Document of The World Bank

FOR OFFICIAL USE ONLY

Report No. 33990-W

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT

FOR A PROPOSED

FIRST PROGRAMMATIC P W A T E AND FINANCIAL DEVELOPMENT POLICY CREDIT

IN THE AMOUNT OF SDR 38 MILLION (US$55 MILLION EQUIVALENT)

TO

SERBIA AND MONTENEGRO

October 3 1, 2005

Finance and Private Sector Development (ECSPF) South East Europe Country Unit (ECCU4) Europe and Central Asia (ECA)

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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ALMP BRA BSA BSC BSL CAD CAMEL CAS CE A CFAA CSD CTR DF DFID DIA DPCIL E A EAR EBRD ECA EOI EPS ESW EU FA FAU FDI FSN FY GDP GNP GOS HIPC IBRD ICA IDA IFC IMF JS A LDP MCI MDGs MEM

SERBIA AND MONTENEGRO - GOVERNMENT FISCAL YEAR January 1 - December 3 1

CURRENCY EQUIVALENTS (Exchange Rate Effective as of October 19,2005)

Currency Unit USSl .OO 71.23 Serbian Dinar (CSD)

Metric System

ABBREVIATION AND ACRONYMS (as applicable, plus others)

Active Labor Market Programs Bank Rehabilitation Agency Bankruptcy Supervisory Agency Bank Supervision Committee Budget System Law Current Account Deficit Capital, Assets, Management, Earnings, and Liquidity Country Assistance Strategy Country Environmental Analysis Country Financial Accountability Assessment Serbia Dinar Commission for the Protection of Tenderers' Rights Development Fund UK Department for International Development Agency for Deposit Insurance Development Policy CreditILoan ~xtended Arrangement European Agency for Reconstruction European Bank for Reconstruction and Development Europe and Central Asia Expression of Interest Elektroprivreda Srbije (Serbia's national electric power utility) Economic Sector Work European Union ~inancial Advisor Fiduciary Assessment Update Foreign Direct Investments Financial Sector Note World Bank Fiscal Year Gross Domestic Product Gross National Product Government of Serbia Heavily Indebted Poor Countries International Bank for Reconstruction and Development Investment Climate Assessment International Development Association International Finance Corporation International Monetary Fund Joint Staff Assessment Letter of Development Policy Ministry of Capital Investments Millennium Development Goals Ministry of Energy and Mining

FOR OFFICIAL USE ONLY MIER MLESP MOE MOF MOH MSEP MTEF MTS , NBFI NBS NMICS NPL . , PA '

PEIR PFM PHRD PIER PLC PPFDPC-1 PPFDPCL PPL PPO PRSP PSC PSN ROSC SAA SAI SAC SaM SAP SDP SDR SEM SME SP SPA SOB SOE TF TPL UNDP USAID US$ ZTP

Ministry of International Economic Relations Ministry of Labor, Employment and Social Policy Ministry of Economy Ministry of Finance Ministry of Health Ministry of Science and Environmental Protection Medium-Term Expenditure Framework Modernized Treasury System Non-Bank Financial Institutions National Bank of Serbia National Mortgage Insurance Corporation of Serbia Non-performing Loans Privatization Agency Public Expenditure Institutional Review Public Financial Management Japan Policy and Human Resources Development Trust Fund Public Expenditure and Institutional Review Paris London Club First Programmatic Private and Financial Development Policy Credit Programmatic Private and Financial Development Policy CredivZoan Public Procurement Law Public Procurement Office Poverty Reduction Strategy Paper Public Service Contracts Private Sector Note Report on the Observance of Standards and Codes Stabilization and Association Agreement Supreme Audit Institution Structural Adjustment Credit Serbia and Montenegro Stabilization and Association Process Supervisory Development Plan Special Drawing Rights Serbia Economic Memorandum Small and Medium Enterprises Social Program Sale and Purchase Agreement State-Owned Banks State and Socially-Owned Enterprises Transition Fund Third Party Liabilities United Nations Development Program United States Agency for International Development United States Dollar Zeleznicko Transportno Preduzece - Belgrade Rail Company

Vice President: Shigeo Katsu Country Director: Orsalia Kalantzopoulos

Sector Director: Fernando Montes-Negret Sector Manager: Gerardo Corrochano

Task Team Co-Leaders: Itzhak Goldberg 1 Michael Edwards

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. -

SERBIA AND MONTENEGRO

FIRST PROGRAMMATIC PRIVATE AND FINANCIAL DEVELOPMENT POLICY CREDIT

CREDIT AND PROGRAM SUMMARY .................................................................................................. 1

......................................................................................................................... I . INTRODUCTION 3

................................................................................................................... . I1 COUNTRY CONTEXT 4 RECENT ECONOMIC DEVELOPMENTS IN SERBIA AND MONTENEGRO ........................... 4 MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY ............................................ 6

............................................................................................ I11 . THE GOVERNMENT'S PROGRAM 8

IV . BANK SUPPORT TO THE GOVERNMENT'S STRATEGY ..................................................... 11 LINK TO CAS ................................................................................................................................... 11 COLLABORATION WITH THE IMF AND OTHER DONORS ..................................................... 12 RELATIONSHIP TO OTHER BANK OPERATIONS .................................................................... 13 LESSONS LEARNED ....................................................................................................................... 14 ANALYTICAL UNDERPINNINGS ................................................................................................. 16

V . THE PROPOSED FIRST PROGRAMMATIC PRIVATE AND FINANCIAL DEVELOPMENT POLICY CREDIT ........................................................................................... 17 OPERATION DESCRIPTION ........................................................................................................... 17 POLICY AREAS ................................................................................................................................ 22

VI . OPERATION IMPLEMENTATION ............................................................................................. 41 ............................................................................................... POVERTY AND SOCIAL IMPACTS 41

........................................................ IMPLEMENTATION. MONITORING AND EVALUATION 42 .................................................................................................................... FIDUCIARY ASPECTS 43

................................................................................................ DISBURSEMENT AND AUDITING 44 ........................................................................................................ ENVIRONMENTAL ASPECTS 45

.................................................................................................... RISKS AND RISK MITIGATION 46

..................................................................................... AhWEX 1 : LETTER OF DEVELOPMENT POLICY 47 ANNEX 2: GOVERNMENT POLICY/OVERALL GOVERNMENT DEVELOPMENT PROGRAM ......... 53

..................................................................................................... ANNEX 3: PPFDPC-1 POLICY MATRIX 55 ANNEX 4: FUND RELATIONS NOTE ......................................................................................................... 61 ANNEX 5: KEY ECONOMIC INDICATORS ............................................................................................... 64 ANNEX 6: KEY EXPOSURE INDICATORS ................................................................................................ 66 ANNEX 7: STATEMENT OF LOANS AND CREDITS ................................................................................ 67 ANNEX 8: STATEMENT OF IFC'S HELD AND DISBURSED PORTFOLIO ............................................ 68 ANNEX 9: COUNTRY AT A GLANCE ......................................................................................................... 69 ANNEX 10: COUNTRY MAP (IBRD 3 1 506R2) ........................................................................................... 71

The First Programmatic Private and Financial Development Policy Credit was prepared by an IDA team consisting of Michael Edwards (Task Team Leader). Itzhak Goldberg (Task Team Co.Leader). Rodney Lester. Laura Ard (OPD); David Kennedy. Martin Humphreys (ECSIE); Michael Stanley (COCPO); Ilker Dornac (ECSPE); Csaba Feher (ECSSD); Alexander Pankov. Thomas Muller. Branko Radulovic. Anna Sukiasyan (ECSPF); Tijen Arin (ECSSD); Siew Chai Ting. Michael Gascoyne. Pascale Kervyn de Lettenhove. Olav Christensen (ECSPS). Gennady Pilch (LEGEC) .

CREDIT AND PROGRAM SUMMARY

SERBIA AND MONTENEGRO

FIRST PROGRAMMATIC PRIVATE AND FINANCIAL DEVELOPMENT POLICY CREDIT

Borrower

Implementing Agency

Amount

Terms

Tranching

Description

Serbia and Montenegro

Ministry of Finance (MOF) of the Republic of Serbia will be responsible for overall implementation of the proposed operation. Other key ministries and agencies responsible for implementation of the operation will include: Ministry of Economy (MOE), Ministry of Labor, Employment and Social Policy (MLESP), Ministry of International Economic Relations (MIER), Ministry of Energy and Mining (MEM), Ministry of Capital Investments (MCI), Privatization Agency (PA), Agency for Deposit Insurance (DIA), National Bank of Serbia (NBS), Elektroprivreda Srbije (EPS), and Zeleznice Srbije (ZS).

SDR 38 million (US$55 million equivalent) IDA credit

Modified IDA terms with a 20 year maturity, including a 10 year grace period, with no acceleration clause.

The full IDA credit is expected to be disbursed in a single tranche of US$55 million equivalent.

The proposed First Programmatic Private and Financial Development Policy Credit (PPFDPC-1) will be the first in a series of up to four programmatic Development Policy CreditsILoans (DPCL) designed to support a multi-year program of assistance to the Republic of Serbia to address key institution building and reform challenges in both private and public sectors.

The overall programmatic DPCL program aims to support sustainable economic growth and employment creation in Serbia. The objective of the PPFDPC-1 is to support Government of Serbia's (Government or GOS) actions in two broad areas: (i) strengthening the fiscal discipline in enterprise, energy and transport sectors, and attracting foreign direct investment (FDI); and (ii) building a more efficient and stable financial sector and improving access to finance.

The objective of the PPFDPC-1 will be achieved through reforms carried out by the GOS which are summarized in two pillars:

Pillar 1: Strengthening fiscal discipline:

Reduction of Ministry of Economy's subsidy program and strengthening the Transition Fund (TF) mechanisms for displaced workers; Privatization, restructuring and bankruptcy of socially-owned enterprises (SOEs); Strengthening the legal framework for mining concessions;

Benefits

Risks

Project ID Number

Agreeing upon a time-bound process for the interim restructuring of Elektroprivreda Srbije, Serbia's national electric power utility; and Beginning to rationalize the railway sector in accord with a time- bound plan.

Pillar 2: Building a more efficient and stable financial sector:

Privatization of state-owned banks (SOB) and divestment of financial assets; Strengthening the insurance sector regulation and resolution regime; Adoption by the National Bank of Serbia of the second phase of .

the Supervisory Development Plan (SDP) to address, inter alia, banking sector supervision, regulation and resolutions. Improving access to finance through adoption of a mortgage law.

The proposed PPFDPC-1 will aid the Government of Serbia to realize key economic growth related goals, as outlined in the Country Assistance Strategy (CAS) through: (i) strengthening fiscal discipline towards SOEs and developing an extraction industry legal framework so as to attract FDI; and (ii) improving the efficiency and stability of the financial sector through divesting state-owned financial assets and further developing capacity of the regulatory authority. The envisaged reform program would be consistent with the GOS's aspiration for eventual membership in the European Union (EU).

Implementation risks are likely to be high. The scope of institutional changes that the series of DPCIL operations seek to address are mostly of a medium-tern nature. The current capacity of some public sector institutions to implement an ambitious reform agenda, while much improved over the past few years, remains relatively weak. The execution risks will be mitigated through utilization of ongoing technical assistance (TA) provided by the Bank and bi-lateral donor community. In addition, support from active and proposed Bank projects in social protection, public sector administration will further serve to mitigate risks.

Domestic and external political risks remain high. These potential risks could include: (i) reform "fatigue" within the Government; and (ii) fluid political situation in Serbia, with possible early parliamentary elections.

The ambitious reform agenda that the programmatic DPCILs propose to support could create social and political stresses which might test the Government's commitment to reform ahead of the next round of elections. However, the domestic political risks are somewhat mitigated by the domestic consensus across the political spectrum towards eventual EU membership.

PO891 16

INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED FIRST PROGRAMMATIC PRIVATE AND FINANCIAL

DEVELOPMENT POLICY CREDIT TO SERBIA AND MONTENEGRO

I. INTRODUCTION

1. This Program Document presents the first in a series of up to four Programmatic Development Policy CreditsJLoans (DPCJL) operations to the Serbia and ~ontenegro' (SaM). As outlined in the FY05-07 Country Assistance strategy, the Bank's assistance in Serbia will concentrate on two parallel streams: (i) the development of a robust private sector through the Programmatic Private and Financial DPCJLs (PPFDPCJL); and (ii) the development of a smaller and more efficient public sector through the Programmatic Public Sector DPCJLs. The two streams of DPCJL are complementary and will address all three of the CAS goals: (i) creating a smaller, more efficient public sector; (ii) creating a larger private sector; and (iii) reducing poverty levels and improving social protection. The private sector DPCJL stream focuses on the first and second CAS goals, while the public sector DPCIL stream concurrently focuses on achieving the first and third CAS goals.

2. The proposed PPFDPCJL series is envisioned to build on three policy themes: (i) strengthening fiscal discipline through enhancing hard budget constraints and reducing subsidies; (ii) building a more efficient and stable financial sector; and (iii) improving the investment climate. Concurrently, the proposed Programmatic Public Sector DPCJL series is expected to support the Government's policy endeavors to (i) create a high quality, fiscally affordable public sector; and (ii) improve the allocative efficiency of public spending-both of which are crucial for growth, macro stability and the formalization of economic activity.

3. Under the umbrella of these objectives, the proposed First Programmatic Private and Financial Development Policy Credit (PPFDPC-I), in the amount equivalent to US$55 million, is envisioned to contain policy measures aimed at: (i) continued progress on restructuring and privatization of real and financial sector assets; (ii) restructuring and resolution of large loss-making state- and socially-owned enterprises; (iii) improved access to finance, particularly for the small and medium enterprise (SME) sector; (iv) energy sector restructuring; and (v) private participation in infrastructure, in particular strengthening the legal and institutional framework of the mining sector, which has a potential to contribute to significant FDI in Serbia.

4. The GOS is committed to carrying out the envisaged fiscal, financial and private sector related legal reforms, initially launched within the framework of previous Bank- supported operations, including the two prior private and financial sector adjustment credits

' Due to the highly devolved nature of the SaM union (most areas of economic policy are in the competence of the member republics) and the different starting points, needs and pace of reforms in the two republics, the Bank's assistance program for SaM is being designed around republic-specific operations. Therefore, for the purposes of this document, the term "Government" or "GOS" designates the Government of the Republic of Serbia, unless otherwise specified.

This report should be read in conjunction with the joint IBRDIIDAIIFC FY05-07 CAS for SaM presented to the Board on December 16,2004.

(PFSAC-I and PFSAC-11) and the structural adjustment credits (SAC and SAC-11). While substantial legal and structural reforms have been completed under these prior operations, further fiscal adjustment and renewed efforts on structural reforms are necessary to bolster macroeconomic stability and lay the foundation for sustainable growth. Divestiture of some of the large loss-making SOEs and overall strengthening of the fiscal discipline in enterprise, energy and transport sectors together with a more efficient and stable financial sector supported by the PPFDPC- 1 are key for the implementation of structural reforms that will reinforce sustainability of Serbia's macroeconomic stabilization.

11. COUNTRY CONTEXT

RECENT ECONOMIC DEVELOPMENTS IN SERBIA AND MONTENEGRO

5. Status of the IMF Program. The GOS's medium-term stabilization and reform program for 2002-05 has been supported by a three-year Extended Arrangement (EA), which was approved in May 2002 for a total amount of SDR 650 million. The arrangement was extended in May 2005 until December 31,2005. The IMF Executive Board concluded in late- June 2005 the Article IV consultation with Serbia and Montenegro and the fifth review of Serbia and Montenegro's economic performance under the EA.

6. The completion of the review enabled the release of an amount equivalent to SDR 125 million (about US$182.9 million), which brought the total disbursement under the program to SDR 587.5 million (about $US859.7 million). In completing the review, the IMF Executive Board also approved Serbia and Montenegro's request for waivers of four performance criteria. In addition, the IMF Executive Board completed a Financing Assurances Review and approved a request to re-phase the eleventh and final disbursement, which would become available upon the completion of the sixth review.

7. Real Economic Activity. GDP growth is estimated to have reached 7.2 percent- above the original projection of 4-5 percent-in 2004 led by a bumper crop in agriculture and solid industrial growth supported by output gains in recently privatized enterprises. Demand increase was led by a rise in consumption and investment induced by strong credit expansion and an estimated 11.2 percent average increase in real wages. Continued strong demand, coupled with growing exports, is projected to yield a GDP growth of 4-5 percent in 2005.

8. Price and Exchange Rate Developments. As a result of largely one-off factors- administrative price increases, higher oil prices, and tax increases-the inflation rate in Serbia rose to 13.7 percent (y-o-y) in December 2004. The upward trend in the inflation rate has continued during the first half of this year as retail prices rose by 17.2 percent (y-o-y) in August 2005. The introduction of the value-added tax (VAT),,increases in the municipal tariffs, and rising oil prices have been the main contributing factors to the rise in the inflation rate. Inflation was also driven by buoyant domestic demand on the back of rapid credit expansion and--during much of 2004-excessive wage growth. In August 2005, Serbia Dinar (CSD) depreciated against the Euro and US dollar (USD) by 14.5 percent (y-o-y) and 12.9 percent (y-o-y), respectively.

9. Against the backdrop of declining demand pressures coupled with more controlled increases in administrative prices and fees, end-period inflation is projected to decline to 12.3 percent by end-2005. Although risks to the projected inflation rate are to the upside, the envisaged corrective measures which, inter alia, include tighter fiscal policy stance, will support attainment of the end year target.

10. Fiscal Developments. Although fiscal policy was on track for most of 2003 (SaM's fiscal deficit of 3.3 percent of GDP was 1.2 percent below the target), it turned expansionary in the run-up to the December 2003 elections in Serbia. Since mid-2004, however, fiscal policy in Serbia has been tightened beyond program targets to contain the external imbalance and inflation. The authorities adopted a re-balanced budget for 2004 in order to offset the spending overruns on subsidies, wages and transfers (0.3 percent of annual GDP) during the first half of 2004 and to reduce the consolidated deficit for 2004 relative to GDP by 0.2 percentage points compared to the original program. According to preliminary data, this in turn led to a budget deficit for the entire year of CSD 4 billion, which is well below the original program target of CSD 32.7 billion. The supplementary 2005 budget, adopted in July, provides for a surplus of the consolidated general government of 1.2 percent of GDP compared to a deficit of 0.3 percent of GDP in 2004.

11. The 2005 Budget for Serbia targets a consolidated general budget surplus of 0.5 percent'of Serbia's GDP, suggesting that tight fiscal policy stance will continue during this year. In the context of the IMF-supported economic program, the authorities are envisaged to further tighten the fiscal policy stance to counter upward inflationary pressures and the higher- than-programmed current account deficit (CAD).

12. External Developments. Preliminary data for Serbia suggests that the CAD deteriorated further in 2004 compared to a programmed improvement of 10.8 percent of GDP (after grants). Preliminary figures indicate that Serbia's CAD (after grants) reached 13.1 percent of GDP due mainly to higher than projected trade deficit, which rose to 3 1 percent of GDP in 2004 from 23.6 percent of GDP in 2003. Higher oil prices and a one-off large increase in anticipation of the introduction of the VAT in January 2005 contributed to observed increase in imports. Preliminary figures for 2005 suggest that the trade balance is improving. In the first half of 2005, exports rose by 43 percent while imports declined by 5 percent compared to the pervious year (in dollar terms). Policy tightening coupled with the expected supply response reflecting acceleration of structural reform are expected to reduce the current account deficit (after grants) in 2005 to about 9.5 percent of GDP.

13. Private remittances remained strong at 17.2 percent of GDP in 2004, though FDI declined to 4.3 percent of GDP as a result of a slowdown in privatization in the first half of the year. Gross foreign reserves rose to US$4.3 billion (around 3.7 months of projected 2005 imports) at end-December 2004. The import coverage of international reserves is expected to increase to 4 months of prospective imports, reflecting a more prudent policy stance in the face of projected rise in external debt service arising from the expiration of grace periods under debt restructuring agreements.

14. The July London Club agreement, which has reduced SaM's debt to the London Club by 62 percent in net present value terms, lowered the country's overall debt burden by 7 percentage points of GDP. Although this development had a favorable impact on the debt

dynamics, the increase in mostly private foreign borrowing by 8 percent of GDP kept the external debt-to-GDP ratio at 62 percent at end-2004. As Serbia received its first rating at B+ from StandardLkPoors (S&P) in November 2004 and has recently been upgraded to BB-, it appears that the outside world regards economic policy as broadly on track.

MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY

15. Although the higher-than-projected CAD in 2004 warrants concern, SaM's medium- term prospects-based on strong implementation of ambitious reform plans as elaborated in the recent CAS-are favorable, with continued progress on key reforms leading to projected GDP growth averaging 5.4 percent per annum in 2004-08 (Table I ) ~ . The base case scenario that was articulated in the CAS contains the following elements: (i) a high quality fiscal adjustment (based on durable non-interest expenditure cuts) that enhances macroeconomic stability and boosts confidence in the policy framework, thereby stimulating private investment; and (ii) an acceleration of policy efforts aimed at improving efficiency, including privatization and enterprise restructuring, along with measures directed at improving competition and the investment climate.

