Download 2 ENSURING A CONDUCIVE MACROECONOMIC ENVIRONMENT

2
ENSURING A CONDUCIVE MACROECONOMIC ENVIRONMENT FOR
SUSTAINABLE GROWTH
A. INTRODUCTION
2.1
International experience provides strong evidence that high fiscal deficits and public
debt are harmful to growth and macroeconomic stability.5 There are several reasons for this.
Higher budget deficits imply lower national savings. T his, in turn can lead to lower investment
as the reduced supply of loan able funds forces interest rates higher. High deficits can also cut
net exports, for at least two reasons: (i) the resulting higher interest rates cause the domestic
currency to appreciate; and (ii) the decline in investment lowers the capital stock, reducing
productive capacity. Lower net exports also increase the economy’s vulnerability to shocks. High
public debt requires higher taxes to finance it and exerts upward pressure on real interest rates,
thereby discouraging private investment. It also undermines the flexibility of macroeconomic
policy by reducing the government’s ability to run a more countercyclical fiscal policy.
Moreover, high public debt can raise fears that an unexpected increase in inflation may be used
to reduce the debt to more sustainable levels.6
2.2
The recent experience of economies in transition also confirms the importance of
fiscal prudence for enhancing growth performance. Macroeconomic stabilization, for which
fiscal discipline is a prerequisite, has been one of the key foundations of sustainable growth.
Indeed, a recent study by Fischer and Sahay (2004) found that a 1 percent rise in fiscal surplus in
relation to GDP led to a roughly 0.5 percent increase in real GDP over the period 1989-2003.
However, the experience of economies in transition also underlines the fact that macroeconomic
stability alone is not sufficient for sustaining growth, which also requires the implementation of a
coherent program of structural reforms. The more rapidly and more consistently these reforms
are carried out, the faster the economy will pull out of the initial recession and the stronger the
subsequent upturn in growth will be.7
2.3
In light of the noted strong links between sound macroeconomic policy and growth,
this chapter discusses the key macroeconomic policy priorities needed to put Serbia on a
sustainable growth path. The remainder of this chapter is organized as follows. The next
section provides a brief overview of the recent reform progress and economic developments.
Section 3 discusses the main macroeconomic policy priorities for growth. The chapter concludes
with a comparison of two illustrative macroeconomic scenarios that bring out both the beneficial
impacts of strong macroeconomic adjustment and structural reforms, and the severe dangers of
unchanged macroeconomic policies combined with slow reforms.
2.4
The principal conclusion of this chapter is that Serbia’s efforts to promote growth should
focus on: (i) reducing the size of the public sector; (ii) altering the composition of public
expenditures; and (iii) stepping up progress in those structural reforms that would enable the
5
See, for instance, papers presented at the Conference organized by the Federal Reserve Bank of Kansas City entitled "Budget
Deficits and Debt: Issues and Options”, Fischer (1993) as well as Easterly and Rebelo (1994).
6
As shown by Calvo (1988), the temptation to inflate the debt away rises with the size of the debt relative to GDP.
7
See, for instance, Havrylyshyn (2001).
Serbian economy to achieve its full potential. With its public debt at around 79 percent of GDP
and public spending at over 45 percent of GDP, Serbia needs to give top priority to achieving a
durable reduction in the share of public expenditures in GDP. A policy shift involving a
reduction in government consumption and an increase in public investment would enhance
macroeconomic stability and improve Serbia’s growth prospects. Policy efforts in the fiscal
sphere will need to be accompanied by reform measures aimed at improving efficiency and
creating an environment that is conducive to productive investments—an issue discussed in
Chapter 4 in greater detail.
2.5
As the illustrative projections demonstrate, a muddle-through approach to reform
cannot be pursued, given Serbia’s vulnerability to internal and external shocks and the
need to improve the business climate and investor confidence. Delayed reforms may defer the
cost some difficult adjustments, but only at a price of more painful adjustments in the future.
Unwavering commitment and determined implementation of the reform program would also
enable Serbia to lock in a virtuous cycle of higher investment, savings, productivity and growth,
hence improved living standards.
B. RECENT REFORM PROGRESS AND ECONOMIC DEVELOPMENTS
The Legacy of the Past
2.6
The 1990s was a lost decade for the Serbian economy. Although the country began the
decade relatively well integrated with the world economy, and with a higher standard of living
than that in many other transition economies, the Serbian economy was devastated as a result of
armed conflicts, international sanctions, and trade shocks stemming from the break up of the
Socialist Federal Republic of Yugoslavia (SFRY) during the 1990s. This, coupled with economic
mismanagement, resulted in hyperinflation and a virtual collapse of the economy. By January
1994, monthly inflation had climbed to more than 300 million percent and recorded industrial
output had declined to less than one-third of its January 1991 level.
2.7
A stabilization program introduced in January 1994 ended the hyperinflation and
laid the foundations for some output growth and financial stability between 1994 and 1998.
Prospects improved further with the gradual stabilization of the region and the partial removal of
economic sanctions from 1995 to 1999. During this period, the economy recorded an average
real growth rate of over 6 percent. After being dramatically reduced to only 3.3 percent in 1994,
the annual inflation rate displayed an upward trend thereafter, reaching 30 percent in 1998.
2.8
These modest successes were erased in 1999, when the outbreak of the Kosovo
conflict led to a further 20 percent contraction in output. As a result, the recorded per capita
GDP fell back to below one-half of the 1989 levels, its lowest level of the decade. Inflation
rebounded to 50 percent in 1999 and over 100 percent in 2000.
2.9
During the 1990s, foreign trade also declined noticeably, with recorded exports and
imports in 2000 being 43.1 and 68.9 percent of 1989 levels, respectively. In addition, the
inability of Serbia and Montenegro (SaM) to service its foreign debt (which led to an
accumulation of interest and principal arrears plus penalties), combined with the decline in real
5
GDP, led to a sharp increase in domestic and external debt ratios, with the latter reaching 132.6
percent of GDP in 2000. Cash fiscal deficits were contained largely through unsustainable
expenditure compression, the accumulation of budgetary arrears, non-servicing of public debt,
and tolerance of quasi-fiscal deficits in the form of extensive direct and indirect subsidies
provided to households and to “socially relevant” enterprises, and directed credit at below market
interest rates.8
2.10 Concurrently, the real sector became increasingly inefficient owing to the lack of
market-oriented ownership structures, the loss of markets, the lack of access to working
capital, delayed investment and maintenance, and repressive and complex taxation and
regulation. This resulted in a decrease in real earnings, with absolute poverty roughly doubling
compared to 1990. Social protection and health services deteriorated as the available financing
fell below the existing entitlement levels. As a consequence of these various adverse
developments during the 1990s, Serbia fell behind in the transition to a market economy.
Policy Response and Donor Support during 2001-03
2.11 In January 2001, Serbia’s new government launched an ambitious program aimed
at a rapid transition to a market economy, the normalization of relations with foreign
creditors, and integration with regional, EU and world markets. The government’s economic
program rested on three pillars: (i) more prudent macroeconomic policies; (ii) market-oriented
structural reforms; and (iii) the mobilization of significant financial and technical support from
donors.
2.12 Macroeconomic policies focused on aligning fiscal deficits with available sources of
non-inflationary financing and reducing massive quasi-fiscal deficits. The greater availability
of non-inflationary fiscal financing (see para. 2.14) actually allowed cash deficits in SaM to
increase from 1 percent of GDP in 2000 to 4.5 percent in 2002.9 In 2003 the deficit was scaled
back to 4 percent of GDP, as structural reforms began to cut expenditure commitments. Quasifiscal deficits (QFDs) have been significantly reduced, partly through more realistic budgeting
(which staunched the growth of budgetary arrears) and the regularization of debt service, and
partly through reforms to contain hidden losses in key sectors such as energy.
