Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.


Serbia and Montenegro—2006 Article IV Consultation and Post-Program Monitoring
Serbia: Concluding Statement of the Mission

June 27, 2006
Montenegro: Concluding Statement

1. Serbia is growing. After stagnation in the 1980s, decline in the 1990s amid the SFRY breakup, and collapse and hyperinflation in 1999-2000, GDP has risen strongly every year since. This reflects the natural rebound following the 2001 stabilization, and a significant—if sometimes interrupted—cumulative fiscal and structural reform effort. Much is going right.

2. But two lost decades are not readily recovered. Though output is up nearly 40 percent since 2000, employment has trended down, unemployment is over 20 percent and still rising, and headline inflation has not been sustained below the mid-teens. Fixed investment is well below transition country norms, yet, even so, the external current account deficit remains unsustainably high—at over 10 percent of GDP. It will be a long haul.

3. Continued structural reform and stability are key. Failed corporate and financial structures—compounded by conflict and policy instability—sapped economic vitality at the end of the 20th century. So it will take completion of the post-2000 reforms to those structures—and policy stability—to restore economic health. This might best be advanced as part of the EU accession process. These matters are considered in turn.

Corporate Restructuring

4. The role of the state has been significantly reduced since 2000. Privatization and retrenchment have reduced the state and socially owned sectors, with private firms expanding alongside. As a result, the private share in non-agricultural non-budget sector employment has risen from 30 to 60 percent between 2001 and 2006. This is a considerable accomplishment, reflected in buoyant exports and improved growth potential.

5. But the core of these corporate reforms has been left until last. Though many tough tasks have been largely completed, including bank restructuring, the more healthy firms were privatized first. So to some extent, the shift towards the private sector has been a change in form rather than substance. And the remaining mixed, socially, and state owned firms still account for over 40 percent of non-budget non-agricultural employment. They incur heavy losses, absorb considerable subsidies, and accrue wage arrears. These firms are largely responsible for low economy-wide corporate savings and impede entry of more productive firms.

6. The remaining restructuring will require sustained commitment. Plans to offer for sale all firms in the privatization agency portfolio by mid-2007 are welcome. But the quality of assets now on offer raises prospects for increased incidence of failed tenders and auctions. In this context, the "two strikes" approach proposed by the IBRD needs to be fully observed. In particular, the tax authorities and the Development Fund should initiate bankruptcies in these cases promptly, while blockages to timely completion of insolvency proceedings—including inefficiencies in the courts—need to be removed. If not, these firms will remain a key constraint on economic performance. Broader business climate and trade arrangements—including regional free trade and WTO membership—should support this effort by encouraging new domestic and foreign investment, while abjuring targeted or firm-specific concessions. And as restructuring proceeds, the high share of administered prices in the CPI can be lowered.

7. The oil sector is an immediate test case. The burden on the economy of high international oil prices is compounded by domestic refinery and distribution inefficiencies—caused by the ban on imported processed product and oil price controls. The sale of shares in the integrated firm to a minority shareholder—albeit with management control and possible eventual majority ownership—with the import ban extended alongside, at best addresses only part of the problem. In addition to these proposals, at the very least the ban should be converted into a tariff scheduled to decline quickly over time, a process that would be consistent with EU and WTO principles. This would lower ex-refinery prices—easing non-oil corporate restructuring challenges—whether or not refining efficiencies are secured, thereby further encouraging realization of those efficiencies by the new management. And it would raise budget revenues.

8. With further corporate restructuring in prospect, employment policy should aim at job creation rather than job preservation. Currently, labor market institutions and remuneration levels discourage employment, which continues to fall even as output rises strongly. And with the toughest restructuring still ahead and the share of the private sector in total employment rising, the inflexibilities of labor market structures are becoming increasingly expensive over time. Hiring and firing rules and unemployment benefit arrangements should be rigorously scrutinized from this perspective.

Financial sector

9. Following earlier bank restructuring, credit has boomed. Drawn by high spreads and a desire to establish early in a new market, foreign parents of banks leveraged surging domestic deposits with external resources, and bank credit has risen over 11 percentage points of GDP in three years. And with credit-to-GDP ratios still regionally low, persistent further expansion is likely—compounding the upward pressures on the external current account deficit emanating from the weaknesses in non-bank corporates.

