May 20, 2013
Serbia’s faces significant economic challenges, including a weak economy and large internal and external imbalances. Macroeconomic policies should urgently aim to tackle the underlying vulnerabilities and ensure macroeconomic stability. Significant and sustained fiscal consolidation, underpinned primarily by curbing mandatory expenditures, is needed to reverse
the rise in public debt. Once fiscal adjustment is firmly on track and provided inflation is under control, a gradual easing of monetary conditions could help revive anemic credit growth, but concerted efforts to address non-performing loans (NPLs) are also needed. Finally, ambitious and comprehensive structural reforms are critical to bolster the export sector and unlock growth potential.
Recent Economic Developments and Outlook: A Fragile Recovery
1. The economic situation is weak. After a tepid recovery in 2010–11, the economy again slipped into recession in 2012 due to weather shocks, closure of a major steel plant, and weakness in the euro area. Unemployment of well over 20 percent is a major social concern. Yet the current account deficit surpassed 10 percent of GDP and food-price shocks and pass-through from exchange rate depreciation pushed inflation to double digits. Election-related fiscal slippages, recapitalization of state-owned banks, and the adoption of an expansionary fiscal decentralization law in late 2011 raised the general government deficit to 7¾ percent of GDP (including the cost of bank resolution, clearance of arrears, and payments for called guarantees) and
public debt to about 62 percent of GDP, despite consolidation measures implemented in late 2012.
2. The outlook is difficult. A recovery of 2 percent is expected in 2013 given the continued strength of FIAT production and assuming a return to a normal agricultural harvest. Inflation is projected to return to the inflation tolerance band by year end as base effects dissipate. Yet medium-term growth prospects largely depend on future policy orientation. A decisive change in the current policy course is needed to resolve the existing internal and external macroeconomic imbalances, raise market confidence, and boost growth potential. Failure to undertake prompt and bold macroeconomic stabilization and structural reforms would undermine Serbia’s prospects of a durable export-based recovery and constrain growth in the medium-term.
3. External risks could hamper the outlook. Given trade and financial linkages, a weaker than expected euro area recovery would dent Serbia’s growth prospects. Higher global risk aversion could increase the cost of financing and heighten rollover risks of the public and private sectors.
Fiscal Policy: Achieving Public Debt Sustainability
4. Sustained fiscal consolidation is needed to put the public finances on a sustainable footing. Tax revenue shortfalls, unbudgeted spending initiatives, public bank resolution costs, clearance of arrears, and the payment for called guarantees would, with unchanged policies, result in a general government deficit above 8 percent of GDP and an increase in public debt over 65 percent of GDP in 2013. The consolidation measures now under consideration—notably adjustment of the wage tax and social contribution rates and discretionary expenditure cuts—are a valuable step in the right direction. If implemented, these measures could reduce the deficit by up to 1 percent of GDP this year. However, alone they are not sufficient to reduce the fiscal
deficit to sustainable levels and reverse the trend increase of public debt. Further fiscal risks arise from the planned issuance of government guarantees, the likely assumption of debt of several public enterprises by the government, and other quasi-fiscal operations. The mission estimates that a cumulative adjustment effort of 7 percent of GDP or possibly more over the medium term would be needed to reduce public debt to the legal ceiling of 45 percent of GDP by 2020—an objective stated in the Government’s 2012 Fiscal Strategy. The mission advises identifying an additional 1 percent of GDP in consolidation measures to avoid a fiscal stimulus this year. If the measures are promptly legislated within a 2013 supplementary budget, it would help keep fiscal policy broadly neutral for the year and send an important signal of the authorities’ resolve to tackle fiscal weaknesses.
5. Fiscal adjustment should focus primarily on curbing mandatory spending. Given their high shares in total expenditures, adjusting wage and pension bills would need to be a central pillar of a credible medium-term fiscal consolidation. These measures should, in any case, strictly control public sector employment and eliminate discretionary bonuses. The authorities’ effort to introduce a registry of public sector employees is therefore welcome. Ambitious parametric reforms of Serbia’s public pension system, such as unifying and increasing the retirement age and introducing actuarial penalties for early retirement, are also needed.
6. Expenditure control in all other areas is essential. Spending initiatives that require rationalization include the costly 2012
increase in agricultural subsidies, other inefficient subsidy programs, and those social assistance benefits that are inefficiently targeted. The recently proposed pension/payroll tax reform package will partly offset the expansionary impact of the 2011 amendments to the Law on Financing Local Governments, but it needs to be complemented by specific measures to improve fiscal outcomes at the local level. Public financial management reforms are also needed to underpin expenditure-based adjustment and limit fiscal risks.
