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—Fall 2008 IMF Staff Visit, Aide Mémoire

September 24, 2008


1. Growth is strong, inflation has peaked, and political uncertainties have waned. But overall economic developments suggest that Serbia's economy remains unable to deliver robust growth with low inflation and—at the same time—keep the external current account deficit at sustainable levels.

• We expect real GDP to continue to expand at a robust 6-7 percent during 2008-09. However, growth remains too dependent on nontradeable activities (banking, shopping, and communication), while exports are not keeping up with surging imports. The growth outlook is also subject to external downside risks, as spillovers from the global financial turmoil could increase the costs of foreign funding and lower external demand.

• Under the NBS's implicit inflation targeting framework, retail price inflation excluding food and energy prices has moderated substantially. However, as elsewhere in the region, food and energy prices have surged over the past year, driving headline inflation well into double digits. Reflecting this year's good harvest and declining international energy prices, these pressures have peaked. Nonetheless, while inflation is likely to recede further, sustained disinflation can not be taken for granted: inflation expectations are high; price setters seem to face little competitive pressure to pass through lower input costs to consumers; and continued loose fiscal policies could again stoke inflation.

• While growth and inflation developments provide grounds for cautious optimism, they have come at the cost of an unsustainable external current account deficit. The external deficit is equal to the gap between what Serbs spend on goods and services (some 3,400 billon dinars in 2008) and what they earn (some 2,900 billion dinars). Thus, we project that overall spending will exceed incomes by about 500 billion dinars (or 18¼ percent of GDP) in 2008. This massive overspending remains so far well covered by capital inflows. But private external debt has soared, increasing the risk of a disorderly external adjustment, particularly in an environment of worsening global financial conditions.

2. Three interconnected features of Serbia's economy seem to account for the observed macroeconomic tensions. First, the economy's supply side has been hampered by a late transition start, slow and inconsistent efforts at privatization, and a difficult investment climate. Second, notwithstanding high unemployment, wage settlements are excessive relative to targeted inflation and labor productivity growth, undermining firms' external cost competitiveness. And third, the large government sector is tuned toward consuming and redistributing resources instead of investing in the country's future. The net outcome has been a low savings, high unit-labor-cost economy that seems only able to achieve robust catch-up growth and low inflation by building up external stability risks. If Serbia were a closed economy, it would most likely suffer from slow growth and high inflation.

3. However, Serbia is an open economy, and abundant capital inflows have, at least until now, largely defused macroeconomic tensions. Capital inflows have smoothly bridged the rapidly widening gap between spending and income, containing excess demand pressures that would have otherwise fuelled inflation. But raising concerns, the growing external deficits seem not to finance a private investment boom, which could pay off in an improved supply side and higher exports down the road, but have rather served to finance high levels of consumption.

4. Adding to Serbia's underlying macroeconomic tensions, since 2006, fiscal policy has been in procyclical mode. After registering a fiscal surplus in 2005, public finances shifted into deficit in 2006 and 2007. Fiscal deficits of about 2 percent of GDP may not seem high by international comparison, and they were largely financed by privatization receipts. But the abrupt shift in fiscal stance was problematic for three reasons. First, it occurred at a time when private sector spending was already outpacing private sector incomes, and the shift in fiscal stance directly widened Serbia's external deficits. Second, looking ahead, when the gap between spending and income eventually narrows back to more sustainable levels—possibly in the context of a sharp economic downturn—the government will be forced to raise taxes or cut spending to contain the deficit. In fact, fiscally more prudent transition economies faced with high external deficits have been running fiscal surpluses. Third, the shift to fiscal deficits signaled to society that lobbying for higher government spending and redistribution remains a high pay-off activity.

The Way Forward

5. The new government's broad economic objectives signal its resolve to achieve robust growth, low inflation, and external stability at the same time. The objectives include sustaining average GDP growth of 7 percent during 2009-12 through raising employment and productivity; reducing inflation to about 4 percent by 2012; and lowering the external current account deficit below 10 percent of GDP over the medium term.

6. But to reach these objectives, the new government needs a comprehensive, coherent, and credible economic reform strategy that tackles the very roots of Serbia's macroeconomic tensions.

Structural Policy Requirements

7. Privatization, enterprise restructuring, and lowering the costs and risks of doing business remain the keys to strengthening the economy's supply side. The main elements of the government's structural reform strategy are promising: (i) deeper EU and regional integration to expand trade and attract FDI; (ii) privatization and restructuring of enterprises to increase the still relatively low share of the economy that responds to market incentives and lives within hard financial constraints; and (iii) pruning Serbia's regulatory jungle. From this perspective, plans to improve and develop public infrastructure are also welcome.

