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Federal Republic of Yugoslavia—Letter of Intent and Revised Memorandum of Economic and Financial Policies

December 26, 2001

The following item is a Letter of Intent of the government of Yugoslavia, which describes the policies that Yugoslavia intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Yugoslavia, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Mr. Horst Köhler
Managing Director
International Monetary Fund
700 19th Street
Washington DC 20431

Dear Mr. Köhler:

The implementation of policies under our stabilization and reform program for 2001, which is supported by a stand-by arrangement approved on June 11 and reviewed on September 19, has been firm, setting the basis for continued reforms and a sustained improvement in the living standards of our citizens. The attached Memorandum of Economic and Financial Policies—which updates and supplements the Memoranda attached to our letters of May 25, 2001 and September 4, 2001—describes our economic objectives and policies for the remainder of the program period. On this basis, we request: (a) completion of the second review under the stand-by arrangement and (b) a waiver of applicability of end-December 2001 performance criteria.

We believe that the policies and measures described in the attached memorandum are sufficient to achieve the program objectives, but we stand ready to take additional measures and seek new understandings with the Fund, if necessary, to keep the program on track. We will remain in close consultation with the Fund in accordance with the Fund's policies on such consultations, and will provide the Fund with all information that it requests to assess the implementation of the program. We propose to combine the last review under the current stand-by arrangement that is scheduled to expire at end-March 2002 with the start of an extended arrangement in support of a medium-term program of adjustment and reform.

Yours sincerely,

Miroljub Labus
Deputy Prime Minister and Minister
of Foreign Economic Relations
Federal Repulic of Yugoslavia
Mladjan Dinkic
National Bank of Yugoslavia
Bozidar Djelic
Minister of Finance
Republic of Serbia
Miroslav Ivanisevic
Minister of Finance
Reuplic of Montenegro

Federal Republic of Yugoslavia
Revised Memorandum of Economic and Financial Policies

Belgrade, December 26, 2001

I.  Introduction

1.  This memorandum updates and supplements the Memorandum of Economic and Financial Policies (MEFP) attached to the Letter of Intent of May 25, 2001, as subsequently revised by the MEFP attached to the Letter of Intent of September 4, 2001. It reports on economic performance and policy implementation under the Fund-supported program for 2001, updates the economic objectives and policy agenda under the program for the remainder of this year, and outlines the key economic and policy objectives for 2002. Annex A to this memorandum describes the quantitative performance criteria and indicative limits for the remainder of the program; and Annex B lists the preconditions for consideration of the second review by the IMF Executive Board, and the structural performance criteria and benchmarks for the remainder of the program.

2.   With macroeconomic and structural policies on track, rapid progress is being made in stabilizing and reconstructing the economy. In FRY as a whole, the fiscal, credit, wage and external targets of the program were achieved by a comfortable margin at end-September 2001. In Serbia, important decisions have been taken regarding reform of the banking system and, despite some initial delays, the privatization process remains on track. Meanwhile, retail price inflation declined to an annualized rate of 42 percent during the first 10 months of the year, from 113 percent last year, the foreign exchange reserves of the National Bank of Yugoslavia (NBY) have more than doubled since the beginning of the year, confidence in the dinar is being steadily restored, and output is on the rise—albeit from low levels. In Montenegro, fiscal pressures have eased somewhat. Further progress has been made in the areas of budget reform and privatization, while important decisions are pending in the area of bank restructuring. Inflation remains relatively high (an annualized rate of 26 percent in DM terms during January-September 2001) reflecting administered price increases as well as the lagged effects of large wage increases until late 2000.

II.  Economic and Policy Objectives For the Remainder of 2001
and For 2002

3.   Achievement of the broad macroeconomic objectives for this year has set the basis for further progress in 2002.

  • Real GDP in FRY is expected to grow by 5½ percent in 2001, somewhat faster than programmed, with strong output growth in agriculture and some services (including tourism in Montenegro) more than offsetting the lackluster performance of industry; in Montenegro, output growth was lower (3½ percent) than in the rest of FRY. Looking ahead, a worsening of economic conditions abroad will affect the FRY economy adversely, by limiting prospects for export growth and inflows of foreign direct investment. According to preliminary projections, GDP in FRY will grow by about 4 percent in 2002, with a resumption of growth in industry from a low level broadly compensating for normal agricultural performance.

