Serbia and Montenegro -- 2005 Article IV Consultation, Concluding Statement of the IMF Mission
February 25, 2005
1. Macroeconomic imbalances are widening, putting at risk some of the impressive earlier achievements. Despite strong economic growth and fiscal tightening, domestic demand is outpacing GDP, spilling over into a large external current account deficit and rising inflation. In 2004, the current account deficit reached 13 percent of GDP, net external borrowing amounted to 4 percent of GDP, and Serbia's core inflation doubled. In Montenegro, inflation remains at low levels of 3.5 percent to 4.5 percent, but the current account imbalance remains large in part due to the high oil price and investment related import growth.
2. Buoyant private consumption and investments appear to be the source of demand pressures. These have intensified despite the notable reduction in the general government deficit in 2004. While data on components of demand are unavailable, indicators suggest that investments by newly privatized enterprises are rising, a much welcomed development. They also point, however, to surging consumption, strong wage growth, and increasing deficits in state- and socially-owned enterprises.
3. The macroeconomic imbalances are to a considerable degree rooted in structural problems in state- and socially-owned enterprises. The private sector still accounts only for about 45 percent of GDP due to slow privatization and restructuring. The inherently weak financial discipline in the state- and socially-owned enterprises is a main source of excessive growth in wages and private consumption; their low productivity is a drag on GDP growth; and their uncompetitiveness is keeping exports at a meager 16 percent of GDP while imports amount to 43 percent of GDP, a staggering structural trade deficit.
4. Recent policy corrections are unlikely to be sufficient, although it is too early to fully judge their impact. On current policies, GDP growth is projected to slow to
4½ -5 percent in 2005, mainly because the contribution of agriculture was exceptional in 2004; the current account deficit to remain at about 13 percent of GDP; and inflation to level off, at best. Looking to the medium term, the current account deficit is projected to stay at double-digits even with strong growth in exports and remittances, implying high external vulnerability. Inflation needs to be set on a clear downward path and the reduction in the current account deficit accelerated.
5. Achieving both objectives requires carefully balanced policies. Domestic demand must be slowed further by tightening fiscal, monetary and incomes policies. The main burden will fall on fiscal policy in order not to risk the recovery in investments through excessively tight monetary policy, and considering the problems in enforcing incomes policy. The mission does not believe that there has been sufficient structural and institutional changes to credibly assume that wage policy can significantly alleviate the burden on fiscal policy in demand management. In the mission's view, further fiscal consolidation beyond that what is entailed by the 2005 budget is required.
6. The exchange rate policy must be flexible in order to prevent a further rise in the already unsustainably high current account deficit. Due to the widespread eurorization, stabilizing the exchange rate or notably limiting the pace of dinar depreciation offer undoubtedly effective means of anchoring inflationary expectations and securing a reduction in inflation in the short run. But the attendant real dinar appreciation would require an even larger fiscal tightening than under a flexible exchange rate policy in order to prevent a further rise in the current account deficit, a rise that must be avoided. This would exacerbate the negative impact of demand management on economic growth. Previous attempts at stabilizing the dinar have been unsuccessful mostly because of insufficient fiscal adjustment to contain wage pressures in state- and socially-owned enterprises. In view of the continued strong pressures in this regard, and considering its discussion of the scope for fiscal adjustment, the mission believes that it would be risky to use the exchange rate to significantly bear down on inflation at this time.
7. Given the high tax burden, fiscal tightening should come from expenditure savings. Tax cuts should be postponed until there has been a significant reduction in inflation and the external current account deficit. As subsidies and social transfers amount to 23 percent of GDP and the general government wage bill to 11 percent of GDP, both very high levels, savings are bound to affect these areas. With a pension fund deficit of 6 percent of GDP and demographic developments set to worsen the situation, pension reform is a matter of urgency. Plans by a large municipality to grant very large wage increases are of immediate concern. While cutting total expenditures, additional resources will be required to support reforms, notably for redundancy payments, and to modernize infrastructure.
8. In Montenegro, there is also a need for fiscal consolidation to reduce the high current account deficit and large external borrowing. Plans for tax cuts should be postponed there as well until this external deficit has been reduced to a sustainable level. The large expected privatization revenues in 2005 should be saved or used to pay back debt.
