive effect on capital. The only amount of the investment is in- and other item reallocation significant negative effect will be an creased on an annual basis to rec- increase in staff costs, which – ac- ognise the parent company’s share Under IAS 39, a bank should recording to the available data – will of the net profits generated by the move a financial asset from its bal- not account for even a tenth of the subsidiaries. The revaluation effect ance sheet when, and only when, positive effect.

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Because of the changed method line with best practice to collect the introduction of IFRS, therefore the of accounting for treasury shares as debt; payment of a potential tax liability the item deductible from capital, – establishing provisions for gen- upon the transition would in no total assets will be lower by the eral banking risks and other risks event be in line with the existing amount of treasury shares. not covered in Article 27 of the taxation legislation. It would be rea- The final effect on capital will Corporate Profit Tax Act, which are sonable that the effects of the recal- thus be positive for the entire bank- recognised as a tax-deductible item culation of economic categories are ing sector as well as for each indi- only after being used or reversed; not included in the tax base upon vidual bank. This will also have a – fair value changes which are the initial application of IFRS, i.e. in favourably effect on banks’ capital recognised for accounting purposes the first year of application, but are adequacy ratio. According to the as loss, whilst for tax purposes only rather included as revenue in the first proposals of the central bank, upon the sale or disposal of assets. tax base for the tax period in which the core (Tier I) capital of the bank According to the current prac- expenses are incurred, for whose under the item reserves and re- tice, the accounting profit is reduced coverage provisions were formed tained earnings is to rise by the ef- by the calculated tax liability before before the first application. In this fect of the released provisions be- the tax charge. This has led to an manner, no one-off outflow of as- cause of the change in valuation. unrealistic profit after taxation. By sets for taxes would be caused. The central bank foresees that only applying the deferred taxes, banks Consequently, this tax would not be the amount of the reserves should calculated on the bases of actual be taken into account, which ac- payments, as it could cause tempo- cording to the resolution of the an- rary liquidity problems of banks. nual general meeting of sharehold- IFRS demand ers will not be appropriated as CONCLUSIONS shareholder dividends or payments recognition to other persons. Other effects are The EU Member States and in not to be included in the supplemen- particular their business sectors sup- tary capital valuation adjustments, of employee port the idea of the application of as provided for in the Council IFRS in all the banks in the EU, as Directive 86/635/EEC, which is benefits known this would lead to harmonization of more likely a sign of an excessive financial reporting and comparabili- precaution and will, should this ty of financial results between the same thing not be excluded also by in advance. EU Member States and beyond the other countries, reduce the competi- EU. Currently, the reporting require- tiveness of the Slovenian banks. ments for internal needs of banks, will be able to adhere to the accru- for the needs of supervisors, statis- INTRODUCING DEFERRED al-based principle. Should the tax tics, accounting, taxation etc. vary TAXES AND THE TAXATION legislation remain unchanged, it can among the EU states. The proposed ASPECT OF THE TRANSITION be expected that the accounting uniform reporting package based profit after taxation will be reduced on the internal needs of reporting Also in Slovenia the changed compared to the previous system, and at the same time meeting the re- taxation legislation introduced at the because of the deferred taxes. quirements of external users would beginning of 2005 will introduce The question of taxes remains lower the costs and facilitate com- the deferred taxes because of the open even half a year before the parisons between the Member provisional differences between ac- transition to IFRS. The Corporate States and within their individual fi- counting profit and tax profit. Profit Tax Act remains silent about nancial sectors, which may hinder The purpose of the deferred tax treatment of effects caused in the establishment of links in the in- taxes is to assure proper recognition the balance sheets upon the IFRS im- dustry, it makes running these institu- of expenses for taxes in the account- plementation. Specific provisions tions more demanding and causes ing of expenses for the income tax recognised as expenses in the calcu- problems in decision-making of di- and thereby to take into account the lated amounts, but only up to the rectors and shareholders. accrual-based principle. This princi- level provided for by the Banking We can only hope that Europe ple says that revenues and costs Act will be partly released accord- will – like in the case of the change- have to be taken into account on ing to IFRS. In accordance with over to the shared currency – gather accrual basis and should be also IFRS 1, a special category of capital enough strength once again and entered to the financial statements will have to be increased by the apply the uniform accounting poli- accordingly. positive differences. cies incorporated in IFRS in a rea- It can be expected that deferred Under the Bank of Slovenia reg- sonable period of time. taxes in banks will emerge from the ulation, specific provisions may only following provisional differences be- be released when the investments REFERENCES: tween the accounting profit and tax are repaid or when the financial position of a debtor improves signif- 1. Commission Regulation (EC) No profit: 1725/2003 of the 29 September 2003 – the write-off of debts, provided icantly. Nothing of the afore-men- adopting certain international accounting that a bank has taken all steps in tioned will happen because of the standards in accordance with Regulation

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(EC) No 1606/2002 of the European 5. European Banking Federation: Speciﬁc 8. Institute of Auditors: Slovenian Accounting Parliament and of the Council. Brussels. comments on the outstanding issues on the Standards. Ljubljana 2001. disclosure requirements contained within CP 2. European Banking Federation: Partial 9. Internal documents of the Accounting 3 – Pillar 3. Basel, July 2003. endorsement of IAS 39. Brussels, 20 July Committee and the Supervisory Board of the 2004. 6. European Financial Reporting Advisory Bank Association of Slovenia. Ljubljana Group: Invitation to the ﬁrst meeting of the 2004. 3. European Banking Federation: FBE EFRAG Advisory Forum on Performance 10. International Accounting Standards comments on the exposure draft of proposed Reporting. Brussels, August 2004. 2001. Translation, Association of amendments to IAS 39 7. IASB: International Financial Reporting Accountants, Financiers and Auditors of 4. European Banking Federation: Comments Standards including International Accounting Slovenia, Ljubljana 2001. on Consultative Paper 3 (CP 3). Basel, July Standards and Interpretations as at 31 11. Secondary legislation promulgated by 2003. March 2004, London. the Bank of Slovenia: http://www.bsi.si.

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FOREIGN EXPERIENCE AND INSTITUTIONAL VIEWS

UDK 336.71:339.738:061.1EU Towards the euro: an institutional view on convergence in the recently acceded Member States Filip Keereman *

The paper gives an he European Council1 completed in Copenhagen as of overview of the state of euro convergence in the December 2002 the accession negotiations with ten new recently acceded Member States. Some countries Member States as the criteria for joining the European like Estonia, Lithuania and Slovenia early joined ERM II and are not in Union were fulfilled. These so-called Copenhagen crite- excessive deficit, but T 2 inflation convergence is a ria, established at another European Council in June 1993, in- watch point. Since joining ERM II in May 2005, cluded political requirements such as the stability of institutions Latvia, Cyprus and Malta have made further guaranteeing democracy, the rule of law and human rights as progress towards convergence. In Latvia, well as economic criteria on the existence of a functioning mar- which is not in an excessive deficit situation, ket economy able to cope with competitive pressures. It led to inflation has recently 3 accelerated considerably. the signing of the Accession Treaty on 16 April 2003 in Athens Cyprus and Malta appear on track to eliminate their and on 1 May 2004, the European Union was enlarged, marking excessive deficit in 2005 and 2006, respectively. the end of a historic transition process from centrally planned The four larger new Member States have taken more time to economic and political regimes to market economies embracing introduce the euro, with public finances being a democracy. key issue. The Czech Republic and Slovakia The next big objective is the adoption of the euro, as reflected appear to be on track in respecting their corrective in Article 4 of the Treaty of Accession, which states that the ten policies adopted to curb the excessive deficit in new countries “participate in Economic and Monetary Union from 2008 and 2007 respectively. Hungary the date of accession as a Member State with a derogation within and Poland face risks in 4 meeting the medium-term the meaning of Article 122 of the Treaty ”. Such countries have deficit objectives in 2005, while in Poland also the not yet adopted the euro, but are expected to do so once they year 2007 for elimination of the excessive deficit is have met the necessary conditions laid down in Article 121(1) at risk.

* Filip Keereman, head of Unit Member States V: Czech Republic, Lithuania, Poland, Slovenia, Slovakia in the Directorate General for Economic and Financial Affairs of the European Commission. Comments and suggestions from J. Baras, M. Buti, P. Kutos, A. Turrini, M. Watson, J. Verhaeven are greatly acknowledged. Any error or shortcoming remains the sole responsibility of the author. Views expressed represent exclusively the position of the author and do not necessarily correspond to those of the European Commission. 1 Available from: http://ue.eu.int/ueDocs/cms_Data/docs/pressData/en/ec/73842.pdf 2 Available from: http://ue.eu.int/ueDocs/cms_Data/docs/pressData/en/ec/72921.pdf 3 Available from: http://europa.eu.int/comm/enlargement/negotiations/treaty_of_accession 2003/table_of_ content_en.htm 4 Available from: http://europa.eu.int/eur-lex/lex/en/treaties/index.htm

