Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 33990-W

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT

FOR A PROPOSED

FIRST PROGRAMMATIC P W A T E AND FINANCIAL DEVELOPMENT POLICY CREDIT

IN THE AMOUNT OF SDR 38 MILLION (US$55 MILLION EQUIVALENT)

TO

SERBIA AND MONTENEGRO

October 3 1, 2005

Finance and Private Sector Development (ECSPF) South East Europe Country Unit (ECCU4) Europe and Central Asia (ECA)

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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ALMP BRA BSA BSC BSL CAD CAMEL CAS CE A CFAA CSD CTR DF DFID DIA DPCIL E A EAR EBRD ECA EOI EPS ESW EU FA FAU FDI FSN FY GDP GNP GOS HIPC IBRD ICA IDA IFC IMF JS A LDP MCI MDGs MEM

SERBIA AND MONTENEGRO - GOVERNMENT FISCAL YEAR January 1 - December 3 1

CURRENCY EQUIVALENTS (Exchange Rate Effective as of October 19,2005)

Currency Unit USSl .OO 71.23 Serbian Dinar (CSD)

Metric System

ABBREVIATION AND ACRONYMS (as applicable, plus others)

Active Labor Market Programs Bank Rehabilitation Agency Bankruptcy Supervisory Agency Bank Supervision Committee Budget System Law Current Account Deficit Capital, Assets, Management, Earnings, and Liquidity Country Assistance Strategy Country Environmental Analysis Country Financial Accountability Assessment Serbia Dinar Commission for the Protection of Tenderers' Rights Development Fund UK Department for International Development Agency for Deposit Insurance Development Policy CreditILoan ~xtended Arrangement European Agency for Reconstruction European Bank for Reconstruction and Development Europe and Central Asia Expression of Interest Elektroprivreda Srbije (Serbia's national electric power utility) Economic Sector Work European Union ~inancial Advisor Fiduciary Assessment Update Foreign Direct Investments Financial Sector Note World Bank Fiscal Year Gross Domestic Product Gross National Product Government of Serbia Heavily Indebted Poor Countries International Bank for Reconstruction and Development Investment Climate Assessment International Development Association International Finance Corporation International Monetary Fund Joint Staff Assessment Letter of Development Policy Ministry of Capital Investments Millennium Development Goals Ministry of Energy and Mining

FOR OFFICIAL USE ONLY MIER MLESP MOE MOF MOH MSEP MTEF MTS , NBFI NBS NMICS NPL . , PA ' PEIR PFM PHRD PIER PLC PPFDPC-1 PPFDPCL PPL PPO PRSP PSC PSN ROSC SAA SAI SAC SaM SAP SDP SDR SEM SME SP SPA SOB SOE TF TPL UNDP USAID US$ ZTP

Ministry of International Economic Relations Ministry of Labor, Employment and Social Policy Ministry of Economy Ministry of Finance Ministry of Health Ministry of Science and Environmental Protection Medium-Term Expenditure Framework Modernized Treasury System Non-Bank Financial Institutions National Bank of Serbia National Mortgage Insurance Corporation of Serbia Non-performing Loans Privatization Agency Public Expenditure Institutional Review Public Financial Management Japan Policy and Human Resources Development Trust Fund Public Expenditure and Institutional Review Paris London Club First Programmatic Private and Financial Development Policy Credit Programmatic Private and Financial Development Policy CredivZoan Public Procurement Law Public Procurement Office Poverty Reduction Strategy Paper Public Service Contracts Private Sector Note Report on the Observance of Standards and Codes Stabilization and Association Agreement Supreme Audit Institution Structural Adjustment Credit Serbia and Montenegro Stabilization and Association Process Supervisory Development Plan Special Drawing Rights Serbia Economic Memorandum Small and Medium Enterprises Social Program Sale and Purchase Agreement State-Owned Banks State and Socially-Owned Enterprises Transition Fund Third Party Liabilities United Nations Development Program United States Agency for International Development United States Dollar Zeleznicko Transportno Preduzece - Belgrade Rail Company

Vice President: Shigeo Katsu Country Director: Orsalia Kalantzopoulos

Sector Director: Fernando Montes-Negret Sector Manager: Gerardo Corrochano

Task Team Co-Leaders: Itzhak Goldberg 1 Michael Edwards

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. -

SERBIA AND MONTENEGRO

FIRST PROGRAMMATIC PRIVATE AND FINANCIAL DEVELOPMENT POLICY CREDIT

CREDIT AND PROGRAM SUMMARY .................................................................................................. 1 ......................................................................................................................... I . INTRODUCTION 3

................................................................................................................... . I1 COUNTRY CONTEXT 4 RECENT ECONOMIC DEVELOPMENTS IN SERBIA AND MONTENEGRO ........................... 4 MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ............................................ 6

............................................................................................ I11 . THE GOVERNMENT'S PROGRAM 8 IV . BANK SUPPORT TO THE GOVERNMENT'S STRATEGY ..................................................... 11

LINK TO CAS ................................................................................................................................... 11 COLLABORATION WITH THE IMF AND OTHER DONORS ..................................................... 12 RELATIONSHIP TO OTHER BANK OPERATIONS .................................................................... 13 LESSONS LEARNED ....................................................................................................................... 14 ANALYTICAL UNDERPINNINGS ................................................................................................. 16

V . THE PROPOSED FIRST PROGRAMMATIC PRIVATE AND FINANCIAL DEVELOPMENT POLICY CREDIT ........................................................................................... 17 OPERATION DESCRIPTION ........................................................................................................... 17 POLICY AREAS ................................................................................................................................ 22

VI . OPERATION IMPLEMENTATION ............................................................................................. 41 ............................................................................................... POVERTY AND SOCIAL IMPACTS 41

........................................................ IMPLEMENTATION. MONITORING AND EVALUATION 42 .................................................................................................................... FIDUCIARY ASPECTS 43

................................................................................................ DISBURSEMENT AND AUDITING 44 ........................................................................................................ ENVIRONMENTAL ASPECTS 45

.................................................................................................... RISKS AND RISK MITIGATION 46

..................................................................................... AhWEX 1 : LETTER OF DEVELOPMENT POLICY 47 ANNEX 2: GOVERNMENT POLICY/OVERALL GOVERNMENT DEVELOPMENT PROGRAM ......... 53

..................................................................................................... ANNEX 3: PPFDPC-1 POLICY MATRIX 55 ANNEX 4: FUND RELATIONS NOTE ......................................................................................................... 61 ANNEX 5: KEY ECONOMIC INDICATORS ............................................................................................... 64 ANNEX 6: KEY EXPOSURE INDICATORS ................................................................................................ 66 ANNEX 7: STATEMENT OF LOANS AND CREDITS ................................................................................ 67 ANNEX 8: STATEMENT OF IFC'S HELD AND DISBURSED PORTFOLIO ............................................ 68 ANNEX 9: COUNTRY AT A GLANCE ......................................................................................................... 69 ANNEX 10: COUNTRY MAP (IBRD 3 1 506R2) ........................................................................................... 71

The First Programmatic Private and Financial Development Policy Credit was prepared by an IDA team consisting of Michael Edwards (Task Team Leader). Itzhak Goldberg (Task Team Co.Leader). Rodney Lester. Laura Ard (OPD); David Kennedy. Martin Humphreys (ECSIE); Michael Stanley (COCPO); Ilker Dornac (ECSPE); Csaba Feher (ECSSD); Alexander Pankov. Thomas Muller. Branko Radulovic. Anna Sukiasyan (ECSPF); Tijen Arin (ECSSD); Siew Chai Ting. Michael Gascoyne. Pascale Kervyn de Lettenhove. Olav Christensen (ECSPS). Gennady Pilch (LEGEC) .

CREDIT AND PROGRAM SUMMARY

SERBIA AND MONTENEGRO

FIRST PROGRAMMATIC PRIVATE AND FINANCIAL DEVELOPMENT POLICY CREDIT

Borrower

Implementing Agency

Amount

Terms

Tranching

Description

Serbia and Montenegro

Ministry of Finance (MOF) of the Republic of Serbia will be responsible for overall implementation of the proposed operation. Other key ministries and agencies responsible for implementation of the operation will include: Ministry of Economy (MOE), Ministry of Labor, Employment and Social Policy (MLESP), Ministry of International Economic Relations (MIER), Ministry of Energy and Mining (MEM), Ministry of Capital Investments (MCI), Privatization Agency (PA), Agency for Deposit Insurance (DIA), National Bank of Serbia (NBS), Elektroprivreda Srbije (EPS), and Zeleznice Srbije (ZS).

SDR 38 million (US$55 million equivalent) IDA credit

Modified IDA terms with a 20 year maturity, including a 10 year grace period, with no acceleration clause.

The full IDA credit is expected to be disbursed in a single tranche of US$55 million equivalent.

