Memorandum on the budget and economic and fiscal policy for the year 2008 including projections for the years 2009 and 2010, 5. july 2007

On the basis of Article 14, paragraph 1, item 1) of the Budget System Law (“The Official Gazette of the Republic of Serbia“, Nr. 9/02, 87/02, 61/05 – state law, 66/05, 101/05 – state law, 62/06 – state law, 85/06 and 86/06 – revision),

The Government hereby adopts the

M E M O R A N D U M

ON THE BUDGET AND ECONOMIC AND FISCAL POLICY

FOR THE YEAR 2008

INCLUDING PROJECTIONS FOR THE YEARS 2009 AND 2010

I. INTRODUCTION

1. The macroeconomic framework

During the year 2006 the Republic of Serbia has achieved significant macroeconomic results with respect to economic growth, macroeconomic stability, export increase, improved efficiency of the economy, inflow of direct foreign investments, accompanied however with a high trade deficit and high unemployment.

The macroeconomic trends of 2006 are characterized by high growth of gross domestic product (GDP) at 5.7% and curbed inflation at 6.6%. Imports also grew significantly at 31.2% accompanied by continued increase of foreign currency reserves. The trend of high economic growth and reducing inflation has been maintained during 2007. The estimated real GDP growth for 2007 is 7%, and the estimated increase of consumer prices is 6.5%. According to the estimates by the Republic Statistical Office the GDP growth during the first quarter of 2007 relative to the same period of the preceding year is 8.7%.

In view of the macroeconomic stability and the structural adjustments processes, the projected real growth of GDP for the period from 2008 to 2010 on the average is 6.3%, with a tendency to accelerate with the progress in restructuring and transition of the economy. The projections foresee a trend of reducing inflation in the forthcoming period with inflation dropping to 4% in the year 2010. Factors to contribute most strongly to achieving the projected GDP growth rates are a strong growth of exports of goods and services at the average annual rate of 21.9%, and growth of investments at the average annual rate of 15.4%. The growth of local and foreign investments is a pre-requisite for the modernization of the economy, especially of the infrastructure and of increased exports as a key component of economic growth. Resulting from increase of GDP and investments it is expected over the next three years to achieve increased employment and better standard of living.

The fundamental preconditions of macroeconomic framework for growth and stability of the Serbian economy during the coming three years include:

· The maintenance of tight fiscal and monetary policy, as the basis for macroeconomic stability;

· Acceleration of structural reforms, especially the finalization of the privatization of the remaining socially owned enterprises and an accelerated restructuring and privatization of state enterprises;

· Strengthening of the private sector which will generate new investments, exports, new employment and will accommodate the redundancies resulting from the economic transition and the young people after completing their education;

· Enhancement of the business climate and the creation of an environment conductive to new investments and changed production structure.

The achievement of stated expectations will result in a dominant share of the private sector in the economy after the privatization of the existing and the establishment of new enterprises, establishment of a comprehensive legal framework for a functional market economy, through the adoption and implementation of systemic laws harmonized with those of the EU, an active role of the Government in managing economic policy and improving the business environment and credibility of the country.

2. Fiscal policy

In the period from 2001 to 2006 the Republic of Serbia has implemented a comprehensive reform of public finance, through the adoption of a new legislative framework and building of new and modernization of existing institutions. The implemented fiscal reforms made a crucial contribution to the achieving of macroeconomic stability and creation of favourable conditions for investment and growth of the Serbian economy.

However, the second half of 2006 saw a significant increase in public expenditures, representing a deviation from the tight fiscal policy that was being implemented since the middle of 2004. Also, during the second half of 2006, protocols and agreements have been signed and laws adopted based on which the level of public expenditures in 2007 increased significantly, while revenues reduced. It is estimated that primarily due to the said measures the share of consolidated public expenditures in the GDP in 2007 increased relative to the preceding year by 3.3 percentage points, while the net outcome (surplus / deficit) deteriorated by about 2.2 percentage points of the GDP. The expansive fiscal policy, accompanied by excessive growth of wages and credit expansion, resulted in an accelerated growth of domestic demand beginning with the last quarter of 2006. The increased demand was for the most part reflected in increased trade deficit and to a lesser degree it “pulled along” the local economy, while prices remained stable. Since the current level of trade deficit is not sustainable in the long term, a mix of measures is needed to reduce it. Fiscal policy has a key role to play in this, although other major factors are wage policy, monetary policy and exchange rate policy.

