Report No. 18456-SLO Slovenia Trade Sector Issues September 29, 1998 Poverty Reduction and Economic Management Unit (ECSPE) Europe and Central Asia Regional Office ., A * .., CURRENCY AND EQUiVALENT UNITS Currency Unit = Slovene Tolar (SIT) 1991 1992 1993 1994 I 1995 I 1996 l 1997 SIT/US$ 55.60 81.28 113.24 128.81 118.52 135.36 159.69 WEIGHTS AND MEASURES Metric System ACRONYMS AND ABBREVIATIONS ACR Agency for Commodity Reserve LFP Labor Force Participation BN Billion LFS Labor Force Survey CAP Common Agriculture Policy LN Natural Logarithm CET Common External Tariffs MFN Most Favourable Nation CCET Centre for Co-operation with the N. A. Non Available Economies in Transition NEO National Employment Office CEE Central and Eastern European NTBs Non Tariff Barriers CEFTA Central European Free Trade OECD Organization for Economic Agreement Cooperation and Development CMEA Council for Mutual Economic PHARE Poland Hungary Assistance for Assistance Economic Reconstruction DEC Development Economics PPP Purchasing Power Parity DEM German Mark PSE Producer Subsidy Equivalent EAA European Association Agreement QRs Quantitative Restrictions EC European Community RCA Revealed Comparative Advantage EFTA European Free Trade Agreement R&D Research & Development EU Europeain Union ROW Rest or the World FDI Foreign Direct Investment SD Standard Deviation FTA Free Trade Agreement SIT Slovene Tolar GATT General .Agreement of Tariffs and SKEP Economic Outlook and Policy Trade Services GDP Gross Domestic Product UN United Nations GEP Global Economic Prospects US United States GZS Chamber of Economy WB World Bank ILO International Labor Organization WPS Working Paper Series IW Institute der Deutschen Wirtschaft WTO World Trade Organization LDC Less Developed Country FISCAL YEAR January 1 to December 31 Vice President: Johannes Linn Country Director: Roger Grawe Sector Director: Pradeep Mitra Country Economist: Carlos Silva-Jauregui TABLE OF CONTENTS Acknowledgments Hii Executive Summary iv 1. Introduction 1 2. Developments In External Linkages: The Challenge of Integration 4 2.1. Stability at the expense of growth 4 2.2. Foreign trade in comparative perspective 6 2.3. Geographic reorientation of foreign trade 7 2.4. Sustainability of external performance 8 3. Export Performance in EU Markets 8 3.1. The impact of the collapse of former Yugoslavia 9 3.2. Changes in commodity composition 10 3.3. Commodity chains: changes in the level of processing 14 3.4. Factor content of EU-oriented exports 15 3.5. How environmentally "clean" are Slovenian exports to the EU? 17 3.6. Top export performers 19 3.7. Sustainability of export performance 20 4. Foreign Direct Investment 21 4.1. FDI inflows: below the potential? 23 4.2. FDI role in restructuring and export performance 25 5. Tariff Protection: Discrimination Against MFN Suppliers 28 5.1. Distortions generated by tariff structure: diversification in protection 29 5.1.1 Protection of agricultural sector: de-escalation 29 5.1.2 Tariff escalation: manufactures 31 5.2. MFN and preferential rates: growing discrepancies 31 5.3. Policy recommendation: adoption of EU MEN rates on industrial imports 33 6. Contestability of Domestic Markets for Goods and Services 34 6.1. Competition policies 35 6.2. State aids 38 6.3. External access to government procurement 40 6.4. Technical standards 41 6.5. The right of establishment and services 42 6.6. Conclusion 44 7. Major Findings and Implications for a Pre-Accession Strategy 44 References 48 Statistical Appendix 51 ii TABLES Table 1 Slovenia's External Performance, 1992-1997 (in US$ million) 5 Table 2 Imports of the EU from Hungary, Poland and Slovenia 6 Table 3 Geographic Composition of Slovenia's Exports and Imports, 1992-97 7 Table 4 Annual Change in the Value of Exports to the EU: Total vs. Most Affected Group 9 Table 5 Exports of Slovenia to the EU (1992-96) and Rest of the World (1992 and 1996) 11 Table 6 Share of Imports from Slovenia in EU Outside Imports by Major Product Categories 13 Table 7 Changes in Slovenia's Exports to the EU in Individual Commodity Chains 15 Table 8 Factor Content of Slovene Exports to EU over 1992-96, in percent 16 Table 9 Factor Content of Slovenia EU-Oriented Exports in Terms of RCA and Shares in EU Outside Imports, 1992-96 17 Table 10 Selected Features of Slovenia's 'Dirty' Exports to the EU, 1992-96 18 Table 11 FDI in Slovenia and Other EU Accession Candidate Countries, 1990-1997 23 Table 12 Share of EU Imports in Total Imports and Estimates of Customs Duties Levied on these Imports 33 Table 13 Types of State Aids and Their Evolution Over 1993-98 39 CHARTS Chart 1 FDI Inflows in Slovenia, 1991-97 22 STATISTICAL APPENDIX Table Al Largest Exporters to the EU in Terms of Four-Digit SITC Categories in 1996 and 1992 51 Table A2 Distribution of FDI Stock in Slovenia by Recipient Industries (millions of US$) 52 Table A3 State Aids Over 1993-98, percent of GDP 53 iii ACKNOWLEDGMENTS This report is based on the findings of a mission that visited Slovenia in March/April 1998. The team was lead by Carlos Silva-Jauregui, Country Economist and Program Team Leader, Policy Reduction and Economic Management Unit (ECSPE), and included Bart Kaminski (DECRG), Nathalie Moreno (ECSPE) and Rossana Polastri (ECSPE). Mr. Kaminski was the principal author of the paper. Ms. Moreno contributed to the paper on the sections on competition policy and state aids, and Ms. Polastri contributed to the paper on the sections on foreign direct investment. The report analyzes selected issues of the foreign trade sector on the road to EU accession. The mission had the opportunity to meet with government officials at the Ministry of Finance, the Bank of Slovenia, the Ministry of Economic Relations and Development, the Ministry of Economic Affairs, the Office for European Affairs of the Ministry of Foreign Affairs, the Statistical Office of the Republic of Slovenia, the Institute of Macroeconomic Analysis and Development, the Ministry of Science and Technology, and the Slovene Export Corporation. The mission also had the opportunity to discuss trade sector issues with a number of academicians and private sector people at the University of Ljubljana, the Institute of Economic Research, SKB Banka, the Delegation of the European Commission and the Center for International Competitiveness. The mission members would like to thank all our Slovene counterparts for the time they spent with us in open and friendly discussions, and in particular Ms. Irena Sodin and Mr. Bojan Pogacar, International Department, Ministry of Finance for their effective support and organization of the agenda. The report benefited from valuable comments and suggestions received from- government officials, in particular from Ms. Alenka Jerkic, Mr. Borut Repansek and Mr. Peter Cernigoj. Research support was provided by Rossana Polastri. Editorial assistance was provided by John Karaagac. The report was processed by Dolly Teju. iv EXECUTIVE SUMMARY i. Slovenia is at the crossroads of a new era. Seven years after independence from the former Yugoslavia, it is not only the most advanced Central and Eastern European (CEE) transforming economy, but it is embarking on a journey to become a full fledged member of an enlarged European Union (EU). This endeavor is perhaps the most important and challenging task for the country and its policymakers during the remaining years of this century. The speed of accession to the EU, and the benefits and challenges that joining the EU and its Single Market will bring, will depend, in large part, on the path of economic reform that Slovenia decides to undertake. ii. The EU Accession Strategy of the Republic of Slovenia has already mapped the road for the country's development agenda. Its goals include'... "(i) faster economic growth and catching up with developed European countries; (ii) higher competitiveness of the Slovene economy; (iii) inclusion into European integrations; and (iv) permanent sustainment of economic growth from the ecological, social and ethical stand-point....". Because of Slovenia's characteristics, a key element for achieving these goals is foreign trade and foreign trade policy. iii. Slovenia can prosper by being an open and outward looking economy. As the government's strategy of international economic relations argues, the challenge for Slovenia is to adjust "... its development model and its economic and legal systems to that of developed (European) countries ... regardless of the outcome of Slovenia's application for full membership in the EU." Reforms establishing a modern market-based regime should lead to improved economic growth performance. A pre-accession strategy for a country like Slovenia -- whose GDP per capita is the highest of the ten countries seeking EU membership, and just below that of a poorest EU-member -- should be fast and sustainable economic growth based on removing barriers to the efficient allocation of resources, thereby generating healthy competitive pressure on domestic producers. iv. Among those countries seeking membership in the EU, Slovenia's position is unique. It is the most developed economy among them, with a physical infrastructure suggesting an enormous potential for economic expansion; it has a very favorable geographical location and its economy has suffered less from socialist misdevelopment. Ultimately, taking advantage of these assets hinges critically on Slovenia's accelerating microeconomic liberalization and structural reforms while consolidating and maintaining macroeconomic stability. v. Just as the crisis of transformation was less acute in Slovenia than in other transition economies so too, it seems, was the political imperative to embark on a path of radical reform. This imperative was further weakened when macroeconomic stability was quickly re-established in 1993, the second year of the transition. The rapid turnaround in economic fortunes has thus favored a piece-meal, incremental approach to structural I See IMAD, "EU Accession Strategy of the Republic of Slovenia: Economic and Social Part," Manuscript, Ljubljana, October 1997. v economic reform. The legacies of the past -- diluted ownership structures and politics built around the notion of negotiated consensus -- have further reinforced this incremental approach. The result has been a slow pace of both restructuring and the opening of some sectors of the economy to foreign investment and, eventually, less output growth than Slovenia's potential. vi. The slow down of the process of microeconomic liberalization has negatively impacted economic developments in Slovenia. A loss of dynamism best describes the current state of the Slovenian economy. Although nothing presages an impending crisis, as the economy is growing and macroeconomic stability does not seem to be in imminent danger, symptoms of declining vigor nonetheless abound. The growth rates of GDP have been moderate, mainly because the export expansion had run out of steam. After a three- year spell of double-digit growth rates over 1993-95, the value of total exports remained flat for the 1996-97 period. In the second half of 1995 and through 1996, export performance was maintained, in large part, due to the depreciation of the domestic currency. Moreover, the slow down in export expansion and the stagnation in net revenues from services could negatively impact the country's capacity to import capital equipment, thus undermining its potential for restructuring and stronger economic growth. Although the current account has been in surplus since 1995 (when it recorded a negligible deficit), considering Slovenia's modernization needs this cautionary policy outcome may not be optimal. vii. Because of its small market, Slovenia's prosperity is critically dependent on expanding external economic ties. Although the value of total exports increased by some 40 percent over 1993-97, there is evidence suggesting a decline in competitiveness of Slovenian firms in international markets. After an initial explosion of trade with the EU, the growth of both exports and imports has slowed down. The shift away from natural resource-intensive and unskilled labor intensive products towards technology-intensive and human labor-intensive products in EU-oriented exports has been much slower than one might anticipate given Slovenia's relatively high level of industrialization and its stock of skilled human capital. To make things potentially even worse, these developments coincide with stagnation of revenues from tourism, a sector of great potential for Slovenia given its natural endowments. viii. From the perspective of Slovenia's accession process to the EU, sustaining the expansion in foreign trade is critically dependent on further expanding external economic ties, since fast and sustainable economic growth would facilitate accession to the EU. There is some evidence that the initial expansion was, in part, driven by redirection of exports from the former Yugoslav markets. This source of expansion seems to have reached its limit, iri large part because too few new firms have emerged as successful exporters. Reviving the former dynamism of foreign trade loans as an important policy issue. ix. Although the share of Slovenian processed commodities in EU external imports has increased, suggesting a shift towards higher value-added products, changes in the factor content of Slovene exports to the EU indicate less restructuring than expected. Given Slovenia's endowments in factors of production, it is likely to specialize in high skilled labor-intensive and technology-intensive products. Although share of these vi products increased between 1992 and 1993, there are two potential problems: (i) the stagnation of high technology exports in terms of their share in EU imports in 1995 and 1996; and (ii) the continuing reliance on unskilled labor-intensive products. While there is nothing wrong with Slovenian exports still deriving their competitive strength from specializing in unskilled labor-intensive products, one would expect a quicker change towards human capital and technology-intensive products, due to the composition of its labor force and their costs vis-a-vis other transition economies seeking markets in the EU. x. From the analysis of change in indices of revealed comparative advantage (RCA) and from rankings of top export performers in successive years of the transition, one may draw the conclusion that there was no significant expansion in new specializations in the Slovenian economy between 1993-94 and 1995-96. Slovenia's RCA profile has become more concentrated with the ten top highest RCA values increasing each year. Although overall, Slovenia continues to have a relatively uniform profile of RCA distribution, indicating a high level of industrial maturity, the "deterioration" may be either a symptom of declining competitiveness or it may indicate that Slovenia's export offers were excessively diversified in the past. A very limited change among the top export performers, however, suggests that new product lines have yet to emerge, and that industrial restructuring has been slow. xi. Although Slovenia formally adheres to the rule of national treatment, there are nonetheless impediments limiting foreign equity. Limits imposed on foreign participation in auditing (49 percent), investment companies dealing with the management of investment funds (20 percent) and stockbroker companies (24 percent) are likely to discourage investment in stocks of Slovene companies. The Company Law contains other provisions determining the make up of firms' management boards: (i) the majority of directors of joint stock and limited liability companies must be Slovenian citizens; (ii) if the management board is made up of only one person, that person must be Slovene, and (iii) representative of foreign firms operating through branches in Slovenia are required to have permanent residence in Slovenia. xii. Although the extent of the negative impact of these various departures from the principle of national treatment is difficult to quantify, the effect seems rather significant and, indeed, might have had a sizable negative impact on foreign investment. Countries located at higher levels on the development ladder are usually attractive places for foreign investment. The existing measures in Slovenia do not create a business climate friendly to foreign investors, and they prevent Slovenia from taking advantage of its substantial created assets. As these measures, each of which adds to the "hassle" cost of doing business, are remedied in future legislation, there will be an expansion in foreign direct investment (FDI) inflows. xiii. Slovenia has, thus far, attracted low flows of FDI, which have played such an important role in the readjustment of other transition economies, most notably Hungary, to world markets. FDI inflows are crucial in incorporating domestic firms into global networks of production and marketing of multinational corporations (MNCs). Although FDI inflows to Slovenia may have been hindered both by the method and speed of privatization, coupled to the relative high labor costs prevailing in the country, taking into account Slovenia's superb location and its relatively high level of industrial development, vii the country has a very high propensity to be a host to FDI and, indeed, should be among its top recipients. One would expect FDI to be hovering around 3-5 percent of GDP, that is, 2-3 times above its current inflow. xiv. Government procurement -- accounting for a significant portion of overall economic activity -- has been virtually unaffected by competition from foreign firms. This may have had one important consequence: the cost of services provided by the state has been probably higher. Although further opening alone would not necessarily lead to foreign firms dominating public procurement, it would nevertheless provide a strong incentive for domestic contractors to improve their competitiveness. The latter should allow them to conmpete for government contracts abroad, especially in EU member countries. xv. Another source of distortion, albeit a comparatively minor one, is foreign trade policy. Given its small size and local markets not offering economies of scale, the best policy option for S:lovenia would have been to unilaterally implement free trade. The government has followed the policy of bilaterally negotiated free trade agreements, excluding agricultural products. The drawback of bilateral liberalization is that the widening gap between tariffs on imports from preferential partners and those levied on most favorable nation (MFN) imports contributes to increased discrimination of exporters from MIFN countries and trade diversion in favor of preferential suppliers. This leads to welfare losses because the range of products available to consumers is unnecessarily restrained; it leads to losses in competitiveness because prices paid by Slovenian users of imports may be higher due to decreased competition from MVFN imports. xvi. At the micro level, the experience of other transition economies amply demonstrates that sustainability of economic growth and foreign trade hinges critically on facilitating the entry of "second generation" firms, i.e., those which were either newly established or successfully restructured. During the first stages of the transition, most exports came from firms with already established links with abroad. Subsequently, new "entrants" -- frequently small and medium firms -- would move to the top. A large proportion of "second generation" firms are foreign-owned or joint ventures; their share in exports has been dramatically increasing in successful transition economies. FDI in Slovenia has been lower than in other EU candidate economies, and there are signs that "second generation" firms are in short supply. Without the supply of high quality services, especially telecommunications and financial ones, and without easy entry into economic activity, the emergence and development of those second generation firms will proceed slowly. xvii. Thus, the task facing the authorities seems to boil down to attracting more FDI inflows and stimulating private sector development t.hrough an acceleration of structural reform. A broadly conceived business climate has, thus far, not been particularly favorable to either foreign investment or further private sector activity in Slovenia. There is, however, one major way to improve the business climate: removing legal obstacles limiting the contesitability of Slovenia's domestic markets. The long-term objective should be achieving competitive and, thereby, contestable markets where relationships among firms are not distorted by governmental or private actions and where there is free viii markef access for foreign goods, services and investment. The following measure could help achieve this: =m to improve competition policy framework, rules and enforcement capacities of competition authorities. One may consider granting anti-trust authority to a single independent institution empowered to assess competition and the welfare impact of important policy decisions, as well as actions taken by firms, affecting the contestability of domestic markets and to monitor their impact ex post; =X to overhaul the current framework of state aids. This would involve establishing transparent monitoring mechanisms, as well as streamlining and reducing the scope of subsidies. State aid should be also subjected to scrutiny by a reformed, competition authority; => to open services to foreign competition. This would involve inter alia removing provisions limiting foreign equity, and opening key sector like telecommunications to foreign capital; =m to fully apply the principle of national treatment in the sphere offoreign investmnent. This would curtail removing legal provisions determining the make up of boards of directors of companies (in its current wording, they discriminate against foreigners) as well as requiring that purchases by foreigners of equity exceeding 20 percent be subject to government clearance; X to change the rules governing the agricultural regime. This would involve supporting the agricultural sector through direct payments rather than through high agricultural prices and trade policy (external border protection and export subsidies). It would involve changing the current structure of incentives to remove the bias against processed agricultural products, since the present structure offers preference to low value added products (which obtain the largest levels of protection); L to align MFN tarif rates on industrial products with those levied by the EU. This would not necessarily involve a formal lowering of statutory tariffs but instead might simply involve the change in applied rates. The revenue consequences are small while gains, both political and economic, are huge; xviii. The challenge of a pre-accession strategy is to identify policy measures that would improve allocative efficiency, reduce adjustment cost and strengthen Slovenia's growth potential within the framework of integration into the EU. Ultimately, the prospects for a quick EU membership and, perhaps more importantly, the ability of the Slovene economy to take full advantage of opportunities offered by being a full member in the EU will depend on shifting to an institutional framework for enhancing growth, competition and economic efficiency. The vehicle for designing a strategy that would simultaneously accelerate accession and provide a sound basis for sustainable, and employment-creating, economic growth is the contestability of domestic markets and a business friendly environment. The latter is important, not only for FDI, but also for domestic firms. The competitiveness of Slovene firms, both domestic and foreign-owned, ultimately depends on competition at home, from imports and domestic sources alike. This, in turn, hinges critically on a liberal trade and investment regime. 