1. Republic of Serbia Fiscal Council 31 July 2014 ANALYSIS OF THE OPERATIONS OF STATE-OWNED ENTERPRISES KEY POINTS AND RECOMMENDATIONS FOR BUDGET REVISION AND MEDIUM-TERM FISCAL ADJUSTMENT: 2015-2017

2. Three pillars of fiscal consolidation 1.Reforms – adoption of laws that will lay the foundation for stable public finances in the medium term −Law on Pension and Disability Insurance, Law on Labour (economy, but also the basis for public enterprises and public administration), Law on Privatization (restructuring)… −Positive assessment, but the biggest challenge is yet to come (downsizing of employees), savings will not be made immediately 2.Bringing order in public and state-owned enterprises – the most difficult and uncertain −Huge problems: political (interest groups) and professional (redundant employees and their benefits, uncollected payment for services, inadequate prices, etc.) – there is still no adequate plan for addressing these issues −If this is not done, there will be an explosion of public expenditure and failure of consolidation 3.Establishing a sustainable level of budget expenditure −Suplementary budget: a step towards reducing the huge deficit and eliminating the biggest imbalances 2

3. Public and state-owned enterprises are the biggest problem Already incurred a large fiscal cost (1 billion euros annually) – And it keeps growing; unless reversed, it will make all savings useless Srbijagas – It has already spent the state funds equal to the value of Telekom and continues to generate losses – Network of problems – the problem is not only Srbijagas, but also Azotara, Petrohemija, MSK, city heating plants…that do not pay for gas EPS – Numerous problems, not only low prices but also redundant employees, poor payment collection, organisational fragmentation, losses in distribution (thefts)… beginning of liquidity problems, now the floods – new Srbijagas? – Other public enterprises have similar problems, but the operations of EPS are measured in hundreds of millions of euros, which is too much for public finances Serbian Railways – There is no progress for decades - huge government subsidies spent, the 19 th century train speed, project funds not withdrawn – Huge system (20,000 employees) with problems, together with EPS nearly 60,000 employees out of the total of 250,000 in all public and state-owned enterprises 3

4. High deficit in 2014 - over 2.6 billion euros (8.3% of GDP) Projected deficit of 2.5 billion euros has been exceeded for about 150 million euros – Combined result of drop in revenues of about 400 million euros and decrease in expenditures of about 250 million euros Public revenue shortfall is primarily the result of changed macroeconomic environment (objectively) – Extremely low inflation (2% instead of expected 5% - lower public revenue), recession and larger drop in formal employment than projected – Missing and budgeted effects of combating grey economy (unrealistically planned) Public expenditures were under control – Finally stopped salary increase above indexation (there are savings) – positive – Inefficient execution of public investment – negative 4

5. Public debt at the end of the year over 70% of GDP In countries like Serbia – even a significantly lower level of public debt leads to a crisis – It is difficult to reverse the growth of public debt – it will reach 80% of GDP (even with substantial cuts) – Creditors can easily lose confidence - a crisis of public debt Large public debt is not the only risk – Annually over 5 billion euros (17% of GDP) needed to finance deficit and pay due debt – According to international standards – there is a risk of crisis with due payments of over 15% of GDP Stopping the growth of public debt share in GDP - fiscal consolidation – Investors need to see a credible plan for medium-term adjustment and stopping of public debt growth in order to continue lending money 5

6. Fiscal consolidation –2 billion euros of savings In order to stabilise the public debt by 2017, the deficit must be reduced to below 1 billion euros (from the current amount exceeding 2.6 billion euros) – However, some expenditures will be growing: payment of interests (as long as there is a growth of public debt) and public investment (currently insufficient) – Required savings of nearly 2 billion euros – Reforms and improvement of public finances are required, but "painful" cuts cannot be avoided (there are no easy solutions) Serbia’s credibility is low and adjustment of 2 billion euros is possible only in the medium term – New arrangements with the IMF required 6

