This record is a partial extract of the original cable. The full text of the original cable is not available.

UNCLAS SECTION 01 OF 06 BELGRADE 000654 
 
SIPDIS 
 
SENSITIVE 
 
OC FOR 4232/ITA/MAC/EUR/OEERIS/SSAVICH 
 
E.O. 12958: N/A 
TAGS: EFIN ECON EINV SR MW
SUBJECT: CENTRAL BANK FIGHTS TO LIMIT CREDIT GROWTH 
 
 
¶1.  Summary:  THE NATIONAL BANK OF SERBIA IS CAUGHT 
BETWEEN TWO CONFLICTING GOALS:  PREVENTING DINAR 
APPRECIATION, WHICH IT PURSUES BY SELLING DINAR TO BUY 
UP FOREIGN CURRENCY, AND CURBING THE INFLATIONARY 
PRESSURE IT CREATES IN THE FIRST STEP.  THIS BALANCING 
ACT HAS PROVED DIFFICULT, AS IT HAS IN OTHER TRANSITION 
COUNTRIES HIT BY SURGING CAPITAL INFLOWS, WITH 
INFLATION OF 17.7 PERCENT IN 2005 AND REAL APPRECIATION 
OF THE DINAR BY 9.6 PERCENT.  WHILE THE CENTRAL BANK'S 
POLICY OF PEGGING THE DINAR HELPED TO REDUCE THE 
CURRENT ACCOUNT DEFICIT TO 8.6 PERCENT OF GDP IN 2005, 
KEEPING CREDIT GROWTH IN CHECK HAS PROVEN MORE AND MORE 
DIFFICULT, WITH THE HIGH LEVEL OF EUROIZATION WEAKENING 
THE EFFECTIVENESS OF MONETARY POLICY.  THE CENTRAL BANK 
FURTHER TIGHTENED THE MONEY SUPPLY ON MARCH 31, AND IT 
WARNED OF MORE RESTRICTIONS TO COME. END SUMMARY. 
 
MONEY SUPPLY RISES ON CAPITAL INFLOWS, REMONETIZATION 
--------------------------------------------- --------- 
¶2.  THE NATIONAL BANK OF SERBIA (NBS) IS FEELING THE 
PAIN OF PROSPERITY.  RENEWED CONFIDENCE IN A BANKING 
SECTOR THAT IS NOW DOMINATED BY FOREIGN BANKS HAS LED 
TO REMONETIZATION, WITH EURO DEPOSITS UP BY 50.6 
PERCENT IN 2005.  DRIVEN BY THE CENTRAL BANK'S POLICY 
OF BUYING EURO FROM EXCHANGE HOUSES WITHOUT LIMIT, ITS 
GROSS RESERVES NOW TOP USD 6.1 BILLION, OR SEVEN MONTHS 
OF IMPORT COVER.  RESERVE MONEY INCREASED BY 66.9 
PERCENT IN 2005, THE NOMINAL RATE OF GROWTH OF M1 
REACHED 30.2 PERCENT, AND M3, WHICH INCLUDES HARD 
CURRENCY DEPOSITS, WAS UP 41.9 PERCENT. 
 
¶3.  FOREIGN BANKS ARE PAYING A HIGH PRICE FOR SERBIAN 
ACQUISITIONS, AND THEY ARE EXPANDING RAPIDLY TO 
GENERATE A RETURN ON THESE INVESTMENTS.  BANK CREDIT TO 
HOUSEHOLDS ROSE IN 2005 BY 76 PERCENT IN REAL TERMS, 
REACHING USD 1.73 BILLION, OR 7 PERCENT OF GDP, WHICH 
IS 30 PERCENT OF TOTAL NON-GOVERNMENT BORROWING, 
ACCORDING TO NBS DATA.  BY COMPARISON, THE PROPORTION 
OF HOUSEHOLD DEBT IN NON-GOVERNMENT BORROWING IN 2004 
WAS 32.5 PERCENT IN HUNGARY, 32.7 PERCENT IN BULGARIA, 
AND IN CROATIA, 55 PERCENT. AT THE SAME TIME, HOUSEHOLD 
BORROWING, AS A PERCENTAGE OF 2004 GDP, WAS 13.1 
PERCENT IN HUNGARY, 10 PERCENT IN BULGARIA, AND IN 
CROATIA, 31.5 PERCENT. (SOURCE: EBRD TRANSITION REPORT 
2005). 
 
 
¶4.  DESPITE PROGRESSIVELY HARSHER CENTRAL BANK 
RESTRICTIONS AIMED AT CURBING THE GROWTH OF LENDING, 
CREDIT GROWTH ACCELERATED AT THE BEGINNING OF 2006. IN 
JANUARY AND FEBRUARY, HOUSEHOLD INDEBTEDNESS INCREASED 
BY 8.4 PERCENT, I.E. USD 145 MILLION.  BY COMPARISON, 
IN THE SAME PERIOD OF 2005, HOUSEHOLD BORROWING 
INCREASED BY 3.6 PERCENT, I.E. USD 38 MILLION. 
 