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of the Treaty (the so-called Maastricht change Rate Mechanism and (iv) low joined as the twelfth participant, criteria5), unlike Denmark and United long-term interest rates. These four cri- based on the Convergence Report Kingdom which are Member States teria are further explained in a proto- 2000. The Convergence Report 2002 with a special status. The op-out ar- col annexed to the Treaty. Finally, concerned only Sweden. rangements6 of the two countries some additional elements such as the The ten New Member States were make the euro adoption, in addition integration of markets and the devel- examined for the first time in the Con- to meeting the Treaty provisions laid opment of the balance of payments vergence Report 2004,7 which also down in Article 121(1), conditional on have to be taken into account. included Sweden. The report con- their notification that they intend to cluded that none of the examined adopt the single currency. Commission Convergence countries fulfilled all euro adoption The euro adoption requirements requirements. In what follows, the Report 2004 (Article 121(1) of the Treaty) include focus is on the recently acceded the compatibility of the national legis- At least every two years or at the countries (table 1). lation with the Articles 108 and 109 request of a Member State with a der- With respect to legal conver- of the Treaty and the Statute of the Eu- ogation (Article 122(2) of the Treaty), gence, the examination mainly covers ropean System of Central Banks the European Commission and the Eu- (i) the objectives of the national cen- (ESCB). Furthermore, a high degree ropean Central Bank (ECB) have to tral banks (price stability), (ii) their in- of sustainable convergence has to be draft a convergence report in which dependence and (iii) and the integra- achieved with reference to (i) price the euro adoption criteria are as- tion into the European System of Cen- stability, (ii) absence of an excessive sessed. The first Convergence Report tral Banks. The first two domains have deficit, (iii) participation in the Ex- was drawn up in 1996 confirming the been taken care of as part of the ac- Council conclusions of Madrid in De- cession negotiations, while in the third 5 Labelled after the Dutch town of Maastricht cember 1995 and of Florence in June domain there remained some incom- where these provisions where included in the 1996 that the single currency could patibilities. Treaty, adopted by the Foreign and Finance Ministers on 7 February 1992 and entering into not be launched early because a ma- In order to assess price stability, force on 1 November 1993. jority of the Member States were not the average annual rate of HICP infla- 6 Article 4 of the protocol on certain provisions ready at that moment. Hence, the tion was calculated to August 2004 related to Denmark and Article 10(a) of the starting date for the euro became 1 protocol on certain provisions related to the UK (latest month available when the Con- (annexed to the Treaty). January 1999 in accordance with Ar- vergence Report 2004 had to be 7 European Commission (2004), “Convergence ticle 121(4) of the Treaty. The 1998 made). The three Member States on report 2004”, European Economy, No 6, Convergence Report indicated the which the reference value was based available from: http://europa.eu.int/comm/ economy_ﬁnance/publications/ eleven countries that could adopt the were Finland, Denmark and Sweden. convergencereports_en.htm. euro. On 1 January 2001 Greece Although the average inflation rate at

Table 1: Performance of the New Member States – 2004 Convergence Raport

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the moment of the examination was should correct their excessive deficits about the authorities’ resolve to tackle lower in Lithuania (–0.2%), this coun- by 2007 and the Czech Republic the mounting government deficits. try was excluded from the calculation and Hungary by 2008. As required by the Treaty, the because countries with negative infla- The exchange rate criterion is as- Convergence Report examined also tion rates are not considered to be the sessed with respect to participation in other factors relevant to economic in- best performers in terms of price sta- ERM II (the successor of the Exchange tegration and convergence, but these bility. Calculated in this way the refer- Rate Mechanism when the euro was are not based on quantitative bench- ence value was 2.4%, which was not introduced) and substantial exchange marks. These additional factors exceeded by the Czech Republic, Es- rate stability vis-à-vis the euro.10 On include the results of financial and tonia, Cyprus and Lithuania. 28 June 2004, the Estonian kroon, product market integration and the The criterion on the government Lithuanian litas and Slovenian tolar development of the balance of budgetary position is met when a joined ERM II with a standard fluctua- payments. country is not in an excessive deficit tion band of ±15 percent around their situation, which is assessed in rela- respective central rates. Estonia and Developments since the tion to the general government deficit Lithuania have successfully main- Convergence Report 2004: and debt. The basis of analysis is the tained their currency boards as unilat- inflation, interest rates, bi-annual fiscal notification, in which eral commitments within ERM II while exchange rates Members give statistical information the Slovenian tolar has remained very and current account to the Commission on their public fi- stable after phasing out the gradual In the four countries, which did not nance situation; the new Member depreciation against the euro. The exceed the inflation reference value at States supplied this information offi- minimum stay of two years in ERM II the time of the 2004 Convergence Re- cially for the first time on 1 March was not respected by any of the new port, inflation increased rapidly ex- 2004. In 2003, the Czech Republic, countries, and hence none fulfilled the cept in Cyprus and in the Czech Re- Cyprus, Hungary, Malta, Poland and exchange rate criterion. Slovakia recorded a general govern- The reference value for assessing 8 See website on the Stability and Growth Pact ment deficit in excess of 3% of GDP. the durability of convergence is maintained by the Directorate-General for Economic and Financial Affairs: http://europa. Cyprus and Malta also posted debt based on 10-year government bench- eu.int/comm/economy_finance/about/ ratios above 60% of GDP. On 5 July mark bonds. It was 6.4% in August activities/sgp/main_en.htm. 2004, the Council decided,8 on a 2004 and was respected by the 9 Council regulation (EC) No 1466/97 on the recommendation from the Commis- Czech Republic, Latvia, Lithuania, Cy- strengthening of the surveillance of budgetary positions and the surveillance and the sion, that an excessive deficit existed prus, Malta, Slovenia and Slovakia, coordination of economic policies (OJ L 209, in these six Member States. At the for which long-term interest data are 2.8.1997) (part of the Stability and Growth same time, the Council adopted, act- available. Based on the analysis of Pact). 10 Observing the standard fluctuation margins of ing on a recommendation from the an interest rate indicator (in the ab- ±15% in ERM II has not been considered Commission, the recommendations sence of benchmark long-term gov- sufficient to fulfil the exchange rate criterion by on how to correct this situation. In ernment bonds) and taking into ac- the Commission in its Convergence reports. In these reports, the Commission assessed line with the convergence pro- count the low level of government exchange rate stability on the basis of the grammes9 submitted by the new debt, there were also no reasons to normal fluctuation margins that existed in the old ERM at the time of drafting the Maastricht Member States for the first time in conclude that Estonia did not meet the Treaty. Deviations from these bands have been May 2004, Cyprus was recommend- interest rate criterion. In Hungary and assessed on a case-by-case basis, taking into ed to bring its deficit below 3% of Poland, the process of interest rate account notably the duration and amplitude, the nature and extent of policy responses, and the GDP already in 2005 and Malta in convergence has been interrupted in direction of the deviation (i.e. appreciation or 2006, whereas Poland and Slovakia the second half of 2003 on concerns depreciation).

Graph 1: Recently acceded Member States. Inflation and interest rate developments since the 2004 Convergence Report

Reference: based on the three countries with the lowest inﬂation rates Source: Commission Services

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public the annual inflation rate With respect to exchange rate sta- more, FDI inflows, which are more dropped considerably in the begin- bility, three more currencies, which to stable than short-term capital flows, ning of this year (1.4% in April 2005). a varying degree had shadowed the have to an important extent financed Underlying the price developments is euro, entered ERM II on 2 May 2005. the current accounts. Still, the large the increase in administrative prices The Cyprus pound was already since external imbalances raise vulnerabili- and indirect taxes, linked to the har- 1999 unilaterally pegged to the euro ties, and policy discipline (including a monisation with EU requirements. In within a ±15% band, but the de facto prudent fiscal stance and effective fi- Malta, average inflation rate re- fluctuation margin had been much nancial supervision) is required to en- mained relatively low. In Poland and smaller. The Latvian lats had shifted sure that developments in domestic Estonia, the 12-month moving average from a SDR to the euro-peg on 1 Jan- saving-investment balances remain inflation rate increased to 4%, but in uary 2005 while the Maltese lira kept compatible with longer-term macr- the former country inflationary pres- its peg to a basket, in which the euro oeconomic and financial stability. sures seem to be easing. Latvia’s infla- had the largest weight, until joining tion rose rapidly to above 6% and is ERM II on 2 May. Also the lats and Public finances: effective now the highest in the EU, while Hun- lira had remained stable vis-à-vis their action, the fiscal notification of gary and Slovakia, with annual infla- respective anchor currencies before March 2005 and the updated tion rates of 3.8% and 2.5% in April ERM II entry. Three of the four curren- convergence programmes 2005 respectively, are dis-inflating cies outside ERM II are floating, either quickly, though inflation differentials freely (Polish zloty) or under a man- In the Council recommendations of remain wide. Slovenia continued on aged float regime (Czech koruna, 5 July 2004, the four-month deadline its steady disinflation path and is slow- Slovak koruna). All three currencies that expired on 5 November was ly narrowing the inflation gap. continued appreciating against the given to take effective action in order Compared to the Convergence Re- euro until March 2005, when they re- to realise the 2005 budgetary tar- port 2004, convergence continued in versed trend after a series of interest gets. Of the six recently acceded the high inflation countries. A setback rate cuts by their central banks. The countries in an excessive deficit situa- was observed in the low inflation coun- Hungarian forint, which is unilaterally tion, only Hungary has been diag- tries, which is mainly attributable to in- linked to the euro with a ±15% band, nosed with failing to live up to its creases in administrative prices and in- followed a similar pattern, but the commitments.11 The 2004 deficit tar- direct taxes in accordance with EU leg- amplitude of fluctuations was much get of 4.6% of GDP (including the islation. In order to ensure price stabili- smaller. burden of the pension reform) was es- ty, it is essential that second round Current account imbalances re- timated to be have been missed by a price effects, which can emerge easily mained wide, particularly in the Baltic wide margin as the outcome was in a catching-up context due to the States, Hungary and Malta (deficits 5.5% of GDP. Furthermore, the Com- strong income expectations that it gen- close to 10% of GDP or above). The mission Services 2004 autumn fore- erates, are avoided. This could prove risk of a balance of payments crisis casts showed that the 2005 target of more difficult in the present environ- is, however, reduced as current ac- 4.1% of GDP was likely to be over- ment of high oil prices and if exchange count deficits have mostly been linked shot at 5.2% of GDP. On a proposal rate policy is constrained. However, as to strong investment activity underly- from the Commission, the Council the case of Slovakia indicates, a rapid ing the catching-up process and im- made on 8 March 2005 a new rec- decline in inflation is possible if a re- proving the export potential. Further- ommendation under Article 104(7) form-minded stability-oriented macroeconomic policy is pursued. Graph 2: Recently acceded Member States. On the whole, long-term interest Exchange rate developments vis-à-vis the euro rate convergence has progressed. Hungary and Poland, which exceeded the reference value in the Conver- gence Report 2004, have lower long- term interest rates thanks to lower inflationary pressures and a stronger currency, but fiscal consolidation remains critical. Of the countries below the reference value, Cyprus’ long interest rates increased for lack of market liquidity, despite significant progress with fiscal consolidation (the deficit is expected to drop below 3% in 2005 according to the Commission spring 2005 forecasts) and inflation remained under control (2.8% on an annual basis in April 2005). ¹¹ Commission communication of 22 December 2004 endorsed by Council conclusions on 18 January 2005. Council decision of 18 January 2005 that Hungary had not taken effective action. Source: Commission Services

