Transition in Serbia

TRANSITION IN SERBIA 2000 - 2005 :
DIFFICULTIES AND CHALLENGES

by

Kosovka Ognjenović*
Jelena Laušev**

Draft paper prepared for the Third ARI Atelier, 6-7 December, 2005

INTRODUCTION

Particularly, three topics of the Serbian economy will be analyzed in the period from 2000 to 2005. Firstlly, we will analyze general characteristics of macroeconomic environment including movement in gross domestic product (GDP) as a general measure of economic activity ; inflation including movement in retail price indices ; rate of unemployment - official and ILO - as a proportion of unemployed workers, who are looking for a job, in total number of the active labour force ; growth in wages in real and nominal terms over the growth in labour productivity and movement in the exchange rate. Then, the subject of this analysis will be the foreign sector including growth and development of export and import commodity, macroeconomic implications of openness and inflow of foreign direct investments. In the last part of this paper we will analyze public expenditure in many aspects including public sector wages, budget subsidies, social transfers, public order and safety spending, capital spending, education spending etc. Survey of the main macroeconomic variables for the Serbian economy is availlabe in Table 1 in Annex.

CHARACTERISTICS OF MACROECONOMIC ACTIVITY IN SERBIA

The economy of Serbia faced numerous changes in the last five years. The economic policy changed depending on priorities which were determined by the two legally chosen Governments, but it was also under the influence of various factors from the international environment and economic conditions inherited from the previous regimes. In order to perceive what changes characterized macroeconomic environment in the last five years, we would first take a look at the basic variables of the economic activity : aggregate value of domestic production, inflation, unemployment rate, earnings and exchange rate. The overview of economic performances in Serbia in the period from 2000 to 2005 is given in the Table 1 in Annex.

Gross domestic product

Serbian economy faced the end of 2000 and the beginning of economic reforms with very low level of gross domestic product. Although real value of GDP was 5.2% higher than the value realized in the previous year, in relation to 1989, which represents one of the most prosperous years in the more recent economic history of Serbia, the value of GDP in 2000 went down to less than 50% of the value realized in 1989. To reach the average of ten countries that became equal members of EU in May 2004, Serbia with the present around US$ 3,000 GDP per capita, cannot allow itself stagnation, not to mention recession of its economic activity in the next years.

In the past five years of economic reforms in Serbia, the highest economic growth was realized in 2004, when the real GDP growth rate of 8.6% was measured. High growth of gross domestic product in the last year is explained by good performances of industrial and agricultural production, which had the highest production gross value added.

However, in the process of forming the GDP value, we have redistribution between agriculture and fishing, industry and civil engineering and services, with the tendency that services sector grows into the leading generator for creating value of domestic production aggregates. Namely, in relation to 2000, when the production activities (industry and agriculture) and civil engineering exceed half of GDP value structure, in GDP of 2003, the sector of services created 56.2% of the value, while industry and civil engineering contributed with 31.7% and agriculture and fishing with 12% in the total value of GDP. Such redistribution of values between services sector and production sector was realized owing to faster growth of services in the previous years.

And while on the production side of GDP, there are activities that generated economic growth such as : (a) industry, (b) agriculture, (c) civil engineering, on the expenditures side, the leading factor of GDP growth was personal consumption. The high growth of personal consumption in the previous years was realized owing to : (a) growth of available household income, which was guided by high real growth of earnings (real growth of earnings significantly exceeded growth of domestic production and productivity aggregates), (b) expansion of consumer credits at commercial banks, and (c) replacing the sales tax with the value added tax. In the period from 2000 to 2004, personal consumption varied in the interval from 80% to 88% of GDP value. Today the usage structure of GDP is such that personal consumption participates in it with over 80%, and state consumption with 25%. High growth of personal consumption was accompanied by significant growth of household indebtedness. Indicator of high indebtedness at banks shows that real value of credits placed to population in 2004, was increased for over 100% on the annual level. Expansion of population indebtedness is present since 2002, and it was especially pronounced in 2004, when indebtedness of population and households increased dramatically. The value added tax was introduced in January 2005. Introducing the value added tax had a passing, but still significant impact on the consumption growth at the end of 2004.

