NationalBankofSerbia. January-June MONETARYPOLICYREPORT

Transcription

1 NationalBankofSerbia 218 January-June SEMI-ANNUAL MONETARYPOLICYREPORT

2

3 218 January June SEMI-ANNUAL MONETARY POLICY REPORT

4 NATIONAL BANK OF SERBIA Belgrade, Kralja Petra 12 Tel.: Belgrade, Nemanjina 17 Tel.: Number of copies: 6 ISSN

5 Introductory note The National Bank of Serbia is required to submit to the Parliament its annual and semi-annual monetary policy reports, explaining all the factors that affected the implementation of monetary policy in the period under review. The annual report must be submitted by 3 June of the following year and the semi-annual by 3 September of the year under review. 1 Pursuant to the Statute of the National Bank of Serbia 2, the above reports must present and analyse the monetary policy strategy, macroeconomic developments (international environment, balance of payments, the country s international investment position, movements in monetary aggregates, prices, wages and employment, and other macroeconomic movements), monetary policy defined and monetary policy implemented (defined vs. achieved monetary policy objectives, monetary policy instruments and measures applied, and other monetary policy-related issues), as well as outline the monetary policy planned. The Semi-Annual Monetary Policy Report for January June 218 was adopted by the NBS Executive Board at its meeting of 6 September 218. Monetary policy reports are available on the National Bank of Serbia s website ( Executive Board of the National Bank of Serbia: Jorgovanka Tabaković, Governor Veselin Pješčić, Vice-Governor Diana Dragutinović, Vice-Governor Željko Jović, Vice-Governor 1 Law on the National Bank of Serbia (RS Official Gazette, Nos 72/23, 55/24, 85/25 other law, 44/21, 76/212, 16/212, 14/215 Constitutional Court decision and 44/218). 2 RS Official Gazette, Nos 12/213, 18/215 and 72/215.

6 ABBREVIATIONS bn billion bp basis point CEFTA Central European Free Trade Agreement CPI Consumer Price Index ECB European Central Bank EMBI Emerging Markets Bond Index FAO Food and Agriculture Organization FDI foreign direct investment Fed Federal Reserve System FOMC Federal Open Market Committee GDP Gross Domestic Product H half-year IFEM Interbank Foreign Exchange Market IMF International Monetary Fund mn million NPL non-performing loan OFO other financial organisation OPEC Organization of the Petroleum Exporting Countries pp percentage point Q quarter q-o-q quarter-on-quarter s-a seasonally-adjusted y-o-y year-on-year Other generally accepted abbreviations are not cited

7 Contents Overview 1 I Strategic monetary policy framework 3 II Monetary policy and achievement of the inflation target 5 1 Monetary policy in January June Monetary policy instruments 6 Open market operations 6 Deposit and lending facilities 7 Required reserves 7 Interest rates 8 Foreign exchange market operations 8 Foreign exchange swaps 8 3 Achievement of inflation target in the period January June III Macroeconomic environment 11 1 International environment 11 2 International transactions 14 Balance of payments and FX reserves 14 International investment position 17 3 Financial market 18 Interest rates 18 Country risk premium 2 Trends in the FX market and exchange rate 21 Stock exchange trends 22 4 Money and loans 23 Monetary aggregates M1, M2 and М3 23 Bank loans 24 5 Dinarisation 26 6 Inflation expectations 28 7 Fiscal trends 29 8 Aggregate demand 3 Domestic demand 31 Net external demand 31 9 Economic activity 33 1 Wages and employment 34 Appendix 1 Monetary Policy Programme of the National Bank of Serbia in Index of charts and tables 4

