## _cr06382

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### I. Overview and summary: Serbia's progress and challenges
- Output is up 40 percent and the share of the private sector in non-agricultural non-budget employment has almost doubled to around 60 percent.
- Important challenges remain across real and financial sectors that could affect sustainability of growth.

### II. Investment, current account deficits, FDI, and external debt (1995–2005)
- Regional stylized facts:
  - Higher fixed investment is generally associated with higher current account deficits in the CEEC region.
  - In the absence of large FDI inflows, higher fixed investment is associated with greater external debt accumulation.
  - For a given level of gross investment, a percentage point increase in public investment (as a share of GDP) is associated with a 0.6 percentage point increase in the current account deficit (as a percent of GDP).
  - No significant effect of a change in private investment on the current account balance in the panel estimation.
  - Where private investment does not decline significantly in response to reduced FDI inflows, external debt increases.
- Country examples and comparative dynamics:
  - Czech Republic: fixed investment 31 percent of GDP during 1995–97; stabilized at 26–27 percent of GDP in more recent years. Current account deficit about 4.4 percent of GDP at the start of transition; external debt stabilized at about 36 percent of GDP.
  - Slovak Republic: fixed investment 32–36 percent of GDP between 1996–98; stabilized at 26–27 percent. Average current account deficit about 8.4 percent of GDP; external debt rose from 30 percent of GDP in 1995 to 52 percent in 1999.
  - Poland: fixed investment rose to 24 percent of GDP by 2000, then stabilized at 18–19 percent. Current account deficit fell to about 2 percent of GDP after investment decline since 2001.
  - Hungary: fixed investment around 23 percent of GDP since 1998; external debt dynamics tied to FDI inflows and current account deficits.
  - Croatia: fixed investment 16 percent of GDP in mid-1990s, reached 27 percent of GDP in 2003.
  - Bulgaria: fixed investment averaged 15 percent in 1995–2000; about 24 percent in 2005.
  - Romania: fixed investment declined from 23 to 18 percent of GDP between 1996–99, then reached 23 percent by 2005.
- Serbia-specific observations:
  - Fixed investment increasing since 2001 but at 19 percent of GDP in 2004 (data before 2004 unreliable).
  - Large current account deficit associated with relatively low investment ratios compared to other CEECs (except Bulgaria)—data doubts remain.
  - Composition skewed toward public investment (including socially owned enterprises), relatively low FDI inflows, and large external debt-to-GDP ratio compared with peers.
  - Implication: financing large investment needs will require higher national savings and attracting larger non-debt creating flows.

### III. Data caveats for Serbia
- National accounts likely underestimated private investment in 2000–03 by about 5 percentage points of GDP; only the 2004 investment figure is considered meaningful.
- Decomposition of public vs private investment is difficult due to data absence and definitional issues (socially owned enterprises).
  - Earlier staff estimate: government 14 percent and non-government 86 percent of total investment.
  - Recently published data: public sector (including socially owned enterprises) 58 percent and private sector 42 percent of total investment.
- Serbia exhibits surprisingly high external deficits given low fixed investment ratios; precedents exist but Serbia's delink is unusual in degree.

### IV. Employment, labor markets, and structural reform implications
- Aggregate labor statistics (2001 – Apr. 2006):
  - Total employment: Sept. 2001 = 2,787,858; Apr. 2006 = 2,600,776; Diff. 06/01 = -187,082.
  - General government: 321,616 → 316,483; -5,133.
  - State-owned enterprises: 187,290 → 164,640; -22,650 (National: 134,938 → 104,250; -30,688; Local: 52,352 → 60,390; 8,038).
  - Socially owned enterprises: 643,709 → 245,980; -397,729.
  - Mixed ownership: 377,035 → 323,048; -53,987.
  - Private sector: 1,258,208 → 1,550,625; 292,417.
    - Non-farmers: 566,479 → 963,917; 397,438 (Companies: 208,546 → 428,384; 219,838; Entrepreneurs and employees: 357,933 → 535,534; 177,601).
    - Farmers: 691,729 → 586,708; -105,021.
  - Memorandum: Non-agriculture non-gen. government: 1,774,513 → 1,697,585; -76,928.
  - Memorandum: State, socially, and mixed-owned enterprises: 1,208,034 → 733,668; -474,366.
- Employment shares (percent of total):
  - Socially owned enterprises: 23.1 → 9.5; -13.6.
  - Private sector: 45.1 → 59.6; 14.5.
  - Non-agriculture non-gen. government: 63.7 → 65.3; 1.6.
  - State, social, mixed in non-agr. non-gen. gov.: 68.1 → 43.2; -24.9.
- Labor market context and recommendations:
  - Unemployment rate at 21 percent and rising; employment in trend decline.
  - Shift to private sector employment may reflect re-classification or net new private employment—data inconclusive.
  - 2005 Labor Law increased “insider” labor market rights; note recommends focus on impacts for young people and females.
  - Labor tax cuts can help at the margin but cannot be central to improving employment performance.
  - Prioritize job creation; review labor law, wage/remuneration setting (especially public sector), macroeconomic and business environment, and tax/social benefit policies related to labor.
  - Consider appropriately designed temporary social assistance programs and containment of early retirement costs via lower pension compensation until full age-based eligibility.

### V. Personal Income Tax (PIT) and Social Security Contribution (SSC) reforms (2006 → 2007 proposals)
- PIT changes:
  - Tax rate on wage income (percent): 14 → 12.
  - Personal tax allowance: 0 → 5,000 dinars per month (applies only to PIT base, not SSC base).
  - Exemption for new entrants & formerly unemployed under 30: None → Full relief from PIT for 2 years if not a trainee or 3 years if a trainee.
  - Exemption for newly employed persons with disability: None → Full relief from PIT for 3 years.
  - Exemption for formerly unemployed over 45: None → Full relief from PIT for 2 years.
- SSC changes:
  - Combined employee-employer SSC rate (percent): 35.8 → 35.8.
  - Exemptions for employer’s part of SSC mirror PIT exemptions (under-30, trainees, disabled, over-45) with the same durations.
  - Minimum base wage for payment of social contributions: 40 percent of the average wage → 35 percent of the average wage.
- Annual Income Tax Threshold:
  - Four average wages → Three average wages.
  - Rates: between 3 and 6 average wages: 10; 6 average wages and above: 15; 1/ To be effective on January 1, 2007. Rate 10.
- Implementation caveats:
  - Exemptions cannot be claimed by government institutions and public enterprises.
  - Exemptions apply only if employment with the newly employed person increases number of employees compared to September 1, 2006.
  - If employer reduces number of employees during utilization/subsequent period (three years for under 30; two years for over 50 after expiry), employer loses exemption and must repay tax as if no exemption used.
- Fiscal cost and offsets:
  - Expected fiscal cost of lowering PIT on wages is high (over 1.4 percent of GDP) and should be compensated by a reduction in current spending or an increase in broad-based indirect taxes, such as the VAT, or a combination of both.

- Effectiveness concerns on targeted exemptions:
  - Potential limitations: deadweight fiscal costs, substitution effects, displacement costs.
  - Employer requirement not to reduce employees from September 1, 2006 may be undermined by substitution/churning and administrative burden.
  - Net employment effects of exemptions are unclear; targeting may produce limited gains.

- National Employment Action Plan (2006–2008):
  - Aim: halve unemployment by 2010.
  - Emphasizes job creation and entrepreneurship, adaptability and mobility, developing human capital, increasing labor supply.
  - Task: translate into ambitious program of specific reforms.

### VI. Privatization and state/socially-owned sector losses
- Severity of loss making in state- and socially-owned sectors indicates privatization cannot be delayed.
- Losses drain domestic savings and account for much of the external current account deficit.
- Job-preservation requirements for purchasers may impede sales; many firms have excess debts hindering swift sales.
- Policy priorities:
  - Prioritize job creation, review labor law, public sector remuneration, macroeconomic and business environment, tax and social benefit policies.
  - Consider temporary social assistance, early retirement with contained costs.

### VII. Banking system, FSAP findings, and subsequent reforms
- Structural transition and credit growth:
  - Rapid credit growth after banking reforms; foreign banks hold over 70 percent share in total assets.
  - Household lending grew by 96.2 percent in the twelve months to June 2006.
  - Credit expansion complicated efforts to reduce inflation and high current account deficit.
- Main financial stability threat:
  - High and rising indirect credit risk: 80 percent of all loans are either fx-indexed or fx-denominated, exposing unhedged borrowers to unexpected depreciation.
  - A decline in profitability of foreign banks seeking market share plus an adverse shock could result in a credit crunch.
- FSAP-identified weaknesses:
  - Weak banking regulation and supervision; significant gaps in law/regulations and weak enforcement (BCP assessment April 2005).
  - Underdeveloped capital markets, poor insurance sector, weaknesses in bankruptcy law, difficulties in taking/executing security, ineffective land registry, undeveloped accounting/auditing, weak corporate governance.
- Legal and regulatory improvements (post-FSAP):
  - New banking law (November 2005) largely in line with Basel Core Principles and EU Directives: consolidated supervision, strengthened fit-and-proper, protection for NBS staff, limits on connected lending, corporate governance requirements, obligation to publish IFRS financial statements.
  - By-laws: most adopted; by-law on consolidated supervision effective end-2006; by-law on competition subject to further discussion.
- Prudential and supervisory measures:
  - From September 30, 2006, fx-indexed or fx-denominated loans in excess of CSD 10 million receive a 125 percent weight in capital adequacy calculation.
  - From October 1, 2006, limit on banks’ exposure to households to 200 percent of capital (some household loan categories exempt, notably budget-subsidized mortgages).
  - Credit bureau (Association of Serbian Banks) functioning for personal lending; business coverage expected by end-2006.
  - NBS reorganized supervision with World Bank assistance; each bank assigned a portfolio manager.
  - Auditing and disclosure requirements improved; progress in enforcing connected lending limits.
- Bank privatization:
  - Five banks privatized since end-2004; privatization of two more (including Vojvodanska Banka) expected by end-2006.
  - EBRD acquired 25 percent of Komercijalna Banka and appointed two Managing Board members; government prefers public offer in Serbian market for eventual privatization.
- Asset quality and NPLs:
  - NPL ratio declined from 22.2 percent at end-2004 to 20.7 percent at end-March 2006 due to large write-offs in state-controlled banks prior to privatization.
  - NPL ratio of foreign banks increased from 10.0 percent to 16.1 percent in same period.
  - High recent credit growth and limited exchange rate volatility suggest asset quality may deteriorate later; caution warranted.