The largest part of aggregate production value belongs to non-financial sector, as this sector participated with 57-59% in GDP structure in the last five years. The importance of household sector is mildly reduced (share of farms and shops production dropped from 28.2%, which was its amount in 2000, to 23.5% in 2003), while state participation is increased (state participation is increased from 7.9% in 2000 to 13.2% in 2003). Financial sector still has small role in creating GDP value. Considering its modest participation of only 6%, banks and other financial institutions, as well as insurance companies, are still to face more significant role in economic activity.

Inflation

Serbia is still struggling with high inflation rates, although it started liberalization of prices in the last quarter of 2000. Compared to other countries from the region, if we exclude Romania, Serbia has the highest inflation, with inflation rate of 10.1% that was realized in 2004. Since the beginning of 2005, retail prices growth was such that this year inflation threatens to exceed the last year inflation.

Inflationary pressures in the last five years grew because of several factors, of which we will mention : (a) deregulation of administrative-controlled prices, (b) growth of industrial producer prices, including high growth of energy sources prices - crude oil and gas, (c) growth of import prices that manifests itself in differences between exchange rates, etc.

The prices of industrial producers realized high growth during the five year period, which is the result of long years of restraining their growth, increase in production costs, and in certain number of cases, monopolistic behavior on the market as well. In 2000, with average annual growth rate of 102.6%, growth of industrial producer prices exceeded annual inflation which at that time amounted to 70%. The lowest growth of industrial producer prices was marked in 2003, when industrial production dropped for 3.5%. Revitalizing activity of manufacturing industry during 2004 was accompanied with somewhat more intensive prices growth. The total prices growth of industrial producers in 2004 of 9.1% was the result of increase in production costs in all three industrial sectors.

Consequently, recession of the economic activity in 2003 resulted by much lower inflation rate, but at price of high interest rates and mild reduction of households and companies consumption. Monthly interest rates, during 2003, stayed on a fairly high level, which followed inflation movements of that period. However, faster growth of producer prices and higher inflation rates caused interest rates to grow again during 2004 and 2005, which did not cause the expected scope of investment activity. On the other hand, high interest rates were not obstacle to population to involve in debts at banks. Namely, to illustrate this, it should be mentioned that, in 2005, interest rates for short term credits to population amounted even over 2.25% per month, and interest rates to consumer credits even up to 1.67%. Weighted active interest rate of banks varies from 1.06-1.17% and interest rate to securities with which National Bank of Serbia performs operations on the open market 1.21% - 1.51%.

Finally, it can be concluded that high inflation still does not allow faster reduction of interest rates and thus reduces economic activity to a certain extent. Today, interest rates and inflation in Serbia move on the level higher than 1% per month.

Unemployment and wages

For labor market in Serbia, as well as labor markets of most other transition countries, it is characteristic that they have unfavorable unemployment structure and great gap between labor supply and demand. Among the unemployed, the most unfavorable position have persons with low education level, persons that wait for employment longer than one year - long-term unemployed, workers of age group over 45 who lost their job as a result of enterprises privatization and restructuring, young people that come to labor market after finishing education and women.

Out of all Republics of the former SFR Yugoslavia, Bosnia and Herzegovina, Serbia and Macedonia have experiences of the highest unemployment rates, even in the region. The registered unemployment rate in 2004 in Serbia amounted to 28%. However, the ILO rate of unemployment calculated according to the Labor Force Survey (LFS), which measures relation of active job seekers in relation to total active population (including individual farmers), is somewhat lower and amounted to 18.5% in 2004. Unemployment rate in Macedonia, evaluated according to the LFS, moved on the level of 37%, while registered unemployment rate in Bosnia and Herzegovina amounted to more than 40% in 2004. Ten new members of the EU have twice as high unemployment rate than 15 old members, for which average the ILO unemployment rate moves on the level of around 7%.

The strategy of dropping high unemployment rate consists of enforcing active labor market programs and measures, which are implemented simultaneously with the passive measures. Around 50,000 unemployed persons pass through these programs every year and significant budget funds are spent for their implementation. Direct creation of new jobs is realized through subventions for encouraging self-employment and opening micro and small enterprises.

