CENTRAL BANK FIGHTS TO LIMIT CREDIT GROWTH

UNCLAS SECTION 01 OF 06 BELGRADE 000654

SIPDIS

SENSITIVE

OC FOR 4232/ITA/MAC/EUR/OEERIS/SSAVICH

E.O. 12958: N/A
TAGS: EFIN ECON EINV SR MW
SUBJECT: CENTRAL BANK FIGHTS TO LIMIT CREDIT GROWTH



1. Summary: THE NATIONAL BANK OF SERBIA IS CAUGHT
BETWEEN TWO CONFLICTING GOALS: PREVENTING DINAR
APPRECIATION, WHICH IT PURSUES BY SELLING DINAR TO BUY
UP FOREIGN CURRENCY, AND CURBING THE INFLATIONARY
PRESSURE IT CREATES IN THE FIRST STEP. THIS BALANCING
ACT HAS PROVED DIFFICULT, AS IT HAS IN OTHER TRANSITION
COUNTRIES HIT BY SURGING CAPITAL INFLOWS, WITH
INFLATION OF 17.7 PERCENT IN 2005 AND REAL APPRECIATION
OF THE DINAR BY 9.6 PERCENT. WHILE THE CENTRAL BANK'S
POLICY OF PEGGING THE DINAR HELPED TO REDUCE THE
CURRENT ACCOUNT DEFICIT TO 8.6 PERCENT OF GDP IN 2005,
KEEPING CREDIT GROWTH IN CHECK HAS PROVEN MORE AND MORE
DIFFICULT, WITH THE HIGH LEVEL OF EUROIZATION WEAKENING
THE EFFECTIVENESS OF MONETARY POLICY. THE CENTRAL BANK
FURTHER TIGHTENED THE MONEY SUPPLY ON MARCH 31, AND IT
WARNED OF MORE RESTRICTIONS TO COME. END SUMMARY.

MONEY SUPPLY RISES ON CAPITAL INFLOWS, REMONETIZATION
-------------- --------------

2. THE NATIONAL BANK OF SERBIA (NBS) IS FEELING THE
PAIN OF PROSPERITY. RENEWED CONFIDENCE IN A BANKING
SECTOR THAT IS NOW DOMINATED BY FOREIGN BANKS HAS LED
TO REMONETIZATION, WITH EURO DEPOSITS UP BY 50.6
PERCENT IN 2005. DRIVEN BY THE CENTRAL BANK'S POLICY
OF BUYING EURO FROM EXCHANGE HOUSES WITHOUT LIMIT, ITS
GROSS RESERVES NOW TOP USD 6.1 BILLION, OR SEVEN MONTHS
OF IMPORT COVER. RESERVE MONEY INCREASED BY 66.9
PERCENT IN 2005, THE NOMINAL RATE OF GROWTH OF M1
REACHED 30.2 PERCENT, AND M3, WHICH INCLUDES HARD
CURRENCY DEPOSITS, WAS UP 41.9 PERCENT.


3. FOREIGN BANKS ARE PAYING A HIGH PRICE FOR SERBIAN
ACQUISITIONS, AND THEY ARE EXPANDING RAPIDLY TO
GENERATE A RETURN ON THESE INVESTMENTS. BANK CREDIT TO
HOUSEHOLDS ROSE IN 2005 BY 76 PERCENT IN REAL TERMS,
REACHING USD 1.73 BILLION, OR 7 PERCENT OF GDP, WHICH
IS 30 PERCENT OF TOTAL NON-GOVERNMENT BORROWING,
ACCORDING TO NBS DATA. BY COMPARISON, THE PROPORTION
OF HOUSEHOLD DEBT IN NON-GOVERNMENT BORROWING IN 2004
WAS 32.5 PERCENT IN HUNGARY, 32.7 PERCENT IN BULGARIA,
AND IN CROATIA, 55 PERCENT. AT THE SAME TIME, HOUSEHOLD
BORROWING, AS A PERCENTAGE OF 2004 GDP, WAS 13.1
PERCENT IN HUNGARY, 10 PERCENT IN BULGARIA, AND IN
CROATIA, 31.5 PERCENT. (SOURCE: EBRD TRANSITION REPORT
2005).



4. DESPITE PROGRESSIVELY HARSHER CENTRAL BANK
RESTRICTIONS AIMED AT CURBING THE GROWTH OF LENDING,
CREDIT GROWTH ACCELERATED AT THE BEGINNING OF 2006. IN
JANUARY AND FEBRUARY, HOUSEHOLD INDEBTEDNESS INCREASED
BY 8.4 PERCENT, I.E. USD 145 MILLION. BY COMPARISON,
IN THE SAME PERIOD OF 2005, HOUSEHOLD BORROWING
INCREASED BY 3.6 PERCENT, I.E. USD 38 MILLION.