8

9 Semi-Annual Monetary Policy Report, January June 218 National Bank of Serbia Overview Inflation slowed down in early 218, consistent with expectations, on account of the drop-out of one-off price hikes in early 217 from the calculation of y-o-y inflation, as well as continued low inflationary pressures reflecting the majority of factors. Y-o-y inflation touched this year s low of 1.1% in April. It began to move towards the target in May, coming at 2.3% in June. That inflationary pressures were low was also indicated by core inflation (excluding the prices of energy, food, alcohol and cigarettes), which as of March stood at.8% y-o-y, its lowest level since measured by CPI. One- and two-year ahead inflation expectations of the financial and corporate sectors remained anchored around the 3% target midpoint. Under the NBS projection, in the next two years inflation will move within the target tolerance band until end- 219 it will most probably be below the midpoint, getting temporarily closer to it in the first months of 219 due to the low base effect from early 218. The main factors underlying medium-term inflation movements are rising aggregate demand and gradual weakening of disinflationary pressures due to past appreciation of the dinar. Working in the opposite direction will be the high base for the prices of fruits and vegetables and petroleum products, as well as food production costs in the short run. Subdued inflationary pressures and favourable macroeconomic trends enabled further monetary policy easing. In March and April, the key policy rate was reduced further by 25 bp each to 3.%, its lowest level in the inflation targeting regime. Bearing in mind the effects of past monetary policy easing and expected movement in inflation and its underlying factors going forward, as well as uncertainties in the international commodity and financial markets, in May and June the Executive Board kept the key policy rate on hold. The international environment was marked by the continued positive global growth outlook, with downside risks primarily due to the heightening of trade tensions. Since early 218, euro area as our most important trade partner witnessed a slowdown. Still, as assessed by the ECB, growth will remain stable and broad-based in the medium run. Led by investment and private consumption, economic growth in the Western Balkan region stepped up. As assessed by the European Commission, the main contribution came from Serbia. A favourable growth outlook is expected in most other economies of the region, which are also Serbia s important trade partners. Although inflation in the international environment was on an increase since early 218 notably due to rising oil prices, it remains moderate in the majority of countries. Monetary policies of leading central banks became more divergent in H1 218, and global financial conditions, though somewhat tightened, remain favourable. This was aided by the ECB s announcement that it will keep its key interest rates unchanged at least through the summer of 219, and that, once it concludes the quantitative easing programme in late 218, it will continue to reinvest principal payments from maturing securities. Monetary policy easing reflected on a further decline in interest rates on dinar loans. The average rate on new corporate dinar loans touched a new low in May (4.6%), and the rate on new dinar household loans in June (1.1%). Despite stepped-up efforts to resolve the NPL issue, lending activity growth accelerated in June to 7.6% y-o-y, benefiting from the lower cost of borrowing in the domestic market, the effects of economic growth, labour market recovery, enhanced interbank competition, a falling country risk premium, and low interest rates in the euro area money market. Owing to successful implementation of the NPL Resolution Strategy and faster lending growth, the share of NPLs in total loans fell to 7.8% in June, the lowest level since 28, when this asset quality indicator was introduced. A favourable macroeconomic environment, continued intensive investment in infrastructure and lower costs of 1

10 National Bank of Serbia Semi-Annual Monetary Policy Report, January June 218 borrowing reflected on a rise in investment. Investment gave the strongest impetus to significant acceleration of gross GDP growth 4.9% in H1, the highest figure in the past ten years. In addition, a higher disposable income based on rising private sector wages and employment and more favourable financial conditions pushed up household consumption, which supported economic growth. On the production side, GDP growth in H1 218 was led mainly by elevated activity in construction and service sectors, owing to intensive implementation of infrastructure projects and the recovery of domestic demand. A positive contribution also came from industry and agriculture which will most probably record above-average growth this year. We expect that in the remainder of the year all production and service sectors will drive up GDP growth of around 4% at year-level, based on our new assessment. On the expenditure side, the main boost to GDP growth is still expected from investment and household consumption. We also expect that further implementation of reforms will ensure that the GDP growth pace of around 4% remains sustainable in the medium run as well. H1 saw a continuation of vibrant and broad-based growth in exports and manufacturing, which came at 1.8% y-o-y, and was recorded in all sectors. On the other hand, the continued current investment cycle and the industry s enhanced needs for equipment and intermediate goods, and to a lesser extent a rise in global oil prices and household consumption, resulted in 11.6% y-o-y growth in euro-denominated commodity imports. However, a higher commodity deficit was fully compensated for by a higher surplus in trade in services and secondary income, and by a smaller primary income deficit. In H1 218, the current account deficit stood at 5.4% of GDP, down by.7 pp y-o-y. Narrowed macroeconomic imbalances, an improved business climate and a more favourable growth outlook helped improve the perception of country risk. In H1 218 capital inflows tripled from the same period a year earlier. FDIs made up the bulk of inflows EUR 1.3 bn net, up by 12.1% from H1 217, and were more than sufficient to cover the current account deficit (13.9%). In H1 218, portfolio investment came at EUR mn net, reflecting non-resident investment in dinar ten-year government securities in the primary market, whose demand at some auctions significantly outstripped supply. We expect the current account deficit to be fully covered by net FDI inflows, which will underpin external sustainability in the medium run. Continued robust growth in exports and high capital inflows fuelled appreciation pressures, which prevailed in H1. As a result, the dinar gained.3% against the euro. To mitigate excessive short-term volatility of the dinar, the NBS intervened in the interbank FX market by purchasing EUR 1,19. net. This was the strongest boost to NBS FX reserves, which were up by EUR 1,142.6 mn in H1 to EUR 11,14.3 mn at end-june. The level of Serbia s FX reserves remained adequate, ensuring protection against external shocks and the coverage of money supply M1 with 195% and more than five months worth of imports of goods and services. H1 saw a continuation of favourable fiscal trends, reflecting a budget surplus at a consolidated level of 1.5% of GDP and a decline in the public debt share in GDP below 6%. This was a result of consolidated revenue rising by 3.2% in real, y-o-y terms, owing to higher mandatory social insurance contributions as a result of the recovery of the formal labour market, as well as to rising excise revenue. At the same time, consolidated expenditure increased by 4.6% in real y-o-y terms, on account of much higher capital expenditure and employee expenses, while interest and activated guarantee expenses declined. As a result of stepped-up issuance of dinar securities, the share of dinar public debt increased (from 23.% at end-217 to 24.9% in June 218), leading to a decline in the currency risk. More favourable than expected fiscal trends since early 218 suggest that the consolidated budget will record a better result this year than planned by the Fiscal Strategy. Favourable economic trends since early 218, led by a vigorous rise in investment, reflected positively on the labour market as well, i.e. a further rise in wages, notably in the private sector, an increase in formal employment and a reduction in unemployment to the lowest level in the past twenty years. Similar tendencies are also confirmed by the Labour Force Survey for Q2 218 the participation and employment rates increased relative to the same period the year before, while the unemployment rate fell to 11.9%, close to its historical minimum of Q IBM Global Locations Trend reports also confirm the results achieved in 216 and 217 Serbia was the world recorder in terms of the relative number of new jobs relating to projects based on FDI inflows, with the estimated 3, job positions per 1 million inhabitants. Maintenance of low and stable inflation in the medium run and preservation of financial stability remain the main tasks of the NBS, this being the best way for a central bank to contribute to the country s economic prosperity. 2

