On behalf of our Serbian authorities, we would like to thank management and staff for supporting the request for a precautionary Stand-By Arrangement (SBA) in the amount of SDR 935.4 million (200 percent of quota). The arrangement will be instrumental in underpinning and strengthening macroeconomic management and keeping Serbia’s fiscal consolidation and structural reforms on track. Our authorities intend to treat the arrangement as precautionary, given the comfortable international reserves position and continued access to external financing. The Serbian authorities very much appreciate staff’s strong engagement as well as the constructive policy dialogue, which has provided an accurate assessment of the Serbian economy. The report highlights important vulnerabilities in the context of the current weak external environment, slower global growth and potential adverse regional spillovers, and highlights the numerous challenges and risks that Serbian policymakers face. The program builds on the already strong reform momentum, and envisages the ambitious, yet essential set of policy reforms to be implemented, including fiscal consolidation and structural fiscal reforms. Moreover, the program design provides a realistic and achievable path to stabilize public debt, strengthen the financial sector, and improve competitiveness.

Outlook

The Serbian government, which took office in April 2014 with a broad and stable parliamentary majority, started its term with a clear aim to (i) stabilize public finances, (ii) accelerate the implementation of needed structural reforms, (iii) improve competitiveness, (iv) strengthen regional cooperation, and (v) advance towards the EU membership. The implementation of this comprehensive reform agenda already started in mid-2014 with the launch of ambitious labor and pension reforms, followed by important fiscal consolidation measures—mostly the implementation of wages and pensions cuts—and the passing of the amendments to the Urban Planning and Construction Law. In the second half of 2014, the government started discussions with the Fund on a possible program to underpin its economic policies and reform momentum. The authorities and staff have subsequently agreed on a 36 month precautionary arrangement to support the implementation of the aforementioned comprehensive reform agenda and reduce vulnerabilities in the financial sector. The authorities consider that the successful implementation of the program will be pivotal in strengthening the credibility of implemented policies and relaunching growth. The Serbian economy weakened in 2014 and is expected to remain slightly negative in 2015, while the growth is expected to pick up in 2016. In May 2014, the country was hit by devastating floods which severely disrupted economic activity. Owing to flood-linked damages and disruptions in the mining and energy sector and the weak growth of Serbia’s trading partners, the Serbian economy contracted in 2014 by two percentage points. Growth in 2015 is expected to be slightly negative, as the weakening in domestic demand due to the significant frontloaded component of consolidation measures, will only be partially offset by higher net exports. A moderate recovery is expected in 2016, based on the upturn of domestic demand and further net exports growth.

Fiscal policy

Fiscal adjustment continues to be at the core of the program with the Fund. The authorities are fully committed to implementing the needed fiscal consolidation within the program framework, with the aim of achieving fiscal sustainability and stabilizing and reducing public debt in the medium term. This implies a package of fiscal measures of 4¾ percentage points over the course of the program. Acknowledging the need to promptly stabilize public finances, the government has started the consolidation process, well before the program discussions, by implementing important fiscal measures. In fact, in the second half of 2014, the authorities have decided to reduce two key expenditure categories, namely wages, both in the public and state owned enterprises (SOEs) sector, and pensions. The authorities have also decided to freeze wages and pensions with the objective of reducing their share in GDP over the medium term from 10 and 13 percent respectively, to 7 and 11 percent. In other words, nominal wages and pensions will remain unchanged until these ratios are achieved.

The other key building blocks of the fiscal consolidation package are (i) a substantial reduction in state aid, particularly to SOEs and (ii) a rightsizing of employment in the public sector. More specifically, on the former (i), the fiscal drag from the loss-making SOE, which has been on the rise in recent years, will be substantially reduced by lowering direct and indirect state aid to these SOEs, limiting issuance of new guarantees and, improving their monitoring, transparency and governance. In cooperation with the World Bank, the restructuring and divestiture of about 500 socially owned enterprises in the portfolio of the Privatization Agency will be accelerated. On the latter (ii), public sector employment will be reduced by five percent annually over the course of the program, through the extension of the attrition rule and targeted layoffs. These rationalization efforts will be underpinned by the recently launched centralized employment registry, which effectively monitors public sector employment and wages.

