CHAPTER 3: MACROECONOMIC CONTEXT AND INVESTMENT CLIMATE PRIORITIES

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1 CHAPTER 3: MACROECONOMIC CONTEXT AND INVESTMENT CLIMATE PRIORITIES Investment climate conditions: Even though Serbia began its economic transition relatively well integrated into the world economy, the loss of markets, international isolation, armed conflicts, and interruption of long-established production relations have left a dire legacy. The period of 1989 to 2000 was marked by macroeconomic instability, aggravated by badly managed economic policies. Rigid real government spending together with eroding real revenues stimulated hyperinflation in that destroyed the national currency and all dinar-denominated assets. In addition to macroeconomic instability and international isolation, the real sector became increasingly inefficient due to the continued dominance of socially-owned firms and ill defined property rights. As the rule of law deteriorated, property rights became very weak. In addition, the regulatory burden was large due to frequent and discriminatory administrative control and taxation of companies. Price controls were also widely used to substitute for effective social policies and to suppress inflation, while the tax system was highly distortionary. Rigid labor regulation was used to protect employees in the social and state sector, preventing labor shedding. The commercial banking and payments systems were used for quasi-fiscal purposes and to administer state support in priority areas, limiting access to finance for the private sector. While a large share of the formal sector of the economy came to depend on explicit or implicit state subsidies, the growing informal sector developed sophisticated means of evading taxes and circumventing laws to finance its activities. This resulted in further expansion of grey economy, accumulation of losses in the real sector, and numerous microeconomic distortions. The use of the commercial banks and state-owned utilities to subsidize households and enterprises left these sectors devastated by the end of the 1990s. In addition to causing pervasive disruption to economic activity, the 1999 war resulted in significant damage to infrastructure. By 2000, recorded per capita GDP had fallen to below one half of its 1989 level. The Economic Reform Program In 2000 the new Government launched an ambitious reform program with the objective of removing large distortions in the economy and placing Serbia on sustainable growth path. The implementation of this program has been successful in establishing macroeconomic stability. By employing the exchange rate as an anchor, the central bank was able to curb inflation. Inflation declined from percent in 2000 to 7.8 percent in Following the liberalization of the foreign exchange market and unification of the exchange rate in October 2000, the national currency has remained relatively stable, while official foreign reserves grew from US$516 million at end-2000 to US$3.55 billion at end International support, 32

2 immediately following upon political changes, made macroeconomic stabilization possible. Serbia s external debt declined significantly from 132 percent of GDP in 2000 to 71 percent in The successful implementation of stabilization and reform program has played an important role in promoting economic recovery. Serbia s GDP has recovered from a sharp contraction of about 18 percent in 1999 owing mainly to the war. After growing by 5 percent in 2000, real GDP continued to grow at an annual average rate of 4.2 percent during Real GDP growth in 2003 is estimated to be around 3 percent. Fiscal performance has also been positive. The government has implemented a fiscal reform program to address major macroeconomic imbalances and reduced the consolidated budget deficit. Tax reform initiated in 2001 aimed to remove tax distortions and simplify the tax system. In 2002 the government introduced tax incentives for investment and employment, while preparations for the introduction of value added tax are underway. In parallel, the government explicitly recognized the size of quasi-fiscal deficit (losses in state-owned utilities) and initiated relative price adjustment. As a result of acceleration of reforms in early-2001, inflows of foreign aid and remittances, recovery in real wages and incomes, and the real appreciation of the dinar, the current account has been recording large deficits. About two-fifths of this increase can be attributed to rising investments following a decade of underinvestment, with the remaining recorded decline in savings primarily being driven by the government sector as it began to unwind the unsustainable cash rationing and arrears accumulation of the 1990s and to incur costs of transition. The increased deficit was funded via donor support, remonetization (the repatriation of funds held abroad and the return of cash foreign exchange into the banking system), and rising FDI from privatization. The government has made significant progress in the implementation of other structural reforms, but has not done so evenly across problem areas. There has been considerable progress in opening the economy, restructuring the banking sector, and adopting legislation in many areas aimed at harmonization with the European Union. Improving the institutional framework for investment will help Serbia integrate into EU structures. However, Serbia is behind in the process, and negotiations on a SAA have not yet started. In many areas, the reforms are still incomplete, badly designed or badly implemented, and in several priority areas the reform process has barely begun. During the 1990s, investment was persistently too low to replenish the existing capital stock, and this had an enormously detrimental effect on capacity over the decade. In addition to the low volume and questionable efficiency of fixed capital investment during the 1990s, the war caused damage to the capital infrastructure of the country. Following a decade of underinvestment, the ratio of investment to GDP did grow modestly from 14.2 percent in 2000 to a projected 15.7 percent in However, the latter level remains extremely low by regional standards and remains insufficient to support rapid sustained growth. The direct negative consequences of this lost decade of investment have been a stock of fixed capital that is largely obsolete. The low levels of capacity utilization in state-owned enterprises (SOEs) cannot be increased by 33

