III. Public Debt Management Strategy

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1 III. Public Debt Management Strategy Pursuant to the Public Debt Law (Official Gazette of the Republic of Serbia Nos. 61/05, 107/09 and 78/11), which constitutes the legal basis for Serbia s borrowing, public debt includes 1 : 1) Debt of the Republic arising from agreements entered into by the Republic, 2) Debt of the Republic arising from securities, 3) Debt of the Republic arising from treaties and/or agreements on rescheduling of liabilities assumed by the Republic under earlier treaties and securities issued under special laws, 4) Debt of the Republic arising from guarantees issued by the Republic or from direct accession to debt in the capacity of a debtor for debt arising from guarantees and/or counter-guarantees issued by the Republic, 5) Debt of local governments and legal entities founded by the Republic whose debt is guaranteed by the Republic. The Law allows borrowing in the country and abroad, i.e. in domestic and foreign markets. The Republic may borrow in local and foreign currency to cover liquidity deficit, to refinance public debt, to finance investment projects and to cover liabilities arising from guarantees issued. Pursuant to Article 9 of the Law on Deposit Insurance Agency, the Republic may also borrow to cover potential loss with commercial banks (Official Gazette of the Republic of Serbia Nos. 61/05, 116/08 and 91/10). Under Article 13 of the Public Debt Law, public debt is an unconditional and irrevocable obligation of the Republic concerning the repayment of principal, interest and any and all borrowing costs. Public debt repayment has a permanent appropriation in the national budget and is prioritized over other public expenditure provided for by the law governing the national budget. The Budget System Law (Official Gazette of the Republic of Serbia Nos. 54/09 and 73/10) lays down general fiscal rules, according to which general government debt, exclusive of liabilities for restitution, may not exceed 45% of gross domestic product (GDP). This provision of the Law was welcomed by international financial institutions, because it limited Serbia s public debt to a relatively low share of GDP. It should be noted that, according to the Maastricht criteria, general government debt includes local government debt, but does not include total guarantees issued by the government. If this methodology were applied, the balance of Serbia s public debt would be even lower than according to the currently applied methodology. According to the same Law, if public debt exceeds 45% of GDP, the Government is required to adopt and put in place measures to restore public debt to the level defined by the law. The Public Debt Law establishes the Public Debt Agency as an authority within the Ministry of Finance and defines its powers and organization for the purpose of recording and managing Serbia s public debt. 1 For the purposes of this Strategy, the balance of central government debt (a methodology defined by the Public Debt Law) includes also non-guaranteed liabilities of local government units.

2 1. Public Debt Balance and Structure in the Period According to the records kept by the Ministry of Finance and Economy of the Republic of Serbia, the Public Debt Agency, more specifically, Serbia s public debt includes all direct liabilities of the Republic arising from borrowing, as well as guarantees issued by the Republic for borrowing by public enterprises and local governments. Public debt of the Republic of Serbia is categorized as direct and indirect liabilities, i.e. liabilities for and on behalf of the Republic and liabilities arising from guarantees issued by the Republic in favor of other legal entities. Direct and indirect liabilities are further categorized as internal debt and external debt, depending on whether they arose from borrowing in the domestic market or in international markets 2. At year-end 2000, Serbia s total public debt as a share of GDP reached 169.3%. As a result of GDP increase, timely public debt servicing, lower budget deficit, partial London and Paris Club debt write-off and other factors, the public debt-to-gdp ratio was cut down to 28.4% in Due to adverse effects of the global economic crisis on Serbian economy, the Republic of Serbia increased borrowing to finance its budget deficit in the period Trends of Serbia s public debt as a share of GDP in the period October 2012 are shown in following Graph: Graph 25. Public debt as a share of GDP, in % 70,0% 60,0% 50,0% 40,0% 30,0% 20,0% 10,0% 0,0% 0,7% 5,2% 29,7% 1,1% 6,3% 1,6% 6,9% 38,2% 41,8% 1,7% 8,3% 49,2% Х Direct Liabilities Indirect Liabilities Local Government Debt (non-guaranted) Increasing budget deficit, low real GDP growth and depreciation of the dinar against foreign currencies in which Serbian public debt is denominated have brought about to an increase in the level of public debt in the past four years, which thus exceeded the limit set by the Budget System Law. At yearend 2011, Serbia s total public debt stood at RSD 1, up from RSD 1,313.2 billion at year-end Public debt as a share of GDP at year-end 2011 was 50.3%. Internal public debt increased considerably in 2011 compared to 2010, from RSD bn to RSD bn. External public debt increased from RSD billion to RSD billion in the course of Direct liabilities of the Republic of Serbia in 2010 amounted to RSD 1,101.8 billion, rising to RSD 1,326.3 billion in the following year. On the other hand, indirect liabilities also increased from RSD billion in 2010 to RSD billion in At the end of October 2012, total public debt stock stood at RSD 1,936.0 billion or 59.2% of GDP. Out of that amount, direct obligations accounted for RSD 1,608.6 billion, indirect liabilities accounted for RSD billion whereas non-guaranteed local government debt accounted for RSD 56.4 billion. Internal 2 For the purposes of this Strategy, the stock of central government debt (a methodology defined by the Public Debt Law) includes also non-guaranteed liabilities of local government units. 3 Including non-guaranteed local government debt. This component of general government s public debt increased from RSD 30.7 bn in 2010 to RSD 51.1 bn in

