Serbia--2007 Article IV Consultation, Concluding Statement of the Mission
November 6, 2007
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.
The Serbian economy continues to grow strongly and inflation has come down markedly, but imbalances are widening. Growth was boosted by inflows and expansionary policies. The inflows allowed for significant official reserve accumulation, but at the same time complicated macroeconomic management by boosting credit and domestic demand. This was compounded by large wage increases. With mixed progress on structural reforms, the current account deteriorated and competitiveness slipped.
These trends call for a significant rebalancing of policies, with faster structural reforms and tighter fiscal policy, relieving the burden on monetary policy. The problems should be tackled at their roots: enterprise restructuring should be accelerated, financial sector risks controlled, wage increases moderated, and fiscal policy significantly tightened. In particular, Serbia should move to fiscal surpluses until the effects of structural reforms take hold. This would alleviate the pressure on monetary policy, allowing it to entrench low inflation and restore confidence in the dinar, while making room for improved competitiveness. Only under these conditions will the current account deficit decline significantly and external sustainability be ensured.
The economy: less rosy than it looks at first glance...
1. Growth is strong but unbalanced—it has been boosted by wage, credit, and public spending increases. Strong economic growth at about 8 percent in the first half of 2007 was impressive. However, while this was in part the welcome result of structural reforms and privatization of the past few years, it also reflected high domestic demand fueled by large wage increases, credit growth, and expansionary fiscal policy of last year. Moreover, consumption far exceeded productive investment. Thus, with some of this short-term boost expected to wear out, growth is likely to decelerate in the second half of the year—also owing to the summer drought—and after reaching about 7 percent in 2007 to slow to around 6 percent next year.
2. Tight monetary policies have been successful in maintaining low inflation, but wage growth has not moderated accordingly. Inflation has come down, despite recent supply shocks and rises in oil and other administered prices. Core inflation—which is targeted by the NBS—declined from 14 percent in 2005 to 6 percent in 2006 and is expected to be about 4½ percent in 2007. Headline inflation went down from 18 percent in 2005 to 8½ percent now. At the same time, real wage increases of 20-25 percent were clearly in excess of productivity growth.
... and vulnerable
3. The current account deficit widened to 15 percent of GDP. With monetary policy geared toward maintaining low inflation, excess demand translated into a rapid growth of imports. Exports grew equally fast, but they are only half of imports, and their rise largely reflected growth in prices rather than volumes. Declining remittances and the pressure put on competitiveness by slow structural reforms and large wage increases further widened the current account deficit.
4. Private external debt has been rising rapidly, as have currency risks. Capital continued to flow into the country, but less in the form of foreign direct investment and more as external, including off-shore, borrowing. Thus, external debt continued to increase. In particular, private debt rose to 38 percent of GDP at end-September, more than double its end-2004 level. Alongside, there has been a very rapid growth in euroized credit.
Current outlook: persistent imbalances
5. Under current policies, external imbalances will persist and external debt continue to rise. The absence of a coordinated policy approach, if continued, would dampen growth prospects, while fueling demand pressures. Thus, we project the current account deficit to remain large, and external debt to rise rapidly. In short, the presently unbalanced domestic policy mix of loose fiscal, tight monetary, and so far slow-moving structural policies would further raise concerns over external stability.
Fiscal policy needs to be tightened significantly
6. Restrictive fiscal policy is the main short-term macroeconomic tool available to reduce external imbalances and curb domestic demand. The small surplus in the first ten months of 2007 and the prospects of a better annual outturn than budgeted—although still resulting in a deficit on IMF definition—are welcome developments. However, the fiscal expansion expected in the remainder of the year—driven by previous commitments to large public sector wage increases—is counterproductive and will likely exacerbate external imbalances. Targeting a tight fiscal stance is important. It would help contain, if not reduce, excess demand pressures and in so doing increase the likelihood of a turn-around in the current account deficit. It would also signal readiness for fiscal discipline and thereby support monetary policy. And it would create fiscal space to finance growth-enhancing infrastructure needs in the medium term.
7. The fiscal stance for next year, as laid out in the revised budget memorandum for 2008-10, is expansionary. Despite efforts in curbing discretionary spending, this memorandum implies a fiscal deficit that is larger than the expected outcome this year and therefore would not curb domestic demand. With planned large public wage bill increases—mostly a result of carry-over wage increases from 2007—and continued high NIP spending, fiscal policy may fuel a further widening of external imbalances.
8. To help contain domestic demand, a surplus in the 2008 budget is needed. Bringing down external imbalances requires sizeable fiscal surpluses of 2-3 percent of GDP until the benefits of structural reforms are reaped. A quick move to such surpluses is essential and the budget should target a surplus of 1 percent already in 2008. Experience from other Eastern European countries shows that such fiscal adjustment is feasible.
9. Fiscal consolidation should focus on expenditure control. Key measures should include stronger-than-envisaged control of public sector wages (both for the general government and public enterprises), larger cuts in the capital budget, subsidies, and other current spending, and indexation of pension benefits to price inflation only. Over the medium term, these measures should be supported by broader civil service and pension reforms.
