Background

The Serbian economy enjoyed fast-paced GDP growth during the five years leading up to the global economic downturn, buoyed by strong domestic demand and an externally funded credit boom. But the economic expansion was strongly tilted towards non-tradable sectors. An increasingly pro-cyclical fiscal policy added further expansionary impulses to domestic demand, while structural reforms proceeded only slowly. As a result, external stability risks increased, reflected in high external deficits, rising private sector external indebtedness, high euroization, and weak export competitiveness.

The global economic and financial crisis quickly spilled over to Serbia. The squeeze in external financing led to a sharp contraction of investment, followed by a significant drop in consumption. The fiscal deficit surged, reflecting higher social spending needs and tax revenues shortfalls on account of lower trade, incomes, and spending.

The authorities responded to the downturn with a comprehensive policy package to safeguard macroeconomic and financial stability. The policy response focused on fiscal adjustment; implementation of a Financial Sector Support Program, including financing assurances from foreign parent banks; and substantial external financing from the IMF, the World Bank, and the European Union. A structural policy reform program was designed to address the roots of the economy’s low capacity to produce, save, and export.

The authorities’ adjustment program—supported by a Stand-By Arrangement—has contributed to limiting the fallout of the global crisis. While the output slump has been limited relative to regional peers, the decline in domestic demand has been significant, resulting in a strong external adjustment. Real GDP contracted by less than 3 percent, and domestic demand by 7½ percent. With the economy’s overall spending shrinking faster than income, the external current account deficit is estimated at 5¾ percent of GDP, down from 17 percent in 2008. Capital inflows have remained low but stable over the last few months; as a consequence, external financing pressures have abated.

The outlook for 2010 points to a slow but balanced recovery. The pick-up in growth will likely be moderate (2 percent), reflecting slow trading partner recovery, protracted corporate deleveraging, nominal freezes in public wages and pensions, and lagging labor market adjustment. The NBS inflation targets for 2010 should be met, but recent disinflation notwithstanding, inflation expectations remain elevated. The program targets a 2010 deficit of 4 percent of GDP and fiscal consolidation over the medium term. After the sharp external adjustment in 2009, the current account deficit is expected to widen slightly reflecting a drop in remittances relative to 2009.

Executive Board Assessment

Executive Directors noted that the Serbian economy has weathered the global financial crisis relatively well. The decline in output has been contained, while falling domestic demand has resulted in significant external adjustment. Going forward, Directors agreed that policies should shift the economy toward more sustainable growth, with resolute reduction of external and fiscal imbalances. Against this background, they welcomed the authorities’ focus on strengthened structural and fiscal policies aimed at raising productivity, exports, and saving.

Directors supported the authorities’ ambitious spending-based adjustment strategy, which aims at reducing high structural fiscal deficits mainly by restraining the growth of public wages and pensions, while increasing public investment to address long-standing infrastructure bottlenecks. They underscored, however, that bold steps are needed to replace these nominal freezes and other ad hoc fiscal measures by structurally sound spending reforms. Directors therefore welcomed the agreed package of parametric pension reforms and looked forward to its early approval by Parliament, while encouraging adoption of an indexation mechanism for pensions consistent with the authorities’ medium-term target for pension outlays. The authorities should also speed up additional spending reforms in the education, health, and administration sectors, while maintaining a well-targeted social safety net. Directors observed that the credibility of the authorities’ fiscal adjustment strategy hinges on early and determined implementation of these reforms. Fiscal consolidation efforts would also benefit from improvements in tax administration.

Directors stressed the importance of maintaining fiscal discipline, particularly in light of pressures for new spending. In this context, Directors welcomed the authorities’ plans to draft fiscal responsibility legislation that could include ceilings on public wages and pensions during 2010-12. Some Directors considered that the authorities should stand ready to take additional fiscal measures or contingency actions as needed.

Directors supported the authorities’ prudent conduct of monetary policy, as reflected in continued disinflation. They agreed that further easing should be pursued cautiously in view of the still elevated inflation expectations. Directors supported the authorities’ plans to streamline and lower reserve requirements, as well as plans to curtail the high level of euroization, both of which could help improve the effectiveness of monetary policy.

Directors welcomed the positive assessment reached in the recent Financial Sector Assessment Program Update. They agreed that adverse spillovers from the global crisis on the Serbian banking system have been contained. However, supervisory challenges remain, including streamlining prudential rules and formalizing memoranda of understanding with key home supervisors. Prudential and supervisory measures should continue to be used to discourage banks from extending new unhedged foreign exchange loans. Directors welcomed foreign parent banks’ re-affirmed commitments under the European Bank Coordination Initiative to keep their subsidiaries liquid and well capitalized. Careful monitoring of possible regional financial spillovers will be important.

Directors stressed that further progress on structural reform is needed to lift Serbia’s growth potential and promote the tradable goods sector. They were encouraged by the recent efforts to streamline business laws and regulations. The authorities need to press ahead with public enterprise reform and privatization as market conditions permit.