The proposed First Programmatic Private and Financial Development Policy Credit (PPFDPC-1) will be the first in a series of up to four programmatic Development Policy CreditsILoans (DPCL) designed to support a multi-year program of assistance to the Republic of Serbia to address key institution building and reform challenges in both private and public sectors.

The overall programmatic DPCL program aims to support sustainable economic growth and employment creation in Serbia. The objective of the PPFDPC-1 is to support Government of Serbia's (Government or GOS) actions in two broad areas: (i) strengthening the fiscal discipline in enterprise, energy and transport sectors, and attracting foreign direct investment (FDI); and (ii) building a more efficient and stable financial sector and improving access to finance.

The objective of the PPFDPC-1 will be achieved through reforms carried out by the GOS which are summarized in two pillars:

Pillar 1: Strengthening fiscal discipline:

Reduction of Ministry of Economy's subsidy program and strengthening the Transition Fund (TF) mechanisms for displaced workers; Privatization, restructuring and bankruptcy of socially-owned enterprises (SOEs); Strengthening the legal framework for mining concessions;

Benefits

Risks

Project ID Number

Agreeing upon a time-bound process for the interim restructuring of Elektroprivreda Srbije, Serbia's national electric power utility; and Beginning to rationalize the railway sector in accord with a time- bound plan.

Pillar 2: Building a more efficient and stable financial sector:

Privatization of state-owned banks (SOB) and divestment of financial assets; Strengthening the insurance sector regulation and resolution regime; Adoption by the National Bank of Serbia of the second phase of .

the Supervisory Development Plan (SDP) to address, inter alia, banking sector supervision, regulation and resolutions. Improving access to finance through adoption of a mortgage law.

The proposed PPFDPC-1 will aid the Government of Serbia to realize key economic growth related goals, as outlined in the Country Assistance Strategy (CAS) through: (i) strengthening fiscal discipline towards SOEs and developing an extraction industry legal framework so as to attract FDI; and (ii) improving the efficiency and stability of the financial sector through divesting state-owned financial assets and further developing capacity of the regulatory authority. The envisaged reform program would be consistent with the GOS's aspiration for eventual membership in the European Union (EU).

Implementation risks are likely to be high. The scope of institutional changes that the series of DPCIL operations seek to address are mostly of a medium-tern nature. The current capacity of some public sector institutions to implement an ambitious reform agenda, while much improved over the past few years, remains relatively weak. The execution risks will be mitigated through utilization of ongoing technical assistance (TA) provided by the Bank and bi-lateral donor community. In addition, support from active and proposed Bank projects in social protection, public sector administration will further serve to mitigate risks.

Domestic and external political risks remain high. These potential risks could include: (i) reform "fatigue" within the Government; and (ii) fluid political situation in Serbia, with possible early parliamentary elections.

The ambitious reform agenda that the programmatic DPCILs propose to support could create social and political stresses which might test the Government's commitment to reform ahead of the next round of elections. However, the domestic political risks are somewhat mitigated by the domestic consensus across the political spectrum towards eventual EU membership.

PO891 16

INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED FIRST PROGRAMMATIC PRIVATE AND FINANCIAL

DEVELOPMENT POLICY CREDIT TO SERBIA AND MONTENEGRO

I. INTRODUCTION

1. This Program Document presents the first in a series of up to four Programmatic Development Policy CreditsJLoans (DPCJL) operations to the Serbia and ~ontenegro' (SaM). As outlined in the FY05-07 Country Assistance strategy, the Bank's assistance in Serbia will concentrate on two parallel streams: (i) the development of a robust private sector through the Programmatic Private and Financial DPCJLs (PPFDPCJL); and (ii) the development of a smaller and more efficient public sector through the Programmatic Public Sector DPCJLs. The two streams of DPCJL are complementary and will address all three of the CAS goals: (i) creating a smaller, more efficient public sector; (ii) creating a larger private sector; and (iii) reducing poverty levels and improving social protection. The private sector DPCJL stream focuses on the first and second CAS goals, while the public sector DPCIL stream concurrently focuses on achieving the first and third CAS goals.

2. The proposed PPFDPCJL series is envisioned to build on three policy themes: (i) strengthening fiscal discipline through enhancing hard budget constraints and reducing subsidies; (ii) building a more efficient and stable financial sector; and (iii) improving the investment climate. Concurrently, the proposed Programmatic Public Sector DPCJL series is expected to support the Government's policy endeavors to (i) create a high quality, fiscally affordable public sector; and (ii) improve the allocative efficiency of public spending-both of which are crucial for growth, macro stability and the formalization of economic activity.

3. Under the umbrella of these objectives, the proposed First Programmatic Private and Financial Development Policy Credit (PPFDPC-I), in the amount equivalent to US$55 million, is envisioned to contain policy measures aimed at: (i) continued progress on restructuring and privatization of real and financial sector assets; (ii) restructuring and resolution of large loss-making state- and socially-owned enterprises; (iii) improved access to finance, particularly for the small and medium enterprise (SME) sector; (iv) energy sector restructuring; and (v) private participation in infrastructure, in particular strengthening the legal and institutional framework of the mining sector, which has a potential to contribute to significant FDI in Serbia.

4. The GOS is committed to carrying out the envisaged fiscal, financial and private sector related legal reforms, initially launched within the framework of previous Bank- supported operations, including the two prior private and financial sector adjustment credits

' Due to the highly devolved nature of the SaM union (most areas of economic policy are in the competence of the member republics) and the different starting points, needs and pace of reforms in the two republics, the Bank's assistance program for SaM is being designed around republic-specific operations. Therefore, for the purposes of this document, the term "Government" or "GOS" designates the Government of the Republic of Serbia, unless otherwise specified.

This report should be read in conjunction with the joint IBRDIIDAIIFC FY05-07 CAS for SaM presented to the Board on December 16,2004.

(PFSAC-I and PFSAC-11) and the structural adjustment credits (SAC and SAC-11). While substantial legal and structural reforms have been completed under these prior operations, further fiscal adjustment and renewed efforts on structural reforms are necessary to bolster macroeconomic stability and lay the foundation for sustainable growth. Divestiture of some of the large loss-making SOEs and overall strengthening of the fiscal discipline in enterprise, energy and transport sectors together with a more efficient and stable financial sector supported by the PPFDPC- 1 are key for the implementation of structural reforms that will reinforce sustainability of Serbia's macroeconomic stabilization.

11. COUNTRY CONTEXT

RECENT ECONOMIC DEVELOPMENTS IN SERBIA AND MONTENEGRO

5. Status of the IMF Program. The GOS's medium-term stabilization and reform program for 2002-05 has been supported by a three-year Extended Arrangement (EA), which was approved in May 2002 for a total amount of SDR 650 million. The arrangement was extended in May 2005 until December 31,2005. The IMF Executive Board concluded in late- June 2005 the Article IV consultation with Serbia and Montenegro and the fifth review of Serbia and Montenegro's economic performance under the EA.

6. The completion of the review enabled the release of an amount equivalent to SDR 125 million (about US$182.9 million), which brought the total disbursement under the program to SDR 587.5 million (about $US859.7 million). In completing the review, the IMF Executive Board also approved Serbia and Montenegro's request for waivers of four performance criteria. In addition, the IMF Executive Board completed a Financing Assurances Review and approved a request to re-phase the eleventh and final disbursement, which would become available upon the completion of the sixth review.

7. Real Economic Activity. GDP growth is estimated to have reached 7.2 percent- above the original projection of 4-5 percent-in 2004 led by a bumper crop in agriculture and solid industrial growth supported by output gains in recently privatized enterprises. Demand increase was led by a rise in consumption and investment induced by strong credit expansion and an estimated 11.2 percent average increase in real wages. Continued strong demand, coupled with growing exports, is projected to yield a GDP growth of 4-5 percent in 2005.

8. Price and Exchange Rate Developments. As a result of largely one-off factors- administrative price increases, higher oil prices, and tax increases-the inflation rate in Serbia rose to 13.7 percent (y-o-y) in December 2004. The upward trend in the inflation rate has continued during the first half of this year as retail prices rose by 17.2 percent (y-o-y) in August 2005. The introduction of the value-added tax (VAT),,increases in the municipal tariffs, and rising oil prices have been the main contributing factors to the rise in the inflation rate. Inflation was also driven by buoyant domestic demand on the back of rapid credit expansion and--during much of 2004-excessive wage growth. In August 2005, Serbia Dinar (CSD) depreciated against the Euro and US dollar (USD) by 14.5 percent (y-o-y) and 12.9 percent (y-o-y), respectively.

9. Against the backdrop of declining demand pressures coupled with more controlled increases in administrative prices and fees, end-period inflation is projected to decline to 12.3 percent by end-2005. Although risks to the projected inflation rate are to the upside, the envisaged corrective measures which, inter alia, include tighter fiscal policy stance, will support attainment of the end year target.

