Report No. 29258-YU Report No. 29258-YU Serbia and Montenegro Republic of Serbia An Agenda for Economic Growth and Employment Public Disclosure Authorized Authorized Disclosure Disclosure Public Public
December 6, 2004
Poverty Reduction and Economic Management Unit Europe and Central Asia Region
Serbia and Montenegr Public Disclosure Authorized Authorized Disclosure Disclosure Public Public
An Agenda for Economic Gr o Public Disclosure Authorized Authorized Disclosure Disclosure Public Public
owth and Employment
Document of the World Bank Public Disclosure Authorized Authorized Disclosure Disclosure Public Public
CONTENTS
ACKNOWLEDGEMENTS ...... v EXECUTIVE SUMMARY ...... vi
1 INTRODUCTION...... 1
2 ENSURING A CONDUCIVE MACROECONOMIC ENVIRONMENT FOR SUSTAINABLE GROWTH ...... 4 A . INTRODUCTION...... 4 B. RECENTREFORM PROGRESS AND ECONOMICDEVELOPMENTS ...... 5 The Legacy ofthe Past ...... 5 Policy Response and Donor Support during 2001-03 ...... 6 Key Achievements to Date ...... 7 Key Impediments to Sustainable Growth ...... 10 c . MAIN MACROECONOMICPOLICY PRIORITIES FOR GROWTH...... 15 D. MEDIUM-TERMOUTLOOK: AN OVERVIEW OF TWO ILLUSTRATIVE SCENARIOS...... 23
3 INTERNATIONAL TRADE AND REGIONAL INTEGRATION...... 28 A . INTERNATIONAL TRADEAND GROWTH:THEORY AND EXPERIENCE...... 28 B. TRADEPOLICY AND PERFORMANCE:1990-2003 ...... 29 The Legacy ofthe Past ...... 29 Recent Reforms during 2001-03 ...... 30 Recent Trade and Export Performance ...... 32 c . KEY CONSTRAINTS TO EXPORTGROWTH ...... 40 Macro-Structural and Supply Constraints ...... 40 Trade Policies ...... 41 Institutions Supporting Exports ...... 43 Foreign Direct Investment (FDI) ...... 49 D. TRADEINTEGRATION: MAXIMIZINGOPPORTUNITIES FOR LONG-TERMGROWTH...... 51 The European and Regional Dimension ...... 53 The Network ofFree Trade Agreements: Maximizing the Benefits ofIntegration ...... 56 E. CONCLUSION AND RECOMMENDATION ...... 59
4 PRIVATE AND FINANCIAL SECTOR REFORM ...... 62 A . INTRODUCTION...... 62 B. ENTERPRISESECTOR ...... 63 Legacy ofthe 1990s and Progress to Date ...... 63 Remaining Challenges ...... 65 Short to Medium-term Reform Agenda ...... 66 C . BUSINESSENABLING ENVIRONMENT ...... 72 Legacy ofthe 1990s and Progress to Date ...... 72 Remaining Challenges ...... 73 Short to Medium-term Reform Agenda ...... 75 D. FINANCIALSECTOR ...... 80 Legacy ofthe 1990s and Progress to Date ...... 80 Remaining Challenges ...... 82 Short to Medium-Term Reform Agenda ...... 84 E. KEYPOLICY RECOMMENDATIONS...... 88 5 LABOR MARKETS ...... 91 A . LABORMARKETS, GROWTH AND EMPLOYMENT...... 91 B. LABORMARKET PERFORMANCE IN SERBIA ...... 92 Participation and Employment ...... 93 Unemployment ...... 96 Wage Dynamics ...... 100 Labor Force Flows ...... 101 &“nry of Labor Market Characteristics...... 103 C . KEY CHALLENGES...... 105 Improving the Functioning of the Formal Labor Market...... 105 Age and Labor Market Performance ...... 111 Macroeconomic Policy and Labor Market Performance ...... 112 Private Sector Development and Labor Market Performance ...... 112 Education and Labor Market Performance ...... 112
6 EDUCATION AND TRAINING ...... 116 A . INTRODUCTION ...... 116 B. SERBIA’S TRADE PATTERNS AND LABORMARKET PERFORMANCE ...... 116 c . POLICY PERSPECTIVES ON THE LINKBETWEEN EDUCATIONAND THE LABORMARKET ...... 117 D. PERFORMANCE OF THE EDUCATIONAND TRAINING SYSTEM ...... 118 E. A REFORM AGENDAFOR SERBIA’S EDUCATIONAND TRAINING SYSTEM ...... 123 F. THECOST OF REFORM...... 127 G . CONCLUSION...... 130 REFERENCES ...... 132
LIST OF BOXES
Box 2.1 Serbia’s Progress in Key Reform Areas Relative to Selected Countries in the Region Box 2.2 Economic Implications ofWorkers’ Remittances Box 2.3 Structural Reforms. Savings. and the Current Account Deficit Box 2.4 Key Aspects ofPublic Administration Reform Box 2.5 On the Potential Growth Rate ofthe Serbian Economy Box 3.1 The Puzzle ofTrade Statistics in SaM Box 3.2 What Makes for a Good Trade/Export Promotion Organization (TPO) Box 3.3 Is Infrastructure an Impediment to Growth? Box 4.1 The Informal Economy Box 4.2 Privatization: The Lessons ofTransition Box 4.3 Approaches to Debt Workout Box 4.4 PICS and BEEPS I1 Box 4.5 Present Structure ofthe Serbian Banking System Box 5.1 Official versus ILO Unemployment Rate Box 5.2 Key Innovations Introduced by the Labor Law of2001 Box 5.3 Which Active Labor Market Programs Work Best in Transition Countries? Box 6.1 Principles for Effective Implementation ofTraining Levy/Grant Schemes Box 6.2 Policy Context for Education Reform List of Tables
Table 2.1 Evolution ofEconomic Activity, 2000-03 Table 2.2 Projections ofExternal Debt Service (in USD millions) Table 2.3 Composition ofExpenditures: Serbia versus Selected Countriesa Table 2.4 Trajectory ofSelected Variables Under Two Illustrative Scenarios, 2003-10 Table 3.1 SaM’s Trade in Goods and Non-factor Services (as % ofGDP) Table 3.2 Harmonization of Tariffs between Serbia and Montenegro Table 3.3 Exports ofGoods and NonFactor Services to GDP (XGNFS/GDP) (in %) Table 3.4 Performance of SEE-8 Economies in EU Markets in 1999-2003 Share in EU Total External Imports (%) Table 3.5 Geographic Distribution ofTrade: SaM and Other CEECs Table 3.6 Serbia’s Trade by End Use Products, 2000-03 Table 3.7 Factor Intensities of SaM’s Trade with the European Union Table 3.8 SaM’s Trade in Parts and Components and Share in EU Markets Table 3.9 Share in EU Imports of Outward Processed Products, 1990-2002 Table 3.10 Intra-industry Trade as Measured by the Grubel Lloyd Index Table 3.1 1 Tariff escalation in Serbia Table 3.12 Net FDI Inflow (millions ofUS$) Table 3.13 Progress of Western Balkans Countries in Trade Integration Table 3.14 Share ofSaM’s Imports Out of Total Imports with FTA Partners 2003 Table 3.15 Conditions ofAccess for SaM Exports to FTA Partners’ Markets 2003 Table 3.16 MFN Tariffs Table 4.1 Privatization Results 2002 - October 2004 Table 4.2 Enterprise Performance by Type ofOwnership Table 4.3 Evolution ofSerbia’s SME sector, 2000-2003 Table 4.4 Indicators of Contract Enforcement Table 4.5 Overview of Serbia’s Financial Sector Table 5.1 Participation and Employment Rates by Age and Gender, (2002) Table 5.2 Serbia: Formal and Informal Employment by Region, 2002 Table 5.3 Unemployment Rates, by Age and Gender, 2002 Table 5.4 Unemployment Rates in Serbia and Selected Transition Economies,a OECD and the EU, 1995-2002 Table 5.5 Unemployment by Educational Level, 2002 (percent) Table 5.6 The Unemployed by Employment History and Reasons for Unemployment, 1996- 2002 Table 5.7 The Evolution of the Unemployment Rate and Long-term Unemployment, 1995-2002 Table 5.8 Serbia: Uncompleted Unemployment Spells by Individual Characteristics, 2002 Table 5.9 Unemployment Rate by Locatioflegion Table 5.10 Net and Gross Monthly Wages in Euros, 2003 Table 5.1 1 Serbia: Transition Probabilities from Employment by Age, Education and Employment Type, 2003 Table 5.12 Transition Probabilities from Unemployment by Age and Education Table 6.1 New Skills for Successful Integration into the Labor Market Table 6.2 Training of Employees by Enterprises, Serbia and Montenegro in a Regional Context, 200 1 Table 6.3 Projections of number of teachers and real salary and non-salary expenditure, by level of education, assuming 4 percent annual average increase in salaries and no change in enrollment rates and pupill teacher ratios, 2003-2010
List of Figures
Figure 2.1 Evolution of the Inflation and Exchange Rates, 2000-03 Figure 2.2 Term Structure of Deposit Rates Figure 2.3 Public Debt, 2000-03 (% of GDP) Figure 2.4 Gross Official Reserves,a 2000-03 Figure 2.5 Exports of Goods and Services, 2003 percent of GDP Figure 2.6 Ratio ofInvestment to Current Account Deficit, 2000-03 Figure 2.7 Public Debt in Serbia and in Selected Countries in the Region 2001-03 Figure 2.8 Income and Government Size: Serbia vs EU-15, ECA, and MENA Figure 2.9 Investment (% of GDP) Figure 2.10 Wage Bill, 2000-04 Figure 2.1 1 Subsidies and Transfers, 2000-04 Figure 2.12 Evolution of Growth, 2004-10 Figure 2.13 Investment, 2005-10 (% of GDP) Figure 2.14 Public Debt 2005-10 (% of GDP) Figure 2.15 Consumption, 2005-10 Figure 3.1 SaM’s Trade Performance (goods and non factor services), 1999-2003 in Euros Figure 3.2 Unofficial Payments to Deal with Customs/Imports Figure 4.1 Comparing Financial Depth and Reliance on Cash Figure 5.1 Evolution of Employment and Output, 1989-2003 Figure 5.2 Evolution of Employment Rates, 1989-2003 Figure 5.3 Evolution of GDP, Productivity, and Wages, 1999-2003 Figure 6.1 Educational Attainment, 15 and over Population, Serbia 2002 Compared with Slovenia 2002 and Estonia 2000 Figure 6.2 Gross Enrollment Rates by Level of Serbia Compared with Slovenia, Estonia and Romania Figure 6.3 Index of Real Public Expenditure on Education under 2 Scenarios, 2003-2010 Figure 6.4 Projections of Real Current Education Budget, with Salary Increase, by Level & Surplus Available by Scenario, 2003-2010
Annexes
3.1 Summary of FTAs Signed by SaM and their Compliance with the MOUCriteria 3.2 Export Specialization Indices* of Selected Product Categories in SEE-8 Exports to the EU 3.3 Hiring and Firing Workers 3.4 Labor Legislation Flexibility, 2003 ACKNOWLEDGEMENTS
This report was prepared by a World Bank team. The preparation of the overall report was led by Ardo Hansson (task manager), Ilker Domaq and Lazar SestoviC, with initial input from Vladimir Gligorov (consultant).
The chapter on macroeconomic policy was prepared by Ilker Domaq, Evgenij Najdov and Lazar SestoviC, with input from Tony Verheijen and Bruce Courtney, and informed by a background paper by Dejan PopoviC (consultant).
The chapter on international trade and regional integration was prepared by ' Alia Moubayed, with input and comments from Costas Michalopoulos (consultant) and Gerald Paul Ollivier.
The chapter of private and financial sector development was prepared by Itzhak Goldberg, Alexander Pankov and Branko RaduloviC, with input from Michael Edwards. This chapter also builds on two other World Bank reports which were prepared simultaneously - Serbia Investment Climate Assessment, and Serbia Financial Sector Note.
The chapter on labor markets was prepared by Lazar SestoviC, Ilker Domaq, and Arvo Kuddo, building on a background paper by Gorana KrstiC (consultant).
The chapter on education and training was prepared by Martin Godfrey (consultant) and Toby Linden, with input and comments from James Stevens.
The team benefited greatly from guidance received from peer reviewers Sanjay Kathuria and Carlos Silva-Jauregui, and from comments received on the concept paper for the report from Peter Sanfey (European Bank for Reconstruction and Development), Peter Grasmann, Christophe Pavret de la Rochefordiere, Uwe Stamm and Leopoldo Rubinacci (European Commission), Balazs Horvath (International Monetary Fund), and numerous World Bank colleagues.
The report was prepared under the overall supervision of Orsalia Kalantzopoulos and Bernard Funck. Its production would not have been possible without excellent support from Emily Evershed (consultant) in editing the document, and Mismake Galatis and Amanda Carqani in processing the document.
V
EXECUTIVE SUMMARY
Since restarting its transition to a market economy in late-2000, Serbia has made good initial progress across a range of areas. This progress began from a very difficult starting point which reflected the legacy of a decade of isolation, conflict, and poor economic management. Strong stabilization efforts coupled with greatly increased capital inflows (from new donor support, remittances, foreign direct investment, and remonetization) have supported a reduction of annual inflation from over 100 percent in 2000 to below 10 percent in 2003. Ratios ofdebt to GDP have declined while foreign exchange reserves have increased substantially. Initial reforms ofthe trade regime, ownership relations, the business environment, the financial sector, the labor market, and the education system, have also begun to lay the foundations for more rapid growth. As a result, Serbia’s previously dysfunctional banks are beginning to attract new deposits and make new loans. Economic activity is being shifted to the private sector. Building on these changes, Serbia’s real GDP grew by an average of4.2 percent per year from 2001 to 2003, with average consumption growing at an even faster pace.
However, deep structural weaknesses remain. Growth rates of around 4 percent per year will not suffice to produce a rapid convergence ofliving standards towards historical levels and levels in the more successful reforming countries of Central and Eastern Europe. As in many economies in transition, the initial output recovery has yet to bring an increase in employment. A significant share of Serbia’s production and employment remains in the informal sector. Key determinants of growth potential such as exports, investment and domestic savings remain extremely low. Still significant albeit reduced macroeconomic imbalances and debt burdens continue to render the economy vulnerable to shocks. Despite a growing private sector and much improved market access, Serbia’s foreign trade remains largely unrestructured, with little reorientation towards the European Union and a largely unchanged commodity composition.
Moreover, the positive elements of Serbia’s recent performance are not sustainable without further adjustment and sustained reform. This is for both macroeconomic and structural reasons. Supported by the sharp increase in capital inflows and by debt restructuring, Serbia’s recent growth was driven by domestic demand. This cushioned the initial impact of reform and helped jump-start investments, but also led to large current account and fiscal deficits, which are unsustainable in the medium-term. Fresh capital inflows are likely to decline and have a lower grant element, while debt service payments will rise as grace periods expire and new debt begins to be repaid. The resulting need to achieve substantial and rapid declines in current account and fiscal deficits will require Serbia to shift to an entirely different type of growth which is led by exports, rather than by domestic demand. The macroeconomic policies which have been successful to date will need to be revised in the face ofthese new challenges.
vi Initial rapid structural reforms have slowed and remain incomplete. A major burst of reforms during 2001 and the first half of 2002 was followed by much slower and less coherent performance, with good progress in some areas tempered by actual or threatened backtracking in others. Political instability has been a major factor hampering reform efforts. Cumulative reforms need to reach a certain critical mass before bringing a robust supply response. Serbia needs to do far more before it can reach that point. Despite the noted initial achievements, measures of cumulative reform progress such as the EBRD Transition Indicators still show Serbia and Montenegro near the bottom ofthe group oftransition economies. Furthermore, Serbia is still at a very early stage in integrating its economy with European structures, an objective which will increasingly drive its future agenda of reform and institutional strengthening. Thus, there is an urgent need to push ahead with reforms across a range ofareas.
This report analyzes Serbia’s recent performance and near-term reform priorities in five areas which are particularly important for growth and employment creation. Macroeconomic policy, international trade and regional integration, private and financial sector development, the labor market, and educatiodtraining, are all crucial for increasing investment, sustaining employment, and improving productivity. They are also important for achieving two other important overarching objectives; (i)moving informal activity to the formal sector; and (ii) gradually integrating Serbia’s economy with European structures.
While reforms need to implemented across the board, some will have more rapid payoffs than others. Given Serbia’s low savings rate and its need to reduce the current account deficit, near-term growth is unlikely to come from major increases in investment rates. As recorded employment rates are already high, near-term growth will also probably not be driven by further increases in employment (which is likely to fall before beginning to rebound). For these reasons, the immediate growth impulse will need to come from improved extemal competitiveness (through adjustments in macroeconomic policy) and enhanced productivity. The greatest potential for rapid increases in productivity lies in reallocating Serbia’s existing resources of land, labor and capital to higher productivity uses. Labor market reforms will be needed to keep the fall in employment to a minimum and to ensure a smooth movement ofworkers to new jobs. In the medium-term, higher productivity will increasingly come from new investments. Reforms of Serbia’s education sector will have a much longer-term impact but need to be implemented now.
The following eight themes emerge as the key reform priorities for enhancing growth and employment generation in Serbia.
1. Enhanced Political stabilitv and improved governance are key prerequisites for sustained growth. A high level ofperceived risk is the single greatest deterrent to both domestic and foreign investment. Surveys of incumbent businesses in Serbia cite policy uncertainty as the single greatest weakness in the business enabling environment. Serbia will only be able to benefit from the technical improvements discussed below if political stability is greatly enhanced, if the risk of sudden shifts or major reversals ofpolicies is eliminated, if perceptions of corruption are reduced, and if the overall quality ofgovernance is further improved.
vii 2. The size of the public sector needs to be reduced. Serbia has made good progress in reducing hidden fiscal burdens, particularly budgetary arrears and losses in the energy sector. However, consolidated public spending has steadily increased to a very high around 47 percent of GDP, very little of which goes to the public investments which is crucial for growth. The resulting high tax burden and budget deficits crowd out private activity or push it into informal channels, while also raising macroeconomic vulnerability. Against this backdrop, the creation of a growth-enhancing public sector will entail focusing on the following policy priorities:
0 Non-interest current spending as a share of GDP needs to be reduced in a significant and sustained fashion. This is required to reduce overall spending while allowing some increase in public investments. The greatest scope for savings is in the following categories of spending - the public sector wage bill, the health sector, public pensions, and subsidies. The rebalanced budget for 2004 and the draft budget for 2005 represent important first steps in this direction, and this progress needs to be consolidated through further such adjustments in later years. Such expenditure adjustments will only become sustainable if they are supported by reforms which directly and permanently address the underlying expenditure commitments and entitlements, and which improve the functioning of Serbia’s public administration and overall public sector.
0 The savings from expenditure containment need to be channeled primarily into deficit reduction. Given its large public debt and need to reduce the current account deficit, Serbia has no scope to ‘stimulate’ economic activity through fiscal policy. Public revenues need to be secured until the underlying expenditure adjustments have been achieved. Any further gradual reductions in tax rates will need to be paired with efforts to broaden the tax base and further improve the effectiveness of tax administration. A continued prudent shift from direct towards indirect taxation could also promote the needed increase in national savings.
3. The strong anti-export bias in the Serbian economy needs to be addressed. Serbia’s large current account deficit reflects very low exports rather than high imports. Starting from such a low base, Serbia has great potential to expand its exports under the right set of policies and institutions. To date, it has been unable to exploit this potential, despite greatly improved formal access to its main markets. Addressing the anti-export bias behind this poor performance requires changes in four broad areas:
0 Past reductions in tariffs need to be deepened, and the institutional framework for trade policy strengthened. Such adjustments could take place in the context of negotiations on WTO accession and the EU Stabilization and Association process. As the current account deficit is an indication ofmacroeconomic imbalance, it should not be addressed through increased protection. This would also reduce the benefits of enhanced competition on productivity, and drive away investors who wish to locate in Serbia to serve a large integrated market. Further reforms should focus on reducing tariffs on finished products in sectors where tariffs are escalated and on eliminating remaining non tariff barriers. Greater clarity in the institutional framework for the
viii formulation and implementation of foreign trade policy is also necessary to reduce costs and avoid distortions in trade transactions within SaM.
0 Regional and global trade integration needs to be accelerated while ensuring close coordination among its various dimensions. EU integration in the context of the Stabilization and Association process and liberalization with neighboring states in South East Europe should go hand in hand in order to avoid potential trade distortions. This needs to be accompanied by stepped up efforts to accede to the World Trade Organization in order to guarantee security over Most Favored Nation market access, reduce potential distortions arising from regional trading arrangements, and modernize the regulatory and legislative framework goveming trade and investment.
0 Institutions which help Serbian firms’ access external markets need to be strengthened. Their poor functioning is one of the main reasons why Serbia has yet to take advantage ofthe very extensive formal market access it has already achieved. Priority reforms include the modernization of standards and technical regulations to achieve compatibility with EU and international standards, and the further strengthening ofcustoms and other border agencies.
0 The mix of macroeconomic policies needs to be adjusted. Serbia’s recent combination of somewhat loose fiscal policy and tight monetary policy has increased domestic demand and contributed to a real appreciation of the dinar. This has fueled imports while reducing the incentives and opportunities to export. To achieve export led growth, Serbia must place a greater share of the burden of stabilization of fiscal policy (the draft 2005 budget is a welcome step in this direction), taking the pressure off ofmonetary policy. The resulting lower domestic demand and a more competitive real exchange rate would simultaneously discourage imports and encourage exports.
4. The privatization of enterprises and banks needs to be completed. A large and strong private sector, supported by an efficient financial sector, is crucial for growth. The report shows that new private and privatized firms in Serbia clearly outperform SOEs. Finns in pre- privatization limbo face little incentive to search for new markets, restructure their production, or create new and more secure jobs. At the same time, Serbia’s inefficient and problem-laden state- owned banks cannot provide intermediation to real sector on a sustainable and affordable basis. While Serbia has laid a solid foundation for the divestiture of enterprises and banks, the initial momentum has not been sustained. Two key priorities stand out in the area ofownership reform:
0 Privatization needs to be reinvigorated, with a continued focus on sales to strategic investors. On the enterprise side, the tender and auction privatization of SOEs in the Privatization Agency (PA) pipeline needs to be accelerated without a fundamental change in the privatization model. The restructuring and subsequent sale oftroubled industrial conglomerates also needs to be speeded. In parallel, Serbia need to achieve the accelerated transparent privatization of viable state-owned banks to strategic investors through open tenders, especially as further delays may lead to the deterioration of the condition ofbanks, and to liquidate or merge those banks which
ix cannot be sold and/or are unlikely to compete effectively even if their balance sheets could be cleaned up.
0 Property rights need to be protected. To continue attracting FDI and local investment, the government must ensure a consistent treatment of the first group of investors which bought companies in tenders. Unless clear illegal transactions have been proven, the reversal of privatization transactions would introduce uncertainty and be detrimental to future transactions.
5. Financial discipline needs to be enhanced, including through greater competition. This is crucial for encouraging enterprises to actively search for new markets, for enhancing efficiency, and for ensuring that poorly performing firms release factors of production to higher productivity uses. By encouraging firms to maintain wage increases in line with productivity growth, it will also promote employment, investment (by increasing retained eamings) and export competitiveness. In addition to the further enhancement of import competition described above, the key reforms for achieving the noted objectives fall into three groups:
0 Improvements in the bankruptcy system need to be effectively implemented. Building on the recent enactment of the important law on bankruptcy, priority reforms include: building institutions required to implement the law; raising the resources and training the personnel required to build the Supervisory Agency and the unit which will administer the socially owned companies; and initiation ofbankruptcy proceedings by the state in its role as creditor through the tax administration, the electric power company (EPS), and state-owned banks.
0 The reform of large utilities needs to be expanded and deepened through: continuation of the unbundling and restructuring (workforce and debts) of public utilities; resolution of the debts of companies under the restructuring program of the PA which have the largest debts to EPS by restructuring and offer for sale of the debtor companies; establishment of an adequate regulatory framework in the relevant sectors prior to privatization; and resolution of the legal problems created by the fact that both the capital and physical assets belong to the state, prior to restructuring or privatization.
0 The regulatory and supervisory regime for the banking system needs to be strengthened through: enhancement of National Bank of Serbia (NBS) supervisory capacity by timely implementation of the Supervisory Development Plan; maintaining proper fiduciary oversight of state-owned banks through coordinated efforts ofthe Bank Rehabilitation Agency, NBS and Ministry ofFinance in the period leading to resolution; conducting on-site examinations at the fastest growing private banks, with appropriate remedial action as may be necessary; and improving the legal and institutional framework for bank exit.
6. The business enabling environment needs to be further improved. Ownership transformation and enhanced discipline will not be enough to secure growth. This also requires the smooth movement ofthe factors ofproduction from low to high productivity enterprises, and
X the ability of these firms (including foreign owned firms) to then expand their production. The access of Serbian firms to export markets described above is one crucial element ofthe business environment, especially from the perspective of foreign investors. Other key priorities identified in the report fall in four areas:
0 Contract enforcement needs to be strengthened through: simplifying enforcement procedures by effectively implementing the recently adopted Law on Execution Procedure; strengthening the performance ofbailiffs by adopting the relevant by-laws and training; and strengthening court resources through education, improved court statistics and information sharing.
0 Access to credit needs to be enhanced through; continuing the establishment of publicly accessible leasing and pledge registries; adopting a new Mortgage law; focusing on the provision of public goods (contractkollateral enforcement) rather than direct state support; and auditing the performance of state-owned credit-granting institutions such as the Development Fund.
0 The regulatory burden on enterprises needs to be reduced, including through: introduction of the public discussion on the draft laws as a rule and not as an exception; requirement of a justification statement for all laws and other regulations that explains the expected benefits and costs of the actions; and identification and removal ofoverlapping functions ofvarious state authorities.
0 Access to land needs to be improved through: changing the constitutional treatment of urban land; removing various administrative barriers to access to land; resolving the issue ofrestitution; implementing a phased decrease and enhanced enforcement of the property transfer tax, with compensating increases in other taxes; and enhancing the human and physical resources in various components of the land management system, such as cadastre.
7. The flexibility of the formal labor market needs to be further enhanced. Despite greatly improved laws on labor and employment, the formal labor market remains rigid and continues to function poorly, while employment continues to move to the much more flexible informal labor market. Such barriers discourage new employment while hindering the movement ofworkers key to better and more secure employment. Youth, women and the less well educated are at a particular disadvantage in the formal labor market. Finally, wage discipline appears to be poor, with recorded real wage growth greatly exceeding productivity growth. Priority reforms of labor markets fall in three broad areas:
0 The removal of 1egaYadministrative and institutional barriers to the functioning of the formal labor market needs to be sustained. Areas for improvement include: further limitation of minimum severance payments; expanding the scope for part- time, short-term and seasonal employment; improving the functioning of social dialogue through stronger and more credible representation of employers; and ensuring that minimum wages do not reach levels which will adversely affect employment prospects, particularly ofyouth and the least skilled.
xi 0 The growth of real wages needs to be kept in line with productivity growth. This is crucial for sustaining the demand for labor and thus supporting higher employment rates. This requires enhanced financial discipline on enterprises, a stronger role of employers in collective bargaining, and the continued imposition of direct limitations on wage growth in the budgetary and SOE sectors.
0 Programs of financial and active support for job losers need to be restructured and reoriented. The scaling back of the costly Social Program could free resources to adequately fund Serbia’s well-designed unemployment benefits, and finance a more targeted set of active labor market programs selected based on transition experience, and in line with available administrative resources of the Labor Market Bureau.
8. Serbia’s education and training; system needs to be re-oriented. The poor quality of and low enrollment rate in secondary education are major bamers to growth. Low secondary enrollment hampers the improvement of Serbia’s already relatively low average levels of educational attainment. Poor quality is reflected in the inability ofthe system to provide the skills required to succeed in today’s labor market, especially a high share of students in vocational streams. The tertiary education system is inefficient, including a very long average period before a student graduates and the fragmented structure of universities. Finally, limited adult education and training opportunities make it difficult for those with inappropriate skills to overcome these shortcomings. Priority reforms in education and training fall into three groups:
0 The serious problems of quality and enrollment in secondary education need to be addressed. Most urgently, the number of students completing a four-year secondary education needs to be increased through a shift away from vocational education programs, particularly those of only three-years duration. This would provide people with the broad and flexible skills demanded in a dynamic market economy, reduce unit costs, and provide resources for investments in quality. Secondary education also requires improved measures ofeducation quality.
0 The efficiency of tertiary education needs to be enhanced. Priorities include reforming the governance of universities towards European-style corporate institutions, and enhancing the incentives for universities to help students graduate on time with the knowledge they need.
0 Opportunities for adult training need to be expanded, particularly in SMEs. This requires encouraging foreign investors (which tend to provide higher levels of training) and establishing a certification and quality control framework for adult education and lifelong learning.
Many of the described reforms will also help Serbia to meet the important challenge of reintegrating informal activity into the official economy. A large informal sector hampers growth by undermining productivity and preventing more productive formal companies from gaining market share. Key reform measures for reducing informality include: gradually reducing
xii taxes on labor while sustaining overall revenue performance by shifting towards indirect taxation, broadening the tax base and improving tax collection and enforcement; reducing smuggling through trade liberalization; implementing the described improvements to the business enabling environment; and enhancing the flexibility ofthe formal labor market.
As demonstrated in greater detail in the report, the outlined package of substantial and permanent fiscal adjustment and sustained progress in structural reform could generate the higher investment rates and more competitive economy which can produce rapid and sustainable growth of living standards over the medium-term. Such policies, need to be implemented with urgency and unwavering commitment. Given Serbia’s tightening macroeconomic constraints and incomplete reform agenda, a muddling-through approach to fiscal adjustment and reform would seriously undermine Serbia’s ability to improve living standards. In fact, an attempt to avoid the necessary adjustments could well place Serbia on a path to slowing and even negative rates of consumption growth, and leave its economy unacceptably vulnerable to external and internal shocks.
xiii 1 INTRODUCTION
1.1 This report aims to identify key obstacles to economic growth and employment generation in Serbia with the objective of determining how policies and institutions can best be improved. The themes of growth and employment generation have moved to the forefront of the economic reform agenda, and are key pillars of Serbia’s recent Poverty Reduction Strategy Paper (PRSP). This increased emphasis on the development agenda is natural for an economy which has largely completed the initial stage of its economic program, which focused on stabilizing the economy, implementing ‘first generation’ reforms (e.g. price and foreign exchange liberalization), laying the foundations for ‘second generation’ reforms, and urgent reconstruction.
1.2 As in the other transition economies in Europe and Central Asia, the second stage which focuses on ensuring long-term economic stability and sustainable growth has proven to be more challenging. Initial progress in key areas of ‘second generation’ reform has been uneven. Significant advances have been made in opening the country to trade and investment, the management of public finances, tax policy, privatization, bank resolution, energy, the labor market, pensions and social assistance. In most areas, however, the reforms are still far from complete, and in several areas (e.g., public administration, health, competition policy), the reform process has hardly begun.’
1.3 As the report discusses in greater detail, the key weaknesses of the Serbian economy include: (i)still very low output and living standards; (ii)a weak employment response-an issue with particular importance since the required reallocation of labor to more efficient uses may lead to even higher short-term unemployment; (iii)low levels ofkey determinants ofgrowth potential such as exports, investments and savings; and (iv) the unsustainable nature of recent growth in the face of still high external imbalances and an impending tightening of macroeconomic constraints.
1.4 Set against this background, how can Serbia attain more rapid and sustainable growth? Economic growth reflects a country’s ability to increase its production of goods and services. According to the simplest classical theory (Solow, 1956), a country uses two inputs- labor and capital-and combines them with know-how to produce output (the knowledge about putting inputs together being referred to as technology). Thus, an economy can produce more output if it has more workers, more machines, or improvements in the efficiency with which labor and capital are utilized. At the level of the economy as a whole, productivity will also be determined by how capital and labor are allocated to specific activities.
1.5 The new growth theory of the 1980s and 1990s built on this simple framework while placing more emphasis on the role of government policies in affecting productivity. According to this theory, policies that constrain work practices or the application of better production methods at the firm level, that reduce knowledge flows through trade, that decrease
’ For a more extensive review of reform performance during 2001-03, see World Bank (2003e). competition, or that divert resources to less productive sectors may reduce the ability of labor, capital, and human capital to produce goods and services.
1.6 The transition experience confirms the importance of government policies in determining growth performance.2 First, and not surprisingly, macroeconomic stabilization is essential: growth has generally been stronger and come sooner in countries that have contained inflation. Second, countries that liberalized prices early and comprehensively experienced the earliest output recoveries. Third, output has also risen more rapidly in countries with high average growth rates of exports, underlining that openness and export orientation are important determinants ofgrowth.
1.7 Fourth, the initial growth impetus is triggered by the efficiency gains resulting from reforms such as hard budget constraints and liberalization, which strengthen incentives for enterprises to become more prod~ctive.~Investment alone does not guarantee early growth and recovery. Also, higher investment often takes two to three years to produce a strong output response. However, as economies reach a more advanced stage of development, higher investment becomes increasingly important if growth is to be sustained.
1.8 Fifth, foreign direct investment (FDI) appears to play an important role, which can be linked to the quality of the business environment. In addition, the share of the private sector in GDP is distinctly larger for countries with rapid and consistent growth than for those with slow and uneven growth. Finally, investments in human capital through more training and education will allow labor to produce more output with the same work effort, thereby raising overall productivity.
1.9 In light of the above, achieving more rapid and sustainable growth in Serbia will require the coherent implementation of reform, institutional strengthening and human capital development measures aimed at ensuring a stable macroeconomic environment and creating a competitive economy with solid export performance and a climate hospitable to foreign and domestic investment. To this end, the report focuses on the following policy areas:
e Ensuring a macroeconomic environment conducive to growth as Serbia’s high, poorly allocated and inefficient government expenditures, coupled with large public and external debts and imbalances, emerge as key impediments for growth and macroeconomic stability.
e Improvements in trade policy and regional integration aimed at increasing the export orientation ofthe economy, enhancing its efficiency through greater competition, and making it more attractive for FDI.
e The development of a vibrant real economy driven by the private sector. This requires policies focused on increasing economic efficiency through continued privatization and harder budget constraints and the creation of a business enabling environment
2 See for instance, World Bank (2002), Fischer and Sahay (2004), Havrylyshyn (2001), and Havrylyshyn and Wolf (1999) Doyle et al. (2001).
2 conducive to investments and improved productivity, supported with measures to create a stable and efficient financial sector.
Promoting a well-functioning andflexible labor market which promotes employment by increasing the demand for labor, improves productivity by supporting the reallocation of labor to more productive uses, and encourages the formalization of employment.
Improvements in education and training systems aimed at enhancing human capital (a key determinant of productivity), improving employment prospects, and facilitating the movement oflabor to more productive and higher paying jobs.
1.10 This report focuses primarily on economic growth and employment generation. These themes are important but only part ofthe economic and social reform agenda, which is too broad to be treated in a single study. This report complements two other recent major World Bank reports which focus on other important dimensions of Serbia’s development agenda: (i) Serbia and Montenegro: Poverty Assessment (2003); and (ii)Serbia and Montenegro: Public Expenditure and Institutional Review (2003).
1.11 In each of the noted policy areas, the report provides a set of measures to meet Serbia’s key challenges, which are also highlighted in the Executive Summary. Each sectoral chapter or sub-chapter begins by describing recent performance and policy reform^.^ It then analyzes the main reasons for the revealed weaker aspects of performance, as a basis for recommending policy actions to improve Serbia’s prospects for growth and employment. In other words, performance is fully outlined before being explained. The main message of this report is that a substantial and permanent fiscal adjustment and deeper structural reform are urgently needed to produce a robust private sector response and lay the foundations of an economy which would produce a more rapid and sustainable growth of living standards over the medium-term.
1.12 The report also underscores that there is no room for complacency. Given Serbia’s vulnerability to internal and external shocks and the still incomplete reform agenda, a muddle- through approach to fiscal adjustment and reform would seriously undermine the country’s ability to raise living standards on a sustainable basis and to move closer to European structures.
This includes extensive comparison of Serbia’s policy settings and outcomes, as well as cumulative reform progress, with other economies in transition and sometimes also with developed market economies. Such benchmarking is intended to illustrate the magnitude of the remaining reform agenda in various areas and to provide some guidance in determining policy priorities. Given Serbia’s much later start in comprehensive market reforms, benchmarking alone does not represent an evaluation of recent reform and policy performance.
3
2 ENSURING A CONDUCIVE MACROECONOMIC ENVIRONMENT FOR SUSTAINABLE GROWTH
A. INTRODUCTION
2.1 International experience provides strong evidence that high fiscal deficits and public debt are harmful to growth and macroeconomic ~tability.~There are several reasons for this. Higher budget deficits imply lower national savings. T his, in turn can lead to lower investment as the reduced supply of loan able funds forces interest rates higher. High deficits can also cut net exports, for at least two reasons: (i)the resulting higher interest rates cause the domestic currency to appreciate; and (ii)the decline in investment lowers the capital stock, reducing productive capacity. Lower net exports also increase the economy’s vulnerability to shocks. High public debt requires higher taxes to finance it and exerts upward pressure on real interest rates, thereby discouraging private investment. It also undermines the flexibility of macroeconomic policy by reducing the government’s ability to run a more countercyclical fiscal policy. Moreover, high public debt can raise fears that an unexpected increase in inflation may be used to reduce the debt to more sustainable level^.^
2.2 The recent experience of economies in transition also confirms the importance of fiscal prudence for enhancing growth performance. Macroeconomic stabilization, for which fiscal discipline is a prerequisite, has been one of the key foundations of sustainable growth. Indeed, a recent study by Fischer and Sahay (2004) found that a 1 percent rise in fiscal surplus in relation to GDP led to a roughly 0.5 percent increase in real GDP over the period 1989-2003. However, the experience of economies in transition also underlines the fact that macroeconomic stability alone is not sufficient for sustaining growth, which also requires the implementation of a coherent program of structural reforms. The more rapidly and more consistently these reforms are carried out, the faster the economy will pull out of the initial recession and the stronger the subsequent upturn in growth will be.’
2.3 In light of the noted strong links between sound macroeconomic policy and growth, this chapter discusses the key macroeconomic policy priorities needed to put Serbia on a sustainable growth path. The remainder of this chapter is organized as follows. The next section provides a brief overview of the recent reform progress and economic developments. Section 3 discusses the main macroeconomic policy priorities for growth. The chapter concludes with a comparison oftwo illustrative macroeconomic scenarios that bring out both the beneficial impacts of strong macroeconomic adjustment and structural reforms, and the severe dangers of unchanged macroeconomic policies combined with slow reforms.
2.4 The principal conclusion of this chapter is that Serbia’s efforts to promote growth should focus on: (i)reducing the size of the public sector; (ii)altering the composition of public expenditures; and (iii)stepping up progress in those structural reforms that would enable the
See, for instance, papers presented at the Conference organized by the Federal Reserve Bank of Kansas City entitled “Budget Deficits and Debt: Issues and Options”, Fischer (1993) as well as Easterly and Rebelo (1994). As shown by Calvo (1988), the temptation to inflate the debt away rises with the size ofthe debt relative to GDP. ’ See, for instance, Havrylyshyn (2001). Serbian economy to achieve its full potential. With its public debt at around 79 percent of GDP and public spending at over 45 percent of GDP, Serbia needs to give top priority to achieving a durable reduction in the share of public expenditures in GDP. A policy shift involving a reduction in government consumption and an increase in public investment would enhance macroeconomic stability and improve Serbia’s growth prospects. Policy efforts in the fiscal sphere will need to be accompanied by reform measures aimed at improving efficiency and creating an environment that is conducive to productive investments-an issue discussed in Chapter 4 in greater detail.
2.5 As the illustrative projections demonstrate, a muddle-through approach to reform cannot be pursued, given Serbia’s vulnerability to internal and external shocks and the need to improve the business climate and investor confidence. Delayed reforms may defer the cost some difficult adjustments, but only at a price of more painful adjustments in the future. Unwavering commitment and determined implementation of the reform program would also enable Serbia to lock in a virtuous cycle of higher investment, savings, productivity and growth, hence improved living standards.
B. RECENT REFORM PROGRESS AND ECONOMICDEVELOPMENTS
The Legacy of the Past
2.6 The 1990s was a lost decade for the Serbian economy. Although the country began the decade relatively well integrated with the world economy, and with a higher standard of living than that in many other transition economies, the Serbian economy was devastated as a result of armed conflicts, international sanctions, and trade shocks stemming from the break up of the Socialist Federal Republic ofYugoslavia (SFRY) during the 1990s. This, coupled with economic mismanagement, resulted in hyperinflation and a virtual collapse of the economy. By January 1994, monthly inflation had climbed to more than 300 million percent and recorded industrial output had declined to less than one-third ofits January 1991 level.
2.7 A stabilization program introduced in January 1994 ended the hyperinflation and laid the foundations for some output growth and financial stability between 1994 and 1998. Prospects improved further with the gradual stabilization ofthe region and the partial removal of economic sanctions from 1995 to 1999. During this period, the economy recorded an average real growth rate of over 6 percent. After being dramatically reduced to only 3.3 percent in 1994, the annual inflation rate displayed an upward trend thereafter, reaching 30 percent in 1998.
2.8 These modest successes were erased in 1999, when the outbreak of the Kosovo conflict led to a further 20 percent contraction in output. As a result, the recorded per capita GDP fell back to below one-half of the 1989 levels, its lowest level of the decade. Inflation rebounded to 50 percent in 1999 and over 100 percent in 2000.
2.9 During the 1990s, foreign trade also declined noticeably, with recorded exports and imports in 2000 being 43.1 and 68.9 percent of 1989 levels, respectively. In addition, the inability of Serbia and Montenegro (SaM) to service its foreign debt (which led to an accumulation of interest and principal arrears plus penalties), combined with the decline in real
5 GDP, led to a sharp increase in domestic and external debt ratios, with the latter reaching 132.6 percent of GDP in 2000. Cash fiscal deficits were contained largely through unsustainable expenditure compression, the accumulation of budgetary arrears, non-servicing of public debt, and tolerance of quasi-fiscal deficits in the form of extensive direct and indirect subsidies provided to households and to “socially relevant’’ enterprises, and directed credit at below market interest rates.*
2.10 Concurrently, the real sector became increasingly inefficient owing to the lack of market-oriented ownership structures, the loss of markets, the lack of access to working capital, delayed investment and maintenance, and repressive and complex taxation and regulation. This resulted in a decrease in real earnings, with absolute poverty roughly doubling compared to 1990. Social protection and health services deteriorated as the available financing fell below the existing entitlement levels. As a consequence of these various adverse developments during the 1990s, Serbia fell behind in the transition to a market economy.
Policy Response and Donor Support during 2001-03
2.1 1 In January 2001, Serbia’s new government launched an ambitious program aimed at a rapid transition to a market economy, the normalization of relations with foreign creditors, and integration with regional, EU and world markets. The government’s economic program rested on three pillars: (i)more prudent macroeconomic policies; (ii)market-oriented structural reforms; and (iii)the mobilization of significant financial and technical support from donors.
2.12 Macroeconomic policies focused on aligning fiscal deficits with available sources of non-inflationary financing and reducing massive quasi-fiscal deficits. The greater availability of non-inflationary fiscal financing (see para. 2.14) actually allowed cash deficits in SaM to increase from 1 percent of GDP in 2000 to 4.5 percent in 2002.9 In 2003 the deficit was scaled back to 4 percent of GDP, as structural reforms began to cut expenditure commitments. Quasi- fiscal deficits (QFDs) have been significantly reduced, partly through more realistic budgeting (which staunched the growth of budgetary arrears) and the regularization of debt service, and partly through reforms to contain hidden losses in key sectors such as energy.
2.13 In parallel, the SaM and Serbian governments began to lay the foundations for a market economy. Very impressive progress in structural reform during 2001 and the first half of 2002 gave way to a period of slower but still broadly sound reform. Progress has been mixed across areas. Notable advances have been made in the following areas: price and foreign exchange liberalization (including early convertibility for current account purposes); opening the country to trade and investment, management of public finances, tax policy, privatization, bank resolution, energy, the labor market, pensions and social assistance. In most areas, however, reforms are still incomplete, and in several areas (e.g., public administration, health, and competition policy) the reform process has hardly begun. loBox 2.1 presents indicators of the level of achieved reforms in key areas, confirming strong progress in some areas (most notably
* For a more extensive discussion of performance during the 199Os, see World Bank (2001a). The figures largely reflect Serbia’s progress, as it comprises the bulk of SaM’s GDP. For a more extensive review of reform performance during 2001-03, see World Bank (2003e).
