Yugoslavia - The challenge of adjustment (Vol. 1 of 2) : Main report

Report No. 6353-YU Yugoslavia The Challenge of Adjustment (In Two Volumes) Volume I: The Main Report July 10, 1987 Europe, Middle East and North Africa Regional Office FOR OFFICIAL USE ONLY Document of the Wbrld Bank This report 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 wi'thout World Bank authorization.  CURRENCY EQUWALENTS Currency Unit - Dinar (Din.) Currency Unit Calendar Year 1986 ' March 1987 US$1 Dinar 379.22 Dinar 532.48 Dinar 1 US$0.0026 US$0.0019 Dinar 1,000,000 US$2,636.99 US$1,878.00 WEIGHTS AND MEASURES Metric System. GLOSSARY OF ABBREVIATIONS AND ACRONYMS A/C Account BOAL Basic Organization of Associated Labor CIFER Communities of Interest for Foreign Economic Relations ELN External Liquidity Normalization FC Federal Council FEC Federal Executive Council FPA Federal Price Agency GDP Gross Domestic Product GSP Gross Social Prouct ICOR Incremental Capital Output Ratio IMF International Monetary Fund JRF Joint Reserve Fund LT Long-Term LTPES Long-Term Program of Economic Stabilization MLT Mediwu- and Long-Term MT Muddle-Through MYRA Multi-Year Rescheduling Arrangement NBY National Bank of Yugoslavia NC Non-Convertible NDA Net Domestic Assets OAL Organization of Associated Labor PPII Producers' Price Index of Industrial Goods RAP Republic and Autonomous Province SAL Structural Adjustment Loan SC Social Compact SDK Social Accounting Service (Sluzba Drustvenog Kujigovodstva) SMA Self-Management Agreement SPCs Socio-political Communities SVRN Socially Verifiable Reproduction Need YBA Yugoslav Bankers' Association FISCAL YEAR January 1 - December 31 Period average.  FOR OMCIAL USE ONLY YUGOSLAVIA THE CHALLENGE OF ADJUSTMENT This report is based on the findings of a World Bank economic mission which visited Yugoslavia in November 1985, followed by subsequent missions to update and discuss the report. The mission consisted of the following: Wafik Grais, Mission Leader Mansour Farsad, Deputy Mission Leader Fahrettin Yagci Frank Lysy lalal Jalali Gilles Michel Jan Svejnar Chandra Pant Manuel Hinds Jacob Yaron Mr. Gyorgy Szapary from the IMF also joined the mission. The draft report was sent to the Yugoslav Government officials in September 1986 and was formally discussed in April 1987. The mission is grateful for the support given to it by the Federal and Republican Authorities. The work of the mission was also facilitated by the support provided by the FSO in compiling statistical information. The mission wishes also to thank Arne Drud, Alexander Meeraus, Sam Pal and Marie Dieck Assad for modeling and computer support. Marissa Navarro had primary responsibility for document production. 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.  ArSTRACT This report reviews the responses of the economy and the authorities to the external shocks of the late 1970s and early eighties and to the pervasive inefficiencies that had crept in during the seventies. It looks first at developments in the 1970s (Chapter I) and then at the macroeconomic stabilization efforts initiated in 1980 (Chapter II). It points out how the external adjustment was attained at a cost of increasing internal disequilibrium, which was manifest in slow growth and accelerating inflation. Supply contractions were associated with credit accommodation, and the result was stagflation. Because of the intricacies and difficulties of the situation, the macroeconomic policies were not