Document o f The World Bank

Report No. 25855 - YU

PROGRAM DOCUMENT

OF THE

INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE

EXECUTIVE DIRECTORS

ON A

PROPOSED SECOND PRIVATE AND FINANCIAL SECTOR

ADJUSTMENT CREDIT

IN THE AMOUNT OF SDR 58.7 MILLION

(US$80 MILLION EQUIVALENT)

TO

SERBIA AND MONTENEGRO

May 14,2003

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

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AML B R A CAS DM EA ECA EPS EU FIU FRY FSD GDP GNI I A S IBRD

IDA IMF IMWG

I S A JAT LDP MEER MIER MOEP MOFE M O U

I-PRSP

GOVERNMENT FISCAL YEAR January 1 - December 3 1

CURRENCY EQUIVALENTS (Exchange Rate Effect ive as o f May 1,2003)

Currency Unit = Serbian Dinar LC = US$0.0176

US$1 = YUD 56.93

WEIGHTS AND MEASURES Metr ic System

ABBREVIATIONS AND ACRONYMS

Anti-Money Laundering Bank Rehabilitation Agency Country Assistance Strategy German Mark Extended Arrangement Europe and Central Asia Electric Power Industry o f Serbia European Union Financial Intelligence Unit Federal Republic o f Yugoslavia Financial Sector Development Gross Domestic Product Gross National Income International Accounting Standards International Bank for Reconstruction and Development International Development Association International Monetary Fund Inter-Ministerial Working Group Interim Poverty Reduction Strategy Paper Insurance Supervisory Authority Yugoslav Airlines Letter o f Development Policy Ministry for External Economic Relations Ministry o f International Economic Relations Ministry o f Economy and Privatization Ministry o f Finance and Economy Memorandum o f Understanding

NBS NBY NSB PA PFSAC

PHRD PLC PRSP PSD SAC S A M SDP SDR SEED SME SOE SOSAC SRC TA TSS TSSU UK DFID

USAID

National Bank o f Serbia National Bank o f Yugoslavia National Savings Bank Privatization Agency Private and Financial Sector Adjustment Credit Policy and Human Resources Development Paris and London Club Poverty Reduction Strategy Paper Private Sector Development Structural Adjustment Credit Serbia and Montenegro Supervisory Development Plan Special Drawing Right Southeast Europe Enterprise Development Small and Medium Enterprise Socially Owned Enterprise Social Sector Adjustment Credit Supervisory Review Committee Technical Assistance Transitional Support Strategy Transitional Support Strategy Update UK Department for International Development United States Agency for International - Development

WE3 World Bank YUD Yugoslavia Dinars

Country Director: Orsalia Kalantzopoulos, ECC04 Sector Director: Paul Siegelbaum, ECSPF Sector Manager: Khaled Sherif, ECSPF

Team Leader: Itzhak Goldberg (PSD), ECSPF

.. 11

IDA PROGRAM DOCUMENT FOR A PROPOSED SECOND PRIVATE AND FINANCIAL SECTOR ADJUSTMENT CREDIT

CREDIT SUMMARY

Borrower: Serbia and Montenegro

Amount: SDR 58.7 mill ion (US$80 mill ion equivalent) Terms: Modified IDA terms with a 20-year maturity, including a 10-year

grace period and no acceleration clause. Onlending to Serbia with the same terms.

Objectives and Description: The proposed Second Private and Financial Sector Adjustment Credit (PFSAC 11) will support the governments Serbia and Montenegro, and i t s largest constituent member state, Serbia, in the implementation o f regulatory, institutional, and structural reforms seeking to significantly accelerate private sector-led growth through: (i) improving the business environment by means o f comprehensive reform o f enterprise entry, operation and exit; (ii) strengthening the financial system by privatizing andor liquidating majority state- owned banks and improving the environment under which banks and other financial intermediaries operate; and (iii) privatizing and restructuring socially-owned enterprises that crowd out private sector growth, hamper banking sector recovery, and incur significant fiscal and quasi-fiscal costs.

Benefits:

Risks:

Implementation o f continued reforms in the enterprise and financial sectors under this operation will enhance Serbia's prospects for growth, and will reinforce the sustainability o f i t s macroeconomic stabilization. The main benefit o f the proposed credit would be the facilitation o f faster private sector growth and job creation, supported by a healthier and more developed financial system. Overall enterprise and financial sector performance i s expected to improve. This improvement may come partly through the sale o f enterprises and banks to local and foreign investors with strong management capacity, and partly through improved financial discipline as a result o f more proactive restructuring. Additionally, formation o f new private sector f i r m s i s expected to accelerate in response to an improved business enabling environment and an increased supply o f productive assets expected to be released from loss making firms as part o f enterprise restructuring efforts. At the same time, a well- functioning, properly regulated and transparent financial system would allow an adequate mobilization o f resources and their better allocation into productive investments needed by the private sector to modernize and expand their businesses.

The operation faces three sets o f risks. First, general political uncertainty related to the implementation o f the new constitutional arrangements in the union o f Serbia and Montenegro and i t s constituent member states. This i s compounded by the recent assassination o f the Serbian Prime Minister, and the failure o f two

... 111

rounds o f the Serbian presidential elections in late 2002 owing to insufficient voter turnout. Second, consequently, the operation also faces a potential risk o f weakening o f political commitment to restructure, privatize and/or liquidate large loss making enterprises and majority state-owned banks, many o f which are politically/socially sensitive because o f their importance to the economy as a whole and the potential social and fiscal costs. Finally, the worsening o f global economic climate would pose a significant risk that could deter the potential private capital inflows to Serbia, affecting the success o f enterprise and bank privatization.

Schedule o f Disbursements: The full credit i s expected to be disbursed in two tranches o f US$40 mill ion equivalent each.

Poverty Category: Not applicable.

Project ID Number: YU-PE-PO74868

Map IBRD No. 3 1506

This operation was prepared by a team including Itzhak Goldberg (PSD Team Leader), Gerard0 Corrochano (FSD Team Leader), Irina Astrakhan, Alexander Pankov, Silvia Minotti, James R. Dick Welch (ECSPF); Branko Radulovic (ECCYU); Lajos Bokros (ECAVP); Laura Ard (BFR); Cari Votava (FSEFI); Peter Kyle (LEGPS); Gregorio Impavido (OPD); Andrew Lovegrove (UK DFID). Legal and Disbursement support were provided by Gennady Pilch (LEGEC) and Joseph Formoso (LOAG1). The peer reviewers were Luigi Passamonti (FSEVP) and Demba Ba (AFTPS).

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I.

11.

111.

A. B.

IV. A. B.

V.

A. B. C. D. E. F. G. H.

PROGRAM DOCUMENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND PRIVATE AND FINANCIAL SECTOR

ADJUSTMENT CREDIT TO SERBIA AND MONTENEGRO

TABLE OF CONTENTS

RECENT ECONOMIC DEVELOPMENTS .............................................................................. 2 OBJECTIVES AND STRUCTURE OF THE PROPOSED PFSAC I1 ...................... . ............. 5 PROGRAM OF REGULATORY AND INSTITUTIONAL REFORMS ................................ 9 Reform o f Business Enabling Environment .................................................................................... 9 Financial Sector Regulatory and Supervisory Framework ............................................................ 13 PRIVATIZATION AND RESTRUCTURING OF BANKS AND ENTERPRISES ............. 17 Banking Sector Ref0 ................................................................................................................... 17 Enterprise Sector Reform .............................................................................................................. 19 THE PROPOSED CREDIT ....................................................................................................... 24 Project Implementation Issues ...... .. .... ....... ... ..... ... ...... , ..... ... ...... ... ........... .... ........... ..... ......... . .. ... ... 24 Board Conditions and Tranche Triggers ....................................................................................... 26 Borrower’s commitment and ownership .. ... ... ..... . ........... ...... ... ... .. ... ..... ....... ...... ... ......... . .... ... .. . .. .. 27 Coordination with the IMF and Donors ........................................................................................ 27 Lessons Learned from Previous Bank Operations ........................................................................ 28 Benefits and Risks ......................................................................................................................... 28 Poverty Implications/Social Impact .... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . 29 Environmental Impact ..... ... ...... ....... ........ ......................... ... ... ... .. .............. ..... .... ..... ............... ...... . 29

ANNEXES Annex 1 Annex 2 Annex 3 Annex 4 Annex 5 Annex 6: Annex 7 M A P

Key Economic Indicators Statement o f Loans and Credits Timetable o f Key Processing Events Letter o f Sectoral Development Policy Policy Action Matrix Fund Relations Note Country at a Glance IBRD 3 1506R

PROGRAM DOCUMENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND PRIVATE AND FINANCIAL SECTOR

ADJUSTMENT CREDIT TO SERBIA AND MONTENEGRO

1. This report constitutes the Program Document on a proposed Second Private and Financial Sector Adjustment Credit (PFSAC 11) for Serbia and Montenegro (SAM)’ in the amount o f SDR 58.7 mil l ion (US$SO mil l ion equivalent) to support Serbia’s sectoral reform program2. The Credit would be on modified International Development Association (IDA) terms, with a final maturity o f 20 years and a grace period o f 10 years3, with no acceleration clause, and would be disbursed in two tranches. This report should also be read in conjunction with the Transitional Support Strategy Update (TSSU) o f the World Bank Group (the Bank) for the Federal Republic o f Yugoslavia (FRY)4.

