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Document o f The World Bank
Report No. 25855 - YU
PROGRAM DOCUMENT
OF THE
INTERNATIONAL DEVELOPMENT ASSOCIATION
TO THE
EXECUTIVE DIRECTORS
ON A
PROPOSED SECOND PRIVATE AND FINANCIAL SECTOR
ADJUSTMENT CREDIT
IN THE AMOUNT OF SDR 58.7 MILLION
(US$80 MILLION EQUIVALENT)
TO
SERBIA AND MONTENEGRO
May 14,2003
Finance and Private Sector Development Unit (ECSPF) South East
Europe Country Unit (ECCU4) Europe and Central Asia Region
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AML B R A CAS DM EA ECA EPS EU FIU FRY FSD GDP GNI I A S
IBRD
IDA IMF IMWG
I S A JAT LDP MEER MIER MOEP MOFE M O U
I-PRSP
GOVERNMENT FISCAL YEAR January 1 - December 3 1
CURRENCY EQUIVALENTS (Exchange Rate Effect ive as o f May
1,2003)
Currency Unit = Serbian Dinar LC = US$0.0176
US$1 = YUD 56.93
WEIGHTS AND MEASURES Metr ic System
ABBREVIATIONS AND ACRONYMS
Anti-Money Laundering Bank Rehabilitation Agency Country
Assistance Strategy German Mark Extended Arrangement Europe and
Central Asia Electric Power Industry o f Serbia European Union
Financial Intelligence Unit Federal Republic o f Yugoslavia
Financial Sector Development Gross Domestic Product Gross National
Income International Accounting Standards International Bank for
Reconstruction and Development International Development
Association International Monetary Fund Inter-Ministerial Working
Group Interim Poverty Reduction Strategy Paper Insurance
Supervisory Authority Yugoslav Airlines Letter o f Development
Policy Ministry for External Economic Relations Ministry o f
International Economic Relations Ministry o f Economy and
Privatization Ministry o f Finance and Economy Memorandum o f
Understanding
NBS NBY NSB PA PFSAC
PHRD PLC PRSP PSD SAC S A M SDP SDR SEED SME SOE SOSAC SRC TA
TSS TSSU UK DFID
USAID
National Bank o f Serbia National Bank o f Yugoslavia National
Savings Bank Privatization Agency Private and Financial Sector
Adjustment Credit Policy and Human Resources Development Paris and
London Club Poverty Reduction Strategy Paper Private Sector
Development Structural Adjustment Credit Serbia and Montenegro
Supervisory Development Plan Special Drawing Right Southeast Europe
Enterprise Development Small and Medium Enterprise Socially Owned
Enterprise Social Sector Adjustment Credit Supervisory Review
Committee Technical Assistance Transitional Support Strategy
Transitional Support Strategy Update UK Department for
International Development United States Agency for International -
Development
WE3 World Bank YUD Yugoslavia Dinars
Country Director: Orsalia Kalantzopoulos, ECC04 Sector Director:
Paul Siegelbaum, ECSPF Sector Manager: Khaled Sherif, ECSPF
Team Leader: Itzhak Goldberg (PSD), ECSPF
.. 11
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IDA PROGRAM DOCUMENT FOR A PROPOSED SECOND PRIVATE AND FINANCIAL
SECTOR ADJUSTMENT CREDIT
CREDIT SUMMARY
Borrower: Serbia and Montenegro
Amount: SDR 58.7 mill ion (US$80 mill ion equivalent) Terms:
Modified IDA terms with a 20-year maturity, including a 10-year
grace period and no acceleration clause. Onlending to Serbia
with the same terms.
Objectives and Description: The proposed Second Private and
Financial Sector Adjustment Credit (PFSAC 11) will support the
governments Serbia and Montenegro, and i t s largest constituent
member state, Serbia, in the implementation o f regulatory,
institutional, and structural reforms seeking to significantly
accelerate private sector-led growth through: (i) improving the
business environment by means o f comprehensive reform o f
enterprise entry, operation and exit; (ii) strengthening the
financial system by privatizing andor liquidating majority state-
owned banks and improving the environment under which banks and
other financial intermediaries operate; and (iii) privatizing and
restructuring socially-owned enterprises that crowd out private
sector growth, hamper banking sector recovery, and incur
significant fiscal and quasi-fiscal costs.
Benefits:
Risks:
Implementation o f continued reforms in the enterprise and
financial sectors under this operation will enhance Serbia's
prospects for growth, and will reinforce the sustainability o f i t
s macroeconomic stabilization. The main benefit o f the proposed
credit would be the facilitation o f faster private sector growth
and job creation, supported by a healthier and more developed
financial system. Overall enterprise and financial sector
performance i s expected to improve. This improvement may come
partly through the sale o f enterprises and banks to local and
foreign investors with strong management capacity, and partly
through improved financial discipline as a result o f more
proactive restructuring. Additionally, formation o f new private
sector f i r m s i s expected to accelerate in response to an
improved business enabling environment and an increased supply o f
productive assets expected to be released from loss making firms as
part o f enterprise restructuring efforts. At the same time, a
well- functioning, properly regulated and transparent financial
system would allow an adequate mobilization o f resources and their
better allocation into productive investments needed by the private
sector to modernize and expand their businesses.
The operation faces three sets o f risks. First, general
political uncertainty related to the implementation o f the new
constitutional arrangements in the union o f Serbia and Montenegro
and i t s constituent member states. This i s compounded by the
recent assassination o f the Serbian Prime Minister, and the
failure o f two
... 111
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rounds o f the Serbian presidential elections in late 2002 owing
to insufficient voter turnout. Second, consequently, the operation
also faces a potential risk o f weakening o f political commitment
to restructure, privatize and/or liquidate large loss making
enterprises and majority state-owned banks, many o f which are
politically/socially sensitive because o f their importance to the
economy as a whole and the potential social and fiscal costs.
Finally, the worsening o f global economic climate would pose a
significant risk that could deter the potential private capital
inflows to Serbia, affecting the success o f enterprise and bank
privatization.
Schedule o f Disbursements: The full credit i s expected to be
disbursed in two tranches o f US$40 mill ion equivalent each.
Poverty Category: Not applicable.
Project ID Number: YU-PE-PO74868
Map IBRD No. 3 1506
This operation was prepared by a team including Itzhak Goldberg
(PSD Team Leader), Gerard0 Corrochano (FSD Team Leader), Irina
Astrakhan, Alexander Pankov, Silvia Minotti, James R. Dick Welch
(ECSPF); Branko Radulovic (ECCYU); Lajos Bokros (ECAVP); Laura Ard
(BFR); Cari Votava (FSEFI); Peter Kyle (LEGPS); Gregorio Impavido
(OPD); Andrew Lovegrove (UK DFID). Legal and Disbursement support
were provided by Gennady Pilch (LEGEC) and Joseph Formoso (LOAG1).
The peer reviewers were Luigi Passamonti (FSEVP) and Demba Ba
(AFTPS).
iv
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I.
11.
111.
A. B.
IV. A. B.
V.
A. B. C. D. E. F. G. H.
PROGRAM DOCUMENT OF THE INTERNATIONAL DEVELOPMENT
ASSOCIATION
TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND PRIVATE AND
FINANCIAL SECTOR
ADJUSTMENT CREDIT TO SERBIA AND MONTENEGRO
TABLE OF CONTENTS
RECENT ECONOMIC DEVELOPMENTS
..............................................................................
2 OBJECTIVES AND STRUCTURE OF THE PROPOSED PFSAC I1
...................... . ............. 5 PROGRAM OF REGULATORY AND
INSTITUTIONAL REFORMS ................................ 9 Reform o f
Business Enabling Environment
....................................................................................
9 Financial Sector Regulatory and Supervisory Framework
............................................................ 13
PRIVATIZATION AND RESTRUCTURING OF BANKS AND ENTERPRISES
............. 17 Banking Sector Ref0
...................................................................................................................
17 Enterprise Sector Reform
..............................................................................................................
19 THE PROPOSED CREDIT
.......................................................................................................
24 Project Implementation Issues ...... .. .... ....... ... .....
... ...... , ..... ... ...... ... ........... .... ...........
..... ......... . .. ... ... 24 Board Conditions and Tranche
Triggers
.......................................................................................
26 Borrower’s commitment and ownership .. ... ... ..... .
........... ...... ... ... .. ... ..... ....... ...... ...
......... . .... ... .. . .. .. 27 Coordination with the IMF and
Donors
........................................................................................
27 Lessons Learned from Previous Bank Operations
........................................................................
28 Benefits and Risks
.........................................................................................................................
28 Poverty Implications/Social Impact .... . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . .
. . . . . . . . . . 29 Environmental Impact ..... ... ......
....... ........ ......................... ... ... ... ..
