Yugoslavia - Adjustment policies and development perspectives (Vol. 1 of 3) : The summary report

Report No.3954-YU Yugoslavia: Adjustment Policies FI7c7\ and Development Perspectives I-E (In Three Volumes) Volume 1: The Summary Report November 2, 1982 Country Programs Department I Europe, Middle East and North Africa Region FOR OFFICIAL USE ONLY H Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Currency, Equivalents 1/ 1976 1 US Dollar = 18.19 Dinars 1 Dinar 0.055 US Dollars 1977 1 US Dollar = 18.30 Dinars 1 Dinar 0.055 US Dollar 1978 1 US Dollar = 18.64 Dinars I Dinar 0.054 US Dollar 1979 1 US Dollar = 19.00 Dinars 1 Dinar 0.053 US Dollar 1980 1 US Dollar = 24.91 Dinars 1 Dinar 0.040 US Dollar 1981 1 US Dollar = 35.51 Dinars 1 Dinar 0.028 US Dollar 1/ Period average exchange rates. The dinar has not been maintained within announced margins since July 12, 1973. Following a devaluation on October 22, 1982, the rate stood at 63.51 Dinars per'US Dollar. Glos,sary of Abbreviations BOAL Basic Organization of Associated Labor COAL Complex (or Composite) Organization of Associated Labor CGE Computable General Equilibrium CIFER Community of Interest for Foreign Economic Relations COI Community of Interest DOD Debt Outstanding and Disbursed DRC Domestic Resource Cost GMP Gross Material Product ICOR Incremental Capital-Output Ratio KBP Kosovska Banka Pristina LDR Less Developed Region(s) MDR More Developed Region(s) MLT Medium- and Long-Term OAL Organization of Associated Labor QR Quantitative Restriction SSE Small Scale.Enterprise(s) YBIEC Yugoslav Bank for International Economic Cooperation Throughout this report, the term 'region' is used to refer to Yugoslavia's six republics and two autonomous provinces.  FOR OFFICIAL USE ONLY YUGOSLAVIA ADJUSTMENT POLICIES AND DEVELOPMENT PERSPECTIVES This report is based on the findings of a World Bank economic mission which visited Yugoslavia in June 1981. The mission consisted of the following: Suman Bery, Chief of mission Petros Aklilu (Agriculture) Deepak Bhattasali (Foreign Trade and Finance) Kosara Gavrilovic (Translator and Interpreter) Paul Harrison (Consultant) (Agriculture) Frederick Kilby (Employment and Regional Development) Francois Laporte (Industry) Surinder Malik (Industry) Leslie Manison (IMF) (Foreign Trade and Finance) Mieko Nishimizu (Total Factor Productivity; Regional Development) Sherman Robinson (Adjustment Policies; CGE Model) Laura Tyson (Consultant) (Adjustment Policies; CGE Model) Assistance to the mission's work in Washington was provided by Jeffrey Lewis and Mukaila Ojelade. Ann Pepper had primary responsibility for document production. A draft of the report was discused with official and academic bodies in Yugoslavia in June and July 1982, and additional material has been included based upon that visit. I This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  ABSTRACT The report uses the start of the 1981-85 plan in Yugoslavia to provide an overall evaluation of performance and policies in the 1976-80 period, and the strategy proposed in the new plan. The report is in two parts. Part I deals with adjustment performance and associated policies at the economywide level, while Part II deals with issues of a more developmental nature in the sectors of agriculture and industry, and in the areas of employment and regional policy. The assessment of adjustment in Part I pays particular attention to trade and payments policy and investment policy and the analysis makes extensive use of a computable general equilibrium (CGE) model of Yugoslavia built for this report. After identifying certain weaknesses in the policy regime in the 1976-80 period the report reviews the measures proposed by the Yugoslav authorities to address these in the new plan, particularly in the light of more restricted access to international capital markets. The sectoral discussion in Part II of the report corroborates the broader perspectives of Part I, and pays particular attention to the implications of slower growth for the less developed regions (LDR) of Yugoslavia. The need for better integration of the industrial sector in the LDR with that of the more developed regions (MDR) is stressed, as is the need for a more labor intensive industrial strategy for the LDR.  YUGOSLAVIA ADJUSTMENT PERFORMANCE AND DEVELOPMENT PERSPECTIVES Table of Contents VOLUME I: THE SUMMARY REPORT Page No. COUNTRY DATA INTRODUCTION PART I: ADJUSTMENT PERFORMANCE AND POLICIES I. The Adjustment Strategy of the 1976-80 Plan .... ..... 2 Background to the Plan .......................... 2 The Adjustment Strategy ......................... 2 II. Plan Performance .................................... 4 Overview ........................................ 4 External Sector Trends .......................... 5 Export Performance ............................... 6 External Debt ................................... 8 Output Growth ................................... 11 Investment ...................................... 11 Saving .......................................... 14 III. The 1976-80 Plan: The Policy Framework .... ......... 15 Capital Allocation .............................. 15 The Foreign Trade and Payments Regime .... ....... 19 Trade Bias ...................................... 20 Exchange Rate Policies .......................... 24 IV. The 1976-80 Plan: A Summary Assessment .... ......... 26 V. The 1981-85 Adjustment Strategy .............. 28 Overview ........................................ 28 Medium-Term Perspectives .................. 37 Capital Account Issues ...................... 38 Policy Issues ................................... 38  Table of Co-itents (Continued) PART II: DEVELOPMENT PERSPECTIVES AND ISSUES Page No. VI. The Industrial Sector ............................... 41 VII. The Agriculture Sector .............................. 43 VIII. Employment ........ .................................. 48 Private Nonagricultural Employment .... .......... 51 Migration ....................................... 53 Labor Market Prospects .......................... 54 IX. Regional Development Issues ......................... 56 Suggestions for Further Policy Reform .... ....... 62 A Program for Kosovo ............................ 64 X. Adjustment Policies and Deyelopment Perspectives .... 60 Stabilization and Trade Policies .... ............ 66 Investment and Financial Policies .... ........... 68 Institutional Reform ........................... 72 Employment and Regional Development Policies .... 72 Concluding Remarks .............................. 73 MAP VOLUME II: THE MAIN REPORT INTRODUCTION PART I: ADJUSTMENT PERFORMANCE AND POLICIES I. The Adjustmen,t Stra,tegy of the, 1976-80 Plan .... ...... 1 A. Background to the Plan ............................ 1 Economic Trends. 1 Institutional Change. 3 B. The Adjustment Strategy. 6  - iii - Table of Contents (Continued) Page No. II. Plan Performance: Overview and External Sector Developments ...... 13 A. An Overview .13 B. The External Sector .15 Sources of Change in the Current Account Deficit .15 Merchandise Exports .19 Performance-in Developed Country Markets .22 Invisibles .24 External Debt .28 III. Plan Performance: -The Domestic Economy .35 A. Sectoral Growth Performance .35 B. Investment .39 C. Capital Efficiency .42 D. Saving Performance .47 Aggregate Trends .47 Household Savings .48 Enterprise Savings .49 IV. The 1976-80 Plan: The Policy Framework .55 A. Investment Allocation .55 B. The Foreign Trade and Payments Regime .66 Institutional Developments .66 Incentive Framework .67 Foreign Exchange Allocation .72 Export Incentives .75 Trade Bias .79 C. Exchange Rate Policy .84 D. Summary Assessment .93 V. The 1981-85 Adjustment Strategy .97 A. Overview .97 B. Medium-Term Prospects .107 Sectoral Implications .112 Capital Account Issues .115 Policy Issues .117  - iv - Table of Contents (Continued) PART II: DEVELOPMENT PERSPECTIVES AND ISSUES Page No. VI. The Industrial Sector ................................ 120 A. Introduction ..................................... 120 B. The 1976-80 Plan .122 Aggregate Targets .122 Investment .123 Output .124 Employment .125 Imports .126 Exports .127 C. The 1981-85 Plan .128 Priority Industries .134 D. Export Potential, Markets and the Incentive System 144 Plan Targets .144 Past Performance .145 Export Markets .146 Export Incentive System .149 Export Promotion Infrastructure .152 E. Some Policy Issues in Industry .... ............... 152 Incentive Policy ............................... 153 Export Credit .................................. 156 Investment Choice .............................. 156 VII. Agriculture .......................................... 159 A. Structure of the Agriculture Sector .... .......... 159 Resource Base .................................. 159 Land Tenure and Production Orientation ... ...... 159 Agricultural Population ........................ 160 Role of Agriculture in the Economy .... ......... 160 B. The Agriculture Sector 1976-1980: Plan and Performance ........ ............................. 162 Plan Objectives and Strategy .... ............... 162 Assessment of Performance ..... ................. 163 Policy Framework ...... ......................... 163 Agricultural Pricing and Subsidy Policies ...... 163  v Table of Contents (Continued) Page No. Investment Allocation ...... .................... 165 Association of Farmers ...... ................... 167 Land Reclamation and Abandonment .... ........... 168 Agricultural Exports ....... .................... 169 C. The 1981-85 Plan .......... ....................... 170 Evaluation of Plan Targets and Measures ........ 170 Land Use ........................................ 171 Food Processing Capacities ..... ................ 176 Summary Evaluation ....... ...................... 177 VIII. Employment ........................................ 180 A. Introduction ...................................... 180 B. Labor Force Trends 1971-75 ...... ................. 180 C. The 1976-80 Plan .......... ....................... 184 Social Sector Employment ...... ................. 184 Private Nonagricultural Employment .... ......... 194 Private Sector Agricultural Employment .... ..... 195 Unemployment ............ ....................... 203 Overall Performance 1976-80 ..... ............... 208 D. Labor Force Balances 1970-80 ..... ................ 210 E. Regional Employment Issues . 212 Regional Demographic Trends . 215 External Migration . 218 Interregional Migration ........................ 220 F. The 1981-85 Plan .................................. 225 IX. Regional Development Issues ........ .................. 233 Introduction ........................................ 233 A. Regional Trends in Output, Population and Per Capita Incomes ........... ................... 234 B. The Framework of Regional Policy ..... ............ 242 The Scale of Impact of Regional Transfers . 242 Other Regional Policy Measures . 245 C. Productivity Growth and Development Policies in the LDR . 246 The Sources of LDR Growth 1965-78 . 248 Changes in the Efficiency of Production . 253 The Role of Enterprises in Productivity Growth . 261 Regional Planning . 262 Competition Policy . 264 The Impact of Regional Fiscal Policy on Resource Allocation . 267 D. Recent Regional Policy Initiatives and Suggestions for Further Policy Reform . 271 Domestic Joint Ventures . 271 Policy Issues . 273 An Action Program for Kosovo . 278  - vi - Table of Contents (Continued) Page No. X. Adjustment Policies and Development Perspectives .... 283 A. Stabilization and Trade Policies .... ............ 284 B. Investment and Financial Policies .... ........... 285 C. Institutional Reform ............................ 289 D. Employment and Regional Development Policies .... 290 E. Concluding Remarks .............................. 290 VOLUME III: METHODOLOGICAL AND STATISTICAL ANNEX Appendix I A Summary Description of the Computable General Equilibrium (CGE) Model for Yugoslavia .... ............ 1 A. Introduction ....................................... 1 B. The CGE Static Model Formulation .... ............... 1 Product Markets and Factor Supplies .... ........ 2 Foreign Trade and Foreign Exchange .... ......... 8 Income and Product Demand ...................... 15 Market Clearing Conditions .... ................. 17 C. The Dynamic CGE Model .............................. 17 D. Trade Policy and Resource Allocation: Some Empirical Results ............................ 17 Measurement and Interpretation of Domestic Resource Cost ........................ 18 The Interpretation and Measurement of Market Clearing and Shadow Exchange Rates ......................................... 20 The Contribution of Various Factors to the Depreciation of the Equilibrium Exchange Rate Over the 1976-80 Period .... .............. 21 Sectoral Market and Social Profitability Rates: Measurement and Interpretation ........ 22 Appendix II Mathematical Presentation of the CGE Model .... .......... 28 A. Introduction ....................................... 28 B. Equations of the Flexible Exchange Rate Model ....... 28 The Operation of Markets ....................... 33 C. Fixed Exchange Rates and Import Rationing .... ..... 34  - vii - Table of Contents (Continued) Appendix III Measurement and Decomposition of Growth in Total Factor Productivity .................................... 35 Appendix IV A Note on Data Classification ........................... 44 STANDARD TABLES ......................................... 45 STATISTICAL APPENDIX .................................... 49  - viii - Table of Contents (Continued) LIST OF TEXT TABLES VOLUME II: THE MAIN REPORT Table No. Page No. Chapter I 1.1 External Sector Developments, 1965-80 .... ....... 4 1.2 External Sector Targets of the 1976-80 Plan ..... 6 1.3 Structure of Investment in Fixed Assets in Economic Sectors 1971-75 and 1976-80 9 1.4 Macroeconomic Indicators 1971-75 (Actual) and 1976-80 (Planned) .10 1.5 Estimated External Financing Requirements of the 1976-80 Plan .11  - ix- List of Text Tables (Continued) Table No. Page No. 3.4 Indicators of the Overall Investment Effort, 1971-80 .41 3.5 Functional Distribution of Real Investment Expenditures, 1971-80 ..... .................... 42 3.6 Incremental Capital-Output Ratios, 1971-80 ...... 44 3.7 Indicators of Aggregate Saving Performance, 1971-79 ......... .............................. 48 3.8 Household Saving Rates (1971-80) .... ............ 49 3.9 Saving Behavior of Social Sector Enterprise, 1971-80 .50 3.10 Distribution of Value-Added of Social Sector Enterprises in the Productive Sector .52 3.11 Indicators of Social Sector Enterprise Saving Behavior ...... ......................... 53 Chapter IV 4.1 Price Trends in Yugoslav Industry, 1970-79 ...... 56 4.2 Indicators of Relative Market Profitability Across Sectors, 1976-80 .57 4.3 A Comparison of Market and Economic Profitability Rates Across Sectors in 1980 .... .............. 60 4.4 Imports by Import Regime, 1971-80 .... ........... 69 4.5 Ratio of Imports to Supply Available for Domestic Use, 1972-79 ..... ..................... 70 4.6 Indicators of Import Elasticity, 1971-1980 ...... 71 4.7 Average Quantity Rationing and Foreign Exchange Premium Rates, 1976-80 .74 4.8 Rental Income From Foreign Exchange Rationing as a Percentage of Sectoral Value Added, 1976-80 76 4.9 Estimated Average Export Subsidy Rate, 1976-80 79 4.10 Estimated Sectoral Domestic Resource Costs, 1980 .81 4.11 Exchange Rates and Indices of External Competitiveness .86 4.12 Actual and Market Clearing Exchange Rates, 1976-80 .89 4.13 Alternative Estimates of Market Clearing Exchange Rates, 1980 .91  x List of Text Tables (Continued) Table No. Page No. Chapter V 5.1 Major Targets of the 1981-85 Federal Plan .106 5.2 Projected Growth of Macroeconomic Aggregates, 1981-85 .109 5.3 Foreign Exchange Rationing Under Alternative Scenarios .110 5.4 Historical and Projected Sources of Changes in Demand for Manufacturing Output, Selected Periods .112 5.5 Sources of Change in Demand for Manufactured Output, Selected Countries and Periods .114 5.6 Projected Growth Rates of Output in the Manufacturing Sector, 1981-85 ..... ............ 115 5.7 Capital Account Projections, 1981-85 .... ........ 116 Chapter VI 6.1 Structure and Growth of Industrial Production 121 6.2 Industrial Sector--Growth and Structure Southern European Selected Countries ......... 121 6.3 Industrial Sector Performance, 1976-1980 ....... 122 6.4 Structure and Growth of Industrial Investment in Fixed Assets ....... ....................... 123 6.5 Development of Basic Raw Materials .... ......... 124 6.6 Industrial Employment ...... .................... 125 6.7 Structure and Growth of Industrial Imports, 1975-80 .126 6.8 Structure and Growth of Industrial Exports, 1975-80 ............ .......................... 127 6.9 Plan Targets in Industry ..... .................. 129 6.10 Plan Output Targets in the Industrial Sector ... 129 6.11 Planned Investments in Priority Sectors ........ 131 6.12 Plan Projections of External Trade .... ......... 133 6.13 Supply and Demand Projections for Finished Steel Products .135 6.14 Nonferrous Metals: Existing and Planned Capacities ........ ........................... 138 6.15 Plan Targets in the Chemicals Sector .... ....... 140 6.16 Plan Projections for Main Chemical Product Groups .......... ............................. 141 6.17 Plan Targets for Metalworking Industries ....... 143  - xi - List of Text Tables (Continued) Table No. Page No. Chapter VII 7.1 Percentage Share of Agriculture and Industry in Social Product .161 7.2 Agricultural Performance, 1971-1980 .162 7.3 Fertilizer Consumption - Active Substance, 1976-1980 ......... ............................ 165 7.4 Livestock Investment Efficiency .... ............ 166 7.5 Planned and Actual Investment in Agriculture and Agroindustries 1976-1980 .166 7.6 Growth Rates for Major Agricultural Products, 1981-85 .171 7.7 British Standard Labor Requirements for Yugoslav Private Agriculture, 1980 ..... ................ 175 7.8 Trade Targets of 1981-85 Plan ..... ............. 175 Chapter VIII 8.1 Employment and Labor Force, 1970-75 .... ........ 182 8.2 Social Sector Employment 1971-75, and Plan Targets 1976-80 ............................... 185 8.3 Growth of Social Sector Output and Employment by Sector 1971-75, 1976-80 .188 8.4 Rates of Growth of Employment, Captial Stock and Capital Intensity of Production, 1971-79 190 8.5 Growth of Labor Productivity and Real Personal Incomes Per Worker 1971-80 .192 8.6 Employment Trends in Private Sector Agriculture 1971-80 .197 8.7 Distribution of Households by Economic Activity and Income Per Active Family Member 1973 and 1978 ............ .............................. 202 8.8 Some Indicators of Unemployment 1975-80 ........ 204 8.9 Structure of Registered Job Seekers 1970-80 .... 206 8.10 Employment and Labor Force, 1975-80 .... ........ 209 8.11 Labor Force Flows 1970-80 ..... ................. 211 8.12 Share of Social Sector Employment in Total Labor Force by Region 1975 and 1980 .213 8.13 Selected Regional Employment Indicators, 1975 and 1980 ......... ............................. 214 8.14 Regional Demographic Trends, 1961-81 .... ....... 216 8.15 Absorption of the Natural Increase in the Labor Force, 1976-80 .217  - xli - List of Text Tables (Continued) Table No. Page No. 8.16 External Migrants by Region of Origin, 1971 and 1981 .219 8.17 Incomes of Social Sector Employees by Region, Selected Years, 1965-79 .223 8.18 Anticipated Changes in the Structure of the Labor Force, 1981-85 .225 8.19 Plan Targets for Social Sector Output, Employment, Labor Productivity and Personal Incomes, 1981-85 ..... ................ 238 8.20 Regional Employment Growth Targets 1981-85 ..... 230 Chapter IX 9.1 Regional Trends in Output, Population and Per Capita Output 1952-65, 1965-68 .235 9.2 Regional Disparities in Income Per Capita, 1954-80 .237 9.3 Household Income Per Capita Differentials, 1978 238 9.4 Demographic Indicators, 1950-78 .240 9.5 Scale of Interregional Transfers, 1980 .243 9.6 Contribution of Federal Fund to Investment in Less Developed Regions, 1976-80 .245 9.7 Some Basic Indicators of Regional Social Sector Productivity in 1978 .247 9.8 Sources of Social Sector Growth for Major Sectors, by Less Developed Region, 1965-78 251 9.9 Percentage Distribution of Social Sector Value- Added According to Relative Levels of Technical Efficiency by Region (1965-1978) .254 9.10 Financial Results of LDR Social Sector Enterprises, 1980 ....... ....................... 264 9.11 Regional Variations in Tax Policy, 1979 .... ..... 269 9.12 Regional Labor Costs in the Social Sector, 1980 277 List of Charts 1 Bosnia-Herzegovina Potential and Actual Social Sector Social Product (Value-Added), 1965-68 257 2 Kosovo Potential and Actual Social Sector Social Product (Value-Added), 1965-78 .258 3 Macedonia Potential and Actual Social Sector Social Product (Value-Added), 1965-68 .259 4 Montenegro Potential and Actual Social Sector Social Product (Value-Added), 1965-68 .260  COUNTRY DATA - YUGOSLAVIA AREA POPULATION DENSITY 255,804 sq. km. 22.3 million (mid-1980) 86 persons per sq. km. Rate of Growth: 0.9% (from 1970 to 1980) 154 persons per sq. km. of agricultural land POPULATION CHARACTERISTICS (1980) HEALTH (1979) Crude Birth Rate (per 1,000) 16.9 Population per physician 1,795 Crude Death Rate (per 1,000) 8.8 Population per hospital bed 167 infant Mortality (per 1,000 live births) 32.6 INCOME DISTRIBUTION (1978) DISTRIBUTION OF LAND OWNERSHIP (1971) Z share of household income, lowest quintile 6.6 % owned by top 10% of owners highest quintile 38.7 (social sector Kombinats) 15.1 % owned by smallest 10% of owners (private smallholders) 84.9 ACCESS TO PIPED WATER (1978) ACCESS TO ELECTRICITY Dweilings with piped water (Z) 40.5 % of all dwellings (1978) 89.0 rural (1971) 80.0 NUTRITION (1977) EDUCATION Per capita Calorie Supply 3,445 Adult Literacy rate (Z) 85 (1975) (136% of requirement) Primary school enrollment (%) 100 (1977) Per capita protein supply (grams/day) 101 Secondary school enrollment (%) 79 (1977) GNP PER CAPITA IN 1981 1/: US02790 GROSS DOMESTIC PRODUCT IN 1981 AVERAGE ANNUAL RATES OF GROWTH (Z, constant prices) US Mln. % 1970-75 1975-80 1981 GDP at Market Prices 69,617 100.0 6.5 5.8 2.2 Total Consumption 45,651 65.6 6.9 5.4 -1.0 Gross Domestic Investment 25,427 36.5 5.5 5.4 1.3 Gross National Savings 24,677 35.4 6.2 5.0 -12.2 Exports of Goods anid Nonfactor 6.7 5.3 10.9 Services 16,354 23.5 6.7 3.2 -3.0 Imports of Goods and Nonfactor Services 17,816 25.6 OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 1980 GDP at Current Factor Cost (1980) Labor Force 4/ Value Added Per Active Resident Worker US$ Mln. % Mln. Z US$ (1980) Z Agriculture 2/ 8,516 13.7 2.50 30.6 3,261 43.2 Industry 3/ 28,801 46.2 2.80 34.3 10,593 140.4 Other 24,993 40.1 2.87 35.1 8,309 110.1 Total 62,310 100.0 8.17 100.0 7,547 100.0 GOVERNMENT FINANCE, consolidated, 1980 US$ Mln. Consolidated Public Sector Receipts 23,588 Expenditures 24,018 Surplus -430 Ratio of Current Receipts to GDP at Market Prices (%) 34.1 MONEY, CREDIT AND PRICES (in billions of dinars) 1976 1977 1978 1979 1980 1981 Money Supply 5/ (end-year position) 206.4 251.1 315.3 375.2 461.6 584.3 Money Supply as Z of GDP at market prices 30.4 30.1 30.9 29.2 26.7 24.7 Bank Credit Total 6/ 569.1 699.3 959.2 1,217.7 1,568.3 1,927.8 Enterprises 440.4 535.8 728.7 943.0 1,225.1 - Government and other Social Sector 78.2 98.4 140.2 157.6 186.5 Households 50.5 65.1 90.3 117.1 156.7 - Price Indices (Annual Percentage Change) Industrial Producer Prices 6 10 9 14 27 45 Agricultural Producer Prices 14 11 13 25 36 54 Retail Prices 10 13 14 22 30 47 1/ The per capita GNP estimate is at market prices, calculated by the same conversion technique as the World Bank Atlas. All other conversions to dollars in these tables are at the prevailing period average exchange rate. 2/ Includes irrigation and forestry. 31 Manufacturing, mining, construction, electricity, gas and water. 4/ Total active resident labor force, excluding unemployed. 5/ Currency in circulation, demand deposits and float. b/ Short- and long-term credits.  BALANCE OF PAYMENTS, MERCHANDISE TRADE AND DEBT Annual Data at Current Prices 1/ (Us5 Millions) 1976 1977 1978 1979 1980 1981 SUMMARY OF BALANCE OF PAYMENTS EXTERNAL DEBT, December 31, 1980 Exports (f.o.b.) 4,878 5,254 5,671 6,794 8,978 10,929 US$ Millions Imports (c.i.f.) -7 367 -9,634 -9,988 -14j019 -15_064 -15 757 Trade Balance -2,489 -4,380 -4,317 -7,225 -6,086 -4,828 Debt Outstanding and Disbused 15,435 Official (4,541) Nonfactor Service Receipts 2,051 2,216 2,380 3,771 4,547 5,425 Private (10,894) Nonfactor Service Payments -888 -888 -1,051 -1,624 -1,565 -2,059 Nonfactor Services Net Balance 1,163 1,328 1,329 2,147 2,982 3,366 Debt Service Ratio 3/ (2) 19.0 Factor Services 6 Transfers Receipts 1,974 2,640 3,120 3,581 4,247 5,927 Fastor Services & Transfers Pa.yests -838 -1_135 -1,775 -2 -3,792 -5,215 Factor Services & Transfers Net Balance 1,136 1,505 1,345 1,077 455 712 Currest Account Balance 165 -1,582 -1,256 -3,661 -2.291 -750 Medium & Long-Term Loans IBRD LENDING, (as of September 30, 1981) (Million US$) Disbursements 2,320 2,665 3,150 3,200 3,802 2,790 Amortization -930 -992 -1,326 -1,704 -1,699 1,807 Outstanding & Disbursed 2,154.7 Net Disbursements 1,390 1,673 1,824 1,496 2,103 983 Undisbursed 894.5 3,049.2 Export Credits Extended (let) -100 -213 -105 -150 -215 -234 Capital Transactions n.e.i. 2/ -277 172 -204 1,173 553 238 Use of Reserves -1,178 -50 -259 1,142 -150 -237 NERCHANDISE TRADE Imports Capital Goods 1,759 2,436 2,559 3,572 2,939 2,877 Intermediate Goods 4,697 5,989 6,325 8,935 10,630 11,987 Consumer Goods 911 1,208 1,099 1,512 1,496 893 Total Merchandise Imports (c.i.f.) 7,367 9,633 9,983 14,019 15,065 15,757 Exports Capital Goods 826 1,080 1,129 1,156 1,362 1,736 Intermediate Goode 2,589 2,667 2,809 3,627 4,581 5,361 Consumer Goods 1,463 1,509 1,730 2,011 3,035 3,832 Total Merchandise Exports lf.o.b. 4,878 5,256 5,668 6,794 8,978 10,929 MERCHANDISE TRADE INDICES 1976=100 lodex of Expurt Dollar Unit Values 100 112 123 141 168 181 Index of Import Dollar Unit Values 100 114 120 143 171 188 Terms of Trade Index 100 98 103 99 98 97 HATE OF EXCHANGE Asnoal Averages US51.00 = Dinar 18.19 18.30 18.64 19.0 24.91 35.51 Dinar = US50.055 0.055 0.054 0.053 0.040 0.028 1/ Valued at statistical exchange catos. 2/ Includes errors and omissions, short-ters lans IMF account, and bilateral balances. 3/ Medium- and long-term debt service as a percentage of gross current account receipts.  YUGOSLAVIA: ADJUSTMENT POLICIES AND DEVELOPMENT PERSPECTIVES THE SUMMARY REPORT INTRODUCTION 0.01 By any standards Yugoslavia's performance since World War II has been extremely impressive. In this period a largely rural, peasant economy, shattered by war, has been transformed into a modern urban industrial society with the abolition of absolute poverty and of hunger. This has been achieved despite the difficulties of nation-building in a multinational state with wide inherited regional disparities, while evolving a system of economic management unique to the country. Past World Bank reports have provided an extensive review of Yugoslavia's development achievements and of the economic institutions fashioned by it over this period; for this reason, this account is not repeated here. 1/ Notwithstanding this highly successful performance turbulence in the international economy in the 1970s confronted the Yugoslav economy with a new set of challenges, as the economy was obliged to adjust to such developments as worsened terms of trade, higher energy prices, recession in the industrial countries, shifts in international sources of capital and diminished prospects for employment of Yugoslavs abroad. This report uses the occasion of the start of the 1981-85 Yugoslav plan to review the performance of Yugoslavia in responding to these challenges, while maintaining the pace of structural change. The report is written at a time of unusual strain for the Yugoslav economy, when many of the institutions and instruments of economic management are being critically reviewed within Yugoslavia. The report attempts to make a contribution to this debate. At the same time it should be recognized that policies, targets and institutions are currently in considerable flux, so that elements of this report could be soon overtaken by events. 0.02 This summary report, as well as the full report from which it is taken, is in two parts. The first part deals with issues of adjustment strategy and policy at the economywide level, concentrating especially on the period of the 1976-80 medium-term plan. The second part deals with issues in the major sectors of agriculture and industry, and with issues of employment and regional policy. While the energy sector has been of central importance to Yugoslavia's adjustment efforts, it is discussed only in passing in this report as it is being concurrently studied in an energy sector survey being undertaken by the World Bank in cooperation with the Yugoslav authorities. Major policy suggestions are summarized in Chapter X. 1/ See Yugoslavia: Development with Decentralization (Baltimore: Johns Hopkins University Press, 1975) based upon the findings of a World Bank economic mission which visited Yugoslavia in 1972, and Martin Schrenk, Cyrus Ardalan and Nawal A. El-Tatawy, Yugoslavia: Self-Management Socialism - Challenges of Development (Baltimore: Johns Hopkins Press, 1979) based upon a World Bank mission which visited Yugoslavia in November 1976.  - 2 - PART I: ADJUSTMENT PERFORMANCE AND POLICIES I. THE ADJUSTMENT STRATEGY OF THE 1976-80 PLAN Background to the Plan 1.01 Yugoslavia entered the 1976-80 plan period in difficult economic circumstances. These were partly caused by a series of adverse external shocks over the 1974-76 period, and in part reflected longer-term structural tendencies which had been in evidence at least since the economic reforms of the 1965-67 period. In addition, the 1976-80 plan was ushered in at a time of substantial change in Yugoslav economic and political institutions. 1.02 In the period following the economic reforms of the mid-sixties, there was a substantial shift in the structure of Yugoslavia's balance of payments. Between 1965 and 1971 there was a substantial increase in the deficit on merchandise trade, from about 3% of GDP to almost 10% of GDP. This trade deficit was offset to some degree by a rising surplus on both nonfactor services and on factor services and transfers, the latter reflecting the growth of workers' remittances, which became an important element in the balance of payments after 1965. Despite this offset to the trade deficit, however, open current account deficits began to emerge and contractionary macroeconomic policies were required to deal with them. 1.03 By the beginning of the 1976-80 plan a stop-go pattern of growth had become an established feature of Yugoslav economic performance. Underpinning this cyclical pattern was the shift in the structure of the balance of payments that had occurred: a large deficit in merchandise trade covered by a relatively predictable surplus on nonfactor services and a substantial but uncertain surplus on factor services and transfers. This was rightly regarded by the Yugoslav authorities as a weak structure and one likely to constrain growth in the future. Accordingly, improvement in the external sector was highlighted as a major structural objective of the 1976-80 medium-term plan. The Adjustment Strategy 1.04 The 1976-80 plan envisaged external adjustment occurring through a combination of export promotion and import substitution, while maintaining high growth of output, investment and employment. Although relatively high growth rates of exports were envisaged, the dominant orientation of the strategy was toward import substitution. This orientation reflected several perceptions. There was, firstly, concern at the rapid increase in the economy's import dependence following the post-1965 liberalization. While a rise in import dependence was consistent with the general aims of the 1965 reforms, which had aimed to open the Yugoslav economy to external trade, Yugoslav policymakers were also influenced by a long-standing belief, that internal price controls and the structure of protection had resulted in a distorted structure of domestic relative prices. As a result of these purported distortions, production in many raw material and basic industries was thought to have lagged behind levels that were economically rational.  - 3 - Concern over increased dependence on intermediate imports was aggravated by world trends in energy and commodity prices which were thought to warrant a substantial effort to develop domestic energy resources, and to restructure domestic plant and equipment in order to reduce dependence on foreign oil. 1.05 These arguments in favor of efficient import substitution were coupled with some pessimism on the prospects for growth in exports much above the historical trend rate. Equally, the oscillations in prices and output in the international economy of the early seventies which had buffeted Yugoslavia (along with other developing countries) made an import substituting strategy appear a more certain route to external balance, one that made the economy less vulnerable to external shocks. Lending support to this export pessimism were developments at the time of preparation of the plan, including the growth of barriers against Yugoslav agricultural exports to the EEC in 1974, and the recession in the developed market economies at that time. 1.06 In general support of these import substitution goals but more specifically to address the structural imbalances in the domestic productive structure, the 1976-80 plan called for an ambitious restructuring of the economy. This was to be achieved through a substantial investment effort, consciously directed at designated priority sectors. These priority sectors were to receive preferential access to investment funds, in order to permit them to grow more rapidly than the rest of the economy. The aim was to increase the share of the priority sectors in total economic investment from approximately 53% in the 1971-75 period, to 65% in the 1976-80 period. 