Serbia August 2011

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Emerging Markets

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Serbia is reclaiming its place in Europe; it expects to receive a candidate status this

year and ties its economic links closer to Italy and Europe. Based on our recent visit,

we see an improved outlook for the country. The government is observing Central

Europe for central banking clues, Slovakia for an export-oriented transformation and

tries hard to cooperate politically with the EU. The NBS runs a relatively free float to

‘dinarise’ a heavily-indexed economy. Measuring by the results, the country’s policy

choices are proving more effective than Croatia’s and the World Bank sees a five-

quarter consecutive export growth reassuring on competitiveness. This should be

reinforced by a prospective flow of foreign investments, including a €1bn project in the

auto industry where the supply chain is substantial. Based on a best-case scenario and

Slovakia’s experience, Serbia’s economic model that was conditioned by past high

consumption standards could transform to an export-oriented one and its growth rate

rise from 3% to 5%-7.5%.

Fiscal populism typically surrounding political elections is a concern. External

vulnerabilities are still large and funding gaps could still surface. The government has

requested a new precautionary IMF SBA, which, in our view, would be necessary to

secure the government’s debut Eurobond scheduled for September/October. This,

otherwise, could be a rare case of an improving credit.

Serbia’s dinarisation problem and the NBS

Serbia has one of the highest and most volatile inflation rates in Europe (after the Ukraine and

Belarus). The National Bank of Serbia is also unique in the region with its monetary regime;

it operates a quasi-free float with active interest rate policy, in an environment of very

low policy credibility. Interest rate policy is therefore ‘aggressive’, as the bank is trying to

build dinar-based financial markets; establish confidence in the local market and reduce

inflation to c. 4%.The prevailing degree of euroisation, however, suggests that the strategy has been as yet

ineffective. This proved to be a single important problem in the crisis management in Serbia

although the impact has been rather well contained. The use of the euro is widespread in the

SEE region and it is the highest in Serbia; 67% in loan portfolio and 70% in deposits. The rate

of euroisation under both fixed exchange rate or inflation-targeting regimes is usually 60% or

less.

The region’s experience with hyperinflation and monetary instability, and widespread

indexation has created a pattern of exchange rate pegs or de facto currency boards. The

NBS, alone in the neighbourhood, is running considerably greater exchange rate flexibility.

This has been facilitating some degree of switch to the RSD in 2008 but the NBS intervened

later asymmetrically; putting a floor under the dinar and preventing excessive depreciation.

The combination of high euro-indexation and exchange rate flexibility remains risky but as we

show below, by the results, more effective than Croatia’s peg. The full scale of exchange rate

adjustment between 2008 and 2011 was c. 35%. This was among the larger nominal

exchange rate depreciations in the region. According to the NBS, however, the deterioration of

banks’ loan quality has not been as large as elsewhere, where the private sector holds

similarly large open currency positions. The NPL ratio reached c. 17%; 24% in the corporate

sector and 8% for households. This is likely to have been possible due to households’ hedge

in the form of large holdings of foreign currency savings and deposits. According to the

OeNB’s EuroSurvey, Serbian households hold on average c. €3,500 euro general cash

reserves or in total c. €9bn, equivalent to over 20% of GDP (2009 survey-time GDP, latest

NBS data €7.3bn), which exceeds that in any other Central Eastern European country.

According to the World Bank, the size of the cash economy is also massive, which has also

helped to ease the crisis.

EM Country Briefing

Serbia: Fights for growth

S&P BB- (stable)

Moody’s NR

Fitch BB- (negative)

Analyst

Barbara Nestor

+44 (0)20 7475 [email protected]

research.commerzbank.com Bloomberg: CBIR

12 August 2011



EM Country Briefing

2 12 August 2011

As part of the dinarisation strategy of the NBS, the government introduced credit support

programs via subsidised dinar loans, which have helped to shore up credit growth during the

crisis. This program reduced slightly the share of foreign currency loans in total from 75% to c.