2.13 In parallel, the SaM and Serbian governments began to lay the foundations for a
market economy. Very impressive progress in structural reform during 2001 and the first half of
2002 gave way to a period of slower but still broadly sound reform. Progress has been mixed
across areas. Notable advances have been made in the following areas: price and foreign
exchange liberalization (including early convertibility for current account purposes); opening the
country to trade and investment, management of public finances, tax policy, privatization, bank
resolution, energy, the labor market, pensions and social assistance. In most areas, however,
reforms are still incomplete, and in several areas (e.g., public administration, health, and
competition policy) the reform process has hardly begun.10 Box 2.1 presents indicators of the
level of achieved reforms in key areas, confirming strong progress in some areas (most notably
8
For a more extensive discussion of performance during the 1990s, see World Bank (2001a).
The figures largely reflect Serbia's progress, as it comprises the bulk of SaM’s GDP.
10
For a more extensive review of reform performance during 2001-03, see World Bank (2003e).
9
6
price liberalization), little progress in others (most notably competition policy), and an across the
board lagging behind the neighboring countries which had been able to commence transition at
an earlier date.11
2.14 Political change, stabilization, and reform have unlocked a greater inflow of
external resources from donors and other sources. Starting in 2001, donor support to SaM,
including support for humanitarian purposes, budget/Balance of Payments and project finance,
jumped to over US$1 billion per year on a commitment basis. As a result, disbursements of
donor support jumped from about US$ 210 million (2.3 percent of GDP) in 2000 to an average
of US$ 756 million (5 percent of GDP) over 2001-03.12 Net capital inflows were also supported
by three other factors:
•
The rescheduling of external debt (including debt to the Paris Club and the
International Bank for Reconstruction and Development (IBRD)) with the granting of
grace periods, which kept initial cash outlays for debt service at relatively low
levels;13
•
Greater privatization proceeds from sales to both foreign and domestic buyers, which
reached over 4 percent of GDP in 2003;
•
“Remonetization” through the inflow of foreign exchange assets previously held
outside the domestic banking system and increased intermediation as evidenced by
the sharp increase in foreign currency deposits from EUR 561 million in 2000 to EUR
1.76 billion in 2003.
Key Achievements to Date
2.15 The successful implementation of the economic program resulted in a number of
important early achievements. Most notably, Serbia was able to restart stabilization and
reforms without lapsing into a new bout of transitional recession of the kind experienced during
the first half of the 1990s by the Central and Eastern European countries (CEECs) and the FRY.
After growing by 5 percent in 2000 (which primarily reflected a rebound from the destructive
impact of the Kosovo crisis), SaM’s real GDP continued to grow at an annual average rate of 4.2
percent during 2001-03 (Table 2.1). Based on limited and preliminary data, this growth appears
11
Throughout this section of the report, Bulgaria, Croatia, Hungary, and Slovak Republic are employed as comparator countries.
In light of Serbia’s special circumstances arising mainly from the break-up the SFRY and a decade of delayed reform, such
benchmarking meant to illustrate the country’s relative performance and provide some guidance in determining policy priorities,
and not as an evaluation of recent reform and policy performance.
12
A large initial grant component has also worked to reduce the future burden imposed by such inflows.
13
The Paris Club agreement of November 16, 2001, involved, inter alia, a phased 66 percent reduction in the net present value of
commercial obligations and a rescheduling of the remaining stock over 22 years with a 6-year grace period. In July 2004, the
Government also reached an agreement with the London Club of commercial creditors settling Serbia’s outstanding US$ 2.7
billion debt. The agreement implies a roughly 62 net present reduction in the net present value of such debt, and reschedules the
rest over the next twenty years with 3.75 percent interest rate in the first five years and 6.75 percent interest during the remaining
fifteen years. This favorable development further supports the authorities’ efforts to reduce the external debt to GDP ratio to a
more sustainable level.
7
to have already produced a rise in the average living standard and a fall in absolute poverty from
2000 to 2002.14
Box 2.1 Serbia’s Progress in Key Reform Areas Relative to Selected Countries in the Region
Index of Price Liberalization
Index of Forex and Trade Liberalization
5
5
4
4
Bulgaria, Croatia, Hungary, Slovak Republic
3
Serbia
Bulgaria
Croatia
Hungary
Slovak Rep.
3
Serbia
2
2
1
1
0
0
2000
2001
2002
2003
2000
Small Scale Privatization
2002
2003
Large Scale Privatization
5
5
Serbia
Bulgaria
Croatia, Hungary, and Slovak Republic
4
3
2001
Croatia
Hungary and Slovak Republic
4
Serbia
Bulgaria
3
2
2
1
1
0
0
2000
2001
2002
2003
2000
Enterprise Reform
2001
2002
2003
Competition Policy
5
5
Serbia
Bulgaria
Croatia
4
Serbia
Hungary
Slovak Republic
4
3
3
2
2
1
1
Hungary and Slovak Republic
Bulgaria and Croatia
0
0
2000
2001
2002
2003
2000
Source: EBRD Transition Report, 2003.
14
See World Bank (2003c), Volume II, p. 10.
8
2001
2002
2003
2.16 The restoration of macroeconomic stability following a decade of high inflation and
rising debt ratios, was also a major achievement. Retail price inflation was reduced from
111.9 percent in 2000 to 7.8 percent in 2003 (Figure 2.1). Long-term interest rates now lie below
short-term rates, indicating some confidence that inflation will continue to be low (Figure 2.2).
Following the liberalization of the foreign exchange market and the unification of the exchange
rate in December 2000, Serbia has also achieved broad exchange rate stability. The dinar
remained close to 30 dinar to the Deutsche Mark (and later 60 dinar to the euro) during 2001 and
2002, before depreciating (appreciating) against the euro (US$) by 11.1 percent (7.4 percent)
during 2003.
Table 2.1 Evolution of Economic Activity, 2000-03
2000
Real GDP growth
GDP Growth (constant prices)
2001
2002
2003
2000
Share in GDP
2001
2002
2003
5.0
5.5
4.0
3.0
100
100
100
100
Domestic Demand
6.3
12.1
10.1
4.8
116.9
120.9
123.1
122.7
Consumption
5.3
12.4
7.5
5.1
102.7
107.2
107.0
107.0
17.0
9.2
34.4
3.2
14.2
13.6
16.1
15.7
Exports
34.8
8.6
12.3
1.8
29.6
23.7
20.7
19.2
Imports
28.6
30.0
26.3
7.2
46.5
44.6
43.8
41.8
Investment
2.17 Concurrently, Serbia’s external debt burden declined significantly from 133 percent
of GDP in 2000 to 69 percent in 2003. As most such debt is government-related, Serbia’s
public debt burden declined in tandem from 119 percent of GDP in 2000 to 79 percent of GDP in
2003 (Figure 2.3).15,16 Official foreign exchange reserves increased substantially from US$516
million at end-2000 (1.2 months of imports of goods and services) to US$3.55 billion (4.4
months of imports) at end-2003 (Figure 2.4). Even discounting the impact of the previously
noted agreement with the Paris Club, such reductions of debt/GDP were major achievements, as
they took place during a period in which pervasive quasi-fiscal problems were being brought
under control and recognized, and when Serbia gained access to new credits from official
sources.
2.18 The combination of improved macroeconomic stability and bold reforms to resolve
loss-making banks also led to a significant increase in bank deposits and large capital
inflows—mainly in the form of foreign exchange deposits. The increased funding (deposits)
allowed banks to increase loans to enterprises and households as a share of total assets from 24
percent in 2001 and 42 percent in 2002 to 46 percent in 2003.17
15
The observed rise in recorded public debt in 2001 was due to the acknowledgment of liabilities arising mainly from frozen
foreign currency deposits and old debt to pensioners.
16
The sharp increase in dollar GDP, which is mainly driven by real appreciation from the highly depreciated level of late 2000,
also played an important role in reducing the debt to GDP ratio.
17
Focusing on the evolution of loans alone in lieu of the share of loans in banks’ total assets would be misleading owing to bank
closures (the total number of banks declined from 83 in 2001to 48 in 2003).
