Documentof The WorldBank FOR OFFICIAL USEONLY ReportNo. 27048-YU MEMORANDUM OF THE PRESIDENTOF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ONA TRANSITIONAL SUPPORT STRATEGY UPDATE FOR SERBIA AND MONTENEGRO February 18,2004 SouthEast Europe Country Unit ECCU4 Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contentsmay not otherwise be disclosed without World Bank authorization. ABBREVIATIONS AND ACRONYMS AAA Analytical andAdvisory Assistance AML Anti-Money Laundering BRA BankingRehabilitation Agency CAS Country Assistance Strategy CDF ComprehensiveDevelopment Framework CEM Country Economic Memorandum CIDA CanadianInternational Development Agency CFAA Country FinancialAccountability Assessment CPAR Country ProcurementAssessment Report CPOT Costanza-Pancevo-Omisalj(pipeline development) DFID Department for International Development DM Deutsche Mark DREPR Danube River Enterprise Pollution Reduction Project EA ExtendedArrangement EBRD European Bank for Reconstruction and Development EC European Commission EIB European Investment Bank ERTP Economic Reconstruction and Transition Program ESW Economic and Sector Work EU European Union FDI ForeignDirect Investment FIAS ForeignInvestment Advisory Service FIU Financial Intelligence Unit FRY Federal Republic of Yugoslavia FSAP Financial Sector Assessment Program GDLN Global Development LearningNetwork GDP Growth Domestic Product GEF Global Environment Facility GGA Governmental Geodetic Authority GNP Gross National Product IBRD International Bank for Reconstruction and Development ICA Investment Climate Assessment ICTY International Criminal Tribunal for Yugoslavia IDA International Development Association IDF Institutional Development Fund IDPs Internally Displaced Persons IFC International Finance Corporation ILO International Labor Organization IMF International Monetary Fund I-PRSP InterimPoverty Reduction Strategy Paper JSA Joint Bank-IMF Staff Assessment JPR Joint Bank-Government Country Portfolio Performance Review LIC Learning and InnovationCredit MDG MillenniumDevelopment Goals MESTAP Montenegro Environmentally Sensitive Tourist Areas Project MEIP Metropolitan Environmental ImprovementProgram MIGA Multilateral Investment GuaranteeAgency MOF Ministry of Finance NATO North Atlantic Treaty Organization NBS NationalBank of Serbia NBFI Non-Bank FinancialInstitutions FOR0JWICIA.LUSEONLY NGO Non-Governmental Organization NMP Net Material Product OECD Organization for Economic Cooperation and Development P E R Public Expenditure Institutional Review PFSAC Privateand Financial Sector Adjustment Credit PI0 Pension Fund PIU Project ImplementationUnit PMU Portfolio Management Unit PRSP Poverty Reduction StrategyPaper PSAPT Private Sector Advisory Service PSD Public Sector Development SAC Structural Adjustment Credit SAA Stabilizationand Association Agreement SAM Serbia and Montenegro SAP Stabilization and Association Process SEE South East Europe SEEREM South EastEurope Regional Energy Market SEED SoutheastEurope Enterprise Development SFRY Socialist FederalRepublic of Yugoslavia SIEPA Serbian Investment andExport PromotionAgency S M E Small -and Medium-SizedEnterprises SOE Socially-owned enterprises SOSAC Social Sector Adjustment Credit STIs Sexually Transmitted Infections TA Technical Assistance TB Tuberculosis TFFRY Trust Fundfor Federal Republic of Yugoslavia TSS Transitional Support Strategy TTFSE Trade and Transport Facilitation in Southeast Europe UN United Nations UNDP UnitedNationsDevelopment Program UNEP UnitedNationsEnvironmentProgram UNICEF UnitedNations Children's Fund UNMIK UnitedNations MissioninKosovo USTDA United States Trade andDevelopment Agency VAT Value Added Tax VB Vojvodjanska Bank VLE Virtual LearningEnvironment WBI World Bank Institute WTO World Trade Organization ZOP Clearingand Settlements Bureau Vice President: Shigeo Katsu Country Director: Orsalia Kalantzopoulos TeamLeader: Nancy J. CookelArdo H.Hansson [Thisdocument has a restricted distribution andmay be used by recipients onlyin the performance of their official duties. I t s contents may not be otherwise disclosed without World Bank authorization. TABLE OF CONTENTS Executive Summary .................................................................................................................................... i I Introduction....................................................................................................................................... . 1 I1. Political and Economic Context........................................................................................................ 1 I11 The Government's Economic and Social Programand Strategic Agenda........................................ . 8 Iv LookingTowards theFuture: MediumTermChallenges ............................................................... . 12 V. MediumTerm Outlook. Sources o f Growth andExtemal FinancingRequirements...................... 14 VI. WorldBank Group Assistance........................................................................................................ 17 FY03 ProgramImplementation....................................................................................................... 17 Proposed Program........................................................................................................................... 20 Intemational FinancialCorporation (IFC) ...................................................................................... 22 Foreign Investment Advisory Service (FIAS) ................................................................................. 24 Multilateral Investment Guarantee Agency (MIGA)...................................................................... 25 VI1. Risks................................................................................................................................................ 25 Boxes Box 1:The Realization of the Uniono f Serbia and Montenegro .............................................................. 2 3 Box 3: Supporting the PRSP Process......................................................................................................... Box 2. Serbia and Montenegro -The Stabilization and Association Process ............................................ Box 4: Poverty in Serbia and Montenegro in2002: Who are the poor?................................................... 5 6 7 Box 6: Donor Support to Serbia and Montenegro ................................................................................... Box 5: S A M -Progress Toward the MillenniumDevelopment Goals .................................................... 16 Tables Table 1:Economic Indicators................................................................................................................. 20 Table 2: Strategic Objectives and the Bank Group Program................................................................. 24 Attachments Attachment I: ......................................... A Programmatic Approach to Poverty inSerbia andMontenegro Attachment 11:.......................................................... Attachment N:............................................................................ Attachment 111:............................................................................................ Special Challenges: Displaced Persons and the Roma RegionalStudies and Initiatives Donor Support to Serbia and Montenegro Attachment V: ....................................... Matrix o f Development Objectives and Performance Benchmarks Attachment VI.............................................................. Attachment VII: ......................................................... Serbia and Montenegro (Pre-Membership Support) Republic of Montenegro (Pre-Membership Support) Attachment VIII: ................................................................ Republic o f Serbia (Pre-Membership Support) Attachment IX:.......................................... Serbia and Montenegro Recent Progress on Structural Reforms Annexes Annex 1:........................................................................................... Serbia andMontenegro-At a Glance Annex 3:................................. Annex 2:.................................................................................................. S A M -KeyEconomic Indicators S A M SelectedIndicatorsof BankPortfolioPerformance andManagement Annex 5:......................................................................... Annex 4:....................................................................................................... ~ ~ProgramSummary~ / A LFC&MIGA ProgramsinSerbia andMontenegro Annex 7:.................................................................................. IBRD/DA andGrants Operations Portfolio Annex 6:............................................................................................... S u ~ ofaNon-LendingServices ~ Annex 8:...................................................................... Statements of IFC's Held andDistributedPortfolio M a p of Serbia and Montenegro (IBRD 31506R1) Memorandum to the Executive Directors of IBRD and IDA Transitional Support Strategy Update for Serbia and Montenegro Executive Summary i. The Transitional Support Strategy Update for Serbia and Montenegro (SAM) provides an assessment of implementation progress during FY03 and outlines the strategic framework for the final period of the World Bank Group Country Assistance Program, funded under an exceptional IDA allocation of US$540 million. This Update also describes the constitutional transition of the Federal Republic of Yugoslavia to the state union of Serbia and Montenegro, realized on February 3, 2003. A full three year participatory CAS covering FY05-07 will be developedjointly with the FC, and presentedto the Board for consideration inlate 2004. The S A M PRSP and Bank-Fund Joint Staff Assessment accompany this TSS Update under separate cover. ii. On the political front, the past fifteen months have presented many diverse challenges with the introduction of the new constitutional union state, the assassination of the Serbian Prime Minister in March 2003 and theformation of a coalition governmentfollowing Serbia's December 2003parliamentary elections. Serbian political parties have experienced some difficulty in working together as evidenced in the post-election period of 2004. The Montenegrin political situation remains stable but the pace of reform has been uneven. Against this complicated backdrop, both Serbian and Montenegrin leaders have placed high priority on establishing a clear path to European integration through the EU Stabilization and Association process and implementation of the InternalMarket and Trade Action Plan for Serbia and Montenegro. Under the Stability Pact for South Eastern Europe, S A M and other partners participate in working tables covering a wide range of initiatives designed, inter alia, to strengthen democratic initiatives, cross border cooperation and intra-regional trade and investment. iii. There has been sound progress in stabilizing the macroeconomic situation, progress in structural reform has remained positive despite domestic and external shocks. Implementation remains the key challenge. Serbia adopted new laws on pension insurance, employment, telecommunications, and tobacco trade and new laws on health insurance, health care provision and pharmaceuticals are being drafted. The Government transferred responsibility for business registration to a new Agency for Business Services and enacted amendments to the Privatization Law, accelerating privatization. In the financial sector area, Serbia also shifted its payments operations from the old Clearing and Settlements Bureau (ZOP) to commercial banks. The National Bank of Serbia has adopted a banking Supervisory Development Plan, and prudential regulations on capital requirements, asset classification, licensing, internal audit and internal controls. The Serbian Government has begun to focus on the resolution of its majority stakes in state-ownedbanks and has engaged a financial advisor to prepare the first three banks for privatization through open tender. The Montenegrin government adopted an extensive Economic Reform Agenda, enacting a law on pension disability insurance which adjusts key parameters of the PAYGO pension system. The recently adopted labor law significantly increasedthe flexibility of the labor market. A number of reforms have focused on creating a more favorable business environment, which include the enactment of new enterprise, bankruptcy, and secured transaction laws. Important reforms have also been introduced in the energy sector. The government successfully introduced a VAT in 2003. After concluding mass voucher privatization, the Montenegrin government is now focused on the sale of banks, hotels and large enterprisesto strategic investors. iv. Given that close to a quarter of thepopulation in both republics is concentratedin a narrow interval just above the poverty line, even small economic shocks impacting Serbia and Montenegro can have potentially large and deleterious effects on poverty. In late 2003 Serbia and Montenegro finalized participatory Poverty Reduction Strategies which support market-oriented economies and look to harmonization with EUstandards for trade and other areas and to WTO membership and eventual accession to the EU. Based on strong poverty diagnostics, these PRSPs contain costed programs with the bulk of the spendingtargeted to education, employment, health and social protection. Financing and costing will require i further work duringimplementation as will monitoring andevaluation. Although off to a solid start, great care must be taken to ensure that the process is firmly institutionalized and sufficient attention is placed on capacity building. v. SAM remains committed to the core objectives of the medium-term Economic Recovery and Transition Program (ERTP), which was presented to donors at the June 2001 Donor Conference. This framework seeks the realization of a society re-integrated with the international, European and regional economies and in which sustained, broad based increases in living standards are generated by a dynamic private sector. The ERTP identified four closely inter-related strategic objectives which continue to underpin Bank assistance: (i) restoring macroeconomic stability and external balance; (ii) stimulating near-term growth and creating the basis for a sustainable supply response; (iii) improving the social well-being of the most vulnerable and building human capacity; (iv) improving governance and building effective institutions. Despite impressive progress, the fragility of medium-termeconomic scenariosunderlinesthe needto maintain the pace of reform and deepenefforts across abroad front inbothrepublics. vi. Sustainable growth is achievable under continued decisive reforms and substantial support from donors and creditors. Growth in 2004 i s estimated at around 4 percent per year, a slight acceleration relative to the initial estimate of 3 percent for 2003. Near-term growth i s expected to be driven by exports, a more vibrant SME sector, and greater donor and bank financing of investments. Faster growth i s likely to be precluded by the high debt burden and the need to manage the social impacts of enterprise and banking reforms, which will work to divert resources from developmental expenditures. Given SAM's starting point, recovery will take time, even under strong reform and concessional assistance. Export performance will be essential to growth and macroeconomic sustainability as will a stable political environment. The limited domestic sources of budget financing and the reduction in external financing to more sustainable levels will require a phasedreduction infiscal deficits. Bank adjustment credits and other donor support will smooth the temporary adverse effects of this fiscal adjustment. Extemal financing requirements will remain large. To achieve this macroeconomic scenario and finance the remaining transition to a market economy, S A M will require substantial capital inflows. Assuming debt relief on appropriate terms, debt service indicators are expected to decline significantly to still high levels. S A M ' s ability to maintain a relatively stable ratio of debt to GDP despite relatively large current account deficits, will initially be facilitated by the high degree of average concessionality of official external financing, and later by increasing inflows of private capital. vii. Sensitivity analyses demonstratethe vulnerability of SAM's outlook to external shocks and slippages in reform effort. A variety of unforeseen external shocks could raise SAM's debt service obligations or reduce the amount of resources available to pay the debt, particularly if they occur simultaneously. The biggestthreats to sustainability would come from sustaineddelays in reform and fiscal consolidation or from an inappropriate policy mix which would undermine S A M ' s competitiveness. If these risks materialized, it would lead to slower GDP and export growth, higher borrowing requirements, which could cause public and external debt service payments to reach unsustainable levels. The financing provided by the Bank and other donors provides an added cushion against external shocks, while the focus of the proposed Bank program on strictly monitored policy-based lending gives maximal support to the reforms and fiscal consolidation needed to achieve sustainedgrowth and improveddebt sustainability. viii. In line with agreed strategic objectives, the Bank Group's FY03 program was delivered as outlined in the July 2002 TSS Update. Seven projects totaling US$225.25 were approved and are under implementation including five projects for Serbia, two projects supporting Montenegro's development and one project covering both republics. Project execution has progressed generally well, although there have been some delays stemming from the constitutional transition and election cycles. A first Joint Bank- Government Project Portfolio Review was organized and an agreed Action Plan i s under implementation. Contributing to the country knowledge base, a large body of analytical and fiduciary work was completed and disseminated; many of the findings and recommendations have informed policymaking. ix. Under the current envelope, seven projects are under preparation and one (Montenegro Environmentally Sensitive Tourist Areas) has been approved for the remaining envelope of US$ 143 million. Proposed operations include: Serbia Second Structural Adjustment Credit; Serbia Real Estate .. 11 Cadastre and Registration Project; Serbia Transport Rehabilitation Project; Serbia Energy Efficiency Project (a complementary GEF Project is being prepared for FY0.5); Montenegro Second Structural Adjustment Credit; Montenegro Health Systems Improvement Project; and a Montenegro Pension Administration Technical Assistance Project. The program also includes a number of capacity buildinginitiatives of WBI as well as significant more policy-oriented economic and sector work including, for both republics, multi-year poverty analysis, public administration and civil service reform diagnostics and fiduciary follow-up activities. For Serbia, an economic memorandum, financial sector policy note, note on privatization, an investment climate assessment, an administrative barriers study (FIAS) and energy sector strategy are in process. For Montenegro, FIAS is preparing an Investment Diagnostic. A Regional Framework Paper for Southeast Europe i s also near completion and a number of regional studies on energy, trade, transport, water, institutional reforms for growth and investment, and HIV/AIDS are completed or inprogress. IFC's Southest Europe Enterprise Development (SEED) program i s also active.IFC and MIGA have robust programs under implementation. x. While the external environment,particularly economic developments in Europe, could constrainthe Serbian and Montenegrin economy, the more immediate risks remain domestic. The risks identified in the previous TSS Update (political, policy and implementation capacity, debt sustainability and regional shocks) remain. Experience during the past 24 months however, gives encouragement that while recovery will remain difficult, the outcome of this complex reform programwill be successful. Poor performance inthe economies of key trading partners, if continued, would dampen export growth and the inward movement of private capital, however the more serious concerns center on the domestic front. The Authorities need to deepen the reform agenda and focus on improvements in fiscal and external sustainability. This will require continued success in rationalizing public expenditures and reduction of fiscal deficits, combined with a macroeconomic policy mix which supports export growth. Serbia faces two risk factors: the pace at which the new government i s able to organize itself and become operational and the sustainability of the governing coalition. It i s encouraging that the likely coalition partners havereaffirmedintentions to support a deepeningof market reforms, but the proof will be in actions. We believe that the depth of the reforms are such that significant backtracking i s unlikely. InMontenegro, program risk centers on capacity constraints and sometimes erratic pace of the reform agenda. External support from the World Bank and other donors for a strong continued reform program will be crucial to program success. In the regional arena, over the last year there has been some political progress in South Serbia and a renewed Kosovo dialogue has been initiated with the establishment of technical working groups on select issues. Nonetheless, any deterioration in this climate/dialogue would heighten uncertainty. Implementation and capacity issues will continue to be constraining factors although they are beingbalanced increasingly by the outcomes of training programs and experience. ... 111 Memorandumto the Executive Directors of IBRD and I D A Transitional Support Strategy Update for Serbia and Montenegro' I. Introduction 1. The Federal Republic of Yugoslavia (FRY -- now Serbia and Montenegro (SAM)) succeeded to the membershipof the former Socialist Federal Republic of Yugoslavia inthe World Bank in May 2001. Initial Bank Group support to S A M was provided in two stages: first, a pre-membership phase funded through a US$30 million Trust Fund for FRY. The second phase, outlined in a Transitional Support Strategy (TSS - Report 22090-YU, June 26,2001), provided a three year program of support for the Economic Reconstruction and Transition Program (ERTP), to be financed with a $540 million temporary and exceptional IDA envelope. A TSS Update (Report 24476-YU, July 18, 2002), described progress in the first year of implementation (FY02) and laid out plans for the FY03 program. This Update describes progress during FY03, including FRY'S constitutional transition to Serbia and Montenegro, and provides the strategic framework for the final year of the three year Bank Group assistance program. A full three year participatory CAS coveringFY05-07 will be developedjointly with the IFC andpresented to the Board for consideration in late 2004. The S A M PRSP and Bank-Fund Joint Staff Assessment accompany this TSS Update under separate cover. 11. PoliticalandEconomic Context 2. Political Outlook. The past fifteen months have been highly eventful inSerbia and Montenegro with two dominant events: the introductionof the new constitutional union State of Serbia and Montenegro and the assassination of Serbian Prime Minister Zoran Djindjic in March 2003. The enormous challenges of creating the new union and internal harmonization of policies commanded the full attention of federal and republican leaders for the better part of a year. Although some question the duration of the union beyond the three year period specified in the Belgrade Agreement (Box l), the new union i s now fully established and functioning; some legal and procedural issues related to state functions are still being handled on an ad-hoc basis. Both Serbian and Montenegrinleaders have placed highpriority on seeking early accession to the European Union. Following protracted discussions, the republics finalized an InternalMarket and Trade Action Plan for Serbia and Montenegro inJuly 2003 which was seen by the EUas a precondition for starting the feasibility study on whether further progresscould be madetowards a Stabilization and Association Agreement (Box 2). 3. Following the February 2003 promulgation of the Constitutional Charter latent tensions in the Serbian domestic political arena came out into the open and evolved into fractious debate. Reformmomentum, which had lagged during the constitutional transition process, again slowed in some areas. The Marchassassination was followed by a crackdown on organized crime and a period of heightenedunity and commitment to reform and cooperation within the Serbian government allowing the reform momentum to pick up. This unity proved short-lived, and early summer saw a reemergence of acrimonious political debate. The Fall 2003 attempt to elect a new Serbian President failed, as had the two rounds of presidential elections in late 2002, owing to insufficient voter turnout. In early November 2003 the Government announced it would undertake new parliamentary elections, one year ahead of schedule. These elections took place on December 28, 2003. None of the parties won a clear majority and the democratic bloc parties are at this writing engaged in attempts to form a governing coalition. Inthis complex political climate it i s important to bear in mind that the basic goals and thrust of the reform agenda have not been seriously challenged. The far reachingreforms initiated in2001 havecontinued against a difficult politicalbackdrop, albeit the pace of implementationhas slowed at On February 4, 2003 the Federal Republic of Yugoslavia (FRY) completed a constitutional transition to the Union of Serbia and Montenegro (SAM), comprised of the two republics. All historic references to FRY may be considered to refer to SAM. This TSS Update (as the prior version) does not cover the province of Kosovo which remains under UN administration according to UNSecurity Council Resolution UNSC-1244. 1 various points. Moreover, while the emphasis on cleaning up organized crime has been welcomed, the assassination and the volatile political climate have been contributing factors fueling investor concerns about the business environment. 4. Montenegro's ruling coalition gamered a strong majority in the 2002 elections, but differences within the coalition resulted in delays in processing various important items o f legislation in Parliament. The authorities have been concerned with defining Montenegro's future role in Europe and addressing harmonization policies and have thus not maximizedthe opportunity to accelerate the domestic reform agenda significantly. At times internal law and order and governance issues have dominated the political agenda and diverted attention from the economic reforms underway. As a result, implementation of the economic reform program has been somewhat hesitant, although, as in Serbia, positive progress continues to be made. 5. Regional Cooperation. Efforts to consolidate stability in the region -- especially the establishment of a clear path to European integration through the EU Stabilization and Association process -- have provided strong incentives for cooperation. Under the Stability Pact for South Eastem Europe, S A M and other partners participate in Working Tables/groups covering a wide range o f initiatives including: strengthening local democracy and cross border cooperation; fostering interregional tradejinvestment compact; developing regional Box 1:The Realizationof the Unionof Serbia infrastructure/energy; fighting organized crime; stabilizing andMontenegro migration and asylum and supporting the reintegration o f On March 14, 2002, an accord ("Belgrade refugees; and creating an independent media. The Bank`s Agreement") setting out a general framework for a closest association with the Stability Pact has been through union between the Republics of Serbia and Working Table I1which covers Economic Reconstruction, Montenegro to replace the Federal Republic of Cooperation and Development. Under Table 11, 21bilateral Yugoslavia, was signed by federal and republican trade agreements covering all the countries o f the region authorities. Following promulgation of a new have been signed, representing a major step forward Constitutional Charter and its implementing law, towards more open trade within the region. Other donor the Union of Serbia and Montenegro ( S A M ) came supported initiatives that will benefit S A M and other into existence on February 4, 2003. Under the provisions of the Constitutional Charter, S A M countries in the Region at large are the programs in regional comprises a Presidency, Parliament, a Council of infrastructure energy and transport. (Bank-supported Ministers, and common foreign and defense regional initiatives are described inpara 47 and Attachment policies. The Constitution envisaged the 111). "establishment and ensurance of an unhindered 6. Economic Developments. S A M ' s leadership i s still . operation of the common market on (the territory grappling with the legacy of a decade of adverse external of Serbia and Montenegro) through coordination and harmonization of the economic systems of the and internal factors. The centralization o f political power at member states in line with the principles and the federal level during the 1990s weakened economic standards of the European Union". The free institutions, exacerbated poor public accountability, and led movement of people, goods, services and capital to more government intervention in markets (e.g., with within S A M i s to be secured in a setting where the price and exchange controls). The effects of poor economic member states retain autonomy in most areas of management were compounded by international sanctions economic policy. As the Law on the (1992-96 and 1998-2000) which severely inhibited trade Implementation of the Constitutional Charter and investment inthe country. B y 2000, recorded per capita envisages central banks and customs authorities GDP had fallen to about one half of its 1989 level. Foreign operating at the member state level, and as the union government is financed by transfers from trade volumes also declined sharply while inflation these member states, the member states operate (including hyperinflation in 1993) was chronic. S A M had under different (but increasingly harmonized), accumulated large domestic and external debts, with the customs and indirect tax regimes. The latter reaching around 131% o f GDP in 2000 GDP (figures Constitutional Charter stipulates that both exclude Kosovo). Although cash deficits o f the consolidated republics retain the right to withdraw from the government were kept low, this was achieved largely union after three years. At the republican level, through unsustainable expenditure compression, the work on a new Serbian constitution is expected to accumulation of budgetary arrears, non-servicing o f public begin shortly. Montenegro will continue to debt, and the toleration o f quasi-fiscal deficits. The real function under the existing constitution. 2 sector became largely inefficient due to the lack of market oriented ownership structures, the loss of markets, lack of access to working capital, delayed investment and maintenance, and repressive and complicated taxation and regulation. This resulted in a decrease in real earnings, with absolute poverty roughly doubling since 1990, and a deterioration in social protection and health services, as available financing fell below existing entitlement levels. 