Republic of Serbia
Staff Report for the 2010 Article IV Consultation, Third Review Under the Stand-By Arrangement, and Financing Assurances Review

This 2010 Article IV Consultation highlights that the authorities’ adjustment program has contributed to limiting the fallout of the global crisis on Serbia. Although the output slump has been limited relative to regional peers, the decline in domestic demand has been significant, resulting in a strong external adjustment. The outlook for 2010 points to a slow but balanced recovery. The pickup in growth will likely be moderate, reflecting slow trading-partner recovery, protracted corporate deleveraging, nominal freezes in public wages and pensions, and lagging labor market adjustment.

Abstract

This 2010 Article IV Consultation highlights that the authorities’ adjustment program has contributed to limiting the fallout of the global crisis on Serbia. Although the output slump has been limited relative to regional peers, the decline in domestic demand has been significant, resulting in a strong external adjustment. The outlook for 2010 points to a slow but balanced recovery. The pickup in growth will likely be moderate, reflecting slow trading-partner recovery, protracted corporate deleveraging, nominal freezes in public wages and pensions, and lagging labor market adjustment.

I. Background

A. Pre-Crisis Macro Diagnostics

1. Before the global financial crisis hit in late-2008, Serbia enjoyed fast-paced GDP growth. Starting from a low base, GDP growth during 2004-08 accelerated to 6¼ percent, reflected in rapid convergence to EU income levels.

uA01fig01

Real GDP Convergence in Emerging Europe, 2004-08

Citation: IMF Staff Country Reports 2010, 093; 10.5089/9781455205622.002.A001

Sources: World Bank; and IMF staff calculations.1/ Speed of convergence measured as the average annual percent change in the index of PPP per capita income.

2. But Serbia’s growth acceleration was accompanied by four troubling symptoms (Figure 1):

  • Lagging tradable sector growth: Growth was strongly tilted toward nontradables, in particular transport and communications, retail trade, and financial services (Table 4).

  • Low domestic savings: With domestic savings close to nil, the economy’s investment level was effectively constrained by remittances from abroad—which were trending downward—and the availability of foreign savings (Table 5).

  • Extensive foreign-exchange (FX) lending: High loan euroization, even if direct cross-border FX loans to Serbian corporates are excluded, in an economy dominated by nontradable producers led to the buildup of large unhedged FX positions.

  • High inflation: Average inflation during 2004-08 was the highest in the region.

Figure 1.
Figure 1.

Eastern Europe: Symptoms of Unsustainable Growth Accelerations, 2004-08

Citation: IMF Staff Country Reports 2010, 093; 10.5089/9781455205622.002.A001

Source: WEO.1/ Tradable sectors defined as agriculture, mining, manufacturing, and tourism. Nontradable sectors defined as including all other services, utilities, and construction.2/ Excluding cross-border loans to Serbian corporates; including cross-border loans, loan euroization would amount to about 83 percent.
Table 1.

Serbia: Quantitative Conditionality Under the SBA, 2008–10 1/

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As defined in the Letter of Intent, the Memorandum on Economic and Financial Policies, and the Technical Memorandum of Understanding.

Cumulative from January 1.

Excluding loans from the IMF, EBRD, EIB, EU, IBRD, KfW, CEB, Eurofima, IFC, and bilateral government creditors, as well as debt contracted in the context of restructuring agreements.

Table 2.

Serbia: Performance for Third Review

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Table 3.

Serbia: Selected Economic and Social Indicators, 2006–11

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Sources: Serbian authorities; and IMF staff estimates and projections.

Fiscal balance adjusted for the automatic effects of both the output gap and the current account gap.

Table 4.

Serbia: Real GDP Growth Components, 2004–11

(Percent)

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Sources: Serbian Statistical Office; and IMF staff estimates and projections.

Contributions to GDP growth.

Table 5.

Serbia: Savings-Investment Balances, 2004–15

(Percent of GDP)

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Sources: Statistics Office; National Bank of Serbia; Ministry of Finance; and IMF staff estimates and projections.

Equal to GDP minus domestic demand.

3. These symptoms were rooted in four unfavorable fundamentals of Serbia’s economy (Figure 2). First, the economy’s supply side was hampered by slow and inconsistent efforts at privatization, reflected in a relatively small private sector, and a difficult business climate, particularly for export-oriented firms that need to operate in the formal sector. Second, the large government sector invested little in the country’s future, as indicated by high untargeted spending on social transfers and a high public wage bill relative to public investment. Third, notwithstanding high unemployment, public-sector-led wage settlements often far exceeded targeted inflation and labor productivity growth, undermining the economy’s cost competitiveness. And fourth, reflecting the severe monetary instabilities of the 1990s, inflation expectations remained stubbornly high relative to actual inflation.