I. RECENT ECONOMIC DEVELOPMENTS

2. SAM and Serbia began the delayed transition to democracy and a market economy under very difficult economic and social conditions. These conditions result from nearly four decades o f inefficient economic management and a decade o f regional conflicts and international isolation that followed the break-up o f socialist Yugoslavia in 1991. By 2000, recorded per capita GDP had fallen to about one half o f i t s 1989 level, total public debt exceeded 130 percent o f GDP and 440 percent o f exports, and inflation had surpassed 1 13 percent.

3. Despite these formidable odds, in less than two years, SAM and Serbia have taken impressive steps to address the daunting legacy o f the past. The SAM and Serbian governments have followed a two- pronged approach combining stabilization measures with decisive steps in an agenda o f structural reforms aimed at initiating the delayed transition. The authorities began their efforts toward stabilizing and reforming the economy in late-2000 by tightening macroeconomic policies, first through their own efforts and later with the strong support o f the international community. These policies were initially supported by an IMF program approved in December 2000, and then by a Stand By Agreement o f US$249 mil l ion equivalent approved in June 2001. Subsequently, a three-year Extended Arrangement (EA) o f US$829 mill ion equivalent was approved in May 2002, spanning the period through end-March 2005.

4. Strong implementation o f these reforms despite the remaining political uncertainties has brought initial macroeconomic stability, while laying the foundations for a sustained recovery and improved living standards (see Table 1). The twelve-month inflation rate declined from 113.5 percent at end-2000 to 39 percent at end 2001, and further to 14.2 percent at end-2002. The nominal Dinar exchange rate to

Formerly known as “the Federal Republic o f Yugoslavia” (FRY). The Constitutional Charter o f Serbia and Montenegro was enacted by the Parliament o f Serbia, the Parliament o f Montenegro and the Parliament o f the Federal Republic o f Yugoslavia effective February 4, 2003 and, as o f that date, the Federal Republic o f Yugoslavia has changed i t s name to “Serbia and Montenegro.” In this document, a l l references to S A M which predate the change o f name should be understood to refer to FRY.

Due to the highly devolved nature o f the S A M union (most areas o f economic policy are in the competence o f the member states) and the different starting points, needs and pace o f reforms in the two member states, the Bank’s assistance program for S A M i s being designed around member state-specific operations. Therefore, for the purposes o f this document, the te rm “Government” would designate the Government o f Serbia, unless otherwise specified.

Modified IDA terms for S A M were agreed by the Board in the context o f the discussion o f SAM’s membership and the Bank’s Transitional Support Strategy (TSS).

Report no. R2002-0142, July 18,2002.

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DM/Euro has been maintained at a relatively stable level in Serbia since late 2000. The National Bank o f Serbia (NBS) official foreign reserves continue to grow, reaching almost US$2.3 bil l ion by end-2003.

Table 1: Key Economic Indicators

1998 1999 2000 2001 2002 2003 2004 2005

National Accounts

GDP (US$ millions) 11 Real GDP growth (%)

Investment (% of GDP)

Gross Domestic Savings ( O h of GDP)

Public Sector Balance

Expenditures ( O h of GDP) olw public investment

Revenue before grants Deficit before grants (% of GDP)

External Accounts

Exports of goods and services (% change) 21 Imports of goods and services (% change) 21

Current account balance as %of GDP

Indebtedness

TDOIXGS 31 TDOIGDP TDSIXGS 31

Prices

20.9 2.1

-660

-15.7

-45.6 -32.8

-764

8603 11577 5.0 5.5

14.2 13.6

-2.7 -7.3

37.6 40.2 3.1 1.6

36.7 38.9 0.9 1.3

18.6 7.7 13.1 28.9

-339 -528 -3.9 -4.6

447.9 428.0 132.6 101.4

2.3 3.9

15658 4.0

16.1

-7.0

47.5 3.4

42.5 5.0

18.2 32.9

-1388 -8.9

360.3 74.6

5.6

19868 20717 21725 4.0 4.0 4.0

16.5 17.2 17.8

-3.5 -1.2 0.6

45.1 45.4 44.5 3.4 4.0 4.4

40.5 41.1 40.6 4.5 4.3 3.9

23.2 13.7 10.4 16.3 4.7 4.7

-1759 -1614 -1442 -8.9 -7.8 -6.6

255.4 243.9 219.6 51.3 53.4 50.7 12.2 15.0 17.1

Retail price inflation (e.0.p.) .. 113.5 39.0 14.2 10.0 7.0 5.0

11 GDP estimates exclude Kosovo. 21 Growth rate of dollar values. 31 Exports exclude workers‘ remittances and non-factor income

5. Real GDP growth rebounded from the highly negative rates o f 1999 (impact o f the Kosovo conflict) to positive rates o f about 5-6 percent in 2000 and 2001. Preliminary results for 2002 show that a growth rate o f 4 percent has been reached. This growth rate had been supported by higher public investment and greater levels o f external budget support. Industrial production has been stagnant in 200 1, reflecting capacity constraints after years o f isolation and the ongoing economic restructuring. Recorded growth o f industrial output for 2002 i s 1.7 percent, with the total industrial output at the end o f 2002 at only half o f 1991 output. Unemployment s t i l l remains very high, with the official recorded rate reaching 30 percent in the f i rst half o f 2002?

6. With regard to foreign trade, following a 18.6 percent increase (in U S dollar terms) in 2000, exports rose by 7.7 percent in 2001 and a further 18.2 percent in 2002. Import growth has also remained high compared to 2001, when the combination o f rising donor support and restored trade contacts led to a growth o f 28.9 percent. Total imports in 2002 were 32.9 percent higher than in 2001, reaching US$6.3 billion. Since exports are so much smaller than imports, the trade balance deficit i s also increasing, and

As shown by the labor force surveys, the actual unemployment rate i s probably much lower (around 10-12 percent) due to the presence o f a large “shadow economy” in Serbia.

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reached US$4 bil l ion at the end o f 2002.6 The current account deficit i s projected for 2002 at around 8.9 percent o f GDP.

7. Thefiscal deficit (before official grants) increased from 1 percent o f GDP in 2000 to an estimated 5 percent in 2002, equivalent to US$782 million. This i s due to the more realistic budgeting o f commitments (Le., lower accumulation o f arrears), and some transition related expenditures, as well as recent increase in debt service payments. The deficit increase has been managed in a manner consistent with ongoing stabilization efforts due to the strong inflow o f donor funding since 2000.

8. In parallel to stabilization efforts, the SAM and Serbian governments took the f i rst steps in an agenda o f structural and institutional reforms aimed at initiating the delayed transition. In addition to resolute enterprise and banking sector measures supported under the f i rst PFSAC (see Sections I11 and IV o f th is report), substantial progress was recorded in reform areas supported by the Bank through the f i r s t Structural Adjustment Credit (SAC), disbursed in early 2002, and the Social Sector Adjustment Credit (SOSAC), currently under implementation, and related technical assistance projects: improvements in the transparency o f public expenditure management; taxation reform; major increases in electricity prices7; reforms to improve the flexibility o f labor markets; pension reform; and initial legal and judicial reforms backed by an anti-corruption strategy for improving governance and institutions.

Medium-Term Prospects and External Financing Requirements

9. Growth prospects. Robust growth in 2000 to 2002 was primarily driven by one-off rebounds from earlier shocks. Under the assumption o f continued decisive stabilization and reforms and substantial support from donors and creditors, real output i s expected to grow at a slightly lower but more sustainable annual rate o f around 4 percent beginning in 2003. Near-term growth i s expected to be driven by exports, a more vibrant SME sector, improved balance in the energy sector, and greater donor financing o f investments. These factors are expected to outweigh the contractionary near-term impact o f further fiscal adjustment and the remaining transitional recession. Medium-term growth wil l also be driven by greater productivity and enhanced financial intermediation, the entry o f new firms, infrastructure rehabilitation and investments in new productive capacity.

