On behalf of the Serbian authorities, we thank staff for the candid policy dialogue and the productive meetings during their visit to Belgrade in late October. The staff report provides a fair assessment of the latest developments in the Serbian economy and the policies implemented under the SBA-supported economic program. The arrangement continues to be instrumental in underpinning and strengthening macroeconomic management and keeping structural reforms on track. Under the program, the authorities have implemented a range of bold and politically difficult reforms to: (i) ensure fiscal sustainability by reducing current expenditures, including public wages and pensions, (ii) minimize contingent fiscal risks stemming from unreformed state-owned enterprises (SOEs), (iii) strengthen the stability of the financial sector and bolster intermediation, and (iv) improve the investment environment.
The implemented policies, underpinned by strong ownership, are continuing to yield tangible results: recovery is ongoing and growth is gaining momentum, the external current account deficit is narrowing, employment and the participation rate are growing, and the financial sector resilience and intermediation have strengthened. Fiscal outcomes have continuously over-performed relative to the targets set under the program. The objective of a 4 percent structural adjustment is expected to be broadly achieved a year ahead of schedule, on the back of high quality and durable structural fiscal measures. Public debt has already reached a turning point in 2015 and is placed on a firm downward path. The Serbian authorities consider the program as an important anchor to strengthen the credibility of macroeconomic policies. They remain firmly committed to the program and its objectives, and confirm their intention to treat it as precautionary.
The growth recovery is well underway, driven by investments, net exports and domestic consumption, and supported by improved sentiment and credit growth. Credible fiscal consolidation and implemented labor market, and other reforms have led to improved confidence and investment sentiment. Further, the resurgence of economic activity and the measures against informality are driving growth of formal employment (3.2 percentage points y-o-y). In parallel, the unemployment rate declined to its lowest level in the past 15 years. The GDP projections for 2016 and 2017 have been revised upwards for the third consecutive time, to 2 ¾ and 3 percent, respectively. Domestic consumption is bolstered by higher private wages and employment growth. The current account deficit continues to narrow, driven by the rebound in exports. The FDI inflows in 2016 remain high at 5 ½ percent of GDP, and are well diversified. The financial account has been hit by global investor repositioning in the first half of the year and increased volatility in global financial markets following the Brexit vote; however, flows have reversed in the second half of the year.
The authorities agree on the risks to the outlook, but consider that they are symmetrical. Key downside risks stem from an activity slowdown in major trade partners, adverse trends in international commodity and financial markets, along with unfavorable agrometeorological conditions. This said, the macroeconomic policies implemented under the program have reduced internal and external imbalances, thus strengthening the economy’s resilience to adverse shocks.
The fiscal adjustment continues to be at the core of Serbia’s arrangement with the Fund. The fiscal consolidation delivered good results in 2016, and continues to over-perform by a substantial margin the targets set under the program. Further, consolidation remains critical for restoring fiscal sustainability and placing public debt on a firm downward path. The authorities remain strongly committed to maintain fiscal discipline and to implement policies aimed at reducing public debt to a more sustainable level.
The overall fiscal deficit at the end of Q3 was only 0.1 percent of GDP, while for 2016 it is expected to reach 2.1 percent, substantially lower than envisaged under the program. The noteworthy fiscal result in 2016 is mostly driven by strong tax and non-tax revenues, in particular VAT, excises, and CIT. In addition to the strong economic activity, the better tax collection is due to improved compliance, reduction in informality and progress in implementing the Tax Administration Transformation Agenda. On the expenditure side, the current budget outlays remain in line with projections, while the execution of capital spending has improved substantially in comparison with previous years. This is particularly relevant from the point of view of the needed upgrade of transport infrastructure. Going forward, the authorities plan to address identified weaknesses in the public sector investment framework, including by setting up a single pipeline for all infrastructure projects, strengthening project prioritization and streamlining appraisal, planning, and execution. The wages and public sector pension expenses continued to gradually decline in real terms during 2016, as a result of the hiring freeze, rationalization in the public sector, and the effects of parametric pension system reform introduced in 2014.
The 2017 budget aims at solidifying fiscal policy gains, and targets additional structural adjustment of 0.2 percent of GDP. Strong fiscal consolidation and the ongoing economic recovery have provided fiscal space for a targeted increase of public wages in critical sectors and the modest increase in pensions—relevant in a context of distributing the gains of difficult reforms. The share of public wages and pensions in GDP will continue to decline in 2017.
The authorities plan to continue with pushing ahead with structural fiscal and PFM reforms, including the further progress in rightsizing the public sector employment, advancing in implementing Tax Administration Transformation Agenda, and improving budget execution by enhancing the coverage of the Financial Management Information System, among other measures.
As a result of prudent fiscal policies, the public debt has already started to decline. It reached a turning point in 2015, and the authorities aim to cement it on a firm downward path. Public debt reached 72 percent of GDP in Q3–2016, form 76 percent at the end of 2015. Public debt at the end of 2016 is expected to be slightly below 74 percent of GDP.
