Republic of Serbia: Sixth Review Under the Stand-By Arrangement

Republic of Serbia: Sixth Review Under the Stand-By Arrangement


Republic of Serbia: Sixth Review Under the Stand-By Arrangement

Executive Summary

The export-led economic recovery has gained momentum, but external risks remain significant. GDP growth is picking up on the back of a competitive exchange rate and rebounding industrial output and exports. Growth is still projected at 1½ and 3 percent in 2010 and 2011, respectively. However, foreign financing risks remain elevated in the context of a still large trade deficit and subdued capital inflows. There are also still significant risks from fresh adverse spillovers from the region and from euro-area periphery developments.

The continued depreciation of the dinar is putting pressure on corporate balance sheets, but banks remain well buffered. The dinar has further depreciated since the Greek crisis, diverging from other flexible currencies in the region, negatively affecting unhedged corporate balance sheets. Serbia’s banking system is liquid and well-provisioned against credit risks but continued vigilance is needed.

Inflation has picked up, resurfacing as a key policy concern. Inflation was consistently below the NBS’ tolerance band during the first half of 2010, but has recently exceeded the band. This reflects mainly food price shocks and depreciation pass-through effects, despite slow nominal wage costs growth and a still-significant output gap. The NBS has hiked the policy rate by 250 basis points since August, and has signaled a continued tightening bias, with the objective of bringing inflation within its tolerance band by end-2011.

In November, the government adopted a 2010 supplementary budget aiming at a fiscal deficit consistent with the program target. Space created by underspending on capital and interest was re-allocated to pressing priorities, including social assistance programs.

The 2011 budget will target a deficit of about 4 percent of GDP, in line with the new fiscal responsibility framework. Achieving this target will require tight control of current spending, including moderating the indexation of public wages and pensions, as well as constraining capital spending. With government financing becoming more difficult, as evidenced by undersubscribed dinar T-bill auctions in spite of higher yields, Telekom privatization proceeds will likely be needed to cover a major part of the financing needs.

The government amended the pension reform law. While the draft law retains most elements of the reform agreed during the fourth review of the SBA, it introduced two changes aimed at strengthening protection for the most vulnerable and women. The Serbian pension system will remain one of the most expensive systems in the region, and further reforms are likely unavoidable.

I. Recent Developments

1. The SBA is broadly on track, but fresh economic and political tensions have emerged. All end-September performance criteria were met. But inflation has increased sharply over recent months and exceeded the upper limit of the inflation consultation target band for end-September (Tables 12). Depreciation pressures have continued. With elections looming, the coalition government’s resolve to maintain spending discipline is wavering. Moreover, under heavy pressure from trade unions, the government re-called the draft pension law that was submitted to parliament in June as a prior action for the fourth review, and made concessions on some of the reform provisions. Re-submitting the draft pension law and submitting the 2011 budget to parliament are prior actions for the sixth review.

Table 1.

Serbia: Quantitative Conditionality Under the SBA, 2009–10 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, Eurofima, CEB, IFC, and bilateral government creditors, as well as debt contracted in the context of restructuring agreements.

Table 2.

Serbia: Performance for Sixth Review

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While the inflation number marginally exceeded the upper limit of the inflation consultation clause, it did not exceed the 1 percentage point deviation that would require a Board consultation.

Remaining reforms related to this structural benchmark to be completed by end-February 2011 (TMU ¶22).

2. An export-led recovery has gained momentum, but the external trade imbalance remains high. GDP growth is picking up, led by rebounding industrial output and exports, helped by the dinar’s sharp real depreciation (Tables 35). Exports to the EU are thriving and have recovered to near pre-crisis level (Figure 1). However, exports to Serbia’s regional trading partners are lackluster, as these economies lag Serbia’s recovery. Key nontradable sectors, the main drivers of the pre-crisis growth boom, remain depressed, with their mostly unhedged balance sheets hard hit by the depreciation. At the same time, and notwithstanding double-digit export growth, Serbia’s large external trade deficit is projected to remain elevated, as imports have also started to recover.

Figure 1.
Figure 1.