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asking Hungary to take corrective ac- GDP in 2007 (up from 1.5% of GDP updated convergence programme of tion by the extended deadline of 8 according to the May 2004 conver- December 2004, Estonia is the only July of 2005, although 2008 remains gence programme) is formulated with- country, which respects the medium- the date for the elimination of the ex- out the impact of the introduction of a term objective. Estonia realised a gen- cessive deficit as indicated in the funded pension scheme estimated to eral government surplus of 1.8% of May 2004 convergence programme. be about 1.5% of GDP. Adding this GDP in 2004 and the updated con- The recommendation included the re- expenditure would bring the Polish vergence programme targets balance quirement to implement additional deficit above the Treaty reference in the period 2005-2008. With 2007 measures of 0.5% of GDP in order to value and the Council opinion of 17 deficits of 1.4% of GDP in Latvia and meet the new target of 3.6% of GDP February 2005 on the updated con- 1.5% of GDP in Lithuania according in 2005 (excluding 1.1% of GDP for vergence programme, based on the to their respective updated conver- the pension reform) specified in the assessment of the Commission, point- gence programmes, the Council opin- updated convergence programme of ed at this risk (see also below: the re- ions of 8 March 2005 indicated that 1 December 2004. form of the Stability and Growth both countries do not meet the medi- The fiscal notification of March Pact). The high-debt new Member um-term objective within the pro- 200512 on the outcome for 2004, in- States foresee in updated conver- gramme period. Also for Slovenia, of dicated that, compared to the targets gence programmes curbing the rising which the updated convergence pro- of the May 2004 convergence pro- trend in their debt / GDP ratio in gramme of January 2005 targets a grammes, government balances most- deficit of 1.1% of GDP in 2007, the ly improved with the exception of Council was of the opinion on 8 Hungary, but none of the six countries March 2005 that the medium-term concerned trimmed its deficit below For the objective was not realised. Given the 3% of GDP. Also the debt GDP ratios relatively low level of the deficit in turned out better than expected, but 2007, though, a sufficient safety mar- Cyprus and Malta did not yet suc- countries gin may exist in 2007 to avoid a defi- ceed to stem the rising trend. With a cit exceeding 3% of GDP. general government deficit of 3% of committed GDP in 2004 (compared to 5.3% of The Commission services GDP in the May 2004 convergence to adopting spring 2005 forecasts: programme), progress was particular- the public finance ly impressive in the Czech Republic. and inflation projections15 This is partly explained by better than euro as early expected growth, but also a change The latest Commission forecasts in budgetary rules contributed which as in 2007, released on 4 April 200516 broadly made it possible to roll-over unspent indicate a further improvement in pub- allocations into 2005. Furthermore a lic finances and the targets set in the guarantee was reclassified to the year the year 2005 convergence programmes are likely it was issued from the year a first in- to be met in 2005. The major excep- stalment was paid. Although the is of particular tions are Hungary and Poland. In re- Czech Republic reduced its deficit to sponse to the new Council recommen- 3% of GDP, there was no ground for dation Hungary increased from 0.5% abrogating the excessive deficit deci- relevance for to 0.8% of GDP its emergency pack- sion as the requirement to reduce the age. Despite its inclusion in the Com- deficit »in a credible and sustainable public finances. mission forecasts, the risk of slippage manner« was clearly not (yet) met. in 2005 remains and further meas- This is evidenced by the rebound of ¹² Eurostat, news release 39/2004 of 18 March the deficit well above the 3% of the 2005, which is the same timing com- 2005. GDP threshold foreseen for 2005 pared to the previous programme in ¹³ In accordance with Article 104(2.a) of the both by the Commission Services the case of Cyprus, but one year ear- Treaty which talks about “... the planned or actual government deficit ...”. (4.5% of GDP according to the spring lier for Malta. ¹4 Resolution of the Amsterdam European 2005 forecasts) and the Czech au- As required by the Stability and Council on the Stability and Growth Pact of 17 thorities themselves (4.7% of GDP ac- Growth Pact, countries not in exces- June 1997 (OJ C 236, 2.6.1997) and Council cording to the autumn 2004 conver- sive deficit should go beyond merely regulation 1466/1997, Article 7 (OJ L 209, 2.8.1997). The 20 March ECOFIN report 13 gence programme). respecting the Treaty reference values (endorsed by the Brussels European Council of For countries in excessive deficit, and aim at a medium-term budgetary 23-24 March 2005) on improving the implementation of the Stability and Growth Pact the updated convergence pro- position close to balance or in sur- allows, depending on the country, for a grammes submitted between Novem- plus.14 The primary purpose is to dis- medium-term objective between –1% of GDP ber 2004 and December 2005 indi- pose of a safety margin with respect and balance or surplus. 15 cate the same year for bringing the to the reference value in case of ad- Technical assumptions are used to set the exchange rates, while the interest rate general government balance below verse cyclical developments. The me- hypotheses are not published. the reference value as that indicated dium-term budgetary objective is, 16 European Commission (2005), “Spring 2005 in the May 2004 convergence pro- however, not a condition for adopting economic forecasts”, European Economy, No 2, available from: http://europa.eu.int/comm/ gramme. However, in the case of Po- the euro. As reflected in the Council economy_finance/publications/european_ land, the deficit target of 2.2% of opinion of 17 February 2005 on the economy/forecasts_en.htm.

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ures are called for. The Council opin- Only measures known in sufficient 2005 Commission Services forecasts ion of 17 February 2005 on the De- detail are included in the Commission the inflationary pressures, stemming cember convergence programme of forecasts; a target is not sufficient. This from the oil price hike and indirect tax Poland pointed at the materialisation working hypothesis is to be kept in increases, are diminishing over the of the risk of a delayed or incomplete mind when interpreting the 2006 fore- forecast horizon and in 2006 greater implementation of the Hausner plan. casts for which no budgets are availa- inflation convergence is likely to be This is reflected in the Commission ble. Under this assumption, only Esto- observed. forecasts, which point at a larger defi- nia and Latvia are expected to meet cit in 2005 than targeted. The other the 2006 targets put in their updated The new Stability and Growth countries are considered on track to convergence programmes. According Pact and the Maastricht criteria realise the 2005 targets. The small to the Commission forecasts, Malta will overshooting of the 2005 deficit tar- have a deficit below 3% of GDP in The 2005 reform package of the get in Malta is not policy-induced, but 2006 as required in the Council rec- Stability and Growth Pact17 leaves the linked to a statistical revision (lower- ommendation of 5 July 2004 on the Treaty rules unchanged, including the ing of GDP level). A statistical revision elimination of the excessive deficit, but convergence criteria for adoption of in Slovenia (inclusion of two extra not meet the target set in the updated the euro, but specifies a set of “other budgetary funds) is also the explana- convergence programme (–2.8% of relevant factors” that the Commission tion for a small overshooting. GDP versus –2.3% of GDP). As target- and the Council will take into account For the countries, which aim at ed in the convergence programme, Cy- when deciding on the existence of an adopting the euro as early as in prus would stop the rising trend of the excessive deficit and when determin- 2007, the year 2005 is of particular debt ratio in 2006, but Malta would ing the deadline for its correction. relevance for public finances. The not succeed according to the Commis- Furthermore, due consideration will Commission Services spring 2005 sion forecasts made on the basis of in- be given to the implementation of sys- forecasts (table 2) would indicate that formation available at the cut-off date temic pension reforms. These adapta- Estonia, Lithuania and Slovenia have (16 March 2005). Debt dynamics are tions apply to all Member States, but general government deficits not ex- particularly relevant when the debt could be of particular importance for ceeding 3% of GDP in 2005 and ratio is above 60% of GDP in order to the new Member States. their debt ratios are also well below evaluate when “ ... the ratio is suffi- The ECOFIN report of 20 March 60% of GDP. It should be noted, how- ciently diminishing and approaching mentions that “other relevant factors” ever, that in Slovenia and particularly the reference value at a satisfactory including, inter alia, potential growth in Lithuania, the margin for compli- pace.” (Article 104(2.b)). and debt sustainability, can be taken ance with respect to the deficit refer- Recently an acceleration of infla- ence value is not very comfortable as tion was noted in the new Member 17 Presidency conclusions of the Brussels European noted in the Council opinions of 8 States (see graph 1), including Esto- Council of 23-24 March 2005 on improving the implementation of the Stability and Growth. March 2005 on their convergence nia and Lithuania, which aim at early Available from: http://ue.eu.int/ueDocs/cms_ programmes. euro adoption. Based on the spring Data/docs/pressData/en/ec/84335.pdf.

