Republic of Montenegro and the IMF

Republic of Serbia and the IMF

Press Release: IMF Approves US$64 Million Tranche Under Stand-By Credit and US$829 Million Extended Arrangement for the Federal Republic of Yugoslavia

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Yugoslavia—Letter of Intent,
Memorandum of Economic and Financial Policies,
and Technical Memorandum of Understanding

April 26, 2002

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.

Use the free Adobe Acrobat Reader to view the Annex A-C (455kb PDF file)

Mr. Horst Köhler
Managing Director
International Monetary Fund
700 19th Street
Washington, D.C. 20431

Dear Mr. Köhler:

Our firm implementation of the economic program supported by the Fund under the current stand-by arrangement has succeeded in restoring financial stability under extremely difficult conditions and in facilitating the adoption of important reform measures. This has set a good basis for continued reforms and progress toward sustainable growth and a viable external position. Over the past several months, in cooperation with Fund and World Bank staffs, we have formulated and begun implementing a medium-term stabilization and reform program. Our program for 2002-05 is described in detail in the attached Memorandum on Economic and Financial Policies. On this basis, we request (a) completion of the third review under the current stand-by arrangement and (b) approval of a three-year extended arrangement in the amount of SDR 650 million.

We believe that the policies and measures described in the attached memorandum are sufficient to achieve its objectives, but we stand ready to take additional measures and seek new understandings with the Fund, as 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. The program will be reviewed by the Fund on a semiannual basis (by May 15 and November 15, respectively). The first, third and fifth reviews will focus in particular on the annual budgets and financial programs for 2003, 2004 and 2005, respectively. Moreover, we understand that each purchase under the arrangement will be subject to a review of the financing of the program.

Yours sincerely,

Miroljub Labus
Deputy Prime Minister and Minister
of Foreign Economic Relations
Federal Republic of Yugoslavia

Mladjan Dinkic
National Bank of Yugoslavia
Bozidar Djelic
Minister of Finance
Republic of Serbia
Miroslav Ivanisevic
Minister of Finance
Republic of Montenegro



I. Introduction

1. This memorandum updates the Memorandum of Economic and Financial Policies (MEFP) attached to the Letter of Intent of May 25, 2001, as subsequently revised by the MEFPs attached to the Letters of Intent of September 4, 2001, December 26, 2001, and January 4, 2002. The memorandum (a) reports on economic performance and policy implementation under the program for 2001 that was supported by the IMF under a 10-month stand-by arrangement approved on June 11, 2001; (b) outlines the key economic and policy objectives of a 2002-05 program of stabilization and reform that could be supported under a prospective Extended Arrangement (EA); and (c) describes the policy measures envisaged during 2002. Annex A to this memorandum contains information on the quantitative performance criteria and indicative limits under the current arrangement and those proposed for 2002 under the envisaged arrangement. Annex B contains information on the structural performance criteria and benchmarks under the current arrangement and those proposed for the envisaged arrangement, as well as the preconditions for consideration by the IMF Executive Board of the third review and the request for an Extended Arrangement. Annex C contains a detailed list of structural policy measures envisaged to be implemented during the EA. Annex D defines the performance criteria and indicative targets and describes the reporting arrangements.

2. Economic performance has been impressive since late 2000, reflecting the firm implementation of macroeconomic and structural reform policies. Inflation during 2001 declined by two-thirds to 39 percent by year-end; adjusting for increases in administered prices and indirect taxes, core inflation is estimated at 15 percent. Real GDP grew by an estimated 5½ percent in 2001. GDP growth is attributed to a rebound (by 25 percent) in agricultural output after the previous year's severe drought, and increasing activity in services. Industrial production was roughly unchanged in 2001 as a whole, reflecting capacity constraints after years of disinvestment and the ongoing economic restructuring, but has recently shown signs of a modest recovery. The external current account deficit (before grants), estimated at US$1.2 billion or 10.9 percent of GDP in 2001, was lower than originally projected owing mainly to buoyant inflows of remittances. The foreign exchange reserves of the NBY more than doubled to US$1.2 billion (2.6 months of projected imports of goods and services) by end-2001.

3. Macroeconomic policy implementation has remained firmly on track. Specifically, quantitative performance criteria at end-December 2001 were observed. The fiscal deficit in FRY was contained to an estimated 1.4 percent of GDP in 2001, against an original target of 6.1 percent of GDP, as a result of revenue overperformance as well as spending compression in response to delays in privatization proceeds and foreign financing. Revenue performance was enhanced by wide-ranging reforms and efforts to curtail tax evasion. Fiscal policy implementation in Montenegro improved in the second half of 2001, while problems in fiscal transparency were being addressed through the establishment of a Treasury in the Ministry of Finance. The NDA and NFA targets were comfortably observed, while the indicative target for wage growth in large state enterprises was exceeded by less than ½ percent.

4. Structural reform has generally proceeded at a fast pace, even though some structural benchmarks were not observed. Following the liberalization of the price, foreign exchange, and trade regimes in early 2001, new institutional frameworks for bank and enterprise restructuring have been implemented with technical assistance from the Fund and the World Bank. The closure in early January of four large insolvent banks--accounting for almost 60 percent of the book value of the banking system assets but less than 20 percent of banking services--represented an important step toward building a healthy banking system. In addition, an excellent start on the privatization program took place in late December, with the sale of three cement companies to foreign investors for the total amount of US$140 million. In Montenegro, important progress was made in reforming the tax system, improving public expenditure management, and privatizing public properties through reliance on the voucher method of mass privatization. Nevertheless, six out of 17 structural benchmarks for the period between mid-December 2001 and end-March 2002 were not observed. In the fiscal area, staffing constraints at the PRA headquarters delayed the set-up of the Large Taxpayer Unit, which is now expected by end-June 2002. The benchmarks related to the central accounting unit and a new system of control will be met after the Treasury has been set up by April 2002. The appointment of privatization advisors by the Serbian Privatization Agency has also been delayed by several weeks, but the privatization program remains on track.

5. Prospects for external sustainability were enhanced by the Paris Club decision to reduce the net present value (NPV) of debt to official bilateral creditors by 66 percent. The first phase of the Paris Club debt reduction (51 percent) will enter into force with the approval of the prospective EA, while the second phase (the remaining 15 percent) will become effective upon successful completion of the EA. Discussions are continuing with other official bilateral and commercial creditors with a view to obtaining debt relief on terms similar to those granted by the Paris Club.

