VZCZCXYZ0000
RR RUEHWEB

DE RUEHBW #1877/01 3241007
ZNR UUUUU ZZH
R 201007Z NOV 06
FM AMEMBASSY BELGRADE
TO RUEHC/SECSTATE WASHDC 9757
INFO RUCPDOC/USDOC WASHDC
RUEATRS/DEPT OF TREASURY WASHDC

UNCLAS BELGRADE 001877 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON ELAB EFIN EIND PGOV SR
SUBJECT:  SERBIAN FISCAL EXPANSION 
 
¶1. (U) SUMMARY: Serbia's macroeconomic outlook appears 
strong as the country moves toward elections.  GDP was up 
6.7 percent in the first half of 2006, inflation likely 
will reach only 9 percent, and strong export growth 
continues, at 27 percent. Record inflows of foreign direct 
investment, mainly from the sale of the former Karic-owned 
cellular operator, have provided the Kostunica government 
with the resources to feed the pre-election recovery 
through increased public spending of 4 percent of GDP in 
¶2006. However, the International Monetary Fund (IMF) raised 
a red flag in its recent Article IV review, warning that 
the pre-election binge will leave a new government a 
sizeable fiscal deficit, especially when real sector 
performance is still weak as a result of the slow pace of 
corporate restructuring.  The possibility that the central 
bank governor would be replaced after the January 21 
election adds to uncertainty. END SUMMARY 
 
REAL FUTURE OR FALSE HOPE? 
--------------------------- 
¶2. (U) At the moment, virtually all economic indicators 
paint a bullish picture of the Serbian economy.  Higher GDP 
growth of 6.7 percent in the first half eclipsed the IMF 
projection of 5.7 percent.  This result is especially 
impressive given that agricultural production was weak and 
the tax component of GDP underperformed. 
 
¶3. (U) Inflation dropped to 9.3 percent (annualized rate) 
in October 2006, compared to price growth of 17.7 percent 
in 2005, but almost half of the consumer price index 
remains under government control. Cumulative inflation in 
the period January-October 2006 was 5.6 percent, and the 
National Bank projects that inflation on the year will not 
exceed 9 percent.  However, the restrictive monetary policy 
of the NBS is only part of the story, since core inflation, 
although slowing, is still high at 5.8 percent. 
 
¶4. (U) Rather, the decline of inflation has been attributed 
mainly to dinar appreciation, the fruit of two major policy 
shifts announced by the National Bank this year. In May, 
the Bank said it would retreat from its wholesale 
intervention in the exchange market and let market forces 
take over.  This was followed by an August announcement 
that monetary policy was moving toward inflation targeting. 
On November 1, the dinar broke the support level of 80 to 
reach 79 per Euro, thus appreciating 13.6 percent in real 
terms since the beginning of 2006. Although Serbia has a 
history of hyperinflation, with inflationary expectations 
routinely factored into prices, such expectations are now 
easing.  Dinar appreciation, external factors such as the 
fall of oil prices, and a GOS delay in price increases for 
electricity all have contributed to the inflation fall. 
 
¶5. (U) Industrial production grew 5.5 percent in the period 
January to September 2006, compared to the same period last 
year. Yet de-seasonalized data show a fall of 2.3 percent 
in September compared to August, calling into question the 
further trend as tighter monetary policy begins to slow 
activity. The service sector continues to grow with 
transport and financial intermediation rising over 20 
percent. However, industrial production in Serbia still 
remains 50 percent less than 1989 levels, and unemployment 
hovers around 21 percent. 
 
¶6. (U) The trade gap remains a key sustainability issue. 
Export growth is robust at over 27 percent, but it has not 
been sufficient to close the gap with imports, even in the 
longer-run, because of the low base and the enormous trade 
gap. Trade figures for the first nine months of 2006, show 
increased exports of 27.4 percent, i.e. 29.2 percent after 
Montenegro is included in the foreign trade balance. Import 
growth is declining, with imports up 23.9 percent year on 
year in the first nine months, mainly as a result of lower 
oil prices.  The trade deficit in the first nine months of 
2006 was USD 4.7 billion, 11.1 percent higher than in the 
same period last year. Due to the higher growth of exports 
relative to imports, coverage of imports by exports 
increased from 43 percent to 48.7 percent in the period 
January-September 2006. 
 