10. Fiscal Developments. Although fiscal policy was on track for most of 2003 (SaM's fiscal deficit of 3.3 percent of GDP was 1.2 percent below the target), it turned expansionary in the run-up to the December 2003 elections in Serbia. Since mid-2004, however, fiscal policy in Serbia has been tightened beyond program targets to contain the external imbalance and inflation. The authorities adopted a re-balanced budget for 2004 in order to offset the spending overruns on subsidies, wages and transfers (0.3 percent of annual GDP) during the first half of 2004 and to reduce the consolidated deficit for 2004 relative to GDP by 0.2 percentage points compared to the original program. According to preliminary data, this in turn led to a budget deficit for the entire year of CSD 4 billion, which is well below the original program target of CSD 32.7 billion. The supplementary 2005 budget, adopted in July, provides for a surplus of the consolidated general government of 1.2 percent of GDP compared to a deficit of 0.3 percent of GDP in 2004.

11. The 2005 Budget for Serbia targets a consolidated general budget surplus of 0.5 percent'of Serbia's GDP, suggesting that tight fiscal policy stance will continue during this year. In the context of the IMF-supported economic program, the authorities are envisaged to further tighten the fiscal policy stance to counter upward inflationary pressures and the higher- than-programmed current account deficit (CAD).

12. External Developments. Preliminary data for Serbia suggests that the CAD deteriorated further in 2004 compared to a programmed improvement of 10.8 percent of GDP (after grants). Preliminary figures indicate that Serbia's CAD (after grants) reached 13.1 percent of GDP due mainly to higher than projected trade deficit, which rose to 3 1 percent of GDP in 2004 from 23.6 percent of GDP in 2003. Higher oil prices and a one-off large increase in anticipation of the introduction of the VAT in January 2005 contributed to observed increase in imports. Preliminary figures for 2005 suggest that the trade balance is improving. In the first half of 2005, exports rose by 43 percent while imports declined by 5 percent compared to the pervious year (in dollar terms). Policy tightening coupled with the expected supply response reflecting acceleration of structural reform are expected to reduce the current account deficit (after grants) in 2005 to about 9.5 percent of GDP.

13. Private remittances remained strong at 17.2 percent of GDP in 2004, though FDI declined to 4.3 percent of GDP as a result of a slowdown in privatization in the first half of the year. Gross foreign reserves rose to US$4.3 billion (around 3.7 months of projected 2005 imports) at end-December 2004. The import coverage of international reserves is expected to increase to 4 months of prospective imports, reflecting a more prudent policy stance in the face of projected rise in external debt service arising from the expiration of grace periods under debt restructuring agreements.

14. The July London Club agreement, which has reduced SaM's debt to the London Club by 62 percent in net present value terms, lowered the country's overall debt burden by 7 percentage points of GDP. Although this development had a favorable impact on the debt

dynamics, the increase in mostly private foreign borrowing by 8 percent of GDP kept the external debt-to-GDP ratio at 62 percent at end-2004. As Serbia received its first rating at B+ from StandardLkPoors (S&P) in November 2004 and has recently been upgraded to BB-, it appears that the outside world regards economic policy as broadly on track.

MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY

15. Although the higher-than-projected CAD in 2004 warrants concern, SaM's medium- term prospects-based on strong implementation of ambitious reform plans as elaborated in the recent CAS-are favorable, with continued progress on key reforms leading to projected GDP growth averaging 5.4 percent per annum in 2004-08 (Table I ) ~ . The base case scenario that was articulated in the CAS contains the following elements: (i) a high quality fiscal adjustment (based on durable non-interest expenditure cuts) that enhances macroeconomic stability and boosts confidence in the policy framework, thereby stimulating private investment; and (ii) an acceleration of policy efforts aimed at improving efficiency, including privatization and enterprise restructuring, along with measures directed at improving competition and the investment climate.

Table 1 : SaM- Medium-tern Macroeconomic Prospects

Act. Act. Est. Proj. Proj. Proj. Proj. 2002 2003 2004 2005 2006 2007 2008

National Accounts

GDP (US$ millions) 11 15,528 20,665 23,996 26,591 28,319 30,485 32,682

Real GDP growth (%) 3.8 2.7 7.2 4.6 4.8 5.0 5.2 Investment (% of GDP) 16.0 16.1 17.6 18.4 19.8 21.2 21.6 Gross Domestic Savings (% of GDP) -7.3 -5.9 -11.3 -5.3 -3.2 -0.4 1.2

Public Sector Balance (as % of GDP)

Expenditures 47.7 46.0 45.5 43.7 43.8 43.7 43.6 olw public investment 3.4 2.5 2.7 2.4 3.8 4.2 4.3

Revenue before grants 43.1 42.7 45.2 44.8 43.8 43.5 43.3 Deficit before grants -4.5 -3.3 -0.3 1.2 0.0 -0.2 -0.3

External Accounts (as % of GDP)

Exports of goods and services Imports of goods and services

Current account balance, (millions of US$) 21 -1,384 -1,996 -3,148 -2,527 -2,790 -2,740 -2,706 Current account balance, as % of GDP 21 -8.9 -9.7 -13.1 -9.5 -9.9 -9.0 -8.3

Indebtedness (external debt)

TDOIXGS 31 TDOiGDP TDSIXGS 31

Prices

Retail price inflation (e.0.p.) 14.2 7.6 13.4 12.3 9.0 6.0 4.0

11 GDP estimates exclude Kosovo; 21 After grants; 31 Exports include workers' remittances and factor incomes.

Serbia's GDP accounts for about 90 percent of SaM's economy.

6

16. The envisaged fiscal adjustment will contribute directly to promoting growth and redressing macroeconomic imbalances. Non-interest current expenditures in relation to GDP are projected to decline from roughly 41 percent in 2004 to 37.6 percent in 2008, primarily reflecting reductions in the wage bill, subsidies, net lending and transfers. This adjustment should have a positive impact on expectations about the future stance of fiscal policy, thereby lowering the risk premium and paving the way for higher private investment.

17. Coupled with adjustments on the revenue side and an increase in public investment, the envisaged cuts in public expenditure as a share of GDP will contribute directly to promoting growth and redressing macroeconomic imbalances. During the period under consideration, further efforts to improve tax collection (supported, among other things, by implementation of bankruptcy legislation) and the introduction of VAT in January 2005 coupled with increase in transfers from profitable state-owned enterprises should boost public revenues. As the current high tax burden (tax revenues as a share of GDP) remains a barrier to private sector-led growth and to formalization of economic activity, any such gains in revenues are expected to pave the way for corresponding reductions in tax rates, particularly on labor. Together with the adjustment in public expenditure, this should have a positive impact on expectations about the future stance of fiscal policy, thereby lowering the risk premium and paving the way for higher private investment. By the same token, public investment, which has been low, is expected to increase during the projection period. In this way, the projected fiscal adjustment will be the cornerstone of the country's efforts to lay the foundations for enduring growth and macroeconomic stability over the medium term.

18. Greater confidence will help to reverse the observed increase in inflation in 2004, while an improved public savings-investment balance, coupled with structural reforms, is expected to have a favorable impact on the current account balance. With greater confidence in the policy framework (reflecting, among other things, the envisaged fiscal adjustment) and prudent monetary policy, inflation is projected to decline steadily to 4 percent in 2008. Concurrently, improvements in the public savings-investment balance and in the competitiveness of the economy should help reduce the CAD (after grants) from 13.1 percent of GDP in 2004 to below 9 percent by 2008.

19. Attaining the noted macroeconomic framework will involve significant financing requirements, particularly because of rising debt service payments4. Gross external financing requirements are projected to be around USD 5-6 billion per annum. With the envisaged improvement in the fiscal balance during the projection period, these financing needs will shift from the public to the private sector, as the expected fiscal retrenchment will leave more room for the private sector to tap domestic and foreign markets at favorable terms. FDI is projected to finance 35 percent of total needs in 2005-08, while long-term loans from multilateral, bilateral, and other creditors are projected to account for 48 percent. The remainder will be covered by other capital inflows (short-term credits, capital not-elsewhere included, and errors and omissions).

Serbia's implementation performance of the above summarized reform agenda will have important consequences for the sustainability of its public debt

7

20. Serbia's implementation performance of the above summarized reform agenda will have important consequences for the sustainability of its public debt. In this connection, the two illustrative scenarios considered in the recent Serbia Economic Memorandum (SEM) can be illuminating. Thefirst scenario, which aims to illustrate the trajectory of the Serbian economy under strong policy efforts, including the following key underlying elements such as: (i) a high quality fiscal adjustment; (ii) a rapid increase in productivity resulting from structural reforms, privatization, and enterprise restructuring; (iii) an improvement in export performance; and (iv) strong external inflows including significant FDI. The second scenario, on the other hand, aims at demonstrating the implications of unsatisfactory progress with the implementation of structural reforms in 2004 and onwards. Under this scenario, the GOS attempts to maintain both the current fiscal policy (through keeping the level and structure of spending relatively constant) and monetary policy stances.

