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.

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.

II. Gross Domestic Capital Formation and External Deficits1

1. This note compares patterns of domestic investment in Serbia for 2000-05 with those in other CEECs2 between 1995-2005, noting the relationships with external balances.

A. Main Findings

2. The main findings are as follows:

  • For the full CEEC region, higher fixed investment is generally associated with a higher current account deficits. In the absence of large FDI inflows, it is also associated with greater external debt accumulation.

  • Similarly, for a given level of gross investment, an increase in public investment is associated with a widening of the current account deficit.

  • And in the full region, a decline in private investment is usually associated with a decrease in FDI inflows and a decline in the current account deficit. In cases where private investment does not decline significantly in response to reduced FDI inflows, external debt increases.

  • In Serbia, the large current account deficit has been associated with relatively low investment ratios compared to other CEECs (except Bulgaria)—although data doubts remain.

  • Looking forward, the experience of other CEECs suggests that an increase in investment in Serbia may put pressure on the current account and external debt.

  • Given Serbia’s large external debt, financing its large investment needs will require achieving higher national savings and attracting larger non-debt creating flows.

B. Domestic Investment and External Deficits in Transition

3. High domestic investment, ceteris paribus, is associated with external imbalances. Thus, the investment needed for reconstruction and restructuring in the transition area might be expected to lead to temporary current account deficits, which would later correct as exports and growth pick up.

4. Several countries in the sample conform to this pattern (Figures 1a and 1b). This may be seen in Bulgaria 1998 onwards, in Croatia in 1997–99 and again in 2002–05, in the Czech Republic in 1995–97 and 1998–99, in Poland between 1995–2003, and in the Slovak Republic where the current account deficit matched developments in investment during the whole period.

Figure 1a.
Figure 1a.

Selected CEEC and SEE Countries: Gross Investment, Current Account Deficit and External Debt (In percent of GDP), 1995-2005

Citation: IMF Staff Country Reports 2006, 382; 10.5089/9781451833638.002.A002

Sources: National Authorities and IMF staff estimates.
Figure 1b.
Figure 1b.

Selected CEEC and SEE Countries: Gross Investment, Current Account Deficit and External Debt (In percent of GDP), 1995-2005

Citation: IMF Staff Country Reports 2006, 382; 10.5089/9781451833638.002.A002

Sources: National Authorities and IMF staff estimates.

5. In Serbia, the analysis of investment is hampered from the outset by the lack of a reliable data series. Specifically:

  • National accounts data for gross fixed capital formation in 2000–03 probably underestimate private investment by about 5 percentage points of GDP, as suggested by preliminary official estimates for 2004 that take into account an improved coverage of the private sector, especially its investment in equipment. Thus, only the 2004 investment figure is meaningful.

  • The decomposition of public and private investment is made difficult by the absence of data and by definitional specificities, i.e., the existence of socially owned enterprises. Investment decomposed between government and nongovernment was previously estimated by Fund staff to be roughly 14 and 86 percent of total, respectively, suggesting low “public” sector investment. However, recently published data estimate “public” sector (including socially owned enterprises) and private sector investment at 58 and 42 percent of total, respectively.

6. With these caveats, Serbia’s data suggests surprisingly high external deficits given lackluster fixed investment ratios. Such delinks are not without precedent—after 2001, the Czech Republic and Hungary both reported continued high external deficits while fixed investment ratios declined, in both cases reflecting weakening domestic savings rates. But overall, Serbia’s performance is unusual in degree—reporting large external deficits alongside low investment ratios.

C. Investment, Income per Capita, and Compositional Factors

7. A key feature in CEECs with relatively high GDP per worker (Croatia, Poland, Hungary, Czech Republic, and Slovak Republic) has been the relatively high level of fixed investment. In the Czech Republic, fixed investment was relatively high during 1995– 97 at 31 percent of GDP, while in the Slovak Republic, it was even higher (32–36 percent of GDP) between 1996–98. In more recent years, fixed investment in these two countries stabilized at a lower, yet healthy level of 26–27 percent of GDP. On the other hand, in Poland, after continuously increasing through 1995–2000 to reach 24 percent of GDP, fixed investment dropped to stabilize at a lower level of 18–19 percent of GDP. In Hungary, fixed investment increased slightly from its 1995 level (20 percent of GDP) and has remained stable at around 23 percent of GDP since 1998. Fixed investment in Croatia started out at a relatively low level of 16 percent of GDP but reached a level comparable to the Czech Republic in 2003 (27 percent of GDP).

8. The countries with the lowest GDP per worker—Serbia, Bulgaria, and Romania—have fixed investment rates that, while increasing since 2001, remain comparatively modest. In Bulgaria, fixed investment only started to pick up in 2001, from an average of 15 percent in 1995–2000, increasing gradually to about 24 percent in 2005. In Romania, fixed investment declined between 1996–99 from 23 to 18 percent of GDP, but the trend reversed in 2000, reaching 23 percent of GDP by 2005. Fixed investment in Serbia has been increasing since 2001, although it was still at a low level of 19 percent of GDP in 2004; however, data before 2004 are unreliable. This evidence suggests that, to some degree, low investment ratios in Serbia reflect the relatively low capital intensity of production (hence, low GDP per capita). But if GDP per capita is to rise in Serbia, then capital intensity and investment ratios will likely need to rise also.

9. The sectoral composition of investment is also unusual in Serbia. For the CEEC group, private fixed investment accounts for the bulk of total investment, while the public share accounts for less than 5 percent of GDP. Thus, since the start of the transition in Poland, Hungary, Czech Republic, and Slovak Republic, public investment has remained around 3–5 percent of GDP, was around 2 percent of GDP in Romania and Bulgaria. Only Croatia, where it is recorded at 6–7 percent of GDP, is relatively high. But even against Croatia’s record, Serbia stands out with public investment—including the large socially owned sector—relatively high at 10–11 percent of GDP. That said, Serbian general government investment is low at about 3 percent of GDP.