10. Fiscal prospects. The limited domestic sources o f budget financing and the reduction in external financing to more sustainable levels wil l require a phased reduction in fiscal deficits. Counterpart funding from the Bank and other donors will work to ensure that the overall fiscal adjustment i s not excessively abrupt. Despite a large increase in public debt service payments and the continued bringing on budget o f quasi-fiscal activities, the consolidated fiscal deficit (excluding official grants) will decrease slightly from 5.0 percent o f GDP in 2002 to 3.9 percent in 2005.' Deficit reductions in the outer years wil l be supported by a leveling o f f o f debt service payments, deeper savings resulting from reforms, and improvements in tax administration. While cash outlays will decline by around 3.0 percentage points o f GDP from 2002 to

' Foreign trade and current account data are presented for SAM. The price of electricity was increased from U S cents 0.9lkWh in late 2000 to an average o f U S cents 1 .GIkWh in

late 2001 and U S cents 3.2 in July 2002. Further upward adjustments are envisioned, reaching around U S cents 4.0 cents in 2003. 'As shown in Table 1, the 2003 consolidated budget envisages a significant reduction in budgetary expenditures as a share of GDP. This i s being driven by reductions in three categories o f Serbian budgetary expenditures which the recent Public Expenditure and Institutional Review (PEIR) identified as relatively high by regional standards - (i) subsidies, (ii) transfers to households, and (iii) wages and salaries. As noted in the PEIR, these reductions are needed to align overall expenditure commitments with available non-inflationary sources o f financing. As debt service i s being regularized following the non-servicing of debt during most o f the 1990s, these shi f ts in the composition o f expenditures are also needed to facilitate the resulting increase in interest payments on public debt.

4

2005, the program also achieves additional cuts in expenditure commitments and hidden quasi-fiscal deficits, with the biggest direct impacts coming from pension, energy and banking reforms.

11. Exports o f goods and services (in U S dollars) are expected to grow by 23 percent in 2003, before falling to a more sustainable but still high 10 percent in 2005. In later years, export recovery could be supported by a rebound in the economies o f key partners, deepened trade integration (including through the EU Stabilization and Association and World Trade Organization accession processes), rehabilitation o f infrastructure, productivity improvements, and higher foreign direct investment.

12. SAM’s current account deficit (including grants) i s expected to decline from 8.9 percent o f GDP in 2002 to around 6.6 percent in 2005. These high levels reflect a structural imbalance between a low savings rate, and increased investment needs following a decade o f underinvestment. Gross domestic investment as a share o f GDP i s expected to rise from 16.1 percent in 2002 to 17.8 percent in 2005. In parallel, and supported by public sector saving, a strengthened banking system,. and an increase in enterprise profitability, gross domestic savings wil l increase from -7.0 percent o f GDP in 2002 to 0.6 percent in 2005. In the early years, donor grant funding will play a significant role in closing the gap between national savings and investment needs.

13. Financing needs. To achieve this macroeconomic scenario and finance the transition to a market economy, the union and Serbia will require substantial capital inflows. Even following the restructuring o f Paris Club debt and a sharp increase in dollar GDP in 2001 and 2002 (largely driven by real appreciation from the highly depreciated level o f late-2000), SAM’s external debt remained a very high 75 percent o f GDP at end-2002. Between 2003 and 2005, gross external financing requirements (excluding for debt rescheduling) are estimated at about US$7.9 billion. These resources are needed to finance US$4.4 bil l ion o f current account deficits (excluding interest and official transfers), US$1.2 bil l ion in increased international reserves, and the remainder o f US$2.3 bil l ion to fulfill net debt service obligations. During this period, as the fiscal deficit i s increasingly brought under control, these needs will shift from the budgetary sector to the private sector.

14. Financing sources. These needs are projected to be met from several sources. With good progress on reforms, foreign direct investment and other private sector finance will grow to total around US$4.3 bil l ion during this three year period. The remaining US$3.6 bi l l ion o f financing during this period wil l come from official bilateral and multilateral sources. The Bank program generally, and the proposed adjustment operations more specifically, would represent a significant share o f this financing, and can thus play a crucial role in helping to ensure adequate financing for the reform programs in Serbia.

15. Assuming debt re l ie f on appropriate terms, debt service indicators are expected to decline significantly to s t i l l high levels. SAM’s total external debt i s expected to fall further to 50 percent o f GDP in 2005, driven by further debt relief and some additional real appreciation. S A M ’ s ability to maintain a relatively stable ratio o f debt to GDP despite relatively large current account deficits, will initially be facilitated by the high degree o f average concessionality o f official external financing, and later by increasing inflows o f private capital. The ratio o f total debt service to exports would fluctuate in the range o f 12-17 percent in the period 2003-2005, and reach a level o f around 20 percent in the medium-term.

11. OBJECTIVES AND STRUCTURE OF THE PROPOSED PFSAC I1

16. Bank Strategy and Background. The first Transitional Support Strategy (TSS, May 2001) outlined a three-year IDA envelope o f up to US$540 mil l ion for SAM, on a temporary and exceptional basis, with actual lending to depend upon performance against agreed benchmarks. I t was envisaged that up to 80 percent o f the program could support policy-based lending. A Transitional Support Strategy

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Update, discussed by the Board on August 8, 2002, described on-track performance, confirmed the overall approach, and laid out the Bank's program for FY03. The World Bank Group's operations assist the Government in achieving i t s overall goals of: (i) restoring macroeconomic stability and external balance; (ii) stimulating near-term growth and creating the basis for a sustained supply response; (iii) improving the social well-being o f the most vulnerable and building human capacity; and (iv) improving governance and building effective institutions. As o f May 8, 2003, nine IDA credits totaling US$297.01 mil l ion had been approved for SAM. Five grants totaling US$30 mill ion have also been approved under the Trust Fund for SAM and are under implementation. A full Country Assistance Strategy (CAS) i s expected to be completed in late 2003, following completion o f the full Poverty Reduction Strategy Paper (PRSP).

Box 1: Private and Financial Sector Reform Propram and Poverty Alleviation

The interim PRSP9 for SAM clearly recognizes that an effective strategy for fighting poverty requires a multi-sectoral approach that fosters policies consistent with an agreed macroeconomic framework. Within these parameters, the Bank and other donors have noted the central role that the SAM authorities have given to growth and economic development in their poverty reduction strategy. In turn, both private and financial sector development reforms are regarded as hndamental pillars to the promotion o f growth, employment creation, and more broadly to the establishment of an adequate business enabling environment that would make early reform efforts more sustainable.

The well defined reform agenda of the Serbian authorities in the private and financial sector, which i s supported by the PFSAC program, reinforces the fact that poverty reduction involves the synergies o f savings, investments, and technology combined to produce jobs. The combination of these factors happens while firms enter the market and grow without barriers, or exit efficiently so that their salvageable assets can be used again for productive purposes and so that they no longer crowd out more productive new firms.

I t i s this context, and in accordance with the initial TSS for SAM, that the authorities' early reform program in the private and financial sectors sought to address the immediate challenges of Serbia's long-delayed structural reform agenda in banks and enterprises. These included the resolution of large insolvent state banks, start o f a multi- track privatization program, and early efforts to improve the regulatory framework for banking and enterprise sectors. Based on the Government's strong performance in these areas during 2001 and the first half o f 2002, a first PFSAC was approved by the Board in May 2002, and h l l y disbursed in a single tranche shortly thereafter.

In the context of the Letter of Development Policy (LDP) for the first PFSAC, the Government of Serbia and the Bank agreed upon an envisioned framework o f medium-term reforms that would constitute the basis o f a follow up PFSAC 11. The proposed operation thus builds on the impressive progress made under the first PFSAC by supporting the continuation of a wide-ranging privatization and restructuring program for majority state- and socially-owned enterprises and banks. Furthermore, the proposed credit supports the Government's longer-term reform agenda aimed at creation of a modem regulatory and institutional framework for sustainable private and financial sector development.

17. The proposed PFSAC I1 i s part o f the ongoing Bank program with the authorities o f Serbia to support enterprise sector reforms that foster private sector growth and job creation, facilitated by a healthier and more developed financial system. Init ial reforms in the financial and enterprise sectors had been supported under the f i rst PFSAC I (US$85 mill ion equivalent)" (see Box 1). As noted above, Serbia has moved swiftly on the fiscal and poverty reform agendas, supported under the f i rs t SAC and, more recently, the SOSAC. Complementary to this agenda, it i s critical to the sustainability o f the overall reform program that the Government continues to devote equal attention to reform o f real and financial sectors. Important complementary activities to the proposed PFSAC I1 include: (i) two Technical

Report No. 24490-YU. lo Report No. P-7529-YU.