1. INTRODUCTION 1. Among countries seeking membership in the European Union, Slovenia is unique in several respects. First and foremost, it is the most developed economy among them, with a physical infrastructure suggesting an even higher level of economic development. Second, it has a very favorable geographical location; it is located between two European Union (EU) members -- Austria and Italy -- and lies within an easy reach of Germany. Third, Slovenian firms have traditionally been much more export-oriented than firms in other former Yugoslav republics or in the former command econornies of Central and Eastern Europe (CEE). Furthermore, their markets were mainly in EU and EFTA countries, with the Council for Mutual Economic Assistance (CMEA) accounting for less than one-fifth of Slovenia' s external (excluding interrepublic exchanges) trade. The loss of markets due to the collapse of import demand was, to some extent, offset by the end of "inter-republic" transfers from Slovenia to other, much poorer, republics in former Yugoslavia. Though the collapse of Yugoslavia was less a shock to Slovenia, which had subsidized other republics, than the collapse of the Soviet Union and CMEA was to other transition economies, the reorientation in foreign trade patterns was nonetheless challenging. 2. For the reasons outlined above, the crisis of transformation was less acute than in other transition economies. As such, Slovenia's economy bounced back by 1993, that is, the second year into the transition.' With macroeconomic stability quickly re-established, the GDP in 1997 exceeded the recorded levels of the late 1980s, that is, before the break up of the former Yugoslav federation. Leaving aside the double challenge of introducing domestic currency and addressing initial macroeconomic disequilibria, policy makers were under less pressure to adopt radical measures than elsewhere. The rapid turnaround in economic fortunes has favored a piece- meal, incremental approach to economic reforms. The legacies of "market socialism" with its diluted ownership structures and politics built around the notion of negotiated consensus, has also influenced policy. While there has been no reform slippage, structural reform proceeded at a slower pace than in other leading CEE transition economies. This has prompted some observers to describe Slovenia's transformation as a-typical.2 3. There were yet other barriers slowing down the process of microeconomic liberalization. First, Slovenia has thus far attracted relatively low inflows of FDI, which have played such an important role in readjustment of other transition economies, most notably in Hungary, to world markets. Several reasons may have influenced these levels of FDI. Concerns about foreign control in financial services, as well as in industry, have produced formal and, mostly informal, obstacles to foreign involvement in restructuring the Slovenian economy. The privatization method used in Slovenia limited access of foreign investors to privatized assets. These inward- oriented pressures have been somewhat checked by Slovenia's aspiration to accede to the EU. Although the European Association Agreement (EAA) with the EU was signed relatively late in The recovery occurred a year earlier than in other transition economies that had successfully implemented stabilization programs. These countries, including the Baltic states, former Czechoslovakia and Poland registered positive rates of growth in the third year of their respective programs. 2 See Bernard (1997). 2 June 1996, it appears that prior legislation efforts had been largely driven by the harmonization of a legislative framework with that of the EU. Other factors such as market size and relatively high labor costs may have also contributed to limit FDI inflows to Slovenia. 4. Second, it is tempting to describe Slovenia as an open economy because of the high share of foreign transactions in GDP, both before and after independence. Although Slovenia had been highly dependent on external markets even before the break up of the former Yugoslav federation, it had not been fully open in terms of policies. In fact, the Former Yugoslavia had not made the transition froim a strategy of import substitution to one based on export orientation. The level of protection afforded to domestic producers was high and strongly biased in favor of finished manufactures.3 The high level of openness, as measured by the ratio of foreign trade to GDP, confounded with openness in terms of a genuine exposure of firms to international competition seems to have actually reduced the pressures for policy makers to introduce measures that would provide a boost to both microeconomic restructuring and the ifternational competitiveness of Slovene firms. In consequence, the task of re-adjustment might have been misjudged: it seems to have been much more serious -- due to previous protection insulating firms from direct competition -- than openness indicators might suggest. 5. Because of its small market size,_ Slovenia's prosperity is critically dependent on expanding its external economic ties. Although the value of total exports increased by some 40 percent over 1993-97, there is evidence suggesting the decline in competitiveness of Slovenian firms in international markets. After an initial explosion of trade with the EU, the growth of both exports and imports has slowed down. The shift away from natural resource intensive and unskilled labor intensive products towards technology intensive and human labor intensive products in EU-oriented exports has been much slower than one might anticipate, given Slovenia's relatively high level of industrialization and its stocks of skilled human capital. These developments coincide with the stagnation of revenues from tourism. 6. Several factors may account for the slow down in foreign trade expansion. On the macroeconomic side, export growth is directly linked to foreign demand and the growth rate of economies in the EU, particularly Germany. The business cycle of Europe is clearly reflected in Slovenia's trade performance. As Europe's recovered in 1997, so have Slovene exports to and imports from the region. On the microeconomic side, the first factor may be the lack of new industrial capacities. During the first stages of the transition most exports come from firms with already established lin]ks abroad. That sustainability, however, hinges critically on the entry of "second generation" firms, i.e., those which were either newly established or successfully restructured. An efficient financial sector is needed for the emergence and development of second generation firms. 7. A second possible explanation may relate to relatively low inflows of FDI. These are crucial in incorporating domestic firms into global networks of production and marketing of 3 On the other hand, Slovenian firms under "market socialism" were less shielded from external competition than those in the economies of other EU candidates, and had well-developed direct contacts with traders in EU countries. 3 multinational corporations (MNCs). These inflows are also crucial to activating the growth driven by "second generation" firms. The high similarity between the composition of Slovenian exports and imports to, and from, the EU suggests that expansion of trade hinges critically on intraindustry rather than interindustry trade. Indeed, it seems that low FDI inflows provide a plausible explanation for the slow down. Although various estimates of the share of interindustry trade in trade with the EU indicate that Slovenia has the highest share among Central and East European countries -- and even higher than some EU-members (e.g., Greece and Portugal) -- the potential for expansion remains significant. With its central location and well-disciplined labor force, Slovenia has an adequate physical infrastructure for taking advantage of a rapidly growing fragmentation of the production process, resulting in a finer international division of labor. Whether the potential for expansion will be fully tapped depends ultimately on its economic policies. 8. Third, the slowdown in export expansion may to some extent be related to foreign trade policy. Given both its small size and that local markets do not offer economies of scale, the best policy option would seem to be that of unilaterally implemented free trade. The government, however, has followed a policy of bilateral negotiated free trade agreements, excluding agricultural products. As in other candidate countries, the major boost to liberalization in tariffs has come from the EAA providing for a gradual elimination of all barriers to industrial imports from the EU. Since the EU is by far Slovenia's largest trading partner, phasing out duty rates has considerably reduced respective average weighted applied rates. Nonetheless, the drawback of bilateral liberalization is that the widening gap between tariff on imports from preferential partners, on one hand, and those levied on MFN imports, on the other, contributes to both increased discrimination of exporters from MFN countries and trade diversion in favor of preferential suppliers. This may lead to losses in welfare because the range of products available to consumers is unnecessarily restrained. It may also lead to losses in competitiveness, since prices paid by Slovenian users of imports may be higher because of decreased competition from MFN imports. 9. Slovenia can prosper the most if it is an open and outward looking economy. As the government's strategy of international economic relations4 rightly argues, the challenge for Slovenia is to adjust "... its development model and its economic and legal systems to that of developed (European) countries ... regardless of the outcome of Slovenia's application for full membership in the EU." Reforms establishing a modern market-based regime should improve economic growth performance. The objective of a EU pre-accession strategy of a country like Slovenia whose GDP per capita is just below than that of a poorest EU-member should indeed be fast and sustainable economic growth. 10. From the perspective of foreign trade and foreign investment, the prerequisites of a good pre-accession strategy generating growth, employment and improved microeconomic efficiency include easy entry of goods, services and capital to domestic markets. This should contribute to economic growth through at least two channels: the reduction of barriers to efficient allocation of resources; and the creation of competitive pressures on domestic producers to reduce costs and 4 See Bobek et al. (1996). 4 launch new initiatives and products. The challenge is to get firms to revamp product lines, streamline marketing efforts, and cut costs. A business-friendly environment and a reliable supply of services, attracting foreign investment and creating opportunities for participation in global division of labor, driven today mostly by vertical product differentiation and fragmented technology, should help attain these goals. 11. The remainder of this report is organized as follows. Section 2 discusses developments in the external sector of the Slovenian economy and the challenges it faces on the path to the EU. It points to a slow down in the expansion of foreign trade. Section 3, focusing on Slovene export performance in EU markets, seeks to determine the extent of this slow down, its sources and possible implications. It examines changes in the commodity composition of Slovenia's exports, their factor content and competitiveness of Slovene products in EU markets. Section 4 examines developments in foreign capital inflows, arguing that liberalization of access to services could provide a boost to growth and efficiency. It seeks to explain whether low inflows are responsible for a slowdown in the pace of change in Slovenia's export basket. The next two sections discuss those policy factors potentially accountable for the loss of momentum. Section 5 examines distortions generated by the tariff structure; it assesses the revenue and welfare consequences of adopting MFN tariffs of the EU. Section 6 analyzes non-tariff measures affecting conditions in access to Slovenian domestic markets through both trade and investment. It argues that the removal of various impediments to contestability of domestic markets would spur readjustment of the Slovene economy. Section 7 concludes the report. 2. DEVELOPMENTS IN EXTERNAL LINKAGES: THE CHALLENGE OF INEGRATION 12. The key to a good economic performance is integration into the world economy. All success stories of economic development over the last two decades have been based on export- oriented policies combined with low, or declining, barriers to imports.5 In each country with a successful economy, the foreign sector has expanded dramatically. Slovenia, which is the most developed country among Central European EU candidates, proves no exception. To the contrary, its small slize makes it particularly vulnerable to external developments. Its transformation thus far has partially set the groundwork for exposing domestic firms to import competition, thereby making them competitive in international markets. The challenge, especially acute in the context of accession to the EU, is to open service sectors to foreign competition, to create an investment-friendly climate adhering to the principle of national treatment, thus boosting economic growth performance. 2.1. Stability at the expense of growth 13. Slovenia appears to have been strongly committed to maintaining macroeconomic and, consequently, external sector stability (see Table 1). With the exception of 1995, its current account has been in surplus from 1992-97 thanks to its net position as exporter of services, mainly related to revenues from tourism. The value of total revenues from foreign tourism almost 5 See Sachs and Warner (1995). 5 doubled between 1992 and 1996, from US$671 million to 1,230 million; it fell slightly in 1997, to US$1,183 million. The balance had been in surplus increasing from US$389 million in 1992 to US$688 million in 1996 and contracting slightly in 1997 to US$639 million. Combined with surpluses in construction and merchant services, this has allowed financing of imports exceeding exports. Approximately three-fourths of imports have been related to either investment or to inputs for current production, i.e., intermediate products.6 14. The observation that one may derive from the data in Table 1 is that imports in 1996-97 seem to be too low in terns of Slovenia's capacity to pay for them. Even if this were the case, Slovenia could have afforded to finance only slightly larger purchases of foreign goods and services, thus increasing its national economic welfare. Slovenia's international reserves have increased during the past years from 1.4 months of imports in 1993 to 3 months in 1996 and 4.25 months 1996. Although the import equivalent of international reserves was certainly too low in 1993, it is close to levels regarded as safe in 1997. In other words, without the increase in foreign earnings and/or inflows of foreign capital, there is no significant room for expanding purchases abroad without jeopardizing external equilibrium. Table 1: Slovenia's External Performance, 1992-1997 (in US$ million) 1992 1993 1994 1995 1996 1997 Exports 6,681 6,083 6,828 8,316 8,310 8,372 Share of EU (in %) 61 63 66 67 65 64 Imnports 6,141 6,501 7,304 9,492 9,421 9,358 Share of EU (in %) 60 66 69 69 68 67 Trade Balance 540 -418 -476 -1,176 -1,111 -986 Current Account Balance 926 188 600 -23 39 70 Foreign Direct Investment, Net 111 113 128 176 186 321 Portfolio Investment, Net -9 3 -33 -14 637 236 International Reserves 720 788 1,499 1,821 2,297 3,315 Source: Bank of Slovenia, Monthly Bulletin, various issues. 15. Considering Slovenia's modernization needs, a surplus on current account cannot be necessarily regarded as positive. In fact, there would be nothing wrong with Slovenia's running a small and sustainable current account deficit provided it is financed by foreign investors. The development of capital markets, the removal of various legal barriers to the development of the private sector and convertibility of the Slovenian Tolar have all enabled inflows of foreign capital. Nonetheless foreign investment inflows, although fast growing in 1996-97, remain relatively low (see Section 4). This reflects either the international investors' lack of confidence in Slovenia's economy or persistent barriers to investment flows. Considering the government's record of credible commitment to macroeconomic stability, as well as Slovenia's other advantages (e.g., political stability, location, industrial tradition), investor confidence does not 6 The composition of imports by end-use has been remarkably stable since 1993 with intermediate products accounting for 57-59 percent, capital goods for 16 percent and consumption goods for 26-27 percent. Calculated from data in Bank of Slovenia: Monthly Bulletin, February 1998. 6 strike one as a possible explanation. The explanation seems instead to lie with home-made barriers to foreign flows, including slow progress in microeconomic liberalization. 16. The developments in a current account position suggest the potential for a significant increase in foreign investment flows. These, in turn, would contribute to higher rates of economic growth than presently registered. Thus, in order to prepare for the accession, government policies should remove disincentives to investment from both domestic and foreign sources. 2.2. Foreign trade in comparative perspective 17. Developments in foreign trade appear to have followed a similar pattern to other successful transition economies with one caveat -- the growth in exports seems to have quickly lost its momentum. As in other countries, there was an initial explosion in EU-oriented exports. This explosion has, however, not been fully captured by Slovenian official trade statistics: as can be calculated from data in Table 1, the value of total exports fell by 9 percent in 1993, while that of exports to the EU by 6 percent. Nonetheless, a different picture emerges from EU data on imports from Slovenia (see Table 2). The value of EU imports from Slovenia increased in 1993 by 53 percent; through 1994-95, it increased further by more than 20 percent each year. But in 1996 the value of EU imports from Slovenia fell by 3 percent (according to Slovenian national statistics it fell by almost 5 percent). This is not only a statistical fluke resulting from a volatility in exchange rates: the value of imports from Hungary and Poland, presumably calculated in the same way, increased by 13 and 12 percent respectively in the same year. Table 2: Imports of the EU from Hungary, Poland and Slovenia l 1989 l 1990 1 1991 l 1992 l 1993 l 1994 l 1995 1996 Value of Imports from (in millions of US dollars) Hungary 3,7051 4,834 5,799 6,537 5,773 7,260| 9,974J 11,231 Poland 5,1671 7,705 8,7811 10,274 9,834 11,9341 15,7601 17,651 Slovenia _ j N/A N/Al 2,415 3,698 4,502 5,617 5,474 Rate of Growth of EU imports from: (in percent) Hungary 30 20 13 -12 26 37 13 Poland 49 141 17 -4 21 32 12 Slovenia N/A N/Al N/A 53 22 25 -3 Source: EU imports as reported to the United Nations COMTRADE data base. 18. Although no complete data are yet available for EU imports in 1997, there are indications that the Slovenian export expansion has run out of steam. According to the official Slovene data, the value of exports in US dollars to the EU fell by 0.8 percent. This may be due to the appreciation of US dollar vis-a-vis currencies of major foreign trading partners of Slovenia: indeed, calculations in terms of German Mark (DM) and in terms of a currency basket (EU exports in DM, and the ROW in US$) point to an increase of 14 and 8 percent respectively. Overall, however, the 21 percent increase in the value of Hungarian exports seems to suggest that the variation in exchange rates cannot be held fully accountable, as the geographic patterns are similar. 7 2.3. Geographic reorientation of foreign trade 19. The change in Slovenia's geographic pattern of trade has been driven by the disintegration of Yugoslavia rather than the collapse of the CMEA. The challenge was formidable: Slovenia had to adjust to both the loss of Yugoslav markets accounting for around one-fourth of its total sales and purchases as well as the fall in import demand from former CMIEA countries which accounted for around 20 percent of Slovenian trade in 1990. Following the collapse of demand in the former Yugoslav republics, there was a reorientation in Slovenia's foreign trade patterns. Their share in Slovenia's trade fell from 40 percent in 1992 to 23 percent in 1997.7 The adjustment so far has been mainly through redirection of trade flows away from former Yugoslavia towards EU markets. The share of the EU -- which had already accounted for the bulk of Slovenia's external trade even before independence -- increased on both the export and import side, amounting to roughly two-thirds of total trade turnover. Table 3: Geographic Composition of Slovenia's Exports and Imports, 1992-97 1992 1993 1994 1995 1996 1997 | _______________ Exports (in percent) EU (15) 60.9 63.2 65.6 67.2 64.6 63.6 EFTA 1.0 1.0 1.0 1.0 1.0 1.0 CEFrA 3.5 4.3 4.5 4.9 5.7 6.0 Former Yugoslavia 21.4 15.8 15.2 14.3 16.7 16.6 of which: Croatia 14.2 12.1 10.8 10.5 10.3 10.0 Other 13.2 15.71 13.7 12.6 12.1 12.8 Imports (in percent) EU 59.6 65.6 69.2 68.9 67.5 67.4 EFTA 2.4 2.3 2.5 2.5 2.6 2.1 CEFTA 4.7 5.1 6.2 6.7 6.8 7.5 Former Yugoslavia 18.5 10.7 8.0 7.1 7.5 6.3 of which: Croatia 13.9 9.2 6.8 6.1 6.3 5.0 Other 14.8 16.3 14.1 14.8 15.5 16.6 Source: Statistical Office of the Republic of Slovenia. 