well-coordinated. The report next deals with the efforts to improve the efficiency of resource allocation, which were developed following the recommendations of the Long Term Program of Economic Stabilization (LTPES) (Chapter I'I). Key measures involved: (i) enforcing financial discipline at banks and enterprises; (ii) reforming the foreign exchange and trade regimes; (iii) improving investment selection; and (iv) freeing domestic prices. While the legal framework put in place to support those efforts includes positive liberalization steps, it also embodies some administrative interventionism that reflects compromises made in reaching consensus. Although progress has been made, much remains to be done to improve the way the economy allocates and uses resources. A third focus of the report is an assessment of the potential of the economy for growth in the period of the 1986-1990 Development Plan (Chapter IV). The analysis indicates that without policy reforms, the economy could muddle through, given a favorable external environment and a willingness of foreign creditors to refinance part of the maturing debt. The vulnerability to eventual shocks would, however, increase and it is not at all certain that the requisite foreign finance would be available. On the other hand, a decisive and carefully implemented package of reforms would yield improvements in productivity that would allow a robust recovery and sustained growth. The report includes a set of proposed policy actions that could lead Yugoslavia out of stagflation and on to a path of growth.  YUGOSAVIA THE CHALLEEGE OF ADJUSTMU TABLE OF CONIENTS Page No. Volume I: Main Report COUTY DATA SZ4WY AND RECOMM&NDATIONSo . . . . . . . . ........... . i-,di I. Growth Without Constraints. . . . . . . . . . . . . . . 1 A. The Early 1970s: Tension Between Adjustment and Growth . . . . . . . . . . . . * * . 2 B. The Seeds of a Crisis: 1976-1979 . . . . . . . . . 5 Appreciating Real Exchange Rate . . . . . . . . 6 Poor Trade Performance. . . . . . . . . ... 8 Factor-Intensive Low-Productivity Growth. . . . 10 Easy Financing. . . . . . . . . . . . . . . . 12 C. External Shocks and Economic Crisis . . . . . . . . 13 II. In Search of Stabilization without Adjustment Costs . . 16 A. Economic Performance 1980-1985: Drawn-Out Stagflation. . . . . . . . . . . . . . . 17 Resource Gap and Domestic Aggregate Demand. . . 17 Efficiency in Production. . . . . . . . . . . . 20 Unbridled Inflation . . . . . . . . .. ... 22 B. Hesitant Macroeconomic Management . . . . . . . . . 22 Containing the Growth of Domestic Demand. . . . 22 Shifting Resources to Exports While Controlling Importss . . . . . . . . . . . . . 31 Alleviating the Debt Service Burden . . . . . . 36 C. Economic Performance in 1986 . . . . . . . . o . . . 37 D. Evaluation and Recommendations. . . . . . . . . . . 38 III. Dealing with the Flaws in the Framework of Resource Allocation. . . . . . . . . . . . . . . . . . 41 A. Overview of the Reforms . . . . . . . . . . . . . . 41 B. Hardening the Budget Constraint . . . . . . . . . . 43 Channels of Financial Indiscipline . . . . . . 44 Implications of the Financial Indiscipline, . . 46 Policy Reforms. . . . . . . . . . . . . . . . . 49 Summary, Assessment and Recommendations . . . 51 C. Trade Incentives, Foreign Exchange Management and Resource Allocation. . . . . . . . . . . . . . 53 Distorted Prices and Market Segmentation: 1982-1985 . . . . . . . . . . . . . . . . 53 The 1986 Reforms . . . . . . . . . . 