1/ The priority sectors chosen were designed to strengthen the raw material and infrastructure base of the economy. 2/ By contrast, relatively little attention was paid to the creation of capacities explicitly for export. The desired acceleration in fixed investment translated itself into a faster growth in aggregate investment over the period, from 5.3% in the 1971-75 plan to 7.2% in the 1976-80 plan. However, given the faster growth projected in aggregate output this involved a virtually unaltered share of investment in GDP, and assumed national savings rates in line with past experience. 1.07 Taken overall and given the circumstances of the time, the 1976-80 plan represented a credible and consistent scenario for the adjustment needs 1/ Yugoslav conventions divide economic activity into economic and noneconomic branches. The principal noneconomic branches are health, education, administration, defense, banking and housing. Investment in these branches is regarded as noneconomic investment. Equally, output from these services is not included in the Yugoslav measure of national output, GMP (gross material product). 2/ The priority sectors chosen were: electrical energy, coal extraction, oil and gas extraction and refining, ferrous metals, nonferrous metals, manufacture of basic chemicals, extraction of nonmetallic minerals, machinery and shipbuilding, agroindustry, highway transportation and foreign tourism.  which the country faced at the end of 1975. Despite the plan's explicit orientation to external adjustment, and despite a conscientious effort to translate its strategy into practice, by the end of the plan Yugoslav was suffering its most intense foreign exchange crisis in two decades, accompanied by unprecedented inflation, and the prospect of sustained low growth rates for five years in a row. The deterioration in the Yugoslav economy that became evident in the post-1979 period raises questions about the factors contributing to the crisis which are of importance not just in themselves, but also in assessing the strategy of the 1981-85 plan and in deriving lessons for policy reform. In both the historical and the forward-looking discussions the analysis makes use of simulations of a computable general equilibrium (CGE) model of Yugoslavia constructed for this report. II. PLAN PERFORMANCE Overview 2.01 The cyclical relationships between imports, exports and domestic growth characteristic of Yugoslavia in the late sixties and early seventies persisted in the 1976-80 period. The economy began the period in a trough caused by policy measures designed to ease the foreign exchange crisis of 1974-75. Depressed domestic conditions, combined with severe restrictions on imports, allowed for a small current account surplus and a build-up in reserves. This gave the authorities confidence to proceed with the more expansive strategy of the five-year plan. Powered by a more liberal monetary and import policy, growth proceeded rapidly after 1977 and the boom in the domestic economy survived into 1979. However, the combination of rising domestic inflation, deteriorating balance of payments trends and the continuing sluggishness of growth in the OECD area made it increasingly clear that the expansion could not be sustained. Three additional shocks aggravated the situation. These were a poor harvest in 1978 (which created a need for substantial agricultural imports in 1979), an earthquake in Montenegro which adversely affected tourism receipts, and the increases in the price of oil imports which raised Yugoslavia's expenditure on such imports by $500 million between 1978 and 1979. 2.02 The combination of these events led to a current account deficit of $3.7 billion in 1979, 5.4% of GDP, the largest deficit in both absolute and relative terms sustained by Yugoslavia since the mid-sixties. A stabilization program was instituted toward the end of 1979 and has been supported by standby arrangements with the IMF since May 1980. This has consisted of tight monetary policy and direct controls on investment expenditures, particularly in the noneconomic sector. In addition in June 1980 the dinar was devalued against the dollar by approximately 30% in gross terms, 1/ the beginning of a policy of more active exchange rate changes which has since continued. These measures had a substantial effect on both growth and the 1/ The devaluation coincided with the abolition of a 10% import surcharge, coupled with some reduction of export rebates. As a result the net devaluation was somewhat less than this.  balance of payments. The growth rate in 1980 was 2.2%, amongst the lowest rates experienced in the postwar period. Imports were cut sharply, while exports grew substantially. The current account deficit was reduced to $2.3 billion or 3.3% of GDP. Despite this drastic slowdown inflation accelerated, reflecting both influences from the external sector and the attempt by enterprises to rebuild liquidity in the face of restricted credit availability. External Sector Trends 2.03 Taking the 1976-80 plan as a whole, Yugoslavia was largely successful in meeting its aggregate growth and investment targets, although as discussed later, in neither case was the sectoral composition according to plan. However, despite the plan's explicit orientation toward external adjustment, Yugoslavia's external position at the end of the plan was even less satisfactory than had been the case at the beginning. It is important to understand why this occurred and to disentangle the relative significance of external shocks and domestic policies in the outcome. One way to do this is to decompose sources of change in the current account deficit in this period. The current account deficit increased by $2.7 billion between 1975 and 1979, from $1 billion in 1975 to $3.7 billion in 1979. This increase can be partitioned into three sets of factors: "real" factors (such as movements in the trade deficit, the nonfactor service deficit and net workers' remittances, valued at 1975 prices), price effects (including both the overall increase in traded goods prices and terms of trade changes), and the effects of increased net interest payments. This decomposition indicates that roughly two-thirds of the increased deficit between 1975 and 1979 was due to the "real" factors defined above, with price effects accounting for a further quarter of the deterioration, and increased interest payments for the remaining one-sixth. 2.04 The growth in the "real" deficit between 1975 and 1979 in turn reflected several developments. After a strong spurt in 1976 (a year of domestic recession), export growth slowed across the board in 1977 and 1978, although there were additional secular influences, such as a sharp decline in the exports of the shipbuilding sector, one of the major exporting sectors at the beginning of the plan. The "real" surplus on nonfactor services stagnated, reflecting both weak demand for tourism and transport services in the early years of the plan, and strong growth in Yugoslav expenditures on transportation services as Yugoslav trade was increasingly carried on ships of foreign registry. Finally, as had been expected, net remittances declined in real terms with the reduction in the overseas work force. 2.05 The syndrome that had characterized the Yugoslav balance of payments in the first half of the 1970s thus persisted into the second half as well. Against the background of sluggish growth in exports, a declining "real" surplus on workers' remittances, and a stagnating "real" surplus on nonfactor services, "real" import growth had to be held in check throughout the period: between 1975 and 1979 merchandise imports grew at 5.7% per year, and declined from 25% to 21% of GDP. The balance of payments was thus at best in a somewhat uneasy balance at the beginning of 1979. The various shocks of 1979 destroyed this balance by simultaneously imposing price shocks, interest rate shocks and an additional need for imports on the  -6- economy. The pattern of response, rather as in 1976, was again a reduction in domestic growth and imports and a renewed spurt in exports. This had the effect of eliminating the "real" deficit that had emerged between 1975 and 1979; the difference between the current account deficit of $2.3 billion in 1980 and $1.0 billion in 1975 thus entirely reflected the effects of inflation in the prices of traded goods, terms of trade changes and increased interest payments. 2.06 From the above analysis it is clear that Yugoslavia had not been able to reorient its balance of payments by the time that the shocks of 1979 occurred, and that the bulk of the difficulty continued to arise from exports, particularly merchandise exports. In order to understand better the factors which determined Yugoslavia's export performance in this period, a more detailed look is now taken at Yugoslavia's export performance over the longer term. Export Performance 2.07 A recent study undertaken by the World Bank l/ has documented the tact that Yugoslavia was a strong exporter in the early sixties. After 1966 Yugoslavia's export effort entered a period of slower growth, and Yugoslavia lost its share of world exports. Concurrent with this slowdown were significant changes in the commodity and market structure of exports. Over the decade of the seventies exports to the industrial market economies of the OECD area (DCs) grew more slowly than those to either the developing countries (LDCs) or the centrally planned economies (CPEs). 2/ In the same period there was also a pronounced shift away from exports of primary goods toward exports of manufactures, which accounted for approximately 68Z of total merchandise exports in 1979. 2.08 The commodity composition of exports has continued to differ significantly by market area: primary product exports have featured more prominently in exports to the developed countries, while trade in manufactures dominates in exports to the CPEs and the LDCs. Since about 1975 the CPEs have been the most important market for Yugoslav exports of manufactures. Yugoslavia is a relatively strong exporter of various categories of machinery and transport equipment and even by developed country standards it is relatively specialized as an exporter of heavy electrical equipment, ships and boats and metal products. In the lighter manufactures Yugoslavia has been successful in exports of furniture and wood products, certain categories of garments and footwear. By international standards exports are extremely diversified; in general manufactured exports have represented a spillover from production for the domestic market, rather than representing the outcome of a sustained attempt at export specialization. However in certain sectors, notably shipbuilding, wood products, and footwear, exports constitute an important part of total production. 1/ Report No. 2972-YU, Yugoslavia: Export Performance and Policies, October 16, 1980. 2/ These market categories in general conform to definitions used in the World Bank's World Development Report. For details please see the discussion in the Main Report, Chapter II.  2.09 As noted above, growth in exports to the developed countries (DCs) has been much slower than that to the other market areas through the 1970s. This trend has been a source of concern to Yugoslav policymakers for several reasons. First the economies of the DCs offer the largest markets and are responsible for the bulk of growth in world trade. Second, trade with the CPE market area tends to be governed by bilateral agreements which cause it to be approximately balanced, while Yugoslavia has a need for uncommitted convertible currency resources to meet its debt service obligations which are largely in convertible currencies. Finally, successful performance in industrial markets is seen as a barometer of the general competitiveness and dynamism of Yugoslav industry. 2.10 In order to develop a better understanding of the factors responsible for this slow growth, the earlier report had undertaken an analysis of Yugoslavia's performance on developed country markets for various commodity groups, both as compared to the growth of the market, and as compared to the performance of a reference group of newly industrialized developing countries (NICs), 1/ for the period between 1970 and 1977. The analysis confirmed that Yugoslav exports had systematically lost market share in the markets of the developed countries. This was partly due to an unfavorable commodity composition of exports but also reflected an adverse "sompetitive" or residual effect. The size of the shortfall was substantial: if Yugoslavia had retained its aggregate share in these markets, the growth in exports to them would have been 36% higher than the growth that in fact occurred. An examination of performance in particular commodity groups indicates that the main losses in market share arose in exports of primary products, both agricultural products and metals and minerals. This reflects several factors at work: poor output performance in several of the sectors concerned, a policy decision by the Yugoslavs to stress exports with higher domestic value added, diversion of output to the home market in response to more favorable prices and buoyant demand, and a diversion of exported output to more lucrative market areas, the oil exporting developing countries in the case of agricultural products, and the CPEs in the case of metals and minerals. In addition it is possible that Yugoslavia was hurt by market integration movements in Western Europe in the 1970s, including the expansion of the EEC in 1973, the reduction in tariffs between the EEC and the EFTA and the growth of preferential trading arrangements between the EEC and certain developing countries. 2.11 Performance in manufactured exports to developed countries was more satisfactory, in that growth of Yugoslav exports more than kept pace with the growth of the market. However, Yugoslavia's performance was considerably weaker than that of the reference group of NICs in the same period and this is uniformly true of all markets examined and for virtually the entire range of manufactures. While Yugoslavia may have been hurt by market access limitations in specific products and specific markets, the uniformly better performance of the NICs suggests that factors affecting the supply of exports from Yugoslavia account for much of the difference. Put somewhat differently, it was a legitimate objective of Yugoslav trade policy 1/ Brazil, Greece, Hong Kong, Israel, Republic of Korea, Mexico, Portugal, Singapore, Spain and Turkey.  - 8 - to aim to move to exports with a higher degree of value added; such a strategy would have implied a voluntary "loss" in market share in primary products which by itself would have constituted little ground for concern. The concomitant of such a strategy however would have been a gain in market share in manufactures. The collective experience of the other NICs indicates that such a performance was a realistic possibility. A stronger performance in manufactures was also a necessity, given the balance of payments situation; however, as argued below, for reasons connected with the pattern of incentives in the economy, such a response was not forthcoming. 2.12 The general picture that emerges is one of a relatively unspecialized structure of exports representing the surplus capacity of enterprises whose primary orientation was to the domestic economy, capable of short bursts of rapid export growth in response to foreign exchange shortages or unusually depressed domestic demand but sluggish over the long haul, and of an economy whose growth potential was increasingly constricted by the shortage of foreign exchange generated by this export performance. These are well-known characteristics of the export performance of an economy whose structure of incentives has been oriented toward import substitution: as has been noted, one of the self-reinforcing phenomena in such an economic regime is that the implicit discouragement of export growth tends to increase the apparent "shortage" of foreign exchange, while the evolution of import substitution means that the economy's vulnerability to shortages of imports (or foreign exchange) become progressively greater. 1/ A detailed analysis of the nature and scale of the bias against exports is presented later in this report; the existence of such biases, and their consequences for the pattern of resource allocation were important underlying factors in the crisis of 1979 and go a long way toward explaining the severity of its consequences for the economy. External Debt 2.13 Total medium- and long-term debt grew at approximately 22% per year in nominal terms in the plan period, about the same rate as in the 1971-75 period, but about 60% higher in nominal terms than the amounts envisaged in the 1976-80 plan. Medium- and long-term debt outstanding and disbursed rose from about 19% to about 23% of GNP over the period. While the aggregate debt service ratio (the ratio of aggregate debt service payments to gross receipts from exports of goods and services) actually fell over the plan, the shift in exports toward the clearing area over the period meant that the debt service ratio in convertible currency rose substantially, from about 18% in 1976 to 23% in 1980. The overall medium- and long-term debt service ratio rose from about 15.5% at the beginning of the plan to about 19% at the end, while the convertible currency ratio rose from an estimated 17% to an estimated 20% over the same period. Both ratios take into account gross receipts from workers' remittances. 1/ See Anne 0. Krueger, "Interactions Between Inflation and Trade Regime Objectives in Stabilization Programs" in William R. Cline and Sidney Weintraub (eds.) Economic Stabilization in Developing Countries, Brookings Institution, Washington, D.C., 1981.  - 9 - 2.14 There was a steady shift away from official sources of finance to commercial sources over the period. Around 63% of gross medium- and long-term capital was provided by trade and equipment credits of various kinds, including guaranteed export credits, commodity credits and World Bank loans, with the remaining 37% being raised through financial credits from commercial banks. While relatively slight use was made of short-term commercial bank credit in the earlier years of the plan, increased reliance was placed upon this source of finance in 1978, 1979 and 1980, although the aggregate amounts remained at acceptable levels. 2.15 There were considerable shifts in the mechanisms for regulating foreign borrowing over the period, in an effort to reconcile the aims of decentralization of responsibility with the need for overall control. After 1965 enterprises were authorized to borrow abroad under the guarantee of their own business banks, without requiring the guarantee of any federal level authorities. Enterprises were, however, required to register their loans with the National Bank of Yugoslavia (NBY), to facilitate monitoring and record-keeping. Control of aggregate borrowing was regulated by the NBY by requiring borrowers to place interest-free dinar deposits with it, thereby raising the effective cost of foreign borrowing. Although this mechanism for controlling the overall level of borrowing was effective, the decentralization of borrowing to enterprises and business banks resulted in an uncoordinated approach to international financial markets, particularly in solicitations for financial credits. This lack of coordination raised concern among foreign lenders on the degree of overall supervision that was in fact being provided, and occasionally resulted in Yugoslav borrowers competing against each other. With the creation of communities of interest for foreign economic relations (CIFER) in 1978 (described more fully below), the system of compensating deposits was abolished, and the allocation of borrowing rights was undertaken within the various regional CIFERs, to be consistent with the overall balance of payments position for the region, within the framework of foreign exchange policy for the federation. At the same time measures were taken to improve the coordination of Yugoslav enterprises in approaching the international capital markets. These included the preregistration of all intended borrowing with the NBY (following approval by the relevant CIFER), and the joint determination by all Yugoslav banks of guidelines for minimum acceptable borrowing terms. In addition, Yugoslav banks were encouraged to approach the international markets as a consortium when soliciting financial credits on behalf of their clients, in order to improve their negotiating position. 2.16 While this has remained the formal mechanism in place at present, its actual workings have been shaped by the turbulent environment that has existed since its inception. The unanticipated shocks to the balance of payments in 1979 made it difficult to adhere to the agreed framework for the year, and therefore to monitor performance by the republics and provinces. The determination to reduce the current account deficit very sharply in the years thereafter has made interrepublican negotiation of the distribution of borrowing rights an extremely contentious affair, leading in 1980 (and again in 1982) to a deadlock which had to be resolved in 1980 by an exceptional  - 10 - decision of the Federal Executive Council. It has also proved very difficult to reach a medium-term agreement to govern regional borrowing rights in the 1981-85 plan. Disciplined control has been maintained over foreign borrowing even in the face of such interregional disagreements, but this has required exceptional measures rather than representing the operation of the system as intended. A further departure from the system of borrowing as envisaged has been the need for the NBY to reenter the markets as a major borrower in its own right, a development made necessary by shifts in market sentiment against lending to Yugoslavia, discussed below. This move violated a basic tenet of the new system of foreign borrowing, which was that enterprises directly, rather than state bodies, should be responsible for foreign borrowing, in full recognition of the obligation this imposes on them to service the debt from their own resources. 2.17 As suggested above, the attitude of foreign commercial banks toward Yugoslavia has remained somewhat tentative even though Yugoslavia's borrowings from them have been in aggregate quite sizable. The evidence suggests that within the syndicated loan market Yugoslavia has throughout been a marginal borrower, liable to be rationed out in periods of market illiquidity, or when market sentiment turns against it. Reasons for this status include the complexity and unfamiliarity of the Yugoslav economic system, and the perceptions of lack of coordination and control cited above. These misgivings were further buttressed by the sharp increase in the current account deficit in 1979, inability of the republics and provinces to reach agreement on the framework for policy in 1980, and the sharp increase in inflation in that year. They were also given added force by events unfolding in Poland over the course of 1980 (and 1981) and a general reassessment of the exposure of commercial banks in Eastern Europe. As a result of these developments Yugoslavia found itself unable to borrow medium- and long-term financial credits from commercial sources in 1980 on the scale that had been planned. This experience both led to the reemergence of the NBY as a borrower, and an increased reliance on lines of credit arranged through the good offices of governments sympathetic to Yugoslavia, rather than strictly on a commercial basis. The reliance on such bilaterally negotiated financial credits has continued into 1981 and 1982. 2.18 For several reasons therefore Yugoslavia's external debt position at the end of the plan was less comfortable than it had been at the beginning. While the growth in medium- and long-term debt outstanding and disbursed was no faster than in the previous plan, the shortening of maturities, the rise in international interest rates, the increasing use of floating rates, the slowdown in export growth and its increased orientation to the bilateral area all made for less room for maneuver, although the situation remained manageable. These developments were, however, compounded by shifts in market sentiment against Yugoslavia, and the combination of these objective and subjective constraints on the capital account have been a powerful determinant of the strategy of the 1981-85 plan.  Output Growth 2.19 Evidence from the 1976-80 plan period reveals that the reorientation of output to the priority sectors did not occur. The data further indicate that, within industry, the largest shortfalls between target and actual growth rates of output occurred in the priority sectors, particularly in ferrous and nonferrous metallurgy, and in shipbuilding. Only in two of the priority industrial sectors, oil and food processing, was output growth close to target, and with the exception of these two sectors and the chemical sector, growth in all other priority industrial sectors was below, not above, the average growth rate realized in industry. By contrast output growth in many of the nonpriority industrial sectors was above plan targets. In addition, in most priority sectors actual growth in the 1976-80 period was significantly below rates achieved in the 1971-78 period. 2.20 The explanations for this outcome are complex and both sectorspecific and general. The designation of a particular sector as a priority sector was in part a reflection of previous difficulties encountered in developing that sector and it is not surprising that these difficulties persisted in the 1976-80 period. In the shipbuilding sector, poor output growth was directly related to the fall-off in external demand for the sector's output. In the ferrous and nonferrous metal subsectors output was capacity constrained, and the failure of output to grow was closely linked with failures in investment implementation, particularly at the primary stage. Thus iron ore production declined over the plan on account of delays in the opening of iron ore mines, and performance in the principle nonferrous ores (copper, aluminium and lead) was also extremely weak. A notable exception to this trend was the performance in coal mining, where investment proceeded on target, and shortfalls in production were due to delays in the completion of associated power plants rather than any weakness in the coal sector itself. Overall it seems fair to say that output difficulties reflected difficulties in investment choice and implementation; the sources of these difficulties are discussed later. The net effect was that the imbalance between growth in raw material producing sectors and that of processed products persisted through the plan. 2.21 Performance in the nonindustrial priority sectors of agriculture, transportation and tourism was also below target; in the case of agriculture growth in the 1976-80 period was significantly below the rate achieved in the 1971-75 period. As discussed in greater detail in Chapter VII below, the major shortfall was in wheat and rye, although growth in livestock production was also lower than in 1971-75. The wheat shortfall was common to both the social and individual sectors, with social sector wheat production declining by about 31% between 1976 and 1979. The poor performance in wheat reflected adverse climatic factors but also a low relative price for wheat which induced a shift in cropping patterns, and low fertilizer usage in the individual sector. Investment 2.22 As mentioned before, the main tool employed by the Yugoslavs for restructuring the economy was the priority allocation of investment  - 12 - resources. The data indicate that the new institutional arrangements succeeded in raising the share of the priority sectors in total fixed investment in the economic sectors by 6.2 percentage points relative to their 1971-75 share. This increase is substantial, and although well short of the planned increase of 11.3 percentage points, supports the conclusion that the new investment allocation mechanism was successful in directing a significantly larger portion of the total investment effort to the priority sectors. 2.23 Behind this success at the aggregate level, however, lie important divergences between planned and actual investment at the sector and branch level. Data are not available for a definitive evaluation, but three tentative conclusions can be drawn: first, over the 1976-80 plan period the target investment share of the basic energy and raw material sectors taken as a group was realized, although there were divergences between actual and target shares for individual sectors; second, the actual investment share for other priority sectors taken as a group fell short of target with the result that the actual investment share for nonpriority sectors, mainly within industry, exceeded target; and third, as a result of the preceding trends the share of basic industries in total industrial investment, although rising as planned, fell short of its target share because of the greater than planned investment in nonpriority industries. 2.24 The structural redirection of the investment effort was achieved within the context of an increase in the overall fixed investment effort to levels even higher than in the 1971-75 period. In terms of the Yugoslav gross material product measure, the share of gross investment in fixed assets rose from about 30% during the 1971-75 period to an estimated 33.7% over the 1976-80 period, nearly 3 percentage points above the 1976-80 plan target of 31%. Nearly 40% of this fixed investment effort was directed into the so-called noneconomic sectors, 1/ of which about 76% went into housing and related public utilities. The continuing large share of noneconomic investment in total fixed investment provides the backdrop against which the priority allocation of investment needs to be understood. Once noneconomic investment is added to the picture, the share of the priority sectors comes to 36% of total fixed investment, and that of the nonpriority sectors comes to only 25% of total fixed investment. Both of these shares are less than the share of noneconomic investment in fixed investment. The scale and behavior of noneconomic investment are thus important components of the investment boom that Yugoslavia experienced during the 1976-80 plan. As discussed below, failure to control the overall investment effort via the capital allocation mechanism had important implications for macroeconomic and balance of payments performance. 2.25 Economywide and sectoral incremental capital-output ratio (ICOR) calculations can be used to examine gross changes in the efficiency of capital use over the 1970s although the limitations of this measure are well known. At the economywide level the numbers indicate a small increase in 1/ Please see footnote one on page 3 for the distinction between economic and noneconomic sectors.  - 13 - the incremental capital-output ratio (ICOR) for economic investment in the 1976-80 period as compared to the 1971-75 period. In contrast the ICORs for total fixed investment (i.e. both economic and noneconomic) indicate a small decline between the two periods. Taken together, the two sets of estimates seem to imply that the efficiency of capital showed some gain in noneconomic uses and some deterioration in economic uses over the time period considered, but differences in the data and in measurement techniques preclude any definite conclusion. At the level of individual sectors, there is a sharp increase in ICORs in virtually all of the priority sectors; the only exceptions are the coal mining and processing and machinery and shipbuilding sectors which accounted for about 10% of total priority investment over the plan. The most striking increase is in the nonferrous metallurgy sector where the ICOR increased sixfold; however the ICOR more than doubled in the oil and gas and nonmetallic mineral sectors as well. Of greater quantitative significance perhaps is the 50% increase in the ICOR of the electrical energy sector, which by itself accounted for 25% of priority investment. 2.26 These results are not unexpected in the light of the poor growth performance of most of the priority sectors and the substantial allocation of investment expenditures to them. Nonetheless the deterioration in the case of most of the priority sectors is quite dramatic, especially given that the overall ICOR for productive investment increased only slightly during the 1976-80 period. The perplexing questions are why the efficiency of capital, as approximated by these ICOR calculations, deteriorated to such an extent in the priority sectors over this period, and why this deterioration was specific to the priority sectors rather than to all productive sector investment. 2.27 A variety of factors suggest themselves. First, as a result of nearly guaranteed access to investment funding, certain priority sector projects appear to have been poorly designed, initiated before supporting technical and market studies were completed, and haphazardly implemented. Second, the sheer scale of the priority projects, which were often the larger projects, made for more complex management requirements and greater risks of slippage. Third, the majority of the ore bodies involved in the priority extractive metal and mineral industries were in the less developed regions with their weaker physical and institutional infrastructure, although the coal mining industry, also predominantly located in the LDR, apparently expanded its facilities without difficulty. Fourth, there appears to have been growing competition for investment goods and finance among investors in both the priority and nonpriority sectors once macroeconomic policy became expansive in 1977 and the investment boom began in earnest. This competition expressed itself in inflation, cost overruns and delay. It seems that the larger, priority sector projects were particularly vulnerable to these cost overruns. In the face of cost overruns, estimated in aggregate at one-third or more of originally programmed dinar costs, the financial allocation mechanisms failed to allocate the amounts needed to permit priority projects to be completed; instead, resources continued to be stretched too thinly among a large number of projects. Thus, while in theory the brunt of adjustment was expected to fall on nonpriority investment projects, the rise in ICORs in all priority sectors as well as the fall-off in priority sector investment in the middle years of the plan suggests that the burden of adjustment fell largely on them.  - 14 - 2.28 It is likely therefore that rising ICORs in the priority sectors, (calculated as these are on the basis of investment expenditure and not installed capacity), primarily reflect increased gestation lags and a large volume of incomplete investment in these sectors at the end of the plan, although, as documented later, there is also evidence of poor project choice in several of the priority sectors. This general finding (which accords with most Yugoslav diagnoses of past plan performance) is substantiated by evidence from particular sectors. For example, in the case of electric power generation only 50% of the hydro capacity which was planned to be commissioned was actually commissioned, and the average delay per plant was of the order of 1.8 years. An analysis of the causes of these delays indicates that the two principal reasons for the slippages in commissioning dates were delays in the delivery of major items of equipment and shortages of finance. In turn, the most frequently quoted reason for the delays in delivering equipment was that domestic suppliers were overburdened by too many orders. On the financial front substantial price increases on both foreign and domestic equipment increased financial requirements, which could not be easily made up from either domestic and foreign sources. The story is similar in the case of thermal plants. Thus, shortages of both domestic and foreign credit delayed commissioning of a 50 MW district heating station in Ljubljana; two lignite-fired plants due to be commissioned in the 1976-80 period in Macedonia had to be slipped into the 1981-85 plan on account of delays in delivery of equipment, and civil works problems (resulting from the large construction program, which caused shortages of essential equipment and manpower and financial difficulties). Though all of the planned foreign credits for the construction of these plants were realized, many of the expected local credits were late, reflecting the general shortage of funds for investment projects. 2.29 Similar examples, of cost overruns both reflecting and leading to implementation delays and cash flow problems, can be found in a variety of sectors, and are well known within Yugoslavia. The general conclusion supports the Yugoslav view of the matter: investment was begun on too broad a front to be sustainable, and the consequence was delay, inflation, balance of payments difficulties and a decline in investment efficiency. The policy framework that contributed to this outcome is discussed in detail below. Saving 2.30 The growing investment effort of the 1976-80 years was sustained by substantial domestic and foreign saving. The share of domestically generated saving in total investment financing (including saving out of remittances by households) fell from an average of about 96% between 1971 and 1975 to an average of 92% between 1976 and 1979, according to data from the flow of funds. The share of foreign borrowing correspondingly increased from an average of about 4% to an average of about 8% of total investment finance. The sharp increase in foreign borrowing filled the gap generated by the inability of domestic saving to keep pace with the investment drive. 2.31 Domestic saving performance over the 1976-80 period can be better understood by examining the saving behavior of households and enterprises in somewhat greater detail. While the available data on household saving rates  - 15 - are somewhat contradictory, it seems that the household saving effort probably increased somewhat in the second half of the 1970s. In the case of enterprise saving the general conclusion is that saving rates out of disposable income rose gradually over the 1976-79 period, and then increased sharply in 1980 as a result of controls on personal incomes. However, at the same time there was a reduction in the "accumulation rate" of enterprises as a ratio to enterprise value-added, reflecting an increased burden of fiscal and parafiscal contributions on enterprises in this period. 2.32 Notwithstanding this seemingly successful savings performance by the enterprise sector, social sector enterprises in the productive sectors continued to be criticized for low savings rates. The basis for this criticism is more apparent if enterprise savings are compared with the value of the capital stock in the enterprise sector. The data reveal that in the 1976-79 period both gross and net enterprise saving fell as a percentage of the capital stock. In absolute terms as well, the net enterprise saving rate relative to the capital stock is low in the light of reasonable estimates of the net marginal product of capital in the Yugoslav economy. 2.33 Only about 58% of enterprise net saving in the 1976-79 period was earmarked for additions to the productive capital stock, with the remainder earmarked for various collective consumption expenditures and noneconomic investments. Net saving for productive capital formation was only about 4.1% of the total replacement value of the productive capital stock during this period. If Yugoslav firms had been required to set aside earnings in relation to their capital use, the resulting saving rates relative to the productive capital stock would probably have been significantly higher than actual rates observed in recent years. II. THE 1976-80 PLAN: THE POLICY FRAMEWORK Capital Allocation 3.01 As discussed above, a major instrument to be used in realizing the plan's objectives was the priority system for the allocation of investment. Compared to the system of investment allocation which it replaced, the new system had two distinct features: the identification of priority sectors whose share in the total investment effort was to be guaranteed, and the greater use of self-management agreements and self-financing schemes among enterprises (pooling of resources) in lieu of both state and bank interventions, as a mechanism to realize the desired distribution of the investment effort. 3.02 Both of these new features were designed to respond to perceived weaknesses in the preexisting investment allocation system. The identification of priority sectors was motivated by concern over structural disproportions in the economy, the most basic of which were deemed to be the relative underdevelopment of the energy and raw material sectors. As noted earlier, a view underlying both the 1971-75 and 1976-80 plans was that the development of these sectors had been retarded by a combination of price  - 16 - controls and commercial policies that favored the processing and manufacturing sectors, and the introduction of a priority allocation scheme reflected the premise that in the absence of such a scheme, decentralized investment decisions by enterprises and banks would not adequately address domestic capacity constraints in energy and raw materials. 3.03 In order to assess the validity of these arguments it is first useful to examine trends in the relative prices of intermediate goods over the 1970s. The data indicate that, over the entire 1970-79 period the producer prices of intermediate goods (and of agricultural goods) rose more rapidly than overall industrial prices, the prices of investment goods and the prices of consumer goods. The tendency for the relative prices of raw materials and intermediates to increase was characteristic of both the 1970- 75 and 1975-79 periods, although the relative price gain was greater in the former period, which coincided with the world boom in commodity prices. All of the priority sectors (with the exception of nonmetallic minerals and chemicals) benefited from large relative price increases over the entire period, with particularly large increases registered for electricity, coal and oil. Looking at the seventies as a whole, it is reasonable to conclude that any biases in domestic relative prices against the raw materials and intermediate sectors were reduced. 3.04 Despite this shift in the structure of producer prices, it is still possible that the profitability of investment was skewed against the priority sectors, thereby necessitating some form of nonmarket allocation, such as the priority allocation scheme, to ensure that adequate investment did flow to these sectors. Using the CGE model it is possible to determine whether market indicators of sectoral profitability, resulting from the complex interplay of market forces and policy variables, would have exercised a resource pull in the direction of the priority sectors or away from them during the 1976-80 period. Overall, the results support the view that, in the absence of a priority allocation mechanism, sectoral profitability rates were such that market guided investment decisions would not have pulled investment resources into several of the priority sectors whose profitability was well below the industrial average. These include the electrical energy, ferrous metals, nonferrous metals, chemicals, and infrastructure sectors, which received approximately 36% of priority investment over the 1976-80 period. While this might be thought to indicate that the priority sectors chosen were the wrong ones, this conclusion is unwarranted since market indicators of profitability were themselves seriously influenced by underlying distortions in the markets for capital, labor and foreign exchange. Given the sectoral priorities mutually agreed upon, even given the changes in producer prices that occurred, some nonmarket mechanism for allocating investment was required. The tension between sectoral priorities and market profitability indicators explains in part why the share of the priority raw material and energy sectors in total industrial investment fell short of target. To the extent that enterprises and banks were able to circumvent the priority allocation mechanism to obtain resources for profitable activities, nonpriority manufacturing branches could have been expected to exceed their target share, as in fact occurred. This tension between market indicators and sectoral priorities, coupled with autonomous pressure for investments in the noneconomic sectors, resulted in excessive growth of investment demand, which created macroeconomic imbalance during the 1976-80 period.  - 17 - 3.05 Quite apart from the tension between the market profitability and the desired allocation of investment, there remains the question whether the priority sectors themselves were correctly chosen. In order to answer this question the CGE model was used to conduct an analysis of the marginal product of capital by sector at estimated shadow prices for labor and foreign exchange. It is recognized that this criterion for capital allocation only reflects considerations of static efficiency, and that other considerations, such as those of dynamic comparative advantage, national defence and geographic location also may legitimately be given weight in arriving at a priority ranking of sectors. 3.06 The pattern of "economic profitability" as measured in this way, broadly reflects the pattern of market profitability, and indicates a low return to investment in the priority sectors of electrical energy, ferrous metals, nonferrous metals, chemicals and in infrastructure. Measured at shadow prices for foreign exchange and labor, the economic return on capital in these branches appears to be substantially below the estimated average economic return on industrial capital. In the case of the electrical energy sector, for example, the economic profitability rate is one-tenth that of the industrial average; in nonferrous metals one-fifth of the industrial average. In the case of electrical energy and infrastructure, the existence of substantial external economies makes this measure of economic profitability a poor guide to investment choice, and it would be reasonable to support the priority allocation of investment resources to these sectors despite the low measured return on investment. A similar argument, however, cannot be easily made in the case of the ferrous metals, nonferrous metals and chemicals sector. Even after correcting for the distorting effects of the trade and exchange rate regime, the rate of return on capital in these sectors remains substantially below the average industrial rate of return. These results at a minimum suggest that there may have been substantial costs entailed in designating these sectors as priority recipients of investment resources. 3.07 By contrast the economic profitability rates indicate that the rates of return on investment resources were higher than the industrial average in the priority sectors of coal, oil and gas, nonmetallic minerals and construction materials, and food processing, suggesting that the choice of these sectors was economically appropriate. The results also indicate that the economic profitability rates in these sectors are higher relative to the industrial average than their market profitability rates, suggesting that price distortions in the economy (particularly those stemming from the trade regime, as discussed below), enhanced the relative market profitability of the nonpriority sectors, making the realization of priority investment objectives more difficult. 3.08 In addition to the identification of priority sectors, the 1976- 80 investment mechanism called for greater use of self-management agreements between enterprises, in the financing and implementation of investment projects. This was seen by the new law on planning as a way of addressing some of the problems of capital mobility and investment allocation that have characterized the Yugoslav economy in most of the postwar period. There was,  - 18 - however, little in the new system to guarantee optimality of capital use at the economywide level. This would have entailed using some economywide indicator of capital scarcity, to guide both the choice of priority sectors and the choice of individual projects in both priority and nonpriority sectors. There was no provision for the use of such a criterion in the Yugoslav arrangements. In the absence of either a price mechanism for allocating investment funds among competing projects, or of some uniform indicator of capital scarcity to evaluate projects (together with an institutional arrangement to make sure that the results of such analysis were taken seriously in arriving at investment decisions), there was little in the new system to generate improvements in the quality of investment decisions made. 3.09 The available evidence from the 1976-80 period suggests that capital misallocation continued to be a significant weakness in the Yugoslav system under the new institutional arrangements. With the combination of constant nominal rates and accelerating inflation, real interest rates fell through time, and nonprice administrative rationing of capital among alternative projects became the dominant allocation mechanism. There is no evidence to suggest that either project evaluation rules or other criteria acted as an effective substitute for the evaluation of projects according to some economywide measure of capital's real scarcity. Instead, anecdotal evidence from banks and planning officials suggests that the criteria used varied from project to project, location to location and time to time. The rationing scheme tended to work to the advantage of projects that were demonstrably in the priority sector, but which may have had little else to recommend them. 3.10 Another general characteristic of the capital allocation process was its continuing fragmentation along regional lines or even along narrower geographic jurisdictions such as the communes. The interest rate structure tended to weaken the interregional mobility of capital since access to financing at negative real interest rates conferred an implicit concessional benefit to the recipient. This situation increased rather than reduced the degree of politicization of investment decisions and aggravated regional conflicts about the fair distribution of investment resources. In part the politicization of investment decisions was also the result of an apparent erosion in the authority of banks vis a vis enterprise borrowers. The ability of the banks to make independent project lending decisions and to monitor the effectiveness of investment projects was circumscribed, as had been intended by the reforms of the investment allocation mechanism. 3.11 The combination of these influences led to examples of unnecessary duplication of investment facilities across regions, and consequent losses of economies of scale. In the agroindustrial sector for example, eight sugar refineries were constructed, located in each of the republics and provinces (with the exception of Montenegro). The location of these was determined by considerations of regional self-sufficiency, rather than the need to supply the larger geographic market. The overall result has been excess capacity in sugar refining, particularly given the shortfalls in sugarbeet production. A similar pattern was also at work in the construction of slaughterhouses, even  - 19 - where transporting livestock to adjacent republics would have been a lower cost alternative. In the case of electric power generation, while republics and provinces did collaborate in several jointly-owned power station projects at large coal mines and hydropower sites, there was still a pronounced tendency for a region to give priority to develop its own sources of supply, even if cheaper sources were available in another republic's territory. Partly because of this preference, the average size of units installed was much smaller than would be justified by the size of the total interconnected system. Such examples are not restricted to the priority sectors, nor are they wholly attributable to the investment allocation process, since an important enabling factor has been the structure and nature of import protection. The investment allocation system was however important in validating regional aspirations for self-sufficiency, with the associated costs in duplication of facilities and loss of competitiveness that these imply. 3.12 In addition to these microeconomic inefficiencies, the capital allocation mechanism played an important role in the macroeconomic instability of the 1976-80 period. Low nominal interest rates artificially stimulated investment demand and artificially depressed saving. In theory, quantitative controls on investment finance and its allocation were intended to ration investment demand within the limits of available saving. In practice, and in keeping with past cyclical experience in Yugoslavia, these quantitative controls did not work smoothly or continuously. Instead the system generated its familiar stop-go pattern, in which rapid increases in investment expenditures initially led to excessive increases in domestic credit creation and foreign borrowing. When the inflationary and balance of payments implications of these increases became unsustainable in 1979 and 1980, investment expenditures slowed dramatically in response to the strengthening of quantitative controls. 3.13 The stop-go nature of the quantitative control system, as in the past, was costly in terms of economic efficiency. In the go phase projects were financed that would have been rejected under a more consistent rationing scheme. In contrast in the stop phase (still in effect) potentially profitable projects have been postponed or shelved for want of funds. In addition the stop-go cycle has distorted the process of domestic resource allocation by requiring the imposition of quantitative controls on imports and thereby strengthening the bias toward import substitution. Finally, given significant downward rigidities in nominal incomes and prices, and given the persistence of inflationary expectations, the stop-go cycle aggravated the inflationary bias of the system and thus increased the severity of the stop phase needed to reduce inflation and restore balance of payments equilibrium. The Foreign Trade and Payments Regime 3.14 While Yugoslavia retained its official commitment to a liberal trade and payments system over the plan period, the institutional arrangements for formulating and executing policy were substantially altered over the course of the plan. These institutional changes were intended to implement the principles of the 1974 constitution in the trade and payments area. The major institutional development was the creation of communities  - 20 - of interest for foreign economic relations (CIFER; known in Yugoslavia as SIZ). These are constituted at the republican and provincial levels, with the regional CIFER in turn providing delegates to a federal CIFER. The CIFER are, inter alia, responsible for preparing regional balance of payments positions, for ensuring the consistency of these positions with the foreign trade plans of their constituent organizations, for the administration of export subsidy and foreign exchange retention schemes and for the allocation of external borrowing rights, consistent with totals set for the region. 3.15 In instituting the CIFER system it was thought that by transferring responsibilities for foreign exchange balance from state bodies at the federal level to regional self-managing bodies, greater discipline would be imposed on importing enterprises through a closer and more direct link with the realized export performance of the republic or autonomous province; also that emergency measures to limit imports, when needed, could be undertaken less disruptively under the auspices of an enterprise-based body such as the CIFER, rather than through state action. 3.16 A further feature of the new legislation was the treatment of foreign exchange retention rights. In recognition of the fact that intermediate producers contribute to exports without being able to realize foreign exchange directly, the new legislation allowed organizations of associated labor to conclude self-management agreements for the distribution of foreign exchange earnings, under the auspices of the regional CIFER. Trade Bias 3.17 Given the relatively poor export performance of the 1976-80 period and the ensuing balance of payments difficulties of the later years of the plan, an important question about the changing foreign trade and payments regime is the direction and strength of the biases that it created for producers to produce for the home market as versus export markets. In Yugoslavia as elsewhere, the overall trade bias of the incentive system reflects the interaction between numerous policy instruments, including the official exchange rate, the structure of tariffs, explicit and informal quotas on imports, export subsidies and selective credit policies. While not all of these influences have been analysed in the present report, an attempt has been made to understand the allocative effects of the major instruments. 3.18 An earlier analysis undertaken by the World Bank 1/ had found that customs tariffs and import quotas as provided for in Yugoslavia's trade legislation were responsible for only a modest bias against exports. The report noted however that this appeared inconsistent with widespread assertions by Yugoslav enterprises that it was more profitable to sell at home than to export over much of the 1976-80 period, and concluded that a substantial anti-export bias did in fact exist, generated through the combination of both the legislated protective structure and more informal mechanisms of commercial policy, particularly the use of quantitative restrictions as instruments of 1/ Yugoslavia: Export Performance and Policies.  - 21 - balance of payments management. A review of the data suggests that a reduction in imports first initiated in the growth pause of 1975-76 was by and large maintained in the 1976-79 period. While it could be argued that this decline reflected voluntary import substitution in response to the changing relative prices of imports and domestic substitutes, it is more plausible to conclude that the observed decline in import dependence reflected greater use of quantitative restrictions. 3.19 In the presence of persistent foreign exchange shortages and particularly after the creation of the CIFER in 1978 the Yugoslavs resorted to a complicated set of rationing devices to allocate available foreign exchange among competing users. Two major forms of rationing were in operation in varying degrees over the period. Simple quantitative restrictions on either the allowable quantity of imports or on the allowable foreign exchange made available for a given import (or to a given class of importer) represent what are referred to in this report as "fixprice" mechanisms for allocating foreign exchange. While these fixprice mechanisms remained important throughout the 1976-80 period there is also anecdotal evidence that there was growing use of a flexible price or "premium rationing" mechanism in 1979 and 1980. The post-1978 institutional arrangements allowed earners of foreign exchange to negotiate self-management agreements to circulate their foreign exchange earnings to other, deficit, users of foreign exchange. This introduced the possibility that such agreements, implicitly or explicitly, could value the foreign exchange being transferred at a rate which represented a premium over the official exchange rate. Anecdotal evidence suggests that a premium valuation of foreign exchange above the official exchange rate increasingly became the norm in such contracts after 1979, reflecting the growing divergence between the official exchange rate and the underlying market clearing exchange rate. 3.20 It appears that both quantitative (fixprice) and premium (flexprice) foreign exchange rationing coexisted in Yugoslavia in 1979 and thereafter but that the premium market worked only partially to equate demand and supply of foreign exchange, constrained as it was by the need for enterprises to arrive at long-term cooperation agreements in order to legitimize the transfer. The coexistence of both fixprice and flexprice modes for allocating foreign exchange implies that different users of the same imports paid different dinar prices for those imports, depending on whether they had access to foreign exchange at the official price, the premium-ridden price, or some combination of the two. The resulting distortions almost certainly reduced the overall efficiency with which foreign exchange was used in the system, in comparison with what would have occurred under either a more flexible exchange rate system or a system of market-determined premia. 3.21 The existence of substantial unsatisfied demand for foreign exchange at the official exchange rate creates substantial rental income in the system, reflecting the gap between the official price of foreign exchange and the valuation that would be placed on foreign exchange in a free market. As might be expected, the scale of these rents rose sharply from 1977 on, reflecting the increasing severity of import rationing over  - 22 - the period. The scale of the gains to be realized through privileged access to foreign exchange was clearly very large, and provides an explanation for the fierceness of the interregional and interenterprise debates on the rules for allocating foreign exchange in this period. 3.22 In the 1976-80 period the Yugoslavs employed three major policies to promote exports. First they continued to grant selective credit at favorable interest rates for the preparation and financing of exports. An estimated 54% of total selective credit was used for this purpose between 1976 and 1980. In addition, projected export performance was supposed to be one of the criteria guiding the allocation of investment resources during the period. No quantitative evidence exists on the share of investment resources allocated to export promotion projects. Second, exports were stimulated by various tariff reimbursement schemes and other tax concessions for firms exporting a certain percentage of their output. The resources devoted to export promotion through such fiscal measures amounted to an estimated 56% of total import duties during the 1976-80 period. Finally, these direct fiscal incentives for exports were bolstered by an export retention scheme that gave exporters discretionary control over a varying fraction of their foreign exchange earnings over the period. The incentive effects of this scheme depended in turn on the workings of the mechanisms for allocating foreign exchange discussed earlier. 3.23 As described earlier, the new legislation on foreign exchange operations gave earners of foreign exchange the right to dispose of it freely via self-management agreements negotiated through the CIFER. This, in theory, implied a substantial increase in retention rates: from an average of 20% in the 1976-78 period to 100% under the new system. The enlargement of formal retention rights was not, however, matched by an equal expansion of effective retention rights, given the growing ad hoc limitations on enterprise use of foreign exchange that developed in response to the foreign exchange crisis. Increasingly over the course of 1979 and 1980, while enterprise rights to import most goods were tightly limited to export earnings, earnings over and above those required for the enterprise's essential imports were subject to reallocation to deficit enterprises through the intervention of the CIFER. Under such circumstances, the ability of exporters to negotiate the disposition of foreign exchange earnings in excess of their needs with deficit importers was increasingly restricted. As a result, not only were the incentive effects of the retention scheme lower than they would otherwise have been, but they also varied considerably across enterprises, sectors and regions of the economy, producing a plethora of effective exchange rates, and distorting the efficiency of economic decisions. 3.24 Combining the foregoing analysis of the import rationing and export subsidy schemes, it is possible to examine the direction and extent of the bias in incentives for exporting and import substituting both within and among sectors of production. The measure of bias used in this report is the domestic resource cost (DRC) of earning or saving a unit of foreign exchange in each sector, through either direct exports or substitution for imports.  - 23 - Within a sector of production, the DRCs for exporting and for import substituting will be the same only if the effective exchange rate between domestic and world prices is the same for imports and exports in that sector. Across sectors, differences in measured DRCs can result both from sectoral differences in the incidence of the trade regime, and from sectoral differences in the domestic costs of equivalent inputs. In order to get a 'pure' measure of the intersectoral effects of the trade regime it is desirable to correct for these intersectoral differences by using shadow prices for wages and for the rental rate on capital. The most important conclusions from these calculations are the following. 3.25 First, within almost all sectors of production, the DRC (at market prices) for import substitution was substantially higher than the DRC for exports, indicating that the incentive system created a strong bias against exports in almost all sectors. This was especially the case in manufacturing, and was most pronounced in the nonferrous metals, machinery, transportation and shipbuilding, electrical equipment and light manufactures categories. Thus in the light manufactures category (textiles, leather, rubber, wood and miscellaneous manufactures) the effective exchange rate on import substitutes was 2.8 times the effective exchange rate on exports; this ratio was 2.5 in the case of transportation equipment and shipbuilding, but only 1.2 in agriculture. These results attest to the bias against exports that was implicit in the trade regime by the end of the plan period. 3.26 Second, the wide dispersion of DRC rates across sectors, especially on the import substitution side, points to the sectoral biases introduced in the system by the trade regime. Sector-specific quantity rationing of imports and sector-specific premium rates resulted in particularly large intersectoral differences in the cost of earning a dollar of foreign exchange via import substitution. As might be expected, in general the highest DRCs for import substitution are in the sectors in which import restrictions were greatest, such as machinery, transport equipment and shipbuilding, electrical equipment, and various categories of consumer goods; textiles, leather, rubber, wood products and miscellaneous manufacturing. 3.27 Third, an evaluation of the DRCs for exporting and import substitution at shadow prices, suggests that an expansion of exports in the large majority of sectors would have been economically justified, in that DRCs for exports in these activities are less than or equal to the entire range of estimates of the economywide shadow exchange rate. In contrast, import substituting activities appear to be socially profitable in only a few sectors of production, including agriculture, coal, nonmetallic minerals and construction materials, and food processing. The major reason for this is that the user price of imports (including premia paid on foreign exchange) was much higher than the price given by the official exchange rate, thereby shielding sale of these goods on the home market. The result is an across the board bias against exporting activities. In industry the bias leads to an average DRC for import substitution which is about 40% above the upper range estimate of the shadow exchange rate.  - 24 - 3.28 The overall lack of social profitability of import substituting activities across most sectors thus calls into question the overall bias toward import substitution as a criterion guiding both sectoral choice and project choice both in the 1976-80 plan and over the longer term. Several qualifications to this conclusion should be noted however. The DRCs for import substitution activities tend to be lower in the priority raw material and energy sectors, with the exception of nonferrous metals, and in the priority agroindustrial complex (agriculture and food processing) than they are in the other industrial sectors. This suggests that, if import substitution as such were a general policy objective (for the reasons listed earlier), the 1976-80 plan did succeed in identifying some of the "least costly" or "least unprofitable" sectors with which to realize this objective. By the same token, risk aversion on the part of planners combined with uncertainty in world market conditions would probably have led planners to tolerate somewhat higher DRCs on import substitution activities than on export-oriented activities, for the higher security that the former activities were considered to confer. Finally these estimates of DRCs are sectoral averages and are calculated ex post. They undoubtedly conceal a wide range of intrasectoral variation and do not necessarily preclude the possibility that carefully chosen investment projects in apparently unprofitable activities might nevertheless be profitable. However, to the extent that the Yugoslav plan itself chose sectors as the unit for priority allocation, these results remain pertinent, particularly in the absence of any more systematic criteria for selecting projects. 3.29 These results therefore highlight the costs incurred by Yugoslavia both of its longer term import substitution efforts, and of dealing with the emerging foreign exchange crisis in the 1976-80 period through import rationing. The existence of persistent and rising implicit and explicit premia on imports caused major distortions in the incentives facing individual sectors, and an overall bias in the incentive system against exporting. The result was a price structure which inhibited exports and encouraged sales on the domestic market to the extent that the cost to the economy in domestic resources of saving a dollar through import substitution was raised 40% above the cost had the same dollar been earned through expanded exports. The performance of other development countries in the markets of the industrial countries over the period suggests that a better export performance was a realistic possibility, but it was one that the pattern of incentives in the Yugoslav system did not encourage. Exchange Rate Policies 3.30 As the foregoing analysis has indicated, the Yugoslav economy was subjected to a series of external and internal disturbances in the 1976-80 period: terms of trade changes, oil price increases, rapid global inflation, increases in nominal and real international interest rates, declining real levels of workers' remittances, deteriorating export performance and a rapid acceleration in domestic inflation. In such an environment decisions on an appropriate exchange rate policy had to take into account a number of considerations and a number of constraints. Maintenance of a given real rate was difficult given the rapidity, scale and heterogeneity of price movements  - 25 - inside Yugoslavia and among the market to which it sells. In addition, several of these developments implied shifts in the real exchange rate which were difficult to assess accurately. 3.31 An analysis of exchange rate movements in the 1976-80 period suggests that the wholesale price deflated effective exchange rate stayed more or less level in the 1976-79 period, appreciating slightly in 1976 and 1977 and then depreciating an equivalent amount in 1978 and 1979. The evidence further suggests a marked improvement in competitiveness in 1980 following a major devaluation of the dinar in June 1980. The analysis suggests therefore that the National Bank of Yugoslavia was successful in implementing its exchange rate policy in this period, which aimed to move the dinar sufficient to offset movements in relative wholesale prices between Yugoslavia and its trading partners. 3.32 The more relevant question is whether an exchange rate policy which aimed merely to offset differential inflation was adequate given the shocks suffered by the economy in this period, which fundamentally affected the balance between demand and supply of foreign exchange. This question has been addressed by using the CGE model to make estimates of market clearing exchange rates over the period. These estimates assume existing tariff and subsidy rates and are predicated on the actual levels of exports and imports and actual levels of foreign and domestic inflation that prevailed in this period. However they assume the complete elimination of the fixprice and flexprice rationing schemes for allocating foreign exchange that were discussed earlier and make certain judgments on 'sustainable' levels of foreign borrowing and reserves growth over this period. 3.33 A comparison between these estimated market clearing exchange rates and the official exchange rates indicates that, even in the first year of the plan, 1976, there was significant overvaluation of the exchange rate, of approximately 23%. The degree of overvaluation lessened in 1977, reflecting the liberalization of imports that occurred in that year, but increased thereafter through 1979, and remained high in 1980 despite the change in the nominal exchange rate that occurred in that year. While these estimates should be regarded as upper bounds of the degree of overvaluation (since it is unrealistic to think of the elimination of all quantitative restrictions on imports) the evidence does suggest nevertheless that, in terms of the balance between the demand and supply of foreign exchange on the domestic market, there was significant, persistent and growing overvaluation of the official exchange rate of the dinar over the period, an overvaluation which necessitated the growing use of the fixprice and flexprice rationing mechanisms described earlier, and which considerably aggravated the difficulties of implementing the new foreign exchange allocation system. 3.34 Analysis of the influences on the market clearing exchange rate in this period further reveals that only about 40% of the change in the market clearing rate was attributable to differential inflation between Yugoslavia and its trading partners, which was the only factor explicitly taken into account by the NBY's attempt at maintaining external competitiveness. The remaining 60% represents changes in the real rate which became necessary to offset developments in this period: the oil price increase, the export slowdown, and the slowdown in net remittances. A real depreciation of approximately 30% would have been needed to maintain a market clearing rate. As against this the real devaluation which did in fact occur was about 10%.  - 26 - 3.35 Putting these various elements of analysis together, the picture that emerges is as follows. Even in the first year of the plan, 1976, there was significant overvaluation of the dinar, even taking into account the formal framework of import protection. The rationing mechanisms used to sustain this overvaluation created substantial incentives against exports and toward the domestic market, which made for a sluggish export performance. The shortages of foreign exchange produced by this export performance perpetuated this overvaluation even when import supplies were liberalized through resort to foreign borrowing. The various shocks of 1979 and 1980 considerably worsened this situation and greatly increased the degree of overvaluation of the dinar. This was only partially addressed by the exchange rate changes that were adopted in mid-1980, almost a year after the major shocks had affected the current account. Finally the efficiency costs of these rationing schemes were greatly heightened by the increased regional fragmentation of foreign exchange flows that the new legislation on the foreign payments system promoted. 3.36 Inappropriate exchange rate policies seem therefore to have been among the most critical contributory factors to the foreign exchange crisis of 1980. The analysis has highlighted the inadequacies of a purchasing power parity rule as the sole guide to exchange rate policy particularly in a period of dramatic shifts in the structure of external sector inflows and outflows. In addition to considerations of external competitiveness, the authorities would have been well-advised to pay due regard to other indicators on the domestic market, such as the relative profitability of export sales versus home sales or the premium at which foreign exchange was being traded between exporting BOALs and domestic BOALs. The need to do this ought to have become particularly apparent in the light of the weak export performance of 1977 and 1978. While a real devaluation of the magnitude required by the end of the period was not an easy target to achieve, a more gradual process of real exchange rate changes would have been preferable to postponing such changes to a major one-time adjustment as was done in 1980. IV. THE 1976-80 PLAN: A SUMMARY ASSESSMENT 4.01 The 1976-80 plan's aims of an ambitious structural transformation of the economy depended in large measure on the ability of the Yugoslav authorities to achieve their structural objectives without slipping into macroeconomic imbalance and balance of payments difficulties. In the event, this requirement was not met. The stop-go pattern of the Yugoslav development cycle reasserted itself, with rapid growth and structural transformation in the 1977-79 period resulting in a foreign exchange crisis and a growth slowdown in 1980, a growth slowdown projected to persist through much of the 1981-85 period. 4.02 Several factors which contributed to the economic difficulties of the plan period have been reviewed above. Looking first at the plan's external adjustment strategy, in retrospect the stress on import substitution appears to have been a mistake. To a degree that was not perhaps envisaged  - 27 - at the time the operation of the incentive system created a conflict between the plan's structural transformation and export promotion objectives. In retrospect, as the resulting foreign crisis and the analysis of domestic resource costs indicate, failure to give even-handed treatment to exports was a costly mistake. 4.03 A related weakness was the conflict that emerged between the desired priority allocation of investment and market indicators of profitability. Market signals guiding the decentralized allocation of investment resources tended to work against the plan's explicit objective of allocating investment to the priority sectors although action was taken to shift the domestic relative price structure in favor of such sectors. Measures of current economic policy accentuated this conflict, as inadequate attention to export performance, along with inappropriate exchange rate policies resulted in high levels of import rationing. The result was to push up the domestic prices of the protected domestic import substitutes and the market profitability of the sectors producing them. 4.04 In addition to these weaknesses in the incentive framework, the continued reliance on quantity rather than price rationing of investment resources produced undesirable effects at both macroeconomic and microeconomic levels. The inability of the capital allocation mechanisms to mediate successfully among competing investment claims led to the overheating of the domestic economy, to consequent inflationary pressure and to the spillover of frustrated investment demand into foreign borrowing. At the same time the quantity rationing regime failed to provide a consistent set of project guidelines to move capital to the most economically profitable sectors and projects, and reinforced regional, sectoral and even intra-enterprise barriers to the mobility of capital. Thus the investment boom was accompanied by the misallocation of investment resources, which became reflected in long project delays, increasing ICORs in the priority sectors, and unviable projects. 4.05 The policy of low interest rates and the continued absence of effective charges on the capital used by self-managed enterprises contributed to the continued insufficiency of enterprise saving. Had Yugoslav firms been forced to set aside earnings in the amount of an appropriate shadow charge on capital, and had they been forced to pay a realistic interest rate on borrowed funds in investment projects as many Yugoslav economists have suggested, the resulting saving rates relative to the productive capital stock would have been noticeably higher than the rates actually observed. In addition, faced with a realistic interest rate on external funds, firms would have moderated their investment demands, making macro control of the economy easier to achieve. 4.06 Finally, and perhaps most importantly, the failure to follow an aggressive exchange rate policy aggravated a bias against exports that had been present at the beginning of the plan. These problems were greatly compounded by the world oil price increase in 1979-80 and other shocks detailed above, which greatly increased the scale of the real devaluation needed to restore equilibrium in the exchange markets, while increasing stringency in the supply of foreign exchange made the achievement of the necessary real devaluation difficult in the last years of the plan.  - 28 - 4.07 The foregoing is not intended to minimize the scale of the external adversities with which Yugoslavia was faced in 1979 and 1980, many of which have persisted since. As already noted, such external factors as international inflation, terms of trade changes and rising international interest rates were a major factor in the deterioration of the current account deficit. These events would have taxed the most flexible of economies. The point is, rather, that after a decade of highly cyclical, balance of payments constrained growth, the objective of the 1976-80 plan was to tackle these problems structurally, in order to make the economy more flexible in its response to external shocks. For the reasons discussed above in this the strategy failed. The pattern of response to the crisis, coupled with a considerably worsened environment in international capital markets has created a much more complicated and difficult situation. The circumstances of this situation have fundamentally shaped the 1981-85 plan, which is now discussed. V. THE 1981-85 ADJUSTMENT STRATEGY Overview 5.01 The Yugoslav response to the economic difficulties of the 1976-80 period, particularly the developments of 1979 and 1980, is set out in the 1981-85 Federal Social Plan, and in the individual five-year plans of the republics and autonomous provinces. The framework for the federal plan was established through prior agreement on five social compacts between the republics and provinces covering the major areas where their joint interests were involved. Notwithstanding this preparatory work, which was concluded at the end of 1980, agreement on major issues of plan implementation had not been reached by the time that the federal plan was adopted, in March 1981. A section of the plan, Part III, therefore specified a long list of supporting agreements that were to be concluded between the republics and provinces. It also provided deadlines by which these agreements needed to be finalized. The unresolved issues included several which were central to the plan's implementation, including agreement on the scale, composition and financing of priority investment projects, the interrepublican allocation of foreign borrowing rights, and social compacts in the areas of agriculture and energy. At the time that the federal plan was finalized not all republican and provincial plans were fully prepared. Ratification of these occurred over the course of 1981. 5.02 Quite apart from these procedural difficulties, the assumptions of the medium-term plan were overtaken by developments in 1981. There was a considerable hardening in the attitudes of the international capital markets toward lending in Eastern Europe. At the same time in the first half of the year there was a sharp acceleration in the domestic inflation rate (to an annualized rate of 56%), accompanied by a disappointing export performance, particularly in the convertible currency area. As a consequence of these trends, emergency action had to be taken to stabilize the economy and to maintain the current account deficit within limits that could be financed.  - 29 - The program of action included the imposition of price controls, export stimulation measures, cuts in imports and a more active policy of exchange rate changes. The program was successful in attaining its immediate goals: in the second half of 1981 there was a sharp deceleration in inflation and a rapid growth in exports, including exports to the convertible area. This strong export growth, combined with further reductions in imports of machinery and equipment, and continued buoyancy in receipts of invisibles led to a current account deficit estimated at $750 million, considerably less than the originally targeted figure of $1.8 billion for the year. 5.03 The combination of a worsened external environment, continued deadlock on major issues of plan implementation and the need to address short-term issues on an urgent basis led to a decision in the second half of 1981 to establish a special commission called the Commission of Federal Social Councils on Problems of Economic Stabilization (hereafter the Stabilization Commission) 1/, which was asked to develop positions on issues of current economic policy, to assist in the resolution of outstanding issues in the implementation of the 1981-85 plan, and to devise a framework of policy and of institutions to guide Yugoslavia's development in the medium-term. While the commission has contributed to the formulation of current economic policy on a continuous basis after its formation, its major effort has been devoted to developing a "Long-Term Stabilization Program." This program is being articulated through a number of documents. The first of these, entitled "Starting Premises of a Long-Term Economic Stabilization Program" was issued in April 1982. This is to be followed by sixteen papers which cover specific areas addressed by the various sub-groups; several of these have since appeared and two are discussed below. The papers are expected to cover such topics as technological strategy; energy strategy; agricultural development; anti-inflation policies; foreign economic relations and the like. At the end of the cycle, the Commission is to issue an overall document summarizing measures to be taken, priorities and a timetable for implementation. Even in the absence of this final document, the review and clearance procedures involved in the issuance of the sub-group reports make them authoritative guides to the Commission's views. In turn, the composition of the commission and the consultative processes involved in its work make it possible to regard these documents as an accurate expression of official policy. 5.04 Two of the first sub-group papers to have been released are entitled the "Anti-Inflation Program" and "Elements of the Policy and System of Foreign Economic Relations." The "Anti-Inflation Program" deals with socioeconomic premises, objectives, methods and measures of anti-inflation policy, with the objective of reducing the rate of inflation from 40% (end 1981) to about 10% by the end of 1985. 1/ The term "stabilization" is used relatively broadly in Yugoslavia to denote an overall policy of balanced development, rather than just the achievement of internal and external macroeconomic balance.  - 30 - 5.05 The approach taken to curtailing inflation is both aggregate and structural. At the aggregate level, continued reliance is placed on restrictive monetary policy. Growth in social product is posited at 2%-3% per annum in the period until 1985, and growth in the money supply is to be calibrated to accord with this. Second, a set of measures are proposed to cut expenditure for general and common needs (i.e., social services of various kinds). These include the replacement of indirect taxes as a source of revenue for these expenditures. Third, several measures are proposed in the area of investment policy. The share of investment in fixed assets is to be reduced from 35% to 25% of gross material product through a variety of financial measures which increase the obligatory share of self-financing and reduce the possibility of financing long-term investments with short-term sources of funds. At the same time, additional stress is to be placed upon objective economic criteria in the evaluation of investment projects by strengthening the role of banking organizations and other appropriate institutions in verifying investment projects. 5.06 The anti-inflation program also sets the basic policy orientation in the areas of price policy, interest rate policy and exchange rate policy. Price policy is seen as continuing to play an important role in the period until 1985, both in controlling aggregate prices and in bringing about a structure of relative prices which reflects world price relationships, before fully liberalized imports become a realistic possibility. The program stresses the need for a realistic exchange rate for the dinar, to be achieved by a policy of regulated (and regular) depreciation of the dinar to offset differential inflation movements. The report acknowledges that such depreciation will add to inflationary pressures, but regards this as an acceptable price to pay. In the same way, the document recognizes the longer-term costs of a regime of consistently negative real interest rates. However, in view of the large differences between existing interest rates and the rate of inflation, and the heavy burden of obligations already being suffered by the economy, the paper concludes that relations between the rate of inflation and interest rates should be normalized primarily by reducing the rate of inflation during the transition period. 5.07 A further element of the anti-inflation program deals with the link between personal incomes and productivity. While the premises of, and criteria for, the distribution of income are still to be established by workers in each self-managing enterprise, these premises and criteria must be such as to provide approximately equal personal income for equal work, regardless of the sector of the economy or the organization in which this income is generated. The actual development of these premises and criteria is to occur through the negotiation of self-management agreements to which the labor unions will be party. The document acknowledges that the institution of self-management agreements and social compacts on these relations has, however, so far not given satisfactory results, but nonetheless urges all involved parties to take up the task of "urgently building an appropriate system of relations in this area".  - 31 - 5.08 The document at various places refers to the need to increase the accountability of enterprise managers and their workers for poor performance. The document also acknowledges, however, that the workings of the anti-inflation program will inevitably result in increased losses as a new structure of relative prices takes hold. The aims and instruments of policy in this transitional period are therefore relatively complex. First, in order to permit effective control of monetary policy it is important to eliminate the role of bank loans in the financing of losses. The document proposes a variety of measures for both reducing the scale of financial losses, and shifting the burden of loss financing away from the banking system. Several measures are proposed to reduce the scale of overt losses: these appear to have been designed to distribute the burden of adjustment evenly between the enterprise in question and society in general. Thus, workers in a loss-making enterprise would be required to sustain a cut in personal incomes (the percentage of this cut is not specified). At the same time, enterprises which show losses will be exempt from such obligations as income taxes, contributions to the Federal Fund for the development of the LDR, or the pooling of resources for priority investments. Such enterprises would also be permitted to defer their compulsory depreciation payments to later years. Loss-making enterprises would also be required to hold elections for a new workers' council and management each year that the enterprise ran a loss. The program further envisages other forms of relief to be offered to loss-making enterprises. Banks would be required to forgive interest due on loans extended; sociopolitical communities and communities of interest would also be expected to make their contributions to rehabilitation of the enterprise by accepting reduced levels of contribution and taxation. The main objective of this program of action is to eliminate the automatic underwriting of business losses. In the past this was done through two principal mechanisms: overdrafts with commercial banks, and contribution from the 'solidarity funds' of OALs at the regional level. Both these mechanisms are to be severely modified. Instead of solidarity funds being used to cover enterprise losses, these funds will now be used only to make resources available for payment of workers' personal incomes (at their reduced levels) if enterprise cash flow is unable to meet personal incomes. The business (commercial) banks would no longer have a role to play. 5.09 The anti-inflation program addresses the question of bankruptcy in rather general terms. The stress of the program is on rehabilitation in the face of losses; however the program notes that organizations that have operated at a loss over a longer period of time and which are not successful in the implementation of their rehabilitation programs would take less long to liquidate than was the case in the past. When an organization is liquidated, attention must be paid to the reemployment of its workers, but only on the basis of economic criteria, and unemployed workers must be provided with social benefits. 5.10 The significance of the anti-inflation program lies most of all in the overall view it takes of economic instruments and economic policy. Taken as a whole, the program represents a substantial commitment to the use of market mechanisms in resource allocation, and to the discipline and  - 32 - sanctions of the market as the primary goad to efficiency. The credibility of the program depends crucially on the follow-up action that is taken in such areas as the link between enterprise losses and diminished personal incomes, and on developing a consistent and enforceable framework for personal income decisions. These have been intractable problems in the past and the anti-inflation program provides no immediate assurance that they will be addressed more successfully on this occasion. Furthermore, while the framework of the anti-inflation program is appropriate for the medium-term, there may still be a need for an explicit incomes policy, couched in nominal terms (rather than linked to the growth of enterprise incomes, as has been the practice in the recent past). 1/ In addition, while not doubting the commitment to a staged reduction in inflation, it must be recognized that inflation control is going to be a difficult and uncertain task in this period, as various relative price adjustments take hold. It seems unfortunate therefore that, in contrast to the approach being adopted with the exchange rate, the approach to realistic real interest rates is being left contingent upon success in fighting inflation. Given the structure of policies that is now being erected to take account of the losses of enterprises, it would be as well to include the adjustment costs to a regime of higher nominal interest rates in the overall package, and to derive the benefits in improved resource allocation that would flow from this measure, rather than leaving such gains wholly dependent on the success or failure of the anti-inflationary efforts. The arguments for a realistic interest rate structure stem from many considerations; these are expanded upon in the last chapter of this report. 5.11 A second working group document issued by the Stabilization Commission pertinent to the themes of this report, deals with the "Elements of the Policy and System of Foreign Economic Relations". The document takes full cognizance of the difficult situation in the world economy at present but concludes that, given sufficient efforts, opportunities do exist for Yugoslavia, and that Yugoslavia has little option but to undertake whatever efforts are necessary. The document is exceedingly frank in acknowledging the autarkic trends in development in the last decade. In part it attributes these to the factors cited in Chapter III above; namely the existence of a protective structure operating through the trade and payments regime. Beyond this, however, lack of international competitiveness is seen to stem from the the low productivity of Yugoslav industry. The report is also critical of some of the consequences of devolving responsibility for foreign exchange allocation to the republics and provinces. It cites the overall context of "rapidly growing inflation, unrealistic demand and chronically unrealistic rate of exchange of the dinar", and views with considerable concern the substitution of the dollar for the dinar as a medium of exchange in the domestic economy. 1/ This appears to have been recognized in a decision to freeze personal incomes, taken in August 1982.  - 33 - 5.12 The policy of foreign economic relations in the forthcoming periods is seen to require a basic shift in development strategy. The most pervasive element of this strategy is a return to a more open economy, with the influence of foreign technology and international prices being reflected more fully in all aspects of the domestic economy. An important byproduct of such an orientation is expected be a more dynamic growth of exports, which would not only ease balance of payments difficulties but would have more generally beneficial effects on the industrial structure. The specific targets provided in the paper are the following: (i) Increase in the share of Yugoslav exports in world imports to 0.6% in the next three or four years (as against 0.25% in the 1976-80 period); (ii) A significant rise in the coverage of visible imports by exports, especially with the convertible area; (iii) A further rise in the share of exports of services in the pattern of overall trade, together with an appreciable improvement in the net inflow of foreign exchange from invisibles. 5.13 In assessing the means and phasing of policies to achieve these ends, a basic principle that is enunciated is that a lasting and consistent economic "interest" must be created in exports, while at the same time there must be a phased liberalization of commodity imports. In order to achieve these goals, prime importance is given to exchange rate policy, where the aim will be to unify the rate of exchange across all transactions and all entities, and to guarantee that a realistic exchange rate is continually maintained. Appropriate exchange rate policies are regarded as the centerpiece of the move to an outward looking strategy; however, the role of such auxiliary measures as tariff policies, fiscal policies, credit and monetary policies, etc. is also acknowledged. The paper indicates policy directions in each of these fields. The basic proposals are for maintenance of duty drawback schemes, and selective export incentives, but for the gradual abolition of quantitative restrictions (quotas) on imports. Further, there is support for tapering tariffs over time, to remove the element of protection as infant industries are built up. 5.14 These measures of exchange rate and commercial policy are complemented by a series of proposals governing the operation of the foreign exchange market. The basic principle that is insisted upon is that the dinar must be the sole legal means of payment in the country, and that domestic transactions must not be denominated or settled in foreign currencies. An extension of this principle is that the statement of gross income of enterprises may be drawn up only in dinars -- implying that income earned will not be credited to the account of the enterprise until funds have been repatriated and converted into dinars. The computation of enterprise income has its own implications for calculation of personal incomes of workers, etc. The paper also touches upon the role that an actively functioning foreign exchange market could play in creating greater fluidity in foreign exchange flows. The view is clearly expressed that the foreign exchange market should supplant the existing CIFER as the dominant mode of foreign exchange allocation, leaving the latter bodies primarily to playing a planning and coordination role.  - 34 - 5.15 Two other areas touched on in the paper are of interest: the system of foreign borrowing and convertibility of the dinar. The paper recognizes the need for some mechanisms to regulate medium-term and short-term borrowing in order to keep them within bounds dictated by the balance of payments of the country, but only states that "more detailed and precise criteria should be worked out" to achieve this. Certain general principles are, however, advanced. Foreign credit must be repaid by the borrower (the ultimate user); there should be no allocation of borrowing rights by republic and province (as had become the practice); foreign borrowing should, in general, be permitted only in the furtherance of certain jointly agreed development priorities; uniform borrowing criteria will be developed in the CIFER; and greater clarity will need to be introduced into the policies and obligations of the National Bank of Yugoslavia and the authorized commercial banks in maintaining external liquidity. 