SERBIAN FISCAL EXPANSION

UNCLAS BELGRADE 001877

SIPDIS

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON ELAB EFIN EIND PGOV SR
SUBJECT: SERBIAN FISCAL EXPANSION


1. (U) SUMMARY: Serbia's macroeconomic outlook appears
strong as the country moves toward elections. GDP was up
6.7 percent in the first half of 2006, inflation likely
will reach only 9 percent, and strong export growth
continues, at 27 percent. Record inflows of foreign direct
investment, mainly from the sale of the former Karic-owned
cellular operator, have provided the Kostunica government
with the resources to feed the pre-election recovery
through increased public spending of 4 percent of GDP in

2006. However, the International Monetary Fund (IMF) raised
a red flag in its recent Article IV review, warning that
the pre-election binge will leave a new government a
sizeable fiscal deficit, especially when real sector
performance is still weak as a result of the slow pace of
corporate restructuring. The possibility that the central
bank governor would be replaced after the January 21
election adds to uncertainty. END SUMMARY

REAL FUTURE OR FALSE HOPE?
--------------

2. (U) At the moment, virtually all economic indicators
paint a bullish picture of the Serbian economy. Higher GDP
growth of 6.7 percent in the first half eclipsed the IMF
projection of 5.7 percent. This result is especially
impressive given that agricultural production was weak and
the tax component of GDP underperformed.


3. (U) Inflation dropped to 9.3 percent (annualized rate)
in October 2006, compared to price growth of 17.7 percent
in 2005, but almost half of the consumer price index
remains under government control. Cumulative inflation in
the period January-October 2006 was 5.6 percent, and the
National Bank projects that inflation on the year will not
exceed 9 percent. However, the restrictive monetary policy
of the NBS is only part of the story, since core inflation,
although slowing, is still high at 5.8 percent.


4. (U) Rather, the decline of inflation has been attributed
mainly to dinar appreciation, the fruit of two major policy
shifts announced by the National Bank this year. In May,
the Bank said it would retreat from its wholesale
intervention in the exchange market and let market forces
take over. This was followed by an August announcement
that monetary policy was moving toward inflation targeting.
On November 1, the dinar broke the support level of 80 to
reach 79 per Euro, thus appreciating 13.6 percent in real
terms since the beginning of 2006. Although Serbia has a
history of hyperinflation, with inflationary expectations
routinely factored into prices, such expectations are now
easing. Dinar appreciation, external factors such as the
fall of oil prices, and a GOS delay in price increases for
electricity all have contributed to the inflation fall.


5. (U) Industrial production grew 5.5 percent in the period
January to September 2006, compared to the same period last
year. Yet de-seasonalized data show a fall of 2.3 percent
in September compared to August, calling into question the
further trend as tighter monetary policy begins to slow
activity. The service sector continues to grow with
transport and financial intermediation rising over 20
percent. However, industrial production in Serbia still
remains 50 percent less than 1989 levels, and unemployment
hovers around 21 percent.


6. (U) The trade gap remains a key sustainability issue.
Export growth is robust at over 27 percent, but it has not
been sufficient to close the gap with imports, even in the
longer-run, because of the low base and the enormous trade
gap. Trade figures for the first nine months of 2006, show
increased exports of 27.4 percent, i.e. 29.2 percent after
Montenegro is included in the foreign trade balance. Import
growth is declining, with imports up 23.9 percent year on
year in the first nine months, mainly as a result of lower
oil prices. The trade deficit in the first nine months of
2006 was USD 4.7 billion, 11.1 percent higher than in the
same period last year. Due to the higher growth of exports
relative to imports, coverage of imports by exports
increased from 43 percent to 48.7 percent in the period
January-September 2006.


7. (U) At a November 1 press conference, Governor Radovan
Jelasic predicted that the current account deficit will
fall to 8.6 percent, well below last year's 10.8 percent.
This would be the result mainly of including Montenegro in
Serbia's foreign trade balance, where Serbia is running a
surplus of about 2 percent of GDP. Still, the IMF is far
less optimistic and projects that the current account
deficit will increase to some 12 percent of GDP, if current
fiscal plans are fully implemented. The difference to some
extent is based on the central bank's expectation that the
effects of increased public spending will be postponed till
the first quarter of 2007.