6

Assistance (TA) Grants for Private and Financial Sector Development o f US$6 mil l ion each (PSD and FSD TA Grants), approved in mid-2001; (ii) the Privatization and Restructuring o f Banks and Enterprises TA Credit o f US$11 mill ion (December 2002); (iii) the US$1.5 mill ion Policy and Human Resources Development (PHRD) Trust Fund Grant from the Government o f Japan; and the Employment Promotion Project, currently under preparation.

18. Links to objectives and medium-term agenda of PFSAC I. As noted in Box 1, the successful implementation o f policy objectives presented in PFSAC I provided an adequate platform for the design o f PFSAC 11. While the detailed descriptions o f recent progress made by the Government in financial and enterprise sector reforms are presented later in this report under specific components, it should be emphasized from the onset that there i s a large degree o f consistency in the way PFSAC I1 conditionality and objectives have followed the medium-term agenda that was laid out in PFSAC I. In particular, the following linkages deserve a special mention:

0 Banking sector reform. The authorities have largely fulfilled their objective to carry on with the resolution program o f troubled majority state-owned banks that was initiated under PFSAC I. All o f the banks which were under the control o f the Bank Rehabilitation Agency have been dealt with diligently and most o f them are candidates for the newly prepared bank privatization program supported by PFSAC 11; independent governance arrangements have been established for al l state banks; and, the overall objective o f privatizing all state-run banks remains an ultimate goal that i s now supported by core conditions under PFSAC 11. However, with hindsight, some o f the timeframes that were presented as medium term targets in PFSAC I have proven to be unrealistic. This i s particularly true if one takes into account recent developments that have considerably increased the number o f majority state-owned banks that are expected to be put for sale over the coming months by the Serbian authorities (see section V.A for more details). As far as the objectives to redefine the mechanisms o f bank resolution and establish a functioning deposit insurance scheme are concerned, these remain part o f the program, yet revamping them while the agenda o f bank privatization i s only starting to get underway has proven to be impractical.

0 Financial sector regulatory and supervisory framework. Further strengthening o f banking prudential and supervisory framework have been actively pursued by the Serbian authorities and remain a central part o f the program. In this regard, the envisioned central objective o f PFSAC I which called for the preparation a Supervisory Development Plan was successfully met, and the implementation o f this plan i s a clearly defined road map to the conditions and objectives in PFSAC 11.

0 Reform of socially-owned enterprises. The Government has maintained i t s efforts to implement the tender privatization component o f the program. However, the estimate that 200 large enterprises could be sold through this method has proven unrealistic because quality o f the companies has been lower than expected. As envisaged under PFSAC I, amendments were passed to the Privatization Law and the Decree on Auctions to further strengthen the Government’s authority over the privatization process and to prevent the managing bodies in socially-owned companies from obstructing it. These amendments have incorporated lessons from the initial implementation period o f auctions, tenders and restructuring. Furthermore, as part o f the package to amend the Privatization Law, the government addressed the issue o f assumption o f liabilities for past environmental damages. Parallel to tender privatizations, progress in the auctions program exceeded expectations. By end-2002, some 500 companies were sold in contrast to only 100 enterprises originally envisaged. Finally, the authorities have made significant progress in building the institutional capacity for implementation o f pre-

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privatization restructuring o f large, heavily indebted industrial conglomerates. Finaiicial advisors for approximately 30 conglomerates have been engaged, and the Government’s Social Program has been utilized to finance severance payments to redundant workers.

0 Reform of business environment. The authorities have also made substantial progress toward creating a modern business environment in Serbia, and PFSAC I1 conditions present a consistent continuation o f actions and objectives which were presented in PFSAC I. Specifically, the authorities developed the drafts o f several key laws and regulations aimed at creating an efficient entry, operation and exit framework for enterprises. The Government has been very keen on establishing a functioning consultation mechanism to ensure the participation o f entrepreneurs and other relevant stakeholders in the design o f business environment reforms. Finally, work has progressed on SME development and FDI promotion strategies, with specially designated agencies established by the Government to implement these strategies.

19. Objectives and structure of PFSAC II. The overall objective o f the PFSAC I1 i s to support the Government’s program o f regulatory, institutional, and structural reforms seeking to significantly accelerate private sector-led growth through: (i) improving the business environment by means o f comprehensive reform o f 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 outdated majority state-owned banks that fail to fulfill their role o f 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. Accordingly, the proposed credit will be conditioned on specific reform measures in the following four areas, which are also consistent with the priority objectives o f the Bank’s TSSU:

Reform of Business Enabling Environment would aim to improve the regulatory and institutional framework for business entry through improving the registration system; to facilitate efficient operations o f business through reforming the Enterprise Law, building institutional capacity for regulatory reform, and improving enterprises’ access to finance; and reducing barriers to the efficient exit and redeployment o f non-productive assets.

0 Reform of Financial Sector Regulatory and Supervisory Framework would seek to create a modern regime for financial sector operations through strengthening the supervision and regulation o f banking and insurance sectors, laying out the foundation for the future implementation o f a sustainable deposit insurance scheme, and creating adequate mechanisms to prevent money laundering activities.

0 Banking Sector Reform would seek to deepen and broaden the scope o f financial intermediation through selling controlling stakes in most privatizable banks to reputable strategic investors, and liquidating all other majority state-owned banks.

0 Enterprise Sector Reform would seek to promote economic growth by putting the country’s industrial assets to more productive use through divestiture o f vast and under-performing socially-owned enterprise sector to foreign and local investors using internationally accepted sales techniques.

20. It i s proposed that the funds be released in two tranches separated by a period o f nine to 12 months. A two-tranche design would allow the Bank to provide the much-needed support in a timely

8

manner, while at the same time giving more flexibility on the timetable for delivery o f the second tranche program.

2 1. The next two sections describe the Government’s short- to medium-term legislative/institutional and structural reform program in the four policy areas included under the proposed PFSAC 11. In each case, attention i s given to the latest developments and pending issues that are considered crucial to structure the overall policy framework o f the proposed operation. The attached Policy Matrix reflects the proposed lSt and 2’ld tranche release conditions which support the objectives o f the operation.

111. PROGRAM OF REGULATORY AND INSTITUTIONAL REFORMS

A. R e f o r m o f Business Enabling Env i ronment

22. Current Status. Notwithstanding the Yugoslav legacy o f social ownership, Serbia’s private entrepreneurial energy i s among i t s greatest assets for economic recovery and has already contributed significantly to growth. The private sector, including the informal sector accounted for two thirds o f GDP by 2001, although it employed less than 10 percent o f capital. Registered small and medium enterprises (SMEs) employed about 590,000 workers in Serbia by end-2001, or about 43 percent o f all formal employment.” A very large informal economy has emerged, accounting for perhaps one-third o f GDP, and employing as many as one mill ion workers, equal to 30 percent o f the labor force. By al l measures, the private sector i s far more efficient and profitable than firms under state, mixed or social ownership.

23. Over the past two years, the SAM and Serbian governments, assisted by the Bank and other donors, have made progress toward business enabling reforms, including liberalization and deregulation o f foreign trade and investment, simplification o f the tax regime, and modernization o f the labor legislation. However, recent surveys indicate that Serbia’s administrative and regulatory environment continues to be hostile to private business start-up and expansion, as witnessed by the lingering presence o f a large informal sector. The recent Joint WB-IMF Staff Assessment o f the FRY-I-PRSP underscores that “reforms o f overall business environment.. . are emerging as policy priorities, which are l ikely to have a significant impact on growth, employment and poverty in the long term.”I2 In many areas, such as simplification o f the regulatory environment, deregulation and re-regulation and quality o f judicial services, there has been l i t t le progre~s.’~

24. Government’s Reform Program. The Government’s agenda i s focused on further upgrading the legal foundations and institutional capacity for a sound business environment. Through i t s implementation the Government hopes to achieve the following objectives: (i) promote sustainable economic growth and enabling private sector employment opportunities with a special focus on SMEs; (ii) create a level playing field between the existing state- and socially-owned enterprise sector and the new private sector; and (iii) develop an environment where the rule o f law i s respected, property rights and claims are recognized, economic agents can have access to capital, and lenders feel secure. To this end, the PFSAC I1 wil l support Government’s priority reforms to: (i) remove administrative and legislative barriers to entry; (ii) facilitate efficient operations o f business through reforming the Enterprise Law, building institutional capacity for regulatory reform and improving enterprises’ access to finance; and (iii) reduce barriers to the efficient exit and redeployment o f non-productive assets.

