May 13, 2002
The authorities of the Federal Republic of Yugoslavia (FRY) welcome the staff report and thank the Executive Board for the continuous support. They are also grateful to management and staff, especially Mr. Zervoudakis and his team, who are performing an excellent job. Our authorities are fully committed to implement the policies defined in the Extended Arrangement (EA). The new agreement will be the third in a period of eighteen months, a period in which the policy orientation has shifted from crisis management to macroeconomic stabilization, to implementation of pro-growth policies.
On the political front, the process of redefining the relations between Serbia and Montenegro has started. The agreement signed in March 2002 foresees the drafting of a new constitutional charter by the end of June and its ratification by the federal and republican parliaments approximately by the end of the year. The agreement provides for a union state with one political identity, but recognizes two different economic systems. The gradual harmonization of the economic systems of the member states with the EU shall overcome the existing differences, primarily in the spheres of trade and customs policies. The federation and both republics are fully committed to the implementation of the agreement.
The pace of economic reforms in FRY has been faster than initially anticipated. In many areas, the results are above expectations. This outcome stems from very strong ownership combined with clear and prudent advice from staff. The authorities have demonstrated strong commitment to avoid partial solutions and to press ahead with bold reforms where and when justified, like for instance in the case of loss-making state owned entities. Severe resource constraints were also a factor for rapid structural reform.
Looking ahead, the authorities are fully aware of the dire state of the economy and the serious reform challenges. The low level of GDP (still 50 percent below the 1990 level) and industrial production (more than 60 percent lower) highlight the importance of stable and rapid economic growth. Rapid growth is also a condition for achieving a sustainable external position and for beginning to solve the problem of widespread poverty.
The main goals of the program under the EA are ambitious; to complete the transition process by 2005 and to prepare the ground for membership negotiations with the EU. This means establishing a competitive export-oriented market economy based on dominant private ownership and modern institutional arrangements, while preserving and fostering the already achieved macroeconomic stability.
Recent Economic Developments
Estimated GDP growth in 2001 was 5.5 percent. The main sources of growth were in the services and agricultural sectors. Industrial output stagnated throughout 2001, with big differences in recovery within the sector. In the first quarter of 2002, industrial production was slightly lower compared to the same period last year, but recent developments show signs of recovery. The service sector is still growing very fast. The authorities are confident that the projected GDP growth of 4 percent for this year will be achieved.
Inflation has declined steeply due to steadfast monetary policy. During 2001, a period in which administered utility prices were adjusted and indirect taxes raised, inflation was lowered by two-thirds to 39 percent. Core inflation was estimated at 15 percent. The declining trend in inflation continued for the four months in 2002, when inflation was 3.4 percent. While significant increases in administered electricity prices are planned before mid-year, the developments over the past four months bode well for the projected inflation rate of 20 percent at end-2002. The current account deficit was lower than projected mainly due to buoyant remittances. The foreign exchange reserves of the NBY reached US$1.2 billion (2.6 months of imports) at the end of 2001 and continued to grow in the first four months of this year.
Fiscal policy has the difficult task of balancing the contradicting goals of ensuring the viability of the exchange rate regime and of providing the necessary resources for deep reforms in major expenditure areas. The support of economic recovery will have to be reconciled with the efforts to further reduce inflation and achieve fiscal sustainability. The fiscal deficits will remain sizable throughout the whole arrangement due to the high costs of maintaining an appropriate social safety net during the transition, the servicing of the large foreign debt, as well as the financing of growth-enhancing infrastructure investment. Foreign assistance and privatization proceeds will be the main sources of financing. In case that foreign assistance or proceeds from privatization do not materialize, the authorities have identified capital spending and subsidies as areas for expenditure cuts.
At the federal level, in line with the recent agreement on a new constitutional framework, large expenditure cuts can be expected. The reform of the military has been initiated with the objective to reduce the size of the officer corps and to shorten the conscription period.
A number of structural reforms have been initiated at the republican levels to further improve revenue collection and expenditure management. By introducing amendments to the Pension Law, better management of the health fund and social welfare programs, the Serbian authorities improved control over social spending, thus creating a sound base for further cuts. In Serbia, the authorities are continuing their efforts to reorganize the Public Revenue Agency, create a Large Taxpayer Unit and a unique taxpayer identification number. The basic functions of the Treasury will be established by the end of September 2002. On the revenue side, the authorities started preparation for the introduction of the VAT in 2004.
