Current macroeconomic developments Radovan Jelašić Governor of the National Bank of Serbia Belgrade, 6 February 2008
Contents Overall economic situation; Inflation movements and inflation expectations; Movements in the world market; Balance of payments; Interest rates and money markets; Forex market and exchange rate of the dinar; Labour market and wages; Fiscal flows; Medium-term projection of core inflation; Monetary policy and regulations.
Economic flows and outlook for the economy are worsening 2007 saw worsening in Serbia s economic circumstances: Inflation is accelerating, which is indicative of the deepening of macroeconomic imbalances; Current account deficit is widening, primarily due to the increasing foreign trade deficit in an environment of ever scarcer and costlier sources of finance needed to cover it; and GDP growth is slowing down and increasingly relying on the services sector due to inadequate development of export-oriented production. Economic outlook for 2008 is also strongly affected by a number of noneconomic factors: external (e.g. turbulences in the international commodity markets, equity markets, meteorological conditions ); and internal (e.g. political uncertainties).
Stabilizing power of monetary policy depends on its response speed The NBS pledged to achieve core inflation within the projected range of 4-8% at end-2007 using monetary policy instruments; The width of the projected core inflation range depends on the underlying risks relating to the outlook for world oil prices, fiscal developments, prices of agricultural products... Monetary policy response to expected upside inflation risks is obvious from the key policy rate dynamics which has become the main instrument of monetary regulation; In such circumstances, stabilizing power of monetary policy depends on the timeliness of its response and effective use of its instruments.
NBS MPC has decided today to raise the key policy rate from 10% to 10.75% Reasons for such decision: Heightened inflation expectations; High core inflation for 5 months running even excluding the effect of agricultural shock, which points to the spilling over of its effect through the rise in inflation expectations as well; Fiscal expansion and increase in public sector wages in December last year; Prevalence of depreciation pressures despite strong inflow of capital from abroad; To achieve core inflation objective for end-2008, monetary policy must be tightened as of today!
Core inflation in 2007 is within the targeted range, but Inflation movements (in %) Annual inflation rates (in %) monthly growth 3.0 2.5 2.0 1.5 1.0 0.5 0.0-0.5 0.4 0.10.0 0.0 Dec- 06 0.1 0.8 0.1 0.9 0.2 1.4 0.6 0.5 0.6 0.2 0.2 1.21.1 1.0 0.8 0.6 0.7 1.1 1.3 0.9 0.7-0.2 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec- Retail prices - monthly rates Core inflation - monthly rates 07 18 15 12 9 6 3 0-3 20 18 16 14 12 10 8 6 4 2 0 17.7 14.5 10.1 7.4 6.6 5.9 5.6 5.1 5.4 4.0 2.8 3.3 2005 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Y-o-y retail price growth rates Y-o-y core inflation Retail prices Core inflation 2007 core inflation measured 5.4%. However, its high growth rates recorded by the end of the year give reasons for concern. Monetary policy can not offset direct effects of the energy and agricultural shocks felt in the second half of 2007, but what it can and must do is absorb their impact on other prices, minimize the spill over effect and anchor inflation expectations!
The «shock»: prices of less than 1/6 of products included in the consumer basket increased 30 times faster than prices of the remaining items, and account for 4/5 of the overall price growth! share in core inflation, in % 35 30 25 20 15 10 5 21.9 17.6 Q4 2007 - average 2.2% househo ld appliances, construction material, textile pro duc ts, s o ft drinks, fre s h meat, hygiene products 7.9 13.7 7.3 5.9 1.8 1.8 2.2 Normal price growth distribution e dible o il, da iry pro duc ts, processed food products, flour products, textile products (winter clothes), frozen vegetables 3.7 16.1 0 average growth range, in % -2.4% 0.2% 0.8% 1.2% 1.9% 2.2% 2.7% 3.2% 3.5% 4.1% 11.8% <- 0,2-0,2-0,5 0,5-1,0 1,0-1,5 1,5-2,0 2,0-2,5 2.5-3,0 3,0-3,5 3,5-4,0 4,0-4,7 4,7 + average growth 0,4% 11,8% = 2,2% price growth structure 15%. + 85% = 100% Deviation from normal price growth distribution is due to: bad weather conditions rise in the prices of processed food products; nominal appreciation of the dinar decline in the prices of tradable goods.
Inflation expectations: measure of the market participants trust in our promises Inflation expectations for the next tw elve months, in % 17 15 Households 13 11 9 7 5 Enterprises Trade unions Financial sector M ar A pr M ay Jun Jul A ug Sep Oct Nov Dec Source: Survey (TNS M edium Gallup). Financial sector expectations regarding inflation levels over the next twelve months rose by 0.6% to 8.6% in January 2008, which is half way between current inflation and the set objective.
