Macroeconomic Developments , October – December 2006

1. Macroeconomic Developments, October – December 2006 RadovanJelašić – Governor Belgrade, 29 January 2007

2. Contents • Inflation • Monetary policy • Capital inflow and external position • Monetary aggregates • Current account balance • Economic growth • Lending activity of banks • Wages and productivity • Fiscal developments

3. All that was achieved in 2006 will be sustained in 2007! Monthly inflation dynamics in 2006 (%) Annual inflation rates (%) NBS key policy rate in 2006 (%) Inflation rate in 2006 (%) Switch to 2W repo securities via fixed-rate auctions 13,00% * Preliminary data until 29 January 2007.

4. For 2007, the National Bank of Serbia has planned only the things it is certain to achieve! • Planned core inflation for 2007: 4 - 8%; NBS will target the lower band of the corridor; • Target fulfillment alone will determine the future trajectory of the NBS key policy rate in 2007! • Inflationary expectations are declining together with inflation! • Although there is still a need for a part of regulated prices to come closer to market prices, it is important to mention prices that have in the meantime moved down – Politika, petrol at NIS petrol stations, white goods, etc.

5. Differences between Serbian and foreign pricescannot be put down to the exchange rate! Example: Samsung LE 27S71 LCD television set* Eltim - Serbia Tehnomarket – Serbia Tehnomania Mediamarkt – Hungary Topvision – Germany RSD 86.195 RSD 64.999 RSD 77.999 HUF 159.999 EUR 1,098 EUR 828 EUR 994 EUR 625 EUR 549 * Exchange rate: EUR 1 = RSD 78.5000

6. All profit from price stabilization! • Pensioners – semiannual indexation to price growth; • Our investors abroad – for every euro invested abroad, they need to allocate (approximately) the same amount of dinars; • All people who save in Serbia – dinar and foreign currency savings, voluntary pension funds, shares and other investments (which erode in the context of dinar devaluation); • Corporate sector – price stability is the best way for the corporate sector to finally focus on productivity and market competition, rather than price and exchange rate movements! • Earlier criticisms such as “prices keep growing and the dinar is unrealistically strong” are now obviously out of place!

7. Decision of the Monetary Policy Committee of 29 January 2007! Key reasons: • Positive trend of declining core and headline inflation; • Need for additional sterilization in Q4 2006 due to increased budgetary spending; • Lessened pressure on the dinar exchange rate; The key policy rate of the National Bank of Serbia on 2-week repo securities has been cut from 14.0% down to 13.0% per annum! Effects on inflation

8. Price movements in the first half of the year will be determined by the following factors • Low inflation rate in Q4 2006; • Appreciation effects; • Fall in prices of petroleum products; • Restrictive monetary policy stance; • Strengthening of trust in the dinar. Price reduction Price rise • Deferred price hikes – central heating and electricity; • More expansive fiscal policies in Q4 2006; • Constitution of Government; • ...

9. 86 85 84 83 82 81 80 79 78 EUR mln The National Bank of Serbia aims at notably reducing its role in exchange rate formation... NBS interventions in IFEM August 2006 – January 2007 and RSD/EUR exchange rate movements Sale Purchase Net result in IFEM -40,1 -15,7 -9,7 +259,4 +153,5 -412,4 Net purchase from exchange offices +162,1 +148,5 +154,4 +130,9 +86,0 +34,1 Total effect on forex reserves +122,0 +132,8 +144,7 +390,3 +239,5 -378,3 * Until and including 25 January 2007.

10. ... and in 2006 its efforts in this direction were successful! Volume of interbank trade outside IFEM NBS purchases from exchange offices EUR bln EUR bln +14,2% -9,3% +13,4% +189% Number of active days of NBS in IFEM Foreign exchange trade in and outside IFEM EUR bln Banks – banks Banks – NBS * Until and including 26 January 2007.

11. Foreign exchange market will be further liberalized over the next three months EUR bln • As of 5 March, the functioning of the fixing session will change – the official middle exchange rate of the dinar against the euro will be set based on the daily weighted average trade in currencies in the overall interbank foreign exchange market; • As of 1 March, the NBS will receive only 3 currencies from exchange offices (EUR, USD, CHF); • On 1 January this year, the NBS cut the incentive fee for exchange offices to 0.5%; by the end of 2007, this fee will be lowered to 0.1%. NBS forex reserves For 2007, data as at 25 January.

12. Future exchange rate movements during 2007 • If necessary, the NBS will be ready to “iron out” excessive daily and periodical oscillations, but without interfering with the overall exchange rate trend; • Clients that have large foreign currency inflows and outflows should safeguard against foreign currency risk – especially those that have foreign currency inflow only! • The NBS aims to minimize the number of days of its participation in the market in the capacity of buyer or seller!