6 price liberalization), little progress in others (most notably competition policy), and an across the board lagging behind the neighboring countries which had been able to commence transition at an earlier date. ’ ’
2.14 Political change, stabilization, and reform have unlocked a greater inflow of external resources from donors and other sources. Starting in 2001, donor support to SaM, including support for humanitarian purposes, budget/Balance of Payments and project finance, jumped to over US$1 billion per year on a commitment basis. As a result, disbursements of donor support jumped from about US$ 210 million (2.3 percent of GDP) in 2000 to an average of US$ 756 million (5 percent of GDP) over 2001-03.’* Net capital inflows were also supported by three other factors:
0 The rescheduling of external debt (including debt to the Paris Club and the International Bank for Reconstruction and Development (IBRD)) with the granting of grace periods, which kept initial cash outlays for debt service at relatively low leve~s;’~
0 Greater privatization proceeds from sales to both foreign and domestic buyers, which reached over 4 percent ofGDP in 2003;
0 “Remonetization” through the inflow of foreign exchange assets previously held outside the domestic banking system and increased intermediation as evidenced by the sharp increase in foreign currency deposits from EUR 561 million in 2000 to EUR 1.76 billion in 2003.
Key Achievements to Date
2.15 The successful implementation of the economic program resulted in a number of important early achievements. Most notably, Serbia was able to restart stabilization and reforms without lapsing into a new bout oftransitional recession of the kind experienced during the first half ofthe 1990s by the Central and Eastern European countries (CEECs) and the FRY. After growing by 5 percent in 2000 (which primarily reflected a rebound from the destructive impact ofthe Kosovo crisis), SaM’s real GDP continued to grow at an annual average rate of4.2 percent during 2001-03 (Table 2.1). Based on limited and preliminary data, this growth appears
” Throughout this section of the report, Bulgaria, Croatia, Hungary, and Slovak Republic are employed as comparator countries. In light of Serbia’s special circumstances arising mainly from the break-up the SFRY and a decade of delayed reform, such benchmarking meant to illustrate the country’s relative performance and provide some guidance in determining policy priorities, and not as an evaluation of recent reform and policy performance. A large initial grant component has also worked to reduce the future burden imposed by such inflows. l3The Paris Club agreement of November 16, 2001, involved, inter alia, a phased 66 percent reduction in the net present value of commercial obligations and a rescheduling of the remaining stock over 22 years with a 6-year grace period. In July 2004, the Govemment also reached an agreement with the London Club of commercial creditors settling Serbia’s outstanding US$ 2.7 billion debt. The agreement implies a roughly 62 net present reduction in the net present value of such debt, and reschedules the rest over the next twenty years with 3.75 percent interest rate in the first five years and 6.75 percent interest during the remaining fifteen years. This favorable development further supports the authorities’ efforts to reduce the external debt to GDP ratio to a more sustainable level.
7 to have already produced a rise in the average living standard and a fall in absolute poverty from 2000 to 2002.'~
Box 2.1 Serbia's Progress in Key Reform Areas Relative to Selected Countries in the Region
Index of Price Liberalization Index of Forex and Trade Liberalization
51I r __-- BSerba '1 3- =Serbia
2-
i-
0 I I 2600 2001 2002 2003 2000 2001 2002 2003
Small Scale Privatization Large Scale Privatization
5
Cmalia, Hungary. and Slovak Republic --D- Bulgana Hungary and Sbvak Repubic 4 ~ llll_l______0 il ISerbia /--- 3 3-1 *--
2 2-
i 1-
0 0 2dOO 2001 2002 2003
Enterprise Reform Competition Policy
5 =Sema
4
Hungary and Slovak Republic 3 I* ...... v." ...... ,...... y...... \......
Bulgaria and Croatia
2
1
0 2dOO 2d01 2d02 2d03 2dOO 2dOl 2d03
burce: EBRD Transition Report, 2003.
l4See World Bank (2003c), Volume 11, p. 10.
8 2.16 The restoration of macroeconomic stability following a decade of high inflation and rising debt ratios, was also a major achievement Retail price inflation was reduced from 1 11.9 percent in 2000 to 7.8 percent in 2003 (Figure 2.1). Long-term interest rates now lie below short-term rates, indicating some confidence that inflation will continue to be low (Figure 2.2). Following the liberalization of the foreign exchange market and the unification of the exchange rate in December 2000, Serbia has also achieved broad exchange rate stability. The dinar remained close to 30 dinar to the Deutsche Mark (and later 60 dinar to the euro) during 2001 and 2002, before depreciating (appreciating) against the euro (US$) by 11.1 percent (7.4 percent) during 2003.
GDP Growth (constant prices) Share in GDP 2000 2001 2002 2003 2000 2001 2002 2003 Real GDP growth 5.0 5.5 4.0 3.0 100 100 100 100
Domestic Demand 6.3 12.1 10.1 4.8 116.9 120.9 123.1 122.7 Consumption 5.3 12.4 7.5 5.1 102.7 107.2 107.0 107.0 Investment 17.0 9.2 34.4 3.2 14.2 13.6 16.1 15.7 Exports 34.8 8.6 12.3 1.8 29.6 23.7 20.7 19.2 Imports 28.6 30.0 26.3 7.2 46.5 44.6 43.8 41.8
2.17 Concurrently, Serbia’s external debt burden declined significantly from 133 percent of GDP in 2000 to 69 percent in 2003. As most such debt is government-related, Serbia’s public debt burden declined in tandem from 119 percent of GDP in 2000 to 79 percent ofGDP in 2003 (Figure 2.3).I5>I6 Official foreign exchange reserves increased substantially from US$5 16 million at end-2000 (1.2 months of imports of goods and services) to US3.55 billion (4.4 months of imports) at end-2003 (Figure 2.4). Even discounting the impact of the previously noted agreement with the Paris Club, such reductions of debt/GDP were major achievements, as they took place during a period in which pervasive quasi-fiscal problems were being brought under control and recognized, and when Serbia gained access to new credits from official sources.
2.18 The combination of improved macroeconomic stability and bold reforms to resolve loss-making banks also led to a significant increase in bank deposits and large capital inflows-mainly in the form of foreign exchange deposits. The increased funding (deposits) allowed banks to increase loans to enterprises and households as a share of total assets from 24 percent in 2001 and 42 percent in 2002 to 46 percent in 2003.17
l5 The observed rise in recorded public debt in 2001 was due to the acknowledgment of liabilities arising mainly from frozen foreign currency deposits and old debt to pensioners. I6 The sharp increase in dollar GDP, which is mainly driven by real appreciation from the highly depreciated level of late 2000, also played an important role in reducing the debt to GDP ratio. Focusing on the evolution of loans alone in lieu ofthe share of loans in banks’ total assets would be misleading owing to bank closures (the total number of banks declined from 83 in 2001to 48 in 2003).
9 Figure 2.1 Evolution of the Inflation and Figure 2.2 Term Structure of Deposit Exchange Rates, 2000-03 Rates 5001?n 400 50 A-
40 I
200
100
3-month Gmonth 12-month upto3.year
2d00 2001 2d02 2003
Figure 2.3 Public Debt, 2000-03 (% of GDP) Figure 2.4 Gross Official Reserves: 2000-03
130
120 -1
110
100
90
80
70
00
50
40 I I 2000 2001 2d02 2003 2000 2d0 1 2002 2003
a: In months of imports of GS of the following year
Key Impediments to Sustainable Growth
2.19 Despite the above achievements, much more remains to be done. As shown in Box 2.1 cumulative progress in key areas ofreform remains below the levels of the most successful CEECs. Despite four years ofgrowth, living standards remain low relative to historical standards and popular expectations, and growth has yet to generate a visible employment response. The still very high share of transactions and bank loans/deposits which are denominated in foreign currency indicates less than full confidence in the long-term stability ofthe national currency. In addition, Serbia's recent macroeconomic performance remains characterized by several inter- related weaknesses.
2.20 First, a temporary increase in net external and fiscal financing allowed Serbia to pursue a type of domestic demand-led growth that cannot be sustained once such financing returns to more normal levels. During 2001-03, the recorded growth of domestic demand (8.8
10 percent per year, period average) outstripped that of GDP (4.2 percent period average). During the same period, total and private consumption recorded average growth rates of 8.2 and 8.6 percent, respectively, while investment grew by 15.6 percent per year. The rapid growth of private consumption also appears to be linked to a rise in remittances, which rose from 6.5 percent of GDP in 1999 and 9.9 percent in 2000 to over 11 percent in 2003 (Box 2.2). Consumption growth was also heled by increased budgetary outlays on wages and social transfers (see below) and by economy-wide wage increases in excess ofproductivity growth. The rapid growth of real wages may have contributed to the jobless nature ofrecovery, as it worked to suppress labor demand (see Chapter 5 for details). By cutting enterprise profitability, rapid real wage growth also reduced the resources available to enterprises to hnd new investments from retained earnings; and by raising relative unit labor costs, undermined competitiveness, contributing to unfavorable current account developments.
2.21 While large and growing capital inflows and remittances helped to cushion the initial effects of transition and to jump start investments, they also fueled a high and risin current account deficit. The combined effect of low and slowly growing exports (Figure 2.5) 15 and rapidly growing imports of goods and services (which grew by an average of 28.7 percent per year in US dollar terms during 2001-03) was an increase in SaM’s current account deficit (excluding official grants) from US$610 million (7.1 percent of GDP) in 2000 to a projected US$2.6 billion (12.6 percent of GDP) in 2003. As is elaborated in the report (see Chapter 4), structural factors such as the mixed performance in privatization, restructuring, and improving the business climate, have contributed to the observed weak supply response and hence the sluggish export growth. Against the backdrop of large capital inflows and remittances, the potential adverse impact of an appreciation of the real exchange rate on the export performance cannot be ruled out. This trend of the real exchange rate-particularly in the presence of recent wage developments and the recent mix of tight monetary policy and still substantial budget deficits--could have been an additional contributing factor to the unsatisfactory export performance and supply response.” The noted developments could, in turn, explain a clear increase in protectionist sentiment and some attempts to stimulate activity through distortive tax incentives-a policy shift which may offer short-term ”solutions” at the expense of longer-term growth potential.
2.22 The structure of SaM’s current account deficit reveals two additional sources of vulnerability. First, the source of this imbalance in a large and persistent deficit in the resource balance (net exports of goods and non-factor services) may signal structural competitiveness problems. Second, as shown in Figure 2.6, Serbia’s large current account deficit primarily reflects a very low level ofsavings. Current account deficits are usually more ofa concern if they stem from low savings as opposed to high investments. This underscores the need to achieve a reduction in current account deficits through fiscal and structural reforms that lead to an increase in national savings rates.
“Figure 2.5 shows the share of exports of goods and services in GDP in SaM and six European countries with a similar population (ca. 8-10 million). Three are economies in transition and three are EU-15 members. In 2003, SaM’s export ratio was only 24-46 percent of the level in comparator countries. As exports in 2000 were also less than 43 percent of 1989 levels, they are clearly well below potential levels. Set against this significant catch up potential, export growth has been sluggish (see Chapter 3 for more). l9The National Bank of Serbia has pursed a more flexible exchange rate policy since at the beginning of2003 as compared to the previous two years.
11 Box 2.2 Economic Implications of Workers’ Remittances
In 2003, workers’ remittances to Serbia and Montenegro reached over 11 percent of GDP, corresponding to a 58.6 percent export of goods and services. Both ratios are among the highest in the region. As a source of foreign currency to finance imports, remittances perform a function similar to private and public capital flows. By increasing national income and savings, they allow an economy to spend more than it produces, to import more than it exports, or to invest more than it saves. If the resulting increase in demand falls on tradable goods, the import bill rises. If it falls on non-tradable goods, the relative prices of such goods increase. As a consequence, a sustained high level of remittances can shift resources away from the tradable sector and into the non-tradable sector, leading to a “Dutch disease” effect. This, in tum, can worsen the economy’s balance on goods and services by reducing export competitiveness and fueling import demand.
Remittances can both positively and negatively affect growth prospects. They can be an important source of investment financing, especially for small entrepreneurs. However, the conditions that initially promoted the migration which led to remittances may also discourage investment. Remittances might also create dependence among recipients accustomed to the availability of these funds-similar to foreign aid supporting inefficient governments-thereby leading to an economic dependence that undermines the prospects for development (Boone 1995). The effects of remittances will therefore depend strongly on the govemment’s policy to promote an economic environment conducive to investment in productive activities (Glytsos 1997).
Different studies lend support to competing arguments about the impact of remittances. However, a particularly comprehensive recent study by Rapport and Docquier (2003) finds that, on balance, migration and remittances produce an overall positive economic impact in the short run (income effects and effects on the balance of payments) as well as in the long run (alleviation of liquidity constraints for households at the middle-to-bottom of the income distribution, increased investments in the urban and rural sectors).
Workers’ Remittances (YOof GDP) Workers’ Remittances (% of exports of G&S)
I 60
50
40
30
20
10
0 2d00 2dOl 2d02 2d03 2dOO 2d01 2d02 2003
12 Figure 2.5 Exports of Goods and Services, Figure 2.6 Ratio of Investment to Current 2003, percent of GDP Account Deficit, 2000-03
90
80
70
BO 50 * * 40 d z 0 0 30
20
10
0 I 2m 2do1 2&3
2.23 The recent domestic demand-led growth and the resulting high current account and fiscal deficits are not sustainable, given the likely reduction in net capital inflows. Serbia needs to reduce its reliance on extemal and domestic fiscal financing on three grounds:
0 New foreign financing is likely to fall. Gross inflows ofdonor aid are likely to decline and increasingly take the form of loans rather than grants. With many attractive enterprises already sold (enterprises in the telecommunications sector being the main exception), privatization proceeds could also decline. “Remonetization” is also not a sustainable major source of extemal financing. FDI as a share of GDP is already near regional averages, although some small increase cannot be ruled out under a very strong reform scenario. Poor creditworthiness will limit Serbia’s access to commercial borrowing.
0 There will be little scope for net domestic financing ofbudget deficits since a growth- oriented policy requires the government not to crowd out the private sector, and since public debt is already very high (see below).
0 As the illustrative projections in Table 2.2 demonstrate, rising payments to service SaM’s foreign and public debt will work to increase capital outflows and raise fiscal financing requirements. Important factors include the expiration of grace periods and the need to begin servicing new borrowing.
Table 2.2: Projection of External Debt Service (in USD millions) 2002 2003 2004 2005 2006 2007 2008 2009 2010 183 436 1,014 1,228 1,217 1,662 2,060 2,241 2,215 Source: IMF Staff Report (July 2004)
13 2.24 The second weakness lies in the fact Figure 2.7 Public Debt in Serbia and in that, despite significant declines since 2000, Selected Countries in the Region, 2001-03 Serbia’s ratios of external and public debt to
GDP remain high when compared to those of 0 Serbia Hungary Bulgana --+-- Slovak Republic selected countries in the region (Figure 2.7). --+- Croatia At end-2003, external debt and total public debt stood at 69 and 79 percent of GDP, 1 respectively, which is still too high for comfort. Serbia’s relatively low level of exports leaves its ratio of debt to exports at a higher level than in other countries of the region.
2.25 The third weakness is that a large and 2001 2002 2003 inefficient public sector remains a serious
(measured by consolidated public spending as a share of GDP, 1998- 2002 average) against the level of income (measured by the logarithm of per capita GDP in PPP at 1995 prices) for the 15 EU members, and countries in the +I
Europe and Central Asia and the ~=76852x+55913 R‘=O 1035 Middle East and North Africa 15 Regions of the World Bank. The 10 fitted regression line captures a 5 1 I clear positive relationship between 23 28 33 18 43 18 size of government and a country’s
2.26 Furthermore, Serbia’s public spending as a share of its GDP increased rather than decreased from 2000 to 2003. Consolidated public expenditures grew steadily from 36.5 percent in 2000 to around 47 percent in 2003. This trend partly reflected positive changes such as the better alignment of cash outlays with commitments, and the bringing on budget of some quasi-fiscal activities. For example, an increase in pension payments or interest costs which reflects a move from non-payment to timely payment of pension or debt obligations is clearly
14 preferable to the continued accumulation of arrears. Similarly, the partial compensation of a cut in the hidden fiscal obligations created by loss-making utilities with targeted subsidies and transfers represents a net fiscal adjustment and increase in transparency. Such factors also mean that the growth in public expenditures will have been much less on a commitment basis than on a cash basis. A part of the increase also reflects needed transition-related expenditures and higher public investments.
2.27 However, a part of the growth of public expenditures also came from areas where Serbia's spending is high by regional standards, namely, the wage bill, subsidies and transfers. As is discussed later in this chapter in greater detail, these components have grown from already high levels, while the level of public investments has been inadequate. Such trends-particularly in the presence of the high public debt-hamper the establishment of an environment conducive to growth and need to be reversed in a sustainable fashion. The revised government budget for 2004 and the proposed budget for 2005 include encouraging first steps in this direction.
2.28 Finally, despite the availability of 'igure 2.9 Investment (YOof GDP) much foreign financing, the level of -"~ Serbia investments in the Serbian economy remains --&-- Bulgaria (average, 20002003) ---D- Cmaba (average, 2000-2003) insufficient to support rapid sustained ---t Hungary (average, 2000-2003) growth. Following a decade of li.oi Slovak Republic (average. 2000-2003) underinvestment, investment/GDP grew 30 - 0 .______* * + slightly from 14.2 percent in 2000 to a * * projected 15.7 percent in 2003. However, the -- 1 20- ,, 3 latter level remains extremely low by regional standards (Figure 2.9), underscoring the great potential for expansion under the appropriate policy framework.20 A failure to achieve such expansion would be likely to impair growth 2600 2obl 2602 2603 prospects. As noted above, low investment rates reflect very low savings rates. During the same period, recorded gross national savings actually declined from 10.3 percent of GDP in 2000 to an estimated 5.5 percent in 2003.2' Serbia will have to achieve a major increase in domestic savings to support a further increase in the investment rate while at the same time reducing current account deficits.
c. MAINMACROECONOMIC POLICY PRIORITIES FOR GROWTH
2.29 The discussion above of the remaining problems shows that Serbia's ability to achieve more rapid and sustained growth while increasing (formal) employment will depend on its ability to meet two difficult and inter-related macroeconomic and structural policy challenges namely:
This is the lowest level in the non-CIS non-Turkey part of the Europe and Central Asia region, where investment is projected to average 24 percent of GDP in 2003. The values for the remaining countries in that group range from 19.5 percent in Bosnia and Herzegovina to 31.3 percent in the Slovak Republic. The average in the CIS is also projected at 22 percent of GDP, with only Uzbekistan being below SaM levels. *' As the gradual regularization of extemal debt reduced the role of debt service arrears as a source of balance of payments financing (the share of debt in arrears was reduced from 90 percent at end-2000 to 40 percent at end-2002), the decrease in savings on a commitment basis would have been less than reported on a cash basis.
15 0 Reducing high fiscal and current account deficits to maintain macroeconomic stability in the face of a likely decline in non-inflationary sources of fiscal and external financing, and to achieve sustained further reductions in public and external debt as a share ofGDP; and
0 Reducing the negative growth impact of a large and inefficient public sector by cutting public expenditures as a share of GDP, while improving the efficiency of public resource use.
2.30 Combining the successful implementation of these polices with key structural reforms that foster growth and investment and harden financial discipline throughout the economy will also promote savings, thereby enabling Serbia to lock in a virtuous circle of falling current account deficits, higher and more productive investment, higher growth and improved macroeconomic stability (Box 2.3).22
Box 2.3 Structural Reforms, Savings, and the Current Account Deficit
The current account deficit (CAD) is the difference between a country’s gross investment (I)and gross national savings (S) and can be written as: CAD = I- S Thus, if Serbia wishes to increase the rate of investment while reducing the current account deficit, it will need to achieve a significant and sustained increase in the savings rate.
An economy’s total savings can be divided into savings by the public sector and savings by the rest ofthe economy (comprising enterprises and households). In Serbia, both sectors will need to contribute. Government savings are the difference between total revenues and total current spending, including interest and transfers. As will be argued below, with public revenues already representing a high share of its GDP, the required increase in public savings will need to come from a deep but well-planned reduction in the share ofcurrent public spending in GDP.
Private savings are the difference between the income and current outlays ofthe enterprise and household sectors. In Serbia, private savings will be driven by three main determinants: (i)the value added by the private sector (which is in turn closely linked to the average level ofenterprise profitability); (ii)private consumption; and (iii)net transfers from abroad (of which remittances represent the largest single component). Thus, a strong increase in enterprise savings will require reforms to raise the average profitability of Serbian enterprises, particularly through reforms which tackle large loss-makers. As noted in the next chapter of the report, these include privatization, enterprise restructuring , the creation of a business friendly environment, and pressing ahead with the banking sector reform, which would, inter alia, improve confidence in the financial system. Enhancing household savings will require policies to moderate the growth of private consumption and ensure a steady flow ofremittances.
2.31 One part of the government’s response to meeting these challenges will work indirectly through policies which affect the non-budget sector. Such polices, which are the subject ofthe remaining chapters ofthis report, and are only briefly noted here, will include:
0 Enhancing the economy’s export orientation and increasing the level ofcompetition from imports (see next chapter).
’‘ There is no consensus on the precise mechanisms through which growth is affected and on the direction of causality among growth, investment, and savings. There is, however, a general agreement that savings and investment are mutually reinforcing, and the policies that promote growth and investment will also promote savings.
16 0 Increasing enterprise and household savings, first through tackling loss making in the enterprise sector, imposing strong enterprise financial discipline, implementing labor market reforms to better align wage and productivity and implementing banking sector reform (see Chapters 4 and 5).
0 Improving the overall investment climate, which would include providing well fhctioning labor, land and capital markets (to encourage reallocation of factors to more productive uses), strengthening incentives for more efficient resource use, improving human capital, etc.
2.32 In parallel, the public sector will directly contribute to promoting growth while containing macroeconomic imbalances through reforms in public finance and administration. Two key elements ofthis agenda, which is the subject ofthe rest ofthis section, are the following:
0 High quality fiscal adj~stment.~~Increasing public investment while containing fiscal balances will require an increase in public savings. As revenues are already high as a share of GDP and interest costs are given, this will require a sustained containment of non-interest current spending as a share of GDP. As noted above, recent trends in the level and composition of Serbia’s public spending have been in exactly the opposite direction.
0 Further tax reform. While the bulk of adjustment must come from the expenditure side of the budget, and containment of fiscal deficits is a priority, some further supportive tax policy measures and improvements in tax enforcement can enhance growth potential by supporting increased savings and efficiency.
High quality fiscal adjustment
2.33 The way in which Serbia achieves the needed reductions in fiscal deficits, current public expenditures and public debt in relation to GDP will affect its ability to attain sustainable growth. International experience suggests that fiscal adjustments based on durable expenditure cuts-in particular, reductions in subsidies and transfers along with the government wage bill-tend to be more permanent and even expansi0na1-y.~~ On the other hand, fiscal adjustments that rely on tax increases .or unsustainable cuts in public investment or non-wage current expenditures tend to be short-lived and contractionary (Easterly, 1999). By adversely influencing expectations about the future stance of fiscal policy, policy measures that are not sustainable would erode and even preclude the potential benefits of fiscal consolidation, such as lower risk premiums and higher private investment.
23 This would increase labor demand, protect the retained earnings which are a major source of investment finance, and help to shift bank credits from consumption to investment. 24 This refers to a type of adjustment in which fiscal savings are generated in a well-planned and sustainable manner backed by reforms which address the structural source of expenditure commitments, as opposed to ad hoc cuts of cash outlays to below levels that can be sustained in the medium term. 25 See, for example, Alesina and Perotti (1 995).
17 2.34 In light of the noted evidence and the present structure of public spending in Serbia, a durable reduction in public expenditures would need to tackle the underlying structural sources of high spending, with a focus on the following areas: wage policy in the public sector, the health sector, public pensions, and subsidies. These issues are explored in greater detail in World Bank (2003d). While that report does not include the most recent developments, its main findings and recommendations remain valid, especially those concerning the needed shifts in the level and composition of public spending. The following paragraphs update and summarize Serbia’s performance in key areas ofpublic expenditure.
2.35 Wage expenditures of the Union and republican governments combined are too high. At over 10.2 percent of Serbia’s GDP in 2003, they account for over 20 percent of total spending (see Table 2.3). Furthermore, as shown in Figure 2.10, this ratio has been growing rather than declining since 2001, a trend that was envisaged to continue in the initial 2004 budget. This dangerous trend needs to be tackled through reforms ofthe systems and policies for determining employment and wage levels in the public administration (see the discussion below),26 accompanied by deep reforms of the main sectors of public employment (including health, education and intemal security). As core wages are low, high spending primarily reflects the large number ofpublic employees.
2.36 Budget subsidies and net lending are also significant at around 4.4 percent of GDP in 2003. While the average level of subsidies in the Serbian budget is not very different from the regional averages, the latter have been displaying a downward trend, while in Serbia subsidies to enterprises are on the rise (Figure 2.11). They are concentrated on a limited number oflarge loss- making enterprises, most notably the state railways. Until 2001, most subsidies were not on budget. Although the rise of allocations for subsidies in 2001-02 could reflect a shift from off- budget to budgetary channels, which improves transparency and accountability, the current level of budgetary subsidies still appears excessive. Similarly, the observed rise in the net lending from 0.1 percent of GDP in 2002 to 0.7 percent in 2003 calls for the containment of on-lending to enterprises as an activity which is outside ofthe core functions ofthe state.
Figure 2.10 Wage Bill,a2000-04 Figure 2.1 1 Subsidies and Transfers,a 2000-04
-- I 24- 10-
20-
18-
2200 2obl 2d02 20b3 2Ob4 2000 20bl 2602 2003 20b4
a: As YOof Serbian GDP.
26 Serbia’s current public employment mechanisms assure overall control over costs, but they entrench current employment allocations and limit the govemment’s ability to re-direct personnel to priority areas.
18 2.37 Serbia’s level of social transfers as a share of GDP is high at around 21 percent of Serbia’s GDP in 2003 and is close to that of much wealthier countries, which raises affordability concerns. The two most important ofthese programs are pensions and health care. The actual level of social transfers displays high volatility, suggesting serious sustainability problems.27
2.38 Capital spending, on the other hand, is noticeably low at 2.3 of GDP in 2003. This item has also been volatile, suggesting its use as an in-year balancing item. Given the low level ofpublic investment (Table 2.3), there is strong rationale for increasing government investment in infrastructure since this type of activity is likely to enhance the productivity of the private sector.
Table 2.3 Composition of Expenditures: Serbia versus Selected Countriesa Serbia Bulgaria Croatia Hungary Slovak Republic Total expenditures and net lending 47.1 40.5 51.5 47.6 41.7 Current expenditures 44.3 38.1 44.7 45.5 37.6 Goods and services 18.2 15.3 24.9 15.6 13.4 Wages and salaries 10.2 4.9 11.8 7.8 7.6 Interest payments 1.o 9.3 1.5 8.5 4.4 Subsidies 3.7 2.8 2.4 4.2 2.8 Transfers 20.8 10.6 15.9 17.1 14.1 Capital expenditures 2.3 3.3 6.5 5.6 4.7 a: Averages for 1995-2002, except Serbia for which preliminary figures for 2003 as a percentage of Serbia’s GDP are presented. Source: World Bank and IMF staff reports, GFS-2001.
2.39 The establishment of an effective system of public administration will be crucial for attaining the noted high quality fiscal adjustment. An effective and efficient system ofpublic administration is needed to prepare government policies that would promote competitiveness and economic growth. To create an efficient and affordable administration, public sector employment conditions need to be overhauled to attract and retain qualified staff. At the same time, the size of public sector employment needs to more sustainable levels. Designing a reform agenda that would help achieve both objectives constitutes a serious challenge, made even more difficult by the currently fragmented administrative structure and the complex coalition politics in Serbia. The development and implementation of a broadly agreed strategic framework for reform, facilitated by an effective reform management system, therefore emerge as important policy priorities for achieving further progress in economic reforms (Box 2.4).
27 Greater detail is found in World Bank (2003d), Volume Two, Chapter 4 and in World Bank (2003~).
19 Box 2.4 Key Aspects of Public Administration Reform
Progress in institutional reform in Serbia has remained limited in spite of the significant donor support provided over the last three years. This in turn poses an increasingly serious threat to the successful implementation of reforms in other areas. The current Serbian public administration system still displays many of the features of the pre-transition period. The civil service remains weak, politicized and demoralized, while the organization and management of the public administration system continues to be fragmented, over-expanded and ill-adapted to the requirements of a market economy. It still operates largely on the basis of legislation adopted in the 1970s, which was created for a state administration in an entirely different economic system. Salary systems are highly compressed, with a ratio between the lowest and the highest pay that is as low as 1:4, while recruitment and promotion decisions related to senior positions are mainly based on political affiliation. Civil servants therefore lack performance incentives and, especially at the highest level, tend to operate on principles of political loyalty rather than in the public interest.
Organizational structures and management systems have remained largely unreformed, as previous attempts to bring about institutional reforms have in most instances failed. The failure of organizational reform also negatively affected the planned rationalization efforts in the administration. As a result, the status quo in staffing levels was largely maintained, as evidenced by the high level of the wage bill in relation to GDP. Strong trade union resistance to staff reductions has further stalled the rationalization efforts.
Serbia’s new govemment attaches a high priority to institutional reform and has initiated a comprehensive reform process. This includes an ambitious legislative reform agenda and the overhaul of the civil service and the broader public sector pay system, to be integrated in an overall strategic framework for public sector reform. Reform management structures have been streamlined, providing a better basis for effective reform design and implementation, though problems remain in staffing levels and in recruiting staff with appropriate skills and competencies.
Successful implementation of this reform agenda hinges on addressing three short-term priorities. The adoption and implementation of a clear administrative reform strategy and action plan that enjoys a broad political consensus is a first key condition for effective reform. Without a broadly supported strategy and a detailed, coasted action plan, it is unlikely that any significant achievements in PAR can be made. To this end, the Ministry of Public Administration and Local-Self Govemment (MPALSG) has prepared a Strategy covering the reform of the central state administration and reforms in the system of local self-govemment along with an Action Plan, which were adopted by the Govemment in November 2004. Addressing deep-seated reforms in the public sector will entail a sustained policy effort over a period of four to five years. Furthermore, gaining the support of the powerful public sector trade Unions is crucial if implementation is to be successful, which adds furthei complications to the process. Therefore, maintaining the current momentum is possible only under strong and consistent political leadership.
The establishment of a reform management structure with clearly assigned responsibilities and accountability is an importan1 second priority for successful administrative reform in Serbia. It would therefore be very important for the new government tc create a strong PAR management structure, with a clear assignment of responsibilities and a well-staffed secretariat. The creatior in June 2004 of a cabinet-level Public Administration Reform Council, chaired by the Prime Minister, constitutes an importan first step. The noted Council would need to be adequately staffed and to coordinate closely with the Govemment Secretariat witk the objective of ensuring that PAR measures are effectively implemented according to set deadlines.
The sequencing of reforms is a crucial third priority for carrying out the PAR agenda in an effective manner. Organizationa reform and the rationalization of public sector employment need to proceed, or at least run parallel with, improvements in thr civil service system, so that reforms will be fiscally affordable. This means that the govemment in its reform package, shoulc prioritize legislation on the institutional structure and organization of the administration, in order to provide a basis fo: rationalization efforts. Improvements in the employment and incentive system can be phased in as rationalization frees up fisca resources. The development of a clearly sequenced Action Plan for reform is therefore a crucial element of the process. The completion of the recent review of the Civil Service Wage System based on which the Ministry of Finance and MPALSG issued a joint policy statement (endorsed by the PAR Council) outlining the direction of reforms in key policy areas represents an important step towards achieving this objective.
The implementation of the noted policy measures in a timely manner is a key condition for the development of an institutional system that can help sustain levels of economic growth while providing an enabling environment for private sector development.28
** These short-term policy actions need to be viewed as the starting point of the reform process and will have to be supported by addressing the following medium-term policy priorities for deepening the reform process: (i)organizational reform in the state
20 2.40 A sustained reduction in fiscal deficits through the policies described above would also improve the macroeconomic policy mix. This would provide more flexibility to the monetary authority to support external and internal policy objectives, including the avoidance of excessive future real exchange rate appreciation which could damage Serbia’s external competitiveness. More specifically, different combinations of monetary and fiscal policies can yield the same level ofaggregate demand, while resulting in different outcomes for the exchange rate, real interest rates, the composition ofoutput, and the current account balance. In the current Serbian context, a combination of tighter fiscal and looser monetary policy would imply a less appreciated real exchange rate, lower interest rates, a higher share ofinvestment (and, in general, of interest-sensitive components of spending) in GDP, and a higher level of net exports. This would help Serbia reduce its current account deficit while sustaining prospects for GDP and export growth.
Tax reform
2.41 Unlike in many countries facing fiscal challenges, poor revenue collection has not contributed to the fiscal deficit in Serbia. Serbia has actually done quite well-total revenues as a share of GDP rose from 36.3 percent in 2000 to 42.8 percent in 2003. The tax take was sustained during the implementation ofa bold and appropriate tax reform in 2001, and during the fiscally risky but important reform of the centralized payments system (ZOP), which had a central role in tax collection (similar reforms in other former Yugoslav countries did bring an initial erosion ofbudgetary revenues).
2.42 As the Serbian tax system raises considerable amounts of revenue, the appropriate agenda for tax policy is to put in place a growth-promoting tax system while safeguarding and deepening the improvements already made. A growth-promoting tax system is one that least distorts work effort and investment as well as savings, and which minimizes demands on administrative resources. Policy efforts aimed at attaining these objectives will in turn entail: (i) sustaining revenues until permanent expenditure adjustment is achieved; (ii)further broadening and harmonizing tax bases with minimal exemptions; (iii)shifting from income towards consumption taxation in a careful manner; and (iv) improving administration and even-handed enforcement.
2.43 Durable reductions in expenditures and public debt as a share of GDP should precede any reduction in public revenues as a share of GDP. With high public debt, large fiscal deficits, and declining sources ofnet non-inflationary fiscal financing (as discussed above), Serbia must achieve a phased reduction in fiscal deficits. The Serbian government has no scope to “stimulate” economic activity through fiscal deficits, and should avoid tax reforms that carry high risks ofrevenue loss. Any further tax reform should be broadly revenue-neutral. Only after the structural reforms to address the underlying causes of high public expenditures are successfully implemented and the public debt is on a clear path to a more prudent level, should the government allow a reduction in tax revenues as a share ofGDP.
administration; (ii)de-politicization of the administration; (iii)design and implementation of new Civil Service Legislation and Civil Service Management mechanisms; and (iv) implementation ofwage reforms.
21 2.44 Given the need to maintain revenue collection, a further broadening and harmonization of tax bases will be a prerequisite for any possible future reductions in overall tax rates. As a general rule, broad-based taxes at lower rates are preferable to high rates caused by the granting of numerous tax exemptions.*’ Lower tax rates also encourage the formalization of economic activity. The removal of exemptions would create a more level playing field for different economic actors, thereby encouraging the allocation of resources to their most productive uses. Simpler taxes with fewer exemptions and more harmonized bases are also easier and less costly to administer and enforce (particularly when the capacity of the tax administration is still being established, as in Serbia), thereby allowing the same revenue to be collected at lower rates. They also reduce the costs for firms and individuals in complying with tax regulations. If carefully designed, such changes can also improve equity by removing any hidden regressive elements in the tax system.
2.45 Serbia’s 2001 tax reform was a classic and very positive application of these principles. The tax system was simplified, which, among other features, involved reducing the number oftaxes from 230 to 6 main taxes. The expansion ofthe base ofthe payroll tax for social security contributions allowed significant (probably excessive) reductions in payroll tax rates. However, later tax reforms in 2003 introduced numerous exemptions which moved in exactly the opposite direction, thereby eroding the base and adding ~omplexity.~’Tax incentives for large and/or foreign investors represent implicit discrimination against the SME sector and domestic investors. The Serbian government should pursue further options for base broadening, including the careful review of some of the changes introduced in 2003. Harmonization of the bases of social contributions and the wage component ofthe personal income tax is also important.
2.46 A carefully formulated further shift from (direct) taxation of income to (indirect) taxation of consumption could improve Serbia’s growth prospects. Such a shift from income to consumption taxation can be justified on the grounds of simplicity and efficiency. The main argument for simplicity is that income is difficult to measure accurately, while the measurement of consumption is relatively easy. The major case for efficiency is that a consumption tax abolishes the tax on savings.31 Any such shift will need to make compensating adjustments in the revenue sources ofthose state institutions which currently depend on direct taxes, such as the pension and health insurance funds.
29 Evidence suggests that tax incentives are not the most significant factor affecting investment decisions of both domestic and foreign entrepreneurs. The business climate, basic infrastructure, economic and political stability play a more important role in influencing investment decisions. Although the benefits of tax incentives are uncertain, the costs associated with their implementation tend to be significant. More specifically, tax benefits are likely to: (i)reduce fiscal revenues and promote illicit behavior; (ii)undermine resource allocation and attract investors focusing on short-term profits; (iii)trigger a bidding war among neighboring countries; and (iv) impose a large administrative burden. 30 The policy of tax incentives in the Republic of Serbia was revised two times between 2001 and 2003 (mid-2001 and early 2003). The most recent changes in the policy of tax incentives included; (i)a ten year tax holiday for investment into fixed assets over 600 million dinars, if it is accompanied with additional employment of at least 100 workers; (ii)five year tax holiday for investment exceeding 6 million dinars into fixed assets, which involves additional employment of at least five new workers in selected regions; (iii) reduction of the enterprise profits tax rate from 20% to 14%; (iv) doubling the investment tax credit; and (v) enlargement of the tax credit for newly employed workers from 40% to 100% of the labor costs. 3’ There are two caveats. First, there is a common perception that a consumption tax would be more regressive than an income tax-an argument that follows from the fact that the savings rate relative to income increases with income. Second, a consumption tax can be a complex tax to administer if it has a multiple rate structure and numerous exemptions.
22 2.47 An efficient tax administration that encourages voluntary compliance and effectively monitors tax payments is one of the most important components of a growth- promoting tax system. Although this report does not address issues of tax administration in detail, the effective implementation of tax policy will have a favorable impact on the formalization of the economy through lowering late payment or non-payment and discouraging evasion as well as fraud by means ofadequate program audits and an appropriate penalty system. Effective pursuit of unpaid taxes is also important for eliminating the hidden subsidization of loss-making enterprises, thereby encouraging them to release factors of production to more efficient uses elsewhere in the economy.
D. MEDIUM-TERMOUTLOOK: AN OVERVIEWOF Two ILLUSTRATIVESCENARIOS
2.48 The package of stabilization and structural reform measures described above would help place Serbia on a significantly more rapid and sustainable growth path. This section aims to demonstrate the net effect of the proposed policy shifts by comparing two of many possible macroeconomic scenarios.32 Actual outcomes could fall within or even outside this range; the scenarios are primarily designed to show the impact of different broad reform strategies. The first scenario, which aims to illustrate the trajectory ofthe Serbian economy under strong policy efforts, includes the following key underlying elements: (i)a high quality fiscal adjustment of the kind described above, which would enhance macroeconomic stability and boost confidence in the policy framework, thereby stimulating private investment; (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.
2.49 The second scenario aims at demonstrating the implications of unsatisfactory progress with the implementation of structural reforms in 2004 and onwards. Under this scenario, the government attempts to maintain both the current fiscal policy (through keeping the level and structure ofspending relatively constant) and monetary policy stances.
2.50 The results show a very different evolution of the economy under the two illustrative scenarios, with Serbia reaching much higher growth rates under the first scenario reflecting strong adjustment and reform. Average real GDP growth is projected to reach over 5 percent per year between 2005 and 2010, which is consistent with the country’s potential growth rate (see Box 2.5 and Figure 2.12). This strong growth performance 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. Such an environment would lead to the higher level of investments as a share of GDP which would sustain high growth rates (Figure 2.13). By contrast, average growth under the second scenario would be around 2.5 percent during the same period as a result of the unsatisfactory implementation of structural reforms and the failure to attain a high quality fiscal adjustment- all ofwhich would also be associated with a disappointing total factor productivity performance.
32 The exercise carried out in this section is for Serbia and Montenegro (SaM), based on data available in June 2004. Serbia accounts for about 93 percent of SaM’s economy. As this exercise is illustrative rather than predictive, it will remain robust to subsequent changes in data for 2004.
23 2.5 1 Moreover, under the second scenario, total public expenditures would remain high averaging 46.8 percent of GDP between 2005 and 2010 (Table 2.4). As can be seen from Table 2.3, the key conditions for high quality fiscal adjustment would not be satisfied under this scenario, as is evidenced by the evolution of the current expenditures (the wage bill as well as subsidies and transfers). Consequently, a mixture of poor fiscal performance, low growth, and high interest rates would lead to an unsustainable path for public debt, which would reach over 73 percent of GDP by 2010 (Figure 2.14). As a result of limited program credibility and the unfavorable debt sustainability outlook, interest rates would remain high and private investments would be crowded out. This would erode the country’s creditworthiness and leave the economy highly exposed to adverse shocks, thereby rendering the economy more prone to a financial crisis. Clearly, such a policy environment would not be conducive to pursuing Serbia’s social agenda.
I Box 2.5 On the Potential Growth Rate of the Serbian Economy Can Serbia attain the average growth rate of over 5 percent envisioned in the credible adjustment scenario? The standard growth accounting framework can shed some light on this question. More specifically, this framework employs the following identity: dYN=adWK+PdL/L+dA/A, where the production function takes the form of Y=AKaLP , and a and p are the elasticity of output with respect to the growth of capital (K) and labor (L). In practice, WA(the rate of growth of total factor productivity, TFP) is calculated as a residual, while a and p are approximated by the profit and labor shares in national income. A recent review ofthe growth prospects ofthe CEEC-5 (Poland, the Czech Republic, the Slovak Republic, Hungary, and Slovenia) suggests that TFP rather than growth of factor inputs is expected to be the main driving force behind the output growth in these countries.33Acceleration of structural reform and institutional strengthening efforts that would bring the country closer to well-performing countries in the region (see Box 2.1) is likely to enhance the country’s productivity. Reforms discussed in this and other chapters can also increase investments as a share of GDP. In addition, although demographic trends suggest that Serbia’s population is aging, improvements in the functioning of labor markets and some reversal of the severe brain drain of the 1990s can potentially raise employment levels. A study by Benhabib and Spiegel (1994) estimates potential TFP growth rates by relying on the theory of income convergence and the important role of human capital and produce the following base line equation: TFP growth rate = 0.0007 * years of schooling + 0.0014 * income gap. Inserting the current Serbian data into this equation produces a projected long-run TFP growth rate of above 4 percent.34 Relying on the above noted production function, holding the capital-output ratio constant, and assuming an average annual growth rate of employment of around 0.5 over the next ten years, the projected TFP growth rate of 4 percent translates into a projected GDP growth rate of around 8 percent per annum. However, this projected growth rate appears to be unrealistic since keeping the capital-output ratio (assumed to be around 2 in 2003) constant will require investments to grow to above 30percent of GDP. A more realistic projection of the potential growth rate ofthe Serbian economy in the medium-term can be obtained from the following baseline equation Barbone and Zalduendo (1997): Ln (GDP/Capita)= - 0.005 - 0.018 * ln(Initia1 GDP/Capita) + 0.019 * ln(1nvestmendGDP) + 0.007 * ln(years of schooling) + 0.020 * ln(economic policies) - 0.400 * ln(ferti1ity rates). Inserting current data for Serbia into the above equation yields a GDP growth rate of around 3 percent per year. However, provided that the investment-to-GDP ratio rises to well over 20 percent, the quality of education improves, and the country makes significant progress in improving the business climate, the Serbian economy could grow under the terms ofthis equation by 5-6 percent per year.
33 Doyle et a1 (2001). 34Accordingto the 2002 Census results, the average years of schooling of the Serbian population above the age of 15 is 8.5. The PPP income gap between Serbia and the United States it is assumed to be between 5.5-6.
24 2.52 Under the second scenario, the economy would be forced to run lower current account deficits due to a lower level of fresh capital inflows (Table 2.4). In the absence of permanent fiscal adjustment, lower FDI, limited donor support, and weaker creditworthiness would entail lower investments (averaging 15 percent of GDP between 2005 and 2010 compared to 21 percent for the same period under the credible adjustment scenario), which would, in tum, contribute to the lower observed growth rates.
2.53 On the other hand, the improved macroeconomic environment and more credible policies under the first scenario would lead to higher FDI, which would reach 3.1 percent of GDP in 2010. This development, together with other reform measures, would enhance the country’s competitiveness, thereby producing a strong export performance (Table 2.4). The net effect of these trends would reduce the current account deficit (excluding grants) to 6.1 percent of GDP by 2010. Moreover, sound policies and the improved confidence in the policy framework that would foster growth and investment would also promote savings: gross domestic savings as a percentage ofGDP would rise to 6 percent in 2010 from -4 percent in 2004.
Figure 2.12 Evolution of Growth, Figure 2.13 Investment, 2005-10 (2004-1 0) (% of GDP)
20
5 15-
4
10- 3
2
1
0 2d05 2d06 2d07 2dO8
2.54 The two illustrative scenarios exhibit strikingly different growth paths of consumption, the main determinant of living standards and poverty levels. Under the second scenario, total consumption growth falls steadily, reaching negative rates (Figure 2.15). As the public sector is not adjusting, the growth rate ofprivate consumption declines even more rapidly, reflecting the combined effect of slower GDP growth and the reduced availability of foreign financing. In contrast, the first scenario requires an initial reduction of consumption growth in 2005 and 2006 to below the levels under the weaker reform scenario to allow investment to reach levels which can produce more rapid economic growth. The subsequent rapid rebound in consumption growth reflects the hits of that investment, of deeper reforms, and of the greater volumes of foreign financing which Serbia could absorb under that scenario.
