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.

2

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.

9

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

16

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 adopted the Act on Ownership Transformation. Once again, the employees were given a right to decide whether or not to initiate privatization. As a result, firms distributed for free, or sold at a large discount, 90 percent o f the shares to employees and pensioners.

B y the time 1997 Law had been replaced the new Privatization Law in 2001, approximately one thousand enterprises completed the sale process. Currently the PA i s trying to complete the privatization o f residual stakes in these 1000 companies in parallel to i t s main program. In 2002, it sold minority shares in 48 companies privatized under the 1997 Law for total worth o f Euro 82 million. Experience in other post-socialist economies has shown the difficulty in selling residual minority shares in enterprises dominated by insiders, with l i t t le protection for shareholders rights and limited possibility o f exit17. Moreover, the removal o f these higher-quality 1000 enterprises made the current privatization program more difficult because many good f i r m s have already been removed fi-om the market.

In designing the new program in 2001, the authorities’ primary criterion for selecting the method o f privatization o f the enterprise (or i t s restructuring via the sale o f i t s parts or assets) was i t s capability to place core, competent, concentrated owners in charge o f the assets. An important secondary consideration was the capacity o f the method to impose hard budget constraints by breaking apart or selling assets o f indebted companies (lest policies to support them impact negatively private sector growth and production). The current Privatization Program, promulgated in the 200 1 Law and i ts 2003 Amendment, i s designed to achieve these goals through i ts multi-track approach: (i) tenders to attract foreign strategic investors to large companies; (ii) auctions to offer SMEs to other investors; and (iii) restructuring to break up hard- to-sell, failing firms with the help o f international or local financial advisors and put their assets to productive use; and (iv) bankruptcy o f the SOEs that could not be dealt with under any o f the other three methods. In many cases, methods (iii) and (iv) encourage the entry and expansion o f de novo private firms, which purchase the assets o f the restructured or bankrupt enterprises.

Two major problems stem from this legacy o f the Yugoslav “social ownership” and the failed privatization programs o f the 1990s: (i) the power o f the trade unions and the management and employees o f the enterprise which could (until the 2003 amendment) block the sale and who insist on generous social post-privatization commitments to be made by the buyer at the time o f the transaction; and (ii) an overhang o f debts to banks, utilities, tax authorities, social funds and trade creditors.

60. Tender Privatization. The tender program was designed to sell the larger companies that are s t i l l majority socially-owned after about 1,000 best companies had been sold to insiders during the Milosevic period. Therefore, attracting foreign investors for the remaining companies, although crit ical for development, remains a challenge. Under the tender program managed by the PA with the help o f TA provided by the Bank and other donors, twelve groups (pools), comprising 55 companies, have now been contracted to investment banks.

The PA i s looking for better strategy to deal with these residual minority shares, including for example, an investment vehicle that would buy out employee shareholders to offer their shares for sale alongside the remaining socially owned shares, thereby creating an attractive investment package.

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61. The Government identified two main obstacles that slowed the initial progress o f the tender program: (i) excessive company staffing levels; and (ii) overly ambitious social program requirements imposed on the potential investors. The excessive staffing levels and mandatory social programs reflect the legacy o f the Yugoslav social ownership philosophy under which employees and managers share the fortunes o f the company and dominate the decision making process. However, the experience o f the initial failed tenders has demonstrated that the social programs deterred buyers, as they were required to guarantee employment for three to five years to redundant employees. Consequently, the Government decided to reduce the requirement that the buyers retain all employees for five years (three years for some companies) to one year and to commit to pay an agreed level o f severance to redundant employees as part o f the sale agreement. These revised terms would be made known to buyers as part o f the tender documentation and the Government’s commitments regarding severance payments would be made effective at the time o f the sale. The estimated annual cost o f redundancies for companies expected to be sold in the year 2003 i s about US$17.2 mill ion or 1.1 bil l ion dinars18. In addition, the Government revised i t s scoring system for the tender results to exclude a weighting for the social program offered by buyers. The revised scoring i s now 100 percent credit for cash and a 20 percent credit for investment commitments. The companies in the tender program that have not yet been tendered w i l l be offered with the new social terms and conditions as wil l those that did not se l l in previous tenders. Depending on their size and financial condition, enterprises that attract no satisfactory bids in the tender process wil l be either auctioned, or put into restructuring, or put into bankruptcy.

62. The Government i s also undertaking some privatizations using i t s own financing. For example, a number o f sugar companies are being privatized as well as Beopetrol, an o i l distribution company. The Government has also opened tenders for two tobacco companies, and i s considering selling i t s interest in Mobtel, a mobile telephone company. Sartid, a large and heavily indebted steel producer, was placed in bankruptcy under the old Bankruptcy Law and the bankruptcy administrator has entered into an agreement with U S Steel to purchase and/or manage certain components. The Government has committed i tse l f to keep the Bank informed on progress for these privatizations and to use open, transparent and competitive methods in their sale.

63. Enterprise Restructuring. As o f March 2003, 50 large problematic SOEs have been tentatively selected by the Government to undergo privatization through restructuring according to relevant provisions contained in the Privatization Law and the Restructuring Decree. Using the technical assistance funding provided by the Bank and other donors (USAID, European Agency for Reconstruction, UK Department for International Development), the PA i s currently in the process o f engaging internationally reputed teams o f financial advisors to lead the preparation and iinplementation o f privatization through restructuring programs for most o f the companies on the l i s t o f 50. In particular, under the recently approved Bank’s TA Credit, the PA has engaged financial advisors to work on four large SOEs in i t s portfolio, with advisors for three more conglomerates to be hired by mid-2003.

64. Government’s restructuring strategy calls for the segmentation (in a typical case) o f the company, incorporation o f new companies created from parts o f the old one, and sale o f these new companies and assets remaining after the break up. This process will consist o f three stages: (i) a feasibility study and a due diligence report, serving as the basis for preparation o f the restructuring program by financial advisors; (ii) implementation o f financial, organizational, legal, and workforce restructuring, including (if necessary) the incorporation of the new companies created from parts o f the old one and negotiations with creditors; and (iii) privatization o f the saleable business units by tender or auction, and disposing o f al l other assets remaining after the reorganization through bankruptcy procedures. This model will be based

l8 The assumptions are that 20 companies wil l be sold with an average o f 971 employees per firm o f which one-third are redundant. The average cost o f severance i s US$2,657 per employee.

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on a transaction-oriented approach, where the ultimate sale o f the enterprise or i t s various viable parts drives the restructuring effort. The underlying premise o f this exercise i s that various subsidiaries and/or assets o f loss-making SOEs can be viable and attractive to potential investors even if as a whole these conglomerates are presently non-viable and non-saleable. The Government expects to have the f i rst sales resulting from restructuring program in the second half o f 2003.

65, Enterprise debts work-out. Central to the successful implementation o f enterprise and banking sectors reform program l ies the need to deal with the excessive debt burden present in the economy, which affects both: (i) bank privatization, where prospective buyers -- traditionally strategic investors -- normally would prefer banks to be cleansed o f their non-performing loan portfolios before the sale; and, (ii) enterprise privatization because the ability o f the PA to restructure and/or privatize larger enterprises i s heavily affected by i t s ability to secure the agreement o f creditors o f the enterprises. The creditors’ agreement to compromise their claims i s based on the principle that the enterprise to be privatized i s worth more to creditors when sold as a going concern rather than when liquidated. In many cases, tender privatization and privatization through restructuring o f companies on going concern basis wil l require pre-privatization financial restructuring, which will make companies more attractive to potential buyers. The Government realizes that if the problem o f excessive indebtedness o f firms in the privatization program i s not dealt with, the privatization and restructuring objectives will not be achieved and economic growth will be negatively affected. Accordingly, important progress in developing mechanisms to facilitate creditor compromise has been made:

0 The 2001 Privatization Law contains provisions for an out o f court mechanism to restructure the indebtedness o f qualifying enterprises as an integral part o f their privatization. I f the enterprise i s restructured, under the restructuring provisions o f the Privatization Law it i s intended that a majority o f the creditors voting on a plan can bind the dissenting minority. In 2001, the Government issued a series o f decrees which allowed the MOFE to write o f f most historical tax debts o f enterprises at the time o f their privatization. The P A and the BRA (in i t s capacity as bankruptcy trustee o f several large banks) in December 2002 entered into a Memorandum o f Understanding (MOU) which addresses the manner in which the BRA will fulfill i t s obligations to the courts and the creditors o f the bankrupt banks in a manner that does not impede the privatization o f socially owned enterprises. Expressed very simply, the M O U stipulates that the BRA will allow an enterprise to be sold free and clear o f amounts owing to the bankrupt banks, in exchange for a negotiated percentage o f the proceeds from the sale.

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66. The Serbian authorities recognize that for the enterprise restructuring and privatization program to function effectively, and to allow the privatization o f the PLC Law-affected banks to proceed smoothly, a mechanism similar to the MOU will have to be put in place to bring these claims within the “umbrella” o f the MOU program. The authorities are now working to develop a strategy and legal and institutional mechanisms to integrate the resolution o f claims on enterprises held by the PLC Law- affected banks, the public utilities, and various public funds within the framework o f the enterprise restructuring and privatization program. Based on this strategy and the lessons from the f i rs t cases o f restructuring, the Government plans to introduce additional amendments to the Privatization Law, PLC Law, and various supporting decrees to provide the legal basis for the implementation o f the above- mentioned strategy, apply similar arrangements to other creditors, and thus enhance the privatization o f indebted enterprises.

67. Dealing with Social Costs. An integral part o f the Government’s reform program wil l be to address the social impact o f restructuring and privatization. As mentioned above, the reform o f SOE sector i s likely to be accompanied by major labor displacement (for additional discussion o f this impact,

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see Section V.F below). The privatization or restructuring program for each enterprise prepared with the help o f financial advisors wil l include a labor redeployment plan, which wil l outline severance or other packages for redundant workers and receive financing from the Serbian budget.

68. Enterprise-specific programs would be guided by the policy framework outlined in the Government’s Social Program for employees dismissed during restructuring and privatization, approved by the Government in March 2002. The Program i s intended to provide a menu o f compensation and redeployment options for dismissed workers in the large SOEs. The Program provides a unified approach for dealing with social costs o f transition and minimizes the prospects o f ad hoc settlements for dismissed workers across different sectors. Retrenched workers may choose between: (i) a lump-sum payment o f 60,000 dinars (around US$lOOO) or 6000 dinars (around U S $ 100) per year o f service (whichever i s higher); and (ii) payment for up to two years, depending on length o f service, at 40-80 percent o f the average wage in Serbia. This package i s generous relative to the packages given to workers in companies outside the Social Program: under the f irst option, workers get about 14 average monthly wages, or on average about three times more than the minimum specified in the Labor Law. However, it i s less generous than packages offered to facilitate large-scale restructuring in other transition economies. The 2003 budget includes an allocation o f 7.5 bil l ion dinars (equivalent to US$l25 million, or 0.8 percent o f projected GDP) to provide the payments to employees o f companies covered by the Social Program. An analogous allocation i s expected to be provided in the next year’s budget. In parallel to these efforts, and supported by the Bank under SOSAC, the Government has proposed reforms to the social protection system to improve i t s immediate and medium-term effectiveness. In addition, the technical assistance provided to the Ministry o f Labor and Employment under the Bank’s Employment Promotion Project i s expected to facilitate monitoring the effect o f the privatization and restructuring programs.

