Serbia and Montenegro: Sixth Review Under the Extended Arrangement, Financing Assurances Review, Request for Waivers of Nonobservance of Performance Criteria, and Proposed Post-Program Monitoring—Staff Report; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Serbia and Montenegro

This paper discusses Serbia and Montenegro’s Sixth Review Under the Extended Arrangement, Financing Assurances Review, Request for Waivers of Nonobservance of Performance Criteria, and Proposed Post-Program Monitoring. Program implementation since the fifth review has been mixed, delaying the conclusion of the sixth and final review. Growth in 2005 reflected strong net exports, with an increasing contribution of domestic demand after mid-year. The slow structural transformation of the economy remains a major constraint on potential growth and stabilization.

Abstract

This paper discusses Serbia and Montenegro’s Sixth Review Under the Extended Arrangement, Financing Assurances Review, Request for Waivers of Nonobservance of Performance Criteria, and Proposed Post-Program Monitoring. Program implementation since the fifth review has been mixed, delaying the conclusion of the sixth and final review. Growth in 2005 reflected strong net exports, with an increasing contribution of domestic demand after mid-year. The slow structural transformation of the economy remains a major constraint on potential growth and stabilization.

I. Introduction

1. Program implementation since the fifth review has been mixed, delaying the conclusion of the sixth and final review.1 Discussions on the sixth review were prolonged, in particular, by the failure to pass the pension reform in line with program commitments. This required the identification of other permanent expenditure savings in the 2006 budget.

2. The political situation in Serbia remains fragile, while Montenegro is preparing for a referendum on independence in April. The governments’ position improved following the start of negotiations with the EU in October on a Stabilization and Association Agreement. In Serbia, the implementation of reforms by the minority government has been difficult. The political agenda for 2006, which includes the status of Kosovo, the potential split of the union, and full cooperation with the international criminal tribunal, will be a challenge for policy making.

II. Recent Developments

A. Macroeconomic Developments

3. Growth in 2005 reflected strong net exports, with an increasing contribution of domestic demand after mid-year (Tables 13, Figures 2 and 3). Output started to recover at mid-year following the drop in early 2005 on the heels of the end-2004, VAT-induced surge in investment and stockpiling.2 Growth was strong in particular in the privatized enterprises and export-oriented sectors, while output declined in the sectors with a large number of unrestructured enterprises. Domestic demand picked up at mid-year, as the larger-than-expected capital inflows3 fuelled credit growth. With still limited competitive domestic supply, this exacerbated macroeconomic imbalances and contributed to inflationary and import pressures. In Montenegro, a good tourism season sustained growth.

uA01fig01

Following strong performance in 2004, GDP growth slowed in Q1 2005 before picking up in Q2–Q3

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Sources: Serbian Statistics Office; and IMF staff estimates.
uA01fig02

Domestic demand dropped temporarily in H1 2005, but recovered strongly in H2.

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

uA01fig04

Credit continued strongly in Q3 2005, including to households,

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Sources: Serbian Office of Statistics: National Bank of Serbia; and IMF staff estimates.
uA01fig05

While imports returned to previous levels, suggesting sustained demand.

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Table 1.

Serbia and Montenegro: Selected Economic and Financial Indicators, 2002–06 1/

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Sources: Statistical Offices of SCG, Serbia, and Montenegro; National Bank of Serbia; State Ministries of Finance; and IMF staff estimates.

Excluding Kosovo (with the exception of foreign debt).

Excluding Montenegro.

Break in series in 2004, when it becomes consistent with Eurostat/ILO definition.

Fiscal operations of all levels of government, except for Montenegro where it excludes local governments.

Including the first phase of the Paris Club debt reduction in 2002 and implementation in 2005 of the London Club agreement.

At current exchange rates.

Excluding frozen foreign currency deposits.

Repo rates refer to 14-day repos. Repo operations replaced the issuance of NBS bills from January 31, 2005 onward.

November 2005.

Corrected for the surge in imports and remittances at end-2004 ahead of the introduction of the VAT in January 2005.

Table 2.

Montenegro: Selected Economic Indicators, 2002–06

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Sources: Ministry of Finance; Central Bank of Montenegro; Statistical Office of Montenegro; and Fund staff estimates.

Excludes local governments.

Includes FFCD repayments.

Data on foreign debt is preliminary.

Balance of Payments data are preliminary. In particular, information regarding the inter-trade between Serbia and Montenegro remains disputed. If data sourced from Montenegro were used the level of the current account deficit would be lower.

Table 3.

Serbia and Montenegro: Macroeconomic Framework, 2002–10

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Sources: SCG authorities; and IMF staff projections.

Including changes in inventories. Break in series in 2004.

Figure 1.
Figure 1.