Employment wages make more than half of the value of available households incomes in Serbia and therefore have decisive impact on forming life standard of population in Serbia. In the past years, high growth of wages was accumulated, both in nominal and real terms. However, high growth of wages was realized in conditions of low productivity. In spite of high unemployment rate, unjustifiable high growth of earnings is a latent determinant of inflation. In 2005 high inflation rates reduced growth of wages, so that their real growth is more inert and is developing somewhat slower that the productivity growth.

Serbia, like other European countries, follows the practice of beneficial system of social protection and workers rights protection. The institution of minimum wage ensures minimum of existence to salary recipients. In Serbia, minimum wage is established two times per year and amounts about 40% of the value of average net wage. Concerning the problem of structural unemployment, minimum wage, apart from maintaining the social minimum, can have negative effect in the sense of intensifying illegal job, which can be caused by drop of demand for workers with low qualifications who dominate among the unemployed.

Exchange rate

Exchange rate was liberalized at the end of 2000. Liberalization of the exchange rate regime meant that from the fixed rate which was bound to currency basket, it transforms into the managed floating exchange rate regime. All countries of ex-socialist block on the road of transforming their economic systems had similar experiences with exchange rate. Exchange rate and inflation in the monetary policy of pre-transition regime served as instruments for financing quasi fiscal deficit. Therefore, it was necessary to create conditions for realizing convertibility of exchange rate.

Significantly slower exchange rate growth of CSD in comparison with DM, that is, EUR, in relationship to inflation, resulted in real appreciation. However, during 2004 and 2005, we had somewhat more significant nominal depreciation of exchange rate and it now moves on the level of around 15%. Entering the EU, that is the EMU, implies complying to strict rules in order to introduce a pegged exchange rate. None of the ten new members of the EU did not access to the EMU because of high exchange rate volatility of their currencies compared to the Euro zone countries.

Serbia has long experience with badly governed exchange rate policy. Today, exchange rate is a topic of scientific polemics. It is considered that the value of exchange rate is underestimated and that it unfavorably manifests to current account deficit, trade deficit and domestic economy competitiveness. On the other hand, it is also considered that more noticeable depreciation of exchange rate would lead to disequilibrium in certain economic sectors, so it is attempted to improve foreign trade performances by creating better institutional conditions for economic activity.

FOREIGN SECTOR

The liberalization of Serbia’s foreign trade regime started in late 2000. However, foreign trade liberalization brought about increase in trade deficit, which reached its maximum in 2004, amounted 2/5 of the GDP. The liberalization affected increase in trade volume, where exports grew at a faster pace in comparison with years preceding the beginning of reforms ; imports also rose considerably relative to their volume from previous years, and more importantly, exceeded export value by more than two times. Serbia today is a small open economy, which is best illustrated by the fact that commodity trade in 2004 accounted for 82% of the GDP, as opposed to 2000, when this percentage was as little as 9.4%. Year 2005 has seen positive trends in foreign trade, since exports have started growing at a faster pace than imports, resulting in slight deficit reduction.

In former Yugoslavia, about 40% of trade was taking place between their republics, and with the disintegration of the country, Serbia lost not only foreign markets, but also a portion of the internal market. Serbia’s leading trade partners today are the EU countries and former republics of Yugoslavia. EU countries account for some 55% in Serbia’s total exports and imports. In terms of specific countries, main trade partners are Italy with 12% and Germany with 16% in Serbia’s imports. However, these two countries have a rather small role in Serbia’s exports : Germany as little as 10% and Italy as little as 13%. Given enormous discrepancy between exports and imports, a considerable portion of Serbia’s deficit is generated from trade with these two countries.

As for new EU Member States, relevant import partners are Slovenia and the Czech Republic. With regard to the former republics of Yugoslavia, Bosnia and Herzegovina and Macedonia rank first according to trade figures. These countries, besides Italy and Germany, dominate Serbia’s exports. However, the only two countries with whom Serbia has considerable trade surplus are Bosnia and Herzegovina and Macedonia. In last two years, Romania has won an important place among importing countries.