69. Following the announcement o f the Social Program, the Bank held extensive discussions with the Government pertaining both to overall costs o f the program and microeconomic incentive issues. Specifically, the questions o f adverse selection, over-payment, and moral hazard were discussed. Adverse selection i s contained in privatizeable enterprises in which wage increases are expected while moral hazard i s mitigated by contractual arrangements to limit rehiring o f laid o f f employees who received severance pay. The Government agreed to the need to keep the overall cost o f the program in check. In order to minimize the microeconomic distortions it agreed to prioritize the payment o f retrenchment benefits to workers from those companies that are undergoing credible restructuring through privatization or bankruptcy. Specifically, under the SOSAC LDP, the Government committed as follows: “With respect to the Social Program, we intend to ensure that fiscal costs are kept under control in the short run and reduced and eventually discontinued in the medium term. In the short run, we plan to make the payments under the Social Program more explicitly linked to specific benchmarks in enterprise restructuring and tender privatization process, such as the adoption by the PA o f the enterprise restructuring and privatization programs, in order to ensure that public resources are spent only on enterprises which are fully committed to fundamental restructuring and change o f ownership.”

70. Nationalizedproperty. In the case o f assets that are subject to privatization, the Privatization Law adopted in June 200 1 established the principle o f compensation for nationalized property in money rather than in kind (Article 15) and allocated 5 percent from privatization proceeds for compensation. The Government has recently established a working group under the MOFE that will draft a new Law on Denationalization. Following a participatory process o f extensive consultation and taking into account public commentary, the Government intends to submit a draft law on restitution for consideration to the Parliament by December 2003. While the details o f the law are s t i l l to be worked out, the law would be based on the following general principles: (i) compensation will be done, as a matter o f general policy, through bonds, and wil l be substantially in accordance with principles o f 2001 Privatization Law; (ii) compensation wil l be done in a fiscally prudent manner; and (iii) to avoid the creation o f new injustices,

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the legally owned non-state property shall not be restituted (in kind) to original owners; other forms o f compensation wil l be used.

7 1. Medium-term reform objectives. The Government strongly believes that completion o f restructuring and privatization o f the socially- and state-owned enterprise sector i s a pre-requisite for achieving sustainable economic growth in Serbia. Accordingly, the following medium term agenda i s envisioned for 2004-2005:

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Tender and auction privatization programs wil l be continued in a transparent, competitive manner, as provided for in the Privatization Law and related regulations. Restructuring and subsequent privatization o f large industrial conglomerates will be continued and accelerated once the effective legislative and regulatory framework for debt workout i s fully put into place. Unsaleable conglomerates and/or parts thereof will be put into bankruptcy under the new insolvency regime. In parallel to continuing the privatization and restructuring o f socially-owned enterprises, the Government plans to accelerate the reform o f the troubled state sector o f the economy. A number o f the state-owned enterprises wil l be privatization candidates over the medium term once their restructuring i s further advanced and satisfactory regulatory regimes have been put in place. Enterprises that would be considered for privatization are: (i) electricity generation, once unbundled and satisfactory regulation i s in place; (ii) telecommunications; (iii) oi l refining and distribution; and (iv) gas distribution. Privatization o f railways and ports, including airports, are further in the future.

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V. THE PROPOSED CREDIT

72. This section provides a summary o f the proposed credit including: (i) details on the credit and i t s implementation arrangements; (ii) proposed Board conditions and tranche triggers; (iii) borrower’s commitment and ownership; (iv) coordination with the IMF and other donors; (v) lessons learned from previous Bank operations; (vi) benefits and risks; (vii) poverty implications; and (viii) environmental impact. The broad rationale and objectives o f the credit, and i t s links to the Bank’s TSSU, are already given in Section 11.

A. Project Implementation Issues

73. Credit Amount, Borrower, Terms, Tranching. The proposed PFSAC 11 Credit amount i s SDR 58.7 mil l ion (US$80 mill ion equivalent). The credit would be made to SAM, represented by the SAM Ministry for External Economic Relations (MEER). The ultimate beneficiary will be Serbia, represented by the Ministry o f Finance and Economy. The credit wil l be on modified IDA terms, with a maturity o f 20 years including a grace period o f 10 years with no acceleration clause. It i s proposed to disburse the Credit in two equal tranches.

74. Disbursements. The f i rs t tranche would be released upon approval o f the Credit and notification by the Bank o f Credit Agreement Effectiveness. The SAM MEER will open and maintain a special Deposit Account in the NBS on terms and conditions satisfactory to the Bank. Upon notification by the Bank o f Credit Effectiveness and submission to the Bank o f a withdrawal application, the proceeds o f the f i rst tranche o f the Credit wil l be deposited by the Bank into the Deposit Account o f the SAM MEER. The Borrower will make available to Serbia in Dinar to i t s general budgetary account the equivalent o f the proceeds o f the Credit under terms and conditions satisfactory to the Bank. Following the approval o f these terms and conditions by Serbia, the Borrower wil l then enact a law related to the above arrangements which is satisfactory to the Bank (a condition o f effectiveness). If, after deposit in the

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Deposit Account, the proceeds o f the credit are used for ineligible purposes (i.e. to finance items imported from non-member countries, or goods and services from the Bank’s standard negative list), the Bank will require the Borrower to either: (i) return the amount to the account for use for eligible purposes; or (ii) refund the amount directly to the Bank.

75. Implementation and Monitoring. During credit preparation, the Bank has assisted the SAM and Serbian governments to ensure timely implementation o f the agreed reforms. To assess the impact o f the proposed operation, and in conjunction with parallel policy-based operations, the Bank wil l monitor progress in meeting the outcome benchmarks (see Policy Matrix in Annex 5) and implementing the medium-term reform strategy described in the LDP (Annex 4). The NBS, with the assistance from the BRA, will bear the primary responsibility for providing the Bank with evidence concerning the progress in financial sector reforms, and the MOEP, assisted by the PA, wil l be the Bank’s main counterpart on the enterprise sector reform agenda. The SAM and Serbian governments are aware that such progress will be evaluated beyond the implementation period o f the proposed operation, and wil l constitute the basis for preparation o f potential follow-up Bank operations or components o f future operations in these areas, This impact assessment will be conducted jointly between staff o f the Bank Office in Belgrade and headquarters-based staff.

76. Reporting, Accounting and Auditing. The NBS would maintain records o f all transactions under the credit in accordance with sound accounting practices. Upon the request o f the Bank, the NBS will prepare a report showing all payments into and from the Deposit Account and wil l have the report audited by independent auditors acceptable to the Bank, in accordance with terms o f reference acceptable to the Bank. The Borrower should furnish the audited report not later than four months after the date o f Bank’s request for such an audit.

77. Fiduciary and accountability environment. The recent Country Financial Accountability Assessment (CFAA) undertook an analysis o f both public financial accountability and fiduciary considerations related to use o f Bank funds in SAM. On fiduciary considerations on use o f Bank funds, the review o f the NBY as a deposit account holder indicated that SAM had appropriate capacity to manage IDA credits, understood the flow o f funds, and had issued well-documented instructions on recording obligations to the Bank. The Bank and the Borrower agreed upon an acceptable mechanism for disbursing and monitoring IDA funds under the recent Serbia SAC, and similar arrangements were confirmed at the recent negotiations for SOSAC. In the interim, the name o f the NBY has been changed to the National Bank o f Serbia, but the institution and i t s current capacity remain the same. On public financial accountability, there were a range o f shortcomings identified by the CFAA which are not uncommon to countries in ECA, including: (a) weak budget planning and preparation, including need for greater comprehensiveness o f budgeting, including for extra budgetary funds; (ii) weak management o f budget execution, in particular lack o f control o f commitments and inefficient cash management; (iii) weak financial controls, including lack o f updated information on the financial position o f l ine ministries, weak follow-up to ensure appropriate use o f budgetary funds, and need to strengthen internal audit and introduce a system o f external audit.

78. The Serbian Government i s moving aggressively to address the weakness identified, including through the new Law on Budget Systems, which anticipates a modern budget system. I n particular, the authorities have established a Treasury within MOFE, and the new system i s expected to be implemented by end 2003, with an interim treasury/general ledger implemented by MOFE in late 2002 to improve cash management and commitment control. Implementation o f the new Treasury and budget process reforms i s being supported by a range o f donors, including EU, USAID, DFID and the Bank. The Bank i s working with the Government to follow up on issues identified in the CFAA.

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79. date as the Bank shall establish.

Closing Date. The expected closing date o f the Credit wil l be December 31, 2004, or such later

B. Board Conditions and Tranche Triggers

80. The overall program to be supported by the proposed credit i s outlined in the Government’s LDP (Annex 4), and the policy conditions and performance benchmarks are set out in the Policy Matrix (Annex 5). In particular, the LDP lays out commitments for a medium term reform implementation agenda which it i s anticipated would be supported by a follow-up adjustment operation. The following are the core program conditions that have been met, in a manner satisfactory to the Bank, prior to the Board Presentation:

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81.

The Government has adopted a decision transferring the responsibility for the business registration system from the commercial courts and municipalities to the to be established Agency for Business Services. The NBS has adopted the following prudential regulations: (i) capital requirements; (ii) asset classification; (iii) licensing; (iv) internal audit; and (v) internal controls. The NBS has formally approved and adopted a Supervisory Development Plan, established a Supervisory Review Committee, and communicated the SDP to all supervisory staff. The Government has adopted a privatization strategy for stakes in banks acquired as a result o f debt-to-equity conversion o f PLC liabilities. The BRA/Government has implemented lending controls and governance arrangements in all majority state-owned banks under the program, including the launching and implementation o f diagnostic audits in eight banks with state majority ownership and one large non-state majority owned bank. The Parliament has enacted amendments to the Privatization Law and relevant supporting regulations to allow the PA to act on behalf o f an enterprise at all stages o f the privatization process. The PA has offered for sale, by open, transparent and competitive tender, 46 companies belonging to the 12 pools in the tender privatization program.” The P A has undertaken 500 auctions under the Accelerated Program with at least 60 percent o f the companies offered being sold. The PA has signed contracts with financial advisors to help it prepare and implement the restructuring programs for four socially-owned conglomerates in the P A portfolio.

