Republic of Serbia Fiscal Council

1. Republic of Serbia Fiscal Council EVALUATION OF THE DRAFT 2014 BUDGET AND FISCAL STRATEGY FOR 2014-2016 November 26, 2013

2. Serious situation – demands more decisive measures than those proposed in the draft budget and Fiscal Strategy • Extremely high deficit in 2014 (7.1% of GDP), it has grown in comparison to 2013 • Additional adjustments of 0.8-1% of GDP (€300 million) are necessary • Public enterprises and banks will cost the budget €560 million • Bringing order in public enterprises and state-owned banks immediately • Good medium-term goals are not supported by adequate measures • More comprehensive measures are necessary, pension reform needs to be adopted in the first half of 2014, reforms in subsidies, non-targeted social contributions… • Recovery of public finances is possible only if all three conditions are met

3. Without solving the problems in public enterprises and banks - no fiscal consolidation • Citizens make savings that are used to cover losses of public enterprises and state-owned banks • The state assumed the liabilities of Srbijagas, Smederevo Steel Mill (Železara Smederevo), ЈАТ (Yugoslav Air Transport), Galenika, Serbian Railway (Železnice Srbije)… • … and financially intervened in the banking sector: Agrobanka, Development Bank of Vojvodina (Razvojna banka Vojvodine), PBB (Economic Bank of Belgrade) • In 2014 unsuccessful enterprises and banks will cost the budget around €560 million (1.7% of GDP) • The sum exceeds the collective effects of increased lower VAT rate (from 8 to 10%) and solidarity tax – total effect of €300 million • That is the main reason for the increase in 2014 deficit when compared to 2013 of around 0.5% of GDP with savings included • They keep producing losses and creating new liabilities for the state even in 2014 (around €630 million of new liabilities)

4. Srbijagas – the biggest problem • Liabilities of over €1 billion • Bank credits – around €800 million (losses financed via liquidity credits with state guarantee) • NIS (Petroleum Industry of Serbia), unsettled liabilities for gas extracted from local fields – €225 million • Fiscal Council has indicated problems in the operations of this enterprise since 2012 • At that moment, the debt amounted to around €400 million, now it is almost three times higher • In June 2013, the Government: no new guarantees, Srbijagas to settle its liabilities independently • On the contrary: • Government assumed the debts • Srbijagas continues making losses – in 2014, new debt of €200 million with state guarantee approved

5. Urgent restructuring necessary • Servicing Srbijagas loans will cost the state at least €150 million in 2014 • It is by far the biggest state aid to a company so far (Serbian Railway - €110 million), higher expenditures than those for science • If the liabilities to NIS are not settled in the future – the expenditures will be even higher • In the coming years, servicing Srbijagas liabilities will grow • Additional credit from 2014 should be also settled (€200 million), variable interest rate (Euribor will grow), grace period for some credits is close to an end… • Restructuring – the state should neither permanently nor in one-off situations allocate new funds… • … not organizational and legal issues

6. Banks cost a lot – order must be regained • State expenditures for banking sector recovery will amount to around €800 million until and including 2014… • …Since, in 2014, the Deposit Insurance Agency will also have to undergo recapitalization/new loans (€360 million) • DIA spent all their funds for the disbursement of insured (but uninsured deposits, too) deposits in bankrupt banks • In the end of 2013, €100 million for PBB (Economic Bank of Belgrade) allocated • It went relatively unnoticed as a technical transaction, but… • … That transaction exhausted all the savings arising from solidarity tax • Are all the problems solved? • Operations control and responsibility in the state-owned banks management are needed

7. Deficit in 2014 – as high as 7.1% of GDP • Budget Law – republic deficit of RSD 183 billion (4.6% of GDP) • However, true republic deficit amounts to 5.2% of GDP • Budget Law does not include project loans (Azerbaijani and Chinese credit) • Local self-government, PuteviSrbije (Serbian Roads), Funds (PIO (Pension and Disability Insurance), RFZO (Republic Fund for Health Insurance), NSZ (National Employment Service)) increase the deficit to 5.5% of GDP • Off-budget financial transactions reach 1.7% of GDP (covering public enterprises’ liabilities, banks)… • …Total deficit of RSD 285 billion (7.1% of GDP) • It is growing when compared to 2013 level of 6.6% of GDP • 5.7% of GDP of consolidated state and 0.9% „below the line“ •  2014 deficit will grow due to the settlement of liabilities of public enterprises and banks 7

8. The span of Government measures for deficit reduction of only 1-1.2% of GDP • In October, Government announced fiscal consolidation measures of over 2% of GDP • However, in Fiscal Strategy, they reduced the objective to 1.65% of GDP • True effect of only 1-1.2% of GDP • The only firm effect – increase in the lower VAT rate from 8 to 10% and solidarity tax • Savings from subsidies do not amount to 0.3% of GDP, but only 0.1% of GDP, since RSD 7.5 billion of savings are used for finansing RTS (Radio Television of Serbia) and RTV (Radio Television of Vojvodina) (revocation of subscription) • There are no planned savings from goods and services – total expenditures for the procurement of goods and services are growing • The increase in tax collection via reduction of grey economy is disputable (planned level of 0.4% of GDP) 8