The Serbian authorities also plan to enact and implement broad civil service reform, with the objective of increasing the quality of public services and improving the efficiency of the public sector. In parallel, the authorities will review the transfers to local governments in order to make the system of intergovernmental transfers increasingly efficient and fair. Expenditure cuts are going to be paired with the broad and overreaching tax administration reform, in line with the Fund’s technical assistance (TA) recommendation, to improve tax collection efficiency and reduce the gray economy. Finally, the containment of pension expenditures in the medium term will be supported by the pension system reform enacted in mid 2014, which equalizes the retirement age for woman and man to 65 years, increases the minimum retirement age to 60 years and introduces actuarial penalties for early retirement.

Monetary and exchange rate policies

The Serbian authorities consider that the inflation targeting framework has served well, apart from some implementation challenges due to a highly euroized economy. Currently, headline CPI inflation is below the target band due to the fall in energy and food prices, unanticipated flat regulated prices and weak domestic demand. However, the National Bank of Serbia (NBS) expects inflation to accelerate in spring 2015, to reach the target band in mid 2015, and respectively reach the target of 4 percent by the end of 2015. On February 12, the NBS Executive Board decided to keep the reference rate unchanged at 8 percent. Our authorities consider that a gradual relaxation of monetary policy will be appropriate once the fiscal consolidation efforts start delivering their effects, taking also into account external financing conditions.

The NBS continues to be committed to the managed floating exchange rate regime for the dinar. Although exchange rate flexibility helped absorbing external shocks, Serbia’s shallow foreign-exchange market remains prone to excessive volatility. Recent NBS interventions were geared towards the objective of smoothing such volatility and preserving financial stability. In moving forward, the NBS interventions will continue to be aimed at smoothing excess volatility and providing liquidity to the market, without targeting a specific level of dinar exchange rate. The level of NBS international reserves remains high by standard metrics.

Financial sector

Serbian banks are well capitalized and liquid due to cautious policies. The weaknesses identified in some state-owned banks have been promptly addressed, in some cases with recourse to public money. The capital adequacy ratio for the banking sector stands at almost 20 percent, and all banks have regulatory capital above the minimum of 12 percent. The non performing loans are relatively high, predominantly within the corporate portfolio; however, large regulatory loan-loss provisioning provides a sizable cushion to a potential distress.

The Serbian authorities have made progress in strengthening the bank resolution and financial network framework, in line with the Fund’s TA recommendations. A set of laws aimed at clarifying roles and actions of different actors in case of bank resolution has been enacted in January 2015. By the end of the third quarter, the authorities will complete diagnostic studies to identify possible vulnerabilities in the banking system and accurately assess possible capital shortfalls. Our authorities consider that the results of this balance sheet quality review will provide additional insights, help pursue adequate policies and improve the oversight of the system. They also expect the outcome of the review to be manageable.

Business environment

With the support of the World Bank, our authorities are pursuing a broad and comprehensive structural reform agenda to enhance the business environment. In July 2014, the authorities have made important adjustments in the labor law to enhance the flexibility of the labor market and unify severance costs. The Urban Planning and Construction Law, which has been amended in December 2014, will significantly simplify and speed up the process of obtaining building permits, including by establishing a one-stop shop. To remove one of the key bottlenecks, the authorities are also committed to developing, by the end 2015, a framework that regulates the conversion of building land usage rights to ownership rights.

EU integration

Serbia is making important progress towards EU membership. After granting Serbia the Candidate status in 2012, the European Council decided in late 2013 to initiate the accession negotiations with Serbia. These negotiations with the EU started officially with the first Intergovernmental Conference, which took place in January 2014. Moreover, in 2014 the screening processes of the several chapters of acqui communautaire were initiated.

Conclusion

The authorities are convinced that the agreed upon policies are adequate for reaching the objectives defined in the Letter of Intent, and placing the country on a more balanced growth path after the expiration of the program. The authorities are aware of the surrounding risks and remaining vulnerabilities, stemming primarily from the volatile external environment and the elevated financing needs but also from potential fiscal slippages. They remain committed to prudent macroeconomic policies, focusing their strategy on containing debt, improving competitiveness, and reducing financial vulnerabilities. If new measures are needed to achieve the program objectives, the authorities stand ready to take such actions in consultation with the Fund. In case of significant changes to the main program assumptions, the authorities are also ready to take, in consultations with the Fund, additional measures to protect the objectives of the program.