11 Semi-Annual Monetary Policy Report, January June 218 National Bank of Serbia I Strategic monetary policy framework The NBS has been implementing a fully-fledged inflation targeting regime since 29, with elements of the regime gradually introduced into practice since 26. In December 28, the NBS Monetary Policy Committee 1 adopted the Memorandum on Inflation Targeting as a Monetary Strategy, defining formal implementation of the inflation targeting regime from 1 January 29. The Memorandum was drafted in accordance with the Agreement on Inflation Targeting between the NBS and the Government of the Republic of Serbia, adopted at the Government session of 19 December 28. In the best collective judgment of the NBS and the Government, this was the most appropriate monetary policy regime under the circumstances prevailing at the time. The inflation targeting regime is pursued by a significant number of central banks worldwide as a pragmatic response to deficiencies of other monetary policy regimes. The choice of the regime was strengthened by the awareness that high inflation rates dampen economic growth and employment and that the monetary policy focus should therefore be shifted from short-term demand management to medium-term price stability which lies at the core of inflation targeting. The inflation targeting regime is a framework rather than a set of rigid monetary policy rules. It is based on a numerical target for inflation in the medium term and a discretionary right to respond to economic shocks in the short term. The NBS inflation target is defined in terms of the headline inflation rate (with a tolerance band) measured as the annual percentage change in the Consumer Price Index (CPI). The target is determined as a midpoint with a tolerance band. Low and stable inflation for three years in a row and significant improvement in macroeconomic indicators and prospects of our economy going forward, supported by successful coordination between monetary and fiscal policies and excellent results of fiscal consolidation, led to the NBS making the decision in November 216, in cooperation with the Government, to lower the inflation target by 1 pp to 3.±1.5% starting from In order to define the framework for medium-term monetary policy decision-making and to anchor and stabilise inflation expectations, one year later a decision was made to keep the target at that level until An important reason for lowering the inflation target from 217 onwards were low and relatively stable inflation expectations of the financial and corporate sectors, both one and two years ahead. At the same time, this served as a confirmation of greater credibility of the NBS monetary policy. In addition, administered price growth in the last three years was much slower than before. Given that the change was the result of the Government s commitment to resolving the inefficiencies in the operation of public enterprises primarily by reducing operating costs, rather than by raising the prices of goods and services of those enterprises, it was concluded that administered price growth should remain relatively low in the period ahead. The lowering of the target confirms the commitment of economic policy makers to keeping inflation low, stable and predictable in the medium term. This contributes to the further improvement of the business and investment climate, encourages a fall in long-term dinar interest rates and greater use of the dinar in financial transactions 1 In line with the Law Amending the Law on the National Bank of Serbia (RS Official Gazette, No 44/21), the Executive Board assumed all powers of the Monetary Policy Committee. 2 The National Bank of Serbia s Memorandum on Inflation Targets until 218 (consolidated version). 3 The National Bank of Serbia s Memorandum on Inflation Targets until 22 was adopted at the meeting of the NBS Executive Board of 7 December

12 National Bank of Serbia Semi-Annual Monetary Policy Report, January June 218 and, by extension, helps lower the currency risk and costs borne by the corporate, household and government sectors. In addition, the new, lower inflation target remains above the level of the quantitative definition of price stability and the level of the inflation target in advanced economies (2.% or 2.5%), leaving room for further price convergence. The width of the target tolerance band was kept at ±1.5 pp, which diminishes the need for frequent monetary policy interventions and contributes to higher predictability of monetary conditions. Being a small and open economy, Serbia is exposed to developments in the international commodity and financial markets, which may cause temporary volatility of headline inflation. The target band leaves to the NBS a broader room to work on the achievement of its second objective financial stability, and to support the Government s economic policy which encourages sustainable economic growth. It should be borne in mind that the inflation target is a medium-term objective, i.e. that the inflation outturn may diverge from the target in the short run due to exogenous shocks. The NBS will allow temporary deviations from the target if bringing inflation back to the target in the short term warrants monetary changes that would cause additional disruptions to macroeconomic processes. This also applies to sudden shocks in primary commodity prices or deviations from the planned growth in commodity prices under direct or indirect government regulation. The NBS strives to achieve the inflation target by changing its key policy rate, applied in main open market operations. This interest rate is the key monetary policy instrument and the decisions on its level are based on the analysis of economic circumstances, assessment of future developments and the medium-term inflation projection. Other monetary policy instruments play a supporting role they contribute to the smooth transmission of the impact of the key policy rate on market rates, as well as to the development of the financial market, without jeopardising financial stability. The NBS implements a managed float exchange rate regime, which implies the right to intervene in case of excessive short-term volatility in the FX market, threats to financial and price stability, and risks to the adequate level of FX reserves. To strengthen the transparency of its monetary policy and the effectiveness of communication with the public, the NBS Executive Board makes monetary policy decisions in line with the agreed schedule of meetings and regularly informs the public about the implementation of inflation targets and measures undertaken to achieve them. Inflation moving within the new, lower target band, further improvement in the macroeconomic performance and outlook of the country, and anchored inflation expectations show that the lowering of the inflation target in November 216 by 1 pp to 3.±1.5% starting from 217 was a well-calibrated and timely decision. 4

