CENTRAL BANK TIGHTENS - AGAIN

UNCLAS SECTION 01 OF 03 BELGRADE 000768

SIPDIS

SENSITIVE

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

E.O. 12958: N/A
TAGS: EFIN ECON EINV SR MW
SUBJECT: CENTRAL BANK TIGHTENS - AGAIN



1. SUMMARY: THE NATIONAL BANK OF SERBIA REACTED TO APRIL'S
HIGHER INFLATION BY FURTHER TIGHTENING MONETARY POLICY. THE
CENTRAL BANK NOT ONLY RAISED THE RESERVE REQUIREMENT ON
OVERSEAS BORROWING BY BANKS, BUT IT ALSO FORMALLY IMPOSE
LIMITS ON BANKS' RETAIL LENDING, TIED TO THEIR BASIC EQUITY
CAPITAL. BANKS COMPLAIN THAT THESE MEASURES WILL DRIVE UP
INTEREST RATES AND ENCOURAGE CORPORATE CLIENTS TO EVADE THE
RESTRICTIONS ALTOGETHER BY BORROWING OVERSEAS. THE
SUBSTANTIAL DETERIORATION IN THE CURRENT ACCOUNT DEFICIT FOR
THE FIRST QUARTER ALSO PLAYED A ROLE IN THE CENTRAL BANK'S
REACTION, WITH THE BANK POINTING TO A CLOSE CORRELATION
BETWEEN CONSUMER CREDIT AND IMPORTS. CENTRAL BANK GOVERNOR
JELASIC REPORTS "ZERO" INTEREST FROM THE IMF IN A NEW FUND
PROGRAM. END SUMMARY.

INFLATION RISING, WHILE CURRENT ACCOUNT DEFICIT WORSENS
-------------- --------------

2. APRIL'S HIGH INFLATION HAS FLATTENED HOPES THAT SERBIA
COULD ACHIEVE SINGLE-DIGIT INFLATION IN 2006. INFLATION WAS
UP 1.8 PERCENT IN APRIL, THUS REACHING 4.1 PERCENT COMPARED
TO DECEMBER 2005, AND 15.6 PERCENT IN THE YEAR ENDING APRIL

30. QUARTERLY INFLATION WAS THE RESULT OF HIGHER OIL PRICES
(0.8 OF THE 4.1 POINTS),ELECTRICITY (0.8 PERCENT)
AGRICULTURAL PRODUCTS (0.5 PERCENT),WHILE CORE INFLATION WAS
2.5 PERCENT. AFTER CONSUMER PRICES ROSE BY 17.7 PERCENT IN
2005, THE FINANCE MINISTER HAD PREDICTED SINGLE DIGIT
INFLATION FOR 2006, BUT CENTRAL BANK GOVERNOR RADOVAN
JELASIC, IN A MAY 9 MEETING WITH ECON CHIEF, NOTED THAT THE
BANK HAD NEVER EMBRACED THAT PREDICTION.


3. AT THE SAME TIME, THE FOREIGN TRADE DEFICIT IN THE FIRST
QUARTER OF 2006 WAS UP BY 34.4 PERCENT COMPARED TO SAME
PERIOD LAST YEAR. HOWEVER, THESE NUMBERS GENERALLY ARE
CONSIDERED SUSPECT BECAUSE THE INTRODUCTION OF THE VALUE
ADDED TAX LAST YEAR SHIFTED IMPORTS INTO DECEMBER 2004
INSTEAD OF Q1 2005. EXPORTS WERE UP BY A HEALTHY 27.6
PERCENT FOR THE FIRST QUARTER. JELASIC NOTED THAT HE IS NOT
WORRIED BY THE CURRENT ACCOUNT RESULTS.


4. JELASIC SAID THAT HE FOUND "ZERO" INTEREST IN A NEW
PROGRAM WHEN HE MET WITH THE IMF WHILE IN WASHINGTON IN LATE
APRIL FOR THE ANNUAL MEETINGS. HE SAID THE FUND REGARDED THE
LAST PROGRAM AS LESS THAN SUCCESSFUL, GIVEN HIGH INFLATION,
AND WAS NOT EAGER TO TRY AGAIN. AND THE FUND WOULD BE
LOOKING FOR AN AMBITIOUS PROGRAM WITH REGARD TO STRUCTURAL
REFORM, EVEN IF SERBIA PUSHED FOR A PROGRAM. THE FUND ALSO
COULD SEEK A REVISED 2006 BUDGET TO COPE WITH INFLATION.


