Documentof The World Bank FOR OFFICIAL USE ONLY ReportNo: 30426-YU THE INTERNATIONALBANK FORRECONSTRUCTIONAND DEVELOPMENT THE INTERNATIONAL DEVELOPMENT ASSOCIATION AND THE INTERNATIONAL FINANCE CORPORATION COUNTRY ASSISTANCESTRATEGY FOR SERBIA AND MONTENEGRO November19,2004 South East Europe Country Unit Europe and Central Asia Region, ECA Southern Europe and Central Asia International Finance Corporation, IFC This document has restricted distribution and may be used by recipients only inperformance o f their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCYEQUIVALENTS (Exchange RateEffectiveOctober7,2004) Currency Unit = Serbian Dinar (CSD) CSD 1.00 = US$0.173 US$1.47 = SDR 1.OO GOVERNMENT'S FISCAL YEAR January 1-December 31 ABBREVIATIONS AND ACRONYMS AAA Analytical and Advisory Assistance AML Anti-Money Laundering BIDFacility BalkanInfrastructureDevelopment Facility BRA BankingRehabilitation Agency CAS Country Assistance Strategy CIDA Canadian International DevelopmentAgency CFAA Country Financial Accountability Assessment CPAR Country Procurement Assessment Report CPOT Costanza-Pancevo-Omisalj-Trieste (pipeline development) CPPR Country PortfolioPerformance Review DFID Department for International Development DM Deutsche Mark DPC Development Policy Credit DREPR Danube River Enterprise PollutionReductionProject EA ExtendedArrangement EAR European Agency for Reconstruction EBRD European Bank for Reconstructionand Development EC European Commission EIB European Investment Bank ERTP Economic Reconstructionand Transition Program EU European Union FDI Foreign Direct Investment FIAS Foreign InvestmentAdvisory Service FIU Financial Intelligence Unit FRY Federal Republic o fYugoslavia FSAP Financial Sector Assessment Program GDLN Global Development LeamingNetwork GDP Gross Domestic Product GEF GlobalEnvironment Facility IBRD Intemational Bank for Reconstructionand Development ICA InvestmentClimate Assessment ICTY International Criminal Tribunal for the former Yugoslavia IDA Intemational Development Association IDF Institutional Development Fund IDPs Internally DisplacedPersons IFC International Finance Corporation ILO Intemational Labor Organization IMF Intemational Monetary Fund JPR Joint Portfolio Review MDG MillenniumDevelopment Goals MEM Montenegro Economic Memorandum MESTAP Montenegro Environmentally Sensitive Tourist Areas Project MIGA Multilateral InvestmentGuarantee Agency MOF MinistryofFinance NBFI Non-Bank Financial Institutions FOROFFICIAL USEONLY NGO Non-governmentalOrganization OECD Organizationfor Economic Cooperation and Development PDPL Programmatic Development Policy Loan PEIR Public Expenditure and Institutional Review PFM Public Financial Management PFSAC Private and Financial Sector Adjustment Credit P I 0 Pension Fund PIU Project ImplementationUnit PMU Portfolio Management Unit PRSP Poverty Reduction Strategy Paper PSAPT Private Sector Advisory Service PSD Public Sector Development SAC Structural Adjustment Credit S A A Stabilizationand Association Agreement SaM Serbia and Montenegro SAP Stabilizationand Association Process SEE South EasternEurope SEED Southeast Europe Enterprise Development SEM Serbia Economic Memorandum SFRY Socialist Federal Republic o fYugoslavia SIEPA Serbia Investment and Export Promotion Agency SME Small and Medium-Sized Enterprises SMECA Serbia and Montenegro Export Credit Agency SOSAC Social Sector Adjustment Credit STIs Sexually Transmitted Infections TA Technical Assistance TB Tuberculosis TFFRY Trust Fundfor FederalRepublic ofYugoslavia TSS Transitional Support Strategy TTFSE Trade andTransport Facilitation inSoutheastEurope UN UnitedNations UNDP UnitedNations DevelopmentProgram UNEP UnitedNations Environment Program UNICEF UnitedNations Children's Fund UNMIK UnitedNations MissioninKosovo USTDA UnitedStates Trade andDevelopmentAgency UVB Udruzena Vojvodjanska Banka VAT Value Added Tax VB Vojvodjanska Banka VLE Virtual Learning Environment WBI World Bank Institute WTO World Trade Organization ZOP Clearing and Settlements Bureau World Bank IFC Vice President: Shigeo Katsu Assaad Jabre Country Director: Orsalia Kalantzopoulos Khosrow Zamani Task Team Leader(s): Carolyn JungdEileen Monnin-Kirby George Konda/Roberto Albisetti This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization. SERBIAAND MONTENEGRO: COUNTRY ASSISTANCE STRATEGY TABLE OF CONTENTS Executive Summary ................................................................................................................................ i I.Introduction........................................................................................................................................ -1 1 A. PoliticalBackgroundand Recent Developments.............................................................................. I1.Country Context . Progress since the Transitional Support Strategy ............................................... 1 C. Medium-Term Economic Outlook and External Financing Requirements....................................... B.RecentEconomic Developments....................................................................................................... 3 5 I11.Medium-Term Challenges................................................................................................................ 8 A.The Governments' Programs............................................................................................................. 8 B.Challenges inMeeting Country Goals............................................................................................. 10 Goal 1: Creating a smaller, more sustainable, more efficient public sector.................................... 10 Goal 2: Creating a larger, more dynamic private sector.................................................................. 14 Goal 3: Reducing poverty levels, and improving social protection and access to public services .18 A.Progress Underthe TSS Programs and Lessons Learned............................................................... IV.World Bank Group Assistance Strategy ........................................................................................ 23 23 B.ProposedWorld Bank Group Program............................................................................................ 24 Goal 1: Creating a smaller, more sustainable, more efficient public sector .................................. 25 Goal 2: Creating a larger, more dynamic private sector ................................................................ 28 Goal 3: Reducingpoverty levels, and improving social protection and access to public services 34 36 D.Implementingthe CAS.................................................................................................................... C. Lending Scenarios and Triggers ...................................................................................................... 39 Partnerships and Donor Coordination............................................................................................ 39 Portfolio Management.................................................................................................................... 40 V. Creditworthiness and Risks............................................................................................................. 41 A.Creditworthiness and Debt Sustainability ....................................................................................... 41 B.Risks................................................................................................................................................ 42 VI. Concluding Remarks...................................................................................................................... 43 Annex 1: Relationswith the EuropeanUnionand Progress on the Stabilization and Association Process ................................................................................................................................. 44 Annex 2: SouthEasternEurope Regional Studies and Initiatives ....................................................... 47 Annex 3: IFC Strategy and Activities .................................................................................................. 50 Annex 4: Millennium Development Goals (MDGs)............................................................................ 56 Annex 5: Core Labor Standards........................................................................................................... 57 Annex 6: Anti-Money Laundering and Combatingthe Financing o f Terrorism ................................ 59 Annex 7: WBIActivities inSerbia and Montenegro, FY05 -FY07................................................... 60 Annex 8: Results-OrientedFramework................................................................................................ 63 Annex 9: Donor Support to Serbia and Montenegro............................................................................ 66 Annex 10: MIGA inSerbia and Montenegro....................................................................................... 68 Tables: Table 1: Evolution o f ConsolidatedFiscal Deficit ................................................................................ 4 Table 2: SaM . Medium-term Macroeconomic Prospects..................................................................... 6 Table 3: FinancingRequirements .......................................................................................................... 7 Table 4: Summary o fResults Matrix ................................................................................................... 26 Table 5: SaM - Bank LendingProgram, FY05-07 LendingTriggers ................................................. 37 Table 6: LendingTriggers.................................................................................................................... 38 Table 7: Key Sustainability, Liquidity and Exposure Indicators ......................................................... 41 Boxes: Box 1: SaM and South EasternEurope.................................................................................................. 9 Box 2: PRSP Implementation in Serbia and Montenegro.................................................................... 10 Box 3: An Overview o f Selected Fiscal Figures.................................................................................. 11 Box 4: SaM Electricity Sector and ECSEE.......................................................................................... 16 Box 5: Poverty in Serbia and Montenegro........................................................................................... 19 Box 6: The Roma Decade in SaM........................................................................................................ 20 Box 7: SEEDin Serbia and Montenegro ............................................................................................. 33 Standard Annexes: Annex A2: Serbia and Montenegro at a Glance................................................................................... 69 Annex B2: SelectedIndicators o fBank Portfolio Performance and Management ............................. 71 Annex B3: Proposed IDNIBRDBase-Case LendingProgram, FY05-07 .......................................... 72 Annex B3: IFC & MIGA Program FY02-05 ....................................................................................... 73 Annex B4: Summary ofNon-lending Services, FY02-07 ................................................................... 74 Annex B5: Serbia and Montenegro Social Indicators.......................................................................... 75 Annex B6: Key Economic Indicators................................................................................................... 76 Annex B7: Key Exposure Indicators ................................................................................................... 78 Annex B8: Status o f Bank Operations (Operations Portfolio) ............................................................. 79 Annex B8: Statement of IFC's Committed and Outstanding Portfolio................................................ 80 Map o f Serbia and Montenegro . 31506R2 IBRD Staff and consultants who contributed to CAS preparation include: Ilker Domac. Ardo Hansson. Nancy Cooke. Sabina Djutovic.Alivodic. N e i l Simon Gray. Bruce Courtney. Itzhak Goldberg. Branko Radulovic. Lazar Sestovic. Michael Edwards. David Kennedy. Mohinder Gulati. Zlatko Slobodan Nikoloski. Tijen Arin. Anita Schwarz. Dena Ringold. Ruslan Yemtsov. Tobias Linden. Peyvand Khaleghian. Andreas Rohde. Usaid El.Hanbali. Miroslav Frick. Marina Petrovic. Vesna Kostic. Sava Jeremic. Zana Ivanovic. Tony Verheijen. Aleksandra Rabrenovic. Alexander Pankov. Tanja Boskovic. Jasna Vukoje. Michael Gascoyne. Siew Chai Ting. Franz Kaps. Manuel Marino. Lynn Holstein. Gennady Pilch. Alexander Rowland. Joseph Formoso. Marjory-Anne Bromhead. Armin Fidler. Francois Decaillet. and Arup Banerji. EXECUTIVESUMMARY i. The proposed FY05-07CAS buildson FY02-04Transitional Support Strategy (TSS) program and i s designed to support the implementation of the European Union (EU) Stabilization and Association process (SAP) and the Poverty Reduction Strategy Paper (PRSP). Serbia and Montenegro (SaM) - formerly the Federal Republic o f Yugoslavia (FRY) - succeeded to the membership o f the former Socialist Federal Republic o f Yugoslavia (SFRY) in the Bank in May 2001. Since then, Bank Group assistance has been provided through a TSS program, supporting the Government's efforts to transform SaM into a market economy and to lay the foundation for sustainable medium-term growth. Building on the TSS program, the new CAS supports the implementation o f two complementary government strategies: the SAP and the PRSP. Together, these strategies present a comprehensive reform agenda designed to achieve sustainable long-term growth and poverty reduction, with the ultimate goal o f European integration. While the issues and challenges are presented in different ways in the two strategies, this reform agenda can be summarized in the three broad, inter-related medium-term country (and republican) goals around which the CAS i s built: > Goal 1: creating a smaller, more sustainable, more efficient public sector; > Goal 2: creating a larger, more dynamic private sector; and > Goal 3: reducingpoverty levels, and improving social protection and access to public services. ii. While SaM has made good progress on macroeconomic stabilization and structural reform over the past four years, further fiscal adjustment and renewed efforts on structural reforms are necessary to bolster macroeconomic stability and lay the foundation for sustainable growth. Building on earlier reform efforts, particularly in Montenegro, the country launched an ambitious reform program in early 2001 aimed at macroeconomic stabilization, rapid transition to a market economy, the normalization o f relations with foreign creditors, and integration with regional, EUand world markets. Although progress in some areas was slower than desired, implementation o f this reform program, together with substantial donor support, has helpedto sustain positive economic growth since 2000. At the same time, however, there i s cause for concern, particularly with respect to the growing current account deficit (which has increased from 3.9 percent o f GDP in 2000 to a projected 10.7 percent of GDP in2004) and the resurgence o f inflationarypressures in2004 (inflation i s projected at 12-13 percent in 2004). Addressing these issues and meeting the three country goals on which the CAS i s built will require a high quality fiscal adjustment (with cuts inthe public sector wage bill, subsidies and net lending, and transfers) coupled with an acceleration and deepening o f structural reforms, includingrestructuring and privatization. iii. Against this backgroundand consistent with SaM's goals, the CASwill support far- reaching structural reforms in the public and private sectors, while seeking to ensure that poverty i s reduced, social protection i s adequate and appropriately targeted, and access to social services by the poor and vulnerable i s improved. To ensure a self-sustaining economy and fiscally sustainable public sector in the medium and long term, the CAS program strives to help the republican Governments to strengthen institutions (with institution and capacity building embedded inall planned activities) and to reduce the weight o f the public sector intheir economies. This is a prerequisite for giving the private sector room to grow, thereby stimulating productive activity, 1 domestic private and public savings, and export growth. In Serbia, the Bank's efforts will concentrate on parallel Programmatic Development Policy Loan (PDPL) programs, one focused on public sector reform (including public administration reform and pension reform) and the other on private sector development (including enterprise and financial sector restructuring and privatization and energy sector reform). The measures envisaged under the PDPL programs, and development policy support inMontenegro, together with other assistance from the World Bank Group (WBG) and complementary assistance from other development partners, should, if implemented effectively, translate into economic growth and employment creation. iv. In recognitionof the unusualcountry circumstances and the success of the IDA program to date, SaM's exceptional and temporary eligibility for IDA resources on modified terms has been extended to FY05-07 to allow for the establishment of credihrorthiness for limitedIBRD borrowing, thereby facilitating a smooth transition from IDA to IBRD. At the same time, however, the amount of IDA resources allocated to SaM over the CAS period i s envisaged to be much lower than the US$540 million three-year TSS envelope, making the establishment o f creditworthiness for limitedIBRD borrowing essential to ensure adequate lending resources to assist SaM inmeeting the three country goals on which the CAS i s built. The IDA envelope for the FY05- 07 CAS period i s expected to be US$225 million. If creditworthiness i s established, these funds would be supplementedby US$175 million o f IBRDlendingunder the base case and US$325 million under the high case, bringingthe total base and high case IDNIBRD lending envelopes to US$400 million and US$550 million, respectively. v. In addition to lending and AAA from the Bank (IBRD and IDA), the CAS program envisages continued strong support from IFC. IFC's program will complement the Bank's program by focusing on development o f the financial sector, post-privatization support to selected enterprises, private sector participation in infrastructure, and private sector investments in selected sectors. Ininfrastructure, for example, IFC will work closely with the Government and the Bank to explore opportunities for private sector financing through public private partnerships, provide technical assistance and pre-privatization support, and help public sector entities attract private investment through its Balkans Infrastructure Development Facility. IFC will also continue its large donor-supported technical assistance program that aims to enhance the development impact o f its investment activities; improve the business environment for SMEs; assist domestic companies in meeting EU standards; facilitate the development o f domestic financial markets through institution- building and the use o f innovative financial products; and provide restructuring and privatization support. vi. While SaM is vulnerable to exogenous shocks, the main risk over the CAS period is slippage on the reform agenda, which could, in turn, complicate the medium-term macroeconomic and growth outlook. The political will to implement difficult reforms in both republics remains highly vulnerable to the shiftingrelations within the respective ruling coalitions, as well as to relations between the two republics. This political commitment will be tested over the CAS period in both republics by the need to undertake measures that result in durable cuts in non- interest current expenditures, while increasing public investment. Compoundingthe impact o f SaM's complex political economy on the pace o f reforms are significant capacity constraints on implementation o f economic legislation and regulations. Against this background, guarding against "reform fatigue," while maintaining strong progress on reforms necessary to underpin fiscal sustainability and sustainable medium-term export-led growth, will be essential to maintain the momentum on the reform agenda. Other factors that could complicate the reform process over the CAS period include a potential referendum on the continuation o f the state union, developments in Kosovo and southern Serbia, failure to satisfy key partners on the depth and pace o f cooperation with 11 the International Criminal Tribunal for the former Yugoslavia, vested interests at all levels o f government (including local and municipal governments), and additional complexities arising from new, constitutionally-mandated, state-level structures. vii. These risks notwithstanding, SAM's impressive track record of solid policy performance in the wake of important political events bodes well for the outcome of the overall reform program during the CAS period and for building the level of confidence essential to fostering growth and investment. Based on this experience, despite formidable challenges ahead, slippage on major components of the reform agenda i s considered unlikely. Ongoing engagement o f the international community, especially in the form o f an increasingly robust portfolio o f long-term lending, will help to ensure continued progress. At the same time, focusing WBG assistance at the republican level i s appropriate given the uncertainties surrounding the duration o f the state union o f Serbia and Montenegro. ... 111 SERBIA AND MONTENEGRO Memorandum to the Executive Directors of the IDA and IBRD Country Assistance Strategy (FY05 - 07) I.Introduction 1. Serbia and Montenegro (SaM) - formerly the Federal Republic of Yugoslavia (FRY) - succeeded to the membership of the former Socialist Federal Republic of Yugoslavia (SFRY) in the Bank' in May 2001.' Initial Bank Group support was provided in two stages. The first phase provided pre-membership support o f US$30 million through the World Bank Trust Fund for FRY (TFFRY). The second phase, outlined ina Transitional Support Strategy (TSS), provided a three-year program o f support for the Economic Reconstruction and Transition Program (ERTP), financed through a temporary and exceptional IDA allocation o f US$540 milli~n.~ In addition, over this period, IFC provided commitments o f US$43 million in support o f private sector development. TSS Updates in 2002 and 20044described progress on implementation and laid out annual lendingplans. 2. The proposed FY05-07 CAS is built on the two complementary government strategies (shared by both republics): the European Union (EU) Stabilization and Association process (SAP) and the Poverty Reduction Strategy Paper (PRSP). With a shared ultimate objective o f EU integration, these two strategies present a comprehensive reform agenda designed to achieve sustainable long-term growth and poverty reduction. This reform agenda can be summarized in three broad, inter-related medium-term country goals: (i) creating a smaller, more sustainable, more efficient public sector; (ii) creating a larger, more dynamic private sector; and (iii) reducing poverty levels and improving social protection and access to public services. The CAS aims to support the authorities in achieving these goals through a carefully selected mix o f Bank (IBRD and IDA) and IFC financing and other World Bank Group (WBG) activities. 11. Country Context-Progress since the Transitional Support Strategy A. PoliticalBackground andRecent Developments 3. In February 2003, FRY completed a constitutional transition to the state union of Serbia and Montenegro. In line with the February 2002 Belgrade Agreement and the 2003 Constitutional Charter (Charter), a state union composed o f the Republic of Serbia and the Republic o f Montenegro was established with a common presidency, parliament, council o f ministers, and foreign and defense policies. The union provides for republican autonomy in most . areas o f economic policy, including currencies, central banking, and tax regimes. Also, it was anticipated that the republics would implement separate, but partly harmonized, trade and customs regimes with a view towards eventual integration with Europe. * TheMarch "Bank" refers to the IBRD and IDA; the "World BankGroup" refers to the Bank, IFC, FIAS andMIGA. On 14,2002, an accord("Belgrade Agreement") settingout the general framework for aunionbetweenthe Republic of Serbiaandthe Republicof Montenegrowas signedby federalandrepublicanauthorities. Underthis accord, on February4, 2003, the FederalRepublicofYugoslavia (FRY) completedaconstitutionaltransitionto the unionof SerbiaandMontenegro (SaM). All historic references to FRY may be consideredto refer to SaM. This CAS does not cover the provinceo f Kosovo, which remainsunderUNadministrationaccordingto UNSecurityCouncilResolutionUNSC-1244. See Transitional Support Strategy (R22090-YU, June 26,2001). See Transitional Support Strategy Updates (R24476-YU, July 18,2002, andR2704S-YU,February18,2004). 1 4. The requisite union-level institutions were reconfigured or established, including a parliament, and the union has been operational since the Charter was effected. The provisos of the Belgrade Agreement allow for a referendumon continuation o f the union after three years o f implementation, and some key figures have indicated a desire to put the issue to a referendum. To date, union-level parliamentarians were elected by party representation. Direct elections for the parliament are slated for early 2005, but various constituencies advocate advancing a referendum on union continuation, rather than holdingunion-level elections. 5. Since March 2003, the Republic of Serbia has undergone a series of elections (three presidential, two parliamentary, and one municipal legislative and mayoral). InJune 2004, in a third round o f presidential elections, Boris Tadic, a pro-western reformer, was elected President of the Republic o f Serbia. Since then, President Tadic has set about realizing his pledge to get Serbia ready for EU membership, stressing the need for broad-based reforms to stimulate private sector development and encourage foreign direct investment. Although President Tadic's Democratic Party (DS) has not joined the ruling four-party minority coalition, it has maintained generally good working relations with the coalition, supporting some key elements o f the reform agenda in parliament. However, early in the fall, differences o f views on the question o f ethnic Serb participationinthe October elections inKosovo strained relations between the DS and Prime Minister Vojislav Kostunica's Democratic Party o f Serbia (DSS). Despite a difficult political backdrop and weak administrative capacity, the governing coalition has managed to maintain remarkably strong policy performance. 6. At the local level, voters went to the polls on September 19, 2004, to elect deputies for 148 municipalities. Mayors o f Belgrade, Novi Sad, Nis, and Kragujevac were contested for the first time through direct elections. These elections were particularly significant given the increased autonomy and power that the new Law on Self Administration grants to the municipalities. The DS and the Serbian Radical Party (SRS) received the highest shares o f the votes. Serbia's new Constitution i s in the final drafting stages and i s expected to be submitted for parliamentary approval in early 2005 (the adoption process could be protracted, however, as a two-thirds majority inparliament is required as well as a referendum). Serbianparliamentary elections are expectedto be held after the adoption o fthe new Constitution, but couldbe advanced. 7. Since 2002, Montenegro's ruling coalition has held a dominant position, while the opposition parties have boycotted parliament. Since early fall, there has been some movement toward the opposition's return to the legislature. Despite the Government's strong parliamentary base in 2004, the reform agenda has advanced more slowly than expected. While some important pieces o f legislation have been enacted, policy has tended to be formulated on an ad hoc basis. Most domestic attention has been focused on harmonization disputes with Serbia and independence prospects, with some political leaders calling for early negotiations with Serbia on the future of the state union. Montenegro's new constitution i s scheduled for parliamentary submission in2005. 8. Inaddition to the question of the durability of the state union, other pressing challenges during the CAS period include realizing significant progress on the SAP. This process has stalled due to problems with the functioning o f the state union and lack o f action on the internal Market and Trade Action Plan (see Annex l), as well as political uncertainty stemming from the parliamentary and presidential elections in Serbia. Recently, the EU endorsed a "twin track" approach to SaM, indicatingwillingness to deal directly at the republican level on issues relating to trade, customs, and economic and sectoral policies, within the overall framework o f the state union. This should help to reinvigorate progress on the SAP agenda (see paragraphs 23-24). SaM faces two additional challenges. First, the depth and pace o f cooperation with the International Criminal Tribunal for the former Yugoslavia (ICTY) i s currently considered inadequate by some key 2 partners, leading to some delays and reductions in donor assistance programs. Second, the challenge o f KOSOVO'Sstatus remains to be determined, all the more pressing in view o f the final resurgence o fviolence in Serbia and Kosovo inMarch 2004. B. Recent EconomicDevelopments 9. SaM began the 1990s relatively well integrated with the world economy, and with a higher standard of living than many other transition economies. However, armed conflicts, international sanctions, and trade shocks stemming from the break-up o f the Socialist Federal Republic o f Yugoslavia (SFRY) during the 1990s had a detrimental effect. Combined with economic mismanagement, these events resulted in hyperinflation and a virtual collapse o f the economy. By 2000, recorded per capita GDP had fallen to below one half o f its 1989 level. Foreign trade volumes also fell noticeably, while the country experienced chronic high inflation. Real earnings declined significantly, with absolute poverty roughly doubling since 1990; social protection and health services deteriorated as available financing fell below entitlement levels; and external debt grew to 132.6 percent o f GDP in 2000 (reflecting both arrears accumulation and the fall inGDP discussed above). 10. Progress on structural reforms has generally been good. By early 2001, both republics had embarked on strong reform programs. Indeed, in January 2001, the country launched an ambitious program aimed at a rapid transition to a market economy, the normalization o f relations with foreign creditors, and integration with regional, EU, and world markets. The Government's (SaM) economic program rested on three pillars: (i) prudentmacroeconomic policies; (ii) market- oriented structural reforms; and (iii) the mobilization o f significant financial and technical support from donors. In addition to establishing macroeconomic stability, progress made on this agenda includes opening the economy, restructuring the banking sector, and adopting legislation in many areas aimed at harmonization with the EU. Nonetheless, the remaining reform agenda i s substantial. Indeed, a report, entitled "Recent Progress on Structural Reforms," prepared by the Bank for the Donor Coordination MeetinginNovember 2003, identified the following areas where progress has been slower than desired: (i) improving the private sector incentive framework; (ii) strengthening the productive, financial, and infrastructure sectors; and (iii) reforming the public sector. 11. Macroeconomic stability, good progress on structural reforms, and significant donor support have helped to sustain positive economic growth since 2000. Following a sharp contraction in 1999, owing mainly to the Kosovo conflict, SaM's GDP grew by 5.5 percent in2001 and 4 percent in2002.5 However, real GDP growth slowed to 3 percent in 2003 (compared with a program target o f 3.5 - 4.5 percent) for two main reasons. First, implementation o f structural reforms and overall economic activity were adversely affected by political uncertainty resulting from the assassination o f Serbian Prime Minister Zoran Djindjic inMarch 2003 and the decision to hold early elections in December 2003. Second, agricultural output suffered because o f the drought in northern Serbia, while industrial output growth was dampened by pre-privatization uncertainties, coupled with insufficient investment and a general lack o f competitiveness. GDP growth i s expected to recover to around 6 percent in2004, bolstered by a recovery in industry(due to accelerated privatization in 2003), strong growth in services, and a rebound in agricultural output. 