Republic of Serbia
Seventh Review and Inflation Consultation Under the Stand-By Arrangement

The global financial crisis unmasked Serbia’s unsustainable pre-crisis growth model. Looking back, the Stand-By Arrangement (SBA) provided effective insurance against a financial meltdown, initiated the needed re-balancing of the economy, but could not prevent large job losses. Looking ahead, the transition to a more sustainable growth model remains incomplete and fragile. The export-led recovery is expected to continue picking up steam, but labor market conditions will remain difficult. The current account deficit is expected to remain relatively high, requiring significant capital inflows to maintain external balance.

Abstract

The global financial crisis unmasked Serbia’s unsustainable pre-crisis growth model. Looking back, the Stand-By Arrangement (SBA) provided effective insurance against a financial meltdown, initiated the needed re-balancing of the economy, but could not prevent large job losses. Looking ahead, the transition to a more sustainable growth model remains incomplete and fragile. The export-led recovery is expected to continue picking up steam, but labor market conditions will remain difficult. The current account deficit is expected to remain relatively high, requiring significant capital inflows to maintain external balance.

I. SBA Context

1. The global financial crisis unmasked Serbia’s unsustainable pre-crisis growth model. Income expectations and consumption habits of the population were conditioned by unrealistic memories of past high consumption standards, as also reflected in very low pre-crisis domestic savings rates (Table 2). Moreover, the oversized public sector focused on consuming rather than investing. Meanwhile, a difficult business climate stymied formal sector growth, providing an especially unfavorable setting for tradable sector activities. However, large capital inflows, intermediated by mostly foreign-owned banks, and remittances covered the resulting large external trade deficit, and kept the exchange rate at a significantly overvalued level. Put differently, Serbia’s pre-crisis external trade imbalance was entrenched, and not the result of a temporary absorption boom as in some other regional peer countries (Figure 1). Euroization was high, and, while banks were largely hedged against currency risk and well-buffered against credit risk, corporates carried large unhedged FX positions on their balance sheets.

Table 1

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 the output gap both on revenue and spending.

Table 2.

Serbia: Savings-Investment Balances, 2004–15

(Percent of GDP)

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

Equal to GDP minus domestic demand.

Figure 1.
Figure 1.

Real GDP and Real Absorption Growth, 2003-08 1/

(average annual percent change)

Citation: IMF Staff Country Reports 2011, 095; 10.5089/9781455249244.002.A001

Source: WEO.1/ Estonia, Latvia, Lithuania calculated 2003-07.

2. Looking backward, the SBA provided effective insurance against a financial meltdown, initiated the needed re-balancing of the economy, but could not prevent large job losses. Exceptional access under the SBA and other official financing provided a large buffer against external downside risks, while the agreement with foreign banks to maintain their exposure vis-à-vis Serbia provided assurance against a sudden cut-off of cross-border credit lines to corporates. Over the last 2½ years, the exchange rate has depreciated to a competitive level, although the adverse impact on unhedged balance sheets hit the corporate sector hard, particularly nontradable companies. Although the economy has started to recover on the back of export-led growth, consumption has contracted through 2010 (Table 3). Moreover, while employment in the public sector was largely unaffected by the crisis during 2008–10, job losses in the private sector, both in the formal and informal segments, have been massive (Table 4).

Table 3.

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 4.

Serbia: Employment Developments, 2008-10

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Source: Labor Force Surveys, Serbian Statistical Office.

3. Looking forward, the transition to a more sustainable growth model remains incomplete and fragile. The public sector is lagging behind private sector adjustment: the long-envisaged rationalization of employment levels in health, education, and public administration has not started, while public sector trade unions are seeking to restore relatively generous compensation levels after two years of nominal freezes; budgetary spending on public wage and pensions has continued to crowd out public investment; additional pension reforms, particularly to increase the effective retirement age, will be needed to ensure the sustainability of the public pension system; and the large public enterprise sector remains to be restructured, against the opposition of well-entrenched special interests. Improving the business climate has also proven an uphill battle, in large part due to public sector coordination and competence problems in a politically fragmented setting.

II. Recent Developments

4. Except for inflation performance, the SBA remained on track. All end-December performance criteria and indicative targets were met (Table 5); the structural benchmark on submitting a corporate debt restructuring law to parliament was also met (Table 6). However, as expected, December CPI inflation (10.3 percent) was more than 1 percentage point above the upper limit of the inflation consultation band (8 percent). In line with the SBA inflation consultation clause, the NBS has provided a letter explaining the inflation deviation and its policy response.

Table 5.

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 6.

Serbia: Performance for Seventh Review

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For the reasons for the deviation and the NBS’s policy response, see NBS letter in Attachment III.

5. Political and economic tensions remain elevated. Participants in the ten-party coalition government are maneuvering to deflect blame for the widespread sense of economic malaise, while the opposition parties are clamoring for moving up the regular elections scheduled for early 2012. Disagreements in the coalition government came to a head with the recent resignation of Minister of the Economy Dinkic, which was followed by a government reshuffle.

6. Exports have sparked an output recovery, but the massive labor shakeout continued. Real GDP grew by an estimated 1¾ percent in 2010, led by strong export growth: a respectable performance relative to peers (Figure 2, Table 3). However, despite the ongoing recovery, employment has continued to contract (Figure 3). At the same time, trends in different labor market segments have diverged markedly (Box 1).