CENTRAL BANK AGAIN SEEKS TO CURB CREDIT GROWTH
-------------- --


5. THE NBS FACED A DIFFICULT TASK AS IT TRIED TO STERILIZE
RISING INFLOWS OF FOREIGN CURRENCY OVER THE LAST 12 MONTHS.
JELASIC SAID THAT THE BANK TOOK IN ANOTHER 612 MILLION
DOLLARS IN THE FIRST QUARTER, WITH THE CENTRAL BANK'S
RESERVES NOW UP TO USD 6.4 BILLION, DESPITE A DECLINE IN THE
BANK'S INTERVENTION IN THE FOREIGN EXCHANGE MARKET. IN 2005,
CAPITAL INFLOWS AMOUNTED TO 3 BILLION EUROS (57 PERCENT OF
M3),AND THAT TENDENCY CONTINUED IN THE FIRST QUARTER OF 2006
WITH AN INFLOW OF 804 MILLION EUROS. ONE NEGATIVE DEVELOPMENT
IS THE HIGH SHARE OF DEBT IN THE TOTAL CAPITAL INFLOW, FROM
61 PERCENT OF FLOWS IN 2005 TO 78 PERCENT IN THE FIRST
QUARTER. THIS REFLECTS COMMERCIAL BANK BORROWING FROM PARENT
COMPANIES ABROAD.


6. THE RISE IN INFLOWS WAS MATCHED BY AN ACCELERATION IN
CREDIT GROWTH. IN THE PERIOD JANUARY-MARCH, COMMERCIAL
BANKS' CREDITS INCREASED BY USD 646 MILLION, I.E. 11.3
PERCENT (CONSUMER LENDING BY 13.1 PERCENT, AND CORPORATE
LENDING, 10.5 PERCENT). IN THE SAME PERIOD OF 2005, CREDIT
GROWTH WAS 10.6 PERCENT (CONSUMER LENDING 8.4 PERCENT,
CORPORATE LENDING 11.3 PERCENT).


7. ALTHOUGH THE CENTRAL BANK HAD JUST INTRODUCED MORE
RESTRICTIONS ON MARCH 30, IT REACTED AGAIN ON MAY 8;
JELASIC TOLD ECON CHIEF THAT HE WAS FORCED TO ACT BY THE
WORSENING INFLATION NUMBERS. THESE MEASURES WERE TAKEN IN
ANTICIPATION OF MORE INFLATIONARY PRESSURES IN MAY, JELASIC
SAID, INCLUDING A FURTHER OIL PRICE INCREASE OF 4-5 PERCENT,
A TELEPHONE PRICE INCREASE OF 10 PERCENT, AND A SEASONAL RISE
OF AGRICULTURAL PRICES. JELASIC SAID THAT HE COULD NOT WAIT
FOR MORE DATA, ESPECIALLY AFTER READING IN A RECENT FITCH
RATING THAT SERBIA HAS THE SECOND HIGHEST INFLATION AMONG 98
COUNTRIES IT RATES.



8. THE CENTRAL BANK MEASURES INCLUDE:

-- AN INCREASE OF THE RESERVE REQUIREMENT ON FOREIGN
BORROWING AND FOREIGN EXCHANGE DEPOSITS OF UP TO TWO YEARS,
FROM 40 TO 60 PERCENT; THE CENTRAL BANK CITED THE JUMP IN
BANKS' SHORT TERM EXTERNAL BORROWING, WHICH ALMOST TRIPLED
OVER LAST 12 MONTHS TO EURO 2.4 BILLION (11 PERCENT OF GDP).
-- HOUSEHOLD LENDING WILL BE LIMITED TO 200 PERCENT OF BANKS'
EQUITY CAPITAL, WITH A PHASE-IN BY SEPTEMBER 30. THE CENTRAL
BANK CITED THE HIGH GROWTH OF CREDITS TO HOUSEHOLDS, AS WELL
AS THE HIGH CORRELATION BETWEEN CONSUMER CREDITS AND THE
CURRENT ACCOUNT DEFICIT.
-- BANKS WILL BE OBLIGED TO PROVIDE ADDITIONAL CAPITAL OF 25
PERCENT FOR LOANS THAT EXCEED 10 MILLION DINARS IN FOREIGN
CURRENCY, OR LINKED TO A FOREIGN CURRENCY, UNLESS THE
BORROWER HAS ADDITIONAL SECURITY AGAINST EXCHANGE RATE RISK,
SUCH AS FOREIGN EXCHANGE REVENUES.
-- ON MAY 15, A SECOND ROUND OF NBS SAVINGS BILLS WILL BE
ISSUED TO RETAIL CUSTOMERS IN THE AMOUNT OF USD 14.3 MILLION,
WITH AN ANNUAL INTEREST RATE OF 24 PERCENT.