5.16 The paper is unequivocal on the ultimate desirability of achieving dinar convertibility. At the same time the paper asserts that achievement of convertibility, however, is not the final act of the long-term economic stabilization policy, but an instrument of that policy. The key prerequisites for achieving dinar convertibility are seen as the return of some stability to the domestic economy, the reorientation of the price system to reflect world prices, the re-establishment of a functioning foreign exchange market, unification of the exchange rate of the dinar at a realistic level and at least partial import liberalization. Once these preconditions have been established through the immediate policy actions described below, a move could be made toward convertibility of the dinar within Yugoslavia for current account transactions, leading ultimately to a situation of full convertibility. 5.17 Having reviewed the long-term goals and targets in the area of foreign economic relations, the document then turns to issues of priority and phasing, given the difficulties of the current period. In the current very tight foreign exchange position, the paper anticipates continuing restrictions on imports for a somewhat lengthy period. In addition, the paper calls for solutions to certain issues "which have not been fully resolved within the present functioning of the foreign exchange system." Included in this list of priorities are definition of the appropriate role of the National Bank of Yugoslavia with respect to the handling of foreign exchange reserves, the allocation of quotas to maintain liquidity in the foreign exchange transactions of the banks, equalization of the system of export incentives across the country and certain other tasks. In addition, the paper proposes an immediate framework for the disposition of foreign exchange earned by OALs. These regulations envisage the sharing of foreign exchange proceeds from exports between the final exporters and suppliers of inputs. However, the Federal CIFER will be empowered to establish national guidelines, by industrial branch, of the needs of exporters for foreign exchange, and to oblige exporters to sell foreign exchange in excess of this to their commercial banks, for inclusion in the foreign exchange market. In arriving at the "retention rights" that individual branches would enjoy, the Federal CIFER will need to take into account other, social needs for foreign exchange, such as those for items of general consumption,  - 35 - needs of enterprises which are not involved in exports etc. In order to ensure that these other needs do not exhaust the foreign exchange available, allocations for these will be made proportionate to the foreign exchange inflow, up to a prescribed amount. The program also envisages immediate enforcement of the principle of dinar accounting for all foreign exchange transactions, with the decision on whether to repatriate funds being taken by the OAL on the basis of its assessment of the costs and benefits of continuing to hold foreign exchange versus converting its resources into dinars. While a return to an active national foreign exchange market is also seen as an indispensable component of the immediate program of action, the paper does not advance specific measures to achieve this, other than asking that further work be done on the modalities of reviving the foreign exchange market. 5.18 As with the anti-inflation program, the major significance of this program lies in the overall view that it offers of the goals to be striven for, and the system to be brought into being. At this level, the orientation is unambiguous: greater openness, liberalization, use of market forces and international prices as the main stimuli to competitiveness and efficiency, and a move away from the regionalized, negotiated allocation of foreign exchange. In its own terms this vision is consistent, radical and well-conceived, but its crucial test lies ahead, in the determination with which the strategy is implemented, in the face of the considerable disruption that such a program is in many respects intended to cause. Taken together, the "Anti-inflation Program" and the "Elements of the Policy and System of Foreign Economic Relations" represent, at least on paper, a serious commitment to policies which are likely to lead to a desirable and efficient adjustment. Of equal significance is the fact that, through the mechanism of the Stabilization Commission, there has been intensive and coordinated discussion of a medium-term strategy on broad issues of factor pricing and incentive policy. This is in contrast to the past orientation in Yugoslavia (as in many other developing countries), of concentrating almost wholly on issues of physical planning, particularly output and investment planning. 5.19 The work of the Stabilization Commission has been paralleled by technical work to rebalance the Federal plan over the course of 1982. The three central features of the 1981-85 plan's macroeconomic strategy are a sustained growth slowdown for the entire five-year period, a reduction in the growth rate of investment and in its share in output and a substitution of export demand for domestic demand as a source of growth. In addition the plan projects sharply reduced foreign financing of the investment program, and a steady reduction in the debt service ratio. The slowdown in growth is to be concentrated in the industrial sector. By contrast, the growth of agricultural output is projected to increase well above the achievements of the last plan; for the first time in the postwar period the targets for agricultural and industrial growth were to be approximately the same. The process of rebalancing this plan is likely to take up most of 1982 and what will emerge is a medium-term program for the 1983-85 period. Some indications have been given by planning officials of the shape of the revised plan, prior to its finalization. The expectation is that growth in  - 36 - social product will be even slower than originally envisaged. In addition, in keeping with the orientation of the anti-inflation program there is expected to be a further reduction in fixed investment, particularly in the non-manufacturing sectors. Whereas the original plan envisaged the ratio of fixed investment to social product being reduced to 29% by 1985, the antiinflation program, as noted, now envisages a ratio of 25% by 1985. In contrast to the earlier expectation of moderate growth in personal consumption, the current scenario calls for continued, although modest, reductions in this item through the plan. 5.20 One form of consistency check is to examine whether the sources of growth in demand for manufacturing output implied by the plan are substantially different from either past Yugoslav experience, or the experience of other semi-industrial economies. Table 5.7 reproduces historical information on sources of change in the demand for manufacturing production in Yugoslavia, and a corresponding decomposition of output growth in the manufacturing sector as projected in the two experiments. 1/ The first column of the table gives the average annual growth of manufacturing output. The remaining four columns decompose this growth in output into four categories: domestic demand expansion, export expansion, import substitution and change in input-output coefficients. 5.21 The shift away from export expansion as a source of growth in manufactured output through the 1970s is clearly revealed by Table 5.7, which reveals the essential similarity of the strategies of the 1971-75 and 1976-80 plans. By contrast the 1981-85 plan implies a substantial reorientation in this pattern of growth, within the much lower growth of output. The major shift is one away from domestic demand expansion toward export expansion. By way of comparison, Table 5.8 provides such a decomposition for a number of other countries, for the 1960s and early 1970s. While these data reflect the period before the first oil shock they do indicate that the rate of growth of manufacturing output envi- sioned under the revised plan strategy is by no means unprecedented, and is in fact relatively low by past experience. The projected contribution of export expansion to manufacturing growth, though high, is within the range of past performance of other countries. 5.22 A further test of consistency and feasibility is the demand that the adjustment strategy makes for radical changes in the growth of output in individual sectors. Table 5.9 provides data on sectoral output growth rates for manufacturing and shows the sectoral distribution of the sharp reduction in aggregate manufacturing output growth implied in the Plan II run. With the exception of the nonferrous metals sector, output growth is reduced in all sectors. Given the combined high rates of investment and employment being projected, such performance would imply no growth of total factor productivity at the sectoral level, reflecting a very pessimistic view of the policy environment in general and its impact on the ability of enterprises to function at anything close to rated capacity. Similar analysis was undertaken for exports and imports of manufactured products; while the results are not reported here, the projected performance under the Plan II strategy remains within feasible limits. Even at the sectoral level, therefore, the revised plan's strategy is both feasible and conservative, reflecting perhaps the which might arise in the implementation of import cuts.  - 37 - Medium Term Perspectives 5.23 Given the multitude of uncertainties surrounding the plan itself and the availability of external capital, it is not possible to make very firm projections at this time. The CGE model can however be used to illuminate some of the key policy issues that arise, and the sensitivity of Yugoslavia's growth prospects to a variety of parameters, both external and internal. Comparing these projections to the scenario emerging in the revisions of the Yugoslav plan, it would appear that the latter imply a conservative view of the growth in imports that can be financed between 1982 and 1985. While the model may overstate the degree of substitutability available to an economy in the short-run, it does serve as a useful reminder that, given the levels of factor inputs being made available, much faster growth of output is possible if the management of foreign exchange could be handled efficiently and that the costs in foregone output of the foreign exchange shortage are extremely high. Indeed while a growth pause is necessary to preserve solvency, the underlying processes of structural adjustment are, if anything, retarded rather than assisted by a reduction in growth. By itself therefore a growth pause is a necessary but not sufficient response to the difficulties in which Yugoslavia currently finds itself. It should be viewed as an opportunity to put in place a framework of policies which will allow growth to resume as quickly as possible, and which will ensure that when growth is resumed, it is of a sort that contributes to a more durable and efficient adjustment than has been the case in the past. This perception is shared by the Yugoslavs, as is evident in the work of the Stabilization Commission reviewed above. 5.24 As noted by the commission, a precondition for any more fundamental program of reforms is likely to be the restoration of more normal conditions in the market for foreign exchange. The differential growth of exports and imports over the plan implies that the perceived shortage of foreign exchange peaks and then falls, as exports finance a growing portion of imports. Given the existence of this profile, and given that the imbalance between demand and supply of foreign exchange remains significant until 1985, a case exists for continuing efforts to bring demand and supply of foreign exchange into balance over the plan period, through continued active exchange rate policies along the lines envisaged by the Stabilization Commission . 5.25 The projections above are based on relatively conservative assumptions on developments in oil prices in the first half of the decade. The current softening in international oil prices should further help restore balance between the demand and supply for foreign exchange on the Yugoslav market. The reduced demand for foreign exchange that a lower real oil price implies will to some degree be offset by a lower supply of foreign exchange from exports both to the oil exporting countries and to the developed countries, since lower oil prices in large measure reflect continued recession in the industrial economies. Lower oil prices can only make a modest, although useful, contribution to resolving the imbalance between demand and supply of foreign exchange on the domestic market. Given the scale of Yugoslavia's import needs, they are no substitute for a strong export performance, particularly to the convertible currency area.  - 38 - Capital Account Issues 5.26 A fundamental determinant of the plan's strategy was the view taken by the Yugoslav authorities on the desirable scale of foreign borrowing over the period, taking into account prudential constraints on debt-service and considerations of aggregate availability of foreign capital. The assessment of these constraints under the original plan implied a net increase in medium- and long-term debt outstanding and disbursed of about $7.2 billion. 5.27 This scenario has been overtaken by events, and the cumulative current account deficit being considered by the Yugoslavs is now likely to be considerably lower. The full elaboration of these targets is not as yet available, nor are the assumptions on terms of debt, anticipated world inflation etc. that are now being made. An attempt has been made to approximate the outlines of the revised plan, with World Bank projections of international inflation and interest rates. The bulk of Yugoslavia's external capital requirements on this scenario are required to amortize past debt, and to a lesser extent to finance the buildup of reserves and to provide medium-term export credit in support of its sales of capital goods. By contrast, the current account deficit is an insignificant component of the demand for external capital. Indeed, apart from estimated interest payments, the current account is projected to run a substantial surplus, of about $8.4 billion in this period. The assumption made in the projections is that Yugoslavia will be able to remain a modest net importer of capital in this period, and that its need for medium- and long-term capital in this period could be met through a combination of medium-term suppliers' credits and financial credits, with additional support being provided by World Bank lending and the standby arrangement with the IMF. On the assumption that gross capital inflows on this scale are made available to Yugoslavia, Yugoslavia's medium- and long-term debt is projected to increase to about $20 billion in 1985. With sustained growth in exports, the aggregate medium- and long-term debt-service ratio declines to about 15% in 1985. Projections beyond 1985 suggest that the debt-service ratio remains at around 15%, before dropping further to around 12% at the end of the decade. 5.28 Given present conditions in international capital markets, it is difficult to make a very precise guess on whether capital in these amounts will be available to Yugoslavia. Conditions are currently not very favorable for further increases in exposure by commercial banks; as a consequence, Yugoslavia has been obliged to diversify its sources of finance to include other sources of capital, notably amongst OPEC countries, and may have to continue to do so, if market sentiment does not become more positive. Some increase in net exposure through the mechanism of officially guaranteed suppliers' credits seems a more credible possibility. Policy Issues 5.29 As discussed extensively above, Yugoslavia has invested a great deal of effort in the work of the Stabilization Commission in devising a policy framework for the medium term. By and large this policy framework is well-conceived and consistent, and addresses many of the structural  - 39 - issues identified in the previous discussion. Equally, the analysis of medium-term prospects in this chapter indicates that Yugoslavia's medium-term outlook is fundamentally sound, provided that adequate external finance can be raised to maintain the momentum of production and exports. If, however, external financing constraints continue to require further cutbacks of imports these are likely to threaten both output and exports, and thus prolong the need for a slow growth period. 5.30 Even with some improvement in access to external finance, Yugoslavia is likely to face a period of foreign exchange stringency for some time to come, and the aim of policy in this transitional period must be to minimize the costs and disruptions of such shortages while building the basis for the more liberalized trade environment envisaged by the Stabilization Commission. In this transitional phase the authorities should continue to be guided by certain principles, most of which are reflected in the current policy framework. The first is to give absolute priority to exports since this is the only realistic means presently available to achieve a quick return to liberalized imports. The second is to continue the policy of maintaining a realistic exchange rate for the dinar, taking into account not only considerations of external competitiveness, but also the balance between demand and supply of foreign exchange in the domestic economy. The implication of such a policy is that if additional external shocks are suffered by the economy (for instance on account of an export shortfall, or more stringent import reduction necessitated by lack of external financing) the effects of these should be reflected in the real exchange rate. This is important for two reasons. Greater reliance on exchange rate changes (rather than rationing schemes) will help to bring about a better allocation of the available imports and will stimulate additional exports. In addition, visible adherence to a realistic exchange rate by the authorities is important to convince investors through the economy of the enduring commitment to a more outward looking stance. 5.31 The ability of the authorities to gauge the right exchange rate would be greatly assisted by a resumption of an active interbank market in foreign exchange, as envisaged in the Stabilization Commission's documents. This in turn requires a commitment by republics and provinces to permit a free flow of foreign exchange across regional boundaries. Much of the opposition to such a free flow is a reflection of the situation of extreme foreign exchange shortage which has existed since 1979; a return to a less constrained environment ought by itself to reduce some of the opposition to free movement of foreign exchange. On grounds of both economic efficiency and the integration of the national market, the key objective should be the attainment, over time, of a uniform de facto exchange rate across the country. 5.32 The stress placed in this discussion on returning to a moderately well-functioning foreign exchange market as a key objective of the stabilization phase implies possible choices between this and other objectives of short-term policy, notably the control of inflation. The fear of provoking inflation is said to be a major reason why exchange rate policy was somewhat less aggressive than warranted in the first half of 1981. In a situation with tight import controls a price shock (such as  - 40 - that provided by a devaluation) can touch off a more sizable inflationary wave than would be the case if such expenditures could be absorbed by imports, so there is merit in the concern felt by the authorities. By the same token, however, the most effective anti-inflationary policy in the medium-run is also likely to be the restoration of a more normal import regime, which in turn is facilitated by correct exchange rate policies. Concern about inflation therefore should not be allowed to inhibit prompt action on the exchange rate as and when indicated. Action on the exchange rate in 1982 as well as the text of the anti-inflation program suggests that this view is now accepted by the authorities. Again, to the extent that a major purpose of exchange rate changes is to bring about relative price shifts, these are inhibited by rigid price controls. While the Yugoslav authorities are alert to these considerations, they probably had little choice in the face of the price explosion of end-1980 and early 1981 but to impose strict price controls, in order to break the inflationary psychology. Once this has been achieved, however, it would be preferable to use such means as nominal incomes policies or the selective allocation of imports as additional measures of price control, over and above the discipline exerted by tight monetary and fiscal policies. 5.33 A further issue is the choice between continued reductions in the current account deficit or some measure of import liberalization, should the external constraints upon Yugoslavia ease. While at the moment this is not a realistic choice, shifts in market sentiment in favor of Yugoslavia could occur. In such a situation Yugoslavia's first priority should be to develop an adequate level of external reserves; once this is done the preference should be for a measure of import liberalization rather than continued reduction in deficits: such liberalization ought to facilitate a better export performance and thereby improve the balance of payments over a longer horizon, while at the same time providing more accurate signals to investors on projects which genuinely reflect Yugoslavia's comparative advantage. 5.34 Given an appropriate policy framework therefore and given reasonable support from the international capital markets, there are grounds for optimism that the most pronounced disequilibria in the economy could be eased before the end of the plan, laying the basis for faster growth and a resumption of the process of structural change in the economy. It would be desirable to let the initial demand stimulus come from the export sector rather than from domestic demand; in particular this is likely to imply continued tight control on investment demand, particularly in the noneconomic sector. As against this, Yugoslavia's external liquidity remains under pressure at present, as does the control that the authorities have over domestic demand. It has to be recognized that were things to go poorly for Yugoslavia on both these fronts the situation could deteriorate still further. A continued demonstration by Yugoslavia of its commitment to the policy framework sketched above, and of its ability to implement such a framework will, it is hoped, induce the international markets to maintain the minimal flow of resources needed to allow the economy to function at reasonable capacity levels and to proceed with the structural reforms that are needed. The Stabilization Commission's proposals for directing future investment and growth more efficiently are discussed in the last chapter of the report, in line with the discussion of issues of a more developmental nature in Part II.  - 41 - PART II: DEVELOPMENT PERSPECTIVES AND ISSUES VI. THE INDUSTRIAL SECTOR 6.01 Yugoslavia's industrial 1/ sector is the mainspring of its economy. It plays a central role in domestic economic activity and dominates foreign trade. Currently, industry accounts for one third of the labor force, over 90% of Yugoslavia's merchandise trade and 39% of social product. In view of its dominant position in the area of foreign trade, industry has borne the brunt of the difficulties associated with the unfavorable external developments of the seventies. Similarly, it is the industrial sector which carries primary responsibility for responding to the challenges of structural adjustment in the eighties. At the same time, however, the character of this response has important implications for the broader goals of economic policy and will largely dictate the pace of overall economic development in the country. 6.02 The 1976-80 plan sought to bring about major structural changes in the composition of industrial production while maintaining high rates of growth. The plan aimed at increased output in certain key areas such as basic chemicals, electric power and ferrous and nonferrous metallurgy, which took advantage of Yugoslavia's raw material base. Industrial branches producing consumer goods were expected to grow more slowly. 6.03 In certain respects the plan targets in industry were realized as both output and employment growth were maintained at high levels. But the composition of output did not change as radically as expected. There were significant shortfalls in practically all priority sectors, especially in ferrous and nonferrous metallurgy, while growth in most nonpriority sectors exceeded the targets established in the plan. This led to a continued reliance on imported raw materials. 6.04 As discussed earlier, there were also divergences between the investment targets of the plan and the final distribution of investment expenditures. Although there was an increase in the share of energy and basic industries in overall industrial investment, the share of this group fell short of target. At the same time, processing industries received a higher share of overall investment than originally planned. This was accompanied by an apparent decline in the efficiency of investment in the industrial sector, particularly in the priority industries. 1/ The industrial sector refers to 35 branches classified under the heading Manufacturing and Mining in the Yugoslav classification of economic activity. It includes the electric power sector, but excludes other public utilities and construction.  - 42 - 6.05 Given the importance of industry in Yugoslavia's trade and the goal of the 1981-85 plan to restructure the balance of payments to a configuration sustainable over the medium term, the industrial sector is called upon to play the lead in the process of adjustment. While to begin with structural priorities of the plan were similar to those of the 1976-80 plan, the subsequent revisions are expected to give it a more pronounced pro-export cast. 6.06 The plan stresses economy in the use of scarce foreign exchange resources by emphasizing modernization, removal of bottlenecks and the completion of ongoing projects as opposed to broad new investment initiatives. Forty-three percent of industrial investment will be for the completion of ongoing projects. The government attaches high priority to bringing these projects to fruition as quickly as possible in order to improve the overall efficiency of investment. Within this framework the structure of industry will remain essentially unchanged, although the share of energy and raw materials in total output is slated to increase marginally relative to the consumer goods and capital goods sectors. 6.07 In the foreign trade area the plan's objective is to increase the coverage of merchandise imports by merchandise exports to over 75% as compared to 60% in 1980. The plan's projections for export growth were made on the basis both of domestic supply considerations and studies of international marketing arrangements and prospects. While the targets for industrial exports appear optimistic when compared with export performance during the last plan period, they are not unrealistic, given an appropriate policy framework and the availability of imports to maintain the tempo of production. Priority in importation will be accorded to those goods which cannot be produced domestically or are in short supply. According to the plan, successful import substitution in the priority sectors will enable imports of essential goods in line with the needs of the economy, although even if this import substitution is achieved the output of some raw materials and inputs will grow at slower rates than total industrial output. 6.08 The developing countries (LDCs), particularly the oil exporting developing countries are expected to be the most dynamic market for Yugoslav industrial exports in the 1981-85 period, with the share of exports to these countries increasing to 26% in 1985 from an estimated 18% in 1980. By contrast exports to both the developed countries and the CPEs are projected to grow much more slowly, at about 5.5% per year to each market area. In contrast to the rather conservative targets for exports to the DCs and CPEs, Yugoslavia's target growth in exports to the LDCs - at a 17% annual rate - is ambitious, and the Yugoslavs are likely to face stiff competition from both developed countries and other semi-industrial developing countries. Certain other considerations also suggest that it may be unwise to make such trade the centerpiece of Yugoslavia's export strategy. First, the the market for capital goods and services in these countries is likely to continue to grow more competitive. Second, such exports are likely to be won substantially on the basis of financing terms. The yield to Yugoslavia's balance of payments from these exports is likely to be spread over time and to be lower in present value terms than would be the case for exports of equivalent value not requiring financing support.  - 43 - 6.09 Despite an impressive long run performance, Yugoslav industry faces a number of problems in adjusting to the difficult period of structural adjustment confronting the economy in the eighties. Its past, somewhat autarkic pattern of development has not succeeded in bringing about the desired measure of structural change and the inward oriented development strategy has accentuated the pressure on the overall balance of payments. In addition, the economy has tended to become insulated from the forces of competition on the domestic market. This has led to a tendency for planners to place more emphasis on domestic and even regional input output relationships rather than the concept of comparative advantage and the need to maintain international standards of competitiveness. 6.10 It is now generally accepted in Yugoslavia that the key to any successful and durable adjustment lies in the performance of exports, and that the poor export performance of the last plan was largely a reflection of developments within the domestic economy. There is an urgent need to formulate a long-term export strategy and to develop true export industries to take advantage of Yugoslavia's resource base, skill levels, location and its experience and craft traditions. The two elements of a policy of industrial restructuring should include; (i) production incentives that are neutral as between exports and import substitution and (ii) investment criteria that more accurately reflect the costs and benefits to the economy of employing resources in each activity. By themselves export incentives cannot overcome the bias against exporting created by the system of domestic protection. Yugoslavia needs to unwind this system over the medium-term by gradually reducing quantitative import restrictions, with duties and subsidies used frugally as temporary incentives in the development or restructuring of certain industries. VII. THE AGRICULTURE SECTOR 7.01 Although the share of agriculture in Yugoslavia's social product and employment has declined steadily in the post-war period, the agricultural sector remains important in the overall development of the country, contributing about 15% of social product. In addition, the agricultural sector is expected to make an important contribution to reducing Yugoslavia's trade deficit and has therefore been accorded a more prominent role in the external adjustment strategy of the 1981-85 plan. Yugoslavia has a relatively strong agricultural resource base, and its four distinct ecological zones have favored the growth of a well diversified agricultural sector with a significant potential for future development. 7.02 Yugoslavia's agriculture is characterized by the coexistence of social and individual (private) sectors. The individual sector accounts for 82% of the cultivable land, although the average holding is small -- 3.2 ha. The individual sector also accounts for a large part of the country's livestock production, and well over half of the country's grain production. A considerable portion of the individual sector's production is however retained for own consumption, and its contribution to marketed output is much lower. Of total maize and wheat produced in the sector only 8% and  - 44 - 19% respectively are delivered to the social sector, and the share of the individual sector in the marketed output of cereals is about 45%. A similar situation prevails in vegetables and fruit, although in livestock a much higher proportion of individual sector output is marketed. The individual sector is a more efficient producer of livestock than the social sector, although a less efficient producer of cereals. Until the early 1970s the individual sector's agricultural potential was not given systematic attention, and social investment funds were directed entirely to the social sector. Since then the sole mechanism for supporting the individual sector has been through its various forms of association with the social sector. Through this mechanism the social sector is expected to disseminate technical innovations and to accelerate the adoption of improved agricultural practices. Despite the benefits to be gained through association, individual farmers have displayed a reluctance to associate with the social sector. This appears largely to reflect a lack of market orientation on the part of small private farms. Those individual farmers who operate relatively large holdings on a commercial basis have shown more interest in association with the social sector and bave correspondingly benefited from substantial increases in yields and improvements in technology. Overall, however, about 85% of social investment funds in agriculture still flow to the social sector. The scale of investment by the individual sector from its own resources is not known. 