Document of The World Bank FOR OFFICIAL USE ONLY ReportNo. 46671-YF INTERNATIONALBANKFOR RECONSTRUCTIONAND DEVELOPMENT PROGRAM DOCUMENT FOR A PROPOSEDLOAN INTHEAMOUNT OFEURO 34.9 MILLION (US$50 MILLIONEQUIVALENT) TO REPUBLIC OF SERBIA FOR PROGRAMMATIC PRIVATE AND FINANCIAL DEVELOPMENT POLICY LOAN February4,2009 FinanceandPrivate Sector Development(ECSPF) SouthEastEuropeCountry Unit (ECCU4) Europeand Central Asia (ECA) This documenthas arestricteddistribution and maybe usedby recipients only inthe performance o f their official duties. Its contents may not otherwise be disclosedwithout World Bankauthorization. REPUBLIC OF SERBIA GOVERNMENT - FISCAL YEAR January 1- December 31 CURRENCYEQUIVALENTS (Exchange Rate Effective as o f January 13,2009) Currency Unit Serbian Dinar RSD 1.00 US$0.02 US$l.OO RSD69.4 Metric System ABBREVIATION AND ACRONYMS (As applicable,plus others) ALMP Active Labor MarketPrograms BSA Bankruptcy Supervisory Agency BSC Bank SupervisionCommittee BSE Belgrade Stock Exchange BSL Budget SystemLaw C A D Current Account Deficit CAMEL Capital, Assets, Management, Earnings, and Liquidity CAS Country Assistance Strategy CEA Country Environmental Analysis CFAA Country Financial Accountability Assessment CTR Commission for the Protection o f Tenderers' Rights DDOR DDORNovi Sad (Serbia's 2ndlargest insurance company) DF Development Fund DFID UKDepartmentfor InternationalDevelopment DIA Deposit Insurance Agency DPL Development Policy Loan EAR European Agency for Reconstruction EBRD European Bank for Reconstructionand Development ECA Europe and Central Asia EMS Electricity Transmission Company EO1 Expression o f Interest EPS Elektroprivreda Srbije (Serbia's national electric power utility) EPP Employment PromotionProject ESW Economic Sector Work EU EuropeanUnion FA FinancialAdvisor FAU Fiduciary Assessment Update FDI Foreign Direct Investments FSN Financial Sector Note FY World BankFiscal Year GDP Gross Domestic Product GNP Gross National Product FOROFFICIAL USE ONLY GoS Government of Serbia HIPC HeavilyIndebtedPoor Countries IBRD International Bank for Reconstruction and Development ICA Investment Climate Assessment IDA International Development Association IFC International Finance Corporation IMF International Monetary Fund IPFMA IntegratedPublic Finance ManagementAssessment IPO Initial Public Offering JSA Joint Staff Assessment JSC Joint Stock Company LDP Letter of Development Policy LLC LimitedLiability Corporation MOI MinistryofInfrastructure MDGs MillenniumDevelopment Goals MME Ministry of Mining and Energy MoESP Ministry of Environment and Spatial Planning MOLSP Ministry of Labor and Social Policy MOERD Ministry of Economy and Regional Development MOF MinistryofFinance MOH Ministry of Health MOP Materijalno Obezbedjenje Porodice (Material Support to Families) MSEP Ministryof Science MTEF Medium-Term Expenditure Framework MTPL Motor ThirdParty Liability MTS Modernized Treasury System NBFI Non-Bank Financial Institutions NBS National Bankof Serbia NES National Employment Service N I S Naftna Industrija Srbije (State Oil Company) NMICS National Mortgage Insurance Corporation of Serbia NPL Non-performing Loans PA Privatization Agency PEIR Public Expenditure Institutional Review PFDPL Programmatic Private and Financial Development Policy Loan PFM Public Financial Management PHRD Japan Policy and Human ResourcesDevelopment Trust Fund PIER Public Expenditure and Institutional Review PLC Paris London Club PPFDPC-1 First Programmatic Private and Financial Development Policy Credit PPL Public ProcurementLaw PPO Public ProcurementOffice PRSP Poverty Reduction Strategy Paper PSN Private Sector Note ROSC Report on the Observance of Standards and Codes This document has a restricted distribution and may be used by recipients only in the performance of their official duties.Its contents may not be otherwise disclosed without World Bank authorization. RSD SerbianDinar SAA Stabilization and Association Agreement SA1 State Audit Institution SAC Structural Adjustment Credit SAP Stabilization and Association Process SBA Stand-By Arrangement SBRA SerbianBusiness RegistersAgency SDP Supervisory Development Plan SDR SpecialDrawing Rights SEM Serbia Economic Memorandum SIDA SwedishInternational Development Cooperation Agency SME Small and MediumEnterprises SP Social Program SPA Sale and PurchaseAgreement SOB State-OwnedBanks SOE Socially-Owned Enterprise TF Transition Fund TPL Third Party Liabilities UNDP UnitedNations Development Program USAID UnitedStates Agency for International Development USDor US$ UnitedStates Dollar ZTP Zeleznicko Transportno Preduzece - Belgrade Rail Company Vice President: Shigeo Katsu Country Director: Jane Annitage Sector Director: Fernando Montes-Negret Sector Manager: Lalit Raina Task TeamLeader: IrinaAstrakhan REPUBLIC OF SERBIA PROGRAMMATICPRIVATEAND FINANCIALDEVELOPMENT POLICYLOAN TABLEOFCONTENTS LOANAND PROGRAMSUMMARY ............................................................................. i I INTRODUCTION . ................................................................................................... 1 Recent Economic Developments InSerbia............................................................... 2 I1. THE GOVERNMENT'SPROGRAM .................................................................. 8 I11. BANKSUPPORTTO THE GOVERNMENT'S STRATEGY .......................... 11 LinkTo Cas............................................................................................................... 11 Collaboration With The ImfAnd Other Donors ....................................................... 11 RELATIONSHIP TO OTHER BANK OPERATIONS............................................ 12 Lessons Learned........................................................................................................ 13 Analytical Underpinnings.......................................................................................... . . 15 IV . THE PROPOSEDPROGRAMMATIC PRIVATE AND FINANCIAL DEVELOPMENT POLICY LOAN .................................................................................. 16 Operation Description ............................................................................................... 16 Policy Areas .............................................................................................................. 17 V . OPERATIONIMPLEMENTATION ................................................................... 41 Poverty And Social Impacts...................................................................................... 41 Implementation, Monitoring And Evaluation........................................................... 44 Fiduciary Aspects ...................................................................................................... 44 Disbursement And Auditing...................................................................................... 45 Environmental Aspects ............................................................................................. 46 RisksAndRiskMitigation........................................................................................ 48 VI . ANNEXES ................................................................................................................ 50 Annex 1: PFDPL Policy Matrix ................................................................................ 50 Annex 2: Letter of Development Policy.................................................................... 56 Annex 3: IMF Press Release..................................................................................... 67 Annex 4: Map (IBRD 34847).................................................................................... 71 The ProgrammaticPrivate and Financial Development Policy Loan (PFDPL) was preparedby an IBRDteam consisting of Irina Astrakhan (Task Team Leader). Alexander Pankov. Itzhak Goldberg. Aurora Ferrari. John Pollner. Andrej Popovic (ECSPF); Aleksandar Crnomarkovic (ECSPS). Eugene Gurenko (FPDSN); Bjorn Hamso. (ECSIE); Arvo Kuddo (ECSHD); Tijen Arin (ECSSD); Ardo Hansson. Ronald Hood. Lazar Sestovic (ECSPE); Siew Chai Ting (ECSPS); Dominique Bichara(LEGEM); andNicholay Chistyakov (LOAFC) . LOANAND PROGRAMSUMMARY REPUBLIC OF SERBIA PRIVATE AND FINANCIALDEVELOPMENT POLICY LOAN Borrower Republic of Serbia Implementing The Ministry of Finance (MOF) of the Republic of Serbia will be responsible Agency for overall implementation of the proposed operation. Other key ministries andagenciesresponsible for the implementation of the operation will include: the Ministry of Economy and Regional Development (MOERD), Ministry of Mining and Energy (MME), Ministry of Infrastructure (MOI), Privatization Agency (PA), Deposit Insurance Agency (DIA), National Bank of Serbia (NBS), Elektroprivreda Srbije(EPS), andNaftnaIndustrijaSrbije(NIS). Financing IBRDloan Data Terms: TBD Amount: Euro 34.9 million (US$50 million equivalent) Operation The proposed Programmatic Private and Financial Development Policy Loan Type (PFDPL) is the first in a series of three programmatic Development Policy Loans (DPLs) designed to support a multi-year program of assistance to the Republic of Serbia to address key institutionbuilding and reform challenges inbothprivate andfinancial sectors. The full IBRDloanis expectedto be withdrawn ina single tranche ofan amount of Euro 34.9 million (US$50 million equivalent) i MainPolicy The objective of the PFDPL will be achieved through supporting reforms Areas carried out by the GoS which are summarized inthree pillars: PillarI: Enhancingbusinessenvironment: Furthersimplificationofbusiness entry through implementation of a single agency approachto businessregistration; Improvingthe legal framework for strengtheningcorporate governance and facilitating business entry and operations; Streamlining regulations o f business operations and reducing business compliance costs; and Improving legal and institutional framework for competition; Pillar11: Strengtheningfinancialdiscipline: 0 Improving financial discipline inthe socially-owned enterprise (SOE) sector; 0 Privatization, restructuring andbankruptcyof socially-owned enterprises; 0 Continuing reforms inthe energy sector; and Establishment and development of a State Audit Institution. Pillar111:Buildinga moreefficientand stable financialsector: Privatization and divestment of state-ownedbanks (SOB) and financial assets (NPLs, insurance companies, equities, etc.); 0 Strengtheninginsurance sector regulation andresolution regime; 0 Enhancing prudential supervision of the banking sector; and 0 Strengtheningcapital markets regulatory and supervisory regime. Key Outcome Reducedregulatory compliance costs of business measuredby BEEPS(9.6% Indicators of managementtime in2005), ICs and other enterprise surveys. Unique business identification number is introduced and assigned to all businesses by end 2010. Increase of private sector share in GDP from 55% (end 2005) to above 60% by the end of the program in 2010, increase in private sector share in employment from 58% (end2005) to 65% by the end of the program in2010. The Government of Serbia's ownership stake inthe banking sector and its holdings infinancial assets reducedfrom 24% in2005 to 15% in2008, and expectedto go below 10% in2010; state share ininsurance sector decreased from 67% ininsurance premiumwritten in2006 to 37% in2008, andbelow 30% by 2010. ii Project The objective o f the proposed PFDPLs is to support the Government o f Serbia Development reform actions in three policy areas: (i)enhancing business environment to Objective and encourage new business and to attract foreign direct investments (FDI); (ii) Contribution strengtheningfinancial discipline by enhancing hardbudget constraints inthe to CPS enterprise sector through continued reform o f SOEs and restructuring of public utilities; and (iii)building a more efficient and stable financial sector through continuing the divestment o f state ownership in the banking and insurance sectors, strengthening prudential supervision o f banking and encouraging development o f the capital markets. The proposed PFDPL will contribute to realization of economic growth related goals, as outlined in the first priority area o f the Country Partnership Strategy (CPS): "Dynamic Private Sector Led Growth to Ensure Incomes Converge with Europe. The envisaged reform program would be consistent " with the GoS' aspiration for eventual membership in the European Union (EU). Risksand The most important domestic and external political risks have been largely Risk mitigated with the election o f the new reform oriented government. Political Mitigation risks stemming from the resolution on KOSOVO'S status have been final immensely reduced with new government's pro-reform and EU agenda. Certain risks still exist and are related to macroeconomic policy and institutional capacity. Key challenges in this regard pertain to budget and current account deficits. They are further exacerbated by potential impact o f the international financial crisis. However, the recently agreed precautionary Stand-By Arrangement (SBA) with the IMF ensures much needed fiscal discipline. NBS has sufficient reserves to meet urgent liquidity pressures and Serbian authorities have also demonstrated readiness to respond promptly and adequately to the challenges posed by the crisis. Operation ID PO96711 ... 111 INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAMDOCUMENT FORA PROPOSEDPRIVATE AND FINANCIAL DEVELOPMENT POLICY LOANTO REPUBLIC OF SERBIA I. INTRODUCTION 1. This program document presents the first in the series o f up to three Programmatic Private and Financial Development Policy Loans (PFDPLs) to the Republic o f Serbia to support the government's structural reform program. The proposed operation i s inthe amount of Euro 34.9 million (US$50 million equivalent). 2. The objective o f the proposed PFDPLs is to support three policy areas: (i)further improve the business environment to encourage new business and to attract foreign direct investments (FDI); (ii) strengthen financial discipline by enhancing hard budget constraints in the enterprise sector through privatization or bankruptcy, o f large SOEs, and the restructuring o f public utilities; and (iii)build a more efficient and stable financial sector through continuing the divestment of state ownership inthe banking and insurance sectors, enhancing prudential supervision of bankingand encouraging development of the capital markets. 3. The proposed PFDPL stream i s fully in line with the goals o f the World Bank Group's assistance to the Government of Serbia (Government or GoS), as outlined in the recently adopted FY08-11 Country Partnership Strategy (CPS), one o f the key areas of which includes encouraging dynamic private sector led growth to ensure incomes convergence with European levels. 4. The PFDPL i s designed to support the government in advancing its financial and private sector related reforms. This PFDPL series builds on the reforms initiated under the earlier Bank-supported operations, such as the three prior private and financial sector adjustment credits (PFSAC-I, PFSAC-I1and PPFDPC-I) and the structural adjustment credits (SAC and SAC-11). It i s envisioned to be complemented by another DPL operation aimed at supporting Serbia's Public Expenditure Management. The policy actions set in the PFDPL program will largely conclude the era of fast-track transition reforms in private and financial sectors of the Serbian economy. The private and financial sector reforms outside the PFDPL context will require a shift from immediate, near-term needs to medium- and longer-term results. 11. COUNTRY CONTEXT RECENT ECONOMICDEVELOPMENTSINSERBIA 5. The economy has grown strongly in recent years, following significant economic changes since 2000. In spite o f a drought, real GDP growth in 2007 reached 7.5 percent, the second highest since the start of the transition. Non-agricultural growth averaged 7.6 percent over the past three years, driven by the services sector which has been growing at double digit rates (inparticular trade, financial services and transport and telecommunication). Output has risen by nearly 50 percent since 2000, as the corporate sector started to post profits and the banking sector was restructured. The positive supply response also appears to reflect increases in productivity and output of recently privatized and de novo firms, as evidenced by the particularly rapid rates of output growth in precisely those sectors which have recently undergone extensive privatization (e.g., steel, cement, rubber, tobacco, dairy, sugar, and banking) or attracted foreign investors. Table 1:Kev economicindicators 2005 2006 2007 2008 est. NationalAccounts GDP (US$ millions) 25,361 29,7 16 39,854 49,348 RealGDPgrowth (YO) 6.0 5.6 7.1 6.0 Gross domestic investment(% ofGDP) 23.6 23.6 24.4 23.9 Gross domestic savings (% ofGDP) 2.8 2.4 0.6 -0.5 Public SectorBalance (as % of GDP) Expenditures 42.0 45.2 44.9 44.9 o/w public investment 2.7 4.0 4.7 3.8 Revenue31 42.8 43.6 43.0 42.8 Balance 3/ 0.8 -1.6 -1.9 -2.1 Public debt as %GDP 56.0 42.5 34.2 33.6 ExternalAccounts, (millions ofUS$) Exports ofgoods 4,970.2 6,44 1.9 8,755.6 10,972.9 Importsofgoods 10,259.8 12,712.6 17,886.0 22,293.6 Current accountbalance,after grants (millions ofUS$) -2,194.0 -2,986.2 -6,333.5 -8,886.4 Current accountbalance,as % ofGDP -8.7 -10.0 -15.9 -18.0 Indebtedness(externaldebt) TDO/GDP 64.0 63.O 61.1 66.2 TDOKGS 245.6 213.8 204.2 219.1 PricesandMonetarvIndicators Retailprice inflation(e.0.p.) 17.7 6.6 10.1 6.8 M2, as % ofGDP 11.4 14.2 16.8 14.4 2 6. Rapid growth during 2005-07 has been led by aggregate demand. Overall investment levels have remainedroughly constant in recent years, and slightly increased to 24.4 percent of GDP in 2007, although public investment levels have beenrising from 2.7 percent of GDP in2005 to 4.7 percent in2007. Real private sector consumption has beengrowingrapidly and increasedby nearly 10percent in2007 alone. Ittook place on the back of: a) a credit boom: Serbia continued to experience rapid credit growth which for 2007 is estimated to be 16.1 percent (average for the year); and the key driver of that growth was credit to householdswhich grew by more than 51percent in 2007 (average for the year); b) expansionaryfiscal policies and significant increases in public spending: consolidated general government spending reached 44.9 percent of GDP in 2007, up from 42 percent in 2005, driven by increases in both capital and current spending; c) increases in real wage levels: the total year-on-year real gross wage increase was 17.9percent in2007, ontop of 12.1percent in2006; d) rapid increases in exports:exports increasedon average 29.6 percent annually (indollar terms) over the 2005-07 period, albeit from alow base. 7. Growth in 2008 is estimated to reach 6 percent, driven by continued strong services sector performance, a much better agriculture season, and a 1.3 percent real growth in manufacturing, as well as an acceleration of export growth of 24 percent in dollar terms (in particular of material products). Preliminary figures for 2008 also indicate more modest and sustainable real wage increases, a relatively small fiscal deficit of about 2 percent of GDP, and continued decline of public debt as share of GDP. 8. Inflationary pressures have reemerged in the first half of the year, but went down afterwards. Since September 2006 the National Bank of Serbia (NBS) has been gradually moving towards inflation targeting, with explicit objectives for core inflation. The National Bank of Serbia has increased the rep0 rate by 775 basis points during 2008. Nevertheless, credit has been increasing rapidly and inflation (measured by retail prices index) reached 12.3 percent (y-0-y) in October 2008, but has fallen to 6.8 percent by the end of 2008. There were important supply side effects inthe first part of the year, includinghigher global prices of food and agricultural products (contributing to nearly 50 percent of total inflation over the past year), and oil products and electricity (contributing about 30 percent of total inflation). These pressures declined with the global decline in commodity prices. However, core inflation i s currently running at about 10 percent, well above the NBS target rate for 2008 of 3-6 percent. Since the NBS has started its move towards inflation targeting, there has been increased exchange rate variability, and a significant overall appreciation of the dinar, which reached a 4-year high against the euro inAugust 2008. However, since then dinar startedto depreciate significantly and especially since early October. The first direct impact of the international financial crisis manifested itself in pressure on dinar which lost 10.9 percent against the euro inOctoberalone. Throughout 2008 dinar depreciatedby 11.8percent. 9. A major concern for policy makers is the widening of the already high current account deficit (CAD). In 2007 the CAD reached 15.9 percent of GDP, a record high level 3 since the beginning of transition. For 2008 a further deterioration of the CAD to 18 percent of GDP is projected. In the first three quarters of 2008 the CAD was USD 7 billion or 14.2 percent of projected annual GDP.' 10. Net FDI covered about 87.2 percent of the current account deficit during 2005-07. Foreign direct investments (net) are estimated to be 6.3 percent of GDP in 2007, while portfolio investments reached 2.3 percent of GDP. Net foreign loans increased from 9.6 to 13 percent o f GDP. As a result of the large surplus in the capital account, gross international reserves increased from USD 11.9 billion (EUR 9 billion) at the end of 2006 to USD 14.2 billion (EUR 9.6 billion) as of December 2007 when they representeda record high coverage of prospective imports (7.5 months). In 2008 the reserves in dollar terms reached a peak in March(USD 15 billion) while in Euro terms they peaked in September(EUR 9.7 billion). In October the National Bank of Serbia began to intervene in the foreign exchange market, selling EUR 266 million, and reserves declined to EUR 9.3 billion by the end of October. Significant intervention at the inter-bank foreign exchange market continued in the later months and consequently reserves declinedto USDl1.5 billion (EUR 8.1 billion). Inthe first three quarters of 2008 net inflows of FDI were USD 2.4 billion (4.9 percent of the annual GDP). 11. Private external debt continues to increase rapidly while the public debt stock is declining. External debt outstanding as a percentage of GDP i s estimated to have decreased slightly from 63 percent in 2006 to 61.1 percent in 2007 despite the increase inprivate sector borrowing due to solid growth of the economy and exchange rate valuation effects. In dollar terms, foreign debt increased from U S 19.6 billion at end-2006 to US 26.2 billion at end- 2007. The share of the private sector in external debt has increased significantly over the last several years and at the end of 2007 i s estimated to be around two-thirds of the total. Public debt (including both domestic and foreign) as a share of GDP declined from 42.5 at the end of 2006 to an estimated 34.2 percent at the end of 2007. Most of the public debt is denominated in foreign exchange (95.4 percent). At the end of November 2008, the total stock of external debt (public and private) reached USD 27.9 billion. Short term debt accounts for 9.8 percent oftotal external debt. 12. Given signals of growing macroeconomic imbalances with external and financial vulnerabilities, insufficient fiscal restraint would be a serious risk to macroeconomic stability inSerbia, especially inthe light ofthe ongoing international financial crisis. The fiscal deficit of the consolidated government sector for 2007 was around 1.9 percent of GDP, following a deficit of 1.6 percent in 2006. Although revenues have continued to grow (from 35.8 percent of GDP in 2001 to 43 percent of GDP in 2007), both capital and recurrent spending have grown even faster. As in previous years, a key generator of the deficit remains the social insurance funds (health, pension and unemployment insurance funds) which on average over the last couple of years ran deficits of over 5 percent of GDP. The deficits of social insurance funds are coveredby transfers from the central governmentbudget. There are some measurement issues with the CAD. Usingthe revised methodology o f the National Bank o f Serbia, where a portion o fremittances has been transferred from the financial to the current account, the C A D (after grants) increased fiom 9.7 percent o f GDP in2006 to an estimated 12.4 percent in2007 and is forecast to deteriorate further last year. There are also issues with the treatment o f reinvested dividends o f foreign owned corporations which iftaken into account would at least partially offset the effect o f the alternative treatment o f remittances on the size ofthe CAD. 4 13. Given Serbia's already high public revenue-to-GDP ratio, limiting growth of overall public spending will be one of the major challenges of the Government, especially given the plans to increase spending for much-needed infrastructure investments. Expenditure reprioritization and a reduction of current expenditures will be critical. Delivery on election campaign promises would increase the expansiveness of fiscal policy and undermine macroeconomic stability. The fiscal deficit in 2008 will crucially depend on budget execution in the last quarter (including of the investment projects) since in the first three quarters the fiscal deficit was 1 percent of annual GDP. The deficit originally projected for the whole year was 1.9 percent of GDP, but due to some one-off but very costly measures the deficit for the year might rise to 2.1 percent of GDP. 14. Potential impact offinancial crisis and mitigation measuresput inplace. As a result of the global financial turmoil, the risk of instability in the domestic financial sector has also increased. However, past tight prudential policies are now paying off in providing a strong I first line of defense against financial crisis spillover. Increased financial sector stability risk stems mainly from recent rapid credit growth inthe banking sector, primarily in Euro or Euro indexed loans and guarantees extended for cross-border borrowing of companies. However, this risk is temperedby the large current liquidity (liquidity rate of 31% as of October 2008) and capital buffers (CAR of 26% as ofthe same date) o fthe banking system. 15. With regards to enhancingmarket confidence, GoS andNBS respondedpromptly to a withdrawal of some 15 percent of foreign currency deposits during the month of October 2008. They put in place a series of confidence building measures, including stepping up ongoing monitoring of liquidity in the banking system and early warning indicators (see Box 1). Withdrawals since the end of October have slowed very sharply and are now negligible. Moreover, much of the net reduction in deposits in October was balanced by injections of liquidity from home country banks, hence the liquidity remains high. Box 1. NBS and GoS Stabilization Measures in Response to Financial Crisis GoS andNBS have taken anumber of measuresto sustain market confidence and increaseliquidity in the system and step up monitoring: Market confidence Appointment of crisis management group Increaseof deposit insurancecoverageto Eur 50,000 per deposit (from Eur 3,000) Monitoring Enhancedsupervisionwith developmentof liquidity and early warning indicatorsmonitoredon a daily basis Targeted diagnosticexaminationsofthe level ofbanks' liquidity andpoliciesfor liquidity management Systemicallyimportantbankshave to submit 2009 business plansand information on early repaymentof cross- border loans Liquidity Mandatoryreserves abolishedfor new cross-borderborrowingfor financial leasing companies; and cross-border linesof credit, including subordinatedcredit lines Updatedguidelineson liquidity risk management, in line with Baselprinciples Reducedtax on foreign currency savings Increasedshare of foreign currency mandatoryreserves (from 20 to 40%) kept indomestic currency to increase banks' foreign currency liquidity and withdraw excessdinars from circulation Reducedbanks' net open foreign currencypositionfrom 20 to 10% Corporate Debt Workout In addition, to mitigate the effects of the crisis on the economy and to minimize potentialcorporate default, NBS has agreed with the bankingsector on the following temporary measures for 2009: i)extension of the repayment periodof the existingloansup to 1year for credit worthy clients; ii)no penalty fees for early loanrepayment. 