7. Since late-2000, the adjustment of fiscal deficits towards levels financeable from non-inflationary sources has been the key policy instrument for restoration of macroeconomic stability. In Montenegro, this focus was motivated by the adoption of the German Mark (DM) (which precludes monetary financing), and by a decline in foreign financing from the very high amounts received in 2000 towards more sustainable levels. In Serbia, it was motivated by the needto confront and managethe hidden fiscal liabilities which grew out of the unsustainablepolicies of the past. 8. These tighter macroeconomic policies have been supported by three successive arrangements with the IMF,most recently by athree-yearlongExtendedArrangement (EA)of SDR650millionspanningthe period through end-March 2005. A highly concessionalNovember 2001 debt restructuring agreement with the Paris Club enhanced medium term fiscal sustainability, but a similar agreement with the London Club remains to be completed. Even following the Paris Club deal and a sharp increase indollar GDP inprevious three years (largely driven by real appreciation from the highly depreciated level of late-2000), S A M ' s external debt remained a very higharound 76 percent of GDP at end-2002, droppingbelow 70 percent in2003. Box 2. Serbia and Montenegro-The Stabilizationand AssociationProcess The Stabilization and Association process(SAP) was initiated by the European Union (EU) at the EUBalkans Summit in Zagreb in November 2000 and reconfirmed as the highest priority for the Western Balkans at the Thessaloniki Summit inJune 2003. The SAP provides a framework for privileged political and economic relations between aspiring countries and the EU and i s an interim step towards becoming candidate countries. SAP itself prepares for the negotiations, conclusions and implementation of the Stabilization and Association Agreement (SAA) which adopts critical aspects of the acquis communitaire, i s weighted towards trade issues, and has a strong emphasis on strengthening institutional capacities. The European Commission's (EC) 2003 Stabilization and Association Report for S A M contains a list of priority areas requiring attention before March 2004. Most of these actions relate to the effective implementation of the Constitutional Charter with the aim o f building a restructured and functional federal state. They include: strengthening the electoral process, improving the parliamentary and judicial systems, fighting corruption, transforming the security and police services, reforming the army, and meeting European standards on human rights and fundamental freedoms. Since the signing of the Constitutional Charter in February 2003, reforms have gained momentumon a number of critical issues among which are improved compliance with the demands of the International Criminal Tribunal for Former Yugoslavia (ICTY) and progress on the harmonization of trade, customs, and excise regimes between Montenegro and Serbia. At the end of July 2003, the Council welcomed the finalization of an Internal Market and Trade Action Plan by Serbia and Montenegro and in September the Commission initiated a Feasibility Study. 9. Progress in structural reform remained positive despite several domestic and external shocks (assassination of Serbian P M Djindjic, issues on the functioning of the common state, cooperation with the International Criminal Tribunal inthe Hague, etc.). A detailed description and assessment of structural reform progress since 2000 which was preparedfor the November 2003 Serbia and Montenegro Donor Coordination Meeting, i s provided in Attachment VI. Serbia adopted new laws on pension insurance, employment, telecommunications, and tobacco trade. New laws on health insurance, health care provision and pharmaceuticals are being drafted, as well. The Government also transferred responsibility for business registration to a new Agency for Business Services and enacted amendments to the Privatization Law. After using most of 2001 to prepare the legal and institutional ground for privatization (using auctions and tenders), Serbia achieved an acceleration of privatization, with receipts reaching EUR 340 million in 2002. This success has continued into 2003, with revenue forecasts again to be comfortably exceeded, mainly due to the recent sale of two tobacco plants and oil distribution company. Privatization receipts in 2003 were above EUR 900 million. In the financial sector area, Serbia also shifted its payments operations from the old 3 Clearing and Settlements Bureau (ZOP) to commercial banks. The National Bank of Serbia has adopted a banking Supervisory Development Plan, and prudential regulations on capital requirements, asset classification, licensing, internal audit and intemal controls. Following the bold decision to close four large insolvent banks in early 2002, the Government has begun to focus on the resolution of its majority stakes in state-owned banks. To assist the authorities in choosing an appropriate resolution strategy, the Bank RehabilitationAgency has completed diagnostic audits for nine banks. It has also recently engageda financial advisor to preparethe first three banks for privatizationthrough open tender. 10. The Montenegrin government adopted an extensive `economic reform agenda,' which covers a wide range of sectors. Montenegro enacted a law on pension disability insurance which adjusts key parametersof the PAYGO pension system to better align entitlements to available resources. The recently adopted labor law significantly increasedthe flexibility of the labor market. A number of reforms have focused on creating a more favorable business environment, which include the enactment of new enterprise, bankruptcy, and secured transaction laws. Important reforms have been introduced in the energy sector including the enactment of a new energy law which establishes a new energy regulator and provides for the restructuring and liberalization of the energy sector. The govemment successfully introduced a VAT in 2003. After concluding mass voucher privatization, the government is now focused on the sale of banks, hotels and large enterprises to strategic investors. The largest Montenegrin bank was successfully sold to a reputable foreign investor. A law on anti-money laundering was adopted in 2003 and the authorities have revoked the licenses of all off-shore banks and have madea concerted effort to ensure that the activities of these banks indeed have come to an end. 11. The strong implementation of stabilization and reform has brought visible progress while laying the foundations for a more sustained recovery. SAM's GDP has rebounded from a steep decline of about 16 percent in 1999 (influenced by the Kosovo conflict). Annual real GDP growth has averaged more than 4 percent in the past 3 years (despite the effects of stagnation of industrial production). In Serbia, annual inflation declined from 113.5 percent at end 2000 to 7.8 percent in 2003. The nominal exchange rate of the dinar to the DM/Euro remained broadly stable in 2001 and 2002, but depreciated 11.1percent during2003. Official foreign reserves of NBS grew to US$3.5 billion at end 2003, exceeding targets under the Government's program supported by the IMF. SAM's consolidated fiscal deficit increased from 1percent of GDP in 2000 to 4.5 percent in 2002. This increase (which was in line with plans and financed by donor support and privatizationproceeds) was driven by a combination of more realistic budgeting of commitments (lower accumulation of arrears), the bringingon budget of some quasi-fiscal activities, the restoration of debt service and public investments, and one-off transition costs. Figures largely reflect Serbia's progress, as it comprises 94 percent of SAM's total population and contributes about 93 percent of SAM's GDP. Starting in 2003, these fiscal deficits are beingscaledback gradually, as structural reforms begin to support a phasedreduction of overall expenditure commitments as a share of GDP, as a result the fiscal deficit i s estimated to decline to 4 percent of GDP in2003. 12. InMontenegro, real GDP is estimated to have grown at low but positive rates of about 4 percent in 2000 and about 2 percent annually inthe past 3 years. Recent growth has been driven by a recovery inthe key tourism sector, as well as, in transport (primarily increased transit of goods to and from Kosovo), and construction. In contrast, as in Serbia, recorded industrial production stagnated (growth in 2002 was 0.6%). Inflation declined from 25 percent in 2000 to around 7 percent in 2003. Montenegro's consolidatedfiscul deficit was cut from about 8 percent of republican GDP in 2000 to 5.3 percent in 2003. The renewal of transfers to cover federaYunion expenditures has placed new pressure on fiscal accounts in 2003. Excluding this transfer, the underlying fiscal deficit for 2003 is expectedto decrease further to about 3 percent of GDP. Foreign grants remained the main source of deficit financing, though domestic financing has been recently increased. 13. As had beenprojected, import growth outstripped export growth inthe first years after the acceleration of reforms in late-2000. SAM's exports of goods and services (in U S dollar terms) rose by 7.7 percent in 2001 and a further 18.2 percent in 2002. This upward trend in exports was expected to continue in 2003 during which they are projected to rise by about 30 percent. Increased donor support and remittances, plus 4 Box 3. Supportingthe PRSPProcess rising real wages, led to a burst of imports, which grew at an average annual rate of 30 percent in 2001-02. The Bank Group, with support from donors, has Although imports were projected to rise by 25 percent in launcheda number of initiatives and events to support 2003, developments during the first ten months of 2003 PRSP development in Serbia and Montenegro. Serbia (the latest for which firm data is available) suggest that and Montenegro each received grants from DFID (UK) and the Multi-Donor Trust Fund administered the actual figure for the entire year may be somehow by the Bank to support PRSP development. The above earlier projections. The trade deficit, which Governments are developing a proposal for a second increased to US$4 billion in 2002 from US$ 2.8 billion ,tranche of the Multi-Donor trust fund to support PRSP in 2001, is expected to be around US$4.8 billion in 2003. Foreign trade and current account data are presented for S A M . The current account deficit (after grants) rose from 3.9 percent of GDP in 2000 to 8.8 percent in 2002. The current account deficit (after grants) i s projected to be around 8.5 percent of GDP in 2003. About two-fifths of this increase can be attributed to rising investments following a decade of under- investment, with the remaining recorded decline in savings primarily being driven by the government sector as it began to unwind the unsustainable cash rationing and arrears accumulation of the 1990s and to incur one- off costs of transition. The increased deficit was funded by rising donor support, remonetization (the repatriation The multi-year programmatic approach to the Bank's of funds held abroad and the return of cash foreign poverty work in S A M helps to ensure that the results exchange into the banking system), and to a lesser extent of the poverty analysis and monitoring are used in the process of policy making. A number of analytical by risingFDI. pieces, including the S A M Poverty Assessment and republican poverty notes have been completed and 14. Poverty. Instability, international isolation, and others are inprogress. A regionalPRSP workshop and economic As had been projected, import growth regionaltraining of trainer seminar were organizedby outstripped export growth in the first years after the WBI in Baden and Budapest, and Bank staff acceleration of reforms in late-2000. S A M ' s exports of organized workshops on poverty-environment goods and services (in US dollar terms) rose by 7.7 linkages in each republic. WBI plans to organize percent in 2001 and a further 18.2 percent in 2002. This another regional Poverty Forum in Spring 2004. In- upward trend in exports i s expected to continue in 2003 country courses on Poverty Analysis for during which they are projected to rise by about 30 policymakers, researchers and NGOs are also being percent. Increased donor support and remittances, plus offered. Capacity building initiatives for stakeholders, rising real wages, led to a burst of imports, which grew includingRoma, are also underway. at an average annual rate of 30 percent in 2001-02. Although imports are projected to rise by 25 percent in 2003, developments during the first ten months of 2003 suggest that the actual figure for the entire year may be somehow-aboveearlieiprojections. The trade deficit, which increased to US$4 billion in 2002 from US$ 2.8 billion in 2001, i s expected to be around US$4.8 billion in 2003.2 The current account deficit (after grunts) rose from 3.9 percent of GDP in 2000 to 8.8 percent in 200L3About two-fifths of this increase can be attributed to risinginvestments following a decade of under-investment, with the remaining recorded decline in savings primarily being driven by the government sector as it began to unwind the unsustainable cash rationing and arrears accumulation of the 1990s and to incur one-off costs of transition. The increased deficit was funded by rising donor support, remonetization (the repatriation of funds held abroad and the return of turmoil adversely affected living standards of a vast majority of the population in Serbia and Montenegro. However, the paucity of data on poverty has beena critical impediment to linkingpoverty analysis to policy making. Over the past 18 months, the Serbian and Montenegrin authorities and NGOs initiated a broad based data collection process through Foreigntradeand current account data are presentedfor SAM. The current account deficit (after grants) is projectedto be around 8.5 percentof GDP in2003. 5 large-scale donor supported household surveys, and crucial initial steps in data analysis have been made. PRSPWorking Groups inboth republics have taken significant steps in institutionalizing poverty monitoring by engaging the Statistical Offices of both Republics in the dialogue, reaching consensus on the need to improve data quality and, in the case of Serbia, by establishing the Republic Commission on Living Standards and Republic Commission for Poverty Monitoring. Building on those efforts, the Banks Poverty Assessment Report employed a participatory process to generate and analyze representative data on living standards in both Republics, so as to arrive at a shared diagnosis of poverty and to establish an adequate baseline to support the PRSPprocesses. Box 4 offers a snapshot of poverty in S A M today and Attachment I1discusses the situation with regard to Roma, IDPs, and Displaced Persons. Poverty monitoring and the link between poverty analysis and policymaking have to be strengthened and streamlined. Box 4. Poverty in Serbia and Montenegro in2002: Who are the poor? Given that close to a quarter of the population in both republics i s concentrated in a narrow interval just above the poverty line, even small economic shocks impacting Serbia and Montenegro can have potentially large and deleterious effects on poverty. B y mid-2002 material poverty affected every tenth person in both Serbia and Montenegro (defined as population with consumption below the country-specific absolute poverty line). Moreover, Serbia experienced extreme poverty with about 2 percent of the population unable to afford even the basic food basket, a situation which has been eradicated elsewhere in the region, with exception of Kosovo and Albania. Many also suffered from deprivation inother aspects of well being, such as health, education, housing, social inclusion, or property rights. Who are SAM's poor?Four factors standout: Poorly educated individuals make up the majority of S A M ' s poor and have the highest poverty risk. Those with primary (elementary) education constitute about 2/3 of all poor and are twice more likely to be poor than secondary school graduates. Multivariate analysis of poverty risks suggests that lower education attainment is the key background factor explaining the higher incidence of poverty of some vulnerable groups, such as rural households orjobless households. Jobless households (Le. families with working-age members in which no one works) have more than twice the average poverty incidence, but households with gainfully employed members make up 75 percent among the poor. The working poor therefore, is the largest group among the poor. S A M ' s poverty has a regional dimension, and often within regions, the rural areas are poorest. The difference in poverty rates across regions of Serbia is significant: the poorest region (rural South East) has 23 percent of its population below the poverty line, while the richest regions (urban areas of Belgrade, Central Serbia and Vojvodina) have only 7 percent of the population in poverty. Montenegro has 1:2 differences in poverty rates between the poorest North and the richest Center. Regional differences in poverty rates cannot be fully accounted for by labor market, education and demographic factors, suggesting the existence of location-specific `pockets' o f poverty. Households with IDPsand refugeesare more likely to be poor than averagecitizens of SAM. Inboth Republics female headed households face a higher risk of poverty. Multivariate techniques suggest that this is related to less active labor market participation, lower levels of education, lower years o f experience and lower pay that is typical of women in Serbia and Montenegro, contradicting a perception of gender equity in S A M . The poor face serious problems of access to most of public services (health, education, sanitation) and suffer disproportionately from the deterioration in the quality o f public service provision. Even though some of the social assistanceprograms are among the best targeted programs in the region, the social protection system as a whole suffers from large exclusion errors, due to poor coordination between programs, low public awareness, and the lack of resources. Serbia and Montenegro Poverty Assessment (Report No. 26011-Yu,November 13 2003) 15. Given the highlevel of vulnerability of SAM's living standards to even minor economic fluctuations a broad growth-based strategy that ensures that the benefits accrue at least proportionately to the poor is central for accelerated poverty reduction. Despite GDP growth by some 4 percent per year in 2000-2003, there was no employment response, and the Labor Force Survey unemployment rate even increased from 14 to 15 percent. Unemployment i s particularly high in Montenegro, reaching one of the highest levels in the region (above 20 percent o f the labor force). Not only is open unemployment a problem (households without working members make up one quarter of all poor (see Box 4), but a large share of the working age 6 population are also inactive or occupying themselves with low productivity and/or occasional work. For the economy-wide perspective this represents output foregone and income lost. Moreover, the important goal of sharing the benefits of growth more equitably among groups and regions proves increasingly elusive when many citizens are trapped inlong-term unemployment. Based on the experience o f other transition economies, the main impulse for employment generation will likely come from the sector of new, small and medium enterprises, whose development critically depends on business environment and restructuring of formerly state owned enterprises. There i s also a need for special programs to address the concentration of the poor in rural areas and in economically depressed regions. Progress toward meeting the Millennium Development Goals i s described in Box 5. Box 5. SAM Progress Toward the Millennium Development Goals - The Millennium Development Goals (MDGs) promote poverty reduction and human development as the key to sustaining social and economic progress. In broad terms, they aim to cut by half the proportion o f people living in poverty by 2015, provide education to all, improve health, and preserve the environment. Although there are varied sources of data, there is broad consistency across sources suggesting that Serbia and Montenegro are more or less on track for meeting the MDGs.However, strong regional disparities within both republics means that meeting the MDGs could be a challenge inthe more deprived areas. Income Poverty: New surveys in both Republics have made it possible to examine absolute poverty on a rigorous basis. According to national poverty lines (2.40 a day in Serbia and 3.50 a day inMontenegro) around 10percent of the population was living in absolute poverty in 2002. Ingeneral, growth is expected to reduce the incidence of poverty by a half. However, widening income inequality and growing regional disparities are likely to pose a challenge to poverty reduction. Moreover, vulnerability to even small shocks remains high. Poverty among refugees and IDPs is significantly higher than within the local populations. Educationand Gender: Serbia and Montenegro are very near full primary enrollment for both boys and girls. This is indicated by both administrative records and survey data in Serbia and administrative records inMontenegro. Although Roma are a very small share of the population, significant primary enrollment problems continue to exist in that group. Beyond primary education, the access of the poor to secondary and higher education (particularly relevant general secondary education) is limited. In addition, education spending as a share of GDP is low in Serbia, which may compromise educational outcomes if not addressedalongside issues of quality and relevance of education. While there are no significant gender disparities in access to education in the two republics, there may be an issue with the excessiveconcentration of boys inpoor quality vocational education. Health: The latest available figures suggest that under-5 mortality is around 16 per 1,000 live births and the two republics are on track to meet the under-5 mortality MDG. In Serbia alone, mortality among children under 5 has declined by nearly 30 percent in the last ten years. While the trends are positive there is some risks arising from signs of a recent slowing in improvement. The republics have low rates of maternal mortality, which is not surprising as almost 100 percent of births are attended by skilled health professionals (data for Serbia only). As a result, although further reductions in overall maternal mortality rates may well occur, the associated MDG target is too low to be relevant to the republics unless disaggregated to focus on vulnerable groups. On HIV/AIDS the currently low levels of testing mean that current measures of incidence and prevalence (practically zero) are likely to understate the true extent of the problem. An increase in intervention i s likely to increase observed incidence -- raising the risk that Serbia and Montenegro will not be able to demonstrate measurable impact from efforts to meet the MDG target (which calls for a reduction in prevalence). Prevalence of TB i s also low (less than 39 per 100,000), but as in the case of HIV/AIDS, progress with reducing prevalence may well be slow. Both republics aim to draw upon the resources of the Global Fundfor Aids, TB and Malaria to improve monitoring and surveillance, as well as to strengthen disease prevention, treatment and support services, and capacity for sustaining prevention strategies. Both republics have also received support from UNICEF and CIDA for HIV/AIDS assessment and preventionactivities. Water and Sanitation. - The Report of for the Federal Republic of Yugoslavia, UNICEF, Belgrade, 2000 (excludes Kosovo and Metohija) indicates that in2000 98.4% of the S A M population had access to safe drinking water; however, this figure does not take into account low quality and breaks inservice due to deterioration of infrastructure. Somerural areas experience serious shortages of drinking water, and urban slums with no or very limited access to clean water at all is the norm. Similarly, although 99.6% of the S A M population i s reported to have "access to improved sanitation", most rural householdshave only septic tanks, many of which have been found to be improperly designed and situated close to drinking water wells. Roma settlements are particularly affected by the lack of sanitation services. 7 Environmental sustainability. In both republics, air and water pollution caused by industrial enterprises and power plants, inadequate waste management, and near absence of municipal wastewater treatment continue to negatively impact the environment and poor communities while also at times threatening economic development. Regulatory and enforcement capacity remains weak and there i s little effort to mainstream environmental protection in sectoral activities. In Serbia, the Draft New Law on System of Environmental Protection has been awaiting parliamentary consideration for over one year. Lack of special treatment of medical and other hazardous waste poses a public health hazard. On the other hand, in 2002 SAM's C02 emissions of 3.7 metric tons per capita were relatively low. Forests cover 28 percent o f Serbia and Montenegro's land area and there has been a decline in forest coverage of 0.4 percent annually during the past 10 years, mainly owing to fires, pest infestation, illegal logging, reduced a forestation, and over harvesting. About 3.3 percent of Serbia and Montenegro's total land area is protected for conservation purposes (Montenegro -- 7.1 percent and Serbia -- 2.7 percent). There is still, however, a need for better management of Serbia and Montenegro's globally significant biodiversity. 16. The PRSP. In April 2002, both republican governments launched the interim-PRSP process. An Interim-PRSP was completed in July 2002 (Federal Republic of Yugoslavia: Interim Poverty Reduction Strategy and Joint Staff Assessment, Report No. 24490-YU, July 2002) and discussedby the Board on August 8, 2002. Extensive participatory consultations were held during 2002-2003 and a full PRSP for Serbia was completed in November 2003 and presented at a Donor Coordination Meeting in Brussels on November 18, 2003. (para 15). The S A M PRSP consists of a state overview and republican strategies for Serbia and Montenegro. The republican strategies, which are based on extensive consultations, both support stable macro-economics and market-oriented economies. The strategies look to harmonization with EUstandards for trade and other areas and to WTO membership and eventual accession to the EU. Based on strong poverty diagnostics, these PRSPs contain costed programs with the bulk of the spending targeted to education, employment, health and social protection. These PRSPs pledge to do more for vulnerable groups, including Roma and IDPs and include goals linked to the MillenniumDevelopment Goals (MDGs). Both affirm the continuation of the privatization of financial and productive assets and emphasize the need to make improvements in the business environment, including legal and judicial reform, to facilitate private investment and growth. Financing plans and costing are inconsistent and vague. During implementation the PRSPs will needto improve intra-sectoral prioritization, strengthen costing and budgeting linkages, and refine monitoring and evaluation. Although off to a solid start, great care mustbe taken to ensurethat the process i s firmly institutionalized and sufficient attention is placed on capacity building. (See the Serbia and Montenegro Poverty Reduction Strategy Paper and Joint Staff Assessment for adetailed assessment). 111. The Government's Economic and Social Programand Strategic Agenda 17. S A M remains committed to the core objectives of the medium-term Economic Recovery and Transition Program (ERTP), which was presented to donors at the June 2001 Donor Conference. This framework seeks the realization of a society re-integrated with the international economy, the Southeast Europe (SEE) region and Europe, administered by strong and accountable institutions, and in which sustained, broad based increases in living standards are generated by a dynamic private sector. The ERTP report highlighted that a retum to sustained growth would require both a sustained program of economic reform on the part of the government and substantialdonor support, including external debt relief. At the June 2001 Donor Conference governments and financial institutions pledged a total of US$1.33 billion toward the ERTP estimated financing requirement of US$1.25 billion in CY2001. Overall needs were estimated at US$3.9 billion over a three to four year program. The ERTP identified four closely inter-related strategic objectives which continue to underpin Bank assistance: (i) restoring macroeconomic stability and external balance; (ii)stimulating near-term growth and creating the basis for a sustainable supply response; (iii) improving the social well-being of the most vulnerable and building human capacity; (iv) improving govemance and building effective institutions. Despite impressive progress, the fragility of medium-term economic scenariosunderlines the needto maintain the pace of reform and deepen efforts across abroad front inbothrepublics. The rest of this sectiondescribesthe key challenges facing the authorities. 8 > (i)Restoringmacroeconomicstability and externalbalance 18. Progress in stabilization and structural reform has been substantial in both member states. However, recent debt sustainability exercises suggest that even with strong effort, SAM's macroeconomic sustainability will remain fragile and vulnerable to external shocks. Any slippage could put the country at additional risk and impair creditworthiness prospects. In this respect, sustained progress in fiscal consolidation will be particularly critical for improving sustainability. Given the already high share of public revenuesin GDP, and the projected increase in public investment and interest payments, these efforts will need to focus on other categories of public expenditures, especially those where spending i s high by regional standards and/or inefficient. The Public Expenditure and Institutional Review and other analysis show that these areas include the government wage bill, defense, social transfers, subsidies (in Serbia) and on-lending and education (in Montenegro). Institutional reform priorities for supporting such an adjustment include strengthening the arrangements for budget planning and execution, developing multi-year fiscal planning mechanisms, and improving accountability. Key targets include: 0 Continued improvements in macroeconomic performance within the three-year framework supported by the IMF, includingprogress in containing key items of public spending such as the wage bill, social transfers and subsidies. 0 Satisfactory progress in expanding the share of budgetary transactions covered by the treasury systems, and infurther strengthening of the internalaudit functions of the Ministriesof Finance. 0 Careful preparation of the foundations for a future VAT (Serbia), and progress in implementing the new VAT, includingthe timely andfull payment of rebates(Montenegro). 9 (ii)Stimulatingnear-termgrowthandcreatingthebasisfor a sustainablesupply response. 19. Building on progress toward modernizing the legal and institutional framework, the Serbian and Montenegrin authorities will continue to direct efforts towards fostering a business environment where the rule of law is respected, property rights and claims are recognized, contracts can be enforced, economic agents have access to capital, and lenders feel secure. Attention is also being paid to creating a level playing field between the existing enterprise sector and the emerging private sector, as well as strengthening regulations in the bank and non-bank financial sectors. Additionally, the authorities are developing a framework, in line with EUprinciples and directives, for provision of secure and competitively priced energy to support industry development and growth. Moreover they are working to ensurefurther trade liberalization. Finally, they are strengtheningthe legal and institutional framework for improved environmental management and working to improverealproperty registration. Government activities include: 0 continued improvements to customs administrations in both republics in the context of the harmonization Action Plan. IDA is supporting this through the Trade and Transport Facility SoutheastEurope (TTFSE)program. 0 progress in transparent tender privatizations of medium and large-scale enterprises and control of indirect subsidization through credits from state agencies (both republics). Adoption of a new Company Law and Bankruptcy Law, reform of business registration, establishment of collateral registry and further progress towards the privatization and restructuring of socially-owned enterprises (Serbia). Bank Group support is provided through the PFSAC 2 and the Privatization and Restructuring of Banks and Enterprises TA project; the, proposed Serbia SAC 2,the proposed Montenegro SAC 2, several grants and sector work. Other support includes an Investment Climate Assessment, a FIASAdministrative Barriers Study (Serbia) and FIAS Investment Study (Montenegro), and IFC and MIGA advisory and technical assistance services, including SEED support in leasing legislation, introduced in 2003. 9 substantial progress in the implementation of a time bound, fiscally sustainable action plan to unwind state ownership of the banking system. Such a plan should focus on privatizatiodliquidation of majority state-owned banks, interim measures to strengthen governance at the banks, and the rapid, transparent divestiture of minority stakes. The complete implementation by the NBS of the a Supervisory Development Plan for Bank Supervision and for the MoF, further improvement of the regulatory and supervisory framework for insurance sector and progress on implementation of anti- money laundering measures (Serbia). Completion of bank privatization, transparent and efficient resolution of assets and liabilities resulting from the resolution process of insolvent banks (Montenegro). Bank Group support through the PFSAC 2, the Privatization and Restructuring of Banks and Enterprises TA project, Montenegro SAC 2, IFC support and several grants and sector work. 0 continued improvements in the financial situation of the energy utilities through improved payments discipline and labor restructuring, social safety net reform, implementation of the energy sector strategy and newly passed energy law in Montenegro and passage of a new law and its implementation in Serbia. IDA provides support through the proposed Serbia Energy EfSiciency, Montenegro Emergency Power and Energy LIC, SerbiaSAC2, Montenegro SAC2, ESW and TA. 0 effective implementation of the new more flexible legal framework embodied in laws on labor and employment (both republics).IDA is supporting through the Serbia SOSAC, and Serbia Employment Promotion LIC. 0 modernization of the legal and regulatory framework for the road and railway sectors, development of the planning, budgeting, and implementation capability of key institutions in these sectors, and improving the use of available public funds. IDA provides support through the proposed Serbia Transport Rehabilitation Project. 