May 25, 2001

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

Over the past several months, we have formulated and started implementing, in cooperation with the Fund and the World Bank, a comprehensive stabilization and reform program for 2001 aimed at setting the basis for sustainable economic recovery and improvement in living standards. Our program is described in detail in the attached Memorandum on Economic and Financial Policies. In support of this program, we hereby request on behalf of the FRY authorities a stand-by arrangement in the amount of SDR 200 million, with an expiration date of March 31, 2002.

We believe that the policies and measures described in the attached memorandum are sufficient to achieve its objectives, but we stand ready to take additional measures and seek new understandings with the Fund, if necessary, to keep the program on track. We will remain in close consultation with the Fund in accordance with the Fund's policies on such consultations, and will provide the Fund with all information that it requests to assess the implementation of the program. The program will be reviewed by the Fund by August 15, November 15, 2001, and February 15, 2002. The first review will focus on developments in the budget and the pension fund, monetary and exchange rate policy, and bank restructuring, while the second review will be the occasion for reaching understandings on fiscal policy for 2002.

Yours sincerely,

MEMORANDUM OF ECONOMIC AND FINANCIAL POLICIES

I. Introduction

1. This memorandum sets forth the economic objectives and policies of the federal and republican governments of the Federal Republic of Yugoslavia (FRY) for 2001, which have been formulated within a medium-term framework geared to achieving sustainable growth and external viability. As described below, the economic program is comprehensive in scope, encompassing policies to address severe macroeconomic imbalances, reform the public finances, and restructure the banking and enterprise sectors. Annex A to this memorandum describes the quantitative performance criteria and indicative limits under the program; Annex B lists the prior actions and preconditions for consideration of the program by the IMF Executive Board, and the structural performance criteria and benchmarks under the program; and Annex C defines the performance criteria and indicative targets and describes the reporting arrangements.

2. The strengthening of democracy in FRY since last October has set the basis for FRY's reintegration with the world economy and the initiation of economic reform. The events of last October ushered in important changes in federal policies and institutions, including at the National Bank of Yugoslavia (NBY). On December 20, 2000, FRY became a member of the Fund and adopted--and has since firmly implemented--a post-conflict program supported by the Fund. Following elections in Serbia on December 23, 2000, a new government was formed in late January 2001, giving new impetus to the reform effort. The federal and both republican governments are fully committed to the implementation of the macroeconomic and structural policies described in this memorandum.

II. Background

3. The economic legacy of ten years of regional conflicts, isolation, and economic mismanagement is dismal. Output stands at about 50 percent of its 1989 level; infrastructure is in disrepair; recorded unemployment is about 30 percent of the work force; 12-month inflation runs at about 120 percent; average wages are at about DM 140 per month; and the external position is nonviable, owing in part to a crushing debt burden. Economic performance in 2000 featured a modest output recovery, with real GDP growing by about 5 percent, recovering partially from a 16 percent decline in 1999 as a result of the Kosovo war. A severe drought resulted in a 19 percent decline in agricultural output, while industrial output rose by 11 percent. Since last September, industrial output has trended downwards apparently due to energy shortages and capacity constraints after a decade of disinvestment. Meanwhile, benefits from the lifting of the sanctions have yet to materialize. Following price liberalization in October and a price jump in the late months of 2000, inflation is now running at an annualized rate of 46 percent, reflecting in part continued administered price adjustments. The economy of Montenegro has also suffered massively as a result of the economic disruptions in the region over the past decade, although the standard of living has declined less than in Serbia. The adoption by Montenegro of the DM (euro) as its sole currency last November has helped stabilize prices and strengthen financial discipline, but has also revealed underlying weaknesses in the economy.

III. Economic Objectives and Policies for 2001

4. The envisaged policies of the federal and republican governments will set the basis for a viable external position and sustainable output recovery by: reducing macroeconomic imbalances, advancing economic restructuring, and catalyzing external assistance, including debt relief. In light of difficult initial conditions, achieving these aims will require generous support from creditors and donors, as well as difficult policy choices at home.

5. Macroeconomic policies in Serbia will be geared to lowering inflation while protecting the most vulnerable groups of the population and supporting a sustainable output recovery. In this regard, credit and fiscal policies will be constrained by the severe demonetization of the economy and the prospect of a gradual recovery of confidence in the dinar. Accordingly, the target for the general government deficit in 2001 is consistent with limited borrowing from the banking system (0.6 percent of GDP in 2001), while the monetary program is based on the assumption of unchanged velocity. Wage policy in the state sector will aim to keep the annual wage bill constant in real terms on the basis of the targeted rate of inflation, which should help limit inflation, including through its demonstration effect.

6. Structural policies in Serbia will seek to reduce price distortions and impediments to growth, although with significant economic and social costs. The program for Serbia includes a major liberalization of the foreign exchange, trade, and price regimes; a radical reform of the public finances; restructuring of the banking system; and important steps in enterprise restructuring and privatization. Policy implementation will impose economic dislocation, which needs to be addressed through targeted social support. Foreign assistance, some of which remains to be secured, should facilitate reform by helping to alleviate social hardship.

7. Consistent with the above policies, the program for Serbia aims at rapid disinflation and a moderate recovery in output. Specifically, the program will aim at lowering 12-month (retail price) inflation to 30-35 percent by end-2001. This is consistent with underlying inflation of 15-20 percent, broadly in line with recent trends, and large adjustments in utility prices. Real GDP is expected to rise by around 5 percent in 2001, owing mainly to a rebound in agricultural output after last year's drought. The rest of the economy will probably grow by 2-3 percent, with the positive effects from the removal of the sanctions being moderated by capacity constraints and the adverse short-term impact of economic restructuring.

8. In Montenegro, macroeconomic policies reflect the republic's own monetary and exchange regimes. As the centerpiece of its economic program, the government in November 2000 successfully adopted the DM (euro) as the legal tender of the Republic, replacing the dual system that had existed for the previous year. This radical currency reform, has revealed underlying weaknesses in the fiscal and banking spheres, and precluded the possibility of superficial correction by recourse to money creation and inflation. For this reason, the burden of fiscal adjustment on Montenegro will be particularly difficult. The advent of price stability has also introduced more realism to the expectations of the population, facilitating a government policy to refrain from any further increases in the minimum wage during 2001. Consistent with these policies, 12-month inflation in Montenegro is expected to decelerate to about 6½ percent by end-2001, compared with about 25 percent at end-2000, while output is expected to rise by 5 percent in 2001.

9. In both republics, external consolidation is a key objective of the program. The program aims at containing FRY's current account deficit (after grants) to US$1.2 billion (11½ percent of GDP) in 2001 and strengthening gross official reserves by the equivalent of about US$200 million, roughly corresponding to purchases from the Fund. Exports are expected to rise by 7½ percent in U.S. dollar terms, reflecting a rebound in the second half of the year in response to the removal of international sanctions. Imports are projected to rise by19 percent in U.S. dollar terms, largely as a result of increased foreign assistance. These projections, as well as assumptions about the capital account, reserve accumulation, and arrears clearance, imply a financing gap of about US$10.7 billion in 2001, of which about US$0.8 billion could be covered by balance of payments and project assistance and the remainder by rescheduling of arrears and current maturities and capitalization of moratorium interest. Financing for a significant part of the remaining gap is expected to be identified in the context of the Donor Conference scheduled for June 29, 2001.

A. External Outlook and Debt Management

10. The outlook for FRY's external position is overshadowed by the crushing burden of its external debt, the bulk of which is in arrears. At around 145 percent of GDP at end-2000, external debt cannot be serviced without unacceptable sacrifice of economic activity. Accordingly, the FRY authorities are requesting from Paris Club creditors a rescheduling on Naples terms, including treatment of arrears; and comparable treatment from other official bilateral and commercial creditors. However, even with concessional debt relief and rescheduling, a substantial financing gap would persist over the next few years, owing to the rising debt service burden and reconstruction needs. Accordingly, in the context of the June Donor Conference and in discussions with official donors and creditors, the FRY authorities will be seeking support of the order of at least US$1.2 billion per year (on a commitment basis) through 2005.