Serbia: Output Indicators

Citation: IMF Staff Country Reports 2011, 009; 10.5089/9781455213634.002.A001

Sources: Serbian authorities and WEO October 2010.1/ Bosnia and Herzegovina, Bulgaria, Croatia, Macedonia FYR, and Romania.2/ The 3-month moving averages for each month expressed in euros are compared with the same month during the pre-crisis period (defined as October 2007-September 2008).3/ Includes Albania, Bosnia and Herzegovina, Croatia, Kosovo, Macedonia FYR, Moldova, Montenegro, and Serbia.
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 on the fiscal position and for social transfers associated with the financial crisis.

Table 5.

Serbia: Balance of Payments, 2008–15 1/

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Sources: NBS; and IMF staff estimates and projections.

Some estimates, in particular for private remittances and reinvested earnings, are subject to significant uncertainty. In addition, intercompany loan transactions are not identified and are recorded as debt flows rather than FDI flows.

3. The dinar has continued to depreciate, notwithstanding FX interventions. Following the depreciation triggered by the Greek crisis, the dinar has remained under pressure, diverging further from trends in other flexible currencies in the region (Figure 2). With the dinar now likely somewhat undervalued, the NBS has continued intervening in the FX market. FDI and other inflows to enterprises have come in significantly lower than expected, reflecting Serbia’s relatively high country-risk premium and banks’ concerns about unhedged corporate balance sheets, particularly in the nontradable sectors, which absorbed most of the pre-crisis capital inflows (Tables 57). Moreover, government dinar T-bill auctions have remained undersubscribed, notwithstanding high offered nominal yields.

Figure 2.
Figure 2.

Serbia: Exchange Rate and Sovereign Risk, 2008-10

Citation: IMF Staff Country Reports 2011, 009; 10.5089/9781455213634.002.A001

Sources: National Bank of Serbia; Bloomberg; and WEO.
Table 7.

Serbia: External Balance Sheet, 2008-15 1/

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Sources: NBS; and IMF staff estimates and projections.

NBS estimates for gross external debt and international reserves. Stock data for other items are staff estimates based on flows since the

+ denotes a net asset position, - a net liability.

Staff estimates (available data on gross external debt assets and other items is not sufficient to accurately estimate the breakdown public/pr

Intercompany loans cannot be identified and are included in external debt rather than in FDI position.

4. Inflation has surprised on the upside, re-emerging as a key policy concern. Inflation was consistently below the NBS’ tolerance band during the first half of 2010 (Figure 3). However, since August, inflation has accelerated sharply, reaching 8.9 percent in October, above the NBS tolerance band of 6.3±2 percent. This occurred despite the continued dampening effect of slow nominal wage costs growth, owing to a depressed labor market and the public wage freeze, and a still significant output gap. The inflation surge reflects three main factors:

  • Food price shocks. Prices have risen due to the effects of bad weather and global food price trends (Serbia is a food exporter), which have been amplified by structural rigidities in domestic food markets, including high trade barriers.

  • Depreciation pass-through effects. Past dinar depreciation is becoming increasingly visible in consumer prices as price setters try to restore compressed profit margins.

  • Rising import prices in foreign currency. Even absent the pass-through, import prices are recovering from their crisis lows, and no longer help restrain inflation.

Figure 3.
Figure 3.

Serbia: Inflation and Monetary Policy, 2008–11

Citation: IMF Staff Country Reports 2011, 009; 10.5089/9781455213634.002.A001

Sources: National Bank of Serbia; Statistical Office of Serbia; and IMF staf f estimates and projections.1/ Average of surveys of the financial sector.

In response to the fresh inflation pressures, the NBS has hiked the policy rate by 250 basis points in four steps since August, while stressing in its communication the relatively persistent but temporary nature of shocks (food prices, FX pass-through) driving inflation.

5. Dinar depreciation and a slow recovery have left many corporate balance sheets overleveraged, but Serbia’s banking system is well-buffered. The net financial position of the corporate sector vis-à-vis the banking system has deteriorated by about 15 percent of GDP since the start of the crisis, mainly reflecting the impact of dinar depreciation. Blocked corporate accounts and corporate non-performing loans have surged (Figure 4). However, reflecting conservative NBS provisioning requirements, Serbia’s banking sector is exceptionally well-provisioned against credit risks, and should be able to absorb even a protracted corporate restructuring process (Table 8).