5 16. Recognizing the risks inherent in the current international financial situation and the large CAD, Serbia requested a Precautionary Stand-By Agreement (SBA) with the IMF. On November 13, the Fund mission and the Serbian government reached agreement on an economic program supported by a potential loan o f USD 516 million (75 percent o f the quota). The agreement limits the overall 2009 budget deficit to 1.75 percent of GDP and incorporates a freeze on increase inpensions in 2009, a freeze on public sector wages (inreal terms) and a significant cut in subsidies. Inaddition to fiscal tighteningthe Fundagreed with the government to accelerate structural reforms in order to create an environment for faster private sector development (including privatization of remaining state banks and large state enterprises and legal reforms that will improve business environment). Additional provisions of the SBA define the roles and responsibilities o f the Deposit Insurance Agency and other authorities based on a Fund Financial Crisis Preparedness Review which judged the legal basis for crisis preparedness to be sound but noted that smooth implementation o f its provisions, should the need arise, may prove challenging. Since Serbia has a comfortable international reserve position and continued access to external financing, the SBA has been formulated under regular, not exceptional, procedures and access limits. The Serbian government indicated that it does not intend to draw on resources made available under the SBA, unless the need arises. The IMF's Boardadopted this arrangement on January 16,2009. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 17. The Serbian economy will be affected by the international financial crisis, like other countries from the region, but growth i s projectedto stay at around 4 percent per year over the medium term. This represents a downward revision of some 2-3 percentage points from earlier estimates but still represent relatively solid growth relative that projected for other European economies. Serbia's success duringthe first years o f transition (2001-2004) was primarily due to the implementation o f key structural reforms typical for transition economies (such as liberalization o f foreign trade, privatization o f socially owned enterprises etc.) which set the stage for fast growth in the future. However, these growth projections are associated with some uncertainty, and could be revised upwards or downwards depending on the depth and length o f the financial crisis. The Serbian economy to large extent depends on availability of credit and investment from abroad, and receives annually about 9 percent o f GDP inthe form o f remittances. Under the presented scenario, investments are projected first to decline slightly (in 2009) but then to recover to levels similar to those of the last two years (reaching 24.5 percent o f GDP by 2011). These levels are still below those characteristic o f the fastest growing economies o f the region. Inflation is projected to decline again to single digit levels by the endo fthis year and to continue declining to levels o f 6-8 percent thereafter. 18. As part o f the agreement with the IMF, the Serbian government committed to cutting public expenditures more significantly relative to GDP. The deficits o f 1.8-2 percent o f GDP that characterized last couple o f years will decline to about 1 percent o f GDP. Consolidated general government expenditures are projected to decline significantly next year: from 44.9 percent of GDP this year to 43.7 percent. A similar trend i s projected through 2011, when public expenditures are projected to reach 42 percent o f GDP. Public revenues are projected to decline as well, but at a somewhat slower pace, thus these will come down from 42.8 percent of GDP (as it i s estimated for 2008) to about 41 percent o f GDP by 2011. These projections incorporate the changes in fiscal policy envisaged by the new arrangement with the IMF which limit the consolidated general government deficit to 1percent of GDP. 6 Table 2: Serbia: Medium-term MacroeconomicProspects Indicators 2008 2009 2010 2011 GDPRealGrowth 6.0 3.5 4.5 6.0 Investments, as %GDP 23.9 23.4 23.9 24.5 Retail price inflation (end-of-period), YO 6.8 8.0 6.5 6.0 Public Finance Revenues(%GDP) 42.8 42.2 41.4 41.0 Expenditure(%GDP) 44.9 43.7 42.4 42.0 FiscalBalance,before grants (%GDP) -2.1 -1.5 -1.0 -1.0 External Position CAD after grants(%GDP) -18.0 -16.2 -15.2 -12.0 Reserves($billion) 11.5 11.1 12.1 13.9 Debt Gen Govt. Debt (%GDP) 33.6 31.0 28.4 25.9 Externaldebt (%GDP) 66.2 72.1 76.1 75.1 19. The medium term macroeconomic projections for Serbia shown above have been revised twice since preparation of the CPS, most recently in December 2008. They reflect ongoing developments inthe financial crisis as well as new fiscal polices adopted inline with the Fundprogram. The debt positionis now projectedto deteriorate (as indicated by increased the share of external debt to GDP) but will then improve in the later years of the projection period. External debt as share of GDP is projected to decline significantly in2008 and then to increase gradually through 2010. It will only to start to decline again in 2011. In 2007 total debt outstanding was 61.1 percent of GDP, and in2011 it is projectedto reach 75.1 percent of GDP. It is important to stress that the composition of external debt will shift towards the private sector which will account for about 80 percent of total external debt by 2011. This partly reflects the expected continued borrowing of foreign owned commercial banks operating in Serbia from their headquartersabroad. Public debt (both domestic and external) i s projected to continue to decline from 30.2 percent of GDP in 2007 to 24.9 percent in 2011, as fiscal deficits are going down and are expected to be easily funded by non-debt creating inflows (i.e., privatization revenues). 20. Some risks to Serbia's external debt sustainability remain, particularly given continuing external imbalances. The current account deficit (after grants) remains very high2 and is projected to increasefrom 15.9 percent of GDP in2007 to 18 percent of GDP this year. Thereafter it will begin to decline, reaching 12 percent of GDP in 2011 primarily as a consequence of a decline inthe trade deficit from 23 percent of GDP in 2007 to 16.6 percent by 2011,largely because of declining imports rather than increasedexports. Private transfers, Le., remittances, at the level of 8-9 percent of GDP will remain a key factor keeping the CAD at a more sustainable level until export growth picks up. Following a massive buildup in the period to 2007, external reserves are projected to decline slightly in2009 (by about 8 percent ineuro terms) andthenwill rise after 2010. * NationalBank of Serbiahave recentlyrevisedthe BalanceofPaymentmethodologyand as a result revisedthe figures for the Current Account Deficit in2007 from 15.5 to 12.4percentofGDP. 7 21. Over the projected period 2009-2011, Serbia will have financing requirements o f about 32.4 percent of GDP to cover its C A D o f about 14-15 percent o f GDP, and to regularly service its debts (amortization accounts for most o f the remaining amount). Reserves are projected to change only marginally innominal terms. A significant portion o f these financing requirementswill be covered from non-debt creating inflows such as foreign direct investment and other capital inflows (including portfolio investments). These two categories are projected to be about 8-9 percent o f GDP, or approximately one third o f financing requirements. However, a major part will be provided through borrowing from abroad - either by private or government sector. Private sector borrowing will rise with its share in total external debt outstanding reaching 80 percent by the end o fprojectionperiod. 22. Despite the GoS' mitigation measures aimed at easing the impact o f the financial crisis, Serbia will not remain immune to the effects o f the global turmoil, which are expected to significantly slowdown economic activity in 2009. Ensuringmacroeconomic stability will require government's continued commitment to structural reforms and adequate response to any adverse development^.^ 11. THE GOVERNMENT'S PROGRAM 23. The PFDPL operation i s designed to support concrete Government led reforms structured in three pillars. Pillar 1 o f the proposed PFDPL operation aims to strengthen the business environment; Pillar 2 is designed to further strengthen the fiscal discipline through reducing the flow o f direct and indirect subsidies to the enterprise sector and, at the same time, accelerating the resolution o f remaining SOEs; and Pillar 3 will encourage further financial sector reforms through divestments and institutional strengthening. 24. As to Pillar 1, the improvement o f business environment is a key factor for ensuring sustainable private sector growth and job creation. While implementation o f the government programs focused on privatization of state- and socially-owned enterprises and strengthening fiscal discipline led to increase o f productivity and freed up scarce government resources, the future economic growth and job creation will depend on the emergence and successful development of a dynamic private sector. To that end, in the last few years the GoS has embarked on a series of successful reforms aimed at improving the business environment. Moreover, the government has closely coordinated its plans and actions with the representatives o f the private sector, such as the Foreign Investors Council, and it has conducted intensive stakeholder consultations in order to address the ongoing business concerns and stimulate further investments. 25. Some recent notable successes include implementation o f a comprehensive reform o f business entry that led to the transfer o f business registration from judicial to purely administrative process managed by the Serbian Business Registers Agency (SBRA); adoption o f such key elements o f commercial legislation as the Company Law and a new Bankruptcy Law; enhancement o f access to finance by adopting Secured Transactions Law, Leasing Law and Mortgage law andestablishing Pledge and Leasingregistries; coordination of Government reform efforts through the Regulatory Reform Council and introduction o f a Regulatory Macroeconomic outlook i s subject to revision given the uncertainties associated with the global economic crisis and an updatedversion will be presentedduring the Board discussion. 8 Impact Assessment (RIA) in Serbian legislative process. These reform efforts have been acknowledged inthe World Bank 2006 Doing Business Report that identified Serbia as one of the top 10 reformers in the world. However, political developments between 2006 - mid 2008, including the dissolution o f the State Union o f Serbia and Montenegro in June 2006, national referendum on a new Serbian Constitution, KOSOVO'S unilateral declaration of independence inearly 2008, andtwo Parliamentary elections a year from each other (2007 and 2008), followed by the difficult prolonged negotiations between the political parties on formation o f the new Government, delayed the implementation o f the planned business environment reforms. Though there was no significant absolute worsening in the business environment observed, businesses in Serbia continue to encounter a number o f administrative barriers and substantial regulatory compliance costs. 26. The Government i s committed to reinvigorate the reform efforts and pursue unfinished reform agenda inimproving the business climate. The World Bank stands ready to assist it. Priority areas that have been agreed upon include: (i) further streamlining o f business registration procedures with an aim of creating a one-stop shop for business registration and eventually introducing a single identification number; (ii)improving legal framework for strengthening corporate governance and facilitating business entry and operations by introducing amendments to the Company Law; (iii)simplifying regulations o f business activities and reducing business compliance costs through the implementation o f a comprehensive regulatory review, the so-called guillotine), and (iv) improving legal and institutional framework for competition. 27. With regards to Pillar 2, the GoS is committed to strengthening the fiscal discipline which is necessary to attain permanent fiscal adjustment, but also required to facilitate the restructuring o f the real sector. Whilst GoS has made good progress intightening fiscal policy in 2004 and 2005 - there was a significant reduction inthe deficit o fthe consolidated general government in 2004 (3 percentage points o f GDP) and surplus in 2005 - the size o f the government remained among the largest in the region. Also, most o f the deficit reduction to date reflected buoyant revenues owing to strong economic growth, inflation and better tax collection rather than efforts to contain spending. Further, 2006 and 2007 witnessed deterioration in fiscal policy, and as a result a fiscal deficit of 1.6% and 1.9% of GDP in2006 and 2007 respectively. Buildingon the achievements o f PPFDPC-I, under this operation the GoS will pursue a two-pronged strategy o f (i) containing the direct and indirect subsidies to the enterprise sector and (ii) accelerating resolution o f the remaining SOEs. 28. In pursing permanent energy sector reforms, Serbia has committed to integrate its energy sector into the regional and pan-European oil, power and natural gas markets and is seeking to enhance energy security through obtaining foreign investments in transit pipelines for natural gas across Serbia. The Government recognizes the need for continued rehabilitation and modernization o f its energy infrastructure, and sees further restructuring and private sector participation as tools to achieve cost-efficient improvements in the sector. In parallel, GoS i s focusing on energy efficiency in the supply chain as well as in energy consumption, and movement towards cost-reflective tariffs i s one o f the elements in the strategy. Furthermore, the Government wants to support renewable energy sources and environmentally acceptable technologies for energy utilization. 29. As to Pillar 3 on financial sector reforms, substantial progress has been made interms o f privatization and sale o f assets and strengtheningo f the legal regulatory framework for both 9 the banking and insurance sector. As a result of these reforms, the financial sector i s now mainly private, foreign players dominate both markets and both markets have expanded significantly. Recently, the Government has also started a review o f the key capital market legislation to promote its development. Notwithstandingthe considerable progress to date, it is important that GoS completes the privatization process o f the bank and insurance sectors, continues to transition to risk based supervision, approves the motor third party liability law and continues to promote the development o fcapital market. 30. Thanks to a substantial privatization effort, including the recent privatization of three banks (Vojvodjanska, Panonska and Komercialna) only 17.2% o f banking sector assets i s still state owned. This stood at 43.7% in2002 when the privatizationprocess started and following the closure of four largest banksovernight in2001. Currently, the majority o fthe sector (over 70% o f total assets) is foreign owned, mainly by European groups. In2007, lending to SOEs was at only 2.1% o f total lending and was primarily extended by private banks to profitable SOEs. As a result o f the reform, the sector has not only become more stable, but has also expanded substantially, with banking sector as a percentage o f GDP reaching 67% in 2007, and insurance premium increasingby 120% over the 2002-2007 period. 31. A major effort to strengthenbankingsector supervisionhas been undertaken with the approval o f a new Law on Banks in 2005 and the new law introduced consolidated risk based supervision, thus addressing a key issue raised inthe 2005 FSAP. The new Law on Banks has also been supported through the adoption o f a number o f regulations. To date these include an updated supervision operating policy, an amended procedural guide on remedial actions, new bank licensing procedures, a new IFRS-compliant banking chart of account, and new capital adequacy requirements for market and foreign exchange exposures. New regulations on risk management, liquidity, loan classification, consolidated financial group reporting and related capital adequacy and reporting requirements have been drafted. NBS has also put considerable effort in the implementation o f the new framework by standardizing supervisory procedures and training inspectors on risk-based supervision. 32. Insurance supervision has also been improved thanks to a complete revamping o f the legal framework, including the introduction o f a licensing requirement for insurance agents, and the enhancement o f the quality o f supervision and o f enforcement. As a result, there has been substantial consolidation in the sector; over the 2001-2008 period, the number o f companies has shrunk from 40 to 21. State ownership in the sector has been substantially reduced. Finally, the work on motor third party liability (MTPL) i s underway. 33. The Government has started a comprehensive review o f the key relevant legislation for capital markets development, the Law on Securities, the Law on Takeovers and the Company Law. Amendments to the Securities Law will take care o f immediate problems until the full review is completedwhich will ultimately ensure that conflicts betweenthe three laws are eliminated and they are in line with international standards. Further, the Government i s committed to the establishment o f a long term government bond market and it has set up a working group to study the legal and institutional framework for a bond market including corporate, municipal, and government bonds. In order to proceed with the restructuring program o f the state owned utilities, the GoS i s preparing legislation to corporatize public utilities (Le. to transform them into companies with a structure that i s in compliance with Serbian company and securities laws). Additionally, there is a need to repeal o f a 1996 Law on Assets o f the Republic o f Serbia, which created an anomaly whereby state owned 10 companies do not own the assets that they use. The Government also intends to privatize or ensure private sector participation in certain public enterprises through IPOs or sales in the market. This recognizes the increasing strength o f the Belgrade Stock Exchange as a mechanism not only for secondary market trading, where citizens and workers entitled under the Law on Gratis Shares can buy and sell, but also as a place where primary fund raising can be carried out as well. Finally, the Government will improve the institutional arrangements for capital markets by providing the Securities and Exchange Commission with more responsibilities and ensuring its impartiality and independence. 111. BANKSUPPORTTO THE GOVERNMENT'SSTRATEGY LINKTO CAS 34. The FY08-FY11 CPS for Serbia, approved by the Board in December 2007, envisages this PFDPL as a base case operation for FY08-FY09. In broader terms, the CPS outlines a possibility for a set o f consecutive development policy operations over a three-year period, depending on the needs and financing requests o f the GoS. This PFDPL would be the first o f such operations, as envisaged inthe CPS. 35. The objectives of the PFDPL are consistent with key objectives and expected outcomes under the first priority area o f the Serbia CPS: "Dynamic Private Sector Led Growth to Ensure Incomes Converge with Europe." The proposed PFDPL would address a set o f objectives outlined under this priority area, such as (i)further improving the business environment, particularly cumbersome licensing and permit arrangements; (ii)strengthening the financial sector intermediation; (iii) completing divestiture o f socially-owned enterprises; (iv) strengthening enforcement o f bankruptcy and other mechanisms to ensure the assets of insolvent socially-owned enterprises unable to be sold can be freed up for productive use; (v) continuing the process o f privatizing and restructuring o f large state-owned enterprises; and (vi) strengtheningthe competitiveness of the enterprise sector. A number of potential PFDPL triggers and program outcomes are featured inthe Policy Matrix. COLLABORATIONWITH THE IMFAND OTHERDONORS 36. The success o f reforms in Serbia over the first seven years o f transition was substantially stimulated by the effective collaboration and coordination betweenthe Bank and other key donors. The Bank maintains close working relations with the IMF and other donors assisting the GoS for the purposes o f harmonizing policy recommendations, seeking synergies among the respective operations, and avoiding overlaps. The IMF has beenprimarily focused on the short-term impacts o f the reforms on macroeconomic stability while the Bank has focused on the medium-term impacts o f structural reforms. The Bank also maintains very good relations and keeps ongoing policy dialogue with various bodies of the EU, either in its headquarters inBrussels or inBelgrade. 37. The IMF and Serbia have successfully completed one Stand-by and a three-year Extended Arrangement since 2001. The final review under the Extended Arrangement was completed on February 07, 2006 after two extensions. Followingthe successful completion o f the Extended Arrangement, the IMF has maintained regular Article IV consultations with Serbian authorities, the last one completed in February 2008. In2006 the Serbian authorities 11 decided to use part o f their privatization revenues to prepay major creditors, including the IMF. Duringthe 2006 Serbia prepaid about USD 600 millionto the Fundwhile the remaining balance due to the Fund was amortized in the first quarter o f 2007, thus completely clearing the outstanding debt. Giventhe abrupt change inglobal financial environment and inorder to safeguard macroeconomic and financial stability, Serbian authorities have requested a precautionary Stand-By Arrangement with the IMF. Duringthe course o f the Fund's mission in Serbia inNovember 2008 the mainparameters o fthe economic programwere agreedupon, and the IMFBoard approved the SBA on January 16,2009. 38. Overall, the Bank has maintained a robust dialogue with the donor community in Serbia in order to avoid duplication o f efforts and leverage support for the GoS' reforms. The Bank is an active participant in macro-level donor coordination mechanisms led by the GoS, and the Bank also coordinates efforts on specific thematic fields directly with other donors. This includes the European Agency for Reconstruction (EAR) and USAID on enterprise sector reform and improving bankruptcy regulatory regime and its enforcement, the U.S. Treasury, SIDA and the DFID on support to the Deposit Insurance Agency's mandate and USAID on its long-standing support to the NBS Supervisory reform initiative. The collaboration between the Bank and SIDA also includes supporting the Serbian Business Registry, development o f regulatory reform strategy, and regulatory impact assessment. 39. The Bank has been closely coordinating with other donors engaged in supporting financial sector development in Serbia, especially related to banking sector restructuring. In particular, the Bank has consulted with EBRD which has equity stakes in two banks with significant state ownership, ensuringclose donor coordination in supporting the government's efforts to further strengthen the banking sector. Most recently, the Bank has been closely coordinating with Swiss Secretariat for Economic Affairs which is finalizing its assistance program to the Government o f Serbia related to restructuring and privatization o f state owned banks. The Bank's coordination and cooperation with the European Union, Serbia's most important current and future development partner, i s increasing and deepening since practically all World Bank assistance is aimed at helping Serbia inthe process o f convergence with the European Union. Finally, the GoS has received a PHRD grant from the Government o f Japan for the preparation o fthis operation. RELATIONSHIPTO OTHER BANK OPERATIONS 40. The proposed PFDPL program follows closely the Programmatic Private and Financial Development Policy Credit (PPFDPC- 1) and a successful series o f two consecutive Private and Financial Sector Adjustment Credits. The PFSAC-I, with a total commitment o f USD 85 million, closed inJune 2003 with a highly satisfactory outcome. This credit focused on initial reform measures in five areas: (i) banking sector reform; (ii) reform o f socially- owned enterprises; (iii)bank asset and enterprise workouts; (iv) financial sector regulatory andsupervisory framework; and (v) business environment reform. 41. The PFSAC-11, with a total commitment of USD 80 million, put inplace the medium- term reforms agreed upon in PFSAC-I. Its overall objective was to support the GoS' program of regulatory, institutional, and structural reforms seeking to significantly accelerate private sector growth through: (i)improving the business enabling environment by means o f comprehensive reform o f enterprise entry, operation and exit; (ii) strengthening the financial system by improving the environment under which banks and other financial intermediaries 12 operate; (iii)privatizing and/or liquidating outdating majority state-owned banks; and (iv) privatizing and restructuring socially-owned enterprises that crowd out private sector growth and incur significant fiscal and quasi-fiscal costs. 42. Under the PPFDPC-1 closed in March 2006, with a total commitment of USD 55 million, the GoS has successfully completed core policy actions in: (i) strengtheningthe 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. To strengthen the fiscal discipline, the GoS reduced subsidies and continued with divestiture o f SOEs through privatization and bankruptcy; and pursued reforms in the energy and railway sector.,The GoS activities aimed at buildingmore efficient and stable financial sector focused on continued privatization and divestment o f state-owned banks and financial assets; strengthening insurance sector regulation and resolution regime; and improving access to finance through the adoption o f a mortgage law. 43. Implementation o f the reform agenda under the PFSAC and PPFDPC-1. programs benefited considerably from and was facilitated through two grants, the Private Sector Development Technical Assistance (PSD TA) and Financial Sector Development Technical Assistance (FSD TA), followed by the recently completed Privatization and Restructuring of Banks and Enterprises Technical Assistance Credit. These operations provided technical assistance and institutional capacity building for (i) privatization and bankruptcy o f SOEs; (ii) implementation o f a comprehensive banking and insurance sector restructuring strategy targeted at creating a more viable financial sector; and (iii)improvement o f the business environment for business entry and sustainable operations. 