2.55 The evolution of consumption under alternative scenarios presented in Figure 2.15 is indeed illustrative of the difficult choices involved in the reform process. Delayed reforms can defer the pain, but only temporarily and at the cost of more painful adjustments in the future. The trajectory of consumption under both scenarios also highlights the fact that the country cannot and should not expect to maintain the rates of consumption growth observed in the recent past, which were a result ofspecific and temporary factors described earlier in the chapter.
25 Table 2.4 Trajectory of Selected Variables Under Two Illustrative Scenarios, 2003-10 2003 2004 2005 2006 2007 2008 2009 2010 Scenario 1 GDP Growth 3.0 4.4 4.5 4.5 5 .o 5.5 6.0 6.0 Gross Domestic Savingsa -7.0 -4.0 -2.5 0.1 2.5 4.0 5.2 6.1 Real GDP per Capita (2004=100) 100.0 104.4 109.0 114.4 120.6 127.8 135.4 Total Public Expenditures" 46.8 47.0 44.9 42.4 41.6 40.8 39.8 39.0 Wages and Salariesa 10.3 10.6 10.1 8.9 8.9 8.8 8.7 8.7 Subsidies and Transfers" 24.1 25.1 21.8 20.6 20 19.6 19.2 18.8 Public Investment" 2.1 2.9 4.0 4.7 4.5 4.5 4.3 4.1 Government Deficit a'b -4.2 -3.4 -2.4 -0.9 -0.8 -0.5 -0.5 -0.1 Total Public Debta 79.0 65.0 63 .O 59.5 56.1 52.5 49.1 45.6 Import" 41.9 41.2 42.8 43.5 44.2 45.1 45.5 46.0 Export" 19.2 20.4 22.8 24.0 25.5 26.9 28.0 29.2 CAB a,b -12.6 -11.0 -9.8 -8.8 -8.1 -7.6 -6.9 -6.2 FDIa 6.7 3.1 5.0 4.0 3.4 3.4 3.1 3.1 Total Foreign Debt" 68.2 64.0 64.0 63.2 63.9 64.5 64.6 64.2 Debt Service / Total Exports 7.4 13.8 11.0 8.9 12.1 12.8 12.3 11.4 Financing Requirements' 3,247.5 2,583.3 2,418.6 2,638.7 2,920.0 3,292.9 3,453 .O 3,382.5 Scenario 2 GDP Growth 3.0 4.4 3.5 3.0 2.5 2.0 2.0 2.0 Gross Domestic Savings" -7.0 -4.0 -4.1 -3.7 -3.1 -1.9 -0.4 1.2 Real GDP per Capita ( 2004=100) 100.0 103.4 106.4 109.0 111.1 113.3 115.5 Total Public Expenditures" 46.8 47.0 47.1 46.7 46.5 46.7 47.0 47.3 Wages and Salaries" 10.3 10.6 10.7 10.9 10.9 11.0 11.0 11.1 Subsidies and Transfers" 24.1 25.1 24.9 24.4 23.5 23.5 23.5 23.5 Public Investment" 2.1 2.9 2.6 2.6 2.6 2.6 2.6 2.6 Government Deficit a'b -4.2 -3.4 -4.6 -4.6 -5.1 -5.4 -5.7 -6.0 Total Public Debt" 79.0 65 .O 63.8 64.8 66.6 68.7 71.0 73.3 Import" 41.9 41.2 40.8 40.2 39.5 38.8 38.1 37.4 Export" 19.2 20.4 20.6 20.8 21.3 22.1 22.8 23.7 CAB a,b -12.6 -11.0 -10.8 -9.9 -9.0 -7.8 -6.6 -5.2 FDIa 6.7 3.1 2.9 2.3 2.1 1.8 1.6 1.4 Total Foreign Debta 68.2 64.0 65.4 66.5 69.7 72.4 74.1 74.9 Debt Service / Total Exports 7.4 13.8 12.6 11.1 14.6 15.7 15.3 15.1 Financing Requirements' 3,247.5 2,583.3 2,962.1 2,605.0 2,924.3 2,899.8 2,762.7 2,505.5 a:% of GDP; b: excluding grants; c: in USD millions.
2.56 All in all, the results suggest that the implementation of a high quality fiscal adjustment and sustained progress with structural reform measures directed at improving productivity and the business climate is Serbia's most promising route to achieving more rapid and more sustainable growth. Unwavering commitment and a determined implementation of the program would also enable Serbia to lock in the virtuous cycle of higher investment, savings, productivity and growth, and - improved living standards. Deviation from this route-as was demonstrated by the second illustrative scenario-would not only leave the economy highly vulnerable to external and internal shocks, but would also have adverse welfare implications: by 201 0, projected per capita real GDP would be about I7percent lower than under the first scenario, and consumption would be declining. As international experience
26 demonstrates, postponing corrective policy actions-i.e., permanent fiscal adjustment and deep structural reforms-often ends up requiring more costly adjustments in the future.
Figure 2.14 Public Debt 2005-10 (% of GDP) Figure 2.15 Consumption,a 2005-10
0 Scenario 2 Scenarw 1 0 Scenario 2 - =ScenaM 1 60
50
40
30
20
10
0 2009~ 2010 I I I I I 2d05 2d06 2607 2608 2005 2008 2007 2008 2009 2010
a: Per capita growth rate
27 3 INTERNATIONAL TRADE AND REGIONAL INTEGRATION
A. INTERNATIONAL TRADEAND GROWTH:THEORY AND EXPERIENCE
3.1 Trade openness and integration can strongly contribute to higher economic growth. Both, theoretical growth models (Solow, 1957) and recent research and experience confirm that the rate of total factor productivity (TFP) growth is a key determinant of long-run economic growth Greater trade integration can increase TFP growth by leading to an improved allocation of resources, as the economy specializes in producing goods and services in which it has the highest levels ofproductivity, according to its comparative advantage (Dollar and Kraay, 2002). These benefits are confirmed in the empirical research of global experience. Sachs and Warner (1995) found that countries which are more integrated with the world economy have recorded above-average rates of economic growth. Dollar and Kraay (2002) found that increases in trade volumes have had a positive impact on growth rates. Other studies at the firm and industry levels show that trade liberalization and the resulting increase in import competition work to improve incentives and contain costs (World Bank, 2003a). “Dynamic productivity gains” are then generated through the “reduced costs of trading” combined with technology spillovers resulting from spreading the knowledge and technological innovations acquired via access to imported inputs.
3.2 The benefits of trade liberalization can be further enhanced by inflows of foreign direct investment (FDI) and by regulatory reforms. Greater trade openness is a catalyst for higher levels of FDI. The latter can increase a country’s rate of output growth by raising total factor productivity through more efficient resource use and efficiency of investment, and by accelerating the rate of capital accumulation (Bosworth and Collins, 1999; Borenzstein et al, 1998). However, these positive effects materialize only when the host country has a minimum threshold of absorptive capacity as measured by human capital, macroeconomic management and infrastructure. Regulatory reforms are also essential for improving the gains from trade liberalization (Bineswaree and Freund, 2004). The effect of increased trade on growth is absent in highly regulated economies, as excessive regulations hamper the reallocation ofresources into their most productive uses.
3.3 The experience of Central and Eastern European countries (CEECs) provides further evidence of the linkages among trade, FDI and growth. Cross-country analysis of CEECs confirms that policy-induced integration, namely through “the EU factor,” has been decisive in attracting FDI and consequently in shaping the CEEC’s foreign trade. In tum, FDI has played a major role in reorienting the CEECs’ exports to the EU towards more advanced stages ofproduction and in integrating some CEEC firms into global networks ofproduction and marketing (Kaminski, 2000). In the early years oftransition, these economies saw a substantially increased contribution of exports to growth (World Bank, 2000a). EU integration has also led to an almost continuous convergence in income per-capita among member countries (World Bank, 2000b). Evidence from firm level data shows that integration with the world economy is not only a source of external finance, but is also an important source of productivity growth through access to foreign intermediate and capital goods, as well as greater access to world markets for the firm’s output (Djankov and Hoekman, 1997). 3.4 The above theory and experience are of relevance to Serbia’s transition to date and future growth prospects. Despite progress in first-generation trade related reforms, Serbia’s poor export Performance and weak record in attracting FDI remains a major bottleneck to economic growth. As shown in chapter 2, for Serbia to embrace a sustained growth path under the “strong reform” scenario, exports to GDP will need to increase from 20.3% in 2003 to 30% in 2010. This chapter aims at providing a better understanding of Serbia’s trade performance and factors affecting its exports growth. It identifies key constraints to export growth and discusses how regional and global integration could contribute to unleashing Serbia’s export potential.
B. TRADEPOLICY AND PERFORMANCE:1990-2003
The Legacy of the Past
3.5 Serbia and Montenegro (SaM) started the 1990s relatively well integrated into the world economy. In 1989, when it was still a part of the Socialist Federal Republic ofYugoslavia (SFRY), SaM’s total recorded trade turnover of goods and non-factor services accounted for 90 percent of GDP (Table 3.1). Levels of exports and imports equivalent to 42 and 48 percent of GDP, respectively, were comparable to those ofother countries of similar size. However, a large share of SaM’s trade was concentrated in the other republics of former Yugoslavia. Inter- republican trade amounted to 54 percent of GDP, compared to only 36 percent of GDP for trade with the rest ofthe world.
3.6 The 1990s brought a major deterioration in trade performance. The loss of markets of the former Yugoslav republics35following the breakup of the SFRY was aggravated by the effects of conflict, by economic sanctions and by the destruction of infrastructure following the NATO bombings in 1999. This seriously disrupted Serbia’s commercial and economic linkages with its regional neighbors and main trading partners, as well as with international production and distribution networks. These effects were compounded by delayed transition and poor economic management, including increased government intervention in markets (e.g., through price and exchange controls). Lack of market-oriented ownership structures, lack of access to capital, multiple exchange rates, protectionism, lack of investment, and repressive regulation and taxation, all worked to hamper the development and performance ofexport-oriented industries.
kable 3.1 SaM’s Trade in Goods and Non-factor Servicedas % of GDP) 1989 1998 2000 Similar size economies Foreign Inter-republican Total Import 48 19 29 31.5 46.5 40-65 Export 42 17 25 22.5 29.6 40-65 Total 90 36 54 53.98 76.15 80-130
35 Trade with these republics dropped significantly, in part because of the conflicts. Trade between SaM and Croatia - was especially hard hit, while SaM’s trade with Bosnia and Herzegovina and FYR Macedonia was less affected, partly because it was used to bypass the sanctions.
29 3.7 By 2000, SaM had lost substantial ground in terms of its trade openness. Exports had declined to less than 30 percent oftheir 1990 Their share of GDP fell from 42 percent in 1989 to 29.6 percent in 2000 (Table 3.1). The impact on imports was similar but less pronounced, with imports in 2000 amounting to less than 50 percent of their 1990 level. The composition of the top 10 types of exports to the EU also witnessed a radical shift. The share of exports of machinery and automobile parts declined sharply from 15.1 percent in 1990 to 5.6 percent in 2000, against a parallel rise in the share of agricultural exports, from 4.8 percent to 19.5 percent, respectively. This reflected a sharp de-industrialization process across productive structures that left Serbia with a much weaker capacity to trade and export.
Recent Reforms during 2001-03
3.8 The Federal and Serbian governments which took office in October 2000 and January 2001, respectively, launched an ambitious program aimed at a rapid transition to a market economy. This program included numerous early measures to liberalize the trade and foreign exchange systems. In December 2000, the exchange rate was unified, current account convertibility was restored, and numerous bureaucratic trade37 and fore restriction^^^ were removed, including almost all licensing and quantitative restrictions. In parallel, a new customs tariff law came into effect on June 1, 2001, stipulating the reduction oftariff bands from 37 rates ranging from 0 to 40 percent to only six rates ranging from 1 to 30 per~ent.~’This reduction in tariff dispersion was accompanied by a decline in the average tariff by 5 percentage points, from 14.4 to 9.4 percent,40and weighted average tariffs from 9.7 to 7.5 percent, re~pectively.~’
3.9 Further liberalization of Serbia’s trade regime accompanied the implementation of the Action Plan for Harmonization of Economic Systems (AP) of the member states of Serbia and Montenegro in July 2003.42 The AP lays down all elements of the trade and economic regime which are expected to be harmonized, and includes rules and regulations governing the free movements of goods, services, persons, and capital in view of creating a single market. While progress has been made on harmonizing over 99 percent of the tariff lines
36 Comparisons of SaM’s trade before and after the breakup of the SFRY need to be treated with some caution for two reasons. First, trade across formal boundaries is easier to measure than trade within a single state, meaning that the data may not be fully comparable. Second, as the potential for trade is reduced by the erection ofboundaries, historical trade volumes within SFRY can overstate trade potential in the new environment. 37 Amendments to the Law on Foreign trade enacted in December 2000 reduced the very large number of administrative barriers to trade through the repeal of several controls, including the minimum requirements related to company capital assets and employment, the annual registration tax of 1000 DM for trading companies, and the obligation to report and to pay a tax on importsiexports transactions to the Federal Ministry ofForeign Economic Relations. 38 In May 2002, the National Bank of Serbia notified the IMF that it accepted the obligations of article VIII(2), (3) and (4) of the IMF Articles of Agreement, committing to refrain from imposing restrictions on the making ofpayments and transfers for current international transactions, and from engaging in discriminatory currency arrangements or multiple currency practices without IMF approval. 39 These autonomous tariff reductions did not affect Montenegro. 40 Popovic and Jovicic (2003). 41 Using 2001 and 2002 weights, respectively. 42 The Constitutional Charter for Serbia and Montenegro of January 2003 stipulates that SaM will establish a common market on its territory, through coordination and harmonization ofthe economic systems ofthe member states in line with the principles and standards of the European Union. Nevertheless, the two member states maintain two different trade and customs regimes, including controls at the administrative borders. The Harmonization Action Plan of July 2003 sets objectives for the harmonization of customs, tax and foreign trade systems and regimes of Serbia and Montenegro. Negotiations on harmonization of economic systems are divided in four main areas: free movement of goods (customs, foreign trade and tax systems), free movement of services (financial and non-financial services), free movement ofcapital and free movement ofpeople.
30 (93% of which are currently applied) and several aspects of the tariff system, many other essential elements of the trade regime are still not defined. Table 3.2 presents key characteristics of Serbia and Montenegro’s actual and expected tariff before, during and after the harmonization process.
3.10 The harmonization exercise reduced Serbia’s average level ofcustoms tariffs by a further 2 percentage points43 from 9.4 percent in 2001 to 7.4 percent in September 2003, and its weighted average tariff from 7.5 percent to 6.1 percent. This was a major step forward that brought Serbia’s simple average tariff rate below the mean and at the median of other transition economies.44 Tariff dispersion, as measured by the standard deviation of tariff rates, also declined. This favorable development reduced price distortions in production and consumption patterns, as well as incentives for smuggling and other corrupt and rent-seeking behavior. At the same time, most licensing requirements on both exports and imports were removed in addition to a number of import and export quotas applied to certain agricultural goods including wheat, live animals, and sugar, were abolished.45
Table 3.2 Harmonization of Tariffs between Serbia and Montenegro RM Ad RS Ad RS Ad RS Ad RS Ad Valorem Valorem Valorem Valorem Valorem Tariff (YO) Tariff (YO) Tariff (YO) Tariff (YO) Tariff (YO) 1-Sep-03 Jul2003 1-Sep-03 1-Mar-05 1-Sep-05 Average Simple Tariff 2.8 9.4 7.4 7.3 6.9 Weighted Average TarifP 7.5 6.1 5.9 5.2 Standard Deviation 2.8 8.7 7.3 7.2 6.8 Total Number ofTariff Lines 8,555 8,555 8,555 Percent of Tariff Lines Harmonized 90.3 91.3 99.3 Percent of Imports Harmonized 85.4 87.9 98.3 Non-harmonized goods (number oflines) 827 742 56 Source; Federal Customs Service. RS=Republic of Serbia, RM=Republic of Montenegro.
3.11 Market reforms were accompanied by policy induced trade integration, both with the EU and with neighboring countries, which further improved opportunities for export growth. Along with other countries of the Westem Balkans, SaM was a beneficiary of the Stabilization and Association process (SAP) launched by the EU in 2000, which provides a road map of reform aimed at future inclusion in the EU. As of 2000, the SAP provided all Westem Balkans countries with non-reciprocal free access to EU markets in the context of Autonomous Trade Preferences (ATPs). Access to EU markets was free of tariffs and quantitative restrictions for almost all products, except a few products regulated by preferential tariff quotas.46 The ATPs were fully extended to SaM in November 2003.
43 Prior to harmonization, Montenegro maintained a relatively low average tariff of 2.81 percent. 44 The average tariffs in SEE in 2002 was 8.5 percent, with the lowest in Croatia and Moldova (5 percent), and the highest is in Romania (17.1 percent). The other intermediate averages are Albania (7.4 percent), Bosnia and Herzegovina (6%), Bulgaria (9.7 percent), FYR Macedonia (12.6 percent) and Montenegro (6.1 percent in 2003). 45 However, in a clear policy reversal, the Serbian govement significantly increased special levies on imports of agricultural products (European Commission, 2003). 46 The preferential tariffquotas under the ATPs are as follows: baby beef (9,975 tons for SaM); trout, and carp (120 and 140 tons, respectively,jointly for SaM, BiH, Albania and FYR Macedonia); sea bream, sea bass, sardines and anchovies (1 15, 100, 70 and 960 tons, respectively, jointly for SaM, BiH, and Albania); wine (152000 hectoliters for all five countries with access by Croatia
31 3.12 In parallel, the SAp explicitly links liberalization of trade with the EU to re ional cooperation and liberalization among the countries of South Eastern Europe (SEE)>‘ SaM has recently progressed on its commitments taken under the “Balkan” Stability Pact Memorandum of Understanding (MOU) on Trade Liberalization and Fa~ilitation.~’The MoU calls for trade liberalization of at least 90 percent of all tariff lines as well as 90 percent of the value of bilateral imports. SaM has been implementing a Free Trade Agreement (FTA) with Bosnia and Herzegovina (BiH) since 2002, which filly liberalized trade between the parties as of 2004. It has also completed the signature ofthe remaining FTAs with Albania, Croatia, Bulgaria, Romania, and Moldova, deepening its commercial ties with its main SEE trading partners. The FTA with FYR Macedonia is in place since 1996. Annex table 3.1 summarizes the main features ofFTAs signed with other SEE countries.
3.13 In addition, SaM signed an FTA with one main trading partner, Russia, that entered into effect in 2002. It also benefits from MFN treatment granted by several WTO members.
Recent Trade and Export Performance
3.14 Despite wider external market access to both the EU and some neighboring markets, SaM’s export response has remained weak reflecting the prominence of internal constraints to export growth. To date, SaM has also experienced less restructuring of the direction and composition of trade flows than did the successful early reformers in the CEECs. As discussed in detail in the previous chapter of the report, weak export growth and strong import growth combined to produce growing external imbalances. This section will analyze trade performance during the period 2000-2003, focusing on the direction and commodity composition of trade, factor intensities, and integration into the production networks ofthe EU. The following section (3) focuses on the major reasons explaining this performance.
Trade Volumes
3.15 Export levels remain low relative to historical standards and stagnant relative to their potential levels.49 In 2003, SaM’s exports of goods and non factor services (XGNFS) as a share of GDP amounted to 22.2 percent only compared to 42 percent in 1989. They also stood well below potential levels as measured by comparing SaM’s exports of goods and services with levels in other European countries (both EU member states and newly acceding countries) of comparable size and population (8-10 million). As shown in Table 3.3, SaM’s ratio of exports of
and FYR Macedonia subject to the exhaustion of the individual quota under their SAAs). In addition, quotas apply to textiles imports originating from SaM. 47 EU council regulation (No. 2007/2000) of September 2000: “ The entitlement to benefit the preferential arrangement shall equally be subject to their readiness to engage in regional cooperation with other countries concerned by the EU’s SAP, in particular through the establishment of free trade areas in conformity with Article XXIV of the GATT 1994 and other relevant WTO provisions.” 48 Signed in Brussels on 27 June 2001 by Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia, Romania and Serbia and Montenegro. Moldova joined in 2003. 49 Potential levels refers to levels registered in comparable size countries (in terms of both GDP and population). Holding all other things constant, a smaller country will tend to conduct more of its trade extemally than intemally, making it inappropriate to compare with ratios for significantly larger or smaller countries.
32 goods and non-factor services to GDP-in 2002 was only 40-60 percent ofthe level in comparator countries, and was the second lowest among the SEE-8 countries after Albania.
Box 3.1 The Puzzle of Trade Statistics in SaM
Quality of Trade Data SaM trade statistics have many flaws related to the reporting ofinternational transactions. This is revealed by the discrepancies encountered when comparing national statistics reported by the authorities with international databases such as the IMF Direction ofTrade Statistics (DOTS), and UN COMTRADE Database that reflect trading partners’ reported statistics. Differences arise with respect to the measure oftotal trade flows, as well as the geographical composition oftrade flows, especially with the EU.
Total Imports and Exports (mns of USD) Share of trade with the EU (in YO) 2000 2001 2002 2003 1997 1998 1999 2000 Serbian authorities Serbian authorities Exports 1,558 1,721 2,075 2,477 Exports 41 46 44 44 Imports 3,330 4,261 5,614 7,324 Imports 39 39 43 43 UNCOMTRADE UNCOMTRADE Exports 1,464 1,615 1,949 Exports 50.3 59.4 61.6 Imports 3,732 4,356 4,878 Imports 43.5 50.0 54.1 IMF DOTS IMF DOTS Exports 1,034 1,146 1,413 1,705 Exports 66.3 78.0 80.3 78.8 Imports 3,310 3,925 4,786 5,886 Imports 55.2 62.5 65.8 66.1
Given the above discrepancies and in view ofensuring coherence with chapter 2 ofthis report, the analysis will rely primarily on national statistics for overall trade flows and direction oftrade. It uses UNCOMTRADE databases for trade by product, where national data is not made available. The EU COMEXT database is used for trade with the EU.
SaM, Serbia, or Montenegro? Another complication with trade data arises from the inability to separate data for Serbia from that ofMontenegro Where data for Serbia are unavailable on a separate basis, the analysis will use figures for SaM. Large Montenegrin imports on behalf of Serbia in 2001-2003 may affect the results. However, Montenegro represents only 8.6% of SaM’s exports.
Table 3.3 Exports of Goods and Non Factor Services to GDP (XGNFS/GDP) (in YO)
2002 20.7 19.0 26.2 53.1 46.3 38.0 35.5 52.3 36.2 2003 22.2 18.9 26.0 53.7 51.8 35.2 33.0 53.7
Source. Intemational Financial Statistics (IFS), IMF, and World Development Indicators (2003), the World Bank.
3.16 Set against this significant catch-up potential, the recovery of exports of goods and services has been sluggish. During the period 2001-03, exports of goods and services registered an annual average growth rate of 11.1 percent in US dollars terms but only 4.2 percent in (the more relevant) euro terms. This compares too much higher rates of import growth, averaging 26.3 percent and 18.9 percent, respectively, in US dollar and euro terms, much of which is
33 associated with large reconstruction needs. Growth was stronger on the goods side (2.5 percent average growth) as services exports grew at a much faster 10% rate, raising the share of services in total exports from 24 percent in 2000 to 28 percent in 2003.
Figure 3.1 SaM's Trade Performance (Goods and non Factor Services), 1999-2003 in Euros
1999 2000 2001 2002 2003
Exports 0 Imports -Ratio of Exports to imports +Current account (% of GDP)
Source: IMF Balance of Payments database.
3.17 The early impetus in registered trade in goods with the EU was also recently reversed. Following years ofwar and sanctions, and faced with a large catch-up potential, SaM outperfonned other SEE&' and CEEC countries in EU market^.^' Its goods exports to the EU recorded an average growth of 19 percent during 2000-03 (in euro terms), improving its relative positioning in the EU markets substantially. Table 3.4 shows the share of SEE4 countries in total EU external imports. SaM's share recorded the highest rise, almost doubling between 1999 and 2003 and bringing SaM to the fourth place behind Romania, Bulgaria and Croatia. Nevertheless, a significant share of this recorded growth has been recently disputed by the findings concerning potentially illicit exports of sugar to the EU52.The latter grew on average by more than 500 percent 53 during 2001-02 and accounted for around 3 to 4 percentage points in SaM's overall exports growth to the EU. In 2003 exports recorded no growth at all.
SEE-8 economies include Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR Macedonia , Moldova, Romania and SaM. 51 Comparative analysis across SEE-8 countries uses EU reported data as in EUCOMEXT databases. 52Theflawed application of rules of origin led the EU to temporarily suspend the Autonomous Trade measures for sugar. 53 According to EU reported statistics
34 Index, 2003 Share in EU imports 1999 2000 2001 2002 2003 2000=100 Albania 0.012 0.012 0.015 0.015 0.018 153.1 Bosnia & Herzegovina 0.018 0.022 0.025 0.026 0.034 159.7 Bulgaria 0.113 0.128 0.142 0.146 0.163 127.1 Croatia 0.093 0.086 0.093 0.092 0.121 139.8 Macedonia, FYR 0.030 0.032 0.026 0.024 0.026 81.6 Moldova 0.007 0.008 0.010 0.011 0.012 151.2 Romania 0.296 0.322 0.386 0.431 0.523 162.2 SerbiaiMontenegro) 0.028 0.033 0.044 0.054 0.057 172.3 SaM's share in SEE-8 EU-oriented exports 4.99 5.45 6.27 7.23 6.39
2.3.1. The Direction of Trade
3.18 Since 2000, SaM has not achieved a significant geographic reorientation of its foreign trade. Despite the extension by the EU of generous trade preferences, the share of SaM's trade with the EU has increased only slightly, from 40.7 percent in 2000 to 43.8 percent in 2003, and probably registered no change when accounting for potentially illicit exports ofrefined sugar. This trend departs from the experience of CEEC economies of similar size, where the provision of preferential market access to the EU under the GSP and later under the Europe Agreements (EAs) contributed significantly to the expansion of exports towards the EU, allowing these countries to compensate for the collapse of their exports to former CMEA countries54 (Table 3.5). Similarly, the redirection of import flows toward the EU remains slow and below the levels registered by comparable CEECs in their early tran~ition.~~
n EU(15) 40.7 46.5 43.6 43.8 42.3 58.1 71.9 49.7 66.0 m$ - SEE-8 32.3 29.5 32 33.6 7.0 3.3 10.5 1.3 1.8 CEECs 10.7 8.6 11.7 10.2 1.7 7.5 15.9 27.0 18.8 w2 $ % ROW 16.3 15.5 12.6 12.4 49.1 31.1 1.8 22.0 13.4 ~ n EU(15) 39.2 39.2 42.2 42 43.2 54.4 63.9 52.8 64.5 m$ 5 SEE-8 22.9 15.2 10.5 9.4 4.0 1.5 1.1 0.3 0.3 2 CEECs 8.5 10.9 12.8 11.9 2.4 6.6 5.9 21.2 12.0 "3 ROW 29.4 --34.7 34.5 36.8 50.4 37.5 29.2 25.6 23.2
54 (2000a). 55 It is worth noting that some CEECs including the Czech Republic and Hungary did not under the Europe Agreements benefit from the same high level oftrade concessions from the EU as Serbia does under the ATPs.
35 3.19 Strong ties with SEE-8 export markets contributed to slowing the redirection of SaM’s trade toward the EU. Despite the loss of markets, SaM maintained strong ties with its closest neighbors. While trade with Croatia dropped considerably during the conflict, strong ties with Bosnia and Herzegovina and with FYR Macedonia allowed it to bypass sanctions and maintain a regular flow of goods. The normalization oftrade and economic relations with Bosnia and Herzegovina, and stability following the end ofthe Kosovo war, contributed to an expansion in SaM exports to the region since 2001. Average export growth to SEE-8 countries registered 27 percent and 11 percent in US dollars and euro respectively, mainly driven by a surge in exports to Bosnia and Herzegovina and FYR Macedonia, which accounted in 2003 for 16.3 percent and 9.3 percent of SaM’s total exports respectively. The importance of SEE-8 countries on the import side declined sharply in 2001, as SaM was turning gradually but slowly to more imports from neighboring CEECs, and the rest ofthe world (ROW) (World Bank, 2000a).
2.3.3. The Structure of Trade
3.20 SaM has experienced little restructuring in the commodity composition of its foreign trade. Table 3.6 presents the structure of its trade by end use product categories. The share of processed products in SaM exports to all its trading partners has not increased. On the contrary, the share of agriculture products in total exports increased, while the share of capital goods and vehicles declined, notably in EU markets. This evolution contrasts with the experience of other CEECs, where a significant shift in the composition of exports away from traditional, low processed inputs towards manufactured components accompanied the redirection of exports to the EU (World Bank, 2000a). Positive changes were nevertheless recorded on the import side, where the sustained increase in the share of machinery and equipment since 2000 could be an early sign for future restructuring through replacement ofobsolete production capacities.
3.21 The concentration of exports in unskilled labor and natural resource intensive products puts future export growth prospects at risk. Three years after the transition, around 75 percent of SaM’s exports consisted ofunskilled labor and natural resource intensive products (Table 3.7), and the shares of capital intensive and skilled labor intensive exports have declined. This contrasts with the experience of the CEECs, where the rapid shift towards skilled labor intensive and capital intensive exports contributed significantly to improving integration with the EU markets at increasingly more sophisticated levels (World Bank, 2000a).
3.22 The factor content of exports matters for several reasons. First, skilled-labor-intensive and capital-intensive industries tend to pay higher wages. Growth ofthose exports would lead to an expansion in production and a likely increase in the standard of living of workers in these sectors. Relying on exports ofnatural resource-based products, which involve little, processing, such as lumber or bovine hides, would have a much smaller effect on wages. Second, while the concentration oftrade patterns in natural resource and unskilled labor intensive products acted as a short-run cushion for job losses for unskilled workers, reliance on relatively low skill-intensive and low value-added exports constrains the possibilities for the economy to generate new jobs in higher value-added, higher-skill content sectors with higher wages and greater growth potential. Moreover, and as illustrated in Chapter 5, labor costs in Serbia are relatively high, and therefore, reliance on unskilled labor-intensive exports, such as textiles and footwear, may not be sustainable in the long run. Over the long term, increased international competition from other
36 low-price labor countries will erode Serbia’s comparative advantage in low-skilled products, making it all the more important for Serbia to focus on upgrading exports and shifting into higher value-added goods.
Table 3.6 Serbia’s Trade bv End Use Products. 2000-03 World EU SEE-8 Product (SITC) 2000 2001 2002 2003 2000 2001 2002 2003 2000 2001 2002 2003
v) Agriculture 24.4 21.8 29.0 26.4 25.2 24.4 34.2 30.6 26.1 23.0 31.4 28.5 Industrial raw matl. 7.8 6.8 5.3 5.8 8.2 6.5 5.7 6.9 9.0 7.7 4.1 3.6 Q Machinery, excl. 11.2 12.1 10.3 10.6 9.8 11.4 7.2 8.6 11.8 10.9 9.9 11.0 Automobiles & parts 2.2 2.0 1.8 1.7 1.4 1.4 1.5 1.2 3.1 2.0 1.4 1.4 Consumer goods 54.0 54.5 49.9 53.2 55.4 55.2 49.4 52.0 49.7 50.1 45.9 50.9 -Fuels 0.3 2.9 3.7 2.4 0.0 1.2 1.9 0.7 0.3 6.4 7.2 4.6 Agriculture 13.4 13.6 12.1 11.0 8.5 10.5 9.2 8.1 13.6 18.2 20.3 20.5 ndustrial raw matl. 3.9 3.1 2.6 2.7 2.1 2.0 1.8 1.7 4.8 7.2 8.3 7.5 Lachinery, excl. auto 14.0 15.7 20.8 22.5 20.6 22.4 27.4 26.8 3.1 4.6 7.1 8.7 Q Automobiles & parts 7.3 4.7 5.1 6.3 14.9 9.0 10.2 13.1 1.0 0.8 1.6 1.8 ME Consumer goods 42.1 43.4 43.3 42.9 52.5 54.3 50.4 49.5 25.2 42.3 48.1 49.6 Fuels ------19.9 19.5 16.1 14.7 1.4 1.7 0.9 0.9 52.3 27.0 14.6 11.8 Source: Federal Statistical Office.
3.23 The slow and limited shift in factor intensity of exports was however accompanied by a sustained increase in imports of capital intensive products from the EU, which could imply a potential restructuring and modernization ofthe industrial and production facilities (Table 3.7).
3.24 SaM exhibits specialization in agriculture and low processed manufacturing products in EU markets. Annex Table 3.2 presents calculations of the Export Specialization Indices (ESI) for SaM and other SEE-8 countries56 in sectors that account for the largest share of its exports to the EU. An ESI value exceeding 1 implies that SaM is more specialized in exporting the product to the EU than an average trading partner ofthe EU. First, SaM maintained a similar pattern of export specialization in EU markets between 1999-2002 as the value of ESI exceeded 1 throughout the period for almost all product categories except textiles and transport equipment. The majority ofthese sectors are in low processed goods and in agriculture. Second, SaM exhibits a pattern of specialization that is similar to other SEE countries. As shown in Annex Table 3.2, the value of the ESI exceeds 1 for almost all SEE-8 countries for product categories such as furniture, iron and steel, agriculture, extractive industries, and low processed consumer goods such as footwear, leather, wood and clothing.
56 The ESI is the ratio of the share of a given product in SaM’s total exports to the share of that same product in the EU’s total external imports. An ESI with a value that exceeds unity suggests a strong specialization in the product (Balassa, 1965).
37 Table 3.7 Factor Intensities of SaM’s Trade with the EuroDean Union SaM SaM SaM SaM SaM Hungary Hungary Hungary Hungary FactorIntensity 1993 1997 2000 2001 2002 1990 1993 1997 2002 Composition of Exports to the EU (YO) Natural Resources 44.7 43.9 47.1 45.2 52.3 42.8 32.1 18.1 10.6 Unskilled Labor 28.1 22.6 22.7 24.1 22.6 21.5 27.0 16.2 12.2 CapitalIntensive 16.3 14.6 10.9 12.2 9.7 21.3 25.6 43.3 50.7 Skilled Labor 10.9 18.9 19.4 18.6 15.4 14.5 15.4 22.4 26.6 Composition of Imports from the EU (%)
Natural Resources 36.5 25.6 22.2 22.8 18.1 13.9 14.3 11.0 8.7 UnskilledLabor 11.4 17.2 16.2 15.4 14.2 16.3 18.1 14.1 11.0 Capital Intensive 39.2 36.4 36.4 38.6 43.1 46.2 39.3 45.0 44.1 Skilled Labor 13.0 20.8 25.2 23.2 24.6 23.6 28.3 29.9 36.2 Source; UNCOMTRADE Databases reported by the EU.
2.3.4 Integration with Global Production Networks
3.25 SaM lags behind in terms of participation in the rapidly emerging global division of labor based on production fragmentation. Kaminski and Ng (2001) show how CEECs producers became part of three EU-based networks57which played a growing role in the CEEC’s trade with the EU. One of the indicators of such participation is the share of network-related exports in manufacturing exports excluding chemicals. The latter stood at around 5 percent for SaM, a relatively low level when compared to the 11.8 percent share registered in Hungary and the Czech Republic four years into their transition (Table 3.8).
Table 3.8 SaM’s Trade in Parts and Components and Share in EU Markets Hungary Hungary Czech Czech Parts and Component Product 20002001 2002 1993 1998 Rep93 Rep98 Share ofparts in EU-oriented manufactured exports (excluding chemicals, in %) 4.4 3.6 4.6 11.1 11.8 4.2 11.8 Note: Parts and components are based on 60 items which were classified in the SITC 7 and 8 (machinery and other manufacturing) products in Rev2. Based on data reported by EU to UN COMTRADE, and Kaminski and Ng (2001). .
3.26 Backward linkages between SaM and EU firms are also very weak, despite proximity to EU markets. At the outset of their transition and expansion of trade with the EU, several CEECs have established themselves as the main backdoor workshops for the supply of outward processed trade (OPT) to EU markets. OPT allows EU producers to export goods temporarily for processing outside the EU and to import the compensating product with a full or partial exemption from duties and levies back again. SaM’s share of total EU imports of OPT stood at only 1.23 percent in 1998, after which it declined further to 0.41 percent in 2002 (Table 3.9). This is a relatively low value when compared to the share of other CEEC countries in their early transition years, or even to neighboring SEE-8 countries such as Albania, Bulgaria or Croatia. One explanation for the slow success of OPT in Serbia could be related to the sustained increase in wages compared to other countries (See Chapter 5) that has made Serbian firms less competitive. Moreover, and as explained in the next section, the lack of modern infrastructure
57 The three networks usually organized around MNCs are for automotive products, telecommunications equipment, office equipment and automatic data processing machines, and furniture.
38 services and their relatively high costs compared to other SEE-8 countries hamper the development ofthese strong linkages.
Table 3.9 Share in EU ImDorts of Outward Processed Products. 1990-2002 1990 1993 1998 2000 2001 2002 Czech Republic 0.00 6.00 6.22 5.35 4.74 5.66 Hungary 6.94 7.99 7.30 6.42 5.59 4.68 Slovenia 0.00 3.40 1.29 0.83 0.75 1.07 Romania 4.26 5.02 7.97 7.79 7.84 7.93 Bulgaria 0.49 1.29 2.17 2.66 2.89 1.22 Albania 0.10 0.26 1.03 1.20 1.27 1.15 Croatia 0.00 3.18 2.12 1.53 1.17 0.80 Bosnia and Herzegovina 0.00 0.02 0.40 0.40 0.36 0.38 Serbia and Montenegro 0.00 0.00 1.23 0.74 0.55 0.41 FYR Macedonia 0.00 1.04 0.82 0.87 0.89 0.64 Source: COMEXT.
3.27 Isolation from production networks locked SaM’s exchanges with the EU and the SEE countries in inter-industry trade. Table 3.10 depicts the share ofintra-industry trade (Le., the two way trade in similar products) with the EU and SEE-8 countries as measured by the Grubel Lloyd (GL) index. This index measures the share ofintra-industry trade in the total trade of a country and can range between zero and 100 percent, the latter occurring in the presence of two way trade across all sectors. The values for SaM point to very low and stagnant levels of intra-industry trade with its main trading partners, although to a higher level with the EU than with the SEE countries. This could be explained by very low levels of FDI and interaction among firms operating in the same networks of production and distribution, such as suppliers of parts and components (World Bank, 2003g) as explained later, given the slow process of building these commercial linkages following a decade of poor economic policies, turmoil and sanctions. Serbia’s performance departs from that ofother transition economies in this respect as well. In their early transition years, the CEECs witnessed increasing intra-industry trade mainly as an outcome of industrial restructuring and FDI flows. The GL index for Hungary and the Czech Republic with the EU in 1998 stood at 55 and 68 percent, respectively (World Bank, 2000a).
Table 3.10 Intra-industrv Trade as Measured bv the Grubel Llovd Index 2000 2001 2002 2003 1993 1998 SaM and the EU 25.5 26.1 27.2 25.2 Hungary and the EU 53 55
SaM and Other SEE-8 14.7 . 11.8 10.1 10.4 Czech Republic and EU 57 68 Source: Staff calculations based on data from the Federal Statistical Office. Calculated at the 2 digit SITC level.
3.28 In summary, despite the implementation of the ATPs, SaM’s external trade developments during 2001-03 have been disappointing if measured against its potential and the challenges of further trade liberalization and economic integration. First, SaM failed to exploit opportunities offered by the proximity and extensive formal access to EU markets and failed to achieve an early reorientation of its trade, as did many other transition economies. Second, SaM’s exports are still dominated by agriculture and a few low-processed manufacturing goods and have still not moved up the value chain. Third, trade with its natural trading partners is of an inter-industry nature, resulting largely from the limited integration of
39 SaM firms with intemational networks ofproduction and distribution, especially those of the EU. Therefore, developments in the external sector still undermine the macroeconomic foundations necessary for sustainable growth.
c. KEY CONSTRAINTS TO EXPORTGROWTH
3.29 The primary constraints to expanding Serbia’s exports are internal rather than external. The weaknesses in trade performance described above appear to indicate the relative importance of domestic structural, institutional and supply constraints. This section explores such bottlenecks in greater detail, beginning with a brief overview of macro-structural and supply constraints (most ofwhich are in areas explored in greater detail in other chapters of the report), followed by a discussion of the ways in which trade policy and institutions affect Serbia’s capacity to expand exports and trade, and ending on the link between FDI and prospects ofexports growth.
Macro-Structuraland Supply Constraints
3.30 Macroeconomic developments and the mix of fiscal and monetary policies have worked to hamper export growth. As described in Chapter 2, Serbia has experienced a period of increased capital inflows and remittances, plus a rapid growth of recorded real wages. These trends have cushioned the initial effects of transition and have helped to jump start investments. However, the resulting boom in domestic demand and the appreciation of the real exchange rate have introduced an anti-export bias into the economy, by promoting rapid import growth while providing little incentive for Serbian enterprises to actively look for new export markets. For this reason, the shifts in fiscal and other policies designed to control the growth of domestic demand which were described in Chapter 2 will be a central element ofa shift towards export-led growth. The imposition of such a “demand barrier” will force Serbian enterprises to more actively pursue export options. As noted in the previous chapter, placing a greater share of the burden of stabilization on fiscal policy will also permit Serbia to achieve the same inflation objectives with a slightly less rigid monetary policy and a more competitive exchange rate. This shift in the mix of macroeconomic policies will further enhance the export orientation of the economy. In addition, such a shift should tackle the obviously increasing and dangerous pressures to address the sluggish growth of GDP and exports and the rapid growth of imports through greater protection ofthe economy, and through distortive subsidies, tax incentives and other measures to artificially stimulate exports and curtail import growth. Such policies promise short-term benefits which cannot be sustained and which come at the expense of the longer-term growth potential that Serbia needs to improve living standards and sustain a macroeconomic balance.
3.31 A second major impediment to export growth and restructuring outside of the direct sphere of trade and customs policy is the weak performance of the enterprise sector, which is the combined effect of delayed reform and outdated productive capacities. These issues are discussed in greater detail in Chapter 4. Despite the remarkable recent progress made in privatization, production and exports are still dominated by state-owned and socially-owned enterprises. In 2002, the latter accounted for 45 percent oftotal exports, down from 95 percent in 1990. As a class, such enterprises appear to face softer budget constraints than their private sector counterparts. One contributing factor is the relative ease with which they have been able to
40 access credit from banks, which are often owned by the state or by the enterprises themselves. The resulting softening ofbudget constraints has contributed to the high domestic demand noted above, and has probably crowded out promising private sector exporters from access to bank credit. Over time, the lack offinancial discipline led to both large losses in state enterprises and a substantial weakening ofthe balance sheets ofbanks. This, in turn, affected private sector credit and growth. The imposition of greater financial discipline throughout the enterprise sector, through policies described in Chapter 4, will be crucial to achieving a strong export response.
3.32 A related impediment to export growth comes from the remaining weaknesses in the business environment, which also act as a deterrent to FDI inflows. These issues are discussed in greater detail in Chapter 4. The various business surveys described in that chapter indicate that the main problems facing companies engaging in export-oriented activities include the lack of access to finance and export credits, the poor quality of infrastructure, the loss of former distribution networks, and difficult repositioning in the international trade arena.
3.33 The slow and delayed pickup in exports of the capitalhechnology-intensive sectors of the economy is also related to deficiencies in the Serbian education and training system. As shown in Chapter 6, Serbia’s population has a lower average level of adult education than many of its European competitors. This helps to explain Serbia’s existing pattern of export specialization and its comparative advantage in low-skilled activities as opposed to the skills/capital/technology-intensive sectors described above. The higher education system and the processes for skill formation are also not geared to supplying the level and the content of the skills required by the rapidly evolving technological progress and production systems. For this reason, reforms in Serbia’s education and adult training systems will be of fundamental importance to achieving a restructuring of Serbia’s production and exports to higher value- added, technologically advanced sectors.
Trade Policies
3.34 Export expansion requires a supportive trade regime that creates incentives to export and enhances the contestability of domestic markets5* While Serbia has made important strides in removing various barriers to trade, additional steps could further improve the environment for export expansion and render the trade regime more conducive to growth. This would entail clarifying the institutional arrangements governing trade policy formulation and implementation, limiting tariff escalation and limiting the use ofnon tariff measures as a tool to manage trade. Any increase in tariffs would constitute a serious policy reversal, undermining other reforms aimed at enhancing productivity and attracting FDI. It would also erode the credibility of SaM’s commitment for further integrating into regional, European and global structures.
3.35 Trade Policv framework: The institutional arrangements for effective formulation and implementation of foreign trade policies need to be defined. As ofJune 2004, the Action
58 The contestability of a market is ensured when relationships among firms are not unduly distorted by anti-competitive governmental or private action and when there is an open market access for foreign goods, services and investments. Liberalization of regulatory regimes, strict adherence to the principle of national treatment of foreign investors, the reduction in tariffs and the removal ofNTBs increase the contestability of domestic markets.