7.03 Agricultural performance during the 1976-80 period was far below expectations, particularly in the individual sector but also in the social sector. In contrast to a planned growth rate of 4.0% in primary production, actual growth was 1.9% Output in the agroindustry subsector was closer to plan, at 6.5% as compared to a target of 8.0%. Inclement weather conditions undoubtedly depressed primary production, but the disappointing performance of the sector also points to certain difficulties in the overall policy framework which are discussed below. The crop subsector and particularly wheat, where growth was negative, was largely responsible for the poor performance; the livestock sector, while below target, achieved respectable growth rates. Agricultural export performance was also below target. Despite the government's attempt to promote agricultural exports through premium payments and other export incentives, domestic markets for maize and meat were frequently more attractive and, as in industry, the export motivation has frequently rested on the need to meet some minimum foreign exchange requirement for import purposes. 7.04 During 1976-80, the responsibility for agricultural policy shifted from the federal level to republican and provincial governments. While the overall development of the sector was governed by a social compact between the republics and provinces, the provisions of this compact did not necessarily guarantee efficient cropping and investment patterns from the point of view of the national economy and, in practice, the objective of regional self-sufficiency was given greater weight. One manifestation of this has been the unwarranted duplication of agroindustrial facilities (notably sugar refineries and slaughterhouses); the excess capacity so generated has been accentuated by shortfalls in primary production, such that significant surplus processing capacities have developed in several areas.  - 45 - 7.05 Jurisdiction for pricing policy in agriculture, and for its implementation, is split between federal and regional levels. The federal government sets indicative and support prices for about 80% of agricultural commodities with the remainder determined by market conditions. In addition republics and provinces are also permitted to pay premia and subsidies in particular cases, and these have become a substantial fiscal burden, especially in the case of the less developed regions. The relative price structure has in certain cases discouraged production for the market. This has, for instance, been true in the case of wheat, where price controls on the wholesale price of flour have inhibited flour mills from offering a competitive price for wheat. In the case of maize, meat and milk however prices have been adequate to stimulate production and sale. 7.06 Over the plan period there has also been a phase-out of federal subsidies on fertilizer. While the intention was that these subsidies would be assumed by the regions, budgetary difficulties have prevented this from happening. Partly for this reason and partly on account of shortages of fertilizer available, fertilizer use has lagged well behind target, despite the critical importance of greater applications for increasing crop yields. 7.07 The 1976-80 plan had anticipated increases in social sector holdings of about 250,000 ha. over the period through land reclamation and purchase from the private sector. However, by 1980 the social sector had increased its land ownership by only 50,000 ha., largely reflecting inadequate funds to finance land reclamation works or land purchases from the private sector. At the same time land abandonment has been increasing and estimates are that 10% of arable land is currently abandoned. The costs in foregone output of this amount of land going out of production could be quite high, although information available on the quality and location of abandoned land is rudimentary. Several republics and provinces have taken legal action both to prevent abandonment of land and to stimulate rental of land, but these measures do not appear to have made much impact on the problem. 7.08 The 1981-85 plan pursues fundamentally similar objectives to the 1976-80 plan. The plan calls for improved primary production to satisfy domestic demand; generation of surplus production to promote agricultural exports; modernization and reconstruction of existing agroindustry facilities; and intensive utilization of currently unused and abandoned lands through land reclamation and social sector purchases. The target growth of agricultural output in the plan is 4.5% per year, with the social sector targeted to grow at 6% and the individual sector at 4%. 1/ Agriculture is also expected to play an important role in reducing the country's balance of payments deficits, with agricultural exports growing at an annual rate of 10% by the end of the plan, and agricultural imports falling at 5% per year. To achieve these objectives the plan provides for investments equal to 9.6% of total productive investment in the social sector, somewhat lower than the 1/ The revised target for the 1983-85 period is likely to be somewhat lower than this, about 3.3%.  - 46 - combined contribution of both agriculture and agroindustry to social product. Overall, the plan represents a relatively optimistic view of agricultural production possibilities. While the technical coefficients (yields, conversion rates, etc.) implicit in the plan are not high in an absolute sense, they are well above current levels, and policy and organizational changes well beyond those currently set out in the plan will be needed to achieve these. The policy framework underlying the plan's targets is supposed to be elaborated in the social compact on the agroindustry complex for the 1981-85 period. Despite extended discussions through the course of 1980, 1981 and the first half of 1982, agreement on the content of this social compact has not been reached; however, the forthcoming working paper of the Stabilization Commission on Agricultural Development may present an agreed position. 7.09 Increases both in cereal production and in the quantities of cereals available for trading are crucial to the plan's objectives of reducing imports of wheat and increasing exports of maize. While total cropped area under grain could reach planned levels if prices were remunerative, the projected increases in yields are contingent on measures to increase the use of hybrid seeds and fertilizer by the individual sector and the necessary measures to achieve this have not been identified. The general expectation is that this will be achieved through increased association between individual and social sector producers. While there is some prospect of this occurring in the case of wheat, there is less likelihood in the case of maize, where the social sector does not have a direct interest in most of the maize crop, and is not therefore using manpower and resources directly to influence technology and input levels for the bulk of small farm maize production. Against the background of the present organization of production and policies for fostering technical change and marketed output, the plan's targets for cereal production and for exports may therefore be difficult to achieve. However, notwithstanding possible shortfalls in maize production (the primary feed base) the projected levels of meat and milk output are likely to be achieved. Planned production of fruits and vegetables ought also to be easily achieved, given past investments in these areas. In response to past overcapacity in agroindustries the new plan stresses modernization and reconstruction of existing facilities. While this strategy for the development of agroindustries is sound, the mechanisms for ensuring consistency in regional investment plans have still not been articulated. 7.10 A variety of constraints are likely to make achievement of the plan's agricultural exports targets difficult. In the case of grains, as noted, the main problems are likely to arise in domestic supply and procurement. In the case of sugar and oilseeds, domestic prices are above world prices and subsidies will be needed to stimulate exports. In the case of fruit, Yugoslavia is likely to face demand limitations in its traditional Western European markets and may need to direct output elsewhere, particularly to Eastern Europe. Similarly in the case of meat exports, a combination of demand and price difficulties will make sales to Western Europe difficult, and markets will need to be sought elsewhere. In general, the expansion of the EEC to include Greece, and perhaps later to Spain and Portugal is likely to inhibit the growth of agricultural exports to this market. Overall it appears that at recent exchange rates Yugoslav producer prices in agriculture for many products are above world prices, and in many cases subsidies will be needed to make exporting attractive.  - 47 - 7.11 Looking to the medium-run, it is clear that agriculture will continue to play an important economic and social role in Yugoslavia. The process of labor shifts out of agriculture will probably continue for the rest of the century. It is likely that in the long-run only a quarter of the present population will be supported by the land, in a commercial agriculture operated by full-time farmers who earn incomes comparable to those earned by workers in industry and services. Such a long-run equilibrium will also necessarily involve a much larger average farm size in the individual sector -- about 17 ha. instead of the present 3.2 ha. The long run framework therefore should encourage an increase in the average size of farms, by facilitating land acquisition and rentals. However there are clear limits to the speed at which labor can be shifted out of agriculture, particularly in a period of slow industrial growth, and in this prolonged transitional period the policy framework should aim at defining roles for the individual and social sectors which exploit their respective comparative advantages, raise efficiency through greater specialization, and make better use of the land resources available to Yugoslavia. 7.12 In general the individual sector's comparative advantage lies in livestock operations rather than cereal production and it is the former set of activities that should be particularly supported by official policies. However the land holdings of the individual sector and its contribution to both total cereals produced and traded makes it costly to ignore any opportunities available to raise yields even in this sector. The policy of providing support to cereals production through association with the social sector has not reached the vast majority of producers, and has resulted in considerably less application of fertilizer, or use of hybrid seeds, than is desirable. While the factors determining association with the social sector are not well-understood, it would be a pity if over-stringent rules of association were to inhibit diffusion of modern techniques to the individual sector since the costs paid by the economy as a whole in supporting inefficient producers are large. At the same time it is unlikely that much improvement in efficiency can be expected from part-time farmers in the individual sector, whose motivation is not usually commercial, and an effort should be made through fiscal and legal measures to encourage the development of full-time farmers in the individual sector. In the case of the social sector, its comparative advantage in extensive cultivation, agroindustry, and in certain high technology livestock activities (such as pig breeding and poultry production) is well established. The challenge here is to maintain pressure for efficiency at international levels, so as to minimize the need for subsidies for domestic consumption or for exports. Such efficiency is likely to be achieved only if a more competitive domestic environment can be achieved, and if economies of scale are achieved in the pattern of investment. The trend toward regional self-sufficiency and the consequent duplication of capacity runs counter to both these objectives, and must be reversed. Finally, even in social sector cereal production there is considerable scope for increasing yields, through a combination of increased fertilizer use and improved management.  - 48 - VIII. EMPLOYMENT 8.01 The rapid growth of social sector employment in the post-war period has facilitated a dramatic shift in the occupational structure of the Yugoslav labor force. The share of employment in low productivity private agriculture has fallen sharply and there has been a rapid increase in the proportion of more productive modern jobs in the industry and tertiary activities. In 1971 the social sector finally overtook private sector agriculture as the major source of employment. Nevertheless, in the early seventies this process of transformation was still incomplete: rural underemployment remained high; earnings and productivity levels in private agriculture were well below those in the social sector; and there were wide regional variations in the level of unemployment. Moreover, more than a million Yugoslavs had migrated abroad in search of temporary employment. Consequently, external migration played a significant role in ameliorating domestic unemployment problems. Yugoslavia's employment position was radically affected by the European recession, which followed the 1973-74 oil price increases. This sharply reduced the demand for Yugoslav workers so that net external migration, which prior to 1973 had made an important contribution to labor demand, became an added source of pressure on the domestic labor market. 8.02 During 1974 and 1975 more than a quarter of a million Yugoslav migrant workers returned to Yugoslavia and the number of registered job seekers climbed from 9% to 12% of the total labor force. This, added to the fact that almost one-third of the labor force was still engaged in agriculture, meant that employment issues became a source of increased concern for Yugoslav society. At the same time, however, in formulating the objectives of the 1976-80 plan, policymakers had to balance this concern for employment generation against the broader needs of the economy for a reorientation of domestic production to meet the goals of external adjustment. 8.03 As noted, the main thrust of the adjustment strategy was to emphasize the development of the relatively capital-intensive sectors of the economy, such as energy and raw materials production, which were not particularly conducive to employment generation. In addition, policymakers also opted for an improvement in labor productivity which was targeted to increase by 3.9% compared with a 2.1% rate of growth recorded during the 1971-75 period. The plan aimed to reconcile these two objectives with the goal of increasing employment opportunities by aiming for a 7.5% rate of social sector growth. This would enable the social sector to increase employment by 3.5%. Although this was below the 4.6% rate of growth achieved during the 1971-75 period, given the larger base it implied the creation of approximately the same number of new jobs as during the previous plan. An additional benefit of this strategy was that it was expected to provide more leeway for the social sector to establish a clear link between productivity and real incomes, so as to provide incentives which would encourage the more efficient use of total resources in the economy.  - 49 - 8.04 Over the 1976-80 plan period industrial employment grew at the same average rate as projected by the plan (3.5%). But nonindustrial employment grew more rapidly than planned, so that, in the productive sector as a whole, employment increased by 4.0%, or 0.5% faster than planned. This growth was generated by sharp rises in the rates of growth of employment in construction and in other productive services (which include financial institutions), communal services and specialized technical institutions, particularly in the middle years of the plan. In addition, employment in the trade and catering sector (which currently accounts for 13.8% of total social sector employment) also increased considerably faster than the target for nonindustrial growth. The only sectors where employment grew at rates significantly lower than the rate planned for nonindustrial employment were transport and communications and agriculture. The relatively slow rate of increase in the transport and communications sector was the result of declines in employment in the railway subsector, which was in the process of reducing its manning levels to more reasonably economic levels. The low rate of employment growth in social sector agriculture did not have an impact on the overall position, since it accounts for less than 4% of total social sector employment. In the nonproductive sectors, employment grew very rapidly in the first three years of the plan, and for the plan period as a whole grew by 4.2%. This exceeded the plan target by 0.7%, a slightly wider margin than in the nonindustrial productive sectors. 8.05 The growth of social sector employment was accompanied by a rapid increase in the social sector's capital stock.l/ During 1976-79 the level of fixed assets in the social sector increased at the same rate as in the previous plan (7.5%). In industry the capital stock increased marginally faster than during 1971-75. Among the nonindustrial sectors, there were significant declines in the rates of growth of fixed assets in construction and in trade and catering, but in the remaining nonindustrial productive sectors the capital stock grew at about the same rate as in the previous plan. Overall, social sector employment also grew at about the same rate as in the previous plan period, so that, as during 1971-75, the growth of social sector employment was associated with a continuous rise in the capital intensity of production. For the productive sector as a whole the level of real fixed assets per worker rose by 3.3% per annum during 1976-79 compared with 3.4% during 1971-75. In industry, however, capital intensity rose significantly faster, reflecting both the shift in the pattern of investment toward capital intensive subsectors such as energy, chemicals and basic metallurgical industries, and increases in the capital intensity of production in a range of other industrial subsectors. There were also significant increases in the rate of capital-deepening in both agriculture and transport and communications. In construction, trade and catering and in the other productive sectors group there was a decline in the rate of capital deepening compared to the 1971-75 period, but here again the capital intensity of production continued to increase at rates of between 2.1 - 2.6%. 1/ These data refer only to the level of fixed assets which are actually in full production; incomplete investment projects are excluded.  - 50 - 8.06 Thus the growth of social sector employment was supported by a significant increase in the productive resources at the disposal of the work force. This capital stock growth provided the social sector work force with a strong base for achieving the increases in labor productivity and real personal incomes planned for the 1976-80 period. Unfortunately, however, although the social sector attained its employment target in industry and surpassed the employment growth targets for both the nonindustrial productive sector and the nonproductive sectors, it was less successful in achieving its labor productivity and real personal income targets. During the 1976-80 period, the growth of labor productivity moved fairly erratically from year to year in the economy. This is understandable given the fact that employment growth tends to be more stable tlhan output growth in Yugoslavia. While it might be expected that social sector enterprises would attempt to smooth out the impact of the swings in the growth of labor productivity on real personal incomes, it is difficult to discern such a pattern. In fact, in absolute terms real incomes fluctuated more widely than labor productivity during the 1976-80 plan. In industry, personal incomes grew at annual rates of between 6.3% (1978) and -5.9% (1980) while labor productivity grew at annual rates ranging between 5.0% and 1.3%. Similarly in the productive sector as a whole incomes also moved more erratically than labor productivity. Although as with the industrial sector, the highest and lowest increases in both labor productivity and real personal incomes occurred in the same year, there is also a rather low association between annual changes in labor productivity and real personal incomes. Consequently, it is reasonably fair to say that at the macroeconomic level the social sector failed in its objective of establishing a closer link between changes in productivity and real personal incomes. 8.07 This outcome not only ran counter to the ideological thrust of the self-management system under which, collectively, enterprises were expected to furnish the bulk of the savings necessary for financing their investment programs from their own resources, but was also a serious strain on the overall economic system. Enterprise liquidity was seriously eroded by simultaneous increases in real wages in exc,ess of labor productivity growth and increases in real investment in excess of enterprise savings capacity. These developments sharply increased the dependence of the enterprises on financial credits mobilized through the banlking system. Unfortunately, however, there was insufficient domestic savings available in the economy to finance the level of investment demand. This resulted in slowdowns in project completion rates, investment bottlenecks and other difficulties which tended to weaken the basis for sustained growth in the economy. 8.08 In 1979 there was a marked reversal of income and productivity trends, as enterprises attempted to rebuild their liquidity and raise their savings levels. Social sector real wages increased by only 0.8% in the productive sector while labor productivity increased by 2.6%. As a result of stabilization efforts in the nonproductive sector, real personal incomes declined by 0.7%. Even these efforts were insufficient to bring the level of social sector savings into line with the level of investments, however, and the economy was still characterized by an excessive imbalance between investment and savings. In 1980, as credit restrictions in the economy were  - 51 - tightened and inflation accelerated, enterprises reacted by reducing real personal incomes by 7.3% in the productive sector. These were complemented by sharp curbs in real expenditures in the nonproductive sector which, in addition to curbing investment, resulted in an 8.5% decline in real wages in this sector. 8.09 As a result of the declines in real wages during 1979 and 1980, the growth of real personal incomes was brought more closely in line with the average growth of labor productivity in the economy. Over the course of the plan, average real personal incomes rose by 1.6% while labor productivity rose by 2.6%. By way of comparison, during 1971-75 personal incomes and labor productivity increased by 1.4% and 2.1% respectively. In the industrial sector during the 1976-80 plan, labor productivity growth averaged 3.5% while personal incomes increased by only 1.3%. During the 1971-75 plan industrial labor productivity increased by 2.8% and real personal incomes rose by 1.3%. 8.10 The lessons which emerge from the pattern of social sector employment growth during the 1976-80 plan are fairly clear. First, although Yugoslavia had an explicit target of maintaining the rate of growth of real personal incomes within the limits set by the growth of labor productivity, at the macroeconomic level there was a significant breakdown in this policy during the first three years of the plan. This resulted in a squeeze on the ability of enterprises to finance their investment programs. At the same time, enterprises sought to attain the goal of increasing labor productivity and real wages by embarking on capital intensive projects. In tandem, these forces created an unsustainable demand for investable resources on the part of the economic sectors in the economy which, when coupled with the rapid increase in noneconomic investment, generated the macroeconomic imbalance discussed in Part I of the report. Private Nonagricultural Employment 8.11 Although the private nonagricultural sector is not a major source of employment in the economy, policymakers in Yugoslavia have made a significant effort, particularly in recent years, to stimulate the growth of employment in this sector. For the 1976-80 period employment was planned to rise at an average rate of 4.3% compared with 3.7% during 1971-75. In support of this target, the authorities introduced a number of measures to encourage the development of small scale enterprises (SSE) 1/ in both the manufacturing and service sectors of the economy. During the past plan, however, employment in the individual nonagricultural sector did not grow quite as rapidly as planned. The Federal Institute for Planning estimates that employment rose by 2.2%, generating an additional 42,000 new jobs in the economy. In part the rather sluggish growth of this sector may have been due to the fact that fewer migrant workers returned to Yugoslavia during 1976-80 1/ These are reviewed in detail in the World Bank report Yugoslavia: Small Scale Industry and Industrial Policy, Report No. 3452-YU, August 28, 1981.  - 52 - than projected by the plan. Many of the regulations introduced to promote the growth of SSE were directly aimed at encouraging returning migrants to use their accumulated savings to set up new businesses. Since fewer migrants returned than expected, this presumably had a negative impact on the rate of new business formation. 8.12 In addition, however, part of the reason for the slow growth of employment in the sector is the relative novelty of the new policy measures. It will take some time before potential investors in SSE become familiar with the practical operation of the new policy framework. In particular, communal authorities need to demonstrate their ability to win the confidence of and cater to the needs of small enterprises, and to simplify their procedures for granting permits to investors in this sector. As experience is gained with the new regulations, however, they may provide the basis for a more rapid expansion of employment and production in this sector than achieved during the 1976-80 plan. Certainly, there is a significant potential for employment growth in the individual sector, both from the formation of new enterprises and more especially through the expansion of existing businesses. At the present time the average individual enterprise has only 1.1 employees, although according these firms may operate with up to five employees. If these small businesses can be encouraged to expand beyond their present size they could therefore make a significant contribution to the level of employment in the economy. 8.13 The strong growth of social sector employment, together with the more modest growth in the individual nonagricultural sector, enabled Yugoslavia to absorb a high proportion of the labor force released from agriculture during this period. In the absence of information from the 1981 census, estimates of the agricultural labor force are tentative, but it is likely that the private sector agricultural labor force declined by about 7% per year during the plan. Consequently, by the end of the plan only about 24% of the labor force were employed in full-time agriculture compared to 35% in 1975. At the same time agricultural output rose by about 2% per year, so there was a strong rise in average labor productivity in the sector. In addition to improving the overall composition of total employment, the continued reduction in the level of agricultural employment has been accompanied by a rapid increase in the level of real personal incomes of the farm workers who remained in agriculture. During 1976-80 real net personal incomes per active worker in agriculture rose at an average annual rate of 8.4%. Real income growth was not quite as swift during the last plan but, nevertheless, increased at an average annual rate of 4.8%. This was a significantly higher rate of real income growth than recorded in the social sector in both periods and therefore resulted in a substantial further narrowing of relative income differentials between individual sector farmers and workers in the social sector. Over the plan period the personal incomes of private farmers increased from 46% to 56% of the social sector average. Nevertheless, this income differential when coupled with the various other benefits accruing to social sector employees continues to fuel the demand for social sector employment, particularly amongst young people.  - 53 - 8.14 The wide divergence between social sector earnings and agricultural incomes has exerted a profound influence on the development path of the economy. First, it has generated enormous social pressures to expand employment opportunities outside agriculture. Second, it has tended to bias the pattern of investment choices in the economy toward capital intensive technologies and sectors. In addition, the bias toward capital intensive investments has been reinforced by the sectoral priorities of both regional and national plans which have given precedence to the development of the capital intensive sectors of the economy. In order to satisfy the demand for employment, the economy has had to maintain a substantially higher investment rate than would be called for if labor intensive industries had been more stressed. Acting in tandem these two forces have generated an enormous demand for investment in the economy, which despite the country's impressive savings performance, has tended to outstrip the available volume of savings in the economy. Thus while Yugoslavia has simultaneously succeeded in rapidly transforming the occupational structure of its domestic labor force, it might be argued that a policy of restraining the growth of real incomes in the social sector coupled with a greater emphasis on light industry and low cost employment generation in the nonindustrial sectors would have enabled the country to achieve this transformation more rapidly or at a lower cost in terms of investment resources. For example, as a recent World Bank economic report pointed out, 1/ between 1971 and 1978, over 50% of the industrial jobs in the economy were generated in six labor intensive branches of Yugoslav industry: leather, footwear, finished textiles, furniture and wood products, electrical products, machinery and metal fabrication. These activities, however, absorbed only 20% of net industrial investment. By shifting the composition of investment toward such products, Yugoslavia could have significantly increased the employment impact of each unit of investment while curbing the level of overall investment in the economy. Migration 8.15 Although one of the assumptions of the plan was that the number of Yugoslav migrant workers would decline by a further one half million, most of the shake-out of Yugoslav migrant workers was over by 1976. In 1976 70,000 workers returned, but as the economic situation in Western Europe gradually improved, the rate of repatriation of migrant labor slowed considerably and during the last three years of the plan the number of returnees averaged only 15,000 - 20,000 workers annually. Consequently, the impact of the decline in the demand for migrant workers was much less severe than expected. Preliminary census data suggest that most of the returning migrants returned to the more developed parts of the country where the unemployment situation was less serious. 8.16 As a result of the slowdown in net migration flows, Yugoslavia's domestic labor force increased by only 1% per annum compared with an implicit plan assumption of almost 2%. This, coupled with the faster than projected employment growth had a favorable effect on the overall employment situation. Nevertheless, the number of registered job seekers climbed rapidly over the course of the plan and the ratio of registered job seekers to the social sector labor force increased from 12.5% in 1975 to 13.9% in 1980. 1/ Raising Productivity in Yugoslay Industry: Some Issues, ibid.  - 54 - Although there is no precise way of linking this increase to the level of open unemployment in the economy, it is fairly likely that there was some rise in open unemployment, particularly amongst workers under the age of 30. The evidence suggests that this increase is linked to the structural shift in the distribution of households toward urban and away from rural activities. Thus the release of agricultural labor in Yugoslavia may be stronger and more persistent (i.e. less dependent on the growth of nonagricultural employment) than Yugoslav planners have tended to assume. This has important implications for the next plan period, because it seems to imply that a slowdown in the pace of employment creation may have a more severe effect on the level of unemployment than envisaged. 8.17 In contrast with external migration flows, internal migration has not played a significant role in alleviating regional imbalances in the domestic labor market. This low degree of labor mobility is the product of complex social and economic factors. The linguistic, ethnic and cultural differences between Yugoslav peoples tends to reduce mobility between regions and the pattern of economic incentives does not favor job search activities in other regions. In general the differential between social sector incomes in the various regions of Yugoslavia is quite modest; this factor coupled with the high costs of searching for employment in other regions (foregone income, housing costs), and the low probability of quickly finding a job in another region has meant that the economic environment within Yugoslavia has not been particularly conducive to internal migratory flows. As a result the labor market has remained largely segmented along regional lines, and there are marked differences in the level of unemployment and employment between regions. Although there are still significant pockets of unemployment and underemployment in some of the more developed parts of the country, Yugoslavia's underemployment problems are becoming increasingly concentrated in the less developed regions of the country (the LDR). On average the ratio of registered job seekers to social sector employment in the LDR is almost double that of the MDR. In the LDR structural underemployment in agriculture and high rates of labor force growth pose an enormous challenge to economic policymakers to create new jobs at a rate which keeps pace with the demand. 