20. As can be seen from data in Table 3, the geographic composition of Slovene foreign trade has remained relatively stable since 1993. The bulk of geographic re-adjustment occurred during the initial phases of transition. One may note a striking similarity to other transition economies. For instance, the adjustment in both Polish and Hungarian directions of trade occurred in 1991- 92. Since then respective patterns have not changed significantly. This implies that subsequently economic policies in these economies may have influenced the pace, but not the direction, of foreign trade growth. 7 Had it not been for an increase in imports into Bosnia and Herzegovina, financed mainly by international donors, this share would have dropped even further. 8 2.4. Sustainability of external performance 21. Among the transition economies, Slovenia was the first to move beyond the level of GDP recorded before the collapse of the old regime and the first to register economic recovery, the second year into the transition. Other successful transition economies rebounded only in the third year of the radical stabilization program coupled to export-led recovery. Export expansion has also spurred Slovenia's turnaround. Between 1993, the first year of recovery, and 1995 trade had been growing faster than GDP. Export growth, initially assisted by growing revenues from tourism, had provided a boost to recovery and expansion in imports. Nonetheless, in 1996-97, GDP growth seems to have been driven by domestic rather than external demand; net revenues from tourism declined slightly. 22. While Slovenia's overall external performance has been impressive, there are signs that it may be difficult to sustain. The slow down in export expansion and the stagnation in net revenues from services can negatively impact the country's capacity to import capital equipment indispensable for the modernization of its industries and the development of needed infrastructure. This hints at weaker economic growth than potential. There are some other indications that the industrial sector may be loosing competitiveness. Some government analysts note the fall in profitability of Slovene exporters.8 The analysis of Slovene export performance in EU markets points to a change that is slower than one might anticipate by contrasting Slovenia against other successful CEEs. 23. The challenge of preparation for EU membership -- and exploiting opportunities it offers in terms of becoming part of a Single Market -- relates to, among other things, restructuring and accelerating economic growth. Slovenia's performance should be assessed against the objective of full integration into the EU. Its moderate growth should not be a major barrier to achieve this goal. Even though the growth of GDP may slow down, other EU candidates would need a relatively long period of double digit growth rates to catch up with Slovenia's GDP per capita. Slovenia will continuie to be regarded as structurally well suited for EU membership. Nonetheless, Slovenia's economic performance could diminish the benefits from membership as well as potentially delay it. Upon accession, Slovene firms would have to be able to cope with competitive pressures coming from the Single Market. 3. EXPORT PERFORMANCE IN EU MARKETS 24. Slovenia had been a gateway of the former Yugoslavia to the European Union. Most of its exports to the EU and to EFTA markets originated in Slovenia. CMEA countries accounted for 16 percent of Slovenia's external (excluding interrepublic exchanges) trade.9 In the aftermath of independence, the reorientation of foreign trade patterns was driven by the collapse of import demand in former Yugoslav republics as well as by changes in Slovenia's economic regime, that is, the opening of domestic markets to external competition. 8 See Bobek et al. (1996) and Rojec (1996, 1998). 9 See OECD (1997). 9 25. The impact of the collapse of exports to Yugoslav markets was mitigated by a dramatic increase of exports to other markets, mainly those in the EU. EU-oriented exports in terms of value increased by 53 percent in 1993 while these to other markets grew by 45 percent. The rapid growth of exports to the EU seems to have run its course by 1995. Since then, there has been a noticeable slow down, not only in sales to the EU, but to other areas as well. 3.1. The impact of the collapse of former Yugoslavia 26. Trade has been a driving force in Slovenia's economic recovery. During the transformational recession in 1992-93 the bright spot were exports to the West, mainly to the EU. Their value surged by 53 percent in 1993; over the next two years, they sustained a double digit expansion, averaging 32 percent per year over 1993-95. This had provided a boost to recovery and expansion in imports. which made available higher variety and quality of products, both for consumption and investment. This, combined with competition from imports, has stimulated local producers to improve their performance. 27. The collapse of import demand in other former Yugoslav republics resulted in redirection of some products to other markets. Before the split, Slovenia's trade relations with the republics were quite intense. Around half of Slovenia's trade turnover with the Yugoslav republics was with Croatia - accounting in 1990 for roughly one eighth of total sales and purchases. In value terms, the increase in exports to markets other than those in the former Yugoslavia between 1990 and 1995 fell by 46 percent of the contraction in exports to the former Yugoslavia over this period: the value of exports to the rest of the world (ROW) increased from US$4.1 billion to US$7.1 billion, whereas exports to former Yugoslavia fell from US$6.7 billion to US$1.2 billion. 10 Table 4: Annual Change in the Value of Exports to the EU: Total vs. Most Affected Group I____________________________ 1992 1993 1994 1995 1996 Change in total EU-oriented exports N/A 53.1 21.7 24.8 -2.5 Change in the most affected group N/A 64.5 24.4 23.4 -7.0 Memorandum: ratio of exports to EU 1.04 1.32 1.61 1.49 1.35 to exports to ROW I___I _ Share in EU-oriented exports 16.9 18.2 18.6 18.4 17.5 Share in ROW-oriented exports 35.0 36.0 36.5 36.3 36.6 Source: Own calculations from data in UN COMTRADE data base. 28. Which sectors of the economy were most affected by the break up of Yugoslav federation and how successful were they in redirecting their sales to the EU? Unfortunately, there are no reliable data available to assess precisely the scope of actual redirection. Some insights, however, can be gained from an examination of exports of these sectors to the EU. If they have displayed initially higher growth rates than the average followed by the decline, one may suspect that this was the case of redirection obtained mainly from distress sales, i.e., highly discounted. With See OECD (1997). The value of exports to countries of the former Yugoslavia increased to US$1.4 billion in 1997. Because of the appreciation of the US dollar, the actual increase is understated. 10 earnings not adequate to modernize production facilities and to develop new products, their capacity to compete will decline. Phasing out various hidden subsidies will have a similar effect. Thus, these exports are not likely to continue expanding without some form of external intervention. 29. Data tabulated in Table 4, identifying the products which relied most on sales in former Yugoslav markets (the so-called "most affected group"), contrast annual changes in total exports against changes in exports of the most affected groups. The product groups most dependent on Yugoslav markets, i.e., with sales in these markets accounting for more than 40 percent of their turnover in 1990, included footwear, chemicals, textiles, metal working, and paper. A cursory examination of data in Table 4 suggests that, during 1993-94, the expansion was driven by these products. Subsequently, however, other product groups have picked up the lead. Their share in Slovenia's exports to EU markets increased from 17 percent in 1992 to 19 percent in 1994 only to begin falling. Interestingly, a different pattern can be observed in exports of these products to less demanding ROW markets--the share of most affected products has been expanding. 30. It would be tempting to conclude that export behavior of identified sectors suggests a simple redirection. As can be seen from data in Table 4, EU-oriented exports of these five product groups seem to fall within this pattern. Their sales in EU markets increased significantly faster than the average growth rate in 1993, the difference was smaller in 1994, and subsequently they displayed weaker growth or more pronounced contraction. On the other hand, ROW markets have remained receptive to these products: except in 1995, their share in exports to these markets have been on the increase. 3.2. Changes in commodity composition 31. The surge in exports to the EU initially triggered by the collapse of former Yugoslav markets has faded somewhat. With the increase in domestic demand, once the economy rebounded from the transfornational crisis, the growth was perhaps less dramatic than in 1993 but fairly consistent iuntil 1996. In addition to rapidly growing export earnings, surpluses in service -- and to a lesser extent, inflows of foreign capital -- have allowed an increase in imports providing higher quality products, both for consumption and investment. In a nutshell, foreign trade has not been a drag on Slovenia's economic performance. As we shall see, however, there are some reasons to be concerned about its sustainability. 32. Has this expansion had any discernible impact on the composition of exports? Has the export growth been driven merely by marketing more of the same products or has it been accompanied by significant changes in export baskets? In seeking answers to this question, the focus will be on EU markets for the following reasons: first, the expansion took place mainly in EU markets; second, the EU accounts for the greater part of Slovenia's external sales; third, for 11 Table 5: Exports of Slovenia to the EU (1992-96) and Rest of the World (1992 and 1996) in thousand of US dolars and percent Memorandum: ROW Product Groups 1992 1993 1994 1995 1996 1992 1996 All food products (0+1+22+4) 76,077 94,903 96,150 81,808 87,719 171,696 124,490 Agricultural materials (2-22-27-28) 58,773 76,207 93,931 139,870 93,914 20,175 37,149 Textile fibers (26) 1,183 2,318 3,317 4,904 3,589 841 1,055 Ores, Minerals and Metals (27+28+68) 90,495 122,078 185,409 228,672 212,288 29,267 42,656 Energy (3) 1,839 2,503 153 4,456 10,763 8,313 6,804 All Manufactured Goods (5 to 8 - 68) 2,170,454 3,374,026 4,097,352 5,137,348 5,039,254 874,304 1,695,560 Chemical elements (51) 33,195 47,404 99,419 133,763 100,730 32,000 73,253 Leather and goods (61) 40,205 52,641 69,248 66,173 63,001 22,493 22,228 Wood manufactures (63) 118,285 178,891 220,214 263,007 236,198 23,758 35,235 Textile yarn and fabric (65) 86,995 147,881 187,241 236,354 214,455 49,808 69,479 Iron and Steel (67) 74,768 102,872 152,364 233,883 193,071 31,575 81,500 Metal manufactures (69) 102,882 182,317 211,550 239,741 279,528 45,072 72,848 Nonelectric machinery (71) 169,192 250,970 336,935 458,942 451,131 55,520 136,885 Electrical machinery (72) 260,221 445,243 566,099 705,651 732,341 87,807 235,959 Transport equipment (73) 319,273 456,773 607,930 782,356 844,941 38,039 60,407 Fumiture (82) 116,490 193,154 251,783 339,080 375,652 52,584 81,792 Clothing (84) 405,428 600,187 580,810 613,609 577,656 31,976 56,198 Footwear (85) 62,484 95,982 87,455 91,568 79,670 32,441 20,990 Scientific instruments (86) 49,607 97,942 110,862 147,566 138,928 15,792 43,163 All goods (0 to 9) 2,415,370 3,698,213 4,501,575 5,616,578 5,474,204 1,118,029 1,937,682 in termns of percent All food products (0+1+22+4) 3.1 2.6 2.1 1.5 1.6 15.4 6.4 Agricultural materials (2-22-27-28) 2.4 2.1 2.1 2.5 1.7 1.8 1.9 Textile fibers (26) 0.0 0.1 0.1 0.1 0.1 0.1 0.1 Ores, Minerals and Metals (27+28+68) 3.7 3.3 4.1 4.1 3.9 2.6 2.2 Energy (3) 0.1 0.1 0.0 0.1 0.2 0.7 0.4 Al Manufactured Goods (5 to 8 - 68) 89.9 91.2 91.0 91.5 92.1 78.2 87.5 Chemical elements (51) 1.4 1.3 2.2 2.4 1.8 2.9 3.8 Leather and goods (61) 1.7 1.4 1.5 1.2 1.2 2.0 1.1 Wood manufactures (63) 4.9 4.8 4.9 4.7 4.3 2.1 1.8 Textile yarn and fabric (65) 3.6 4.0 4.2 4.2 3.9 4.5 3.6 Iron and Steel (67) 3.1 2.8 3.4 4.2 3.5 2.8 4.2 Metal manufactures (69) 4.3 4.9 4.7 4.3 5.1 4.0 3.8 Nonelectric machinery (71) 7.0 6.8 7.5 8.2 8.2 5.0 7.1 Electrical machinery (72) 10.8 12.0 12.6 12.6 13.4 7.9 12.2 Transport equipment (73) 13.2 12.4 13.5 13.9 15.4 3.4 3.1 Furniture (82) 4.8 5.2 5.6 6.0 6.9 4.7 4.2 Clothing (84) 16.8 16.2 12.9 10.9 10.6 2.9 2.9 Footwear (85) 2.6 2.6 1.9 1.6 1.5 2.9 1.1 Scientific instruments (86) 2.1 2.6 2.5 2.6 2.5 1.4 2.2 All goods (0 to 9) 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Source: Derived from data in United Nations COMTRADE data base. 12 the reasons above, new trends, if any, would emerge in these markets rather than elsewhere; and, fourth, global trade statistics are notoriously unreliable."' 33. A first glimpse at the evolution of Slovenian exports can be obtained from data in Table 5. First, a striking characteristic is the convergence in export baskets to the EU and the ROW. This occurred because of the fall in value of agricultural exports, coupled to a two-fold increase in exports of manufactures, boosting their share to 88 percent in 1996 from 78 percent in 1992. Second, total agricultural exports have lagged behind other exports. Their growth may have been hampered by restrictions in access to EU markets. Better performnance on less restricted markets for agricultural materials (an increase by 50 percent) seems to give credence to this assertion.12 34. Last but not least, exports of manufactured goods have recorded impressive growth: between 1992 and 1996 with their value more than doubled. The share of manufactured goods in merchandise exports to the EU increased from 90 percent in 1992 to 92 percent in 1996, and was driven mainly by machinery and transport equipment. The share of this product group (SITC 7) increased in this period by 6 percentage points, from 16 to 22 percent, while the value of their exports increased more than twofold, by 139 percent. 35. How have Slovenian exporters performed in comparison with other suppliers in EU markets? A crude measure of competitiveness is the change in import share. The capacity of Slovenian firms to conapete internationally seems to have significantly improved. In fact, they have consistently outperformed suppliers from other countries: the share of products made in Slovenia in EU outside imports (i.e., excluding trade among EU members) increased each year between 1992 and 1996 (Table 6). 36. Leaving aside product groups with shares in EU imports below 0.5 percent in 1996, the "traditional" sectors have turned out to be most successful in EU markets. Despite barriers in access to EU markets, the largest increase was for steel with their share increasing more than threefold. This was closely followed by a resource-intensive sector -- ores, minerals and metals. This sector's share increased three times over 1992-96, as did that of chemical components. The share of transport equipment, nonelectric and electrical machinery, agricultural materials, and textile yarn and fabric all doubled over the same period. The only two product groups that were outperformed in EU markets were clothing and footwear; between 1992 and 1996 their shares fell by 19 and 27 percent respectively. The alternative would be to resort to Slovenia's foreign trade statistics. However, until the 1996 customs reform (introducing Standard Administrative Document and the EU-version of the Harmonized System), Slovenian foreign trade statistics, albeit regarded as very good by standards of post-communist economies, were much less reliable than those reported by Western market economies. 12 It is interesting to note, however, that the share of EU imports of food products from Slovenia remained flat at around 0.16--0.18 percent over 1992-96, whereas the share of agricultural materials doubled from 0.26 to 0.56 percent. See next section. 13 Table 6: Share of Imports from Slovenia in EU Outside Imports by Major Product Categories 1992-96 (in percent) Index 1992 1993 1994 1995 1996 1992 -1996 Base 1992=100 All food products (0+1+22+4) 0.16 0.18 0.17 0.14 0.17 105 Agricultural materials (2-22-27-28) 0.26 0.33 0.47 0.69 0.56 213 Textile fibers (26) 0.02 0.04 0.07 0.11 0.10 514 Ores, Minerals and Metals (27+28+68) 0.30 0.41 0.69 0.87 0.91 302 Energy (3) 0.00 0.00 0.00 0.00 0.01 540 All Manufactured Goods (5 to 8 - 68) 0.75 0.97 1.10 1.32 1.33 178 Chemical elements (51) 0.24 0.33 0.66 0.85 0.71 291 Leather and goods (61) 1.55 1.62 2.47 2.32 2.27 146 Wood manufactures (63) 4.79 5.47 6.40 6.58 6.16 129 Textile yarn and fabric (65) 0.76 1.06 1.31 1.62 1.59 210 Iron and Steel (67) 0.96 1.28 2.14 3.09 3.20 334 Metal manufactures (69) 1.66 2.44 2.54 2.64 3.19 192 Nonelectric machinery (71) 0.28 0.36 0.46 0.60 0.60 214 Electrical machinery (72) 0.61 0.88 1.03 1.25 1.27 208 Transport equipment (73) 0.88 1.00 1.19 1.57 1.94 222 Furniture (82) 4.59 6.31 7.11 8.13 8.64 188 Clothing (84) 1.91 2.13 1.70 1.65 1.55 81 Footwear (85) 2.08 2.50 1.73 1.75 1.51 73 Scientific instruments (86) 0.28 0.47 0.50 0.63 0.64 231 All goods (0 to 9) 0.51 0.66 0.78 0.94 0.98 192 Source: See Table 5. 37. Changes in shares of various products in EU imports provide insights into the competitive position of Slovenian firms vis-a-vis other suppliers. In order to assess emerging patterns of specialization of the Slovenian economy as viewed through the lenses of EU markets, it is useful to look in the changes in "revealed comparative advantage," assessed not against the world trade but that of the EU. The value of revealed comparative advantage index (RCA) for a product above one suggests a country's revealed specialization in producing this product."3 In terms of broad product groups, as used in Tables 5 and 6, the estimates of RCA confirm an improvement in Slovenia's position in those EU markets where, even before the independence, its firms were significant suppliers. Along these broad product groups, there were no significant changes in Slovenia's comparative advantage. 38. A less aggregate picture emerging from estimates for 807 four-digit SITC (Rev. 1) adds some new elements. Among the top ten products with the largest values of RCA, there were only 13 A country's "revealed" comparative advantage in a product "j" is defined as the ratio of the share of "j" in the country's exports to the share of the product "j" in world trade (Balassa 1965). A value for this index below unity indicates a comparative disadvantage. If the index takes a value greater than unity, the country is considered to have a "revealed" comparative advantage in the product. In this particular case, Slovenia has a revealed comparative advantage in a product if its export of that item as a share of its total exports exceeds the EU imports of the item as a share of EU total imports. 14 minor changes in terms of both ranks and new entrants. There were some rearrangements among leather products: leather belts (6121) moved to the top in 1995-96 while leather articles (6112 and 6119) did not make to the top ten. Neither roasted iron (2814) nor builders wood (6324) nor vessels for breakup (7358) made the top ten. The number of product categories with RCA above unity declined from 149 in 1993-94 to 136 in 1995-96. 39. Thus, it seems there was no significant expansion in new specializations in the Slovenian economy between 1993-94 and 1995-96. Numerous empirical studies show that, as a country develops, the distribution of RCA becomes less skewed and a number of manufactures with RCA above unity increases.14 This is clearly not the case in Slovenia during transition. The RCA profile has become more concentrated with the ten top highest RCA values increasing each year. The top ten values of RCA have been on the increase: the total for RCA indices in 1993-94 was 175 and 190 in 1995-96. The highest RCA value increased from 29.5 (blankets--6566) in 1993- 94 to 37.5 (6121- leather belts) in 1995-96. The average for the top 10 increased from 16.4 to 17.9 in the same period. Consequently, within a smaller number of products with comparative advantage in EU markets, the distribution has become much less uniforrn. 40. The meaning of this is ambiguous. Slovenia continues to have a relatively uniform profile of RCA distribution, indicating a high level of industrial maturity. The "deterioration" may indicate that Slovenia's export offers were excessively diversified in the past. Conversely it may indicate industrial devolution and declining competitiveness. 3.3. Commodity chains: changes in the level of processing 41. While Slovenia's export offer has remained relatively stable, an interesting question is whether there has been a change towards more "advanced" products in terms of processing. To examine this question, we use a classification developed by the World Bank, one that analyzes different levels of processing of commodities.15 The classification identifies 48 commodities, in various forms of processing, that both developed developing countries export. The World Bank's commodity processing classification scheme distinguishes, at a minimum between, two stages i.e., a primary and processed stage product (for instance, the primary stage of vegetable chain consists of fresh vegetables whereas the processed stage includes preserved vegetables). The classification frequently distinguishes among three stages including a semifabricated or intermnediate stage. For instance, the primary stage of the wheat chain consists of unmilled wheat (SITC.Rev.1. 041); a semi fabricated stage includes wheat mill or flour (046); bread or biscuits (04841) comprise the final stage item. 42. The share of 48 commodity processing chains in Slovenian exports to the EU has been steadily declining from 25 percent in 1992 to 21 percent in 1996 (Table 7). The most important chains in terms of their share as EU-directed exports are those based on wood with an average share of 5.5 percent in 1995-96; paper-pulpwood (3.04 percent); leather (2.96 percent); rubber 14 See for instance Yeats (1994). For a discussion and presentation of the cormmodity processing classification, see Yeats (1991). 