¶7. (U) At a November 1 press conference, Governor Radovan 
Jelasic predicted that the current account deficit will 
fall to 8.6 percent, well below last year's 10.8 percent. 
This would be the result mainly of including Montenegro in 
Serbia's foreign trade balance, where Serbia is running a 
surplus of about 2 percent of GDP.  Still, the IMF is far 
less optimistic and projects that the current account 
deficit will increase to some 12 percent of GDP, if current 
fiscal plans are fully implemented.  The difference to some 
extent is based on the central bank's expectation that the 
effects of increased public spending will be postponed till 
the first quarter of 2007. 
 
¶8. (U) Restrictive monetary policy started to bear fruit as 
bank borrowing from abroad remained at the same level as 
last year, about USD 1.6 billion for the first nine months. 
The growth rate of corporate borrowing also slowed, from 
USD 0.8 billion in first nine months of 2005 (16.7 percent 
in real terms) to USD 0.7 billion (10 percent in real 
terms) in the same period 2006.  The growth of consumer 
lending also slowed, from USD 0.6 billion (48 percent) in 
the first nine months of 2005, i.e. to USD 0.8 billion (38 
percent) in the same period this year.  Analysts point to 
this lower corporate borrowing as the cause of the recent 
stagnation of industrial production. 
 
¶9. (U) Responding to lower inflation and credit growth, the 
central bank on November 1 loosened reserve requirements on 
dinar deposits, from 18 to 15 percent, but the key reserve 
requirement on foreign bank borrowing under two years 
remains at 60 percent.  (The high Euroization of Serbia's 
economy means that the dinar reserve requirement has a 
limited impact.)  Some banks reacted by boosting the 
interest rate on dinar deposits, e.g., Raiffeisen bank 
increased interest rate from 12 to 13 percent for three 
months deposits and from 13 to 14 on six-month deposits 
(nominal interest rates).  The NBS also announced a cut in 
the reference interest rate on two-week repo operations 
from 18 to 17.5 percent. 
 
¶10. (U) Capital account inflows went through the roof 
mainly as a result of foreign direct investments (FDI) 
projected to exceed USD 4 billion this year. The headline 
deals included sale of the former Karic cellular operator 
to Norwegian company Telenor for USD 1.92 billion (of which 
the GOS took USD 1.4 billion, with the remainder to the 
Austrian co-owner who had bought out Karic.)  Vojvodjanska 
Banka was sold to National Bank of Greece for USD 460 
million, and German concern Stada acquired pharmaceutical 
manufacturer Hemofarm for USD 570 million. 
 
¶11. (U) NBS foreign exchange reserves skyrocketed to USD 10 
million, or about 10 months of import cover, although this 
stock is inflated by the central bank's tough reserve 
requirements on bank borrowing abroad.  Thus, the NBS's own 
foreign exchange reserves were USD 4.3 billion, or about 4 
months of imports.  (The net stock was calculated by taking 
total foreign exchange reserves, minus required reserve, 
minus the government's foreign exchange deposits with 
central bank).  The GOS took advantage of high reserve 
levels to prematurely pay half of its USD 1 billion debt to 
the IMF.  Serbia also announced plans for early repayment 
of USD 410 million to the World Bank by the end of 2006. 
 
PRE-ELECTION LARGESSE FEEDS ECONOMIC GROWTH 
--------------------------------------------- 
¶12. (U) With elections now set for January 21, Finance 
Minister Dinkic, clearly determined to boost the prospects 
of his G17 party, pushed through a budget revision in 
September that substantially increased spending by relying 
on one-time revenues.  Parliament adopted an amended budget 
for 2006 that projects an increase of current spending by 
3.8 percent, but also introduces an ambitious National 
Investment Plan (NIP) that would add capital spending equal 
to 4 percent of GDP in 2006.  The NIP is a two-year public 
investment plan, financed from privatization revenues. 
 
¶13. (U) The amended wage bill of the central government 
would increase by 6.8 percent relative to the original 2006 
budget.  Thus, in 2006, in nominal terms, young employees 
in government administration will get wage increase of 62 
percent, employees in the health sector will get 48 
percent, in higher education, 32 percent, in the Ministry 
of Interior, 27 percent and in the Army, 20 percent. 
Dinkic also addressed the senior vote by announcing a 
decision to repay by the end of 2006 pension arrears from 
1990s of 1.5 percent of GDP.  NBS Governor Jelasic warned 
that all these measures will intensify pressure on domestic 
demand and inflation, as well as widen the trade deficit. 
 