6. Relations between Serbia and Montenegro will be reformed. On March 14, 2002, the federal and republican authorities, under the auspices of the EU, reached agreement on a new constitutional framework. The agreement provides for the streamlining of common administrative institutions; acknowledges the existence of different monetary, exchange, customs, and tax regimes; and envisages harmonization of the economic systems of Serbia and Montenegro with that of the EU. A draft Constitutional Charter is to be submitted to the federal and republican parliaments by end-June 2002. By the same date, the Serbian and Montenegrin authorities will reach agreement on how to resolve the issue of inter-republic trade regarding customs, excises and VAT. Changes to policies and program conditionality, to reflect the evolving constitutional framework, will be discussed in the context of the program reviews.

II. Economic and Policy Objectives for 2002-05

7. The economic objectives for 2002-05 envisage achievement of sustainable growth and improved living standards, low inflation, and a viable external position:

  • Real GDP is projected to grow by 4 percent in 2002, on the expectation that normal growth in agricultural output after last year's strong rebound will be accompanied by nonagricultural growth of 4 to 5 percent (as compared with an estimated 1½ percent in 2001), reflecting increased foreign assistance, inflows of FDI, and the response of the economy to improved incentives. Beyond this, the medium-term growth rates are expected to increase to about 5 percent as a result of the implementation of reforms and a projected rise in the level and efficiency of domestic investment.

  • Inflation (retail prices) in Serbia is targeted to be halved to 20 percent by end-2002, which would correspond to a core inflation rate of about 10 percent after accounting for further large adjustments in administered prices; to 12 percent by end-2003; and to 8 percent by end-2004. In Montenegro, inflation is projected to be halved to 12 percent by end-2002 and to decelerate further in 2003-04. Over the medium term, inflation in FRY is projected to converge toward EU levels, with the margin explained by further increases in administered prices (notably for electricity).

  • The external current account deficit in FRY is expected to widen to US$1.6 billion (12.9 percent of GDP) in 2002 reflecting a resumption in external debt service as well as higher project-related imports. Thereafter, the current account deficit as a share of GDP should show a steady improvement to 2005, mostly due to a recovery of exports to their historical levels. In 2002, the current account deficit will be financed largely by official grants and loans that have already been pledged; financing assurances are expected for the remainder. For 2003-05, consistent with indications provided at the June 2001 Donors conference, an average of US$840 million in additional financing is expected from bilateral donors as well as multilateral lending agencies, including the World Bank, EBRD and EIB. FDI inflows will play an increasing role as the privatization program and other economic reforms reach an advanced stage.

  • Official foreign reserves will be targeted to rise to the equivalent of 4½ months of imports of goods and services by end-2005, with a view to ensuring a strong external position in anticipation of a peak in debt servicing obligations in the second half of the decade.

8. The 2002-05 program envisages the continuation of prudent macroeconomic policies. Moreover, given the uncertainty surrounding medium-term macroeconomic prospects, the fiscal and other policy targets will be kept under close review to achieve the key objectives of low inflation, sustainable growth, and a resilient external position.

  • The fiscal deficit will remain sizable--in line with the experience of other transition and post-conflict countries--owing to the investment needs in the country's dilapidated infrastructure, external debt service requirements, and the higher costs of maintaining an adequate social safety net during the transition. The deficit will be financed mostly by foreign grants and concessional loans, which have been estimated on the basis of past and expected donor commitments, as well as projected privatization receipts. The government's recourse to domestic financing will be subject to a limit--to be treated as a performance criterion--of around ½-1 percent of GDP throughout the EA.

  • Monetary policy will be geared to lowering inflation while supporting economic recovery. The monetary program for 2002 assumes a further recovery of confidence in the dinar in line with recent trends.. Even though the current level of the exchange rate appears to be appropriate, developments in the foreign exchange market will be monitored closely and exchange rate policy will be assessed regularly during the program reviews with a view to safeguarding competitiveness.

  • Wage policy in the state sector (government and major state enterprises) will serve as an inflation anchor and as a means of encouraging a streamlining of employment to raise labor efficiency.

9. Achievement of the economic objectives will also require implementation of an ambitious structural reform agenda aimed at fostering private sector-led growth, with the support of the World Bank and other donors. The program will include (a) further fiscal reforms, mainly to improve tax administration, expenditure management, the targeting of social services and transfers, and the finances of the pension fund in addition to addressing the implications of fiscal decentralization; (b) legal and regulatory measures to strengthen further the financial position of commercial banks, following up on recent progress in closing insolvent banks; and (c) rapid progress in restructuring the enterprise sector, which is mostly decapitalized and overstaffed, and creating a business environment that supports the development of the private sector.

10. Considerable progress toward fiscal and external sustainability should be achieved during the EA. The program envisages a much-needed reduction in government indebtedness in relation to GDP, a streamlining of expenditures and revenues, and steadily declining deficits. Increases in government and nongovernment savings would permit a sizable rise in the investment/GDP ratio during 2001-2005, notwithstanding an envisaged decline in foreign assistance and increasing interest payments on external debt. Moreover, external debt indicators, while remaining relatively high, are expected to improve both during and after the EA, reflecting largely the phased debt reduction and the reliance on grants, concessional loans, and FDI inflows to finance the current account deficits. A prudent policy of external debt management will underpin progress towards external sustainability. The federal and republican authorities will aim to clear all remaining external arrears, observe the limits on non-concessional borrowing specified under the program, and avoid the accumulation of new external arrears.

A. Fiscal Policy


11. The fiscal framework for 2002 supports investment in infrastructure and economic restructuring. After substantial compression of expenditure in 2001 due to delays in foreign financing and privatization proceeds, the general government deficit is projected to reach 5.7 percent of GDP and will be financed mainly by foreign assistance and privatization proceeds. Domestic borrowing will be limited to the equivalent of ½ percent of GDP. Budgeted foreign assistance (mainly from the World Bank and the EU) appears to be firm, assuming that policy conditionality is met, while the target for privatization receipts in 2002 is likely to be comfortably met. In the event of a shortfall in revenue or in foreign assistance and privatization proceeds, possible expenditure cuts have been identified. Any excess privatization proceeds will be used, in the first instance, to reduce net government indebtedness and, in consultation with Fund and World Bank staffs in the context of program reviews, to facilitate enterprise privatization.