15 (2.61 percent); and bauxite (1.96 percent). These five chains account for approximately 80 percent of commodity exports. Table 7: Changes in Slovenia's Exports to the EU in Individual Commodity Chains Indexl996 1992 1996 1992=100 Share of Primary Stage Products 6.52 3.91 60 Share of Intermediate Stage Products 19.79 17.85 90 Share of Final Stage Products 73.69 78.24 106 Share of Commodity Chains in Total Exports to the EU 24.53 21.15 86 Memorandum: share in EU imports Primary Stage Products 0.03 0.03 102 Intermediate Stage Products 0.19 0.32 170 Final Stage Products 0.29 0.50 175 Commodity Chains, total 0.17 0.28 170 Source: See Table 6. 43. The contribution of commodity chains to Slovenian exports to the EU, as well as the share of primary stage products, fell between 1992 and 1996. At the same time, Slovenian presence in EU markets for commodity chains has increased because of expansion in exports of processed commodities. The largest improvement in competitiveness, as measured by the increase in the share of EU imports, has occurred for final stage products. Assuming that higher level of processing implies higher value-added, this may be regarded as a positive development. 3.4. Factor content of EU-oriented exports 44. According to the Heckscher-Ohlin Theorem, commodity trade patterns reflect differences in comparative advantage as determined by different factor endowments among countries. A country tends to export those goods which use factors in relative abundance -- signifying a competitive market mechanism efficiently allocating resources. 45. To test the hypothesis we cluster commodity groups as classified in the SITC into four groups reflecting their distinct relative factor intensities. These groups are: natural resource- intensive products; unskilled labor-intensive products; technology-intensive products; and, human capital-intensive products.16 The first two groups represent lines of production characterized by low value added, high natural resource-intensiveness and simple technologies. They account for the dominant export share of countries at the lower end of the industrial 16 The first group consists of food, beverages, crude materials, mineral fuels, animal and vegetable oils, leather, plywood, mineral manufactures, diamonds and non-ferrous metals. The second group, representing commodities with the lowest value added per worker, includes textiles, garments, furniture, glass, etc. The third group of technology-intensive products are goods with the highest ratios of R&D (Research and Development) expenditures to value added, whereas the human-capital-intensive group contains goods with the lowest ratios of R&D expenditures to value added. The third group includes chemicals (plastics, fertilizers, etc.), some capital equipment, telecommunications equipment, medical, scientific, and measuring equipment, and photographic supplies. The fourth group includes such goods as paints, rubber, paper, TV and radio sets, etc. 16 pecking order.17 While the line dividing the technology- and capital-intensive groups is fuzzy, they both contain products requiring more sophisticated inputs than is found in the first two groups. 46. Considering Slovenia's large pool of relatively low-cost labor (vis-a-vis the EU) and its modest endowment in natural resources, one would expect that labor intensive products and technology-intensive products would eclipse natural resource-intensive groups. Adding to this an abundance of high skilled labor relative to Slovenia's GDP per capita, one would assume that, within labor-intensive products the human capital-intensive group should account for a much larger allotment. The composition of Slovenian exports seems to corroborate these expectations. Indeed, technology- and labor-intensive products accounted for between 81 and 85 percent of Slovenian exports to the EU over 1992-95 (see Table 8). Table 8B: Factor Content of Slovene Exports to EU over 1992-96, in percent Relative Factor Intensity Groups _1992 1993 1994 1995 1996 Natural Resource Intensive 18.4 16.2 16.7 16.0 14.9 Unskilled Labor Intensive 31.2 31.8 28.5 26.9 27.0 Technology ;[ntensive 16.6 17.6 19.3 20.4 20.4 Human Capital Intensive 33.0 33.5 34.8 36.3 37.2 Source: Own calculations. Data on Slovenia's exports as reported by the EU to UN COMTRADE data base. 47. Given the relatively high quality and degree of scientific education in the countries studied, Hamilton and Winters (1992) point to a positive correlation between education in Central European cotntries and comparative advantage in sophisticated engineering goods. They thus predicted a better-than-average performance in human capital intensive products. While this prediction turned out to be wrong for developments during the initial stages of almost all transition economies, Slovenia has proved an exception. In contrast to other transition economies, where initial expansion has been pulled by unskilled labor intensive products, Slovene export expansion was driven by both technology-intensive and human capital intensive manufactures. Their aggregate share in EU-oriented exports rapidly increased from 50 percent to in 1992 to 57 percent. The share of technology intensive products rose from 16 percent in 1992 to 20 percent in 1995, and remained at this level in 1996. At the same time, a discernible shift in the export basket toward human capital intensive products seems to have occurred. The share of these products has been steadily increasing from 33 percent in 1992 to 37 percent in 1996. 48. Indeed; calculations of Slovenia's revealed comparative advantage (RCA) in EU markets bolsters these observations. Human capital-intensive products were at a comparative advantage in trade of these products over 1992-96, these products revealed a comparative advantage index growing from 2.2 in 1992 to 2.7 in 1996 (Table 9.A). This group recorded the largest increase between 1992 and 1996; its share in EU imports more than doubled over this time, increasing 17 For an extensive discussion of links between level of development and factor content of exports, see Balassa (1978) and Yeats (1989). 17 from 0.9 percent to 2.2 percent (Table 9.B), which indicates that these products outperformed other suppliers of human capital intensive goods. Table 9: Factor Content of Slovenia EU-Oriented Exports in Terms of RCA and Shares in EU Outside Imports, 1992-96 A. Revealed Comparative Advantage Indices Index 1996 Relative Factor Intensity Groups 1992 1993 1994 1995 1996 Base 1992=100 Natural Resource Intensive 0.5 0.5 0.5 0.5 0.4 86 Unskilled Labor Intensive 2.2 2.1 2.0 2.0 1.9 90 Technology Intensive 0.5 0.5 0.6 0.6 0.6 110 Human Capital Intensive 2.2 2.3 2.5 2.6 2.7 121 B. Share in EU Imports Natural Resource Intensive 0.2 0.3 0.4 0.4 0.3 157 Unskilled Labor Intensive 0.9 1.4 1.5 1.5 1.4 163 Technology Intensive 0.2 0.3 OA 0.4 0.4 201 Human Capital Intensive 0.9 1.5 1.8 2.0 2.0 220 Source: Own calculations on the basis of data from UN COMTRADE data base. 49. Although the importance of unskilled labor intensive exports has been declining, Slovenian exports continue to derive their competitive strength in EU markets by specializing in unskilled labor intensive products. Exporters of unskilled labor-intensive products have had the second highest share of EU imports over 1992-96. That share increased by almost 60 percent from 0.9 percent in 1992 to 1.5 percent in 1995, and slightly declined in 1996 to 1.4 percent. The decline in values of RCA for unskilled labor -- the source of Slovenia's competitiveness in EU markets at the outset of transition to competitive markets - was, though significant, less steep. 50. The share of Slovenian technology-intensive products in EU outside imports has doubled. The increase, however, took place between 1992 and 1994; over 1995-96 these exports remained flat. They have failed to increase their presence in EU markets. These products as well as natural resource intensive products seem to be at a comparative disadvantage in EU markets. 3.5. How environmentally "clean" are Slovenian exports to the EU? 51. It is to be expected that environmentally dirty industries tend to concentrate in countries where environmental control measures are less stringently applied. Since these measures affect costs, as more demanding measures impose higher costs of compliance, countries with more lax environmental regulations tend to specialize in so called "dirty" industries. Less developed countries have less demanding compliance rules, and one would expect the less developed countries to have revealed comparative advantage in markets for dirty products. Some empirical studies do confirm the shift in specialization in these products away from highly developed to developing countries.18 18 See Low and Yeats 1992. 18 52. Low and Yeats methodology defined environmentally dirty industries as those incurring the highest level of pollution abatement and control expenditures in the United States, i.e., equal or higher than one percent of the value of their sales in 1988. The weighted average of expenditure/output ratio for all US industry was 0.54 percent with cement having the highest ratio of over 3 percent.19 Using this classification, one hundred eighty eight four-digit SITC industries were selected. They included all four-digit SITC products in ferrous metals (SITC 67), nonferrous metals (S][TC 68) metal manufactures (SITC 69), pulp and paper products (SITC 251), refined petroleum products (SITC 332), organic chemicals (SITC 512), inorganic chemicals (SITC 513 and SITC 514), mineral tars and petroleum chemicals (S1TC 521), manufactured fertilizers (SITC 561), agricultural chemicals (SITC 599), wood products (SITC 631 and 632), paper and paper articles (SITC 641 and 642), cement and other building products (SITC 661). 53. The share of environmentally dirty products in Slovenia's EU exports has moderately increased during 1992-1995, declining in 1996. The share of such production increased from 21 percent in 1992-93 to 24 percent in 1994-95 (Table 11). Exports of pollution-intensive products remain highly concentrated, with the top ten four-digit SITC.(Rev 1) industries accounting for approximately 50 percent of 'dirty' exports. The most important item has been builders woodwork (6324), contributing on average around 14 percent to dirty exports to the EU over 1994-96. With the vatlue of exports reaching US$173 million, this share was 14.1 percent in 1996, down from its peak level of 17 percent in 1992. Table 10: Selected Features of Slovenia's 'Dirty' Exports to the EU, 1992-96 1992 1993 1994 1995 1996 Share in EU oriented exports 21.36 21.11 23.64 24.50 22.39 ShareinEU "dirty" imports 0.18 0.33 0.39 0.39 0.38 0 RCA Indices 1.23 1.27 1.37 1.33 1.32 Source: Own calculations from data in UN COMTRADE data base. 54. The sectors responsible for a persistently high share of dirty products in EU-oriented markets include metal manufacturing, aluminum and iron and steel products. The share of base metal manufacturing (6324) rose from 5.5 percent in 1992 to 9.2 percent; those of aluminum alloys unwrought (6841) and aluminum worked (6842) rose from 5.3 and 4.1 to 7.2 and 4.5 percent, respectively; and that of iron and steel bars (6732) rose from 3.7 to 4.6 percent. It is also interesting to note that exports of steel industry rose from US$65 million in 1992 to US$180 million in 1996, with their share in dirty exports increasing from 12.5 to 14.6 percent. 55. Slovenia's exports of environmentally dirty products to EU markets seems to be high considering the country's geography, environmental awareness and its potential for developing tourism. Note that the share of dirty products is only seven percentage points lower than Poland's exports to the EU, which was 30 percent in 1995.20 Considering the differences in natural resource endowment and the level of industrialization between the two countries, the share of 19 For:a detailed discussion see a footnote #6 in Low and Yeats (1992:91). 20 See Kaminsky,(1998). 19 environmentally dirty products among Slovenia's exports should be considerably lower. In fact, the environmentally dirty sectors have been at a comparative advantage in the trade of these products: the value of RCA increased between 1992 and 1994 and then steadied at the level of around 1.4. Their share in EU imports, however, has been expanding, especially in 1994 and 1995. 56. Without a more detailed analysis of environmental regulations it would be impossible to attribute Slovenia's apparent competitiveness in pollution-intensive sectors to lax environmental standards. Nor does the mere existence of dirty industries automatically amount to dirty environment. Nonetheless, it seems that since its environmental standards are somewhat lower than in the EU, Slovenia has still to comply with the EU' s environmental directives. Considering that investment in the environment will bring rapid return in terms of increased revenues from tourism, a closer examination of the environmental impact of existing resource allocation incentives might be worth pursuing. The improvement in comparative advantage in "dirty" products should actually serve as a warning that incentive structures and state policies may need to be adjusted. 3.6. Top export performers 57. The analysis has thus far focused on total exports to the EU. An interesting question is whether there has been any major rearrangement among the largest exporters. We shall first compare the largest exporters to the EU in 1996 with those of 1992 and 1993. The year 1993 was selected as a base to eliminate these "random" developments likely to occur in the first year of independence. We shall then identify the emergent stars among the top performers, i.e., those that recorded the largest increases. This should shed some light on future developments in factor content of Slovenia's exports. 58. Even a cursory examination of the top twenty exporters to the EU among the 811 SITC four-digit items shows that there was little change between the two periods. Their share in total exports to the EU increased slightly, from 57 percent in 1992 to 59 percent in 1996 (for details see Table 1 in Statistical Appendix). Among the top twenty of 1996, there were three new entrants: pumps (7192); meters and counters (8618); and iron and steel bars (6732). These made to the top bumping out paper articles (6429); non-air piston engines (7115); and yarn of synthetic fibers (6516). 59. As for the emerging top performers, the analysis proceeds as follows. For the 811 four- digit SITC.Rev.1 items, average growth rates in value of EU-destined exports over 1992-96 as well as changes in shares in EU outside imports between 1992 and 1996 were calculated. Products with export values exports below US$5 million in 1996 were not taken into account. For the top performers, the factor content was identified. The same calculations were conducted comparing average shares in EU imports in 1993-94 and 1995-96 for exports exceeding US$1 million. 60. The results are as follows: Top performers from 1992-96 accounted for 34 percent of Slovenian exports to the EU in 1996--in 1992 the share of this group was 20 percent. Among the 20 top performers, exports of machines and transport equipment (SITC. 7) - US$847 million in 1996 - dominated, accounting for 47 percent of the value of exports of top performers, mainly because of passenger car (7321) exports. The largest single product was passenger cars (US$676 million) accounting for 37 percent of the total. This was followed by furniture (8210) accounting for 20 percent, and then base metal manufactures (6989) with a share of 6 percent. 61. Alcohol and phenols (SITC 5122), aircraft engines (7114) and clocks (8642) recorded the largest increases in terms of EU imports. Nonetheless, their respective shares have not exceeded the level of 1 percent. Among top performers, the largest shares included base metal office supplies (8951) whose share increased from 0.98 in 1992 to 4.14 percent in 1996; furniture, whose share increased from 0.59 to 1.79; iron castings (6791) with a share in EU imports growing from 0.49 to 1.73; and glass (6649), with a share increasing from 0.21 to 1.06 percent. 62. In terms of factor intensities, products responsible for the largest share of exports of top 40 performers have been human capital-intensive. They generated export revenues of US$932 million, accounting for 51 percent of exports of the "successful" group. Technology- intensive products, with exports of US$393 million, accounted for 21 percent of the total. Hence, the two groups at the higher end of the value added spectrum accounted for 76 percent of exports with above-average performance. 63. Products typical of a low level of industrial development accounted for the remaining 24 percent of exports. The second largest contribution came from unskilled labor intensive products -_ with US$472 million in exports. They accounted for 26 percent of the total. The value of exports of products belonging to the natural resource-intensive group was US$34 million. 64. The ranking, based on share changes in EU imports between the averages for 1993-94 and 1995-96, includes a smaller number of manufactures and a larger number of resource intensive products. While the share of Slovenian exports in EU imports increased by 7 percent, the share of products on the top forty list increased by between 49 and several thousand percent. The top three positions were taken by resource intensive products; motor spirit, gasoline (3321), margarine (0914) and oil seeds (2218). Admittedly, their respective shares were minuscule in 1993-94, i.e., well below the average of 0.3 percent for total exports. The largest share in this group had leather belts (6121) -- 11 percent, followed by reclaimed rubber (2313) of 5 percent. An impressive performance of firms producing machinery (SITC. 71), accounting for 16 percent of the value of exports of top 40 products, is worth noting. 3.7. Sustainability of export performance 65. The conclusions of this section thus far are that unskilled labor intensive products, despite a slowdown in their overall growth, continue to account for a sizable portion of exports; that human capital-intensive products have recorded the fastest growth in 1992-96 but slowed down considerably in 1995-96; that Slovenia does not seem to have comparative advantage in EU markets in technology intensive products, i.e., values of RCA indices are well below unity; that Slovenia seems to have excessive specialization in environmentally dirty products; and that after 21 an initial burst, exports slowed down considerably. These conclusions, taken together, raise concerns about the future of Slovenia's export competitiveness.21 66. Consider first the stagnation in Slovenia's high technology exports. Given Slovenia's endowments, it seems that the key to a sustainable export expansion is growth in human capital- intensive and technology-intensive products. However, the stagnating share of technology- intensive products in EU imports since 1994 raises concern over its future performance. While exports of human capital-intensive products have been the driving force behind a significant expansion of Slovenian sales to EU markets, the performance of technology intensive products leaves much to be desired. 67. Another source of concern is a perceptible stagnation in the overall competitiveness of Slovenian exports in EU markets as measured by its share in EU imports, including imports from other EU-members.22 While this share almost doubled in 1993 increasing from 0.15 percent to 0.26 percent, it remained flat at around 0.29 percent through 1994-96. In fact, it even contracted slightly in 1996. This contrasts rather sharply with the performance of Hungarian and Polish exporters, whose shares increased from 1.18 and 1.94 percent in 1994 to 1.51 and 2.26 percent respectively in 1996. 68. Among the factors that may account for the declining competitiveness of Slovenia's exports as revealed in stagnation of its share in EU outside imports over 1995-96, the domestic productivity growth seems to stand out. The fall in export competitive edge usually boils down to real exchange rate appreciation, that is, an overvalued domestic currency, as well as to increases in labor cost not fully compensated by productivity growth. If Slovenia succeeds in exporting only by repeatedly devaluing its currency, then its purchasing power over imports as well as domestically produced goods will decline. The key is productivity growth. Considering the huge share of foreign trade in GDP, such growth must be faster relative to other countries, otherwise economic growth performance will deteriorate, as will the standard of living. 4. FOREIGN DIRECT INVESTMENT 69. Foreign Direct Investment (FDI) inflows to Slovenia increased from US$111 million in 1992 to around US$186 million over 1996. The average over the 1992-94 period was merely around US$117 million. The value of FDI increased by 37 percent in 1995 and remained almost flat the following year, increasing by just 5 percent. The signature of the EU agreement in mid- 1996 an the favorable opinion of the EU towards Slovenia in 1997 sent a clear signal to the 21 The OECD report also notes "... a significant deterioration of the export competitive edge between mid-1994 and mid-1995." (OECD 1997:25). From the 1996 data, it seems, however, that if there was improvement in the second half of 1995, it was not sustained in 1996. 22 Although the stagnation in exports may be reversed relatively quickly through further depreciation of domestic currency, the improvement will be at the expense of standard of living unless domestic productivity growth outstrips that of major competitors in international markets. 22 international community. As a result, FDI inflows increased by 73 percent in 1997, reaching US$321 million (see Chart 1).23 Chart 1: FDI Inflows in Slovenia 1991-97 350.0 300.0 250.0 200.0 150.0 50.0 0.0 1988 1989 19901 1991 1992 1993M- 19941 19915 1996 1997 -50.0 Source: Bank of Slovenia. 70. ,As measured ag ainst GDP, the current level in terms of the share in GDP is almost three times higher than the pre-accession shares in Portugal and Spain. 24 Nonetheless, the share in GDP - which rose from slightly below 1 percent over 1992-96 to 2 percent in 1997 -- remains relatively low. Although FDI inflows looked impressive against the 1980s standards, they looked less impressive against those in the 1990s, which have witnessed a dramatic surge in FDI worldwide. More significantly, FDI inflows-in terms of GDP have been below levels recorded not only by other candiidates for EU Enlargement but also by other transition economies. 25 71. In fact, FDI inflows thus far have been lower than expected. Taking into account Slovenia's superb location and its relatively high level of industrial development, it has a high 23 This is according to data from Bank of Slovenia. Direct investment is reported on the basis of payments through domestic banks and data from customs declarations. 