Monetary and exchange rate policies
The monetary policy remains accommodative, consistent with the price stability objective of the National Bank of Serbia. On December 8, the NBS Executive Board decided to keep the reference rate unchanged at 4 percent. Notwithstanding declining inflation expectations, NBS considers that cautious monetary policy is warranted, given uncertainties in global financial and commodities markets, as well as the dynamics of monetary policies of the US Fed and ECB and their impact to global capital flows.
In early November, the NBS announced that it will lower its inflation target from currently 4 to 3 percent, effective from January 2017. The inflation tolerance band will remain unchanged at ± 1.5 percentage points. The key reasons for the revision of the inflation target were the improved macroeconomic fundamentals and outlook, in particular the sustainable narrowing of external and internal imbalances, and the decline of risk premia for Serbia. The decision to lower the inflation target was further informed by stable and low inflation over the past three years, and declining inflation expectations. The NBS expects that inflation will return to the tolerance band by the early 2017. In November, headline CPI inflation stood at 1.5 percent.
Driven by the accommodative monetary stance, credit activity grew by 4.3 percent in Q3. Lending rates continued to decline in Q3 both for lending in dinars, as well as for euro-indexed lending, owing to monetary easing, a decline in sovereign risk premia, increased competition between banks, and low euro-area interest rates. Underpinned by progress in achieving macroeconomic stability and by the authorities’ dinarization strategy, credit denominated in dinars is continuing to increase. The share of dinar-denominated credit reached 31 percent of the total credit stock in Q3, about 2.7 percentage points higher than at end-2015. The share of foreign currency deposits in the Serbian banking sector stands at 74 percent.
The Serbian authorities remain committed to the inflation targeting regime. The current level of international reserves is high by standard metrics. The central bank remains committed to maintain an adequate reserves level throughout the program. Further, given the high euroization of the economy, volatility of capital flows and the financial stability concerns, the exchange rate regime continues to be a managed float, with the foreign exchange interventions aimed at smoothing excessive exchange rate volatility, without targeting a specific level or path of the exchange rate.
The Serbian banking sector remains robust, with large liquidity and capital buffers. Capital adequacy is high, at 21.6 percent, well above the regulatory minimum of 12 percent and above the regional average. Profitability of the sector is on the rise, driven by declining credit losses. NPLs have declined by about 3 percent, supported by the comprehensive set of measures implemented under the authorities’ NPL reduction strategy. While the NPLs still remain high, they are fully provisioned.
The NPL strategy continues to be implemented and is delivering good results. The NBS implemented a range of prudential and regulatory measures envisaged under the NPL strategy, including the introduction of additional provisioning practices, enhanced asset quality reporting, and guidance for preparation of the NPL resolution strategies for individual banks. NBS has also issued an official interpretation of the application of banking secrecy rules, while the Ministry of Finance issued the official interpretation of the treatment of the impairment provision for CIT purposes. Further, the law on regulation of real estate appraisers is expected to be enacted by end-December. The law will unify technical standards and rules and will provide a uniform and sufficiently conservative valuation of real estate for collateral purposes.
The government is also updating its strategy for the remaining state-owned banks and is strengthening the oversight over the financial institutions with state-ownership. The privatization of Komercijalna Banka—the second largest bank by assets—remains on track. The government also issued a guidance to the state-owned Banka Poštanska Štedionica, to gear its business model towards retail and SME market segments. Due diligence of Dunav Osiguranje, the biggest Serbian insurer, has been completed and the remedial measures will be implemented, as needed.
Structural reforms, state-owned (SOE) and socially-owned enterprise reforms
Notable progress in improving the business climate has been achieved over the last two years. In the latest Doing Business Report, Serbia was ranked 47th place out of 190 economies. In addition, Serbia was among the ten economies that most improved over the 2015/16 in areas tracked by Doing Business. The authorities remain committed to further improve the business environment. They continue to be supported by the World Bank and the EBRD in this endeavor.
As pointed out by staff, the authorities are working towards resolving remaining socially-owned companies in the portfolio of the former Privatization Agency (PA). Bankruptcy moratorium for the 17 strategic socially-owned companies under moratorium protection was lifted in May 2016. Six of those companies have been fully resolved. Out of about 500 companies in the former PA portfolio, around 330 has been resolved, while 172 companies with 45,000 employees remain to be resolved, either through bankruptcy or privatization. The government is actively searching for strategic partners for the biggest companies.
The Serbian authorities are well aware of contingent fiscal risks stemming from the large, unstructured SOEs. They continue to work with the support of IFIs, including World Bank and the EBRD in advancing SOE restructuring agenda, with the following objectives: (i) address organizational, financial and governance issues in SOEs, (ii) minimize fiscal risks, and (iii) reduce state aid to SOEs substantially and on a systematic basis. The focus is on major companies in the electricity, mining, gas distribution and transportation sectors. Financial and corporate restructuring plans, and the rightsizing plans for the electricity utility EPS and the Serbian Railways have been adopted and are in process of implementation. Organizational restructuring and a debt restructuring plan for the gas distribution utility Srbijagas were adopted, and the financial consolidation of the company has been initiated.