57 Evaluation and Recommedations .# . . . . . . 59  Page No. D. Investment, Planning and Capital Mobility . . . . 63 Overview. . . . . . . . . . . . . . . . . . . . 63 Recent Reforms. . .. . . . . . . . . . . . . . 63 Evaluation and Recommendations. . . . . . . . . 67 E-. Reform in Pricing Policy. . . . . . . . . . . . . . 68 The Pre-1985 Regime and Its Implications. . . . 68 The New Regime. . . . . . . . . . . . . . . . . 70 Implementation of the New Law . . . . . . . . . 72 Evaluation and Recommendations. . . . . . . 73 F. A New Drive Toward Restructuring. . . . . . . . . 73 Evaluation. . . . . . . . . . . . . . . . . . . 75 IV. Prospects for Recovery and Sustained Growth . . . . . . 76 A. Initial Conditions . . .. . ... . . . . . . . 76 The Debt Overhang . . . . . . . . . . . . . . . 77 The Macroeconomic Balance . . . . . . . . . . . 78 Inefficient Production and Trade. . . . . . . . 80 B. The Development Strategy. . . . . . . . . . . . . . 81 The Long-Term Program of Economic Stabilization. . . . . . . . . . . . . . . . . 81 The 1986-1990 Development Plan. . . . . * . . . 83 C. Medium-Term Outlook: The Temptation to Muddle Through . .. . . . . . . . . . . . . . . . 86 Outlook With and Without Structural ANdjustment .................. 89 Coping with External Shocks . . . . . . . . . . 91 TABLES I. 1.1 Effects of Changes in Nominal Domestic Demand as X of Changes in Nominal Domestic Demand (NDD). . . 2 1.2 Real Exchange Rate Against the US Dollar. . . . . 5 1.3 Decomposition of rhanges in the Current Account . 9 1.4 Relative Prices ................ 10 1.5 Trend in Labor Productivity and Real Personal Income per Worker, 1971-1979 . . . . . . . . . . 11 1.6 Currency Composition of M2. . . . . . . . . . . . 1' II. 2.1 Trade Performance, 1979-1985. . . . . . . . . . . 18 2.2 Growth of GSP and Final Demand. . . . . . . . . . 19 2.3 Efficier.Zy in Production, Selected Indicators, 1979-1985S. . . . . . . . . . . . . . . . . . . . 21 2.4 Structure of GSP, 1979-1984 . . . . . . . . . . 21 2.5 Value of Investment in Construction in 1983 by Year of Commencement, Social Sector. . . . . . . 21 2.6 Consolidated Revenue and Expenditures of the Public Sector . . . . . . 24 2.7 Credits of the Banking System ..25 2.8 Changes in Money and Credit Accounts of the Banking System. 27  - {iii - Page No. 2.9 Sources of Changes in Nominal Domestic Demand Shares of MI and K2 in GDP . . . . .. . . 28 2.10 Growth of Inter-Enterprise Credits. . . . . . . . 28 2.11 Comparison of Income Velocities of K2 and Its Components by Currency . . . . . . . . .. . . . 29 2.12 Growth in Personal Income per Worker in the Social Sector, 1979-1984 .... ,....... e X X a 30 2.13 Growth of Income in the Rousehold Sector. . . . . 31 2.14 Trends in Cash Export Incentives. . . . . . . . . 33 2.15 Relative Size of Cash and Exports . . . . . . . . 33 2.16 Growth of Export Credits.. . . . . o . . . . . . 34 2.17 Trends in Trsde Restrictions. . . . . . . . . . . 35 2.18 Index of Relative Price of Tradeable vs. Non-Tradeables . . . . . . . . . . s . . . . # . 35 III. 3.1 Arrears and the Long-Term Loan Portfolio Affected by Arrears of the Commercial Bauking System, '-981-1984 . . . . . . . . . . . . . . . . . . a . 48 3.2 Annual Profits of the Commerc.al Banking System, :981-1984. . . . . . . . . . . . . . . . . . . 48 3.3 Equity of the Commercial Banking Systems 1981-1984. . . . . . . . . . . . . . . . . . . . 48 IV. 4.1 Selected Debt Service Indicators, 1979-1985 . . . 