Risk drivers and outlook

Risks related to the political situation sensu stricto are relatively moderate. Indeed, over the past few years, Serbia has improved its relation with the EU while maintaining strong ties with Russia, its historical ally. Over the coming years, EU accession is likely to remain a key anchor for reforms. That being said, the country is likely to remain caught between conflicting demands of the EU accession process, its close relation with Russia and nationalist rhetoric.

Growth prospects are strong but remain somewhat impeded by low but rising national savings and domestic investment and a weak but improving business environment. Serbia has seen its current account balance improve thanks to a continuous increase in exports of goods and non-factor services and being a net fuel importer, while private transfers were slightly under pressure.

The moderate to high financial risk is on a downward trend. Indeed, after years of external debt build-up, the external debt and debt service ratios have decreased and are likely to remain on a downward trend over the coming years. Fiscal consolidation efforts have been impressive in 2015 and 2016. However, public debt remains high. In the coming years, further improvement of public finances is expected.

Thanks to the combination of the improvement of the financial-economic situation and a stable political situation, Credendo upgraded its MLT political risk to category 5 (from category 6) in January 2017. Given ongoing fiscal consolidation and an expected additional decrease in external debt, the MLT political risk is likely to improve further in the coming years.

The combination of low short-term debt, favourable liquidity indicators and a favourable but decreasing level of foreign exchange reserves explained the category 2 classification for the short-term political risk.

The commercial risk is moderate, in category B. On the positive side, growth perspectives have improved, the current account deficit is moderate, and credit is available. On the negative side, financial cost remains somewhat high and business environment remains weak despite recent improvements.

Facts & figures

Pros

  • EU candidate status
  • Strong exports of goods and non-factor services
  • Good growth prospects

Cons

  • Difficult but improving business climate
  • Weak public finances
  • Weak state-owned enterprises

President

  • Tomislav Nikolic

Head of government

  • Aleksandar Vucic

Description of electoral system

  • Presidential election: next in April 2017
  • Legislative election: next in 2020

Population

  • 7.1 million

Per capita income (USD)

  • 5,500

Income group

  • Upper middle income

Main export products

  • Manufactured exports (35.6% of current account receipts), private transfers (16.3%), food (10.1%), ores and metals (5.6%), transport services (5.2%), travel (4.8%)

Country risk assessment

Improving relations with EU and good ties with Russia, its historical ally

Following the conflict in Kosovo (1998-99) and the removal of Milosevic from power in 2000, Serbia has improved its relation with the EU while continuing to pursue good relations with Russia, its historical ally. In 2006, Montenegro took its independence from Serbia in a rather smooth transition. Kosovo declared its independence from Serbia in 2008, a move not recognised by Serbia so far.

In 2013, following an agreement between Serbia and Kosovo that led to the normalisation of diplomatic relations, the EU decided to open accession negotiations with Serbia. Apart from the institutional reforms required to join the EU, the accession process is likely to be marked by issues dating back to the Yugoslav wars of the 90s, such as the punishment of war criminals, the deterioration of relations with Croatia (on the back of a refugee crisis and issues related to the Croat minority in Serbia) and the recognition of the independence of Kosovo. On top of that, a growing share of EU citizens opposes enlargement which could also have implications on Serbia’s ambition to join the EU. What is more, unhappy Serb minorities in Bosnia-Herzegovina and Kosovo could have a spillover impact on Serbia. Indeed, tensions in neighbouring countries could increase nationalist sentiments in Serbia.

In April 2016, Prime Minister Aleksandar Vucic – a former ultranationalist – organised early elections in order to secure a mandate for reforms and reaffirm Serbia’s path toward EU accession. The latest contests were won by the Serbian Progressive Party (SNS), the party of Prime Minister Vucic. Under the leadership of Vucic, the party has been strongly committed to pursuing EU membership, although the party – and its former leader Tomislav Nikolić – is also keen on promoting good relations with Russia, alongside a policy of military neutrality. Another important party, led by Ivica Dacic, is the Socialist Party of Serbia of former president Slobodan Milosevic. It is a centre-left party which generally supports EU accession, but many of its members are pro-Russian.

Mr Vucic has formed a government that will continue to pursue painful fiscal consolidation. The implementation of structural reforms remains constrained by political resistance given the presence of vested interests, especially in state-owned enterprises (SOEs). What is more, progress in winding down loss-making public companies raises the risk of social unrest.