Source: National Bank o f Yugoslavia - Payment Service (ZOP). 11 l2 The World Bank (2002). Joint IDA-IMF Staff Assessment o f the Interim Poverty Reduction Strategy Paper, p. 6 l3 This i s partly due to the lack of clear constitutional framework before the recent changes in the powers of the SAM and Serbian governments has been introduced. Slow progress i s also partly due to lack of institutional capacity in the Government, with an over-worked cadre of reformers dealing with a wide array o f other reforms such as SOE privatization and restructuring.

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25. Business entry. Serbia needs a better business registration system t o promote development o f the private sector. This puts Serbia at a clear disadvantage. The Government launched a comprehensive reform o f business registration at the end o f 2002 and plans to complete the reform by the end o f 2003. The Government’s objective i s to reduce the number o f days and costs needed to register an enterprise. The structure for a proposed new registration system, developed with the support o f the Bank, converges with good European practices and aims to: (i) create a unified Serbian business register that includes a l l business activities covered under the current Enterprise L a w and L a w on Private Entrepreneurs; (ii) administer the new unified registry through an independent administrative agency; (iii) allow businesses to start activities immediately after registration; (iv) streamline data requirements for each class o f business according to European Union (EU) benchmarks; (v) expand electronic registration and updating, and ensure easy electronic accessibility t o the database; and, (vi) create a single unique identifying number for each enterprise that would serve a l l government needs. The system wil l be administered by an independent expert agency that i s committed to supporting the needs o f businesses and i s accountable to the Government for delivering information o f a timeliness and quality t o serve public needs such as inspections. The Business Services Agency would administer the business registry and other registries as appropriate. Once it i s fully operational, the new business registration system should be self-financing, and preliminary cost and revenue estimates suggest this i s feasible.

Box 2: Public Consultation Process in Serbia

To facilitate a more active role o f the private sector in institutional and regulatory reforms, the Ministry o f Economy and Privatization established an SME Advisory Board with 14 business members. Another important step in the direction o f a more open consultative process was the establishment o f the Inter-Ministerial Working Group on Regulatory Reform in 2001, which has been recently transformed into a Council on Regulatory Reform. The Council reviews draft laws and other major regulations for their impact on the private sector. The Council has invited the chair o f the SME Advisory Board to sit as a permanent member to bring business interests into i ts deliberations.

Supported by PFSAC 11, the Council has initiated reform o f the Rules o f Operations o f the Government in order to establish the public discussion of laws and decrees as a rule and not as an exception. This wi l l significantly improve the transparency o f policy making by bringing in a wider range o f affected interests. The Government has already launched several successful public consultation processes, such as public-private sector dialogue on the draft Leasing Law, the Company Law, and, more recently, the Business Registration Law and the Bankruptcy Law.

26. Business operations. As previously stated, one o f the key areas o f reform relates to facilitating the efficient operation o f businesses. T o this end, the Government program focuses adopting the new Enterprise Law, one o f whose main objectives i s modernizing corporate governance, adopting a L a w 011 Concessions to facilitate public-private participation, building institutional capacity for regulatory reform, and improving enterprises’ access to finance

27. Modernizing the Enterprise Law. The Government i s committed to changing the Enterprise L a w which occupies a central position in the system o f commercial law. I t interacts with the new laws on bankruptcy, privatization, business registration, accounting, capital markets, investment funds and secured transactions that have either been passed recently or will be passed in the near future. The new law wil l be drafted so that it i s consistent with EU practices. The rapid progress in privatization and new private business development i s exposing significant legal weaknesses, particularly in the area o f corporate governance, including the duties and responsibilities o f directors and managers, guidelines for shareholders’ meetings and voting, etc. The experience o f other transition countries shows that a l l o f these issues can be exploited effectively by unscrupulous shareholders, directors and managers. With the

10

privatization process rapidly accelerating and foreign investment returning to Serbia, good corporate governance becomes absolutely essential for successful transition.

28. The new Enterprise Law will also provide for more flexible and effective legal forms for enterprises. At this time, most entrepreneurs choose not to incorporate, partly because o f administrative barriers, and partly because the Enterprise Law does not encourage sole entrepreneurs and very small businesses to use the legal forms provided by this law. Entrepreneurs are governed by a separate law, which treats them differently in almost every regard. The revised law will make i t easier for entrepreneurs to incorporate; it will also provide small corporations (the “Limited Liability Corporation” form) with more o f the protections accorded to large firms. The objective will be to create a single law governing al l enterprises using a corporate form.

29. New Law on Concessions. The Foreign Investors Council o f Belgrade has pointed out that the current concessions system suffers from legal inconsistencies between different levels o f government. A new Law on Concessions has been drafted with the support of the donor community, with the German GTZ leading the process. The purpose o f this law i s to promote and regulate investment in public infrastructure. The draft law replaces auctioning with a more transparent tendering, as the mechanism for awarding concessions. I t will ensure equal and fair treatment o f investors and competitive and transparent concession granting. The law i s based on the idea of a “framework” law consisting mostly o f general principles, to be specified in a forthcoming subsidiary “tender and contracting regulation” and “uniform contract terms” which are broken down to a toolkit o f a basic Concession Contract, a Catalogue o f typical provisions and a summary o f typical annexes.

30. Building institutional capacity. In recent months, significant attention has been given to building the institutional capacity within the Government which would allow to manage reforms across various ministries. In 200 1 the Government established an Inter-Ministerial Working Group on Regulatory Reform (IMWG) to promote regulatory reform, ensure coordination across government agencies, and facilitate business-government dialogue. Although the I M W G began i t s activities at the end o f 200 1, i t s progress has been limited. In September 2002 the Government took significant steps to revitalize the IMWG.

3 1. Specifically, the Ministry o f Economy and Privatization (MOEP) proposed to the Government that the Group i s transformed into a Council on Regulatory Reform, which would become a permanent advisory body to the Government on laws and policies affecting businesses by receiving the authority to review al l draft laws and government decrees prior to adoption. This very important change aims to prevent the proliferation o f laws and regulations that keep imposing barriers to business entry and operations. In order to strengthen capacity o f the Council to review systemically and in a timely fashion PSD-related draft laws and regulations, the Bank provided significant amount o f technical assistance. This will allow the Council to develop a concrete action program, establish procedures, and begin systematically reviewing draft legislation that impact business activities.

32. Improving access to finance. Limited access to finance continues to be one o f the most severe constraints to private sector development. The financial difficulties and s t i l l low level o f confidence in the state-owned banks and the relatively low capitalization o f the existing private banks have precluded the financial sector to respond adequately to the growing demands o f the private sector. In addition to reforming the financial sector, the legal and regulatory framework needs to provide the right incentives for banks and non-bank financial institutions to finance the private sector. The Government’s reform program centers on two areas to promote enterprise access to finance: (i) introduction o f a system o f secured financing; and (ii) support for the establishment o f regulatory framework conducive for leasing operations.

11

0 The objective o f the securedfznancing system reform i s to create a modern, enabling, legal framework and appropriate implementing institutions that will support credit transactions which involve movable property as collateral. I t will provide the legal structure within which modern secured financing o f inventory, equipment, accounts and consumer goods can develop, and wil l improve the cost o f credit and the efficiency o f the market for secured transactions. The Government reform program includes: (i) adopting the Law on Secured Transactions, and the regulations o f the Collateral Registry, and ensuring consistency with other relevant commercial laws and regulations; (ii) establishing centralized collateral registry operating as public information provider; and (iii) improving understanding o f the new legal provisions and their practical use. The introduction o f the secured financing system will be followed by broad dissemination activities aimed at: (i) training o f judges, bankers and entrepreneurs to improve understanding o f the new legal provisions and their means o f enforceinent; and (ii) dissemination o f information on the new system o f secured financing to potential credit users, lenders, lawyers, accountants, and others likely to use or benefit from the new system.

0 The lack o f an appropriate legal framework limits leasing operations. A review o f existing laws and regulations affecting the development o f leasing operations has been carried out by a Working Group established by the Ministry o f International Economic Relations (MIER) and supported by the Southeast Europe Enterprise Development (SEED). Based on the results o f the review, a draft Leasing Law has been discussed with major stakeholders in the business community. In parallel, the work i s underway to introduce required amendments to other relevant laws, in particular in the areas o f taxation, accounting and customs.

