Yugoslavia - Current economic position and prospects (Vol. 3 of 3) : Memorandum on the economic situation

RLE Co Y EA162 ey ~~~~~~~~~~VOL. MAY 23. 1967 YUGOSLAVIA Memorandum on the Economic Situation 1. This memorandum is designed to supplement and bring up to date the Economic Report of September, 1966 (EA-162a). The Report EA-162a outlined the progress of the Yugoslav economy and the evolution of the Yugoslav system of economic organization over the post-war period. It described the Economic Reform of July, 1965 and the measures associated with it which constituted a further major step towards the creation of an economy guided by market forces. The Economic Reform 2. Though Yugoslavia had achieved a remarkable record of economic growth since World War II, by the early 1960's certain weaknesses in the structure and organization of the economy had emerged. The great emphasis given to the expansion of manufacturing had resulted in a distortion in the pattern of production, reflected in lagging output of agricultural products and raw materials and deficiencies in power and transport services. The author- ities had pressed industrial diversification to a point where in some sectors too great a range of products was produced in too small a quantity to be economic. Moreover, the diversity of production and the emphasis given to developing the capital goods industries required large investments if industry were to keep pace with advances in technology and remain competitive. It had become clear also that given the limited internal market the continued growth of the economy would in future require a greater emphasis on production for export. 3. While enterprises, operating under the system of workers self- management, had gradually been given greater autonomy and had been guided increasingly by market forces, government at various levels continued until the mid 1960's to be mainly responsible for certain major economic decisions, for example, decisions on investment, on the use of foreign exchange, and to a considerable extent on prices. This had resulted in an undue weight being given to political considerations, particularly in regard to investment decisions,which in turn had led to some misallocation of resources. 4. Thus, the Economic Reform and the measures associated with it were designed to achieve three major objectives: (1) to give still greater responsibility to enterprises and further limit the role of government in the economy by reducing the taxation of enterprises and leaving to them decisions on investment; (2) to correct by major price adjustments the long-standing distortions in the pattern of output; and (3) by devaluing the dinar, approximately halving customs tariff rates, and liberalizing imports and the foreign exchange regime to stimulate Yugoslav exports, to bring pressure on Yugoslav enterprises to increase their efficiency, and to integrate more closely the Yugoslav with the world economy.  - 2 - 5. The various measures in this process occurred over a period of several years. The major reductions in the taxation of enterprises occurred in 1964, the devaluation of the dinar and the principal price adjustments in July 1965, membership in GATT in August 1966, and the liberalization of imports and the foreign exchange regime in January 1967. 6. The impact of the Reform which began to be felt in 1966, will be felt more strongly in 1967. The role of government in the direction of investments has already been sharply curtailed. The reductions in taxa- tion of enterprises and the changes in relative prices have put agriculture and the industries producing raw materials and basic services in a strong financial position, even after meeting large wage increases in the second half of 1965. Although the effect on output of these changes in 1966 was necessarily limited, (agriculture, however, with favourable weather enjoyed a bumper year) the raw material and service industries were better able to undertake the required investments in new capacity. At the same time, the pressure brought to bear on producers of final products, whose prices increased much more moderately, stimulated them to increase their efficiency, to econo- mize in the use of labor, (industrial employment fell by 1% in the year) to bargain harder with suppliers and to give greater attention to export markets. Furthermore the required modernization and specialization in industry pro- gressed as indicated by the rising share of expenditures on new plant and equipment in total industrial investment (imports of capital equipment rose by a third in 1966) and by the growing number of agreements between enter- prises to concentrate on particular product lines. These trends will be strengthened as a result of the liberalization of imports and the foreign exchange regime in January 1967. The Growth of Output 7. Real output grew rapidly, by 8.6%, in 1966 due mainly to the record year in agriculture. Agricultural production is estimated at 18% above the level of 1965. The latter was a poor year, but the growth of