Table 1 : SaM- Medium-tern Macroeconomic Prospects

Act. Act. Est. Proj. Proj. Proj. Proj. 2002 2003 2004 2005 2006 2007 2008

National Accounts

GDP (US$ millions) 11 15,528 20,665 23,996 26,591 28,319 30,485 32,682

Real GDP growth (%) 3.8 2.7 7.2 4.6 4.8 5.0 5.2 Investment (% of GDP) 16.0 16.1 17.6 18.4 19.8 21.2 21.6 Gross Domestic Savings (% of GDP) -7.3 -5.9 -11.3 -5.3 -3.2 -0.4 1.2

Public Sector Balance (as % of GDP)

Expenditures 47.7 46.0 45.5 43.7 43.8 43.7 43.6 olw public investment 3.4 2.5 2.7 2.4 3.8 4.2 4.3

Revenue before grants 43.1 42.7 45.2 44.8 43.8 43.5 43.3 Deficit before grants -4.5 -3.3 -0.3 1.2 0.0 -0.2 -0.3

External Accounts (as % of GDP)

Exports of goods and services Imports of goods and services

Current account balance, (millions of US$) 21 -1,384 -1,996 -3,148 -2,527 -2,790 -2,740 -2,706 Current account balance, as % of GDP 21 -8.9 -9.7 -13.1 -9.5 -9.9 -9.0 -8.3

Indebtedness (external debt)

TDOIXGS 31 TDOiGDP TDSIXGS 31

Prices

Retail price inflation (e.0.p.) 14.2 7.6 13.4 12.3 9.0 6.0 4.0

11 GDP estimates exclude Kosovo; 21 After grants; 31 Exports include workers' remittances and factor incomes.

Serbia's GDP accounts for about 90 percent of SaM's economy.

6

16. The envisaged fiscal adjustment will contribute directly to promoting growth and redressing macroeconomic imbalances. Non-interest current expenditures in relation to GDP are projected to decline from roughly 41 percent in 2004 to 37.6 percent in 2008, primarily reflecting reductions in the wage bill, subsidies, net lending and transfers. This adjustment should have a positive impact on expectations about the future stance of fiscal policy, thereby lowering the risk premium and paving the way for higher private investment.

17. Coupled with adjustments on the revenue side and an increase in public investment, the envisaged cuts in public expenditure as a share of GDP will contribute directly to promoting growth and redressing macroeconomic imbalances. During the period under consideration, further efforts to improve tax collection (supported, among other things, by implementation of bankruptcy legislation) and the introduction of VAT in January 2005 coupled with increase in transfers from profitable state-owned enterprises should boost public revenues. As the current high tax burden (tax revenues as a share of GDP) remains a barrier to private sector-led growth and to formalization of economic activity, any such gains in revenues are expected to pave the way for corresponding reductions in tax rates, particularly on labor. Together with the adjustment in public expenditure, this should have a positive impact on expectations about the future stance of fiscal policy, thereby lowering the risk premium and paving the way for higher private investment. By the same token, public investment, which has been low, is expected to increase during the projection period. In this way, the projected fiscal adjustment will be the cornerstone of the country's efforts to lay the foundations for enduring growth and macroeconomic stability over the medium term.

18. Greater confidence will help to reverse the observed increase in inflation in 2004, while an improved public savings-investment balance, coupled with structural reforms, is expected to have a favorable impact on the current account balance. With greater confidence in the policy framework (reflecting, among other things, the envisaged fiscal adjustment) and prudent monetary policy, inflation is projected to decline steadily to 4 percent in 2008. Concurrently, improvements in the public savings-investment balance and in the competitiveness of the economy should help reduce the CAD (after grants) from 13.1 percent of GDP in 2004 to below 9 percent by 2008.

19. Attaining the noted macroeconomic framework will involve significant financing requirements, particularly because of rising debt service payments4. Gross external financing requirements are projected to be around USD 5-6 billion per annum. With the envisaged improvement in the fiscal balance during the projection period, these financing needs will shift from the public to the private sector, as the expected fiscal retrenchment will leave more room for the private sector to tap domestic and foreign markets at favorable terms. FDI is projected to finance 35 percent of total needs in 2005-08, while long-term loans from multilateral, bilateral, and other creditors are projected to account for 48 percent. The remainder will be covered by other capital inflows (short-term credits, capital not-elsewhere included, and errors and omissions).

Serbia's implementation performance of the above summarized reform agenda will have important consequences for the sustainability of its public debt

7

20. Serbia's implementation performance of the above summarized reform agenda will have important consequences for the sustainability of its public debt. In this connection, the two illustrative scenarios considered in the recent Serbia Economic Memorandum (SEM) can be illuminating. Thefirst scenario, which aims to illustrate the trajectory of the Serbian economy under strong policy efforts, including the following key underlying elements such as: (i) a high quality fiscal adjustment; (ii) a rapid increase in productivity resulting from structural reforms, privatization, and enterprise restructuring; (iii) an improvement in export performance; and (iv) strong external inflows including significant FDI. The second scenario, on the other hand, aims at demonstrating the implications of unsatisfactory progress with the implementation of structural reforms in 2004 and onwards. Under this scenario, the GOS attempts to maintain both the current fiscal policy (through keeping the level and structure of spending relatively constant) and monetary policy stances.

2 1. The strong growth performance under the first scenario would arise from a robust private sector response engendered by reforms to improve the business climate and the permanent fiscal adjustment, which would lead to greater confidence in the policy framework. Under this scenario, the combination of strong economic growth, permanent fiscal adjustment, and lower interest rates would lead to a favorable debt sustainability outlook as evidenced by the declining debt to GDP ratio (Figure 1).

22. Under second scenario, On Figure 1: The Evolution of Public Debt Under Two Illustrative Scenarios

the other hand, a mixture of poor fiscal perfomance, low growth- *----- arising from the unsatisfactory implementation of structural reforms and the failure to attain a

50

high quality fiscal adjustment-and high interest rates would lead to an 40

unsustainable path for public debt, which would reach over 73 percent of GDP by 201 0. This, in turn, --s Scenano 2

would erode the country's creditworthiness and leave the economy highly exposed to adverse 2010

shocks, thereby rendering the Source Serbla Econom~c Memorandum (2004)

economy more prone to a financial crisis. Clearly, such a policy environment would not be conducive to pursuing Serbia's social agenda.

111. THE GOVERNMENT'S PROGRAM

23. As stressed in the CAS, whilst GOS has made good progress in containing the accumulation of hidden fiscal deficits, consolidated public spending has steadily increased. These fiscal deficits threaten growth and macroeconomic stability by: (i) keeping taxes and interest rates high, thereby crowding out private.activity, discouraging private investment and encouraging the informal sector; and (ii) reducing fiscal flexibility in the event further adjustments are later needed. Pillar 1 of the proposed PPFDPC-1 operation aims to break the

vicious circle of a fiscal deficit fueled, inter alia, by subsidies which, in turn, delay real sector restructuring, hence requiring continued subsidization. Stricter fiscal discipline will not only be necessary to attain permanent fiscal adjustment, but is required to promote the restructuring of the real sector. There was a very sizeable reduction in the deficit of the consolidated general government in 2004 (3 percentage points of GDP). However, most of this reduction reflected buoyant revenues owing to strong economic growth rather than efforts to contain spending. Looking forward, the rationale for further fiscal adjustment is not only based on "fiscal deficits that threaten growth and macroeconomic stability", but also on the need to compensate for the expected further deterioration in the private sector's saving-investment balance by generating a further improvement in the public sector's saving-investment balance.

24. The lessons of experience show that fiscal discipline promotes restructuring because hardening the budget constraint persuades all parties - unions, workers, managers - that the present situation is unsustainable. In other transition economies, hardening budget constraint has proven key for putting the assets, including real estate, of loss-makers back to productive use. This has been especially helpful to the important SME sector, where entrepreneurs are in particular need of the land and storefronts, as well as other assets, so often controlled by non- productive large firms. In particular, the entry, market access and access to credit of SMEs are crowded-out by un-restructured enterprises that continue to function in a soft budget environment.

25. The GOS continues to provide substantial financial support to public, state-owned and socially-owned companies. The 2005 budget allocates a total of CSD 32 billion to subsidies for non-financial public corporations, representing 7 percent of the total budget expenditure. Major recipients of subsidies include enterprises in the agricultural sector (CSD 11 billion), the railway (CSD 8.5 billion), socially-owned enterprises (CSD 5 billion), and public media (CSD 2.8 billion). In addition to these direct subsidies, companies receive a variety of indirect subsidies through un-enforced arrears on utility charges, social contributions, taxes and credits from state-owned banks. Yet, the GOS now recognizes that continued subsidization is unsustainable and that a reallocation of funds from direct subsidies, financing wages and other working capital is essential to finance severance payments, which accelerate the restructuring efforts.

26. The Government's on-going commitment to the ambitious program for privatizing and restructuring socially-owned enterprises is the sine qua non condition for sustainable growth. Substantial progress has been achieved though auction and tender privatization. Yet, an acceleration of the restructuring of large SOEs is an important challenge. Among the prerequisites to achieving such acceleration are the recently adopted amendments to the Privatization Law, prescribing new rules for restructuring of debt to state creditors. Furthermore, the implementation of the new Bankruptcy Law is essential to move restructuring ahead. Building the capacity of the Privatization Agency to act as bankruptcy administrator of insolvent state- and socially-owned enterprises is an important priority.

27. The GOS, supported by the Bank and other donors, took several major steps to improve the Republic of Serbia business environment in 2004, including the adoption of business-related laws. Previous Bank operations supported wide range of reforms covering business entry, operations and exit. These reforms improved the regulatory and institutional framework for business entry through improving the registration system; facilitating efficient

operations of business through reforming the Company Law, and enforcement procedures, building institutional capacity for regulatory reform, and improving enterprises' access to finance through the creation of the leasing and pledge registry; and reducing barriers to the efficient exit and redeployment of non-productive assets through the introduction of the Bankruptcy Law and helping the creation of the institutional capacity in this area. As a result of the improved investment climate, the number of new registrations jumped 42 percent between first quarter of 2004 and first quarter of 2005. As a result new "Doing Business in 2006: Creating Jobs" places Serbia at the top of the list of reformers. While this progress is impressive, Serbia still lags behind other transition economies, thus hurting its ability to attract FDI.

28. Attracting FDI is another priority on GOS priority agenda. Most of Serbia's FDI since 2001 occurred through privatization of SOEs. An increasing interest by foreign investors in Serbia's mineral resources could bring much needed "greenfield" FDI. To further realize the sector's potential, the GOS plans to undertake reforms to transition the state from a role of owner-operator of mineral assets to that of regulator and sector administrator. In particular, the Government has to: (i) ensure that investors are fairly treated and the envisaged royalties framework is able to attract private investment by adhering to international standards regarding competitive taxation, banking, and customs; and (ii) build the capacity to serve within a regulatory role in accordance with the mining sector's specific requirements.

29. The restructuring of EPS is another key component of tightening fiscal discipline in the economy. Following a 10 percent power tariff increase in mid-2004 and strengthening of the sector social safety net, and passage in the third quarter of 2004 of the Energy Law, an Energy Strategy was adopted by the GOS. The Government also made a decision whereby EPS will be unbundled into two successor companies (an integrated generation and distributionlsupply company, and a separate transmission company), and adopted a plan for restructuring of the . underground coal mining sector. Regarding tariffs, a 2005 tariff increase will be required to maintain cost recovery. To this end, EPS was recently authorized a tariff increase of 10% effective on July 1.

30. The railway is the largest public utility and imposes a high fiscal cost on the budget and its early restructuring is critical. The core of the proposed reform in the railway sector is the new Railway Law, passed in March 2005, required the reorganization of the Belgrade Rail Company, or Zeleznicko Transportno Preduzece (ZTP). In accordance with the law, a new railway entity, Zeleznice Srbije, was established, to which the operating assets of ZTP have been transferred. In addition, ZS has prepared a new five year restructuring plan, which will be followed by a new five year business plan for 2005-2009, with technical assistance from EBRD and input fi-om the World Bank.

3 1. Over the past four years, Serbian authorities have improved greatly the legal and institutional framework providing for a general social safety net. Three main unemployment programs are now in effect: cash unemployment benefits, active labor market programs, and severance payments. Serbia's Labor Market Bureau offers a wide range of active labor market programs, although, inadequate funding and staffing erode their effectiveness. Programs include advisory and mediation activities targeted to jobseekers (such as vacancy notification and vacancy and job fairs), training and retraining, special employment programs for the disabled, and entrepreneurship assistance.

32. In March 2002, the GOS adopted a Social Program (SP) providing a range of compensation and redeployment options for workers in large SOEs dismissed due to restructuring and privatization. Retrenched workers could receive a package worth, on average, about Euro 2,000. This sum is quite generous relative to the packages given to workers in companies outside the SP. Under this scheme, dismissed workers receive about three times the minimum specified in the Labor Law. However, it is less generous than packages offered to facilitate large-scale restructuring in other transition economies. Moreover, it is relatively less generous than similar inducement schemes adopted in privatization programs in Asia and Latin America, the long-term effects of which have generally been assessed as positive. An amended draft SP is now being discussed by the GOS. The main changes in comparison to the existing SP are the following: (a) defining the lump sum severance payment under the SP in Euro terms, Euro 100 per recorded year of work history; (b) introducing contribution and tax waivers for companies employing people laid off by companies qualifying for participation in the SP; (c) introducing the option of an in-kind severance benefit; and (d) the option of investing inlpurchasing a workplace for a limited period of time.

33. After a rather protracted start, the GOS as shareholder, acting through the Agency for Deposit Insurance (formerly Bank Rehabilitation Agency or BRA), simultaneously began to strengthen its monitoring of banks and the process of merging and divesting its bank holdings. The first majority state-owned bank was sold in January 2005; two other state-owned banks are currently under contract with foreign buyers and along with a smaller bank, the largest majority state-owned bank is slated to be offered for sale in late 2005. The DIA's offering of financial assets (loans and private enterprise equity stakes) has been similarly delayed, though the first such asset offering has recently been launched.

34. In parallel, the NBS initiated a series of steps beginning in 2001 to begin to modernize the regulatory and supervisory framework for banks and more recently, the insurance sector. Despite recent progress in aligning banking sector regulations with best practice, the compliance with the Base1 Core Principles is still highly unsatisfactory.

35. Current limited access to medium and longer term finance and high overall cost of financing present a major challenge for the development of the financial and enterprise sectors in Serbia. In an effort to address these recognized deficiencies, the GOS is currently preparing a draft Mortgage Law, which would improve existing arrangements for valuing collateral and enforcing mortgages and overall aid in the further development of residential mortgage finance.

IV. BANK SUPPORT TO THE GOVERNMENT'S STRATEGY

LINK TO CAS

36. The FY05-07 CAS for SaM sets the strategic context for the programmatic DPC/L program in three overarching country goals aimed at: (i) creating a smaller, more sustainable, more efficient public sector; (ii) creating a larger, more dynamic private sector; and (iii) reducing poverty levels, and improving social protection and access to public services. The CAS envisages up to four DPC/L operations: PPFDPC-1 and PPSDPL-1 in the base case and

PPFDPCIL-2 and PPSDPL-2 in the high case5. The two streams of DPCIL are complementary and will address all three of the CAS goals. The private sector DPCIL stream focuses on the first and second CAS goals, while the public sector DPCIL stream concurrently focuses on achieving the first and third CAS goals.

37. This PPFDPC-1 credit would be the first in a series of four Programmatic Development Policy CreditsILoans designed to support the Government's economic reform program over a two year period. This operation is funded on full IDA terms as SaM's eligibility for access to IBRD resources has not yet been determined.

38. PPFDPC-1's objectives are consistent with the key objectives and expected outcomes during this CAS period under Goal 2 through: (i) continued progress on restructuring and privatization of real and financial sector assets; (ii) restructuring and resolution of large loss- making state- and socially-owned enterprises; (iii) improved access to finance, particularly for the SME sector; (iv) energy and rail sector restructuring; and (v) private participation in infrastructure, in particular strengthening the legal and institutional framework of the mining sector, which has a potential to contribute to significant FDI in Serbia.

39. Thereafter, consistent with Goals 1 and 3 of the CAS, the proposed FY06 First Programmatic Public Sector Development Policy CreditILoan operation envisages policy measures designed to foster: (i) reduction of the public sector wage bill as a share of GDP; (ii) reduction of social transfers as a share of GDP; (iii) strengthening public administration; and (iv) enhancing efficiency of public spending.

40. Going forward through the CAS period, the envisaged PPFDPCIL-2 would be designed to address the remaining, unfulfilled aims of Goal 2, such as: (i) eliminating any residual constraints to fiscal discipline as its regards subsidies provided to the SOE sector and improving the business environment and existing social safety net for redundant workers of sold or restructured state-owned enterprises, rail and utilities sectors; (ii) further measures needed to strengthen the bank and non-bank financial sector (including capital markets and insurance) and its regulatory regime, with the clear aim to displace government as the owner (majority or minority) of banks and insurance companies. Altogether, these follow-on reforms should result in strengthening Serbia's bid for eventual EU membership. A number of potential PPFDPCIL-2 triggers and programmatic DPCIL program outcomes are featured in the Policy Matrix (Annex 3).

COLLABORATION WITH THE IMF AND OTHER DONORS

41. The success of reforms in Serbia over the past four years was substantially stimulated by the effective collaboration and coordination between the Bank and other key donors. The Bank has maintained a robust dialogue with the donor community in Serbia in order to avoid duplication of efforts and leverage support for the GOS' reforms.

42. During the preparation of PPFDPC-1, the Bank has maintained close working contacts with the IMF and other donors assisting the GOS in the private, financial, energy, and

High case lending triggers, outlined in Table 6 of the CAS, include implementation of agreed public administration reforms, accelerated progress on the divestment of state-owned bank and financial asset holdings, improvements to the business environment and implementation of energy sector reforms.

railway sectors for the purposes of harmonizing policy recommendations, seeking synergies among the respective operations, and avoiding overlaps. Initial consultations with the IMF have centered around the main components of the proposed operation and the Bank's dialogue with GOS on the proposed reform. The IMF is supporting the GOS through a three-year '

Extended Arrangement in the amount of SDR 650 million, initiated in May 2002. Both the IMF and the Bank, along with the donor community, share the goals of achieving a higher degree of fiscal discipline and strengthening the financial sector through the continued implementation of structural reforms.

43. The GOS has received a PHRD grant from the Government of Japan for the preparation of this operation. Close coordination has been on-going with the US Treasury advisors on the reforms in banking and insurance sectors; with USAID on banking supervision reform; and with the EAR on advancing privatization of SOEs with the objective to strengthen fiscal discipline.

RELATIONSHIP TO OTHER BANK OPERATIONS

44. The private sector stream of the Programmatic Development Policy CreditsILoans program (the proposed PPFDPC-1 and in the high case, the PPFDPC/L-2) follow closely from a successful series of two consecutive Private and Financial Sector Adjustment Credits. The PFSAC-I, with a total commitment of USD 85 million, was approved in May 2002 and closed in June 2003 with a highly satisfactory outcome. This credit focused on putting in place the initial reforms in the following five areas: (i) banking sector reform; (ii) reform of socially-owned enterprises; (iii) bank asset and enterprise workouts; (iv) financial sector regulatory and supervisory framework; and (v) business environment reform.

45. The recently closed PFSAC-11, with a total commitment of USD 80 million, put in place the medium-term reforms agreed upon in PFSAC-I. The overall objective of PFSAC I1 was to support the GOS' program of regulatory, institutional, and structural reforms seeking to significantly accelerate private sector growth through: (i) improving the business enabling environment by means of comprehensive reform of enterprise entry, operation and exit; (ii) strengthening the financial system by improving the environment under which banks and other financial intermediaries operate; (iii) privatizing and/or liquidating outdating majority state-owned banks that fail to fulfill their role of financial intermediaries; and (iv) privatizing and restructuring socially-owned enterprises that crowd out private sector growth, hamper banking sector recovery, and incur significant fiscal and quasi-fiscal costs. One of the key achievements of the PFSAC program was the reduction of the time to register a limited- liability company in Serbia from 70 days in 2001 to 40 days in 2003 and to less than 10 days in 2005, the latter following the introduction of a new business registration system, one of the most modem and streamlined in Europe.

46. Implementation of the PFSAC program profited considerably from and was facilitated through two grants, the Private Sector Development Technical Assistance (PSD TA) grant and Financial Sector Development Technical Assistance (FSD TA) grant. The grants provided technical assistance in institutional capacity building for the Privatization Agency, Agency for Deposit Insurance, Agency for SME, and Serbian Investment and Export Promotion Agency.

47. The on-going Privatization and Restructuring of Banks and Enterprises Technical Assistance Credit builds on the reforms launched in the PFSAC program and supported through PSD and FSD TA grants, and aims at facilitating the private sector growth, in particular through (i) restructuring and privatization and bankruptcy of large problematic SOEs; and (ii) implementation of a comprehensive banking and insurance sector restructuring strategy targeted at creating a more viable financial sector.

48. In addition to the reform dimensions outlined in both PFSACs, the Structural Adjustment Credit (SAC) program, implemented through SAC, SAC II and SOSAC has also laid a foundation for implementation of the envisaged PPFDPC-1 reforms. In particular, the recently closed SAC-I1 focused on: (i) improving the business climate; (ii) institutional development and improving performance within the energy sector; (iii) strengthening social protection; and (iv) improving public administration. The SOSAC supported the GOS in implementing reforms in social protection, labor, and health with the objectives to: (i) reduce short- and medium-term fiscal pressures from social programs, through a combination of entitlement reform, and efficiency improvements; and (ii) maximize the poverty alleviation impact of a given level of public spending, through improved targeting of, and sustained access for the poor to services.

