Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 58222-YF

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED POLICY BASED GUARANTEE OF UP TO EUR 300 MILLION (NOT TO EXCEED THE EQUIVALENT OF US$400 MILLION)

TO

REPUBLIC OF SERBIA

FOR

PRIVATE AND FINANCIAL SECTOR

POLICY BASED GUARANTEE

January 14, 2011

Private and Financial Sectors Development Unit (ECSPF) South East Europe Country Unit (ECCU4) Europe and Central Asia (ECA) This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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REPUBLIC OF SERBIA - GOVERNMENT FISCAL YEAR January 1 – December 31

CURRENCY EQUIVALENTS (Exchange Rate Effective as of January 14, 2011)

Currency Unit Serbian Dinar

RSD 1.00 US$ 0.01 US$ 1.00 RSD 79.81

Metric System

ABBREVIATION AND ACRONYMS (As applicable, plus others)

bp Basis Points CAD Current Account DeficitCAR Capital Adequacy RatioCPI Consumer Price IndexCPS Country Partnership StrategyDB Doing BusinessDFID UK Department for International DevelopmentDIA Deposit Insurance AgencyDPL Development Policy LoanEAR European Agency for ReconstructionEBRD European Bank for Reconstruction and Development EC European CommissionECA Europe and Central AsiaEPS Elektroprivreda Srbije (Serbia’s national electric power utility)EPP Employment Promotion ProjectEU European UnionEUR Euro FDI Foreign Direct InvestmentsFRL Fiscal Responsibility LawFSAP Financial Sector Assessment Program FX Foreign ExchangeFY World Bank Financial YearGDP Gross Domestic ProductGoS Government of SerbiaIBRD International Bank for Reconstruction and Development ICA Investment Climate AssessmentICTY International Criminal Tribunal for the former Yugoslavia ICR Implementation Completion Report IFC International Finance CorporationIFI International Financial InstitutionIMF International Monetary FundJSC Joint Stock Company ISR Implementation Status and Results Report KfW Kreditanstalt für WiederaufbauLDP Letter of Development PolicyMOERD Ministry of Economy and Regional Development MOF Ministry of FinanceMOJ Ministry of Justice

MOP Material Support to Families (MOP in its Serbian acronym) MOU Memorandum of UnderstandingNBS National Bank of SerbiaNIS Naftna Industrija Srbije (State Oil Company)NPL Non-performing LoansPA Privatization AgencyPDMA Public Debt Management AuthorityPEDPL Public Expenditure Development Policy LoanPER Public Expenditure ReviewPFDPL Programmatic Private and Financial Development Policy LoanPFM Public Financial ManagementPFMA Public Financial Management AssessmentPFSPBG Private and Financial Sector Policy Based Guarantee PPFDPC Programmatic Private and Financial Development Policy CreditPSN Private Sector NoteREER Real Effective Exchange RateRIA Regulatory Impact AnalysisROA Return On AssetsROE Return On EquityRoS Republic of SerbiaRSD Serbian DinarSAA Stability and Association Agreement SBA Stand-By ArrangementSBRA Serbian Business Registers AgencySDR Special Drawing RightsSECO State Secretariat for Economic AffairsSIDA Swedish International Development Cooperation Agency SOE Socially-Owned EnterpriseTA Technical AssistanceTF Transition FundUN United NationsUSAID United States Agency for International Development US$ United States DollarVAT Value Added TaxWEO World Economic Outlook

Vice President:

Country Director:Sector Director:Sector Manager:

Task Team Leader:

Philippe H. Le Houerou Jane Armitage Gerardo Corrochano Lalit Raina Aurora Ferrari

REPUBLIC OF SERBIA PRIVATE AND FINANCIAL SECTOR POLICY BASED GUARANTEE

TABLE OF CONTENTS

I.  INTRODUCTION ........................................................................................................................................ 1 

II.  COUNTRY CONTEXT ............................................................................................................................... 2 

A.  POLITICAL CONTEXT .................................................................................................................................. 2 B.  MACROECONOMIC PERFORMANCE ............................................................................................................. 3 C.  ELIGIBILITY FOR POLICY-BASED GUARANTEE .......................................................................................... 14 D.  RECENT BANKING SECTOR DEVELOPMENTS ............................................................................................ 19 

III.  THE GOVERNMENT’S PROGRAM ................................................................................................. 21 

A.  ENHANCING BUSINESS ENVIRONMENT ..................................................................................................... 22 B.  STRENGTHENING FINANCIAL DISCIPLINE IN THE NON-PRIVATE ENTERPRISE SECTOR ............................. 26 C.  BUILDING A STABLE AND MORE EFFICIENT FINANCIAL SECTOR ............................................................. 31 

IV.  BANK SUPPORT TO THE GOVERNMENT’S STRATEGY ......................................................... 34 

A.  LINK TO CPS ........................................................................................................................................... 34 B.  COLLABORATION WITH THE IMF AND OTHER DONORS .......................................................................... 34 C.  RELATIONSHIP TO OTHER BANK OPERATIONS ......................................................................................... 35 D.  LESSONS LEARNED .................................................................................................................................. 36 E.  ANALYTICAL UNDERPINNINGS ................................................................................................................. 37 

V.  THE PROPOSED PRIVATE AND FINANCIAL SECTOR POLICY BASED GUARANTEE ........ 38 

A.  OPERATION DESCRIPTION ........................................................................................................................ 38 B.  POLICY AREAS ......................................................................................................................................... 40 C.  GUARANTEE INSTRUMENT ....................................................................................................................... 42 

VI.  OPERATION IMPLEMENTATION .................................................................................................. 44 

A.  POVERTY AND SOCIAL IMPACTS .............................................................................................................. 44 B.  IMPLEMENTATION, MONITORING AND EVALUATION ............................................................................... 45 C.  FIDUCIARY ASPECTS ................................................................................................................................ 46 D.  ENVIRONMENTAL ASPECTS ...................................................................................................................... 47 E.  RISKS AND RISK MITIGATION .................................................................................................................. 47 

ANNEX 1. LETTER OF DEVELOPMENT POLICY ..................................................................................... 49 

ANNEX 2: PFSPBG POLICY MATRIX ........................................................................................................... 62 

ANNEX 3: DEBT SUSTAINABILITY ANALYSIS ......................................................................................... 65 

ANNEX 4. IBRD GUARANTEE ........................................................................................................................ 74 

ANNEX 5. IMF PROGRAM PRESS RELEASE.............................................................................................. 81 

ANNEX 6: TENTATIVE TIMELINE FOR PROCUREMENT AND APPROVAL OF A COMMERCIAL LOAN WITH IBRD GUARANTEE .................................................................................................................. 82 

ANNEX 7: COUNTRY AT A GLANCE ........................................................................................................... 83 

The Private and Financial Sector Policy Based Guarantee (PFSPBG) was prepared by an IBRD team consisting of Aurora Ferrari (Task Team Leader), Andrej Popovic (ECSPF); Irina Astrakhan (AFCZA); Lewis Hawke (ECSPS), Eugene Gurenko (FPDSN); Nikola Ille (ECSSD); Alexandru Cajocaru, Caterina Ruggeri Laderchi, Dusko Vasiljevic, Marina Wes (ECSPE); Nikolai A. Soubbotin (LEGEM); Nicholay Chistyakov (LOAFC); Gianfranco Bertozzi, Tomas Inge Magnusson, Hiroshi Tsubota (BDM); Neil Pravin Ashar, Thomas A. Duvall (LEGCF); and Xavier Cledan Mandri-Perrott (FEUFS). Aida Japarova and Jasna Vukoje provided support to the team.

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LOAN AND PROGRAM SUMMARY

REPUBLIC OF SERBIA

PRIVATE AND FINANCIAL SECTOR POLICY BASED GUARANTEE

Borrower Republic of Serbia

Implementing Agency

The Ministry of Finance (MOF) of the Republic of Serbia will be responsible for overall implementation of the proposed operation. Other key ministries and agencies responsible for implementation of the operation will include: the Ministry of Economy and Regional Development (MOERD), the Ministry of Justice (MoJ), the Privatization Agency (PA), the Deposit Insurance Agency (DIA), the National Bank of Serbia (NBS), and the Serbian Business Registers Agency (SBRA).

Financing Data

IBRD policy based guarantee. The guarantee will cover the principal amount of a commercial bank borrowing of up to EUR 300 million, not exceeding the equivalent of US$400 million, with a six year bullet maturity on a non-accelerable basis. The exact Euro amount will be fixed using the exchange rate of the last day of the calendar month preceding the negotiation of the loan agreement. Procurement of the underlying commercial loan is being finalized; the tender has been completed and the Government of Serbia (GoS) has selected Société Générale. The transaction is contingent on the IBRD guarantee being in place at the time of signing. Following approval of the guarantee by the IBRD Board, and as per process established in the Public Debt Law, the Parliament of Serbia will ratify the Indemnity Agreement and adopt the Law authorizing the loan of Société Générale (see Annex 6 for details on the process and timeline). Terms of the commercial loan by Société Générale are as follows: six year bullet, interest rate equivalent to Euro swap rate plus 100bps, and 50bps arrangement fee. Standard IBRD guarantee fees would apply: a front end fee of 25 basis points and a guarantee fee of 50 basis points for the maturity of the guarantee.

Operation Type

The proposed Private and Financial Sector Policy Based Guarantee (PFSPBG) is designed to support a program of assistance to the Republic of Serbia to remove obstacles to private sector led-growth.

The IBRD Policy-based Guarantee of up to EUR 300 million, not exceeding the equivalent of US$400 million will be used to enhance a borrowing transaction from the international loan market. The Guarantee will lead to improvements in pricing and tenor, and it will contribute to enhancing Serbia's further access to international financial markets.

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Main Policy Areas

The PFSPBG supports the following three pillars of the Government of Serbia (GoS) program:

(i) Enhancing business environment, (ii) Strengthening financial discipline, and (iii) Building a stable and more efficient financial sector.

Key Outcome Indicators

Improved legal framework for corporate governance in place. Over the medium term, such a framework will support: (a) increased independence of the internal supervision body in Joint Stock Companies (JSCs); (b) increased shareholders rights; (c) stronger role of non-executive and independent members of the board; and (d) increased transparency of reporting. New set of regulations in place reflecting: (a) the elimination of not less than 190 unnecessary regulations, and (b) the amendment of 25 regulations and 20 laws by the end of 2011. Implemented recommendations are to lead to annual cost savings for businesses of at least EUR 120 million by end 2011. Establishment of a comprehensive record of state support measures, including subsidies and grants contributing to better expenditure management and more transparency. Capital Adequacy Ratio (CAR) of the banking system maintained at the level of at least 12 percent. Bank resolution framework improved through the introduction of: (i) bridge bank resolution on a closed bank basis for systemic banks; and (ii) financial assistance in the form of grants, loans or guarantees based on a least cost test performed by the DIA, and emergency funding arrangements for DIA. Consolidation of the RoS holdings in banking sector: banks with majority RoS ownership reduced from 4 to 2 by 2010.

Project Development Objective and Contribution to CPS

The objective of the PFSPBG is to support reforms in three policy areas: (i) enhancing business environment to encourage private sector investment; (ii) strengthening financial discipline with continued reform of the non private enterprise sector with a particular focus on bankruptcy; and (iii) building a stable and more efficient financial sector through continued restructuring of state holdings in banking, enhancing crisis preparedness, supporting insurance sector development, and promoting development of capital markets.

The proposed PFSPBG is consistent with the Country Partnership Strategy (CPS) and the CPS Progress Report. The envisaged reforms are also in line with the GoS’ aspiration to join the European Union (EU). PFSPBG continues the successful reforms supported under the Private Financial Development Policy Loan (PFDPL) I and II: the reforms proposed under the originally planned PFDPL III form the basis for the PFSPBG.

Risks and Risk Mitigation

Two sets of risk have been identified: macroeconomic and political. The residual macroeconomic risk is substantial. Serbia went into the financial

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crisis with a high current account deficit, aggravated by rapid foreign currency credit growth and large cross-border borrowing of domestic enterprises. An ongoing IMF program supports ambitious fiscal adjustment targets and requires significant external financial support and private sector debt rollover. Specific risks include: (i) The global economic outlook, while improved, remains uncertain. Economic risks are partially mitigated by the multilateral support package including from the IMF enhanced stand-by arrangement of EUR 3 billion, developed in close cooperation with the proposed PFSPBG.

(ii) Despite external adjustment, Serbia faces considerable balance of payments financing needs over the next few years. Risks are partially mitigated by Serbia’s robust agenda of policy reform, and as above, also by the size of the multilateral support package.

(iii) Potential vulnerabilities of the banking sector remain in the context of substantially reduced profitability and stable but high non-performing loans (NPLs). Mitigating factors include: (i) the high capitalization of the system, which can withstand the current level of NPLs, which are high but have stabilized in the past few months, (ii) the improvements in the bank resolution framework supported by the PFSPBG.

The residual political risk is moderate. A coalition Government facing prospects of elections within a year and a half could be pressured to reduce the pace of reforms. Mitigating factors include: (i) the economic crisis that has highlighted the urgency of reform, and (ii) a national consensus on the need for progress towards EU membership. EU Council's decision to forward Serbia's application to the European Commission for an opinion has boosted Serbia’s membership bid and the stability of coalition government.

Operation ID P102651

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INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A

PROPOSED PRIVATE AND FINANCIAL SECTOR POLICY BASED GUARANTEE TO THE REPUBLIC OF SERBIA

I. INTRODUCTION

1. This program document describes the Private and Financial Sector Policy Based Guarantee (PFSPBG) to the Republic of Serbia to support the Government’s structural reform program and mitigate the effects of the global economic crisis. The proposed policy based guarantee (PBG) is of up to EUR 300 million, not exceeding the equivalent of US$400 million. It will cover the principal amount of a commercial loan. The procurement process for the lender to the Government of Serbia (GoS) is in an advanced stage—the lead arranger has been selected by the GoS, and the respective law is scheduled to be submitted to the Parliament for approval upon approval of the PFSPBG by the World Bank Board. More details on the public procurement process of the lender and required steps are included in Annex 6.

2. A policy based guarantee is proposed in light of Serbia’s strong track record in macro, structural and social policies, sustainable external financing plan, and coherent borrowing strategy. After transition-related declines in GDP and following the armed conflicts of the 1990s, Serbia restored macroeconomic stability over the past decade and achieved high growth until 2008 on the back of structural reforms, although external debt levels reached 79 percent in 2009. During the last three years, the Republic of Serbia (RoS) has taken steps to improve its debt management capacity. The latest debt management strategy calls for increased dinar exposure in the medium term and for a diversification of sources of Euro funding in the short term. The PFSPBG will assist the GoS gain access to new and cheaper sources of funding with longer tenors. The PFSPBG underwrites the first international non-concessionary borrowing of the Republic of Serbia. A more detailed analysis of how Serbia meets the eligibility criteria for a policy based guarantee is presented in Section II.C.

3. The objectives of the PFSPBG are to improve the business environment, strengthen financial discipline in the non-private enterprise sector, and build a stable and more efficient financial sector. The business environment pillar aims to: (i) simplify regulatory requirements and compliance costs for business entry and operations; (ii) enhance corporate governance, (iii) strengthen legal framework for competition, and (iv) improve enforcement of court decisions and based on authentic documents. The financial discipline pillar supports: (i) creation of a registry of regional development measures and incentives; and (ii) facilitation of the resolution of socially owned enterprises. The financial sector pillar supports: (i) crisis preparedness, including assessment of capital adequacy, enhancement of bank resolution framework, and strengthening of deposit insurance payout functions; (ii) continued restructuring/divestment of the GoS’s holdings in the banking sector; (iii) improved insurance sector regulation; and (iv) further capital market development.

4. The use of an IBRD guarantee will help the GoS gain access to international markets at lower costs and longer maturities. The proposed PFSPBG would allow Serbia to issue a relatively sizable commercial debt (of up to EUR 300 million, not exceeding the equivalent of US$400 million) in a challenging environment and help GoS expand its existing

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investor base. The design of the underlying financing and of the guarantee coverage has been driven by the GoS need to match its debt (portfolio risk) management and reduce funding costs. Procurement of the underlying commercial loan is being finalized; the tender has been completed and the GoS has selected Société Générale. The transaction is contingent on the IBRD guarantee being in place at the time of signing. Following approval of the guarantee by the IBRD Board, and as per process established in the Public Debt Law, the Parliament of Serbia will ratify the Indemnity Agreement and adopt the Law authorizing the loan of Société Générale (see Annex 6 for details on the process and timeline). The terms of the commercial loan offered by Société Générale represent a significant improvement in interest rate charged for borrowing in hard currency, considerably extend the maturity, and further the process of Serbia’s full integration into the international financial market. Furthermore, the GoS’ status as a global borrower will be solidified, which may lead to better terms for borrowing banks and companies in Serbia. The benefits of a policy-based guarantee are discussed in more detail in Section II.

5. The proposed operation is consistent with the FY08-FY11 Country Partnership Strategy (CPS) and FY09 CPS Progress Report for Serbia, and builds on successful implementation of reforms supported by PFDPL1 and PFDPL2. The CPS supports three GoS priorities: (i) private sector led growth to ensure income convergence with European levels; (ii) increased opportunities and participation in growth; and (iii) management of emerging environmental and disaster risks. The reform program in the PFSPBG focuses on (i) and (ii) priorities. The CPS and CPS Progress Report envisaged support in the private and financial sector through a series of three Private and Financial Development Policy Loans (PFDPL). In the context of preparation of the third operation under the PFDPL series, the GoS has requested to avail of an IBRD PBG rather than a loan. As a PBG is not a DPL option under OP 8.60 (Development Policy Lending) and a "Programmatic PBG" option does not exist under OP 14.25 (Guarantees), the PFDPL series has been terminated after PFDPL 2, and PFDPL 3 has been transformed to a stand-alone PBG operation, with the same policy matrix as originally envisaged in PFDPL 3.

II. COUNTRY CONTEXT

A. POLITICAL CONTEXT

6. The past year featured a period of political stability although the aftermath of international economic crisis is bringing new challenges. The government coalition remains stable despite economic and political challenges. In the past two years it has handled a number of difficult political issues (including the arrest of some of the International Criminal Tribunal for the former Yugoslavia (ICTY) indictees and economic challenges resulting from the global crisis. A number of positive international developments have provided comfort to the coalition in the past year. These include the visa liberalization with EU, the joint EU-Serbia resolution on Kosovo in the UN, and the unanimous decision of the EU Council to forward Serbia's membership application to the European Commission for an opinion. Nevertheless, economic hardships and popular discontent with certain structural reforms are becoming a significant challenge. This combined with the prospects of parliamentary elections scheduled for early 2012 could lead to a slowdown in reforms. Kosovo continues to play an important role in external and internal politics posing additional risks to the dynamic of Serbia's EU accession path.

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B. MACROECONOMIC PERFORMANCE

Pre-crisis and crisis 7. Serbia began its transition to a market economy late and under difficult circumstances. Unlike in other transition economies, the 1990s was a lost decade for Serbia. Although the country started the period relatively well-integrated with the world economy and with higher living standards than many other transition economies, its economy was devastated as a result of regional conflicts, international sanctions, and trade shocks stemming from the break-up of the former Yugoslavia in 1991. These effects were compounded by delayed transition and poor economic management. By 2000 recorded GDP had fallen to below one-half of its 1989 level, while other central and eastern European countries had made significant progress on the transition path.

8. In January 2001, the new Government launched an ambitious reform program aimed at reversing the legacy of the past through a rapid transition to a more market-oriented economy, normalization of relations with foreign creditors, and integration with regional, EU and world markets. Facing unsustainable fiscal and quasi-fiscal positions and high inflation, the authorities tightened macroeconomic policies through a combination of expenditure cuts and measures to increase revenues. In addition, the central bank stopped (to a large extent) extending credits to the budget and to public enterprises. Fiscal balance was achieved in 2004, as structural reforms began to have impact and expenditure commitments were reduced, and a surplus of 0.8 percent of GDP was achieved in 2005. Quasi-fiscal deficits were also reduced significantly through improved budgeting, regularization of debt service, and reforms to contain hidden losses in key sectors (such as energy).

9. Strong stabilization efforts coupled with increased capital inflows (from new donor support, remittances, foreign direct investment and re-monetization through the inflow of foreign exchange assets previously held outside the banking system) supported a reduction of annual inflation from 112 percent in 2000 to below 10 percent by 2003. Serbia started the transition with a crushing public debt burden at more than 240 percent of GDP, a large part of which was successfully restructured.1 The ratio of public debt to GDP declined from 115 percent of GDP in 2001 to 33 percent in 2005. Gross foreign exchange reserves increased substantially from less than US$1 billion in 2000 (covering just 1.4 months of imports of goods and services) to over US$15 billion by 2009 (enough to cover around 9 months of imports of goods and services). The economy was also successfully re-monetized as the ratio of broad money to GDP increased from just 15 percent in 2000 to around 40 percent in 2007. Foreign currency deposits of households, which were almost non-existent in 2000 (at US$50 million), rapidly increased to around US$8.5 billion by end-2009 as confidence in the banking system returned and overall macroeconomic stability improved. Foreign direct investment (FDI) increased from US$50 million in 2000 (0.6 percent of GDP) to an annual average of US$2.2 billion between 2003 and 2008 (an average annual 7.2 percent of GDP). See Table 1.

1 The Paris Club Agreement of November 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 2004, the Government also reached an agreement with the London Club of commercial creditors, which implied a 60 percent reduction in the net present value of the debt, and rescheduled the rest over the next twenty years, with 3.75 percent interest during the first five years, and 6.75 percent interest during the remaining fifteen years.

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Table 1: Selected Macroeconomic Indicators (2000-2010) Indicators 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

2010 est.

Gross domestic product (US$ mln)

8,661 11,433 15,099 19,671 23,712 25,234 29,332 39,389 48,834 41,637 38,043

Real GDP growth (%) 5.3 5.6 3.9 2.4 8.3 5.6 5.2 6.9 5.5 -3.1 1.5

Gross domestic investment (% of GDP)

8.8 13.9 12.9 18.5 29.7 23.7 24.1 28.2 28.6 24.6 25.0

Gross domestic savings (% of GDP)

-7.9 -4.2 -7.6 -0.9 3.2 2.8 2.6 4.3 5.3 7.6 8.2

Public sector balance (as % of GDP)

General government revenues and grants

33.5 36.8 42.4 42.3 42.9 43.0 44.2 43.5 41.9 40.7 40.0

Value-added taxes 5.9 9.5 11.3 11.1 11.5 12.8 11.5 11.5 11.1 10.5 10.6

Social security contributions

10.3 10.1 10.1 10.2 11.1 11.0 11.8 11.7 11.5 11.3 10.6

Excises 2.8 3.4 4.6 5.1 5.3 4.2 4.4 4.3 4.0 4.8 4.9

Taxes on international trade

2.2 1.9 2.5 2.5 2.5 2.3 2.3 2.5 2.4 1.7 1.4

General government expenditures

33.7 37.2 45.6 45.2 42.8 42.2 45.8 45.4 44.5 45.0 44.9

Current expenditure 30.9 35.0 41.7 42.1 40.1 39.2 41.1 40.1 40.0 41.0 40.2

wages and salaries 8.7 8.6 9.7 10.0 9.6 10.2 10.4 10.4 10.8 10.7 10.2

Pensions .. .. .. .. .. 11.3 11.6 11.3 12.2 13.8 13.0

goods and services 7.3 7.6 7.9 7.8 7.6 7.5 8.0 8.4 7.6 7.5 7.4

Capital expenditure 2.9 1.4 3.4 2.5 2.6 2.7 4.1 4.8 3.8 3.2 3.7

Balance -0.2 -0.4 -3.2 -2.9 0.0 0.8 -1.6 -1.9 -2.6 -4.3 -4.9

Public debt as % of GDP

241.7 114.5 81.2 77.3 65.2 56.3 43.0 35.2 33.4 36.8 43.5

External accounts (millions of US$)

Exports of goods 1,645 1,821 2,212 3,319 4,082 4,970 6,442 8,733 10,835 8,322 9,374

Imports of goods 3,227 4,129 5,440 7,340 10,551 10,260 12,713 17,816 21,989 15,440 15,741

Current account balance, after grants

-153 -285 -1,247 -1,420 -2,871 -2,194 -2,986 -6,276 -8,958 -2,869 -3,553

Current account balance, as % of GDP

-1.8 -2.5 -8.3 -7.2 -12.1 -8.7 -10.2 -15.9 -18.3 -6.9 -9.3

Foreign direct investment, net

50 165 475 1,365 965 1,550 4,264 2,491 2,648 1,904 1,297

Indebtedness (external debt)

Total debt outstanding (US$ millions)

10,830 11,125 11,230 13,575 14,099 15,467 19,606 26,236 30,709 32,887 30,063

in % of GDP 125.0 97.3 74.4 69.0 59.5 61.3 66.8 66.6 62.9 79.0 79.0

Prices and monetary indicators

Consumer price inflation (e.o.p.)