9
Figure 2.1 Evolution of the Inflation and
Exchange Rates, 2000-03
Figure 2.2 Term Structure of Deposit
Rates
500
400.0
400
70
Inflation (retail prices)
EUR (y-o-y)
USD (y-o-y)
441.7
2001
2003
60
2002
50
300
40
30
200
20
111.9
10
100
40.7
1.8
0
14.8
7.1
0
7.8
3.0
11.0
2000
2001
2002
3-mont h
6- mont h
12- mont h
up t o 3-year
-7.4
-12.8
2003
Figure 2.3 Public Debt, 2000-03 (% of GDP) Figure 2.4 Gross Official Reserves,a 2000-03
5
130
120
4
110
100
3
90
80
2
70
60
1
50
40
0
2000
a: In
2001
2002
2003
2000
2001
2002
2003
months of imports of GS of the following year
Key Impediments to Sustainable Growth
2.19 Despite the above achievements, much more remains to be done. As shown in Box
2.1, cumulative progress in key areas of reform remains below the levels of the most successful
CEECs. Despite four years of growth, living standards remain low relative to historical standards
and popular expectations, and growth has yet to generate a visible employment response. The
still very high share of transactions and bank loans/deposits which are denominated in foreign
currency indicates less than full confidence in the long-term stability of the national currency. In
addition, Serbia’s recent macroeconomic performance remains characterized by several interrelated weaknesses.
2.20 First, a temporary increase in net external and fiscal financing allowed Serbia to
pursue a type of domestic demand-led growth that cannot be sustained once such financing
returns to more normal levels. During 2001-03, the recorded growth of domestic demand (8.8
10
percent per year, period average) outstripped that of GDP (4.2 percent period average). During
the same period, total and private consumption recorded average growth rates of 8.2 and 8.6
percent, respectively, while investment grew by 15.6 percent per year. The rapid growth of
private consumption also appears to be linked to a rise in remittances, which rose from 6.5
percent of GDP in 1999 and 9.9 percent in 2000 to over 11 percent in 2003 (Box 2.2).
Consumption growth was also fueled by increased budgetary outlays on wages and social
transfers (see below) and by economy-wide wage increases in excess of productivity growth. The
rapid growth of real wages may have contributed to the jobless nature of recovery, as it worked
to suppress labor demand (see Chapter 5 for details). By cutting enterprise profitability, rapid
real wage growth also reduced the resources available to enterprises to fund new investments
from retained earnings; and by raising relative unit labor costs, undermined competitiveness,
contributing to unfavorable current account developments.
2.21 While large and growing capital inflows and remittances helped to cushion the
initial effects of transition and to jump start investments, they also fueled a high and rising
current account deficit. The combined effect of low and slowly growing exports (Figure 2.5)18
and rapidly growing imports of goods and services (which grew by an average of 28.7 percent
per year in US dollar terms during 2001-03) was an increase in SaM’s current account deficit
(excluding official grants) from US$610 million (7.1 percent of GDP) in 2000 to a projected
US$2.6 billion (12.6 percent of GDP) in 2003. As is elaborated in the report (see Chapter 4),
structural factors such as the mixed performance in privatization, restructuring, and improving
the business climate, have contributed to the observed weak supply response and hence the
sluggish export growth. Against the backdrop of large capital inflows and remittances, the
potential adverse impact of an appreciation of the real exchange rate on the export performance
cannot be ruled out. This trend of the real exchange rate—particularly in the presence of recent
wage developments and the recent mix of tight monetary policy and still substantial budget
deficits—could have been an additional contributing factor to the unsatisfactory export
performance and supply response.19 The noted developments could, in turn, explain a clear
increase in protectionist sentiment and some attempts to stimulate activity through distortive tax
incentives—a policy shift which may offer short-term ”solutions” at the expense of longer-term
growth potential.
2.22 The structure of SaM’s current account deficit reveals two additional sources of
vulnerability. First, the source of this imbalance in a large and persistent deficit in the resource
balance (net exports of goods and non-factor services) may signal structural competitiveness
problems. Second, as shown in Figure 2.6, Serbia’s large current account deficit primarily
reflects a very low level of savings. Current account deficits are usually more of a concern if they
stem from low savings as opposed to high investments. This underscores the need to achieve a
reduction in current account deficits through fiscal and structural reforms that lead to an increase
in national savings rates.
18
Figure 2.5 shows the share of exports of goods and services in GDP in SaM and six European countries with a similar
population (ca. 8-10 million). Three are economies in transition and three are EU-15 members. In 2003, SaM’s export ratio was
only 24-46 percent of the level in comparator countries. As exports in 2000 were also less than 43 percent of 1989 levels, they
are clearly well below potential levels. Set against this significant catch up potential, export growth has been sluggish (see
Chapter 3 for more).
19
The National Bank of Serbia has pursed a more flexible exchange rate policy since at the beginning of 2003 as compared to the
previous two years.
11
Box 2.2 Economic Implications of Workers’ Remittances
In 2003, workers’ remittances to Serbia and Montenegro reached over 11 percent of GDP,
corresponding to a 58.6 percent export of goods and services. Both ratios are among the highest in the
region. As a source of foreign currency to finance imports, remittances perform a function similar to
private and public capital flows. By increasing national income and savings, they allow an economy to
spend more than it produces, to import more than it exports, or to invest more than it saves. If the
resulting increase in demand falls on tradable goods, the import bill rises. If it falls on non-tradable
goods, the relative prices of such goods increase. As a consequence, a sustained high level of
remittances can shift resources away from the tradable sector and into the non-tradable sector, leading
to a “Dutch disease” effect. This, in turn, can worsen the economy’s balance on goods and services by
reducing export competitiveness and fueling import demand.
Remittances can both positively and negatively affect growth prospects. They can be an
important source of investment financing, especially for small entrepreneurs. However, the conditions
that initially promoted the migration which led to remittances may also discourage investment.
Remittances might also create dependence among recipients accustomed to the availability of these
funds—similar to foreign aid supporting inefficient governments—thereby leading to an economic
dependence that undermines the prospects for development (Boone 1995). The effects of remittances
will therefore depend strongly on the government’s policy to promote an economic environment
conducive to investment in productive activities (Glytsos 1997).
Different studies lend support to competing arguments about the impact of remittances.
However, a particularly comprehensive recent study by Rapport and Docquier (2003) finds that, on
balance, migration and remittances produce an overall positive economic impact in the short run
(income effects and effects on the balance of payments) as well as in the long run (alleviation of
liquidity constraints for households at the middle-to-bottom of the income distribution, increased
investments in the urban and rural sectors).
Workers’ Remittances (% of GDP)
Workers’ Remittances (% of exports of G&S)
12
60
10
50
8
40
6
30
4
20
2
10
0
0
2000
2001
2002
2003
2000
12
2001
2002
2003
Figure 2.5 Exports of Goods and Services, Figure 2.6 Ratio of Investment to Current
2003, percent of GDP
Account Deficit, 2000-03
90
10
Serbia
Bulgaria (average, 2000-03)
Croatia (average, 2000-03)
Belgium
80
70
8
Czech R. Hungary
60
Bulgaria
Hungary (average, 2000-03)
Slovak Republic (average, 2000-03)
Austria
50
6
Sweden
40
4
30
20
SaM
2
10
0
0
2000
2001
2002
2003
2.23 The recent domestic demand-led growth and the resulting high current account and
fiscal deficits are not sustainable, given the likely reduction in net capital inflows. Serbia
needs to reduce its reliance on external and domestic fiscal financing on three grounds:
•
New foreign financing is likely to fall. Gross inflows of donor aid are likely to decline
and increasingly take the form of loans rather than grants. With many attractive
enterprises already sold (enterprises in the telecommunications sector being the main
exception), privatization proceeds could also decline. “Remonetization” is also not a
sustainable major source of external financing. FDI as a share of GDP is already near
regional averages, although some small increase cannot be ruled out under a very
strong reform scenario. Poor creditworthiness will limit Serbia’s access to
commercial borrowing.
•
There will be little scope for net domestic financing of budget deficits since a growthoriented policy requires the government not to crowd out the private sector, and since
public debt is already very high (see below).