3 providing working capital alone; sustainable growth will require new investment and restructuring. While the government in Serbia has made progress in implementing business enabling reforms such as liberalization and deregulation of foreign trade and investment, privatization, simplification of the tax regime, and modernization of the labor legislation, it has yet to focus on the related institution building. The implementation of recently drafted legislation aimed at improving business entry, corporate governance, access to finance, and business exit has yet to start and requires extensive institution building to take effect. In view of the limited capacity of the government and decreased foreign assistance, the prioritization of investment climate reforms and implementation efforts is critical. What are the barriers that discourage the private sector the most and what policy steps could encourage investors? Perceptions of the domestic business community In the 2003 PICS survey, Serbian managers were invited to rate 18 dimensions of the investment climate in terms of whether they were important obstacles to doing business. These dimensions were rated from 0 (factor is no problem at all) to 4 (factor is a major obstacle). Economic policy uncertainty was considered the biggest obstacle (Figure 6), which is understandable in light of the assassination of Prime Minister Djindjic in March 2003, not long before the survey took place. The factor that managers believed presented the least problems was access to land, a finding that is not as surprising at it first appears, for reasons discussed below. Figure 6: Perceived Investment Climate Constraints in Serbia and other transition countries Access to land Title or leasing of land Transportation Electricity Telecommunications Organised crime/mafia Street crime/theft/disorder Skills and education of ava... Labor regulations Business licensing and per... Corruption Functioning of the judiciary Customs and trade regulations Contract violations by cu... Anti-competitive practice... Access to financing Tax administration Macroeconomic instability Cost of financing Tax rates Economic policy uncertainty Serbia Other transition countries Source: BEEPS II, PICS 34

4 What can we learn for these results? Although the survey should not serve as the only basis for defining policy priorities, it should be taken into account together with other inputs in making decisions about the business environment 21. The survey results need to be interpreted with certain precautions. 22 Land is not rated as a major obstacle in large part because the respondents are managers of going concerns. The entrepreneurs who want to set up firms but cannot because they cannot get access to land are not covered in the survey. Taxes are rated by managers as a major business obstacles, but their responses would be different if the question also identified what public services would have to be cut (or what the level of inflation would rise to) as a consequence of tax cuts. Indeed, in surveys such as PICS and BEEPS, taxes are usually identified by managers as a major obstacle to doing business, whatever the country. Perceptions of Foreign Investors Foreign Direct Investment (FDI) has yet to play an important role for the private sector in Serbia. FDI per capita in Serbia in was US$200 in comparison to US$1,400 in Croatia US$560 in Bulgaria, US$460 in FYR Macedonia, and US$419 in Romania. 23 Foreign investors 24 share the views of their domestic peers that Serbia is a risky place in which to invest. The World Economic Forum (WEF) Global Competitiveness Report ranked Serbia 77 among 102 countries in terms of its overall competitiveness (Table 4). Serbia also leads SEE region in terms of overall riskiness to investors, according to the Economist Intelligence Unit. 21 A recent OED report 21 discusses at some length. 22 See Doing Business in 2004 Understanding Regulation, pp on shortcomings related to enterprise surveys. 23 EBRD Transition Report The Foreign Investment Council (FIC), which represents most foreign investors in Serbia, has just published its 2004 White Book which elaborates the perceptions of FIC members and priority list of essential policy measures. The FIC list of Laws to be adopted is fully consistent with the priorities in the IMF and the WB s policy adjustment credits. A similar list was adopted by the ad hoc committee of donors on Legal Reform (chaired by the WB) before the new Government was formed. 35