112.0 40.7 14.8 7.6 13.7 17.7 6.6 11.0 8.6 6.6 10.6

M2, as % of GDP 15.5 14.7 19.2 20.9 22.3 27.2 31.1 38.4 35.6 41.9 42.5

Source: Government of Serbia, IMF, World Bank.

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10. The Serbian economy grew rapidly until 2008, fuelled by exports and domestic demand, and significant economic reforms since 2000. GDP growth averaged 5.4 percent per year during 2001-08, with exports growing at an average annual rate of around 30 percent, albeit from a low base2. Output rose in real terms by nearly 50 percent between 2000 and 2008, as the corporate sector started to post profits and the banking sector restructured. The supply response also reflected increases in productivity and output in recently privatized and de novo firms, as evidenced by the particularly rapid rates of output growth in precisely those sectors which underwent extensive privatization (e.g., steel, cement, rubber, tobacco, dairy, sugar and banking) or attracted foreign investors. About 80 percent of growth was attributed to non-tradable sectors (financial, telecoms, retail).

11. Economic growth helped improve social conditions, with poverty falling from 13.4 percent of the population in 2002 to 6.1 percent in 2008. This lifted about 500,000 people out of poverty (before rising again with the onset of the global financial crisis).

12. Strong economic growth was, however, accompanied by a widening external current account deficit and increasing private sector debt in the period immediately preceding the financial crisis. Although exports grew rapidly, imports grew even faster and the trade deficit reached 22.8 percent of GDP in 2008. As a result, the external current account deficit sharply increased, from 8.7 percent in 2005 to 18.3 percent in 2008. The deficit was driven by a widening private sector savings-investment imbalance (it accounted for about 90 percent of the deficit in 2008). Although until 2006 the external imbalances were financed largely by FDI, 2007-08 saw a rise in debt-financing. In addition, while the central bank tightened prudential regulation on bank activity, many companies switched to direct foreign borrowing. Inflationary pressures also reemerged in the run up to the crisis, driven primarily by supply side factors3.

13. Although much of the external inbalance had a private origin, fiscal policies contributed as well to the current account deficit with the general government balance moving from a surplus of 0.8 percent of GDP in 2005 to a deficit of 2.5 percent in 2008. Two ad hoc extraordinary pension increases in 2008 increased spending on pensions from 11.3 percent of GDP in 2007 to 13.8 percent in 2009. Large wage increases were also granted in this period (e.g. wages of health workers were increased by 24 percent in real terms in 2007). In parallel, revenues declined from 42.9 percent of GDP in 2005 to 40.9 percent in 2008, primarily due to lower collection of VAT, excises and personal income tax. Capital revenues also decreased sharply.

14. In 2009, after the onset of the global financial crisis, the Serbian economy went into recession as domestic (investment) demand contracted. GDP decreased by 3.1 percent in 2009, a relatively shallow decline compared to regional peers. This was driven by a 17.3 percent decline in investment, while consumption dropped by 3.5 percent. The industrial output went down by around 20 percent between mid-2008 to mid-2009. Unemployment increased from 14.0 percent to 17.4 percent in October 2009. The increase in the unemployment rate was further aggravated by the transition dynamics; Serbia started its transition later than most other regional peers, and some of the privatization related layoffs coincided with the onset of the crisis. 2 The ratio of exports of goods and services to GDP increased from 20 percent in 2002 to 30 percent in 2008, still low compared to regional peers. 3 In 2007, for instance, higher prices of foods and agricultural products contributed to nearly 50 percent of total inflation while oil products and electricity contributed to about 30 percent.

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Exports fell by nearly 30 percent over the same period, while imports declined even more sharply. The reduction in the trade deficit paired with strong unrecorded remittances resulted in a sharp correction in the external current account deficit from 18.3 percent of GDP in 2008 to 6.9 percent in 2009. With decreased economic activity, and lower food and energy prices, inflation pressures also receded (to about 4 percent).

15. The authorities responded with a fiscal adjustment package, supported by the IMF. The IMF approved a 15-month Stand-by Arrangement (SBA) for SDR 350.8 million, of a precautionary nature in January 2009. Spending was contained by a range of expenditure measures, including most potently a nominal wage and pension freeze, and cuts in subsidies and capital expenditures. But revenues fell sharply, reflecting the contraction in aggregate demand as well as lower collection of trade taxes in line with the implementation of the Stability and Association Agreement (SAA) with the EU. As a result, the 2009 fiscal deficit increased to 4.3 percent of GDP. In May 2009, the IMF approved an augmented arrangement for SDR 2.6 billion (around EUR 3 billion, or 10 percent of GDP). The program period was extended to 27 months and the arrangement was made non-precautionary.

Recent Economic Developments

16. The 2010 fiscal deficit target of 4.9 percent of GDP, a balanced response to continued economic weakness and the need for medium-term fiscal consolidation, has been met. Revenues as a share of GDP have fallen by a further 0.7 percent of GDP in 2010, while expenditures have stabilized. A supplementary 2010 budget was approved by the Parliament in November 2010. Revenues are roughly in line with projections and the deficit target in nominal terms has remained unchanged since the initial budget. However, space created by underspending on capital and interest was re-allocated to pressing priorities, including social assistance programs. The deficit is financed through a combination of domestic and external sources (including the EU and the World Bank budget support), with domestic financing accounting for about 80 percent of the total (Table 4). Placement of T-bills has, however, become increasingly difficult in 2010 owing to exchange rate volatility and increasing risk premia following the Greek crisis; and commercial bank loans have become the major source of deficit financing. This noted, Serbia has very recently managed to issue a first ever Euro-indexed T-bills, in response to these pressures. 17. Data for first three quarters of 2010 indicate that export-led economic recovery is gaining momentum and GDP growth for 2010 is estimated to have reached 1.5 percent, but unemployment remains high. Industrial output and exports have rebounded, and exports to the EU have recovered to near pre-crisis levels. Key non-tradable sectors, however, remain depressed, indicating a welcome re-balancing of Serbia’s growth sources. The poverty rate, a lagging indicator, has increased to 8.8 percent in the first half of 2010, thus reversing some of the progress made in the pre-crisis years. Unemployment was recorded at 20.1 percent in April 2010.

18. The nominal exchange rate has depreciated by about 40 percent and the real exchange rate by about 20 percent since the beginning of the crisis, facilitating external current account adjustment and boosting competitiveness. The exchange rate is currently estimated to be slightly undervalued. While dinar depreciation has improved external price competitiveness, it has also put pressure on corporate balance sheets (gross non-performing loans

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(NPLs) as a share of total loans stood at 17.8 percent as of end-September 2010, up from 10.2 percent in September 2008). However, due to conservative pre-crisis provisioning requirements by the National Bank of Serbia (NBS), banks are considered well-provisioned against credit risks and able to absorb even a protracted corporate restructuring process.

19. After narrowing, the external current account deficit is expected to have increased slightly in 2010, while the trade deficit continues to fall. On the back of dinar devaluation, merchandise exports rose by 20 percent year-on-year for the first nine months of 2010, outpacing the 9 percent growth of imports and cutting the merchandise trade deficit by 5 percent year-on-year. But owing mostly to a drop in unrecorded remittances, the current account deficit is projected to rise this year. Combined with the weakening of capital and financial inflows, the overall balance of payments is projected to be negative in 2010. Loans by foreign parent banks to the private sector have declined most, driven by corporate sector cross border deleveraging. FDI has held up moderately well, reaching 4.6 percent of GDP in 2009 and an estimated 3.4 percent of GDP in 2010 - in part due to receipts from privatizations completed in previous years.

20. Monetary policy has been tightened after inflationary pressures resurfaced. Inflation dropped from 14 percent year-on-year in the first half of 2008 to 4 percent in the first half of 2010 as the economic activity contracted. However, since summer inflation has increased rapidly, and at end-2010 it stands at 10.3 percent, partly owing to a recent spike in food prices and exchange rate depreciation. The central bank is taking steps to counter further increases in inflation expectations, and has increased the reference rate by 350bp since August.

21. The banking system has weathered the external shocks well and foreign banks have generally maintained their exposure to Serbia. Liquidity of the banking sector remains high with the ratio of liquid assets to total assets at 25.1 percent in September 2010. Capitalization remains strong, with the capital adequacy ratio of the banking sector at 20.1 percent as of end-September 2010. While possible spillover effects from foreign parent banks (especially Greek) to subsidiaries are a potential risk, so far banks have broadly maintained their exposures to Serbia in the context of the Vienna initiative. Further, after a sharp drop and thanks also to the Government’s program of subsidized loans, credit activity is starting to pick up again. However, the modest expansion in the private sector credit through the domestic banking system is almost completely offset by the cross-border deleveraging of companies.4

22. The Government is committed to implementation of the IMF arrangement. All end-September 2010 quantitative performance criteria and indicative targets were met, although inflation was marginally above the agreed limit. The IMF completed the Sixth Review of the SBA with a Board meeting held on December 22, 2010, which has enabled Serbia to draw a further EUR 370 million.

Medium-term macroeconomic outlook and debt sustainability 23. Consistent with forecasts supported by the IMF arrangement, growth is projected to accelerate to 5-5.5 percent of GDP over the medium term, and to rely increasingly on

4 After increasing at a rate of more than EUR 1 billion per quarter from Q2 2007 to Q3 2008, the stock of cross border loans decreased by approximately EUR 700 million in 2009 and by an additional EUR 410 million in first half of 2010.

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exports and investments. GDP is forecast to grow at 3 percent in 2011, thanks to a reinvigorated tradable sector (Table 2). Consumption is projected to remain suppressed in 2011, but will thereafter start expanding again (although more modestly than pre-crisis). Net exports will drive growth in 2011, while consumption (in 2012) and investment (in 2013 and beyond) are forecast to become the main drivers of growth in the medium term. On the back of the significant exchange rate depreciation, and following 20 percent year-on-year export growth (in euro terms) for the first nine months of 2010, merchandise exports5 are projected to grow by 13 percent in euro terms in 2011 and an ambitious 21 percent in 2012, while imports are forecast to increase by 6 and 10 percent respectively (linked to increases in imports of energy and intermediate goods). As a share of GDP, merchandise exports are forecast to gradually increase from 25 percent of GDP in 2010 to around 31 percent in 2015 (still low compared to regional peers). This will be supported by the fact that with the 40 percent nominal depreciation of the currency in last two years, Serbia’s economy has regained much of the price competitiveness that it lost in the pre-crisis years. However, despite solid growth of GDP in the outer projection years, the unemployment rate is forecast to improve only gradually from the current level of 20 percent, to about 15 percent by 2015.

24. The projected recovery is ambitious and requires continued structural adjustment consistent with the Government’s reform program and the EU accession agenda, resulting in a rebalancing of the economy away from consumption-led, to export-led growth. Post-crisis growth is underpinned by higher exports and savings, with more modest consumption growth.6 The domestic savings rate is ambitiously forecast to improve from 8.2 percent of GDP in 2010 to 17.6 percent of GDP in 2015. About half of the projected improvement in the savings rate will come from the increases in public sector savings, brought about mainly by moderation in pensions and public sector wage spending. Increased savings of the public sector are supported by the recently adopted Fiscal Responsibility Legislation (FRL). Increased private sector savings are underpinned by the improvements in the business environment and further privatizations, which will gradually improve corporate productivity and profitability. The reforms supported by the PFSPBG and preceding PFDPL series are at the center of this agenda. The PFSPBG also supports financial sector reforms that should increase households’ confidence in the sector and should contribute to mobilizing retail savings. Additionally, re-establishing Serbia as a viable investment destination for global companies will be important in rebalancing the economy, as global companies bring access to markets that was lost during the 1990s. The Government has recently taken an increasingly active approach in attracting foreign investments in tradable sectors, for example through forming a joint venture with the FIAT car company. However, these measures are just starting and the progress has been patchy. Yet, despite the challenges, there is a broad political consensus that a shift to a new growth model is necessary, as set out in the recently presented Government strategy, Serbia 2020.

25. A return to the pre-crisis model of consumption-led growth would risk development of an unsustainable external balance. If consumption were to return to pre-crisis levels, external debt would start increasing again, driven by the further buildup of private sector debt. In this scenario, external debt would likely be above 85 percent of GDP by 2015 and rising,

5 Serbia’s main exports are food and agricultural products, steel and metal products, and chemicals. 6 As a share of GDP, consumption is forecast to gradually decrease from around 92 percent in 2010 to around 83 percent in 2015. About two thirds of this relative decrease will come from private sector and one third from public sector.

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potentially threatening external stability. With higher consumption, the tax to GDP ratio would improve and the headline fiscal deficit would narrow, but the structural fiscal deficit would remain elevated.

Table 2: Macroeconomic Data and Projections

Indicators 2008 2009 2010 est

2011 proj

2012 proj

2013 proj

2014 proj

2015 proj

GDP real growth 5.5 -3.1 1.5 3.0 5.0 5.5 5.5 5.0 Investments, percent GDP 28.6 24.6 25.0 25.3 24.8 26.1 27.4 28.3 Consumption, percent GDP 94.7 92.4 91.8 89.5 87.4 85.6 83.9 82.4 Consumer price inflation (end-of-period)

8.6 6.6 10.6 5.8 4.0 4.0 4.0 4.0

Public finance (as % of GDP)      Revenues 41.9 40.7 40.0 38.7 38.3 38.3 38.4 38.5

Value-added taxes 11.1 10.5 10.6 10.4 10.2 10.0 9.9 9.7 Expenditure 44.5 45.0 44.9 42.8 41.1 39.9 39.2 39.0 Current 40.0 41.0 40.2 38.3 37.0 35.8 34.6 33.7

wages and salaries 10.8 10.7 10.2 9.5 9.2 8.7 8.3 7.9 pensions 12.2 13.8 13.0 12.2 11.9 11.6 11.3 11.0 goods and services 7.6 7.5 7.4 7.2 6.9 6.9 6.9 7.0

Capital expenditure 3.8 3.2 3.7 3.4 3.5 3.8 4.5 5.2 Fiscal Balance, after grants -2.6 -4.3 -4.9 -4.1 -2.8 -1.7 -0.8 -0.5

External position      CAD after grants (percent of GDP) -18.3 -6.9 -9.3 -8.6 -7.0 -6.0 -6.0 -5.8

Trade balance (percent of GDP) -22.8 -17.1 -16.7 -14.7 -12.2 -11.7 -11.3 -10.7 Reserves (US$ billion) 11.5 15.3 12.1 12.5 13.7 14.9 16.1 17.3

in months of imports of goods and serv. 7.7 8.8 7.3 6.9 6.9 6.8 6.7 6.6

Debt    Public debt (percent of GDP) 33.4 36.8 43.5 40.9 39.9 38.0 35.5 33.2 External debt (percent of GDP) 62.9 79.0 79.0 73.1 72.7 70.6 68.4 66.8

o/w Private ext. debt (percent of GDP)

44.5 53.7 52.2 49.4 50.7 51.6 51.5 50.5

Source: Government of Serbia, IMF, World Bank.

26. Continued wage restraint and efforts to tighten monetary policy are needed to contain inflation, although it is projected to remain elevated until 2011. CPI inflation is projected to stay above the NBS target level, due to continuing high food prices, the pass through of the large exchange rate depreciation, as well as increased inflationary expectations. The central bank has indicated that it will further tighten monetary policy if needed, using all policy tools available. The key to bringing inflation back to target will be to contain second round spillover effects, particularly on wages. The proposed capping of the January 2011 indexation adjustments for public wages and pensions will be helpful in this regard.

27. Fiscal policy is anchored in the recently adopted FRL, which sets the medium-term deficit target at 1 percent of GDP, and outlines wage and pension indexation formulae until at least 2015. The FRL sets out numerical targets for the general government deficit over the medium term, as well as a cap on the overall level of public debt (standing at 45 percent of GDP, not including restitution liabilities that could potentially arise from the compensation for assets

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confiscated after World War II). Government revenues are projected to gradually decline over the medium term due to lower consumption and lower taxes on foreign trade. The structural declines in revenues are projected to be offset through improvements in the capacity of the tax administration as well as through further expenditure reforms. Expenditure reprioritization and a reduction in current spending will remain necessary, especially given the Government’s plans to increase spending on infrastructure. Progress with structural public expenditure reforms in the largest spending sectors (pensions, education, public wages) is critical in this regard, and is supported by the Public Expenditure Development Policy Loan Series (PEDPL - see Section IV.C). Nevertheless, the Government continues to face pressures from the labor unions over the proposed pension reform.

28. The planned 2011 budget deficit of approximately 140 billion dinars, or about 4.1 percent of GDP, is in line with FRL. Achieving the fiscal target will require tight control of current spending, including moderating the indexation of public wages and pensions, as well as constraining capital spending. Transfers to local governments are projected to only be slowly restored to pre-crisis levels, and most subsidies will be frozen at their nominal 2010 level. The cost of the credit support programs in the 2011 budget will be reduced considerably, including by phasing out cash loans and curtailing the subsidy rate for liquidity loans.

29. Telekom privatization proceeds (projected at about 4 percent of GDP) will likely cover the major share of 2011 budget financing needs. There is a strong political commitment and a consensus in the ruling coalition to go forward with the Telekom privatization. Market prospects for this privatization appear very good as seven companies have qualified for participation in a public tender for the sale.7 Bids have to be submitted by February 21, 2011 and will be opened by the end of February 2011. The process is expected to be completed in the first half of 2011. In the unlikely event that the sale of Telekom Serbia does not go ahead, the authorities plan to cover the shortfall through a Eurobond complemented by additional borrowing from domestic banks and T-bill issuance. In this case Government’s gross financing needs would increase compared to the baseline by approximately 1 percentage point of GDP throughout the forecast period. Public debt in 2015 would stand at around 37 percent of GDP, compared to 33 percent of GDP in the baseline case. If necessary, further expenditure restructuring would have to take place; the authorities have demonstrated their ability and commitment to do this effectively in the context of the crisis.

7 The companies that qualified are: Deutsche Telekom, France Telecom , Telekom Austria, America Movil, Turkcell, VimpelCom and Weather investments.

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Table 3: Fiscal deficit financing, in billions of dinars

2008 2009 2010 est 2011 proj

Fiscal balance (cash basis) -72 -120 -148 -140

in percent of GDP -2.6 -4.3 -4.9 -4.1

Financing 71 120 148 140 Privatization proceeds 33 59 4 150

in percent of GDP 1.2 2.1 0.1 4.4 Equity investment .. .. .. -4 Domestic 61 21 118 -41

in percent of GDP 2.3 0.7 3.9 -1.2 Banks 55 -61 105 -30

Commercial banks loans ... 0 65 20 Non-bank 6 82 12 -11

External -23 40 25 35 in percent of GDP -0.8 1.4 0.8 1.0

Program ... 42 34 52 Project ... 11 17 20 Amortization ... -13 -26 -37

Source: IMF, Government of Serbia.

30. The external current account deficit is forecast to stabilize and remain in nominal terms at the 2010 level. As mentioned earlier, robust performance of exports is forecast (on the back of further structural reform, a competitive exchange rate, and progress towards EU accession) and a gradual recovery of imports (aided by the adjustment in the exchange rate, as well as slower growth in domestic consumption). Nevertheless, the external trade deficit is projected to remain high, declining to 10.7 percent of GDP at the end of the forecasting period. Despite these projected adjustments, Serbia still faces considerable balance of payments financing needs.

31. Serbia’s external financing requirements will be high. Serbia’s gross financing needs amount to EUR 6.1 billion in 2010 and to EUR 8.2 billion in 2011 (Table 4). These financing requirements are largely due to high private sector debt amortization. Accordingly, financing needs are projected to be covered largely by private inflows. FDI inflows are expected to spike in 2011, reflecting the privatization of Telekom Serbia, and projected to stabilize at about 4 percent of GDP annually afterwards. As corporate restructuring restores investor confidence, other private external flows, mostly to enterprises, are also projected to resume. Disbursements from international financial institutions (IFIs) and other multilaterals, including the IMF, the EU and the Bank, will help assure that the program is fully financed. 32. Foreign exchange reserves are forecast to remain at a comfortable level. Serbia’s reserve coverage continues to compare favorably to other emerging markets. Following a decline in 2010, gross international reserves are expected to stabilize in 2011, and rise in the outer years. As of October 2010, gross foreign exchange reserves are at a comfortable level, as indicated by standard indicators (gross foreign reserves are enough to cover 8 months of imports and the ratio of gross foreign reserves to M1 stands at 429 percent; ratio of gross foreign exchange reserves to short term external debt plus medium and long term amortizations is projected at 2.0 in 2010 and not falling below 1.7 throughout the forecast period).

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Table 4: External Financing Requirements

Financing (EUR , billions) 2008 2009 2010 est 2011 proj 2012 proj 2013 proj

Financing Requirements 9.75 8.68 6.12 8.23 8.87 10.10 Current account deficit 6.13 2.06 2.74 2.76 2.43 2.29 Debt amortizations 3.62 4.25 4.59 5.17 5.23 6.13

Medium- and long-term debt 2.67 2.65 2.98 3.57 3.62 4.52 o/w Public sector 1) 0.12 0.14 0.25 0.29 0.30 0.36 o/w Private sector 2.55 2.51 2.73 3.28 3.32 4.16

Short term debt3) 0.94 1.61 1.61 1.61 1.61 1.61 Gross reserves accumulation 0.00 2.36 -1.21 0.30 1.00 1.00 Repayment of prospective IMF credits ... ... ... ... 0.21 0.68

Financing sources 9.75 8.68 6.12 8.23 8.87 10.10 Private investment (net) 1.73 1.31 1.06 2.80 1.43 1.57 Debt financing 5.53 4.78 4.71 5.17 7.44 8.52

Medium- and long-term debt 4.86 3.18 3.10 3.54 5.83 6.91 o/w Public sector 1) 2) 0.18 0.43 0.50 0.65 0.61 0.68 o/w Private sector 4.68 2.75 2.60 2.95 5.22 6.23 Commercial banks 0.23 0.90 0.40 0.24 0.74 0.90 Corporate sector 4.46 1.85 2.20 2.67 4.48 5.33

Short term debt3) 0.67 1.61 1.61 1.61 1.61 1.61 Other capital flows4) 0.88 1.46 0.00 0.21 0.00 0.00 IMF financing 0.00 1.12 0.35 0.06 ... ...

Source: IMF. 1) Excluding IMF; 2) Includes prospective WB and EU financing. 3) Original maturity of less than 1 year. Stock at the end of the previous period. 4) Includes all other net financial flows, SDR allocations, and errors and omissions.

33. Under the baseline scenario outlined, both external and public debt remain sustainable. External debt is projected to gradually decline to 67 percent of GDP by 2015 (Table A.1). Similarly, public debt is forecast to decline after 2010 and fall to 34 percent of GDP by 2015. Strong policies and structural reforms (including those supported by Bank programs) will underlie higher growth rates and improved public and external balances, underpinning the declining path of both external and public debt over the forecasting period. Other debt and debt service indicators also do not point to immediate areas of concern (see Annex 3. Debt Sustainability Analysis).

34. Standardized debt stress tests, however, point to sizeable risks if some assumptions do not materialize: the sustainability of Serbia’s external debt depends on the performance of growth and exports and the stability of the exchange rate. External debt does not stabilize under scenarios in which exports and growth consistently underperform, thus underlining the need for strong reforms and prudent macroeconomic policies. Also, there are risks from exchange rate shocks. Real depreciation of 30 percent would bring the external debt to GDP ratio to just over 110 percent. While the debt to GDP ratio declines afterwards, gross financing needs remain elevated (Figure A. 1). However, further large real exchange rate depreciation is considered unlikely. Serbia’s public debt outlook is sensitive to underperformance of growth, delays in fiscal consolidation, and exchange rate shocks. If the growth rate underperforms by two percentage points annually over the forecast period, public debt reaches 48 percent by 2015 (Figure A. 2). Towards the end of the forecast period, gross financing needs in case of such a growth rate shock would be some five percentage points of GDP higher than in the baseline

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scenario. However, Serbia's track record under the IMF, the EU and the World Bank supported programs and its macroeconomic and development policy programs provide comfort that the policy mix will be adjusted to avoid such a scenario. With more than 70 percent of public debt denominated in foreign currency, a real depreciation shock of 30 percent would initially push the public debt to around 60 percent of GDP.8 Public debt would then gradually decline.

35. Overall, Serbia’s macroeconomic framework is adequate for this operation. Post crisis, the economy will be geared towards a more sustainable growth paradigm. This will require higher domestic savings and increased competitiveness. With respect to the latter, continued progress in business environment reforms remains crucial to solidify Serbia’s rebalancing of growth sources. Enhanced competitiveness will also require investment in infrastructure. To free up fiscal space to invest in infrastructure, privatization and financial discipline of non-private enterprise will be important as will structural reforms in pensions and public sector wages. In this regard, reducing pension spending (which is very large by any measure) is particularly critical and draft legislation, which has been submitted to the Parliament, is a step in the right direction.