### VIII. Transition to risk-based supervision and supervisory capacity
- Transition status and objectives:
  - Transition to risk-based supervision in early stages; requires staff able to evaluate banks’ pricing, risk management, mitigation, and controls.
  - Supervisors must identify poor risk management and prescribe corrective measures.
- Human resources and pay:
  - Recruitment focuses on university graduates with limited practical commercial banking experience.
  - Salary constraints at NBS limit market competitiveness; interim bonus of 25 percent for on-site inspection staff.
  - Recommendation: consider flexible pay structure and benefits to retain scarce skills.
- Transitory remedies:
  - Hire experienced late-career staff to mentor younger staff.
  - Outsource specialist tasks to accounting/consultant firms, with banks paying for remedial investigations where necessary.
- Organizational and training needs:
  - Flatter organizational structure, appointment of portfolio managers, improved horizontal/vertical communication.
  - High premium on intensive internal and external training.
- Reporting and accounting standards:
  - NBS requirements differ from IFRS, particularly in asset valuation; some foreign banks publish two sets of accounts (NBS and group IFRS).
  - No progress in establishing national accounting and auditing standards body despite legal provision.
- Legal/information infrastructure improvements:
  - Credit bureau extension to corporates, improved land registries, pledge registry for movable property, legislative changes for debt recovery and bankruptcy.
  - Uncertainty remains whether creditor rights now comparable to other countries.
- Market structure and competition:
  - 38 banks remain; competition intense; margins under pressure especially for large corporate business when reserve requirement increases are considered.
  - SME lending requires branch networks and relationship managers; consumer lending boom can offset some margin pressure.
  - Expectation of further consolidation; some smaller banks may find profitability and franchise value challenged.
- Euroization, reserve requirements, and currency-related risks:
  - Virtually all deposits except transactions accounts are fx-denominated.
  - About 80 percent of credit to nongovernment sector is fx-denominated or fx-indexed.
  - Reserve requirements statutory rates:
    - 40 percent for fx-denominated deposits and banks’ foreign borrowing with maturities over two years.
    - Since May 2006—60 percent for banks’ foreign borrowing with maturities up to 2 years.
    - Dinar-denominated deposits reserve requirement: 18 percent.
  - Implied wedge in lending rates (assuming cost of funds 5 percent and unwillingness to shift to dinar deposits): about 3.3 and 7.5 percentage points, respectively.
  - Disintermediation risk and avoidance behaviors noted (offshore booking, use of parents, leasing subsidiaries).
  - Prudential step: 125 percent risk weight for loans to unhedged borrowers; needs complementing by intensified bank internal procedure assessment.
- Liquidity risk and market development:
  - High reserve requirements moderate liquidity risk but NBS cannot create liquidity in euro.
  - No supervisory limit on maturity transformation; maturity data not disaggregated by currency; supervisors may miss currency mismatches.
  - Market development needs: a flexible exchange rate regime, forward market, short-dated swaps, deeper FX and dinar money markets to aid repo transmission.

### IX. Monetary and exchange rate framework: regime choice and operational recommendations
- Interpretation caveats:
  - Velocity volatility flags monetary shocks but may reflect return of depositor confidence; data series are short and structural breaks exist.
  - Parameter estimates (e.g., exchange rate pass-through) are period- and methodology-specific; exercise on regime choice should be cautious.
- Regime choice recommendation:
  - Float supported by fiscal and monetary policies targeting stability may be best fit given capital flow risks and political uncertainties.
  - High euroization and openness argue for stability in regime operation (e.g., limited discretionary intervention, stable nominal exchange rate).
- FX intervention and reserve strategy:
  - NBS should determine long-run reserve targets (gross or net-of-claims), potentially adjust targets over time, and announce general intervention approach for meeting long-term reserve targets.
  - Recommend preannouncing schedules for foreign exchange purchase auctions to enhance transparency.
  - Suggest moving away from preferential “stimulation” rates for exchange office purchases via a phased, preannounced elimination schedule (examples include phased resales of FX acquired from exchange offices).
- Managing daily dinar volatility:
  - Options: allow volatility to deepen market or adopt a “leaning against the wind” rule to smooth daily moves beyond a set percentage threshold without resisting sustained trends.
  - Consistency is critical to avoid misinterpretation of interventions.
- Exchange rate trends and discretionary intervention:
  - Prefer phasing out discretionary FX intervention; fiscal response or repo rate adjustments preferred to absorb trend inflows.
  - Avoid discretionary FX intervention that undermines repo as main instrument.
- Repo operations: strengthen framework and signaling:
  - Current practice: two-week and two-month repos using variable rate tenders; since mid-May 2006 tender announcements omit maximum bid rate.
  - Drawbacks: dilution of two-week repo signaling; abolition of maximum bid rate undermined signaling; two-week repo rate declined by almost 100 basis points after abolition without public statement.
  - Recommendations:
    - Make the two-week repo rate the principal policy rate; deemphasize or abandon two-month repos.
    - If two-month repos retained, revise auction method and reduce volumes.
    - Link other NBS interest rates closely to the repo rate to create an economically meaningful interest rate corridor.
    - Communicate repo decisions clearly after each Monetary Council meeting and align Monetary Council schedule with reserve maintenance periods.
- Auction methods and liquidity provision:
  - Fixed rate tenders preferred during transition to give least ambiguous policy signal and support communication.
  - Variable rate tenders foster market development and provide information; transition from fixed to variable may be warranted if overbidding/underbidding occurs.
  - If variable tenders used, return to announcing maximum bid rates to reduce market confusion.
  - Complement tenders with liquidity guidance (regular publication of short-term and medium-term liquidity forecasts) or announce quantities to be withdrawn if forecasts not trusted.
  - Eligible collateral limited: stock of T-bills held by banks fell to "SRD 120 million at end-June"; consider scope for bills of exchange as collateral if asset quality secured.
- Interest rate corridor and money market pass-through:
  - No economically meaningful interest rate corridor currently; Beonia (May–July 2006) fluctuated between "7.3 percent and 23.8 percent," average "13½ percent."
  - Policy options: link deposit facility rate to two-week repo rate and narrow spread; consider raising deposit facility rate to above Beonia average to establish meaningful corridor.
  - Link lending facility rates to two-week repo rate rather than weighted monthly average of all repo maturities.
- Transmission from repo rate to exchange rate:
  - Repo rate changes can influence exchange rate; example: early 2006 repo rate increase and March revision of open fx-position regulations strengthened upward pressures on dinar.
  - Increase in repo volume end-2005 to end-April 2006: "SRD 17.6 billion," corresponding to "31.3 percent of commercial banks’ net foreign borrowing" during this period; for seven most active foreign banks this share is "36 percent."
  - Constraints: repo market dominated by six foreign banks; parent bank exposure limits and foreign currency borrowing may limit further repo demand.
  - Deepening money markets and disinflation that reduces risk premia on dinar deposits would strengthen transmission via portfolio adjustments.
- Foreign exchange market restructuring:
  - Prefer broker/dealer system replacing fixing sessions; emphasize publishing reserve data rather than central bank transaction minutiae.
  - Phase out preferential stimulation rates (reduced from 1 percent to 0.9 percent on April 1 and to 0.7 percent on June 1) via a binding monthly schedule toward zero over a reasonable horizon.

### X. Inflation and exchange rate pass-through: empirical findings and asymmetries
- Data context:
  - Core prices about "52 percent" of the retail price index, excluding agricultural and regulated prices.
  - Short data sets, structural breaks, and data quality concerns limit confidence in estimates.
- Empirical models and key reported estimates (preserve reported values exactly):
  - Monthly, m/m(-1) sample results (2003m3 - 2006m6 and 2003m3 - 2005m9):
    - Constant: "0.30" and "0.15" (standard errors "(0.14)" and "(0.17)").
    - Lag of Core Inflation: "0.41" and "0.31" (standard errors "0.14" and "(0.15)").
    - Exchange Rate: "0.24" and "0.44" (standard errors "(0.11)" and "(0.15)").
    - Sample Size: "40" and "31".
    - Adjusted R-squared: "0.28" and "0.36".
    - Cumulative pass-through into inflation, %: "40.3" and "63.8".
    - Pass-through rates into prices, %:
      - 1 month: "24.0" and "44.1".
      - 2 months: "36.0" and "63.7".
      - 6 months: "45.0" and "73.7".
      - 12 months: "45.2" and "73.8".
      - 24 months: "45.2" and "73.8".
  - Three-month, m/m(-3) sample results (2003m3 - 2006m6 and 2003m3 - 2005m9):
    - Constant: "0.18" and "-0.08" (standard errors "(0.24)" and "(0.25)").
    - Lag of Core Inflation: "0.74" and "0.69" (standard errors "0.14" and "0.08(0.08)").
    - Exchange Rate: "0.19" and "0.30" (standard errors "(0.07)" and "(0.09)").
    - Sample Size: "31" and "30".
    - Adjusted R-squared: "0.77" and "0.83".
    - Cumulative pass-through into inflation, %: "75.6" and "96.2".
    - Pass-through rates into prices, %:
      - 1 month: "9.4" and "30.2".
      - 2 months: "36.6" and "57.1".
      - 6 months: "80.6" and "119.9".
      - 12 months: "100.6" and "140.4".
      - 24 months: "104.9" and "142.9".
- Interpretation and caveats:
  - Using monthly growth rates, average exchange rate pass-through to price level within one year was "about 74 percent" during the rising depreciation episode but "dropped to just over 45 percent" in the full sample.
  - Three-month growth rates improve model fit and yield pass-through coefficients above unity; while not interpretable conventionally, they suggest persistent depreciation trends pass through more fully to core inflation.
  - High noise-to-signal ratio and short samples weaken confidence; estimates should be revisited with more data.
- Asymmetry and policy implications:
  - Twelve-month pass-through appears high (over 70 percent) in periods of rising depreciation.
  - Asymmetries imply the costs of disinflation and loss of competitiveness estimates depend on depreciation trend; supportive fiscal policy important during disinflation.