  • Inflation in Serbia is expected to decline by almost two-thirds to 40 percent during 2001, compared to a program target of 35 percent. Adjusting for the effects of administered price increases and higher indirect taxes, core inflation is estimated at about 15-20 percent. For 2002, inflation is targeted to be halved to 20 percent; in light of further adjustments in administered prices, this would imply a core inflation rate of about 10 percent. In Montenegro, inflation is projected to decline by two-thirds to 8 percent during 2002.

  • Recent developments in the external accounts are consistent with the program target for the current account deficit in 2001. For 2002, the `underlying' current account deficit (adjusted for interest payments and project-related imports) is expected to decline slightly in relation to GDP.

4.   The updated policy targets for 2001 and the key policy parameters for 2002 are consistent with a strengthening of stabilization and reform. The fiscal deficit in the whole of FRY is now estimated at 2.4 percent of GDP in 2001, compared with a revised program target of 4.0 percent, reflecting revenue overperformance and some spending compression in response to delays in foreign financing and privatization receipts that had been programmed for late 2001. In the area of monetary policy, the NBY has revised the NFA and NDA targets for the remainder of 2001 to lock in and sterilize some of the continued external overperformance. Looking ahead, the fiscal program for 2002 will emphasize reliance on foreign assistance and privatization receipts to meet the new burdens on the budget, and—as a key fiscal objective—will strictly limit recourse to borrowing from the banking system to 0.6 percent of GDP. This should create some room for the restructured banking sector to support expansion of private sector economic activity. The overall fiscal deficit in FRY is tentatively projected to rise by 3.8 percentage points, to 6.2 percent of GDP in 2002. The increase in the deficit is entirely explained by a projected rise in interest payments on external debt, bank and enterprise restructuring costs, and investment spending. Adjusted for these categories of spending, the underlying fiscal deficit would decline by the equivalent of 1.6 percent of GDP in 2002. If progress in stabilization is slower than envisaged, macroeconomic policies will be tightened as needed to ensure achievement of the program objectives.

A.  External Debt Management

5.   Progress toward normalizing relations with external creditors has gained momentum in the past few months. An agreement was reached with Paris Club creditors on November 16, involving inter alia a phased 66 percent reduction in the net present value of commercial obligations and a rescheduling of the remaining stock over 22 years with a 6-year grace period. A Bank Advisory Committee for Yugoslavia's London Club creditors has been officially constituted and discussions were initiated in October. Treatment comparable to the Paris Club restructuring agreement will be sought from London Club as well as other bilateral creditors with government-guaranteed claims. As regards multilateral creditors, the regularization of arrears is nearly complete. EIB arrears of US$209 million were cleared on October 17, 2001 with the assistance of an EU macro-financial loan. Agreement was also reached in November 2001 on the restructuring of around US$1.8 billion in arrears to the World Bank, which involves a repayment of obligations over 30 years and paves the way for the commencement of lending operations. Discussions with the Eurofund were held in early October and agreement is expected on a restructuring of arrears over a ten year period. Efforts toward settlement with the two remaining multilateral creditors, the International Bank for Economic Cooperation in Moscow and the IFC, are continuing.

6.   The federal and republican authorities remain committed to observing the limits on non-concessional borrowing specified under the program. In this regard, a disbursement that shall not exceed US$50 million is planned from the KfW by mid-December to be used to assist the electricity generating company to carry out critical investment and repairs.

B.  Fiscal Policy


7.   Notwithstanding a difficult and uncertain environment, fiscal policy has remained on track in FRY as a whole in 2001, while important reforms have enhanced the efficiency of the tax and expenditure systems. The deficit of the consolidated general government in FRY is now envisaged to amount to 2.4 percent of GDP in 2001, compared with an original target of 6.1 percent and a revised target of 4.0 percent of GDP, while the limit on net government borrowing from the banking system (of up to 0.8 percent of GDP) will be observed. In Montenegro, the budget remained under pressure, contributing to arrears accumulation by the health fund. Meanwhile, a wide-ranging tax reform in Serbia, as well as improvements in tax administration in Montenegro, contributed significantly to buoyant tax revenue.