13 Semi-Annual Monetary Policy Report, January June 218 National Bank of Serbia II Monetary policy and achievement of the inflation target 1 Monetary policy in January June 218 In H1 218, monetary policy was pursued in accordance with the Monetary Policy Programme of the National Bank of Serbia in As envisaged by the Programme, the NBS strives to achieve the defined inflation target through consistent and predictable changes in the key policy rate, taking into account the inflation projection, economic trends in the domestic and international environment, and the impact of these changes on financial stability. According to the Programme, in 218 the NBS will maintain caution in making monetary policy decisions, bearing in mind uncertainties from the international environment. The key policy rate as the main monetary policy instrument was cut in H1 by 5 bp to 3.%, its lowest level in the inflation targeting regime. By lowering the key policy rate, in an environment of low inflationary pressures, the NBS gives additional support to lending activity and economic growth, which are gaining traction. By carefully monitoring and analysing trends in the domestic and international environment, the Executive Board assessed that expected movements in inflation and its underlying factors, along with further strengthening of domestic indicators, creates room for further monetary policy easing. Consistent with this, in March and April the Executive Board made decisions on additional key policy rate cuts, by 25 bp each, to 3.%. In parallel with the key policy rate cuts, in April the Executive Board narrowed the interest rate corridor, from ±1.5 to ±1.25 pp relative to the key policy rate. Since early 218, inflation pressures were lower than expected. Inflation fell to 1.4% in March, only to decelerate further to 1.1% y-o-y in April. That inflationary pressures were low is also indicated by core inflation moving at.8% y-o-y, its lowest level since inflation is measured by CPI. Short- and medium-term inflation expectations were anchored around the target midpoint (3.%). What enabled further monetary policy easing, in addition to low inflationary pressures, was the significant lowering of macroeconomic risks. As emphasised by the Executive Board, owing to structural improvements and narrowed internal and external imbalances, Serbia increased its resilience to potential negative effects of global factors. The results achieved in the field of fiscal consolidation and public finance sustainability were best illustrated by the fiscal deficit shifting to a surplus last year, a lower risk premium and higher credit rating of the country. Judging by the price they were ready to pay for government securities, investors consider Serbia a much safer investment destination. According to the Executive Board s assessment, the improvement in Serbia s risk perception is of key importance for a more favourable treatment and financial conditions that the government can obtain in the international financial market. Improvement in the country s risk perception also leads to lower costs of corporate and household borrowing. In addition, the fact that investors now see Serbia as a much safer destination results in a rise in FDI inflows and non-resident investment in dinar government securities, contributing to continued appreciation pressures in the FX market this year. A reduction in the key policy rate to its lowest level in the inflation targeting regime, together with enhanced 4 RS Official Gazette, No 111/217. 5