### XI. Inflation Targeting (IT) lessons and institutional design considerations
- Lessons from emerging market adopters (Chile, Brazil, Czech Republic, Poland, Israel, South Africa):
  - Design elements: missing/escape clauses, explanation clauses, disinflation prior to IT, speed of transition, target formulation, forecasting frameworks.
  - Escape/explanation clauses:
    - Czech Republic uses explicit escape clause for exogenous shocks.
    - South Africa moved from escape clause to explanation clause in November 2003.
    - Israel and Brazil have explanation clauses (Israel: explanation required for deviations >1 percent; Brazil: open letter to Ministry of Finance).
    - Poland and Chile do not use escape or explanation clauses.
- Target specification trade-offs:
  - Decisions: point vs range, horizon, price index.
  - All six central banks currently target headline inflation; Serbia has a high share of regulated prices (45 percent).
  - Target ranges with mid-points are common; range widths have been narrowed over time in adopters.
- Forecasting and institutional capacity:
  - Reliable forecasting framework crucial; methods include indicator-based approaches, ARIMA/VAR, and small structural models (demand curve, Phillips curve, asset market condition, policy reaction function).
  - Structural models increasingly used by Brazil, Czech Republic, Israel.

### XII. Appendix: Selected non-core price index weights and regulatory notes (selected items)
- Total weight: 48.19.
- Selected item weights:
  - Agricultural products: 3.25.
  - Electricity (Fixed administratively): 7.16.
  - Liquid fuel: 8.33.
  - Housing, public-utilities services: 8.55.
  - Post, Telegraph and Telephone services: 4.65.
  - Medical and other health products: 2.29.
  - Transport services: 3.18.
- Regulatory arrangements (selected):
  - Electricity: Fixed administratively; responsible agencies include Ministries of Energy, Mining, Finance and Trade; Cabinet of Ministers.
  - Liquid fuel: automatic formula; responsible Ministries of Energy and Mining, Finance and Trade.
  - Housing/public utilities: fixed administratively for public facilities; local authorities and Ministry of Finance involved.
  - Post/Telephone: fixed administratively except mobile phone charges (weight 0.0116) which are market determined.

_Prepared by Haimanot Teferra and Eric Mottu, based on IMF staff notes and excerpts from the IMF chapter contained in _cr06382_._

### 2.         Selected CEEC and SEE Countries: Current Account Deficit, FDI Inflows and

### 2.         Selected CEEC and SEE Countries: Current Account Deficit, FDI Inflows and External Debt, 1995–2005

### I. Overview and summary: Serbia's progress and challenges
- Serbia has made significant economic progress since 2000: "Output is up 40 percent and the share of the private sector in non-agricultural non-budget employment has almost doubled to around 60 percent."
- Despite progress, important challenges remain across real and financial sectors that could affect sustainability of growth.

### II. Key findings on gross domestic capital formation and external deficits
- For the full CEEC region, higher fixed investment is generally associated with a higher current account deficits.
- In the absence of large FDI inflows, higher fixed investment is associated with greater external debt accumulation.
- For a given level of gross investment, an increase in public investment is associated with a widening of the current account deficit.
- In the full region, a decline in private investment is usually associated with a decrease in FDI inflows and a decline in the current account deficit.
- Where private investment does not decline significantly in response to reduced FDI inflows, external debt increases.
- In Serbia, the large current account deficit has been associated with relatively low investment ratios compared to other CEECs (except Bulgaria)—although data doubts remain.
- The experience of other CEECs suggests that an increase in investment in Serbia may put pressure on the current account and external debt.
- Given Serbia’s large external debt, financing its large investment needs will require achieving higher national savings and attracting larger non-debt creating flows.

### III. Data caveats for Serbia
- National accounts data for gross fixed capital formation in 2000–03 probably underestimate private investment by about 5 percentage points of GDP, as suggested by preliminary official estimates for 2004 that take into account an improved coverage of the private sector, especially its investment in equipment. Thus, only the 2004 investment figure is meaningful.
- The decomposition of public and private investment is made difficult by the absence of data and by definitional specificities, i.e., the existence of socially owned enterprises.
  - Fund staff previously estimated investment decomposed between government and non-government to be roughly 14 and 86 percent of total, respectively, suggesting low “public” sector investment.
  - Recently published data estimate “public” sector (including socially owned enterprises) and private sector investment at 58 and 42 percent of total, respectively.
- Serbia’s data suggest surprisingly high external deficits given lackluster fixed investment ratios; such delinks have precedents (e.g., Czech Republic and Hungary after 2001) but Serbia’s performance is unusual in degree.

### IV. Employment, labor markets, and structural reform implications (summary from overview)
- Unemployment rate at 21 percent and rising; employment reportedly in trend decline.
- Employment structure has shifted to the private sector; data are not conclusive whether this reflects re-classification due to privatization or net new private employment.
- The 2005 Labor Law increased “insider” labor market rights; given high unemployment among young people and females, the note recommends focusing on the impact of labor market rules on these groups.
- With corporate challenges ahead, labor tax cuts can be helpful at the margin but cannot play a central role in improving employment performance.

### V. Financial sector and monetary/exchange rate framework implications (summary from overview)
- Rapid credit growth followed earlier banking reform; the 2005 FSAP pointed to the need to strengthen banking regulation.
- The 2005 banking law brought the legal regulatory framework largely in line with Basel Core Principles; the key challenge is implementation.
- Credit is largely fx-indexed lending to unhedged borrowers; strengthened regulatory capacity is required to monitor and manage indirect credit risk from foreign exchange exposures.
- Given high euroization and high exchange rate pass-through, a relatively stable nominal exchange rate is desirable, but strength of capital inflows and reversal risk point to the need for flexibility.
- On balance, the note suggests increased exchange rate flexibility is appropriate; proposes a flexible regime managed with little or no discretionary foreign exchange intervention while using other policies to avoid excessive nominal volatility.
- Operational implications of greater exchange rate volatility (anticipating inflation targeting):
  - Distinguish intervention goals (e.g., maintenance of import cover vs. “leaning against the wind”).
  - Avoid market misinterpretation of intervention as attempts to determine the exchange rate path.
  - Make the repo rate the main instrument for influencing the exchange rate path and other monetary policy purposes.
  - Recommend changes to repo operations, including focusing on the 14-day maturity and linking other NBS interest rates closely to the repo rate to establish a meaningful interest rate corridor.
- The transition to a new monetary and exchange rate regime will not be straightforward and requires full fiscal support to ensure effectiveness.

### VI. Inflation and exchange rate pass-through (summary from overview)
- Evidence on the impact of the exchange rate on core inflation is uncertain, reflecting short data sets and multiple structural shocks.
- Evidence points to continued high pass through rates, perhaps particularly following exchange rate depreciations.
- Lessons from other emerging markets that adopted inflation targeting with similar uncertainties:
  - How they set inflation goals.
  - How they evolved policy structures.
  - Use of “escape” clauses to balance commitments under inflation targeting with technical constraints.

*Prepared by Haimanot Teferra and Eric Mottu, based on IMF staff notes for Selected CEEC and SEE Countries, 1995–2005.*

### 7.      A key feature in CEECs with relatively high GDP per worker (Croatia, Poland,

### 7.      A key feature in CEECs with relatively high GDP per worker (Croatia, Poland, Hungary, Czech Republic, and Slovak Republic)

### Investment levels and trends across CEECs
- Czech Republic: fixed investment was 31 percent of GDP during 1995–97; stabilized at 26–27 percent of GDP in more recent years.
- Slovak Republic: fixed investment was 32–36 percent of GDP between 1996–98; stabilized at 26–27 percent of GDP in more recent years.
- Poland: fixed investment increased through 1995–2000 to reach 24 percent of GDP, then dropped and stabilized at 18–19 percent of GDP.
- Hungary: fixed investment increased slightly from its 1995 level of 20 percent of GDP and remained stable around 23 percent of GDP since 1998.
- Croatia: fixed investment started at 16 percent of GDP and reached 27 percent of GDP in 2003.

- Bulgaria: fixed investment averaged 15 percent in 1995–2000; picked up from 2001 and increased gradually to about 24 percent in 2005.
- Romania: fixed investment declined from 23 to 18 percent of GDP between 1996–99, reversed in 2000, reaching 23 percent of GDP by 2005.
- Serbia: fixed investment has been increasing since 2001 but was still at 19 percent of GDP in 2004; data before 2004 are unreliable.

- Interpretation: low investment ratios in Serbia partly reflect relatively low capital intensity of production (hence low GDP per capita). If GDP per capita is to rise in Serbia, capital intensity and investment ratios will likely need to rise also.

### Sectoral composition of investment
- For the CEEC group, private fixed investment accounts for the bulk of total investment; public share is less than 5 percent of GDP in most cases.
- Poland, Hungary, Czech Republic, and Slovak Republic: public investment around 3–5 percent of GDP since start of transition.
- Romania and Bulgaria: public investment around 2 percent of GDP.
- Croatia: public investment recorded at 6–7 percent of GDP.
- Serbia: public investment—including the large socially owned sector—relatively high at 10–11 percent of GDP; Serbian general government investment is low at about 3 percent of GDP.

### Physical composition of investment
- Ratio of construction to equipment investment:
  - Czech Republic, Hungary, Poland, Romania, and Serbia: 3:2.
  - Croatia: 2:1.
- Investment in construction as percent of GDP:
  - Croatia, Czech Republic, Hungary, Poland, Slovak Republic: about 10–14 percent of GDP.
  - Serbia: 7 percent of GDP.

### Current account deficits, FDI, and external debt developments
- Relationship emphasized: current account deficits often move with investment; external debt accumulation depends on non-debt creating flows such as FDI.