.............. ..... .... ..... ............... ...... . 29
ANNEXES Annex 1 Annex 2 Annex 3 Annex 4 Annex 5 Annex 6: Annex 7
M A P
Key Economic Indicators Statement o f Loans and Credits
Timetable o f Key Processing Events Letter o f Sectoral Development
Policy Policy Action Matrix Fund Relations Note Country at a Glance
IBRD 3 1506R
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PROGRAM DOCUMENT OF THE INTERNATIONAL DEVELOPMENT
ASSOCIATION
TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND PRIVATE AND
FINANCIAL SECTOR
ADJUSTMENT CREDIT TO SERBIA AND MONTENEGRO
1. This report constitutes the Program Document on a proposed
Second Private and Financial Sector Adjustment Credit (PFSAC 11)
for Serbia and Montenegro (SAM)’ in the amount o f SDR 58.7 mil l
ion (US$SO mil l ion equivalent) to support Serbia’s sectoral
reform program2. The Credit would be on modified International
Development Association (IDA) terms, with a final maturity o f 20
years and a grace period o f 10 years3, with no acceleration
clause, and would be disbursed in two tranches. This report should
also be read in conjunction with the Transitional Support Strategy
Update (TSSU) o f the World Bank Group (the Bank) for the Federal
Republic o f Yugoslavia (FRY)4.
I. RECENT ECONOMIC DEVELOPMENTS
2. SAM and Serbia began the delayed transition to democracy and
a market economy under very difficult economic and social
conditions. These conditions result from nearly four decades o f
inefficient economic management and a decade o f regional conflicts
and international isolation that followed the break-up o f
socialist Yugoslavia in 1991. By 2000, recorded per capita GDP had
fallen to about one half o f i t s 1989 level, total public debt
exceeded 130 percent o f GDP and 440 percent o f exports, and
inflation had surpassed 1 13 percent.
3. Despite these formidable odds, in less than two years, SAM
and Serbia have taken impressive steps to address the daunting
legacy o f the past. The SAM and Serbian governments have followed
a two- pronged approach combining stabilization measures with
decisive steps in an agenda o f structural reforms aimed at
initiating the delayed transition. The authorities began their
efforts toward stabilizing and reforming the economy in late-2000
by tightening macroeconomic policies, first through their own
efforts and later with the strong support o f the international
community. These policies were initially supported by an IMF
program approved in December 2000, and then by a Stand By Agreement
o f US$249 mil l ion equivalent approved in June 2001.
Subsequently, a three-year Extended Arrangement (EA) o f US$829
mill ion equivalent was approved in May 2002, spanning the period
through end-March 2005.
4. Strong implementation o f these reforms despite the remaining
political uncertainties has brought initial macroeconomic
stability, while laying the foundations for a sustained recovery
and improved living standards (see Table 1). The twelve-month
inflation rate declined from 113.5 percent at end-2000 to 39
percent at end 2001, and further to 14.2 percent at end-2002. The
nominal Dinar exchange rate to
Formerly known as “the Federal Republic o f Yugoslavia” (FRY).
The Constitutional Charter o f Serbia and Montenegro was enacted by
the Parliament o f Serbia, the Parliament o f Montenegro and the
Parliament o f the Federal Republic o f Yugoslavia effective
February 4, 2003 and, as o f that date, the Federal Republic o f
Yugoslavia has changed i t s name to “Serbia and Montenegro.” In
this document, a l l references to S A M which predate the change o
f name should be understood to refer to FRY.
Due to the highly devolved nature o f the S A M union (most
areas o f economic policy are in the competence o f the member
states) and the different starting points, needs and pace o f
reforms in the two member states, the Bank’s assistance program for
S A M i s being designed around member state-specific operations.
Therefore, for the purposes o f this document, the te rm
“Government” would designate the Government o f Serbia, unless
otherwise specified.
Modified IDA terms for S A M were agreed by the Board in the
context o f the discussion o f SAM’s membership and the Bank’s
Transitional Support Strategy (TSS).
Report no. R2002-0142, July 18,2002.
2
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DM/Euro has been maintained at a relatively stable level in
Serbia since late 2000. The National Bank o f Serbia (NBS) official
foreign reserves continue to grow, reaching almost US$2.3 bil l ion
by end-2003.
Table 1: Key Economic Indicators
1998 1999 2000 2001 2002 2003 2004 2005
National Accounts
GDP (US$ millions) 11 Real GDP growth (%)
Investment (% of GDP)
Gross Domestic Savings ( O h of GDP)
Public Sector Balance
Expenditures ( O h of GDP) olw public investment
Revenue before grants Deficit before grants (% of GDP)
External Accounts
Exports of goods and services (% change) 21 Imports of goods and
services (% change) 21
Current account balance as %of GDP
Indebtedness
TDOIXGS 31 TDOIGDP TDSIXGS 31
Prices
20.9 2.1
-660
-15.7
-45.6 -32.8
-764
8603 11577 5.0 5.5
14.2 13.6
-2.7 -7.3
37.6 40.2 3.1 1.6
36.7 38.9 0.9 1.3
18.6 7.7 13.1 28.9
-339 -528 -3.9 -4.6
447.9 428.0 132.6 101.4
2.3 3.9
15658 4.0
16.1
-7.0
47.5 3.4
42.5 5.0
18.2 32.9
-1388 -8.9
360.3 74.6
5.6
19868 20717 21725 4.0 4.0 4.0
16.5 17.2 17.8
-3.5 -1.2 0.6
45.1 45.4 44.5 3.4 4.0 4.4
40.5 41.1 40.6 4.5 4.3 3.9
23.2 13.7 10.4 16.3 4.7 4.7
-1759 -1614 -1442 -8.9 -7.8 -6.6
255.4 243.9 219.6 51.3 53.4 50.7 12.2 15.0 17.1
Retail price inflation (e.0.p.) .. 113.5 39.0 14.2 10.0 7.0
5.0
11 GDP estimates exclude Kosovo. 21 Growth rate of dollar
values. 31 Exports exclude workers‘ remittances and non-factor
income
5. Real GDP growth rebounded from the highly negative rates o f
1999 (impact o f the Kosovo conflict) to positive rates o f about
5-6 percent in 2000 and 2001. Preliminary results for 2002 show
that a growth rate o f 4 percent has been reached. This growth rate
had been supported by higher public investment and greater levels o
f external budget support. Industrial production has been stagnant
in 200 1, reflecting capacity constraints after years o f isolation
and the ongoing economic restructuring. Recorded growth o f
industrial output for 2002 i s 1.7 percent, with the total
industrial output at the end o f 2002 at only half o f 1991 output.
Unemployment s t i l l remains very high, with the official
recorded rate reaching 30 percent in the f i rst half o f 2002?
6. With regard to foreign trade, following a 18.6 percent
increase (in U S dollar terms) in 2000, exports rose by 7.7 percent
in 2001 and a further 18.2 percent in 2002. Import growth has also
remained high compared to 2001, when the combination o f rising
donor support and restored trade contacts led to a growth o f 28.9
percent. Total imports in 2002 were 32.9 percent higher than in
2001, reaching US$6.3 billion. Since exports are so much smaller
than imports, the trade balance deficit i s also increasing,
and
As shown by the labor force surveys, the actual unemployment
rate i s probably much lower (around 10-12 percent) due to the
presence o f a large “shadow economy” in Serbia.
3
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reached US$4 bil l ion at the end o f 2002.6 The current account
deficit i s projected for 2002 at around 8.9 percent o f GDP.
7. Thefiscal deficit (before official grants) increased from 1
percent o f GDP in 2000 to an estimated 5 percent in 2002,
equivalent to US$782 million. This i s due to the more realistic
budgeting o f commitments (Le., lower accumulation o f arrears),
and some transition related expenditures, as well as recent
increase in debt service payments. The deficit increase has been
managed in a manner consistent with ongoing stabilization efforts
due to the strong inflow o f donor funding since 2000.
8. In parallel to stabilization efforts, the SAM and Serbian
governments took the f i rst steps in an agenda o f structural and
institutional reforms aimed at initiating the delayed transition.
In addition to resolute enterprise and banking sector measures
supported under the f i rst PFSAC (see Sections I11 and IV o f th
is report), substantial progress was recorded in reform areas
supported by the Bank through the f i r s t Structural Adjustment
Credit (SAC), disbursed in early 2002, and the Social Sector
Adjustment Credit (SOSAC), currently under implementation, and
related technical assistance projects: improvements in the
transparency o f public expenditure management; taxation reform;
major increases in electricity prices7; reforms to improve the
flexibility o f labor markets; pension reform; and initial legal
and judicial reforms backed by an anti-corruption strategy for
improving governance and institutions.
Medium-Term Prospects and External Financing Requirements
9. Growth prospects. Robust growth in 2000 to 2002 was primarily
driven by one-off rebounds from earlier shocks. Under the
assumption o f continued decisive stabilization and reforms and
substantial support from donors and creditors, real output i s
expected to grow at a slightly lower but more sustainable annual
rate o f around 4 percent beginning in 2003. Near-term growth i s
expected to be driven by exports, a more vibrant SME sector,
improved balance in the energy sector, and greater donor financing
o f investments. These factors are expected to outweigh the
contractionary near-term impact o f further fiscal adjustment and
the remaining transitional recession. Medium-term growth wil l also
be driven by greater productivity and enhanced financial
intermediation, the entry o f new firms, infrastructure
rehabilitation and investments in new productive capacity.