5. ALTHOUGH MUCH OF THE GROWTH OF RESERVE MONEY IS
DRIVEN BY THE CENTRAL BANK'S EURO PURCHASES, NBS
OFFICIALS ARE ESPECIALLY WORRIED BY FLOWS OF FOREIGN
CAPITAL INTO COMMERCIAL BANKS. "WE WOULD WISH THAT
BANKS DIRECT THEIR ENERGY TO THE COLLECTION OF DEPOSITS
IN COUNTRY, AND NOT TO BORROWING FROM ABROAD," SAID
VICE GOVERNOR DIANA DRAGUTINOVICH, WHO DIRECTS MONETARY
POLICY, IN A RECENT INTERVIEW. "THAT'S WHY WE WANT, BY
THESE MEASURES, TO LIMIT THE BORROWING OF BANKS, WITH
THE GOAL THAT THEIR CREDIT ACTIVITY BE LIMITED, LET'S
SAY, TO LAST YEAR'S LEVEL."


6. IN 2005, BANKS' FOREIGN LIABILITIES INCREASED BY 78
PERCENT, OR USD 1.4 BILLION, TO USD 2.5 BILLION.
FOREIGN BANKS, DETERMINED TO MAKE THEIR NEW INVESTMENTS
PAY, CAN BORROW FROM OFFSHORE PARENTS CHEAPLY, SAY AT 4-
5 PERCENT, AND LEND AT RATES OF 12-16 PERCENT, ON FEE-
HEAVY, EURO-LINKED RETAIL CREDITS. MARGINS ARE
LUCRATIVE, WITH SPREADS NOW DOWN TO PERHAPS 10
PERCENTAGE POINTS, FROM 13-15 PERCENT LAST YEAR,
ACCORDING TO THE NBS.


7. RISING DEPOSITS CONTRIBUTED EQUALLY TO ADDITIONAL
LIQUIDITY. HARD CURRENCY DEPOSITS LAST YEAR INCREASED
BY 50.6 PERCENT TO USD 3.7 BILLION. DINAR SAVINGS
DEPOSITS WERE UP BY 35 PERCENT TO 0.7 BILLION
(EXCLUDING CURRENT ACCOUNTS). EURO DEPOSIT RATES RANGE
FROM 1 TO 5 PERCENT, DEPENDING ON MATURITY, LEAVING
AMPLE ROOM FOR PROFIT AS THE BANKS RECYCLE THEM INTO
LENDING. (NOTE: BANKERS SAY THAT RATES OFTEN ARE LOWER
IN THE CORPORATE SECTOR, WHERE COMPETITION IS GREATER
AND BORROWERS, MORE PRICE-CONSCIOUS.)

CENTRAL BANK FIGHTS TO KEEP CONTROL
--------------

8. THE INTERNATIONAL MONETARY FUND, IN ITS FINANCIAL
SYSTEM STABILITY ASSESSMENT, PUBLISHED IN MARCH, RAISED
THE ALARM: "THERE ARE EMERGING SIGNS THAT THE RAPID
PACE OF CREDIT GROWTH IS BEGINNING TO ERODE FINANCIAL
STABILITY." THE REPORT NOTES THAT SERBIA HAS A LOWER
RATIO OF BANK CREDIT TO GDP THAN MOST COMPARABLE
COUNTRIES, BUT PROJECTS THAT THE CURENT RATE OF GROWTH
COULD PUSH SERBIA'S DEBT LEVELS HIGHER THAN REGIONAL
AVERAGES WITHIN A FEW YEARS. THE IMF ASSESSMENT ALSO
NOTED THAT LEVELS OF NON-PERFORMING LOANS ARE RISING.


9. THE IMF ALSO POINTED TO THE "HIGH LEVEL OF EURO-
IZATION" AND THE FACT THAT ALMOST ALL LENDING IS IN
EUROS, WHICH EXPOSES BORROWERS (AND, THUS, INDIRECTLY
THE CREDITORS AS WELL) TO "CONSIDERABLE FOREIGN
CURRENCY RISKS." THE IMF ALSO SINGLED OUT REMAINING
STATE-OWNED BANKS AS PARTICULARLY VULNERABLE, IN LIGHT
OF THEIR WEAK BALANCE SHEETS AND MANAGEMENT. (NOTE:
SERBIA'S FIFTH-LARGEST BANK, STATE-OWNED VOJVODJANSKA
BANKA, IS BEING PRIVATISED NOW, AFTER WHICH KOMERCIALNA
BANK WILL BE THE LAST STATE-CONTROLLED BANK AMONG THE
10 LARGEST.)


10. THE NATIONAL BANK INITIALLY WAS SLOW TO RESPOND TO
FUND CONCERNS. DURING 2005, GOVERNOR JELASIC TALKED
FREQUENTLY OF THE NEED TO LOWER RATES, ARGUING THAT
BANKS' SPREADS WERE TOO HIGH. INDEED, REAL RATES IN
THE CENTRAL BANK'S REPO OPERATION, A KEY TOOL FOR
STERILIZING CAPITAL INFLOWS, WERE NEGATIVE AND DID NOT
BEGIN RISING AGAIN UNTIL OCTOBER.