11. In light of the difficult external debt position and the prospects for substantial external support on highly concessional terms, the federal and republican governments and the NBY will refrain from borrowing or guaranteeing foreign loans on nonconcessional terms. The only exception to this policy will be loans provided directly by the EBRD, EIB, IBRD, or IFC.

12. The FRY authorities will intensify efforts to reach agreement with the other successor states on the division of the assets of the former Yugoslavia. Frozen gold and foreign exchange deposits of the NBY with banks abroad amount to about US$0.9 billion. The division of these and other disputed assets among the successors to the former Yugoslavia is likely to be a complex process.

B. Fiscal Policy

13. Fiscal policy in 2001 will be geared to disinflation, supporting a sustainable economic recovery, addressing the costs of the transition, and enhancing transparency in government operations. Specifically, the fiscal program for 2001 provides for: (i) strict limits on general government borrowing from the banking system; (ii) increased social transfers targeted toward the most vulnerable groups of the population; and (iii) a bold fiscal reform in Serbia to eliminate major tax distortions and enhance transparency in spending. A large portion of investment and economic restructuring programs in Serbia has been explicitly identified as contingent on external financing. This segment of expenditures will be presented at the Donor Pledging Conference in June 2001 as Serbia's supplementary "budget for recovery and reconstruction," with a view to attracting foreign financial assistance. Excluding Serbia's supplementary budget, total public expenditure on a consolidated basis will reach some 43.6 percent of GDP in FRY, with the federal government, Serbia and Montenegro accounting for 6.7, 33.1, and 3.8 percentage points, respectively. On this basis, the overall cash deficit (before grants and privatization receipts) of the general government in FRY is projected to reach 3.8 percent of GDP in 2001. This will be financed by recourse to the banking system in an amount equivalent to 0.6 percent of GDP, privatization receipts of 1.4 percent of GDP, and foreign grants and loans of US$180 million or 1.8 percent of GDP. Excluding foreign assistance in support of Serbia's budget for recovery and reconstruction, an additional US$550 million (5½ percent of GDP) of humanitarian and reconstruction foreign assistance is estimated to be delivered outside budget channels. The supplementary budget--whose scope and size will depend on commitments at the June Donor Conference--is preliminarily estimated at about 2.3 percent of GDP in 2001. Such spending is likely to have limited, if any, inflationary effects--since it will be fully foreign-financed, have a large import component, and tend to involve idle resources in the construction sector--while it would help remove bottlenecks in infrastructure and enhance productive capacity.

14. Budget execution will be subject to a high degree of uncertainty owing to major structural fiscal reforms and bank and enterprise restructuring. To facilitate orderly budget execution, the federal and the republican governments shall (i) in close collaboration with Fund staff, monitor revenue performance to allow for timely corrective actions; (ii) backload discretionary expenditure to create additional cushioning; (iii) refrain from allocating any part of general reserves to existing budget programs until the last quarter of the year, and consult with Fund staff prior to any major allocation of general reserves; (iv) identify expenditures of 0.5 percent of GDP in the Serbian budget that will only be undertaken after consultation with the Fund staff and taking into account overall fiscal trends; and (v) if budget execution data point to a higher consolidated general government deficit than envisaged under the program, immediately impose fiscal measures to maintain the budget deficit within the agreed target on a sustainable basis.

15. Achieving fiscal sustainability over the medium term will be a challenging task. The fiscal position of the general government in FRY will remain under heavy pressure over the medium term, owing in part to the resumption of external debt servicing, the gradual repayment of frozen foreign currency deposits, enterprise and bank restructuring costs, and open unemployment, putting pressure on the unemployment fund and the budget. With a view to alleviating these pressures, the federal and Serbian governments have decided to modify the original schedule of repaying frozen foreign currency deposits (FFCDs), by rephasing repayments as needed to ensure that they will be limited to no more than 0.9 percent of projected GDP in 2005 and subsequent years, compared to over 2 percent of projected GDP in 2005-11 on average under the original repayment schedule. In light of uncertainty about the overall size of the obligation--as indicated by the limited withdrawals in 2000 and so far in 2001 under the repayment scheme--the government will issue bonds only up to amounts corresponding to repayments of DM 10,000 per account during the period through end-2001, and will discuss the revised repayment schedule for 2005 and subsequent years in the context of the second review under the stand-by arrangement.

Federal government

16. The federal government has adopted new fiscal measures to ensure that the targeted decline in federal spending--by 0.8 percent of GDP--is effected in an orderly fashion. In particular, salaries in the federal administration and the federal army have been frozen at their January level, and wage payments will be limited to the equivalent of 12 months salary. Military pension entitlements will be reviewed with a view to bringing them more in line with civilian pension entitlements. Investment expenditure will be reduced by some YUD 1.4 billion (or 0.2 percent of GDP). Finally, in order to ensure that spending on material costs is kept in line with budgetary resources, military spending will be brought under civilian control and its transparency will be enhanced. To this end, accounting and other financial functions of the military have been moved from the General Staff headquarters to the Ministry of Defense and will, therefore, be subject to the standard accounting procedures of the federal government.

Serbian government

17. Tax reform in Serbia will eliminate the most distortionary elements of the tax system. With regard to consumption taxes, all surtaxes have been abolished and a single rate final-stage tax of 17 percent has been introduced with a narrow set of exemptions. The effective tax rate has been thereby raised by 1.8 percentage points. A federal surtax of 3 percent will be applied to the same taxable base. Multiple excise taxes have been replaced with a system of simplified specific excises, while a variety of taxes on financial transaction has been replaced with a single financial transaction tax. New draft legislation will regulate all forms of property taxes, which will be assigned to local governments. Finally, the existing local taxes on wages paid by employers have been unified into a single local tax. The new tax laws and amendments were approved by parliament, in conjunction with the 2001 Budget. As of June 1, 2001, the tax base for personal income tax and social security contributions will be broadened to include all forms of cash benefits paid to employees; tax and contribution rates will be lowered by 10 percent compared to revenue neutral rates.

18. To improve transparency, all previous extra-budgetary programs financed by earmarked special surtaxes have been integrated into the budget and all earmarking of revenues in the Serbian budget has been abolished. While the social security funds (pension, health care, and unemployment) remain separate budget entities with their own revenues from social security contributions, all surtaxes previously earmarked to these funds have been abolished and revenues from these taxes have been replaced by transfers from the republican budget. These transfers will be adequately sized to ensure that social security funds do not accumulate new arrears.

19. The Serbian budget submitted to Parliament is consistent with an overall deficit (before privatization receipts and grants) of YUD 21.8 billion or 3.2 percent of GDP. This includes a total transfer of YUD 23.4 billion (3.4 percent of GDP) to the social security funds. As a result of the tax reform discussed above and the tax administration measures described below, total revenue is expected to increase by 1.7 percentage points of GDP. Concerning expenditures, the total net wage bill is budgeted to remain unchanged in real terms on the basis of the targeted rate of inflation, with teachers benefiting from a real increase of 14 percent to reduce inequities. In order to create room for more competitive salaries in the public sector, employment in central government in Serbia will be reduced by 4,000 people or some 6 percent by the end of the year. Severance payments to laid off civil servants will amount to YUD 1.2 billion, or some 0.2 percent of GDP. The budget provides for substantially increased funds for social assistance to the most vulnerable families (2.4 percent of GDP, compared to 1.4 percent last year). Subsidies to producers will amount to 2.4 percent of GDP, up from 2 percent last year, concomitant with a reduction in quasi-fiscal deficits. Funds in the amount of 0.3 percent of GDP have been allocated to provide training for workers laid-off as a result of fiscal reforms and to cover the operational costs of the Bank Rehabilitation Agency (BRA). The share of the Serbian budget for interest payments on restructured foreign debt is estimated to amount to 0.5 percent of GDP, while its share for the cost of repayment of frozen household foreign-exchange deposits will be 0.8 percent of GDP.

