December 19, 2022

Like many counties in the region, Serbia has been hit hard by the external energy price shock, which was further exacerbated by shortfalls in domestic electrical energy production since late 2021. The authorities flexibly used available fiscal space to secure energy supply, while cushioning the impact of high energy prices on firms and households. This resulted in a need for large fiscal support to two key state-owned enterprises (SOEs) in the energy sector, EPS and Srbijagas. The value of energy imports doubled compared to 2021, leading to higher fiscal and current account deficits, and increased fiscal and balance of payments (BOP) financing needs. Against this backdrop—and further exacerbated by prevailing uncertainty, tightening global financing conditions, and risk-averse global capital markets—Serbia is requesting a two-year Stand-By Arrangement (SBA) with the Fund to help it bridge transitory BOP needs. Under the baseline, the authorities plan to draw on the SBA in 2022 and 2023 only, while the resources reserved for 2024 will be treated as precautionary and only used if downside risks—well described in staff’s adverse scenario—materialize.

The SBA is a continuation of Serbia’s uninterrupted and productive engagement with the Fund since 2015, including through a precautionary SBA and two consecutive Policy Coordination Instruments (PCIs). Given the unforeseen external energy shock, constrained access to capital markets, and the related BOP needs, the authorities are requesting a financing arrangement with the Fund while the non-financing PCI will be canceled. The SBA-supported program is geared toward restoring external and internal stability and will focus on preserving macroeconomic and financial stability while addressing vulnerabilities in the energy sector, including by securing financial viability and cost-recovery of EPS and Srbijagas. The structural agenda under the SBA will build on reforms initiated under the PCI.

The authorities attach great value to the engagement with the Fund, as reflected in the continuous engagement and strong performance in implementing key reforms under successive arrangements. Strengthened policy frameworks, enhanced credibility, and ample fiscal and external buffers—a valuable and lasting legacy of the prior arrangements with the Fund—were critical in cushioning the impact of the pandemic, limiting output loss, and paving the way to a robust recovery in 2021.

Outlook

Building on the strong post-COVID recovery and growth momentum in 2021, growth in the first half of 2022 was robust, at about 4.1 percent. However, it slowed abruptly to 1.1 percent in the third quarter. Consequently, the activity outlook for 2022 has been revised downwards to the range of 2-3 percent, mostly as a consequence of a decline in agricultural production, the adverse impact of higher energy prices, and weakening demand from the main trading partners. The decline in agricultural production is related to the drought recorded over the summer and partially to a suboptimal use of fertilizer given the sharp increase in fertilizer prices. Economic growth for 2023 is forecast within the same range, driven by domestic demand, while the contribution of net exports is expected to be negative. The current account deficit will widen to about 9 percent of GDP this year and remain high in 2023, fueled by an increase in volume and prices of energy imports. Over the medium term, the recovery of exports—underpinned by near-shoring and export-oriented FDI—as well as the recovery of external demand and favorable adjustments in the terms of trade will be contributing to a gradual decline in the current account deficit and to restoring external equilibrium. FDI inflows continue to be strong, also in 2022, facilitated by a favorable business environment, and are mainly directed to tradable sectors.

Energy sector developments and fiscal response

Against the background of (i) high global energy prices driven by the war in Ukraine, (ii) the need to import electricity to compensate for the shortfalls in domestic production, and (iii) the need to secure enough gas for the heating season, the republican budget provided assistance to EPS and Srbijagas through subsidies, budgetary lending, and sovereign guarantees. Fiscal support to these energy SOEs was necessary to secure energy imports and avoid supply disruptions. At the same time, the impact of rising energy costs was not immediately passed to final users, in order to cushion the impact of the sharp price increase on households and the economy, given the ongoing cost of living crisis and the need to allow companies to adapt. This led to sizable fiscal outlays and a widening of the fiscal deficit compared to the baseline.

In August and September, the authorities started with the gradual increase of gas and electricity prices. Going forward, the SBA-supported program envisages staggered increases of retail and corporate gas and electricity tariffs, aiming to achieve full cost recovery for the energy sector SOEs. It is assessed that the full cost recovery for EPS can be achieved by mid-2023, while the cost recovery for Srbijagas is expected to be achieved towards the end of the program in 2024, conditional on international gas prices. This approach will imply gradually decreasing fiscal outlays to support energy imports in both 2023 and 2024. In addition, to dampen the oil price shock, the retail margins on oil derivatives were capped, and the excise taxes on oil derivatives were temporarily reduced. These measures had no tangible impact on the key oil company in Serbia, NIS.

Despite the substantial energy-related increase in the fiscal deficit as well as the growth slowdown, public debt will continue to decline in terms of GDP in 2022 and over the course of the arrangement. In 2022, the non-energy deficit is expected to be below 2 percent of GDP, well below the 3 percent target set under the PCI. Under the conservatively projected baseline, the public debt ratio will be on a firm downward path over the course of the program and will decline to about 53 percent by the end of 2024. Over the medium term, the fiscal path will be guided by a revamped deficit-based fiscal rule that is also incorporating a debt anchor.

Serbia’s robust track record of implementing difficult reforms provides assurances that the key objectives of the program—stabilization in the energy sector and rebuilding fiscal space—will be met. The authorities continue to be firmly committed to prudent fiscal policy with the aim of restoring hard-won stability. Fiscal prudence is a cornerstone of their economic policy.

The reforms planned to be implemented under the program to improve the financial position of Srbijagas and EPS will ensure their solvency over the medium term while minimizing fiscal risks. At the same time, these efforts will be supported by a series of structural reforms in the energy sector. These reforms include the transformation of EPS to a joint stock company, the completion of the unbundling of Srbijagas, corporate restructuring, and governance reforms. To cushion the impact of rising energy prices, the authorities also expanded the energy-vulnerable consumer protection program—which aims at reducing energy bills to vulnerable households between 20 and 40 percent—to include about 190,000 eligible households. In addition, the authorities will prepare a priority list of key investments in the energy sector, consistent with the National Energy and Climate Plan, aimed at enhancing energy security while fostering climate objectives.

Monetary policy

To contain persistent inflationary pressures, the National Bank of Serbia (NBS) continues with the tightening cycle. On December 8, the monetary council of the NBS increased the key reference rate by 50 basis points to 5 percent. Since April, the reference rate has been cumulatively increased by 400 basis points. These rate hikes are aimed at limiting second round effects of global food and energy price inflation, while preventing inflationary expectations to get entrenched. Driven by imported inflation and the drought in Serbia and the region, CPI inflation reached 15.1 percent year-on-year in November, while core inflation stood at 9.7 percent. The authorities note that the relative stability of the exchange rate is a key factor in curbing core inflation and keeping it well below headline inflation. The NBS expects inflation to remain high in the first half of next year, and to start declining in the second half of 2022, as a consequence of the ongoing tightening of domestic monetary conditions, easing global food and energy price pressures, and softening external demand.

Following a period of increased depreciation pressures in March, the dinar stabilized in April, while since May it has been exposed to mild appreciation pressures fueled by strong foreign exchange inflows. In October, foreign exchange reserves of the NBS were at a historic high of EUR 16.9 billion, EUR 435 million higher compared to the beginning of the year, and well above 100 percent of the Fund’s ARA metric. At the same time, prevailing uncertainty and volatile global energy prices call for strengthening buffers, including through support from the SBA.