•
As the illustrative projections in Table 2.2 demonstrate, rising payments to service
SaM’s foreign and public debt will work to increase capital outflows and raise fiscal
financing requirements. Important factors include the expiration of grace periods and
the need to begin servicing new borrowing.
Table 2.2: Projection of External Debt Service (in USD millions)
2002
2003
2004
2005
2006
2007
2008
183
436
1,014
1,228
1,217
Source: IMF Staff Report (July 2004)
13
1,662
2,060
2009
2010
2,241
2,215
2.24 The second weakness lies in the fact
that, despite significant declines since 2000,
Serbia’s ratios of external and public debt to
GDP remain high when compared to those of
selected countries in the region (Figure 2.7).
At end-2003, external debt and total public debt
stood at 69 and 79 percent of GDP, respectively,
which is still too high for comfort. Serbia’s
relatively low level of exports leaves its ratio of
debt to exports at a higher level than in other
countries of the region.
Figure 2.7 Public Debt in Serbia and in
Selected Countries in the Region, 2001-03
120
Serbia
Bulgaria
Croatia
100
Hungary
Slovak Republic
80
60
40
20
0
2.25 The third weakness is that a large and
2001
2002
2003
inefficient public sector remains a serious
barrier to private sector led growth. Excessive government spending negatively affects growth
by requiring the maintenance of a high tax burden (as manifest in a high ratio of tax revenues to
GDP), which hamper investment and productivity growth, and which encourage informal
activities and rent-seeking behavior. High levels of current public spending also crowd out the
public investments which will be needed to reverse the delayed investment and maintenance of
the 1990s. In 2003, Serbia’s consolidated public expenditure reached a remarkably high 47.1
percent of its GDP. Figure 2.8 Figure 2.8 Income and Government Size: Serbia vs
plots the size of government EU-15, ECA, and MENA
(measured by consolidated public
spending as a share of GDP, 19982002 average) against the level of
S e rbia
income (measured by the logarithm
of per capita GDP in PPP at 1995
prices) for the 15 EU members,
and countries in the Europe and
Central Asia and the Middle East
and North Africa Regions of the
World Bank. The fitted regression
line captures a clear positive
relationship between size of
government and a country’s level
of development. Serbia’s public
spending in 2003 is well above the Source: World Bank data.
typical level for a country at its level of income.
50
45
40
35
30
25
y = 7. 6852x +5. 5913
20
R 2 = 0. 4035
15
10
5
-
2. 3
2. 8
3. 3
3. 8
4. 3
4. 8
2.26 Furthermore, Serbia’s public spending as a share of its GDP increased rather than
decreased from 2000 to 2003. Consolidated public expenditures grew steadily from 36.5
percent in 2000 to around 47 percent in 2003. This trend partly reflected positive changes such as
the better alignment of cash outlays with commitments, and the bringing on budget of some
quasi-fiscal activities. For example, an increase in pension payments or interest costs which
reflects a move from non-payment to timely payment of pension or debt obligations is clearly
14
preferable to the continued accumulation of arrears. Similarly, the partial compensation of a cut
in the hidden fiscal obligations created by loss-making utilities with targeted subsidies and
transfers represents a net fiscal adjustment and increase in transparency. Such factors also mean
that the growth in public expenditures will have been much less on a commitment basis than on a
cash basis. A part of the increase also reflects needed transition-related expenditures and higher
public investments.
2.27 However, a part of the growth of public expenditures also came from areas where
Serbia’s spending is high by regional standards, namely, the wage bill, subsidies and
transfers. As is discussed later in this chapter in greater detail, these components have grown
from already high levels, while the level of public investments has been inadequate. Such
trends—particularly in the presence of the high public debt—hamper the establishment of an
environment conducive to growth and need to be reversed in a sustainable fashion. The revised
government budget for 2004 and the proposed budget for 2005 include encouraging first steps in
this direction.
2.28 Finally, despite the availability of Figure 2.9 Investment (% of GDP)
much foreign financing, the level of
50
Serbia
investments in the Serbian economy remains
Bulgaria (average, 2000-2003)
Croatia (average, 2000-2003)
insufficient to support rapid sustained
Hungary (average, 2000-2003)
40
Slovak Republic (average, 2000-2003)
growth.
Following
a
decade
of
underinvestment,
investment/GDP
grew
30
slightly from 14.2 percent in 2000 to a
projected 15.7 percent in 2003. However, the
20
latter level remains extremely low by regional
standards (Figure 2.9), underscoring the great
10
potential for expansion under the appropriate
policy framework.20 A failure to achieve such
0
expansion would be likely to impair growth
2000
2001
2002
2003
prospects. As noted above, low investment
rates reflect very low savings rates. During the same period, recorded gross national savings
actually declined from 10.3 percent of GDP in 2000 to an estimated 5.5 percent in 2003.21
Serbia will have to achieve a major increase in domestic savings to support a further increase in
the investment rate while at the same time reducing current account deficits.
C. MAIN MACROECONOMIC POLICY PRIORITIES FOR GROWTH
2.29 The discussion above of the remaining problems shows that Serbia’s ability to achieve
more rapid and sustained growth while increasing (formal) employment will depend on its ability
to meet two difficult and inter-related macroeconomic and structural policy challenges namely:
20
This is the lowest level in the non-CIS non-Turkey part of the Europe and Central Asia region, where investment is projected
to average 24 percent of GDP in 2003. The values for the remaining countries in that group range from 19.5 percent in Bosnia
and Herzegovina to 31.3 percent in the Slovak Republic. The average in the CIS is also projected at 22 percent of GDP, with
only Uzbekistan being below SaM levels.
21
As the gradual regularization of external debt reduced the role of debt service arrears as a source of balance of payments
financing (the share of debt in arrears was reduced from 90 percent at end-2000 to 40 percent at end-2002), the decrease in
savings on a commitment basis would have been less than reported on a cash basis.
15
•
Reducing high fiscal and current account deficits to maintain macroeconomic stability
in the face of a likely decline in non-inflationary sources of fiscal and external
financing, and to achieve sustained further reductions in public and external debt as a
share of GDP; and
•
Reducing the negative growth impact of a large and inefficient public sector by
cutting public expenditures as a share of GDP, while improving the efficiency of
public resource use.
2.30 Combining the successful implementation of these polices with key structural reforms
that foster growth and investment and harden financial discipline throughout the economy will
also promote savings, thereby enabling Serbia to lock in a virtuous circle of falling current
account deficits, higher and more productive investment, higher growth and improved
macroeconomic stability (Box 2.3).22
Box 2.3 Structural Reforms, Savings, and the Current Account Deficit
The current account deficit (CAD) is the difference between a country's gross investment (I) and gross national
savings (S) and can be written as:
CAD = I - S
Thus, if Serbia wishes to increase the rate of investment while reducing the current account deficit, it will need to
achieve a significant and sustained increase in the savings rate.
An economy’s total savings can be divided into savings by the public sector and savings by the rest of the economy
(comprising enterprises and households). In Serbia, both sectors will need to contribute. Government savings are the
difference between total revenues and total current spending, including interest and transfers. As will be argued
below, with public revenues already representing a high share of its GDP, the required increase in public savings
will need to come from a deep but well-planned reduction in the share of current public spending in GDP.
Private savings are the difference between the income and current outlays of the enterprise and household sectors. In
Serbia, private savings will be driven by three main determinants: (i) the value added by the private sector (which is
in turn closely linked to the average level of enterprise profitability); (ii) private consumption; and (iii) net transfers
from abroad (of which remittances represent the largest single component). Thus, a strong increase in enterprise
savings will require reforms to raise the average profitability of Serbian enterprises, particularly through reforms
which tackle large loss-makers. As noted in the next chapter of the report, these include privatization, enterprise
restructuring , the creation of a business friendly environment, and pressing ahead with the banking sector reform,
which would, inter alia, improve confidence in the financial system. Enhancing household savings will require
policies to moderate the growth of private consumption and ensure a steady flow of remittances.
