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Emerging Markets

EM Country Briefing
Serbia: Fights for growth
Serbia is reclaiming its place in Europe; it expects to receive a candidate status this year and ties its economic links closer to Italy and Europe. Based on our recent visit, we see an improved outlook for the country. The government is observing Central Europe for central banking clues, Slovakia for an export-oriented transformation and tries hard to cooperate politically with the EU. The NBS runs a relatively free float to dinarise a heavily-indexed economy. Measuring by the results, the countrys policy choices are proving more effective than Croatias and the World Bank sees a fivequarter consecutive export growth reassuring on competitiveness. This should be reinforced by a prospective flow of foreign investments, including a 1bn project in the auto industry where the supply chain is substantial. Based on a best-case scenario and Slovakias experience, Serbias economic model that was conditioned by past high consumption standards could transform to an export-oriented one and its growth rate rise from 3% to 5%-7.5%. Fiscal populism typically surrounding political elections is a concern. External vulnerabilities are still large and funding gaps could still surface. The government has requested a new precautionary IMF SBA, which, in our view, would be necessary to secure the governments debut Eurobond scheduled for September/October. This, otherwise, could be a rare case of an improving credit.

12 August 2011

S&P Moodys Fitch

BB- (stable) NR BB- (negative)

Serbias dinarisation problem and the NBS


Serbia has one of the highest and most volatile inflation rates in Europe (after the Ukraine and Belarus). The National Bank of Serbia is also unique in the region with its monetary regime; it operates a quasi-free float with active interest rate policy, in an environment of very low policy credibility. Interest rate policy is therefore aggressive, as the bank is trying to build dinar-based financial markets; establish confidence in the local market and reduce inflation to c. 4%. The prevailing degree of euroisation, however, suggests that the strategy has been as yet ineffective. This proved to be a single important problem in the crisis management in Serbia although the impact has been rather well contained. The use of the euro is widespread in the SEE region and it is the highest in Serbia; 67% in loan portfolio and 70% in deposits. The rate of euroisation under both fixed exchange rate or inflation-targeting regimes is usually 60% or less. The regions experience with hyperinflation and monetary instability, and widespread indexation has created a pattern of exchange rate pegs or de facto currency boards. The NBS, alone in the neighbourhood, is running considerably greater exchange rate flexibility. This has been facilitating some degree of switch to the RSD in 2008 but the NBS intervened later asymmetrically; putting a floor under the dinar and preventing excessive depreciation. The combination of high euro-indexation and exchange rate flexibility remains risky but as we show below, by the results, more effective than Croatias peg. The full scale of exchange rate adjustment between 2008 and 2011 was c. 35%. This was among the larger nominal exchange rate depreciations in the region. According to the NBS, however, the deterioration of banks loan quality has not been as large as elsewhere, where the private sector holds similarly large open currency positions. The NPL ratio reached c. 17%; 24% in the corporate sector and 8% for households. This is likely to have been possible due to households hedge in the form of large holdings of foreign currency savings and deposits. According to the OeNBs EuroSurvey, Serbian households hold on average c. 3,500 euro general cash reserves or in total c. 9bn, equivalent to over 20% of GDP (2009 survey-time GDP, latest NBS data 7.3bn), which exceeds that in any other Central Eastern European country. According to the World Bank, the size of the cash economy is also massive, which has also helped to ease the crisis.

Analyst Barbara Nestor


+44 (0)20 7475 1690 barbara.nestor@commerzbank.com

research.commerzbank.com Bloomberg: CBIR

For important disclosure information please refer to page 7.