- Czech Republic vs Slovak Republic:
  - Both had comparable fixed investment at beginning of transition (30 and 33 percent of GDP respectively).
  - Czech Republic: current account deficit about only 4.4 percent of GDP, indicating high domestic saving.
  - Slovak Republic: current account deficit on average 8.4 percent of GDP.
  - External debt:
    - Slovak Republic: increased from 30 percent of GDP in 1995 to 52 percent of GDP in 1999 (higher current account deficit and relatively low FDI inflows).
    - Czech Republic: external debt increased from 30 percent in 1995 to 38 percent in 1999 due to higher FDI—including privatization—inflows.
  - 2000–03: FDI inflows in the Slovak Republic exceeded current account deficits, reaching 16 percent of GDP in 2002 (more than twice the current account deficit). In the Czech Republic, FDI inflows continued to outpace current account deficits.
  - Result: external debt seems to have stabilized at about 36 percent of GDP for the Czech Republic, while it is increasing continuously in the Slovak Republic.

- Hungary and Poland:
  - 1996–99: high fixed investment (~23 percent of GDP) and large current account deficits accompanied by external debt accumulation.
  - Poland: decline in fixed investment since 2001 reduced the current account deficit to about 2 percent of GDP, but debt accumulation continued with a decline in FDI inflows, requiring greater debt-financing.
  - Hungary: external debt declined between 1995–97 due to large FDI inflows, but increased again in 1998–99 when current account deficits almost doubled without a corresponding increase in FDI flows. In 2002–03, decline in FDI inflows without a reduction in current account deficits was associated with an increase in external debt.
  - Croatia and Serbia: FDI flows modest up to 2003 relative to external deficits, putting upward pressure on external debt ratios.

### Econometric findings on investment composition and current account
- A panel estimation (random effect GLS for unbalanced panel) used current account deficit as the dependent variable and gross investment, public, and private investment as percent of GDP as independent variables.
- Finding: For a given level of gross investment, a percentage point increase in public investment as a share of GDP is associated with a 0.6 percentage point increase in the current account deficit as a percent of GDP.
- Finding: No significant effect of a change in private investment on the current account balance.
- Interpretation: private capital formation tends to be financed by non-debt creating flows (notably internal financing by firms), while public—including state-owned—investment is more debt intensive.

### Serbia: atypical features and implications
- Atypical features:
  - Overall investment rates are atypically low, even accounting for low income per capita.
  - Composition skewed towards public investment, with adverse consequences for the external deficit and debt.
  - Relatively low rates of FDI financing compound these difficulties.

- Key implications for Serbia given large external deficit and high external debt:
  - Need for higher investment financed by raising national savings and non-debt creating flows.
  - Serbia’s investment level in 2004 is comparable to Croatia and Poland at start of their transition, but those countries had comparatively low external deficits and less than half of Serbia’s external debt-to-GDP ratio.
  - In Croatia, financing the external deficit through external borrowing was feasible; in Poland, relatively large FDI inflows helped limit external debt accumulation.
  - Increased domestic savings will likely be key to Serbia’s investment and medium-term growth prospects.

*Source: National Authorities and IMF staff estimates (extracts from the provided IMF chapter).*

### 13.      The severety of loss making in the state- and socially-owned sectors indicates

### _cr06382 - 13.      The severety of loss making in the state- and socially-owned sectors indicates

### Severity of losses and privatization imperative
- The severity of loss making in the state- and socially-owned sectors indicates that privatization cannot be delayed.
- Losses are:
  - Draining domestic savings.
  - Accounting for much of the external current account deficit.
- Attempts to preserve jobs in these sectors:
  - Come at high cost in terms of employment elsewhere in the economy.
  - Requirements for purchasers to maintain existing jobs may impede efforts to sell the firms.
  - Many firms already have excess debts, which stand in the way of swift sales; additional job-preservation requirements may not be feasible.

### Prioritizing job creation and policy areas to review
- Efforts need to prioritize job creation given considerable direct job loss likely from privatization and restructuring.
- Arrangements to be reviewed from the job-creation perspective:
  - Labor law.
  - Wage and remuneration setting arrangements, especially in the public sector.
  - Overall macroeconomic and business environment policies to ensure conditions propitious to new domestic and foreign private investment.
  - Tax and social benefit policies pertaining to labor.

### Fiscal measures and social assistance
- Appropriately designed temporary social assistance programs, possibly including early retirement, may be considered.
- To ensure affordability, costs of early retirement programs could be contained by providing lower pension compensation until beneficiaries reach full age-based eligibility.

### Personal Income Tax (PIT) and social security contribution reforms (proposals)
- The government has adopted amendments to the personal income tax law and the law on mandatory social insurance contributions with a view to stimulate employment. The proposal envisages:
  - Reduction of the personal income tax (PIT) on wages from 14 to 12 percent.
  - Introduction of personal allowance.
  - Two-to-three year exemptions from personal tax and the employer’s portion of social security contributions for previously unemployed and new job market entrants under the age of 30 and over the age of 45 as well as the disabled (see Table 2).

- Expected fiscal cost and recommended offset:
  - The expected fiscal cost of lowering PIT on wages is high (over 1.4 percent of GDP) and should be compensated either by a reduction in current spending or an increase in broad-based indirect taxes, such as the VAT, or a combination of both to preserve macroeconomic stability.

### Effectiveness concerns regarding targeted exemptions
- Reduction of PIT on wages could facilitate employment in some contexts; empirical evidence suggests in countries with imperfect competition and less flexible labor markets, lowering direct taxes on labor may help increase employment.
- However, the effectiveness of the proposed exemptions for the young and near-retirees appears to be unclear:
  - Benefits from targeted wage or social security tax reductions are limited due to:
    - Deadweight fiscal costs (some subsidized employment would have occurred anyway).
    - Substitution effects (biasing hiring toward subsidized groups at the expense of non-eligible workers).
    - Displacement costs (firms receiving tax relief expand and displace employment in firms that do not receive tax relief).
  - Legislation contains a provision requiring employers not to reduce the number of employees without exemptions as of September 1, 2006, but:
    - Substitution and displacement effects may dominate, making overall employment effects minimal.
    - The floor on the number of employees a firm must maintain to qualify for an exemption presents an additional market rigidity.
    - Employers can churn employment by replacing expired-exemption workers with new beneficiaries.
    - Administering these exemptions could be a major burden.

### National Employment Action Plan
- The 2006-2008 National Employment Action Plan (developed with the European Agency for Reconstruction (EAR)) aims to halve unemployment by 2010.
- Consistent with EU guidelines, the action plan emphasizes:
  - Job creation and entrepreneurship.
  - Promotion of adaptability and mobility in the labor market.
  - Developing human capital.
  - Increasing labor supply.
- The task ahead is to turn this into a sufficiently ambitious program of specific reforms.

### Employment by ownership: key statistics (2001–Apr. 2006)
- Total employment:
  - Sept. 2001: 2,787,858
  - Apr. 2006: 2,600,776
  - Diff. 06/01: -187,082
- Sectoral highlights (absolute and Diff. 06/01):
  - General government: 321,616 → 316,483; -5,133
  - State-owned enterprises: 187,290 → 164,640; -22,650
    - National: 134,938 → 104,250; -30,688
    - Local: 52,352 → 60,390; 8,038
  - Socially owned enterprises: 643,709 → 245,980; -397,729
  - Mixed ownership: 377,035 → 323,048; -53,987
  - Private sector: 1,258,208 → 1,550,625; 292,417
    - Non-farmers (of which): 566,479 → 963,917; 397,438
      - Companies: 208,546 → 428,384; 219,838
      - Entrepreneurs and their employees: 357,933 → 535,534; 177,601
    - Farmers: 691,729 → 586,708; -105,021
- Memorandum items:
  - Non-agriculture non-gen. government: 1,774,513 → 1,697,585; -76,928
  - State, socially, and mixed-owned enterprises: 1,208,034 → 733,668; -474,366
- Employment shares (percent of total) — Total employment remains 100.0 across years; selected shares:
  - Socially owned enterprises: 23.1 → 9.5; -13.6
  - Private sector: 45.1 → 59.6; 14.5
  - Non-agriculture non-gen. government: 63.7 → 65.3; 1.6
  - State, social, mixed in non-agr. non-gen. gov.: 68.1 → 43.2; -24.9
- Source: Statistics Office. (Table 1. Serbia: Employment by Ownership, 2001-06)

### Table 2: Changes to PIT and Social Security Contributions (2006 → 2007)
- Personal Income Tax (PIT)
  - Tax rate on wage income (percent): 14 → 12
  - Personal tax allowance: 0 → 5,000 dinars per month (This allowance applies only to the base of PIT, not SSC base)
  - Exemption for new entrants and formerly unemployed under 30: None → Full relief from PIT for 2 years if not a trainee or 3 years if a trainee
  - Exemption for newly employed persons with disability: None → Full relief from PIT for 3 years
  - Exemption for formerly unemployed over 45: None → Full relief from PIT for 2 years
- Social Security Contributions (SSC)
  - Combined employee-employer SSC rate (percent): 35.8 → 35.8
  - Exemption for new entrants and formerly unemployed under 30: None → Relief from the employer part of SSC for 2 years if not a trainee or 3 years if a trainee
  - Exemption for newly employed persons with disability: None → Relief from the employer part of SSC for 3 years
  - Minimum base wage for payment of social contributions: 40 percent of the average wage → 35 percent of the average wage
- Annual Income Tax Threshold:
  - Four average wages → Three average wages
  - Rates: between 3 and 6 average wages: 10; 6 average wages and above: 15; 1/ To be effective on January 1, 2007. Rate 10
- Implementation caveats:
  - These exemptions cannot be claimed by government institutions and public enterprises.
  - Exemptions apply only if entry into labor relation with the newly employed person results in an increase in the number of employees of the employer compared to September 1, 2006.
  - If during utilization and the subsequent period (three years for newly employed under 30 and two years for newly employed over 50 after expiry) the employer reduces the number of employees compared to the reference level, the employer shall lose the right to exemption and repay its tax obligation as if it had not been using the tax exemption.