20. The budget execution system will be strengthened. Serbia's budget execution system has been highly inefficient, contributing to a waste of public funds. To address the most immediate problems, the Serbian authorities are committed to carry out a set of short-term measures to improve cash management and budget reporting and introduce commitment control. These measures have been formulated with the assistance of a recent IMF Fiscal Affairs Department technical assistance mission. The Serbian government is committed to an ambitious medium-term agenda for improving expenditure management, which will include the creation of a Treasury Department. Concerning arrears, the government's efforts in 2001 will focus on avoiding the accumulation of new arrears, while allowing for a modest reduction of accumulated arrears, mainly in child care benefits and agricultural pensions.

21. The envisaged reform of old-age and disability pension insurance is key to the attainment of fiscal sustainability over the medium to long run. Presently, the pay-as-you-go system is burdened by an unusually high dependency ratio (in the Serbian fund, the ratio of contributors to beneficiaries fell from 2.6 in 1990 to 1.4 in 2000) and one of the highest replacement rates in Central and Eastern Europe (83 percent for old-age pensions in Serbia). A government-appointed expert group is analyzing the pension system and is expected to present recommendations by end-June. The government plans to restructure the present system by, among other things, raising the statutory retirement age, changing the benefit formulas, and giving more equal treatment to men and women. More immediately, the government plans to sever the link between pensions and wages, and replace it by indexation to either the cost of living or a combination of the cost of living and wages. Also, with a view to more immediate results, the government plans to raise the indexation trigger--which is presently a 5 percentage point cumulative increase in wages--for the upper one third of the pensioners. These two latter measures will be introduced before end-June 2001. The Serbian budget includes a total transfer of YUD 16.3 billion (2.4 percent of GDP) to the pension funds. However, since the amount of this transfer was determined on the assumption that the short-term measures mentioned above would be introduced together with the approval of the 2001 Budget, the delayed changes will require an additional transfer of YUD 1.3 billion (0.2 percent of GDP) to be charged against the general reserves of the republican budget.

22. A set of structural measures will be introduced to improve the operation of the Health Care Fund. In particular, the government will extend and redesign the existing system of co-payments to promote a more rational use of the services offered by health care providers under the state-financed health insurance scheme. The most vulnerable parts of the society will be exempted from co-payments. The new system will be in place by end-May 2001 and will generate YUD 0.8-1 billion (0.1 percent of GDP) additional revenue for the Health Care Fund on an annual basis. In accordance with WHO recommendations, the government will revise the list of drugs offered to the insured population in state pharmacies, to bring expenditure on drugs in line with the financial resources available to the health care system. A decree stipulating the new list of pharmaceuticals will be issued by end-June 2001. These measures should ensure that the Health Care Fund does not require a transfer from the republican budget in excess of the budgeted amount of YUD 2 billion (0.3 percent of GDP) in 2001, while meeting its current obligations in full. Regarding medium-term reforms, the government plans to appoint a special committee to produce a concept paper on reform of the health care system in cooperation with experts from the World Bank.

23. The Labor Market Fund will be allocated increased resources. Reflecting the fiscal implications of enterprise restructuring, this fund will require a total transfer of YUD 3 billion (0.5 percent of GDP) from the republican budget, some YUD 1.5 billion higher than originally budgeted. The increase in allocation to the fund will be charged against the general reserves of the government. As noted in ¶46 below, new labor legislation will seek to improve the effectiveness of the Labor Market Fund.

24. A preliminary government review of the social safety net suggests that there is room for improvement in its administration and targeting. In both republics, social protection is dominated by child protection programs (with budgeted child allowances in 2001 amounting to 1.7 percent of GDP), followed by programs of welfare assistance to families in greatest need (about 30,000 households in Serbia and 8,000 in Montenegro, with a total budgeted cost of 0.3 percent of GDP). The allocation for child allowances in the Serbian budget in 2001 was increased by nearly 1 percent of GDP to 1.6 percent of GDP in 2001 to fully fund statutory entitlements and settle arrears. Its targeting will be improved through greater reliance on regional social protection centers, while regional inequities will be alleviated through the temporary programs of social assistance related to economic reform. In particular, a fund amounting to 0.4 percent of GDP will be used to assist vulnerable families' adjustment to administered price increases and the tax reform. A social protection strategy for the medium term will be elaborated further in close collaboration with the World Bank, by September 2001.

Montenegrin government

25. Partly as a result of a failure to capture a substantial share of economic activity in the tax net, and also partly because of the need to provide social support to vulnerable sections of the community, the fiscal situation remains very difficult. In 2000, the overall fiscal deficit on a cash basis (wholly financed by foreign grants) reached approximately DM 136 million (10.5 percent of Montenegro's GDP), while arrears rose by some DM 64 million (4.9 percent of GDP). A series of minimum wage adjustments during 2000 (by 60 percent to DM 80 per month) were partly warranted to correct distortions caused by a period of high inflation, but they also severely aggravated the fiscal burden by increasing public sector pay and benefit levels. This was also largely responsible for the rise in planned expenditure on wages and salaries in the budget sphere and extra-budgetary funds of almost 50 percent in DM terms and a projected increase in pensions of 20 percent in 2001. In addition, health expenditures are expected to rise by some 15 percent during 2001. These increases cannot be met by an expected 19 percent (DM 115 million) increase in current revenue collection relative to 2000, and the shortfall will be further aggravated by a possible 35 percent decline in foreign grants.

26. Faced with such a difficult situation, the government intends to cut expenditures with a view to limiting the fiscal deficit (before grants) to DM 95 million (6.5 percent of Montenegro's GDP) in 2001, in line with expected foreign grants. Enterprise and quasi-government subsidies will be reduced by 56 percent and material expenses by 19 percent. The achievement of such planned reductions in expenditures should be facilitated by the adoption of a new Public Procurement Law in mid-2001. In addition, the government intends to complete the liberalization of prices of basic foodstuffs in August 2001, which will generate savings of DM 24 million (1.7 percent of Montenegro's GDP) in annual budgetary subsidies. The impact of this measure on socially vulnerable households will be compensated by additional direct payments costing some DM 7.5 million. At the same time, an augmentation of the system of family material support, which is means-tested, will cost DM 24 million on an annual basis, but will be partially offset by a scaling back of the inadequately targeted system of child benefits, saving DM 15 million. These expenditure plans are rather ambitious on the aggregate and--despite some DM 9.6 million (0.7 percent of Montenegro's GDP) that has been set aside in unallocated expenditures--the fiscal position remains precarious. In an effort to minimize deviations from the budgetary plans and to improve the flexibility of budgetary policies, the government will de-link the statutory minimum wage from public sector pay and social benefit levels by end-September 2001. Moreover, should revenue projections (including grants) not meet expectations, the government is prepared to take other measures, as necessary, to balance the budget and avoid the accumulation of new arrears.

27. The preparations for introduction of a Treasury system from mid-2002 are already well advanced. This system will substantially improve budgetary control. The government has adopted an organic budget law, to be enacted (in amended form) in mid-2001, which mandates adoption of a standard budget classification system and a centralized treasury system operating within the Ministry of Finance. It also includes a provision empowering the Minister of Finance to close the accounts of line ministries. In addition, a reorganization of the Ministry of Finance should improve operational capacity during 2001. The introduction of a GFS classification system for the central government budget will be extended to cover the extra-budgetary funds during the course of this year, leading to the development of reliable consolidated central government accounts for 2002.

28. The extra-budgetary funds remain a critical source of concern and will require radical overhaul. The government has already prepared a general review of the pension system (with the help of USAID experts) and intend to consider a number of reforms during the remainder of this year, for possible introduction during 2002. An overhaul of the health system will, however, have to await much-needed technical assistance.

29. Plans for a systematic overhaul of Montenegro's tax policy regime have already been set in place. By mid-year, the government will approve a Tax Action Plan delineating adequate measures for the planning and implementation of a comprehensive tax code and with a view to improving tax collection, broadening the effective tax base, and lowering tax rates. Tax administration will be bolstered by a reorganization that could involve the merger of all tax functions into a unified revenue authority.