3 direct liabilities amounted to RSD billion, while external direct liabilities amounted to RSD billion. As regards indirect liabilities, internal debt stood at RSD 67.4 billion, while external debt reached RSD billion. If broken down into internal and external public debt, total public debt amounted to RSD billion and RSD 1,134.9 billion, respectively. Table 30 shows internal and external debt balance (absolute and relative) at year-end over the period October It also contains figures showing internal and external debt as a share of GDP. Table 31 shows the absolute balance of Serbia s direct and indirect liabilities and their respective balance as a share of GDP: Table 30. Internal and external public debt in the period October /X in RSD billion Public debt , , ,936.0 Internal public debt External public debt ,134.9 Of which central government: , , ,879.6 Internal public debt External public debt ,114.4 In % of GDP Public debt Internal public debt External public debt Of which central government: Internal public debt External public debt Table 31. Direct and indirect liabilities in the period October /X in RSD billion Public debt , , ,936.0 Direct liabilities, of which: , , ,608.6 Internal public debt External public debt Indirect liabilities, of which: Internal public debt External public debt Local government debt (non-guaranteed by central government) Internal public debt External public debt as % of GDP Public debt Direct liabilities, of which: Internal public debt External public debt Indirect liabilities, of which: Internal public debt External public debt Local government debt Internal public debt External public debt

4 It should be noted that Serbia s public debt does not include liabilities arising from restitution. Those liabilities will become due and payable in The Law on Restitution and Compensation (Official Gazette of the Republic of Serbia No. 72/11) provides for relevant time limits, conditions, methods and procedures which will apply to the Restitution Agency in the restitution of property nationalized after WWII. The Law states a preference for restitution in kind, but where this is not possible, restitution will be made in treasury bonds and cash. The total amount of compensation must not be such as to threaten Serbia s macroeconomic stability and economic growth. The total amount earmarked for this purpose is maximum EUR 2 billion, increased by the sum of accrued interest payable to all compensation subjects at the rate of 2% per annum for the period from 1 January 2015 to the maturity dates provided for by the Law. The maturity of these bonds will be fifteen years, with annual installments payable as from In specific cases, compensation in cash will be paid in advance, with the maximum amount of such advance payments limited to EUR 10,000. Internal public debt Pursuant to the Public Debt Law, internal public debt includes direct and indirect liabilities of the Republic of Serbia to domestic investors and lenders. As at 31 October 2012, internal public debt included RSD billion in direct liabilities and RSD 67.4 billion in indirect liabilities. Serbia s total internal public debt, inclusive of non-guaranteed local government debt (RSD 35.9 bn) stood at RSD bn. Table 32 shows the structure of Serbia s internal public debt as at 31 December 2009 through 2011 and as at 31 October 2012: Table 32. Internal public debt structure in the period Oct /X in RSD billion Internal public debt Government securities, of which: Government bills and bonds Frozen Forex savings bonds Long-term securities (debt to NBS) Loan for economic revival Other Non-guaranteed local government liabilities The Government issued securities for the first time in 2003, and their maturities were 3 and 6 months. As privatization proceeds were high and primary fiscal result was relatively balanced in the period , the government did not issue any securities over that period and the amount of government securities was therefore relatively low at year-end In the past four years, the government issued securities with different maturities, and a dinar yield curve was created for maturities ranging from three months to five years. Table 33 shows the stock of government securities at year-end in 2009, 2010 and 2011, and as of 31 October 2012: 4 The figures include both public debt balance calculated according to the methodology defined in the Public Debt Law (central government level) and local government liabilities, i.e. their non-guaranteed debt. As at 31 October 2012, this component accounted for RSD 40.3 billion of internal public debt 4