¶5.  ALTHOUGH MUCH OF THE GROWTH OF RESERVE MONEY IS 
DRIVEN BY THE CENTRAL BANK'S EURO PURCHASES, NBS 
OFFICIALS ARE ESPECIALLY WORRIED BY FLOWS OF FOREIGN 
CAPITAL INTO COMMERCIAL BANKS.  "WE WOULD WISH THAT 
BANKS DIRECT THEIR ENERGY TO THE COLLECTION OF DEPOSITS 
IN COUNTRY, AND NOT TO BORROWING FROM ABROAD," SAID 
VICE GOVERNOR DIANA DRAGUTINOVICH, WHO DIRECTS MONETARY 
POLICY, IN A RECENT INTERVIEW. "THAT'S WHY WE WANT, BY 
THESE MEASURES, TO LIMIT THE BORROWING OF BANKS, WITH 
THE GOAL THAT THEIR CREDIT ACTIVITY BE LIMITED, LET'S 
SAY, TO LAST YEAR'S LEVEL." 
 
¶6.  IN 2005, BANKS' FOREIGN LIABILITIES INCREASED BY 78 
PERCENT, OR USD 1.4 BILLION, TO USD 2.5 BILLION. 
FOREIGN BANKS, DETERMINED TO MAKE THEIR NEW INVESTMENTS 
PAY, CAN BORROW FROM OFFSHORE PARENTS CHEAPLY, SAY AT 4- 
5 PERCENT, AND LEND AT RATES OF 12-16 PERCENT, ON FEE- 
HEAVY, EURO-LINKED RETAIL CREDITS.  MARGINS ARE 
LUCRATIVE, WITH SPREADS NOW DOWN TO PERHAPS 10 
PERCENTAGE POINTS, FROM 13-15 PERCENT LAST YEAR, 
ACCORDING TO THE NBS. 
 
¶7.  RISING DEPOSITS CONTRIBUTED EQUALLY TO ADDITIONAL 
LIQUIDITY. HARD CURRENCY DEPOSITS LAST YEAR INCREASED 
BY 50.6 PERCENT TO USD 3.7 BILLION. DINAR SAVINGS 
DEPOSITS WERE UP BY 35 PERCENT TO 0.7 BILLION 
(EXCLUDING CURRENT ACCOUNTS). EURO DEPOSIT RATES RANGE 
FROM 1 TO 5 PERCENT, DEPENDING ON MATURITY, LEAVING 
AMPLE ROOM FOR PROFIT AS THE BANKS RECYCLE THEM INTO 
LENDING.  (NOTE: BANKERS SAY THAT RATES OFTEN ARE LOWER 
IN THE CORPORATE SECTOR, WHERE COMPETITION IS GREATER 
AND BORROWERS, MORE PRICE-CONSCIOUS.) 
 
CENTRAL BANK FIGHTS TO KEEP CONTROL 
------------------------------------ 
¶8. THE INTERNATIONAL MONETARY FUND, IN ITS FINANCIAL 
SYSTEM STABILITY ASSESSMENT, PUBLISHED IN MARCH, RAISED 
THE ALARM:  "THERE ARE EMERGING SIGNS THAT THE RAPID 
PACE OF CREDIT GROWTH IS BEGINNING TO ERODE FINANCIAL 
STABILITY."  THE REPORT NOTES THAT SERBIA HAS A LOWER 
RATIO OF BANK CREDIT TO GDP THAN MOST COMPARABLE 
COUNTRIES, BUT PROJECTS THAT THE CURENT RATE OF GROWTH 
COULD PUSH SERBIA'S DEBT LEVELS HIGHER THAN REGIONAL 
AVERAGES WITHIN A FEW YEARS.  THE IMF ASSESSMENT ALSO 
NOTED THAT LEVELS OF NON-PERFORMING LOANS ARE RISING. 
 
¶9. THE IMF ALSO POINTED TO THE "HIGH LEVEL OF EURO- 
IZATION" AND THE FACT THAT ALMOST ALL LENDING IS IN 
EUROS, WHICH EXPOSES BORROWERS (AND, THUS, INDIRECTLY 
THE CREDITORS AS WELL) TO "CONSIDERABLE FOREIGN 
CURRENCY RISKS."  THE IMF ALSO SINGLED OUT REMAINING 
STATE-OWNED BANKS AS PARTICULARLY VULNERABLE, IN LIGHT 
OF THEIR WEAK BALANCE SHEETS AND MANAGEMENT. (NOTE: 
SERBIA'S FIFTH-LARGEST BANK, STATE-OWNED VOJVODJANSKA 
BANKA, IS BEING PRIVATISED NOW, AFTER WHICH KOMERCIALNA 
BANK WILL BE THE LAST STATE-CONTROLLED BANK AMONG THE 
10 LARGEST.) 
 
¶10.  THE NATIONAL BANK INITIALLY WAS SLOW TO RESPOND TO 
FUND CONCERNS.  DURING 2005, GOVERNOR JELASIC TALKED 
FREQUENTLY OF THE NEED TO LOWER RATES, ARGUING THAT 
BANKS' SPREADS WERE TOO HIGH.  INDEED, REAL RATES IN 
THE CENTRAL BANK'S REPO OPERATION, A KEY TOOL FOR 
STERILIZING CAPITAL INFLOWS, WERE NEGATIVE AND DID NOT 
BEGIN RISING AGAIN UNTIL OCTOBER. 
 
