Republic of Serbia
Request for Stand-by Arrangement: Staff Report; Staff Statement; Press Release; and Statement by the Executive Director for the Republic of Serbia.

Serbia’s transition to a more sustainable growth model remains incomplete and fragile. A precautionary Stand-By Arrangement (SBA) has been requested to insure against external risks and to provide a policy anchor. The program represents a prudent step in the present uncertain global and regional environment. However, without improving Serbia’s difficult investment climate, the economy cannot deliver sustainable growth. Executive Directors expect that a steadfast program implementation along with responsiveness to new adverse developments will lead the Serbian economy to overcome its present difficulties.

Abstract

Serbia’s transition to a more sustainable growth model remains incomplete and fragile. A precautionary Stand-By Arrangement (SBA) has been requested to insure against external risks and to provide a policy anchor. The program represents a prudent step in the present uncertain global and regional environment. However, without improving Serbia’s difficult investment climate, the economy cannot deliver sustainable growth. Executive Directors expect that a steadfast program implementation along with responsiveness to new adverse developments will lead the Serbian economy to overcome its present difficulties.

I. Background

1. Serbia’s transition to a more sustainable growth model remains incomplete and fragile. The global financial crisis in 2008-09 unmasked Serbia’s unsustainable growth model, which relied too much on nontradable sector growth, low domestic savings, and excessive external borrowing. While the economy has started to rebalance toward more export-based growth, the rebalancing has been accompanied by massive private sector job losses. Serbia’s external imbalance has declined markedly since 2008, but significant capital inflows are still required to cover it. At the same time, given Serbia’s politically fragmented setting, it has proven difficult to reduce high government sector employment levels, restructure the large public enterprise sector, and improve the adverse investment climate.

2. The authorities have requested a precautionary SBA to insure against external risks and to provide a policy anchor. This follows a 27-month, exceptional access SBA, which expired on April 15 with all reviews completed, and the completion of an ex-post assessment of Serbia’s program engagement with the Fund (Box 1). However, with global growth sputtering and sovereign balance sheet and banking tensions in the euro area unresolved, spillover and contagion risks from a potential second crisis wave to the region have mounted in recent months. Moreover, the authorities and other stakeholders, including foreign investors, reckon that a new SBA could act as an effective commitment device to anchor Serbia’s fledgling fiscal responsibility framework. Finally, the SBA could help catalyze specific structural reforms that address three long-standing growth bottlenecks: uncertain property rights; an oversized public sector; and a dysfunctional labor market.

3. However, SBA implementation will likely face political headwinds. Serbia’s fragmented and fractious politics provides a challenging backdrop to any commitment-based policy framework. Moreover, with parliamentary and local elections scheduled for early-2012, the new SBA would straddle the transition between the present and the next government, increasing implementation risks.

II. Recent Economic Developments

4. GDP continued to expand in the first half of 2011, but there are signs that the recovery is stalling for now. With investment and exports as the main drivers, the estimated first-half year GDP growth (2¾ percent) was in line with previous projections (Figure 1). However, a large negative trade shock is percolating through the region, as reflected in a sudden drop-off in steel demand from regional trading partners. Moreover, recent leading indicators in key trading partners, including Germany and Italy, suggest that the recovery will likely pause for the remainder of 2011.

Figure 1.
Figure 1.

Serbia: Output and Labor Market Indicators, 2008-11

Citation: IMF Staff Country Reports 2011, 311; 10.5089/9781463922672.002.A001

Sources: Serbian authorities and WEO.1/ 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).2/ CEFTA--the Central European Free Trade Agreement--includes Albania, Bosnia and Herzegovina, Croatia, Kosovo, Macedonia FYR, Moldova, Montenegro, and Serbia.3/ Includes estimated informal employment based on labor surveys.

5. Labor shedding in the private sector has continued. While the public sector has maintained its (high) employment level, the private sector has shed about 20 percent of its jobs since 2008 (Figure 1). With a significant number of jobs in companies that are dependent on subsidies, the official statistics may still not fully capture Serbia’s labor market malaise.

Main Messages of the Ex Post Assessment and Ex Post Evaluation1

Going forward, reform efforts, with or without a Fund arrangement, should focus on the following objectives:

  • Securing low and stable inflation and achieving durable fiscal adjustment while creating fiscal space for investment. The inflation-targeting regime should be strengthened further. Fiscal policy should be anchored by the new fiscal responsibility framework, with further spending reforms needed to achieve the adjustment required by the fiscal rules. Capital budgeting should be strengthened to increase the effectiveness of public investment.

  • Strengthening financial sector stability. Moving to Basel II should be a priority to further strengthen the banking sector’s regulatory framework and adopt internationally accepted approaches for sound corporate governance, risk and capital management, and transparency. Efforts to de-euroize the economy should continue.

  • Implementing structural reforms that support balanced catch-up growth to EU income levels: (i) large public enterprises should be restructured and eventually privatized, and the problem of unsuccessfully privatized formerly socially-owned enterprises should be addressed; transparency of public enterprise operations should be increased, and government control of their financial plans strengthened; (ii) the cost of doing business should be reduced by facilitating land ownership transfer, improving property registration, streamlining the licensing system, strengthening contract enforcement by courts, and promoting competition; (iii) the labor market needs to be made more flexible.

A new SBA should center on a few key reform bottlenecks and assure strong ownership by the authorities. Prior actions could be established on vital conditions ahead of program approval. There should be close collaboration with the World Bank and the EU on reforms outside the Fund’s core area of expertise.