Figure 4.
Figure 4.

Serbia: Corporate Balance Sheet and Banks' Buffers, 2008-10

Citation: IMF Staff Country Reports 2011, 009; 10.5089/9781455213634.002.A001

Source: National Bank of Serbia; and GFSR.1/ Financial assets minus liabilities of enterprises vis-à-vis the banks, including cross-border loans. The valuation effect reflects the impact of the currency depreciation.2/ Data for 2010 is through August.
Table 8.

Serbia: Banking Sector Financial Soundness Indicators, 2005-10

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Source: National Bank of Serbia.

Ratio of total provisions for potential losses for on and off-balance sheet exposures to gross NPLs.

Gross operating income in this ratio excludes FX gains due to their volatility and distortionary impact.

Non-interest expenses in the calculation of this ratio abstracts from FX losses.

Cash, repos, t-bills, and mandatory reserves.

Sum of first- and second-degree liquid receivables of the bank.

Includes only risk-classified off-balance sheet items.

II. Policy Discussions

A. Macroeconomic Framework

6. The export-led recovery is projected to gain further momentum, in line with a welcome rebalancing toward more sustainable growth. Supported by a competitive exchange rate, net exports are projected to remain the main growth engine in 2011, while domestic demand will remain subdued until 2012 (Table 9). Formal-sector job growth is unlikely to turn positive before 2012.

Table 9.

Serbia: Medium-Term Program Scenario, 2008–15 1/

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

Definitions and coverage as in previous tables.

7. Inflation is projected to stay temporarily above the NBS’s tolerance band. Despite projected continued sub-par growth and a depressed labor market, CPI inflation is projected to hover well above the upper bound of the tolerance band for some time (Figure 3). With significant monetary tightening already in the pipeline, and as the effects of food price shocks and FX pass-through dissipate, inflation is projected to revert back into the NBS’s tolerance band during the second half of 2011.

8. The current account deficit is expected to remain relatively high, requiring significant capital inflows to maintain external balance. While Serbia’s external cost fundamentals have improved significantly, the flow fundamentals underlying the high external deficit, particularly the low private savings rate, are projected to adjust with a lag (Table 10). FDI inflows in 2011 are projected to spike, reflecting the privatization of Telekom Serbia, while other external flows, mainly to enterprises, are assumed to normalize at about 6 percent of GDP starting in 2012. Gross international reserves are projected to stabilize in 2011, following a decline in 2010. Under these assumptions, gross external debt would peak at almost 80 percent of GDP in 2010, but then decline over the medium term.

Table 10.

Serbia: Savings-Investment Balances, 2004–15

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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.

9. While risks to short-term growth are to the upside, risks of higher inflation and external financing shortfalls have also increased. Growth, particularly in the export sector, has been robust, and could well exceed present projections, assuming other macro stability risks do not materialize. However, this is unlikely to result in a rapid narrowing of the large external trade imbalance, and the associated high external financing requirements. Moreover, on the external side, fresh adverse shocks to the country risk premium, including from a possible new round of euro-area periphery spillovers, could cloud the external financing outlook. This could re-ignite depreciation pressures, adding to inflationary pressures, and weaken further corporate balance sheets. On the internal side, already heightened political and social tensions could spill over into looser fiscal policies. This could create a feedback loop into inflation, while fiscal loosening could also clash with tight budget financing constraints.

B. Fiscal Policy

10. There was agreement that fiscal policy had made a key contribution to stabilizing the economy, but there were also growing signs of policy tensions and austerity fatigue. Following a large, spending-based upfront fiscal adjustment in early-2009, the authorities have maintained a broadly neutral fiscal stance since then, allowing automatic fiscal stabilizers to operate (Table 11). Serbia seemed to have avoided a vicious circle of disappointing growth triggering fiscal tightening, which in turn would have further lowered growth. However, the mission also noted growing tensions in a number of areas: (i) an export-led recovery accompanied by low wage growth, while good for rebalancing the economy, was not providing as much boost to fiscal revenues as pre-crisis consumption-led growth; (ii) spending adjustments during 2009–10 were largely based on ad-hoc measures, nominal freezes and across-the-board cuts, while the pace of structural fiscal reforms was generally disappointing; and (iii) after two years of austerity and with elections looming, there were growing social and interest-group pressures to relax spending discipline, particularly as regards public wages, goods and services, and subsidies, while there is little effective lobbying to protect capital spending.