12. Despite positive growth, unemployment in Serbia has increased. Similar to the experience o f other countries intransition, Serbia has experienced the problem o f "jobless growth." This phenomenon mainly reflects labor hoarding during the 1990s that, as a result o f ongoing Serbia accounts for about 93 percent of SaM's economy. privatization and restructuring efforts, has been converted into open unemployment. The Labor Force Survey (LFS)-based unemployment rate increased slightly from 9.6 percent in 2000 to 11.1 percent in 2002.6 Based on preliminary data from the LFS for 2003, this increase appears to have been sustained. Registered unemployed i s much higher than suggested by the LFS, reflecting incentives to register at the Labor Market Bureau. Importantly, registered unemployment started declining in2003 for the first time since the late 1980s. 13. The exchange rate-based stabilization program has been very effective in reducing inflation, but inflationary pressures increased in 2004. Retail price inflation declined from 113.5 percent in 2000 to 14.2 percent in 2002 and further to 7.6 percent in 2003. Although the nominal exchange rate o f the dinar to the DWEuro remained broadly stable and unified during 2001 and 2002, it depreciated (appreciated) against the Euro (USD) by 11.1percent (7.4 percent) in 2003 compared to end-December 2002. As a result o f higher electricity prices, more flexible exchange rate policy,' rising oil prices, and increases in excise taxes, inflation i s projected at 12-13 percent in 2004. The credibility o f program implementation will determine whether the adverse impact o fthe one-off factors will be permanent or temporary.' 14. Fiscal performance - gauged by meeting the program targets under the IMF supported economic program - has been favorable (see Table 1). The consolidated budget deficit o f 1.4 percent o f GDP in 2001 was considerably lower than the program target o f 6.1 percent o f GDP. The target o f 5.7 percent o f GDP for 2002 was also comfortably met. SaM's 2003 fiscal deficit o f 3.2 percent o f GDP was 1.3 percent o f GDP below the target under the IMFprogram, due to slower than expected disbursement o f grants and foreign financed projects. Table 1: Evolutionof Consolidated Fiscal Deficit (YOof SaM GDP)a Serbia SaM ProgramTarget Actual ProgramTarget Actual 2001 5.7 1.o 6.1 1.4 2002 5.3 4.3 5.7 4.6 2003 4.1 2.8 4.5 3.2 a/ Before grants. 15. Between 2001 and 2004, the country has experienced large current account deficits following the resolution of the regional conflict and removal of international sanctions. The combined effect of disappointing export performance and rapidly growing imports (which grew by an average o f 28.7 percent per year inU S dollar terms during 2001-03) led to an increase in SaM's current account deficit (after grants) from 3.9 percent o f GDP in 2000 to an estimated 9.6 percent of GDP in 2003.9 During this period, capital inflows were larger than the current account deficit, particularly in 2003 when net foreign direct investment (FDI) inflows, driven largely by privatizations, were exceptionally large. As a result, foreign exchange reserves rose to US$3.6 billion (4.4 months o f projected 2004 imports) in 2003 from a negligible level 3 years earlier. The unemployment rate in Serbia i s still above the levels ofwell-performing economies, such as Hungary, Slovenia, and the Czech Republic, and also above the average for OECD and EUcountries. Moreover, the surveyed unemployment rate i s likely to be somewhat underestimated, as it does not cover redundant workers who perceive themselves as employed and declare accordingly in surveys. 'In nominal terms, the dinar depreciated by 14 and 4.1 percent in October 2004 (year-on-year) against the Euro and the USD, respectively. 'In response, the National Bank of Serbia raised its mandatory reserve requirement for commercial banks from 18 percent to 21 percent starting from August 11, 2004. Saki's exports in 2000 were less than 43 percent of 1989 levels, suggesting that exports are clearly well below potential levels. Inspite of this significant catch-up potential, export growth has been sluggish. 4 SaM's external and public debt position has also improved primarily due to Paris and London Club agreements (achieved in 2002 and 2004, respectively) and an increase in dollar GDP. Public debt declined to a projected 65 percent o f GDP in2004 from 123.2 in2001 (see paragraphs 114-116). 16. As a result of the combination of higher oil prices, a surge in-imports, and slow growth of exports during the first eight months of 2004, the current account deficit projection for 2004 is revised to 10.7 percent of GDP. In response to unfavorable external developments and rising inflationary pressures, the Parliament o f Serbia adopted a re-balanced budget for 2004 in October, which represents an important step towards reducing public consumption. Primarily as a result o f expenditure cuts, these revisions reduced Serbia's planned central government budget deficit in 2004 to 2.5 percent o f Serbia GDP from 3.9 percent in 2003. The draft budget for 2005 suggests that fiscal policy will continue to remain tight in 2005. The shift to taxing consumption instead o f income will be continued with the introduction o f the VAT in January 2005 and the removal o f some small taxes. Measures will also be taken to improve compliance and taxpayer services. Finally, the size o f the Government will be reduced also by cutting, and improving the efficiency of, current expenditures, while allowing higher capital spending and a lower tax burden. C. Medium-Term Economic Outlook and External Financing Requirements 17. Under the base case scenario, SaM's medium-term prospects are favorable, with continued progress on key reforms leading to projected GDP growth averaging 5.1 percent per annum in 2004-07 (see Table 2). The base case scenario assumes: (i) a high quality fiscal adjustment (based on durable non-interest expenditure cuts) that enhances macroeconomic stability and boosts confidence inthe policy framework, thereby stimulating private investment; and (ii) an acceleration o f policy efforts aimed at improving efficiency, including privatization and enterprise restructuring, along with measures directed at improving competitionand the investment climate. 18. Non-interest current expenditures in relation to GDP are projected to decline from roughly 41.3 percent in 2004 to 35.5 percent in 2007 (just under 2 percentage points o f GDP per annum). Inaddition to reductions inpurchases o f goods (around 0.3 percentage points o f GDP per annum), this decline primarily reflects reductions in the wage bill, subsidies, net lending, and transfers (see paragraphs 28-30). The wage bill as a share o f GDP could be reducedby around 0.3- 0.5 percentage points per annum, supported by public administration reform and reforms in the main sectors o f public employment, including health, education, defense, and internal security. Roughly half o f the remaining 1.2 percentage point per annum decline in non-interest current expenditures as a share o f GDP could come from cuts in subsidies and net lending, with the other half coming from reductions intransfers. Cuts in subsidies and net lendingwill result from, among other things, restructuring and, where appropriate, privatization o f large loss-makers, including railways, and from reforms o f budget-financed lendinginstitutions such as the Development Fund. Reductions intransfers are expected to result from a variety o f measures, including those designed to improve the financial sustainability o f the pension and healthcare systems. 5 Table 2: SaM Medium-term Macroeconomic Prospects - Act. Act. Act. Est. Proj. Proj. Proj. Proj. 2000 2001 2002 2003 2004 2005 2006 2007 National Accounts Real GDP growth (%) 11 5.0 5.5 4.0 3.0 6.0 4.6 4.8 5.0 Investment (% o f GDP) 14.2 13.6 16.2 15.9 16.5 17.8 20.4 21.0 Gross domestic savings (% o f GDP) -2.7 -7.2 -7.2 -6.6 -8.6 -7.3 -3.3 -1.3 Public Sector Balance (as % o f GDP) Expenditures 37.6 40.3 47.8 46.3 45.3 43.5 43.0 42.3 oiw public investment 3.1 1.6 3.5 2.3 2.6 2.3 4.8 4.9 Revenue before grants 36.7 38.9 43.3 43.1 43.3 42.8 42.0 41.2 Deficit before grants 0.9 1.4 4.6 3.2 2.0 0.7 1.0 1.1 External Accounts (as % o f GDP) Exports o f goods and services 29.6 23.7 20.9 19.9 24.2 27.3 29.9 31.7 Imports o f goods and services 46.5 44.6 44.3 42.4 49.4 52.4 53.5 54.0 Current account balance (US$ million) 21 -339 -528 -1,383 -1,960 -2,492 -2,372 -2,049 -1,861 Current account balance 21 -3.9 -4.6 -8.9 -9.6 -10.7 -10.2 -8.7 -7.6 Indebtedness (external debtj TDOiXGS 31 307.1 266.2 219.6 205.9 143.8 125.2 113.8 105.8 TDOiGDP 133.2 103.2 76.5 69.9 57.8 56.4 54.4 52.6 TDS1XGS 31 1.5 2.4 3.4 6.7 11.2 13.3 13.1 14.9 Prices Retail price inflation (e.0.p.) 113.5 39.0 14.2 7.6 12.6 9.6 5.7 4.1 11 GDP estimates exclude Kosovo. 21 After grants. 31 Exports includeworkers' remittances and factor incomes. 19. Together with adjustments on the revenue side and an increase in public investment, these cuts in public expenditure as a share of GDP will contribute directly to promoting growth and redressing macroeconomic imbalances. Duringthe CAS period, further efforts to improve tax collection (supported, among other things, by implementation o f bankruptcy legislation) and increase transfers from profitable state-owned enterprises should boost public revenues. As the current high tax burden (tax revenues as a share o f GDP) remains a barrier to private sector-led growth and to formalization o f economic activity, any such gains inrevenues are expected to pave the way for corresponding reductions in tax rates, particularly on labor. Together with the adjustment inpublic expenditure discussed above, this should have a positive impact on expectations about the future stance o f fiscal policy, thereby lowering the risk premiumand paving the way for higherprivate investment. Bythe same token, public investment, which has been low, i s expected to increase during the projection period. In this way, the projected fiscal adjustment will be the cornerstone o f the country's efforts to lay the foundations for enduring growth and macroeconomic stability over the mediumterm. 20. Greater confidence will help to reverse the projected increase in inflation in 2004, while an improved public savings-investment balance, coupled with structural reforms, is expected to have a favorable impact on the current account balance. With greater confidence in the policy framework (reflecting, among other things, thq envisaged fiscal adjustment) and prudent monetary policy, inflation i s projected to decline steadily to 4 percent in 2007. At the same time, improvements in the public savings-investment balance and inthe competitiveness o f the economy should help to reduce the current account deficit (after grants) from 10.7 percent o f GDP in2004 to 6 7.6 percent by 2007. Gross domestic savings as a percentage o f GDP would rise to -1.3 percent in 2007 from -8.6 percent in2004. 21. SaM's financing requirements under the base case scenario are projected to remain high, partly because of rising debt service payments (see Table 3 and paragraph 114-116). Between 2004 and 2007, gross external financing requirements are projected at about US$12.8 billion. These resources are required to finance: (i)large but declining current account deficits (excluding grants and official transfers) amounting to roughly US$8.8 billion; (ii) an increase in international reserves o f US$1 billion; and (iii) amortization o f external debt amounting to US$3 billion. With the envisaged improvement in the fiscal balance during the projection period, these financing needs will shift from the public to the private sector, as the expected fiscal retrenchment will leave more room for the private sector to tap domestic and foreign markets at favorable terms. FDI is projected to finance 33 percent of total needs in 2005-07, while long-term loans from multilateral, bilateral, and other creditors are projected to account for 35.7 percent. The remainder will be covered by other capital inflows (short-term credits, capital not-elsewhere included, and errors and Omissions'O). 22. While good policy performance is expected under the base case, based on strong implementation of ambitious reform plans, both republics expect to move to a high case scenario in terms of policy performance as early as possible in the CAS period(inaddition to strong policy performance, access to IBRD lending would depend on establishment o f creditworthiness for limited IBRDborrowing- see paragraphs 107-108). Under this scenario, the growth rate in 2006 and 2007 would accelerate to 5 percent and 5.5 percent, respectively, as broader and deeper reforms lead to a stronger private sector response. This scenario also foresees deeper cuts innon-interest current spending in 2006 and 2007. These developments would also be consistent with stronger export performance and a more favorable external position. Overall, under this scenario, SaMwouldbe ina stronger positionto achieve a virtuous cycle ofhigher investment, savings, productivity, andhence GDP growth. Table 3: FinancingRequirements (US$ million) Act. Est. Proj. Proj. Proj. Proj. Financingrequirements 2002 2003 2004 2005 2006 2007 FinancingRequirements(incl.IMF) 2,242.0 3,085.7 3,071.8 3,348.5 3,061.0 3,288.3 Current account deficit (after grants) 1,383.0 1,959.7 2,492.0 2,372.1 2,048.9 1,860.8 Longterm amortizations (excl. IMF) 43.O 204.0 412.5 625.0 830.8 1,077.5 Reserves Changes of Monetary Auth. 1,111.o 1,270.0 173.3 424.3 141.5 239.5 . IMFCredit (net) -295.0 -348.0 -6.0 -73.O 39.8 110.5 Financingsources 2,242.0 3,085.7 3,071.8 3,348.5 3,061.0 3,288.3 Private investment (net) 562.0 1,395.0 966.0 1,181.0 988.4 1,034.9 Long-term disbursements 421.0 911.0 1,414.4 1,085.7 1,125.2 1,249.9 Adjustmentsto scheduled debt service 32.0 121.0 0.0 0.0 0.0 0.0 Other catital flows 1,227.0 658.7 691.4 1,081.7 947.4 1,003.5 loThe large errors and omissions o f around US$400 million in2002 and 2003 reflect the combination o f the following factors: (i)underiover-invoicing ofrecordedtrade,unrecordedtrade; (ii) flowsthathavenotbeenassignedtoremittances;(iii) private measurement errors coming from Kosovo and Montenegro; (iv) remonetization flows stemming from previously unrecorded cash entering the banking system (as occurred on a large scale when the DMiEuro changeover happened); and (v) exchange rate valuation effects. 7 111. Medium-TermChallenges A. The Governments'Programs 23. The republican Governments' reform programs are built on implementation of two complementary strategies: the SAP and the PRSP." With a shared ultimate objective o f EU integration, these two strategies present a comprehensive reform agenda designed to achieve sustainable long-term growth and poverty reduction. While the issues and challenges are presented in different ways in the two strategies, the reform agenda envisaged under the SAP and the PRSP - and, hence, the Governments' programs- can be summarized in the three broad, inter-relatedmedium-termcountry (andrepublican)goals: P Goal 1: creatinga smaller, moresustainable, more efficientpublicsector; P Goal2: creatinga larger, moredynamic privatesector; and P Goal 3: reducing poverty levels, and improving social protection and access to public services. 24. SAP. The SAP agenda is very broad, encompassing political as well as economic criteria and reforms (see Annex 1). SaM i s in the early stages o f the process. Among other things, this reflects difficulties in resolving harmonization issues between the two republics, including the creation o f a single internal market. The "twin track" approach recently endorsed by the EU i s intended to break this logjam by dealing with each republic individually on economic and trade policies, while dealing with the union on issues such as international political obligations and human rights, all within the context o f an eventual single agreement with SaM. A Feasibility Study on the opening o f negotiations on a Stabilization and Association Agreement i s expected to be completed in early 2005. Deepened regional cooperation i s also an important element o f the SAP (see Box 1). 25. Inadditionto maintainingmacroeconomic stability, the SAP envisages economic reforms in the following key areas. Public sector reform: Ensuringeffective functioning o f the state and financial viability o f state institutions; reform o f the army and electoral law, public administration reform including reform o f the civil service pay system, and preparation o f comprehensive anti-corruption strategies; formalizing the grey economy, and broadening the tax base and implementing the tax reform package, including VAT; establishing an effective public procurement regime; and developing reliable statistics. Private sector development: Liberalizing remaining prices and removing administrative controls; speeding up restructuring, privatization andor liquidation, developing a stable and functioning landreal estate market, and developing and implementing a comprehensive strategy to promote employment and combat unemployment; abolishing export duties and import levies and modernize customs; and improvingbusiness registration. The PRSP, which was completedin late 2003, comprises aunion-level overview and aPRSP for each o f the two republics andbuilds on the InterimPRSP for FRY (presentedto the Boardsof IDA and o f the IMF inAugust 2002 -ReportNo. 24490- YU andEBD/02/118,7/24/02). The republicanPRSPscontaindetailedpolicy matricesindicatingthe time frame for implementingreforms andare broadly consistent with other Governmentstrategic plans. For Montenegro, this includesthe Agenda of Economic Reforms, while, for Serbia, it includesSerbia on the Move. 8 Box 1: S a M andSouthEasternEurope A regional perspective on trade, energy, transport, environment, water resource management, and other areas of potential mutual interest can benefit all South Eastern Europe (SEE) countries, especially through improved prioritization o f infrastructure investments (see Annex 2). Deepened regional co-operation i s also an essential element of the SAP. Over the past few years, considerable progress has beenachieved inthis area as indicatedby the increasing number of bilateral trade agreements between the countries o f SEE, as well as the detailed agreements on the integration o f the region's energy systems. SaM i s actively engaged in a number o f regional initiatives and programs, foremost among them the Stability Pact,I2 including the Working Tables on democratization and human rights; security issues; and economic reconstruction, development, and cooperation. The Bank is actively involved inthe latter. The development o f regional infrastructure in SEE - connected and compatible with existing and planned trans-European networks within the EU - i s important to support overall economic growth, improvement in the quality o f life, and social cohesion in the region. The Infrastructure Steering Group for SEE (ISG), overseen jointly by the EC and the Bank, aims to ensure that both the SEE countries and the international community take a regional strategic approach to infrastructure development. The ISGaddressesparticular needs inthe areas o f transport, energy, water, the environment, and cross-border or trade facilitation. This CAS supports regional cooperation through numerous Bank studies, initiatives, and activities undertaken at the regional level. 26. PRSP. The SaM PRSP lays out an overall strategy for poverty reductionaimed at improving living standards for the poor through reforms focused on establishing the conditions for dynamic, `equitablegrowth (see Box 5 on SaM's poverty profile). Within this overall framework, inaddition to eventual accession to the EU and World Trade Organization (WTO) membership, the republican-level PRSPs share core objectives in line with the three medium-term country goals outlined above: (i) public sector reform consistent with macroeconomic stability and development o f a market economy; (ii)development o f the private sector through hrther privatization o f financial and productive assets and improvements in the business environment; and (iii) poverty reduction (based on strong poverty diagnostics), improvements in the effectiveness o f social programs, and attainment o f the Millennium Development Goals (MDGs, see Annex 4). 27. In addition to the overall policy challenges involved in implementing the Governments' programs and country goals discussed below (see paragraphs 28-62), PRSP-specific implementation challenges include improving costing, establishing clear linkages with the republics' budget processes, and strengthening the framework for PRSP implementation, monitoring, and evaluation (including identifylng indicators for reporting on progress). While implementation progress since the PRSPs were completed in late 2003 has been slow in both republics, recent developments are more promising, in part because o f development o f stronger links with the SAP (see Box 2). Buildingon this momentum will require renewed interest inthe PRSP on the part o f the international community, including provision o f financial support for PRSP implementation. l2 The Stability Pact was formed by more than 40 countries and organizations at the initiative of the EUafter the Kosovo crisis. It encourages SEE countries to develop common perspectives innumerous social, political, and economic areas. 9 Box 2: PRSPImplementationin Serbia and Montenegro Serbia. After a strong start, implementation languished for several months following the parliamentary elections. Recently, however, momentum was restored when the Deputy Prime Minister's Office assumedresponsibility for the PRSP fimction, which is to be coordinated with EU integration, allowing for improved linkages in policy formulation. Near-term priorities include: (i) developing the linkages with the SAP - inparticular, development of a joint action plan for five to six sectors aimed at fostering improved intra-ministerial communications; (ii) developing a framework for monitoring and evaluation, including a template o f objectives and indicators for public discussion and use; (iii)continuing the participatory process through local level activities with civil society organizations; and (iv) organizing o f a PRSP Conference aimed at, among other things, better public dissemination o f the PRSP. Montenegro. The Government has been active inpromoting the PRSP concept inthe media, and there is interest inimproving the budgetary linkages. There have also been favorable developments in terms of better linkages betweenthe SAP and the PRSP. Near-termplans include: (i) reactivating the Expert Task Force to work with the Ministry of Finance on budget linkages; (ii)holding participatory conferences aimed at strengthening prioritization and disseminating lessons from experiences; and (iii) organizing consultations with other regional PRSP teams. Financial Support. While adequate during the development phases, fmancing for PRSP implementation i s proving problematic in both republics. In addition to support from DFID and UNDP, PRSP preparation was financed through a Multi-Donor PRSP Trust Fund, administered by the Bank. In Montenegro, the two donor grants supporting implementation have been depleted and the sole bilateral grant will not be extended. The Montenegrin Ministry of Labor and Social Affairs, which oversees the effort, has been able to cover short-term operational costs, but lacks resources to provide the expertise necessary to start the prioritization process and to linkthe PRSP to the annual budget. UNDP continues to support the process through its on-the-ground presence. Although a request for a second grant from the Multi-Donor PRSP Trust Fundto support implementation inboth republics i s planned, increased support from the international community will be necessary to sustainthe process over the medium term. B. Challenges inMeeting Country Goals 28. Both republics will face considerable challenges inimplementingtheir reform programs and meetingthe three country goals. The discussion below highlightsthe main issues under each o f the three goals. Goal 1: Creating a smaller, more sustainable, more efficient public sector 29. The overall challenge in terms of public sector reform in S a M i s to reduce public expenditure as a share of GDP while ensuring adequate levels of public investment. While SaM has made good progress in containing the accumulation o f hidden fiscal deficits (particularly budgetary arrears and losses in the energy sector), consolidated public spending has steadily increased, reaching a projected 45.3 percent o f GDP in 2004 (Box 3).13 This threatens growth and macroeconomic stability by: (i) keeping taxes and interest rates high, thereby crowding out private activity, discouraging private investment and encouraging the informal sector; and (ii) reducing fiscal flexibility. SaM therefore needs to implement fiscal adjustment based on durable cuts in non-interest expenditure while ensuring adequate public investment (which i s currently low as a share o f GDP and often used as an in-year balancing item). l3Increasesinwages andtransfers were the key contributingfactors to the rapid expansion of government expenditure. 10 Box 3: An Overview of Selected FiscalFigures (YOof GDP) Evolution of Consolidated Public Spending inSaM Wage Bill: SaM vs Selected Countries 50 14 Estimae 12 Croatia 40. 10 30 8 6 20. 4 10 2 0. 0 2000 2001 2002 2003 2004 Subsidies: SaM vs Selected Countries Transfers: SaM vs Selected Countries' 5 25 Hunoarv SaM 20 15 10 5 0 Capital Spending: SaM vs Selected Countries' 7- Cmaia Source: WorldBank and IMF stafreports, GFS-2001. Averagesfor 1995-2002,except SaMfor whichpreliminaly figuresfor 2003 as apercentage of SaM's GDParepresented 1 11 30. Efforts to reduce public expenditures as a share of GDP should focus on: the public sector wage bill; subsidies and net lending; and social transfers; particularly pensions and healthcare. The level of spending as a share o f GDP on each o f these underlying structural components i s higher in SaM than for other countries in the region (Box 3). The public sector wage bill, which has been growing rather than declining since 2001, accounted for 10.5 percent o f GDP or 22.6 percent o f total spending in2003. As core wages are low, this highlevel o f spending primarily reflects the large numbero f public employees. Budget subsidies and net lending, both o f which increased in 2003, are also significant contributors to the high level o f public expenditureat around 4.3 percent o f GDP in2003. While the level o f subsidies inthe budget has increased since 2001, this reflects the introduction o f more transparent budget management with a shift away from off-budgetary expenditures. Social transfers at around 20 percent o f GDP are close to the level o f wealthier countries, raising affordability concerns. Within social transfers, the two most important areas are the pension and healthcare systems. 31. Addressing these underlyingstructuralsources of high expenditurewill require strong progress on structural reforms. Reducing the public sector wage bill will require public administration reform, together with deep reforms in the main sectors o f public employment, includinghealth, education, defense, and internal security. Reducing subsidies and net lendingwill require accelerated progress on restructuring and, where appropriate, privatization o f large loss makers, particularly railways. Reducing social transfers will requireboldmeasures to improve the sustainability o f the pension and healthcare systems. Against this background, the key structural reforms to be addressed under Goal 1 o f the CAS are: (i) public administration reform; and (ii) pension reform. Restructuring and privatization will be addressed under Goal 2, and healthcare, including financing issues, will be addressed under Goal 3. Public administration reform 32. Progress on public administration reform in Serbia has so far been limited. l4Lack o f political consensus on administrative reform measures has stymied necessary institutionalreforms, resulting in continued major distortions in staffing numbersin individual sectors, politicization o f key positions (often down to head o f department level in ministries), a highly compressed and inadequate remuneration system based on years on service and ad hoc benefits, and reliance on donor-funded temporary expert staffto overcome capacity constraints. These weaknesses inpublic administration, which have beenfurther exacerbated by implementation o f the Belgrade Agreement and the Constitutional Charter, affect the quality o f state administration and the continuity o f its work over time, and create a strong disincentive for highly quality staff to stay in the civil service. Overcoming these weaknesses will improve the efficiency and effectiveness o f public administration, and contribute to macroeconomic stability by reducing the public sector wage bill and to private-sector led growth by building a strong independent regulatory management system. Inaddition, public administration reform is essentialto facilitate much-neededeconomic and social sector reforms. 33. The medium-term agenda in Serbia is substantial. Necessary medium-term reforms include: (i)right-sizing the administration through a comprehensive review ofthe needs of individual sectors; (ii)de-politicization; (iii)reform o f the pay and benefits system; (iv) modernizing the legal basis for operation o f the civil service and public administration; (v) l4It is generally recognized that weaknesses in the institutional systems in both republics will seriously affect the design and implementation o f economic and social reform programs if a substantial improvement in the quality o f public administration systems is not achieved. Furthermore, unreformed administrative systems will continue to impose a high fiscal burden, as salary and wage costs as a percentage o f GDP remain among the highest in Europe, especially in Montenegro. Finally, the objective o f integration into European structures o f both republics requires radical progress in institutional reform if institutional capacity criteria for EUmembership are to be met inthe mediumto long term. 12 modernizing the regulatory management system; (vi) enhancing accountability in the public administration; and (vii) re-allocating hnctions across levels o f government. The new Constitution, currently under preparation, will helpto set the framework for some o f these reforms by clarifying the administrative structure o f the republic, settling some key issues in central-local government relations, and creating the basis for the adoption and implementation o f key administrative reform legislation. Given fiscal constraints, the reform o f the salary system will needto be accompanied by retrenchment efforts. 34. The Government of Montenegro launched an ambitious, comprehensive public administration reform process in 2003, in response to growing distortions in public administration, which led to wage costs as a share o f GDP spiraling to among the highest levels in Europe. Significant progress has been made, particularly in terms o f the legislative framework. Laws on State Administration and Inspection Scrutiny were enacted in mid-2003. The former foresees the reform o f the structures o f ministries, with policy-making fimctions to be separated from service delivery and regulatory functions, while the latter sets out modern principles and procedures o f inspection oversight o f public administration, private companies, and citizens. In addition, Laws on General Administrative Procedures and on Administrative Disputes (Judicial Review) were enacted inOctober 2003, and Laws on Civil Service and on Salaries were adopted in April 2004. The latter two laws provide the legal basis for establishment o f a professional, merit- based civil service system, including de-politicization o f appointments below the level o f Assistant Ministerand Secretary-General, and de-compressionandmodernization ofthe pay system. 35. While good progresshas been made over the past year, the agenda remains substantial and continued efforts will be requiredover the mediumterm, as demonstrated by the number and scope o f initiatives currently under way. These include gradual implementation o f the new salary system beginning with the 2005 budget, including initial steps on wage de-compression; implementation o f the new human resource management system (including performance-based assessment); mandatory regulatory and policy fiscal impact analysis with a plan to expand coverage to include environmental, economic, and social impact analysis; and, with the aim o f reducing abuse o f office and corruption and creating a more responsive client-oriented administration, establishment o f an Ombudsman's office and an administrative court and special appellate court. Pension reform 36. Further pension reform is also essential to improve fiscal sustainability in both republicsand to make roomfor better targeted social protectionprograms. Social protection spendinginboth republics is dominated bypensions (accounting for more than 12 percent of GDP in Serbia). The pension system in Serbia, which is supposed to be financed by employer and employee contributions, requires budgetary transfers to cover more than half o f its expenditures, while less than two-thirds o f the elderly are even receiving pensions and an even smaller percentage o f the current labor force i s contributing to the pensions system. Pension expenditures inMontenegro are 13 percent ofGDP and contributions cover less than 60 percent ofexpenditures, given the 2004 reduction in contribution rates. This level o f expenditure distorts labor market decisions and jeopardizes fiscal sustainability, as well as crowding out other forms o f social expenditure that could be more targeted towards the poor. Both republics undertook significant pension reforms in 2002-03: raising the retirement age, widening the calculation period, lowering accrual rates through a points-based formula, tightening the indexation mechanism, eliminating non-pension benefits, tightening disability eligibility, and eliminating temporary disability. However, these reforms notwithstanding, the pension systems continue to carry significant deficits. 