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

2. Serious situation – demands more decisive measures than those proposed in the draft budget and Fiscal Strategy Extremely high deficit in 2014 (7.1% of GDP), it has grown in comparison to 2013 1.Additional adjustments of 0.8-1% of GDP (€300 million) are necessary Public enterprises and banks will cost the budget €560 million 2.Bringing order in public enterprises and state-owned banks immediately Good medium-term goals are not supported by adequate measures 3.More comprehensive measures are necessary, pension reform needs to be adopted in the first half of 2014, reforms in subsidies, non-targeted social contributions… Recovery of public finances is possible only if all three conditions are met 2

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

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

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

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

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

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

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

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

11. Room for fiscal consolidation is getting smaller 11 Crisis can be avoided only if all three key conditions of fiscal consolidation are met 1)Additional deficit reduction in 2014 2)Bringing order in public enterprises and state-owned banks 3)Adoption of a credible plan for medium-term savings and launch of reforms Reduction of wages and pensions and tax increase are useless if those savings are spent a priori for Srbijagas, Železara Smederevo, bankrupt banks, Galenika… 11

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

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

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

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

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

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

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

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