24 The different national classification methods .of EDI complicate comparisons between countries. While in Portugal non-cash contributions are taken into account as part of FDI, in Spain and Slovenia only money inflows are considered. This leads to an inflation of the Portuguese data. Different sources of methodological and data problems also exist. 25 Despite a two-fold increase in 1997, the share of EDI in GDP in Slovenia (1.9 percent) was lower than in Bulgaria (4.7 percent), Latvia (4.4 percent), Romania (2.1 percent) and Lithuania (2.1 percent). 23 propensity to be a host to FDI and should be among its top recipients. One would expect FDI to be hovering around 3-5 percent of GDP, that is, 2-3 times above its current inflows. These low levels of FDI may have reduced Slovenia's potential for further export expansion and be in part the cause for the relatively small changes in Slovenia's export baskets. Indeed the experience of other transition economies seems to strengthen this hypothesis 4.1. FDI inflows: below the potential? 72. The amounts of FDI inflows that Slovenia has thus far attracted seem to fall short of its potential: other EU candidate countries have attracted remarkably more FDI. On a per capita basis Slovenia's cumulative FDI over 1990-97 were around one-third of Hungary (Table 11). They were only larger than Poland's - a country with almost 20 times the population but around three-times lower GDP per capita than Slovenia. But the average FDI inflows in terms of GDP were the lowest among EU candidate countries. FDI stock in terms of 1997 GDP is almost 10- times lower than in Hungary, five times lower than in Estonia and Czech Republic, and almost three times lower than in Poland. 73. Although the breakup of the former Yugoslavia and the circumstances associated with independence could hardly create an environment favorable to foreign investors, the remarkable political stability that had elapsed since Slovenian independence was sufficient to compensate for initial barriers. In fact, among transition economies only the Czech Republic and Hungary had an advantage of an earlier start to attract FDI. As for the remaining candidates, Poland became a significant recipient of FDI only around 1995, after it signed the private debt restructuring agreement with private creditors under the aegis of the London Club, while Estonia became a sovereign entity in late 1991, like Slovenia. Nonetheless, both countries have received larger inflows than Slovenia. Table 11: FDI in Slovenia and Other EU Accession Candidate Countries, 1990-1997 Cumulative FDI, 1990-97 Cumulative Fl)I, 1995-97 FDI Stock/GDP per capita in GDP per capita in GDP in 1997 (in US dollars) (in percent) (in US dollars) (in percent) (in percent) Estonia 620 3.61 315 3.26 15 Czech Republic 770 2.74 469 3.48 15 Hungary 1,464 5.02 825 6.62 29 Poland 350 1.77 231 2.38 8 Slovenia 522 2.30 341 1.18 12 Sources: Global Development Finance 1997 and Monthly Bulletin, Bank of Slovenia. 74. Except for Renault's investment and the more recent Goodyear Tire & Rubber joint venture with Slovenia's Sava Group, a producer of car tires, firms investing in Slovenia have been small to medium in size -- a pattern reminiscent of FDI in Poland during the initial stages of the transition, that is, before an FDI "take-off' in 1994-95. There was, however, one notable difference. Slovenia's distinct feature has been a significant involvement of commercial partners: there has been a large number of investment contracts involving Western commercial partners acquiring equity in their Slovene suppliers. 24 75. Foreign firms have invested mostly in manufacturing (US$836 million) which accounted for around 43 percent of total FDI stock at the end of 1996. This was followed in importance by financial institutions (17 percent, or US$331 million), electricity production (14 percent, or US$265 million), and trade and services (12 percent, or US$239 million).26 A sector that has increasingly attracted foreign capital is the service sector, particularly, the financial sector with the share of total FDI stock rising from a mere 0.2 percent in 1991 to 17 percent in 1996. These flows into services seem to have helped remedy an important legacy of 'market socialism,' namely the underdeveloped service sector. Nonetheless, with many areas of services still partially blocked to foreign capital (see Section 6.5), the potential is yet to be fully explored. 76. FDI in manuiacturing has yet to contribute to significant changes in the industrial structure. FDI has concentrated in sectors which were already well developed before independence. There has been so far no significant greenfield investment. Within manufacturing, the most important recipient sectors were pulp and paper (US$143 million), motor vehicles (US$140 million) and chemicals (US$113 million). These three sectors took up 20 percent of total FDI stock at the end of 1996, or 47 percent of all foreign investments in manufacturing. 77. It seems that FDI should have been at much higher levels. Indeed, Slovenia is particularly well endowed to be a host to FDI on all counts. According to contemporary FDI theories, the amount of FDI directed to one country by others varies according to four factors -- the location, the level of economic development, the structure of created and natural resource endowments, and government polices. Compared to other transition economies, Slovenia has superb location. It is also the most developed country, with a GDP per capita about 30-40 percent higher than in Czech Republic, the second most developed economy of this group. 78. The structure of created and natural resource endowments also puts Slovenia ahead of 27 the group. As a country moves up the ladder of development, it derives its competitive advantage less from the availability of natural resources -- including its pool of relatively unskilled labor -- than from its created assets, most notably "... its technological capabilities, its educational, transport, and communications infrastructure and the quality of its entrepreneurship and the ethos of its people towards wealth-creating activity." The presence of these factors, combined with the quality of labor (rather than cost of labor which really counts mostly for Least Developed Economies?8), explains why firms do engage in FDI. Again, while each component of created assets does not render itself to a straightforward numerical appraisal, Slovenia would rank very high among transition economies. 79. A key element to explain Slovenia's low FDI inflows seems to be the stalled reform effort. Despite significant progress in market reforms, Slovenia still lags behind the group of countries seeking EU accession. A study on capital inflows to Central European and former 26 For details, see Table 2 of the Statistical Appendix. 27 See Dunning (1996). 28 Empirical studies confirm this observation. For instance, an examination of Belgian FDI in Central and Eastern Europe leads to the conclusion that "... most observed FDI (...) is related to other reasons than wage costs." (Konings, 1996). 25 Soviet Republics, utilizing panel data for 21 countries in transition, corroborates this observation.29 The study identified three major factors explaining FDI during the 1992-96 period in transition economies: reform efforts, EU accession, and creditworthiness. Slovenia is among countries that has signed an EAA and initiated discussion on accession, and signals from the international capital market point to Slovenia's strong creditworthiness. 80. Not only has its reform process been slower, but privatization--which has played a very important role in attracting FD30 -- was not conducive to significant foreign participation. The privatization program in Slovenia has by contrast favored insiders; foreign buyouts were exceptional only during the first phase of privatization. The program has explicitly reduced the scope for trading, as shares acquired through vouchers in the mass privatization could not be sold for two years. Furthermore, access by foreign firms to service sectors has been restricted by the existing regulatory framework. 81. Thus, low FDI inflows have been the result of domestic impediments. With its high technological capabilities, its disciplined and educated workforce, and its well-developed physical infrastructure, Slovenia should have been host to much larger inflows of foreign capital. All things considered, the ratio of FDI stock to GDP of 3 percent in 1997 might have been at least five times larger, i.e., similar to that in Estonia and Czech Republic (both 15 percent). Considering the positive impact that FDI have had in transition economies, on restructuring and integration into international markets, the absence of an active strategy to open the economy has resulted in significant losses for Slovenia in terms of welfare and economic efficiency. 4.2. FDI role in restructuring and export performance 82. The experience of transition economies FDI extends over a period long enough to draw some generalizations as to their impact on restructuring and integration into international markets. FDI has helped integrate domestic production capacities into global networks of production and distribution, by acting as a powerful vehicle for transfers of technology and best practices in management. FDI contributes to intraindustry linkages, allowing economies of scale through to greater product specialization in differentiated products - particularly important for small economies. While conventional comparative advantage brings about interindustry specialization, as it operates on groups of products rather than within them, the force driving two-way trade in similar differentiated products are economies of scale associated with supplying a larger market. The reason a country cannot produce a complete range of these products relates to fixed costs of production. Consequently, countries with similar factor endowments find reasons to trade with each other. 83. Intraindustry trade has several advantages over interindustry exchange. For one, it does not involve relocation of whole industries, since both factors of production, labor and capital, gain from it. Furthermore, it is less vulnerable to swings in the domestic business cycle, thus 29 See Claessens, Oks and Polastri (1998). 30 Privatization-driven FDI associated privatization, as a share of total FDI in Europe and Central Asia, amounted to 40 percent (the World Bank Privatization Database). 26 assuring a higher degree of stability in the country's export earnings; in contrast to interindustry trade, it leads to lesser inequalities in regional development and income distribution.31 In consequence, specialization in differentiated products associated with interindustry trade poses fewer adjustment problems than interindustry trade. 84. The experience of EU candidates with FDI has also helped dispel fears that engagement in a preferential trading arrangement with the highly developed EU might lead to a catastrophic relocation of domestic industries. These fears may have been justified, to some extent, by findings of the new tr,ade theory and economic geography models. While the new trade theory suggests the overall benefits are likely to be significantly larger than those suggested by traditional approaches,32 economic geography models allow for the possibility that gains -- especially during the early stages of integration -- will be distributed in favor of a more developed partner, the EU.33 Firms operating under the conditions of imperfect competition and economies of scale, i.e., in increasing returns-to-scale industries, tend to cluster together drawn by the availability of supplies due to the higher concentration of demand, which occurs in a higher developed country. 85. This "agglomeration economies" effect may be further exacerbated by the hub-and-spoke arrangements with firms in a spoke country (e.g. Slovenia). These firms are likely to have larger costs for two reasons. IFirst, they face higher barriers than hub firms when importing inputs from the other spokes. Second, they tend to be penalized by lower demand from other spokes due to trade barriers.34 Nonetheless CEFTA and, more recently, the Pan-European cumulation agreement combining rules of origins of the EU, CEFTA, EFTA, the Baltic states and Bulgaria have significantly weakened the hub-and-spoke effect. On the other hand, good access to EU markets, low wages, -and investment by MNCs thanks to their global marketing networks have prevented relocation of increasing returns-to-scale industries and have generated dynamic growth effects.35 86. Another lesson from FDI is that they enhance export capabilities, thus contributing to reintegration into the world economy. Consider the evidence from Slovenia, Poland and Hungary. A study of Slovenian firms finds foreign firms larger in size, more capital intensive and much more export oriented than locally-owned firms36. In Poland, firms with foreign capital generated 12.4 percent of total income and accounted for 7 percent of total employment in 1995, 31 For a thorough discussion, see Krugman (1994. pp.38-51). 32 Traditional trade models suggest that capital and/or labor mobility brings convergence; thanks to changes in relative prices brought about by lower import prices and improved export prices, and a higher marginal product per capita attracting higher investment and growth (Baldwin 1989). Furthermore, since a share of Slovenia's trade with the EU is higher than that for the EU, trade will be of more benefit to Slovenia. 33 For the analysis of this problem, see Krugman (1987) and Krugman and Venables (1993). 34 The concern that EU's "associates" in Central Europe would become marginalized into spokes was forcefully expressed in Baldwin (1994). 35 While forces at hand rnight have been different, a similar phenomenon was observed in Ireland albeit after accession to the EU. See F. Barry (1996). 36 See Rojec (1996, 1998). 27 but their shares in exports and imports were 34.4 and 42.1 percent respectively. About 78 percent of exports and 75 of imports of the foreign-owned firms was with the EU. 87. But the most telling is the case of Hungary -- a country which has made the largest strides in opening its economy, especially services, to foreign capital. As in Slovenia, foreign firms are more profitable than domestic firms. Foreign firms set their eye mainly on external markets. Consider that the share of foreign firms in exports was 69 percent in 1996, while revenues in net sales amounted to 45 percent.37 Foreign firms, together with prudent macroeconomic policy, have been the force driving the recent expansion of Hungarian exports. While the average export growth was 21 percent in 1997, exports from companies (mostly foreign-owned) operating in customs-free industrial zones grew by 77 percent. 88. Hungary's success in attracting FDI has been largely due to opening financial services and telecommunications to foreign investors. The crux of the matter is not only that the sale of a bank or a telecommunication company generates inflows of cash thereby raising the value of FDI stock in a country, but also the impact it has on the business environment. The availability of high quality services thanks to MNCs, combined with a friendly business climate, attracts more foreign firms. MNCs have links with banks in their home countries: the availability of their services in a host country influences their decision. 89. Much more important, however, is the positive impact that foreign competition has on the overall quality of services. Among the forces fueling current international trade is a rapidly 38 growing fragmentation of the production process, resulting in a finer and finer division of labor The process of globalization of production through fragmentation of production is driven by the quality of available services, ranging from transportation and telecommunications to insurance and banking. Services allow for splitting production into smaller blocs and locating them in different countries. Since these blocs must interact in a precise manner, they require a well- functioning environment providing easy access to reliable, cheap and easily obtainable services. The growing availability of these services explains Hungarian success in attracting FDI over 1994-97. 90. In all, the experience from FDI in transition economies suggests that foreign firms provide a base for a sustainable export growth performance. Low inflows of FDI into Slovenia seem to offer an explanation of its loss of export momentum. Given its location and infrastructure, it seems that Slovenia's pre-accession strategy should be built around, among other things, attracting fragmented production technology. This can be accomplished with reforms that open services such as transportation, telecommunications, insurance and banking to foreign competition. 3 See Elteto (1998). 38 See Jones and Kierzkowski (1992). 28 5. TARITF PROTECTION: DISCRIMINATION AGAINST MFN SUPPLIERS 91. The former Yugoslavia had neither an open economy nor a state monopoly over foreign trade. The Yugoslav "market socialism" was based on self-management: firms had considerable autonomy in conducting business transactions, although they were closely monitored by the state. Note that in the 1980s, all imports were subject to administrative controls, and domestic markets were additionally protected by high tariffs.39 Taxes on exports of raw materials underlined an anti-export bias of the Yugoslav foreign trade regime. Large state-owned firms -- which in contrast to "socially owned" firms were oriented more towards OECD markets rather than domestic markets -- had a virtual monopolistic position, and faced little, if any, competition from domestic or foreign sujppliers. Liberalization of foreign trade preceded the break up of former Yugoslavia; by 1990 quantitative restrictions (QRs) covered 22 percent of imports. 92. With a formal recognition of Slovenia's independence in early 1992 and with accession to the General Agreement on Tariffs and Trade,40 the process of dismantling vestiges of "market socialism" accelerated. By 1996, most QRs have been removed; they affected less than 2 percent of Slovenia's imports in 1996. Export taxes have also been removed -- the last ones were levied on exports of unworked wood and iron or steel scraps and were abolished before 1996. Furthermore, with the introduction of a new customs legislation (Customs Code and Customs Tariff Law) in line with EU regulations, customs entry procedures have been modernized and simplified, thus improving conditions of access to domestic markets. 93. Slovenia's tariiff structure has two characteristics: it affords high levels of protection to agricultural products, and it is diversified in favor of final products. Its agricultural import regime is reminiscent of that of the EU with perhaps one caveat -- it seems to provide more protection to low value added agricultural products. Consequently, prices of food products are higher than under free trade and the standard of living is lower. Tariff rates escalate with the level of processing, thus providing incentive to firms to produce more processed goods. While the levels of implied effective rates of protection had fallen, they still seem to distort allocation of resources. 94. Leaving aside trade liberalizing commitments associated with WTO-membership, Slovenia has opted in favor of bilateral, rather than unilateral, liberalization of its foreign trade policy. Membership in CEFIA (since 1996) and especially the entry in the trade component of the Association Agreement (in 1997) have resulted in a significant fall in applied tariff rates on industrial imports. The average tariff is 10.7 percent, whereas an average applied tariff rate was 5.7 percent in terms of 1996 imports41. These agreements, however, have also resulted in the 39 The average rate of effective protection was estimated at 53 percent in 1986 (Bernard 1997: p. 80). 40 In January of 1992, Slovenia was recognized as an independent and sovereign state by the European Union, and in May became a member of the United Nations. The process of integration into international economic structures had been slower but persistent: in October of 1994 Slovenia acceded to the GATT and became the member of the WTO in July; in January of 1996, Slovenia became a full member of CEFTA and signed the EAA in June, 1996. 41 See IMAD (1997a). 29 increase in inverse discrimination of suppliers from countries which do not have a free trade agreement (FTA) with Slovenia, as tariff margins enjoyed by preferential suppliers widened. 95. Higher levels of protection to agricultural products and final manufactures, combined with the discrimination due to preferential trading agreements, result in the diversification in the structure of tariffs. Different tariff rates trigger changes in the relative prices of products which, in turn, may seriously distort production and consumption patterns. In contrast, a low and uniform tariff rate minimizes the net welfare cost.42 5.1. Distortions generated by tariff structure: diversification in protection 96. Slovenia's tariff structure is relatively low but not uniform. The higher the dispersion in tariff rates, as measured by the standard deviation (absolute dispersion between items), the larger the potential distortions -- as the variance in tariff rates causes the variation in imported product prices. The overall standard deviation of Slovenian MPFN rates of .... percent is larger than that in OECD countries.43 97. Slovenia's tariff schedule still retains two characteristics of the "market socialism" approach to economic development: it affords high levels of protection to the agricultural sector, and it is biased in favor of final products. They are both the source of distortions in resource allocation. The former ties up resources in subsidized, low value added activities, the latter tends to distort production patterns by discriminating against the production of intermediate products and components. The latter has lost its significance because of the opening mandated by both the Association Agreement and membership in CEFTA. Yet, it still applies to some products exempted from these agreements, which include a number of agricultural products. 