Republic of Serbia Fiscal Council 11 February 2015 2015 – 2017 FISCAL STRATEGY ASSESSMENT AND SIGNIFICANCE OF PUBLIC INVESTMENTS FOR ECONOMIC GROWTH.

Republic of Serbia Fiscal Council

11 February 2015

2015 – 2017 FISCAL STRATEGY ASSESSMENT AND SIGNIFICANCE OF PUBLIC INVESTMENTS FOR

ECONOMIC GROWTH

Fiscal Strategy: painful, though adequate measures• A demanding multi-year plan for public finances recovery and public

sector reforms– It shows Government’s clear intention to start addressing accumulated problems in

public finances

– It envisages difficult and painful cuts (reforms and discharging employees in public companies, administration, health care and education systems, as well as wage and pension freeze, restructuring process completion etc.)

– Major professional, political, but social challenges as well

• Fiscal Council finds that savings measures are adequate– Due to the magnitude of the problem, there is no actual alternative to severe savings

measures

– No resolute deficit reduction would mean explosion of public debt and certain fiscal crisis: deep GDP decline, strong Dinar weakening and high inflation

• Basis for concluding a three-year arrangement with IMF– Significantly improves the prospects for the entire programme success

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Ambitious multi-year plan – implies risks

• Fiscal consolidation will have to include 2018 as well: a four-year plan instead of a three-year one is necessary– Fiscal deficit reduction to 3.8% of GDP is not enough for public debt stabilization by

2017

– Additional deficit reduction by 1 p.p. of GDP in 2018 is necessary

• Two crucial reform blocks carry the greatest risks– Public and state-owned companies: putting the operation of Srbijagas, EPS, Železnice

in order, resolving the fate of Železara Smederevo, Petrochemical Complex

– Public (budget) sector: reduction of employees number along with all-encompassing reforms

– Deadlines are short (couple of months), but precise plans are still not in place

• Sharp reversal in fiscal policy, while economy is in recession– Unfavourable macroeconomic environment significantly aggravates necessary

implementation of fiscal consolidation

– Macroeconomic policy measures are necessary for economic growth incentive3

Public investments are the best antirecessionary measure

• Serbia’s economy has been in recession since 2014 – economic activity decline by app. 1.7%– Savings measures will have a temporary negative effect on economic growth and will

deepen the current recession

– Prolonged and uncontrolled recession can endanger fiscal consolidation

• Government investments in infrastructure may alleviate negative effect of consolidation on the economic growth– In a short-term, the effect of public investments on economic growth (fiscal

multiplier) is at least twice bigger than other forms of government spending

• Negative effect on economic growth due to a deficit/spending reduction by 2 p.p. of GDP can be offset by increasing investments by 1 p.p. of GDP

– In a medium-term, the improvement of road and railroad infrastructure as well as of energy capacities will create conditions for a faster economic growth

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Poor infrastructure condition requires an investment growth

• General state of infrastructure is alarmingly poor - Serbia is among the worst rated countries in international rating lists– According to overall infrastructure quality, Serbia is ranked as 111st out of a total of 148

countries – the worst in the region

– By road quality it is 114th (only Romania is rated worse in the region)

• Budget allocations for public investments are undoubtedly low – only 2.5% of GDP in 2014 – They need to be doubled – public investments in the comparable countries of Central and

East Europe amount to more than 4% of GDP at an average

• Adequate projects and financing sources exist– The projects to improve infrastructure quality exist (eg. road and railroad Corridor 10)

– Financing for infrastructure projects has been ensured on preferential terms– loans by the World Bank, EIB, EBRD with log repayment period and low interest rate

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Public investment growth is justified even at the cost of a slightly higher deficit

• Public investments can be increased in 2015 by 1 p.p. of GDP through more efficient implementation of current projects– Fiscal Strategy plans only 0.5 p.p. increase, which is not enough

– An important stimulus for domestic economic activity

• Ideally, the room for somewhat bigger growth of investments should be found in the planned budget framework– By reducing other, less productive expenditures, like subsidies