8.   Fiscal policy will continue to support economic stabilization and recovery. The preparation of the budgets for the next year, now underway, is subject to considerable uncertainty--related in large part to the amounts of foreign budgetary assistance and privatization receipts as well as tax revenues. Based on preliminary estimates, the fiscal deficit in FRY is expected to reach 6.2 percent of GDP in 2002 and to be financed largely by grants (1.2 percent of GDP), foreign loans (3.0 percent of GDP), and privatization proceeds (1.4 percent of GDP). Borrowing from the banking system will be limited to the equivalent of 0.6 percent of GDP. On current policies, the revenue/GDP ratio in FRY would rise by 1.6 percentage points, reflecting the full-year effect of tax reform measures introduced since last April and increases in excises, partly offset by a substantial reduction in the distortionary tax on financial transactions and sales tax exemptions for selected basic food items and medicines in Serbia. The expenditure/GDP ratio in FRY would rise by about 5.5 percentage points, accommodating an increase in (a) interest payments associated with the resumption of debt service to bilateral creditors and the World Bank (1.8 percentage points), (b) bank and enterprise restructuring costs (1.6 percentage points), and (c) investment spending (2.0 percentage points). Other spending, including wages, would remain broadly unchanged in relation to GDP. This appropriate fiscal policy stance will be accompanied by continued reforms of the budget system supported by a World Bank Public Expenditure and Institutional Review (PEIR).

9.   The repayment of frozen foreign currency deposits (FFCDs) will continue as envisaged under the program (MEFP of May 25, 2001, paragraph15). Bonds have already been issued to repay deposits up to DM 10,000 per account. A decision on the issuance of bonds to repay amounts in excess of DM 10,000 per account will be taken in 2002 in the context of the formulation of a medium-term program, consistent with limiting repayments to no more than 0.9 percent of projected GDP in 2005 and subsequent years.


10.   The execution of the federal budget in 2001 is expected to be in line with the program. Strong revenue performance on account of the sales tax and the customs duties, coupled with a prudent wage policy, have created room for clearance of outstanding arrears to military suppliers, full payment of military pensions, and additional spending related to the security zone in southern Serbia, in line with international agreements. A salary freeze through September at the level of November 2000 generated considerable savings from the budgeted amounts, which were only partly used to pay for the 15 percent wage raise granted in the last quarter. The introduction of civilian control over military spending, following the end-August transfer of responsibility for defense spending from the General Staff to the Defense Ministry, has significantly improved fiscal transparency and expenditure management. An internal audit of the defense budget will be initiated soon with a view to generating savings and averting further accumulation of expenditure arrears.

11.   The federal budget for 2002 will continue to operate with a cash balance and avoid any new accumulation of arrears. In light of the 15 percent wage increase in the last quarter in 2001, further wage increases during 2002 will be strictly limited to keep the real wage bill constant on a year-on-year basis. Defense spending is expected to be contained to 3.8 percent of GDP through measures to restructure the military, including a shortening of the compulsory military service, offset by increased spending in southern Serbia to address security needs in accordance with international treaties.


12.   The Serbian government continues to execute the budget cautiously. Strong revenue performance and containment of spending have compensated for delays in foreign budgetary assistance and privatization receipts that were programmed for late 2001. Revenue is expected to exceed the program target by the equivalent of 1½ percent of FRY's GDP due to strong performance by the sales tax, excises, and the personal income tax. Spending is expected to be lower than originally programmed by the equivalent of 2.3 percent of GDP owing mainly to a shortfall in foreign-financed projects and lower interest payments on foreign debt. Larger transfers to the social security funds would be offset by savings in material spending and subsidies.