0 continued efforts to address real property markets by lowering transaction costs and increasing buyer confidence levels by building a more efficient property registration and cadastre system. Draft Medium-Term Development Plan for the real estate cadastre system 2004 - 2008 pending adoption. IDA will support theproposed Real Estate Cadastreand Registration Project. 0 further development ofthe nationalenvironmental action planandkey legislationincludingthe Waste Management Law and by-laws to the Law on Privatization (Serbia). Identifying national environmental priorities in the Agenda for Economic Reforms and assessing legal reform needs for harmonization with EU environment directives (Montenegro). Bank Group project support includes Montenegro MESTAP and MEIP and several grants, GEF activities and TA and IFC solid waste project. In Serbia, the Bank provides TAfor integrating environmental concems into theprivatization process. TheBank also is coordinating with the UNDP and the republican govemmentsin developing a GEF supportedBiodiversity Action Plan. 0 inbothrepublics, there is progresstoward adoption of an agriculture/rural sector strategy with clearly identified objectives and private and public sector roles, along with identification of priority public goods investments inrural areas that government can support, given existing budget constraints. IDA support is provided through the Serbia Agricultural Sector Review, 2003 and policy notes. SEED ofsers support through its dairy and herbal programs. >(iii) Improving the social well-beingof the most vulnerable and building human capacity. To ensure the sustainability of the reform effort the governments will continue to focus on effecting fiscally sustainable programs in social protection, health, labor and education, providing core benefits and services to the poor and vulnerable and strengtheninghuman capital. Priorities include: 10 0 implementing a full participatory Poverty Reduction Strategy and strengthening civil society participation in both Republics. IDA supports poverty analysis, monitoring and PRSP development/implementation. 0 institutionalizingpoverty surveys and further improvements in the targeting of social assistance based on poverty survey results, and further progress on de-linking benefit eligibility from wage levels in both Republics. Implementation of a new pension law (Montenegro) and passage and implementation of a new law on voluntary pensions (Serbia). Streamlining and rationalization of social contributions (Serbia). Further development of a fiscally sustainable program and institutional framework to handle mass redundancies (Serbia). IDA has a multiyear program of supportfor the poverty monitoring and analysis programs in both republics, and isfinancing the Serbia SOSAC, the proposed Montenegro SAC 2 and a proposed Montenegro pension systems improvement project. 0 establishing a Health Finance Policy Unit to strengthen the work of the Health Insurance Fund and Ministry of Health (Serbia); assuring financing for health care for vulnerable groups and refugees (Serbia); adoption of a new drugs law (Serbia); completion of health services restructuring plans (Serbia); planning and policy development for primary health care (Montenegro); development of health information strategies (both Republics). IDA is supporting a health sector reform project in Serbia and in Montenegro it is developing a health project and a second SAC. 0 monitoring the impact of education spending across municipalities in accordance with the law on local self-government. Improving the definition of the role of municipalities and school boards in managing education (Serbia). IDA is financing the Serbian Education Reform project and has begun work on an educationproject in Montenegrofor FY05. 0 Identifying priority environmental and natural resource management actions to mitigate negative impact of degradation on the poor and on public health in general (as part of the PRSP process). IDA and the GEF provide an ongoing program of advisory supportfor the environment in both republics. 9 (iv) Zmproving governance and building effective institutions. Following the new constitutional arrangements, the authorities have recognized that the building of effective union and republican institutions and implementation of comprehensive legal and judicial reforms i s critical to the sustainability of the reform effort and has made these key areas for action. Political uncertainty, weak state institutions, poor govemance, an inefficient judiciary, and concerns about crime, as well as, corruption in state institutions all contribute to fiscal risk and deter potential investors. Key elements of the institutionbuildingagenda are: updating republican constitutions and laws inline with the new union Constitution. drafting a diagnostic assessment and development of a strategy for public administration reform and adapting institutional structures to the new constitutional realities. IDA is supporting these assessments. reviewing and assessingof the public sector pay system. IDA is supporting these assessments. Undertaking a diagnostic assessment of capacity inthe courts and the Ministry of Justice's court administration capacity. IDA is supporting this activity through an IDF grant to Serbia. amending the July 2002 Public Procurement Law to remedy weaknesses identified inthe Bank's Country Procurement Assessment Report. IDA is providing ongoing technical advice to both republics. building environmental monitoring capacity. The Bank hopes to support this through the GEF projects in both republics. 11 0 de-politicization of top government posts through adoption of new Civil Service Law (Montenegro); adoption of Law on Salaries to establish merit based civil service system (Montenegro); introduction of effective controls on the fiscal cost of proposed legislation by requiring a fiscal impact assessment (Montenegro); establishment of Ombudsman office and administrative and appellate courts to improve accountability of the public sector (Montenegro). Theproposed Montenegro SAC 2 may include supportfor such reforms.. IV. Looking Towards the Future: MediumTerm Challenges 20. Despite significant progress and successes, the mediumterm agenda remains formidable. Creating the legal and economic foundations and incentives capable of generating sustainable economic growth and job creation as a basis for poverty reduction should be at the core of the authorities' reform agenda. Building on the PRSP, the next CAS will address this challenge indetail. The following section provides a short overview of priority areas. At the state level, the authorities will needto continue, within the framework of the Belgrade Agreement, to further strengthen and refine the requisite state institutions and processes under the union structure and to accelerate harmonization to the extent feasible. Additionally, the authorities will need to demonstrate during the Feasibility Study, capacity to meet the commitments which would be undertaken under a Stabilization and Association Agreement, including accelerated institutional harmonization with the EU.At bothrepublican levels, improvingpublicadministration willbe acorepriority. 21. Financial sector development is instrumental to achieving private sector-led economic growth and poverty reduction. Therefore, the financial sector reform needs to be pursued in parallel and close coordination with enterprise sector reformand improvements inthe business enabling environment. InSerbia, key medium-term objectives include: further strengthening banking sector supervision and early warning systems in order to anticipate future systemic risks; establishing an adequate regulatory and supervisory framework for non-bank financial intermediaries to foster financial diversity, improve access to finance, and develop capital markets; implementing the revamping of the deposit insurance system in a manner consistent with intemationally recognized best practices; continuing the institutional development of the Serbian Financial Intelligence Unit to combat money laundering; and modernizingthe payments system. Completing the restructuring and privatization of the banking sector i s a pre-requisite for the full development of the financial sector's ability to support economic growth. The remaining reform agenda includes: completion of the privatization of all remaining state stakes in banks; closure of all remaining insolvent banks; pro-active disposition of financial and non-financial assets of bank receiverships; rapid progress in the workout of non- performing bankrupt and PLC law-affectedbanks' claims on the enterprise sector. InMontenenro's financial sector, priority areas of focus will include: completing the restructuring and privatization of the remaining state bank; resolving bad assets carved-out of privatized banks; and withdrawing Government deposits from the commercial banks 22. Inthe mediumterm, bothrepublics will needto buildon existingbusiness environmentreforms and develop a more efficient and market-friendly investment climate if privatization, market reforms, and trade and investment liberalization are to support sustainable growth of a competitive market economy. Improvements ingovernance, rule of law, andjudicial reform will also need to feature prominently in both republican agendas and sustained implementation will be critical to the country's prospects. In Serbia, key strategic objectives include: ensuring proper implementation and operation of the modemized bankruptcy regime; developing proper corporate govemance institutions that would improve the efficiency of the enterprise sector and support the future development of transparent capital markets; conducting a comprehensivejudicial reform to ensure proper contract enforcement; developing anti-monopoly legislation and institutionalcapacity for enforcing it, to facilitate integration with EUmarkets; improving S M E access to finance through the development of leasing and factoring, as well as, developing mechanisms of support and promotionof exports; laying the foundations for the development of a knowledge-based economy, including a focus on the telecommunications sector. Reform of the Serbian enterprise sector will focus on restructuring 12 and subsequent privatization of large industrial conglomerates. This processwill be facilitated through putting inplace an effective legislative and institutional framework for debt workout, including claims held by the state and state-controlled entities. Unsaleable conglomerates will be put into bankruptcy under the new insolvency regime. Restructuringof state-owned utilities (electricity, telecoms, oil refining and distribution, gas distribution) will also accelerate, with the objective to prepare them for transparent privatization once a satisfactory regulatory regime has beenput into place. 23. Laying the foundation for aknowledge economy and encouraging private investment inR&D, which in turnincreases productivity, are important with a view to sustainable growth and to EUaccession.Inline with EU priorities designed to increase R&D intensity by 2010, will need to focus on: (i)protection of intellectual property rights (ii) strengthening the link between higher education and basic research with businessR&D; (iii) support for private R&D; for example, via matching grants to innovative SMEs and public public-private cooperation in start up capital; and (iv) improving the information and communications technologies infrastructure. These measures are part of an overall restructuringof privatized enterprises and encouraging entry of new ones. 24. Reforms and quality improvements in the infraslructure and energy sectors will be instrumental in acceleratingand maintaining growth inSAM.Improvingthe infrastructure stock of the country and its energy sector, coupled with adequate reforms to increase its efficiency and accountability to guarantee adequate and good quality, reliable services, will improve business environment and employment creation potential, particularly in those sectors that are expectedto be the engines for growth inthe shorter and medium term in both Serbia and Montenegro. 25. The focus of the Serbian energy reform agenda going forward will be to establish the legal framework to enable commercialization in the sector, improve governance through the establishment of an independent regulator, and increasecompetition within the sector. An Energy Law has been drafted and sent to parliament for ratification, which will enable the regulator to be established and restructuring to take place. Through improved corporate governance and increased competition energy costs can be reduced, decreasing the upward pressure on prices. In addition to easing affordability constraints, cost reductions and increased competitiveness will support GDP growth. Improved industry financial viability through industry commercialization will reduce the quasi fiscal deficit related to the energy sector and will also enable environmental issues, particularly air pollution problems, to be addressed. InMontenemo, the authorities will need to turn attention to implementing the new energy law and, as in Serbia, improving payments discipline, regulation, and governance. Successful implementation here would have benefits in regards to affordability, growth, and the fiscal deficit. 26. In the Serbian transport sector, the focus will be on reducing those barriers to internal and external trade that result from transport inefficiencies. The agenda will include further institutional and regulatory improvement, including adoption of the EU's acquis communautaire, restructuring and privatizing the sector's large State owned enterprises whenever possible, increasing the funding and effectiveness of road maintenance, and careful upgrading of the infrastructure in a national and international perspective. In the Montenegrin transport sector, the focus will be on adapting the transport sector to the changing demands of the economy through the development of an adequate regulatory framework, including incorporating the EU's acquis communautaire, developing the Government's ability to manage the sector and enforce regulations, and improving the corporate governanceof large State owned enterprises. 27. Reform in the water and sanitation sectors inboth rewblics will need to focus on improving efficiency of municipal utilities incharge of providing these services, including their corporatization and separationfrom other municipal services. Furtherand increasedprivate sector participation, particularly in larger cities would also contribute to this goal. Through increased efficiency and accountability it i s expected that the current substantial operating deficits of these utilities would be reduced, thus improving their sustainability and capacity to contribute to the investment needs. Water and Sanitation sector priorities in both republics should be directed to recovering from the last decade of neglected maintenance and almost no new investments, with 13 emphasis on improving service quality, safety and reliability. In Serbia, private sector participation may be feasible and effective in addressingsome of the problems of the larger cities. InMontenegro, coastal pollution reduction, improved services and protection of important natural assets that form the basis for the tourism sector potential growth, such as coastal water quality, are essential elements of the "business environment", and the efforts to comply with the EU's acquis communautaire are important building blocks for sustained growth inthe short and mediumterm. 28. The broad strategic agenda in the Serbian health sector includes: further fiscal adjustment, further measures to strengthen governance and accountability in public healthcare institutions, possibly some public sector human resources issues (e.g. professionalization of management, merit based hiring), and further measures inpharmaceutical procurement. Mediumterm health priorities in Montenegro lie inthe same vein -- fiscal adjustment, enactment and implementation of key framework legislation covering health insurance, pharmaceuticals, and a law governing public health care providers. Tertiary education will be a key focus in both the Serbian and Montenemin education agenda -- improving efficiency, increasing cost-recovery, expanding choice and improving quality. For both republics, social protection over the medium term will require further measures to promote fiscal consolidation and administrative efficiency in the pension systems and improvements in equity and efficiency of social welfare programs. Serbia will also need to focus on improving supervision of voluntary pensions. 29. Looking ahead, in Serbia and Montenegro's agriculture sectors and rural areas overall development strategies are neededto revitalize agriculture and promote poverty-reducing rural growth. Further steps should be taken to finalize these strategies. They should consider, among other actions: the reform of public institutions for farmer support; reform of land administration bodies; promotion of regional development (including non-agricultural activities such as tourism, especially in Montenegro and Southern Serbia), and restoration of irrigation, drainage and flood control infrastructure (especially in Serbia). Finally, further progress should be made in preparing a joint S A M approach to WTO negotiations within the context of the overall rural/agriculture sector strategy. V. MediumTermOutlook,Sourcesof GrowthandExternalFinancingRequirements 30. Sustainable growth is achievable under continued decisive reforms and substantial support from donors and creditors. Growth beginningin 2004 i s estimated at around 4 percent per year (Table l), a slight acceleration relative to the initial estimate o f 3 percent for 2003. Near-term growth i s expected to be driven by exports, a more vibrant SME sector (includingtourism inMontenegro), and greater donor and bank financing of investments. These factors are expected to outweigh the contractionary impact of further fiscal adjustment and the remaining transitional recession. Medium-termgrowth will also be driven by greater productivity and enhanced financial intermediation, the entry of new firms, infrastructure rehabilitation, and further investments in new productive capacity. Faster growth i s likely to be precluded by the high debt burden and the need to manage the social impacts of enterprise and banking reforms, which will work to divert resourcesfrom developmental expenditures. Given SAM's startingpoint, recovery will take time, even under strong reform and concessional assistance. Export performance will be essential to growth and macroeconomic sustainability. The first TSS noted that exports would recover more slowly than GDP. Infact, the ratio of exports to GDP has fallen by nearly 10 percentage points since 2000, but is expected to begin increasing during the next few years. Near-term export recovery will be supported by the restoration and creation of new business contacts (includingthrough new bilateral free trade agreements in the SEE region and autonomoustrade preferences granted by the EU), some financial re-intermediation, and greater access to export credits. In later years, export recovery could be supported by a recovery in the economies of key partners, deepenedtrade integration (including through the EUStabilizationand Association and World Trade Organization accession processes), rehabilitation of infrastructure, productivity improvements, and higher foreign direct investment. 14 31. Medium-term growth will depend on increased and more effective investments. Gross domestic investment as a share of GDP i s expected to rise from 16.1 percent in 2002 to 19.2 percent in 2006. Donor funding will play a significant role in closing the gap between national savings and investment needs. Following the recent high levels of support for the Serbian energy sector, donor support is now expanding to the transport sector. The primary overall investment needs are in the enterprise sector (including agriculture, finance, and tourism in Montenegro), where modestly higher investments should beginto follow from recent and ongoing reforms to improve the business environment, to privatize enterprises in a way which is conducive to attracting new investors, and to restore the public confidence needed for revival of the banking sector. In parallel, and supported by public sector saving, a strengthened banking system, and an increase in enterprise profitability, gross domestic savings i s projected to increase from -7.0 percent of GDP in 2002 to 0.7 percent in 2006. As savings growth modestly outstrips investment growth, SAM's current account deficit (including grants) i s expected to decline from 8.8 percentof GDPin2002 to around 7.3 percent in 2006. Table 1: Key Economic Indicators 2000 2001 2002 2003 2004 2005 2006 National Accounts GDP (US$ millions) 11 8603 11577 15662 20627 20915 21077 21851 Real GDP growth (%) 5 .O 5.5 4.0 3 .O 4.0 4 .O 4.0 Investment (% o f GDP) 14.2 13.6 16.1 16.3 17.5 18.1 19.2 Gross Domestic Savings (% of GDP) -2.7 -7.3 -7 .o -4.7 -3.0 -1.6 0.7 Public Sector Balance (as % o f GDP) Expenditures 37.6 40.3 47.3 45.0 44.6 44.3 43.7 olw public investment 3.1 1.6 3.4 2.5 2.9 3.5 3.9 Revenue before grants 36.7 38.9 42.8 40.9 40.9 40.6 40.1 Deficit before grants 0.9 1.4 4.5 4.1 3.7 3.7 3.6 External Accounts (as % of GDP) Exports of goods and services 29.6 23.7 20.7 20.3 22.9 25.7 27.7 Imports of goods and services 46.5 44.6 43.8 41.3 43.3 45.4 46.2 Current account balance, (millions of US$) 21 -339 -528 -1384 -1750 -1768 -1636 -1601 Current account balance, as % of GDP 21 -3.9 -4.6 -8.8 -8.5 -8.5 -7.8 -7.3 Indebtedness TDOIXGS 31 261.5 220.9 184.6 160.6 133.1 128.7 TDOIGDP 101.4 76.0 62.7 59.9 54.1 55.1 TDSIXGS 31 3.4 6.5 9.9 11.0 10.9 Prices Retail price inflation (e.0.p.) 113.5 39.0 14.2 7 ..-6 . 7 .n . .- -5.-n -5._ n 11 GDP estimates exclude Kosovo. 21 After grants 31 Exports include workers' remittances and non-factor income. 32. A phased reduction in fiscal deficits. The limited domestic sources of budget financing and the reduction in external financing to more sustainable levels will require a phased reduction in fiscal deficits. Bank adjustment credits and other donor support will smooth the temporary adverse effects of this fiscal adjustment. Despite a large increase in public debt service payments and the continued bringingon budget of quasi-fiscal activities, the consolidated fiscal deficit (excluding official grants) i s expected to decrease slightly from 4.5 percent of GDP in 2002 to 3.6 percent in 2006.4 Deficit reductions in the outer years will be 4Asshown in Table 1, the 2003 consolidated budget envisages a significant reduction in budgetary expenditures as a share of GDP. This is being driven by reductions in three categories of Serbian budgetary expenditures which the recent Public Expenditure and Institutional Review (PEIR) identified as relatively high by regional standards- (i) subsidies, (ii) transfers to households, and (iii) wages and salaries. As noted in the PEIR, these reductions are needed to align overall 15 supportedby deeper savings resulting from reforms and improvements intax administration. Cashoutlays are projected to decline by around 3.6 percentage points of GDP from 2002 to 2006. However, as the program would make further inroads into budgetary arrears and other hidden fiscal liabilities, particularly in energy and pensions, it would achieve even greater reductions inexpenditure commitments. Box 6: Donor Support to SAM Currently, about 25 multilateral and bilateral donors are providing developmental assistance to S A M . Approximately US$500 million, including humanitarian assistance, was pledged to meet Serbia and Montenegro's urgent needs at an initial Donor Coordination Meeting inDecember 2000. At the June 2001 Donor Meeting, the Economic Recovery and Transition Program (ERTP) report estimated external assistance needs (additional to commitments made at the December 2000 meeting) on a commitments basis, of US$3.9 billion (then about 4.6 billion) over three to four years. Needs for 2001 were estimated at US$1.25 billion, against which donors pledged US$1.34 billion. A non-pledging Donor Coordination Meeting was held on November 18,2003 inBrussels. At that time, it was anticipated that about 3.5 billion would be committed by the end of 2003. During 2004 the overall donor commitments in support of Serbia and Montenegro could reach an additional 1.1billion. Attachment IV provides information on areas of sectoral involvement by donors. 33. External financing requirements will remain large. To achieve this macroeconomic scenario and finance the remaining transition to a market economy, S A M will require substantial capital inflows. Unexpectedly high privatization receipts in 2003 did eliminate the financing gap for 2003. Nonetheless, significant financing gaps remain for 2004-2006, particularly in view of the envisaged high current account deficits and the expiration of the Paris Club grace periods-all of which renders the importance of continued external assistance for sustainability of the reformprocess. Between 2004 and 2006, gross external financing requirements (excluding for debt rescheduling) are estimated at about US$7.6 billion, or around US$2.5 billion per year. On an average annual basis, these resources are needed to finance US$1.5 billion of current account deficits (excluding interest and official transfers), US$O.1billion in increased international reserves, and the remainder of US$0.9 billion to service foreign debt. These needs are projected to be met from several sources. With good progress on reforms, foreign direct investment and other private sector finance are expected to grow to average US$0.6 billion per year. The remaining US$1.9 billion of average annual financing will need to come from official bilateral and multilateral sources. Although the next CAS will provide a more detailed discussion concerning the financing plan and the possible Bank involvement, preliminary projections suggest that the Bank program would represent an important share of this financing between 10 and 20 percent, thereby playing a crucial role in helping to ensure adequate financing for the reform programs in SAM. Overall donor assistance will need to include adequate provision of quick disbursing funds strongly tied to performance. The Bank program, with its large share of adjustment lending, will assist inmeeting this crucial need. 34. Assuming debt relief on appropriate terms, debt service indicators are expected to decline significantly to still high levels. SAM's total external debt i s expected to fall further to 55 percent of GDP in 2006, driven by further debt relief and GDP growth. S A M ' s ability to maintain a relatively stable ratio of debt to GDP despite relatively large current account deficits, will initially be facilitated by the high degree of average concessionality of official external financing, and later by increasing inflows of private capital. The ratio of total debt service to exports would fluctuate around 10percent inthe period 2004-2006.5 35. Sensitivity analyses demonstrate the vulnerability of SAM's outlook to external shocks and slippages in reform effort. A wide variety of unforeseen external shocks could raise S A M ' s debt service obligations or reduce the amount of resources available to pay the debt, particularly if they occur simultaneously. These expenditure commitments with available non-inflationary sources of financing. As debt service is being regularized following the non-servicing of debt during most of the 1990s, these shifts in the composition of expenditures are also neededto facilitate the resulting increasein interest payments on public debt. Exports inthis definition include workers remittances and non-factor income. 16 include a slower than expected export growth due to weak foreign demand for S A M ' s products and services and higher foreign interest rates. However, the biggest threats to sustainability would come from sustained delays in reform and fiscal consolidation or from a policy mix which would reduce SAM's external competitiveness. By slowing GDP and export growth and raisingborrowing requirements, such developments could cause public and external debt service payments to reach unsustainable levels. These illustrative scenarios indicate the importance of appropriate macroeconomic policies, sustained reformeffort, and strong donor support - as well as the extent to which these are inter-linked. The financing provided by the Bank and other donors provides an added cushion against external shocks, while the focus of the proposed Bank program on strictly monitored policy-based lending gives maximal support to the reforms and fiscal consolidation neededto achieve sustainedgrowth and improveddebt sustainability. VI. WorldBank GroupAssistance 36. Pre-membership Assistance. Five projects totaling US$30 million approved under the Trust Fundfor the Federal Republic of Yugoslavia (TFFRY) in the pre-membership phase are currently under implementation. These were financed from grant funds allocated by the Board from the World Bank's surplus. In Serbia these include: a private sector development technical assistance grant (US$6 million) and a financial sector development technical assistance grant (US$6 million) which support the ongoing Bank- financed private and financial sector adjustment program; a social protection grant (US$lO million) which supports the ongoing social sector adjustment project; an electric power emergency reconstruction project (US$6 million) which underpins sectoral reforms and complements the proposed Energy Efficiency project. In Montenegro, an environmental infrastructure project (US$2 million) has laid the foundation for the FY04 Montenegro Environmentally Sensitive Tourist Areas project (MESTAP). Descriptions of these projects are found inAnnexes VI1and VIII). 37. FY02-04 Transitional Support Strategy. On May 8, 2001, FRY succeeded to membership in the World Bank. On the same day the Bank`s Board of Directors endorsed a first Transitional Support Strategy (TSS) for the Federal Republic of Yugoslavia. This was based on the four objectives of underpinning the Economic Reconstruction and Transition Program. The original TSS was funded with a three-year IDA envelope of US$540 million on a temporary and exceptional basis, with actual lending to depend upon performance against agreedperformance benchmarks. Given existing need, it was envisaged that up to eighty percent of the program could support policy basedlending. An update of the TSS (Report 2276-YU, July 18, 2002) which provided details on the first year implementation under the program and described plans for FY03, was discussed by the Board on August 8, 2002. This Update describes FY03 progress and outlines operational plans for the final year program. Dialogue on the next CAS program, includingterms and volume of lendingfor the periodFYO5-07, will take place throughout 2004. The CAS, ajoint effort with the IFC, will buildonthe PRSP. It is anticipated that the CAS would be finalized inlate 2004. FY03ProgramImplementation 38. Inline with agreed strategic objectives, the FY03 program was delivered as outlined inthe July 2002 TSS Update. Five projects were approved and declared effective for Serbia: a Social Sector Adjustment operation, a second Private and Financial Sector adjustment program and a complementary Enterprise and Bank Restructuring Technical Assistance project, an Employment Promotion Learning and Innovation Project, and a Health Reform project. Two credits supported Montenegro's development: a Structural Adjustment Credit and an Energy Sector Learning and Innovation Project. An Export Finance Facilitation project which covers both republics was also approved. Contributing to the country knowledge base, a large body of analytical work was completed and many of the findings and recommendations have been taken into account in policymaking. These include: the S A M Poverty Assessment; the Public Expenditure and Institutional Review and associated workshops and seminars; the S A M Environment Report, the Urban Transport study and a number of workshops on the Country Financial Accountability Assessment (CFAA), 17 and Country Procurement Assessment Report (CPAR). In addition the Bank organized and sponsored participation by government counterparts at a number of seminars and workshops via GDLN and staff provided hands-on technical advisory services in debt and public expenditure management, trade policy, poverty analysis, social policy, and environmental analysis. Attachments VI-VI11 describe all projects financed and analytical work at the federal and republican levels under the TSS program, including the proposedFY04lendingand AAA programs. 