Public Information Notice

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On June 29, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Serbia and Montenegro.¹

Background

Macroeconomic imbalances in Serbia and Montenegro have widened in 2004 putting at risk some of the impressive earlier achievements. Growth, around 5 percent in non-agriculture since 2002, has been fueled by a surge in domestic demand. Lack of competitive domestic production has led to increased imports and a widening current account deficit. Annual inflation returned to double-digit levels reflecting demand pressures and faster dinar depreciation coupled with widespread euro-indexation. The current account deficit reached 15 percent of GDP in 2004; the increase only partly explained by the value added tax (VAT) induced shift of imports in late 2004. In Montenegro, the adoption of the euro has stabilized inflation at 3-4 percent. However, a large current account deficit, financed by foreign borrowing and, in 2005 by privatization receipts, risks eroding domestic competitiveness.

The attempts to use exchange rate policy to address rising inflation or deteriorating external balances have failed due to important structural rigidities. Exchange rate depreciation led to surging inflation given the high euro-indexation of prices, and small share of competitive supply, and fixing the exchange rate worsened the external balances, as a rigid spending structure limited fiscal tightening and loose wage policy boosted demand.

The fiscal stance has increasingly been tightened to strengthen demand management. The deficit declined from over 5 percent of GDP in 2002 to a projected surplus in 2005. However, the bulk of the adjustment was due to an increase in revenues, while cuts in current spending have been more limited. As a result, the revenue burden and the size of government, with expenditures at 45 percent of GDP, remain the highest in the region. Monetary policy has been accommodating, weakened by increasing euroization and complicated by a credit boom.

The slow structural reform is at the core of the macroeconomic imbalances and rigidities. With the private sector at barely half of the GDP, the competitive supply remains limited. The weak financial discipline in many of the public enterprises has reduced public savings and undermined the tight fiscal policy pursued at the central government level. Given the external financing constraint to investment, enterprise restructuring is increasingly important for growth and for the efficient reallocating resources within the economy.

The main policy challenge is to maintain macroeconomic stability while accelerating structural reform. Fiscal policy needs to be tightened substantially, and its flexibility increased by reducing the large share of non-discretionary spending. A tighter monetary policy, despite the high level of euroization, is necessary to slow down the credit boom and foreign borrowing fuelling imports. Structural reforms should be deepened through the privatization and liquidation of socially owned companies, restructuring of the state enterprises, and hardening financial discipline. The successful bank privatization should continue, with the entry of new banks boosting competition. Bank supervision is to be strengthened to deal with increased foreign currency risk and credit activity.

Executive Board Assessment

Executive Directors commended the authorities of Serbia and Montenegro for the tightening of the fiscal stance over recent years, and the decrease in inflation from triple-digits that helped create a basis for stronger GDP growth. However, Directors expressed concern over the recent widening of the macroeconomic imbalances. Despite tight fiscal policy, domestic demand has remained strong, putting pressure on inflation and the current account, as the slow pace of structural reforms continued to suppress competitive domestic supply and exports. The increased recourse to foreign debt to finance imports has heightened external vulnerabilities.

Directors stressed that structural rigidities are at the core of the macroeconomic imbalances and difficult policy dilemmas which the authorities are facing. Slow progress in addressing these rigidities has hampered productivity growth, discouraged investments, including foreign direct investment, and increased the cost of doing business. Weak financial discipline in many state- and socially-owned enterprises, together with a rigid public expenditure structure and high euroization, complicate macroeconomic management. Against the backdrop of the current imbalances, Directors stressed that using the exchange rate to bear down on inflation would need to be accompanied by a tightening of macroeconomic policies along with an acceleration of structural reforms. They were encouraged by the authorities' recent policy adjustments and commitments in this regard.

Directors welcomed the envisaged reduction in the fiscal deficit. While immediate fiscal consolidation relies on a combination of higher revenues and expenditure cuts, the challenge now is to improve the quality of fiscal adjustment. Given the high tax burden, this will need to be achieved through strong and sustained efforts to identify permanent expenditure savings and reorient spending priorities towards supporting growth. Savings should focus on reducing the high levels of nondiscretionary spending, in particular by cutting the wage bill and restoring the financial viability of the pension fund. On the revenue side, Directors encouraged further improvements in tax administration.

Directors emphasized that a further tightening of monetary policy will be needed to contain demand, in particular to curb the strong growth in credit. They welcomed the increase in the reserve requirement on foreign currency deposits of enterprises and commercial banks' foreign borrowing, and the recent significant increase in the level of repo operations to mop up dinar liquidity. Acknowledging that high and rising euroization has reduced the effectiveness of monetary policy in Serbia, Directors underlined the need to complement monetary policy tools with the continued use of prudential measures to slow credit growth and safeguard the quality of the banks' credit portfolio.

Directors highlighted the risks of using the exchange rate to anchor inflation, while, more generally, the use of the exchange rate to pursue different objectives over time was seen as weakening the credibility of economic policy. Directors noted that previous attempts to use exchange rate depreciation to reduce the external imbalances had contributed to higher inflation due to the widespread euro-indexation of prices in Serbia. While the authorities' decision to use the exchange rate to bear down on inflation is understandable, this policy has in the past also contributed to a worsening of the current account deficit. Accordingly, Directors stressed that the preference for slower depreciation would necessitate tighter fiscal, monetary, and income policies, while simultaneously accelerating structural reforms in the publicly controlled enterprise sector.