41 Plan for Harmonization of the Economic Systems (AP) between Serbia and Montenegro aiming at creating a single economic space as stipulated by the Constitutional Charter was still not filly implemented. This has created obstacles to the free flow of goods and services across both Republics, and delayed the SAA negotiations, as well as WTO accession process. However, on October 11, 2004, the EU General Affairs Council expressed its support for the twin track approach for SaM. This would imply a single SAA with distinct negotiations with the member states on trade, economic and possibly other relevant sectoral policies. This twin track approach is based on the recognition that Serbia and Montenegro will find it difficult to achieve the level ofinternal economic harmonization requested.
3.36 Despite the Constitutional Charter, Serbia and Montenegro have so far failed to (re)build a functioning internal market between them. This which could create a high level of uncertainty for investors. Particular problems that have hampered trade between Serbia and Montenegro and with third parties include:59a) the application of different product related norms and standards in each republic, and the absence of a horizontal mechanism for consultation and notification of technical regulations prior to their adoption; b) the application ofdifferent value added taxes and excises create instances ofdouble taxation that hurt the free movement of goods; c) non-uniform application of special levies on agricultural products creating the risk oftrade deflection: and d) service sector regulations differ across the two republics, and thus hamper market access and freedom of operations of service providers.60 The above situation casts great uncertainty on trade and investment operations in both Serbia and Montenegro and has negatively affected the overall business environment. SaM should rapidly establish a coherent, transparent and finctioning foreign trade regime and institutions.
3.37 Tariff escalation: The tariff regime establishes tariff escalation in some key sectors. This phenomenon-occurs when duty rates on raw materials and intermediate inputs are set at lower rates than for finished or processed products. This practice tends to distort market signals and to discourage the development of intermediate industries and the production and export of parts and components, which, as mentioned above, have been a major source of manufactured export growth in the CEECs and other developing countries. Table 3.11 below reveals that the tariff structure discriminates against intermediate goods in favor of producers of final goods of light manufacturing, including textiles and leathers, and wood and furniture. Other sectors do not receive similar treatment. Removal of tariff escalation in the context of gradual tariff reduction under the SAA negotiations and accession to the WTO will contribute to removing these distortions.
3.38 Resurgence of Non Tariff Measures: Despite the removal of major quantitative restrictions on trade, a small number of non tariff measures on imports and exports continue to apply, primarily on agricultural produce. Despite the removal of the majority of non-WTO compatible export and import restrictions in 2001 and 2003, Serbia maintains export controls on a number of basic agricultural goods, with the stated goal of ensuring domestic food supplies, and on other ferrous products.6' Such restrictions on exports create a general bias
59 European Commission (2003). 6o Some service providers are subject to duplicate licensing or authorization requirements. For some 22 tariff lines in the field ofblack and colored metallurgy, export duties of 15% are imposed, in addition to an export tariffs of 20% imposed for the export of raw skins (16 tariff lines). Moreover Serbia has recently introduced export bans on
42 against tradable, by increasing their costs and reducing their competitiveness in international markets. In addition, import licenses (reportedly allocated in an unclear and often non- transparent way) continue to apply to about 160 steel and iron products for an undefined transitional period.62 Such non-tariff barriers result in the transfer of rents from consumers broadly to license holders, because the restriction on imports results in domestic prices that are above the world market price.63 The introduction of time-limited, transparent and WTO- consistent safeguard mechanisms, which can shelter an industry during a period of restructuring, would be preferable to maintaining import licenses. Existing import approvals for oil derivatives are also not justified under the WTO and will need to be abolished.
Table 3.11 Tariff Escalation in Serbia (in percent) Intermediate Final Primary inputs product Maximum Average STDEV Food Beverages and Tobacco 18.9 17.6 30.0 7.6 6.7 Wood and Furniture 3.7 9.3 15.0 6.1 3.8 Textiles and Leather 1.8 7.0 14.0 30.0 12.4 6.7 NonMetallic Mineral Products 4.6 7.9 20.0 7.8 5.9 Chemicals, Petroleum and Rubber 2.0 3.0 7.2 30.0 3.2 3.4 Basic Metal Industries 1.o 5.2 18.0 5.2 5.2 Source: Calculation based on data from Federal Customs Service.
3.39 Introduction of new NTBs would be a serious policy reversal which would hurt competitiveness of Serbian export, distort trade, and possibly undermine the business environment by adding to the instability in the policy environment. The recent resurgence of other types ofnon tariff barriers, namely the reported use ofreference prices to determine import value, should also be abandoned. The new Customs Law (see section on trade facilitation) is compatible with WTO provisions on customs valuation, where import value is primarily determined based on the invoice. Nevertheless, and for some goods imported from specific countries, the value to which the tariff rate is applied is determined based on reference prices, imposing higher customs duties on these imported products. Departing from existing customs regulations on custom valuation in order to protect domestic producer raises input costs and distorts competition. In addition, it departs from Serbia’s objective of rendering its trade and customs regime compatible with the WTO.
Institutions Supporting Exports
3.40 To successfully integrate into the world economy and reap the benefits of trade liberalization through export expansion, Serbia needs to complement trade policy reforms with a series of “behind the border” measures. These include institutional and regulatory reforms related to standards and norms, trade facilitation (including customs and infrastructure), and export promotion.
cereals and rawhide in order to prevent shortages following the 2003 drought. Export licenses for these are issued by the Commission established by the Minister of Intemational Economic Relations. European Commission (2003). 63 There is evidence that in developing countries such rents are a major source of inefficiency from rent-seeking activity, i.e., from the spending of real resources to obtain import licenses and influence policy in general (Krueger, 1974).
43 Standards and Norms
3.41 Standards and technical regulations are essential elements in facilitating trade within countries and international exchange between countries. The ability to comply with standards applied in overseas markets is a main determinant of access to those markets. In addition to the writing of standards, an essential element of the system of standardization is conformity assessment (i.e.; the technical procedures such as testing, verification, inspection and certification, which confirm that products fulfill the requirements laid down in regulations and standards). Despite the assistance received from various donors, including the EU, Serbia news to make steady progress in this area as the reform agenda in rehabilitating and modernizing the standards system remains significant.
3.42 Development of standards on the basis of international, and European standards should be consolidated. Poor quality standards prevent Serbian farmers and entrepreneurs from taking full advantage ofmarket access opportunities, most notably the ATPs granted by the EU. Most of the standards applied by SaM producers were issued by the government before the breakup of the SFRY, and are not in conformity with current international standards. This is equivalent to a self-imposed barrier to trade. Only recently have standards been developed on the basis of international and EU standards (World Trade Organization, 2001). This approach should be consolidated and institutionalized in order to reinforce the voluntary nature of the standards regime.
3.43 Another impediment to external market penetration is the non-recognition of SaM’s conformity assessment certificates in foreign markets. The Yugoslav Accreditation Body (JUAT) is still not a member of the International Laboratory Accreditation Cooperation (ILAC) and other multilateral arrangement^.^^ This prevents Serbian exporters from guaranteeing the recognition of their locally issued certificates in other countries. The government should prompt JUAT to join intemational accreditation bodies and should encourage conformity assessment providers to seek accreditation to international standards.
3.44 Some mandatory technical regulations constitute a hindrance to the free flow of goods.65 Most SaM technical regulations do not provide any protection higher than the relevant international standards and guidelines. Nevertheless, products meeting foreign governments’ technical regulations and based on international standards are not permitted automatic entry into the SaM market without undergoing additional tests.66 Although SaM is a signatory to a number of international agreements for mutual recognition (MRAs) of certification and test results for specific productsY6’ these agreements are not well implemented and add to the cost of the imported inputs used in production. The conclusion of new MRAs with other major trading partners and recognition of technical regulations conforming to intemational standards and
64 JUAT became the associate member ofthe European Cooperation for Accreditation (EA) in November 2002. Technical regulations primarily deal with products such as household appliances, electrical equipment, food products, cement, and building materials. A number also deal with shelf-life requirements, especially for food products. 66 Products subject to technical regulations may not be circulated until an appropriate proof of conformity is obtained from an entity (as specified in a technical regulation). 67 Article 32 of the Law on Standardization allows JUAT to recognize certificates and test reports on the basis of bilateral and multilateral agreements.
44 which are issued by foreign governments, could also contribute to lowering the cost ofimported inputs.
3.45 The notification system for technical regulation needs to be improved. Until recently, technical regulations could be elaborated and enacted by any federal ministry within the sphere of its competence and in consultation with the federal Institute for Standardization. However, following the establishment of the state union and reduction in the competences of the union level entities, the union Ministry of Internal Economic Relations is the only one responsible for technical regulations. In the absence of a transparent and up-to-date notification system, this practice risks creating unnecessary confusion in the markets. The intention of SaM to designate the Institute for Standardization as the official inquiry point for standards, technical regulations and conformity assessment procedures required under the Agreement on Technical Barriers to Trade, is an important first step in this direction. The enactment of new laws goveming standards, technical regulations and conformity assessment procedures that comply with the Agreement on Technical Barriers to Trade a new Law on Technical Barriers to Trade and the Law on Norms and Standards will add greater clarity to the overall system of norms and standards.
3.46 Besides improving the mechanisms and institutions for the supply of norms and standards in SaM’s market, steps are needed to promote a greater demand for a modern standards and norms infrastructure. At present, the majority of domestic firms are not necessarily aware of the requirements for international and European norms and standards, nor do they have the resources to contract such services. Demand for accreditation and norms have featured high on the list ofmost needed elements for improving exports by firms participating in the BEEPS.68 Increased technical assistance and enterprise development programs that focus on the quality aspects of productions are likely to stir demand for continuous improvements of norms and standards institutions and regulations in Serbia.
Export Promotion and Finance
3.47 Institutions dedicated to export promotion and export finance are at a nascent stage and need to be empowered. Serbia’s Investment and Export Promotion Agency (SIEPA) was established in 2001, and its export promotion department created only recently. The latter lacks both the capacity and the resources needed to generate and support a strong and sustained export impetus. While SIEPA receives considerable support from donors, the enactment of a law that clearly delineates its roles and responsibilities and asserts its autonomy in the area of export promotion is needed. In this respect, SIEPA should regain its competence for contributing to the resolution of domestic supply constraints in addition to impediments facing exporters in extemal markets. At present, SIEPA’s role has been confined to the latter, with emphasis on the provision of information and the organization of fairs. Box 3.2 describes features of successful export promotion organization. Moreover, export financing activities including export credit insurance could be strengthened to accompany the overall strategy for export promotion while paying due attention to avoiding any additional fiscal burden.
68 http://info.worldbank.orgigovemance/beeps/
45 3.48 Upon the upcoming introduction of the VAT, the implementation of a VAT rebate mechanism could enhance the positioning of Serbian exporters in international markets. Exports have also been discouraged by the absence of duty drawback or rebate mechanism^.^^ For a long time, Serbia’s exports incurred additional costs that rendered them less competitive in international markets relative to suppliers from other countries that benefit from such schemes.” Nevertheless, the latest decline in the average tariff in 2003 and the prohibition of duty-drawback or tariff rebate schemes under the Pan-European Cumulation Agreement for exports within the Pan-European market for industrial products, renders the re-introduction of a duty drawback scheme inappropriate. Rather, an efficient VAT rebate system (which allows exporters to claim back the VAT they paid on imported inputs) would be a first step for reducing the costs of imported inputs (Jenkins and Kuo, 2002). If administered without delays in refunding tax credits, the VAT rebate could contribute to enhancing the positioning of Serbian exporters in international markets.
Trade Facilitation
3.49 Trade facilitation encompasses the entire environment in which trade transactions take place.” In addition to the logistics of moving goods through ports or the required documentation at customs posts at borders it also involves domestic policies and institutional structures. While there are no specific studies for Serbia, recent research and experience show that the ability of a country to deliver goods and services in time and at low costs is a key determinant of export competitiveness.’* Given the relatively high import content of Serbian products, higher customs and logistics costs translate directly into higher costs that could undermine the competitiveness of Serbian products in both domestic and international markets.
3.50 Inefficient and costly border crossing procedures undermine the competitiveness of exports. Such procedures exact a cost from businesses, make a country less attractive to foreign investment, and reduce the ability ofdomestic firms to participate in global production networks.
3.51 The government has made recent progress in rationalizing and strengthening Serbia’s Customs administration with a view to improving the services and reducing the associated trade and transport impediments. The modernization process was formally launched in 2001 with the adoption by the Cabinet of a Customs Service Development Strategy based on modem customs principles. The strategy included the introduction of selective controls at border and clearance facilities. In July 2003, the Serbian Parliament adopted the Law on Customs and the Law on Customs Service to enhance efficiency and internal controls. These laws became effective on January 1, 2004. The new Customs Law is compatible with the WTO Agreement on Customs Valuation, and will facilitate the further modernization of Customs once the implementing regulations become effective. This modernization process, led by the Customs
69 Such mechanisms reduce or eliminate the duties paid on imported intermediate goods or raw materials used in the production of exports. These incentive systems are often justified on the grounds that they tend to correct the anti-trade bias imposed by high tariff levels. For a more extensive discussion, see Hoekman, Michalopoulos, Schiff and Tar (2001). 70 Countries that apply a duty drawback or rebate mechanism are Romania (drawback), Bulgaria, and Croatia. 71 For further information, see World Bank (20030. 72 Wilson, Mann and Otuki (2003) estimated that enhancing global trade facilitation capacity would increase world trade by around US377 billion (9.7 percent). About 28 percent of this gain would come from improving port efficiency, 9 percent from improving customs procedures, 22% from improving the regulatory environment, and 41% from improving services, including e- business usage.
46 Administration, is supported by the Trade and Transport Facilitation in South East Europe (TTFSE) and by the EU-funded CAFAO program. These programs provide extensive support for the formulation of a proper legal and regulatory framework, for enhanced human resource management, and for organizational restructuring, training, inspection equipment and a modern information system, while ensuring that new procedures are duly implemented at border crossing points and clearance facilitie~.’~
Box 3.2 What Makes for a Good Trademxport Promotion Organization (TPO)75?
Country experiences point to seven features essential for ensuring a successful trade promotion organization
Promote incentives favorable to exports: Trade promotion can only function well if the existing trade and customs regime does not create overall disincentives for exports. Anti-export bias often stems from an overvalued exchange rate, tariffs that provide high nominal and effective protection, non-tariff barriers resulting from dysfunctional customs practices and poor quality controls, and absence of trade finance, costly infrastructure services (roads, ports) and excessive bureaucratic control of trade.
Seek autonomous operations: In order to influence policies, mobilize resources and services to support exports and deliver them as needed, a TPO needs to be flexible, and autonomous and to operate with the top political support and ensure formal and informal links with the public and private sectors. It needs to respond quickly to changing circumstances without having to obtain time-consuming clearances.
Support a demand driven strategy: The private sector should play a dominant role in defining, implementing, and monitoring the strategy of the TPO. There is no single model to ensure such partnership, as country circumstances vary. Boards of TPOs are made up mostly of recognized exporters and are headed by business leaders of recognized integrity.
Strike a balance between offshore and onshore objectives: A TPO should not only focus on offshore activities such as information gathering, market research, trade representation and trade fairs, but should also be attentive to supply conditions and provide well targeted enterprise support to potential exporters facing supply bottlenecks. These include pricing, quality standards and norms, availability of supportive infrastructure services, and supply of inputs (often faced with high protection).
Ensure quality staffing: The staff of a TPO usually work under civil service rules that result in unattractive pay and low motivation, and bring in bureaucratic behavior that is incompatible with private sector practice. A good TPO can pay its staff salaries similar to those paid by the private sector. A partial solution could be to give TPOs more autonomy in setting recruitment and salary standards and to draw on the experience of external consultants.
Provide adequate funding: A successful TPO should have sustainable funding mainly derived from domestic sources. Donor financing can initially be useful, but such support should be temporary and should be followed by sufficient domestic resources. Much can be gained by charging fees for services. Yet there are limits to the latter as some potential exporters do not have the needed resources or do not fully appreciate the available services until the) succeed in exporting.
Evaluate the results: The effectiveness and efficiency of a TPO must be periodically evaluated. Evaluations car document export performance at the macro level, and at the enterprise level for those that benefited from the TPO’r services. Such evaluations can be supplemented by client surveys. New Zealand has made the greatest progress ir these evaluations.
3.52 As a result of the modernization plan and of increased trade flows, the measured efficiency of Customs operations has improved. Revenue collection increased more rapidly
73 www.seerecon.ordttfse. 74 A strategic decision regarding the upgrading of the existing customs information system is expected by the autumn of 2004. The new platform will allow, inter alia, the introduction of effective modules for direct trader inputs of customs data, direct payments, enhanced management of transit flows, and active application of risk management and selectivity across the Serbian territory. 75 World Bank (2001b).
47 than trade. Revenues collected by Customs increased between 2002 and 2003 by 23 percent (or by 330 percent since 2000), while the number of staff declined. Each staff processed on average US$3.8 million in trade in 2003, compared to US$1.8 million in 2000. Moreover, over the past three years, the number of examinations decreased as a result of the introduction of risk management and selectivity: about 50 percent of trucks are examined for clearance and 35 percent when crossing borders.
3.53 However, business survey results suggest that Customs regulations and practices remain a problem for Serbian enterprise^.'^ In 2002, 40.8 percent ofbusiness respondents to BEEPS (see Chapter 4 for a description ofBEEPS) reported that Customs constitutes an obstacle to business operation and growth: 17.1 percent considered it a “major” obstacle compared to 16.7 percent in Bosnia and Herzegovina, 9.9 percent in Croatia and only 5.8 percent in Hungary. Moreover, perceptions about corruption at customs are higher than in other SEE countries. Only 46 percent of respondents reported never using unofficial payments to deal with customs upon the import ofproducts into Serbia (Figure 3.3), compared to 57 percent in Croatia, 67 percent in Hungary and 84 percent in Slovenia. This reflects, to a large extent, corruption and fraud in the recording of imports and the payment of customs duties, in addition to falsification of origins of goods and smuggling. Such practices exact a high toll from the economy. The most recent scandal related to exports of sugar to the EU based on falsified rules of origin for instance, caused the temporary suspension ofmarket access preferences on all sugar exports to the EU.
Figure 3.2 Unofficial Payments to Deal with Customs/Imports
I Country
3.54 Limited improvements in overall processing time, particularly for entry times at the border, remain a major problem. Customs controls are becoming more effective, with better detection rates. Heightened security concerns tend nonetheless to offset customs efforts to reduce rates ofinspection. In addition, various agencies are still enforcing border inspection. This results in a high rate of border examinations, which cannot, under the present law, be delegated to
76 These results should be treated with some caution. Many respondents could attribute whatever happens at the border to Customs, even when delays are in fact created by private service providers such as customs brokers, or other border agencies such as phyto-sanitary or veterinary controls. Detailed performance measurements at border locations over the past year indicate that about 80 percent of vehicles waiting beyond 6 hours are delayed due to other border agencies than Customs, and that the longest part of border processing time or clearance time relates to the preparation of documents by brokers for submission to border agencies. Customs has established a plan to strengthen the capacity of brokers by January 2005 (through training and certification) and is working actively with other border agencies to coordinate efforts and enhance collective efficiency at crossing points.
48 Customs, as would be the case in most Western countries. Other agencies similarly insist on carrying out checks at the border that could either be delegated to Customs or performed at the inland point ofde~tination.~~
3.55 Future border and customs reforms should focus on two main priorities. First there is the implementation ofa customs reform strategy and integrated border management strategy to improve trade facilitation, with support from the TTFSE project and the CAFAO. Progress toward this goal is measured monthly through performance indicators covering major border crossing points and the Belgrade clearance facility. This process should include better coordination among agencies, using the recently created border agency commission, chaired by Customs. It should also include a reduction in physical examinations across agencies, made possible by enhanced information flow and risk management, and by the strengthened capacity of brokers to submit advance information regarding incoming shipments. A second priority is reinforcing the credibility of Customs by enhancing the control of smuggling and fraud, including verification of the origin of goods. Any remaining doubts about Serbia’s ability to guarantee the origin of exported products can negatively affect its qualification for trade preferences, creating added uncertainty for traders. Strong recent progress in this area needs to be sustained through well-designed control mechanisms which are effective, yet with low compliance costs for businesses.
Foreign Direct Investment (FDI)
3.56 The experience of other transition economies confirms the critical role of FDI in boosting export competiti~eness.~’More particularly, greenfield FDI has been essential for enterprises to increase the efficiency of their operations, to modemize their production technology, and to expand stable commercial and production links with the supply chains of production and marketing, particularly those of the EU (Kaminski and Ng, 2001). This type of greenfield FDI is motivated by two key determinants. The first is market size and ease of access to external markets. The second is access to lower cost resources and services inputs that increase the efficiency of operations. This section will discuss how Serbia lags behind on both counts.
3.57 To date, the majority of FDI inflows to Serbia have resulted from privatization, with few greenfield investments or cross-border acquisition^.^^ Despite its proximity to the EU and SEE markets, Serbia received a smaller amount of FDI during the past decade than the majority of other SEE countries, with the second lowest cumulative per capita FDI inflows after Bosnia and Herzegovina. While this is not surprising given the developments in the 1990s described above, this has left Serbia with a weak capacity to export. Since 2000, inflows of FDI have picked up (Table 3.12). From a low level ofUs25 million in 2000, FDI inflows increased substantially to US$1395 million in 2003. Cumulative FDI remained relatively low at US$3. lbillion, representing only 10 percent oftotal cumulative FDI in the SEE region, compared to 20 percent in Bulgaria and 33 percent in Romania. The recent surge in FDI in 2003 was
77 As many of these agencies do not operate at night, trucks often have to wait until moming to be allowed into the country. ’*World Bank (2000a). ’’ World Bank (2004d).
49 inordinately high, owing to a few privatization deals, and may not be an indication ofunderlying trends.
3.58 Inefficient and high cost provision of service inputs remains a major deterrent to increased FDI inflows and export growth. Serbia has a strong potential to take advantage of new opportunities for the relocation and fragmentation ofproduction facilities, given its location at the heart ofthe transit corridor between the EU, Eastern Europe, Turkey and the Middle East. Nevertheless, and as shown in the next chapter, the lack of a legal framework for the enforcement of competition rules, and the existing limitations on the entry of firms in major backbone service sectors including banking, insurance, telecommunications and transport, have raised input costs, undermining the potential for FDI inflows and export growth. While the regime may be relatively open and non-discriminatory, government control and ownership of important service providers” resulting from slow progress in privatization, and market reforms in general, have been the main bottlenecks to progress (Box 3.3).
3.59 Promoting a more conducive environment for the provision of and trade in services is a key to developing and modernizing the range of “backbone services” to provide for cheap, efficient and rapid linkages with neighboring countries (Kaminski and Ng, 2001). Proceeding with the liberalization and privatization of major backbone services such as telecommunication and transport is a priority. This would need to be accompanied by the ratification and proper implementation of the Competition Law.81 The government should also take measures to further consolidate the national treatment principle governing the treatment of foreign investment operations, with specific attention to removing the remaining restrictions to new investment in the banking and insurance sectors. Progress in accession to the WTO will further contribute to services liberalization in the transport and telecommunications sectors in the future (Box 3.3).
Albania 90 48 45 41 143 204 135 178 1,083 338.4 BiH 0 0 100 90 150 130 230 320 1,020 248.8 Bulgaria 137 507 537 802 998 803 876 1398 6,302 808 Croatia 486 347 835 1420 1085 1404 591 1875 8389 1906.7 FYR Macedonia 11 30 128 32 175 441 78 94 1023 503.7 Romania 263 1224 2040 1025 1048 11740 1128 1485 10,232 469.4 SaM 0 740 113 112 25 165 562 1395 3112 374.9
Many of the main actors in Serbia’s transport sector, except road freight transport and some of the larger road maintenance enterprises, are under public ownership. A number ofthe parastatals, such as the national railway (SZ), the national airline (JAT), and the Belgrade public transport company (GCP) are ofa significant size, and face similar problems in terms of overstaffing and weak finances.
50 3.60 Another impediment to attracting FDI is Serbia’s relatively small market size and still limited integration with regional and global markets.’* Although it is one of the largest among the SEE economies, Serbia’s market remains limited compared to those of other SEE-8 neighbors, such as Bulgaria and Romania.. Moreover, Serbia has not integrated with other neighboring markets and major trading partners to the same extent as other transition economies, resulting in a considerably limited the “effective size” of its market. This explains why differences in factor endowments, rather than economies of scale associated with supplying a larger market have driven and shaped trade patterns and confined them to inter-industry type of exchanges. It also confirms the necessity for Serbia to engage more dynamically in regional and global trade integration processes as a condition for boosting FDI inflows.
3.61 In summary, the previous analysis identified three main key constraints affecting Serbia’s poor export performance and where action is needed, besides the macro structural constraints discussed in other chapters. First, Serbia needs to add coherence to its trade policy framework and institutional arrangements and remove the existing anti-export bias inherent to its trade regime. Second, institutions that support export and facilitate trade need to be strengthened, namely, in the area of standards, border crossing, and export promotion. Third, improving the environment for foreign investment is a must. In addition to the discussion in the next chapter, more efficient provision of backbone services and wider stable access to external markets are necessary incentives for efficiency-seeking and market-seeking FDI which could help boost Serbia’s exports.
D. TRADEINTEGRATION: MAXIMIZINGOPPORTUNITIES FOR LONG-TERMGROWTH
3.62 Integration into the world economy is a key to unlocking the trade potential of SaM and Serbia. Such integration encompasses three dimensions (i)a European dimension involving SaM’s relations with the EU in the context of the SAP; (ii)a regional dimension covering its relations with neighboring SEE-8 countries; and (iii)a multilateral dimension through accession to the WTO. Embracing the three processes will allow Serbia to gradually remove several of the constraints identified in the previous section. First, integration with the EU and neighboring countries will gradually reduce the protection levels and remove the remaining non-tariff measures that hinder the efficient allocation of resources. Second, the perspective for the EU integration and accession to the WTO will introduce a wide-ranging institutional, legal and regulatory reform that will improve the quality and capacity of the institutions supporting exports, namely, the standards regime and Customs. Finally, by integrating regionally and multilaterally, Serbia would gain greater access to external markets and would thus increase its effective market size, providing greater incentives for FDI inflows.
3.63 Accelerated trade integration has become more important in the light of recent changes in SaM’s external environment. Despite progress in reforms for the liberalization of its trade regime, SaM still lags behind in terms of trade integration both regionally and multilaterally. While it has taken a step further on the regional track with the recent signature of FTAs with seven SEE c~untries,’~SaM remains behind all other SEE-8 countries in terms of
82 Bevan and Estrin (2003) show strong linkages between the host country’s size as measured by its GDP and FDI inflows. 83 The other agreements are awaiting ratification by the Parliaments of both Serbia and Montenegro as a necessary condition for adoption at the State Union Level.
51 integration with its main trading partner, the EU, in the context of the SAA, and is still in the very early stages ofaccession to the WTO (Table 3.13). Building on the previous discussion, this places Serbia at a disadvantage, as decisions by foreign companies to invest and locate will be driven by consideration of the country’s market size and its ability to serve other countries through free trade. The challenge is to manage these intertwined processes in a coherent and coordinated fashion, by adopting the necessary reforms and policy to take advantage of the opportunities provided while minimizing the possible distortionary effects of preferential trade arrangements.
Box 3.3 IsInfrastructure an Impediment to Growth? Low quality and high cost transport and telecommunications services could negatively affect Serbia’s productivity and reduce its attractiveness to FDI, creating another impediment to economic growth. Notwithstanding the importance of reducing tariff and non-tariff barriers to trade, the rehabilitation and modernization of the transport and telecommunications infrastructures is key to promoting growth and to better integrating Serbia into regional and global networks. The rehabilitation and modernization of transport infrastructure and greater private sector participation in the delivery of services is key to facilitating trade and boosting exports. Transport assets in Serbia are in a poorer condition than in any ofthe neighboring countries, with the possible exceptions of Albania and Bosnia and Herzegovina. Out of a network of about 14,000 km of arterial and regional roads, approximately, 25 percent of the main and regional roads are in good condition, 19 percent are in fair condition and 56 percent are in bad or very bad condition by way of contrast, the comparative figures for Croatia, according to a recent survey, are 32 percent, 46 percent, and 22 percent respectively. Similarly, in Central and Eastern Europe, in an assessment sponsored by the World Bank in 1991, the comparable figures were 37 percent, 41 percent, and 22 percent, respectively. One hundred kilometers ofthe main international Pan-European railway corridor require immediate reconstruction, and only one-third of the locomotives and freight wagons and half of the passenger coaches of Serbian Railways are regularly available. The average age ofthe facilities and equipment at river ports exceeds 25 years, age, and the associated weakening ofriver navigation systems has increased the risks and the costs ofriver transport. An improved road management and financing system is needed that will strengthen Serbia’s procedures for planning and budgeting road expenditures and for setting priorities for road maintenance, in view ofreducing the cost and enhancing the quality of Serbia’s roads. Greater participation by the private sector in financing, managing and delivering all transport services should be encouraged through further liberalization and the removal of existing restrictions. This would also contribute to improving cost recovery in the various transport sectors. The liberalization of the telecommunications sector and greater competition would allow for more efficient and low cost telecommunications that could substantially contribute to the facilitation of trade and investment. Improved communications services played a major role in the emergence of global production links that permit the efficient coordination of geographically dispersed production processes. In Serbia, the charges for international calls are well above costs and those for local calls are below costs. Moreover, the BEEPS survey reveals that SaM is the worst performer in the ECA region in terms of connectivity to its fixed line telephone network. Delays since the date of application reached 30 days in 2001 compared to 5 days in Croatia, 4 days in Hungary and 2 days in BiH. As a consequence Serbia has fallen behind its peers in the diffusion and application ofInformation and Communications Technology The penetration and usage rates for telecommunications and the Internet in Serbia are low in comparison with its peers. Serbia was ranked seventy-seventh of 102 countries in the latest World Economic Forum “Network Readiness Index” (by comparison, Estonia ranked twenty-fifth, Slovenia ranked thirtieth, and Croatia ranked forty-eighth). The effective liberalization of the telecommunications market in 2005 will give an important boost to Serbia’s economy and will allow the rebalancing of the structure of its telecommunications tariffs. Steps to move the mobile operations to the private sector are needed. In this way the sector could take full advantage ofprivate management, technology and capital to increase the digital capacity of its network. Source: Serbian Road Directorate: these data were obtained from Pavement Condition Surveys undertaken in 1997-98, and are likely to represent a conservative estimate ofthe state ofthe current network. Table 3.13 Progress of Western Balkans Countries in Trade Integration SaM Albania BiH Bulgaria Croatia Romania FYROM WTO Noworking 2000 1St working 1996 2000 1995 2003 party held party Nov 03 Yet SAA Feasibility Negotiating Feasibility Pre-accession Interim Pre- Applied study Study done Agreement accession 2004 expected on trade applied. SAA under ratification. FTAsb 4 applied 4 applied 6 applied 6 applied 6 applied 6 applied 6 applied 3 signed 3 signed 1 signed 1 signed 1 signed 1 signed 1 signed Note: aAnInterim Agreement, covering the trade and trade-related measures, was concluded in parallel with the SAA, and entered into force on 1 March 2002. Croatia submitted an application for EU membership on 21 February 2003. The Commission recommended in its opinion to the European Council in April 2004 opening negotiations with Croatia. Stability Pact for South Eastem Europe http:/iwww.stabilit~act.or~/trade/O403-fta-matrix.doc
The European and Regional Dimension
3.64 Progress regarding the SAA should accompany Serbia’s recent advances in liberalizing trade with neighboring SEES. Theory and evidence indicate that regional trade liberalization yields greater benefits if it is accompanied by multilateral liberalization, and if it involves deeper integration with highly developed partners like the EU (World Bank, 2000b). SaM is already implementing the FTAs with Russia, Bulgaria, FYR Macedonia and Bosnia and Herzegovina, and is in the process ofratifying, another five agreements. However, slow progress in the implementation of the Harmonization Action Plan between the two Republics is holding back the launching of negotiations over the SAA, which aims, at establishing a free trade area with SaM gradually over a period of 6 to 10 years.84 Why is it so important for SaM to accelerate its talks with the EU over the SAA in parallel to recent advances in intra-SEE trade liberalization? What are the potential benefits for long-term growth and export expansion from synchronizing the two dimensions?
3.65 The most important benefit from the SAA is generated by the dynamic gains in the medium to long term that would result from the alignment of the legal and regulatory frameworks to the EU acquis. Experience from CEECs and recent evidence from other countries that are signatories to the Association Agreement point to the positive effect exerted by the dynamic ofreform required under the SAA, namely, in areas related to state aid, competition, standards, and technical regulations.
3.66 Liberalization with the EU will also contain any potential trade diversion expected from FTAs with SEE-8. Preferential trade agreements can be a source of distortions because of the tariff wedge created between MFN applied rates and the redwedzeroed tariff rates applied
84 Negotiations over the SAA will not start before the finalization of the Feasibility Study, itself pending the full implementation of the Harmonization Action Plan. The transitional period for gradual removal of customs tariffs is a matter of negotiation and could also last less than six years. It should also last less than 10 years, which is the maximum WTO accepted transitional period for regional trade agreements to be compatible with Art. XXIV GATT.
53 under the FTAs.~~The extent oftrade diversion would be greater, the higher the tariff wedge is, the lower the share ofmutual trade is between parties prior to the FTAs, and the lower the share ofintra-industry trade between them. In 2003, FTA partners accounted for a small share of total imports amounting to 23 percent only, against 77 percent for MFN suppliers, suggesting a high potential for trade diversion. Nevertheless, with a large share of industrial products in imports from FTA partnersYs6the extent of reverse discrimination is likely to be limited given the low MFN rate (5.2 percent) applied on industrial imports into Serbia (Table 3.14). Yet, minimizing the potential for trade diversion by reducing reverse discrimination against MFN suppliers would be important and will necessitate acceleration of the SAA talks and negotiations. This would allow for a reduction oftariffs on imports from the EU, and will shorten the period during which SEE-8 firms could enjoy preferential tariff margins over suppliers from the EU
3.67 Another benefit derives from increased competition as a result of tariff dismantlement. With the EU’s enlargement in place, reducing tariffs on imports from the EU2587(close to 54 percent of total imports in 2003) will bring more intense market competition which could reduce the monopoly power of local firms as they are induced to cut prices and expand sales benefiting both consumers and producers, including exporters.88 Dynamic gains are generated through the reduction in the “cost of trading” as well as from technology spill over effects (World Bank, 2003a). This can be expected to increase total factor productivity and would stimulate a higher level of investment.
3.68 The SAA also allows SaM to benefit from greater stability in EU-SaM relationships. The SAA will bring little immediate improvement in formal market access to EU25 over that provided under the ATPs. Moreover, and as shown in the previous section, the recent poor performance in EU markets confirms that Serbian producers’ inability to reap the benefits from existing opportunities is probably linked to broader structural constraints both at the macro and at the firm level. Nevertheless, the SAA provides contractual assurances of access for Serbia’s exports to EU markets and will reduce the risk of the suspension of preferences on a unilateral basis. The combined effect of higher competition, technological innovation and cost-cutting restructuring that further enhances productivity should lead to increased exports to the EU in the long run (Kaminski 2000).
” By granting preferential treatment to suppliers in order to compensate for their cost disadvantage, the risk of trade diversion increases as the importer will chose that supplier’s product over another supplier whose product may be available at a lower cost. Moreover, the exporter from this preferential area, although otherwise competitive in world markets, may price its products to capture the rent up to a preferential margin below the MFN applied rate. ‘6 Tariffs on almost all industrial imports would be eliminated upon entry into force of SEE-8 FTAs. 87 EU-15 and the newly acceding countries. ” Recent research finds that price-cost margins tend to fall with import competition, and that foreign competition tends to improve manufactures’ efficiency (Tybout, 2001). Hoekman, Kee and Olarreaga (2001) found that import competition reduces industry markup. The effect of import competition is particularly powerful when a few oligopolists dominate markets. See World Bank (2003a), Chapter 3.
54 Table 3.14 Share of SaM’s Imports Out of Total Imports with FTA Partners 2003 (in percent) Albania BiH Bulgaria Croatia Romania Moldova FYROM Russia % of total 0.004 2.3 1.78 1.7 1.8 0.012 1.8 14 imports %ofdutyfree 40.2 100 90.7 90 98.4 100 100 n.a. imports % of 95.4 88.9 90.4 83.4 98.4 74.02 70.8 99.1 industrial imports Source: Calculations based on data for SaM provided by Federal Statistical Office
3.69 Increased intra industry trade, exports and FDI inflows could be maximized if diagonal accumulation of rules of origins under the Pan European Cumulation of Origin (PCO) is applied for Serbia in its exchanges with the EU.89 The decision to apply pan European diagonal cumulation of origin in Serbia’s exchanges with the EU lies with the latter and is only possible ifSaM signs a bilateral free trade area, i.e the SAA with the EU. Diagonal cumulation allows economic operators to use components originating from any of the participating countries in the PCO without losing the preferential status ofthe final product when exported to the EU. The absence of diagonal cumulation will discourage exporters from countries associated with the PCO system from sourcing their inputs from Serbia because the latter does not qualify for local content of the product. This will negatively affect the export prospects of Serbian intermediary products and will hamper the development of intra-industry trade.g0 Moreover, without diagonal cumulation, Serbian exporters would be constrained when using inputs from their SEE partners, as only inputs sourced from the EU would be accepted as local content under the bilateral cumulation oforigin rules prevailing in the majority ofthe SAAs (FYR Macedonia and Croatia). Agreement among SEE-8 countries participating in the network ofbilateral FTAs to allow for diagonal cumulation among themselves, would further enhance the benefits ofthe various FTAs, and further strengthen regional integration.
3.70 The application of the PCO system will only be available following concerted efforts to strengthen the capacities of both Customs and local Serbian producers. Rules of origin under the PCO system are sophisticated and could be difficult to implement by local customs authorities and by small and medium enterprises of EU-partner co~ntries.~~Targeted support is needed in order to avoid making these rules an impediment to export growth. This includes streamlining the PCO system into the Customs regime and strengthening the capacities of the border administration in testing and certifying the application of rules in a speedy and accurate manner in order to guarantee preferential access of exports to EU markets. A parallel effort is needed to raise the awareness of local producers and exporters about the requirements for proving origin, and to support them in bearing its cost.
89 EU preferential rules of origin define the requirements for the local content of raw materials, components and value added, including the minimum level of transformation necessary for a product to qualify as originating and thus benefiting from preferential treatment in access to the EU market. Since 1997, a system of European cumulation, based on a network of free trade agreements and protocols, has been established among the EU, the EFTA countries, the Central and Eastem European countries and Turkey. Since 2002, the system was extended to the Southem Mediterranean countries as signatories of Association Agreements with the EU. 90 “Study on the economic impact of extending the pan-European system of cumulation of origin to the Mediterranean partners’ part of the Barcelonaprocess”, The Sussex European Institute, University of Sussex. ”Brenton and Manchin (2003) The cost of proving origin involves satisfying a number of administrative procedures to provide the required documentation, in addition to the cost of maintaining the accounting system an accurately accounts for imported inputs from different geographic locations.
55 3.71 Finally, while the “EU factor” via the SAA offers immense prospects for attracting FDI if measures to improve the overall investment climate are taken, an effective implementation of the FTAs with other SEES is necessary to reduce the potential hub and spoke effects. As noted earlier, other SEE countries are ahead in the process of negotiating or implementing their SAAs with the EU. Failure on the part of Serbia to liberalize is arrangements with neighboring countries in parallel with liberalizing its trade with the EU will give rise to negative hub and spoke effects. The latter emerge because of distortions that provide EU firms (the hub) with better market access to other SEE markets (the spokes) than that provided to Serbian firms. This might create a relocation of industrial activities to the EU at the expense of Serbia, and would discourage domestic and foreign investment in the country. Effective implementation of the FTA should go beyond the simple reduction of tariffs to deeper forms of integration, as suggested below.
The Network of Free Trade Agreements: Maximizing the Benefits of Integration
3.72 In addition to minimizing potential trade diversion effects, SaM should seek to maximize its benefits out of the FTAs. As shown in section 1, SEE countries capture around 34 percent of Serbia’s export markets with Bosnia and Herzegovina and FYR Macedonia leading the way. The existing and newly signed FTAs provide an opportunity to further consolidate SaM’s strong positioning in SEE markets and expand its presence beyond its closest next door neighbors. This would be possible by deepening trade integration with its SEE partners; and improving further market access for agricultural exports to SEES.
3.73 While market access to other SEES has significantly improved, gains from intra- regional trade hinge first on broadening integration. Despite the liberalization oftrade for up to 90 percent of tariff lines and value of imports, the various FTAs provide for different preferential treatment, product coverage and transitional periods. This creates inconsistencies and increases the risk oftrade deflection. In the short term, mitigating this effect requires broadening integration through further harmonization of the FTAs to ensure similar product ~overage.’~ This would considerably reduce the costs of business and the administrative strain on Customs, enhancing the flow of Serbian exports and imports across boundaries. In the medium term, moving towards a multilateral option by establishing a simple free trade area among SEE-8 countries should be pursued.
3.74 Deepening integration through greater harmonization of national regulations and addressing ttbehind-the-border’tbarriers to trade are also needed. First, cooperation with customs authorities of other SEE countries on border crossing and customs procedures should be strengthened in order to ensure a more rapid flow of Serbian exports. As discussed earlier, despite the improvement in Serbian customs procedures, this would have a limited impact if it is not accompanied by similar improvements in neighboring customs administrations and border crossing points. Second, and in addition to measures at the national level, regional cooperation in harmonizing technical regulations in line with EU and international standards would enhance regional integration. Serbia could substantially reduce possible technical barriers to trade arising
92 For example, SaM needs to ensure that all its FTAs liberalize the same products, by the same dismantlement schedule, across all FTAs with all partners.
56 from differing standards and conformity assessment procedures in SEE markets. Collaboration would also allow for a greater burden sharing of costs in developing the legal and regulatory texts pertaining to standards and technical regulations. However rules governing various trade areas under the FTAs should always ensure consistency with those of the EU and the WTO, in order to ensure complementarity and synergy among the various processes.
3.75 Prospects for greater market access to SEE markets could further be enhanced. As shown above, SaM maintains strong ties with SEE-8 export markets, with 30 percent of its exports destined to these markets. As SEE-8 countries move along the path to EU integration through implementation of the acquis and convergence with EU structures, they hold the potential for higher growth as experienced in other transition economies. As of 2003, SaM enjoys, on average, free market access for 84 percent of its exports to SEE-8 markets and benefits from relatively better access for its agricultural products than other SEEs. The possibilities for further enhancing market access opportunities are twofold. First, it can do this by negotiating the removal of quantitative restrictions constraining its exports to other SEE markets, especially with Albania, Romania, Croatia and Bulgaria (see Table 3.15). Second, Table 16 indicates that an important share of SaM’s exports of agriculture products to Romania, Bulgaria, Croatia and Albania is still subject to relatively high tariff barriers. Given the export potential of SaM’s agricultural products in the EU markets, demonstrated earlier, the country has a stake in moving forward with the agenda for agricultural liberalization among SEEs.
Table 3.15 Conditions of Access for SaM Exports to FTA Partners’ Markets 2003
YOof agric exports % of exports YOof exports share of industrial Share in % of exports not not subject to subjects to subjects to products in total total subject to duties duties TRQs QRs exports exports Current Russia 77 98 0.0 0 92.0 5.1 FYROM 100 100 0.0 0 68.3 8.9 BiH 100 100 0.0 0 15.9 Future Albania 76.6 57.7 0.0 10 44.7 0.6 Bulgaria 92.5 19.0 2.2 0.0 90.7 2.2 Croatia 88.8 45.9 4.7 0.0 79.3 3.1 Moldova 100 100 0.0 0 97.3 0.1 Romania 87.0 1.o 6.4 0 86.8 2.9
3.76 Moving towards a single free trade area would bring substantial benefit to SaM and other SEE countries. Experience from other regional arrangements such as CEFTA and BFTA generated higher intra-regional trade flows and greater export growth when combined with the Europe Agreements (Adam, Kosma and McHugh, 2003). By adopting the described measures for further broadening and deepening integration, SEE countries including SaM would avoid the hub-and spoke pattern inherent in the SAA agreements with the EU and provide greater incentives to attract FDI. Moreover, a revised single free trade agreement could allow for the further liberalization of the agriculture sector, in services and harmonize legislation related to competition, contingent protection and standards necessary for the facilitation of trade and investment flows among these countries.
57 Accession to the WTO or the Multilateral Dimension
3.77 Proceeding with WTO accession in parallel to EU and intra-regional integration offers further opportunities. First, WTO accession will provide an anchor for the conduct of trade and tariff policy, and will contribute to the removal of all quantitiave barriers and restrictions not acceptable under the GATT. This would reduce the cost of imported inputs and would greatly remove the existing distortions imposed by these schemes. Moreover, the practice of tariff binding will reduce the risk of any policy reversal93 and add greater credibility to the reform measures adapted to date. Second, by acceding to the WTO, SaM will acquire the security of legally guaranteed MFN access to other non FTA WTO members. Some ofthe latter are currently offering MFN status to SaM on a unilateral basis, such as the US. Third, many of the benefits will accrue through services liberalization and regulatory reform. Based on the available review of SaM leg is la ti or^,^^ most of the existing rules and regulations governing the services sector are not restrictive, except two important ones in the banking and insurance industries. Liberalization of these and other backbone services will be important for fostering competition in the major finance and infrastructure sectors and providing lower cost services input to other sectors.