¶11.  THE PROBLEM OF RAPID MONEY SUPPLY GROWTH - AND 
ACCOMPANYING INFLATION - HAS BEEN DEVELOPING THROUGH 
¶2005. RESERVE MONEY ROSE BY 66.9 PERCENT, M1 BY 30.2 
PERCENT, AND M3 BY 41.9 PERCENT. THIS TREND SLOWED ONLY 
AT THE BEGINNING OF 2006, MAINLY AS A RESULT OF 
SEASONAL FACTORS. THIS GROWTH WAS REFLECTED IN THE RISE 
OF INFLATION TO 17.7 PERCENT, FROM 13.4 PERCENT IN 
¶2004.  DRAGUTINOVICH TOLD ECON CHIEF THAT THE NATIONAL 
BANK FINDS A HIGH CORRELATION BETWEEN THE GROWTH OF 
BROAD MONEY - M3 - AND INFLATION.  SHE SAYS BROAD MONEY 
IS THE KEY MONETARY TARGET. 
 
¶12.  THE IMPACT ON THE CURRENT ACCOUNT DEFICIT WAS LESS 
APPARENT, AS THE GAP NARROWED FROM 12.6 PERCENT IN 2004 
TO 8.6 PERCENT OF GDP IN 2005.  THIS RELATIVE SUCCESS 
WAS DUE IN PART TO THE NATIONAL BANK'S DETERMINATION TO 
KEEP THE DINAR ROUGHLY STABLE AS A WAY OF DAMPING 
INFLATION EXPECTATIONS. BUT THE BANK AVOIDED NOMINAL 
APPRECIATION OF THE DINAR - AND, IN THEORY, HIGHER 
IMPORTS - ONLY BY BUYING UP EUROS AT A BRISK PACE. 
DESPITE NBS INTERVENTION IN THE FOREIGN EXCHANGE 
MARKET, THE DINAR DEPRECIATED RELATIVE TO THE EURO 8.1 
PERCENT IN NOMINAL TERMS OVER 2005, BUT IT APPRECIATED 
9.6 PERCENT IN REAL TERMS. 
 
¶13.  UNDER PRESSURE FROM THE FUND, THE NATIONAL BANK 
TIGHTENED MONETARY POLICY STEADILY THROUGHOUT THE 
SECOND HALF OF 2005.  ITS APPROACH COMBINED BOTH 
STANDARD OPEN MARKET OPERATIONS, SEEKING TO WITHDRAW 
DINAR LIQUIDITY THROUGH ITS REPO OPERATIONS, AND A 
STEADY RAMPING UP OF SO-CALLED "RESERVE" REQUIREMENTS," 
WHICH FUNCTION IN MANY RESPECTS AS INDIRECT CAPITAL 
CONTROLS. 
 
¶14. TO INCREASE THE PRESSURE ON BANKS AND THUS DECREASE 
THE SUPPLY OF CONSUMER CREDIT, THE NBS IMPLEMENTED THE 
FOLLOWING MEASURES OVER 2005, IN SEVERAL STEPS: 
-- THE REQUIRED RESERVE FOR FOREIGN CURRENCY DEPOSITS 
WAS GRADUALLY INCREASED FROM 21 PERCENT TO 38 PERCENT; 
-- THE BASE FOR REQUIRED RESERVES WAS BROADENED BY 
INCLUDING DINAR DEPOSITS THAT ARE INDEXED TO A HARD 
CURRENCY; 
-- A RESERVE REQUIREMENT ON BORROWING FROM ABROAD WAS 
INTRODUCED AND INCREASED FROM 7 TO 38 PERCENT; 
-- LEASING ALSO WAS TARGETED WITH AN OBLIGATORY RESERVE 
OF 10 PERCENT OF BORROWING FROM ABROAD. 
 
¶15.  THE NATIONAL BANK HAS CONSISTENTLY TRIED TO 
BROADEN USE OF THE DINAR, EVEN ISSUING RETAIL SAVINGS 
BONDS DIRECTLY TO CONSUMERS TO BOOST DINAR DEPOSIT 
RATES. IT DECREASED THE RESERVE REQUIREMENT ON DINAR 
DEPOSITS TO 18 PERCENT, VICE 40 PERCENT FOR FOREIGN 
CURRENCY DEPOSITS.  NONETHELESS, EURO DEPOSITS REACHED 
98 PERCENT OF TOTAL SAVINGS AT THE END OF 2005, UP FROM 
97 PERCENT AT THE END OF 2004.  (DINARS MAINLY ARE HELD 
ONLY IN CURRENT ACCOUNTS, FOR PAYMENT PURPOSES.) 
 