8. However, both regional country experiences and Serbia's own track record suggest that implementing structural reforms will be an uphill battle. Volatile politics, vested interests, and limited administrative capacities could all conspire to bog down reforms. Clear timetables, openness, and transparency will be essential to ensure progress on enterprise privatization and restructuring.

Fiscal Policy Requirements

9. Fiscal policy should be geared toward macroeconomic stability and promoting sustainable growth. Fiscal policy should help stabilize the economy, in coordination with monetary policy. This objective calls for avoiding the type of procyclical policies seen over the last two years. And there is also a need to reduce the deadweight burden of the government sector on the economy, while attending to the population's social protection needs. This objective would call for significant cuts in the level of recurrent spending (as a percent of GDP), improving spending efficiency, and investing more in Serbia's future.

10. The new government's announced fiscal policy intentions clearly point in the right direction, as they aim at bringing the general government balance into surplus by 2010, mainly by cutting recurrent spending.

11. The supplementary budget for 2008 was a first opportunity to build fiscal credibility—but the new government seems to have missed it. The revised general government budget in 2008 is likely to accommodate a deficit of about 3 percent of GDP, thus prolonging the stretch of procyclical budgets of the past two years. This is mainly due to the very expensive 10 percent across-the-board increase in pensions, which has been added to the normal indexation adjustment. At the same time, we believe that heavy underexecution of the approved capital budget—as happened in 2007—will limit the cash deficit outcome for 2008 to about 2 percent of GDP.

12. Looking ahead to the 2009 budget, we are aware that the government is considering several fiscal deficit-boosting initiatives. These include: (i) raising average pensions to up to 70 percent of average net wages; (ii) increasing public investment on selected road and railway projects; and (iii) various tax cuts and fiscal investment incentives. We estimate that these promises—if fully implemented—could add up to 5 percent of GDP to the fiscal deficit in 2009. Accumulated road fund arrears equivalent to about 1 percent of GDP will also need to cleared. Hard budgetary choices will have to be made, as these promises can only fit within a responsible budget envelope by trading them off against cuts in already existing spending programs. We also note that, with more limited privatization receipts and potentially high interest rates on new Serbian debt, financing large fiscal deficits could become quite expensive.

13. Magnifying concerns about fiscal policy going forward, there are several other costly fiscal proposals endorsed by various interest groups. These include a massive raise in wage allowances for public sector employees; providing social payments to veterans; and expanding maternity benefits. We estimate that fully implementing these initiatives could cost up to another 6½ percent of GDP in 2009.

14. Against this backdrop, any new recurrent spending increases or revenue losses should be resisted across-the-board, and additional measures should be taken to curtail recurrent spending. Given the present economic outlook, the new government should aim at least at balancing the general government position in 2009, paving the way for a surplus in 2010—in line with the government's own announced intentions. Therefore, a stability-oriented 2009 budget should include the following broad measures: price indexation of pensions consistent with the current pension law, allowing to bring the average pension-to-wage ratio in line with more sustainable levels; freezing real spending on wages as well as goods and services; lowering subsidies to transport and agriculture, and the financial sector; and limiting net lending to public enterprises and public financial institutions. If current spending cannot be curtailed sufficiently to reach the balanced budget target, the capital budget may need to be scaled back, or, as a last resort, indirect taxes be raised. Looking beyond 2009, a reform blueprint for a more sustainable pension system is urgently needed.

Monetary and Financial Stability Policies

15. The NBS should continue to focus on containing inflation, in line with its fledgling inflation-targeting framework. In the face of the surge in food and energy prices that has affected many other countries as well, the central bank has acted decisively to tighten monetary policy. Looking forward, recent declines in agricultural and energy prices point to a substantial easing of immediate inflationary pressures. However, as highlighted by the NBS's August Inflation Report, risks for missing the 2009 inflation targets are clearly tilted upward, particularly if fiscal and incomes policies remain loose. The authorities should continue to upgrade the inflation targeting framework, including by strengthening the central bank's operational capacity and independence, providing strong public government support, and adopting a sound medium-term fiscal framework.

16. Although the ongoing global financial market turmoil has had so far little direct impact on Serbia, financial stability risks need to be monitored closely. In particular, Serbia's widening financial spreads indicate a worsening external environment, indirect credit risks stemming from currency mismatches in the private sector have kept growing, and banks striving to meet ambitious return and market share targets may underestimate direct credit risks. In this uncertain environment, the central bank's tight macroprudential stance and high mandatory reserve requirements remain appropriate by helping to maintain much-needed financial buffers, notwithstanding valid concerns over disintermediation and circumvention.

* * * * * *

We would like to thank the authorities for the high level of cooperation with the mission, the constructive discussions, and the warm hospitality.


Public Affairs    Media Relations
E-mail: E-mail:
Fax: 202-623-6220 Phone: 202-623-7100