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Emerging Markets
For important disclosure information please refer to page 7.
Serbia is reclaiming its place in Europe; it expects to receive a candidate status this
year and ties its economic links closer to Italy and Europe. Based on our recent visit,
we see an improved outlook for the country. The government is observing Central
Europe for central banking clues, Slovakia for an export-oriented transformation and
tries hard to cooperate politically with the EU. The NBS runs a relatively free float to
‘dinarise’ a heavily-indexed economy. Measuring by the results, the country’s policy
choices are proving more effective than Croatia’s and the World Bank sees a five-
quarter consecutive export growth reassuring on competitiveness. This should be
reinforced by a prospective flow of foreign investments, including a €1bn project in the
auto industry where the supply chain is substantial. Based on a best-case scenario and
Slovakia’s experience, Serbia’s economic model that was conditioned by past high
consumption standards could transform to an export-oriented one and its growth rate
rise from 3% to 5%-7.5%.
Fiscal populism typically surrounding political elections is a concern. External
vulnerabilities are still large and funding gaps could still surface. The government has
requested a new precautionary IMF SBA, which, in our view, would be necessary to
secure the government’s debut Eurobond scheduled for September/October. This,
otherwise, could be a rare case of an improving credit.
Serbia’s dinarisation problem and the NBS
Serbia has one of the highest and most volatile inflation rates in Europe (after the Ukraine and
Belarus). The National Bank of Serbia is also unique in the region with its monetary regime;
it operates a quasi-free float with active interest rate policy, in an environment of very
low policy credibility. Interest rate policy is therefore ‘aggressive’, as the bank is trying to
build dinar-based financial markets; establish confidence in the local market and reduce
inflation to c. 4%.The prevailing degree of euroisation, however, suggests that the strategy has been as yet
ineffective. This proved to be a single important problem in the crisis management in Serbia
although the impact has been rather well contained. The use of the euro is widespread in the
SEE region and it is the highest in Serbia; 67% in loan portfolio and 70% in deposits. The rate
of euroisation under both fixed exchange rate or inflation-targeting regimes is usually 60% or
less.
The region’s experience with hyperinflation and monetary instability, and widespread
indexation has created a pattern of exchange rate pegs or de facto currency boards. The
NBS, alone in the neighbourhood, is running considerably greater exchange rate flexibility.
This has been facilitating some degree of switch to the RSD in 2008 but the NBS intervened
later asymmetrically; putting a floor under the dinar and preventing excessive depreciation.
The combination of high euro-indexation and exchange rate flexibility remains risky but as we
show below, by the results, more effective than Croatia’s peg. The full scale of exchange rate
adjustment between 2008 and 2011 was c. 35%. This was among the larger nominal
exchange rate depreciations in the region. According to the NBS, however, the deterioration of
banks’ loan quality has not been as large as elsewhere, where the private sector holds
similarly large open currency positions. The NPL ratio reached c. 17%; 24% in the corporate
sector and 8% for households. This is likely to have been possible due to households’ hedge
in the form of large holdings of foreign currency savings and deposits. According to the
OeNB’s EuroSurvey, Serbian households hold on average c. €3,500 euro general cash
reserves or in total c. €9bn, equivalent to over 20% of GDP (2009 survey-time GDP, latest
NBS data €7.3bn), which exceeds that in any other Central Eastern European country.
According to the World Bank, the size of the cash economy is also massive, which has also
helped to ease the crisis.
EM Country Briefing
Serbia: Fights for growth
S&P BB- (stable)
Moody’s NR
Fitch BB- (negative)
Analyst
Barbara Nestor
+44 (0)20 7475 [email protected]
research.commerzbank.com Bloomberg: CBIR
12 August 2011
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EM Country Briefing
2 12 August 2011
As part of the dinarisation strategy of the NBS, the government introduced credit support
programs via subsidised dinar loans, which have helped to shore up credit growth during the
crisis. This program reduced slightly the share of foreign currency loans in total from 75% to c.