3.78 Multilateral liberalization need to accompany intra-regional liberalization with the SEEs and the EU. Being on the EU integration path, the long-term objective for SaM should be the alignment of its MFN applied tariff schedule to that of the EU, especially with respect to industrial products. First, maintaining high MFN tariffs amounts to protecting Table 3.16 MFN Tariffs FTA suppliers, including EU suppliers, Average MFN Applied Tariffs (YO) Country All Goods Agriculture Industrial Goods from MFN competition. Thus, the Serbia (03) 7.4 15.7 6.2 alignment of applied MFN tariffs on Montenegro (03) 6.1 12.2 5.2 industrial products to those of the EU Euro eanUnion o1 ) 4.4 9.4 4.2 CET would significantly improve contestability of Serbia’s domestic markets. As a result, competitive pressures on either preferential suppliers or domestic producers, or both, would significantly increase. Second, lowering tariff rates on a unilateral basis does not reduce SaM’s leverage in tariff negotiations, as these concern the bound rather than applied levels. Moreover, the welfare losses in the case of the bilateral FTAs of SaM with other SEEs can be converted into gains, if all countries adopt the EU external tariffs on industrial imports (World Bank, 2003g). Finally, the alignment of Serbia’s tariffs with the CET would signal to the investment community the government’s commitment to addressing weaknesses in Serbia’s domestic business climate. The latest trade liberalization measures of August 2003 went in that direction and reduced substantially preferential margins over EU suppliers as shown in Table 3.16. The challenge is to maintain tariffs at existing levels and avoid counterproductive policy reversals.
93 According to the GATT, tariff binding cannot be changed without compensation or resorting to the dispute settlement mechanism. 94 World Trade Organization (2001).
58 E. CONCLUSION AND RECOMMENDATION
3.79 Despite early first generation trade reforms, Serbia still lags behind other transition economies in terms of trade openness and structural transformation. Unlike the experience of other CEECs economies in their early transition years, Serbia failed to seize the benefits of the recent liberalization of the trade regime, and market access opportunities following the implementation of Autonomous Trade Preferences by the EU, that could have generated an export impetus and boosted greenfield FDI. To date, Serbia has still not witnessed an early reorientation of its trade towards the EU; it has still not engaged in diversified its exports away from agriculture and a few low-processed manufacturing goods, and has not seen its producers integrate into international networks ofproduction and distribution, especially those ofthe EU.
3.80 The key constraints to export growth indicates the relative importance of domestic structural, institutional and supply constraints. First, the recent mix of macroeconomic policies fueled growth in domestic demand and the appreciation of the real exchange rate, and introduced an anti-export bias into the economy, by promoting rapid import growth while providing a disincentive for exporters to seek export opportunities. Second slow restructuring of enterprises and loose budget constraints has left Serbia with outdated productive structures with little capacity to trade and export. Third, the unfavorable business environment is hindering FDI and limiting opportunities for upgrading and modernizing production structures. Moreover, institutions to support exports have been weak. Further information on the proposed reform agenda in the first three areas is provided in other chapters ofthis report.
3.8 1 Changes in trade policy should consolidate the progress made towards liberalization and simplification of the trade regime and enhance the export orientation of the economy by removing the existing anti-export bias, reducing tariff escalation and departing from the (recently resurgent) use of non-tariff measures as a tool to manage trade. The introduction of a transparent and effective VAT rebate system upon implementation of the VAT in the future could also help promote exports. Moreover, greater efforts to establish functioning institutional arrangements goveming trade policy formulation and implementation at the State and member state level will be necessary in order to reduce facilitate trade within SaM, and with extemal trading partners.
3.82 Immediate and sustained efforts to strengthen trade-related domestic institutions would enhance export competitiveness. Three areas are of crucial importance: First, ongoing customs reforms should be continued and focused on streamlining border crossing procedures and restoring Customs credibility by enhancing control of fraud and smuggling. Second, modernizing the standards and technical regulations regimes to make it more compatible with the EU and international standards is a must for improving the penetration of Serbian products into external markets. Finally, consolidating the institutional and regulatory regime for export promotion is needed to support endeavors ofan existing and future exporters.
3.83 Attracting greenfield FDI is a key for Serbia’s exports to move up the value chain. Integrating into international networks based on production fragmentation requires sustained FDI inflows. Besides the conducive environment for business operations, this will necessitate the provision of rapid, efficient and least cost backbone services, such as transport and telecommunications. Another necessary incentive for inviting more FDI into Serbia is through
59 increasing the effective market size of Serbia by expanding the scope and depth of Serbia’s integration with the rest ofthe world.
3.84 Accelerating the process of regional and global trade integration, while ensuring close coordination among its various dimensions would further improve prospects for export growth. In the context ofthe Stabilization and Association process, both EU integration and liberalization with neighboring SEESshould go hand in hand in order to avoid potential trade distortions and risks ofhub and spoke effects. Accelerated movement to SEE and EU free trade in the next three to five years and convergence to EU tariffs over a longer term period should be considered. Prospects for increased intra-industry trade will also hinge on Serbia’s adoption of the Pan European Cumulation of Rules of Origin, and its active participation in efforts to broaden and deepen integration in the Westem Balkans. This needs to be accompanied however by stepped up efforts to accede to WTO in order to guarantee security for MFN market access, reducing the potential distortions arising from regional trading arrangements and modemizing the regulatory and legislative regime governing trade and investment.
60 Annex 3.1 Summary of FTAs Signed by SaM and their Compliance with the MOU Criteria Quantitative Trade coverage Liberalization pace restrictions Share of HS Share oftrade Share ofHS End of Number oflines FTA Country lines liberalized liberalized lines freed transitional with QRs upon (entry into force) (%> (%) upon eif (%) period entry into force ALB-S&M Albania 89.7 37.5 85'9 1 Jan. 2007 (2003) SaM 89.3 89.1 88.6 25 BIH-S&M BiH 100.0 100.0 25.6 18 (2002) SAM 100.0 100.0 99.9 Jan. 2004 (QR on exports) BUL-S&M Bulgaria 88.4 87.4 1 Jan. 2007 (2003) SAM 87.6 94.0 78.1 25 CRO-S&M Croatia 94.7 90.3 5 (on exports) 89'1 1 Jan. 2007 (2003) SAM 93.9 77.6 91.1 25 MAC-S&M Macedonia 100.0 99.9 97.4 1 Jan. 1999 62 (on exports) (1996) (1996.00) SaM 100.0 99.9 98.7 129 (on exports) ROM-S&M Romania 88.8 89.9 86.2 1 Jan. 2007 (2003) SaM 88.5 96.9 86.9 25
Serbia Albania Croatia Bulgaria Romania BiH 1999 2002 1999 2002 1999 2002 1999 2002 1999 2002 1999 2002 Food products 3.06 3.89 0.82 1.01 0.50 0.99 1.51 1.50 0.52 0.34 0.28 0.33 Agriculturalmaterials) 3.27 2.79 3.41 3.27 3.82 4.16 1.50 1.25 1.20 0.84 9.25 6.96 Ores,Minerals&metals 3.43 4.29 0.56 1.11 1.17 1.61 3.18 3.06 1.30 0.90 4.38 5.74 Plastics (57) 3.15 3.53 0.01 0.00 8.02 4.40 1.41 1.21 1.14 0.66 1.12 0.01 Leather (61) 4.02 1.27 6.35 5.84 1.18 4.40 1.13 0.62 1.16 1.34 0.56 0.63 Rubber (62) 9.57 9.66 0.06 0.05 0.26 0.22 1.00 0.71 1.07 1.63 0.42 0.03 Woodproducts(63) 2.31 2.09 1.36 1.16 3.62 3.46 2.28 1.97 2.64 3.05 3.03 2.71 Clothing (84) 2.44 1.87 6.18 5.26 4.29 3.72 4.59 4.49 6.50 6.42 4.44 2.98 Footwear (85) 4.19 5.05 29.22 30.80 7.55 5.91 4.55 4.61 11.41 11.74 12.84 12.97 Ironand steel (67) 4.11 2.99 2.99 2.25 0.82 0.70 7.69 5.01 3.54 2.08 2.14 1.47 Furniture (82) 1.96 1.54 0.77 0.84 3.70 4.39 1.44 1.59 5.49 4.06 2.60 7.58 Transport equipment 1.04 0.74 0.01 0.02 1.24 0.86 1.54 1.57 0.96 0.90 0.18 0.88
61 4 PRIVATE AND FINANCIAL SECTOR REFORM
A. INTRODUCTION
4.1 The development of a competitive enterprise sector in Serbia, including a vibrant SME component, is absolutely essential for generating sustainable economic growth and employment. In turn, this requires the restructuring of enterprises that “crowd out’’ SMEs by preserving a non-level “playing-field”, the establishment of a business-friendly investment climate and the emergence of healthy financial system capable of providing intermediary services on an affordable basis. The functioning of the private and financial sectors will impact directly on the three components of the classical growth accounting framework described in Chapter 1 - capital accumulation, higher employment, and the growth of total factor productivity. A dynamic private sector can also contribute to macroeconomic stability and improved debt dynamics. The strong link between these sectors and economic growth is also demonstrated by ample evidence from other transition economies (World Bank, 2002).
4.2 The transition experience has also shown that an integrated approach is necessary to successfully reform the real and financial sectors. The privatizatiodliquidatiori of state- and socially-owned enterprises, and the entry ofnew firms (both local and foreign) facilitated by the improved business-enabling environment, are expected to lay the basis for sustainable growth. At the same time, financial sector reforms are expected to encourage domestic savings and enable better access to financing, thus generating the working capital and investment finance needed for the private sector to expand. At the interface between private and financial sector reforms is the problem of very large historic debts in the Serbian economy, which is central to the resolution oflarge enterprises and state-owned banks.
4.3 The main objectives ofthe present chapter are:
0 To provide an up-to-date snapshot of the Serbian enterprise and financial sector, highlighting the progress made since the start ofreforms in 2001. 0 To identify remaining constraints that prevent the enterprise and financial sector from fully contributing to growth and employment creation. 0 Based on this analysis, to provide policy recommendations to the Serbian authorities concerning priorities in private and financial sector reform over the next three years.
4.4 The rest ofthis chapter looks in more detail at each ofthe three broad policy areas facing the authorities - enterprise sector reform, business environment reform, and financial sector reform - focusing in each case on current status, existing impediments to growth, and main policy recommendations. The contents of each section are underpinned by the detailed data analysis undertaken for two recent or upcoming more focused World Bank analyses - Investment Climate Assessment (ICA), and Financial Sector Note (FSN). Readers are encouraged to tum to these reports for more in-depth coverage ofissues raised. B. ENTERPRISESECTOR
Legacy of the 1990s and Progress to Date
4.5 As briefly noted in Chapter 2, Serbia’s real sector became largely inefficient during the 1990s. This was the result of several factors, including macroeconomic instability, loss of markets, isolation from technological advances, continued dominance of socially-owned enterprises, and ill defined property rights. Disinvestment and isolation during the 1990s had an extremely harmful effect on Serbia’s international competitive position as the country’s industry largely missed a whole decade of rapid technological improvements. In addition, the Kosovo conflict of 1999 caused pervasive disruption to economic activity and significant damage to the country’s capital infrastructure.
Box 4.1 The Informal Economy
The 2003 Poverty Reduction Strategy Paper for Serbia estimated that about one million people in Serbia in 2002 were involved in the informal economy (IE), which represents a little less than one third (30.6 percent) of those who actively participated in the labor market. Apart from this, 10.8 percent of the persons that had a main job in the regular economy had an additional job in the IE. Those involved in the gray economy represented 42 percent of poor employees in 2002. A recent survey of formally registered companies found that almost one quarter of their sales have not been reported.
One can easily recognize some similarities between the situation in Serbia, and Hemando De Soto’s famous work on informality in Peru. (De Soto, 2002). His argument is that formalization of business could be encouraged by secure property rights which in tum require contract enforcement. Recent research suggests that the real cost of the informal economy to govemments, in addition to the reduced tax base, is the cost of programs to help the “informal poor” (Djankov, Lieberman, Mukherjee and Nenova (2003)). The leakage in social support stemming from the higher unemployment levels and lower reported income increases the fiscal cost of the programs. In other words, because proper targeting of social support is more difficult when more people appear unemployed or to have low income than the true number of eligible poor and unemployed, the cost of the program goes up and there may be more pressures to lower the benefits, to the detriment of those whose living depends entirely on these payments. Serbia should focus or continue to focus on the following three issues that could have attracted entrepreneurs to the formal sector, had they believed that formal firms do enjoy these benefits: (i)contract enforcement (especially the functioning of the courts); (ii) access to finance (particularly bank credits); and (iii)clear title to land and real property.
The EBRD’s Transition Report 2000 argued that incentives for participation in the informal sector differ depending on the country’s stage of reform. In economies at a mature stage of reform (e.g., EU accession countries), the motives tend to be more ‘market-related’ and guided by a desire to evade taxes and avoid other bureaucratic constraints. In economies at an initial stage of reform, informal activity is interpreted as being driven by poor opportunities in the formal sector and is seen as providing a ‘coping strategy’ for survival. Both motives co-exist in Serbia at this stage. As a recent survey shows, formal enterprises try to keep their activities “blended” in order to avoid the administrative and financial burden of taxation and regulation (EBRD, 2000, p. 97). Currently, the profits of many registered small businesses largely depend on the evasion oj existing payroll taxes and social security contributions.
4.6 During the 1990s, the regulatory burden increased due to frequent and discriminatory administrative control and taxation of companies. Price controls were also widely used in order to substitute for effective social policies and to suppress inflation, while the tax system was highly distortionary. Rigid labor regulation protected redundant employees in the social and state sector, preventing labor shedding. While a significant share ofthe formal sector of the economy came to depend on explicit or implicit state subsidies, a very large informal sector developed sophisticated means of evading taxes and circumventing laws to finance its activities (see Box 4.1).
63 4.7 At the core of Serbia’s enterprise sector reform strategy over the past three years has been the ambitious program of privatizing socially-owned enterprises (SOEs). The program is based on the Privatization Law adopted in June 2001, which incorporated international best practice and lessons learned from other transition economies. The law stipulates three methods of privatization: (i)tenders of large enterprises, offering to a strategic investor at least 70 percent of the shares; (ii)auctions of medium enterprises; and (iii) restructuring and subsequent tenders and/or auctions of large loss-making enterprises and/or parts thereof.
4.8 The progress made by the Serbian Privatization Agency (PA) in pursuing tender and, especially, auction privatization tracks has been considerable, although as ensuing sections will demonstrate, there has been much less progress with the resolution of large problematic SOEs. As shown in Table 4.1, well over 1,000 firms have been sold through auctions. It is now expected that a total of 2,500 firms (including those already sold) will be divested by this method. The tender privatization program has made good progress up to now in a difficult sales environment although progress has been limited by: (i)excessive company staffing levels; (ii)overly ambitious requirements imposed on the potential new owners to retain most or all of the labor inherited; (iii)recession in European markets; and (iv) the perceived risk of Serbia. A number of tenders are still underway, either as initial tenders or re-tenders from failed first tenders. Finally, the Share Fund sold a number of minority stakes remaining in state hands in companies privatized before 2001 on the Belgrade Stock Exchange (BSE).
Table 4.1 Privatization Results 2002 - October 2004 Total Tender Auction Share Fund No. ofenterprises offered 1,615 74 1,22 1 320 No. ofenterprises sold 1,256 39 1,027 190 Success rate 78% 53% 84% 59% No. of employees in sold enterprises 173,155 38,456 94,885 34,977 Proceeds (in 000 EUR) 1,395,576 812,860 404,992 177,724 Investment Commitments (in 000 EUR) 802,636 685,157 111,578 5,902 Source: Privatization Agency of Serbia.
4.9 Private companies are outperforming state-owned and socially-owned firms. Although it is too early to analyze the effect ofthe 2001-2003 privatization on the productivity of the firms privatized under the 2001 Law, the performance ofthe new (de novo) private firms and even the firms privatized before 2001 is clearly better than that of the socially owned firms. A statistical analysis of 408 firms in Serbia in 2003 indicates strong and statistically highly significant ownership effects in all measures ofperformance (see Table 4.2).95
95 Privatized firms are 18 percent more likely to be making profits than SOEs; new private firms are 32 percent more likely. Privatized and new private firms have sales growth rates that are 15-20 percent faster than those of SOEs. Employment growth in new private firms is 6 percent faster than in either privatized firms or SOEs. Lastly, labor productivity growth in privatized firms is 12 percent faster than in SOEs.
64 Table 4.2 Enterprise Performance by Type of Ownership Performance difference TFP (%) Profit-making Sales growth L growth L productivity vs. socially-owned (probability, in (YOp.a.) (YOp.a.) growth(% p.a.) enterprises YO) Privatized firms +89.0* +15.4* +15.6** 1.7 +12.7* New private firms +242** +32.5** +17.6** +6.4** +8.1 Based on Serbia Productivity and Investment Climate Survey (sample ranges from 229 to 408 firms). * = Significant at the 5% level. ** = Significant at the 1% level.
4.10 The analysis shows that the level of total factor productivity (TFP) of privatized firms is about 90 percent higher than that of SOEs; the TFP level of new private firms is closer to three times higher. However, there is a potential endogeneity or reverse causality problem with these apparently powerful results for privatized firms. The 1997 privatization law allowed employees to take firms private if they so chose, and many of the best firms were privatized in this way. The better performance of some privatized firms may simply reflect the fact that only employees in the better companies decided to take their firms private. The results for new entrants, however, are unambiguous: new private firms in Serbia are more productive and growing more rapidly than socially owned enterprises. By being more profitable than the rest of real sector, private enterprises provide an increasing contribution to the overall savings rate, an important factor given Serbia’s current account position (see Chapter 2). These strong empirical results imply that the continued commitment to private ownership via either privatization (which -may take place via bankruptcy or require restructuring) or facilitating new private entry is a key engine for the increased profitability and productivity ofenterprises.
Remaining Challenges
4.1 1 Despite the progress made over the past three years, Serbia still has a long way to go in building a private sector comparable to the other Central European countries. Following the privatization in 2001-2003, the share of employment in private enterprises is consistent with the EBRD’s estimate that 50 percent of Serbian GDP is produced in the private sector as ofmid- 2004 (EBRD, Transition Report 2004). In this respect, Serbia compares unfavorably to 80 percent in Hungary and the Czech Republic, 75 percent in Bulgaria and in Poland, 70 percent Romania and 65 percent in Slovenia and FYR Macedonia or 60 percent in Croatia.
4.12 As the private sector is clearly emerging as the primary engine of growth continued reform of SOEs through privatization of viable companies and exit of unviable ones is essential to sustain growth. The five most important challenges for the future of the privatization and restructuring program are as follows:
(i) Protection of property rights in general and of investors in particular is a critical necessary condition for the success ofall the reforms mentioned below.
(ii) Continued privatization and restructuring of large SOEs by breaking up non- marketable firms and by hardening budget constraints in order to put their assets to productive use.
65 Establishing an effective bankruptcy mechanism to facilitate the reallocation of capital and human resources ofun-restructured and failing firms for alternative, higher productivity uses.
Transparent sale of minority stakes remaining in state hands in the large number of companies privatized before 2001 under previously prevailing laws, with a view to improving the corporate governance and thus performance ofthese companies, some of which have good potential for growth.
Reform of state-owned infrastructure firms, the privatization of which will require considerable preparation in policy and regulatory terms.
Short to Medium-term Reform Agenda
Protection of Property Rights
4.13 The protection of property rights is critical for attracting FDI and local investment. Unless clear illegal transactions have been proven, the reversal of privatization transactions would introduce uncertainty and be detrimental to future transactions. Major changes in the Privatization Law, such as those discussed in the spring of 2004 by the Parliamentary Privatization Committee, would undermine investors’ confidence. To attract FDI and local investment, the Government must ensure a consistent treatment of the first group of investors which bought companies in tenders. With high risk and without abundant natural resources, almost all FDI in Serbia in the first period 2001-2003 was related to privatization. Moreover, the success of these “brownfield” investments could play a key positive role in lowering the perception ofrisk of new potential “greenfield” investors. However, this will happen only if the current “brownfield” investors find the investment climate acceptable and are treated fairly. The experience so far is limited but sometimes worrisome.
Continued Restructuring and Privatization of SOEs
4.14 The authorities need to continue the tender and auction privatization of SOEs remaining in the PA pipeline. Although structural reforms in Serbia have advanced more slowly than-desired in certain areas since late-2003, owing mainly to political uncertainties, the implementation pace has picked up since mid-2004, as evidenced by the approval of a series of key economic reform laws by the Parliament of Serbia including those on bankruptcy, VAT, and energy. Enterprise privatization has also resumed with the issuance of tenders for eight socially- owned enterprises and 191 auctions. This progress needs to be maintained through the launching of further tenders and auctions based on the existing model of strategic ownership. As described in Box 4.2 below, the experience of other countries has shown the failures of privatization methods that are not based on strategic ownership. Against this background, any major changes in the Privatization Law, such as a give-away of shares of auctioned companies to employees or increased social program requirements, would inhibit the interest from potential investors and the chances ofa successful transaction.
66 4.15 As of end-2003, some 60 large problematic industrial conglomerates had been selected by the authorities to undergo organizational and/or financial restructuring as they cannot be sold in their current condition. Using the technical assistance funding provided by donors, the PA engaged teams of international and local advisors to lead the preparation and implementation ofprivatization through restructuring programs for most ofthese companies.
4.16 The challenge in 2004-2005 will be to expedite the resolution of the remaining companies in the restructuring program in a transparent manner. The restructuring and braking up ofnon-marketable firms has proven a key channel in transition economies for putting the assets, including the real estate, of loss-makers back to productive use. This is especially helpful for the important SME sector. Such restructuring, along with the elimination of hidden subsidization through soft loans from the Development Fund (and elsewhere), will be crucial for hardening budget constraints, and ending the tolerance of arrears. To this end, the authorities should be prepared to exercise the companies’ public debt restructuring in cases when there is an attractive bid (see Box 4.3). Lack of cooperation from state creditors has proven to be a key obstacle to restructuring. To this end, amendments to the Privatization Law are being drafted which will incorporate the new debt resolution scheme. The Government/PA also need to improve the regulatory framework for the sale of enterprise assets by describing the mechanism for establishment of the escrow account and the use of the proceeds out of the escrow for creditors. Finally, unsaleable loss-making conglomerates and/or parts thereof should be subject to bankruptcy procedure under the new bankruptcy law (see below).
Establishing an Effective Bankruptcy Mechanism
4.17 A well-functioning bankruptcy/liquidation regime will promote efficiency and productivity. It will do so in two ways. First, by supporting creditor’s rights, it will facilitate lending to firms that are going concerns. A regime that fails to protect creditors when a firm defaults will cause creditors to be unwilling to lend or to do so only at high cost. Second, the bankruptcy/liquidation regime promotes efficiency by enabling bankrupt firms to be financially restructured (if the firm is viable as a going concern and has a pure debt problem), physically or organizationally restructured (if the firm is viable as a going concern but only after, say, managerial change or restructuring or sell-offs of some production facilities), or shut down with assets being disposed (if the firm is not viable as a going concern). “Exit” in the sense of stopping production activity is not enough; what is also needed is the reallocation of the assets that are freed up, and this is what a good bankruptcyAiquidation framework facilitates.
4.18 Institutional strengthening and strong political will are needed to implement the new bankruptcy framework. The new Law on Bankruptcy sets the basis for improving creditor rights by simplifying and accelerating bankruptcy. However, the law cannot work unless the requisite institutions are established. In many other post socialist economies, bankruptcy cases were fraught with collusion among bankruptcy administrators, judges and creditors. For this reason the creation of a specialized institution that will take care over bankruptcy administration of a socially- or state-owned enterprise is a promising concept if properly implemented. Under the law, the court will make more judicial rather than operative decisions, while a bankruptcy administrator will have a more active role, yet still be subject to oversight and supervision by the court and the creditors committee. The administrator will have much more authority to manage
67 the procedure without prior judicial approval or direction. The temporary centralization of the administration function in the PA is as much a challenge as an opportunity. However, until now the Government did not focus much time on these issues. The PA will need significant technical assistance to implement this task. Finally, the effectiveness of the new bankruptcy regime will require political will by the government to initiate bankruptcy proceedings in its role as creditor of SOEs through the tax administration, the electric power company (EPS), and state-owned banks.
Box 4.2 Privatization: The Lessons of Transition
No method ofprivatization is perfect. In addition, every method imposes some pain and costs on the economy and society. Worldwide experience suggests that trying to do “painless privatization”- or not doing privatization at all- imposes the highest costs ofall.
The privatization methods in Serbia prior to the 2001 Law were based on a “give-away” of most of the shares to the employees. These methods are quite similar to the voucher privatization used in Russia and many other post- socialist countries. The results both in Serbia and in the other countries were disappointing: all too often, former managers remained in control and did not change the way the firms worked. These “insider” owners failed to restructure fm to allow them to compete in a market environment. Corrupt managers and agile outsiders took advantage of an unsettled legal environment to “tunnel” (as the Czechs called it) the best assets out of firms and into their own hands, leaving the mass ofshareholders with debt-ridden shells.
On the other hand, the post-socialist countries that had better results from privatization- Hungary, Estonia, the former German Democratic Republic and now Serbia under the 2001 Law - did not use the voucher approach to any significant extent. Their prime goal was to find “real” owners; that is, investors willing to put some capital at risk to obtain a majority or dominant position, thus giving them an incentive to turn the companies around. Firms privatized by sale to these “concentrated” investors performed muchbetter then firms privatized to workers, former managers, or the broader public.(Djankov and Murrell, 2002). In countries where both approaches were used, firms sold to core investors far outperformed those sold by “mass” means (e.g., in the Czech Republic) (World Bank, 1999).
The Slovenian privatization model was also considered but found inappropriate for Serbia. Slovenia was able to allocate most shares in its enterprises to employees and to state-owned funds, because its enterprises were relatively stable and productive. In Serbia, however, the initial conditions were so disastrous that it became cleai that only new owners could salvage the de-capitalized loss-making enterprises from even Mhercollapse. In fact, a Slovenian-type privatization was tried in Serbia from 1997 until 2000. Under the 1997 Privatization Act, lOOC companies, including some ofthe best in Serbia, were given away to insiders, yet most ofthese companies are still faltering and only a handful are successful.
Another lesson of regional experience is that a lack of institutional capacity affects the quality ofnew owners, the proceeds generated, the fairness to minority shareholders and the level of corruption involved in the process, anc the amount and pace ofpost-privatization restructuring. Having learned this lesson, Serbia moved fairly quickly tc establish and staff the PA, and to build capacity to hire and supervise international financial advisors. The PA war able to attract experienced investment banks on a fixed fee plus a success fee compensation basis, in spite of higl. country risk and low quality ofthe companies. The hiring process for the financial advisors was competitive anc transparent. Auctions started slowly because of inadequate design and legislation, and lack of administrativt capacity. Initially, the PA was able to attract good local staff because it was able to pay salaries competitive wit1 the private sector, foreign banks and companies. However, over time the salaries in the private sector rose and tht PA is now losing many ofits most talented and experienced staff.
I
68 I Box 4.3 Approaches to Debt Workout If bad debts are carved out from banks to allow their privatization, where should these debts be placed? Asset Management Companies (AMCs) have a mixed record at best. Recent researchg6distinguishes between two types ofAMC: those set up to help and expedite corporate restructuring and those established as vehicles for rapid asset disposition. Only one in three ofthe corporate restructuring AMCs achieved their goals, while the experience with the other type was only a little better.
One option would be to put the BRA (Bank Rehabilitation Agency) in charge ofthe carved-out debt. The BRA as a specialized financial organization that conducts rehabilitation, bankruptcy and liquidation of banks is already setting up a Bank Consolidation Unit (BCU) that would manage assets taken over from banks in bankruptcy or rehabilitation. A second option would be to put the PA in charge of the carved-out debt. Here, distinguishing between claims on socialized firms to be privatized and claims on private sector firms may be useful. The PA or an agency in it could act as a rapid disposal AMC for claims on private sector firms; there is, of course, already some expertise in the PA on selling off assets. Claims on socialized firms to be privatized would be managed by the PA as part of its privatization mandate and would when necessary be written down or written off as part of privatization deals. This represents a time-limited process with a clear endpoint (privatization). The PA is as well or better placed than other government agencies to exercise corporate govemance via these claims. It reduces coordination problems associated with privatization and debt write-offs. To the extent it speeds privatization, it reduces the total volume ofsubsidies these firms are able to extract from the government.
Secondary Privatization
4.19 According to the 1997 Privatization Law, firms could be privatized by offering shares to employees at a generous discount and on generous terms, that is, below the valuation price with easy payment arrangements. Up to 60 percent of the shares could be distributed free ofcharge. By the time the 1997 Act was replaced by the 2001 Privatization Law, almost one thousand enterprises had completed privatization through a majority of shares being transferred to employees. The remaining shares in these companies were retained either directly by the government or placed in government controlled special funds. Experience in many other post-socialist economies has shown the difficulty of selling residual minority shares in enterprises dominated by insiders in settings where there is very little legal protection for shareholders rights and limited possibility of exit. Moreover, and as noted, the removal of these higher-quality enterprises from the market depresses investor interest and thus hinders the program’s main goal: to put as many firms as possible in the hands ofgood new core owners.
4.20 However, since October 2003, the introduction of several regulations and measures has limited the scope for the minimum price - minimum quantity method and largely brought Share Fund (SF) sales to a halt. To enable smooth continuation of sales, the government should:
1. Create a strategy for disposal of all SF assets, which would include a review of the present portfolio, an assessment of stakes likely to revert to the SF as a result of defaults, and an assessment of which stakes should be disposed of and by what method. It should also assess the feasibility of such disposal within the 2007 deadline and the implications
96 See, for example, Klingebiel(2000).
69 of such disposal for the SF’s operations. The focus would be primarily on disposal of stakes that cannot be sold through the MPMQ method;
2. Enable the SF to protect the value it holds by allowing it to vote its shares in circumstances were the value would be damaged; and
3. Remove barriers to the sale of stakes larger than 25 percent and the use of the MPMQ sales methodology so that sales ofsuch larger stakes - the ones most likely to achieve the best financial and economic result for the govemment - can resume.
Reform of State-owned Utilities
4.21 The Serbian state directly owns a number of significant infrastructure companies (airline, electric power, gas and oil, post, water, telecommunications). Most ofthem could be offered for privatization after some initial restructuring (workforce and debts) is completed and an adequate regulatory framework is put into place. Some of the companies are profitable, like the petroleum company NIS. Others are losing large amounts (e.g. the railway ZTP that lost 171 millions euros in 2002). In between, EPS, the power utility, improved its profitability with the steady increase in prices but still needs to be unbundled and restructured before the privatization of some of its components can become an option. This report does not elaborate in greater detail on the financial situation of the utilities, which will be revealed by several important studies of these issues currently under preparation. However, that the continued subsidization of ZTP is a serious fiscal burden, and the overall financial situation and cost levels ofthat company impose a significant burden on the whole economy.
4.22 In a high-risk environment, foreign investors can be attracted only by enterprises which have a stable market as in communications and energy. To ensure such an outcome and to avoid lack of transparency (which is a risk when the company itself spins offs its units by a joint venture with a foreign partner or even worse when assets are sold outright), spin offs from the unbundling ofthe large state owned enterprises need to be sold through tender privatization.
4.23 Yet, despite the urgent need for improved infrastructure performance, one must proceed with caution. The experiences of other transition countries, corroborated by evidence from Latin America (the region where reform and private participation in infrastructure has been most extensively applied), reveals the many and serious pitfalls ofhastily prepared privatization in general and infrastructure privatization in particular (Harris, 2003). The principal lesson of experience from the 1990s is that ownership change alone will not solve all the performance problems of poorly performing infrastructure firms. Reforming governments must pay careful attention, prior to the handing over of infrastructure firms to private ownership or management, to the five legal/policy areas mentioned above. If not, negative outcomes can occur, in both efficiency and equity terms. Ownership certainly matters, but governments-and the market- guiding institutions that they create and sustain-matter as well.
4.24 The political economy of infrastructure divestiture must be handled carefully. Poorly handled infrastructure privatization has in many instances contributed to declining political support for the enacting regime. Indeed, based on world experience, the substantial
70 technicaVfinancia1 improvements that usually follow private participation in infrastructure have often not been sufficient to offset negative public reaction to these privatizations. Common criticisms are that privatization in general, and infrastructure privatization in particular, results in a loss of sovereignty; i.e. the handing over of what many consider to be key national assets to foreign management and control. A second criticism is that privatization increases unemployment and results in higher prices for essential services (especially in water, electricity and transport), thus contributing to increased inequality and poverty.97 Third, there is a widespread belief that many large privatization and concession transactions have been tainted by collusion between bidders and officials, or fraud and corruption of some sort. This belief is especially common in transition countries, where the breakdown of the old institutional-legal system, and the embryonic nature of its replacement, has increased the potential for abuse in transaction^.^'
4.25 Additional legal complications must be resolved before the restructuring and privatization of utilities can be considered. When the capital of a company is purchased, investors expect that they can use the purchased assets (equipment, buildings, etc.) as they see fit. This assumption, however, applies only when the privatized firm actually possesses the assets. Unfortunately, this is sometimes not the case for state owned companies in Serbia. The Law on property owned by the Republic of Serbia adopted in the early 1990s stipulates that all assets being used by state owned companies are the property of the Republic, rather than of the company itself. As a result, Serbia is facing an unusual situation where both the capital and physical assets belong to the state. This creates a number of legal problems, the most important ofwhich is that it is not feasible to privatize the capital without prior resolution ofthe ownership of the assets. The adoption of the new Company Law constitutes an important step in this respect.
4.26 The restructuring and privatization of the largest debtors to the public utilities needs to be accelerated. The sale of the debtors or, more likely, parts thereof (which indicates that a genuine restructuring has started) is a pre-requisite for stopping the continued pressure for subsidies via accumulation of new arrears to EPS and others. Previously, the PA had already offered for sale three of EPS’ large electricity debtors. This process needs to be extended by launching the restructuring of more companies from the “list of 12”.
Competition
4.27 Enhanced inter-enterprise competition is essential for improving productivity. Serbia’s inherited industrial structure is characterized by enterprises which are large relative to market demand, although often small relative to their international competitors. Subjecting these
97 The conclusion that privatization invariably and inevitably increases poverty and inequality levels is not based on hard evidence (see Birdsall and Nellis, 2002). Nonetheless, recent and rigorous empirical studies of the equity impact of infrastructure privatizations in four Latin American countries conclude that privatization contributed only slightly to rising general unemployment levels; that “. . . privatization has a very small effect on inequality”; and that “privatization either reduced poverty or has no effect on it.” (McKenzie and Mookherjee, 2003, p. 195). 98 Indeed Serbia has already witnessed a sub-optimal infrastructure partial privatization. In June of 1997, the Serbian govemment sold a 49% stake in PTT Traffic, the Serbian telephone company to foreign state-owned telecommunications firm. The transaction brought significant revenues. However, from the outset the transaction was criticized as not meeting standards of transparency. The high price reflected the monopoly position that was granted to the investors, which has hampered the dynamic development of the Serbian telecommunications sector.
71 firms to greater competition is the key to enhancing their efficiency, and thus their contribution to economic growth.
4.28 In the short term, the most effective competition will come from imports. In fact, the greater exposure of tradable producers to the international market following the foreign trade reforms of 2000 and 2001 (see Chapter 3), combined with progress in other structural reforms, appears to have moderately enhanced competitive pressures in the Serbian economy. Recent surveys (see Box 4.4) show that while 29 percent ofthe surveyed firms in 2001 stated they have no competition in the domestic market, only 12 percent perceived no competition in 2003. These surveys also find stronger competition among new private firms than in privatized businesses or SOEs. However, the role oftrade is still constrained by non-tariff-barriers, which work to protect local producers, for example, by requiring certification, as described in Chapter 3.
4.29 In the medium-term, Serbia will also benefit from a legal and institutional framework to directly promote competition. The first step in this process will be the adoption of a new Competition Law. The adoption of this law needs to followed by creation of an independent authority that will have the power to deny requests for mergers and set maximum prices for monopoly products. Most difficultly, it may need to order and oversee the break up of companies that abuse their dominant position. The new Authority is likely to meet strong opposition from powerful interests which oppose the break up of their groups. Therefore, the establishment of such authority will not be an easy task and it is unlikely that the authority will be hlly effective for several years.
C. BUSINESSENABLING ENVIRONMENT
Legacy of the 1990s and Progress to Date
4.30 Since late 2000, the Serbian authorities have made significant progress toward improvement of the business environment, including liberalization of foreign trade and investment, simplification ofthe tax regime (albeit with some slippage in 2003), modemization of labor legislation, and some reduction of the regulatory burden imposed by a myriad of required licenses and permits. The number of SMEs has grown, as shown in Table 4.3.
Table 4.3: Evolution of Serbia’s SME sector, 2000-2003 2000 2001 2002 2003 Number Workers Number Workers Number Workers Number Workers Number of 2 16780 223796 234027 239270 registered SMEs Nimber of 61722 610619 63985 581193 66219 654768 67703 669442 active SMEs Number of 176724 353448 188812 377624 195186 390372 207596 415192 shops Source: SME Agency and Solvency Center
4.3 1 In parallel, the authorities initiated reform of the administrative and legislative barriers to entry by introducing the new Law on Business Registration, and by building institutional capacity for regulatory reform. Recognizing the importance of improved access
72 to finance for the private sector to reviving the Serbian economy, the Government worked to reform the financial sector as well as the legal and regulatory framework necessary to provide the right incentives for banks and non-bank financial institutions to finance the private sector. The Government has introduced the legislation needed to establish the system of secured financing and leasing. In addition, to simplify land acquisition and to improve access to the development and use ofconstruction land, a new Law on Urban Planning and Construction was enacted in April 2003.
Remaining Challenges
4.32 Despite the progress described above, Serbia’s business climate has major remaining weaknesses. One indication is the results ofvarious surveys of Serbian businessmen. To this end we look at two key surveys - Productivity and Investment Climate Survey and Business Environment and Economic performance Survey (see Box 4.4) - that enable us to track investment climate changes over time as well as to compare Serbia to other relevant countries. The World Bank Serbia Investment Climate Assessment (ICA) examines these issues in greater detail.
4.33 In these surveys, the factor which is rated as the biggest obstacle is economic policy uncertainty. This is understandable in light of the collective memory of the hyper-inflation, political instability and the assassination of Prime Minister Djindjic in March 2003, not long before the PICS took place. In such circumstances it has been difficult or impossible for business owners to plan long term investments. Only investments with very high internal rates of retum are attractive but they are accompanied with very high risks offailure.
Box 4.4 PICS and BEEPS I1
Two main fm level surveys used for this report are Productivity and Investment Climate Survey (PICS) and Business Environment and Enterprise Performance Survey (BEEPS 11).
PICS is composed of a core set of questions and several modules that can be used to explore in greater depth specific aspects of the investments climate and its links to firm-level productivity. The PICS sample conducted in Serbia differed from that used in other countries as it did not exclusively cover manufacturing firms. This was done to ensure comparability with the same survey done in 2001. The sample is relatively large (408 firms) and representative ofthe composition ofthe Serbian economy.99
BEEPS 11, a survey by the European Bank for Reconstruction and Development and the World Bank, utilized a standard survey instrument applied virtually simultaneously to nearly all countries in Eastem Europe and Central Asia, thus ensuring comparability. BEEPS I1 is a follow-up of an earlier BEEPS survey conducted in 1999. The survey in Serbia had a sample size of approximately 230 firms in 2002 (BEEPS Idid not cover Serbia). Most BEEPS I1 questions can be found in the core PICS instrument. Generally, sampling strategy is different in BEEPS I1which is hghly skewed toward smaller
4.34 A synthesis of numerous information sources reveals several particularly problematic aspects of Serbia’s business enabling environment, both from the perspective of
99 See http://www.worldbank.org/privatesector/ic/ic_ica_tools.htm. looSee http://info.worldbank.org/govemance/beeps/
73 the Serbian business community, and from a comparisons of Serbia to other countries. These sources include the noted and other firm-level surveys, expert analyses such as the ICA and “Cost of Doing Business”, and discussions and meetings with representatives of the Serbian private sector. Notwithstanding the legislative changes undertaken by the government, major weaknesses remain in the following key areas:
0 Contract enforcement. Serbia is characterized by a weak contract enforcement in courts (with weak judicial capacity increasing the case backlog), and an evident pro- debtor bias incorporated in the legislation. As a result, firms tend to use courts only as a last resort. This also makes firms less willing to deal with new customers and suppliers, thus resulting in fewer transactions. Combined with the inability of the courts to resolve disputes effectively, the legislation has led to uncertainty and confusion and provided a fertile ground for corruption. The difficulty of enforcing contracts also encourages informal activity, as a firm gains little from registering its business activity.
0 Access tofinance. Poor access to credit forces businesses to rely on their own sources of capital - either internal funds and retained eamings or money borrowed from friends and family. The lack of credit combined with the institutional uncertainties and political risks provides strong incentives to stay at least partly informal and short- term oriented. Therefore, making the legal and institutional environment more conducive to greater intermediation represents the key to establish financial system capable of delivering an adequate range of credit and other financial services to the enterprise sector, and especially to its expanding SME component that will represent a major contribution to real sector growth and employment generation.
0 Regulatory burden. The overall cost of compliance with regulatory norms, as well as the predictability of the business rules, and the fairness in their application represent serious problems in Serbia. The process often involves corruption and a high degree of inconsistency in the application of the rules, with public servants having wide discretionary powers in making decisions on minor issues that affect the issuance of permits, licenses and certificates.
0 Access to land and formalization of real property. Secure ownership and the ability to exchange land are critical for the investment climate particularly for foreign investments. Restrictions on land use and pervasive state ownership and control of urban land (particularly land that is open for construction) are major issues for the construction and services sector. In addition, the unresolved issue of restitution continues to create uncertainty and deter many real estate and other investors. Finally, the Serbian land administration system is in a poor state. In addition to almost 80 percent of apartments not being registered, the burdensome construction permitting procedures deserve the attention ofthe authorities.
4.35 All of these weaknesses lead to high transaction costs that also contribute to the significant and lingering presence of the informal economy. Reducing the cost of doing business (transaction costs) in an environment which is already perceived as uncertain represents
74 conditio sine qua non for raising the private sector’s productivity and competitiveness, as otherwise too high transactions costs would force business either to close or to “acclimatize” to avoid these costs. The next section outlines specific reforms in the above-mentioned four areas which will be crucial for improving the business environment and encouraging the formalization ofeconomic activity.
Short to Medium-term Reform Agenda
Contract Enforcement
4.36 Serbia’s courts are viewed as not functioning well and the administration of justice is slow and inefficient. This is a serious problem because contractual compliance and enforcement mechanisms-both formal and informal-represent a key feature of the investment climate. Companies rely on other institutions and informal practices to enforce contracts and reduce uncertainty in transactions e.g. relying heavily on pre-payments and by building long- lasting relationships (relational contracting) with suppliers and customers. However, relational contracting limits market dynamism as enforcement rests on the ability of the firm to punish its trading partner if it does not cooperate. A competent and trustworthy court system will encourage new partners firms to take part in more complex business interactions and produce more sophisticated goods, as they no long fear being cheated in their transactions.
4.37 While poorly functioning judiciaries are common for many economies in transition, the situation is particularly bad in Serbia. Table 4.4 presents the average number of procedures, duration and cost of collecting a debt through a rather straightforward lawsuit in the court systems of Serbia and some neighboring countries, based on the Cost of Doing Business Survey.’o’ The average time to collect on a debt through Serbia’s courts is almost three years (1028 calendar days). This is several times higher than in most neighboring countries (although some economically advanced transition countries with similar legal traditions, such as Poland and Slovenia, do not fare much better).
4.38 In addition to its problematic way of resolving disputes, Serbia’s court and judiciary system has a number of other deficiencies. Serbia’s judiciary has been under pressure for a long period oftime, and is characterized by passivity, lack ofresources and perceived corruption. There is an evident need for the court personnel to be trained, evaluated and compensated adequately. Lack of information sharing among judges leads to an increase in avoidable court cases and unnecessary appeals. This overloads the courts with many inactive or abandoned case files that create additional administrative burdens in organizing and maintaining active case files.
4.39 Near-term policy recommendations center on court reform. The recent adoption of the new Law on Execution Procedure represents an important step towards this objective. The new legislation promises some improvements even before the courts are reformed. Presently, for example, debtors use a series of articles to lengthen the process and to undermine the seizure of their property. The new law should allow judges to prevent these abuses. The equally important establishment of institutional capacity to improve contract enforcement is a more difficult long
lo’World Bank (2004~).Database available at http:/lrru.worldbank.org/DoingBusiness/.