Although Serbia’s exports have been recovering from more than a decade of negative trends, export structure is still unfavorable. What dominate in exports are materials for reproduction, which have accounted for more than 60% in recent years, while the share of finished products has been in decline, constituting 28% of the total export value. However, current export structure corresponds to the level of economic activity. Manufacturing fields which are recording permanent output growth are also seeing export growth. In the export structure, manufacturing products account for about 95% of the total value, while agricultural products constitute some 4%. On import side, besides manufacturing products which constitute 80% of the import value, the import of energy sources, with a 13% share, also has a relevant place.

Foreign direct investment (FDI) inflows in Serbia in the period 2000 - 2005 have amounted to US$ 4.2 billion, or US$ 550 per capita. The largest inflow was recorded in 2003 in the amount of US$ 1.4 billion. However, year 2005, with FDI totaling US$ 1.2 billion in the first nine months, is likely to be the year with the largest inflow of foreign capital so far. The major portion of FDIs concerns inflows on the basis of privatization of socially-owned and state-owned enterprises. The share of greenfield investments in FDIs is still irrelevant and there is no considerable difference between Serbia and other transition countries.

In terms of geographical distribution of FDIs in the Western Balkans so far, Croatia has been the most attractive for foreign investors, generating more than a half of all investments made in this part of the world. On the other hand, of all CEE transition countries, the Czech Republic attracted most FDIs during the period of economic transformation - more than US$ 40 billion.

As for Serbia, big public telecommunications and energy enterprises, which has not been privatized or which has not been fully privatized so far, are expected to be a considerable source of foreign investments in the upcoming period. Given the share of FDIs in GDP, which ranged between irrelevant 0.3% in 2000 to a very high 7.4% in 2003, it may be concluded that their role so far has been manifold. The main significance of FDIs can certainly be their role in financing current account deficit, which, in the absence of domestic savings, was a source of financing for growing consumption and investment.

PUBLIC EXPENDITURE AND TRANSITION IN SERBIA AND MONTENEGRO

In the last tragic dacade Serbia and Montenegro has been through armed conflicts, international sanctions, hyperinflation and trade shocks resulting from the breakup of the SFRY that led to a 50 percent output decline over 1990-1993, and a sharp increase in unemployment and poverty.

In Serbia, progress since the 2000 elections has been extensive, with major liberalization of prices, foreign trade, and foreign exchange ; tax reform ; improved privatization and bank restructuring regimes ; enhanced transparency in the budget process ; and reductions in the gray economy and smuggling.

Sustainable and accountable public finances are the keystone for broader market-oriented reforms, strong growth and poverty alleviation outcomes, and successful re-integration into the European and global economic structures. In both Republics, reforms affect both the revenue side (simplified tax structure, more efficient revenue administration), and the expenditure side (improved budget management, reform of the pension system). The new Laws on the Budget System (LBS) adopted by Montenegro in 2001 and by Serbia in early 2002, outline further stages of reforms.

In that process Serbia and Montenegro faced with many problems.

Owing to the halfway reforms, it was not possible to create an environment that would be attractive to new (local and foreign) investments as the sole means of arresting the growing balance-of-payments deficit, which was upwards of 13% of the GDP, and the growing unemployment rate, which had reached 34%. After four years of transition, the GDP is now estimated at about US$ 3000 per capita (about US$ 5200 according to purchasing power parity) and a little less than 11% of the Serbian population lives below the poverty line, while about 20% are considered to be poor.

Nevertheless, the level of public spending by the Republic and Federal Governments combined exceeds that of many wealthier countries. Yugoslavia traditionally had an extensive social protection system, and expectations of the society in all ex-SFRY states that social benefits would continue may be the strongest explanation for the "stickiness" of public expenditure at high levels.

In addition to high public expenditures the following structural characteristics of public spending suggest that its efficiency has been very low : (i) duplication of functions across the Federal/Republic levels of government, estimated to be "worth" over 1 percent of Serbia’s GDP ; (ii) apparent excessive spending in individual categories (e.g., public wages) and functions (e.g., defense).

According to WB staff estimates government spending in Serbia by Function in 2001 was 44.2% on Social protection, 6.3% on Education, 6.1% on General public services, 9.5% on Defense, Public order and safety 6.7%, Economic affairs 8.3%, Health 12.8%, Housing 6.0%, Recreation, culture and religion 0.4%.