Table 2: The Commission spring 2005 forecasts

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Graph 3: Government balances, second pillar pension funds and Maastricht criterion

Source: Commission Services spring 2005 forecasts (for 2005 and 2006). December 2004 convergence programmes (for 2007 and 2008) into account in all the steps of the ex- Conclusion tives in 2005, while in Poland also the cessive deficit procedure except ab- year 2007 for elimination of the exces- rogation. The reformulation of the ex- The euro adoption criteria for the sive deficit is at risk. ceptionality clause of a ‘severe eco- new Member States were for the first nomic downturn’ is also important. time examined in the Convergence Re- REFERENCES: Both the Commission and the Coun- port 2004 by the Commission and the 1. Available from: http://ue.eu.int/ueDocs/ cil, when assessing and deciding on European Central Bank. It was con- cms_Data/docs/pressData/en/ec/73842.pdf the existence of an excessive deficit cluded that none of the recently acced- 2. Available from: http://ue.eu.int/ueDocs/ cms_Data/docs/pressData/en/ec/72921.pdf may consider an excess above 3% as ed countries was ready to adopt the exceptional as long as it remains euro, but considerable progress was 3. Available from: http://europa.eu.int/ made in stabilising the economy com- comm/enlargement/negotiations/treaty_of_ ‘close to the reference value’ and accession 2003/table_of_content_en.htm pared to the early years of transition. ‘temporary’ and if it results from a 4. Available from: http://europa.eu.int/eur- negative growth rate or from the out- Some countries, like Estonia, Lithuania lex/lex/en/treaties/index.htm put loss accumulated during a pro- and Slovenia early joined ERM II and 5. European Commission (2004), tracted period of very low growth rel- are not in excessive deficit, but infla- “Convergence report 2004”, European ative to potential growth. tion convergence is a watch point. Es- Economy, No 6, available from: http://eu- With respect to pension reform, tonia and Lithuania have large current ropa.eu.int/comm/economy_finance/publications/convergencereports_en.htm. the ECOFIN report stipulates that ex- account deficits, which, however do not appear to pose a sustainability 6. See website on the Stability and Growth cess close to the deficit reference Pact maintained by the Directorate-General value which reflects the implementa- issue at present. In joining ERM II in for Economic and Financial Affairs: http:// tion of a mandatory, fully-funded pil- May 2005, Latvia, Cyprus and Malta europa.eu.int/comm/economy_finance/ lar, should be considered carefully have made further progress with con- about/activities/sgp/main_en.htm. for five years after introduction or vergence. In Latvia, which is not in an 7. Council regulation (EC) No 1466/97 on from 2005 for Member States that excessive deficit situation, inflation has the strengthening of the surveillance of budgetary positions and the surveillance have already introduced such a re- lately accelerated considerably. Cy- and the coordination of economic policies form. In the first year 100% of the im- prus and Malta appear on track to (OJ L 209, 2.8.1997) (part of the Stability pact on the deficit can be consid- eliminate their excessive deficit in and Growth Pact). ered, declining to 20% in the fifth 2005 and 2006, respectively. The 8. European Commission (2005), “Spring year. This is potentially important for four larger new Member States take 2005 economic forecasts”, European Economy, No 2, available from: http://eu- decisions on the euro adoption by more time to introduce the euro, with ropa.eu.int/comm/economy_finance/publi- Hungary, Poland and Slovakia, which public finances being a key issue. The cations/european_economy/forecasts_ are in excessive deficits and have re- Czech Republic and Slovakia appear en.htm. cently introduced multi-pillar pension on track to respect their adjustment 9. Presidency conclusions of the Brussels reforms. Tentative calculations, based path for correcting the excessive defi- European Council of 23-24 March 2005 on on data on pension funds provided cit, in 2008 and 2007 respectively. improving the implementation of the Stability and Growth. Available from: http://ue.eu. by national authorities, are presented Hungary and Poland face risks in int/ueDocs/cms_Data/docs/pressData/en/ in graph 3. meeting the medium-term deficit objec- ec/84335.pdf.

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UDK 336.71(489):339.738:061.1EU Experience of Danish credit institutions in ERM II Jens Thomsen *

Due to the long-standing enmark maintains fixed-exchange-rate policy vis-a-vis` Danish experience with consistent fixed- the euro area. Since the start of the third stage of the exchange-rate policy, the participation in ERM II did Economic and Monetary Union in the EU on 1 January not imply any changes in the monetary framework 1999, the formal framework for the fixed-exchange- under which the Danish credit institutions Drate policy has been the European Exchange-Rate Mechanism, operate. The last decade or so has ERM II. Denmark participates in ERM II with a narrow fluctua- been characterised by some significant changes tion band of +/– 2.25 per cent around the central rate. The in the structure of the Danish credit-institution central rate is a conversion of the central rate of the krone sector. There have been a number of major Nordic vis-à-vis the D-mark in the previous European Exchange-Rate cross-border mergers into the Danish banking Mechanism (ERM), and the central parity of the Danish krone sector, and the mortgage- credit sector has vis-à-vis the anchor has now been unchanged for more than experienced increased domestic competition 18 years. based on new products. None of these Due to this long-standing experience with consistent fixed- development trends seem in any significant way to exchange-rate policy, the Danish participation in ERM II has not be related to the introduction of the euro implied any changes in the monetary framework within which or the Danish fixed- exchange-rate policy vis- the Danish credit institutions operate. It may however be of à-vis the euro. However, credible fixed-exchange- interest to review the structural development in the Danish cred- rate policy and stability- oriented economic it-institution sector during the last decade or so, and see if any policies during the last decade have provided a lessons regarding fixed-exchange-rate policy and financial-sector stable macroeconomic framework within which developments can be learned. the Danish credit institutions have The rest of this article is organised as follows: Section performed their business. 2 outlines the Danish experience with fixed exchange rates as a mechanism to orient policies towards stability and convergence. Section 3 reviews the development in the Danish banking sector during the last decade whereas section 4 covers the mortgage-credit sector. Finally, section 5 provides a tentative conclusion.

* Jens Thomsen, Member of the Board of Governors of Danmarks Nationalbank

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The Danish ﬁxed-exchange- no longer be considered an econom- been very stable close to its central rate policy1 ic-policy instrument. This was fol- rate against the D-mark and later the lowed by a significant tightening of euro, and in the foreign-exchange Today the macroeconomic funda- fiscal policy and an abolition of the market market participants now take mentals of the Danish economy are automatic cost-of-living adjustment of positions in expectation of a stable sound and fairly robust: Low inflation, wages. During the 1980s the fixed- krone rate, thereby contributing to surpluses on the current account as exchange-rate policy evolved into a keeping the krone rate stable. well as on the general government policy whereby the krone was held In the Danish case two fairly gen- budget, and a relatively low level of stable vis-à-vis the core currencies of eral lessons have been learned re- unemployment. the ERM, in which the D-mark in reali- garding macroeconomic stabilisation This has not always been the ty was the anchor. The credibility of policy in a fixed-exchange-rate re- case. Today’s sound macroeconomic the fixed-exchange-rate policy im- gime. environment has its background in in- proved within a short period of time – First, an unconditional willing- consistent macroeconomic policies and increased in the subsequent ness to follow the “rules of the game” and poor performance of the Danish years in parallel with reduced infla- of monetary policy within a fixed-ex- economy in the 1970s and the begin- tion expectations. The inflation differ- change-rate system is important: ning of the 1980s. Unemployment in- ential between Denmark and Without capital controls there is just creased rapidly during the 1970s, Germany was eliminated in the begin- one monetary-policy instrument – the government deficits approached 10 short-term interest rate – so monetary per cent of GDP in the beginning of policy cannot meet other targets than the 1980s, the current account of the the exchange rate.2 This implies that balance of payments showed a chron- Denmark other aspects than the exchange rate ic deficit, and inflation was often in – e.g. cyclical developments in double-digits. In principle, a fixed-ex- maintains fixed Denmark – are not considered in rela- change-rate policy was pursued with- tion to monetary policy. in the European exchange-rate co-op- – Second, a medium-term horizon eration, but the krone was devaluated exchange-rate in the annual fiscal-budget-planning several times against the D-mark dur- process without ad hoc based and ing the second half of the 1970s and policy vis-a-vis` shortsighted changes in the fiscal poli- the early 1980s. Therefore, de facto cy contributes to an environment that the exchange rate did not serve as is supportive to the fixed-exchange- the economy’s “nominal anchor”. As euro area. rate policy. a consequence of high inflation and These two characteristics of the lack of credibility, long-term central- macroeconomic policy framework – government interest rates reached ning of the 1990s, cf. Chart 2. As a together with a number of structural more than 20 per cent in the begin- consequence, the long-term yield dif- economic reforms during the last two ning of the 1980s and the long-term ferential to Germany also narrowed decades3 – have led the Danish econ- interest-rate differential between rapidly. omy on a path of stable economic de- Denmark and Germany was above Despite the widening of the fluctu- velopment with low and stable infla- 10 per cent, cf. Chart 1. ation bands in ERM in 1993 and tion. Furthermore, the fluctuations in In the early 1980s, a radical major devaluations by some of the krone vis-à-vis the euro are now so change in policies occurred. When a Denmark’s main trading partners, moderate that most ordinary house- change of government took place in Denmark has continued to pursue a holds and business enterprises no September 1982, the incoming gov- “hard” fixed-exchange-rate policy, cf. longer take them into consideration. ernment stated that devaluation would Chart 3. Since 1997 the krone has The consistent fixed-exchange-rate policy, the stability-oriented fiscal pol- Chart 1: 10-year bond yields in Denmark and Germany 1970-2005 icy and other economic policies during the last decade have provided a stable macroeconomic framework under which the Danish credit institutions have operated. The degree of stability is illustrated by the unemployment rate in Chart 4. Since the late 1990s it has been considerably lower and more stable than in the 1980s, and the current level of unemployment is also relatively low and stable in an

1 Elaborations may be found in Christensen (1999), Christensen & Topp (1997), Danmarks Nationalbank (2003a), Gaard and Kieler (2004) and Jensen (2001). 2 Cf. Storgaard (2004). 3 Regarding e.g. increased incentive to work Source: Danmarks Nationalbank. (labour-market reforms) or save (tax reforms).