10. Fiscal prospects. The limited domestic sources o f budget
financing and the reduction in external financing to more
sustainable levels wil l require a phased reduction in fiscal
deficits. Counterpart funding from the Bank and other donors will
work to ensure that the overall fiscal adjustment i s not
excessively abrupt. Despite a large increase in public debt service
payments and the continued bringing on budget o f quasi-fiscal
activities, the consolidated fiscal deficit (excluding official
grants) will decrease slightly from 5.0 percent o f GDP in 2002 to
3.9 percent in 2005.' Deficit reductions in the outer years wil l
be supported by a leveling o f f o f debt service payments, deeper
savings resulting from reforms, and improvements in tax
administration. While cash outlays will decline by around 3.0
percentage points o f GDP from 2002 to
' Foreign trade and current account data are presented for SAM.
The price of electricity was increased from U S cents 0.9lkWh in
late 2000 to an average o f U S cents 1 .GIkWh in
late 2001 and U S cents 3.2 in July 2002. Further upward
adjustments are envisioned, reaching around U S cents 4.0 cents in
2003. 'As shown in Table 1, the 2003 consolidated budget envisages
a significant reduction in budgetary expenditures as a share of
GDP. This i s being driven by reductions in three categories o f
Serbian budgetary expenditures which the recent Public Expenditure
and Institutional Review (PEIR) identified as relatively high by
regional standards - (i) subsidies, (ii) transfers to households,
and (iii) wages and salaries. As noted in the PEIR, these
reductions are needed to align overall expenditure commitments with
available non-inflationary sources o f financing. As debt service i
s being regularized following the non-servicing of debt during most
o f the 1990s, these shi f ts in the composition o f expenditures
are also needed to facilitate the resulting increase in interest
payments on public debt.
4
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2005, the program also achieves additional cuts in expenditure
commitments and hidden quasi-fiscal deficits, with the biggest
direct impacts coming from pension, energy and banking reforms.
11. Exports o f goods and services (in U S dollars) are expected
to grow by 23 percent in 2003, before falling to a more sustainable
but still high 10 percent in 2005. In later years, export recovery
could be supported by a rebound in the economies o f key partners,
deepened trade integration (including through the EU Stabilization
and Association and World Trade Organization accession processes),
rehabilitation o f infrastructure, productivity improvements, and
higher foreign direct investment.
12. SAM’s current account deficit (including grants) i s
expected to decline from 8.9 percent o f GDP in 2002 to around 6.6
percent in 2005. These high levels reflect a structural imbalance
between a low savings rate, and increased investment needs
following a decade o f underinvestment. Gross domestic investment
as a share o f GDP i s expected to rise from 16.1 percent in 2002
to 17.8 percent in 2005. In parallel, and supported by public
sector saving, a strengthened banking system,. and an increase in
enterprise profitability, gross domestic savings wil l increase
from -7.0 percent o f GDP in 2002 to 0.6 percent in 2005. In the
early years, donor grant funding will play a significant role in
closing the gap between national savings and investment needs.
13. Financing needs. To achieve this macroeconomic scenario and
finance the transition to a market economy, the union and Serbia
will require substantial capital inflows. Even following the
restructuring o f Paris Club debt and a sharp increase in dollar
GDP in 2001 and 2002 (largely driven by real appreciation from the
highly depreciated level o f late-2000), SAM’s external debt
remained a very high 75 percent o f GDP at end-2002. Between 2003
and 2005, gross external financing requirements (excluding for debt
rescheduling) are estimated at about US$7.9 billion. These
resources are needed to finance US$4.4 bil l ion o f current
account deficits (excluding interest and official transfers),
US$1.2 bil l ion in increased international reserves, and the
remainder o f US$2.3 bil l ion to fulfill net debt service
obligations. During this period, as the fiscal deficit i s
increasingly brought under control, these needs will shift from the
budgetary sector to the private sector.
14. Financing sources. These needs are projected to be met from
several sources. With good progress on reforms, foreign direct
investment and other private sector finance will grow to total
around US$4.3 bil l ion during this three year period. The
remaining US$3.6 bi l l ion o f financing during this period wil l
come from official bilateral and multilateral sources. The Bank
program generally, and the proposed adjustment operations more
specifically, would represent a significant share o f this
financing, and can thus play a crucial role in helping to ensure
adequate financing for the reform programs in Serbia.
15. Assuming debt re l ie f on appropriate terms, debt service
indicators are expected to decline significantly to s t i l l high
levels. SAM’s total external debt i s expected to fall further to
50 percent o f GDP in 2005, driven by further debt relief and some
additional real appreciation. S A M ’ s ability to maintain a
relatively stable ratio o f debt to GDP despite relatively large
current account deficits, will initially be facilitated by the high
degree o f average concessionality o f official external financing,
and later by increasing inflows o f private capital. The ratio o f
total debt service to exports would fluctuate in the range o f
12-17 percent in the period 2003-2005, and reach a level o f around
20 percent in the medium-term.
11. OBJECTIVES AND STRUCTURE OF THE PROPOSED PFSAC I1
16. Bank Strategy and Background. The first Transitional Support
Strategy (TSS, May 2001) outlined a three-year IDA envelope o f up
to US$540 mil l ion for SAM, on a temporary and exceptional basis,
with actual lending to depend upon performance against agreed
benchmarks. I t was envisaged that up to 80 percent o f the program
could support policy-based lending. A Transitional Support
Strategy
5
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Update, discussed by the Board on August 8, 2002, described
on-track performance, confirmed the overall approach, and laid out
the Bank's program for FY03. The World Bank Group's operations
assist the Government in achieving i t s overall goals of: (i)
restoring macroeconomic stability and external balance; (ii)
stimulating near-term growth and creating the basis for a sustained
supply response; (iii) improving the social well-being o f the most
vulnerable and building human capacity; and (iv) improving
governance and building effective institutions. As o f May 8, 2003,
nine IDA credits totaling US$297.01 mil l ion had been approved for
SAM. Five grants totaling US$30 mill ion have also been approved
under the Trust Fund for SAM and are under implementation. A full
Country Assistance Strategy (CAS) i s expected to be completed in
late 2003, following completion o f the full Poverty Reduction
Strategy Paper (PRSP).
Box 1: Private and Financial Sector Reform Propram and Poverty
Alleviation
The interim PRSP9 for SAM clearly recognizes that an effective
strategy for fighting poverty requires a multi-sectoral approach
that fosters policies consistent with an agreed macroeconomic
framework. Within these parameters, the Bank and other donors have
noted the central role that the SAM authorities have given to
growth and economic development in their poverty reduction
strategy. In turn, both private and financial sector development
reforms are regarded as hndamental pillars to the promotion o f
growth, employment creation, and more broadly to the establishment
of an adequate business enabling environment that would make early
reform efforts more sustainable.
The well defined reform agenda of the Serbian authorities in the
private and financial sector, which i s supported by the PFSAC
program, reinforces the fact that poverty reduction involves the
synergies o f savings, investments, and technology combined to
produce jobs. The combination of these factors happens while firms
enter the market and grow without barriers, or exit efficiently so
that their salvageable assets can be used again for productive
purposes and so that they no longer crowd out more productive new
firms.
I t i s this context, and in accordance with the initial TSS for
SAM, that the authorities' early reform program in the private and
financial sectors sought to address the immediate challenges of
Serbia's long-delayed structural reform agenda in banks and
enterprises. These included the resolution of large insolvent state
banks, start o f a multi- track privatization program, and early
efforts to improve the regulatory framework for banking and
enterprise sectors. Based on the Government's strong performance in
these areas during 2001 and the first half o f 2002, a first PFSAC
was approved by the Board in May 2002, and h l l y disbursed in a
single tranche shortly thereafter.
In the context of the Letter of Development Policy (LDP) for the
first PFSAC, the Government of Serbia and the Bank agreed upon an
envisioned framework o f medium-term reforms that would constitute
the basis o f a follow up PFSAC 11. The proposed operation thus
builds on the impressive progress made under the first PFSAC by
supporting the continuation of a wide-ranging privatization and
restructuring program for majority state- and socially-owned
enterprises and banks. Furthermore, the proposed credit supports
the Government's longer-term reform agenda aimed at creation of a
modem regulatory and institutional framework for sustainable
private and financial sector development.
17. The proposed PFSAC I1 i s part o f the ongoing Bank program
with the authorities o f Serbia to support enterprise sector
reforms that foster private sector growth and job creation,
facilitated by a healthier and more developed financial system.
Init ial reforms in the financial and enterprise sectors had been
supported under the f i rst PFSAC I (US$85 mill ion equivalent)"
(see Box 1). As noted above, Serbia has moved swiftly on the fiscal
and poverty reform agendas, supported under the f i rs t SAC and,
more recently, the SOSAC. Complementary to this agenda, it i s
critical to the sustainability o f the overall reform program that
the Government continues to devote equal attention to reform o f
real and financial sectors. Important complementary activities to
the proposed PFSAC I1 include: (i) two Technical
Report No. 24490-YU. lo Report No. P-7529-YU.