EM Country Briefing

As part of the dinarisation strategy of the NBS, the government introduced credit support programs via subsidised dinar loans, which have helped to shore up credit growth during the crisis. This program reduced slightly the share of foreign currency loans in total from 75% to c. 67%, although the support scheme is being phased out and the increased use of the dinar may fade out again. According to the OeNBs survey the practise of setting prices and wages in euro and denominating them in dinar only for legal purposes prevails, while payments for large consumer durable goods are made almost exclusively in foreign currency. As macroeconomic credibility is perceived to be low, the best hedge remains to be denominating contracts and prices in foreign currency. The favourable interest rate differential of foreign currency denominated financial services arouse from (previously) easy access to abundant foreign currency liquidity from abroad from parent banks and remittances (the latter c. 8% of GDP p.a.). A lack of a liquid government bond or bill market beyond the shortest maturities means the pricing benchmarks for local currency financial instruments and hedging products is missing. The authorities nevertheless continue to maintain a co-ordinated support for dinarisation, which involves the development of hedging markets, the NBS offering FX swaps and the Ministry of Finance issuing local debit instruments and lengthening T-bill maturities from three months to two years. The next hurdle is to encourage a secondary market in T-bills. Serbias monetary policy operation resembles that of Hungarys in its early inflation targeting period; it runs at high interest rate volatility, due to the overwhelming role of exchange rate transmission. When the exchange rate background is stable, the carry trade catches on; year-todate the NBS reports c. 0.7bn foreign portfolio investments in short debt instruments (361D+ Tbills, available to non-residents); one-half of the outstanding stock. With a shallow currency market this makes the RSD vulnerable (100m daily turnover, 300m-400m pre-crisis, catching up to Romania). According to local banks the (quasi-) free-float and non-resident participation in the local market helps the market to develop. The float, therefore, could prove a healthier strategy than Croatias quasi-fix (see more on this below), provided that the local market grows in liquidity and hedging instruments. The IFC is taking an active role in technical assistance, and a growing number of multinational corporate operations should also facilitate this. The NBS says that inflation volatility encourages euroisation more than exchange rate volatility. Therefore it is likely to continue to allow exchange rate volatility, as long as it can control inflation, but interest rates are likely to be held at a foreign currency risk premium to Europe. A turnaround into a currency board like fix, similar to Croatia, is not considered. (For comparison, annual average. EUR/RSD depreciation was 15% and 9.5% in 2009 and 2010, respectively, as against weighted average interest rate on Republic of Serbia Tbills of 14% and 11%). CHART 1: Foreign currency loans as % of GDP
90 80 70 60 50 40 30 20 10 0 Macedonia Moldova Hungary Serbia Albania Bulgaria Lithuania Belarus Romania Ukraine Russia Croatia Poland Turkey Latvia

CHART 2: Foreign currency loans as share of private credit


100 90 80 70 60 50 40 30 20 10 0 Macedonia Moldova Hungary Bulgaria Croatia Poland Lithuania Albania Belarus Turkey Romania Ukraine Russia Serbia Latvia Foreing currency loan as share of household Foreign currency loans as share of corporate loans Indexed

Source: Commerzbank Corporates & Markets, EBRD

Source: Commerzbank Corporates & Markets, EBRD

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EM Country Briefing

Damages from the crisis


Regulatory strength
The banking sector is a strong pillar of the economy. While the above would suggest that exchange rate volatility has been harmful, banks have withstood the crisis and deposit withdrawal without outside support, due to outstandingly conservative NBS provisioning requirements. Banking sector balance sheets continued to expand even during the crisis and credit growth is faster than in regional markets; at a rate of 15% year on year. This has been stimulated by subsidised RSD credit schemes, which are being phased out. Large cross-border exposure to foreign banks was the systems key vulnerability. The NBS administered closely the Vienna initiative, and in particular, exposure floors bank by bank. Exposure limits of foreign banks were lowered from 100% to 80% in April 2010; nevertheless, Serbia still has large foreign claims originated by its lenders equal to c. 65% of GDP. Eurozone periphery banks hold among the highest concentration of local banking assets in Serbia, up to 40% of GDP. Eurozone periphery banks have claims of up to 20%-50% of GDP in the regions banking systems. This capital is not fully callable and local banking regulation tightly limits the amount of capital that can be withdrawn, but the amounts highlight the relative importance of parent bank funding for individual countries. Croatia and Bulgaria stand out with foreign claims of close to 50% of their GDP originated by Greek and Italian lenders. Serbia and Macedonia have somewhat lower foreign claims as % of GDP, but, together with Bulgaria 60% or more of that is owed to the Eurozone periphery lenders. These credit lines may tighten. TABLE 1: Foreign claims by lender countries to Central Eastern Europe as % of GDP
Bulgaria Austria Italy Spain Portugal Greece European banks 11.1 17.00 0.19 0.00 31.64 77.47 Czech R 32.04 8.56 0.30 0.01 0.00 94.03 Croatia 56.4 51.59 0.11 0.07 0.30 125.45 Hungary Macedonia 26.04 16.03 0.67 0.21 0.17 86.80 3.86 0.25 0.03 n/a 20.25 27.38 Poland 3.17 10.02 1.37 3.22 1.71 58.33 Romania 24.7 8.40 0.23 0.44 13.05 67.16 Serbia 17.38 18.92 0.01 0.02 17.94 65.09

Source: Commerzbank Corporates & Markets, BIS

TABLE 2: Banking sector ownership in the CEE and SEE, by assets (% share)
Bulgaria Greece Italy Hungary Austria Germany 28.7 15.8 12.5 9.9 6.0 Poland Italy Germany Netherlnd Spain Austria Portugal other domestic 10.8 16.3 other domestic 14.1 10.8 7.5 7.2 5.2 4.6 20.6 30 other 20.2 domestic 12.2 domestic 29 other 8 domestic 13 domestic 4.2 Romania Austria 31.8 France 14 Hungary Austria Italy Belgium Germany other 24 20 14 13 0 Serbia Italy 21.5 Greece 15.4 Austria 17.1 France Germany 7.9 2.6 Czech Belgium 20.8 Austria 25.3 France 16.4 Italy 6.4 Croatia Italy Austria France Hungary other 41 33.8 7.5 3.5 10