C. Quasi-Fiscal Deficits and Enterprise Financial Discipline

30. Mindful of the enormous costs to the economy caused by the supply difficulties of Serbia's electricity utility (EPS), electricity tariffs were raised by 60 percent on average on April 15, 2001 and will be increased further by 40 percent on June 1 and another 40 percent on October 1, 2001. The April and June price adjustments will bring the price to a level estimated by World Bank staff as sufficient to cover most operational costs this year, thereby substantially limiting the need for budgetary subsidies, while at least US$80 million in donor assistance will be needed to cover capital repair and maintenance costs. The October price adjustment will be the next step toward bringing the electricity price closer to medium-term economic cost. The government has agreed with EPS on cost-cutting measures to ensure rational utilization of the increased revenue stream.

31. The Serbian government is adopting measures to strengthen financial discipline in the state-owned enterprise sector. The eight largest state-owned companies account for 6 percent of registered employment and provide key inputs to the rest of the economy. The Serbian government is presently establishing the necessary mechanisms to monitor and control revenue and expenditure developments, in particular wage costs and bank borrowing in these companies. Work on preparing restructuring programs, in cooperation with the new managements, has commenced for the largest among them. In the meantime, to encourage rationalization in employment and cost control, the wage bills for 2001 of all state-owned companies in which average wages exceed those for the economy as a whole by more than 20 percent have been frozen at their January level, thereby ensuring that the state-owned company wage bill will remain roughly unchanged in real terms in 2001 on the basis of the targeted rate of inflation.

D. Monetary and Exchange Rate Policy

32. The NBY will maintain tight credit conditions with a view to lowering inflation. Quarterly credit and money targets for end-June and for the remainder of 2001 are consistent with projected nominal GDP growth, unchanged velocity of seasonally adjusted broad money, and end-2001 NFA at US$25 million above its end-2000 level. The assumption of unchanged velocity reflects conservative assumptions regarding the rebuilding of confidence in the dinar. In the event of higher-than-projected NFA, the NBY will seek to ascertain the reasons behind this development and its implications for credit policy, in consultation with Fund staff. If higher-than-projected NFA reflects temporary and reversible factors, the NBY will seek to sterilize the foreign exchange inflows by maintaining NDA below the program ceiling. If, instead, it reflects improved confidence in the currency, this would allow a correspondingly higher level of reserve money. In any event, owing to the uncertainties about the monetary transmission mechanism and the economic outlook, the NBY intends to review the credit targets on a quarterly basis.

33. Exchange rate policy will be consistent with safeguarding external competitiveness and the foreign reserve target. Despite a substantial real appreciation in recent months, the exchange rate of the dinar appears to be adequate, judging from its historical real levels and the absence of downward pressures on the NFA of the NBY. Nevertheless, the NBY will monitor developments in the foreign exchange market closely and will allow the exchange rate to depreciate as needed to ensure an adequate level of external cost competitiveness and to achieve the objective for external reserves. Exchange rate policy will be the subject of reviews under the program.

34. Monetary policy will be increasingly conducted on the basis of market-oriented policy instruments. The NBY has doubled the interest rate charged on shortfalls in required reserves to 4 percent and, for reasons of transparency, has started recording such shortfalls as credits to banks. Moreover, the NBY will raise the discount rate to a level that better reflects conditions in the money market and will conduct auctions of its securities in quantities sufficient to absorb the excess liquidity in the market and accept the resulting interest rates. Such policies would permit a relaxation of exchange and trade restrictions without undue pressure on the exchange rate.

35. Further progress toward relying on market-based monetary policy instruments should be made once the proper institutional framework is in place. Following the restructuring of the banking system in the coming months and in line with recommendations of the Fund's Monetary and Exchange Affairs Department, the NBY intends to replace the current reserve requirement system with one based on average reserve deposits, gradually reduce the required reserve ratio from its current level of 24.5 percent as monetary conditions permit, widen reserve requirements coverage to include foreign exchange deposits, and increasingly rely on open market operations in dinars and foreign exchange for the conduct of monetary policy

E. Foreign Exchange and Trade Regimes

36. The NBY will further liberalize the foreign exchange market, with the aim of accepting the obligations under Article VIII of the Fund's Articles of Agreement following a review of the exchange system by the Fund's Legal Department. The foreign exchange regime has undergone major improvements since last October, as evidenced by the unification of the exchange rate and abolition of onerous exchange restrictions last December (in the form of mandatory sales of foreign exchange by importers and exporters), and the adoption of a managed float at the beginning of this year. In addition, administrative procedures regarding payments for imports have been simplified, and responsibility for verification of the nature of the relevant transactions has been shifted to commercial banks. Moreover, the ceilings for pre-payment of imports were abolished for raw materials and equipment imports, while a 30 percent ceiling has been maintained for specific categories of consumer goods. While the aim of this restriction has been to prevent capital flight, it could act to also prevent legitimate current transactions, and the NBY abolished it in April. The NBY also abolished the exceptional penalty on commercial banks regarding payments for imports that do not eventually take place. In addition, the recently amended foreign exchange law will be revised further, with a view to explicitly allowing foreign exchange transactions to take place at any exchange rate, i.e., even at rates other than those set at the interbank foreign exchange market under the supervision of the NBY; in the meantime, a NBY decision has allowed the conduct of foreign exchange transactions at exchange rates that fall within a 5 percent range around the exchange rate determined at the interbank foreign exchange market.

37. The program provides for a major liberalization of foreign trade and a tariff reform in Serbia. Some initial steps in liberalizing trade were taken last December when the federal parliament adopted a number of amendments to the Law on Foreign Trade with a view to reducing barriers to entry into the trading industry. Nevertheless, the foreign trade regime continues to suffer from numerous quantitative restrictions and pervasive licensing requirements, while the tariff schedule is characterized by high rates with substantial variation and escalation. In cooperation with Fund and World Bank staff, the federal authorities adopted, in mid-May 2001, legislation to: (a) abolish most of the quantitative restrictions; (b) adopt a new tariff schedule; and (c) make progress toward eliminating export quotas. Non-tariff barriers were removed with the exception of about 40 (out of 8,500) tariff lines covering steel products, and measures to enforce environmental, health and safety standards, as well as those related to national security. Quantitative restrictions limiting the imports of steel products will be phased out according to a yet-to-be-established timetable, which will be formulated in the context of a restructuring of the steel industry. In any case, these measures will be removed in the context of FRY's WTO accession negotiations. The new import tariff schedule consists of 6 tariff bands with rates of 1, 5, 10, 15, 20, and 30 percent; the simple average import duty was reduced from about 14 percent to under 10 percent. For the time being, export quotas remain in force on some 30 tariff lines, including wheat, corn, live animals, edible oil and sugar. However, as the domestic food supplies increase, the government intends to remove these export restrictions on a case-by-case basis.

38. In Montenegro, the authorities intend to continue to foster an open international trading system, building on the significant liberalization already implemented over the past two years. This will be enshrined in a new Foreign Trade and Customs Law--to be adopted by end-June 2001--that will also seek to contain traffic in illegal substances and maintain appropriate national health and safety standards.

F. Bank Reform

39. The NBY is making good progress in diagnosing the problems of the banking sector in preparation for intervening the insolvent banks. Reflecting the dire conditions of the enterprise sector, inadequate banking supervision, and poor corporate governance over many years, the banking system is largely insolvent and unable to perform its intermediation function. Against this background, in late 2000 the new NBY management sought to ascertain the financial condition of banks by undertaking a bank survey that covered most banks in Serbia on a voluntary basis, with the assistance of a reputable international accounting firm. Based on this survey, banks in Serbia were divided into four categories: (A) healthy; (B) solvent but undercapitalized; (C) insolvent with some systemic importance or potential economic value; and (D) insolvent of no systemic importance. Category A banks will be monitored in the future with normal supervision tools. Category B banks will be subject to enhanced supervision and asked to develop specific recapitalization plans, under which they will be given a limited amount of time to restore their capital to satisfactory levels. Since February, the NBY has been preparing diagnostic reports, based in part on on-site examinations, on category C and D banks (28 banks, including six major banks, jointly accounting for about 80 percent of the assets of the banking system). The diagnostic reports for the six major banks as well as a considerable number of smaller banks are expected to be completed by end-April, and all diagnostic reports for the problem banks have been completed as of May 20, 2001. As described in the following paragraph, these diagnostic reports will form the base for the intervention of all banks confirmed to be insolvent.