• If this is not possible, even a smaller deficit reduction would be acceptable if the reason was a stronger investment growth– Due to a strong positive effect on the economic growth, the increase in capital

expenditures will affect the deficit less as compared to all other public expenditures

– New borrowings are not necessary for financing an additional increase in public investments – the funds have already been approved

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Public and state-owned companies: The need for significant reforms

• Resolving the accumulated problems of public and state-owned companies is a key reform move for the Government – we support that– This will not yield the biggest savings; however, if their operations are not put under

control in 2015, a complete cave-in of public finances is possible

– Much more important – reform should ensure that public companies be the boosters of economic growth

• Instead of being loss-makers and social institutions

• Resolving the status of companies under restructuring = eliminating the “parasite sector”– Many companies with no perspective, however, have been draining huge funds from

the economy and budget for years

• There are chances for this to end– First concrete steps are visible: liquidation of 188 companies under restructuring, changes in the

EPS, privatization of Železara Smederevo?7

Public and state-owned companies: Complex problems, yet short deadlines

• The Government has implicitly committed to addressing the biggest problems already in the first half of 2015 – very uncertain– No budget funds for the Srbijagas in 2015 means resolving the fate of the

biggest gas debtors even by mid year (Železara, Petrohemija, Azotara, MSK)

– Železara Smederevo is a problem per se - facing closing without Esmark?

– Lower subsidies for the Železnice in the budget - is this sustainable without a plan for employee discharging and rationalization of services?

– There is a real danger for the EPS’ losses to be transferred to the government – the biggest problems must be resolved without delay (redundant employees, poor collection, low price etc.)

• Detailed plans are still not in place, whilst the first deadlines have already been breached – February?

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Decrease in the number of employees without detailed plans is a big risk

• Fiscal Strategy envisages successive decreases in the budget sector employment of 5% per year by 2017– According to the plan, in three years the health care and education systems, as well as

state and local administration, should have 15% less employees (app. 75.000)

• Such a big decrease in the number of employees cannot be achieved by natural outflow only – neither this would be desirable– Natural outflow through retirement of employees with a limited filling in the vacant

posts can only ensure one half of the planned employment decrease

– This is also an uncontrollable process – both the redundant employees and the ones that are necessary retire

– Detailed plans, detailed sector analyses and discharging criteria are crucial for a successful rationalization of the number of employees – those are still not in place

• Employment rationalization must be accompanied by fundamental reforms of the biggest government systems – health care and education– Risks are substantial—detailed reform plans are needed which would ensure that the quality of services is at

least maintained in these sectors despite the smaller number of employees9

Risks are substantial, yetthere are no contingency measures

• Public companies reform and employment rationalization carry numerous challenges – savings might be lower than planned– The implementation is challenging both politically and professionally – delays are

possible and it can jeopardize the entire fiscal consolidation

• The Government must have contingency measures prepared upfront, to become automatically effective if fiscal goals are not achieved– The credibility of the programme would be stepped-up with the investors and creditors

– the Government would guarantee reaching the basic fiscal goals

– Presenting contingency measures in the Fiscal Strategy would make a timely public debate possible, while the ad hoc solutions would be avoided

• A stringent, and a de facto four-year, fiscal consolidation programme is not possible without the IMF arrangement– Systematic monitoring of the implementation of measures would significantly lower the

risk of “skidding”, giving up and failure of the programme. Only the IMF arrangement can provide for the international credibility of the programme - an increasing debt for at least three more years is not credible for the creditors 10

Public debt stabilization

Additional measures and deficit reduction below 3% of GDP in 201811

Government’s assumptions

• Real Dinar appreciation– This is optimistic (key difference)– FC assumes unchanged real exchange rate

• GDP growth-0.5%, 1.5% and 2% during 2015-2017– GDP is realistic for 2015, overrated for 2016 (0%)– Growth of 2% in 2017 is possible only with investment increase

• Moderate interest rates increase– Adequate projection

• Possible additional risks– A more significant increase in interest rates, protracted recession, realistic