2.31 One part of the government’s response to meeting these challenges will work
indirectly through policies which affect the non-budget sector. Such polices, which are the
subject of the remaining chapters of this report, and are only briefly noted here, will include:
•
Enhancing the economy’s export orientation and increasing the level of competition
from imports (see next chapter).
22
There is no consensus on the precise mechanisms through which growth is affected and on the direction of causality among
growth, investment, and savings. There is, however, a general agreement that savings and investment are mutually reinforcing,
and the policies that promote growth and investment will also promote savings.
16
•
Increasing enterprise and household savings, first through tackling loss making in
the enterprise sector, imposing strong enterprise financial discipline, implementing
labor market reforms to better align wage and productivity growth,23 and
implementing banking sector reform (see Chapters 4 and 5).
•
Improving the overall investment climate, which would include providing well
functioning labor, land and capital markets (to encourage reallocation of factors to
more productive uses), strengthening incentives for more efficient resource use,
improving human capital, etc.
2.32 In parallel, the public sector will directly contribute to promoting growth while
containing macroeconomic imbalances through reforms in public finance and
administration. Two key elements of this agenda, which is the subject of the rest of this section,
are the following:
•
High quality fiscal adjustment.24 Increasing public investment while containing
fiscal balances will require an increase in public savings. As revenues are already
high as a share of GDP and interest costs are given, this will require a sustained
containment of non-interest current spending as a share of GDP. As noted above,
recent trends in the level and composition of Serbia’s public spending have been in
exactly the opposite direction.
•
Further tax reform. While the bulk of adjustment must come from the expenditure
side of the budget, and containment of fiscal deficits is a priority, some further
supportive tax policy measures and improvements in tax enforcement can enhance
growth potential by supporting increased savings and efficiency.
High quality fiscal adjustment
2.33 The way in which Serbia achieves the needed reductions in fiscal deficits, current
public expenditures and public debt in relation to GDP will affect its ability to attain
sustainable growth. International experience suggests that fiscal adjustments based on durable
expenditure cuts—in particular, reductions in subsidies and transfers along with the government
wage bill—tend to be more permanent and even expansionary.25 On the other hand, fiscal
adjustments that rely on tax increases or unsustainable cuts in public investment or non-wage
current expenditures tend to be short-lived and contractionary (Easterly, 1999). By adversely
influencing expectations about the future stance of fiscal policy, policy measures that are not
sustainable would erode and even preclude the potential benefits of fiscal consolidation, such as
lower risk premiums and higher private investment.
23
This would increase labor demand, protect the retained earnings which are a major source of investment finance, and help to
shift bank credits from consumption to investment.
24
This refers to a type of adjustment in which fiscal savings are generated in a well-planned and sustainable manner backed by
reforms which address the structural source of expenditure commitments, as opposed to ad hoc cuts of cash outlays to below
levels that can be sustained in the medium term.
25
See, for example, Alesina and Perotti (1995).
17
2.34 In light of the noted evidence and the present structure of public spending in Serbia,
a durable reduction in public expenditures would need to tackle the underlying structural
sources of high spending, with a focus on the following areas: wage policy in the public
sector, the health sector, public pensions, and subsidies. These issues are explored in greater
detail in World Bank (2003d). While that report does not include the most recent developments,
its main findings and recommendations remain valid, especially those concerning the needed
shifts in the level and composition of public spending. The following paragraphs update and
summarize Serbia’s performance in key areas of public expenditure.
2.35 Wage expenditures of the Union and republican governments combined are too
high. At over 10.2 percent of Serbia’s GDP in 2003, they account for over 20 percent of total
spending (see Table 2.3). Furthermore, as shown in Figure 2.10, this ratio has been growing
rather than declining since 2001, a trend that was envisaged to continue in the initial 2004
budget. This dangerous trend needs to be tackled through reforms of the systems and policies for
determining employment and wage levels in the public administration (see the discussion
below),26 accompanied by deep reforms of the main sectors of public employment (including
health, education and internal security). As core wages are low, high spending primarily reflects
the large number of public employees.
2.36 Budget subsidies and net lending are also significant at around 4.4 percent of GDP
in 2003. While the average level of subsidies in the Serbian budget is not very different from the
regional averages, the latter have been displaying a downward trend, while in Serbia subsidies to
enterprises are on the rise (Figure 2.11). They are concentrated on a limited number of large lossmaking enterprises, most notably the state railways. Until 2001, most subsidies were not on
budget. Although the rise of allocations for subsidies in 2001-02 could reflect a shift from offbudget to budgetary channels, which improves transparency and accountability, the current level
of budgetary subsidies still appears excessive. Similarly, the observed rise in the net lending
from 0.1 percent of GDP in 2002 to 0.7 percent in 2003 calls for the containment of on-lending
to enterprises as an activity which is outside of the core functions of the state.
Figure 2.10 Wage Bill,a 2000-04
Figure 2.11 Subsidies and Transfers,a 2000-04
28
12
24
10
20
8
16
6
12
4
8
2
4
0
0
2000
2001
2002
2003
200 4
2000
2001
2002
2003
200 4
a: As % of Serbian GDP.
26
Serbia’s current public employment mechanisms assure overall control over costs, but they entrench current employment
allocations and limit the government’s ability to re-direct personnel to priority areas.
18
2.37 Serbia’s level of social transfers as a share of GDP is high at around 21 percent of
Serbia’s GDP in 2003 and is close to that of much wealthier countries, which raises
affordability concerns. The two most important of these programs are pensions and health care.
The actual level of social transfers displays high volatility, suggesting serious sustainability
problems.27
2.38 Capital spending, on the other hand, is noticeably low at 2.3 of GDP in 2003. This
item has also been volatile, suggesting its use as an in-year balancing item. Given the low level
of public investment (Table 2.3), there is strong rationale for increasing government investment
in infrastructure since this type of activity is likely to enhance the productivity of the private
sector.
Table 2.3 Composition of Expenditures: Serbia versus Selected Countriesa
Serbia
Bulgaria
Croatia
Hungary Slovak Republic
Total expenditures and net lending
47.1
40.5
51.5
47.6
41.7
Current expenditures
44.3
38.1
44.7
45.5
37.6
Goods and services
18.2
15.3
24.9
15.6
13.4
Wages and salaries
10.2
4.9
11.8
7.8
7.6
Interest payments
1.0
9.3
1.5
8.5
4.4
Subsidies
3.7
2.8
2.4
4.2
2.8
Transfers
20.8
10.6
15.9
17.1
14.1
Capital expenditures
2.3
3.3
6.5
5.6
4.7
a: Averages for 1995-2002, except Serbia for which preliminary figures for 2003 as a percentage of Serbia’s GDP
are presented.
Source: World Bank and IMF staff reports, GFS-2001.
2.39 The establishment of an effective system of public administration will be crucial for
attaining the noted high quality fiscal adjustment. An effective and efficient system of public
administration is needed to prepare government policies that would promote competitiveness and
economic growth. To create an efficient and affordable administration, public sector employment
conditions need to be overhauled to attract and retain qualified staff. At the same time, the size of
public sector employment needs to more sustainable levels. Designing a reform agenda that
would help achieve both objectives constitutes a serious challenge, made even more difficult by
the currently fragmented administrative structure and the complex coalition politics in Serbia.
The development and implementation of a broadly agreed strategic framework for reform,
facilitated by an effective reform management system, therefore emerge as important policy
priorities for achieving further progress in economic reforms (Box 2.4).
27
Greater detail is found in World Bank (2003d), Volume Two, Chapter 4 and in World Bank (2003c).