49. The planned Bor Regional Development Project, which is expected to be presented to the Board in FY07, following the successful completion of the tender for copper mining and processing conglomerate of RTB Bor, pursues objectives that are cross-reinforcing with those of PPFDPC-1, as RTB Bor is one of the two single largest recipients of GOS subsidies among socially-owned enterprises.

LESSONS LEARNED

50. The PPFDPCILs have built upon the experience accumulated during the preparation of PFSAC I and 11 that started in November 2000, about 30 days after the Serbian "velvet" revolution. Significant volume of analytical work and technical assistance preceded the first policy operations SAC I and PFSAC I. The PFSAC experience has demonstrated that an integrated approach is needed to reform of the financial and enterprise sectors in parallel. Under the earlier PFSAC-I and I1 programs, financial sector reform aimed to boost financial intermediation, encourage domestic savings and generate much needed liquidity to support real sector expansion. Concurrently, the continued privatization of socially-owned enterprises (and more recently, banks) and the adoption of early measures to strengthen the business climate drew in increased foreign investment in 2005.

5 1. A key lesson from other transition experiences and from the first four years of transition in Serbia is the need for sequencing: the initial steps should be the immediate goals of price liberalization and fiscal stability, followed by structural reforms in industrial enterprises and banks and, only then, in the third stage, pursue reforms in utilities, non- banking institutions and capital markets. Moreover, due to the political economy of post- conflict Serbia, it was important to start enterprise privatization with sellable companies - or "early wins" - and only later move onto restructuring of the politically sensitive large loss- makers. The focus of the three stage sequencing must include lessons on the timing and design of social policies aimed at directly addressing poverty reduction and mitigating some of the adverse social impacts potentially caused by the three transition stages. In parallel, from the

start of the reforms, long-term efforts should be undertaken which are aimed at creating a robust, transparent regulatory and institutional framework for utilities, financial markets and the business environment. In the case of utilities, privatization should be preceded by unbundling and commercialization on the basis of an appropriate market structure; moreover, the negative experience of some transition countries forewarns that the proper preparation is required to attract interest from international considerable, reputable strategic investors. Continued pursuit of these aims will need to be closely aligned and sequenced with GOS' efforts to provide adequate social protection for those displaced by the envisaged restructurings andlor privatizations.

52. Reform implementation is heavily dependent upon an effective champion who takes the early 'ownership' of the reforms sought. Equally, it is important that the domestic reform champions are well advised as to the positions assumed and actions taken. For example, the willingness of key counterparts at NBS and MOF to take key decisions, inter alia, to significantly reign in regulatory forbearance, take additional robust measures to further strengthen the bank and insurance regulatory regimes, withdraw licenses of banks and insurers and offer a number of state-owned banks and assets for sale has enabled key elements of the financial sector reform agenda to be advanced. Similarly, the effective management of the enterprise privatization process by MOE and PA facilitated progress in the reforms of the socially-owned sector.

53. The ability to provide extensive technical assistance on a timely basis has been crucial to enabling the PFSAC-I and I1 operations to achieve their objectives. The early provision of substantial grant funding and the effective coordination by the Bank of support from bi-lateral donors (notably EU, DFID and USAID) for the earlier (and on-going) reform agenda proved critical for developing institutional capacity at the DIA, PA and NBS to implement early high impact measures.

54. Good economic sector work (ESW) contributes significantly to a robust dialogue with counterparts and successful adjustment operations. In 2004 the Bank presented the GOS a number of key papers: the Serbia Economic Memorandum; the Financial Sector Note (FSN); the Investment Climate Assessment (ICA); the Private Sector Note (PSN); the Poverty Reduction Strategy Paper (PRSP); and in December, the Country Assistance Strategy. To aid in shaping the envisaged PPFDPC-1, in mid-2005 the Bank disseminated a number of other key reports, namely the Fiduciary Assessment Update, Public Expenditure Review, Accounting and Auditing Report on Observance of Standards and Codes (ROSC) and Financial Sector Assessment Program (FSAP) reports.

55. Finally, it is important to note that Serbia differs from most other transition economies in two ways. First, its system of socialism, based on worker management and the concept of "social capital," did not entail classic central planning; and secondly, due to the break-up of the former Yugoslavia and the resulting conflict and sanctions, Serbia was relatively late in embarking on the journey to a full-fledged market economy. These factors meant that the fundamental transitional task of reforming banks and enterprises had to be adjusted to these different initial conditions: auctions replaced voucher privatization (differently from other transition economies), the four largest state-owned banks were closed and finally, the approach to restructuring of utilities and of the largest loss-makers has been more gradual than that of the early reformers.

ANALYTICAL UNDERPINNINGS

56. The PRSP rightly emphasized that improvements in the business environment are key preconditions for sustainable private sector-led growth. The strategy for Serbia acknowledges the need for streamlining the registration process, reducing administrative barriers to business operation, improving corporate governance, and establishing a modem bankruptcy regime. Similarly, comprehensive reform of the financial sector represents an important cornerstone of governments' growth strategy. The Serbian PRSP correctly identifies the short- to medium- term actions needed to strengthen bank supervision, restructure and privatize remaining state- owned banks, and improve access to finance. With proper implementation, these reform steps should help significantly in allowing the Serbian financial system to play its proper role in channeling resources into productive investments.

57. In the energy sector, the PRSP notes that Serbia needs to move towards a more cost- reflective tariff structure. In the transport sector, the government strategy underscores the importance of the road transport sector in infrastructure investment. Efforts to improve railways, ports and marine transport and rural roads, the condition of the main and secondary road networks also require considerable improvement.

5 8 . The PPFDPCIL program heavily relies on findings of the extensive economic sector work undertaken by the Bank. The policy recommendations integrated into the relevant components of the PPFDPCIL are stemming from the three key documents - PSN, ICA and an accompanying FSN, - as well as other diagnostic work by the Bank and other institutions.

59. According to an empirical analysis in the ICA and the PSN, private firms are more productive than socially-owned firms, i.e. ownership matters. But post-privatization performance does not necessarily show that privatization improves firm performance; rather it may indicate that only the better, higher potential firms get privatized first. The results for new entrants, however, are unambiguous: new private firms in Serbia are more productive, more profitable, and growing more rapidly than socially-owned firms. The problem is simply that there are not enough of them. Although the new private firms are better performers, their scope for growth, and the possibility of entry by new entrepreneurs, are severely limited by the deficient investment climate. The implementation of recently drafted legislation aimed at improving business entry, corporate governance, access to finance, and business exit requires long and extensive institutional building to take effect.

60. Despite the impressive reform progress described above, the FSN demonstrates that Serbia's financial sector remains underdeveloped by regional benchmarks, and the existing level of financial intermediation is unable to fully contribute to economic growth. The bank- by-bank performance analysis presented in the FSN shows that the cost, profit and other efficiency parameters of Serbian banks have more in common with the non-Baltic countries of the former Soviet Union than with the neighboring Central European economies. Moreover, the best quartile of Serbian banks, while clearly outperforming the rest of the banking system, accounts for only a minority of total banking system assets. Narrowing the efficiency gaps between the better and the weaker Serbian banks, and between the better Serbian banks and the leading CEE and EU banks, will be the key to increasing the level of financial intermediation in Serbia. This requires creating the conditions under which the weaker banks lose ground rapidly to the better banks either through the liquidation of the weaker (mostly

state-owned) banks, or their rapid re-invention, through new strategic investment. In parallel, the development of non-bank financial institutions (NBFI), such as insurance companies, could offer a broader array of intermediary services and instruments, often unavailable from banks.

V. THE PROPOSED FIRST PROGRAMMATIC PRIVATE AND FINANCIAL DEVELOPMENT POLICY CREDIT

OPERATION DESCRIPTION

6 1. The PPFDPC-1 , the first of up to four development policy lending operations envisaged under the FY05-07 CAS, is designed to strengthen fiscal discipline in enterprise, energy and transport sectors and develop a more efficient, stable financial sector. Through putting in place a well targeted, key set of irreversible structural reform measures, the following development objectives are sought: (i) permanently reduce subsidies and staffing levels at SOEs and public utilities, thereby facilitating their restructuring and ultimate privatization; (ii) improve the legal and regulatory framework for the mining industry so as to attract green field FDI; (iii) substantially divest the government's remaining holdings in the banking and insurance industries; (iv) further strengthen the financial supervisory regime; and (v) provide new opportunities for access to longer-term real estate mortgage finance. A summary of agreed PPFDPC- 1 prior actions are included in the Policy Matrix (Annex 3) and the agreed conditions are featured in the Box 1 below.

Box 1. Conditionality for PPFDPC-1

The GOS has agreed upon and implemented the following prior actions before the presentation of the credit to the Bank Board of Directors:

1. The macroeconomic policy framework of the Borrower and the Republic of Serbia is satisfactory, as measured on the basis of indicators agreed between the Borrower and the Republic of Serbia, and the Bank.

2. (a) The Government of the Republic of Serbia has proposed to the Parliament of the Republic of Serbia to decrease the direct subsidies to socially-owned enterprises undergoing restructuring from CSD 5 billion, allocated for such purposes in the 2005 State Budget, to CSD 3.85 billion in the 2006 State Budget.

(b) The Government of the Republic of Serbia has agreed to make available CSD 4.5 billion from the Transition Fund for severance payments to employees of socially-owned enterprises, such enterprises having been set forth in the list agreed upon by the Bank.

3. Starting December 1, 2004: (i) the Privatization Agency of the Republic of Serbia has offered for sale no less than eighteen socially-owned enterprises and sold at least nine socially-owned enterprises through its tender program; (ii) the PA offered for sale through auctions no less than 180 socially-owned enterprises, and sold at least 40 percent of such socially-owned enterprises; (iii) the PA has offered for sale no less than eight socially-owned enterprises, or significant parts thereof (i.e., representing no less than 50 percent of the total assets), from the list of enterprises undergoing restructuring, using, as applicable, tenders, auctions and asset sales procedures, and sold at least three socially-owned enterprises set forth in the restructuring list; and (iv) Republic of Serbia owned or controlled creditors have requested the courts of the Republic of Serbia to initiate bankruptcy proceedings for at least six large state owned enterprises set forth in the restructuring list.

4. The Government of the Republic of Serbia has submitted to the Parliament of the Republic of Serbia amendments to the Law on Mining, satisfactory to the Bank, incorporating a new royalties framework.

Box 1. Conditionality for PPFDPC-1 (continued)

5. The Government of the Republic of Serbia has launched an international tender to engage a financial advisor for Elektroprivreda Srbije, in accordance with terms of references and procedures satisfactory to the Bank.

6. Zeleznice Srbije has reduced ZS staff engaged in core ZS activities by 1900, or 7.2 percent of total ZS core staff of 26,212 employed as of January 1,2005, and ZS and the Government of the Republic of Serbia have adopted the 2005 Business Plan, satisfactory to the Bank.

7. The Agency for Deposit Insurance of the Republic of Serbia has offered for sale, on behalf of the Government of the Republic of Serbia, a majority (i.e., more than 50 percent) of Vojvodjanska banka shares.

8. The amendments to the Insurance Law have been enacted, and are satisfactory to the Bank.

9. The Supervisory Review Committee of the NBS Banking Supervision Department and the Governor of the National Bank of Serbia have adopted the second phase of the Supervisory Development Plan, satisfactory to the Bank, and the NBS Banking Supervision Department has continued its implementation.

10. The Government of the Republic of Serbia has submitted to the Parliament of the Republic of Serbia a draft Law on Mortgage, satisfactory to the Bank.

62. Strengthening Fiscal Discipline. The GOS continues to provide substantial financial support to state-owned (mainly the railroads) and socially-owned companies, representing 2.4 percent and 1.1 percent, respectively, of the total budget expenditure. These subsidies create disincentives to the restructuring of the state- and socially-owned enterprises and contribute to the persistence of the fiscal deficit in Serbia. In addition to these direct subsidies from the government budget, companies occasionally receive indirect subsidies in the form of un- enforced arrears on utility charges, social contributions, taxes and credits andlor forbearance from state-owned banks.

63. The GOS has undertaken early efforts to reduce the overall direct subsidies to socially- and state-owned enterprises in the Serbian economy in order to signal that it will not provide indefinite support to the loss-making companies, and to stimulate the restructuring of those companies and their privatization. To this end, the 2005 budget included a reduction of the MOE direct subsidies to socially-owned enterprises in the process of restructuring from CSD 6.5 billion in 2004 to CSD 5 billion in 2005. Further decreases are envisaged in 2006 as discussed below. In parallel, the GOS is to increase the allocation to the Transition Fund in order to facilitate severance of redundant labor, which both spur restructuring and increase privatization prospects. Finally, while recently there were first signs of the strict enforcement of disconnection policies towards worst offenders, the GOS has to make further concerted efforts to block this subsidy route. To this effect, the MOE in cooperation with the tax authorities and main utilities needs to improve monitoring system for the large SOEs in order to ensure the full enforcement of hard budget constraints and to prevent further accumulation of arrears.

64. Privatization, Restructuring, and Bankruptcy of Socially-Owned Enterprises. Continued existence of a large SOE sector requiring public support imposes considerable risks of disrupting fiscal discipline and represents one of the main challenges facing the Serbian economy today. Most of the sector remains inefficiently organized, loss-making, and

excessively indebted. SOEs continue to benefit from non-competitive regulations, blocking potential competition from the private sector.

65. Over the past four years, the authorities have achieved significant progress in pursuing an ambitious, multi-track privatization program aimed at divestiture of socially- owned assets. The Government is committed to complete, to a large extent, the privatization program started in 2001 by offering for sale all SOEs currently in the PA tender and auction portfolio, and all saleable assets from the restructuring portfolio. In particular, the restructuring and subsequent privatization of large loss-making SOEs are expected to accelerate with the passage of the amendments to the Privatization Law related to debt restructuring. For SOEs that fail to attract reputable buyers, bankruptcy procedures will be initiated under the new insolvency regime.

66. Concessions. Serbia needs to continue strengthening its legal and regulatory framework and appropriate implementing institutions that will support further inflow of FDI. So far, the bulk of Serbia's FDI since 2001 occurred through privatization of SOEs. However, concessions could bring much needed "greenfield" FDI. The first major step in improving regulatory environment was the adoption of the "framework" Concessions Law in 2003. However, for its implementation sector-specific laws and institutional framework are very important. In the area of research and exploitation of mineral ores, the legal and regulatory framework conducive to private sector investment is generally defined in the Law on Mining (1995) and Law on Geological Exploration (1995). Recently, an effort to improve the existing framework by amendments to both of these laws has begun. In addition, the GOS has yet to define an overarching sector strategy towards mining in Serbia and to establish clear rules regarding royalties.

67. Energy Sector. Following the third quarter 2004 passage of the Energy Law and strengthening of the energy sector social safety net, a number of measures to support energy sector reform were undertaken in late 2004. In particular, an energy strategy was adopted by the GOS, members of the board of the new energy regulator have been proposed to the Parliament and the Government agreed to unbundle EPS into two successor companies and to adopt a longer term plan for restructuring. Additionally, EPS was granted a tariff increase from July 1,2005 in order to maintain cost recovery.

68. Railway Sector. Serbian Railways ZS (former ZTP) has a network of 3,809 route km, of which 1,724 krn are mainline and 1,247 are electrified. The former ZTP was heavily loss- making. In 2003, subsidies provided 63 percent of total revenue, while freight and passenger businesses provided only 25 percent and 9 percent, respectively. On the expense side, labor accounted for 30 percent (55 percent of expenses requiring cash), while depreciation was 47 percent. ZTP had produced an operating loss of CSD 11 billion in 2003. The subsidy of CSD 10.2 billion was sufficient, however, to allow ZTP to cover its cash operating costs. ZTP had poor resource productivity. Labor productivity (measured by traffic units produced per employee) and network density (measured by traffic units per track-km) are both much lower than railways with similar traffic. The management of former ZTP had recognized this, and has developed plans to reduce excess staff, stations and track.

69. Financial Sector. Relative to the size of the economy, the banking sector remains overpopulated and fragmented: there is clear scope for further consolidation of the domestic banks, some of which are very small and provide only local or regional coverage.

70. The NBS has recently recognized a number of deficiencies in the existing banking and insurance legislation and, in collaboration with the MOF, is in the process of preparing a new and substantially revised banking law. The new law will incorporate numerous changes to be substantially in line with EU banking directives and best practice. In addition, law amendments are currently pending on the introduction of a new deposit insurance scheme, bank liquidation procedures, insurance resolutions, etc. Moreover, the NBS raised the minimum bank capital requirement to Euro 10 million and the risk adjusted capital adequacy ratio to 10 percent from 8 percent as of January 2005. Although the regulatory framework for banking sector is now largely in place, the capacity of supervisors to adequately assess risks and undertake prompt corrective actions remains limited.

71. The recent FSAP mission concluded that the financial system is broadly stable, but that the main potential systemic vulnerabilities are: (i) banks' credit risk, exacerbated by 47 percent growth of lending (mostly foreign exchange linked) in 2004 and a reported 23 percent non-performing loan ratio at end 2004; and (ii) the 15 majority and minority held state-owned banks, most of which are not competitive and only a few others (including the largest) are slated for privatization by early 2006.

72. Additionally, the recent Base1 Core Principle assessment, conducted as part of the FSAP, provided a rather negative assessment of bank supervision, which raises concerns as to the quality of banks' financial reporting. Moreover, the capacity of supervisors to adequately assess risks and undertake prompt corrective actions remains limited, especially towards state- owned banks. As well, the lack of consolidated supervision of banking groups is an important gap which could impact the solvency of such banks.

73. Further, the insurance sector has begun to undergo sweeping change, as responsibility for the regulation and supervision of the insurance sector was transferred in mid-2004 to the NBS with passage of a new law. The insurance industry, long dominated by two socially owned insurers, has recently experienced the closure of 18 private insurance companies. Foreshadowing additional changes, the GOS is prepared to launch the divestment in 2005 of one of the two largest socially-owned insurers, whilst restructuring the other for its eventual sale. Moreover, there remains considerable scope for further consolidation within the sector as the NBS undertakes on-site examinations of the remaining insurers.

74. Access to Finance. Administrative barriers, limited access to finance and high cost of financing are still major impediments to successful business development. Through passage of a new Mortgage Law, the GOS intends to improve the efficiency of mortgage creation and enforcement, which inhibits development of the secondary mortgage markets and mortgage securities.

75. In addition to the above agreed Board presentation conditionality, Box 2 outlines the triggers for the follow-on PPFDPC-1 operation. Overall program outcomes envisaged through the FY07 CAS period are featured in the last column of the Policy Matrix (Annex 3).

76. Principal benefits of the proposed PPFDPC-1 operation center around key structural reforms that will reinforce sustainability of Serbia's macroeconomic stabilization by: (i) strengthening fiscal discipline; (ii) building a more efficient and stable financial sector; and (iii) further improving the investment climate. In particular, to put its finances on a more sustainable basis, the GOS, as part of the PPFDPC-1 program, is to reduce on-going subsidies so as to facilitate staff redundancies, permitting the restructuring andlor sale of affected state enterprises and targeted public utilities. Only when such chronic loss-makers are resolved through sale or commercially viable restructuring will the GOS be immune from these regular fiscal pressures. Secondly, the efficiency of the financial sector - and indirectly the GOS' contingent liabilities - will be reduced through the PPFDPCIL program, which aims to substantially reduce the Government's holdings in the banking and insurance sectors and to sell down or resolve its large financial asset holdings. Additionally, by further strengthening the regulatory and supervisory regimes, the stability of the financial sector will be improved, which in combination with a more stable macro-economic environment will increase borrowers' access to longer term real estate finance and further improve the investment climate. In sum, the envisaged policy measures underlying PPFDPC-1 will contribute to an irreversible and measurable impact upon the reform of the Serbian economy.

Box 2. Triggers for PPFDPCL-2

As part of the series of programmatic creditslloans, the Government has agreed on the following actions as triggers for moving to PPFDPCIL-2:

1. Reduction in the direct MOE subsidies in the 2006 budget to CSD 3.85 billion.

2. Starting on October 1, 2005, the PA will: (i) offer for sale no less than 18 SOEs and sell at least 9 through its tender program; (ii) offer for sale through auctions no less than 450 socially-owned enterprises, and sell at least 40% of them; (iii) offer for sale no less than 25 SOEs from the list of companies under restructuring, or significant parts thereof (i.e., representing no less than 50% of the total assets), using, as applicable, tenders, auctions and asset sales procedures, and sell at least 7 SOEs from the same list.

3. Starting on October 1, 2005, Republic of Serbia-owned or controlled creditors will request the courts to initiate bankruptcy proceedings for: (i) at least 8 large SOEs from the Restructuring List; and (ii) a number of additional SOEs that have unsuccessfully been offered for sale twice through auction or tender.

4. The Government of the Republic of Serbia will submit the Take-over of Companies Law and amendments to Securities Markets Law to the Parliament.

5. Regulations that define procedures for assessment of annual mineral production, surface and filing fees: royalties and payment procedures, and resolution of disputes and conflicts are in place.

6. Financial Adviser to deliver to GOS recommendations on restructuring of EPS. Regulatory framework is in place providing for transparent rules for setting cost recovery tariffs.

7 . Core ZS staff have been reduced by a further 1,000 employees, or 3.8% of total ZS core staff as of January 1, 2005. ZS has withdrawn passenger services from a further 6.3 percent (218km) of the network by about mid-2006, unless service specific PSCs are agreed. ZS has transferred 3 additional non-core activities to PA.