14 National Bank of Serbia Semi-Annual Monetary Policy Report, January June 218 interbank competition, a low country risk premium and low interest rates in the euro area money market, propped up lending activity. In addition, further improvement of the business climate, a high and project-diversified FDI inflow, implementation of infrastructure projects and past monetary policy easing should continue to buoy investment, which will remain one of the drivers of economic growth. A rising positive contribution is expected from household consumption owing to further labour market recovery. Those were the main factors guiding the Executive Board to conclude that GDP growth in 218 would accelerate to its ten-year high, keeping a similar pace in 219. GDP growth was projected at around 3.5% this year, but as investment outperformed expectations, the Executive Board stated in May it was more likely that economic growth would exceed the estimated figure. In August, the Board raised the growth forecast for this year to 4%. According to the Executive Board s assessment, economic growth will continue to dampen disinflationary pressures generated by domestic demand. In addition to domestic demand, the Executive Board expected that external demand would also continue to underpin GDP growth in the medium run. Growth in our most important trade partners the euro area and countries of the region, along with the effects of past investment, should have a positive impact on a further rise in exports. Still, the Executive Board was cautious in its assessments due to rising protectionism in international trade and the heightening of geopolitical tensions. As euro area growth slowed from the start of the year, in June the ECB adjusted downward the euro area growth projection for this year, by.3 pp to 2.1%, while the growth projections for 219 and 22 remained unchanged. However, the ECB assessed that euro area growth in the medium run remained stable and broadbased in terms of sector and geography. Given the uncertainties in the international environment, the effects of past monetary policy easing and expected movement in inflation and its underlying factors, in May and June the Executive Board kept the key policy rate on hold. Caution in decision-making was warranted by uncertain movements in international commodity and financial markets. Oil prices were on an upward path in H1, up by 36% y-o-y. Global oil prices were under the sway of both demand- and supply-side factors, most notably rising demand in leading economies, supply variations over geopolitical tensions, and production deals between the OPEC and Russia. Movements in global primary agricultural commodity prices were also uncertain as of June, these prices headed down over increasingly stronger global trade tensions. Uncertainties in the financial market stemmed from diverging monetary policies of leading central banks the Fed and ECB, which could impact their currency relations and capital flows towards emerging economies, including Serbia. In H1, the Fed continued with monetary policy normalisation in March and June it raised its fed funds rate. On the other hand, the ECB pursued monetary accommodation, maintaining its key rates at a historical low (the main policy rate at a zero and the deposit facility rate below zero) and continued to implement net securities purchases, though in reduced amounts from early 218 (EUR 3. bn). The ECB announced it would maintain this pace of purchases until end-september 218, and scale them back by the year-end (EUR 15. bn). However, the Executive Board assessed that the resilience of our economy to potential negative effects from the international environment increased owing to the strengthening of domestic macroeconomic fundamentals and more favourable prospects. The Executive Board will continue to implement a wellcalibrated mix of monetary policy measures aimed at maintaining low and stable inflation, while preserving financial stability and supporting economic growth. 2 Monetary policy instruments The basic monetary policy instrument of the NBS is the key policy rate, i.e. the interest rate on the main open market operations. The role of the key policy rate is supported by the corridor of interest rates on deposit and lending facilities and by other open market operations. In addition to the key policy rate, the NBS uses other instruments of monetary regulation, notably required reserves and operations in the FX market. Open market operations The main open market operations of the NBS in H1 were again one-week reverse repo transactions, i.e. repo sale of securities (liquidity absorbing). The NBS implemented repo transactions through own securities. For the purposes of repo sale, in 218 the NBS issued one series of T-bills in the nominal amount of RSD 5. bn. The issuing of one series of high nominal value is consistent with the practice in earlier years which enables more adequate management of securities 6

15 Semi-Annual Monetary Policy Report, January June 218 National Bank of Serbia Chart II.2.1 Key policy rate and interest rate corridor (daily data, p.a, %) Chart II.2.3 Volume of sterilisation by monetary policy instruments (RSD bn) Key policy rate Interest rate on deposit facility Interest rate on lending facility OMOs purchase price RSD required reserves FX required reserves Source: NBS. Source: NBS. Deposit and lending facilities Chart II.2.2 Stock of sold/bought NBS securities (RSD bn) Stock of sold securities Stock of bought securities Source: NBS. within the same series and facilitates liquidity management for banks. In H1 218, twenty-six repo sale auctions were organised. Auctions were organised once a week, upon the model of the variable multiple interest rate. Total securities sales amounted to RSD 1,35.75 bn, which was lower than in H2 217 (RSD 1,51.75 bn). The stock of NBS bills in banks portfolios averaged RSD 51.5 bn in H1 218, down by RSD 6.7 bn from H Relative to end-217, the stock of these bills increased by RSD 19.9 bn, to RSD 65 bn at end-june. In H1 218, banks placed overnight deposits with the NBS. In the observed period, the average daily stock of such deposits came at RSD 16.2 bn, which is RSD 1. bn more than in H Observed by month, the highest average monthly stock was recorded in March (RSD 18.5 bn) and the lowest in April (RSD 13. bn). In H1, banks used lending facilities only as intraday loans (six banks). Intraday loans were worth a total of RSD 11.7 bn, the largest volume being disbursed in January (RSD 8.5 bn). Required reserves In H1, there were no regulatory changes governing required reserves, i.e. the Decision on Banks Required Reserves was not amended. In the observed period, the amount of calculated required reserves allocated in dinars increased by RSD 6. bn, standing at RSD bn in June. This increase is a result of growth in purely dinar required reserves (by RSD 2.4 bn) and FX required reserves allocated in dinars (by RSD 3.6 bn). At the same time, the amount of calculated required reserves allocated in foreign currency increased by EUR 73.1 mn, to EUR 1,762. mn. Such movement reflected the rise in the FX base by EUR mn, due to greater foreign borrowing and household FX savings. 7