CURBS ON MONEY SUPPLY INEFFECTIVE, EVEN 
COUNTERPRODUCTIVE 
--------------------------------------------- --------- 
 
¶16.  DESPITE THE NATIONAL BANK'S EFFORTS, INTEREST 
RATES ON HOUSEHOLD BORROWING REMAINED LARGELY 
UNCHANGED, DUE TO A NUMBER OF FACTORS.  MARGINS ON SUCH 
LENDING ALREADY WERE HIGH, AND COMPETITION AMONG THE 
GROWING NUMBER OF FOREIGN BANKS TENDED TO KEEP RATES 
DOWN.  AT THE SAME TIME, BANKS HAVE FOUND LESS 
TRANSPARENT WAYS TO RAISE EFFECTIVE INTEREST RATES, 
THROUGH FEES AND DOWN PAYMENT REQUIREMENTS.  AND, AS 
RAFFEISEN BANK CEO OLIVER ROEGEL NOTES, THE PENT-UP 
DEMAND FOR CONSUMER CREDIT IS SO GREAT THAT BORROWERS 
APPEAR TO BE READY TO PAY ANY INTEREST RATE. 
 
¶17.  THE CENTRAL BANK'S NEW MEASURES APPEAR TO HAVE HAD 
LITTLE IMPACT ON CREDIT GROWTH, WHICH CONTINUED TO 
ACCELERATE THROUGH THE SECOND HALF OF 2005.  DOMESTIC 
CREDIT WAS UP 15.3 PERCENT IN THE FIRST HALF, BUT 
SURGED BY 24.3 PERCENT IN THE SECOND. THE NATIONAL 
BANK'S GROSS RESERVES WERE UP 72 PERCENT ON THE YEAR, 
TO USD 6.1 BILLION, LARGELY DRIVEN BY THE FLOW OF MONEY 
FROM EXCHANGE HOUSES TO THE CENTRAL BANK. 
 
¶18.  AT THE SAME TIME, THE NATIONAL BANK WAS FIGHTING 
INCREASED CAPITAL INFLOWS. AS MENTIONED ABOVE, BANKS 
INCREASED THEIR BORROWING, OFTEN FROM THEIR FOREIGN 
PARENTS, BY USD 1.4 BILLION, TO USD 2.5 BILLION AT THE 
END OF 2005, I.E. 10 PERCENT OF GDP. THE BANK REACTED 
BY FIRST IMPOSING "RESERVE REQUIREMENTS" ON SUCH 
BORROWING, AND THEN STEADILY INCREASING THE RATE TO 
EQUALIZE IT WITH THE RATE ON HARD CURRENCY DEPOSITS. 
BANKERS POINT OUT THAT SUCH RESERVE REQUIREMENTS ARE 
NOT NEEDED ON INTRABANK LOANS, SINCE A PARENT BANK IS 
NOT LIKELY TO PULL A LOAN AND PUT PRESSURE ON ITS 
SUBSIDIARY, IN THE SAME WAY THAT DEPOSITORS EN MASSE 
CAN WITHDRAW DEPOSITS. 
 
¶19.  AGAINST THESE HEAVY CAPITAL INFLOWS, THE NBS WAS 
ABLE TO STERILIZE, OR WITHDRAW FROM CIRCULATION, 
THROUGH ITS OPEN MARKET REPO OPERATIONS, ONLY DINARS 
WORTH USD 0.443 BILLION DOLLARS. THE VOLUME OF REPO 
OPERATIONS INCREASED GRADUALLY OVER THE YEAR, IN PART 
BECAUSE IT WAS A NEW INSTRUMENT FOR THE CENTRAL BANK, 
AND IN PART BECAUSE THE BANK WAS RELUCTANT TO PUSH UP 
RATES.  INTEREST RATES VARIED FROM 20 PERCENT AT THE 
VERY BEGINNING OF THE YEAR, TO THEIR LOWESTS IN JUNE AT 
13.5 PERCENT, AND THAN GRADUALLY RISING TO 20 PERCENT 
BY YEAR-END.  THE LATEST RATE IS ABOUT 24 PERCENT. 
 
¶20. COMPARED TO THE SIZE OF THE INFLOWS, THIS IMPACT 
CLEARLY WAS MINOR, FORCING THE BANK TO RESORT TO 
RESERVE REQUIREMENTS. AND AS EUROIZATION INCREASES, THE 
CENTRAL BANK'S ABILITY TO AFFECT THE MONEY SUPPLY 
THROUGH A DINAR INSTRUMENT BECOMES PROGRESSIVELY 
WEAKER. BANK OFFICIALS SAY THEY WERE ABLE TO STERILIZE 
87 PERCENT OF CAPITAL INFLOWS, BUT ABOUT 1.428 BILLION, 
OR THREE-QUARTERS, WAS WITHDRAWN VIA RESERVE 
REQUIREMENTS. 
 
¶21. "A PARADOXICAL SITUATION IS CREATED,'' ECONOMIST 
STOJAN STAMENKOVIC POINTS OUT IN A RECENT ANALYSIS. 
"ON ONE HAND, THE BUSINESS BANKS, WITH THE GOAL OF 
CREATING EXTRA INCOME (ON THE BASIS OF THE DIFFERENCE 
BETWEEN THE INTEREST RATE ON DOMESTIC AND FOREIGN 
FINANCIAL MARKETS), TAKE CREDITS FROM OVERSEAS, AND THE 
CENTRAL BANK IS FORCED TO, THROUGH AN EXPENSIVE 
MECHANISM OF STERILIZATION, TO OFFSET THE EFFECT OF 
THESE CREDITS IN THE DOMESTIC FINANCIAL MARKET.  THE 
EARNINGS BELONG TO THE BANKS, AND THE EXPENSE OF ANTI- 
INFLATION ACTION TO THE CENTRAL BANK.... SUCH A 
MONETARY POLICY IS VERY EXPENSIVE." 
 