### Banking system: introduction and FSAP findings
- The note examines recent developments in the Serbian banking system and implementation of FSAP recommendations.
- FSAP context:
  - Rapid move from limited state-controlled to dynamic market-driven financial sector created benefits and policy challenges.
  - Rapid credit expansion largely fueled by foreign banks (share in total assets has risen to over 70 percent).
  - Rapid credit growth has complicated efforts to reduce inflation and the high current account deficit.
  - FSSA noted emerging signs that rapid credit growth had started to erode systemic financial stability by contributing to an increase in NPLs.

- Main potential threat to financial stability:
  - High and rising indirect credit risk: 80 percent of all loans are either fx-indexed or fx-denominated, exposing unhedged borrowers to unexpected depreciation.
  - A decline in profitability of foreign banks seeking market share, coupled with an adverse shock—especially an unexpected depreciation—could result in a credit crunch.

- Other FSAP-identified weaknesses:
  - Weaknesses in banking regulation and supervision; Basel Core Principles assessment (April 2005) identified significant gaps in banking law and regulations and weak enforcement.
  - Nascent development of other financial market segments: lack of capital market development, poor insurance sector, weaknesses in bankruptcy legislation, difficulties in taking and executing security, ineffective land registry, undeveloped accounting and auditing practices, weak corporate governance.

### Developments subsequent to the FSAP
- Legal and regulatory improvements:
  - New banking law adopted in November 2005 largely in line with the Basel Core Principles (BCPs) and EU Directives.
  - New law provides for:
    - Consolidated supervision of banking groups.
    - Strengthened “fit and proper” requirements.
    - Protection for the NBS and its staff in execution of duties.
    - Limits on lending to parties connected to the bank, its directors and shareholders, in line with EU requirements.
    - Improvements in corporate governance by making directors responsible for risk management and requiring banks to appoint audit committees.
    - Obligation to publish financial statements compiled in accordance with International Financial Reporting Standards (IFRS).

- By-laws and implementation:
  - NBS adopted most by-laws necessary for implementation; all but two issued before legal deadline of 30 June, 2006.
  - By-law on consolidated supervision will take effect from end-2006; by-law on competition in the banking sector subject to further discussion.
  - By-laws provide enhanced powers for the NBS to require banks to classify assets and provide for diminution in value, taking account of fx-lending risks to unhedged domestic borrowers.
  - Other by-laws cover licensing, capital adequacy, external audit, risk management, conduct of supervision, enforcement of NBS recommendations, and ‘know your customer’ requirements.

- Prudential measures and supervisory improvements:
  - From September 30, 2006, fx-indexed or fx-denominated loans in excess of CSD 10 million will receive a 125 percent weight in the capital adequacy calculation.
  - To contain household lending (which grew by 96.2 percent in the twelve months to June 2006), NBS limited banks’ exposure to households to 200 percent of capital, effective October 1, 2006. (Some categories of household loans are exempt, most notably mortgage loans subsidized from the budget.)
  - Credit bureau (set up by the Association of Serbian Banks in 2004) is fully functioning for personal lending; includes information about credit outstanding and default information. Coverage of business lending expected by end of 2006.
  - NBS reorganized supervision with World Bank assistance; each bank has a ‘portfolio manager’ responsible for supervision strategy and implementation, improving asset quality supervision and enforcement.
  - Auditing and disclosure requirements improved; progress in dealing with breaches of statutory limits on connected lending.

- Bank privatization progress:
  - Five banks privatized since end-2004; privatization of another two banks (including Vojvodanska Banka) expected to be completed by end-2006, leading to major diminution in systemic risk.
  - EBRD acquired a 25 percent interest in Komercijalna Banka and appointed two members of the Managing Board; government prefers a public offer in the Serbian market for eventual privatization.

### Remaining steps and risks
- Implementation challenge:
  - New legal framework needs swift implementation; NBS is preparing internal guidance for consistent and effective application.
  - Time required for banks to familiarize themselves with new law and supervisory processes.
  - Decisions do not yet provide for capital requirements for market risk beyond foreign exchange position risk; NBS has postponed proposals to subject other market risks to capital charges.

- Nonperforming loans (NPLs) and asset quality:
  - Brisk credit growth led to increases in the already high share of NPLs.
  - Overall NPL ratio declined from 22.2 percent at end-2004 to 20.7 percent at end-March 2006, reflecting large write-offs in state-controlled banks prior to privatization.
  - NPL ratio of foreign banks increased from 10.0 percent to 16.1 percent during same period.
  - Increase reflects stepped-up enforcement of prudential provisions and reclassification of loans whose quality may have deteriorated before 2005; foreign banks saw little evidence in portfolios of deterioration in underlying assets during 2005 and 2006 so far.
  - Looking forward, caution warranted:
    - Recent high growth, limited exchange rate volatility, and early stage of credit cycle mean asset quality may become a larger concern.
    - Uncertainties in banks’ risk management capacity to handle borrowers’ exchange rate exposure could exacerbate future asset-quality problems.

*Source: _cr06382 - 13.      The severety of loss making in the state- and socially-owned sectors indicates (IMF PDF chapter content).*

### 14.      The transition from compliance- to risk-based supervision is in its early stages.

### 14.      The transition from compliance- to risk-based supervision is in its early stages.

### Risk-based supervision: objectives and supervisory capacity
- Risk-based supervision requires staff who understand financial risks and can initiate a dialogue with banks on the nature and extent of risks, and the methods by which the bank prices, manages, mitigates, and controls those risks.
- Supervisors must be able to identify poor risk management and specify measures to correct these deficiencies.
- The transition to risk-based supervision is in the early stages.

### Human resources, recruitment, and pay
- Current recruitment strategy: university graduates, mainly with economics or law qualifications, almost always without much practical experience in commercial banking, accounting, or information technology.
- Salary constraints: Salary levels in the NBS are low compared to market salaries for individuals with the skills needed, making it difficult to compete despite job security.
- Interim pay measure: Decision to grant bonuses of 25 percent to supervision staff during on-site inspections.
- Recommendation: Consider a more flexible pay structure and other benefits that can reward scarce skills and strong performers.

### Transitory remedies and staffing alternatives
- Possible short-term measures:
  - Hire experienced individuals at the end of their careers to pass on experience and knowledge to younger staff.
  - “Outsource” part of the supervisor’s activity to accounting and other specialist firms; where a bank lacks good quality systems, require the bank to commission a consultant to investigate and recommend remedial action, with terms of reference specified by the supervisor and the firm hired and paid by the bank.

### Organizational changes and training
- Organizational adjustments needed for risk-based supervision:
  - Flatter structure and improved horizontal as well as vertical communication.
  - Appointment of portfolio managers responsible for the total supervisory effort for each supervised institution to support continuous iterative supervision where on-site examination verifies implementation of approved policies.
- High premium on training: keeping abreast of new developments in risk management requires intensive internal and external training.

### Financial reporting and accounting standards
- Major unresolved issue: NBS requirements differ from IFRS, particularly in the valuation of assets.
- Practical consequence: Some foreign banks prepare and publish two sets of accounts:
  - One in accordance with NBS classification and provisioning rules (also used by tax authorities for corporate income tax).
  - A second set in accordance with group accounting policies and audited as part of group financial statements (for 2005 this resulted in lower provisions and thus higher profits).
- Associated issue: No progress in establishing a national accounting and auditing standards body as provided in the recently passed law on accounting and auditing.

### Legal remedies, information infrastructure, and collateral enforcement
- Improvements made:
  - Credit bureau now provides full information about potential individual borrowers with details of credit outstanding and payment performance; system being extended to corporate borrowers.
  - Improvements in land registries facilitate taking mortgages on commercial and residential real estate.
  - A separate pledge registry set up enabling banks to take a lien over movable property.
  - Legislative changes enacted improving banks’ ability to recover debts and improvements in bankruptcy legislation.
- Remaining uncertainty: Many changes are very recent; it is too soon to say whether the rights of creditors have been sufficiently enhanced to provide protection comparable to other countries.
- Note on data sharing: Some large lenders reluctant to share proprietary information with potential competitors; Association of Serbian Banks expects the scheme to be implemented with full coverage.

### Competition, profitability, and market structure
- Market structure:
  - 38 banks remaining, many seeking increased market penetration; competition for market share is intense.
- Competitive effects:
  - Margins, especially for large corporate business, have been declining once recent increases in reserve requirements on fx-liabilities are considered.
  - Profit on relationships with major multinationals’ Serbian affiliates may derive from added services rather than lending margin.
  - SME lending competition has had less effect on margins; requires branch networks and relationship managers.
  - Consumer lending boom (less price sensitive) can partially compensate.
- Credit bureau effect: Reduces barriers-to-refinancing-by-borrowers by enabling easier switching among banks; extension to corporates should strengthen competition.
- Profitability and consolidation:
  - Overall profitability sufficient to maintain banks’ appetite for rapid credit expansion and capital strength.
  - Some foreign banks report losses after credit costs on Serbian accounting standards; others report higher profits on an IFRS basis.
  - Exposure limits set by foreign parent banks could become binding constraints on further expansion because exposures include funding of a large part of the lending book.
  - Expectation of further consolidation; some smaller banks may find it difficult to maintain profitability and franchise value may decline.

### Euroization, reserve requirements, and currency-related risks
- Degree of euroization:
  - Virtually all deposits except transactions accounts are fx-denominated.
  - About 80 percent of credit to the nongovernment sector is fx-denominated or fx-indexed, implying a high share of borrowers without a foreign currency cash flow.
- Reserve requirement policy (statutory as of text):
  - 40 percent for fx-denominated deposits and banks’ foreign borrowing with maturities over two years.
  - Since May 2006—60 percent for banks’ foreign borrowing with maturities up to 2 years.
  - Dinar-denominated deposits reserve requirement: only 18 percent.
- Impact on lending rates:
  - Assuming a cost of funds of 5 percent and banks unwilling to shift to dinar-denominated deposits, this implies a wedge of about 3.3 and 7.5 percentage points, respectively.
  - Several banks claim increased reserve requirements have started to constrain lending, but strong credit growth suggests expected profitability is generally still sufficient.
- Behavioral effects and avoidance:
  - Disintermediation risk: Current reserve requirements may lead to disintermediation, as suggested by strong direct corporate borrowing.
  - Foreign banks can use parent companies to book loans offshore or lend via parents or book domestic borrower loans elsewhere; euro-indexation of lending facilitates this.
  - Use of leasing companies to avoid reserve requirements has been constrained by a reserve requirement of 20 percent on leasing subsidiaries’ foreign borrowing.
- Prudential responses:
  - Introduction of a 125 percent risk weight for loans to unhedged borrowers in the capital adequacy calculation is a step in the right direction, but must be complemented with intensified assessment of banks’ internal procedures.