The following core program conditions will need to be met, in a manner satisfactory to the Bank, prior to release o f 2nd tranche o f PFSAC 11:

0

The Law on Business Registration and the Law on the Agency for Business Services will be enacted. The draft Enterprise Law wil l be prepared and made available to the public for discussion and commentary.

l 9 Satisfactory procedure would include: (i) for all the companies in the tender privatization program (except for seven companies identified with the Bank that are in the process o f tendering), the mandatory social requirement wil l be reduced to a maximum o f one year before they are offered in tender; (ii) labor redundancy payments at a pre- agreed level wi l l be paid by the Government for companies sold in the tender program; (iii) companies, already tendered with 2 to 5 year social requirements, and not sold, wil l be re-tendered with mandatory one year social requirements and, if not sold, offered in auction or placed under bankruptcy; (iv) evaluation o f the tender offers by financial advisors and the Government wil l provide a weighting of 100 percent for cash and 20 percent for promised investment.

26

0

0

0

0

0

0

0

e

0

0

C.

82.

The Bankruptcy Law will be enacted. The NBS will reach satisfactory progress in the implementation o f the SDP. The FIU will begin to function in a manner satisfactory to the Bank. The BRA will appoint a privatization advisor for Niska Banka. The BRA will issue the tender for the sale o f the state stakes in three banks. The Government will approve and begin to implement a time-bound action plan for the resolution o f the largest bank remaining under the bank restructuring program. The Law on Insurance will be enacted. The PA wil l sel l through tender, initiate the restructuring proceedings, or initiate bankruptcy proceedings with respect to at least 35 percent o f the SOEs agreed upon by the Government and the Bank, such actions having been conducted in a manner and on terms and conditions satisfactory to the Bank, including the provision in the offer o f sale through tender o f a legally binding commitment to finance the applicable severance payments for all redundant employees o f such enterprises. Starting on April 1,2003, the PA will: (a) offer for sale through auctions, in a manner satisfactory to the Bank, no less than 560 SOEs; and (b) sel l through auctions at least 250 SOEs. The P A will offer for sale two socially-owned conglomerate enterprises agreed upon by the Government and the Bank, or has offered for sale viable parts o f such enterprises, al l in a manner and on terms and conditions satisfactory to the Bank.

Borrower’s commitment and ownership

The SAM and Serbian governments are fully committed to the transformation o f Serbia into a frill- - fledged market economy and to i t s integration into the European Union. Recognizing difficulties and risks involved, the authorities are determined to help Serbia’s enterprise and financial sectors adjust to the new market-economy environment by completing the ownership transformation o f inefficient and insolvent SOEs, establishing a more competitive and service oriented banking system that can mobilize a rising level o f financial resources and provide for the credit needs o f a growing economy, and developing a modern legislative and institutional framework for operations o f enterprises and banks. The striking difference in profitability (and by implication, productivity) between private and non-private sectors provides a key rationale for the proposed reform strategy.

83. The Government’s commitment to the development o f vibrant private and financial sectors i s reflected in major progress achieved over the past two years, largely supported through PFSAC I. The Government requested support through this operation during the TSSU discussions, and confirmed the need for support during the recent CAS consultations held in Belgrade in February 2003. The Government and the Bank agreed on the broad agenda for the proposed operation in Apr i l 2002, recorded in the medium-term sections o f the LDP for PFSAC I. The authorities have since taken a number o f resolute reform steps in pursuance o f this agenda, as described in the Government’s LDP for th is operation.

D. Coordination with the IMF and Donors

84. The proposed project has been developed in close collaboration with the IMF and other key international donors. The Government’s overall reform program has been designed within a framework for macroeconomic stability consistent with SAM’s Extended Arrangement approved by the IMF in May 2002. The Fund has also provided technical assistance in some areas o f financial sector reforms throughout various stages o f the proposed structural reform program, while the Bank input has been instrumental in developing the structural elements o f the EA.

27

85. Several bilateral and multilateral donors are providing important financial and technical assistance in all four areas supported by the PFSAC 11. They include the European Commission, European Bank for Reconstruction and Development, UK DFID, USAID, U S Treasury, Japan, Sweden, and the Netherlands. PFSAC I1 i s specifically designed to provide an umbrella framework for channeling the efforts o f donors in business environment reform and enterprise privatization and restructuring. The Bank will continue to liaise closely with donors to ensure broad agreement in overall reform priorities and specific policies. In particular, the Bank would regularly inform the European Commission o f progress in PFSAC I1 implementation to ensure that the Government’s policies are consistent with SAM’s long-term aspirations to jo in the EU.

E. Lessons Learned from Previous Bank Operations

86. The project design incorporates the lessons from the implementation o f PFSAC I, as well as from transition reforms in the ECA region during the past decade. Experience has shown that an integrated approach i s needed to reform the private and financial sectors in Serbia. Under the proposed operation, financial sector reforms are expected to boost financial intermediation, and encourage domestic savings, generating the much needed working capital and investment finance needed for the real sector to expand. At the same time, the privatization o f socially-owned enterprises and a more vibrant small and medium enterprise sector supported by the reforms o f business-enabling environment, are expected to lay the basis for sustainable growth. Very importantly, the proposed project will be sequenced with the Government’s ongoing efforts, supported by the Bank and other donors, to provide adequate social protection for those displaced by restructuring and privatization.

87. Another key lesson from transition experiences elsewhere i s the need for careful sequencing o f the more immediate structural reforms in enterprise and financial sector with the long-term efforts aimed at creating an adequate regulatory and institutional framework for sustainable economic growth. As noted above, the authorities, with the Bank’s support through PFSAC I, have moved swiftly on the pressing transition reforms, including privatization o f socially-owned enterprises and liquidation o f insolvent banks. I t i s critical to the sustainability o f the overall reform program that the Government now devotes equal attention to regulatory and institutional reforms. Accordingly, the PFSAC I1 would focus strongly on the regulatory and institutional reform agenda to create adequate enabling environment for enterprise and financial sectors, while seeking to ensure that the structural reform agenda retains equal priority.

F. Benefits and Risks

88. Benefits. The main benefit o f the proposed credit would be 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 firms 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 f i r m s 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 better allocation into productive investments needed by the private sector to modernize and expand their businesses.

89. Very importantly, privatization and, in some cases, liquidation o f some o f the largest loss-making SOEs, as well as majority state-owned banks will reinforce sustainability o f Serbia’s macroeconomic stabilization and fiscal discipline by removing a long-standing source o f budget drain. Finally, the Bank’s support o f the Government’s reform efforts will send a positive signal, both to other donors wishing to provide budgetary support and to potential private investors and creditors.

28

90. Risks. The proposed 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 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.

G. Poverty Implications/Social Impact

91. The Government’s structural reform program supported by PFSAC I1 will have an important impact on poverty, both in the short and medium term. In the short term, some reforms, such as privatization and, particularly, restructuring o f large SOEs, could have significant social costs as redundant labor would be released.20 The Serbian Government has demonstrated a clear concern for and interest in mitigating any negative social impact o f reforms. In 2002, the Government has adopted a Social Program to deal with the social consequences o f privatization restructuring (see more details in section N.B above). The Bank i s committed to working closely with the Government to ensure that any social issues arising from the operation are properly addressed in the context o f the recently approved SOSAC and Labor LIC.

92. In the longer term, PFSAC I1 i s expected to have an overall positive impact on poverty i n Serbia. I t i s expected that crowding out o f the private sector by large loss making f i rms wil l cease, enterprise sector performance will significantly improve, and the Serbian economy will embark on a steady growth path. The formation o f new private sector firms and formalization o f the vibrant informal economy are expected to accelerate in response to an increased supply o f productive assets that will be released from loss making firms as part o f a restructuring effort. At the same time, the business environment reforms supported by t h i s operation wil l result in creation o f new jobs, which would absorb some o f the displaced labor. Such a reconfiguration and the spin-off and outsourcing o f functions are important for the development o f the formal SME sector. Consistent with the Bank’s latest thinking on poverty reduction, the establishment o f transparent competition regime in which new firms can enter the market, substandard firms are allowed to fail, and good firms face few barriers to growth, represents an essential precondition for development o f dynamic Serbian economy capable o f creating wealth and alleviating poverty.

H. Environmental Impact

93. The proposed PFSAC I1 i s not expected to result in any direct negative impact on the environment. For the purposes o f Operational Directive 4.01, the ECSSD review rated the Credit as Category C, which does not require an environmental assessment.

94. The indirect environmental implications o f the Government’s reform program supported under PFSAC I1 are expected to be limited and primarily relate to the restructuring o f some o f the large SOEs. The Government, however, has already taken important measures to ensure adequate environmental safeguards based on recommendations o f the Bank. All major enterprises undergoing privatization

*’ In practice, the social disruption associated with labor redeployment may be overstated. Many o f the workers in large SOEs are on administrative leave and working in the informal sector. These workers only receive minimal wages and benefits from their “official” jobs.

29

through tender are being subject to environmental assessments. The results o f the assessments are included in the Information Memorandum, which stipulates the commitments that the investor/buyer needs to undertake regarding possible environmental liabilities. In February 2003, the MOEP submitted an amendment, which was adopted by Parliament, to the Privatization Law which stipulates the assumption by the state o f liabilities for past environmental damages. The methodology for determining the extent o f these liabilities, as well as mechanisms for addressing them, will be described in a series o f by-laws, to be developed jointly by the Ministry of Environment and MOEP and the PA, with the Bank’s technical assistance.

95. In the medium term, the Government, assisted by the Bank and other donors, i s expected to address the issues of environmental compliance and industrial pollution in the enterprise sector, and implement a reform agenda that would encompass improvement of the environment-related legislative framework, regulatory and institutional capacity, and mitigate the negative impact of the previous environmental policies and practices in the enterprise sector.

