Country Report Serbia
Following a lacklustre recovery from the 2009 recession, economic growth in Serbia turned negative once more last year, as weakening euro area demand added to the difficulties at home imposed by very high unemployment and a drought. Economic growth this year is expected to come in at 1%, but weaker-than-expected demand for Fiat car exports to the currently ailing European auto market poses a major downside risk. Meanwhile, Serbia's worryingly high twin deficit worsened, as a pre-election spending binge led to a further deterioration of the stubbornly high budget deficit to almost 6% of GDP last year. As related public debt issuance has replaced Western banks' funding for their local subsidiaries as the main source of financing of Serbia's large current account deficit (11% of GDP), fiscal consolidation is urgently needed to restore investor confidence and avoid balance-of-payments difficulties.
Economic structure and growth
Serbia today ranks among the smaller south-eastern European economies, as nominal GDP came in at USD 38bn last year. Given a total population of 7.3m, nominal GDP per capita amounted to USD 5,406 (USD 11,448 in PPP terms), which is relatively low compared to Croatia's USD 13,206 (USD 17,904 in PPP terms) or Slovenia's USD 22,621 (USD 28,169 in PPP terms). Industrial production, mainly the production of steel, manufactured goods, chemicals and Fiat 500L cars, generates about a-fifth of total output, while agriculture still contributes about 10% of GDP. Similar to other former Yugoslav republics, Serbia's economy is characterized by significant state ownership in various sectors, which contributes to weak competitiveness. Moreover, the country's business climate is relatively unattractive, given widespread corruption, problems in contract enforcement and considerable administrative burdens for enterprises.
Notwithstanding, the country managed to attract sizeable amounts of foreign direct investment (FDI) prior to the onset of the global economic crisis, which brought with it, among others, the opening of a Fiat car factory in Kragujevac last year. Serbia's exports, mostly manufactured goods and foodstuffs, are mainly destined for Bosnia & Herzegovina, Italy and Germany, which exposes the country to both the ongoing crisis in the euro area and the lingering economic problems in the former Yugoslav republics. Moreover, given that fuel imports account for 20% of all imports, energy price fluctuations can have a marked impact on the country's already weak balance-of- payments and volatile inflation levels.
Serbia's banking sector remains strongly capitalized, even as the systemwide capital adequacy ratio declined from about 20% in mid-2011 to around 16% in the third quarter of last year. Asset quality, however, is quite poor, as non-performing loans amount to one-fifth of total loans. Non-performing corporate loans account for about two-thirds of the banking system's non-performing loans. Similar to other former Yugoslav republics, a considerable part of the banking sector is controlled by subsidiaries of foreign banks from other European countries and Russia. Given a loan-to-deposit ratio of about 120%, the sector remains dependent on wholesale financing and funding from foreign parent banks of local subsidiaries. Moreover, Serbia's banking sector is heavily euroized, as 71% of all deposits and 62% of all loans are denominated in euros. Serbian dinar-denominated loans only amounted to a quarter of total lending last year. We note that the current structure of the sector exposes it to a marked depreciation of the Serbian dinar vs. the euro, as well as a general increase in risk aversion vis-à-vis Serbia, which could lead to strongly rising funding costs. Contingent liabilities for the Serbian state should be manageable, as total bank assets amount to a limited 90% of GDP and bank capitalization levels remain relatively solid.
Following a rather lackluster recovery in the wake of the deep 2009 recession, Serbia’s economy fell back into recession last year, when growth declined to -1.7% (down from 1.6% in 2011). While weakening external demand from other former Yugoslav republics and the euro area was a major drag on growth, very high unemployment at home (standing at 26% in 2012) depressed domestic demand. Moreover, strongly declining agricultural output due to a severe drought also contributed to last year’s recession. Economic growth this year is expected to recover to about 1% on the back of rising exports, as well as strengthening private consumption and gross fixed investments. We caution, however, that the risks to the growth outlook are tilted to the downside, as external demand, particularly in the euro area and the Western Balkans, could come in weaker than expected. Moreover, Serbia’s sizeable deficits on the current and fiscal account expose economic growth to a sudden rise in risk aversion and a consequent fall in external financing.
