High capital inflows and rising vulnerabilities underscore the importance of a comprehensive approach to ensuring stability. Standard balance sheet indicators mask a substantial build-up of exposures to exchange rate, maturity, and rollover risks. Household balance sheet risks originate from currency mismatches owing to credit euroization. The fiscal balance has a strong and significant impact on the current account in Serbia. The model is broadly able to reproduce recent economic and policy developments in Serbia. The analysis indicates that privatization can result in sizable fiscal savings.

Abstract

High capital inflows and rising vulnerabilities underscore the importance of a comprehensive approach to ensuring stability. Standard balance sheet indicators mask a substantial build-up of exposures to exchange rate, maturity, and rollover risks. Household balance sheet risks originate from currency mismatches owing to credit euroization. The fiscal balance has a strong and significant impact on the current account in Serbia. The model is broadly able to reproduce recent economic and policy developments in Serbia. The analysis indicates that privatization can result in sizable fiscal savings.

I. Overview of Vulnerabilities1

Objective: To provide an integrated assessment of Serbia’s vulnerabilities.

Main findings: Despite improvements in public sector finances, external and financial vulnerabilities have increased in recent years, as reflected in the rapidly rising current account deficit, external debt, and highly euroized private credit. Moreover, the high official reserves may be only partly available to mitigate risks due to large short-term obligations of the central bank.

Policy implications: A comprehensive approach, underpinned by structural reforms and strong fiscal and financial sector policies, is critical to reduce the growing imbalances.

1. As most countries in Eastern Europe, Serbia started its transition with large investment needs and limited resources, implying high borrowing needs. The resulting external deficits have been accumulated with the expectation that improved policies and structural reforms would spur economic activity and thus ensure medium-term sustainability.

2. But several years into transition, economic policies seem to be lagging behind the growing imbalances, which has made the country more vulnerable (Figure 1). In the public sector, one-off factors have improved finances and key indicators, although the resurgence of fiscal deficits in 2006–07 is worrisome. These slippages combined with so far slow structural reforms and, consequently, a vulnerable corporate sector have raised private sector external vulnerabilities. The latter are reflected in the persistently rising current account deficits and private sector external indebtedness, against a backdrop of a small and poorly diversified export sector. Alongside, a combination of rapid growth of household credit, high euroization, and surging off-shore borrowing by enterprises has increased vulnerabilities in the financial sector. This chapter provides an overview of the key sectoral vulnerabilities.

Figure 1.
Figure 1.

Economy-Wide Vulnerability Indicators 1/

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A001

1/ Outward shift denotes worsening.

A. Public Sector Vulnerabilities

3. Several one-off factors have reduced public sector vulnerabilities in recent years. General government debt more than halved since 2002 due to Paris and London Club debt restructuring, strong fiscal performance in 2004–05 and large privatization-related receipts since 2005 (Table 1).

Table 1.

Public Sector Vulnerability Indicators

(in percent of GDP, unless indicated otherwise)

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Sources: Serbian authorities and Staff estimates.

Includes central bank obligations. The 2007 projection is based on the stock of NBS bills as of October 2007.

As of end-October 2007.

4. Besides reducing the level of external public debt, these factors also improved its composition (Table 2). At present, over 80 percent of external public debt is owed to non-private creditors, suggesting little rollover risks. Maturities are also favorable, as most loans are either medium- or long-term.

Table 2.

External Public Debt, Aug. 2007

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Source: NBS.

5. But these gains are not sustainable without long-lasting improvements in flow balances—inconsistent with the recent fiscal slippages. Following gradual improvements in 2002–05, fiscal policies sharply reversed posting deficit in 2006 and 2007. Combined with generous pay raises in the public sector, these slippages forced a tighter monetary policy. This, in turn, contributed to a rise in the stock of central bank securities (about 8 percent of GDP) and an appreciation, resulting in quasi-fiscal losses of the central bank (over one percent of GDP in 2006). Moreover, the resulting burst in aggregate demand further fueled current account deficits, thereby aggravating external sector vulnerabilities. In combination with accelerated spending of the one-time privatization receipts, these imbalances, if continued, can revive public sector vulnerabilities in the years ahead.

B. External Sector Vulnerabilities

6. Structural policy weaknesses ultimately resulted in a relatively slow transformation of Serbia’s productive sectors. Consequently, the rising import demand and large capital inflows, half of which were debt-creating, have been by far outpacing domestic supply. This translated into sharply rising current account deficits (Figure 2).

Figure 2.
Figure 2.

External Debt and Current Account

(in percent of GDP)

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A001

Source: National Bank of Serbia.

7. The persistent external deficits were partly financed by rapid accumulation of private external debt. External indebtedness of the private sector more than doubled in the past three years. Over three quarters—or 100 percent of exports—is owed by the domestic non-bank sector which is not fully hedged against exchange rate risks. And whereas the external debt in the public sector declined because of one-time external receipts, the hikes in private indebtedness are due to persistent structural imbalances between domestic spending and saving.

