Comment by Pavle Petrović, President of the Fiscal Council of Serbia

Why is Serbia’s economy growing slower than CEE economies?

The Serbian economy has been a growth underachiever for almost a decade, and that is the major structural issue at present. As a result, with respect to its level of development and living standards, Serbia ranks at the very bottom compared to EU countries

Serbia’s GDP per capita (in PPP) is half that of Central and Eastern European countries and a mere third of those of developed Western European countries. While economic theory and empirical research suggest that a country with a lower initial GDP per capita level should systematically grow faster than more developed economies, due to the catch-up effect, this is not what we observe in Serbia. Quite the opposite in fact: GDP growth has actually been significantly lower than growth in CEE countries since 2010, which only served to further increase the existing gap between Serbia and these countries.

But why is Serbia failing to catch up to more developed European countries, even though it should be doing so, i.e. why is Serbia’s economy growing slower than those of CEE economies, even though convergence dictates otherwise? The answer appears to be threefold: deficient institutions (specifically lacking on the rule of law and control of corruption), a low level of public and private investments, and the gap in educational achievement that hampers Serbia’s long-term economic growth prospects.

The broader reform of social and economic fundamentals is needed if Serbia is to achieve its potential growth and eventually catch-up with comparable CEE countries, but some time is needed for that to bear fruit

Serbia scores very poorly when it comes to the quality of institutions in all relevant international studies. As troubling as it is that the country is lagging behind comparable countries, it is even more troubling that the trend has reversed since 2014: from gradual improvement on the control of corruption and the rule of law to their deterioration. Furthermore, Serbia is investing only about 18% of its GDP, which is 5-6 p.p. lower than it should be, considering the country’s level of economic development and investments in comparable CEE countries.

It is estimated that Serbia is currently growing at two percentage points below its potential long-term growth rate: above 3% instead of around 5%. The greatest single negative impact on economic growth (almost 1 p.p.) comes from underperforming institutions, while the rest can be attributed to low investment level (0.7 p.p.) and a poor education system (0.2 p.p.). These factors, thus, almost entirely explain Serbia’s aforementioned GDP growth gap.

On top of these underlying, structural issues facing the Serbian economy, some current problems have brought additional uncertainties in 2019. Specifically, solid economic growth totals of 4.3% in 2018 mask the worsening macroeconomic trends in the second half of the year. Certainly contributing to this to some extent was the slowdown in the growth of large European economies, but it was primarily due to domestic factors, such as a sharp decline in EPS’ production of electricity that started in August 2018. The Government has thus far failed to respond adequately to these unfavourable short-term trends.

Although the slowdown in the second half of 2018 was evident, the Government missed an opportunity to compensate for it in 2019 by increasing public investments in infrastructure and allowing for larger reductions in the tax burden on private sector wages. Instead, the priority was given to excessive wage growth in the general government and the procurement of equipment for the military and police. Similarly, the Government of Serbia has yet to react to the obvious problems at EPS that led to a tangible drop in GDP growth rates for the second time in the past two years.

These policies – increasing its own investment and reforming EPS and other public enterprises – are the main tools at the government’s disposal for supporting short-term GDP growth. The broader reform of social and economic fundamentals is needed if Serbia is to achieve its potential growth and eventually catch-up with comparable CEE countries, but some time is needed for that to bear fruit. The main pillars of such reform should be improving the currently very poor business climate (i.e. control of corruption and the rule of law) and the poor quality of basic infrastructure in Serbia, while raising the country’s current low credit rating could also stimulate private investments.