12. Fiscal policy over the medium term will aim to support economic recovery and reform while ensuring progress toward further disinflation and fiscal sustainability. The overall expenditure/GDP ratio--which is projected to reach 48½ percent in 2002--will be targeted to decline by about 3 percent of GDP over the EA period, while making room for increased debt servicing and capital spending. This would require noninterest current spending to be lowered in relation to GDP over the medium term, by containing real increases in such spending. To this end, all governments will embark on a major overhaul of subsidies, the civil service, healthcare, pensions, and other social benefits. On the revenue side, the policy effort will focus on improving tax administration to widen the tax base and, to the extent permitted by the fiscal situation, lower tax rates.


13. The federal government will continue with a balanced budget in 2002 coupled with expenditure reform. Expenditure and revenue will remain constant in relation to GDP. Capital spending will be slightly higher in relation to GDP, while the share of excises in total revenue will increase significantly, offset by a corresponding decline in sales tax revenue, as result of a new federal-Serbian revenue-sharing formula. Fiscal reporting will improve substantially following the adoption of GFS classification with the 2002 budget. The military has initiated restructuring to enhance its efficiency, in part though downsizing the officer corps and shortening the conscription period from 12 months to 9 months. This, combined with expected expenditure savings in the federal administration in light of the recent agreement on a new constitutional framework, should permit spending currently undertaken by the federation to decline in relation to GDP over the medium term.


14. The 2002 Serbian budget bears most of the new fiscal burdens of the FRY economy. Expenditure will increase by about 5½ percentage points of GDP owing to higher debt service, bank and enterprise restructuring costs, capital spending and higher transfers to social funds. Tax revenue will increase by about 2 percent of GDP on account of the carry-over effect of tax reform initiated mid-2001, the change of the revenue-sharing formula with the federal budget, and the increase in excises (jointly contributing about 3 percent of GDP), which will be partly offset by a reduction in the financial transactions tax and some reclassification of state agencies' own-revenue (a loss of revenue of about 1 percent of GDP). Since the 2002 budget was prepared with the new GFS classification, budget reporting and monitoring should improve during the year, thereby facilitating the conduct of fiscal policy. In the event of a shortfall in revenue and foreign financing, or other developments that may endanger achievement of the macroeconomic objectives, possible expenditure cuts of ½ percent of GDP have been identified in the areas of subsidies and capital spending.

15. Further structural reforms in the fiscal area will involve tax policy, tax administration, public expenditure management and social spending. In light of the wide-ranging tax reforms adopted last year, the introduction of the VAT is the key remaining tax policy reform in Serbia. Technical preparations have already begun for the introduction of the VAT in January 2004. In the area of tax administration, a Law on Tax Administration Organization and a Law on Identification, Control and Payment of Public revenue are expected to be adopted by parliament by end-June 2002 (to be monitored as a structural benchmark). The Ministry of Finance intends to reorganize the Public Revenue Agency (PRA), move to a modern computerized system and--to be monitored as structural benchmarks--establish a Large Taxpayer Unit (LTU) and create a unique taxpayer identification number.(see Annex C). In the area of public expenditure management, a Treasury with some basic functions will be set up by end-September 2002 (to be monitored as a structural benchmark). With World Bank support (including Public Expenditure and Institutional Review missions), policy reforms affecting pensions, healthcare, and social welfare programs will help streamline social spending, while the planning and policy analysis capacity of the Serbian Ministry of Finance (MoF) will be strengthened.


16. The 2002 budget for Montenegro puts fiscal policy on a more sustainable basis by containing non-interest current expenditure in relation to GDP. Spending across the board will either remain largely constant or decline as a share to GDP; an increase in the share of wages is entirely explained by the underpayment of social security contributions in 2001 because of a delay in the receipt of foreign budgetary grants. Total revenue will be higher by about 2 percent of GDP mainly on account of increased own-revenues of state agencies that have been reflected in the Treasury single account for the first time in 2002, while expenditure is higher mainly on account of external debt service and the aforementioned anomaly in the wage bill data. On the whole, foreign grants and concessional loans will be sufficient to finance Montenegro's consolidated government deficit of 6.3 percent of Montenegro's GDP as well as to repay funds borrowed from the Central Bank of Montenegro last year.

17. Fiscal reforms will concentrate on the implementation of recently adopted tax legislation, pension and healthcare reform, and improvement in Treasury operations. The government adopted a set of six tax laws in December 2001, envisaging their phased implementation in 2002. The most visible changes will affect tax administration, which is now undergoing reorganization and preparing for the introduction of new excises in April, the personal income tax in July, and the VAT and the property tax in January 2003. At the same time, the government is preparing regulations that will change the current net wage system to a gross concept that is consistent with the new personal income tax law. The Treasury already controls about 55 percent of total transactions, with full coverage expected by mid-2003. Reforms in the pension system have been initiated with World Bank assistance and will involve a phased increase in the retirement age by 3 years as well as a shift in the pension indexation scheme from wage increases to an arithmetic average of wage and price increases (to be monitored as a structural benchmark).

B. Wage and Pricing Policies

18. The growth of the wage bill in the state sector will be strictly controlled during 2002-05, with a view to containing wage pressures in the economy, lowering inflation, and encouraging labor shedding. In 2002, the state sector wage bill in relation to GDP would be kept constant; thereafter, the share in GDP should be lowered gradually, while real average wages could rise as a result of streamlining the civil service, the education & health sectors, and the public utilities. Private and socially-owned companies will continue to face a hard budget constraint, while a recently adopted Serbian labor law that liberalizes employment contracts and wage determination--along with a similar Montenegrin law that is expected to be adopted soon--will raise labor market flexibility.

19. Administered prices for electricity will be adjusted to cost-recovery levels. Electricity prices in Serbia were raised by 120 percent during 2001 to US¢2.03 per kWh, while production costs were contained and the collection rate was increased. Electricity prices will be raised further by about 50 percent to a level that covers operational costs by mid-2002 (to be monitored as a performance criterion) and to "full-cost recovery" (estimated at US¢4.5 per kWh by World Bank staff on the basis of regional comparisons) by mid-2004. To facilitate further liberalization and future privatization, an independent regulator of electricity and other energy prices will be established with World Bank assistance by end-2003. In Montenegro, electricity prices will be raised by October 2002 to at least 4.6€cents/kWh (US¢4.2 per kWh),excluding the aluminum plant, thereby reducing cross-subsidies.