13 37. This is particularly true in Serbia, where the Government is looking for additional ways to improve the sustainability of its pension system. Over a five year period, the reforms already being implementedare expected to reduce the burdeno f the pension system by 2 percentage points o f GDP, leaving a deficit that will need be financed from the central budget in the absence o f increases in contributions or further reforms. Expenditures are expected to decrease the pension to GDP ratio below 10 percent in the next 7-10 years due to a slower inflow o f new pensioners, less generous indexation, and the impact o f expectedreal wage growth coupled with declining inflation. Further improvements in financial sustainability will require additional parametric reforms, improvements in both collections and enforcement, and, at a minimum, administrative consolidation of Serbia's three pension funds. It i s important to note, however, that, while extremely important, these measures will not have a substantial positive impact on the pension deficit in the near term. Together with the measures already taken, improvements in collections and enforcement, coupled with parametric reforms such as moving to inflation indexation o f pensions after retirement and raising the retirementage for women, could lower the deficit from its current level o f more than 5 percent o f GDP to less than 2 percent o f GDP by 2020. Efforts to establish the legislative, administrative, and supervisory framework for a multi-pillar system should also be continued alongside the measures discussed above with a view to introducing second and thirdpillars inthe mediumto longterm. 38. Additional pension reform may also be necessary in Montenegro. The pension deficit as a share o f GDP was slightly lower than in Serbia at 3.9 percent o f GDP in 2002. As outlined above, significant reforms were introduced in late 2003. These changes could lower the pension deficit to less than 1 percent of GDP in 2006 and could eliminate the pension deficit by 2009. However, the impact of these reforms i s somewhat uncertain due to the lowering o f the contribution rate in2004 and the envisaged transfer o f collectionresponsibilities to the Department o f Public Revenuesin2005. Goal 2: Creating a larger, more dynamic private sector 39. Achieving Goal 2 will require progress in a number of difficult areas. First, a package o f reforms - including continuedprivatization, enforcement of hardbudget constraints, improvements inthe business environment, and continued financial sector reform -is required to reduce the size o f the public sector in economic activity (thereby also contributing to Goal l), create a favorable environment for the development o f the private sector, and improve the competitiveness o f domestic companies. Second, restructuring, and eventually privatization, o f the energy sector i s needed to address financial sustainability (thereby also contributing to Goal 1) and improve the reliability o f energy supplies. Third, reforms are required to boost agricultural production and improve the competitiveness o f farmers and ago-processors, particularly in EU markets. Fourth, further progress on cleaning up and protecting the environment i s necessary to ensure quality economic growth over the mediumterm. Enterprise andjhancial sector reform 40. Good progress has been made in both republics on enterprise and financial sector reform since 2001. Despite a difficult sales environment, the tender and auction privatization o f socially-owned enterprises has made good progress. The authorities have also made substantial improvements in the legal and institutional fi-amework aimed at efficient entry, operation, and exit o f enterprises. In parallel, important steps have been taken towards rebuilding the financial architecture through liquidation o f deeply insolvent banks, restructuring o f banking sector arrears, privatization o f state-owned banks, and updating o f the regulatory framework for the banking and insurance sectors. Despite these achievements, however, SaM i s near the bottom on indicators o f enterprise sector reform progress, such as the Bank's "Cost o f Doing Business," suggesting that 14 much remains to be done. Similarly, the financial sectors inboth republics remain underdeveloped by regional benchmarks, with the existing level o f financial intermediation being unable to fully contribute to the economic growth agenda. 41. Resolution of state- and socially-owned enterprises to be completed. Enterprise data show that new private and privatized firms clearly outperform state-owned enterprises. Firms in pre-privatization limbo face little incentive to search for new markets, restructure their production, or create new and more securejobs. Financial and organizationalrestructuring and subsequent sale o f troubled industrial conglomerates, or viable parts thereof, needs to be speeded up. Unsaleable loss-making conglomerates should be subject to bankruptcy procedure under the new insolvency laws inthe respective republics. 42. Financial discipline needs to be strengthened to enhance restructuring and to attain permanent fiscal adjustment. This i s crucial to: (i) encourage poorly performing firms to push ahead with restructuring, thereby releasing factors o f production (non-core assets) to higher productivity users; and (ii) encourage viable enterprises to actively search for new markets and reduce costs (including maintaining wage increases in line with productivity growth). These objectives can be achieved through: (i) out direct and indirect subsidies, including the phasing Development Fund and forbearance o f arrears; (ii)effective implementation o f bankruptcy legislation; (iii) continuation o f the unbundling and restructuring (workforce and debts) o f public utilities; and (iv) establishment o f an adequate regulatory framework in infrastructure sectors, paving the way for private sector participation in management, financing, and ownership o f infrastructure. Sustainable fiscal adjustment i s impossible without permanent restructuring and privatization o f the real sector (in parallel with public administration reform) because, as experience inECA shows, un-restructured large ("too big to fail") enterprises continue to lobby for subsidies and crowd out the private sector. 43. The business environment needs to be further improved. This will facilitate the smooth movement o f the factors o f production from low to high productivity enterprises, allowing these firms (including foreign-owned firms) to expand their production. The main challenges in improving the business environment are: (i)strengthening contract enforcement by updating relevant legislation and enhancing the capacity o f courts; (ii)improving access to credit by establishing an institutional and legal framework conducive to lending operations; (iii) reducing the regulatory burden on enterprises through public discussion o f draft laws and removal o f overlapping functions o f various state authorities; (iv) improving access to land by changing the constitutional treatment o f urban land, removing administrative barriers, resolving the issue of restitution, and establishing a modern cadastre system; and (v) improving infrastructure, particularly water, energy supply, and solid waste disposal. 44. Accelerated reform and modernization of financial sector should proceed in parallel with reforms of the real economy and business environment. The current domination of Serbia's financial system by inefficient and problem-laden local banks, many o f which are state- owned, presents significant risks and limits the potential for intermediation for the real sector on a sustainable and affordable basis. Based on the experiences o f other transition economies, Serbia needs speedy, yet transparent, privatization o f state-owned banks to strategic investors through open tenders. Those banks that cannot be sold and/or are unlikely to compete effectively even if their balance sheets could be cleaned up will need to be merged or liquidated. The challenges for Montenegro include the completion o f divestiture o f state-owned banks and the resolution o f non- performing assets accumulated inthe system. Inparallel to the resolution o f state-owned and non- performing assets, authorities in both republics need to establish and enforce stronger regulatory and supervisory discipline across the whole o f the banking sector, with a view to minimizing vulnerabilities and promoting further consolidation. Finally, legal and institutional foundations 15 should be laid for development o f viable non-bank financial institutions, with a particular focus on insurance sector reform. Energy sector reform 45. Improving the performance of the power sector is also essential to underpin fiscal sustainability and encourage private sector-led growth (see Box 4). Good progress has been made in this regard in Serbia since early 2001. First, tariffs have been steadily increased - accompanied by appropriate social welfare measures - and now cover operating costs plus debt service and depreciation. Average (residential, commercial, and industrial) power tariffs were increased from 0.9 U S c/kWh in January 2001 to 4.2 U S c/kWh in July 2004. Second, residential collection rates have increased to around 92 percent and efforts are being made to improve collections from industrial consumers through restructuring and privatization. Third, a new Energy Law was passed in July 2004. This law will unlock the industry reform process, most notably through enabling the establishment o f an energy regulator and the restructuring o f energy companies. Fourth, progress has been made on commercialization o f the electricity utility Elektroprivreda Srbije (EPS) by spinningoff non-core assets (including coal mines). Box 4: S a M Electricity Sector and ECSEE An important development is the EC-sponsored, and Bank-supported, initiative to establish the Energy Community o f South Eastern Europe (ECSEE), focusing on electricity and natural gas. SaM i s a signatory o f the "Athens Memorandum," which launched the process for the establishment o f ECSEE, together with Albania, Bosnia and Herzegovina, Bulgaria, Croatia, KOSOVO, the former Yugoslav Republic o f Macedonia (FYR Macedonia), and Turkey. The EC and the Stability Pact also signed the Memorandum as its sponsors. The participants have agreed to adopt rules relating to the organization and functioning o f the electricity and gas markets designed to facilitate competition and ensure that access to networks i s non-discriminatory, transparent, and fairly priced. The markets are to be based on the principles set out in the Electricity Directive, the Gas Directive, and other legislation relating to the operation o f the EU's Internal Energy Market, including environmental legislation. A recent Bank-sponsoredstudyhas shown that electricity shortages could develop inthe region unless significant investments are made in installing new generation capacity, rehabilitating existing aging capacity, and upgrading transmission networks. SaM could benefit significantly from the creation o f ECSEE. Its participation in the regional energy market will improve the reliability o f supply, reduce the need for additional generation capacity, increase security o f energy supply, and strengthen incentives to connect the Balkan region to Caspian and North African gas supplies. The on-going Serbia Emergency Electric Power Reconstruction Project, co-financed by nine donors, supports SaM's participation inECSEE. Inparticular, investments under this project have included transmission network rehabilitation and installation o f cross-border meters, both o f which were part o f the technical requirements for the regional market. In addition, generation rehabilitation under the project will ease the near-term capacity deficit, thereby also supporting the evolution o f competition. The institutional components o f the project have supported reforms, including development of an energy law and restructuring o f the power utility, both o f which will help Serbia to comply with the requirements o fthe Athens Memorandum. The Bank intends to continue to play an important role in supporting SaM's efforts to participate in ECSEE beyond the completion o f the EEPP project, as well as through the Montenegro Emergency Power LIC, by providing strategic advice and preparing regional projects to finance relevant priority investments. For example, deficiencies that constrain SaM's participation in ECSEE will be addressed under the planned Regional Energy APL inSerbia inFY05 andinMontenegro inFY06. 46. Looking forward, the challenge is to implement the new Energy Law, including restructuring of EPS. Two key components o f the Energy Law are the establishment o f a sector regulatory framework and restructuring o f EPS's core business. The latter will involve separating ownership o f power generation, distribution, and transmission, together with labor restructuring 16 (EPS i s currently overstaffed, as evidenced by low levels o f labor productivity). There i s also a need for further improvements in payments discipline. Performance here (both as regards collections and commercial losses) remains poor relative to Western European standards. Necessary actions to support improvement in this area include power distribution network re- metering; the development o f a billing, collection, and disconnectionmanual; and implementation o f the existing Ministry o f Energy/EPS plan for reduction o f commercial losses. Further increases intariffs are also likely to beneededto finance investmentsinthe mediumterm. 47. Good progress has been made in power sector reform in Montenegro; the big challenge i s implementation. Most notably, an Energy Law was enacted in June 2003 and an independent regulator, which has already issued licenses for various energy companies, was subsequently established. Tariffs have been increased to an average o f almost 5 US c/kWh (sufficient to cover operating costs). Going forward, the challenge i s to buildon this progress through implementation of the Energy Law, particularly as it relates to Elektroprivreda Cme Gore (EPCG) restructuring. The Law envisages that EPCG will be unbundled in the first quarter o f 2005 and that power generation, transmission, and distribution will function as separate entities. While there i s a need to reform tariffs for large customers, the overall focus should be on improved payments discipline through increased collections, reductions in losses, and, in the case o f commercial customers, an eradication o f payments through offsets. To ensure that tariffs cover operating costs on an ongoing basis, the regulator needs to develop secondary legislation on tariff methodologies. Inaddition, the Government should undertake an energy affordability study and introduce social protection measures as requiredto protect poor and vulnerable groups. Agriculture 48. A number of difficult issues need to be tackled to realize the agricultural sector's full potential, particularly in Serbia. The contribution o f agriculture to GDP has increased over the last 10 years. Primary agricultural production and ago-processing currently account for around 25 percent o f GDP, and agricultural products comprise about 26 percent o f Serbia's exports. At the same time, however, while farm land i s largely privately owned (86 percent), agricultural reform has beenrelatively slow and there are significant barriers to realizingthe sector's full potential. In particular, public and private institutions associated with agriculture need to be strengthened; the necessary private markets for land, rural finance, and agricultural produce and inputs need to be developed; reform o f trade and incentive policies needs to continue; agricultural competitiveness needs to be improved, particularly interms o f food quality and productioncosts; and the authorities needto continue to tackle landregistration and titling. 49. In 2004, the Government of Serbia initiated several new programs of rural assistance. The agricultural credit scheme aims to encourage rural lending by commercial banks and to help rural borrowers access financing by establishing credit histories. However, early feedback suggests that there i s scope for increasing the effectiveness o f this program. The rural development grant fund seeks to enhance the sustainability o f primary agricultural production, develop the rural economy, and improve the livelihoods o f rural households through improved diversification of income source^.'^ These schemes have been accompanied by introduction o f a farm registry, with the eventual aim o f building, in line with EU standards, a single payment agency. While registration i s voluntary, only registered farms are eligible for rural development grants, subsidies, and rural credits, and for receiving agricultural advice from the state agricultural extension system. With EU funding, the Government also began a program o f upgrading veterinary, phyto-sanitary, The fund provides partial grants (20-50 percent o f the value of investments) for farm and marketing improvements and village community development through non-agricultural economic activities, such as ago-tourism. 17 and food safety laboratories, training laboratory staff, and establishing a network o f regional animal health, local food safety andphyto-sanitary laboratories. 50. Looking forward, the Government of Serbia is expected to focus its efforts on increasing agricultural competitiveness and improving natural resource management. Agricultural advisory services have an important role to play in improving competitiveness. In particular, farmers need advice on: (i) technical, management, and marketing skills; (ii) food safety EU standards; and (iii)access to finance. Inthe short run, the Government intends to improve the rural credit system and rural development grant fbnd (based on the EU model) and to reorient the agricultural advisory system to focus on the needs o f farmers and ago-processors ina competitive, open market economy. Efforts to improve natural resource management, including flood and drainage management, agricultural pollution reduction, and agro-biodiversity are also expected. However, improvements in water resource management are essential to increase agricultural productivity through rehabilitation o f the irrigation and drainage system; reduce land, crop, property, and infrastructure damage through rehabilitation o f flood management infrastructure; and strengthen the associated institutions. Environmental management andprotection 51. While considerable progress has been made in Serbia, the institutional and regulatory framework needs to be strengthened and core environmental problems need to be tackled. Environmental management continues to suffer from limited institutional capacity, overlapping competencies, an inadequate legal framework, and a lack o f investment fbnds for core problem areas. Completion and implementation o f the National Environmental Action Plan (NEAP) and four Local Environmental Action Plans, along with a new set o f laws governing environmental protection, environmental impact assessment, and pollution prevention and control, should help to address some o f these weaknesses and lay the groundwork for overcoming core environmental problems. The latter include solid and hazardous waste management; pollution o f surface and groundwater sources by industrial, municipal, and agricultural sources; localized severe air pollution near mines and power plants; deteriorating drinking water quality and lack o f adequate sewerage (especially in poor urban settlements and rural areas); energy inefficiency; inadequate forest and biodiversity management; and a threat to forests from uncontrolled cutting. Enforcement o f new laws will be a significant challenge requiring stronger political commitment and institutional capacity. 52. In Montenegro, effective landscape and watershed management, including flood and erosion control, are key to sustainable development of tourism. Achieving this would, however, require an improvement in institutional capacity, the legislative framework, and enforcement, as would overcoming important environmental problems. The latter include air, water, and soil pollution by a few large hotspot industries, mines, and plants; lack o f satisfactory waste and waste water management; and unsustainable natural resource and coastal zone management. As in Serbia, efforts, supported by donors, are underway to develop environmental legislation inline with EUstandards, but strong political commitment will be required for effective enforcement. Goal 3: Reducing poverty levels, and improving social protection and access to public services 53. As outlined in the PRSP, in addition to robust sustainable economic growth, there are three key challenges under Goal 3: (i) combating rural poverty; (ii) improving social protection (excluding pension reform - discussed under Goal 1); and (iii)improving access to quality, affordable health and education for all citizens, including poor and vulnerable populations. As 18 described in Box 5, poverty in both Serbia and Montenegro i s relatively shallow with a sizeable portion o f population living "at risk" o f poverty (50 percent above the poverty line). This profile, together with experience from other countries in Europe and Central Asia (ECA), suggests that robust, sustainable economic growth i s essential to reduce poverty. At the same time, however, special attention i s required to address growing regional disparities; to improve the coverage, targeting, and reliability o f transfers for social protection; and to improve the quality and financial sustainability o f health and education for all citizens (see Box 6 for a discussion o f Roma issues). Box 5: Poverty in Serbia and Montenegro PRSPs and Poverty. Bank work onpoverty inSaM follows a programmatic approach geared towards supporting the PRSP processes withineach republic. This work has several aims: (i) collecting and analyzing representative data on living standards; (ii) arriving at a diagnosis o f poverty shared by the authorities and the Bank; and (iii) establishing adequate baseline data to monitor changes in poverty over time. The f i s t output o f the Bank's poverty program inSaM was the Poverty AssessmentReport released inJune, 2003 (Report No. 26011YU). This report is being followed by a series o f analytical studies (covering rural poverty, ethnic dimensions o f poverty, andpoverty and the environment) and ongoing data collection to trace the evolution o f the riskofpoverty as well as its specific characteristics and dimensions. Poverty Incidence. Inmid-2003, material poverty (defined as a consumption level below the country-specific absolute poverty line) affected around 10percent o f the population o f both Serbia and Montenegro. However, this favorable poverty profile reflects the Governments' decisions to use the bottom o f the estimated range o f the poverty line in order to focus their policies on the neediest. When the top o f the range i s used (inline with common practice in Central and Eastern Europe), around 20 percent of the population of SaM i s poor. In addition, proper accounting for marginalized groups (including Roma and internally displaced persons - IDPs), who are under-represented in the regular household sample surveys, further raises the estimates o f poverty. Poverty in SaM i s also relatively shallow: the economic recovery experienced by Serbia in 2002-03 reduced absolute povertyby one-third. Poverty Dimensions. The proportion o f the population "at risk" o f poverty (those livingjust above the poverty line) is relatively high inboth republics at around20 percent. This suggests even small economic shocks can have potentially large effects on poverty. At the same time, non-income dimensions o f poverty are relatively good, including decent housing, access to water and sanitation, and basic education, all o f which are within the reach of the majority o f the poor. There are, however, important pockets o f poverty inwhich the population faces multiple deprivations, notably the poor in rural areas and in new urban slums, as well as ethnic minorities and IDPs. Moreover, poor households face serious problems accessing the healthcare systemdue to the burden o f informal payments and the lack o f full health insurance coverage. Who are the poor in SaM? Two-thirds of the poor have only primary (elementary) education. Multivariate analysis o f poverty risks suggests that lower education attainment i s the key background factor explaining the higher incidence of poverty for rural households andjobless households. Jobless households (families with working age members where no one works) have more than twice the average poverty incidence and are prone to chronic poverty. Working households (families with at least one employed member) account for 75 percent o fthe poor -"the working poor." Rural households have a higher incidence o f poverty than urban ones. Poverty incidence is double the national average insouthern Serbia (and did not benefit from the 2002-03 recovery, thereby widening the gap with the rest o f the country). In Montenegro, poverty incidence in the north is twice the level in the centerisouth. 0 Households with IDPs, refbgees, or ethnic minorities, especially Roma, experience high levels of poverty. Roma households are likely to experience high levels o f poverty on all dimensions and suffer from persistent chronic poverty. 0 While the risk o fpoverty is the roughly the same for male- and female-headed households, the latter are more prone to the risk o f chronic poverty. Multivariate analysis suggests that this reflects less active participation and fewer years o fexperience inthe labor market, as well as lower pay. 19 Ruralpoverty 54. Rural poverty in SaM is high and increasing. Rural poverty rates have doubled since 1990. As o f 2003, 75 percent o f all poor in Serbia live inrural areas, despite the fact that the rural share o f the total population i s less than 45 percent. The problems o f rural youth are particularly acute. Surveys indicate limited opportunities, a widespread pessimistic attitude (with a gap existing between reality and expectations, and the risk o f anti-social behavior), a perception of corruption in education systems, and participation in a grey economy, often including human trafficking. 55. In addition, deteriorating rural infrastructure is contributingto public health risksand rising costs of transport for rural communities. O f particular concern i s the quality and reliability o f the water supply; surveys have indicated that the great majority o f rural water supply systems do not comply with bacteriological standards and that nitrate pollution, caused by both domestic waste water and agricultural activity, i s o f serious concern. Rural water supply services are currently confronted with an institutional and legal vacuum, relying entirely on a tradition of self-reliance. Moreover, about 45 percent o f solid waste in rural areas i s inappropriately disposed o f or dumped. As villages are often grouped with larger urban municipalities, local govemment spending priorities may reflect urban, rather than rural, priorities. 56. While active assistance programs for the agricultural sector will help, a more broad- based approach to rural development will be required in the poorest regions. Encouraging agricultural production and improving the competitiveness o f the agricultural sector will play an important role in alleviating rural poverty, particularly in Vojvodina and Central Serbia (see paragraphs 48-50). In the poorest areas of the two republics, southern Serbia and northern Montenegro, however, a more broad-based approach to rural development i s requiredto boost rural livelihoods, improve access to services, and build an awareness and appreciation for the environment andbiodiversity. Box 6: The Roma Decade in SaM Roma constitute a large and vulnerable minority group inboth Serbia and Montenegro. According to the 2002 Serbian census, Roma constituted 1.4 percent o f the population, while estimates by NGOs and international organizations place the Roma population at about 4 percent o f the population. Approximately 20,000 Roma are estimated to live in Montenegro. Roma in both republics are significantly poorer than the general population. Estimatedpoverty among Roma in2003 was 68 percent in Serbia, or 8 times higher than the total population, and 52 percent inMontenegro, or 4 times higher than the total population. Roma poverty is multi-faceted; more Roma are out o f work and more Roma children out o f school than inthe rest o fthe population. In2003, only 7 percent o f Roma children were inschool. Housing conditions are also poor and many Roma live in illegal settlements. Many Roma in SaM are IDPs from the Kosovar conflict. According to UNHCR, some 40,000 to 50,000 Roma were forced to leave Kosovo in 1999. Living conditions for displaced Roma are extremely poor and some municipalities have beenreluctant to accept Roma IDPs. InJuly 2003, Serbia and Montenegro participated inthe first high level regional conference on Roma. Federal Minister o f National and Ethnic Communities, Rasim Ljajic, and Milo Djukanovic, Prime Minister of Montenegro, participated and committed Serbia and Montenegro, along with seven other Central and South Eastern European Countries to launch a Decade o f Roma Inclusion from 2005-2015. Working groups at the republican and federal level, comprising govemment officials and Roma NGO leaders, have worked on select goals inthe areas of education, employment, health, and housing that the republics will try to achieve during the Decade. The Decade is being coordinated with the Ministry for Minorities' National Strategy for Roma, which was adopted inApril 2004, and the PRSPs. 20 Sources: Serbia Roma 2003 Poverty Survey, ISSP Household Survey of Roma, Ashkaelia and Egyptians, Refugees and Internallv Disulaced Persons. 2003 21 Social Protection 57. Further measures are needed in both republics to strengthen the social safety net to protect the poorest households, including improved coverage and targeting of cash benefits and a modernized system of social services for vulnerable groups. Both republics have moved beyond addressing immediate humanitarian needs o f refugees and IDPs to systemic reforms designed to support fiscal sustainability while continuing to provide core benefits and services to the population. While some progress has been made, areas for further reform include: (i) improving coverage through increased spending on some o f the more effective and better targeted programs (especially, Material Support to Families (MOP)); (ii) improving in the targeting and administration of other programs that transfer resources to vulnerable groups (such as child allowances, caregiver's allowance, veterans and disabled allowances, and parental allowances); and (iii)improving the effectiveness of social services for vulnerable groups (including the development o f standards, regulations, and monitoring and evaluation mechanisms, and o f special approaches for specific groups - children without parental care, young with behavioral problems, disabled, elderly, and Roma). In addition, there i s a need to build capacity in local governments and non-governmental organizations (NGOs) in developing and delivering services, thereby improving access for poor and vulnerable groups, including Roma, IDPs, and refugees. 58. In Serbia, recent legislative reforms to extend the coverage of MOP need to be accompanied by administrative reform and efforts at improving social service delivery. The MOP program in Serbia i s well-targeted but coverage i s low. Recently completed legislative reforms are designed to improve MOP coverage: (i) establishing a uniform national eligibility threshold for MOP; (ii) indexingbenefits to the cost of living; and (iii) increasing benefit levels. However, the results o f these changes will need to be monitored to ensure that they improve the welfare o f the poorest households. Moreover, these legislative changes need to be supported by further administrative reform, including building the capacity o f local governments to deliver benefits and services and improving efficiency by consolidating the MOP program and child benefits (currently delivered by different agencies). Improving the effectiveness and quality o f social services, and shifting away from over-reliance on institutional care, i s a core element o f the republic's PRSP. The Social InnovationFund(SIF) i s a key instrumentinthis respect - it i s a fast- track social reform mechanism that aims to support innovative social service projects at the local level and feed the results into policy development. 59. Montenegro introduced reforms in 2001 that improved coverage of the MOP, but overall coverage remains low, targeting i s poor, and there are also serious problems with payments arrears (around Euro 10 million, in addition to around Euro 6.5 million o f old arrears on child allowances). The Government is aiming to expand local government and NGO involvement in social services - particularly to further the development of altemative, community-basedmechanisms for social care. Health and Education 60. While recent progress in Serbia has been encouraging, reforms are needed to improve the financial sustainability and affordability of healthcare, as well as service delivery. Despite highpublic and total spendingon healthcare (around 7 and 11percent o f GDP, respectively), the publicly-financed health system suffers fiom chronic arrears16and other signs o f financial distress, and access to healthcare by the poor i s limited by high out-of-pocket costs (in the 2003 Poverty l6Net accumulated arrears by the end of 2001 were CSD 6.7 billion (1 percent o f GDP). Deficits have been met through a combination of commercial loans, delays in payments to suppliers and providers, artificially low reimbursement prices, and contractual revenues levels that do not ensure full cost recovery. 