44. Inaddition to the private and financial sector reformdimensions outlined inthe above mentioned operations, the Structural Adjustment Credit (SAC) program has also laid a foundation for the implementation o f the envisaged PFDPL program. Inparticular, the SAC-I1 focused on: (i) improving the business climate; (ii) institutional development and improving performance withinthe energy sector; (iii) strengthening social protection; and (iv) improving public administration. The planned DPL operation to support the Public Expenditure Management will provide assistance to the GoS inwider public financial management issues. 45. The approved Bor Regional Development Project, which included supporting the government inthe assets resolution o f copper miningand smeltingcomplex RTB Bor, pursues objectives that are cross-reinforcing with those o f PFDPL, as RTB Bor was the single largest recipient o f GoS subsidies to the SOE sector. LESSONSLEARNED 46. The PFDPL program builds upon the experience accumulated during the preparation and implementation of the previous private and financial sector operations. This experience has demonstrated that an integrated approach i s needed to reform the financial and enterprise sectors inparallel. Underthe earlier programs, financial sector reform aimedto boost financial intermediation, encourage domestic savings and generate much needed liquidity to support real sector expansion. Concurrently, the continued privatization o f SOEs and the adoption o f early measures to strengthen the business climate drew inincreased foreign investments. 13 47. A key lesson from other transition experiences and from the first seven years of transition in Serbia was the need for sequencing: the initial steps should be the immediate goals o f price liberalization and fiscal stability, followed by structural reforms in industrial enterprises and banks and, only then, in the third stage, pursue reforms in utilities, non- banking institutions and capital markets. Moreover, due to the political economy o f post- conflict Serbia, it was important to start enterprise privatization with sellable companies - or "early wins" - and only later move onto restructuring o f the politically sensitive large loss- makers. The focus o f the three stage sequencing must include lessons on the timing and design o f social policies aimed at directly addressing poverty reduction and mitigating some o f the adverse social impacts potentially caused by the three transition stages. In parallel, from the start o f the reforms, long-term efforts should be undertaken which are aimed at creating a robust, transparent regulatory and institutional framework for utilities, financial markets and the business environment. In the case o f utilities, privatization should be preceded by unbundling and commercialization on the basis of an appropriate market structure. Moreover, the negative experience o f some transition countries forewarns that the proper preparation i s requiredto attract interest from international reputable strategic investors. 48. In recent years, Serbia has proven to posses sufficient technical capacities be very effective in implementing economic reforms. However, given an unstable political situation the pace of reform has been noted to be stop-go. Therefore, in designing this programmatic approach the Bank has adopted a modular strategy, striving to ensure that the achievements in the first DPL are incremental and largely irreversible, serving as a strong foundation for further structural reforms later on inthe program. 49. Reform implementation i s heavily dependent upon an effective.champion who takes the early `ownership' o f the reforms sought. Equally, it is important that the domestic reform champions are well advised as to the positions assumed and actions taken. For example, the willingness o f key counterparts at NBS and M O F to take key decisions, inter alia, to significantly reign in regulatory forbearance, take additional robust measures to further strengthenthe bank andinsurance regulatory regimes, withdraw licenses o fbanksand insurers and offer a number of state-owned banks and assets for sale has enabled the financial sector reform agenda to be substantially advanced. Similarly, the effective management o f the enterprise privatization process by M O E and P A facilitated progress in the reforms o f the socially-owned sector. 50. The ability to provide extensive technical assistance on a timely basis has been crucial to enabling the PFSAC-I and I1 operations to achieve their objectives. As well, the early provision o f substantial grant funding and the effective coordination by the Bank o f support from bi-lateral donors (notably EU, DFID, PHRD and USAID) proved critical for developing institutional capacity at the DIA, PA and NBS to implement early highimpact measures. 51. Finally, it i s important to note that Serbia differs from most other transition economies in two ways. First, its system o f socialism, based on worker management and the concept o f "social capital," did not entail classic central planning; and secondly, due to the break-up o f the former Yugoslavia and the resulting conflict and sanctions, Serbia was relatively late in embarking on the journey to a full-fledged market economy. These factors meant that the fundamental transitional task o f reforming banks and enterprises had to be adjusted to these different initial conditions and to take lessons o f experience into consideration: auctions replaced voucher privatization, so typical for many other transition 14 economies, the four largest state-owned banks were closed and lastly, the approach to restructuring of utilities and of the largest loss-makers has beenmore gradual than that of the early reformers. ANALYTICAL UNDERPINNINGS 52. The PFDPL program heavily relies on findings of the extensive economic sector work undertaken by the Bank. The policy recommendations integrated into the relevant components of the program are stemming from a number of key documents presented to the GoS in2004- 2007. They includethe Serbia Economic Memorandum; the Financial Sector Note (FSN); the Investment Climate Assessment (ICA); the Private Sector Note (PSN); the Fiduciary Assessment Update, the Public Expenditure Review, the Accounting and Auditing Report on Observance of Standards and Codes (ROSC), the Financial Sector Assessment Program (FSAP) report and most recently, the Integrated Public Finance Management Assessment (IPFMA), the Labor Market Study and the Public Expenditure Review update. The new CPS for FYOS-FY11 was adopted in December 2007 following extensive discussions with the incominggovernment basedon a set of policy notes. 53. According to an empirical analysis in the ICA and the PSN, private firms are more productive than the socially-owned ones, proving that ownership does matter. Further, according to an EU sponsored study from 2005, companies privatized under the 2001 Law have generally improved their financial performance and have invested in modernizing their production process in comparison to companies privatized to employees under the pre-reform 1997 Law, although originally the latter were, on average, of better quality companies thanthe firms privatized after 2001. Moreover, the ICA demonstrates that new private firms in Serbia are unambiguously more productive, more profitable, and growing more rapidly than the socially-owned ones. The problem is simply that there are not enough of them. Although the new private firms are better performers, their scope for growth and the possibility of entry by new entrepreneurs are severely limited by the improving, but still deficient business environment. 54. The PRSP rightly emphasizedthat improvements inthe businessenvironment are key preconditions for sustainable private sector-led growth. The strategy for Serbia acknowledges the needfor streamlining the registration process, reducing administrative barriersto business operation, improving corporate governance, and establishing a modem bankruptcy regime. Similarly, comprehensivereformof the financial sector represents an important cornerstone of governments' growth strategy. The SerbianPRSP and FSAP alike each identifies a set of the short- to medium-term actions needed to strengthen financial sector supervision, privatize remaining state-owned banks, and improve access to finance. With proper implementation, these reform steps should help significantly in allowing the Serbian financial system to better fulfillits role inchanneling resourcesintoproductive investments. 55. Inaddition, the results of Business Environment and EnterprisePerformanceSurveys (BEEPS), as well as the Doing Business indicators were analyzed to help identify main areas of concern for private sector development. These datasets not only provide valuable insight in the regulatory environment and administrative practices in Serbia, but also allow for benchmarking against other countries in the region and the world, a further measure to identify where Serbia might be underperforming incomparison with other countries. 15 56. Several regulatory reform areas that are targeted within the scope o f this operation have been identified in the I C A and other studies as priorities for private sector development and increased investment: (i)reduction o f the regulatory compliance burden, including continuous streamlining o f business registration and operations, (ii)simplification o f the burdensome procedures for obtaining construction permits, which in turn are linked to the problems of urban planning and land management; and (iii)improvements in competition legislation and implementation capacity o f the government. 57. The FSN demonstrates that Serbia's financial sector remains insufficiently developed by regional benchmarks, andthe existing level o f financial intermediation cannot fully address the needs of economic growth. Narrowing the efficiency gaps between the weaker Serbian banks, and the leading CEE and EUbanks began only in2005 as a result o f local acquisitions by foreign banks. In this context, further development of non-bank financial institutions (NBFI), such as insurance companies and capital markets, is particularly important as they may offer the potential o f a broad array o f intermediary services and instruments currently unavailable from most banks. 58. The recent IPFMA report significantly improved our understandings o f the sequence and needed measures to strengthen the fiduciary environment. The IPFMA suggests that despite the recent public disclosure o f basic fiscal and budget execution data, the lack o f transparency and operating checks and balances in public finance still appear to be an overarching problem in Serbia and the fiduciary risk associated with the PFM system i s high. Although significant steps have been taken towards strengthening PFM, such as modernization o f the interim treasury system, the establishment o f an internal audit and the adoption o f the law on the state audit institution inNovember 2005, a lot remains to be done. This includes strengthening transparency and accountability in PFM, strengthening SAI, and continuing strong Government leadership o f the ongoing reforms requiredto bring Serbia on par with other EU-aspiring countries inthe region. IV. THE PROPOSEDPROGRAMMATIC PRIVATE AND FINANCIAL DEVELOPMENT POLICY LOAN OPERATION DESCRIPTION 59. The PFDPL is the first o f three development policy lendingoperations in the private and financial sector stream o f DPLs envisaged under the FY08-11 CPS. The operation is designed to enhance business environment, continue strengthening fiscal discipline in the enterprise and energy sectors and build a more efficient and stable financial sector by putting inplace a well targeted set of key, irreversible structural reform measures through the above three pillars. 60. The business environment (or first) pillar aims to: (i)further simplify regulatory requirements and compliance costs for the business entry and operations, including business registration and procedures for obtaining construction permits, (ii)enhance the legal framework for strengthening corporate governance, and (iii) strengthen institutional capacity and regulations for ensuring competition. The fiscal discipline (or second) pillar will support: (i)further reductionof subsidies and staffing levelsat SOEs andpublic utilities, thereby facilitating their restructuring and ultimate resolution through privatization or, in some case, 16 bankruptcy, as well as putting government finances on a more sustainable basis, (ii) continuation of reforms inthe energy sector. The financial sector (or third) pillar i s to support: (i) substantialdivestmentofthegovernment's remainingholdingsinthebankingand the insurance industries; (ii)strengthening of the banking and insurance sector regulation and supervision regime; and (iii) progress inthe development o f the capital markets. 61. A summary o f agreed PFDPL actions are included inthe Policy Matrix and the agreed prior actions are featured in Box 2 below. The overall program outcomes envisaged through the FY07 CAS period are featured inthe last column o f the Policy Matrix. Box 2. CorePriorActions for PFDPL The following constitute the prior actions for presentation o f the Loan to the Bank's Board of Directors: 1. The GoS has adopted the principles for consolidating business registration procedures related to issuance o ftax, pension, and social security identification numbers inthe SBRA. 2. The GoS has adopted a strategy for the implementation o f a comprehensive review of regulations governingbusiness activities ("regulatory guillotine "), 3. The GoS has offered for sale, or initiated the search for a strategic partner to take over the core assets of two o f its largest recipients of state subsidies. 4. The GoS has enacted the amendments to its Privatization Law (dated December 26, 2007) setting December 31,2008 as the deadline for launching the privatizationprocess o f SOEs. 5. Starting September 1, 2007, the PA has: (a) offered for sale, through tenders, at least 40 socially owned enterprises and sold at least 15 o f them; (b) offered for sale, through auctions at least 350 SOEs, and sold at least 40% o f them; (c) offered for sale at least 7 SOEs from the list o f companies under restructuring or companies of which a significant part thereof is under restructuring, using as applicable, tender, auction and asset sale procedures, and sold at least 4 SOEs from the said list. 6. The Budget of the Republic o f Serbia has beenenacted including a budget allocation for its SA1as a separate line item. 7. The GoS has transferred adequate funds for the initial capitalization o f its Deposit Insurance Scheme (DIS). 8. DDOR Drivatization has been comdeted, POLICY AREAS PILLAR I-EnhancingBusinessEnvironment 62. The improvement o f the business environment is anchored in several of the Government programs and is central to ensuring sustainable economic growth and poverty alleviation. The Poverty Reduction Strategy Paper for Serbia identifies job creation as one o f 17 the main avenues for poverty reduction. A better investment climate will encourage investment flows, thus contributing to export expansion and job creation. The privatization program and measures to strengthen fiscal discipline implemented in the last few years and supported by a number o f World Bank operations have increased productivity and freed up scarce government resources. However, future economic growth will depend on the emergence o f a more dynamic private sector and its sustainable development. 63. New sources o f growth will have to come from increased private sector investments, domestic and foreign, in both new and existing enterprises, and a more conducive business environment is vital. Serbia has already made substantial progress inthis respect, but the pace o f the reform slowed down in the period o f political instability and change o f government. However, the new government fully embraced the remaining priorities o f business environment reform agenda, as reflected in the new draft National Program for Integration with EU, and a number o freform initiatives got new impetus. 64. The proposed PFDPL operation will build on the earlier achievements and progress in the implementation o f the business environment reform agenda, focusing in particular on (i) further simplification o f business entry through implementation o f a single agency approach to business registration; (ii) developing legal framework for strengthening corporate governance and improving conditions for business operations; (iii) conducting comprehensive regulatory review to streamline regulations o f business operations and reduce business compliance costs; and (iv) improving legal and institutional framework for competition. Policy Area 1.1:Further simplification of the business entry through the implementation of single agency approachfor business registration 65. The recent progress with the implementation o f the comprehensive business registration reforms and institutional strengthening o f the Serbian Business Registers Agency (SBRA) was remarkable. In 2004, the authority for registering companies was transferred to the SBRA from trade courts and local administrative bodies. Previously, registering a company took 51 days, a minimum o f $5,000 o f founding capital, and the registration cost o f US$202. After the reform, total administrative procedures for registeringa company take 23 days (of which just 3 days for registration inthe SBRA); the minimumcapital requirement has been reduced to Euro 500 and registration costs to US$60. 66. Equally, the .institutional capacity o f the SBRA and its efficiency increased dramatically. In addition to the business registration, the Agency also maintains registries o f leasing deals, pledges, bankruptcies and liquidations. As a result, in the course o f 2007, 12,100 new companies were registered (compared to 6,329 in 2004). About 40 firms are registered every day with the number o f newly opened businesses rising at an annual pace o f 10%. At the same time the agency registers 150 new entrepreneurs every day, with 48,700 new registrations in 2007. A complete electronic database on business entities and entrepreneurs i s now fully functional. This created the basis for the electronic exchange of relevant data between all state institutions. 67. Despite these strong early results no major improvements were achieved during 2006 and 2007. The reform started to gain momentum again at the end o f 2007 and is fully supported by the new government. While Serbia has surpassed regional averages in certain business registration indicators, its performance i s still below best international standards. 18 Currently, after registering in the SBRA, businesses still have to visit the Public Revenue Office to obtain a tax number as well as both the pension and health insurance bureaus to register for social security. The GoS decided that the reform measures in this area should focus on transforming the SBRA into a one-stop-shop (OSS) for all procedures related to starting a business, including issuance o fthe tax number. 68. It is envisionedto implement the OSS concept for business registration intwo phases. During Phase I the focus will be on securing authorization that the SBRA performs all activities necessary to support starting a business. To this end, the Ministry o f Economy has prepared a proposal on a streamlined model, which would eliminate redundant forms, regulations, steps and processes and would merge the various informational requirements necessary to start a business. The Government has adopted the proposed model and once the necessary amendments to the relevant legislation are introduced, the SBRA will assignthe tax identification number. This reform measure will lead to a substantial reduction o f a number o f days required to start a business from 23 to 12 and reduce the number o f steps from 11to 8. In the medium term (Phase 2), the reform efforts will be focused on the introduction of a unique business identification number that will be used for all purposes. The SBRA advanced the reform implementation by (i) establishing cooperation with all relevant institutions; (ii) commissioning feasibility study and technical needs assessment for establishing interconnection o f all relevant public databases; and (iii)commencing unification o f registration procedures for entrepreneurs on a pilot basis. 69. Actions to be taken under the PFDPL:the Bank agreed with MoERD and MoF that the following measures will betaken under the timeframe o fthe PFDPL: The GoS has adopted the principles for consolidating business registration procedures related to issuance of tax, pension, and social security identification numbers inthe SBRA.; 70. Proposed actionsfor future PFDPL operations (triggers are bolded): 0 Amendments to the relevant laws and regulations are drafted and approved by the GoS, and incase o f laws submittedto the Parliament for adoption; 0 Introductiono f single identification number i s completed. Policy Area 1.2: Improving the legal framework for strengthening corporate governance andfacilitating business entry and operations 71. The GoS is committed to advance the reform measures aimed at making the existing legal framework more conducive for improvement o f corporate governance and facilitation o f business entry and operations. The agreed reform program includes amendments to several key areas o f the Company Law o f 2004, (the Law on Business Entities),which was adopted to make the legislation more clear and consistent with international business practices and to introduce modern concepts and provisions on corporate governance and protection o f investors. In the course of its practical implementation certain problems with its application and the areas that required additional regulation were identified. This relates in particular to the following areas: (i) corporate governance provisions, (ii) detailed regulation o f new forms 19 o f operation (such as branch offices o f foreign legal entities); (iii)clear and consistent regulation o f status changes (mergers, divisions). 72. Several key areas will require substantial improvements. First o f all, the Entrepreneurs Law still remains in force. It has not been harmonized with the Law on Business Entities and imposes burdensome registration requirements and other excessive regulations o f entrepreneurial activities. Unification o f all provisions regulating the establishment and the operation of entrepreneurs and companies, including explicit elimination o f all unnecessary requirements and thereby annulling and replacing the Law on Entrepreneurs entirely are required. Secondly, the Law on Business Entities allows for the establishment o f branch oflces offoreign legal entities, but several important issues related to their foundation, operation and ceasing the activities are not regulated. Thirdly, the legal form o f business association has been omitted in the existing Law, and therefore new business associations cannot be established, while the legal status o f already registered ones i s unclear. Fourthly, regulation o f complex forms o f business organization and operation (concern, holding, group o f companies) is not adequate. Inaddition, status changes (mergers, divisions) regulations lack consistency and clarity. 73. The Ministry o f Economy and Regional Development established expert working group that drafted amendments to the Company Law covering inter alia the following areas: (i)enhanced corporate governance provisions, (ii)detailed regulation of new forms of operation; (iii) clear and consistent regulation o f status changes; (iv) explicit elimination o f all unnecessary requirements for the establishment and operation o f entrepreneurs and companies, sunset provisions for the Entrepreneurs Law. Once finalized, the amendments will be subject to broad public consultations. At the same time, the Ministry o f Finance has preparedamendments to the Law on Securities to address some immediate concerns raised by the industry representatives; it i s also planning to undertake a comprehensive review o f Securities and Takeover Laws inthe next few months. Therefore, it i s important to ensure full coordination indrafting amendments to these laws. 74. Actions to be taken under the PFDPL:the Bank agreed with the MOERD that the following measures will be taken under the timeframe o fthe PFDPL: 0 Amendments .to the Company Law, including those substituting for the Law on Entrepreneurs are drafted inclose coordination with review of Securities legislation. 75. Proposed actionsfor future PFDPL operations (triggers are bolded): 0 Amendments to the Company Law, includingthose substituting for the Law on Entrepreneurs, are approved by the GoS and submitted to Parliament for adoption; Amendments to the Company Law are enacted. Policy Area 1.3: Streamlining Regulations of Business Operations and Reducing Business ComplianceCosts 76. By introducing a Regulatory Impact Analysis (RIA) requirement into the legislative process, the GoS took measures to ensure that the introductiono f future regulatory regimes i s 20 based on a clear, rationale, and proper analysis of costs and benefits, and includes appropriate consultation with affected stakeholders. The proper implementation of RIA will ensure the quality of new regulations - the legislative flow, which has a particular importance in the context of legislation harmonization with the EU requirements. To support capacity building in this area the Council for Regulatory Reform with the support of the Bank and Swedish International Development Agency is implementing RIA project. 77. However, it i s impossible to create a secure and transparent legal environment without dealing with existing stock of legislation. In order to tackle this issue, the MoERD proposed to conduct a comprehensive regulatory review of existing regulations known as a "regulatory guillotine", a technique that can speed up the process of reviewing, eliminating, and streamlining unnecessary outdated regulations. To initiate the reform a set of Principles which will determine a timeline and institutional framework for the implementation of a comprehensive regulatory review has been developed and approved by the GoS. This document has defined the approach to the "guillotine" implementation, its scope, required resources, and will help to build consensus regarding the reform within the government and gain support of other key stakeholders. 78. Procedures related to obtaining planning and construction permits and the associated costs remain the most burdensome constraint for business development, in this area Serbia ranks worse than most other countries of the world. The GoS demonstrates commitment to streamline the proceduresrelated to obtaining planning and construction permits and to reduce related compliance costs. Building on the work supported by Austrian, German and Swiss donor agencies and local experts, the Ministry of Infrastructure and other local counterparts continue working on a set of draft Laws on Urban Planning and Construction. This area of business regulations will definitely benefit from comprehensive regulatory review as a part of the proposed"guillotine process." 