8. Vojvodjanska banka sale or resolution consummated. Sale launched for at least two minority-owned banks held as of end-2004. Upon Commercial Court of Belgrade approval, second NPL package offered for sale.

9. Liquidators have submitted opening financial statements for all 18 insurers closed. DDOR is in process of privatization. The independent diagnostic audit report of Dunav has been submitted to MOF, and a time-bound restructuring plan prepared, adopted by GOS and implementation begun by DIA.

10. By-laws needed to implement the new Banking Law are in place, including by-law(s) addressing sound risk management processes and accurate and timely reporting of risks.

11. By-laws or regulations, if any, needed to support implementation of Law on Mortgage adopted

POLICY AREAS

PILLAR I - Strengthening fiscal discipline

77. The recent CAS identified the strengthening of fiscal discipline as a priority for the sustainable success of Serbia's economic development. The proposed operation will improve fiscal discipline through: (i) phasing out of direct and containing indirect subsidies; (ii) accelerating privatization of socially-owned enterprises (iii) effective implementation of bankruptcy legislation; (iv) developing a more robust framework for mining concessions; and (v) continuation of the unbundling and restructuring (workforce and debts) of public utilities.

Policy Area 1.1: Reduction of MOE subsidyprogram and strengthening of the TF mechanism

78. Description. The major recipients of the MOE direct subsidies are among some 60 large socially-owned enterprises that have been slated for restructuring by the GOS. The 15 largest subsidy recipients among the companies in restructuring in 2001-2004 represent 57 percent of the total subsidy program. Zastava Automobili, the car manufacturer in Kragujevac in Central Serbia (26 percent), and a copper mining and processing complex, RTB Bor, in the less developed Eastern Serbia (13 percent) are by far the two single biggest recipients of subsidies. Yet, as of end-2004 firms on the restructuring list employed 103,045, which represents a reduction of about 23 percent from 2002, a clear indication that significant downsizing has taken place. Furthermore, there is a clearly progressive reduction of personnel as the enterprises move closer to privatization: the reduction was 30 percent in firms in tender, 20 percent in mid-process and 6 percent before privatization started.

79. Challenge. Many SOEs survive only because they receive new money from the state or state-influenced sources. In 2003, for example, 52 of the largest SOEs posted almost Euro 200 million in aggregate (mostly cash-flow) losses, and their debt increased by more than Euro 150 million. These companies continue to operate despite these substantial losses because they receive new money through various forms of direct and indirect government support: non-payment or partial payment of taxes; arrears to state-owned utilities, arrears to other state-owned financial institutions and the MOE subsidies which are used for supporting current operations and clearing arrears rather than investment.

80. Over the past 4 years, the Government has reduced the number of employees in the 15 biggest subsidy-receiving socially-owned enterprises from roughly 90,000 employees to 54,000, (a total (net) reduction of 36,000). Labor reductions in 2003 were circa 22,000 employees, declining substantially in 2004 to some 10,000. It has been estimated that there will be a need for some 18,000 redundancies in 2005 and 21,000 in 2006 from all companies, of which 10,000 and 13,500 respectively will come from enterprises within the RestructuringPrivatization Program. The cost of these terminations from the Transition Fund, at some Euro 2,500 per employee6, has been estimated at about Euro 57 million a year for

The standard amount for calculation purposes is 2,000 Euros per employee, but we have estimated costs conservatively at 2,500 Euros per employee due to the pressures coming from higher settlements with SOEs and a potential for inflation adjustment of the amount based on a 2002 agreement.

22

2005 and 2006. Two large companies, Zastava and RTB Bor, reflect the largest need, where the required level of redundancy is estimated at 9,000 and 6,500 personnel respectively. While direct subsidies represent a recurrent burden on the budget, severance payments to redundant employees are a one-time payment which allows companies to decrease their labor force and wage bill, thus making the reduction in direct subsidies more sustainable.

8 1. Government Actions. The Government actions include two main areas: (i) Reduction in the MOE direct subsidies, and (ii) strengthening of a redundancy payment mechanism to compensate surplus labor through the TF', a budgetary item, which received a CSD 5 billion budget allocation in 2005. The MOE direct subsidies allow loss-making companies to survive without painful restructuring and thus do not provide incentives to management and employees to cooperate, which is crucial to encourage poorly performing firms to push ahead with restructuring, thereby releasing non-core assets to higher productivity users, and encourage viable enterprises to actively search for new markets and reduce costs. In particular, the entry, market access and access to credit of SMEs are crowded-out by un-restructured enterprises that continue to function in a soft budget environment. Moreover, the TF resources to date are not sufficient to finance the amount of redundancies required to facilitate privatization and restructuring of large SOEs and public utilities.

82. Bank's Assessmenr/Recommendation. As analyzed in the PSN, the MOE subsidy program not only contributes substantially to the fiscal deficit, it also represents a potential disincentive to restructuring and privatization of the companies that receive subsidies. The continuation of subsidies results in material disincentives for management and employees in the recipient companies to progress with restructuring and resolution. Redundancies must be resolved before privatization because offering a company with the redundant labor risks deterring investors altogether as the investor places high risk on implementing the redundancy package. Moreover, as the privatization of a company is closer, employees are less willing to leave the company, hoping for wage increases by the new owner. Given the scarcity of TF resources and in order to increase net budget proceeds from privatization, TF payments need to be focused only on companies in which the availability of TF severance pay can make the difference whether a company is sellable or not. The Government agreed with the Bank about a target list of companies for budget-financed social programs that will include only companies that, based on the study of the consultants of the PA and the opinion of the Financial Advisors, can be made sellable by decreasing the cost of severance to potential investors.

83. As mentioned above, in addition to the direct subsidies from MOE, many SOEs benefit from indirect subsidies in the form of un-enforced arrears on utility charges and various social and tax obligations. The Bank seeks to eliminate this source of soft budget constraints by assisting the GOS with restructuring of EPS and NIS in preparation for their eventual privatization. In parallel, the MOE, in cooperation with the tax authorities and main utilities, will establish monitoring system for the large SOEs in order to ensure the full enforcement of hard budget constraints and to prevent further accumulation of arrears.

84. Measures to be Undertaken as Part of the Proposed PPFDPC-I. In order to speed- up restructuring, the MOE will commit to decrease the direct subsidies to socially-owned

' In reality, the "Transition Fund" is not a fund as it does not have either capital or personnel

2 3

enterprises in restructuring from CSD 5 billion in 2005 budget to CSD 3.85 billion in 2006. Secondly, to encourage restructuring and to mitigate social implications of the lay-offs resulting from the decreasing subsidies, the transition fund budgetary allocation in the amount of CSD 4.5 billion will be made available in 2006 budget. To ensure that severance pay will be used for employees in companies that are most likely to be privatized, a list of such companies for 2006 (including the number of redundancies per company) has been agreed upon.

85. Triggers for PPFDPC/L3. Reduction in the direct MOE subsidies in the 2006 budget to CSD 3.85 billion.

Policy Area 1.2: Privatization, Restructuring, and Bankruptcy of Socially-Owned Enterprises

86. Description. To release the assets held by the SOEs for productive use, the GOS embarked in 2001 on an ambitious, multi-track privatization program, which sought to incorporate international best practice and lessons learned from more than a decade of experience in other transition economies. The Privatization Law (issued in 2001, amended in 2003 and 2005) stipulates three methods of privatization: (i) tenders of large enterprises, offering to a strategic investor at least 70 percent of the shares; (ii) auctions of small and medium-sized enterprises; and (iii) restructuring and subsequent tenders and auctions of a select group of large, presently loss-making but potentially viable enterprises or parts thereof.

87. In the period 2001-2004, the PA, assisted by the Bank and other donors, achieved significant progress in implementing the Government's privatization program. By the end of 2004, more than 1,000 SMEs had been sold in auctions and circa 35 large enterprises were sold through tenders, most of them to international strategic investors. Notwithstanding difficult political environment, the overall scope, pace and transaction quality of these early privatizations compared favorably to similar stages of reform in other transition economies.

88. Challenges. Despite the impressive progress, only a fraction of the overall enterprise sector has been turned over to fully private, new and dynamic owners. With the share of employment in private enterprises consistent with the EBRD's estimate that 50 percent of Serbian GDP is produced in the private sector as of mid-2004~, Serbia compares unfavorably to the neighboring transition economies (80 percent in Hungary and the Czech Republic, 75 percent in Bulgaria and in Poland, 70 percent Romania, 65 percent in Slovenia and FYR Macedonia, and 60 percent in Croatia). As noted above, the financially (and politically) damaging role of the SOE sector in the Serbian economy is highlighted by the continued prevalence of direct subsidies and soft budget constraints.

89. The core of the problem is located in some 60 loss-making, heavily indebted industrial conglomerates, which employ about 100,000 people and have been selected by the authorities to undergo organizational and/or financial restructuring as they cannot be sold in their current condition. Despite the extensive technical assistance funding provided by the Bank and other donors, the PA has achieved only limited progress with resolution of these

EBRD, Transition Report 2004.

SOEs, with only a handful of companies from the restructuring list, or significant parts thereof, having been sold in the recent months.

90. Apart from continued existence of soft budget constraints, the lack of cooperation among state creditors and the absence of effective insolvency regime have been identified as two key obstacles to the resolution of companies in restructuring. The major creditors of these SOEs are state-controlled (or heavily state-influenced) entities - tax authorities, social funds, public utilities, state-owned banks (some in bankruptcy process) - which typically hold about three quarters of the company's total debt. However, in contrast to private creditors, the state- controlled or influenced creditors have been reluctant to accept any write-down that could facilitate privatization process. At the same time, the credible exit mechanism for unsaleable SOEs has long been absent in Serbia due to historical weakness of the bankruptcy regime, with court procedure lasting for seven years on average.

91. Government Actions. The GOS is committed to offer for sale all SOEs currently in the PA tender and auction portfolio, and all saleable assets on the restructuring list, by the end of 2006. In parallel, the SOEs that have failed the market test will be subject to bankruptcy under the new insolvency framework

92. Auctions. The GOS is committed to complete the very successful auction privatization program started in 2002. In 2004, around 380 companies were offered for sale and 260 of these were sold, a success rate of 68 percent. In the first nine months of 2005, 180 enterprises are expected to be offered for sale through auction, and additional 550 auctions will be held until the end of 2006, with the success rate forecasted at 40 percent. The obvious slowdown should not be cause for concern as the decline in number and quality are a result of the early success of the program and the finite number of companies available for sale. Given that the vast majority of buyers are given six years to pay, the PA will need to strongly monitor these payments over time.

93. Tenders. Tender sales accounted for almost all FDI that came to Serbia in 2002-2004 (so-called "brownfield" investment). Therefore, attracting reputable strategic investors for the relatively attractive SOEs remains a priority. At the moment some 30 large SOEs remain in the PA's tender pipeline. With the help of TA provided by the Bank and other donors, the PA has engaged international financial advisors to prepare and execute tenders for these enterprises. Depending on their size and financial condition, enterprises that attract no satisfactory bids in the tender process will be either auctioned or put into restructuring or bankruptcy.

94. Privatization through Restructuring. Accelerating the restructuring of large loss- making SOEs, and their subsequent divestiture through, as applicable, tender, auction, and asset sales procedures, constitutes one of the Government's key challenges in the near to medium term. This process is expected to be greatly facilitated with the passage of the amendments to the Privatization Law related to debt restructuring. The amendments make possible increased use of debt restructuring by the state and state-controlled entities to facilitate the privatization of large SOEs. To avoid generating moral hazard, the debt restructuring will become effective only at the moment of sale. The privatization proceeds from the sale of the debtor company will be distributed among the creditors proportionally to the amount of debt restructured, up to the nominal amount to their debts. Very importantly,

the central coordination of public bodies having claims will be necessary if the legislative policy on public debt restructuring in privatization sales is to be made effective.

95. Bankruptcy of SOEs: After enactment of the new Bankruptcy Law by the Parliament of Serbia in July 2004, the implementation of one of the most important reform regulations started on February 1,2005. The Law envisages several bodies in charge of carrying out of the bankruptcy procedure: the bankruptcy council, the bankruptcy judge, the trustee in bankruptcy, the assembly and the board of creditors. With the help of technical assistance provided by the Bank and other donors, significant progress has been made in recent months to create the two crucial institutional pillars of new insolvency regime: (i) the Bankruptcy Supervisory Agency (BSA) to license and oversee bankruptcy trustees; and (ii) the Bankruptcy Unit within the PA to act as the bankruptcy administrator of insolvent socially- and state- owned enterprises.

96. As noted above, effective bankruptcy process is a prerequisite for successful enterprise restructuring, and for establishment of hard budget constraint with regards to SOE sector. Although it can prepare a plan for restructuring and privatization through bankruptcy, the PA does not have the authority to initiate the formal bankruptcy process. State creditors, mainly the MOF or the Development Fund, are authorized to petition the courts to initiate bankruptcy proceedings under the new law. In the course of 2005 the Government will ensure that the state creditors request the court to initiate bankruptcy procedures against a number of large SOEs which have been receiving subsidies and fail to show tangible progress in restructuring. More generally, the state creditors are expected to file for bankruptcy against all enterprises that have twice failed a market test, within 90 days of the second unsuccessful auction or tender.

97. Bank's Assessmenf/Recornmendation. Notwithstanding impressive progress to date, the following issues remain to be addressed by the GOS, with support of PPFDPCIL program, in the near (PPFDPC- 1) to medium (PPFDPCIL-2) term:

completing the tender and auction privatization program for SOEs currently in the PA portfolio by the end of 2006; accelerating restructuring and privatization of large problematic SOEs, with the objective to offer for sale all saleable assets on the restructuring list by the end of 2006; using the new bankruptcy regime to resolve SOEs that cannot be sold, both for large subsidy recipients from the restructuring list and for all other SOEs that have twice failed the market test.

98. Measures to be Undertaken as Part of the Proposed PPFDPC-1. The following measures are being undertaken. Starting December 1,2004:

the Privatization Agency of the Republic of Serbia has offered for sale no less than eighteen socially-owned enterprises and sold at least nine socially-owned enterprises through its tender program; the PA offered for sale through auctions no less than 180 socially-owned enterprises, and sold at least 40 percent of such socially-owned enterprises;

the PA has offered for sale no less than eight socially-owned enterprises, or significant parts thereof (i.e., representing no less than 50 percent of the total assets), from the list of enterprises undergoing restructuring, using, as applicable, tenders, auctions and asset sales procedures, and sold at least three socially-owned enterprises set forth in the restructuring list; and Republic of Serbia owned or controlled creditors have requested the courts of the Republic of Serbia to initiate bankruptcy proceedings for at least six large state owned enterprises set forth in the restructuring list.

99. Triggers for PPFDPC/L-2.

Starting on October 1,2005, the PA will: (i) offer for sale no less than 18 SOEs and sell at least 9 through its tender program; (ii) offer for sale through auctions no less than 450 socially-owned enterprises, and sell at least 40% of them; (iii) offer for sale no less than 25 SOEs from the list of companies under restructuring, or significant parts thereof (i.e., representing no less than 50% of the total assets), using, as applicable, tenders, auctions and asset sales procedures, and sell at least 7 SOEs from the same list. Starting on October 1,2005, Republic of Serbia-owned or controlled creditors will request the courts to initiate bankruptcy proceedings for: (i) at least 8 large SOEs from the Restructuring List; and (ii) a number of additional SOEs that have unsuccessfully been offered for sale twice through auction or tender9. The Government of the Republic of Serbia will submit the Take-over of Companies Law and amendments to Securities Markets Law to the Parliament.

Policy Area 1.3: Concessions Framework for Mining Sector

100. Description. The underlying metallic mineral potential of Serbia is promising, as demonstrated by past mineral production, the delineation of undeveloped geological resources within known mining districts, and increasing interest expressed by foreign investors. In order to realize sector potentia1;the Republic of Serbia has undertaken reforms to transition the state from a role of owner operator of mineral assets to that of regulator and sector administrator. As part of this transition, the government has to improve legal and regulatory framework conducive to private sector investment.

101. Challenges. Mining sector reforms should meet a broad objective of developing a set of practical and implemental arrangements that will assist Serbia in strengthening its legal and institutional framework for increased private investment in the exploitation of mineral ores. To this end, the pending legislation should strengthen fiscal performance of the sector by adhering to international standards regarding competitive taxation, foreign investment, and customs issues unique to mining and establish framework for the negotiation, assessment, and payment of royalties in a transparent manner. Success in the implementation of these reforms will then be conditional upon sector governance, enforcement of contracts and collection of royalties. To fulfill these goals the Government has to build capacity to improve

The exact number of SOEs for this trigger will be determined by the end of 1'' quarter of 2006.

administrative processes that will attract private investment commensurate with the resource potential and increase revenue to the government.

102. Government Actions. To address these issues the GOS has prepared amendments to the Law on Mining and to the Law on Geological Exploration to improve clarity on several matters including: (i) state ownership of mineral resources and authorization to assign mineral rights / licenses to private parties; (ii) role of the state as a regulator within the sector; (iii) administrative frameworks for mines cadastre, mines inspectorate, and other authorizations; and (iv) compliance with mineral rights and laws including royalty, surface fee, and other financial obligations. As the next step, the GOS has to prepare regulations that define procedures for assessment of annual mineral production, surface and filing fees, royalties as well as payment procedures, and resolution of disputes and conflicts.

103. Bank's Assessment/Recommendation. The GOS has to identify deficiencies and/or gaps relating to the Mining Law and Law on Geological Exploration and carefully review the royalty rates and how they are negotiated and assessed in order to improve sector governance and increase transparency

104. Measures to be Undertaken as Part of PPFDPC-I

The Government of the Republic of Serbia has submitted to the Parliament of the Republic of Serbia amendments to the Law on Mining, satisfactory to the Association, incorporating a new royalties framework.

105. Triggers for PPFDPC/L-2. Regulations that define procedures for assessment of annual mineral production, surface and filing fees, royalties and payment procedures, and resolution of disputes and conflicts are in place.

Policy Area 1.4: EPS Restructuring

106. Description. There has been much progress in recent years on energy sector reform, particularly as regards power tariff reform and development of an enabling framework to support power industry commercialization.

107. Further reform in these two areas will be required in order that power industry sustainability - defined as well functioning and providing affordable / competitively priced power - is achieved. Power industry sustainability is important from a macroeconomic perspective - both as regards fiscal aspects and because performance of the power industry is an important influence on GDP growth - and as a determinant of quality of life for the population.

108. Challenges. Power tariffs were increased from USD 0.9 cents / kwh in 2001 to around 4 cents / kwh from July 2004. Increases were necessary in order that the power industry was financially viable and able to provide reliable supply to consumers. Tariff increases were successful in reducing power outages from high levels in the winter of 2000- 2001 to current low levels which are in line with international standards.

109. Going forward, it will be important to ensure that power tariffs continue to provide adequate revenues for cost recovery. The important categories of cost here are operating cost, maintenance, investment, and debt service (to Paris Club creditors, local suppliers, and the GOS). To this end, in order that increasing investment costs are covered, real power tariff increases to this end are likely to be required in the medium term. Absent tariff increases, either Government support would be required, or investments would be postponed and system security j eopardized.

11 0. One means for mitigating the extent of required tariff increases would be through commercialization of EPS (the national power company). Currently there is scope for EPS to improve performance significantly, both as regards cost reduction and enforcement of payments discipline. EPS restructuring would support commercialization through strengthening management incentives to perform. In addition, EPS restructuring would support Serbia's accession to the regional power market, which would in turn increase commercial pressure on EPS.

1 1 1. Evidence suggests that introduction of a strategic investor can result in improved performance of the power sector, with the proviso that the supporting institutional arrangements are in place (for example, a regulator has been established). It is likely that introduction of a strategic investor in the Serbian context would support efforts to commercialize the power sector, although this is likely to be feasible in the medium rather than the near term.

112. Government Actions. As noted above, the GOS has undertaken a number of measures to support power sector sustainability, both as regards tariffs and development of a framework to support industry commercialization. Much remains, however, to be done.

1 13. In particular, a tariff increase will be required in 2005 in order to provide for ongoing financial viability of EPS. The GOS is very much aware of the need for a tariff increase, and has established a working group comprising representatives of the Ministry of Energy and Mining, the MOF, and the Ministry of Labor and Social Affairs. The working group will propose a tariff increase to be implemented from July 1,2005.

114. On EPS restructuring, and as noted above, the GOS has agreed to establish a separate power transmission company. The GOS recognizes that this is a first step, and that there are a number of measures relating to restructuring that currently need to be addressed, both to support participation in the regional energy market, and to strengthen performance incentives with a view to improving payments discipline and reducing costs. The GOS accepts that private sector participation in the power sector could be potentially beneficial in the medium term.

11 5. Bank's Assessment/Recommendation. The Bank team has worked with staff from MEM and EPS to develop a financial model of the power industry upon which revenue requirements and tariff increases can be estimated. In agreeing inputs to the model, there have been extensive discussions on the EPS investment program, which focuses on coal mine development, and the rehabilitation of power plants and networks.

116. Based on the discussions and the financial modeling, the Bank's recommendation is that a tariff increase of the order 10-12 percent from July 1st would allow EPS to cover operating, maintenance and investment costs and Paris Club debt service. A 10-12 percent increase would provide incentives for EPS to improve performance, both as regards strengthening payments discipline and reducing operating costs; targets for improvement are implicit in the 10-12 percent figure. An increase above 10-12 percent would weaken incentives and would not be appropriate. Real tariff increases should take place as the regulatory framework is developed, as EPS becomes commercialized, and as investment requirements increase.