39. Implementation. As of end January 2004, in addition to the five pre-membership grants, 13 projects designed in line with TSS objectives totaling $404.01 million of IDA funds had been approved, of which roughly US$285 million has been disbursed. Consistent with the agreed strategy, about 80 percent of the IDA program to date has been directed toward providing quick disbursing funds to support macroeconomic stabilization and structural reforms to stimulate private sector-led growth, protect the vulnerable and develop human capital, and develop institutional capacity inbothrepublics. 40. DuringFY03, the effectiveness of a number of newly approved IDA-financed projects was delayed by the constitutional changes involving the creation of Serbia and Montenegro and some active projects experienced temporary disruption. To streamline project ratification and implementation, the federal and republican governments are developing, with Bank and other donor input,A Law on Borrowing and Issuing of Guarantees of the State Union, which specifies new procedures and guidelines governing new loadcredit borrowing authorization and approvals. The Law has beenfinalized and i s pending Parliamentary action. 41. Through three completed adjustment operations (Serbia SAC I,Serbia PFSAC I, and the Montenegro SAC I) the Bank has provided considerable policy support. The policy impact has been considerable; these reforms and initial outcomes are described inparagraphs9 and 10and Attachment VI. As for the two ongoing adjustment operations, the Serbia SOSAC and Serbia PFSAC 2 programs are progressing, though behind schedule, in part owing delays related to the recent elections. The composition of the S A M lending program has begun to change slightly from a primarily quick-disbursing portfolio to include more investmenflA operations. In consequence, during FY03 IDA placed emphasis on capacity building and training to facilitate project implementation. One project, Serbia HealthReform, i s currently rated as unsatisfactory. InSerbia, the government has made effective use of the core fiduciary (procurement, disbursement, financial management) capacity in several large PIUs. In Montenegro, the Government has decided to develop capacity for core fiduciary services in one technical unit to facilitate project implementation. Efficient planning and staffing will be a challenge and central to effective implementation as new investment lending comes on line. 42. A first Joint Bank-Govemment Country Portfolio Performance Reviews (JPR) was conducted in Belgrade and Podgorica inFebruary 2003 addressing issuesrelated to constitutional changes and taking stock of compliance with policy benchmarks and fiduciary measures. A JPR Action Plan was agreed with measures specified at the union and republican levels. A short review of progress on this Action Plan was held in both republics inJune 2003. A second JPR for S A M will be organized as soon as the new Serbian Government i s in place. Capacity building remains an important program element, particularly in light of the need to accommodate recent constitutional changes and to ensure continuation of institutional memory among counterparts as a number of positions have turned over. As recommended in the 2002 CPAR, a regional procurement training course was organized in Belgrade inFebruary 2003 and a follow-on Workshop i s slated for 2004. An interactive video conference was held among the Banks Legal, Accounting and Loan department staff and PIU staff on accounting, disbursement and legal matters in early July. The Bank's Belgrade-basedFinancialManagement expert has beenproviding hand-on training and advisory services over the year in both republics. Follow up work to the 2002 Country Financial Accountability Assessment is ongoing. The Bank is working to assist the Central Bank of Montenegroto undertake its fiscal agent role for the Bank Group. 43. The Country Financial Accountability Assessment (CFAA) conducted in FY02 identified a number of fiduciary risks related to Bank grant and lending operations in SAM. These risks, and the associated mitigation measures, fall into four broad categories. Banking system - special accounts could only be 18 established in 3 pre-approved intemational commercial banks, none o f which had operations in Montenegro. An additional 4 commercial banks, 2 of which are based in Montenegro, were reviewed in FY04 and subsequently approved to hold special accounts. Audit environment - Bank funded activities could only be audited by 2 pre-approved international audit firms. InFY04, all the international audit firms present inS A M were re-evaluated, and a number o f local firms were also evaluated and, following completion o f the evaluation process, all 4 intemational firms have been pre-approved to audit Bank funded projects. Project financial management capacity - IDA has organized a number of procurement, disbursement and financial management training events for PMU and government staff and, in FY03, IDA has placed an accredited financial management specialist in the Country Office to provide continuous hands on training. Znstitutional capacity within the Ministries of Finance - investment operations' funds flows are managed through specially created Project Implementation Units and adjustment lending proceeds are channeled through special ring- fenced deposit accounts and correspondent bank accounts. Recent audits o f adjustment operations in Serbia indicated non-compliance with the disbursement procedures specified in the respective credit and grant agreements. After careful review o f past transactions, the Banks management determined that problems were essentially technical in nature and did not require the Bank to exercise legal remedies. The Bank and the authorities subsequently agreed on detailed disbursement procedures and FM requirements to be followed regarding future disbursements. Table 2 StrategicObjectives and the Bank GroupProgram - Strategic World Bank GroupProgram Objective (Programbenchmarks for FY04 are outlined in AttachmentI) Restoringmacro- FY02 economic stability Lending:SerbiaSAC I and external AAA: SAM PublicExpenditureReview (withCPAR andCFAA); EconomicRecoveryandTransition balance Program FY03 Lending:SerbiaSOSAC andPFSAC11, MontenegroSAC I, AAA fiscal sustainability analysisto be incorporatedinthe Country EconomicMemorandum(FY04) Proposed Lending:SerbiaSAC 2; MontenegroSAC 2: SerbiaEnergy Efficiency AAA: SerbiaEM; CFAA updateandROSC Stimulating near- FY02 term growth and Lending:PFSAC I(transitionreforms); SerbiaPSDTA (TFFRY); SerbiaFSDTA (TFFRY); SerbiaPower creatingthe basis Rehab (TFFRY); MontenegroCoastal EnvironmentalInfrastructure(TFFRY); SerbiaSocialProtection for a sustainable (TFFRY); FRY Trade andTransport SoutheastEurope supply response AAA:, FIAS Barriers to Entry Study IFC, MIGA, FIAS programs;SoutheastEuropeEnterpriseDevelopment (SEED), SerbiaInvestmentExport PromotionAgency (SIEPA) FY03 Lending:SerbiaPFSAC11, SerbiaBank andEnterpriseRestructuringandPrivatizationTA, Montenegro Energy LIC, SerbiaEmploymentPromotion LIC, ;FRY ExportCreditFacility AAA: SerbiaEnergy Sector Strategy, SerbiaAgriculture SectorReview, SAM EnvironmentSector Review, SerbiaUrbanTransportSector ;IFC, MIGA, FIAS programs, IFC-USAIDBalkansInfrastructure DevelopmentFacility (BID), SEED andSIEPA Proposed Lending:SerbiaEnergyEfficiency; SerbiaReal Property andCadastre; SerbiaTransport Rehabilitation; MontenegroMESTAP AAA: SerbiaEM; Private Sector PolicyNote; FinancialSectorPolicy Note; InvestmentClimate Assessment; FIAS AdministrativeBarriers Study; EnergySector Strategy; regionalstudies on institutional reforms for investmentandgrowth, energy, water, transport, trade andtrade andtransport facilitation; IFC, MIGA, FIAS programs,IFC-USAIDBalkansInfrastructureDevelopment(BID) Facility ,SEED and SIEPA Improvingsocial FY02 well-being of the Lending:SerbiaEducationImprovementProject;SerbiaSocialProtectionTFFRY, SouthemSerbiapost mostvulnerable conflict grant and building -SAM AAA: Povertyhouseholdsurveys; SAM PublicExpenditureReview humancapacity 19 Lending:MontenegroSAC I(fiscalsustainability); SerbiaSOSAC, SerbiaHealthProject, Montenegro Environment,Labor LIL AAA:SAM PovertyProfilesandbackgroundpapers;SAM PovertyAssessment, PRSPrelatedassistance WBI -program inpoverty alleviation,community empowerment, healthsector reform FY04 Lending:SerbiaSAC 2: MontenegroSAC 2: MontenegroHealthSystems Improvement,Montenegro PensionsSystemImprovement I AAA: SAM OngoingPovertyProgram; RomaCapacityBuilding Trust Fund;WBI programs;PRSPsuppor Improving FY02 governance and Lending:SAC I;SerbiaEducationImprovementProject; 2 postconflict grants; building effective -LegalandJudicial AAA: Diagnostic FY03 I institutions Lending:SAM Public ExpenditureManagementCapacity Building; SerbiaHealthProject AAA: SAM fiscal sustainabilityanalysis (inputto CEM); SerbiaUrbanTransport SectorStudy IDFgranton court administrationreform(Serbia) Proposed Lending:MontenegroHealthSystems ImprovementPolicy; MontenegroSAC 2; SerbiaSAC 2; MontenegroPensions SystemImprovement &Public AdministrationDiagnosticandPolicyNotes(SerbiaandMontenegro);Social Scientists Capacity Building Trust Fund; ongoingwork on financial accountability 44. Duringthe first two years ofthe TSS Program, the Bankfocused considerable attention oncompleting a body of sound analytical work which has been appreciated by the Borrower. Nonetheless, dialogue with the client suggests two areas for improvement: (i)future Bank sector work will be more concise and policy- focused with shorter delivery times; (ii) dissemination of each report will be an ongoing process rather than a one time event. This is particularly critical when there i s significant turnover among counterpart staff. Outreach should go beyond the main cities, as feasible and warranted. Government collaboration, already strong, will be further enhanced. The collaborative multi-year programmatic approach to poverty analysis (Attachment I) provides a soundmodel. ProposedProgram 45. The objectives of the original TSS remain valid and operationally relevant for the reminder of the programand are consistentwith the objectives goals of the recently completed PRSP. The programcontinues to have high quick disbursing lending mix but a number of new investment/TA projects are also encompassed. The following operations, described in detail in Attachments VI, VI1and VI1(by republic) are underpreparation. Final credit amounts may vary slightly within the totalfixed envelope. 0 Serbia Second Structural Adjustment Credit (US$40 million). 0 Serbia Real Estate Cadastreand Registration Project (US$21 million) 0 Serbia TransportRehabilitation Project (US$25 million) 0 Serbia Energy Efficiency Project (US$21 million) 0 MontenegroSecond Structural Adjustment Credit (US$l8 million) 0 MontenegroHealth Systems ImprovementProject (US$7 million) 0 MontenegroPensionAdministration TechnicalAssistance Project (US$4 million) 46. In line with strategic development objectives and PRSP priorities the Bank has a full program of analytical work in both republics in process. A more detailed description of each study i s provided in Attachments VI, VI1and VIII. 20 (Serbiaand Montenegro)Diagnostic and Policy Note: Public Administration and Civil Service Reform. Assessment of ongoing and planned reforms at the SerbianMontenegrinand Union levels. (Serbia and Montenegro) Poverty Analysis - continuation of the multi-year programmatic approach describedinAttachment I. (Serbia and Montenegro)follow up on 2002 Country Financial Accountability Assessment - the Bank will undertake assessments of local audit f m s selected commercial banks for purposes of holding Special Accounts. An Investment Climate Assessment (ZCA) is systematically analyzing core conditions for private investment and enterprise growth through a standard core investment survey instrument and an assessment of investment climate conditions. (Serbia) Economic Memorandum. Comprehensive review of the economy with an emphasis on key sources of, and policies for, sustainable growth and employment creation. A report on Montenegro will be undertaken inFY05. (Serbia) Financial Sector Policy Note will provide an up-to-date analysis on Serbia`s banking sector, in particular, benchmarking levels of financial intermediation in Serbia. The study will lay the groundwork for an FSAP scheduledfor FY05. (Serbia) A Policy Note on Privatization will provide an overview of the progress of privatization in Serbia since 2001to date and an evaluation of the remaining challenges in 2004-2006. (Serbia) FZAS AdministrativeBarriers Study (Montenegro)FZAS ZnvestmentDiagnostic 47. Regional Studies and Initiatives. Over the past year, greater attention has been paid to ensuring an integrated regional approach to common challenges. A draft Regional Framework Paper for South Eastem Europe provides a regional framework for the formulation of individual country assistancestrategies, with the objective to ensure that programs have the greatest impact both at the country level and also at the regional level. The Strategy identifies areas of activity where there exist cross-border externalities or economies of scale, or opportunities for "scaling up" successful interventions across borders. It also identifies opportunities to encourage regional cooperation within the ambit of our activities, and provides a common path toward integration in European structures. Within this umbrella, the Bank i s collaborating on a variety of regional programs, initiatives and studies which will benefit Serbia and Montenegro as well as the Balkans, described in Attachment 111, including: an HN/AIDS study; a Regional Transport study for the Balkans; a Regional Energy Study for the Balkans; a Regional Water Study; a Regional Trade study; a Regional Study on InstitutionalReforms for Investment and Growth in South EasternEurope; a Trade and Transport Facilitation Program for South Eastern Europe; a Social Development Initiative for South Eastern Europe. The Bank continues to support selected regional initiatives under the Stability Pact, including the Znvestment Compact and the Anti-Corruption Initiative, in collaboration with the OECD and other partners. It i s anticipated that these activities may be followed up by investment lendingat the regional level. 48. Program Performance and Monitoring. Policy performance against the FY03 benchmarks has been solid; achievements are detailed in Attachment V which also includes 2004 benchmarks. The current Bank lendingprogram remains weighted toward policy-based lending. The full CAS, anticipated in late 2004 will providea detailed framework with outcome performance based indicators for the future. 21 49. FY05. The FY05 lending program will be finalized in the CAS process. For planning purposes, preliminary work has begun to identify a number of possible projects consistent with PRSP priorities. The FY05 Serbian program may include further adjustment lending, a municipal water and sanitation project, a water resources project, and possibly a social innovation fund. For Montenegro, for FY05 work i s underway to prepare an education project. Three GEF projects, Serbia Energy Efficiency, Serbia Danube River Enterprise Pollution Reduction and Montenegro Lake Skadar, are also being developed for FY05. It i s expected that the share of adjustment lending will decline gradually during the next CAS period. Analytical work will be more policy-oriented. 50. Partnerships. The Bank, particularly through the Country Office, works closely with the multilateral and bilateral donors who are providing support for S A M ' s reformprogram. The European Commission i s the key partner, sharing the mandate with the World Bank to facilitate coordination of donor assistance to S A M and the other countries of the region. Attachment IV outlines areas of donor involvement in Serbia and Montenegro by sub-sector. It i s anticipated that duringthe next phase of the transition, the S A M Authorities will strengthen donor coordination capacity and the international community will strive for greater selectivity and complementarity in accordancewith the PRSP. As a priority, the Bank and the Commission are working jointly with the Governments toward harmonization of procurement and financial management policies. In addition, the Stability Pact for South Eastern Europe remains an important vehicle for cooperation with the donor community. The Bank also works closely with the EBRD and EIB to foster private sector development. The PRSP process enhanced opportunities for consultation and partnership with the donor community and civil society in both republics. Collaboration with the UNDP on the PRSP and MDGs has been fruitful. The Bank i s also collaborating with the IMF on the PRSPprocess, and has worked closely with the Fund to support reforms in public expenditure management, the energy sector, the pension system and privatization. The Bank has enhancedits outreach with civil society through a variety of workshops, seminars and stakeholder forums on the PRSP, ESW and project design. 51. World Bank Institute (WBI). WBI's programin SAM aims to enhance nationaland regional capacity in(i) community empowerment; (ii) intergovernmental relations and urban management; (iii) governance and poverty; (iv) corporate social responsibility and investment climate. WBI will continue its multi-year support program for the PRSP process and will tailor its efforts to accommodate regional priorities outlined in Attachment 111. A Community Empowerment and Social Inclusion program for Roma, designed to support capacity enhancement efforts linked directly with the Decade of Roma Inclusion and the Roma Education Fund, will provide: a local language websitehirtual learning environment (VLE) and a regional training course on social accountability and follow-up technical assistance. WBI i s considering possible collaboration with Open Society Institute Local Governance Initiative on sub-regional local govemment capacity enhancementprogram for South East Europe aimed at improving policy making at local levels with special emphasis on poverty reduction and on achieving the MDGs. The program will include a Needs Assessment Workshop, a Southeast Europe (SEE) Regional Course in UrbanManagement, and a SEE Regional Course in Decentralization and Local Financial Management. The regional courses could be replicated in Serbia and Montenegro by a carefully selected national partner institution.. In addition WBI i s considering a pilot city level diagnostic work in assessing the current status of MillenniumDevelopment Goals and the necessary actions to achieve them. An Export Promotion through Improved Competitiveness course will be offered using a network of regional training institutions to disseminate regional knowledge and best practices relevant to Serbia and Montenegro. In cooperation with ECA GDLN, WBI will also deliver a series of video conferences on Corporate Social Responsibility and Investment Climate. InternationalFinancial Corporation(IFC) 52. Serbia and Montenegro is a major IFC priority, although the business and institutional environment still presentsmany difficulties to foreign investors. DuringFY02-03 IFC has committedabout US$43 million in5 projects, three in financial markets and two in manufacturing. Also, IFC has developed a strong technical assistance program both for institutional strengthening (insurance sector, leasing, banking) and for investment 22 project preparation (energy sector, electronics, IT, hotel). Opportunities of new investment projects are under development in both the financial and manufacturing sectors. In the financial sector IFC i s looking for investment opportunities in commercial banking, insurance and leasing. In the real sector, IFC strategy is focused in steel industry, retail-distribution, tourism, agribusiness, mechanical and electronic industry,paper, pharmaceuticals, and health sector. IFC, in cooperation with the Bank and other multilaterals, i s also pursuing the opportunities to implement the public-privatepartnership approach, especially in oil and gas transport and distribution, solid waste management services, and power sector, as a way to attract the private sector and support the significant infrastructure needs in Serbia and Montenegro. Inthis context, IFC i s also working for the establishment of the Balkan Infrastructure Development facility, which will help in preparation and development of infrastructure projects, to be financed through non-sovereign means. 53. As strengthening financial markets is key to reaching a large number of businesses, investments and advisory work in this sector i s a focal point of IFC's strategy in Serbia and Montenegro. IFC has been working intensively to catalyze strong foreign strategic investors in the country and establishing viable financial institutions. To increase the availability of funds for small and micro enterprises, IFChas established the first Microfinance Bank in the country and has supported RaiffeisenBank. IFC i s focused on assisting in the restructuring and privatization of Vojvodjanska Bank (VB) and its former associatedbanks. With the view of recovering its arrears, IFC would convert part or its entire loan outstanding into the equity of the five remaining VB banks. Using SIDA trust funds, IFC will also provide technical assistance to VB in several areas, including evaluation of asset quality, governanceimprovement and operations enhancement. Also, very selectively, IFC is assistingdomestic privatebanks to attract strategic partners. 54. Inthe insurance sector, IFC has already provided extensive due diligence to the Serbian Insurance Regulator on various aspects of improving the regulation of insurance, including the drafting of a new insurance law. IFC i s now focused on assisting in the restructuring and privatization of Dunav Insurance Company. Inaddition, IFC i s looking for opportunities to develop and support the non-bank financial sector, such as in leasing and securities market development, through both investment and technical assistance. To target investment opportunities particularly in the privatization process in Southern Europe, including in Serbia and Montenegro, IFC i s disbursing a US$20million investment ina regional equity fund. 55. A highdevelopment impact is being achieved with IFC's Euro 20 million investment inTigar Michelin Holding, a leadingregional producer of highquality car tires. IFC sees good potential for more projects inthe manufacturing sector. After providing a technical assistance to evaluate the technical and market potential, IFC i s considering an investment inthe capacity expansion of a cardboard factory. IFC has provided technical assistance for a comprehensive feasibility study for the re-development of a hotel. IFC i s also pursuing another investment opportunity inthe pharmaceutical sector. 56. Ininformationandcommunication technologies sector, the regulatory environment is fragmented and could benefit from technical assistance. A technical assistance project is beinglaunched to identify the market opportunities for investing in the Internet sector development in Serbia. IFC i s interested to support the wireline and wireless sector upon resolution of a number of impediments, including the Government's direct and indirect shareholdings in competing cellular operators and Government decision on a strategy for further sector liberalization. 57. Costanza-Pancevo-Omisalj (CPOT) Oil pipeline project, a cross border oil transportation pipeline, which is expectedto offer an environmentally safe alternative route to bring Central Asian and Russian crude oil to SouthernandWestern Europe, crossing Romania, Serbia and Montenegro, and Croatia. This pipeline is of great interest to the governments of these countries. The project is at a preliminary stage of development. USTDA has financed a feasibility study with a grant to the Croatian Government on behalf of the three interested countries (Croatia, Serbia and Montenegro, Romania). The Serbian Govemment, on behalf of the three countries, has asked IFC to consider supporting a follow-up technical assistance assignment. It would include the pre-development strategy aimed at coordinating the early institutional efforts to prepare the legal framework ineach country, and promotingthe project with potential investors and users. 23 58. Since March 2002, IFC has been working on the restructuring of the Belgrade municipal solid waste system, in order to prepare the ground for the concession to private sector of the solid waste management services and for introduction of a Public-Private Partnership. This will be the first major infrastructure privatization inSerbia and Montenegro since the controversial telecom sale. 59. Donor supported technical assistance has been important to the success of IFC investments in Serbia and Montenegro. Serbia andMontenegro i s among IFC's client countries which benefits from IFC's technical assistance program. During the last two years IFC has mobilized about US$4 million of trust fund resources for technical assistance, mainly from Sweden and Italy, for technical assistance to Serbia and Montenegro that have beenusedto conduct more than twenty assignments. 60. IFC has committed substantial technical assistance resources in the reform and restructuring effort of the energy sector for: (i) strategic restructuring of the national oil conglomerate NIS (NAFTA Industrja Serbia) and; (ii) early institutional and market development of the CPOT Oil pipeline project. Important assignments are still under way for: (i) the Ministry of Economy and Privatization, in the electronic industry segment (Electronska Industrija restructuring and privatization); (ii) a capacity support to the Privatization Agency; (iii) the health sector (private Policlinic feasibility); and (iv) IT sector (Internet and IT industry). IFC has advised the City of Belgrade on the restructuring of the Belgrade municipal solid waste system, in order to prepare the ground for the concession to private sector of the solid waste management services and for introduction of a Public-Private Partnership. Technical Assistance support has also been given to some private initiatives in food and consumer goods, textile apparel industry,rubber industry, lodging, paper, light mechanical industry, and packaging industry. New technical assistance programs will be directed to evaluate private viable projects inrenewable energy projects, education, gas distribution services, and agribusiness. 61. IFC i s supporting the SME sector through its Southeast Europe Enterprise Development (SEED) facility. SEED, a multi-donor initiative, i s a regional development facility operating in Albania, Bosnia, Serbia and Montenegro and FYROM. Its focus is on SMEs increasing their competitiveness through training and focused consulting, developing the local business development services being provided by consulting and training companies, and improving the business enabling environment through highly focused interventions. These interventions are structured around different strategic client groups: (i) financial sector with a focus on access to finance issues (leasing, factoring, alternative dispute resolution); (ii) supply chain issues and the links between large companies and SMEs; (iii) interventions with business membership organizations deep (BMOs) that strengthens these organizations and the companies in the membership, and finally; (iv) institutional strengthening that helps to provide additional capacities for private sector (SME) development. Of note has been SEED'Scentral role in developing and introducing leasing legislation in 2003. Inthe next year SEED is looking to deliver substantial interventions in the construction, wood processing, agro- processing, and retailing sectors. In agro-processing, SEED will be focusing its activities on the rural economies of southern Serbia, an economically depressed area. It plans to roll out its alternative dispute resolution programacross the region, includingSerbia and Montenegro. After successful implementation of "Supply Chain Management" scheme in Tigar project, SEED will be looking to replicate it to other large companiesinthe region. ForeignInvestment Advisory Service (FIAS) 62. FIAS is preparing an Administrative Barriers Study in Serbia, a sequel to its diagnostic review of the foreign investment climate "Republic of Serbia: The Climatefor Foreign Direct Investment" 2001. The Study i s a collaborative effort between the Government of Serbia, the South East Enterprise Development (SEED) and the Economic Institute of Belgrade, and uses FIAS' self-assessment approach. The Administrative Barriers report will be the focus of a workshop for stakeholders, the government and donors around March 2004, which i s expected to lead to the preparation of an Action Plan for administrative and regulatory reform and its subsequent implementation. The Study also includes results from a second `Costs of Doing Business' 24 survey that was completed in FY03 in collaboration with the Bank. FIAS i s carrying out an investment diagnostic inMontenegro at the request of the Government. Multilateral Investment Guarantee Agency (MIGA) 63. MIGA is providing strategic assistance to SerbiaandMontenegro's efforts to attract foreign investment. On Guarantees, the agency supported three foreign investments in FY03, and has supported two more in FY04. MIGA i s currently underwriting two projects in the manufacturing and financial sectors, with total potential MIGA coverage of US$58 million. As of December 31, 2003, MIGA's outstanding portfolio inthe Serbia and Montenegro consists of five contracts of guarantee: four in the finance sector and one in the construction sector, with a total gross exposure of US$65.1 million, and a net exposure of US$58.6 million. The total estimated amount of foreign direct investment facilitatedwas US$77.3 million. 64. MIGA is also providing technical assistance for capacity buildingto SIEPA, Serbia's investment and export promotion agency, to help Serbia attract additional FDI in the coming years. The program, funded under a World Bank grant to Serbia, is aimed at strengthening the promotional capacity of the agency. As of December 2003, several major program components have been implemented, includingthe preparation of an FDIpromotion and related sector-specific targeting strategies, a review of SIEPAs IT strategy (focusing on website, investor tracking system and use of Internet-based researchand analysis tools) and the delivery of a number of skills development and training programs. Inthe coming months, MIGA will continue working with SIEPA on the implementation of a number of marketing and outreach activities in three priority sectors (automotive components, electronics, agribusiness). 65. MIGA has also started working with the European Agency for Reconstruction (EAR) on the design of an EU-funded follow-on capacity building program for SIEPA. The FDIpromotion strategy prepared under MIGA'scurrent assistance program will be providing the foundation for the future EAR/MIGAassistance; it i s expected that such a program would cover a three year period, starting approximately in mid-2004. In addition, MIGA will be establishing a new, donor-funded investor outreachand marketing facility which will allow the countries of the Western Balkan region (including Serbia and Montenegro) to better reach out to the European investor community. Finally, both Serbia and Montenegro are regular content providers to MIGA's on-line investment promotion services (www.fdixchange.com, www.Drivatizationlink.com and www.ipanet.net), featuring updated information on investment opportunities and the related legal and regulatory environment. VII. Risks 66. The previous TSS identified two levels of risks for the Serbia and Montenegro program --internal: political, policy and implementation capacity risks and extemal: regional shocks. Although several of the risks have materialized, the Government has been able for the most part to take measures to minimize or mitigate the impact of events in order to avoid severely negative consequences to the reformprogramand the subsequentgrowthof the economy. 67. Regarding political risk, Serbia successfully weathered the March 2003 assassinationof Prime Minister Djindjic without damaging the economic recovery. Inthe immediate aftermath, the Government was able to take strong measures to address the uncertainties that resulted from this event by deepening and accelerating the economic reforms so that the risks to reform program implementation were mitigated. Although this strong united front did revert to partisan debate inthe ensuing months, support for the reform program itself has held together throughout and policv performance has been strong. While the establishment of the Union did lead to temporary delays in legislative reforms and day to day economic management, there has been no longer term impact on the reform program. Implementation and capacim issues were correctly identified as constraining aspects for the implementation of many of the new economic laws, rules and regulations and they remain as such. The new constitutional structure has added additional complexity. 