VZCZCXYZ0000
RR RUEHWEB

DE RUEHBW #0840/01 2321116
ZNR UUUUU ZZH
R 191116Z AUG 08
FM AMEMBASSY BELGRADE
TO RUEHC/SECSTATE WASHDC 0300
INFO RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUCPDOC/DEPARTMENT OF COMMERCE WASHINGTON DC

UNCLAS BELGRADE 000840 
 
SENSITIVE 
SIPDIS 
 
USDOC FOR 4232/ITA/MAC/EUR/OEERIS/SSAVICH 
 
E.O. 12958: N/A 
TAGS: ECON EINV EFIN SR MW
SUBJECT: SERBIA: FINANCIAL VULNERABILITIES RISING 
 
SUMMARY 
------- 
 
¶1.  With a large and growing current account deficit estimated at 
almost 20% of GDP in the second quarter of 2008, Serbia's financial 
vulnerabilities are on the rise.  Increasing levels of external 
corporate borrowing and a strengthening dinar are raising concerns 
about medium-term sustainability and the prospect of an eventual 
hard landing.  The National Bank of Serbia (NBS) appears to be 
sanguine about near-term risks, but more hesitant about 2009 and 
2010, especially if government spending and public-sector wages 
continue their ascent.  The situation also highlights the need for 
greater levels of greenfield foreign direct investment (FDI) to 
boost Serbia's export capacity, reduce the trade deficit, and 
enhance the country's long-term competitiveness.  End Summary. 
 
 
A DETERIORATING FINANCIAL OUTLOOK 
--------------------------------- 
 
¶2.  According to unpublished data from the National Bank of Serbia 
(NBS), Serbia's current account deficit reached approximately 20% of 
GDP in the second quarter of 2008, up substantially from 13% in 
¶2007.  The increase is driven by a soaring trade deficit which 
widened by more than 20% in the first five months of the year, 
compared to the same period in 2007.  Foreign funding has covered 
the burgeoning external deficit in recent years, but at a declining 
rate which raises questions about long-term sustainability.  Capital 
inflows raised the NBS' foreign exchange reserves by $5.4 billion in 
2006, but only by $1.2 billion in 2007.  From January through May of 
2008, reserves decreased by $550 million as a result of NBS 
intervention to stabilize the dinar and a net decline in short-term 
portfolio inflows. These declining portfolio flows caused Serbia's 
total inflows to fall $200 million short of the $3.6 billion current 
account deficit through May. 
 
¶3.  Veselin Pjescic, General Manager of the Monetary System and 
Policy Department of the NBS, told us on August 12 that the current 
account deficit was becoming "one of the biggest challenges to the 
government" and was "not sustainable."  As domestic demand remains 
robust, foreign liabilities continue to grow.  From January through 
July, the stock of corporate sector debt rose from $12.2 billion to 
$13 billion.  In February 2008 the International Monetary Fund (IMF) 
reported that Serbia's private external debt has more than doubled 
since 2003, with total external indebtedness at 62% of GDP, above 
the 49% average for emerging markets. 
 
¶4.  Ironically, increased investor confidence in the Serbian 
government in the second half of 2008 could prove to be a mixed 
blessing.  Renewed portfolio inflows and external borrowing on the 
part of banks threaten to increase debt accumulation, strengthen the 
dinar, and expand the trade deficit.  Pjescic believed the dinar -- 
which had strengthened by 8% since May -- was overvalued, though he 
was uncertain by how much.  Calculations suggest the dinar could be 
overvalued by at least 13%, taking into account the inflation 
differential between Serbia and Europe and assuming equal 
productivity rates.  Serbia's year-on-year inflation rate of 15% in 
July and euro zone inflation of 4% imply that the dinar should have 
depreciated by 11% over the past year.  With the dinar at 79.5 
dinars per euro in July 2007, this suggests that the dinar should be 
traded at about 88, instead of the current 77. 
 