67%, although the support scheme is being phased out and the increased use of the dinar may

fade out again. According to the OeNB’s survey the practise of setting prices and wages in euro

and denominating them in dinar only for legal purposes prevails, while payments for large

consumer durable goods are made almost exclusively in foreign currency. As macroeconomiccredibility is perceived to be low, the best hedge remains to be denominating contracts

and prices in foreign currency.

The favourable interest rate differential of foreign currency denominated financial services

arouse from (previously) easy access to abundant foreign currency liquidity from abroad from

parent banks and remittances (the latter c. 8% of GDP p.a.). A lack of a liquid government bond

or bill market beyond the shortest maturities means the pricing benchmarks for local currency

financial instruments and hedging products is missing. The authorities nevertheless continue to

maintain a co-ordinated support for dinarisation, which involves the development of hedging

markets, the NBS offering FX swaps and the Ministry of Finance issuing local debit instruments

and lengthening T-bill maturities from three months to two years. The next hurdle is to

encourage a secondary market in T-bills.

Serbia’s monetary policy operation resembles that of Hungary’s in its early inflation targeting

period; it runs at high interest rate volatility, due to the overwhelming role of exchange rate

transmission. When the exchange rate background is stable, the carry trade catches on; year-to-

date the NBS reports c. €0.7bn foreign portfolio investments in short debt instruments (361D+ T-

bills, available to non-residents); one-half of the outstanding stock. With a shallow currency

market this makes the RSD vulnerable (€100m daily turnover, €300m-€400m pre-crisis, catching

up to Romania). According to local banks the (quasi-) free-float and non-resident participation in

the local market helps the market to develop. The float, therefore, could prove a healthier

strategy than Croatia’s quasi-fix (see more on this below), provided that the local market

grows in liquidity and hedging instruments. The IFC is taking an active role in technical

assistance, and a growing number of multinational corporate operations should also facilitate

this.

The NBS says that inflation volatility encourages euroisation more than exchange rate

volatility. Therefore it is likely to continue to allow exchange rate volatility, as long as it

can control inflation, but interest rates are likely to be held at a foreign currency risk

premium to Europe. A turnaround into a currency board like fix, similar to Croatia, is not

considered. (For comparison, annual average. EUR/RSD depreciation was 15% and 9.5% in

2009 and 2010, respectively, as against weighted average interest rate on Republic of Serbia T-

bills of 14% and 11%).

CHART 1: Foreign currency loans as % of GDP CHART 2: Foreign currency loans as share of private credit

0

10

20

30

40

50

60

70

80

90

B e l a r u s

R u s s i a

T u r k e y

M o l d o v a

P o l a n d

M a c e d o n i a

R o m a n i a

A l b a n i a

U k r a i n e

S e r b i a

H u n g a r y

B u l g a r i a

L i t h u a n i a

C r o a t i a

L a t v i a

0

10

20

30

40

50

60

70

80

90

100

B e l a r u s

R u s s i a

T u r k e y

P o l a n d

M o l d o v a

U k r a i n e

M a c e d o n i a

B u l g a r i a

R o m a n i a

H u n g a r y

A l b a n i a

S e r b i a

L i t h u a n i a

C r o a t i a

L a t v i a

Foreing currency loan as share of household

Foreign currency loans as share of corporate loans

Indexed

Source: Commerzbank Corporates & Markets, EBRD Source: Commerzbank Corporates & Markets, EBRD



EM Country Briefing

12 August 2011 3

Damages from the crisis

The banking sector is a strong pillar of the economy. While the above would suggest that

exchange rate volatility has been harmful, banks have withstood the crisis and deposit

withdrawal without outside support, due to outstandingly conservative NBS provisioning

requirements. Banking sector balance sheets continued to expand even during the crisis and

credit growth is faster than in regional markets; at a rate of 15% year on year. This has been

stimulated by subsidised RSD credit schemes, which are being phased out.

Large cross-border exposure to foreign banks was the system’s key vulnerability. The NBS

administered closely the Vienna initiative, and in particular, exposure floors bank by bank.