13.   The social security funds have been affected more adversely by the mid-year tax reform than initially envisaged. High growth in recorded wages in July–August—which seems to have moderated thereafter—in conjunction with delays in amending the pension indexation scheme, have worsened the financial position of the pension fund. As a result, budget transfers to the pension fund will need to increase by the equivalent of 1.1 percent of GDP. Pension arrears incurred in February 2001 are expected to be eliminated by end-March 2002. The health care fund and the labor market fund, on the other hand, will be able to clear some of their arrears to beneficiaries and maintain the current level of services, with transfers to them from the budget contained below programmed levels.

14.   The 2002 Serbian budget will face serious challenges as bank and enterprise restructuring will drain substantial resources and debt servicing will rise sharply following normalization of relations with foreign creditors. Based on preliminary estimates, revenue will improve relative to GDP owing to the full-year impact of the tax reform that started mid-year in 2001 and increases in excises, partly offset by a lowering of the financial transactions tax and sales tax exemptions for selected basic food items and medicines. On the expenditure side, the Serbian budget will bear most of the external debt servicing obligations of the FRY. The budget will also need to provide for spending on bank and enterprise restructuring of about 1.5 percent of GDP, in the form of severance payments to redundant bank and enterprise workers and limited payments to depositors of banks undergoing liquidation. Wage policy will be guided by the principle of maintaining a constant wage bill in relation to GDP. Other spending will also be kept constant in relation to GDP. Most importantly, the pension system was reformed through the adoption of legislation in December 2001 that raised immediately the retirement age by 3 years and changed the indexation scheme for pensions along the lines of the Swiss model, with a view to keeping pensions in line with available resources. The Serbian budget is expected to run a cash deficit of about 5.6 percent of GDP in 2002, to be financed by 1.0 percent of GDP of grants, 2.7 percent of GDP of foreign borrowing on concessional terms, 1.3 percent of privatization receipts, and 0.6 percent of GDP of domestic bank borrowing. The privatization proceeds anticipated in the budget (equivalent to about US$150 million) compare with a Privatization Ministry estimate of US$200–400 million for 2002 (paragraph 28 below). Privatization receipts in excess of the amount that is anticipated in the budget would be used, in the first instance, to reduce the government's net indebtedness and, in consultation with the Fund and the World Bank, for the restructuring of enterprises with a view to facilitating their privatization.

15.   Fiscal reform continues. Following the wide-ranging tax and budgetary reforms in the first half of 2001, further progress has been made in improving expenditure management. The health fund adopted a revised drug list consistent with WHO guidelines and the line ministries' sub-spending accounts were eliminated, in line with structural benchmarks for end-September. Moreover, a set of draft laws, including the Organic Budget Law and the Public Procurement Law, were adopted by the government recently and are to be submitted to parliament by end-December 2001, while draft Tobacco and Lottery laws are to be submitted to parliament by end-January 2002. A new law on tax assessment and collection is being prepared; after revisions to take into account the anticipated reform to the payment system it will be submitted to parliament by mid-February 2002. Preparations for the establishment of Large Taxpayer Offices are running behind schedule owing to staffing constraints, but these are being addressed with the assignment of additional staff and the assistance of a resident tax administration advisor. In addition, progress is envisaged toward the establishment of a Treasury in the Ministry of Finance by mid-2002.


16.   Fiscal pressures eased somewhat in Montenegro after mid-year, on the basis of stronger revenue performance. Tax revenue is projected to be higher than budgeted by about 4 percent of Montenegro's GDP, mainly on account of sales tax and custom duties, reflecting a robust tourist season and measures to fight smuggling and tax evasion. In the context of higher than programmed inflation, the budget experienced expenditure overruns in almost all spending categories--with the exception of wages and salaries due to a nominal wage freeze. The consolidated general government of Montenegro is estimated to register a deficit (after grants) of about DM 28 million for the full year, down from DM 50 million at mid-year, while the central government is expected to effect previously delayed transfers to the social funds, thus permitting the clearance of arrears of about DM 22 million which had been accumulated by these funds earlier in the year.