1 See Ex Post Assessment of Longer-Term Program Engagement and Ex Post Evaluation of Exception Access, Country Report No. 11/213, at: http://www.imf.org/external/pubs/cat/longres.aspx?sk=25097.0.

6. Headline inflation has peaked, and the NBS responded by reversing its policy stance. Headline inflation in April reached almost 15 percent, but has declined substantially since then on the back of a reversal of food price inflation, in turn supported by the good agricultural season and lower global commodity prices (Figure 2). The NBS reversed its policy stance in June, cutting the policy rate by 125 basis points in several steps, to 11¼ percent. The dinar had appreciated considerably earlier in the year supported by portfolio investments attracted by high dinar yields, but with increased tensions in the euro area, and in line with regional peers, it subsequently lost much of its previous gains. Amid substantial volatility in the FX market, but also increased trading volumes, the NBS conducted only modest FX interventions (Figure 3).

Figure 2.
Figure 2.

Serbia: Inflation and Monetary Policy, 2008–12

Citation: IMF Staff Country Reports 2011, 311; 10.5089/9781463922672.002.A001

Sources: National Bank of Serbia; Serbian Statistical Office; and IMF staff estimates and projections.
Figure 3.
Figure 3.

Serbia: BOP Flows, Treasury-Bills, Exchange Rate and Sovereign Spread Developments, 2008-11

Citation: IMF Staff Country Reports 2011, 311; 10.5089/9781463922672.002.A001

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

III. The SBA-Supported Program

A. Program Objectives and Strategy

7. The new Fund arrangement’s overall objectives are to maintain macroeconomic and financial stability, while addressing key bottlenecks in the investment climate. To achieve these objectives, the program provides additional insurance against external downside risks, anchors the fiscal responsibility framework, supports mitigation of financial sector stability risks, and targets specific structural reforms:

  • Insurance against external downside risks. Serbia is still only partly integrated in the EU’s regional supply chain. Nevertheless, as illustrated by the 2008–09 crisis spillover experience, present trade links can quickly lead to a synchronized region-wide slowdown in trade that can hit Serbia’s exports hard. Moreover, given the composition of Serbia’s commodity trade structure, the terms of trade effect of a severe regional trade shock would likely be negative. And although Serbia’s external current account gap is now much smaller than in 2008, it still relies on significant FDI and bank-intermediated capital inflows that could quickly dry up in a sharp external downside scenario. Serbia’s comfortable level of FX reserves, a flexible and competitive exchange rate, and relatively assuring indicators of bank funding risks may provide a sturdy first line of defense. Nevertheless, contagion risk from vulnerable regional economies is high, and the relatively large proposed access under the precautionary SBA is intended to reinforce Serbia’s financial buffers.

  • Anchoring the new fiscal responsibility framework. During the brief interlude between the previous and the new proposed program, parliament adopted a populist fiscal decentralization law that transferred taxes equivalent to about 1¼ percent of GDP additional to local governments without devolving commensurate spending responsibilities. This was done over the explicit objections of the Fiscal Council, illustrating that the new fiscal rules remain open to political challenge. Thus, the SBA would serve as a commitment device to protect the fiscal responsibility framework.

  • Mitigating financial stability risks. This includes developing local financial markets to facilitate FX hedging and maintaining adequate liquidity and capital buffers in the banking system. In case a severe downside scenario materializes, the program would likely have to be adjusted to include a private sector involvement component, as under the previous SBA.

  • Catalyzing structural reforms. In coordination with other international financial institutions (IFIs), the program seeks to soften up key growth bottlenecks, using a targeted and realistic structural reform approach that focuses on areas where IMF staff has some expertise and where a critical mass of ownership can be mobilized.

B. Macroeconomic Framework

8. Slowing global and regional growth will dent Serbia’s output outlook, and prospects for a turnaround in the labor market remain dim. Slower growth in Serbia’s main trading partners, especially the euro area, will likely result in GDP growth pausing during the second half of 2011, notwithstanding what could be an above-par agricultural season. For the year as a whole, growth has been revised downward to 2 percent. Although the recovery is projected to resume again in 2012, growth is unlikely to exceed 3 percent, but catch-up growth is projected to resume over the medium term (Tables 14).

Table 1.

Serbia: Selected Economic and Social Indicators, 2006–12

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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, 2006–15

(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.

Table 3.

Serbia: Real GDP Growth Components, 2006–12

(Percent)

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

Contributions to GDP growth.

Table 4.

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.

9. Inflation is projected to return within the NBS’s target tolerance band in the first half of 2012. Barring new shocks, the rapid decline of food and agricultural prices during the summer and base effects will ensure the return of inflation to single-digit inflation by the end of 2011, although it will still be above the NBS’s target tolerance band. Assuming a continued tight monetary stance, a large output gap, and reasonably anchored inflationary expectations, the disinflation trend is expected to continue during 2012, with inflation moving toward the center of the band by the end of the year (Figure 2).

10. External financing needs will remain relatively high but are projected to be fully covered under the program’s baseline scenario. With net exports rising in response to earlier FDI inflows—for example, Fiat is scheduled to start car production in 2012—the trade imbalance is expected to narrow gradually (Table 5). The external financing needs will be mostly covered by FDI and net inflows to banks, as well as a moderate drawdown of FX reserves in 2012 (Tables 6). Gross external debt would decline to 75 percent of GDP in 2011 and continue on a downward path over the medium term, although this re-assuring projection is quite sensitive to exchange rate assumptions (Table 7 and Appendix I).

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, due to data shortcomings, intercompany loan transactions are recorded as debt flows rather than FDI flows.

Table 6.

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.

For 2011, the financing gap is for the first quarter.

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 beginning of transition.

+ 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/private).

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