13. in EUR mln 6,000 Foreign 5,000 direct 2,667 4,000 investment 3,000 1,135 2,000 Borrowing 2,601 1,000 1,471 0 -1,602 Current -1,000 -2,248 account -2,000 -3,000 I-XI 2005 I-XI 2006 Capital inflow in the first 11 months well exceeded the current account deficit – there is no 1990-1991 scenario! Import and export movements in EUR mln (January-November) +11,1% 10,500 8,500 +29,3% 6,500 10,611 9,553 4,500 6,159 2,500 4,762 500 Export Import -1,500 2005 2006 • In December, annual growth rates of reserve money and broad and narrow money supply stood at 41.7%, 39.8% and 37.1%, respectively; • Total sterilization in 2006 was RSD 239 billion – RSD 125 billion through repo operations and RSD 114 billion against reserve requirement. • Import/export coverage ratio in the first 11 months of 2006 amounted to 58.1%, compared to 49.8% in the same period in 2005(excluding effects of VAT introduction).

14. 2006 2001 2002 2003 2004 2005 projection 0 -2 -4 -6 -8 -8.2 -10 -9.6 -10.5 -10.8 -11.0 -12 -12.4 -14 Ratio of current account deficit to GDP declined in 2006 and, according to projections, will be lower than in the preceding two years Current account balance excluding grants (in % of GDP) • Current account balance is improving regardless of 2006 appreciation!

15. Public external debt of the Republic of Serbia EUR bln 9 8 6.8 7 Level and structure of external debt of the Republic of Serbia 6.0 5.9 5.8 5.8 6 in EUR bln in % 5 16 65 13.1 14.9 4 15 3 60 14 8.9 2 9.9 55 Private 9.1 13 1 debt 50 12 0 54,0% 45 11 2002 2003 2004 2005 November 41,2% 10 2006 40 Private external debt of the Republic of Serbia 9 35 32.3% 8 EUR bln 25,8% 27,2% 30 7 9 8.1 25 6 Public 8 5 40,0% 20 debt 7 51.9% 59.7% 64.3% 65.7% 4 5.4 15 6 3 5 10 2 4 3.2 5 Kosovo and 1 2.5 2.3 3 8.6% 8.5% 8.1% 6.8% 6,0% Metohija 0 0 2 2002 2003 2004 2005 30.11.2006. 1 0 Share in GDP (right scale) Source: NBS. 2002 2003 2004 2005 November 2006 Private debt is gaining predominancein total external debt Strengthening of EUR against USD had a notable effect on total debt (debt increased by 27.2% in USD terms and 13.7% in EUR terms compared to end-2005).

16. Prices of petroleum products have now returned to their June 2005 level Ural oil price per barrel (USD) World oil price trends reversed in August 2006. From close to USD 70 in July, the price of Ural oildeclined to around USD 50 in January this year. Over the past five months, this has led to a 20% drop in prices of petroleum products. Retail price of petrolMB 95

17. In Q3 2006, GDP growth was around 4.6% Real GDP growth in % • Industrial production grew by 4.6% and processing sector production by relatively high 5.3% in the first 11 months of 2006 compared to the matching period of 2005; • Key contributors to such growth were the production of basic metals and non-metals, food and chemical products; Source: RSO. • Overall economic growth, including industry, has been slowing down: 8.4% in 2004, 6.2% in 2005, but 5.8% (preliminary) in 2006! • Serbia needs another “injection” and acceleration of reforms!

18. Industry unit labour costs have declined Movements in productivity and real wages in industry (2005=100) 130 • Industry productivity gains (12.3% in the first eleven months) outstripped growth in real gross wages (11.9%); unit labour costs therefore declined by around 0.4%. 120 110 100 90 80 70 60 1 3 5 7 9 11 1 3 5 7 9 11 1 3 5 7 9 11 2004 2005 2006 Productivity Real gross wages

19. In the second half of 2006, growth in lending activity underwent a slowdown! RSD bln Growth in lending activity • 2005 credit growth stood at RSD 149.4 billion, while in 2006 it equaled RSD 105.4 billion. • Lending activity slowed down appreciably in the latter half of 2006: absolute growth was lower than a year earlier; • Lending activity growth in Q4 2006 drew mainly on domestic sources of financing (corporate, household deposits, etc.).

20. Dinar savings always beat inflation! • The National Bank of Serbia launched a campaign promoting dinar savings, which not only bear a higher interest rate than foreign currency savings, but also invariably beat inflation! • For banks, dinar savings deposits are the most attractive source of financing, as they are subject to a reserve requirement ratio of only 10%, compared to 40% and 45% ratios on foreign currency savings deposits; • The aim of the campaign are not NBS savings bills, but dinar savings in commercial banks; • Over the coming months, the NBS will actively promote dinar savings in all media – the first who start saving in dinars will get the best interest and the best earnings!

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