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Viewing cable 08BELGRADE708, Serbia: Inflation Challenges Ahead for the New Government

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Reference ID Created Released Classification Origin
08BELGRADE708 2008-07-18 17:49 2011-08-30 01:44 UNCLASSIFIED Embassy Belgrade
VZCZCXRO1912
RR RUEHAG RUEHAST RUEHDA RUEHDF RUEHFL RUEHIK RUEHKW RUEHLA RUEHLN
RUEHLZ RUEHPOD RUEHROV RUEHSR RUEHVK RUEHYG
DE RUEHBW #0708/01 2001749
ZNR UUUUU ZZH
R 181749Z JUL 08 ZDK
FM AMEMBASSY BELGRADE
TO RUEHC/SECSTATE WASHDC 0172
INFO RUEBAAA/DEPT OF ENERGY WASHINGTON DC
RUCPDOC/USDOC WASHDC
RUEHZL/EUROPEAN POLITICAL COLLECTIVE
UNCLAS SECTION 01 OF 02 BELGRADE 000708 
 
SIPDIS 
USDOC FOR 4232/ITA/MAC/EUR/OEERIS/SSAVICH 
 
E.O. 12958: N/A 
TAGS: ECON EINVETRD SR MW
SUBJECT: Serbia: Inflation Challenges Ahead for the New Government 
 
BELGRADE 00000708  001.2 OF 002 
 
 
Summary 
------- 
 
1.  Despite continued strong GDP growth of 8.2% in the first quarter 
2008, the new government will face serious economic challenges.  The 
immediate challenge will be reducing the estimated $700 million 2008 
budget gap in the face of expensive campaign and coalition promises. 
 Medium term challenges include suppressing annual inflation that 
reached 12.1% in June and decreasing the current account deficit. 
Long term stability can be achieved only with painful public sector 
reform and controlling public expenditure growth.  Economists 
question the new government's resolve.  End Summary. 
 
Immediate Challenge: 2008 Budget Gap of $700 Million 
--------------------------------------------- ------- 
 
2.  Despite continuing strong GDP growth of 8.2% in the first 
quarter 2008, mostly driven by domestic demand and service sector 
growth, the new government will face serious economic challenges. 
The immediate challenge will be closing the 2008 budget gap of $700 
million that is expected in the second half of the year due to lower 
privatization revenues.  Political uncertainty contributed to the 
failure of the recent large privatizations of mining firm RTB Bor, 
Genex Kopaonik's tourist properties, and tractor manufacturer IMT, 
and delayed other planned privatizations.  As a result, Prime 
Minister Cvetkovic announced the government would issue $600 million 
in bonds to cover the deficit, most likely in September. 
 
Stamenkovic: Budget Gap Much Wider 
---------------------------------- 
 
3.  Stojan Stamenkovic of the Economic Institute publicly estimated 
that the budget gap would be much wider since pensions alone are 
headed for an $800 million deficit in 2008 due to the promised 10% 
pension increase.  In addition, the Pension Fund is receiving lower 
than expected direct revenues and the inflation adjustment, 
originally planned for 8% in 2008, will likely reach 11%. 
 
Despite The Gap, PM Announces Pensions Increase 
--------------------------------------------- -- 
 
4.  In his opening remarks to parliament, Prime Minister Cvetkovic 
announced an increase in pensions from the current level of 55% of 
the average wage to "up to the maximum level of 70% in accordance 
with economic and fiscal capacities of the country."  Economists 
agree that this is not sustainable and is higher than in any other 
transitional country.  Rough estimates show that this increase would 
cost $1.3 billion in 2009.  On the other hand, DPM and Economy and 
Regional Development Minister Dinkic announced a cut in the wage tax 
from 12 to 10% and an increase in non-taxable wage level.  Dinkic 
also announced a goal to speed up privatizations in an effort to 
fill the budget gap with additional privatization revenues. 
 
Medium Term Challenge: Inflation Suppression 
--------------------------------------------- 
 
5.  The new government will have to deal with growing internal and 
external imbalances -- inflation and the current account deficit. 
Overall annual inflation reached 12.1% in June 2008, while core 
inflation which excludes state controlled prices reached 10%, far 
above the National Bank of Serbia (NBS) projected range of 3-6%. 
Inflation growth is due to external factors, including increased oil 
and food prices worldwide, but also from growing internal demand as 
a result of fiscal expansion and credit growth. 
 
6.  Although the NBS managed to curb credit growth from 39% in 2007 
to 9% in the first quarter of 2008 via restrictive administrative 
measures in order to slow down personal consumption growth, public 
consumption remains high at 44% of GDP in 2007.  The average net 
wage in May 2008 reached $643, in nominal terms up 19.1% over May 
2007, but in real terms only 3% higher due to a 15.7% increase in 
the cost of living for the same period.  NBS raised its benchmark 
interest rate from 10.75% in early January to 15.75% in May, but 
core inflation continued to rise. 
 
Additional Challenge: Current Account Deficit 
--------------------------------------------- 
 
7.  The current account deficit significantly widened from January 
to May 2008 to $3.63 billion (16% of GDP) and was up 66% compared to 
January-May 2007, mainly due to a record trade deficit that jumped 
45% over the same period.  In addition to an overvalued dinar that 
resulted in cheap imports and less competitive exports, the deficit 
grew due to the lack of competitive domestic production.  The new 
government will need to stimulate investment to increase the 
competitiveness of domestic production and exports. 
 
Reserves Decrease 
----------------- 
 
 
BELGRADE 00000708  002 OF 002 
 
 
8.  Serbia's balance of payments deteriorated in the second quarter 
of 2008 because of a reversal in a nearly steady increase in 
reserves over the last eight years in its foreign exchange reserves. 
 From January to May 2008 reserves fell by $555 million.  This was 
largely due to a shift in portfolio investments from an inflow of 
$562 million in January-May 2007, to an outflow in January-May 2008 
of $95 million.  Serbia's foreign exchange reserves were $15.45 
billion on May 31, 2008. 
 
Long Term Solution: Public Sector Reform 
---------------------------------------- 
 
9.  Stamenkovic highlighted public sector reform as the biggest 
challenge for the new government.  Inflation was driven by 
structural problems linked to public sector and state consumption 
and the solution is public sector reform.  He said reform should 
include: corporatization and privatization of public companies; 
reform of land policies - especially city land; reform of public 
expenditures including cancelling public company subsidies and 
transfers to social insurance funds and including rationalization 
and modernization of public services; decreasing the number of 
employees in the administration; etc.  According to Miladin 
Kovacevic, Deputy Director of Statistics, growing imbalances would 
lead to rapid inflation growth within two years without serious 
reform. 
 
Comment 
------- 
10.  Finance Minister Dragutinovic will face significant challenges 
in containing government spending in an environment where 
pork-barrel spending remains the rule rather than the exception. 
As a former NBS Vice-Governor Dragutinovic understands the hard work 
needed on the fiscal side to fight inflation and bolster 
macroeconomic stability, but many analysts doubt the government is 
prepared to take the necessary, but painful and unpopular actions. 
The Belgrade Stock Exchange has showed little optimism for the new 
government and has continued to fall since the government's 
formation.  There is a possibility that this government may 
ultimately deliver economic results in order to build a larger 
coalition majority in the next elections, which could be up to four 
years away.  However, in the shorter term, the economic pressures of 
fulfilling the government's expensive campaign and coalition 
promises, such as increasing pensions, may threaten the fiscal 
prudence needed to keep inflation under control.    End Comment. 
 
BRUSH