11. Nevertheless, the government was determined to stick to its new fiscal responsibility framework. In October, parliament had adopted amendments to the Budget System Law, introducing a two-tiered structure of fiscal rules. While the first-tier rules are designed to limit future fiscal deficits and debt, the second-tier rules are designed to constrain key spending items, particularly public wages and pensions (Box 1). Failure to adhere to this fiscal responsibility framework would not only raise external and internal balance risks, but could also trigger a budget financing crunch–potential creditors could hold the government accountable for changing course on its fiscal responsibility pledges.

Serbia’s Fiscal Rules and the Inflation Surge

On October 12, 2010, Serbia’s parliament adopted amendments to the Budget System Law (BSL) that committed fiscal policy makers to numerical fiscal rules. This box discusses what to do if conflicts between the rules arise given unexpected large shocks to the economy, such as the recent surprise surge in the inflation rate. The box argues that deficit and debt target rules should be considered as the priority or first-tier rules, which are being underpinned by second-tier spending rules for public wages and pensions.

The first-tier rules are:

  • First, an error-correction rule for the general government deficit:
    d(t)=d(t-1) - α[d(t-1)d*] - β[g(t)g*(t)],

    where d is the deficit-GDP ratio, d*=1.0 is the medium-term general government deficit target, g is the real GDP growth rate, g*=4.0 is the assumed medium-term GDP growth rate; α=0.30 and β=0.40 are parameters that capture how responsive the deficit would be to deviations from the target deficit and GDP fluctuations around average growth, respectively.

  • Second, a ceiling on general government debt:

    where b is the gross general government debt-GDP ratio, including public guarantees.

The second-tier spending rules relate to public wages and pensions, which account for about 60 percent of general government spending. These rules prescribe numerical indexation for public pensions and wages with a view to reaching medium-term targets of reducing total spending on the two budget items to 10 and 8 percent of GDP, respectively (see fifth review, LOI ¶13–14 for details).

With inflation during the second half of 2010 now projected to surge to 5.8 percent (in September, the program projected only 2.2 percent), not capping the indexation rules would in practice have made it impossible to reach the 2011 deficit target set by the fiscal balance rule (4.1 percent of GDP). Faced with this conflict between first- and second-tier rules, the authorities opted for capping wage and pension increases in January at 2 percent.

12. The supplementary 2010 budget, adopted in November, will maintain the agreed fiscal deficit target (Table 11, LOI ¶9–10). The main obstacle for reaching agreement on the revised 2010 budget was how to allocate available space (resulting from projected underexecution of budgeted spending) across different ministries, with strong pressures for additional spending emerging from all sides. The mission insisted that such re-allocations should be transparently identified in the revised budget, and targeted social assistance programs for the most vulnerable groups received an additional allocation.

13. In line with the newly adopted fiscal balance rule, the 2011 budget targets a deficit of about 4 percent of GDP (Table 11, LOI ¶11–13). A baseline budget projection for 2011 indicated a fiscal gap of RSD 62 billion (1¾ percent of GDP). Although the measures taken to close this gap focused on recurrent spending, including capping the indexation of public wages and pensions in January 2011 at 2 percent, capital spending also suffered cutbacks. The authorities argued, however, that co-financing of FDI projects, particularly the new Fiat plant, should be seen as close substitutes to capital projects (although such spending is allocated to net lending and subsidies).