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international perspective.4 A stable which the Danish Unibank and the Denmark, Norway, Sweden and economic development contributes to Norwegian Christiania Bank were in- Finland. Furthermore, in 2001 Svenska solid economic fundamentals for cluded in 2000. In 2001 the group Handelsbanken acquired the Danish households’ and business enterprises’ was renamed “Nordea”. Nordea has Midtbank, which was transformed into investment and saving decisions and considerable market shares in a branch of Handelsbanken the subse- thereby also to stability in the banking sector. Chart 2: Annual growth in consumer prices in Denmark, Germany Even though the euro area is and the Euro area 1971-2005 clearly Denmark’s most important trading partner – accounting for more than 50 per cent of the weight basis in the effective krone-rate index – there has been no sign of currency substitution in Denmark. By the end of 2004 euro-denominated deposits accounted for less than 0.2 per cent of households’ total deposits in the Danish banking sector.

Recent trends in the Danish banking structure

The beginning of the 1990s saw a number of major mergers in the Source: ECB, OECD and Statistics Denmark. Danish banking sector, which has led to an increased concentration. Danske Chart 3: Exchange rate of the krone vis-à-vis the Euro 1987-2005 Bank, Handelsbanken and Provinsbanken merged in 1990 into a new Danske Bank. At the same time Unibank was created by a merger of Privatbanken, Andelsbanken and Sparekassen SDS. In 1990 these two new large banks accounted for 59 per cent of the total amount of non- bank deposits in all commercial banks and savings banks.5 Apparently these events by and large ended the potential for further domestic mergers in the Danish banking sector – at least for a while. During the last 15 years there has only been one major merger6 in the Danish banking system solely in- Note: Before 1999, a synthetic krone rate vis-à-vis the euro is applied, calculated on the volving domestic banks. basis of the krone rate vis-à-vis the D-mark and the D-mark-to-euro conversion rate ﬁxed at In 1975 the first foreign banks es- 1 January 1999. tablished units in Denmark. By the end Source: Danmarks Nationalbank of 1990 the number of branches and subsidiaries of foreign banks had Chart 4: Unemployment rate in Denmark 1980-2005 reached 8 in total, but they accounted for less than 1 per cent of the total lending and deposits of the Danish banking sector. However, the second half of the 1990s saw a number of major cross-border bank mergers into the Danish banking sector that led to increased international integration.7 In 1997, the Swedish Nordbanken and the Finnish Merita formed a group into

4 Cf. Christensen and Hansen (2003). 5 At end-2003 the corresponding ﬁgure was 68 per cent. 6 The merger between Danske Bank and BG Bank in 2001. 7 Cf. Danmarks Nationalbank (2004). Source: Statistics Denmark.

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Table 1: Foreign ownership interest in the Danish banking sector ment in the number of branches and 1998–2004 subsidiaries of foreign banks is lower 1998 2004 in Denmark than in the euro area. If anything the contrary actually seems Number of banks 203 194 to be the case, since the number of – of which branches of foreign banks 7 7 branches and subsidiaries of foreign – of which from Euro area 3 3 credit institutions in the euro area – of which subsidiaries of foreign banks 2 10 member states declined from 1998 to 2003 and their market share has only – of which from Euro area 0 3 increased slightly.11 Foreign ownership share of Danish banking sector (a), per cent 0 13 The last decades’ increased inte- Note: gration of the Nordic banking sectors (a) Foreign direct investment (FDI) in Danish banks in per cent of the total capital and therefore suggest that the Nordic reserves in the Danish banking sector. banks have been relatively active in Source: Danmarks Nationalbank. utilising the opportunities provided by quent year. Although Handelsbanken Norway and Iceland also apply infla- the free cross-border movement of is not one of Denmark’s largest banks, tion targeting and are furthermore not capital in their business development. its market share in Denmark is not in- members of the EU. The structural significant. Finally, in 2004 the Structural changes in the Icelandic Kaupthing Bank acquired Danish mortgage-credit sector12 the Danish bank FIH. The number of subsidiaries of for- The number The main features of today’s mort- eign banks in Denmark has increased gage-credit sector in Denmark have from 2 in 1998 to 10 in 2004, while of subsidiaries deep roots in the past. The first the number of branches of foreign Danish mortgage-credit institution was banks has been unchanged at 7, cf. founded in 1797 and provided loans table 1. In total, the foreign owner- of foreign secured by mortgage on real proper- ship share of the Danish banking sec- ty financed by the issuance of negoti- tor has increased from virtually zero banks able debt securities. The financing of in 1998 to 13 per cent in 2004.8 mortgage loans through the issuance The last couple of decades have of exchange-quoted bonds has been also seen an increased internationali- in Denmark a key characteristic of the Danish sation of the Danish banking sector mortgage-credit system ever since. through the establishment abroad of rose from two The mortgage-credit institutions have branches and subsidiaries of Danish to comply with the so-called “balance banks. Danske Bank established a principle” requiring a continuous bal- subsidiary in Luxembourg in 1976. in 1998 ance between the payments received Subsequently Danish banks estab- from the borrowers and the total pay- lished foreign units in a broad range to ten in 2004. ments made to the bondholders. This of countries, including UK, Germany, implies that the assets and liabilities Singapore and USA. By the end of of a mortgage-credit institution are by 1980 the Danish banks had 8 units changes in the Danish banking sector and large matched in terms of interest abroad and a decade later the corre- during the last decade does therefore rates and maturity. sponding number was 39. The inter- not seem to be related to the introduc- During the 1970s and the 1980s national orientation of the Danish tion of the euro or the Danish fixed- the lending terms of the Danish mort- banking sector has persisted during exchange-rate policy vis-à-vis the gage-credit institutions were used as the most recent decade. Danske Bank euro in any significant way. Rather, a policy tool for macroeconomic sta- acquired for instance the Swedish the development has probably been bilisation, and the mortgage-credit Östgöta Enskilda Banken in 1997 and driven by some of the “traditional” market was closely regulated in terms the Norwegian Fokus Bank in 1999, factors that motivate cross-border of maturities, loan-to-value ratios and and in 2004 Danske Bank entered mergers and acquisitions in the bank- other features of the loan. In the late into an agreement to purchase ing industry such as cost reductions National Irish Bank (based in Ireland) due to economies of scale.9 8 However, since loans to Danish residents from foreign branches might be booked outside and Northern Bank (based in In view of the still relatively low Denmark these ﬁgures do not give a full picture Northern Ireland). level of cross-border mergers and ac- of the signiﬁcance of foreign participation in the The increased international repre- quisitions activity within the euro Danish-banking sector. 9 sentation in the Danish Banking sector area-banking sector in general,10 the Cf. also Danmarks Nationalbank (2003b). 10 absence of major cross-border merg- Cf. page 8–9 in European Central Bank has until now mainly involved banks (2004) and page 78–80 in European Central from the Nordic countries. Among the ers into the Danish banking sector by Bank (2005). Nordic countries only Finland is a euro area banks does not appear to 11 Cf. page 42–45 in European Central Bank member of the euro area. Sweden is be a result of Denmark being outside (2004) and page 80 in European Central Bank (2005). a member of the EU, but pursues an the euro area. Nor are there any indi- 12 Cf. e.g. Christensen and Kjeldsen (2002), inflation target in monetary policy cations that the level of financial inte- Frankel et al. (2004) and Danmarks and is not a member of ERM II. gration as measured by the develop- Nationalbank (2005a, 2005b).