33. Business exit. A functioning bankruptcy law i s required in Serbia to provide an efficient alternative to the methods o f privatization o f social and state capital set out in the Privatization Law. The MOEP has led the preparation o f a draft new insolvency law, with the assistance o f foreign and local experts with considerable input from the Bank. The provisions o f the new law are consistent with EU practices and have been designed to minimize the impact o f existing institutional deficiencies in the judiciary and the trustee community. First, a Supervisory Body wil l be established to license, supervise, and regulate bankruptcy administrators (trustees). Second, in view o f the experience o f other post- socialist economies where bankruptcy cases were fraught with collusion among bankruptcy administrators, judges and creditors, a creation o f a specialized Bankruptcy Administration Agency has been envisaged. This Agency, associated with the MOEP, would be the only party which could be appointed as the trustee o f a socially- or state-owned enterprise. The draft new law also contains a specific provision designed to expedite the opening o f bankruptcy proceedings, as well as a comprehensive section on reorganization o f viable debtors. The bankruptcy process for socially- and state- owned enterprises will continue to be carried out under the authority and supervision o f the courts, as will all other bankruptcy proceedings. The MOEP, with United States Agency for International Development (USAID) and Bank support, has begun to develop a general trustee training course and a program to educate the judges on the concepts contained in the new draft.

34. Medium-term reform objectives. As noted above, Serbia needs a more efficient and market- friendly business environment if privatization, market reforms, and trade and investment liberalization are to support sustainable growth o f a competitive market economy. Therefore, sustainability and continuation o f the current reform program must be ensured. The four key objectives o f the program include:

i. ensuring proper implementation and operation o f the modern bankruptcy regime, which i s needed not only to create financial discipline and allow exit o f unviable enterprises but to allow the privatization and restructuring o f the potentially viable ones;

12

.. 11. developing proper corporate governance institutions that would support the future development

and better management o f capital markets; 111. developing anti-monopoly legislation and institutional capacity for enforcing it, which i s crucial

if Serbia i s t o build the foundations for i t s plans to j o i n the EU; and, iv. laying the foundations for the development o f a knowledge-based economy, to ensure that Serbia

can be competitive in the global economy, by strengthening the intellectual property rights, increasing competition in the telecommunication sector, and improvements in the R&D infrastructure.

...

These four pillars will be pursued in conjunction with a serious commitment to scale up the ongoing program o f restructuring o f state- and socially-owned enterprises (see section 1V.B below).

B. Financial Sector Regulatory and Supervisory Framework

Current Status

35. Banking supervision. The onset o f the reform period in early 2001 required the National Bank o f Yugoslavia (NBY) --today the National Bank o f Serbia -- bank supervision department to devote i t s energies to bank diagnostic reviews and subsequent corrective action or resolution. These activities called for selected changes to banking legislation and placed escalated demands on supervisory staff. At the same time, supervisory management initiated a strengthening program aimed at rebuilding the department’s oversight capacity and procedural methodology. The Bank’s support provided under PFSAC I helped to guide the necessary, init ial legislative changes and the first steps in the strengthening process. Since then, a Supervisory Development Plan (SDP) has been designed by management (with assistance from USAID) and was adopted as an official statement for the future direction o f supervision. This document maps out the building process, particularly the organizational and process changes needed to establish and implement a new supervisory approach based both on risk analysis and compliance verification.

36. Whi le the SDP was formally adopted at the beginning o f the year, work to meet the development steps began in earnest during the fourth quarter o f 2002. Several key benchmarks have already been achieved. A Supervisory Review Committee (SRC) was established, composed o f the senior managers o f the department and the N B S Vice-Governor, to oversee and monitor both supervisory activities and progress against the plan. A mission statement which formally presents the NBS’s supervisory objectives and direction was approved by the Committee and the N B S Governor and presented to the public. Whi le further steps and progress have been made, key to the future o f the program have been the department’s init ial steps to prepare supervisory strategies for individual banks and i t s improved dialog with the banking community. The banks’ supervisory strategies (and execution thereof) will ultimately represent, in large part, the culmination o f the new risk based supervisory approach and the redirected supervisory methodology. In concert with the steps taken in the supervisory process arena, a number o f enhanced and new prudential regulation^'^ have been prepared and formally approved by the NBS. Banks are also now required to adhere to and report according to International Accounting Standards (IAS), consistent with the recently passed new Accounting Law. Annual reports for the financial year 2003 will be prepared and reported using IAS.

37. Whi le many important steps have been made, much remains to be accomplished. The SDP outlines further development steps; however, the key to real change and more effective oversight o f the

l4 The now formally approved prudential regulations include areas o f capital adequacy, investment limitations, liquidity, internal controls, internal audit functions, credit classification, and credit policy.

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banking industry will be the rigorous implementation o f the new supervisory approach. This wil l require the increased involvement o f senior and executive management and the active participation and support o f all levels o f supervisory staff. Also, governance o f the NBS remains a concern as it has been operating without a formal supervisory board. While this may have provided the ability to act swiftly and decisively in the past, in going forward the NBS should adhere to proper internal governance principles.

3 8. Deposit insurance. More than a decade ago SAM established the Bank Rehabilitation Agency (BRA) to carry out i t s mandate o f deposit insurer. In September 2001, in order to quickly implement a significant bank resolution program, the mandate and powers o f the BRA were expanded to include bank liquidation functions. However, the BRA Law, as well as i t s statute, do not provide the inter im corporate governance and financial management arrangements that are required to ensure the separation o f responsibilities, accountability, and resources for it to carry out effectively i t s current dual mandate. In addition, the levels o f premiums and coverage o f deposit insurance have not been adjusted over t ime to reflect the changing state and structure o f the banking system and macroeconomic conditions. Thus the funds available are not sufficient to provide the agency with the financial resources to reimburse insured depositors in case o f a significant bank failure, and insured depositors have been de facto benefiting from a blanket government guarantee with i t s moral hazard implications.

39. Money laundering. Although it i s difficult to estimate the level o f money laundering (funds from illegal activities flowing through the legitimate financial system), many observers consider Serbia to be a transit country for smuggling between Asia and the Balkans. A lack o f funds and modern equipment hinders monitoring o f goods transiting the country. These factors together with the still-developing supervisory capacity in the banking system make SAM a prime target for money laundering. Decisive efforts from the SAM and Serbian Governments have brought a new anti-money laundering law (AML) which took effect on July 1, 2002. The new AML law authorized the creation o f a Serbian financial intelligence unit (FIU) with the following functions: (i) receive reports o f suspicious transactions froin financial institutions and develop a database; (ii) analyze the reports to identify possible criminal activity; (iii) forward reports o f suspect transactions to appropriate law enforcement officials for investigation and possible prosecution; and, (iv) establish effective cooperation with foreign counterpart FIUs to share information, when appropriate, to support the cross-border investigation and prosecution o f money laundering cases.

40. Insurance sector reform. Insurance regulation and supervision in SAM was traditionally carried out by the Insurance Supervisory Authority (HA) department within the SAM Ministry o f Finance. Activities o f insurance companies and their supervision are regulated by the Law on Property and Personal Insurance, as well as six additional regulations that have been enacted by the ISA. However, the current insurance legislative and regulatory framework does not comply with internationally accepted insurance regulatory and supervisory principles and needs modernizing. N o effective supervision takes place because the ISA i s understaffed and does not have sufficient resources to retain qualified staff. In addition to these shortcomings, the functions o f the ISA are currently being transferred to the Serbian Ministry o f Finance and Economy (MOFE) thus further straining i t s already limited capacity.

Government’s Reform Program

4 1. Banking supervision. The NBS i s committed to continuing to implement the roadmap provided by the SDP and all i t s attendant requirements. Good initial progress has been made in establishing a new framework for supervision. However, the challenge now facing supervisory management (and which wil l continue into the future) i s the need to implement the developing framework at al l levels o f supervisory staff, management, and the banking industry. This will require increased executive and senior management involvement and interaction with staff and the banking industry. Furthermore, the new

14

methodology, by definition, calls for a more anticipatory approach to supervision through which risk trends are detected, monitored and addressed within individual banks and the system as a whole.

42. The next steps to which the authorities are committed and which wil l assist in the implementation phase o f the SDP, include the development of a supervisory operating procedure which details, internal to the NBS, the specific methodology for implementation of the new supervisory approach. This is, in part, addressed through the overall supervisory strategy that has been prepared in conjunction with the mission statement. Implementation of the new methodology also wil l be promoted through the further preparation and refinement o f supervisory strategies for each bank in the system. Other steps that are planned and that wi l l support the implementation of the methodology include: (i) establishing lines o f delegated decision making within the supervisory department; (ii) establishing a system of internal M I S for senior and executive management and SRC reporting; (iii) elevation of the role and responsibility o f bank boards and management through increased supervisory interaction; and (iv) enhancing the schedule of risk stratified bank examinations to be completed during the upcoming year. The examination procedure manual and the bank risk rating system wi l l also continue to be refined during the upcoming period.