11. THE PROBLEM OF RAPID MONEY SUPPLY GROWTH - AND
ACCOMPANYING INFLATION - HAS BEEN DEVELOPING THROUGH

2005. RESERVE MONEY ROSE BY 66.9 PERCENT, M1 BY 30.2
PERCENT, AND M3 BY 41.9 PERCENT. THIS TREND SLOWED ONLY
AT THE BEGINNING OF 2006, MAINLY AS A RESULT OF
SEASONAL FACTORS. THIS GROWTH WAS REFLECTED IN THE RISE
OF INFLATION TO 17.7 PERCENT, FROM 13.4 PERCENT IN

2004. DRAGUTINOVICH TOLD ECON CHIEF THAT THE NATIONAL
BANK FINDS A HIGH CORRELATION BETWEEN THE GROWTH OF
BROAD MONEY - M3 - AND INFLATION. SHE SAYS BROAD MONEY
IS THE KEY MONETARY TARGET.


12. THE IMPACT ON THE CURRENT ACCOUNT DEFICIT WAS LESS
APPARENT, AS THE GAP NARROWED FROM 12.6 PERCENT IN 2004
TO 8.6 PERCENT OF GDP IN 2005. THIS RELATIVE SUCCESS
WAS DUE IN PART TO THE NATIONAL BANK'S DETERMINATION TO
KEEP THE DINAR ROUGHLY STABLE AS A WAY OF DAMPING
INFLATION EXPECTATIONS. BUT THE BANK AVOIDED NOMINAL
APPRECIATION OF THE DINAR - AND, IN THEORY, HIGHER
IMPORTS - ONLY BY BUYING UP EUROS AT A BRISK PACE.
DESPITE NBS INTERVENTION IN THE FOREIGN EXCHANGE
MARKET, THE DINAR DEPRECIATED RELATIVE TO THE EURO 8.1
PERCENT IN NOMINAL TERMS OVER 2005, BUT IT APPRECIATED
9.6 PERCENT IN REAL TERMS.


13. UNDER PRESSURE FROM THE FUND, THE NATIONAL BANK
TIGHTENED MONETARY POLICY STEADILY THROUGHOUT THE
SECOND HALF OF 2005. ITS APPROACH COMBINED BOTH
STANDARD OPEN MARKET OPERATIONS, SEEKING TO WITHDRAW
DINAR LIQUIDITY THROUGH ITS REPO OPERATIONS, AND A
STEADY RAMPING UP OF SO-CALLED "RESERVE" REQUIREMENTS,"
WHICH FUNCTION IN MANY RESPECTS AS INDIRECT CAPITAL
CONTROLS.


14. TO INCREASE THE PRESSURE ON BANKS AND THUS DECREASE
THE SUPPLY OF CONSUMER CREDIT, THE NBS IMPLEMENTED THE
FOLLOWING MEASURES OVER 2005, IN SEVERAL STEPS:
-- THE REQUIRED RESERVE FOR FOREIGN CURRENCY DEPOSITS
WAS GRADUALLY INCREASED FROM 21 PERCENT TO 38 PERCENT;
-- THE BASE FOR REQUIRED RESERVES WAS BROADENED BY
INCLUDING DINAR DEPOSITS THAT ARE INDEXED TO A HARD
CURRENCY;
-- A RESERVE REQUIREMENT ON BORROWING FROM ABROAD WAS
INTRODUCED AND INCREASED FROM 7 TO 38 PERCENT;
-- LEASING ALSO WAS TARGETED WITH AN OBLIGATORY RESERVE
OF 10 PERCENT OF BORROWING FROM ABROAD.


15. THE NATIONAL BANK HAS CONSISTENTLY TRIED TO
BROADEN USE OF THE DINAR, EVEN ISSUING RETAIL SAVINGS
BONDS DIRECTLY TO CONSUMERS TO BOOST DINAR DEPOSIT
RATES. IT DECREASED THE RESERVE REQUIREMENT ON DINAR
DEPOSITS TO 18 PERCENT, VICE 40 PERCENT FOR FOREIGN
CURRENCY DEPOSITS. NONETHELESS, EURO DEPOSITS REACHED
98 PERCENT OF TOTAL SAVINGS AT THE END OF 2005, UP FROM
97 PERCENT AT THE END OF 2004. (DINARS MAINLY ARE HELD
ONLY IN CURRENT ACCOUNTS, FOR PAYMENT PURPOSES.)