2 1. The strong growth performance under the first scenario would arise from a robust private sector response engendered by reforms to improve the business climate and the permanent fiscal adjustment, which would lead to greater confidence in the policy framework. Under this scenario, the combination of strong economic growth, permanent fiscal adjustment, and lower interest rates would lead to a favorable debt sustainability outlook as evidenced by the declining debt to GDP ratio (Figure 1).

22. Under second scenario, On Figure 1: The Evolution of Public Debt Under Two Illustrative Scenarios the other hand, a mixture of poor fiscal perfomance, low growth- *----- arising from the unsatisfactory implementation of structural reforms and the failure to attain a

50

high quality fiscal adjustment-and high interest rates would lead to an 40

unsustainable path for public debt, which would reach over 73 percent of GDP by 201 0. This, in turn, --s Scenano 2 would erode the country's creditworthiness and leave the economy highly exposed to adverse 2010

shocks, thereby rendering the Source Serbla Econom~c Memorandum (2004) economy more prone to a financial crisis. Clearly, such a policy environment would not be conducive to pursuing Serbia's social agenda.

111. THE GOVERNMENT'S PROGRAM

23. As stressed in the CAS, whilst GOS has made good progress in containing the accumulation of hidden fiscal deficits, consolidated public spending has steadily increased. These fiscal deficits threaten growth and macroeconomic stability by: (i) keeping taxes and interest rates high, thereby crowding out private.activity, discouraging private investment and encouraging the informal sector; and (ii) reducing fiscal flexibility in the event further adjustments are later needed. Pillar 1 of the proposed PPFDPC-1 operation aims to break the

vicious circle of a fiscal deficit fueled, inter alia, by subsidies which, in turn, delay real sector restructuring, hence requiring continued subsidization. Stricter fiscal discipline will not only be necessary to attain permanent fiscal adjustment, but is required to promote the restructuring of the real sector. There was a very sizeable reduction in the deficit of the consolidated general government in 2004 (3 percentage points of GDP). However, most of this reduction reflected buoyant revenues owing to strong economic growth rather than efforts to contain spending. Looking forward, the rationale for further fiscal adjustment is not only based on "fiscal deficits that threaten growth and macroeconomic stability", but also on the need to compensate for the expected further deterioration in the private sector's saving-investment balance by generating a further improvement in the public sector's saving-investment balance.

24. The lessons of experience show that fiscal discipline promotes restructuring because hardening the budget constraint persuades all parties - unions, workers, managers - that the present situation is unsustainable. In other transition economies, hardening budget constraint has proven key for putting the assets, including real estate, of loss-makers back to productive use. This has been especially helpful to the important SME sector, where entrepreneurs are in particular need of the land and storefronts, as well as other assets, so often controlled by non- productive large firms. In particular, the entry, market access and access to credit of SMEs are crowded-out by un-restructured enterprises that continue to function in a soft budget environment.

25. The GOS continues to provide substantial financial support to public, state-owned and socially-owned companies. The 2005 budget allocates a total of CSD 32 billion to subsidies for non-financial public corporations, representing 7 percent of the total budget expenditure. Major recipients of subsidies include enterprises in the agricultural sector (CSD 11 billion), the railway (CSD 8.5 billion), socially-owned enterprises (CSD 5 billion), and public media (CSD 2.8 billion). In addition to these direct subsidies, companies receive a variety of indirect subsidies through un-enforced arrears on utility charges, social contributions, taxes and credits from state-owned banks. Yet, the GOS now recognizes that continued subsidization is unsustainable and that a reallocation of funds from direct subsidies, financing wages and other working capital is essential to finance severance payments, which accelerate the restructuring efforts.

26. The Government's on-going commitment to the ambitious program for privatizing and restructuring socially-owned enterprises is the sine qua non condition for sustainable growth. Substantial progress has been achieved though auction and tender privatization. Yet, an acceleration of the restructuring of large SOEs is an important challenge. Among the prerequisites to achieving such acceleration are the recently adopted amendments to the Privatization Law, prescribing new rules for restructuring of debt to state creditors. Furthermore, the implementation of the new Bankruptcy Law is essential to move restructuring ahead. Building the capacity of the Privatization Agency to act as bankruptcy administrator of insolvent state- and socially-owned enterprises is an important priority.

27. The GOS, supported by the Bank and other donors, took several major steps to improve the Republic of Serbia business environment in 2004, including the adoption of business-related laws. Previous Bank operations supported wide range of reforms covering business entry, operations and exit. These reforms improved the regulatory and institutional framework for business entry through improving the registration system; facilitating efficient

operations of business through reforming the Company Law, and enforcement procedures, building institutional capacity for regulatory reform, and improving enterprises' access to finance through the creation of the leasing and pledge registry; and reducing barriers to the efficient exit and redeployment of non-productive assets through the introduction of the Bankruptcy Law and helping the creation of the institutional capacity in this area. As a result of the improved investment climate, the number of new registrations jumped 42 percent between first quarter of 2004 and first quarter of 2005. As a result new "Doing Business in 2006: Creating Jobs" places Serbia at the top of the list of reformers. While this progress is impressive, Serbia still lags behind other transition economies, thus hurting its ability to attract FDI.

28. Attracting FDI is another priority on GOS priority agenda. Most of Serbia's FDI since 2001 occurred through privatization of SOEs. An increasing interest by foreign investors in Serbia's mineral resources could bring much needed "greenfield" FDI. To further realize the sector's potential, the GOS plans to undertake reforms to transition the state from a role of owner-operator of mineral assets to that of regulator and sector administrator. In particular, the Government has to: (i) ensure that investors are fairly treated and the envisaged royalties framework is able to attract private investment by adhering to international standards regarding competitive taxation, banking, and customs; and (ii) build the capacity to serve within a regulatory role in accordance with the mining sector's specific requirements.

29. The restructuring of EPS is another key component of tightening fiscal discipline in the economy. Following a 10 percent power tariff increase in mid-2004 and strengthening of the sector social safety net, and passage in the third quarter of 2004 of the Energy Law, an Energy Strategy was adopted by the GOS. The Government also made a decision whereby EPS will be unbundled into two successor companies (an integrated generation and distributionlsupply company, and a separate transmission company), and adopted a plan for restructuring of the . underground coal mining sector. Regarding tariffs, a 2005 tariff increase will be required to maintain cost recovery. To this end, EPS was recently authorized a tariff increase of 10% effective on July 1.

30. The railway is the largest public utility and imposes a high fiscal cost on the budget and its early restructuring is critical. The core of the proposed reform in the railway sector is the new Railway Law, passed in March 2005, required the reorganization of the Belgrade Rail Company, or Zeleznicko Transportno Preduzece (ZTP). In accordance with the law, a new railway entity, Zeleznice Srbije, was established, to which the operating assets of ZTP have been transferred. In addition, ZS has prepared a new five year restructuring plan, which will be followed by a new five year business plan for 2005-2009, with technical assistance from EBRD and input fi-om the World Bank.

3 1. Over the past four years, Serbian authorities have improved greatly the legal and institutional framework providing for a general social safety net. Three main unemployment programs are now in effect: cash unemployment benefits, active labor market programs, and severance payments. Serbia's Labor Market Bureau offers a wide range of active labor market programs, although, inadequate funding and staffing erode their effectiveness. Programs include advisory and mediation activities targeted to jobseekers (such as vacancy notification and vacancy and job fairs), training and retraining, special employment programs for the disabled, and entrepreneurship assistance.

32. In March 2002, the GOS adopted a Social Program (SP) providing a range of compensation and redeployment options for workers in large SOEs dismissed due to restructuring and privatization. Retrenched workers could receive a package worth, on average, about Euro 2,000. This sum is quite generous relative to the packages given to workers in companies outside the SP. Under this scheme, dismissed workers receive about three times the minimum specified in the Labor Law. However, it is less generous than packages offered to facilitate large-scale restructuring in other transition economies. Moreover, it is relatively less generous than similar inducement schemes adopted in privatization programs in Asia and Latin America, the long-term effects of which have generally been assessed as positive. An amended draft SP is now being discussed by the GOS. The main changes in comparison to the existing SP are the following: (a) defining the lump sum severance payment under the SP in Euro terms, Euro 100 per recorded year of work history; (b) introducing contribution and tax waivers for companies employing people laid off by companies qualifying for participation in the SP; (c) introducing the option of an in-kind severance benefit; and (d) the option of investing inlpurchasing a workplace for a limited period of time.

33. After a rather protracted start, the GOS as shareholder, acting through the Agency for Deposit Insurance (formerly Bank Rehabilitation Agency or BRA), simultaneously began to strengthen its monitoring of banks and the process of merging and divesting its bank holdings. The first majority state-owned bank was sold in January 2005; two other state-owned banks are currently under contract with foreign buyers and along with a smaller bank, the largest majority state-owned bank is slated to be offered for sale in late 2005. The DIA's offering of financial assets (loans and private enterprise equity stakes) has been similarly delayed, though the first such asset offering has recently been launched.