30

Annex 1: Key Economic Indicators

Estimate Projected Indicator 1998 1999 2000 2001 2002 2003 2004 2005

National accounts (as % o f GDP) Total Consumption .. 102.7 107.3 107.0 103.5 101.2 99.4 Gross domestic investment .. 14.2 13.6 16.1 16.5 17.2 17.8

Government investment 3.1 1.6 3.4 3.4 4.0 4.4 Private investment .. 11.1 12.1 12.7 13.1 13.2 13.4

Exports (GNFS)" Imports (GNFS)

Gross domestic savings Gross national savings

.. 29.6 23.7 20.7 20.1 21.9 23.1

.. 46.5 44.6 43.8 40.1 40.3 40.3

-2.7 -7.3 -7.0 -3.5 -1.2 0.6 .. 10.3 9.1 7.2 7.6 9.4 11.2

Memorandum items Gross domestic product .. 8603 11577 15658 19868 20717 21725 (US$ million at current prices)

Real annual growth rates ("h, calculated from 2000 prices)

Real annual per capita growth rates (%, calculated from 2000 prices)

Gross domestic product at market prices 5.0 5.5 4.0 4.0 4.0 4.0

Gross domestic prod& at market prices Total consumption Private consumption

Exports (GNFS)" Merchandise FOB

Imports (GNFS)" Merchandise FOB

Resource balance Ne t current transfers Current account balance

Ne t private foreign direct investment Long-term loans (net)

Balance o f Payments (US$ millions)

Officialb Private

Other capital (net, incl. errors & ommissions)

Change in reserves'

Memorandum items Resource balance ("? o f GDP) Annual dollar-value growth rates Merchandise exports (FOB) Merchandise imports (CIF)

3947 3033 5270 4849

655 -1323

-660

113 25 25 0

407 115

23.9 1 .o

2148 1677 3539 3296

-1391 668

-764 112 12 12 0

529 111

-44.7 -32.0

2547 1923 4004 3711

-1457 1119 -339

25 213 213

0 347

-246

-16.9

14.7 12.6

5.4 3.9 12.4 7.5 14.2 6.3

2743 3241 2003 2412 5160 6857 4837 6320

1915 2343 -2417 -3616

-528 -1388 165 562 502 673 333 626

94 47 383 1264

-522 -1 11 1

-20.9 -23.1

4.2 20.4 30.3 30.7

3.9 5.1 3.0

3993 2972 7915 7375

-3982 2553

-1759

73 1 777 732 45

639 -387

-20.0

23.2 16.7

3.9 3.9 1.1 1.4 2.0 2.3

4539 5013 3402 3780 8353 8746 7752 8118

2569 2723 -3814 -3732

-1614 -1442

750 800 1071 645 625 275 248 268 195 404

-402 -407

-18.4 -17.2

14.5 11.1 5.1 4.7

31

Annex 1: K e y Economic Indicators (continued)

Estimate Prqjected Indicator 1998 1999 2000 2001 2002 2003 2004 2005

Public finance (as YO o f GDP at market prices)d Current revenues and grants 0.0 39.6 43.6 41.2 41.7 41.0 Current expenditures 0.0 38.6 44.1 41.7 41.4 40.1 Current account surplus (+) or deficit (-) 0.0 1.0 -0.5 -0.5 0.3 0.9 Capital expenditure 0.0 1.6 3.4 3.4 4.0 4.4 Overall balance 0.0 -0.6 -3.9 -3.9 -3.7 -3.5

Monetary indicators M2/GDPe 9.1 8.0 11.0 10.2 10.7 11.3

Price indices( 2000 =loo) Real exchange rate (US$/LCU)f .. 100.0 134.0 164.4 190.0 186.4 184.2

Retail price index (YO change) .. 49.9 113.5 39.0 14.2 10.0 7.0 5.0

a. "GNFS" denotes "goods and nonfactor services." b. Includes use o f IMF resources. c. On a gross basis. d. Consolidated general govemment. e. Comprises Serbian dinar-denominated money supply only. f. "LCU" denotes "local currency units." An increase in US$/LCU denotes appreciation,

32

Annex 1: K e y Economic Indicators (continued)

Serbia and Montenegro - K e y Exposure Indicators

Estimate Projected Indicator 1998 1999 2000 2001 2002 2003 2004 2005

Total debt outstanding and disbursed (TDO) (US$mJ

Net disbursements (US$mj

Total debt service (TDS) (US$m)

Debt and debt service indicators (%) TDOKGSC TDOiGDP TDSiXGS

IBRD exposure indicators (YO) IBRD DSipublic DS' Preferred creditor DSipublic DS (%J IBRD DSiXGS

IDA TDO (US$m) IBRD TDO (US$mf

0 0

0 0

0.0 0.0 0.0 0.0 0.0 0.0

1128 1148 0 0

11407

229

56

447.9 132.6

2.3

0.0 0.0 0.0

1119 0

11741

502

107

428.0 101.4

3.9

0.0 51.1 0.0

1012 0

11678 10198

753 857

183 488

360.3 255.4 74.6 51.3

5.6 12.2

56.7 36.1 75.8 65.2 2.5 2.8

2175 2305 168 339

1 1072

1151

682

243.9 53.4 15.0

22.4 76.7

2.6 2372

539

1 1009

725

857

219.6 50.7 17.1

22.8 74.1

2.7 2364

539

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

b. Reflects debt service relief. c. "XGS" denotes exports o f goods and services. d. Public debt includes the IMF. e. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the

f. Excludes interest arrears and penalty interest through 2001.

term capital.

Bank for Intemational Settlements.

33

N

0 m W W N W

d ~ m m r ~ m - m ~ m~ > o o o o o 0 0 0 0 0 0 3 0 0 0 0 0 0 0 0 0 0 0 r l N N N N N N N N N N N

d M

Annex 3: Timetable o f K e y Processing Events

Identification Mission:

Preparation Mission

I C M review:

Appraisal:

Negotiations:

Board presentation:

July 2002

October 2002

January 2003

February 2003

Apri l 2003

June 10,2003

35

Annex 4: Letter of Sectoral Development Policy

Second Private and Financial Sector Adjustment Credit

to Serbia and Montenegro

April 30,2003

Mr. James Wolfensohn President The Wor ld Bank 1818 H Street N.W. Washington D.C., 20433

Dear Mr. Wolfensohn,

I. Introduction

I t has been nearly one year since we wrote to you in reference to the first stage o f sectoral reforms in private and financial sector development, wh ich were successfully supported by the Wor ld Bank's f irst Private and Financial Sector Adjustment Credit (PFSAC). This Letter o f Sectoral Development Pol icy presents the current status o f such reforms, and i t outlines the continuation o f this agenda in Serbia and Montenegro (SAM) and its largest member state, Serbia. I t also requests support f rom the Wor ld Bank for a second PFSAC.

F rom the onset, we want to stress that the S A M and Serbian governments remain firmly committed to the principles and objectives o f the PFSAC program. In this regard, we remain consistent w i th our v iew that reforms in the enterprise and financial sectors are not only important to cementing our overall goal o f rapid transition to a well-functioning market economy, but are also central to achieving growth and economic development. Consequently, we consider that the implementation o f regulatory, institutional, and structural reforms policies supported by the second PFSAC are essential 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. Our enterprise and financial sector reform program i s also embedded in the macroeconomic framework supported by a three year IMF Extended Arrangement which was approved by the IMF Board in M a y 2002.

A s you are aware, the Parliaments o f the member states o f the union o f Serbia and Montenegro have recently approved a new Constitutional Charter, which provides the legal framework for new relations at the union level. The Charter has also effectively transferred a number o f responsibilities to the member states, including the implementation o f the private and financial sectors reform program supported by the second PFSAC. Therefore, as far as the reform program that is presented in this letter, and consistent w i th

what we have expressed to you before, it should be understood that a l l policies and objectives that are hereby presented refer to the reform program o f the Government o f Serbia.

11. Recent Economic Developments

S A M and Serbia began the delayed transition to democracy and a market economy under very dif f icult economic and social conditions. These conditions result f rom nearly four decades o f inefficient economic management and a decade o f regional conflicts and international isolation that fol lowed the break-up o f socialist Yugoslavia in 1991. By 2000, recorded per capita GDP had fallen to about one ha l f o f i t s 1989 level, total public debt exceeded 140 percent o f GDP and 440 percent o f exports, and inf lat ion had surpassed 1 13 percent.

Despite these formidable odds, over the past two years, our governments have taken major steps to address the daunting legacy o f the past. W e have fol lowed a two-pronged approach combining stabilization measures with decisive steps in an agenda o f structural reforms aimed at initiating the delayed transition. We began efforts toward stabilizing and reforming the economy in late-2000 by tightening macroeconomic policies. These were init ial ly supported by an IMF program approved in December 2000, and then by a Stand By Agreement o f US$249 mi l l ion equivalent approved in June 2001. Subsequently, a three-year Extended Arrangement (EA) o f US$829 m i l l i on equivalent was approved in M a y 2002, spanning the period through end-March 2005. Such an arrangement was a prerequisite for implementing the significant debt reduction which we negotiated with the Paris Club in November 2001, which cuts our debt substantially in line with adequate performance under the EA.

In parallel to stabilization efforts, our governments took the f irst steps in an agenda o f structural reforms aimed at initiating the delayed transition. In addition to resolute enterprise and banking sector measures supported under the first PFSAC, described below in this letter, significant steps have been taken in key reform areas supported by the Wor ld Bank through the first Structural Adjustment Credit (SAC) and the Social Sector Adjustment Credit (SOSAC).

Strong implementation o f these reforms despite the remaining political uncertainties has brought ini t ial macroeconomic stability, while laying the foundations for a sustained recovery and improved living standards. The twelve-month inflation rate declined f rom 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 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 bi l l ion in February 2003.

Real GDP growth rebounded from the highly negative rates o f 1999 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 2001, 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 ha l f o f 1991 output. Unemployment s t i l l remains very high, with the off icial recorded rate reaching 30 percent in the f i rs t ha l f o f 2002.

With regard to foreign trade, fol lowing a 18.6 percent increase (in U S dollar terms) in 2000, exports rose by a further 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 reached US$4 bi l l ion at the end o f 2002. The current account dejk i t is projected for 2002 at around 8.9 percent o f GDP.

2

The fiscal deficit (before off icial grants) increased from 1 percent o f GDP in 2000 to an estimated 5 percent in 2002, equivalent to US$600 mil l ion. This i s due to the more realistic budgeting o f commitments (i.e., lower accumulation o f arrears), as we l l as recent increase in debt service payments. The deficit increase has been managed in a manner consistent w i t h ongoing stabilization efforts due to the strong in f low o f donor funding since 2000. Significant port ion o f the deficit was financed by revenues f rom privatization, which amounted to approximately US$220 mi l l ion in 2002.

To achieve the macroeconomic objectives for 2003-2005 and support implementation o f further structural reforms, our governments will require substantial capitd inflows. Even fol lowing the restructuring o f Paris Club debt and a sharp increase in dollar GDP in 2001 and 2002, our 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$4.7 b i l l i on o f current account deficits (excluding interest and off icial transfers), U S $ l . l b i l l i on in increased international reserves, and the remainder o f US$2.1 bi l l ion to fulfill net debt service obligations. Dur ing this period, as the fiscal deficit i s increasingly brought under control, we expect that these needs wil l shift f rom the budgetary sector to the private sector.

W e expect our financing needs to be met f rom several sources. With good progress on reforms, foreign direct investment and other private sector finance should grow to total around US$4.3 b i l l i on during this three year period. The remaining US$3.6 bi l l ion o f financing during this period is expected come f rom off icial bilateral and multilateral sources. W e hope that the Wor ld Bank program generally, and the proposed adjustment operation 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.

111. Program of Regulatory and Institutional Reforms

A. Business Environment Reform

Context. Our the init ial reform efforts, supported by the Wor ld Bank under the PFSAC I, focused o n launching pressing transition reforms, including privatization o f socially-owned enterprises. At this stage, we consider improvements in the business environment as key and highly complementary to the current program. The sustainable growth o f the Serbian economy requires a business environment conducive to the development o f the private sector. Serbia’s private entrepreneurial energy is among its greatest assets for economic recovery and has already contributed significantly to growth.

W i th assistance from the Wor ld Bank and other donors over the past two years, we 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. For instance, according to the Wor ld Bank’s Do ing Business survey, i t takes 16 procedures, 71 days and US$202 (app. 20 percent o f 2000 GNI per capita) that a start-up must bear before it can operate legally. Many problems in Serbia’s business environment are o f transitional nature, but others are structural, and wil l be resolved only w i th continued, more coordinated, and more comprehensive reforms.