67%, although the support scheme is being phased out and the increased use of the dinar may
fade out again. According to the OeNB’s survey the practise of setting prices and wages in euro
and denominating them in dinar only for legal purposes prevails, while payments for large
consumer durable goods are made almost exclusively in foreign currency. As macroeconomiccredibility is perceived to be low, the best hedge remains to be denominating contracts
and prices in foreign currency.
The favourable interest rate differential of foreign currency denominated financial services
arouse from (previously) easy access to abundant foreign currency liquidity from abroad from
parent banks and remittances (the latter c. 8% of GDP p.a.). A lack of a liquid government bond
or bill market beyond the shortest maturities means the pricing benchmarks for local currency
financial instruments and hedging products is missing. The authorities nevertheless continue to
maintain a co-ordinated support for dinarisation, which involves the development of hedging
markets, the NBS offering FX swaps and the Ministry of Finance issuing local debit instruments
and lengthening T-bill maturities from three months to two years. The next hurdle is to
encourage a secondary market in T-bills.
Serbia’s monetary policy operation resembles that of Hungary’s in its early inflation targeting
period; it runs at high interest rate volatility, due to the overwhelming role of exchange rate
transmission. When the exchange rate background is stable, the carry trade catches on; year-to-
date the NBS reports c. €0.7bn foreign portfolio investments in short debt instruments (361D+ T-
bills, available to non-residents); one-half of the outstanding stock. With a shallow currency
market this makes the RSD vulnerable (€100m daily turnover, €300m-€400m pre-crisis, catching
up to Romania). According to local banks the (quasi-) free-float and non-resident participation in
the local market helps the market to develop. The float, therefore, could prove a healthier
strategy than Croatia’s quasi-fix (see more on this below), provided that the local market
grows in liquidity and hedging instruments. The IFC is taking an active role in technical
assistance, and a growing number of multinational corporate operations should also facilitate
this.
The NBS says that inflation volatility encourages euroisation more than exchange rate
volatility. Therefore it is likely to continue to allow exchange rate volatility, as long as it
can control inflation, but interest rates are likely to be held at a foreign currency risk
premium to Europe. A turnaround into a currency board like fix, similar to Croatia, is not
considered. (For comparison, annual average. EUR/RSD depreciation was 15% and 9.5% in
2009 and 2010, respectively, as against weighted average interest rate on Republic of Serbia T-
bills of 14% and 11%).
CHART 1: Foreign currency loans as % of GDP CHART 2: Foreign currency loans as share of private credit
0
10
20
30
40
50
60
70
80
90
B e l a r u s
R u s s i a
T u r k e y
M o l d o v a
P o l a n d
M a c e d o n i a
R o m a n i a
A l b a n i a
U k r a i n e
S e r b i a
H u n g a r y
B u l g a r i a
L i t h u a n i a
C r o a t i a
L a t v i a
0
10
20
30
40
50
60
70
80
90
100
B e l a r u s
R u s s i a
T u r k e y
P o l a n d
M o l d o v a
U k r a i n e
M a c e d o n i a
B u l g a r i a
R o m a n i a
H u n g a r y
A l b a n i a
S e r b i a
L i t h u a n i a
C r o a t i a
L a t v i a
Foreing currency loan as share of household
Foreign currency loans as share of corporate loans
Indexed
Source: Commerzbank Corporates & Markets, EBRD Source: Commerzbank Corporates & Markets, EBRD
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EM Country Briefing
12 August 2011 3
Damages from the crisis
The banking sector is a strong pillar of the economy. While the above would suggest that
exchange rate volatility has been harmful, banks have withstood the crisis and deposit
withdrawal without outside support, due to outstandingly conservative NBS provisioning
requirements. Banking sector balance sheets continued to expand even during the crisis and
credit growth is faster than in regional markets; at a rate of 15% year on year. This has been
stimulated by subsidised RSD credit schemes, which are being phased out.
Large cross-border exposure to foreign banks was the system’s key vulnerability. The NBS
administered closely the Vienna initiative, and in particular, exposure floors bank by bank.