Political and social situation
Following the May 2012 elections, Serbia is currently governed by a coalition government comprising the Serbian Progressive Party (SNS), the Socialist Party of Serbia (SPS), and the United Regions of Serbia (URS) party. Even though the SNS won the elections, the cabinet is headed by Ivica Dačić of the SPS as a reward for the party's decision not to join a coalition with the Democratic Party (DS) of the previous Serbian president Boris Tadić. As the SNS might change its mind on the current set-up and claim the post of prime minister for one of its members, the stability of the current cabinet could be put to the test. Since the coalition cabinet controls 133 out of 250 seats in parliament, it should not face major obstacles in policy implementation, provided cabinet cohesion can be maintained. In contrast to the previous government, the main parties of the current cabinet trace their roots back to Serbia's nationalist movements. While the SNS was formed in 2008 when current president Tomislav Nikolić split from the Serbian Radical Party (SRS), the SPS is the party of former president Slobodan Milošević. We note, however, that the current coalition's nationalist credentials have not led to a marked shift in economic and foreign policies, as eventual EU accession remains an overarching foreign policy objective.
So far, however, EU accession is still far away, even as neighboring Croatia will join the EU on July 1st, 2013. Together with 5 other Western Balkan countries, Serbia was identified as a potential candidate for EU membership in 2003 and received candidate country status in March 2012. Moreover, following the conclusion of an agreement with Kosovo in April 2013, the EU will likely propose a date for the start of accession negotiations in June. Serbia's strained relations with its former runaway province Kosovo have so far been a major stumbling block for EU accession, as new member states are expected to have no external conflicts. The agreement, which had been reached under EU auspices, normalizes bilateral relations between the two countries. It also provides for considerable autonomy for Serbian minorities living in Kosovo, while subordinating their police forces to the Kosovo authorities. Even though both countries' parliaments approved the agreement, Kosovo's Serbian minority remains opposed, however. Notwithstanding the recent progress made, Serbia still needs to address various domestic issues before a definite EU accession date will be published. In its recent progress report, the European Commission (EC) noted ongoing concerns about the rule of law, as well as recent legal changes affecting the Constitutional Court and the independence of the central bank. The functioning of Serbia's judiciary received particular attention in the report, as the EC stressed the need to ensure its independence, impartiality and efficiency. The Serbian population's support for EU accession has weakened, however, following the recent acquittal of Croatian and Albanian military leaders by the Yugoslavia War Crimes Tribunal in The Hague.
Similar to other former Yugoslav republics, Serbia's social climate is currently characterized by a very tense situation on the labor market, which might turn into rising anti-austerity sentiment once the government embarks on urgently needed fiscal consolidation this year. Serbia's unemployment rate rose from 14% in 2008 to 26% in 2012, while the overall employment level dropped from an already low pre-crisis 54% of the total population to 46% in October 2012. In part, this development was compensated by employment opportunities provided by Serbia's substantial informal sector. As fiscal consolidation measures will likely lead to layoffs at Serbia's various uncompetitive state-owned enterprises and the public sector as a whole, a further worsening of the situation can be expected.
Serbia's external relations mainly focus on the other former Yugoslav republics, the EU, and its traditional ally Russia, which agreed to support the country financially amid funding problems last year. While bilateral relations with Kosovo remain tense, former enemy Croatia promised to help Serbia on its path to EU membership.
Prior to its cessation in February 2012 due to non-compliance with fiscal guidelines, Serbia’s economic policies were guided by an IMF standby agreement that mainly focused on still lagging privatization and enterprise restructuring. Earlier progress on the associated policy targets has been undone, however, as difficult economic conditions forced the government to reacquire previously-privatized companies. So far, the government has not been able to find suitable buyers for these enterprises, including the Smederovo steel plant, Serbia’s largest exporter. Yet, reducing the state’s role in the economy will likely be a main criterion for the renewal of the IMF standby agreement. Meanwhile, progress on the needed liberalization of Serbia’s labor and product markets has been lackluster, even as aspired EU accession should provide the country with incentives to boost the competitiveness of its economy.
Serbia's recent fiscal policies were dominated by the May 2012 general elections, which led to populist pre-election spending increases that eventually triggered the cessation of the IMF standby agreement. Even though new fiscal rules established in 2011 committed the previous government to reducing the fiscal deficit to 1% of GDP by 2015 and keep public debt below 45% of GDP, it implemented detrimental fiscal policies in an attempt to boost its support ahead of the vote. In particular, frontloading subsidy payments, indexing wages and pensions, as well as increasing local governments' share in budget revenues without compensating for lost revenues at the central government level, proved harmful to central government finances. The pre-election spending binge, as well as rising interest costs, led to a further worsening of the budget deficit to 5.8% of GDP in 2012, up from 4.9% of GDP in 2011. In 2013, Serbia's government strives to bring the budget deficit down to 3.6% of GDP, whereby the presented measures mainly aim at the revenue side. We doubt, however, that the proposed measures, including a 2% hike of the VAT-rate and the profit tax rate, will generate sufficient revenues given the current weak state of Serbia's economy. Major expenditure cuts have not been considered, however, as this would likely ask for a comprehensive discussion on the government's currently dominant role in the economy through widespread state-ownership.