117. If EPS is required to service historic debt to suppliers and to the Government, then the revenue requirement would be higher. In the event that the working group proposes a higher tariff increase to finance debt service, the Bank has suggested that affordability impacts should be offset through strengthening of the safety net. The Bank team has suggested also that the issue of debt service should be resolved as part of a more global financial restructuring exercise involving state-owned companies and budget entities.

11 8. On EPS restructuring, the Bank concurs with the GOS on the need to appoint an advisor to support this process. The EAR is willing to fund such an assignment. The Bank and the EAR have worked together to develop an agreed terms of reference for the assignment, which will shortly be sent to the GOS and to EPS for comment. The terms of reference envisage that the assignment will be overseen by a steering committee comprising representatives of the GOS (MEM, MOF, and PA), EPS, EAR and the Bank.

11 9. It would not be appropriate to move quickly with privatization at the current time, given the need to build political support. In addition, the required restructuring of EPS will take up to several years to implement. It is noteworthy that the time taken from the start of restructuring to closing of privatization in neighboring countries - Bulgaria, FYR Macedonia, Romania - has been in excess of five years. It is noticeable also that where privatization happened more quickly in the ECA region, this subsequently failed, with Georgia and Kazakhstan notable examples. In the context of the regional energy market, Serbia is obliged to restructure but not to privatize EPS.

120. Measures to be Undertaken as Part of PPFDPC-1. The GOS adopted a power tariff increase in mid-2005 that is acceptable to the Bank. In conjunction with the tariff increase, the GOS will propose how debt service shall be treated. Secondly, the Government of the Republic of Serbia will launch an international tender to engage a financial advisor for Elektroprivreda Srbije, in accordance with terms of references and procedures satisfactory to the Bank.

12 1. Triggers for PPFDPC/L-2.

Financial Adviser to deliver to GOS recommendations on restructuring of EPS. Regulatory framework is in place providing for transparent rules for setting cost recovery tariffs.

Policy Area 1.5: Railway Sector

122. Description. The railway sector component of PPFDPC-1 will focus on facilitating the institutional changes necessary to reform the sector, encompassing labor retrenchment, network rationalization and the divestiture of non-core activities. This component will build on the recent passage of the railway law, and a production of a new 5 year restructuring plan for ZS, to achieve an agreed reduction in the number of core ZS staff, the attainment of the conversion of an agreed proportion of the network to 'manipulation status as a step on the path to closure, and the commencement of the divestiture of non-core activities.

123. Challenges. ZTP used to produce a one year business plan every year, based on a five year strategic plan, the most recent of which was prepared with technical assistance from the EBRD. The 2004-2008 version of the latter was not accepted by the GOS, because it envisaged continuing high levels of government subsidy. ZTP produced a 2005 Annual Business Plan, which has been approved by the GOS, and a 2005-2008 Restructuring Plan, which detail the specific plans to reduce labor, privatize non-core activities, and retrench services and lines for the years 200512006,

124. As to railway line closures, ZS has committed to withdraw services and convert 7.5 percent of the network to manipulation status immediately, and convert a further 6.3 percent of the network by the end of 2005 if service specific subsidy is not achieved. The Board of Management of ZS met on May 22,2005 to determine further possible cuts in the network. The primary constraints to the swift execution of service withdrawal and line closure are both process and local political sensitivities.

125. As it regards the divesture of non-core activities, the management of ZS has commenced the process of divesting all non-core activities, through the establishment of 14 wholly-owned subsidiary companies, offering services as diverse as travel agency, housing, import-export services to engineering consultancy. This process needs to continue by offering the separated businesses for sale to private investors in an open and transparent process beginning in late 2005.

126. Government Actions. The railway is the largest public utility which imposes a high fiscal cost on the budget and its early restructuring is critical. As of January 1,2005 ZTP had 26,212 employees in the core railway and 5,000 in daughter companies (total of 31,212 employees). ZS plans to reduce total railway labor by about 3,800 in 2005, reducing core ZS staff by 1,900, for a 7.4 percent reduction in core staff. ZS plans to reduce total labor by an additional 3,496 in 2006. ZS have stated the objective of reducing overall core staff to 18,000 by the end of 2007.

127. The core of the proposed reform in the railway sector surrounds the new Railway Law and associated decree on the reorganization of ZTP as was, the former of which became effective on March 1,2005. A new railway entity, Zeleznice Srbije, has recently been established, to which the operating assets of ZTP have been transferred. This law provides for an infrastructure manager to maintain and operate the railway infrastructure and for multiple operators with equal access to provide train service over the infrastructure. Initially, ZS will be both infrastructure manager and operator, although the law allows for other manager and

operators.10 A Railway Directorate is being formed to license infrastructure managers and train operators. The law permits operators to apply to government for subsidy of loss-making services and to cease providing loss-making services that are not compensated. It provides for the infrastructure operator to set infkastructure tariffs in accordance with standards articulated by the Railway Directorate.

128. Bank's AssessmentLRecommendation. Notwithstanding progress to date through passage of the new Railway Law and adoption of the well-developed 2005 Business Plan, the following issues remain to be addressed by the GOS, with support of PPFDPCIL program, in the near to medium term:

Retrenchment of core labor from ZS and its subsidiaries; Withdrawal of uneconomic passenger services and the closure of uneconomic lines; and Divestiture of non-core activities.

129. Measures to be Undertaken as Part of PPFDPC-1. The following represent the specific core and non-core conditions that were discussed and agreed with the Government and ZS as PPFDPC-1 tranche release conditions:

Zeleznice Srbije has reduced ZS staff engaged in core ZS activities by 1,900, or 7.2 percent of total ZS core staff of 26,212 employed as of January 1,2005, and ZS and GOS have adopted the 2005 Business Plan. ZS to begin the withdrawal of all passenger services from 7.5 percent of the network (260km), convert them to manipulation lines in 2005 and finalize plans for similar activities through 2009 in the 2005-2009 Strategic Plan. Begin implementation of the approved 2005 Business Plan, satisfactory to the Bank, pending receipt and acceptance by the MOF and MCI of the new 2005-2009 Strategic Plan.

130. Triggers for PPFDPC/L-2. The following represent the prospective triggers for PPFDPCIL-2 that were discussed and agreed with the Government and ZS:

Core ZS staff have been reduced by a further 1,000 employees, or 3.8% of total ZS core staff as of January 1,2005. ZS has withdrawn passenger services from a further 6.3 percent (218km) of the network by about mid-2006, unless service specific Public Service Contracts (PSC) are agreed. ZS has transferred 3 additional non-core activities to Privatization Agency.

PILLAR I1 - Building a more efficient and stable financial sector

13 1. Beginning in 2001 the authorities set out to deal with the critical condition of the Serbian banks. Given the inability of the budget to re-capitalize the most seriously distressed banks, and the likely negative franchise value of most such banks, some 25 insolvent banks --

lo ZS is to be divided into infrastructure and operating companies, held within the same holding company.

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(representing nearly two-thirds of the assets of the banking system) were closed between 2001 and 2003. The D M was given extended authority by the Bankruptcy Court to administer banks in bankruptcy.

132. Both the banking and insurance sectors have witnessed substantial consolidation in the past few years, as the number of banks in Serbia has been reduced from 83 (2001) to 41 (end-March 2005) and more recently the number of insurers has been reduced from 41 to 23. In parallel, the authorities initiated a series of steps to modernize the regulatory framework for banks and more recently, the insurance sector. As well, significant early progress has been achieved in aligning banking and insurance sector regulations with best practice, although the full effect of these changes - especially as it regards bank and insurance supervision - will not be seen until passage of the respective law amendments and the NBS' implementation of the second phase of the Supervisory Development Plan.

133. Challenges in Serbia's banking sector however are not confined to the state-owned banks. The spotlight given by the authorities and the donor community to resolution of state- owned banks should in no way distract attention from the potential problems posed by the rapid credit expansion of domestic private and foreign-owned banks." More specifically, the 2004 FSN analysis demonstrated that none of the local banks driving the recent growth score unambiguously well on a mix of effectiveness, regulatory or loan-quality indicators. This gives rise to the major concern that some of the larger local private banks (of which a number are minority-owned by the government) are storing up future problems by lending on unsustainable terms that may result in the future deterioration of asset quality. A major credit risk is also foreseen by the foreign exchange clause on virtually all CSD-denominated loans, which could lead to a sharp deterioration in banks7 asset quality in the event of a marked depreciation of the exchange rate.

Policy Area 2.1: Resolution of state-owned banks (SOB) and divestment offinancial assets (non-performing loans and equities)

134. Description. In the second semester of 2004, the government as the (then) majority and minority shareholder of 16 banks, began the process of divesting its holdings in the sector through the DM. The process of divestiture of the SOB holdings is now well underway, suitably resourced and managed. In January 2005 the first state-owned bank was successfully sold to a Greek banking group and two other banks have since been sold to separate foreign bidders. It is envisaged that at least one more majority held state-owned banks may be sold in 2005 and two others (including the largest) offered for sale late in 2005. Equally, it is noteworthy that the largest domestic private bank was sold in February 2005 to an Italian banking group. However, importantly, as it regards the further divestment of banks and financial assets, there are no concrete plans in place beyond early 2006. Thus, if successful with the currently envisaged sale of additional majority-owned banks, at mid-2006 the government would still retain (majority and minority) ownership stakes in at least 8 banks.

" Although it is often presumed that the "private" banks are exempt from the stresses and distortions suffered by the state banks, the reality is unlikely to be quite so straightforward. As many private banks have been closely affiliated with specific interest groups, they lack the advantages of clean balance-sheets and the more prudential culture brought by the foreign banks.

135. Additionally, the DIA, as agent for the Bankruptcy Court, holds claims totaling almost USD $10 billion equivalent from failed, sold and merged banks. However, as more than 95 percent of the total claims represent Paris-London Club (PLC) loans due from socially- or state-owned enterprises, off-balance sheet items or other state related debt, only a small portion of assets (both loans and equity stakes) are from private entities and thus available for sale. As the DM has no delegated authority from the Court to resolve any claim for less than the outstanding balance, its efforts to recover value from the loans and other enterprise equity holdings have been considerably delayed.

136. Challenge. In the near-term, to ensure that the decision making and performance at each of the government's remaining 15 (majority and minority) bank holdings are subject to regular scrutiny by the DIA as agent for the MOF as shareholder. Longer term, to divest or merge its remaining bank equity stakes, so the government is substantially out of the business of banking by FYE07. And lastly, to reduce the DIA's financial asset holdings through periodic, transparent asset auctions.

137. Government Actions. After a rather protracted start, the GOS, acting through the DIA, has begun to consolidate and divest its bank holdings. As well, utilizing a World Bank grant facility and coordinated bi-lateral assistance from three countries, the DIA has substantially expanded its capacity to monitor banks' performance and prepare banks for sale. The agency and its financial advisors have developed a Sale and Purchase Agreement (SPA) contract complying with Serbian law to use as a template for subsequent bank sales. The authorities are committed to extend their sale program to other majority-owned bank holdings and thereafter, off-load their minority-owned bank holdings.

138. Bank's Assessrnent/Recomrnendation. Progress in the past year in organizing the first tenders for the divestment of banks has been excellent. Equally, the DIA has taken numerous steps to further strengthen its oversight and control of the remaining state-owned banks and organize its first sale of financial assets. Notwithstanding this progress to date and the envisaged majority-owned bank offerings in late 2005 and early 2006, it is important the government mitigate its operational risks whilst developing and executing a strategy for the divestment of its remaining bank equity holdings and other financial assets.

139. Measures to be Undertaken as Part of PPFDPC-1. The bank and financial asset divestment strategy supported under PPFDPC-1 includes the following key elements:

The Agency for Deposit Insurance (DIA) of the Republic of Serbia has offered for sale, on behalf of the Government of the Republic of Serbia, a majority (i.e., more than 50 percent) of Vojvodjanska banka shares. DIA has appointed Financial Adviser for Credy Banka and has agreed to recommend resolution strategy for Privredna Banka Pancevo to the DIA Management Board. Binding bids for NPL sale received and recommended to the Commercial Court of Belgrade for approval.

140. In the event that the majority-owned banks now held1* are taken up by the market in the coming year, it is expected that the GOS will reduce its holding of majority-owned banks in the sector to below 11 percent of total banking system assets by end-200513. As to the sale of NPL or private enterprise equity holdings, the DIA is committed to do so with the approval of the Bankruptcy Court. The first sale of assets is expected to be closed in the third quarter of 2005, and subsequent sales announced upon Court approval.

141. Triggers for PPFDPC/L-2. The key expected financial sector triggers are the consummation of the sale or resolution of the largest state-owned bank to a strategic buyer and the launch of tenders for at least two of the remaining stakes in minority state-owned banks. However, to the extent that the government does not receive acceptable bids for majority- owned banks held, it is prepared to resolve (by merger or closure) its remaining stakes in banks. Likewise, in the event of Court approval, the DIA should launch the sale of a second package of financial assets.

Policy Area 2.2: Strengthening insurance sector regulation and resolution regime

142. Description. In recognition of the fact that the Serbian insurance regulatory and supervisory apparatus was transitioned to the NBS in mid-2004 through passage of a new law, the insurance sector is being re-established going forward within a more healthy governance environment. The NBS as the new insurance supervisor, with its substantial experience in the banking sector, has already taken vigorous actions to address the more egregious issues facing the industry through the closure of eighteen insurers.

143. Challenges. While it has been necessary for the NBS to assume new responsibilities towards the insurance sector, it has also highlighted certain weaknesses - a lack of experience, in particular - within the supervisory ranks, and deficiencies in the legal structures upon which the supervisor depends. There are three urgent issues that need to be addressed in the insurance sector, the first two of which emerged from the recent closure of a substantial number of insurers. These are:

The definition, management and hnding of claims incurred by the closed insurers, and third party liability (TPL) claims in particular; The process of resolution of the closed insurers; and The disposition and restructuring of the two state-owned insurance companies.

144. Supervisory strengthening is a longer-term issue and will be addressed through the envisaged PPFDPCIL-2, as particular emphasis is needed to develop off-site actuarial analysis skills, on-site inspections and report preparation skills.

145. At present TPL insurance continues to be regulated under the relevant provisions of the old Insurance Law. TPL claims against failed insurers are met from a guarantee fund set up under this law. These claims are payable, with accrued interest, once bankruptcy

12 With the exception of new banks likely to be transferred to the DIA and Cacanska bank, wherein EBRD is under discussion with government about its taking an equity stake. l 3 Minority holdings in banks are necessarily more difficult to place, though GOS is committed to do so in the medium term.

proceedings have finalized, which takes many years. Under the new insurance law, claimants continue to have claims against an insurer until it is deemed to have ceased trading (compared to ceasing trading once insurer's license was withdrawn), making the guarantee fund responsible for claims arising after an insurer has had its license withdrawn. In addition it creates a moral hazard in that vehicle owners may not feel obliged to take out a new TPL contract - the normal requirement in most markets.

146. It is estimated that approximately 25 percent of all drivers in Serbia now have questionable TPL insurance coverage following the closure of 8 companies in November 2004 and another 7 in January 2005 (3 additional companies gave up their licenses). Estimates of the resulting cost to the guarantee facility are as high as CSD 3 billion, producing total liabilities of approximately US$100 million. This represents approximately 80 percent of current TPL declared annual premium income in Serbia, and will need to be funded over several years if the figure proves near correct.

147. Government Actions. The key short term issues required of the GOS involve setting the scene for the reforms that will underpin the tranche release. One of these, the commencement of technical assistance to develop a strategy and formulate law to put TPL onto a sound long-term footing, has commenced. The others relate to sectoral restructuring and include the commencement of a detailed on-site inspection of DDOR Novi Sad, one of the two large state-owned insurers, production of audited accounts for the two state-owned insurers using current accounting standards, and the submission of law amendments to the Parliament to enable the DIA to commence liquidation for the 18 recently closed insurers.

148. Bank's Assessment/Recommendation. The Bank's main recommendations concern the ongoing TPL reform and sectoral restructuring efforts. The most difficult issue affecting TPL will be the development of a funding mechanism to meet guarantee fund obligations. In addition, there is a need to ensure that drivers take out new coverage when an insurer loses its license, which is a common requirement in other countries, including those in the region. Some of the key restructuring and resolution concerns that will need to be addressed going forward in the law amendments and supporting regulations include: (i) the responsibilities of the various parties involved (NBS, administrators, courts etc) should be clearly laid out; (ii) the minimum qualifications and appointment processes for administrators and liquidators should be specified; (iii) the powers of the supervisor to guide the processes in the interests of policyholders should be clearly laid out; (iv) severe penalties for dealing in assets after NBS serves a ceasing of business order should be introduced; and (v) there should be scope to unwind related party or suspected related party transactions made within a certain period before a ceasing business order is introduced.

149. Measures to be Undertaken as Part of PPFDPC-I. The requirements for tranche release follow on from the preliminary actions listed above and include passage of enabling laws amendments to the insurance law, the appointment of advisors to restructurel privatize DDOR Novi Sad, the beginning of the diagnostic audit process for Dunav Osiguranje and the beginning of the implementation of the recommendations arising from the TPL technical assistance. In particular, the insurance sector reforms to be addressed under this pillar of the PPFDPC-1 will include:

Specific Administration and Wind Up Procedures are in place through amendments to the insurance law and are in accord with new Bankruptcy Law and consistent with relevant EU Directives and international assessment standards Core Principals; New TPL Law and guarantee arrangements are submitted to Parliament which will offer coverage on a sustainable basis; Financial Advisor has been appointed for DDOR privatization; and Launch tender for Dunav diagnostic audit.

150. Triggers for PPFDPC/L-2. The triggers for PPFDPCIL-2 involve the substantial realization of the TPL and sectoral restructuring efforts described above. These include the commencement of the DDOR privatization and a time-bound plan prepared for Dunav's restructuring and the submission of liquidators' reports for the 18 closed insurers.

Policy Area 2.3: Second phase of the Supervisory Development Plan (SDP)

15 1. Description. Banking sector regulation and supervision has been one of the key areas targeted since the inception of the Serbian reform program. Initial steps by the NBS to close the four largest banks in 2001 started a process of banking sector reform and restructuring. At the heart of this reform was the acknowledged need to strengthen bank supervision processes, which had lost considerable ground in the prior decade. At the initiative of the NBS and as a part of the previous World Bank PFSAC-1 and PFSAC-2 programs, objectives for regulatory and supervisory reform were established, in part, through the development of a Supervisory Development Plan (SDP). Currently a new, revised SDP is being finalized to address continuing needs and introduce further, risk based tools and processes.

152. As a matter of serious concern, the NBS bank examination process repeatedly identifies the need to make additional - often significant - loan loss provisions. This raises the concern that some banks may not have accurate internal classification and loan provisioning systems, and therefore, that capital and overall bank condition may not be accurately conveyed through correct and truthful financial reporting to the public or regulator. Consistent, effective follow up of issues and enforcement of supervisory actions must be improved.

153. Challenges. Risk based supervision is, in essence, drawing conclusions about a bank's level, nature, and management of risks. As a corollary, the NBS should institute processes for the ongoing supervision of such risks, proactively taking steps with the board and management before a bank's viability is threatened. These key processes (and the underlying changes needed to institutional risk based supervision) have only just begun to be adopted by the NBS. Thus, while much remains to be accomplished to achieve a sustained degree of implementation, numerous steps have been taken to date, including:

Key staffing changes, including new senior and executive supervisory management; Formation of a "Bank Supervision Committee" (BSC) to help support decision making; Adoption of a standardized report of examination format; Improved communications within the supervision department; Introduction of a CAMEL risk rating process; and

Preparation of individual bank supervisory strategies which form the framework to prompt key risk conclusions and to link them with supervisory responses and plans.

154. The rapidly growing large private banks and two large and systemically important state-controlled banks should be priority candidates for early on-site examinations to determine whether their high loan growth rates (most of which are foreign exchange linked) are compromising asset quality or putting at risk longer-tern capital adequacy. To this end, enforcement capacity of the NBS Supervision Department is slated to be further improved through implementation of the second phase of the SDP. Going forward, the NBS supervisors need to consistently enforce their prudential regulations without exceptions and take prompt corrective or remedial actions as necessary. The Base1 Core Principles assessment, undertaken as part of the recent FSAP confirmed that there is substantial scope to improve regulations and moreover, supervisory practices.

155. In this regard, the Serbian authorities should be prepared to deal promptly with potential bank failures that may result from the convergence of market, financial and regulatory pressures, such a result of, through the increased minimum capital requirement, more rigorous enforcement of the existing prudential regime, increased competition resulting from the entry of new foreign banks, the removal of government and NBS deposits from commercial banks, etc. In addition to this, it is possible that some (private or state-owned) banks offered up for sale may not attract a suitable buyer, whilst others may be found capital deficient or may experience liquidity constraints. The NBS should put in place a proper early warning system and in collaboration with the GOS, amend the bank exit / resolution mechanism to minimize the fiscal cost, protect depositors' insured accounts, asset values and overall, to minimize possible systemic risks. The orderly consolidation of the banking system should be seen as a key objective of the envisaged changes to the regulatory and supervisory regime.

156. Government Actions. As a result of the relatively uneven implementation of supervisory processes, the NBS agreed with the need for a time-bound, prioritized "second phase" SDP. This follow on SDP is intended, in part, to identify steps to accomplish key tasks to implement risk based supervision and to elevate those supervisory areas still requiring management attention. These needed steps fall into 6 key categories:

Legal tools (revision of the Law on Banks and other affected regulation); Risk analysis and conclusions - in credit, foreign exchange, and liquidity areas; Corrective action program to address banks' deficiencies in operations; External audit: adequacy and use as a supportive supervisory input; Accurate and truthful disclosure and transparency; and Enhanced bank governance.