Exposure limits of foreign banks were lowered from 100% to 80% in April 2010; nevertheless,

Serbia still has large foreign claims originated by its lenders equal to c. 65% of GDP. Eurozone

periphery banks hold among the highest concentration of local banking assets in Serbia,

up to 40% of GDP.

Eurozone periphery banks have claims of up to 20%-50% of GDP in the region’s banking

systems. This capital is not fully callable and local banking regulation tightly limits the amount of

capital that can be withdrawn, but the amounts highlight the relative importance of parent bank

funding for individual countries. Croatia and Bulgaria stand out with foreign claims of close to

50% of their GDP originated by Greek and Italian lenders. Serbia and Macedonia havesomewhat lower foreign claims as % of GDP, but, together with Bulgaria 60% or more of

that is owed to the Eurozone periphery lenders. These credit lines may tighten.

TABLE 1: Foreign claims by lender countries to Central Eastern Europe as % of GDP

Bulgaria Czech R Croatia Hungary Macedonia Poland Romania Serbia

Austria 11.1 32.04 56.4 26.04 3.86 3.17 24.7 17.38

Italy 17.00 8.56 51.59 16.03 0.25 10.02 8.40 18.92

Spain 0.19 0.30 0.11 0.67 0.03 1.37 0.23 0.01

Portugal 0.00 0.01 0.07 0.21 n/a 3.22 0.44 0.02

Greece 31.64 0.00 0.30 0.17 20.25 1.71 13.05 17.94

European banks 77.47 94.03 125.45 86.80 27.38 58.33 67.16 65.09

Source: Commerzbank Corporates & Markets, BIS

TABLE 2: Banking sector ownership in the CEE and SEE, by assets (% share)

Bulgaria Poland Romania Hungary Serbia Czech Croatia

Greece28.7

Italy14.1

Austria 31.8 Austria 24 Italy 21.5 Belgium 20.8 Italy 41

Italy15.8

Germany10.8

France 14 Italy 20 Greece 15.4 Austria 25.3 Austria 33.8

Hungary12.5

Netherlnd7.5

Greece 12.3 Belgium 14 Austria 17.1 France 16.4 France 7.5

Austria9.9

Spain7.2

Netherlnd 3.4 Germany 13 France 7.9 Italy 6.4 Hungary 3.5

Germany6.0

Austria5.2

Italy 6.1 other 0 Germany 2.6 other 18.1 other 10

Portugal4.6

other10.8

other20.6

other 20.2 other 8

domestic 16.3 domestic 30 domestic 12.2 domestic 29 domestic 27.5 domestic 13 domestic 4.2

Source: Commerzbank Corporates & Markets, National Central banks

The banking system, nevertheless, has a strong ‘regulatory hedge’. The corporate sector

suffered the largest damage from balance sheet exposure, but banks are able to absorb

substantial credit risks; the capital adequacy ratio is among the highest in the region above 20%.

According to stress tests under the IMF’s oversight, banks are sufficiently well capitalised to

absorb even a protracted corporate restructuring process. A new decision on reserving

requirements that promotes the use of longer maturity RSD sources will further regulate funding

vulnerabilities.

According to local banks, Serbia is one of ‘the safest banking markets in the world’. This

is due to the fact that lending is done nearly purely from capital; the system has a capital stock of

c. €3.5bn for a loan portfolio of €14bn. As long as prudential regulations are kept tight, banks

should remain stable in the face of unhedged private sector balance sheets.

Regulatory strength



EM Country Briefing

4 12 August 2011

CHART 3: CAR % tier 1 CHART 4: Loan/deposit %

0

5

10

15

20

25

H u n g a r y

P o l a n d

C z e c h

R o m a n i a

B u l g a r i a

C r o a t i a

S e r b i a

0

20

40

60

80

100

120

140

160

C z e c

h

P o

l a n

d

C r o a

t i a

S e r b

i a

B u

l g a r i a

R o m a n

i a

H u n g a r y

Source: Commerzbank Corporates & Markets, National banks and bank

regulators, Fitch Ratings

Source: Commerzbank Corporates & Markets, National banks and bank

regulators, Fitch Ratings

The IMF oversight and fiscal position

Serbia completed its IMF Stand-by Program in April with good progress; securing five tranches