36. Still, considerable risks remain. The global economic outlook, while improved, remains uncertain, which may result in slower export growth and lower capital flows (FDI and portfolio). Spillovers from Euro area include risks of lower growth in Serbia’s main trading partners slowing Serbia’s own growth and current account adjustment. In this scenario, external debt would remain at around 75 percent of GDP throughout the forecast period (as opposed to gradually decreasing in the baseline) and external financing needs would be higher by some 3 percent of GDP (for further details, see Annex 3). Further, lower growth could also cause the public debt to move to a potentially unsustainable path. There are also risks of external financing shortfalls, including to the envisaged telecom privatization. The external financing outlook could also be impacted by increases in the country’s risk premium due to external shocks, including possibly a new round of euro-area periphery spillovers9. Under such scenarios, macroeconomic policies will have to be adjusted with a greater focus on stabilization rather than countercyclical policies. As the crisis has illustrated, the authorities are committed to act quickly and decisively if the need for larger fiscal consolidation arises. Political challenges, including opposition of some unions to the pension reform and potential backlash from prolonged public sector wage freezes, could slow progress on the reform agenda. The 2012 elections are likely to intensify spending pressures, although the FRL and creation of the Fiscal Council are aimed at containing those pressures.

8 Ministry of Finance’s Budget Memorandum estimates that 1 percent depreciation of the nominal effective exchange rate would increase the public debt to GDP ratio by 0.33 percentage points. Thus, nominal depreciation of 30 percent would increase the public debt to GDP ratio by 10 percentage points. 9 Direct spillovers from the Greek crisis are likely to be limited. Greek banks account for about one sixth of Serbia’s banking sector, but they are well capitalized and liquid. Trade links with Greece are relatively minor, and although Greece has been one of the largest investors in Serbia in the early years of the transition in 2008-2010 Greece accounted for a small share of total FDIs. However, indirect channels (risk perception, interest rate spread and in medium to long term EU accession skepticism) may present a problem.

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C. ELIGIBILITY FOR POLICY-BASED GUARANTEE

Criterion A: The country should have a strong track record of performance, and its structural, social and macroeconomic policy package should be satisfactory. 37. After transition-related declines in GDP and armed conflict in the 1990s, Serbia restored macroeconomic stability over the past decade, achieving high growth until 2008. Output has risen in real terms by nearly 50 percent since 2000, as the corporate sector started to post profits and the banking sector was restructured. In US$ terms, GDP per capita has risen from about US$2,000 in 2002 to just over US$5,800 in 2009.

38. Growth was aided by stabilization measures introduced after 2000 that have brought the hyper-inflation of the 1990s under control. The NBS scaled up its modeling and forecasting capacity and introduced formal inflation targeting in 2009. Improvements have also been made in communicating with the public and increasing the transparency of monetary policy, including through a regular quarterly Inflation Report, which discusses the achievement of the inflation target, expected inflation outturns and the underlying macroeconomic developments, as well as monetary policy measures to be taken in order to achieve inflation targets in the future.

39. Structural reforms in the public enterprise and financial sector played a crucial role in boosting growth. Between 2000 and 2008, Serbia privatized more than 2,400 companies. This generated nearly Euro 2.9 billion in privatization and unlocked important assets in the country, and substantially reduced the demand for subsidies. In addition, significant strides have been made in business climate reforms, and gains are particularly evident in the time and cost required to start a business. More recently, a comprehensive regulatory review was completed. In this context, 2,000 laws and regulations impacting economic activities were reviewed, 196 regulations were abolished, and 20 regulations and 10 laws were amended. It is estimated that will result in annual cost savings to businesses of around EUR 50.8 million (see Box 2 for a description of how this costs savings have been calculated).

40. In the same period reforms were implemented in the financial sector. The reform of the banking sector revolved around the closure of large unviable public banks and the entry of Western European groups, which currently dominate the market. The state share in banking sector assets was reduced to 18.51 percent as of Q3 2010. In parallel, a new regulatory regime compliant with international standards was introduced. As a result, the banking sector deepened and intermediation increased. The insurance sector was also consolidated and became predominantly privately owned, thanks to better regulations and enforcement and the privatization of a large insurance company.

41. A series of tax reforms since 2001 (including the introduction of VAT in 2005) has strengthened the revenue base. The highly complex and inefficient tax system inherited from ex-Yugoslavia, characterized by numerous levies, widespread exemptions, and high tax rates, has been transformed into a fairly modern tax system.

42. Public sector reforms included improved public expenditure and debt management. A new Budget System Law (BSL) was adopted in 2009, which established medium term spending ceilings for budget beneficiaries. BSL amendments from 2010 have further

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strengthened the basis for introducing a three year medium term fiscal framework as well as introducing FRL provisions and establishing an independent Fiscal Council. A new Law on Public Procurement was adopted in 2008. Starting later than the other ex-Yugoslav republics, Serbia now has a treasury system with all elements of a modern treasury that is organized around the concept of a Treasury Single Account (TSA). The TSA records all government operations in a ledger system and provides controls on the speed at which budget users can execute their budgets. A modernized treasury system, providing treasury services for all budget beneficiaries through a comprehensive TSA system, has led to improvements in the control and auditing environment for Serbia. Following the establishment of the Supreme Audit Institution, a first external audit was prepared of the 2008 budget. As a result of these improvements, the draft public expenditure and fiscal accountability (PEFA) review completed by the Government in 2010 shows improved scores in budget execution and auditing.

43. The Government has made progress in implementing pension reforms, improving fiscal sustainability while maximizing poverty alleviation effects. In the face of substantial fiscal imbalances in the pension system, a series of reforms with wide ranging parametric changes were implemented in 2001 and 2005. Nevertheless pensions remain the single largest spending item also on the back of two large ad hoc pension increases in 2008. A reform law (supported by PEDPL2), which lays the basis for a third round of pension reform, has been adopted by the Parliament in late December 2010. This should help move the system further towards long run sustainability including through parametric reforms tightening early retirement rules and limiting extra service credits and through new pension indexation arrangements.

44. A well-targeted social assistance program has been put in place through a series of legislative and institutional reforms. The Material Support for Low Income Households (MOP), the primary poverty reduction program, has over 60 percent of benefits going to families in the poorest quintile and the extreme poor.10 Coverage is an issue however with only 6.4 percent of the poorest quintile and 40 percent of the extreme poor receiving benefits from the MOP program (LSMS, 2007), and a new law at an advanced stage of preparation (supported by PEDPL2) aims to scale up the MOP to cover a higher share of the poor. Proposed changes include (i) increases in the benefits paid to multi-member households/families; and (ii) a 20 percent higher MOP for certain vulnerable groups (including where no household members are capable of work and single parent families).

45. Governance indicators for Serbia also continue to improve, although from a low base, particularly perceptions of strengthened rule of law, government effectiveness and control of corruption (see Table 5). The WBI rule of law indicator shows for instance that Serbia’s ranking has improved from a 19th percentile rank in 2003 (meaning that 19 percent of countries were below Serbia) to a 42nd percentile rank in 2009 (meaning that 42 percent of countries were below Serbia). BEEPS data provide a generally similar picture; for example, the number of firms reporting that bribes in courts are frequent fell from 22 percent in 2005 to 9 percent in 2008.

10 The 2006 HBS does not single out household/family income from the MOP. For that reason, a proxy (broader) social benefit income category has been used to assess the coverage and targeting of the MOP, and the data should be treated with some caution.

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Table 5: WBI Governance Indicators (Percentile rank) 2003 2009 Voice and Accountability 46 58 Government Effectiveness 33 50 Regulatory Quality 27 50 Rule of Law 19 42 Control of Corruption 37 52

Criterion B: The country should have sustainable external financing plan. 46. At nearly 80 percent of GDP, Serbia has a high outstanding external debt stock and external financing requirements will remain high. According to the IMF projections under the SBA, high financing requirements are mostly due to private sector debt amortization requirements and accordingly financing needs are projected to be covered largely by private inflows, in particular flows to the corporate sector. Medium and long term borrowing to the corporate sector amounted to around 13 percent of GDP in 2006-08, but then dropped to well below 10 percent in 2009-10. As the economy gains momentum and companies rebuild their balance sheets, it is forecast that these flows will recover and by 2012 reach around 12 percent of GDP. This would be facilitated by the EU accession process; as the country moves closer to the EU and companies integrate with EU markets, new lending to the corporate sector is forecast to pick up. FDI is also forecast to increase gradually, with a spike in 2011 reflecting the Telekom privatization. Disbursements from IFIs and other multilaterals, including the IMF, the EU and the Bank, will help assure that the program is fully financed. 47. During the last three years, the Republic of Serbia has taken steps to improve its debt management capacity. In spring 2008, a debt management strategy was developed, focusing on the need to increase the dinar portion of the government debt, which at that time amounted to only 3 percent of the debt portfolio. In September 2009, an important organizational change was undertaken by establishment of a designated debt management agency (the Public Debt Management Authority - PDMA). Serbia has now a government entity with around 20 staff members that is solely focused on debt management. Among its priorities during its first year has been to make the present debt management system (TRASSET) fully operational, to prepare procedures manual for the main debt management activities, to issue more dinar-denominated securities in the local market, and to update the debt management strategy. 48. The strategy prepared by PDMA is more comprehensive than the earlier strategy. On the foreign currency exposure (87 percent at the beginning of 2010), the strategy for the upcoming 3-year period is to increase issuance of dinar-denominated securities in the domestic market. If, however, the exchange rate volatility, particularly the dinar depreciation against the euro, continues, the exit strategy is additional borrowing in foreign currencies, preferably long-term euro. On the interest rate risk, the present interest rate structure with 76 percent fixed and 24 percent with variable interest rates should remain. 49. The country’s external financing needs are summarized in Table 3. Access to external financing is helping the Government continue its reform agenda and maintain social programs aimed at protecting vulnerable groups. With the implementation of further structural

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reforms and renewed growth, Serbia is expected to meet its financing needs through a blend of domestic and foreign financing. Despite the adjustments, Serbia still faces large balance of payments financing needs. Serbia’s gross financing needs in 2010 amount to 6.2 billion euro and to 8.2 billion euro in 2011 (Table 4). Criterion C: The country should have a coherent borrowing strategy, which will enable it to become a borrower in its own name without a guarantee in the medium term.

50. Forty percent of Serbia’s public debt is not on commercial terms. The remainder is characterized by short maturities and is predominantly denominated in foreign currency. Serbia’s concessionary debt is either owed to IFIs or is related to frozen foreign currency deposits; to compensate citizens of Serbia for the loss of foreign deposits in the 1990s, the GoS issued certificates of deposits with long maturities and a nominal rate of around 2 percent. Commercial debt of the GoS includes short term securities, i.e. up to 24 months, and borrowing from commercial banks with an average life of three years. The bulk of Serbia’s debt is still denominated in foreign currency (72 percent in 2010), although this has been declining over time (foreign denominated debt accounted for 89 percent in 2002).

51. The GoS has never accessed international markets independently. Serbia did borrow once, but as Serbia and Montenegro, in 2005, with the issuance of US$1 billion 20-year Eurobond designed to exchange old London Club debt. However, this bond is currently thinly traded in markets, and it yields roughly 7 percent, with somewhat limited volatility. Otherwise, the GoS has tapped only the local capital market and the domestic banking sector, the latter primarily through club loans. Borrowing heavily from local market sources, banks in particular, has increased the risk of collusion among financial actors. Moreover, reliance on local markets may lead to some crowding out of the corporate and household sectors in the context of more deleveraging by subsidiaries of international banks operating in Serbia.

52. To improve its debt management capacity, the GoS approved a medium-term debt management strategy and created a debt management agency. The strategy, which covered the years 2009-2011, was included in the Budget Memorandum. The main objective of the original strategy was to increase the share of government debt denominated in local currency. This objective was to be reached in two stages. In a first phase, dinar-denominated securities would be issued only for short-term liquidity financing, while long-term securities in dinars would be considered in the medium-term once the dinar-euro interest rate spread had declined. The establishment of the PDMA in 2009 strengthened the institutional framework for government debt management. The PDMA is now fully staffed with 23 officials. Its priorities are enhancement of the debt management system, preparation of a procedures manual, and issuance of more dinar-denominated securities in the local market.

53. Subsequent debt strategies were more comprehensive. Increased dinar exposure in the medium-term was complemented by aims to diversify Euro sources in the shorter-term. The updated strategy for 2010-2012 continued to focus on increasing local currency exposure in the medium term. In addition, the 2011-2013 strategy aims to access new sources of financing in global markets, specifically Euro-denominated debt, in an effort to reduce the interest paid and lengthen the maturity of the debt.

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54. The design of the financing underlying the IBRD guarantee and the coverage of the latter has been driven by the GoS needs to match its debt (portfolio risk) management and reduce funding costs. The latter drove the selection of the financing underlying the guarantee (i.e. loan rather than a bond), while both considerations guided the design of the guarantee (i.e. 100 percent coverage of the principal and 6 year bullet repayment for the commercial loan). The need to match the existing debt (portfolio risk) management is particularly relevant, as the GoS plans to use a considerable portion of the financing to repay exiting and maturing debt.

55. Market soundings indicated that the IBRD guarantee added more economic value when combined with a commercial loan than with a public bond offering. Market indications suggested that the guaranteed loan transaction could be arranged at 100bp-200bp lower cost than an equally guaranteed bond. While both structures could generate savings compared to non-guaranteed structure, the guaranteed loan format could create US$15-25 million in additional net present value savings for the Republic of Serbia. This can in part be explained by the fact that the investor base for emerging market bonds has difficulty pricing disparate blends of borrower risk (i.e. Republic of Serbia and IBRD risks), which reduces ability to trade such an instrument. Conversely, loan markets may price the transaction more favorably, because the IBRD guarantee substantially reduces the capital that the commercial bank needs to allocate against the loan.

56. Following a procurement process, the GoS has finalized the selection of a commercial lender which is Société Générale. The GoS issued the Request for Proposals on October 29, 2010, inviting interested international and local financial institutions to submit bids for the transaction supported by the PFSPBG. Proposals from the following banks were received by December 21, 2010, the closing date: Credit Swiss, Deutsche Bank, Goldman Sachs, JP Morgan, Raiffeisen, Societe Generale, Citi-HSBC, and Banca Intesa-Banca Infrastruturre Innovazione e Sviluppo. The GoS has approved Société Générale, as the winning bidder, on January 10, 2011. The interest rate offered by Société Générale on the 6 year bullet loan is equivalent to Euro swap rate plus 100bps with a 50 bps arrangement fee. Details on the public procurement process of the lender and required steps are included in Annex 6. The proposed guarantee term-sheet (see Annex 4) has been provided to the bidders.

57. The PFSPBG will help the GoS gain access to international markets at lower costs and longer maturities. The terms offered by Société Générale represent a significant improvement in interest rate charged for borrowing in hard currency and most importantly in the extension of maturity. Figure 1 below compares the cost of borrowing of EUR 300 million from local banks with no guarantee and from Société Générale with the proposed IBRD guarantee. The longer term maturity will strengthen Serbia’s debt portfolio by reducing refinancing risks, particularly given uncertain financial markets conditions in the near term.

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Figure 1: Cost comparison of the GoS borrowing with and without IBRD guarantee

* Spread extrapolated from recent borrowing at 550bps for 3year average life or half the maturity of transaction envisaged with SG

**Arrangement fees are not included in the comparison

58. The PFSPBG would also enable Serbia to expand its investor base. In the medium terms it will likely reduce borrowing costs for the GoS and domestic entities. By establishing itself as a global borrower, future market borrowing by the GoS may occur at increasingly improved terms, with integration into markets strengthened and relationship with lenders solidified. The expected terms of the transactions should also bear positive signaling effects to markets about the GoS access to alternative sources of financing, which may reduce the perceived credit risk over time. Corporate credit risk is intimately tied to sovereign credit risk, which provides a ceiling for private sector borrowers. Gains in creditworthiness at the sovereign level generally create tangible gains for corporate borrowers in these markets.

D. RECENT BANKING SECTOR DEVELOPMENTS

59. The Serbian banking sector has grown significantly in the past few years. Banking sector assets accounted for 80.6 percent of GDP in September 2010 compared to 52 percent in 2005. In the same period, and through privatization, the share of majority state owned banks declined substantially. In Q3 2010 majority state-owned banks’ share had decreased to 1.9 percent. In addition to majority state-owned banks, the RoS has significant stake in five banks. These include two banks in which the EBRD, the IFC and the state constitute the majority shareholder (11.71 percent of market share), and three banks in which the state alone holds around 20-30 percent (4.87 percent of market shares). Foreign ownership stood at 73.51 percent of the assets in 2010 Q3, with the subsidiaries of Austrian, Greek and Italian banks within the top five banks in the country in terms of assets. Banks from these three countries combined have 57.2 percent of market share, with French and German banks also among the top 12 banks. Most of the local private banks tend to be specialized in specific geographic regions, type of clients, or sectors.

GoS borrowing from Société Générale with guarantee

GoS borrowing from local banks with no guarantee

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60. The banking system has weathered the global financial crisis, although not without costs. Confidence in the banking sector was affected, reflected in a withdrawal of 18 percent of household deposits from banks in late 2008 and early 2009. Nonetheless, a conservative regulatory approach had left the banking system with capital and liquidity buffers large enough to withstand these shocks. Confidence was restored through a coordinated response by the NBS and the GoS, in close cooperation with the banking community, IFIs, and the European Union, under the so-called Vienna initiative (more details on the authorities policy response to the crisis are included in Section III C). As a result, the deposits currently stand at over EUR 6.2 billion and exceed the pre-crisis levels.

61. Turbulence in Greece has not had a noticeable impact on the Serbian banking sector. There are four subsidiaries of Greek banks operating in Serbia: Alpha, EFG, Piraeus and Vojvodjanska (NBG), which account for 15.37 percent of total banking sector assets and 16.68 percent of total deposits as of September 2010. Spillover of the Greek crisis to Greeks’ subsidiaries in Serbia could happen through liquidity withdrawal by the parent or depositor panic. As far as liquidity is concerned, the subsidiaries do not depend on their parents for funding, except for one. While depositors panic cannot be ruled out for the future, the banking sector has remained stable. Moreover, the recent recapitalization of NBG group and the presence of an IMF program in Greece with a banking recapitalization fund should provide comfort.

62. The slowdown of the real economy has impacted the banking sector via credit contraction and declining asset quality. Both contributed to falling profitability. The growth of credit to the private sector has declined sharply (in Euro terms) in 2009. This trend has been reversed albeit gradually in the early 2010 (see Figure 2). Gross NPLs have stabilized in recent months at 17.8 percent (September 2010). As a result, the profitability of the banking system has dropped significantly; the return on equity (ROE) fell by 50 percent between September 2008 and September 2010 (see Figure 3).

63. Although the banking sector is well capitalized and liquid, declining asset quality and falling profitability are key risks. As of September 2010, the aggregate CAR was 20.1 percent and the banking system’s liquid assets covered 40 percent of short term liabilities. While the sector has enough cushion to withstand the current rate of NPLs, an increase could pose a risk to the solvency of the system.

64. As the situation in the banking sector stabilizes, the authorities are unwinding crisis arrangements. Under the Vienna initiative, parent banks committed in 2008 to maintain their exposure to Serbia unchanged from pre-crisis level. In 2009 the initiative was renewed for another year and banks committed to maintain an exposure equivalent to 80 percent of pre-crisis levels. The initiative ended in December 2010. The level of the NBS reserves and the recently enhanced liquidity framework should provide the authorities with the necessary tools to intervene, if necessary. As credit growth has started picking up again, the Government’s interest rate subsidy program for liquidity and investment loans for private companies has been discontinued at the end of 2010.11

11 To support credit growth, the GoS launched an interest rate subsidy program for liquidity and investment loans for private companies. The program is administered through private banks. The loan subsidy amounted to 5 percent with a maximum allowable interest rate under the program of 8 percent on FX loans. The total disbursed amount in 2010 has been EUR 1.5 bn through end-October. FX liquidity loans were discontinued in favor of dinar liquidity

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Figure 2: Private Sector Credit Growth (%) Figure 3: Trends in ROA and ROE

Source: NBS

Source: NBS

65. To boost profitability and support credit growth, the NBS has been decreasing required reserves on FX liabilities. Due to the high level of Euroization, which makes monetary policy less effective, the NBS has been using the reserves on FX liabilities to limit credit expansion in the pre-crisis period. This contributed to the reduction in bank profitability in the context of weak asset growth and rising NPLs. In response to this trend and to the contraction in credit, the NBS has lowered required reserves to 25 percent for foreign currency loans (5 percent for RSD), compared to 45 percent (and 10 percent for RSD) before the crisis.

III. THE GOVERNMENT’S PROGRAM

66. The GoS has put private sector development at the center of its strategy to promote growth and income convergence with European levels. To increase the private sector contribution to growth, the GoS has implemented a series of policy measures to increase productivity and investment rates. This included upgrading physical infrastructure (especially the road network), improving the business environment and the quality of infrastructure, privatizing non-private enterprises, and promoting financial sector policies aimed at increasing efficient intermediation. These measures should increase the productivity and the competitiveness of the private sector, crucial factors in boosting exports. Given the small size of the economy, the GoS has also actively promoted FDIs.

67. Business environment improvements, financial discipline/divestment of non-private enterprises, and financial sector development are at the core of the GoS’ growth agenda. To promote private sector led growth the GoS is committed to: (i) decrease the cost of doing business, (ii) improve fiscal discipline in the non-private enterprise sector by reducing the GoS direct ownership in the economy and free up fiscal resources for needed public investment, and (iii) divest state holdings in the financial sector, enhance the regulatory and bank resolution framework, and promote development of the non-banking financial sector.

68. Reforms described in this section have been supported by the preceding PFDPL series as well as by the proposed PFSPBG. Key reforms supported by the PFDPL series are listed in the Box 1 below; in turn these reforms build on previous budget support operations that the GoS has implemented successfully since the early 2000s (see a summary in Section IV.C). A description of the policy actions underpinning the proposed PFSPBG is presented in Section V.A and Section V.B. loans in May 2010. The share of credit support programs in total fresh lending was 17 percent in the period January-August 2010.

0

2

4

6

8

10

12

14

16

18

ROA (%)

ROE (%)

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69. The GoS remains committed to completing the substantial reform program implemented thus far in private and financial sector areas. While, the GoS has made considerable progress in the business environment, privatization/restructuring of non-private enterprises, and in financial sector development, the reform agenda has not yet been completed. To this end and in the short term the GoS is planning to focus businesses environment reforms on improving construction permits and completing the implementation of the regulations of business activities recommendation. As far as privatization and restructuring is concerned, the GoS plans to proceed with the incorporation of Railways and Post, two large state owned enterprises, and with the privatization of Telekom. Finally regarding the financial sector, the GoS plans to divest its minority stakes in banks, privatize the last state owned insurance company, Dunav. On the regulatory front, the NBS is planning implementation of Basel 2 by the end of 2011.

A. ENHANCING BUSINESS ENVIRONMENT

Business Entry

70. To facilitate business entry, the GoS has transformed the Serbian Business Registers Agency (SBRA) into a one-stop-shop for business registration and has enhanced its operational efficiency. Over time the SBRA has been given the responsibility to provide tax numbers, to file businesses financial statements, to maintain registries of leasing deals, pledges, bankruptcies and liquidations, amongst others. Reforms related to the operationalization of the one-stop shop and filing of financial statements are expected to yield annual savings to entrepreneurs in the order of EUR 2.2 million of which EUR 1 million from the single point filing of financial statements (previously statements had to be submitted to the SBRA, the NBS’ Solvency Center, and the Tax Authority). The operational efficiency of the SBRA was also enhanced thanks to the introduction of a complete electronic database on business entities and

Box 1: Key reforms supported by PFDPL 1 and 2 PFDPL 1: Adoption of a GoS decision on the commencement of a review of regulations of business activities Enactment of amendments to the Privatization Law that sets a time limit for the completion of the process Continuation of privatization of SOEs – as a result some 300 socially owned enterprises were sold Capitalization of the DIF Privatization of DDOR. PFDPL2: Adoption of the Law on Protection of Competition, Law on Bankruptcy, Law on Control of State Aid Sale of residual shares of 39 socially owned enterprises, thus completing the privatization of the same (*) Diagnostic assessment of all the banks in the system Adoption by the NBS of a liquidity framework Strategy of consolidation of state owned banks Adoption of Law on Mandatory Traffic Insurance (related to motor third party liability).

(*) According to the 2001 Law on Privatization, 70 percent of the companies offered in tender procedure was to be sold to a strategic investor, 15 percent was given to employees, and 15 percent was to be placed in the Privatization Register designated for citizens who did not receive shares as employees of companies. Subsequently, the GoS took the decision to sell in the market the 15 percent allocated for the public and distribute the proceeds in cash to the same.

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entrepreneurs, serving as a basis for the electronic exchange of relevant data between all state institutions. As a result of this transformation, the time to register a company decreased from 23 days in 2006 to 5 days in 2009.