10. These credit patterns suggest that a further examination of the competitive environment among banks may be warranted. Margins appear to have been falling in some activities—though data on this are unavailable—and unremunerated reserve requirements exact an additional toll on bank profits. But banks' continued appetite to lend suggests that total anticipated returns remain highly attractive. Competition was likely reinforced by the activation of the credit registry in 2004 and, more recently, the pledge registry and legislation on enhancing creditor rights over collateral. But other steps could be considered, including providing banking customers with standardized interest rate formulations and helping them to understand the burden of the debts they take on. Reinforced competition, by securing efficient spreads, may help encourage greater attentiveness by banks to macroeconomic and prudential risks in credit extension.

11. Alongside, supervision should continue to be strengthened. The pace and recent genesis of credit growth raise concerns about credit quality, as does the overwhelming dominance of FX-indexed in total credit and high NPL ratios. The recent banking law establishes the basis for enforcement of Basle Core Principles (BCPs), to take effect once the NBS has adopted detailed "decisions" to implement them. The law and the drafts reflect international and EU best practice. More challenging, however, will be to ensure an appropriately qualified cadre of supervisors to implement the law, deliver the transition from compliance to risk-based supervision, and monitor risks arising from greater exchange rate flexibility. A review of the adequacy of conditions of employment for supervisors from this perspective may be appropriate.

Fiscal policy

12. Fiscal options will remain constrained in the medium-term until corporate profitability improves and credit slows. Until reforms in these areas decisively boost domestic private savings, fiscal policy is constrained to deliver domestic savings—lest investment be constrained by lack of funding and the external current account becomes unsustainable. With external vulnerabilities high—as signaled by external debt at 58 percent of GDP and private external debt up some 6 percentage points of GDP in 2005—and immediate political and regional uncertainties considerable, there appears to be little room for fiscal maneuver.

13. These concerns underlie the need for fiscal consolidation and budget surpluses. Adjustment of 5½ percentage points of GDP in the three years to 2005 represents a further major policy achievement. But that effort was overwhelmed by surging credit and the depth of corporate ailments, so that excluding VAT effects, the high external current account deficits barely budged since 2003. In that light, a budget surplus of 2½ percent of GDP (on IMF fiscal definitions) was anticipated under the Extended Arrangement with the IMF. This implied a further consolidation of 1.8 percentage points of GDP in 2006, and declines in public debt, even excluding the Paris Club write-down. Once the tough corporate reforms take root and credit decelerates, scope may be created to allow the fiscal stance to be re-anchored to fiscal sustainability—thereby accommodating some fiscal relaxation.

14. Tax options are limited. Public revenues are already burdensome at some 44 percent of GDP and tax administration is overstretched in the difficult enforcement environment. Thus, even the envisaged shift from direct to indirect taxation should not go ahead if it prejudices the fiscal balance.

15. This puts the focus on public expenditure reform. Ambitions to raise real public spending within fiscal balance targets would best be secured by growth—and growth of tax revenues—via corporate and other reforms, not by raising tax ratios. Until then, there is ample scope to curb current spending. Spending on transfers, budget wages, and subsidies—17, 10, and 3½ percent of GDP respectively in 2006—contains considerable inefficiencies. As part of a reform effort, an accounting of the costs of the September 2005 government decision to "close" pension contribution gaps is urgent. In that light, recent pension reforms can be taken further, including by rationalizing early retirement. And corporate restructuring could be aided by reduced subsidies and by the impact of budget wage restraint on general wage trends. These actions would create room within fiscal balance targets for long overdue increases in budget investment, including on roads and the social infrastructure.

Inflation, and monetary and exchange rate frameworks

16. A renewed assault on inflation would support restructuring. Still in the mid teens, headline inflation is regionally high. And it constitutes a loud signal of macroeconomic disorder—to the detriment of efforts to raise domestic and foreign investment. Disinflation, by signaling strengthened policies, would encourage investment. In this way, it would not be at the expense of jobs but an essential element in their creation. Unless the NBS takes the view that the prospective fiscal stance is insufficiently supportive, it should not be postponed.

17. Recent changes in monetary arrangements have prepared well for this. Greater exchange rate volatility has already been announced and achieved. And the dinar has strengthened in recent months in the wake of the 500 basis point hike in repo rates from Q4 2005, with banking dinar borrowing and lending rates also rising. These developments demonstrate that repo operations have matured into an effective monetary policy instrument. As the NBS continues to scale back its engagement with foreign exchange bureaus—and with it its forex intervention—the repo will become yet more powerful. Given high pass-through rates from the exchange rate to core inflation, all this signals that monetary policy can be effective through the exchange rate channel in combating inflation. And it is effective notwithstanding high rates of financial euroization and the currently limited impact of dinar interest rates on aggregate demand. Finally, adjustments to reserve requirements on foreign currency-denominated liabilities will continue to play a useful role as a measure of last resort in containing credit growth and the external balance in the context of insufficient fiscal support for these objectives.