¶22. THE INEFFECTIVENESS OF MONETARY POLICY GOES BEYOND 
THE PROBLEM OF CAPITAL INFLOWS, STAMENKOVIC EXPLAINED 
TO ECON CHIEF.  AS THE NBS WITHDRAWS DINAR LIQUIDITY 
THROUGH RESERVE REQUIREMENTS, REPO OPERATIONS, AND 
SAVINGS BONDS, HOUSEHOLDS OR FIRMS, WHICH HOLD MOST OF 
THEIR ASSETS IN FOREIGN CURRENCY, REACT BY SIMPLY 
CONVERTING MORE EURO TO DINAR. AND THE DUAL CURRENCY 
NATURE OF THE ECONOMY MAKES IT DIFFICULT FOR THE 
CENTRAL BANK TO MASTER THIS MECHANISM, SINCE CORPORATE 
AND RETAIL FOREIGN CURRENCY RESERVES ARE HIGHER THAN M1 
MONEY SUPPLY. 
 
¶23.  THE BANK CLEARLY RECOGNIZES ITS DILEMMA.  VICE 
GOVERNOR DRAGUTINOVICH, IN A RECENT PRESS INTERVIEW, 
SAID THAT THE HIGH RATES THE CENTRAL BANK PAYS IN THE 
REPO MARKET ARE IN FACT A MOTOR DRIVING BANKS TO BORROW 
MORE OVERSEAS. AND SHE NOTED THAT SOME CENTRAL BANK 
SECURITIES FOUND THEIR WAY, NOT INTO THE BANKS' 
PORTFOLIOS, BUT INTO THOSE OF OVERSEAS INVESTORS WHO 
ARE LOCKING IN AN INTEREST RATE PLAY, SAFEGUARDED BY 
THE CENTRAL BANK'S VITUAL PEG OF THE DINAR.  ROEGL, OF 
RAFEISSEN, CONFIRMED THAT SOME FOREIGN BANKS ARE ACTING 
ON BEHALF OF OVERSEAS SPECULATORS IN THE CENTRAL BANK'S 
REPO OPERATIONS. 
 
¶24.  "THE TIME IS, THEN, TO CONSIDER WHETHER THIS HIGH 
INTEREST RATE IN CONDITIONS OF A VERY LIBERAL INFLOW OF 
CAPITAL RAISES THE LEVEL OF FINANCIAL INSTABILITY," 
DRAGUTINOVIC SAID IN THE PRESS INTERVIEW. 
 
CENTRAL BANK SIGNALS COMMITMENT, BUT RESISTANCE GROWS 
--------------------------------------------- --------- 
 
¶25.  THE NATIONAL BANK'S LATEST MEASURES, ANNOUNCED ON 
MARCH 31, RAISED THE RESERVE REQUIREMENT FROM 38 TO 40 
PERCENT ON HARD CURRENCY DEPOSITS AND DINAR DEPOSITS 
INDEXED IN EURO.  BANKS ALSO MUST ALLOCATE 20 PERCENT 
AS A RESERVE ON BORROWINGS BASED ON SUBORDINATED 
CAPITAL, WHILE THE RESERVE REQUIREMENT ON LEASING WAS 
RAISED TO 20 PERCENT, VICE 10 PERCENT. 
 
¶26. GOVERNOR JELASIC, IN ANNOUNCING THE NEW 
RESTRICTIONS, SAID THAT THE NBS WANTS TO DECREASE 
INFLATIONARY PRESSURE BY WITHDRAWING AROUND 13.7 
BILLION DINARS (5.5 PERCENT OF RESERVE MONEY FROM 2005) 
FROM BANKS' LIQUIDITY TO BRING THE MONEY SUPPLY DOWN TO 
THE LEVEL AT THE END OF LAST YEAR.  HE ALSO WARNED THAT 
THERE IS MORE TO COME, THAT THE CENTRAL BANK WILL REACT 
TO FUTURE INFLATION BY INCREASING RATES ON REPO 
OPERATIONS, BY FURTHER BOOSTING REQUIRED RESERVES, BY 
ISSUING MORE SAVINGS BILLS AND THROUGH ENHANCED 
SUPERVISION OVER BANKS AND LEASING COMPANIES.  HOWEVER, 
THE MARCH 31 MEASURES FOLLOWED CLOSE ON DATA THAT 
SHOWED MARCH INFLATION WAS ONLY 0.3 PERCENT, BRINGING 
THE INCREASE IN CONSUMER PRICES TO 2.2 PERCENT FOR THE 
FIRST QUARTER. 
 