9. JELASIC DEFENDED THE MEASURES BY ARGUING THAT BANKS ARE
FREE TO CONTINUE CONSUMER LENDING AS LONG AS THEY ARE WILLING
TO INCREASE THEIR EQUITY. HE NOTED THAT ONE TARGET OF THE
MEASURES WAS THE PRACTICE OF CERTAIN BANKS TO FUND THEIR
LENDING VIA SHORT-TERM DEPOSITS FROM PARENT BANKS. THE BANK
HOPES TO PROMOTE A GREATER RELIANCE ON DOMESTIC DEPOSITS TO
FINANCE LENDING, SINCE THEY REMAIN SUBJECT TO A LOWER RESERVE
REQUIREMENT OF 40 PERCENT. WHEN ECON CHIEF ASKED WHEN HOW
THE BANK PROPOSED TO EXIT FROM SUCH QUANTITATIVE LIMITS ON
RETAIL LENDING, JELASIC SAID THAT THE LIMITS COULD BE
ADJUSTED OVER TIME AS CONDITIONS WARRANT.


10. THE TIGHTENING PROVOKED VOCAL OPPOSITION AMONG COMMERCIAL
BANKS. JUST TWO DAYS AFTER THE NATIONAL BANK INTRODUCED THE
MEASURES, GERMAN-AUSTRIAN HVB BANK ANNOUNCED THAT IT WOULD BE
FORCED TO INCREASE RATES ON ALL RETAIL CREDITS, EXCEPT
MORTGAGES. ANNUAL INTEREST RATES FOR CONSUMER CREDITS WILL
RISE TO 14.77 PERCENT. ALEXANDER PICKER, HVB GENERAL MANAGER,
SAID HIS BANK WOULD FEEL THE PINCH IMMEDIATELY, SINCE IT
ALREADY IS AT THE 200 PERCENT LIMIT FOR RETAIL LENDING IN
RELATION TO EQUITY. OTHER BANKS, WHICH ARE MORE HIGHLY
LEVERAGED, WOULD BE HIT HARDER, HE SAID. THE CENTRAL BANK'S
APPROACH IS NOT MARKET-BASED, HE COMPLAINED.


11. THE HEAD OF THE MANAGEMENT BOARD OF RAIFFEISEN BANK,
BUDIMIR KOSTIC, AGREED THAT THE LATEST MEASURES WILL PUSH
BANKS TO RAISE INTEREST RATES BY 2-2.5 PERCENTAGE POINTS. HE
ARGUED THAT THE CENTRAL BANK'S POLICY WILL DECREASE
COMPETITIVENESS BY INCREASING COSTS TO THE CORPORATE SECTOR.
KOSTIC, WHO ALSO IS THE HEAD OF THE SERBIAN ASSOCIATION OF
BANKS, WARNED THAT THE CENTRAL BANK'S TOUGH MONETARY POLICY
HAD FAILED TO CURB INFLATION OVER THE PAST TWO YEARS. HE
ATTRIBUTES HIGHER INFLATION TO LOW PRODUCTIVITY, HIGH PUBLIC
SPENDING AND FUEL PRICE HIKES, RATHER THAN LENDING TO THE
ECONOMY.