6
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Assistance (TA) Grants for Private and Financial Sector
Development o f US$6 mil l ion each (PSD and FSD TA Grants),
approved in mid-2001; (ii) the Privatization and Restructuring o f
Banks and Enterprises TA Credit o f US$11 mill ion (December 2002);
(iii) the US$1.5 mill ion Policy and Human Resources Development
(PHRD) Trust Fund Grant from the Government o f Japan; and the
Employment Promotion Project, currently under preparation.
18. Links to objectives and medium-term agenda of PFSAC I. As
noted in Box 1, the successful implementation o f policy objectives
presented in PFSAC I provided an adequate platform for the design o
f PFSAC 11. While the detailed descriptions o f recent progress
made by the Government in financial and enterprise sector reforms
are presented later in this report under specific components, it
should be emphasized from the onset that there i s a large degree o
f consistency in the way PFSAC I1 conditionality and objectives
have followed the medium-term agenda that was laid out in PFSAC I.
In particular, the following linkages deserve a special
mention:
0 Banking sector reform. The authorities have largely fulfilled
their objective to carry on with the resolution program o f
troubled majority state-owned banks that was initiated under PFSAC
I. All o f the banks which were under the control o f the Bank
Rehabilitation Agency have been dealt with diligently and most o f
them are candidates for the newly prepared bank privatization
program supported by PFSAC 11; independent governance arrangements
have been established for al l state banks; and, the overall
objective o f privatizing all state-run banks remains an ultimate
goal that i s now supported by core conditions under PFSAC 11.
However, with hindsight, some o f the timeframes that were
presented as medium term targets in PFSAC I have proven to be
unrealistic. This i s particularly true if one takes into account
recent developments that have considerably increased the number o f
majority state-owned banks that are expected to be put for sale
over the coming months by the Serbian authorities (see section V.A
for more details). As far as the objectives to redefine the
mechanisms o f bank resolution and establish a functioning deposit
insurance scheme are concerned, these remain part o f the program,
yet revamping them while the agenda o f bank privatization i s only
starting to get underway has proven to be impractical.
0 Financial sector regulatory and supervisory framework. Further
strengthening o f banking prudential and supervisory framework have
been actively pursued by the Serbian authorities and remain a
central part o f the program. In this regard, the envisioned
central objective o f PFSAC I which called for the preparation a
Supervisory Development Plan was successfully met, and the
implementation o f this plan i s a clearly defined road map to the
conditions and objectives in PFSAC 11.
0 Reform of socially-owned enterprises. The Government has
maintained i t s efforts to implement the tender privatization
component o f the program. However, the estimate that 200 large
enterprises could be sold through this method has proven
unrealistic because quality o f the companies has been lower than
expected. As envisaged under PFSAC I, amendments were passed to the
Privatization Law and the Decree on Auctions to further strengthen
the Government’s authority over the privatization process and to
prevent the managing bodies in socially-owned companies from
obstructing it. These amendments have incorporated lessons from the
initial implementation period o f auctions, tenders and
restructuring. Furthermore, as part o f the package to amend the
Privatization Law, the government addressed the issue o f
assumption o f liabilities for past environmental damages. Parallel
to tender privatizations, progress in the auctions program exceeded
expectations. By end-2002, some 500 companies were sold in contrast
to only 100 enterprises originally envisaged. Finally, the
authorities have made significant progress in building the
institutional capacity for implementation o f pre-
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privatization restructuring o f large, heavily indebted
industrial conglomerates. Finaiicial advisors for approximately 30
conglomerates have been engaged, and the Government’s Social
Program has been utilized to finance severance payments to
redundant workers.
0 Reform of business environment. The authorities have also made
substantial progress toward creating a modern business environment
in Serbia, and PFSAC I1 conditions present a consistent
continuation o f actions and objectives which were presented in
PFSAC I. Specifically, the authorities developed the drafts o f
several key laws and regulations aimed at creating an efficient
entry, operation and exit framework for enterprises. The Government
has been very keen on establishing a functioning consultation
mechanism to ensure the participation o f entrepreneurs and other
relevant stakeholders in the design o f business environment
reforms. Finally, work has progressed on SME development and FDI
promotion strategies, with specially designated agencies
established by the Government to implement these strategies.
19. Objectives and structure of PFSAC II. The overall objective
o f the PFSAC I1 i s to support the Government’s program o f
regulatory, institutional, and structural reforms seeking to
significantly accelerate private sector-led growth through: (i)
improving the business 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 operate; (iii) privatizing
and/or liquidating outdated majority state-owned banks that fail to
fulfill their role o f financial intermediaries; and (iv)
privatizing and restructuring socially-owned enterprises that crowd
out private sector growth, hamper banking sector recovery, and
incur significant fiscal and quasi-fiscal costs. Accordingly, the
proposed credit will be conditioned on specific reform measures in
the following four areas, which are also consistent with the
priority objectives o f the Bank’s TSSU:
Reform of Business Enabling Environment would aim to improve the
regulatory and institutional framework for business entry through
improving the registration system; to facilitate efficient
operations o f business through reforming the Enterprise Law,
building institutional capacity for regulatory reform, and
improving enterprises’ access to finance; and reducing barriers to
the efficient exit and redeployment o f non-productive assets.
0 Reform of Financial Sector Regulatory and Supervisory
Framework would seek to create a modern regime for financial sector
operations through strengthening the supervision and regulation o f
banking and insurance sectors, laying out the foundation for the
future implementation o f a sustainable deposit insurance scheme,
and creating adequate mechanisms to prevent money laundering
activities.
0 Banking Sector Reform would seek to deepen and broaden the
scope o f financial intermediation through selling controlling
stakes in most privatizable banks to reputable strategic investors,
and liquidating all other majority state-owned banks.
0 Enterprise Sector Reform would seek to promote economic growth
by putting the country’s industrial assets to more productive use
through divestiture o f vast and under-performing socially-owned
enterprise sector to foreign and local investors using
internationally accepted sales techniques.
20. It i s proposed that the funds be released in two tranches
separated by a period o f nine to 12 months. A two-tranche design
would allow the Bank to provide the much-needed support in a
timely
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manner, while at the same time giving more flexibility on the
timetable for delivery o f the second tranche program.
2 1. The next two sections describe the Government’s short- to
medium-term legislative/institutional and structural reform program
in the four policy areas included under the proposed PFSAC 11. In
each case, attention i s given to the latest developments and
pending issues that are considered crucial to structure the overall
policy framework o f the proposed operation. The attached Policy
Matrix reflects the proposed lSt and 2’ld tranche release
conditions which support the objectives o f the operation.
111. PROGRAM OF REGULATORY AND INSTITUTIONAL REFORMS
A. R e f o r m o f Business Enabling Env i ronment
22. Current Status. Notwithstanding the Yugoslav legacy o f
social ownership, Serbia’s private entrepreneurial energy i s among
i t s greatest assets for economic recovery and has already
contributed significantly to growth. The private sector, including
the informal sector accounted for two thirds o f GDP by 2001,
although it employed less than 10 percent o f capital. Registered
small and medium enterprises (SMEs) employed about 590,000 workers
in Serbia by end-2001, or about 43 percent o f all formal
employment.” A very large informal economy has emerged, accounting
for perhaps one-third o f GDP, and employing as many as one mill
ion workers, equal to 30 percent o f the labor force. By al l
measures, the private sector i s far more efficient and profitable
than firms under state, mixed or social ownership.
23. Over the past two years, the SAM and Serbian governments,
assisted by the Bank and other donors, have made progress toward
business enabling reforms, including liberalization and
deregulation o f foreign trade and investment, simplification o f
the tax regime, and modernization o f the labor legislation.
However, recent surveys indicate that Serbia’s administrative and
regulatory environment continues to be hostile to private business
start-up and expansion, as witnessed by the lingering presence o f
a large informal sector. The recent Joint WB-IMF Staff Assessment o
f the FRY-I-PRSP underscores that “reforms o f overall business
environment.. . are emerging as policy priorities, which are l
ikely to have a significant impact on growth, employment and
poverty in the long term.”I2 In many areas, such as simplification
o f the regulatory environment, deregulation and re-regulation and
quality o f judicial services, there has been l i t t le
progre~s.’~
24. Government’s Reform Program. The Government’s agenda i s
focused on further upgrading the legal foundations and
institutional capacity for a sound business environment. Through i
t s implementation the Government hopes to achieve the following
objectives: (i) promote sustainable economic growth and enabling
private sector employment opportunities with a special focus on
SMEs; (ii) create a level playing field between the existing state-
and socially-owned enterprise sector and the new private sector;
and (iii) develop an environment where the rule o f law i s
respected, property rights and claims are recognized, economic
agents can have access to capital, and lenders feel secure. To this
end, the PFSAC I1 wil l support Government’s priority reforms to:
(i) remove administrative and legislative barriers to entry; (ii)
facilitate efficient operations o f business through reforming the
Enterprise Law, building institutional capacity for regulatory
reform and improving enterprises’ access to finance; and (iii)
reduce barriers to the efficient exit and redeployment o f
non-productive assets.