19
Box 2.4 Key Aspects of Public Administration Reform
Progress in institutional reform in Serbia has remained limited in spite of the significant donor support provided over the last
three years. This in turn poses an increasingly serious threat to the successful implementation of reforms in other areas. The
current Serbian public administration system still displays many of the features of the pre-transition period. The civil service
remains weak, politicized and demoralized, while the organization and management of the public administration system
continues to be fragmented, over-expanded and ill-adapted to the requirements of a market economy. It still operates largely on
the basis of legislation adopted in the 1970s, which was created for a state administration in an entirely different economic
system. Salary systems are highly compressed, with a ratio between the lowest and the highest pay that is as low as 1:4, while
recruitment and promotion decisions related to senior positions are mainly based on political affiliation. Civil servants therefore
lack performance incentives and, especially at the highest level, tend to operate on principles of political loyalty rather than in the
public interest.
Organizational structures and management systems have remained largely unreformed, as previous attempts to bring about
institutional reforms have in most instances failed. The failure of organizational reform also negatively affected the planned
rationalization efforts in the administration. As a result, the status quo in staffing levels was largely maintained, as evidenced by
the high level of the wage bill in relation to GDP. Strong trade union resistance to staff reductions has further stalled the
rationalization efforts.
Serbia’s new government attaches a high priority to institutional reform and has initiated a comprehensive reform process. This
includes an ambitious legislative reform agenda and the overhaul of the civil service and the broader public sector pay system, to
be integrated in an overall strategic framework for public sector reform. Reform management structures have been streamlined,
providing a better basis for effective reform design and implementation, though problems remain in staffing levels and in
recruiting staff with appropriate skills and competencies.
Successful implementation of this reform agenda hinges on addressing three short-term priorities. The adoption and
implementation of a clear administrative reform strategy and action plan that enjoys a broad political consensus is a first key
condition for effective reform. Without a broadly supported strategy and a detailed, coasted action plan, it is unlikely that any
significant achievements in PAR can be made. To this end, the Ministry of Public Administration and Local-Self Government
(MPALSG) has prepared a Strategy covering the reform of the central state administration and reforms in the system of local
self-government along with an Action Plan, which were adopted by the Government in November 2004. Addressing deep-seated
reforms in the public sector will entail a sustained policy effort over a period of four to five years. Furthermore, gaining the
support of the powerful public sector trade Unions is crucial if implementation is to be successful, which adds further
complications to the process. Therefore, maintaining the current momentum is possible only under strong and consistent political
leadership.
The establishment of a reform management structure with clearly assigned responsibilities and accountability is an important
second priority for successful administrative reform in Serbia. It would therefore be very important for the new government to
create a strong PAR management structure, with a clear assignment of responsibilities and a well-staffed secretariat. The creation
in June 2004 of a cabinet-level Public Administration Reform Council, chaired by the Prime Minister, constitutes an important
first step. The noted Council would need to be adequately staffed and to coordinate closely with the Government Secretariat with
the objective of ensuring that PAR measures are effectively implemented according to set deadlines.
The sequencing of reforms is a crucial third priority for carrying out the PAR agenda in an effective manner. Organizational
reform and the rationalization of public sector employment need to proceed, or at least run parallel with, improvements in the
civil service system, so that reforms will be fiscally affordable. This means that the government in its reform package, should
prioritize legislation on the institutional structure and organization of the administration, in order to provide a basis for
rationalization efforts. Improvements in the employment and incentive system can be phased in as rationalization frees up fiscal
resources. The development of a clearly sequenced Action Plan for reform is therefore a crucial element of the process. The
completion of the recent review of the Civil Service Wage System based on which the Ministry of Finance and MPALSG issued
a joint policy statement (endorsed by the PAR Council) outlining the direction of reforms in key policy areas represents an
important step towards achieving this objective.
The implementation of the noted policy measures in a timely manner is a key condition for the development of an institutional
system that can help sustain levels of economic growth while providing an enabling environment for private sector
development.28
28
These short-term policy actions need to be viewed as the starting point of the reform process and will have to be supported by
addressing the following medium-term policy priorities for deepening the reform process: (i) organizational reform in the state
20
2.40 A sustained reduction in fiscal deficits through the policies described above would
also improve the macroeconomic policy mix. This would provide more flexibility to the
monetary authority to support external and internal policy objectives, including the avoidance of
excessive future real exchange rate appreciation which could damage Serbia’s external
competitiveness. More specifically, different combinations of monetary and fiscal policies can
yield the same level of aggregate demand, while resulting in different outcomes for the exchange
rate, real interest rates, the composition of output, and the current account balance. In the current
Serbian context, a combination of tighter fiscal and looser monetary policy would imply a less
appreciated real exchange rate, lower interest rates, a higher share of investment (and, in general,
of interest-sensitive components of spending) in GDP, and a higher level of net exports. This
would help Serbia reduce its current account deficit while sustaining prospects for GDP and
export growth.
Tax reform
2.41 Unlike in many countries facing fiscal challenges, poor revenue collection has not
contributed to the fiscal deficit in Serbia. Serbia has actually done quite well—total revenues
as a share of GDP rose from 36.3 percent in 2000 to 42.8 percent in 2003. The tax take was
sustained during the implementation of a bold and appropriate tax reform in 2001, and during the
fiscally risky but important reform of the centralized payments system (ZOP), which had a
central role in tax collection (similar reforms in other former Yugoslav countries did bring an
initial erosion of budgetary revenues).
2.42 As the Serbian tax system raises considerable amounts of revenue, the appropriate
agenda for tax policy is to put in place a growth-promoting tax system while safeguarding
and deepening the improvements already made. A growth-promoting tax system is one that
least distorts work effort and investment as well as savings, and which minimizes demands on
administrative resources. Policy efforts aimed at attaining these objectives will in turn entail: (i)
sustaining revenues until permanent expenditure adjustment is achieved; (ii) further broadening
and harmonizing tax bases with minimal exemptions; (iii) shifting from income towards
consumption taxation in a careful manner; and (iv) improving administration and even-handed
enforcement.
2.43 Durable reductions in expenditures and public debt as a share of GDP should
precede any reduction in public revenues as a share of GDP. With high public debt, large
fiscal deficits, and declining sources of net non-inflationary fiscal financing (as discussed above),
Serbia must achieve a phased reduction in fiscal deficits. The Serbian government has no scope
to “stimulate” economic activity through fiscal deficits, and should avoid tax reforms that carry
high risks of revenue loss. Any further tax reform should be broadly revenue-neutral. Only after
the structural reforms to address the underlying causes of high public expenditures are
successfully implemented and the public debt is on a clear path to a more prudent level, should
the government allow a reduction in tax revenues as a share of GDP.
administration; (ii) de-politicization of the administration; (iii) design and implementation of new Civil Service Legislation and
Civil Service Management mechanisms; and (iv) implementation of wage reforms.
21
2.44 Given the need to maintain revenue collection, a further broadening and
harmonization of tax bases will be a prerequisite for any possible future reductions in
overall tax rates. As a general rule, broad-based taxes at lower rates are preferable to high rates
caused by the granting of numerous tax exemptions.29 Lower tax rates also encourage the
formalization of economic activity. The removal of exemptions would create a more level
playing field for different economic actors, thereby encouraging the allocation of resources to
their most productive uses. Simpler taxes with fewer exemptions and more harmonized bases are
also easier and less costly to administer and enforce (particularly when the capacity of the tax
administration is still being established, as in Serbia), thereby allowing the same revenue to be
collected at lower rates. They also reduce the costs for firms and individuals in complying with
tax regulations. If carefully designed, such changes can also improve equity by removing any
hidden regressive elements in the tax system.
2.45 Serbia’s 2001 tax reform was a classic and very positive application of these
principles. The tax system was simplified, which, among other features, involved reducing the
number of taxes from 230 to 6 main taxes. The expansion of the base of the payroll tax for social
security contributions allowed significant (probably excessive) reductions in payroll tax rates.
However, later tax reforms in 2003 introduced numerous exemptions which moved in exactly the
opposite direction, thereby eroding the base and adding complexity.30 Tax incentives for large
and/or foreign investors represent implicit discrimination against the SME sector and domestic
investors. The Serbian government should pursue further options for base broadening, including
the careful review of some of the changes introduced in 2003. Harmonization of the bases of
social contributions and the wage component of the personal income tax is also important.