25 68. The impact of the external environment on aid flows was identified among potential external shocks that could strain Serbia and Montenegro's ability to maintain a sustainable macroeconomic framework and return to growth. In fact, aid flows have continued at levels in line with originally identified needs. While the Paris Club debt relief was negotiated satisfactorily, delays inthe London Club negotiations have continued, thereby postponing the access of Serbia andMontenegro to external financial markets. 69. The possibility of a marked slowdown in the economy of key trading partners that could reduce the growth of exports and the inflow of private capital was also postulated as a risk.A modest such slowdown did occur during the latter part of 2002 and the first half of 2003. Despite this somewhat less favorable external environment, exports did still grow at a modest level and FDIflows have slightly exceeded projections of a modest increase towards average levels observedinthe ECA region. IDA financing proved to be important as a way of mitigating all these events and maintaining a positive momentum in the economic reform being implemented while minimizing the social impact of these reforms. An unexpected setback for economic growth, particularly in the rural areas, was the severe drought in the summer of 2003. Since agriculture contributes roughly 24 % of GDP this has had a significant dampening effect on growth, reducing it by at least a percentagepoint. 70. Looking to the future, many of the risks identified in previous assessments, notably concerns on debt sustainability, remain the same, but the ability of the Governments and authorities to minimize impacts of similar events during the last 24 months gives encouragement that while recovery will remain difficult, the outcome of this complex reform programwill be successful. Although poor performance in the economies of key trading partners, if continued, would dampen export growth in Serbia and Montenegro and the inward movement of private capital, more serious concerns center on the domestic front. The Authorities need to focus on improvements in fiscal and external sustainability which will require continued success in rationalizingpublic expenditures and reduction of fiscal deficits, combined with a macroeconomic policy mix which supports export growth through the maintenance of external competitiveness. Reform fatigue backlash continues to be a concern. In Serbia, there are two risk factors: first, the pace at which the new government is able to organize itself and become operational; and second, the sustainability of the coalition. It is encouraging that the likely coalition partners have reaffirmed intentions to support a deepening of market reforms, but the proof will be in actions. We believe that the depth of the reforms are such that significant backtracking i s unlikely. In Montenegro, programrisk centers on capacity constraints and sometimes erratic pace of the reform agenda. External support from the World Bank and other donors for a strong continued reform program will be crucial to program success. In the regional arena, over the last year there has been some political progress in South Serbia and a renewed Kosovo dialogue has been initiated with the establishment of technical working groups on select issues. Nonetheless, any deterioration in this climate/dialogue would heighten uncertainty. Zmplementation and capacity issues will continue to be constraining factors although they are being balanced increasingly by the outcomes of training programs and experience. 71. In sum, while the external environment, particularly the economic developments in Europe, could constrain the Serbian and Montenegrin recovery, the more immediate risks for Serbia and Montenegro are domestic. The Authorities will need to take firm and sustained measures to maintain fiscal sustainability and deepenthe reformprogram. Washington, D.C. James D.Wolfensohn February 23,2004 President By ShengmanZhang 26 Attachment Z A Programmatic Approach to Poverty AnalysisinSAM The Poverty Assessment i s the first product in a series of tangible outputs: analytical reports, poverty maps, information support for the national strategiesfor poverty reduction, and a series of background papers on key policy topics (labor, inequality, rural poverty, etc.). These outputs will be strategically timed to respond to the needs of the Governments. In particular, additional efforts will be made toward further analysis to fully understand the causes of poverty, with a focus on labor market, its regional characteristics and ethnic dimensions, such as poverty situation of ethnic minorities (with an emphasis on Roma). This approach also focuses on capacity building and continuous dissemination of results. At the next stage of the Poverty Assessment work the analysis will directly engage Statistical offices of both Republics, and a series of skills- focused training course will be offered to data producers and users in cooperation with WBI. As a result, a critical step towards the institutionalizationof the poverty monitoringwill be made Key activities and outputs FY02 FY03 FY04 FY05 Poverty Survey J J Poverty Assessment: BaselineReport J Background Paper: Poverty Profile for Montenegro J Background Paper: Evaluationof Social Assistance System in Serbia J Background Paper: Monitoring Poverty in Serbia (Buildinga Statistical System) J Background Paper: Chronic Poverty and Social Exclusion in S A M J Background Paper: Rural Poverty in S A M J Background Paper: Private Sector Development, Labor Market and Poverty J Poverty Map for S A M J Background Paper: Enterprise Restructuring and Unemployment inSAM J Background Paper: Options for PensionReformand Poverty inMontenegro J Background Paper: Vulnerability to Poverty and HealthCare ReformIssues in Serbia J Background Paper: Education Reform and Poverty Reductionin S A M J Poverty Update Report J 27 Attachment II Special Challenges: Displaced Persons and the Roma The situation of Displaced Persons (DP --refugees and internally displaced persons) and the Roma in S A M represents a special challenge. Nearly half a million people, perhaps seven percent of the total population, remain displaced in the country. Roughly sixty percent of these are refugees from neighboring Bosnia and Croatia displaced for nearly a decade. The rest are IDPs from Kosovo, displaced since 1999. The unequal geographic distribution of the displaced has put particular pressure on specific areas of the country where concentrations are higher, emphasizing the fact that workable strategies require both central and local government engagement. Refugees and IDPs represent as high as 40% of the population of some municipalities. Various surveys, including the recent Survey of Living Standards in Serbia and Household Survey of Roma, Ashkaelia and Egyptians, Refugees and IDPs in Montenegro, indicate that levels of poverty among both refugees and IDPs remain significantly higher compared to the local population. Those refugees who were able to return home or to otherwise find sustainable situations in other countries have already taken such options. The population which remains displaced represents a residual group whose survival strategies are fragile and highly sensitive to external shocks. According to the recent household survey of Roma, Ashkaelia, and Egyptians in Montenegro, 52 percent of this population lives below the poverty line -- a rate 5.5 times that of the rest of the population. Education indicators are also dismal -- only 7 percent of Roma, Ashkaelia, and Egyptians above 6 years old attend school. Even with an improving economy without special measures the displaced may not benefit to the same degree as other segments of the population and risk becoming a permanent under-class. Their unemployment rates are already much higher than others. Their shelter situations are perhaps of the most concern. International humanitarian assistance, a mainstay of DP survival strategies, has been shrinking for several years and is scheduled to stop altogether by early 2004, leaving behind a significant gap in financing. The government faces a major dilemma with potentially serious social, economic and political implications. Without investing in sustainable strategies of self-reliance andlor integration, a deterioration inthe situation of DPs as well as potential social tension seems inevitable. However, pressures on public expenditure are already severe and it seems highly unlikely that sufficient domestic resources will be available to address this situation. The government has recognized the looming problem and has requested support from donors to assist in a transitional strategy for the sustainable integration of refugees in S A M , however, these efforts at fund-raising have beenlargely unsuccessfulto date. According to the 2002 Serbian census, Roma constituted 1.44 percent of the population of the Republic of Serbia. Most are concentrated in the south where in some municipalities, Roma comprise as much as one- third of the total population. The Roma population is significantly younger than the rest of the population, with an overall average age of less than 20 years. Many lack education. A survey of Roma in Belgrade found that 13 percent of men and 26 percent of women had no education. Only 7 percent of Roma in Serbia attend preschool and nearly 37 percent of Roma children do not speak Serbian at all before they start school. Many Roma live in settlements, called mahalas, on the outskirts of towns and villages. 80 percent of Roma in Belgrade live in poor conditions in settlements. Most of these are unregistered and do not have adequate access to water, electricity and waste collection. In Montenegro, in the 199lcensus 3,282 persons declared themselves to be Roma out of a population of 615,035. However, as many Roma declare themselves as other ethnicities, the actual number i s thought to be between 20,000 and 28,000, mostly concentrated around the capital of Podgorica. The majority of Montenegrin Roma are MuslimRoma from Kosovo. Data suggests that education levels are low, few graduate from primary school. The majority also tend to be unemployed or work inmenialjobs. 28 At the union level, the authorities recently drafted a "Strategyfor the Integration and Empowerment of the Roma," which marks its first comprehensive effort to develop policies addressing education, housing, employment, health, women's issues, and the specific situation of IDPs.Roma expert groups were involved in the formulation of the Strategy. However, its implementation will likely be challenging, particularly in Montenegro where implementation prospects may be less clear. Inthe context of the Serbian PRSP process and the World Bank's poverty assessment program, a specialized household survey i s being conducted (field work started in June 2003), which will facilitate poverty estimates of Roma, including Roma IDPs, and comparisons with the rest of the population. In Montenegro, the UNDP, the Bank, and a local research instituteinitiated a small survey in summer 2003 that will cover Romaas part of the PRSPprocess. 29 Attachment ZZZ Regional Studies and Initiatives Over the past year, greater attention has been paid to ensuring an integrated regional approach to common challenges. A draft Regional Framework Paper for South Eastern Europe provides a regional framework for the formulation of individual country assistance strategies, with the objective to ensure that programs have the greatest impact both at the country level and also at the regional level. The Strategy identifies areas of activity where there exist cross-border externalities or economies of scale, or opportunities for "scaling up" successful interventions across borders. It also identifies opportunities to encourage regional cooperation within the ambit of our activities, and provides a common path toward integration in European structures. Within this umbrella, the Bank is collaborating on a variety of regional programs, initiatives and studies including: (i) anHZV/AZDSstudy willreviewtheHIV/AIDSsituationinagroupofwesternBalkancountriesto assess the need for further policy development and investments in these area. This study will also review the situation regarding sexually-transmitted infections (STIs) and tuberculosis (TB) due to the overlap between the three diseases. (ii) aRegionalTransportStrategyfor theBalkansisaimedatpromotingtradeingoodsandintransport services among the Balkan countries and between these countries and the EU. The strategy will identify the main transport related regional institutional and regulatory measures, as well as, the priority investments in the international transport networks. (iii)aRegionalEnergyStrategyfor theBalkanscoveringtheSouthEastEuropeRegionalEnergyMarket (SEEREM)will elaboratethe Banks approachto supporting institutionalreformand investment inthe power and gas sectors of SEE with a view to increasing energy trade. (iv) a Regional Water Study will review experience with water resource management in the ECA region since the transition. Inlight of water resourceconstraints, broader economic considerations, and regional and corporate goals, it will also define a framework within which the Bank should prioritize its support in this sector inthe Europe and Central Asia Region. (v) a Regional Trade Study (Trade Policies and Institutions in the Countries in the EU Stabilization and Association Process Report) was prepared to support integration of the five countries that are currently engagedwith the European Union inthe Stabilization and Association processinto the world and particularly, the European, economy. The report also supports the activities of the Stability Pact Working Group on Trade Liberalization and Facilitation. (vi) a Regional Study on Institutional Reforms for Investment and Growth in South Eastern Europe, in collaboration with the EBRD, is carrying out a major empirical study of the institutional barriers to investment and growth inthe eight SEE countries. The study focuses infour areas: competition and economic barriers to entry/exit; corporate governance and finance; dispute resolution; and the regulatory regime governing utilities. (vii) the Trade and Transport Facilitation Program for South Eastern Europe aims to reduce non-tariff costs to trade and transport, to reduce smuggling and corruption at border crossings, and to strengthen customs and border control agencies inthe region. (viii) the Social Development Znitiative for South Eastern Europe aims at promoting social cohesion and reducing inter-ethnictensions through capacity buildingand community development. (ix) the Bank continues to support selected regional initiatives under the Stability Pact, including the Investment Compact and theAnti-Corruption Initiative, incollaboration with the OECD and other partners 30 0 Y & 0 k h O B Y h I 00 m Attachment VI Serbia and Montenegro (activitiesatfederal level or covering both republics) Pre-Membership Support ERTP. As part of the overall donor coordination responsibilities inthe Southeast Europe (SEE) region, the World Bank was asked to develop, in partnership with the European Commission (EC), an Economic Recovery and Transition Program (ERTP) for the Serbia and Montenegro. The ERTP was presented at a Donor PledgingMeetingfor S A M held in 2001. The two-volume report outlines a comprehensive structural reform agenda, a priority public investment program and needed sectoral policy reforms to support the design, implementation and financing of a program for transition and recovery. Serbia and Montenegro FY02Program (activities atfederal level or covering both republics) SAM Trade and Transport Facility Southeast Europe (TTFSE) (US$6.76 million). The TTFSE i s part of a regional program in Southeast Europe. It seeks to reduce non tariff costs to trade and transport and to reduce smuggling and corruption at border crossings through providing support for customs modemization, improved information systems, enhanced information dissemination among the trading community and border control agencies, equipment for enforcement and pilot initiatives. Analytical work and technical assistance: Country Procurement Assessment Report (CPAR). This report which was prepared jointly with the S A M Country Accountability Financial Assessment (CFAA): (i) assessesthe current legislation goveming public procurement at three levels; (ii) assesses the commercial laws and laws on concessions; (iii) identifies the need for future legislative reform in the area of public procurement; (iv) examines the foreign trade aspect of public procurement; (v) quantifies the current level of expenditure on public procurement; (vi) sets standards for public procurement applicable to both federal and republic levels; and (vii) examines implementation arrangements and institutional strengthening requirements for projects financed by the World Bank andEBRD. Serbia and Montenegro FY03Program (activities atfederal level or covering both republics) Lending: Serbia and Montenegro Export Credit Facility (US$11S O million). This project supports sustainableeconomic growth by catalyzing and facilitating trade transactions through the creation of the Serbia and Montenegro Export Credit Agency (SMECA). SMECA supports both import and export activities through the following facilities: export credit insurance; working capital loans and guarantees; exporter performance insurance; mediumterm import insurance/guarantee; and technical assistance to exporting enterprises on marketingmatch-making. Imports are facilitated through political risk insurance; and limited comprehensive import credit insurance. 39 Analytical work and technical assistance: (Serbia and Montenegro) environmental sector review was designed to assess policy reforms, identify priority actions, and highlight linkages between economic reconstruction, social policy and environmental protection in both republics. The ESR serves as a pilot for testing the concept of Country Environmental Analysis--analyzing environmental problems from principles based on economic costs as well as developing the Banks strategy for the environment sector in S A M . It will also serve as a basis for helping the Governments to develop a comprehensive national environmental action plan. (Serbia and Montenegro) national workshop on environment-poverty linkages were conducted in both republics and the outcomes provided inputs to the PRSP process, emphasizing the following issues : (a) poverty and quality of environment linkages, (b) poverty and sustainability of natural resource management; (c) poverty and vulnerability to natural disasters; and (d) poverty and vulnerable social groups (notably IDP, refugee and Roma communities). (Serbia and Montenegro) poverty profiles for both republics, and supporting background papers on labor market, gender, social impact of reforms and targeting of social transfers, were completed. The second stage, a participatory Poverty Assessment (linked to the PRSP process) was also completed during2002-2003. Public Expenditure and Institutional Review (PEZR). The PEIR provides an overview of the public expenditure reform agenda of the FRY and its two constituent republics. The report i s organized around four broad themes: fiscal sustainability, allocative efficiency, pension and health care reforms, and budgetary management. In both Serbia and Montenegro, the fiscal sustainability theme includes a case study of the electricity sector, which i s the largest reservoir of quasi-fiscal deficits. For Serbia, the allocative section also includes a case study of public sector wages. Country Financial Accountability Assessment (CFAA). This CFAA assesses risk by comparing the financial management standards and practices of S A M agencies using (or regulating the use of) funds against intemational or "best practice" standard. The risk assessment covers two dimensions: the risk to public funds (public financial accountability), and the riskto funds lent by the World Bank (fiduciary dimension). Serbia and MontenegroProposedProgram (activities atfederal level or covering both republics) Planned analytical work and technical assistance: (Serbia and Montenegro) A review of Public Administration and Civil Service Reform has been initiated to assess ongoing and planned reforms at Serbian, Montenegrin and Union level. The review will provide the basis for discussions on possible further World Bank involvement in these areas. The corruption prevention dimension of civil service and public administration reform will be given specific attention inthe review work. 40 0 (Serbia and Montenegro) An Znvestment Climate Assessment (ZCA) i s systematically analyzing conditions for private investment and enterprise growth. The ICA includes two components: (i) a standard core investment climate survey instrument, and (ii)an assessment of investment climate conditions. The ICA will seek to provide a policy recommendations that will guide the future country strategy and operations, in the areas of the investment climate specifically, and PSD more broadly. The ICA will complement the upcoming CEM and it will provide the underpinning for the Business Environment chapter of the CEM. In addition, a PSD policy note i s expected to provide an overview of the progress of privatization in Serbia since 2001 to date, and to evaluate the remaining challenges in the 2004-2006 period. The PSD note will focus on lessonslearned from and future prospects for the Serbian privatizationprogram. 0 (Serbia and Montenegro) Poverty Analysis. As part of the multi-year analyticalprogram in FY04 the Bank will prepare the following background papers: Monitoring Poverty in Serbia (Building a Statistical System); Chronic Poverty and Social Exclusion in S A M ; Rural Poverty in SAM; Social and Environmental Impact of Energy Tariff Reform in S A M ; BusinessEnvironment, Private Sector Growth andPoverty inSAM. 0 (Serbia and Montenegro) -Country Financial Accountability work will include assessments of selected local auditing companies to determine eligibility to work with the Bank and of commercial banks to determine eligibility for holding special accounts. 41 Attachment VZZ Republicof Montenegro Pre-MembershipSupport Duringthe first stage of World Bank assistanceto SAM, the Bank establishedatrust fund using $30 million of IBRDsurplusnet income to providegrant financingfor selectedpriority activities. One project for Montenegro is under implementation (bellow). Montenegro Environmental Znfrastructure Project (US$2.00million) inMontenegro focuses on improving solid waste disposal inthe coastalarea of Montenegro and improving the quality of the water supply inthe republic's Zeta Valley. Republicof MontenegroFY03Program Lending: Montenegro Energy Sector Learning and Innovation Credit (LZC)(US$5 million) The LIL is designed to (i) consumer response to the introduction of remote electricity metering and assess introduce automated billing and demand side management; (ii)facilitate the eventual privatization of distribution services; and (iii)lay the basis for comprehensive institutional strengtheninginthe energy sector. Montenegro SAC (US$15 million). The operation is designed to assist the republic in the implementation of a structural reform agenda in (i) publicexpenditure management; (ii) pensions; (iii) sector;(iv)labormarkets;and(v)thebusinessenvironment. energy Republicof MontenegroProposedProgram Lending: Montenegro Second Structural Adjustment (US$18 million). Building on SAC 1, the project would provide support for key reforms in Montenegro aimed at promoting economic growth and the consolidation of a sustainable fiscal framework. The reforms supported by SAC 2 are likely to be concentratedon: health care and pensions; the energy sector; and the business environment. Montenegro Health Systems Improvement Credit (US$7 million). This project will support the Ministry of Health and Health Insurance Fund to develop their reform program, including changes in laws, regulations and standards. It will invest in primary care and health information systems development. In collaboration between the Ministries of Health and Social Affairs and Labor, the project will also develop new models of financing and service delivery for old people andpeople with longterm mental illness and disability. Montenegro Environmentally Sensitive TouristArea ( U S 7 million). The overall objectives of the Project are to improve the environmental conditions in Montenegro's tourist areas. The Project Development Objectives will be achieved through the rehabilitation of the environmental infrastructure in the affected coastal municipalities. The total project costs will be 6.50 million 42 US$, of which US$ 5.00 million will be financed by IDA. Component Iwill include rehabilitation of the environmental infrastructure in the coastal municipalities, and Component I1 will assume closing of existing uncontrolled disposal site to detect any potential environmental hazard it might produce inthe future. Montenegro Pension System Zmprovement TAProject (US$4.00 million) (tentative- discussions on this project underway) will help to improve the effectiveness and transparency of the pension systemparticularly as it relatesto collecting social contributions and payingbenefits. The project would (i) strengthen the Pension Fund (PIO) particularly in its revenue and data collection functions; (ii)support improvements in the area of planning, process analysis, internal controls and communications particularly as they relate to the first pillar (public pension system), (iii) provide support for software development and consultancy, particularly as they relate to data exchange and enforcement functions with TreasuryMOF, and (iv) strengthen human resource management including a human resourcesassessment and basedon this, training for management and staff. 43 Attachment VZZl Republicof Serbia Pre-MembershipSupport Duringthe first stage of World Bank assistance to SAM, the Bank establisheda trust fund using $30 million of IBRD surplus net income to provide grant financing for selectedpriority activities. Four projects for Serbiaare under implementation. Serbiaprivate sector development technical assistance grant (US$6.00 million), supported by two co-financing grants from the Netherlands and Sweden (totaling around US$3.5 million) i s designed to provide urgent assistance to the Serbian Agency for Privatization to jumpstart privatization of socially-owned enterprises through tender (54 SOEs to be sold to strategic investors) and auction (small and mediumSOEs), strengtheninstitutional capacity in the Agencies for Privatization, Foreign Investment Promotion and S M E Development, and support measuresto improve the investment climate; Serbiafinancial sector development technical assistance grant (US$6.00 million) provides technical assistance to strengthens FRY'S Bank Rehabilitation Agency and to support the rehabilitation and rapid privatization of select majority state-owned banks and support the liquidation of insolvent banksnot selectedfor privatization. Serbia social protection grant (US$lO.OO million) for Serbia aims to improve the equity of the existing safety net while developing a more sustainable framework, support policy development for reform of the social insurance system, and promote a more market-oriented labor relations framework to facilitate initial restructuring. Serbia electric power emergency reconstruction project (US$6.00 million) for Serbia complements an EC-funded program, designed to help restore reliable electricity supply through urgent facility repair. It also supports improvements in the financial management of the electric power company and legal and policy advisory services. Republicof Serbia Post-ConflictFundGrants Post Conflict Grant - Southern Serbia Municipal Improvement and Recovery Program (SSMZRP) (US$ 1.00 million). The Project aimed at consolidating peace, preventingconflict and increasing livelihoods in multi-ethnic and minority regions in Serbia through the promotion of non-discriminatory governancetied to economic and social recovery initiatives. It has targeted the municipalities of Presevo, Bujanovac, Vranje, Medvedja, Lebane and Leskovac. The main objectives of this Project were: (i) establishing a locally owned development investment fund for 6 municipalities in Southern Serbia which would directly benefitthe populations of those municipalities; (ii) capacity building inkey local governance institutions and the economic development of the disadvantaged area; (iii) reduction of tensions between local communities of ethnic Albanians, Serbs and Roma; and (iv) supporting civil society initiatives to promote social cohesion and multi-ethnic activities. (completed January 31,2003) 44 Post Conflict Grant SerbiaDevelopmentand Piloting of a Financing Model and Delivery - Strategy for the Basic Health Services Pilot Project in Kraljevo Municipality/Dom Zdravlja. (US$ 97,900). The Grant aimed at supporting the implementation of an ongoing larger project financed by the International Committee of the Red Cross (Basic Health Services Pilot Project). The financing pilot has provided some early operational experience for the Bank to draw upon as it assisted Serbia with larger health sector reform issues. (completed January 31, 2003). Post Conflict Grantfor Public Support Serbia ConsensusBuildingfor the Reform. (US$ - 96,000). The main objective of this Project was to provide a channel for state-society dialogue and consultations on reforms and to assist federal and Serbian governments in their efforts to communicate their policies and gedprovide feedback from the stakeholders, experts and the civil sector. The financing was used for organization of several (10) sessions of the Reform Policy Forum (government officials, NGO's, experts, trade unions, chambers of commerce, professional associations) to debate and further develop the main aspects of the reform process, preparation and dissemination of policy papers in mass media (brochures, books, etc), round tables in ten cities in Serbia, which had discussed the main aspects of the reform. (completed June 30,2002). Republicof Serbia FY02Program Serbia Structural Adjustment Credit (SACI).