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Table 2: Structural changes in the Danish mortgage-credit REFERENCES: sector 1998-2004 1. Christensen, A. M. (1999), Comment, in: Andersen, T. M., S. E. H. Jensen and O. 1998 2004 Risager (eds.), Macroeconomic Perspectives Domestic lending to non-MFIs, billion kroner 988 1488 on the Danish Economy, London: MacMillan, pp. 261–263. – of which in foreign currency (mainly euro), per cent 0 6 2. Christensen, A. M. and K. Kjeldsen – of which adjustable-rate loans, per cent 3 44 (2002), Adjustable-Rate Mortgages, – of which deferred-amortisation loans, per cent 0 16 Danmarks Nationalbank Monetary Review, 2nd Quarter, pp. 57–74. Source: Danmarks Nationalbank 3. Christensen, A. M. and J. Topp (1997), 1980s and the 1990s the mortgage- cy denomination of the households’ Monetary policy in Denmark since 1992, credit legislation was gradually liber- wages and salaries). BIS Policy Papers, No. 2, pp. 5–23. alised, which enabled the mortgage- The last decade has thus markedly 4. Christensen, A. M. and N. L. Hansen credit institutions to supply a wider transformed the Danish mortgage- (2003), Volatility in Inflation and Economic range of products. In 1993 the two credit system from a system based Activity in the Nordic Countries, Danmarks largest Danish banks established their mainly on long callable fixed-interest Nationalbank Monetary Review, 4th own mortgage-credit institutions. This rate loans to a system with many dif- Quarter, pp. 29–39. further intensified the competition in ferent types of loans and a high share 5. Danmarks Nationalbank (2003a), the mortgage-credit market. In addi- of adjustable-rate loans. However, the Monetary Policy in Denmark. tion, mortgage loans from banks, i.e. driving forces behind this develop- 6. Danmarks Nationalbank (2003b), Cross- bank loans against the home as col- ment have been liberalisations and in- Border Groups, Danmarks Nationalbank lateral, have become increasingly creased domestic competition. It does Financial Stability 2003, pp. 81–87. popular in recent years. not seem in any significant way to be 7. Danmarks Nationalbank (2004), Traditionally, the Danish mort- related to the introduction of the euro Branches of Foreign Credit Institutions, gage-credit institutions offered fixed- or the Danish fixed-exchange-rate Danmarks Nationalbank Financial Stability rate loans with a maturity of up to 30 policy vis-à-vis the euro. 2004, pp. 67–76. years. However, in 1996 a new type 8. Danmarks Nationalbank (2005a), New products for home financing, Box 2 in of adjustable-rate mortgages were in- CONCLUSION troduced and they quickly became Recent Economic and Monetary Trends, Danmarks Nationalbank Monetary Review, very popular. By the end of 1998 Due to the long-standing Danish 1st Quarter, p. 13. they accounted for 3 per cent of the experience with a consistent fixed-ex- total volume of outstanding domestic change-rate policy the participation 9. Danmarks Nationalbank (2005b), The interest-rate exposure of Danish mortgage-credit loans while the corre- in ERM II did not imply any changes homeowners, Danmarks Nationalbank sponding figure at end-2004 was 44 in the monetary framework under Financial Stability 2005. per cent, cf. table 2. The innovation which the Danish credit institutions 10. European Central Bank (2004), Report of new types of mortgage loans has operate. on EU Banking Structures, November. continued in recent years. Loans with The last decade or so has been deferred amortisation for up to 10 characterised by some significant 11. European Central Bank (2005), Consolidation and diversification in the euro years were introduced in 2003, and changes in the structure of the Danish area banking sector, ECB Monthly Bulletin, towards the end of 2004 mortgage- credit-institution sector. There have May, 79–87. credit institutions began to offer mort- been a number of major Nordic 12. Frankel, A., J. Gyntelberg, K. Kjeldsen gage loans with an embedded cap cross-border mergers into the Danish and M. Persson (2004), The Danish on interest rates for up to 30 years. banking sector, and the mortgage- mortgage market, BIS Quarterly Review, Even though the mortgage-credit credit sector has experienced in- March, 95–109. institutions offer euro-denominated creased domestic competition based 13. Gaard, S. and M. Kieler (2004), Two loans, these loans only accounted for on new products. decades of structural reform in Denmark: a 6 per cent of the total volume of out- None of these development trends review, Oesterreichische Nationalbank 32nd standing domestic mortgage-credit seem in any significant way to be re- Economic Conference, May 27 and 28, Vienna. loans at end-2004. This should prob- lated to the introduction of the euro or ably be viewed in light of the low in- the Danish fixed-exchange-rate policy 14. Jensen, H. F. (2001), Costs and benefits terest-rate differential between vis-à-vis the euro. However, a credible of ERM II: The Danish experience, in: National Bank of Poland (2001), The Polish Denmark and the euro area, cf. Chart fixed-exchange-rate policy and stabil- Way to the Euro, Conference 22–23 1. At such low interest-rate spreads, ity-oriented economic policies during October 2001, pp. 252–262. the Danish households and firms ap- the last decade have provided a sta- 15. Storgaard, P. E. (2004), Monetary- parently find it more convenient to ble macroeconomic framework under Policy Targets and Instruments, Danmarks borrow in their base currency (i.e. which the Danish credit institutions Nationalbank Monetary Review, 2nd Danish kroner, since this is the curren- have performed their business. Quarter, pp. 51–67.

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UDK 336.1/.7(474.2):339.738:061.1EU Estonia’s preparations for joining the euro area Andres Sutt *

The aim of the paper is f the new EU Member States, Estonia has been in the to give a brief overview of the issues related to group of forerunners when it comes to the issue of join- Estonia’s entry into the euro area. The paper ing the European Monetary Union (EMU). Estonia has examines the motive of Estonia to join the euro always asserted that it seeks to join the euro area area from the optimum currency area theory Osooner rather than later and entered the European Exchange perspective, analyses Estonia’s ﬁrst year Rate Mechanism (ERM II) on 28 June 2004, shortly after acced- experience in ERM II and reviews the current stage ing to the European Union. The authorities’ target date for join- of practical preparations for euro changeover. The ing the euro area is 1 January 2007. main conclusion is that there are indeed strong Why is Estonia looking for rapid integration with the euro arguments for early entry into the euro area, as area? The current paper examines the motive of Estonia to join possible costs stemming from joining the the euro area sooner rather than later from the optimum curren- monetary union are essentially non-existent in cy area theory perspective. Whereas it is clear that participation case of Estonia. The ﬁrst year in ERM II can be in the monetary union entails several economic benefits, it is also regarded successful as economy has developed important to consider possible costs. Therefore the first section mostly as predicted and there have been no of the paper reviews the most important aspects of the existence tensions in the exchange rate market. Practical of the optimum currency area between Estonia and the euro preparations are under way as well with the area, based on the article of Lättemäe and Randveer (2004). aim of preparing Estonia for joining the euro As potential tensions of belonging to the monetary union area on the target date of 1 January 2007. should become obvious already during the participation in ERM II, the first year experience with ERM II is analysed in the second section of the paper. Finally, the current stage of practical preparations is reviewed in order to assess whether the current target for introducing the euro is feasible from the practical viewpoint.

What is the rationale for Estonia’s early entry into ERM II? The main driver for Estonia’s early entry is to reap the economic benefits of the monetary union through the increased

* Andress Sutt, Deputy Governor of the Bank of Estonia

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trade and financial integration, as percent deficit threshold only once financial structures (Mongelli, 2002). well as by fostering economic growth (during the Russian crisis related short EU Member States, especially the and real convergence. The latter in- recession in 1999) and our public Nordic countries, play a very impor- clude maintaining strong policy disci- debt is less than five percent of GDP. tant role as a source of FDI inflows pline, an increase in the economic Secondly, Estonian economy is and are dominant players in the and financial integration of the Estoni- increasingly integrated with the EU. Estonian financial industry. Swedish an economy with the euro area, re- Strong trade links between countries, and Finnish investors own 70% of FDI duction of the transaction costs and a especially when intra-industrial trade stock and 97% of the Estonian bank- decrease in the interest rates by the is included, are expected to reduce ing sector, whereas the rest of the elimination of the exchange rate risk the exposure to asymmetric shocks. Member States account for an addi- premium. Estonia is a small and highly open tional 16% of FDI. The effect of poten- Joining the monetary union or economy with total exports and im- tial asymmetric shocks to Estonia is participating in ERM II is usually ports (including services) accounting thus mitigated by a high degree of fi- deemed to entail some costs in other for about 170% of GDP. Estonia has nancial integration with the EU, dem- areas, e.g. short-term costs of fiscal close trade relations with the EU as onstrated by massive cross-border consolidation and the cost of giving EU members accounted for about capital flows (Lättemäe and Randveer up independent monetary policy and 83% of our export structure and 2004). Estonia was one of the first flexible exchange rates as stabiliza- about 86% of Estonian foreign direct acceding countries to fully liberalize tion tools. These possible costs that its capital account already in 1994. we know from the optimum currency Comparable economic structures area literature (Mundell 1996, McKin- decrease the risk of asymmetric eco- non 1963, Kenen 1969) are essential- In general, nomic shocks and increase the simi- ly non-existent in case of Estonia, as larity of shocks within the monetary ERM II and later on full participation union (see Tavlas 1994). The structure in the EMU do not call for major ad- Estonian of Estonian economy (both in terms of justments in our macroeconomic poli- value added and employment) disag- cies, Estonian economy is increasingly economy gregated into three main sectors has integrated with EU Member States, virtually converged to the economic the Estonian non-financial sector is is most closely structure of the EU. Some differences sufficiently flexible and monetary poli- exist on a more disaggregated level: cy transmission is similar (Lättemäe the agriculture sector is still somewhat and Randveer 2004). connected to larger and the services sector smaller First, no substantial adjustments than in the euro area, both in terms of in current macroeconomic policies the economies economic size and employment distri- are needed. The currency board with bution, reflecting the ongoing restruc- its limited discretion is usually per- turing process and lower per capita ceived to be the closest monetary re- of Finland income level. gime to a full monetary union. The Several studies have empirically costs related to possible loss of inde- and Sweden. estimated the correlation of supply pendent monetary policy are non-ex- and demand shocks between old and istent in Estonia. We have not new EU members in order to draw smoothed out the monetary policy im- investment (FDI) stock in 2004. This is conclusions about possible costs of pacts of the ECB and market-driven comparable to the share of intra-euro joining the monetary union. Although adjustment mechanisms under fixed area trade among the current EU the results of such studies vary the exchange rate regime by our own ac- members. In general, Estonian econo- general conclusion is that economic tive monetary policy (ibid.). Estonia my is most closely connected to the cycles in several Central and Eastern has operated a successful currency economies of Finland and Sweden. European countries are highly corre- board vis-à-vis EUR (DEM) for almost These connections are visible in both lated with the euro area cycle. For thirteen years now. Due to the success trade and investment, as Finland and example, Frenkel and Nickel (2002), of the currency board arrangement Sweden account for 40% of exports Fidrmuc and Korhonen (2001), and (CBA) Estonia maintained it also in and about 70% of FDI inflows to Boone et al. (2002) have found that ERM II as a unilateral commitment. Estonia. Sweden does not participate Estonia has achieved a certain de- Fiscal discipline has been strongly in the euro area but its exchange rate gree of convergence with the euro entrenched in our political culture, vis-à-vis the euro is relatively stable, area cycle. Similar conclusion for too; together with the flexible labour hence our foreign trade and invest- Estonia is drawn in recent meta-analy- market it is one of the most important ments composition still supports sis of different studies by Fidrmuc and prerequisites for smoothly operating Estonia’s motivation to join the euro Korhonen (2004). currency board systems. Therefore, area soon. Thirdly, the non-financial sector joining the monetary union does not Similarly to trade links, strong fi- has demonstrated flexibility. call for any significant changes in our nancial links should also reduce the According to the optimum currency fiscal policy, as it has been in line exposure to asymmetric shocks, as area theory the need for nominal ex- with the Stability and Growth Pact they should smooth out the impact of change rate adjustments is lower (SGP) principles for more than twelve asymmetric shocks by cross-border when wages and prices are flexible years. Estonia has exceeded the three capital flows and by convergence of (especially downwards) and/or pro-

