New G rowth M odel in Serbia : New Investment O pportunities

1. New GrowthModel in Serbia:New Investment Opportunities Diana Dragutinović

2. Main Themes • Serbian economy has gone through the crisis well • Financial sector is resilient and well managed • No signs of direct Greek contagion • Macroeconomic management further strengthening • Monetary policy based on IT (inflation targeting) • Efforts to increase transparency of budgetary procedures and implement a rule-based medium-term fiscal sustainability framework • Campaign to reduce euroization of the economy • Large investment opportunities • Exchange rate depreciation has sheltered the economy during the crisis, while at the same time adding to the attractiveness of domestic assets • Investors to bring technology, infrastructure investments

3. Before the Crisis • The growth of 6.5% in period 2004-2008 was one of the strongest GDP in CEE • Like in other countries in the Region, the growth came from big capital inflow • donor support (2001 -2003) • FDIs, mainly privatization • bank privatization and recapitalization from abroad • cross - border lending  • High growth, but also high CAD • CA deficits huge by regional standards • Only meaningful if used to build an export base and generate future savings

4. Growth record impressive? • Judging against the past – the growth rate was impressive: judging against the potential – not impressive at all • The catch-up growth potential should be much bigger given the starting conditions of • Low productivity • Low capital base • Relatively highly educated labor force

5. Previous growth model not sustainable • Based on domestic consumption • share of private consumption close to 75%, largely covered by imports • low (virtually zero) private sector domestic savings flows • Investment share in GDP low, in particular in the export sector • Low export base • Based on non-tradable sector • While three non-tradable sectors(trade, transport and telecommunications and the financial sector) grew rapidly (15% on average) generating 75% of the overall growth, industry was mainly stagnant (growth of 2% per year) –growth model which resulted from the structure of FDI inflows: 20% in tradable and 80% in non-tradable in 2004-2008 period

6. Weak points, but also strengths • In October 2008, Serbia suffered a sudden stop and strong ER depreciation, but trigger was more psychological, less fundamental • After the news spun that a company with the name resembling the name of one local bank failed, the reaction of households was panicky; • household started to withdraw their deposits; • they withdrew almost one billion (20% of HH savings)

7. Weak points, but also strengths • Crisis showed us weak points, but also strengths • Weak points • External imbalance • Financial system vulnerable to E.R. fluctuations • Procyclical fiscal policy • Frequent elections led to loose fiscal policy • Strengths • Low level of public debt • Adequate level of FX reserves • Very robust financial sector, with strong liquidity and capital base

8. Serbia has gone through crisis well • Serbia did not avoid the downturn, like China and Poland, but frequent crises in the past made Serbia more resilient and adaptable • Better growth performance than the region • Decline in GDP was bellow 3% in 2009, but with enormous CA adjustment (deficit decreased from 18.5 to 5.7%) • Net exports recovering fast in response to exchange rate depreciation

9. Serbia has gone through crisis well • Relatively small drop in output

10. Serbia has gone through crisis well • Inflation on the target during the crisis • Only recently undershooting – expected to be back on target in 2011 • First time in years inflation is on a similar level as in regional peers

11. Sound macroeconomic management during the crisis • Flexible IT monetary policy • Responsible fiscal policy striking a balance between the cyclical deficit and debt sustainability • IMF program

12. Sound macroeconomic management during the crisis • Flexible IT monetary policy • NBS increased interest rate to defend ER and intervened at F/X market provided floor for ER and FX liquidity, but allowed moderate exchange rate depreciation • Prudently managed and resilient financial (banking) sector

13. Sound macroeconomic management during the crisis • Responsible fiscal policy striking a balance between the cyclical deficit and debt sustainability • Government froze public sector wages, pensions and purchasing goods and services, to make more room for fiscal stimulus: • Investment in major road network Corridor 10 • subsidized loans to provide liquidity / investment for companies • subsidized loans for newly built apartments to boost construction industry • measures focused on keeping people in work • extendingsubsidies / lending to companies with perspective • covering the part of labor costs to support current and new jobs