CURBS ON MONEY SUPPLY INEFFECTIVE, EVEN
COUNTERPRODUCTIVE
-------------- --------------


16. DESPITE THE NATIONAL BANK'S EFFORTS, INTEREST
RATES ON HOUSEHOLD BORROWING REMAINED LARGELY
UNCHANGED, DUE TO A NUMBER OF FACTORS. MARGINS ON SUCH
LENDING ALREADY WERE HIGH, AND COMPETITION AMONG THE
GROWING NUMBER OF FOREIGN BANKS TENDED TO KEEP RATES
DOWN. AT THE SAME TIME, BANKS HAVE FOUND LESS
TRANSPARENT WAYS TO RAISE EFFECTIVE INTEREST RATES,
THROUGH FEES AND DOWN PAYMENT REQUIREMENTS. AND, AS
RAFFEISEN BANK CEO OLIVER ROEGEL NOTES, THE PENT-UP
DEMAND FOR CONSUMER CREDIT IS SO GREAT THAT BORROWERS
APPEAR TO BE READY TO PAY ANY INTEREST RATE.


17. THE CENTRAL BANK'S NEW MEASURES APPEAR TO HAVE HAD
LITTLE IMPACT ON CREDIT GROWTH, WHICH CONTINUED TO
ACCELERATE THROUGH THE SECOND HALF OF 2005. DOMESTIC
CREDIT WAS UP 15.3 PERCENT IN THE FIRST HALF, BUT
SURGED BY 24.3 PERCENT IN THE SECOND. THE NATIONAL
BANK'S GROSS RESERVES WERE UP 72 PERCENT ON THE YEAR,
TO USD 6.1 BILLION, LARGELY DRIVEN BY THE FLOW OF MONEY
FROM EXCHANGE HOUSES TO THE CENTRAL BANK.


18. AT THE SAME TIME, THE NATIONAL BANK WAS FIGHTING
INCREASED CAPITAL INFLOWS. AS MENTIONED ABOVE, BANKS
INCREASED THEIR BORROWING, OFTEN FROM THEIR FOREIGN
PARENTS, BY USD 1.4 BILLION, TO USD 2.5 BILLION AT THE
END OF 2005, I.E. 10 PERCENT OF GDP. THE BANK REACTED
BY FIRST IMPOSING "RESERVE REQUIREMENTS" ON SUCH
BORROWING, AND THEN STEADILY INCREASING THE RATE TO
EQUALIZE IT WITH THE RATE ON HARD CURRENCY DEPOSITS.
BANKERS POINT OUT THAT SUCH RESERVE REQUIREMENTS ARE
NOT NEEDED ON INTRABANK LOANS, SINCE A PARENT BANK IS
NOT LIKELY TO PULL A LOAN AND PUT PRESSURE ON ITS
SUBSIDIARY, IN THE SAME WAY THAT DEPOSITORS EN MASSE
CAN WITHDRAW DEPOSITS.


19. AGAINST THESE HEAVY CAPITAL INFLOWS, THE NBS WAS
ABLE TO STERILIZE, OR WITHDRAW FROM CIRCULATION,
THROUGH ITS OPEN MARKET REPO OPERATIONS, ONLY DINARS
WORTH USD 0.443 BILLION DOLLARS. THE VOLUME OF REPO
OPERATIONS INCREASED GRADUALLY OVER THE YEAR, IN PART
BECAUSE IT WAS A NEW INSTRUMENT FOR THE CENTRAL BANK,
AND IN PART BECAUSE THE BANK WAS RELUCTANT TO PUSH UP
RATES. INTEREST RATES VARIED FROM 20 PERCENT AT THE
VERY BEGINNING OF THE YEAR, TO THEIR LOWESTS IN JUNE AT
13.5 PERCENT, AND THAN GRADUALLY RISING TO 20 PERCENT
BY YEAR-END. THE LATEST RATE IS ABOUT 24 PERCENT.


20. COMPARED TO THE SIZE OF THE INFLOWS, THIS IMPACT
CLEARLY WAS MINOR, FORCING THE BANK TO RESORT TO
RESERVE REQUIREMENTS. AND AS EUROIZATION INCREASES, THE
CENTRAL BANK'S ABILITY TO AFFECT THE MONEY SUPPLY
THROUGH A DINAR INSTRUMENT BECOMES PROGRESSIVELY
WEAKER. BANK OFFICIALS SAY THEY WERE ABLE TO STERILIZE
87 PERCENT OF CAPITAL INFLOWS, BUT ABOUT 1.428 BILLION,
OR THREE-QUARTERS, WAS WITHDRAWN VIA RESERVE
REQUIREMENTS.


21. "A PARADOXICAL SITUATION IS CREATED,'' ECONOMIST
STOJAN STAMENKOVIC POINTS OUT IN A RECENT ANALYSIS.
"ON ONE HAND, THE BUSINESS BANKS, WITH THE GOAL OF
CREATING EXTRA INCOME (ON THE BASIS OF THE DIFFERENCE
BETWEEN THE INTEREST RATE ON DOMESTIC AND FOREIGN
FINANCIAL MARKETS),TAKE CREDITS FROM OVERSEAS, AND THE
CENTRAL BANK IS FORCED TO, THROUGH AN EXPENSIVE
MECHANISM OF STERILIZATION, TO OFFSET THE EFFECT OF
THESE CREDITS IN THE DOMESTIC FINANCIAL MARKET. THE
EARNINGS BELONG TO THE BANKS, AND THE EXPENSE OF ANTI-
INFLATION ACTION TO THE CENTRAL BANK.... SUCH A
MONETARY POLICY IS VERY EXPENSIVE."