22 Assessment, over 30 percent cited high costs and lack o f insurance coverage as principal reasons for lack o f access to healthcare services). Despite reductions in contribution and co-payment exemptions, the level o f revenues to the Health Insurance Fund(HIF) i s low because o f the large informal economy and administrative weaknesses, while budget transfers to cover healthcare for vulnerable groups and rehgees have been grossly inadequate and poorly executed." Issues in service delivery include deficiencies in clinical and patient registration practices in primary healthcare and capitation-basedpayments for primary health care providers. 61. In particular, further progress on establishing the legislative and institutional foundations for health reform (including the development o f new framework laws on healthcare, health insurance, and pharmaceuticals) and on reforming the health insurance system are necessary- a major challenge given weak institutional capacity. These measures can be expected to provide a basis for addressing many o f the key challenges facing the sector, including: a mix o f public and private healthcare provision; a gate-keeping role for primary care doctors; patient choice o f provider; a licensing system for doctors; autonomy for the HIF; new provider payment methods; a more rational approach to identifylng health benefits on the basis o f cost- effectiveness; better monitoring o f prescriptions; and a pharmaceutical regulatory and procurement system based on principles o f competition, cost-effectiveness, and quality. However, the institutional capacity to carry out this work i s limited, both in terms o f personnel and information systems. 62. Montenegro has taken important first steps toward reform of the health sector, but measures are required to improve both quality and financial sustainability. In 2003, Parliament endorsed a health strategy that set the overall direction for reforms in the organization, financing, and provision o f healthcare services. Framework laws on health care and health insurance were subsequently adopted in2004, and a revised law on medicinalproducts i s currently under public discussion. However, as in Serbia, total health spending i s high (about 11percent o f GDP) and Montenegro's HIF runs arrears (accumulated arrears in 2003 totaled Euro 12 million). This reflects high pharmaceutical expenditure, an unaffordable benefits package, and provider payment methods that lack efficiency incentives. Health insurance contributions - until recently the mainstay o f health finance - were reduced in 2003 as part of the Government's efforts to improve the investment climate for SMEs, thereby increasing reliance on budgetary transfers. l8 Improving the reliability and timeliness o f budget execution i s therefore critical to reform efforts and essential to the financial stability o f the HIF. Failure to improve financial sustainability could result in an increase in out-of-pocket payments and deterioration in access, which would disproportionately affect poor and vulnerable populations. To address these issues, the authorities are preparing a medium-termfinance program for the health sector for 2005-2007. Although the recent strengthening o f financial and technical capacities in the HIF,19together with the ongoing promotion o f a comprehensive, technically sound primary health care reform agenda, portend well, full implementation o freforms is necessary to ensure quality, affordable healthcare. 63. As outlined inthe PRSP, fighting poverty means providingpeople leaving the education system with better skills and targeting education sector resources in favor of disadvantaged groups in both republics. The key challenge i s to improve the overall efficiency and quality o f l7 The amounts required for covering vulnerable groups in 2004 was estimated at CSD 5.9 billion, while the budgetary allocation was only CSD 2.83 billion. Data from Q1 2004 showed that actual transfers were running 75 percent below budgeted amounts for the quarter, raising concerns about the timeliness and completeness o f budget execution. '*The 2003 cuts were compensated by a combination o f expenditure cuts by the HIF and the promise o f increased budget transfers from the Ministry o f Finance. The reliability o f budget transfers to the HIF has historicallybeen poor, especially on behalfo f refugees and vulnerable groups. l9 A number o f expenditure control measures have been successfully introduced over the past 18 months, including a tightening o f dental, sick leave, and treatment-abroad benefits; a new pharmacy information system; and a first attempt at internationaltendering for drugs. 23 education, while improving the financial sustainability o f recurrent expenditure. In addition, improving the skills and knowledge o f those leaving education (especially those leaving at the end o f secondary education given the high rates o f unemployment among this group) and developing incentives to increase adult education and training will make a significant contribution to Goal 2, the creation o f a larger, more dynamic private sector. 64. Effective leadership is key to tackling education reforms in both republics. Some o f the key issues in one or both o f the republics include: exceptionally high arrears (estimated as highas 50 percent o f the total public education budget in Montenegro); administrative inefficiencies (including a large number o f small schools in Montenegro); emerging but under-utilized information systems; ineffective professional development practices; secondary education programs that provide only limited vocational training; inadequate infrastructure and equipment; and a fragmented higher education system characterized by low rates o f on-time graduations. Moreover, the considerable challenges facing the sector are made more complex by the presence o f strong teachers' unions advocating for higher wages and benefits. In Serbia, progress on education reform has slowed since late 2003 because o f political uncertainty and policy disagreements. In Montenegro, by contrast, the Government i s pursuing a strong reform strategy, including staff reductions and measures to address Roma issues. IV. World Bank Group Assistance Strategy A. Progress Under the TSS Programs andLessonsLearned 65. The FY02-04 TSS for FRY provided a substantial program of support to the new democratic Government elected to office with a mandate to pursue modernization, market economy reforms, and international reintegration. The TSS set out an overarching framework for a three-year country assistance program and presented pre-membership support and a detailed FY02 program. Subsequent annual programs were outlined inannual TSS Updates (July 2002 and February 2004). Despite the considerable changes that took place during the TSS period, including the February 2003 constitutional transformation from FRY to SaM, the TSS assistance program was implemented largely as anticipated with only slight deviations inresponse to changing country circumstances. While a formal review has not been undertaken, a preliminary assessment of implementation performance and lessons learned i s laid out below. While the FY02-04 TSS objectives were appropriate, the future program should pay greater attention to the poverty impact o f Bank activities and to regional linkages. Givenits transitional nature and the urgency o f programdevelopment, the TSS reliedprimarily on outputs as indicators o f success. The future program, by contrast, should be built on outcome indicators, linkedto the PRSP (and MDGs) and the SAP. While the TSS program unfolded largely as planned, many additional areas requiring support emerged during implementation. Moreover, in some instances, insufficient selectivity was exercised and trade-offs were not sufficiently defined, evaluated, and effected. Given limited resources, increased selectivity should be applied during both future program formulation and implementation. Despite well-intended plans and successes in some areas, capacity buildingwas more limited than envisaged, largely due to frequent changes in the responsibilities and governing structure o f the federal and republican programs, and in ministerial and agency staffing. Against this background, the future program should include substantial capacity building and institutional strengthening. 24 > The decision to maintain separate lendingprograms by republic, including adjustment lending, worked well. The two union-level projects, while now beginning to show some improvement, have proven particularly problematic inimplementation. The CAS should continue to focus on activities at the republican level, supplementedby select regional activities. > The high share of development policy lending under the TSS program proved an extremely effective mechanism for assisting the Government in undertaking difficult policy reforms and in coordinating and catalyzing donor support. Inpart, this reflects the fact that development policy lending was generally accompanied by significant institutional reform. The investment portfolio has proven less successful overall, suffering from implementation delays (many related to the constitutional transition and the complex state union and republican legal framework) and, from time to time, weak government support. This experience suggests that the CAS should continue to provide substantial development policy support and that new investment operations should, where possible, be more closely linked to the reform agenda being pursued under the development policy operations to ensure a stronger and more consistent focus to the Bank's policy dialogue. > Strong donor coordination proved important in delivering results during the TSS implementation period, but the extensive time and costs to the Bank required to support effective donor coordination and partnerships were insufficiently recognized and planned for in the TSS. The best results were achieved when IDA and other donors worked on well-defined, properly targeted, adequately resourced multi-year programs o f cooperation. Particularly strong examples were seen in energy, social assistance, and private and financial sector development. Active efforts to accelerate harmonization and improve donor coordination should be part o f the CAS program. Government coordination o f donor assistance has improved in Serbia, but will needto be strengthened inboth republics over the CAS period. > Strong analytical work must continue to underpin Bank activities. The multi-year poverty analysis program, the Public Expenditure and Institutional Review (PEIR), the Country Financial Accountability Assessment (CFAA), and the Country Procurement Assessment (CPAR) were particularly successful in enhancing and informing the adjustment lending program duringTSS implementation. These tasks proceeded inparallel with the preparation o f development policy lending often with the same teams participating in both, allowing the preliminaryresults o f AAA to feed quickly and seamlessly into policy discussions. > Within SaM's complex political economy, flexibility is critical to program and implementation success. The TSS program had sufficient flexibility to allow the Bank to providejust-in-time advice, including policy notes for the new Serbian Government. > The Bank's Country Office was instrumental in implementing the TSS. An expanded work program under the CAS will require strengthened expertise in procurement, financial management, and legal services, as well as additional sectoral technical expertise. B. ProposedWorld Bank Group Program 66. The proposed CAS for FY05-07 reflects SaM's track record over the past four years and i s anchored in the SAP and the PRSP. All activities envisaged under the CAS will contribute to meetingone or more o f the three country goals that summarize the overall economic objectives and reforms envisaged under the SAP and the PRSP, and around which the CAS i s built: 25 P Goal 1: creating a smaller, more sustainable, more efficient public sector; P Goal 2: creating a larger, more dynamic privatesector; and > Goal3: reducing poverty levels, and improving social protection and access to social services. 67. Consistent with SaM's goals, the CAS will support far-reaching structural reforms in the public and private sectors, while seeking to ensure that poverty is reduced, social protection is adequate and appropriately targeted, and access to social services by the poor and vulnerable i s improved. To ensure a self-sustaining economy and fiscally sustainable public sector in the medium and long term, the CAS strives to help the Governments to strengthen institutions (with institution and capacity buildingembeddedinall planned activities) and to reduce the weight o f the public sector in their economies. This i s a prerequisite for giving the private sector room to grow, thereby stimulating productive activity, domestic private and public savings, and export growth. The WBG will support government efforts to increase efficiency inthe public sector (including in the delivery o f pro-poor social and economic services), while significantly improving governance inboth the private and public sectors and encouraging the development o f a vibrant private sector. In Serbia, the Bank's efforts will concentrate on parallel Programmatic Development Policy Loan (PDPL) programs, one focused on public sector reform (including public administration and pension reform) and the other on private sector development (including enterprise and financial sector restructuring and privatization and energy sector reform). The measures envisaged under the PDPL programs, and development policy support in Montenegro, together with other assistance from the WBG and complementary assistance from other development partners, should, if implemented effectively, translate into economic growth and employment creation. The anticipated major outcomes o f the CAS program are summarized in Table 4 below. Goal 1: Creating a smaller, more sustainable, more efficient public sector 68. The key objectives and expected outcomes during this CAS period under Goal 1 include: (i) consolidation; (ii)leaner and more efficient public administration; (iii) fiscal a better delivery o f state services; and (iv) improved financial sustainability o f pensions, healthcare, and education. Specific outcomes that the Bank would contribute to over the CAS period are shown in Table 4. 69. Support from ongoing WBG projects. In Serbia, Goal 1 i s supported by two ongoing investment projects. The Serbia Employment Promotion Project seeks to improve the efficiency and cost-effectiveness of government-financed labor programs by piloting and testing innovative labor redeployment programs and employment services for the unemployed. The Serbia Health Project has two main components: health services restructuring and health finance, policy and management reform. It i s the second o f these components that relates specifically to Goal 1inthat it seeks to buildthe government capacity to develop, communicate, andimplement healthfinancing mechanisms, health policy, and health sector regulation. 26 Table 4: Summaryof ResultsMatrix Long-term country goals Principalproblems Outcomesthat the Bank Selected ongoing or proposedBank and IFC and IFC (Goal 2) will (Goal 2) activities influencein the CAS period Goal 1: Creatinga smalle moresustainable, more ficient public sector +Reduction in non-interest 4 smaller, more * Fragile current expenditures to GDP Lending Serbia:Employment Promotion, Health sustainable, more efficient macroeconomic by around 4-6 percentage wblic sector stability points New- SAC 2, Pensions (OS), PDPL 2 (06), PDPL * 4 (07) J Maintain Highpublic + Leaner, more efficient macroeconomic expenditures as a share public administration as Montenemo: SAC 2, Pensions System stability o f GDP (47% in2004), Administration, Health System Improvement reducing fiscal measuredby reduction inthe public sector wage bill as a New - DPC 3 (07), Education (OS) 1 Improvefiscal flexibility and keeping share of GDP by 1-1.5 AAA PEIR Update (06), Serbia Economic sustainability taxes and interest rates high percentage points and Memorandum(04), Montenegro Economic progress on wage Memorandum (05), Debt Sustainability Update (05) 1 Moreefficientpublic decompression administration * High spending on public sector wage bill, subsidies, and social + Improvedfinancial transfers, particularly sustainability o fpensions, pensions and health measured by increase in collections and a lower pension deficit as a share o f GDP by 1 percentage point Goal 2: Creatinga larger, lore dynamicprivatesec ir Lending& other financing 4 larger, more dynamic * No effective +Accelerated privatization, m a : Privatization and Restructuring o f Banks vrivate sector bankruptcy or contract with at least 25 tender and Enterprises TA Credit, Private Sector TA enforcement privatizations Grant, FinancialSector TA Credit, Export Finance mechanisms Facilitation, Employment Promotion, TTFSE, Real Improve the business +Increasedrestructuring and Estate Cadastre and Registration, Energy Efficiency, environment * Limited access to EU resolution o f large loss- Electric Power Reconstruction, Transport markets for agricultural making state- and socially- Rehabilitation; IFC support for bank and insurance Accelerate privatizatio products owned enterprises, measured restructuring and privatization, development o f non- and restructuring o f re by a reduction insubsidies bank financial sector and financial sectors * Poor access to finance and net lending as a share o f GDP by 1.1-1.4 percentage New - SAC (OS), PDPL 1 (06), PDPL 3 (07), Regional Energy (OS); Bor Regional Development Develop financial marl * Large state subsidies points (06), Irrigation and Drainage (06), Rural Business to loss-making Environment (07); IFC support to Telekom Srbija, Improve agricultural enterprises + Improvedaccess to Secondary Privatization Pilot output finance, particularly for and exports * Inadequate legislative SMEs Montenemo: SAC 2, TTFSE, Export Finance and regulatory Facilitation, EmergencyPower Reconstruction, Increase private sector framework for private +Restructuring inthe energy Environmentally Sensitive Tourist Areas; IFC involvement in sector participation in sector, measured by the support for bank restructuring and privatization infrastructure infrastructure separation o f ownership o f New - DPC 1 (071, Regional Energy (06), Tourism generation, distribution, and and Agriculture (06); IFCsupport to Telekom transmission, as well as a Montenegro, bank restructuring andprivatization reduction inEPS staffing AAA PEIR Update (06), Serbia Economic + Farmers and agro- Memorandum (04); Montenegro Economic processors more competitive, Memorandum (05); Private Sector Note (05, FSAP with more farmers meeting (05), Agricultural Competitiveness Study (06), EUstandards Labor market policy note (06) IFC Advisory and BIDFacility, regional +Improved landtitling infrastructure projects, SEED 27 Goal3: Reducing povertylevels, and improvingsocial lrotectionand access to publicservii S I Reducingpoverty levels, * Highand increasing rural + Improved coverage and targeting Lending and improving social poverty o f social protection s a : Health, EducationImprovement orotection and better New - PDPL, Bor Regional access topublic services * + Improved quality, access and Development (06), Rural Business Poor coverage and financial sustainability o f Environment (07), Primary Health Care 0 Mitigate social targeting o f social healthcare and education (0 7) impacts o f economic protection, andpoor modemization and reliability o fbudget restructuring transfers for social protection 0 Improvedelivery of Montenepro: SAC 2, Health System social services * Limited access, Improvement especially for the especially for poor and New -DPC 1 (07) poor and vulnerable vulnerable populations, to affordable, quality AAA Programmatic poverty activities, 0 Improveaccessto healthcare and education Serbia Economic Memorandum(04), quality health and Montenegro Economic Memorandum education services (05), Poverty Assessment (07), PRSP implementation 0 Reducepoor and "at risk" populations 70. In Montenegro, Goal 1 is supported by the three recently approved projects. SAC 2 is a multi-sectoral project that will contribute to each o f the three country goals. Interms o f Goal 1, the main contribution o f SAC 2 i s public administration and health sector reform. The Pensions System Administration Investment Project seeks to improve the financial position o f the pension fund by increasing tax and contribution compliance; restructuring and modernizing the key institutions o f the pension system; and strengthening capacity for evaluation and analysis o f the pension system and pension reforms. The main objectives o f the Health System Improvement Project are to improve the financial sustainability o f the healthcare system by strengthening institutional capacity and information systems and to improve quality, efficiency, and access to primary healthcare services. 71. New WBG projects. In Serbia, Goal 1 will be supported primarily through development policy lending, initially through continuation o f the SAC program (SAC 2 Serbia, FY05), and then through programmatic development policy support (PDPL 2 under the base case lendingprogram and PDPLs 2 and 4 under the high case). These operations will form a multi-year program o f assistance to the Government in addressing the key institution building and reform challenges described in Section 111.The program will likely focus on reforms in: (i) public finance; (ii) public administration; (iii) pensions; and (iv) healthcare. The PDPL program in privatization and restructuring o f real and financial sector assets described under Goal 2 (see paragraph 82) will also support rationalization o f the public sector. In terms o f investment lending, under both the base and high case lending programs, the public sector PDPL program under Goal 1will be supported by a PensionAdministration Reform Project inFY05. Like the recently approved pension project in Montenegro, this project offers an opportunity for scaling up and will target improvements in collections and enforcement under the mandatory first pillar, provide assistance in building capacity for policy analysis in the pensions sector, and seek administrative consolidation o f the three pension funds. 72. In Montenegro, Goal 1 will also be supported through policy-based lending. Building on SAC 2, DPC 1 (FY07) will likely be a multi-sectoral operation incorporating measures designed to assist the authorities in meeting all three o f the country goals. With reference to Goal 1, DPC 1 28 will likely focus on deepening reforms and capacity building in the areas of public finance and public administration. 73. Analytical, Advisory and Other Activities. The analytical foundation for both Serbia and Montenegro for the restructuring o f public finances envisaged under Goal 1, particularlythe PDPL program, i s provided by the 2003 PEIR, which will be updated in FY06, and the 2002 CPAR and Country Financial Accountability Assessment. Over the CAS period, the Bank's knowledge base on public financial management (PFM) will be strengthened as necessary. Building on the CPAR and the CFAA, a limited Fiduciary Assessment focused on Serbia's budgetary resource management system i s planned inFY05 to support PDPL 1. This will be followed by an integrated PFM report for SaM in FY06, alongside the PEIR update, that will deepen the Bank's financial management andprocurement analysis. 74. Further analytical support will be provided by the Serbia Economic Memorandum (SEM FY04) and the Montenegro EconomicMemorandum (MEMFY05). The recently completed SEM covers macroeconomic issues (particularly public expenditure), trade, labor market reform, private and financial sector development, and education. The MEM will be completed in FY05 and i s expected to focus on macroeconomic issues (particularly public expenditure), labor market reform, infrastructure, and the business climate. A debt sustainability analysis update for SaM i s also planned for FY05. Additional support for improving the efficiency and effectiveness o f the public sector in Montenegro will be providedthrough an Institutional Development Fund(IDF) grant that aims to strengthen the capacity o f the Central Bank o f Montenegro in term o f internal audit and internal controls. Goal 2: Creating a larger, more dynamic private sector 75. The key objectives and expected outcomes during this CAS period under Goal 2 include: (i) continued progress on restructuring and privatization o f real and financial sector assets; (ii) restructuring and resolution o f large loss-making state- and socially-owned enterprises; (iii) improved access to finance, particularly for the SME sector; (iv) energy sector restructuring; and (v) where appropriate, private participation in infrastructure. Specific outcomes that the Bank and IFC would contribute to over the CAS period are shown inTable 4. 76. Support from ongoing WBG projects. The Bank and IFC are providing substantial ongoing support for the privatization and restructuring o f real and financial assets in Serbia. The main pillar o f the Bank's program i s the Privatization and Restructuring o f Banks and Enterprises Technical Assistance Credit. This Credit supports the launching and implementation o f the restructuring and privatization process o f some o f the most problematic, large socially-owned enterprises and implementation o f the Government's banking sector restructuring strategy. There are also two other ongoing projects in this area. The Private Sector Development Technical Assistance Grant primarily supports the Government's tender and auction enterprise privatization program, and also funds a legal consultancy for the drafting o f a regulation on the conditions and procedure for defining the liability o f the state for past environmental damage caused by enterprises under The Financial Sector Development Technical Assistance Project primarily supports the Government's bank rehabilitation and privatization program. The Serbia Employment Promotion Project i s designed to support the privatization and restructuring process through efficient and effective labor re-deployment and active labor market programs. In Serbia, IFC has facilitated an agreement between a regional investment fund and the PrivatizationAgency (PA) to pilot a secondary privatization scheme. This scheme could foster a wholesale approach to 2oThis will allow for clarity during the privatizationprocess as to who will be legally responsible for environmentaldamage that occurredprior to privatization. Such clarity will help attractmore reputableandstrategic investors. 29 secondary privatization, whereby a special equity fund re-privatizes a large number o f companies with limited access to capital. Inthe bankingsector, havingreachedagreement onthe restructuring o f Udruzena Vojvodjanska Banka (WB) arrears to IFC, IFC i s supporting the restructuring and privatization o f W B successor banks. (Additional information on IFC's current program i s provided inAnnex 3.) 77. Assistance in this area i s also being provided to Montenegro by both the Bank and IFC. In particular, the Bank, together with IFC, i s supporting financial sector reform through SAC 2, particularlythe privatization o f Podgoricka Banka and the carving out and subsequent resolutionby the Ministry o f Finance of bad loan assets from the banking sector. The recent signing of a protocol with the Government o f Montenegro on IFC's claims on Montenegrin enterprises and banks should pave the way for additional support for privatization and restructuring from IFC. 78. Inthe area o f trade and export promotion, the Bank is providing support through two credits, both o f which cover Serbia and Montenegro. The Trade and Transport Facilitation in Southeast Europe Project (TTFSE) i s one o f eight parallel country projects under the regional Trade and Transport Facilitation Program, which aims to lower non-tariff costs o f trade and transport, reduce smuggling and corruption at border crossings, and strengthen regional partnerships and expand trade. In SaM, TTFSE supports modernization o f the Customs Administration o f the two republics, establishment o f modem information systems shared across border agencies (with the ultimate objective o f establishing a single electronic window for traders), transparency o f information on official requirements, and implementation o f new customs procedures at selected border crossings. The Export Finance Facilitation Project supports the efforts o f the Serbia and Montenegro Export Credit Agency (SMECA) to facilitate , and expand cross border trade by offering political risk insurance, working capital loans and guarantees, and export performance and credit insurance. 79. The Bank also has ongoing projects in both Serbia and Montenegro that are designed to foster sustainable private sector development through improvements in land registration and infrastructure, notably energy, transport, and solid waste management. Inthe energy sector, there are two projects in Serbia and one in Montenegro. The Serbia Energy Efficiency Project seeks to promote energy efficiency through investments and capacity building, while the Serbia Electric Power Emergency Reconstruction Project seeks to improve system security, financial management o f EPS, and institutional capacity o f EPS and the Ministry o f Miningand Energy. The Montenegro Emergency Power Reconstruction Project seeks to improve payment discipline and reduce losses. In transport, the Serbia Transport Rehabilitation Project supports highway rehabilitation, winter and routine maintenance, and capacity building in the Serbia Road Directorate. In solid waste management, the Montenegro Environmentally Sensitive Tourist Areas Project (MESTAP) supports the development o f the tourism sector by developing ecologically and commercially sustainable solid waste collection and disposal services in Montenegro coastal municipalities. Finally, the Serbia Real Estate Cadastre and Registration Project will contribute to the development o f effective property markets by developing an efficient property registration and cadastre system. 80. IFC i s also active in Serbia in the energy sector, solid waste management, and the water and waste water sectors. IFC i s supporting the Ministry o f Mining and Energy with three technical assistance projects focused on project development in the energy sector: (i) preparation o f the required legal framework and feasibility assessment for the Constanza-Pancevo-Omisalj (CPOT) oil pipeline project;21 (ii) development o f a restructuring and privatization strategy for Naftna Industrija Srbjie; and (iii) development o f a cogeneration study to survey market potential and 21IFC expects thispipelineto offer an environmentallysafe alternativeto bringhighquality crude oil from CentralAsia and Russiato SouthernEurope. 30 identify opportunities for private sector participation. In addition, IFC is providing technical assistance on pre-privatization and restructuring measures to Elektronska Industrija and financing an advisor to the PA. In solid waste and water and waste water, IFC has provided advice on the restructuring of the Belgrade municipal solid waste management system (including the development of public-private partnerships and the preparation o f a tender for private participation) and, together with EBRD and European Agency for Reconstruction (EAR), has supported the City o f Belgrade in its efforts to encourage private sector participation in water and waste water services. 81. MIGA's outstanding guarantee portfolio in SaM consists o f fourteen guarantee contracts: twelve in the financial sector, one in the services sector, and one inthe manufacturing sector, with a total gross exposure o f US$296.3 million and a net exposure o f US$151.7 million. In addition, MIGA is currently considering two guarantee projects totaling US$35.7 million that are expected to be completed by end-2004 - one each inthe financial and services sector. MIGA also provides TA (institutional development and capacity building) on investment promotion to both Serbia and Montenegro. An initial project benefiting the Serbia Investment and Export Promotion Agency (SIEPA) i s nearing completion. A comprehensive follow-on project with a two- to three-year time horizon i s expected to be launched in early 2005; this project will be implemented by MIGA on behalf o f the EAR. In Montenegro, also with financial support from the EAR, MIGA i s currently implementingan initial capacity building project in support o f the new Montenegrin Investment Promotion Agency. MIGA's TA activities in SaM are feeding into a new, regional FDI outreach and marketing initiative for the Western Balkans which MIGA launched in summer 2004 (that is, the European Investor Outreach Program for the WesternBalkans). Annex 10provides additional information on MIGA's activities. 