Statement by the IMF Staff Representative

1. Thank you for the opportunity to participate in this meeting. I will concentrate my remarks on the current economic situation in SM, relations with the IMF, and the outlook for 2004.

2. Economic performance remains generally favorable.

• Inflation at end-2003 is projected to be at, or slightly below, the lower end of the 9-11 percent target, compared with 14 percent at end-2002.

• Real GDP is expected to grow by about 3 percent in 2003, somewhat less than programed.

• The current account deficit (before grants) is expected to decline in relation to GDP, in line with the program, reflecting a deceleration in both exports and imports and buoyant private remittances. However, it remains large at a projected 11 percent of GDP in 2003 and its financing depends in large part on private capital inflows that are sensitive to changes to market sentiment.

• Owing largely to unexpectedly large privatization proceeds, the capital account surplus in 2003 has been large enough to not only cover the current account deficit but also to raise the official foreign exchange reserves to about $3.5 billion or 4.5 months of imports. FDI is expected to amount to $1.2 billion (6 percent of GDP) in 2003, twice the amount targeted under the program.

3. Policies are generally on track. The IMF Executive Board completed the second review under the 2002-05 Extended Arrangement in July. The end-September fiscal, credit and external targets-monitored through performance criteria-were observed comfortably.¹. Indicative targets regarding the wage bill of the 7 largest enterprises and the ceiling on the Serbian banking system NDA were observed, but problems have persisted in the area of government expenditure arrears. All but one of the structural benchmarks through end-September have been observed, albeit with some delays. Adoption of a resolution plan for the largest Serbian bank has been delayed in part by management changes at the central bank and the Bank Rehabilitation Agency.

4. The IMF staff mission that visited Belgrade and Podgorica in the second half of October for discussions on the third review under the Extended Arrangement reached preliminary agreement on most aspects of a program for 2004. The IMF Board could have considered the third review (including a financing assurances review) in January 2004 assuming agreement on a few remaining issues and 2004 budgets consistent with policy understandings. However, the holding of early elections in Serbia will delay completion of the review. An IMF staff mission is envisaged to return to Belgrade, once a new government is in place, to review the situation and seek to finalize discussions on policies for 2004, including a Serbian budget. Against the backdrop of relatively modest output and export growth, and a large current account deficit reflecting in part strong consumer demand, we expect that the new government's policy strategy for 2004 will remain unchanged and aim to strengthen external competitiveness and narrow the current account deficit, including by containing the growth in domestic demand and costs.

5. The October mission reached a preliminary agreement on reducing the fiscal deficit in 2004 but the staff continues to be concerned about the composition of the fiscal adjustment in the Serbian budget submitted to parliament and the policies underlying the draft Montenegrin budget.² According to the proposed Serbian budget, total spending would remain roughly unchanged in relation to GDP, with investment spending rising by 0.6 percentage points. Spending on wages and subsidies-which remains rather high-would decline only slightly in relation to GDP, reflecting in part above-average wage increases for the police and the retrenchment costs arising from the restructuring banks and enterprises. The new government should consider a further containment of wage spending and subsidies as a basis for the 2004 budget. It should also proceed, as currently envisaged, with the implementation of a major tax reform, including the introduction of a VAT and the streamlining of income tax and social security contributions in mid-2004. As regards Montenegro, the staff is concerned about the implications for the deficit and fiscal sustainability of recently announced plans to lower personal income taxation.

6. Structural reforms should cover a broad area. In the banking sector, progress is envisaged in restructuring the largest domestic bank in preparation for its privatization and in privatizing the remaining banks in which the state has an equity participation. With the pipeline of readily privatizable socially-owned enterprises drying up, focus will shift toward the restructuring of state enterprises and insolvent socially-owned enterprises to facilitate their privatization. The implementation of a new bankruptcy law should underpin the hardening of budget constraints.

7. SM's external financing needs will remain large over the medium term. While the current account deficit is expected to narrow further in 2004 and beyond, it would remain relatively high given the substantial need for investment imports. On the other hand, the early success in generating once-off, large privatization proceeds from the sale of enterprises in highly profitable sectors cannot be sustained as the privatization effort shifts to less successful enterprises. Accordingly, privatization proceeds in 2004 are expected to be sharply lower than in 2003, and financing needs-to be met by external grants and loans from official creditors, excluding purchases from the Fund-are estimated at about $1.0 billion, of which $0.3 billion in the form of BoP/budgetary support. In this connection, the authorities should continue their efforts to reach debt restructuring agreements with remaining creditors on terms comparable to those granted by the Paris Club.

8. External and public sector debt sustainability will require sustained implementation of policies to support growth and strengthen the external position. In light of the initial conditions, the policy challenges-notably in restructuring the largely insolvent enterprise sector without endangering the fiscal position-are daunting and will require continued support for the reforms at home and abroad.

¹ The general government deficit in Serbia, net of foreign-financed projects, amounted to 1.7 percent of annual GDP in January-September, in line with the annual target, reflecting good revenue performance and expenditure reallocation to provide for the higher-than-envisaged need for transfers to the social funds. The general government deficit in Montenegro was 0.2 percent of annual GDP (2.9 percent of Montenegro's GDP) in January-September 2003, in line with the program target, reflecting a substantial improvement in tax revenue over the first half-year.

² Montenegro accounts for about 7 percent of the SM economy.