79. Based on the consensus built around the Principles for the implementation of the regulatory "guillotine," it is expected that a comprehensive regulatory review of existing regulations will be carried out in 2008-2009 and the required amendments to laws and regulations will be introduced, includingthe regulatory framework for obtaining planning and construction permits. These reform measures would lead to dramatic simplification of the regulation of business activities and decrease inthe regulatory compliance costs. 80. Actions to be taken under the PFDPL:the Bank has agreed with the MoERD and MOF that the following reformmeasures will betaken under the timeframe of the PFDPL: 0 The GoS has adopted a strategy for the implementation of a comprehensive review of regulations governingbusiness activities("regulatory guillotine").. 81. Proposed actionsfor future PFDPL operations (triggers are bolded): 0 Comprehensive review of regulations of business activities ("regulatory guillotine") i s underway; Comprehensive review of regulations of business activities ("regulatory guillotine") completed, the results reflected inlegislativehegulatory amendments. 21 Policy Area 1.4: Improving legal and Institutional Frameworkfor Competition 82. The GoS has taken some important steps to protect consumers and strengthen the competitive environment by adopting a new Competition Law in 2005. However, the implementation o f this Law has proven problematic. Three years after implementation all local counterparts agree that this Law has several important deficiencies which need to be tackled, including: (i) time required for a merger, which contradicts the privatization law the takeover procedures; (ii)unclear delineation o f responsibilities amongst the Competition Commission, the Privatization Agency and the NBS; (iii)the very low thresholds for concentration o f capital notifications - requiring almost every mergerhale/ tender to have to undergo scrutiny by the Commission; (iv) strengthening institutional arrangements; and (v) the basis for notification fees and applicable fines should be clearly defined so as not to lead to prohibitively highcompliance costs. 83. The Ministry o fTrade and Services has ledthe work on preparingthe amendments to Competition Law which addressed the described priorities, and the proposed amendments were approved by the previous government. However, due to the new parliamentary elections the procedure requiredanother GoS approval o f the proposed amendments. Instead, the GoS has, with the assistance o f European Agency for ReconstructiordEuropean Commission, opted for a more ambitious approach o f drafting a brand new law which would include all o f the previously drafted amendments and eliminate additional deficiencies in order to ensure effective implementation o f the legislative provisions. The new Law i s expected to address all major business concerns and to be fully in line with EU standards. In addition to the new Law, two other secondary regulations are being drafted - on block exemption on horizontal and vertical agreements - which should be adopted following the passage o f the new Law. Finally, further capacity building o f the Commission for Protection o f Competition remains a part o f a medium term reform objective as well. The Bank team expressed its readiness to comment on the draft Law and secondary regulations prior to their approval by the Government, and subsequent adoption inthe Parliament. 84. Actions to be taken under thePFDPL: New Competition Law i s drafted and submittedfor approval to GoS. 85. Proposedactionsfor future PFDPL operations(triggers are bolded): 0 New CompetitionLaw is submittedto Parliamentfor adoption; 0 Regulations andby-laws required for Competition Law implementationare drafted and approved by the GoS. PILLAR I1 Strengtheningfinancialdiscipline - 86. Under PPFDPC-1, the GoS took important steps towards strengthening of financial discipline in enterprise sector. The proposed operation will build upon and expand the PPFDPC-1 agenda in this crucial area, focusing on: (i)the further reduction of direct and indirect subsidies; (ii)accelerating restructuring, privatization and, where applicable, bankruptcy and/or forced liquidation o f socially-owned enterprises; and (iii) continuation o f the unbundlingand restructuringo fpublic utilities. 22 Policy Area 2.1: Reduction in direct and indirect subsidies 87. Diagnostic. The GoS continues to provide substantial financial support to the enterprise sector. Despite their operating losses, many socially-owned enterprises on the restructuring list continue to survive largely because they benefit from both direct and indirect subsidies, extended by the state and state-controlled entities. The direct subsidy i s drawn from the annual allocation in the state budget, which is administered by the Ministry o f Economy. Generally, it is used by SOEs for supporting current operations and clearing arrears rather than investment. The indirect subsidy can take many forms: non-payment or partial payment o f taxes; arrears to state-owned utilities such as EPS and NIS; arrears to public funds on pension, social security, and unemployment contributions; and "soft" loans extended by the state-controlled banks. While it i s difficult to measure indirect subsidies with any precision, a crude analysis o f the financial statements for sixty SOEs undergoing restructuring process suggests that in 2004 they amounted to nearly Euro 200 million, thus dwarfing the direct (MOE) subsidy extended to these SOEs over the same period (Euro 53.9 mln). 88. It is important to note that both the direct and indirect subsidies are concentrated in just a handful of SOEs on the Government's restructuring list4. In 2004, the top twenty subsidy recipients accounted for more than 80 percent o f the combined direct and indirect subsidies extended to the SOEs in restructuring. Two o f the largest remaining SOEs, car maker Zastava Group and miningcomplex RTB Bor, absorbed more than a quarter o f the total subsidy envelope over the past several years, with roughly half o f this figure coming in the form o f direct support fromthe MOE. 89. Government Actions. The GoS i s aware o f the subsidies' pernicious effect, and i s committed to strengtheningthe financial discipline inthe SOE sector. Under the framework o f PPFDPC-1,the 2006 state budget allocation for MOE direct subsidy to SOEs was reduced to RSD 3.85 billion in the 2006 budget and further reduced to RSD 3.1 billion in the 2008 budget, down from RSD 5.0 billion in 2005. In addition to working on privatization o f socially-owned enterprises, the GoS has also formally initiated privatization o f two state o w e d companies, namely underground coal mining enterprise PEU Resavica, and national airline company JAT Airways. While PEU Resavica i s still in the preparation stage, the tender for JAT Airways has been announced but no bids were received. The government has also announced that it will initiate minority/majority privatization o f other state-owned companies, thus contributing to their efficiency. It is important to note that this initiation o f privatization o f state-owned companies i s a positive reform signal, since a lot o f state-owned companies are not performing well and are heavily dependent on GoS assistance. However, this process may be delayed due to the current financial crisis. 90. In parallel, the GoS contributes to the improvement o f financial discipline in the enterprise sector through implementing an ambitious program of public sector reforms. The adoption o f a value added tax (VAT) in 2005, accompanied by measures to strengthen the public revenue service, have resulted in better tax collection. The resolute privatization o f state-owned holdings inthe banking sector has all but eliminated the practice o f concessionary loans used to prop up failing SOEs, which had a long history in Serbia. Finally, as part o f its For more details related to the companies inrestructuring please refer to paragraph 99 23 restructuringprocess, EPS has increased its overall collection rates from 86.7 percent at end- 2003 to more than 90 percent as o f end-2007. At the same time, EPS' collection rates for the group o f SOEs inrestructuring reached only 60 percent in 2005, equivalent to almost RSD 2 million inaccumulated arrears. 91. Bank's Assessment4lecommendation. The existence o f subsidies not only contributes substantially to the fiscal deficit, it also represents a significant obstacle to restructuring and resolution through the sale or bankruptcy of the loss-making SOEs. The direct and indirect support provided by the state allows the management and employees o f poorly performing enterprises to postpone the painful restructuring, thereby releasing non-core assets to higher productivity users. At the same time, the entry and market access o f private firms are crowded-out by un-restructured SOEs that continue to function in a soft budget environment. 92. Inaddition to MOE's visible direct subsidies, some SOEs are able to bypass the hard budget constraints through an increase in liabilities (taxes, wages, pension contributions, utilities bills, etc.). These types o f indirect subsidies represent a much greater (and more difficult to measure) source o f fiscal burden, which is ultimately more damaging in the long run. Accumulation of arrears from SOEs undermines the solvency ofpublic institutions, such as the pension fund andthe national health-service. Inthe case o fpublic utilities such as EPS, the unpaid liabilities result in higher cost o f services and deprive the companies o f financial resources for much-needed modernization. 93. It is thus crucial for the resolution of the remaining SOEs that the GoS systemically addresses the financial discipline problem by closing off the actual and potential sources o f direct and indirect subsidies at the same time. In this respect, the team anticipates that the continuation of public sector reform, particularly state-owned utility companies, will help reduce the supply o f subsidies. However, both regional and global experiences provide ample evidence that the soft budget problem will persist for as long as there exists the demand for state support in the form o f loss-making, inefficient SOEs. Given the high concentration o f subsidies among a group of a few large enterprises on the restructuring list, it is thus imperative that the GoS accelerates the resolution o f these worst offenders o f financial discipline through privatization or bankruptcy. 94. Inthis regard it is important to underscore that over the past three years the GoS has shown consistent commitment to resolution o f top subsidy recipients. Since October 2005, the GoS has offered for sale through the PA of 17 SOEs from the list of top 20 recipients o f combined direct and indirect subsidies, and sold nine o f them. In addition, one large SOE from this list has been placed into bankruptcy after all attempts at sale failed. Most significantly, the GoS has made substantial progress in identifying strategic private investors for the core assets o f Zastava Group and RTB Bor, the two largest subsidy recipients in the SOE sector. Infact, the GoS has signed a strategic partnership agreement on Zastava with the Italian car maker Fiat, andlaunched a tender for a strategic partnership for RTB Bor. 95. Actions to be taken under the PFDPL:Based on the above analysis and the discussions with the MOF, MOERD, andP A counterparts, the Bank has agreed with GoS on the following measures: 24 0 Reduction inthe direct MOERD subsidy to SOE sector inthe 2008 budget to RSD 3.1 billion (0.1 1 YOo f GDP) from RSD 4.1 billion (0.19 % o f GDP) in2006; 0 The GoS has offered for sale, or initiated the search for a strategic partner to take over the core assets of two of its largest recipients of state subsidies. 96. Proposed actionsfor future PFDPL operations (triggers are bolded): Reduction in the direct MOERD subsidy to the SOE sector in the 2009 budgets to RSD [ ] billion (0.xx YOof GDP) from RSD 3.1 billion (0.11 % of GDP) in 2008 budget; 0 The GoS will offer for sale the third largest recipient of state subsidies; Registry o f recipients o f state aid i s established within the SBRA and fully operational. Policy Area 2.2: Privatization, Restructuring, and Bankruptcy of Socially-Owned Enterprises 97. Diagnostic. At the core o f Serbia's enterprise sector reform strategy over the past seven years has been the ambitious program o f privatizing socially-owned enterprises (SOEs). The principles o f the approach are laid out in the Privatization Law o f June 2001, which incorporated international best practice and lessons learned from other transition economies. The principle lesson drawn from experience o f other transition countries was that privatizations that put core, dominant investors in charge o f the firms worked better, from a variety o f viewpoints, then those that passed ownership to diffused, inexperienced groups o f workers or citizens. The law thus stipulated three methods o f privatization: (i) tenders o f large enterprises, offering to a strategic investor at least 70 percent o f the shares; (ii) auctions o f medium-sized enterprises; and (iii)restructuring and subsequent tenders and/or auctions o f large loss-making enterprises and/or partsthereof. 98. The selected privatization model was aimed to overcome the problems which arose from the voucher-privatization model implemented in many other transition countries in Eastern Europe; it was more conducive to improving corporate governance and real sector efficiency, attracting foreign capital and technology, and ultimately fueling Serbia's economic growth. Finally, a significant amount o f time was devoted to development o f the necessary regulatory framework, institutional capacity building, and preparation o f companies for privatizationprior to actually offering them inthe market. 99. Despite the impressive progress to date, the process o f ownership transformation i s not yet complete. As noted above, the financially (and politically) damaging role o f the SOE sector inthe Serbian economy i s highlighted by the continued prevalence o f direct and indirect subsidies and soft budget constraints. The core o f the problem was in some 80 loss-making, heavily indebted industrial conglomerates, which have been selected by the authorities, to undergo organizational and/or financial restructuring under privatization through restructuring method specified inthe Privatization Law, as they could not be sold intheir current condition. Over the past three years significant progress was achieved with successful resolution o f 30 o f these enterprises. 25 100. Government Actions. Between 2001 and 2005, the Privatization Agency (PA), supported by the Bank at both policy and technical level, achieved significant progress in implementing the Government's privatization program. By the end of 2005, more than 1,200 SMEs hadbeen sold inauctions andcirca 60 large enterprises were sold through tenders, most of them to international strategic investors. Notwithstanding the difficult political environment, the overall scope, pace and transaction quality of these privatizations compared favorably to similar stages of reform in other transition economies. Further, the progressive trend has continued after the 2005, as reflected in the following table exhibiting results from the period immediately following the previous operation (PPFDPC-1) as well as the results achievedunder the current project (PFDPL): Oct.1/05 Aug. 31/ - Sep.l/07- Aug.31/ Total for 07 os Oct.1/05 -A~g.31/07 Auctions 377 284 661 Tenders (incl. restructuring) 43 17 60 Restructuring 16 4 20 Total 420 301 721 101. Overall, as of end-November 2008, Serbia has privatized over 2,400 companies, ensuring improved corporate governance and significantly eliminating the demand for of subsidies, and realized nearly EUR 2.9 billion inprivatization revenues since 2002. Further, new owners have pledged nearly EUR 1.4 billion in investment plans, and over EUR 276 million in social programs, thus contributing both to future economic growth and social cohesion. It is important to note that the rate of privatization has not slowed down significantly, despite the fact that the current PA portfolio is of much'lower quality than in early years of privatization. As an illustration, the PA has beenselling enterprises via tenders and auctions at an average rate of 18, 55, 21, 28, 26, and 34 enterprises per month in 2002, 2003, 2004, 2005, 2006 and 2007 respectively. During the first two quarters of 2008, the average monthly sales rate has stood at 24 enterprises a month. 102. As stipulated in the recently amended Privatization Law, the GoS is committed to offering for sale all SOEs currently in the PA tender and auction portfolio, and all saleable assets from the restructuring portfolio, by end-2008. Inparallel, the SOEs that have failed the market test through tender or auction three times will be subject to bankruptcy under the improved insolvency regime. All unsold SOEs remaining inthe PA portfolio after the end of 2008 will be subject to compulsory liquidation. 103, Auctions. The GoS is committed to complete the very successful auction privatization program started in 2002. Some 750 SOEs remained on the'books of the PA's Auction Center as of September 2008, includingalmost 300 enterprises that have beenclassified as candidates for bankruptcy and/or liquidation. The current management of the PA has strengthened the processing capacity of the Auction Center which resultedinmore companies being offered per sale every month, and a higher success rate. 104. Tenders. Bringing reputable strategic investors through the tender process for the relatively attractive SOEs remains a priority for the GoS. At the moment there are 89 SOEs are left in the PA's tender pipeline, including the non-core assets spun off from state utilities. 26 With the help of TA funding, provided by the Bank and EAR, the PA has engaged experienced financial advisors to prepare and execute tenders for these enterprises. 105. Privatization through Restructuring. Completing the restructuring o f large loss- making SOEs, andtheir subsequent divestiture through, as applicable, tender, auction, or asset sale procedures, constitutes one o f the Government's key challenges. Assisted by the financial advisors hired through the Bank and the EAR TA funding, the P A has been puttingto market test most o f the SOEs on the restructuring list. The restructuring process has been given a major impetus by the passage (in Spring 2005) of the debt restructuring amendments to the Privatization Law, supported under PPFDPC-1. The amended law made possible the use o f debt write-off by the state and state-controlled creditors against the future sale proceeds, to enable the privatization o f heavily indebted large SOEs. To avoid generating moral hazard, the debt restructuringwill become effective only at the moment o f sale. As a result, core assets of at least 30 SOEs from the restructuring list were sold over the past three years. 106. At the same time, in order to facilitate privatization and to mitigate the social cost of the lay-offs resulting from the decreasing subsidies, the authorities continue to use the Transition Fund (TF) resources to address the problem o f surplus labor at large SOEs. The TF5represents a budgetary item which received a RSD 7.3 billion budget allocation in 2008, as opposed to RSD 6.5 billion and RSD 9.95 billion in the 2006 and 2007 budgets, respectively (a more detailed description o f the social assistance options supported by the TF can be found in section VI, Poverty and Social Impacts). Experience has shown that the necessary labor shedding needs to occur before privatization because the levels o f surplus labor in large SOEs risk deterring investors altogether, or reducing the cash price offer to a politically unacceptable level. It i s important to note the difference between the Government's subsidy program and the severance payment financed by the TF: the former represents a recurrent burden on the budget, the latter i s a one-time payment which allows companies to decrease their labor force and wage bill, thus leading to a reduced subsidy need and ultimate resolution of the enterprise. Finally, it i s important to note that Transition Fund, as it name suggests, was set up as a temporary vehicle to assist the redundant workers during the privatization process to finance their salaries, contributions/taxes, retraining and/or severance payments, thus facilitating the enterprise sector reforms. After the privatization process i s over, which will last for the next few years, this Fundwill be no longer needed. 107. Bankruptcy of SOEs. Having an effective bankruptcy instrument is a prerequisite for successful enterprise restructuring, and for the establishment of hard budget constraints with regards to the SOE sector. The implementation o f the new bankruptcy law started on February 1, 2005 and the progress to date is encouraging. As o f end 2007, 392 bankruptcy administrators have been trained to apply the new law and have received licenses. The Bankruptcy Unit (BU) has been established within the P A to act as the bankruptcy administrator o f insolvent socially- and state-owned enterprises. By end-September 2007, the BU had more than 360 SOEs in its portfolio, two-thirds of which represented cases opened under the newlaw. 108. The Governmentfaces two major problems inits efforts to implement the Bankruptcy Law. First, although the PABU can prepare a plan for restructuring and privatization through bankruptcy, it does not have the authority to initiate the formal bankruptcy process. As in any Inreality, the "Transition Fund" is not a fundas it does not have either capital or personnel. 27 market oriented bankruptcy regime, the creditors are authorized to petition the courts and to initiate bankruptcy proceedings against insolvent SOEs. However, few state creditors have exercised this right over the first two years o f the new law's life. Another major problem i s the insufficient (although improving) capacity o f the commercial courts to decide on the resolution o f bankruptcy procedure. To resolve first obstacle, the Government plans to appoint dedicated bankruptcy units within state creditor bodies that would be capable o f initiating and monitoring the bankruptcy process for multiple SOEs. In sum, the MoF i s committed to take clear actions to speed up the initiation o f bankruptcy procedures against unsaleable enterprises remaining inthe PA's portfolio. Inaddition, the recent amendments to the Privatization Law provide for the option of a "forced liquidation" by the PA of companies that do not start the privatization process by the endof 2008 incases where: (i) announcement o f public tendedauction has not been published; (ii) the company (capital/assets) was not sold even after the third attempt (tendedauction); and (iii) the entity subject to privatization if failed to submit its financial report to the business registration agency for two years in a row. This new provision o f the law may require adopting by-laws regulating forced liquidation procedure. 109. Distribution of Shares to the Public. According to the 2001 Privatization Law, 70% o f a company offered on tender was to be sold to a strategic investor to ensure sound corporate governance, 15% was given to the workers (which in the Yugoslav model were de facto owners), and 15% was designated for citizens who did not receive gratis shares as employees of companies. Under the recently enacted Law on Citizens' Rights to Gratis Shares and Cash Benefits inthe Privatization Process (hereinafter Law on Gratis Shares), those shares allocated for the public (15%) in the industrial companies sold in tenders to date and held by the Privatization Register are being sold in the market, and the proceeds will be distributed in cash to the citizens entitled under that law. The Law on Gratis Shares (Article 12) provides that the sale o f those shares will be conducted in an open and transparent manner by competitive biddingto obtain the best prices for the citizens. 110. The Law on Gratis Shares further provides that 15% o f the capital allocated for citizens in the six large public utilities (NIS, Telekom Serbia, EPS, JAT, Airport, Galenika) will be distributedto the eligible citizens. However, in view of the high value of the large public utilities, the Government succeeded in convincing the trade unions to agree to the provision in the Law on Gratis Shares which reduced the gratis allocation to present and former employees o f those enterprises: they agreed to receive free shares inthe value o f EUR 200 per year o f service (for a maximum o f 35 years o f service) which i s expected not to exceed 2.5% o f shares inpublic enterprises, incontrast to 15% inthe other enterprises. 111. Privatization of state-owned enterprises. The corporatization and eventual privatization o f public utilities i s a major challenge facing the Government in next several years. The Government i s now selling 51% o f shares inNIS to a strategic investor, while its attempt to sell majority stake in JAT has recently failed as no bids were received. Further,the government i s planning to sell majority stake in Galenika as well, and to offer shares o f Telekom Serbia, EPS, Airport, and perhaps other companies, through an initial public offering. These planned actions require these public enterprises first to be converted into companies through an incorporation process. Finally, the ongoing global financial crisis may delay the implementation o f these plans. With Bank's assistance the government is, currently starting a project to incorporate the state-owned companies and to amend the Law on Assets 28 of the Republic of Serbia adopted during the 1990s which created a legal anomaly stripping the state-ownedenterprises of their assets. 