Figure 2.
Figure 2.

Serbia: Output Indicators

Citation: IMF Staff Country Reports 2011, 095; 10.5089/9781455249244.002.A001

Sources: Serbian authorities and WEO.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.
Figure 3.
Figure 3.

Serbia: Labor Market Developments, 2008-10

Citation: IMF Staff Country Reports 2011, 095; 10.5089/9781455249244.002.A001

Source: Serbian Statistics Office and IMF staff calculations.

Serbia’s Three Labor Market Dualisms

The recession and rebalancing of the economy has hit Serbia’s labor market hard, and the output recovery has so far provided little relief (Figure 3). However, the incidence of the labor shakeout has been highly uneven across different labor segments:

  • Public versus private sector jobs: Public sector employment not only held up, but even expanded somewhat since 2008. By contrast, private sector employment has contracted sharply as companies tried to retrench in response to shifting patterns of demand and to repair their balance sheets given tighter credit standards and the large depreciation.

  • Formal versus informal sector jobs: Formal sector jobs during 2008-10 fell by about 11 percent, but informal sector jobs slumped by almost 30 percent (Table 4). Informal sector jobs are mostly low-skilled, low-paid positions in the private nontradable sectors.

  • Tradable versus non-tradable sector jobs: While both sectors have suffered large job losses, the available data suggest that private non-tradable sector jobs cuts have been particularly deep, especially in construction.

7. Inflation has surged to uncomfortably high levels. Inflation started to pick up in August, and the year-on-year figure reached 10.3 percent in December, significantly above the upper end of the NBS’ inflation tolerance band (6±2 percent) (Figure 4). Three main drivers seem to account for the inflation surge: (i) depreciation pass-through from the large cumulative dinar depreciation since end-2008; (ii) local weather-related and international food supply shocks; and (iii) rising import prices (in euros).

Figure 4.
Figure 4.

Serbia: Inflation and Monetary Policy, 2008–12

Citation: IMF Staff Country Reports 2011, 095; 10.5089/9781455249244.002.A001

Source: National Bank of Serbia; Serbian Statistical Office; and IMF staff estimates and projections.1/ Average of surveys of the financial sector.

8. Monetary policy has responded aggressively to keep inflation expectations anchored. Since August, the NBS has hiked its policy rate by a cumulative 425 basis points, to 12¼ percent, one of the highest nominal policy rates among emerging markets. The forceful and quick policy response was directed at curbing inflationary pressures from the food price shock and dinar depreciation, but also seeking to bolster the NBS’s policy credibility. The NBS has also postponed part of the previously-envisaged easing of mandatory reserve requirements, in part to alleviate the need for further policy rate hikes that might result in excessive capital inflows. Against this backdrop, inflation expectations have so far remained reasonably well anchored (Figure 4).

9. Foreign investor interest in Serbia has picked up, contributing to a reversal of earlier exchange rate depreciation pressures and lowering T-bill yields. Following previous one-sided depreciation pressures, the dinar has appreciated somewhat since December, and, for the first time under the program, the NBS’s FX interventions resulted in net purchases, albeit small, in recent months (Figure 5). In addition, the demand for dinar T-bills has increased significantly, contributing to a sharp decline in T-bill yields, particularly at longer maturities.

Figure 5.
Figure 5.

Serbia: Exchange Rate and T-Bill Market developments, 2008-11

Citation: IMF Staff Country Reports 2011, 095; 10.5089/9781455249244.002.A001

Source: National Bank of Serbia; Bloomberg; and WEO.1/ Net free FX reserves are defined as Net Foreign Assets of the NBS minus the stock of repos.

III. Policy Discussions

A. Macroeconomic Framework

10. The export-led recovery is expected to continue picking up steam, but labor market conditions will remain difficult. Growth is projected to increase to about 3 percent in 2011, driven by net exports, whereas consumption growth is expected to remain subdued (Table 3). Given that the transition away from domestic absorption and toward net exports will require labor reallocation from non-tradable to tradable sectors, private sector job growth is unlikely to turn positive before 2012.

11. Inflation is projected to stay temporarily above the NBS’s tolerance target band. Despite projected continued sub-par growth and a depressed labor market, CPI inflation is projected to remain above the upper bound of the tolerance band for some time (Figure 4). Given the monetary policy tightening and exchange rate appreciation in recent months, and as the effects of food price shocks and the earlier depreciation wear off, inflation is projected to revert back into the NBS’s tolerance band at the turn of 2011–12.

12. The current account deficit is expected to remain relatively high, requiring significant capital inflows to maintain external balance. FDI inflows in 2011 are projected to spike, reflecting the expected privatization of Telekom Serbia, while other external flows, mainly to enterprises, are assumed to normalize (Table 7 and 8). As a result, gross international reserves are projected to stabilize in 2011, following a decline in 2010. Under these assumptions, gross external debt would peak at about 80 percent of GDP in 2010, but then decline over the medium term (Table 9).

Table 7.

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.

Table 8.

Serbia: External Financing Requirements and Sources, 2008–15

(Billions of euros, unless otherwise indicated)

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Sources: NBS; and Fund staff estimates and projections.

Excluding IMF.

Includes all other net financial flows, SDR allocations, and errors and omissions.

Table 9.

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/pi

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