82. New WBG projects. In Serbia, support to Goal 2 will include substantial development policy lending, initially through continuation o f the SAC program (SAC 2 Serbia) and then through programmatic development policy support (PDPL 1 under the base case lending program and PDPLs 1 and 3 under the high case). These operations will form a multi-year program o f assistance to the Government in addressing the key institution building and reform challenges described in Section 111. The PDPLprogramwill likely focus on: (i) resolution o f state holdings in the banking sector; (ii)development o f the non-bank financial sector, including an appropriate regulatory and supervisory framework; (iii) restructuring and resolution o f large loss-making state- and socially-owned enterprises, including the railways; and (iv) further improvements in the business environment. 83. IFC's program complements the Bank's program by focusing on development o f the financial sector, post-privatization support to selected enterprises, private sector participation in infrastructure, and private sector investments in selected sectors (the pharmaceutical, mechanical, and paper sectors). Inthe financial sector, IFC will provide assistance indevelopment o f insurance and leasing, bank and insurance company privatization, and the participation o f foreign strategic investors in the sector. Also, to support the development o f housing finance in Serbia, IFC i s considering financing a few banks, accompanied by substantial technical assistance. In the real sector, IFC will focus on post-privatization support to export-oriented companies with a view to enhancing their competitiveness in EUmarkets. In infrastructure, IFC will work closely with the Government and the Bank to develop projects that can attract private sector financing through public private partnerships (PPP). In Serbia, IFC will consider technical assistance to Telekom Srbije and stands ready to discuss the possibility of pre-privatization investment with the Government. In addition, IFC i s establishing the Balkans Infrastructure Development Facility (BIDFacility) incooperation with USAID and European donors to help public sector entities inthe region attract private investment, particularlyinenergy, transport and sanitation. 31 84. The Bank's development policy lendingprogram in Serbia will be supported by a number o f new investment operations. The Bor Regional Development Project (FY06) will support the Government's efforts to restructure and resolve the state's share in the copper mining and processing conglomerate, RTB Bor, and to encourage diversified growth and job creation in the Bor region by improving the local business climate, supporting development o f small and medium- sized enterprises, developing labor redeployment and active labor market programs, and improving environmentally damaged areas. Bor i s one o f the poorest regions o f Serbia and the restructuring o f RTB Bor i s likely to lead to a large number o f redundancies in an already severely depressed regional labor market (RTB i s the largest employer with a work-force o f around 8,000). 85. In addition, four Bank projects in Serbia will support the development of a strong and sustainable agricultural sector, which i s very important given the still relatively high share o f agriculture in GDP and the potential o f Serbia's food processing industry. The Rural Business Environment Project (FY07) will seek to assist farmers in accessing EU markets by providing advice on access to finance, EU quality standards, and modem production techniques, as well as improving applied agricultural research and dissemination. The Danube River Pollution Reduction Project (FY05), funded by the Global Environment Facility (GEF), seeks to reduce nutrient pollution by helping farmers and slaughterhouses develop and implement more environmentally friendly production techniques. The Agro-biodiversity Conservation Project (FY06), also funded by the GEF, will help to conserve the globally important eco-system o f the Stara Planina Nature Park by encouraging farmers to favor locally adapted animal breeds. The Irrigation and Drainage Rehabilitation Project (FY06) will seek to boost agricultural output through pilot irrigation schemes, particularly in Central and Southern Serbia, clearing drainage channels to improve drainage and reduce flooding, emergency rehabilitation o f dykes to reduce flood risks, and institutional capacity building. IFC i s also supporting the development o f the agricultural sector through technical assistance to Agroziv, a large private meat processing company, in its efforts to modernize and meet international standards. 86. Projects in Montenegro in support o f Goal 2 will include development policy lending and a number o f investment operations. Buildingon the progress made under SAC 2, DPC 1(FY07) will likely seek to support private sector development through reforms in the energy sector and inthe business environment. The Tourism and Agriculture Development Project (FY06) will seek to encourage economic growth by further developing the infrastructure base required for successful tourism development. Two projects focused on improving the environment, funded by the GEF, will also helpto boost tourism inthe poorer northern part o f the country and around Lake Shkoder and to ensure quality private sector growth. The Tara and Lim Basins Flood Hazard Management Project (FY06) will seek to improve flood management and mitigation capacity, including potential impact o f dam failure in mine tailing ponds, and to promote sustainable forest and land management practices. The Lake Shkoder Integrated Ecosystem Management Project (FY06) will assist the Governments o f Albania and Montenegro in implementing the Lake Shkoder Strategic Action Plan aimed at achieving more sustainable use o f the natural resources o f Lake Shkoder and its watershed. IFC will focus on institution building in the financial sector (including micro-credit institutions), tourism, and telecommunications. With respect to the latter, IFC i s considering a pre- privatization investment inTelekom Montenegro. 87. Finally, support for Goal 2 also includes two regional energy projects, one in Serbia (FY05) and the other in Montenegro (FY06). These projects will help both republics integrate into the regional energy market (including harmonizing market rules and technical operations) and give consumers access to competitive suppliers from across the region (see Box 4). This will reduce energy costs for large industrial consumers, thereby boosting competitiveness, and compel national utilities to be more efficient by subjecting them to competitive pressures. 32 88. Analytical, Advisory and Other Activities. In Serbia, the analytical base for activities under Goal 2 related to restructuring and privatization o fbanks and enterprises, development o f an appropriate supervisory framework for the banking sector, and development o f a favorable business environment i s provided primarily by the recently completed Investment Climate Assessment (ICA) and FinancialSector Note -the findingso fwhich are synthesizedinthe SEM(see paragraph 74). Going forward, this analysis will be supplemented by a Private Sector Note, a Financial Sector Assessment Program review (FSAP, FY05), and a Labor Market Policy Note (FY06). The latter would support the PDPL program and could include analysis o f the constraints to job creation and o f informal labor markets. Similarly, in Montenegro, the analytical base for these activities, together with reforms in energy and infrastructure, will be provided by the forthcoming MEM, which will synthesize the findings o f supporting studies o f energy, infrastructure, and business environment constraints (see paragraph 74). The MEMwill also include some analysis o f the labor market. 89. The Serbia Rural Business Environment Loan will reflect the findings o f Serbia Agriculture Report (2003) and a new piece o f analysis in FY06 looking at the constraints to the development o f the agricultural sector and the broader challenges in rural development. In FY05, the Bank is carrying out a sub-regional study, including SaM, on the capacity to carry out Environmental Impact Assessments and environmental management in general. The study will also explore business environment aspects related to environmental management. SaM would also be part o f a regional study on weathedclimate forecasting agencies and strategies to adapt to climate change, which may be responsible for increased variation in extreme climatic events, including the severe drought that caused a significant fall in agricultural production in 2003 and severe floods in the previous year in Serbia. The outcome o f the study may be identification o f a GEF co-funded project concept that aims to introduce loss mitigation measures. Technical assistance will be provided to the Government o f Serbia in FY05 to review the draft Water Law from the point o f view o f compliance with the EUWater Framework Directive. 90. As noted in Section 111, one o f the main challenges under Goal 2 is the development o f an effective legal and judicial system. In 2002, the Bank conducted a comprehensive legal and judicial diagnostic. This was followed in 2003 by approval o f an IDF grant for strengthening the court administration system in Serbia (including training and an assessment o f problems in court administration and case management). The remaining funds under this grant are expected to be used to assist the authorities in developing a comprehensive medium-termjudicial reform strategy and institutional strengthening o f the Ministryo f Justice inthe area o f donor coordination. 91. IFC's large donor-supported technical assistance program i s intended to support the development o f a pipeline o f potential investments in SaM by helping entities in target sectors or subsectors become bankable projects. Around US$4 million in donor funds has been mobilized to support institutional development, restructuring, and project preparation, mostly from the Swedish and Italian Governments. Looking forward, IFC will continue to provide significant technical assistance through a variety o f instruments, ranging from broad sector analyses and capacity buildingprograms to highly specialized restructuring and privatization assistance. IFC's technical assistance in,SaM will focus on enhancing the development impact o f its investment activities, improving the business environment for SMEs, assisting domestic companies in meeting EU standards, facilitating the development o f domestic financial markets through institution-building and the use o f innovative financial products, and restructuring and privatization support, particularly inthe financial sector and infrastructure. 92. IFC will also continue to provide support to SMEs through its well-established Southeast European Enterprise Development (SEED) facility (see Box 7). Full integration o f SEED'S technical assistance with IFC's investment work i s being pursued in order to further develop ajoint 33 approach to project development. SEED will be working on linkage programs designed to integrate SMEs into the supply chains o f large companies and IFC will seek to provide appropriate financing. In agri-business, SEED i s working with business associations to support herbal and food-processing companies, as well as working with farmers on supply chain management to a large vegetable oil producer and with food processors supplyinga large supermarket chain. Box 7: SEED inSerbia andMontenegro SEED is a multi-donor partnership, led by IFC, in support of SME development inthe region. In2004, SEED was fully integrated into IFC's regional strategy. SEED is currently planning programs supporting SMEs and private sector development in:(i) access to fiance; (ii) (iii) membership organizations; and (iv) linkages; business EUstandards. The access to finance pillar addresses SME financing issues through the development and advocacy o f new financing solutions. For example, leasing has been introduced by SEED to supplement conventional lending. Looking forward, IFC is planning to develop alternative dispute resolution mechanisms (ADR) by increasing the number o f courts using mediation. Inaddition, a corporate governance programthat targets selected enterprises i s beingpreparedand, in2005, IFC will explore the possibility o f a housing program. The linkages pillar, which i s based on SMEs that function in a supply chain, will be more sharply focused on specific sectors. Currently, IFC is developing a program to address the role o f Roma insupplying recycled scrap (glass, steel, paper, and plastics) to processors inthe region. With an estimated 60,000 working inrecycling, this will offer Roma considerable opportunities to strengthen their business, while also strengthening the overall environment for recycling. The successful business membership organization pillar will be extended to additional organizations, while continuing to focus on improving general and advocacy capacities of new organizations and on providing training and consultancy services to the growing number o f companies that rely on these organizations. Inrecognition ofthe growing needfor exporters to meet EUstandards to access EUmarkets, aprogramis being designed to develop the requisite knowledge base at the local level and supporting organizations. 93. FIAS i s providing support on improving the business enabling environment. Inparticular, FIAS has assisted the government with a self-assessment o f administrative procedures for doing business, following up on earlier FIAS study on the general investment climate in Serbia.22 While many o f the recommendations o f the first study were already adopted, the second study was initiated in response to continued weak foreign direct and domestic investment. The first study identified land acquisition and land development as the most important investment constraints, while the second study identifiedthree major areas o f concern. These are: (i) procedures start-up (with improvements needed inexpatriate employment conditions, company registration, licensing, and institutional and intellectual property rights); (ii) locating procedures (acquisition o f land, real estate registration, construction permits, infrastructure, leasing, and privatization practices); and (iii)operating procedures (tax reform, improving the foreign exchange regime, customs inspections, payment operations, and standardization). The Government subsequently prepared an Action Plan to strengthen the Regulatory Council in its efforts to improve the overall regulatory environment. 94. WBI will continue to support WBG efforts to advance private sector development in the region, including SaM. Workshops on improving export promotion, including support to the Serbian export promotion agency, will be carried out in FY05, complementing implementation o f ongoing Bank projects and the CAS program. WBI will also provide training and institution 22 The first FIAS studyundertaken in SaM, "Republic o f Serbia- The Climate for ForeignDirect Investment", was completed inJanuary, 2002. The survey accompanying the second study on administrative proceduresis based on interviewswith 408 firms, o f which 49 percent were small, 34 percent medium, and 17 percent large enterprises and covers the conditions, regulatorycosts, andproductivity ofdoingbusinessinthe country. The survey was finalized inJune 2003. 34 strengthening as a part o f the Bank's broader program o f support for the development o f SMEs and enterprise restructuring and privatization, building on GDLN video conferences on the main findings o f the ICA. WBI staff also recently led a small team that prepared a series o f knowledge economy assessments for the Balkan countries and will remain engaged in subsequent program development and implementation. Looking forward, WBI will seek to expand the regional focus o f its support to measures related to Goal 2, seeking to encourage an exchange o f lessons and knowledge in a region with significant potential for closer economic ties. The full scope o f WBI's activities plannedinsupport o f this CAS i s providedinAnnex 7. Goal 3: Reducing poverty levels, and improving social protection and access to public services 95. The key objectives and expected outcomes during this CAS period under Goal 3 include improvements in: (i) for rural communities; (ii) coverage, targeting, and reliability o f support the transfers for social protection; and (iii) quality, access, and financial sustainability o f health and the education for all citizens. 96. Support from ongoing WBG projects. In Serbia, Goal 3 i s supported by two ongoing investment projects. The Serbia Health Project has two main components: health services restructuring and health finance, policy, and management reform. It is the first o f these components that relates specifically to Goal 3. Under this component, the project supports planning and implementation o f the Government's strategy for improving the efficiency o f healthcare delivery while maintaining quality. This support includes restructuring and rehabilitation o f physical and human capacity at four regional hospital centers, which should lead to a visible improvement in both the availability and quality o f secondary healthcare services in these four areas. The Serbia Education Improvement Project also has two main components: building capacity and information to promote education reform, and improving teaching and learning in schools, and empowering local communities to take responsibility for their schools. In addition to helping to design and implement an information system, the project provides small innovation grants to schools, supports the development o f capacity for measuring student performance, and promotes decentralization. 97. In Montenegro, Goal 3 is supported by SAC 2, which seeks to improve the reliability of transfers to the pension and health funds and to assist the Government in developing a medium- term financing framework for both pensions and healthcare services. In addition, Goal 3 is supported by the recently approved Montenegro Health System Improvement Project. As explained under Goal 1 (see paragraph 69), the main objectives o f this project are to improve the financial sustainability o f the healthcare system by strengthening institutional capacity and information systems and to improve quality, efficiency, and access to primary healthcare services. 98. New WBG projects. In Serbia, support for Goal 3 will be provided through both development policy lending and investment operations. In terms o f development policy lending, the public sector reform PDPL program (see paragraph 71) will likely target both improvements in social protection and reforms in health and education. Policy-based lending will be accompanied bythree projects that will have direct impact on the objectives outlinedabove. 99. As noted earlier, the Bor region i s one o f the poorest areas o f Serbia and the proposed Bor Regional Development Project (FY06) i s specifically designed to assist the authorities in alleviating poverty by encouraging the growth o f the regional economy (see paragraph 84). In addition to providing support to farmers to improve agricultural competitiveness (see paragraph 48- 50), the Rural Business Environment Project (FY07) will seek to address the challenges to alleviating rural poverty described in Section I11 (see paragraphs 54-56), including the 35 disillusionment of the youth. Indoing so, the project may seek to buildon the Government's rural development grant scheme by providing matching grants for selected activities designed to boost employment and improve access to services in rural communities. The Primary Health Care Project (FY07) will seek to address the challenges to providing quality primary healthcare outlined inSectionI11(see paragraphs 60-62). 100. In Montenegro, support for Goal 3 will also be provided through both policy-based lending and investmentoperations. DPC 1(FY07) i s expected to include a component designed to improve the coverage and targeting o f social protection and, perhaps, a component designed to further improve the financial sustainability o f the pensions and health systems. The Montenegro Education Development Project (FY05) will also support the achievement o f the objectives o f Goal 3. This project seeks to improve: (i) efficiency o f public spendingon education (thereby also the contributing to meeting Goal 1); (ii)management o fthe education sector through capacity building; and (iii) quality o f educationby focusing on developing teachers' skills. the 101. Analytical, advisory and other WBG activities. In both Serbia and Montenegro, the primary analytical base for activities under Goal 3 i s the PRSP, the 2003 PEIR, and the 2003 Poverty Assessment. Going forward, this analytical base will be updated (a PEIR update i s planned in FY06 and a Poverty Assessment in FY07) and deepened through regular poverty monitoring, as well as monitoring of, and reporting on, PRSP implementation. InSerbia, activities inpoverty monitoring and analysis over the CAS period include notes on rural poverty and Roma poverty and a social protection study. In Montenegro, regular poverty monitoring will be supplemented by reports on the targeting and efficiency o f social programs and on health and poverty. 102. Activities under Goal 3 in Serbia and Montenegro will also reflect the findings o f the SEM and MEM,respectively (see paragraph 74). Studies are also under way or planned on youth in SEE (FY05), social capital in Serbia (FY06), and on social protection for poor and vulnerable groups, including Roma, IDPs, and refugees, in Montenegro (FY06/FY07). The latter will assist in the preparation o f DPC 1. Activities under the Roma Decade o f Inclusion (see Box 6), including the development and implementation o f the associated action plans, will also help to assist inmeeting Goal 3. 103. To support the PRSP process, WBI has led a series o f development debates and seminars open to all Balkan countries, including a well-attended Second PRSP Forum, enabling participants to exchange experiences and derive lessons learned. In FY05, follow-up activities will focus on a ThirdPRSP Forum and similar related events, and a Basic Poverty Measurement and Diagnostics course, all intended to fbrther engage participants from previous events as well as new stakeholders. Other activities planned for FY05 will focus on regional training on select topics including a course on Social Accountability and Monitoring; support o f Roma participation in various activities; and support for the development o f websites and virtual learning environments promoting regional networking with special emphasis on education issues and Roma women. For both the country-specific and regional/global programs, the GDLN Network will be used as appropriate to ensure cost efficiency and maximum knowledge sharing and dissemination. WBI activities will also actively support partnerships particularly in the area o f private sector development. Annex 7 elaborates upon W B I ' s role inthe delivery o f the SaM CAS program. C. Lending Scenariosand Triggers 104. The proposed lending program envisages a gradual transition from IDA to IBRD beginningin FY06. Inrecognition o f the unusual country circumstances and the success o f the IDA program to date, SaM's exceptional and temporary eligibility for IDA resources on hardened 36 terms has been extended to FY05-07 to allow for the establishment o f creditworthiness for limited IBRD borrowing, thereby ensuring a smooth transition from IDA to IBRD. At the same time, however, the amount of IDA resources allocated to SaM over the CAS period i s envisaged to be much lower than the US$540 million three-year TSS envelope, making the establishment o f creditworthiness for limited IBRD borrowing essential to ensure adequate lending resources to , assist SaM inmeeting the three country goals on which the CAS i s built. 105. The IDA envelope for the CAS period is expected to be US$225 million (subject to policy performance - meeting the lending triggers for the base case discussed below), supplementedby IBRD funds, if creditworthiness for limitedIBRD borrowingis established. Inaddition, US$20 million of regional project funds under IDA14 has been requestedto support the two regional energy Planned IDA lendingi s front-loaded to allow the establishment and strengthening o f creditworthiness, with US$lOO million available in FY05, US$75 million in FY06 and US$50 million inFY07. SaM's IDA envelope for FY05 was reduced by US$18 million because o f IDA'Sconstrained commitment authority (these funds were originally part o f the FY04 envelope). The ECA region i s exploring the possibility that these funds could be allocated in FY06-07 and used to increase the size o f planned investment operations. A debt sustainability update i s planned for end-FYO5 as an input into an assessment o f SaM's creditworthiness for borrowing from IBRD. Ifcreditworthiness for limited IBRD borrowing i s established, the IDA envelope o f US$225 million would be supplemented by US$175 million o f IBRD lending under the base case and US$325 million under the high case, bringing the total base and high case lendingenvelopes to US$400 million andUS$550 million, respectively. Lendingto Montenegro is expected to account for roughly 10 percent o f total envelope under the base and high case scenarios. In light o f the importance o f the regional agenda (see Box 1) and the possibility o f generating positive externalities through a regional approach, the creation o f incentives for participation in regional projects, in addition to the country-specific allocations, will remain an issue with SaM's envisagedtransition ftom IDA to IBRDborrowing. 106. The level of lending will be closely linked to policy performance at the republican level. Defining lendingtriggers for SaM as a whole i s neither possible nor appropriate, since the responsibility for economic policy lies at the republican level and the policy challenges facing the republics, while covering the same basic areas, are different. Having separate lending triggers for each republic will allow flexibility to respond to pace o f reforms at the republican level. While both republics are currently in the base case, inpractice, this means that one o f the republics could move to the highcase programwhile the other remains inthe base case. Inaddition to satisfactory portfolio performance, the triggers for remaining in the base case for both republics target continued macroeconomic stability and steady progress on key elements o f the structural reform . agenda (see Table 6, and Section TI1 for the main challenges). The proposed base case lending program i s strongly performance-oriented and i s centered around development policy support in ' both republics targeting public sector reform and private sector development. Development policy lending would account for around 50 percent of base case lending, in view o f the authorities' emphasis on significant structural reforms over the CAS period. However, as noted above, in addition to meeting the base case triggers, access to IBRD funds under the base case will depend on establishment of creditworthiness for limited IBRDborrowing. 23Futureavailability of regional project funds from IDA (implemented on a pilotbasis since FY04)is contingent on the outcome o f the ongoing IDA 14(FY06-08)replenishment negotiations and on a forthcoming review o f the guidelines for regional projects. The current guidelines enable two-thirds o f the credit amount for eligible regional projects to be financed fromregionalproject funds, with the remaining one-thirdbeingmet fromthe country allocation. 37 Table 5: SaM - Bank Lending Program, FY05-07(US% million) FY05-BaseCase -All IDA Serbia StructuralAdjustment Credit2 45 RegionalEnergy ' 7 Pensions 25 Montenegro Education 5 StructuralAdjustment Credit2 18 FY05 TotalIDA 100 FY06 BaseCase HighCase - - - IDA IBRD Total - - IDA IBRD Total Serbia Serbia Prog. Development Policy Loan 1 41 14 55 Prog.DevelopmentPolicy Loan 1 41 14 55 Prog. DevelopmentPolicy Loan 2 0 55 55 Irrigationand Drainage Rehabilitation 25 0 25 Irrigationand DrainageRehabilitation 25 0 25 Bor Regional Development 0 30 30 Bor Regional Development 0 23 23 Montenegro Montenegro Tourism and Agriculture 6 6 12 Tourismand Agriculture 6 9 15 RegionalEnergy ' 3 0 3 Regional Energy 3 0 3 FY06 Total 75(+6) 100 175 FY07 Serbia Serbia Prog. DevelopmentPolicy Loan 2 46 44 90 Prog. DevelopmentPolicy Loan 3 46 54 100 Prog. DevelopmentPolicy Loan 4 0 100 100 PrimaryHealth 0 35 35 PrimaryHealth 0 26 26 Rural BusinessEnvironment 0 40 40 RuralBusinessEnvironment 0 27 27 Montenegro Montenegro Development Policy Credit 3 4 6 10 Development Policy Credit 3 4 18 22 FY07 Total 50 125 175 FY07 Total 50 225 275 TotalFY05-07 400 550 Global EnvironmentFacility -- FY05: Serbia DanubeRiver EnterprisePollution Reduction Project (USS9 million); FY06: SerbiaAgro- biodiversity ConservationProject (USS5million); Montenegro Lake Shkoder IntegratedEcosystemManagementProject (USS5 million); Montenegro Tara and LimFlood HazardsMitigation Project (estimatedUSS 3-6 million). Fundingfrom regionalproject fundshasbeenrequestedfor these projects. Future availability of suchregionalfunds, however, is contingent on the ongoingIDA 14replenishmentnegotiations and on aforthcomingreview of the guidelines for regionalprojects. InFY06, IDA regionalfunds would be sought to supportboth the SerbiaRegionalEnergyProject, as supplementto the countryIDA allocationproposedfor FY05, and the Montenegro RegionalEnergyProject, inthe amount of US$14millionandUS$6million, respectively. * Dependingon the Government's priorities andprojected financingrequirements, some or all of these funds maybe used for investment lending insupportofactivitiesinenvironmentand/or agriculture. 107. High case lending triggers are linked to accelerated and deepened progress on structural reforms, which will strengthen creditworthiness and lay the foundation for sustainable growth over the medium term. The triggers indicate the areas o f the Governments' programs that will be monitored in order to make a judgment on the pace and depth o f policy reform during the CAS period (see Table 6, which also presents some indicators that will be used in making such a judgment). In addition to the areas covered by the base case triggers, the assessment o f policy performance under the high case will focus on reforms in public administration; the enterprise and financial sectors and the business environment; and the energy sector. Consistent with a scenario o f strong progress on structural reform, the high case lending program, particularly inthe case o f Serbia, envisages a highlevel o f development policy lending in support o fthe Governments' reform efforts. 