40. The banking resolution strategy will seek rehabilitation or liquidation of banks on an expeditious basis, taking into account the prospects for privatization and the resource constraints. Following the conclusion of the on-site inspections of the problem banks, the authorities have prepared a detailed strategy for intervention of the insolvent banks and their resolution, in consultation with the Fund and the World Bank. The strategy specifies the modalities of the workout of the assets carved out of banks. The NBY envisages that the intervention of at least the largest banks will take place at or around mid-June 2001. Banks that are presumed to have some systemic importance and value (category C, likely to include at least the six largest banks) will be placed under the control of the BRA for rehabilitation or liquidation. The rest will have their licenses revoked and be liquidated under court supervision. Bank rehabilitation will be undertaken only if it is expected to produce a viable bank with good prospects for privatization through a sale to a private strategic investor at a reasonable price; and can be implemented with identifiable fiscal resources. Banks for rehabilitation will be restructured financially--through a carving out of bad debt and partial creditor haircuts--as well as operationally, with a view to their achieving core profitability (i.e., after taking into account the effect of the negative net worth on income) within a period of 12 months. If this appears to be unachievable based on performance during the first six months--owing, say, to failure to reach agreement on a haircut that respects the fiscal constraints and/or unduly slow progress in operational restructuring--the banks will be closed and liquidated. During the rehabilitation period, the banks' activities will be tightly restricted, with a view to limiting contingent government liabilities. In general, the principle of no new net lending will apply and all non-retail credit activity will be subject to BRA approval. The NBY will deal with the temporary liquidity needs of the problem banks strictly within the limits of the monetary program. In the case of liquidation, creditors' claims will be satisfied in accordance with existing legislation on the seniority of claims and the government will not assume any liabilities (including through the granting of new guarantees) in excess of existing guarantees on deposits. Given the need for the BRA to focus exclusively on the management and supervision of bank restructuring, the authorities will explore the possibility of transferring operational control of BRA's assets to the Privatization Ministry or another specialized government agency.

41. The costs of bank restructuring will be significant--albeit difficult to estimate at this stage--pointing to the need for external assistance. According to preliminary estimates, the uncovered potential losses of the insolvent banks--excluding liabilities related to the Paris Club, London Club, and households' frozen foreign currency deposits--amount to about US$1.1 billion (11 percent of GDP in 2001). This amount could be reduced significantly were bank creditors to share in the losses. This will depend on whether the BRA will be able to negotiate partial creditor haircuts. The Serbian budget for 2001 provides YUD 600 million for bank restructuring costs incurred by the BRA. In addition, funds are expected to be available from multilateral institutions (including a portion of the World Bank's US$30 million trust fund to support TA for bank resolution), the EU, and bilateral donors.

42. The NBY has embarked upon an ambitious program to strengthen bank supervision. The program includes a review of prudential regulations, strengthening of off-site reporting and analysis, introduction of on-site risk-based supervision, development of enhanced supervision and enforcement measures, and strengthening loan classification and provisioning regulations. Specifically, a review of prudential regulations, carried out with technical assistance from the Bundesbank, will be completed by end-May. The review has identified the need to strengthen legislation and regulations regarding (i) capital adequacy, (ii) large exposures, (iii) lending to connected parties, and (iv) risk management. The new standards will come into effect from January 1, 2002, based on legislation presented to Parliament by end-June, and supported by new regulations, staff training, dissemination of internal manuals, and bank awareness measures to be carried out during the remainder of 2001. Under the new regulations, banks will be expected to produce monthly reports to bank supervisors on the basis of new reporting requirements. Supervision and enforcement will also be strengthened through the publication of an enforcement manual by end-June 2001, including asset classification and provisioning guidelines. Banks will be given a grace period to improve compliance with the new regulations before their rigorous application from January 1, 2002.

43. In Montenegro, the restructuring of the banking system will be a major plank of reform policies for 2001. The Council of the Central Bank has been recently appointed, thereby empowering the bank to implement the Central Bank Law approved in November 2000 and to complete the establishment of core central bank operations and functions. With donor assistance, good progress has been made in enhancing the Central Bank's supervisory capacity. Legislation and accompanying regulations have been adopted, establishing rigorous licensing provisions and financial reporting and performance requirements for commercial banks, and containing strong, prompt, corrective action and bank exit provisions. The Central Bank has also initiated an independent external financial audit of the Clearing and Settlements Bureau (ZOP), and intends to move ahead with reform of the payments system as soon as practicable. Meanwhile, Montenegro's largest domestic bank is suffering from a severe liquidity shortage. The Council of the Central Bank has appointed a temporary administrator to assume responsibility for running this bank, which is now precluded from making any new loans. The future of the bank will be determined after two months of a possible 12-month term of the administrator and a thorough analysis of the financial and operational conditions of the bank has been carried out. A foreign strategic partner may be sought for the bank but, in any event, no public money will be expended on the bank's rescue or recapitalization. However, the social costs from the reform of the payments system and the restructuring of the banking system will be significant. Given the severity of the budget situation, the authorities intend to request financial assistance in support of the reform efforts.

G. Private Sector Development

44. In Serbia, a new approach to privatization has been adopted, with support from the World Bank. In line with the new approach, at least 70 percent of enterprise equity will be offered to strategic investors with a view to establishing clearly defined ownership and dominant owners. Employees and management will not be given preferential treatment in the sale of these enterprises, and the entire process will be conducted under strict rules to ensure transparency. The first draft of the new privatization law has already been completed in cooperation with the World Bank, and the full legal framework for privatization will be in place by end-June 2001. Steps to design the organizational structure and legal underpinnings of the Privatization Agency and decisions regarding its staffing are being taken in parallel, so that full operation of the Agency can be expected by mid-July 2001. In the meantime, privatizations under the 1997 Privatization Law were stopped shortly after the new Serbian government assumed power. Those enterprises that have begun or completed self-privatization under this law (about one seventh of medium and large enterprises) will be allowed to retain the new ownership structure. However, the authorities plan to use the unallocated share of ownership presently held by the government, and encourage employee-owners to offer a share of the ownership in their hands, to offer controlling stakes for sale to strategic investors in these companies as well. To facilitate the further transformation of ownership in previously privatized enterprises, the new privatization law will remove restrictions on the trading of employee shares.

45. Serbia's new privatization program will move along two tracks. First, through the Privatization Agency, the government will take charge of initiating and executing the privatization of the eight largest state-owned companies, mainly utilities, as well as of some 120-150 socially owned enterprises of strategic importance. In the case of the utilities, their sale will be preceded by the establishment of adequate regulatory frameworks. Strategically important socially owned enterprises will be sold through tenders offering at least 70 percent of ownership to strategic investors. Some 15 percent of capital of the state-owned and strategic socially owned enterprises will be distributed free of charge to enterprise employees, while another 15 percent will be placed in a privatization register for eventual distribution free of charge to citizens at large. The government is in the process of privatizing three cement factories under the authority granted to it by the 1997 law and, in cooperation with the World Bank, selecting another 31 strategic enterprises--to be divided into seven pools--for early privatization under the new law. The authorities envisage to have at least 4 (of the seven) contracts with investor advisors signed by end-October 2001, and to be in the position to offer at least one pool of enterprises for sale by end-December 2001. Second, with regard to the remaining 4,000 enterprises (7,000, including subsidiaries) privatization may be initiated either by the enterprises themselves or by the Privatization Agency, which can propose either a tender or an auction to attract potential strategic investors. In any case, the preparation and execution of the privatization of all enterprises will be closely supervised by the Privatization Agency and subject to well-defined tender and auction rules to ensure full transparency and accountability in the process. To provide incentives to workers and managers for rapid privatization under this scheme, the costless allocation of ownership shares to employees would decline steadily from a maximum of 30 percent to zero after four years from the coming into effect of the new law. If after four years there are still enterprises that have not been sold, their privatization will be taken over by the Agency.