Exposure limits of foreign banks were lowered from 100% to 80% in April 2010; nevertheless,
Serbia still has large foreign claims originated by its lenders equal to c. 65% of GDP. Eurozone
periphery banks hold among the highest concentration of local banking assets in Serbia,
up to 40% of GDP.
Eurozone periphery banks have claims of up to 20%-50% of GDP in the region’s banking
systems. This capital is not fully callable and local banking regulation tightly limits the amount of
capital that can be withdrawn, but the amounts highlight the relative importance of parent bank
funding for individual countries. Croatia and Bulgaria stand out with foreign claims of close to
50% of their GDP originated by Greek and Italian lenders. Serbia and Macedonia havesomewhat lower foreign claims as % of GDP, but, together with Bulgaria 60% or more of
that is owed to the Eurozone periphery lenders. These credit lines may tighten.
TABLE 1: Foreign claims by lender countries to Central Eastern Europe as % of GDP
Bulgaria Czech R Croatia Hungary Macedonia Poland Romania Serbia
Austria 11.1 32.04 56.4 26.04 3.86 3.17 24.7 17.38
Italy 17.00 8.56 51.59 16.03 0.25 10.02 8.40 18.92
Spain 0.19 0.30 0.11 0.67 0.03 1.37 0.23 0.01
Portugal 0.00 0.01 0.07 0.21 n/a 3.22 0.44 0.02
Greece 31.64 0.00 0.30 0.17 20.25 1.71 13.05 17.94
European banks 77.47 94.03 125.45 86.80 27.38 58.33 67.16 65.09
Source: Commerzbank Corporates & Markets, BIS
TABLE 2: Banking sector ownership in the CEE and SEE, by assets (% share)
Bulgaria Poland Romania Hungary Serbia Czech Croatia
Greece28.7
Italy14.1
Austria 31.8 Austria 24 Italy 21.5 Belgium 20.8 Italy 41
Italy15.8
Germany10.8
France 14 Italy 20 Greece 15.4 Austria 25.3 Austria 33.8
Hungary12.5
Netherlnd7.5
Greece 12.3 Belgium 14 Austria 17.1 France 16.4 France 7.5
Austria9.9
Spain7.2
Netherlnd 3.4 Germany 13 France 7.9 Italy 6.4 Hungary 3.5
Germany6.0
Austria5.2
Italy 6.1 other 0 Germany 2.6 other 18.1 other 10
Portugal4.6
other10.8
other20.6
other 20.2 other 8
domestic 16.3 domestic 30 domestic 12.2 domestic 29 domestic 27.5 domestic 13 domestic 4.2
Source: Commerzbank Corporates & Markets, National Central banks
The banking system, nevertheless, has a strong ‘regulatory hedge’. The corporate sector
suffered the largest damage from balance sheet exposure, but banks are able to absorb
substantial credit risks; the capital adequacy ratio is among the highest in the region above 20%.
According to stress tests under the IMF’s oversight, banks are sufficiently well capitalised to
absorb even a protracted corporate restructuring process. A new decision on reserving
requirements that promotes the use of longer maturity RSD sources will further regulate funding
vulnerabilities.
According to local banks, Serbia is one of ‘the safest banking markets in the world’. This
is due to the fact that lending is done nearly purely from capital; the system has a capital stock of
c. €3.5bn for a loan portfolio of €14bn. As long as prudential regulations are kept tight, banks
should remain stable in the face of unhedged private sector balance sheets.