¶27.  JELASIC TOLD ECON CHIEF ON APRIL 5 THAT THE 
NATIONAL BANK IS NOT FIXATED ON HITTING THE SINGLE 
DIGIT INFLATION TARGET FOR 2006, BUT RATHER IS FOCUSED 
ON MAINTAINING A DOWNWARD TREND.  DRAGUTINOVICH 
CONFIRMED THAT THE BANK IS CONSIDERING EVEN TIGHTER 
RESTRICTIONS, SUCH AS MARGINAL RESERVE REQUIREMENTS ON 
NEW BORROWINGS ABROAD, IF INFLATION NUMBERS ARE 
ALARMING. 
 
¶28. THE MARCH MEASURES FOLLOWED CLOSE ON THE HEELS OF 
MORE RESTRICTIONS ANNOUNCED IN FEBRUARY, WHEN THE NBS 
IMPOSED PROVISIONING MEASURES AIMED AT LIMITING 
HOUSEHOLD BORROWING. THESE MEASURES REQUIRE THAT BANKS 
HOLD A DEPOSIT OF 20 PERCENT ON ALL CONSUMER CREDITS 
AND THAT THE MONTHLY INSTALLMENT NOT EXCEED 30 PERCENT 
OF HOUSEHOLD INCOME. IN EVENT OF NON-COMPLIANCE, BANKS 
ARE REQUIRED TO SET ASIDE A MANDATORY RESERVE OF 100 
PERCENT OF THE LOAN. 
 
¶29. THE NATIONAL BANK'S CONTINUED DETERMINATION TO 
CLAMP DOWN ON CREDIT GROWTH - AND BRING INFLATION UNDER 
CONTROL - HAS PROVOKED INCREASING OPPOSITION.  FOR 
INSTANCE, AT A PUBLIC MEETING OF THE FOREIGN INVESTOR'S 
COUNCIL ON MARCH 15, MILAN PARAVODIC, MINISTER FOR 
INTERNATIONAL ECONOMIC AFFAIRS, OPENLY CRITICIZED THE 
CENTRAL BANK'S LATEST RESTRICTIONS, ARGUING THAT EASIER 
ACCESS TO CREDIT WAS NECESSARY FOR DEVELOPMENT. 
 
¶30.  GORAN PITIC, HEAD OF SOCIETE GENERALE BANK, SAID 
AT THE SAME EVENT THAT THE CENTRAL BANK'S POLICIES HAD 
BEEN UNSUCCESSFUL, SINCE CREDIT GROWTH CONTINUED AND 
INFLATION PERSISTED.  THIS SHOWS THAT HIGH INFLATION IS 
DRIVEN NOT JUST BY MONETARY DEVELOPMENTS, PITIC SAID, 
AND WARNED THAT A FURTHER INCREASE OF OBLIGATORY 
RESERVES OR INTRODUCTION OF NON-MARKET MEASURES WOULD 
INCREASE LENDING RATES. ALEXANDER PICKER, THE HEAD OF 
AUSTRO-GERMAN HVB BANK, WAS EVEN SHARPER, ACCUSING THE 
BANK OF USING POPULIST RHETORIC IN ITS CAMPAIGN AGAINST 
LENDING PRACTICES, AND OF EMPLOYING DISCRIMINATORY 
POLICIES IN ITS USE OF AUDITS.  (NOTE: SOME BANKING 
SCENE OBSERVERS SAY THE FOREIGN BANKS BELIEVE THE 
CENTRAL BANK TO BE UNDULY PROTECTIVE OF THE SERBIAN 
BANKS; FOR INSTANCE, IT IS COMMONLY SAID THAT CENTRAL 
BANK AUDITORS SPEND ALMOST ALL THEIR TIME IN THE 
FOREIGN BANKS.) 
 
¶31.  ROEGL, OF RAIFFEISEN, ELABORATED ON PICKER'S 
CHARGES IN APRIL 3.  HE SAID THAT THE NATIONAL BANK IS 
USING AUDITS TO IMPOSE CREDIT LIMITS ON THE LARGEST 
BANKS IN AN ATTEMPT TO RESTRAIN LENDING.  RAIFFEISEN, 
THE MARKET LEADER, HAS WORKED HARD TO APPLY GOOD RISK 
MANAGEMENT, ROEGL SAID, BUT CENTRAL BANK AUDITORS 
SIMPLY JUDGED ITS PRACTICES INADEQUATE AND IMPOSED 
QUANTITATIVE LIMITS ON ITS CREDIT ISSUANCE.  IN 
ADDITION, THEY INSIST ON USING PROVISIONING STANDARDS 
THAT EXCEED INTERNATIONAL STANDARDS.  THE RESULT IS 
SIMPLY TO SLOW RAFFEISEN'S GROWTH, HE SAID. (NOTE: THE 
IMF RESIDENT REPRESENTATIVE RECENTLY TOLD ECON CHIEF 
THAT THE CENTRAL BANK HAD AGREED TO STOP IMPOSING SUCH 
CREDIT LIMITS.) 
 