C. Monetary and Exchange Rate Policy

20. Monetary policy in 2002 will continue to be guided by the same principles as in 2001. Reserve money growth will be driven by increases in NFA arising from foreign exchange inflows and a portfolio shift to the domestic currency by residents, while the NDA will continue to be strictly limited. Reserve money will be targeted to rise by about 37 percent, implying a further decline in velocity of about 7 percent, compared with a decline of about 32 percent during 2001. (The end-2001 base data have been adjusted for the effects on reserve money of the closure of four large banks as well as the envisaged change in the reserve requirement.) Growth in the NDA and in the NFA of the NBY is projected to contribute 12 and 25 percentage points, respectively, to reserve money growth. In the event of higher-than-projected NFA, the NBY would consult with the Fund staff on the implications for credit policy and--if the NFA overperformance does not appear to reflect increased money demand--would maintain the NDA below the program ceiling. The NBY will conduct auctions of its securities in quantities sufficient to absorb the excess liquidity in the interbank market, consistent with the NDA target, and accept the resulting interest rates. The discount rate will be set to reflect market conditions.

21. The managed float policy--which has served Serbia well, inter alia in lowering inflation and strengthening confidence--will be continued and implemented flexibly with the goal of striking the right balance between attaining the disinflation objectives of the program and avoiding an unsustainable appreciation of the real exchange rate. The broad stability of the exchange rate of the dinar against the euro since the beginning of 2001 continues to be associated with favorable developments in the foreign exchange market, as indicated by broad balance of demand and supply in the interbank market (i.e., even excluding autonomous foreign exchange inflows, such as those related to foreign assistance and privatization proceeds) and continuing increases in the NFA of the NBY. Meanwhile, the dinar has appreciated substantially in real terms since late 2000, albeit from very low levels. Looking ahead, exchange rate policy will be kept under close review taking into account not only conditions in the interbank market but also developments in exports, imports, and wages.

22. The foreign exchange market will be further liberalized. A proposed new foreign exchange law, to be submitted to the federal parliament by end-April 2002, and implementing regulations under preparation will streamline the operation of the foreign exchange market and pave the way for FRY's acceptance of the obligations of Article VIII, Sections 2, 3 and 4 of the Fund's Articles of Agreement. In general, all restrictions on payments and transfers for current international transactions will be eliminated, and capital account transactions will be considerably liberalized with the exception of lending and investing abroad and short-term capital movements. Documentation requirements for permitted transactions will be sharply reduced. Transactions will be allowed at exchange rates other than those set in the daily fixing session of the interbank foreign exchange (as an interim measure, the banks have been recently allowed to trade within a range of +/- 2.5 percent). Banks will be allowed to purchase foreign exchange from the NBY on their own account for the purpose of covering open positions as well as for carrying out current and legitimate capital account transactions on behalf of their customers. The restrictions on purchases and sales of foreign banknotes by commercial banks will be repealed. The NBY will consult with the IMF's Legal Department with a view to identifying and removing any remaining exchange restrictions, thus paving the way for FRY to accept the obligations of Article VIII, Sections 2, 3 and 4, by mid-2002.

23. Important progress in bank restructuring has set the stage for reform of monetary policy instruments, the development of the financial market, and reform of the payments system. With Technical Assistance from the Monetary and Exchange Affairs Department (MAE) of the IMF, the reserve requirements system will be reformed by end-March 2002, through a widening of the deposit base to include all broad money deposits (with the exception of individuals' "new"--i.e., made since July 1, 2001--foreign currency deposits that are subject to a 50 percent liquidity requirement), the adoption of a lower reserve requirement ratio, and the introduction of an averaging system. Measures in line with MAE recommendations are also being implemented to develop the nascent financial market. A draft Securities Law will be submitted to the federal parliament by end-June 2002 to enhance the protection of investors and the efficiency and transparency of transactions (to be monitored as a structural benchmark.) In the area of payments reform, following some delays, policy efforts have been intensified with a view to introducing a modern payments system. In particular, from January 1, 2003, commercial banks will be permitted to initiate and settle payments among themselves on behalf of enterprises and individuals without the mandatory intervention of the domestic payments service (ZOP) or any other agency (to be monitored as a performance criterion).

D. Foreign Trade System

24. Most of the remaining trade barriers will be removed during the EA period. At the federal level, the trade system was greatly simplified in the first half of 2001, when most quantitative or licensing restrictions were removed and the tariff system was reformed. The remaining restrictions on imports and exports--other than those maintained for health, environmental and security reasons--will be phased out by end-2003 and end-2004, respectively. In the areas of trade in services and foreign investment, Yugoslavia will maintain its liberal regime. Montenegro's export and import quotas will be phased out by end-2003 and end-2004, respectively.

E. Bank Restructuring

25. The focus of the bank reform effort will now shift to ensuring proper governance of the remaining banks. With the closure of the four large insolvent banks--which represents major progress toward cleaning up the banking system--the next steps in bank reform will involve the strengthening of bank supervision and strict enforcement of prudential rules and regulations with a view to improving bank management and further enhancing the financial position of the banking system. Out of 47 remaining banks, further action is needed in terms of resolving the remaining banks under the control of Bank Rehabilitation Agency (BRA) and under NBY administration or enhanced supervision (with a decision on these banks expected by end-June 2002, to be monitored as a structural benchmark), and following up on the banks that were required to increase their capital to comply with new stricter prudential regulations. Prudential regulations in line with international standards will be introduced following the expected adoption of the new Law on the National Bank and amendments to the Law on Banks in the coming months(to be monitored as a structural benchmark). IAS-based financial statements of the NBY will be published by end-June 2002, while the Accounting Law is expected to be amended by end-September 2002 to adopt IAS as the permanent accounting framework of all financial institutions (to be monitored as structural benchmarks). The government and the NBY are elaborating plans to accelerate the privatization of banks--including the recently established National Savings Bank--and the physical assets of the bank liquidation estates. In addition, to underpin the soundness of the banking system in the aftermath of the January bank closures, the state and state-owned entities will no longer contribute capital to banks. In Montenegro, legislation will be adopted to empower Central Bank of Montenegro to supervise the existing offshore banks in line with the rules and regulations applicable to onshore banks (to be monitored as a structural benchmark). In addition, a decision on the resolution of Montenegro Banka, Jugobanka ad Podgorica, and Beranska Banka that is yet to be relicensed will be taken by end-May and will not involve direct or indirect fiscal resources except for appropriate social programs (to be monitored as a structural benchmark).