2.46 A carefully formulated further shift from (direct) taxation of income to (indirect)
taxation of consumption could improve Serbia’s growth prospects. Such a shift from income
to consumption taxation can be justified on the grounds of simplicity and efficiency. The main
argument for simplicity is that income is difficult to measure accurately, while the measurement
of consumption is relatively easy. The major case for efficiency is that a consumption tax
abolishes the tax on savings.31 Any such shift will need to make compensating adjustments in
the revenue sources of those state institutions which currently depend on direct taxes, such as the
pension and health insurance funds.
29
Evidence suggests that tax incentives are not the most significant factor affecting investment decisions of both domestic and
foreign entrepreneurs. The business climate, basic infrastructure, economic and political stability play a more important role in
influencing investment decisions. Although the benefits of tax incentives are uncertain, the costs associated with their
implementation tend to be significant. More specifically, tax benefits are likely to: (i) reduce fiscal revenues and promote illicit
behavior; (ii) undermine resource allocation and attract investors focusing on short-term profits; (iii) trigger a bidding war among
neighboring countries; and (iv) impose a large administrative burden.
30
The policy of tax incentives in the Republic of Serbia was revised two times between 2001 and 2003 (mid-2001 and early
2003). The most recent changes in the policy of tax incentives included; (i) a ten year tax holiday for investment into fixed assets
over 600 million dinars, if it is accompanied with additional employment of at least 100 workers; (ii) five year tax holiday for
investment exceeding 6 million dinars into fixed assets, which involves additional employment of at least five new workers in
selected regions; (iii) reduction of the enterprise profits tax rate from 20% to 14%; (iv) doubling the investment tax credit; and
(v) enlargement of the tax credit for newly employed workers from 40% to 100% of the labor costs.
31
There are two caveats. First, there is a common perception that a consumption tax would be more regressive than an income
tax—an argument that follows from the fact that the savings rate relative to income increases with income. Second, a
consumption tax can be a complex tax to administer if it has a multiple rate structure and numerous exemptions.
22
2.47 An efficient tax administration that encourages voluntary compliance and
effectively monitors tax payments is one of the most important components of a growthpromoting tax system. Although this report does not address issues of tax administration in
detail, the effective implementation of tax policy will have a favorable impact on the
formalization of the economy through lowering late payment or non-payment and discouraging
evasion as well as fraud by means of adequate program audits and an appropriate penalty system.
Effective pursuit of unpaid taxes is also important for eliminating the hidden subsidization of
loss-making enterprises, thereby encouraging them to release factors of production to more
efficient uses elsewhere in the economy.
D. MEDIUM-TERM OUTLOOK: AN OVERVIEW OF TWO ILLUSTRATIVE SCENARIOS
2.48 The package of stabilization and structural reform measures described above would
help place Serbia on a significantly more rapid and sustainable growth path. This section
aims to demonstrate the net effect of the proposed policy shifts by comparing two of many
possible macroeconomic scenarios.32 Actual outcomes could fall within or even outside this
range; the scenarios are primarily designed to show the impact of different broad reform
strategies. The first scenario, which aims to illustrate the trajectory of the Serbian economy under
strong policy efforts, includes the following key underlying elements: (i) a high quality fiscal
adjustment of the kind described above, which would enhance macroeconomic stability and
boost confidence in the policy framework, thereby stimulating private investment; (ii) a rapid
increase in productivity resulting from structural reforms, privatization, and enterprise
restructuring; (iii) an improvement in export performance; and (iv) strong external inflows
including significant FDI.
2.49 The second scenario aims at demonstrating the implications of unsatisfactory progress
with the implementation of structural reforms in 2004 and onwards. Under this scenario, the
government attempts to maintain both the current fiscal policy (through keeping the level and
structure of spending relatively constant) and monetary policy stances.
2.50 The results show a very different evolution of the economy under the two illustrative
scenarios, with Serbia reaching much higher growth rates under the first scenario
reflecting strong adjustment and reform. Average real GDP growth is projected to reach over
5 percent per year between 2005 and 2010, which is consistent with the country’s potential
growth rate (see Box 2.5 and Figure 2.12). This strong growth performance would arise from a
robust private sector response engendered by reforms to improve the business climate and the
permanent fiscal adjustment, which would lead to greater confidence in the policy framework.
Such an environment would lead to the higher level of investments as a share of GDP which
would sustain high growth rates (Figure 2.13). By contrast, average growth under the second
scenario would be around 2.5 percent during the same period as a result of the unsatisfactory
implementation of structural reforms and the failure to attain a high quality fiscal adjustment—
all of which would also be associated with a disappointing total factor productivity performance.
32
The exercise carried out in this section is for Serbia and Montenegro (SaM), based on data available in June 2004. Serbia
accounts for about 93 percent of SaM’s economy. As this exercise is illustrative rather than predictive, it will remain robust to
subsequent changes in data for 2004.
23
2.51 Moreover, under the second scenario, total public expenditures would remain high
averaging 46.8 percent of GDP between 2005 and 2010 (Table 2.4). As can be seen from Table
2.3, the key conditions for high quality fiscal adjustment would not be satisfied under this
scenario, as is evidenced by the evolution of the current expenditures (the wage bill as well as
subsidies and transfers). Consequently, a mixture of poor fiscal performance, low growth, and
high interest rates would lead to an unsustainable path for public debt, which would reach over
73 percent of GDP by 2010 (Figure 2.14). As a result of limited program credibility and the
unfavorable debt sustainability outlook, interest rates would remain high and private investments
would be crowded out. This would erode the country’s creditworthiness and leave the economy
highly exposed to adverse shocks, thereby rendering the economy more prone to a financial
crisis. Clearly, such a policy environment would not be conducive to pursuing Serbia’s social
agenda.
Box 2.5 On the Potential Growth Rate of the Serbian Economy
Can Serbia attain the average growth rate of over 5 percent envisioned in the credible adjustment scenario? The
standard growth accounting framework can shed some light on this question. More specifically, this framework
employs the following identity: dY/Y=αdK/K+βdL/L+dA/A, where the production function takes the form of
Y=AKαLβ , and α and β are the elasticity of output with respect to the growth of capital (K) and labor (L). In
practice, dA/A (the rate of growth of total factor productivity, TFP) is calculated as a residual, while α and β are
approximated by the profit and labor shares in national income.
A recent review of the growth prospects of the CEEC-5 (Poland, the Czech Republic, the Slovak Republic, Hungary,
and Slovenia) suggests that TFP rather than growth of factor inputs is expected to be the main driving force behind
the output growth in these countries.33 Acceleration of structural reform and institutional strengthening efforts that
would bring the country closer to well-performing countries in the region (see Box 2.1) is likely to enhance the
country’s productivity. Reforms discussed in this and other chapters can also increase investments as a share of
GDP. In addition, although demographic trends suggest that Serbia’s population is aging, improvements in the
functioning of labor markets and some reversal of the severe brain drain of the 1990s can potentially raise
employment levels.
A study by Benhabib and Spiegel (1994) estimates potential TFP growth rates by relying on the theory of income
convergence and the important role of human capital and produce the following base line equation: TFP growth rate
= 0.0007 * years of schooling + 0.0014 * income gap. Inserting the current Serbian data into this equation produces
a projected long-run TFP growth rate of above 4 percent.34 Relying on the above noted production function, holding
the capital-output ratio constant, and assuming an average annual growth rate of employment of around 0.5 over the
next ten years, the projected TFP growth rate of 4 percent translates into a projected GDP growth rate of around 8
percent per annum. However, this projected growth rate appears to be unrealistic since keeping the capital-output
ratio (assumed to be around 2 in 2003) constant will require investments to grow to above 30percent of GDP.
A more realistic projection of the potential growth rate of the Serbian economy in the medium-term can be obtained
from the following baseline equation Barbone and Zalduendo (1997):
Ln (GDP/Capita)= - 0.005 - 0.018 * ln(Initial GDP/Capita) + 0.019 * ln(Investment/GDP) + 0.007 * ln(years of
schooling) + 0.020 * ln(economic policies) - 0.400 * ln(fertility rates).