of financing of $1.5bn. The government drew only half of the $3bn available, observing funding

costs (the loan rate jumps at $1.5bn from 2% to 4%). According to the Fund, the 2009 SBA

achieved the fiscal adjustment targets but relied on low quality ad hoc measures, including a cut

in the public wage bill and across-the-board discretionary spending, as opposed to setting a

long-term spending structure. The IMF is likely to be available for a new program, although sees

high implementation risks ahead of the 2012 elections. It has served the role of a political co-

ordinating mechanism, and is likely to stay engaged for this purpose; and set structural

benchmarks that can be done piecemeal or back loaded. The new structural benchmarks would

be related to (1) restructuring of SOEs (quasi-fiscal deficit generators), (2) labour market

deregulation, (3) competition policy and break-up of monopolistic sectors.

The government has pledged to observe the fiscal ceiling of 4.2% of GDP and 3% of GDP next

year, although the required expenditure cuts of an estimated 2.7% of GDP (1.2% and 2.5% due

to the decentralisation of revenue collection to the regions) are seen as hardly feasible. The

original budget deficit target for 2010 was revised upwards from 4.0% to 4.8% of GDP last

September, and the IMF estimates that during the last ten years the fiscal cost of a typical pre-

election year in Serbia was about 3% of GDP, which adds risks to a new Program. The

government has passed fiscal responsibility legislation last year, which caps the public debt-to-

GDP ratio at 45% of GDP, and cuts the fiscal gap to 1% of GDP in the medium term, observing a

long-term target of public cost structure, but the Fund still expects slippage on short-term targets.

The government is preparing a $1bn debut Eurobond for September/October this year, $200m of

which would be an RSD-denominated inflation-linked bond. Local banks argue the government

can fund itself at 4.5%-5.85% with euro-indexed RSD treasury bills and would seek to avoid the

‘Montenegro mistake’ which we believe is a high-price market issue (Montenegro sovereign

bond issued at 7.85%-7.25%). We think that an IMF precautionary agreement would be key

for Serbia’s Eurobond issue (and for investors), both for policy restraint and liquidity

reasons, so as to insure against event risks such as delay to the country’s recognition as

an EU candidate, political instability or the ‘Italy risk’.

New economic model and external balances

Serbia’s devaluation proved to be less harmful overall; the exchange rate and current account

adjustment have been more extensive than in peer countries, while the contraction in GDP was

moderate. The World Bank believes that export growth has helped to pull the economy out of

recession; five consecutive quarters of c. 20% year-on-year export growth suggests

competitiveness adjustments.

Serbia’s pre-crisis growth model was conditioned by past high consumption standards, and

unlike elsewhere in the CEE, its external deficit was structural. Serbia, as a republic of former

Yugoslavia exported c.70% of its production, compared to 20%-30% today. The government has

set out to support the transformation of the economy to an export-oriented one, with the help of a

favourable momentum in FDI. Fiat has chosen Serbia, Kragujevac over Turin for a €1bninvestment (including €250m government support and €400m EIB funds). This coincides with a

smaller, but labour intensive and export-oriented investment by Benetton, a c. €600m-€800m

Tendency to overshoot

Auto and steel industry investments promise a turnaround



EM Country Briefing

12 August 2011 5

also Italian investments in renewable energy generation and additional infrastructure projects

financed by China. According to World Bank estimates, given the small size of the economy the

Fiat investment alone would generate an extra GDP growth of 1.7% GDP, and if the 2014

production plan of 200,000 units is met, an extra 1% over the long term. More importantly, the

supply chain of the auto industry is sizeable. Using IMF base case projection and best-case

scenario for prospective investments, Serbia’s growth rate could rise from 3% pre-crisis

to 5%-7.5%. The country’s attraction as a manufacturing base lies in its harmonisationwith the EU and simultaneous free trade zone with the CIS, cheap availability of high

voltage electricity, which could kick-start an investment cycle. There is, however, a lot to be

done on the investment environment and macroeconomic stabilisation.