8.18 It is clearly unrealistic to expect that increased internal mobility would by itself resolve the problems of imbalances in domestic labor markets. But given the emerging labor shortages in some of the MDR, there is a case for a more coordinated approach to employment planning that would facilitate the interregional mobility of labor. At the same time, given that labor mobility is likely to remain low there is a case for embodying a much stronger employment focus in Yugoslavia's development strategy, particularly in the LDR. Labor Market Prospects 8.19 The medium-term outlook for the Yugoslav economy is one of slower growth as compared to the rates recorded in the 1976-80 plan period. Against this background the plan sets a lower target for social sector employment growth (2.5%) than recorded during the last plan (4.0%). Even at this reduced pace, however, the share of social sector employment in the  - 55 - total labor force is expected to rise from 60% to 67%. This is comparable to the level attained by Croatia -- Yugoslavia's second most developed republic -- in 1980. Two factors will help in easing Yugoslavia's employment situation: a projected slowdown in the growth of the labor force, and the likelihood that the external demand for migrant workers will stabilize at its current level. This means that external migration is unlikely to be a source of added pressure on the domestic labor market in the medium term. 8.20 On the other hand, the plan implies that the agricultural outflow will slow considerably during the next five years. However, it is likely that the shake-out of the agricultural labor force will continue at a rapid pace. Given the unpredictability of the agricultural outflow it is difficult to make a reliable estimate of the level of future unemployment in the economy, although it could well be higher than assumed by the plan. This could mean that the numbers of registered job seekers may not decline as rapidly as forecast by the end of the plan and may even rise in absolute terms. Nevertheless, even with a slowdown in the rate of social sector employment growth Yugoslavia should continue to make some progress in resolving its structural unemployment problems. 8.21 Given the projected rate of growth of the economy over the medium term, Yugoslavia is faced with the difficult choice of either reducing the rate of social sector employment growth or accepting even slower rates of labor productivity growth. At the same time, there is little scope for increasing real personal incomes during the plan. It will not be easy to restrain real personal incomes for such a long period particularly given the declines in real incomes which have occurred in both 1979 and 1980, but the alternative would be to forego the hard won improvements in enterprise savings levels which have been achieved since 1979. In turn this implies that Yugoslavia will have to maintain fairly strict limits on the growth of nominal personal incomes or there may be a resurgence of inflationary cost push pressures which could make the process of macroeconomic adjustment more difficult. 8.22 With the exception of Kosovo, the planned regional rates of social sector employment growth should be sufficient to accommodate the demographic increase in the labor force and allow for some reduction in the pool of unemployed and underemployed labor. There is also some scope for internal migration from the LDR to the MDR. But the impact of these flows on the relative level of employment and underemployment in the rest of Yugoslavia is unlikely to be very substantial. Consequently, the basic solution to the problems of unemployment and underemployment in the LDR will continue to rest in the accelerated development of the LDR. By their nature these problems are incapable of resolution in the short term but can only be resolved over a much longer span. In this context one of the major challenges facing the Yugoslav economy in the eighties will be to develop a consistent set of policies which will favor the efficient development of labor intensive activities in the LDR. In some instances this will involve the relocation of certain activities from the MDR to the LDR. But given that many of these industries are likely to continue to expand in the future it may also be achieved by aiming for faster growth of such labor intensive industries in the LDR relative to the MDR.  - 56 - IX. REGIONAL DEVELOPMENT ISSUES 9.01 There are pronounced differences in the degree of economic development of Yugoslavia's constituent republics and provinces. On average, per capita output in the MDR is currently just over double that of the LDR. At the extremes, the level of economic output (GMP) per capita in the most developed region (Slovenia) is over 6 times that of the least developed region (Kosovo). These regional differences are deeply rooted in the historical origins of modern day Yugoslavia. One of the basic goals of postwar economic policy has been to promote a faster rate of economic growth in those parts of the country which have been defined as less developed regions. The aim of this policy is the alleviation and eventual elimination of the inherited differences in regional levels. Given Yugoslavia's multinational composition, regional differences in economic development are a sensitive issue and government policy has consistently sought to promote economic development in all regions of the country. 9.02 Given the extent of these differences in regional development the reduction of regional disparities is inherently a long-term process. Viewed within this longer-term perspective it is clear that Yugoslavia has made significant progress in promoting the development of the LDR. Every region of the country has paticipated in Yugoslavia's rapid postwar growth. Modern industrial and tertiary activities have expanded and spread across the country, there has been a sharp increase in real incomes and even the least developed parts of the country have been transformed into modern, industrially based communities. Until 1970, this growth was accompanied by a widening of disparities in GMP per capita. Since then, however, with the important exception of Kosovo, regional disparities have stabilized. Since 1965 the rate of economic growth in the LDR has virtually matched the average for the MDR. But higher rates of population increase in the LDR have diluted the benefits of economic growth in these regions and have accounted for almost the entire difference in growth of GMP per capita. 9.03 Yugoslavia devotes a considerable proportion of its national income to the development of the LDR. In the last plan period regional resource transfers were equivalent to almost 3% of Yugoslavia's total GMP and represented an inflow equivalent to about 11% of the LDR's GMP. The main conduits for regional resource transfer are the resources provided by the Federal Fund For the Development of the Less Developed Republics and the Autonomous Province of Kosovo ("the Federal Fund") and support provided by the federal budget to the budgets of the LDR. The Federal Fund provides low cost, long-term finance for investment projects in the LDR. During the last plan period resources provided by the Federal Fund accounted for over 18% of LDR investment. Budgetary support is used to help finance the provision of social services in the LDR. 9.04 Household budget surveys show that the differences in household per capita income are much narrower than GMP per capita figures might suggest. For example, GMP per capita is less than one third of the  - 57 - national average in Kosovo, but household per capita incomes in Kosovo are closer to one half the national average. In the other LDR, household per capita incomes are also closer to the national average than GMP per capita. At the other end of the scale, in Slovenia, where GMP per capita is about double the national average, household incomes are only about 60% higher than the Yugoslav average. The main reason for this is the high level of interregional resource transfer which takes place within Yugoslavia, as mentioned above. In addition, remittances from migrant workers abroad (and to a lesser extent from relatives in other parts of the country) further boost household incomes in the LDR. 9.05 In 1978 per capita household incomes in the LDR were equivalent to about 75% of the national average; in the MDR per capita household incomes were about 25% higher. Household sizes are much larger in the LDR than the MDR. However, the number of active family members per household is fairly similar in both groups of regions. This is largely a reflection of the higher birth rates in the LDR which means that the proportion of the population of working age in the LDR is considerably lower than in the MDR. In 1980 41% of the LDR population was under 20 years old while in the MDR only 28% of the population was under 20. Interregional differences in the per capita incomes of nonagricultural households are significantly lower than the average. This is because most of these households are employed in the social sector where interregional wage differentials are quite narrow. The main reason for the interregional differences of incomes in this socioeconomic group are the variations in family size. This fact is particularly important in explaining the below average level of incomes of nonagricultural households in Macedonia and Kosovo. 9.06 There are also significant variations in the incomes of agricultural, mixed and nonagricultural households. Incomes in the agricultural sector are considerably lower than among the mixed and nonagricultural households. Within regions, agricultural incomes are between 45% and 65% of those of nonagricultural households. The poorest socioeconomic groups are the agricultural households in the LDR, where per capita incomes range between 35% and 59% of the national average. Agricultural incomes are also considerably below average in Serbia and Croatia. In Slovenia and Vojvodina, however, the agricultural incomes are very close to the national average. The higher level of agricultural incomes in the MDR reflects the fact that the social transformation of these regions has gone further than in the LDR. In the LDR a higher proportion of the population is engaged in agriculture. Farm sizes are generally larger in the MDR and agricultural households are smaller. In the MDR, farms are frequently operated by elderly people who may have additional sources of income such as a pension. On the other hand, farms are a much more important source of livelihood for younger workers in the LDR who have more limited opportunities for nonagricultural employment. Thus in terms of relative poverty, the greatest and most intractable problems are found among the agricultural households of the LDR. 9.07 In Yugoslavia, regional policy is a more significant aspect of overall development policy because, under the self-management system, the individual republics and provinces are responsible for their own economic planning. In addition, each region has a far greater range of policy tools  - 58 - at its disposal than are usually available in other countries. In effect, the national development strategy consists of an aggregation of regional plans. Moreover, the responsibility for plan implementation has also been largely delegated to the regions; each region has significant scope for the discretionary use of such economic policy instruments as credit allocation, fiscal policy and foreign exchange allocation, in order to achieve its goals. Thus regional policy is perhaps a more pervasive influence on national development in Yugoslavia than in any other country. 9.08 In many respects, the productivity of LDR social sector enterprises falls far short of that attained in the country as a whole. With the exception of Macedonia, the capital-output ratio in the LDR is higher than the Yugoslav average. This is most pronounced in industry, because of the concentration of LDR production in basic industrial subsectors; however, the capital-output ratio for social sector production is also higher than the Yugoslav average. This means that the average productivity of capital use is lower in the LDR than in the MDR. At the same time, again with the exception of Macedonia, the capital intensity of production (as measured by value of fixed assets per worker) is higher in the LDR than in the MDR. Despite the higher value of capital resources at the disposal of the social sector work force in the LDR, however, labor productivity in the LDR is in fact below the Yugoslav average. Consequently, the more capital-intensive pattern of production in the LDR is not reflected in commensurately higher levels of labor productivity. Given that both labor productivity and capital productivity are lower than in the MDR, the total efficiency of resource use (i.e., total factor productivity) is by definition below that of the MDR. 9.09 This difference in productivity performance between social sector enterprises in the LDR and the MDR has important implications for Yugoslavia's regional development strategy, because it implies that the level of production in the LDR is falling short of the levels which might be achieved if LDR productivity levels matched those of the rest of the country. If the efficiency of resource use in the LDR could be improved, then the LDR might be able to increase the growth rates relative to the MDR and to make more substantial progress in reducing the gap between their incomes and incomes in the more developed parts of the country. 9.10 In common with the rest of Yugoslavia the pattern of LDR growth has been characterized by rapid increases in both capital inputs and employment in the social sector. The increase in social sector value added in the LDR was almost entirely attributable to the growth of capital and labor inputs. The contribution of total factor productivity growth (which may be thought of as capturing the effect of improvements in the technical efficiency of resource use) was very modest. During this period the LDR pursued what has been termed an "extensive growth path" requiring high levels of factor inputs in order to achieve increase output. Insofar as this extensive growth path has resulted in significant employment creation, this pattern has been appropriate, given the employment objectives of the LDR. As has already been noted, one of the basic goals of the LDR has been to expand social sector employment in order to reduce the proportion of their labor force engaged in low productivity private sector agriculture.  - 59 - The LDR have been extremely successful in expanding social sector employment opportunities and the growth of employment in this period has been a considerable achievement. At the same time, however, it has to recognized that this growth path has required a very high level of capital input and has been accompanied by a steady decline in the efficiency of investment. 9.11 The overall environment in which LDR social sector enterprises operate does not seem to have been especially conducive to improvements in the technical efficiency of production in the LDR. This is somewhat surprising since it would have been reasonable to expect fairly substantial improvements in the efficiency of production in the LDR as they gradually mastered the production techniques developed in more efficient regions. The analysis of the report suggests that the rate of technical diffusion (the pace at which the best practice techniques are transferred from one region to another) has been rather slow. As a result, the gap in the technical efficiency of production between the LDR and the best practice regions has in general been closing fairly slowly and in the case of some sectors has widened. Consequently, the LDR have been unable to reap the potential productivity gains which would follow from the successful introduction of the more efficient techniques developed in the best practice regions. 9.12 One factor which may account for the relatively slow pace of technical diffusion in Yugoslavia is the lack of nationally based enterprises. The experience of other countries suggests that transregional enterprises could play a significant role in disseminating technological expertise from one region to another. Efficient national firms have a strong incentive to transmit their technical expertise from one region to another, since this will raise productivity and incomes throughout the enterprise. When enterprises operate largely within the confines of a specific region the opportunities for this type of dissemination are significantly reduced. This problem may be further compounded by the regional character of the planning system. While the regional approach to planning carries with it many specific advantages including the opportunity to tailor the development process according to the needs and wishes of each region, there are also certain shortcomings in the system. One of the weaknesses of the system is the difficulty of meshing regional plans into a coordinated national development strategy which takes full advantage of the opportunities for regional specialization. As documented above, there is a tendency for each region to attempt to obtain the maximum possible benefit from intraregional linkages, and to plan production flows on the basis of regional self-sufficiency. This has in many instances led to a duplication of capacity and an erosion in the unity of the domestic market. Cumulatively the weight of such decisions has imposed considerable costs on the economy as a whole. 9.13 In general the lower technical efficiency of social sector production in the LDR is reflected in the financial results of social sector enterprises. Workers receive lower personal incomes while enterprise accumulation (savings) rates are lower than the Yugoslav average both in relation to total earnings and capital employed. These poor  - 60 - financial results are not necessarily an obstacle to the expansion of LDR enterprises, however, because of their favored access to subsidized investment credits. These credits constitute the major source of infant industry protection for LDR enterprises, since fiscal subsidies are not extensively used as an instrument of development policy. The dependence of LDR enterprises on capital subsidies may also be an important explanation for the strong increase in the capital intensity of LDR production. It seems likely that the pattern of fiscal incentives has reinforced the stimulus to adopt capital intensive production techniques and discouraged the use of labor-using technologies. 9.14 In the past the thrust of regional policy in Yugoslavia has tended to be almost exclusively aimed at regional resource transfers. The most striking feature of Yugoslavia's regional development strategy has been the absence of any formal "infant industry" policy, designed to protect some of the fledgling industries of the LDR until they are capable of competing effectively on the domestic market. There is no broad policy or consensus on the amount, type or length of subsidy which these industries should be given. In theory, new enterprises in the LDR and the MDR are exposed to the forces of domestic competition from the outset of their operations. In practice, however, new (and even well established) enterprises in both the LDR and the MDR are insulated to some degree from these forces. As bas been noted, each region possesses a powerful set of instruments which it can use to influence economic activity within its territory. Thus the absence of a formal infant industry policy has resulted in the growth of an ad hoc framework of protection which varies from industry to industry and from region to region. This ad hoc framework has tended to overinsulate enterprises from the consequences of their inefficiency and has not been conducive to the narrowing of interregional productivity differentials. 9.15 There is a strong case for developing a more explicit infant industry policy in Yugoslavia which would aim to provide a clear pattern of incentives that encourage the development of labor intensive industries in the LDR. This aim should be to tilt the balance of incentives away from subsidies on capital use toward incentives which stimulate the use of labor. In formulating any new infant industry policy the objective should be to narrow the relationship between financial and economic performance so as to provide a clearer picture of the costs of employing social resources in each activity. An attempt should be made to reduce the scope of investment subsidies and to place more reliance on fiscal incentives, which at a minimum, should be neutral with respect to factor use and which ideally would have a proemployment bias. 9.16 The decentralized character of fiscal policymaking has considerably increased the flexibility of the fiscal structure from the point of view of promoting regional development. So far, however, relatively little attention has been paid to ensuring that the individual policies of each region are harmonized in such a way as to maximize the potential that a regionally based fiscal structure offers for regional development. Each region has sought to develop a fiscal policy framework which addresses its specific economic policy objectives. As a result business conditions vary markedly from one part of the country to another.  - 61 - Yugoslavia has emerged with what are in effect eight separate and distinct fiscal systems. It is far from clear that the aggregate impact of these eight separate fiscal systems best serves either the national interest or the interests of the individual regions. This does not mean that the fiscal system should be unified in the sense that the structure of taxation should be equalized throughout the country. Rather the tax structure should be harmonized so that a fiscal structure can be developed which provides a clear impetus to the goals of regional development. The aim should be to provide a clear pattern of incentives that will encourage the healthy development of new industries in the LDR and will help these regions to solve their employment problems. 9.17 One of the new features of the 1981-85 plan is a restructuring of the finances of the Federal Fund to provide a greater encouragement to the formation of joint ventures between the MDR and the LDR. This is a positive development which should contribute toward stimulating closer economic cooperation between MDR and LDR enterprises. Indeed one of the most important contributions that the joint venture mechanism may have to offer is that such enterprises may play a significant role in helping disseminate technological and technical expertise from one region to another. It is too early to assess whether the new policy framework will be more successful in stimulating joint venture activity than previous policy measures. Nevertheless, there are encouraging signs of a renewed interest in joint venture activities on the part of the MDR. In the first year of the 1981-85 plan approximately 130-140 joint venture agreements projects were reportedly identified. A further 100 projects are said to be under negotiation. At the same time, a number of difficulties need to be surmounted before these potential projects can be transformed into practical investments. Many of these projects are still in their formative stage and may represent little more than project concepts at this point. It will take some time before these ideas can be transformed into realistic detailed investment plans. 9.18 The experience of the past year points to other practical difficulties which will need to be addressed if the joint venture mechanism is to attain its full potential. One of the most serious problems which is the financing of the foreign exchange costs of these projects. Under the current foreign exchange regime each region is responsible for controlling its foreign exchange expenditures within agreed limits. Consequently, when a joint venture project is identified, agreement must be reached on the responsibility of each region for contributing to the foreign exchange costs of the project. Consequently, if an MDR investor is required to contribute toward part of the foreign exchange costs of a joint venture he must first obtain agreement from the relevant bodies in the MDR to transfer foreign exchange rights to the LDR. This is an extremely complex task given the number of participants involved in this process and the current scarcity of foreign exchange for investment purposes. These difficulties multiply further if the project requires any imported inputs for production. Apparently, issues concerning the rights and responsibilities of each partner in the provision of foreign exchange have proved to be a major stumbling block in a number of projects.  - 62 - 9.19 Given that the financial returns to MDR investors in joint ventures are likely to be fairly uncertain (at least in the initial years of the project), most of the interest of the MDR has centered on the potential for increasing the production of energy and raw materials in the LDR. As such, many of these project ideas are based on capital intensive technologies with very high costs per job created. Relatively little attention has been paid to creating financial incentives which would encourage the MDR to invest for example in processing industries which take advantage of the LDR's existing capacities in basic industries. These projects would have a more favorable impact on employment, since the costs of job creation are much smaller in these industries. However, one of the difficulties associated with developing projects in these labor intensive activities is that despite the lower levels of personal incomes in the LDR, the LDR do not have a significant labor cost advantage over MDR enterprises. The lower level of personal incomes is offset by the lower level of labor productivity in the LDR, so that unit labor costs tend to be higher in the LDR than in the MDR. 1/ This tends to reduce the profitability of labor intensive industries in the LDR and discourage joint ventures in these areas. At the same time, joint venture projects have access to very favorable financing arrangements, since the cost of borrowing resources from the Federal Fund is negative in real terms. This access to subsidized capital significantly improves the expected financial return on capital intensive projects, since capital charges are an important cost element in these types of investment. Suggestions for Policy Reform 9.20 The joint venture policy represents an important step in the process of enhancing interregional coordination and lowering the regional barriers to capital mobility in Yugoslavia. As has already been noted, transregional enterprises could play an important role in the transmission of technical skills and experience from one region to another. They would also help in improving the marketing links between organizations in different parts of the country and therefore help to preserve the unity of the Yugoslav market. However, if the joint venture policy is to achieve its full potential Yugoslavia must develop a more cohesive regional policy which gives explicit attention to the problems of infant industries. Moreover, in view of the magnitude of unemployment problems in the LDR, particular emphasis needs to be placed on establishing an incentive framework which will provide more encouragement to the growth and development of labor intensive industries in these regions. 9.21 In many ways there is an intimate link between these broader regional policy considerations and the joint venture policy. This is because a regional policy framework which promotes the development of efficient industries--capable of competing on the domestic and international markets--will also be conducive to the formation of joint ventures. What is required is for the LDR and the MDR jointly to develop an infant industry policy which establishes a clearly defined set of rules for economic interventions and subsidies. The goal should be to ensure that economically efficient projects remain financially viable during their 1/ See Raising Productivity in Yugoslav Industry, pp. 24-26.  - 63 - initial years, but that any subsidies paid to an enterprise would be gradually reduced, so that after an agreed period the enterprise would be expected to operate without any subsidies. *This would provide a stimulus tor productivity growth and ensure that the enterprise would not remain an "infant", but eventually reach the productivity levels of other more mature enterprises. Such a policy would not only help in improving the productivity levels of LDR enterprises, but would also provide an incentive for MDR enterprises to invest in the LDR. If the MDR enterprises perceive that the economic policy framework is designed so as to help enterprises in the early and difficult years of a new investment and that it gives them an opportunity to earn a reasonable level of income from the project once these difficulties are surmounted, then they will be much more interested in joint ventures in the LDR. Thus a well balanced infant industry/regional policy is not only in the interest of the LDR, but would also be of benefit to the country as a whole. 9.22 While, on balance, the LDR have demonstrated an impressive capacity to generate new employment opportunities, the cost of this employment generation has been considerably higher than in the MDR. This problem largely reflects the decision of the LDR to develop capital-intensive sectors and the use of capital subsidies as an investment incentive. In view of the continuing unemployment problems in the LDR, and the lower rate of investment anticipated, there is a growing case for shifting the balance of development subsidies away from subsidies on the use of capital and in favor of subsidies on the use of labor in production. The resources of the Federal Fund which are made available to the LDR in the form of low interest loans contain a large grant element. This grant element is appropriate for interregional resource transfer but it is not usually desirable for this grant element to be passed on to LDR enterprises in the form of capital subsidies. Consideration might be given to increasing the charges on the use of these resources to sub-borrowers, and using the earnings from the interest rate differential for other developmental purposes along the lines used by the World Bank in its IDA credits. 9.23 In this connection attention could be given to using fiscal policy as an important component of an overall infant industry policy. Such a policy should be based on two principles. First, any fiscal incentives provided to infant industries should have a proemployment bias, or, at a minimum, should be neutral with regard to factor use. Second, there should be an explicit timetable for reducing the level of subsidies granted to the industry over time. A strong argument can also be made for reforming the fiscal structure so that the burden of taxation falls more evenly between the use of capital and labor in production in the LDR. The object could be to keep net personal incomes at their existing levels while reducing the level of gross personal incomes being paid. At the same time, as gross personal incomes are reduced, direct taxes on enterprise income would be increased at a proportional rate so as to maintain the overall revenue base. It would not be possible or even desirable to introduce such a radical reform of the tax structure overnight, particularly given the current situation where price controls are an important element in the overall counterinflationary policy framework. However, the aim should be to move gradually but purposefully in the direction over the remainder of the current plan and to consolidate these reforms in the next plan period.  - 64 - A Program for Kosovo 9.24 The economic position of Kosovo, which is the least developed region of the country, is considerably weaker than that of the other LDR. This fact is recognized by Yugoslav policymakers and, as in previous periods special efforts will be made in the 1981-85 plan to assist Kosovo in its development efforts. During the current plan Kosovo will receive over two-fifths of the development assistance channeled through the Federal Fund, and a similar share of budgetary grants for social services, even though it accounts for only one fifth of the population of the LDR. Despite considerable past efforts Kosovo's economic performance has been disappointing and the region's relative per capita income level has slipped steadily. In addition, Kosovo's unemployment problems, which have been exacerbated by a very capital intensive development path, have been a source of serious concern for economic policymakers. 9.25 These concerns are reflected in the current five year plan (1981-85) which calls for a shift in investment toward more labor intensive projects. However, given the magnitude of Kosovo's employment problems there is a strong case for buttressing these changes in investment strategy with additional incentives which would provide more encouragement to labor intensive activities. Specifically, consideration should be given to introducing a job subsidy program. Such a program would not only stimulate the expansion of existing labor intensive industries by improving their cost competitiveness relative to other regions, but would also encourage the development of labor intensive joint venture projects. Consequently, a job subsidy program would help in ensuring that joint venture projects would have a favorable impact on employment growth in the region. In addition, it would foster the right forms of managerial, marketing and technical cooperation with other regions which Kosovo must acquire, if it is to succeed in restructuring its economy in the direction of more labor intensive development. 