7. Possible savings (million EUR) Time of full effectCurrent situationRisks Public and state-owned enterprises 400 – 500Next 3 to 4 yearsUnfavourable – problems are rapidly increasing instead of decreasing High – professional (plan and downsizing of employees, appropriate prices, collection of receivables, technical improvements and investment, etc.) and political (interest groups) Cutting salaries and pensions by 15% 8002015Pending political decisionLow – possible exemption from salary cuts for individual public sector categories Combating grey economy 300 – 350Next 2 to 3 yearsInitiated personnel changes in the Tax Administration, some positive effects are already noticeable: increased collection of contributions and excise tax on oil products, decreased revenue from cigarette excise taxes Moderate – presently on the right track, but major challenges still lie ahead Reforms (of earnings and employment, pension reforms, etc.) 300 – 400Next 2 to 3 years, longer for pension reform Adopted the reform Law on Pension and Disability Insurance; the central registry data are being prepared; beginning of the salary grade scale reform announced for autumn; there is no information about downsizing plans at the local level, in the sectors of health care, education, state administration, etc. Low – for pension reform Moderate – for salary grade scale High – for redundancies Total ≈ 1,900By 2017Unfavourable – trends of deficit, enhanced problems of public enterprises Favourable – still low interest rates, political environment The highest risk – bringing order in the business operations of public enterprises

8. Fiscal consolidation must be comprehensive It is futile to cut salaries and pensions without solving the issue of public and state- owned enterprises (∙∙∙∙∙). It is insufficient to solve the issue of public enterprises without cutting salaries and pensions (----); it is necessary to do both ( ─ ). In order to stabilise the public debt, it is necessary to reduce salaries and pensions by 15% smaller reduction of salaries and pensions would require additional adjustment measures, most probably further tax increase – an inferior measure 8

9. Fiscal consolidation and growth The major deficit adjustment (3% of GDP) in the first year of consolidation (2015) – Front-loading – Each successful fiscal consolidation has the biggest deficit reduction in the first year – Important for entire programme credibility - a smaller deficit makes the continued fiscal consolidation less risky - will be rewarded with confidence – Political economy – it’s now or never Strong deficit reduction leads to reduced economic activity, which can be mitigated – Fiscal consolidation of 3% of GDP would lead to a temporary drop of GDP by roughly 1% – If not mitigated = deflation and recession  failure of programme – It can be avoided with a broader package of fiscal and monetary policy measures to boost economic activity – Positive effect on economic growth from increased public investment (recovery after the flood), business environment (Law on Construction, etc.), attracting investors, perhaps considering fiscal and credit incentives 9

10. Public revenue in 2014 Revenue shortfall of about 50 billion dinars 30 to 35 billion objectively, due to changed economic circumstances – Inflation below the lower bound: 2-2.5% against the projected 5.5% – Greater drop in employment: 1.5% against the expected 0.7% – Economic recession, floods 20 billion dinars due to optimistic budgeting – Revenue from grey economy included in advance; however, measures have not been implemented in the first half of the year The 2013 trend of weakening tax discipline has been stopped – Efficiency of VAT collection unchanged compared to 2013 – Collection of payments for contribution partially improved – Pace of excise tax collection is extremely divergent 10

11. Excise tax revenue A large growth of excise tax collection recorded for oil products A large drop recorded for tobacco products 11 Oil products Tobacco

12. Combating grey economy One of conditions for fiscal consolidation and sustainable economic growth It is possible to increase revenue by 350 million euros by 2017 It requires a systemic approach and political support −Ad hoc measures implemented in 2013, attracting media attention, are not the right solution Some progress has already been made ​​, but substantial efforts are still needed −Personnel improvements, more efficient control system −Coordination of tax authorities, inspections, judiciary 12

13. State-owned enterprises Revenues are not sufficient even for salaries Illiquidity −Explosion of short-term debt and spillover to the state Failure to collect payment for supplied goods and covering debts of loss-generating enterprises Low sales prices of goods and services −Imposed social function High number of employees and mass of earnings −Number of employees, salaries, 13 th salary, bonuses, loans Public procurement −Possible savings Low investment −Lagging behind for decades Poor management, party management −Inappropriate selection of management, sponsorship, public procurement, incorrect accounting reports 13

14. Problem solving guidelines Professionally and politically challenging process: – Concurrent elimination of several problem sources (Srbijagas, EPS, etc.) – Problem diagnosis and awareness exist, we need consistent implementation – Reform of public enterprises affects interests and it is politically and socially challenging This has to be done: – Privatization; stop the practice of selling without collecting payment; price liberalisation; downsizing of employees and reducing salaries; greater investment and improvement of performance indicators; hard budget constraints; transparency; resolving the future status of enterprises in restructuring; corporate governance; centralised monitoring of the operations of enterprises 14