10. Serbia follows CEEC norms in the physical composition of investment. The ratio of construction relative to equipment investment is 3:2 in Czech Republic, Hungary, Poland, Romania, and Serbia, and 2:1 in Croatia. Nevertheless, low total investment in Serbia means that whereas in Croatia, the Czech Republic, Hungary, Poland, and the Slovak Republic, investment in construction is about 10–14 percent of GDP, in Serbia it is a low 7 percent of GDP.

D. Current Account Deficits and External Debt Developments

11. Although current account deficits often move in tandem with investment, external debt accumulation depends on the magnitude of non-debt creating flows, such as foreign direct investment (FDI). The two countries with the highest fixed investment, the Czech Republic and the Slovak Republic, financed the increase in investment quite differently. While both countries had a comparable level of fixed investment at the beginning of the transition period (30 and 33 percent of GDP respectively), in the Czech Republic, the current account deficit was about only 4.4 percent of GDP, indicating a high level of domestic saving, while in the Slovak Republic, it was on average 8.4 percent. External debt developments indicate that part of the current account deficit was financed through foreign borrowing in both countries. However, debt accumulation in the Slovak Republic was much higher (from 30 percent of GDP in 1995 to 52 percent of GDP in 1999) because of both its higher current account deficit and relatively low FDI inflows. In the meantime in the Czech Republic, external debt increased only from 30 percent in 1995 to 38 percent in 1999 due to higher FDI—including privatization—inflows. It is only in the later stages of transition (2000–03) that FDI inflows in the Slovak Republic exceeded current account deficits, even reaching 16 percent of GDP in 2002, more than twice the current account deficit. In the Czech Republic, FDI inflows continued to outpace current account deficits. As a result external debt seems to have stabilized at about 36 percent of GDP for the Czech Republic, while it is increasing continuously in the Slovak Republic.

12. In Hungary and Poland, low FDI flows relative to external imbalances led to significant external debt accumulation. In 1996–99, high fixed investment (around 23 percent of GDP) and large current account deficits were accompanied by external debt accumulation. In Poland, while the decline in fixed investment since 2001 reduced the current account deficit to about 2 percent of GDP, debt accumulation continued along with the decline in FDI inflows, requiring greater debt-financing. In Hungary, external debt declined between 1995–97 due to large FDI inflows, but increased again in 1998–99 when current account deficits almost doubled without a corresponding increase in FDI flows. Similarly, in 2002–03, a decline in FDI inflows without a reduction in current account deficits was associated with an increase in external debt. Patterns in Croatia and Serbia were similar, with FDI flows modest, certainly up to 2003, relative to external deficits. This put upward pressure on external debt ratios.

13. Econometric analysis points further to the nature of links between domestic capital formation and external debt. It suggests for the CEEC group that for a given level of gross investment, an increase in public investment is associated with a widening of the current account deficits whereas increases in private investment are not. A panel estimation (using a random effect GLS for unbalanced panel) was run with the current account deficit as the dependant variable and gross investment, public, and private investment as a percent of GDP as independent variables. We find that for a given level of gross investment, a percentage point increase in public investment as a share of GDP is associated with a 0.6 percentage point increase in the current account deficit as a percent of GDP. In contrast, we find no significant effect of a change in private investment on the current account balance. This points to the role of non-debt creating financing of private capital formation—notably internal financing by firms, and to the more debt intensive financing of public—including state-owned—investment.

14. Thus, Serbia is atypical in several ways. Overall investment rates are atypically low, even taking low income per capita into account, their composition is skewed towards public investment, with adverse consequences for the external deficit and debt, and relatively low rates of FDI financing compound these difficulties.

15. Key implications for Serbia, given its large external deficit and high external debt, are the need for higher investment and the requirement to finance it by raising national savings and non-debt creating flows. While Serbia’s investment level in 2004 is comparable to the level of Croatia and Poland at the start of their transition, these countries had comparatively low external deficits and less than half of Serbia’s external debt-to-GDP ratio. There, a strong base of domestic savings also meant that the widening of current account deficit, associated with the high investment that jumpstarted the transition, did not push external debt to unsustainable levels. In the case of Croatia, financing the external deficit through external borrowing was feasible, while in Poland, the relatively large FDI inflows helped to limit external debt accumulation. Increased domestic savings will thus likely be key to Serbia’s investment, and hence its medium-term growth prospects.

Figure 2.
Figure 2.

Selected CEEC and SEE countires: Current Acount Defict, FDI Inflows and External Debt (In percent of GDP), 1995-2005

Citation: IMF Staff Country Reports 2006, 382; 10.5089/9781451833638.002.A002

Sources: National Authorities and IMF staff estimates.
1

Prepared by Haimanot Teferra and Eric Mottu.

2

In addition to Serbia, the Central and Eastern European Countries considered are Bulgaria, Croatia, the Czech Republic, Hungary, Poland, Romania, and the Slovak Republic.

Republic of Serbia: Selected Issues
Author: International Monetary Fund
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    Selected CEEC and SEE Countries: Gross Investment, Current Account Deficit and External Debt (In percent of GDP), 1995-2005

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    Selected CEEC and SEE Countries: Gross Investment, Current Account Deficit and External Debt (In percent of GDP), 1995-2005

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    Selected CEEC and SEE countires: Current Acount Defict, FDI Inflows and External Debt (In percent of GDP), 1995-2005