12. MOST OF THE COMMERCIAL BANKS, AT LEAST MARKET LEADERS
SUCH AS RAIFFESEN BANK AND HYPO ALPE ADRIA BANK, GRUDGINGLY
ACKNOWLEDGE THAT THE NBS HAS REASON TO FOCUS ON RETAIL
LENDING, BUT THEY ARGUE THE MEASURES SHOULD NOT TARGET THE
CORPORATE SECTOR. THEY WORRY THAT MORE COMPANIES WILL SIMPLY
BORROW OVERSEAS; SOME BANKERS WARNED THAT LOCAL BANKS WILL
SIMPLY SELL THEIR LOANS TO THEIR OVERSEAS PARENTS. AT THE
SAME TIME, BANKERS AGREE THAT CONSUMERS WILL CONTINUE TO
BORROW, DESPITE HIGHER RATES, BECAUSE OF PENT-UP CREDIT
DEMAND.

INFLATION DEBATE CONTINUES
--------------


13. THE CENTRAL BANK AND ECONOMISTS AGREE THAT HIGH AGGREGATE
DEMAND IS CAUSING BOTH INFLATION AND CURRENT ACCOUNT
PRESSURES. THE DEBATE FOCUSES ON THE EXTENT TO WHICH DEMAND
PRESSURE IS THE RESULT OF RISING PRIVATE CONSUMPTION DRIVEN
BY SURGING COMMERCIAL BANK LENDING, AS OPPOSED TO THE HIGH
LEVEL OF PUBLIC SPENDING AND AN UNRESTRUCTURED PUBLIC SECTOR.


14. ALTHOUGH SERBIA RECORD A BUDGET SURPLUS OF 2.2 PERCENT OF
GDP IN 2005 AND PROJECTS A 1.3 PERCENT SURPLUS THIS YEAR,
MANY BELIEVE THAT THE HIGH LEVEL OF SPENDING (CONSOLIDATED
BUDGET REVENUES IN 2005 WERE 43.5 PERCENT OF GDP) IS FUELING
INFLATION. THE GOS EXPECTS A PRIVATIZATION WINDFALL THIS
YEAR, WITH ADDITIONAL REVENUES OF MORE THAN 1 BILLION EUROS
EXPECTED FROM SELLING THE SECOND CELLULAR PROVIDER AND TWO
BANKS. ALTHOUGH THE GOS PROMISED THE INTERNATIONAL MONETARY
FUND (IMF) THAT IT WOULD SAVE ALL ADDITIONAL REVENUES,
FINANCE MINISTER DINKIC HAS ARGUED PUBLICLY THAT INFLATION IS
NOT A SERIOUS THREAT, WHILE THE NEED TO GENERATE GROWTH AND
EMPLOYMENT THROUGH PUBLIC WORKS IS MORE PRESSING. JELASIC
WARNED THAT 1 BILLION EUROS IS 17 PERCENT OF SERBIAN BUDGET;
SUCH EXPENDITURES, EVEN OVER SEVERAL YEARS, SURELY WOULD
EXACERBATE INFLATION.


15. AT A RECENT ROUNDTABLE IN THE NATIONAL BANK, STOJAN
STAMENKOVIC, A PROMINENT LOCAL MACROECONOMIST, MAINTAINED
THAT HIGH INFLOWS OF FOREIGN CAPITAL ARE THE MAIN CAUSE OF
INFLATION, TOGETHER WITH THE LOW DEGREE OF COMPETITION IN THE
RETAIL SECTOR. ON THE OTHER HAND, VLADIMIR GLIGOROV, AN
ANALYST WITH THE VIENNA INSTITUTE FOR INTERNATIONAL ECONOMIC
STUDIES, ARGUES THAT ALL OTHER COUNTRIES IN THE REGION HAVE
FACED SIMILIAR INFLOWS, ALONG WITH SIMILAR PROBLEMS SUCH AS
THE GROWTH OF SALARIES ABOVE PRODUCTIVITY AND EUROIZATION,
BUT ALMOST NONE OF THEM HAVE SUFFERED SUCH INFLATION. HE LAYS
THE BLAME ON HIGH PUBLIC EXPENDITURES.