Regulatory strength
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EM Country Briefing
4 12 August 2011
CHART 3: CAR % tier 1 CHART 4: Loan/deposit %
0
5
10
15
20
25
H u n g a r y
P o l a n d
C z e c h
R o m a n i a
B u l g a r i a
C r o a t i a
S e r b i a
0
20
40
60
80
100
120
140
160
C z e c
h
P o
l a n
d
C r o a
t i a
S e r b
i a
B u
l g a r i a
R o m a n
i a
H u n g a r y
Source: Commerzbank Corporates & Markets, National banks and bank
regulators, Fitch Ratings
Source: Commerzbank Corporates & Markets, National banks and bank
regulators, Fitch Ratings
The IMF oversight and fiscal position
Serbia completed its IMF Stand-by Program in April with good progress; securing five tranches
of financing of $1.5bn. The government drew only half of the $3bn available, observing funding
costs (the loan rate jumps at $1.5bn from 2% to 4%). According to the Fund, the 2009 SBA
achieved the fiscal adjustment targets but relied on low quality ad hoc measures, including a cut
in the public wage bill and across-the-board discretionary spending, as opposed to setting a
long-term spending structure. The IMF is likely to be available for a new program, although sees
high implementation risks ahead of the 2012 elections. It has served the role of a political co-
ordinating mechanism, and is likely to stay engaged for this purpose; and set structural
benchmarks that can be done piecemeal or back loaded. The new structural benchmarks would
be related to (1) restructuring of SOEs (quasi-fiscal deficit generators), (2) labour market
deregulation, (3) competition policy and break-up of monopolistic sectors.
The government has pledged to observe the fiscal ceiling of 4.2% of GDP and 3% of GDP next
year, although the required expenditure cuts of an estimated 2.7% of GDP (1.2% and 2.5% due
to the decentralisation of revenue collection to the regions) are seen as hardly feasible. The
original budget deficit target for 2010 was revised upwards from 4.0% to 4.8% of GDP last
September, and the IMF estimates that during the last ten years the fiscal cost of a typical pre-
election year in Serbia was about 3% of GDP, which adds risks to a new Program. The
government has passed fiscal responsibility legislation last year, which caps the public debt-to-
GDP ratio at 45% of GDP, and cuts the fiscal gap to 1% of GDP in the medium term, observing a
long-term target of public cost structure, but the Fund still expects slippage on short-term targets.
The government is preparing a $1bn debut Eurobond for September/October this year, $200m of
which would be an RSD-denominated inflation-linked bond. Local banks argue the government
can fund itself at 4.5%-5.85% with euro-indexed RSD treasury bills and would seek to avoid the
‘Montenegro mistake’ which we believe is a high-price market issue (Montenegro sovereign
bond issued at 7.85%-7.25%). We think that an IMF precautionary agreement would be key
for Serbia’s Eurobond issue (and for investors), both for policy restraint and liquidity
reasons, so as to insure against event risks such as delay to the country’s recognition as
an EU candidate, political instability or the ‘Italy risk’.
New economic model and external balances
Serbia’s devaluation proved to be less harmful overall; the exchange rate and current account
adjustment have been more extensive than in peer countries, while the contraction in GDP was
moderate. The World Bank believes that export growth has helped to pull the economy out of
recession; five consecutive quarters of c. 20% year-on-year export growth suggests
competitiveness adjustments.
Serbia’s pre-crisis growth model was conditioned by past high consumption standards, and
unlike elsewhere in the CEE, its external deficit was structural. Serbia, as a republic of former
Yugoslavia exported c.70% of its production, compared to 20%-30% today. The government has
set out to support the transformation of the economy to an export-oriented one, with the help of a
favourable momentum in FDI. Fiat has chosen Serbia, Kragujevac over Turin for a €1bninvestment (including €250m government support and €400m EIB funds). This coincides with a
smaller, but labour intensive and export-oriented investment by Benetton, a c. €600m-€800m
Tendency to overshoot
Auto and steel industry investments promise a turnaround
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EM Country Briefing
12 August 2011 5
also Italian investments in renewable energy generation and additional infrastructure projects
financed by China. According to World Bank estimates, given the small size of the economy the
Fiat investment alone would generate an extra GDP growth of 1.7% GDP, and if the 2014
production plan of 200,000 units is met, an extra 1% over the long term. More importantly, the
supply chain of the auto industry is sizeable. Using IMF base case projection and best-case
scenario for prospective investments, Serbia’s growth rate could rise from 3% pre-crisis
to 5%-7.5%. The country’s attraction as a manufacturing base lies in its harmonisationwith the EU and simultaneous free trade zone with the CIS, cheap availability of high
voltage electricity, which could kick-start an investment cycle. There is, however, a lot to be
done on the investment environment and macroeconomic stabilisation.
