Lessons from Slovenia's Curiously Unexpected Financial Crisis
Unexpectedly, Slovenia is going through a financial crisis despite a record of sound behavior on many fronts. Its government bond yields surged above 7 percent in August, and the country is having trouble maintaining access to international financial markets. The question today is whether Slovenia will join the roster of countries needing a bailout program from the International Monetary Fund (IMF) and the European Union. Many lessons are to be learned from Slovenia's difficulties, but one likely to be important for other troubled countries is that continuing too long with fiscal stimulus, even when that policy is encouraged by the International Monetary Fund, can backfire.
This is a surprising development because Slovenia has in many ways been a persistent star performer among the post-communist countries. It managed to escape Yugoslavia early in June 1991 after only one week of war. With only 2 million people, it has fashioned itself as a little version of its neighbor Austria—orderly, hard-working and wealthy. It swiftly became a market economy and all along has been the richest of the post-communist nations. It is thoroughly democratic and free with good governance and little corruption. In 2004, it joined the European Union and the North Atlantic Treaty Organization (NATO), and in 2007, as the first post-communist country, it was allowed to adopt the euro.
Financially, Slovenia has been highly responsible. Until 2009, it had minimal budget deficits and at the end of 2008 its public debt was only 22 percent of GDP. During the European boom years of 2005–07, Slovenia held back from excesses indulged by other countries. Its current account deficit was small and only in 2008 was it too high at 6.7 percent of GDP. Similarly, only then Slovenia's inflation was too high at 5.7 percent. Economic growth was sound but not excessive, peaking at 6.9 percent in 2007.
What has gone wrong? The standard explanation is that Slovenia was hit hard by the financial crisis and the renewed euro area crisis, but that is not quite true. Slovenia's GDP fell by 8.1 percent in 2009, which is slightly more than the EU average, and the expected output decline in 2012 is merely 2 percent. By 2009, the Baltic countries and Bulgaria could only envy Slovenia. The primary problems rest elsewhere: an irresponsible fiscal policy during the crisis, state ownership of the big banks, and lack of confidence in the euro area. Thus the country must address two problems. It needs to recapitalize three banks and regain access to affordable government financing, which has dried up.
Facing the financial crisis, the Slovenian government abandoned its traditionally conservative fiscal policy. During the three years of 2009–11, the country recorded an annual budget deficit of 6 percent of GDP, and by the end of 2011 its public debt had soared to 47.6 percent of GDP. It had more than doubled in three years. There are three combined reasons for this fiscal misfortune.
First, after parliamentary elections in September 2008, a four-party center-left government came to power and, unlike the departing center-right government, it favored a fiscal stimulus. In 2011, that government slowly disintegrated, which naturally undermined its fiscal discipline. Yet a good fiscal policy should be able to withstand such calamities. In early elections in December 2011, the left was routed In February 2012, a five-party center-right coalition took over, adopting an austerity program.
Second, one reason why Slovenia had pursued such strict fiscal policy was that it wanted to become a member of the Economic and Monetary Union (EMU) early on. After it had achieved the euro in 2007, this motive disappeared, and membership in the EMU undermined Slovenia's fiscal discipline. In 2009, the EU average budget deficit was actually even larger than in Slovenia.
Third, and most shocking, the IMF agitated for fiscal stimulus in 2009. In its Article IV review of the Slovenian economy dated April 28, 2009, the IMF stated: "Staff supported the size of the fiscal stimulus package (2.1 percent of GDP…) and projected the fiscal deficit to deteriorate to 4.2 percent of GDP in 2009…" Still, the report warned: "Looking forward, staff stressed that the fiscal position should be reverted to a more conservative stance as the crisis subsides." Well, a deficit is difficult to predict in the midst of a crisis and in reality it became 6.1 percent of GDP. Yet, the IMF management seems to have desired an even looser fiscal policy. In a follow-up statement two weeks later, the IMF egged Slovenia on: "Staff welcomes the authorities' commitment to maintain fiscal discipline but cautions against prematurely withdrawing fiscal stimulus in presence of an increasing output gap." Thus the IMF actively helped to drive Slovenia to the edge of fiscal crisis.
Commentators draw parallels between the banking crises in Slovenia with those in Ireland or Spain, but Slovenia's crisis is quite different because Slovenia has not had great leverage or any major credit-and-housing boom. By its nature, the banking crisis is more reminiscent of Bulgaria 1996. The underlying problem is that, unlike all other new eastern EU members, Slovenia never privatized its big banks. Now its two biggest banks are in trouble. They are both state-owned and they account for about 40 percent of bank assets. The Fitch rating agency concluded that the needed bank recapitalization would be 8 percent of GDP. The closest parallel is Latvia, where the collapse of the domestically owned Parex Bank led to a need for an IMF program, but Parex was at least private. In other eastern EU countries, almost all banks were privatized and eventually sold to West European banks, which have recapitalized their valuable subsidiaries at no cost to any taxpayers. After the crisis is over, Slovenia should at long last privatize its state banks.
Finally, its membership of the EMU has come back to haunt Slovenia. Rather than reducing its bond yields, EMU membership now boosts the yields and reduces its sovereign rating. This is another illustration of the costs of the slow resolution of the euro crisis.
Few countries have ended up in financial crisis after committing so few mistakes, so Slovenia deserves respect and support. The general conclusion for the world at large is that countries with seemingly strong public finances that intentionally carried out fiscal stimulus in the midst of the crisis can easily be stuck with an excessive fiscal deficit for years. This is also true of Spain and Cyprus. It illustrates the folly of the IMF policy of advocating substantial fiscal stimulus in all kinds of countries that it reckoned possessed "fiscal space." Sadly, the IMF has made a major contribution to aggravating the severity of the fiscal crisis in Europe.