7. Revenue measures should concentrate on broadening the tax base. Eliminating numerous costly CIT and PIT exemptions and allowances, and streamlining items that qualify for the lower VAT rate are priorities. While the scope for tax rate increases is limited, the reduced VAT rate could be increased from 8 to 10 percent consistent with the recent increase in the main rate. Furthermore, improvements in tax administration should address the unanticipated weaknesses in collection across all revenues, partly associated with the recent tax amnesty. Finally, the authorities should refrain from frequent changes in the tax framework to improve tax predictability.
Monetary and Exchange Rate Policy: Keeping Inflation Under Control
8. The NBS’ commitment to its inflation targeting (IT) framework is welcome. The mission supports Serbia’s commitment to price stability and maintaining the important role of the flexible exchange-rate regime as a shock absorber given significant price and wage rigidities. Reducing the inflation level and volatility would support dinarization and thus help improve the monetary transmission mechanism. As food price shocks account for a significant share of inflation volatility, greater trade liberalization in agricultural products would have a stabilizing role.
9. The NBS should err on the side of caution in relaxing monetary policy conditions. The mission supports the recent reduction of the key policy rate, but advises against reducing the average reverse repo rate at this time. Monetary conditions should be relaxed only when fiscal consolidation firmly takes hold, provided that there are no adverse shifts in capital flows and monthly inflation subsides as expected. A gradual reduction of the key policy rate, while broadly maintaining money market interest rates, would allow a narrowing the existing rate gap, and reducing uncertainty about direction of monetary policy. If risks of reversal in capital flows arise, excess dinar liquidity should be promptly absorbed.
Financial Sector: Preserving Financial Stability and Reviving Credit Growth
10. The financial system remains stable overall. Capitalization and liquidity indicators are high and NPLs are well-provisioned.
However, recent resolution cases are suggestive of weaknesses in some state-owned banks. Maintaining regular communication between MOFE, NBS and the Deposit Insurance Agency (DIA), developing a strategy for state-owned banks, and improving their management, would minimize the need for future resolutions.
11. Addressing structural impediments to credit growth and reducing banking-system vulnerabilities are priorities. Serbia’s banking sector has not been as impacted by deleveraging pressures as other European peers. However, credit growth is low despite abundant liquidity in the banking system due to perceived lending risks and high non-performing loans (NPLs). Relevant policy issues include:
•Addressing high NPLs. While several measures have been taken recently, reducing bottlenecks in corporate debt restructuring and work on additional actions for NPL resolution discussed during the Belgrade Forum, such as improving out-of-court debt
restructuring procedures, the judicial system, and collateral execution procedures, should be expedited.
• Implementing a comprehensive strategy of dinarization. This should include deepening local currency financial markets and fostering development of institutions that are likely to operate in these markets, such as insurance companies and pension funds.
• Avoiding significant relaxation of prudential policies. Serbia’s tight regulatory policies in this area have helped establish vital safety cushions to guard against the resurgence of financial stress. Changes to the provisioning framework before additional analysis should therefore be avoided.
Structural Reform: Increasing Growth and Competitiveness
12. Serbia’s growth model needs rebalancing towards exports. Expanding and diversifying Serbia’s export base is needed to achieve resilient growth and external sustainability, spur job creation, and accelerate income convergence towards EU. This implies removing long-standing structural bottlenecks that undermine competitiveness and hamper FDI inflows into tradable
sectors. The authorities’ recognition of the need for broad-based ownership and steadfast implementation of structural reforms is welcome.
13. Structural challenges need to be urgently addressed. Serbia’s economy is hampered by excessive regulations, a large and inefficient public enterprise sector, and a highly rigid and protected labor market. Policy reform priorities therefore include:
•Regulatory reforms. Recent steps to improve the complex regulatory framework are welcome, but Serbia’s business environment remains weak. The authorities should simplify business laws and regulations, strengthen the regulatory impact analysis of new legislation, modernize tax and customs administration, and streamline the regime of land registration and transfer.
•Public enterprise reform. Given the extensive subsidization and protection of public enterprises, the mission welcomes the authorities’ intention to accelerate (in coordination with the World Bank) the privatization and corporatization plans of public
enterprises and improve the transparency of their operations. Rigorous wage and employment policies based on performance criteria, a gradual increase in public utility tariffs to cost recovery levels, and the enforcement of strict limits on subsidies and the issuance of guarantees to those enterprises should also be pursued.
•Labor market reforms. These reforms are urgently needed to foster private-sector job creation. Priorities should be given to delinking severance-payments from lifetime employment, decentralizing wage bargaining, and relaxing complex legal
and administrative restrictions on the separation process, which in turn would improve incentives for hiring. Minimum wage increases should not outpace productivity gains.
The mission is grateful to the authorities and all other counterparts for their excellent cooperation and frank and open discussions.