Greece 12.3 Netherlnd Italy 3.4 6.1

other 18.1

domestic 27.5

Source: Commerzbank Corporates & Markets, National Central banks

The banking system, nevertheless, has a strong regulatory hedge. The corporate sector suffered the largest damage from balance sheet exposure, but banks are able to absorb substantial credit risks; the capital adequacy ratio is among the highest in the region above 20%. According to stress tests under the IMFs oversight, banks are sufficiently well capitalised to absorb even a protracted corporate restructuring process. A new decision on reserving requirements that promotes the use of longer maturity RSD sources will further regulate funding vulnerabilities. According to local banks, Serbia is one of the safest banking markets in the world. This is due to the fact that lending is done nearly purely from capital; the system has a capital stock of c. 3.5bn for a loan portfolio of 14bn. As long as prudential regulations are kept tight, banks should remain stable in the face of unhedged private sector balance sheets.

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EM Country Briefing

CHART 3: CAR % tier 1


25

CHART 4: Loan/deposit %
160

20

140 120

15

100 80

10

60 40

5
20 Romania Hungary Czech Poland Croatia Serbia Bulgaria 0

0 Hungary Poland Czech Romania Bulgaria Croatia Serbia

Source: Commerzbank Corporates & Markets, National banks and bank regulators, Fitch Ratings

Source: Commerzbank Corporates & Markets, National banks and bank regulators, Fitch Ratings

The IMF oversight and fiscal position


Tendency to overshoot
Serbia completed its IMF Stand-by Program in April with good progress; securing five tranches of financing of $1.5bn. The government drew only half of the $3bn available, observing funding costs (the loan rate jumps at $1.5bn from 2% to 4%). According to the Fund, the 2009 SBA achieved the fiscal adjustment targets but relied on low quality ad hoc measures, including a cut in the public wage bill and across-the-board discretionary spending, as opposed to setting a long-term spending structure. The IMF is likely to be available for a new program, although sees high implementation risks ahead of the 2012 elections. It has served the role of a political coordinating mechanism, and is likely to stay engaged for this purpose; and set structural benchmarks that can be done piecemeal or back loaded. The new structural benchmarks would be related to (1) restructuring of SOEs (quasi-fiscal deficit generators), (2) labour market deregulation, (3) competition policy and break-up of monopolistic sectors. The government has pledged to observe the fiscal ceiling of 4.2% of GDP and 3% of GDP next year, although the required expenditure cuts of an estimated 2.7% of GDP (1.2% and 2.5% due to the decentralisation of revenue collection to the regions) are seen as hardly feasible. The original budget deficit target for 2010 was revised upwards from 4.0% to 4.8% of GDP last September, and the IMF estimates that during the last ten years the fiscal cost of a typical preelection year in Serbia was about 3% of GDP, which adds risks to a new Program. The government has passed fiscal responsibility legislation last year, which caps the public debt-toGDP ratio at 45% of GDP, and cuts the fiscal gap to 1% of GDP in the medium term, observing a long-term target of public cost structure, but the Fund still expects slippage on short-term targets. The government is preparing a $1bn debut Eurobond for September/October this year, $200m of which would be an RSD-denominated inflation-linked bond. Local banks argue the government can fund itself at 4.5%-5.85% with euro-indexed RSD treasury bills and would seek to avoid the Montenegro mistake which we believe is a high-price market issue (Montenegro sovereign bond issued at 7.85%-7.25%). We think that an IMF precautionary agreement would be key for Serbias Eurobond issue (and for investors), both for policy restraint and liquidity reasons, so as to insure against event risks such as delay to the countrys recognition as an EU candidate, political instability or the Italy risk.