Directors welcomed the increased pace of banking sector reforms, and the authorities' commitment to follow through on the recommendations of the recent Financial Sector Assessment Program (FSAP) review. Completing the sale of the remaining state-controlled banks is a priority, and should spur competition in the sector and reduce the high spread between borrowing and lending rates. Directors emphasized the need to further strengthen banking regulation and supervision to bring them in line with international best practices. Enhancing risk management and supervisory practices will be particularly important for addressing the increasing risks and vulnerability emanating from rapid credit growth and the growing share of euro-indexed loans to unhedged borrowers.

Directors urged the authorities to continue to push ahead with the privatization and liquidation of socially-owned enterprises and with the restructuring of state-owned enterprises. In this regard, they highlighted the importance of proper legal frameworks, and supported the provision of appropriate safety nets. To strengthen financial discipline and allocate resources for increased growth, Directors stressed the need to step up the use of bankruptcy procedures against unviable socially-owned enterprises and to end the forbearance of arrears to the main utility companies, while pressing ahead with their restructuring to recover operational costs. The importance of further streamlining administrative regulations to improve the business and investment climate was also highlighted. Going forward, Directors pointed to further integration with the European Union as providing support and direction to future reform efforts.

Directors were encouraged by the recent macroeconomic developments in Montenegro, where inflation has dropped to low single digits following the adoption of the euro. However, the subdued rate of economic growth and high current account deficit remain a source of concern, and Directors urged the Montenegrin authorities to continue to press forward with structural reforms and the rationalization of public spending. The authorities should also resist pressures to use the large proceeds from privatization expected for 2005 for fiscal spending.

Serbia and Montenegro: Selected Economic and Financial Indicators, 2001-05 1/
	2001	2002	2003	2004	2005
				Est.	Proj.
Real economy
Real GDP (percent change)	5.5	3.8	2.7	7.2	4.6
Retail prices (percent, period average)	91.1	21.2	11.3	9.5	15.4
	(In percent of GDP)
General government finances 2/
Revenue	38.9	42.8	42.7	45.2	44.8
Expenditure	40.3	47.3	46.0	45.5	43.7
Overall balance (cash basis)	-1.4	-4.5	-3.3	-0.3	1.2
Gross debt 3/ 4/	123.2	85.4	79.2	60.2	53.1
Of which: Forex-denominated (in percent of total)	92.0	91.9	90.3	87.9	95.1
	(12-month percent change)
Money supply (end-of-period) 3/
Money (M1) 5/	125.2	79.8	10.9	8.0	6.9
Broad money (M2) 5/	104.9	52.7	27.5	30.3	22.4
Credit to non-government 6/	7.6	49.6	25.1	48.1	27.0
	(In percent)
Interest rates (weighted average, end-of-period)
Lending rate	32.5	19.2	14.8	14.6	...
Deposit rate	4.1	2.6	2.7	3.6	...
	(In billions of U.S. dollars, unless otherwise indicated)
Balance of payments
Current account balance, before grants	-1.1	-2.0	-2.5	-3.7	-2.9
(In percent of GDP)	-9.7	-12.9	-12.3	-15.5	-11.0
Underlying current account balance (percent of GDP) 7/	...	...	...	-13.7	-12.6
Exports of goods (f.o.b.)	2.0	2.4	3.1	4.2	5.5
Imports of goods (c.i.f.)	-4.8	-6.3	-7.9	-11.7	-12.6
Current account balance, after grants	-0.5	-1.4	-1.5	-3.1	-2.5
(In percent of GDP)	-4.6	-8.9	-7.3	-13.1	-9.5
External debt (end of period) 4/	11.9	11.8	14.3	14.9	15.2
(In percent of GDP)	103.2	76.2	69.2	62.0	57.1
Gross official reserves	1.2	2.3	3.6	4.3	5.6
(In months of prospective imports of GNFS)	2.4	3.1	3.3	3.7	4.3
Exchange rate (dinar/euro, period average)	59.7	60.7	65.1	72.6	...
REER (annual average change, in percent;
- indicates depreciation) 3/	23.8	17.1	5.5	-3.5	...
Sources: Statistical Offices of Serbia and Montenegro; National Bank of Serbia; State Ministries of Finance; and IMF staff estimates and projections. 1/ Excluding Kosovo (with the exception of foreign debt). 2/ Fiscal operations of all levels of government, except for Montenegro where it excludes local governments. Frozen Foreign Currency Bond payments are recorded below the line. Data for 2004 include previously off-budget fiscal operations in Montenegro, amounting to 0.2 percent of GDP. 3/ Excluding Montenegro. 4/ Including the first phase of the Paris Club debt reduction in 2002 and implementation in 2005 of the London Club agreement. 5/ At current exchange rates. 6/ At constant exchange rates. 7/ Corrected for the surge in imports and remittances at end-2004 ahead of the introduction of the VAT in January 2005. 1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.