Revised Memorandum on the budget and economic and fiscal policy for the year 2008, including projections for years 2009 and 2010, october 2007

On the basis of Article 14, paragraph 1, item 1) of the Budget System Law (“Official Gazette of the Republic of Serbia” Nos. 9/02, 87/02, 61/05 – state law, 66/05, 101/05 – state law, 62/06 – state law and 85/06),

The Government hereby adopts the revised

MEMORANDUM

ON THE BUDGET AND ECONOMIC AND FISCAL POLICY FOR THE YEAR 2008, INCLUDING PROJECTIONS FOR YEARS 2009 AND 2010

I. INTRODUCTION

1. Macroeconomic framework

In 2006, the Republic of Serbia recorded significant macroeconomic results in terms of economic growth, curbed inflation, exports growth, improved efficiency of the economy, financial sector growth, FDI inflow and FX reserve increase, accompanied however with high foreign trade deficit, soaring unemployment, high local currency appreciation, increased public spending and wage growth out of pace with the growth of productivity.

Macroeconomic trends in 2006 were characterized by high growth of gross domestic product (GDP) at 5.7% and curbed inflation at 6.6%. In addition, the country saw a considerable growth of exports, translated into EUR, at 41.4%, as well as growth of NBS foreign exchange reserves, which amounted to EUR 9 billion at the end of 2006. The trend of high economic growth has continued through 2007. It is estimated that real GDP growth in 2007 would be about 7%, with a consumer price growth of 8.5%.

Given the country’s macroeconomic stability and ongoing structural adjustments, real GDP growth for the period from 2008 to 2010 is projected at an average rate of 6.3%, with an upward tendency as the process of restructuring and transition develops further. The projected rate of GDP growth is expected to be achieved primarily through goods and services exports growth at an average of 24.1% p.a. and investment growth at an average of 16.1% p.a. Growth of local and foreign investment is crucial for modernization of the economy, and infrastructure in particular, as well as for boosting exports, which are the key component of economic growth. The projected growth of GDP and investment over the following three years is expected to contribute to higher employment and better standard of living.

The projections anticipate curbing of inflation in the forthcoming period, with a target of 4% to be reached in 2010. In the course of 2007, total inflation (8.5%) increased at a higher rate than in 2006 (6.6%), with core inflation (4-4.5%) slowing down compared with 2006 (5.9%) and non-core inflation (12.6%) increasing relative to 2006 (7.4%). The main drivers behind this increase of non-core inflation in 2007 included administrative measures taken to eliminate price disparities, increasing prices of oil products triggered by soaring crude oil prices, increased prices of agricultural and food industry products in August and September due to drought and existence of uncompetitive structures in Serbian economy.

Key assumptions underlying the macroeconomic framework for growth and stability of Serbian economy include:

Stringent fiscal and monetary policy, providing the basis for macroeconomic stability;

Expedited structural reforms, in particular finalization of privatization in the remaining socially-owned enterprises and expedited restructuring and privatization of State-owned enterprises;

Strengthening of the private sector, as a generator of new investment, exports and employment, which will absorb the redundant workers laid off in the transition process and young persons completing their education;

Improved business climate and emergence of a competitive environment, conductive to new investment and changing production structure.

Once these activities have been implemented, they will result in a dominant position of the private sector in Serbia’s economy after the privatization of the existing enterprises and formation of new ones, which in turn will bring about to the creation of a comprehensive legal framework for a functional market economy, primarily through the enactment and implementation of systemic laws harmonized with acquis communitaire and WTO principles. Consequently, the Government will emerge as an active player, responsible for managing economic policy and improving the business environment and credibility of the country.

2. Fiscal policy

Between 2001 and 2006, Serbia saw a comprehensive reform in the field of public finance through the enactment of a new legislative framework and building of new institutions and modernization of already existing ones. Fiscal reforms implemented thus far have been crucial in the establishment of macroeconomic stability and creation of conditions conductive to investment and economic growth.