F. Enterprise Restructuring and Privatization

26. In parallel with policies to enhance the efficiency of the state and socially-owned enterprise sector, appropriate legal and institutional structures will be put in place to allow the economy to grow. The problems of socially and state-owned enterprises will be addressed through the privatization of entire companies, the reorganization of some companies prior to privatization, liquidations leading to sales of assets, and workouts to extract viable business lines from failing firms. In addition, the business environment will be improved by removing bureaucratic obstacles to the entry and growth of new private firms, developing supporting institutions, and improving access to capital.

27. Building on the institutional framework that was established in 2001, privatization and restructuring of socially and state-owned enterprises in Serbia will gain momentum during the EA period. Over the EA period, the Privatization Agency will offer for sale through international tenders some 100 large socially-owned enterprises that are considered to be viable, with technical assistance from the World Bank. Procedures are well advanced for some 27 of these enterprises, which are expected to be sold during 2002. As regards the bulk of the other socially-owned enterprises (over 4,000), these are envisaged, under the existing law, to initiate their own privatization under the supervision of the Privatization Agency and have been given incentives (in terms of cost-free allocation of shares to employees) to complete their privatization by mid-2005. Even so, a large number of these enterprises are nonviable, pointing to the need for strengthening bankruptcy procedures to facilitate restructuring. With World Bank technical assistance, the bankruptcy law will be amended by end-2002 to allow for privatization through bankruptcy of socially-owned enterprises and facilitate implementation of the amended law. Some 40 conglomerates will be restructured prior to privatization, starting with 6 conglomerates during 2002 and all conglomerates by 2004.

28. Montenegro has relied on a Mass Voucher Privatization Plan (MVP) for minority stakes in selected enterprises as well as tenders and auctions for majority stakes in enterprises with a view to attracting strategic investors. The MVP was completed in late 2001 when vouchers were distributed to all citizens and widespread share ownership was established. During 2002, sales of shares in selected companies to strategic investors are expected to raise at least some Euro 25 million in revenue.

29. The business environment will be further improved. Some progress has already been made through the adoption of a labor law that liberalizes employment contracts and wage determination, a simplification of the tax system, and a reduction of the rate of wage taxation to encourage official rather than informal employment. The web of regulations hindering business activities is being addressed through a process of eliciting public comments on existing and new public policy initiatives that is coordinated by the Serbian Ministry of International Economic Relations. In addition, with World Bank support, envisaged legal and regulatory changes will provide better incentives for financial institutions to finance the private sector. These include a reform of collateral laws and the establishment of a collateral registry. Montenegro has liberal business registration procedures, and future efforts will focus on improving the overall business environment, including through the envisaged liberalization of the labor market.

III. Program Monitoring

30. Policy performance under the EA will be monitored on the basis of the quarterly quantitative performance criteria and indicative targets that have been employed under the current stand-by arrangement (Annex A). In addition, the performance criterion for domestic government borrowing at the FRY level will be supplemented by indicative targets for the consolidated governments of each of the two republics. Progress in structural reform will be monitored through structural performance criteria and benchmarks on some key policy measures (Annex B). For 2002, performance criteria and structural benchmarks are proposed for end-June, end-September and end-December.

31. There will be six reviews under the arrangement at approximately six-month intervals. All reviews will include a focus on progress in implementing structural reforms, especially in the bank and enterprise sectors, and on financing assurances. The first, third and fifth reviews will hinge upon reaching understandings on the annual budgets and financial programs for 2003, 2004 and 2005, respectively. A schedule of structural reforms will be included on an annual rolling basis.



Technical Memorandum of Understanding

I. Introduction

1. This memorandum sets out the understandings regarding the definitions of quantitative and structural performance criteria and benchmarks, as well as indicative targets, for the FRY program for which assistance has been requested in the form of an Extended Arrangement (EA), as well as the related reporting requirements. To monitor developments under the program, the Yugoslav authorities will provide the data listed in each section below to the European 1 Department of the Fund, in accordance with the indicated timing. The quantitative performance criteria and indicative targets will be monitored on the basis of the methodological classification of monetary and financial data that was in place on December 31, 2001, except as noted below. For program purposes, the public sector consists of the consolidated general government (comprising the federal, Serbian Republican and local governments, the Montenegrin Republican government, the Serbian and Montenegrin social security funds, and the Serbian special budgetary programs) and the National Bank of Yugoslavia (NBY). The authorities will inform the Fund staff of any new funds or special extrabudgetary programs that may be created during the program period to carry out operations of a fiscal nature as defined in the IMF's Manual on Government Financial Statistics, and will ensure that these will be incorporated within the definition of consolidated general government. Quantitative performance criteria and indicative targets for end-June, end-September and end-December 2002 are specified in Annex A-2 of the Memorandum of Economic and Financial Policies (MEFP).

II. Quantitative Criteria: Definitions and Reporting Standards

A. Floor for Net Foreign Assets of the NBY

2. Definition. Net foreign assets (NFA) of the NBY consists of foreign reserve assets minus foreign reserve liabilities.

  • For purposes of the program, foreign reserve assets shall be defined as monetary gold, holdings of SDRs, the reserve position in the IMF, and NBY holdings of foreign exchange in convertible currencies. Any such assets shall only be included as foreign reserve assets if they are under the effective control of, and readily available to, the NBY. In particular, excluded from foreign reserve assets are: frozen assets of the Federal Republic of Yugoslavia (FRY), undivided assets of the Socialist Federal Republic of Yugoslavia (SFRY), long-term assets, NBY claims on resident banks and nonbanks, as well as Yugoslav commercial banks located abroad, any assets in nonconvertible currencies, encumbered reserve assets pledged as collateral for foreign loans, reserve assets pledged through forward contracts, and precious metals other than gold. Monetary gold shall be valued at an accounting price of US$277.50 per ounce, and SDRs at SDR1 = US$1.25447 based on gold prices and exchange rates prevailing on December 31, 2001. On December 31, 2001 the NBY's foreign reserve assets as defined above amounted to US$ 1,169 million, including gold valued at US$164.5 million.