Serbia: Fiscal Adjustment Measures in 2011

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14. Telekom privatization proceeds will likely be needed to cover the major share of 2011 budget financing needs (LOI ¶14–15). Earlier plans to put Telekom privatization proceeds (projected at about 4 percent of GDP) aside to finance only “special projects” over the next few years have had to be shelved, with gross financing needs for 2011 now projected at about 6 percent of GDP. At the same time, if the sale of Telekom does not go ahead, the authorities noted that their “Plan B” would be to cover the shortfall through a eurobond complemented by additional borrowing from domestic banks and T-bill issuance. However, this alternative financing strategy would be subject to uncertainties, and it could also add the equivalent of about ¼ percent of GDP to interest payments in 2011.

15. Under trade union pressure, the government amended the pension reform law (LOI ¶16). The government argued that maintaining social and political stability required some concessions. The mission noted that the previously agreed pension reform law represented only a modest step toward putting Serbia’s public pension system on a more sustainable footing. With spending on pensions amounting to about 14 percent of GDP and an effective pensioner-contributor ratio close to one, Serbia’s pension system is one of the most expensive and demographically-exposed systems in the region. The mission suggested that further reforms to raise effective retirement ages will likely be unavoidable.

16. The pension law changes have raised fresh concerns about Serbia’s resolve and ability to adopt and implement much-needed fiscal structural reforms. With fiscal revenue growth likely lackluster for some time given the export-led recovery, stop-gap spending measures will not be sufficient to meet the targets mandated by the new fiscal responsibility legislation. Serious structural spending reforms would be the preferable strategy given the above-par size and below-par productivity of Serbia’s government sector. But if such reforms cannot be implemented, consideration would have to be given to hefty indirect tax increases.

C. Monetary and Exchange Rate Policies

17. Inflation risks were seen as tilted to the upside, and monetary policy has been appropriately tightened (LOI ¶19). The recent flare-up in inflation had surprised all observers. There was agreement that idiosyncratic features of Serbia’s food market, including monopolistic structures, high import duties, and agricultural policies regarding commodity reserves and subsidies, have magnified the effect of adverse weather on agricultural prices. Moreover, threshold effects from exchange rate pass-through also seem to have played a key role as price setters sought to restore profit margins. Putting the present inflation volatility in context, past deviations from the NBS’s inflation targets have also been relatively large and persistent compared with advanced-economy inflation-targeting (IT) regimes—echoing the inflation experiences of several other emerging-market IT regimes, including Brazil and South Africa. Looking ahead, the NBS assessed that inflation risks were still on the upside, and it stood ready to continue its resolute tightening of the monetary stance, using all policy tools available if needed. The key to bring inflation back to target would be to contain second-round effects, particularly to wages. In this context, the NBS welcomed the envisaged capping of January indexation for public wages and pensions. More generally, with the economy recovering, it was agreed that fiscal policy, and relevant structural policies, would need to do most of the heavy lifting to restore and maintain external balance.

18. The NBS will continue to strengthen its communication strategy (LOI ¶20). The NBS sees effective communication as particularly important in a setting where policy credibility has still to be firmly established and where the nominal exchange rate is seen as a more natural anchor than inflation targets by many, particularly businesses with unhedged balance sheets. While the NBS views publishing minutes of policy meetings as premature, it plans to be more open in its press releases and IT reports about the different options considered by policy makers.

19. Given the fickleness of capital flows to the region, the authorities are rightly concerned about risks from a possible re-surge of inflows. At this point, Serbia is more concerned about flows being insufficient to cover its still large external imbalance. However, past experience suggests that turnarounds in capital flows can happen quickly. The NBS noted that the major problem with pre-crisis capital flows was not so much their size, but that the flows had led to unbalanced risk sharing, with risks from currency and maturity mismatches mainly borne by Serbian businesses and households. If faced with a resurgence of capital inflows, the NBS has pledged to avoid a recurrence of unequal risk sharing, including, if needed, through using punitive reserve requirements and prudential tools. But the NBS also hoped that foreign investors, particularly foreign banks, would do their part to achieve a more balanced sharing of risks.