New economic model and external balances


Auto and steel industry investments promise a turnaround
Serbias devaluation proved to be less harmful overall; the exchange rate and current account adjustment have been more extensive than in peer countries, while the contraction in GDP was moderate. The World Bank believes that export growth has helped to pull the economy out of recession; five consecutive quarters of c. 20% year-on-year export growth suggests competitiveness adjustments. Serbias pre-crisis growth model was conditioned by past high consumption standards, and unlike elsewhere in the CEE, its external deficit was structural. Serbia, as a republic of former Yugoslavia exported c.70% of its production, compared to 20%-30% today. The government has set out to support the transformation of the economy to an export-oriented one, with the help of a favourable momentum in FDI. Fiat has chosen Serbia, Kragujevac over Turin for a 1bn investment (including 250m government support and 400m EIB funds). This coincides with a smaller, but labour intensive and export-oriented investment by Benetton, a c. 600m-800m

12 August 2011

EM Country Briefing

also Italian investments in renewable energy generation and additional infrastructure projects financed by China. According to World Bank estimates, given the small size of the economy the Fiat investment alone would generate an extra GDP growth of 1.7% GDP, and if the 2014 production plan of 200,000 units is met, an extra 1% over the long term. More importantly, the supply chain of the auto industry is sizeable. Using IMF base case projection and best-case scenario for prospective investments, Serbias growth rate could rise from 3% pre-crisis to 5%-7.5%. The countrys attraction as a manufacturing base lies in its harmonisation with the EU and simultaneous free trade zone with the CIS, cheap availability of high voltage electricity, which could kick-start an investment cycle. There is, however, a lot to be done on the investment environment and macroeconomic stabilisation. Slovakia is a model economy that showed unstable growth prior to the Dzurinda reforms and was of similar size. It received two large greenfield investments in the auto industry of 2%-3% of GDP, which (together with market reforms) attracted annual FDI flows of 5%-6% of GDP over a period of 4-5 years and lifted Slovakias growth rate from c. 3% to 5%-7% over the medium term. CHART 5: Hourly labour cost ()
30 25
80%

CHART 6: Export to GDP %


100% Export to GDP %_Hungary 90% _Serbia _Croatia

20 15 10 5 0 Hungary Czech R. Germany Bulgaria Lithuania Slovenia Greece Serbia Latvia Poland Croatia Romania Slovakia Portugal UK

70% 60% 50% 40% 30% 20% 10% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Commerzbank Corporates & Markets, Eurostat

Source: Commerzbank Corporates & Markets, Ecowin

CHART 7: Exports 12mma, 2007=100


2008 150 140 2009 2010 2011

CHART 8: CAD % of GDP 2007 and 2010


Macedonia Romania Hungary Bulgaria Croatia Poland Serbia Czech -2.4 2007 2010

2.0
130

1.2

-3.0
120

-1 -4.1 -3.5

-1.3 -3.4 -7.1

-8.0
110

-13.0
100

-18.0
90

-23.0
80 Serbia Croatia Romania Bulgaria Hungary

-28.0

Source: Commerzbank Corporates & Markets, Ecowin

Source: Commerzbank Corporates & Markets, IMF

TABLE 3: The governments macroeconomic framework


2009 GDP growth % y/y GFCF % Export % Import % Current A/c deficit % of GDP -3.5 -22.8 -13.8 -23.6 -7.9 2010 1 3.3 19.1 4 -8.0 2011 3 7.6 11.7 6.4 -8.2 2012 4 10.8 12.5 7.8 -8.0

Source: Commerzbank Corporates & Markets, Ministry of Finance

12 August 2011

EM Country Briefing

The governments macroeconomic framework is based on the assumption of a new economic model; 10% annual gross fixed capital investment growth in 2011-13 which produces a recovery in growth to 3% and 4.5%. The share of exports in GDP, and domestic savings would increase over the medium term. Serbias export results already stand out in comparison with Croatia. Most regional peers show a sustained export recovery in 2010-11 (and over the 2007 base), while Croatia is notably lagging behind (chart 7). Croatias exchange rate peg and lack of internal devaluation over the recent period has been highlighted as a structural drag, and by the results, Serbias policy choices appear to have been better. While the countrys current account gap is still among the largest in the region, an estimated 7%7.5% of GDP (including c. 10% of GDP worth of remittances from abroad), capital flows are improving and FDI could reach between 5% and 6%. A funding gap may still be present this year if the government fails to issue the planned Eurobond, which is to replace the postponed privatisation of Telekom Sbrja (1.4bn). On the back of the prospective investments the sustainability of Serbias external position should gradually improve (one-third of its current account deficit alone could be covered by Fiat operations). Serbias growth opportunities have improved and it could become a new growth market in Central Europe.

CHART 9: Export, import and trade balance 12mma


Trade bal.12mma (rhs) 60 50 40 -4 30 20 10 0 -10 -12 -20 -30 -40 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 -14 -16 -6 -8 Exports 12mma % y/y Imports 0 -2

CHART 10: Balance of payment accounts, m 12mma


12,000 10,000 8,000 6,000 4,000
-10

Portfolio cap.

Commercial loans

FDI

CAD

2,000 -2,000 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10 Apr-11

Source: Commerzbank Corporates & Markets, Ecowin

Source: Commerzbank Corporates & Markets, Ecowin

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EM Country Briefing

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