Priority reforms: Our Government has put in motion, in coordination with the Wor ld Bank, the IMF, and other donors, a key set o f reforms which a im to: (i) remove administrative and legislative barriers to entry; (ii) facilitate efficient operations o f business through reforming the Enterprise Law and the L a w o n

3

Concessions, building institutional capacity for deregulation and improving enterprises’ access to finance; and (iii) reduce barriers to the efficient exit and redeployment o f non-productive assets.

W e have launched a comprehensive reform o f business registration at the end o f 2002 and plan to complete the reform by the end o f 2003. Our objective i s to reduce the number o f days needed to register an enterprise f rom the current 71 to 15-20. The structure for a proposed new registration system converges with best European practices and aims to: (i) create a unif ied Serbian business register that includes a l l business activities; (ii) administer the new unif ied 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 Un ion (EU) benchmarks; (v) expand electronic registration and updating, and ensure easy electronic accessibility to the database; and, (vi) create a single unique identifying number for each enterprise that wou ld serve al 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 to serve public needs such as inspections. In addition, we are working o n a new construction law, which wil l facilitate the issue o f construction permits helping remove an important barrier to entry.

W e are committed to adopting a new, modernized version o f the Enterprise Law which occupies a central position in the system o f commercial law. With the privatization process rapidly accelerating and foreign investment returning to Serbia, good corporate governance becomes absolutely essential for successful transition. The new Enterprise L a w will be drafted so that i t i s consistent with EU practices o n corporate governance, including the duties and responsibilities o f directors and managers, guidelines for shareholders’ meetings and voting, etc. The new law will also provide for more flexible and effective legal forms for enterprises, making it easier for small entrepreneurs to incorporate. The objective will be to create a single law governing a l l enterprises using a corporate form.

In response to foreign investors’ concerns over legal inconsistencies in the current regime for concessions, we have drafted, with the support o f the donor community, a new L a w on Concessions. 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.

In recent months, we have also given significant attention to building the institutional capacity within the Government which would al low to manage reforms across various ministries. Specifically, the Ministry o f Economy and Privatization (MOEP) proposed to the Government that the Inter-Ministerial Working Group on Deregulation, established in late 2001, i s transformed into a Counci l o n Regulatory Reform, which wil l become a permanent advisory body to the Government o n laws and policies affecting businesses by receiving the authority to review a l 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.

We have also initiated the secured Jinancing system reform, with the objective to create a modern, enabling, legal framework and appropriate implementing institutions that wil l 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. Our reform program includes: (i) adopting the Law o n 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.

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T o promote the development o f leasing operations in Serbia, the Ministry o f International Economic Relations, supported by the Southeast Europe Enterprise Development, conducted a review o f existing laws and regulations. Based o n the results o f the review, our Government has prepared a new draft Leasing L a w wh ich had been discussed with major stakeholders in the business community.

Finally, our Government i s committed to the creation o f a functioning bankruptcy regime in Serbia. The MOEP has led the preparation o f a draft new Bankruptcy Law, w i th the assistance o f foreign and local experts with considerable input f rom the Wor ld 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 MOEP has begun to develop a general trustee training course and a program to educate the judges o n the concepts contained in the new draft.

Policy actions supported by PFSAC II. By M a y 2003, our Government intends to undertake the fol lowing pol icy actions in the area o f business enabling environment reform supported by PFSAC 11: (i) decision wil l be taken o n transferring responsibility for the business registration system f rom the commercial courts and municipalities to a newly dedicated Agency for Business Services; (ii) draft L a w on Business Registration wil l be approved by the Government; (iii) draft L a w o n the Agency for Business Services will be approved by the Government; (iv) principles upon which the new Enterprise L a w is to be based wil l be adopted; (v) draft L a w o n Concessions wil l be approved by the Government; (vi) Secured Transactions L a w wil l be approved by the Government; (vii) draft Leasing L a w will be approved by the Government; (viii) the Council o n Regulatory Reform wil l be established; (ix) draft Bankruptcy L a w w i l l be approved by the Government; and (x) training curriculum for bankruptcy trustees wil l be prepared.

By the end o f 2003, the fol lowing pol icy actions wil l be completed: (i) L a w o n Business Registration and the L a w on the Agency for Business Services will be adopted by the Parliament; (ii) Agency for Business Services wil l be established; (iii) new business registration system wil l start functioning within the Agency for Business Services; (iv) draft o f a new Enterprise L a w wil l be prepared and made available to the public for discussion and commentary ; (v) L a w on Concessions wil l be adopted by the Parliament, and model Concession Contracts wil l be developed and adopted by the Government; (vi) new Collateral Registry wil l be established within the Agency for Business Services; (vii) new Leasing L a w will be adopted by the Parliament; (viii) the Counci l o n Regulatory Reform will become fully operational; (ix) new Bankruptcy L a w wil l be adopted by the Parliament; (x) new trustee licensing and regulatory agency wil l be established; and (xi) an agency under the MOEP to act as a trustee o f bankrupt SOEs will be established.

Medium-term reform objectives. As mentioned 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 wil l be ensured. The four main objectives o f our medium-term program in the area o f business environment are as follows:

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

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ii. developing proper corporate governance institutions that would support the future development o f capital markets;

111. developing anti-monopoly legislation and institutional capacity for enforcing it, which i s crucial if Serbia i s to 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.

...

B. Financial Sector Regulatory and Supervisory Framework

Context. Building on the progress in bank supervision and regulation discussed in our LDP o f April 2002, we will further strengthen the regulatory and supervisory mechanisms for the financial sector. In the banking sector, at the beginning o f 2002 the National Bank o f Serbia (NBS) adopted a Supervisory Development Plan (SDP) as an off icial statement for the future direction o f supervision. This document maps out the organizational and process changes needed to establish and implement a new supervisory approach based both o n r isk analysis and compliance verification. Work o n implementing the development steps in the SDP 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 Vice-Governor, that wil l oversee and monitor both supervisory activities and progress against the plan. A mission statement which formally presents the NBS’s supervisory objectives was approved by the Committee and the N B S Governor and presented to the public. Whi le further steps and progress has been made, we are conscious that the key to the future o f the program remains l inked to supervisory strategies for individual banks and NBS ’s improved dialog w i th 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 regulations 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 wil l be prepared and reported using IAS.

W e also recognize the need to strengthen the legal and institutional regime for deposit insurance. More than a decade ago, the former SFRY established the Bank Rehabilitation Agency (BRA) to be the deposit insurer for the banking system. In September 2001, in order to quickly implement the init ial steps o f the significant bank resolution program we described to you in our LDP o f April 2002, the mandate and powers o f the BRA were expanded to include bank liquidation functions. However, we recognize that the BRA L a w does not provide the interim 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 its 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 deposit insurance fund i s no t sufficient to provide the financial resources to reimburse insured depositors in case o f a significant bank failure.

Although it i s dif f icult to estimate the level o f money laundering, we remain concerned that Serbia may continue to be a transit country for smuggling between Asia and the Balkans. A lack o f funds and modem equipment hinders monitoring o f goods transiting the country. These factors together w i th the still- developing supervisory capacity in the banking system make Serbia a prime target for money laundering. In line with best international practice, during 2002 our Government began efforts to combat money laundering through a new anti-money laundering l aw (AML) which took effect o n July 1, 2002. The new

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AML law authorized the creation o f a Serbian financial intelligence unit (FIU) with the fol lowing functions: (i) receive reports o f suspicious transactions f rom financial institutions and develop a database; (ii) analyze the reports to identify possible criminal activity; (iii) forward reports o f suspect transactions to appropriate l a w enforcement officials for investigation and possible prosecution; and, (iv) establish effective cooperation with foreign counterpart F IUs to share information.

Insurance regulation and supervision in Serbia was carried out by the Insurance Supervisory Authority (ISA) department within the former Federal Ministry o f Finance. Today, those responsibilities are being transferred to the Serbian MOFE. Activities o f insurance companies and their supervision are regulated by the L a w o n Property and Personal Insurance, as we l l as six additional regulations that have been enacted by the ISA. However, we are aware that the current insurance legislative and regulatory framework does not comply w i th internationally accepted insurance regulatory and supervisory principles and needs modernizing, and that no effective supervision takes place because the I S A i s understaffed and lacks qualified staff.

Priority reforms. In the area o f bank supervision, our Government and the N B S are fully committed to the implementation phase o f the SDP and the development o f a new supervisory approach. This is, in part, addressed through the overall supervisory strategy that has been prepared in conjunction with the mission statement. Implementation o f 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 will support the implementation o f the methodology include: (i) establishing lines o f delegated decision making within the supervisory department; (ii) establishing a system o f internal M I S for senior and executive management and SRC reporting; (iii) elevation o f the role and responsibility o f bank boards and management through increased supervisory interaction; and (iv) enhancing the schedule o f risk stratified bank examinations to be completed during the upcoming year. The examination procedure manual and the bank r isk rating system wil l also continue to be refined during the upcoming period.

In addition to the above-mentioned improvements to bank supervision, our Government and the N B S wil l make several legislative changes needed to reflect the new constitutional arrangement between Serbia and Montenegro. The legal basis for the former NBY has already been adjusted to establish the new NBS. The former “Law o n the National Bank o f Yugoslavia” wil l be changed to reflect the new framework. In consultation with the Wor ld Bank, a new L a w o n the National o f Serbia i s expected to be drafted and passed by Parliament before the end o f this year and wil l ensure the continued independence o f the N B S and, thus, the ability o f the supervisory function to make and administer decisions free f rom pol i t ical and other outside interference. Likewise, the governance o f the N B S wil l be further strengthened with the new law, by requiring the appointment o f a supervisory board that wil l be responsible for the oversight o f the N B S and its key functions. Changes to prudential banking regulation are expected to support the evolving supervisory process. Specifically, new supporting regulation for the licensing process is planned. This wil l be particularly important in light o f the ownership and structural changes the banking industry i s currently undergoing.

With regards to deposit insurance reform, the BRA’S deposit insurance division, w i th support f rom the Wor ld Bank and key donors, has made progress in setting up basic procedures to ensure accurate and prompt payment o f premiums, reimbursement o f depositors’ claims, and collection o f premiums f rom the insured institutions. I t i s envisioned that once the bank resolution program is completed, the BRA would function only as the deposit insurer. In this regard, our Government has decided to migrate towards a new deposit insurance scheme that wil l be consistent with EU Directives, internationally recognized best practices, and in l ine w i th the expected structure and r isk profile o f the banking system and macroeconomic conditions. To that end, we will: (i) amend the law and statute o f the BRA to introduce institutional and corporate governance arrangements enabling an effective cohabitation o f the deposit insurer and bank liquidator for the time necessary to complete the bank resolution program; (ii) increase -

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in the medium-term premiums collected from insured banks up to levels closer to that foreseen or foreseeable under the new deposit insurance law; and, (iii) prepare a new deposit insurance law. W e also want to make i t clear that we wil l not launch the implementation o f this new deposit insurance scheme until actions to restructure the banking system have been substantially completed.