After significant problems in 2001, the Montenegrin authorities managed to improve the budget situation by widening the tax base and by cutting capital expenditures. Further fiscal reforms will concentrate on the pension and health care reform and on improving Treasury operations. The reform of the pension system aims at increasing the retirement age and shifting the indexation scheme to a more appropriate model. The Montenegrin authorities are in an advanced stage of establishing a fully functioning Treasury, which will further improve expenditure management and budget monitoring.
Monetary and Exchange Rate Policy
The National Bank of Yugoslavia (NBY) has continued to pursue a tight monetary policy in line with its goal of reducing inflation, thus creating conditions for economic recovery. This policy was successful in lowering the inflation rate and in raising real money balances, which reflects the growing confidence in the domestic currency. In order to create a conducive environment for banks to improve the efficacy of monetary policy, and to support the development of a money market, the NBY recently simplified considerably the reserve requirements system and reformed its credit window facility. The new foreign exchange law liberalizes foreign exchange market thus paving the way for FRY’s acceptance of the obligation of Article VIII, Sections 2,3 and 4.
The exchange rate policy based on a managed float has served Serbia well in raising confidence in the dinar and containing inflationary expectations. This policy will continue in the future with some added flexibility. The aim is to have a balanced approach towards the disinflation objective of the program and the prevention of an unsustainable appreciation of the real exchange rate that could undermine external competitiveness. The authorities agreed with staff that the exchange rate policy has to be kept under close scrutiny taking into account not only the situation in the interbank market, but also developments in exports, imports and wages.
The acute phase in restructuring the banking system that led to an initial concentration and to closures of banks will end in June 2002, with a final decision regarding the destiny of banks that are under the control of Bank Rehabilitation Agency (BRA) or directly administered by the NBY. The policy will focus on the privatization of the remaining state banks and the strengthening of banking supervision through regulation based on international standards. The BRA has already started a process of selling physical assets of closed banks. To underpin the support for a sound and resilient banking system, the authorities decided that state and state owned entities would no longer contribute capital to banks.
The authorities have embarked on actions that will create an environment favorable to business and investment. Some improvements have already been made with the liberalization of the labor market, where employment contracts and wage determination have become flexible. The taxation rate on wages was lowered, thus encouraging official rather than informal employment. Barriers to entry and foreign trade are also addressed and there are clear moves to simplify the process of enterprise creation and to reduce or remove unnecessary red tape. The changes in public administration, which are under preparation, will ease the fight against corruption. This is also the area where some progress has been achieved. To boost growth, the authorities intend to attract sizable official and private assistance and investment for major infrastructure projects of regional importance.
The combination of privatization efforts and the creation of a business friendly environment has improved the prospects for economic growth. Although the privatization process has been slower that expected, there are signs that privatization in Serbia will gain momentum in the near future. With the help of the World Bank, 27 companies are slated for privatization through tenders. The first privatization auction for smaller companies has been successfully closed, and the Action Fund has started to sell shares of companies that had been partially privatized under the old regulation.
The Montenegrin privatization has been more diversified. The sale of majority stakes in enterprises to strategic investors through tenders and auctions are accompanied by mass voucher privatizations for minority stakes in selected enterprises.
With the assistance from the World Bank and the Fund, the I-PRSP strategy is in the initial phase of preparation. According to the first results from two studies prepared by NGOs, poverty in Serbia is widespread and results from the prolonged depression. It is mostly an urban phenomenon and many people who are formally employed are under the poverty line. In addition, many workers will lose their jobs in the transition process, so the strategy for fighting poverty has to define adequate preventive actions. In designing and implementing the strategy, the authorities will need financial support from donors and technical assistance for quite some time.
The approval of the new arrangement with the Fund will trigger an agreement with the Paris club and will reduce the net present value of FRY foreign debt. Meanwhile, the FRY already signed bilateral agreements with five creditors from the Paris club. Negotiation with the London club and other bilateral and commercial creditors are under way, but so far without tangible results. Our authorities expect that the improvement in external debt indicators will continue after the expiration of the EA, as a result of phased debt reduction and the reliance on grants, concessional loans and FDI that will finance the current account deficits. A prudent policy of external debt management will underpin the progress towards external sustainability.
Our authorities wish to underscore the excellent cooperation with the Fund during the arrangements that have resulted in rapid and comprehensive reforms. They are fully aware that the new agreement provides an essential framework for completing the stabilization agenda and pursuing vigorous structural r forms. Therefore, the EA is of critical importance for the country. The authorities again stress their firm commitment to continue with the reforms in a transparent way.