71. To further ease business entry, the GoS has established a single window for registration of new employees, as an interim step preceding the transfer of this function to the Central Registry for Mandatory Social Insurance. Following the enactment of the Law on the Central Registry for Mandatory Social Insurance in early 2010 and the necessary by-laws, a single form is being used to register new workers. The employers are now able to choose whether to submit the single form either to the Pension Fund or the Health Fund (previously the procedure required registering new workers at the Pension Fund, the Health Fund, and the National Employment Service). Either of the two institutions receiving the single form have the obligation to notify the other relevant institution within one day. This will represent a considerable reduction in business compliance costs resulting in annual savings of approximately EUR 15 million, calculated according to the standard cost model. This solution will serve as an interim one, until the Central Registry is equipped to register new employees, a process which by law has to be completed by December 31, 2012.

Corporate governance

72. To strengthen corporate governance and facilitate business operation, a new Law on Business Entities has been approved by the GoS. The new law, which is in compliance with new EU directives, includes provisions to: (i) harmonize presently conflicting provisions of the Law on Business Entities and the Law on Securities Market (e.g., provisions on conditions for public offerings, listing of securities etc.); (ii) regulate entrepreneurs (at the same time the existing Law on Private Entrepreneurs will be abolished); (iii) regulate existing business associations (i.e. Association of Banks), which have been omitted in the existing Law on Business Entities; (iv) regulate the establishment, operations and closure of branch offices of foreign legal entities, and (v) define the duties and responsibilities of management and improve corporate governance by allowing the option of choosing between one- or two-tier corporate governance system for Limited Liability Companies (LLCs) and JSCs. Reforms under (ii) alone should lead to a reduction of administrative costs for businesses of approximately EUR 6 million per year. The Law has undergone public consultation, has been approved by the GoS, and submitted to the Parliament for approval in the next parliamentary session.

Regulatory reforms

73. The GoS introduced a Regulatory Impact Analysis (RIA) requirement in the legislative process in 2004 to improve the quality of new regulations. The implementation of the RIA will ensure that new regulations – the legislative flow – are based on a clear rationale and adequate analysis of costs and benefits. This is particularly important in the context of harmonization with the EU requirements. The implementation of the RIA includes also consultations with relevant stakeholders. The entity that has been tasked with the function of performing such analysis is the Secretariat of the Council for Regulatory Reform under the MoERD. Most recently the GoS has commenced the process of institutionalizing the regulatory impact analysis with a formal decision to create a permanent body in charge of this process.

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74. To review and reduce compliance cost of existing business regulations (legislative stock), a comprehensive regulatory review was completed. The regulatory review was initiated in early 2009 and consisted of four phases: inventory, analysis, recommendations, and implementation. As a result of the inventory, 2,000 laws and regulations were identified as impacting economic activity. In the analysis phase the responsible regulatory bodies had the obligation to justify the need to retain the respective legislation. At the same time, to solicit input from the business community, the GoS launched a media campaign calling for all interested parties to propose amendments and/or cancellation of laws and regulations. The Council for Regulatory Reform also formed ten working groups chaired by a representative of the private sector to further analyze the 2,000 laws and regulations.

75. Based on the review, the GoS approved 304 recommendations requiring the amendments of laws and regulations. In addition, the GoS approved the elimination of 192 regulations. The review contained 340 recommendations to amend laws and regulations and a proposal to abolish 196 regulations. Of these, the GoS approved 304 recommendations and ordered the elimination of 192 regulations. The implementation of 304 recommendations requires the amendments of 30 regulations and 30 laws. So far, 79 recommendations have been implemented through amendments of 20 regulations and 10 laws. It is estimated that this will result in annual cost savings to businesses of around EUR 50.8 million. The implementation of the remaining 225 approved recommendations is expected by the end of 2011. Approximately 90 recommendations of the remaining 225 have been included in the new draft Law on Business Entities, which will be approved by the GoS on December 23, 2010. The implementation of the remaining 225 recommendations should yield additional reduction in business compliance costs of around EUR 91.5 million, thus bringing to total estimated savings to about EUR 142 million. Details of the methodology to calculate the cost savings and specific examples are presented below in Box 2.

Box 2: Cost savings resulting from the review of regulation of business activities The estimated savings have been calculated following the Standard Cost Model. Variables used in the calculations are: (i) T (tariff) – cost of one hour of the worker performing an administrative procedure, calculated based on the average

income of employees in Serbia for 2009; (ii) N - time needed to perform an administrative requirement. This is established by interviewing representatives of relevant

businesses; (iii) E – additional cost, such as administrative tax that needs to be paid in the administrative procedure. The cost of the individual procedure for each company is obtained by multiplying T by N, and subsequently adding E. The total cost of the procedure is then multiplied by the number of business entities affected by the prescribed procedure and number of times that such procedure needs to be applied within one year. Statistics on business entities were obtained from the SBRA, while information on the number of times a certain administrative procedure needs to be implemented within one year was obtained either from businesses, or from regulatory bodies applying the respective procedure. It should be noted that it was possible to perform this calculation only for about 10 percent of recommendations, while for the remaining recommendations it was impossible to quantify the impact.

Examples of the cost savings associated to some of the recommendations are presented below: Introduction of single window approach for registering workers - EUR 15 million. Simplification of existing procedures such as extending the deadline for businesses to place their daily cash revenue into

their bank accounts from one to seven days - EUR 39.5 million. Requiring the Tax Authority to ensure electronic submission of required tax filing documents - EUR 8.5 million. Eliminating the requirement for preparing and stamping the travel requests for using the company vehicles each time the

vehicle is used - EUR 21 million. Eliminating the requirement for posting the company name on the company vehicles - EUR 2.6 million.

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Improving competition

76. To protect consumers and strengthen competition, a new Law on Protection of Competition was enacted. In 2005, the GoS adopted a Law on Protection of Competition. However, in the course of implementation a number of deficiencies were identified in the Law. These included: (i) long procedures to implement mergers, which also contradict the privatization law; (ii) unclear delineation of responsibilities among the Commission for Protection of Competition, the Privatization Agency and the NBS; (iii) low thresholds for concentration of capital notifications – requiring almost every merger/sale/tender to undergo scrutiny by the Commission; (iv) weak institutional arrangements; and (v) lack of clarity with respect to the basis for notification fees and applicable fines, leading to prohibitively high compliance costs. In consultation with the European Agency for Reconstruction (EAR)/European Commission, the GoS decided to draft a brand new law, rather than amend the existing one. The new Law was approved in the summer of 2009.

77. Eight new regulations required to implement the new Law on Protection of Competition have been adopted. These include: (i) Regulation on criteria defining relevant market; (ii) Regulation on content of request for individual exemption; (iii) Regulation on categories and special conditions for block-exemptions; (iv) Regulation on the form and content of the official identification; (v) Regulation on content and the manner for notification of concentration; (vi) Statute of the Commission for Protection of Competition; (vii) Regulation on criteria for measurement of the amounts of fines, the manner and payment timeframe under the measure for protection of competition and procedural penalties and on conditions for definition of other measures; and (viii) Regulation on conditions of relief from pecuniary fines under measures for protection of competition (Leniency Program).

Enhancing enforcement of court decisions and based on authentic documents

78. Enforcement mechanisms remain a stumbling block for business operations. According to the 2011 Doing Business indicators on enforcing contracts Serbia ranks 94th in the world, with 635 days necessary for enforcement. Also, a survey commissioned by a USAID-funded project showed that 73 percent of companies in Serbia “never or rarely” use the court for enforcement due to inefficient implementation. Moreover, the survey found the recovery rate for judgments in commercial courts is less than 5 percent. The European Court of Human Rights has also ruled nine times against Serbia in the past three years over human rights violations resulting from the inability to enforce court judgments in Serbia.

79. To speed up enforcement processes, the Government is preparing a new Law on Enforcement and Security. The new Law will enhance the enforcement of court decisions as well as enforcement based on authentic documents, such as contracts and invoices. To this end, the Law will introduce the concept of professional enforcement officers (i.e. private bailiffs) licensed and supervised by the MoJ. The Law has undergone public consultation, has been approved by GoS, and submitted to Parliament for approval in the next parliamentary session. Further, the MoJ will prepare the necessary implementation regulations, which will be adopted following the enactment of the Law. Amongst other, the regulations are expected to discipline the work of professional enforcement officers including their selection, preparation of annual reports, monetary awards and reimbursement of costs, mandatory insurance, issuance and revocation of ID cards registries, code of conduct and so forth.

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B. STRENGTHENING FINANCIAL DISCIPLINE IN THE NON-PRIVATE ENTERPRISE SECTOR

80. The non-private sector consists of numerous and varied enterprises, employing roughly 7.4 percent of the employed workforce (Table 6). The Republic of Serbia owns some 35 larger state-owned enterprises. In addition, there are 282 socially-owned enterprises, which used to belong to the “society” and operated via self-management12 and 221 former socially owned enterprises, which have been transferred in state ownership after unsuccessful privatization. About 550 municipally owned enterprises are controlled by the municipalities, but are legally owned by the state. Finally, there are enterprises owned by the Province of Vojvodina, which are outside of the purview of this document.

Table 6: Universe of non-private enterprises, 2010

Type Number of enterprises Number of employees Large state owned enterprises 35 100,000 Socially owned enterprises 282(*) 30,594 State owned enterprises in the Privatization Agency portfolio**

221 62,852

Municipal enterprises 550 60,000 TOTAL 1,088 253,446

Sources: PA data and World Bank estimates * excludes the 673 enterprises in bankruptcy/forced liquidation, but includes 201 socially owned enterprises where privatization has been temporarily suspended (for companies whose founders are former Yugoslav republic, as well as veterinary stations, public media, companies with activities related to waterworks, etc,). ** These are previously privatized socially-owned companies for which the privatization contracts were cancelled, upon which they were returned to PA portfolio as state-owned companies. 81. Most non-private enterprises benefit from both direct and indirect subsidies. In FY10 direct subsidies to the sector are expected to amount to approximately EUR 241.1 million or 0.8 percent of GDP (see Table 7). Most direct subsidies are direct budget transfers to state-owned enterprises (e.g., the Railways and Resavica mining complex) by the MoF and the Ministry of Mining and Energy, or, in the case of socially-owned enterprises they take the form of soft loans from the MoERD through the Development Fund. In addition, to direct subsidies, many non private enterprises benefit from indirect subsidies such as non-payment or partial payment of taxes; arrears to state-owned utilities (e.g. EPS), arrears on pension, social security, and unemployment contributions. No data is available on indirect subsidies, but based on a 2004 assessment of sixty socially-owned enterprises, they are estimated to be more than three times the size of direct subsidies. No subsidies are channeled through the state owned banking sector.

12 The concept of socially-owned enterprises was unique to ex-Yugoslavia and was at the center of the economic organization at the time.

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Table 7: Direct subsidies to non-private enterprise sector, 2008-2010

Type 2008 2009 2010

EUR mln Percent

GDP EUR mln

Percent GDP

EUR mln (planned)

Percent GDP (estimate)

Total state owned enterprises

149 0.45 121 0.39 140.8 0.47

Railways 130 0.39 105 0.34 120.4 0.40

Resavica 19 0.06 16 0.05 20.4 0.07

Total socially owned enterprises

43.9 0.13 36.38 0.12 40.1 0.13

Zastava 17(*) 0.05 14.82(*) 0.05 13.6(*) 0.04

Total municipally owned enterprises

94.5 0.28 54 0.17 60.2 0.20

TOTAL 287.4 0.86 211.38 0.68 241.1 0.8

Sources: World Bank estimates (*) This does not include the GoS incentives provided to the newly created enterprise (Fiat Automobile Serbia). It is estimated that these will amount to EUR 150-200 million over the next few years (i.e. in the factory, local roads and infrastructures, etc.)

82. To create fiscal space for needed public investment, the GoS is committed to strengthening financial discipline in the non-private sector. Most of the enterprises are loss making and state subsidies are primarily geared at keeping the companies afloat rather than - for example - addressing market failures. To mitigate the drain on the fiscal budget, the GoS has committed to:

(i) Privatize or restructure socially owned enterprises and closing socially owned enterprises where privatization/restructuring was unsuccessful;

(ii) Corporatize/selectively privatize state owned enterprises; and (iii) Control subsidies in all non private sector enterprises that cannot be privatized in the

short-term.

Privatization/Restructuring socially owned enterprises and closing socially owned enterprises where privatization/restructuring was unsuccessful

83. Since 2001, the GoS pursued a systematic privatization strategy for socially owned enterprises. The principles and approach are laid down in the 2001 Law on Privatization, which incorporated lessons learnt from other transition economies. The main lesson learnt from experience of other transition countries was that privatizations that put core, strategic investors in charge of the firms worked better than those that passed ownership to diffused, inexperienced workers or citizens. The selected privatization model was more conducive to improving corporate governance and real sector efficiency, attracting foreign capital, and technology. Based on the 2001 Law on Privatization, socially-owned enterprises should be sold by the Privatization Agency (PA) via: (i) tenders offering at least 70 percent of the shares to a strategic investor, if the enterprise is large; (ii) auctions for medium-sized enterprises; and (iii) restructuring and subsequent tenders and/or auctions for large loss-making enterprises and/or parts thereof.

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84. However, the privatization process was lengthy and, in 2008, legislation was passed to complete the process by end-2008 by mandating that companies for which privatization had not started would be closed. The Law on Privatization was amended in 2008 requiring that the privatization of all socially-owned enterprises be initiated by the end of the same year. Mandatory liquidation/bankruptcy13 must be introduced when: (i) announcement of public tender/auction has not been published; (ii) the company (capital/assets) has not been sold even after the third attempt; and (iii) the entity subject to privatization fails to submit its financial report to the business registration agency for two years in a row. Moreover, in 2010 the Law on Privatization Agency was amended and previously privatized socially owned companies for which the privatization contract are cancelled, largely due to investors’ unfulfilled contractual obligations, now return to the PA portfolio as state-owned companies. These companies are then subject to a new resolution process (privatization and/or bankruptcy).

85. Consequently, 430 socially-owned companies were sold for about EUR 362 million in the period 2008-2009. 28 companies were privatized in 2010 due to market conditions, but 162 were put in bankruptcy. As of early November 2010, there were 955 socially owned companies in the PA portfolio (see Table 8). Of these 673 enterprises were in bankruptcy/forced liquidation; in 2010 162 companies from the PA portfolio were put in bankruptcy. In 2010 there were further 81 companies in auction, tender and restructuring procedure in the PA; progress with the latter category is well underway and should be completed by mid 2011. Privatization for the remaining 201 was temporarily stopped for various reasons, such as unresolved ownership status with former Yugoslav republics.14 The state owned enterprises reflected in the Table 8 represent previously privatized socially-owned companies for which the privatization contracts were cancelled.

Table 8: PA Portfolio - Status as of November 2010 Status Number of socially owned

enterprises Number of state owned

enterprises

Bankruptcy/ Forced Liquidation 673 0 Auction 25 47 Tender 6 19 Restructuring 50 84 Privatization suspended 201 50 Under Preparation 0 21 Total 955 221 Grand Total 1,176

Sources: PA data

86. State-owned companies in the PA portfolio will be again subject to the resolution process and, due to slow progress, bankruptcy remains an option. Currently, public invitation has been issued for the tender of two companies and auction of additional two. By the

13 Forced liquidation is initiated by the Privatization Agency when the assets exceed the liabilities of the company. Bankruptcy is initiate by the Privatization Agency (that acts as bankruptcy administrator for socially owned enterprises) when liabilities exceed the assets. 14 The state owned enterprises in the table represent previously privatized socially-owned companies for which the privatization contracts were cancelled, largely due to investors’ unfulfilled contractual obligations. These were returned to the PA portfolio as state-owned companies and will also be subject to the new resolution process (privatization and/or bankruptcy).

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end of 2010, the PA is expected to announce additional three tenders. The sale of capital/assets in remaining companies is planned by the second quarter of 2011. Finally, restructuring is underway in 84 companies. To facilitate resolution of unviable enterprises, especially socially owned enterprises, the GoS has enhanced the new bankruptcy framework (see Section Improving the bankruptcy framework).

Selectively privatize state owned enterprises

87. In 2008, the GoS also decided to corporatize and eventually privatize selected state-owned enterprises. These included EPS, JAT, NIS, Belgrade Airport, Telekom, and Galenika. Until now, only NIS was sold (51 percent was sold to Russian Gazprom). The privatization of Galenika, a pharmaceutical company, was delayed and the GoS is currently in the process of selling 51 percent stake in Telekom. Moreover, the GoS is planning to carve out the good assets of JAT, transfer them to “a new company“ and offer it for sale.

Controlling subsidies in the non-private enterprise sector 88. Despite restructuring and privatization, direct subsidies to the non-private sector have hovered around 0.8 percent of GDP in the 2008-2010 period. See Table 7. There are several reasons for this:

Even with restructuring it takes time for savings to show up in financial performance. A number of privatization contracts for socially owned enterprises were cancelled (91 in

2009 alone due to unfulfilled contractual obligations by the buyers). This group of companies, including large enterprises such as Azotara Pancevo, Letex, Magnohrom, were returned to the PA portfolio and had to be subsidized in the period.

Companies left for privatization at this stage are the worst performers, as the best enterprises were sold earlier in the process.

Up-front investment is sometimes needed. In 2008, to resolve Zastava the GoS funded retrenchment and active labor market programs and transferred selected assets to a new company (Fiat Automobile Serbia), which is owned at 33 percent by the GoS. Subsidies provided to Zastava alone accounted for 41 percent of the socially owned company subsidies in 200915 and it is planned that the socially owned company will receive about 34 percent of the 2010 allocation. In addition, as part of the deal with FIAT the GoS has committed to invest between EUR 150-200 million over the next few years (i.e. in the factory, local roads and infrastructures, etc.).

89. To improve transparency of state aid, the GoS introduced a new State Aid Framework. This included the adoption of a Law on Control of State Aid in 2009 that regulates amounts and types of subsidy, and the creation of an operationally independent Commission for Control of State Aid. The Commission will be responsible for ex-ante control of state aid as per the Stabilization and Association Agreement with the EU. The Commission for Control of State Aid was formally established in December 2009 and it consists of 5 members from the following entities: the MoF, the Commission for Protection of Competition, the MoERD, the Ministry of Infrastructure, and the Ministry of Environment and Spatial Planning. In total, the Commission

15 The subsidies to Zastava administered by the MOERD were aimed at the Zastava Group (in restructuring) and not the Fiat Automobile Serbia, which is being funded from other sources.

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has approved allocation of state aid in the amount of nearly RSD 1.1 billion (around EUR 10.2 million). To ensure transparency, all decisions are available on the website of the MoF.

90. To better monitor state aid, a Registry of Regional Development Measures and Incentives has been established under the SBRA. The Registry will record all measures and incentives funds by the GoS and international organizations to a variety of entities including companies. Further, the Registry will record the following type of information: type, purpose and form of incentive, providers and users, financial information, and territorial focus. The government institutions obliged to report to the Registry include: the MOERD, the Ministry for National Investment Plan, the Ministry of Infrastructure, the Ministry of Agriculture, Forestry, and Waterworks, the MoF, the Development Fund, the National Employment Service, the Serbian Investment and Export Promotion Agency, the National Agency for Regional Development, the Agency for Insurance and Financing of Exports, the AOFI and the EU Integration Office.

Improving the bankruptcy framework

91. To increase recovery in bankruptcy in general and especially in the context of non-private enterprises, a new Law on Bankruptcy was introduced in 2009. The new Law increased process efficiency, established automatic triggers for bankruptcy, and created new rules for pre-packaged reorganization. In addition, the new Law also improved the current bankruptcy framework, particularly in regards to the addition of the set-off provisions, the improvements to the reorganization process, and the avoidance of pre-bankruptcy transactions. Furthermore, it clarified issues with respect to licensing, appointment, removal, and disciplining of bankruptcy administrators. The Doing Business 2011 report credited government efforts in this area, and Serbia was ranked 86th globally in ‘Closing a Business’ indicator or 15 spots higher than the previous year.

92. Following the enactment of the new Law on Bankruptcy, bankruptcy administration is being enhanced. This effort includes already adopted amendments to the Law on Agency for Licensing of Bankruptcy Administrators, as well as revisions to the National Standards for Administering the Bankrupt Estate and the Code of Ethics. Moreover, to track case activities, an electronic reporting system has been established. Finally, eleven implementation regulations for the new Law on Bankruptcy have been approved. These include regulations on the code of ethics, implementation of reorganization, pre-packaged reorganization, registry of bankruptcy estate, awards and fees of bankruptcy administrators.

93. The introduction of automatic bankruptcy triggers has resulted in initiation of bankruptcy for some 11,000 privately and socially owned entities. The Law on Bankruptcy requires automatic bankruptcy proceedings for enterprises with accounts blocked for over three years16. Based on this new procedure, the NBS sends the candidate list to the commercial courts, which formally declare bankruptcy. The debtor or the creditors have 60 days to pay an advance

16 The blocked account system refers to the use of promissory notes authorizing creditors to block delinquent borrowers’ bank account. An account freeze, administered by the NBS claim and enforcement department is applied to all bank accounts in the system. When balances on bank accounts are insufficient to repay creditors requesting the blockage, the accounts remains blocked until balances are repaid, creditors withdraw their request to block or until the borrower is put into bankruptcy. Bank accounts may also be blocked by tax, customs authorities seeking collection of unpaid claims.

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fee to the Courts that will then formally open a bankruptcy case and determine whether the company is to be liquidated/bankrupted or reorganized. If no fee is paid within 60 days, the Court will automatically open and close the bankruptcy case and transfer any assets to the state that is the Directorate for Property of the Republic of Serbia. Any legal claims on assets (i.e., loans, mortgages) would still remain valid. Only if there are no assets and no parties are interested in opening a bankruptcy case, the SBRA will erase the entities from the Registry of companies.

C. BUILDING A STABLE AND MORE EFFICIENT FINANCIAL SECTOR

Strengthening crisis preparedness and bank resolution

94. To prevent possible withdrawals of foreign banks in the wake of the crisis, the GoS and the NBS implemented a comprehensive program to maintain stability in the banking sector. Given the large presence of foreign banks in the country, ensuring that the latter remained committed to the Serbian market was paramount. To this end, the GoS implemented a program under the auspices of the “Vienna initiative” in late 2008. The initiative is voluntary and open to all banks. Signatory banks are required to keep their exposure vis-à-vis Serbia at 80 percent of the 2008-level and to keep their subsidiaries sufficiently capitalized. Incentives include access to two liquidity facilities established by the NBS and amendments to risk management regulations, namely an increase in the limit of sub-debt to tier 1 capital ratio from 50 to 75 percent and an increase in the net open position from 10 to 20 percent. The program has expired in December 2010 and it will not be renewed.

95. To ensure that the system is well capitalized a bank diagnostic and triage exercise has been implemented. In December 2009, the NBS completed the stress testing for the entire banking sector (i.e., 34 banks). As a result, Metals Banka was recapitalized by the Province of Vojvodina and Komercijalna Banka, a state owned bank with EBRD minority ownership, raised more equity from existing and new shareholders17, including the IFC. Further, Credy Bank was recapitalized by Nova KBM from Slovenia.

96. The deposit insurance fund has been strengthened. The fund increased in size to around EUR 140 million at Q3 2010 due to an initial capitalization by the GoS and raising of premium. Its current size is adequate to cover the failure of a mid-size bank18. More recently, the capacity of the fund to deal with large payouts has been strengthened by developing payout procedures, introducing a payout software, adopting a Memorandum of Understanding (MoU) on information sharing between the DIA and the NBS. Amendments to the legal framework to specifically provide for extraordinary funding and equate the depositors of banks in liquidation with those of banks in bankruptcy have also been approved. Finally, to better target the size of the fund, the DIA has developed a risk management tool.

97. To deal with problem banks in a more effective and less costly manner, the existing bank resolution framework is being overhauled. The previous bank resolution framework included only liquidation and bankruptcy as resolution tools. Under the new framework, purchase and assumption and bridge bank on a closed bank basis have been added, as well as

17 In addition to the EBRD and the IFC, other new shareholders include German DEG and Swedish Swedfund. 18 In the absence of a risk assessment model, the rule of thumb is that a deposit insurance scheme should be able to deal with small and medium size bank failures, as opposed to systemic failures.

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financial assistance for these tools on a least cost basis. Finally, to ensure that the DIA has access to emergency funding for bank resolution/payout, the implicit government guarantee included in the existing DIF and the Law on DIA has been made explicit with the approval of 2011 budget law. RSD 110 million (approximately EUR 1 million) have been allocated to cover the commitment fee for a EUR 100 million stand-by credit line from commercial banks to the DIA for contingency purposes. By doing so the implicit GoS’s guarantee to the DIA will be made explicit.