  • For purposes of the program, foreign reserve liabilities shall be defined as any short-term loan or deposit (with a maturity of up to and including one year), swaps (including any portion of the NBY gold that is collateralized), and forward liabilities of the NBY-in convertible currencies to residents and nonresidents; IMF purchases; and loans contracted by the NBY after December 31, 2001 from international capital markets, foreign banks or other financial institutions, and foreign governments, irrespective of their maturity. Undivided foreign exchange liabilities of SFRY are excluded. On December 31, 2001, the NBY's foreign reserve liabilities, as defined above, to nonresidents were US$272 million and to residents were US$302 million.

  • All assets and liabilities denominated in convertible currencies other than the U.S. dollar shall be converted at their respective exchange rates against the U.S. dollar prevailing on December 29, 2001. All changes of definition or valuation of assets or liabilities, as well as details of operations concerning sales, purchases or swap operations with respect to gold shall be communicated to the Fund staff within one week of the operation.

3. Reporting. Data on foreign reserve assets and foreign reserve liabilities of the NBY shall be transmitted to the European 1 Department of the Fund on a weekly basis within four business days of the end of each business week. To facilitate program monitoring, the NBY will provide the data at the indicated constant prices and exchange rates, as well as at current exchange rates (Annex A). The NBY will report if any of the reported foreign reserve assets are illiquid or pledged, swapped, or encumbered.

4. Adjusters. For program purposes the reported net foreign assets will be adjusted downward pari passu to the extent that: (i) since January 1, 2002, the NBY has recovered frozen assets of the FRY, assets of the SFRY, long-term assets, and foreign-exchange-denominated claims on resident banks and nonbanks, as well as Yugoslav commercial banks abroad; and (ii) the restructuring of the banking sector by the Bank Restructuring Agency (BRA) involves a decline in NBY foreign-exchange-denominated liabilities to resident banks.

B. Ceiling on Net Domestic Assets of the NBY

5. Definition. For purposes of the program, net domestic assets (NDA) of the NBY are monitored on a monthly average basis and defined as the difference between reserve money (as defined in section E) and net foreign assets (as defined in section A), with the latter being converted from U.S. dollars into dinars at the program accounting exchange rate of US$1 = YUD 67.6702, which was the rate prevailing on December 29, 2001 and the exchange rates of the US$ vis-a-vis other currencies prevailing on that day. As of December 31, 2001, the domestic assets of the NBY so defined were valued at YUD 2,286 (Annex A). The monthly average of NDA is calculated as the difference of the monthly average of reserve money and monthly average of NFA. The monthly average of NFA (for the purpose of estimating average NDA) will be adjusted so that the disbursements of World Bank program loans and EU macro-financial assistance are counted as if they occur on the first day of the month.

6. Adjustor. In the event of a budgetary foreign financing shortfall (excess) in Serbia which is not offset by higher (lower) than budgeted privatization revenue (specified in paragraph 10), of up to YUD 5 billion, the ceiling of NDA will be adjusted upward (downward) by 50 percent of the amount of the shortfall (excess). The basis for estimating the amount of the shortfall is presented in Section C.

7. Reporting. The ceilings will be monitored on the basis of daily data on the accounts of the NBY, reporting foreign reserves assets and liabilities as defined under section A and reserve money as defined under section E supplied to the European 1 Department of the Fund by the NBY, within four business days of the end of each business week. To facilitate program monitoring, the NBY will provide daily NBY's foreign reserves liabilities as well as the amount and date of the disbursements of the World Bank program and EU macro-financial assistance at the current and the agreed constant exchange rates.

C. Ceiling on the Net Credit of the Banking System to the
Consolidated General Government

8. Definition. The banking system comprises the NBY, commercial banks in Serbia, and all banks in Montenegro. The consolidated general government was defined above.

  • For program purposes, net credit of the banking system to the consolidated general government is defined as all claims (i.e., credits, securities, and other claims in both dinar and foreign currencies) of the banking system on the consolidated general government less all deposits of the consolidated general government with the banking system, including foreign currency deposits. Foreign currency deposits and foreign-currency denominated credits to the general government will be reported at the end-December 2001 exchange rates. Any holdings of government securities by commercial banks above the actual amounts held at end-December 2001 (YUD 394 million) will be included in the credit of the banking system to the consolidated general government. (Net bank credit to the consolidated general government in Montenegro will be monitored on the basis of data supplied by the Montenegrin authorities; at end-December 2001, net credit of the banking system in Montenegro to the consolidated general government in Montenegro amounted to €23.1 million (equivalent to YUD1,378 million))

9. Reporting. The ceilings will be monitored from end-weekly data on the accounts of the banking system supplied to the European 1 Department of the Fund with a lag not to exceed two weeks.

10. Adjusters. For program purposes, the ceilings on net credit of the banking system to the consolidated general government will be adjusted downward by the cumulative increase in the stock of government debt held by the nonbank public (other than that related to the frozen foreign currency deposits), starting from January 1, 2002, and upward for any decrease. The ceilings will be adjusted to the extent that the credits of the banking system to the consolidated general governments at end-December 2001 are revised from the currently-reported levels of YUD 741million in Serbia and €23.1 million in Montenegro. In addition, in the event of a budgetary foreign financing shortfall (excess) which is not offset by higher (lower) than budgeted privatization revenue, of up to YUD 5 billion, the ceilings for Serbia will be adjusted upward (downward) by 50% of the amount of the shortfall (excess). For Montenegro, in the case of a budgetary foreign financing shortfall (excess), which is not offset by higher (lower) than budgeted privatization revenue, of up to US$10 million, the ceilings for Montenegro will be adjusted upward (downward) by 50% of the amount of the shortfall (excess).The estimation of the shortfalls (excesses) in foreign financing will be based on the following projections of foreign financing and privatization receipts (cumulative from the beginning of 2002):

Serbia (In billions of dinars)
  end-Mar. end-June end-Sep. end-Dec
Foreign financing 9.3 15.5 26.2 34.7
Privatization proceeds 0.0   8.6   0.0 11.4

Montenegro (In millions DM)
  end-Mar. end-June end-Sep. end-Dec
Foreign financing 10.0 24.0 61.9 100.9
Privatization proceeds 0.0   0.0 20.0   47.0

D. Ceiling on Change in Arrears

11. For program purposes, indicative targets will be set on the change in domestic arrears. Separate indicative targets will be set for the federal government, the consolidated general government of Serbia, and the consolidated general government of Montenegro.