9. Additional savings of 0.8-1% of GDP need to be made • The Government October goal - a good one (adjustment of 2% of GDP) • It was supported (conditionally) by the Fiscal Council as well • However, real effects of measures are of smaller scale: 1-1.2% of GDP • New adjustments of 0.8-1% of GDP need to be made • More importantly – additional savings would decrease 2014 deficit if compared to 2013 • Positive signal to investors from whom budget financing depends • Government credibility is already low – in 2013, 3.6% of GDP deficit was planned, 6.6% of GDP deficit will be realized • It would bring us closer to the necessary arrangement with the IMF 9

10. Deficit reduction needs to be prolonged to the medium term, too • The seriousness of the problem of public finances in Serbia asks for longstanding fiscal adjustments • Some other countries – Greece, Portugal, Croatia… are going through a similar process • Fiscal Strategy envisaged planned deficit reduction in the period 2015-2016 of 3.9 pp of GDP • The adjustment level in 2015 and 2016 is good • Such adjustment would stop public debt growth in 2016 (if additional savings are made in 2014 and budget funds outflow into public enterprises and banks is stopped) • Measures for medium-term adjustments are partly unbalanced and almost unfeasible • About 2/3 of savings in expenditures for wages and for interest rates (replacing an expensive debt with a cheaper one) • While, over dimensioned expenditure for pensions, some subsidies, non-targeted social contributions still remain… 10

11. Room for fiscal consolidation is getting smaller • Crisis can be avoided only if all three key conditions of fiscal consolidation are met • Additional deficit reduction in 2014 • Bringing order in public enterprises and state-owned banks • Adoption of a credible plan for medium-term savings and launch of reforms • Reduction of wages and pensions and tax increase are useless if those savings are spent a priori for Srbijagas, Železara Smederevo, bankrupt banks, Galenika… 11

12. Public debt and financing • At the end of 2013, public debt of 64% of GDP and still growing • In the coming years, it will exceed the level of 70% of GDP – very dangerous • Reduction of the public debt share in GDP is not possible before 2017, but only if • Substantial adjustments are made and deficit reduced to about 2% of GDP in 2017 • Issuing new guarantees for public enterprises debts is stopped or limited • The state has to provide €5 billion every year (for financing deficit and repayment of the public debt principal) until public debt is reduced substantially • It will be ever more difficult to manage this and more expensive if the high fiscal deficit is not reduced promptly • Conditions available internationally are also prone to change – the time when countries similar to Serbia had cheap loans is probably over 12

13. Fiscal consolidation itself is not sufficient for economic growth • Fiscal consolidation is essential – otherwise, crisis is inevitable • However, its objective is not to launch economic growth but to create conditions under which the growth could be possible at all • State measures stimulating economic growth • Amendment to the Labour Law • Simplification and shortening the period for construction permits issuance • Deciding upon the fate of 153 enterprises undergoing restructuring • Public enterprises reform • First test – adoption of the new Labour Law by the end of 2013 • If the Government does not realise their intentions, the implementation of other necessary measures is uncertain, taking into account that they are more demanding 13

14. Public expenditure in 2013 • In 2013, public consumption dropped drastically • General state expenditures were lower than those initially planned by RSD 70 billion • Possible reasons: low inflation, new (complex) law on public procurement, more efficient spending, ad hoc savings measures • But: • Expenditures “below the line” of RSD 33 billion • Capital expenditures lowest ever • Scarce funds (health care system) • Transferring expenditures to 2014

15. 2014 Republic budget • There is no further expenditure reduction: planned savings will be annulled by new expenditure • Expenditure control: low indexation, decrease in some of subsidies and budget credits, reduction of transfers to the local level and PIO Fund • Expenditure growth: interest rates, social care contributions (unreformed area); subsidies for the public service, covering arrears (judiciary, ecological fund), redundancy payments; and still ungrounded extra allowances in some ministries • Risks to see expenditures overstep the plan: subsidies (for investors, Srbijagas, Železara) and redundancy payments

16. Efficiency in VAT collection Drop in tax discipline during the 2008-2012 crisis and additional huge drop in 2013!

17. Big drop of tax discipline in 2013 • Tax indiscipline endangers fiscal consolidation • VAT revenues without collection drop would have reached the level of RSD 30 billion higher than those in 2013 • Existing “reprogramming” and “zero tolerance” measures yield no results

18. Monthly VAT revenue tempo “Zero tolerance” to tax evasion is not visible in the data!

19. Systemic solutions are necessary • Unrealistic expectations of the Tax Administration • € 1 billion (and a half) from grey economy? • Electronic tax applications exclusively? • Ad hocmeasures such as online reading of cash registers are not an adequate response • Unsuccessful wireless reading • Fight against grey economy asks for systemic solutions and responsibility • Adequate incentives, penalties and responsibility