22. THE INEFFECTIVENESS OF MONETARY POLICY GOES BEYOND
THE PROBLEM OF CAPITAL INFLOWS, STAMENKOVIC EXPLAINED
TO ECON CHIEF. AS THE NBS WITHDRAWS DINAR LIQUIDITY
THROUGH RESERVE REQUIREMENTS, REPO OPERATIONS, AND
SAVINGS BONDS, HOUSEHOLDS OR FIRMS, WHICH HOLD MOST OF
THEIR ASSETS IN FOREIGN CURRENCY, REACT BY SIMPLY
CONVERTING MORE EURO TO DINAR. AND THE DUAL CURRENCY
NATURE OF THE ECONOMY MAKES IT DIFFICULT FOR THE
CENTRAL BANK TO MASTER THIS MECHANISM, SINCE CORPORATE
AND RETAIL FOREIGN CURRENCY RESERVES ARE HIGHER THAN M1
MONEY SUPPLY.


23. THE BANK CLEARLY RECOGNIZES ITS DILEMMA. VICE
GOVERNOR DRAGUTINOVICH, IN A RECENT PRESS INTERVIEW,
SAID THAT THE HIGH RATES THE CENTRAL BANK PAYS IN THE
REPO MARKET ARE IN FACT A MOTOR DRIVING BANKS TO BORROW
MORE OVERSEAS. AND SHE NOTED THAT SOME CENTRAL BANK
SECURITIES FOUND THEIR WAY, NOT INTO THE BANKS'
PORTFOLIOS, BUT INTO THOSE OF OVERSEAS INVESTORS WHO
ARE LOCKING IN AN INTEREST RATE PLAY, SAFEGUARDED BY
THE CENTRAL BANK'S VITUAL PEG OF THE DINAR. ROEGL, OF
RAFEISSEN, CONFIRMED THAT SOME FOREIGN BANKS ARE ACTING
ON BEHALF OF OVERSEAS SPECULATORS IN THE CENTRAL BANK'S
REPO OPERATIONS.


24. "THE TIME IS, THEN, TO CONSIDER WHETHER THIS HIGH
INTEREST RATE IN CONDITIONS OF A VERY LIBERAL INFLOW OF
CAPITAL RAISES THE LEVEL OF FINANCIAL INSTABILITY,"
DRAGUTINOVIC SAID IN THE PRESS INTERVIEW.

CENTRAL BANK SIGNALS COMMITMENT, BUT RESISTANCE GROWS
-------------- --------------


25. THE NATIONAL BANK'S LATEST MEASURES, ANNOUNCED ON
MARCH 31, RAISED THE RESERVE REQUIREMENT FROM 38 TO 40
PERCENT ON HARD CURRENCY DEPOSITS AND DINAR DEPOSITS
INDEXED IN EURO. BANKS ALSO MUST ALLOCATE 20 PERCENT
AS A RESERVE ON BORROWINGS BASED ON SUBORDINATED
CAPITAL, WHILE THE RESERVE REQUIREMENT ON LEASING WAS
RAISED TO 20 PERCENT, VICE 10 PERCENT.


26. GOVERNOR JELASIC, IN ANNOUNCING THE NEW
RESTRICTIONS, SAID THAT THE NBS WANTS TO DECREASE
INFLATIONARY PRESSURE BY WITHDRAWING AROUND 13.7
BILLION DINARS (5.5 PERCENT OF RESERVE MONEY FROM 2005)
FROM BANKS' LIQUIDITY TO BRING THE MONEY SUPPLY DOWN TO
THE LEVEL AT THE END OF LAST YEAR. HE ALSO WARNED THAT
THERE IS MORE TO COME, THAT THE CENTRAL BANK WILL REACT
TO FUTURE INFLATION BY INCREASING RATES ON REPO
OPERATIONS, BY FURTHER BOOSTING REQUIRED RESERVES, BY
ISSUING MORE SAVINGS BILLS AND THROUGH ENHANCED
SUPERVISION OVER BANKS AND LEASING COMPANIES. HOWEVER,
THE MARCH 31 MEASURES FOLLOWED CLOSE ON DATA THAT
SHOWED MARCH INFLATION WAS ONLY 0.3 PERCENT, BRINGING
THE INCREASE IN CONSUMER PRICES TO 2.2 PERCENT FOR THE
FIRST QUARTER.