43. Several legislative changes need to occur in the near future. With the advent o f the new constitutional arrangement between Serbia and Montenegro, the legal basis for the former NBY has been adjusted to establish the new NBS. The former “Law on the National Bank of Yugoslavia” wi l l be revised to reflect the new framework. The new law wil l ensure the continued independence o f the NBS and, thus, the ability o f the supervisory function to make and administer decisions free from political and other outside interference. Likewise, the governance o f the NBS wi l l be further strengthened with the new law, by requiring the appointment of a supervisory board that wi l l be responsible for the oversight o f the NBS and i t s key functions. Changes to prudential banking regulation are expected to support the evolving supervisory process. Particularly, new supporting regulation for the licensing process i s planned. This wil l be particularly important in light o f the ownership and structural changes the banking industry i s currently undergoing.

44. Deposit insurance reform With donor support (UK DFID), the BRA’S deposit insurance division has made progress in setting up basic procedures to ensure accurate and prompt payment of premiums, reimbursement of depositors’ claims, and collection of premiums from the insured institutions. It i s envisioned that once the bank resolution program i s completed, the BRA would function only as the deposit insurer. The authorities have decided to migrate towards a new deposit insurance scheme that wi l l be consistent with EU directives, internationally recognized best practices, and in line with the expected structure and risk profile o f the banking system and macroeconomic conditions. To that end, the Government’s program includes the following actions: (i) amendment of the law and statute o f the BRA to introduce institutional and corporate governance arrangements enabling an effective cohabitation of the deposit insurer and bank liquidator for the time necessary to complete the bank resolution program; and, (ii) an increase - in the medium term -- in the premiums collected from insured banks up to levels closer to that foreseen or foreseeable under the new deposit insurance law; (iii) preparation of a new deposit insurance law. The authorities have made it clear that the envisioned revamping o f the existing deposit insurance system wi l l not be launched until 2004, when pending resolution action in the banking system are expected to be substantially completed.

45. Anti-money laundering. Government’s efforts to foster AML reform aim at developing the FIU that was created under the AML law. The newly established FIU has been staffed and i s working toward becoming fully operational to standards set forth by the Egmont Group of FIUs, which may soon accept the Serbian FIU as a new member. The FIU has hired five commissioners, established a website, and i s now performing basic operational tasks, including receiving reports o f suspicious transactions from banks -- some o f which have been forwarded to law enforcement authorities for investigation. The FIU i s currently in the process of establishing an electronic database to maintain reports o f suspicious

15

transactions, and formalizing procedures for cooperating with foreign FIUs and relevant domestic agencies. The FIU has thus laid the foundation to become an effective intelligence unit and can become fully effective in 2003 provided that: (i) adequate budget allocation i s made for i t s operations in 2003; (ii) technical assistance from donors and counterpart FIUs continues; (iii) the FIU meets criteria for membership in Egmont Group o f FIUs; and, (iv) the FIU demonstrates that it can protect and process confidential financial information in support o f international and domestic investigations and prosecutions o f cases o f money laundering and terrorist financing.

46. Insurance sector. The Government’s reform program focuses on the following measures aimed to modernize the regulatory and supervisory framework for the insurance sector: (i) development and implementation o f a new insurance law compliant with IAIS core supervisory principles in areas such as licensing, changes in control, investment regulation, and internal audit function; (ii) the establishment o f a new insurance supervisory unit within MOFE; and, (iii) the development and implementation o f an action plan to strengthen insurance supervision. Technical assistance in these areas i s being provided by the Bank and other donors.

47. Medium-term reform objectives. Reform objectives for banking supervision in the medium term will play directly o f f NBS’s mission statement and the SDP and reflect the changing banking and enterprise environment. The thrust o f the strengthening program i s to introduce a proactive, risk based method o f oversight which wil l be critical during the current period o f structural change and privatizatioii o f banks and enterprises. Furthermore, the independent oversight role o f the supervisor must be clearly exercised with banks made aware that the NBS will continue to require strict, safe and sound underwriting standards. Growth trends, new products, and new and changing risk profiles in banks and in the system as a whole must be detected and monitored in a timely manner. Therefore, the supervisory function must continue to focus on more effective communication within the department itself, within the NBS as a whole and within the banking industry, boards and management. In t h i s regard:

i. offsite monitoring processes and early warning systems must be further developed and become firmly entrenched in the supervisory process;

ii. the examination process must be risk focused and must not falter as this i s one o f the more important tools for detecting and monitoring trends in the system;

iii. the examination schedule will continue to be carefully prepared and monitored by the SRC and executive management on an ongoing basis; and,

iv. the processes and mechanisms within the NBS, such as the SRC, early warning systems, and overall supervisory procedures wil l continue to be established and refined i n order to more effectively anticipate the future systemic risks.

48. Beyond the development o f banking supervision, and as the overall financial sector further expands i t s activities, the supervisory and regulatory process must keep pace. The insurance and capital markets sectors are expected to expand at an increasing pace and assume growing significaiice in the country’s financial system. As a result, the authorities need to also focus on building supervision in these additional two areas. Thus they wil l have to begin formulating their medium- and long-term view on how the structure o f financial sector supervision should evolve. While no decisions have been made, further research and evaluation o f the current and alternative structures will continue.

49. framework also include:

Medium term objectives in the other areas o f the financial sector regulatory and supervisory

i. implementing the revamping o f the deposit insurance system in a manner consistent with the European Directive, internationally recognized best practices, and in line with the expected

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11.

... 111.

A.

50.

structure and risk profile o f the banking system following the outcome o f ongoing restructuring efforts, continuing the adequate operation o f the Serbian FrU in accordance with acceptable international standards to combat AML; and, establishing an adequate regulatory and supervisory framework for the insurance sector, that wil l be followed by the restructuring and privatization o f the insurance sector.

IV. Privatization and Restructuring o f Banks and Enterprises

Banking Sector Reform

Current Status. Supported by PFSAC I and related technical assistance provided by the Bank and other donors, the authorities made significant progress in the restructuring o f the banking sector during 2001, culminating in the closure o f the four largest banks in January 2002. During th is period, under remarkable leadership o f the NBS, 23 insolvent banks representing nearly two thirds o f the assets of the system were either liquidated or put under bankr~ptcy '~. To support these efforts, and following key legislative amendments passed in mid-200 1, the BRA became the designated administrator for banks in bankruptcy. With substantial Bank and donor support, the BRA has successfully executed i t s expanded duties, including the closure and commencement o f bankruptcy proceedings for the four largest banks. The implementation o f remedial plans for the five banks that were in rehabilitation at the end o f 2001 continued during 2002 and, as a result, four o f these banks were merged to form a viable larger bank - Niska Banka - in late 2002, which was recapitalized by the BRA and now meets prudential requirements. The BRA has successfully turned around Niska Banka, which now has positive income and operating cash flows, and i s expected to be a candidate for early privatization in 2003. The remaining bank i n rehabilitation i s considered to be non-viable by the BRA and i s pending a NBS and Government decision that i s likely to call for i t s liquidation or gradual closing.

5 1. As a result o f the restructuring process and the entry six new foreign banks, confidence has begun to return to the Serbian banking system. This i s evidenced by the rapid growth o f foreign exchange deposits, which rose from Euro 538 mill ion at end-June 2001 to over Euro 1 bil l ion at end-2002. Progress has also been made during 2002 in reducing the state majority stake in the recently created National Savings Bank (NSB) and in separating i t s governance from the NBS. During 2002 while the authorities worked on developing a viable strategy for resolution o f the s t i l l large number o f banks with asset quality problems (largely but not exclusively derived from credits financed using Paris and London Club (PLC) liabilities prior to 1990). One response to this challenge was the Serbian Government decision to pass the PLC Law in July 2002, which provided for the mandatory debt-to-equity conversion o f banks' PLC liabilities into equity to be owned by Serbia. The consequence o f this law has been a de facto nationalizatioii o f a large proportion o f the banking system (15 banksI6), including a majority state position in two o f the three largest banks in the system, and a significant stake in the largest private bank in the country. The PLC Law also stipulated the state's obligation to initiate the privatization process o f the nationalized banks within six months o f the actual execution o f the debt-to-equity conversion.

l5 This included the four largest Serbian banks, representing 61 percent of the assets of the banking system. l6 A total of 17 banks were affected by the Serbian Government decision to pass the PLC Law. Of these banks, five were already in rehabilitation and under fill state control at the time of passage of the law, three o f which were subsequently merged. As of December 2002 there were thus: 12 PLC Law-affected banks not in rehabilitation and three in rehabilitation. These 15 banks account for more than half of the banking system of Serbia. With one significant exception, all o f the 15 banks were either under state control or under ownership o f socially-owned enterprises prior to the debt-to-equity conversion mandated by the PLC law.