Movements in the international markets of raw materials 96 92 88 84 80 76 72 68 64 60 56 52 48 44 48,4 48,4 52.5 56.9 60,1 65,3 62,8 World price of Ural oil per barrel (in USD) 63.1 67,6 68.8 73,9 Јan Feb Маr Аpr Маy Јun Јul Аug Сep Оct Nov Dec Јan 2007 2008 73.7 67.5 71.3 Average for the accounting period Although the prices of Brent oil futures were slightly below the market price in mid-january 2008, some economic analysts believe that the prices of crude oil will continue to grow; 76.4 84.4 90,6 89.0 88,8 93,1 87.4 The second half of 2007 saw further growth in the prices of other raw materials (gold, platinum, non-ferrous metals, cereals and food).
Movements in the international financial markets have clear effects on Serbia as well! Turmoil in the international financial markets caused an increase in the risk premium for transition countries, particularly those outside the EU; Together with unfavourable balance of payments data, this has dampened investor mood towards Serbia and pushed the costs of external financing up. Risk premium indicator - EMBI* (mo nthly data, in basis po ints) basis points Five-year credit default sw aps 0 50 100 150 200 250 300 350 Czech Republic (26) 300 Poland (44) Jun-07 Jan-08 250 Croatia (88) Romania (111) 200 Russia (86) 150 Serbia (151) 100 Source: Jan JP Morgan. Feb Mar Apr Маy Јun 2007 Jul Aug Sep Oct Nov Dec Source: Financial Times, 29 January 2008 * Emerging Markets Bond Index
Serbia s s balance of payments: current transactions Export and import of goods (in USD millio n) 2,000 1,800 1,600 1,400 Import Current account deficit amounted to around 16.1% of GDP in 2007 (12.5% in 2006); 1,200 1,000 800 600 400 Export Deficit on the balance of goods and services reached 20.7% of GDP (20.0% in 2006). 200 12 3 6 9 12 2005 2006 Original data Trend-cy cle 3 6 9 12 2007 Seasonally -adjusted Note: For the purpose of comparability with the preceding period, dat a on t rade wit h M o nt enegro are not included. Though still recording high growth rates, export is slowing down (increasing by 37.5% in 2007), while import is rising (growing by 39.1% in annual terms).
Serbia s s balance of payments: credit-financial transactions Structure of capital inflow (in USD million) Net medium- and long-term foreign credits (in USD million) 3,500 3,000 2,500 2,000 1,500 1,000 500 0-500 199 821 408 701 1,222 94 1,709 495 808 I II III 2006 FDI, net 1,655 460 1,143 873 357 264 1,328 1,126 576 629-253 575 IV I II III 2007 1,001 2,096-203 IV 1,600 1,400 1,200 1,000 800 600 400 200 0-200 -400 I II III 2006 Banks IV I II III 2007 Enterprises IV Net borrowing (including early repay ment of debt) Other inf low, net Non-credit sources of finance (foreign investment and domestic savings) cover 73% of the current account deficit or around 11.8% of GDP. Net borrowing accounted for capital inflow of around 10.9% of GDP.
Money market interest rates reflect movements in the key policy rate 18 Interest rates in 2007 (at annual level, in %) 16 14 12 10 8 6 BEONIA 4 Јan Мar Мa Јul Sep Nov Dec BELIBOR 2-w eek BEONIA 2-w eek repo Deposit facility Lending facility Source: National Bank of Serbia and Reuters. Sharp decrease in government deposits by end-2007 led to high dinar liquidity of banks, decline in Beonia and deviation of market interest rates from the key policy rate. However, December rise in the key policy rate induced withdrawal of dinar liquidity and retreat of interbank rates within the interest rate corridor as soon as in early 2008.
Bank lending: one of the sources of growth in aggregate demand 50 45 40 Year-on-year growth in credits to enterprises (in %) Credits to households,, in RSD billion 120 110 100 35 30 35 30 25 20 15 10 90 80 70 60 25 20 5 0 1 2 3 4 5 6 2006 7 8 9 10 11 12 1 2 3 4 5 6 2007 50 7 8 9 10 1140 12 30 15 Nominal grow th 20 10 Real grow th Jan Feb Mar Apr May 6/1/2007 Jul Aug Sep Oct Nov Dec Cash credits - left scale Housing construction - lef scale Credit cards - right scale Consumer credits - right scale NBS measures contributed to the slowdown in cash lending. Borrowing by enterprises from domestic banks and foreign sources is stepping up: total domestic and foreign borrowing by enterprises reached 57.5% of GDP (growth of 11% of GDP in 2007).
