Erste Bank Research - Long-term Outlook Serbia

Relevant Changes

The real economy outlook remained unchanged from 4Q. The current account deficit forecast has been additionally revised to account for strong 1Q performance. 1Q inflation developments only confirmed the deviation from the 2011 NBS inflation target, while the NBS decided to also allow nominal appreciation to tame inflation pressures.

As expected, the hiking cycle reached the peak in the 12-13% region, while we continue to see relaxation in 2H11, with moderating inflation pressures. The exchange rate risk further diminished on the favorable interest differential and stabilizing FX outlook.

EU negotiations

Serbia moved closer to obtaining candidacy status, with the green light being given to the European Commission to draft an opinion on Serbia, a process likely to last for about a year. In the smoothest scenario, Serbia should be granted candidacy status by the end of 2011. The EU negotiations timetable gains importance with parliamentary elections approaching (somewhere in 1H12).

Real economy

After some slowdown in 4Q (+1.7% vs. 3.1% y/y in 3Q), the beginning of 2011 brought a rebound, with flash estimates suggesting 3% y/y 1Q GDP growth. Short-term indicators are suggesting a positive contribution from industrial production (+5.6% y/y) and ongoing strong exports momentum (30+% y/y). On the other hand, accelerating inflation hurt purchasing power (combined with a still fragile labor market), bringing real retail trade turnover back into the negative region, suggesting consumer spending weakness. As far as the remainder of the year is concerned, we are counting on stable positive impact from external demand, as the exports market economic outlook remains fairly supportive. Also we continue to see investments acceleration as playing an important role in shaping GDP growth, where the postponed telecom privatization would likely burden the pace of public investments to some extent, i.e. Coridor X. Our call for FY11 growth remains unchanged at 3%, where picking-up remains driven by external demand, while domestic demand performance is set to remain a bit shaky. In the medium term, the main challenge remains to maintain the present transition towards exports led growth, i.e. stepping up structural reforms, enhancing competitiveness and fiscal tidiness.

External balance

1Q brought ongoing robust export performance that kept up a 30+% growth rate on an annual level, being supported by consumer goods and intermediaries performance. Imports also rebounded, accelerating to 23% y/y, being predominantly driven by intermediaries and investments goods and resulting in a 10% higher 1Q trade balance deficit and a 4pp lower exports/imports coverage ratio. Given the strong 1Q performance, we revised our CAD estimate for 2011 slightly downwards, expecting it to land in the region of 7.5-8-0% of GDP. On the financing side, delayed state telecom privatization brings some risks to the financing mix, being more reliant on debt-generating funding and portfolio investments. We see only modest FDI recovery this year, being able to cover less
than 50% of CAD on a net basis. The focus would thus remain on debt-creating financing. The financing mix thus remains sensitive to global sentiment and risks appetite, where we see the potential new precautionary arrangement with the IMF as a supportive factor and with fiscal prudence additionally alleviating the risks. In 2011, we expect some acceleration of foreign debt growth (though still remaining in the single-digit region). Foreign debt to GDP ratio is seen as stabilizing, though at a rather uncomfortable 75% of GDP. However, the level of FX reserves and low proportion of short-term debt favor a stable external position.



Prices

YTD inflation developments maintained an adverse tone, with inflation gaining strongly on monthly levels and accelerating further on the annual level, approaching the 15% level, predominantly on ongoing energy and food-related developments. Clearly, the NBS target is out of reach for 2011, where we see headline inflation 2-3pp above 3-6% targeted band. We see inflation peaking during 2Q, while we anticipate inflation reverting back to the single-digit region towards year-end. Strong RSD performance in the recent period, in combination with additional key policy rate tightening, should also be a supportive factor for inflation moderation. Apart from potentially volatile commodity prices developments, negative risks remain related to potential fiscal relaxation, i.e. more aggressive wages and pensions hikes.

Labor market

The October LFS results showed some stabilization on the labor market, as the unemployment rate remained flat with respect to April, standing at 19.2%. However, employment maintained a downward trajectory. The labor market shows ongoing structural weakness, calling for policies aiming to increase labor participation. The recovering economic activity suggests some additional stabilization in 2011.

Public sector

Serbia successfully completed its stand-by arrangement, drawing slightly more than 50% of the total EUR 3bn deal. It is likely that Serbia will open negotiation on a new (and this time) precautionary arrangement, in order to support policy credibility. We see a new SBA in place sometime in 4Q as a likely option. With the approaching elections, the IMF - as a watchdog - should limit possible deviations from mid-term fiscal goals and facilitate further structural reforms. The fiscal result for 2010 landed inside the 4.8% of GDP target, arriving some 0.3pp lower, on a somewhat stronger revenue performance. The target for 2011 is set at 4% of GDP, demanding a high degree of discipline. On the other hand, the ability to meet the fiscal targets would send a strong positive signal to investors. It would also help to stabilize the rising public debt below the 45% threshold set as a ceiling in the above-mentioned fiscal responsibility law.



Monetary policy

At recent monetary policy meetings, the tone of the NBS became less aggressive, with the NBS deciding to take smaller 25bp steps, hiking twice to 12.50% and bringing the cumulative hikes to 450bp since the beginning of the hiking cycle. Clearly, the NBS decided to allow some tightening via FX channels, tolerating RSD strengthening below the 100 threshold and also aiming to anchor inflation expectations that are traditionally strongly linked with FX developments. With expected inflation peaking in 2Q, we see the hiking cycle reaching the peak at present 2W repo rate level. Solid exchange rate developments are suggesting a more comfortable position, so we see a very limited chance for more aggressive NBS moves. The timing and extent of relaxation remains dependent on the rapidity of headline inflation reversal to target band and exchange rate developments. The NBS also seems determined to further tackle high euroization, aiming to improve the effectiveness of monetary policy.

Exchange rate

After stabilization signs towards year-end, the exchange rate so far also recorded robust performance in 2011, returning to the double-digit region. Favorable global market sentiment heavily supported the dinar in the recent period. The NBS opted to use nominal appreciation to tame inflation pressures, resulting in a less aggressive hiking cycle. The outlook remains volatile, with risks in both directions. The intended Eurobond issuance (if successful) and potential new precautionary arrangement with the IMF would reduce the risks, but most likely not before autumn. Therefore, to support investor confidence, maintaining fiscal prudence in the pre-election period is highly desirable. Taking into account strong developments in the recent period, we shifted the targeted band towards 95-105 for 2011, where on average we see the exchange rate slightly above 100 and ongoing pronounced volatility and risks being skewed towards stronger RSD.

Narodna banka Srbije Beograd

Erste Bank a.d. Novi Sad

Delegacija Evropske unije u Republici Srbiji Beograd

Telekom Srbija a.d. Beograd

Vlada Republike Srbije

Međunarodni monetarni fond-MMF Beograd

National Bank of Serbia

NBS

Erste Bank

inflation

reference interest rate

European Commission

EU candidate status

GDP

Telekom

Corridor 10

IMF

Government of Serbia