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52. The central issue facing the authorities in the next two years i s thus the resolution o f the PLC Law-affected banks: whether by privatization or by closure and liquidation. The latter outcome i s likely in a number o f cases where the debt-to-equity conversion may be insufficient to restore solvency. In early 2003, the authorities began to address this issue by: (i) approving a banking resolution strategy for implementing the resolution process which centers on attempts to privatize the PLC Law-affected banks without the use o f fiscal resources; (ii) implementing enhanced controls and governance over the affected banks to preserve their value; and, (iii) launching diagnostic audits o f state majority ownership banks (and one additional private bank with a significant state participation) to ascertain their true condition after application o f the provisions o f the PLC Law. Simultaneously, tenders for a strategic adviser to the Government for the privatization process and for privatization advisers for three banks have been launched. This i s expected to result in the launch o f privatization tenders for the f i rst three PLC Law- affected banks in the second half o f 2003.

53. Linkages with Enterprise Restructuring and Privatization. The approach to resolution o f the banking system’s claims on the enterprise sector has a major impact on the ability o f the authorities to restructure and privatize the enterprise sector itself. This point f i rst became an important issue when the authorities sought to address the conflict between the BRA’S responsibilities as the liquidator o f banks (i.e. as the enforcer o f the banks’ claims on enterprise borrowers) and the objective o f the Privatization Agency (PA) o f moving forward as rapidly as possible with the enterprise restructuring and the privatization program. Subsequently, the issue has become more complex as the implications o f the PLC Law have become apparent. Additional background on the linkages between the banking and enterprise sector restructuring and the Government’s program to facilitate workouts are described in the section on enterprise sector reform (paragraphs 60-6 1).

54. Government’s Reform Program. The Government’s program for reform o f the banking system builds on the progress made under PFSAC I, and targets resolving the interconnected problems o f the PLC debts o f banks and enterprises. The f i rst phase o f the bank restructuring program (launched under PFSAC I) will move toward issuing a tender for privatization o f Niska Baiika in late 2003 and, during the course o f 2003, the resolution o f a bank remaining under BRA control for which recapitalization and privatization i s not considered a viable option. Further progress will be made in the liquidation o f the non- financial assets o f bankrupt banks being liquidated by the BRA, with the target o f completing the sale or leasing out 40 percent o f these assets by end-2003.

55. The second phase o f bank restructuring - triggered by the enactment o f the PLC law - will accelerate as a result o f the Government’s adoption o f a comprehensive strategy to privatize or liquidate al l banks that have been affected by the PLC law. The strategy includes the following main features: (i) emphasizes the importance o f attracting strategic investors to take over the banks; (ii) calls for implementation o f controls over the operations o f the banks during the pre-privatization period; (iii) requires diagnostic audits and the application o f reinforced supervisory measures (including closure) for banks found to be insolvent; (iv) excludes the possibility o f utilizing fiscal resources to recapitalize banks; and, (v) provides workable institutional arrangements to manage and execute the implementation process. Additional work i s now underway to develop a parallel strategy for integrating the resolution o f PLC assets now held by the banks with the privatization and restructuring program for state and socially owned enterprises, The Bank and donors are providing substantial technical assistance support for implementation o f the PLC bank resolution and privatization strategy. Finally, the Government will signal i t s intention to withdraw from an ownership role in the banking sector by reducing the state-owned or controlled stake o f the NSB to less than 25 percent by end-2003.

56. Medium-term reform objectives. The authorities recognize that completing the restructuring and privatization o f the banking sector i s a pre-requisite for the full development o f the financial sector’s ability to support economic growth. Accordingly, the authorities have adopted an ambitious medium term

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agenda to be completed by end-2004 which includes: (i) completion o f the resolution o f all remaining state stakes in banks (including all o f the PLC Law-affected banks); (ii) closure o f all remaining insolvent banks; (iii) the aggressive disposition o f the non-financial assets o f bank receiverships; (iv) completion o f the liquidation or leasing out o f the assets o f banks closed in 2001-2002; and, (v) rapid progress in the resolution o f non-performing bankrupt and PLC law-affected banks’ claims on the enterprise sector.

B. Enterprise Sector R e f o r m

57. Current Status. As stated in the TSSU, the real sector in Serbia i s in very poor condition. The past decade brought macroeconomic instability, loss o f markets, and isolation from technological advances. The mass o f productive assets tied up in socially- or state-owned firms requires change o f ownership and, in many cases, restructuring if these firms are to survive and compete in open, global markets (see Box 3). The MOEP and the PA have the mandate to offer for sale the capital or property o f about 4,000 SOEs over the next three years. Among these SOEs, some 100 companies can be privatized through tenders to strategic investors. Another 1,500 to 2,000 companies can be sold through auctions and a limited number (probably less that 100) can be restructured and privatized, all or in part. The remaining companies will have to be subject to bankruptcy under the new insolvency legal and institutional framework described in Section 1II.A above. The initial progress made by the P A in implementing the Government’s ambitious privatization program has been considerable, although in some areas (see below), serious problems remain and if not resolved, w i l l undermine the process.

58. Government’s Reform Program. The Serbian privatization strategy i s based on the new Privatization Law adopted, with the Bank support, in June 200 1, and incorporating the international best practice and lessons learned from other transition economies. The law requires offering to a strategic investor at least 70 percent o f the shares. An amendment to the Privatization Law, adopted by the Parliament in March 2003, provides full and exclusive authority to the PA to negotiate and sign sale and purchase agreements. This i s a major achievement because, due to the legacy o f social ownership, before the amendment, employees’ representatives could refuse to sign the agreements if they did not l ike the investor who won the tender. The law stipulates three methods o f privatization: (i) privatization tenders o f large enterprises; (ii) auctions o f medium enterprises; and (iii) restructuring and subsequent tenders and/or auctions o f large loss-making enterprises and/or part thereof. Tender privatization i s used for SOEs that are sufficiently large, important and attractive to require the case-by-case approach for their privatization. The auctions program has been designed to address the structural difficulty which has been faced in many transition economies o f privatizing in a relatively short period o f time a large number o f companies, while the domestic purchasing power i s very limited, by insisting on cash payments but allowing extended payments and the use o f government bonds (issued in exchange o f the frozen foreign exchange deposits). Finally, large loss-making SOEs that cannot be sold through auction or tender in their current condition (due to excessive employment, heavy debt burden, etc.) are required under the Privatization Law to undergo “privatization through restructuring.” The legal framework for restructuring i s elaborated in the Restructuring Decree that stipulates the procedures for reorganization, dealing with creditors and debt, management o f the company during restructuring and deadlines for third parties to meet the requirements o f the decree.

59. Auction Privatization. Following a revision o f the Auctions Decree in July 2002, which simplified the process and reduced the unreasonable starting prices, the program has been moving forward with new momentum. Auctions now start with cash and move to the bonds for frozen foreign exchange deposits, if no cash bids are made. This flexible approach has greatly increased the participation in auctions and has led to a success rate o f about 70 percent, with the PA now running two auctions a week. In the f i rs t half o f 2003, 500 companies will be sold, with another 560 expected to be sold by end o f 2003. The average selling price o f the companies offered in auction averages about Euro 300,000. The

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Government i s already setting up new capacity to help manage the program for the next 1,000 companies when the first 1,000 auctions are finished.

Box 3: Privatization of Socially-Owned Enterwises in Serbia

The bulk o f the real sector in Serbia has been organized as socially owned enterprises (SOEs). In the SOEs, workers collectively hold major rights to management and disposal o f enterprise assets or residual income. This unique form o f industrial organization contributed to Yugoslavia’s earlier economic successes, but i s inappropriate and ineffective in a market economy. Dismantling this system and replacing it with more efficient and competitive forms o f ownership and operation represents a key challenge for the Government.

The f i rst attempt to change social ownership had been made in 1989 when the first Yugoslav law was passed allowing firms to be privatized by employees. In 1994, an amendment o f the privatization law revalued capital, reversing much o f the privatization that had taken place, resulting in popular discontent, extensive litigation, and a completely failed attempt at privatization. In July 1997, the Serbian Govemment ad