16 National Bank of Serbia Semi-Annual Monetary Policy Report, January June 218 Interest rates In H1, the NBS key policy rate was trimmed twice, in March and April, each time by 25 bp, to 3.%. The interest rate corridor was narrowed in April, from ±1.5 pp to ±1.25 pp relative to the key policy rate. The interest rate at which the NBS calculates and pays the interest on average daily stock of allocated dinar required reserves was cut in March and April, each time by 25 bp, to 1.25%. Foreign exchange market operations Under the 218 Monetary Policy Programme, the NBS continued implementing the managed float exchange rate regime. Its interventions in the FX market aimed to ease excessive short-term volatility of the exchange rate, safeguard price and financial stability and maintain an adequate level of FX reserves. In H1 218, the dinar gained.3% against the euro in nominal terms, mostly as a result of: 1) more balanced FX supply and demand of domestic enterprises (favourable balance of payment developments); 2) higher interest of foreign investors to invest in longterm dinar government securities; 3) increased bank lending (a rise in net indexed assets) 5 and 4) seasonally higher FX inflow from tourism in Q2 6. In H1 218, the NBS intervened in the IFEM as a net buyer of EUR 1,19. mn (buying EUR 1,37. mn and selling EUR 18. mn). The NBS intervened as a price taker, strictly under market conditions. The dinar gained.1% against the euro in nominal terms in Q1. January was marked by depreciation pressures, caused primarily by seasonal factors (chiefly heightened FX demand of domestic enterprises energy importers), while appreciation pressures prevailed as of February. In January the dinar lost.2% against the euro nominally, and the NBS intervened by selling foreign currency worth EUR 18 mn. As of February, the dinar was exposed to appreciation pressures, which in February and March were caused mostly by non-resident activity in the domestic financial market. Namely, non-residents sold foreign currency in order to buy government securities, mainly ten-year benchmark securities. In February and March, the NBS intervened by purchasing foreign currency in the total amount of EUR 58. mn. In Q2, the dinar gained.3% against the euro in nominal terms, and the NBS exclusively purchased foreign currency in the IFEM (EUR 79 mn). The appreciation pressures in this period were caused primarily by the higher net purchase of foreign cash and the increase in FX-indexed bank assets, as well as by dynamic exports and FDI inflow. Foreign exchange swaps In H1 218, the NBS continued to hold its regular threemonth and two-week swap auctions of FX purchase and sale for dinars, in order to stimulate the development of interbank swap trading and facilitate liquidity management for banks. Overall, 48 regular two-week swap auctions were held, with the NBS swap purchasing and selling EUR 25. mn each, as well as 48 regular three-month swap auctions, at which it swap sold and bought EUR 18. mn each. The highest performance in H1 was recorded in January, when the NBS swap sold and bought EUR 43. mn. At end-h1, the stock of FX receivables and FX liabilities of the NBS in respect of three-month swap auctions equalled EUR 28. mn each, while there were no receivables and liabilities in respect of two-week swap auctions. 3 Achievement of inflation target in the period January June 218 In early 218, y-o-y inflation slowed down, as expected, mostly owing to the drop-out of early-217 one-off price hikes from the y-o-y calculations and the still low inflationary pressures under the majority of factors. In April, y-o-y inflation reached this year's low of 1.1%. As of May, it started moving towards the target, coming at 2.3% in June. Low inflationary pressures are also indicated by core inflation (excluding prices of 5 Aiming to balance their long open foreign currency positions, thus reducing exposure to foreign exchange risk, banks sell foreign currency, which results in the strengthening of the dinar. 5 Usually during Easter and May Day holidays and during the spring tourist season. 8

17 Semi-Annual Monetary Policy Report, January June 218 National Bank of Serbia Chart II.3.1 Price movements (y-o-y rates, in %) Chart II.3.2 Contribution to y-o-y consumer price growth (in pp) Consumer prices (CPI) CPI excluding energy, food, alcohol and cigarettes Trimmed mean 15% Targeted inflation Target tolerance band Sources: SORS and NBS calculation Fruit and vegetable prices Processed food prices Non-food inflation Administered prices Petroleum product prices Consumer prices (%) Targeted inflation Target tolerance band Sources: SORS and NBS calculation. energy, food, alcohol and cigarettes), which has been standing at.8% y-o-y since March, its lowest level since inflation is measured by the CPI. Y-o-y, all categories of products and services contributed positively to the consumer price growth of 2.3% in June, though the greatest contributions came from the prices of unprocessed food (.5 pp) and energy (.7 pp). Consumer price growth in H1 amounted to 2.2%. In quarterly terms, inflation in Q1 came at.8% and was driven by the increase in prices of a small number of products, mainly the seasonal increase in the prices of fresh fruit and vegetables and the February hike in cigarette excise tax. Working in the opposite direction was the seasonal decline in the prices of clothes and footwear, and travel packages. Consumer prices picked up by 1.4% in Q2. Their growth was driven by the higher prices of vegetables and petroleum products than usual for that time of the year, and by seasonal rise in prices of travel packages. Unlike Q1, administered prices almost stagnated in Q2, with an unchanged y-o-y growth. Core inflation rose by.4% in H1, reflecting mainly the seasonal rise in prices of travel packages, footwear and clothing in Q2. The administered price growth of 1.2% in H1 is almost entirely attributable to the rise in cigarette prices in Q1 amid excise tax adjustment. Under NBS projection, y-o-y inflation will continue to move within the target tolerance band in the next two Table II.3.1. Contribution to y-o-y consumer price growth (in pp) June 217 June 218 Difference Consumer prices (CPI) Unprocessed food Fruit and vegetables Fresh meat Processed food Industrial products excluding food and energy Energy Petroleum products Services Sources: SORS and NBS calculation. ble II.3.2 Growth and contribution of components to consumer price growth in H1 218 Growth rates (%) Contribution (pp) Consumer prices (CPI) Unprocessed food Processed food.8.2 Industrial products excluding food and energy.4.1 Energy Services Core inflation indicators CPI excluding energy CPI excluding energy and unprocessed food.8.6 CPI excluding energy, food, alcohol and cigarettes.4.2 Administered prices Sources: SORS and NBS calculation. 9