9.26 Kosovo faces enormous challenges in reorienting its economy toward a more labor intensive development path. Most of its industry is based on capital intensive energy and raw material processing industries, such as the production of caustic-calcined magnesite, as well as coal, lignite and lead ore mining. Kosovo's output of light industrial products such as finished textiles, footwear, wood products and consumer durables is relatively insignificant. 1/ The technical efficiency of production in Kosovo is significantly below that of the other LDR, and any competitive edge which might stem from its lower personal income levels is generally more than offset by poor labor productivity. Kosovo lacks many of the skills necessary for producing light industrial products, and it will be difficult for the region to match the price and quality standards set by existing producers in other regions. Moreover, its local market is quite small, which means that, to be successful, these new industries will have to be capable of competing on the wider domestic market, where other producers are already well established. 1/ In 1980 Kosovo produced 3% of Yugoslavia's shoes, 2% of the country's knitwear and about 1% of Yugoslavia's output of furniture.  - 65 - 9.27 The joint venture initiative should be regarded as an important element in this strategy, since it will encourage the transfer of managerial skills to the province. But by itself the joint venture mechanism may be insufficient to provide the needed injection of technical expertise required. Thus, additional programs must be developed to train and develop Kosovo's future managers. In this respect Kosovo should consider launching a formal managerial development program in cooperation with enterprises in other regions. There are a number of enterprises in Yugoslavia which are well-managed by international standards. These firms, regardless of whether they become involved in joint ventures, should be encouraged to provide places for future managers from Kosovo in their organizations. This would permit a much more rapid expansion of the pool of skilled managers than might otherwise be possible, while increasing the exposure of the province to the managerial techniques adopted by the most successful enterprises in other parts of the country. 9.28 Kosovo's associated bank (Kosovska Banka Pristina) could play a more substantial role in the future development of the province. It occupies a strategic position at the center of the region's banking structure and deals with virtually all investment projects and project proposals in the province. As such it acts as a conduit for about 80% to 90% of all investment funds available in the Province. Despite its preeminent position in the financial system, however, KBP has so far played a relatively passive role in the generation of investment ideas. Given the province's desire to reorient its economy toward more labor intensive projects, and given the goals of developing joint ventures with enterprises from other parts of the country and of encouraging the growth of small-scale industry there is a clear case for establishing a body within KBP which could promote these activities. 9.29 Although the Yugoslav economy is unlikely to maintain the rate of growth recorded during the last plan, given appropriate policies, Kosovo should be capable of lifting its growth rate above the national average. But it will not be easy to achieve the 7% planned rate of growth in the face of a less buoyant domestic market and a sluggish international trading environment. The volume of resources being channeled into Kosovo over the plan could lay the foundation for a much better growth performance than the 3.2% rate achieved during the last plan. However, this will require more efficient use of investment resources than was exhibited in the past. Many of the large investment projects launched during previous plans have proved to be highly capital intensive and have yielded very poor results in terms of employment and production. This has offset many of the gains which might have been expected given the region's past investment effort. For the future, Kosovo is aiming to restructure its economy in favor of more labor intensive activities. This strategic reorientation must, however, be complemented by a comprehensive shift in economic policies which will promote the development of the labor intensive sectors of the economy. This would  - 66 - help provide the correct signals for the decentralized decision making of enterprises in the region, and thereby contribute to improving the productivity of investment and help in resolving the unemployment situation. Given a willingness to experiment with fresh approaches to the issues of managerial development and more appropriate factor pricing policies, Kosovo could emerge with a healthier more labor intensive industrial base. This would not only accord with the developmental needs of the region, but would also contribute to the balanced economic development of the country as a whole. X. ADJUSTMENT POLICIES AND DEVELOPMENT PERSPECTIVES 10.01 Despite a record of decisive and in many ways successful policy action by its predecessor in 1980 and 1981, the new government which assumed power in May 1982 continues to face a formidable and complicated task of economic management. The immediate, short-term challenges are to restore normalcy in the domestic environment, and to regain room for maneuver on the external front. At the same time, action needs to be taken to design a policy and institutional framework to ensure that the pattern of growth, once it resumes, is both more efficient and more sustainable than Yugoslavia's experience in the 1970s. The two sets of objectives interact with each other, in that the policies adopted in the first, transitional phase will have a powerful influence both on the timing and on the shape of the medium-term growth path that emerges. At the same time, policies that are desirable from a medium-term perspective (such as import liberalization) may not be feasible in the transitional period, because of external and internal constraints. Notwithstanding these constraints it seems reasonable to expect that Yugoslavia would be able to emerge from the transitional phase toward the end of the present plan period and be in a position to resume faster growth thereafter. 10.02 The analysis of Part I of this report pointed to certain deficiencies in the macroeconomic policy framework which were in large measure responsible for the difficulties encountered in the post-1979 period. These included inappropriate trade and exchange rate policies, which led to an increasing orientation toward production for the domestic market, inadequate control over aggregate investment, given the volume of savings available for financing, and the absence of sufficient incentives for efficient investment choice, given the multiplicity of structural and regional objectives that investment policy was intended to serve. While the interplay of these factors was responsible for the macroeconomic imbalance that became visible after 1979, they also contributed to declining growth in total factor productivity through much of the decade. Quite apart from the drain on national resources represented by this trend, its consequence has been to make segments of Yugoslav industry relatively high cost by international standards, and thereby less able to make the transition to an export orientation. Accordingly, the full adjustment facing Yugoslavia is likely to be lengthy, involving numerous changes at the plant and sector level. These changes are more likely to be made in a faster rather than slow growth environment; it is for this reason that a pause in growth, though essential in the short term, may be counterproductive if maintained for too  - 67 - long. This also implies that the medium-term policy and institutional framework should be put in place relatively quickly, to guide growth as soon as this can be allowed to resume. 10.03 Many of these views and perspectives appear to be shared by the various and numerous authors of the Long-Term Program of Economic Stabilization and its associated working papers. While the bulk of the analysis of the present report was completed before the documents of the Stabilization Commission were issued, those documents agree in most respects with the diagnoses presented here on the sources of Yugoslavia's current difficulties, and the path to be followed out of them. As noted in Chapter V, the credibility and efficacy of the Commission's program depends crucially on the speed and commitment with which the specific legislative and executive action needed to implement it are undertaken. These initial statements of the Commission nevertheless are impressive in their acceptance that the present situation requires radical and interconnected reforms and that piecemeal action will no longer suffice. The Commission has opted, with certain exceptions, for a greater use of product and factor markets and of international competition to induce greater efficiency in the Yugoslav economy. It has also drawn the links between such a program of action and issues of bankruptcy and frictional unemployment. What has not been addressed so far are the difficult implications of a market-oriented program of action for regional disparities in Yugoslavia, given the unequal levels of efficiency and productivity between the republics and provinces. Also not fully addressed to date are the problems of genuinely ensuring free flow of goods and investable resources throughout the economy, which must comprise elements of any comprehensive market-oriented blueprint. In the paragraphs that follow, an attempt is made to sketch such a program of reform, combining both transitional and structural objectives. In many respects this coincides with the program presented by the Stabilization Commission to date; in other respects this deviates from, or goes beyond that program. A. Stabilization and Trade Policies 10.04 The framework for macroeconomic policies in the transition period has been discussed in some detail in Chapter V of this report, and accords in many respects with the policy framework currently in place within Yugoslavia. The policy strategy described here is based on the view that restoring balance between the demand and supply of foreign exchange is the first priority and is a prerequisite for returning to an efficient medium-term growth path. As discussed, the elements of policy in this period should be to facilitate fast export growth by maintaining a consistent policy of realistic exchange rates, keeping growth in domestic demand in check, addressing bottlenecks in domestic supply, and dismantling the ad hoc quantitative restrictions that have emerged particularly since the foreign exchange crisis of 1979. The speed at which this liberalization can be accomplished will depend on other developments in the current and capital accounts of the balance of payments, including the pace of export growth which gets established, developments in oil prices and international interest rates, and Yugoslavia's access to capital markets. The aim should be to return to the structure of protection which is actually incorporated in Yugoslavia's trade legislation as soon this is possible. While there are  - 68 - reasons to feel optimistic on a better balance being struck between the demand and supply of foreign exchange before the end of the plan period, this process would be considerably assisted by the commitment to realistic exchange rate policies affirmed in the Long-Term Program of Economic Stabilization. Such a program of action would go far to establish a more neutral pattern of trade incentives in the economy and would greatly support the planned export effort. 10.05 This program of action would need to be supplemented by various additional measures. First, the mobility of foreign exchange across regional boundaries should be improved, with the medium-term goal of establishing a functioning and unified national market for foreign exchange. The ability to introduce such a market will become esier once a market clearing exchange rate becomes established. The problems involved are more political than technical, and the solutions must therefore be those that are found to be politically acceptable. 10.06 A second set of measures would aim for a decontrol of domestic prices as import supplies eased and as inflationary expectations subsided, so that the relative price shifts that exchange rate changes are intended to bring about can begin to make themselves felt. It is preferable to use incomes policies rather than price controls as the principal anti-inflationary tool in this period, since this would have less effect on the structure of relative prices; as noted in Chapter V, incomes policies in the short-term are likely to be more effective in curbing inflation if they are expressed as absolute nominal targets, rather than related to growth in enterprise incomes as has been the case in the past. While the latter mechanism has been successful in bringing about reductions in real personal incomes, it has only done so through the inflationary mechanism. More generally over the medium-term, ways will have to be found to keep growth in personal incomes in line with increases in productivity, difficult though this will be in a period of slow productivity growth; otherwise both the accummulation and the export targets of the stabilization program could be threatened. Related to this is the more general issue of aggregate demand policies. Given the slow growth of aggregate supply it makes sense to let additional demand emanate from the export sector. This would involve continued restrictions on investment expenditure particularly in the nonproductive sector. B. Investment and Financial Policies 10.07 The analysis of this report has indicated significant and continued weaknesses in a variety of aspects of investment policy which need to be addressed as a package. These are issues which have been contentious throughout the history of modern Yugoslavia and have been the object of numerous previous attempts at reform. At the macroeconomic level the problem has been to reconcile investment demand in periods of fast growth with the true possibilities of the economy, so as to prevent booms from degenerating into macroeconomic instability. At the microeconomic level the problems are those of reconciling the disparate objectives of the individual republics and provinces within an efficient whole for the country; to devise mechanisms which permit Yugoslavia to realize its priority investment objectives with  - 69 - efficiency and speed; and more generally to institute institutional mechanisms which encourage efficiency in investment choice, and which encourage savings to be directed to the highest yielding projects in the country. 10.08 At the aggregate level, the combination of negative real interest rates on borrowed funds, a protected domestic market and the absence of bankruptcy risk has made the attractiveness of investment to Yugoslav enterprises irresistible. The mechanisms that are supposed to hold these tendencies in check are the planning system (particularly in the case of priority investments) and the banking system (particularly in the case of nonpriority investments). The evidence suggests that both sets of mechanisms have been overwhelmed by the scale of the task they were called upon to discharge, and that they have lacked the institutional authority to make their decisions binding. In addition, the pervasive use of capital subsidies as a major instrument of investment policy, particularly (but not exclusively) in the LDR has had an adverse influence on the capital intensity of the investments undertaken. 10.09 Against this background a more active use of interest rate policies could serve to limit the flow of investment proposals to be considered by the banks and the planning system, in addition to the beneficial effects such a regime would have on improved efficiency of investment choice. A flexible use of interest rate policy could also provide the monetary authorities with a more discriminating countercyclical instrument with which to regulate investment instead of the credit rationing which is currently used. Such measures would be complementary to other mechanisms currently in use in Yugoslavia, including minimum requirements for self-financing of investment projects by firms and public authorities, and regulations governing consumer installment credit. While increasing the self-financing ratio may act as a curb on aggregate investment, it does so at the cost of reducing the mobility of capital among enterprises and regions; as such it is inadvisable to place total reliance on this mechanism for controlling investment demand. 10.10 A regime of generally higher interest rates (approaching 'real' levels, given anticipated inflation) would offer corresponding benefits on the deposit side as well, in that it would offer enterprises a yield-bearing financial alternative to their own investment, thereby reducing aggregate investment demand, and increasing the mobility of funds within the enterprise sector. At the same time higher capital charges would supplement existing amortization (depreciation) payments as an additional mechanism for resource mobilization from the enterprise sector, bringing saving and investment more closely into line. Additionally, higher interest rates offered to the household sector could act as an inducement for them to direct their asset holdings waay from foreign exchange deposits toward dinar deposits. This would, over time, reduce the 'overhang' of such deposits, which represent a contingent claim on the country's foreign exchange resources and which make the task of monetary management more complicated. For such a scheme to be effective it would need to provide a sufficiently high real yield to compensate, at the margin, for the lack of access to foreign goods and services that a dinar denominated instrument represents. Finally,  - 70 - appropriate capital charges would make it easier to devise equitable incomes policies, by nullifying the advantage that currently accrues to workers in more capital intensive branches. 10.11 An encouraging start has been made toward more active use of interest rate policies in 1982. In February the National Bank of Yugoslavia increased its rediscount rate on general purpose advances from 6% to 12%, while the business banks incresed the rates offered to households on their dinar savings deposits to a maximum of fifteen percent for a 36 month deposit. The rate on household dinar savings deposits has been further increased, to a maximum of 20% for 36 month deposits, effective October 1, 1982. While these steps are welcome, they would be strengthened in their effect if certain complementary actions were undertaken. First, there continues to be a substantial element of subsidy in the selective credit facilities offered by the National Bank of Yugoslavia for a multitude of priority purposes, a subsidy which is passed on to the final user of the funds. While these are usually provided for short-term uses (such as shipping credits for exporters) rather than to finance investment, the element of capital subsidy is likely to have undesirable allocative effects, while the scale of these facilities makes the task of monetary management more difficult. It would therefore be desirable to review the scope of the selective credit mechanism to see if the purposes for which such credits are granted could be narrowed; at the same time the rediscount rate on these instruments ought to be brought more closely into line with the general rediscount rate of the National Bank of Yugoslavia. Second, while the increases in the deposit interest rates offered to households are helpful, it would be desirable to extend these provisions to the time deposits of enterprises as well, to facilitate mobility of savings within the enterprise sector and to offer an alternative to their own investment. 10.12 The impact of these higher deposit rates on the lending rates of banks has so far been deflected primarily onto loans for nonpriority purposes. However, the likelihood is that the share of priority investments in total economic investments will be higher in the next few years than it was in the recent past, even while the overall investment rate is reduced. For a regime of more realistic interest rates to have the desired effect on both aggregate investment and investment allocation, it is essential that priority sector projects also be exposed to more realistic pricing of capital. As was noted in Chapter III, priority sector projects were particularly prone to problems of capital misallocation in the last plan. In an environment of increasing capital scarcity, with an underlying objective of improving the competitiveness of the economy, there are obvious dangers involved in exempting the core sectors of the economy from any overall program of increased financial accountability. Accordingly, while it may remain appropriate to designate certain sectors for special attention, individual projects in these sectors should be subject to the same searching appraisals as projects in nonpriority sectors, and be required to pay the same cost of funds as other projects. The main benefit that should be accorded a priority sector project is continued access to funding, and such access to foreign exchange and foreign borrowing as the project in question legitimately needs, to insulate it from shocks, and to ensure that the priority projects get completed on time.  - 71 - 10.13 These considerations also apply to projects in the LDR financed by the Federal Fund. As argued in Chapter IX, the subsidy to capital provided by the resources of the Federal Fund tends to favor the choice of capital intensive projects over labor intensive projects. While it is entirely appropriate for there to be a flow of concessional resources to the less developed regions, there is much less of a case for passing this subsidy, as a capital subsidy, to the final investor. Instead, these funds should be onlent at market rates, and the differential used for other development purposes such as job training schemes, or, particularly in the case of Kosovo, employment subsidies on new investments. 10.14 Even with a greater reliance on a capital pricing mechanism to filter investment proposals, there remains the need for improvements in the institutional framework of investment choice noted earlier. The system of priority investments did not work satisfactorily in the last plan. It did not succeed in selecting the best projects, in protecting these projects against macro imbalance, or in rationalizing investment across republics in the priority sectors. This does not weaken the underlying case for having coordinated development of priority sectors, as Yugoslavia's experience with a completely liberalized investment allocation process in the early 1970s testifies. The effort must therefore be to find better ways of making the system work, both in planning and in implementation. 10.15 The current framework of planning, with its increasingly regional orientation, does not provide sufficient reinforcement for specialization or for the identification of potential economies of scale, thereby running the risk that even new investment will continue to be uncompetitive by international standards. A possible solution to this would be to have more direct competition from imports on the home market, but neither the current balance of payments situation nor the underlying characteristics of the Yugoslav economy make this a very realistic prospect at present. The planning system will therefore need to impose this discipline through its appraisal and selection criteria, by evaluating projects consistently across regions using international prices for inputs and outputs, and only accepting those which are shown to be competitive at international prices. The successful operation of such a system would require both coordination between the planning system (in framing criteria) and the banking system (in implementing them), and agreement among republics and provinces to abide by a uniform system. Steps toward implementing such a system have been taken in Slovenia and Croatia, where the objectives of the plan have been translated into specific criteria for appraisal of investment projects; even in these cases the scope of the appraisal could be made more comprehensive, and greater use made of international prices. A consistent national policy would require agreement on such criteria at a national level, and a mechanism for enforcing the results of such analysis. 10.16 Certain additional issues arise with the designation of priority sectors and priority projects in the 1981-85 plan. The general decision has been taken to complete ongoing investment projects from the last plan before proceeding with new investments. This decision should be taken on a case by case basis, with no necessary presumption that all projects must be  - 72 - completed; otherwise there is danger that the capital budget will again become overburdened, and will not be able to accommodate the more efficient export-oriented projects that the altered pattern of incentives is intended to produce. C. Institutional Reform 10.17 While the above program of measures will serve to correct the pattern of incentives facing enterprises in the economy, the actual responsiveness of enterprises to these stimuli will be greatly affected by the overall economic environment within which they operate. Partly as a response to the increasing ad hoc interventions that have been necessitated by the macro disturbances of the last few years, and partly in response to the drive for regional self-sufficiency, the financial accountability of Yugoslav enterprises has weakened, and the competitiveness of the domestic market environment in which they operate has been eroded. Both sets of outcomes have been inimical to efficiency and need to be reversed, to return to the model of self-management socialism that was originally conceived. A program of action designed to do this would need to be coordinated with the pricing reforms as described earlier, and in many ways would be a prerequisite for the success of those reforms. 10.18 As described earlier, the "Anti-Inflation Program" contains several proposals to restore financial accountability to the operations and decisions of enterprises. These include elimination of the automatic underwriting of business losses by banks and solidarity funds, obligatory cuts in personal incomes for loss-making enterprises, various forms of fiscal relief for a transitional period and re-election of workers' councils and management. As noted, the program also envisages the possibility of bankruptcy in extremis, if the various rehabilitation efforts are not successful. While the proposals in principle strike a reasonable balance between sanctions on the firm and its workers and sanctions on the community and allied institutions, the credibility of the program will depend on the consistency with which it is enforced. While this program of communal support is appropriate in a transitional period, the aim should be, over time, to elminate most of these avenues of relief, leaving only the fund for payment of personal incomes and reduced depreciation payments as the avenues open to the loss-making firm. While the anti-inflation program does assent to the principle that "unemployment benefits must be paid to redundant workers" the issue is wider than this. Many social benefits (including, most importantly, housing) for a Yugoslav worker are associated with his or her place of employment, and loss of a job involves loss of these benefits. It may therefore be necessary to reconsider the organization and funding of social services to reduce the disincentive to labor mobility that they now constitute; otherwise the political costs of the various measures being proposed to increase financial accountability will be too high, and the program will not be implemented. There will still be cases when, for economc or social reasons, a need for subsidization exists. In such cases the principle to be promoted is that subsidies should be explicit and provided ex ante, in preference to the absorption of losses ex post.  - 73 - 10.19 Put somewhat differently, given the widely different levels of development and productivity in the country, there is an inbuilt tendency for protection of the weaker industries in the weaker regions, and it is both more tempting and easier to do this through resort to market barriers rather than through explicit subsidization. However, as the analysis of this report has suggested, the overall costs of this response and the further complications that ensue are very high, and making the necessary subsidies explicit and finite is greatly preferable. D. Employment and Regional Development Policies 10.20 The policy choices facing the less developed republics and the province of Kosovo are likely to be even more complex than those faced by the national economy in the forthcoming period. The combination of reduced investment and slow national growth will make it more difficult to absorb the additions to the labor force. This will be compounded by their efforts to increase the productivity of the existing economic structure, to make it more competitive both with the industries of the north and in international trade. There is thus an urgent need to move the LDR on to a growth path which stresses efficient labor intensive development with more consistency and commitment than has been the case in the past, and a number of proposals to this end have been made in the last chapter. 10.21 The program of measures outlined for the national economy would help the economies of the LDR by reducing the cyclical oscillations of the economy, and by encouraging specialization according to factor endowment across the country. In addition the new joint venture mechanism should assist in the process of technical diffusion and managerial skills in the country. There remains a need however for a more formal interrepublican agreement on industrial policy, with explicit and finite subsidization of nascent industries and agreement on the creation of new capacities in the more labor intensive branches. The resources of the Federal Fund could be used more selectively in support of such a policy. Equally, such an agreement would facilitate identification of mutually acceptable and beneficial joint venture projects. 10.22 While a number of these remarks also apply to it, the case of Kosovo remains special and extremely disturbing, with its output levels stagnating, and its level of development falling further behind that of the other LDR. Special efforts will be needed to launch Kosovo on its new path of more labor intensive development. Thought should be given to use of the Federal Fund's resources for job subsidies on new investments. In addition a more aggressive promotional role could be played by KBP, the associated bank of the province; however, this will require some changes in its present organization and procedures. E. Concluding Remarks 10.23 The next few years are likely to be difficult ones for the Yugoslav economy, as for many middle income developing countries. An unsettled interational trading environment, uncertainties on availability of external finance and volatility in international interest rates considerably  - 74 - complicate the adjustment tasks facing Yugoslav policymakers. it is to their great credit that, having recognized the seriousness of the situation they have been willing to contemplate radical revisions in the framework of policy. It is understandable that, in seeking a major redirection of policy, the Yugoslavs have undertaken the widespread consultations characteristic of their system. It is now imperative to put the new framework of policies into place as quickly as possible, to establish their credibility internally and externally, and to capitalize on the mood of acceptance they have worked hard to generate. The Program of Long-Term Economic Stabilization and the Anit-Inflation Program are appropriate blueprints for the program of reform that an effective adjustment requires. Provided adequate support is provided by the international community, and the program is executed with commitment and consistency, Yugoslavia could emerge from the present crisis a much more efficient and flexible economy.  14' ~~~~~~~~~~~~~~~~~~~~~~~~~IBIRD 15675 A U 14' 2Rb A YUGOSLAVIA MAY 198 / REGIONAL DISTRIBUTION OF SOCIAL PRODUCT IN 1979 ri 0r A'd,pg H U N GA Ri Yn ;iing and manufacturing ~~~EGED ~~~~~Agriculture and forestry Major roads 46 0d '\R:O MAN I A -~Railroads Viro ~~~ti a0~~~ ,p- Se~nra 'ikinda .--- Rivers TRIEITf 0 evi Tf~~~~~~~~~~~~~~~~~~~~~~~~JM[l iARA ~ , Ports K 7 +~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~f Airports Sisa z _.~~~~~~~~~~~~~~~~--Repub~lic boundari'es Ogu in ov Vi~~~~~~~~~~~~~~n vu a ~~~~~~~- Autonomous province 6aundaries c ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~~ - -International bounare Plana i SCALE: MILLION DINARS PUI ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~300,000 abac.. ~~~~ LORADE 7C k va200,000 aspc ederevo 10O0OO B N I A ~~~~~~~~~~Sm. srvka Pa lanka 252,0000 Z.ni Ica No Prho . 44- 4~~~~~~~~~~~~~~~~~~~~~~~~~'Qza or~~~~~~~~~~~~~~~~~~~~~~~~~~4 / \ - ~~~~~~~~~SARAJEIVO Uiice Zj, 2 EEO RE \<S~SO A~ 'r uss Tia \ TIORD . f .. B U L G A R I A YUGOSLAVI (- .- W5.nkUOLVA t - otSffini A L BAN A MACED !'r Jf I1T A L 0' Th dULA I oo,n.t,on os.On5 d and the y5r9 ,\- A \< ~ { . \; do oo Wo pldd, anitsttffilitoths . SObrid Bilotla / Ti, Trhessair/nitik ~'' <tX ALe057 S E orVtecarptt0avvcsoftstunh@0f'5m nt 5) 20 tf