(US$70million, fully disbursed), was designed to strengthen public expenditure management; and initiate reforms in energy, social pro.tection, health, and labor markets. (completed) Serbia Private and Financial Sector Structural Adjustment Credit (PFSAC I)(US85 million - fully disbursed) was designed to assist the Government in: (i)strengthening the financial system through an improved policy and regulatory environment and liquidation of troubled banks; (ii) privatizing and restructuring socially owned enterprises that crowd out private sector growth, hamper banking sector activity and are a source of quasi-fiscal risk; and (iii) improving the investment climate and business environment. (completed) Serbia Education Improvement Project (US$lO million - approved May 2002) aims to (i) build institutional capacity in the Ministry of Education, (ii) provide systematic information to policymakers to promote reform and improve teaching and learning, and (iii) empower local communities to take responsibilities for the schools. The project i s implementing well. It has directly benefited about 150 of Serbia's 1,120 primary and secondary schools, and helped to establish an Examinations and Assessment Center. Through this latter initiative, Serbia now participates in two international assessment initiatives which will help provide comparative feedback to policy makers and stakeholders on the overall quality and relevance of the country's education system. Republicof SerbiaFY03Program Lending: 0 The Social Sector Adjustment Credit (SOSAC) (US80 million) supports systemic reform of the pension system, improved targeting, equity and efficiency in the operation of social 45 assistance and child protection programs, reforms in active and passive programs for the unemployed, as well as key reforms in the health sector, including health financing and service. A Second Private and Financial Sector Adjustment Credit (PFSAC 11) (US$80 million) builds on and deepens the reforms implemented under the first PFSAC by supporting the process of enterprise restructuring and privatization in close coordination with the restructuring and liquidation of majority state-owned banks. The credit also supports the strengthening of business enabling environment in Serbia, the establishment of sound prudential oversight capacity for banking sector, and the development of sound regulatory environment for the non-bank financial institutions. A Bank and Enterprise Privatization and Restructuring Technical Assistance Credit (US11.0million) supportsthe implementation of structuralreforms initiatedunder PFSACI and continued underthe recently approved PFSAC 11. A Labor Learning and Innovation Credit (LZC) (US2.75 million) i s designed to build capacity in the public sector to promote more cost effective labor redeployment programs in partnership with a range of actors, piloting innovations in services for the unemployed and promoting an effective balance in privatization and restructuring programs between social mitigation, fiscal sustainability and facilitating re-entry to the labor market. It would also support efforts to monitor and evaluate the employment and other social impacts of different interventions. A Health Sector Reform project (US20 million) approved in May 2003, complements the policy reforms planned under the SOSAC by ensuring the availability of accurate and timely data for health policy making and developing the capacity of the health system to use these data effectively; modemizing the health financing system; improving the quality and access of health services by implementinghealth services restructuring as the first phase of a master plan to rationalize and modernize the health care delivery system; and strengthening the capacity of the Government to introduce soundhealth policy, planning and regulation. An ZDF Grant to assist Serbia in reforming its court administration system has been developed. The proposed Grant assists the MOJ and the judiciary to intensify their knowledge of the problems and needs of the court administration system in Serbia and'of existing models in other countries, build capacity and skills for court administration through provision of equipment and training, and prepare short-term measures as well as a medium- to-long-term masterplan for modemizing the court administration system. Analytical work and technicalassistance: e Serbia Motorway Sector and the Potential for Public-Private Partnerships Report. This report reviews of motorway sector in Serbia, highlight the lessons of experience with private sector involvement in other (especially CEE) countries, assess the main issues in the Serbian context, and clarifying the pros and cons of various options for addressing these issues. e Urban Transport in Belgrade Policy Note. Belgrade has undertaken a wide-ranging initiative to improve transport infrastructure and services following a decade of economic crises, war and political strife. The city is investing in its public transport fleet, rehabilitating roads and tram lines, constructing parking garages, and updating the traffic control system. At 46 the same time, it is overhauling its transport institutions and regulations within the framework of legislative reforms which are moving Serbia towards a market-basedeconomy. Partnersin this endeavor include the national Government, external donors and international financial institutions such as the EBRD and EIB. This note is written in the context of cooperation between the City Government and the World Bank. This note concentrates on unresolved policy and institutional issues; other partners focused primarily on investments. 0 Serbia Agricultural Sector Study (i) identified the major constraints inhibiting productivity and growth and (ii) develop the mainpriorities for short and medium-termaction consistent with a coherent long-term strategy for broad based agriculture and rural development. 47 Republic of Serbia ProposedProgram Lending: Second Structural Adjustment, Republic of Serbia. (US$40 million). Building on SAC 1, PFSAC 1 and 2 and SOSAC, the project would provide continued support for Serbian reform agenda. The reforms will focus on economy-wide structural reforms aimed at laying the foundation for enduring economic growth. The program will also contain policy measures to strengthenfiscal discipline, social protection, andpublic administration. Serbia Real Estate Cadastreand Registration Project (IDA US$21 million). The development objective for the proposedproject is to buildmore efficient real property registration and cadastre systems, with the purpose of contributing to the development of efficient real property markets. This will be achieved by improving the real estate cadastre and registration system operated by the Governmental Geodetic Authority (GGA) and its regional cadastre centers and local cadastre offices. More specifically, the project will support the phased transfer of the real property registration system - currently operating in the municipal courts into GGA, as stipulated in the - SSCR Law. This project will support the implementation of many parts of the SSCR Law including, establishing a one-stop-shop or window for real property registration and cadastre services, and providing access to this information for civil society and government. Serbia Transport Rehabilitation Project (IDA US$25 million). The main project objective is to help increase the efficiency of the transport sector and improve transport sector governance in Serbia. The Project would provide technical assistance, training and equipment for the Ministry of Transport and Communications and the Serbian Roads Directorate. It would also include implementation of two pilot contracts for current maintenance of the main and regional road network for three years. Serbia Energy Efficiency (IDA US$21million). The development objectives of the project are to (a) reducethe local and global environmental impact of the use of dirty fuels for heating buildings in Serbia, and (b) make heating more affordable by improving end-use energy efficiency. These objectives will be achieved by financing (a) the replacement of inefficient lignite and oil-fired boilers, at the end of their economically useful life, with a gas-fired plant at the Clinic Center in Belgrade; (b) energy efficiency improvements in selected public buildings such as schools and hospitals throughout Serbia, including selected buildings in the Clinic Center; (c) technical assistance to the Serbian Energy Efficiency Agency for capacity building, developing a pipeline of projects, institutional development, public outreachkommunications and monitoring and evaluation. An associatedGEF residential energy efficiency project is envisioned. While the IDA project will focus on improving the functional and health environments of public/social sector buildings, the GEF project would support the removal of bamers to energy efficiency improvements inresidential buildings. Planned analytical work and technical assistance: (Serbia) A Financial Sector Policy Note will provide an up-to-date analysis and gather data on Serbia's banking sector. The note will build upon reform efforts pursued under the ongoing PFSAC I1program which focuses on completing the resolution of troubled state banks. Inparticular, the study will attempt to benchmark levels of financial intermediation in Serbia, and provide an analytical basis of the performance of the country's banking 48 sector. This study will feed into the SAM's Financial Sector Assessment Program (FSAP) that i s currently planned for next year. 0 (Serbia) Economic Memorandum. A comprehensivereview of the Serbian economy with an emphasis on key sources of, and policies for, sustainable growth and employment creation. The report will focus on four areas where policies and further reforms are central to meeting these objectives: (i) the macroeconomic framework; (ii) internationaltrade; (iii) the private and financial sectors; and (iv) labor markets (including relevant issues in education reform). The report is designed to assist the incoming Serbian government in determining strategic reform priorities, and will also inform the development of the upcoming World Bank Country Assistance Strategy. 0 (Serbia) A Note on Privatization will provide an overview of the progress of privatization in Serbia since 2001 to date and an evaluation of the remaining challenges in 2004-2006. The report will review the application of the lessons learnt from the experience of other post-socialist countries that were applied in the Serbian privatization program. Special attention will be given to the challenge presented by the legacy of social ownership, a major obstacle to be overcome in the privatization of socially-owned enterprises. To provide a foundation for Banks future work inthe area, the study will discuss the prospects for privatization in Serbia with a special emphasis on the companies that were privatized under the old law as well as discussion of possibilities and benefits of the future privatization of the state-owned infrastructure. 0 FIAS i s working on an Serbian Administrative Barriers study which i s a sequel to FIAS's first diagnostic review "Republic of Serbia: The Climate for Foreign Direct Investment". It i s one of the first "self-assessment" studies carried out by FIAS, whereby much of the data collection from the government departments and private sector and initial analytical work is being done by a local consultant team using self-assessment tools devised by FIAS. The final draft report will be the focus of a workshop, sometime in the autumn 2003, and i s expected to lead to the preparation of an Action Plan for administrative andregulatory reform for submission to the government. 0 Serbia Energy Sector Study. The Serbia Energy Sector Study i s designed to formulate a medium-term strategy for the Bank involvement in the energy sector, focusing on electricity, oil and gas issues. The focus of the energy reform agenda going forward will be to establish the legal framework to enable commercialization in the sector, improve governance through the establishment of an independent regulator, increased use of competition within the sector and improved corporate governance from better accounting, auditing and financial management. 49 Attachment I X SERBIA AND MONTENEGRO Recent Progress on Structural Reforms November 11.2003 This report has been prepared by the Europe and Central Asia Region of the World Bank for the Donor Co-ordination Meeting for Serbia and Montenegro, to be held inBrussels on November 18,2003. It was prepared based on information and comments provided by Bank staff, government officials in Serbia and Montenegro, multilateral agencies, bilateral donors, and NGOs. The report reflects the views of World Bank staff. It is designed as a selective overview of progress in structural reforms, rather than as a systematic or comprehensive review of progress in all areas which have received donor support, or as a detailed sector-by-sector evaluation of relative progress inthe two republics. For this reason, it does not cover macroeconomic and fiscal policy, humanitarian assistance, or areas which, while important andor supported by donors, are not directly associated with structural reforms. 50 AttachmentI X Serbia and Montenegro Recent Progress on Structural Reforms Introduction 1. The transition of Serbia and Montenegro' to democracy and a market economy began under very difficult economic and social conditions. These conditions were the result of more than five decades of inefficient economic management and a decade of regional conflicts and international isolation that followed the break-up of Socialist Federal Republic of Yugoslavia in 1991. By 2000, recorded per capita GDP was less than half of its 1989 level, external debt exceeded 130percent of GDP, and annual inflation was over 113 percent. The authorities began to stabilize and transform the economy by tightening macro-economic policies and recommencing market-oriented structural reforms, combining their own efforts and with the strong support of the international community. In general, the reform process started earlier in Montenegro, while political events in Serbia prevented substantial reform before early 2001 when the newly elected republican government took office. 2. The renewed transition of Serbia and Montenegro to a market economy i s based on a .... government strategy with four mainpillars: restoringmacroeconomic stability and external balance; stimulating near-term growth and creating the basis for a sustainable supply response; improving the social well-being of the most vulnerable and buildinghuman capacity; and improving governance andbuildingeffective institutions. 3. The strategy was presented to a Donor Conference in June 2001, and summarized by the World Bank and European Commission in the medium-term Economic Recovery and Transition Program (ERTP).2 The assembled financial institutions and donors together pledged financial resources of around $1.3 billion to support the first phase of the program. Subsequently, additional support has come through new commitments of similar annual magnitudes and from debt rescheduling through the Paris Club, while negotiations continue with the London Club. One of the overall goals of the ERTP was to facilitate increasing integration with the European Union (EU)and the World Trade Organization (WTO). 4. The donors will reassemble in Brussels in November, 2003, to assess progress made on implementing the agenda, and to discuss future reform and assistance priorities. The purpose of this paper is to review performance under the ERTP during the past two and one-half years, in 'The Federal Republic of Yugoslavia completed its constitutional transition to Serbia and Montenegro in February 2003. In this report, the treatment of Serbia excludes the province of Kosovo, which is under U.N. administration according to UNSecurity Council ResolutionUNSC-1244. World BankEuropean Commission, Breaking with the Past: The Path to Stability and Growth, (Wash. DC, 2001), and Government of Serbia, The Reform Agenda of the Republic of Serbia: The Needsfor International Financial Assistance, (Ministry of International Economic Relations, Belgrade, 2003), and Government of Montenegro, Economic ReformandRecovery Strategy (National Aid Coordination Unit, Podgorica, 2001). 51 Attachment ZX terms of structural reform progress, problems encountered, and priorities for the f ~ t u r e .The key ~ areas treated are grouped into four main areas, as follows: Private Sector Incentive Framework Trade liberalization and customs reform Business environment Labor law reform Productive/ Financial/ Infrastructure Sectors Financial sector Agriculture Energy Transport Telecommunications Environment, water and waste management Public Sector Governance and public sector reform Privatizatiodpublic enterprise reform Judicial reform Social Sectors . Education Health Pension reform Social and child protection 0verview 5. Substantial progress has been made in almost all areas of the ERTP, although some have advanced further than others. As republican parliaments and governments retain most of the legislative and executive power, reforms have proceeded at different paces in each of the two republics. In Serbia, very impressive progress during the first roughly one and one half years of reform gave way to a period of slower but still broadly sound progress. The renewed commitment to reform and cooperation following the tragic assassination of the Serbian Prime Minister inMarch 2003 was short-lived, and the early summer saw a reemergence of politicking. While Montenegro's ruling coalition garnered a strong majority in the 2002 elections, political divisions and concerns of various stakeholders combined to work against an awaited major acceleration of structural reforms. In both republics, the need to agree on a new constitutional framework for the country required significant attention by government officials, also distracting attention from the reform effort. The relative cumulative progress in economic reform varies sectorally across the two republics, with Serbia more advanced in some areas and Montenegro in others. A separatepresentationby staff of the InternationalMonetary Fund, will review recent macroeconomic developments. 52 Attachment I X I. PrivateSectorIncentiveFramework Trade Liberalization and Customs Reform 6. Trade in general, and particularly the foreign trade regime, was under tight control of the previous political and economic elite during the 1990s. This was partly the heritage o f policies from the Communist era and partly the desire of empowered groups to maintain special benefits. As a result, the trade regime was non-transparent, highly protectionist (including non-tariff barriers) and overly regulated. 7. In FRY/Serbia, initial deregulation of foreign trade began in December 2000, when the then Federal Government cut various administrative barriers. Tariff reform began in 2001 with the passage of a greatly improved Customs Tariff Law. Average tariffs (unweighted) dropped from 14 to 9.4 percent, and the tariffs simplified from 37 to six rates, ranging from 1 to 30 percent. A large number of quotas and licensing requirements was also abolished. However, export controls continue on certain agricultural products, and import licenses continue on certain steel products. Any resurgence of protectionist sentiment i s inconsistent with the further liberalization required to enhance competition and create the foundations for export-led growth. InMontenegro, tariff reform began earlier, in 1999, and was more extensive. Tariff rates were set in a range of 0 to 15 percent, with an unweighted average of 3.4 percent. The existence of two tariff regimes, however, presents many problems within the State and i s a barrier to deepening SAM's relations with the WTO and EU, and also with the other countries of the region with which S A M intends to conclude free trade agreements. 8. An Internal Market and Trade Action Plan to harmonize trade, customs and excise regimes between the two republics and to create the single market envisaged by its Constitutional Charter was approved in August 2003. The result i s an initial harmonization for 93 percent of products at a rate somewhat between the relatively low rates of Montenegro, and the higher rates of Serbia, with some exceptions such as iron and steel products. A further group of tariffs will be harmonized over a period of 18 to 24 months, achieving an average unweighted tariff rate of about 7 percent. However, the schedule for the reduction of tariffs on 56 strategic (agricultural) goods has yet to be defined and special import charges and levies remain at the republican level. Other liberalization measures in the past year include the phasing out of non-tariff barriers on exports, with those on imports to be eliminated by end-2004 (except for steel products and certain illegal goods). SaM i s an active participant in the Stability Pact initiative to establish free trade agreements with other Pact countries. Autonomous trade measures (ATMs) have been unilaterally granted by the EU, permitting SaM unlimited duty free access to the EU market (with some minor exceptions, such as wine, baby beef, fish and textiles). Further work i s needed in the areas of customs administration, and especially in the coordination of phyto-sanitary controls and certification of origin. BusinessEnvironment 9. The pre-reform private sector environment in SAM was not business-friendly owing to a variety of factors, including: the collapse of rule of law; lack of regulatory legislation in many fields; lack of access to credit due to the poor state of the banking sector; non-transparent tax 53 Attachment I X systems with a high level of corruption in state administration; loss of foreign markets due to international sanctions; and the poor state of physical infrastructure. 10. Over the past two years, the governments of both Serbia and Montenegro have made progress in business-enabling reforms, including liberalization and deregulation of foreign trade and investment, simplification of the tax regime, and modernization of labor legislation. However, despite such progress, significantly higher domestic private investments have yet to be realized. The recent sharp increase in foreign direct investment has primarily come through privatizations in a few attractive sectors, with the high sales prices of some major firms partly reflecting the artificial erection of tariff and other barriers to competition. 11. Serbia. The Government of Serbia set an ambitious reform agenda aiming to: improve the regulatory framework for business entry; facilitate the efficient operation of business through modification of the Enterprise Law; improve enterprises' access to finance; and reduce barriers to the efficient exit and redeployment of non-productive assets. The Government launched a comprehensive reform of business registration at the end of 2002, and plans to complete the process by the second quarter of 2004. These laws would create a unified Serbian business registry that includes all business activities covered under the current Enterprise Law andLaw on Private Entrepreneurs. Considerable progress has already been made in achieving the objective of reducing the number of days and costs to register an enterprise. 12. The authorities have adopted a number of key laws and regulations aimed at creating a legal and institutional framework to support credit transactions and easier access to finance. The Law on Secured Financing initiated a framework that will be completed with the introduktion of the new pledge registry. The adoption of the new Law on Financial Leasing contributed to the establishment o f a leasing sector that i s enabling easier access to capital. A new Law on Concessions replaced the auctions approach with a more transparent tendering mechanism for awarding concessions, and i s expected to facilitate privatizations through BOT (Build, Operate, Transfer) schemes and similar arrangements. 13. The Government has drafted a new Bankruptcy Law. This very important act i s designed to create financial discipline that will encourage and facilitate the exit of unviable enterprises, as well as the restructuring of potentially viable firms (through U S Chapter 11-style reorganizations). The Law envisages the establishment of the Bankruptcy Administration Agency, and includes provisions to expedite bankruptcy proceedings and improve creditor rights. The rapid adoption and effective implementation of this long delayed law, which awaits parliamentary action, will be critical for hardening enterprise budget constraints and for reallocatingresources to the most effective uses. 14. The rapid progress in privatization and new private business development has exposed significant legal weaknesses, particularly in the area of corporate governance. The Government has prepared the draft law on Economic Entities (Enterprises) that aims to address these weaknesses, and provide for more flexible and effective legal forms for enterprises. This law i s expected to be considered by the Parliament in 2004. 54 Attachment ZX 15. Serbia has over 200,000 registered SMEs, including sole proprietorships. A new Small and Medium Enterprise Agency established in 2001 has since formed ten regional S M E agencies. The agency provides technical assistance and training to S M E entrepreneurs, and helps facilitate access to commercial credit. A new strategy on SME development was adopted in 2003, and the SME Agency has also been involved in the drafting of flaws on business environment, especially the Law on Private Entrepreneurs. 16. Montenegro. A similar program of improvements to the business climate has been undertaken in Montenegro. These include new business registration procedures which have significantly reduced the time for a basic start-up, and a new Bankruptcy Law that aims to make the process faster and more efficient, and permits the use of licensed trustees from the private sector. A Law on the Private Sector Participation in Delivery of Public Services sets the stage for the use of concessions, such as BOT and other devices to permit greater private sector involvement. The remaining capital controls on foreign transactions are expected to be phased out this year. In general, Montenegro i s more advanced in completing the legal framework for private sector development, but may face greater challenges in developing the institutional capacity neededto ensure their effective implementation. LaborLaw Reform 17. Both Republics inherited a system of labor laws that provided generous and unsustainable social protection both to workers and the unemployed, at the price of raising labor costs and discouraging labor mobility. At the same time, an inefficient system of labor bureaus focused mainly on providing free social services to the unemployed rather than on pro-active employment programs, such as retraining and education. High wage taxes and levies (70-100% of net wages) and benefits dictated through national and sectoral collective bargaining agreements, discouraged formal sector employment. As a result, a large gray economy developed of workers who are outside of the formal system and do not contribute to social security or other taxes, which in tum leaves these workers with little real protection and reduces government revenues from these sources. For the future, there i s a need to ensure that rigidities removed from labor laws are not simply replicated elsewhere, for example in collective bargainingagreements. 18. Serbia. A revised labor law passed in December, 2001 creates the scope for enhanced labor mobility andjob creation by simplifying the process of hiring and terminating employees, and by reducing labor costs. The law establishes basic employment criteria (age limits, working ability, prohibition of discrimination). Minimum levels of severance payments have been lowered from levels which were the highest in the world, and firing procedures have been simplified. Minimum wages can now be set independently by the Government, and can vary across job categories. Other wages are subject to collective bargaining agreements, including an overall national agreement. A new Law on Employment (July 2003) provides a basis for the reform of the existing Labor Market Bureau and allows for the establishment of private employment agencies. The law aims to foster a more pro-active employment policy by strengthening linkages between labor supply and demand. Recent reductions in the real level and duration of unemployment benefits, along with improved controls over payments, will improve the financial sustainability of the system and enhance incentives for seeking new 55 AttachmentZX employment. Nonetheless, benefits remain high by regional standards, and further reforms are required. 19. Montenegro. Labor legislation in Montenegro was reformed in 2003 with the long delayed enactment of a new labor law that reduced minimumrequired severance payments, paid maternity and other leave. Severance payments on job termination are set at 6 months of salary in the new law, down from an exceedingly high 24 months under the previous law. While the new law represents a major step forward, further amendments will be required to address remaining rigidities. Most specifically, labor markets continue to be regulated by a complex three-level set of collective agreements; a general agreement at the national level, as well as sector and specific company-level agreements. Minimumwages are set under these agreements for each job based on a negotiation between employer and unions. Also, many collective agreements call for severance payments and other benefits that are more generous than those specified in the law. The general agreement requires that workers laid off because of adverse economic conditions, etc. are entitledto continue to receive 50 percent of their salaries. Again, the challenge i s to ensure that rigidities removed from the labor law are not simply recreated at the level of such agreements. 20. High wage taxes remain a major deterrent to new job creation by the private sector. Wage taxes and contributions average about 94 percent for middle-level jobs (defined to be ones payingE250 per month), and even higher for higherpayingjobs. These taxeskollections include social security, income tax, unemployment fund, development fund and health levies, as well as some taxes introduced by local communities. The Government has instituted a temporary one- year reduced rate of 20 percent for jobs legalizedthis year. The result was a growth of registered employment of over 20,000 "new" jobs, and a 30 percent drop in registered unemployment. However, many o f these jobs appear to be brought on to the books from the gray economy, and could again disappear into the shadow economy once subject to normal levels of taxation. 11.ProductiveLFinanciaVnfrastructureSectors FinancialSector 21. The financial sector in both republics was in a very poor state for a long time prior to 2000. During the 199Os, there was no notable activity in credit markets and mobilization of resources for new investments was negligible. Much of the system, and particularly the largest banks, suffered from a chronic lack of liquidity. Public confidence in the sector was almost entirely lost due to recurrent shocks (freezing of private foreign currency savings, pyramid schemes, hyperinflation, etc). 22. Both republics have made concerted efforts to restore the viability o f the banking sector, improve supervision, privatize publicly-owned institutions and attract foreign banks to enter the market. Initial work has also begun on areas in the non-bank financial sector, including modernization of the stock exchange, and improved regulation of insurance companies. Despite this initial progress, interest rates remainhighand are a major deterrent to new investment. 56 Attachment I X 23. Serbia. Under the leadership of the National Bank of Serbia (NBS), 25 insolvent banks representing nearly two-thirds of the assets of the banking system have been liquidated or put under bankruptcy. The boldmeasuresto place the four largest state-owned banks into bankruptcy in early 2002 played a crucial role in restoring public confidence in the banking sector, which has led to a quite visible rebound in bank intermediation. A Bank Rehabilitation Agency (BRA) has been given authority to administer banks in bankruptcy. Seven new banking licenses have been issued (mainly to foreign banks), reflecting growing confidence in the Serbian banking system. In July, 2002, the Government initiated a debt-for-equity swap to resolve debts owed to the Paris and London Club financiers. This process, which remains incomplete, resulted in a de facto nationalization of a large part of the banking system, with the state currently holding controlling equity stakes in eight banks (including two of the three largest banks) and a significant stake in eight other banks (including the largest private bank in the country). These stakes will be offered for sale during 2004 - 2005, with tender procedures for the first three or four banks planned for first half of 2004. The closure of the ZOP (Accounting and Payment Operations Office) in early 2003 ended the government's monopoly on inter-bank settlements, and has helped foster financial sector growth. In 2003, Serbia joined the Egmont Group of Financial Intelligence Unitswhich work to combat money laundering. 24. Montenegro. The largest bank, Montenegrobanka, was sold in July 2003 after many assets and liabilities related to sovereign lending had been lifted out. The privatization of PodgorickaBanka, the last bank with a direct majority ownership of the state, i s underway. The offshore banks that had been registered in Montenegro, but produced little if any benefit to the legal economy in that republic, have now had their licenses revokedby the Ministry of Finance. All correspondent bankingrelationships with licensed banks havebeen terminated, and offices of these banks in Montenegro are under investigation. A Law on Anti-Money Laundering was also adopted in 2003. A recent Base1 I1Core Principles Assessment gave a positive assessment of banking supervision in Montenegro, with the Central Bank now moving to address those issues where compliance was not strong. With the closure of private Ekos bank in 2003, the liquidation of Jugobanka, and the assets lift and subsequent sale of Montenegrobanka, the central bank considers all banks to be liquid and in compliance with capital requirements. The transparent privatization of Podgoricka Banka and the creation of a viable mechanism for recovering the maximum amount from carved out assets and liabilities of restructured banks represent important near-term benchmarks inbanking reform. A deposit insurance scheme i s expected to be initiated in mid-2004, but capital is neededto finance the insurance fund. A new Insurance Law has also been drafted. Agriculture 25. Agriculture i s an important sector for both republics in terms of export, production and potential for poverty reduction. Agriculture i s estimated to represent over 20 percent of Serbia's GDP, and about 15 percent of Montenegro's GDP. Like other sectors, it has suffered from poor state policies, serious mismanagement (particularly within large state agro-enterprises), disinvestments and infrastructure destruction, and losses of international markets. In an attempt to prevent social unrest, past governments firmly controlled prices of food and agricultural products at low levels, discouraging production and investment in the sector, and leading to food 57 Attachment I X shortages. The rural sector continues to have high levels of poverty and low productivity and needs to be a focus in future poverty reduction plans. 