Slovakia is a model economy that showed unstable growth prior to the Dzurinda reforms and
was of similar size. It received two large greenfield investments in the auto industry of 2%-3% of
GDP, which (together with market reforms) attracted annual FDI flows of 5%-6% of GDP over a
period of 4-5 years and lifted Slovakia’s growth rate from c. 3% to 5%-7% over the medium term.
CHART 5: Hourly labour cost (€) CHART 6: Export to GDP %
0
5
10
15
20
25
30
S e r b i a
B u l g a r i a
R o m a n i a
L i t h u a n i a
L a t v i a
P o l a n d
H u n g a r y
S l o v a k i a
C r o a t i a
C z e c h R .
P o r t u g a l
S l o v e n i a
G r e e c e
U K
G e r m a n y
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Export to GDP %_Hungary _Serb ia _Croatia
Source: Commerzbank Corporates & Markets, Eurostat Source: Commerzbank Corporates & Markets, Ecowin
CHART 7: Exports 12mma, 2007=100 CHART 8: CAD % of GDP 2007 and 2010
80
90
100
110
120
130
140
150
Serbia Croatia Romania Bulgaria Hungary
2008 2009 2010 2011
-1
-7.1
-4.1 -3.5
-1.3
1.2
-3.4-2.4
-28.0
-23.0
-18.0
-13.0
-8.0
-3.0
2.0
B u l g a r i a
S e r b i a
R o m a n i a
M a c e d o n i a
C r o a t i a
H u n g a r y
P o l a n d
C z e c h
2007 2010
Source: Commerzbank Corporates & Markets, Ecowin Source: Commerzbank Corporates & Markets, IMF
TABLE 3: The government’s macroeconomic framework
2009 2010 2011 2012
GDP growth % y/y -3.5 1 3 4
GFCF % -22.8 3.3 7.6 10.8
Export % -13.8 19.1 11.7 12.5
Import % -23.6 4 6.4 7.8
Current A/c deficit % of GDP -7.9 -8.0 -8.2 -8.0
Source: Commerzbank Corporates & Markets, Ministry of Finance
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EM Country Briefing
6 12 August 2011
The government’s macroeconomic framework is based on the assumption of a new
economic model; 10% annual gross fixed capital investment growth in 2011-13 which
produces a recovery in growth to 3% and 4.5%. The share of exports in GDP, and domestic
savings would increase over the medium term.
Serbia’s export results already stand out in comparison with Croatia. Most regional peers
show a sustained export recovery in 2010-11 (and over the 2007 base), while Croatia is notably
lagging behind (chart 7). Croatia’s exchange rate peg and lack of internal devaluation over the
recent period has been highlighted as a structural drag, and by the results, Serbia’s policy
choices appear to have been better.
While the country’s current account gap is still among the largest in the region, an estimated 7%-
7.5% of GDP (including c. 10% of GDP worth of remittances from abroad), capital flows are
improving and FDI could reach between 5% and 6%. A funding gap may still be present this
year if the government fails to issue the planned Eurobond, which is to replace the postponed
privatisation of Telekom Sbrja (€1.4bn). On the back of the prospective investments the
sustainability of Serbia’s external position should gradually improve (one-third of its
current account deficit alone could be covered by Fiat operations). Serbia’s growth
opportunities have improved and it could become a new growth market in Central Europe.
CHART 9: Export, import and trade balance 12mma CHART 10: Balance of payment accounts, €m 12mma
-40
-30
-20
-10
0
10
20
30
40
50
60
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11
-16
-14
-12
-10
-8
-6
-4
-2
0
Trade bal.12mma (rhs) Exports 12mma % y/y Imports
-2,000
-
2,000
4,000
6,000
8,000
10,000
12,000
Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10 Apr-11
Portfoli o cap. Com merci al loans FDI CA D
Source: Commerzbank Corporates & Markets, Ecowin Source: Commerzbank Corporates & Markets, Ecowin
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