18. These steps would best be taken further. A process towards eventual formal adoption of a new nominal anchor—inflation targeting—could be initiated. Within this process, the NBS would publicly adopt "objectives" for core inflation for 2006 and 2007 in the form of a range, extending this projection horizon every six months or so. Simultaneously, the Ministry of Finance would issue objectives for administered prices over the same rolling horizon, in consultation with the NBS. The repo would become the key instrument used to achieve NBS objectives, to be adjusted upwards when core inflation is projected to exceed objectives and vice versa. Forex intervention would be reduced to a daily "leaning against the wind" role.

19. Over a longer horizon, further developments can be envisaged. Once experience is gained with the new framework, the NBS could consider changing its inflation range "objectives" into formal "targets". And other elements of a full-fledged inflation targeting framework could be built. These include modeling, transparency, decision making procedures within the central bank, and final determination of institutional responsibility to set the inflation target band. And as corporate restructuring reduces the share of administered prices in the CPI, the NBS will progressively become responsible for a greater share of CPI developments.

Policies for 2006-07

20. Demand growth remains strong. Notwithstanding weakness in early 2006—reflecting interrupted gas imports followed by flooding—and several measures of monetary tightening, credit growth remains buoyant. VAT collections before refunds confirm that consumer spending is still surging, with concomitant effects on underlying imports.

21. Thus, a firm fiscal stance remains appropriate. The policy goals for the external current account balance—a reduction by 1¾ percentage points of GDP (corrected for the VAT effect) in 2006 and the planned reduction of ½ a percentage point for 2007—are not yet secure. Vulnerabilities would be compounded if those goals are missed, and efforts to disinflate complicated. In this light, a slippage from the anticipated budget surplus of 2½ percent of GDP (on IMF definitions) would best be avoided, and a further improvement to a surplus of 3 percent of GDP is recommended for 2007 (Text table).

22. In this context, disinflation can be purposefully pursued. With core inflation already at 10 percent, the central bank could announce an inflation "objective" range for 2006 of 7-10 percent, declining to 4-7 percent for 2007, and adjust the repo rate as needed to secure these objectives.

23. But a major weakening of budget balance targets is being considered. The suggestion is to commence a multiyear investment program with planned spending of up to 1½ percent of GDP in Q4 2006, funded by privatization and one-off MOBI63 license receipts. This implies, on IMF definitions, a budget deficit of ½ of one percent of GDP in 2006, fully 3 percentage points weaker than target. And if proposed personal tax reforms and Public Private Partnership projects for 2007 go ahead alongside, without spending cuts to offset the non-recurrence of MOBI63 receipts, then the budget would go significantly further into deficit in 2007.

24. These proposals raise again the specter of loss of fiscal discipline, putting at risk the hard-won progress made through reform in recent years. Though the proposed public spending is not debt financed, it will, if implemented fully, significantly impact the current account deficit—raising it towards 14 percent of GDP in 2006, some 3 percentage points weaker than targeted, with further deterioration in 2007 in prospect if the budget deficit enlarges further. Furthermore, the haste of project preparation and disbursement raises doubts about its quality—with considerable waste likely. If the program proceeds on anything like the scale and pace envisaged, investment costs will be raised, gains limited, and competitiveness will be harmed by the impact on non-tradable prices. And if the PIT reforms weaken the fiscal balance further, these adverse effects will be amplified.

25. Disinflation ambitions may also be harmed. Even—perhaps especially—if the fiscal weakening in 2006-07 is sizeable, the suggested reforms to the monetary and exchange regimes should go ahead. But to the extent that the central bank assesses that the fiscal stance is inadequate, it may need to scale back the specificity and ambition of its objectives for core inflation in order to shield, however modestly, the current account balance from the adverse impact of the fiscal loosening.

26. And PPM undertakings would not be observed. In the first quarter, though health sector savings are lower than anticipated and the budget wage bill target was exceeded somewhat, the budget, army reform, headline inflation, and the current account balance are all broadly on track with PPM commitments. Thus these objectives are well within reach, absent the redirection of fiscal policy now under consideration.

Concluding remarks

27. After two decades of disappointment, Serbia has made significant progress in recent years in an exceptionally challenging environment. To continue with this good progress, we urge you to carefully plan the scope and phasing of your new fiscal initiatives.
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The mission is grateful for the warmth of the welcome it has received.


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