8. (U) Restrictive monetary policy started to bear fruit as
bank borrowing from abroad remained at the same level as
last year, about USD 1.6 billion for the first nine months.
The growth rate of corporate borrowing also slowed, from
USD 0.8 billion in first nine months of 2005 (16.7 percent
in real terms) to USD 0.7 billion (10 percent in real
terms) in the same period 2006. The growth of consumer
lending also slowed, from USD 0.6 billion (48 percent) in
the first nine months of 2005, i.e. to USD 0.8 billion (38
percent) in the same period this year. Analysts point to
this lower corporate borrowing as the cause of the recent
stagnation of industrial production.


9. (U) Responding to lower inflation and credit growth, the
central bank on November 1 loosened reserve requirements on
dinar deposits, from 18 to 15 percent, but the key reserve
requirement on foreign bank borrowing under two years
remains at 60 percent. (The high Euroization of Serbia's
economy means that the dinar reserve requirement has a
limited impact.) Some banks reacted by boosting the
interest rate on dinar deposits, e.g., Raiffeisen bank
increased interest rate from 12 to 13 percent for three
months deposits and from 13 to 14 on six-month deposits
(nominal interest rates). The NBS also announced a cut in
the reference interest rate on two-week repo operations
from 18 to 17.5 percent.


10. (U) Capital account inflows went through the roof
mainly as a result of foreign direct investments (FDI)
projected to exceed USD 4 billion this year. The headline
deals included sale of the former Karic cellular operator
to Norwegian company Telenor for USD 1.92 billion (of which
the GOS took USD 1.4 billion, with the remainder to the
Austrian co-owner who had bought out Karic.) Vojvodjanska
Banka was sold to National Bank of Greece for USD 460
million, and German concern Stada acquired pharmaceutical
manufacturer Hemofarm for USD 570 million.


11. (U) NBS foreign exchange reserves skyrocketed to USD 10
million, or about 10 months of import cover, although this
stock is inflated by the central bank's tough reserve
requirements on bank borrowing abroad. Thus, the NBS's own
foreign exchange reserves were USD 4.3 billion, or about 4
months of imports. (The net stock was calculated by taking
total foreign exchange reserves, minus required reserve,
minus the government's foreign exchange deposits with
central bank). The GOS took advantage of high reserve
levels to prematurely pay half of its USD 1 billion debt to
the IMF. Serbia also announced plans for early repayment
of USD 410 million to the World Bank by the end of 2006.

PRE-ELECTION LARGESSE FEEDS ECONOMIC GROWTH
--------------

12. (U) With elections now set for January 21, Finance
Minister Dinkic, clearly determined to boost the prospects
of his G17 party, pushed through a budget revision in
September that substantially increased spending by relying
on one-time revenues. Parliament adopted an amended budget
for 2006 that projects an increase of current spending by
3.8 percent, but also introduces an ambitious National
Investment Plan (NIP) that would add capital spending equal
to 4 percent of GDP in 2006. The NIP is a two-year public
investment plan, financed from privatization revenues.


13. (U) The amended wage bill of the central government
would increase by 6.8 percent relative to the original 2006
budget. Thus, in 2006, in nominal terms, young employees
in government administration will get wage increase of 62
percent, employees in the health sector will get 48
percent, in higher education, 32 percent, in the Ministry
of Interior, 27 percent and in the Army, 20 percent.
Dinkic also addressed the senior vote by announcing a
decision to repay by the end of 2006 pension arrears from
1990s of 1.5 percent of GDP. NBS Governor Jelasic warned
that all these measures will intensify pressure on domestic
demand and inflation, as well as widen the trade deficit.