14. Sound macroeconomic management during the crisis • Government agreed on program with IMF providing support for f/x reserves and giving the credibility to policies • Based on 3 pillars: • Fiscal adjustment in Serbia – to lower domestic demand, and to ease pressures to the CAD • Commitment of the foreign banks to continue supporting Serbia (Vienna accord – prevents potential capital outflows, and ease pressures to corporate BS • Role of the IFI’s – project loans and budget support, provide FX inflows, liquidity to the budget and infrastructure projects that stimulates the economy

15. Good initial position for addressing a possible Greek contagion • Greek scenario is not a threat • Deficits of 4%, public debt of 30% • Greek contagion possible only indirectly • through parent banks • through general aversion to risk • But we are not seeing any signs of a serious contagion • Banking sector is liquid, profitable, with high capital buffers, share of Greek banks relatively small • Newly introduced auctions of 18M T-bills met with a great interest of both domestic and international investors

16. Resilience of the banking system: well capitalized Capital adequacy ratios ( in %) ( in bln RSD) CAR regularly stress tested Source: NBS, national central banks

17. Resilience of the banking system: liquid Source: NBS

18. Resilience of the banking system: well funded Source: NBS

19. Resilience of the banking system: profitable despite rising NPLs Source: NBS

20. Resilience of the banking system: share of Greek banks small • Greek owned banks well capitalized and relatively limited exposure Source: NBS

21. Financial system vulnerability: high FX exposure Source: NBS

22. Agenda for Going Forward • Make growth more robust • Ensure sustainable external balance • Make the financial system more resilient with respect to exchange rate risks • Make monetary and fiscal policies more effective and transparent

23. Serbia faces four interlinked transitions • From consumption to export led expansion • From using foreign savings to generating domestic savings • From a highly euroized to a dinar based economy and financial system • From a traditional fiscal system based on rolling deficits and discretion to a rule-based framework and sustainable structural deficit

24. 1. Moving to Export-led Growth • Why? • we need growth that is consistent with external balance • Successful export led strategy generates sustainable demand for other sectors and services • How? • improve formal sector business environment • Upgrade infrastructureneeded to support the export led strategy • Tax system conducive to growth and employment, while remaining tax competitive • Sustainable fiscal policy • Weeker dinar may be of help in rebalancing economy • Serbian mentality and competitive labor force (half of population speak some English); efforts to contain wage growth below productivity growth • revive privatization • foster trade flows (Western Balkan Trade Pact, EU SAA, WTO) • FDI in tradables (the clear vision of which non-financial sector will drive growth in the future)

25. 1. Moving to Export-led Growth: Foreign investments • Capital inflows of all sorts and maturities are welcome • Capital inflows needed even in the new growth model • But we give preference to such flows and arrangements in which the risks are shared by the foreign investor and not left with the domestic economy and its financial system • Before the crisis, much of the currency, credit and maturity risk was born by domestic consumers, businesses and the local banking sector • Ideal examples are FDIs, joint-ventures or direct purchase of T-bills In such investments • the investor is expressing the faith into the domestic economy and share its potential

26. 2. Encouraging savings • Why? • Domestic savings would increasingly be a source of domestic investment (foreign savings are too high and unstable in Serbia); • Serbia seems to save (and invest) much less than peers (Rom, Bul, Cro) • How? • Sustained growth acceleration • Public saving • Privatization (corporate savings) • Deeper capital markets? • Pension system pillar II? • Other incentives? – at least make the level play field for savings

27. 2. Encouraging savings: ongoing • We are developing the government T-bill market • Main current constraints can be sorted out soon • Low volumes • Short maturities • Absence of foreigners • Currently most buyers are local banks whose needs are not yet satiated – i.e. have no interest to sell on the secondary market • Remaining technical/legal constraints on OTC trading • We are building institutions: • Secondary T-bill market • Corporate / municipal bond market • FX hedging and derivative market • We are building a yield curve • We shift from short maturity (3 or 6 months) to longer maturity (12, 18, 24 months)