17.   For 2002, the Government of Montenegro is committed to improve expenditure efficiency and reduce non-interest current expenditure in relation to GDP to restore fiscal balance and bring the budget on a path of sustainability. The government will delink the minimum wage from public sector pay scale so that the announced 12.5 percent increase in minimum wage will not lead to automatic increases in the public sector wages and benefits. Wage policy in 2002 will maintain the wage bill broadly constant in relation to GDP, reflecting a 5.4 percent rise in the base salary, increased employment mainly to fight the gray economy, and a corrective increase in teachers' salaries. Capital expenditure will also remain constant in relation to GDP, while subsidies to enterprises will increase in relation to GDP owing to the counterpart of foreign-financed electricity imports. As a result, the share in GDP of other non-interest current expenditure will decline, so as to accommodate the sharply higher external debt servicing cost. This would result in a deficit of 6.5 percent of GDP, financed entirely by foreign grants and loans (5.5 percent) and privatization revenue (2.6 percent), after taking into account a repayment of 1.6 percent of GDP to the central bank.

18.   The government has achieved substantial progress in fiscal reform. Specifically, the new Organic Budget Law and Public Procurement Law were adopted by the parliament in August 2001. An interim Treasury was set up in October, and is expected to operate fully from the beginning of 2002. Furthermore, six new drafts of tax codes covering personal income tax, corporate income tax, excises, property tax, the VAT and tax administration are being discussed in the government and parliamentary approval is expected by end-2001. With a view to enhancing fiscal transparency and efficiency, the Ministry of Finance requested a reputable foreign accounting firm to undertake an audit of the financing of the budget. The report, which was completed on November 15, 2001, revealed inter alia weaknesses in internal controls over budget borrowing and issuance of guarantees. This helps explains the issuance of government guarantees for two loans (totaling DM 200,000) from a commercial bank to an enterprise with mixed state/social ownership, in violation of a performance criterion. These problems are being addressed, in part by the newly established (with assistance from the USAID) Treasury in the Ministry of Finance.

C.  Wage and Pricing Policies

19.   Wage policy is geared to protecting competitiveness and lowering inflation. Wage policy in Serbia has generally aimed at maintaining the real wage bill of the state sector in 2001 unchanged from 2000 on the basis of the targeted rate of inflation. Consistent with this policy, wages in the federal government were raised in the last quarter of this year by 15 percent, unwinding the freeze that had been in place from November 2000; and wages in state enterprises, which had been frozen at their January level, were allowed to rise by about 10 percent in September in the context of cost-cutting restructuring measures. Wages in the Serbian government, which, unlike wages in the federal government and state enterprises, did not benefit from a large increase in late 2000 or early 2001, were instead allowed to rise in the course of 2001, with the annual wage bill kept unchanged in real terms from last year. Looking ahead, the federal and Serbian authorities will continue to contain wage growth to prevent an increase in the state sector wage bill in relation to GDP in 2002. In Montenegro, where public sector wages and the minimum wage have been kept constant since late 2000 in the context of an annual rate of inflation of over 20 percent, a tight wage policy will remain in effect so as to contain inflation and protect external competitiveness. In light of a 12.5 percent increase in the minimum wage as of January 1, 2002, to compensate partially for inflation over the past year, public sector wages and social benefits will be delinked from the minimum wage by end-2001, in line with an undertaking under the program (monitored through a structural benchmark). So as to manage the public spending on wages and social benefits in a fiscally sustainable manner, public sector wages and social benefits will no longer be based on the minimum wage but on a new "base wage," which for 2002 will rise by 5.4 percent. In both republics, the demonstration effect of wage restraint in the state sector should help contain wage growth in the rest of the economy. In addition, recent changes in labor legislation in Serbia have enhanced the flexibility of the wage determination process, while privatization should help improve corporate governance and financial discipline at the enterprise level.