112. Bank AssessmenZlRecommendation.Notwithstanding impressive overall progress to date, the following issues remain to be addressed by the GoS: (i) completing the tender and auction privatization program for SOEs currently in the PA's portfolio, with the objective to offer for sale all saleable enterprises by end-2008; and (ii)using the improved bankruptcy regime andthe powers of state-controlled creditors to resolve SOEs that fail the market test. 113. Actions to be taken under the PFDPL: To this end, the Bank has agreed on the following privatization and bankruptcytargets with the GoS and the PA, to be achieved inthe timeframeof PFDPL: The GoS has enactedthe amendments to its PrivatizationLaw (dated December 26, 2007) setting December 31, 2008 as the deadline for launching the privatizationprocessof SOEs;; 0 The Law on Citizens' Rights to Gratis Shares and Cash Benefits inthe Privatization Process i s submittedto the Parliament; StartingSeptember 1,2007, the PA has: (a) offeredfor sale, throughtenders, at least 40 socially owned enterprises and sold at least 15 of them; (b) offered for sale, through auctions at least 350 SOEs, and sold at least 40% of them; (c) offeredfor sale at least7 SOEs from the list of companies underrestructuringor companies of which a significant part thereof is under restructuring,using as applicable, tender, auction and asset sale procedures, and sold at least 4 SOEs from the said list;; Starting on September 1, 2007 Republic of Serbia-owned or controlled creditors will request the courts to initiate bankruptcy proceedings for: (i)at least 20 SOEs that have unsuccessfully been offered for sale through auction; and (ii)at least 2 SOEs that have unsuccessfully been offered for sale twice through tender; MOERD approves a transparent and competitive procedure, acceptable to the Bank, for the sale of shares from the Privatization Register proposed by Share Fund. 114. Proposed actionsfor future PFDPL operations (triggers are bolded): The Law on Assets of the Republicof Serbia is repealedand a new Law on Public Property returning ownership of assets from the Republic of Serbia to public enterprises/municipalitiesis approvedby GoS, and submittedto the Parliament; Strategy for privatization of municipal enterprises is approved by GoS; To facilitate the participation of government creditors in initiating companies' bankruptcy, specialist Bankruptcy units will be created within the Tax Office, Public Prosecutor's Office and other State creditors, with the right and power to represent the State's claims including filing, voting, negotiating, and agreeing their claims with the Bankruptcy Administrator; 29 0 New BankruptcyLaw is draftedand submittedto GoS for approval; The sale of shares of socially owned enterprises in the PR shall be conductedin accordancewith the proceduresestablishedby the MoERD; O f the 340 "real" cases inthe PABU portfolio as o f June 30,2007 (with the exception o f reorganization) all the assets inmore than 85% o f cases will have been sold; All companies with 51% or more social capital whose auctiodtender has not been announced by December 31,2008 will be subject to forced liquidation by December 31,2009; Regulation in place to support the Bankruptcy Supervision Agency to implement a system of oversight and discipline, including de-licensing and lesser sanctions, of bankruptcy administrators. Policy Area 2.3: Energy Sector Reform 115. Serbia has a comprehensive energy industry controlled by state-owned companies: EPS is in charge o f virtually all the power generation and distribution; EMS is the power transmission company; N I S controls domestic production o f oil and gas, two refineries, and petroleum products distribution systems including gasoline stations (largest operator); Transnafia undertakes oil transportation; and Serbiagas i s one of two transmission companies for natural gas. Serbian oil and gas reserves and production are small; coal reserves and production are substantial. Domestic power production largely meets domestic demand for the time being, and gas is imported from Russia. An import banfor petroleum products, expiring at the end of 2010, gives market protection to the two refineries. 116. Over the past few years, the Serbian energy sector has undertaken a considerable amount o f investments; partially donor funded, and has, in the case o f electricity, made progress in improving the supply system to a level that allowed reconnectionto the European interconnected power network (UCTE) in 2004. In 2005, Serbia joined the EU-supported Energy Community of Southeast Europe. The power and gas sectors have recently been structured in compliance with EU's internal market regulations, i.e. transmission functions have been separated from production, distribution, and sales activities. A regulatory agency for energy was established in2005. 117. The Serbian government gives considerable weight to energy security. Therefore, in January 2008 an intergovernmental energy agreement was entered into with Russia. The agreement, which establishes a framework for subsequent negotiation o f detailed agreements, provides for the building o f a large transit pipeline for Russian natural gas across Serbia. The agreement further involves the sale of a majority o f shares in N I S to Gazprom, a majority state-owned Russian oil and gas company. Furthermore, Russian financial support in developing gas storage in Serbia i s part o f the framework agreement. 118. One o f the major and costly challenges facing the Serbian energy sector i s the replacement o f retiring power generation units and the addition o f new generation capacity to meet increasing national and, potentially, regional demand for power. In agreement with the 30 Bank under this PFDPL operation, the government will decide through its approval of EPS' Business Plan 2008-2012, on a strategy and time-bound action plan inwhich the private sector would take majority control of and manage major power generation assets to be built during the coming 5-7 years. The Bank considers this an important step in the direction of creating a more competitive market environment inthe power sector of Serbia and the region. 119. NIS refineries in Pancevo and Novi Sad are uncompetitive until major investments can be undertaken. The government keeps the refineries in operation through market protection inthe form o f a temporary import ban on petroleum products. The government has agreed under this PFDPL that the lifting of the import ban and the introduction of full, open competition inpetroleum products shall take place no later than December 31, 2010. 120. End-user tariffs for electricity and gas have been raised significantly over the last several years but are not yet covering costs, and payment collections of only about 80 percent from household electricity consumers add to the financial strain in the sector. The government recognizes the substantial financial requirements to maintain gas and power systems, to undertake environmental investments, and to expand supply capacities. It has therefore agreed, in the context of this PFDPL, to implement gradual tariff adjustments to reachcost-recovering tariffs for electricity and natural gas no later than in20106. 121. The government and the management of EPS recognizes that the power utility will have to enhance its operational efficiency and undertake some further restructuring inorder to utilize its resources in the best possible way and to prepare for the competitive pressures in generation and marketing that are emerging in the Energy Community of South East Europe. A major efficiencyhestructuring study has been undertaken for EPS by international consultants. Guided by such expertise, the government plans to adopt a strategy and time- bound action plan to restructure and improve operational efficiency of EPS, also with the facilitation of private sector participation in the power sector in mind. Finally, EPS management board has endorsed 2008-2012 business plan in July 2008 and sent it to the MinistryofMiningandEnergy for GoS approval. 122. Pollution from the consumption of low quality petroleum products i s considered a serious problem in Serbia. In 2008, the government plans to develop a timed action plan for introducing EU-basedpetroleum product quality standards and to agree with the Bank on such a planunder the 2009 follow-up operation of the PFDPL. 123, Actions to be taken under the PFDPL: 0 The Government has developed a strategy and time-bound action plan for private sector to invest in, take majority control of, and manage assets inpower generation; 0 The Government has committed to fully remove obstacles to competition in refined petroleum products no later than by December31,2010; 0 The Government has committed to undertake gradual annual tariff adjustments in order to reachcost-recovering tariffs for power and gas no later than in2010. Although Serbiahas establisheda regulatory agency for energy, the SerbianEnergyLawprovidesthe Governmentwith the authority to approveadjustmentsto electricity andgas tariffs. 31 124. Proposed actionsfor future PFDPL operations (triggers are bolded): 0 Request for a proposal has been issued for at least one new thermal power plant; 0 Tariffs for electricity and gas have been increased; 0 The Government has adopted a strategy and time-bound action plan, guided by international expertise, to restructure and improve operational efficiency o f EPS to facilitate private sector participation inthe power sector; The Government has developed a timed action plan for introducing EU-based petroleumproduct quality standards; 0 Financial closure achieved for at least one new thermal power plant; Satisfactory progress instrategy implementation (to be agreed upon). IndependentAudit Institution Policy Area 2.4: State Audit Institution 125. Budget System Law prescribes that final accounts will be subject to external audit. However, final accounts for the years 2002-2007 have not been audited. In order to register improvementsinthis area, the Law on state Audit Institution was adopted inNovember 2005 with a view to establishing an independent and competent body responsible for the audit o f public sector accounts. With some delay, a five member Council, as the highest body o f State Audit Institution (SAI), was appointed inlate September 2007 under provisions o fthe Law on SAI. According to the Law, the Council is obliged to submit to the Parliament operations manual, work program and annual plan within three months from the establishment o f the Council, hence the due date being late December 2007. Draft documents were submitted to the Parliamentbythe due date. The documents were reviewedbythe Bankand are found to be acceptable to our standards. A reasonable SA1budget was included as a separate line item in the 2008 budget of the Republic of Serbia and adopted by the Parliament. Further,the same policy has continued as reflected inthe 2009 draft budget o fthe Republic o f Serbia. 126. In the medium-term, reasonable progress should be made towards making the SA1 fully functional. This would include securing adequate premises and equipment, employing the sufficient qualified staff, adopting the Audit Manual specifying work methodology, training the core staff, and commencing audits in accordance with the program o f work submittedto the Parliament. In addition, audit of 2007 government accounts, performed by the SA1or its agent, should be submitted to the Parliament. Finally, full implementation o f the Law on State Audit Institution should be achieved, providing sufficient resources and capacity buildingfor the SA1to perform all o f its responsibilities and procedures inrelationto auditees covered by the Law. Corresponding to that, the audit o f 2008 accounts should be submittedto the Parliament. 127. Actions to be taken under the PFDPL: 32 0 The Budget of the Republic of Serbia has been enacted including a budget allocationfor its SA1as a separate lineitem. 128. Proposed actionsfor future PFDPL operations (triggers are bolded): The Government has submittedaudits of 2007 accountsto the Parliament; The Government has submittedaudits of 2008 accountsto the Parliament. PILLARI11 Buildinga moreefficientand stable financialsector - 129. Thanks to an aggressive reform program, supported by three World Bank lending operations, the banking and insurance sectors have grown sharply and undergone a fundamental shift in ownership. State ownership in banks and insurance companies has been significantly reduced to approximately 17.2% and 34% of total banking and insurance assets respectively. To complete the privatization of the sectors, the Management Board of the Deposit Insurance Agency (DIA - which i s also in charge of privatization of the financial sector) will approve a strategy for each bank and insurance company with state and socially owned capital. NBS has also taken steps to enhance market confidence by capitalizing the deposit insurance fund, strengthen the legal framework, and enhance supervision. Finally, in an effort to strengthen the capital markets regulatory and supervisory regime, the GoS has drafted amendmentsto the Securities Law. Policy Area 3.1: Resolution of state-owned banks (SOB) and the divestmentoffinancial assets (non-performing loans and equities) and deposit insurance capitalization 130. Privatization and the divestment of state-owned banks and financial assets have progressed substantially since PPFDPC-1 and, as a result, state's ownership of the banking sector has been reducedto 15 % oftotal banking systemassets as of end 2007. Going forward, the major challenge will be to sustain the privatization process, especially ina context where the banks left for sale are not as attractive as those that have beenprivatized inthe first rounds andthe crisis has driven investors from the financial sector. 131. A number of actions have beenundertaken by GoS inthe past couple of years. First, in2006, the DIA successfully completed the privatization ofthree banks.It sold 99.4% ofthe share capital of Vojvodjanska Bank to the National Bank of Greece, 87.39% of the share capital of Panonska Bank to San Paolo IMI from Italy, and 89.29% of Niska Bank to OTP Bank from Hungary. In the same year DIA sold 25% of Cacanska Bank and Komercijalna bank to EBRD. In accordance with the shareholders agreement, both shareholders will be selling their shares by 2009 and 2010 respectively. The shareholders also committed to implementing an institutional development plan inbothbanks untilthen. As a result RoS still has ownership in nine banks (see table 4 below), which account for 17.2% of assets, 20% of deposits and 15.9% of equity inthe banking sector. Secondly, in2007, DIA launchedthe sale of 6 packages of non-performing loans (NPLs) of bankrupt banks inthe total amount of RSD 433,424,670.38 and USD 35,342,978.93. Only one NPL package inthe total amount of USD 11,121,516.4 was sold for USD 1,107,000 in January 2008 while there were no offers for other NPL packages. Despite this, DIA will continue working on resolution of the remaining NPLs in its portfolio. Thirdly, in 2008, the DIA developed a privatization strategy for all the banks and insurance companies that still have state or socially owned capital. The strategy 33 proposed a three pronged approach for the sale of banks and insurance companies in which RoS has the majority shares, for banks inwhich RoS has the minority shares, and for banks in which RoS is a majority shareholder together with EBRD. Given the recent financial crisis and abrupt deterioration of global financial sentimenttowards the region, the Strategy is being updated to reflect recent market developments and available privatization and restructuring options. Majority ownership of Minority ownership of RoS JUBMES banka a.d. Beograd 21.11 8.33 29.44 PB Agrobanka a.d. Beograd 20.07 0.55 20.62 Majority Komercijalna banka a.d. Beograd 40.3 1 6.89 47.2 ownership of Cacanskabanka a.d. Cacak 38.84 4.46 43.3 RoS and EBRD 132. Finally, to increase market confidence, the government transferred RSD 700 million to the DIA and thus increased the capital of Deposit Insurance Fund to 1.18 percent of insurable deposits, against a set target of 5 percent. 133. Actions to be taken under the PFDPL: 0 Strategy for banks and insurance companies with ROS ownership i s developed; 0 Pre-qualification for bidders for second tender of non-performing loans of bankrupt bankscompleted andfinal offers solicited; 0 The GoS has transferred adequate funds for the initial capitalization of its Deposit Insurance Scheme (DIS). 134. Proposed actionsfor future PFDPL operations (triggers are bolded): 0 Strategy for banks and insurance companies with ROS ownership is finalized and approved by GoS; 0 Institutional Development plan for Postanska Stedionica Banka developed and approved; 0 Additional packageof non-performing loans of bankruptbanks resolved; 34 0 Thirdbank inwhich GoS has majority ownership offered for sale; 0 GoS shares inCacanska Banka offered for sale; 0 Institutional Development plan for Postanska Stedionica Banka i s being implemented accordingto the agreed schedule; 0 Resolution o f all 223 non-performing loans o f bankrupt banks completed. Policy Area 3.2: Strengthening the insurancesector regulation and resolution regime 135. The government and NBS have been effective to date inmoving the insurance sector reform agenda forward. Significant and substantive transformation marked the Serbian insurance sector in 2007. During this time, the market has experienced consolidation, increased share of foreign ownership, and significant growth. While the volume o f the gross insurance premium written (GPW) in2007 has increased from 38.3 to the estimated 45 billion dinars, the number of insurance companies active in the market declined from 40 to 21 (18 insurance licenses were revoked by the NBS, 5 companies undertook voluntary liquidation, there was 1 merger, 1 company transformed to a pension fund and 6 new greenfield licenses were issued). Currently, 13 out o f 21 insurers are foreign owned. With the completion o f the recent sale o f DDOR to Fondiaria (Italy), Dunav will remain the only government-owned company in the market, accounting for slightly over 30 percent o f the insurance premium written. At the same time, the quality o f the insurers' balance-sheets has seen considerable improvement. Further, the quality o f insurance supervision has improved as evidenced by the introduction of licensing requirements for insurance agents (128 institutional licenses were revoked and 154 new issued), the launch o f a comprehensive regulatory framework (20 by- laws were issued), improved market transparency and commencement o f pro-active on-site and off-site market supervision. 136. The matters still outstanding tendto involve multiple constituencies and will require a degree o f negotiation to finalize. Government's key achievements have been the privatization of DDOR, closure and liquidation o f more than a dozen insolvent insurance companies, significant achievements o f the turn around work in Dunav, including the completion o f an independent actuarial review o f its liabilities, introduction of centralized IT systems for cash and claim management and reorganization o f its business operations along functional lines, improved quality of insurance regulations and insurance supervision. 137. All regulations required under the new Insurance Law have now been produced and amendments passed to enable the privatization o f the socially owned insurers. In addition, a law dealing with bank and insurer bankruptcy and liquidation has come into force (No. 61/ 2005). The major outstanding piece o f insurance related legislation is the Motor Third Party Liability Law (MTPL). Key areas to be addressed before the MTPL Law can be finalized are the mode of funding o fthe MTPL Guarantee Fund.The MOF has provided a draft law to The World Bank which appears to be largely inline with current practice inthe region. 138. The other major challenge is the extent o f work required to maintain the competitiveness of Dunav prior to its privatization or at minimum, a sale of sizeable stake to a strategic investor. Actions taken to date by management have been successful so far in maintaining the company's market share and improving its profitability and solvency. To a 35 large extent, these noticeable improvements inthe financial performance of the company have been the result of a newly installed IT system that enable it to centralize cash and claims management and restructure its operations along functional lines. Yet, due to the growing competition from several private players with global brand names, the ability of the company to successfully compete is impaired by the lack of operational experience and appropriate IT systems that are neededto run a highly cost efficient distribution network enjoyed by several other players inthe market. 139. Aside from the adoption of a new MTPL Law and privatization (or a partial sale to a strategic investor) of the last remaining socially owned insurer, key outstanding matter relates to the liberalization of the reinsurance segment of the market, which can be facilitated by selling an equity stake inDunav Reto a strategic investor. 140. Actions to be taken under the PFDPL: 0 Run-offMTPL liabilities of bankrupt insurers have been computed and an action plan to fund the liabilities is developed; 0 MTPL Law has beendrafted and subjectedto public debate; 0 DDORprivatizationhasbeen completed; 0 Dunav's liabilities have beenfully quantifiedthrough an independent actuarial review; 0 Dunav's strategic restructuring plan is being implemented in accordance with the agreedperformance indicators. 141. Proposed actionsfor future PFDPL operations (triggers are bolded): 0 Run-off MTPL liabilities of bankrupt insurers have beenfunded; 0 MTPL Law has been approvedby GoS and submittedto the Parliament; 0 Privatization of Dunav Re through a sale of an equity stake to a reputable foreign reinsurerhas beeninitiated; 0 Preparation for sale of an equity stake in Dunav to a strategic investor has been initiated. Policy Area 3.3: Enhancingprudential supervision of the banking sector 142. To enhance prudential supervision a number of steps have been taken by the government and NBS. First a new Law on Banks became effective on October 1, 2006. The Law includes the introduction of a risk based supervisory approach and consolidated supervision; thus capturing many of the regulatory issues cited by the 2005 FSAP. The Law has been further supported by the adoptiodamendment of regulations. These included, inter alia, requirementson bank disclosure and pricing, `know your client' directives, updating of capital adequacyhegulatory solvency requirements, new guidelines on external auditing requirements, and updated guidance on conducting bank supervision. Recent additions 36 included procedures related to an updated supervision operating policy and the updating of corrective/remedial action procedures. New bank licensing procedures were also recently issued, as well as an IFRS-compliant chart of banking accounts for regulatory reporting and regulations on capital requirements for foreign exchange and other marketrisks. 143. NBShas also focused on improving and formalizing the processof supervision. First the concept and implementation of the bank supervisory cycle has been refined and the internal working procedures of bank supervision have been upgraded. Second, supervisory strategies and associated regulations are more frequently updated, and, together with recently adopted risk matrices, form an increasingly enhanced picture of each banks' risk profile. Third, the role and reliance on the internal Senior Supervisory Oversight Committee is increasing in stature and visibility, which in turn, assists in objective and informed supervisory decisions. Finally, the staffing levels have been augmented and staff has received more extensive training. 144. Additionally, new regulations on loan/asset classifications, bank liquidity requirements, and consolidated financial group reporting including the requisite capital adequacy requirementshave beenapproved. Actions to be taken under the PFDPL: The Key SDP and Regulatory objectives have been met. In particular NBS has: (i) disseminated an updated Supervision Operating Policy; (ii)revised the Manual on corrective/remedial actions; (iii) a new bank licensing manual; and a new IFRS issued compliant chart of accounts; (iv) issued capital adequacyrequirementsto cover market and forex risks; loadasset classification; and liquidity requirements; and (iv) introduced consolidated financial group reporting (andsupporting CAR regulations). Proposed actionsfor future PFDPL operations (triggers are bolded): TheNBShas finalized aBasel I1implementationroadmap; NBShas establisheda framework for-and first trial version of its Financial Stability Reporting; Bank stress tests are implementedbyNBSas anearly warning tool; Consolidated financial group reporting i s mainstreamedand supervision is coordinated across banks andnon-banks; TheNBS develops a strategy for homehost supervision includingcoordination on solvency and risk measures; NBSimplementsfinancial reporting for BaselI1covering the requisite FINREP and COREP standards; Regulatory standards for NBS implementation of Basel 11's pillars 2 and 3, specified. 37 PolicyArea 3.4: Developing CapitalMarkets 147. Serbian capital market remains relatively underdeveloped and lags behind the banking and insurance sector in pursuing reforms that require a comprehensive national strategy to address a range o f development agendas, from revision o f legislation to improvement in supervision. However, to fulfill the market functions efficiently in terms o f reliability of execution and settlement o f transactions, as well as the integrity of ownership records at the Central Depositary - a completely new continuous trading system was introduced in January 2008 with a capacity to handle greater volumes. Out o f 1,778 companies traded (the trading facility i s not a listing) at the Belgrade Stock Exchange (BSE), only about 100 companies are traded actively. Only 4 meet full listing requirements; no major capital raising IPO has beenmade due to the expense, complexity, andthe delay inobtaining a full listing. Despite this, the trading volumes are quite large, and inthe Balkans interms of market capitalization, the BSE i s second only to Zagreb, a much longer established market where market capitalization is dominated by major telecoms companies. Ifplans to proceed with the IPOs of public enterprises identified inthe Law on Gratis Shares are implemented, market capitalization will double and the range of choice, liquidity, and volumes of trading will increase considerably. 148. In terms o f government securities, the major Dinar denominated marketable instruments are short term bills issued by the MoF and NBS with a maturity o f less than six months. Treasury bonds with longer maturities are totally held by NBS. Though frozen foreign currency bonds (FFCBs) are traded, providing regular market turnover, more than a third o f value has already been redeemed and the remainder will be redeemed inthe coming years, with the final issue being redeemed in 2016. The market o f government bonds denominated in dinars i s expected to shrink due to the government's continued prudent fiscal policy, although a major expansion o fbondmarkets is beingplanned. 149. The almost nonexistent primary market for equities and corporate bonds deprives the Serbian firms o f access to either equity or long-term dinar debt financing because most bank lending i s short-term foreign currency denominated or indexed. The size o f the domestic marketable government securities is too small for a viable market, accounting for less than 4% o f GDP, although the total public debt over GDP reached 50 percent. The current Treasury and NBS bills form segmented markets with a different discount rate o f 15 percent and 25 percent respectively, due to a strict sterilization monetary policy, thus hindering the establishment o f a reference rate in the debt market. The absence o f long term government bonds in local currency is a major impediment for the private sector's issuance o f debt securities. 150. As in many other transitional economies, the privatization reform to date has produced little impact on development o f the equity market beyond secondary trading o f minorities in companies sold by tender and the long tail o f shares owned by over 1 million citizens as a result o f several previous privatization attempts. Establishment o f a robust institutional and legal environment will require adequate government policies. As to the secondary market, the number o f tradable shares i s being constantly reduced as a result o f "takeover" activities, since new supply o f (quality) shares does not occur through initial and secondary public offerings. Due to the non-existence o f government bond trading, there i s no reliable yield curve of risk free securities. As a result, the nascent industry of insurance and 38 private pensions suffers from the dearth o f investable assets and reference tool to evaluate their investments. Moreover, in the absence o f an effective regulation and enforcement system, corporate abuses amongst public companies continue to undermine the investors' confidence in the stock exchange. Acute problems in the Serbian capital market are the legal and regulatory framework for the protection of shareholders rights. Currently, the Securities Commission (SC) has four enforcement officers and five legal staff out o f 45 staff in total, which falls far short o f covering 150 brokers and traders licenses in about 80 brokerage firms and the 12 asset management companies licensedunder the new Investment FundsAct. 