77 4.2 Aggregate Resource Balance, 1984. . . . . . . . . 80 4.3 Macro Projections of the Plan . . . . . . . . . . 83 4.4 Grose Disbursements and Net Capital Outflow . . . 88 4.5 Trends in Selected Macroeconomic Indicators . . . 89 4.6 Estimated Trends in Selected Debt Indicators. . . 91 4.7 Impact of External Shocks on the Growth Rates of Selected Macroeconomic Indicators. . . . . . . . 92 FIGURES I. 1.1 GDP Growth Rates and Trade Balance. . . . . . . . 4 1.2 Real Effective Exchange Rate. . . . . . . . . . . 7 II. 2.1 Real Effective Exchange Rate Index. . . . . . . . 32 KP  - - cOuNITRY OAtA - YUGOSLAI 256,804 sq. ko. 23.1 million (mid-1985) 90 perons per sq. km. Rate of Growth (mid-1985): o.A8 POPULATIM CHRApSTKRITIS I liBEl1124 Crude Birth ute (per 1.000) 15.9 population pWr physician & dentist 492 Crude DOeattP Rte (per 1,000) 9.1 Population Aer hospital bed 151 nfant Noryality (per l,000 live births) - IEN= a SILRTTI elei ftSRS?fMOF ASDIULTURAL- LAnD O1mERSNIP 11841 X share of household Inme, lowest quintile 6.6 X osd by socigl sector 31.5 highst quintile 38.7 1 owutd by Individual sector 68.5 AC:Ess To PIm TER 119781 A 1S TQ [LECTI=IY Owellings with piped water (X) 40.5 x of all dwellins (1978) 89.0 Per capita Calorie Supply (1983) 3,575 Frlisfy school enrollment 18) 101 (19S3) (1411 of requirement) Sev.iary school enrollment (O) 82 (93) GrP PER CAITA IN 19R5: UU2.070 A/ GROSS DOMESTIC PROMUCT IN 198 S AVERAGE ANNUAL ZOF 1. egitant oreS GOP at Market Prices; 47.613 106.0 6.5 4.1 0.5 Total Consuzwtion 28,297 59.4 6.9 6.3 0.4 Gross D04sstic Investment 18.470 38.8 5.8 5.4 -1.7 Gross National Savings 19.303 40.5 6.2 3.2 -1.0 Exports of Goods and Nonfactor Services 14,203 29.8 6.7 5.2 5.0 Imports of Goods and Nonfactor Services 13,357 28.1 6.7 5.0 -0.5 OUTPU. LABOR MORC AND PRODUCVITY G3P at Cu nt factbor a/ fgre y.ue Added Per RA sidet Wert USS Hn- djL, __&_ U5E 11284 1 S/ -% Agriculture h/ 5,128 11.5 2.7 30.6 2.119 44.5 Industry c/ 20,474 46.1 2.9 33.0 6,310 132.6 Other l8,764 42.3 3.2 36.4 5,563 116.9 Total 44,369 100.0 8.8 100.0 4.757 100.0 laOVERET FINANCE. Consolidated. 1985 Consolidated Public Sector Receipts 12,910 Expenditures 12,770 Surplus -140 Ratio of Current Receipts to GOP at Narket Prices (X) 27.1 MONEY. CREDIT AND PRICES tin billions of dinars) Money Supply J/ (end-year position) 461.7 584.3 739.8 888.6 1,272.0 1,863.6 Honey Supply as X of GOP at market prices 25.6 23.3 22.8 19.9 18.2 - Bank Credit Total g/ 1,S64.3 1,919.2 2,370.0 3,176.0 4,710.3 7,031.6 Enterprises 1,232.1 1,519.8 1,891.8 2,665.1 4,088.3 6,211.7 Govermaent and other Social Sector 175.5 191.6 20S.0 203.4 206.7 233.0 Households 156.7 207.8 273.2 307.5 415.3 586.9 Price Indices (Annual Percentage Change) Industrial Producer Prices 27 45 25 32 * 57 82 Agricultural Producer Prices 36 53 35 46 49 56 Retail Prices 30 46 30 39 s7 76 a/ The per capita GNP estimate is at market prices, calculated by the sawe conversion teehnique as the World Bank Atlas. All other conversions to dollars in these tables are at the prevailing Period average exchange rate. b/ Includes Irrigation and forestry. L/ Panufacturing, mining, construction, electricity, gas and water. d/ Total active resident labor force, including unexloyed. a/ Due to the inclusion of the u'Imployed. these US$ values are under-estimated. fI Currency in circulation, demand deposits and float. gJ Short- and long-term credits. (OO35H)  Annual at C ice Ni illen) twom teat It) teAs 1a teal , *IMDW OF M.LA~~~E OP *AttUMlS