Serbia

Oxford Economic Country Briefings, Sep 15, 2008

Highlights and Key Issues

* Growth reached 7.5% in 2007 as spending rose ahead of the election and inward investment financed a wider external deficit. But the rate is slowing sharply in 2008-09 as the new government tackles inflation, which reached 12% in April, and tries to rein in a trade deficit that widened in Q1 due to higher energy and consumer imports.

* The pro-EU Democrats won the 11 May election and should be able to form the next government, though they may need difficult alliances to counter a strengthened Radical opposition. Pre-election signing of the EU stabilisation agreement points the way to more structural assistance, WTO accession and improved business confidence.

* But loss of budget discipline ahead of the election has forced the central bank to tighten monetary policy sharply, and the consequent drop in investment will force this year's growth rate well below the 7% target set by the outgoing government. Delays in forming a government, as the Democrats search for allies, could be a further barrier to early revival of investment.

* Slowdown during this year's adjustment will give way to growth of about 5% as reform parties stay engaged with the EU despite protest on Kosovo, unlocking more structural funding. While Russian firms are central to recently agreed energy projects, those from the EU and US can expect a bigger role.

Overview

Democratic Party beats nationalists...

* The pro-EU Democratic Party (DP), whose leader Boris Tadic retained the presidency in January, is set to take power after winning over 39% of the vote in the 11 May general election. A DP-led government is now likely despite the Democratic Party of Serbia (DPS), led by outgoing premier Vojislav Kostunica, holding coalition talks with the opposition Radicals. Despite rallying protest votes against Kosovo's independence declaration, which most EU member states have endorsed, the Radicals won 29% of the vote, and the similarly bellicose DPS won around 12%. The DPS will be wary of an alignment with the Radicals that would exclude it from EU dialogue. But the DP is keen to avoid further reliance on the DPS, which parted company with it over Kosovo and is also less committed to EU-driven economic reform.

...and will build on EU association

* Outgoing foreign minister Vuk Jeremic billed the election as a referendum on the EU, and Brussels did its best to swing opinion in favour of Tadic's Coalition for a European Serbia by signing the long-awaited Stabilisation and Association Agreement (SAA) and agreeing to ease visa restrictions later this year. Slovenia, with the EU presidency until mid-year, has promised "ever faster towards membership" following the vote, and the SAA raises the chances of joining the WTO next year. EU relations will improve even if the DP's new coalition has to include the Socialists, who recovered to around 9% of the vote. And with the DPS out of power, Russia is likely to lower its resistance to international recognition of Kosovan autonomy.

* However, substantial benefits from the SAA will not start to flow until the new government can stabilise the economy. Inflationary pressures have worsened despite a slowdown in growth from last year's 7.5%, and the situation could deteriorate if a growing external deficit forces a decline in the exchange rate or more interest rate rises to prevent it. Inflation quickened to 12% in April, as sharp food price rises lifted the CPI by 1.1% on the month, and core inflation (which excludes these) rose to 7% in March. The official target of 6.5% inflation for the full year is already out of reach, and containing it near current levels will require continued real appreciation of the CSD, only achievable if inward investment increases.

Greater capital inflow needed...

* The Q1 trade deficit, at US$2.9bn, was 40% higher than a year earlier, with rising consumer goods imports offsetting the stronger prices obtained for raw and semi-processed exports. Although term contracts at lower prices have offered some protection from rising world oil prices, the current account deficit is still more than 15% of GDP. This will cause afresh rise in foreign debt at a time when strains on global liquidity are adding to its cost. As well as financing the external deficit, new capital inflow is needed to modernise a supply side whose neglect has left the economy largely dependent on agricultural and mineral exports. Fiat announced a US$1 bn jointventure investment in new Zastava car models at the end of April, and the new government may look for EU-based alternatives to recent energy deals with Russian companies, including the construction of new power stations.

...as deficits force monetary squeeze

* Policy discipline was eroded in the long run-up to elections, restoring a familiar pattern of the central bank tightening monetary policy to offset pre-election fiscal loosening. It raised base interest rates by three points (to 14.5%) in mid-March and then to 15.25% on 24 April ; but the increases will have less effect than in the past because of increased scope for private borrowers to raise funds abroad. The central bank openly criticised a pre-election rise in state sector wages, which it fears will feed directly back into inflation. Increased borrowing costs are helping to restrain consumers but also subduing investment, despite wide scope for import substitution. Subdued agricultural investment has limited the scope for profiting from high European grain prices. This year's growth will probably be closer to 4.5% than the official target of 7%.