Restructuring and divesting state owned banks

98. The GoS has continued the divestment program for state owned banks. To consolidate the state-owned banking sector and reduce likely capital injections, the GoS adopted a strategy in May 2009, which called for the reduction of majority state owned banks from four to two over the next two years. The strategy identified Credy, Postanska Stedionica, and Privredna Banka Pancevo as candidates for either merger or privatization, while the forth majority state owned banks, Srpska Banka, would continue to operate independently. Accordingly, Credy Bank was sold to Nova KBM (NKBM) from Slovenia in 2009. Following two rounds of capital injections, NKBM owns 72.38 percent of Credy Bank, while the RoS owns 15.24 percent. Postanska Stedionica and Privredna Banka Pancevo were instead merged; the legal merger was completed in September 2010 and the operational merger will be finalized in the course of 2011. The entity that will emerge from the merger will hold 1.5 percent of the banking assets of the system, but will have a large number of deposits, primarily pensioners’. An institution building expert will be engaged to develop a business plan defining, amongst others, the relationship with the postal network and identifying the best delivery channel for its dispersed clientele.

Strengthening the insurance sector

99. Performance of the insurance sector has improved since 2008. These improvements have taken place thanks to the NBS’ supervision, which led to the exit from the market of loss making insurance companies and entry of foreign players. Furthermore in 2008, the DDOR, a large and loss making insurance company was sold to the Italian Generali, which improved substantially the performance of the company. The regulatory framework has also been enhanced. Notable example is the approval of the Law on Mandatory Traffic Insurance. Prior to this, the motor third party liability segment, the main class of non-life insurance business, was not sufficiently regulated.

100. However, the sector remains small and almost a third of the market is dominated by a state owned insurance company. With insurance consumption of EUR 76 and EUR 10 per capita for non-life and life insurance, respectively, Serbia lags behind most of its neighbors in South Eastern Europe. In 2009, the industry accounted for only 4.6 percent of total assets and 5.6 percent of total capital of the financial sector. Dunav, a state owned insurance company, accounts for 28 percent of the market. While Dunav’s performance has been improving thanks to a restructuring plan, its underwriting performance is lagging. Moreover, business decisions made by Dunav management in the past (e.g., substantial reductions in premium rates in the motor third party liability business) distorted the market, but given the company considerable market power.

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101. In light of the possible market distortion, the GoS has committed to future privatization of Dunav. As a first step this will require the transformation of Dunav from a socially owned to a state owned entity due to the fact that social ownership is no longer a valid legal form as per the new Constitution. To this end, the GoS has approved and submitted to the Parliament legal amendments to the Law on Insurance that define the process of transformation of socially owned capital in the insurance sector into state owned. Furthermore, the amendments mandate the commencement of privatization of at least 20 percent of state owned capital in insurance companies by the end of 2013.

102. To reduce the potential for systemic risk in the sector, insurance companies will be required to separate the life and non-life insurance businesses. Separation of life and non-life insurance is not yet required in Serbia. The existing status quo creates opportunities for management of insurance companies to use often sizable life insurance reserves as a substitute for risk capital (in lieu of reinsurance) in considerably more volatile non-life insurance business, which creates the potential for misuse of life reserves, price distortions in non-life segment of the market and systemic risk in the sector. To address this issue, amendments to the Law on Insurance have been enacted requiring the separation of life and non-life business by the end of 2011.

Supporting capital market development

103. Capital markets in Serbia remain underdeveloped, with limited equity market activity and only emerging domestic bond market. Although the financial sector has deepened in recent years, it continues to be largely dominated by the banking segment. Serbia’s market capitalization accounts for 30 percent of GDP. Currently, there are only six companies19 fully listed on the Belgrade Stock Exchange, and approximately 1,700 on the non-regulated market, of which only a few dozen are actively traded. Additional securities include certificates of deposits issued by the GoS to compensate citizens of Serbia for the loss of foreign deposits during the 1990s. Further, during the course of last year the GoS has gradually extended the maturity of Treasury Bills from three to up to 24 months.

104. The financial crisis has highlighted the importance of domestic saving mobilization, especially for countries whose banking sector is funded largely from international capital flows. This risk is real for Serbia in light of the dominance of foreign banks and of their reliance on parent funding to lend in the country. To offset this risk, the GoS has been trying to develop the capital market, as a mean to increase domestic savings.

105. The establishment of a yield curve and a conducive legal framework are essential to support capital market development. In 2009, due to the crisis, the GoS started relying more heavily on issuing T-bills to fund its fiscal needs, and initially it experienced problems with unsuccessful auctions. A diagnosis of key obstacles was conducted, following which the coordination between the MoF (debt market policy) and the NBS (liquidity management policy) was strengthened, auctions have gradually improved in this period and the maturity of T-bills was gradually extended from 3 months to 6 months and 1 year. As a result, in 2009, the total stock of T-bill debt reached around EUR 1 billion20(up from around EUR 15.7 million in 2008).

19 Energoprojekt, Sojaprotein and Tigar (Prime Market – “A listing”) and Alfa plam, Komercijalna Bank, and Metalac (Standard Market). 20 Breakdown of funds raised by maturity of T-bills in 2009: 3-month: 62 percent; 6-month: 30 percent; and 1 year: 8 percent.

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In May 2010, the GoS issued 18-months, and subsequently 24 months T-bills. Most recently, the GoS issued a first ever Euro-indexed T-bills. The GoS is also working on a new Law on Securities Market, which needs to be harmonized with the Law on Business Entities (currently in the making) and aligned with relevant EU Directives and IOSCO21 principles.

106. Strengthening of the GoS debt management capacity is supported by the PEDPL 2. These include the full staffing of the PDMA and the completion of the following activities: (i) Establishment of a comprehensive debt database; (ii) Preparation of a comprehensive medium-term debt management strategy; (iii) Description and a qualitative risk assessment of all outstanding Government guarantees; and (iv) Preparation of procedures manuals for the main debt management activities. All required prior actions were met. The PDMA was established and fully staffed. Among the achievements are preparation of a comprehensive medium-term debt management strategy, and a listing in the Budget Memorandum of the loan guarantees that are assessed as high risk. In addition, the revision of the Law on Public Debt is underway, and once adopted it should additionally strengthen Government's debt management capacity.

IV. BANK SUPPORT TO THE GOVERNMENT’S STRATEGY

A. LINK TO CPS

107. The proposed operation is consistent with the FY08-FY11 CPS and FY09 CPS Progress Report for Serbia. The Serbia CPS “Dynamic Private Sector Led Growth to Ensure Incomes Converge with Europe” supports three GoS priorities: (i) private sector led growth to ensure income convergence with European levels; (ii) increased opportunities and participation in growth; and (iii) management of emerging environmental and disaster risks. The CPS and CPS Progress Report envisaged support to the first and second areas through a series of three PFDPLs. In the context of preparation of the third operation under the PFDPL series, the GoS has requested to avail of an IBRD PBG rather than a loan. As PBG is not a DPL option under OP 8.60 (Development Policy Lending) and a "Programmatic PBG" option does not exist under OP 14.25 (Guarantees), the PFDPL series has been terminated after PFDPL 2, and PFDPL 3 has been transformed in a stand-alone PBG operation, with the same policy matrix as the originally envisaged PFDPL 3.

B. COLLABORATION WITH THE IMF AND OTHER DONORS

108. The program supported by the PFSPBG has been developed in collaboration with IFIs and other development partners engaged in private and financial sector development. Agencies engaged in the sector include: (i) USAID and KfW supporting commercial legislation reform; (ii) the EAR and USAID focusing on enterprise sector reform and bankruptcy and enforcement regime; (iii) the U.S. Treasury and USAID sponsoring financial sector reforms; (iv) KfW strengthening the deposit insurance fund; (v) and SIDA supporting the implementation of the regulatory reform. Collaboration in the area takes place through monthly meetings chaired by the Bank country manager.

21 International Organization of Securities Commissions

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109. To safeguard macroeconomic and financial stability, Serbian authorities agreed on a EUR 3 billion stand-by arrangement with the IMF in May 2009. The program involves a multi-sector approach based on fiscal adjustment, private sector involvement in a financial sector support package, and external financing from IFIs and the EU. Fiscal discipline is anchored in wage and pensions expenditure restraint, while financial policies focused on limiting adverse spillovers including through assurances from foreign parent banks to at least maintain their external exposures to Serbia, while keeping their subsidiaries capitalized and liquid.

110. The PFSPBG financial sector pillar is directly supported by State Secretariat for Economic Affairs (SECO) of the Swiss Confederation TA to the DIA and investments in undercapitalized banks by the EBRD and the IFC. The SECO of the Swiss Confederation has allocated a grant of EUR 2.7 million to strengthen the DIA in its function as manager of the GoS shares in banks and socially-owned capital in insurance companies. Following the banking sector diagnostic, the EBRD increased Komercijalna’s capital by EUR 48 million and the IFC (via the Bank Capitalization Fund) by EUR 4 million. Additional post-crisis investments by the IFC included a EUR 40 million loan to Societe Generale for agri-business and EUR 20 million to ProCredit for micro and small enterprises.

C. RELATIONSHIP TO OTHER BANK OPERATIONS

111. The policy actions supported by the PFSPBG are a continuation of the program supported by the PFDPL series and previous budget support operations. In the context of preparation of the third operation under the PFDPL series, the GoS has requested to avail of an IBRD PBG rather than a loan. As PBGs are stand-alone operations, the PFDPL series was terminated and PFDPL 3 has been transformed in a stand-alone PBG operation, with the same policy matrix as the originally envisaged PFDPL 3. Budget support operations preceding the PFDPL series and focused on private and financial sector include the two Private and Financial Sector Adjustment Credits (PFSAC1 and PFSAC2) and the Programmatic Private and Financial Development Policy Credit (PPFDPC-1). All supported the GoS in: (i) strengthening fiscal discipline in enterprise, energy and transport sectors, and attracting foreign investment; and (ii) building a more efficient and stable financial sector and improving access to finance, including continued privatization, divestment of state-owned banks and financial assets, strengthening insurance sector regulations and improving access to finance through the adoption of a Law on Mortgage. 112. TA for regulatory reform, incorporation of state owned enterprises, capital market development, and crisis preparedness further support the reform agenda underpinning the PFSPBG. A World Bank Trust Fund funded by SIDA supported the regulatory review process. Going forward, the World Bank’s Institutional Development Fund (IDF) grant will support the creation of a permanent government body in charge of the regulatory impact assessment. A second IDF grant is assisting the GoS in designing an adequate framework for incorporation of state owned enterprises, a process which should enhance their corporate governance. The framework will also be implemented with a pilot incorporation of Serbian Railways and of Post (which owns Postal Bank and Telecom). Under the Capital Markets Development TA, assistance has been provided to the PDMA to identify key issues in the area of government securities market development, provide support in initiating their resolution, and strengthen the PDMA’s technical capacity. Finally assistance in upgrading the crisis framework for the

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financial sector, and in particular on strengthening the DIA and bank resolution framework, has been provided under the regional World Bank funded Western Balkans Facility.

113. The proposed PFSPBG is complemented by the PEDPL series. The objective of the latter is to help reduce the size of Serbia’s large public sector by supporting reforms that will help improve the productivity of public spending. In particular, the series are structured around three key policy areas: (i) public expenditure allocation reforms to improve the quality of spending in the largest spending sectors; (ii) public expenditure and debt management reforms to address poorly managed fiscal spending and to help improve fiduciary conditions; and (iii) social assistance, especially for cushioning the impact of the economic crisis and enhancing the coverage of the social assistance programs going forward.

D. LESSONS LEARNED

114. The program supported by the PFSPBG and preceding PFDPL series builds on lessons learned from other transition experiences. These include the importance of:

a. Sequencing market reforms and privatizations. Successful transition reform programs have been sequenced as follows: (i) introduction of policies to liberalize prices and ensure fiscal stability; (ii) structural reforms in industrial enterprises and banks; and (iii) reforms in utilities, non-banking institutions and capital markets. In parallel, private sector growth should be facilitated through business environment reforms. “Early wins” are essential for program sustainability with restructuring of more politically sensitive large loss-makers coming later. Under the PFDPL series, the GoS adopted the sequence defined above, completing the early win phase and reforming substantially the business environment. However, as Serbia embarked on the restructuring of politically sensitive large loss-makers, the global crisis hit. Therefore, progress with respect to the latter has been more modest.

b. Identifying reform champions and supporting them in implementation. The

reform program is firmly anchored in the MoF, the MoERD, and the NBS. Two technical agencies have also been created to support the implementation of the reforms, the PA in charge of privatizing socially-owned enterprises, and the DIA responsible for the privatization of the banking sector. Both agencies have benefitted extensively from TA, provided also under the PFDPL series.

c. Providing extensive technical assistance on a timely basis. In the case of

Serbia, substantial grant funding is provided by the EU, the DFID, the SIDA, the Bank and the USAID. The TA design and delivery is enhanced by effective donor coordination. 115. Serbia differed somewhat from other transition economies, and lessons learnt have accordingly been adjusted. First, its system of socialism, based on worker management and the concept of “social capital,” did not entail classic central planning; and secondly, due to the break-up of the former Yugoslavia and the resulting conflict and sanctions, Serbia was late in embarking on the journey to a full-fledged market economy. These factors meant that the fundamental transitional task of reforming banks and enterprises had to be adjusted to these different initial conditions: auctions replaced voucher privatization typical for other transition

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economies, the four largest state-owned banks were closed, and the approach to restructuring of utilities and of the largest loss-makers has been more gradual than that of the early reformers.

116. The program supporting the PFSPBG and preceding PFDPL series has also benefitted from Bank engagement in previous financial crises. These highlight the importance of focus, selectivity and coordination with partners.22 The financial sector pillar of the program addresses these issues by supporting aspects of crisis management in which the Bank has traditionally had a comparative advantage. The reforms underpinning the pillar have been designed in cooperation with the IMF. 117. Lessons learnt from previous PBGs have also been incorporated in the design of the PFSPBG23. The evaluation of the two PBGs that have been issued to date, i.e. to Argentina (1999) and Colombia (2001), indicates that in both cases, guarantees exerted considerable leverage and allowed the countries to get access to international markets at a time when investors’ interest was minimal or when they were constrained to small volumes.24 The report further points out that PBGs work best when the underlying reform programs are part of a sustained effort. Therefore, hybrid policy loan/guarantee operations provide better sequencing than standalone policy guarantee operations. This was the case in Colombia, where the PBG was issued in lieu of a second tranche of a Financial Sector Adjustment Loan. PFSPBG is a similar case, in that the policies underpinning the operation are part of the reform effort supported by the preceding PFDPL series (the last operation of the series has been transformed in a PBG). The usage of the guarantee has allowed the GoS to leverage a larger volume of resources, and provided greater leverage to complete complex structural reforms initiated under the PFDPL series, such as the new bank resolution framework.

E. ANALYTICAL UNDERPINNINGS

118. The program supported by the PFSPBG and preceding PFDPL series builds on the findings of the economic sector work undertaken by the Bank. These include the Investment Climate Assessment (ICA); the Private Sector Note (PSN); and the Financial Sector Assessment Program (FSAP) report. The ICA and PSN laid the ground for the privatization program by demonstrating that private firms were more productive, more profitable, and growing more rapidly than the socially-owned ones. The analysis also highlighted the importance of the business environment for new firms—entry by new entrepreneurs and growth of existing private firms were limited by the costly business environment. 119. Progress of reforms under the three pillars has been assessed by the 2009 FSAP update, the annual Doing Business and 2008 Public Expenditure Review (PER). The FSAP

22 A comprehensive review of Bank operations and research is included in “Lessons from Past Financial Crisis”, Independent Evaluation Group. 23 A review of the usage and effectiveness of World Bank Group guarantees is presented in “The World Bank Group Guarantee Instruments 1990-2007.Guarantee Instruments, 1990–2007”. Guarantee Instruments, 1990–2007”. 24 The report further highlights that the Argentine PBG that supported its 1999 structural reform program failed, because of broader weaknesses in the specific programs rather than the guarantee instrument itself. Following the collapse of the Argentinean financial system, the country’s adjustment program went off track, and reforms that were intended to be supported by a Bank adjustment loan as well as the PBG financing were not achieved. Guarantee Instruments, 1990–2007”.

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update provided recommendations for further reforms in the areas of banking regulation and supervision, liquidity and securities market issues, crisis management framework, bank resolution, deposit insurance scheme, corporate and household debt, and insurance sector. The annual DB report provides analytical foundation for much of the business environment pillar. The PER highlighted that direct and indirect subsidies25 amounted to around 4 percent of GDP in 2008 and 9 percent of general government spending. In 2008 alone, the average subsidy per employee was equivalent to national average monthly net wage (from December 2008), thus each worker effectively allocates one month’s salary for employees in subsidized sectors.

V. THE PROPOSED PRIVATE AND FINANCIAL SECTOR POLICY BASED GUARANTEE

A. OPERATION DESCRIPTION

120. The objectives of the PFSPBG are to improve the business environment, strengthen financial discipline in the non-private enterprise sector, and build a stable and more efficient financial sector. The business environment pillar aims to: (i) simplify regulatory requirements and compliance costs for business entry and operations; (ii) enhance corporate governance, (iii) strengthen legal framework for competition, and (iv) improve enforcement of court decisions and of authentic documents. The financial discipline pillar supports: (i) creation of a registry of regional development measures and incentives; and (ii) facilitation of the resolution of socially owned enterprises. The financial sector pillar supports: (i) crisis preparedness, including assessment of capital adequacy, enhancement of bank resolution framework, and strengthening of deposit insurance payout functions; (ii) continued restructuring/divestment of the GoS’s remaining holdings in the banking sector; (iii) improvement in the insurance sector regulation; and (iv) supporting capital markets development. 121. All policy actions for the PFSPBG are included in the policy Matrix. Prior actions are featured in Box 3. The outcomes of the policies underpinning for PFSPBG are featured in the last column of the Policy Matrix.

Box 3: Prior Actions for PFSPBG 1) The Borrower’s Government has approved the draft Law on Business Entities, satisfactory to the Bank, and submitted it to its Parliament for adoption;

Status: A draft law has been finalized and public consultation is underway. The GoS has adopted the law on December 23, 2010. The law has been submitted to the Parliament.

2) The Borrower has completed a comprehensive review of regulations of business activities, and the Borrower's Government has approved the recommendations of that review; Status: The Government has approved a total of 304 out of 340 recommendations to amend laws and/or regulations, as well as abolishment of 192 regulations out of 196 recommended. This action was completed with the adoption of the Government decisions of December 29, 2009 and November 26, 2010.

25 Subsidy is defined as a government action that lowers the cost of production, raises the price received by producers or lowers the price paid by consumers.

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3) The Registry of Regional Development Measures and Incentives, satisfactory to the Bank, has been established within the Serbian Business Registers Agency and is operational;

Status: This action was completed on December 2, 2010.

4) The National Bank of Serbia has completed a diagnostic assessment of all banks operating in Serbia in accordance with the methodology adopted under the Second Programmatic Private and Financial Development Policy Loan provided by the Bank, and enforced bank recapitalization to a capital adequacy ratio of at least 12%;

Status: This process was completed by February 2010.

5) The Borrower’s Parliament has: a) enacted amendments satisfactory to the Bank to the Law on Banks, Law on Bankruptcy and Liquidation of Banks and Insurance Companies, Law on Deposit Insurance and the Law on the Deposit Insurance Agency; and b) enacted the Law on Budget for the year 2011 which contains a provision satisfactory to the Bank on the State Guarantee to the Deposit Insurance Agency.

Status: The amendments have been approved by the Parliament on November 29, 2010. Budget Law for 2011 has been approved on December 29, 2010.

6) Banks with Borrower majority ownership have been merged, privatized or restructured in accordance with the strategy adopted under the Second Programmatic Private and Financial Development Policy Loan provided by the Bank.

Status: The majority of Credy Bank was sold to Nova KBM from Slovenia in March 2010, Postanska Stedionica and Privredna Banka Pancevo were legally merged in September 2010. The restructuring of the new entity will take place in the course of 2012. Tender to select an institution building adviser was launched on November 30, 2010.

122. The GoS regulations require consultations with all relevant stakeholders for significant legislative amendments. Article 41 of the Rulebook of the GoS requires public consultations for all legislative amendments that regulate issues which are of particular interest to the public. Only following public discussion, and further inter-ministerial harmonization, can the proposed legal amendments be submitted for the Parliament’s consideration. Regulations that explicitly or implicitly deal with environmental issues are reviewed by the Inter-ministerial Regulatory Review Unit, which ascertains potential impact on the environment, and the final decision is taken by the ministry in charge of environmental protection. 123. The Government’s reform program underpinning the PFSPBG has benefitted from consultations with relevant stakeholders (as required by OP 8.60). The Law on Business Entity, the Law on competition, the Law on Enforcement, Amendments to the Law on Banks, the Law on Bankruptcy and Liquidation of Banks and Insurance Companies, the Law on Deposit Insurance and the Law on Deposit Insurance Agency have been classified as systemic laws. Therefore, as per the GoS own rules, their finalization has undergone extensive consultations with all interested stakeholders. Furthermore the review of regulations of business activities has been designed with the help of representatives of business membership organizations, who participated in all the thematic working groups.

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B. POLICY AREAS

PILLAR I – Enhancing Business Environment 124. Pillar 1 of the PFSPBG supports policies aiming to enhance the business environment. These include measures to simplify business entry, strengthen corporate governance, easing the business environment, make the competition framework operational, and improve enforcement of court decisions and of authentic documents such as contracts and invoices. 125. Under the PFSPBG, the one-stop shop concept has been expanded to include employees’ registration and a new Law on Business Entities has been approved by the GoS. Under the proposed PFSPBG business entry has been further simplified by creating a single window for registration of new employees. As an interim step preceding the transfer of this function to the Central Registry for Mandatory Social Insurance by 2012, new employees can be registered either with the Pension or the Health Fund. This is expected to generate EUR 15 million savings annually for entrepreneurs operating in Serbia. Furthermore, under the PFSPBG a new Law on Business Entities has undergone public consultations, has been approved by GoS, and submitted to the Parliament for approval in the next parliamentary session. 126. The PFSPBG supports the completion of a comprehensive review of regulations of business activities and the adoption by the GoS of the majority of the recommendations. The Government has approved a total of 304 out of 340 recommendations to amend laws and/or regulations, as well as abolishment of 192 regulations out of 196 recommended. All 192 regulations have been abolished and 79 of the recommendations have been implemented. The latter required the amendments of 10 laws and 20 regulations have been amended. The implementation of the already implemented recommendations is estimated to lead to annual cost savings for businesses of EUR 50.8 million, while following full implementation the estimated savings are expected to reach around EUR 142 million. 127. Under the PFSPBG, regulations supporting the Law on Protection of Competition have been adopted and a new Law on Enforcement and Security will soon be submitted to the GoS. The regulations to implement the Law on Protection of Competition have been drafted and adopted, thus making it fully operational. The new Law will strengthen enforcement power of the Commission for Protection of Competition. Finally, the proposed new Law on Enforcement and Security will greatly enhance the effectiveness of enforcement of court decisions and of authentic documents such as contracts and invoices. This will be achieved, amongst other, by streamlining of the enforcement process and introducing professional enforcement officers (i.e. private bailiffs). The Law on Enforcement has undergone public consultations, has been approved by the GoS, and was submitted to the Parliament for approval in the next parliamentary session. PILLAR II - Strengthening Financial Discipline 128. Under Pillar 2 of the PFSPBG the GoS has taken important steps to strengthen financial discipline in the non-private enterprise sector. These included continuation of the resolution of socially owned enterprises, strengthening of the bankruptcy procedures, as well as better monitoring of the subsidies for the sector.

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129. The PFSPBG supports the implementation of the new and more efficient bankruptcy process, to facilitate resolution of unviable enterprises, and in particular socially owned enterprises. With the onset of the crisis, the GoS strategy to systematically privatized socially owned enterprises became less tenable. As a consequence, the GoS decided to focus on utilizing bankruptcy mechanism for resolution of qualifying enterprises, and decided to improve the bankruptcy framework. Consequently a new bankruptcy framework was introduced. Under the PFSPBG all the (11) required regulations to implement the recently introduced Law on Bankruptcy have been adopted. In addition to this, in 2010 the NBS submitted a list of 13,425 entities with accounts blocked for over three years to the commercial courts in line with the new Law on Bankruptcy, which introduced automatic bankruptcy trigger for entities with accounts blocked for more than three years. 130. The PFSBPG supported the continuation of the privatization process of socially owned enterprises, which, due to different circumstances, resulted in a large number of bankruptcies. Due to market difficulties and value of remaining companies in the PA portfolio, and in light of the improved bankruptcy framework, the PA has been focusing on utilizing bankruptcy as a tool for resolution of unviable socially owned enterprises. As a result, 162 qualifying socially owned companies from the PA portfolio were sent to bankruptcy in 2010. Some of these companies were previously privatized but the contracts were cancelled, some were initially scheduled for forced liquidation, and some simply qualified for bankruptcy instead of privatization. 131. Under the PFSPBG a Registry of Regional Development Measures and Incentives has been established under the SBRA. The registry will record all measures and incentives funded by the GoS and international organizations to a variety of entities including companies. The government institutions obliged to report to the Registry include: the MOERD, the Ministry for National Investment Plan, the Ministry of Infrastructure, the Ministry of Agriculture, Forestry, and Waterworks, the MoF, the Development Fund, the National Employment Service, the Serbian Investment and Export Promotion Agency, the National Agency for Regional Development, Agency for Insurance and Financing of Exports, the AOFI and the EU Integration Office. It is expected that this registry will represent a comprehensive record of various types of state support measures, including subsidies and grants.