46. Envisaged labor market reform should improve the business environment and facilitate economic restructuring. In this regard, draft laws on labor relations will be submitted to the federal and Serbian parliaments by end-June. Similarly, new laws on Employment and the Rights of the Unemployed will be submitted to parliament by end-August. The new legislation will: (a) guarantee core labor standards, including the freedom of association and participation in collective bargaining for employees and employers; (b) streamline and reduce minimum statutory benefits for employment termination and unemployment; (c) liberalize hiring procedures and allow for flexibility in the modality of employment (fixed-term contracts, part-time employment, seasonal, and casual labor); (d) liberalize wage determination, except for the minimum wage; and (e) bring statutory minimum leave and maternity benefits to levels affordable to the majority of the economy.

47. The federal and Serbian authorities are establishing task forces to review existing commercial and bankruptcy legislation, as well as to identify the obstacles to its effective enforcement. The legal system currently favors debtors over creditors regarding rights arising in foreclosures, bankruptcies and enterprise liquidations, while the processes themselves are lengthy and uncertain. The goal is to identify the institutional changes necessary to harden the budget-constraint and increase the security of property. Pending implementation of these institutional changes, new regulations to be adopted by end-June will allow for greater reliance on out-of-court procedures that will run in parallel or in lieu of bankruptcy and liquidation.

48. In Montenegro, private sector development will be predicated on an acceleration of the privatization program and the creation of a market-friendly climate for investors. Privatization of the majority of shares in all enterprises will be conducted by international tender to attract strategic investors and improve corporate governance, while minority shares will be preserved for a mass voucher privatization program that is set to begin this year. Also, during the course of 2001, the government intends to approve a new Company Law consistent with international best practices, as well as a new Bankruptcy Law to promote the rapid and efficient transformation of the enterprise sector. A new Foreign Investment Law aimed at protecting investments and guaranteeing the right to profit repatriation was already approved in 2000.

ANNEX A

 

Yugoslavia: Quantitative Performance Criteria and Indicative Limits Under the 2001-2002 Stand-By Arrangement1 (In millions of dinars, unless otherwise noted)
	2000		2001
	end-December		end-March	end-June	end-September	end-December
	Actual		Estimate	Target	Target	Target
A. Quantitative performance criteria
Floor on the net foreign assets of the NBY2	-308		-231	-283	-303	-283
Ceiling on net domestic assets of the NBY	39,315		34,526	39,064	41,766	42,909
Ceiling on net credit of the banking system to the consolidated general government3,4	3,373		294	5,373	7,373	7,373
Ceiling on contracting or guaranteeing of new nonconcessional external debt with original maturity of more than one year by the public sector2,5	. . .		0	0	0	0
Ceiling on new external debt owed by the consolidated general government or guaranteed by the public sector with an original maturity of up to and including one year2,6	. . .		0	0	0	0
Ceiling on new guarantees and the assumption of enterprise debt to banks by the public sector7	. . .		0	0	0	0
Ceiling on outstanding external debt service arrears8	. . .		0	0	0	0
B. Indicative targets
Ceiling on net domestic assets of the banking system9	19,433		15,720	24,604	28,226	31,226
Ceiling on change in the arrears of the federal government	. . .		0	0	0	0
the consolidated general government        in Serbia	. . .		0	0	0	0
the consolidated general government in        Montenegro	. . .		0	0	0	0
Ceiling on the wage bill of the 8 largest public enterprises, cumulative from beginning of year10	9,992		4,328	8,756	13,207	17,658
1Quantitative performance criteria and indicative targets are defined in Annex C. 2In millions of U.S. dollars; definitions have been revised to take foreign-exchange denominated liabilities into account. 3For program purposes, the ceilings on net credit of the banking system to the consolidated general government will be adjusted downward by the cumulative increase in the stock of government debt held by the nonbank public, starting from January 1, 2001, and upward for any decrease. 4The consolidated general government comprises the federal, the Serbian republican and local governments, the Montenegrin republican government, the Serbian and Montenegrin social security funds, and the Serbian special extrabudgetary programs. 5Excluding loans from the EBRD, EIB, IBRD, or IFC. The public sector comprises the consolidated general government and the National Bank of Yugoslavia. 6Excluding normal import-related credits. 7Excluded is indebtedness arising from the fulfillment of existing guarantees. 8Excludes debts subject to rescheduling/negotiations. The nonaccumulation of new external arrears is also a continuous performance criterion. 9Foreign currency denominated loans and deposits at program exchange rates. 10P Elektroprivreda Srbije, JP Nafna Industrija Srbije, JP PTT Srbije, JP Jugoslovenski Aerotransport, JP Zelenicko Transportno Preduzece Srbije, JP Radio Televizija Srbije, JP Srbija Sume, and JP Srbija Vode. Wage bill ceilings are consistent with nominal wages being maintained throughout the year at their January 2001 level, in accordance with the Decree on the Level of Wages and Other Earnings in Public Enterprises, Official Gazette, 19/01.

ANNEX B

ANNEX C

Federal Republic of Yugoslavia:
Technical Memorandum of Understanding

May 25, 2001

I. Introduction

1. This memorandum sets out the understandings between the Yugoslav authorities and staff of the International Monetary Fund (IMF) regarding the definitions of quantitative and structural performance criteria and benchmarks, as well as indicative targets, for the
10-month stand-by arrangement (SBA), as well as the mechanisms to monitor the program and related reporting requirements. To monitor the evolution of the economy during the program period, the Yugoslav authorities will provide the data listed in each section below to the European 1 Department of the Fund, in accordance with the indicated timing. The quantitative performance criteria and indicative targets will be monitored on the basis of the methodological classification of monetary and financial data that was in place on December 31, 2000, except as noted below. For program purposes, the public sector consists of the consolidated general government (comprising the federal, Serbian Republican and local governments, the Montenegrin Republican government, the Serbian and Montenegrin social security funds, and the Serbian special budgetary programs) and the National Bank of Yugoslavia (NBY). The authorities will inform the Fund staff of any new funds or special extrabudgetary programs that may be created during the program period to carry out operations of a fiscal nature as defined in the IMF's Manual on Government Financial Statistics, and will ensure that these will be incorporated within the definition of consolidated general government. Quantitative performance criteria and indicative targets for end-June, end-September and end-December 2001 are specified in Annex A of the Memorandum of Economic and Financial Policies (MEFP).

II. Quantitative Criteria: Definitions and Reporting Standards

A. Floor for Net Foreign Assets of the NBY

2. Definition. Net foreign assets (NFA) of the NBY consists of foreign reserve assets minus foreign reserve liabilities.

• For purposes of the program, foreign reserve assets shall be defined as monetary gold, holdings of SDRs, the reserve position in the IMF, and NBY holdings of foreign exchange in convertible currencies. The assets should be under the effective control of, and readily available to, the NBY. Excluded from foreign reserve assets are frozen assets of the Federal Republic of Yugoslavia (FRY), undivided assets of the Socialist Federal Republic of Yugoslavia (SFRY), long-term assets, NBY claims on bank and nonbank residents, as well as Yugoslav commercial banks located abroad, any assets in nonconvertible currencies, encumbered reserve assets pledged as collateral for foreign loans, reserve assets pledged through forward contracts, and precious metals other than gold. Monetary gold shall be valued at an accounting price of US$272.60 per ounce, and SDRs at SDR1 = US$1.3029. On December 31, 2000 the NBY's foreign reserve assets as defined above amounted to US$516 million, including gold valued at US$125 million.

• For purposes of the program, foreign reserve liabilities shall be defined as any short-term loan or deposit (with a maturity of up to and including one year), swaps (including any portion of the NBY gold that is collateralized), and forward liabilities of the NBY--in convertible currencies to residents and nonresidents; IMF purchases; and loans contracted by the NBY after December 31, 2000 from international capital markets, foreign banks or other financial institutions, foreign governments, and bridging loans from the BIS, irrespective of their maturity. On December 31, 2000, the NBY's foreign reserve liabilities, as defined above, to nonresidents were US$152 million and to residents were US$672 million.