Dinar depreciation 12

Public debt management

• A 2 billion Dollar debt converted to Euro in 2003– Dollar depreciation 25%– Exchange rate loss ~ 300 million Euro

• Since 2011 we have been borrowing through Dollar Eurobonds, without insurance against FX risk– Dollar appreciated over 10% during 2014– Public debt increased by 500 million Euro– Interest expenditures in 2015 increased ~ 8 billion Dinars

• Conclusion: Serbia has no consistent borrowing strategy– FX losses are unnecessarily endured 13

Serbia is lagging behind in infrastructure investments

Relative to comparable countries, Serbia has the lowest level of public investments (2.5% against 4.5% of GDP)

Public investments in Serbia are decreasing, both relative to GDP and the total public expenditures (2005-2014, %)

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The current state of infrastructure does not allow for postponing the investments

• Serbia is the worst in the region by infrastructure (111st position out of 148; Slovenia is the 34th and Croatia the 44th)

• Since 2008 an average of 30 km of highway has been constructed per year (50 km in Croatia). Only 10 km was constructed in 2012

• Average train speed is 40 km/h (55% of the tracks are from the 19th century)

(Source: World Economic Forum)

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The funds are available but not withdrawn

• App. 5 billion Euro has been approved for current infrastructure projects of the government and public companies, out of which 3.7 billion Euro remains not withdrawn (11% of GDP)

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in mill. EUR

Area FinancierApproved loan

amountWithdrawn amount Remaining

EIB 869 170,8 698,2EBRD 330 110,3 219,7

World Bank 355 97,5 257,5Azerbaijan 300 153 147

EXIM 429 158 271

EIB 80 66,2 13,8EBRD 295 54,2 240,9Kuwait 25,8 0 25,8Russia 758 13 745

EIB 64,5 22,4 42,1EBRD 302,5 70,8 231,7

World Bank 21 8 13EXIM 231 135 96KfW 205 48 157

EIB 515 158,9 356,1World Bank 60 0,0 60

KfW 138 28 110

4.979 1.294 3.685Source: Fiscal Council analysis

Other

Roads

Railroads

Energy sector

Most unwithdrawn loans are in the road infrastructure sector

• If new, certain loans are also included (EXIM bank loan for Kostolac), another 500 million will be received in 2015; With Belgrade-Budapest railroad, UAE…the numbers grow further

• On average 20% of the planned (budgeted) investments are not executed each year• Important: a decrease in public investments is not part of the targeted savings, it is a

consequence of non-executed plans• Our estimate is that the value of the currently delayed projects amounts to over 1 billion

Euro• Due to delays in withdrawing approved funds for infrastructure, Serbia pays yearly

penalties of app. 4 million Euro 17

Realistic increase in public investments in 2015 is app. 1% of GDP

• An increase of 1% (1.5% with public companies) is only possible along with a significant increase in investing efficiency

• If all planned infrastructure projects were implemented in time (hardly achievable), the increase in budget investments in 2015 would amount to 1.3% of GDP (2.5% with public companies)

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in mill. EUR

AreaApproved loan

amount Remaining

Maximum increase in 2015

% of GDP

Roads 2.283 1.593 313 0,95%Railroads 1.159 1.025 251 0,76%

Energy sector 824 539 138 0,42%Other 713 526 117 0,35%

4.979 3.683 819 2,48%

Source: Fiscal Council analysis

A possible increase in investments in roads is app. 313 million

• Corridor 10: with current deadlines the increase of app. 130 million Euro (750 available);• Corridor 11: assuming the same dynamics in the sections the work on which is underway;

uncertain launching of the new ones;• Projects for road reconstruction and safety: execution estimate is app. 56 million Euro in