27. JELASIC TOLD ECON CHIEF ON APRIL 5 THAT THE
NATIONAL BANK IS NOT FIXATED ON HITTING THE SINGLE
DIGIT INFLATION TARGET FOR 2006, BUT RATHER IS FOCUSED
ON MAINTAINING A DOWNWARD TREND. DRAGUTINOVICH
CONFIRMED THAT THE BANK IS CONSIDERING EVEN TIGHTER
RESTRICTIONS, SUCH AS MARGINAL RESERVE REQUIREMENTS ON
NEW BORROWINGS ABROAD, IF INFLATION NUMBERS ARE
ALARMING.


28. THE MARCH MEASURES FOLLOWED CLOSE ON THE HEELS OF
MORE RESTRICTIONS ANNOUNCED IN FEBRUARY, WHEN THE NBS
IMPOSED PROVISIONING MEASURES AIMED AT LIMITING
HOUSEHOLD BORROWING. THESE MEASURES REQUIRE THAT BANKS
HOLD A DEPOSIT OF 20 PERCENT ON ALL CONSUMER CREDITS
AND THAT THE MONTHLY INSTALLMENT NOT EXCEED 30 PERCENT
OF HOUSEHOLD INCOME. IN EVENT OF NON-COMPLIANCE, BANKS
ARE REQUIRED TO SET ASIDE A MANDATORY RESERVE OF 100
PERCENT OF THE LOAN.


29. THE NATIONAL BANK'S CONTINUED DETERMINATION TO
CLAMP DOWN ON CREDIT GROWTH - AND BRING INFLATION UNDER
CONTROL - HAS PROVOKED INCREASING OPPOSITION. FOR
INSTANCE, AT A PUBLIC MEETING OF THE FOREIGN INVESTOR'S
COUNCIL ON MARCH 15, MILAN PARAVODIC, MINISTER FOR
INTERNATIONAL ECONOMIC AFFAIRS, OPENLY CRITICIZED THE
CENTRAL BANK'S LATEST RESTRICTIONS, ARGUING THAT EASIER
ACCESS TO CREDIT WAS NECESSARY FOR DEVELOPMENT.


30. GORAN PITIC, HEAD OF SOCIETE GENERALE BANK, SAID
AT THE SAME EVENT THAT THE CENTRAL BANK'S POLICIES HAD
BEEN UNSUCCESSFUL, SINCE CREDIT GROWTH CONTINUED AND
INFLATION PERSISTED. THIS SHOWS THAT HIGH INFLATION IS
DRIVEN NOT JUST BY MONETARY DEVELOPMENTS, PITIC SAID,
AND WARNED THAT A FURTHER INCREASE OF OBLIGATORY
RESERVES OR INTRODUCTION OF NON-MARKET MEASURES WOULD
INCREASE LENDING RATES. ALEXANDER PICKER, THE HEAD OF
AUSTRO-GERMAN HVB BANK, WAS EVEN SHARPER, ACCUSING THE
BANK OF USING POPULIST RHETORIC IN ITS CAMPAIGN AGAINST
LENDING PRACTICES, AND OF EMPLOYING DISCRIMINATORY
POLICIES IN ITS USE OF AUDITS. (NOTE: SOME BANKING
SCENE OBSERVERS SAY THE FOREIGN BANKS BELIEVE THE
CENTRAL BANK TO BE UNDULY PROTECTIVE OF THE SERBIAN
BANKS; FOR INSTANCE, IT IS COMMONLY SAID THAT CENTRAL
BANK AUDITORS SPEND ALMOST ALL THEIR TIME IN THE
FOREIGN BANKS.)


31. ROEGL, OF RAIFFEISEN, ELABORATED ON PICKER'S
CHARGES IN APRIL 3. HE SAID THAT THE NATIONAL BANK IS
USING AUDITS TO IMPOSE CREDIT LIMITS ON THE LARGEST
BANKS IN AN ATTEMPT TO RESTRAIN LENDING. RAIFFEISEN,
THE MARKET LEADER, HAS WORKED HARD TO APPLY GOOD RISK
MANAGEMENT, ROEGL SAID, BUT CENTRAL BANK AUDITORS
SIMPLY JUDGED ITS PRACTICES INADEQUATE AND IMPOSED
QUANTITATIVE LIMITS ON ITS CREDIT ISSUANCE. IN
ADDITION, THEY INSIST ON USING PROVISIONING STANDARDS
THAT EXCEED INTERNATIONAL STANDARDS. THE RESULT IS
SIMPLY TO SLOW RAFFEISEN'S GROWTH, HE SAID. (NOTE: THE
IMF RESIDENT REPRESENTATIVE RECENTLY TOLD ECON CHIEF
THAT THE CENTRAL BANK HAD AGREED TO STOP IMPOSING SUCH
CREDIT LIMITS.)