Despite its strong commitment to move towards EU accession, Serbia is likely to remain caught in the coming years between conflicting demands of the EU accession process, its close relation with Russia and nationalist rhetoric.

Improving growth prospects
 

Ever since the financial and economic crisis in 2008, growth has been lacklustre (on average -0.1% in 2009-2015). However, recently, the real GDP growth perspective has improved markedly thanks to recovery in industrial production and agriculture and stronger investment. Real GDP growth is forecast to reach 2.8% this year, compared to 2.5% in 2016. Growth prospects are good but remain impeded by low but rising national savings and domestic investment, and by the weak but improving business environment. Indeed, Serbia’s ranking in the World Bank doing business indicators improved from rank 54 in 2016 to rank 47 in 2017. Despite this improvement, the business climate remains somewhat constrained by, among other things, the quality of the judiciary system, non-price competitiveness issues and the large role of SOEs in the economy (in 2014, Serbia had over 1400 SOEs accounting for 15 to 20% of total formal employment).

The reform of SOEs is one of the centrepieces of the 3-year IMF Stand-By Arrangement, approved in February 2015 and treated by Serbia as precautionary. So far, the pace of reforms has been slow but some progress has been made. Indeed, some public enterprises entered bankruptcy and others were privatised which led to an increase in foreign direct investments (e.g. China’s HeSteel announced an investment of USD 120 million in 2017 to upgrade Serbian steel mill Zelezara Smederevo which it bought in 2016). The government is likely to continue its efforts to reform SOEs; additional privatisations have already been announced.

Ongoing fiscal consolidation

Due to deep fiscal deficits, large costs from state-controlled enterprises (estimated at 2% of GDP in 2014) and lacklustre economic growth, the public finances deteriorated quickly after the 2008 global economic and financial crisis. The general government debt, mostly externally owned, surged from 35% of GDP in 2009 to a peak of more than 75% in 2015. Beside that increase, the interest payments to public revenues ratio has increased as well but remains relatively moderate. Fiscal consolidation efforts have been impressive in 2015 and 2016. This led to an improvement of the fiscal balance and a slight decrease in general government debt in 2016. In the coming years, further improvement of public finances is expected although fiscal slippages in the run-up to the presidential election (scheduled for this spring) cannot be ruled out. What is more, despite progress, fiscal controls remain weak as evidenced by the accumulation of domestic payment arrears by some municipalities and SOEs.

Narrowing current account deficit and decreasing external debt

Over the past few years, the current account balance to GDP ratio has improved somewhat and is likely to continue to improve slightly this year. This improvement is explained by a continuous increase in the exports of goods (supported notably by past FDI) and non-factor services while private transfers have been slightly under pressure. The net fuel importer has also benefitted from low oil prices. FDI inflows (in the automobile sector, agriculture, mining and air transport) have been strong over the past few years and are expected to remain strong in the coming years (partly driven by privatisation).

The foreign exchange reserves have declined slightly in relative and absolute terms. However, their level remains favourable as they still covered almost 5 months of imports in October 2016 and more than three times the short-term debt. The ratio of short-term debt to current account revenues has been rather low and stable over the last three years. The combination of low short-term debt, favourable liquidity indicators and a favourable but decreasing level of foreign exchange reserves explained the category 2 classification for the short-term political risk.

The central bank pursues a managed float exchange rate policy and thus sporadically intervenes with its foreign exchange reserves in the exchange rate market. Inflation is low. Over the last year, the Serbian dinar depreciated slightly compared to the euro (0.8%) and the US dollar (3%). The evolution of the currency over the next months will depend on whether Serbia will succeed in obtaining enough capital flows (such as FDI or portfolio investment) to finance its moderate current account deficit.

The risk related to the banking sector has also improved. Before the 2008 crisis, the country’s strong economic growth was partly fuelled by credit expansion which led to the deterioration of the loan-to-deposit ratio and an increase in the banking sector’s reliance on external funding. Since then, the net foreign assets position has strengthened markedly and reached -2.3 % of GDP in August 2016 compared to -13.4% of GDP in 2013. Asset quality and profitability are on the rise even if progress made by individual banks is uneven.

Financial risk is on a downward trend. Indeed, following years of external debt build-up, external debt peaked in 2012. Since then, it has broadly decreased and was likely to reach around 80% of GDP in 2016. A large share of external debt is owed by the public sector. Hence, thanks to ongoing fiscal consolidation efforts, the downward trend in external debt is expected to continue. Along with the decline in external debt, the debt service ratio has also followed a downward trend.