151. Strengthen the Legal Framework: The GoS i s making significant progress in enhancing the legal framework. The Takeover Act and Investment FundsAct were adopted by Parliament in 2006 and detailed implementation regulations have been issued. The revisions of the Takeover Act shouldbe designedto make the takeover process more efficient and more transparent allowing investors greater decision making power in deciding whether or not to accept a takeover bid. The GoS will take further reform measures in amending the Securities Act, which i s being subjected to both short term emergency amendments and longer term full review. The emergency revisions to the Securities Act (SA), prepared in close collaboration with market participants, have been approved by GoS and submitted to the Parliament. The main improvements to be put in place through the new SA will be made in the areas of: (i) improving prospectus for fuller disclosure; (ii)shifting the issuance regulation to disclosure system; (ii)clarifying and extending legal authority o f the SC; (iii) re-defining connected person o f inside trading; (iv) allowing for the brokerage houses to open client accounts. A comprehensive revision will take place later in 2008. When the full new SA i s enacted with above-mentioned two critical securities related laws, the Serbian capital market would align more closely to IOSCO core principles and EUdirectives. 152. Improve the Government Bond Market: The GoS has made progress in debt management and domestic debt market development. In 2005, the Treasury Sector was merged with the Public Payment Agency to form a separate agency under the MOF. A new Public Debt Law was enacted in July 2005, allowing the M o F to: (i)issue domestic government securities indinars to refinance FFS; (ii) issue securities longer than one year; and (iii)possiblyrestructure thepensiondeficit withmarketable government securities. TheIT based public debt management will be further strengthened with support o f the European Agency for Reconstruction. The GoS will have to resolve the market fragmentation o f Treasury bills and NBS bills through gradually migrating from issuingNBS bills to auctioning add-on T-bills. Measures to encourage the development o f both government and corporate bond markets are underway and a working group, set up by the Ministry o f Finance, will report with recommendations in March 2008. It aims to strengthen the regulatory capacity, build capacity for major public offerings, and harmonize tax regimes between public and private sector securities. It will provide inter alia recommendations for comprehensive improvements inthe procedures for issuance o f longer term government bonds, corporate and infrastructure bonds. 153. Enhance the Regulatory Capacity: The SC has an ambitious plan for improving its institutional capacity through IT investment and staff training supported by the USAID TA program. When the budget is approved by the Parliament, the SC would launch a new business plan aiming at (i)strengthening the institutional effectiveness, (ii)enhancing the accountability, and (iii)improvingawareness and professional capacity o fmarket participants. The adequate financing is critical for enhanced capacity building and better compensation - 39 making it financially self-supporting i s a fine idea in principle, but in practice, may result in excessive fees, inadequate staffing and low salaries because the securities market i s not yet big enough to support it financially. 154. Promote Public offerings: The Government is considering the launch o f a public offering to promote new issuance o f securities. The Share Fund (SF) hiredboth financial and legal advisors to evaluate the marketability o f its shareholdings and effects o f a potential capital increase of several leading public enterprises with full cooperation o f the incumbent management. The SF has identified five preliminary candidate companies in its portfolio for potential sale. The shares o f state-owned banks and insurance companies, and public utility companies are being proposed in the Law on Gratis Shares as candidates for public offering and listing on the BSE in a capital raising exercise. Public offerings of government shares could serve as a benchmark for future equity financing o f the local firms as well as create a demonstration effect for the local individual investors and bring in both local and foreign institutional investors attracted by better quality companies with greater liquidity. 155. Introduce a Neutral Tax System or Private Sector Securities: Within the broad context of pending 2006 tax reforms, the GoS is prepared to revamp the taxation system concerning the capital market so as to remove distortionary effects on private sector securities, as currently government shares and debt instruments and NBS bills are exempt from all taxation. First, three key tax laws will have been amended to introduce a neutral tax system; the property tax, corporate income tax, and personal income tax. Under the proposed tax reforms, private securities will be treated equally with the government securities in terms of interest and dividend incomes, capital gains, and transactions. Second, tax treatments o f the securities incomes and transactions o f non-residents will be streamlined. Third, new tax rules will be set out for private pension funds as well as investment funds in accordance with the international standards. 156. Actions to be taken under the PFDPL: Based on the discussions with MoF, the following benchmark for the proposed PFDPL operation were agreed upon: 0 Amendments to Securities Law approved by the GoS and submitted to the Parliament. 157. Proposed actionsfor future PFDPL operations (triggers are bolded): 0 A joint working group between MOF and MOERD to undertake a comprehensive reviewof Securities and Takeover Laws is established; 0 The Working Group submitsto GoS proposals for the establishment of the market for mediudlong term state securities, corporate and municipal bonds, including delineation o f responsibility for issuance between the Ministry of Finance and the NBS; 0 New draft laws submittedto Parliament; 0 Range o f government bonds issued inmarket to establish benchmark yield curve. 40 V. OPERATION IMPLEMENTATION POVERTY AND SOCIAL IMPACTS 158. As of end-June 2008, Serbia posted over EUR 2.8 billion in privatization revenues since 2002. More than 2,300 companies were sold in tenders and actions and on the capital market, with buyers pledging over EUR 1.2 billion in investment plans, and over EUR 276 millioninsocial programs. 159. Since the latest stage of reform began in 2001, job losses have been large, as Serbia has embarked on a program of restructuring and privatization. At the same time, job creation inthe private sector has been slow, despite fairly strongeconomic growth inrecentyears. Like many other transition countries, Serbia has been facing a "job loss growth" in recent years. According to the data of the semi-annual employment survey conducted by the Statistical Office, the total number of employedhas declined from 2.521 million employed in September 2006 to 2.502 million in September 2007. The decline was due to reduction inthe number of employees in enterprises, institutions and organizations from 1.447 million to 1.428 million while the number of individual entrepreneurs, self-employed, and agricultural workers has been relatively stable. At the same time, the unemployment rate has, according to the labor force survey data, decreased from 21.8 percent in 2005 to 18.8 percent in 2007 (aged 15-64) but the rate is still more than double the EU-27average.The reforms supportedby PFDPL are expected in the medium term to lead to job creation and a more efficient allocation of labor. However, the same reforms are also likely to result in a transitory increase in unemployment as some 850 socially owned enterprises have yet to go private. However, it is important to note that while privatization i s initially always a net destroyer of jobs, in the long run it contributes to job sustainability and growth. Moreover, the empirical studies conducted in Serbia have shown the increase in productivity of privatized firms, while the employment in some socially owned enterprises prior to privatization was only formal, as a lot of them did not pay regular salaries and/or contributions. 160. Therefore, it is important that the social impacts of the privatization and the restructuring of SOEs be mitigated and, consequently, political support for ongoing and planned reforms can be maintained. It is also important, at the same time, that social protection measures are designed in a fiscally sustainable manner and provide strong incentives against relying on welfare transfers and for finding gainful employment. 161. To mitigate the welfare and employment impact of the ongoing and expected SOE reforms, the GoS introduced the Social Program' in 2002. In July 2005, the Social Program was revised, changing the benefit formula for extended severance payments, and offering 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; and (iii) severance pay according to the Labor Law. 'Officially,the Program for ResolvingRedundancy inthe Process of RationalizationRestructuringand Preparation for Privatization 41 162. Since its inception, the Social Program has provided support to around 172,600 redundant workers (2002-2007) through this mechanism. However, only a portion o f all the redundantworkers are supportedby the Social Programwhile others receive regular severance according to the Labor code. In2002-2004, mostly big SOEs dominated among the recipients o f its funds. Starting 2005, the list o f enterprises approved for funds includes also a number o f state-owned utilities. During 2007, 214 enterprises and 22,700 redundant workers benefited from the Social Program.* The average redundancy payment in Serbia equals to about US$ 2,100 which i s far more generous compensation package than the registered unemployed with insurance record can claim. The benefits offered though the Social Program in Serbia are in line with many other countries in the region: the Czech Republic spends about US$2000, Hungary US$2500 and Poland US$37OO9per redundant worker for severance payments and additional training benefits. 163. In 2004-2006, tracer surveys of workers made redundant from 2002-2003 were conducted inPancevo, Kraljevo, Nis and Lazarevac, and they provided important insights into the Government Social Program. The workers with longer tenure, and respectively older workers dominated among the displaced workers. For example, in Pancevo, over 25 percent o f displaced workers had job tenure o f over 30 years, and only 6 percent, less than 10 years. By their job profile, most displaced workers were blue collar workers with narrowly specialized skills. This made their redeployment a more challenging tasks. The largest share o f redundant workers included craftsmen, plant and machine operators and assemblers, elementary occupations workers, and office clerks. Most redundant workers had very low salaries prior to dismissal, and 81 percent o f them earned less than Euro 100 per months (in 2003, average net salaries inthe country were around Euro170, and in2002, around Euro150). This indicates that many o f them may not have been fully employed prior to dismissal or were on administrative leave. 164. As for the current labor market status, the largest number o f displaced workers who were surveyed in 2006 and who were beneficiaries o f the Social Program, remained unemployed (64 percent); 5 percent have remained out o f the labor market, whereas 31 percent found new employment; 18 percent out o f those who found new employment are now working in the private sector, five percent in the public sector, whereas another five percent developed their own business and three percent o f the redundant workers are involved in casual jobs. 165. As shown in paragraph 104 above, the GoS is committed to using the SP as an instrumentto reduce the level o f excess employment in large SOEs in preparation for their privatization. Therefore, it is important that the TF continues to receive adequate resources, while recurrent subsidies to SOE sector are reduced. In reflection o f these needs, the Government almost doubled allocations to the Program between 2004 and 2006 to over 6 billon dinars, and increased these expenditures to 9.971 billion dinars (about EUR 125 million) in2007. Inaddition, the Government intendsto clear up the arrears incash payments for severance from the Transition Fundaccumulated over the past years. * It is estimatedthat around one fifth of workers inenterprises includedinto the Government Social Program are made redundant and benefit from the program. 9 It is limited to afew coal mining sector enterprises only. 42 166. Inaddition to the Social Programdescribed above the GoS provides social assistance, including cash benefits and services, to poor households. The main social assistance benefits are: (i)MOP - Material Support to Families whose income i s lower than the guaranteed "social security level", and (ii)child allowances - cash transfers to poor households with children, includingthe families o f redundantworkers. 167. The workers, who are not included into the Government Social Program, are entitled to an unemployment benefit. The duration o f benefit payment varies from three months, ifthe insurer has been insured for the period o f 1 to 5 years, to 24 months ifthe insurer i s older than 55 years and has been insured for the period longer than 25 years. The benefit size i s 50-60 percent (depending on the duration) o f the average earnings inthe month before employment contract was terminated. All redundant workers and employees are entitledto ALMPs, such as training and retraining programs, self-employment assistance, counseling and training for business start-ups, reassignment to other jobs, etc. In 2006, ALMPs covered about 398,700 unemployed persons, or about two fifth of the average number o f registered unemployed. However, funds available for these additional activities especially by NES are limited. 168. The Bank i s providing two types o f assistance to the Government to mitigate the social impact o f redundancies resulting from corporate restructuring, privatization and bankruptcies: (i) general budget support through the programmatic loan series in order to reduce the short-term fiscal pressures generated by severance payments, and (ii)technical advice and funding offered through various ongoing and planned investment operations. In particular, the Employment Promotion Project (EPP; 2003-2006) supported the GoS in designing and the implementing enterprise-based labor redeployment programs, provided through Worker Transition Centers which act as a resource center providing information on workers' redeployment options and options related to the Government's Social Program, and assist in implementation o f enterprise social plans. As part o f the EPP project, 13 such pilot Transition Centers were launched in enterprises undergoing privatization which provided counseling services and training to over 18,000 workers. The planned Bor Regional Development Project would support social mitigation measures aimed at redundant workers, and creation o f new sources o f diversified growth and employment in one o f Serbia's poorest regions. 169. Building on our fruitful policy dialogue in this area (through SACS 1 and 2 and SOSAC), in 2006 the Bank conducted a labor market study and a study on social protection system in Serbia that informed the design o f public sector development policy loan and a potential social sector operations. Policy and procedural advice provided to the GoS will be based partially on these studies, as well as, on projections concerning the expected fiscal implications o f future layoffs. 170. Given that the Serbia country program includes operations explicitly dealing with mitigation of social consequences o f reforms, PFDPL will not include conditionality directly influencing labor legislation and social policy. In the longer term, however, PFDPLs will assist the Government to reduce poverty through creating the necessary conditions for accelerated economic growth. First, strengthened fiscal discipline and divestiture o f state and socially-owned assets will improve resource allocation and the country's growth prospects, and will also reduce the risk o f macroeconomic shocks, which disproportionately affect the poor. Second, reform measures directed at improving the business climate will create the basis for investments neededfor medium-term growth and employment creation, and thus for more 43 sustainedpoverty reduction. Third, policy efforts aimed at building a more efficient and stable financial sector will underpin economic growth and increase the resilience of the Serbian economy to potential adverse shocks-both of which are prerequisites for increasing employment andreducing poverty. IMPLEMENTATION, MONITORINGAND EVALUATION 171. The MOF will be responsible for the overall implementation of the proposed operation and for reporting process and coordinating actions among other concerned ministries and agencies. The Bank will monitor actions and review progress of the implementation of the proposed operation, as well as the subsequent actions of the GoS program by using the short term and the overall program outcomes outlined in the Policy Matrix. 172. At the same time, the overall status of the GoS program will be monitored during supervision to determine whether the specific conditions of the proposed operation have changed. In addition, supervision missions will not only allow the Bank to continue the policy dialogue with the institutions involved in the implementation of the reform program, but will also ensure synergieswith other donors to avoid conflicting advice to the Government inthe policyandtechnical areas involvedinthe reforms. FIDUCIARY ASPECTS 173. This fiduciary information section and the set of agreed fiduciary measures included below for the operation draw on the findings and recommendations of the 2007 Integrated Public Financial Management Assessment (IPFMA) and assessment of more recent developmentsinthe public financial managementsystemfor Serbia. 174. Public financial management (PFM) system: A Country Financial Accountability Assessment (CFAA), a Country Procurement Assessment Report (CPAR) and a Public Expenditure and Institutional Review (PEIR) were completed in 2002 and 2003. The initial diagnostic was updated inJune 2005 with a PEIR Update and a Fiduciary Assessment Update (FAU) for public financial management and procurement. Integrated Public Financial ManagementAssessment (IPFMA) was publishedinFebruary 2007. 175. The overall conclusion of the IPFMA suggests that despite the recent public disclosure of basic fiscal and budget execution data, the lack of transparency and operating checks andbalances inpublic finance still appear to be an overarching problem in Serbia. This i s reflected in the relative poor performance on several PFM performance indicators relating to internal and external audit, internal control and predictability of funds availability. Significant steps have been taken towards strengthening PFM, such as modernization of the central treasury'system incorporating a single treasury account and new integrated financial managementinformation system, the establishmentof a central unit inthe Ministry of Finance responsible for internal audit, and the establishment of the State Audit Institution Council in September 2007. Further improvements in financial controls have been proposed and are awaiting finalization of the new Budget System Law, currently under development. While these efforts are encouraging, this assessment suggests that much remains to be done to strengthen transparency and accountability in PFM in Serbia and strong Government leadership of the ongoing reforms will be required to bring Serbia at par with other EU- aspiring countries inthe region. 44 176. The IPFMA suggests that the fiduciary risks associated with the PFM system inSerbia are high. Whereas some o f the greatest fiduciary risks are associated with poor performance in the areas o f external financial reporting, external auditing and the extent o f unreported government operations, significant risks are also associated with the public procurement system, the stock o f expenditure arrears and internal control and internal audit systems. The IPFMA also suggests that attention need to be paid to specific anti-corruption measures. 177. Mitigating fiduciary risks will require strong and sustained commitment towards transparency and accountability in budget management. The government has taken steps to strengthen budget execution and reporting arrangements and i s developing improved arrangements for public internal financial control and audit as part o f its pre-accession program. Establishment o f the SA1 Council and provision o f separate budget allocation in 2008 was a positive step, but not sufficient to provide an effective external audit function to date. 178. The operation will support the further actions required to attain acceptable fiduciary arrangements. Thus, the following actions have occurred: (i)the Institution has presented acceptable Operations Manual (rules and regulations) and has submitted it to the Parliament; and (ii) acceptable first annual plan and work program have been submitted by the SA1to the Parliament's Finance Committee; (iii) Institution's 2008 budget as separate line item inthe the Budget of the Republic o f Serbia has been adopted by the Parliament. Draft documents were submitted to the Parliament within agreed timeframe. The documents were reviewed and found acceptable to the Bank. Reasonable SA1budget as a separate line item i s included in 2008 budget o fthe Republic of Serbia adopted by the Parliament. 179. Dependingupon the progress achieved inimplementingthe agreed fiduciary reforms, additional public financial management fiduciary pre-conditions may be formulated to address, inter alia: (a) the extent o f unreported Government funded operations and transparency o f government financial reporting; (b) public procurement arrangements; (c) internal control and audit; (d) implementation o f the Modernized Treasury System and (e) anti-corruption measures. DISBURSEMENT AND AUDITING 180. Borrower and Loan Amount: The Borrower i s the Republic o f Serbia. This operation i s a single-tranche loan. The loan proceeds would be made available to the Borrower upon the effectiveness of the Loan Agreement between the Bank and the Republic o f Serbia. 181. Disbursement: Upon approval of the loan and notification by the Bank o f the effectiveness of the Loan Agreement between the Bank and Serbia, the Borrower will submit a withdrawal application to the IBRD. At the request o f the MOF, the IBRD will deposit the proceeds o f the loan into the designated account at the National Bank o f Serbia (NBS) which forms part of the country's official foreign exchange reserves. This account will be managed by and subject to control o f the MOF. The Borrower shall ensure that upon the deposit of the Loan into said account, an equivalent amount i s credited in local currency to the Single Treasury Account (ifthey use one) also kept inNBS and that is available to finance budgeted expenditures. 45 182. If, after depositing funds in the dedicated foreign currency deposit account at the NBS, the proceeds of the loan are used for ineligible purposes as defined in the Loan Agreement, the Bank will require the Borrower to either: (i) return that amount to the account for use for eligible purposes; or (ii) refund the amount directly to the Bank, in which case the Bank will cancel an equivalent undisbursed amount o f the loan. 183. Auditing: Due to nature o f the DPL, being a single tranche transaction intended to supplement general Republic of Serbia budget funds, and considering the unqualified audit findings on NBS financial statements, no specific auditing arrangements are provided in the loan agreement. The Bank does, however, require a confirmation from the Government on movements into and out o f the designated account, including dates and details within 30 days following any and all transactions. The corrective actions taken by the National Bank of Serbia to safeguard funds inthe foreign exchange account are deemed adequate.lo ENVIRONMENTAL ASPECTS 184. The major pillars o f the PFDPL have been assessed for likely significant effects on the environment, forests and natural resources under the requirements o f the World Bank's OP 8.60. The principal concerns inthe sectors supported under PFDPL arise from the handlingo f environmental liabilities (e.g. water, air and waste emissions) from past and current operations caused by socially- owned enterprises (SOEs), including especially inthe energy sector, being privatized or allowed to go bankrupt.The screening also noted that one possible impact from electricity tariff increases could be an increase in uncontrolled wood cutting. Discussion o f these issues immediately follows a review o f the institutional and legal framework for environmental management below. 185. The environmental legal framework for environmental management in Serbia has undergone significant reform along the lines o f the EU acquis, however, enforcement and implementation still need substantial strengthening. Four key environmental laws were adopted in recent years: Law on Environmental Protection, Law on Environmental Impact Assessment, Law on Strategic Environmental Assessment, and Law on Integrated Pollution Prevention and Control. Further,new law on waste management has also been drafted. Serbia has also signed the South Eastern European Energy Community Treaty which subjects it to key pieces o f the acquis, notably the Large Combustion Plants Directive. This directive places restrictions on local pollution emissions (sulfur dioxide, nitrogen oxides and particulate matter). Serbia has also recently ratified the Kyoto Protocol. The Government o f Serbia has lo IMFconductedasafeguardsassessmentoftheNationalBankofYugoslavia (now NBS) inNovember The 2001 and concluded that substantial risks may exist in the financial reporting framework, internal audit mechanism, and system o f internal controls. The mission proposed a series of measures to address the identified weaknesses. The report on the Sixth review under the Extended Arrangement (IMF Country Report No. 06/58) noted that the measures were being implemented by the NBS. In November 2008 the IMF announced the establishment o f a precautionary stand-by arrangements under regular procedures and access limit noting that the policies envisaged under the program are adequate to maintain macroeconomic and financial stability. The N B S received an unqualified opinion from its auditor in respect o f its latest available financial statements December 31,2007. 