75 term process. This will require strengthening the performance ofbailiffs through the adoption of the relevant by-laws and training, that should improve their skills and lower the possibility of delaying the execution and ofcorruption. Court resources (education, court statistics, information sharing) should be improved, in order to enhance overall court administration and management capabilities and to identify the courts’ primary users and key bottlenecks.
Table 4.4 Indicators of Contract Enforcement Number of cost Duration (days) procedures (YOof debt) Bulgaria 34 440 14.0 Croatia 22 415 10.0 Macedonia, FYR 27 509 32.8 Poland 41 1000 8.7 Germany 26 184 10.5 Romania 43 335 12.4 Serbia 36 1028 23.0 Source; Cost of Doing Business 2004
Access to Finance
4.40 In countries with weak legal and financial systems, the private sector obtains less external financing, and especially less term financing, than in countries with better developed systems. Significant gaps in the institutional arrangements for lending in Serbia raise the costs that banks need to incur in order to offer loans and other services safely (e.g., the weak arrangements from valuing and enforcing collateral). In addition, the high cost ofbank products, limited long-term sources of finds and poor technical skills inhibit the growth of credit to the real sector (see the ensuing section for analysis of Serbia’s banking sector). Finally, the fact that many potential clients of banks prefer to operate in the parallel economy (see Box 4.1) also reduces the population of good clients and projects available to banks. As a result, Serbian enterprises are forced to rely mostly on internal funds and retained earnings, thus deterring private sector growth and investment efficiency and impeding efficient reallocation of factors of production.”*
4.41 Several institutions that are key to creditors rights are still missing or have only recently been established. The establishment of a central collateral registry and credit registry have been recognized by the banking sector critical for improving access to finance. Although the Law on Secured Transactions was adopted in 2003, a centralized collateral registry had not yet been established in mid-2004. Finally, as an institutional response to the problem of asymmetric information in credit markets, especially as clients do not have clear credit history, Serbia has recently established a credit ranking agency (Solvency Center) while the banks under the umbrella ofthe Bank Association established a credit bureau.
4.42 Recently introduced government facilities aimed at improving the accessibility of credit, and at lowering the interest rate by reducing risk to banks, need to be restructured.
lo’What is unusual is the high absolute level of the ratio in Serbia (more than 80 percent). It is substantially higher than the corresponding figures based on the BEEPS survey in Croatia (52 percent), Hungary (63 percent), Bulgaria (66 percent), Poland (68 percent), Slovakia (69 percent) and Romania (70 percent).
76 These facilities include the continuation of the financing from the Development Fund (DF) and allocations of budgetary funds for the Guarantee Fund as well as several other mechanisms. In the past, the activities of DF raised significant concerns with regards to the governance, the transparency of its operations and the principles that should be driving the distribution of state resources. The experience of other countries in the region, as well as in Latin America and Africa, suggests that without proper oversight from the Government, such institutions may result in a significant fiscal burden and a deterioration ofthe financial discipline ofthe recipients ofthe subsidies. The use of funds needs careful monitoring as do their targeting to the most promising segments of the economy, and their timely repayment. Moreover, the present patterns oflending by the DF, and the use ofnon-market criteria for its credit allocations, may inhibit the growth of private lending to enterprise sector. Consequently, the purpose, scope, and mechanisms of DF operations should be revisited by the Serbian authorities as a matter of priority. The continued existence ofthis institution in its present form may have a negative impact not only on the future fiscal position of the state but also inhibit the establishment of a market-based, transparent and competitive financial system.
4.43 In the near term, the Government should focus more on the provision of public goods (contractkollateral enforcement) rather than on providing direct state support. New legislation that would improve access to financing (Mortgage law) should be introduced, while the performance of state-support funds needs to be audited. In addition, if macroeconomic stability is preserved and sound financial sector prudential regulation is enforced (see the next section), there is significant potential to increase the volume of the credit lines at unsubsidized interest rates through financial intermediaries that meet minimum eligibility criteria.
Regulatory Burden
4.44 A country’s general governance structure and business-government interactions are important components of the investment climate. In general, these include the burden firms face in complying with regulations, the quality of the services provided by these regulations and the extent to which corruption is associated with the procurement ofsuch services.
4.45 The network of government bodies with control functions in Serbia is complex, and their responsibilities are often vaguely defined and frequently overlapping. As a result, pervasive and confusing business regulations impose high costs on formal businesses. The time that senior managers have to spend dealing with government officials and regulatory activities provides a measure of the burden that regulation places on firms (so called “time-tax”). Both BEEPS and PICS record a tremendous loss of time. According to PICS, senior management spends an average of 17.2 percent of their time on dealing with requirements imposed by the government regulations, such as taxes, customs, labor regulations, licensing and registration. This is far more than in any other comparable transition economy. Private firms are burdened most heavily by the bribe tax (measured as the percentage of total sales paid in unofficial payments). They are paying on average 5 percent of their total sales to “get things done”. The PICS results point to the presence of a non-competitive bribe “market” among bureaucrats (Serbia appears higher on the bribe tax but more moderate on frequency suggesting more concentrated bribery). Surveyed firms also perceive a significant level of state capture, i.e. they are concerned that some firms are in a more favorable position (e.g. highest influence on laws
77 and regulations) because of “political connections” or their size (dominant firms or conglomerates in key sectors ofthe economy).
4.46 As noted in Chapter 2 an efficient tax administration that encourages voluntary compliance and effectively monitors tax payments is a central component of a growth- promoting tax system. However, the PICS survey findings point to cumbersome tax procedures and a large burden of tax inspections that placed the tax administration as the very problematic regulatory area for the operation and growth ofbusiness (in front ofprocedures for access to land and premises, documentation requirements or inspections). In addition, tax rates are ranked among top five investment climate constraints. While it is quite common that in business surveys worldwide virtually all firms complain about “high tax rates”, these complaints in the case of Serbia are sometimes justified.
4.47 The Government needs to take action on several fronts to reduce the regulatory burden. The public administration reform discussed in Chapter 2 is one important aspect. In addition, public discussions on the draft laws should be introduced as a rule and not as an exception. In some cases the inclusion of various stakeholders would contribute to improved govemment decision-making and oversight through voice and participation. The recent introduction of Regulatory Impact Analysis (RIA) represents an important step towards improving the regulatory environment. In order to improve the quality of regulations and to anticipate their impact on the economy, the implementation of the RIA requires a justification statement for all laws and other regulations that explains the expected benefits and costs of the actions, including the results of public consultations, which will have to precede each law or regulation. There is also a need to identify and remove overlapping functions of various state authorities (e.g. clear separation of areas ofcompetence, procedures, authorities and duties ofthe market inspection against other inspection authorities). The reforms of standards and technical norms described in Chapter 3 are also crucial.
Access to Land and Formalization of Real Property
4.48 Secure land ownership, the ability to trade real estate, and a functioning system for issuing construction licenses can promote economic growth by reducing risks and start-up and transactions costs. Countries with insecure property rights to land have lower rates of investment and less developed mortgage financing. Investors and bankers look for a clear property situation, well recorded in public documentation, with few barriers to changes of ownership and no disputes about restitution. The ability to trade property is also crucial for increasing overall productivity through moving property to its highest value uses. In addition, the issuing ofconstruction permits should be cheap, fast and free ofcorruption.
4.49 There are serious weaknesses in the system of land tenure and rights in Serbia. The Constitution of the Republic of Serbia enshrines urban construction land as public property, to which occupants possess only land use rights. In addition, the unresolved issue of restitution continues to create uncertainty about land ownership and deter many real estate and other investors. The new government has yet to announce its plan regarding the draft law on restitution. Unclear land ownership also creates problems in the agricultural sector, since it blocks the privatization ofagrokombinats and prevents the most productive use ofarable land.
78 4.50 High transaction costs in changing land ownership are an obstacle for the transfer of property and the maintenance of a proper cadastre. A very high 5 percent transfer tax apples to residential sales. In addition, a fee of 0.5 percent of contract value is charged for the court’s contract certification function, which is the equivalent of notary charges. Based on experience of other countries, excessive transaction costs may discourage registration of transactions and ultimately lead to long-term problems for the cadastre system. In addition, the Serbian real estate cadastre (land administration) system is in a poor state.’03 Almost 80 percent of houses and apartments are not registered and there is a significant backlog in civil courts (about 20 percent ofcases are land or property related).
4.51 The construction permitting process has been slow and complicated. It is too early to assess the results of the recently adopted Law on Urban Planning and Construction, but the evidence from the past points to burdensome procedures. The PICS reports that the average number of days for acquiring the necessary permits for construction and land to begin construction in Belgrade was from 6 to 12 months. This process has often been linked with corruption on various levels, which further increased the costs to investors. The combination of problems with licensing and land acquisition and the lack of effective public control resulted in a tremendous increase in the number of illegal buildings. The legalization of these buildings started with the enactment of the new law, and is ongoing. An estimated one million illegal dwellings will be covered. lo4
4.52 The creation of a favorable business climate requires the resolution of all outstanding issues concerning the urban land market. The impending constitutional reform provides an opportunity to modernize the constitutional treatment of urban land. Following the experience of other transition economies, this should at a minimum convert from “use” and construction rights to modern leases with defined durations and market rents. Full private land ownership should also be considered. In the near term, the government should also focus on further removal of various administrative barriers related to the access to land. A phased decrease and enhanced enforcement ofthe property transfer tax, with compensating increases in other taxes, should also be considered. In the longer-term this could include an enhanced role for taxes on the asset value of property. Serbia also needs to continue to enhance the currently limited human and physical resources in various components of the land management system, such as cadastre, conveyance, surveying, property valuation, mortgaging and other institutional services. All of these factors have to be in place before a land market can be expected to play a full role in the development ofthe private sector and the economy.
lo3Land records often do not match those in the legal registers kept in municipal courts, which results in a long waiting period for the resolving of such problems. In addition, real estate registers are incomplete and outdated. In large number of cases there are no proper records on the nationalization of the land, which may slow down restitution efforts. IO4 Although it is too early to see results, the law will contribute to the development of the real estate market, as 375,000 citizens as well as more than 7,000 enterprises applied for legalization. On average, the construction costs of a one-family illegal building is approximately 30,000 - 40,000 euros, which corresponds to more than 15 years ofthe average net salary. Although illegal construction is not a phenomenon solely related to marginalized social groups such as refugees and intemally-displaced persons, it will enable these groups easier access to finance and the establishment of new firms.
79 D. FINANCIALSECTOR
Legacy of the 1990s and Progress to Date
4.53 Similar to the situation in enterprise sector, the challenges of financial sector reform in Serbia should be discussed in the context of uniquely unfavorable circumstances preceding the country’s transition to market economy. A decade of sanctions and mismanagement resulted in huge macroeconomic imbalances, large-scale demonetization of the economy, and a discredited and deeply distressed banking sector.
4.54 Recognizing the importance of a functioning financial sector to reviving the Serbian economy, after January 2001 the new Serbian authorities set out to deal with the critical condition of country’s banks. The diagnostic audits prepared by intemational consultants and completed in spring 2001 confirmed that many of the existing banks simply had no further economic purpose, due to their legacy of non-performing assets, inadequate human capital and technology, and lack of public trust. Given the inability of the budget to re-capitalize the more seriously distressed banks, and the likely negative franchise value of most such banks, some 25 insolvent banks representing nearly two-thirds of the assets of the banking system were closed over the past three years. This process culminated in early 2002, when the authorities made a bold decision to apply the same definitive solution to the country’s four largest banks, which at the time represented 57 percent of total recorded banking assets.lo5 The Bank Rehabilitation Agency (BRA) was given extended authority to administer banks in bankruptcy. Together with some mergers and acquisitions, these actions reduced the number of banks in Serbia from 83 (2001) to 46 (mid-2004) (see Box 4.5).
4.55 In parallel, the authorities took initial steps to modernize the regulatory and institutional framework for financial sector operations. Substantial progress has been achieved in aligning banking sector regulations with intemational best practice, although the full effect of these changes will not be felt until the implementation of Supervisory Development Plan by the National Bank of Serbia (NBS) is completed. The new accounting law has been enacted, requiring all banks to adopt International Accounting Standards (IAS) from 2004. In early 2003, the payment system was transferred from a centralized operator to commercial banks without major disruption. New laws on leasing and secured transactions were adopted in 2003, and the improved law on insurance and amendments to securities market law were enacted in May 2004. Early efforts were also made on drafting ofa law on non-state pension funds.
4.56 In July 2002, the Government of Serbia initiated a debt-for-equity swap to cover the resolution of debts owed by Serbian banks to the Paris and London Club creditors. This conversion process remains incomplete due to earlier delays in reaching a final settlement with the London Club. Nonetheless, one result of this operation was a de facto nationalization of a large part ofthe banking system, with the state currently holding controlling equity stakes in nine banks [(including the third largest bank in the system)] and significant minority stakes in seven others (including the second largest bank in the country by total assets). Although the stated
The timely resolution of problem banks meant that associated costs to the budget (including payouts to depositors and severance pay of bank employees) have so far been much lower in Serbia (some US$83 million for the four largest banks, or around 0.7% of GDP) than in the neighboring economies where the authorities attempted costly rehabilitation programs with mixed results (20.6% of GDP in the Czech Republic, 26.5% in Bulgaria, 12.9% in Hungary). Source: Tang, et. al. (2000)
80 objective of this move was to speed up reform of the sector through offering the government stakes for rapid sale, the privatization process has suffered significant delays during the recent period of political uncertainty. As of June 2004, the authorities launched the tender process for one bank, announced plans to offer two more medium-sized banks for sale by September 2004, and preparations are underway for the sale of one smaller bank by early 2005. Importantly, the timing and method ofdivestiture ofstate holdings in other banks are yet to be determined.
Box 4.5 Present Structure of the Serbian Banking System
The banking sector that has emerged from the first stage of reforms comprises three distinct segments - state- owned banks, local private banks, and foreign banks. The structure and relative importance of Serbia’s remaining 46 banks (as at end March 2004) can be summarized as in Table 4.4 below.
Number of banks, 03/04 17 9 20 46 (of which small banks) (7) (5 1 (14) (26) Total Assets, 06/03 (Dinar bln) 152.2 51.4 94.2 297.8 Share in Total 51% 17% 32% Total Assets 12/03 (Dinar bln) 164.7 71.8 1 18.5 355.0 Share in Total 46% 20% 34% Total Assets, 03/04 (Dinar bln) 162.6 85.5 124.6 372.6 Share in Total 44% 23% 33% Total Regulatory Capital, 12/03 (Dinar bln) 39.2 10.4 34.3 84.1 Share in Total 47% 13% 40% Total Funds-mobilized, (deposits and 12/03 119.6 59.5 78.5 257.6 borrowing - Dinar bln) Share in Total 46% 23% 31% Includes all banks with majority and minority state stake Defined as having less than Dinar 3 billion in funds mobilized Source: National Bank of Serbia data as indicated except Society General and Raj Bank for which only end-June 2003 figures are available for capital and funds mobilized.
In spite ofthe rapid expansion of several foreign banks in the deposit market, the Serbian banking system remains predominantly domestically-owned. The domestic banks made up almost 80 percent oftotal assets and 87 percent ofregulatory capital at the end of 2003. By regional standards, Serbia is characterized by a very high level ofstate ownership, with over 46 percent of total assets held by banks with some state stake, and around 33.5 percent by majority state-owned banks. In comparison, the end-2002 asset share of majority state-owned banks amounted to just 4 percent in Croatia, 103 percent in Hungary, and 14.1 percent in Bulgaria.
Relative to the size of the economy, the banking sector is overpopulated and fragmented, and there is clear scope for further bank consolidation. Some ofbanks are very small with only local or regional coverage; many serve as “agent banks” or similar to a treasury division of large enterprises. At the moment, Serbia is the only country in the region with the share of the five largest banks lower than 50 percent of the total banking assets.
4.57 The volume of Serbia’s monetary aggregates and levels of financial depth have shown marked improvement over the past three years in response to macroeconomic stabilization and reform. Most remarkably, the public’s holdings of foreign currency deposits rose from virtually negligible levels in 2000, to Euro 802 million by end-2001, and to nearly Euro 1.8 billion at end-2003. This trend indicates a gradual restoration of confidence in the
81 banking system albeit with a strong foreign currency component, confirming the ongoing hedging ofrisks. As reserve requirements were progressively reduced and the economy started to revive, banks resumed lending to the real sector. Total credit to the non-government sector (including credit to households) expanded from Euro 1.6 billion at end-2001 to almost Euro 3.0 billion at end-2003.lo6 Reflecting growing investor awareness of the potential for business opportunities, foreign bank penetration of the sector has been rapid with eight new licenses issued in 2001-03. The foreign banks' asset share of 23 percent at end-March 2004 is impressive ' given their very recent start-up and the absence of large entry pointskapital injections through privatization of local banks.
Remaining Challenges
4.58 Despite the early progress described above, Serbia's financial sector remains underdeveloped and the existing level of financial intermediation is unable to fully contribute to economic growth. With banks accounting for more than 90 percent of whole financial system, their total assets amounted to only US$6.9 billion at the end of 2003, or 35.8 percent of GDP (see Table 4.5). Not only this is a very small figure for an entire banking system, being smaller than the total assets of many commercial banks in Westem Europe, but it is also comparatively small when measured on a per capita basis. At end-2003, per capita banking system assets in Serbia were only $684, compared to $1,2 18 in Bosnia and Herzegovina, $1,286 in Bulgaria, $7~88 in Croatia, and $5,984 in Hungary.
4.59 The relative weakness of Serbian financial system is further highlighted by the benchmarking of its banking sector against comparator countries in the region of Central Europe and the Former Soviet Union (FSU). As can be seen from Figure 4.2, the banking sector is comparable in size to many countries of the FSU (including Russia), but still has far to go to match the size of deposits relative to GDP now found in most of the Central European economies. The cash to deposits ratio is also higher in Serbia than in most of these Central European comparator countries, which signifies ongoing lack of faith in the domestic banks. Although Serbian banks have shown the ability in the past three years to mobilize significant volumes of foreign currency deposits, it is estimated that more than 40 percent of total money supply is still retained in cash by population. At the same time, the high interest rates and imperfect legal and institutional environment are having a negative effect on banks' ability to Wher expand lending to the real sector. Serbia lags behind neighboring economies with bank credit to the enterprise sector representing 18.7 percent of GDP at the end of 2003, compared to 42.3 percent in Bosnia and Herzegovina, 26.6 percent in Bulgaria, 57.3 percent in Croatia, and 42.7 percent in Hungary. As shown by the recent business surveys,1o7 bank credit still accounts for less than 5 percent of enterprise financing ofboth the working capital and new investments.
4.60 The bank-by-bank analysis of performance presented in the recent Serbia Financial Sector Notelo8shows that the cost, profit and other efficiency parameters of Serbian banks
The uncompetitive placement of state and NBS deposits with commercial banks (both private and majority state-owned) for use in directed lending schemes has partially contributed to an expansion of credit. Such practice results in misallocation of scarce lending resources at the expense of emerging private sector and is likely show up in problems on banks' balance sheets in the years to come. Io'Productivity and Investment Climate Survey (2003). 'Os World Bank (2004a).
82 have more in common with the non-Baltic countries of the FSU than with the neighboring Central European economies. Looking at the variety of bank performance indicators for the period from the beginning of 2002 (closure of four big banks) to September 2003, this analysis is usehl in tracking specific reasons why Serbian banks in general, and certain categories of banks in particular, are failing to deliver greater volumes ofintermediation. The best quartile of Serbian banks, while clearly outperforming the rest ofthe banking system, account for only a minority of total banking system assets. More significantly, th’e efficiency indicators of even these better Serbian banks are far worse than those of leading CEE banks. For example, the top quartile of Serbian banks have costs to income earning asset ratios ofaround 7 percent as against an average for leading CEE banks of around 2 percent. The weaker Serbian banks (the other three quartiles) have an average cost/asset ratio of around 13 percent, while some of the state banks have cost/asset ratios in the range of 20-30 percent and spreads several times greater what one would expect in a well-functioning CEE bank.
Table 4.5 Overview of Serbia’s Financial Sector 2001 2002 2003’ Banking Sector Number of banks 86 50 47 Total assets (millions ofDinars) 89 1,947 330,494 377,264 Total assets (millions ofUS$) 13,181 5,603 6,905 Assets as a share of GDP (YO) 113.63 35.69 35.81
Non Bank Financial Institutions Number of insurance organizations 33 36 39 Total premiums (millions of US$) 256 3 65 ... Premiums as a share of GDP (“h) 2.9 3.07 ...
Number of leasing companies’ 0 1 6 Total assets (millions ofUS$) 0 ... 36 Assets as a share of GDP (“3) 0 ... 0.28
Number of non-bank credit institutions ...... 14 Total assets (millions ofUS$) ...... 24 Assets as a share of GDP (YO) ...... 0.19
Number ofnon-state pension schemes3 ...... 6 ’ Banking sector and leasing indicators are as of year-end 2003, remaining NBFI data are as of June 2003 Experts-estimate Asset data are not available Source: NBS, Ministry of Finance, Department of Insurance Supervision
4.61 Perhaps more worryingly, no apparent correlation was found between the level of operational effectiveness and gains in market share for those (mostly domestic private) banks which have seen the fastest balance-sheet growth in recent years. On the contrary, there is some evidence of a positive correlation (not the expected negative correlation) between the rate of market share gain achieved by some private banks and their combined spread and fee yield. This may indicate a supply-constrained environment where the banks that are capturing most of the growth in the market are able to charge a premium for providing sought after services, particularly credit. It suggests that the Serbian financial system, with too many banks
83 yet half of its assets in state-owned limbo, needs more genuine competition in order to keep pricing under control and facilitate increased efficiency ofbank operations.
4.62 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 that currently include, but are not confined to, the foreign banks. That shift in the structure of the sector will need either the liquidation of more of the weaker (mostly state-owned) banks, or their rapid re- invention, through new strategic investment, as stronger banks. In parallel, the growth of non- bank financial institutions (NE3FIs) such as insurance companies could offer a broader array of intermediary services and instruments, often unavailable from banks. The ensuing section will focus on several key areas of the financial sector reform agenda for establishing a large financial system capable ofproviding adequate intermediation on a sustainable and more affordable basis.
Ggure 4.1 Comparing Financial Depth and Reliance on Cash
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Total NBNGS deposits as a % GDP (mid-2002)
Source: Central banks
Short to Medium-Term Reform Agenda
4.63 The accelerated reform and modernization of Serbia’s financial sector should proceed in parallel with reforms of the real economy and business environment. As shown above, the alternative of an extended period with today’s status quo cannot possibly create the dynamic for a sustainable, efficient and affordable channeling of financial resources to serve the needs of a growing economy. In addition to making the legal and institutional environment more conducive to greater intermediation, described in the section on business environment reform, the Serbian authorities are encouraged to focus on the following key areas of financial sector reform in the near to medium term: (i)better management and expedited divestiture of state-held stakes in the banking system; (ii)strengthened regulation and supervision of banks, with a view
84 to minimizing vulnerabilities and promoting further consolidation; and (iii)the development of non-bank financial services, with a focus on the insurance sector.
Resolution of state-owned banks
4.64 Based on the experiences of other transition economies, the current domination of Serbia’s financial system by state-owned banks presents si nificant risks, while also limiting the potential for developing viable financial markets?‘9 Given the historic role of banks in the Serbian economy, state banks are inherently prone to be misused as vehicles for patronage and/or directed lending, which would worsen the prospects for competitive market development and incur significant macroeconomic and fiscal costs. This risk is particularly acute as the current scope of shareholder oversight and controls employed by government at the sixteen banks in which it has an equity stake is neither well coordinated nor resourced. At the same time, as shown by the bank performance analysis in the Financial Sector Note (FSN) (World Bank, 2004a), a number of state banks are gradually turning into ineffective shells that fail to perform a useful intermediation role. In view of these risks, the authorities should in the nearest future adopt a comprehensive strategy that identifies a clear, time-bound resolution scenario for all state stakes (including minority holdings), based on the careful application of costs versus benefits review in each particular case.
4.65 International experience indicates that the transparent privatization of viable banks to strategic investors represents the most efficient way to dilute today’s dominant share of state ownership. The benefits of this approach are often thought of in terms of the profit which the government might derive from privatizing a bank after incurring the costs of its successful restructuring, i.e., recognizing unrecoverable non-performing assets and replacing them with good quality claims. Yet, in the case of Serbia’s delayed transition, there is unlikely to be significant goodwill in most ofthe banks to be privatized. Rather, the benefits are more likely to accrue in the medium to long term through the attraction of new strategic investors, including foreign banks, who will bring to the country appropriate credibility, as well as the new capital and managerial and technological know-how. Due to the magnitude of existing problems with asset quality and liquidity ratios, local placement of shares (e.g., through an PO) is unlikely to provide the financial resources, managerial controls or needed information technology investments to turn the state banks around. To the extent that there might be any goodwill embedded in the brands ofthe more effective state-controlled banks, their speedy revival through privatization to strategic investors will help introduce viable competition at the top end of a market that today appears to be supply constrained.
4.66 The timing and method of sale are crucial for organizing the orderly exit of the state from the banking sector. The four medium-sized banks, whose privatization has only just begun after substantial delays, account for less than 10 percent of total bank assets. Meanwhile, the authorities have not yet decided on the timing and modality ofprivatization of state stakes in two of the system’s three largest banks, which together account for nearly 23 percent of total assets. As neither the BRA nor Ministry of Finance have sufficient capacity to effectively monitor the banks’ performance or provide timely guidance to the boards, further delays may lead to deterioration of banks’ condition and, ultimately, greater fiscal costs required for their
IO9 Sherif, et. al. (2003)
85 resolution. The economic value at risk fi-om firrther delays in privatization is likely greater than any value that could be added by existing management or government trying to restructure the banks in lieu of a strategic investor. In particular, the Serbian authorities can hopefully benefit flom numerous lessons in the region (as witnessed by millions of dollars thrown by governments, time and again, to support failing state banks) that suggest that any recapitalization and/or debt conversion should occur only at the moment ofbank’s sale, insofar as this is needed to ensure a successful transaction. At the same time, cost-benefit analysis along the lines suggested above will probably show that a number of state-owned banks are unlikely to ever be able to compete effectively even if their balance sheets could be cleaned up. For these banks, liquidation will be the least costly option and should be acted upon promptly.
Strengthening banking sector regulation and supervision
4.67 In parallel to pursuing the resolution agenda, the authorities have a critical task to establish and enforce a stronger regulatory and supervisory discipline across the whole of the banking sector. As a matter of priority, the MOF, NBS and BRA should act jointly to strengthen the fiduciary oversight of state-owned banks, closing the opportunities for regulatory arbitrage by bank management which could negatively impact their sale or resolution. At minimum, each bank should be subject to robust and regular monitoring by the BRA, as an agent of the government, as well as close scrutiny by the NBS supervisory team. The government’s direct representation and participation in the board of directors is a pre-requisite to protecting its interest and ability to hold management accountable for the bank’s financial and operational performance, including, to the extent practical, in cases where the state holds a minority stake.
4.68 Problems in Serbia’s banking sector are not confined to the state-owned banks. The spotlight given by the authorities and the donor community to resolution of state-owned banks should in no way distract attention from the potential problems posed by the rapid asset expansion ofdomestic private banks.’” More specifically, the FSN analysis has shown that none ofthe local banks driving the recent growth score unambiguously well on a mix of effectiveness, regulatory, or loan-quality indicators. This gives rise to the major concern that some ofthe larger local-private banks are storing up future problems by lending on unsustainable terms that are likely to result in the future deterioration of asset quality. A major risk is also presented by the foreign exchange clause on practically all dinar-denominated loans, which could lead to a simultaneous deterioration in banks’ asset quality in case of a marked depreciation of the exchange rate.
4.69 The rapidly growing large private banks should be priority candidates for early on- site examinations to determine whether their high loan growth rates are compromising asset quality and longer-term capital adequacy. To this end, enforcement capacity of the NBS Supervision Department should be improved through implementation of the comprehensive, three-year Supervisory Development Plan. Most importantly, NBS supervisors need to be seen as consistently enforcing their prudential regulations without exceptions, and taking remedial
‘loAlthough it is often presumed that the “private” banks are exempt from the stresses and distortions suffered by the state banks, the reality is unlikely to be quite so straightforward. As many private banks have been closely affiliated with specific interest groups, they lack the advantages of clean balance-sheets and the more prudential culture brought by the foreign banks.
86 actions as necessary. Likewise, the NBS “fit and proper” criteria for ownership should also be re- evaluated, to decrease the number of “pocket banks”.
4.70 One of the key lessons of the past decade is that the tendency of authorities to delay action on weak banks creates potential for financial crises with subsequent transfer of losses to society at large (World Bank, 2004b). In this regard, the Serbian authorities should be prepared to deal promptly with potential bank failures that may result from the convergence of market, financial and regulatory pressures, such as the increased minimum capital requirement, removal of government and NBS deposits from commercial banks, and the implementation of bank privatizations. It is quite probable that in the next year or two, some banks offered up for sale may not attract a buyer, while others may be found capital deficient or may experience liquidity constraints. The NBS and government are encouraged to organize a high-level working group to study existing vulnerabilities and put in place a proper early warning system. Amendments to the bank exit/resolution mechanism may need to be developed, to minimize the fiscal cost, while protecting depositors’ insured accounts and maintaining asset values and minimizing possible systemic risks. Given that Serbia had 47 licensed banks at the end of 2003, orderly consolidation of banking system should be seen as the end objective of changes in the regulatory and supervisory regime (Roe et al., 2003).
Development of non-bank financial institutions
4.71 The limited access to finance and high cost of banking services highlighted above present a major challenge as well as an opportunity for non-bank financial institutions (NBFIs) to expand their client base. The recent experience of EU accession countries demonstrates that NBFIs can offer a broader array of financial services and instruments, often unavailable from banks (Bakker, et al., (2004)). Moreover, some types of non-bank credit organizations such as credit unions are particularly well-suited for targeting low-income and socially vulnerable groups in both urban and rural areas, thus positioning themselves in market niches usually unattractive for mainstream banking services. At the same time, international experience during the 1990s showed that poorly regulated NBFIs can easily become the breeding grounds for serious financial malpractice and even systemic crises.”’ Hence, although Serbian NBFIs are currently small relative to the banking sector, an adequate regulatory and supervisory framework for their expansion needs to be put in place as soon as possible.
4.72 Numerous institutional factors inhibit the successful development of NBFIs in Serbia. On the supply side, these include delays with establishing the legal and regulatory framework for voluntary private pensions; incomplete and EU non-compliant regulations; weak and fragmented supervisory capacity ofthe financial regulators; often non-existing information disclosure requirements; unreliable reporting; and low transparency ofthe market. Moreover, the poor quality of services, bad marketing and deep distrust of the public associated with numerous failures of credit institutions and insurance companies in the 1990~~coupled with the poor conditions for consumer and investor protection, discourage the demand for NBFI services.
I” E.g., compare the systemic problems caused by pyramid schemes in Albania in mid-1990s or bank cooperatives in Romania in the late 1990s. Outside transition economies, one could look at the role played by the “finance companies” in the period leading to the Thai financial crisis of 1997 (see e.g., Lauridsen (1998)).
87 4.73 In view of its size relative to other NBFIs, and the potential vulnerabilities resulting from cross-ownership links with the banking sector, priority needs to be given to reform of the insurance industry. The recent reform of regulatory environment through a passage ofnew Insurance Law should be promptly followed by robust supervisory actions with regards to the two large state-owned insurers and several dozen smaller companies, to set the stage for rapid sector clean-up and consolidation.
4.74 As witnessed by the experience of virtually all transition economies, the Zeusing industry could grow very rapidly and provide much needed resources for SME finance and assets modernization, provided that a streamlined, publicly accessible registration system for lease transactions is created. Given the weakness of Serbia’s creditor rights system, leasing provides an affordable alternative to more sophisticated forms of finance such as bank credit, as the lesser in case ofdefault already has legal ownership title to the underlying asset.
4.75 Capital markets cannot be expected to grow fast in the absence of institutional and portfolio investors. Thus, the authorities need to focus on establishing a sound legal framework for the emergence and operations of investment funds. Special legislation on mortgage securities is needed to allow the issue of lower risk secured mortgage bonds and mortgage-backed securities. Development ofviable capital markets also requires major improvements in corporate governance, particularly in the area of minority shareholder protection. In the longer run, Serbia may increase its access to long-term finance through entering into strategic partnerships with other exchanges in the region.
E. KEY POLICYRECOMMENDATIONS
4.76 Drawing on the analysis presented in this chapter, the following emerge as key issues in the near- to medium-term. They are listed in approximate order ofpriority:
0 Protection of property rights and preventing backsliding in privatization: retroactive actions to undo legal privatizations or mid-stream changes in the “rules of the game”, such as major amendments to the Privatization Law, could undermine investor confidence.
0 Completing the resolution of state banks through: (i)conversion into state equity of the remaining London Club obligations ahead of the banks’ resolution; (ii)adoption of a divestiture strategy that would identify clear, time-bound resolution scenarios for all state-owned banks (including minority holdings), based on the careful consideration of costs and benefits in each particular case; (iii)transparent privatization ofviable large state-owned banks to strategic investors through an open tender process; (iv) liquidation or merger of all other state banks that cannot be sold and/or are unlikely to compete effectively even if their balance sheets could be cleaned up; and (v) sale of minority state stakes and divestiture of assets of banks in liquidation.
0 Continued restructuring and privatization of SOEs through: (i)continuation with the tender and auction privatization of SOEs remaining in the PA pipeline; (ii)
88 acceleration of the resolution of remaining companies in the restructuring program and readiness to exercise the companies’ public debt restructuring in cases when an attractive bid is conditional on partial debt write-off; (iii)sale ofminority state stakes and divestiture of assets ofthe Share Fund; and (iv) movement ofthe unsaleable loss- making conglomerates or parts to bankruptcy.
Establishing an effective bankruptcy mechanism through: (i)building the requisite institutions; (ii)raising the resources and training the personnel required to build the Supervisory Agency and the unit which will serve as administrator of the socially owned companies; and (iii)initiation of bankruptcy proceedings by the state in its role as creditor through the tax administration, the electric power company (EPS), and state-owned banks.
0 Reform of state-owned utilities through: (i)continuation of the unbundling and restructuring (workforce and debts) of public utilities; (ii)resolution of the debts of companies under the restructuring program of the PA which have the largest debts to EPS (the “list of 12”) by restructuring and offer for sale of the debtor companies (iii) establishment of an adequate regulatory framework in the relevant sectors prior to privatization; and (iv) resolution of the legal problems created by the fact that both the capital and physical assets belong to the state, prior to restructuring or privatization.
Improving contract enforcement through: (i)simplifying enforcement procedures by effectively implementing the recently adopted Law on Execution Procedures; (ii) strengthening the performance ofbailiffs through the adoption ofthe relevant by-laws and training; and (iii)strengthening court resources through education, improved court statistics and information sharing.
0 Improving access to finance and monitoring the use of state funds through: (i) strengthening of the legal and institutional framework for lending, including the introduction of the new Mortgage law; (ii)focusing on the provision ofpublic goods (contract/collateral enforcement) rather than direct state support; (iii)continuation with the establishment ofthe publicly accessible leasing and pledge registry; and (iv) audit ofthe performance ofstate-support funds.
0 Reducing the regulatory burden through: (i)introduction of the public discussion on the draft laws as a rule and not as an exception; (ii)requirement of a justification statement for all laws and other regulations that explains the expected benefits and costs of the actions; and (iii)identification and removal of overlapping functions of various state authorities.
0 Resolution of outstanding urban land market issues through: (i)changing the constitutional treatment of urban land, converting it to at least modem leases with defined durations and market rents or to private land ownership; (ii)removal of various administrative barriers related to access to land; (iii)resolving the issue of denationalization (restitution); (iv) implementing a phased decrease and enhanced
89 enforcement of the property transfer tax, with compensating increases in other taxes; and (v) enhancement ofthe currently limited human and physical resources in various components ofthe land management system, such as cadastre.
0 Strengthening the regulatory and supervisory regime across the banking system through: (i)enhancement of NBS supervisory capacity by timely implementation of the Supervisory Development Plan; (ii)in the period leading to resolution, maintaining proper fiduciary oversight of state-owned banks through coordinated efforts of BRA, NBS and MOF; (iii)conducting on-site examinations at the fastest growing private banks, with appropriate remedial action as may be necessary; and (iv) improving the legal and institutional framework for bank exit, including revision of the BRA status to give the Agency greater powers in pursuing its bank resolution mandate.
0 Laying the foundations for the development of a viable NBFI sector through: (i) urgent establishment of insurance sector supervisory capacity and examination of insurers with the view to facilitating market consolidation; (ii)restructuring and subsequent privatization of two largest state-owned insurance companies; (iii) adoption of medium-term development strategy for the NBFI sector, highlighting the objectives and expected results of the reforms for various types of NBFIs; and (iv) based on the above strategy, addressing the remaining regulatory obstacles and gaps.
90
5 LABORMARKETS
A. LABORMARKETS, GROWTH AND EMPLOYMENT
5.1 A well-functioning labor market and sound labor and employment protection policies can contribute to economic growth by facilitating the reallocation of labor to its most efficient uses, by encouraging investment in human capital, and by making the economy more competitive and better able to adapt to changing circumstances. When combined with enhanced incentives for the jobless to seek new employment, the resulting improved balance between labor supply and demand can also work to increase employment and cut unemployment, and can shorten the average duration of unemployment. These positive effects are more likely to emerge in the presence of macroeconomic stability, competitive product markets and a favorable business environment. Sound employment protection policies can also help workers manage the risks associated with unemployment, lost income, and poor working conditions.
5.2 A flexible labor market becomes especially important in a transition economy such as Serbia, which is facing an impending major restructuring towards different and more productive forms of economic activity. The recent experiences of other transition economies show that: (i)regulations that make hiring and firing difficult or expensive can adversely effect employment by making firms wary of offering a job for fear they will be obliged to provide permanent employment; (ii)high payroll taxes, often earmarked for social programs, raise the cost of labor, thereby undermining competitiveness and creating incentives to evade taxes by hiring workers informally; (iii)government mandates requiring extremely generous bonuses, sick leave, and paid holidays also increase labor costs, adding to the reluctance of employers to create new positions; (iv) rules which prohibit part-time and contract work or compel able- bodied workers to retire at an arbitrary age reduce employment by barring willing workers from the labor market; and (v) bureaucratic red tape can make hiring new workers needlessly slow and expensive.112
5.3 Most countries of Central and Eastern Europe faced similar problems while going through the transition from socialism to a market economy and experienced quite similar labor market outcomes. First, the initial decline in employment tumed out to be significantly smaller than the contraction of output, particularly in the CIS and the SEE countries. Second, as the private sector was initially slow in creating new jobs, labor shifted to low-productivity services and subsistence agriculture, which, together with labor hoarding by enterprises, acted as shock absorbers. Other common characteristics of labor market performance in the CEEC have included: i)an increase in unemployment to levels much higher than in the EU or OECD; ii)a high incidence of long-term unemployment and continued lengthening of the average jobless spell; iii) high youth unemployment, often combined with low youth participation; iv) high unemployment among those with secondary education or less; and v) the emergence of huge regional disparities in unemployment within each country.
'I2See Riboud et a1 (2002), Haltiwanger et a1 (2003) and OECD (1 994). 5.4 Serbia’s pre-reform labor market exhibited several characteristics that differ from the typical experience of former socialist economies. These specifics were shared by the other economies of former Yugoslavia, and three such characteristics stand out. First, the labor market was shaped by the particular legacy ofthe “self-management” system for enterprises. This led to an even higher level ofjob protection and overall rigidity, and to huge labor hoarding. Somewhat reformed legislation adopted in 1989 gave employers the formal right to lay off workers. However, this change had a limited impact on actual flexibility, since dismissal procedures remained complex and costly (according to the 1996 Law on Labor Relations, minimum severance payments were set at an extremely high 24 months wages) and firms had obligations which in market economies are met labor market agencies and social funds. During the period of UN sanctions (especially during the first half ofthe 1990s), firing was prohibited by government decree. Second, while many other socialist countries adhered to a policy of full employment under central planning, open unemployment emerged in former Yugoslavia in the 1960s and increased during the turbulent mid-1980s. Finally, informal employment was for many years tolerated by the government since it was one ofthe key survival strategies during the 1990s. This led to situation in which about one-third oftotal employment was in the informal sector.
5.5 Given the importance of the functioning of the labor market for overall economic performance, and set against the background of the performance of other transition economies, the objectives of this chapter are to analyze the recent performance of Serbia’s labor market and to identify policy measures that would improve its functioning as a means of promoting economic growth and employment generation. The assessment of labor market policies and performance is a challenging task, especially in an economy undergoing profound structural change, since labor market outcomes can be influenced by a broad range of macroeconomic and structural policies and external factors. In addition, since the benefits of labor market reforms are likely to materialize in the long term, and because Serbia introduced most such measures only very recently (since 2001), their impact may not yet be fully discernible. These factors should be borne in mind when considering Serbia’s recent labor market policies and performance.
B. LABORMARKET PERFORMANCE IN SERBIA
5.6 The following section provides an overview of the recent performance of Serbia’s labor market, with extensive comparisons with some neighboring countries, as well as with EU and OECD averages. This includes discussions of the levels and structure of participation, employment and unemployment, the size of the informal sector and wage dynamics. Most analyses are based on the Labor Force Survey (LFS) and the Living Standards Measurement Survey (LSMS) - keeping in mind the many disadvantages of the data available from the Labor Market Bureau. The LFS is based on international standards and recommendations, which allows cross-country comparison. However, for certain flow data that are not available from the LFS, we used the LSMS. The latter has some minor differences from the LFS, which are elaborated below.
92 Participation and Employment
5.7 Serbia's recorded labor force participation rate (the share of employed and unemployed in the total working-age population) has decreased slightly since 2000, but remains relatively high. This indication ofthe supply of labor is a few percentage points above the average for the CEE countries, but slightly below averages for the EU and OECD. The latter diffience is almost entirely driven by levels of participation by youth (age 15-24) which are about 15 percentage points lower than in the EU or OECD (see Table 5.1). When compared with CEE countries, Serbia's participation rate exceeds that of Slovenia, Poland, Hungary, Bulgaria and FTR Macedonia, but falls below that of the Czech Republic, the Slovak Republic and Estonia.
Table 5.1 Participation and Employment Rates by Age and Gender, (2002) Gender Participation rate Employment rate Slovak Slovak Age Serbia Bulgaria Hungary Rep. OECD EU Serbia Bulgaria Hungary Rep. OECD EU All 15 to 64 67.5 61.9 60.1 69.9 69.9 69.7 60.0 50.6 56.6 56.8 65.1 64.3 15 to 24 35.8 30.9 34.4 43.4 50.3 47.7 22.0 19.4 30.1 27.0 43.7 40.6 25 to 54 84.3 80.7 76.9 88.6 80.3 82.8 76.7 67.6 72.9 75.0 75.5 77.2 55 to 64 44.8 31.8 27.5 26.9 51.9 42.8 43.3 27.0 26.6 22.8 49.4 40.1
Male 15to64 76.2 66.4 67.7 76.7 80.4 78.4 69.3 53.7 63.5 62.4 75.0 72.8 15 to 24 40.1 34.1 37.8 47.5 55.1 51.3 26.1 20.4 32.9 28.7 47.6 43.7
25 to 54 92.6 83.0 84.3 93.4 92.2 92.4 86.5 69.0 79.7 79.5 87.0 86.8 55 to 64 60.4 43.7 38.2 46.3 63.8 53.4 58.0 37.0 36.7 39.1 60.4 50.1 Female 15 to 64 58.7 57.5 52.9 63.2 59.6 60.9 50.6 47.5 50.0 51.4 55.4 55.6 15 to 24 31.2 27.6 30.9 39.2 45.5 44.1 17.7 18.4 27.3 25.3 39.8 37.4 25 to 54 76.2 78.4 69.5 83.9 68.6 73.2 67.1 66.1 66.1 70.6 64.1 67.4 55 to 64 29.2 21.5 18.9 11.1 40.6 32.5 28.6 18.2 18.5 9.5 38.9 30.5 Sources: LFS, 2002 Serbia; Employment in Europe, 2003 - EC; Employment Outlook, 2003 - OECD.
5.8 Serbia's recorded employment rate has fallen slightly over the last several years, but remains above the average for the CEEC and close to the level of the better performing transition economies. More specifically, it is above that of Hungary, Poland, FYR Macedonia or the Slovak Republic, but below that of Slovenia, Estonia and the Czech Republic. However, it is below the average levels of the EU-15 and the OECD (where employment is also increasing over time). One reason for relatively high recorded employment appears to be the still very high levels of hidden unemployment or fictitious employment within socially owned enterprises (SOEs). As some respondents perceive themselves as being employed while they are actually redundant within their companies, the official figures may overstate the actual employment rate. This factor was highlighted in the recent Productivity and Investment Climate Survey (PICS),' l3 which showed that only 25 percent of companies have an optimal level of staffing. As expected, the situation is worst within the SOEs, ofwhich nearly 80 percent have problems with redundant
'I3World Bank (2003b).