¶14. (U) The IMF calculates that the revised budget will 
result in a 2006 fiscal deficit of 0.6 of GDP, compared to 
the targeted surplus of 2.7 percent agreed with the IMF as 
part of the Extended Arrangement that ended in February. 
The Fund said that the deficit would be 1.4 percent of GDP 
if the GOS were able to spend the money as projected, but 
it regards this as unlikely.  The Fund predicts that the 
impact of current policies - including tax cuts and 
generous public sector wage increases - could result in a 
general government deficit of 3.5 percent of GDP for 2007, 
and up to 6.5 percent if the GOS is able to implement fully 
spending under the National Investment Plan.  The Fund 
predicts that this fiscal largesse will complicate 
disinflation, increase the current account deficit and 
compromise competitiveness and medium-term growth. 
 
¶15. (U) Still, finance minister Dinkic considers the budget 
sustainable, despite the fact that VAT revenues are below 
planned levels for 2005 by about 5 percent, or a shortfall 
of 3 percent of total budget revenues.  One-off revenues 
from the sale of the mobile license will be used to finance 
current spending.  (Austrian cellular provider Mobikom was 
the only bidder for the third mobile license, at a minimum 
bid of Euro 320 million). 
 
¶16. (U) Local experts have joined the IMF in criticizing 
the National Investment Plan.  All agree that the state is 
not an efficient investor, with low project quality and 
poor monitoring of implementation, and emphasize that NIP 
spending will crowd out private investment in the short- 
run.  Prominent economist Stojan Stamenkovic estimated that 
NIP implementation would imply the rise of public 
investment to one third of total investment, which would 
cause a proportional reduction of private consumption. 
Instead, local economists suggest that excess privatization 
proceeds should be invested in further reduction of public 
debt, reform of the pension system and tax relief. 
 
CORPORATE RESTRUCTURING LAGS 
----------------------------- 
¶17. (U) The IMF statement pointed to continuing corporate 
sector losses, "largely reflecting weak governance and soft 
budget constraints," as the source of Serbia's continuing 
external deficits.  The chairman's statement at the Article 
IV review renewed the call to sell remaining socially-owned 
enterprises and consistently initiate bankruptcy. 
 
¶18. (U) However, despite lip service to the policy of "two 
strikes and you're out," the Agency for Privatization 
continues to regard bankruptcy as the policy of last 
resort.  At an October 24 meeting with econ chief, an 
assistant minister of economy revealed that the GOS intends 
to pursue a "third way" of privatizing insolvent 
enterprises that have not found a buyer after two attempts 
at privatization via tender or auction, by selling assets 
selectively.  While he said that some 236 socially-owned 
enterprises would be sent to bankruptcy, in addition the 
346 in bankruptcy already supervised by the privatization 
agency, this means that the GOS still must deal with some 
600 of the remaining 850 enterprises. 
 
New Central Bank Governor? 
--------------------------- 
¶19. (SBU) The uncertainty regarding economic policy 
following the election was compounded when NBS Governor 
Jelasic complained publicly on November 10 that the just- 
passed law implementing the Constitution would subject his 
job to political horse-trading.  The law says simply that 
the new Parliament will name a new governor, although 
Jelasic began his five-year term only in February, 2004. 
Comments by several party officials indicated that they 
indeed regard the governor's position as one subject to a 
future coalition agreement, despite the five-year term 
written into the central bank law to preserve independence. 
We intend to point out the folly of such political 
manipulation with a key, supposedly independent, economic 
policy position. 
 
COMMENT 
------- 
¶20. (SBU) Comment:  Now former Finance Minister Dinkic 
demonstrated once again a single-minded dedication to the 
immediate political objective by abandoning fiscal targets 
agreed with the IMF and embarking on a highly politicized 
relaxation of fiscal policy as elections loom.  This policy 
will reverse the hard-won shrinkage of the public sector 
and leave the next government facing austerity to avoid 
even larger deficits.  Dinkic also did not engage on 
corporate restructuring, leaving this crucial area to 
Economy Minister Bubalo, whose focus on reform sometimes 
seems more rhetorical than real.  The result is, at best, a 
pronounced pause on economic reform.  One way out of this 
hiatus would be renewed engagement with the IMF and the 
World Bank after elections, but such re-engagement would be 
problematic after the manner in which the GOS abandoned its 
previous commitments on reform.  Under any circumstances, 
such a move is not even possible until a new government is 
formed after the January election. 
 
POLT