• All assets and liabilities denominated in convertible currencies other than the U.S. dollar shall be converted at their respective exchange rates against the U.S. dollar prevailing on December 31, 2000. All changes of definition or valuation of assets or liabilities, as well as details of operations concerning sales, purchases or swap operations with respect to gold shall be communicated to the Fund staff within one week of the operation.

3. Reporting. Data on foreign reserve assets and foreign reserve liabilities of the NBY shall be transmitted to the European 1 Department of the Fund on a weekly basis within four business days of the end of each business week. To facilitate program monitoring, the NBY will provide the data at the indicated constant prices and exchange rates, as well as at current exchange rates (Annex A). The NBY will report if any of the reported foreign reserve assets are illiquid or pledged, swapped, or encumbered.

4. Adjusters. For program purposes the floor on net foreign assets will be adjusted upward pari pasu to the extent that: (i) the NBY recovers frozen assets of the FRY, undivided assets of the SFRY, long-term assets, and foreign-exchange-denominated claims on resident banks and nonbanks, as well as Yugoslav commercial banks abroad; (ii) the restructuring of the banking sector by the Bank Restructuring Agency (BRA) involves a decline in NBY foreign-exchange-denominated liabilities to resident banks; and (iii) cumulative World Bank disbursements of program loans during 2001 exceed interest payments on the World Bank consolidation loan by more than US$20 million. The floor will be adjusted downwards to the extent that cumulative disbursements of EU macro-financial assistance during 2001 fall short of debt service and arrears payments to the EIB, subject to a maximum adjustment of US$50 million.

B. Ceiling on Net Domestic Assets of the NBY

5. Definition. For purposes of the program, net domestic assets (NDA) of the NBY are defined as the difference between reserve money (as defined in section E) and net foreign assets (as defined in section A), with the latter being converted from U.S. dollars into dinars at the program accounting exchange rate of US$1 = YUD 63.1659, which was the rate prevailing on December 31, 2000 and the exchange rates of the US$ vis-a-vis other currencies prevailing on that day. As of December 31, 2000, the domestic assets of the NBY so defined were valued at YUD 39,315 (Annex A).

6. Reporting. The ceilings will be monitored on the basis of daily data on the accounts of the NBY, reporting foreign reserves assets and liabilities as defined under section A and reserve money as defined under section E supplied to the European 1 Department of the Fund by the NBY, within four business days of the end of each business week.

C. Ceiling on the Net Credit of the Banking System to the
Consolidated General Government

7. Definition. The banking system comprises the NBY and the commercial banks, including all banks in Montenegro. The consolidated general government is defined above.

• For program purposes, net credit of the banking system to the consolidated general government is defined as all claims (i.e., credits, securities, and other claims in both dinar and foreign currencies) of the banking system on the consolidated general government less all deposits of the consolidated general government with the banking system, including foreign currency deposits. Foreign currency deposits and foreign-currency denominated credits to the general government will be reported at the end-December 2000 exchange rates. Any holdings of government securities by commercial banks mandated by the NBY against reserve requirements above the actual amounts held at end-December 2000 (YUD 174 million) will be included in the credit of the banking system to the consolidated general government. Before undertaking any changes to reserve requirements, the NBY will consult with the Fund staff. (Net bank credit to the consolidated general government in Montenegro will be monitored on the basis of data supplied by the Montenegrin authorities; at end-December 2000, net credit of the banking system in Montenegro to the consolidated general government in Montenegro amounted to minus DM 84.8 million.)

8. Reporting. The ceilings will be monitored from end-weekly data on the accounts of the banking system supplied to the European 1 Department of the Fund with a lag not to exceed two weeks.

9. Adjusters. For program purposes, the ceilings on net credit of the banking system to the consolidated general government will be adjusted downward by the cumulative increase in the stock of government debt held by the nonbank public (other than that related to the frozen foreign currency deposits), starting from January 1, 2001, and upward for any decrease.

D. Ceiling on Change in Arrears

10. For program purposes, indicative targets will be set on the change in domestic arrears. Separate indicative targets will be set for the federal government, the consolidated general government in Serbia, and the consolidated general government in Montenegro.

11. Definition

• For the purpose of establishing compliance with this indicative target, the federal government is defined to comprise all budgetary institutions financed from the federal budget, including the federal army and the federal pension fund for retired military personal. The consolidated general government in Serbia is defined to comprise all budgetary institutions financed from the Serbian republican budget, the Republican Pension and Invalidity Insurance Fund for Employees, the Republican Pension and Invalidity Insurance Fund for Self-employed, the Republican Pension and Invalidity Insurance Fund for Agricultural Workers, the Republican Health Insurance Fund, the Republican Labor Market Agency, all republican special directorates, the Serbian Development Fund, and all other budgetary and extrabudgetary funds created by the government of Serbia existing before or created during the period of the program. The consolidated general government in Montenegro is defined to comprise all budgetary institutions financed from the republican budget, the Republican Pension and Invalidity Insurance Fund, the Republican Health Insurance Fund, the Republican Labor Market Fund, and all other budgetary and extrabudgetary funds created by the government of Montenegro existing before or created during the period of the program.

• The outstanding stock of domestic arrears comprises wage and pension arrears; arrears with respect to accrued tax and social security contribution obligations, including personal income tax and social security contributions of employees withheld at source; arrears on social entitlement benefits (apart from pensions) to households; arrears incurred with respect to the purchases of goods and services from suppliers; and arrears related to the servicing of domestic debt.

• The outstanding stock of wage arrears at a particular date are defined as total accumulated unpaid wages of all employees on the regular payroll of all units belonging to the parts of the general government as defined above, up to the latest preceding regular pay date, which have not been settled by the test date. The total stocks of wage arrears, thus defined, are on a gross basis and are calculated by summing the wage arrears of all units of government with regard to their own employees; transfers between different levels of government for making wage or other payments are excluded from the estimates of these wage arrears.

• Pension arrears are defined as total accumulated pensions due but not disbursed by the pension funds concerned to all pensioners in the pension rolls up to the latest preceding pension disbursement date.

• The outstanding stocks of tax and social contribution arrears at a particular date comprise total accumulated accrued tax obligations of the parts of the general government as defined above that have not been paid by the test date. The total stocks of such arrears are on a gross basis and are calculated as the sum of such arrears.

• Social entitlement payments, apart from pensions, are defined as all cash payments due directly to, or on behalf of, the population in accordance with stipulations in the law and which are not contingent upon the provision of any services or sale of any goods or assets to the general government by such members of the population in return for these payments. The stock of such entitlement arrears are defined as total accumulated payments due but not disbursed by all units of government up to the test date. Thus defined, these arrears are also on a gross basis and do not include the netting out of any transfers made between different units of the general government for the payment of such entitlements.

• Arrears to suppliers comprise payments delayed beyond what was explicitly specified in relevant contracts, or in the absence of such specification, for two months from the date of submission of bills, for already-effected purchases of goods or services by the government concerned. These include, inter alia, arrears to utility companies, arrears incurred with respect to service and maintenance contracts, and payments not made for the purchase of goods and supplies such as equipment and furniture. These arrears are also defined on a gross basis and overdue tax and other obligations to the government of the relevant enterprises are not included in the calculation of the arrears of the government unless there is mutual agreement on the cancellation of debts. Netting out of any transfers made between different units of the general government for the payment of such arrears and obligations are also not taken into consideration.

• Arrears to domestic banks and nonbank lenders comprise all overdue payments related to financial contracts between the government and domestic banks, nonbank financial institutions, nonfinancial institutions, and private lenders.

• At end-December 2000, the stock of arrears of the Federal government was estimated at YUD 7.063 billion; and the stock of arrears of the consolidated general government in Serbia was estimated at YUD 32.522 billion.

• DM denominated claims on government will be converted at the exchange rate of DM 1 = YUD 30; claims denominated in currencies other than the DM will first be converted at their respective exchange rates against the DM prevailing on December 31, 2000. The change in arrears is defined as the change in the end-period stock of arrears. Changes in wage and pension arrears will be adjusted for the changes in the average wage and average pension in the economy relative to their respective values in December 2000.