2015 (project launching);• The Sava bridge: remaining 83 million Euro must be used in 2015 due to withdrawal deadline;

there was no execution in 2014;• Belgrade bypasses: expected increase of 44 million Euro 19

in EUR m

Area Project App. Date Approved amount Used Available

EIB Belgrade Bypass A Oct-07 60 28 32EIB Corridor X E75 Oct-09 314 39,8 274,2EIB Belgrade Bypass B Sep-10 40 21 19EIB Corridor X E80 Nov-10 265 75,1 190EIB Sava bridge Nov-10 90 7 83EIB Road rehabilitation and safety Nov-13 100 0 100

EBRD Road rehabilitation and safety Nov-13 100 0 100EBRD Belgrade Bypass Jul-02 80 68,8 11,2EBRD Corridor X Sep-09 150 41,5 108,5

WB Corridor X Jul-09 275 97,5 177,5WB Road rehabilitation and safety Apr-13 80 0 80

Azerbejan Highway Е763 (Ljig-Preljina) Apr-12 300 153 147EXIM Bridge Zemun-Borca Apr-10 180 124 56EXIM Highway Е763 (Obrenovac-Ljig) Aug-13 249 34 215

2.283 690 1.593Source: Fiscal Council Analysis

• The second railroad track of the Pancevo bridge to Pancevo town section and reconstruction of a section of the Corridor 10 track (112 km) : 44 million Euro in 2015

• The beginning of the works on the Stara Pazova-Novi Sad railroad track and the reconstruction of the Belgrade-Vrbnica (Bar) railroad track : 170 million in 2015

• The Prokop railroad station: 26 million• The purchase of the railroad vehicles: increase of 11 million (from two loans)• It is not certain if the reconstruction of the railroad Corridor 10 will begin in 2015–project

is being redone, while the elaboration of technical documentation is progressing slowly 20

Investments in the railroads may increase by app. 251 million

in mill. EUR

Financier Project Approval dateApproved loan

amount Withdrawn

amount Remaining

EIB Railroad reconstruction 2а Dec-06 80 66 13,8EBRD Trains May-09 100 31 69,1EBRD Railways of Serbia - CorridorX Sep-10 100 22,3 77,7EBRD Rehabilitaion and modernisation Corridor X Jan-12 95 0,95 94,05Kuwait Prokop rail. station Dec-12 25,8 0 25,8Russia Annexe 1 - Belgrade-Pancevo railroad Nov-12 64 6* 58Russia Аnnexe 2 - Corridor X modernization Nov-12 64 7* 57Russia Аnnexe 3 - Stara Pazova - Novi Sad railroad Nov-12 316 0 316Russia Аnnexe 4 - Belgrade - Vrbnica (Bar) railroad Nov-12 200 0 200Russia Belgrade - Novi Sad railroad Nov-12 34 0 34Russia Metrovagonmas trains Nov-12 80 0 80

1.159 133 1.025* estimates based on the monthly report of the Public Debt Department (December 2014)

Source: Fiscal Council analysis

• Long postponed purchase of the electricity meters – 78 million Euro• HPP Zvornik: a dispute with the bidder is resolved, 9 million increase • Construction of 32 small hydro power plants – 11 million• Kostolac TPP (terminals and railroad infrastructure)– 13 million• Kostolac Desulphurization factory – 53 million• Kolubara coal homogenization improvement – 18 million • Kostolac: the 1st phase completion decreases investments by 59 million (the 2nd phase

launching may increase by 100 million) 21

131 million in the energy sectorin EUR m

Area Project App. Date Approved amount Used Available

EIB EMS network upgrade Jun-09 24,5 22,4 2,1EIB EPS electric meters Nov-10 40 0 40

EBRD EPS electric meters Sep-10 40 1,6 38,4EBRD Srbijagas; liq and gas storage Feb-10 150 50 100EBRD Kolubara Jul-11 80 18,7 61,3EBRD Small hidroplants Dec-11 32,5 0,5 32

WB Reg. development of Bor Jun-07 21 8 13EXIM Phase 1 - Kostolac B1 B2 Dec-11 118 118 0EXIM Phase 1 - Kostolac desulphuring Dec-11 87 17** 70**EXIM Phase 1 - Kostolac port Dec-11 11 0 11EXIM Phase 1 - Kostolac railways Dec-11 15 0 15KfW Envir. Protection Dec-07 46 40,2 5,8KfW Zvornik hidroplant Okt-10 70 6,7 63,3KfW Kolubara - coal homogenization Okt-12 74 1,15 72,85KfW En. Eff. In public buildings Nov-14 15 0 15