157. Overarching this initiative, the NBS in collaboration with the MOF is undertaking a full review of the Law on Banks and Banking. Upon seeking comment from the industry, public, the World Bank and IMF, it is envisaged amendments to the law will be introduced to Parliament in late 2005. The thorough review and introduction of revisions to the Law on Banks and Banking is in line with the recommendations of the recent FSAP mission and is IMF structural performance criteria for mid-November 2005. Consistent with NBS intentions, there is a clear need to focus, inter alia, on: (i) assigning clear board and management

responsibility and accountability for the safe and sound operation of their banks; (ii) ensuring that legal parameters and tools are firmly in place to enable supervisory remedial (including insolvency) decisions to be taken on a methodical basis; (iii) promptly exercising remedial measures in the event inaccurate financial reporting is disclosed to the public or the supervisory authorities.

158. Bank's Assessment/Recommendation. As outlined above, a number of key steps remain to be put in place, as the risk based supervisory framework and responsibilities therein have not been thoroughly integrated into day-to-day bank supervisory activities to enable such results. The NBS must concretely demonstrate its ability to put in place the agreed measures in the second SDP.

159. Finally, the supervisor should continue its recent efforts in evaluating the results of and differences between the year-end audited financial statements and bank examinations to determine divergence in reporting, particularly in the area of required loan loss provisions and accuracy of financial reporting. Action plans addressing, inter alia, issues of inaccurate financial reporting and capital inadequacy, bank internal control systems, and board and management responsibility for such, should be prepared, reviewed by the subject bank(s), and approved and signed by both parties.

160. Measures to be Undertaken as Part of PPFDPC-1. The NBS would formally adopt a comprehensive "second phase" SDP which reinforces the importance of key supervisory activities requiring NBS management attention. The updated SDP will also elevate expectations for a sound, increasingly risk based supervisory approach demonstrated by: (i) revised draft of a comprehensive SOP, satisfactory to the Bank; (ii) risk matrices and supervisory strategies for banks examinations completed as of September 30, 2005; (iii) a time-bound corrective action plan to address Base1 Core Principles weaknesses identified; (iv) for those banks whose deadline for implementation of corrective action measures has expired as of September 20,2005, the NBS is to verify that provisions have been taken by the deadline specified in the corrective action plan and are reflected on subject banks' financial and regulatory reports; (v) NBS has issued a new regulation, effective January 1,2006, that requires the examined banks to book NBS directed provisions no later than the end of the quarter of the NBS' issuance of the corrective measures and make necessary changes in regulatory reports.

16 1. Triggers for PPFDPC/L-2. The following represents the prospective triggers for PPFDPCIL-2 that was discussed and agreed with the Government and the NBS:

By-laws needed to implement the new Banking Law are in place, including by-law(s) addressing sound risk management processes and accurate and timely reporting of risks.

Policy Area 2.4: Access to Finance

162. Description. Improving access to finance has been an important component of prior structural adjustment operations, which resulted in significant increases of consumer (and to a

lesser degree, corporate) lending.14 Further, the legal framework for creating and enforcing security agreements has been markedly improved. As well, the GOS has begun work on the establishment or development of the key institutions for the implementation of the Pledge Registry and Real Estate Cadastre. In addition, a new Credit Bureau is operating, demonstrating the willingness of major lenders to cooperate amongst themselves in making borrower data available. However, the last piece in the framework for secured lending, the Mortgage Law, is not in place.

163. In Serbia mortgages on buildings are the most frequently requested type of collateral and account for approximately 45 percent of all bank collateral in year 2003.15 Currently, the institution of mortgages is stipulated by only a few provisions of the Law on the Principles of Property Relations. Because of weaknesses in the legal framework and lack of experience with the execution procedures, banks often require collateral and other forms of security in addition to a mortgage to limit their credit risk (multiple guarantors, non-real estate collateral, direct salary deduction for loan payments, bills of exchange, etc.). In addition, financing new construction is limited because it is not possible to mortgage a building under construction, thereby preventing development of an efficient financing mechanism and sharply limiting the potential of the construction industry

164. Challenge. The current limited access to medium- and longer- term finance and the high cost of all financing present a major challenge for the development of the financial and enterprise sector in Serbia. This includes further improvements of the arrangements for valuing collateral and enforcing liens, as it especially effects residential and commercial mortgage loans. These deficiencies preclude most borrowers' ability to receive funds, as the costs of such credits and related services are quite high. Although interest margin and real interest rates are decreasing, Serbia still has higher interest rates compared to other neighboring countries.

165. There is an urgent need to reform the mortgage-based lending system owing to:

a the lack of adequate legal and regulatory framework; a the absence of the efficient supporting administration, i.e. real estate registration16; and

the absence of secondary market mechanisms.

166. Even though a few foreign-owned banks have begun providing mortgage lending for residential flats, most domestic banks lack the ability to attract, and thus, offer long-term funding, which precludes their entry into mortgage lending. The GOS recently established National Mortgage Insurance Corporation of Serbia (NMICS) which assumes the major part

l 4 PFSAC I and I1 as well as the recent SAC I1 approved by the Board in December 2004. l 5 World Bank "Serbia Investment Climate Assessment" (December, 2004) l6 A large portion of real estate in Serbia is not properly registered and even when it is registered, it is not unusual for there to be discrepancies between the facts and the data contained in the public register. The absence of clarity on these issues makes it riskier and more costly for lenders to assume exposure in housing or commercial real estate. The objective of the World Bank the Real Estate Cadastre and Registration Project is to increase confidence and lower transaction costs by building a more efficient property registration and cadastre system. However, in addition to providing technical mapping, the project focuses on the registration of property rights by establishing the real estate cadastre throughout the whole country and improving service delivery for secondary real estate transactions (sales, mortgages).

of the credit risk in mortgage lending. The NMICS provides mortgage guarantee insurance, and once k l ly operational, could act as a secondary market maker. While the default risk can be shared with the banks through mortgage insurance, there is a broad concern as to the creation of a large contingent liability for the government, having in mind the weaknesses in the banking, legal and administrative area. Nevertheless, this new scheme cannot substitute for proper contracting and registration of mortgage interests.

167. Government Actions. In an effort to address these recognized deficiencies, the GOS is currently preparing a drafi Mortgage Law which regulates contracting and registration of mortgage, as well as the settlement of a mortgage creditor. The major aim of the law is to improve the efficiency of mortgage creation and enforcement, which is a well-known problem in Serbia, and which inhibits development of the secondary mortgage markets and mortgage securities. The future development of the secondary mortgage market in Serbia will depend on the existence of the sufficient legal, tax and regulatory framework and capital market preparedness.

168. Bank's AssessmentLRecommendation. Notwithstanding impressive progress to date, reform of the mortgage-based system of lending will assist Serbia in strengthening its legal and institutional framework for improved access to finance. The draft law also needs to address the issue of the registration of mortgages that are not included as yet in the real estate cadastre.

169. Measures to be Undertaken as Part of PPFDPC-1. Specific task under this pillar of the PPFDPC-1 will be the submission to Parliament of the draft Mortgage Law, satisfactory to the Bank.

170. Triggers for PPFDPC/L-2.

By-laws or regulations, if any, needed to support implementation of Law on Mortgage adopted.

VI. OPERATION IMPLEMENTATION

POVERTY AND SOCIAL IMPACTS

171. Although Serbia's recent poverty reduction experience is encouraging, the Government's recent PRSP demonstrated that deep pockets of poverty and social exclusion continue to be important policy challenges. The ambitious reform program launched in 2001 has led to higher living standards and reduced poverty over the last few years. Evidence suggests that the economic growth in Serbia has not resulted in change in poverty levels between 2002 and 2003. Access to services, especially for the poor, has not improved. As a result, further reforms will be required to ensure that growth is sustained and that it reaches the poorest.

172. In the near to medium term, the reforms supported by PPFDPC-1 are expected to increase unemployment. For example, the redundancies in the copper mining and processing complex, RTB Bor, in Eastern Serbia, which currently employs 9,000 workers,

could reach 6,000 persons over 3 to 5 years. Yet, the alternative scenario - without restructuring - will result in an unsustainable fiscal burden and eventual collapse (bankruptcy or liquidation) of the enterprises, which would have much higher negative social costs. Although PPFDPC-1 objectives are not designed to have geographically concentrated effects, one-company towns (such as RTB Bor) would be most affected.

173. In order to mitigate the welfare and employment impact of the ongoing and expected SOE reforms, the GOS instituted a Social Program in 2002. The SP introduced generous lump sum severance payment as an alternative to the severance package provided for by the Labor Code. The SP, although generous in terms of payout, suffers from shortcomings, the most important of which are: (a) financial sustainability, (b) choice and application of quasi-financial and non-financial assistance instruments, and (c) the enforceability of the linkage to restructuring. Based on experiences from other transition economies, the team will seek to identify additional policy issues (e.g., in the areas of pensions and health insurance), that could be addressed in the course of programmatic DPCIL program to mitigate the effects of labor redeployment associated with restructuring.

174. The program will seek to provide assistance to the GOS in revising its Social Program and the manner in which Transition Fund resources are applied. A poverty and social impact analysis - operationally attached to the proposed Bor Regional Development Project - will shed light on worker preferences, while results from a study produced within the framework of the Employment Promotion Project will evaluate the effectiveness and efficiency of the passive and active labor market instruments applied thus far. Policy and procedural advice provided to the GOS will be based partially on these studies as well as on projections concerning the expected fiscal implications of future layoffs.

175. In the longer term, the PPFDPC-1 will improve the capacity of the Government to reduce poverty through several channels. First, implementation of measures aimed at strengthening fiscal discipline-through enhancing hard budget constraints and reducing subsidies-will not only improve resource allocation and the country's growth prospects, but also reduce the risk of macroeconomic shocks, which can adversely affect the living standards of the poor. Second, reform measures directed at improving the business climate will create the basis for investments needed for medium-term growth and employment creation, and thus for more sustained poverty reduction. Third, policy efforts aimed at building a more efficient and stable financial sector will underpin economic growth and increase the resilience of the Serbian economy to potential adverse shocks-both of which are prerequisites for increasing employment and reducing poverty.

IMPLEMENTATION, MONITORING AND EVALUATION

176. The MOF will be responsible for overall implementation of the proposed operation and for reporting process and coordinating actions among other concerned ministries and agencies. The Bank will monitor actions and review progress of the implementation of the proposed operation, as well as the subsequent actions of the GOS program by using the short term and overall program outcomes outlined in Annex 3 of the Policy Matrix.

177. At the same time, the overall status of the GOS program will be monitored during supervision to determine whether the specific conditions of the proposed operation have

changed. In addition, supervision missions will not only allow the Bank to continue the policy dialogue with the institutions involved in the implementation of the program of reform, but will also ensure synergies with other donors to avoid conflicting advice to the Government in the policy and technical areas involved in the reforms.

FIDUCIARY ASPECTS

178. Public financial management (PFM) system. The Bank has up-to-date knowledge of the PFM system of the Republic of Serbia. A Country Financial Accountability Assessment (CFAA), a Country Procurement Assessment Report (CPAR) and a Public Expenditure and Institutional Review (PEIR) were completed in 2002 and 2003 respectively. The initial diagnostic was updated in June 2005 with a Public Expenditure Note and a Fiduciary Assessment Update (FAU) for public financial management and procurement.

179. The 2005 FAU found that since 2002, progress has been made in a number of areas, including on the legislative front with the adoption of a comprehensive Budget System Law (BSL) and an improved Public Procurement Law (PPL) in 2002, and on the institutional front with the creation of new administrative entities for public resource management. A Public Procurement Office (PPO) was established and issued secondary procurement legislation as well as standard procedures. A Commission for the Protection of Tenderers' Rights (CTR) was also created. Another institution, the Administration for the Prevention of Money Laundering has proven effective in investigating and initiating prosecution of high profile money laundering cases. Last but not least, entities for budget analysis, treasury management (cash, debt and accounting policies), financial control and internal audit have been created and have started functioning in the MOF, in line with the 2002 CFAA recommendations.

180. However, significant weaknesses remain. By and large, implementation of the BSL and the PPL remains a challenge. Budget institutions are not yet able to ensure comprehensive, transparent and reliable information and processes for budget execution. Perhaps most significant is the absence of a sound internal control framework despite progress in expenditure engagement (commitment) and payment control. Also, capacity constraints remain paramount in these units as well as in line ministries (direct budget beneficiaries). The 2005 budget preparation process (and particularly the Budget Memorandum) does not match transparency achieved in previous years.

18 1. In addition, whereas many recommendations of the 2002 CFAA have been implemented, some'of the most hndamental ones have incurred significant delays. This is the case in particular for financial reporting and external oversight, both basic foundations of fiscal transparency and accountability. Specifically, the law for the creation of a Supreme Audit Institutions is likely to be adopted by Parliament in the Fall of 2005. Bank input has been provided to the draft law under the responsibility of Finance committee of the National Assembly. Similarly, public accounts for 2002,2003 and 2004 have not been audited. The National Assembly is only now in the process of approving the nomination of a private audit firm, as required by the BSL.

182. The FAU also assessed that corrective actions taken by the National Bank of Serbia to safeguard funds in the foreign exchange account were deemed adequate. On this basis, the

continued imposition of additional fiduciary safeguards on the NBS in the use of ring-fenced accounts appears unwarranted.

183. As a result of the above, fiduciary risk associated with the Serbian PFM system and measured by selected PFM performance indicators remains high. Mitigating fiduciary risks will require strong and sustained commitment towards transparency and accountability in budget management. As outlined in the Letter of Development Policy (LDP), the Government is committed to address weaknesses in the PFM environment through a broad set of sweeping reforms to be supported by the Bank through the proposed stream of public sector DPCILs, beginning with PPSDPL-1.

184. Irreversible improvements in the fiduciary environment will be largely the outcome of subsequent operations and particularly PPSDPL-1. In the meantime, fiduciary arrangements for PPFDPC-1 will be strengthened as to protect proceeds from the loan, as described in the paragraphs below.

DISBURSEMENT AND AUDITING

185. Borrower and Credit Amount. The Borrower is Serbia and Montenegro, represented by the Ministry for International Economic Relations. The proceeds of the credit will be made available by SaM to the Republic of Serbia following the enactment by SaM of Laws on Ratification and on Borrowing. This operation is a single-tranche credit of US$55 million equivalent. The credit proceeds would be made available to the Borrower upon the effectiveness of the Development Credit Agreement between the Bank and SaM.

186. Disbursement. The high risk fiduciary environment justifies tracking the use of the proceeds from the credit. As foreign exchange expenditure is easier traceable than local currency expenditure, the Bank will require, as presented in subsequent paragraphs, that the proceeds of the credit be used only for eligible foreign currency expenditures.

187. Upon approval of the credit and notification by the Bank of the effectiveness of the Development Credit Agreement between the Bank and SaM, the Borrower will submit a withdrawal application to the International Development Association (IDA). The IDA will deposit the proceeds of the credit into a foreign exchange account designated by the Borrower and acceptable to the Bank, such account to be held at the NBS. This account will be managed by and subject to control of the MOF. No other funds will be allowed on that account.

188. If, after depositing funds in this NBS account, the proceeds of the credit are used for ineligible purposes as defined in the Development Credit Agreement, the Bank will require the Borrower to either: (i) return that amount to the account for use for eligible purposes; or (ii) refund the amount directly to the Bank, in which case the Bank will cancel an equivalent undisbursed amount of the credit.

189. Accounts, Auditing and Closing Date. The MOF will be required to maintain accounts and records showing that disbursements from the above account were in accordance with the provisions of the Development Credit Agreement. Such accounts and records will be maintained in a form acceptable to the Bank. The Bank exercised its right to audit the deposit accounts under earlier adjustment operations. Some minor technical breaches were noted

during the audit of one such operation. The Government subsequently amended its procedures in respect of the handling of Bank funds and no further breaches were noted. Under PPFDPC- 1, the Bank will again exercise its right to audit the transactions from the above deposit account to the ultimate beneficiaries' accounts.

190. The IMF conducted a safeguards assessment of the NBS in November 2001 and concluded that substantial risks may exist in the financial reporting framework, internal audit mechanism, and system of internal controls. The mission proposed a series of measures to address the identified weaknesses. The fourth review under the Extended Arrangement (report 05/13) noted that the measures are being implemented by the NBS.

191. The NBS received an unqualified opinion from its auditor in respect of its latest financial statements (December 3 1,2003). The auditor also provided a comprehensive management letter. The NBS responded to each issue raised in the management letter and in most cases documented the actions it would undertake to resolve the issues.

192. The closing date of the credit is March 3 1, 2006.

ENVIRONMENTAL ASPECTS

193. Environmental issues related to the interventions supported under PPFDPC- I include environmental liabilities during the privatization of socially- and state-owned enterprises, impact of electricity price increases on fuelwood consumption and sustainable forest management and environmental control in mining operations.

194. The Bank's 2003 SaM Country Environmental Analysis (CEA) emphasized the environmental damage caused by industrial and agricultural enterprises, including notably by SOEs, and pointed out the need for clearly defining liabilities for past (stock) and ongoing (current) damage. Serbia has provided assurance to potential investors that they will be responsible only for that damage caused after the conclusion of the sale, while also establishing the new owners as responsible for taking measures to mitigate pollution in the course of their operations. As a result, the Law on Privatization was amended to reflect that the state is responsible for damage inflicted prior to execution of the sales contract and refers to secondary legislation for the establishment of this liability. Under the Privatization and Restructuring of Banks and Enterprises Technical Assistance Project, the Bank provided technical assistance to the GOS for the drafting of such a regulation.

195. The draft regulation is now available and includes provisions on the preparation and evaluation of the environmental audit report, implementation of a remediation plan for past damages and obligations of the buyer to prevent future damage, and supervision and control responsibilities. The timetable for the Government adoption of the regulation is to be finalized.

196. In the overall context of the legal and institutional framework for sound environmental management, it should be also noted that the GOS has been taking steps to harmonize its legislation with the EU acquis communataire. In late 2004, four new laws were enacted, including a New Law on Environmental Protection, and the a Law on Environmental Impact assessment, a Law on Strategic Environmental Impact Assessment and a Law on

Integrate Pollution Prevention and Control. The latter three are transpositions of the respective EU Directives and should substantially strengthen the government's ability to identify responsible entities and mediate environmental concerns.

197. The potential increase in stress on Serbian forests as a result of increased electricity tariff would be best monitored through regular household surveys. The team will raise this issue with the Serbia poverty monitoring team to include it in the poverty monitoring agenda for the coming years.

RISKS AND RISK MITIGATION

198. At the macro level, the reforms supported by the PPFDPC-1 may be threatened by ongoing social and political instability in Serbia, where opposition may weaken the Government's resolve to pursue the reform program. The following policy areas are among the riskiest in terms of exacerbating political and social instability: reduction of longstanding MOE subsidies and reforms in the energy, banking, insurance and real sectors. The reform program will be monitored closely and the GOS and the Bank will consult on whether further actions are required to maintain the economy on a sustainable path. Furthermore, in an effort to mitigate the risk, a gradual approach to the reforms' phase will be adopted throughout the DPCIL program. The social risks of the PPFDPC-1 program can also be mitigated through the GOS' preemptive reforms in addressing the social sector issues supported through PPSDPL-1, which will be implemented subsequent to this operation.

199. The Bank recognizes that a multi-sectoral approach of the PPFDPC-1 is rather ambitious and may be perceived as complex, thus risking timely completion of reforms. The cumulative and irreversible effects of the envisaged reforms validate the approach taken through the DPCIL program. Risks related to the inter-connectedness of the proposed reforms and the large number of governmental institutions involved in the implementation will be mostly mitigated through the MOF, which will assume the role of the overall DPCIL program coordinator.

200. Other risks relate to specific actions of the reform program:

Delays in the implementation process of the overallprogram. The current capacity of some public sector institutions to implement an ambitious reform agenda, while much improved over the past few years, remains relatively weak. The execution risks will be mitigated through utilization of continued technical assistance facilities and active coordination of bi-lateral donor funded technical assistance. Furthermore, support from ongoing and proposed Bank projects in social protection, public sector administration will further serve to mitigate risks. Delays in the Parliamentary approval of apackage of laws which serves as a precursor to successful implementation of the reform program.

201. Domestic and external political risks also remain high. These potential risks could include: (i) reform 'fatigue' within government; and (ii) new Parliamentary elections prior to Board date.

ANNEX 1: LETTER OF DEVELOPMENT POLICY

Serbia and Montenegro (SaM): First Programmatic Private and Financial Development Policy Credit

October 20,2005

Mr. Paul Wolfowitz President The World Bank 18 18 H Street, N.W. Washington, D.C., 20433

Dear Mr. Wolfowitz:

1. We are writing to request, on behalf of Serbia and Montenegro and the Republic of Serbia, the First Programmatic Private and Financial Development Policy Credit (PPFDPC-1) of US$55 million to support our economic reform program. This Letter of Development Policy sets out the key actions that the Government of Serbia (GOS) is committed to undertake over the medium-term to enhance economic growth in Serbia.

2. As per the constitutional charter of the Serbia and Montenegro, a number of responsibilities are transferred to the member states. Given different reform challenges and priorities faced by the two constituent member states, Republic of Serbia and Republic of Montenegro, we believe the two constituent republics should seek World Bank assistance separately. As a consequence, the implementation of all reforms included in the PPFDPCIL program would be the responsibility of the Republic of Serbia.