Source: National Bank o f Yugoslavia - Payment Service (ZOP). 11
l2 The World Bank (2002). Joint IDA-IMF Staff Assessment o f the
Interim Poverty Reduction Strategy Paper, p. 6 l3 This i s partly
due to the lack of clear constitutional framework before the recent
changes in the powers of the SAM and Serbian governments has been
introduced. Slow progress i s also partly due to lack of
institutional capacity in the Government, with an over-worked cadre
of reformers dealing with a wide array o f other reforms such as
SOE privatization and restructuring.
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25. Business entry. Serbia needs a better business registration
system t o promote development o f the private sector. This puts
Serbia at a clear disadvantage. The Government launched a
comprehensive reform o f business registration at the end o f 2002
and plans to complete the reform by the end o f 2003. The
Government’s objective i s to reduce the number o f days and costs
needed to register an enterprise. The structure for a proposed new
registration system, developed with the support o f the Bank,
converges with good European practices and aims to: (i) create a
unified Serbian business register that includes a l l business
activities covered under the current Enterprise L a w and L a w on
Private Entrepreneurs; (ii) administer the new unified registry
through an independent administrative agency; (iii) allow
businesses to start activities immediately after registration; (iv)
streamline data requirements for each class o f business according
to European Union (EU) benchmarks; (v) expand electronic
registration and updating, and ensure easy electronic accessibility
t o the database; and, (vi) create a single unique identifying
number for each enterprise that would serve a l l government needs.
The system wil l be administered by an independent expert agency
that i s committed to supporting the needs o f businesses and i s
accountable to the Government for delivering information o f a
timeliness and quality t o serve public needs such as inspections.
The Business Services Agency would administer the business registry
and other registries as appropriate. Once it i s fully operational,
the new business registration system should be self-financing, and
preliminary cost and revenue estimates suggest this i s
feasible.
Box 2: Public Consultation Process in Serbia
To facilitate a more active role o f the private sector in
institutional and regulatory reforms, the Ministry o f Economy and
Privatization established an SME Advisory Board with 14 business
members. Another important step in the direction o f a more open
consultative process was the establishment o f the
Inter-Ministerial Working Group on Regulatory Reform in 2001, which
has been recently transformed into a Council on Regulatory Reform.
The Council reviews draft laws and other major regulations for
their impact on the private sector. The Council has invited the
chair o f the SME Advisory Board to sit as a permanent member to
bring business interests into i ts deliberations.
Supported by PFSAC 11, the Council has initiated reform o f the
Rules o f Operations o f the Government in order to establish the
public discussion of laws and decrees as a rule and not as an
exception. This wi l l significantly improve the transparency o f
policy making by bringing in a wider range o f affected interests.
The Government has already launched several successful public
consultation processes, such as public-private sector dialogue on
the draft Leasing Law, the Company Law, and, more recently, the
Business Registration Law and the Bankruptcy Law.
26. Business operations. As previously stated, one o f the key
areas o f reform relates to facilitating the efficient operation o
f businesses. T o this end, the Government program focuses adopting
the new Enterprise Law, one o f whose main objectives i s
modernizing corporate governance, adopting a L a w 011 Concessions
to facilitate public-private participation, building institutional
capacity for regulatory reform, and improving enterprises’ access
to finance
27. Modernizing the Enterprise Law. The Government i s committed
to changing the Enterprise L a w which occupies a central position
in the system o f commercial law. I t interacts with the new laws
on bankruptcy, privatization, business registration, accounting,
capital markets, investment funds and secured transactions that
have either been passed recently or will be passed in the near
future. The new law wil l be drafted so that it i s consistent with
EU practices. The rapid progress in privatization and new private
business development i s exposing significant legal weaknesses,
particularly in the area o f corporate governance, including the
duties and responsibilities o f directors and managers, guidelines
for shareholders’ meetings and voting, etc. The experience o f
other transition countries shows that a l l o f these issues can be
exploited effectively by unscrupulous shareholders, directors and
managers. With the
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privatization process rapidly accelerating and foreign
investment returning to Serbia, good corporate governance becomes
absolutely essential for successful transition.
28. The new Enterprise Law will also provide for more flexible
and effective legal forms for enterprises. At this time, most
entrepreneurs choose not to incorporate, partly because o f
administrative barriers, and partly because the Enterprise Law does
not encourage sole entrepreneurs and very small businesses to use
the legal forms provided by this law. Entrepreneurs are governed by
a separate law, which treats them differently in almost every
regard. The revised law will make i t easier for entrepreneurs to
incorporate; it will also provide small corporations (the “Limited
Liability Corporation” form) with more o f the protections accorded
to large firms. The objective will be to create a single law
governing al l enterprises using a corporate form.
29. New Law on Concessions. The Foreign Investors Council o f
Belgrade has pointed out that the current concessions system
suffers from legal inconsistencies between different levels o f
government. A new Law on Concessions has been drafted with the
support of the donor community, with the German GTZ leading the
process. The purpose o f this law i s to promote and regulate
investment in public infrastructure. The draft law replaces
auctioning with a more transparent tendering, as the mechanism for
awarding concessions. I t will ensure equal and fair treatment o f
investors and competitive and transparent concession granting. The
law i s based on the idea of a “framework” law consisting mostly o
f general principles, to be specified in a forthcoming subsidiary
“tender and contracting regulation” and “uniform contract terms”
which are broken down to a toolkit o f a basic Concession Contract,
a Catalogue o f typical provisions and a summary o f typical
annexes.
30. Building institutional capacity. In recent months,
significant attention has been given to building the institutional
capacity within the Government which would allow to manage reforms
across various ministries. In 200 1 the Government established an
Inter-Ministerial Working Group on Regulatory Reform (IMWG) to
promote regulatory reform, ensure coordination across government
agencies, and facilitate business-government dialogue. Although the
I M W G began i t s activities at the end o f 200 1, i t s progress
has been limited. In September 2002 the Government took significant
steps to revitalize the IMWG.
3 1. Specifically, the Ministry o f Economy and Privatization
(MOEP) proposed to the Government that the Group i s transformed
into a Council on Regulatory Reform, which would become a permanent
advisory body to the Government on laws and policies affecting
businesses by receiving the authority to review al l draft laws and
government decrees prior to adoption. This very important change
aims to prevent the proliferation o f laws and regulations that
keep imposing barriers to business entry and operations. In order
to strengthen capacity o f the Council to review systemically and
in a timely fashion PSD-related draft laws and regulations, the
Bank provided significant amount o f technical assistance. This
will allow the Council to develop a concrete action program,
establish procedures, and begin systematically reviewing draft
legislation that impact business activities.
32. Improving access to finance. Limited access to finance
continues to be one o f the most severe constraints to private
sector development. The financial difficulties and s t i l l low
level o f confidence in the state-owned banks and the relatively
low capitalization o f the existing private banks have precluded
the financial sector to respond adequately to the growing demands o
f the private sector. In addition to reforming the financial
sector, the legal and regulatory framework needs to provide the
right incentives for banks and non-bank financial institutions to
finance the private sector. The Government’s reform program centers
on two areas to promote enterprise access to finance: (i)
introduction o f a system o f secured financing; and (ii) support
for the establishment o f regulatory framework conducive for
leasing operations.
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0 The objective o f the securedfznancing system reform i s to
create a modern, enabling, legal framework and appropriate
implementing institutions that will support credit transactions
which involve movable property as collateral. I t will provide the
legal structure within which modern secured financing o f
inventory, equipment, accounts and consumer goods can develop, and
wil l improve the cost o f credit and the efficiency o f the market
for secured transactions. The Government reform program includes:
(i) adopting the Law on Secured Transactions, and the regulations o
f the Collateral Registry, and ensuring consistency with other
relevant commercial laws and regulations; (ii) establishing
centralized collateral registry operating as public information
provider; and (iii) improving understanding o f the new legal
provisions and their practical use. The introduction o f the
secured financing system will be followed by broad dissemination
activities aimed at: (i) training o f judges, bankers and
entrepreneurs to improve understanding o f the new legal provisions
and their means o f enforceinent; and (ii) dissemination o f
information on the new system o f secured financing to potential
credit users, lenders, lawyers, accountants, and others likely to
use or benefit from the new system.
0 The lack o f an appropriate legal framework limits leasing
operations. A review o f existing laws and regulations affecting
the development o f leasing operations has been carried out by a
Working Group established by the Ministry o f International
Economic Relations (MIER) and supported by the Southeast Europe
Enterprise Development (SEED). Based on the results o f the review,
a draft Leasing Law has been discussed with major stakeholders in
the business community. In parallel, the work i s underway to
introduce required amendments to other relevant laws, in particular
in the areas o f taxation, accounting and customs.