Driven by recurrent sizeable budget deficits, weak economic growth and the marked depreciation of the Serbian dinar, Serbia's public debt ratio increased from 29% of GDP in 2008 to 61% of GDP last year. As Serbia's elevated inflation rate boosts nominal GDP growth, the public debt ratio is expected to stabilize at about 60% of GDP in the coming years. Still, we remain concerned about debt sustainability going forward, as a sizeable part of public debt is denominated in euros and consequently rises in Serbian dinar-terms if the local currency depreciates, while its level in real terms cannot be reduced through elevated local inflation levels. The cessation of the IMF standby agreement and last year's fiscal deterioration confronted Serbia's government with rising difficulties in debt refinancing. Even though the country managed to successfully tap international capital markets this year, as ample liquidity spurs a search for yield among investors, the country is also looking for additional financial support from the IMF and long-time ally Russia. While negotiations about another IMF agreement remain inconclusive, Russia agreed to provide a low-cost USD 500m 10-year loan, part of which will depend on the conclusion of another IMF standby agreement, however. Notwithstanding Serbia's recurrent success in raising sufficient funding, rising global risk aversion or less liquidity on international capital markets due to reduced monetary stimulus by major central banks could shut the country out of international capital markets.
Besides Serbia's fiscal deterioration, recent appointments and legal changes affecting the country's central bank also raised investors' concerns last year. A new law restoring parliamentary oversight over the central bank triggered concerns about central bank independence, as did the appointment of the new governor Jorgovanka Tabaković, a party member of president Nikolić's SNS party. Addressing these concerns, the new central bank head reaffirmed that the central bank would continue to target inflation within a band of 4+/-1.5%. Its performance so far has been relatively poor, however, as considerable euroization limits the effectiveness of local monetary policy and inflation constantly exceeded the upper bound of the inflation target band in recent years. Following an inflation rate of 11.2% in 2011, consumer prices increased by 7.3% last year. While volatile commodity prices explain part of last year's high inflation, considerable exchange rate pass-through has also been a main driver. Even though the Serbian central bank intervened heavily to halt the fall of the currency amid fiscal and political concerns, foreign bank deleveraging and the suspension of an IMF standby agreement, the local currency depreciated by about 10% against the euro last year. Going forward, we do not exclude a further slide of the local currency, particularly if the government fails to conclude a new IMF standby agreement or exports were to disappoint. Given the need to stabilize the dinar-exchange rate amid sizeable euroization, this could lead to a further erosion of Serbia's foreign exchange reserves.
Balance of payments & external position
Serbia's balance of payments remains quite weak, even as contracting domestic demand and rising family remittances brought about a major improvement of the country's large pre-crisis current account deficits (22.5% of GDP in 2008). Still, given last year's current account deficit of 11% of GDP, Serbia's remains heavily dependent on external financing, which exposes it to a rise in foreign investors' risk aversion. Even though increasing car exports are expected to reduce the structural trade balance deficit from 20% last year to 18% in 2013, the current account deficit will likely remain at worrisome levels and could fail to improve if car exports were to disappoint. As foreign direct investment inflows covered a mere 25% of the current account deficit in recent years in spite of sizeable investments by Fiat, the remaining external financing needs were mainly covered by debt inflows.
While foreign parent bank funding for Serbian subsidiaries accounted for the lion's share of these debt inflows, they have recently been replaced by public debt issuances, as foreign parent banks' deleveraging continues and the Serbian government increasingly taps international capital markets. In our view, this trend is rather worrying, as it strengthens the link between current account financing and the government's shaky fiscal credentials. Even worse, as last year's FDI and debt inflows could not completely finance the current account deficit, the country's foreign exchange (FX) reserves had to be used to plug the gap. This led to a 7% decline (USD 1bn) of Serbia's FX reserves to USD 13.8bn last year. So far, given an import cover of about 7 months, the FX reserves level is still acceptable, but recurrent large current account deficits and ongoing dinar depreciation could lead to a further decline. However, Serbia's low amount of short-term external debt of USD 1.2bn (2012) and limited debt service costs of about 40% of current account receipts provide some comfort, even as the level of foreign debt of about 85% of GDP is high. Still, given that a sizeable part of Serbia's external debt is denominated in foreign currencies, a further depreciation of the Serbian dinar would lead to both rising debt levels and increasing debt service costs.