Figure 2.
Figure 2.

Eastern Europe: Adverse Fundamentals Underlying Unbalanced Growth, 2008–10

Citation: IMF Staff Country Reports 2010, 093; 10.5089/9781455205622.002.A001

Sources: EBRD; National Bank of Serbia; Agency Strategic Marketing; and IMF staff calculations.1/ Public investment may be understated in countries making significant use of public-private partnerships.2/ Nominal wage growth minus targeted inflation rate minus productivity growth.

4. A policy response sufficient to rebalance the economy did not emerge. The authorities undertook efforts, until 2006 under the aegis of IMF-supported programs, to foster more balanced growth: some public investment programs were launched to address infrastructure gaps, but implementation was slow; inflation targeting was adopted to better anchor inflation, but inflation expectations remained stubbornly above actual inflation; and prudential and supervisory rules were tightened to increase capital and liquidity buffers in the banking system, but foreign banks used direct cross-border loans to circumvent these rules. In a setting of volatile politics, the authorities’ responses remained too fragmented to ensure a more sustainable growth acceleration.

B. Financial Crisis Spillovers and Policy Responses

5. By 2008, a massive absorption gap had opened up, with excess domestic spending mainly reflected in a ballooning external imbalance. Absorption (domestic demand) growth before the crisis far outpaced the rate consistent with internal and external balance, reflected mainly in a surge of imports and a widening external imbalance. However, a tide of capital inflows, intermediated by the largely foreign-owned banking system, smoothly financed the rapidly widening current account gap.

Serbia: Internal and External Imbalances, 2005-08

(Percent of potential GDP)

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Source: IMF staff estimates.

Absorption gap defined as actual minus sustainable level of absorption.

Current account gap defined as actual minus estimated equilibrium current account deficit.

6. In late-2008, the global financial crisis rapidly spilled over to Serbia through both finance and trade channels (Figure 3). Country risk indicators soared, capital inflows stopped suddenly, households withdrew a sizeable share of their deposits, and both exports and imports plunged.

Figure 3.
Figure 3.

Serbia: Global Financial Crisis Spillovers 2008-10

Citation: IMF Staff Country Reports 2010, 093; 10.5089/9781455205622.002.A001

Sources: National Bank of Serbia; and Bloomberg.

7. Faced with a large projected external financing gap, the authorities adopted a three-pronged approach, embedded in an IMF-supported SBA:

  • Fiscal adjustment to facilitate external rebalancing, buttress market and public confidence, observe tight financing constraints, and restore fiscal sustainability.

  • Private sector involvement as part of an innovative Financial Sector Support Program (FSSP), including assurances from foreign parent banks to at least maintain their external exposures to Serbia, while keeping their subsidiaries capitalized and liquid.

  • External financing from IFIs and the EU to close the remaining gap.

8. Fiscal adjustment in 2009 was in line with plans (Table 6). The economy’s abrupt downturn unmasked a weak underlying fiscal position—the structural fiscal deficit in 2008 is estimated at 4½ percent of GDP. The revenue-GDP ratio dropped sharply in line with the contracting absorption gap, while spending was restrained through nominal freezes of public wages and pensions but also cuts in capital spending.

Table 6a.

Serbia: General Government Fiscal Operations, 2008–2012 1/

(Billions of RSD)

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Sources: Ministry of Finance; and IMF staff estimates and projections.

Includes the republican budget, local governments, social security funds, and the Road Company.

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

Including clearance of arrears of the Road Company.

Table 6b.

Serbia: General Government Fiscal Operations, 2008–2012 1/

(Percent of GDP)

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Sources: Ministry of Finance; and IMF staff estimates and projections.

Includes the republican budget, local governments, social security funds, and the Road fund.

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

Actual fiscal balance adjusted for the automatic effects of both the output gap (internal imbalance) and the current account gap (external imbalance) on the fiscal position.

Percentage deviation between actual absorption and the level consistent with internal and external balance.

Percentage deviation of actual from potential GDP.

Including clearance of arrears of the Road Company.

Serbia 6c:

Intergovernmental Fiscal Operations, 2010 Program

(Billions of dinars)

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Source: Ministry of Finance; and IMF staff estimates.

Including Vojvodina.