On the anti-money laundering front, our Government wil l continue to support the development o f the FIU with the objective o f j o in ing the Egmont Group o f FIUs, in the near future. This support wil l include the provision o f an adequate budget for the FIU in 2003 and fol lowing years. W e wil l also continue to seek donor support and cooperation for the FIU, and wil l ensure that 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.

Finally, in order to support the modernization o f the regulatory and supervisory framework for the insurance sector, our Government wil l develop and implement a new insurance law compliant w i th I A I S core supervisory principles in areas such as licensing, changes in control, investment regulation, and internal audit function. We are also committed to establishing a new insurance supervisory unit w i th in the MOFE, and to developing and implementing an action plan to strengthen insurance supervision.

Policy actions supported by PFSAC II. By M a y 2003, our Government intends to undertake the following pol icy actions in the area o f financial sector regulatory and supervisory framework reform supported by PFSAC 11: (i) regulations o n capital requirements, asset classification, licensing (i.e., shareholder approvals, fit and proper requirements), internal audit, and internal controls wil l be approved by the NBS; (ii) guidelines o n implementation o f I A S wil l be prepared by the N B S and disseminated to the banks; (iii) N B S wil l formally approve and adopt the Supervisory Development Plan (SDP), establish a Supervisory Review Committee, and start the implementation o f SDP; (iv) changes to the BRA’S operational procedures to segregate deposit insurance f rom operating funds wi l l be implemented, and new prudent investment pol icy for the deposit insurance fund will be adopted; (v) membership o f the BRA Council wil l be restructured to give designated representatives o f the Government o f Serbia a majority; (vi) adequate funding from the Serbian budget wil l be provided for the operation o f BRA and FIU in 2003; (vii) application for membership o f FIU in Egmont Group wil l be off icial ly submitted, and action plan for building capacity o f the FIU will be prepared; (viii) the new draft L a w o n Insurance wil l be prepared and reviewed by a qualified reviewer f rom a EU jurisdiction; and (ix) a team o f advisors wil l be hired to prepare a run-off c la im analysis on al l insurance companies.

By the end o f 2003, the fol lowing pol icy actions wil l be completed: (i) new L a w on the N B S wil l be adopted by the Parliament; (ii) newly adopted N B S regulations will be fully implemented; (iii) banks’ compliance w i th chart o f accounts consistent with I A S wil l be enforced by the NBS; (iv) implementation o f SDP wil l be continued; (v) new L a w o n Deposit Insurance will be prepared; (vi) amendments to AML law wil l be submitted to the Parliament; (vii) FIU will perform functions in compliance w i th the Egmont Group definition o f a Financial Intelligence Unit; (viii) new L a w o n Insurance wil l be adopted by the Parliament; (ix) Institutional Development Plan for the newly established insurance supervisory unit will be adopted, and (x) a run-off analysis and a resolution plan wil l be prepared for a l l insurance companies.

Medium-term reform objectives. The rapid evolution o f the financial system, growth, new products, and new and changing risk profiles in banks, insurance companies, and other participants in the financial sector means that in the medium term our Government must take further steps to modernize and reform the functioning o f mechanisms for the supervision and regulation o f the sector. In the banking sector, our Government would fully support the N B S to (i) further develop offsite monitoring processes and early warning systems and firmly entrenched them supervisory process, (ii) make the examination process risk focused, and (iii) ensure that the processes and mechanisms w i th in the NBS, such as the SRC, early

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warning systems, and overall supervisory procedures continue to be refined in order to more effectively anticipate the future systemic risks.

In other areas o f the financial sector, our Government’s medium term objectives include: (i) implementing the revamping o f the deposit insurance system in a manner consistent with EU Directives, internationally recognized best practices, and in line with the expected structure and risk profi le o f the banking system fol lowing the outcome o f ongoing restructuring efforts; (ii) continuing the adequate operation o f the Serbian FIU in accordance w i th acceptable international standards to combat AML; and (iii) establishing an adequate regulatory and supervisory framework for the insurance sector, and restructuring and privatizing the state insurance sector. Beyond the specific banking and insurance issues described in this letter, our Government w i l l also start formulating a longer term strategy to define the level o f integration o f the broader financial sector to ultimately extend i t s regulatory and supervisory capacity to a l l non-bank financial institutions.

IV. Privatization and Restructuring of Banks and Enterprises

A. Banking Sector Reform

Context. As it was stated in our L D P o f April 2002, supported by the Wor ld Bank’s PFSAC I and related technical assistance projects, we have made significant progress in the restructuring o f the banking sector during 2001. These efforts culminated w i th the closure o f the four largest state banks in January 2002. During this period, 23 insolvent banks representing some two thirds o f the assets o f the system were closed. Fol lowing legislative amendments we made in mid-200 1, the BRA became the designated administrator for banks in bankruptcy and, with substantial donor and Bank support, it has successfully executed these duties. The implementation o f remedial plans for the f ive banks that were in rehabilitation in the BRA 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. Niska Banka, which now has positive income and operating cash flows, i s expected to be a candidate for early privatization during this year. The remaining bank in rehabilitation has been thoroughly analyzed by the BRA and the N B S and is considered to be non-viable. Yet due to its political and social sensitivity, we have considered prudent to delay until the end o f this year to commence i ts liquidation or gradual closing.

As a result o f the restructuring process and the entry o f a number o f foreign banks, confidence has begun to return to the banking system. This i s evidenced by the rapid growth o f foreign exchange deposits, which rose from Euro 32 mi l l ion at end-June, 2001, to nearly Euro 1 b i l l i on at end-2002. Progress has also been made during 2002 in reducing the state majori ty stake in the recently created National Savings Bank (NSB) and in separating i t s governance from the NBS. During 2002 while we worked o n developing a viable strategy for the resolution o f the st i l l large number o f banks w i th asset quality problems. One response to this challenge was the passage o f the P L C L a w in July 2002, which provided for the mandatory debt-to-equity conversion of banks’ P L C liabilities into equity to be owned by the state. The consequence o f this law has been that the state has acquired a significant stake in 17 banks, 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.

We are conscious that the P L C L a w also stipulated our obligation to initiate the privatization process o f these banks within six months o f the actual execution o f the debt-to-equity conversion. In this regard, and in close coordination w i th the PFSAC program, we have recently approved a comprehensive banking resolution strategy which centers on attempts to privatize the PLC Law-affected banks without the use o f fiscal resources. We have also implemented enhanced controls and governance over the affected banks to preserve their value, and launched diagnostic audits o f state majori ty ownership banks (and one additional

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private bank with a significant state participation) to ascertain their true condition after application o f the provisions o f the P L C Law. In parallel to these efforts, we have launched tenders for a strategic advisor to the Government for the privatization process and for privatization advisers for the first three banks that we intend to sale before the end o f th i s year.

Priority reforms. Our program for reform o f the banking system builds o n the progress made under PFSAC I, and targets resolving the interconnected problems o f the PLC debts o f banks and enterprises. The first phase o f the bank restructuring program wil l move towards issuing a tender for the privatization o f Niska Banka in late 2003 and, during the course o f 2003, the resolution o f the remaining two banks under BRA control for which recapitalization and privatization i s not 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, w i th the target o f completing the sale o r leasing out 40 percent o f these assets by end-2003.

The phase o f bank restructuring associated to the enactment o f the PLC law will accelerate as a result o f our adoption o f a comprehensive strategy to privatize or liquidate a l l banks that have been affected. Our strategy emphasizes the need for implementing controls and adequate governance over the operations o f the banks. Thus we are fully committed to exerting such controls to the extent that i s necessary to maintain the value o f these banks during the pre-privatization period. Consistent with this objective, we wil l require diagnostic audits and the application o f reinforced supervisory measures (including closure) for banks found to be insolvent. As stated, our strategy excludes the possibility o f ut i l iz ing fiscal resources to recapitalize banks and provides workable institutional arrangements to manage and execute the implementation process. Addit ional work is now underway to develop a parallel strategy for integrating the resolution o f P L C assets now held by the banks w i th 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 P L C bank resolution and privatization strategy. Finally, we wil l also signal our intention to privatize the banking system by continuing a transparent and competitive divestiture o f the most o f the remaining state-controlled ownership o f the N S B by end-2003.

Policy actions supported by PFSAC II. By M a y 2003, our Government intends to undertake the fol lowing pol icy actions in the area o f banking sector reform supported by PFSAC 11: (i) BRA will implement rehabilitation measures to assure the maintenance o f positive operating cash f l ow by Niska Banka, and will submit a proposal to the Government recommending its privatization; (ii) privatization strategy for banks with significant state stakes will be adopted; (iii) BRA will implement lending controls and governance arrangements in a l l majori ty state-owned PLC-affected banks, including the launching and implementation o f diagnostic audits in eight banks with state majority ownership and one large non- state majority owned bank; (iv) tender fo r a strategic advisor to support the privatization process will be launched; (v) tender for a privatization adviser in at least three banks wil l be launched; (vi) independent governance arrangements for the National Savings Bank wil l be fully implemented; and (vii) sale or leasing o f 15% by original book value o f the non-financial assets o f the four large bank receiverships wil l be achieved.

By the end o f 2003, the fol lowing pol icy actions wil l be completed: (i) al l insolvent banks under the BRA that are not included in the privatization program wil l be closed; (ii) BRA will appoint an advisor for the 'privatization o f Niska Banka; (iii) BRA will issue a tender for sale o f the state-owned stakes in three banks; (iv) BRA w i l l approve and begin to implement a time-bound action plan for the resolution o f the largest bank remaining under the program; (v) BRA will prepare a time-bound resolution strategy for al l other banks under the program; (vi) state-owned or controlled stake in the National Savings Bank will be reduced to less that 25 percent o f the bank's capital ; and (vii) sale or leasing o f 40% by original book value o f the non-financial assets o f the four large bank receiverships wil l be achieved.

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Medium-term reform objectives. W e 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 abi l i ty to support economic growth. Accordingly, we have adopted an ambitious medium term agenda to be completed by end-2004, which aims at: (i) completion o f the resolution o f a l l remaining state stakes in banks (including al l of the P L C Law-affected banks); (ii) closure o f a l l remaining insolvent banks; (iii) aggressive disposition o f the non-financial assets o f bank receiverships; (iv) completion o f the liquidation or leasing out of the assets o f banks which were closed in 2001-2002; and, (v) rapid progress in the resolution o f non-performing bankrupt and P L C law-affected banks’ claims o n the enterprise sector.

B. Enterprise Sector Reform

Context. The real sector in Serbia remains in very poor condition. The past decade brought macroeconomic instability, loss o f markets, and isolation f rom technological advances. The mass o f productive assets t ied up in socially- or state-owned enterprises (SOEs) requires change o f ownership and, in many cases, restructuring if these f i r m s are to survive and compete in open, global markets. Our privatization strategy, as described in the LDP for PFSAC I, i s based o n the Privatization L a w adopted, with the Bank support, in June 2001, 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 Privatization Agency (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.