D. Financial Sector Policies

20. Credit support programs helped shoring up credit growth during the height of the crisis, but cost-benefit considerations are arguing to phase out these programs (LOI ¶22). With credit markets normalizing and the recovery on track, the fiscal cost and supply-side distortions of credit support programs are increasingly outweighing possible benefits. Moreover, these programs tend to counteract the NBS’s efforts to tighten monetary policy. There was thus agreement that the credit support programs should be phased out, with the budgetary costs of the programs to be reduced by about 40 percent in 2011, although the pace of phase-out would differ across specific programs.

21. The authorities have also taken steps to further reduce financial vulnerabilities:

  • The authorities have drafted the necessary amendments to existing laws for the adoption of the Basel II framework, although implementation will have to be delayed by one year (LOI ¶24).

  • In addition, drawing on long-standing World Bank support, parliament has adopted amendments to a number of financial sector laws, establishing transparent procedures and tools in the event of a systemic banking crisis (LOI ¶27).

  • The end-November structural benchmark regarding strengthening Serbia’s debt collection and restructuring framework was only partially observed (Table 2). Legislation for an out-of-court loan workout mechanism in tune with Serbia’s specific circumstances has been drafted (Box 2). But the legislation remains to be submitted to parliament, and specific tax incentives for the out-of-court mechanism still have to be agreed and costed (LOI ¶23).

Corporate Debt Restructuring: Why a Voluntary Out-of-Court Loan Workout Mechanism for Serbia?

Putting in place more effective debt collection and restructuring mechanisms is likely Serbia’s most pressing financial sector issue, particularly given mounting corporate debt problems in the nontradable sectors. Bankruptcy procedures handled by the courts tend to be lengthy and costly. Using the option of blocking debtors’ accounts is a relatively efficient procedure for debt collection during normal times, but provides overly strong incentives to “rush to block” in times of high uncertainty about the soundness of corporate balance sheets.

Serbia’s policy response to addressing its corporate debt problems needed to balance two considerations. On the one hand, its legal culture argues for a debt restructuring framework based firmly on laws and regulations, as opposed to voluntary guidelines (as recently introduced in Latvia). On the other hand, the limited credibility of government intervention, the large informal economy, and the well-buffered banking system argued for leaving many degrees of freedom for informal, private-sector driven restructuring solutions, while arguing against the option of public asset management companies (such as used in some Asian countries in the 1990s).

Given these considerations, the approach chosen by the authorities was to establish an out-of-court debt restructuring mechanism by law to provide a legal base for voluntary agreements between debtors and creditors, to be mediated by the Chamber of Commerce. Under this approach, the government’s role would be confined to providing tax and provisioning incentives to encourage debt restructuring (similar to the experiences of Mexico in 1995 and Indonesia in 1998).

E. Structural Policies

21. The slow pace of progress on growth-oriented structural reforms remains a bottleneck (LOI ¶28–29). The government and the main think tanks have rallied around a new “post-crisis economic growth and development model,” which promises to generate average growth of 5¾ percent and 400,000 new jobs during 2011–20. However, like other countries in the region, Serbia has found it difficult to take decisive steps to address well-known shortcomings in the business environment (Table 17). There was agreement that these steps would need to be taken to implement the vision of a more export- and investment-based growth model. Towards this end, in the short term the authorities plan to focus on the unfinished agenda of pro-active and defensive steps, including the regulatory “guillotine,” competition by-laws, restructuring of public utilities, and limiting the spread of fiscal levies and charges.

Table 17.

Serbia: Rankings of Selected Competitiveness and Structural Indicators 1/

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Sources: EBRD; Transparency International; World Bank; World Economic Forum; and IMF staff calculations.

For comparability, all indices normalized so that they range from 0 (lowest) to 100 (best).

Country name and index of best performers among: Albania, Bosnia-Herzegovina, Bulgaria, Croatia, Estonia, Hungary, Latvia, Lithuania, FYR Macedonia, Montenegro, Poland, Romania, Serbia, Slovak Republic, and Slovenia.

Country names are not shown for EBRD transition indicators due to the presence of multiple entries.

Distance of Serbia from best performer for each index.

As pointed out in an independent evaluation of the Doing Business survey (see, care should be exercised when interpreting these indicators given subjective interpretation, limited coverage of business constraints, and a small number of informants which tend to overstate the indicators' coverage and explanatory power.