Inserting current data for Serbia into the above equation yields a GDP growth rate of around 3 percent per year.
However, provided that the investment-to-GDP ratio rises to well over 20 percent, the quality of education
improves, and the country makes significant progress in improving the business climate, the Serbian economy could
grow under the terms of this equation by 5-6 percent per year.
33
Doyle et al (2001).
According to the 2002 Census results, the average years of schooling of the Serbian population above the age of 15 is 8.5. The
PPP income gap between Serbia and the United States it is assumed to be between 5.5-6.
34
24
2.52 Under the second scenario, the economy would be forced to run lower current
account deficits due to a lower level of fresh capital inflows (Table 2.4). In the absence of
permanent fiscal adjustment, lower FDI, limited donor support, and weaker creditworthiness
would entail lower investments (averaging 15 percent of GDP between 2005 and 2010 compared
to 21 percent for the same period under the credible adjustment scenario), which would, in turn,
contribute to the lower observed growth rates.
2.53 On the other hand, the improved macroeconomic environment and more credible
policies under the first scenario would lead to higher FDI, which would reach 3.1 percent of
GDP in 2010. This development, together with other reform measures, would enhance the
country’s competitiveness, thereby producing a strong export performance (Table 2.4). The net
effect of these trends would reduce the current account deficit (excluding grants) to 6.1 percent
of GDP by 2010. Moreover, sound policies and the improved confidence in the policy
framework that would foster growth and investment would also promote savings: gross domestic
savings as a percentage of GDP would rise to 6 percent in 2010 from -4 percent in 2004.
Figure 2.12 Evolution of Growth,
(2004-10)
Figure 2.13 Investment, 2005-10
(% of GDP)
8
25
Scenario 2
Scenario 1
Scenario 2
Scenario 1
7
20
6
5
15
4
10
3
2
5
1
0
0
2005
2006
2007
2008
2009
2010
2005
2006
2007
2008
2009
2010
2.54 The two illustrative scenarios exhibit strikingly different growth paths of
consumption, the main determinant of living standards and poverty levels. Under the second
scenario, total consumption growth falls steadily, reaching negative rates (Figure 2.15). As the
public sector is not adjusting, the growth rate of private consumption declines even more rapidly,
reflecting the combined effect of slower GDP growth and the reduced availability of foreign
financing. In contrast, the first scenario requires an initial reduction of consumption growth in
2005 and 2006 to below the levels under the weaker reform scenario to allow investment to reach
levels which can produce more rapid economic growth. The subsequent rapid rebound in
consumption growth reflects the fruits of that investment, of deeper reforms, and of the greater
volumes of foreign financing which Serbia could absorb under that scenario.
2.55 The evolution of consumption under alternative scenarios presented in Figure 2.15 is
indeed illustrative of the difficult choices involved in the reform process. Delayed reforms can
defer the pain, but only temporarily and at the cost of more painful adjustments in the future.
The trajectory of consumption under both scenarios also highlights the fact that the country
cannot and should not expect to maintain the rates of consumption growth observed in the recent
past, which were a result of specific and temporary factors described earlier in the chapter.
25
Table 2.4 Trajectory of Selected Variables Under Two Illustrative Scenarios, 2003-10
2003
2004
2005
2006
2007
2008
2009
2010
Scenario 1
GDP Growth
Gross Domestic Savingsa
Real GDP per Capita (2004=100)
Total Public Expendituresa
Wages and Salariesa
Subsidies and Transfersa
Public Investmenta
Government Deficit a,b
Total Public Debta
Importa
Exporta
CAB a,b
FDIa
Total Foreign Debta
Debt Service / Total Exports
Financing Requirementsc
3.0
-7.0
46.8
10.3
24.1
2.1
-4.2
79.0
41.9
19.2
-12.6
6.7
68.2
7.4
3,247.5
4.4
4.5
4.5
5.0
5.5
6.0
6.0
-4.0
-2.5
0.1
2.5
4.0
5.2
6.1
100.0
104.4
109.0
114.4
120.6
127.8
135.4
47.0
44.9
42.4
41.6
40.8
39.8
39.0
10.6
10.1
8.9
8.9
8.8
8.7
8.7
25.1
21.8
20.6
20
19.6
19.2
18.8
2.9
4.0
4.7
4.5
4.5
4.3
4.1
-3.4
-2.4
-0.9
-0.8
-0.5
-0.5
-0.1
65.0
63.0
59.5
56.1
52.5
49.1
45.6
41.2
42.8
43.5
44.2
45.1
45.5
46.0
20.4
22.8
24.0
25.5
26.9
28.0
29.2
-11.0
-9.8
-8.8
-8.1
-7.6
-6.9
-6.2
3.1
5.0
4.0
3.4
3.4
3.1
3.1
64.0
64.0
63.2
63.9
64.5
64.6
64.2
13.8
11.0
8.9
12.1
12.8
12.3
11.4
2,583.3 2,418.6 2,638.7 2,920.0 3,292.9 3,453.0 3,382.5
Scenario 2
GDP Growth
3.0
4.4
3.5
3.0
2.5
2.0
2.0
2.0
-7.0
-4.0
-4.1
-3.7
-3.1
-1.9
-0.4
1.2
Gross Domestic Savingsa
Real GDP per Capita ( 2004=100)
100.0
103.4
106.4
109.0
111.1
113.3
115.5
46.8
47.0
47.1
46.7
46.5
46.7
47.0
47.3
Total Public Expendituresa
10.3
10.6
10.7
10.9
10.9
11.0
11.0
11.1
Wages and Salariesa
24.1
25.1
24.9
24.4
23.5
23.5
23.5
23.5
Subsidies and Transfersa
2.1
2.9
2.6
2.6
2.6
2.6
2.6
2.6
Public Investmenta
-4.2
-3.4
-4.6
-4.6
-5.1
-5.4
-5.7
-6.0
Government Deficit a,b
79.0
65.0
63.8
64.8
66.6
68.7
71.0
73.3
Total Public Debta
a
41.9
41.2
40.8
40.2
39.5
38.8
38.1
37.4
Import
19.2
20.4
20.6
20.8
21.3
22.1
22.8
23.7
Exporta
-12.6
-11.0
-10.8
-9.9
-9.0
-7.8
-6.6
-5.2
CAB a,b
6.7
3.1
2.9
2.3
2.1
1.8
1.6
1.4
FDIa
68.2
64.0
65.4
66.5
69.7
72.4
74.1
74.9
Total Foreign Debta
Debt Service / Total Exports
7.4
13.8
12.6
11.1
14.6
15.7
15.3
15.1
3,247.5 2,583.3 2,962.1 2,605.0 2,924.3 2,899.8 2,762.7 2,505.5
Financing Requirementsc
a:% of GDP; b: excluding grants; c: in USD millions.
2.56 All in all, the results suggest that the implementation of a high quality fiscal
adjustment and sustained progress with structural reform measures directed at improving
productivity and the business climate is Serbia’s most promising route to achieving more
rapid and more sustainable growth. Unwavering commitment and a determined
implementation of the program would also enable Serbia to lock in the virtuous cycle of higher
investment, savings, productivity and growth, and - improved living standards. Deviation from
this route-as was demonstrated by the second illustrative scenario-would not only leave the
economy highly vulnerable to external and internal shocks, but would also have adverse welfare
implications: by 2010, projected per capita real GDP would be about 17 percent lower than
under the first scenario, and consumption would be declining. As international experience
26
demonstrates, postponing corrective policy actions-i.e., permanent fiscal adjustment and deep
structural reforms-often ends up requiring more costly adjustments in the future.
Figure 2.14 Public Debt 2005-10 (% of GDP) Figure 2.15 Consumption,a 2005-10
80
8
Scenario 2
Scenario 1
Scenario 2
Scenario 1
70
6
60
50
4
40
2
30
20
0
10
0
-2
2005
2006
2007
2008
2009
2010
2005
a: Per capita growth rate
27
2006
2007
2008
2009
2010