5 Table 4: Perceptions of Foreign Investors: Global Competitiveness and Country Riskiness World Economic Forum Rankings* EIU** Growth competitiveness Macroeconomic environment Public institution Technology Overall country risk Slovenia Hungary Poland Croatia Romania SAM FYROM Bulgaria Source: * World Economic Forum Global Competitiveness Report The table shows the rank of the countries based on the indexes. The growth competitiveness index is composed of three component indexes (the technology index, the public institutions index and the macroeconomic environment index). ** EIU Country Risk Service (December 2003). Overall risk scores are in the range (higher score equals higher risk). The scores are obtained on the basis of the county political, economic policy and liquidity risk. Almost all FDI in Serbia in the first period was related to privatization. Such brownfield investments potentially could play a positive role in encouraging greenfield investors. However, this requires that current investors find the investment climate acceptable and they are treated fairly. While experience so far is limited, the treatment of investment at times has been uneven. 25 Investors have been mistreated in other ways: after the transactions are signed, the Government cannot ensure registration of land ownership or ensure that state creditors of the enterprise write off debts or overrule a reluctant management which refuses to cooperate with then new owners. In view of the new Government s reluctance to deal with the legacies of excessive debts or excessive employment, combined with their high price expectations, investors are turning away from Serbia and are pursuing investments in neighboring countries with which Serbia and Montenegro has signed free trade agreements. Priority areas for improving the Serbian investment climate The views of Serbian managers can, however, help answer the question of whether Serbia differs from other countries, in the sense of whether Serbian managers perceive the investment climate in the same basic ways as managers and policy makers in other countries. This question can been addressed using the technique of factor analysis (detailed in Appendix 1). The analysis shows shows what Serbian managers or businessmen interviewed perceive to be the largest consraints to their businesses in order of importance: (i) policy instability; (ii) high taxation and bad enforcement; (iii) lack of access to finance; (iv) insecure property rights; (v) high burden of regulations; 25 For example, the experience of Henkel one of the world leading firms in the detergent sector investing in the privatization of Meirma has not positive. Without prior notice, Henkel was asked to pay tax on the severance payments for privatized firm s employees, although it had already agreed on the terms of the severance pay package with the government. Other major investors, such as LaFarge, and Philip Morris, have had similar experiences after buying companies that were being privatized. 36

6 (vi) bad infrastructure. Serbian perceptions compared to other transition countries is presented below (Figure 7). Figure 7: Combined investment climate measures Infrastructure Regulation Property rights Finance Taxation Macro All 26 transition countries Serbia Source: BEEPS II, PICS 2003 Serbia 37

7 Box 2. Reducing the Informal Economy in Serbia According to the 2003 Poverty Reduction Strategy Paper for Serbia, an estimated one million people were involved in the grey or informal economy in Serbia in This represents almost one third of those who actively participated in the labor market. In addition, 10.8 percent of the persons that had a primary job had an additional job in the grey economy. Among poor employees, those involved in the grey economy represented 42 percent in Serbia s large informal economy is a main consequence of a poor investment climate. Given the depth and persistence of the informal economy, a main government priority is to identify policy reforms and other measures that will create incentives for firms to formalize. A number of works have analyzed the root causes of informal economies and ways to increase formalization. In his well-known work on Peru, Hernando De Soto argues that formalization of business could be encouraged by secure property rights which in turn require contract enforcement (as discussed in Chapter 4). Based on these findings, it is recommended that Serbia focus on the following three issues to attract entrepreneurs to the formal sector: Contract enforcement: If it is hard to enforce contracts, an informal firm gains little from formalization; Access to credit: If formal companies cannot get credit from banks, the incentive to formalize is small. Land and property rights: If formal entrepreneurs cannot get clear title to land or real property, it will not be a factor pushing a businessman to formalize. According to the EBRD s Transition Report 2000, incentives for participation in informal sector differ depending on the country s stage of reform. In economies at a mature stage of reform (e.g., central and eastern European countries), the motives tend to be more marketrelated and guided by a desire to evade taxes and avoid other bureaucratic constraints. In economies at an initial stage of reform, informal activity is interpreted as being driven by poor opportunities in the formal sector and is seen as providing a coping strategy for survival. Both motives exist in Serbia at this stage, and as PICS indicates, formal enterprises try to keep their activities blended in order to avoid the administrative and financial burden of regulation. 38