12. Reporting. Before the last business day of each month, data on end-period stocks of arrears for the previous month will be supplied to the European 1 Department of the Fund by the Federal Ministry of Finance, the Ministry of Finance of Serbia, and the Ministry of Finance of Montenegro.

E. Definition of Reserve Money

13. Definition. Reserve money is defined as the sum of currency in circulation (NBY Bulletin, September 2000, Table 3A, column 8) and reserves banks are required to hold under the standard reserve requirement, plus excess reserves of the commercial banks at the NBY. Shortfalls in reserves that banks are required to hold, will be included in required reserves (and therefore in reserve money), as well as in bank borrowing from the NBY. Reserves that banks are required to hold under the standard reserve requirement are currently set at 24.5 percent of the base as defined in the NBY Decision of September 24, 1999. Reserves that banks hold at the NBY to satisfy other additional or special reserve requirements will not be included as part of the amounts necessary to satisfy the standard reserve requirement. The amounts that banks are permitted to hold in securities to satisfy the statutory reserve requirement will be limited to the amount that banks were holding as of December 31, 2000 banks YUD 174.1 million. Excess reserves include commercial bank balances in Giro accounts 620 and 625 with the NBY and cash in commercial bank vaults.

14. Data on reserve money will be monitored from the daily indicators data of the NBY, which shall be supplied to the European 1 Department of the Fund weekly by the NBY with a three-day lag. On December 31, 2000, currency in circulation amounted to YUD 10,933 million while required reserves amounted to YUD 4,824.0 million, and excess reserves to YUD 4,088 million. Data on effective reserve requirements and the deposit base used in reserve requirement calculations will be supplied to the European 1 Department within two days of the 11^th, 18^th, and 28^th day of each month.

15. Adjusters. For program monitoring purposes, reserve money will be adjusted as follows: Should the standard reserve requirement increase (decrease) from the level prevailing on [December 31, 2000], the ceiling on net domestic assets would be increased (decreased) by an amount equivalent to the change in the standard reserve requirement ratio multiplied by the programmed deposit base used in the calculation of required reserves. Before making any such changes, the NBY will consult with Fund staff. Required reserves of banks placed under BRA administration or liquidation will remain part of reserve money for program purposes.

F. Ceiling on External Debt-Service Arrears

16. Definition. External debt-service arrears are defined as overdue debt service arising in respect of obligations incurred directly or guaranteed by the public sector, except on debt subject to rescheduling or restructuring. The program requires that no new external arrears be accumulated at any time under the arrangement.

17. Reporting. The accounting of nonreschedulable external arrears by creditor (if any), with detailed explanations, will be transmitted on a monthly basis, within two weeks of the end of each month. This accounting will include, separately, arrears owed by the Federal, Serbian and Montenegrin governments, and other public sector entities; arrears owed by Yugoslav Airlines; and arrears owed to Paris Club creditors, non-Paris club creditors, and other creditors. Data on other arrears, which are reschedulable, will be provided separately.

G. Ceilings on External Debt

18. Definitions. First, with regard to the ceiling on contracting or guaranteeing of new nonconcessional external debt by the public sector with original maturity of more than one year: This performance criterion applies not only to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt adopted on August 24, 2000 (Decision No. 12274-(00/85), see attachment to this Annex) but also to commitments contracted or guaranteed for which value has not been received. Excluded from this performance criterion are loans from, or other indebtedness to, the EBRD, the EIB, the IBRD, the IMF, and the IFC. Concessionality will be based on a currency-specific discount rate based on the ten-year average of the OECD's commercial interest reference rate (CIRR) for loans or leases with maturities greater than 15 years and on the six-month average CIRR for loans and leases maturing in less than 15 years. Under this definition of concessionality, only debt with a grant element equivalent to 35 percent or more will be excluded from the debt limit. Second, with regard to the ceiling on new external debt with original maturity of up to and including one year owed by the consolidated general government or guaranteed by the public sector : The term "debt" has the meaning set forth in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt adopted on August 24, 2000 (Decision No. 12274-(00/85). Excluded from this performance criterion are short-term import credits.

19. Reporting. A debt -by-debt accounting of all new concessional and nonconcessional debt contracted or guaranteed by he public sector, including the original debt documentation, as well as all relevant supporting materials, will be transmitted on a quarterly basis within four weeks of the end of each quarter.

III. Other Reporting Requirement for Program Monitoring

A. Macroeconomic Monitoring Committee

20. A macroeconomic monitoring committee, composed of senior officials from the Federal Government, Serbian and Montenegrin Ministries of Finance, the NBY, and other relevant agencies, shall be responsible for monitoring the performance of the program, informing the Fund regularly about the progress of the program, and transmitting the supporting materials necessary for the evaluation of performance criteria and benchmarks.

B. Developments on Structural Performance Criteria and Benchmarks

21. The authorities will notify the European 1 Department of the Fund of developments on structural performance criteria and benchmarks as soon as they occur. The authorities will provide the documentation, according to the dates in Annex B, elaborating on policy implementation. The authorities will also notify the European 1 Department of the Fund of any economic developments or policy measures that could have a significant impact on the implementation of this program.

C. Data Reporting

Production and prices

22. The following information will be transmitted at the time of their publication:

• The retail price index, the industrial price index, the industrial production index, wages and employment, and exports and imports.

23. Any revision to the national accounts data will be transmitted within three weeks of the date of the revision.

Public finance

24. Monthly data on public finance will require a consolidated budget report of the Federal and Republican governments comprising:

• The revenue data by each major item, including that collected by the federal and the republican governments;

• Details of the recurrent and capital expenditure of the federal and republican governments; and

• Details of budget financing, domestic, and external data will be transmitted within four weeks of the end of each month.

Monetary sector data

25. The following data will be transmitted on a daily/weekly/biweekly basis within one/five working days of the end of each day/week.

• Daily movements in gross foreign exchange reserves of the NBY at current exchange rates, indicating amounts sold/bought at the auction, purchases through ZOP, purchases on the interbank market, inflows of foreign grants, inflows of foreign loans, and repayments of frozen currency deposits.

• Daily movements in foreign exchange denominated liabilities of the NBY to (i) non-residents; (ii) Yugoslav banks; and (iii) Yugoslav residents.

• Daily movements in liquid foreign exchange assets of Yugoslav banks as reported by these banks to the NBY.

• Daily movements in reserve money, indicating currency in circulation, the basis upon which required reserves are calculated, required reserves, reserves held, and excess reserves.

• Treasury bill auction details (rates, amounts per maturity and number of banks participating in the auction per maturity); and

• Interbank foreign exchange rates and volume of transactions.

• Public sector borrowing and lending from commercial banks and the NBY

26. The balance sheet of the NBY and the consolidated balance sheets of the commercial banks, including all banks in Montenegro, will be transmitted on a monthly basis within three weeks of the end of each month. The stocks of government and mandatory and voluntary NBY securities held by banks and by non-banks, as available to the NBY, detailed information on interbank money market transactions (terms, duration, and participating institutions), and interest rate developments will be transmitted on a monthly basis within two weeks of the end of each month.

External data

27. The following data will be transmitted as follows:

• The interbank market exchange rate, as the simple average of the daily-weighted average buying and selling rates, will be transmitted on a weekly basis within five business days of the end of the week;

• Balance of payments data on services, private transfers, and capital account transactions will be transmitted on a quarterly basis within four weeks of the end of each quarter; and

• Detailed monthly data on the volume and prices exports and imports, including a separate report on imported petroleum products.

Executive Board Decision No. 6230-(79/140)
(Guidelines on Performance Criteria with Respect to Foreign Debt)
adopted August 3, 1979, as amended by Executive Board
Decision No. 11096-(95/100) adopted October 25, 1995,
and as amended on August 24, 2000

Point No. 9

(a) For the purpose of this guideline, the term "debt" will be understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows:

(i) loans, i.e., advances of money to the obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans and buyers' credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements);

(ii) suppliers' credits, i.e., contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and

(iii) leases, i.e., arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the lessor retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property.

(b) Under the definition of debt set out in point 9(a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. However, arrears arising from the failure to make payment at the time of delivery of assets or services are not debt.