34. In parallel, the NBS initiated a series of steps beginning in 2001 to begin to modernize the regulatory and supervisory framework for banks and more recently, the insurance sector. Despite recent progress in aligning banking sector regulations with best practice, the compliance with the Base1 Core Principles is still highly unsatisfactory.

35. Current limited access to medium and longer term finance and high overall cost of financing present a major challenge for the development of the financial and enterprise sectors in Serbia. In an effort to address these recognized deficiencies, the GOS is currently preparing a draft Mortgage Law, which would improve existing arrangements for valuing collateral and enforcing mortgages and overall aid in the further development of residential mortgage finance.

IV. BANK SUPPORT TO THE GOVERNMENT'S STRATEGY

LINK TO CAS

36. The FY05-07 CAS for SaM sets the strategic context for the programmatic DPC/L program in three overarching country goals aimed at: (i) creating a smaller, more sustainable, more efficient public sector; (ii) creating a larger, more dynamic private sector; and (iii) reducing poverty levels, and improving social protection and access to public services. The CAS envisages up to four DPC/L operations: PPFDPC-1 and PPSDPL-1 in the base case and

PPFDPCIL-2 and PPSDPL-2 in the high case5. The two streams of DPCIL are complementary and will address all three of the CAS goals. The private sector DPCIL stream focuses on the first and second CAS goals, while the public sector DPCIL stream concurrently focuses on achieving the first and third CAS goals.

37. This PPFDPC-1 credit would be the first in a series of four Programmatic Development Policy CreditsILoans designed to support the Government's economic reform program over a two year period. This operation is funded on full IDA terms as SaM's eligibility for access to IBRD resources has not yet been determined.

38. PPFDPC-1's objectives are consistent with the key objectives and expected outcomes during this CAS period under Goal 2 through: (i) continued progress on restructuring and privatization of real and financial sector assets; (ii) restructuring and resolution of large loss- making state- and socially-owned enterprises; (iii) improved access to finance, particularly for the SME sector; (iv) energy and rail sector restructuring; and (v) private participation in infrastructure, in particular strengthening the legal and institutional framework of the mining sector, which has a potential to contribute to significant FDI in Serbia.

39. Thereafter, consistent with Goals 1 and 3 of the CAS, the proposed FY06 First Programmatic Public Sector Development Policy CreditILoan operation envisages policy measures designed to foster: (i) reduction of the public sector wage bill as a share of GDP; (ii) reduction of social transfers as a share of GDP; (iii) strengthening public administration; and (iv) enhancing efficiency of public spending.

40. Going forward through the CAS period, the envisaged PPFDPCIL-2 would be designed to address the remaining, unfulfilled aims of Goal 2, such as: (i) eliminating any residual constraints to fiscal discipline as its regards subsidies provided to the SOE sector and improving the business environment and existing social safety net for redundant workers of sold or restructured state-owned enterprises, rail and utilities sectors; (ii) further measures needed to strengthen the bank and non-bank financial sector (including capital markets and insurance) and its regulatory regime, with the clear aim to displace government as the owner (majority or minority) of banks and insurance companies. Altogether, these follow-on reforms should result in strengthening Serbia's bid for eventual EU membership. A number of potential PPFDPCIL-2 triggers and programmatic DPCIL program outcomes are featured in the Policy Matrix (Annex 3).

COLLABORATION WITH THE IMF AND OTHER DONORS

41. The success of reforms in Serbia over the past four years was substantially stimulated by the effective collaboration and coordination between the Bank and other key donors. The Bank has maintained a robust dialogue with the donor community in Serbia in order to avoid duplication of efforts and leverage support for the GOS' reforms.

42. During the preparation of PPFDPC-1, the Bank has maintained close working contacts with the IMF and other donors assisting the GOS in the private, financial, energy, and

High case lending triggers, outlined in Table 6 of the CAS, include implementation of agreed public administration reforms, accelerated progress on the divestment of state-owned bank and financial asset holdings, improvements to the business environment and implementation of energy sector reforms.

railway sectors for the purposes of harmonizing policy recommendations, seeking synergies among the respective operations, and avoiding overlaps. Initial consultations with the IMF have centered around the main components of the proposed operation and the Bank's dialogue with GOS on the proposed reform. The IMF is supporting the GOS through a three-year '

Extended Arrangement in the amount of SDR 650 million, initiated in May 2002. Both the IMF and the Bank, along with the donor community, share the goals of achieving a higher degree of fiscal discipline and strengthening the financial sector through the continued implementation of structural reforms.

43. The GOS has received a PHRD grant from the Government of Japan for the preparation of this operation. Close coordination has been on-going with the US Treasury advisors on the reforms in banking and insurance sectors; with USAID on banking supervision reform; and with the EAR on advancing privatization of SOEs with the objective to strengthen fiscal discipline.

RELATIONSHIP TO OTHER BANK OPERATIONS

44. The private sector stream of the Programmatic Development Policy CreditsILoans program (the proposed PPFDPC-1 and in the high case, the PPFDPC/L-2) follow closely from a successful series of two consecutive Private and Financial Sector Adjustment Credits. The PFSAC-I, with a total commitment of USD 85 million, was approved in May 2002 and closed in June 2003 with a highly satisfactory outcome. This credit focused on putting in place the initial reforms in the following five areas: (i) banking sector reform; (ii) reform of socially-owned enterprises; (iii) bank asset and enterprise workouts; (iv) financial sector regulatory and supervisory framework; and (v) business environment reform.

45. The recently closed PFSAC-11, with a total commitment of USD 80 million, put in place the medium-term reforms agreed upon in PFSAC-I. The overall objective of PFSAC I1 was to support the GOS' program of regulatory, institutional, and structural reforms seeking to significantly accelerate private sector growth through: (i) improving the business enabling environment by means of comprehensive reform of enterprise entry, operation and exit; (ii) strengthening the financial system by improving the environment under which banks and other financial intermediaries operate; (iii) privatizing and/or liquidating outdating majority state-owned banks that fail to fulfill their role of financial intermediaries; and (iv) privatizing and restructuring socially-owned enterprises that crowd out private sector growth, hamper banking sector recovery, and incur significant fiscal and quasi-fiscal costs. One of the key achievements of the PFSAC program was the reduction of the time to register a limited- liability company in Serbia from 70 days in 2001 to 40 days in 2003 and to less than 10 days in 2005, the latter following the introduction of a new business registration system, one of the most modem and streamlined in Europe.

46. Implementation of the PFSAC program profited considerably from and was facilitated through two grants, the Private Sector Development Technical Assistance (PSD TA) grant and Financial Sector Development Technical Assistance (FSD TA) grant. The grants provided technical assistance in institutional capacity building for the Privatization Agency, Agency for Deposit Insurance, Agency for SME, and Serbian Investment and Export Promotion Agency.

47. The on-going Privatization and Restructuring of Banks and Enterprises Technical Assistance Credit builds on the reforms launched in the PFSAC program and supported through PSD and FSD TA grants, and aims at facilitating the private sector growth, in particular through (i) restructuring and privatization and bankruptcy of large problematic SOEs; and (ii) implementation of a comprehensive banking and insurance sector restructuring strategy targeted at creating a more viable financial sector.

48. In addition to the reform dimensions outlined in both PFSACs, the Structural Adjustment Credit (SAC) program, implemented through SAC, SAC II and SOSAC has also laid a foundation for implementation of the envisaged PPFDPC-1 reforms. In particular, the recently closed SAC-I1 focused on: (i) improving the business climate; (ii) institutional development and improving performance within the energy sector; (iii) strengthening social protection; and (iv) improving public administration. The SOSAC supported the GOS in implementing reforms in social protection, labor, and health with the objectives to: (i) reduce short- and medium-term fiscal pressures from social programs, through a combination of entitlement reform, and efficiency improvements; and (ii) maximize the poverty alleviation impact of a given level of public spending, through improved targeting of, and sustained access for the poor to services.

49. The planned Bor Regional Development Project, which is expected to be presented to the Board in FY07, following the successful completion of the tender for copper mining and processing conglomerate of RTB Bor, pursues objectives that are cross-reinforcing with those of PPFDPC-1, as RTB Bor is one of the two single largest recipients of GOS subsidies among socially-owned enterprises.

LESSONS LEARNED

50. The PPFDPCILs have built upon the experience accumulated during the preparation of PFSAC I and 11 that started in November 2000, about 30 days after the Serbian "velvet" revolution. Significant volume of analytical work and technical assistance preceded the first policy operations SAC I and PFSAC I. The PFSAC experience has demonstrated that an integrated approach is needed to reform of the financial and enterprise sectors in parallel. Under the earlier PFSAC-I and I1 programs, financial sector reform aimed to boost financial intermediation, encourage domestic savings and generate much needed liquidity to support real sector expansion. Concurrently, the continued privatization of socially-owned enterprises (and more recently, banks) and the adoption of early measures to strengthen the business climate drew in increased foreign investment in 2005.