8. These developments are particularly worrying given a small export base. The volume of exports currently stands at only 27 percent of GDP—one of the lowest in the region—and just over half of the country’s imports. And the seemingly high growth of exports—which increased by over 8 percentage points of GDP since 2002—is still below average in Emerging Europe (Figure 3).

Figure 3.
Figure 3.

Exports in Selected Emerging Market Economies

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A001

Sources: WEO, NBS, and IMF Staff estimates

9. Furthermore, Serbia’s exports are not well diversified. Metals and food items represent over 40 percent of Serbia’s exports, making it vulnerable to terms-of-trade shocks. The high import content of exports further lowers the effective foreign exchange receipts.

10. The combination of high external deficits and export weaknesses make Serbia one of the vulnerable economies in the region. In a sample of 17 emerging European market economies, three countries—Bulgaria, Estonia and Latvia—have current account deficits larger than that of Serbia (Figure 4). Unlike Serbia, however, these countries are members of the EU and have export sectors that are 2-3 times larger than Serbia’s.

Figure 4.
Figure 4.

Current Account and Exports in Selected European Emerging Economies, 2006

(percent of GDP)

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A001

Sources: WEO, NBS, and IMF Staff estimates.

11. High official reserves mitigate the rising external vulnerabilities, but they need to be interpreted taking into consideration the central bank’s contingent liabilities (Figure 5). Gross official reserves have more than tripled since 2004, reaching USD 14 billion or 7.5 months of imports in 2007—the highest in the region. However, rapid reserve accumulation was partly a result of the prudential tightening and increased reserve requirements on commercial banks’ foreign exchange liabilities in 2006. This boosted commercial banks’ foreign currency deposits to about USD 5 billion. Because these deposits represent commercial banks’ obligations to the domestic and foreign private sectors, the central bank cannot fully rely on them in times of distress.

Figure 5.
Figure 5.

Forex Reserves and NBS Securities

(billions of USD)

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A001

Source: National Bank of Serbia.

12. This lowers the effective official reserve coverage and brings it closer to regional levels (Table 3). High commercial bank deposits obscure cross-country comparisons of reserve coverage ratios because in many of Serbia’s peers, banks are either allowed or required to maintain reserves in local rather than foreign currency. After taking this into consideration, Serbia’s import cover drops to 4.6 months of imports, which is not significantly higher—accounting for disparities in currency account deficits—than in the rest of the Southeastern Europe.

Table 3.

Reserve Coverage in Selected SEE Economies, 2006

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Sources: Glen and Singh (2004), NBS and Staff estimates.

Gross reserves in months of imports.

Share of forex deposits of commercial banks at the central bank in gross reserves.

Com. bank deposits were estimated based on forex liabilities of com. banks and the 40% reserve requirement.

13. Furthermore, the large stock of short-term central bank securities presents an additional risk to official reserves. The tight monetary policy in 2006–07—and the associated high dinar/euro interest rate differentials—attracted over USD 3 billion in commercial banks’ investments in the two-week repo securities. Despite their dinar denomination, the investments also reflected carry trade by foreign banks, and were a major driving force behind the fast reserve accumulation. Thus, a shock to investors’ confidence in the dinar could to lead to major pressures on reserves. Notwithstanding Serbia’s floating exchange rate regime, such pressures need to be accounted for as a contingency when examining reserve coverage. After subtracting both the commercial banks’ deposits and the stock of NBS bills, official reserves drop to just about 3 months of imports, underscoring the underlying vulnerability.

C. Financial Sector Vulnerabilities

14. The banking sector underwent a significant transformation in the past five years (Figure 6). Increased foreign presence (over 70 percent of the market) brought about technological innovation, new credit products, and access to credit lines from abroad. As a result, bank assets more than quadrupled since 2002 and their composition is more diverse.

Figure 6.
Figure 6.

Deposit Banks: Structure of Assets

(Billions of RSD)

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A001

Source: National Bank of Serbia.

15. Along with growth of the banking sector, household credit also surged. Virtually non-existent before 2002, it expanded almost tenfold, reaching 22 percent of bank assets and 12 percent of GDP as of October 2007 (Table 4). The share of Serbia’s household credit in GDP is still among the lowest in the region (Figure 7). This partly fits the common “catch up” explanation of the credit booms in Eastern Europe. That is, that the invigoration of domestic credit markets prompted consumers to use credit to smooth their consumption along Serbia’s transition path.2 A comparison with regional averages suggests scope for further accumulation of household debt.

Table 4.

Household Credit.

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Source: National Bank of Serbia.
Figure 7.
Figure 7.

Household Credit and Euroization in Selected European Emerging Market Economies, 2006

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A001

Sources: WEO, NBS, and Staff estimates.

