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Poor Institutions Inhibit Economic Growth

The possible higher-than-expected economic growth in 2021 is good news, but isn’t also an indicator of a sustainable trend. Serbia needs far better quality institutions, less corruption and consistent respect for the law in order to overcome constantly lagging behind the EU and its new members. All international surveys rank Serbia bottom among European countries according to these indicators.

The greatest economic challenge confronting Serbia is achieving high economic growth and maintaining it over the long run. Serbia currently stands at about 55% of the level of economic development of the countries of Central and Eastern Europe that are EU member states (CEE11) and at about 35% of the level of development of Western Europe. In order to reduce this excessive difference and move Serbia closer to the CEE11 countries, and then to developed Europe – it is necessary to achieve relatively high GDP growth rates of at least 5% per year in continuity. That 5% is an appropriate benchmark because the comparable CEE countries had the same rate of economic growth when they were at a similar level of economic development as Serbia.

However, Serbia has long since failed to reach and maintain such economic growth rates. In the years prior to the health crisis, from 2017 to 2019, economic growth reached an average of 3.6% annually, which was lower than the average growth of CEE11 countries (over 4%). This means that, even before the crisis, Serbia was moving further and further away from those countries in terms economic development, instead of narrowing the gap.

We have analysed and quantified the factors inhibiting Serbia’s economic growth, and the poor quality of institutions stood out as the most significant factor by far. The poor quality of institutions is primarily reflected in pronounced corruption and an insufficient level of the rule of law. All international surveys rank Serbia bottom among European countries according to these indicators. Alongside the improving of institutions (which is crucial), structural reforms are also important to ensuring Serbia’s faster economic growth, such as education reform, reforming the operations of public companies and others. The empirical analysis that we conducted shows that improving institutions could accelerate economic growth permanently by over one percentage point annually, while other reforms could add another 0.5 p.p. to that.

With a somewhat narrower horizon, looking only at 2021, the Fiscal Council’s latest forecast is that Serbia’s GDP growth could total around 5.5%. The European Commission made a similar forecast (5.3%), while the Government’s forecast of 6% is slightly more optimistic but still attainable. Growth of approximately 5.5% in 2021 would be a good result, considering that Serbia didn’t experience an excessively deep decline in economic activity during the crisis of 2020, as well as the fact that lower GDP growth in 2021 is currently forecast for the CEE11 countries (slightly under 4.5%). However, this relatively good result is not sustainable in the long run. Behind the growth of Serbia’s GDP in 2021 aren’t only market trends, but also a strong increase in public investments. With the recently adopted supplementary budget revision, public investments have increased to a very high 7.5% of GDP (compared to 5.4% in 2020). Were it not for that increase in government investment, GDP growth would most likely total around 4% in 2021.

The Fiscal Council welcomed, in principle, the planned strong increase in public investment in 2021. This is a good fiscal policy measure during a crisis, and there is a need for that because the country’s basic infrastructure is in bad condition. Within the scope of the increase in state investments, it is particularly positive that in 2021 slightly larger funds (of approximately 150 million euros) have been allocated for the first time to reduce the country’s environmental pollution (with the construction of sewers, water treatment facilities, sanitary landfills etc.). But no matter how much the increase in public investments has its good sides, Serbia’s relatively high economic growth cannot be based on them permanently. In order for the rate of economic growth to be constantly maintained at over 5%, public investment would have to increase annually by a new 2% of GDP, to 9.5% of GDP in 2022, 11.5% of GDP in 2023, and so on. That is impossible. Serbia has neither the capacity to implement that, nor a budget that can afford it. So, the truth must be faced, and that truth is that the only really sustainable way for Serbia to permanently accelerate its economic growth, reach the level of CEE11 countries and become a successful European economy is by strengthening institutions, work on which must begin immediately.

The country’s public finances are currently stable, but anyone who deals seriously with fiscal policy in serbia feels unease when public debt is at around 60% of gdp, which is currently the case

The fiscal policy that Serbia led during the health crisis of 2020, and even in 2021, was very expansive. The budget deficit of 8.1% of GDP realised in 2020 was among the largest in the CEE region (where it averaged 6.5% of GDP), and a similar policy is planned for 2021, as the recently adopted supplementary budget rebalance envisages that deficit as being at about 7% of GDP. Increasing the expansiveness of fiscal policy during the crisis is justified. A significant part of the economy and citizens were imperilled by the health crisis and it was economically acceptable for the state to assist them. However, the majority of the anti-crisis measures were non-selective, so budgetary funds were also received by those citizens and companies that didn’t need them. The same influence on remediating the crisis could be achieved with far less spending of budgetary funds, and the main criticisms of the Fiscal Council were directed accordingly.