5 1. A key lesson from other transition experiences and from the first four years of transition in Serbia is the need for sequencing: the initial steps should be the immediate goals of price liberalization and fiscal stability, followed by structural reforms in industrial enterprises and banks and, only then, in the third stage, pursue reforms in utilities, non- banking institutions and capital markets. Moreover, due to the political economy of post- conflict Serbia, it was important to start enterprise privatization with sellable companies - or "early wins" - and only later move onto restructuring of the politically sensitive large loss- makers. The focus of the three stage sequencing must include lessons on the timing and design of social policies aimed at directly addressing poverty reduction and mitigating some of the adverse social impacts potentially caused by the three transition stages. In parallel, from the

start of the reforms, long-term efforts should be undertaken which are aimed at creating a robust, transparent regulatory and institutional framework for utilities, financial markets and the business environment. In the case of utilities, privatization should be preceded by unbundling and commercialization on the basis of an appropriate market structure; moreover, the negative experience of some transition countries forewarns that the proper preparation is required to attract interest from international considerable, reputable strategic investors. Continued pursuit of these aims will need to be closely aligned and sequenced with GOS' efforts to provide adequate social protection for those displaced by the envisaged restructurings andlor privatizations.

52. Reform implementation is heavily dependent upon an effective champion who takes the early 'ownership' of the reforms sought. Equally, it is important that the domestic reform champions are well advised as to the positions assumed and actions taken. For example, the willingness of key counterparts at NBS and MOF to take key decisions, inter alia, to significantly reign in regulatory forbearance, take additional robust measures to further strengthen the bank and insurance regulatory regimes, withdraw licenses of banks and insurers and offer a number of state-owned banks and assets for sale has enabled key elements of the financial sector reform agenda to be advanced. Similarly, the effective management of the enterprise privatization process by MOE and PA facilitated progress in the reforms of the socially-owned sector.

53. The ability to provide extensive technical assistance on a timely basis has been crucial to enabling the PFSAC-I and I1 operations to achieve their objectives. The early provision of substantial grant funding and the effective coordination by the Bank of support from bi-lateral donors (notably EU, DFID and USAID) for the earlier (and on-going) reform agenda proved critical for developing institutional capacity at the DIA, PA and NBS to implement early high impact measures.

54. Good economic sector work (ESW) contributes significantly to a robust dialogue with counterparts and successful adjustment operations. In 2004 the Bank presented the GOS a number of key papers: the Serbia Economic Memorandum; the Financial Sector Note (FSN); the Investment Climate Assessment (ICA); the Private Sector Note (PSN); the Poverty Reduction Strategy Paper (PRSP); and in December, the Country Assistance Strategy. To aid in shaping the envisaged PPFDPC-1, in mid-2005 the Bank disseminated a number of other key reports, namely the Fiduciary Assessment Update, Public Expenditure Review, Accounting and Auditing Report on Observance of Standards and Codes (ROSC) and Financial Sector Assessment Program (FSAP) reports.

55. Finally, it is important to note that Serbia differs from most other transition economies in two ways. First, its system of socialism, based on worker management and the concept of "social capital," did not entail classic central planning; and secondly, due to the break-up of the former Yugoslavia and the resulting conflict and sanctions, Serbia was relatively late in embarking on the journey to a full-fledged market economy. These factors meant that the fundamental transitional task of reforming banks and enterprises had to be adjusted to these different initial conditions: auctions replaced voucher privatization (differently from other transition economies), the four largest state-owned banks were closed and finally, the approach to restructuring of utilities and of the largest loss-makers has been more gradual than that of the early reformers.

ANALYTICAL UNDERPINNINGS

56. The PRSP rightly emphasized that improvements in the business environment are key preconditions for sustainable private sector-led growth. The strategy for Serbia acknowledges the need for streamlining the registration process, reducing administrative barriers to business operation, improving corporate governance, and establishing a modem bankruptcy regime. Similarly, comprehensive reform of the financial sector represents an important cornerstone of governments' growth strategy. The Serbian PRSP correctly identifies the short- to medium- term actions needed to strengthen bank supervision, restructure and privatize remaining state- owned banks, and improve access to finance. With proper implementation, these reform steps should help significantly in allowing the Serbian financial system to play its proper role in channeling resources into productive investments.

57. In the energy sector, the PRSP notes that Serbia needs to move towards a more cost- reflective tariff structure. In the transport sector, the government strategy underscores the importance of the road transport sector in infrastructure investment. Efforts to improve railways, ports and marine transport and rural roads, the condition of the main and secondary road networks also require considerable improvement.

5 8 . The PPFDPCIL program heavily relies on findings of the extensive economic sector work undertaken by the Bank. The policy recommendations integrated into the relevant components of the PPFDPCIL are stemming from the three key documents - PSN, ICA and an accompanying FSN, - as well as other diagnostic work by the Bank and other institutions.

59. According to an empirical analysis in the ICA and the PSN, private firms are more productive than socially-owned firms, i.e. ownership matters. But post-privatization performance does not necessarily show that privatization improves firm performance; rather it may indicate that only the better, higher potential firms get privatized first. The results for new entrants, however, are unambiguous: new private firms in Serbia are more productive, more profitable, and growing more rapidly than socially-owned firms. The problem is simply that there are not enough of them. Although the new private firms are better performers, their scope for growth, and the possibility of entry by new entrepreneurs, are severely limited by the deficient investment climate. The implementation of recently drafted legislation aimed at improving business entry, corporate governance, access to finance, and business exit requires long and extensive institutional building to take effect.

60. Despite the impressive reform progress described above, the FSN demonstrates that Serbia's financial sector remains underdeveloped by regional benchmarks, and the existing level of financial intermediation is unable to fully contribute to economic growth. The bank- by-bank performance analysis presented in the FSN shows that the cost, profit and other efficiency parameters of Serbian banks have more in common with the non-Baltic countries of the former Soviet Union than with the neighboring Central European economies. Moreover, the best quartile of Serbian banks, while clearly outperforming the rest of the banking system, accounts for only a minority of total banking system assets. Narrowing the efficiency gaps between the better and the weaker Serbian banks, and between the better Serbian banks and the leading CEE and EU banks, will be the key to increasing the level of financial intermediation in Serbia. This requires creating the conditions under which the weaker banks lose ground rapidly to the better banks either through the liquidation of the weaker (mostly

state-owned) banks, or their rapid re-invention, through new strategic investment. In parallel, the development of non-bank financial institutions (NBFI), such as insurance companies, could offer a broader array of intermediary services and instruments, often unavailable from banks.

V. THE PROPOSED FIRST PROGRAMMATIC PRIVATE AND FINANCIAL DEVELOPMENT POLICY CREDIT

OPERATION DESCRIPTION

6 1. The PPFDPC-1 , the first of up to four development policy lending operations envisaged under the FY05-07 CAS, is designed to strengthen fiscal discipline in enterprise, energy and transport sectors and develop a more efficient, stable financial sector. Through putting in place a well targeted, key set of irreversible structural reform measures, the following development objectives are sought: (i) permanently reduce subsidies and staffing levels at SOEs and public utilities, thereby facilitating their restructuring and ultimate privatization; (ii) improve the legal and regulatory framework for the mining industry so as to attract green field FDI; (iii) substantially divest the government's remaining holdings in the banking and insurance industries; (iv) further strengthen the financial supervisory regime; and (v) provide new opportunities for access to longer-term real estate mortgage finance. A summary of agreed PPFDPC- 1 prior actions are included in the Policy Matrix (Annex 3) and the agreed conditions are featured in the Box 1 below.

Box 1. Conditionality for PPFDPC-1

The GOS has agreed upon and implemented the following prior actions before the presentation of the credit to the Bank Board of Directors:

1. The macroeconomic policy framework of the Borrower and the Republic of Serbia is satisfactory, as measured on the basis of indicators agreed between the Borrower and the Republic of Serbia, and the Bank.

2. (a) The Government of the Republic of Serbia has proposed to the Parliament of the Republic of Serbia to decrease the direct subsidies to socially-owned enterprises undergoing restructuring from CSD 5 billion, allocated for such purposes in the 2005 State Budget, to CSD 3.85 billion in the 2006 State Budget.

(b) The Government of the Republic of Serbia has agreed to make available CSD 4.5 billion from the Transition Fund for severance payments to employees of socially-owned enterprises, such enterprises having been set forth in the list agreed upon by the Bank.

3. Starting December 1, 2004: (i) the Privatization Agency of the Republic of Serbia has offered for sale no less than eighteen socially-owned enterprises and sold at least nine socially-owned enterprises through its tender program; (ii) the PA offered for sale through auctions no less than 180 socially-owned enterprises, and sold at least 40 percent of such socially-owned enterprises; (iii) the PA has offered for sale no less than eight socially-owned enterprises, or significant parts thereof (i.e., representing no less than 50 percent of the total assets), from the list of enterprises undergoing restructuring, using, as applicable, tenders, auctions and asset sales procedures, and sold at least three socially-owned enterprises set forth in the restructuring list; and (iv) Republic of Serbia owned or controlled creditors have requested the courts of the Republic of Serbia to initiate bankruptcy proceedings for at least six large state owned enterprises set forth in the restructuring list.