### Liquidity risk, market development, and supervisory information
- High reserve requirements moderate liquidity risk because the NBS cannot create liquidity in euro.
- Current supervisory coverage:
  - Banks are subject to a stock liquidity requirement.
  - No supervisory requirement limiting the extent of maturity transformation.
  - NBS collects maturity information but it is not disaggregated by currency, so supervisors may not be aware of currency mismatches.14
- Implication: If asset quality deteriorates and assets do not mature as expected, currency mismatches could cause problems; currently mitigated by large required reserves at the NBS.
- Market development needs:
  - A flexible exchange rate regime should help develop a deeper foreign exchange market.
  - A forward market and a market for short-dated swaps could help provide a term structure to the dinar money market and aid transmission of the NBS’s repo rate to dinar interest rates.15

### Overall assessment and supervisory priorities
- The Serbian banking system remains vulnerable despite recent legal and regulatory reforms.
- Key vulnerabilities:
  - Rapid credit growth.
  - Rising exposure of unhedged borrowers to exchange rate risk in the context of a transition to a flexible exchange rate regime.
  - Limited history of default and rapid customer base growth mean deterioration may creep up on lenders without much warning.
  - Competitive pressures mounting; potential for further consolidation.
- Supervisory implications:
  - NBS now has adequate powers to deal with arising problems but supervisory capacity must be strengthened further to detect early warning signs.
- Footnotes referenced in text:
  - Credit growth: The 12-month growth rate of credit to the nongovernment sector has exceeded 40 percent since August 2004 and 50 percent since January 2005.
  - 14: Banks are, however, required to prepare liquidity management policies, dealing, inter alia, with liquidity on a currency by currency basis. These policies must include contingency plans.
  - 15: Currently the inter-bank market is small and mainly consists of overnight lending, and—as such lending is largely unsecured—not all banks with surplus liquidity are prepared to lend to all those who need funding.

*Source: _cr06382 - 14.      The transition from compliance- to risk-based supervision is in its early stages.*

### 5.      Though useful, care is needed in interpretation of the results. For example, the

### _cr06382 - 5.      Though useful, care is needed in interpretation of the results. For example, the

### Interpretation caveats on indicators of monetary instability
- Evidence that Serbia exhibits monetary shocks is based on the volatility of velocity estimates compared to other countries.
- Velocity has changed significantly in Serbia since 2000 largely because of a sustained increase in depositor confidence in banks; this change may reflect a return to stability even though the exercise flags it as instability.
- The exercise requires somewhat arbitrary assumptions about the periods over which indicators are measured; the Serbian data reported are largely for the period since the late 1990s.
- The most relevant period would be that which agents use to determine their own monetary behavior, which cannot be directly observed but may be inferred indirectly from choices regarding financial euroization.
- Persistence of financial euroization, despite sharp reductions in inflation since 2000, reflects lingering skepticism about inflationary prospects due to the two hyperinflations in recent memory.
- Consequently, datasets used for such assessments arguably should be longer because agents’ euroization behavior indicates they view monetary instability as high, regardless of the recovery of confidence in banks reflected in the velocity of broad money since 2000.

### Reliability of parameter estimates
- Parameter estimates (e.g., pass through from exchange rates to inflation; synchronization of activity with major trading partners) can be both period- and methodology-specific.
- A variety of pass through estimates for Serbia are available; variation may reflect inadequacies with the techniques applied (see Chapter 7).
- Short data sets and multiple structural shocks severely constrain the reliability of such parameter estimates.
- Implication: The choice of exchange rate regime drawn from behavioral-parameter estimates should be approached with caution.

### Structural change and its implications
- Basic indicators and parameter estimates summarize information about the past; structural change may be moving ahead rapidly and future structural characteristics are the more pertinent basis for choosing an exchange rate regime.
- Key prospective structural change: increasing access to international financial markets, currently limited by immediate political uncertainties and limited development of domestic financial markets.
- If political difficulties are resolved, Serbia is likely to experience a rapid and significant deepening in access to international capital markets.
- This prospect argues for progress towards greater flexibility in exchange rate arrangements now so as to anticipate the development.

### Mechanisms to reduce monetary shocks and regime choice trade-offs
- The literature’s suggestion that a high incidence of monetary shocks points towards a fixed exchange rate is qualified because other mechanisms can reduce the incidence of such shocks.
- A fix is one “technology” to reduce monetary shocks; adoption of a strong “inflation targeting” regime could be another technology, even though it typically anticipates a float.
- In Serbia, considerations such as openness to capital flows argue against a fix.

### Weighting indicators and relative importance of capital flows
- The exercise requires weighting of various structural indicators, which is particularly acute when indicators point in different directions.
- Given large shocks to capital flows experienced by emerging markets and market reassessments since Spring 2006, capital flows concerns should probably loom large in relative weighting, pointing towards flexibility.

### Operational implications: regime operation vs. regime choice
- Assessments may yield conclusions about how a given exchange rate regime should be operated, rather than determining the regime itself.
- Structural characteristics that point towards a fix may instead point to policies aimed at minimizing exchange rate volatility under a float (e.g., foreign intervention under a fix or other means under a float).
- Other means include strong supportive fiscal policy—swift and high quality responses to macroeconomic shocks—and policy towards the central monetary policy interest rate (See Chapter 6).

### Policy recommendation: float supported by stability-targeting fiscal and monetary policy
- A float supported by fiscal and monetary policies targeting stability may be the best fit for Serbia.
- With capital flows issues and political uncertainties looming large, the case for a float is strong.
- High euroization, openness, and other structural factors calling for stability should be reflected in how the regime is operated.
- Specific operational recommendations include:
  - Strong and appropriately flexible supportive policies—abjuring discretionary intervention.
  - Development of derivative markets to facilitate exchange risk hedging.
  - These measures could provide agents with a degree of stability in the external exchange rate appropriate to Serbia’s structural characteristics.

### Foreign exchange intervention and reserve strategy (summary of operational guidance)
- Four primary FX intervention issues: determination and realization of long run foreign exchange reserve targets; policy regarding daily volatility in the dinar market; determination of any remaining role of fx-intervention in guiding exchange rate trends; and institutional reforms in the fx-market.
- Reserve accumulation:
  - The NBS will need to hold an adequate stock of international reserves, balancing opportunity costs against the probability and size of external shocks and the role of reserves in forestalling currency crises.
  - Decision required on whether to set reserve targets in gross terms or net of commercial banks’ claims on the central bank:
    - Gross terms appropriate if depositor confidence in the domestic banking system is expected to be maintained.
    - Net-of-claims appropriate if a crisis is expected to be accompanied by a loss of confidence in banks.
  - Targets may change over time and could move in line with imports to maintain import coverage; targets may also be set ahead of contingencies (e.g., Kosovo-related uncertainties).
- Intervention to realize targets should be consistent with market determination of the exchange rate; interventions should minimize the risk of being misperceived as action to achieve an exchange rate target.
- Policy recommendation: announce general interventions to meet “long-term” reserve targets and make purchases over time; consider preannouncing schedules for foreign exchange purchase auctions to enhance transparency and confidence.
- Structural reform consideration: encourage establishment of a broker/dealer system in the foreign exchange market to replace current fixing sessions to focus market attention on regularly published reserves data rather than individual central bank transactions.

### Managing daily dinar volatility
- Exchange rate volatility may be excessive in a thin fx-market.
- Options:
  - Allow volatility to entice private agents into the market, deepening it over time.
  - Or adopt a “leaning against the wind” approach to daily foreign exchange intervention to smooth daily changes if the deepening process is deemed too slow or would permit excessive volatility.
- Operational example for “leaning” approach: intervene if daily appreciation or depreciation exceeds a certain percentage threshold to smooth daily shocks, while not resisting cumulative daily appreciation or depreciation that represents sustained trend changes.
- The adopted rule need not be publicly announced but should be applied consistently to balance regime credibility with short-term smoothing needs.

### Restructuring the foreign exchange market and preferential rates
- The NBS has purchased foreign exchange from exchange offices at preferential “stimulation” rates; these flows largely reflect remittances and conversion of euro-denominated “mattress money.”
- Preferential rates created no incentive for exchange offices to sell receipts to commercial banks; NBS purchases have been reflected in foreign reserve accumulation because they were not resold in daily fixing sessions.
- The NBS reduced the stimulation rate from 1 percent to 0.9 percent on April 1 and to 0.7 percent on June 1, marking an exit process.
- Suggested path:
  - Announce a schedule for complete elimination of the preferential rate, balancing the shock of immediate withdrawal against signaling commitment to terminate discretionary FX intervention.
  - A binding monthly schedule to reduce the stimulation rate to zero, say over a six month horizon, should be accompanied by consultations with banks to facilitate their preparations.
- Interim measures:
  - Aim to resell FX acquired from exchange offices in fixing sessions, net of accumulation for long-term reserve goals.
  - Consider preannounced phased resales (e.g., resell 20 percent through October 31, 40 percent through December 31) while weighing shock risks; a schedule several months long is preferred, with readiness to adjust via other instruments (repo rate adjustments, monetary policy transparency).
  - A weaker approach: immediately resell 20 percent and commit to assessing increases of 20 percentage points every two months, presuming increases absent serious disturbances.

### Exchange rate trends and the role of discretionary intervention
- Official influence on exchange rate trends may persist via macroeconomic objectives reflected in repo rate policy.
- The instinct to phase out discretionary FX intervention rather than abandon it in one step should be resisted because interim discretionary intervention may undermine the effectiveness of the repo.
- Example: trend excess capital inflows putting upward pressure on the currency—discretionary intervention could stem appreciation and create domestic liquidity but would displace the repo as the central monetary policy instrument.
- Preferred approach: use fiscal policy response to absorb trend inflows; if fiscal response not available, lower the repo rate rather than rely on discretionary FX intervention.
- Doubts about repo effectiveness should be addressed through appropriate reforms of repo operations.