Serbia and Montenegro: Performance under the EA, 2002–2005

(In percent of GDP, unless otherwise noted)

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Sources: Serbia and Montenegro authorities; and IMF staff estimates and projections.1/ projections.
Figure 2.
Figure 2.

Serbia: Selected Economic Indicators, 2002–2005

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Sources: National Bank of Serbia; Statistics Office of Serbia; and Fund staff estimates.
Figure 3.
Figure 3.

Montenegro: Economic Developments, 2002–2006

(In percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Sources: Montenegro Statistical Office, Central Bank and Ministry of Finance of Montenegro; and IMF staff estimates and projections.

Performance Under the EA, 2002–05

During the EA, policies were shifted to deal intermittently with the inflation and current account objectives. The initial program in 2002 aimed at disinflation with a quasi-fixed exchange rate anchor and reconstruction of the economy through increased public investment and privatization. Although inflation dropped in 2002–03, the current account deficit widened, as slow structural reforms did not generate sufficient exports, and weak incomes policies undermined competitiveness. To contain external imbalances, a managed float was adopted in 2003, supported by greater fiscal tightening than anticipated. As the current account deficit and inflation persisted in 2004, the authorities returned to a crawling exchange rate anchor, to be supported by tighter fiscal and incomes policies, and faster structural reforms.

Performance under the EA, 2002–2005

(In percent of GDP, unless otherwise indicated)

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Sources: IMF Staff Reports.

The EA contributed to stabilizing the economy, but important vulnerabilities remain. Since 2001, growth, external reserves, public debt, and the fiscal balance have improved more than initially programmed. Moreover, the public expenditure-to-GDP ratio declined by close to 4 percentage points between 2002–05. The substantial fiscal adjustment during the program was needed to compensate for the worse-than-expected private sector savings-investment balances. In this vein, both inflation and the current account deficit have exceeded the initially set targets and remain unsustainably high, and the still high external and public debt-to-GDP ratios are sources of vulnerability.

The slow structural transformation of the economy remains a major constraint on potential growth and stabilization. The initial program focused on resolution and privatization of banks and large socially owned enterprises, but had no commitments to restructure public enterprises. During 2001–2004, trade liberalization and tax reforms improved the investment climate, but enterprise privatization lost momentum in mid-2003. With the re-orientation of the program in 2004, privatization of banks accelerated, several bankruptcies were declared, and the restructuring of public utilities advanced. Overall, despite progress in selling smaller socially owned companies, a significant number of large enterprises remain to be restructured and sold, and the share of the private sector in GDP increased only from 40 to 55 percent between 2001–2005.

uA01fig03

Serbia: Privatization of Socially Owned Enterprises, 2002–05

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Source: Privatization Agency; and IMF staff estimates.

4. Inflation stabilized, but at a very high level. Annual headline inflation in Serbia remained at 17–18 percent throughout 2005 (against the end-year target of 13.8 percent set at the fifth review). In addition to strong demand, this reflected a series of shocks, including the VAT introduction, disruptions to agricultural supply due to flooding, and the rise in world energy prices, which were amplified by the widespread indexation of prices. On the other hand, the decline in core inflation through August, on the heels of the slowing in dinar/euro depreciation as of early 2005, suggests that the pass-through from the exchange rate to prices was high and that the exchange rate helped anchor inflationary expectations (Figure 4). However, this improvement was offset more recently by second-round effects from energy price increases and renewed demand pressures.

Figure 4.
Figure 4.

Serbia: Inflation Developments, 2004–05

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Sources: Serbian Statistical Office; National Bank of Serbia; and IMF staff estimates.

5. The current account deficit improved more than programmed, but remains large (Tables 46, Figure 5). Aided by favorable commodity prices and the impact of FDI and restructuring, exports grew by 38 percent year-on-year in the first three quarters in dollar terms. In absolute terms, however, they were still less than half of imports, pointing to the structural nature of the trade deficit. Despite rising oil prices, import growth was subdued, reflecting the VAT effect, in addition to tighter macroeconomic policies. Real effective exchange rate developments, market share, and comparative cost calculations suggest that competitiveness in Serbia remained adequate, while it continues to be a concern in Montenegro.

uA01fig06

In Serbia, the real exchange rate appreciated against the euro in 2005, while the REER suggested a depreciation.

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Sources: National Bank of Serbia; and IMF staff calculations.
uA01fig07

In Montenegro, the real exchange rate started to depreciate in 2005.

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Sources: Central Bank of Montenegro; and IMF staff calculations.
uA01fig08

Serbia’s export share to the EU and USA has increased

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Source: IMF staff estimates.
uA01fig09

...and wages reflect productivity (2004)

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

GDP per Employee ($U.S., log scale) (Proxy for productivity)
Table 4.

Serbia and Montenegro: Balance of Payments, 2003–09

(In millions of U.S. dollars, unless otherwise indicated)

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Sources: SCG authorities; and IMF staff estimates.

