Mission Concluding Statement 

March 15, 2007

1. As a new administration is about to form, Serbia faces two linked macroeconomic challenges:

• to sustain economic growth; and

• to entrench low inflation.

This will be tough.

2. Growth has averaged 6½ percent since 2003. Meanwhile, the Central Bank has successfully lowered inflation sharply, notably during 2006. Over the last 7 months, the core price level has been unchanged—zero core inflation.

3. But growth has been unbalanced. It has been associated with persistent double-digit external current account deficits and high unemployment, both largely reflecting profound weaknesses in state- and socially-owned enterprises.

4. And, in 2006, unbalanced growth was compounded by very rapid nominal wage growth—20-30 percent on average—and a major weakening of budget policy. The budget balance weakened substantially from a surplus of ¾ of a percent of GDP in 2005 to a deficit of 1½ percent of GDP in 2006.¹

5. Boosted by these wage and budget developments, the current account deficit widened even further to 13 percent of GDP (excluding grants), financed by additional external borrowing. Consequently, external debt rose to 62 percent of GDP.

6. These imbalances cannot persist. If policies are not soon profoundly recast, Serbia will remain on a path that, eventually, leads to disorderly external adjustment by markets. That adjustment would be at the expense of growth, stability, jobs, and prosperity.

7. Growth needs to be rebalanced.

8. To this end, "discipline" will not suffice. In the past, a broad-based wage freeze in the context of double-digit inflation has secured significant—albeit temporary—real adjustment. But inflation is no longer present. So, unlike the past, a wage freeze now will not secure adjustment.

9. And having finally lowered inflation—so that Serbia no longer has the weakest regional inflation performance—there is no case to bring it back, even to assist wage adjustment. A re-emergence of inflation would signal disorderly macroeconomic policies, jeopardizing investment and jobs. At the outset of a new administration, inflation would constitute a highly undesirable sign of policy intentions.

10. Instead, real actions are needed to rebalance growth. Most fundamentally, having granted high real wage increases in 2006, it is more urgent than ever to proceed with the structural reforms: comprehensive unqualified privatization; bankruptcy; strengthened competition; and an assault on corruption. These are now essential to raise productivity and thereby "pay" for the elevated wage awards. Prosperity cannot be sustained otherwise.

11. In addition, at the absolute minimum, the most egregious of the 2006-07 wage awards, both in the budget and non-budget sectors, should be swiftly rescinded. This would clearly signal the firm intention of the new administration to secure real wage moderation and low inflation.

12. And these steps will need to be supported by strong budget policies, for 2007 and beyond. To curb demand and set Serbia on a sustainable path, the budget balance needs to go back into surplus. We propose a surplus of some 2¾ percent of GDP in 2007. Even so, the external current account deficit would remain very high in 2007.

13. This is not proposed in the draft 2007 budget now before parliament. On our estimates, that budget implies a deficit for 2007 of 2¾ percent of GDP. Accordingly, we advise against the adoption of this budget.²

14. Implementing budget adjustments on this scale will be testing. But the scale is necessitated by the underlying imbalances, compounded by the scale of the wage rises and the budget weakening in 2006.

15. Accordingly, in addition to the budget wage bill, we urge review of all government spending, particularly on security and subsidies. And as planning for the so-called National Investment Program has been so weak, its projects should be suspended until the entire program is redesigned, put on a sound basis, and fully incorporated into the budget.

16. If—and only if—sufficient spending efficiencies are not identified, indirect taxes should be raised to secure the recommended 2007 budget surplus.

17. Growth, rebalanced in this way, would be sustained and would underpin sustained low inflation. In support of these policies, the Central Bank would do well to diminish further the frequency and volume of its interventions in the foreign exchange market, while continuing to raise or lower the repo rate so as to secure its objectives for core inflation.

18. But if policies are not recast so as to rebalance growth, near-term options for the Central Bank narrow sharply:

• To curb demand, the reserve requirement and macro-prudential regulations will have to remain restrictive.

• With high budget spending and wage increases boosting imports, efforts to contain inflation via the repo rate—and hence a strong dinar—will be at the expense of further increases in external deficits.

• And, as in 2006, the adverse budget and wage policy environment could cause disinflation efforts to be reflected in further accrued losses on Central Bank operations.

In this way, imbalances, which have their roots in inadequate budget, structural, and wage policies will become evident in pressures on monetary policy.

19. We urge the new administration to choose the better path, difficult as this will be. Delayed action will spur further wage rises, boost imports and external debt further, jeopardize low inflation, and ultimately undermine economic growth.

20. It can be done. Delay will raise the risks considerably. Now is the time to act.