93 labor. This suggests that recorded employment could decline when the intensification of enterprise restructuring converts hidden into open unemployment.
5.9 As in most CEECs, the resumption of economic growth has not resulted in a parallel increase in employment, reflecting labor hoarding. As shown in Figure 5.1, once output for CEE countries started to recover, employment stagnated for several years and only recently began to grow at a slow rate. In the SEE countries, including Serbia, employment continued to decline even after output began to recover in the current decade. CEE countries also tended to experience smaller changes in both output and employment (in particular, a lower decline in output), while Serbia and other SEE countries tended to have a steeper decline of output with a slower recovery afterwards in comparison with the CEE countries.
Figure 5.1 Evolution of Employment Figure 5.2 Evolution of Employment Rates, and Output: 1989-2003 1989-2003
120 -,
1W
80
BO
40 50
2c 45
0 40 I1 02 0 i9 io si I2 93 ?ob8 l&Q 2doo 2&1 2&2 a: (1989=100). Sources: ECA Regional Database - WB; Economic Survey of Europe, UNECE; Employment in Europe - EC; LFS - Serbia.
5.10 Youth (especially young females) have the lowest participation and employment rates. These rates are also much lower than for the same groups in the EU, the OECD and successful transition economies. More specifically, Serbia’s youth employment rate is 22 percent, only one-half of the OECD average of 43.7 percent. Serbia’s youth participation rate is about 15 percentage points below the OECD average. These relative gaps are even more striking for young females, whose employment rate is less than one-half of the OECD or EU averages. On the other hand, older groups seem to have participation and employment rates above the averages for transition countries, which probably indicates delays in restructuring the real sector.
5.1 1 One of the most striking and important features of Serbia’s labor market is a very high share of employment in the informal sector (Table 5.2). Although the informal sector existed during socialism, it became more prominent in the 1990s and continued to grow in the early years of transition. In fact, calculations based on the LSMS suggest that informal employment accounted for 31 and 35 percent of total employment in 2002 and 2003, respectively. Serbia, where the highest incidence of informal employment is 37 percent in Central Serbia, has one of the highest shares of informal employment in Europe, second only to Bosnia and Herzegovina.
94 Table 5.2 Serbia: Formal and Informal EmDlovment bv Region. 2002 (Dercent) Serbia Belgrade Central Serbia Voivodina Total employment 100.0 100.0 100.0 100.0 Formal employment 69.4 79.1 64.4 71.7 Informal employment 30.6 20.9 35.6 28.3 Source: LSMS 2002.
5.12 Flexible forms of employment (part-time and temporary work) are almost entirely absent in Serbia's formal sector. In 2002, part-time jobs comprised only 1 percent of total wage employment. In contrast, part-time employment represents around 18 and 15 percent of total employment in the EU and OECD, respectively. While low levels ofpart-time employment are characteristic of many transition economies (the corresponding ratios were only 1.9 percent in the Slovak Republic, 3.6 percent in Hungary and 2.5 percent in Bulgaria), the Serbian levels are particularly low. Similarly, work under temporary or fixed term contracts is fairly insignificant, accounting for only 5 percent of total employment in 2002. Part-time jobs have been one of the key factors in increasing employment and participation rates in some OECD countries over the past several decades. These flexible forms of employment can be particularly important in improving the employment prospects for females and youth, the least employed groups in Serbia, and for formalizing existing employment.
5.13 The share of self-employment in total non-agricultural employment in Serbia is one of the lowest among CEE and SEE countries. This ratio is about 5 percent in Serbia, compared to over 10 percent in Slovenia, Hungary, Poland and the Czech Republic, and about 14 percent in the OECD and EU-15. This finding highlights the slow progress in self-employment activity compared to the advanced transition economies of Central Europe, where such activity has played an important role during the transition (Dutz et al., (2001). The relatively low share of employment in small and medium size enterprises, which stood at 29 percent in 2000, also confirms the unsatisfactory performance in this area.' l4
5.14 While the last several years have seen a noticeable shift of employment from the state sector to the private sector, total employment in the private sector remains low. According to the LFS, employment in the private non-agricultural sector rose by 21 percent between 2000 to 2002, while its share in overall employment grew from 24 percent in 2000 to 29 percent in 2002, keeping the state sector as the dominant employer. This trend appears to reflect primarily the privatization of socially-owned enterprises rather than the creation ofjobs in the de novo private sector, which probably indicates a still unfavorable business environment (primarily due to barriers to the entry of small businesses), and the relatively slow privatization of large state and public enterprises.
'I4 This share is still among the lowest in transitional countries, even if one accounts for small firms operating in the informal sector.
95 Unemployment
5.15 Contrary to many transition countries where official (registered) unemployment rates usually underestimate the level of joble~sness,''~in Serbia such figures overstate the actual unemployment rate. Various incentives to register lead most of the unemployed to register with the Labor Market Bureau (LMB). The unemployment benefit isnot the main reason for registration, as only around 6 percent of the registered unemployed actually receive such a benefit. Moreover, payment of the benefit is in arrears for about six months. The incentives to register come largely from the fact that the registered unemployed can qualify for a broad range of other benefits, such as: health and pension insurance, social assistance benefits, subsidized child care, subsidized local transportation, and access to several active labor policy programs.116 Box 5.1 provides a more detailed description of the differences between the two main official indicators ofunemployment.
Box 5.1 Official versus ILO Unemployment Rate
The unemployment rate in Serbia in 2002, based on the LFS data, was 11 percent while the official unemployment rate was around 29 percent. The major source of this discrepancy originates from the different sources of data and different definitions of labor force status used in defining the unemployment rate. The LFS uses the standard International Labor Organization (ILO) definition whereby a person is defined as unemployed if the following conditions are jointly met: (i)the person does not have a job; (ii)the person is actively seeking a job; and (iii)the person is available for work."' The official unemployment rate is based on the registered number of unemployed with the LMB. The registration data on unemployment do not necessarily meet the above conditions. For example, some individuals may register in order to have access to various types ofbenefits provided by the LMB (especially health insurance), although they actually have informal sector jobs and, as a result, may not be actively searching for a job. Another reason is that in certain situations registration with the LMB is required to acquire a new job (e.g., graduates who must register first even if they have already found a job). Thus, registration data overstate the actual level of unemployment in Serbia. The second difference between the official rate and the ILO survey-based unemployment rates comes from the discrepancy in the number of employed. More specifically, the official unemployment rate relies on the number of employed persons estimated by the Statistical Office, which does not cover farmers, family workers, on part-time and occasional workers. In addition, the gap between the two measures is a reflection ofthe large informal sector. Thus, employment based on the LFS appears much larger, as it covers all of those employment categories. The ILO unemployment rate not only provides a more accurate picture of the situation in the labor market, but is also internationally comparable.
5.16 Unemployment in Serbia has steadily increased since the initiation of reforms in late 2000 but remains relatively low compared to many other transition economies. The LFS- based unemployment rate increased slightly from 9.6 percent in 2000 to 11.1 percent in 2002."* Based on preliminary data from the LFS for 2003, this increase appears to have been sustained in 2003. Although Serbia's unemployment rate is fairly average for economies in transition, it is above the levels of well-performing economies such as Hungary, Slovenia and the Czech Republic, and also above the average for OECD and EU countries (see Table 5.4). The surveyed unemployed rate is likely to be somewhat underestimated, as it does not cover redundant workers
'I5See EBRD (2000). The latest changes in legislation dealing with employment policies and unemployment insurance (introduced in 2003) reduced' the scope and size of unemployment benefits. The third condition is not used in this study, as this information is not available in the LFS. For this analysis we calculated the unemployment rate for Serbia using strict ILO definitions which brings certain differences compared to data published by the Statistical Office. Re-classification of data was done in order to count as employed certain groups which are usually counted by the Statistical Office as either unemployed or inactive. More on this issue can be found in World Bank (2003~).
96 who perceive themselves as employed and declare this in surveys. This situation will change when accelerated restructuring converts hidden into open unemployment.
Table 5.3 Unemployment Rates, by Age and Gender, 2002 Gender Unemployment rate Age Serbia Bulgaria Hungary Slovakia OECD EU All 15 to64 11.1 18.1 5.6 18.6 6.9 7.7 15 to 24 38.4 35.5 11.9 37.3 13.1 15.1 25 to 54 9.1 n.a. n.a. n.a. 6.0 n.a. 55 to 64 3.3 n.a. n.a. n.a. 4.9 n.a. Male 15 to64 9.0 18.7 6.0 18.4 6.7 6.9 15 to 24 35.0 39.0 12.6 38.3 13.5 14.8 25 to 54 6.7 n.a. n.a. n.a. 5.6 n.a. 55 to 64 4.0 n.a. n.a. n.a. 5.3 n.a. Female 15 to 64 13.8 17.4 5.1 18.8 7.2 8.7 15 to 24 43.1 31.4 11.0 36.1 12.7 15.5 25 to 54 12.0 n.a. n.a. n.a. 6.4 n.a. 55 to 64 1.8 n.a. n.a. n.a. 4.2 n.a. Sources: LFS, 2002 Serbia; Employment in Europe, 2003 - EC; Employment Outlook, 2003 - OECD.
5.17 As in other CEECs, unemployment mainly affects the young. The unemployment rate for those age 15-24 is almost three times the OECD average for the same age group. While Serbia’s total unemployment rate is lower than that in selected transition economies (Bulgaria and the Slovak Republic), its youth unemployment rate is several percentage points higher. This gap is even more striking for young females. Serbia’s youth unemployment rate is 3.5 times the overall unemployment rate, compared to about 2.0 in the OECD and EU.
Table 5.4 Unemployment Rates in Serbia and Selected Transition Economies, OECD and the EU, 1995-2002 1995 1996 1997 1998 1999 2000 2001 2002 Bulgaria 15.7 13.5 13.7 12.2 14.1 16.4 19.2 18.1 Croatia ... 10.0 9.9 11.4 13.6 16.1 15.8 14.8 HwwY 10.2 9.6 9.0 8.4 6.9 6.3 5.6 5.6 Serbia 10.7 10.4 103 10.5 9.5 9.6 10.0 11.1 Slovak Rep. 13.1 11.3 11.8 12.5 16.7 18.7 19.4 18.6 OECD 7.3 7.2 7.0 6.9 6.7 6.3 6.5 6.9 EU 10.1 10.2 10.0 9.4 8.7 7.8 7.4 7.7 Sources: LFS, 2002 Serbia; Employment in Europe, 2003 - EC; Employment Outlook, 2003 - OECD.
5.1 8 Unemployment is concentrated among individuals with primary and secondary education (Table 5.5). The unemployment rate for those with a secondary education (13.5 percent), is over twice the level for university degree holders (5.9 percent). This is made even more striking by the fact that persons with a secondary education comprise about two-thirds of
97 the labor force. By contrast, those with less than a primary education have the lowest unemployment rate (of 2.9 percent) and their share in total unemployment is low (less than 2 percent). One possible reason is that these persons are more likely to accept job opportunities and are mainly employed in “physical” work in construction or subsistence agriculture.
Table 5.5: Unemployment by Educational Level, 2002 (percent) Unemployment Share in Share in rate unemployment employment All 11.1 100.0 100.0 Less than primary 2.9 1.9 8.1 Primary completed 10.1 19.9 22.2 Secondary completed 13.5 69.1 55.2 Higher 8.9 4.8 6.1 University 5.9 4.2 8.4 Source: LFS 2002.
5.19 The structure of the unemployed by previous labor market status has changed over the last two years, with an increased, but still low, share of job losers compared to new entrants. After remaining stable over the period 1996-2000, the share of job losers in total unemployment increased significantly, from 29 percent in 2000 to 43 percent in 2002 (Table 5.6). However, this fraction is lower than in Croatia (56 percent [Rutkowski, 2003~1and considerably lower than in advanced transition countries (for example, Hungary and Poland) and in OECD countries (around 75 percent), which underscores the rigidities of the labor market and the slow pace ofrestructuring during the first two years of transition.
Table 5.6 The Unemployed by Employment History and Reasons for Unemployment, 1996-2002 (in percent) 1996 2000 2001 2002 All unemployed New entrants 72.0 70.8 59.7 57.1 Job losers 28.7 29.2 40.3 42.9
Those who lost jobs Layoffs 42.2 56.6 55.3 57.6 Termination of temporary employment 33.1 22.8 19.2 22.2 Voluntary quits and other reasons 24.7 20.7 25.5 20.2 Source: LFS 2002.
5.20 The duration of unemployment has been declining, but it remains extremely high, with nearly three-quarters of the unemployed looking for a job for one year or longer. Long-term unemployment is a serious problem, since many of those who wait several years for a job eventually become inactive, which represents a waste of human capital and an additional burden on the social funds. The share of long-term unemployed in the total peaked at 84 percent in 2000 and declined gradually thereafier (Table 5.7). In this respect, Serbia lies between countries such as Bulgaria (64 percent) and Croatia (56 percent) with lower shares, and FYR
98 Macedonia with the highest fraction of long-term unemployed (80 percent).”’ The corresponding OECD average of about 30 percent points to the much more rigid labor market for new entrants in Serbia compared to OECD countries.
Table 5.7 The Evolution of the Unemployment Rate and Long-term Unemployment, 1995-2002 1995 1996 1997 1998 1999 2000 2001 2002 Unemploymentrate 10.7 10.4 10.3 10.5 9.5 9.6 10.0 11.1 Share of long term 75.0 77.5 76.6 77.7 80.1 83.9 70.4 71.5
unemployed~~ Source: LFS 1995-2002.
5.21 In 2002, the average uncompleted unemployment spell was 47 months (Table 5.8). Three groups were most affected: women, the middle-aged, and the poorly educated. Women are more likely to be long-term unemployed and have longer unemployment spells relative to men, despite their higher average level of educational attainment. Prime-aged adults require more than twice as long to find ajob as do young workers (59.7 months as compared to 24 months for the young). Workers with less than primary education tend to be unemployed for over twice as long as university .educated workers, who find jobs, on average, in 33 months. The long average duration of unemployment for most workers may indicate a stagnant unemployment pool in Serbia.’20
Table 5.8 Serbia: Uncompleted Unemployment Spells by Individual Characteristics, 2002 Mean Median All 46.8 26 Gender Male 35.3 23 Female 56.5 36
Age groups 15-24 24.0 18 25-54 59.7 42 55-64 31.3 20
Education Less than primary 69.1 60 Primary completed 48.0 25 Secondary completed 46.2 28 Higher 52.4 28 University 32.9 13 Source: LFS 2002.
‘I9See Rutkowski (2003a, 2003b, 2003~). I2O Given the fact that unemployment spells represent censored variables due to the availability of LFS stock data, these results should be interpreted with caution. The major disadvantage of the LFS data on unemployment lies in the fact that the LFS data do not represent a panel, so it is not possible to monitor the same individuals over time and investigate changes in their labor market status. This is done using the panel (LSMS 2002-2003).
99 5.22 While the unemployment rate appears to be similar in urban and rural areas, it varies considerably across the regions (Table 5.9). Surprisingly, Vojvodina, which is the most developed and richest part of Serbia, has the highest unemployment rate, at 15.2 percent. The other two regions have much lower rates, especially Belgrade, at 6.4 percent, and Central Serbia, at 10.5 percent. This could be attributed to two factors: (i)the large presence ofrefugees who are more likely to be unemployed (58 percent of all rehgees are located in Vojvodina); and (ii)the faster pace of restructuring (43 percent of all unemployed who were laid off owing to restructuring come from Vojvodina). This may indicate that once restructuring accelerates in the whole country, total unemployment may increase significantly, possibly to levels above those in Vojvodina.
Table 5.9 Unemployment Rate by Location/Region (percent) Unemployment rate Urban (city) 11.4 Other 10.7
Regions Belgrade 6.4 Central Serbia 10.5 Voivodina 15.2 Source: LFS 2002.
Wage Dynamics
5.23 The adjustment in the labor market to declining output during the 1990s occurred in the form of lower real wages, with relatively little change in labor force participation and employment. One good representation of this adjustment is from 1999, when real GDP and real wages declined by 18 percent and 21 percent, respectively, while the unemployment rate rose by only 1 percent. At the same time, the labor force participation rate increased &om 68.1 percent in 1998 to 69.4 in 1999. Such outcomes reflected a continuation of the previous practice under which the state as the dominant employer was reluctant to fire redundant workers. Another form of adjustment to lower levels of economic activity has been non-payment of wages. Some estimates for 2003 showed that over 120,000 employees were not receiving wages, or were receiving wages with long delays, sometimes reaching several years.
5.24 This pattern changed dramatically with the initiation of reforms in late 2000, after which recorded real wage growth rose to well above real GDP and productivity growth (Figure 5.3).12' By cutting labor demand, this may have contributed to the observed increase in unemployment, (i.e., had wage increases been more moderate, growth could have come with better employment outcomes). Measured in euro terms, average net monthly wages grew very significantly from about 60 euros in early 2001 to about 180 euros in early 2004. This reflected not only real wage growth, but also the real appreciation ofthe dinar over the same period. As
I2l The upward trend in real wages also reflects an increase in the coverage (in terms of more employees) and the scope (inclusion of lunch, transportation, etc.) of the wage data.
100 shown in Table 5.10, the average Figure 5.3 The Evolution of GDP, Productivity, and euro value ofmonthly wages is now Wages, 1999-2003 significantly above the levels in 60 neighboring Romania and Bulgaria. This could undermine the competitiveness of Serbia’s economy and erode its ability to attract needed foreign investments. -~20 I \ On the other hand, the increase in wages to relatively high levels is a 10 phenomenon observed in most 0 former Yugoslav republics (data for -10 0 Real GDP growth FYR Macedonia and Croatia are -IC PmductivitygrowVl -20 --6-- Growth rate of real net wges presented in Table 5.10), and probably reflects a common 30 1999 2000 2001 2002 2003 heritage of labor market institutions and practices from the former Sources: IMF and Serbian Statistical Bureau SFRY, as well as the high average wage level (over US$500 per month) of the early 1990s.
Table 5.10 Net and Gross Monthly Wages in Euros, 2003 Serbia, Serbia, Serbia, Bulgaria Romania NR Croatia Macedonia 2001 2002 2003 Net Wages 115.1 129.6 193.6 520.9 98.3 151.8 176.2 Gross Wages 145.2 179.4 326.7 742.9 . 146.4 218.8 255.0 Source: National statistical offices; calculations into EUR based on official exchange rates as published by central banks.
Labor Force Flows
5.25 The entire labor market, including both the formal and informal sectors, shows relatively ood flexibility as measured by flows between employment, unemployment and inactivity. E2 This relatively good average performance is primarily driven by a very flexible informal sector, which comprises about one-third of total employment. The informal sector generates the majority of flows - it absorbs redundant workers, employs those who were previously inactive, exhibits a high probability of job loss, and allows flexible forms of employment. Only 63 percent of those employed in the informal sector maintained the same status one year later, compared to 82 percent in the formal sector. The informal sector is not only more flexible itself, but annual labor flows between the formal and informal sectors are also significant. Among those workers from the formal sector who remained employed in 2003, around 18 percent were absorbed by the informal sector. By contrast, over a third ofthe workers in the informal sector were integrated into the formal sector within one year.
122 Labor force flows are analyzed using LSMS data on the same individuals for 2002 and 2003. As within-year transitions between different labor force states cannot be captured using the above data, they underestimate actual labor movements during the year.
101 5.26 The probabili of finding a job in Serbia is relatively high by the standards of transition ec~nomies?;~According to the LSMS data, almost one-half of the unemployed found a job within one year.'24 This proportion is higher than in Russia, Poland and the Czech Republic, all countries with relatively high flows from unemployment to jobs among transitional countries. However, over one-half ofthe previously unemployed who found a job within the year are in the informal sector. Another important characteristic is that job-to-job transitions are considerable in Serbia, as 9 percent of workers change jobs within a year. This figure is much higher than in Poland and Lithuania, were it amounts to between 4 and 6 percent of employment. Youth (especially those without previous work experience) and those with a lower educational attainment have the lowest probability of finding a job. Flows from inactivity to employment are also high, although the majority ofthese are movements absorbed by the informal economy.
Table 5.1 1: Serbia: Transition Probabilities from Employment by Age, Education and Employment Type, 2003 (percentage ofpopulation in 2002) 2003 Employed Unemployed Out ofthe labor Employed in 2002 force Total Employed 81.8 3.3 14.9 Age 15-29 76.1 8.3 15.6 30-45 89.8 3.6 6.5 46+ 77.2 1.4 21.4 Education Less than Primary 64.3 0.4 35.3 Primary 77.8 3.5 18.7 Secondary 85.6 4.0 10.4 Higher/university 90.5 3.1 6.4 Type of ownership of employer Non-private 91.2 2.6 6.2 Private 73.1 4.0 22.8 Type of employment Formal 86.3 2.8 11.0 Informal 71.1 4.7 24.2 Source: LSMS 2002 and 2003.
5.27 The probability of becoming unemployed is low relative to both transition and OECD countries, but the young and the poorly educated face the highest risk of joblessness. Around 3 percent of Serbian workers who were employed in 2002 became unemployed in 2003. This is about the same rate as that for Polish workers during the mid-1990s
See OECD (2003). There are certain differences between the data from LFS and LSMS. For example, the share of long-term unemployed differs between flow and stock data. Around onequarter of the unemployed were long-term unemployed in 2003 using flow LSMS data, while this fraction was over two-thirds based on the LFS of 2002. There are two possible explanations for such discrepancies. First, stock data from LFS may overestimate the proportion of long-term unemployed in overall employment. When asked about the duration of their job search, people tend to neglect short spells of employment (e.g., casual, temporary and/or informal jobs). They may also ignore spells out of the labor force, when they were not actively looking for a job, or were not available for a job. The second possible reason is that the 25 percent figure is biased downward owing to the selection bias, the long-term unemployed being more likely to exit the sample (non-response, etc.) than those looking for a job for less than a year.
102 and Russian workers in the early 1990s (Bell, 2001), and is also in line with the average for EU countries.’25 Young workers (aged under 30) are more than twice as likely to move to unemployment as middle-aged workers. Workers with only a primary or secondary education face the highest probability of becoming unemployed, a feature also observed in ather transition and market economies.
5.28 However, a part of this low risk of moving to unemployment appears to reflect significant flows to inactivity. About 15 percent of those who were employed became inactive one year later. This can reflect the “discouraged worker” effect. Over one-quarter of the unemployed (26.9 percent in 2002) withdrew from the labor market one year later. It can also reflect the low marketability of skills among those losing their jobs owing to restructuring (e.g., older redundant employees of SOEs going directly into retirement).
Table 5.12 Transition Probabilities from Unemployment by Age and Education (percentage ofpopulation in 2002) 2003 2002 Employed Unemployed Out ofthe labor force Unemployed 47.7 25.4 26.9 Age 15-29 43.7 27.7 28.6 30-45 55.0 22.9 22.1 46+ 49.4 21.1 29.5 Education Less than primary 27.3 12.7 60.0 Primary 46.0 24.6 29.4 Secondary 48.3 25.9 25.9 Highermniversity 51.6 27.2 21.2 Source: LSMS 2002 and 2003.
Summary of Labor Market Characteristics
5.29 The above analysis shows that Serbia’s labor market shares most of the typical characteristics of transition economies. This includes an increase in unemployment in the early years of transition, a high incidence of long-term unemployment, high unemployment among youth and those with a secondary education or less, and the emergence of huge regional disparities in unemployment. Serbia’s labor market seems to have a relatively good level of flexibility measured by flows between employment, unemployment and inactivity. However, a disproportionate share of these flows is generated in the informal sector, which accounts for about one-third oftotal employment and is growing over time.
5.30 The increase in unemployment in Serbia has been noticeably moderate to date compared to that in other transition economies. This phenomenon appears to be associated
125 OECD (2003) discusses transition probabilities for EU as a whole (actually only for the 11 EU member countries for which data were available). This report also provides more detailed data for part-time and full-time employed in the EU. The probability of those with part-time jobs becoming unemployed is 4.7 percent, while the analogous figure for those with full-time jobs is 2.7 percent.
103 with the slower pace of enterprise restructuring. Experience from other countries that have already progressed with the transition (and even from Vojvodina) show that once restructuring starts, both the level and structure of unemployment may deteriorate. At the same time, Serbia has to date experienced similar qualitative trends in employment as other ECA countries. The eventual recovery ofoutput came not with a rise but with a further fall in employment.
5.31 This analysis reveals a labor market which is dual in several dimensions, the most striking being between the formal and the informal sectors. The relatively satisfactory overall performance of the labor market reflects the average of a poorly functioning and relatively rigid formal labor market which offers high rates of statutory employment protection, and a very flexible and growing informal labor market which offers no employment protection at all. High levels of informal employment reflect the tolerance of such practice throughout 199Os, tax evasion, inefficient tax collection etc. The chances of both finding and losing a job are much greater in the informal sector. The formal sector (and within it especially SOEs and companies privatized under pre-2000 programs) has yet to respond fully to the more flexible legislation mainly due to unchanged corporate governance and institutional behavior with respect to the labor market. However, this is not a sustainable solution, since informal sector companies have limits on their ability to develop and grow. In addition, those employed in the informal sector have little social security but are financed by contributions from the formal sector.
5.32 Another important duality is between younger (age 15-24) and older workers. The low youth participation rate shows that many young people are not even looking for work. The high average level, but relatively short average duration, of youth unemployment suggests that young people are able to find some jobs (probably low quality or short-term seasonal jobs) but cannot hold onto them for long. This is confirmed by the noted high probability of becoming unemployed. In contrast, older workers have high recorded employment and participation rates, lower levels of unemployment, but very long durations of unemployment once they lose their jobs.
5.33 Women have much lower participation and employment rates than men. While a similar pattern is observed in most economies in transition, the difference is much larger in Serbia (although a few countries such as Bulgaria, Hungary and the Slovak Republic have gaps which are almost as large). Interestingly, the ratio of male to female participation rates (1.3) is still below the OECD average (1.35). Unlike in most other economies in transition, and despite lower levels of labor force participation, the unemployment rate for women in Serbia is much higher than for men. The ratio of female to male unemployment rates is 1.5, a figure only matched by the Czech Republic, although not much higher than the 1.3 average for the EU-15. In contrast, several economies in transition (Hungary, Romania, Estonia and Latvia) have higher unemployment rates for men than for women. In Serbia, women are also more likely to be long- term unemployed and tend to have longer unemployment spells than men.
5.34 The labor market also shows a duality between poorly educated and well-educated workers. People with a higher education have a low unemployment level, have better chances of keeping their job, have higher wages, and spend the least time looking for work. Those with a secondary education are in a much worse situation, are faced with the highest risk oflosing a job and have the highest unemployment rate. While it is hard to split the data between those with
104 general and vocational secondary education, the highly specialized and outdated vocational secondary education system limits labor mobility.
5.35 Finally, the relatively flexible labor market in the private sector contrasts with a rigid labor market in the budgetary, state and socially-owned sectors. Like the informal sector, the private sector creates most ofthe flows between unemployment and employment (and vice versa), provides much more flexibility (in terms of offering temporary and part-time jobs), provides wages that are more closely linked to the results of work, and is less burdened with redundancy. On the other hand, the state sector provides higher job security but at the expense of lower productivity and efficiency. Also, the role of trade unions is much higher in the state/socially owned sector. With these differences in mind, the functioning of the overall labor market will change with privatization and public sector restructuring, which will shift a majority ofthe employed to the private sector.
5.36 In addition, while there are concerns about wage data, Serbia appears to have moved from emphasizing the primacy of sustaining employment through control of real wage growth in the 1990s to allowing more rapid real wage growth at the expense of employment growth since 2000. This has led to a less equal distribution of the costs of transition between “insiders” and “outsiders” and has contributed to “jobless growth.” By raising unit labor costs, this trend also works to erode Serbia’s competitiveness and may endanger macroeconomic balances.
C. KEYCHALLENGES
5.37 The key challenges for policy makers include: (i)moving employment from the informal to the formal sector and reducing the duration of unemployment by improving the flexibility of formal labor markets and by continuing reforms that will expand the share of private sector activities; (ii)sustaining the existing (high by regional standards) overall level of employment and participation; (iii)improving the quality ofjobs and overall living standards by facilitating the reallocation of labor to more efficient sectors; and (iv) dealing with the specific problems of youth and the less we1 educated. Meeting these challenges will require synchronized policies in the areas of labor legislation, the institutional framework for the labor market, severance and unemployment benefits, and active labor market measures. These policies need to be complemented by reforms in macroeconomic policy (including tax policy and administration), privatization and private sector development, restructuring, and education at all levels. The remainder of this chapter begins with a discussion of direct labor market reforms, followed by a brief discussion ofreforms outside the labor market.
Improving the Functioning of the Formal Labor Market
5.38 Serbia’s significant recent progress in reforming rigid labor market legislation to meet the requirements of a market economy needs to be preserved and selectively deepened. This is because more modest employment protection for all is preferable to a system which provides high statutory protection for the few while leaving many others with no protection at all. A new Law on Labor, adopted in December 2001, provided more flexibility in both the hiring and firing of workers (see Box 5.2). These changes are the basis for the efficient
105 reallocation of labor so as to increase the productivity of existing and new enterprises. Annex 2 shows indexes constructed under the World Bank project “Cost of Doing Business,” where a common methodology allows cross country comparisons.’26 This exercise shows that Serbia and Montenegro (data are not separated by republic) has most values close to averages for the transition economies of Europe and Central Asia, but that it maintains terms of hiring and conditions of employment which are more rigid than those in OECD countries. This suggests that the main cause of rigidity in Serbia’s labor market is no longer the labor legislation. The recent improvements need to be maintained, and further improvements in flexibility should be considered, especially in the areas identified in the above analysis. Otherwise, foreign and local investors may be reluctant to take part in privatization or to start new business. Also, the government as a large employer might face large fiscal costs with respect to hiring and firing of its employees. The main remaining weaknesses in the functioning of Serbia’s formal labor market must be found in other factors that influence institutional flexibility, such as social partnership, minimum wages, unemployment benefits, active labor market programs and tax policy. These factors are explored in the following paragraphs.
Box 5.2 Key Innovations Introduced by the Labor Law of 2001
The labor law and other related laws adopted during the previous three years have significantly improved the legal and institutional environment for Serbia’s labor market. This is primarily reflected in simplification and reduced costs related to hiring and firing processes as well as the better regulation ofworking conditions. Hiring has become much easier, faster and less costly since the employer is no longer obliged to announce vacancies, the trial period is shortened, and flexible forms of employment (i.e. part-time and term jobs) are ajlowed. This should enhance employment prospects, especially for youth and women. Employers can terminate the labor contract if the need for carrying out a certain task ends due to technological, economic or organizational changes. Severance payments were reduced from between 24 and 36 monthly salaries in the previous Law to between two and five monthly wages, depending onjob tenure. This will greatly reduce disincentives to hue new workers.
Conditions for work are better regulated and terms are harmonized with most transition economies. Limits on overtime work, the minimum duration ofannual leave, as well as maternity leave are all precisely defined and in line with regional standards. Minimum wages are set by mutual agreement of the government, unions and employers. Collective agreements have become less restrictive while the representation ofunions and employers is more precisely defined. The general and special collective contracts are binding only those employers who are members of the employers association that is the signatory to the collective contract or who have joined the association subsequently. According to the previous legislation the general and special collective contracts were applied directly and were binding upon all the employers in the republic or in a branch. The minister in charge of labor may expand the application of the special collective contracts to include non-members of the employers association. The minister is obliged to request the opinion of the signatories to the collective contract before deciding on such expansion.
These changes need time to show their full impact, which depends on reform of the institutional setting of the labor market and on reforms in other sectors. One already observable result is a decline ofregistered unemployment since mid-2003, the first such decline in over ten years. At this stage of economic development, when the restructuring of large SOEs as well as the attraction of FDIs is so important, flexible labor regulation is much needed.
“World Bank (2004~).The Employment Laws Index covers three areas: flexibility of hiring, conditions of employment, and flexibility of firing (see Annex 5.2 for cross-country comparisons and for more details on how the index is constructed). Each sub-index takes values between 0 and 100, with higher values implying more regulation. The Employment Laws Index is an average of the three indices.
106 5.39 Social partnership has not functioned properly in the initial phase of transition. Social partners are not well institutionalized and some are weakly represented. In addition, the legitimacy of certain social partners is questioned. In general, unions provide workers with a collective voice, increasing their bargaining power relative to management. They can help improve work safety conditions, but can also impose efficiency In addition, if employers are not represented properly, the outcomes oftripartite negotiations might worsen the business environment and lead to wage pressure, slowing the growth of output and emp1oyment.l2* In Europe and Central Asia, membership in trade unions was mandatory under socialism. In the early years of transition, trade union members still comprised the majority of the labor force - the average union density for the transition countries was 58.1 percent. By the late 1990s, union membership had been further eroded, with only one out of three workers still being a union member. In Serbia, the strong presence of trade unions is evident only in recently privatized companies (66.4 percent) and state and socially owned companies (83 percent of all employed are union members). According to PICS, only 6.2 percent of workers within the new private sector are members of a trade union. In the future, it will be important not to broaden the legally mandated coverage of collective agreements, as this could erode recent important improvements in labor market flexibility
5.40 The further growth of minimum wages relative to average wages could negatively affect employment, especially among young and less skilled workers. Minimum wages are in place in virtually all transition economies, but their generosity has declined over time. While minimum wages can boost the earnings of those low salaried individuals who manage to retain employment, they can also lead to unemployment where the minimum wage is above the market- clearing level and is thus binding. Overly high minimum wages can particularly reduce the chances of being hired for young or low-skilled ~0rkers.l~~Thus, minimum wages should be kept at a modest level which will not adversely affect the employment prospects of those who are already the most disadvantaged in Serbia’s labor force, namely, youth and those with limited education and low or inappropriate skills. Serbia’s current Labor Law determines that minimum wages shall be established by mutual consent of the representatives of the government, trade unions and the association of employers. This principle is in line with the ILO Minimum Wage Fixing Convention, and should be maintained. Recently, the national minimum wage was 38.8 percent of the average net wages in 2002 and 39.4 percent in 2003. This is relatively high in comparison with other transition countries. Further increases should be avoided and a slight reduction ofthis ratio could be considered.
5.41 The recent shift away from legayadministrative employment protection (including through lower minimum severance payments) is positive, but needs to be complemented by well-targeted, effective and affordable programs of financial and active support for job losers. Protecting employment by directly restricting layoffs discourages the creation of new jobs and actually hinders the needed reallocation of labor to higher productivity uses which would lead to growth and sustainable employment in profitable enterprises. In contrast, programs which provide financial and other direct support can protect redundant workers while speeding
’” Rashid and Rutkowski,( 2001). ’’’ For example, employers should not be represented by the Chamber of Commerce, which is inconsistent with ILO conventions. OECD (1 999). In Hungary, the minimum wage was increased in 2001 and 2002 by 60 percent and 25 percent, respectively. A study by Kertesi and Kollo (2002) estimated that this reduced the employment of unskilled workers by 4 percent and B percent, respectively. The impact on total employment in 2001 and 2002 was a decrease of 2.5 percent and 4 percent, respectively.
107 and smoothing labor reallocation. In Serbia, the three main unemployment programs are cash unemployment benefits, severance payments (including those under the government’s “Social Program”), and active labor market programs (ALMPs). We now discuss each ofthese programs in tum.
5.42 Serbia’s unemployment benefits (UB) system is well-designed and thus is not a limiting factor to job creation, but is under-funded. The duration of unemployment benefits payment is three months, if the insured has had unemployment insurance for 1 to 5 years, and up to 24 months if the insured person is older than 55 years and has paid insurance contributions for more than 25 years. These rules to a large extent explain the low number of unemployment benefits recipient^.'^' The benefit replacement rate is relatively modest by regional standards - 60 percent of the previous average salary of the unemployed for the first three months, and 50 percent for the remaining period for which he/she was granted the right to compensation. The low coverage and generosity of benefits may have reduced the otherwise adverse impact of unemployment benefits on job creation, and, unlike in many OECD countries, may have limited the impact of unemployment benefits on the overall level of unemployment. In Serbia, compulsory unemployment insurance contributions are quite modest by regional ~tandards.‘~’ Despite the modest benefits and low coverage, the full and timely payment of unemployment benefits represents a significant problem for the Labor Market Bureau (LMB). Currently, the benefit payment is in arrears for 6 months on average. This erodes the ability of the UB system to act as an effective social safety net and could also be driving people into the informal sector.
5.43 The government’s “Social Program” needs to be scaled back and restructured. This program is targeted at employees who become jobless through the privatization, restructurin or liquidation of a select group of enterprises approved by the government on an ad hoc basis. I&In 2003, 32 companies used funds under the program. This is high compared to other countries, where similar programs focus only on a handful of particularly difficult cases (e.g., in mono- enterprise communities). Severance payments under this program tend to substantially exceed the minimums specified under the Law on Labor, which are already high by regional standards. In 2003, 5.4 billion dinars (equivalent to 0.5 percent of GDP) was spent under the program. This is much more than, for example, the 0.9 billion dinars spent on ALMPs, or the 1.2 billion dinars spent on Material Assistance for Families, the well-targeted main program of social assistance in Serbia.’33 It is almost as large as the 5.6 billion dinars spent on unemployment benefits, which are well-designed and must cover a much larger group of ~0rkers.l~~In the initial phase of transition, when structural reforms could result in mass layoffs, there is a rationale for such a government program. However, in the near-term, substantial resources for this program can only
I3O In some transition countries, unemployed workers who have exhausted their eligibility for unemployment benefits can continue to receive benefits under a means-tested program called unemployment assistance (Bulgaria, Hungary, and Slovenia). I3l The current contribution rate is 1.1 percent (0.55 percent by employers and 0.55 percent by employees). 13* The program was approved in March 2002. A surplus employee can choose one of three options: (i)a lump sum monetary compensation amounting to 10 average earnings in the economy (altematively, the benefit amounts to around US$lOO, for each year of employment); (ii)a special training and retraining program; and (iii)self-employment assistance, which, among other assistance, includes ‘stimulus funds’ in the amount of about US$ 500. In 2003,36,900 individuals benefited from the program, of which 97.7 percent opted for cash payment, 2.2 percent participated in training programs, and 0.1 percent received self- employment assistance. 133 See World Bank (2003~). ‘34 The budget for unemployment benefits included an additional 2.3 billion dinars paid as contributions to the pension and health funds on behalf of the unemployed.
108 be justified if is re-designed to be fiscally viable, targeted to the most needy, and with clear incentives for firms which receive support under the program to deepen rather than delay restructuring. Over the medium term, such a restructured program might be kept for a few particularly troubling firms. In the long term, it needs to be phased out. The saved resources could instead be used for better balancing the resources and commitments of unemployment benefits, for select promising ALMFs, and for other reforms which can encourage employment.
5.44 Serbia’s Labor Market Bureau offers a wide range of active labor market programs, but inadequate funding and staffing erode their effectiveness. ALMPs are designed to tackle specific labor market issues. They include advisory and mediation activities targeted to jobseekers (like vacancy notification and vacancy and job fairs), training and retraining, special employment programs for the disabled and entrepreneurship assistance. Most ALMPs are being introduced in an ad hoc fashion as a quick response to perceived problems which emerge as the reforms progress. During the first years of transition, the LMB has spent only a fi-action of its overall budget (between 4 and 8 percent) on ALMPs. The proliferation of programs also reduces the fbnding available for any given program. Another problem is that the LMB has one of the heaviest workloads of a public service anywhere in the region. One employment counselor, on average, handles a roster of more than 2000 unemployed persons. In the EU countries, caseloads can be approximately 150 to 400 in number.
5.45 The divergent payoffs of various programs, combined with limited financial and administrative resources, means that ALMPs need to be very selectively chosen and carefully targeted. As shown in Box 5.3, the worldwide and transition experiences with ALMPs have varied greatly. Counseling and job search assistance have often been effective in helping workers who have been displaced by fictional unemployment find jobs at relatively low unit costs. Some general training programs, including on-the-job andor institutional training, have had a mixed but generally positive record in dealing with structural unemployment. Training programs targeted at youth, as well as wage and/or employment subsidization programs, appear to have had the poorest results. Also, programs focused on providing subsidized credits to redundant or unemployed workers have often proved to be inefficient (being costly and with low success rates). Effectively implementing a few promising and well-functioning programs is vastly preferable to maintaining an array of dysfunctional activities. Since the various programs are more effective at assisting some groups of people than others, it is essential to match the program to the client group.
5.46 In summary, Serbia should continue with the shift from the administrative/legal protection of employment to a better functioning unemployment insurance system primarily based on unemployment benefits and some ALMPs. For example, minimum severance payments, while much reduced and not high by the standards of other former Yugoslav republics, remain high compared to other countries in ECA. These and other remaining legal rigidities could be addressed. As noted above, resources should be shifted from the Social Program to unemployment benefits (which should have sufficient resources to meet actual commitments under the existing legislation) and a targeted set of ALMPs, which have been selected on the basis of transition experience and which are in line with available administrative resources ofthe LMB.
109 5.47 High rates of labor taxation and weak enforcement of labor taxes can discourage formal employment (see Chapter 2). The tax reform of 2001, which lowered labor taxes and contribution rates while broadening the base for such taxes, left Serbia with labor tax and contribution rates that are in line with regional averages. These initial reforms have not yet brought a visible reduction in informal employment and an increase in overall employment. One reason why informal employment remains so entrenched is the degree to which it was tolerated in the 1990s, when it served as a survival strategy for many households. Serbia may need even stronger encouragement to formalize. For this reason, a hrther phased and well-planned reduction in payroll taxes (compensated by equivalent increases in other taxes, and with adjustments to compensate the resulting lost income of the social funds) could be considered. Formalization can also be promoted by stronger and non-selective enforcement oftax collection, including the reform of the tax administration, a better IT system, and changes in the work of inspections.
Box 5.3 Which Active Labor Market Programs Work Best in Transition Countries?
A new, comprehensive evaluation of active labor market programs (ALMPs) around the world (Betchennan et al., 2003) provides some useful evidence for policymakers in this field, as follows.
The most cost-effective program is job search assistance. This is particularly so in transition and industrialized countries. Program costs are relatively low, and results are often positive, although more so if economic conditions are positive.
Training programs for the unemployed have a mixed record, but are consistently positive in transition countries. The authors are puzzled by this. It may be because the programs are imparting new skills relevant to a market economy, or because the pace oftransformation of these economies is picking up. Certainly, as with job search assistance, these programs perform better when the economy is performing well.
There is very little evidence of the effectiveness of retraining programs for workers in mass layoffs in transition countries. The Emergency Demobilization and Reintegration project Bosnia and Herzegovina is judged to have had a positive impact on employment and earnings (Impaq International 2001; Benus et al., 200 l),although deadweight and substitution effects are not estimated.
Training programs specifically aimed at youth have the poorest track record of all ALMPs. All the evidence is from industrial rather than transition countries. Some general training programs in transition countries (Hungary, Poland, the Czech Republic) have been found to have some positive impacts for youth but these are likely to be outweighed by the high costs ofsuch programs (Godfrey, 2003).
The limited evidence on the impact of wage and employment subsidy programs in transition countries is uniformly negative. Deadweight and substitution effects are likely to be particularly important in such programs and are very difficult to estimate.
5.48 Informal employment is also encouraged by the relative ease with which the registered unemployed gain access to a range of social benefits such as free health insurance. To the extent that the registered unemployed are actually working in the informal sector, such ease of access represents a subsidy to the informal sector, as it frees informal employers from the need to cover the same benefits as formal entrepreneurs who regularly report their employment and pay their contributions. There are several options which could increase the number of insurees. These measures include: the inclusion of those who work part-time or under short-term contracts in the network of insurees; better administrative coverage (primarily of the
110 self-employed and farmers), and more intensive control that recipients of such benefits are in fact unemployed. Some ofthese measures have already been implemented in Serbia, like inclusion of part-time and short-term workers in the insurance system. The more radical measure would be to require by law that everyone pay a social insurance contribution so that they and their dependents are covered by a health insurance scheme.
Age and Labor Market Performance
5.49 The analysis above showed very different labor market outcomes for youth and older workers. As was elaborated in paragraph 5.31 above, young people have tended to move in and out of employment,. finding jobs but not being able to keep them for long. In contrast, older workers have not lost jobs so easily, but when this has happened, it has tended to be for a long period oftime and has often led to exit from the labor force.
5.50 This pattern appears to reflect the limited extent of restructuring combined with the poor skills of adults. As many non-restructured old firms are simply trying to stay afloat ahead ofprivatization and are not actively hiring, youth are blocked from access to employment in such firms. This forces the young to either seek odd and seasonal jobs unrelated to their area of education or to exit the labor market.'35 As soft budget constraints allow the same firms to behave paternalistically and avoid major layoffs, older workers have largely managed to keep these jobs. However, as many of these older workers do not possess the skills in demand on the market, they can find it extremely difficult to gain new employment after losing a job.
5.51 The current disadvantage for younger workers relative to older workers could change once restructuring takes hold. After privatization, firms which begin to face harder budget constraints might become more dynamic and might shift their activities, and thus might search for new types of workers. This could improve the prospects for youth. At the same time, this would be likely to leave older workers facing higher levels of chronic unemployment. Solving this problem would require creating opportunities for older workers to update and change their skills, and this would required the reform of adult training (which is discussed more extensively in Chapter 6). Early retirement at an actuarially fair rate could also be considered. Of course, a general improvement in the business climate is also required to facilitate the creation of new positions for these redundant workers.