26. Serbia. The principal reform effort in the sector has focused on agricultural trade policy. In2001, the maximum tariff was reduced from 40 percent to 30 percent, and the tariff structure was simplified. However, most agricultural commodities continue to benefit from the maximum protection rates of 20 percent and 30 percent, and trade policy remains a major form of support for producer prices. Additional unit tariffs, which were imposed on top of the ad valorem tariffs, have been reduced from a maximum of about 20 percent (tariff equivalent) to 15 percent. However, new temporary export license requirements were imposed in response to the drought of 2003. 27. The Government plans to develop a new law on cooperatives, which will help restore their ability to reduce input and marketing costs, and provide agricultural credit. While cooperatives have been an active element in the republic since the late 19thcentury, actions of the prior government destroyed much of their capital. The Government also plans to draft a national rural development plan, including the establishment of an Agency for Rural Development. This agency will focus on the problems of the republic's numerous small farmers. The Government also plans to improve the profitability of agriculture and the food industry by providing technical, management and marketing advice to farmers, food processors and traders. An additional need i s the rehabilitation of the irrigation system. The Government has already earmarked E40 million for this purpose. The Ministry of Agriculture has also drafted new modem laws on veterinary services and plant health protection, and i s drafting several other key pieces of agricultural legislation which are expected to be finalized by the end of 2003. 28. Montenegro. Agriculture in Montenegro i s heavily concentrated in livestock and fisheries. Nevertheless, the republic produces only 60 percent of its needs, and i s a net importer of meat, dairy and cereals. There are few subsidies, and price controls on milk were recently removed. A large one-fifth of the Government's budget for agriculture goes to provide pensions for farmers. A previous weak extension system has been reformed to bring better linkages with research institutes, and to provide workers with greater mobility. Likewise, the Inspection Service for veterinary and phyto-sanitary areas has been upgraded. Recent legislation has helped to set quality standards and provide regulation for fisheries and olive growing. The lack of agricultural credit remains an important constraint, as does the shortage of processing capacity for export products. Energy 29. The energy sectors in both republics suffered from a variety of problems prior to the reform period, including underpricing of services, lack o f adequate maintenance and investment expenditures, lack of competition, excessive employment and a resulting large fiscal drain on government resources. An additional factor in Serbia was the destruction caused by the conflict of 1999. As a consequence, there were frequent shortages in supply and unsustainable functioning of the electric power companies inboth republics. Significant steps have been taken to reform institutions andrestore financial viability to the sector. 58 Attachment ZX 30. Serbia. The Government of Serbia has made extensive efforts over the past three years to rehabilitate key sector assets, repair war damages, and restore a reliable supply of energy. Through as series of tariff adjustments, the average price of power was increased from 0.9 cents per kWh at the beginning of 2001 to nearly 4 cents per kWh at present. In parallel, the state- owned electric utility, EPS, has taken steps to contain its operating costs, including its real wage bill. The number of employees inthe core business has been reduced by around 900. About 20 subsidiary enterprises have been separated out of EPS and are slated for eventual privatization. The ratio of collections to new billings has improved from about 60 percent in late-2000 to 87 percent during the first eight months of 2003. The combination of bold reforms to improve finances of EPS and major donor-financed plant improvements has reduced winter electricity outages from 56 days in 2000/01 to zero in 2002103. In parallel, the quasi-fiscal deficit created by EPS has been reduced from 10 percent of GDP in late-2000 to about 4 percent in 2002. While present electricity prices are close to operating costs, a price of about 5 cents i s likely to be necessary to cover long runmarginal costs and eliminate the quasi-fiscal deficit. The planned combination of separation of entities and declaration o f redundancies, will lower total employment in EPS from 58,000 in 2000 to 33,000 by 2005. EPS still continues to pay the wages of more than 7000 employees that worked in Kosovo before the conflict of 1999. 31. Driven by the objective of EUaccession, the Government plans to expose energy entities to regional competition in the South East European Regional Energy Market (SEEREM) for both gas and electricity, and later to competition in the large EUmarket. A crucial new Energy Law, expected to be considered by Parliament in late 2003, will open up the electricity market to foreign competition, and give independent producers access to the transmission system, which will be taken out of EPS and made an independent entity. A new independent agency will be set up to regulate the sector, which will improve governance and provide a framework for private investment in the sector. Efforts to increase the efficiency o f energy use are being addressed by a new Energy Efficiency Agency. 32. The existing block tariff system provides highly subsidized electricity to low-level customers, which represent 70% of the total. These tariff blocks need to be adjusted so that the implicit cross-subsidy i s directed to poor households. 33. Montenegro. The sector suffers from a shortage of capacity, as no new major production investments have been made in the last 20 years. Local production i s approximately 2/3 hydro and 1/3 coal fired thermal. Thermal plants are very inefficient and have emissions levels well beyond EU standards. Montenegro imports about 30 percent of its needs (depending on rainfall and hydro production), largely due to the consumption of KAP, the large aluminum producer, which uses nearly 40 percent of the total. In 2001, Montenegro suffered from drought-induced electricity blackouts both in summer and winter seasons. Recent efforts have been successful in improving the situation. Prices were increasedby 23 percent in 2003, and now average about 4.6 Euro cents per kWh. However, electricity sales to KAP are currently set at 2 US cents per kWh, well below marginal cost. The publicly owned power producer, EPCG, i s currently in the initial stages of functional unbundlingwith the eventual goal of separation of transmission, distribution and production aspects. The new EUcompliant Energy Law passed in July 2003 establishes an independent regulator and sets the stage for regional and European integration. The new agency will be empowered to issue licenses for production, distribution and transmission of power, and 59 Attachment ZX to set rates. Efforts are beingmade to identify renewable, non-hydro energy sources, and well as the possible use of small hydro projects to close the energy gap. Prices need to be further adjusted towards full cost recovery levels, with implicit cross-subsidies more carefully targeted to the poor. Transportation 34. As in energy, the quality of transport infrastructure had deteriorated in the period preceding the reforms, as of a result of mismanagement, conflict in 1999, weak institutions, unsustainable tariff and financial policies, and misuse of funds. The capital stock was not maintained, and there was under-investment in rehabilitation, so that the quality of transport infrastructure i s lower than in most neighboring countries. An adequate transport network i s an essential prerequisite for sustained economic growth and integrationwith the European Union. 35. Serbia. During the past two years, the Government of Serbia has started needed institutional reforms, and rehabilitationheconstruction of equipment and infrastructure. Changes in management in state agencies and enterprises have led to better planning, and control of functions within the sector. Institutional reforms included the preparation of many important laws for the functioning of the sector, including drafts laws for railways, roads and road transport. The draft law on road transport will clarify the relationship between the Ministry of Transport and the RoadDirectorate, placingthe policy formulation functions with the Ministry. 36. The reconstruction of roads has been initiated with support from bilateral and multilateral donors and creditors. In 2002, 800 km of roads were repaired and this pace has continued into 2003. A Road Recovery Program i s being designed to define priorities and future needs. The Road Directorate i s moving to institute a new system of maintenance based on performance targets. However, more attention needs to be given to ensuring sustainability through funding adequate levels of maintenance, in order to stop long term deterioration in the network. The Government also needs to adjust its system of road user charges. 37. Physical rehabilitation of the railways also started in 2002, especially along Corridor X, which links Greece with other Member States of the EU. Due to a still significant backlog of maintenance and upgrading, much more work will be needed in the future. In addition, the very limited efforts to date at restructuring and financial strengthening o f the state railways company (which i s a major direct and indirect drain on the government budget) will need to be significantly accelerated through concerted measures to cut costs and raise revenues. Air transport faces similar problems. A major reconstruction i s needed of the airport in Nis, which was destroyed in 1999. There i s also a needto improve public transportation within larger cities. 38. Montenegro. Initial conditions of transport sector inMontenegro were similarto those in Serbia - institutional and regulatory weaknesses, deteriorated assets, etc. Reforms within this sector were heavily supported by multilateral donors and included technical assistance for development of regulatory bodies and rehabilitatiodrenewal of infrastructure and equipment. Transport i s an important issue for Montenegro which needs to reestablish links with neighboringnetworks and increase the use of installed capacities (e.g. the Port of Bar). 60 Attachment ZX 39. The Government i s taking steps to bring better organization to the roads sector. A new draft Roads Law would consolidate and coordinate roads planning and expenditures. At present, these responsibilities are divided between the Ministry of Public Works, the Directorate for Highways, and the Ministry of Transport. The result i s an imbalance between construction and maintenance, and the lack of proper planning for new road construction. An Air Traffic Control agency, jointly owned with the Republic of Serbia, has been set up to bring this operation up to European standards. Likewise, a new Maritime Safety Agency has been established to regulate shipping, including ship inspections, navigational aids, search and rescue, and ecological controls, again in keeping with EU standards. A new law for railways i s proposed, which will separate the maintenance of the infrastructure from the operations of the railway, opening up the possibility for the eventual privatization of the latter. An efficient railway operation i s seen as essential to maintain operations at the Port of Bar, which i s now working at only 20 percent of capacity. Telecommunications 40. Serbia. Reform in the Information and Communications Technology (ICT) sector, especially telecommunications, i s being driven by the EU accession agenda. The new telecommunications law was drafted taking into account the acquis communautaire. In recent years there has been a focus on rebuilding the ICT infrastructure but the effective monopoly held by Serbia Telecom and the lack of a clear regulatory regime has not been conducive to fostering private sector investment. As a result, the fixed telecommunications network in many areas i s inadequate in terms of the supply of basic telephone services, let alone sustainingbroader based economic development. 41. At a detailed level, there is lack of clarity in the regulatory regime and inadequate transparency in the regulatory processes. Asymmetric regulatory decisions between the mobile operators and the absence of an effective dispute settlement procedure are other areas of concern. In combination, these features of the regulatory regime act as a brake not only to the development of the ICT infrastructure but also to internet access and service development which represent the cornerstones of e-commerce development. 42. Montenegro. A new telecommunications law, broadly compatible with EUrequirements, was adopted in 2000. This law established a fully competitive environment from January 2004. Recent investment in the basic telecommunications infrastructure, both fixed and mobile, has resulted in a relatively well developed network in terms o f digitization and capacity. Future reforms of the sector will be concentrated on changes in market structure including the ownership/privatization of Montenegro Telecom and the requisite strengthening of the regulatory processes. Environment,Water andWaste Management 43. Serbia. Environmental management continues to suffer from an inadequate legal framework, overlapping competencies, limited institutional capacity and lack of investment funds for core problem areas. The latter include: lack of adequatemanagement of waste, notably hazardous industrial waste; pollution of surface and groundwater bodies; severe air pollution in 61 Attachment I X large cities and industrial areas, particularly near lignite-fired power plants and associated mines; deteriorating drinkingwater quality; and the lack of adequate sewerage, especially in poor urban settlements. Nevertheless, since 2001 the Government, supported by donors,' has taken initiated significant steps towards harmonizing its environmental management system with EUdirectives. 44. In the spring of 2002, the Government approved a Law on the System of Environmental Protection. The enactment of this law will be crucial for the establishment of a credible legal basis for improved environmental enforcement. New laws that deal with forestry, waste, and water are also in the pipeline, as well as by-laws on environmental impact assessment and strategic environmental assessment, integrated pollution prevention and control, and public participation. The Government recently also approved a National Strategy on Waste Management. A National Environmental Action Plan (NEAP) and four Local Environmental Action Plans are being prepared. The NEAP will have a special focus on stakeholder participation inprioritization and identificationof funding sources for the priority actions. 45. The draft Law on the System of Environmental Protection provides, inter alia, the basis for the establishment of an Environmental Protection Agency (EPA), which is an essential element for strengthening compliance and enforcement. There will be donor support to build capacity in the EPA, but the critical issue of adequate staffing and competitive salaries will require Government attention in the larger context of civil service reform. Another crucial issue for effective enforcement will be the streamlining of EPA competences with those of related agencies. This i s particularly the case for the water management sector. 46. Montenegro. The main environmental problems remain: severe air, water and soil pollution by a few large hotspot industries, mines and power plants; lack of satisfactory waste management and of wastewater treatment threatening the Adriatic coast and inland water bodies; shortage of drinkingwater in coastal areas during the summer months; limited public awareness on environmental protection, shortage and low quality water supply and appropriate sewerage in some rural areas, and recurring floods that have increased in severity inrecent years 47. Since 2001, some structural measures have been taken that will improve environmental protection. In some cities, notably Podgorica, tariffs for municipal wastewater and waste collection have been increased to levels that are closer to covering operating costs. This has helped improve the quality of services. The Govemment i s developing strategies for waste and wastewater management. It i s also developing by-laws on environmental impact assessment and strategic environmental assessment, integrated pollution prevention and control, and public participation. 48. Even with these advancements, there is still a serious need for capacity building for environmental management and for cooperation among governmental agencies. Adequate water and sanitation facilities are a limiting factor for the coastal tourism sector. Environmental concerns need to be incorporated into the privatization process of heavily polluting industries, particularly the aluminum smelter inPodgorica and the ironworks in Niksic. 49. In both republics, water and sanitation sector priorities are recovering from the last decade of neglected maintenance and almost no new investments, with an emphasis on 62 Attachment ZX improving service quality, safety and reliability. The efficiency of municipal utilities in charge of providing water and sanitation services needs to be improved, including through corporatization and separation from other municipal services. Greater efficiency and accountability would reduce the current substantial operating deficits of these utilities, thus improving their sustainability and capacity to contribute to investment needs. Increased private sector participation, particularly in larger cities, would also contribute to these goals. In Serbia, private sector participation may be feasible and effective in addressing some of the problems in the water and sanitation sectors of the larger cities. In Montenegro, improved coastal water quality and services, as well as the protection of important natural assets that form the basis for the tourism sector, are essential elements of the "business environment" and important building blocks for sustained growth inthe short and medium term. 111. Public Sector RefordGovernance Public Sector Reform 50. Inboth republics, the needto improve the efficiency andtransparency of the public sector i s a high priority. A decade of politicization and centralization of authority, combined with economic collapse and the outflow of educated and skilled people have left most public institutions in a very poor state. Frequent changes in regulations and institutions through non- transparent processes, little strategic planning, widespread corruption, and misuse of state institutions for political purposes all made public administration highly inefficient and a serious impediment to private sector growth. 51. Independent surveys of the business climate in SaM frequently point to serious concerns related to governance and corruption. SAM Authorities have begun to redress this legacy, and have taken steps to tighten financial controls and increase surveillance. Nonetheless, perceptions of corruption and the lack of financial transparency remain serious problems, and the magnitude of the challenges which lie ahead i s daunting. 52. Serbia. Ever since taking office, the Serbian government has identified public administration reform and improvements in governance as high priorities, equal to the need to reduce poverty and raise living standards. While there are positive achievements to report, particularly in public expenditure management, the pace of reform efforts so far has been below expectations. In2002, the Parliament approved the Law on the Budget System, which i s critical for a range of reforms and institutional changes to improve budget formulation, execution and control. These changes include establishing a more comprehensive medium term framework for budget formulation, improvements in budget execution (including the establishment of an interim treasury, and tighter controls over spending and new commitments), and greater accountability based on enhanced budget inspection and internal audit. In addition, the public procurement system was somewhat improved through the enactment in 2002 of a new Law on Procurement. However, further modifications to the legal framework are necessary, and the capacity of the new Public Procurement Agency needs to be significantly strengthened. The Parliament has also passed new laws on money laundering, combating organized crime, and the establishment of an ombudsman. However, laws related to establishment of an anti-corruption 63 Attachment ZX agency, conflict o f interest, and civil servant code of conduct, have stalled in the drafting process and have not yet been sent to Parliament. The Ministry of Finance and Economy has completed an inspection of all major govemment agencies and social funds, and its report was submitted to the Serbian Parliament. This report uncovered numerous cases involving possible criminal offenses. However, the public prosecutor has yet to move on most of these criminal cases. 53. The lack of progress in public administration restructuring and civil service reform is a cause for serious concem. Whereas donor-funded replacement capacity has filled some immediate gaps, the method through which this was achieved i s unsustainable. The availability of significant donor funding without related conditionality has left Serbia with a largely unreformed public administration system which hampers its ability to implement economic and social sector reforms. This i s both due to the lack of capacity in the middle and lower ranks of the administration and to weak incentives for better performance. The recent transfer of functions from the State level put further near-term pressure on the public administration system, which had to accommodate a large number of new functions, as well as on the Serbian budget. However, this i s likely to pose mainly a temporary challenge. Finally, the policy-making system remains highly fragmented, with low inter-ministerial coordination capacity and a largely administrative Government Secretariat. 54. The Govemment has recently shown awareness of the urgency of addressing weak public sector management capacity by initiating a reform of the management structures for public administration reform and re-launching the stalled process of developing the public administration reform strategy. The strategy should provide the basis for the implementation of a more consistent and effective public administration reform policy and create in the medium term the necessary capacity in the administration to effectively implement economic and social sector reforms. 55. Montenegro. Montenegro started the process of reforming its administration as early as 1998. However, the process stalled during the conflict in 1999 and the subsequent period of political instability in the republic. Following the formation of the new government, the reform process was re-launched. Montenegro's small size makes it particularly crucial to improve the efficiency of public administration, as a large civil service will be unaffordable, but experience to date shows that weak state capacity has been a major barrier to effective implementation of policies and reforms. 56. The welcome adoption of the public administration reform strategy and Law on Public Administration in summer 2003 provides the policy and legal framework for far reaching reforms inthe public administration system. In April, 2003, the government announced a plan to reduce public employment by 3,500, with an initial reduction of 1,000 this year. These redundancies will largely take place among police and teachers, which constitute the bulk of public employment. In addition, the Govemment is taking other steps to improve public administration, including the implementation of a new system to monitor budget execution and management. However, the long awaited establishment of internal and external audit functions has experienced significant delays. 64 Attachment I X 57. The Law on Ombudsman put in place a new independent oversight institution, with a broad mandate. The office i s currently being set up. The institution could potentially make an important contribution to the fight against corruption, as it can investigate charges on abuse of office. 58. A further package of legislation, governing both the internal management of the civil service and the accountability regime, i s scheduled for parliamentary action in late 2003. This includes the Civil Service law, the Law on Salaries, and legislation to establish the administrative justice system. The Law on Civil Service will establish a clear system for selection, promotion, and job descriptions in the civil service, and set up a Human Resources Agency to administer personnel matters within the Government. However, one key concern is whether the Montenegrin budget will be able to accommodate the creation of a large number of new institutions at this point intime. PrivatizatiodEnterprise Reform 59. Most of the companies in Serbia and Montenegro (like in other ex-SFRY republics) were organized as socially-owned, with ownership rights divided between employees, managers, and pensioners. This was one of the main raisons for enterprise inefficiency, misuse of funds and slow implementationof pro-market reforms. The first attempt to change social ownership was in 1989, when the first Yugoslav law allowed firms to be privatized by employees, at their initiative. In 1994, an amendment of the privatization law changed the privatization rules, resulting in popular discontent, extensive litigation, and a halt to the privatization process. In July 1997, the Serbian Government adopted the Act on Ownership Transformation. Once again, employees were given a right to decide whether or not to initiate privatization. As a result, shares in firms were distributed for free, or sold at a large discount, with 90 percent going to employees and pensioners. 60. Serbia. Under the Privatization Law passedinJune 2001, the Privatization Agency (PA) and the Ministry of Economy and Privatization have the mandate to sell about 2000 socially- owned enterprises. The law authorized the PA to adopt three approaches: privatization by tender for large enterprises, auctions of small and medium enterprises, and restructuring and subsequent tendedauction for larger enterprises that cannot be sold in their current condition. Significant progress has been made, with a total of 1113 enterprises offered for sale, and 895 sold (as of October 20034). The bulk of these have been sold under auction, where domestic natural persons can take up to six years to make payments, without interest. 61. About two-thirds of privatization revenues have so far come from the larger firms sold through tenders. Tender sales have been going more slowly, in part because these enterprises often have high debt levels, excessive employment, and in some cases excessive commitments to expensive social programs. A group of 49 socially-owned enterprises has been identified for intensive restructuring to bring their balance sheets to a position of positive net worth, if possible, or to be privatized by sale of assets. The PA has been working with creditors to establish viable settlement strategies that would enable privatization to go forward along with a program of new investment from strategic investors. Social programs for redundant workers are Of the total of 895, 140represent share sales of minority government interests held inthe Shares Fund. 65 Attachment I X normally a part of the package, giving redundant workers severance payments greater than the amount requiredby law. Given their precedent setting and fiscal effects, and their crowding out of better targeted social programs, such relatively generous severance packages are a source of concern. Revisions in the law passed in March 2003 have simplified the whole process by making it easier for buyers to acquire these assets, and reduces the requirement to retain redundant workers. 62. Major privatizations have included the sale of three cement factories, the fuel retailer Beopetrol, and two large tobacco companies. The significant increase in privatization revenues in 2003 partly reflects the granting of deficto tariff protection and other barriers to competition in key sectors. Adherence to the principles of openness and transparency in all privatizations will be crucial for a successful completion of the program. Despite progress with industrial enterprises, there has been very little progress in restructuring and privatizing large public corporations in infrastructure and transport, such as those for electricity, oil and gas, railway, airlines, and telecommunications. These enterprises create major fiscal pressures and have high levels of excess employment. 63. Montenegro. In Montenegro, privatization has occurred through the issuance of vouchers under the Mass Voucher Privatization (MVP) program and through direct sale via tenders and auctions. About 40 percent of industry remains in state hands, although the Government's target i s to sell several large companies by the end of 2003. In 2002, the Government sold 54 percent of the oil company Jugopetrol Kotor. Tenders have been prepared for large enterprises including major units of the giant aluminum conglomerate (KAP), the Niksic steel company, and the tobacco company. The government has offered 13 hotels for sale, of which nine have been sold. A tender for the state telecommunications monopoly was not taken up, possibly reflecting general problems with the global telecommunications market. This enterprise will be probably re-offered next year. The MVP program unfortunately generated many problems, since it fragmented ownership, which in turn blocked changes in corporate governance and made it more difficult to bringin strategic investors with fresh capital. The bulk of the shares for most firms remained with the Government and its share funds, including the Pension Fund. The Govemment i s designing a program to address these issues, partially through assistance to companies to cover redundancy costs, through restructuring of state debt, and through the reorganization provision of the new bankruptcy law. JudicialReform 64. The authoritarian regime prior to 2000 left the judicial system very weak, and opened the way for arbitrary decision malung and abuses. The corrupted and inefficient court system became one of the main obstacles for development of democracy and market economy duringthe 1990s. Prosecution and adjudication decisions were highly politicized, since the government directly influenced the prosecutor's office and judges. While S A M had long tradition of commercial law litigation, the system of commercial courts was not appropriate for a modem marketeconomy anddidnot enjoy the confidence of business people. 65. Serbia. In early 2002, the Govemment enacted five laws intended to bring the judicial system to European standards. These included the Law on Courts, which draws a line between 66 AttachmentI X judicial authority and executive and legislative authority. It also introduces a Court of Appeals and Administrative Tribunal. Other laws regulate the status of judges, guaranteeing their independence. A High Judiciary Council has been established to regulate the nomination of judges and prosecutors. Overall, although the judiciary appears to be operating more independently and effectively than in the past, problems remain, particularly with the commercial courts which still need more work on modernization of procedures and changes of staff. Large civil backlogs continue to exist. 66. Montenegro. InDecember 2001, the Montenegrin Parliament enacted a new Courts Act, which makes significant changes in the structure and operations of the judiciary. Under the new act, two new courts, an Appellate Court and an Administrative Court, are to beginoperations no later than July 1, 2004. Both courts are designed primarily to relieve caseload pressure on the Supreme Court, which currently i s requiredto handle large numbers of appeals from all courts in the system. This overload has adversely affected the ability of the Supreme Court to dispose of appeals in a timely manner and has slowed the issuance of necessary supervisory guidance from the Supreme Court to the other courts. The new Appellate Court will serve as an intermediate appeals court between the Supreme Court and the Superior, Commercial and Basic courts. The new Administrative Court i s to serve as the locus for the review of final administrative actions from government agencies. 