824 285 539EXIM Phase 2 - Kostolac B3 Nov-13EXIM Phase 2 - Drmno Nov-13

1.326 285 1.041* Funds are expected even though not approved yet (State budgets both for 2014 and 2015 include guarantees for it).** Estimation based on project commencement and the expected completion datesSource: Fiscal Council Analysis

502* 0 502

Another 125 million in other areas

• Investment works in the flood damage recovery– 60 million• Belgrade, Novi Sad, Kragujevac clinical centers– 40 million• Municipal water supply improvement - 25 million

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in mill. EUR

Financier Project Approval date Approved amount Withdrawn

amount Remaining

EIB Municipal and regional infrastructure Dec-08 50 49,5 0,5EIB Municipal infrastructure Jun-09 25 0 25EIB Watersupply (Nis, Novi Sad) Jun-04 25 7,7 17,3EIB Clinical centers A Dec-06 80 18,5 61,5EIB Clinical centers B Dec-08 70 0 70EIB Public sector - research and development Mar-10 200 70,3 129,8EIB Modernization of public schools Jun-10 50 12,9 37,1EIB Renovation of Judicial buildings Oct-11 15 0 15

World Bank Emergency flood reconstruction Oct-14 60 0 60KfW Municipal water supply system (phase 1) Jun-05 25 10,7 14,3

KfW & EU Municipal water supply system (phase 1) - donation 2007 23,5 12,2 11,3KfW Municipal water supply system (phase 2) 2008 17,5 2,3 15,2

KfW & EU Municipal water supply system (phase2) - donation 2008 11 2,9 8,1KfW Wastewater management 2009 46 0 46

KfW & EU Wastewater management - donation 2009 14,8 0 15713 187 526

Source: Fiscal Council analysis

Reasons for low public investments

• There are failures at all levels and at all stages of implementation– From the ministries, over state-owned companies in charge of organizing the performance of infrastructure

works, designers, to contracting companies

• Ill-defined responsibilities even at the level of ministries, lack of coordination and cooperation – The Žeželj bridge or the Pancevo water supply, for example,

• The capacities of the government bodies and companies in charge of infrastructure managing and exploitation are insufficient for selecting, implementing, supervising and evaluating undertaken investments

• Adequate feasibility studies are lacking, while a project selection decision is often based on the political influence– Priority selection is often guided by the reasons other than the needs of society– Large projects are being announced without their profitability being verified by adequate studies. For some

of them not even the exact role of and expense of the government is clear– Administrative hindrances stand in place of a substantial profitability analysis

• Frequent delays, as well as numerous errors in the technical documentation and financial calculations are obvious in the project elaborations– According to the assessment of the Ministry of Construction, Transport and Infrastructure , the damage

caused by the “low quality projects” in the area of roads and transportation safety is estimated to 100 million Euro

• Inefficient issuing of construction and utilization permits, as well as expropriation process23

Recommendations• Public investments should be institutionalized as a priority• Responsibility for public investments must be firmly and hierarchically established,

starting from the Government level:– A dedicated operational sector for execution of capital investments, like the ones in UK or Australia

• Ministries and ministers must be held accountable before the Government, and thus act as direct as agents securing efficient investments

• A three-year plan of public investments should be made, accompanied by more detailed annual plans– Capital expenditures in the Budget and Fiscal Strategy are not accounted properly (there is only a

declarative support for their increase)

• Ministry of Finance must have more saying in early stages of project development, and accordingly its capacities must be strengthened

• Concessions (transport), other PPPs and private investments (energy) should be utilized where appropriate

• Special attention must be paid on characteristics of individual projects, namely on the agreed financial and construction/execution terms– Imports of goods and services (even labor force) decrease benefits for the local economy

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