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Wednesday, February 6, 2008

Serbia's Economy Looking Towards Europe..... But Facing Mounting Ageing and Demographic Problems

by Edward Hugh: Barcelona

This post constitutes a brief economic review and report on Serbia to accompany Manuel's election report .

Boris Tadic, the Serbian president-elect, was reportedly hoping on Monday to capitalise on his success in Sunday’s election by pressing ahead with a co-operation agreement with the European Union. At the time of writing, however, it is still unclear whether he willl prove able to secure sufficient backing from Serbia’s fragile coalition government, in which Mr Tadic’s Democratic party shares power with Vojislav Kostunica, the nationalist-leaning prime minister. So on one side there are grounds for at least a bit more optimism as far as Serbia is concerned.

But since in Sebia's somewhat tragic recent history it seems that nothing is ever given without being immediately snatched away, the country also received a dose of cold-shower reality checking, in the form of an observation from credit rating agency Standard & Poor's on Jan. 21 that the outcome of the Serbian presidential elections would have no immediate impact on the country's sovereign credit rating of BB-, which still howevers at a perilously low level, three full steps below investment grade.

So where is Sebia likely to be heading in the coming months? Well in this brief note I will be arguing that unfortunately Serbia seems to have and to be about to receive the just about the worst of both possible worlds. While still locked outside the European Union it nevertheless faces many of the inflation-ridden, remittances-driven consumer-boom problems - severely aggravated by out-migration and long term low-fertility-provoked labour shortages - which also bedevil most of the existing members of the EU10 European Union accession group.

Long Term Population Decline

It is impossible to understand what is currently happening in Serbia, and what is most likely about to happen next, if we lose sight of the fact that Serbia's population, like that of many othercountries in central and Eastern Europe, is both ageing rapidly and declining. The official population of the Republic of Serbia - as monitored by the Serbian statistics office - has been falling since the late 1990s.

At the same time Serbia's population median age is rising quite rapidly, and has now passed the sensitive 40-year-old barrier.

This is significant, since what experience we have with ageing tends to show us that as median ages move up beyond 40 the momentum of internal demand starts to slacken, and a country's economy comes to depend increasingly on exports for growth. This is significant, of course, in Serbia's case, since Serbia currently runs a sizeable trade deficit.

The reason for Serbia's rising median age is threefold: low fertility, increasing life expectancy, and substantial out migration of people in younger age groups.

If we look at fertility we can see that it is presently around 1.6TFR, and while this is still somewhat above the general norm for East and Central Europe countries - which are normally hovering in the 1.2/1.3 TFR range - it is nonetheles well below replacement levels, and looks set to fall further yet awhile as the birth postponement process gathers pace.

The impact of this steady decline is that the annual number of live births also declines, at the same time as the annual number of deaths rises since the number (and proportion) of people in the older age groups also rises. I don't have long term data for Serbia alone, but the pattern for Serbia and Montenegro (with Serbia at the time in question including Kosovo) is revealing enough.

And then if we look at the balance of births and deaths for the Republic of Serbia alone from the turn of the century, we can see how the natural rate of increase has turned negative, regardless of out migration.

At the same time male life expectancy - at 72.49 - while being quite high in an East European context, is still comparatively low in developed country terms (it is more or less in the same range, for example, as countries like Tunisia, Mexico and Paraguay), so this age is likely to continue rising steadily, thanks to the arrival of better medical technologies and medicines.

But here is just where we find a problem for a country like Serbia, since most of this increase in life expectancy will come from improving the outlook for the over 60 group, and this will have a significant on-cost (in health and pensions) with little positive economic (as opposed to human) benefit.

So the basic picture to take away from all of this is that Serbia, which is still a comparatively poor country, is going to face the possibility of increasing labour shortages as she grows, while at the same time having fiscal strains produced by the weight of the elderly population group, and productivity issues in trying to replace the "missing" people in the 20 to 30 age groups with more workforce participation from those over 55, many of whom may have little work experience (rural women), poor education, or may have been through an extended period of long term unemployment. None of which are evident "plusses" when it comes to the nitty gritty rapid catch-up economic growth.

GDP Growth and Inflation

Economic growth in Serbia has been pretty strong in recent years, and Serbia's economy has grown at an annual rate of over 7 percent for the last three consecutive quarters (up to Q3 2007) for which we have data. But in a pattern which is now becoming increasingly common across emerging markets across Central and Eastern Europe this strong growth has sparked widespread inflation and overheating concerns, problems which make Serbian government attempts to bring the economy into line with European Union criteria increasingly difficult.

Indeed, due to the steady increase in the value of the Dinar against the US dollar, the rise in the dollar value of Serbian GDP has been little short of spectacular.