18 National Bank of Serbia Semi-Annual Monetary Policy Report, January June 218 years below the target midpoint by late 219, though it will temporarily approach it in the first months of 219 owing to the low base effect. The main drivers of inflation in the medium run will be the rise in aggregate demand and the gradual waning of disinflationary pressures on account of the dinar s appreciation in the previous period, while the high base of fruit and vegetables and petroleum products will work in the opposite direction. In the short term, low costs of food production will have a disinflationary effect. 1

19 Semi-Annual Monetary Policy Report, January June 218 National Bank of Serbia III Macroeconomic environment 1 International environment Since the start of the year, global economic growth has remained stable, though less balanced across countries, with increased risk in terms of prospects for the period ahead, primarily due to tensions in international trade. Economic growth in the euro area, Serbia s largest foreign trade partner, has slowed down since the start of the year, but the ECB expects it to remain stable and broadly dispersed over the medium term. Inflation in the international environment was on the upward trajectory mainly owing to the rising oil prices, though it is still moderate in the majority of countries. Having posted robust growth in 217, the euro area economy grew at a somewhat slower pace in H1 218, though growth has remained broad-based across countries. Supported by private consumption and investment, GDP rose at the rate of.4% s-a in Q1 and, according to the Eurostat flash estimate, it retained a similar pace in Q2 as well. The economic slowdown is partly a reflection of adjustments towards long-term sustainability, given that for some time already, the euro area economy has been growing at rates higher than those that can be sustained for long, and partly a consequence of temporary factors, such as adverse weather conditions, strikes, etc. Favourable financing conditions and movements in the labour market, as well as a stable rise in corporate income and profit, are expected to continue to support economic growth in the euro area. However, due to lower results at the start of the year, the IMF revised the euro area growth forecast down to 2.2% for 218. In 219, growth is Chart III.1.1 Revisions of real GDP growth forecasts for 218 and 219 by the IMF (in %) Chart III.1.2 HICP across selected countries (y-o-y rates, in %) Euro area Germany Italy USA Russia China 218 (previous projection) 219 (previous projection) 218 (new projection) 219 (new projection) Sources: IMF WEO (April 218) and IMF WEO Update (July 218) Romania Montenegro Croatia Macedonia* Bulgaria BiH* Euro area Sources: Eurostat and statistical offices of selected countries. *CPI. 11

20 National Bank of Serbia Semi-Annual Monetary Policy Report, January June 218 expected to decelerate to 1.9% due to supply-side factors, such as high utilisation of capacities and insufficient labour force in some member countries. According to the ECB, risks to the projection pertain to the heightened instability in international financial markets and the possibility of further exacerbation of tensions in international trade. At a meeting in July, the presidents of the European Commission and the USA reached an agreement on cooperation that would aim to remove trade barriers, whereby risks on this account have been somewhat mitigated. In early 218, average y-o-y inflation in the euro area was lower than in the same period a year earlier due to the effect of prior appreciation of the euro against other currencies, and on average it equalled 1.2% y-o-y in Q1. Average inflation growth of 1.7% y-o-y in the euro area in Q2 was largely a consequence of the rising prices of energy and unprocessed food. Inflation peaked in June, reaching its highest level since February 217 (2.% y-oy). Though core inflation remained relatively low in H1 (1.% y-o-y on average), the ECB expects it to rise gradually over the medium term on the back of monetary policy measures and continuing economic growth. In the June meeting, the ECB noted the significant progress that has been achieved in terms of inflation approaching its target level and voiced its expectation that it will continue to hover around the target in the coming period, owing to strong economic growth and anchored long-term inflation expectations. Relative to March, inflation projections for 218 and 219 were revised up in June, by.3 pp each, while the forecast for 22 remained unchanged, hence the inflation rate of 1.7% for the entire projection horizon. US GDP growth accelerated to 1.% s-a in Q2, following a period of somewhat subdued growth rate early in the year (.5% s-a in Q1). It was supported by movements in the labour market, high consumer confidence and fiscal incentives, and in Q2 by net exports as well. Q2 saw the highest economic growth in almost four years (4.1% per annum), while the output gap entered the positive territory for the first time since 27. The unemployment rate stood at 4.% in June, while the number of new nonfarm payrolls remained relatively high more than 2, a month on average during H1. The IMF kept its projection for the USA at the April level 2.9% for 218 and 2.7% for 219, bearing in mind the effects of fiscal incentives and strong private consumption. Chart III.1.3 Exchange rates of selected national currencies against the dollar* (daily data, 31 December 213 = 1) Euro UK pound sterling Swiss franc Source: IMF database. * Growth indicates appreciation. Japanese yen Russian ruble Inflation in the USA in H1 was still higher than in the majority of advanced countries. In March 218, it reached its highest level in 12 months (2.4% y-o-y), mostly due to the low base effect from the prices of mobile telephony services. Afterwards, it continued on the upward trajectory, driven largely by higher energy prices, only to reach 2.9% y-o-y in June, its highest level since February 212. Also, measured by the personal consumption expenditure index, inflation rose in Q1 and continued up in Q2 (2.2% y-o-y according to the preliminary assessment) on the back of rising income. Measured by the personal consumption expenditure index, FOMC members June inflation projection for end-218 is slightly above the target (2%) and is expected to remain there until end-22. The economic upturn in the Central and Southeast European region continued in 218, though at a slower pace in some countries due to dampened external demand. Investment and private consumption are expected to remain the main drivers of growth in the period ahead, given the rise in wages and stepped-up utilisation of EU development funds. According to the latest report of the European Commission, economic growth in the Western Balkans accelerated in Q1 from 2.7% to 3.5% y-o-y, mostly on account of growth posted by Serbia. Most of the other countries in the region also noted an accelerated rise in GDP. Owing to declining unemployment rates and rising lending activity, investment and private consumption are still the main drivers of economic growth. 12