Government Spending by Economic Category for 2001 was distributed 41% on Transfers, 23% on Wages and Salaries, 21% on Goods and Services, 11% on Subsidies and Net Lending, 3% Capital Expenditures and 2% on Interest Payments.

Public Sector Wages. Federal and Republic Government wage expenditures combined are close to 10 percent of Serbia’s GDP, absorbing over 23 percent of total spending. Public wage expenditures are above the regional averages in both Republics, and in Montenegro their level is among the highest in the region.

Interest on debt is rising steeply in both Republics, due to the normalization of their relations with external creditors.

Defense spending has been declining in Serbia, but is still at more than twice the CEE average.

Budget subsidies to inefficient public enterprises have declined over the past few years in Montenegro, and are now low, but in Serbia they are above the regional averages. Budget subsidies and loans are significant at 3-4 percent of GDP and they go almost entirely to nine public enterprises that are the largest loss-makers.

Serbia’s level of social transfers as a share of GDP is high, and close to that of much wealthier countries, which raises affordability concerns. The actual level of social transfers
displays high volatility, suggesting serious sustainability problems.

Capital Spending. Over the past decade, and possibly longer, Serbia was under-investing in public assets. As a share of GDP, this category was less than half the regional average. It was also volatile, suggesting its use as an in-year balancing item. Only in 2000 was there a rise in capital spending, related to the post-conflict reconstruction. In 2001, substantial donor funds went into extrabudgetary capital spending, but budgeted capital expenditure dropped sharply. Cuts in capital spending are still used to balance the budget.

Public order and safety spending is slightly above the regional comparators. It will need to be adequate to combat crime and improve the judiciary system.

Education spending has been declining throughout the past decade. It bottomed out in 2001, reaching one of the lowest levels for the region, even if local government spending is included. Teacher salaries dropped well below public sector averages, schools were starved for basic education supplies and equipment, while many school buildings were past the age that provides normal conditions for learning. In 2002, the Republic Government acted strongly to revert the decline of public education and increased capital spending.

Social protection programs account for close to 45 percent of the S&M consolidated public expenditures. The two most important of these programs are pensions and health care. The Serbian pension system faces serious sustainability challenges. It currently absorbs 12.7 percent of GDP and is able to meet its legal obligations only with the help of budgetary transfers amounting to 4 percent of GDP. In the absence of reforms, the pension system’s deficit will grow further. Serbia’s health care system is in need of considerable restructuring. In its current format it is not fiscally sustainable and delivers poor quality health care in an inefficient and inequitable way. Inefficiencies are particularly evident in the level of overcapacity of the hospital system and the high number of non-clinical staff, such as cleaners, catering assistants, and administrators. Inefficiencies arise from the lack of adequate incentives for cost minimization, separation of financial responsibilities and the lack of accountability and monitoring capacity at all levels of the system.

Aiming to contain the level of spending and to improve equity in the system, the government introduced in late 2001 a range of parametric measures, which will reduce the deficit but will not eliminate it entirely. Deeper structural reforms are essential to bring the system back into balance because sustainability cannot be enhanced by a further increase in overall tax rates, since this could damage growth. Further significant increases in public expenditure could have adverse consequences for long-term growth and private sector development, and the reintegration of the gray sector into the official economy.

No government can simultaneously reform all aspects of the public spending mechanism, nor are all reforms equally pressing. However, some recommendations can be given.

Of particular relevance is the need to elaborate and implement an effective public sector employment and wage policy. The core wages are low, and the main reason for the high level of spending is the large number of public employees. Salary differentials between highly skilled and unskilled labor are small and do not provide incentives to retain staff with much-needed skills. The current organizational model of public service is not flexible enough to attract the skills the governments need to modernize their public expenditure systems.

Budget execution should rest upon modem treasury practices and strong commitment controls. Decisions are currently taken within a one-year framework, which can generate future fiscal imbalances. A multi-year perspective needs to be integrated into budget analysis and decisions. At the same time, there exists a need for an independent external audit institution that could safeguard the usage of public funds and the quality and credibility of reported fiscal data. Better targeting and reform of social programs is needed to eliminate waste and to free up resources.