20.   Pricing policy aims to reduce distortions and quasi-fiscal deficits. Electricity prices in Serbia were increased by 15 percent on October 1, 2001, bringing the cumulative increase since the beginning of this year to almost 120 percent. With the last increase, revenues would cover operating costs, after taking account of some DM 170 million in grants and DM 50 million in soft loans that are expected to fund reconstruction of assets destroyed or neglected during the 1990s and electricity imports during the winter season. The electricity price in Serbia is expected to be further increased from US¢ 2.03 to US¢ 3.0 per kWh by end-2002. This strategy will necessitate YUD 5 billion in budgetary support, in addition to envisaged donor support for maintenance and reconstruction. The prices of other utilities as well as the administered price of bread have also been adjusted by large amounts. In Montenegro, most administrative price controls have been removed with the exception of electricity and other utility prices. Electricity prices were effectively increased by 50 percent in November 2001 to the equivalent of US¢ 2.7 per kWh and will be further increased in during 2002.

D.  Monetary and Exchange Rate Policy

21.   The financial program targets for 2001 have been further revised to take account of the remonetization of the economy. The much higher-than-programmed growth in reserve money is explained entirely by net NBY purchases of foreign exchange from the public, an indication of growing confidence in the dinar. In light of these developments, reserve money is now targeted to grow by about 76 percent during 2001 (compared with 46 percent under the revised program), with the NDA and the NFA of the NBY contributing 10 and 66 percentage points to this growth, respectively, as compared with contributions of 25 and 21 percentage points, respectively, under the revised program. Within reserve money, currency in circulation is expected to rise by 90 percent in line with recent trends, while the other components of reserve money are expected to decline sharply in real terms mostly on account of the banks' excess reserves (these were relatively high at end-2000 and have since been absorbed through money market operations). In the event of higher-than-projected NFA, the NBY will consult with the Fund staff on the implications for credit policy and—if the NFA overperformance does not appear to reflect increased money demand—will maintain the NDA below the program ceiling.

22.   Exchange rate policy will seek to strike a balance between safeguarding external competitiveness and stabilizing inflation expectations. The broad stability of the exchange rate of the dinar against the DM (euro), in conjunction with the strengthening of foreign reserves, has contributed to the restoration of market confidence. Furthermore, the current level of the exchange rate appears to be broadly adequate, considering that the NBY continues to be a net purchaser from the foreign exchange market and that the real exchange rate of the dinar is still below its level in 1998, when international sanctions were still in effect. However, in light of the sizable real appreciation of the dinar since the beginning of the year, the NBY will continue to monitor closely developments in the foreign exchange market with a view to adjusting exchange rate policy as needed to safeguard the external position. Owing to uncertainty about the external outlook and underlying position, exchange rate policy will be reviewed quarterly under the program.

23.   The NBY is liberalizing further the foreign exchange market and reforming monetary policy instruments. In the first quarter of 2002, a new foreign exchange law will be adopted, along with changed regulations on open positions, which will allow banks to participate actively in the foreign exchange market. Pending the adoption of this law, the exchange rate band within which commercial banks may transact outside the interbank market will be widened to +/-2½ percent, and the NBY will repeal the surrender requirement for foreign currency banknotes. In addition, the reserve requirement system is being reformed through (a) the abolition of the supplemental reserve requirements as of September 2001 and (b) the adoption, in January 2002, of a unified system of monthly averaging for reserve requirements (in both domestic and foreign currencies) at a rate that leaves the effective reserve requirement unchanged (around 15 percent), compared to the current rate of 24.5 percent). To complement the change in required reserves, the NBY will simultaneously lower liquidity requirements on foreign exchange deposits in a compensating fashion (by about 15 percentage points) and abolish liquidity requirements on dinar deposits. To facilitate banks' short-term liquidity management needs, a marginal lending facility and a permanent deposit window will be developed by end-March 2002.

24.   Further measures to accelerate financial market development will facilitate monetary operations and privatization. A new Law on Securities will be submitted to Parliament by March 2002 and a Law on Investment Companies will be submitted to Parliament by June 2002 to facilitate the operation of primary and secondary securities markets. By December 2001, a working group will be established to promote financial market development through the issuance of market-friendly instruments that are issued to repay frozen foreign currency deposits. Another working group, including representatives of the Belgrade Stock Exchange, will be established to develop money market infrastructure.