4. The Government of the Republic of Serbia has submitted to the Parliament of the Republic of Serbia amendments to the Law on Mining, satisfactory to the Bank, incorporating a new royalties framework.

Box 1. Conditionality for PPFDPC-1 (continued)

5. The Government of the Republic of Serbia has launched an international tender to engage a financial advisor for Elektroprivreda Srbije, in accordance with terms of references and procedures satisfactory to the Bank.

6. Zeleznice Srbije has reduced ZS staff engaged in core ZS activities by 1900, or 7.2 percent of total ZS core staff of 26,212 employed as of January 1,2005, and ZS and the Government of the Republic of Serbia have adopted the 2005 Business Plan, satisfactory to the Bank.

7. The Agency for Deposit Insurance of the Republic of Serbia has offered for sale, on behalf of the Government of the Republic of Serbia, a majority (i.e., more than 50 percent) of Vojvodjanska banka shares.

8. The amendments to the Insurance Law have been enacted, and are satisfactory to the Bank.

9. The Supervisory Review Committee of the NBS Banking Supervision Department and the Governor of the National Bank of Serbia have adopted the second phase of the Supervisory Development Plan, satisfactory to the Bank, and the NBS Banking Supervision Department has continued its implementation.

10. The Government of the Republic of Serbia has submitted to the Parliament of the Republic of Serbia a draft Law on Mortgage, satisfactory to the Bank.

62. Strengthening Fiscal Discipline. The GOS continues to provide substantial financial support to state-owned (mainly the railroads) and socially-owned companies, representing 2.4 percent and 1.1 percent, respectively, of the total budget expenditure. These subsidies create disincentives to the restructuring of the state- and socially-owned enterprises and contribute to the persistence of the fiscal deficit in Serbia. In addition to these direct subsidies from the government budget, companies occasionally receive indirect subsidies in the form of un- enforced arrears on utility charges, social contributions, taxes and credits andlor forbearance from state-owned banks.

63. The GOS has undertaken early efforts to reduce the overall direct subsidies to socially- and state-owned enterprises in the Serbian economy in order to signal that it will not provide indefinite support to the loss-making companies, and to stimulate the restructuring of those companies and their privatization. To this end, the 2005 budget included a reduction of the MOE direct subsidies to socially-owned enterprises in the process of restructuring from CSD 6.5 billion in 2004 to CSD 5 billion in 2005. Further decreases are envisaged in 2006 as discussed below. In parallel, the GOS is to increase the allocation to the Transition Fund in order to facilitate severance of redundant labor, which both spur restructuring and increase privatization prospects. Finally, while recently there were first signs of the strict enforcement of disconnection policies towards worst offenders, the GOS has to make further concerted efforts to block this subsidy route. To this effect, the MOE in cooperation with the tax authorities and main utilities needs to improve monitoring system for the large SOEs in order to ensure the full enforcement of hard budget constraints and to prevent further accumulation of arrears.

64. Privatization, Restructuring, and Bankruptcy of Socially-Owned Enterprises. Continued existence of a large SOE sector requiring public support imposes considerable risks of disrupting fiscal discipline and represents one of the main challenges facing the Serbian economy today. Most of the sector remains inefficiently organized, loss-making, and

excessively indebted. SOEs continue to benefit from non-competitive regulations, blocking potential competition from the private sector.

65. Over the past four years, the authorities have achieved significant progress in pursuing an ambitious, multi-track privatization program aimed at divestiture of socially- owned assets. The Government is committed to complete, to a large extent, the privatization program started in 2001 by offering for sale all SOEs currently in the PA tender and auction portfolio, and all saleable assets from the restructuring portfolio. In particular, the restructuring and subsequent privatization of large loss-making SOEs are expected to accelerate with the passage of the amendments to the Privatization Law related to debt restructuring. For SOEs that fail to attract reputable buyers, bankruptcy procedures will be initiated under the new insolvency regime.

66. Concessions. Serbia needs to continue strengthening its legal and regulatory framework and appropriate implementing institutions that will support further inflow of FDI. So far, the bulk of Serbia's FDI since 2001 occurred through privatization of SOEs. However, concessions could bring much needed "greenfield" FDI. The first major step in improving regulatory environment was the adoption of the "framework" Concessions Law in 2003. However, for its implementation sector-specific laws and institutional framework are very important. In the area of research and exploitation of mineral ores, the legal and regulatory framework conducive to private sector investment is generally defined in the Law on Mining (1995) and Law on Geological Exploration (1995). Recently, an effort to improve the existing framework by amendments to both of these laws has begun. In addition, the GOS has yet to define an overarching sector strategy towards mining in Serbia and to establish clear rules regarding royalties.

67. Energy Sector. Following the third quarter 2004 passage of the Energy Law and strengthening of the energy sector social safety net, a number of measures to support energy sector reform were undertaken in late 2004. In particular, an energy strategy was adopted by the GOS, members of the board of the new energy regulator have been proposed to the Parliament and the Government agreed to unbundle EPS into two successor companies and to adopt a longer term plan for restructuring. Additionally, EPS was granted a tariff increase from July 1,2005 in order to maintain cost recovery.

68. Railway Sector. Serbian Railways ZS (former ZTP) has a network of 3,809 route km, of which 1,724 krn are mainline and 1,247 are electrified. The former ZTP was heavily loss- making. In 2003, subsidies provided 63 percent of total revenue, while freight and passenger businesses provided only 25 percent and 9 percent, respectively. On the expense side, labor accounted for 30 percent (55 percent of expenses requiring cash), while depreciation was 47 percent. ZTP had produced an operating loss of CSD 11 billion in 2003. The subsidy of CSD 10.2 billion was sufficient, however, to allow ZTP to cover its cash operating costs. ZTP had poor resource productivity. Labor productivity (measured by traffic units produced per employee) and network density (measured by traffic units per track-km) are both much lower than railways with similar traffic. The management of former ZTP had recognized this, and has developed plans to reduce excess staff, stations and track.

69. Financial Sector. Relative to the size of the economy, the banking sector remains overpopulated and fragmented: there is clear scope for further consolidation of the domestic banks, some of which are very small and provide only local or regional coverage.

70. The NBS has recently recognized a number of deficiencies in the existing banking and insurance legislation and, in collaboration with the MOF, is in the process of preparing a new and substantially revised banking law. The new law will incorporate numerous changes to be substantially in line with EU banking directives and best practice. In addition, law amendments are currently pending on the introduction of a new deposit insurance scheme, bank liquidation procedures, insurance resolutions, etc. Moreover, the NBS raised the minimum bank capital requirement to Euro 10 million and the risk adjusted capital adequacy ratio to 10 percent from 8 percent as of January 2005. Although the regulatory framework for banking sector is now largely in place, the capacity of supervisors to adequately assess risks and undertake prompt corrective actions remains limited.

71. The recent FSAP mission concluded that the financial system is broadly stable, but that the main potential systemic vulnerabilities are: (i) banks' credit risk, exacerbated by 47 percent growth of lending (mostly foreign exchange linked) in 2004 and a reported 23 percent non-performing loan ratio at end 2004; and (ii) the 15 majority and minority held state-owned banks, most of which are not competitive and only a few others (including the largest) are slated for privatization by early 2006.

72. Additionally, the recent Base1 Core Principle assessment, conducted as part of the FSAP, provided a rather negative assessment of bank supervision, which raises concerns as to the quality of banks' financial reporting. Moreover, the capacity of supervisors to adequately assess risks and undertake prompt corrective actions remains limited, especially towards state- owned banks. As well, the lack of consolidated supervision of banking groups is an important gap which could impact the solvency of such banks.

73. Further, the insurance sector has begun to undergo sweeping change, as responsibility for the regulation and supervision of the insurance sector was transferred in mid-2004 to the NBS with passage of a new law. The insurance industry, long dominated by two socially owned insurers, has recently experienced the closure of 18 private insurance companies. Foreshadowing additional changes, the GOS is prepared to launch the divestment in 2005 of one of the two largest socially-owned insurers, whilst restructuring the other for its eventual sale. Moreover, there remains considerable scope for further consolidation within the sector as the NBS undertakes on-site examinations of the remaining insurers.

74. Access to Finance. Administrative barriers, limited access to finance and high cost of financing are still major impediments to successful business development. Through passage of a new Mortgage Law, the GOS intends to improve the efficiency of mortgage creation and enforcement, which inhibits development of the secondary mortgage markets and mortgage securities.

75. In addition to the above agreed Board presentation conditionality, Box 2 outlines the triggers for the follow-on PPFDPC-1 operation. Overall program outcomes envisaged through the FY07 CAS period are featured in the last column of the Policy Matrix (Annex 3).