33. Business exit. A functioning bankruptcy law i s required in
Serbia to provide an efficient alternative to the methods o f
privatization o f social and state capital set out in the
Privatization Law. The MOEP has led the preparation o f a draft new
insolvency law, with the assistance o f foreign and local experts
with considerable input from the Bank. The provisions o f the new
law are consistent with EU practices and have been designed to
minimize the impact o f existing institutional deficiencies in the
judiciary and the trustee community. First, a Supervisory Body wil
l be established to license, supervise, and regulate bankruptcy
administrators (trustees). Second, in view o f the experience o f
other post- socialist economies where bankruptcy cases were fraught
with collusion among bankruptcy administrators, judges and
creditors, a creation o f a specialized Bankruptcy Administration
Agency has been envisaged. This Agency, associated with the MOEP,
would be the only party which could be appointed as the trustee o f
a socially- or state-owned enterprise. The draft new law also
contains a specific provision designed to expedite the opening o f
bankruptcy proceedings, as well as a comprehensive section on
reorganization o f viable debtors. The bankruptcy process for
socially- and state- owned enterprises will continue to be carried
out under the authority and supervision o f the courts, as will all
other bankruptcy proceedings. The MOEP, with United States Agency
for International Development (USAID) and Bank support, has begun
to develop a general trustee training course and a program to
educate the judges on the concepts contained in the new draft.
34. Medium-term reform objectives. As noted above, Serbia needs
a more efficient and market- friendly business environment if
privatization, market reforms, and trade and investment
liberalization are to support sustainable growth o f a competitive
market economy. Therefore, sustainability and continuation o f the
current reform program must be ensured. The four key objectives o f
the program include:
i. ensuring proper implementation and operation o f the modern
bankruptcy regime, which i s needed not only to create financial
discipline and allow exit o f unviable enterprises but to allow the
privatization and restructuring o f the potentially viable
ones;
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.. 11. developing proper corporate governance institutions that
would support the future development
and better management o f capital markets; 111. developing
anti-monopoly legislation and institutional capacity for enforcing
it, which i s crucial
if Serbia i s t o build the foundations for i t s plans to j o i
n the EU; and, iv. laying the foundations for the development o f a
knowledge-based economy, to ensure that Serbia
can be competitive in the global economy, by strengthening the
intellectual property rights, increasing competition in the
telecommunication sector, and improvements in the R&D
infrastructure.
...
These four pillars will be pursued in conjunction with a serious
commitment to scale up the ongoing program o f restructuring o f
state- and socially-owned enterprises (see section 1V.B below).
B. Financial Sector Regulatory and Supervisory Framework
Current Status
35. Banking supervision. The onset o f the reform period in
early 2001 required the National Bank o f Yugoslavia (NBY) --today
the National Bank o f Serbia -- bank supervision department to
devote i t s energies to bank diagnostic reviews and subsequent
corrective action or resolution. These activities called for
selected changes to banking legislation and placed escalated
demands on supervisory staff. At the same time, supervisory
management initiated a strengthening program aimed at rebuilding
the department’s oversight capacity and procedural methodology. The
Bank’s support provided under PFSAC I helped to guide the
necessary, init ial legislative changes and the first steps in the
strengthening process. Since then, a Supervisory Development Plan
(SDP) has been designed by management (with assistance from USAID)
and was adopted as an official statement for the future direction o
f supervision. This document maps out the building process,
particularly the organizational and process changes needed to
establish and implement a new supervisory approach based both on
risk analysis and compliance verification.
36. Whi le the SDP was formally adopted at the beginning o f the
year, work to meet the development steps began in earnest during
the fourth quarter o f 2002. Several key benchmarks have already
been achieved. A Supervisory Review Committee (SRC) was
established, composed o f the senior managers o f the department
and the N B S Vice-Governor, to oversee and monitor both
supervisory activities and progress against the plan. A mission
statement which formally presents the NBS’s supervisory objectives
and direction was approved by the Committee and the N B S Governor
and presented to the public. Whi le further steps and progress have
been made, key to the future o f the program have been the
department’s init ial steps to prepare supervisory strategies for
individual banks and i t s improved dialog with the banking
community. The banks’ supervisory strategies (and execution
thereof) will ultimately represent, in large part, the culmination
o f the new risk based supervisory approach and the redirected
supervisory methodology. In concert with the steps taken in the
supervisory process arena, a number o f enhanced and new prudential
regulation^'^ have been prepared and formally approved by the NBS.
Banks are also now required to adhere to and report according to
International Accounting Standards (IAS), consistent with the
recently passed new Accounting Law. Annual reports for the
financial year 2003 will be prepared and reported using IAS.
37. Whi le many important steps have been made, much remains to
be accomplished. The SDP outlines further development steps;
however, the key to real change and more effective oversight o f
the
l4 The now formally approved prudential regulations include
areas o f capital adequacy, investment limitations, liquidity,
internal controls, internal audit functions, credit classification,
and credit policy.
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banking industry will be the rigorous implementation o f the new
supervisory approach. This wil l require the increased involvement
o f senior and executive management and the active participation
and support o f all levels o f supervisory staff. Also, governance
o f the NBS remains a concern as it has been operating without a
formal supervisory board. While this may have provided the ability
to act swiftly and decisively in the past, in going forward the NBS
should adhere to proper internal governance principles.
3 8. Deposit insurance. More than a decade ago SAM established
the Bank Rehabilitation Agency (BRA) to carry out i t s mandate o f
deposit insurer. In September 2001, in order to quickly implement a
significant bank resolution program, the mandate and powers o f the
BRA were expanded to include bank liquidation functions. However,
the BRA Law, as well as i t s statute, do not provide the inter im
corporate governance and financial management arrangements that are
required to ensure the separation o f responsibilities,
accountability, and resources for it to carry out effectively i t s
current dual mandate. In addition, the levels o f premiums and
coverage o f deposit insurance have not been adjusted over t ime to
reflect the changing state and structure o f the banking system and
macroeconomic conditions. Thus the funds available are not
sufficient to provide the agency with the financial resources to
reimburse insured depositors in case o f a significant bank
failure, and insured depositors have been de facto benefiting from
a blanket government guarantee with i t s moral hazard
implications.
39. Money laundering. Although it i s difficult to estimate the
level o f money laundering (funds from illegal activities flowing
through the legitimate financial system), many observers consider
Serbia to be a transit country for smuggling between Asia and the
Balkans. A lack o f funds and modern equipment hinders monitoring o
f goods transiting the country. These factors together with the
still-developing supervisory capacity in the banking system make
SAM a prime target for money laundering. Decisive efforts from the
SAM and Serbian Governments have brought a new anti-money
laundering law (AML) which took effect on July 1, 2002. The new AML
law authorized the creation o f a Serbian financial intelligence
unit (FIU) with the following functions: (i) receive reports o f
suspicious transactions froin financial institutions and develop a
database; (ii) analyze the reports to identify possible criminal
activity; (iii) forward reports o f suspect transactions to
appropriate law enforcement officials for investigation and
possible prosecution; and, (iv) establish effective cooperation
with foreign counterpart FIUs to share information, when
appropriate, to support the cross-border investigation and
prosecution o f money laundering cases.
40. Insurance sector reform. Insurance regulation and
supervision in SAM was traditionally carried out by the Insurance
Supervisory Authority (HA) department within the SAM Ministry o f
Finance. Activities o f insurance companies and their supervision
are regulated by the Law on Property and Personal Insurance, as
well as six additional regulations that have been enacted by the
ISA. However, the current insurance legislative and regulatory
framework does not comply with internationally accepted insurance
regulatory and supervisory principles and needs modernizing. N o
effective supervision takes place because the ISA i s understaffed
and does not have sufficient resources to retain qualified staff.
In addition to these shortcomings, the functions o f the ISA are
currently being transferred to the Serbian Ministry o f Finance and
Economy (MOFE) thus further straining i t s already limited
capacity.
Government’s Reform Program
4 1. Banking supervision. The NBS i s committed to continuing to
implement the roadmap provided by the SDP and all i t s attendant
requirements. Good initial progress has been made in establishing a
new framework for supervision. However, the challenge now facing
supervisory management (and which wil l continue into the future) i
s the need to implement the developing framework at al l levels o f
supervisory staff, management, and the banking industry. This will
require increased executive and senior management involvement and
interaction with staff and the banking industry. Furthermore, the
new
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methodology, by definition, calls for a more anticipatory
approach to supervision through which risk trends are detected,
monitored and addressed within individual banks and the system as a
whole.
42. The next steps to which the authorities are committed and
which wil l assist in the implementation phase o f the SDP, include
the development of a supervisory operating procedure which details,
internal to the NBS, the specific methodology for implementation of
the new supervisory approach. This is, in part, addressed through
the overall supervisory strategy that has been prepared in
conjunction with the mission statement. Implementation of the new
methodology also wil l be promoted through the further preparation
and refinement o f supervisory strategies for each bank in the
system. Other steps that are planned and that wi l l support the
implementation of the methodology include: (i) establishing lines o
f delegated decision making within the supervisory department; (ii)
establishing a system of internal M I S for senior and executive
management and SRC reporting; (iii) elevation of the role and
responsibility o f bank boards and management through increased
supervisory interaction; and (iv) enhancing the schedule of risk
stratified bank examinations to be completed during the upcoming
year. The examination procedure manual and the bank risk rating
system wi l l also continue to be refined during the upcoming
period.