### Repo operations: strengthening the framework
- Current practice: NBS conducts repos with two maturities (two weeks and two months) using variable interest rate tenders (U.S. style).
- Prior to mid-May 2006, tender announcements included a maximum bid rate; since mid-May 2006, tender announcements consist solely of the offered quantity.
- Drawbacks noted:
  - By conducting two-week and two-month repos while controlling interest rates for both, the NBS dilutes the signaling function of the two-week repo rate.
  - The two-week repo rate has assumed little prominence in NBS publication strategy, leaving market participants unclear about the monetary framework.
  - The abolition of the maximum bid rate has undermined the signaling function of the two-week repo rate; market participants query if the revision intended to yield a decline in the policy rate.
- Empirical note: Since the abolishment of the maximum bid rate, the two-week repo rate declined by almost 100 basis points; this decline was not accompanied by a public statement by the NBS on its policy intentions.
- Recommendations:
  - Establish the two-week repo rate as the key policy rate by deemphasizing the role of two-month repos.
  - Abandoning two-month repo operations would establish the two-week repo as the sole monetary policy rate, facilitating transmission to interbank rates.
  - If two-month repos are maintained, revise the auction method: use variable rate tenders with pre-announced volume, with the NBS acting as a rate taker.
  - Reduce the volume of two-month repos to a minor share of total repo operations.
  - Communicate that the 2-month repo rate, by design, does not reflect the monetary policy stance.

_https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06382.pdf_

### 20.      In respect to the auction method for two-week repos, fixed rate tenders may be

### _cr06382 - 20.      In respect to the auction method for two-week repos, fixed rate tenders may be

### Auction method for two-week repos: fixed vs variable rate tenders
- Fixed rate tenders may be preferable during the transition to the revised monetary operations framework because they:
  - "provide the least ambiguous policy signal" and "be easily supported by a communication strategy."
  - Help establish the central role of the 2-week repo rate within the new regime.
- Variable rate tenders:
  - Could work well and lead to only small fluctuations in the actual repo rate, but such fluctuations "may still cause confusion in the markets about policy intentions."
  - Benefits of variable rate tenders include (i) fostering market development by creating incentives for banks to improve liquidity projections and portfolio management; and (ii) providing information to the central bank about banks’ interest rate expectations and liquidity needs.
  - A transition from fixed rate to variable rate tenders "may be warranted in the event of overbidding or underbidding, possibly resulting from expectations of interest rate adjustments."21
- If the NBS continues with variable rate tenders, it "should return to the recently abolished practice of announcing maximum bid rates" because recent volatility in the highest accepted rate and average weighted repo rate since end-May has "given rise to doubts among market participants about monetary policy intentions."22

### Liquidity guidance and collateral for liquidity-providing repos
- The NBS may need to complement fixed interest rate tenders with guidance on envisaged liquidity withdrawal to avoid excess or shortfall of aggregate bids relative to NBS liquidity forecast, especially given prevailing segmentation of the interbank market.
- Possible forms of guidance:
  - Regular publication of short-term (14 day) and medium-term (2 months) liquidity forecasts.
  - If forecasts are not reliable or not trusted, publish in the tender announcement the quantities that the NBS intends to withdraw.
- Availability of eligible assets for liquidity-providing repos:
  - Stock of T-bills held by banks fell to "SRD 120 million at end-June."
  - FFCD bonds held by banks are transitory and do not constitute a long-term solution.
  - The NBS may discuss with banks "the scope for using bills of exchange as collateral, provided sufficient asset quality is secured."
  - Foreign exchange swaps could be considered, but caution is warranted because they "may give rise to the misinterpretation that the NBS is targeting a specific future exchange rate level."

### Communication and Monetary Council scheduling
- The 2-week repo rate should assume a prominent role in NBS public relations:
  - Press statements after each Monetary Council meeting should explain reasons for adjusting the two week repo rate or leaving it unchanged, covering risks to the inflation objective and transmission channels from the repo rate to inflation.
- The NBS may consider aligning the schedule of Monetary Council meetings with the reserve maintenance period to avoid severe over- or under-bidding induced by market speculation about imminent repo rate changes.

### Interest rate corridor and money market pass-through
- Current situation:
  - "There is no economically meaningful interest rate corridor."
  - In 2005 the NBS linked lending facility rates to the weighted monthly average interest rates of repos of all maturities and raised the deposit facility rate to "6 percent."
  - These measures left the Belgrade Overnight Index Average (Beonia) effectively delinked from the two-week repo rate.
- Beonia behavior (May–July 2006):
  - Beonia fluctuated between "7.3 percent and 23.8 percent," with the average rate amounting to "13½ percent."
  - Within that range, Beonia is driven by short-term liquidity conditions (amounts at NBS deposit facility and difference between banks’ giro accounts and calculated required reserves), producing uncertain and possibly delayed pass-through from the repo rate.
- Policy options:
  - Link the deposit facility rate to the two-week repo rate and narrow the spread between them.
    - In determining the spread, weigh effectiveness (favoring narrow spread) against market development (an overly narrow spread could induce banks to rely on the deposit facility and impede interbank market development).
    - Corridor narrowing could be phased; however, "establishing an economically meaningful corridor" requires a sizeable first step, which "could consist of raising the deposit facility rate to a level above the current Beonia average of 13½ percent."
  - Link interest rates on NBS lending facilities to the two-week repo rate rather than to the weighted monthly average of repo rates of all maturities to make the instrument usable and strengthen the signaling function of the two-week repo rate.

### Transmission from the repo rate to the exchange rate
- Evidence that repo rate changes can influence the exchange rate:
  - In early 2006 a significant increase in the repo rate and a March revision of open fx-position regulations strengthened upward pressures on the dinar despite strong foreign exchange intervention.
  - Increase in repo volume between end-2005 and end-April 2006 was "SRD 17.6 billion," which corresponds to "31.3 percent of commercial banks’ net foreign borrowing during this period."
  - For the seven foreign banks most active in the repo market (accounting for "88.9 percent of the total increase in the repo volume"), this share amounts to "36 percent."
- Limitations to smooth transmission:
  - The repo market is dominated by "six foreign banks," implying reliance on a small number of players; exposure limits of parent banks may constrain additional capital inflows.
  - Banks’ foreign borrowing denominated in foreign currencies and allowed open fx-position ceilings can limit additional demand for repos following a repo increase.
- Prospects for broader transmission:
  - High financial euroization means portfolio adjustments by residents (given high fx-denominated deposits) can be a key channel for exchange rate response to monetary stance changes.
  - This channel strengthens if sustained disinflation reduces risk premia on dinar deposits and banks offer attractive dinar deposit rates, which also depends on banks’ ability to expand non-indexed dinar-denominated loans.
- Risks:
  - Major policy or international shocks and the strength of medium- and long-term capital inflows will challenge monetary policy; "adjustments in the repo rate may, therefore, need to be large."
  - Need to stabilize the broader policy environment—"notably in respect of fiscal and structural policies"—and to broaden and deepen money and financial markets to widen the interest rate channel of monetary policy.

### Inflation: exchange rate pass-through to core inflation — empirical findings
- Context:
  - The NBS is considering moves toward an inflation targeting regime; identifying reliable predictors of future inflation is required and exchange rate behavior is a candidate.
  - Core prices comprise "about 52 percent of the retail price index and mostly exclude agricultural and regulated prices."
- Data and methodological cautions:
  - Short data sets and structural breaks (hyperinflation and disinflation between 1999 and 2002; changes in exchange rate regime including post February 2006) limit structural model reliability.
  - Quality concerns exist for statistical series, notably unit labor cost data and monthly wage and employment data.
- Visual inspection and general considerations:
  - Pass-through appears larger for more persistent exchange rate shocks: co-movement between exchange rate and core inflation is stronger for three-month and twelve-month growth series than for monthly changes.
  - Pass-through may be slower when depreciation rates decline (two episodes noted: pre-2003 exchange rate-based disinflation and late 2005 onwards high capital inflows with greater exchange rate flexibility).
- Empirical approach:
  - A single-equation autoregressive distributed lag model was estimated for two samples to explore asymmetries:
    - 2003:3 through 2006:5 — full post-hyperinflation sample.
    - 2003:3 through 2005:9 — period between two main structural breaks with a rising trend in depreciation.
  - Monthly and three-month growth series were used to examine dependence on persistence of exchange rate shocks.
- Key quantitative findings from Text Table 2 (preserve reported values exactly):
  - Monthly, m/m(-1) sample results (2003m3 - 2006m6 and 2003m3 - 2005m9):
    - Constant: "0.30" and "0.15" (standard errors "(0.14)" and "(0.17)").
    - Lag of Core Inflation: "0.41" and "0.31" (standard errors "0.14" and "(0.15)").
    - Exchange Rate: "0.24" and "0.44" (standard errors "(0.11)" and "(0.15)").
    - Sample Size: "40" and "31".
    - Adjusted R-squared: "0.28" and "0.36".
    - Cumulative pass-through into inflation, %: "40.3" and "63.8".
    - Pass-through rates into prices, %:
      - 1 month: "24.0" and "44.1".
      - 2 months: "36.0" and "63.7".
      - 6 months: "45.0" and "73.7".
      - 12 months: "45.2" and "73.8".
      - 24 months: "45.2" and "73.8".
  - Three-month, m/m(-3) sample results (2003m3 - 2006m6 and 2003m3 - 2005m9):
    - Constant: "0.18" and "-0.08" (standard errors "(0.24)" and "(0.25)").
    - Lag of Core Inflation: "0.74" and "0.69" (standard errors "0.14" and "0.08(0.08)").
    - Exchange Rate: "0.19" and "0.30" (standard errors "(0.07)" and "(0.09)").
    - Sample Size: "31" and "30".
    - Adjusted R-squared: "0.77" and "0.83".
    - Cumulative pass-through into inflation, %: "75.6" and "96.2".
    - Pass-through rates into prices, %:
      - 1 month: "9.4" and "30.2".
      - 2 months: "36.6" and "57.1".
      - 6 months: "80.6" and "119.9".
      - 12 months: "100.6" and "140.4".
      - 24 months: "104.9" and "142.9".
- Interpretation and caveats:
  - Using monthly growth rates, average exchange rate pass-through to the price level within one year was "about 74 percent" during the rising depreciation episode but "dropped to just over 45 percent" in the full sample.
  - Using three-month growth rates improved model fit and produced pass-through coefficients "above unity" for both data periods; while above-unity estimates are "not interpretable as conventional pass-through coefficients," they suggest that changes in the depreciation trend (rather than short-lived changes) could be expected to pass through almost fully into core inflation.
  - High noise-to-signal ratio in monthly series and short sample lengths weaken confidence and call for revisiting estimates as more data become available.