Both Republics have stated their intention to begin preparations for eventual EU accession. This should provide further impetus to expenditure reform, as they will have to meet the Maastricht fiscal responsibility criteria. Eventually, complying with the acquis communautaire could require an increase in spending in such areas as education, environmental standards, and transportation but the gains from restructuring will come in the medium term.

We can conclude that the political context of conducting reforms was much more difficult than in other countries in transition. However, a change was called for in the first place because (I) the balance-of-payments deficit became unsustainable, (II) public expenditures were too high and tended to push private investment out, (III) institutional frame is practically obstructing the further privatization of the state and socially owned sectors, and (IV) failure of the export income to grow to any substantial extent is bringing into question the ability to service foreign debts and threatening to give rise to a debt crisis. This means that it would be necessary to cut subsidies and other public expenditures, bring the wage increases in line with productivity rises and complete the privatization of the state and socially owned firms, in addition to dealing with redundant civil servants and public enterprise employees.

CONCLUSIONS

Serbia, as a constituent of State Union with Montenegro, still has to tackle many problems it has been facing for years. The period in which Serbia would manage, in terms of its economic performance, to get closer the rest of Western Balkan countries which are the leaders in SAP - Bulgaria and Romania, that is, countries which are its main competitors in the process of association - Croatia, Bosnia and Herzegovina, Macedonia and Albania, would certainly depend on the way it has solved economic difficulties and how efficient it was, but also on political will in the country. Challenges for any Government would be as follows : (a) to reduce huge public spending (in 2003 it exceeded GDP value by 7%) ; (b) to reduce inflation rate ; (c) to reduce foreign trade deficit ; (d) to reduce current account deficit ; (e) to reduce high unemployment rate ; (f) to ensure sustainable economic growth in the medium and long term ; (g) to ensure stability of exchange rate ; (h) to ensure stable conditions for doing business, etc.

Discussion issue :

"SERBIA AND MONTENEGRO AND WESTERN BALKAN COUNTRIES : COMPARISONS OF ECONOMIC PERFORMANCE"

VALUABLE SOURCES OF INFORMATION :

1. G17 Institute, Economic Review, different issues. Available on the web site : www.g17institut.co.yu ; www.institutespi.org.
2. G17 Institute, Transition Report for Serbia and Montenegro, 2004.
4. National Bank of Serbia, Monthly Bulletin, different issues. Available on the web site : www.nbs.yu.
5. Statistical Office of the Republic of Serbia, Statistical Yearbook, different issues.
6. Statistical Office of the Republic of Serbia, Studies and Analyses : The System of National Accounts of the Republic of Serbia 2000-2003, June 2005.
7. World Bank, Transition : The First Ten Years, 2002.

Annex
Table 1. GENERAL MACROECONOMIC INDICATORS FOR SERBIA, 2000-2005
Indicator200020012002200320042005(Forecast)
GDP
Real growth rate, %5.25.14.52.48.66.71)
Inflation
Annual average, %70.091.819.511.710.116.51)
End of year, %111.940.714.87.813.716.01)
Producer prices in manufacturing industry
Annual average, %102.687.88.84.69.1…
End of year, %143.929.16.14.612.0…
Unemployment rate
Registered unemployment rate, %…24.727.127.828.027.51)
Unemployment rate according to LFS, %…12.213.314.618.5…
Wages
Average net wage, in CSD2,3895,3759,20811,50014,10816,8001)
Nominal growth rate, %9012571252319.51)
Real growth rate, %6164714104.31)
Exchange rates
CSD per EUR, annual average51.059.560.765.072.686.71)
CSD per USD, annual average54.966.464.457.558.4661)
Foreign trade
Commodity export as % of GDP3.012.814.516.920.2…
Commodity import as % of GDP6.432.139.145.661.6…
Deficit as % of GDP-3.4-19.3-24.6-28.8-41.3…
Source : GDP growth rate, inflation, producer prices, wages, export, import, trade deficit, unemploymnet rate acccording to the Labour Force Survey (Statistical Office of the Republic of Serbia, G17 Institute). Registered unemployment rate (National Employment Service). Exchange rate (National Bank of Serbia).
1) Forecast (G17 Institute).
… Not available.

Dernière modification : 02/05/2006

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