output in 1966 was by "normal" standards exceptional. Production of wheat and corn rose by about 21% and 31% respectively above the 1963-65 average, and most other branches did well. This reflected unusually favourable weather as well as the application of additional inputs. Prosperity in agriculture and the rapid growth of tourism provided a stimulus to demand in industry, but fixed investment as a whole did not rise in 1966 (increased investment in mining and agriculture was offset by a decline in housing and social investment) and there were shifts in the pattern of consumer expenditures as well as a sharp rise in household savings. Industry proved less flexible in adjust- ing to demand changes than had been expected and imports of both capital and consumer goods rose sharply while exports increased much more slowly. As a result industrial output rose by only 4.3% compared with growth rates averaging 11% annually from 1960-65. 8. Real private consumption grew by about 5%, and in line with the objectives of the Economic Reform, public consumption declined by almost the same propor- tion. With the stability of fixed investment and a near balance on interna- tional transactions, the fast growth of output was reflected in a sharp increase in inventories, estimated to have risen by about 25% in the year.  9. Some part of the increase in inventories resulted from the rise in agricultural output, and these stocks will fall as agricultural exports proceed and in the normal course of consumption. Other stock increases resulted from the production of goods for which with changes in the pattern of demand there was no market at prevailing prices. By further credit restrictions in the early months of 1967, the authorities brought pressure on firms to clear excess stocks even at the cost of sharp price reductions. Prices and Wages 10. With the major price adjustments of the third and fourth quarters of 1965, designed to correct earlier price distortions and align prices to the extent feasible with international prices, producer prices of manufactured goods rose on average by about 15% (prices of materials rose by 18.5%, of consumer goods by 12% and of capital goods by 5.5%) while prices of agricultural products rose by a further 15% after increases totalling more than 60% in the preceding 18 months. Consumer prices measured by the cost of living index rose by almost 30% with particularly sharp increases in rents (63%) and fuel and light (55%). Since the end of 1965, with some exceptions, prices have remained relatively stable. Producer prices of manufactures rose by 2-3% and of agricultural products by little more than 4%, while the cost of living index rose by about 7% during 1966, with rents and prices of services increasing most sharply. Rents are to be raised further, eventually to an economic level, and while the price control authorities expect to make further adjustments to correct emerging distortions or to meet changes in international prices, the broad objective is to keep the rate of price increase in line with that among Yugoslavia's major trading partners. 11. Prices of about 90% of manufactured products were controlled after the Economic Reform, but at present about 35% of industrial and mine product prices are free, as well as prices of agricultural products and imports. Prices will be progressively freed when the authorities consider that domestic supplies are sufficient to meet demand and when imports can act as a check on price policies of domestic suppliers. Thus, the further freeing of prices will be linked partly to the progress of import liberali- zation. 12. The Government's policy was that the price increases in the second half of 1965 should be compensated by increases in wages, and enterprises in determining personal incomes kept within this guideline until about the middle of 1966. In line with the price changes of 1965, the assets of enterprises were to be revalued as a basis for determining depreciation provisions and the capital tax (see para. 23). The revaluation of assets was however not completed and made effective until the end of 1966. As a result of this delay, enterprises made "book profits" in 1966 which in some cases stimulated payment of increases in personal incomes in the second half of the year which the Government felt were excessive. Nominal  -14- personal incomes were more than 30% higher in the third quarter of 1966 than in 1965. Real incomes for the year are estimated to have been 12% higher than in 1965 while labor productivity rose by 8%. 