5.1.1. Protection of agricultural sector: de-escalation 98. Agriculture accounts for a relatively low share of total employment (7 percent in 1997) and GDP (around 5 percent) in comparison to other EU first wave candidates. Because of its privileges in terms of subsidies coming directly from the state budget or indirectly from consumers. High agricultural prices are supported mainly through trade policy -- external border protection and export subsidies.44 99. Slovenia's agricultural import regime is reminiscent of the EU's'. The level of protection is similar, but the tools differ, in that Slovenia relies on administrative micromanagement rather 42 The welfare loss (total deadweight) increases as tariff structure becomes more diversified. A uniform nominal tax minimizes the net welfare cost insofar as two conditions are met: import demand elasticities are uniform across commodities, and cross-price effects are negligible. See Panagariya and Rodrik (1993). 43 In 1993 the standard deviation of EU NIFN tariffs was 6.1 percent; US tariffs was 8.6 percent; and Finland's tariffs amounted to 12.7 percent. See [OECD: 1996: p. 40]. 44 Direct price support remains limited (WB 1997:23). The Slovenian agricultural regime diverges widely from the general thrust of the 1992 CAP reform seeking to replace price supports with direct payments to producers. Only in the case of milk, direct payments have replaced price supporting measures beginning in 1997. 30 than competitive private markets.45 Prices are kept at high levels even relative to agricultural prices in the EU, through various mechanisms including: market intervention and export subsidies, tariffs and quantitative restrictions on imports, and an administrative pricing system that is still maintained for several crops and animal products. Since the focus of protection is on low processed products, whereas processed food products are much less protected, the effective protection rates at various levels of food marketing chains tend to de-escalate, rather than escalate as is the case with most national tariff schedules. 100. Import levies, specific tariffs, variable import levies for live animals, meat, dairy products, eggs and wine erect high barriers to external suppliers. In addition, some imports are subject to a system reminiscent of arrangements existing in the past. This concerns pricing practices, the actual management of exports and imports, the allocation of production, buffer stocks and strategic reserves. Prices of wheat, rye, milk, sugar and pork are centrally administered. Slovenia still retains a state trading monopoly in wheat and sugar, exercised through the Agency for Commodity Reserves (ACR) that was established on 1 January, 1996. Although the ACR is not directly involved in import purchases, it has the exclusive right to select trading enterprises to nmake purchases abroad on its behalf.46 The scope of products subject to administrative micromanagement is limited to wheat and sugar: on the basis of a forecast, the guaranteed price for domestic purchases of wheat and sugar is set for each year. Since domestic production meets about 60 percent of wheat consumption and 45 percent of sugar consumption, the balance purchased abroad is de facto subject to variable levy equal to the difference between import price and domestic guaranteed price. If a domestic price is lower than the equivalent world price, the difference is paid from the state budget. 101. If, however, domestic prices were lower, that is, if domestic producers were internationally competitive, the system would defy its purpose of assuring "... price stability on a level below the domestic production cost and above the world market prices."47 One can safely assume -- without a detailed examination of respective domestic and international prices -- that thanks to the existing agricultural foreign trade regime, which is biased against foreign trade, domestic prices are subsidized by consumers. 102. In fact, the cost of the agricultural regime seems to be quite significant. Consider the following. First, it raises the level of agricultural prices: the so-called Producer Subsidy Equivalent (PSE) was 42 percent in 1995.48 This was slightly below the EU level of 49 percent in 1995 but still twice as high as in other CEFrA countries. Although the level of direct and 45 The European Commission notes: "The main policy measures in sectors with market organizations are similar, or close to, EC policies. However, a number of sectors have very few market intervention mechanisms other than extemal trade protection." (EC 1997:55). 46 For this reason, the ACR does not fall under state trading. But since it is accorded exclusive and special privileges, the Government of Slovenia had to notify the WTO Working Party on State Trading Enterprises about the ACR. 47 As stated in a Notification Pursuant to Article XVIL:4(a) of the GAiT and Paragraph 1 of the Understanding on the Interpretation of Article XVII submitted to the WTO by the Government of Slovenia on July 18, 1996. 48 See Rednak, Erjavec and Turk (1997), as quoted in [WB; 1998A]. 31 indirect subsidization of agriculture is estimated to be somewhat below that in the EU, prices are "... in most cases higher than the lowest prices registered in EU markets." (EU 1997: 55). Second, it accords particularly high levels of protection to such products as sugar beets, wheat and rye. These are not only low value added products but they also put an extra burden on Slovenia's fragile ecosystem. Third, it creates a structure of incentives that strongly discourages domestic food processing. It would seem that the shift towards products at a higher end of value added would facilitate the restructuring process in agriculture and agroindustry. Last, but not least, it ties both capital and labor in subsidized activities, and raises the cost of other activities. Dismantling the current regime would free both capital and labor for productive uses. It would also improve the competitiveness of Slovenian exports of manufactures, simply because it would increase purchasing power of the employed. 103. Taking into account the objective of EU membership, should Slovenia dismantle the current system of agricultural protection? The answer is that the current system should be drastically changed -- in line with the EU proposed reform measures of the CAP.49 This would involve dismantling vestiges of direct administrative controls of wheat, rye and sugar; it would involve shifting from price support to direct payments and developing a coherent rural policy to accompany this process. This, however, should not involve moving towards the levels of subsidies provided under the CAP. 5.1.2. Tariff escalation: manufactures 104. Tariff rates escalate with the level of processing, thus providing firms an incentive to produce more processed goods. The levels of implied effective rates of protection had dramatically fallen. With "zeroing" of tariff rates on most manufactures traded with preferential partners, tariff escalation affects only trade with MFN partners. The basket of imports from non- preferential partners is heavily skewed to both raw materials and low processed internediate products. Consequently, protection (or assistance) offered to domestic producers tends to be neutral among products at various stages of processing. 105. Since the amount of protection afforded to the domestic content of a product Slovenia's tariff structure affects only marginal cases of imports from non-preferential trading partners, it provides yet another argument in favor of lowering MFN tariff rates to those in the EU. Taking into account that protection of processing activity -- as measured by the difference between the rates of effective protection and nominal protection--has been almost completely wiped out, there is little sense in maintaining it against non-preferential suppliers. 5.2. MFN and preferential rates: growing discrepancies 106. Preferences and exemptions from uniform treatment of external suppliers may result in losses because of reliance on supplies from a higher cost source than otherwise available. Slovenia's import regime (not unlike that of the EU) is characterized by a myriad of preferential arrangements. Maximum tariff rates, as well as average weighted and simple tariff rates, are 49 For a brief overview of theEU strategy to reform the CAP, see [EU 1997a]. 32 highly diversified reflecting differences in baskets of Slovenian imports from various trading partners as well as differences due to preferential agreements. 107. Granting of a preferential treatment to suppliers may be purely trade diverting if it simply compensates for their cost disadvantage. Imports from preferential partners -- the EU, EFTA, the Baltic states and CEFTA countries -- accounted for more than three-fourths of Slovenia's total imports in 1997.50 In addition, Slovenia has signed FTAs with other countries including Croatia, in operation since January 1998 and Israel, signed in May 1998 but awaiting ratification in Israel. With the FTA is signecl with Croatia, the share of imports from preferential partners increases from 75 to 82 percent in terms of Slovenia's 1997 imports. These will be subject to lower tariff rates (zero rates on almost all manufactures) than those from other sources. 108. The Pan-European cumulation agreement of July 1, 1997 established a multilateral free trade area encompassinig the EU, EFTA and ten Central and Eastern European Countries (CEEs).51 It has the same duty and quota dismantling schedule, and the same product coverage as the European Association Agreements. By the year 2002, all duties and other restrictions on trade in manufactures will be effectively abolished. The emergence of the EU/EFTA/CEEs trading bloc will dramatically extend the scope of zero-tariff imports into Slovenia because of cumulation of rules of origin.52 109. Because of their geographical proximity and because of the economic superpower status of the EU, these countries seem to be Slovenia's natural trading partners. Although the potential for trade diversion seemis limited, there is nevertheless one important caveat. The potential for trade diversion has increased since 1997 as a result of the growing divergence between MFN and preferential treatment of imports. This divergence is reflected in the increased difference between duties on imports from the EU, EFTA, Baltic states and CEFTA partners and those from ME;N partners. 110. These reverse tariff preferences for industrial products will increase further, with annual reductions in tariff rates on imports from the EU and EFTA leading to the elimination of almost all duties on manufactures in 2000 (see Table 12) and with the elimination of duties in manufactures trade with CEFTA. Although MFN rates will also be reduced, the tariff-induced margin for preferred suppliers will increase in comparison with 1997. 111. It would be difficult to quantitatively assess the welfare cost of discrimination of MIFN suppliers. But one point is clear -- there is no reason to offer preferential treatment to external 50 The EU accounted for 67.4 percent, EFTA for 2.1 percent, CEFTA for 7.5 percent, and Baltic states for 0.1 percent of Slovenia's total imports in 1997. 51 CEEs included in the Agreement are Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic, and Slovenia. 52 While prior to the Agreement there were several free trade areas in Europe, the Agreement has established a common relationship. For instance, the EU and EFTA-member Switzerland have free trade relations; they had no common relationship with, say, Slovenia. For instance, an Agreement between a CEFTA-member with EFTA permitted the use of EFTA and CEFTA originating input in terms of cumulation. If a 70 percent value-added rule is not met, there their products must pay tariffs upon imports into either EFTA or CEFTA. 33 suppliers beyond the levels imposed by the policy objective of acceding to the EU. These levels are determined by EU commercial policy -- more specifically, tariff measures in place when accession negotiations are likely to be completed. There are two arguments in favor of adopting EU external tariffs. First, it does not make sense to create opportunities for preferential suppliers to obtain rents at the expense of Slovenian import users. Although the EU is both an economic superpower and Slovenia's natural trading partner, it does not necessarily produce all products at lowest cost worldwide. These which are not at the lowest cost and yet are sold in Slovenia, thanks to high MFN tariffs, obtain rents at the expense of their Slovenian users. Table 12: Share of EU Imports in Total Imports and Estimates of Customs Duties Levied on these Imports, 1994-2001 (excluding inward/outward processing and agriculture basic products and processed foods) 1994 1996 1997 1998 1999 2000 2001 Customs Customs Share in duties and Share in duties Customs Customs Customs Customs Customs List (number of total M other total M and other duties duties duties duties duties codes) from EU charges from EU charges (estimate) (estimate) (estimate) (estimate) (estimate) A (3964) 41.1 4.6 41.0 2.5 0.0 0.0 0.0 0.0 0.0 B (2337) 28.5 7.6 26.6 6.3 3.2 2.3 1.1 0.0 0.0 C (2092) 30.3 13.1 32.4 10.5 7.2 5.9 2.0 2.1 0.0 TOTAL (8393) 100.0 8.1 100.0 6.1 3.2 2.5 0.9 0.7 0.0 Note: (1) Averages weighted by 1996 imports; (2) Inward/outward processing, agricultural basic products and processed foods are excluded. Source: Own estimates based on data in Majcen 1997. 112. Second, the argument of granting extra protection to domestic producers does not hold either. Lowering MFN rates to those in the EU would not affect the level of protection enjoyed by domestic producers. Slovenian producers -- because of FTA -- are already exposed to competitive pressures from imports from these partners, most significantly from the EU. Lowering the MIFN rate would merely increase competitive pressures on EU suppliers -- an outcome which cannot harm Slovenian economy. In brief, no matter how large or how small the welfare gains, there is no reason against aligning Slovenia's MIFN trade policy with that of the EU. 5.3. Policy recommendation: adoption of EU MFN rates on industrial imports 113. Slovenia's tariff structure does not serve the objective of maximizing the national welfare. Its major deficiencies stem from the diversification in the structure of tariffs as well as the discrimination due to preferential trading agreements. With regard to efficiency and political economy, the best option is a relatively low uniform tariff structure. It is desirable on grounds of administrative simplicity and transparency for it: eliminates incentives to misclassify products, simplifies customs clearance procedures thereby reducing import costs, and it countervails lobbying efforts for protection. 114. Two policy options are possible to ease adjustment to future membership and to improve economic growth performance during the pre-accession stage. The first would be to adopt EU's post-Uruguay MNIN tariff schedule at least for industrial products, simply because the divergence between zero tariff rates with the EU and high tariffs with other trading partners implies 34 distortions in Slovenia's foreign trade patterns. The rule of thumb for reducing MFN applied tariff rates on industrial products might be as follows: lower an MFN applied tariff rate to its level applied on the products from the EU in a given year insofar as it does not exceed the EU's MFN applied rate; if the Slovenian "EU-oriented" tariff rate is larger than the EU's MFN applied rate, adopt the EU's rate. 115. Some recommend that countries seeking accession should early on join the EU customs union. The informal alrangement has considerable advantage over the formal customs union. Under the shadow arrangement, the EU NTBs would not have to be observed. Although an informal arrangement rather than a formal customs union agreement would entail the loss of some benefits associated with lack of need for rules of origins increasing significantly transaction costs, the benefits of not observing NTBs would probably offset these costs. Furthermore, customs union would have to be negotiated; this takes time and would be a distraction from much more important accession negotiations. Therefore, a formal customs union does seem to be a viable policy course. 116. The second option is an informal, 'shadow' customs union without loss of sovereignty over foreign trade policy. It would be initially limited to industrial products. Slovenia would not only have to adopt EU MFN applied tariff rates but would also extend preferential treatment to all countries having special relations with the EU, including its associates in North Africa and developing countries of the Lome Convention. Since this would further complicate Slovenia's foreign trade regime and increase its administrative burden, it does not seem to be an attractive policy. 117. Thus, the best option seem to be the first one, limiting the scope of the arrangement to adoption of EU's MFN applied tariff rates on manufactures. It is simple and easy to implement. There would be little, if any, domestic opposition from import-competing sectors which already face formidable competitors from the EU. It would not contaminate the Slovenian foreign trade regime with complex preferential arrangements. Last but not least, it would not require a formal notification of the WTO of change in statutory rates. Slovenia could simply lower applied rates to those in the EU without changing statutory rates. 6. CONTESTABILITY OF DOMESTIC MARKETS FOR GOODS AND SERVICES 118. Markets are contestable if there is an easy entry of goods, services, capital and people. From an international perspective, contestability includes issues of market access for foreign products, as embodied in tariffs and narrowly conceived non-tariff barriers. Contestability also includes market access implications of domestic policies and regulations (e.g., standards requirements, environ,mental standards, phyto-sanitary measures) underpinning business activities. Ideally, one would like to see full adherence to the principle of national treatment and the absence of differentiation in treatment of imports or foreign investment, i.e., the choice whether to export products or launch production through FDI. 35 119. The desired outcome of the transition from central planning is the emergence of competitive and contestable markets. Markets are contestable when relationships among firms are not unduly distorted by anticompetitive governmental or private action and when there is unencumbered market access for foreign goods, services and investment. Contestability declines with restrictive regulatory regimes, differentiation in treatment of local and foreign competitors; it increases with border and nonborder protection, and anticompetitive practices. 120. In both trade policy and competition policy, the goal of acceding to the EU introduces two types of constraints establishing an upper and lower bond for reform measures. First, given the goal of Slovenia's integration into the EU, the government has a strong incentive against introducing liberalization measures towards the rest of the world that would go beyond the prevailing levels in the EU. For instance, reducing tariffs below the EU applied rates would be counterproductive, as it might entail compensations to Slovenia's non-EU trading partners. The second constraint comes in EAA imposition, specifically upper threshold by banning substantial reversals in already introduced reform measures at least vis-a-vis the EU and obliging the government to converge to the EU acquis communautaire. The EAA, however, leaves considerable discretion in designing procedural and institutional provisions. As a result, there is a large area for unilateral maneuver but bounded by these upper and lower constraints on economic policy. 121. The contestability of domestic markets is largely shaped by conditions of entry (for both domestic and foreign firms) to sectors as well as to markets for their respective products including services. An assessment of international contestability of Slovenian markets entails an assessment of the extent to which the government regulations and policies encourage development of competition irrespective whether it originates with domestic and foreign firms. This in turn, entails an assessment of the disciplines, which Slovenia has committed itself to by signing the EAA, and how they help the development of competitive markets. A caveat here is that the EAA does not reach all domains of public policy, and has a number of temporary "exits." 122. In a market economy, it is the responsibility of the state to remove restraints upon, and barriers to, competitive transacting, both within and across national markets. The former is usually associated with competition policy; the latter is in the domain of foreign trade policy. Both, if properly used, may contribute to a smoother adjustment to EU accession. They facilitate the efficient allocation of economic resources, contribute to improved international competitiveness and thereby maximize national economic welfare. They may be complementary, especially in nontradables, because of location of specific markets where foreign competition is inadequate. Last but not least, state actions often distort competition through subsidies (or state aids) and establishing national champions. 6.1. Competition policies 123. Competition policy, policy vis-a-vis foreign investors and foreign trade policy play a major role in the process of transition to competitive markets. Free trade policy complements competition policy: both maximize national welfare as unfettered competition, including that 36 from imports, is the best way to foster economic efficiency. It does not replace competition policy, because some markets (for non-tradables) are difficult to access by foreign firms and, second, foreign firms may become engaged in anticompetitive practices. Slovenia has pursued an active, foreign trade policy designed to improve conditions in access to its most important markets though bilateral free trade agreements. In the process, the degree of protection afforded to domestic production (or factors of production) has significantly declined. So has the importance of competition rules and policies to offset welfare losses due to the reduction in contestability of domestic markets by foreign firms. 