Gross domestic product in fact grew by 7.2 percent in the third quarter of 2007, and this followed growth of 7.7 percent in the second quarter and 8.4 percent in the first three months of the year. Policy makers at the central bank have become increasingly nervous and concerned that this swift growth, which is more than twice the pace of the 15 nation eurozone, will destabilize the economy, and especially since they have been keeping a weather eye on capacity constraints and what has been happening elsewhere in Eastern Europe.

Serbian inflation which had been declining over recent years abruptly started to accelerate again towards the end of 2007, reaching an 11.9% rate in December, a level which prompted the bank to raise the benchmark rate by three quarters of a percentage point at the end of December and by a further half a point today (6 February), in the process bringing the rate up to 10.75 percent, which is the highest current rate in Europe, amid accusations from the central bank governor Radovan Jelasic that the Cabinet is not doing enough to calm inflation. In particular, and ignoring advice from the IMF, instead of aiming for a surplus the Serbian Parliament last December adopted a 2008 budget that includes a deficit of 0.5 percent of GDP and an inflation target of 6 percent.

"Only a deaf man cannot hear inflation knocking at our door" central bank Governor Radovan Jelasic said in a press conference recently. "Today's passivity will be paid for dearly in few months." December inflation rate soared to 11.9 percent in December from 10.4 percent in November.

Remittances and Migration

Given that the present median age is fairly high (40.6) and since fertility has been low, but not disastrously so, while life expectancy is not especially high it would seem to be a reasonable deduction that there has been a fair amount of outward migration in the 20-40 age range over the last decade or so. I say reasonable assumption since unfortunately, in a manner which is all too common in East European societies, the situation is complicated by the fact that the Serbian government has not made migration figures public since publishing the results of the last census in 2002. What appear to be reasonably accurate figures for the period up to the census are available on the statistics office website, so it is perfectly possible that the administration themselves have no real idea of what the numbers actually are, as this paper on migration in the Serbian context makes clear).

Some indication of the extent of Serbian out-migration can be obtained from the remittances flows, which were estimated by the World Bank to be running at a rate of 17.7% of GDP in 2006. Now this is a very large share in GDP value, and has lead people to use the expression "labour export" driven development in the case of countries like Moldova and Serbia. But this view misses one important feature of the situation, and that is that - unlike high fertility socities like Pakistan or the Philippines - Serbia is not resource rich in labour. Labour is a precious and potentially scarce resource in a low fertility society, and far from exporting, Serbia needs to hang onto what it has, and even attract back many of those who have left.

Back in 2002, according to the statistics office, there were roughly half a million Serbs working abroad, about 100,000 of those being in Germany. In that year there were 2 billion dollars worth of remittances coming back. In 2006 there were roughly 4.7 billion dollars coming in, so we could estimate that the number of those working abroad has more or less doubled to near the million mark over these years. In a country with a labour force in the 3 to 4 million region, this is a lot of people.

The whole issue of Eastern European migration is a complex one, and has been the subject of a recent World Bank report. Basically we are witnessing a systematic east-west migration process taking place across Europe at the present time, driven mainly by the existence of a substantial wage gradient.

So Serbia has, along with most of the rest of Eastern Europe, a substantial problem in retaining its young native-born human capital. Indeed, according to the above cited paper, a staggering 70% of Sebian students indicate that they would like to leave the country on completing their studies. But on top of this Serbia - along with a whole swathe of other Eastern European countries (Croatia, Macedonia, Moldova, Ukraine, Georgia, Armenia etc.) - faces the problem of being excluded (at least in the short term) from the European Union. Unfortunately with the current climate towards enlargement inside the EU this situation is unlikely to change much in the near future, and these are likely to be critical years in the demographic history of these countries as the full weight of the second stage of the demographic transition - low fertility and medically driven extensions in life expectancy - comes increasingly to exert an effect.

Perhaps the final bucket of very cold water is thrown on all this by the most recent authoritative statement on the state of the Serbian economy: the October 2006 IMF selected issues Serbia paper, from which I now freely quote:

Serbia has made significant economic progress since 2000. Output is up 40 percent and the share of the private sector in non-agricultural non-budget employment has almost doubled to around 60 percent. These advances have reversed the decline of the previous two decades. In light of this progress, these notes aim to shed light on the challenges ahead.