9. Monetary conditions should be tightened in Serbia. Structural changes and increased confidence in the banking system are causing a credit boom. A number of well reputed foreign-owned banks that have entered the market in recent years have attracted considerable deposits and been able to borrow abroad. This has enabled banks to increase credits sharply, with almost two-fifths of the increase accounted for by consumer loans. While the increase in confidence and attendant rise in financial intermediation are in many respects desirable, this is also fueling demand pressures. The mission, therefore, agrees with the recent imposition of restrictions through prudential means on consumer credits and the inclusion of foreign borrowing in the calculation of reserve requirements. It believes, however, that a further tightening of monetary policy is needed to set inflation on a renewed downward path in the coming months.
10. There has been considerable progress on restructuring the banking system, but supervision must be strengthened. The rapid credit expansion is testimony to this progress, and the government's plans for early privatization of remaining state-owned banks suggest that the transformation of this sector will continue apace. However, the sharp increase in credits makes it imperative to strengthen banking supervision and enforce sound prudential standards much more rigorously. The upcoming Financial Sector Assessment Program with the Fund and the World Bank provides a timely opportunity to assess risks and institutional capacities in this area.
11. In Montenegro, further progress with bank privatization is needed to consolidate the progress to date. The current tender of a major bank should be completed as soon as possible. The brisk credit growth calls for continued vigilance in bank supervision in Montenegro as well.
12. The imposition of a limit on the wage bill in large state-owned enterprises is welcomed considering their weak financial discipline. However, lack of an agreement on business plans consistent with such limits is casting doubts on the effectiveness of this measure. As these enterprises account for only 8 percent of non-agricultural employment, other means for enforcing financial discipline must be forcefully invoked as well. In particular, state-owned enterprises must cut services to delinquent customers and bankruptcy procedures should be initiated in case of prolonged arrears.
13. Boldly accelerating privatization is undoubtedly the overriding economic policy challenge facing the Government. This is key to overcoming the financial indiscipline that is the root cause of longstanding macroeconomic problems. More important, with the large structural current account deficit leaving little scope for increasing the low share of investments in GDP, sustained economic growth will require redeploying labor and existing capital to more productive usages. This points to the urgency of creating a dynamic private sector through fast privatization. State- and socially-owned enterprises are unlikely to offer the competitive products required for export-led growth, which is the only realistic way of achieving sustained increases in real incomes and employment.
14. In view of this, the ambitious plan to offer all socially-owned enterprises for privatization by end-2006 is much welcomed. Implementing it will be a formidable task considering the resistance from vested interests. The challenge will be particularly strong in the case of the 65 large financially troubled enterprises, which are generally burdened with high debt, considerable excess labor, and obsolete technology. Privatization of the large number of small and medium sized enterprises should, however, be much easier, as debt overhang and excess labor is considerably less of a problem among them and many of them are potentially competitive with only limited additional investments by new owners. Moving boldly on privatizing these enterprises, while still pressing ahead with restructuring and privatization of large enterprises, offers a realistic way of ensuring the urgently needed export driven growth. To meet its ambitious goal for privatization, it is imperative that the Government does not hesitate to initiate bankruptcy procedures in the case of financially troubled enterprises that do not attract investors.
15. Reforms of state-owned enterprises are overdue. Given significant overstaffing and depleted capital, accelerating labor retrenchment and restructuring is key to improving financial performance. In this context, establishing independent regulatory agencies should be a matter of priority. Early privatization and the spin-off of non-core activities could possibly attract important new investments and generate employment.
16. In Montenegro, privatization should also be a priority in order to enhance investment and growth. In this regard, it is important that the authorities proceed without promises of subsidies, including for electricity consumption, to avoid potentially large fiscal costs in the future.
17. The prospects for sustained export-led growth depends on an early resolution of political problems holding up integration with the European Union. While outside the scope of the mission, such integration is key to the unhindered participation in international trade, access to capital markets and high foreign direct investments necessary for restructuring the economy. This integration process has also proven crucial for improving the domestic investment climate and catalyzing broader political support for economic reforms in other Central and Eastern European countries. From being among the front runners when the countries in the region started the transition process, Serbia and Montenegro have now fallen well behind and a bold move to integrate with the European Union appears to be the only realistic path for making up lost ground.