¶32.  THE BANK'S MEASURES MAY ALSO HAVE UNINTENDED 
EFFECTS, ROEGL WARNED. BY INCREASING BANKS' FUNDING 
COSTS THROUGH RESERVE REQUIREMENTS, THE NATIONAL BANK 
MAY PUSH COMMERCIAL BANKS TO FOCUS EVEN MORE ON 
CONSUMER LENDING, WHERE THE MARGINS ARE HIGHER.  THIS 
TREND IS COMPOUNDED BY THE ABILITY OF THE BEST 
CORPORATE CUSTOMERS TO BORROW OVERSEAS DIRECTLY, IN 
WHICH CASE CENTRAL BANK CREDIT CONTROLS ARE EVADED 
COMPLETELY. 
 
THE OUTLOOK AND RISKS 
---------------------- 
 
¶33. JELASIC NEVER PASSES UP AN OPPORTUNITY TO REMIND 
THE PUBLIC THAT THE CENTRAL BANK CANNOT CONTROL 
INFLATION ON ITS OWN, THAT FISCAL POLICY AND STRUCTURAL 
REFORM MUST PLAY THEIR PART.  STAMENKOVICH ECHOES THIS 
POINT, ARGUING THAT THE BURST IN INFLATION SEEN IN 2005 
IN PART WAS CAUSED BY THE FINANCE MINISTRY.  HE POINTS 
OUT THAT THE BUDGET REBALANCE CARRIED OUT IN MID-2005, 
BY CHANGING METHODOLOGY, OBSCURED WHAT IN FACT WAS A 
SIGNIFICANT INCREASE IN SPENDING OF 0.7 PERCENT OF GDP. 
 
¶34.  FISCAL RISKS MAY ARISE AGAIN THIS YEAR, 
STAMENKOVICH SAID.  VAT REVENUES FOR JANUARY AND 
FEBRUARY ARE 3 PERCENT BELOW PROJECTION, AND THE 
GOVERNMENT WILL BE TEMPTED TO MAKE UP THE DIFFERENCE 
FROM PRIVATIZATION REVENUES, WHICH WOULD HAVE AN 
INFLATIONARY IMPACT.  INDEED, JELASIC, AT HIS MARCH 31 
PRESS CONFERENCE, ALSO POINTED TO THIS ISSUE, CLAIMING 
THAT THE GOVERNMENT ALREADY IS FINANCING SOME PROJECTS 
FROM PRIVATIZATION REVENUES. AND THE FINANCE MINISTER 
HAS BEEN PUBLICLY PROMOTING A 1 BILLION EURO (5 PERCENT 
OF GDP) INVESTMENT PLAN. 
 
¶35.  THE RISE OF NON-PERFORMING LOANS (NPL) ALSO POSES 
RISKS, A POINT RAISED BY THE IMF IN ITS MARCH 
ASSESSMENT. "THE APPARENT INCREASE IN THE NPL TO TOTAL 
LOAN RATIOS OF MOST FOREIGN BANKS DURING 2005 COULD BE 
AN EARLY SIGN OF A WORSENING OF FINANCIAL STABILITY," 
THE IMF REPORTED. THE BAD LOAN RATE AT FOREIGN BANKS 
INCREASED FROM 3.9 PERCENT IN 2003 TO 10.7 PERCENT IN 
SEPTEMBER 2005.  MORE RECENT DATA SHOWS THAT NON- 
PERFORMING LOANS ARE UP, FROM THE SECOND QUARTER OF 
2005 THROUGH THE FOURTH QUARTER, FROM 8.79 TO 14.45 TO 
16 PERCENT FOR FOREIGN BANKS, FROM 38.9 TO 29.5 TO 37.7 
PERCENT FOR STATE-CONTROLLED BANKS, AND FROM 21.13 TO 
20.34 TO 46.63 PERCENT FOR DOMESTIC PRIVATE BANKS. 
HOWEVER, BANKERS CONSISTENTLY SAY THAT CONSUMER CREDITS 
PRESENT FEW NON-PAYMENT PROBLEMS, A FACT THAT ROEGL 
RECENTLY CONFIRMED. 
 
¶36.  STAMENKOVIC, IN A RECENT PAPER WITH SEVERAL OTHER 
ECONOMISTS, WARNS THAT THE CURRENT POLICY THREATENS TO 
INCREASE INTEREST RATES, RAISE THE RISK OF RECESSION, 
AND AT THE SAME TIME INCREASE CAPITAL INFLOWS.  SUCH 
INFLOWS LIKELY WILL LEAD TO SOME APPRECIATION OF THE 
DINAR - DESPITE THE CENTRAL BANK'S EFFORTS TO AVOID 
THIS OUTCOME - JEOPARDIZING EXPORT COMPETITIVENESS. 
HIS PREFERENCE WOULD BE FULL LIBERALIZATION OF THE 
CURRENCY MARKET AND FULL LIBERALIZATION OF THE CAPITAL 
MARKET.  CAPITAL INFLOWS COULD, TO SOME EXTENT, BE 
OFFSET BY CAPITAL OUTFLOWS AS SERBS ARE PERMITTED TO 
BUY OFFSHORE ASSETS.  HE NOTES THAT A HIGH CAPITAL 
INFLOW CAN CREATE AN ASSET BALLOON IN THE DOMESTIC REAL 
ESTATE MARKET, GIVEN THE SHORTAGE OF INVESTMENT 
OPTIONS. 
 