¶5.  Pjescic discounted the possibility of a speculative attack on 
the currency this year, noting that the NBS had 6 billion euros of 
reserves or 4 to 5 months' worth of imports.  He was much more 
circumspect about prospects in 2009-2010 and voiced concern about 
"non-economic" factors (i.e. political turmoil) that might scare 
investors.  In addition, adverse developments in global markets will 
continue to weigh on Serbia's financial stability.  Spreads on 
sovereign debt remain elevated at around 350 basis points (bp), 
which shot up from 200 bp last fall because of the credit crisis. 
Five-year spreads on credit default swaps (financial contracts which 
insure lenders against default; higher spreads indicate greater risk 
aversion) have stayed at 250 bp for months after rising sharply from 
150 bps last year.  At that time the dinar depreciated 10% before 
stabilizing at the end of December. 
 
MINORITY REPORT: A MORE PESSIMISTIC VIEWPOINT 
--------------------------------------------- 
 
¶6.  There is disagreement as to how much free reserves the NBS could 
bring to bear to fend off currency speculation.  We also met on 
August 8 with Miroslav Zdravkovic who works in the Economic Analyses 
and Research Department at the NBS.  Zdravkovic was convinced the 
situation was urgent and that there could be a speculative attack on 
the dinar in September because of loan repayments falling due during 
the month.  His position was counter to Pjescic who believed 
liquidity was sufficient to absorb such outflows this year. 
Zdravkovic claimed foreign reserves were equivalent to only one 
month's worth of imports and estimated that the dinar should trade 
at 86 or 87 per euro. The Central Bank should also make large 
purchases of euros to bring the dinar down and move away from its 
hawkish anti-inflationary stance, according the Zdravkovic. 
Ultimately, only export-oriented, greenfield FDI and stringent 
fiscal discipline would ease the pressure by reducing the trade 
deficit and containing domestic demand. 
 
FISCAL POLICY UNLIKELY TO HELP MATTERS 
-------------------------------------- 
 
¶7.  Indications of fiscal restraint are scarce.  Finance Minister 
and former NBS Vice Governor Diana Dragutinovic was quoted on August 
8 in the V.I.P. Daily News Report saying the external deficit 
reflected "overwhelming demand" in the economy right now and that a 
restrictive fiscal policy was needed.  In a bit of dry humor, 
Finance Ministry State Secretary Janko Guzijan, whose responsibility 
is to draft the government's budget, joked to us during a brief 
exchange on August 8 about the spending pressures placed upon him: 
"the less I work, the better it is for the country!"  The Ministry's 
May 2008 policy memorandum forecasts a budget deficit of 1.7% of GDP 
for 2008 and 0.4% for 2009 and surpluses of 1.0% and slightly above 
for 2010-2011.  These projections do not include the anticipated 
revisions in September to increase pensions by 10% and any other 
spending increases between now and 2011. 
 
¶9.  Pjescic expressed hope that the Finance Ministry could contain 
public consumption and achieve better coordination with the Central 
Bank on fiscal policy now that his former NBS colleague was Finance 
Minister.  However, his attitude towards the government's fiscal 
restraint was guardedly pessimistic because of the new coalition's 
social promises, which he believed could pose increasing financial 
hazards in 2009 and 2010, a view strongly shared by Zdravkovic. 
Standard & Poor's last month pointedly did not raise the outlook on 
Serbia's sovereign credit rating from "negative" to "neutral."  The 
ratings agency cited "pro-cyclical fiscal policies" as its main 
reason, despite the reduction in political risk from the extradition 
of fugitive war criminal Radovan Karadzic to the Hague War Crimes 
Tribunal. 
 
COMMENT 
------- 
 
¶10.  The NBS for several years has imposed numerous banking and 
credit restrictions which almost certainly have kept domestic demand 
and financial imbalances from expanding even further.  Ultimately, 
for Serbia to avoid a harsh adjustment, the investment climate needs 
to improve to attract greenfield FDI which will expand export 
capacity and increase productivity.  The key to enhancing Serbia's 
prospects for a soft landing therefore may rest with the Economy 
Ministry.  It has the chief responsibility for privatizations, 
corporate restructuring, and bringing in foreign investors.  The 
structural reforms that the IMF, Standard and Poor's, and other 
observers deem necessary to increase competitiveness fall under the 
Economy Ministry's writ.  If the budget cannot assist in reducing 
domestic demand, the burden of mitigating the country's financial 
risks could fall entirely on the Economy Ministry and the Central 
Bank.  End Comment. 
 
 
BRUSH