SERBIA: FINANCIAL VULNERABILITIES RISING

UNCLAS BELGRADE 000840 SENSITIVE SIPDIS USDOC FOR 4232/ITA/MAC/EUR/OEERIS/SSAVICH E.O. 12958: N/A TAGS: ECON EINV EFIN SR MW SUBJECT: SERBIA: FINANCIAL VULNERABILITIES RISING SUMMARY -------------- ¶1. With a large and growing current account deficit estimated at almost 20% of GDP in the second quarter of 2008, Serbia's financial vulnerabilities are on the rise. Increasing levels of external corporate borrowing and a strengthening dinar are raising concerns about medium-term sustainability and the prospect of an eventual hard landing. The National Bank of Serbia (NBS) appears to be sanguine about near-term risks, but more hesitant about 2009 and 2010, especially if government spending and public-sector wages continue their ascent. The situation also highlights the need for greater levels of greenfield foreign direct investment (FDI) to boost Serbia's export capacity, reduce the trade deficit, and enhance the country's long-term competitiveness. End Summary. A DETERIORATING FINANCIAL OUTLOOK -------------- ¶2. According to unpublished data from the National Bank of Serbia (NBS),Serbia's current account deficit reached approximately 20% of GDP in the second quarter of 2008, up substantially from 13% in ¶2007. The increase is driven by a soaring trade deficit which widened by more than 20% in the first five months of the year, compared to the same period in 2007. Foreign funding has covered the burgeoning external deficit in recent years, but at a declining rate which raises questions about long-term sustainability. Capital inflows raised the NBS' foreign exchange reserves by $5.4 billion in 2006, but only by $1.2 billion in 2007. From January through May of 2008, reserves decreased by $550 million as a result of NBS intervention to stabilize the dinar and a net decline in short-term portfolio inflows. These declining portfolio flows caused Serbia's total inflows to fall $200 million short of the $3.6 billion current account deficit through May. ¶3. Veselin Pjescic, General Manager of the Monetary System and Policy Department of the NBS, told us on August 12 that the current account deficit was becoming "one of the biggest challenges to the government" and was "not sustainable." As domestic demand remains robust, foreign liabilities continue to grow. From January through July, the stock of corporate sector debt rose from $12.2 billion to $13 billion. In February 2008 the International Monetary Fund (IMF) reported that Serbia's private external debt has more than doubled since 2003, with total external indebtedness at 62% of GDP, above the 49% average for emerging markets. ¶4. Ironically, increased investor confidence in the Serbian government in the second half of 2008 could prove to be a mixed blessing. Renewed portfolio inflows and external borrowing on the part of banks threaten to increase debt accumulation, strengthen the dinar, and expand the trade deficit. Pjescic believed the dinar -- which had strengthened by 8% since May -- was overvalued, though he was uncertain by how much. Calculations suggest the dinar could be overvalued by at least 13%, taking into account the inflation differential between Serbia and Europe and assuming equal productivity rates. Serbia's year-on-year inflation rate of 15% in July and euro zone inflation of 4% imply that the dinar should have depreciated by 11% over the past year. With the dinar at 79.5 dinars per euro in July 2007, this suggests that the dinar should be traded at about 88, instead of the current 77. ¶5. Pjescic discounted the possibility of a speculative attack on the currency this year, noting that the NBS had 6 billion euros of reserves or 4 to 5 months' worth of imports. He was much more circumspect about prospects in 2009-2010 and voiced concern about "non-economic" factors (i.e. political turmoil) that might scare investors. In addition, adverse developments in global markets will continue to weigh on Serbia's financial stability. Spreads on sovereign debt remain elevated at around 350 basis points (bp), which shot up from 200 bp last fall because of the credit crisis. Five-year spreads on credit default swaps (financial contracts which insure lenders against default; higher spreads indicate greater risk aversion) have stayed at 250 bp for months after rising sharply from 150 bps last year. At that time the dinar depreciated 10% before stabilizing at the end of December. MINORITY REPORT: A MORE PESSIMISTIC VIEWPOINT -------------- ¶6. There is disagreement as to how much free reserves the NBS could bring to bear to fend off currency speculation. We also met on August 8 with Miroslav Zdravkovic who works in the Economic Analyses and Research Department at the NBS. Zdravkovic was convinced the situation was urgent and that there could be a speculative attack on the dinar in September because of loan repayments falling due during the month. His position was counter to Pjescic who believed liquidity was sufficient to absorb such outflows this year. Zdravkovic claimed foreign reserves were equivalent to only one month's worth of imports and estimated that the dinar should trade at 86 or 87 per euro. The Central Bank should also make large purchases of euros to bring the dinar down and move away from its hawkish anti-inflationary stance, according the Zdravkovic. Ultimately, only export-oriented, greenfield FDI and stringent fiscal discipline would ease the pressure by reducing the trade deficit and containing domestic demand. FISCAL POLICY UNLIKELY TO HELP MATTERS -------------- ¶7. Indications of fiscal restraint are scarce. Finance Minister and former NBS Vice Governor Diana Dragutinovic was quoted on August 8 in the V.I.P. Daily News Report saying the external deficit reflected "overwhelming demand" in the economy right now and that a restrictive fiscal policy was needed. In a bit of dry humor, Finance Ministry State Secretary Janko Guzijan, whose responsibility is to draft the government's budget, joked to us during a brief exchange on August 8 about the spending pressures placed upon him: "the less I work, the better it is for the country!" The Ministry's May 2008 policy memorandum forecasts a budget deficit of 1.7% of GDP for 2008 and 0.4% for 2009 and surpluses of 1.0% and slightly above for 2010-2011. These projections do not include the anticipated revisions in September to increase pensions by 10% and any other spending increases between now and 2011. ¶9. Pjescic expressed hope that the Finance Ministry could contain public consumption and achieve better coordination with the Central Bank on fiscal policy now that his former NBS colleague was Finance Minister. However, his attitude towards the government's fiscal restraint was guardedly pessimistic because of the new coalition's social promises, which he believed could pose increasing financial hazards in 2009 and 2010, a view strongly shared by Zdravkovic. Standard & Poor's last month pointedly did not raise the outlook on Serbia's sovereign credit rating from "negative" to "neutral." The ratings agency cited "pro-cyclical fiscal policies" as its main reason, despite the reduction in political risk from the extradition of fugitive war criminal Radovan Karadzic to the Hague War Crimes Tribunal. COMMENT -------------- ¶10. The NBS for several years has imposed numerous banking and credit restrictions which almost certainly have kept domestic demand and financial imbalances from expanding even further. Ultimately, for Serbia to avoid a harsh adjustment, the investment climate needs to improve to attract greenfield FDI which will expand export capacity and increase productivity. The key to enhancing Serbia's prospects for a soft landing therefore may rest with the Economy Ministry. It has the chief responsibility for privatizations, corporate restructuring, and bringing in foreign investors. The structural reforms that the IMF, Standard and Poor's, and other observers deem necessary to increase competitiveness fall under the Economy Ministry's writ. If the budget cannot assist in reducing domestic demand, the burden of mitigating the country's financial risks could fall entirely on the Economy Ministry and the Central Bank. End Comment. BRUSH