Outlook

The recovery of the Serbian economy is underway. Since the inception of the program, the economic outlook has been revised upwards twice and growth is now projected to be positive in 2015. The driving factors are (i) strong export performance, (ii) better-than-expected response of domestic consumption to fiscal consolidation, (iii) a rebound in investment, and (iv) declining energy prices. The Serbian authorities are confident that the recovery will strengthen in 2015. Inflation remains below the inflation tolerance band, mostly as a consequence of low imported inflation, relatively stable exchange rate, and delays in increases of regulated prices. Headline CPI inflation is projected to reach 2.2 percent in December and return within the inflation tolerance band in early 2016. The current account deficit has narrowed to around four percent, financed by strong capital inflows, in particular foreign direct investments. While exports continue to grow, net exports were slightly weaker than expected in Q3, mostly as a consequence of higher equipment imports. Growth is expected to further accelerate in 2016, building on the sound macroeconomic policies, the ongoing structural reforms, the relatively stable external environment and increased confidence. Regarding the EU integration, Serbia continues to make important progress towards EU membership. After obtaining the candidate status in 2012, the formal membership negotiations have started in 2014 and the screening phase for all chapters of acquis communautaire has been successfully completed. The opening of the negotiation of the first chapters is expected in late 2015 or in early 2016.

Fiscal policy

Serbia has recorded noteworthy progress in fiscal consolidation since the initial measures were implemented in 2014 and has over-performed by a sizable margin the fiscal targets agreed under the SBA. The authorities’ strong ownership and policy implementation have led to fiscal outcomes that largely exceeded expectations. In the first half of the year, fiscal performance has been strong. The projected fiscal deficit for 2015 was reduced to four percent of GDP, down from 5.9 percent assumed at the inception of the program. Also, the central government has been recording a primary surplus in the first eight months of 2015. This substantial fiscal over-performance is mainly stemming from stronger-than-expected revenues, resulting from stronger tax collection and improved discipline in SOEs’ profit transfers to the government—together with the containment of expenditures and the control of state aid to SOEs. Fiscal revenues additionally benefited from the authorities’ strong effort to introduce legal changes that allowed for broader labor inspection and more effective fight against gray economy activities.

Looking forward, the authorities remain committed to the overarching fiscal policy objectives of stabilizing public finances, putting the public debt on a downward trend and increasing the efficiency of public sector. In particular, the Serbian authorities remain committed to rationalize and rightsize the public sector as well as reduce the public sector wage bill. The rightsizing exercise will be supported by the public sector employment registry, created to better monitor and control the employment in the public sector, including the identification of areas of over-employment. The government will adopt the plan for targeted separation for 2015 by end-November, in line with the program objectives, building on the 5 to 1 attrition rule that has been already yielding substantial results in reducing employment in the public sector. These measures will be complemented by fiscal structural reforms to strengthen tax administration and public financial management.

The strong policies implemented by the Serbian authorities have yielded additional fiscal space. The authorities are considering using part of it to support the recovery, without jeopardizing program objectives and in close consultations with the Fund. The authorities and staff have agreed on a new deficit target for 2015 of four percent of GDP, considered appropriate to keep with the strong consolidation momentum. In structural terms, this corresponds to an adjustment of two percent of GDP.

Monetary and exchange rate policies

Accommodative monetary policy remains appropriate, as pointed out by staff’s analysis. Headline CPI inflation is projected to remain below the National Bank of Serbia (NBS) inflation tolerance band as average inflation was revised down to 1.6 percent. Such low inflation rates, paired with fiscal consolidation and benign external conditions, allowed the NBS to continue with the easing cycle. Since the beginning of 2015, the reference rate has been lowered in seven consecutive steps of 50 basis points and currently stands at its historic minimum of 4.5 percent. Inflation is expected to return in the band in early 2016 and reach the target of four percent by mid 2016. The NBS is also gradually lowering the statutory reserve requirements, which remain relatively high in Serbia compared with the peer countries. These policies will help reduce the cost of refinancing and support lending.