13. With the revaluation of assets, the greater competition afforded by import liberalization and still more restrictive credit policies in the early months of 1967, there are indications that the rise in incomes has been greatly moderated. The Government's policy is that wage increases should be in proportion to productivity gains but it exercises no direct controls over enterprises in determining wage levels. Indirectly, however, the government can exert strong pressures on wages, partly through price control, partly by influencing the overall level of demand and partly by influencing the share of earnings which enterprises have to plough back. With the progressive removal of price controls, the government's influence on wage levels will diminish somewhat, but where monopolistic conditions exist a cQntinuation of price regulation by a public authority is envisaged. Banking and Credit 14. The banking structure and credit policy continued to evolve in 1966 in a manner consistent with the broad objectives of the Economic Reform. The earlier differentiation between commercial banks and investment and savings banks was dropped and in the new concept all banks are potentially able to perform all types of banking operations. The number of banks was roughly halved in the course of the year as banks amalgamated, and with the removal of the geographical limitation on operations the larger banks began to establish networks of branches. The process of consolidation is expected to continue. The eleven largest banks now conduct more than 60% of all banking business in the country. 15. Techniques of credit control were modified in 1966, with the emphasis changing from qualitative to quantitative controls. Whereas previously the regulation of short-term bank credits to enterprises had defined the conditions under which and the purposes for which the commercia'l banks could lend, with almost automatic rediscount facilities at the National Bank, from the end of 1966 the commercial banks have been given greater freedom in their lending operations while the National Bank will control the overall volume of credit by regulating its own lending to the commer- cial banks. The latter can borrow from the National Bank by rediscounting specified paper to a limit which is presently set at 15% of their sight liabilities (reduced from 20% in March 1967). Rediscounts above this limit may be granted only to finance exports. In addition, the National Bank is presently making available special credit facilities equal to the difference between the amount of credit extended to each bank at the end of 1966 and 20% of its sight liabilities. This special credit facility is a transitional arrangement; it has already been quite sharply curtailed and may eventually disappear. At that point, the principal instruments of credit regulation would be the reserve ratio (set at 35%, the legal maximum, since 1965) and the rediscount facilities, though credit ceilings on the commercial banks might also be employed. Besides varying the reserve  and rediscount ratios from time to time, the National Bank envisages changes in the types of paper to be discounted, thus securing a measure of control over the quality as well as the quantity of bank credit. 16. In January 1967, the commercial banks established arrangements by which banks with reserves in excess of legal minimum requirements could lend excess reserves to banks in "deficit". This is the first step in arrangements for inter-bank short-term lending and may well foreshadow the gradual evolution of more sophisticated instruments of a modern money market. 17. Regulation of investment credits from the banks is primarily in terms of defining the banks' resources which may be used for investment credits, the only specific regulation being that not less than 20% of a bank's investment resources should be used to finance permanent working capital. 18. A restrictive credit policy was followed in 1966, the 5% increase in short-term credits over the year being less than half that of 1965. Having regard to the growth in output and the increase in the price level compared with 1965, the expansion in short-term credit was very moderate. Even so, towards the end of the year the authorities felt that in view of the excessive build-up of stocks, credit had been granted too liberally, and further restrictions were therefore imposed in the early months of 1967. In the context of the stand-by agreement with the ITM of December 1966, the Yugoslav authorities agreed that short-term credits outstanding should not exceedD 43 billion during 1967, 8% above the level of December 1966. At April 30, 1967 the total outstanding was D 39 billion. 19. Following the reductions in taxation of enterprises and persons accompanying the economic reform, the banks are intended to play a major role in mobilizing the savings of enterprises and households and in channeling savings to productive uses. The banks compete for savings and time deposits and the interest rate ceiling was raised from 8% to 10% in January, 1967. The Banks' share in financing fixed investment including housing rose slightly in 1966 (to 39% from about 37% in 1965), but there was a much sharper increase (over 100%) in savings and time deposits, the total of which equalled almost half of the banks' lending for fixed investment. The banks are thus beginning to play their ex- pected role as mobilizers of funds. In the absence of a more developed capital market, however, and given the limited forms of savings instru- ments and the fact that loans for investment can be made only on fixed terms, the authorities are considering possible new outlets for savings which would provide an attractive long-term return notwithstanding price inflation, and are in process of introducing new legislation which would permit enterprises to invest in other enterprises on what would approxi- mate to an equity basis, sharing in both management and profits. This legislation, which would also allow foreign investors to participate in Yugoslav enterprises on approximately similar terms is expected to be enacted by the middle of 1967.  -6- Public Finance 20. In accordance wfith the objectives of the Economic Reform the influ- ence of the public sector on the economy was further reduced in 1966. Though public expenditures (of all budgets) rose by 7.5%, expenditures in real terms after taking into account the rise in prices were substantially below those of 1965, which were in turn less than in 1964. Subsidies to the economy were reduced, export premiums abolished, and efforts were made to keep the rise in defense and administrative expenditures to a minimum, though wages and salaries rose to offset the sharp price increases of the second half of 1965. A small surplus on the Federal budget was a- chieved in 1966 compared with a small deficit in 1965; on all budgets to- gether the surplus recorded in 1966 was three times that of 1965 though only 2% of total expenditures. 21. As a step to enforcing greater budgetary discipline a law of July 1966 precluded short-term bank lending to governments to compensate for uneven flows of revenues. Governments are required to build up reserve funds to cover this need; the regulation applies to all governments other than the Federal Government from January 1967 and to the Federal Govern- ment from January 1968. Governments, are however, permitted to borrow long-term resources from banks to finance investment. 22. With regard to extra-budgetary funds, a further step in divesting political entities of control of investment was the abolition of the social housing funds and the transfer of these resources to the banks. Taxes at the communal level were reduced accordingly, in the expectation that finance for housing construction would in future be mobilized largely by banks from the savings of enterprises and households, and it was hoped that by gradually introducing economic rents it would be possible to a- chieve a mQre economic distribution of housing space and also stimulate home ownership. On the other hand, a partial reversal of the process of divesting government of control over investment funds occurred in 1966 when a large part of the resources of the social investment funds which had been transferred to the banks in 1963 and 1964 were converted into loans from governments to the banks. The Federal Government arranged to make its investment resources available through the banks on the basis of contracts with the banks. Governments at other levels followed the ex- ample of the Federal Government but their resources for investment have been sharply reduced. Thus, although financing of fixed investments by the Federal Government roughly doubled in 1966 as compared with 1965, financing by all governments together fell by 4OM, and their share of total financing of fixed investments was only 15% compared with 62% in 1960. 23. There were no major tax changes in 1966, but measures were taken to simplify the turnover tax which had proved cumbersome in operation. No changes in taxation are foreseen in 1967. The rate of tax on the net capital assets of enterprises, which is the principal source of extra-  - 7 - budgetary investment resources of the Federal Government, was reduced from 4.0% to 3.5% in 1966, though after allowing for exemptions the average effective rate of tax rose slightly above the 2.9% of 1965. External Sector 24. Commodity exports rose by 12% to $1.22 billion in 1966 with exports to convertible currency countries rising by about a fifth and exports to bilateral trading partners (accounting for 40-50% of total exports) re- maining stable. Imports rose by almost 20% to $1.57 billion with a particularly fast expansion of imports from bilateral countries, which rose by approximately 33%. Yugoslavia had accumulated substantial credit balances with some bilateral partners in 1965 and the authorities there- fore encouraged higher imports from these countries in 1966. Part of the rise in imports was accounted for by greater food purchases following a poor harvest in 1965, part by greater purchases of selected consumer goods which were imported to ease the pressure of rising demand on prices and part by a sharp jump in imports of capital equipment. Overall the trade deficit in 1966 rose by about two-thirds to $253 million. The increase, however, represented almost wholly the change in bilateral trade, the deficit with convertible currency countries being little changed. After taking into account increases in net invisible earnings (particularly from tourism and transportation which rose by 30% and 20% respectively) and private transfers (mainly workers' remittances) the current deficit with convertible currency countries was substantially reduced, while a desirable reduction was achieved in the current surplus with bilateral partners. 