3. The macroeconomic framework of our reform program centers on: a high quality fiscal adjustment that will enhance macroeconomic stability and policy framework, thereby stimulating private investment; and an acceleration of policy efforts aimed at improving efficiency, including privatization and enterprise restructuring, along with measures directed at improving competition and the investment climate. We are implementing our reform program in the context of the noted macroeconomic framework supported by the IMF under the Extended Arrangement (EA), which is described in greater detail in a Memorandum on Economic and Financial Policy attached to the Letter of Intent of May 21,2004.

4. Real GDP is expected to grow by about 4.6 percent in 2005 reflecting an upturn in industry as privatization and enterprise restructuring continue, and cumulative FDI

inflows reach higher levels. Due mainly to one-off factors-i.e., higher oil prices, rise in the electricity prices, and increase in excise taxes-the inflation rate is projected to be around 12.3 percent in 2005 but is targeted to gradually decline to low single digits over the medium term.

5. The overarching objective of programmatic development policy reform program is to promote economic growth and development in the country through: (i) creating a smaller, more sustainable, more efficient public sector; (ii) creating a larger, more dynamic private sector; and (iii) reducing poverty levels, and improving social protection and access to public services. Public sector efficiency will be considerably strengthened under the DPL program, particularly during programmatic public sector development policy reform (PPSDPL-1 and PPSDPL-2), where the GOS is expected to build foundations of public resource, including financial management, transparency and accountability.

6. Financial management reforms will support improved budget processes including procurement, availability and transparency of government's financial information as well as building of accountability mechanisms, and particularly internal and external audit. Already, under PPFDPC-1 the GOS will initiate reforms with the submissions of the 2004 accounts to the National Assembly and the appointment of an auditor for the audit of the 2003 and 2004 accounts as per the ~ u d ~ e t System Law.

7. This PPFDPC-1 operation, the first of up to four such programmatic operations, will support our reform program in achieving the second Country Assistance Strategy objective by focusing on two key themes: (i) strengthening fiscal discipline, and (ii) building a more efficient and stable financial sector.

8. We aim to achieve the following short-term outcomes through PPFDPC-1: (i) increase Transition Fund resources to CSD 4.5 billion for redundancy payments for employees of enterprises set forth in the list agreed upon with the World Bank, which both spur restructuring and privatization prospects; (ii) privatization and bankruptcy of SOEs eliminated the need for annual direct subsidies in the order of over $30 million in 2005; (iii) by-laws to the new Law on Mining incorporating new royalties framework are in place to support implementation of the law; (iv) financial advisors for Elektroprivreda Srbije (EPS) engaged and EPS' power supply disruptions recorded as less than one day per annum along with a positive operating cash flow during 2005; (v) withdrawal of all passenger services from 7.5 percent of the Zeleznice Srbije's (ZS) network started, whilst core ZS staff reduced by 1,900 (or 7.2 percent) by end-2005 and commensurately reducing 2006 budget subsidies; (vi) the state's holdings in majority-owned banks held at end-2004 are reduced to below 11 percent of total banking system assets and the non- performing loan inventory of the Agency for Deposit Insurance (DIA) is reduced; (vii) failed insurers liquidated in accordance with the new law, financial advisor with appropriate international qualifications appointed to manage the privatization of DDOR, and the new Third Party Liabilities Law is in place to offer coverage on a sustainable basis and to fund guarantee arrangements; (viii) the new Banking Law is enacted by the Parliament; and (ix) new Mortgage Law is adopted and the legal framework for lending

improved and strengthened. Our reform plans to reach these outcomes are briefly outlined as follows.

I. Strengthening fiscal discipline

Kev obiective: To reduce Ministry of Economy's (MOE) subsidy program and strengthen Transition Fund mechanisms

9. Over the past four years, we have made a significant progress in multi-track privatization program aimed at divestiture of socially-owned assets. Over this period, we have also undertaken initial steps towards reducing the overall direct subsidies to socially- and state-owned enterprises in the Serbian economy. The GOS is committed to the private sector development reforms and we will continue to reduce state's involvement in the support of socially-owned enterprises (SOE) and accelerate the restructuring of those companies and their privatization. As such, we have already included a reduction of the MOE direct subsidies to socially-owned enterprises from CSD 6.5 billion in 2004 to CSD 5 billion in 2005. In parallel, we have increased the allocation for the Transition Fund to facilitate redundancies, which both spur restructuring and privatization prospects.

10. With regards to indirect subsidies, we intend to strictly enforce the disconnection policies towards SOEs to prevent further accumulation of energy arrears. To this end, the MOE, in cooperation with the tax authorities and main utilities, will establish monitoring system for the large SOEs in restructuring in order to ensure the full application of hard budget constraints.

Key objective: To continue with privatization, restructuring and bankruptcy proceedings of socially-owned enterprises

11. We realize that continued existence of a large SOE sector imposes considerable risks of disrupting fiscal discipline. As you may know, the GOS has achieved significant progress in its privatization program from 2001 to 2004, whereas as of end-2004, more than 1,000 small- and medium-size enterprises had been sold in auctions and 35 large enterprises were sold through tenders, most of them to international strategic investors. The GOS recognizes the importance of continuing with the privatization of SOEs, and is committed to complete, to a large extent, the privatization program started in 2001 by offering for sale all SOEs currently in the PA tender and auction portfolio, and all saleable assets from the restructuring portfolio. We envision that the restructuring of large SOEs will accelerate with the passage of the proposed amendments to the Privatization Law related to debt restructuring. In particular, we will accelerate the resolution of RTB Bor and Zastava, the two largest recipients of direct subsidies, while also putting into place appropriate social mitigation mechanisms in these mono-industrial communities

12. Effective bankruptcy process is a prerequisite for successful enterprise restructuring and for establishment of hard budget constraint with regards to SOE sector.

After enactment of the new Bankruptcy Law by the Parliament of Serbia in July 2004, the implementation of one of the most important reform regulations started on February 1, 2005. In the course of 2005, the Republic of Serbia-owned or controlled creditors have requested the court to initiate bankruptcy proceedings against a number of large SOEs which have been receiving subsidies and failed to show tangible progress in restructuring. More generally, the state creditors are expected to file for bankruptcy against all enterprises that have twice failed a market test, within 90 days of the second unsuccessful auction or tender.

13. In March 2002, the GOS adopted a Social Program providing a range of compensation and redeployment options for workers in large SOEs dismissed due to restructuring and privatization. Under this scheme, dismissed workers receive about three times the minimum specified in the Labor Law. The GOS recognizes the importance of the Social Program and is currently in the process of discussing amendments to this program.

Key obiective: To improve concessions framework

14. Republic of Serbia has undertaken reforms to transition the state from a role of owner-operator of mineral assets to that of regulator and sector administrator. As part of this transition, the GOS will pursue improvement in the legal and regulatory framework conducive to private sector investment. The proposed new legislation will strengthen fiscal performance of the sector by adhering to international standards regarding competitive taxation, foreign investment, and customs issues unique to mining and establish framework for the negotiation, assessment, and payment of royalties in a transparent manner.

Key obiective: To restructure EPS and prepare for eventual private participation

15. After the Parliament of Serbia has passed the Energy Law in the third quarter of 2004, the GOS has adopted a tariff reform, strengthening of the energy sector social safety net, and put in place an Energy Strategy. The GOS acknowledges the importance of reforms in the energy sector and is committed to restructure EPS through, inter alia, its unbundling into two successor companies: an integrated generation and distributiodsupply company, and a separate transmission company.

Kev obiective: To pursue reforms in the railway sector through restructuring of ZTP

16. The GOS recognized the need to restructure ZTP, the largest public utility which imposed a high fiscal cost on the budget. In March 2005, the Parliament of Serbia has passed the new Railway Law and decree on the reorganization of ZTP. A new railway entity, Zeleznice Srbije, was established, to which the operating assets of ZTP were transferred. In addition, ZS has prepared a new five year strategic business plan, with technical assistance from EBRD and input from the World Bank.

11. Building a more efficient and stable financial sector

Key obiective: To continue privatization and divestment of state-owned banks and financial assets

17. The GOS is committed to continue the reforms in the banking sector. As you may know, three majority state-owned banks have been sold in 2005 and three other banks, including the largest majority state-owned bank, are to be offered for sale beginning in late 2005. The GOS aims by end-2007 to have sold off all its majority-owned banks and most remaining minority stakes held. The DIA has recently launched its first offering of financial assets (loans and private enterprise equity stakes). The GOS is dedicated to extend its sale program to other majority-owned bank holdings and thereafter, to off-load minority state-owned bank holdings through a transparent competitive mechanism.

Kev obiective: To strengthen insurance sector regulation and resolution regime

18. The NBS has recently initiated a series of steps to begin to modernize the regulatory and supervisory framework for the insurance sector. It is essential that the insurance sector restructuring include the NBS' commencement of an on-site inspection of DDOR, and the production of audited accounts for the two publicly-owned insurers. The Parliament adopted the amendments to Insurance Law on July 18,2005, thus enabling the DIA to commence liquidation procedures for the 18 closed insurers. In addition to which, the recent commencement of technical assistance has begun to develop a strategy and formulate needed regulations to put motor third-party liability scheme onto a sound, long-term footing.

Key obiective: To launch the second-phase of the Supervisory Development Plan (SDP)

19. As a consequence of the uneven implementation of bank supervisory processes, the NBS has agreed to develop a time-bound, prioritized and comprehensive "second phase" SDP. This follow on SDP is intended, in part, to identify steps to accomplish key tasks to implement risk based supervision. The National Bank of Serbia (NBS) Governor is slated to formally adopt this "second phase" SDP which reinforces the importance of key supervisory activities. Overarching this initiative, the Ministry of Finance and the NBS are undertaking a full review of the Law on Banks and Banking. Upon seeking comment from the industry, public, the World Bank and IMF, it is envisaged the new law will be introduced to Parliament in late 2005.

Key obiective: To improve access to finance

20. The GOS recognizes that administrative barriers, limited access to finance and high cost of financing are still major impediments to successful business development. Through a passage of a new Mortgage Law, the GOS intends to improve the efficiency of mortgage creation and enforcement, which in turn will encourage rapid development of the primary mortgage market and ultimately, the secondary mortgage market.

21. The GOS is undertaking major actions to address pending structural problems and improve the business climate. We remain resolute to deepen the reforms in the future, and to complement them with measures aimed at strengthening fiscal discipline and building a more efficient and stable financial sector together with policy actions directed at enhancing the competitiveness of the Serbian economy.

22. The GOS undertakes to continue working on these policy issues, for which the support by the World Bank and the rest of the international community will be of vital importance in attaining our objectives of placing the country on a path of sustainable and equitable growth as well as integration into European structures.

23. In conclusion, we would like to reiterate the commitment of SaM and Republic of Serbia to all these reforms, and we trust that this request for World Bank support for their implementation will receive your favorable consideration.

Minister for International Economic Relations Minister of i"inal.icc Serbia and Montenegro Republic uf Serbia

ANNEX 2: GOVERNMENT POLICYIOVERALL GOVERNMENT DEVELOPMENT PROGRAM

1. Serbia's reform program is anchored in the Stabilization and Association Process (SAP) and the Poverty Reduction Strategy Paper. With a shared objective of EU integration, these two strategies present a comprehensive reform agenda designed to achieve sustainable long-term growth and poverty reduction.

2. At the European Summit in Thessalonica held in June 2003, the European Union offered European Partnership as one of the key instruments of the EU pre-accession strategy for the potential EU membership candidates. The Partnership outlines both short-term (12-24 months) and medium-term (3-4 years) priorities for the preparations for further integration in the EU. This mechanism shall exclusively determine relations between the EU and SAM until the Stabilization and Association Agreement has been signed. However, the SAP agenda is very broad, encompassing political as well as economic criteria and reforms and Serbia and Montenegro are in the early stages of the process.

3. Recently, the state union of Serbia-Montenegro on April 13th 2005 received a positive assessment of the country's feasibility study for concluding the Stabilization and Association Agreement (SAA) with the EU."

4. In addition to maintaining macroeconomic stability, the SAP envisaged economic reforms in (i) Private sector development: liberalizing remaining prices and removing administrative controls; speeding up restructuring, privatization andlor liquidation, developing a stable and functioning land real estate market, and developing and implementing a comprehensive strategy to promote employment and combat unemployment; abolishing export duties and import levies and modernize customs; and improving business registration (ii) Public sector reform: ensuring effective functioning o f the state and financial viability of state institutions; reform of the army and electoral law, public administration reform including reform of the civil service pay system, and preparation of comprehensive anti-corruption strategies; formalizing the grey economy, and broadening the tax base and implementing the tax reform package, including VAT; establishing an effective public procurement regime; and developing reliable statistics.

5 . This Serbian Government prepared an "Action Plan for Meeting the Priorities of the European Partnership" as adopted in April 2004. As a follow-up to consultations with the representatives of the EU Commission, amendments to the Action Plan were adopted in November 2004. In this way the Government devised a plan of short- and medium-term activities within the framework of the Stabilization and Association ~ r o c e s s . ' ~

I' The Feasibility report for SAM considers of a number of criteria: the degree of compliance with SAP political and economic conditions, the overall functioning of the State Union, the existence o f a single trade policy and a single market, progress on sectoral reforms and on those institutions at the state level necessary to implement the possible SAA.

l 8 Document and the detailed matrix available at http://www.seio.sr.gov.yu/

6. Among the other goals the GOS Action Plan has explicitly listed the following objectives, consistent with the PPFDPC-1:

Take account of the inevitable costs of structural reforms and rising interest payments, clearly prioritize public spending in short and medium term budgeting; in particular reduce subsidies, transfers and the civil service wage bill. Continue fiscal adjustment and consolidation to reduce relatively high fiscal and in particular external imbalance. Adjust energy prices towards cost recovery levels. Accelerate restructuring, privatization andlor liquidation or large socially and state- owned enterprises. Accelerate the restructuring of large publicly-owned utilities (electricity, oil and gas, railway, airline, telecommunications etc.) Continue banking sector reform more vigorously and in particular the preparation of privatization of the state-owned banks. Ensure allocation of sufficient budgetary resources for redundancy and restructuring costs. Complete the enterprise privatization process. Complete financial (bank) restructuring. Strengthen a business environment conducive to private sector development and employment with competitive markets, level playing fields and access to finance through financial sector development.

7. In parallel to the above referenced Action Plan, the Government has adopted a more focused plan for the removal of administrative barriers to foreign investment, in May 2004. The Action plan for the removal of administrative barriers to foreign investment is divided into four sections: (i) Company start-up procedures, (ii) Infi-astructure development, (iii) Company operational procedures; and (iv) Other systemic measures, public administration reform and judiciary reform. It contains concrete measures, with set deadlines, which is to be monitored via an inter-ministerial Committee for the promotion of investments into Serbia that meets on a regular basis.

ANNEX 3: PPFDPC-1 POLICY MATRIX

POLICY ACTTONS

SUBJECT

in the banking and insurance sectors and of financial assets, strengthen the respective regulatory and supervisory regimes, increase access to real estate finance and overall, further improve the investment climate.

Programmatic Private and Financial DPL series is to strengthen fiscal discipline in the enterprise, energy and transport sectors, build more efficient and stable financial sector, and improve the investment climate through series of policy reforms.

Conditions of PPFDPC-I Tranche Release

facilitatc staff redundancies, thcreby permitting the restructuring andlor sale of effected statc enterprises and public utilities, minimizing market distortions created by such enterprises. Additionally the program outcomes are to reduce the government's holdings

I PPFDPCn PILLAR I: Strengthening fiscal discipline 1

OVERAIRAIIA PPFDPCIL PROGRAM OBJECTIVES: The objective of

1. Macro- cconomic Framework

2. Reduction of MOE subsidy program and strengthening of Transition Fund mechanisms

OVERALL PPFDPCL PROGRAM OUTCOMES: Reduce subsidies so as to

Short-term Outcomes

The macroeconomic policy framework of the Borrower and the Republic of Serbia is satisfactory, as measured on the basis of indicators agreed between the Borrower and the Republic of Serbia, and the Bank.

The Government of the Republic of Serbia has proposed to the Parliament of the Republic of Serbia to dccrcasc the direct subsidies tu socially-owned

Triggers for PPFDPC/L2

enterprises undergoing restructuring from CSD 5 billion, allocated for such purposes in the 2005 State Budget, to CSD 3.85 billion in the 2006 State Budget.

The Government of the Republic of

Overall Program Outcomes

Serbia has agreed to make available CSD 4.5 billion from the Transition Fund for severance payments to employees of socially-owned

Counterpart1 Responsible

Entity

TF funds available for redundancy payments for the companies in the List increased to 4.5 billion.

MOE, MOF, MLESP

CAS High Case Trigger: Reduction in budget subsidies.

enterprises, such enterprises having been set forth in the list agreed upon by the Bank.

Substantial reduction in the direct MOE subsidies over the

SUBJECT

3. Privatization, Restructuring and Bankruptcy of Socially-Owned Enterprises

Conditions of PPFDPC-1 Tranche Release

Starting December 1,2004: (i) the Privatization Agency of the Republic of Serbia has offered for sale no less than eighteen socially-owned enterprises and sold at least nine socially-owned enterprises through its tender program; (ii) PA has offered for sale through auctions no less than 180 socially-owned enterprises, and sold at least 40 percent of such socially-owned enterprises; (iii) PA has offered for sale no less than eight socially-owned enterprises, or significant parts thereof (i.e., representing no less than 50 percent of the total assets), from the list of enterprises undergoing restructuring, using, as applicable, tenders, auctions and asset sales procedures, and sold at least three socially-owned enterprises set forth in the restructuring list; and (iv) Republic of Serbia-owned or controlled creditors have requested the courts to initiate bankruptcy proceedings for at least 6 large SOEs set forth in the restructuring list.

Short-term Outcomes

Privatization and bankruptcy of SOEs removes the need for annual direct subsidies in the order of $30 million in 2005.

, POLICY ACTIONS

Triggers for PPFDPCIL-2

CAS High Case Triggers: Reduction in the state's share in economic activity. Restructuring of state debt that impedes enterprise restructuring. Privatization of viable enterprises and bankruptcy of those that cannot be sold.

Starting on October 1, 2005, the PA will: (i) offer for sale no less than 18 SOEs and sell at least 9 through its tender program; (ii) offer for sale through auctions no less than 450 socially- owned enterprises, and sell at least 40% of them; (iii) offer for sale no less than 25 SOEs from the list of companies under restructuring, or significant parts thereof (i.e., representing no less than 50% of the total assets), using, as applicable, tenders, auctions and asset sales procedures, and sell at least 7 SOEs from the same list.

Starting on October 1, 2005, Republic of Serbia-owned or controlled creditors will request the courts to initiate bankruptcy proceedings for: (i) at least 8 large SOEs from the Restructuring List; and (ii) a number of additional SOEs that have unsuccesshlly been offered for sale twice through auction or tender.

The Government of the Republic of Serbia will submit the Take-over of Companies Law and amendments to Securities Markets Law to the Parliament.

Overall Program Outcomes

Increase in private sector share of employment and industrial output

Reduction in subsidies allocated to SOE sector.

Government Counterpart/ Responsible

Entity MOE, PA

SUBJECT

4. Concessions

5. EPS

1 6. Railway sector

POLICY ACTIONS

Conditions of PPFDPC-1 Tranche Release

The Government of the Republic of Serbia has submitted to the Parliament of the Republic of Serbia amendments to the Law on Mining, satisfactory to the Bank, incorporating a new royalties framework

Short-term Outcomes

The Law on Mining is adopted by the Parliament.

Triggers for PPFDPC/L-2

Regulations that define procedures for assessment of annual mineral production, surface and filing fees, royalties and payment procedures, and resolution of disputes and conflicts are in place.

Overall Program Outcomes

Transactions under the new law have been initiated.

Government Counterpart1 Responsible

Entity MIER, MEM, MOF

The Government of the Republic of Serbia has launched an international tender to engage a Financial Adviser for Elektroprivreda Srbije, in accordance with terms of references and procedures satisfactory to the Bank.

Zeleznice Srbije (ZS) has reduced ZS staff engaged in core ZS activities by 1,900, or 7.2 percent of total ZS core staff of 26,212 employed as of January 1,2005, and ZS and GOS have adopted the 2005 Business Plan.

ZS to begin the withdrawal of all passenger services from 7.5 percent of the network (260km), convert them to manipulation lines in 2005 and finalize plans for similar activities through 2009 in the 2005-2009 Strategic Plan.

Begin implementation of the approved

EPS Financial Adviser engaged.

Power supply disruptions recorded as less than one day per annum.

EPS' operating cash flow to be positive for 2005.

Core ZS staff will have been reduced by 1,900, or 7.2%, by end-2005, commensurately reducing CY2006 budget subsidies.

ZS will have withdrawn all passenger services from 7.5% of the network.

CAS High Case Trigger: Strong progress on EPS restructuring. Establishment and then strengthening of the energy regulator with a view to moving to full tarzff-setting authority.

Financial Adviser to deliver to GOS recommendations on restructuring of EPS.

Regulatory framework is in place providing for transparent rules for setting cost recovery tariffs.

CAS High Case Trigger: Restructuring of the railways.

Core ZS staff have been reduced by a further 1,000 employees, or 3.8% of total ZS core staff as of January 1,2005.

ZS has withdrawn passenger services from a further 6.3 percent (218km) of the network by about mid-2006, unless service specific Public Service Contracts (PSC) are agreed.