32. THE BANK'S MEASURES MAY ALSO HAVE UNINTENDED
EFFECTS, ROEGL WARNED. BY INCREASING BANKS' FUNDING
COSTS THROUGH RESERVE REQUIREMENTS, THE NATIONAL BANK
MAY PUSH COMMERCIAL BANKS TO FOCUS EVEN MORE ON
CONSUMER LENDING, WHERE THE MARGINS ARE HIGHER. THIS
TREND IS COMPOUNDED BY THE ABILITY OF THE BEST
CORPORATE CUSTOMERS TO BORROW OVERSEAS DIRECTLY, IN
WHICH CASE CENTRAL BANK CREDIT CONTROLS ARE EVADED
COMPLETELY.

THE OUTLOOK AND RISKS
--------------


33. JELASIC NEVER PASSES UP AN OPPORTUNITY TO REMIND
THE PUBLIC THAT THE CENTRAL BANK CANNOT CONTROL
INFLATION ON ITS OWN, THAT FISCAL POLICY AND STRUCTURAL
REFORM MUST PLAY THEIR PART. STAMENKOVICH ECHOES THIS
POINT, ARGUING THAT THE BURST IN INFLATION SEEN IN 2005
IN PART WAS CAUSED BY THE FINANCE MINISTRY. HE POINTS
OUT THAT THE BUDGET REBALANCE CARRIED OUT IN MID-2005,
BY CHANGING METHODOLOGY, OBSCURED WHAT IN FACT WAS A
SIGNIFICANT INCREASE IN SPENDING OF 0.7 PERCENT OF GDP.


34. FISCAL RISKS MAY ARISE AGAIN THIS YEAR,
STAMENKOVICH SAID. VAT REVENUES FOR JANUARY AND
FEBRUARY ARE 3 PERCENT BELOW PROJECTION, AND THE
GOVERNMENT WILL BE TEMPTED TO MAKE UP THE DIFFERENCE
FROM PRIVATIZATION REVENUES, WHICH WOULD HAVE AN
INFLATIONARY IMPACT. INDEED, JELASIC, AT HIS MARCH 31
PRESS CONFERENCE, ALSO POINTED TO THIS ISSUE, CLAIMING
THAT THE GOVERNMENT ALREADY IS FINANCING SOME PROJECTS
FROM PRIVATIZATION REVENUES. AND THE FINANCE MINISTER
HAS BEEN PUBLICLY PROMOTING A 1 BILLION EURO (5 PERCENT
OF GDP) INVESTMENT PLAN.


35. THE RISE OF NON-PERFORMING LOANS (NPL) ALSO POSES
RISKS, A POINT RAISED BY THE IMF IN ITS MARCH
ASSESSMENT. "THE APPARENT INCREASE IN THE NPL TO TOTAL
LOAN RATIOS OF MOST FOREIGN BANKS DURING 2005 COULD BE
AN EARLY SIGN OF A WORSENING OF FINANCIAL STABILITY,"
THE IMF REPORTED. THE BAD LOAN RATE AT FOREIGN BANKS
INCREASED FROM 3.9 PERCENT IN 2003 TO 10.7 PERCENT IN
SEPTEMBER 2005. MORE RECENT DATA SHOWS THAT NON-
PERFORMING LOANS ARE UP, FROM THE SECOND QUARTER OF
2005 THROUGH THE FOURTH QUARTER, FROM 8.79 TO 14.45 TO
16 PERCENT FOR FOREIGN BANKS, FROM 38.9 TO 29.5 TO 37.7
PERCENT FOR STATE-CONTROLLED BANKS, AND FROM 21.13 TO
20.34 TO 46.63 PERCENT FOR DOMESTIC PRIVATE BANKS.
HOWEVER, BANKERS CONSISTENTLY SAY THAT CONSUMER CREDITS
PRESENT FEW NON-PAYMENT PROBLEMS, A FACT THAT ROEGL
RECENTLY CONFIRMED.


36. STAMENKOVIC, IN A RECENT PAPER WITH SEVERAL OTHER
ECONOMISTS, WARNS THAT THE CURRENT POLICY THREATENS TO
INCREASE INTEREST RATES, RAISE THE RISK OF RECESSION,
AND AT THE SAME TIME INCREASE CAPITAL INFLOWS. SUCH
INFLOWS LIKELY WILL LEAD TO SOME APPRECIATION OF THE
DINAR - DESPITE THE CENTRAL BANK'S EFFORTS TO AVOID
THIS OUTCOME - JEOPARDIZING EXPORT COMPETITIVENESS.
HIS PREFERENCE WOULD BE FULL LIBERALIZATION OF THE
CURRENCY MARKET AND FULL LIBERALIZATION OF THE CAPITAL
MARKET. CAPITAL INFLOWS COULD, TO SOME EXTENT, BE
OFFSET BY CAPITAL OUTFLOWS AS SERBS ARE PERMITTED TO
BUY OFFSHORE ASSETS. HE NOTES THAT A HIGH CAPITAL
INFLOW CAN CREATE AN ASSET BALLOON IN THE DOMESTIC REAL
ESTATE MARKET, GIVEN THE SHORTAGE OF INVESTMENT
OPTIONS.