The reduction of the trade deficit requires a strong fiscal adjustment during 2008 through reduced share of public expenditures in the GDP by 1.5 to 2 percentage points. It is planned that during 2009 the share of public expenditures in the GDP is to be reduced by an additional 0.5% of the GDP. The objective of the planned fiscal adjustment is to reduce the high trade deficit through reduced local demand.

Key measures needed to reduce public expenditures as share of the GDP are: freezing the total amount of funds for wages of budget beneficiaries throughout the year 2008 at the level prevailing in November 2007, i.e. after the implementation of previously signed protocols on wages increase; reduction of expenditures for goods and services in the budget of the Republic by 10% relative to the amounts stated in the budget for the year 2007; reduction of subsidies by 5% relative to the amounts stated in the budget for the year 2007; reduction of public investments from the Republic budget by about 20% relative to the amounts stated in the budget for the year 2007.

Consolidated public revenues will maintain a more or less same share of the GDP, accompanied in the same period by a reduced share of public expenditures. Such trends of public revenues and public expenditures will result in balanced consolidated balance of the public sector in 2008, accompanied with a moderate surplus in the last two years of the mid-term period.

Fiscal reforms will continue over the forthcoming period including improved tax system, restructuring of public expenditures, increasing transparency of public finance, strengthening the tax and customs administrations, etc.

3. Structural reforms

The planned macroeconomic objectives relevant to high rates of economic growth, export growth and investments in fixed assets will not be achieved unless the process of structural reforms continues. The major tasks in the domain of structural reforms will be the finalization of privatization of socially owned enterprises, banks and insurance companies, continued restructuring and beginning of privatization of public enterprises, building of an incentive business environment for the development of small and medium enterprises and attracting direct foreign investments, as well as continued reform in managing public finance and public administration reform.

During the forthcoming period the Government priorities in the public sector will focus on the implementation of the remaining necessary measures in public enterprises, in order to make them viable in the market to be followed by partial or complete privatization.

Continued implementation of structural reforms will increase the pressures in the labour market, so a necessary part of Government policy will be the promotion of development and growth of small and medium enterprises in order to accommodate the negative pressures caused by structural reforms in the economy. A major contribution to reversing the negative trend in the labour market could come through attraction of foreign direct greenfield investments, but for this to happen it is necessary to further improve the investment environment, primarily the legal system.

Management of public finance is subject to permanent improvement. The focus of reforms in the coming period will be on strengthening the controls of public finance by establishing the Supreme Audit Institution, improving the system of medium term planning, reducing expenditures by reforming the pension and other social security systems, increasing efficiency in tax collection and narrowing the scope for tax evasion. Adequate state investments in infrastructure will increase the competitiveness of the Republic of Serbia, and will be an impetus for economic growth and achievement of projected strategic objectives. One of the fundamental principles of state policy will be the removal of regional disparities in terms of economic development.

Public administration reform will focus on creating efficient administration and will be based on the principles of decentralisation, depolitisation, professionalization and rationalization.

Appropriate policy coordination, based on adopted strategies, will enable the achievement of identified objectives and will create conditions for further progress of the Republic of Serbia. The structural reforms in the coming period must be characterized by the speed of their implementation, in order to rectify as soon as possible the existing economic and social disparities and in order to establish conditions needed to achieve sustainable and a relatively high economic growth and development over the mid-term period. It is evident that the costs associated with the implementation of structural reforms in many sectors in the short-term may be very high, but the resulting benefits of their implementation should contribute to further growth and development of the Serbian economy and society on the whole.

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Memorandum on the budget and economic and fiscal policy for the year 2008 including projections for the years 2009 and 2010, 5. july 2007