43. Several legislative changes need to occur in the near
future. With the advent o f the new constitutional arrangement
between Serbia and Montenegro, the legal basis for the former NBY
has been adjusted to establish the new NBS. The former “Law on the
National Bank of Yugoslavia” wi l l be revised to reflect the new
framework. The new law wil l ensure the continued independence o f
the NBS and, thus, the ability o f the supervisory function to make
and administer decisions free from political and other outside
interference. Likewise, the governance o f the NBS wi l l be
further strengthened with the new law, by requiring the appointment
of a supervisory board that wi l l be responsible for the oversight
o f the NBS and i t s key functions. Changes to prudential banking
regulation are expected to support the evolving supervisory
process. Particularly, new supporting regulation for the licensing
process i s planned. This wil l be particularly important in light
o f the ownership and structural changes the banking industry i s
currently undergoing.
44. Deposit insurance reform With donor support (UK DFID), the
BRA’S deposit insurance division has made progress in setting up
basic procedures to ensure accurate and prompt payment of premiums,
reimbursement of depositors’ claims, and collection of premiums
from the insured institutions. It i s envisioned that once the bank
resolution program i s completed, the BRA would function only as
the deposit insurer. The authorities have decided to migrate
towards a new deposit insurance scheme that wi l l be consistent
with EU directives, internationally recognized best practices, and
in line with the expected structure and risk profile o f the
banking system and macroeconomic conditions. To that end, the
Government’s program includes the following actions: (i) amendment
of the law and statute o f the BRA to introduce institutional and
corporate governance arrangements enabling an effective
cohabitation of the deposit insurer and bank liquidator for the
time necessary to complete the bank resolution program; and, (ii)
an increase - in the medium term -- in the premiums collected from
insured banks up to levels closer to that foreseen or foreseeable
under the new deposit insurance law; (iii) preparation of a new
deposit insurance law. The authorities have made it clear that the
envisioned revamping o f the existing deposit insurance system wi l
l not be launched until 2004, when pending resolution action in the
banking system are expected to be substantially completed.
45. Anti-money laundering. Government’s efforts to foster AML
reform aim at developing the FIU that was created under the AML
law. The newly established FIU has been staffed and i s working
toward becoming fully operational to standards set forth by the
Egmont Group of FIUs, which may soon accept the Serbian FIU as a
new member. The FIU has hired five commissioners, established a
website, and i s now performing basic operational tasks, including
receiving reports o f suspicious transactions from banks -- some o
f which have been forwarded to law enforcement authorities for
investigation. The FIU i s currently in the process of establishing
an electronic database to maintain reports o f suspicious
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transactions, and formalizing procedures for cooperating with
foreign FIUs and relevant domestic agencies. The FIU has thus laid
the foundation to become an effective intelligence unit and can
become fully effective in 2003 provided that: (i) adequate budget
allocation i s made for i t s operations in 2003; (ii) technical
assistance from donors and counterpart FIUs continues; (iii) the
FIU meets criteria for membership in Egmont Group o f FIUs; and,
(iv) the FIU demonstrates that it can protect and process
confidential financial information in support o f international and
domestic investigations and prosecutions o f cases o f money
laundering and terrorist financing.
46. Insurance sector. The Government’s reform program focuses on
the following measures aimed to modernize the regulatory and
supervisory framework for the insurance sector: (i) development and
implementation o f a new insurance law compliant with IAIS core
supervisory principles in areas such as licensing, changes in
control, investment regulation, and internal audit function; (ii)
the establishment o f a new insurance supervisory unit within MOFE;
and, (iii) the development and implementation o f an action plan to
strengthen insurance supervision. Technical assistance in these
areas i s being provided by the Bank and other donors.
47. Medium-term reform objectives. Reform objectives for banking
supervision in the medium term will play directly o f f NBS’s
mission statement and the SDP and reflect the changing banking and
enterprise environment. The thrust o f the strengthening program i
s to introduce a proactive, risk based method o f oversight which
wil l be critical during the current period o f structural change
and privatizatioii o f banks and enterprises. Furthermore, the
independent oversight role o f the supervisor must be clearly
exercised with banks made aware that the NBS will continue to
require strict, safe and sound underwriting standards. Growth
trends, new products, and new and changing risk profiles in banks
and in the system as a whole must be detected and monitored in a
timely manner. Therefore, the supervisory function must continue to
focus on more effective communication within the department itself,
within the NBS as a whole and within the banking industry, boards
and management. In t h i s regard:
i. offsite monitoring processes and early warning systems must
be further developed and become firmly entrenched in the
supervisory process;
ii. the examination process must be risk focused and must not
falter as this i s one o f the more important tools for detecting
and monitoring trends in the system;
iii. the examination schedule will continue to be carefully
prepared and monitored by the SRC and executive management on an
ongoing basis; and,
iv. the processes and mechanisms within the NBS, such as the
SRC, early warning systems, and overall supervisory procedures wil
l continue to be established and refined i n order to more
effectively anticipate the future systemic risks.
48. Beyond the development o f banking supervision, and as the
overall financial sector further expands i t s activities, the
supervisory and regulatory process must keep pace. The insurance
and capital markets sectors are expected to expand at an increasing
pace and assume growing significaiice in the country’s financial
system. As a result, the authorities need to also focus on building
supervision in these additional two areas. Thus they wil l have to
begin formulating their medium- and long-term view on how the
structure o f financial sector supervision should evolve. While no
decisions have been made, further research and evaluation o f the
current and alternative structures will continue.
49. framework also include:
Medium term objectives in the other areas o f the financial
sector regulatory and supervisory
i. implementing the revamping o f the deposit insurance system
in a manner consistent with the European Directive, internationally
recognized best practices, and in line with the expected
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11.
... 111.
A.
50.
structure and risk profile o f the banking system following the
outcome o f ongoing restructuring efforts, continuing the adequate
operation o f the Serbian FrU in accordance with acceptable
international standards to combat AML; and, establishing an
adequate regulatory and supervisory framework for the insurance
sector, that wil l be followed by the restructuring and
privatization o f the insurance sector.
IV. Privatization and Restructuring o f Banks and
Enterprises
Banking Sector Reform
Current Status. Supported by PFSAC I and related technical
assistance provided by the Bank and other donors, the authorities
made significant progress in the restructuring o f the banking
sector during 2001, culminating in the closure o f the four largest
banks in January 2002. During th is period, under remarkable
leadership o f the NBS, 23 insolvent banks representing nearly two
thirds o f the assets of the system were either liquidated or put
under bankr~ptcy '~. To support these efforts, and following key
legislative amendments passed in mid-200 1, the BRA became the
designated administrator for banks in bankruptcy. With substantial
Bank and donor support, the BRA has successfully executed i t s
expanded duties, including the closure and commencement o f
bankruptcy proceedings for the four largest banks. The
implementation o f remedial plans for the five banks that were in
rehabilitation at the end o f 2001 continued during 2002 and, as a
result, four o f these banks were merged to form a viable larger
bank - Niska Banka - in late 2002, which was recapitalized by the
BRA and now meets prudential requirements. The BRA has successfully
turned around Niska Banka, which now has positive income and
operating cash flows, and i s expected to be a candidate for early
privatization in 2003. The remaining bank i n rehabilitation i s
considered to be non-viable by the BRA and i s pending a NBS and
Government decision that i s likely to call for i t s liquidation
or gradual closing.
5 1. As a result o f the restructuring process and the entry six
new foreign banks, confidence has begun to return to the Serbian
banking system. This i s evidenced by the rapid growth o f foreign
exchange deposits, which rose from Euro 538 mill ion at end-June
2001 to over Euro 1 bil l ion at end-2002. Progress has also been
made during 2002 in reducing the state majority stake in the
recently created National Savings Bank (NSB) and in separating i t
s governance from the NBS. During 2002 while the authorities worked
on developing a viable strategy for resolution o f the s t i l l
large number o f banks with asset quality problems (largely but not
exclusively derived from credits financed using Paris and London
Club (PLC) liabilities prior to 1990). One response to this
challenge was the Serbian Government decision to pass the PLC Law
in July 2002, which provided for the mandatory debt-to-equity
conversion o f banks' PLC liabilities into equity to be owned by
Serbia. The consequence o f this law has been a de facto
nationalizatioii o f a large proportion o f the banking system (15
banksI6), including a majority state position in two o f the three
largest banks in the system, and a significant stake in the largest
private bank in the country. The PLC Law also stipulated the
state's obligation to initiate the privatization process o f the
nationalized banks within six months o f the actual execution o f
the debt-to-equity conversion.
l5 This included the four largest Serbian banks, representing 61
percent of the assets of the banking system. l6 A total of 17 banks
were affected by the Serbian Government decision to pass the PLC
Law. Of these banks, five were already in rehabilitation and under
fill state control at the time of passage of the law, three o f
which were subsequently merged. As of December 2002 there were
thus: 12 PLC Law-affected banks not in rehabilitation and three in
rehabilitation. These 15 banks account for more than half of the
banking system of Serbia. With one significant exception, all o f
the 15 banks were either under state control or under ownership o f
socially-owned enterprises prior to the debt-to-equity conversion
mandated by the PLC law.