37. DRAGUTINOVICH TOLD ECON CHIEF THAT THE NATIONAL
BANK IS PLANNING TO LIBERALIZE THE EXCHANGE MARKET THIS
YEAR. IT WILL WITHDRAW FROM ITS ROLE AS EXCLUSIVE
PURCHASER OF FOREIGN EXCHANGE FROM EXCHANGE HOUSES AND
ALLOW THE BANKS TO TAKE OVER THIS ACTIVITY, REDUCING
ITS ROLE IN EXCHANGE RATE FORMATION. (NOTE: THE
CENTRAL BANK ALSO DICTATES RATES TO THE EXCHANGE
HOUSES.) INDEED, SHE SAID THAT THE BANKS INCREASINGLY
TRADE FOREIGN CURRENCY AMONG THEMSELVES, ALTHOUGH IT IS
NOT A FORMAL MARKET. AT THE SAME TIME, SHE WAS NON-
COMMITTAL ON THE ISSUE OF CAPITAL OUTFLOWS.

38. ON THE PLUS SIDE, JELASIC'S POSITION AT THE
NATIONAL BANK APPEARS TO BE SOMEWHAT STRONGER. HIS FIVE-
YEAR TERM ENDS IN 2009, MORE THAN A YEAR AFTER THE
KOSTUNICA GOVERNMENT MUST FACE ELECTIONS. HE APPEARS
TO HAVE SURVIVED THE "SUITCASE" SCANDAL, WHICH RESULTED
IN THE ARREST OF THE VICE GOVERNOR FOR THE BANKING
SECTOR ON BRIBERY CHARGES. THE VICE GOVERNOR RECENTLY
WAS RELEASED FROM PRE-TRIAL CONFINEMENT, AND MANY
BELIEVE THAT THE ENTIRE EPISODE WAS AN EFFORT TO
PRESSURE THE CENTRAL BANK OVER LICENSING ISSUES.


39. AT THE SAME TIME, THE CENTRAL BANK AT TIMES
APPEARS A BIT LOST. FOR INSTANCE, DRAGUTINOVIC KNEW
NOTHING ABOUT THE ROLE THAT INSURANCE COMPANIES PLAY IN
INSURING CONSUMER CREDIT, ALTHOUGH THIS PRACTICE ALMOST
CERTAINLY IS SPURRING RETAIL LENDING. BANKS, FOR A
MODEST PREMIUM, CAN OFFLOAD THEIR CREDIT AND FOREIGN
EXCHANGE RISK ON THE STATE-OWNED - AND FEE-HUNGRY -
STATE-OWNED INSURANCE COMPANIES. JELASIC IS AWARE OF
THE MORAL HAZARD INVOLVED, BUT APPARENTLY HAS NOT
BROUGHT THIS ISSUE INTO MONETARY POLICY DISCUSSIONS.
(WE RECENTLY WERE INFORMED BY THE MAIN PLAYER, DUNAV
INSURANCE, THAT THEY HAVE CEASED WRITING SUCH
COVERAGE.)


40. COMMENT: CAPITAL INFLOWS AND THE RAPID CHANGES IN
SERBIA'S BANKING SECTOR POSE A CHALLENGE TO THE CENTRAL
BANK. ITS RESPONSE HAS BEEN CONVENTIONAL, AND
EFFECTIVE IN THE SHORT TERM, ALTHOUGH THE BANK IS
BUILDING A SIGNIFICANT RISK IN THE MAGNITUDE OF ITS
STERLIZATION PROGRAM. THE CZECH REPUBLIC BUILT A LARGE
STERILIZATION POSITION ONLY TO SEE THE FOREIGN MONEY
HEAD FOR THE DOOR IN MAY 1997, LEADING TO A 10 PERCENT
DEVALUATION OF THE KORUNA. MOST AGREE THAT THE BANK
SHOULD BE SELECTIVE IN TARGETING CONSUMER CREDIT GROWTH
THROUGH PRUDENTIAL MEASURES, RATHER THAN RISK DRAINING
CREDIT FROM THE ENTERPRISE SECTOR AND SLOWING GROWTH.
A LIBERAL STANCE ON CAPITAL OUTFLOWS WOULD BE SENSIBLE,
AND THE NEW FOREIGN EXCHANGE LAW MAY PROVIDE AN
OPPORTUNITY FOR PROGRESS. IN ADDITION, WHILE PROSPECTS
FOR A NEW IMF AGREEMENT AFTER THE MONTENEGRO REFERENDUM
ARE UNCERTAIN, THE IMF RESIDENT REPRESENTATIVE SAYS
THAT THE FUND IS BRINGING IN AN EXPERIENCED MONETARY
ECONOMIST TO WORK AS AN ADVISER IN THE NATIONAL BANK.
THE TRANSITION TO A MORE MARKET-DRIVEN EXCHANGE RATE
WILL BE A MAJOR CHALLENGE FOR THE CENTRAL BANK,
ESPECIALLY AS THE DINAR APPRECIATES. END COMMENT.

POLT