PILLAR III - Building a More Efficient and Stable Financial Sector

132. Under Pillar 3 of the PFSPBG, the GoS has taken steps to build a stable and more efficient financial sector. These include measures to: (i) enhance crisis preparedness, including assessment of capital adequacy, improvement of bank resolution framework, and strengthening of deposit insurance payout functions; (ii) continue the restructuring/divestment of the GoS’s majority holdings in the banking sector; (iii) improve the insurance sector; and (iv) strengthen capital markets. 133. Under the PFSPBG and to ensure that the banking sector is well capitalized, a bank diagnostic and a triage exercise have been conducted for the entire sector. All banks operating in Serbia underwent a diagnostic and stress testing exercise and the NBS has enforced a recapitalization to CAR 12 for banks that were found to be undercapitalized. Following the diagnostic, three banks were recapitalized.

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134. The PFSPBG supports a complete overhaul of the bank resolution framework to increase efficiency and reduce the cost of resolving banks. Amendments to the Laws on Banks, Bankruptcy and Liquidation of Banks and Insurance Companies, and Deposit Insurance and Deposit Insurance Agency have been enacted. Under the new framework, purchase and assumption and bridge bank on a closed bank basis have been added, as well as financial assistance for these tools on a least cost basis. Finally, to ensure that the DIA has access to emergency funding for bank resolution/payout, the implicit government guarantee included in the existing DIF and the Law on DIA has been made explicit with the approval of 2011 budget law. RSD 110 million (approximately EUR 1 million) have been allocated to cover the commitment fee for a EUR 100 million stand-by credit line from commercial banks to the DIA for contingency purposes. By doing so the implicit GoS’s guarantee to the DIA will be made explicit.

135. The PFSPBG has also supported policy actions aimed at strengthening the DIF. Payout procedures have been adopted and a payout software introduced. An MoU on information sharing with the NBS has been implemented and legal amendments to equate the depositors of banks in liquidation with those of banks in bankruptcy have been enacted. Finally a risk management tool is being developed to better target the size of the fund. 136. Under the PFSPBG, the GoS has consolidated the majority state owned banking sector. Of the four majority state owned banks, Credy Banka was sold to a foreign group, Postanska and Privedna Pancevo were merged, and Srpska Banka will remain as is. As a result the number of majority state owned banks has decreased from 4 to 2. 137. To strengthen the insurance sector, and under the PFSPBG, life and non-life insurance businesses will be separated and the process of privatizing Dunav will be initiated. To reduce the potential for systemic risk in the sector, insurance companies will be required to separate the life and non-life insurance business. Further, to avoid possible market distortion, the GoS has submitted to the Parliament amendments to Law on Insurance converting social ownership into state ownership, which is the first step for preparing the privatization of Dunav. The latter accounts for 28 percent of the market and, business decisions made by Dunav management in recent past (e.g., substantial reductions in premium rates in the motor third party liability business) distorted the market. 138. Finally, to promote capital market development, and under the PFSPBG, the GoS has gradually extended the maturities of T-bills. To increase domestic savings mobilization, the GoS is committed to developing capital markets. The establishment of a yield curve is essential in this respect. The GoS has therefore gradually extended the maturity of the GoS T-bills from 3 months to up to 2 years.

C. GUARANTEE INSTRUMENT

139. Details of the indicative terms and conditions of the IBRD Guarantee of the Loan to Serbia are included in Annex 4. 140. The PFSPBG has been designed to enable risk sharing with commercial creditors, be simple and generate adequate market valuation. The proposed PFSPBG covers the

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principal risk on the loan and would be callable only on the scheduled bullet maturity in year 626. The initial Bank exposure under the guarantee (measured as the present value) would be around Euro [270] million, or [84] percent of the face amount of debt to be mobilized27, and thus the proposed PFSPBG would help the country mobilize sizable debt by leveraging limited IBRD resources. Full principal coverage has been included to ensure that the guarantee receives adequate market valuation in the current challenging global financial market environment.

141. Borrower and Lender: The Borrower is the Republic of Serbia. Following a competitive international tender, which satisfied Serbian procurement rules, the GoS has selected Société Générale as the lender. Following approval of the guarantee by the IBRD Board, and as per process established in the Public Debt Law, the Parliament of Serbia will ratify the Indemnity Agreement and adopt the Law authorizing the loan of Société Générale.

142. Guarantee Amount: This operation is a Policy-based Guarantee from the IBRD. The guarantee will cover the principal amount of a commercial bank borrowing of up to EUR 300 million, not exceeding the equivalent of US$400 million, with a 6-year bullet maturity on a non-accelerable basis. The loan proceeds would be made available to the Borrower upon the effectiveness of the Loan Agreement with Société Générale. The transaction is contingent on the IBRD guarantee being in place at the time of signing. 143. Structure of the Loan: Société Générale has submitted a proposal to finance a 6 year bullet loan, with principal amount guaranteed by IBRD, on a non-accelerable basis. 144. Interest rate of the Loan: The commercial loan offered by Société Générale carries an interest rate equivalent to Euro swap rate plus 100bps. In addition, a 50bps arrangement fee is included.

145. Disbursement: Upon approval of the guarantee and notification by the Bank of the effectiveness of the Guarantee Agreement between the Bank and Serbia, the Borrower may request withdrawal of the loan proceeds from the Private Lender within a defined drawdown period. Serbia will utilize a portion of the proceeds of the loan to cover front end fees for the PBG and annualized guarantee fees and deposit the remainder into a government account at the National Bank of Serbia. The account will be managed by, and subject to control of, the Ministry of Finance. 146. Guarantee Fees: Consistent with the current Bank policy, there is a front-end fee 25 basis points on the face value of the guarantee exposure and a guarantee fee of 50 basis points per annum (equivalent to the contractual spread for loans) on the present value of Bank’s exposure from the transaction. The guarantee fee will be collected upfront on a net present value basis, as per agreement with the GoS28.

26 Based on the estimates received from the market. 27 At the presumed IBRD’s Euro discount rate of [2.9] percent for a maturity comparable to the proposed non-callable period. 28 The Bank’s Board typically reviews the IBRD fees once a year at the beginning of the fiscal year. The present value is calculated by using IBRD’s estimated funding cost as a discount rate. The applicable Guarantee Fee schedule as calculated above at the beginning of the transaction will prevail through the guarantee term.

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147. Callability of the Guarantee: As the borrower, the Republic of Serbia, has the obligation to ensure timely repayment to the lender(s). If Serbia fails to make a payment on the uncovered interest obligation, the lender could seek to accelerate the loan. However, the Bank will not pay the covered principal due to the lender until maturity. Alternatively, if Serbia fails to make the guaranteed principal payment at maturity, the lender could call on the Bank’s guarantee for repayment of the amounts due. Following payment by the Bank under its guarantee, the Bank would have sole discretion to decide whether to demand immediate repayment from Serbia or to extend terms for repayment over time, and in the latter case, would have sole discretion as to the terms to be extended.

VI. OPERATION IMPLEMENTATION

A. POVERTY AND SOCIAL IMPACTS

148. Poverty and unemployment have increased in Serbia since the onset of the crisis. After significant poverty reduction between 2006 and 2008 when the share of households in poverty declined from 8.8 to 6.1 percent (equivalent to more than 230,000 people being lifted out of poverty), in 2009 the rate rose again to 6.9 percent. Similarly, according to labor force survey data, the unemployment rate which had decreased to 14.9 percent as of April 2008, reached 18.8 percent in October 2009. 149. Social assistance targeting is being improved by reforms supported by the PEDPL2. The GoS provides social assistance, including cash benefits and services, to poor households, in addition to special purpose social programs. The main social assistance benefits are: (i) material Support to Families (MOP in its Serbian acronym) for families whose income is lower than the guaranteed “social security level”, and (ii) child allowances - cash transfers to poor households with children, including the families of redundant workers. Targeting under the programs will be strengthened by policies supported by Pillar 3 of the PEDPL2 - strengthening social assistance and protecting the most vulnerable. 150. Policies supported by pillar 1 (enhancing business environment) - and pillar 3 (strengthening the financial sector) of the PFSPBG are likely to help create jobs. Reform measures under Pillar 1 are all targeted at decreasing business compliance costs, creating better conditions for private local and foreign investments, and ultimately leading to job creation. The reforms supported under Pillar 3 increased the safety of savings by increasing deposit insurance coverage and enhancing payout speed. Furthermore, measures supporting banking sector capitalization ensure that the system is stable and has enough resources to continue intermediating. 151. Enterprise restructuring measures under Pillar 2 could have a potentially negative impact on workers and hence on poverty levels. In practice it is highly unlikely that such impact will materialize. Under Pillar 2, the GoS has committed to complete the privatization of socially owned enterprises and to put into bankruptcy companies (private and socially owned) with blocked accounts. Potentially three sets of workers could be affected: (i) workers of companies with blocked accounts for which bankruptcy initiated, and (ii) workers of socially owned companies that will be placed in bankruptcy/forced liquidation. In practice, over the past year (the year over which the policy actions supported by this operation took place) the GoS has

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focused on filing for bankruptcy socially owned companies that could not be sold and on putting companies with blocked account into bankruptcy. The employment impacts of these measures are limited. For example, it is estimated that the 160 socially owned enterprises for which bankruptcy was initiated in 2010 employed 1861 employees. As many workers have not been receiving salaries for years, losing a job might not necessarily result in an income shock for their households 29. Moreover, as claims for unpaid salaries rank either first or third in the list of creditors’ priority, employees are likely to receive part if not all of the due salaries in the bankruptcy process. Concerns for a negative poverty impact have also been limited by the fact that restructuring of large companies has been put on hold during the crisis, with the GoS subsidies contributing to keep the firms afloat. 152. Formal measures to mitigate the employment shock on redundant workers are also in place, such as the Transition Fund (see Box 4), and active labor market programs. The World Bank is supporting the strengthening of active labor market programs by building monitoring and evaluation capacity in this area, and by supporting the impact evaluation of one of the largest programs in support of self-employment. As it is not possible to identify retrenched workers from the privatization process in the existing household survey or labor force data, and there is no tool for tracking their performance following dismissal, the statistical office is exploring the option of introducing specific questions in the Labor Force Survey.30

Box 4. The Transition Fund The Transition Fund (TF) is a budget line with resources earmarked for severance pay in the budget of the MoERD. The fund was set up in 2005 and has been managed by the MOERD since 2007. The GoS earmarked RSD 6.036 billion in 2010 to fund the Transition Fund (up from RSD 6.036 billion which was implemented in 2010). Resources from the Transition Fund are allocated based on proposals for funding submitted to the MOERD by the heads of state enterprises and state owned companies for which the restructuring or privatization process has started. Proposals need to meet the criteria set by the MOERD and the Privatization Agency, and are reviewed by a Committee set up for the purpose and signed by the Minister. Unions’ agreement is required for the packages provided.

The fund offers three (lump-sum) options for redundant workers: (i) remuneration amounting to 10 average gross wages in the Republic in the industry sector for employees with more than 10 years of insurance record; (ii) remuneration amounting to Euro 100 per year of service in Dinar equivalent; (iii) severance pay according to the Law on Labor, which allows recipients to receive regular unemployment benefits. A fourth option administered by the Employment Office exists for workers who are five years or less before retirement. Under this option workers are paid up to 60 monthly installments equal to 60 percent of the average wage, as a sort of early retirement or bridging retirement compensation. The Employment Office monitors whether the recipient is employed or not, and stops the compensation when the recipient resumes work. The duration of unemployment benefits for the workers who qualify varies with the number of years workers have been insured and the benefit size is 50-60 percent (depending on the duration) of the average earnings in the month before employment contract was terminated.

B. IMPLEMENTATION, MONITORING AND EVALUATION

153. While the MOF is responsible for the overall implementation, monitoring and evaluation is supported by various data sources collected by different stakeholders. 29 Even if these jobs have stopped paying salaries, workers might have been able to receive benefits through GoS programs covering health benefits and pensions to support workers. Those workers who would lose their health insurance after redundancy can still receive health care either through a program for registered unemployed or for a program for the uninsured. 30 A major concern in this context is whether sample size would be appropriate to capture this group

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Baseline and medium term outcomes are stated in the matrix (Annex 2). Stakeholders involved in monitoring and evaluation include: (i) the MOF, (ii) the MOERD, (iii) the MoJ, (iv) the PA, (v) the NBS, (vi) the DIA, and (vii) the SBRA. The baselines and outcomes are objective, concrete and measurable indicators of economic, financial and institutional performance. 154. As specified in paragraph 31 of BP 14.25 (Guarantees), supervision will be carried out in accordance with procedures applicable to Development Policy Lending (OP /BP 8.60). The Bank will complete an ICR evaluation of the PFSPBG transaction within one year of its financial close (i.e. within one year after the issuance of the Guarantee). The policy impact of the PFSPBG will be evaluated in a manner similar to development policy loans; the financial impact will be assessed against the specific financial impact indicators detailed in the results framework for this operation, including incremental market access, leverage and the costs to the borrower. The assessment will take into account the volume, maturity, and costs of subsequent market borrowings by the recipient countries. 155. As specified in paragraph 32 of BP 14.25, Implementation Status and Results Reports (ISRs) will be completed annually until Guarantee expiration. These ISRs will assess compliance of the GoS with contractual undertakings under the financing agreement and whether circumstances exist that would lead to a call on the guarantee. ISRs will also assess, in more detail as new information comes to light, the financial impact of the PFSPBG in terms of increased market access, leverage etc.

C. FIDUCIARY ASPECTS

156. Two aspects of Serbia’s fiduciary arrangements are relevant to the operation: the implications for the Bank assets of the guarantee and the consequences of activating the guarantee; and the public financial management (PFM) arrangements underpinning the Government’s capacity to manage resources to meet its obligations to the Bank under the facility. 157. The guarantee would involve no immediate transfer of funds from the Bank but sufficient funds would need to be provisioned from the Bank assets to meet a call on the guarantee if required. When called under conditions provided for under the Agreement, the payment from the Bank will be made as a single payment to the lender or agent of the lender. The indemnity agreement between Serbia and the World Bank provides that the former will repay the latter on demand or as the Bank otherwise directs, if the guarantee is called. 158. The PFM arrangements in Serbia were assessed as high risk in the 2007 Public Financial Management Assessment (PFMA) conducted by the Bank. More recent assessments by the IMF Fiscal Affairs Department in December 2008 and 2009 concluded that, although several key areas of the PFM system work well, important areas of budget coverage, preparation and execution, accounting and fiscal reporting, internal controls, external audit and debt and cash management require improvement. 159. The GoS has implemented improvements to the PFM since the 2007 PFMA including full operation of a new financial management system and associated improvements in budget execution and reporting arrangements. The State Audit Institution commenced audits of the final accounts and budget beneficiaries and issued its first report in December 2009. The

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PFM arrangements continue to improve through revisions of the Law on Budget System in 2009 and 2010 to increase transparency, strengthen accountability and internal control, improve fiscal responsibility oversight, improve administration of debt and cash management, and apply international accounting and reporting standards. The GoS is being assisted in these reforms by the Bank, the IMF, the EC and bilateral donors. 160. The corrective actions taken by the NBS to safeguard funds in the foreign exchange account are deemed adequate. An IMF Safeguards Assessment, conducted in March 2009, found that the NBS’s framework had been strengthened and the quality of financial statements and internal audit had improved since the initial assessment in 2001. Key recommendations include strengthening external oversight of the NBS operations and amending the Law on NBS to increase operational and financial independence, which have been addressed through refinements to legislation.

D. ENVIRONMENTAL ASPECTS

161. Policies supported under the PFSPBG are not expected to have negative impact on the environment, as assessed under OP 8.60. The policies supported by Pillars 1 and 3 are not likely to have any effect on the country’s environment and natural resources, while those under Pillar 2 would have a positive impact.

Policies adopted under Pillar 1 have neutral impact on the environment. Legal and

regulatory reforms adopted under Pillar 1 do not modify the existing environmental framework in any way; neither the RIA nor the comprehensive regulatory review deal with environmental matters.

Policies adopted under Pillar 2 are likely to have a positive impact on the environment. As per existing Law on Privatization, an environmental audit is carried out prior to each privatization to identify historic and potential future liabilities. Liability for environmental damage caused up to the date of privatization rest with the state, while private investors have to take ownership of potential future liabilities in compliance with the environmental management framework of Serbia. The framework has been assessed and is mostly compatible with relevant EU legislation, although operationalization of the framework has not been uniform.

Legal and regulatory changes implemented under Pillar 3 do not allow the banking sector to circumvent environmental regulations governing investments.

E. RISKS AND RISK MITIGATION

162. Two sets of risks have been identified, related to the macroeconomic situation and to the political environment. 163. The residual macroeconomic risk has been identified as substantial. Serbia went into the financial crisis with a high current account deficit, aggravated by rapid foreign currency credit growth and large cross-border borrowing of domestic enterprises. An ongoing IMF program hinges on ambitious fiscal adjustment targets and requires very significant external financial support and private sector debt rollover. Specific risks include:

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The global economic outlook, while improved, remains uncertain. Furthermore, potential fallout from weaknesses and risks in eurozone economies could have a significant impact on Serbia; Greece in particular has been the second largest investor in Serbia since the beginning of the transition. Economic risks are somewhat mitigated by the multilateral support package including from the IMF enhanced stand-by arrangement of EUR 3 billion, developed in close cooperation with the proposed DPL.

Despite external adjustment, Serbia faces considerable balance of payments financing

needs over the next few years. Risks are somewhat mitigated by Serbia’s pursuit of a robust agenda of policy reform, and as above, also by the size of the multilateral support package.

Potential vulnerabilities of the banking sector remain in the context of substantially reduced profitability and stable but high NPLs. Key mitigating factor is the very high capitalization and liquidity of the system. As of September 2010, the aggregate CAR was 20.1 percent and the banking system’s liquid assets covered 40 percent of short term liabilities. While the sector has enough cushions to withstand the current rate of NPLs, which has stabilized at around 17.8 percent in recent months, an increase could pose a risk to the solvency of the system. Should such situation occur, the bank resolution framework supported by the PFSPBG provides the authorities with effective tools to deal with problem banks.

164. The residual political risk has been identified as moderate. Reforms underpinning the program include potentially difficult ones, such as closure of loss making socially owned enterprises for which there are no buyers in the current economic environment. The pace of reforms could be undermined by the fact that the Government is based on a large coalition of diverse political parties and that elections are expected to take place within a year and a half. The political risk is mitigated by the economic crisis, which has highlighted the necessity and urgency of reform, though significant challenges remain with implementation of key, but unpopular, adjustment measures. Furthermore, the stability of the coalition government has been boosted by the recent, unanimous decision of the EU Council to forward Serbia's membership application to the European Commission for an opinion, thus bringing Serbia one step closer to become an official candidate for EU membership.

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ANNEXES

ANNEX 1. LETTER OF DEVELOPMENT POLICY

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Unofficial translation

National Bank of Serbia Bank Supervision Department

IV-24/1/2011

Belgrade, 06 January 2011

Ministry of Finance

Dear Sirs, Pursuant to ongoing preparations for the PFSPBG Project (Private and Financial Sector Policy Based Guarantee) and drafting the Letter of Development Policy aimed at continuing cooperation with the World Bank, hereby we inform you on the status of a previously defined benchmark for the activity to be implemented by the National Bank of Serbia in conformity with the PFDPL 3 Project set during our previous cooperation with the World Bank. Namely, one of the envisaged benchmarks set by the PFDPL 3 defines that the National Bank of Serbia shall conduct diagnostic assessment of banks applying a methodology adopted within the PFDPL 2 and if needed, impose extraordinary share capital increase in order to reach capital adequacy of 12% at least. The National Bank of Serbia conducted diagnostic assessment of banks in the period from May to December 2009. Firstly the NBS performed direct diagnostic assessment as of 31 March 2009 assessing assets quality and its impact to banks capital adequacy indicator. In the second phase, it performed stress testing using data obtained from the diagnostic assessment to indicate potential adverse effects of deterioration in macroeconomic indicators. It was determined that there was no need for special and extraordinary share capital increase, while several bank managed to improve their capital position during that period upon presentation of results from assessment and stress testing. Therefore the afore-said benchmark as well as the obligation of the National Bank of Serbia in that respect has been fully accomplished. It should be stressed that representatives of the World Bank and of the International Monetary Fund were informed on the course and results of these activities during their regular visits to the Republic of Serbia. Best regards, Deputy General Manager Djordje Jevtic

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Unofficial translation

Privatization Agency Republic of Serbia

10-25/11 January 10, 2011 Republic of Serbia Ministry of Finance Dear Sirs, Pursuant to ongoing preparations for the PFSPBG Project and drafting the Letter of Development Policy aimed at continuing cooperation with the World Bank, hereby we confirm that the Privatization Agency is appointed as an official receiver in 162 companies from its portfolio in 2010 alone. Best regards, Vladislav Cvetkovic (signed) Privatization Agency Director

ANNEX 2: PFSPBG POLICY MATRIX

SUBJECT INCREASED MARKET ACCESS OVERALL PROGRAM OUTCOMES31

The IBRD guarantee will facilitate access to international markets. The IBRD guarantee will assist the GoS to access longer tenor loans at lower interest rates.

The GoS will raise funding independently from international market. The GoS will raise Euro loan funding with a maturity of more than three year at an interest rate below euribor plus 500bps.

SUBJECT POLICY ACTIONS32 OVERALL PROGRAM OUTCOMES33

PILLAR I: ENHANCING BUSINESS ENVIRONMENT 1. Further simplification of business entry through implementation of a single agency approach.

Single window to register employees is established in the Pension and Health Funds

Reduction of the business compliance costs estimated at up to EUR 15 million by end 2011.

2. Improving legal framework for strengthening corporate governance and facilitating business operations.

The Borrower’s Government has approved the draft Law on Business Entities, satisfactory to the Bank, and submitted it to its Parliament for adoption.

Improved legal framework for corporate governance in place. Over the medium term, such a framework will support: (a) increased independence of the internal supervision body in JSCs; (b) increased shareholders rights; (c) stronger role of non-executive and independent members of the board; and (d) increased transparency of reporting.

3. Streamlining regulations of business activities and reducing business compliance costs.

The Borrower has completed a comprehensive review of regulations of business activities, and the Borrower's Government has approved the recommendations of that review.

New set of regulations in place reflecting: (a) the elimination of not less than 190 unnecessary regulations, and (b) the amendment of 25 regulations and 20 laws by the end of 2011. Implemented recommendations are to lead to annual cost savings for businesses of at least EUR 120 million by end 2011.

4. Improving legal and institutional framework for competition.

Regulations required for the implementation of the Law on Protection of Competition are approved by the GoS.

Improved competition framework in place which, over the medium term, will strengthen the authority of the Commission for Protection of Competition in: (a) determining abuse of dominant position and existence of cartels, and (b) imposing enforcement measures.

5. Improving effectiveness of enforcement of court decisions and authentic documents.

The new Law on Enforcement and Security is approved by the Government and submitted to the Parliament for adoption.

Improved enforcement framework in place which supports, over the medium term: (a) streamlined proceedings; and (b) introduction of professional enforcement officers.

31 The impact of the guarantee in increasing market access will be measured both in ISRs as well as ICR. Please see Section IV.B for a description of how monitoring and evaluations will be organized. 32 Bolded policy actions are prior actions for PFSPBG. 33 Outcomes related to policy actions will be assessed in the ICR only. Please see Section IV.B for a description of how monitoring and evaluations will be organized.

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PILLAR II: STRENGTHENING FINANCIAL DISCIPLINE

6. Facilitating Bankruptcy of Socially-Owned Enterprises.

Implementation regulations for Law on Bankruptcy approved by the MOERD and/or the GOS. Bankruptcy procedures filed for at least 10,000 entities with accounts which have been blocked for over three years. Bankruptcy procedures initiated for at least 160 qualifying companies from the PA portfolio between January 1, 2010 and November 30, 2010.

Improved bankruptcy framework, which, over the medium term, will lead to: (a) an increase of initiation of bankruptcy cases of qualified entities, (b) higher recovery rates and lower costs, and (c) shorter resolution time. Number of entities with accounts which have been blocked for over 3 years reduced by 6,600 by end 2010. The portfolio of companies in the PA restructuring, auctions and tenders is reduced as bankruptcy procedures are undertaken, sending an additional positive signal to markets.

7. Improving financial discipline in the socially and state owned sector.

The Registry of Regional Development Measures and Incentives, satisfactory to the Bank, has been established within the Serbian Business Registers Agency and is operational.