5.52 Serbia needs to examine the factors that block the entry of youth into employment and to seek to remove such constraints. International experience shows that low levels of youth employment and participation often reflect long schooling andor the high costs of hiring and firing (Garibaldi and Mauro, 1999). Education issues are discussed in more detail in the next chapter, but it is obvious that the formal education system fails to prepare the majority of youth for employment. A relatively high minimum wage could be increasing the costs of hiring and may need to be addressed. On the other hand, youth might perceive starting wages offered as very low, which may discourage them from entering the labor market. The use of flexible forms of employment, and the simplification of the administrative procedures of employment, would increase youth employment as well as overall employment.
13' The results of a 2002 survey suggest that 42 percent of employed youth respondents do not work in jobs for which they were educated.
111 Macroeconomic Policy and Labor Market Performance
5.53 Serbia needs to maintain wage growth in line with productivity growth. This would result in three types of benefits. First, by sustaining the overall demand for labor, it would enhance the employment generating effect of economic growth. Second, if coupled with a changed macroeconomic policy mix (see Chapter 2), it would keep the euro value of wages at levels which maintain Serbia’s external competitiveness, thus promoting export-led growth. Third, it would sustain the slower growth ofconsumption as a share ofGDP and the higher rates of enterprise profitability which (as described in Chapter 2) are necessary to increase private savings as a basis for containing Serbia’s current account deficit.
5.54 The government can also directly moderate wage growth in the budgetary and state- owned sectors. The public administration together with state owned enterprises employs a considerable number of people, many of whom earn wages well in excess of averages for the economy. Thus, in the last three years, the average wage in the public sector was about 30 percent above the Serbian average, which indicates room for fkrther adjustment. This moderation would also support the reduction of the public sector wage bill as a share of GDP, which was shown to be crucial for fiscal sustainability in Chapter 2. Failure to do this could push up wage demands in the private sector.
Private Sector Development and Labor Market Performance
5.55 A growing private sector would absorb the declining employment in the state sector, could improve overall labor market performance and would lead to a long-term improvement in the quality of jobs. As shown above, the labor market in the budgetary and state-owned sectors functions less well than in the private sector. The private sector is subject to harder budget constraints, and is thus more dynamic, with more hiring and more firing. Knowing the transition experience, and in view of the current labor hoarding in many socially-owned and state-owned firms, the initial impact of a shift towards the private sector is likely to be a net loss of employment. In addition, the very small role of self-employment reflects remaining problems in the business enabling environment. These weaknesses could be mitigated by an improved business environment which would allow new enterprises to develop and which would attract foreign investors, who usually bring in modem technologies and provide intensive training for employees. A growing private sector facing harder budget constraints would contain real wage growth, leading to a enhanced demand for labor. For this reason, the completion of ownership reform and the establishment of a sound business climate are crucial for increasing overall labor demand, and for encouraging the shifting of labor to more productive firms which can create higher quality employment. If the loss-makers tend to be large capital-intensive industries, while the new enterprises are labor-intensive SMEs in the services sectors, the shift towards the private sector could promote employment in the long run. The policies for achieving these objectives were discussed in Chapter 4.
Education and Labor Market Performance
5.56 Labor market outcomes vary greatly according to levels of educational attainment. The worst outcomes are for those with secondary or less than a secondary education, which is
112 most likely due to the high level of specialization provided by vocational education. In addition, the impending and necessary, restructuring ofthe Serbian economy will leave many persons who have already left formal education with an inappropriate set of skills. This will require that Serbia invest in significant amounts of high quality training and re-training. For these reasons, the reform of Serbia’s education and training system will be crucial to putting Serbia on a path of faster growth and to ensuring the creation ofmore and better jobs. The final chapter ofthis report describes the functioning and needed changes in education and training.
113 Annex 5.1 Hiring.5. and Firing.CI Workers Flexibility ofltiriiig Sshl ButgariY Croatia Hungary Siuwtb Rep. Part-time employment is prohibited no NO no no no Part-time workers are not exempt from mandatory benefits of contractsPart-time full time workers yes yes yes yes Yes It is not easier or less costly to terminate part-time workers than yes yes yes yes no full time workers Fixed-term contracts are only allowed for fixed-term tasks no no Yes no no Fixed-term What is the maximum duration of fixed-term contracts (in contracts 36 12 36 60 36 months)?.- C'ond$ions of Employment What is the mandatory minimum daily rest? 12 12 12 11 12
What is the maximum number ofhours in a work week? 40 40 40 40 40 Hours of What is the premium for overtime work? 0.26 0.5 0.5 0.5 0.25 work There are restrictions on night work? yes yes yes yes Yes
There are restrictions on "weekly holiday" work? yes yes yes yes Yes
Days of annual leave with pay in manufacturing? 18 20 18 21 22
Paid time off for holidays is mandatory yes yes yes yes Yes
There is a mandatory minimum wage yes yes yes yes Yes Minimum Wage yes, yes, yes, yes, yes. Conditions of employment in the constitution express express express express pyn~prc -,.v.-"" Aht nght nght right . .-... I__- . Flexibility of Firing - It is unfair to terminate the employment contract without cause Yes Yes Yes Yes Yes Grounds for The law establishes a public policy list of "fair" grounds for firing dismissal no Yes no no Yes Redundancy is not considered a "fair" ground for dismissal no no no no no The employer must notify a third party before dismissing one redundant employee no no Yes no Yes The employer needs approval of a third party to dismiss one no no no no no redundant employee The employer must notify a third party prior to a collective Yes no yes yes Yes Firing dismissal The employer needs the approval of a third party prior to a procedures no no no Yes no collective dismissal The law mandates retraining or replacement prior to dismissal Yes no Yes no Yes There are priority rules applying to dismissal or lay-offs no no yes yes Yes There are priority rules applying to re-employment Yes no Yes no no Notice and Legally mandated notice period (in weeks) after twenty years 2 4 12 12 12 severance Severance pay as number of months for which full wages are 4 1 6 5 3 payment Davable after covered emlovment of twentv vears Right to job mentioned mentioned security in Right to job security in the constitution no express right the generally generally no constitution Source: Cost of Doing Business Database, World Bank, 2003
114 Annex 5.2 Labor Legislation Flexibility, 2003 Region Conditions of or Of Employment Flexibility of Employment Hiring Index Firing Index Laws Index Economy Index ECA 51 82 39 57 OECD 49 58 28 45 BiH 53 63 31 49 Bulgaria 43 90 26 53 Croatia 76 89 31 65 Czech Republic 17 63 27 36 Hungary 46 92 23 54 Macedonia, FYR 65 53 32 50 Serbia and Montenegro 51 88 29 56 Slovak Republic 34 89 60 61 United States 33 29 5 22
115
6 EDUCATION AND TRAINING
A. INTRODUCTION
6.1 Education and training can enhance growth by raising employment and increasing overall productivity. This chapter looks at the extent to which the education and training system in Serbia is able to provide individuals with the skills and knowledge that they need in order to be successful in the labor market, both now and in the future.’36 The chapter starts by considering the relevant issues that emerge from other parts ofthis report, and then analyzes the implications for the education and training system.
B. SERBIA’S TRADEPATTERNS AND LABORMARKET PERFORMANCE
6.2 Three key points regarding the relationship between skills and economic performance emerge from the chapter on international trade (Chapter 3). First, Serbia’s current exports are concentrated in products which require mainly unskilled, labor-intensive processes or are exports of raw materials. However, this is changing. Recent falls in these types of exports (e.g., textiles and clothing) and the resulting loss ofjobs reflect a number of factors, including those related to poor skills.’37 These trends will continue, given the increased competition fkom other low-price labor countries and Serbia’s desire to increase the number of higher-skilled and higher-paying jobs. Second, enterprises in Serbia appear to be preparing to make the shift towards these higher value-added jobs, as evidenced by the sustained increase in the share ofimports of machinery and equipment since 2000. Finally, Serbia’s delayed transition means that it needs to catch up in attracting foreign direct investment, especially greenfield investments. From the education and training perspective, these last two points are linked. International companies will increase their investments in Serbia, and capital investments (from domestic or foreign sources) will yield improvements in productivity (and result in higher wages) only if the workforce has the skills, knowledge and attitudes to utilize and exploit the new investments. Evidence from other countries’38 shows that in Serbia it will be necessary for a large proportion of the workforce to either have good quality and adaptable or more general secondary education, or to be able to improve its overall skills to these levels. As is discussed below, this is the major challenge facing Serbia’s education system.
6.3 Chapter 5, on the labor market, shows that those with more education do better in the labor market--but with important exceptions. Those with the lowest educational attainment - less than a primary education - have very low unemployment rates. This is unusual, compared with the experience in other countries, but it can be explained by the prevalence of low skilled employment. However, despite lower unemployment rates, people with less than a primary education have the lowest probability ofbeing employed one year later, and have very high rates ofgiving up the work search and exiting the labor market altogether. Thus the employment status of this group of people is insecure. Despite the prevalence of low skilled jobs in the economy,
136 Of course, the education system also has other objectives, such as social cohesion, promoting citizenship and a knowledge of one’s country. 13’ For example, sluggish textile exports also reflect poor product quality, problems of access to the EU market, and the very rapid growth of wages measured in foreign currency terms. 13* For example, see de Ferranti et a]., (2003) for Latin American countries. the situation of those with only a primary education is as expected - a high unemployment rate, lower wages, and a high probability ofleaving the labor market within a year.
6.4 What is most unusual in Serbia is that secondary education graduates appear to be no more successful in the labor market than those with just a primary education. Secondary graduates have the highest unemployment rates. Their wages are only about two-thirds of the wages of those with university degrees (though the gap appears to be falling) and are not much higher than the wages of those with a primary education. As expected, those with a tertiary education’39 do well when they join the labor market.
6.5 A striking feature of Serbia’s labor market is its degree of turbulence, with high rates of movement year on year between employment, unemployment, and inactivity. Movement between categories or between jobs can be a positive sign of flexibility if workers gain more experience and if their newly acquired skills and knowledge are recognized by higher wages and better jobs. However, in Serbia, most people are unable to find stable employment in this turbulent environment. Indeed, only those with tertiary education - who constitute only 11 percent ofthose in employment - can successfidly navigate these waters.
6.6 As Serbia’s labor market becomes more flexible and dynamic with higher levels of investments, those who have been out of employment for some time will be at an increasing disadvantage. Any work experience of older persons will become less marketable and will lose its comparative advantage. This already appears to be the case in Serbia as the middle-aged have a harder time finding jobs. Moreover, there is a sizable group of young people in the labor market who are experiencing difficulty finding long-term employment and so are unable to acquire good work experience and new skills. This group will become even more vulnerable if improvements to the formal education system allow young secondary and tertiary education graduates to enter the labor market with better skills and knowledge than those already in the labor force.
c. POLICY PERSPECTIVES ON THE LINKBETWEEN EDUCATIONAND THE LABORMARKET
6.7 The connection between education, on the one hand, and economic growth and employment, on the other, can be analyzed in two broad ways. The first way - the manpower requirements approachi4’ - has been discredited as an economic theory. It argues that an economy’s demand for qualified people is projected by detailed educational and occupational category, for comparison with projections of supply. This comparison yields estimates of ‘shortages’ and ‘surpluses’ over a planning period. The pattern of shortages is then taken as an indicator of the detailed education and training “needs” of the economy. In this approach, which is still prevalent in Serbia, the pattern of jobs is relatively stable and the role of education and training is seen as passive - policies for education are derived from what is predicted to happen to the economy.
’39 In this chapter, the term “tertiary education” will be used instead of “higher education” to describe the university and post- secondary education sector. This is because “higher schools” exist in Serbia which offer upper secondary level education. ”Tertiary education” has become the standard term referring to all types of post-secondary institutions, including universities (see OECD 1998). I4O Pioneers of this approach were Harbison and Myers (1964).
117 6.8 Alternative approaches which emphasize the active rather than the passive role of education in shaping the labor market and the economy look potentially more useful as a guide to education and training policy in Serbia.14' This is because the Serbian economy is in accelerated transition, within a rapidly changing European and global economy. An education system that confines itself to eliminating specific mismatches between its output and the demands labor market demands will never catch up. The role of the initial, formal education system is therefore to provide people with the skills and knowledge to respond to changes in the labor market. The fi-ont-runners in intemational competitiveness tend to be those that have followed this kind ofhuman resource development policy. In the 2003 Growth Competitiveness Index rankings of the World Economic Forum, out of 102 countries the top three transition countries are Estonia (which placed 22nd), Slovenia (31st) and Latvia (37th). Serbia was in 77th place. This approach to the expected outcomes from the education system has significant implications for various aspects ofeducation policy, to be discussed in more detail below.
D. PERFORMANCE OF THE EDUCATIONAND TRAININGSYSTEM
6.9 Serbia has a relatively low average level of education Figure 6.1 Educational Attainment, 15 and Over Population, among its adult population. In Serbia 2002 Compared with Slovenia 2002 and Estonia 2000 1991, only 42 percent of Serbia's adult population had secondary or tertiary qualifications. As Figure 6.1 shows, this im roved to 53 percent in 2002,p42 but this compares poorly with 67 percent in Estonia and S10venia.l~~ No schooling Incomplete Complete Secondary Tertiary Serbia's relatively low average basic basic educauon educational attainment (along Jte: Basic education corresponds to primary education in Serbia (ISCED 2A). with its outdated technology) Tertiary education includes non-university post-secondary institutions. helps to explain why its most Source: Population censuses. successfbl exports are lower-level processed goods and unskilled, labor-intensive products.
14' For the purposes ofthis discussion, several different theories have been included with this 'active' approach. The first is rates of retum, which compares the costs and benefits to individuals and society of investment in human capital: see Psacharopoulos and Patrinos (2002) for a recent example of this approach. The second theory is endogenous growth models, in which investments in education and training give rise to extemal benefits (implying that social gains exceed private gains); there are increasing returns to the use ofmore skilled workers in certain sectors (in the sense that marginal costs decline as output and such employment increase); and knowledge (in the production and dissemination of which individual capacities are critical) is a public good, the use of which by one individual does not reduce its use by others (Behrman 1997 reviews these models). The third theory is intemational trade theory which argues that changes in the quantity and quality of education can shift a country's comparative advantage away from products and services based on cheap, relatively unskilled labor towards skill-based products and services (see Wood, 1994). '42 Part ofthis change may reflect the inclusion of Kosovo in the 1991 figures and its exclusion from the 2002 data. '43 There are also differences in the proportions with tertiary education, but, given differences in definitions and in quality, comparisons at this level can be misleading.
118 6.10 Serbia's average level of educational attainment has Figure 6.2: Gross Enrollment Rates by Level of been improving and will Serbia Compared with Slovenia, Estonia & Romania continue to do so. However, with the present trends, this improvement will be slower than for key competitors (and many of these competitors have not suffered the same decline in GDP and education enrollments as Serbia). As Figure 6.2 shows, Serbia's total secondary enrollment rate in Serbia Slovenia Estonia Romania 2001, at 76 percent, was slightly higher than that of Source: Serbia, Ministry of Education; Other countries, UNICEF MONEE database. Romania but much lower than in Slovenia and Estonia. The flow of school-leavers and graduates on to the labor market depends not only on enrollment rates but also on repetition and dropout rates within levels. The big problem here is in the universities, from which only 11 percent of students graduate on time, and for which the average length of study is about eight years (Turajlic, 2003). In short, Serbia is still likely to be at a quantitative disadvantage as far as its stock of educated adults is concerned relative to many ofits competitors, unless enrollment rates are raised significantly.
6.1 1 Serbia also faces problems regarding the quality of its education. As in many other formerly planned economies, the predominant approach to teaching and learning in Serbian educational institutions (schools, universities and pre-service teacher training) is based on memorization, which builds strength in the acquisition of facts or in solving a known class of problem. To acquire the new skills that determine success in the labor market of a knowledge economy subject to global pressures, students need to know how to apply a given technique, or to select an a propriate technology or technique to solve a new problem or a real-life challenge (Table 6.l)." This shift has wide-ranging implications for the education and training system. For example, if students are to acquire analytical skills and to be independent learners, teachers must do more than lecture to students and assess their memory for facts, and the materials available to students must be varied and must spark their interest. If young people are going to work in teams in the workplace (rather than in highly hierarchical organizations) - learning from but also helping their colleagues and taking collective responsibility for quality products - then this practice should start in schools and universities.
6.12 Reliable measures of educational quality in Serbia are only just emerging, but the available evidence gives cause for concern. Serbia did not participate in the OECD PISA 2000 study (OECD 2001), which sets out to measure the extent to which 15-year-olds in 32 countries possessed new skills of this kind and their capacity to use what they had learned in language, mathematics and science to meet real-life challenges. However, Serbia was included in a new
Fifteen-year-olds in three out of the four transition countries that answered this question in the OECD Programme for International Student Assessment (PISA) study tended to make greater use of memorization than their OECD counterparts and less use of a cooperative approach to learning.
119 round of PISA tests in 2003 and in the more academic Trends in Intemational Mathematics and Science Study (TIMSS) tests (see Mullis et al., 2000 and Martin et al., 2000). Serbia’s results in these assessments are not available but can be predicted from two sources. First, a study of eighth-grade students in Serbia in 2000 which tested similar skills reported disappointing results. In general, the students’ test results did “not meet the functional standards of basic literacy on which the tests were based” (UNICEF, 2001:105). The only subject in which the number who passed (scoring 4-7) exceeded the number who failed (scoring less than 4) was the Serbian language, and the proportion achieving scores of 6 (very good) and 7 (excellent) was small - 25 percent in language, 7 percent in mathematics and 1 percent in science. Students had particular problems with questions that probed their ability to use what they had learned in all three subjects.
Old skills: New skills: Apply knowledge acquired by rote 0 Apply problem-solving strategies Use invariant sources ofinformation 0 Acquire, evaluate information from diverse sources Work as a ‘solo practitioner’ Work as a collaborator or member of a team 0 Operate in routine, unchanging ways Operate in a flexible, self-correcting way
6.13 Second, Serbian 15 year-olds taking PISA tests in 2003 are reported to have found questions that tested their ability to use knowledge in real-life situations unfamiliar and ~0nfusing.l~~This is consistent with the experience of other transition countries. While the students tended to do well on the more academic TIMSS (and very well for their level of GDP per capita), they did poorly on the PISA. Serbia’s results could be expected to be similar.
6.14 An important part of the explanation for the poor quality and the low overall educational attainment is the performance of the country’s vocational schools, which in socialist economies such as pre-transition Serbia provided the link to the labor market. While many transition countries have moved away from this model, a very high 75 percent of Serbia’s secondary enrollment is still in such schools. The initial vocational schools (providing two and three year programs) are in particular crisis because of the collapse in their funding and in the demand for their graduates, and also because of their obsolete equipment, their previous narrow and early specialization approach, their poorly qualified professors, and their lack of a link with the newly emerging type of labor market. For these reasons, and because they do not provide a route to higher levels of education, these vocational schools are unpopular with students and parents, who do not choose them willingly and would prefer general secondary education (OECD, 2001a) but are unable to acquire secondary education because of enrollment limits set by the g~vernment.’~~
6.15 Sufficiently detailed data on Serbia are not yet available to compare the labor market performance of vocational and general education graduates. However, in Bosnia and Herzegovina (a country with a similar educational legacy) a recent study (Papps and Burton,
14’ Information from the Center for Evaluation and Assessment. 146 Some parents think that by attending a three-year program their children will quickly learn a skill which will get them a job. Unfortunately, the statistics show that this is rarely the case, except for low-paying and insecure jobs. Many of these young people therefore drop out ofthe labor market.
120 2003) found that the private rate ofreturn to three-year secondary vocational schooling was zero, compared with a 4 percent retum to secondary general education. These relative returns are driven by the higher costs of vocational education and the fact that these students overwhelmingly get poorly paidjobs.'47 In Serbia, too, vocational education is more expensive - 28 percent higher (UNICEF, 2001)'48 - even with obsolete equipment and constrained budgets. However, the poor performance of three-year vocational programs is not simply a function of low levels of investment. Programs at the secondary level which attempt to track small changes in the demand for particular skills in the labor market cannot be successful for the large number of Serbian students currently in these programs, most of whom will need a flexible set of skills so that they can learn new skills on the job as the nature of production or services changes. So, while there is a need to give more young people access to secondary education, it is not simply a question of more of the same. Instead there needs to be a shift towards more general education and to improved quality.
6.16 Serbia's tertiary education system'49 also fails to provide a steady supply of graduates with appropriate skills for successful adaptation to a changing labor market. On some measures, the tertiary system seems to do well. For example, in 2002, people with tertiary education qualifications showed much lower rates of unemployment (6 percent compared with the national average of 11 percent), greater penetration into the formal sector (representing 12 percent ofthe formal sector as against 3 percent ofinformal sector workers), and higher incomes (48 percent more than those with only secondary school qualifications). In particular, incomes for university graduates are relatively higher in the informal economy, which suggests an ability to respond flexibly to market opportunities.
6.17 However, one cannot conclude directly from these encouraging figures that degree holders have the right set of skills. A more plausible explanation is that employers, faced with a large pool ofjob applicants because of the high levels of unemployment, choose those with the highest levels of educational attainment.'5o In any case, those with tertiary education are relatively scarce (representing only 11 percent ofthe adult population) because ofpast migration of tertiary graduates and current low enrollment rates plus high dropout and repetition rates which double the average time actually taken to get a degree and result in the fact that over 60 percent ofenrolled students never succeed in getting a degree.'51
6.18 Examining the organization of tertiary education and the nature of its programs reinforces this conclusion. The autonomous faculty system leads to costly duplication in
14' Three-year vocational education students are weaker than those in secondary general schools, whether because of worse preparation in primary education or because of a disadvantaged social background. Their eamings may have been lower than those of stronger students, whatever type of schooling they had. This means that relative rates of retum have to be treated with care, but adjustment for this would be unlikely to invalidate the contrast. 14' While this figure is for all types of vocational education, three year programs are generally even more expensive because they require higher levels of practical equipment and have smaller class sizes. 14' See Turajlic (2003) for a full discussion of tertiary education. Other evidence also suggests that employers are choosing university graduates for reasons in addition to the skills they have acquired at university and that there is some discrimination in the labor market. For example, 13 percent of formal sector employment is in the govemment, in which university graduates are over-represented and, though a higher proportion of women have university degrees, they have higher levels of unemployment (14 percent compared with 9 percent for men) and lower wages (15 percent below men with similar characteristics). 15' While the lack of private institutions may have meant that Serbia has avoided problems of the poor quality often seen in other countries, it has also meant a low enrollment rate.
121 teaching (with each faculty organizing its own courses in subjects outside of its specialization), administration and services. In the absence of real accountability, it has also led to outdated curricula and teaching methodologies and reading lists and mono-disciplinary programs that are highly theoretical and unrelated to labor market reality.
6.19 The shortcomings of the initial, formal education system are compounded by the weaknesses in the supply of quality adult education and training opportunities. As result, those with weak or inappropriate skills and knowledge are particularly affected by these shortcomings. The legacy of a network of adult education institutions and organizations has not been preserved (DespotoviC et al., 2003). The number of schools offering primary education to adults has dwindled from several dozens in the 1980s to 16 in 2003, which offer remedial courses to adolescents who are too old for primary education and/or have learning difficulties. In 2003, there were only about 7,500 people in these courses. Secondary vocational schools allow adults to take examinations in certain subjects but do not make special provision for training them (unfortunately, no enrollment data are available). There are a few programs of continuing education in the universities, but these are limited to former students. The active labor market programs described in Chapter 5 are also part of the lifelong learning system and can help the unemployed and the disadvantaged improve their position in the labor market.
6.20 In principle, the active labor market programs, financed by the National Employment Service (NES), provide a range of training and retraining programs, but in practice these are not available. The training of up to three months includes: (i)basic training designed to boost the skills of employees with little or no schooling; (ii)training for current and future skill needs (e.g., English language and information technology); and (iii)employer- focused training in response to the expressed needs of particular companies. In fact, the income from the unemployment insurance levy (1.1 percent of the wage bill) is only sufficient to cover 60 percent of the NES budget, which is spent almost entirely on passive programs such as employment benefits, rather than on active measures such as training, job search assistance and counseling. Job search assistance, which is based on international experience is one of the most cost-effective active labor market interventions (see Chapter 5), is underdeveloped in Serbia. The tracking ofprogram participants is nonexistent (World Bank, 2003~).
6.21 In all economies, the biggest financiers and organizers of training are enterprises. This type of training in Serbia is weak. Data from the World Bank's Business Environment and Enterprise Performance Survey (BEEPS) for 2001 are rather worrying, as Table 6.2 shows: those who work for the few firms in Serbia and Montenegro that offer training do relatively well, but the proportion of firms that offer training at all levels is below the average for comparable transition countries.
6.22 Firms are investing too little in training, given the need for an accelerated transition. For example, Papps and Burton (2003) showed that enterprises are generally passive in response to a difficult business environment - waiting for it to change - and have not taken all the steps they could to improve their own organizational performance (in part through acquiring new knowledge, ideas and techniques through training). In addition, the Productivity and Investment Climate Survey (PICS) suggests that the situation may have deteriorated recently. The proportion of companies in SaM offering formal (beyond on-the-job) training to their
122 employees fell from 56 percent in 2001 to 31 percent in 2003, and there was a contrast between small companies (only 21 percent of which offered training) and medium and large companies (41 percent of which offered training). Even in companies which offered training, a relatively small proportion of employees received it and for relatively short periods. Interviews with enterprises and with the Chamber of Commerce underline the importance of attracting direct foreign investment as a means of upgrading skills through enterprise training and of boosting competitiveness. As noted above, a key factor in attracting this type ofinvestment is a high level ofskills in the labor force.
Table 6.2 Training of Employees by Enterprises, Serbia and Montenegro in a Regional Context, 2001 Managers Professionals Skilled Unskilled Support workers workers workers 1. % of SaM firms which offered formal training at this level 27% 31% 33% 8% 9% 2. Ranking of SaM among 18 comparable transition countries a 13 15 11 15 15 3. % ofworkers at this level in these fiiwho received training 64% 59% 59% 51% 82% 4. Ranking ofSaM among 18 comparable transition countries a 8 7 4 7 1 5. % ofworkers in SaM fiiwho received training at this level (row 1 x 17% 18% 19% 4% 7% row 3) a Comparator countries are: Slovenia, FYR Macedonia, Bosnia and Herzegovina, Croatia, Estonia, Lithuania, Latvia, the Czech Republic, Hungary, the Slovak Republic, Poland, Russia, Ukraine, Belarus, Moldova, Bulgaria and Romania. Source: Business Environment and Enterprise Performance Survey (2001).
6.23 A problem for all types of adult education and training at all levels is the weakness in certification and quality control. Qualifications within the formal adult education system are lacking, and in the non-formal system the situation is chaotic. Courses in non-profit institutions usually do not lead to a vocational qualification that is recognized in the labor market. As for private schools, anyone can open such a school; some even sell their certificates, which in any case are not valid nationally. Thus enterprises that are looking for off-plant training for their employees, and the National Employment Service when it is looking for sub-contractors for active labor market programs, have little evidence about the relative quality ofwhat is on offer.
E. A REFORM AGENDAFOR SERBIA’S EDUCATIONAND TRAININGSYSTEM
6.24 As this chapter has demonstrated, Serbia’s education and training system faces a number of critical problems. Addressing all ofthese problems will require a carefully designed strategy with short, medium and longer term reforms, which can be managed within the fiscal and staff capacity limitations of the country. This section offers some considerations for reform based on international good practice, while the next section provides some guidance as to the most significant costs ofthe proposed package.
6.25 The most urgent need is to address the problems of quality and enrollment in secondary education so that the graduates can acquire the skills and knowledge they will need to be successful in the labor market.
123 6.26 Reliable measures of educational quality, which can inform policymakers, students, parents, schools and the public, are an essential feature of a strong education system. Such measures are beginning to emerge in Serbia, thanks to the high quality work being done by the Center for Evaluation and Asses~ment'~~established in 2001. The lessons of the PISA and TIMSS results should be studied when they are ready, as the starting point for building a reform agenda. They are likely to give evidence of the need for a shift to teaching and learning approaches that enable students to acquire new types of skills and knowledge. Such as shift should be given top priority. An overhaul ofthe teacher training system may be necessary so that it is driven by the analysis of student and school performance rather than by bureaucratic accreditation requirements. Intemational practice suggests that training is most effective when carried out in small chunks over an extended period of time, to give teachers a chance to try out their new skills before coming back to discuss their experiences with, and to learn from, their col~eagues.'~~
6.27 In the medium term, the number of students completing four-year secondary education should be increased, because this is becoming the minimum standard for successful labor market experience in EU countries (OECD 2001b). For reasons of efficiency and of quality, this implies a shift away from vocational education programs, especially those of only three-year's duration. In four-year programs the curriculum should be broadened to provide more flexible skills for students, away from narrow job specifications and towards skills and knowledge common to a family or range ofoccupations.
6.28 Urgent attention is also needed for those with low skills who are already in the labor market and have few good prospects. An estimated 3 million adults already in the labor market have not completed secondary education but need to do so to get better jobs and to be more productive. Providing this by using vocational schools and higher education institutions for adult education and lifelong learning would be more effective and efficient than creating a new set of designated centers. Finally, urgent attention is needed to address the problem of the more than 12,000 people between the ages of 15 and 35 who, according to the 2002 census, were completely illiterate.
6.29 It is important to decentralize management to the principals of schools and to school boards, with the amount of funding for each school determined by a formula (based mainly on the number of students enrolled). This policy should create incentives to increase efficiency and raise the quality of education. Schools would receive block grants, no longer tied to line items in the budget. This would enable principals to increase efficiency by, for example, reducing the number of teachers and paying higher salaries, increasing the proportion of fhds going to maintenance and materials, or providing locally determined curriculum content. There is
Under the recently passed amendments to the Education Law, this Center will become the Education Quality Evaluation Institute. Information and communication technologies have the potential to promote new forms of teaching, but we would not recommend a large program to increase the penetration of computers at the moment, as this is very expensive and many teachers do not know how to use the technology - an experience all too common even in OECD countries (OECD 2004). Current penetration rates of computers are low: in gymnasiums (the most privileged schools) there are approximately 35 students per computer. Teachers need to be trained in how to use ICT in teaching their subjects, and they need materials for ICT-based teaching and the capacity to develop their own materials. Moreover, 3 1 percent of schools are without a telephone connection of any kind (Bogojevic et al., 2002).
124 considerable international experience regarding formula funding' 54 from which Serbia could benefit and which should enable Serbia to keep a focus on quality improvement and avoid problems of unfettered competition that would lead to a deterioration in equity of access and outcomes.
6.30 The key issue in tertiary education is its inefficiency. Our calculations indicate that if the average length of time it takes to graduate were reduced from the current eight years to six years, then 25,000 more students could be educated for the same amount of public money as is currently spent. This would raise the enrollment rate from 32.1 percent to 36.2 percent. Increasing the number of university graduates need not lower the quality of education (although there is a need for a new system of quality assurance to verify what is being learned). Under the current arrangements, there is a clear incentive to make it difficult for students to graduate as this generates more money for institutions and individual professors and for students most ofthe cost of education is met from public funds. The incentive for the institution should encourage it to help students graduate on time and with the knowledge that they need.
6.3 1 Reforming the governance of universities, away from autonomous faculties and towards European-style corporate institutions, is essential to provide incentives to improve the efficiency of the tertiary system. The financing and promotion system should include incentives for good teaching and not merely for research. The rule that places a 30 percent limit on the extent to which publicly funded colleges can top up staff salaries should also be abolished: the only way that such colleges can attract and retain teachers in marketable subjects is to pay them closer-to-market salaries. Creating a central management structure of universities and abolishing the separate legal status of faculties would also create the conditions that would enable them to offer shorter, more flexible courses which would be more attractive to adults (another way to increase enrollment and revenue). Reducing the number of staff would enable the remaining staff to have higher salaries.
6.32 These new curricular, financial and quality assurance reforms in tertiary education will require some additional resources; but the sums required are not large. In the longer term, beyond the 2010 horizon, expansion of tertiary education would require additional resources. The Government will need to consider carefully whether expansion can continue to be funded from the state budget or whether private sources, for example through higher student fees, will need to be tapped. In the longer term, too, the Government should consider creating greater equality in treatment with respect to financial support for those older people studying in higher education on a part-time basis and those younger people in full-time education to encourage lifelong learning.
6.33 The National Competitiveness Council (NCC) has highlighted the need for improving the skills and openness to learning of enterprises and employees (National Competitiveness Council 2003). Among its recommendations, there is a clear need for better management training (see also Papps and Burton, 2003), whether in the form of management degrees, short non-degree courses, or customized training for particular enterprises. Some of this
154 For a review of such schemes, see Ross and LevaCiE (1999). The cost of introducing a formula-based school financing scheme would be only small - of the order of 200-300 million dinar - to train the relevant staff, buy the software and equipment, and to provide transitional funding so that individual schools' budgets do not fluctuate too sharply in the short run.
125 training might be developed, as the NCC suggests, by establishing connections with leading universities around the world to obtain access to the latest training materials. However, the argument for the use ofpublic funds for this purpose is not strong, given that companies already tend to use their training budgets more heavily for managers. Another activity that could be started even more immediately would be to develop a more effective internship program which would match university students with competitive firms. International experience suggests that this can be beneficial for all parties: the universities acquire knowledge about how leading companies work; the student works on real-life problems and often is recruited by the company; and the company acquires an employee who is often able to solve problems by using the new knowledge acquired at university. The problem in Serbia seems to be that the expectations of each party (university, company, and student) are not sufficiently explicit or thought through, and the link between the study program and real activity in the workplace is weak.
6.34 One important element in lifelong learning is training provided by enterprises, which is currently confined to a relatively small number of larger firms. A particular challenge is providing training and skill upgrading for those people in small and medium-size enterprises (SMEs), especially those in the informal sector. Given the size of the informal sector in Serbia, this is a matter ofparticular concern. SMEs generally do not invest significantly in the training of their employees because they see the certainty ofcosts of lost production outweighing some fbture potential gain fiom improved productivity as a result of training. These companies can therefore find themselves caught in a low-skill, low investment trap.
6.35 In the short term, the best immediate hope for an increase in enterprise training activity probably lies in an increase in the inflow of foreign investment, since foreign-owned companies are typically better at providing training programs for employees at every level. This has the potential to help SMEs, if they can become part of the supply chain to larger, export- oriented companies who set higher standards for quality and productivity. Previous chapters of the report discuss measures to improve the climate for FDI. A culture ofenterprise training needs to be developed to ensure that firms are ready to participate. This is a role for government.
6.36 The government should also consider whether some kind of training levy/grant would be appropriate and fiscally prudent (typical amounts are 1-2 percent of payroll costs). The international evidence shows that levies can increase the amount of training although some key principles need to be observed (Box 6.1).'55 While an overall increase in training is clearly desirable, the govemment should design the scheme so as create the greatest incentives for training for workers with the least skills, as companies tend to be more ready to invest their money in training for managers (who after all make decisions about the training budget!). The Singapore Skills Development Fund has such incentives (Kuruvilla et al., 2002).
6.37 In the case of SMEs, some public investment will almost certainly be necessary to create a demand for training, so that an appropriate training market for SMEs can develop (Ziderman, 2004). Given that state intervention in the informal and SME sector is fraught with the danger of over-regulation, any program for training support should start small and be evaluated carefully.
Is' Further discussion of training levies and other schemes can be found in Middleton, Ziderman and Adams (1993), Ziderman (2003), Kuruvilla et al., (2002), and Dar, Canagarajah, and Murphy (2001).
126 Box 6.1 Principles for Effective Implementation of Training Levy/Grant Schemes
Employer buy-in. Governments should ensure that employers are consulted at an early stage and are involved in the design, implementation and evaluation of the scheme.
Administrative efficiency and transparency. This would include effective levy collection mechanisms, efficiency in processing and reimbursing claims, and clear and transparent application procedures which promote employer compliance. In poorer countries, where admmistrative capacity is not as well developed, non-compliance rates tend to be higher, especially among smaller employers.
Fund design should ensure that government and non-governmental training providers are able to compete on a level playing field to provide training funded from the scheme.
Evaluation is essential to improve the effectiveness of schemes once they are operational.
Source: Adapted from Dar, Canagarajah and Murphy (2001).
F. THE COST OF REFORM
6.38 Public spending on education is planned to rise from 3.6 percent of GDP in 2003 to 4.5 percent in 2010, according to the targets in the Poverty Reduction Strategy Paper (PRSP)'56. Figure 6.3 shows the implications for public expenditure on education'57 of the two illustrative scenarios developed in Chapter 2 of the report. As can be seen, real public expenditure on education is projected to rise by 51 percent in the period under the weaker reform scenario and by 77 percent under the stronger reform scenario.
6.39 The number of students over whom the resources will have to be spread is falling, which opens up the possibility of a shift in spending to quality-enhancing inputs. Between 2003 and 2010, if enrollment rates remain unchanged, the number of pupils can be expected to fall:
0 At the primary level, by 36 percent, even allowing for the increase in duration from eight to nine years (or eight years of primary and one year of compulsory pre- school education) 0 At the secondary level, by 19 percent, and 0 In tertiary education by 8 percent.
6.40 If cost per student, enrollment rates and pupilheacher ratios in primary, secondary and tertiary education remained as they were in 2003, real resources needed to fund these levels of education would decline at the same rate as their student numbers, yielding a large surplus for
156 For the purposes of this Chapter, these PRSP projections have been used, since they represent the Govemment's plans. These increased allocations will bring Serbia significantly closer to, but still below, EU and regional averages, which in any case are also rising. As will be seen below, even with the PRSP projected budget allocations, there are, with certain important assumptions, sufficient resources to fund the reforms outlined in this Chapter. Moreover, any further increases in budget allocation must be predicated on improved efficiency and effectiveness of that spending, along the lines suggested in this Chapter. 15' This excludes public expenditure relevant to education and training which falls outside of the budget of the Ministry of Education and Sport, such as the active labor market programs of the National Employment Service or expenditure or forgone revenue in support of enterprise training.
127 other purposes. If, however, teachers' salaries were increased at a rate of 4 percent a year (in order to attract and retain good quality graduates in the profession in the interests of quality improvement), the composition of real current expenditure on education would change, with significant increases in quality-enhancing non-salary expenditure (Table 6.3). This projection depends critically on the ratio of pupils to teachers continuing at the present level, which is in line with relevant comparison countries.
Figure 6.3: Index of real public expenditure on education
under two scenarios, 2003-2010 ~
~ - - - 180.0 ,II 170.0 , 160.0 I 1 150.0 1 0 +Mddle through 8 140.0 N, -Credible adjustment 8 130.0 --F 120.0 , *,/- 4 110.0 i 100.0 --- ~ 2003 2004 2005 2006 2007 2008 2009 2010 ,
6.41 Over the whole period, on these assumptions, the current budgets at each level would change as shown in Figure 6.4: the current budget for primary education would rise by 6 percent, for secondary education by 17 percent, and for tertiary education by 25 percent. The funds available for reform purposes would increase from 6.5 billion dinars (or 0.7 per cent of GDP) in 2003 to something like 20.3 billion dinars to 29.0 billion dinars (1.7 to 2.1 percent of GDP) in 2010 depending on the rate of overall economic adjustment. Over the whole period, the total amount available for the reform agenda could amount to between 105.3 and 127.9 billion dinars.
Table 6.3 Projections of number of teachers and real salary and non-salary expenditure, by level of education, assuming 4 percent annual average increase in salaries and no change in enrollment rates and pupil/ teacher ratios, 2003-2010 2003 2004 2005 2006 2007 2008 2009 2010 Primary No. of teachers ('000) 41 37 35 32 34 31 29 26 Salary expenditure ('000 mn dinars) 7.9 7.5 7.2 6.9 7.7 7.3 7.0 6.7 Non-salary exp ('000 mn dinars) 6.6 7.0 7.0 7.0 8.0 8.0 8.0 9.0 Secondary No. of teachers ('000) 23 22 22 21 21 20 19 18 Salary expenditure ('000 mn dinars) 3.9 3.9 4.0 4.0 4.3 4.2 4.2 4.1 Non-salary exp ('000 mn dinars) 3.1 3.0 3.0 3.0 4.0 4.0 4.0 4.0 Tertiary education No. of teachers ('000) 6.4 6.3 6.3 6.3 6.3 6.2 6.1 5.9 Salary expenditure ('000 mn dinars) 3.7 3.8 3.9 4.0 4.2 4.3 4.4 4.5 Non-salary exp ('000 mn dinars) 1.9 2.0 2.0 2.0 2.0 2.0 2.0 3 .O
128 ---I-____ - - __ ~ Figure 6.4: Projections of real current education budget, with salary increase, by level & surplus available by sce na rio, 2003-201 0
70.0
~ 60.0 1 50.0 5 Available for other purposes ' 5 40.0 if rmddle through Ii E 30.0 0 Higher 0 g 20.0 Secondary I 10.0
0.0 Rimary
- .. ._......
6.42 Some of these extra resources should go to capital expenditure (equivalent to only about 5 percent of current expenditure at present). Serbia's educational institutions are in great need of repair and renovation. A survey of schools in 2001-02 found many ofthem lacking basic power, water and sewage facilities (Bogojevic et al., 2002). It would be possible to spend all of these extra resources - and more - on capital investment. But this would not be a good use ofthis money given the other priorities that this chapter has identified. Perhaps 25 percent of the additional resources might be used for this purpose.
6.43 To provide a complete secondary education for those with only primary education would cost approximately 8.4 billion dinars.158 Unfortunately no figures are available for providing courses for those who are not functionally literate or numerate, though funding these programs should be a priority.
6.44 To increase the secondary enrollment rate to 100 percent would cost around 8.4 billion dinars over the whole 2004-2010 period, assuming the current pattern of student enrollment was retained. However, the cost of increasing the number of students in upper secondary education depends directly on the type ofeducation provided. A shift away from more expensive and ineffective vocational education, particularly three-year education, is proposed partly because it will release resources to be used elsewhere. If, for example, the proportion of upper secondary students in vocational schools were reduced from 76 percent to 50 percent then the cost savings would be around 3.7 billion dinars over the whole period. This is about half the estimated cost ofmaking secondary enrollment universal.' 59
This assumes all the 2.5 million people in this category take the equivalent of 2 years of additional schooling. 159 The costs of any remaining vocational schools could be reduced by designating some of them (one in four or five) as resource centers, which, while still functioning as schools, would provide clusters of schools with access to learning materials, resources and modem equipment and production machinery for training purposes. Such centers could also be used for skills testing, teacher training, course development information and dissemination. However, equipping the resource centers would be costly, and schools would still need a full set of lower-level basic equipment.
129 6.45 Finally, there are currently around 23,000 secondary education teachers in Serbia and training them all for 5 days each year for three years would cost an estimated 0.8 billion dinar - training all primary education teachers as well might cost an additional 1.4 billion dinar.
6.46 All in all, there should be ample resources within the sector to finance both an increase in capital and non-salary current expenditure, to the benefit of quality and an increase in salaries for teachers. This assumes, however, that a scenario close to credible adjustment prevails and the spending increases projected in the PRSP are forthcoming, as well as a significant reduction in the number ofteachers in line with the fall in pupil numbers.
6.47 This reform agenda depends on the government taking specific actions, in some cases reversing recent policy moves. The uncertainty of the reform context is outlined in Box 6.2.
Box 6.2 Policy Context for Education Reform
1 The policy context for education reform is uncertain. The previous Government passed an Education Law (in 2003) which proposed many significant changes for the system - for example, extending compulsory education to nine years and changing the phases for basic education, creating seven centers outside the Ministry responsible for various education issues, and giving greater autonomy to schools. That Government also drafted a law on higher education which would have significantly restructured the fragmented university system.
G. CONCLUSION
6.48 The impact of the augmented reform package would be broadly as follows:
0 The quantity of educated people would be increased by raising the upper secondary enrollment rate, accelerating the graduation rate of students in the tertiary education system, and providing the certification and quality control framework within which adult education and lifelong learning can flourish.
0 Educational quality would be improved by a shift in teaching and learning approaches towards the generation ofthe new broad and flexible skills demanded in a competitive knowledge economy: the decentralization of management to schools within the framework of a national system for curriculum, testing and inspection; a reduction in the weight of vocational education relative to general secondary education; and increases in teachers' salaries and in non-salary current expenditure.
130 The improvements in quantity and quality would boost economic growth through the direct impact on enterprise performance of the increasing use of more skilled
' workers, and external benefits generated from knowledge as a public good.
The role of government as protector of the disadvantaged would be strengthened by shifting secondary education away from dead-end and ineffective three-year vocational education; by introducing a fimding formula in schools that would give greater weight to schools which educate students from poor backgrounds; and by nurturing a culture oftraining in enterprises.
0 The efficiency of public spending would be increased by improvements in the efficiency of restructured universities and within autonomous schools; reductions in the number ofteachers in line with the fall in the number ofpupils; and expansion of general secondary enrollment in relation to vocational secondary enrollment.
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