Abstract
This note compares patterns of domestic investment in Serbia with those in other central and eastern European countries, noting the relationships with external balances. The structure of participation and employment rates suggests a need for analysis of the impact of labor market institutions on youth and women. A further focus on redeployment services would be appropriate. The Serbian banking system, the implications of the structure of Serbia’s economy, the operational framework of monetary policy, and the adoption of an inflation targeting regime have been discussed.
I. Overview and Summary
1. Serbia has made significant economic progress since 2000. Output is up 40 percent and the share of the private sector in non-agricultural non-budget employment has almost doubled to around 60 percent. These advances have reversed the decline of the previous two decades. In light of this progress, these notes aim to shed light on the challenges ahead.
2. Chapter II considers gross domestic capital formation in a regional context. With capital formation rates regionally low and employment reportedly falling, much of the economic recovery since 2000 has reflected growth in total factor productivity. In part, this is the dividend of corporate reforms which have increased efficiency. But even with the exceptional steel investment in 2004, Serbia’s investment ratios are well below those in other transition countries. Even allowing for data quality uncertainties, these investment patterns raise questions about the sustainability of Serbia’s recent economic growth. The note infers that these investment patterns indicate that a significant further reform agenda—ranging from improved business and political climates, to bankruptcy and privatization—still lies ahead. Such an agenda would address the roots of low investment by both domestic and foreign investors. And evidence from the region that domestic non-government savings rates move in tandem with non-government investment points—as do other macroeconomic indicators in Serbia—to the need to prioritize increased corporate savings.
3. Chapter III focuses on employment. With the unemployment rate at 21 percent and rising, employment reportedly in trend decline, and future restructuring set to result in further layoffs, the issues are challenging. The note is exploratory, suggesting lines of enquiry rather than firm conclusions about the way ahead. It reports that the employment structure has shifted to the private sector, but cautions that data are not yet conclusive as to whether this is re-classification due to privatization or whether private firms are creating new jobs. It suggests that Serbia’s labor institutions could be reassessed in view of the high and rising unemployment, including the complex wage setting mechanisms in the public sector inherited from the Yugoslav era. In that light, it queries the benefits of the 2005 Labor Law, which increased “insider” labor market rights and, noting particularly high unemployment among young people and females, recommends that the impact of labor market rules on these groups should form a particular focus for any review. It suggests that with corporate challenges still ahead, initiatives such as labor tax cuts, while helpful at the margin, cannot play a central role in improving employment performance.
4. Chapter IV turns to financial market issues. With rapid credit growth one of the consequences of earlier reform, notably of the banking system, the 2005 FSAP pointed to the need to strengthen banking regulation. Given that the 2005 banking law brought the legal regulatory framework largely in line with Basel Core Principles, this note emphasizes that the key challenge now is implementation. It notes that credit, which is largely fx-indexed lending to unhedged borrowers, requires strengthened regulatory capacity to monitor and manage indirect credit risk arising from foreign exchange exposures.
5. Drawing on these real and financial sector assessments, Chapter V considers issues in the choice of the exchange rate regime. Given the depth of the economic challenges inherited from the pre 2000 period, the monetary and exchange rate frameworks in Serbia since 2000 have had to strike difficult compromises between internal and external objectives. Partly to resolve these choices, the National Bank of Serbia (NBS) has begun taking steps towards eventual adoption of inflation targeting. The note observes that while several characteristics of the Serbian economy—most notably high euroization and high exchange rate pass-through—suggest the desirability of a relatively stable nominal exchange rate, others—notably the strength of capital inflows and associated risk of reversal—point towards the need for flexibility. In suggests that, on balance, increased flexibility in the exchange rate is appropriate. But the note goes on to posit that a flexible regime, managed with little or no discretionary foreign exchange intervention, but with other policies aimed to avoid excessive volatility in the nominal exchange rate, could provide the best fit for Serbia.
6. Following on from this, Chapter VI points to the operational implications of ambitions to increase exchange rate flexibility—anticipating inflation targeting. Given that greater exchange rate volatility necessitates a reformulation of foreign exchange intervention policies, the note suggests that operational distinctions should be drawn between various goals for intervention—such as maintenance of import cover, and “leaning against the wind” functions. It outlines how these purposes could be pursued while avoiding their misinterpretation by markets as official attempts to use intervention to determine the path for the exchange rate. It emphasizes, however, that this approach does not imply loss of official influence over the exchange rate path—but rather that the repo rate would become the main instrument for this and other monetary policy purposes. To this end, the note recommends a number of changes to repo operations, including focusing on the 14-day maturity and linking other NBS interest rates closely to the repo rate to establish a meaningful interest rate corridor. That said, the note cautions that even in the best of circumstances, the transition of the monetary and exchange rate regime will not be straightforward, underscoring the need, in particular, for full fiscal support to ensure its effectiveness.
7. Chapter VII discusses broader issues in the new monetary framework. It considers evidence for Serbia on the impact of the exchange rate on core inflation, observing that the great variety of parameter estimates for this relationship reflects both the short data sets and the multiplicity of structural shocks during even those short periods. While uncertainties remain, the evidence points to continued high pass through rates, perhaps particularly following exchange rate depreciations. Accordingly, the note considers lessons from other emerging market countries which adopted inflation targeting in the face of similar uncertainties about the determinants of inflation. It reviews how they set inflation goals, evolved their policy structures, and used “escape” clauses so as to balance need under inflation targeting for the authorities to provide inflation commitments with the technical constraints on their ability to achieve specific targets.