28. 3. Trimming Euroization: a tall order? • Why? • To make monetary policy more effective and resilient; re-establish key IT links (interest rate and credit channels) • Enhance benefits from the flexible exchange rate regime (i.e., for trade) • Protect balance sheets from ER shocks – strengthening exporters’ hand • Achieve balanced financial market development • How? • Flexible exchange rate IT monetary policy • Educational campaign • Promotion of T-bill, bond and hedging markets • Facilitation of FX to dinar credit conversions • Government provides only dinar based credits (with only one exemption – mortgage loans); provides subsidies only to dinar based credits and deposits or for FX to dinar conversions

29. 4. Fiscal policy for the stable future • We are aware that the fiscal policy should be the magic wand that we are looking for • On the expenditure side, fiscal responsibility legislation is on our agenda • How to achieve medium-term fiscal sustainability? • Base monetary and fiscal policies on the same principles • For a fiscal framework to be credibly sustainable it must be based on: • Transparency in targets and instruments • Simple rules • Clear mandate and independence of analysis

30. Medium-term fiscal sustainability: Targets and Instruments • Targets • aim at fiscal balance over the cycle • Instruments • Based on expenditure rather than revenue • Revenues based more on indirect than direct (especially labor) taxes • Simple expenditure ceilings and rules • Allow for easy monitoring and individual accountability • May be countercyclical by design: if growth is on the upside, use the revenues for debt reduction

31. 4. Medium-term fiscal sustainability: Adjustment period • Adjustment period: 2011 – 2015 • Bring the deficit down gradually to 0%-1% GDP in 2015 • Key issues – 2011 fiscal adjustment, particularly wage and pension policy (real growth below GDP growth) • After 2015 – balanced (over the cycle) rules • aim at fiscal balance over the cycle: the primary structural deficit close to zero

32. Medium-term fiscal sustainability: Transitional rules • Transitional rules • We set a path for public expenditures cuts (by 0.75pp per year), but excluding investments • We set a rule for public sector wages / pensions adjustment (expected inflation plus 50% of real growth) • We set corrective mechanisms (in case we do not make public expenditure cuts that we planned, the taxes will be increased) • We set the limit on public debt (including guarantees) to 40% • We set the limit on new net borrowing (including guarantees) to max 2.5%

33. Medium-term fiscal sustainability: Transparency and Mandate • A more efficient and transparent budget process • Already partly implemented • Clear procedural rules allowing for all information to be available on time • Enhances discipline and accountability • More comprehensive and detailed information gathering and analysis • Independent fiscal council • Legal proposals on the new rule-based system are on the table • Should also include a reform on a municipal level

34. Is fiscal consolidation appropriate in the post-crisis situation? • Consolidation can be successful both in stabilizing debt levels as well as being pro-growth • Especially if the program is decisive and based on expenditure cuts (and eventually) indirect taxes • Decisiveness and sense of urgency (wrt to Greece fallout) may help to make consolidation popular with the electorate • Channels • People’s expectations of an even worse situation in the absence of consolidation create a positive wealth effect of consolidation • Lower costs of borrowing – both private and public • Higher attractiveness of domestic stocks and bonds • Induce higher labor supply

35. Is fiscal consolidation feasible? • Political will to embrace these proposals is critical • Credible rules cannot be imposed from outside • The program needs to be made equitable • Improve the efficiency of the social safety nets

36. Fiscal policy for the stable future • On revenue side • Tax system reform • Shift towards consumption taxation, diminishing taxation of factors of production • Downsize the tax wedge on wages – effects on competitiveness, employment • Better property taxation • Rethought fiscal decentralization

37. Thank you!