CEFTA - SERBIA SEEKS COMPROMISE ON CIGARETTES;

UNCLAS BELGRADE 001974

SIPDIS

C O R R E C T E D COPY--ADDRESSEE ADDED

STATE FOR EUR/SCE RIEHL
USEU BRUSSELS FOR MOZUR

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ETRD ECON PREL HR SR
SUBJECT: CEFTA - SERBIA SEEKS COMPROMISE ON CIGARETTES;
U.S. BUSINESS INTERESTS INVOLVED

REF: ZAGREB 1400

SUMMARY
--------------

1. (SBU) In order to break an impasse on the initialing of
the Central European Free Trade Agreement (CEFTA),the
Government of Serbia (GOS) has offered a concession to
Croatia on cigarette duties. In a November 30 letter,
Serbia's chief negotiator offered to lower the overall
level of protection for imports, a move that would be
consistent with WTO standards, according to local experts.
Serbian officials believe that Croatia's position is overly
inflexible given market realities, but hope that a
resolution can be reached that would allow initialing of
the CEFTA agreement by December 19. Philip Morris, which
owns the largest cigarette factory in Serbia, is pressuring
the Serbian Government to honor the commitments it made to
support domestic manufacturers until the end of 2009. END
SUMMARY.

COMMITMENTS TO FOREIGN INVESTORS
--------------

2. (SBU) The Government of Serbia announced on November 9
that it would not initial CEFTA, but, clearly feeling the
pressure, it has continued to seek a way out of the
stalemate. Serbia's reluctance stems from Croatia's demand
that Serbia reduce its excise tax on imported cigarettes to
the level of excise on domestic cigarettes, without
increasing cigarette import duties. However, the GOS faces
strong pressure from foreign cigarette producers because of
prior commitments made to Philip Morris, British American
Tobacco and Japan Tobacco International. Philip Morris
purchased the largest cigarette factory in Serbia for
hundreds of millions of dollars in 2003.


5. (U) The current protection for the cigarette industry
was a commitment to foreign investors who took on heavy
obligations regarding investment, employment, and use of
local tobacco in their privatization agreements. The
excise tax favors domestic manufacturers over foreign in a
1:10 ratio with a 30 percent ad valorem tax. In January
2007, the ratio goes to 2:10 with a 40 percent ad valorem
tax, before reaching a 5:5 ratio with a 50 percent ad
valorem tax in 2010. However, Serbia came under heavy
pressure from all quarters to abandon this system, which is
clearly discriminatory.


6. (SBU) On November 6, Serbia proposed an alternative that
is consistent with World Trade Organization (WTO) and
European Union standards. It would equalize excise taxes
while increasing Serbia's relatively low import duties on
cigarettes, with no net increase in protection. It also
provided a phased structure that would put all CEFTA
cigarette manufacturers on equal footing by 2010. The EU,
in a November 21 letter from Commissioners Rehn and
Mandelson, affirmed the WTO-consistent status of the Serb
offer, while Stability Pact trade expert Mary O'Mahony
confirmed that the Serbian offer provides an equivalent
level of protection.


7. (SBU) Croatia, however, rejected Serbia's proposal on
the principle that CEFTA negotiations could be concluded
only on the basis of a standstill in protection levels --
that is that tariff levels in the previous bilateral
agreements, in effect, constitute a ceiling for the new
CEFTA agreement. Such a position poses a dilemma for
Serbia: if it abandons the discriminatory excise, while
keeping its tariff level low, it would have no other means
to provide the promised protection to domestic producers.


8. (SBU) Philip Morris, in particular, has been outspoken
in demanding that the GOS not retreat from the overall
protection guaranteed in privatization agreements. (Philip
Morris has invested about USD 560 million in its Nis
cigarette operation and is the market leader in Serbia.)
However, Eugenio Sidoli, general director of Philip Morris,
told econoff that the industry, which is sensitive to
Serbia's desire to initial the CEFTA pact, had agreed to
the lower protection level in Serbia's November 30 offer to
Croatia, which would reduce the current level of protection
from EURO 8.9 per 1,000 cigarettes to 8.4 in April, 2007.


9. (SBU) Croatia's insistence on a standstill has further
complicated prospects for a deal, O'Mahony pointed out,
because such a stance also undercut a tentative agreement
between Bosnia and Croatia on agricultural tariffs.
Croatia had agreed on October 20 to higher tariffs for

agricultural imports in Bosnia and Herzegovina (BIH),but
the Croats reportedly did an about-face on November 7 and
have asserted the standstill principle in further
discussions both with Serbia and Bosnia. "They were
willing to change it for Bosnia, till Serbia requested the
same treatment," O'Mahony said.


10. (SBU) O'Mahony said that Stability Pact officials are
concerned that, even if the Serbs and Croats find some way
to work around the cigarette impasse, Bosnia could still be
left out in the cold over agricultural tariffs. Rehn and
Mandelson, in their November 21 letter to Croatian Prime
Minister Sanader, zeroed in on this issue: "We were
particularly disappointed to learn that, after having
reached an agreement in principle with the Bosnian side at
the last negotiating round; the Croatian negotiators were,
in an apparent change of position, unable to confirm a
possible deal on agricultural concessions."


11. (SBU) Many in Serbia's tobacco industry perceive
Croatia's position as unreasonable. Eugenio Sidoli,
general director of Philip Morris, told econoffs that
Croatia's monopoly producer controls 6 percent of Serbia's
market, which is three times larger than Croatia's.
However, Serbian producers have zero market share in
Croatia because of a discriminatory tobacco classification
system that categorizes all imported cigarettes, regardless
of brand, in the category with the highest excise tax. He
said that during accession negotiations, the EU had asked
Croatia to change this system, but the transition period
could last years.


12. (SBU) O'Mahony, who termed the latest Serb offer
"quite attractive," is at a loss to explain the Croatian
stance. While the Sanader government certainly faces
pressure from its government-owned tobacco producer, other
Croatian producers should be in a position to exploit a
more liberal trade regime, she explained. (Croatia
exported USD 9.3 million in cigarettes to Serbia in 2005,
roughly 6 percent of the total market, while total exports
were only USD 17.3 million, far less than 1 percent of
Serbia's total imports.) O'Mahony said that, given the
underlying economics, Croatia's position simply doesn't
make sense.


13. (SBU) COMMENT. Serbia will continue to seek ways out
of this impasse; it clearly wants to sign the CEFTA deal in
Bucharest on December 19. But cigarette producers here
have told the GOS bluntly that they want compensation if
the protection levels are substantially reduced before the
promised phaseout at the end of 2009. There is a strong
feeling in Belgrade that Zagreb is being unreasonable and
that its position is, in essence, that what's ours is ours,
while yours is negotiable.

POLT