38 Table 6: LendingTriggers S bia To stay inthe base case To move to and stay inthe high case All base case triggers plus: P Continued satisfactory portfolio performance - No more than twoproblemprojects > Implementationo f the public administration reform > strategy agreed with the Bank Continued satisfactory macroeconomic performance ---Reductions in the number of civil servants (including improved external balances, as Introduction of new pay and grading system appropriate) - Increase in the compression ratio to at least 1:6 Durable reductions in public expenditure as a resolving govemment - share of GDP P Accelerated progress on: (i) Staying on track with the IMFprogram holdings inthe banking sector, large state- and socially- > owned large loss makers, and insolvent insurers;and (ii) Continued satisfactory progress on resolving improving the business environment govemment holdings inthe bankingsector and on - Progress in resolving state shares in large banks and enterprise restructuring and privatization non-performing assets held by the BRA --Reduction in budget subsidies - Restructuring of state debt that impedes enterprise Reduction in the state's share in economic activity - restructuring Privatization of viable enterprises and bankruptcy of P Continued satisfactory implementation o f the PRSP -- those that cannot be sold Progress on the PRSP actionplan Restructuring of the railways Establish and maintain periodic poverty -- Improvement in contract enforcement indicators monitoring and analysis > Implementationof energy sector reform -- Strongprogress on EPS restructuring Establishment and then strengthening of the energy regulator with a view to moving tofull tariffetting authority To stay inthe base case To move to and stay inthe high case > Continued satisfactory portfolio performance All base case triggers plus: - No more than twoproblemprojects > Implementation o f the public administrationreform P Continued satisfactory macroeconomic performance strategy - Durable reductions in public expenditure as a - Adoption and application of merit-based recruitment - share of GDP andpromotion Staying on track with the IMFprogram - Gradual increase in the compression ratio to at least 1:6 P Continued satisfactory progress towards completing - Conversion of management-level posts to career civil resolution of government holdings inthe banking , serviceposts sector - Completion of the sale of Podgoricka Banka > Accelerated efforts to resolve govemment holdings in - Steadyprogress in resolving non-performing loan large enterprises assets held by the MoF -- Reduction in the state share in economic activity Resolution of the state share in KAP P Continued satisfactory implementation o f the PRSP --Progress on the PRSP action plan > Aggressive implementation o f energy sector reform Establish and maintainperiodic poverty Strongprogress on EPCG restructuring monitoring and analysis -- Signature of an acceptable PPA between EPCG and KAPi 108. Both republics expect to move to the high case scenario in terms of policy performance as early as possible inthe CAS period. However, access to IBRD funds would also depend on the establishment of creditworthiness for limited IBRD borrowing. Specific measures that would indicate such strong policy performance in the near term are listed below. In Serbia, in addition to passage by Parliament o f a budget for 2005 that envisages a high quality fiscal adjustment (including a cut in the public sector wage bill o f around 0.4 percentage points o f GDP and cuts insubsidies o f around 0.5 percentage points o f GDP, including the Development Fundand the railways), policy performance consistent with the high case in the near term would be 39 demonstrated by achievement o f at least 3 o f the following: (i)enactment of core public administration legislation, including the Law on State Administration and the Law on Salaries; (ii) completion o f the ongoing sales o f 3 state banks and launching the tender for privatization o f another large bank inwhich the state has a majority share (which intotal account for more than 20 percent o f the assets o f the banking system); (iii) completion in FY05 o f 10 tender privatizations and resolution of a fbrther 5 companies, or parts thereof, through restructuring (these 5 companies are expected to account for around 10 percent o f the total workforce in companies on the Government's restructuring list); and (iv) legal unbundlingo f EPS (creation o f separate generation and distribution subsidiaries and a separate transmission company). Similarly, in Montenegro, in addition to passage by Parliament o f a satisfactory budget for 2005 specific measures that would contribute to a favorable assessment o f progress on reform are: (i) implementation o f the new Law on Salaries in the 2005 budget; and (ii) conclusion o f an acceptable power purchase agreement between Kombinat Aluminijuma Podgorica (KAP) and EPCG. 109. In the event that the base case triggers are not met, lending will shift to a low case. Bank lending under the low case would be around US$50 million per annum -less than half the amount envisaged under the base case - and would be focused on capacity building, social sector service delivery, and regional projects. These projects would seek to alleviate the impact o f the changing country circumstances on poor and vulnerable populations, while also seekingto capture externalities from regional projects. D. Implementingthe CAS Partnerships and Donor Coordination 110. The Bank works closely with multilateral and bilateral donors providing support for the overall reform program, particularly through the Country Office. The European Commission (EC) i s the Bank's key partner, promoting reforms linked with the SAP and sharing the mandate with the Bank to facilitate coordination o f donor assistance to SaM.24 The Bank and the EC are working jointly with the SaM authorities, and other donors, particularly DFID, towards harmonization, including procurement and financial management policies. Aiming at closer economic, political, and social ties amongst SEE member countries, the Stability Pact and its various Working Groups provide a useful platform for dialogue and cooperation with donors (see Box 1). The Bank also works closely with the EBRD and EIB to foster private sector development, and with UNDP and bilateral donors, including DFID, in assisting the Governments' in PRSP implementation and monitoring, as well as on integration o f the MDGs and the PRSP. Duringthe CAS period, the Bank will also continue to work with the IMF to address the underlying structural causes o f macroeconomic imbalances. As described in Sections I11and IV o f the CAS, World Bank activities under Goals 1 and 2 in particular will support the Government's efforts to reduce non-interest current expenditures in a sustainable manner and to increase competitiveness. Given the close link between successful implementation o f reforms designed to meet these goals and fiscal and external sustainability, continued close collaboration between the Bank and the IMF i s essential. Donor involvementby sub-sector in SaM i s highlightedinAnnex 9. 111. As part of their harmonization efforts, both Serbia and Montenegro intend to strengthen donor coordination capacity. Intandem, the international community (IC) needs to work towards greater complementarity and selectivity within and among programs - a significant challenge given the continued shift in assistance from post-conflict reconstruction to deepened support for growth and equitable development, and the projected decline in the volume `of donor 24 Between 2000 and 2003, the Bank and the EC together coordinated 3 donor conferences, raising some USS4.1 billion in pledgeddonor assistanceon behalfof SaM's economic reform program. 40 assistance. A good example o f this collective effort by the I C to intensify donor coordination i s the multi-donor (GTZ, WB, USAID, EBRD, EAR, SIDA, Switzerland, and WTO) working group that supports the development o f the financial sector. The Serbian Ministry o f International and Economic Relations i s progressively assuming more responsibility and accountability for coordinating and reporting donor assistance, but faces substantial capacity constraints. Overcoming capacity constraints also represents a major hurdle in Montenegro, and donors, including the Bank, are working to achieve improved complementarity in terms o f both programming and implementing assistance in order to reduce the burden o f coordination on the authorities and to maximize program outcomes. In both republics, the PRSP process has significantly enhanced opportunities for new and ongoing consultation and partnership with civil society and the donor community. PortfolioManagement 112. The SaM portfolio has grown rapidly since 2000. A total o f 29 operations have been approved over the last four years. Total commitments to date amount to US$603.6 million (including US$30 million in grants from IBRD net income and a further US$33.6 million in trust funds and cofinancing) o f which US$401 million has been disbursed. The current SaM portfolio consists o f 20 projects with an undisbursedbalance o f US$223 million. Given the relatively large portfolio compared to the level o f commitments envisaged over the CAS period, effective portfolio implementation will be key to achieving the three country goals around which the CAS program i s built (see ResultsFramework inAnnex 8). 113. Continued efforts will be required to strengthen portfolio implementation. There are currently two problem projects (Serbia Education Improvement Project and Serbia Health Project). Detailed action plans for improving performance have been developed for both o f these projects and the results to date are encouraging. There are currently no projects at risk. Continued close portfolio monitoring will be necessary to maintain, and improve, SaM's implementation track record - in this respect, it i s important to remember that the SaM portfolio i s very young, with an average age o fjust 1.5 years. While the FY04 JPR highlighteda number o f cross-cutting project issues, particularly in Serbia (which accounts for 13 o f the 18 projects currently under implementation), most o f the delay in project implementation experienced to date are project- specific and relate primarily to political changes and associated policy uncertainties. Interms o f cross-cutting issues, the key issue raised inboth republics was the need for a focal point within the Ministryo fFinance empoweredto oversee the Bank's portfolio onbehalfofthe Ministryandto act as a liaison for Project Implementation Units (PIUs). Both republics have now appointed focal points and all PIUs have been informed accordingly. In view o f the need to build capacity in procurement and financial management, a Technical Services Unit was recently established in Montenegro under the Deputy Prime Minister to handle these aspects o f project implementation for Bank projects. Responsibility for all other aspects o f project implementation remains with the Ministryhes concerned. This separation o f responsibilities should enable effective implementation o f the Montenegro portfolio. The decentralization o f responsibility for portfolio management to the Country Office should also help to support implementation inboth republics. 41 V. Creditworthiness andRisk A. Creditworthiness andDebt Sustainability 114. SaM's external debt to GDP ratio has declined from over 103 percent in 2001 to a projected 57.8 percent in 2004 (see Table 7). This improvement reflects the normalization o f relations with Paris and London Club creditors, as well as an increase indollar GDP. InNovember 2001, SaM secured a highly concessional debt restructuring agreement with the Paris Club. This agreement involved, among other things, a phased 66 percent reduction in the net present value o f Paris Club obligations and a rescheduling o f the remaining stock over 22 years with a 6-year grace period. In July 2004, SaM also reached an agreement with the London Club o f commercial creditors settling Serbia's outstanding US$2.7 billion debt. The agreement implies roughly a 62 percent net present value write-off, and reschedules the rest over 20 years at an interest rate o f 3.75 percent duringthe first 5 years and 6.75 percent duringthe remaining 15 years. Table 7: Key Sustainability, Liquidity, and Exposure Indicators Act. Est. Proi. Proi. Proi. Proi. 2002 2003 2004 2005 2006 2007 PUBLIC DEBT Solvencyratios TDOiGDP 85.5 79.9 65.1 57.7 56.3 54.1 TDOiRevenue 197.6 185.4 150.4 134.8 134.2 131.3 FOREIGNDEBT Solvencyratios TDOiGDP 76.5 69.9 57.8 56.4 54.4 52.6 TDOiXGS 219.6 205.9 143.8 125.2 113.8 105.8 Liquidity ratios TDSiXGS 3.4 6.7 11.2 13.3 13.1 14.9 INTiXGS 2.6 3.7 4.3 5.3 5.4 5.2 TDSiGDP 1.2 2.3 4.5 6.0 6.3 7.4 TDSigross official reserves 8.1 13.0 28.1 33.4 34.4 40.2 WORLD BANK EXPOSURE INDICATORS DO to IDA (US$million) 167.0 282.0 446.3 564.7 650.1 699.6 DO to IBRD (US$ million) 2175.0 2607.0 2607.0 2590.9 2550.8 2544.1 share of IDA inTDO (%) 1.4 2.0 3.3 4.3 5.1 5.4 share o f IBRD inTDO (%) 18.4 18.2 19.4 19.8 19.9 19.6 DSto WB (US$million) 75.5 105.5 125.8 143.5 182.0 201.6 share of DS to WB inTDS (%) 41.1 22.8 12.0 10.3 12.3 11.1 Interest to IBRD 75.0 104.5 122.7 116.2 114.9 112.0 Principalto IBRD 0.0 0.0 0.0 19.1 56.7 75.2 Repaymento IBRD 75.0 104.5 122.7 135.3 171.5 187.3 Repaymentto IBRD as %TDS 40.8 22.6 11.7 9.8 11.6 10.3 DSto IBRD as %XGS 1.4 1.5 1.3 1.3 1.5 1.5 DS to IBRD as % ofpublic DS 56.0 36.0 23.4 23.3 29.5 23.0 42 115. External debt to GDP i s projected to decline further over the CAS period, but the outlook for liquidity indicators is less favorable. External debt to GDP i s projected to decline to 52.6 percent by 2007, suggesting that the base case macroeconomic framework satisfies the long- runsustainability condition. However, the picture interms ofliquidityindicators is less favorable, reflecting a combination o f expiration o f grace periods on new and restructured debts and rising short-term borrowing (see Table 7). For instance, the ratio o f TDS to exports i s projected to fluctuate betweenroughly 11 and 15 percent between 2004 and 2007, well above its 2002 and 2003 levels o f 3.4 percent and 6.7 percent, respectively. All other things being equal, this less favorable outlook renders the country more vulnerable to adverse external shocks, including slower than expected export growth due to weak foreign demand for SaM's products and services and faster real exchange rate depreciation. 116. While IBRD's current and projected exposure to SaM i s high, SaM has established a strong record of servicing Bank debt since 2001 and exposure indicators are projected to improve over the CAS period. IBRD exposure i s high measured on a per capita basis or as a share o f GDP or exports, and IBRD debt accounts for a large share o f SaM's total debt outstanding." Debt service ratios are more favorable, however. IBRD debt service to exports o f goods and services i s projectedto increase moderately over the CAS period but remains low at less than 2 percent. Bank debt service as a share o ftotal public debt service i s projected to decline from its current level o f 23.4 percent in 2004 to 23 percent in 2007. The share o f IBRD debt in SaM's total debt outstanding i s projected to remain at around 19 percent during the period o f consideration. SaM i s not currently considered creditworthy for IBRDlending, and all IBRDloans to SaM are innon-accrual status. B. Risks 117. Both republics continue to face tremendous political, policy, and implementation capacity pressures that could lead to slippage on the reform agenda, thereby complicating the medium-term macroeconomic and growth outlook. The establishment o f the state union, together with the heightened partisan debate that followed the assassination o f Serbian Prime Minister Djindjic, led to temporary delays in legislative and economic reforms, and slippages in day-to-day economic management. Since early 2004, however, the Government o f Serbia has demonstrated remarkably strong policy performance, responding by deepening and accelerating the economic reforms, thereby mitigating - at least temporarily - the risks to reform program implementation. 118. Nonetheless, the political will to implement difficult reforms in both republics remains highly vulnerable to shifting relations within the respective ruling coalitions (both faced with approving new republican constitutions inthe near future), as well as to relations between the two republics. This political commitment will be tested over the CAS period in both republics by the need to enact measures that result in durable cuts in non-interest current expenditures, while increasing public investment. Compounding the impact o f SaM's complex political economy on the pace o f reforms are considerable capacity constraints on implementation o f economic legislation and regulations. Against this background, guarding against "reform fatigue," while maintaining strong progress on reforms necessary to underpin fiscal sustainability and sustainable medium-term export-led growth, will be essentialto maintainthe momentum on the reform agenda. Other factors that could complicate the reform process over the CAS period include a potential referendum on the continuation o f the state union, developments in Kosovo and southern Serbia, 25The noted high share o f IBRD debt in the total was inherited from SFRY. At the end o f 2000, the share of IBRD debt inthe country's total debt was 15.6 percent. As a result of the dollarieuro exchange rate developments, debt to IBRD increased both interms ofits share inthe total debt (to 18.2 percent at the end of2003) and inUS$ terms-from US$ 1.8 billion at the end o f 2000 to USS 2.6 billion at the end of 2003. 43 failure to satisfy some key partners on the depth and pace o f cooperation with ICTY, vested interests at all levels o f government (including local and municipal governments), and additional complexities arising from new, constitutionally-mandated, state-level structures. 119. SaM's ability to maintain a sustainable macroeconomic framework, achieve a recovery of growth, and deepen economic competitiveness could be adversely affected by exogenous shocks. The projected resurgence in exports, which i s important for debt sustainability (liquidity ratios) as well as the broader economic growth agenda, may not materialize inthe event o f weaker than anticipated foreign demand associated with potential slowdown in economic activity amongst keytrading partners. Similarly, SaM's medium-termfinancing picture relies on a markedrebound in foreign direct investments that may not materialize inthe event of unfavorable development in global and/or EU markets. Economic growth could also be affected by poor agricultural output (agriculture accounts for around 25 percent o f GDP) inthe event o f adverse weather. VI. ConcludingRemarks 120. SaM's impressive track record of solid policy performance in the wake of important political events bodes well for the outcome of the overall reform program during the CAS period and building the level of confidence essential to fostering growth and investment. Based on this experience, despite formidable challenges ahead, slippage on major components o f the reform agenda i s considered unlikely. Ongoing engagement o f the international community, especially in the form o f an increasingly robust portfolio o f long-term lending, will help to ensure continued progress. At the same time, the risks associated with continuation o f the state union will bemitigatedby focusing the WBG's assistance at the republican level. 44 Annex 1 Relations with the European Union and Progress on the Stabilization and Association Process Relations between the EU and the countries o f the Western Balkans, including SaM, have been developing since 1999 within the broader context o f the SAP. The SAP calls for far-reaching political and economic obligations by prospective member countries in exchange for assistance in achieving closer integration with the European Union. The SAP framework includes a potential contractual relationship, or Stabilization and Association Agreement (SAA), and an assistance program (CARDS) to help participating countries to progress, at their own pace, towards EU membership.26 The EU's goal o f full integration o f the Balkans was reaffirmed at the Feira Council in May 2000, and again in Zagreb in November 2000, when the countries o f the region committed themselves to SAP conditions and objective^.^' Here, the EU offered the prospect o f full accession basedon the Treaty o fthe EuropeanUnion(Maastricht Treaty) and the Copenhagen criteria.28 The EU's efforts to continue the SAP with full speedwere reaffirmed at the Thessaloniki Council in2003, when it introducedthe so-called Thessaloniki Agenda. Through this agenda, SAP was expandedto include the creation o f two new instruments: European Partnerships and a set o f tools based on the EU's enlargement methodology. The European Partnership identifies specific priorities and obligations to be fulfilled by each country in the short and medium term. These obligations, grouped into four categories which follow the format o f the Copenhagen criteria, predicate the EC's financial assistance through the CARDS program. For SaM, an Enhanced Permanent Dialogue (EPD) was established in July 2003 to build on the work o f previous Consultative Task Force meetings in providing a framework for technical and policy dialogue. The recommendations ensuing from the EPD serve as guidelines and benchmarks for relevant reform measure^.'^ Furthermore, the Thessaloniki agenda stipulates: political cooperation in the area o f Common Foreign and Security Policy (CFSP); enhanced support for institution building; promoting economic development; and opening the EU community programs to the Western Balkans countries. Inrecent years, relations between SaM andthe EUhave followed a generally positive trend. The EU HighRepresentative for Common Foreign and Security Policy, Javier Solana, witnessedthe signing o f the "Belgrade Agreement" inMarch, 2002. Immediately following the assassination o f Serbian Prime Minister Djindjic, Javier Solana and Chris Patten, the EU external affairs commissioner, flew to Belgrade not only to express their condolences, but also to show their support for the tremendous efforts that SaM has put into securing their stability. The progress of SaM in the SAP has been charted annually through three consecutive Stabilization and Association Reports for 2002,2003 and 2004. The first annual report from 2002 26SAA are very similar to the EuropeAgreements, which the EuropeanUnion introducedfor the countries of CentralEastem Europe(CEE) inthe beginningof 1990s. 27FRYugoslaviaCountryStrategypaper 2002-2006, The EuropeanCommission. 28The EuropeanCouncil in Copenhagen1993 spelled out the Copenhagencriteria, by which candidatecounties wouldbe judged for accession: 1) stability of institutionsguaranteeingdemocracy, the rule oflaw, humanrights andrespect for and '' protectionofminorities; 2) existence of afunctioning market economy, as well as capacityto copewith competitivepressure and market forceswithin the EU; and3) ability to take on the obligationsof membership, includingadherence to the aims of olitical, economic andmonetaryunion- i.e. acquis communautaire. . Serbia and Montenegro, Stabilization and Association Report 2004, the EuropeanCommission. 45 Annex 1 dealt with issues prior to the adoption o f the SaM Constitutional Charter, notably the fragility of, and lack o f clearly defined roles for, the State institutions. The second report, produced shortly after the adoption o fthe Constitutional Charter inFebruary, 2003, accentuated the needfor further implementation o f the Constitutional Charter and capacity buildingon the State level. According to the report, only with full commitment and co-operation within the state, and decisive action to pick up the pace of reform, would the state be able to make the necessary progre~s.~'This emphasis on the functioning o f the state union remained as the central issue o f the thirdEUannual report, where progress has been classified as mixed at best. It noted that, although the Constitutional Charter had been adopted, which according to the EC i s an achievement in its own right, the implementation o f reforms has been slow and incomplete. The EC also noted with alarm that the lack o f consensus on the union level was weakening joint institutions and policies, which are sine qua non for progress on political and economic reforms and for developing relations between SaM and the EU.3' This slow process on implementingthe necessary reforms has, to date, prevented SaM from establishing a contractual relationship with the European Union. Nonetheless, as a result o f the adoption o f the Constitutional Charter and the Internal Market and Trade Action Plan in early 2003, the European Union commenced work on a Feasibility Study, a necessary prelude to the possibility to open negotiations on a SAA. The Feasibility report for SaM considers of a number o f criteria: the degree o f compliance with SAP political and economic conditions, the overall functioning o f the State Union, the existence o f a single trade policy and a single market, progress on sectoral reforms and on those institutions at the state level necessary to implement the possible SAA.32 Subsequently, however, attempts to complete the Feasibility Study were delayed due to the lack o f agreement within the country on how to proceed towards an Agreement and because o f the ICTY issue. It was not until October 2004, following a visit by Messrs. Patten and Solana to Belgrade that the EC decided to re-start its work on the Feasibility Study, as a result of political decision-makers in SaM agreeing to the so-called "twin track approach". Under this approach, the EU would deal with the republics on policies that each conducts separately, including trade, economic and sectoral policies. Simultaneously, it would continue to work with the Union o f SaM where it i s the competent authority, including, for example, on matters of international obligation and human rights, with a view to an eventual single SAA with SaM. It i s currently anticipated that the Feasibility Study couldbe completed by spring2005. The 2004 European Partnership for SaM, identified the most pressing near-term priorities with furtherwork on the Feasibility Study dependent upon fulfillment ofthese priorities. Inthe area o f democracy and the rule of law, SaM was advised to continue implementing the Constitutional Charter, to establish the State Court as well as to adopt the State Parliamentary rules o fprocedure. Significant weight i s given to the adoption o f defense strategy and military doctrine. Emphasis was also placed on Serbia completing the ongoing electoral law reform, adopting a comprehensive strategy on public administration reform, and continuing the preparations for the implementation o f the Criminal Code and Criminal Procedure Code, as Serbia i s unequivocally lagging behind Montenegro in these areas. Montenegro was advised to continue implementing the strategy on public administration reform. Finally, both republics were advised to prepare a comprehensive anti-corruption strategy and adopt law on conflict o f interests. 30 Serbia and Montenegro Stabilization and Association Report, 2003 p.2 31 Serbia and Montenegro Stabilization and Association Report 2004 p.1 32 The FeasibilityReportwas postponedinorder to give the authoritiesmoretime to address the remainingkey issues, including inparticularpolitical conditionality, constitutionalissues andthe Action Plan. Serbia and Montenegro, Stabilization and Association Report 2004, The EuropeanCommission. 46 Annex 1 Inthe area o fhumanrights andprotection ofminorities, the EUencourages establishing a Human Rights Ombudsman Office in Serbia, while strengthening the administrative capacities o f Ombudsman office in Montenegro. Both republics are urged to adopt legislation on property restitution. The most important obligation in terms o f regional and international cooperation relates to full cooperation o f the State with the International Criminal Tribunal for former Yugoslavia. In the area o f market economy and structural reform, SaM is encouraged to sustain its macroeconomic stability. This would entail continuing a prudentmonetary policy stance, backed upbyappropriate exchange rate policy, and establishingmore efficient monetary instrumentswith a view to improving the targeting o f monetary aggregates. Furthermore, SaM i s advised to accelerate the restructuring and privatization, as well as liquidation o f large, socially and state- owned enterprises, while fully liberalizingprices and removing administrative controls. Both entities are strongly advised to accelerate further alignment o f the national legislature with the acquis c~mmunautaire~~especially in the field o f trade (domestic and foreign), customs administration, public procurement, anti-trust measures and the protection o f intellectual property rights. Attention i s also focused on cooperation inthe field o fjustice and home affairs, especially in the areas o f border management, combating organized crime, human trafficking, illicit drugs trafficking, money laundering and terrorism. Mediumtermpriorities also address issues o fcapacity buildingofthe State and local governments including: strengthening the European integration offices within the government, adopting the civil service andpublic administration laws and strengthening the economic policymakingprocess and promoting local governments, i.e. accelerating decentralization. Moreover, SaM i s recommended to continue the sustainable macroeconomic policies, but also to introduce new reformmeasures, includingthe reduction o f state subsidies, transfers and public service wage bill. 33This i s the body o f EUlegislation,policiesand court precedentsto which future EUmembersmust subscribe 47 Annex 2 South Eastern Europe Regional Studies and Initiatives Inthe past few years, greater attention has beenpaidto ensuringan integrated regional approach to common challenges. Within the Bank, the Regional Framework Paper for South Eastern Europe provides the structure for the formulation o f individual country assistance strategies to ensure that programs are designedto have optimal impact at both the country and regional level. The Framework identifies areas o f activity with cross-border externalities, economies o f scale, or opportunities for "scaling up" successful interventions across borders. It also identifies opportunities to encourage regional cooperation within the ambit o f Bank activities, and a common reference for supporting SEE countries on the path toward integration in European structures. Within this conceptual umbrella, the Bank i s engaged in a variety o f regional programs, initiatives and studies includingthe following. A Framework for the Development of the RegionalTransport System inthe Balkans was commissioned to synthesize the contents, conclusions, and recommendations o f a series o f sector reports in the road, railway and inland water transport sectors, together with other related initiatives focusing on trade and transport facilitation and road safety. The main objective i s to identify and describe, in actionable terms, measures o f regional importance that: (i) are considered necessary to promote the efficiency and effectiveness o f the transport sector; and (ii)would promote trade in goods and transport services among the Balkan countries and between these countries and the EU. The Framework is scheduled for completion inFY05. The Trade and Transport Facilitation Program for South Eastern Europe aims to reduce non-tariff costs to trade and transport, reduce smuggling and corruption at border crossings, and strengthen customs and border control agencies in the region. It includes all eight countries o f South Eastern Europe (Albania, Bosnia and Herzegovina, Bulgaria, Croatia, FYR FYR Macedonia, Moldova, Romania and Serbia and Montenegro) with a focus on Customs and road transport. Details about the program, including performance measurement, can be found at www.seerecon.org/ttfse. At the request o f South East European countries, the Bank has initiated the preparation o f a larger scale trade and transport facilitation program building on the achievements o f the first program. The new program, TTFSE 11, would focus on the development o f trans-european transport networks (road, rail, maritime transport modes, data integration), and integrated border management for freight to increase the competitiveness o f firms in SEE and their ability to access markets. A Regional Energy Strategy for the Balkans, covering the South Eastern Europe regional energy market, which i s set to open from 2006, lays out the Bank's approach to supporting institutional reform and investment in the power and gas sectors o f SEE with a view to increasing energy trade. The regional context for the strategy and its implications for implementing the SaM CAS are described inBox 4 on page 16. Trade Policies and Institutions in the Countries of South Eastern Europe in the EU Stabilization and Association Process. This study (dated M a y 2003) reviews the economic performance o f Albania, Bosnia and Herzegovina, Croatia, FYR Macedonia, and Serbia and Montenegro with a focus on international trade. It covers the current status of each country regardingparticipation inthe WTO and relations with the EU, with each other, and with other countries in Central and Eastern Europe. The study contains an institutional and policy 48 Annex 2 analysis covering trade in goods and services, including the main challenges these countries face inglobal integration. P Building Market Institutions in South Eastern Europe: Comparative Prospects for Investment and Private Sector Development. This study, published in May, 2004, was prepared in collaboration with the EBRD. It carried out a major empirical review o f the institutional barriers to investment and growth inthe eight SEE countries. The study focuses on four areas: competition and economic barriers to entry/exit; corporate governance and finance; dispute resolution; and the regulatory regime governing utilities. P Regional Study on Public Expenditure Policies in South Eastern Europe. Public expenditure policies have in general lagged behind the reform needs in SEE. Public expenditures as a share o f GDP have remained relativelyhigh inthe past decade, though there i s significant variance across countries. The main objective o f the study, underway, i s 1 to distill the lessons learned that emerge from select SEE countries' efforts to reform their expenditure policies, in order that they may be applied to increasing the effectiveness o f interventions across the region. Inparticular, the study will highlight the successhl efforts to consolidate public expenditures and reduce public expenditures as a share o f GDP. The study also aims to generate debate and explore the scope for a region-wide approach to select public expenditure issues. P The Priorities for the Early Prevention of HIV/AIDS in the Western Balkans study, underway, reviews the HIV/AIDS situation in the western Balkan countries, assessing the need for further policy development and investments inthis area. This study also reviews the situation regarding sexually-transmitted infections (STIs) due to the overlap between the diseases. P The Social Development Initiative for South Eastern Europe aims at promoting the design of policies and programs that: (i) social cohesion through improved integration o f support ethnic minorities and youth as agents o f social change and development: and (ii) reduce social tensions at the country and regional level. Advice to SEE governments and donors i s provided in this process, and includes capacity-building for institutions and social analysis. The Initiative has been supported by the Italian Government and the Bank's Post-Conflict Fund. P The study Young People inSouth EasternEurope: FromRiskto Empowerment provides a roadmap for youth development in SEE to assist governments, donors, and multi-lateral financial institutions better align public expenditures and investments, respectively, with the needs and priorities o f youth in the region. The study outlines an integrated approach to the social, economic, and political participation o f young people in society and identifies priority areas. It has been disseminated to governments and youth groups for feedback, after which it will be finalized for publication. P A RegionalWater Management Study reviews experience with water resource management in the Europe and Central Asia region since the transition. In light of water resources constraints, broader economic considerations, and regional and corporate goals, it also defines a framework within which the Bank would prioritize its support inthis sector. P An Integrated Regional Environment Project for the Protection of the Adriatic, Ionian and Aegean Seas (Adaptable Lending Project - APL) will focus on assisting countries 49 Annex 2 bordering the Adriatic, Ionian and Aegean Seas34to address the challenges o f complying with Land-Based Sources and Activities Protocol (LBS) o f the Barcelona Convention, thereby contributing to the sustainable protection and use o f the Seas and their watersheds. The program i s also designed as a pilot which could be replicated in other Mediterranean countries. Dependingupon the availability o f financing, the APL will support: (i) institutional development and knowledge sharing; (ii) pollution control and integrated management; (iii) water supply improvements; and (iv) protection o f ecologically sensitive areas. > The World Bank and UNDP are proposing a GEF Strategic Partnership for the Mediterranean Sea Large Marine Ecosystem to assist countries in implementing policy reforms and priority investments that address transboundary pollution reduction priorities in hotspots as identified in two Strategic Action Plans for the Mediterranean Sea. The Partnership would support: capital investments; economic instruments; implementation o f policy reforms, strengthening o f public institutions and public participation through two elements: a regional technical assistance project, implementedby UNEP and an Investment Fund for Pollution Reduction in the Mediterranean Sea, implemented by the World Bank. The Investment Fund- supported by a US$60-70 million, multiple-tranche GEF grant and other donors' contributions - i s proposed as a vehicle for catalyzing investments and accelerating urgent actions that are necessary for reducing pollution inthe Seas, especially the Mediterranean and Adriatic. 