25.   The NBY is committed to improve its accounting, audit, and control systems. Accordingly, by end-December 2001, the NBY will take a decision to (i) address the accounting treatment of unresolved succession issues and (ii) prepare financial statements for financial year 2001 on the basis of International Accounting Standards (IAS). By mid-February 2002, the Internal Audit Department of the NBY, as part of its regular audit cycle, will review the reconciliation of the accounting records and the NFA data submitted to the Fund for program purposes on a monthly basis, effective with the end-December 2001 data. In addition, by mid-February 2002, the NBY will strengthen the functioning of the Internal Audit Department by: (i) defining its role with the development of a charter and ensuring an appropriate degree of independence and objectivity; (ii) continuing to recruit additional staff with skill levels necessary to successfully conduct financial and information systems risk-based audits; and (iii) commissioning an independent assessment of the Internal Audit Department. Furthermore, it is envisaged that: by mid-2002, the Law on the NBY will be amended to (i) adopt IAS as the permanent accounting framework, and (ii) provide for a Supervisory Board (the By-laws of the NBY will also define the establishment of an Audit Committee). Finally, by end-June 2002, the IAS-based financial statements of the NBY will be published.

E.  Bank Restructuring

26.   Substantial progress in bank restructuring has been made in line with the Bank Restructuring Strategy prepared by the NBY last May. Of about 85 banks, 19 banks have been closed as insolvent and nonviable, another 17 banks have been merged (or are in the process of being merged) with other banks to meet capital requirements, and one small bank has been placed under NBY administration owing to irregularities. In addition, five solvent but undercapitalized banks have been placed in the problem bank unit of the NBY and 8 insolvent banks (including five large ones) have been brought under the control of the Bank Rehabilitation Agency (BRA) for possible rehabilitation. The BRA Board, based on the recommendations of the NBY, has appointed new managers, recognized the losses on bad loans, written off the equity capital, and established the BRA as the exclusive owner of the five largest banks. In late September, the federal Parliament approved amendments to the Law on the Financial Rehabilitation, Bankruptcy, and Liquidation of Banks, as well as to the Law on the Agency for Deposit Insurance and Bank Rehabilitation, Bankruptcy and Liquidation or the BRA law, which will allow for speedier resolution through the authorization of the BRA to become designated as the receiver and liquidator of banks while curtailing the powers of the bankruptcy judge as regards banks. As a step toward deciding on the future of the large banks that are under BRA administration, detailed information has been compiled on the income, expenses, and cash flow of these banks and their liquidity positions are closely monitored. Problems related to these banks will be resolved in an expeditious and fiscally prudent manner.

27.  Banking supervision at the NBY will be strengthened through new legislation and improvements in technical capacity. In particular, by end-2001, an amendment to the Law on the National Bank setting out its supervision functions will come into effect, and revisions to the Law on Banks would empower the NBY to issue regulations on bank supervision in line with international practice. Implementing regulations will take effect at the beginning of 2002, covering, inter alia, capital adequacy, exposures, liquidity, lending to connected parties and shareholders, loan classification and provisioning, internal control and risk management, credit activities, and investment in fixed assets as well as other bank and enterprise capital. The NBY has increased the number of staff trained to carry out on-site supervision and a computerization project is underway to automate off-site supervision. From the beginning of 2002, the frequency of bank reporting will increase from quarterly to monthly. Lastly, to facilitate NBY's efforts to curtail opportunities for money laundering from the outset of EURO conversion process, the Bankers' Association has agreed upon regulations requiring banks to report transactions in excess of DM 20,000.

28.  The Central Bank of Montenegro (CBM) has taken steps to restructure the banking system. The largest bank, Montenegro Banka (MB), is under Central Bank control and the authorities have eschewed the possibility of a capital injection. A decision regarding privatization or liquidation of the bank will be made by end-December 2001. Documents inviting investors to acquire MB, in part or in full, have been made available to potential investors and posted on the website of the CBM. If liquidation is adopted, a program will be designed to mitigate the social impact of bank closure, costing about DM 1.8 million for an expected 440 layoffs. Diagnostic reports for the remaining 10 commercial banks in Montenegro have been completed with assistance from bilateral donors. Four of these banks have been re-licensed based on new regulation. A decision regarding the re-licensing of the remaining six banks will be made by mid-January 2002, following the expected adoption of the proposed amendments to the Law on the Banks.