Large fluctuations of the exchange rate of the dinar in the past three months RSD/EUR exchange rate RSD/EUR 86 85 84,75 84, 68 84 83 82,98 82,9 82 81,88 81,57 81,82 81,38 81 80,76 80,30 80 79,90 80,78 79,96 79 80,00 79,58 79,66 78,89 79,7 78 79,03 78,51 78,60 78,67 77 78,19 77,89 77,20 76 76,81 Јan 2007 Feb Mar Apr May Jun Јul Аug Sep Oct Nov Dec Jan 2008 Stronger fluctuations in the value of the dinar: End-November depreciation was caused by the ripple effects of global movements and psychological factors, which explains why the exchange rate resumed its previous level relatively quickly; January depreciation was clearly a result of the fundamental mismatch of demand and supply, i.e. notable deterioration in investor sentiment towards Serbia.
The exchange rate for the dinar was determined by market supply and demand Foreign exchange purchase/sale by the NBS in the fixing session and euro exchange rate -20,000-40,000-60,000-80,000-100,000-120,000 ( 000 EUR) 0 RSD/EUR 85 84 83 82 81 80 79 78 77 76 Composition of banking sector trading in the IFEM* in EUR mln 3,500 3,000 2,500 2,000 1,500 1,000 500 NBS interventions in the IFEM (left scale) Exchange rate (right scale) 0 Jan Feb Mar Apr May Jun-07Jul Aug Sep Oct Nov Dec 1-29 Jan Bank - bank Banks - NBS * In the IFEM, the NBS sells a portion of foreign exchange p urchases from exchange dealers. The NBS last intervened in the foreign exchange market on 29 November 2007 (by selling EUR 4 million).
December boom in wages: monthly growth 38 36 34 32 30 28 26 24 22 20 18 16 14 12 10 8 Movements in average net wages in 2007 (in %) Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 40 30 20 10 0-10 -20 28.4-15.3 1.9 Movements in average public sector net wages in 2007 (in % ) 3.1-0.6 4.9 0.0-0.3 2.7-0.8 2.3 2.5 Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Nominal monthly rate Year-on-year nominal growth rate 17.7 Year-on-year nominal growth rate Year-on-year real growth rate Monthly year-on-year growth in nominal wages ran above 26% throughout 2007 (except in December, as wage increase in late 2006 was particularly sharp); Real wage growth slackened notably in response to a slowdown in economic activity relative to Q2 2007; Unit labour costs in industry rose by 2.3 in Q4 2007 relative to Q4 2006;
Rise in consolidated expenditure and deficit Quarterly consolidated revenue and expenditure, IMF methodology Quarterly consolidated fiscal result, IMF methodology RSD bln 350 RSD bln 20 300 10 0 250-10 -20 200-30 -40-50 150 I 2006 II III IV I 2007 consolidated revenue II III IV consolidated expenditure -60 I 2006 II III IV I 2007 II III IV Rise in wages and other fiscal expenditure triggered a surge in fiscal deficit and its monetary effects in the latter half of 2007; 2007 fiscal deficit came to 1.9% of GDP (1.8% in 2006); Q4 fiscal deficit is estimated at 7.4% of the quarterly GDP.
Both core and headline inflation are expected to slow down in Q1 2008 End-Q1 annual inflation rate is expected to equal 11.1% (March to March); Growth in regulated prices is expected to be above the average (in particular, prices of energy, bread, milk, cigarettes, utilities, transport and social services), and to measure 4.6% p.a.; Contribution to retail price growth (in percentage points) 4.5 3.5 2.5 1.5 0.5-0.5-1.5 *NBS estimate. 1. 2 2.9 3.0 2.6 I II III IV I 2007 2008* Core inflation Prices of agricultural products Regulated prices Retail prices 2.1 Core inflation will be influenced by the following factors: a) rise in inflation expectations; b) indirect effects of growth in prices of petroleum products; c) current nominal depreciation of the dinar; and d) rise in prices of excise products (coffee and alcoholic beverages); At the end of Q1 2008, annual core inflation will move at around 7% as a result of an expected rise in core prices in this quarter, but also of relatively low core inflation in Q1 2007 (-0.1%).
Core inflation objective for 2008 will be met Projected core inflation (year-on-year rates, in %) 9 8 7 6 5 objective for 2007 4-8% met: 5.4% objective for 2008 3-6% 4 3 2 1 0 I II III IV 2007 I II III IV 2008 I II III 2009 Despite an expected slowdown in monthly dynamics, annual rates of core inflation will continue to rise in the first half of 2008; The annual rate of core inflation is expected to settle within the projected range (3-6%) in Q4 2008.
Main reasons for adopting amendments to regulations Full harmonization of regulations on capital adequacy with Basel I requirements and its subsequent amendments, primarily through introduction of additional capital requirements for market risks; Improved credit risk identification, assessment and management through gradual harmonization of provisioning rules with IFRS requirements (International Financial Reporting Standards); Standardization of in-house risk management by banks, through a more detailed definition of systems and management of individual risk exposure of banks; Strengthening the risk management and corporate governance function; Preparations for Basel II.