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52. The central issue facing the authorities in the next two
years i s thus the resolution o f the PLC Law-affected banks:
whether by privatization or by closure and liquidation. The latter
outcome i s likely in a number o f cases where the debt-to-equity
conversion may be insufficient to restore solvency. In early 2003,
the authorities began to address this issue by: (i) approving a
banking resolution strategy for implementing the resolution process
which centers on attempts to privatize the PLC Law-affected banks
without the use o f fiscal resources; (ii) implementing enhanced
controls and governance over the affected banks to preserve their
value; and, (iii) launching diagnostic audits o f state majority
ownership banks (and one additional private bank with a significant
state participation) to ascertain their true condition after
application o f the provisions o f the PLC Law. Simultaneously,
tenders for a strategic adviser to the Government for the
privatization process and for privatization advisers for three
banks have been launched. This i s expected to result in the launch
o f privatization tenders for the f i rst three PLC Law- affected
banks in the second half o f 2003.
53. Linkages with Enterprise Restructuring and Privatization.
The approach to resolution o f the banking system’s claims on the
enterprise sector has a major impact on the ability o f the
authorities to restructure and privatize the enterprise sector
itself. This point f i rst became an important issue when the
authorities sought to address the conflict between the BRA’S
responsibilities as the liquidator o f banks (i.e. as the enforcer
o f the banks’ claims on enterprise borrowers) and the objective o
f the Privatization Agency (PA) o f moving forward as rapidly as
possible with the enterprise restructuring and the privatization
program. Subsequently, the issue has become more complex as the
implications o f the PLC Law have become apparent. Additional
background on the linkages between the banking and enterprise
sector restructuring and the Government’s program to facilitate
workouts are described in the section on enterprise sector reform
(paragraphs 60-6 1).
54. Government’s Reform Program. The Government’s program for
reform o f the banking system builds on the progress made under
PFSAC I, and targets resolving the interconnected problems o f the
PLC debts o f banks and enterprises. The f i rst phase o f the bank
restructuring program (launched under PFSAC I) will move toward
issuing a tender for privatization o f Niska Baiika in late 2003
and, during the course o f 2003, the resolution o f a bank
remaining under BRA control for which recapitalization and
privatization i s not considered a viable option. Further progress
will be made in the liquidation o f the non- financial assets o f
bankrupt banks being liquidated by the BRA, with the target o f
completing the sale or leasing out 40 percent o f these assets by
end-2003.
55. The second phase o f bank restructuring - triggered by the
enactment o f the PLC law - will accelerate as a result o f the
Government’s adoption o f a comprehensive strategy to privatize or
liquidate al l banks that have been affected by the PLC law. The
strategy includes the following main features: (i) emphasizes the
importance o f attracting strategic investors to take over the
banks; (ii) calls for implementation o f controls over the
operations o f the banks during the pre-privatization period; (iii)
requires diagnostic audits and the application o f reinforced
supervisory measures (including closure) for banks found to be
insolvent; (iv) excludes the possibility o f utilizing fiscal
resources to recapitalize banks; and, (v) provides workable
institutional arrangements to manage and execute the implementation
process. Additional work i s now underway to develop a parallel
strategy for integrating the resolution o f PLC assets now held by
the banks with the privatization and restructuring program for
state and socially owned enterprises, The Bank and donors are
providing substantial technical assistance support for
implementation o f the PLC bank resolution and privatization
strategy. Finally, the Government will signal i t s intention to
withdraw from an ownership role in the banking sector by reducing
the state-owned or controlled stake o f the NSB to less than 25
percent by end-2003.
56. Medium-term reform objectives. The authorities recognize
that completing the restructuring and privatization o f the banking
sector i s a pre-requisite for the full development o f the
financial sector’s ability to support economic growth. Accordingly,
the authorities have adopted an ambitious medium term
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agenda to be completed by end-2004 which includes: (i)
completion o f the resolution o f all remaining state stakes in
banks (including all o f the PLC Law-affected banks); (ii) closure
o f all remaining insolvent banks; (iii) the aggressive disposition
o f the non-financial assets o f bank receiverships; (iv)
completion o f the liquidation or leasing out o f the assets o f
banks closed in 2001-2002; and, (v) rapid progress in the
resolution o f non-performing bankrupt and PLC law-affected banks’
claims on the enterprise sector.
B. Enterprise Sector R e f o r m
57. Current Status. As stated in the TSSU, the real sector in
Serbia i s in very poor condition. The past decade brought
macroeconomic instability, loss o f markets, and isolation from
technological advances. The mass o f productive assets tied up in
socially- or state-owned firms requires change o f ownership and,
in many cases, restructuring if these firms are to survive and
compete in open, global markets (see Box 3). The MOEP and the PA
have the mandate to offer for sale the capital or property o f
about 4,000 SOEs over the next three years. Among these SOEs, some
100 companies can be privatized through tenders to strategic
investors. Another 1,500 to 2,000 companies can be sold through
auctions and a limited number (probably less that 100) can be
restructured and privatized, all or in part. The remaining
companies will have to be subject to bankruptcy under the new
insolvency legal and institutional framework described in Section
1II.A above. The initial progress made by the P A in implementing
the Government’s ambitious privatization program has been
considerable, although in some areas (see below), serious problems
remain and if not resolved, w i l l undermine the process.
58. Government’s Reform Program. The Serbian privatization
strategy i s based on the new Privatization Law adopted, with the
Bank support, in June 200 1, and incorporating the international
best practice and lessons learned from other transition economies.
The law requires offering to a strategic investor at least 70
percent o f the shares. An amendment to the Privatization Law,
adopted by the Parliament in March 2003, provides full and
exclusive authority to the PA to negotiate and sign sale and
purchase agreements. This i s a major achievement because, due to
the legacy o f social ownership, before the amendment, employees’
representatives could refuse to sign the agreements if they did not
l ike the investor who won the tender. The law stipulates three
methods o f privatization: (i) privatization tenders o f large
enterprises; (ii) auctions o f medium enterprises; and (iii)
restructuring and subsequent tenders and/or auctions o f large
loss-making enterprises and/or part thereof. Tender privatization i
s used for SOEs that are sufficiently large, important and
attractive to require the case-by-case approach for their
privatization. The auctions program has been designed to address
the structural difficulty which has been faced in many transition
economies o f privatizing in a relatively short period o f time a
large number o f companies, while the domestic purchasing power i s
very limited, by insisting on cash payments but allowing extended
payments and the use o f government bonds (issued in exchange o f
the frozen foreign exchange deposits). Finally, large loss-making
SOEs that cannot be sold through auction or tender in their current
condition (due to excessive employment, heavy debt burden, etc.)
are required under the Privatization Law to undergo “privatization
through restructuring.” The legal framework for restructuring i s
elaborated in the Restructuring Decree that stipulates the
procedures for reorganization, dealing with creditors and debt,
management o f the company during restructuring and deadlines for
third parties to meet the requirements o f the decree.
59. Auction Privatization. Following a revision o f the Auctions
Decree in July 2002, which simplified the process and reduced the
unreasonable starting prices, the program has been moving forward
with new momentum. Auctions now start with cash and move to the
bonds for frozen foreign exchange deposits, if no cash bids are
made. This flexible approach has greatly increased the
participation in auctions and has led to a success rate o f about
70 percent, with the PA now running two auctions a week. In the f i
rs t half o f 2003, 500 companies will be sold, with another 560
expected to be sold by end o f 2003. The average selling price o f
the companies offered in auction averages about Euro 300,000.
The
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Government i s already setting up new capacity to help manage
the program for the next 1,000 companies when the first 1,000
auctions are finished.
Box 3: Privatization of Socially-Owned Enterwises in Serbia
The bulk o f the real sector in Serbia has been organized as
socially owned enterprises (SOEs). In the SOEs, workers
collectively hold major rights to management and disposal o f
enterprise assets or residual income. This unique form o f
industrial organization contributed to Yugoslavia’s earlier
economic successes, but i s inappropriate and ineffective in a
market economy. Dismantling this system and replacing it with more
efficient and competitive forms o f ownership and operation
represents a key challenge for the Government.
The f i rst attempt to change social ownership had been made in
1989 when the first Yugoslav law was passed allowing firms to be
privatized by employees. In 1994, an amendment o f the
privatization law revalued capital, reversing much o f the
privatization that had taken place, resulting in popular
discontent, extensive litigation, and a completely failed attempt
at privatization. In July 1997, the Serbian Govemment ad