However, in the second half of 2006 there was a dramatic increase in public spending, in what can be seen as a departure from the stringent fiscal policy implemented since mid 2004. Furthermore, the second half of 2006 was the time of signing protocols and agreements and of adopting laws which resulted in a significant increase in public spending in 2007, unmatched by a similar increase in revenues. It is estimated that, primarily due to these measures, consolidated public expenditure as a share of GDP in 2007 would rise by 2.4 percentage points compared with the previous year, while the net result (surplus/deficit) would drop by about 2.1 percentage points of GDP. The country’s expansive fiscal policy, combined with excessive wage growth and credit expansion, resulted in increasing domestic demand from the last quarter of 2006 onward. This expansion of demand translated for the most part into higher trade deficit, which was even higher than initially planned, while the “boost” effect for local economy was far more modest. As the current level of trade deficit is not sustainable in the long term, it will be necessary to apply a mix of measures aimed at its reduction. Fiscal policy will play the key role in this, but Serbia’s wage policy, monetary policy and exchange rate policy could also make substantial contributions.

A cut in the trade deficit will require curbing of domestic demand through heavy fiscal adjustments in 2008, which will see the reduction of public expenditures as a share of GDP by 1.2 percentage points. Plans are to further reduce public expenditures as a share of GDP by 0.8 percentage points in 2009.

Key measures needed to reduce the ratio between public spending and GDP include: freezing the real wages in public administration and public services throughout 2008 at the level attained at the end of 2007, i.e. after the previously signed protocols on wage increases have taken effect; a cut in subsidies by 5% compared with those from the 2007 budget; and a cut in public investment from the Republic Budget by more than 10% relative to the amounts allocated from the 2007 budget.

Consolidated public revenues (excluding license fees) as a share of GDP will remain at approximately the same level in the forthcoming period, with the share of public expenditures decreasing. These trends in public revenues and expenditures will result in a deficit in the consolidated public sector balance in 2008, with a moderate surplus in the last two years of this mid-term period.

Fiscal reforms will continue over the forthcoming period and will include tax system improvements, restructuring of public spending, increased transparency in public finance, tax administration and customs administration capacity building etc.

3. Structural reforms

The planned macroeconomic objectives – high economic growth rates, exports growth and growth of fixed investments – will remain out of reach unless the process of structural reforms is expedited. Primary tasks in the field of structural reforms include completion of privatization in socially-owned enterprises, banks and insurance companies, continued restructuring of public enterprises and commencement of their privatization, creation of a business environment conductive to SMEs startup and FDI attraction and continued reforms in public finance management and public administration.

A priority for the Government in the following mid-term period as far as public sector is concerned will be to implement the remaining necessary measures in public enterprises, so as to render them viable in the market, which would be followed by their partial or full privatization.

Further implementation of structural reforms will increase pressures in the labour market; in response to this challenge, a priority for the Government’s economic policy will be promotion of SMEs development and growth, so as to buffer the negative effects of structural reforms of the economy. Attraction of foreign direct “greenfield” investment could hold the key to reversing the negative trend in the labour market, but for this to happen it will be necessary to further improve the investment environment, in particular the legal system.

Public finance management is being improved on an ongoing basis. In the forthcoming period, reforms in this field will be focused on strengthening public finance supervision by the State Audit Institution, upgrading the mid-term planning system, cutting expenditures through reforms in the pension system and other social insurance systems, higher efficiency of tax collection and narrowing the possibilities for tax evasion. Adequate public investment in infrastructure will increase Serbia’s competitiveness, give an impetus to economic growth and enable the attainment of identified strategic objectives. A fundamental principle underlying public investment will be to level out the regional disparities in terms of economic development.

Public administration reform will focus on creating an efficient administration, built around the principles of decentralization, depoliticizing, professional operations and downsizing.

Adequate coordination of policies based on the adopted strategies will enable the attainment of identified objectives and will enable Serbia to progress further. Structural reforms in the forthcoming period will require swift implementation, in order to address as soon as possible the existing economic and social disparities and introduce the conditions needed to achieve sustainable and relatively high economic growth and development over the mid-term period. Admittedly, short-term costs of implementing structural reforms could indeed be very high for many sectors, but the benefits to be reaped from their implementation will spur further growth and development of Serbian economy and society as a whole.

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