2008 Budget Revision and Fiscal Policy Guidelines for 2009

1. 2008 Budget Revision and Fiscal Policy Guidelines for 2009 Minister Dr Diana Dragutinovic

2. Assessment of latest macroeconomic trends • Fast economic growth: • Average growth rate over the past three years was 6.5%, expected growth this year is around 7% • The growth is relatively widely diversified (a large number of branches has average and above average growth) • Export grows at around 25% rate and is also highly diversified • But with large imbalances: • current account deficit last year was 14.7% of GDP; it will reach some 18.4% this year • external debt isaround 60 % of GDP, • y-o-y inflation at the moment is 9.5%, it will probably be slightly lower • This growth model is unsustainable in the long!

3. Macroeconomic outlook for 2009 • Positive tendencies in Serbian economy are expected to continue: • 6.5% GDP growth • inflation rate declining to 6%-7% • cutting unemployment rate by 0.8 percentage points of GDP • cutting current account deficit by 0.6 percentage points of GDP

4. Assumptions for realization of macroeconomic objectives • Accelerating reforms toward building a complete market economy • Continued European integrations • A counter-cyclical combination of monetary and fiscal policy that would lead to: • cutting the inflation to 4% in 2012 • reducing current account deficit • Raising investments rate to 25-27% annually (EUR8-10 billion annually) • creating a favorable climate for private investments • building a modern transport, energy and telecommunications infrastructure

5. Macroeconomic projections

6. Major macroeconomic risks • Continued expansion of domestic demand, realized through: • rising current expenditure • pension increase • subsidies etc. increase • rising wages • rising credit activity • planned high investment growth • Continued global market crisis

7. Potential effects of the global financial crisis on Serbia • Dynamic economic growth, with relative macroeconomic stability, is sustained due to foreign capital inflow in the form of loans and foreign investments amounting to at least 18% of GDP (EUR 6-7 billion) • A considerable and lasting drop in capital inflow would cause a crisis on the forex market and in the balance of payments • Forex market destabilization may accelerate inflation • A considerably lower inflow of foreign loans and direct investments would result in declining investments and decelerated economic growth of Serbia • Unfavorable situation on the global financial market would complicate financing of the fiscal deficit and realization of infrastructure projects in Serbia

8. The role of fiscal policy in realization of macroeconomic objectives and risk minimization • Fiscal policy should: • Contribute to lowering of the aggregate demand, which is vital for reducing inflation and foreign deficit and maintaining foreign and public deficit within sustainable framework • Contain the current expenditure, which is of vital importance: wages, pensions, subsidies, soft budget loans etc. • Use public investments and tax and other incentives to contribute to increase of economic activity, higher employment and reduction of regional differences • Use regulatory reform to create a more favorable climate for growth of private investments and employment

9. METHODOLOGICAL NOTES • To measure overall fiscal results, we will use the standard methodology (comprehensible worldwide) that enables comparisons with other countries • However, it is wise to be conservative and not creative when applying the standard methodology on a non-standard case • The previous methodology on average: • overestimated regular revenue (mobile telephony license); • underestimated regular expense (soft loans, debt to pensioners, etc.); • made the total fiscal result better!

10. Assessment of Serbia’s fiscal performances • Fiscal burden and government expenditure in Serbia are high • revenueat 42.7% of GDP, expenditureat 45.4% of GDP • Government expenditure and revenue to GDP ratio in Serbia are: • slightly above the level of Central European countries, whose level of development is two times higher than Serbia’s • considerably higher than in countries that are at the same level of development as Serbia (Bulgaria, Romania...) • Fiscal deficit in Serbia: • spans between 1.5 and 2.7% of GDP, • which is far above the average of countries in transitions • and meets the Maastricht requirement • ... but is inadequate for Serbian economy: • because of the high domestic private demand • because of the need for large investments, though domestic saving is low

13. Reasons for 2008 Budget Revision • New priorities of the new government: • accelerated building of infrastructure • financial incentives for strategic investments, • improving situation of pensioners, • financial assistance to talented persons etc. • Part of the priorities has already been formalized through regulations and agreements: • Decree on Extraordinary Pension Increase • Agreement with FIAT • Agreements with infrastructure contractors • Decree on Talented Persons • Aligning the budget with macroeconomic developments

14. 2008 Budget Revision

15. Financing of the Republic of Serbia budget deficit and debt repayment in 2008

16. The political agreements left little room for managing a sustainable fiscal policy • However, proposed Revision is a reasonable compromise in the given political circumstances (reasonable, because fiscal rules have been observed!)