¶37.  DRAGUTINOVICH TOLD ECON CHIEF THAT THE NATIONAL 
BANK IS PLANNING TO LIBERALIZE THE EXCHANGE MARKET THIS 
YEAR.  IT WILL WITHDRAW FROM ITS ROLE AS EXCLUSIVE 
PURCHASER OF FOREIGN EXCHANGE FROM EXCHANGE HOUSES AND 
ALLOW THE BANKS TO TAKE OVER THIS ACTIVITY, REDUCING 
ITS ROLE IN EXCHANGE RATE FORMATION.  (NOTE: THE 
CENTRAL BANK ALSO DICTATES RATES TO THE EXCHANGE 
HOUSES.) INDEED, SHE SAID THAT THE BANKS INCREASINGLY 
TRADE FOREIGN CURRENCY AMONG THEMSELVES, ALTHOUGH IT IS 
NOT A FORMAL MARKET.  AT THE SAME TIME, SHE WAS NON- 
COMMITTAL ON THE ISSUE OF CAPITAL OUTFLOWS. 
¶38.  ON THE PLUS SIDE, JELASIC'S POSITION AT THE 
NATIONAL BANK APPEARS TO BE SOMEWHAT STRONGER. HIS FIVE- 
YEAR TERM ENDS IN 2009, MORE THAN A YEAR AFTER THE 
KOSTUNICA GOVERNMENT MUST FACE ELECTIONS.  HE APPEARS 
TO HAVE SURVIVED THE "SUITCASE" SCANDAL, WHICH RESULTED 
IN THE ARREST OF THE VICE GOVERNOR FOR THE BANKING 
SECTOR ON BRIBERY CHARGES.  THE VICE GOVERNOR  RECENTLY 
WAS RELEASED FROM PRE-TRIAL CONFINEMENT, AND MANY 
BELIEVE THAT THE ENTIRE EPISODE WAS AN EFFORT TO 
PRESSURE THE CENTRAL BANK OVER LICENSING ISSUES. 
 
¶39.  AT THE SAME TIME, THE CENTRAL BANK AT TIMES 
APPEARS A BIT LOST.  FOR INSTANCE, DRAGUTINOVIC KNEW 
NOTHING ABOUT THE ROLE THAT INSURANCE COMPANIES PLAY IN 
INSURING CONSUMER CREDIT, ALTHOUGH THIS PRACTICE ALMOST 
CERTAINLY IS SPURRING RETAIL LENDING. BANKS, FOR A 
MODEST PREMIUM, CAN OFFLOAD THEIR CREDIT AND FOREIGN 
EXCHANGE RISK ON THE STATE-OWNED - AND FEE-HUNGRY - 
STATE-OWNED INSURANCE COMPANIES.  JELASIC IS AWARE OF 
THE MORAL HAZARD INVOLVED, BUT APPARENTLY HAS NOT 
BROUGHT THIS ISSUE INTO MONETARY POLICY DISCUSSIONS. 
(WE RECENTLY WERE INFORMED BY THE MAIN PLAYER, DUNAV 
INSURANCE, THAT THEY HAVE CEASED WRITING SUCH 
COVERAGE.) 
 
¶40.  COMMENT:  CAPITAL INFLOWS AND THE RAPID CHANGES IN 
SERBIA'S BANKING SECTOR POSE A CHALLENGE TO THE CENTRAL 
BANK.  ITS RESPONSE HAS BEEN CONVENTIONAL, AND 
EFFECTIVE IN THE SHORT TERM, ALTHOUGH THE BANK IS 
BUILDING A SIGNIFICANT RISK IN THE MAGNITUDE OF ITS 
STERLIZATION PROGRAM. THE CZECH REPUBLIC BUILT A LARGE 
STERILIZATION POSITION ONLY TO SEE THE FOREIGN MONEY 
HEAD FOR THE DOOR IN MAY 1997, LEADING TO A 10 PERCENT 
DEVALUATION OF THE KORUNA.  MOST AGREE THAT THE BANK 
SHOULD BE SELECTIVE IN TARGETING CONSUMER CREDIT GROWTH 
THROUGH PRUDENTIAL MEASURES, RATHER THAN RISK DRAINING 
CREDIT FROM THE ENTERPRISE SECTOR AND SLOWING GROWTH. 
A LIBERAL STANCE ON CAPITAL OUTFLOWS WOULD BE SENSIBLE, 
AND THE NEW FOREIGN EXCHANGE LAW MAY PROVIDE AN 
OPPORTUNITY FOR PROGRESS.  IN ADDITION, WHILE PROSPECTS 
FOR A NEW IMF AGREEMENT AFTER THE MONTENEGRO REFERENDUM 
ARE UNCERTAIN, THE IMF RESIDENT REPRESENTATIVE SAYS 
THAT THE FUND IS BRINGING IN AN EXPERIENCED MONETARY 
ECONOMIST TO WORK AS AN ADVISER IN THE NATIONAL BANK. 
THE TRANSITION TO A MORE MARKET-DRIVEN EXCHANGE RATE 
WILL BE A MAJOR CHALLENGE FOR THE CENTRAL BANK, 
ESPECIALLY AS THE DINAR APPRECIATES. END COMMENT. 
 
POLT