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duction factors are mobile across and flexibility, e.g. during the adverse The interest rate transmission from within countries. It should be stressed shock of the Russian crisis in 1998– the euro area into Estonia has been that despite relatively weak economic 1999. increasingly strong since 2000 when ties with Germany in the early and The means-tested character of the Estonia’s EU prospects started to clar- mid 1990s when the Estonian curren- social safety net has also supported ify. During the last five years Estonian cy board was introduced, our growth the flexibility of labour market by curb- short-term interest rate spreads and export performance has been fa- ing the negative impact of unemploy- against the euro area have continu- vourable (Lättemäe and Randveer ment benefits (until 2003 the replace- ously decreased, falling to about 50 2004). As this has occurred under ment ratio was less than 10% of the basis points prior to joining the rigidly fixed exchange rate regime, average gross wages) (Lättemäe and European Union and to about 25 the latter indirectly points to the fact Randveer 2004). To balance market basis points already prior to joining that there is at least some flexibility in forces and social protection a manda- ERM II and has stayed at that level. the Estonian non-financial sector to tory unemployment insurance scheme This development clearly points to the cope with asymmetric shocks without was introduced in 2002, which has relevance of the European Union and needing help from a more flexible ex- made the unemployment benefits more ERM II integration process on the change rate policy (ibid.). comparable to the EU average in credibility of the Estonian monetary Most studies have concluded that terms of amount and duration of the system. in international comparison Estonian benefits (50% of the previous pay dur- The price movements can be labour markets appear to be relative- clearly associated also with real con- ly flexible and the labour market has vergence issues. Currently the final been able to absorb serious (asym- consumer price level is approximately metric) shocks by adjusting labour Interest rate 60% of the EU-15 average. Thus, in costs and employment levels to new the long term, the price level is ex- market conditions. The structure of pected to converge to the EU level Estonian employment has changed transmission due to higher productivity growth and considerably during the 1990s mean- through the Balassa-Samuelson (BS) ing that labour has been mobile from euro area effect. Relevant studies have conclud- across sectors and that job tenure is ed that the impact of productivity rather short (ibid.). to Estonia growth differential on Estonian CPI in- The dynamics and flexibility of the flation would be about 0.6 percent- labour force has been found relative- age points (Burgess et al. 2003) to ly high, especially in 1992–1994 has been 2.5 percentage points (Egert 2002). when the average yearly hiring and Whereas 1–2 percentage points of firing rates reached well above 20% increasingly the BS effect is the most common pre- as transition-related phenomena. sumption, Burgess et al. (2003) moti- Labour flows between sectors in vates their lower estimate for the BS Estonia have been larger compared strong since effect in Estonia with the heavy to industrial countries as well as to weight of the tradable sector in other acceding countries (Faggio & 2000. Estonia relative to the euro area, Konings (1999), Haltivanger, which will significantly limit the extent Vodopivec, Gross (1999) and Eamets to which productivity convergence (2001)); however, such mobility has ing the first 100 days and 40% of the translates into higher consumer price been slightly decreasing over the previous pay during the next 80 days). inflation. All in all, as the nominal ex- years. Firing restrictions are compara- Finally, Estonia has similar trans- change rate is fixed, the inflation rate ble to those of an average EU coun- mission mechanisms and nominal con- in Estonia is expected to remain try in terms of their strictness (accord- vergence is advancing. The currency slightly higher than in the EU, making ing to the OECD index).1 board arrangement together with free the Maastricht inflation criterion most The institutional framework sup- financial flows from 1994 onwards demanding for us. ports labour market flexibility. Wages have created a nominal anchor for are mostly bargained at the individual stable inflation and interest rates in Developments after level and collective contracts are usu- Estonia and have facilitated the con- the entry into ERM II ally broader than mere wage convergence of monetary transmission tracts. At national level, for example, mechanisms with the EMU. As discussed above, in the ab- the contracts do not include direct Although theoretically the scope sence of theoretical reasons for de- wage increase but concentrate on for possible discretionary monetary laying the monetary integration proc- minimum wages, unemployment bene- policy under CBA is limited up to the ess, Estonia joined the exchange rate fits and other basic questions of in- amount of excess reserves of the cen- mechanism ERM II on 28 June 2004 come policy and participation democ- tral bank, Eesti Pank has followed together with Lithuania and Slovenia. racy (Lättemäe and Randveer 2004). rather orthodox CBA in practice, Participation in ERM II should be Ex-ante indexation has no role in which has strengthened such mone- viewed as an additional test for pos- Estonian wage setting system. Under tary policy transmission further (ibid.). these conditions wages in Estonia Therefore, the interest rates in Estonia 1 The OECD index may overestimate the fact that in Estonia these restrictions are set by laws have demonstrated downward real have closely followed short-term inter- instead of being included into the collective (in the tradable sector even nominal) est rates in the euro area. contracts at the industry and enterprise level.

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sible tensions that may stem from it is important to emphasize that con- Estonia continues to participate in joining the euro area. tinuously high level of current account ERM II with a unilateral commitment When Estonia joined ERM II, a deficit does not point to problems with to the currency board. The exchange communiqué on Estonia was issued competitiveness. The productivity and rate against the euro has remained stating, “The agreement on participa- export growth in 2004 outperformed stable without any tensions. One tion of the kroon in ERM II is based the forecasts of the Estonian and could even say that Estonia’s acces- on a firm commitment by the Estonian European authorities. Furthermore, sion to ERM II was a “non-event” from authorities to continue with sound fis- Estonian companies have continuously the angle of currency markets. cal policies, which are essential for increased their market share in our preserving macroeconomic stability, partner countries’ total imports as the Practical preparations for supporting an orderly and sub- growth rate of exports to our ten big- stantial reduction of the current ac- gest trading partners has remained Besides the need to be able to fulfil count deficit and for ensuring the sus- higher than that of imports from those the Maastricht criteria and maintain tainability of the convergence proc- countries (14.8% and 6.8%, respec- sustainable economic policy, every ess ... To help reduce the external im- tively, in 2004). The latest forecast of country needs to undertake an enor- balance and contain it at a sustaina- Eesti Pank believes that both the level mous exercise of practical prepara- ble level, they will take the necessary of the current account deficit and cred- tions before the adoption of the euro. measures to contain domestic credit it growth peaked in 2004. Estonian authorities have declared that growth and ensure effective financial Estonia should be technically ready for supervision, and they will promote the euro changeover by summer 2006 wage moderation.” and the target date for the euro adop- Comparing the commitments of the As for cash tion is 1 January 2007. In January authorities in the communiqué and the 2005 the government decided to es- developments in Estonian economy tablish a national changeover commit- during the ten months that have transactions tee led by the Secretary General of passed since Estonia joined ERM II we the Ministry of Finance (MoF) and can conclude with some satisfaction Estonia intends comprising representatives of the that things have developed mostly as Ministries of Justice, Economic Affairs we predicted last spring. Domestic de- to have and Communications, Internal Affairs, mand grew more or less at the expect- State Chancellery and the central ed pace. Government’s fiscal position bank. The changeover committee re- helped to balance economic develop- a two-week ports to the government. The commitments more than we had assumed: tee has established six working while the central bank predicted a dual circulation groups: cash and settlements (led by balanced budget outcome for 2004 the central bank with participants from and the European Commission and all credit institutions), legal issues (led the Ministry of Finance expected a period. by MoF), public sector readiness very small surplus, the actual surplus (MoF), communications (MoF), busi- was 1.8% of GDP. Looking ahead, the ness environment (MoF) and consumer government intends to continue with a The inflation criterion is seen as protection issues (Ministry of Economic balanced budget policy and we ex- the most demanding of all Maastricht Affairs and Communications). In the pect to fulfil both Maastricht fiscal cri- criteria and meeting it as a highly dif- last two working groups business sec- teria (Estonia’s government debt is ficult task. As expected, the inflation tor representatives are present as well. below 5% of GDP, i.e. the lowest in rate picked up after the EU acces- Our timeline assumes that the na- the EU) with comfortable margin. sion. Our calculations show that the tional changeover plan will be submit- As domestic demand continued to effect of the EU accession on HICP ted to the government by end-June increase in the second half of 2004, was around 1.8 percentage points, 2005. In addition to that the central the contraction of the current account mainly related to the increase in the bank has its own detailed master plan deficit (CAD) has been slower than as- prices of sugar (almost tripled after concerning the activities of the central sumed. The high level of CAD in 2004 the introduction of customs tariffs) bank before summer 2006. is partly related to the accumulation of and fuel (increase in excise duty). The present changeover scenario goods imported prior to the EU acces- The underlying inflation rate has re- foresees the “big bang” approach in sion but is also influenced by low inter- mained stable and no broader price the case of settlements, contracts etc. In est rate environment in the euro area. pressures can be observed. Thus, the cash area Estonia intends to have a Low level of interest rates has kept after the base effect of May 2004 two-week dual circulation period. In Estonia’s monetary environment expan- have passed, we expect the annual order to reduce the burden of the retail sionary. Financial integration with the HICP to be around 3% this summer sector in the first two weeks of January EU has deepened further, prompting and to continue to fall to approxi- 2007 Estonian credit institutions have the external indebtedness of the econ- mately 2.7% in 2006, as the 2005 agreed to exchange cash kroons to omy to grow faster than earlier pre- level is influenced by a hike in elec- cash euros with the central rate and dicted. In addition, about half of CAD tricity prices on 1 March 2005. An without any service fees already in is caused by negative income bal- inflation rate of around 2.7% is likely December 2006. After the end of the ance, which is a mirror image of the to be within the range of the dual circulation period commercial strong profitability of FDI. In this vein, Maastricht criteria. banks will continue to exchange kroons