The NBS also continues to be committed to the managed floating exchange rate regime for the dinar and to reduce euroization. As the exchange rate flexibility provides a buffer against external shocks, foreign exchange interventions will be limited to smoothing excessive exchange rate volatility without targeting a specific level or path for the exchange rate. The current level of gross international reserves is very comfortable and the central bank will maintain adequate coverage throughout the program. The Serbian authorities are also considering additional measures to promote dinar lending—as opposed to prevailing euro-indexed loans—in particular in the context of buoyant euro zone liquidity and low euro interest rate. Steady increase of share of dinar lending is pivotal to strengthen monetary policy transmission and prevent buildup of balance sheet risks within the economy.

Financial sector

The Serbian banking sector remains stable and well capitalized. Regulatory capital to risk weighted assets is high, and liquidity is supported by continuous growth of deposit. However, the banking sector is burdened by a large stock of non-performing loans (NPL), mostly within the corporate portfolio. While the NPLs are broadly covered by large prudential loss reserves, the NPL overhang represents a source of vulnerability and constrains banks’ intermediation function. The authorities are well aware that reducing NPLs will play a key role in re-launching much-needed credit to the private sector.

The Serbian authorities have recently adopted a comprehensive strategy to tackle the broad range of issues which hamper NPL resolution. The strategy includes measures to (i) enhance the regulatory treatment of NPLs, (ii) improve the insolvency framework and procedures for voluntary out-of-court restructuring, (iii) introduce collateral valuation standards, (iv) remove tax disincentives which impede NPL resolution, (v) speed-up procedures and increase efficiency in bankruptcy cases, and (vi) promote creditor coordination in cases of debt restructuring for large corporates. The strategy was developed based on the TA provided by the Fund. While this work is ongoing, progress has already been made in number of areas, including the legal changes in areas of mortgage and tax legislation. Given the complexity and scope of envisaged measures to be introduced, a high level inter-institutional Working Group was established to coordinate all efforts.

To further evaluate the health of individual banks and accurately assess possible capital shortfalls, the authorities have launched special diagnostic studies (asset quality reviews) which are expected to be completed by end-October. The results of these studies will also support efforts to improve banking supervision.

Structural policies

The Serbian authorities are pursuing a comprehensive structural reform agenda including the restructuring of SOEs and the resolution of socially owned companies in the portfolio of the Privatization Agency. They take good note of staff’s assessment that “the overall scope and progress of this work has been impressive”.

The authorities are well aware of the need to (i) address organizational, financial and governance issues in SOEs, (ii) minimize fiscal risks, and (iii) reduce state aid to SOEs substantially and on a systematic basis. The three most important SOEs (the electricity company EPS, Srbijagas and Serbian Railways) already went through organizational changes, while the financial restructuring is ongoing. These companies also benefited from enhanced monitoring by line ministries, as well as from the continuous support from IFIs including the World Bank and EBRD. Regarding the socially owned companies in the portfolio of the Privatization Agency, only 17 of them remain protected under a bankruptcy moratorium. Seven of them will be resolved before year end and the remaining ones before May 2016. The bankruptcy moratorium has been revoked in May 2015 for all other companies in the portfolio of the Privatization Agency. Many of them are either in process of bankruptcy or tender privatization. The recently approved changes to the Law on Payments in Commercial Transactions will strengthen the payment discipline in the public sector, including SOEs. The investment climate is further benefiting from the enactment of the new Investment Law, the improvements in regulation regarding construction permits, and the labor market flexibility embedded in recently amended Labor Law.

Conclusion

The Serbian authorities remain committed to the agreed upon policies and consider them adequate to reach the program objectives. The implemented policies are yielding good results—fiscal adjustment has been strong, the economy started to grow and unemployment is declining. The strong performance created some fiscal space for growth enhancing measures, which will be discussed with staff in the context of the 2016 budget during the third program review. The public debt stabilization agreed under the program, supported by the high quality fiscal adjustment, remains the authorities’ overarching objective. The authorities are aware of the risks and remaining vulnerabilities, in particular stemming from politically difficult SOE reform. The authorities keep a strong track record in implementing difficult reforms, and remain committed to SOE restructuring. If new measures are needed to achieve the program objectives, the authorities stand ready to consider such measures in consultation with the Fund.