34Albania, Bosnia and Herzegovina,Bulgaria, Croatia, FYRMacedonia, Greece, Italy, Serbia and Montenegro, Slovenia and Turkey. 50 Annex 3 IFC Strategy and Activities Introduction SaM i s a major IFC priority in South East Europe. DuringFY02-03 IFC committed about US$43 million in 5 projects, three in financial markets and two in manufacturing. Donor-supported technical assistance has been an important component o f the IFC strategy to develop a pipeline o f potential investments in SaM. Duringthe last two years IFC has mobilized about US$4 million o f trust fund resources for TA that have been used to conduct more than twenty assignments. IFC has developed a strong TA program on institutional strengthening in the insurance sector, leasing, and banking. Also, in order to position itself in strategic sectors and generate more investment opportunities, IFC has supported, through its TA program, project preparation in the energy sector, electronics, information technology, and hotels. Its results will materialize inthe kture depending on the pace o f policy reforms and liberalization in sectors still controlled by the Governments such as insurance, telecommunications, and energy, all o f which are good candidates for pre-privatization investments. Though foreign investors' country risk appetite remains modest, opportunities for new IFC investment projects are being actively pursued in both the financial and manufacturing sectors. IFC's program development, however, depends on hrther implementation o f the Governments reform agenda, the creation o f a favorable business climate, and the acceleration o f the privatization process. While inthe short term IFC will continue to expand its activities in general manufacturing and the financial sectors, in the longer term IFC will look for opportunities to support SaM with investments in the energy and telecommunication sectors, as well as in the infrastructure sector. Financial Sector Overall the financial sector in SaM has made impressive progress over the past three years. The government's reform agenda to date has been concentrated on stabilization and urgent first stage restructuring inthe banking sector and parallel but also incomplete reforms in the regulatory and institutional framework for financial sector operations. The country's financial sector remains severely underdeveloped and the existing level o f financial intermediation i s still unable to contribute hlly to the economic growth agenda. The current government's stated commitment to accelerating the reform o f financial sector gives hope that SaM could see rapid financial re- deepening rather than an extended period o f financial sector stagnation that has haunted some economies inthe region. Today's status quo i s one in which many banks, primarily those in state ownership, are seriously fettered by their backlogs o f non-performing loans to large socially-owned enterprises. At the same time, most private and foreign banks find the alternative o f servicing the emerging private SME sector unattractive in the present, imperfect legal and institutional environment. The banking system i s overpopulated and segmented, dominated by local banks with their historic problems, and characterized by an unsustainably high level o f state ownership. A handful o f larger majority state-owned banks have relatively good effectiveness ratings, despite their problems with historic loans. Their revival through speedy privatization to strategic investors would help to introduce more viable competition at the top end o f a market that today appears to be supplyconstrained. 51 Annex 3 The currently limited access to finance and the high cost o f banking services present a major challenge as well as an opportunity for non-bank financial institutions (NBFI) in expanding their clientele base and serving the needs o f the economy. As in many other transition economies, the NBFIs sector (capital markets, leasing, mortgage providers, pension funds) in SaM is lagging behind the developments in the banking sector both in terms o f its size and market share o f all financial services, as well as in terms o f quality o f services and its public recognition. The sector faces a number o f legal, regulatory, and institutional constraints. The experiences o f other transition countries show that poorly regulated NBFIs can easily become breeding grounds for serious financial malpractice and even systemic crises. Hence, although the NBFIs are currently small relative to the banking sector, a sound framework for their expansion needs to be put in place as soon as possible to ensure their sound development inthe future. Strengthening financial intermediation through both investments and advisory services i s critical to IFC's strategy to enhance local investments and reach a large number o f businesses. IFC has contributed to strong foreign strategic investor interest in the financial sector and to establishing viable financial institutions. Through its equityinvestments, IFC supported the first Microfinance Bank and the establishment of RaiffeisenBank in the country. In Montenegro, IFC approved an investment in Opportunity Bank Montenegro for a line o f credit o f up to Euro4 million to fund micro-enterprise and SME lending. IFC has been working to support the Government o f Serbia with restructuring and the privatization o f the banking sector. IFC i s supporting the restructuring and privatization o f UVB successor banks. The Government o f Serbia and IFC have already agreed on restructuring o f UVB arrears to IFC. This agreement will facilitate the initial stage o f the bank privatization process in Serbia, including the privatization o f Vojvodjanska Banka. Also, the recent agreement between IFC and the Government o f Montenegro on the restructuring o f IFC's claims on Montenegrin enterprises and banks, should pave the way for additional IFC restructuring and privatization support. This includes IFC's support for Podgoricka Banka, one o f the largest banks in Montenegro, through restructuring of its arrears, pre-privatization investments, and a broad- ranging technical assistance program. Despite strong demand, the development o f non-bank financial intermediaries i s still modest in SaM, mainly because of the weak system for registration o f collateral security and court enforcement procedures. IFC i s looking for opportunities to develop and support housing, leasing, and securities market development, through both investment and TA. To support the development o f housing finance, IFC i s considering financing to a few banks in Serbia complementedby the provision o f substantial TA. IFC's SEED has provided extensive assistance to the institutional development o f leasing and i s preparing a leasing market survey to feed into the preparation o f a multi-country leasing facility aimed at a more extensive outreach to eligible leasing operators. The ability to issue equity inthe primary market is not yet an option for companies, untilfurther reforms are implemented to strengthen the institutions needed to create a liquid secondary market. Very few companies are listed in the Belgrade stock exchange and banks cannot be listed. The P A in Serbia has contributed to the development o f the stock market through the launching o f auction privatizations with the mandatory listing in the stock exchange. The P A i s planning to launch the first initial public offerings on a few private companies with stronger business fundamentals, by placing the shares of the State Share Fund and State Pension Fund. IFC would consider supporting the P A to prepare the first IPOs. 52 Annex 3 To target investment opportunities inthe privatization process in South Eastern Europe, including in SaM, IFC has invested US$40 million intwo regional equity funds, Bancroft and Poteza. In addition, IFC has facilitated an agreement between Bancroft and the P A to pilot test a new privatization scheme. Bancroft i s screening potential companies in the Share Fund portfolio to select a first candidate to buy enough stock to reach a majority equity package, combined with large minority stakes heldin the State Share Fund's portfolio, and then jointly sell it to qualified buyers. If the pilot case i s successful, it may facilitate a wholesale approach by setting up a special equity fund to re-privatize a large number o f selected companies with limited access to capital because of their unclear corporate governance. IFC has already provided extensive due diligence to the Serbian Insurance Supervisor on drafting a new law and recommending actions to improve regulation and the supervisory function capacity. Also, IFC has conducted a preliminary due diligence on the restructuring and privatization of Dunav Insurance Company. Its findings and recommendation, together with a pre-privatization investmentproposal, have been submittedto the Government. Corporate Sector Despite major progress to date, enterprise sector reform still has a long way to go. Serbia's private sector share o f GDP was only 52 percent in 2002 compared to 74 percent in Bulgaria. IFC's investment opportunities in the corporate sector are limited by state ownership in large companies, weak corporate governance, employee and management shareholding in larger manufacturing companies, lack o f financial discipline, and weak accounting standards in most o f local businesses. Also, private ownership i s concentrated and channeled through less than transparent offshore holding vehicles, and potential exposure to reputation risk with some local individual sponsors i s relatively high. FDI has yet to play an important role in investment. FDI per capita inSerbia in 1989-2002 was $200, comparedto $1,400 inCroatia, $560 inBulgaria, and $460 inFYRMacedonia. Within these constraints, IFC has been working to develop investment opportunities in retail- distribution, tourism, agribusiness, electronic industry, paper, and pharmaceuticals. IFC has achieved good results investing Euro 20 million in Tigar Michelin Holding, a leading regional producer o f high quality car tires. The financing was accompanied by extensive TA to the company and its suppliers, supported by IFC trust funds and SEED linkages program, resultingin highdevelopment impact. IFC intends to replicate this successful model inother manufacturing companies. Moreover, IFC pays particular attention to potential regional investmentopportunities with the capacity to enhance regional economic integration. IFC is providing an innovative TA program to Elektronska Industrija, a Serbian manufacturer o f consumer electronic products and home appliances, to help the company with pre-privatization restructuring and to facilitate the joint ventures and/or direct sales to foreign investors. With targeted TA, IFC has also supported private initiatives in food and consumer goods, textile apparel industry, rubber industry, paper, light mechanical industry, and packaging industry. The early TA projects had identified a few potential IFC investment candidates, most o f them, however, ultimately did not qualify under IFC credit quality criteria or reach the minimum investment threshold. Nonetheless, the relevant preparatory work has been useful to the beneficiary company to find locally alternative sources o f commercial financing. 53 Annex 3 Infrastructure The quality o f key infrastructure services in SaM i s poor and the sector requires fundamental reform and restructuring, as well as investments to meet the directives on infrastructure o f the European Union, associated with the SAP35(see Annex 1). The infrastructure sector would play a critical role for sustained economic growth and international competitiveness, and IFC foresees potentially significant opportunities for expanding its products and services in the sector. For these reasons, the IFC strategy in SaM will complement the Bank's program o f support for establishing the proper regulatory and institutional foundation in the infrastructure sector. In tandem with the Bank's program o f support, IFC will be committed to supporting the restructuring and preparation for privatization o f the sector, as well as facilitating private sector participation in sector relatedmanagement, financing, and ownership. Through its Balkans Infrastructure Development Facility (BIDFacility), IFC will help public sector entities in the South East Europe region, including SaM, to attract private sector participation and investments in infrastructure, primarily in the energy, transport and water and sanitation sectors (Box 1). IFC focus will be to explore, facilitate, and support public-private partnership (PPP) opportunities, particularly in solid waste and water management services (city o f Belgrade), oil and gas transport and distribution (Constanza-Pancevo-Omisalj-Trieste pipeline and pre-privatization o fNaftna Industrija Srbije), and the power cogeneration sector. Annex 3 Box 1: BalkanInfrastructure Development Facility - A poor andunreliable infrastructure continues to discourage private investors and hinder economic growth inthe Balkan region. In turn, slower economic growth reduces the availability o f government funds to improve infrastructure. To break this cycle, IFC i s establishing the Balkans Infrastructure Development Facility in cooperation with USAID and European donors. The facility will help public sector entities in the Southern Europe region (including SaM) to attract private sector investments in infrastructure, focusing on the energy, transportation, and water and sanitation sectors. The facility reflects the World Bank Group strategy to broaden engagement inthis sector to ensure efficient, affordable, and sustainable delivery o f infrastructure services. The facility will help identify, develop, structure, and reach financial closure on infrastructure projects, so that committed public sector entities can engage more effectively with the private sector and attract investments critical to the region's economic development. IFC will launchthe Facility inFY05. Since March 2002, IFC has been working on the restructuring o f the Belgrade municipal solid waste system, to prepare the tender for the concession to the private sector o f the solid waste management services and to introduce a public-private partnership (PPP). This i s expected to be the first major municipal infrastructure privatization in SaM. In 2003, IFC signed a mandate to advise the City o f Belgrade in the development and implementation o f a PPP for its water sector concessionincooperationwith the EARand EBRD. In the area of information and communication technology, IFC will explore investment opportunities in the sector. IFC i s willing to help the Governments o f Serbia and Montenegro with the privatization o f Telecom Srbija and Montenegro Telecom, respectively. IFC is now considering a pre-privatization investment opportunity in Telekom Montenegro. IFC intends to provide TA to Telekom Serbia and to help the company to prepare a strategy for hrther sector liberalization. IFC i s open to discuss with the government a potential pre-privatization investment. A TA project has also been completed to identify potential opportunities for 35 Some 29 percent o f sampled water supplies inSerbia do not meet bacteriological standards; 56 percent of Serbianroads are classedas in"very bad conditions"; and there i s a 20 percent forced outage rate inelectrical supply. 54 Annex 3 investing in the Internet sector development in Serbia. The findings o f the study have been disseminated by IFC duringa seminar targetedto potential investors. In the energy sector, IFC has been active supporting an advisory assignment to prepare a restructuring and privatization strategy o f the Serbian oil company Naftna Industrija Srbije (NIS), as well as launching a Power Cogeneration study to survey the market potential and identify opportunities for private sector participation and PPP. As part o f its strategy inthe energy sector, IFC i s helping the institutional effort to develop PPP opportunities in Costanza-Pancevo-Omisalj- Trieste (CPOT) Oil pipeline project. CPOT i s a cross border oil transportation pipeline which i s expected to offer an environmentally safe alternative route to bringhighquality Central Asian and Russian crude oil to Southern and Western Europe, crossing Romania, Serbia and Montenegro, and Croatia. This pipeline i s strongly supported by the governments o f these countries. The United States Trade and Development Agency (USTDA) has financed a feasibility study with a grant to the Croatian Government on behalf o f the three interested countries. IFC i s supporting a second phase o f a TA assignment, focused on providing capacity building to the three country Interstate Committee. This Committee i s responsible for the pre-development strategy and coordination o f early institutional efforts to assess feasibility and prepare the project legal framework and to promote the project with potential investors and users. IFC will consider the possibility o f financing this project, subject to the pipeline's economic indicators and business interests from strong sponsors. Social Sectors IFC will explore opportunities to bring a strategic investor and to finance the establishment o f the MBA School for the University of Belgrade, as well as for a private polyclinic in Belgrade. Another foreseen opportunity exists with respect to the restructuring o f the Igalo Health Center. SME Sector SaM i s still far from having a business environment attractive to entrepreneurs and investors. Consequently, the number o f SMEs i s far below the CEE average; Serbia i s even lagging behind within the more geographically limited SEE region. The weak interest in SME lending i s due largely to the high fixed costs of loan processing, the practice o f informal accounting, and the reliance on mortgages which are difficult to enforce. Lines o f credit funded by international financial institutions (e.g. EAR, EIB, KfW) and supported by TA for credit risk assessment and management have prompted some progress in lending to SMEs. However, the majority o f credit applications are rejected because o f the lack o f transparency in financial statements, inadequate collateral, incomplete business plans, or insufficient capitalization o f the borrowers. IFC i s developing new investment opportunities for intermediary lending operations with selected commercial banks aimed at increasing access to finance for SMEs. IFC i s supporting the SME sector through the Southeast Europe Enterprise Development (SEED) facility, a multi-donor partnership led by IFC, operating in Albania, Bosnia and Herzegovina, Serbia and Montenegro and FYR Macedonia. SEED continues to focus its efforts on supporting: (i)increased competitiveness of SMEs inthe region: (ii) strengthened business development services (BDS) markets: and (iii) improvements inthe business environment for SMEs. To better position itself on hlfilling its mandate, SEED has recently introduced a new integrated and demand-driven approach, targeting four major strategic objectives as indicated in the CAS text Box 7. This approach ensures integration o f SEED'S products with the needs o f the local key partner by mobilizing internal and external resources to act as a local implementer. This has 55 Annex 3 brought significant scope to SEED's activities allowing it to operate on several levels including consulting, training, capacity building programs and business enabling environment interventions. In 2004, SEED came under the direct managementof IFC's SECA hubinIstanbul. Existingties have been strengthened to enable a fully inclusive investment and TA strategy to evolve in the region. A clearer set o f deliverables to our host country i s now punctuatedby a fully integrated approach to addressingthe needto tie technical assistance more closely to IFC's investment work. Annex 3 Box 2: Some NotableAchievements of SEED - IFC's SEED facility has been operating in Serbia and Montenegro since 2001. Since then the country program has had some notable achievements, includingthe following. 1. The financial leasing law was passedwith the help o f SEED inMay 2003. Twelve leasing companies have been established. Also, SEED helped to broker an agreement between all the leasing companies to form the Association o f Leasing Companies inSerbia. The value o f leasing contracts reached Euro150 million inthe first year o f business. Estimates show that growth o f 30 percent per annum is expected and by 2008 the leasing industrymay account for as muchas Euro 500million a year. 2. Following up on the investment made by IFC into the Tigar Tyre Plant, SEED developed an extensive program to advise the company on critical linkage projects: (i) provided assistance on identification o f its non- core assets and plans to spin them off; (ii) advised on the development o f a franchised retail and distribution system inthe country to support its core tire manufacturing function; and (iii) trained and advised Tigar AD and its distribution staff on the dynamics o fa modem supply chain. 3. IFC's SEED and Corporate Citizenship Facilities joined up to support an HerbalBusiness Association based in southern of Serbia, an economically depressed region. SEED's program follows its tested business association model and achieved the following: (i) the association has engaged the government to establish a quote system for collection and as a result an improved licensing mechanism to control the collection o f wild herbs has been introduced; (ii) provided 13 different training modules to 300 collectors in co-operation with localNGOs; and (iii) inone year, increasedmore thenthree times the membership ofthe association. 4. IFC SEED has beenundertaking additional assessmentsfor commercial loans to qualify for a risk reserve scheme established by Austria Wirtshaftsservice GmbH (AWS). To date, the scheme has contributed Euro8 million to fourteen SMEs. Eachloan is unique inthe market for its lowered collateral coverage, longer tenor and pricing. SEED intends to further extendthis successful project. 56 Annex 4 MillenniumDevelopmentGoals(MDGs) F ~Situation in ECA Current Situationin SAM ~ ~~ Projectionsby2015 Halve between 1990 and From 1990to 1999the In2002, theproportion ofthepopulationlivingin Zurrently too few data to comment on poveq 2015 the proportionof proportionof ECA's absolute poverty (consumption per capitabelow rends. people in extremepoverty people living on less than the national absolutepoverty line basedon SLS andwho suffer from US$1 a day increased from data) was 10.6percentin Serbia (it would be hunger 1.4 percent to 5.1 percent, more accurateto use the interval from 9.4 to 11.8 and for those living on less percent, since certain groups are not coveredby than USS2from 6.8 the survey). percent to 20.3 percent. InMontenegro the relevant number is 9.2 percent, while with the inclusion ofthe most vulnerable groups may be revised upward by as muchas a fifth from 9.4 to 12.2percent. In2002, theprimary In2000 theprimary educationcompletionrate for Followingwar in the region, the accuracyof data is completion ofprimary education completion rate S A M was 96.1 percent (Net enrollment data i s uncertain. However, SAMi s expectedto re-attain educationby 2015 for both for ECA region was 93 not available becauseof the inability to nearly 100percentprimary completion rate within boys and girls percent. disaggregate the Kosovo population in the data.). few years. The MDGtarget i s likely to be met. Eliminate gender In2001/02, girls' In2001102, ratio ofgirls' to boys inprimaryand MDGtarget i s likely to be achieved. disparities inprimary and enrollments inprimary and secondary education was 100.7 percent. secondary education by secondaryeducationas 2005 and for all levels by percentageof boys 2015. accountedfor 97 percent. Reduceinfant and child Under-5 mortality rateper U5MR i s trending downwards and MDGappears mortalityrate by two- 1,000 live births decreased Modeled estimates of USMRhave decreased likely to be met. However, while U5MRs fell thirds between 1990 and from 44 in 1990to 37 in from 30 in 1990to 19 in2002. dramatically in the 90s, progress seems to have 2015. 2002. slowed over the past few years. This needsto be watched carefully and could result in a downgrade to `maybe' inthe next 1-2 years. Reduce matemal mortality In2000 the estimated Modeled estimates of M M Rhave decreased from Basedon official data andmodeled estimates, rate by three-quarters number of matemal deaths 15in1995tollin2000 MMRs are already similar to those of other between 1990and2015. for the region was 58 per industrializedcountries and as suchthe MMRMDG 100,000 live births. i s consideredto have already been achieved Halt andreverse by 2015 The number of HIV- .HIVinfectionrateshaveremainedrelatively Too hard to tell ifMDGtarget will be met. the spread of HIViAIDS infectedpeople increased constant(below 10per million population) over Low and stable incidence figures are encouraging and other diseases from 30,000 in 1998to 1,5 recent years. Similarly, TB incidence has but various million in 2003 remained pretty constant at around40 per social and demographic factors put Serbia at a risk 100,000 population over the last decade of a rapid rise in HN/AIDS and its weak surveillance system makes the reliability of reported incidence figures difficult tojudge. Reduce by halfthe In2000 about96% of Trend 1995-2000 shows stable 99% (urban) and Populationwith access to improved water source is proportion ofpeople ECA's urban population 97% (rural)in Serbia; and 99% (urban), 90% higher in Serbia & Montenegro than in ECA. There without sustainable access had access to improved (rural) for MontenegroFor sanitation around are problems with interruptionsof water supply: to safe drinkingwater. water source, and about 10%-20% ofpopulation i s still relying in around 25%-30% ofpopulation experiences 83% of ECA's rural traditional pit latrines inboth countries interruptions, of which 5%-10% daily and 13%-20% population. Average during the summer. Ingeneral, water supply figures for ECA for systems are deteriorating due to lack ofinvestments sanitation arenot but not as fast as in other ECA countries. This is registered. also valid for sanitation systems. Inrural areas, problem lays with proper treatment of the sewerage Integratethe principles of 0.45 kgoe per GDP n.a. There are no quantitative targets set for any of the sustainable development 6.7 metric ton per C02 declining from 12to 4 metric ton per indicators of sustainable development at present. into country policies and capita capita in1990-1999 Energy informationhas not yet fed into international programs; reverse loss of Forestarea i s 39.7% Land area coveredby forests amountsto 27% databases,but energy intensity i s higher than in environmental resources. Protectedareas are Protectedareas amount to 3.3% other ECA countries. Indicators for forest area and 6.8% Ranges between 20%-70% in Serbia protected areas are lower than the averageof ECA, 1% and high percentage ofpopulation uses solid fuels. Majority or rural communities live in or around forests and have direct access and therefore use fuel wood for their energyrequirements. Achieve improvement in No systematicdata Basedon the different indicatorsfor slums the Target i s worldwide andnot specified per regions, lives of at least 100 million collection estimates for Serbia & Montenegro are as there i s no specific country target at this moment. slumdwellers, by 2020 follows: Trends in degrading housing quality, problems with Lack ofwater 3% heating and IDPs and refugeesare not properly Lack of Sanitation 12% monitored. Lack clean heating46% Overcrowding N/a Poor housingquality 30% No secure tenure 20%-33% 57 Annex 5 CoreLabor Standards Both Serbia and Montenegro have ratified (or re-ratified the conventions which were ratified by ex- Yugoslavia) all 8 ILO core labor conventions. These conventions are: Forced Labor (No. 29), Abolition o f Forced Labor (No. 105); Minimum Age (No. 138), Worst Forms o f Child Labor (No. 182); Equal Remuneration (No. loo), Discrimination in Employment and Occupation (No. 111); Freedom o f Association (No. 87), Right to Organize and Collective Bargaining (No. 98). In recent years, national legislation was largely updated with respect to provisions in the above named conventions. InSerbia, the legislative framework ofcollective bargaining and social dialogue includes the following laws and agreements: the Labor Act (2001), the Employment and Unemployment Insurance Act (2003), the General Collective Agreement (200l), and the FoundingAgreement o f the Socio-economic Council o f the Republic o f Serbia (2001). In Montenegro, the legal framework i s based on the new Labor Law (2003), the Law on Terms and Conditions o f Employment (2002), the General Collective Agreement (2003), and the Government Decree On the Establishment o f the Economic and Social Council (2001). The key event in the development o f social dialogue in Serbia was the establishment o f Socio- economic Council in August 2001. Regional Socio-economic councils were also established in 26 industrial centers in Serbia. The experience with the work o f the Council has been mixed. Shortly after the setting up o f the Council its work was broken down by the leave o f one o f the union representatives. The Council remained blocked till April 2002 when a new mutual "Agreement on Improving the Work o f the Social Economic Council" was concluded by the parties involved and the work restarted. The new Labor Act defines some criteria for representativeness o f trade unions and employers' organizations: a trade union affiliating at least 15 percent o f all the employees o f an employer i s considered a representative trade union for the conclusion o f the collective contract with the employer, and an affiliation o f at least 10 percent o f the employers inthe Republic or inthe branch or activity for which the collective contract i s being concluded i s considered a representative employers association. The following organizations may qualify as representative organizations o f social partners: from the trade unions' side, Association o f Free and Independent Trade Unions, Federation o f Autonomous Trade Unions o f Serbia, United Branch Trade Union "Nezavisnost" (Independence), and from the employers' side, Union o f Serbian Employers and Serbian Association o f Industryand entrepreneur^.^^ However, while collective agreements at the national level have a long tradition in both Serbia and Montenegro, the strategy for development o f collective agreements at other levels o f the society, and especially at the enterprise and local levels need to be created. One o f the features of the Serbian labor legislation is that by the new Labor Act from 2001, and similar to few other countries in Europe, the minister in charge o f labor may expand the application o f the special collective agreements to include the non-members o f the employers association. The minister i s obliged to request the opinion o f the signatories to the collective contract before deciding about such expansion. The possibility was not providedby the previous legislation. 36The MoLSP i s in the process of determining organizations that can be considered nationwide as the representative trade unions andthe representativeemployers' associationsrespectively. 