86 BV 7-8/2005 FOREIGN EXPERIENCE AND INSTITUTIONAL VIEWS

to euros without additional charges for cast and there have been no tensions 3. Burgess, R., Fabrizio, S., Xiao, Y. (2003) further 6–12 months. The central bank in the exchange rate market. Domestic Competitiveness in the Baltics in the Run-Up to EU Accession. IMF, April 2003. changes any remaining kroons to euros demand has grown more or less at the without additional chargers indefinitely. expected pace, whereas government’s 4. Eamets, R. (2001) Reallocation of Labour During Transition Disequilibrium and Policy In order to make the changeover fiscal position has helped to balance Issues: The Case of Estonia. University of as smooth as possible we have to put economic developments. Although the Tartu, PhD Thesis, 2001, 252 p. a lot of emphasis on communication low level of interest rates has upheld 5. Egert, B. (2003) Nominal and Real issues. The first priority is to make all Estonia’s monetary environment ex- Convergence in Estonia: The Balassa- necessary information available to pansion and the external indebted- Samuelson (Dis)connection. Tradable Goods, Regulated Prices and Other different target groups in a way, ness of the economy has grown faster Culprits. Working Papers of Eesti Pank, which enables all Estonian people than forecast, Eesti Pank assesses that No 4, 2003. and stakeholders to cope with the both the level of the current account 6. Faggio, G. and Konings, J. (1999) Gross change. For example, the older gen- deficit and credit growth peaked in Job Flows and Firm Growth in Transition eration might associate the changeo- 2004. While the headline inflation Countries: Evidence Using Firm Level Data ver with past monetary reforms that picked up after the EU accession as on Five Countries. CEPR Discussion Paper, No 2261. led to reducing the value of their sav- expected, the underlying inflation rate 7. Frenkel, M., Nickel, C. (2002) How ings. Hence, one of our main messag- has remained stable and no broader Symmetric Are the Shocks and the Shock es is that we are changing one stable price pressures can be observed. Adjustment Dynamics Between the Euro Area currency for another. Practical preparations are also well and Central and Eastern European under way in order for Estonia to be Countries? IMF Working Papers, WP/02/222, 2002. Conclusions technically ready for the euro changeover by summer 2006 and join the euro 8. Fridmuc, J., Korhonen, I. (2001) Similarity of Supply and Demand Shocks Between the Estonia aims to join the euro area area on 1 January 2007. Practical Euro Area and the CEECs. Bank of Finland preparations are led by the national on 1 January 2007. This paper has 9. Fridmuc, J., Korhonen, I. (2004) A meta- examined the motive of Estonia to join changeover committee (composed of analysis of business cycle correlation the euro area from the optimum cur- representatives of ministries, the central between the euro area and CEECs: What rency area theory perspective, has bank and the State Chancellery) who do we know – and who cares? Bank of works in close cooperation with the Finland, BOFIT Discussion Papers, No 20, analysed Estonia’s first year experi- 2004. ence in ERM II and reviewed the cur- private sector. The committee is expect- 10. Haltivanger, J., Vodopivec, C., Gross, M. rent stage of practical preparations ed to submit the national changeover (1999) Worker and Job Flows in a Transition for the euro changeover. Summing up plan to the government by end-June Economy: An Analysis of Estonia. World the optimum currency area theory as- 2005. In addition, the central bank Bank, Policy Research Working Paper, No pects of joining the euro area rather has in place its own detailed master 2082, 73 p. rapidly, possible costs stemming from plan concerning the activities of the 11. Kenen, P. (1969) The Theory of Optimum central bank before summer 2006. Currency Areas. An Eclectic View. Chicago, joining the monetary union are essen- University of Chicago Press, Monetary tially non-existent in case of Estonia. In conclusion, considering the theo- Problems in the International Economy ERM II and later on full participation retical aspects, actual developments, (ed. Mundell, R. A. and Swoboda, A. K), in the EMU do not call for major ad- and the practical preparations there pp 41–60. justments to our macroeconomic poli- are good reasons for Estonia to join 12. Lättemäe, R., Randveer, M. (2004) cies. This is confirmed, inter alia, by the euro area sooner rather than later. Monetary Policy and EMU Enlargement: Issues Regarding ERM II and Adoption of the first year of successful participa- the Euro in Estonia. Atlantic Economic tion in ERM II. The economy is in- BIBLIOGRAPHY AND SOURCES: Journal, No 32(4), December 2004, pp 293–301. creasingly integrated with the current 1. Bayoumi, T., Eichengreen, B. (1993) and future EU Member States and the Shocking Aspects of European Monetary 13. McKinnon, R. I. (1963) Optimum non-financial sector has demonstrated Integration. In Torres, F. and Gavazzi, F.: Currency Area. American Economic Review, sufficient flexibility. These factors Growth and Adjustment in the European September 1963, pp 717–725. Monetary Union, pp 193–230, 1993. make full participation in the EMU 14. Mundell, R. (1961) A Theory of Optimum 2. Boone, L., Maurel, M., Babetski, J. (2002) Currency Areas. American Economic Review, and ERM II more appealing for us. 51, pp 657–665. The first year in ERM II can be re- Exchange Rate Regimes and Supply Shocks Asymmetry: The Case of the Accession 15. Tavlas, G. (1994) The Theory of garded successful as economic devel- Countries. CEPR Discussion Paper No 3408, Monetary Integration. Open Economies opment has largely followed the fore- June 2002, 43 p, London. Review, 5/2, pp 211–230.

Lithuania – another EU Member State in ERM II The editorial board of Bančni vestnik has invited The assessment contained in the Commission’s all new participants in Exchange Rate Mechanism Convergence Report 2004 dated 20 October 2004 is (ERM II) to give their angle on the impact that the that Lithuania fulfils the price stability criterion, its gov- preparations for the euro adoption has had on their ernment budgetary position and the long-term interest banking systems so far. Regrettably, the Association rate criteria are within the set limits. However, Lithuania of Lithuanian Banks has cancelled participation at the dos not fulfil the exchange rate criterion and it remains last moment. “Member State with a derogation”. EL.

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STATISTICAL APPENDIX

Selected macroeconomic and banking indicators

Matjaž Noč *

1. INDICATORS OF ECONOMIC DEVELOPMENT

GDP per capita (PPS in EUR, 2004)

Comparison of price levels (EU12=100, 2003)

* Matjaž Noč, Analysis and Research Department, Bank of Slovenia

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2. ECONOMIC ACTIVITY AND MACROECONOMIC STABILITY

Real GDP growth (%)

Unemployment (in % at the end of period)

Inﬂ ation (HICP annual average in %)

General government balance (in % GDP)

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Current and capital account of balance of payments (in % GDP)

3. FULFILMENT OF THE MAASTRICHT CRITERIA

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4. OWNERSHIP AND BALANCE SHEET STRUCTURE OF BANKS

Ownership of the banking systems (asset share in %, 2003)

*Excludes cooperative banks and international banking units, but includes Cooperative Central Bank (for Cyprus).

Structure of assets and liabilities of the banking systems (December 2004)

CYPRUS

Reserves Demand deposits Other

Foreign assets

Claims on Foreign private sector liabilities Other deposits Claims on government

CZECH REPUBLIC

Reserves Claims Capital and other Claims on central bank on other Government Demand residents deposits deposits Foreign assets

Bonds

Foreign assets

Other deposits Claims on government

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ESTONIA

Reserves Capital and other Demand Government deposits Foreign assets deposits

Claims Other on government deposits Claims on Foreign private sector Bonds liabilities

LATVIA

Capital and other Demand deposits Claims on private sector Foreign assets Government deposits Other deposits

Foreign assets Foreign Claims liabilities on government

LITHUANIA

Demand deposits Claims on private sector Reserves

Capital Other Foreign and other deposits assets Government deposits

Claims on government Foreign liabilities

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HUNGARY

Claims on Capital government and other Demand deposits Claims on monetary authorities

Foreign Foreign assets liabilities

Reserves Claims on Other residents deposits Bonds

MALTA (December 2002)

Reserves Claims on Other deposits private sector

Foreign assets Demand deposits Claims on Capital government and other Foreign liabilities

POLAND

Claims Government Claims on government deposits Demand on monetary deposits authorities Foreign liabilities

Foreign assets

Reserves

Claims on residents Other deposits

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SLOVAK REPUBLIC (November 2004)

Capital Claims on Claims on and other monetary government Demand authorities deposits Government deposits

Foreign Foreign assets Liabilities Reserves Bonds Claims on residents Other deposits

SLOVENIA

Reserves Foreign liabilities Claims on monetary Government authorities Bonds deposits Capital and other

Foreign assets

Claims on private Demand deposits sector Claims on government Other deposits

5. INDICATORS OF BANKING SECTOR PERFORMANCE IN 20031

Return on equity (in %)

1 Because of the partly non-harmonised methodologies, data are not completley comparable.

BV 7-8/2005 95 STATISTICAL APPENDIX

Return on assets (in %)

Cost-income ratio (in %)

STATISTICAL SOURCES: 1. Bančni vestnik (The Bank Association of Slovenia, different numbers). 2. Banking Structures in the New EU Member States (ECB, January 2005). 3. Bulletin (Bank of Slovenia, different numbers). 4. Central banks. 5. Economic Indicators for Eastern Europe (BIS, April/May 2005). 6. Ekonomski indikatorji mednarodnega okolja (Bank of Slovenia, April 2005). 7. EU Banking Sector Stability (ECB, November 2004). 8. Eurostat. 9. International Financial Statistics (IMF, April 2005). 10. Convergence Report 2004 (ECB). 11. Annual Report 2004 (ECB). 12. Report on EU Banking Structures (ECB, November 2004).

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