16. However, there is less clarity about the appropriate speed of convergence to higher levels of household debt. Besides longer transition tenures, most of Serbia’s peers have gone through much lengthier periods of macro stability and structural transformation, suggesting important differences in these countries’ fundamentals. Moreover, household credit growth is also driven by banks’ ambitious market share targets, which may lead to concerns over asset quality due to the rapid growth, rather than level, of household credit. In addition, the speed of convergence should be assessed through the prism of the multiplicity and intertwinement of Serbia’s vulnerabilities. Even in the absence of immediate credit risks arising from the level of debt relative to measures of household income, such as GDP, vulnerabilities in other areas—notably external—may constrain the households’ effective debt-carrying capacity.

17. High credit euroization and significant external vulnerabilities suggest—even after controlling for low debt to GDP ratios—a lower debt-carrying capacity of Serbia’s households relative to its neighbors. The share of forex-denominated and forex-indexed domestic credit exceeds 70 percent and is among the highest in emerging Europe (Figures 7 and 8), exposing borrowers in Serbia to larger currency risks. In addition, low exports, rapidly growing euroized liabilities in the corporate sector, and other external vulnerabilities discussed above are closely linked to the financial sector. In these circumstances, even moderate disturbances may eventually lead to changes in the household sector’s balance sheets and could quickly spill over to the rest of the economy. These considerations suggest that on balance, the current rapid growth of household credit is making the country more vulnerable, and that there is a need for reforms that could boost economic growth, thereby creating space for additional household borrowing and allowing consumption smoothing without jeopardizing sustainability.

Figure 8.
Figure 8.

Household Credit and Euroization

(percent)

Citation: IMF Staff Country Reports 2008, 055; 10.5089/9781451834901.002.A001

18. The rapid growth of household credit also creates uncertainty about the quality of banks’ loan portfolios. Over 20 percent of bank loans are classified as risky.3 Although time series data on non-performing loans is not available, a survey of the nine largest banks conducted by the NBS revealed a rise in household NPLs by 43 percent during the first half of 2007. Despite the relatively modest level of household NPL, 4 these trends are worrisome given the rapid growth of the overall loan volumes.

19. These uncertainties prompted the central bank to take a tight prudential stance. In 2006, the NBS to raised reserve requirements on commercial banks’ forex liabilities, while in August 2007, it introduced additional regulations limiting retail lending to 150 percent of banks’ capital and shortening the maturity of cash loans from ten to two years.

20. But so far, the measures seem to have caused disintermediation and higher external borrowing with a mixed net impact on financial sector vulnerabilities. In response to tighter regulations, domestic lending to enterprises slowed down considerably and its share in banks’ assets dropped by ten percentage points since 2005. Alongside, direct off-shore borrowing by enterprises rose sharply during the same period (Table 5). 5 On one hand, the disintermediation lowered financial sector vulnerabilities by transferring some credit risks away from the domestic banking system 6 and lowering interest rates. But it also exposed the corporate sector to heightened exchange rate risks and created moral hazard because more risky borrowers will generally be less able to borrow off-shore. Similarly, the initial slowdown of household credit growth in September 2007, was followed by acceleration in October and November, indicating circumvention.

Table 5.

External Private Debt, 2005-07 1/

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Source: National Bank of Serbia.

The 2007 numbers are through August.

D. Concluding Remarks

21. High capital inflows and rising vulnerabilities underscore the importance of a comprehensive approach to ensuring stability in the context of transition. Such an approach could be threefold, reflecting the need to strengthen aggregate supply, contain growth of domestic demand, and minimize vulnerabilities stemming from the rising mismatches in the private sector. Strong structural reforms are crucial to improving the economy’s capacity to efficiently absorb foreign inflows in a sustainable fashion, and to generate domestic savings. This includes continued restructuring, privatization, and improvements in the business environment. Greater absorptive capacity, in turn, would eventually lower pressures on the public sector. In the meantime, however, constraining public spending is important to create space for rising private demand, while helping to reduce the external deficit and alleviating pressures on monetary policy. Finally, financial sector policies need to explore ways of limiting exposures to exchange rate risks.

References

  • International Monetary Fund, 2006, “Household Credit in Emerging Market Economies,” Global Financial Stability Report, September (Washington).

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  • International Monetary Fund, 2007a, “Managing Rapid Financial Deepening in Emerging Europe,” Regional Economic Outlook: Europe, November (Washington).

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  • International Monetary Fund, 2007b, “Country and Regional Perspectives,” World Economic Outlook, October (Washington).

1

Prepared by Tokhir Mirzoev (EUR).

2

IMF (2006, 2007a, 2007b) discuss rapid credit growth in emerging European economies.

3

This represents the share of loans in C, D, and E risk categories, which, among other criteria, include loans to borrowers with repayments overdue by over 90 days, and are subject to 20-100 percent provisioning. The overall NPL ratio of the nine largest banks surveyed by the NBS in June 2007 stood at 10.4 percent.

4

The household NPL ratio of these nine banks stood at 4.4 percent. See chapter III for a more detailed analysis of household sector vulnerabilities.

5

Chapter II discusses corporate sector vulnerabilities in greater detail

6

Many off-shore loans are guaranteed by domestic banks which raises financial sector vulnerabilities.

Republic of Serbia: Selected Issues
Author: International Monetary Fund