12. Definition

  • · For the purpose of establishing compliance with this indicative target, the federal government is defined to comprise all budgetary institutions financed from the federal budget, including the federal army and the federal pension fund for retired military personnel. The consolidated general government of Serbia is defined to comprise all budgetary institutions financed from the Serbian republican budget, the Republican Pension and Invalidity Insurance Fund for Employees, the Republican Pension and Invalidity Insurance Fund for Self-employed, the Republican Pension and Invalidity Insurance Fund for Agricultural Workers, the Republican Health Insurance Fund, the Republican Labor Market Agency, all republican special directorates, , and all other budgetary and extrabudgetary funds created by the government of Serbia existing before or created during the period of the program. The consolidated general government of Montenegro is defined to comprise all budgetary institutions financed from the republican budget, the Republican Pension and Invalidity Insurance Fund, the Republican Health Insurance Fund, the Republican Labor Market Fund, and all other budgetary and extrabudgetary funds created by the government of Montenegro existing before or created during the period of the program.

  • The outstanding stock of domestic arrears comprises wage and pension arrears; arrears with respect to accrued tax and social security contribution obligations, including personal income tax and social security contributions of employees withheld at source; arrears on social entitlement benefits (apart from pensions) to households; arrears incurred with respect to the purchases of goods and services from suppliers; and arrears related to the servicing of domestic debt.

  • The outstanding stock of wage arrears at a particular date are defined as total accumulated unpaid wages of all employees on the regular payroll of all units belonging to the parts of the general government as defined above, up to the latest preceding regular pay date, which have not been settled by the test date. The total stocks of wage arrears, thus defined, are on a gross basis and are calculated by summing the wage arrears of all units of government with regard to their own employees; transfers between different levels of government for making wage or other payments are excluded from the estimates of these wage arrears.

  • Pension arrears are defined as total accumulated pensions due but not disbursed by the pension funds concerned to all pensioners in the pension rolls up to the latest preceding pension disbursement date.

  • The outstanding stocks of tax and social contribution arrears at a particular date comprise total accumulated accrued tax obligations of the parts of the general government as defined above that have not been paid by the test date. The total stocks of such arrears are on a gross basis and are calculated as the sum of such arrears.

  • Social entitlement payments, apart from pensions, are defined as all cash payments due directly to, or on behalf of, the population in accordance with stipulations in the law and which are not contingent upon the provision of any services or sale of any goods or assets to the general government by such members of the population in return for these payments. The stock of such entitlement arrears are defined as total accumulated payments due but not disbursed by all units of government up to the test date. Thus defined, these arrears are also on a gross basis and do not include the netting out of any transfers made between different units of the general government for the payment of such entitlements.

  • Arrears to suppliers comprise payments delayed beyond what was explicitly specified in relevant contracts, or in the absence of such specification, for two months from the date of submission of bills, for already-effected purchases of goods or services by the government concerned. These include, inter alia, arrears to utility companies, arrears incurred with respect to service and maintenance contracts, and payments not made for the purchase of goods and supplies such as equipment and furniture. These arrears are also defined on a gross basis and overdue tax and other obligations to the government of the relevant enterprises are not included in the calculation of the arrears of the government unless there is mutual agreement on the cancellation of debts. Netting out of any transfers made between different units of the general government for the payment of such arrears and obligations are also not taken into consideration.

  • Arrears to domestic banks and nonbank lenders comprise all overdue payments related to financial contracts between the government and domestic banks, nonbank financial institutions, nonfinancial institutions, and private lenders.

  • At end-December 2001, the stock of arrears of the Federal government was estimated at YUD 0 billion; and the stock of arrears of the consolidated general government in Serbia was estimated at YUD 26.123 billion.

  • € denominated claims on government will be converted at the exchange rate of
    €1 = YUD 60.597055; claims denominated in currencies other than the € will first be converted at their respective exchange rates against the € prevailing on December 31, 2001. The change in arrears is defined as the change in the end-period stock of arrears. Changes in wage and pension arrears will be adjusted for the changes in the average wage and average pension in the economy relative to their respective values in December 2001.

  • 13. Reporting. Before the last business day of each month, data on end-period stocks of arrears for the previous month will be supplied to the European 1 Department of the Fund by the Federal Ministry of Finance, the Ministry of Finance of Serbia, and the Ministry of Finance of Montenegro.

E. Definition of Reserve Money

14. Definition. Reserve money is defined as the sum of currency in circulation (NBY Bulletin, September 2000, Table 3A, column 8) and dinar reserves banks are required to hold, plus excess reserves of the commercial banks at the NBY. Shortfalls in reserves that banks are required to hold, will be included in required reserves (and therefore in reserve money), as well as in bank borrowing from the NBY. Reserves that banks are required to hold are set at 20 percent effective on April 11, 2002 of the base as defined in NBY Decision of March 28, 2002. The amounts that banks are permitted to hold in securities to satisfy the statutory reserve requirement will be limited to the amount that banks were holding as of December 31, 2000 (YUD 174.1 million). Excess reserves include commercial bank balances in Giro accounts 620, 621, 623, and 625 with the NBY and cash in commercial bank vaults.

15. Data on reserve money will be monitored from the daily indicators data of the NBY, which shall be supplied to the European 1 Department of the Fund weekly by the NBY with a three-day lag. Required reserves at end-December 2001 have been adjusted (a) downward by YUD 357 billion to take into account that part of the deposits in Beobanka, Beogradska Banka, Jugobanka, Investbanka and Astra Banka will not be paid out; (b) an expansion in the dinar reserve deposit base; and (c) the lower reserve requirement ratio of 20 percent from 24.5 percent. Foreign exchange denominated reserves of commercial banks with the NBY are included in foreign exchange liabilities to domestic residents; they are not included in reserve money. On December 31, 2001, currency in circulation amounted to YUD 25,266 million while required reserves amounted to YUD 7,720 million, and excess reserves to YUD 8,167 million. Data on effective reserve requirements and the deposit base used in reserve requirement calculations will be supplied to the European 1 Department each week with a lag of less than a week.