76. Principal benefits of the proposed PPFDPC-1 operation center around key structural reforms that will reinforce sustainability of Serbia's macroeconomic stabilization by: (i) strengthening fiscal discipline; (ii) building a more efficient and stable financial sector; and (iii) further improving the investment climate. In particular, to put its finances on a more sustainable basis, the GOS, as part of the PPFDPC-1 program, is to reduce on-going subsidies so as to facilitate staff redundancies, permitting the restructuring andlor sale of affected state enterprises and targeted public utilities. Only when such chronic loss-makers are resolved through sale or commercially viable restructuring will the GOS be immune from these regular fiscal pressures. Secondly, the efficiency of the financial sector - and indirectly the GOS' contingent liabilities - will be reduced through the PPFDPCIL program, which aims to substantially reduce the Government's holdings in the banking and insurance sectors and to sell down or resolve its large financial asset holdings. Additionally, by further strengthening the regulatory and supervisory regimes, the stability of the financial sector will be improved, which in combination with a more stable macro-economic environment will increase borrowers' access to longer term real estate finance and further improve the investment climate. In sum, the envisaged policy measures underlying PPFDPC-1 will contribute to an irreversible and measurable impact upon the reform of the Serbian economy.

Box 2. Triggers for PPFDPCL-2

As part of the series of programmatic creditslloans, the Government has agreed on the following actions as triggers for moving to PPFDPCIL-2:

1. Reduction in the direct MOE subsidies in the 2006 budget to CSD 3.85 billion.

2. Starting on October 1, 2005, the PA will: (i) offer for sale no less than 18 SOEs and sell at least 9 through its tender program; (ii) offer for sale through auctions no less than 450 socially-owned enterprises, and sell at least 40% of them; (iii) offer for sale no less than 25 SOEs from the list of companies under restructuring, or significant parts thereof (i.e., representing no less than 50% of the total assets), using, as applicable, tenders, auctions and asset sales procedures, and sell at least 7 SOEs from the same list.

3. Starting on October 1, 2005, Republic of Serbia-owned or controlled creditors will request the courts to initiate bankruptcy proceedings for: (i) at least 8 large SOEs from the Restructuring List; and (ii) a number of additional SOEs that have unsuccessfully been offered for sale twice through auction or tender.

4. The Government of the Republic of Serbia will submit the Take-over of Companies Law and amendments to Securities Markets Law to the Parliament.

5. Regulations that define procedures for assessment of annual mineral production, surface and filing fees: royalties and payment procedures, and resolution of disputes and conflicts are in place.

6. Financial Adviser to deliver to GOS recommendations on restructuring of EPS. Regulatory framework is in place providing for transparent rules for setting cost recovery tariffs.

7 . Core ZS staff have been reduced by a further 1,000 employees, or 3.8% of total ZS core staff as of January 1, 2005. ZS has withdrawn passenger services from a further 6.3 percent (218km) of the network by about mid-2006, unless service specific PSCs are agreed. ZS has transferred 3 additional non-core activities to PA.

8. Vojvodjanska banka sale or resolution consummated. Sale launched for at least two minority-owned banks held as of end-2004. Upon Commercial Court of Belgrade approval, second NPL package offered for sale.

9. Liquidators have submitted opening financial statements for all 18 insurers closed. DDOR is in process of privatization. The independent diagnostic audit report of Dunav has been submitted to MOF, and a time-bound restructuring plan prepared, adopted by GOS and implementation begun by DIA.

10. By-laws needed to implement the new Banking Law are in place, including by-law(s) addressing sound risk management processes and accurate and timely reporting of risks.

11. By-laws or regulations, if any, needed to support implementation of Law on Mortgage adopted

POLICY AREAS

PILLAR I - Strengthening fiscal discipline 77. The recent CAS identified the strengthening of fiscal discipline as a priority for the sustainable success of Serbia's economic development. The proposed operation will improve fiscal discipline through: (i) phasing out of direct and containing indirect subsidies; (ii) accelerating privatization of socially-owned enterprises (iii) effective implementation of bankruptcy legislation; (iv) developing a more robust framework for mining concessions; and (v) continuation of the unbundling and restructuring (workforce and debts) of public utilities.

Policy Area 1.1: Reduction of MOE subsidyprogram and strengthening of the TF mechanism

78. Description. The major recipients of the MOE direct subsidies are among some 60 large socially-owned enterprises that have been slated for restructuring by the GOS. The 15 largest subsidy recipients among the companies in restructuring in 2001-2004 represent 57 percent of the total subsidy program. Zastava Automobili, the car manufacturer in Kragujevac in Central Serbia (26 percent), and a copper mining and processing complex, RTB Bor, in the less developed Eastern Serbia (13 percent) are by far the two single biggest recipients of subsidies. Yet, as of end-2004 firms on the restructuring list employed 103,045, which represents a reduction of about 23 percent from 2002, a clear indication that significant downsizing has taken place. Furthermore, there is a clearly progressive reduction of personnel as the enterprises move closer to privatization: the reduction was 30 percent in firms in tender, 20 percent in mid-process and 6 percent before privatization started.

79. Challenge. Many SOEs survive only because they receive new money from the state or state-influenced sources. In 2003, for example, 52 of the largest SOEs posted almost Euro 200 million in aggregate (mostly cash-flow) losses, and their debt increased by more than Euro 150 million. These companies continue to operate despite these substantial losses because they receive new money through various forms of direct and indirect government support: non-payment or partial payment of taxes; arrears to state-owned utilities, arrears to other state-owned financial institutions and the MOE subsidies which are used for supporting current operations and clearing arrears rather than investment.

80. Over the past 4 years, the Government has reduced the number of employees in the 15 biggest subsidy-receiving socially-owned enterprises from roughly 90,000 employees to 54,000, (a total (net) reduction of 36,000). Labor reductions in 2003 were circa 22,000 employees, declining substantially in 2004 to some 10,000. It has been estimated that there will be a need for some 18,000 redundancies in 2005 and 21,000 in 2006 from all companies, of which 10,000 and 13,500 respectively will come from enterprises within the RestructuringPrivatization Program. The cost of these terminations from the Transition Fund, at some Euro 2,500 per employee6, has been estimated at about Euro 57 million a year for

The standard amount for calculation purposes is 2,000 Euros per employee, but we have estimated costs conservatively at 2,500 Euros per employee due to the pressures coming from higher settlements with SOEs and a potential for inflation adjustment of the amount based on a 2002 agreement.

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2005 and 2006. Two large companies, Zastava and RTB Bor, reflect the largest need, where the required level of redundancy is estimated at 9,000 and 6,500 personnel respectively. While direct subsidies represent a recurrent burden on the budget, severance payments to redundant employees are a one-time payment which allows companies to decrease their labor force and wage bill, thus making the reduction in direct subsidies more sustainable.

8 1. Government Actions. The Government actions include two main areas: (i) Reduction in the MOE direct subsidies, and (ii) strengthening of a redundancy payment mechanism to compensate surplus labor through the TF', a budgetary item, which received a CSD 5 billion budget allocation in 2005. The MOE direct subsidies allow loss-making companies to survive without painful restructuring and thus do not provide incentives to management and employees to cooperate, which is crucial to encourage poorly performing firms to push ahead with restructuring, thereby releasing non-core assets to higher productivity users, and encourage viable enterprises to actively search for new markets and reduce costs. In particular, the entry, market access and access to credit of SMEs are crowded-out by un-restructured enterprises that continue to function in a soft budget environment. Moreover, the TF resources to date are not sufficient to finance the amount of redundancies required to facilitate privatization and restructuring of large SOEs and public utilities.

82. Bank's Assessmenr/Recommendation. As analyzed in the PSN, the MOE subsidy program not only contributes substantially to the fiscal deficit, it also represents a potential disincentive to restructuring and privatization of the companies that receive subsidies. The continuation of subsidies results in material disincentives for management and employees in the recipient companies to progress with restructuring and resolution. Redundancies must be resolved before privatization because offering a company with the redundant labor risks deterring investors altogether as the investor places high risk on implementing the redundancy package. Moreover, as the privatization of a company is closer, employees are less willing to leave the company, hoping for wage increases by the new owner. Given the scarcity of TF resources and in order to increase net budget proceeds from privatization, TF payments need to be focused only on companies in which the availability of TF severance pay can make the difference whether a company is sellable or not. The Government agreed with the Bank about a target list of companies for budget-financed social programs that will include only companies that, based on the study of the consultants of the PA and the opinion of the Financial Advisors, can be made sellable by decreasing the cost of severance to potential investors.

83. As mentioned above, in addition to the direct subsidies from MOE, many SOEs benefit from indirect subsidies in the form of un-enforced arrears on utility charges and various social and tax obligations. The Bank seeks to eliminate this source of soft budget constraints by assisting the GOS with restructuring of EPS and NIS in preparation for their eventual privatization. In parallel, the MOE, in cooperation with the tax authorities and main utilities, will establish monitoring system for the large SOEs in order to ensure the full enforcement of hard budget constraints and to prevent further accumulation of arrears.

84. Measures to be Undertaken as