10. The plan to provide restitution should be carefully prepared to avoid endangering fiscal and macro stability. The currently contemplated ceiling of euro 4 billion (more than 10 percent of GDP) is very large and in the absence of compensating expenditure measures will deteriorate the fiscal position and deepen macro imbalances. In case of financial compensation through the issuance of bonds, these should be denominated in local currency to limit foreign exchange exposure of the government.
Monetary policy should continue to focus on inflation
11. Following years of instability, the new monetary policy framework has successfully brought inflation down to single digits. Alongside, the repo interest rate has matured into the reference rate for the dinar markets. These gains could be further entrenched by eventual adoption of formal inflation targeting once government support and sound fiscal policies are in place.
12. With core inflation low, there seems scope for further gradual lowering interest rates, barring new shocks to inflation. The recent slowdown of growth of food prices and notable strengthening of the dinar following prudential tightening in August point to easing of the underlying inflationary pressures.
13. Nevertheless, the inflation objectives—and central bank credibility—should not be compromised, pointing to limited room for maneuver. In this context, the NBS should aim at the middle bound of the 3-6 percent core inflation target range in 2008. In determining the degree of ambition in longer-term inflation objectives, the NBS should consider the appropriate balance between the desire to further lower inflation and the need for structural convergence of prices during transition.
14. Competitiveness concerns should be addressed through corporate restructuring and wage moderation and not through exchange rate policies. The latter has been tried in Serbia in the past, but eventually resulted in high inflation. Attempts to inflate away the loss of competitiveness, which has its roots in excessive wage increases, slow structural reforms, and relatively loose fiscal policies, would damage the credibility of monetary policy while providing no sustained relief for exports. And the direct impact of inflation on public sector wages would further compound the scope for potential macroeconomic instability. Interventions in the exchange market should be used only to smooth shocks.
Accelerating structural reforms is key, but will take time to bear fruit
15. Reforming the corporate sector is the only way to achieve durable growth and should be accelerated. Wide-ranging privatization and restructuring is needed to reduce financial losses in the state- and socially owned corporate sector, thereby laying the ground for stronger growth, exports, and employment. During the process of corporate restructuring, which will take time, macro conditions should be kept stable in order not to jeopardize the economic gains from the reform operation.
16. We welcome the renewed efforts to accelerate privatization or bankruptcy of socially owned enterprises. But the deadlines have been regularly pushed back, and we urge completion of the process as soon as possible. Furthermore, the bankruptcy process should be strengthened, and government and public authorities should initiate bankruptcies without delay. Unviable companies that cannot be sold rapidly should be liquidated to free up productive assets.
17. Regrettably, less progress has been made so far with respect to state-owned enterprises, and plans remain unclear. We continue to support selling a majority stake in the state-owned oil company, selling the airline company, and opening the capital of other state-owned companies, which are the only ways to modernize and ensure the viability of these companies. Major efforts are needed to improve the business environment, including by streamlining regulations.
Financial sector: strong supervision and capital market development
18. Financial sector vulnerabilities have risen. Rapid credit expansion—albeit from a low base—of highly euroized credit to unhedged borrowers underpins rising vulnerabilities. As a result, there has been some decline in the asset quality of household credit. Strong competition and overoptimistic market share targets raise concerns over profitability. Mortgage lending, notably in foreign currency, can potentially feed into asset price inflation as surging demand for housing—partly encouraged by the state-sponsored mortgage insurance and subsidies—outpaces supply.
19. But financial soundness of banks has largely been preserved by building adequate buffers. Rigorous provisioning and risk classification rules, as well as high reserve and capital requirements, were appropriate to address rapidly rising vulnerabilities. As a result, the banking sector is well capitalized with capital adequacy of over 25 percent as of June 2007. Notwithstanding concerns about circumvention and disintermediation, prudential measures should remain restrictive until macro and financial vulnerabilities subside.
20. The recent turbulence in international financial markets has so far had little impact on Serbia, but underscores the need for increased vigilance going forward. As Serbia continues to integrate into global financial markets, it has to build capacity for responding to shocks in the broader markets. The work of the NBS' new financial stability unit and its plans to conduct periodic stress tests will help the NBS and the banks to better prepare for systemic risks.
21. The regulatory and the supervisory framework should continue to strengthen. Banking supervision has improved following the entering into force of the new banking law. Safeguarding financial stability requires continued close monitoring of banks' risk management and resilience to shocks. Further progress could be achieved by continuing to build capacity and by strengthening the dialogue with banks and foreign supervisors.
22. Developing capital markets can help diversify the financial system and contribute to financial stability. Currently, liquidity in the stock market is shallow and domestic bond markets are largely absent. A strategy to develop a benchmark government yield curve would allow banks to better price dinar products with longer maturities, paving the way for reducing unhedged borrowing. In addition, it would strengthen the effectiveness of the repo rate in monetary transmission, foster growth of the domestic institutional investor base, and increase private savings.