14. (U) The IMF calculates that the revised budget will
result in a 2006 fiscal deficit of 0.6 of GDP, compared to
the targeted surplus of 2.7 percent agreed with the IMF as
part of the Extended Arrangement that ended in February.
The Fund said that the deficit would be 1.4 percent of GDP
if the GOS were able to spend the money as projected, but
it regards this as unlikely. The Fund predicts that the
impact of current policies - including tax cuts and
generous public sector wage increases - could result in a
general government deficit of 3.5 percent of GDP for 2007,
and up to 6.5 percent if the GOS is able to implement fully
spending under the National Investment Plan. The Fund
predicts that this fiscal largesse will complicate
disinflation, increase the current account deficit and
compromise competitiveness and medium-term growth.


15. (U) Still, finance minister Dinkic considers the budget
sustainable, despite the fact that VAT revenues are below
planned levels for 2005 by about 5 percent, or a shortfall
of 3 percent of total budget revenues. One-off revenues
from the sale of the mobile license will be used to finance
current spending. (Austrian cellular provider Mobikom was
the only bidder for the third mobile license, at a minimum
bid of Euro 320 million).


16. (U) Local experts have joined the IMF in criticizing
the National Investment Plan. All agree that the state is
not an efficient investor, with low project quality and
poor monitoring of implementation, and emphasize that NIP
spending will crowd out private investment in the short-
run. Prominent economist Stojan Stamenkovic estimated that
NIP implementation would imply the rise of public
investment to one third of total investment, which would
cause a proportional reduction of private consumption.
Instead, local economists suggest that excess privatization
proceeds should be invested in further reduction of public
debt, reform of the pension system and tax relief.

CORPORATE RESTRUCTURING LAGS
--------------

17. (U) The IMF statement pointed to continuing corporate
sector losses, "largely reflecting weak governance and soft
budget constraints," as the source of Serbia's continuing
external deficits. The chairman's statement at the Article
IV review renewed the call to sell remaining socially-owned
enterprises and consistently initiate bankruptcy.


18. (U) However, despite lip service to the policy of "two
strikes and you're out," the Agency for Privatization
continues to regard bankruptcy as the policy of last
resort. At an October 24 meeting with econ chief, an
assistant minister of economy revealed that the GOS intends
to pursue a "third way" of privatizing insolvent
enterprises that have not found a buyer after two attempts
at privatization via tender or auction, by selling assets
selectively. While he said that some 236 socially-owned
enterprises would be sent to bankruptcy, in addition the
346 in bankruptcy already supervised by the privatization
agency, this means that the GOS still must deal with some
600 of the remaining 850 enterprises.

New Central Bank Governor?
--------------

19. (SBU) The uncertainty regarding economic policy
following the election was compounded when NBS Governor
Jelasic complained publicly on November 10 that the just-
passed law implementing the Constitution would subject his
job to political horse-trading. The law says simply that
the new Parliament will name a new governor, although
Jelasic began his five-year term only in February, 2004.
Comments by several party officials indicated that they
indeed regard the governor's position as one subject to a
future coalition agreement, despite the five-year term
written into the central bank law to preserve independence.
We intend to point out the folly of such political
manipulation with a key, supposedly independent, economic
policy position.

COMMENT
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20. (SBU) Comment: Now former Finance Minister Dinkic
demonstrated once again a single-minded dedication to the
immediate political objective by abandoning fiscal targets
agreed with the IMF and embarking on a highly politicized
relaxation of fiscal policy as elections loom. This policy
will reverse the hard-won shrinkage of the public sector
and leave the next government facing austerity to avoid
even larger deficits. Dinkic also did not engage on
corporate restructuring, leaving this crucial area to
Economy Minister Bubalo, whose focus on reform sometimes
seems more rhetorical than real. The result is, at best, a
pronounced pause on economic reform. One way out of this
hiatus would be renewed engagement with the IMF and the
World Bank after elections, but such re-engagement would be
problematic after the manner in which the GOS abandoned its
previous commitments on reform. Under any circumstances,
such a move is not even possible until a new government is
formed after the January election.

POLT