46 also introduced the use o f pollution charges for S02, NOx and particulate matter which also apply to thermal power plants. Environmental oversight in Serbia i s shared among the Ministry of Environment and Spatial Planning (MoESP), the Autonomous Provinces of Vojvodina and municipalities. The mandate o f the nascent Serbian Environmental Protection Agency is limited to data collection and reporting. Recent years have also witnessed delegation o f environmental oversight functions, such as some o f EIA and permitting, to local government agencies. However, variation o f capacity in local government agencies and lack o f secondary legislation related to the new laws lead to delays and variations in the interpretation and application o f laws. Such delays and inconsistencies are detrimental to the business climate and warrant inclusion inthe regulatory review. 186. Environmental liabilities of SOEs/public enterprises. Thermal power plants (TPPs) remain key polluters which continue to be significant emitters o f S02, while recent investment at one o f the TPPs has reduced particulate matter emissions to admissible levels. Air pollution leads to substantial damages to public health, agricultural products and ecosystems. Uninsulated ash dumps also contribute to air and water pollution. As a monitorable condition o f the PFDPL an environmental audit (EA) will be carried out and action plans to control and remediate damages will be developed for those SOEs/public enterprises deemed to have significant environmental impact. The combination of EAs and action plans will not only ensure remediation o f environmental damage, but also help attract serious international investors and possibly lead to higher bids as the new owner's risk o f facing unexpected environmental liabilities i s reduced. 187. Ongoing air pollution from TPPs i s as much a matter o f financial capability o f the national electric power utility EPS as it i s o f enforcement. The increase o f electricity tariffs which is supported under this loan will allow EPS to obtain larger revenues part o f which it can use to install abatement technology. The newly instituted pollution charges will provide an added incentive. 188. Since the privatization process began in the early 2000s, Serbia has made significant progress in integrating environmental concerns in the privatization process. Recognizing that strategic investors will be reluctant to invest or will heavily discount their offer prices if there are significant unassigned environmental liabilities in 2003, the Government amended the Law on Privatization to state that liability for environmental damage caused by a socially or state-owned enterprise up to the date o f privatization rests with the state. In the process of privatizing the Copper Mining and Smelting Complex o f Bor, one o f Serbia's foremost environmental hot spots, this legal clarification has played an important role in determining financial responsibilities for cleaning up "historical pollution" and mitigating "current pollution" associated with the enterprise's ongoing operations. The Government will use World Bank support for cleaning up historical pollution at this site under the Bor Regional Development Project. The operation was made possible by cooperation between the MoESP and the Privatization Agency. The only outstanding issue relates to the adoption o f a bylaw definingthe scope o f state's environmental liabilities 189. Similar past environmental damage and liability issues arise with SOEs that are too unviable to be privatized and will be allowed to go bankrupt.According to the "Polluter Pays" principle which is firmly established in the Environment Law enacted in 2004, liability for 47 such damage lies with the state. It is recommended that GoS prepare a clear action plan on how to deal with such liabilities. 190. Increases in electricity tariffs are inevitable for economic efficiency. However, this may increase the use o f fire wood and excessive/illegal cutting especially on private lands. The recent UNECE Environmental Performance Review for the Republic of Serbia (2007) indicates that "Seven per cent o f households heat with wood. As wood is often used directly by rural communities without entering the commercial market, the total amount o f firewood used is unknown. But risingpoverty has caused more use of firewood, and illegal logging has increased." The non-commercial nature o f firewood use makes it difficult to quantify the relationship between electricity tariff increases and firewood consumption. As a result, the changes in fuel wood use would best be monitored in regular household surveys that gauge poverty levels inrural and semi-urban areas. The GoS i s urged to use this monitoring tool and feed this information into plans for targeted electricity tariff design and forest inspection efforts. RISKS AND RISKMITIGATION 191. Political risks related to the unresolved Kosovo status issue, previously fragmented political situation and finalizing the cooperation with the International Criminal Tribunal for the former Yugoslavia (ICTY) have been largely mitigated with the election o f the new Government o f Serbia. The advent o f the new democratic government and its commitment to EU integration indicated renewal o f stability and pursuit o f economic reforms. The fact that the Stabilization and Association Agreement, an important step towards accession, with the EUhas been signed and ratified inthe Serbian Parliamentwill provide a significant anchor for further reforms which would have beenvirtually impossible without it, as the process o f EU integration i s unique in the world, demanding from all new prospective members to implement dynamic economic, political, and institutional reforms. Both sides o fthe coalition government are firmly focused on implementing further economic and political reforms and vigorously pursuing EU agenda. The election o f democratic government was yet another confirmation o f Serbia's commitment to European integration, following the presidential elections in February 2008 in which incumbent president was entrusted with another 5-year mandate running on pro-reform and EU agenda. While final status o f Kosovo remains an issue, economic reforms and associated EU agenda are no longer subordinated to the status o f Kosovo. Nevertheless, while the government i s committed to advancing the development agenda, there is still some uncertainty how obstructive the opposition parties inthe Parliament are going to be. Current developments indicated that the government is well aware that moving ahead with European integration is arguably the most important factor for Serbia's long term development prospects and stability, and that it will find a way to implement this agenda. 192. The impact o f the international financial crisis on Serbia and readiness o f the Serbian authorities to respond promptly and adequately are additional risk factors to be considered. The impact of the international financial crisis so far was not as dramatic as in many other countries in the region. Nevertheless Serbia will experience lower inflows of FDI and cross- borderborrowing, which inturnwill lead certainly to slower growth o f economy. The revised growth rate for 2009 for Serbia is 3.5 (instead o f the 7 percent projected for the unified survey). Serbia has significant external stability risk due to high financing requirements, 48 increasing external debt, high euroization o f the banking sector and low level o f export. The government quickly responded and created a joint committee with the National Bank of Serbia to monitor developments at the financial market and to prepare the policy response. The Committee had several meetings with representatives o f banks, insurance companies and investment funds. As a result the government decided to increase the amount that is insured with the National Deposit's Insurance Corporation, from EUR 3,000 to EUR 50,000 which effectively means that 99 percent o f deposits in Serbia will be insured. Inaddition, there will be some fiscal incentives to increase private sector savings. The NBS also decidedto abolish the 40 percent reserve requirement on subordinated loans to foreign-owned local banks thereby increasingthe liquidity o f the banking sector. It is important that the government has ready responses to all challenges inthe real and financial sector and the cooperation with the Fundvia the recently agreed Stand-by Arrangement is a major step forward. 193. The precautionary SBA ensures much needed fiscal discipline. The SBA will last through March 2010 when global financial turbulence i s likely to be most intense. However, it will be important that the government not relax its efforts thereafter. The Serbian government needs over the medium term to remain committed to countercyclical fiscal policies not only due to constraints on finance inthe shorter term but also inorder to reassure investors and the Serbianpublic that it remains committed to implementation o f structural reforms and a private sector-lead economy over the longer term. 194. Finally, relatively weak institutional capacity including for fiduciary management raises concerns including on internal controls. Improving the public expenditure management system i s an important component o f the operation, but institutional change comes slowly. The Programmatic Private and Financial Sector Development Policy Loans will include benchmarks on the external audit o f the Government accounts and strengthening the Supreme Audit Institution. The government is also proceeding with adoption o f SAA requirements, includingpublic internal financial control. Renewal o f the Budget System Law is inprogress and other reform initiatives are under consideration in preparation for a separate DPL to supportpublic expenditure reform initiatives. 195. Other potential risks relate to specific actions of the reform program include delays in the implementation process o f the overall program. The current capacity o f some public sector institutions to implement an ambitious reform agenda, while much improved over the past few years, remains relatively weak. The execution risks will be mitigated through utilization o f continued technical assistance facilities and active coordination of bi-lateral donor funded technical assistance. Furthermore, support from ongoing and proposed Bank projects in social protection, public sector administration will further serve to mitigate risks. Another potential risk may include delays in the Parliamentary approval of a package o f laws, due to filibustering o f some opposition parties, which serves as a precursor to successful implementation o f the reform program. 49 I ! U 8 5 e, 0 Y EL c bu 8 m IA -0 I 2C 4 % " I ANNEX 2: LETTER OF DEVELOPMENTPOLICY REPUBLICOFSERBIA MINISTRY OF FINANCE NO:401-2835/2008-001-003 Belgrade,Janurary30,2009 LETTEROFDEVELOPMENTPOLlCY Mr.Robert 3. Zoellick President The World Bank 1818 H Stteet,N.W. Washington, D.C., 20433 Dear Mr.Zoellick, 1. We are Writingto request, on behalfof the Government o f the Republic of Serbia (GoS),the first Programmatic Private and Financial Development Policy Loan (PFDPL) of US$50 million equivalent to support our economic reform program. This Letter of Development Policy sets out the key actions that the GoS is committed to undertake over the near termto enhanceeconomic growth inSerbia. 2. The macroeconomic framework of our refom program centers on 8 high quality fiscal adjustment that will enhancemacroeconomic stability and boost confidence in the policy fiarnework, thereby stimulatingprivate investment. Further, an acceleration o f policy efforts aimed at improving eficiency, including privatization and enterprise restructuring and strengthening of bankruptcy mechanisms, dong with measures directed at improvingcompetition and the investment ciimate will elevate the economic reform agenda vis-&vis the policy framework. Finally, we aim to strengthen the financial sector in Serbia with continued restructuring and divestment of stab-owned holdings, and overhauling o f capital msrkets Eramework. 3. In2007, Serbia hadrobustreal GDP growthof 7.1 percent, retlectinganupturn in industry as privatization and enterprise resmcuring continued and cumulative FDI inflows since the beginning of transition in 2001 reached $10.4 billion. However, inhtion picked up and reached IO. 1 percent in2007 and is projected at some 9.5% at the end of ZOOS. This was primarily due to exogenous shocks, such as oil price increase. Nevertheless, the infiation is targeted ro gradually dedine to law single digits over the 56 medium term, specifically to 4% in 2012. The GoS intends to ensure continued annual growth despite the current financial crisis, to gradually reduce a current account deficit from 15.9% in 2007 to 8% in2012, increase the share of investments from 24% ofGDP to 2628% in 2012, and to create at least 200,000 new jobs over the next four years, reducing unemployment from 18.1% to 11.9%. We plan to achieve these ambitious targets with a set of diverse reforms, some of which will be supported with this DPL operation. 4. The overarchingobjective of the programmatic DPL is to promote economic growthanddevelopment inthe country. It will suprt our reformprogramthat fits under the first priority area of the recently adopted Country Partnership Strategy for the Republic of Serbia: dynamic private sector led growth to ensure incomes convergence withEurope.The proposedPFDPLoperation, the first of threeprogrammaticoperations, will focus on three specific areas: (i)enhancingbusinessenvironment to stimulate more private sector-led investments, (ii)strengthening financial discipline in enterprise sector to improve our fiscal position, and (iii) building a more eficient and stable financial sector to maximize its potential growth dividend, We aim to achieve the following outcomesthroughimpfementationofthe PFDPLsupportedreformprogram. 5. En order to improve business environment we are applying a two-pronged approach: improving the quality of new regulations through introduction of the Regulatory Impact Assessment (RIA) in the legislative process of Serbia (2004) and facilitation of a public consuitationsprocess, and streamhing and simplifying regulation of business activity through conducting comprehensive review of the existing stock of business regulations. To this end, in October 2008 the GoS has adopted a Strategy for implementation of comprehensive regulatory review (also known as a regulatory guillotine). The proposed reform of business registration based on the single agency approach is expected to decrease the number of procedures and rime for business registration from I f proceduresand 23 days in2008 to 8-9 proceduresand 7 days by the end of the reform program We expect that by the end of the reform program, all businesses will be assigned a single registrationnumber, regulatory compliance costs of business will decrease substantially, particularly as regards to obtaining construction licensingandpermits. Additionally, regulatory frameworks for competition development will be strengthened. 6. We me committedto further strengtheningthe financia{disciplinein enterprise sector inorder to ensure lastingfiscal adjustment. We also recognizethat enforcementof hard budget constraintsis essentialfor completion ofthe restructuringof the socially and state-owned enterprise sector, started in 2001. To this effect, we will build upon and expand the earlier efforts in this crucial area, focusing on: (i)khe furher reduction of direct and indirect subsidies provided to enterprise sector; and (ii)accelerating restructuring, privatization and, where applicable, bankruptcy of socially-owned enterprises. 7. The GoS intends to introducesignificant improvementsin the energy sector as well. Recognizingthe potential value ofprivatesectorparticipationinenergy generation, we will fwus ondevelopinga strategyand time-boundactionplanfor privateinvestorsto 57 invest in, take majoritycontrol of, andmanage assets inpowergeneration. We will also commit to filly removingobstacles to competition inrefinedpetroleumproducts by the end of 2010. Finally, within the sameperiodwe intendto undertake gradualannual tariff adjustments inorder to eachcost-recoveringtariffs for power andgas. 8. Building on the successful financial sector privatization program, which .includedthe recentprivatizationofthrw banks (Vojvodjanska,Niska, and Panonska) and of the second largest insurance company (DDOR), and the launch of the tender for the sale of 6 packages of non-performingloans of bankrupt state owned banks, the GoS will finalize the Strategy for the remaining banks and insurance companies with ROS ownership. We will also continueto strengthenthe insurancesector with the new MTPL Law and restructuring of Dunav insurance company. Further, NBS will work on approving key policy and procedures laid out in the second SDP, and will update/issue banking sector regulations. Finally, we have drafied and approved the urgent amendments to Securities Law which is now in the Parliament awaiting adoption, thus contribuzingto ongoingdevelopmentof capital markets. We also planto prepare a brand new Securities Law in the near future. We expect that these measures will result in decreased state sector share in the bankingsector from 17.29% af total assets as of mid- 2008 to 510% in2010, while the reductionof state ownership will continueininsurance sector as well From 62% in insurancepremiumwritten in 2006 to 34.2% inmid-2008, - and continuing slide to below 30% in the following years. The proposed reform measures will also contribute to improvedaccess to finance, broader range of financial services availablefar the companiesand individuals. 9. Our reformplans to reachtheseoutcomes arebriefly outlinedas follows. I. EnhsnefngBusinessEnvironment 10. We intend to undertake measures which should lead to removal of multiple adrninistr&ive barriers for business development and continuous reductionof regulatory compliance costs. Additionally, these measures will also support strengthening of corporategovernance, competitiondevelopment andbetter functioningmarkets. Further Sirnplifreatjon of Business Entry through Implementation of a Single Agency Approach for Business Registration 1 I. Building on the Serbian achievements in implementation of the business registration reform and institutional strengthening of the Business Registers Agency (SBRA), we would like to focus on transforming the SBRA into a real one-stop-shop (OSS), ensuringthat the SBRA performs all proceduresrequired for starting a business, including issuance of the tax number. To this end we have adopted the Principles of consolidatinginthe SBRA of business registrationprocedures relatedto issuance of tax, pension, and social security identification numbers, as a necessary prerequisite for the implementationof the Single Agency Approach. Over the medium term, the Parliament i s expected to adopt relevant regulationsto create legal framework for introduction of a singleidentificationnumber f ~all Serbianbusinesses. r 58 Improving Legal Framework for Strengthening Corporate Covernernce and FacilitatingBusinessEntry andOperations 12. While we have made substantial efforts to advance the reform activities aimed at making the existing legal fr?unmork more conducive for improvement of corporate governance and facilitation of business entry and operations, further refomis are necessary. This will primarilyinclude amendmentsto several key meas of the Company Law of 2004, where the gaps and shortcomings have been identified in the course of its practical implementation, namely: (i)corporate governance provisions, (ii)detailed regulation of new forms of operation (such as branch offices of foreign legat entities); (iii) andconsistentregulationofstatuschanges(mergers,divisions); (iv)unification clear of all provisions regulating wtablishent and operation ofentrepreneurs and companies, including explicit elimination of at1unnecessary requirements and thereby annullingand replacing the Law on Entrepreneurs entirely. Finally, we plan to conduct a round of broad public consultations for the proposedamendmentsto the Company Law, including those substituting the Law on Entrepreneurship, and submit them for Parliamentary approval. Sfreamlining Regulatiorrs of Business Operations and Reducing Business ComplianceCosts 13. By introducing a Regulatory Impact Analysis (REA) requirement into the legislative process, we took measuresto ensure that the introduction of future regulatory regimes is basedon a clear rationale, a proper analysis of costs and benefits, and includes appropriate consultation with af%ected stakeholders. However, in order to createa secure and tramparent legal environment we need to start dealing with stock of legislation. In order to tackle this issuewe have proposalto conduct 8 comprehensiveregulatory review of existing regulations knownas a "regulatory guillotine*a,a technique t b t can speedup the processof reviewing, eliminating, and streamlining unnecessaryoutdated regulations. To this end the GoS has approved a Strategy which determined a timeline and institutional framework for a comprehensive regulatory review, defined the approach to the "guillotine" implementation andits scope, . 14. Since Serbia still has rather complicated and costly proceduresrelated to issuing planning and construction permits, the GoS remains committed to dealing with this problem. We feel that this area of businessregulations couldbenefit from comprehensive regulatory review as a part ofthe proposed "guillotine process". Inthis regard we intend to pursuethis issue further and introduceanew set oflandreform laws inthe near future. 15, The regulatory "guillotine" of existing regulations will be conducted in 2009- 20IO along with the introduction of necessary amendmentsto laws and regulations. We are certain that the intended reforms will &matically simplify the regulation of business activities and decrease the regutatory compliance costs. 59 ImprovingLegal end InstitutionetFramework for Competition 16. The GoS has &ken a number of important steps to protect consumers and strengthen the competitive environment by adopting a new Competition Law in 2005. However, two years into implementationof the Law several important deficiencies have been identified which needto beresolved. Initiallythe COSapprovedamendments to the Law aimed at addressing the majority of existing business concerns (Le., the time required for a merger, tow threshoids for concentrationof capital notifications, definition of the basis for notification f e s and applicable fines that leads to prohibitively high compliance costs, etc.) and submitted the amendments for the Parliament approval. However, following the fomtion of the new government, we have decided to draft a brand new Competition Law which wodd include all of the previously prepared amendments, eliminate additional deficiencies, and be fully inline with EU regulations. Further, two secondary regulations - on block exemption on horizontal and vertical agreements - are being drafted and will be approved following the passage of the new Law. We expect that the new Law and accompanying regulations and bylaws will become effective in the near term.. The introduced changes would both improve competition and reduce regulatory compliance costs to businesses. Thus, the proposed increase of the thresholds for concentrationnotification, which proved to be too low in practice, will significantly duce compIiancecosts to businesses. Finally, strengthening both independenceand capacity of the Commission for Protection of Competition will remaina part ofa mediumtern reformagenda. 11,StrengtheningFinancieIDiscipline 17. Over the past seven years, we have made a significant progress in multi-track privatizationprogramaimedat divestitureofsocially-ownedassets. Over this pcriod, we have also undertaken steps aimed at reducing, gradually, the direct subsidiesto socially- and stateawned enterprises in the Serbian economy. The proposednew operation will assist us withcontinuingreformsinthis crucial area, focusing on: (i) reductionof further direct and indirect subsidies to enterprise sector; (ii)acceierated restructuring, privatization and, where applicable, bankruptcy andor forced fiquidation o f socially- owned enterprises; and (iii)continuation of unbundling and restructuring of public utilities. Reductionin Directand IndirectSubsidies 18. We have fbrther reduced the budget allocations for direct (MOE) subsidies provided to SOEs in 2008 budget to CSD 3.1 billion from CSD 4,1 billion in 2006. Additionally, we aim to continue improving EPS collection rates for SOEs. In paralIe1, we are working to reduce the demand for subsidies by pursuing divestiture, through privatization or bankruptcy, of no less than 15 SOEs among the top twenty largest recipients of combined direct and indirect subsidies, including the core assets of Zastava Group and RTB Bor. No less than 10 of these enterprises have been either privatizedor put into bankruptcyprocedureby endof August 2008. Finally, when It comes to Zastava we have established a strategic partnership with Italian car manufacturer Fiat, and we 60 have also launched a tender far prospectivestrategic- partners for RTB Bor, We expect that the laterdeal will be finalized inearly 2009. Privatization, RestructuringandBankruptcyof SOEs 19. We realize that continuedexistence ofa large SOE sector imposes considerable risks of disrupting fiscal discipline. As you may know, the GoS has achieved significant progress in its privatization program, and despite many changes in the political environment, the privatization of SOEs through open tender and auction process has steadily continued over the past seven y m . The Privatization Agency (PA) has accelerated the privatization process with the objective to offer for sale all remaining saleable socially-owed enterprises inthe PA portfolio by the end of 2008. We have also developed a transparent and competitive procedure for the sale of shares from the Privatization Register in order to comply with the provision of the Law on Citizens' Rightsto Gratis Shares and Cash Benefits inthe PrivatizationProcess, 20. Over the medium term we intend to make the necessary arrangements for privatization of municipal enterprises, and inthis regardthe MoERDis planning to haw the strategy ready for government approval by June 2009. When it comes to further strengthening bankruptcy mechanism one important measure will include setting up specialist bankruptcy units within Tax OEce, Public Prosecutor's Ofice and other State creditors, with the right and power to represent the State's claims. Additionally, we intendto strengthen the regulatorycapacityof BankruptcySupervisionAgency (BSA) by developing an appropriate regulationto support the BSA in implementing a system of oversight and discipline, including de-licensing and lesser sanctions, of bankruptcy administrators. Finally, we intend to continue the process of restructuring and corporatization of state owned companies, leading to their eventual majority or partial privatization, including Initial Public Offerings (IPO) andjoint ventures. In this regard, we have conducted a tender for JAT Airways, offering majority ownership to reputable foreign investor with considerable experience in this industry, but due to the current masker conditions no bids were received. We intendto finalize the sale of a majority stake in NIS (natiod oil company) and restructure the airline company JAT following the failed tender, . EnergySector 21, Over the last few years, we have recorded significant progress in restructuring our power and gas sectors, primarily by separating power transmission from generation and distribution, andby separatingSrbijagas (gas transmissionanddistributioncompany) from MS. Serbia has therefore met EU standards for unbundlingof formerly vertically integrated utilities. Furthermore, in 2005 we established a regulatory agency, thereby makingsignificantprogressinlicensingandtarifl'systemdevelopmentin2006,2007 and 2008. We have undertaken significant increases in utility tariffs overthe last few years to get closer to cost-recoveringlevels. 