21 Semi-Annual Monetary Policy Report, January June 218 National Bank of Serbia Table III.1.1 Economic growth projections by country (in %) April 218 July Poland Czech Republic Hungary Albania Bulgaria Bosnia and Herzegovina Macedonia Romania Slovenia Croatia Source: Consensus Forecast. Some Central and Southeast European countries had lower inflation in June 218 than at end-217 Poland (2.% y-o-y), Macedonia (1.4% y-o-y) and Serbia (2.3% y-o-y). Y-o-y inflation in Hungary slightly overshot the central midpoint and measured 3.1% in June, while in Bulgaria it rose to 3.2%, in Croatia to 2.4%, in Bosnia and Herzegovina to 1.9%, and in Montenegro to 3.4% y-o-y. Inflation in Russia measured 2.3% y-o-y at end-h1, which is still below the level from December 217. Romania s inflation rate has been trending above the inflation target since the start of the year and has reached its five-year maximum (5.4% y-o-y in June). Depreciation of the lira, which spilled over onto domestic prices through growth in import prices, was conducive to the rise of inflation in Turkey, which came at 15.4% in June, while the central bank s target is 5.±2%. The divergence between the monetary policies of the ECB and Fed was even more pronounced during H1 due to the still expansionary monetary policy of the ECB and the Fed s interest rate hike, with slightly tighter, though still favourable, global financing conditions. In its June meeting, the ECB announced that it would run its net asset purchases programme at the monthly rate of EUR 3 bn until end-september, then cut it to EUR 15 bn, provided inflation continues to be aligned with expectations, and wrap it up at the end of the year. It also underlined that it would continue to reinvest the principal payments from maturing securities purchased under the QE programme for an extended period of time, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation. The ECB kept its interest rates record low in H1 as well key rate at %, and deposit and marginal lending facility rates at -.4% and.25% respectively. The June meeting was the first time the ECB mentioned a time frame when announcing future movements in the key rate, stating that it expects the rates to remain unchanged at least through the summer of 219, and in any case for as long as necessary to ensure sustainable movement of inflation towards the ECB target. As expected, FOMC members passed a unanimous decision in June to raise the target range for the Fed s rate once again, as they did in March, by another 25 bp to %. The gradual increase in the federal funds rate is said to be consistent with sustainable growth in economic activity, favourable labour market trends and inflation which is close to the 2% target in the medium run. The biggest uncertainty regarding future movements arises from the aggravation of tensions in international trade that might reflect on the decline in business confidence and impact investment decisions. The Fed stated it would continue normalising its balance sheet the reinvestment of principal payments was reduced by USD 3 bn in June, and as of July it is trimmed by USD 4 bn a month. Monetary policies of countries in Central and Southeast Europe differed in character during H1, reflecting the varying strength of inflationary pressures and their economies current stage in the cycle. The Czech and the Romanian central banks raised their key policy rates to 1% and 2.5% respectively. As the lira dropped to a record low, leading to stronger inflationary pressures on this and other accounts, the central bank of Turkey raised its key policy rate by a total of 5 bp to 17.75% in H1. On the other hand, using a set of unconventional measures introduced in January, the Hungarian central bank continued with monetary easing, at the same time keeping the key policy rate record-low (.9%). The central bank of Poland maintained its key policy rate at 1.5%, where it has stood since March 215. After trimming it by.25 pp in February and March, to 7.25%, the Russian central bank did not change its key policy rate during Q2, in view of the considerable depreciation of the ruble and impact of proposed fiscal measures (VAT increase) on the inflation rate and inflation expectations. February saw higher volatility in the international financial market triggered by uncertainty in terms of the Fed s monetary policy normalisation and fears of several leading US tech firms about tightening regulations, but the spike in volatility was short-lived. At end-h1, the implicit measure of financial market volatility (VIX) was 13