Of course it is important to remember here that back in 2000 the Serbian economy was virtually in ruins, so climbing back up was not so difficult, it is what comes next which is important:

With capital formation rates regionally low and employment reportedly falling, much of the economic recovery since 2000 has reflected growth in total factor productivity. In part, this is the dividend of corporate reforms which have increased efficiency. But even with the exceptional steel investment in 2004, Serbia’s investment ratios are well below those in other transition countries. Even allowing for data quality uncertainties, these investment patterns raise questions about the sustainability of Serbia’s recent economic growth. The note infers that these investment patterns indicate that a significant further reform agenda—ranging from improved business and political climates, to bankruptcy and privatization—still lies ahead.

and on employment:

With the unemployment rate at 21 percent and rising, employment reportedly in trend decline, and future restructuring set to result in further layoffs, the issues are challenging. The note is exploratory, suggesting lines of enquiry rather than firm conclusions about the way ahead. It reports that the employment structure has shifted to the private sector, but cautions that data are not yet conclusive as to whether this is re-classification due to privatization or whether private firms are creating new jobs. It suggests that Serbia’s labor institutions could be reassessed in view of the high and rising unemployment, including the complex wage setting mechanisms in the public sector inherited from the Yugoslav era.

Also note the rapid growth of credit, especially to unhedged borrowers (shades of the Hungarian disease):

With rapid credit growth one of the consequences of earlier reform, notably of the banking system, the 2005 FSAP pointed to the need to strengthen banking regulation. Given that the 2005 banking law brought the legal regulatory framework largely in line with Basel Core Principles, this note emphasizes that the key challenge now is implementation. It notes that credit, which is largely fx-indexed lending to unhedged borrowers, requires strengthened regulatory capacity to monitor and manage indirect credit risk arising from foreign exchange exposures.

And note these two points from the Main Findings section:

In Serbia, the large current account deficit has been associated with relatively low investment ratios compared to other CEECs (except Bulgaria)—although data doubts remain.

Given Serbia’s large external debt, financing its large investment needs will require achieving higher national savings and attracting larger non-debt creating flows.

and this:

Given these caveats, Serbia’s data suggests surprisingly high external deficits given lackluster fixed investment ratios. Such delinks are not without precedent—after 2001, the Czech Republic and Hungary both reported continued high external deficits while fixed investment ratios declined, in both cases reflecting weakening domestic savings rates. But overall, Serbia’s performance is unusual in degree—reporting large external deficits alongside low investment ratios.

I think the very last sentence really says it all. Capital has continued to flow into Serbia in recent years, but less in the form of foreign direct investment and more as external, including off-shore, borrowing. External debt has continued to increase. In particular, private debt rose to 38 percent of GDP at end-September, more than double its end-2004 level, and at the same time there has been a very rapid growth in euroized credit. So we have very much the same combustible mixture we have been seeing all over Eastern Europe, with the only distinction that the intensity and degree in Serbia are just that bit stronger.

The Serbian average wages increased by nearly 30 percent in the 12 months to November 2007, while during the same period retail prices rose by only 10.4 percent. That means that in November 2007 the average wage bought about 20 percent more goods or services than in November 2006! In manufacturing, real wages rose by 20 percent. While this was the smallest increase of all sectors, it still exceeded by far the estimated 13–14 percent rise in industrial labor productivity. Thus, industrial labor became less competitive. This is all clearly unsustainable.

It is highly probable that under these circumstances foreign direct investors will find Serbia less attractive, and privatization and restructuring of enterprises with skyrocketing wage bills will become more difficult. The problem is at its worst in the public sector. Real net wage growth in public sector in the 12 months to May 2007 was 30 percent, while productivity increases were relatively small. A few examples: Health workers received an average 42 percent salary increase. At the same time, the health sector is busy taking out additional loans to finance necessary maintenance and capital expenditures. Somebody will need to repay the loans. Real wages in the electricity sector went up by 30 percent in the year to April, while EPS received a 15 percent increase in electricity prices in May. It also consistently requested more price hikes to cover its expenditures.

Higher wages increase consumption and imports, thus further deepening the current account deficit. They also increase inflation in the non tradable sector and thus make the job of the National Bank more difficult.

So Serbia seems to be caught in a kind of trap, where out-migration produces remittances and an increase in consumer and loan demand, and this increase in demand fuels a wage price spiral which seems to be hurtling out of control (remember that euro denominated loans carry a much lower rate of interest than dinar denominated ones, thus effectively circumventing the central banks monetary tightening), and all of this while unemployment - according to official data - runs at over 20%. What happens next? This is very hard to say, since no-one really has ever been here before, but the result will certainly be worth watching, if only to see what can be learnt from the experience.

Some further explanation of the theorectical logic that lies behind this argument can be found in:

Inflation in Russia: Too Much Money Chasing Too Few People?


Catch Up Growth and Demographics - Evidence from Eastern Europe