The most important changes Decision on Capital Adequacy (1/2) Current decision Definitions Supplementary capital I Capital adequacy Capital (core + supplementary I) credit risk+foreign exchange risk =12% paid-up share capital in respect of cumulative preference shares; premium on the issue of cumulative preference shares; portion of revaluation reserves which refers to fixed assets and shares in capital; reserves from earnings against general banking risks; New decision hybrid instruments (displaying characteristics of both capital and liabilities); Capital (core + supplementary I + II) CR*+ FXR*+MR* =12% subordinated obligations. Supplementary capital II Short-term subordinated obligations; Market risk price risk (on debt and equity securities); settlement/delivery risk and counterparty risk. At present, the capital adequacy ratio of the banking sector is around 25%, while the first maintenance period to which the new decision will apply is Q3 2008.
The most important changes Decision on Capital Adequacy (2/2) Current decision New decision Risk weights 0% claims insured by funds established by the RS; 0% claims insured by funds established by the RS, guaranteed by the RS; 50% claims + mortgage (commercial or residential) 125% claims in foreign currency or RSD with foreign currency clause > RSD 10,000,000 + persons with unmatched foreign currency position 50% claims in RSD + mortgage (residential) 75% claims in foreign currency or RSD with foreign currency clause + mortgage (residential, performance of activity, lease) + persons with unmatched foreign currency position* 125% claims in foreign currency or RSD with foreign currency clause + persons with unmatched foreign currency position mortgage * Borrowers whose foreign currency inflow or foreign currency clause indexed dinar inflow covers less than 80% of their obligations
2. Risk weights example Example: A bank grants a loan of EUR 60,000 to a natural person with an unmatched foreign currency position who has taken a mortgage on a flat Current decision New decision Risk weight: 50% Risk-weighted balance sheet assets = EUR 60,000 x 0.5 = EUR 30,000 Risk weight: 75% Risk-weighted balance sheet assets = EUR 60,000 x0.75 = EUR 45,000
The most important changes Decision on Classification of Balance Sheet Assets and Off-balance Sheet Items Classification of claims Current decision All claims on related parties are classified in the same category, based on the borrower classified in the least favourable category А 30 days B 31-90 days C 91-120 days D 121-180 days E over 181 days New decision Claims are classified for each individual borrower; Claims on a single borrower may be classified in several categories; Possibility of provisioning at group level (small loan portfolio); Changed number of days of delay: A 30 days B 31-60 days C 61-90 days D 91-180 days E over 181 days Explicit obligation to set up an internal model for credit risk assessment and testing of such model; Obligation to form higher provisions against general banking risks in case of over 15% annual growth in balance sheet and off-balance sheet assets subject to classification (with the exception of newly incorporated banks 3 years) 15%-20% 0.25% growth 20%-25% 0.50% growth 25% 0.75% growth Methodology defined in more detail
Tax Administration In cooperation with the Tax Administration unit of the Ministry of Finance, the National Bank of Serbia is actively working on enhancing reliability of data on regular net monthly income of households requested by commercial banks when approving loan applications of clients; Subject to client s approval, commercial banks will at all times be able to check the taxable annual income of each client; The NBS will request commercial banks to check their clients annual income with the Tax Administration for a part of their credit portfolio; Upon credit approval, the client will be required to submit to the bank at its request the tax payment certificate for the prior year in line with the tax liability calculation regularly supplied by one s employer by 31 January; This proposal was endorsed by representatives of the Serbian Banking Association.
Expected effect of regulatory amendments More efficient risk management and increased transparency of bank operations introduction of market risk; A more objective account of capital requirements and capital adequacy of banks following introduction of additional capital requirements for market risks; Improvement of the bank s risk management practice and adjustment to the bank s risk profile a detailed definition of the risk management framework; Unification of the database on losses resulting from the bank s operational risk and regular reporting to the NBS on such losses will contribute to a more efficient management of the operational (significant) risk; Banks will be given sufficient time to improve presentation of historical data to enable adequate assessment of the necessary level of provisioning; The concept of regulatory amendments (to strengthen the function of risk management internal methodology and risk assessment) is a step forward to creating preconditions for introduction of the Basel II
Expected effects of regulatory amendments Measures will be applied retroactively to the entire portfolio In their calculations, banks have already taken into account information from regulatory amendments First maintenance period Q3 2008
Monetary policy in 2008 There is a clear need for tightening of the monetary policy stance; Policy response must be adequate and timely, as only measures taken in the first half of the year will reflect on this year s inflation: first, raising the key policy rate as the main monetary policy instrument; and second, depending on the urgency and size of the problem, taking other measures to contain growth in aggregate demand.