Debt service due after debt reduction granted by bilateral and commercial creditors, but before capitalization of moratorium interest (in “debt relief”).

Official grants and loans recorded above-the-line are amounts based on conservative assumptions; further possible amounts are shown below-the-line.

Negotiations are on-going to clear all remaining external arrears.

Including July 2004 debt reduction from London Club, and assuming completion of Paris Club debt relief operation and comparable debt relief by non-Paris Club and commercial creditors in 2006.

Excluding all debt relief concluded or assumed after end-June 2004.

Table 5.

Serbia and Montenegro: Indicators of External Vulnerability, 2002–05 1/

(In percent of GDP, unless otherwise indicated)

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Sources: SCG authorities; and IMF staff estimates.

All stocks are measured end-of-period. Excludes Kosovo, except for external debt.

Weighted average of interest rates on commercial paper, bank bills, and certificates of deposit.

Excluding IMF and liabilities to domestic residents. In 2002, the NBS assumed short-tem external debt of commercial banks of $100 million.

Includes overdue obligations on debt related to imports of oil and gas. Short-term external debt by remaining maturity also includes amortization due in the following year on medium- and long-term debt.

Assuming all long- and medium-term external debt of banks and enterprises is government guaranteed.

Increase denotes appreciation.

Table 6.

Serbia and Montenegro: Stock of External Debt at September 30, 2005 1/

(In millions of U.S. dollars)

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Sources: SCG authorities, and IMF staff estimates.

Debt figures reflect the Paris Club debt rescheduling agreement (November 2001) and London Club restructuring (signed in July 2004).

Regular and late interest calculated in accordance with terms of original agreements.

Debt is not owed by government and does not have government guarantees.

Overdue obligations (trade credits) owed to oil and gas enterprises in Russia.

Figure 5.
Figure 5.

Serbia and Montenegro: External Sector Developments, 2001–05

(In percent of GDP, unless noted otherwise)

Citation: IMF Staff Country Reports 2006, 058; 10.5089/9781451833591.002.A001

Sources: Serbian Statistics Office; National Bank of Serbia; and IMF staff estimates.1/ Projection.

6. Higher-than-expected foreign borrowing increased macroeconomic vulnerability to “sudden stops” or exchange rate shocks. The surge in foreign loans since 2004 has mainly been related to better access to external capital by recently privatized or newly established enterprises, banks, and leasing companies, in particular from their parent companies abroad. Although short-term debt remains modest, the continued strong foreign borrowing by the private sector, amounting to about 6–7 percent of GDP in Serbia in 2004–05, is of concern. The debt-to-GDP ratio has remained high at about 61 percent. Coupled with large inflows of remittances, equivalent to over 14 percent of GDP, and mostly privatization-related FDI, this boosted gross foreign reserves of the NBS to $5.4 billion at end-November.

Serbia: Financing of the Current Account Deficit, 2004–2005

(In percent of GDP)

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Source: National Bank of Serbia; and IMF staff estimates.

B. Policy Developments

7. Tight fiscal policies helped contain demand pressures in 2005 (Tables 710), but plans for large infrastructure projects can create future fiscal risks. As described in Box 1, fiscal policy since 2002 has been significantly tighter than in the initial program to compensate for the worse-than-expected private sector savings-investment balances. The general government surplus through September, at 0.6 percent of GDP, reflected these continued prudent policies. Over the whole of 2005, the overall and cyclically adjusted balances (Figure 6) are projected to improve by 1.2 percent of GDP to a consolidated SCG surplus of 0.9 percent of GDP. The small revenue underperformance, mainly due to cuts in oil excises to contain prices, was compensated by savings in subsidies and goods and services, which also helped accommodate overruns in municipal wages and higher capital spending. Moreover, employment rationalization in the army, health, education, and public administration paved the way for permanent expenditure savings. However, the steps initiated in Serbia toward public-private partnerships (PPPs) for the construction and management of toll highways, at an estimated total cost of close to 6 percent of GDP over three years, is of concern. Because of their uncertain economic profitability, these projects, although initially privately funded and managed, may result in large future contingent liabilities as a result of implicit government guarantees.4 In Montenegro, the programmed fiscal stance was achieved by higher-than-expected tax revenues, as expenditure targets were undermined by delays with civil service reform and increased capital outlays.

Table 7.

Serbia and Montenegro: General Government Fiscal Operations, 2003–06 1/

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Sources: Ministry of Finance of the Republic of Serbia and the Republic of Montenegro; and IMF staff estimates.

Includes the union, republican, and local governments (except for Montenegro), social security funds, and extrabudgetary programs.

GDP of Serbia and Montenegro, excluding Kosovo.

Excluding foreign currency deposit payments to households, reclassified below-the-line.