124. Yet, one should not draw the conclusion that anti-trust regulations and their enforcement has lost its relevance in the Slovene economy. Even though border barriers are either nonexistent or very low at least for manufactures, this has no impact on competition in markets for nontradables. Moreover, there are many markets where foreign competition is inadequate as -- despite the globalization rhetoric to the contrary -- state borders still present a formidable barrier. Consider that -- although NAFTA has removed practically all obstacles to free trade and there is no language barrier -- trade among Canadian provinces at the border of the US is still around twenty times higher than that with the US. Furthermore, collusion may involve dominant foreign suppliers to Slovene markets. For these reasons, even under a mostly free trade regime competition authorities have an important role to play. 125. Competition rules impose disciplines on firms, whereas integrationist arrangements such as the European Association Agreement (EAA) extend those disciplines to governments. The basic competition rules of the EU have been designed to complement its internal trade policy, i.e., free trade among its members. Their goal is to make sure that the progress in integration is not hampered by a member-government's actions or those taken by firms and resulting in market segmentation. The EAA envisages a free trade and free foreign investment posture towards the EU, once various transition periods are over. Under the EAA, Slovenia must (i) apply the EAA competition rules to cases affecting trade between the EU and Slovenia, and (ii) approximate its competition law with the EC rules. The first obligation is also binding on the EU. The EAA includes commitments by Slovenia to harmonize its laws with the EU and adopt competition disciplines of the Treaty of Rome so that the switch to a free trade regime between Slovenia and the EU for industrial products is not circumvented by competition-restricting practices. 126. Slovenia's competition policy framework, rules and enforcement capacities, is neither fully harmonized with that of the EU nor it provides the authorities with an effective instrument to combat monopolistic practices. The competition rules, as laid down in the 1993 Law on Protection of Competition, do not comply fully with EU competition legislation. The main "not- harmonized" areas are substantive rules (restrictive practices, block exemption and merger control) as well as procedural rules. For instance, the Law does not provide satisfactory provisions on the prohibition of restrictive agreements and abuse of dominant position along the lines of Articles 85 and 86 of the Treaty of Rome. Exclusive and special rights granted by the Law to public utilities (electricity, oil, gas, railways, telecommunications) are not compatible with the Community's acquis. 37 127. The capacity to enforce anti-trust legislation continues to be limited. Consider the following: First, procedural rules including investigation procedures of the Competition Office are not spelled out in the Law. Although the Office may initiate its own investigations of companies and also at the request of private companies, it lacks the power to issue fines in case the law on the protection of competition has been broken. 128. Second, the Office is understaffed, and its political autonomy remains doubtful as it is not constitutionally recognized. Under the current arrangements, it is a part of the Ministry of Economic Relations and Development, which tends to represent producers' interests rather than those of consumers. The Office should obtain a more autonomous position in the government to be able to balance producer and consumer interests, and its staff should be strengthened if the law is to be effectively enforced. 129. Third, the power to fine companies rests with Slovenian courts. While the Office has found several companies guilty of unfair practices, the courts have yet to issue a single monetary fine. Although some cases have been in the court system for two years, only one antitrust has been so far reviewed. Weaknesses in legal underpinnings as well as the lack of judges well- versed in anti-trust legislation undermine the enforcement of the competition rules. 130. Some important sectors remain beyond reach of competition authorities. Separate regulation applies to the sectors of financial services, banking and insurance. The exemption from competition in the telecommunication sector is to be terminated by 2001. Until then, Slovenia Telecom will retain its monopolistic position over public telephone and fixed-wired network. While the impact of these measures on the economy is not easily quantifiable, one should note that services of exempted sectors play crucial role in facilitating commercial transactions, both between domestic and international actors, and availability of these services contribute to foreign investment inflows. 131. Economies in transition from central planning need a strong and assertive competition policy. Although Slovenia has dismantled most legacies of market socialism, it still has to solve many structural problems in order to increase its international competitiveness. Despite a significant progress since 1992, large firms with weak corporate control structures still dominate the economy. Slovenia's industrial structure remains biased in favor of heavy industries, and despite expansion in trade the import penetration remains low. Simplification of substantive rules in close cooperation with the EC and granting larger power and resources to the anti-trust authorities would enhance competition in domestic markets. 132. Taking into account exigencies of the EAA as well as changes in the global post-Uruguay environment, one might consider granting authority to a single institution to assess competition and welfare impact of important policy decisions affecting contestability of domestic markets and monitor their impact ex post. It might involve enhancing the status and independence of the existing Office for Consumer Protection and Competition. The Office should have a final say over the impact of trade measures on market structure, concentration, etc. As the social costs of anticompetitive structures and conduct are probably much higher in transition economies from those in mature market economies, the anti-trust authority should be more activist, should 38 operate according to sjimpler and less subtle rules of action, and should trust less in the discretion of public agencies. 133. Since the EAA does not provide strong disciplines in this respect, the responsibility for designing them rests solely with the Slovenian authorities. Thus, in addition to enhancing status of competition-rules enforcement, one might consider coordinating competition policy with other CEFTA-members. Sirnplification of substantive rules in close cooperation with the European Commission together with adoption of these rules by Slovenia and other CEFTA countries would go a long way to increase Slovenia's international competitiveness and attract FDI to the region. 6.2. State aids 134. Subsidies, or state aids, distort competition. They give to some domestic firmns an unfair advantage in competing with other firms, domestic or foreign. The Commission is endowed with authority to determine whether state support violates the rules and can require that subsidies be repaid. These rules automatically apply to EU members, but not to its associates in Central and Eastern Europe. Article 63 (iii) of the EAA prohibits state subsidies distorting (or threatening to distort) competition. The agreement, however, allows for four years of adjustment after its entry into force, thus GATT subsidy disciplines effectively continue to apply.53 135. GATT disciplines on subsidies (or state aids) are not as restraining as the provisions of the EAA. Therefore, the accession process via the Accession Partnership seeks to address these shortcomings, and calls for the Government of Slovenia to introduce a coherent legal framework on state aids and establish a single agency that would administer and monitor state aids. At present, state aids are still administered by various ministries and government agencies according to different, usually non-transparent procedures. 136. While it would be impossible to assess quantitatively the distortionary impact of state aids on competition, the legacies of "market socialism" suggest that it might be quite considerable. In fact, st:ate aids -- in the form of direct transfers of funds, foregone revenues (tax concessions or credits), etc. -- continue to be a prominent feature of Slovenian economic policy. Independence has not produced a decisive break with financial practices characteristic of the old economic regime: firms were not allowed an exit, and the government's support to agriculture and industrial sectors intensified in the aftermath of independence. In fact, the increase in state interventionism had been justified by the harsh economic and financial circumstances triggered by the loss of former Yugoslav markets. 137. In consequence, the channels of state aids are multiple and subsidies are designed to bring remedies in a whole array of different situations. These range from subsidies to agriculture, 53 The so-called state aids are covered by the provisions of the Agreement on Subsidies and Countervailing Measures binding for all members of the WTO. WTO members--in line with Article 25 of the Agreement--must notify all subsidy programs to the WTO secretariat on an annual basis. Slovenia has submitted required subsidy notifications to the WTO Committee on Subsidies and Countervailing Measures. Under article 65 of the EAA Slovenia is to ensure transparency in state aids and provide information similar to these required by the GATT 1994. 39 railways, social security, export credit refunds, coal mines to guarantees on loans granted to enterprises and public works. Even an aggregate consolidated table includes almost 40 different items (see Table 3 in the Statistical Appendix). 138. Slovenian state budget distinguishes among five main types of subsidies: subsidies to enterprises; expenditures on restructuring programs of banks and enterprises; expenditure on active employment programs; guarantees on loans to enterprises; and capital transfers to enterprises. The share of these subsidies gradually fell between 1993 and 1997 from 3.9 percent to 2.3 percent of GDP. But these five-type state aids scheme does not exhaust all forms of state subsidies. One should also include other channels such as allotment of revenues from privatization to enterprises, debt relief and investment subsidies granted to local governments. This slightly raises the overall amount of state aids to 4.4 and 2.8 percent of GDP in 1993 and 1997 respectively. 139. The composition of state aids within these broad categories has changed. The share of restructuring programs of banks and enterprises accounting for the largest portion dropped from around 40 percent in 1994 to 30 percent in 1997. This was due mainly to the contraction in expenditures on restructuring of railways and steel mills. Subsidies to enterprises increased from 17 percent in 1994 to 21 percent in 1997. These are projected to grow to 28 percent of the total in 1998. The largest items within this groups are price subsidies to railways and subsidies to agriculture. In terms of GDP they remained at the same level (for details see Statistical Appendix Table 3). Table 13: Types of State Aids and Their Evolution Over 1993-98 1993 1994 1995 1996 1997 1998p 1. Subsidies to Enterprises 0.75 0.59 0.80 0.53 0.68 0.78 2. Expenditure on Restructuring Programs of Banks and Enterprises 1.49 1.37 1.11 1.09 0.98 0.98 3. Expenditure on Active Employment 1.08 0.70 0.56 0.37 0.30 0.36 Programs 4. Govermnent Payments for Guarantees 0.29 0.20 0.40 0.08 0.05 0.09 on Loans Granted to Enterprises 5. Capital Transfers from State Budget to 0.25 0.27 0.15 0.11 0.28 0.13 Enterprise Sector A. Total State Budget Expenditure 3.86 3.12 2.65 2.19 2.29 2.33 on State Aids (1+2+3+4+5) B. Subsidies and Investment Expenditures 0.29 0.26 0.21 0.29 0.30 0.30 of Municipalities C. Amortization of Debt Paid from the 0.26 0.25 0.50 0.39 0.29 0.13 State Budget as a Form of the State Aids D. Expenditure of Revenues from - - 0.32 0.40 0.42 - Privatization as a Part of State Aids Total State Aid (A+B+C+D) 4.41 3.54 3.67 3.26 3.29 2.76 140. It is difficult to assess the direct impact of state aids on competition, as no clear picture of Slovene industrial policy emerges from these data. For one, it does not target any potential "sunrise" sector. It does not single out national champions, which is always a risky endeavor -- 40 particularly so in the case of transition economies where, within industrial sectors, there is enormous variation in economic performance of individual firms. There are signs that direct aid to enterprises, which wisually distorts competition, has been on the decline. This conclusion can be drawn from the contraction in government payments of guarantees on loans to enterprises. On the other hand, expenditures of revenues from privatization to assist enterprises were, however, quite significant in the 1995-97 period accounting for more than 10 percent of the total. In all, it is impossible to infer any policy vision from the use of state aids -- these do not seem to provide incentives to new activities but rather seem to allow survival of activities that would have been rejected by markets. 141. One might thus conclude that (a) overall level of subsidies in terns of GDP exceeds the EU average (around 17 percent); (b) there has been a downward trend suggesting a significant contraction in state aids; (c) despite a contraction the range of programs remains very extensive; (d) these programs are defensive, i.e., petrifying status quo, rather than seeking to assist regions in adjustment to a new political economy environment; (e) some of them target individual enterprises which is against the letter and the spirit of EC policies on state aids; and (f) Slovenia has made little progress in "state aids" legislation that would introduce transparency and monitoring mechanisms. Taken together, state aids in their present form stifle competition and slow down the shift of resources to internationally competitive sectors. 6.3. External access to government procurement 142. General government spending accounts for around 46 percent of GDP. A significant proportion of it amounting to around 10 percent, or almost US$2 billion, is spent on procurement of goods and services. A large number of government and public entities funded from the state budget are involved in procurement and outsourcing decisions. In consequence, the total market for government (public) procurement is quite substantial, and practices governing government policies may significantly alter conditions in contestability of domestic markets. 143. The importance of this market has been recognized by the GATT before the Uruguay Round of multilateral trade negotiations. The Agreement on Government Procurement - originally negotiated during the Tokyo round of multilateral trade negotiations in the 1970s - is a plurilateral component, i.e., applicable to signatories, of the Uruguay Round Agreement. Signatories of this Agreement, most OECD members, pledge to observe the principle of national treatment and nondiscrimination for purchases by government entities. 144. Slovenia - like other transition economies - has not yet sign the Agreement on Government Procurement. Therefore, Government procurement and sourcing policies, regulated by the 1992 Decree of the Minister of Finance and the Law on Government Procurement enacted in May 1997, do not have to adhere to its disciplines prohibiting preferences for domestic firms and imposing competitive and open tendering to all pre-qualified firms including foreign firms. 145. Although the Law on Government Procurement does treat all suppliers equal, regardless of country of origin, the procurement regulations implicitly favors domestic firms through a provision stipulating that contracts with domestic content exceeding 50 percent automatically 41 receive a 10 percent preference. This type of preference for domestic suppliers is not uncommon. Poland and Hungary, as an example, use a 20 percent preference level on domestic suppliers. 146. Transparent tendering procedures are also essential to avoid biases in favor of domestic firms effectively keep foreign firms from obtaining government contracts. In Slovenia offers received are public, and government purchases in the amount exceeding SIT 5 million are publicly announced. This limit is substantially lower than the one set by the Agreement on Government Procurement. equivalent to S1T20 million. and used by EU and WTO. Slovenia also applies fewer exemptions for cases where public announcement is not required.54 Moreover, Slovenia's regulation does not favor small enterprises ("set-aside") or other specific groups. 147. In spite of this transparency, foreign firms can hardly compete for goods and services accounting for a sizable percent of total domestic spending. This result, however, does not depart too much from the situation in other countries. In the EU, most orders are awarded to local suppliers. Only 2 percent of public orders above the SIT20 million threshold are taken by suppliers outside the EU. Similarly, the award of a public procurement contract to a foreign firm in Slovenia is rare. Foreign bidders usually reach the local public procurement market through a local firm. This helps them overcome the language barriers and facilitates the adjustment to domestic legal system governing public procurement. 148. Slovenia has been a member of WTO from its very beginning, however it is not in the minority of the high developed members who have already signed the Agreement on Government Procurement. It intends to do so in the near future. Moreover, Slovenia is strongly decided to adopt the EU procurement legislation. In many international agreements Slovenia has already excluded the use of preference 10% for bidders who bid more than 50% of domestic component in their bid. 149. The organization and practice of not-skilled-enough administration, inherited habits and lack of internal control in the government administration is the weak point of public procurement in Slovenia. It results in vague adherence to the government procurement regulation. Improvement in this area is one of the most important task in the transition period of Slovenia. Increasing access of the system to foreign contractors over the next years, along the lines of the GATT's Agreement on Government Procurement, would yield at least two important benefits: it would reduce the cost of services provided by the State, and it would improve competitiveness of domestic contractors. The latter should allow them to compete for government contracts abroad, especially in EU member countries. 6.4. Technical standards 150. Because technical standards -- technical regulations and certification systems -- can increase unit costs of production, they often emerge as a barrier to international trade. While their 54 Public announcements are published since 1992 in the Official Gazette and information about suppliers is available on an Internet page. 42 existence may be often justified in terms of safeguarding public or animal health, or the environment, many governments use technical standards as a tool to restrict market access. But this does not seem to lbe the case of Slovenia. Its technical regulations are mostly worded in terms of performance rather than product design; conformity assessment procedures are applied on a nondiscriminatory basis; and it recognizes accreditation issued by intemational standardizing bodies as a proof of meeting adequate technical regulations. 151. In order to avoid conflicts over its trade policy, Slovenia has recognized test reports issued by certified bodies since 1994.55 The focus of over 250 new regulations has been on harmonizing technical regulations and certification systems with those in force in the EU, with a particular emphasis oln directives in the second Chapter of the White Paper (foodstuffs, medical devices). 152. In a nutshell, the process has been driven by the desire to become a full-fledged member of the EU Single Market rather than offering extra protection to domestic producers. Hence, one may conclude that in contrast to government procurement, which is not governed by the principle of national treatment and heavily skewed towards domestic firms, technical standards are not used to curtail competition from imports. 6.5. The right of establishment and services 153. The altemative to providing goods and services from abroad is to establish facilities in a recipient country. In the case of goods, this involves building new production facilities (greenfield investment) or purchasing controlling equity in an existing enterprise (portfolio or direct investment depending on the percentage of equity acquired). In the case of services, this may simply involve registering a firm, opening offices or purchasing a domestic firm or bank. The legal framework governing the right of establishment in Slovenia dates back to pre- independence--the 1988 Foreign Investment Law. This principle was further confirmed in the EA. However, both the 1988 Foreign Investment and subsequent amendments are wanting as they restraint the choice between external and "from within" supply of goods and services. The new legislation affecting foreign investment decisions, that would cover portfolio investment, company structure, takeovers and foreign exchange transactions, aim at liberalizing markets and opening the economy to foreign investment. 154. The draft laws enhance the principle of national treatment guaranteeing equal treatment of domestic and foreign-owned companies. A foreign company conducting business in Slovenia is in principle equal to domestic companies concerning its own rights, obligations and responsibilities. Yet, enitry to many areas remains restricted. 55 According to Information on certification system in Slovenia (Ministry of Science and Technology, Ljubljana, March 24, 1998), foreign test reports are accepted if the testing laboratory is a member of the European Accreditation EAL; if the laboratory has a contract on mutual recognition with a Slovenian Standards and Metrology Institute; if iit is a notified body at EU commission; and if the body is accredited by the Slovenian Standards and Metrology Institute. 43 155. In fact, some sectors of the economy are either partially closed to foreign penetration or access to them is controlled in ways defying the principle of national treatment. The areas formally excluded from foreign ownership in Slovenia are fairly typical, albeit not fully justifiable. These include defense-related industries, railroads, air transport communications, telecommunications and insurance. While one may defend exclusion of foreign firms from operating in military production on national security grounds, the argument in maintaining ban on foreign firms in transport (air, rail) and telecommunications is much weaker. Opening of these sectors to competition from domestic and external sources has been proven to benefit the economy as a whole through lowering prices of provided services and attracting inflows of foreign capital. 