16. ON THE OTHER HAND, SOME ECONOMISTS CLAIM THAT NATIONAL
BANK SHOULD FURTHER TIGHTEN THE MONETARY POLICY, TO CURB
DEMAND AND INFLATION. STAMENKOVIC EVEN SUGGESTED THAT
ADMINISTRATIVE MEASURES FOR LIMITING THE FOREIGN CREDITS
SHOULD BE CONSIDERED. HE PROPOSED LIMITS ON FOREIGN DEBT
CONNECTED TO A BANK'S EQUITY CAPITAL, ALONG WITH A DECREASE
OF THE REQUIRED RESERVE ON DOMESTIC DEPOSITS FROM THE PRESENT
40 PERCENT.

RISING CURRENT ACCOUNT DEFICIT AND EXCHANGE RATE
-------------- --------------


17. THE CENTRAL BANK ALSO IS CLOSELY WATCHING THE CURRENT
ACCOUNT. THE FOREIGN TRADE DEFICIT IN THE FIRST QUARTER OF
2006 WAS 34.4 PERCENT HIGHER THAN IN THE SAME PERIOD OF 2005,
BUT ABOUT 10 PERCENTAGE POINTS LOWER THAN THE SAME PERIOD OF

2004. HOWEVER, JELASIC, POINTING TO THE DISTORTION OF EARLY
2005 RESULTS BY IMPOSITION OF A VAT, SAID HE WAS NOT
ESPECIALLY WORRIED BY THE FOREIGN TRADE NUMBERS.


18. THE POSITIVE DEVELOPMENT OF EXPORTS, UP BY 27.6 PERCENT
IN THE FIRST QUARTER, CONTINUED DESPITE DINAR APPRECIATION.
(THE DINAR APPRECIATED IN REAL TERMS 3.5 PERCENTAGE POINTS
RELATIVE TO THE EURO.) THIS INDICATES THAT THE LOW RATIO OF
EXPORTS TO GDP (ABOUT 20 PERCENT IN 2005) IS MORE THE RESULT
OF STRUCTURAL WEAKNESSES IN THE ECONOMY. JELENA PETKOVIC,
THE GENERAL MANAGER OF TIGAR CORPORATION, SERBIA'S THIRD
LARGEST EXPORTER, SAID THAT TIGAR WOULD NOT EXPORT MORE IF
THE EXCHANGE RATE HAD BEEN DIFFERENT, ALTHOUGH SHE DID
EXPRESS CONCERN OVER INFLATION.


19. THE CURRENT ACCOUNT DEFICIT FOR THE FIRST QUARTER REACHED
EURO 478 MILLION, WELL BELOW THE FOREIGN CAPITAL INFLOW (EURO
804 MILLION). HOWEVER, THE FINANCING WAS THROUGH RISING
INDEBTEDNESS.


20. ECONOMISTS AND BANKERS AGREE THAT THE EXCHANGE RATE
SHOULD BE SET BY THE MARKET, THAT DINAR SHOULD BE LET TO
APPRECIATE. HOWEVER, JELASIC SAID THAT THE BANK IS STEADILY
DECREASING ITS INTERVENTION IN THE FOREIGN EXCHANGE MARKET BY
LOWERING ITS PURCHASES FROM EXCHANGE BUREAUS. DATA BEARS OUT
HIS ASSERTION; THE NBS SHARE OF FOREIGN EXCHANGE PURCHASES
FROM RETAIL EXCHANGE DEALERS DECREASED FROM 55 PERCENT IN
2005 TO 44 PERCENT IN THE FIRST QUARTER. JELASIC SAID THAT
THE BANK MORE AND MORE WAS FINDING DEMAND FOR EURO WEAK IN
ITS FIXING SESSIONS, WITH COMMERCIAL BANKS UNDERCUTTING THE
CENTRAL BANK'S RATE.


21. ECONOMIC ANALYSTS AGREE THAT CAPITAL OUTFLOWS SHOULD BE
LIBERALIZED TO PERMIT THE MARKET TO DETERMINE THE EXCHANGE
RATE AND TO RELIEVE THE PRESSURE FROM HARD CURRENCY INFLOWS.
ACCORDING TO JELASIC, THE NATIONAL BANK WILL NOT INTERVENE TO
STOP DINAR APPRECIATION, BUT STILL WILL NOT FULLY LIBERALIZE
CAPITAL OUTFLOWS BY ENDING RESTRICTIONS FOR INDIVIDUALS.

POLT