22. The Government is committed to obtaining full cost-recovery tariffs for electricity and gas no later than by 2010. While undertakinggradual tariff increases, we 61 will give proper attention to adequate mitigation measures to deal with social impactsof higherutility tariffs. 23. Our view is that Serbia would benefit from privatesector participationinpower generation, and we will take steps to put this idea into practice. The Government will approve EPS' Business Plan for 2008-2012which includes the stmtegy and time-bound action plan for private sector participationwith majority control in the development of new major power generationunits. Furthermore, we havemade the decisionto open the market for petroleum products to free, international competition from no later than December 31,29IO. 24. Over the medium. term we intend to adopt a strategy to restructtm and improve operationalefficiency of EPS, thereby also facilitating private sector participationin the power sector. Also, in the medium tern we will develop a time-bound plan for introducingEU-basedpetroleumproductquality stanch& inSerbia. EstablishmentandDevelopment:of the State Audit Institutfon 25. Inorder toestablishan independentandcompetentbodyresponsiblefor auditing public sector accounts, the Law on State Audit Institution was adopted in November 2005. The Council, as the highest body of State Audit Institution{SAI), was appointedin late September 2007. Within three monthsfrom establishment, the Council has prepared the operations manual, work program, and annual plan and submitted them to the Parliament, thus meeting ail legal requirements. Finally, the Institution was atlocated a budget suflticient for conducting its activities. The budget was shown as a separate line item in the Budgetofthe RepublicofSerbia. 26. Inthe mediumterm, we will ensure that SA1becomesfully functional. This will include securing adequate premises and equipment, employing the core staff, defming work methodology, training the core staff, and commencingactual audits. It is expected that SA1will, possibly with the assistance of another country's supreme audit institution or commercial audit firm, complete the audit of government accounts for 2007 and submit them to the Parliament. Finally, the adequate capacity building measures for responsible bodiedinstitutions will ensure regular audits of all government accounts without any exceptions 1x4. Buildinga More Efficient and Stable Financial Sector Response to the Potential SpiIIovers of GlobelFinancialCrisis 27. Though Serbian banking sector indicators remained sound inlight of the globat financial crisis, the Government and the National Bank have introduced additional precautionary measures to ensure its stability and mitigate the spillover risks. Building on the past prudential and supervisory measures, robust internationalreserves (covering four months of imports), high aggregate liquidity-asset ratio, and one of the highest capital adequacy ratios in the region, the NationaJ Bank has introduced further stabilization incasures, enhancing its supervisory capacity and focusing on closely 62 monitoring liquidity,NPLlevels, deposits, and foreignexchange bufferson a daily basis. Specific liquidity indicators and early warning mechanisms were put inplace to preempt any potentialproblems. Further, the NBS h s requestedsystemically important banks to submit their businessplansfor 2009, alongwith informationonearly repayment ofcross- border loans. Additionally, the NBS remains in close contacts with home country supewisors to ensure coordinated monitoring, which is an important mmure given that 75% of Serbian banking sector is foreign owned. The plan for targeted diagnostic measureshas also beenprepared, as well as the guidelines on liquidity risk management, inline with the Baselprinciples. Inadditionto closely monitoringliquidity the NBShas also introduced measures for boosting it by abolishing mandatory reserve requirements on n mcross-brder borrowingfor financial leasingcompanies, and cross-borderlines of credit, includingsubordinatedones. 28. The NBS has also agreed certain temporary measures with the banks to provide short-termrelief to banking sector clients, such as extension of repaymentperiod of the existing loans for up tu one year for credit-worthy clients, applying no costs on early repayments, and Eurther stimulating RSDEUR denominated toms. These measures are complementary to GoS decision to increase the deposit insurance from EUR 3,000 to EUR 50,000 per deposit, and reduce taxes on foreign currency savings, thus fixther boostingconsumer confidence. GoS andNBShave formed high level monitoring teams, working in concert and in close contacts with financial industry, strengthening crisis response capacity. 29. Given the abrupt shiA inglobal financial environment and in order to safeguard macroeconomic and frnancial stability, we requested precautionary Stand-By Arrangement (SBA) with the IMF, although we do not intend to draw on Fund's resources unless the need arises. Further economic measures will focus on fiscal restraintsover the next two years, containing inflation, strengtheningcrisis preparedness, and facilitating reformsto boosteconomy's supply side. Privatizationand Divestmentof State-OwnedBanksand FinancialAssets 30. The GoS is committedto continue the reformsinthe bankingsector. As you may know. in 2006 the Deposit Insurance Agency (DIA) successfully completed the privatization of three banks. It sold 99.4% of the share capital of Vojvdjanska Bank to the NationalBankof Greece, 87.39% ofthe share capitalof PanonskaBank to San Paolo IMIfrom Italy, and 89.4% of Niska Bank to UTPBank from Hungary. inthe same year DIA sold 25% of Cacanska Bank and Komercijalnabank to EBRD. Inaccordance with the shareholders agreement, both shareholders are planning to sell their shares in 2009 and 2010 respectively.The shareholdersalso committed to implementing an institutional development plan in bothbanks until then, Additionally, in20137, DIA launched the sale of 6 packages of non-performingfoam (NPLs) of bankrupt stateawnedkmks inthe total amount and soldone NPLpackageinJanuary2008. 3 I. To date RoS has still ownership jn nine banks (majority stake in 4, and minority in 5) which accounts for 17.2% of assets, 20% of deposits and 15.9% of equity of the banking sector. The MoF and DIA have developed a privatization strategy for the 63 banking and insurancesectorouttininga three-pronged approach orbanks andinsurance companies in which RoS has majority shares, for banks in which RoS has minority shares, and for banks in which RoS is a majority shareholder together with EBRD. However, due to the global fkmcial crisis we are revisiting the Strategy in order to adjust it to reflect the current market developments. Further, we have provided initial capitalization for Deposit InsuranceScheme strengthening DIA's capacity in light of the crisis. We are also committed to continue supporting financially the DIA whose experience is cruciat in ensuring that the Strategy is successfully implemented. In the medium em, the Government intends to divest all of its holdingsin the banks where it has majority ownership, as well as to implement an institutional development plan in Postanska Stdianica. Further, we intend to complete the resolution of all remaining NPLsofbankrupt state ownedbanks. StrengtheningInsuranceSector Regulationand Resolutionregime 32. In 2007, the Serbian insurance sector has been in the process of a major transformation. During this time, the market has experienced consolidation, increased share of foreign ownersbip, and significant growth. While the volume of insurance activities increased substantially in 2007, the number of insurance companies active in the market declined from 40 to 21 (I8 insurance licenses were revoked by the NBS, 9 companies undertook voluntary liquidation, there was 1 merger, 1 company transformed to a pension hnd and 6 new Greenfield iicenses were issued). Currently, 13 out 21 insurersare foreign owned. With the complehnof the recent sale of DDOR to Fondiaria (Italy), Dunav remains the only govemment-owned company in the market*As a result, the state ownership share in insurance sector decreased in two times and now accounts for slightly over than 30 percent of insurance premium written. At the Same time, the quality of the insurers' balance-sheets has seen considerable improvement. Further, the quality of insurance supervision has improved as evidenced by the introduction of licensing requirements for insurance agents (128 institutionallicenses were revokedand 154 new issued), the launchof a comprehensiveregulatory framework (20 by-laws were issued), improved market transparency and commencement of pro-active on-site and off- site market supervision. 33, Dunav insurance company has successfully completed the first stage of its restructuring plan by centralizing the cash and claims management functions and reorganizing its operations along business lines. Additionatly the company also fully quantified its long-tail liabilities by carrying out an independent actuarial review. We intend to continue with remcturing of DWY in order to ensure its campetitive position in the Serbian insurance market. Going forward we are considering partial and/or fufl privatization, as well as a strategic partnership with a reputable international insurer that could help the company to adopt the cutting edge insurance technologies and hence maintain itscompetitivenessinthe long-run. 34. We have prepared the &aft MTPL law and we intend to include the funding strategy for the unfunded liabilitiesof the JnsuranceGuaranteeFund inthe Action Planof the Government Strategy for banks and insurancesector, which is now beingfinalized. 64 EnhancingPrudentSal Supervisionsfthe BankingSector 35. The NBS has, in call&oration with the World Bank, developed a Supervisory DevelopmentPlan(SDP) in2005, which hasbeenadequatelyupdatedover the past three years. A number of regulatory reforms, aimed at updating the framework for bank risk management and cometlswate supervisory focus, hme been implemented or me in the processofbeingapproved. Regulatoryreformsor directives and guidanceto the banking industry have included addressing issues such as requirements on bank disclosure of interest rates and pricing, updating of capital adequacy requirements, new guidelines on external auditing, bank licensing and supervision. In this regard, the NBS has recently completed priority actions supporting SDP objectives including the dissemination of a supervisionopmtingpolicy, revision and updateof the proceduresfor correctiveactions, issuance of new bank iicensingproceduresand new bank chart of accounts in line with IFRSaccountingstandards. 36. Further, we plan to issueandpublisha number of regulatory updates, including new capital adquacy requirements covering market risks and foreign exchange risk exposures, loanand asset classifications, new minimum bank liquidity requirements, and requirementfor consolidatedreportingon a financial group basis. These new regulations will ensure accurate financial disclosures and reporting. In 2009 reform priorities will include Basel IIimplementationmadmap,reportingpracticeson financial stability issues, implementing stress testing to detect individual bank potential weaknesses, and mainstreaming consolidated bank group supewision. Going further into 2010, NBS priorities will fwus on developing a horne/host supervision strategy indicating banking risks and home vs. host supervisory responsibilities and respective corrective measures, implementation of financial reporting standatds rSqUid under Basel fl standards, and rolling out standards and procedures for implementation of Basel 11's pillars 2 and 3 relatedto supervisoryreviewprocessand marketdiscipline/disclosure. StrengtheningCapital MarketsRegulatoryand Supervisory Regime 37. The Government has undertaken initial steps aimed at reforming regulatory regime to support further strengtheningof capital markets. The Ministry of Finance has prepared short-term, emergency amendments to the Securities Law, which have been submitted to the Parliament following a roundof publicdiscussionwith key stakeholders. Beyond this, the government is committed to enswing that progress is being made on comprehensive and coordinated revision of key laws relevant to capital markets during the course of 2009, including the developmentof brand new Securities Law, in order to establisha firm anddurable foundation for their f h r e development. 38. Also, the Government made strategic decisions on majority privatization and/or tPOs of key sate owned companies, as well as subsequent distribution G ffree shares to citizens and employees. Before any decisions can be taken on the options available for the future of these enterprises, their existing structure, in which the state owns the assets of the company will be thoroughly revised with the objective of converting them into openjoint stock companies inconformity with Serbia's existing legislation. The Ministry of Finance has engaged a focal consultant inearly 2008, whose task is to define the steps 65 necessary for full corporatisation of the state owned companies+The Government also plans to engage financial advisers to preparethem for privatization and IPO. Finally, any funher steps will take intoconsideration the ongoing market developmentsresulting from the fimcial crisis. 39. Both the National Bank of Serbia and the Ministry of Finance are conscious of the need to develop debt markets in Serbia. At present the only form of government financing is through short term (3 month) treasury bills. fn order to provide greater stability in government financing bills and bonds with a longer tenor are needed. The resultant development of a benchmark yield curve will make possible the issuance of municipal, corporate, and infr.astructure bonds. The Ministry o f Finance has set up a working group to recommend necessary steps towards this goal, whose report is due shortly. 40. Further, we will proceedwith implementation of a planto devefop debt markets, and eventually aim at issuing local currency instruments with tenor 6 months to 2 years, as well as assisting municipalities inissuing debt securities. 41. The GoS is undertaking major actions to address pending structural problems and improvethe business climate. We remain resoluteto deepenthe reforms inthe fitture, and to complement &em with measures aimed at strengthening fiscal discipline and buildinga more effkienl and stable financial sector together with policy actions directed at enhancingthe competitiveness of the Serbianeconomy. 42. The Government undertakes to continue working on these policy issues, for which the support by the World Bank andthe rest of the international cornunity will be of vital importance in attaining our objectives of placing the country on a path of sustainable and equitable growth, as well as, integration into European structures. In conclusion, we would like to reiterate the commitment o f the GoS to all these reforms, and we trust that this request for World Bank support for their implementation will receive your favorable consideration. 66 ANNEX 3: IMFPRESSRELEASE IMF Approves 402.5 million Stand-By Arrangement for Serbia Press Release No. 09/12 January 16, 2009 The Executive Board of the International Monetary Fund (IMF) today approved a 15-month SDR 350.8 million Stand-By Arrangement (about 402.5 million or US9530.3) to support the authorities' program aimed at maintaining macroeconomic and financial stability. The approval makes SDR 233.9 million (about 268.4 million or US$353.3) immediately available. However, the Serbian authorities intend to treat the arrangement as precautionary, and not to draw on Fund resources unless the need arises. The authorities' program aims at safeguarding macroeconomic and financial stability, in view of the global financial turmoil. It focuses on measures aimed at maintaining market confidence, complementing the large buffers in the financial system. Policies include upfront fiscal restraint, with the 2009 deficit limited to 13/4percent of GDP; containing inflation, while maintaining a managed float to facilitate external adjustment; strengthening crisis preparedness; and reforms to boost the economy's supply side. Following the Executive Board discussion, Mr. Murilo Portugal, Deputy Managing Director and Acting Chair, issued the following statement: "Serbia's recent stretch of robust growth and moderate underlying inflation-underpinned by large capital inflows-has been accompanied by the build-up of sizable external imbalances and vulnerabilities. With the global financial turmoil spilling over to Serbia, a rebalancing of the economy through a sharp slowing of credit and domestic demand seems necessary. "The authorities' program-supported by the SBA-is an appropriate response to the current challenges, and seeks to safeguard macroeconomic and financial stability through a comprehensive policy package. Determined implementation of this program should poise the Serbian economy to resume more balanced and sustained real income growth. "Strong fiscal measures are being taken to achieve the tighter 2009 deficit target. Because of the procyclical fiscal policy stance since 2006, limited budgetary financing options, and the need to ensure the credibility of the program, there is no scope now for countercyclical fiscal loosening. The slowdown in public wage and pension growth, as well as other savings measures, preserve fiscal space for much-needed infrastructure investment. "Monetary policy will continue to focus on inflation within a strengthened framework, supported by a managed float with foreign exchange interventions limited to ensuring orderly market conditions. Given the uncertain economic environment, the monetary stance will need to be adjusted flexibly. "Past prudential policies are now paying off in providing a strong first line of defense against spillovers from the financial turmoil. These policies have succeeded in building large liquidity and capital buffers in the banking system, although they may also have encouraged risky cross-border borrowing. The authorities need to strengthen the financial stability framework, mainly by improving the monitoring of risks and setting up comprehensive contingency plans. "Structural policies need to address the economy's weak supply side, with a view to delivering balanced and sustainable catch-up growth toward EU income levels. The program calls for privatizing, restructuring, or liquidating a wide range of state- and socially owned- enterprises, as well as lowering the cost of doing business, to help expand the undersized private sector. "The authorities have started to implement their program steadfastly. This gives confidence that the Serbian economy, with the support of the international community, will succeed in overcoming the present difficulties," Mr. Portugal said. 67 Annex Recent Economic Developments The global financial turmoil began to spill over to Serbia in the fourth quarter of 2008, as for the region as a whole. The stock market plummeted; sovereign spreads soared; households withdrew some of their deposits; and, amid high volatility and frequent NBS interventions to maintain foreign exchange market liquidity, the dinar depreciated. Growth, which so far was strong, seemed to be losing momentum. At the same time, the reversal of the region-wide food and energy price shocks eased headline inflation pressures. These outcomes were accompanied by the build-up of an increasingly unbalanced external position. The current account deficit could reach 18 percent of GDP in 2008, although it has so far been easily financed by capital inflows, resulting in rising international reserves. Consequently, external stability risks have increased substantially in the current international environment. These reflect Serbia's unsustainably large external deficit; the private sector's high external indebtedness; high euroization; and indications of weak export competitiveness. Financial stability risks have also increased, but the banking sector's liquidity and capital buffers are comforting. Program Summary The authorities' program, supported by the SBA, responds to the abrupt deterioration in the short-term outlook: trading partner growth and prices of key Serbian exports, particularly metals, are projected to slow sharply in 2009; and formerly plentiful capital inflows can no longer be taken for granted, further constraining domestic and cross-border credit growth. The program's objective is to safeguard macroeconomic and financial stability through strengthened policies, designed to underpin an orderly rebalancing of the economy. The policy package focuses on four main features: 0 Tightening of the fiscal stance in 2009-10, with the 2009 general government deficit limited to 1%percent of GDP, followed by further fiscal consolidation in 2010. This involves strict incomes policies for containing public sector wage and pension growth and a streamlining of non-priority recurrent spending, which helps create fiscal space to expand infrastructure investment. Strengthening the inflation targeting framework while maintaining a managed floating exchange rate regime. Making good use of the accumulated financial sector buffers, while enhancing financial crisis preparedness. Implementing structural policies to address the roots of the economy's low capacity to produce, save, and export. The main elements of the fiscal package include The program's macroeconomic framework assumes a decline of foreign inflows and domestic credit, which should lead to a slowdown in domestic demand, output growth, and inflation, and a narrowing of external imbalances. Real GDP growth is projected to decelerate to 3% percent in 2009 but should rebound in 2010. With the inflation-reducing effects of commodity price declines and slowing activity being counteracted by pressures on the exchange rate, inflation is projected to slow only gradually to 8 percent by end-2009. Serbia joined the IMF on December 14, 1992; its quota is SDR 467.7 million (about 541 million or US$707 million) and it has no outstanding use of IMF credit. Its latest arrangement with the IMF was an Extended Fund Facility, completed on February 28, 2006, 68 Serbia: Selected Economic and Social Indicators, 2006-10'' 2006 2007 2008 2009 2010 Est. Proj. Proj. (Change in percent, unless otherwise indicated) Output, prices, and labor market Real GDP 5.6 7.1 6.0 3.5 4.5 Real GDP excluding agricultural 6.3 8.9 5.9 3.9 5.0 sector Real domestic demand (absorption) 6.5 11.8 6.3 2.6 2.2 Consumer prices (end of period) 2/ 6.6 10.1 9.5 8.0 6.5 Core retail prices (end of period) ... 2/ 5.9 5.4 10.5 E . . (In percent of GDP) General government finances Revenue 43.6 43.0 42.8 42.0 41.2 Expenditure 45.2 44.9 45.2 43.8 42.2 Fiscal balance -1.6 -1.9 -2.3 -1.8 -1.0 Gross debt 42.5 34.2 33.8 30.9 28.3 (End of period 12-month change, in percent) Monetary sector Money (Ml) 37.1 25.3 -8.2 18.2 8.7 Broad money (M2) 38.4 44.5 7.9 5.2 13.5 Domestic credit to non-government 17.1 36.9 29.6 6.1 12.3 (In percent of GDP, unless otherwise indicated) 69 Balance of payments Current account balance -10.0 -15.9 -17.9 -16.0 -15.4 Exports of goods 21.7 22.0 22.3 20.5 21.7 Imports of goods 42.8 44.9 46.1 42.3 41.6 Trade of goods balance -21.1 -22.9 -23.8 -21.8 -19.8 External debt (end of period) 63.0 61.1 66.6 71.6 75.8 of which: Private external debt 35.8 40.0 46.0 50.8 56.0 Gross official reserves (in billions of 9.0 9.6 9.0 8.1 8.7 euro) (In months of prospective imports of 6.7 6.3 6.2 5.1 5.3 GNFS) Exchange rate (dinar/euro, period 84.2 80.0 81.5 ... . a . average) Real effective exchange rate (annual 6.6 7.2 5.0 ... average change, in percent; + I . . indicates appreciation) SociaI indicators Per capita GDP (2008): US$6,685. Poverty rate (poverty line is US$5 per day, 2007): 6.6 percent. Unemployment rate (2008): 14 percent . Sources: Serbian authorities; and IMF staff estimates and projections. *'Excluding Kosovo (with the exception of external debt). Retail prices until 2008. Monitoring of core retail price indices to be discontinued in 2009. 70 IBRD 34847 19°E To 20°E 21°E Kiskoros To Szeged SERBIA H U N G A R Y SELECTED CITIES AND TOWNS SuboticaSubotica KanjizaKanjiza To 46°N Arad OKRUG (DISTRICT) CAPITALS BajmokBajmok SentaSenta POKRAJINE (PROVINCE) CAPITALS BackaBacka Kikinda Kikinda To Topola pola AdaAda Timisoara SomborSombor NATIONAL CAPITAL ApatinApatin RIVERS SivacSivac Veliki BecejBecej KulaKula ROMANIA MAIN ROADS V O J VTisaO D IElemirElemirA N RAILROADS CROATIA Temerin emerin To OKRUG (DISTRICT) BOUNDARIES Timisoara BackaBacka ZrenjaninZrenjanin POKRAJNE (PROVINCE) BOUNDARIES To PalankaPalanka Vinkovci INTERNATIONAL BOUNDARIES Novi Sad Novi Sad To SidSid VrsacVr Vinkovci Fruska Gora AlibunarAlibunar This map was produced by the Map Design Unit of The World Bank. 45°N RumaRuma IndijaIndija The boundaries, colors, denominations and any other information shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, or any PancevoPancevo Bela Crkva Bela Crkva endorsement or acceptance of such boundaries. Sremska Sremska To Carbunari Sabac Sabac Mitrovica Mitrovica To To ZeleznikZeleznik BELGRADEBELGRADE KovinKovin Bijeljina Sava Gura Vail ZminjakZminjak Danube PrnjavorPrnjavor PozarevacPozarevac Vlasic ObrenovacObrenovac SmederevoSmederevo Golubac Golubac Kladovo Kladovo LoznicaLoznica Planina Jovan Deli MladenovacMladenovac Drina Velika- elika- Velika Homoljske Majdanpek Majdanpek Petrovac Petrovac P lanina NegotinNegotin LjubovijaLjubovijaPValjevo ljevo To S E R B I A ZagubicaZagubica Sarajevo ovlen Maljen PlanaPlana oraMva To BOSNIA Gornji Gornji Beljanica BorBor Vidin 44°N Milanovac Milanovac KragujevacKragujevac 44°N AND RogacicaRogacica Ravni Gaj Ravni Gaj CuprijaCuprija ´ To CacakCacak Vidin HERZEGOVINA UziceUzice JagodinaJagodina ZajecarZajecar Pozega Pozega (Svetozarevo)(Svetozarevo) Paracin Paracin ´ Rtan To Gorazde Zlatibor SokoSoko KraljevoKraljevo Zapadna Juhor Banja Banja Morava Knjazevac Knjazevac Zaglavak Ivanjica Ivanjica Midzor (2168 m) Jastr Velebac iki PrijepoljePrijepolje Javor Cemerno AleksinacAleksinac KrusevacKrusevac Usce Usce Zelgin NisNis BelaBelaBalkan Sjenica Sjenica Raska Raska ProkupljeProkuplje PalankaPalanka Golija Su Beloljin Beloljin JuznaMorava Planivna a PirotPirotMts. Novi Pazar Novi Pazar Sit Radan 43°N Rogozna Kopaonik cian PrepolakPrepolak LeskovacLeskovac 43°N To KosovskaKosovska VlasotinceVlasotince To Podgorica MitrovicaMitrovica Sofia To Vucitrn ucitr Sofia MONTENEGRO PecPec´ PristinaPristina Priboj Priboj SurdulicaSurdulica BULGARIA DaravicaDaravica B (2656 m) (2656 m) ile K O S O V O Vranje ranje mirD GnjilaneGnjilane BosilegradBosilegrad To OrahovacOrahovac Bujanovac Bujanovac Pernik DakovicaDakovica UrosevacUrosevac LjubotenLjuboten PresevoPresevo (2486 m) (2486 m) SERBIA LakeLake ScutariScutari PrizrenPrizren To To Sar nina To Kumanovo Kukes Pla Tetovo To Skopje 0 25 50 75 Kilometers ALBANIA FYR 0 25 50 Miles MACEDONIA 19°E 20°E 21°E 22°E AUGUST 2006