58 Annex 5 InMontenegro, while the Ministryo fLabor and Social Protectionis cooperating with other employers' organizations, such as Union o f Employers o f Montenegro, Montenegro Business Alliance, and Montenegro Business Market, by the Labor Law the General Collective Agreement can be signed only bythe Chamber ofCommerce as the only representativeo femployers. Companies are obliged to pay a contribution to the Chamber o f Commerce (0.32 percent o f gross salaries o f every worker). This violates ILO recommendations (in particular, Recommendation No 113 and 152 and Convention No 144), which suggest that the social partners can only be the voluntary organizations o f workers and employers, and not the chambers o f commerce that exist on the basis o f the legal obligations o f the companies to pay the contributions to them. Trade unions are represented by one union - the Federation o f Independent Trade Unions o f Montenegro. All workers, with no regard to their membership, have to pay a contribution to the union (0.2 percent o f their gross salaries). Representationo f worker voice through unions and collective bargaining tend to reduce discrimination. Unions are also known to reduce wage disparities within their members; ensure management abides by collective agreements and the law; and improve working conditions in firms. But unions can also impose efficiency costs. Also successful development o f the system o f collective bargaining depends on proper the interactive confidence among the main actors involved. In Serbia, however, due to the difficulties the social partners have faced the level o f confidence among them has not reached yet the necessary level. Consequently reestablishing the confidence constitutes serious challenge for further development o f collective bargaining. The new Labor Act of Serbia and the Labor Law o f Montenegro provide protection against discrimination o f any employee inthe workplace based on gender, birthplace, language, race, national identity, religion, marital status, family responsibilities, political or any other viewpoint, social background, personal wealth, membership in particular political organization, Unions or any other personal trait. The integration o f disadvantaged persons in the labor market i s important to prevent social exclusion, to raise employment rates and to provide for sustainability o f social protection system. Despite an updated legislation, recent labor market analyses in SaM have revealed that there are individuals andor groups o f individuals that are currently facing difficulties in accessing and remaining in the labor market. Some o f the difficulties identified are explicit or hidden forms o f gender, disability or ethnic discrimination. While in the formal sector o f the economy, core labor standards are basically enforced, not much i s known about relevant labor relations in the informal sector. Calculations based on the Serbia LSMS suggest that informal employment i s very significant and accounted for 31 and 35 percent o f the total employment in 2002 and 2003, respectively. In Montenegro, around 30 percent o f employed people are believed to work without contract. The World Bank i s engaged in a number o f activities that promote good practice related to core labor standards. Bank efforts to enhance the participatory process o f PRSPs specifically involve trade unions. The Bank has already engaged in some efforts to enhance the capacity o f the social partners in Serbia as well, including involvement in regional PRSP training events along with other members o f civil society and training events specifically geared for trade unions active inthe PRSP process. The Bank was actively involved in preparation o f the new Labor Act in Serbia and the Labor Law in Montenegro. In Serbia, the Bank has also provided technical assistance or financially supported the preparation o f other relevant labor legislation, via SOSAC loan and SPEAG Grant, including the Employment and Unemployment Insurance Act; and the following laws still in draft: on Employers' Associations; on Trade Unions, on Socio-Economic Council; and on Strikes. 59 Annex 6 Anti-Money LaunderingandCombatingthe Financingof Terrorism Attention to money laundering and terrorist financing has increased because these activities are recognized not only as serious risks to security, but they also seriously affect a country's ability to improve financial stability and establish a level playing-field for private sector (particularly SME) development. Serbia and Montenegro have made notable efforts over the past two years to lay the legal foundations necessary for the implementation o f international standards for anti-money laundering. This i s important as organized criminal groups, engaging in the illegal smuggling o f drugs, humans and other commodities, are believedto be active inthe region The first law on anti-money laundering adopted by the FRY Parliament in July 2002. This law made money laundering a criminal activity, and authorized the creation o f a FinancialIntelligence Unit (FIU) at the national level. Due to the constitutional transition to the Union of Serbia and Montenegro, and subsequent autonomy agreements between the two republics the AML law was adopted by the Serbian Republic Parliament and the FIU became an agency o f the Serbian government. Montenegro has since adopted its own AML law and i s in the process o f establishing a separate FIU. Thus, Serbia has progressed farther in implementinginternational AML standards than Montenegro, and is laudably serving as a `mentor' to both Montenegro3' and Bosnia38intheir AML/CFT efforts. Serbia and Montenegro are (`jointly) a member inthe Council o f Europe's Anti-Money Laundering Committee (MONEYVAL), however, only Serbia has to date met standards for membership in, and been accepted as a member o f the Egmont Although the AMLKFT regimes in Serbia and Montenegro are gradually developing, laws in both republics which criminalize terrorist financing are still needed, as are various amendments to the Criminal Code and Criminal Procedure Code in order to meet international standards. Due to the international nature o f money laundering and terrorist finan~ing,~'autonomous territories in which enforcement o f national laws may be weaker provide attractive havens for money launderers, organized crime groups and financiers o f terrorism to profitably thrive and evade authorities. This situation also makes it relatively easy for criminal groups to conduct profitable activities in territories where AML/CFT enforcement i s stronger, yet hide their profits and proceeds in the territories where enforcement may be weaker. This critical problem can only be addressed by a high degree o f coordination and cooperation between financial sector supervisors and law enforcement authorities o f these adjacent countries and territories. Among the Republics and territories o f Serbia and Montenegro, such coordination and cooperation i s improving but work i s still needed on the (sub-) regional level. In both Serbia and Montenegro, resources are needed to build capacity, and for technical assistance and training particularly for analysts in the FIU, as well as for Ministry o f Justice officials, prosecutors and judges who handle money laundering and terrorist financing cases. 37Serbia FIU officials have assessedthe FIUinMontenegro inthe context o f its application for membershipinthe Egmont Group. Serbiaplans to sponsor Montenegro's application for membership inEgmont (see footnote 3.) 38Serbian FIUofficials have beenproviding a limited amount o f advice and technical assistance to the BosnianFIUwhich will become operational on 28 December 2004. Serbia FIUofficials will make an on-site visit to the BosniaFIUinJanuary, 2005. 39The Egmont Group i s the recognized international network o f FIUs, the goal o fwhich i s to enhance mutual legal assistance and coordination inAMLICFT activities. 40Most money laundering and terrorist financing activities involve cross-border transactions. 60 Annex 7 WBI activities in Serbia and Montenegro, FY05 FY07 - Summary: Significant capacity constraints pose a risk that the three broad goals identified inthe CAS will not be reached to the extent hoped for. Weak institutional capacity i s a common problem in the public, private and social sectors. The current and proposed WBI programs will complement the Bank Group's AAA activities in Serbia and Montenegro intendedto address the challenges to makingprogresstowards meetingthese goals. Capacity constraints: The CAS identifies three goals: (i) more efficient public sector, (ii) a a more dynamic private sector and (iii) lower poverty levels and improved social protectiodaccess to key public services as key objectives. Supporting Bank activities would include a substantial non-lending program to which WBI would contribute. In designing and implementing the AAA programs, a key issue to address is that institutions generally remain weak despite relatively high education levels. There i s significant capacity constraints associated with the CAS objectives: Economic andpublic sector management: Institutional reform priorities include strengthening arrangements for budgetplanning and execution, developing multi-year planning mechanisms and improving accountability. Key targets include containing items o f public spending (wage bills, social transfers, subsidies), expanding the share o fbudgetary transactions coveredbythe treasury systems, and strengthening o f the internal audit hnctions o f the Ministries o f Finance. Institutional strengthening i s needed to implement policies for sustained macro- economic stability and the external balance, and to build effective union and republican institutions able to support both economic andjudicial reform. Private sector development: Within the broader capacity objective o f building institutions that are able to foster a stable business environment, specific capacity gaps include the ability to pursue the privatizationagenda and support the growth o f exports (and trade in general). In addition, there remains a need to establish the proper "division o f labor" between the public, civil and private/corporate sectors o f society, and strengthen the institutions that implement the policiesbehindthis. Social sector development: Capacity gaps include weak institutions responsible for the broad poverty reduction agenda and, more specifically, improving the social well-being o f the most vulnerable groups. Legislation and regulations related to health, education and pensions are either inplace or will be so inthe foreseeable future, but appropriate implementation remains a challenge. The 2003 PRSP pledges for government to do more for vulnerable groups, including the Roma. Current and future activities: Current and hture WBI supported activities address issues which are linkedprimarily with the CAS Goals 2 and 3 and include the following. Goal 2: Private sector development: Two countries specific and one regional activity are currently supported by WBI. 61 Annex 7 (i) Export promotion: Workshops on improving export promotion and support to the Serbian export promotion agencies are being carried out during FY05, and complement related ECSPF activities. (ii) Small and medium enterprises development and restructuring;/privatization: This program focuses on training and institution strengtheningo f the Serbian PA and also complements ECSPF's work in this field. Activities in FY05 include two 2-day workshops with emphasis on contract enforcement and private sector regulation, respectively, complemented by GDLN video conferences on the main findings o f the recently completed Serbia and Montenegro InvestmentClimate Assessment. (iii) Knowledgeeconomy:WBIstaffrecentlyledasmallteamwhichpreparedaseriesof knowledge economy assessments for the Balkan region and countries. There is now a proposal for ECSPF to develop a more focused and project oriented output with emphasis three specific thematic areas and the linkages between them: (i) enhancing applied R&D, knowledge transfer and innovation in the enterprise sector, (ii) increasing telecom density and internet penetration, and (iii)scaling up o f e- government services. WBI would stay involved in follow-up activities as requested by ECSPF, including the development o f policy recommendations and further involvement o f and discussions with relevant stakeholders in SaM and the other countries. As the current country specific activities are completed (2005), WBI would consider shifting its PSD work further to regional activities, possibly to promote private participation in, and regional integration of, infrastructure (transport, energy). PRSP Process: Activities supporting the PRSP process have focused on a series o f development debates and seminars open to all Balkan countries, including SAM, where participants involved in their country's PRSP process exchange experiences. The latest round of development debates took place inearly 2004, mainly through video conferencing, and was followed by a well-attended Second PRSP Forum in Thessalonica, Greece. Follow-up activities may include a Basic Poverty Measurement and Diagnostics course in mid FY05 with clinics on topics determined by the participating countries' PRSP teams, and further development debates and a Third PRSP Forum. WBI's evaluation group could also offer learning events on monitoring and evaluation based on Bank supported projects" Inthe field o fsocial sector development, WBI support focuses on regional follow-up activities to the Roma conference, including policy dialogue and capacity building through country and regional training. Main activities planned for FY05 include regional training on select topics including a course on Social Accountability and Monitoring, and support o f Roma participation in various activities. Websites and virtual learning environments would be supported to promote regional networking for on-going dialogues and on-line information exchanges with special emphasis on education issues and Roma women. In addition, SAM delegates would continue to be invited to other regional and global WBI programs throughout the planning period. The scope o f and audience for such invitations would be determinedjointly with the Bank's Country Office in Belgrade. For both the country specific and regional/global programs, the GDLN Network will be used as appropriate to ensure cost efficiency and maximum knowledge sharing and dissemination. Partnerships: WBI activities are developed in collaboration with local and international counterparts and donors, and coordinated with the Country Offices and relevant task teams in ECA. The PSD activities are supported by an ItalianTrust Fundand Universita Cattaneo 62 Annex 7 Castellanza and Chamber o f Commerce inMilan. Privatization activities are done through the P A under the Republic o f Serbia Ministry of Economy and Privatization (MOEP). The export promotion activities are done through the Serbian Export Credit Agency. The Roma conference follow-up activities are done inpartnership with the Open Society Institute. WBIsponsored activitiesin Serbia-Montenegro ~~ A: Ongoing country specific activities (i)x~orDromotion-seeabove E t I (ii) and medium entemrises develoDment and restructurindmivatization - see above Small I B: Ongoing andtentative future regional activities A: Public sector management Intergovernmental Fiscal Relations and Local Financial Management Course for ECA (Budapest, DarticiPants from all ECA countries) I I B: Private sector development Regulating the Private Sector: Corporate Governance and Compliance, FYRMacedonia, Serbia, Bosnia and Russia inpartnership with ECA GDLN ECA Cross-Regional GDLNPolicy Dialogue on InvestmentClimate Issues Hazard RiskManagement inECA workshop (to be deliveredinTurkey, 60 participants from ECA countries) 1 Knowledge economy - see above Urban and City Management for SEE (conditional upon donor fimding, proposal to Italian TF) Albania, Bosnia and Herzegovina, FYRMacedonia, Serbia and Montenegro C: Poverty alleviation, Social sector development/social monitoring and accountability Mainstreaming Gender aspects into the PRSP process, Balkan countries Basic Poverty Measurement and Diagnostics Courses; Balkan countries PRSP related clinics, under consideration; Balkan counties Development Debates and 3rd PRSP Forum for the Balkan countries Regional Flagship Course on Health Sector Reform for ECA Advanced Flagship Course on Poverty, Equity, and Health for ECA Roma Leadership Capacity Building(Serbia and Montenegro, FYRMacedonia, Croatia, Bulgaria, Romania, Hungary, Czech Republic, Slovakia) 63 hY t .-.-.? M U Y U m Y 0 0 0 0 0 I 0 0 0 0 W W m a X 4 Annex 10 MIGA in Serbia andMontenegro SaM has been a member o f MIGA since 1993. MIGA is a key partner for the government o f SaM through the provision o f guarantees and technical assistance, to help the country attract foreign investment. Guarantees. MIGA currently has fourteen guarantee contracts in SaM: twelve in the financial sector, one in the services sector and one in the manufacturing sector. MIGA's total gross exposure in SaM is US$296.3 million. MIGA is considering two projects in its pipeline for SaM. One is in the financial sector (leasing) and the other in the services sector (retail), with a total potential for MIGA coverage o fUS$35.7 million. These projects are expectedto be underwrittenand executedby the end o f FY05. Technical Assistance. MIGA i s currently completing its support to a long-term, 18-months capacity building program for SIEPA. The hands-on institutional development program focuses on the preparation o f an FDI promotion strategy for SIEPA, the strengthening o f necessary investment promotion and facilitation skills in the agency, and the implementation o f a series o f pilot investor outreach programs in a number o f priority sectors. The program i s funded under a World Bank Private Sector Development grant to Serbia and benefited from strong cross-links with other economic development programs, such as USAID's competitiveness project and the EAR'Sexport development and SME support programs in Serbia. EAR has asked MIGA to help design and manage a follow-on assistance program that will help further strengthen Serbia's investment promotion capacity. It i s expected that the EAWMIGA program will be launched in early CY05, subject to the Serbian government fiilfilling a number o f conditions (such as the passing o f the law on SIEPA). In April 2004, with donor funding from the European Agency for Reconstruction, MIGA also launched a new technical assistance program in Montenegro, aimed at assisting the country in establishing a new investment facilitation and servicing unit. The one-year program will support the establishment o f the unit, including the development o f a start-up strategy and work plan, skills development and training, and support for initial information dissemination activities. Serbia and Montenegro both also benefit from a new regional initiative that MIGA i s launching for the Western Balkan region. Under the European Investor Outreach Program (EIOP), MIGA will implement over the next two and a halfyears a donor-funded pilot initiative that has been designed to strengthen the capability o f Western Balkan countries (Albania, Bosnia-Herzegovina, Croatia, FYR Macedonia, and Serbia and Montenegro) to attract inward investment from across Western Europe. The goal i s to increase investor awareness o f the region's potential, encourage investors to undertake site visits to explore investment opportunities, and ultimately to support actual investments in the region. MIGA's on-line investment promotion services (www.fdixchange.com and www.ipanet.net) feature 270 documents on investment opportunities and the related legal and regulatory environment in SaM. MIGA also has established a content provider partnership for its online services with the Serbian Ministryo fEconomy and Privatization andwith SIEPA. 69 Annex A2 Serbia and Montenegro at a glance 11/11/04 ' Serbia EuroDe& Lower- POVERTYand SOCIAL and Central middie- Montenegro Asia income 1 Developmentdiamond' 2003 Population,mid-year (millions) 8.3 473 2,655 Lifeexpectancy GNI per capita (Atlas method, US$) 1,900 2,570 1,480 1 GNI (Atlas method, US$billions) 15.8 1,217 3,934 Average annual growth, 1997-03 T Population(%) 0.0 0.9 Laborforce (%) 0.2 1.2 Gross primary Most recent estimate (latest year available, 1997-03) capita enrollment Poverty (% of population belownationalpovertyIlne) 10 Urban population(% of totalpopulation) 53 63 50 Lifeexpectancyat birth (years) 72 69 69 - infant mortality(per 1,000live births) 12 31 32 Child malnutrition (% of childrenunder 5) 11 Access to improvedwater source Access to an improved water source (% ofpopulation) 91 81 Illiteracy(% ofpopulation age 15+) 3 10 Gross primaryenrollment (% of school-age population) 103 112 Serbia andMontenegro Male 104 113 Lower-middle-incomegroup Female 102 111 KEY ECONOMICRATIOS and LONG-TERMTRENDS 1983 1993 2002 2003 1 Economicratios' GDP (US$ billions) 15.5 20.5 Gross domestic investmenffGDP 16.2 15.9 Exports of goods and services/GDP 20.9 19.9 Trade ~ Gross domesticsavingsiGDP -7.2 -6.6 Gross nationalsavingsiGDP 7.2 6.3 Current account balance/GDP -8.9 -9.6 Interest payments/GDP 0.9 1.3 Total debffGDP 76.5 69.9 Total debt servicelexports 3.4 6.7 Present value of debffGDP Present value of debffexports I Indebtedness 1983-93 1993-03 2002 2003 2003-07 (average annualgrowth) GDP 4.0 3.0 4.7 Serbia and Montenegro GDP per capita 4.3 3.2 5.0 Lower-middle-income arouo Exports of goods and services 12.3 4.3 15.5 STRUCTURE of the ECONOMY (% of GDPJ Agriculture Industry Manufacturing Services Privateconsumption 86.9 88.3 General governmentconsumption 18.3 18.4 Importsof goods and services 44.3 42.4 (average annualgrowth) Agriculture 40 IndustryManufacturing id Services " 10- Q Privateconsumption 6.3 5.5 0 69 Annex A2 - continued Serbia and Montenegro PRICES and GOVERNMENT FINANCE 1983 1993 2002 2003 Domestic prices (% change) Consumer prices Implicit GDP deflator 240 149 Government finance (% of GDP, includes currentgrants) Current revenue 43.3 42.7 ~ 58 95 00 01 02 03 Current budget balance -1.1 -1.3 -GDP deflator +CPI Overall surplus/deficit -4.6 -3.2 TRADE I Exportand import levels (US$ mill.) (US$ miilions) 2o02 2003 I Total exports (fob) Food Other fuel Manufactures Total imports (cif) .. 6,320 7,957 Food " Fuel and energy 2,000 Capital goods :: Export price index (1995-700) 97 58 55 00 01 02 03 Import price index (1995=100) Exports w Imports Terms oftrade (1995=100) I BALANCE of PAYMENTS 1 (US$ millions) lgg32o02 2003 Current account balance to GDP (%) 1 Exports of goods and services Imports of goods and services Resource balance .. -3,616 -4,606 Net income -111 -249 Net current transfers .. 2,343 2,895 Current account balance ., -1,384 -1,961 Financing items (net) 2.495 3.231 -" T Changes in net reserves .... -1,111 -1;270 i.121 I Memo: Reserves includinggold (US$ millions) .. 2,280 3,550 Conversion rate (DEC, local/US$) 64.3 57.5 EXTERNAL DEBT and RESOURCE FLOWS 1983 1993 2002 2003 (US$ millions) Total debt outstandingand disbursed 11,768 14,303 IBRD .... 2,175 2,607 IDA 167 262 G 2,596 A 2,607 Total debt service 184 435 IBRD 76 106 B 262 IDA 0 1 C 913 Compositionof net resourceflows Official grants Official creditors F 2,857 1 Private creditors 1,396 Foreigndirect investment Portfolioequity E. 3,650 World Bank program Commitments E Bilateral Disbursements 159 95 D - Other multilateral F Private -- 0 t:i:,"" " ~ Principal repayments 0 C-IMF G - Short-term Net flows 159 95 Interestpayments 75 107 Nettransfers 64 -12 DevelopmentEconomics 11/11/04 70 Annex B2 Serbia and Montenegro Selected Indicators* of Bank Portfolio Performance and Management As Of Date 11/04/2004 Fiscal Year Indicator 2002 2003 2004 2005 Portfolio Assessment Number of Projects Under Implementation a 8 15 19 18 Average implementation Period (years) 0.6 1.0 1.4 1.5 Percent of Problem Projects by Number a, 0.0 6.7 15.8 11.1 Percent of Problem Projects by Amount 0.0 4.2 27.3 7.0 Percent of Projects at Risk by Number 37.5 6.7 21.1 16.7 Percent of Projects at Risk by Amount 13.9 4.2 29.1 9.2 Disbursement Ratio (%) e 52.9 22.1 13.9 1.2 Portfolio Management CPPR during the year (yes/no) yes yes Supervision Resources (total US$) 330 735 1,375 Average Supervision (US$/project) 41 49 72 Memorandum item Since FY 80 Last Five FYs Project Evaluation by OED by Number 3 3 Project Evaluation by OED by Amt (US$ million) 175.9 175.9 % of OED Projects Rated U or HU by Number 0.0 0.0 % of OED Projects Rated U or HU by Amt 0.0 0.0 a. As shown in the Annual Reporton Portfolio Performance(exceptfor current FY). b. Average age of projects in the Bank's country portfolio. c. Percentof projects rated U or HU on development objectives (DO) and/or implementationprogress (IP). d. As defined under the Pottfolio ImprovementProgram. e. Ratioof disbursements during the year to the undisbursed balanceof the Bank's portfolio at the beginningof the year: Investmentprojectsonly. * All indicatorsare for projectsactive in the Portfolio,with the exceptionof DisbursementRatio, which includes all active projects as well as projectswhich exited during the fiscal year. 72 Annex B3 Serbia and Montenegro IDA Program Summary Proposed IDNIBRD Base-Case Lending Program FYO5-07 Fiscalyear Project US$(M) Strategic Implementation Rewards b b Risks (H/M/L) (H/M/L) 2005 STRUCTURAL ADJUSTMENT CREDIT 2 45 H H REGIONAL ENERGY* 7 H M PENSIONS 25 H M EDUCATION (MONTENEGRO) 5 M M STRUCTURAL ADJUSTMENT CREDIT 2 (MN) 18 H H Result 100 2006 PROGRAMMATIC ADJUSTMENT LOAN 1 55 H H IRRIGATIONAND DRAINAGE REHABILITATION 25 M M BOR REGIONAL DEVELOPMENT 30 H H TOURISM AND AGRICULTURE (MONTENEGRO) 12 H H REGIONAL ENERGY (MONTENEGROT 3 H M Result 125 2007 PROGRAMATICADJUSTMENT LOAN 2 90 H H PRIMARY HEALTH 35 H M RURAL BUSINESS ENVIRONMENT 40 H M STRUCTURAL ADJUSTMENT CREDIT 3 (MN) 10 H H Result 175 Overall Result 400 *Reflects regular IDA allocation; additional IDA regional allocations would be sought (see also Table 5 of CAS). 73 Annex B3 Serbia and Montenegro IFC and MlGA Program, FY2002-2005 2002 2003 2004 2005 IFC Commitments (US$m) 32.78 9.04 0.00 0.85 Sector (%) Finance & Insurance 25 100 100 Food & Beverages 21 Plastics and Rubber 54 Total 100 0 0 0 Investment instrument(%) Loans 76 89 87 Equity 13 11 13 Quasi-Equity 11 Other Total 100 100 0 100 Note; Source is IFC's MIS; FY05 figures are as of October 31, 2004; IFC's own account only MlGA guarantees (US$m) 0 0 196.86 296.26 74 Annex B4 SerbiaandMontenegro Sunmaryof NonlendingServices, FY02 07 - - Product COrrpletionW Cost(US$000) Audiencea Objective Recentcompletions SaMCFA4 02 129 G,D,B,PD KG, PS SaMcPPR 02 90 G, D, B, PD KG, PS SaMPElR 03 436 G, D, B, PD KG, PS SaMpovertyNote&Assessmt (rdlingprcg.) 03 204 G, D B, PD , KG,PS,PD Serbia&ticulture Report 03 167 G,D,B,PD KG,PS,PD SaM Environmt Report 03 52 G,D,B,PD KG,PS,PD SaMDebtSustainability 03 77 B KG, PS SaM Diagnosticand PdicyNotehblicWrrinistrati 04 100 G, D, B, PD KG, PD, PS SaM lnvestrnentclimtek s e " t (104) 04 50* G,D,B,PD KG, PD, PS SaMFiduciaryWork 04 50 G,D,B KG, PS SaMPdrrinistrativeBaniers(FIAS) 04 da G,D,B,PD KG, PD, PS SaM InvestmentDiagnostic(FIAS) 04 da G,D,B,PD KG, PD, PS W i a Emorrlc lvlmmndum 04 317 G, D, B, PD KG, PD, PS SerbiaFinanadSector Note 05 80 G, D, B, PD KG, PD, PS SaMWBGSupportfor PRSPImplmntation 05-07 125 U * W m aprivateSector Note 05 90 G, D, B, PD KG, PD, PS fvbntenegro Emorrlchknmrandum 05 80 G,D,B,PD KG, PD, PS SaMRcgramnatic PovertyWork 05-07 20 G, D, B, PD KG, PD, PS MontenegroPivSectodFin Note 05 50 G, D, B, PD KG, PD, PS Planned SaMDebtSustainabilityAnalysis Update 05 30 G, PD,PS KG, PD, PS SerbiaFSAP 05 51 G, D, B, PD KG, PD, PS SaMYcuthinSEE 05 70 G,D,B,PB KG, PD, PS Serbia&ticulture CmpetitivenessStudy 06 50 G,D,B,PD KG, PD, PS SaMSupportfor RomDecadeof lndusion 06 5 SaM PElRupdate(integrated PFM) 06 5 G,DtB,PD KG, PD, PS MontenegroW d Protection m-07 60 G,D,B KG, PS m aLaborm e t policyNote 06 80 G, D, B, PD KG, PD, PS SaMPovertyAssessment Update 07 200 G, D, B, PD KG, PD, PS *alsohasnetvuxktinanang a. Government,donor, Bank,publicdisserrination. b. Kmdedgegeneration,publicdebate, problem-ding. 75 Annex B5 Serbia and Montenegro Social Indicators Latest single year Same regionlincome group Europe & Lower- Central middle- 1970-75 1980-85 1997-2003 Asia income POPULATION Total population, mid-year (millions) 9.3 10.2 8.1 472.7 2,655.2 Growth rate (% annual averagefor period) 1.o 0.9 -4.5 0.0 0.9 Urban population (YOof population) 43.0 48.7 52.0 62.6 49.7 Total fertility rate (births per woman) 2.3 2.2 1.7 1.6 2.1 POVERTY (% of population) National headcount index Urban headcount index Rural headcount index INCOME GNI per capita (US$) 1,910 2,570 1,480 Consumer price index (1995=100) Food price index (1995=100) 1,720 INCOMElCONSUMPTlONDISTRIBUTION Gini index Lowest quintile (% of income or consumption) Highest quintile (% of income or consumption) SOCIAL INDICATORS Publicexpenditure Health (% of GDP) 6.5 4.3 2.6 Education (YOof GDP) 4.3 4.0 Social security and welfare (% of GDP) Net primaryschool enrollment rate (% of age group) Total 75 91 ' Male 75 92 Female .75 91 Access to an improvedwater source (% of population) Total 98 91 81 Urban 99 96 94 Rural 97 82 70 Immunizationrate (% of children ages 12-23months) Measles 91 92 93 78 DPT 89 95 92 84 Child malnutrition (% under 5 years) 2 11 Lifeexpectancy at birth (Years) Total 70 71 73 69 69 Male 68 68 70 64 67 Female 72 73 75 73 71 Mortality Infant (per 1,000 live births) 54 36 16 31 32 Under5 (per 1,000 live births) 72 44 19 37 40 Adult (15-59) Male (per 1,000 population) 166 164 180 317 214 Female(per 1,000 population) 121 106 100 137 135 Maternal (modeled, per 100,000 live births) 11 Births attended by skilled health staff (%) 99 Note: 0 or 0.0 means zero or less than half the unit shown. Net enrollment rate: break in series between 1997and 1998due to change from ISCED76to ISCED97. Immunization: refers to children ages 12-23 months who receivedvaccinations before one year of age. World DevelopmentIndicatorsdatabase August 2004, World Bank 76 Annex B6 SerbiaandMontenegro Key EconomicIndicators - Actual Estimate Projected Indicator 2000 2001 2002 2003 2004 2005 2006 2007 National accounts (as YOof GDP) Total Consumption 102.7 107.2 107.2 106.6 108.6 107.3 103.3 101.3 Gross domestic fixed investment 15.3 13.3 15.9 15.6 16.2 17.5 20.1 20.7 Government investment 3.1 1.6 3.6 2.2 2.6 2.3 4.6 4.7 Private investment 12.2 11.7 12.3 13.4 13.6 15.2 15.5 16.0 Exports (GNFS)b 29.6 23.7 20.9 19.9 24.2 27.3 29.9 31.7 Imports (GNFS) 46.5 44.6 44.3 42.4 49.4 52.4 53.5 54.0 Gross domestic savings -2.7 -7.2 -7.2 -6.6 -8.6 -7.3 -3.3 -1.3 Gross national savingsc 10.4 9.1 7.2 6.3 5.8 7.5 11.6 13.5 Memorandum item GNIper capita (US$, Atlas method) 1,220 1,250 1,400 1,900 2,530 2,770 2,870 2,960 Real annual growth rates (%, calculated from 1998prices) Gross domestic product at market prices 5.0 5.5 4.0 3.0 6.0 4.6 4.8 5.0 Gross Domestic Income 5.1 5.5 4.0 3.1 6.0 5.0 4.8 5.0 Real annual per capita growth rates (%, calculated from 1998prices) Gross domestic product at market prices 5.5 5.7 4.3 3.2 5.9 4.5 4.7 4.9 Total consumption 5.2 13.1 7.8 8.7 10.7 2.3 -0.4 2.3 Private consumption 19.1 15.1 6.6 8.5 11.8 3.0 0.5 2.3 Balance of Payments (US$ millions) Exports (GNFS)b 2,547 2,743 3,241 4,069 5,623 6,326 7,028 7,808 Merchandise FOB 1,923 2,003 2,412 3,015 3,925 4,493 5,047 5,669 Imports (GNFS)~ 4,004 5,160 6,857 8,675 11,463 12,138 12,591 13,303 Merchandise FOB 3,711 4,837 6,320 7,957 10,244 10,858 11,221 11,838 Resource balance -1,457 -2,417 -3,616 -4,606 -5,840 -5,812 -5,563 -5,494 N e t current transfers 1,119 1,915 2,344 2,895 3,745 3,970 3,942 4,072 Current account balance -339 -528 -1,383 -1,960 -2,492 -2,372 -2,049 -1,861 N e t private foreign direct investment 25 165 562 1,395 966 1,181 988 1,035 Long-term loans (net) 213 299 378 697 1,059 867 724 706 Other capital (net, incl. errors & omissions) 328 587 1,554 1,138 640 748 478 360 Change inreservesd -227 -523 -1,111 -1,270 -173 -424 -141 -239 Memorandum items Resource balance (% of GDP) -17 -21 -23 -22 -25 -25 -24 -22 77 Annex B6 SerbiaandMontenegro Key EconomicIndicators - (Continued) Actual Estimate Projected Indicator 2000 2001 2002 2003 2004 2005 2006 2007 Public finance (as 'YOof GDP at market prices)e Current revenues 36.7 38.9 43.3 42.7 43.2 42.7 41.9 41.1 Current expenditures 34.5 38.7 44.3 44.0 42.8 41.3 38.2 37.4 Current account surplus (+) or deficit (-) 2.2 0.2 -1.1 -1.3 0.5 1.5 3.7 3.7 Capital expenditure 3.1 1.6 3.5 2.3 2.6 2.3 4.8 4.9 Foreign financing 0.0 0.0 1.8 1.2 0.9 1.1 1.0 1.0 Monetaryindicators M2/GDP 8.5 7.8 10.6 10.1 9.9 9.8 10.0 10.1 Growth o fM2 (%) .. 83.9 76.2 12.1 14.0 16.5 14.4 10.7 Priceindices Consumer price index (% change, period average) 69.9 91.1 21.2 11.3 9.5 11.3 6.2 4.0 GDP deflator (% change) 88.5 91.7 24.0 14.9 9.8 11.9 7.1 4.4 a. GDP at factor cost b. "GNFS"denotes "goods andnon-factor services." c. Includesnet unrequitedtransfers excluding official capital grants. d. Includes use o fIMFresources. e. Consolidated general government. 78 Annex B7 Serbia and Montenegro Key Exposure Indicators - Actual Estimate Projected Indicator 2000 2001 2002 2003 2004 2005 2006 2007 Total debt outstanding and 11,460 11,948 11,841 14,302 13,404 13,060 12,805 12,951 disbursed (TDO) (USSm)" Net disbursements (US$m)a 353 502 832 1,111 1,188 1,090 812 695 Total debt service (TDS) 56 107 184 463 1,047 1,387 1,477 1,819 (uS$m)a Debt and debt service indicators ("h) TDO~XGS~ 307.1 266.2 219.6 205.9 143.8 125.2 113.8 105.8 TDOiGDP 133.2 103.2 76.5 69.9 57.8 56.4 54.4 52.6 TDSiXGS 1.5 2.4 3.4 6.7 11.2 13.3 13.1 14.9 ConcessionaliTDO 2.3 2.4 22.1 23.5 27.1 21.5 20.5 19.1 IBRDexposure indicators (%) IBRDDSipublic DS .. 56.0 36.0 23.4 23.3 29.5 23.0 Preferred creditor DSipublic D S (%)' .. 24.5 74.6 69.0 91.7 97.8 75.0 63.8 IBRDDSiXGS .. 1.4 1.5 1.3 1.3 1.5 1.5 IBRD TDO (US$mld 1,781 1,840 2,175 2,607 2,607 2,591 2,551 2,544 Ofwhichpresent value o f guarantees (US$m) Share o f IBRDportfolio (%) 100.0 100.0 92.9 90.2 85.4 82.1 79.7 78.4 IDA TDO (us$mId 0 0 167.0 282.0 446.3 564.7 650.1 699.6 a. Includes public andpublicly guaranteed debt, private non-guaranteed, use o f IMF credits andnet short- term capital. b. "XGS" denotes exports o fgoods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the Bank for International Settlements. d. Includespresent value o fguarantees. e. Includes equity and quasi-equity types o fboth loan and equity instruments. 79 00 a (D (D (D co 0 cc, I 00 a 4 3 0 0 r r = ? O O T - r : 3 0 0 6 6 0 0 0 - r 0 0 0 - y 0 0 0 + 6 c L c L MAP SECTION