25. The overall deficit on current account in 1966 was $32 million. Only once before in the last decade - in 1965 - had Yugoslavia ended the year without a large current deficit. Nevertheless the hoped for increase in gold and foreign exchange reserves did not occur. Reserves at $126 million in December 1966 were only $10 million more than a year earlier. The authorities had planned to introduce a substantial measure of import liberalization as an essential step in the Economic Reform, but with exchange reserves equivalent to less than six weeks' imports from convertible currency countries and heavy debt servicing obligations, the authorities were hesitant to take this step while they were uncertain that inflationary pressures in the economy had been brought under control. However, after two years of credit restraint and supported by a new standby credit of $45 million from the IMF, partial import liberalization was introduced on January 1, 1967. Importers are now permitted to buy without restriction items estimated to comprise about a quarter by value of total imports from convertible currency countries. A further 20% of imports from the convertible area have been liberalized subject to the fulfillment of import obligations in terms of bilateral trade agreements. The degree of liberalization is greatest for imports of raw materials and semi-manufacturers and smallest for imports of consumer goods.  - 8 - 26. The degree of import liberalization might have been larger had Yugoslavia met with greater success in her efforts to reschedule the heavy foreign debt payments due in 1966-1969. Payments of almost $39 million were deferred in 1966 amounting to a sixth of total medium- and long-term debt repayments in that year. Deferrments for 1967 and 1968 total only $15 million in each year. 27. Liberalization already appears to have had some impact on imports in the early months of 1967. Food imports, however, should be sharply reduced this year and prospects are that restrictive credit policies will slow the growth of import demand. With regard to export prospects markets in eastern Europe are good, particularly for consumer products, but Yugo- slavia needs to expand its exports to the convertible area and here pros- pects are somewhat less favourable as a result both of additional restric- tions on trade in agricultural products imposed by the EEC and of the slowdown in the German economy. On the other hand Yugoslavia as a full member of the GATT should benefit from the tariff reductions negotiated at the Kennedy round. The authorities estimate imports in 1967 rising by 7% and exports by just over 9% with a trade deficit little larger than in 1966 so that with a moderate rise in net earnings from services (tourist receipts are expected to rise sharply - by 24g - but also tourist expenditures) an approximate balance on current account is forecast for the year. Prospects 28. The Development Plan 1966-1970, outlined in the Economic Report (EA-162a), has not been revised, but the authorities recognize that developments in 1966 and prospects for 1967-may necessitate revisions. Though output in 1966 grew at the rate projected in the Plan (7.5-8.5%) this resulted from the unexpectedly good year in agriculture. The growth of industrial production at 4.3% was much below the target rate of 9-10%. For 1967, the growth of output is tentatively projected at 2-2.5% and industrial production at 4-4.5%. Agricultural production is estimated to decline by about 7% but would still be substantially higher than in 1965. Although the authorities expected below average growth rates in the first two years of the Plan, as enterprises adjusted to the new conditions brought about by the Economic Reform, it now appears that the changes required of enterprises were greater and the adjustment process slower than had been expected, and that the overall growth target of the Plan may not be realized. Nevertheless, the investments needed to realize specific targets, e.g. in steel, copper, lead and zinc, electric power, oil and chemicals are proceeding, and prospects appear good of realizing the targets for agriculture. The 1970 targets for production of wheat, sugar beet and corn were reached in 1966, and although this level is not expected to be maintained in 1967, with the stimulus provided by higher agricultural prices to increased inputs, already evidenced on both private and social holdings, the targets for 1970 might well be exceeded. This is less likely for livestock where with adverse changes in export markets, particularly for pig products, output has fallen, though this could be partly offset by a faster expansion in other sectors of the industry.  - 9 - 29. In the external sector, the Plan projected exports rising by 11-12% annually, and imports by 10-12%. As indicated above, the growth rates for exports and imports forecast for 1967 are somewhat below the rates in the Plan. It may be asked whether a growth of output of only 2.0-2.5% is consistent with a 9% rise in merchandise exports. Here the agricultural sector is the key; agricultural output is expected to fall in 1967 while food exports will be boosted as a result of the bumper crops of 1966. If, as seems likely, the rate of growth of output achieved over the Plan period is somewhat below the projected rate, this will imply a slower growth of foreign trade. There seems, however, no reason at present to revise the authorities' expectation of an approximate balance on current account during the Plan period. In these circumstances Yugoslavia would need to borrow abroad little more than the amounts required to roll over existing- debt during the next four to five years. 30. In the past year Yugoslavia incurred little new debt. The total debt outstanding repayable in convertible currencies (including undisbursed) rose by less than $100 million to $1.8 billion at December 31, 1966, com- pared with a rise of $340 million in 1965. The short-term debt barely increased and repayment terms for new credits lengthened. Debt repayment obligations over the next several years have not risen in the past year except for 1968 when a German loan, originally due in 1966, is repayable. Thus the broad projection of Yugoslavia's gross capital requirements of approximately $250 million a year in 1966-70 given in the Economic Report (EA-162a) still seems appropriate. 31. Almost $400 million of Yugoslavia's external debt is owed to inter- national organizations. $640 million represent official loans from Western countries and $780 million are suppliers' and bank credits. Yugcalavia's heavy reliance on suppliers' credits reflected the very limited availability of longer-term loans from the West. Repayment periods for official loans and suppliers credits are relatively short so that debt service in the next four years is high - equivalent to about 25% of prospective convertible currency earnings. It must be remembered, however, that in the case of Yugoslavia this figure relates to the total, not only the "public", external debt. While there are good prospects of rolling over suppliers' credits, Yugoslavia will need further assistance - preferably on longer- term - if essential import requirements are to be met. 32. Despite difficulties encountered in carrying out the Economic Reform, there can be little doubt that the directions in which ahe Yugoslav economy is now moving will lead to a more rational allocation of resources and to the further development of those sectors where Yugoslavia enjoys a compara- tive advantage. The Yugoslav authorities have consistently adhered to the objectives of the Reform and have firmly pressed forward its implementation. As economic enterprises adjust more fully to the changes brought about by the Reform an acceleration in the growth of output and exports is likely. In these circumstances and having regard to the continuing restraint shown by the authorities in incurring new short- and medium-term debt, as evidenced over the past eighteen months, Yugoslavia can be regarded as creditworthy for further Bank financing. May 23, 1967 Europe and Middle East Department Attachment: Annex 1: Statistical Appendix  Yugoslavia Annex 1 STATISTICAL APPENDIX Gross Social Product 1966: D 98.56 billion (Preliminary) Rate of growth (1960-65): 7.5% (1966) : 8.6% Per capita (1966) : U.S. $500 (approx.)l/ Per cent of Gross Social Product 1966 Agriculture and forestry 31 Mining and.manufacturing 33 Construction 7 Transport and communications 8 Trade and catering 15 Other 6 Per cent of Gross Social Product 1965 1961-64 Gross investment 3 42 Gross savings 38 40 Current deficit on the balance of payments -- 2 Investment income payments 1 0.5 Government current revenues 22 23 Money and Credit 1966 Rate of Change (D. billion) 1962-66 Total money supply 23.9 14% Time and savings deposits 18.1 20% Short-term credit to private sector 30.1 13% Rate of change in prices (retail) 7.0% 18% Public Sector Operations 1966Z/ Rate of Change (D. bilin) 1964-66 Government current receipts 17.4 9.0% Government current expenditures 16.1 9.6% Surplus 1.3 -- Government capital expenditures 0.9 -- 1/ AdJusted to OECD National Accounts concept. 2/ Provisional  - ii - Yugoslavia External Public Debt 1966 1960-65 (U.S. $ million) Average Total debt outstanding 2,141 1,090 Annual debt service 240 140 Ratio of debt service to foreign exchange earnings 15% 14% Balance of Pa ents 19661/ Rate of Change -(U.S. $ mi-lion) 1960-65 Exports 1222 14% Imports - 1575 9% Net invisibles of which 272 26% investment income - 70 31% Net current balance - 32 -- Foreign Exchange Reserves 1966 1960-65 (U.S. $ million) (December) Average Convertible currencies 126 66 Payments agreements 91 39 217 105 I.M.F. Position 1966 1960-65 (U.S. $ million) (Dec.) Average Quota 150 120 Drawings outstanding 108 81 1/ Provisional Currency Equivalents U.S. - 12.50 dinars 1 dinar-U.S. $0.08