Priority reforms. 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. According to our estimates, 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 l imited number (probably less that 100) can be restructured and privatized, al l or in part. The remaining companies wil l have to be subject to bankruptcy. The init ial progress made by the PA in implementing the Government’s ambitious privatization program, supported under PFSAC I, has been considerable, although we acknowledge that in some areas (see below), serious problems remain and if not resolved, wil l undermine the process.

The auction privatization program has been moving forward with new momentum fol lowing a revision o f the Auctions Decree in July 2002, which simplified the process and reduced the unreasonable starting price. 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 ha l f o f 2003, 500 companies wil l be auctioned, with another 560 expected to be auctioned by end o f 2003. The average selling price o f the companies offered in auction averages about Euro 300,000.

Under the tender program managed by the PA with the help o f TA provided by the Wor ld Bank and other donors, twelve groups (pools), comprising 55 companies, have now been contracted to investment banks. We have identified two main obstacles that slowed the init ial progress o f the tender program: (i) excessive company staffing levels; and (ii) overly ambitious social program requirements imposed on the potential investors. The excessive staffing levels and mandatory social programs reflect the legacy o f the Yugoslav social ownership philosophy under which employees and managers share the fortunes o f the company and dominate the decision making process. However, the experience o f the in i t ia l failed tenders has demonstrated that the social programs deterred buyers, as they were required to guarantee employment for three to f ive years to redundant employees. Consequently, we decided to reduce the requirement that the buyers retain al l employees for five years (three years for some companies) to one year and to commit to pay an agreed level o f severance to redundant employees as part o f the sale agreement. W e wil l make

these revised terms known to buyers as part o f the tender documentation and the our commitments regarding severance payments would be made effective at the time o f the sale. W e estimate that the cost o f redundancies for companies expected to be sold in year 2003 will be about US$17.2 mi l l ion or 1.1 b i l l i on dinars. The companies in the tender program that have not yet been tendered wil l be offered with the new social terms and conditions as wil l those that did not sell in previous tenders. Depending o n their size and financial conditions, enterprises that attract no satisfactory bids in the tender process will be either auctioned, o r put into restructuring, or put into bankruptcy.

We are also undertaking some tender privatizations using the Government’s own financing. For example, a number o f sugar companies are being privatized as we l l as Beopetrol, an o i l distribution company. Our Government has opened tenders for two tobacco companies, and is considering selling i ts interest in Mobtel, a mobile telephone company. The heavily indebted steel conglomerate Sartid had been placed in bankruptcy under the existing Bankruptcy Law. Recently, the bankruptcy administrator has entered into an agreement w i th U S Steel to purchase andor manage certain components. Finally, in 2002, we have sold minority shares in 48 companies privatized under the 1997 L a w for total worth o f Euro 82 mil l ion. W e are committed to keep the public and donor community informed o n progress for these privatizations and to use open, transparent and competitive methods in their sale.

In recent months, we have tentatively selected 50 large problematic SOEs to undergo privatization through restructuring according to relevant provisions contained in the Privatization L a w and the Restructuring Decree. Using the technical assistance funding provided by the Wor ld Bank and other donors, the P A i s currently in the process o f engaging internationally reputed teams o f financial advisors to lead the preparation and implementation o f privatization through restructuring programs for most o f the companies o n the l ist o f 50. In particular, under the recently approved Wor ld Bank’s TA Credit, the PA has engaged financial advisors to work o n four large SOEs in i t s portfolio, with advisors for three more conglomerates to be hired by mid-2003.

Our restructuring strategy calls for the segmentation (in a typical case) o f the company, incorporation o f new companies created from parts o f the o ld one, and sale o f these new companies and assets remaining after the break up. This process wil l consist o f three stages: (i) a feasibility study and a due diligence report, serving as the basis for preparation o f the restructuring program by financial advisors; (ii) implementation o f financial, organizational, legal, and workforce restructuring, including (if necessary) the incorporation o f the new companies created f rom parts o f the o ld one and negotiations with creditors; and (iii) privatization o f the saleable business units by tender or auction, and disposing o f a l l other assets remaining after the reorganization through bankruptcy procedures. This model will be based o n a transaction-oriented approach, where the ultimate sale o f the enterprise or its various viable parts drives the restructuring effort. The underlying premise o f this exercise i s that various subsidiaries andor assets o f loss-making SOEs can be viable and attractive to potential investors even if as a whole these conglomerates are presently non-viable and non-saleable. W e expect to have the first sales resulting f rom restructuring program in the second ha l f o f 2003.

We recognize that central to the successful implementation o f enterprise and banking sectors reform program lies the need to deal w i th the excessive debt burden present in the economy, which affects both: (i) bank privatization, where prospective buyers -- traditionally strategic investors --normally would prefer banks to be cleansed o f their non-performing loan portfolios before the sale; and, (ii) enterprise privatization because the ability o f the PA to restructure andor privatize large heavily indebted enterprises i s affected by i t s ability to secure the agreement of creditors o f the enterprises. The first step in that direction is the existing Memorandum o f Understanding (MOU), now anchored in a government decree, between the PA and the BRA which addresses the way in which the BRA will fulfill its obligations to the courts and the creditors o f the bankrupt banks, in a manner that does not impede the privatization o f socially owned enterprises. We are currently working to develop a broader strategy,

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including proper legal and institutional mechanisms, for resolution o f claims held by state (arrears to tax authorities and various public funds) and quasi-state entities (debt to P L C Law-affected banks and utilities) against a select group o f large SOEs scheduled for case-by-case privatization and restructuring.

An integral part o f our reform program will be to address the social impact o f restructuring and privatization. The privatization or restructuring program for each enterprise prepared with the help o f financial advisors wil l include a labor redeployment plan, which wil l outline severance or other packages for redundant workers and receive financing f rom the Serbian budget. Enterprise-specific programs would be guided by the pol icy framework outlined in the Government’s Social Program for employees dismissed during restructuring and privatization, approved by the Government in March 2002. The Program is intended to provide a menu o f compensation and redeployment options for dismissed workers in the large SOEs. The Program provides a unif ied approach for dealing w i th social costs o f transition and minimizes the prospects o f ad hoc settlements for dismissed workers across different sectors. Retrenched workers may choose between: (i) a lump-sum payment equivalent to Euro 1,000 or Euro 100 per year o f service (whichever i s higher), and (ii) payment for up to two years, depending o n length o f service, at 40- 80 percent o f the average wage in Serbia. The 2003 budget includes a special allocation o f 7.5 b i l l i on dinars (equivalent to US$125 million) to provide the payments to employees o f companies covered by the Social Program, and a comparable allocation wil l be provided in the next year’s budget. Given the high fiscal cost o f the Program, we are committed to prioritizing the payment o f retrenchment benefits to workers f rom those companies that are undergoing credible pre-privatization restructuring. W e intend to ensure that fiscal costs are kept under control in the short run and reduced and eventually discontinued in the medium term. In the short run, we plan to make the payments under the Social Program more explicitly l inked to specific benchmarks in enterprise restructuring and tender privatization process, such as the adoption by the PA o f the enterprise restructuring and privatization programs, in order to ensure that public resources are spent only on enterprises which are fully committed to fundamental restructuring and change o f ownership.

We expect that any indirect environmental implications o f the our enterprise reform program supported under PFSAC I1 to be l imited and primari ly relate to the restructuring o f some o f the large SOEs. W e are committed to ensure adequate environmental safeguards based on recommendations o f the Wor ld Bank and to subject a l l major enterprises undergoing privatization through tender to environmental assessments. The results o f the assessments are and wil l continue to be included in the Information Memoranda, which stipulate the commitments that the investorhuyer needs to undertake regarding possible environmental liabilities. In February 2003, we initiated, and the Parliament adopted, an amendment to the Privatization L a w which stipulates the assumption by the state o f liabilities for past environmental damages. The methodology for determining the extent o f these liabilities, as we l l as mechanisms for addressing them, wil l be described in a series o f by-laws, to be developed jo in t l y by the Ministry o f Environment and MOEP and the PA, w i th the Bank’s technical assistance. In the medium term, we expect, w i th the assistance o f Wor ld Bank and other donors, to address the issues o f environmental compliance and industrial pol lut ion in the enterprise sector, and implement a reform agenda that would encompass improvement o f the environment-related legislative framework, regulatory and institutional capacity, and mitigate the negative impact o f the previous environmental policies and practices in the enterprise sector.

Finally, we are seeking to resolve the problem o f property nationalized during the socialist period. Building upon the Privatization L a w adopted in June 2001, we have established a working group which has been working o n a draft o f a law o n restitution. Fol lowing a participatory process o f extensive consultation and taking into account public commentary, our Government intends to submit a draft law on restitution for consideration to the Parliament by December 2003. While the details o f the law are st i l l to be worked out, the law would be based o n the fol lowing general principles: (i) compensation will be done, as a matter o f general policy, through bonds, and will be substantially in accordance w i th principles

13

o f 2001 Privatization Law; (ii) compensation wil l be done in a fiscally prudent manner; and (iii) to avoid the creation o f new injustices, the legally owned non-state property shall not be restituted (in kind) to original owners; other forms o f compensation wil l be used.

Policy actions supported by PFSAC ZZ. By M a y 2003, our Government intends to undertake the following pol icy actions in the area o f enterprise sector reform supported by PFSAC 11: (i) Parliament will adopt amendments to the Privatization L a w to al low the PA to act o n behalf o f an enterprise at a l l stages o f the privatization process; (ii) decree wil l be passed endorsing and expanding the use o f the MOU principles; (iii) PA will offer for sale, by open, transparent and competitive tender, 46 companies belonging to the 12 pools in the tender privatization program.; (iv) PA wil l undertake 500 auctions (since the start o f the Accelerated Program), with at least 60 percent o f the companies offered being sold; (v) PA will sign contracts with financial advisors to help it prepare and implement the restructuring programs for four socially-owned conglomerates in the PA portfolio, as agreed w i th the Wor ld Bank; and (vi) PA will start the tendering process by publishing a request for proposals and sending out an RFP to selected f i r m s for a financial advisor to help it prepare and implement the restructuring programs for three more socially-owned conglomerates in the P A portfolio, as agreed with the Wor ld Bank.

By the end o f 2003, the fo l lowing pol icy actions wil l be completed: (i) Government will approve a strategy for the integration o f the resolution o f claims on SOEs held by the P L C Law-affected banks, bankrupt banks in BRA portfolio, public utilities, and various public funds w i th in the framework o f the tender privatization and privatization through restructuring program; (ii) PA will sell through tender, initiate the restructuring proceedings, or initiate bankruptcy proceedings w i th respect to at least 35 percent o f the socially-owned enterprises agreed upon by the Government and the Wor ld Bank, including the provision in the offer o f sale through tender o f a legally binding commitment to finance the applicable severance payments for a l l redundant employees o f such enterprises.; (iii) starting on April 1,2003, the PA will offer for sale through auctions, no less than 560 socially-owned enterprises, and sell through auctions at least 250 socially-owned enterprises; and (iv) P A wi l l offer for sale two socially-owned conglomerate enterprises agreed upon by the Government and the World Bank, or wil l offer for sale viable parts o f such enterprises.