Establishment of a comprehensive record of state support measures, including subsidies and grants contributing to better expenditure management and more transparency.

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PILLAR III: BUILDING A STABLE AND MORE EFFICIENT FINANCIAL SECTOR

9. Strengthening crisis preparedness and bank resolution.

The National Bank of Serbia has completed a diagnostic assessment of all banks operating in Serbia in accordance with the methodology adopted under the Second Programmatic Private and Financial Development Policy Loan provided by the Bank, and enforced bank recapitalization to a capital adequacy ratio of at least 12%. The Borrower’s Parliament has: (a) enacted amendments satisfactory to the Bank to the Law on Banks, Law on Bankruptcy and Liquidation of Banks and Insurance Companies, Law on Deposit Insurance and the Law on the Deposit Insurance Agency; and (b) enacted the Law on Budget for the year 2011 which contains a provision satisfactory to the Bank on the State Guarantee to the Deposit Insurance Agency. Strengthened Deposit Insurance Payout functions, as evidenced by: (i) Managing Board approved a satisfactory procedure for payout of insured deposits, and a concept paper on adjustment of premium levels to the optimal size of the DIA; (ii) the DIA designed and tested an adequate payout software; and (iii) provisions of the DIA and the NBS MoU on sharing of information have been implemented.

CAR of the banking system is maintained at the level of at least 12 percent. Bank resolution framework improved through the introduction of: (i) bridge bank resolution on a closed bank basis for systemic banks; and (ii) financial assistance in the form of grants, loans or guarantees based on a least cost test performed by the DIA, and emergency funding arrangements for DIA. Through introduction of payout software and payout procedures and implementation of MOU with the NBS, the deposit insurance scheme can make fast payouts.

10. Restructuring and divestment of state-owned banks.

Banks with Borrower majority ownership have been merged, privatized or restructured in accordance with the strategy adopted under the Second Programmatic Private and Financial Development Policy Loan provided by the Bank.

Consolidation of the RoS holdings in banking sector: banks with majority RoS ownership reduced from 4 to 2 by 2010.

11. Strengthening the insurance sector.

Amendments to the Law on Insurance setting the framework for converting Dunav’s ownership from social to state-owned is approved by the Government and submitted to the Parliament for approval. Amendments to the Law on Insurance requiring the separation of life and non non-life insurance by the end of 2011 are enacted by the Parliament.

Dunav’s social ownership structure is replaced by state ownership hence paving the way for subsequent privatization. Life and non-life insurance business lines are separated by end of 2011.

12. Supporting capital market development.

Range of longer maturity T-bills issued to establish a benchmark yield curve: maturities of T-bills will increase from 3 months to 6, 12, 18, and 24 months.

Increased mobilization of capital by providing more options to investors and longer term funding for the GoS in local currency.

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ANNEX 3: DEBT SUSTAINABILITY ANALYSIS

1. Serbia has come a long way in improving its debt sustainability outlook during the last decade, but both external and public debt levels remain elevated. Even after the restructuring of Paris Club debt, public debt34 still stood at more than 100 percent of GDP in 2001, reflecting years of economic stagnation and turmoil during the 1990s, which resulted in accumulation of liabilities on the budget (most notably non-performing external debt, frozen foreign currency deposits and pension arrears). Strong growth coupled with fiscal consolidation brought public debt down to 33 percent of GDP by 2008. However, the recent global crisis reversed this trend and in 2010 public debt is projected to have increased to around 43 percent of GDP.

2. External debt35 declined from around 150 percent of GDP in 2000 to around 55 percent in 2004. With large capital inflows starting to go into Serbia in the middle of the decade, external debt increased to 67 percent of GDP by 2007. External debt declined in 2008 to 63 percent of GDP as private foreign investors retreated but public borrowing during the crisis increased the external debt to GDP ratio to 79 percent by 2010.

3. Under the baseline scenario outlined in the main text, both external and public debt remain sustainable. External debt is projected to gradually decline to 67 percent of GDP by 2015 (Table A.1). Similarly, public debt is forecast to enter a declining path after 2010 and fall to 33 percent of GDP by 2015. Strong policies and structural reforms (including those supported by Bank programs) will underlie higher growth rates and improved public and external balances, underpinning the declining path of both external and public debt over the forecasting period. Other debt and debt service indicators also do not point to immediate areas of concern. After declining for several years, the ratio of external debt to exports of goods and services spiked in 2009 at a high 279 percent, caused in part by the crisis induced drop of exports. The ratio will remain high over the forecasting period, although with the exports recovering in 2010 it is forecast to return to below 250 percent, and it is forecast to fall to below 200 percent by 2013 on the back of improved export performance. The ratio of total external debt service (debt amortization and interest payments on medium and long term debt) over exports of goods and services is forecast to remain stable (around 40 percent) throughout the period. The ratio of public debt over public revenues is forecast to peak in 2010 and is forecast to fall below 100 percent by 2014.

Table A.1. Serbia: Debt dynamics, 2008-2015

Indicators 2008 2009 2010 proj

2011 proj

2012 proj

2013 proj

2014 proj 2015 proj

External debt

TDO/GDP 62.9 79.0 79.0 73.1 72.7 70.6 68.4 66.8

TDO/XGS 207.0 278.8 239.7 217.6 199.8 189.5 180.1 169.3

TDS/XGS 34.9 39.1 41.7 42.8 37.8 40.8 41.6 43.7

INT/XGS 8.5 7.9 10.9 9.5 7.8 7.5 7.1 6.6

                     

Public debt

TDO/GDP 33.4 36.8 43.5 40.9 39.9 38.0 35.5 33.2

TDO/Public Revenue 79.8 90.3 108.7 105.7 104.2 99.2 92.5 86.1

Source: Government of Serbia, IMF, World Bank.

34 Public debt includes general government debt and the debt of public enterprises that carry government guarantees. As of December 2010 slightly more than one half of public debt is to external creditors and the remainder is domestic public debt. 35 External debt includes general government external debt and private sector external debt.

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NOTE: TDO/GDP – ratio of total debt outstanding to GDP; TDO/XGS – ratio of total debt outstanding to exports of goods and services; TDS/XGS – ratio of debt service (amortizations and interest on medium and long term debt) to exports of goods and services; INT/XGS – ratio of interest payments on medium and long term debt to exports of goods and services;

4. Still, debt sustainability would be threatened if certain assumptions did not materialize. External debt does not stabilize under a sluggish growth scenario while financing needs surge temporarily under scenarios with one-off depreciation and underperforming current account. Public debt is unsustainable in case the fiscal accounts fail to consolidate or growth underperforms. However, given the commitment of the authorities to macroeconomic stability, supported also by past performance and most recently by legislation adopted, the team believes that such an outcome is unlikely.

A. External Debt

5. Serbia’s external debt is not excessive and is generally under favorable terms. Similar to other countries in the region, Serbia’s external debt was increasing prior to the crisis as the large external imbalances were financed largely by private capital flows. However, private sector borrowing quickly slowed down by late 2008 as the global crisis spread to Serbia and the region. Still, external debt increased to 79 percent of GDP in 2009, as the country was able to borrow significant amounts as part of the stabilization effort supported by the IMF, the World Bank and the EC, but also reflecting the depreciation of the domestic currency36. As a result, the structure of debt is generally favorable: most of the debt is medium and long-term and carrying favorable interest rates.

6. Under the baseline scenario, external debt will gradually decline over the projection period. External debt to GDP is forecast to remain stable in 2010 at 79 percent of GDP, before entering a declining trend, supported by strong growth performance and a substantial adjustment of the current account deficit. The current account deficit is projected to decline to below 6 percent of GDP by 2015 aided by the realignment of the exchange rate, which depreciated by some 40 percent nominally since the beginning of the crisis, thus improving prospects for exports and a more moderate growth of imports, as well as by the gradual fiscal consolidation supported by the FRL. Gross financing needs as percent of GDP are expected to gradually moderate while the export to debt ratio improves.

Table A. 2. Serbia: Composition of the external debt, 2005-2010 2005 2006 2007 2008 2009 2010 (June)

In US$ millions Total 15,467 19,606 26,236 30,708 32,887 29,094 Public 8,740 8,240 8,870 9,033 10,534 10,163 Private 6,726 11,365 17,365 21,675 22,353 18,931 In percent of GDP Total 61.3 66.8 66.6 62.9 79.0 76.5 Public 34.6 28.1 22.5 18.5 25.3 26.7 Private 26.7 38.7 44.1 44.4 53.7 49.8

Source: National Bank of Serbia, staff estimates.

7. The sustainability of Serbia’s external debt critically depends on the performance of growth and exports and the stability of the exchange rate. External debt does not stabilize under scenarios in which exports and growth consistently underperform, thus underlining the need for strong

36 With most of Serbia’s external debt euro or dollar denominated, the depreciation of the dinar accounted for roughly one half of the increase in the debt to GDP ratio in 2009. While nominal GDP in dinars increased by some 3 percent in 2009, it shrank by 11 percent and 15 percent respectively in euro and dollar terms. On the other hand, the debt stock expressed in euro and dollar terms increased by 5 and 7 percent respectively.

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reforms and prudent macroeconomic policies. Also, there are some risks from exchange rate shocks. Real depreciation of 30 percent would bring the external debt to GDP ratio to just over 110 percent. While the debt/GDP ratio declines afterwards, gross financing needs remain elevated (Figure A. 1). However, further large real exchange rate depreciation is deemed as unlikely. The real effective exchange rate has already depreciated by almost 20 percent since the start of the crisis in September 2008 and according to the IMF’s recent estimates it now appears to be slightly undervalued. Furthermore, the reserves appear comfortable which should enable the Central Bank to mitigate additional speculative pressures on the foreign exchange market37. The external debt stabilizes or declines under all other scenarios considered (growth rate shock, interest rate shock etc.) though with somewhat higher gross financing needs.

Table A. 3. Serbia: Detailed composition of the external debt, in US$ millions

2004 2005 2006 2007 2008 2009 2010 June

TOTAL DEBT 14,099 15,467 19,606 26,236 30,708 32,887 29,094A. MEDIUM AND LONG-TERM 12,918 13,847 17,843 24,182 27,185 29,359 26,814

International financial organizations 5,089 4,722 4,776 5,360 5,538 7,152 7,023IMF 962 866 244 0 0 1,595 1,811IBRD 2,472 2,133 2,129 2,364 2,237 1,779 1,660IDA 432 468 550 627 650 674 643EUROFIMA 160 161 169 167 160 144 120IFC 119 73 210 294 272 310 254EIB 282 326 510 764 835 1,066 1,135European Community 354 324 360 403 385 393 334EUROFOND - CEB 29 22 33 32 73 86 71EBRD 280 349 504 617 823 971 872EFSE 0 0 68 92 103 134 124

Governments and their agencies 3,690 3,680 3,131 3,372 3,363 3,254 3,015Paris Club 3,016 2,945 2,351 2,548 2,492 2,537 2,308 - consolidated debt 2,806 2,581 2,093 2,241 2,170 2,114 1,929 - credits concluded after 20

Dec 2000 210 364 258 307 323 424 379Other governments 674 734 780 824 871 717 707

China 277 297 318 335 358 205 52Libya 1) 40 42 44 46 49 51 52Kuwait 329 345 370 398 423 376 654Poland 27 50 48 45 41 38 36Hungary 0 0 0 0 0 0 205Croatia 0 0 0 0 0 0 376Slovenia 0 0 0 0 0 47 37

London Club - regulated debt 1,080 1,076 1,076 1,076 1,076 1,076 1,040London Club - non-regulated debt 2) 84 88 72 76 79 86 0Other creditors 2,976 4,282 8,788 14,299 17,130 17,934 15,736

B. SHORT-TERM DEBT 999 1,514 1,657 1,948 3,417 3,280 2,174Russia - trade debt for gas import 240 233 228 33 27 22 19Other 759 1,281 1,429 1,915 3,391 3,257 2,156

C. NON-CONVERTIBLE 1)

182 106 106 106 106 106 106Source: National Bank of Serbia 1) Debt to these creditors is nonregulated and completely in arrears. 2) API - Alternative Participation Instruments - exit bonds that were issued in 1988 to the creditors not willing to participate in the rescheduling of the debt under the New Financing Agreement (NFA).

37 As of end-October gross FX reserves stand at 9.8 billion Euros. Gross fx reserves to M1 ratio stands at 429 percent, while net foreign assets stand at 4.9 billion Euros (NFA floor for end-2010 has been set in agreement with IMF at 4 billion Euros).

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Table A.4. Serbia: External Debt Sustainability Framework, 2008-2015 (in percent of GDP, unless otherwise indicated)

1/ Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt. 2/ The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator). 3/ Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period. 4/ The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP. 5/ Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year. NOTE: Large residual term in 2010 is mostly explained by exchange rate developments. About 77 percent of Serbia’s external debt at end-2009 was in Euros (approximately EUR 17.6 billion Euros out of the total debt of EUR 22.9 billion), while DSA framework is in US Dollars. Euro is forecast to depreciate against the Dollar by some 10 percent, so the Euro denominated debt stock is decreasing when expressed in Dollars. In fact, 17.6 billion Euros at end-2009 exchange rate is US$25.3 billion, and according to forecasted end-2010 exchange rate it is US$22.7 billion. The difference is approximately US$2.6 billion, or 7 percent of GDP. This significant difference, brought about by EUR/US$ exchange rate dynamics, is offset by the residual term and hence it’s large value.

Projections2008 2009 2010 2011 2012 2013 2014 2015

Debt-stabilizingnon-interest

current account 5/External debt 62.9 79.0 79.0 73.1 72.7 70.6 68.4 66.8 -6.6

Change in external debt -3.7 16.1 0.0 -5.9 -0.4 -2.1 -2.2 -1.5Identified external debt-creating flows 0.3 13.4 13.2 -5.8 -2.9 -4.3 -4.3 -3.5

Current account deficit, excluding interest payments 15.8 4.7 5.7 5.4 4.2 3.2 3.3 3.2Deficit in balance of goods and services 23.4 17.0 16.7 14.7 12.2 11.7 11.3 10.7

Exports 30.4 28.3 33.0 33.6 36.4 37.3 38.0 39.4Imports 53.7 45.3 49.7 48.3 48.6 49.0 49.3 50.2

Net non-debt creating capital inflows (negative) -5.1 -4.4 -3.6 -8.8 -4.1 -4.1 -4.1 -4.1Automatic debt dynamics 1/ -10.3 13.1 11.1 -2.5 -3.0 -3.4 -3.5 -2.5

Contribution from nominal interest rate 2.6 2.2 3.6 3.2 2.8 2.8 2.7 2.6Contribution from real GDP growth -3.0 2.3 -1.3 -2.2 -3.4 -3.7 -3.5 -3.2Contribution from price and exchange rate changes 2/ -9.9 8.6 8.8 -3.5 -2.5 -2.6 -2.6 -2.0

Residual, incl. change in gross foreign assets -4.0 2.7 -13.1 -0.1 2.5 2.3 2.0 1.9

External debt-to-exports ratio (in percent) 207.0 278.8 239.7 217.6 199.8 189.5 180.1 169.5

Gross external financing need (in billions of US dollars) 3/ 14.2 9.5 9.7 10.2 10.1 11.0 12.2 13.8in percent of GDP 29.0 22.9 25.4 24.9 22.6 22.6 22.9 23.9

Key Macroeconomic Assumptions

Real GDP growth (in percent) 5.5 -3.1 1.5 3.0 5.0 5.5 5.5 5.0GDP deflator in US dollars (change in percent) 17.5 -12.0 -10.0 4.6 3.5 3.7 3.8 3.0Nominal external interest rate (in percent) 4.8 3.0 4.2 4.4 4.2 4.2 4.2 4.1Growth of exports (US dollar terms, in percent) 24.8 -20.5 6.3 9.8 17.7 12.1 11.6 12.3Growth of imports (US dollar terms, in percent) 23.1 -28.0 0.1 4.7 9.3 10.3 10.2 10.0Current account balance, excluding interest payments -15.8 -4.7 -5.7 -5.4 -4.2 -3.2 -3.3 -3.2Net non-debt creating capital inflows 5.1 4.4 3.6 8.8 4.1 4.1 4.1 4.1

Scenario with key variables are at their historical averages in 2010-2015 4/ 79.0 74.4 72.6 70.6 68.5 66.4 -13.3

Actual

I. Baseline Projections

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Figure A. 1: External Debt Sustainability – Bound Tests 1/

Sources: International Monetary Fund, Country desk data and staff estimates. 1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Five-year historical average for the variable is also shown. 2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance. 3/ One-time real depreciation of 30 percent occurs in 2010.

Historical

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Non-interest current account shock (in percent of GDP)

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B. Public Debt

8. Serbia’s public debt is modest by regional standards and large parts of it are under very favorable terms. Over one fifth of the debt relates to frozen foreign currency deposits (FFCD) debts, which carry a very low nominal interest rate of 2 percent. About one sixth of the debt is IBRD and IDA debt. The average nominal interest rate on the entire debt stock is 2.5 percent38, resulting in a significant element of concesionnality of public debt. About one half of Serbia’s public debt is to external creditors and one half to domestic creditors. However, with considerable part of domestic debt being indexed to foreign exchange (including FFCD debt), around 72 percent of public debt is foreign currency denominated.

Table A.5. Serbia: Composition of the central government debt stock, August 2010

share (in percent)

USD millions of subcategory of total

TOTAL 13,853 100.0 100.0

Domestic direct 5,364 100.0 38.7 FFCD 3,048 56.8 22.0 T-bills 1,626 30.3 11.7 Other 690 12.9 5.0

External direct 6,392 100.0 46.1 IBRD 1,738 27.2 12.5 IDA 652 10.2 4.7 Paris club 2,107 33.0 15.2 London club 1,040 16.3 7.5 EIB 425 6.6 3.1 Other 431 6.7 3.1

Domestic indirect 379 100.0 2.7

External indirect 1,718 100.0 12.4 EBRD 448 26.1 3.2 EIB 624 36.3 4.5 Other 646 37.6 4.7

Source: Ministry of Finance

Table A.6. Serbia: Share of foreign currency denominated public debt, in percent of total

2002 2003 2004 2005 2006 2007 2008 2009 2010 e

89 88 86 91 89 88 88 80 72 Source: Ministry of Finance

9. Under the baseline scenario, public debt is forecast to peak in 2010 at 43.5 percent of GDP, and to gradually decline to 33 percent of GDP by 2015. Consolidation of the public debt will be anchored by the recently adopted FRL, drafted in coordination with the IMF as part of the exit strategy from the SBA. FRL will serve as a key commitment device that will underpin fiscal restraint over the medium term in avoiding a shift back to the pre-crisis pro-cyclical fiscal policy behavior. FRL sets numerical targets for the overall deficit and it also caps the public debt at 45 percent of GDP (not including possible restitution debt).

38The average nominal interest rate was around 2.5 percent in the 2005–2009 period. It is forecast to increase to about 4 percent in next several years, because much of the new public debt is either T-bills or loans from commercial banks, which carry a higher interest rate than the existing debt stock. The average inflation rate is forecast at 6.2 percent for 2010 and 9.4 percent in 2011. The combination of low nominal interest rates and moderate inflation implies that the real interest rate will be around zero.

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10. Serbia’s public debt outlook is sensitive to underperformance of growth and exchange rate shocks. If the growth rate underperforms by two percentage points annually over the forecast period, public debt does not stabilize and reaches 48 percent by 2015 (Figure A. 2). Towards the end of the forecast period, gross financing needs in the case of growth rate shock would be some 5 percentage points of GDP higher than in the baseline scenario. However, Serbia's track record under IMF, EU and World Bank supported programs and its appropriate forward macroeconomic and development policy programs should provide comfort that the policy mix will be appropriately adjusted to avoid such a scenario. A scenario of no policy change (where key variables – real GDP growth, real interest rate, and other identified debt-creating flows – remain at the level of the last projection year), further illustrates the need to adjust policies in accordance with the baseline. On the other hand, with more than 70 percent of public debt denominated in foreign currency, a real depreciation shock of 30 percent would initially push the public debt to around 60 percent of GDP.39 Public debt would then gradually decline. However, gross financing needs in this scenario would be some 4 percentage points of GDP above the baseline. Public debt remains sustainable and financing needs only slightly elevated under other scenarios considered (primary balance shock, interest rate shock, combined etc.).

11. There are few sources of contingent liabilities that could affect public debt. Few public enterprises are running large quasi-fiscal deficits. While most of their debt is already included in the general government debt stock, (since they carry government guarantees40) additional risks could emerge. Furthermore, according to the IMF, state subsidies to the private sector (interest subsidies on loans) could potentially add up to 2 percent of GDP to public debt. However, recently adopted FRL mitigates these risks by capping public debt at 45 percent of GDP (excluding possible restitution debt). Contingent liabilities stemming from the financial sector (possible financial sector distress that could lead to the need for public sector support of the financial system) seem minor given the degree of capitalization and liquidity in the financial system. Finally, the restitution process, currently planned to start in 2012, could increase debt by up to about 16 percent of 2010 GDP. However, experiences from other countries of the region suggest that this debt is not recognized immediately, but over time and that it carries favorable terms thus partly mitigating the risks.

39 Ministry of Finance’s Budget Memorandum estimates that 1 percent depreciation of the nominal effective exchange rate would increase the public debt to GDP ratio by 0.33 percentage points. Thus, nominal depreciation of 30 percent would increase the public debt to GDP ratio by 10 percentage points. 40 This includes debts of the Railroad Company and the Roads Company, which are two public enterprises with by far the largest debt.

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Table A.7. Serbia: Public Sector Debt Sustainability Framework, 2008-2015 (in percent of GDP, unless otherwise indicated)

1/ Includes general government and guaranteed debt (gross). Public enterprises debt that has Government guarantees is included, while non-guaranteed debt is not included (almost all of public enterprises debt is guaranteed). 2/ Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar). 3/ The real interest rate contribution is derived from the denominator in footnote 2/ as r-π (1+g) and the real growth contribution as -g. 4/ The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r). 5/ Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period. 6/ Derived as nominal interest expenditure divided by previous period debt stock. 7/ The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP. 8/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year. NOTE: Spike in gross financing need in 2010 is due to an increase in short term debt through large issuances of T-bills in 2009. Prior to 2009 stock of T-bills was negligible.

Projections2008 2009 2010 2011 2012 2013 2014 2015

Debt-stabilizingprimary

balance 8/Public sector debt 1/ 33.4 36.8 43.5 40.9 39.9 38.0 35.5 33.2 -1.4

o/w foreign-currency denominated 29.3 29.3 34.0 30.9 27.4 24.1 21.2 19.1

Change in public sector debt -1.8 3.4 6.7 -2.6 -1.0 -1.9 -2.5 -2.3Identified debt-creating flows 0.6 2.8 7.2 -3.7 -0.6 -1.8 -2.5 -2.3

Primary deficit 2.0 3.4 3.6 2.8 1.3 0.3 -0.5 -0.8Revenue and grants 41.9 40.7 40.0 38.7 38.3 38.3 38.4 38.5Primary (noninterest) expenditure 43.9 44.1 43.6 41.5 39.6 38.6 37.9 37.7

Automatic debt dynamics 2/ -0.2 1.6 3.7 -2.1 -2.0 -2.1 -2.0 -1.5Contribution from interest rate/growth differential 3/ -4.8 -0.2 -1.4 -3.5 -2.3 -2.2 -2.1 -1.7

Of which contribution from real interest rate -3.2 -1.2 -0.8 -2.4 -0.5 -0.2 -0.2 -0.1Of which contribution from real GDP growth -1.6 1.0 -0.5 -1.2 -1.9 -2.0 -1.9 -1.6

Contribution from exchange rate depreciation 4/ 4.6 1.8 5.1 1.4 0.4 0.1 0.0 0.2Other identified debt-creating flows -1.2 -2.1 -0.1 -4.4 0.0 0.0 0.0 0.0

Privatization receipts (negative) -1.2 -2.1 -0.1 -4.4 0.0 0.0 0.0 0.0Recognition of implicit or contingent liabilities 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Other (specify, e.g. bank recapitalization) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Residual, including asset changes -2.4 0.5 -0.5 1.1 -0.4 -0.1 0.0 0.0

Public sector debt-to-revenue ratio 1/ 79.8 90.3 108.7 105.7 104.2 99.2 92.5 86.1

Gross financing need 5/ 4.5 6.3 10.8 11.1 10.6 10.2 10.1 10.0in billions of U.S. dollars 2.2 2.6 4.1 4.5 4.7 5.0 5.4 5.8

Key Macroeconomic and Fiscal Assumptions

Real GDP growth (in percent) 5.5 -3.1 1.5 3.0 5.0 5.5 5.5 5.0Average nominal interest rate on public debt (in percent) 6/ 2.1 2.8 3.8 3.5 3.8 3.7 3.7 3.9Average real interest rate (nominal rate minus change in GDP deflator, in percent) -10.0 -3.9 -2.4 -5.9 -1.0 -0.3 -0.3 -0.1Nominal appreciation (increase in US dollar value of local currency, in percent) -14.6 -5.7 -15.2 -4.4 -1.3 -0.3 -0.2 -1.0Inflation rate (GDP deflator, in percent) 12.1 6.7 6.2 9.4 4.9 4.0 4.0 4.0Growth of real primary spending (deflated by GDP deflator, in percent) 3.7 -2.6 0.3 -2.0 0.4 2.6 3.7 4.4Primary deficit 2.0 3.4 3.6 2.8 1.3 0.3 -0.5 -0.8

Scenario with key variables are at their historical averages in 2010-2015 7/ 43.5 37.7 34.1 31.0 28.3 26.1 -2.9

Actual

I. Baseline Projections

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Figure A. 2: Public Debt Sustainability – Bound Tests 1/

Sources: International Monetary Fund, Country desk data and staff estimates. 1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Five-year historical average for the variable is also shown. 2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate and primary balance. 3/ One-time real depreciation of 30 percent and 16 percent of GDP shock to contingent liabilities occur in 2011, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator). NOTE: Spike in gross financing need in 2010 is due to an increase in short term debt through large issuances of T-bills in 2009. Prior to 2009 stock of T-bills was negligible.

