Serbia

Oxford Economic Country Briefings, May 8, 2007

Highlights and Key Issues

* An inconclusive election adds downside risk to growth, already slowing to around 5% this year due to budget deficit reduction and continued tight monetary policy. The main risk is of falling inward investment and stalled privatisation undermining external deficit finance and causing the currency to weaken.

* Inflation has slowed to post-socialist lows as a result of fiscal restraint and a rising currency; but the rate could pick up from the 4.6% achieved in April (retail prices) if lower capital inflows cause the dinar to weaken, or budgetary curbs force faster removal of price controls.

* Although substantially better balanced, the central budget moved into surplus last year only through a one-off telecoms auction, and plans to keep the deficit below 1% of GDP this year could fail unless a strong reformist coalition returns.

* New elections must be called if a coalition does not emerge by 14 May, and reformers could lose again if Kosovo's independence wins UN approval. Investment will remain subdued while there is risk of the nationalist Radicals, still the largest parliamentary party, capitalising on stalled EU integration to take power and try a different approach.

Overview

Reform parties shy away from pact...

* As expected, Prime Minister Kostunica's Democratic Party of Serbia (DPS) lost substantial ground in the 21 January election, securing only 16% of the vote. But the 23% secured by President Boris Tadic's Democratic Party makes possible the continuation of a centre-left/centre-right coalition, keeping out the more nationalistic Radicals (SRP) who came top with 28%. Despite initial hopes of a deal, Tadic and Kostunica have so far failed to agree on a pact, with the DPS upset by DP insistence that its candidate, economist Bozidar Djelic, becomes prime minister. There is a danger of their talks slipping past the 14 May deadline after which new elections would have to be called. Rumours of an alternative DPS-SRP pact have been denied on both sides, the Radicals preferring to hold out for fresh elections.

* The incentive for coalition deals has been weakened by the imminent UN move to bring independence to Kosovo, which no party wants to endorse. The UN special envoy Martti Ahtisaari's proposal of independence under EU supervision will be forced on Serbia unless Russia uses its security Council veto. EU threats not to resume stabilisation agreement (SAA) talks - suspended a year ago over war-crimes cooperation - until there is an acceptable government are designed to speed up its formation; but they risk amplifying the swing to the opposition in any new election. Montenegro, which began talks at the same time, has already initialled its SAA.

...as Kosovo independence looms

* Although partly punished for high unemployment and slower growth during earlier phases of adjustment, governing parties have mainly lost ground due to the succession of post-war political setbacks, culminating in last year's secession by Montenegro and the imminent Kosovo loss. EU countries are expected to push for the Kosovo issue to be settled this month, but Russia may play for time, and the UN decision cannot be reached before the coalition-forming deadline. Having effectively promised to deflect the issue with a Russian veto, Kostunica's image could be further damaged if this is not delivered. His joint appeal with Tadic for continued Serbian sovereignty is unlikely to sway the EU, which is concerned about protest among Kosovo's Albanian majority.

Inward investment at risk...

* Economic news flow remained positive during Q1 despite the political standstill that has stalled economic reforms and privatisation. Retail price inflation has slowed further, to 4.6% in April from 5.6% in March, and the core rate (excluding seasonal food prices) down to 3.4%. Although held down by an appreciating dinar that is vulnerable to the external deficit, and by caps on some state utility prices that may have to be removed to reduce the budget, these rates are the lowest since the socialist system ended. Capital inflows have remained strong despite an uncertain build-up and outcome to the January election. This allowed the current account deficit to widen to around 13% of GDP in 2006 without constraining growth.

...as budget and asset sales stall

* However, the long political vacuum and risk of new elections with a further rightward swing are expected to impact negatively on investment and growth in Q2. The Kosovo impasse has raised fears of capital inflows slowing or even reversing if domestic politics swing towards the nationalists, and of a refugee influx adding to the already severe unemployment problem. Inward investment exceeded US$4bn in 2006 as privatisation augmented a rise in greenfield projects, but may drop below the targeted US$3bn in 2007.

* As well as being unable to finalise the 2008 budget (which targets a surplus of 0.7% of GDP), finalise the flagship NIS oil privatisation or implement planned cost cuts in the present one, the interim government is stalling over the appointment of a governor for the central bank, raising fears that its independence could be compromised. Rising expenditure and recent tax reductions will send the fiscal deficit back above 3% of GDP this year, after narrowing to 1.6% in 2006 (a 1.5% surplus after the addition of telecoms licence receipts). Deficit reduction with those receipts under the outgoing government has not prevented public debt from going above 60% of GDP. The fall in inward investment necessitates a slowdown in growth if the current account is to stay financeable. If demand is not reined in fast enough through tighter fiscal policy, the dinar will have to adjust downwards, fuelling an upturn in inflation. Early repayment in March of outstanding IMF debt, though good for the budget, may actually prove negative for investment, since it reduces external creditor discipline on policy.