17. Macroeconomic consequences of the budget revision • Revenue/GDP ratio increased by 0.4%, expense/GDP ratio rose by 0.6%, while deficit/GDP ratio grew by 0.2% • The Revision has not increased considerably the expansiveness of the fiscal policy, but it was realized in an atmosphere of high demand and overheated economy • It is necessary to take the turn toward cutting the share of government expenditure and fiscal deficit in GDP as of 2009 already

18. Macroeconomic frameworks for a sustainable fiscal policy in 2009 • Cutting consolidated government expenditure from 45.4% of GDP in 2008 to 44.3% of GDP in 2009 • Reducing the fiscal deficit from 2.7% of GDP in 2008 to below 2% of GDP in 2009 • Considerable change in the structure of government expenditure toward increasing the share of public investments (Corridor 10 etc.) • Enhancing government spending management • Continued tax system reforms

19. Fiscal policy measures – government revenue • Objectives: to continue tax reforms and tackle tax evasion • Aggregate result of changes to tax legislation every year should be revenue-neutral or positive • Tackling the grey economy • Nonselective combating of classic forms of evasion (smuggling, black labor market), • Streamlining regulations in order to tackle “new” forms of fraud, • Enhancing the coordination between the Ministry of Finance, Ministry of Internal Affairs and the Prosecutor’s Office in exposing and sanctioning fraud

20. Fiscal policy measures – government expenditure • Real wage bill growth around 2% in 2009 • Cutting the expenditure on goods and services from 7.2% of GDP in 2008 to 6.7% in 2009 • Cutting the share of subsidies in GDP from 2.8% in 2008 to 2.6% in 2009 • Reducing budget borrowing and recapitalization from 0.9% of GDP in 2008 to 0.7% in 2010 • Redirecting savings made on subsidies, lending and recapitalization to public investments, primarily to Corridor 10. • Directing at least 50% of the NIP towards financing of Corridor 10

21. Conclusions • Continued fast economic growth calls for reducing internal and external imbalances to a sustainable level, meaning: • gradual reduction of government expenditure relative to GDP, • moving from a fiscal deficit into a fiscal surplus, • restrictive monetary policy... • It is macroeconomically unsustainable to increase synchronously expenditure for: • pensions, • investments into infrastructure, • incentives for strategic investments, • start-up loans, • farm subsidies, • population policy, • science, • environmental protection etc. • Therefore, we need to establish priorities within a macroeconomically sustainable fiscal policy

22. Conclusions • In the area of fiscal policy, it is vital to define priorities on the expenditure side • Establishment of priorities entails that: • some projects are realized entirely, • while others are realized only partly, • realization of some projects is postponed for a particular period of time, • some projects are abandoned. • The criteria for project selection should be their potential contribution to economic and social objectives defined in the Memorandum, the Prime Minister’s exposé and coalition agreements • The result of projects/plans selection should be a lower share of government expenditure and fiscal deficit relative to GDP

23. Conclusions • Any attempt to realize all election campaign promises and all demands of budget beneficiaries and interest groups would result in a higher fiscal deficit. • It is very unlikely that the deficit could be financed because: • expected privatization receipts are modest, • domestic financial market is underdeveloped, • the end to the global financial crisis is nowhere in sight, • Serbia’s credit rating is low and would be even lower with such a policy. • Due to inability to provide funds to finance the deficit, there would be delays in settling the liabilities.

24. Conclusions • For a successful realization of the Government’s economic objectives, all coalition members need to assume responsibility for the government’s overall results, and not only for results in “their” line ministries. • Teamwork would entail relinquishing the previous practice of various ministries autonomously undertaking obligations, without consulting the Ministry of Finance and the government. • It is necessary that all ministries introduce rigorous savings measures and to make a rationalization plan of revenues within their jurisdiction. • Major tax rates cannot be reduced in the coming period • Within the EU accession process, Serbia will lose around 1% of GDP in customs duty revenues over the next 2-3 years.