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(right scale)Combined shock

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Growth shock

48

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No policy change

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ANNEX 4. IBRD GUARANTEE

OUTLINE OF INDICATIVE TERMS AND CONDITIONS OF POTENTIAL WORLD BANK

GUARANTEE OF LOAN TO SERBIA

This term sheet contains a summary of indicative terms and conditions of a potential IBRD Policy-Based Guarantee (the IBRD Guarantee) for a private-sector loan to the Republic of Serbia.

This term sheet does not constitute an offer from IBRD to provide an IBRD Guarantee. The provision of the Guarantee is subject, inter alia, to satisfactory appraisal by IBRD of the related Program, review and acceptance of the financing structure and transaction documentation, and the approval of the Management and the Board of Directors of IBRD in their sole discretion.

IBRD Guarantee and Guaranteed Loan:

Guarantor:

International Bank for Reconstruction and Development (IBRD).

Borrower: Republic of Serbia.

Guarantee Beneficiaries:

Commercial bank lender(s) to be identified (the Lender(s)).

Purpose: In support of the multi-year program of actions, objectives and policies to enhance Serbia’s business environment, strengthen financial discipline and build a stable and more efficient financial sector.

Guarantee Term: Term of underlying loan, expected to be six years.

Guaranteed Event: Failure by the Borrower to repay the principal amount of the IBRD Guaranteed Loan at stated maturity.

Guarantee Support: IBRD Guarantee would cover any outstanding scheduled payment of principal (up to the total Loan Amount), which the Lender(s) would have otherwise received from the Borrower under the IBRD Guaranteed Loan Agreement, but for the occurrence of a Guaranteed Event.

IBRD Guaranteed Loan Amount:

Principal amount of up to EUR 300 million, not exceeding the equivalent of US$400 million.

IBRD Guaranteed Loan Interest Rate:

A fixed rate equivalent to EURIBOR plus a margin to be determined.

Maturity: Six year bullet maturity.

Currency: Euro.

Governing Law: [England] [New York].

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IBRD Guarantee Provisions:

41 If syndicate of banks selected. 42 If single lender selected.

Negative Pledge: The terms of the IBRD Guaranteed Loan and the IBRD Guarantee will restrict the ability of the Borrower and IBRD, as the case may be, to create certain liens on their property or assets without equally and ratably securing the IBRD Guaranteed Loan or the IBRD Guarantee, respectively.

Status of the IBRD Guarantee:

The obligations of IBRD under the IBRD Guarantee will constitute direct, unsecured obligations of IBRD ranking pari passu, without any preference among themselves, with all its other obligations that are unsecured and unsubordinated.

Status of the IBRD Guaranteed Loan:

The IBRD Guaranteed Loan will constitute direct, general, unconditional, unsecured and unsubordinated external indebtedness of the Borrower ranking pari passu with all other unsecured and unsubordinated external indebtedness of the Borrower.

IBRD Policy-Based Guarantee:

IBRD will guarantee to the Lender(s) the payment by Borrower of the principal of the IBRD Guaranteed Loan at scheduled maturity and will agree to pay on demand from the [Agent Bank]41 [Lender]42 as provided in the IBRD Guaranteed Loan Agreement, all of the amounts of principal which are due and payable by the Borrower, provided that the maximum aggregate amount of principal for which IBRD shall have liability shall not in any circumstances exceed the amount of the IBRD Guarantee.

Demand Notice for Payment under the IBRD Guarantee:

The [Agent Bank] [Lender] will notify IBRD no later than ten business days after the scheduled maturity date of any amount of principal that has fallen due and payable and remains unpaid after the scheduled maturity date. Such notice shall also constitute a demand on IBRD for payment.

IBRD shall have 30 days from and inclusive of its receipt of such demand notice to make payment in respect thereof.

The obligations of IBRD under the IBRD Guarantee constitute a guarantee of payment and not of collection. Any demand notice must be received by IBRD within ten (10) business days of the date any amount of principal referenced in such demand notice becomes due and payable under the IBRD Guaranteed Loan Agreement.

Reduction of Demand: If after the [Agent Bank] [Lender] has made a demand on IBRD for payment under the IBRD Guarantee but before IBRD has made payment of the amount so demanded , the Borrower pays the [Agent Bank] [Lender] [and/or the Banks] (or the [Agent Bank] [Lender]

76

[and/or the Banks] recover otherwise than from IBRD) any sum which is applied to the satisfaction of the whole or any part of the such principal amount, the [Agent Bank] [Lender] shall promptly notify IBRD of such fact and IBRD’s liability under the IBRD Guarantee in respect of such demand shall be reduced by an amount equal to the portion of principal so paid by the Borrower (or so recovered by the [Agent Bank] [Lender] [and/or the Banks]) and so applied.

No Discharge: Neither the obligations of IBRD under the IBRD Guarantee nor the rights, powers and remedies conferred upon the Lender(s) with respect to IBRD by the IBRD Guarantee or by applicable law or regulation shall be discharged, impaired or otherwise affected by: (i) any insolvency, moratorium or reorganization of debts of or relating to the Borrower; (ii) any of the obligations of the Borrower under the IBRD Guaranteed Loan Agreement being or becoming illegal, invalid, unenforceable, void, voidable or ineffective in any respect; (iii) any time or other indulgence being granted to the Borrower in respect of its obligations under the IBRD Guaranteed Loan Agreement; (iv) any amendment to, or any variation, waiver or release of, any obligation of the Borrower under the IBRD Guaranteed Loan Agreement or (vi) any other act, event or omission (other than the failure of the [Agent Bank] [Lender] to make a demand under the IBRD Guarantee) which might otherwise operate to discharge, impair or otherwise affect any of the obligations of IBRD under the IBRD Guarantee or any of the rights, powers or remedies conferred on the Lender(s) by the IBRD Guaranteed Loan Agreement or be applicable law or regulation.

No Amendment without IBRD Consent:

The IBRD Guarantee shall terminate and any written demand from the [Agent Bank] [Lender] pursuant to the IBRD Guarantee shall be void if any amendment is made to the IBRD Guaranteed Loan Agreement, or any waiver or consent is given in writing with respect thereto, without IBRD’s prior written consent.

IBRD Obligations Binding: IBRD’s obligations under the IBRD Guarantee shall be binding upon IBRD and inure to the benefit of the Lender(s) and shall be enforceable only by the [Agent Bank] [Lender], provided that the obligations of IBRD under the IBRD Guarantee shall not be treated as a separate obligation of IBRD independent from the principal amount guaranteed, and the benefit of such obligations may only be transferred by a Lender in accordance with the provisions below, as more fully described in the IBRD Guaranteed Loan Agreement.

Assignment: Except as IBRD may otherwise agree, any assignment of the IBRD Guaranteed Loan may be made only to an assignee established as a bank or financial institution duly licensed to carry out banking or financial business in its country of domicile. Such assignee may be a partly or wholly government-owned institution, but cannot be an export credit agency, multilateral institution or state entity. Such assignee must not have been declared ineligible to be awarded an IBRD- or IDA-financed contract in accordance with World Bank

77

Sanctions Procedures and must not be an entity included on the consolidated list of individuals and entities maintained by the United Nations Security Council Committee established pursuant to United Nations Security Council Resolution 1267. Non-Serbian-domiciled assignees must have an international long-term foreign currency rating of investment grade by an internationally-recognized credit rating agency.

The assigning Lender(s) shall provide advance notice of potential assignments to IBRD as provided in the IBRD Guaranteed Loan Agreement.

Subrogation: Upon payment by IBRD of amounts under the IBRD Guarantee, IBRD shall, to the extent it has not been reimbursed by the Borrower under the Indemnity Agreement (as discussed below), be immediately entitled to recover from the Borrower the amount so paid by IBRD in respect of principal and for this purpose IBRD shall be immediately subrogated to the rights of [the Lender] [each Lender receiving any part of such payment in respect of principal] to the extent of the amount in respect of principal so received by such Lender, regardless of whether such Lender has been fully prepaid or repaid by the Borrower, and [the Lender] [each Lender] shall forthwith assign or transfer to IBRD, without representation, warranty or recourse, all of such Lender’s] claims, interests, rights and security which it then has against Serbia under the IBRD Guaranteed Loan Agreement in respect of principal so received.

Withholding of Payment: If at any time between the effective date of the IBRD Guaranteed Loan Agreement and the maturity date of the IBRD Guaranteed Loan (i) there is substantial evidence that the [Agent Bank or any] Lender has, in connection with the IBRD Guaranteed Loan, engaged in fraudulent, corrupt, coercive or collusive practices or (ii) the [Agent Bank or any] Lender has been declared ineligible to be awarded a contract financed by the International Bank for Reconstruction and Development or the International Development Association in accordance with the World Bank Sanctions Procedures, then IBRD shall be entitled to withhold payment of all amounts otherwise payable under the IBRD Guarantee by IBRD on account of such Lender(s) or the Agent, as the case may be.

Role of IBRD: The Lender(s) will acknowledge and agree that IBRD will be acting under the IBRD Guaranteed Loan Agreement solely in its capacity as guarantor of the principal of the IBRD Guaranteed Loan as provided therein and in no other capacity. IBRD shall incur no liability under the IBRD Guaranteed Loan Agreement nor have any other duties or responsibilities, except to the extent expressly specified in the IBRD Guaranteed Loan Agreement or in any document delivered by IBRD under or pursuant to that agreement.

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IBRD Guarantee-Related Fees:

IBRD Guarantee Fees:

IBRD charges a guarantee fee of 0.5% per annum on the present value of IBRD’s exposure under the IBRD Guarantee, [payable semiannually]43 in advance by the Borrower. IBRD may terminate the IBRD Guarantee if any installment of the IBRD Guarantee Fee is not paid by either of the Borrower or the [Agent Bank] [Lender] on or before the fourteenth (14th) business day following the date of a notice provided by IBRD to the [Agent Bank] [Lender].

IBRD Front-end Fees:

IBRD charges a front-end fee of 0.25% of its maximum exposure (in this case, an amount of up to EUR 300 million, not exceeding the equivalent of US$400 million) under Policy-Based Guarantees. There are no other initiation or processing fees. This fee is payable by the Borrower.

Stand-by Fees: None.

Conditions Precedent to the IBRD Guarantee:

Conditions Precedent:

Usual and customary conditions for financing of this type including the following:

a) [Relevant programmatic conditions precedent from previous IBRD Development Policy Loans to Serbia];

b) Provision of relevant legal opinions satisfactory to IBRD;

c) Payment in full of the Front-end Fee, and the first installment of the Guarantee Fee;

d) Conclusion of an IBRD Guaranteed Loan Agreement among the Lenders, the Borrower and IBRD and an Indemnity Agreement between IBRD and Serbia.

43 Alternately, Guarantee Fee to be paid up-front.

Cross-Default Restriction: The IBRD may require a cross-default provision in the IBRD Guaranteed Loan Agreement, including a restriction on the ability of the Lender(s) to accelerate the IBRD Guaranteed Loan upon a default by the Borrower under any World Bank loans such that the IBRD Guaranteed Loan may only be accelerated in the event of a material default on World Bank loans.

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IBRD Documentation:

IBRD Guaranteed Loan Agreement:

The terms and conditions of the IBRD Guarantee would be contained in the IBRD Guaranteed Loan Agreement among IBRD, the Borrower and the Lender(s).

IBRD will represent and warrant to the Lender(s) that (in addition to standard representations about due authorization, enforceability and power to execute) its obligations pursuant to the IBRD Guaranteed Loan Agreement rank pari passu with all other unsecured and unsubordinated obligations of IBRD.

The Lender(s) will represent and warrant that they have not engaged in and are not engaging in fraudulent, corrupt, coercive or collusive practices, and will covenant, inter alia, to apply all amounts received by them under the IBRD Guaranteed Loan Agreement towards payment of the principal amounts covered by the IBRD Guarantee which were the subject of the relevant demand notice.

Indemnity Agreement: The Borrower would enter into a separate Indemnity Agreement with IBRD. Under the Indemnity Agreement, the Borrower would undertake to indemnify IBRD on demand, or as IBRD may otherwise determine, for any payment made by IBRD under the terms of the Guarantee. The Indemnity Agreement will follow the legal regime, and include dispute settlement provisions, which are customary in agreements between member countries and IBRD.

Any obligation by the Borrower to reimburse IBRD for payments made under the IBRD Guarantee will rank pari passu with all other external indebtedness of the Borrower, including external indebtedness of the Borrower to IBRD.

The Indemnity Agreement will also contain provisions on the deposit and use of proceeds of the IBRD Guaranteed Loan. The Borrower shall agree to deposit the proceeds of the IBRD Guaranteed Loan in an account acceptable to IBRD, with appropriate tracking of amounts deposited therein in the Borrower’s budget management system. The Borrower will make withdrawals from such account for use in support of its development policy program, and will agree not to use such withdrawals to finance any excluded expenditures, which shall include, inter alia, goods included in groups or subgroups of the United Nations Standard International Trade Classification, Revision 3, military goods, environmentally hazardous goods, certain payments prohibited by a decision of the United Nations Security Council taken under Chapter VII of the Charter of the United Nations, or expenditures with respect to which IBRD determines that corrupt, fraudulent, collusive or coercive practices were engaged in

80

by representatives of the Borrower. If any such withdrawals are used for excluded expenditures, the Borrower shall deposit an equivalent amount in the account or prepay the Lender(s) an equivalent amount.

In the event that the Borrower fails to make any payment to or to indemnify IBRD under the Indemnity Agreement or otherwise defaults on its obligations under the Indemnity Agreement, IBRD shall be entitled, in addition to any other rights and remedies it may have, to suspend or cancel in whole or in part the Borrower’s right to make withdrawals under any [other] loan or guarantee between IBRD and the Borrower or under any development credit agreement or financing agreement between IBRD and the Borrower, or to declare the outstanding principal and interest of any such credit or loan due and payable immediately.

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ANNEX 5. IMF PROGRAM PRESS RELEASE

82

ANNEX 6: TENTATIVE TIMELINE FOR PROCUREMENT AND APPROVAL OF A COMMERCIAL LOAN WITH IBRD GUARANTEE

83

ANNEX 7: COUNTRY AT A GLANCE

Serbia at a glance 2/25/10

Europe & UpperKey D evelo pment Indicato rs Central middle

Serbia Asia income(2008)

Population, mid-year (millions) 7.4 441 948Surface area (thousand sq. km) 88 23,916 47,176Population growth (%) -0.4 0.3 0.8Urban population (% of to tal population) 52 64 75

GNI (Atlas method, US$ billions) 42.2 3,274 7,472GNI per capita (Atlas method, US$) 5,740 7,418 7,878GNI per capita (PPP, international $) 11,150 12,220 12,297

GDP growth (%) 5.5 5.5 4.7GDP per capita growth (%) 6.0 5.2 3.8

(mo st recent est imate, 2003–2008)

Poverty headcount ratio at $1.25 a day (PPP, %) .. 4 ..Poverty headcount ratio at $2.00 a day (PPP, %) .. 9 ..Life expectancy at birth (years) 73 70 71Infant mortality (per 1,000 live births) 7 21 21Child malnutrition (% of children under 5) 2 .. ..

Adult literacy, male (% of ages 15 and o lder) .. 99 95Adult literacy, female (% of ages 15 and o lder) .. 96 93Gross primary enro llment, male (% of age group) 97 99 112Gross primary enro llment, female (% of age group) 97 96 108

Access to an improved water source (% of population) 99 95 94Access to improved sanitation facilities (% of population) 92 89 82

N et A id F lo ws 1980 1990 2000 2008 a

(US$ millions)Net ODA and official aid .. .. 1,134 834Top 3 donors (in 2007): European Commission .. .. 471 271 United States .. .. 108 105 Germany .. .. 99 78

Aid (% of GNI) .. .. 18.0 2.1Aid per capita (US$) .. .. 151 113

Lo ng-T erm Eco no mic T rends

Consumer prices (annual % change) .. .. 70.0 11.7GDP implicit deflator (annual % change) .. .. 79.6 12.8

Exchange rate (annual average, local per US$) .. .. 63.2 55.7Terms of trade index (2000 = 100) .. .. .. ..

1980–90 1990–2000 2000–08

Population, mid-year (millions) .. 7.6 7.5 7.4 .. -0.1 -0.3GDP (US$ millions) .. .. 6,295 50,085 .. -4.2 5.4

Agriculture .. .. 20.6 13.0 .. .. ..Industry .. .. 31.4 28.4 .. .. .. M anufacturing .. .. .. .. .. .. ..Services .. .. 48.1 58.6 .. .. ..

Household final consumption expenditure .. .. 88.7 78.1 .. .. 5.4General gov't final consumption expenditure .. .. 18.9 21.3 .. .. 4.8Gross capital formation .. .. 8.4 23.4 .. .. 15.8

Exports of goods and services .. .. 23.0 29.7 .. .. 12.1Imports of goods and services .. .. 39.1 52.4 .. .. 12.8Gross savings .. .. 12.8 9.1

(average annual growth %)

(% of GDP)

6 4 2 0 2 4 6

0-4

15-19

30-34

45-49

60-64

75-79

percent of total population

Age distribution, 2008

Male Female

0

20

40

60

1990 1995 2000 2007

Serbia Europe & Central Asia

Under-5 mortality rate (per 1,000)

-40

-30

-20

-10

0

10

20

95 05

GDP GDP per capita

Growth of GDP and GDP per capita (%)

84

Serbia

B alance o f P ayments and T rade 2000 2008

(US$ millions)

Total merchandise exports (fob) 1,645 10,842Total merchandise imports (cif) 3,227 21,997Net trade in goods and services -1,441 -11,404

Current account balance -153 -8,044 as a % of GDP -2.4 -16.1

Workers' remittances and compensation o f employees (receipts) 1,132 5,538

Reserves, including go ld 524 14,383

C entral Go vernment F inance

(% of GDP)Current revenue (including grants) 32.4 40.9

Tax revenue 29.1 35.8Current expenditure 29.8 39.0

T echno lo gy and Infrastructure 2000 2008Overall surplus/deficit -0.2 -2.5

Paved roads (% of to tal) 62.7 ..Highest marginal tax rate (%) Fixed line and mobile phone Individual .. 15 subscribers (per 100 people) .. 173

Corporate .. 10 High technology exports (% of manufactured exports) 3.2 4.3

External D ebt and R eso urce F lo ws

Enviro nment(US$ millions)Total debt outstanding and disbursed 11,499 30,918 Agricultural land (% of land area) .. ..Total debt service 120 4,738 Forest area (% of land area) .. ..Debt relief (HIPC, M DRI) – – Nationally pro tected areas (% of land area) .. ..

Total debt (% of GDP) 182.7 61.7 Freshwater resources per capita (cu. meters) .. ..Total debt service (% of exports) 3.5 22.6 Freshwater withdrawal (billion cubic meters) .. ..

Foreign direct investment (net inflows) 25 2,992 CO2 emissions per capita (mt) .. ..Portfo lio equity (net inflows) 0 -57

GDP per unit of energy use (2005 PPP $ per kg of o il equivalent) 3.8 4.1

Energy use per capita (kg of o il equivalent) 1,775 2,303

Wo rld B ank Gro up po rt fo lio 2000 2008

(US$ millions)

IBRD Total debt outstanding and disbursed 1,097 2,276 Disbursements 0 0 Principal repayments 0 22 Interest payments 0 96

IDA Total debt outstanding and disbursed 0 655 Disbursements 0 34

P rivate Secto r D evelo pment 2000 2008 Total debt service 0 5

Time required to start a business (days) – 23 IFC (fiscal year)Cost to start a business (% of GNI per capita) – 7.6 Total disbursed and outstanding portfo lio – 310Time required to register property (days) – 111 o f which IFC own account – 308

Disbursements for IFC own account – 53Ranked as a major constraint to business 2000 2008 Portfo lio sales, prepayments and (% of managers surveyed who agreed) repayments for IFC own account – 22 n.a. .. .. n.a. .. .. M IGA

Gross exposure – 40Stock market capitalization (% of GDP) 4.6 24.3 New guarantees 0 0Bank capital to asset ratio (%) 18.3 17.1

0 25 50 75 100

Control of corruption

Rule of law

Regulatory quality

Political stability

Voice and accountability

Country's percentile rank (0-100)higher values imply better ratings

2008

2000

Governance indicators, 2000 and 2008

Source: Kaufmann-Kraay-Mastruzzi, World Bank

IBRD, 2,276IDA, 655

IMF, 0Other multi-

lateral, 1,831

Bilateral, 2,538

Private, 19,495

Short-term, 4,123

Composition of total external debt, 2008

US$ millions

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Millennium Development Goals Serbia

With selected targets to achieve between 1990 and 2015(estimate closest to date shown, +/- 2 years)

Go al 1: halve the rates fo r extreme po verty and malnutrit io n 1990 1995 2000 2008

Poverty headcount ratio at $1.25 a day (PPP, % of population) .. .. .. .. Poverty headcount ratio at national poverty line (% of population) .. .. .. .. Share of income or consumption to the poorest qunitile (%) .. .. .. .. Prevalence o f malnutrition (% of children under 5) .. .. .. 1.8

Go al 2: ensure that children are able to co mplete primary scho o ling

Primary school enro llment (net, %) .. .. .. 95 Primary completion rate (% of relevant age group) .. .. .. .. Secondary school enro llment (gross, %) .. .. 89 88 Youth literacy rate (% of people ages 15-24) .. .. .. ..

Go al 3: eliminate gender disparity in educat io n and empo wer wo men

Ratio o f girls to boys in primary and secondary education (%) .. .. 101 102 Women employed in the nonagricultural sector (% of nonagricultural employment) .. .. .. 42 Proportion of seats held by women in national parliament (%) .. .. .. 22

Go al 4: reduce under-5 mo rtality by two -thirds

Under-5 mortality rate (per 1,000) .. 16 13 8 Infant mortality rate (per 1,000 live births) .. 14 11 7 M easles immunization (proportion of one-year o lds immunized, %) 83 86 89 95

Go al 5: reduce maternal mo rtality by three-fo urths

M aternal mortality ratio (modeled estimate, per 100,000 live births) .. .. .. .. B irths attended by skilled health staff (% of total) .. .. .. 99 Contraceptive prevalence (% of women ages 15-49) .. .. .. 41

Go al 6: halt and begin to reverse the spread o f H IV/ A ID S and o ther majo r diseases

Prevalence o f HIV (% of population ages 15-49) 0.1 0.1 0.1 0.1 Incidence of tuberculosis (per 100,000 people) .. .. .. 32 Tuberculosis cases detected under DOTS (%) .. .. .. 80

Go al 7: halve the pro po rt io n o f peo ple witho ut sustainable access to basic needs

Access to an improved water source (% of population) .. .. .. 99 Access to improved sanitation facilities (% of population) .. .. .. 92 Forest area (% of to tal land area) .. .. .. .. Nationally pro tected areas (% of to tal land area) .. .. .. .. CO2 emissions (metric tons per capita) .. .. .. .. GDP per unit of energy use (constant 2005 PPP $ per kg o f o il equivalent) 5.1 3.6 3.8 4.1

Go al 8: develo p a glo bal partnership fo r develo pment

Telephone mainlines (per 100 people) .. .. .. 42.0 M obile phone subscribers (per 100 people) .. .. .. 130.9 Internet users (per 100 people) .. .. .. 32.1 Personal computers (per 100 people) .. .. .. 24.4

Serbia

0

25

50

75

100

125

2000 2002 2004 2006 2008

Primary net enrollment ratio

Ratio of girls to boys in primary & secondary education

Education indicators (%)

0

50

100

150

200

2000 2002 2004 2006 2008

Fixed + mobile subscribers

Internet users

ICT indicators (per 100 people)

0

25

50

75

100

1990 1995 2000 2007

Serbia Europe & Central Asia

Measles immunization (% of 1-year olds)