1. This note summarizes economic developments and key reform priorities based on discussions held, and data collected, during a recent mission to the Federal Republic of Yugoslavia (FRY). As the very weak data will require further in-depth analysis, and as the reform priorities are based on initial perceptions, the conclusions below are preliminary.

2. Recent economic developments. While data problems obscure precise trends, the qualitative picture is clear. Since 1989, FRY has seen severe declines in incomes and output, particularly in industry. Average annual growth of 5 percent in 1994-1998 was halted in 1999, when recorded national income fell by 20 percent and exports dropped by 50 percent. This was the combined effect of the Kosovo conflict, tightened sanctions, and chronic delays in structural reforms (the latter supporting disinvestment in the enterprise sector). As a result, recorded per capita GDP (relative to domestic prices) reached 40 percent of its 1989 level, one of the largest declines in the region. Assessment of per capita GDP at market exchange rates is complicated by the multiple exchange rate regime, especially by the recent large differential between official and market exchange rates. Preliminary estimates of 1999 per capita GDP range widely from US$700 at the highly depreciated market exchange rate, to over US$1300 at the official exchange rate. An intermediate value of US$1,000 would place per capita GDP near levels in Bosnia and Herzegovina and Albania. So far in 2000, total and industrial output have rebounded modestly, as have foreign trade volumes. Expected annual GDP growth of around 5% reflects the low 1999 base, with output and trade volumes remaining well below 1998 levels. It is difficult to assess if even this modest growth rate could be achieved, given the disastrous drought which heavily affected output of the still large agricultural sector.

3. The macroeconomic environment remains highly unstable. Despite extensive controls on prices of 'essentials', recorded retail price inflation rose from 50 percent in December 1999 to 100 percent in September 2000. The recent post-election removal of many price controls could bring higher values for 2000 as a whole. This reflects the reliance on monetary financing of past budget deficits, including a pre-election burst in spending. The precise fiscal deficit is obscured by incorrect classification of revenues, by extensive off-budget spending, and by the large role of quasi-fiscal deficits (central bank losses, enterprise losses due to low fixed output prices, etc). Quasi-fiscal liabilities in the form of arrears are an economy-wide problem. The government has accumulated arrears on pensions, family allowances, state sector wages, and payment to farmers. Inter-enterprise debts, many of which will fall on the budget, appear large and unsustainable. Government policy to avoid massive bankruptcies only fueled such arrears. The existence of this huge, albeit difficult to measure, overhang represents a serious threat to economic stability in the short- and medium-term, which calls for prompt and coherent policy responses.

4. Balance of payments data are particularly weak. For example, 1999 figures report a current account deficit of US$1.34 billion (over 15 percent of GDP at the market exchange rate). However, with errors and omissions of nearly the same magnitude, and with numerous biases in data, the true current account deficit is far from clear. FRY's ability to finance its current account without visible capital inflows (limited FDI, financial embargo) or significant foreign exchange reserves remains a puzzle. Part of the financing could come via the shadow economy. From late1999, official financing may account for around $500 million. FRY also appears to be running up arrears to foreign firms (particularly for energy payments), some of which are increasingly reluctant to continue such financing. With few obvious sources of financing, it is likely that actual current account deficit is lower.

5. Foreign exchange reserves of the National Bank of Yugoslavia (NBY) are now reported at US$385 million, or 1.2 months of goods imports. Current Bank staff estimates place the stock of external debt, excluding recent large trade credits, at around US$12 billion. The World Bank's share amounts to some US$1.8 billion, 95 percent of which is in arrears. Using the Atlas GNP for 1999 of US$ 10.8 billion, the ratio of debt to GDP would be around 110 percent.

6. Poverty. About 46 percent of the population is recorded as living below a US$1/day poverty line, and about two-thirds below US$2/day poverty. Unlike in most ECA countries, poverty appears concentrated in urban areas, which were hardest hit by sanctions, conflict-related damage and delayed reforms. Official unemployment (which excludes workers on unpaid leave) is expected to rise from 26.5 percent in 1999 to 30 percent in 2000. Unofficial estimates put the current rate at closer to 50 percent. About three-quarters of the jobless have been unemployed for over one year. Average net wages in the Republic of Serbia are US$40-45/month, about one-half the level in the Republic of Montenegro, while average pension are about US$30/month.¹ Arrears of two months on basic pension payments, and of two years on farmers' pensions, and family and maternity benefits, erode the effectiveness of the social protection system. Most of FRY is now experiencing rolling power brownouts. There remain about 500,000 refugees (from Bosnia and Herzegovina and Croatia) and 200,000 internally displaced persons (primarily from Kosovo).

7. Policy reform priorities. To reverse the negative trends of the recent past, FRY needs to: restore macro stability and internal/external balance; create the basis for sustained growth; and improve social security for all of its citizens. The near-term agenda (for the next one-half year) is focused on social protection (humanitarian aid focused on the energy sector), immediate stabilization measures, and reintegration with the international community. This period will also allow commencement of some particularly high-return public works projects, e.g. clearing the Danube, provided these can be funded externally.

8. The medium-term agenda combines rebuilding and investment with transition to a market economy. The former may need to focus less on direct damage (which one FRY estimate places at US$4 billion), and more on undoing the legacy of chronic economy-wide underinvestment and lack of maintenance, and the associated weakness of enterprise balance sheets. For these reasons, and due to chronic delays in reform, FRY faces a surprisingly extensive agenda of first generation transition reforms. These are aimed at improving fiscal sustainability, raising efficiency and reducing unemployment. Anti-corruption will be important for supporting poverty reduction, growth and fiscal sustainability agendas. Initial assessments point to 12 key areas of reform.