29.  Further progress has also been made in strengthening the CBM's bank supervision capacity. The Law on Bankruptcy and Liquidation of Banks and amendments to the Law on the Central Bank, which regulates banks' lending as well as purchases and sales of government securities, have been passed. Decisions on liquidity risk, internal control, internal and external audit, and implementation of the CAMEL system have been issued. A law on the International Accounting Standards (IAS) is expected to be adopted by end-November 2001 and a decision implementing a new chart of accounts for banks—in line with IAS—is expected to become effective in January 2002. This would allow for, inter alia, better monitoring of credits to government. To enable CBM to supervise the existing offshore banks, in line with the rules and regulations applicable to onshore banks, an amendment to the Law on Banks is being drafted and is expected to be submitted to parliament by year-end. Meanwhile, the Ministry of Finance has ceased issuing licenses to new off-shore banks since late 2000. The CBM is well advanced in its plans to introduce the euro on January 1, 2002, in line with the Law on the Central Bank.

F.  Enterprise Restructuring and Privatization

30.   Privatization is moving forward in Serbia despite some delays in obtaining privatization receipts. Tenders for the three cement companies were published in late October and, in light of strong interest among investors, the transactions are expected to be completed in January 2002, slightly later than envisaged under the program, and to generate substantial fiscal revenues. Moreover, 27 companies are to be privatized under the World Bank-supported program: 15 companies in 4 pools, to be followed by 12 companies in 2 pools. A structural benchmark for the conclusion of at least four contracts for the privatization of pools of companies by end-October, 2001 was missed due to a slowdown in consultations with the World Bank, in the wake of the September 11 events. Under the revised schedule, for the first 4 pools, advisors are to be appointed in January 2002, tenders are to be launched in February/March 2002 and privatization is expected to take place in 2002 Q2. For the remaining 2 pools, advisors will be appointed in March 2002 and privatization is expected to be completed in 2002 Q3. In addition to these 27 companies, two other large enterprises (Beopetrol and Frikom) will be offered for sale through international tender during 2002. Auctions and sales of minority interests in selected companies will also start in 2002. Auctions can be initiated by the Ministry, the workers or potential investors. The authorities intend to initiate the auction process of some 30 companies during 2002 and to encourage further interest in this process by publishing basic information on some 500 socially-owned small and medium-sized companies. Total privatization revenue could reach the equivalent of US$200–400 million during 2002. Some 28–35 large diversified and insolvent companies will be restructured over the next two years prior to their privatization, starting with the automobile company Zastava. Restructuring of up to 10 other companies will be undertaken with assistance from the European Agency for Reconstruction.

31.   The processes of bank and enterprise restructuring will be coordinated. A memorandum of understanding between the Privatization Agency (PA) and the BRA will guide the restructuring of debts to banks under BRA administration. A write-off of tax arrears and a haircut of BRA claims either directly or through a debt/equity swap would facilitate the privatization process significantly. If legally feasible, a memorandum of understanding will give BRA creditors equal treatment to at least the recovery percentage that all creditors could realize under current bankruptcy procedures. The Supreme Court will be invited to give its opinion on this approach by end 2001. Moreover, the state will not remove or "clean" bank assets (related to frozen foreign currency deposits, World Bank, Paris Club, and London Club debts) prior to or during liquidation of banks; these will remain as assets of the banks and as liabilities to government.

32.   Progress in privatization is also being made in Montenegro. The mass privatization plan is proceeding as envisaged and 51 percent in Montenegro's telecom company is being offered for sale through a tender. Six privatization investment funds, representing Montenegrin and foreign investors from 15 foreign entities, have been licensed to manage privatization vouchers. These companies control over 60 percent of all vouchers. During December, these companies and the citizens of Montenegro will receive shares in 227 companies. Following registration of the shares with the Central Depository Agency in January 2002, shareholder meetings will be called to appoint new directors to all privatized companies. Tenders for a majority share will be offered in selected companies including the Montenegrin telecommunications and Yugopetrol (Montenegro) that are expected to be completed during 2002.

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