One particularly controversial measure was the distribution of 100 euros to all adult citizens in 2020, which was extended to 2021 in a similar form. The analysis we conducted unequivocally shows this to be an inefficient and poor economic policy measure. The impact of the non-selective distribution of funds to citizens on stimulating economic growth is insignificant, totalling only 0.1 to 0.2 pp, and only about 10% of the funds paid were returned to the budget through taxes as a result of increased spending. This is also a poor measure from the perspective of social policy, because there is no justified measure of social policy in which the same amount of funds are given to both poorer and wealthier citizens. At the same time, there was no money in the budget to cater for such a policy, so the state first had to borrow (with interest) over a billion euros in order to non-selectively distribute funds to citizens (600 million euros in 2020 and around 450 million euros in 2021).

Serbia also misspent funds allocated to assist the economy in a similar way. Specifically, practically all private companies were entitled to assistance, including pharmacies, food delivery companies and others that were even more successful during the health crisis than they’d been before. Other European countries, as a rule, distributed state aid much more responsibly and directed funds to where there was a objective need for that.

As a result of very high fiscal deficits in 2020 and 2021, Serbia’s public debt has grown relatively strongly and could easily exceed 60% of GDP by the end of 2021. This may not seem like excessive indebtedness at first glance, considering that EU countries’ public debt was an average of around 90% at the end of 2020. However, the key difference is that Serbia pays much higher interest rates on its debt compared to EU countries. Due to interest rates being so much higher, Serbia paid 2% of GDP from the budget to cover interest in the servicing of public debt in 2020, while EU countries – with significantly higher debt – paid only about 1.4% of GDP. The Fiscal Council constantly warns the government and the wider public that public debt of about 60% of GDP is too big for Serbia and that the benchmarks that apply to us aren’t the same as those that apply to developed Europe.

The costs of excessive public debt could be even higher in the future, considering the global acceleration of inflation happening over the last few months. If such an acceleration of inflation continues, it will translate into rising interest rates and could become a source of fiscal problems in the future. Fortunately, the prevailing assessment for now is that the acceleration of global inflation is transient, i.e. temporary, and will not have such consequences. Nonetheless, such changes are a clear warning of how easily things can slip in the wrong direction when public debt is excessive. In summary, the country’s public finances are currently stable, but anyone who deals seriously with fiscal policy in Serbia feels a sense of unease when the public debt hovers at around 60% of GDP, which is currently the case.

In order for the rate of economic growth to be permanently maintained at over 5%, serbia should sharply improve its institutions, specifically rule of law and control of corruption and reform education

The fiscal policy priority of the next few years should, therefore, be to halt the growth of public debt, and then reduce it over the medium term to a level below 50% of GDP. In order to achieve this, the budget deficit should not exceed 3% of GDP in 2022, and then it would have to be gradually reduced to about 0.5% of GDP over the following years.

The first step in this plan, i.e. reducing the fiscal deficit from around 7% of GDP in 2021 to 3% of GDP (or less) in 2022, is achievable. The lion’s share of the deficit from 2021 consists of temporary, anticrisis measures that will automatically disappear when the health crisis ends, thereby automatically reducing the deficit. Alongside that, it is necessary to control the growth of salaries in the public sector, which have grown much faster than was economically justified in recent years. This will be a major political challenge, especially given that elections have been announced for 2022.

The further reducing of the fiscal deficit in the medium term, along with stricter controls of public sector wages, through consistent application of the objective Swiss formula for increasing pensions, requires reforms of public and state-owned enterprises. These enterprises, as a rule, operate unsuccessfully and are constantly recorded as budget expenses through various forms of subsidies. The biggest public enterprise, EPS [Electric Power Industry of Serbia], is simultaneously also the biggest challenge. In addition to solving the operational problems of employment at EPS, it is also necessary to resolve strategic issues: an overreliance on coal in the production of electricity and the excessive environmental pollution generated by this company.