*Source: NBS.*

### 7.      Possible asymmetries of pass-through have important implications for policy.

### _cr06382 - 7.      Possible asymmetries of pass-through have important implications for policy.

### Asymmetries of exchange rate pass-through and policy implications
- Twelve-month pass-through of exchange rate shocks "still seems high, over 70 percent, at least in times of rising depreciation."
- Three-month series yield "unrealistically high" pass-through coefficients because of persistence in the series; overlapping three-month changes also tend to overstate persistence and estimates of pass-through rates.
- Monthly growth rates are dominated by noise; three-month growth rates pick up more persistent changes but may overstate persistence; using twelve-month changes "strengthens this finding even further."
- High noise-to-signal ratios in monthly inflation warrant caution in policymakers’ reaction to short-term fluctuations.
- Slower pass-through in times of decelerating depreciation affects estimates of the costs of disinflation in terms of loss of competitiveness and highlights the importance of a sufficiently supportive fiscal policy in times of disinflation.

### Summary assessment of estimation difficulties and empirical conclusions
- Technical difficulties produce a wide range of pass-through estimates; care is required in interpretation.
- Problems identified:
  - Three-month based estimates biased upward due to persistence.
  - Structural breaks and/or asymmetry of pass-through with respect to low depreciation cast doubt on low pass-through estimates from full-sample estimates.
- Net assessment: twelve-month pass-through appears high (over 70 percent) in periods of rising depreciation.

### Inflation Targeting (IT): emerging market experience — lessons for Serbia
- Many emerging market adopters of IT exhibited lower apparent exchange rate pass-through but faced similar uncertainties about inflation determinants.
- Case studies highlighted: Chile, Brazil, Czech Republic, Poland, Israel, South Africa.
- Key transition design elements where experience is instructive:
  - Missing targets, escape/explanation clauses, disinflation prior to adopting IT, speed of transition, formulation of targets, development of forecasting frameworks.

### Escape clauses and accountability provisions
- Central banks sometimes specify circumstances (typically outside their control) under which breaches of targets would be tolerated (escape clause) or require specific actions/explanations when targets are missed (explanation or accountability clauses).
- Among the six reviewed countries:
  - Only the Czech Republic currently employs an explicit escape clause. Quoted policy text (published on the central bank’s website):
    - “In the inflation targeting regime, the need for escape clauses derives from the occurrence of large shock changes in exogenous factors (particularly supply-side shocks) that are completely or largely outside the purview of central bank monetary policy. Attempts to keep inflation on target in these circumstances might cause undesirable volatility of output and employment. If such a shock deflects projected inflation from the target, the CNB does not respond to the primary impacts of the shock. It will apply an exemption (escape clause) from the obligation to hit the inflation target and accept the deviation of the inflation forecast from the target caused in this way. There are a whole range of shocks which can create room for applying such escape clauses. They include, for example, major deviations in world prices of energy raw materials or major deviations in agricultural producer prices. A specific type of exogenous shock is administrative measures that have strong price impacts, in particular major changes in the structure or rates of indirect taxes and major changes in the segment of regulated prices.”
  - South Africa had an escape clause historically; in November 2003 it replaced it with an explanation clause requiring the Reserve Bank to explain deviations and indicate when inflation would return within the target range.
  - Explanation clauses are in place in Israel and Brazil. Examples:
    - Israel: public explanation required for deviations from the target of more than 1 percent.
    - Brazil: central bank must issue an open letter to the Ministry of Finance explaining reasons for the breach and measures taken and the time required to bring inflation back on track.
  - Poland and Chile do not employ either escape or explanation clauses.

### Is achieving low inflation essential before transitioning to IT?
- Argument exists that lowering inflation first helps establish central bank credibility and test policy instruments.
- Experience of the six countries suggests pre-existing low inflation is not necessary; Chile, Israel and Poland started their transition with double digit inflation rates (see Text Table 3 referenced).

### Speed and modalities of transition to formal IT
- Speed of transition varied widely across countries.
- Except for South Africa, all countries reviewed used a crawling peg before moving to IT; South Africa targeted broad money growth and inflation with a flexible exchange rate.
- Brazil and Czech Republic switched to formal IT immediately.
- Other countries moved gradually — e.g., Chile took 9 years; Poland took 3 months.
- Text Table 4 (transition dates as reported):
  - Brazil: Jun-99 Jun-99
  - Chile: Sep-90 Sep-99
  - Czech Republic: Dec-97 Dec-97
  - Israel: Dec-91 Jun-97
  - Poland: Oct-98 Mar-99
  - South Africa: Aug-99 Feb-00

### Specification of targets: trade-offs and practices
- Three central decisions for target specification:
  - Whether to target a point or a range.
  - Appropriate horizon of the target.
  - Price index to be targeted.
- Trade-off: ease of communication (favoring an annual point target for a recognizable index like CPI) versus implementability (favoring a range, longer horizon, and a price index the CB can influence, e.g., core CPI).
- Headline versus net/core targeting:
  - Ability to target headline inflation depends on weight of volatile or non-market-determined prices (e.g., fuel, administered prices).
  - All six central banks currently target headline inflation.
  - Czech National Bank began with net inflation (excluding administered prices) but switched to headline CPI in 2004; share of administered prices cited as 10 percent and fuel 5-6 percent in the Czech case.
  - Poland: share of administered prices cited as 25 percent.
  - Serbia: share of regulated prices is 45 percent (either directly or indirectly).
- Target ranges:
  - All six central banks specify target ranges with a mid-point rather than single point targets.
  - Range widths have varied over time. Examples:
    - Israel and Chile started with width of 5 percent (range of 15-20 percent) and were gradually brought down to 2 and 1 percent respectively (ranges of 2-4 percent and 2.5-3.5 percent).

### Data shortcomings, forecasting methods, and institutional implications
- A reliable forecasting framework is crucial for determining targets and understanding transmission lags.
- Forecasting is especially challenging in emerging markets due to short IT experience and changing structural relationships.
- Practical forecasting approaches used by central banks include combinations of:
  - Indicator variables and qualitative judgment.
  - Time series econometric models (e.g., ARIMA, VAR).
  - Structural quantitative economic models (small structural models with common elements).
- Notes on modeling:
  - Time series models impose less economic structure and usually provide better short-term forecasts; ARIMA models are accurate at very short horizons but worsen rapidly at longer horizons.
  - Structural forecasting models commonly include: an open economy demand curve, a (New Keynesian) Phillips curve, an international asset market equilibrium condition (some version of uncovered interest parity with adjustment for risk premium), and a monetary policy reaction function.
  - Emerging economies have traditionally relied less on structural models, but Brazil, the Czech Republic, and Israel now work with three- or four-equation models similar to those used in industrial countries.
  - Structural models offer benefits beyond forecasting, providing a coherent framework to think through policy transmission channels and to frame policy discussions.

### Appendix data: Serbia non-core price index composition (selected items and weights)
- Total weight48.19
- Agricultural products3.25
- Wheat and bread2.44
- Maize floor, type 500.51
- Wheat flour bread, type i0.26
- Wheat flour bread, type ii1.67
- Fresh milk1.06
- Tobacco products3.19
- Medical and other health products2.29 (component items include: Analgetic 0.09; Antipyretic 0.18; Antirheumatic 0.15; Beviplex 0.01; Ologovit 0.12; Antibiotics 0.55; Bactrim 0.16; Penicilin 0.06; Cough syrup 0.06; Nose drops 0.06; Antihypertensive 0.35; Antihistaminic in 0.06; Kardiotonici 0.04; Anksiolitici 0.34; Vitamin c, 20 tablets 0.04; Hansaplast 0.01; Thermometer, personal 0.01)
- Firewood1.15
- Coal0.33
- Liquid heating fuels and gas0.82
- Electricity7.16 (Fixed administratively)
- Liquid fuel8.33 (Motor petrol, bmb 95, l1.97; Motor petrol, mb 95, l2.68; Motor petrol, mb 98, l0.47; Gas oil d22.25; Euro diesel0.96)
- Housing, public-utilities services8.55 (Water for household3.23; Wastewater0.39; Taking out rubbish from flat1.26; Central heating3.23; Fee for keeping motor vehicles0.44; Mandatory car insurance0.80)
- Transport services3.18 (Bus city transport1.38; Monthly ticket1.35; Railway passenger transport0.32; Air passenger transport, etc..0.13)
- Post, Telegraph and Telephone services4.65 (Postal services0.33; Telephone and telegraph4.32)
- Social welfare services1.56 (Monthly kindergarten fee1.39; Monthly payments for high school and college students0.17; TV subscription0.58)
- Regulatory arrangements noted (selected):
  - Electricity: Fixed administratively; Ministries of Energy, Mining, Finance and Trade; Cabinet of Ministers.
  - Liquid fuel: Formula automatically applied if i) the price has not been updated for 15 days or more; or ii) if the dinar price of crude oil has changed by more than 1.5 percent since the previous adjustment. Responsible: Ministries of Energy and Mining, Finance and Trade.
  - Housing/public utilities: Fixed administratively but only for public facilities; local authorities and Ministry of Finance involved.
  - Post/Telephone: Fixed administratively, except for mobile phone charges (weight 0.0116), which are market determined; Ministries of Capital Investments, Trade and Finance; Cabinet of Ministers.

*Italicized source attribution: IMF staff report content from _cr06382 - 7.      Possible asymmetries of pass-through have important implications for policy.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06382.pdf_