1) Managing the accumulated stock of fiscal liabilities. This is the most difficult element of the reform agenda. FRY's external debt stands at about US$ 12 billion, three-quarters of which is in arrears. Domestic fiscal liabilities are also large. The most significant (about US$3 billion) arises from a past government promise to compensate household foreign exchange deposits frozen nearly a decade ago. Other claims will arise from the cost of restructuring severely decapitalized enterprises and banks, and from meeting accumulated arrears on wages, pensions and social benefits. Total public debt is at least 150 percent of GDP. Such commitments will severely strain public finances over a sustained period, especially as Kosovo and the Republic of Montenegro do not contribute to federal tax revenues.

2) Restoring medium-term fiscal sustainability. FRY must also stem the creation of new fiscal commitments. Limiting hidden liabilities requires greater transparency and comprehensiveness in budget and public debt management. Greater central bank independence would reduce the ease of financing deficits. Better control of commitments would limit the growth of direct budgetary arrears, while the hardening of enterprise budget constraint would limit the creation of quasi fiscal deficits. Finally, there is a need to review current public expenditures with a view to limiting the crowding out of those most crucial for economic efficiency and social justice. Based on a cursory analysis, the most obvious shifts in expenditures would be a move away from defense, police, hidden enterprise subsidies and pensions, and towards public investments and targeted social protection.

3) Pension reform. The current pension system is fiscally unsustainable yet unable to ensure adequate income for the elderly. In 1999, state pension payments represented 16 percent of GDP, with a reported replacement rate (average pens pension/average wage) of 75 percent. The 32 percent payroll tar rate allocated to pensions and disability creates disincentives for employment. At the same time, pension arrears of two months in the main system, and 24 months in the farmers' pension system, can have serious poverty implications. For example, pension arrears are not indexed, farmers' pensions have fallen to around US$ 4/month.

4) Tax reform. The tax system is excessively complex (up to 240 different levies), distorted towards income taxation (particularly towards high payroll taxes), and allows too much discretion to grant ad hoc tax relief (thereby supporting corruption). All of these factors hamper efficiency improvement and employment. In addition, with tax rates being high in an already tight fiscal environment, fiscal sustainability will be promoted by a rationalization of the current tax system.

5) Anti-corruption. In addition to liberalization to remove sources of rents, and reduction of the level of discretion in policy, FRY needs to adopt a comprehensive program to fight official corruption.

6) Labor market reform. The combination of a brain drain and large refugee population places additional strains on an already rigid labor market. This is part of the reason for high unemployment. These rigidities include a rigid collective bargaining structure, distortive unemployment benefits, and ineffective employment bureaux.

7) Liberalization of domestic and foreign trade. Until recently, controlled prices represented 60 percent of the consumer basket. This was less a legacy of socialism than of emergency economic policy. Most prices need to be freed, with a regulatory regime for those which remain fixed. To enhance competition, FRY needs to abolish excessive trade restrictions (e.g. maximum margins, limits on number of participants, etc.). In foreign trade, there is a need to abolish trading monopolies, simplify the structure of tariffs and lower their level, remove restrictions on trade with Bosnia and Herzegovina and the Republic of Montenegro, and reduce discretionary power of foreign trade and customs authorities. This should be followed by deeper reform of customs.

8) Banking restructuring and privatization. The combination of recession, the limited level of reported bad loans, and weak banking supervision (including a very accommodating approach to large banks) makes it likely that most 'old' banks are technically insolvent. In addition, these banks are burdened by the legacy of frozen foreign exchange deposits. Financial restructuring of banks, a prerequisite for their privatization, can be very costly for the state budget. Yet, without good banks, enterprise restructuring will fail. As in other former Yugoslav republics, there is a need to reform the state monopoly payments system.

9) Enterprise restructuring and privatization. As noted, sustained price controls have led to the decapitalization of many larger firms, and to the accumulation of inter-enterprise debts. These firms will require financial restructuring before privatization. Future restructuring will be supported by limitation of state support and by imposition of a hard budget constraint. The best model for privatization (stalled in the Republic of Serbia but proceeding in the Republic of Montenegro) remains unclear, but the process clearly needs to be made mandatory for firms and placed on a clear timetable, with both domestic and foreign firms allowed to participate.

10) Energy sector reform. This sector (especially electrical power and local utilities) suffered particularly from price controls and underinvestment, and in some cases from direct damage. Thus, it combines high physical investment needs with an extensive reform agenda, including a review of pricing policy to prevent new losses and to ensure protection of the poorest.

11) Social protection. The new authorities cite the weakness of the social safety net as a reason to postpone otherwise needed increases in prices for key essentials. Unemployment insurance benefits are poorly targeted, with high benefits for some classes of workers eroding the incentives to search for new employment. Arrears on child support and maternity benefits have also reached about two years.

12) Statistical capacity. Design and monitoring of a policy program is hampered by weaknesses in economic and social data. Some data problems reflected particular incentives (e.g. to smuggle and to under/overreport certain variables) which will be reduced by a better policy environment. In part this also reflects the erosion of capacity resulting from the brain drain and sustained lack of external contacts.