67. The Courts Act also changes the structure and operations of the Judicial Council, which i s responsible for a variety of functions relating to the election, removal and discipline of judges and lay judges, defining responsibilities regarding the functioning of the courts, determining the number ofjudges and lay judges for each court, and for proposing the budget for the courts. The Council's responsibilities with regardto election, removal and discipline ofjudges, as well as the procedures to be followed in each case, are spelled out in detail in the new law. Planning for the implementation of these changes i s currently at a very preliminary stage within the government. There are a number of issues that need to be resolved, including space, personnel, equipment, training and other requirements. IV. Reforms inthe Social Sectors Education 68. Both Serbia and Montenegro see improved education as fundamental to raising labor productivity and reducing poverty in the long run. While both have accomplished much in education, including nearly 100% primary enrollment, the education system continues to suffer from a lack of relevance to the labor market (particularly in secondary and higher education), inefficient resource allocation at all levels, dilapidated infrastructure, limited capacity in monitoring and evaluation, and overly centralized and outdated management structures. In addition, there are issues involving the participation of certain groups, such as the Roma and the IDPS. 69. Serbia. Education reform has been a key priority of the Govemment, as expressed inthe PRSP and elsewhere. The republic has achieved near universal primary enrollment, but still has 67 Attachment I X problems meeting the needs of minority groups, especially the Roma population. Serbia's success in targeting resources on both improved qualityh-elevance and on disadvantaged populations will be contingent on finding efficiency gains, particularly in the secondary and higher education sectors. Both relevance and inefficiency issues in secondary education are related to the over-specialization of many programs and the lack of broad-based skills and competencies for secondary age children. In higher education, relevance and efficiency problems are caused by the fragmented university structure, low graduation rates and the fact that many students - who tend to come from the highest socio-economic levels -- receive free admittance andor state subsidies and have little direct incentive to limit the duration of their programs or choose programs with economic relevance. 70. The Government has developed an education reform strategy through consultations with stakeholders and drawing on international expertise and experiences. The first wave of this strategy focused on: decentralization and democratization; curriculum reform at primary and secondary levels; assessment and evaluation; teacher training; and improvements in vocational education. Inthe area of decentralization, the first major reform was the establishment of school boards with representatives of parents, teachers and the local community. The school boards were given authority to select school principals. In addition, the Ministry of Education and Sports has been reorganized and strengthened both at the central and at the regional level, and a better information system i s being put in place with World Bank funding. The new Law on Education, adopted on June 2003, provides a clear legal framework for the decentralized governance of education, and a system of professional development and licensing of teachers. A major curriculum reform i s being phased in at the primary school level, focused on ensuring learning outcomes through the implementation of student-centered teachingleaming approaches. Elementary education has been extended to a nine year program including compulsory and elective subjects. Steps have been taken to modernize the curricula in secondary vocational education, with a goal of integrating general and technical subjects, and setting the stage for life- time learning and improved mobility of the workforce. Following these efforts to modernize the curriculum, upgrading the skills of teachers to deliver these new programs are the highest priority. A Strategy for RomaEducation was presented for public discussion in October 2003. 71. Reforms in tertiary education have increased the flexibility in course and subject selection as well as the emphasis on science and technology. Much remains to be done, however, in terms of restructuring management at the University of Belgrade and improving the efficiency of public resource allocation. A new National Standards and Evaluation Center will focus on evaluation and outcome monitoring, modernizing student assessment, and establishing national standards for assessment and examination. 72. Montenegro. Given its common roots, Montenegro's education system shares many of the strengths (nearly full primary enrollments) and weaknesses (lack of relevance, inefficiencies, lack of monitoring and evaluation capacity, etc.) of the Serbian system. While an education law has been passed, it i s not as focused on decentralization as in Serbia. There have been excellent stakeholder consultations on education reform, and the PRSP and the Government's strategy document give a useful examination of the problems and possible solutions, including decentralization, teacher training, and curriculum reform. However, the Ministry of Education lacks both the institutional capacity and investment funding required to implement the desired 68 AttachmentI X reforms. As in Serbia, Montenegro should be focused on promoting better efficiency in secondary and higher education so that resources can be freed up to support quality and relevance, and to target disadvantaged groups. In order to achieve economies of scale, Montenegro could focus on regional cooperation, particularly with Serbia, to promote its reform efforts andmake it more viable for donors to support such a small population. Health 73. Health services in Serbia and Montenegro were always the responsibility of republican governments. By the end of 198Os, they reached a relatively high level of quality. With overall crises in the country, this sector suffered as chronic fiscal pressures left health prevention programs under-funded, equipment and buildings became dilapidated, and the supply of most of basic pharmaceuticals and materials was irregular and insufficient. All of these severely affected the working conditions for medical staff and the quality of health services provided, especially to the poor. 74. Serbia. Serbia's health care system still suffers from chronic fiscal imbalances. Efforts to stabilize it are needed both on the revenue and expenditure sides, and also need to focus on efficiency improvement to ensure continued access to and quality of services. Public spending on health was estimated at close to 7 percent of GDP in 2001. Once estimates of private expenditure are added, total health expenditure would range between 9 and 11percent of GDP, among the highest in the region. Financing is done via a combination of compulsory public health insurance and private out-of-pocket payments by patients. The cornerstone of the public system i s the Health Insurance Fund(HIF)which receives earmarked payroll contributions from employees, employers, self-employed, farmers and the Pension and Employment Funds. Transfers from the Republic budget are meant to cover health care provision for the uninsured, including the unemployed, refugees and IDPs. Budget funds also finance some capital investment, training and public health programs. In recent years, there have been arrears in payments of some transfers to the HIF, and the IF,hospitals and health centers have accumulated debts to suppliers and run arrears in payments to utilities. 75. Health reform has been delayed because of a lack of continuity in ministerial leadership and fragmentation of responsibility for health policy and planning, and because health policy has not yet attracted high priority attention from the Government. Some initial progress has been made in tackling the problems of the sector, primarily in reducing arrears in health sector revenues and controlling HIF expenditure via contracts with public healthcare providers, though there are concerns that blunt expenditure control may have reduced patient access to care. In addition, extensive analytical work and consultation over health policy and strategy has taken place. Other important reforms have included the adoption of a new and more limiteddrug list for publicly financed drugs, and the introduction of co-payments for selected health services. However, further efforts need to be made to eliminate the extensive exemptions on co-payments which are not well targeted to the needy. In addition, the Government has sent to the Parliament new pharmaceuticals law that will increase access and competition in the market, and strengthen quality and safety regulation. 69 Attachment I X 76. A major issue yet to be addressed is the inefficiency and inequity in the health care delivery network. Many hospitals have low capacity utilization and inefficiently configured infrastructure. There i s overstaffing and low productivity, particularly among non-medical staff, and sub-optimal distribution of staff (areas of shortages in some places, with overstaffing in others places). 77. Montenegro. Montenegro's health system faces challenges in finance and governance, and in the delivery of health services. Public and total health expenditures are high (public expenditure was 7 percent of GDP in 2001 and estimated total health expenditure about 10 percent of GDP). The level of expenditure per capita at around US$lSO in 2002 i s low, although it is higher than in Serbia, Bosnia-Herzegovina, or FYR Macedonia. The current public health financing and delivery system i s not financially sustainable due to problems of inadequate revenues, arising from contribution waivers, difficulty of collecting contributions from small businesses, farmers and the informal sector, and lack of adequate budget transfers for the uninsured, including refugees and IDPs. Inaddition, there has been a failure to adjust the generous benefits package and capacity to reduced economic circumstances. Pharmaceutical expenditure has grown rapidly in recent years and now stands at a very high almost 30 percent of HIF expenditure, plus widespread out-of-pocket payment. Montenegro's health sector institutions have limited capacity for policy-development, planning, forecasting, managing and monitoring the system, and information systems and data for these functions are weak. 78. The Montenegro Ministry of Health and Health Insurance Fund have developed a Health Sector Strategy to address a number of these issues, and the Health Insurance Fundhas embarked upon information systems investment to support improvement in revenue collection and control of pharmaceuticals expenditure. 79. Although Montenegro has achieved substantial improvement in health indicators for the population, there has been some stagnation or decline in key health indicators in recent years. A particular challenge i s that of meetingthe health needs of the highnumber of refugees and IDPs, including many Roma, that entered Montenegro following the Bosnia and Kosovo crises. The Ministry of Health i s in the process of developing new laws and policies to respond to a number of these issues, including new laws on health care, health insurance and pharmaceuticals and medical devices. It i s planning substantial investment in development of primary health care, and i s developing plans for upgrading the Institute of Public Health, and for developing mental health services. PensionReform 80. Both republics have suffered from a heavy burden of pension obligations, as a result of an overly generous pension benefit scheme combined with an aging population, growing informal employment, and an inadequate tax base. General economic crises led to an accumulation of arrears towards pension funds since entitlements were not adjusted in line with reduced resources, and since many employers, particularly large state enterprises, were not able to pay contributions for their employees. This constellation of adverse factors ledto large deficits inthe pension funds that hadto be met from general budget revenues. 70 Attachment I X 81. Both republics have taken important steps to reform their pension systems, in the first step focusing on reformulating the parameters of their PAYGO systems. Reforms in both republics were designed along the similar lines and included increase in pension retirement age, widening of the calculation period, lowering the accrual rates through introduction of a point- based formula, reducing the generosity of indexation, transferring or eliminating many non- pension benefits, and tightening eligibility for disability. 82. Serbia. One fifth of the population of Serbia receives pensions, and the ratio of active contributors to pensioners among employees was 1.35:1 in 2002. Pension outlays (excluding military pensions and health contributions) totaled about 13 percent of GDP. Prior to launching a pension reform package, the contribution rate was lowered from 32 percent to 20.6 percent of salaries. The bold changes to Serbia's PAYGO pension system, introduced through two rounds of reforms in 2001 and 2003, rank among the most important achievements so far in Serbia's overall reform program. Specific changes included raising the retirement age limit by three years to 63 for men and to 58 for women. Benefits are indexed by a combined index of wages and prices (Swiss formula), and pensions are now based on life-time earnings. A minimum pension of around 20 percent of the average gross salary was also established. Benefit rules for disability pensions were also tightened. Over time, these reforms are expected to reduce the cost of the pension program by 2 percent of GDP, but still leave a deficit. 83. Serbia remains the only economy in the region with three separate PAYGO funds; workers, farmers and self-employed. Only the Self-employed Fund i s current on pension benefits, while the others have arrears ranging from 1.5 months (workers) to 16 months (farmers). The government has been considering the possibility of merger of the three funds to promote efficiency. The pension reformists in Serbia will have to consider the pros and cons of further reform of the mandatory system. The government has already fostered work on introduction of a voluntary pension pillar. 84. Montenegro. Pension expenditures equal about 13 percent of GDP, and there are 1.3 workers for one pensioner. Wage taxes for social security account for 24 percent of salaries (employees 12 percent, employers 12 percent). However, contributions cover only 60 percent of pension costs. After significant delay, a reform law was passed in September 2003. This law putsforth certain parametric reforms of the PAYGO system, most notably a five-year increase in retirement age (to 60 and 65 respectively for women and men, to be phased in over ten years), indexing (Swiss formula of wages and prices), and benefit calculation (move to a point system). Benefits will be based on total lifetime contributions, not the most recent 10 years, but this reform will be phased in over 15 years. The introduction of some funded elements i s expected to follow. Even with the reform deficits from the system will continue, in part because the reforms are phased in over time, and in part because of the need to pay veteran and other special pensions. Social andChildProtection 85. Both republics retained the key features of the former Yugoslav social welfare system, though in Serbia, in particular cash transfers became increasingly dysfunctional during the 1990s. Like other sectors, social and child protection suffered from chronic lack of finances 71 Attachment I X which led to decrease of average benefits paidand an accumulation of arrears. Efforts have been made recently to target benefits to the poor, and eliminate duplication. 86. Serbia. Total social assistance and child assistance expenditures equal about 1.2 percent of GDP, lower than in most other countries in the region. The main social assistance benefit, Material Support for Families (MSF, or MOP in Serbian), i s aimed at individuals and families whose income i s lower than the guaranteed "social security level". Only about 40,000 households currently receive the MSF,compared to about 230,000 households below the poverty line, Decentralization of eligibility thresholds for social assistance has contributed to low coverage rates in poorer areas. In 2001, the Ministry of Social Affairs (MOSA) introduced some temporary corrections to increase the size of the MSF in these areas. In 2002, the M O S A proposed legal amendments to introduce a republic-wide eligibility threshold and index benefit levels to the cost of living. These changes are expected to increase the number of welfare beneficiaries to about 53,000. In addition, they will increase benefits for over 20,000 household with seriously disabled members in need of regular care in the home. The government has recently introduced emergency measures to mitigate the negative impact on the very poor and vulnerable households of risingutility prices. This includes new cash benefits duringthe heating season to around 46,000 households with seriously disabled members, and selected poor households with low energy use. 87. The system of child support provides cash grants for children of poor families. About 500,000 children (160,000 families) benefit from the program. A new law on financial support to families with children improves targeting of the child protection system, allowing adequate and sustainable benefits for children from poor .households. The new law aims to strengthen support to children through promoting equal access throughout Serbia, tightening targeting o f child allowances, maintaining the real value of support to poor families, and reducing the duplication of benefits. It seeks to eliminate any overlap between the social assistance and child protectionprograms. The effect i s expected to be a reduction inthe number of beneficiaries, and a lower level of overall expenditures. 88. In the past, during the Government's financial crisis, many social payments were delayed. In2001 and 2002, the Government established, with donor support, a special "one-off' fund which allowedit to clear arrears and increasingly bringpayments upto date. 89. Montenegro. The republic has a system similar to that of Serbia, and spends about 6 percent of its total budget on social protection activities (excluding pensions). The main program i s also the MSF. Eligibility includes those who are unable to work, who have no family to support them, or who must support minor children. Eligibility depends on a family's size and income relative to the average wage. For instance, a family of four i s eligible if their income i s less than 70 percent of the average wage. The maximum benefit i s 95 Euros per month for a family of five. The MSF income supplement i s designed to bring their total income up to the eligibility amount. About 10,000 families currently receive the benefit, an increase from 8,000 in 2001. This increase was largely due to a liberalization of eligibility in 2001to include those who are capable of working but must support minor children. 72 Attachment ZX 90. The system of child protection initially provided child allowances to all families with children. Changes introduced in 2001 limitedthis benefit to those under the MSF, so that the number of beneficiaries was sharply reduced, but limitedtherefore to those who were poor. For the future, the Government will introduce new legislation which will further unify the two programs, integrate these programs better with the work of NGOs, and provide for greater decentralization to municipalities. Conclusions 91. The reform process has made significant progress in many areas, particularly in macroeconomic stabilization, trade liberalization, privatization, bank resolution, pension reform and social protection. Major efforts have been made to open the country to foreign trade and investment, and adopt the practices of a modern, market economy. Ultimately, the goal i s to invigorate the growth process, so as to increase income levels, reduce poverty and provide jobs for the unemployed. The past reforms have helped lay the basis for this economic recovery, and for an future association to the EUand WTO membership. However, in many areas the reforms are still incomplete, and in several areas the reform process has hardlybegun. One of the highest priorities i s the reform of the public sector, whose institutions are critical for the implementation of the overall reform agenda. 92. Key specific priorities for improving the private sector incentive framework include: adopting and implementingthe new laws and regulation on business registration and bankruptcy (Serbia); taking steps to further reduce labor taxation, and to limit the impact of collective bargaining agreements on labor costs; completing an internal market between Serbia and Montenegro as laid down in the Constitution; achieving further multilateral trade liberalization; fully implementingthe free trade agreements concluded with neighboring countries; completing the single foreign trade policy of the State, including establishing appropriate institutions; and agreeing on a timetable to harmonize remaining tariffs and other import charges. 93. Key priorities for strengthening the productive, financial and infrastructure sectors include: continuing with the privatization of financial institutions; harmonizing phyto-sanitary controls with EU standards; adjusting energy prices (including to large customers in Montenegro) so that only poor consumers are subsidized; bringing greater commercialization of the energy sector, including the establishment of an independent regulator; making more concerted efforts to restructure the state railways; and taking steps to replace deteriorated transport infrastructure. 94. Key specific priorities for reforming the public sector include: taking steps to reorganize and modernize institutions, including the establishment of a professional civil service; making further improvements in accountability and transparency; developing and implementing a sound anti-corruption strategy and its legal and institutional framework, including passage of laws governing conflict of interest (Serbia); making further progress on the establishment o f an independent judiciary, including implementation of new laws (Serbia), and the passage of new laws (Montenegro); and completing the privatization and restructuring of industrial enterprises, 73 Attachment ZX focusing on some of the larger and more difficult cases, using where necessary the new bankruptcy laws. 95. K e y priorities for reforming the social sectors include: further reform of secondary and higher education, including efficiency enhancements; increasing efficiency in the delivery of social services, particularly in health; undertaking efforts to replace deteriorated health and education infrastructure; and reforming the administration of state pensions. 74 Annex 1 Serbia and Montenegro at a glance 2/4/04 Europe & Lower- POVERTYand SOCIAL Serbla and Central mlddle- Montenegro Asla Income 1Developmentdiamond. 2002 Population, mid-year(millions) 8.3 475 2,164 Lifeexpectancy GNI per capita (Atlas method, US$) 1,400 1,960 1,240 GNI (Atlas method, US$ billions) 11.6 930 2,677 T Average annual growth, 1996-02 Population (%) 0.1 0.1 1.o Laborforce (%) 0.4 0.6 1.2 GNi Gross per primary Most recent estimate (latestyear available, 1996-02) capita nrollment Poverty (% ofpopulation belownationalpovew line) 10 Urbanpopulation(% of totalpopulation) 53 63 46 Lifeexpectancy at birth (years) 72 69 69 Infant mortality(per 1.000livebirths) 12 20 33 Childmalnutrition(% of children under5) 2 11 Access to improvedwater source Accessto an improvedwater source (% ofpopulation) 90 60 Illiteracy (% of populationage 754 3 15 Gross primaryenrollment (% of school-agepopulation) 69 102 107 -Serbia andMontenegro Male 69 103 107 Lower-middie-incomegroup Female 70 101 107 KEY ECONOMIC RATIOSand LONG-TERMTRENDS 1982 1992 2001 2002 Economic ratios. GDP (US$ billions) 11.6 15.7 Gross domestic investmenVGDP 13.6 16.1 Exportsof goods and ServicedGDP 23.7 20.7 Trade Gross domestic savingdGDP -7.2 -7.0 Gross nationalsavingdGDP 9.1 7.2 T Current account balance/GDP -4.6 -8.8 InterestpaymentdGDP 0.6 3omestic Investment Total debffGDP 101.4 76.0 savings Total debt seNice/exports 2.4 3.5 Presentvalue of debffGDP A. Presentvalue of debffexports Indebtedness 1982-92 1992-02 2001 2002 2002-06 (averageannualgrowth) GDP 5.5 4.0 3.8 -Serbia andMontenegro GDP per capita 5.7 4.3 3.8 .......Lower-middieincomeD~UD Exportsof goods and services 7.7 18.2 16.8 STRUCTUREof the ECONOMY (77 of GDP) Agriculture Industry Manufacturing Services Privateconsumption 97 98 99 w 01 02 Generalgovernmentconsumption 17.4 18.3 Importsof goods and services .. 44.6 43.8 (averageannualgrowth) Agriculture 40- Industry Manufacturing Services Privateconsumption .. 14.9 6.3 Generalgovernmentconsumption 6.1 11.6 97 98 99 w 01 02 Gross domestic investment 9.2 34.4 Expotts -O-lrl?pOltS Importsof goods and services .. 30.0 26.3 Note:2002 data are preliminaryestimates. Group data are through 2001 *Thediamondsshow four key indicators inthe country(inbold) comparedwith its incomegroup average. if data are missing,the diamondwill be incomplete. 75 Annex 1- continued Serbia and Montenearo PRICES and GOVERNMENTFINANCE 1982 1992 2001 2002 Domestic prices lnflatlon (%) 1 ph change) Consumer prices 91.1 21.2 ImplicitGDP deflator 91.7 25.5 Government finance pA of GDP, includescurrentgrants) Current revenue 38.9 42.8 96 97 98 99 00 01 Current budget balance 0.2 -1.1 I Overall suroluddeficit -1.4 -4.5 -GDPdeflator - 0 ' C P I TRADE 1982 1992 2001 2002 (US$millions) Export and Import levels (US$mill.) Total exports (fob) 2,003 2,412 I Food 6.000 Other fuel 5,WO Manufactures 4,000 Totalimports (cif) 4,837 6,320 3 . m Food 2,OW Fuel and energy I i.wo Capital goods 0 Exportprice index (1995=100) 98 97 98 99 W 01 Importprice index (1995=100) Exports W Imports Terms of trade (1995=100) BALANCE Of PAYMENTS 1982 1992 2001 2002 1 Current (US$ millions) account balance to GDP(Oh) Exportsof goods and services 2,743 3,241 0 Imports of goods and services 5,160 6,857 1 Resourcebalance -2,417 -3,616 2 -3 Net income -26 -111 4 Net current transfers 1,915 2,343 5 4 Current account balance -528 -1,384 7 Financingitems (net) 923 2,2m 8 Changes in net reserves -395 -816 9 Memo: Reserves including gold (US$millions) 1,169 2,280 Conversion rate (DEC, loca//US$) 66.7 64.2 I EXTERNAL DEBT and RESOURCEFLOWS 1982 1992 2001 2002 (US$millions) Composltlon of 2002 debt (US$mlll.) Total debt outstandingand disbursed 11,740 11,912 IBRD 1,840 2,175 IDA 0 167 Total debt service 107 168 iBRD 75 IDA 0 Compositionof net resource flows Official grants Official creditors 242 Privatecreditors Foreigndirect investment Portfolioequity E 2.837 World Bank program Commitments A IBRD E Bilateral Disbursements B IDA D Other multilateral - F Private Principal repayments 0 C IMF --- G Short-term --- Netflows Interestpayments 75 Nettransfers DevelopmentEconomics 2/4/04 76 Annex 2 Serbia and Montenegro Key Economic Indicators - Actual Estinrated Projected Mcator 1998 1999 ZOO0 Mol 2002 2003 2004 2005 2006 Nationalaccounts(as % of GDP) Total Consumption 97.6 102.0 102.7 107.2 107.0 104.7 103.0 101.6 99.3 Grossdomestic fixed investment 11.7 14.2 13.6 13.3 15.8 16.0 17.3 17.8 19.0 Govemmentinvestment 1.8 2.4 3.1 1.6 3.6 2.5 2.9 3.5 3.9 Private investment 9.9 11.8 10.5 11.7 12.2 13.5 14.4 14.3 15.3 Exports (GNFS)a 22.5 21.0 29.6 23.7 20.7 20.3 22.9 25.7 28.0 Imports(GNFS) 31.5 34.6 46.5 44.6 43.8 41.3 43.3 45.4 46.0 Gross domestic savings -2.7 -7.2 -7.0 -4.7 -3.0 -1.6 0.2 Gross national savingsc 10.4 9.1 7.2 7.8 9.0 10.4 12.4 Memorandum items Grossdomestic product 8603 11577 15662 20627 20915 21077 21851 (US$millionat currentprices) Real annualgrowthrates (%, calculated from 1998prices) Gross domestic product at market prices 5.0 5.5 4.0 3.0 4.0 4.0 4.0 Balanceof Payments(US$ millions) Exports (GNFS)a 3947 2147 2547 2743 3241 4188 4781 5411 6062 MerchandiseFOB 3033 1676 1923 2003 2412 3011 3352 3799 4267 Imports (GNFS)a 5270 3538 4004 5160 6857 8526 9054 9572 10087 MerchandiseFOB 4849 3295 3711 4837 6320 7809 8220 8694 9176 Resourcebalance -1323 -1391 -1457 -2417 -3616 -4338 -4274 -4161 -4025 Net current transfers 655 668 1119 1915 2343 2818 2856 2955 2935 Current accountbalance -660 -764 -327 -528 -1384 -1750 -1768 -1636 -1601 Net private foreign direct investment 113 112 25 165 562 1205 500 600 800 Long-termloans (net) 25 12 213 299 378 715 761 1004 639 Official b 774 666 881 626 Private -59 95 123 13 Other capital (net, incl. errors & omissions) 407 529 335 459 1260 597 550 300 355 Change inreserves c 115 111 -246 -395 -816 -767 -43 -268 -193 Memorandum items Resourcebalance(% of GDP) -16.9 -20.9 -23.1 -21.0 -20.4 -19.7 -18.4 Annual dollar-value growth rates Merchandiseexports(FOB) -44.7 14.7 4.2 20.4 24.8 11.3 13.3 12.3 Merchandiseimports (CIF) -32.0 12.6 30.3 30.7 23.6 5.3 5.8 5.5 77 Annex 2 - continued Serbia and Montenegro Key Economic Indicators - (Continued) Almal Estimate Projected IRdiaOr 1998 1999 m 2.001 2.m 2003 2008 2w5 2006 Public finance (as % of GDP at market prices) d Current revenues 36.7 38.9 42.8 40.9 40.9 40.6 40.1 Current expenditures 34.5 38.7 43.9 42.5 41.7 40.8 39.8 Current account surplus (+) or deficit (-) 2.2 0.2 -1.1 -1.6 -0.8 -0.2. 0.3 Capital expenditure 3.1 1.6 3.4 2.5 2.9 3.5 3.9 Overall balance -0.9 -1.4 -4.5 -4.1 -3.1 -3.7 -3.6 Monetary indicators M2/GDP e 14.0 18.6 22.8 25.0 29.4 33.0 Price indices Real exchangerate (US$/LCU) (2OW=l00) f .. 100.0 134.0 164.4 190.0 186.4 184.2 181.0 Retail price index - periodaverage(% change) 69.9 91.1 21.2 11.2 9.7 7.5 5.4 a. "GNFS" denotes "goods andnon-factor services." b. Includesuse of IMFresources. c. Ona gross basis d. Consolidated generalgovernment e. Comprises Serbian dinar-denominated money supply only f. "LCU" denotes "local currency units". An increaseinUS$/LCU denotesappreciation 78 Annex 3 Serbia and Montenegro Selected Indicators*of Bank Portfolio Performanceand Management As Of Date 1/28/2004 Indicator 2001 2002 2003 2004 PortfolioAssessment Numberof Projects Under Implementationa 2 a 15 15 Average ImplementationPeriod(years) 0.0 0.6 1.o 1.5 Percentof Problem Projectsby Number 0.0 0.0 6.7 6.7 Percentof Problem Projectsby Amount a, 0.0 0.0 4.2 7.6 Percent of Projectsat Risk by Number a * d 0.0 37.5 6.7 6.7 Percentof Projectsat Risk by Amount 0.0 13.9 4.2 7.6 DisbursementRatio (YO)e 0.0 52.9 22.1 7.2 PortfolioManagement CPPR duringthe year (yes/no) SupervisionResources(total US$) Average Supervision(US$/project) MemorandumItem Since FY 80 Last Five FYs Proj Eva1by OED by Number 1 1 Proj Eva1by OED by Amt (US$millions) 69.6 69.6 Yo of OED Projects RatedU or HU by Number 0.0 0.0 Yo of OED Projects RatedU or HU by Amt 0.0 0.0 a. As shown inthe Annual Reporton Portfolio Performance(exceptfor current FY). b. Averageage of projects in the Bank'scountry portfolio. c. Percentof projects rated U or HU on developmentobjectives(DO) and/or implementationprogress (IP). d. As defined under the Portfolio Improvement Program. e. Ratioof disbursementsduringthe year to the undisbursedbalanceof the Bank's portfolioat the beginningof the year: Investmentprojectsonly. * All indicatorsare for projectsactive in the Portfolio,with the exception of Disbursement Ratio, which includes all active projects as well as projectswhich exited duringthe fiscal year. 79 Annex 4 Serbiaand Montenegro IBRDADAProgramSummary - As of 01/28104 ProposedIBRDADABaseCaseLendingPrograma Fiscalyear Proj ID StrategicRewardsb Implementation b US&?) (WWL) Risks (WWL) 2004 ENERGY EFF 11.0 H ENVIRONMENT(MONTENEGRO) 7.0 H REAL ESTATECADASTRE 11.0 H SAC2 (MONTENEGRO) 19.0 H SAC2 (SERBIA) 70.0 H TRNSPTREHAB 15.0 M PENSIONIMPROVEMENT (MONTENEGRO)* 3.0 M HEALTHSYSTEM(MONTENEGRO) 7.0 H OverallResult 143.0 *tentative 80 Annex 5 CAS Annex B3 (IFC & MIGA)for Serbia & Montenegro SerbiadkMontenegro IFC andMIGA Program, FY 2001-2004 - 2001 2002 2003 20( IFC approvals (US$m) 0.00 32.90 9.00 Sector (%) FINANCE& INSURANCE 0 27 100 FOOD& BEVERAGES 0 21 0 PLASTICS& RUBBER 0 52 0 Total 0 100 100 Investmentinstrument(%) Loans 0 75 89 Equity 0 15 11 Quasi-Equity 0 10 0 Other 0 0 0 Total 0 100 100 JMIGA guarantees (us$m) 0.00 0.00 37.60 65 Note: Sourcefor IFC Financial Data is MIS 81 Annex 6 Serbiaand Montenegro Summaryof NonlendingServices - As Of Date01/28/2004 Product CompletionFY Cost (Us$ooO) Audiencea Cbjectiveb Recent completions G, D, B, PD KG, PS SerbiaandMontenegroPEIR 3 436 G, D, B, PD KG, PS SerbiaandMontenegroCFAA 2 129 G, D, B, PD KG, PS SerbiaandMontenegroCPAR 2 90 G, D, B, PD KG, PS SerbiaandMont.Poverty Note& Assessme 3 204 G, D, B, PD KG, PS, PD SerbiaAgr. Report 3 167 G, D, B, PD KG, PS, PD SerbiaandMontenegroEnvironmentRepor 3 52 G, D, B, PD KG, PS, PD Debt Sustainability 3 77 B KG, PS Underway SerbiaandMontenegroPoverty(3year pro 03-05 ria G, D, B, PD KG, PD, PS SerbiaEconomic Memorandum 03-05 317 G, D, 8, PD KG, PD, PS SerbiaPrivatizationPolicyNote 04 80 G, D, B, PD KG, PD, PS Serbia PrivateSector DevelopmentStudy 04 90 G, D, B, PD KG, PD, PS SerbiaandMontenegroFSAP 04-05 125 G, B KG, PS SaM Diagnosticand PolicyNotePublicAdn 04 100 G, D, B, PD KG, PD, PS SaM Investment ClimateAsseSSment 04 50* G, D, B, PD KG, PD, PS SaM FiduciaryWork 04 50 G, B, D KG, PS Administrative Barriers(FIAS) 04 G, D, B, PD KG, PD, PS InvestmentDiagnostic(FIAS) 04 G, D, 8, PD KG, PD, PS *also has networkfinancing a. Govemment, donor, Bank, public dissemination. 82 M W m 00 X c 3 -a m x Y s3 c