Slovakia is a model economy that showed unstable growth prior to the Dzurinda reforms and

was of similar size. It received two large greenfield investments in the auto industry of 2%-3% of

GDP, which (together with market reforms) attracted annual FDI flows of 5%-6% of GDP over a

period of 4-5 years and lifted Slovakia’s growth rate from c. 3% to 5%-7% over the medium term.

CHART 5: Hourly labour cost (€) CHART 6: Export to GDP %

0

5

10

15

20

25

30

S e r b i a

B u l g a r i a

R o m a n i a

L i t h u a n i a

L a t v i a

P o l a n d

H u n g a r y

S l o v a k i a

C r o a t i a

C z e c h R .

P o r t u g a l

S l o v e n i a

G r e e c e

U K

G e r m a n y

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Export to GDP %_Hungary _Serb ia _Croatia

Source: Commerzbank Corporates & Markets, Eurostat Source: Commerzbank Corporates & Markets, Ecowin

CHART 7: Exports 12mma, 2007=100 CHART 8: CAD % of GDP 2007 and 2010

80

90

100

110

120

130

140

150

Serbia Croatia Romania Bulgaria Hungary

2008 2009 2010 2011

-1

-7.1

-4.1 -3.5

-1.3

1.2

-3.4-2.4

-28.0

-23.0

-18.0

-13.0

-8.0

-3.0

2.0

B u l g a r i a

S e r b i a

R o m a n i a

M a c e d o n i a

C r o a t i a

H u n g a r y

P o l a n d

C z e c h

2007 2010

Source: Commerzbank Corporates & Markets, Ecowin Source: Commerzbank Corporates & Markets, IMF

TABLE 3: The government’s macroeconomic framework

2009 2010 2011 2012

GDP growth % y/y -3.5 1 3 4

GFCF % -22.8 3.3 7.6 10.8

Export % -13.8 19.1 11.7 12.5

Import % -23.6 4 6.4 7.8

Current A/c deficit % of GDP -7.9 -8.0 -8.2 -8.0

Source: Commerzbank Corporates & Markets, Ministry of Finance



EM Country Briefing

6 12 August 2011

The government’s macroeconomic framework is based on the assumption of a new

economic model; 10% annual gross fixed capital investment growth in 2011-13 which

produces a recovery in growth to 3% and 4.5%. The share of exports in GDP, and domestic

savings would increase over the medium term.

Serbia’s export results already stand out in comparison with Croatia. Most regional peers

show a sustained export recovery in 2010-11 (and over the 2007 base), while Croatia is notably

lagging behind (chart 7). Croatia’s exchange rate peg and lack of internal devaluation over the

recent period has been highlighted as a structural drag, and by the results, Serbia’s policy

choices appear to have been better.

While the country’s current account gap is still among the largest in the region, an estimated 7%-

7.5% of GDP (including c. 10% of GDP worth of remittances from abroad), capital flows are

improving and FDI could reach between 5% and 6%. A funding gap may still be present this

year if the government fails to issue the planned Eurobond, which is to replace the postponed

privatisation of Telekom Sbrja (€1.4bn). On the back of the prospective investments the

sustainability of Serbia’s external position should gradually improve (one-third of its

current account deficit alone could be covered by Fiat operations). Serbia’s growth

opportunities have improved and it could become a new growth market in Central Europe.

CHART 9: Export, import and trade balance 12mma CHART 10: Balance of payment accounts, €m 12mma

-40

-30

-20

-10

0

10

20

30

40

50

60

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

-16

-14

-12

-10

-8

-6

-4

-2

0

Trade bal.12mma (rhs) Exports 12mma % y/y Imports

-2,000

-

2,000

4,000

6,000

8,000

10,000

12,000

Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10 Apr-11

Portfoli o cap. Com merci al loans FDI CA D

Source: Commerzbank Corporates & Markets, Ecowin Source: Commerzbank Corporates & Markets, Ecowin



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Serbia August 2011