ZS has transferred 3 additional non-core activities to Privatization Agency.

GOS has begun restructuring of EPS in accordance with agreed action plan to further improve its financial performance and to meet internal and external pre- conditions for private sector participation.

Following the retrenchment of surplus labor, the withdrawal of passenger services from unviable lines, and the divestiture of non-core activities, as defined in the project, overall budget support to the railway sector will be significantly reduced (in constant prices).

MEM

ZS, MCI, MOF

SUBJECT

Supervisory Development Plan (SDP)

POLICY ACTIONS I Government

company.

Conditions of PPFDPC-1 Tranche Release

Strategy for TPL refonn has been agreed and a draft law submitted to the Parliament.

Short-term Outcomes

The Supervisory Review Committee of the NBS Banking Supervision Department (BSD) and the Governor of the NBS have adopted the second phase of the Supervisory Development Plan, satisfactory to the Bank, and the NBS BSD has continued its implementation.

Implementation has been demonstrated by:

(i) revised draft of a comprehensive SOP, satisfactory to the Bank,

(ii) risk matrices and supervisory strategies for banks examinations completed as of September 30, 2005;

(iii) a time-bound corrective action plan to address Basel Core Principles weaknesses identified;

qualifications has been appointed to manage privatization of DDOR.

New TPL Law is in place to offer coverage on a sustainable basis and to fund guarantee arrangements.

New Banking Law enacted by the Parliament.

Triggers for PPFDPCk-2 Overall Program

Outcomes

sound financial and operating basis.

A new TPL regime has been introduced to secure the rights of legitimate claimants.

By-laws needed to implement the new Banking Law are in place, including by-law(s) addressing sound risk management processes and accurate and timely reporting of risks.

1 (iv) for those banks whose deadline for I

The NBS has + I significantly strengthened its capacity to regulate and supervise banks on a consolidated basis and is consistently holding accountable bank Directors and Officers for misstatements in banks' published financial statements.

Counterpart1 Responsible

Entity

NBS (Bank Supervision Department)

SUBJECT I

10. Access to Finance

POLICY ACTIONS

Conditions of PPFDPC-1 Tranche Release

implementation of corrective action measures has expired as of September 20, 2005, the NBS is to verify that provisions have been taken by the deadline specified in the corrective action plan and are reflected on subject banks' financial and replatory reports;

(v) NBS has issued a new regulation, effective January 1,2006, that requires the examined banks to book NBS directed provisions no later than the end of the quarter of the NBS' issuance of the corrective measures and makc necessary changes in regulatory reports.

The Government of the Republic of Serbia has submitted to the Parliament of the Republic of Serbia a draft Law On Mortgage, satisfactory to the Bank.

Short-term Outcomes

New Mortgage Law adopted.

Triggers for PPFDPCIL-2

By-laws or regulations, if any, needed to support implementation of Law on Mortgage adopted.

Overall Program Outcomes

Development of the legal Eramework for the primary market (market based housing finance system) and help a creation of secondary mortgage market to ensure sustainability of lending.

Counterpart/ Responsible

MIER, MOF

ANNEX 4: FUND RELATIONS NOTE

On June 29, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Serbia and Montenegro (Public Information Notice No. 05/84). The Executive Board also completed the fifth review of Serbia and Montenegro's economic performance under an Extended Arrangement (Press Release No. 051155). The completion of the review enables the release of an amount equivalent to SDR 125 million (about US$182.9 million), which would bring the total disbursement under the program to SDR 587.5 million (about $US859.7 million). In completing the review, the Board also approved Serbia and Montenegro's request for waivers of four performance criteria. In addition, the Board completed a Financing Assurances Review and approved a request to rephase the eleventh and final disbursement, which would become available upon the completion of the sixth review.

The Extended Arrangement was approved in May 2002 for a total amount equivalent to SDR 650 million (about U S 9 5 1.1 million) to support Serbia and Montenegro's 2002-2005 economic program (see Press Release No. 02/25). The arrangement was extended in May 2005 until December 3 1,2005.

Following the Executive Board's discussion on Serbia and Montenegro, Mr. Takatoshi Kato, Deputy Managing Director and Acting Chair, stated:

"Following a mixed program implementation during the third year of their Extended Arrangement with the Fund, the authorities of Serbia and Montenegro have agreed on an appropriate set of corrective actions to deal with the growing macroeconomic imbalances. While economic growth has been commendably strong, the continued strength of domestic demand, sustained by a credit boom and inflows of remittances, as well as the constraints stemming from the high euroization and structural rigidities have contributed to a resurgence in inflation and a persistently large current account deficit. The authorities' policies of further fiscal and monetary tightening and accelerated structural reforms should help reverse the imbalances.

"The tighter fiscal stance is welcome. Following the heavy reliance in the short run on higher revenues, it will now be important to implement the cuts in permanent spending, mostly through pension reform and lower subsidies, that will help achieve a sustainable reduction in the size of the public sector.

"The envisaged monetary tightening should help contain demand and inflationary pressures. The strong pressure from recently established foreign banks competing for market shares to increase credit calls for heightened vigilance, and the authorities should stand ready to take further measures to tighten monetary conditions if needed. The privatization of the two largest state-owned banks in Serbia will be a key priority for the period ahead.

"The use of the exchange rate to bear down on inflationary pressures is understandable given those pressures and the extent of euroization. However, the approach is sustainable only in the measure in which the tightening of macroeconomic policies offsets the impact of this policy on the current account. More fundamentally, structural reforms, in particular, privatization and restructuring of publicly controlled enterprises, need to be accelerated to stimulate export growth, and enhance medium-term external sustainability. Strict enforcement of bankruptcy procedures is also needed to reallocate resources within the economy.

"In Montenegro, the implementation of the agreed reduction in the fiscal deficit of about one percent of GDP will help contain demand and the external deficit in line with the program. The large privatization revenues should be used mainly to retire domestic debt. The development of a debt and

asset management strategy, strengthened revenue collection and acceleration of civil service reform will be essential to create room for additional public investment.

"Strong implementation of the envisaged policy package will be key to lowering macroeconomic imbalances, containing program risks, and boosting growth in the medium term. This will also be key to ensuring the international community's continued support for Serbia and Montenegro's adjustment and reform efforts," Mr. Kato said.

Background

Macroeconomic imbalances in Serbia and Montenegro have widened in 2004 putting at risk some of the impressive earlier achievements. Growth, around 5 percent in non-agriculture since 2002, has been fueled by a surge in domestic demand. Lack of competitive domestic production has led to increased imports and a widening current account deficit. Annual inflation returned to double-digit levels reflecting demand pressures and faster dinar depreciation coupled with widespread euro- indexation. The current account deficit reached 15 percent of GDP in 2004; the increase only partly explained by the value added tax (VAT) induced shift of imports in late 2004. In Montenegro, the adoption of the euro has stabilized inflation at 3-4 percent. However, a large current account deficit, financed by foreign borrowing and, in 2005 by privatization receipts, risks eroding domestic competitiveness.

The attempts to use exchange rate policy to address rising inflation or deteriorating external balances have failed due to important structural rigidities. Exchange rate depreciation led to surging inflation given the high euro-indexation of prices, and small share of competitive supply, and fixing the exchange rate worsened the external balances, as a rigid spending structure limited fiscal tightening and loose wage policy boosted demand.

The fiscal stance has increasingly been tightened to strengthen demand management. The deficit declined from over 5 percent of GDP in 2002 to a projected surplus in 2005. However, the bulk of the adjustment was due to an increase in revenues, while cuts in current spending have been more limited. As a result, the revenue burden and.the size of government, with expenditures at 45 percent of GDP, remain the highest in the region. Monetary policy has been accommodating, weakened by increasing euroization and complicated by a credit boom.

The slow structural reform is at the core of the macroeconomic imbalances and rigidities. With the private sector at barely half of the GDP, the competitive supply remains limited. The weak financial discipline in many of the public enterprises has reduced public savings and undermined the tight fiscal policy pursued at the central government level. Given the external financing constraint to investment, enterprise restructuring is increasingly important for growth and for the efficient reallocating resources within the economy.

The main policy challenge is to maintain macroeconomic stability while accelerating structural reform. Fiscal policy needs to be tightened substantially, and its flexibility increased by reducing the large share of non-discretionary spending. A tighter monetary policy, despite the high level of euroization, is necessary to slow down the credit boom and foreign borrowing fuelling imports. Structural ieforms should be deepened through the privatization and liquidation of socially-owned companies, restructuring of the state enterprises, and hardening financial discipline. The successful bank privatization should continue, with the entry of new banks boosting competition. Bank supervision is to be strengthened to deal with increased foreign currency risk and credit activity.

Serbia and Montenegro: Fund Relations As of May 3 1,2005

I. Membership Status: Joined December 14, 1992 (succeeding to membership of the former SFR Yugoslavia); adopted Article VIII on May 13, 2002.

LI. General Resources Account Quota Fund Holdings of Currency

111. SDR Department Net cumulative allocation Holdings

IV. Outstanding Purchases and Loans Extended arrangement Stand-by arrangements

SDR Million %Quota 467.70 100.00

1,036.56 22 1.63

SDR Million %Allocation 56.66 100.00

1.90 3.35

SDR Million 462.50

72.50

V. Latest Financial Arrangements D2.E Approval Expiration Amount Approved Amount Drawn

Date Date (SDR Million) [SDR Million) EFF 5/14/02 12/31/05 650.00 462.50 Stand-by 611 1/01 513 1/02 200.00 200.00

VI. Projected Payments to Fund (Expectation as is)'^ (SDR Million; based on existing use of resources and present holdings of SDRs)

Forthcoming 2005 2006 2007 2008 2009

Principal 87.60 27.08 50.00 11 6.67 145.83 Charges/Interest 10.66 18.75 17.70 14.93 10.27 Total 98.26 45.83 67.70 131.59 156.11

Contact persons: Ms. Piritta Sorsa (psorsa(i?Jirnf.org, 202-623-8657), Mr. Eric Mottu (emottu@imf.org), Mr. Andreas Westphal (awesiahal@imf.org, 202-623-7389), and, for Montenegro, Mr. Magnus Alvesson (malvesson@,imf.org, 202-623-6372).

l 9 This schedule presents all currently scheduled payments to the IMF, including repayment expectations where applicable and repayment obligations otherwise. The IMF Executive Board can extend repayment expectations (within predetermined limits) upon request by the debtor country if its external payments position is not strong enough to meet the expectations without undue hardship or risk.

ANNEX 5: KEY ECONOMIC INDICATORS

Serbia and Montenegro - Key Economic Indicators

Total Consumption 1 0 3 . 107 107 106 111 109 110 107 105 Gross domestic fixed investment 15 13 16 16 18 16 18 20 20

Government investment 3 2 3 2 3 3 4 4 4 Private investment 12 12 12 13 15 13 14 15 16

Exports (GNFS)~ 30 24 21 Imports (GNFS) 47 45 44

Gross domestic savings -3 -7 -7

Gross national savingsC 10 9 7

Memorandum items Gross domestic product 8603 11576 15528 (US$ million at current prices) GNI per capita (US$, Atlas method) 1220 1260 1390

Real annual growth rates (%, calculated from 1998 prices) Gross domestic product at market prices 5.0 5.5 3.8 Gross Domestic Income 5.0 5.4 3.9

Real annual per capita growth rates (%, calculated from 1998 prices) Gross domestic product at market prices 5.4 5.7 4.1 Total consumption 4.8 13.6 7 7 Private consumption 18.5 15.8 6.2

Balance of Payments (US$ millions) ports (GNFS)~ 2547 2743 3241

Merchandise FOB 1923 2003 2412

Imports ( G N F S ~ 4004 5160 6857 Merchandise FOB 3711 4837 6320

Resource balance -1457 -2417 -3616 Net current transfers 1119 1915 2343 Current account balance -337 -528 -1384

Net private foreign direct investment 25 165 562 Long-term loans (net) 213 299 378 Other capital (net, incl errors & ornrniss~ons) 345 459 1260

Change in reservesd -246 -395 -816

Memorandum items Resource balance (% of GDP) -16 9 -20.9 -23.3

Serbia and Montenegro - Key Economic Indicators (Continued)

Actual Estlmate Projected Indicator 2000 2001 2002 2003 2004 2005 2006 2007 2008

Public finance (as % of GDP at market prices)' Current revenues 37.5 39.6 44.2 42.5 44.8 43.6 43.5 43.2 43.1 Current expenditures 34.4 37.7 43.7 42.3 41.9 41.1 40.2 39.5 39.3 Current account surplus (+) or deficit (-) 3.1 2.0 0.6 0.3 3.0 2.4 3.3 3.8 3.8 Capital expenditure and net lending 3.3 2.5 3.8 3.8 3.7 2.7 3.8 4.2 4.3 Foreign financing 0.0 0.0 1.8 1.2 1.0 1.4 0.1 -0.3 -0.7

Monetary indicators M2IGDP Growth of M2 (%)

Price indices( YR98 =loo) Real exchange rate (USSILCU)' 100.0 77.8 60.3 50.4 50.0 48.1 48.6 48.0 47 7

Consumer price index (% change) 69.9 91.1 21.2 11.3 9.5 13.0 7.7 6.6 4.4 GDP deflator (% change) 88.5 91.7 24.6 16.0 9.9 14.4 7.9 7.3 4.9

a. GDP at factor cost b. "GNFS" denotes "goods and nonfactor services." c. Includes net unrequited transfers excluding officlal capital grants. d. Includes use of IMF resources. e. Consolidated central government. f. "LCU" denotes "local currency units." An increase in USSILCU denotes appreciation.

ANNEX 6: KEY EXPOSURE INDICATORS

Serbia and Montenegro - Key Exposure Indicators

Actual Estimate Projected Indicator 2000 2001 2002 2003 2004 2005 2006 2007 2008

Total debt outstanding and 10830 10941 11841 14302 14790 14578 16305 17730 19102 disbursed (TDO) S US$^)^

Net disbursements (US$m)a .. 502 677 1236 1291 1354 1929 2025 2071

Total debt service (TDS)

(US$m)l

Debt and debt service indicators

(%I TDOIXGS~ TDOIGDP TDSIXGS ConcessionaliTDO

IBRD exposure indicators (%)

IBRD DSipublic DS Preferred creditor DSlpublic

DS (%)'

IBRD DSIXGS IBRD TDO US$^)^

Of which present value of guarantees (US%m)

Share of IBRD portfolio (%) .. 91.8 89.3 86.0 83.1 79.6 77.3 76.4

IDA TDO ( ~ ~ $ m f .. 168 273 462 574 711 805 842

a. Includes public and publicly guaranteed debt, private nonguaranteed, use of IMF credits and net short- term capital.

b. "XGS" denotes exports of goods and services, including workers' remittances. c. Preferred creditors are detined as IBRD, IDA, the regional mulhlateral development banks, the IMF, and the

Bank for International Settlements. d. Includes present value of guarantees. e. Includes equity and quasi-equity types of both loan and equity instruments.

ANNEX 9: COUNTRY AT A GLANCE

Serbia and Montenegro at a glance 1o124105

Serbia POVERN and SOCIAL and

Montenegro 2004 Population, mid-year (millions) 8.3 GNI per capita (Atlas method, US$) 2,620 GNI (Atlas method, US$ billions) 21.7

Average annual growth, 1998-04

Population (%J -0.2 Labor force (%) -1 0

Most recent estimate (latest year avallable, 1998-04)

Poverty (% of population below national poveify line) 10 Urban population (% of totalp0p~iati0i7) 52 Life expectancy at birth (years) 73 Infant mortality (per 1,000 live births) 16 Child malnutrition (% of children under 5) 2 Access to an improved water source (% ofpopulation) 98 Literacy (% ofpopulation age 15+) Gross primary enrollment (% of school-age population) 99

Male 99 Female 99

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1984 1994

GDP (US$ billions) .. 10.9 Gross capital formationlGDP Exports of goods and serviceslGDP Gross domestic savingslGDP Gross national savings1GDP

Current account baiancelGDP interest paymentslGDP Total debffGDP Total debt servicelexports Present vaiue of debWGDP Present vaiue of debffexports

Europe B Central

Asia

Lower- mlddle- income I Development diamond' I

e i capita ~f

1 Access to improved water source ~ I -Serbia and Montenegro

- Lower-middle-income group I 1 Economic ratios' I

Trade -

I Domestic Cap~tal savlngs formation

Indebtedness 1984-94 1994-04 2003 2004

(average annual growth) GDP .. 1.4 2.7 7.2 GDP per capita .. 4.9 2.8 7.1 Exports of goods and services .. 9.4 7 3 42 5

-Serbia and Montenegro

---- Lower-middle-income group I STRUCTURE of the ECONOMY

Growth of capital and GDP (%) 4 0 - I (% of GDP)

Agriculture lndustry

Manufacturing Services

Househoid final consumption expenditure Generai gov't final consumption expenditure Imports of goods and services

Growth of exports and imports (%)

60 - I (average annual growth) Agriculture Industry

Manufacturing Services

Househoid final consumption expenditure General gov't final consumption expenditure Gross capital formation Imports of goods and services

Note: 2004 data are preliminary estimates

'The diamonds show four key indicators in the country (in bold) compared with its income-group average If data are missing, the diamond will be incomplete.

Serbia and Montenegro

PRICES and GOVERNMENT FINANCE

Inflation (%) I Domestic prices (% change) Consumer prices implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overaii sumius/deflcit

TRADE

Export and import levels (US$ mill.)

14.000 - I (US$ millions) Total exports (fob)

Food Other fuel Manufactures

Total imports (cif) Food Fuel and energy Capital goods

Export price index (2000=100) Import price index (2000=100) Terms of trade (2000=100)

BALANCE of PAYMENTS

Current account balance to GDP (%) I Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves

Memo: Reserves including gold (US$ millions) Conversion rate (DEC, locai/US$)

EXTERNAL DEBT and RESOURCE FLOWS

1 ~ o m ~ o s i t i o n of 2004 debt (US$ mill.) I Total debt outstanding and disbursed

IBRD IDA

Total debt service IBRD IDA

Composition of net resource flows Official grants Official creditors Private creditors Foreign direct investment (net inflows) Portfolio equity (net inflows)

World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

190 181 A - I B R D E - Bilateral 95 164 B - IDA D - Other rnulfilateral F - Pnvate

0 0 C - IMF G - Short-term I Develo~ment Economics 10124/05

MAP SECTION

M O N T E N E G R OM O N T E N E G R O

K O S O V OK O S O V O

V O J V O D I N AV O J V O D I N A

S E R B I AS E R B I A

Foca

Vucitrnˇ

Vrsacˇ

BackaTopola

ˇ

Bosilegrad

SokoBanja

Majdanpek

RaskaˇSjenica

Ivanjica

Pozegaˇ

Kladovo

Petrovac

GolubacPozarevacˇ

Smed.Palanka

GornjiMilanovac

Bujanovac

Knjazevacˇ

Paracin ´´

Bor

Dakovica

Berane

Herceg-Novi

Leskovac

Negotin

Novi PazarPirot

Prizren

Vidin

Vranje

Pljevlja

Pec

Orahovac

Tetovo

Urosevacˇ

Priboj

Presevoˇ

Gnjilane

KosovskaMitrovica

Zajecarˇ

Cetinje

Bar

Ulcinj

Shkodër

Aleksinac

Kraljevo

Valjevo

Uziceˇ

Prijepolje

Prokuplje

Krusevacˇ

Velika-Plana

Loznica

Cacakˇ

Kragujevac

Jagdiina Cuprija´

BelaCrkva

Pancevoˇ

Kovin

Ada

Apatin

Bajmok

Kikinda

KulaOsijek

Senta

Sombor

Bijeljina

Ruma

Obrenovac Smederevo

AradSzeged

KanjizaˇSubotica

Mohács

Pécs

Vinkovci

Sidˇ

Zeleznikˇ

Brckoˇ

Sabacˇ

Alibunar

Temerin

SrbobranBecejˇ

BackaPalanka

ˇ

Indija

Zrenjanin

Sivac

Mladenovac

Bijelo Polje

BelaPalanka

Niksicˇ ´

Rogacica

Ljubovija

Nis

Elemir

Zagubicaˇ

Timisoara

SARAJEVO

SKOPJE

Pristinaˇ

Novi Sad

Podgorica

BELGRADE

M O N T E N E G R O

K O S O V O

V O J V O D I N A

S E R B I A

H U N G A R Y

ROMANIA

ALBANIA

BULGARIA

FYR MACEDONIA

CROATIA

BOSNIA ANDHERZEGOVINA

CROATIA

Tisa

Danube

Sava

Dr i na

Tara

BeliD

rim

AdriaticSea

Zapad na Morav a

Juzna M

or ava

Veli ki

Uvac

Sitnica

Lim

LakeScutari

Veli kaM

orava

This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other informationshown on this map do not imply, on the part of The World BankGroup, any judgment on the legal status of any territory, or anyendorsement or acceptance of such boundaries.

SERBIA ANDMONTENEGRO

EUROPEAN HIGHWAYS

OTHER CLASS I HIGHWAYS

RAILWAYS

AIRPORTS

TOWNS

REPUBLIC OR PROVINCE CAPITALS

NATIONAL CAPITALS

PROVINCE BOUNDARIES

REPUBLIC BOUNDARY

INTERNATIONAL BOUNDARIES

IBRD 31506R2

JULY 2004

22°

45°

44°

43°

42°

20° 21°

43°

44°

45°

46°

21°20°19°18° 23°

22°

46°

Serbia andMontenegro