Medium-term reform objectives. W e recognize that completing the restructuring and privatization o f the socially- and state-owned enterprise sector is a pre-requisite for achieving sustainable economic growth in Serbia. Accordingly, we envision the fol lowing medium term agenda for 2004-2005:

0 Tender and auction privatization programs w i l l be continued in a transparent, competitive manner, as provided for in the Privatization Law and related regulations.

0 Restructuring and subsequent privatization o f large industrial conglomerates will be continued and accelerated once the effective legislative and regulatory framework for debt workout i s fully put into place. Unsaleable conglomerates andor parts thereof will be put into bankruptcy under the new insolvency regime.

0 In parallel to continuing the privatization and restructuring o f socially-owned enterprises, we plan to accelerate the reform o f the troubled state sector o f the economy. A number o f the state-owned enterprises wil l be privatization candidates over the medium term once their restructuring i s further advanced and satisfactory regulatory regimes have been put in place. Enterprises that would be considered for privatization are: (i) electricity generation, once unbundled and satisfactory regulation i s in place; (ii) telecommunications; (iii) o i l ref ining and distribution; and (iv) gas distribution. Privatization o f railways and ports, including airports, are further in the future.

14

V. Conclusion

W e remain conscious that the challenges ahead of us are significant, and that our ambitious goals wil l require a concerted effort f i om our Governments. At the same time, we are confident that this letter outlines a coherent reform agenda that includes the most crucial policy priorities to reform the enterprise and financial sectors. We remain convinced that both o f this areas o f reform are essential to achieving sustained growth and economic development. In closing, we just want to reiterate that the continued support o f the World Bank and the international community will be essential if the S A M and Serbian Governments are to achieve these ambitious goals.

- 1- -7 /A L L.x?-: 7 Branko Lukovac

Minister for External Economic Relations Council o f Ministers o f Serbia and Montenegro

Minister o f Finance and Economy Republic o f Serbia

Aleksandar VlahoviC Mladjan DinluC Minister o f Economy and Privatization

Republic of Serbia Governor of the National Bank o f Serbia

Republic o f Serbia

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Press Release No. 03/5 1 April 16, 2003

Annex 6: Fund Relations Note

International Monetary Fund Washington, D.C. 20431 USA

IMF Approves US$137 Million Credit Disbursement Under Extended Arrangement with Serbia and Montenegro

The Executive Board o f the International Monetary Fund (IMF) today completed i ts f irst review o f Serbia and Montenegro’s economic performance under the Extended Arrangement. This wil l enable Serbia and Montenegro to draw SDR 100 mil l ion (about US$137 million) under the arrangement immediately.

The Extended Arrangement was approved on May 14, 2002 for a total o f SDR 650 mill ion (about US$889 million) to support Serbia and Montenegro’s economic program in 2002-2005 (see Press Release No. 02/25). So far, Serbia and Montenegro has drawn SDR 100 mil l ion (about US$137 million) from the IMF.

Following the Executive Board discussion, Anne Krueger, First Deputy Managing Director and Acting Chair, said:

“The IMF commends the authorities o f Serbia and Montenegro for the impressive further progress in stabilization and reform achieved in 2002. Firm macroeconomic policy implementation contributed to rapid disinflation, a strengthening o f foreign reserves, and a continued recovery in output and exports. Significant advances were also made in structural reform. Equally welcome i s the renewed commitment to reform o f the new government formed following Premier Djindjic’s tragic assassination.

“Looking ahead, continued prudence and vigilance in policy implementation will remain essential to safeguard the authorities’ inflation and external objectives, especially in light o f macroeconomic uncertainties and the challenges remaining in the area o f structural reform. On the macroeconomic front, there i s a need for a tightening o f monetary policy and further fiscal consolidation. On the structural front, continued progress wil l require strong resolve as reforms move to a more difficult phase. The authorities’ demonstrated commitment to reform augurs well for achieving these objectives and laying the basis for durable growth, and merits continued support from the international community.

“Fiscal policy in 2003 will aim not only at containing the external imbalance, but w i l l also continue to support restructuring and an appropriate social safety net. Owing to the unusual risks to the macroeconomic outlook and tax collections, the authorities intend to contain discretionary spending commitments below the program level until revenue prospects become clearer. Revenue efforts will focus on improving tax administration and broadening the tax base. Fiscal transparency and management should improve with the channeling o f all privatization proceeds through the budget and the planned use o f any excess privatization proceeds to reduce the government’s net indebtedness.

“The planned tightening o f monetary policy will help lower inflation further and safeguard foreign reserves. Exchange rate policy should be kept under close review in light o f trade, price, and wage developments and conditions in the interbank foreign exchange market. In light o f the rapid increase in bank credit to enterprises since mid-2002, prudential regulations should be enforced strictly to ensure that new lending remains sound. The IMF welcomes the further liberalization o f the country’s foreign exchange system and the authorities’ acceptance o f the obligations under Article VIII, Sections 2,3, and 4 in 2002.

63

“The authorities intend to press ahead with structural reform. Attracting strategic investors for the envisaged privatization o f the 16 nationalized banks, while ensuring their proper governance, will be key to building a healthy banking system. The recent streamlining o f enterprise privatization procedures should help attract investor interest in financially weaker enterprises and maintain the pace o f privatization.

“The formation o f the state union o f Serbia and Montenegro in early 2003 will enhance political stability and provide a unique window o f opportunity for carrying forward the reform process. The envisaged normalization o f economic relations between Serbia and Montenegro under the new constitutional framework-notably by harmonizing the trade, customs, and indirect tax regimes as they converge toward EU directives-should help improve economic efficiency in both states,” Ms. Krueger said.

For questions please contact Mr. Emmanuel Zervoudakis, Assistant Director, European I Department, IMF, tel. no: 202-623-8814.

64

Annex 7: Serbia and Montenegro at a Glance 5/14/03

POVERTY and SOCIAL Serbia and Montenegro

2002 Population, mid-year (millions) I/ GNi per capita (Atlas method, US$) 7/ GNI (Atlas method, US$ billions) 7/

Average annual growth, 1996-02

Population (%) Labor force (%)

Most recent estimate (latest year available, 1996-02)

Poverty (% of population below national poverty line) Urban population (% of total population) Life expectancy at birth (years) Infant mortality (per 7,000 live births) Child malnutrition (% of children under 5) Access to an improved water source (% ofpopulationj Illiteracy (% ofpopulation age 75+) Gross primary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1982

GDP (US$ billions) Gross domestic investmenffGDP Exports of goods and services/GDP Gross domestic savings/GDP Gross national savingslGDP

Current account balance/GDP Interest payments/GDP 21 Total debVGDP Total debt servicelexports 2/ Present value of debffGDP Present value of debffexports

1982-92 1992-02 (average annual growth) GDP GDP per capita Exports of goods and services 3l

8.3 1,400 11.6

0.1 0.4

53 72 12 2

1992

2001

5.5 5.4 7.7

Europe 8, Central

Asia

475 1,960

930

0.1 0.6

63 69 20

90 3

102 103 101

2001

11.6 13.6 23.7 -7.3 9.0

-4.6 0.6

100.0 3.9

2002

4.0 3.9

18.2

Lower- middle- income

2,164 1,240 2,677

1 .o 1.2

46 69 33 11 80 15

107 107 107

2002

15.7 16.1 20.7

7.2

-8.9 0.9

74.6 5.6

64.4 354.4

2002-06

4.0 3.9

10.0

-7.0

1 Development diamond'

Life expectancy

7 I

I 1 GNt Gross per primary

I capita enrollment

Access to improved water source

I I Serbia and Montenegro - Lower-middle-income group

I Economic ratios'

I Trade

-

Indebtedness

Serbra and Montenegro - ~ Lower-mrddle-income WOUD

STRUCTURE of the ECONOMY

(% of GDP) Agriculture Industry

Services

Private consumption General government consumption Imports of goods and services

Manufacturing

(average annual growth) Agriculture Industry

Services

Private consumption General government consumption Gross domestic investment Imports of goods and services 3/

Manufacturing

1982 2000

.. 17.6

.. 37.6

.. 44.8

1982-92 1992-02

2001

89.9 17.4 44.6

2001

14.0 6.1 9.2

28.9

2002

88.7 18.3 43.8

2002

4.9 9.0

28.0 32.9

I Growth of investment and GDP (%) 40 -

I 20 -

w 01 02

-40

-GDI -GDP I ~~~

I Growth of exports and imports (x) 40 -

I -60 -

I -Exports IO-lmporls

Note: 2002 data are preiiminaryestimates. Group data are through 2001

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

I / Excludes Kosovo. 2/ On a cash basis. 3/ In dollar terms.

65

Serbia and Montenegro

PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplusldeficit

TRADE

(US$ millions) Total exports (fob) 4/

Food, beverages, tobacco Fuel and energy Capital goods

Total imports (cif) 4/ Food, beverages, tobacco Fuel and energy Capital goods

Export price index (1995=100) Import price index (7995=700) Terms of trade (1995=700)

BALANCE of PAYMENTS

(US$ millions) Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves 51

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

EXTERNAL DEBT and RESOURCE FLOWS

(US$ millions) Total debt outstanding and disbursed 6/

IBRD IDA

Total debt service IBRD IDA

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

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

1982

I982

1982

1982

1992

1992

1992

1992

0 0 0 0 0 0

2001

91.1 91.7

39.6 1 .o

-0.6

2001

2,003 308 52

256 4,838

542 1,001 1,030

2001

2,743 5,160

-2,417

-26 1,915

-528

923 -395

1,169 74.5

2001

1 1,580 1,840

0

107 0 0

591 296 132 165

0

0 0 0 0 0 0

2002

21.2 25.5

43.6 -0.5 -3.9

2002

2,412 533 82

270 6,320

638 1,068 1,631

2002

3,241 6.857

-3,616

-115 2,343

-1,387

2,203 -816

2,280 86.2

2002

11,680 2,175

168

220 75 0.4

624 533 183 562

0

226 168

0 168 75 93

0 97 98 99 w 01

~ -GDPdeflator - 0 I C P I

I Export and import levels (US$ mill.)

7WO- E 000 - 5wo-

O2 I ' 98 97 98 99 w 01

Exports Imports

I Current account balance to GDP ("A)

-2 - -3 - -4 - -5 - -8 -

-8 - -9 - 10 -

:omposition of 2002 debt (US$ mill.)

E 3,296

4 - IBRD B - IDA D -Other multilateral F - Private C ~ IMF

E ~ Bilateral

G - Short-terr

Development Economics 41 Breakdown is preliminary WB staff estimate. 5/ Includes IMF net purchases. 6/ Excludes an estimated $160 million in bond buybacks

5/14/03

66