156. There are impediments limiting foreign equity. Limits imposed on foreign participation in auditing (49 percent), investment companies dealing with the management of investment funds (20 percent) and stockbroker companies (24 percent) are likely to discourage investment in stocks of Slovene companies. For instance, audits of companies listed on stock exchange by well-established auditing firms provide a guarantee as to reliability of financial disclosures. Foreign ownership in publishing and broadcasting restricted to 33 percent may discourage foreign investment in existing firms, especially if ownership is not highly dispersed. It also discourages the establishment of new companies by foreigners. Given the fears of 'hot' capital destabilizing the economy, the requirement stipulating that all purchases exceeding 20 percent of equity be cleared with government seems to be counterproductive and inhibiting foreign direct investment. 157. The Company Law contains other provisions determining make up of management boards. These are the following: (i) the majority of directors of joint stock and limited liability companies have to be Slovenian citizens; (ii) if the management board is made up of only one person, that person must be Slovene, and (iii) representative of foreign firms operating through branches in Slovenia are required to have permanent residence in Slovenia. 158. Finally, regulations governing the foreign exchange regime erect yet another barrier to foreign investment. As part of its policy to limit capital inflows, in February 1997 the Bank of Slovenia introduced restrictions on the acquisition of securities by foreigners. This regulation compels non-residents to use custodian accounts with authorized domestic banks to conduct portfolio investments in Slovenia. 159. The extent of the negative impact of these various departures from the principle of national treatment on capital flows is difficult to judge, yet it seems to be very significant. They might have had a limited impact on investment in development of natural resources. But they have a huge negative impact on foreign investment in technology and information-intensive sectors. Countries located at higher levels of development ladder are usually an attractive place for foreign investment. Surveys examining preferences stress the importance of created assets (rather than natural or related to the cost of factor production) as the determinant of locational preferences.56 The existing measures do not create a business climate friendly to foreign 56 See Dunning (1995). 44 investors, and prevent Slovenia to take advantage of its substantial created assets. Removal of these restrictive measures, each of which adds to the hassle cost of doing business in Slovenia, is likely to increase FDI inflows. 6.6. Conclusion 160. Slovenia has made significant strides in opening its economy to the external world. This has resulted in increased contestability of domestic markets. Lower levels of border protection, and tariffs have not been replaced by various forms of non-border protection. Despite pressure from domestic producers, the government has refrained from using technical regulations, phyto- sanitary standards or other non-tariff barriers to protect domestic markets. Overall, access to domestic markets for goods has remained unrestrained despite cuts in tariffs. 161. There are some notable exceptions, however. First, the principle of national treatment has not been extended to government procurement which offers preferential treatment to domestic firms. Its consequence is the increased the cost of services provided by the state, and the elimination of competitive pressures on many domestic contractors, which might make them competitive in markets for government contracts abroad, especially in EU member countries. Second, state aids to enterprises distort competition. Although its levels have been declining, they are still quite extensive. The drawback is that they tie up resources in unproductive activities at the expense of internationally competitive sectors. 162. The existing legal framework underpinning activities of foreign firms reduces the contestability of domestic markets through either closing some sectors to foreign capital or less comprehensive measures but with similar impact. With domestically owned companies shielded from potential competition, markets are less competitive, the quality is lower, and prices are higher. This often negatively affects the capacity of domestic firms, users of these inputs, to compete in international markets. 163. Last but not least, contestability of domestic markets does not have strong institutional supporting mechanisms. Competition in domestic markets is likely to increase if the independence and status of the Office for Consumer Protection and Competition is enhanced. 7. MAJOR FINDINGS AND IMPLICATIONS FOR A PRE-ACCESSION STRATEGY 164. Slovenia is neither in economic crisis nor has experience spectacular economic growth over the past years. But its macroeconomic stability, impressively restored in 1992-93, could become increasingly precarious unless the structural reform agenda is advanced. The symptoms of the loss of dynamism in the economy, are mainly traceable to stalled structural reform agenda and its impact on microeconomic liberalization efforts, that may further inhibit Slovenia's real growth potential. 165. The loss of dynamism best captures the current state of the Slovenian economy. Although nothing presages an oncoming crisis, as the economy is growing and macroeconomic stability 45 does not seem to be in imminent danger, symptoms of declining vigor are abound. The growth rates of GDP have been at most moderate, and the rates of export growth to the EU markets have been declining. After three-year expansion over 1993-95, the dollar value of total exports remained flat over 1996-97. In the second half of 1995 and through 1996, export performance was maintained in large part thanks to the depreciation of domestic currency. The slow down in export expansion and stagnation in net revenues from services could negatively impact the country's capacity to import capital equipment essential for modernization of its industries. Although the current account has been in surplus since 1995 (when it recorded a negligible deficit), considering Slovenia's modernization needs it suggests low levels of foreign investment in the economy. 166. From the perspective of Slovenia's commercial interaction with the EU, several developments raise concern. First, export expansion has been running out of steam. After an initial explosion of trade with the EU, the growth of both exports and imports has considerably slowed down. While overall Slovene exporters have been increasing their presence in EU markets, the pace of improvement in their competitive position declined in 1996. There is some evidence that the initial expansion was in part driven by redirection of exports from former Yugoslav markets. This source of expansion seems to have reached its limit, in large part because too few new firms have emerged as successful exporters. 167. Second, the factor content of Slovene exports has undergone some significant changes. Some of these are troubling, however. Given Slovenia's endowments in factors of production, it should specialize in high skilled labor intensive and technology intensive products. Although the share of these products significantly increased between 1992 and 1993, there are two potentially distressing problems: stagnation of high technology exports in terms of their share in EU imports in 1995 and 1996; and continuing reliance on unskilled labor intensive products. While -- given the difference in labor cost -- a significant share of these products in Slovene exports is not surprising, one would expect that it would fall faster. This share fell significantly in 1994, only slightly in 1995, but increased in 1996. Although there is nothing wrong with Slovenian exports still deriving their competitive strength from specializing in unskilled labor intensive products, one would expect a quicker change towards human capital and technology intensive products. 168. Third, from the analysis of change in indices of revealed comparative advantage and rankings of top export performers in successive years of the transition, one may draw the conclusion that there was no significant expansion in new specializations in the Slovenian economy between 1993-94 and 1995-96. Slovenia's RCA profile has become more concentrated with ten top highest RCA values increasing each year. Although overall Slovenia continues to have a relatively uniform profile of RCA distribution indicating a high level of industrial maturity, the "deterioration" may be either a symptom of industrial devolution and declining competitiveness or merely indicate that Slovenia's export offers was excessively diversified in the past. A very limited change among top export performers, however, suggests that new product lines are yet to emerge. 169. On the other hand, this conclusion does not find support in a finding that the contribution of commodity chains to Slovenian exports to the EU and the share of primary stage products fell 46 between 1992 and 1996. Simultaneously, the share of Slovenian processed commodities in EU extemal imports has increased, a shift towards higher value-added products. 170. These developments may presage future difficulties in sustaining expansion in foreign trade, the engine of growth in Slovenia. Since Slovenia's prosperity is critically dependent on expanding external economic ties, and fast and sustainable economic growth would facilitate accession to the EU, reviving former dynamism of foreign trade strikes one as a key policy issue. 171. At a micro level, the experience of transition economies amply demonstrates that sustainability of economic growth and foreign trade hinges critically on creating environment facilitating entry of "second generation" firms, i.e., those which were either newly established or successfully restructured. During the first stages of the transition most exports came from firms with already established links with abroad. Subsequently, new "entrants" -- frequently small and medium firms -- would move to the top. A large proportion of "second generation" firms are foreign-owned; their share in exports has been dramatically increasing in successful transition economies. As has been argued, FDI in Slovenia has been lower than in other EU candidate economies, and there are signs that "second generation" firms are in short supply. 172. Thus, the task seems to boil down to attracting more FDI inflows and stimulating private sector development through acceleration of microeconomic reforms. The broadly conceived business climate -- including the financial sector, conditions in entry for domestic and foreign firms, legal framework enforcing property rights and contracts -- has not been particularly favorable to foreign investment and private activity in Slovenia. There is one major way of improving business climate: the removal of legal obstacles limiting contestability of Slovenia's domestic markets. The long-term objective should be achieving competitive and, thereby, contestable markets vvhere relationships among firms are not distorted by governmental or private actions and there is free market access -- as stipulated in the EAA -- for foreign goods, services and investment. 173. The challenge of a pre-accession strategy is to identify policy measures that would improve allocative efficiency, reduce adjustment cost and strengthen Slovenia's growth potential within the framework of integration into the EU. Ultimately, the prospects for a quick EU membership and, perhaps more importantly, the ability of the Slovene economy to take full advantage of opportunities offered by membership will depend on shifting to an institutional framework enhancing growth, competition and economic efficiency. The vehicle for designing a strategy that would simnultaneously accelerate accession and provide a sound basis for sustainable and employment-creating economic growth is contestability of domestic markets and business friendly environment. The latter is important not only for FDI but also for domestic firms. The competitiveness of Slovene firms, both domestic and foreign-owned, ultimately depends on competition at home from imports and domestic sources alike. This, in turn, hinges critically on liberal trade and investment regime. 174. Institutional and policy measures that would improve the business climate and improve the performance of Slovenia's economy have as common denominator is liberalization of foreign trade and investment regime. These measures can be summarized as follows: 47 * to improve competition policy framework, rules and enforcement capacities of competition authorities. One may consider granting anti-trust authority to a single independent institution empowered to assess competition and welfare impact of important policy decisions as well as actions taken by firms affecting contestability of domestic markets and monitor their impact ex post; * to overhaul the current framework of state aids. It would involve establishing transparent monitoring mechanisms, streamlining and reducing the scope of subsidies. State aids should be also subjected to scrutiny by competition authority once it is reformed; * to open services to foreign competition. This would involve inter alia removing provisions limniting foreign equity, and opening telecommunications and insurance to foreign capital; * to apply fully the principle of national treatment in the sphere of foreign investment. This would involve removing legal provisions determining the make up of boards of directors of companies (in its current wording, they discriminate against foreigners) as well as requiring that purchases by foreigners of equity exceeding 20 percent are subject to government clearance; * to change the rules governing the agricultural regime. This would involve supporting the agricultural sector through direct payments rather through high agricultural prices and trade policy (external border protection and export subsidies) and changing the current structure of incentives to remove bias against processed agricultural products, since the present structure offers preference to low value added products (which obtain the largest levels of protection); * to align MFN tariff rates on industrial products with those levied by the EU. This would not necessarily involve a formal lowering of statutory tariffs but might simply involve the change in applied rates. 48 REFERENCES Balassa, B. 1965. 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Table Al: Largest Exporters to the EU in Terms of Four-Digit SITC Categories in 1996 and 1992 1996 Share in Cumulative 1992 in thousands Share in Cumulative Commodity in million of exports to share (in %) Commodity of US dollars exports to share (in %) US dollars EU (in %) EU 7321 pass motor veh exc buses 676,919 12.37 12.37 8411 textile clothes not knit 261,225 10.82 10.82 8411 textile clothes not knit 397,588 7.26 19.63 7321 pass motor veh exc buses 202,796 8.40 19.21 8210 furniture 375,652 6.86 26.49 8210 furniture 116,490 4.82 24.03 7250 domestic electric equip 311,014 5.68 32.17 7250 domestic electric equip 114,656 4.75 28.78 6324 builders woodwrk,prefabs 172,835 3.16 35.33 8414 clothing, accessories knit 113,358 4.69 33.47 7221 electric power machinery 156,065 2.85 38.18 6324 builders woodwork ,prefabs 90,110 3.73 37.20 8414 clothing, accessories knit 138,614 2.53 40.71 8510 footwear 62,484 2.59 39.79 6989 other base metal manufactures 112,190 2.05 42.76 7221 electric power machinery 57,606 2.38 42.18 6291 rubber tires, tubes 96,220 1.76 44.52 7328 motor vehicle parts nes 56,764 2.35 44.53 7328 motor vehicle palts nes 95,494 1.74 46.26 6291 rubber tires, tubes 54,462 2.25 46.78 6841 aluminum, alloys, unwrought 87,568 1.60 47.86 6429 paper etc. articles nes 33,560 1.39 48.17 8510 footwear 79,670 1.46 49.32 7115 piston engines non-air 30,032 1.24 49.41 7192 pumps, centrifuges 76,904 1.40 50.72 6989 other base metal manufactures 28,170 1.17 50.58 7199 machine parts, accessories nes 73,942 1.35 52.07 6841 aluminum, alloys, unwrought 27,211 1.13 51.71 7222 switch gear etc. 72,772 1.33 53.40 7193 mechanical handling equ 26,168 1.08 52.79 7193 mechanical handling equ 69,306 1.27 54.67 7199 machine parts, accessories nes 23,678 0.98 53.77 8930 articles of plastic nes 62,983 1.15 55.82 6842 aluminum, alloys worked 21,400 0.89 54.66 8618 meters, counters non elect. 58,566 1.07 56.89 8930 articles of plastic nes 21,008 0.87 55.53 6732 iron, steel bars etc. 56,331 1.03 57.92 6516 yam of synthetic fibers 20,936 0.87 56.39 6842 aluminum, alloys worked j 54,810 1.00 58.92 7222 witch gear etc. 20,420 0.85 57.24 52 Table A2. Distribution of FDI Stock in Slovenia by Recipient Industries (millions of US$) NACE Industries 1994 1995 1996 Food products and beverages 14.8 16.7 37.7 Textiles 8.4 9.5 9.8 Wearing apparel 4.7 5.1 3.8 Wood and wood proc. Exc. furniture 0.5 1.2 7.5 Pulp, paper and paper products 120 135.7 142.7 Publishing and printing 6.6 10.8 12.9 Chemical and chemical products 77.9 113.8 112.8 Rubber and plastic products 14.4 22.1 22.7 Other non-metal mineral products 27.3 47.2 48.3 Basic metals 7.4 10.8 19.1 Fabricated metal products 7.2 9.7 13 Machinery and Equipment 79.7 93.5 104.3 Electrical imachinery and apparatus 21.9 29 28 Radio, television and equipment 14 24.9 26.2 Medical and precision instruments 8.6 20.7 20.5 Motor vehicles and trailers 142.4 138.1 139.6 Furniture, manufacture n.e.c. 4.1 4.8 6.3 Electricity, gas steam & water supply 296.6 302.7 264.5 Sale and repair of motor vehicles/fuels 56.6 58.6 73.6 Wholesale and commission trade 98 140.9 170.2 Retail trade and other repairs 33.7 43.5 47.7 Hotels and restaurants 7.5 12.2 2.7 Land transport 7.9 10.1 7-7 Support and aux. transport actv., travel 9.6 10.3 10.7 Financial intermediation 103.4 244.7 330.8 Insurance and pension funding 10.7 9.2 6.4 Real state business 2.5 5.5 7.1 Computer and related activities 2.5 3.2 10.1 Other business activities 92.1 152 176.5 Recreational, cultural and sport. actv. 0.2 14.5 21.9 Other activities 49.9 42.7 49.2 TOTAL 1331.1 1743.7 1934.3 53 Table A3 (page 1 of 2) Table A3. State Aids Over 1993-98, percent of GDP 1993 1994 1995 1996 1997 1998p I. Subsidies to Enterprises 0.75 0.59 0.80 0.53 0.68 0.78 1. Price Subsidies to Railways 0.28 0.25 0.24 0.22 0.28 0.33 2. Subsidies to Agriculture 0.36 0.32 0.27 0.27 0.36 0.40 3. Repayments of Import Duties 0.10 0.01 0.00 0.00 0.00 0.00 4. Subsidies of Soc. Sec. Contributions to Exporters 0.00 0.00 0.22 0.00 0.00 0.00 5. Interest Rates Subsidies 0.00 0.00 0.06 0.02 0.30 0.02 6. Export Credits Refunds 0.01 0.01 0.01 0.02 0.02 0.02 II. Expenditure on Restructuring Programs of 1.49 1.37 1.11 1.09 0.98 0.98 Banks and Enterprises (II./1.+11.2.) _ II/1. Expenditure on Restructuring 0.67 0.82 0.65 0.64 0.52 0.44 Program of Banks 1. Covering the Frozen Foreign Currency 0.32 0.31 0.27 0.25 0.15 0.07 Deposits in Banks (Bonds RS-4) - Interests 2. Rehabilitation of Banks (bonds RS-5) - Interests 0.35 0.51 0.35 0.32 0.31 0.32 3. Already Repaid Foreign Currency Deposits 0.00 0.00 0.03 0.07 0.06 0.05 of the individuals (Bonds RS-6)-Interests II./2. Expenditure on Restructuring 0.82 0.54 0.46 0.46 0.46 0.54 Programs of Enterprises 1. Restructuring of Mines 0.08 0.08 0.11 0.17 0.15 0.20 1.1 Coal Mines 0.01 0.02 0.06 0.12 0.10 0.14 1.2 Other Mines 0.07 0.06 0.05 0.05 0.06 0.06 2. Restructuring of Steel Mills 0.30 0.08 0.07 0.07 0.09 0.15 2.1 Coal Mines 0.07 0.08 0.07 0.07 0.06 0.06 2.2 Other Mines 0.23 0.00 0.00 0.00 0.00 0.00 2.3 Recapitalization of Steel Mills 0.00 0.00 0.00 0.00 0.03 0.09 3. Restructuring of Slovene Railways 0.11 0.04 0.04 0.03 0.03 0.02 3.1 Interest Payments for Railways 0.11 0.04 0.04 0.03 0.03 0.02 4. Restructuring of Enterprise Sector 0.34 0.33 0.24 0.18 0.19 0.17 4.1 Bonds RS-1 (general restructuring of 0.05 0.06 0.04 0.02 0.01 0.00 enterpr.)-Interests I__ 4.2 Bonds RS-2 (export companies)-Interests 0.10 0.09 0.08 0.07 0.06 0.06 4.3 Bonds RS-3 (Iraq)-Interests 0.00 0.02 0.02 0.01 0.01 0.01 4.4 Other Support to Enterprise Restructuring 0.07 0.01 0.00 0.00 0.01 0.01 4.6 Support to New Small Enterprises 0.05 0.03 0.02 0.01 0.01 0.03 4.7 Support to Technological Development of 0.06 0.11 0.09 0.05 0.07 0.05 Enterprises _ 4.8 Resources for Ecological and Communal 0.01 0.01 0.00 0.02 0.02 0.01 Projects I 54 Table A3 (page 2 of 2) 1993 1994 1995 1996 1997 1998p III. Expenditure on Active Employment Programs 1.08 0.70 0.56 0.37 0.30 0.36 1. Training and Re-training Programs for 0.13 0.05 0.07 0.07 0.04 0.04 Unemployed 2. Self Employment Assistance 0.06 0.05 0.06 0.03 0.02 0.02 3. Severance Payments for Redundancy 0.12 0.11 0.04 0.03 0.01 0.01 4. Co-Financing of Job Creation 0.20 0.12 0.12 0.07 0.11 0.11 5. Public Works 0.04 0.04 0.04 0.05 0.06 0.10 6. Retraining Programs for Miners 0.01 0.01 0.00 0.00 0.00 0.00 7. Development Fund for 100 Companies 0.38 0.10 0.04 0.02 0.00 0.00 8. Programs of Restructuring and Creation of New 0.13 0.20 0.18 0.10 0.05 0.08 Jobs IV. Government Payments for Guarantees on Loans 0.29 0.20 0.40 0.08 0.05 0.09 Granted to Enterprises V. Capital Transfers from State Budget to Enterprise 0.25 0.27 0.15 0.11 0.28 0.13 Sector 1. Capital Transfers to Agriculture 0.06 0.05 0.04 0.04 0.03 0.03 2. Capital Transfers to Less Developed Regions 0.10 0.09 0.05 0.04 0.04 0.05 3. Other Capital Transfers to Enterprises 0.10 0.13 0.05 0.03 0.20 0.05 A. Total State Budget Expenditure on State Aids 3.86 3.12 2.65 2.19 2.29 2.33 (I.+II.+III.+IV.+V.) I B. Subsidies and Inv. Expenditures of Municipalities 0.29 0.26 0.21 0.29 0.30 0.30 C. Amortization of Debt Paid from the State Budget 0.26 0.25 0.50 0.39 0.29 0.13 as a Form of the State Aids 1. Bonds RS-1 (general restruct. of enterp.) - Principal 0.26 0.22 0.18 0.15 0.14 0.00 2. Bonds RS-3 (Iraq) - Principal 0.00 0.00 0.02 0.03 0.03 0.03 3. Bonds RS-4 - Principal 0.00 0.03 0.03 0.03 0.03 0.03 4. Bonds RS-5 - (rehabilitation of banks) - Principal 0.00 0.00 0.09 0.08 0.00 0.00 5. Railways - Principal 0.00 0.00 0.19 0.09 0.09 0.07 D. Expenditure of Revenues from Privatization as a _ _ 0.32 0.40 0.42 Part of State Aid 1. Restructuring of Enterprises _ _ 0.05 0.09 0.07 2. Development of Small Enterprises _ _ 0.04 0.03 0.05 3. Capital Transfers to Enterprise Sector _ _ 0.02 0.04 0.03 4. Capitalization of Fund for Regional Development _ _ 0.04 0.08 0.06 5. Support to Slovene Export Promotion. Company _ _ 0.09 0.09 0.13 6. Support to Economic Development of Minorities | _ 0.01 0.01 0.00 7. Capitalization of Technology Fund _ 0.03 0.03 0.02 8. Capitalization of Ecology Fund _ 0.03 0.03 0.05 Total State Aid (A.+B.+C. + D.) 4.41 3.54 3.67 3.26 3.29 2.76