16. Adjusters. For program monitoring purposes, reserve money will be adjusted as follows: Should the standard reserve requirement increase (decrease) from the level prevailing on April 11, 2002, the ceiling on net domestic assets would be increased (decreased) by an amount equivalent to the change in the standard reserve requirement ratio multiplied by the programmed deposit base used in the calculation of required reserves. Before making any such changes, the NBY will consult with Fund staff. Required reserves of banks placed under BRA administration or liquidation will remain part of reserve money for program purposes.

F. Ceiling on External Debt-Service Arrears

17. Definition. External debt-service arrears are defined as overdue debt service arising in respect of obligations incurred directly or guaranteed by the public sector, except on debt subject to rescheduling or restructuring. The program requires that no new external arrears be accumulated at any time under the arrangement on public sector or public sector guaranteed debts.

18. Reporting. The accounting of nonreschedulable external arrears by creditor (if any), with detailed explanations, will be transmitted on a monthly basis, within two weeks of the end of each month. This accounting will include, separately, arrears owed by the Federal, Serbian and Montenegrin governments, and other public sector entities; arrears owed by Yugoslav Airlines; and arrears owed to Paris Club creditors, non-Paris Club creditors, and other creditors. Data on other arrears, which are reschedulable, will be provided separately.

G. Ceilings on External Debt

19. Definitions. First, with regard to the ceiling on contracting or guaranteeing of new nonconcessional external debt by the public sector with original maturity of more than one year: This performance criterion applies not only to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt adopted on August 24, 2000 (Decision No. 12274-(00/85), see attachment to this Annex) but also to commitments contracted or guaranteed for which value has not been received. Excluded from this performance criterion are loans from, or other indebtedness to, the EBRD, the EIB and EU, the IBRD, the IMF, and the IFC. Concessionality will be based on a currency-specific discount rate based on the ten-year average of the OECD's commercial interest reference rate (CIRR) for loans or leases with maturities greater than 15 years and on the six-month average CIRR for loans and leases maturing in less than 15 years. Under this definition of concessionality, only debt with a grant element equivalent to 35 percent or more will be excluded from the debt limit. Second, with regard to the ceiling on new external debt with original maturity of up to and including one year owed by the consolidated general government or guaranteed by the public sector, the term "debt" has the meaning set forth in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt adopted on August 24, 2000 (Decision No. 12274-(00/85). Excluded from this performance criterion are short-term import credits.

20. Reporting. A debt-by-debt accounting of all new concessional and nonconcessional debt contracted or guaranteed by the public sector, including the original debt documentation, as well as all relevant supporting materials, will be transmitted on a quarterly basis within four weeks of the end of each quarter.

III. Other Reporting Requirement for Program Monitoring

A. Macroeconomic Monitoring Committee

21. A macroeconomic monitoring committee, composed of senior officials from the Federal Government, Serbian and Montenegrin Ministries of Finance, the NBY, and other relevant agencies, shall be responsible for monitoring the performance of the program, informing the Fund regularly about the progress of the program, and transmitting the supporting materials necessary for the evaluation of performance criteria and benchmarks.

B. Developments on Structural Performance Criteria and Benchmarks

22. The authorities will notify the European 1 Department of the Fund of developments on structural performance criteria and benchmarks as soon as they occur. The authorities will provide the documentation, according to the dates in Annex B, elaborating on policy implementation. The authorities will also notify the European 1 Department of the Fund of any economic developments or policy measures that could have a significant impact on the implementation of this program.

C. Data Reporting

Production and prices

23. The following information will be transmitted at the time of their publication:

  • The retail price index, the industrial price index, the industrial production index, wages and employment, and exports and imports.

24. Any revision to the national accounts data will be transmitted within three weeks of the date of the revision.

Public finance

25. Monthly data on public finance will require a consolidated budget report of the Federal and Republican governments comprising:

  • The revenue data by each major item, including that collected by the federal and the republican governments;

  • Details of the recurrent and capital expenditure of the federal and republican governments; and

  • Details of budget financing, domestic, and external data will be transmitted within four weeks of the end of each month.

Monetary sector data

26. The following data will be transmitted on a daily/weekly/biweekly basis within one/five working days of the end of each day/week.

  • Daily movements in gross foreign exchange reserves of the NBY at current exchange rates, indicating amounts sold/bought at the auction, purchases through ZOP, purchases on the interbank market, inflows of foreign grants, inflows of foreign loans, and repayments of frozen currency deposits.

  • Daily movements in foreign exchange denominated liabilities of the NBY to (i) non-residents; (ii) Yugoslav banks; and (iii) Yugoslav residents.

  • Daily movements in liquid foreign exchange assets of Yugoslav banks as reported by these banks to the NBY.

  • Daily movements in reserve money, indicating currency in circulation, the basis upon which required reserves are calculated, required reserves, reserves held, and excess reserves.

  • Treasury bill auction details (rates, amounts per maturity and number of banks participating in the auction per maturity); and

  • Interbank foreign exchange rates and volume of transactions.

  • Public sector borrowing and lending from commercial banks and the NBY.

27. The balance sheet of the NBY and the consolidated balance sheets of the commercial banks, including all banks in Montenegro, will be transmitted on a monthly basis within three weeks of the end of each month. The stocks of government and mandatory and voluntary NBY securities held by banks and by non-banks, as available to the NBY, detailed information on interbank money market transactions (terms, duration, and participating institutions), and interest rate developments will be transmitted on a monthly basis within two weeks of the end of each month.

External data

28. The data below will be transmitted as follows:

  • The interbank market exchange rate, as the simple average of the daily-weighted average buying and selling rates, will be transmitted on a weekly basis within five business days of the end of the week;

  • Balance of payments data on services, private transfers, and capital account transactions will be transmitted on a quarterly basis within four weeks of the end of each quarter; and

  • Detailed monthly data on the volume and prices exports and imports, including a separate report on imported petroleum products.