5 Table 33.Debt balance by Government securities ( Oct. 2012) Instrument type % /X Nominal in RSD bn % Nominal in RSD bn % Nominal in RSD bn % Nominal in RSD bn 3M Government bills M Government bills M Government bills indexed in EUR M Government bills W Government bills W Government bills M Government bills M EUR Government bills M Government bills Y Government bonds amortizing Y EUR Government bonds Y Government bonds Y Government bonds inflation indexed Y EUR Government bonds Y Government bonds Y Government bonds inflation indexed Y EUR Government bonds Total In early 2009, aiming to finance the budget deficit, the Government issued 3-month bills, followed by issues of 6-month and 12-month bills. The total market value of issued Government bills in that year was RSD billion, while the balance of debt arising from Government bills at year-end 2009 was RSD billion. In the course of 2010, debt from government securities increased, peaking at RSD billion at year-end. In an effort to boost the development of the Serbian capital market, the Public Debt Agency of the Serbian Ministry of Finance issued the first 18-month and 24-month Government bills in March In February 2011, the Public Debt Agency of the Serbian Ministry of Finance issued a 15-year eurodenominated coupon bond, as well as a 53-week euro-denominated T-bill, followed by the issue of the first 3-year dinar-denominated coupon bond in March June 2011 saw the first issue of a 3-year euro-denominated coupon bond in the Serbian market and in July 2011 an 18-month euro-denominated T-bill was issued. At year-end 2011, the debt based on dinar-denominated government securities amounted to RSD billion, while that based on euro-denominated government securities issued in the domestic market stood at RSD 57.9 billion. Efforts to introduce new long-term dinar-denominated instruments continued in 2012 in order to extend the maturity structure of government securities and increase the share of dinar-denominated public debt. The first 5-year dinar-denominated bond with a 10% coupon was issued on 24 January 2012 in an issue worth RSD 2.7 billion, and was followed by the second issue on 29 May 2012 worth RSD 520 million. In an effort to diversify the debt, on 1 August 2012, a 2-year amortizing coupon-bond tied to the key policy rate of the National Bank of Serbia was issued. As at 31 October 2012, the debt based on dinar-denominated government securities amounted to RSD billion while the debt based on euro-denominated government securities issued in the domestic market stood at RSD 98.5 billion. 5

6 External public debt Pursuant to the Public Debt Law, external public debt includes direct and indirect liabilities to foreign investors and creditors. The following table shows the structure of Serbia s public debt at year-end 2009, 2010 and 2011 respectively and as at 31 October 2012: Table 34. External public debt structure in the period /X in RSD bn Multilateral creditors, of which: Paris Club IBRD EIB London Club IDA IMF EBRD CEB Others Bilateral creditors, of which: Italy EU China Russia France Libya Others Other borrowing Of which Eurobonds Guaranteed external debt Local governments debt Total external public debt ,134.9 At year-end 2011, debt to multilateral creditors amounted to EUR 5.2 bn (RSD bn), or 35.1% of total public debt, as opposed to EUR 5.1 bn (RSD bn), or 41.8% of total public debt, in Paris Club debt at year-end 2011 amounted to EUR 1.6 bn (RSD bn), or 10.7% of total public debt, compared with EUR 1.6 bn (RSD bn), or 13.3% of total public debt, in London Club debt at year-end 2011 amounted to EUR mil (RSD 75.4 bn), or 4.9% of total public debt, compared with EUR 748 mil (RSD 79.6 bn), or 6.2% of total public debt, in As at 31 October 2012, Paris Club debt stood at EUR 1.49 bn (RSD bn). EBRD loans amounted to EUR 1.46 bn (RSD bn), London Club debt was EUR 0.66 bn (RSD 75.2 bn) and bilateral loans stood at EUR 0.86 bn (RSD 98.0 bn). IDA loans amounted to EUR 0.53 bn (RSD 60.5 bn), IMF loans amounted to EUR 0.46 bn (RSD 52.2 bn), and EIB loans amounted to EUR 0.53 bn (RSD 60.3 bn). In September 2011, the Republic of Serbia issued for the first time a Eurobond in the international financial market with the nominal value of USD 1 bn. The terms of issue included a 7.25% coupon and a 7.5% rate of yield to maturity. Spread at the time of issue compared with the US benchmark bond was 561 base points, while bond price from the time of issue to the end of November 2011 ranged from 90 to 102. US investment funds bought more than two thirds of the primary issue of this security. 6

7 In percentage This issue gave Serbia a liquid bond which will be used as a benchmark for future Eurobond issues in the international financial market. In the first ten months of 2012, the price ranged from USD 96.9 to USD 110.5, while yield rates ranged from 5.73% to 7.71%. In September, yield rates on the first Serbian Eurobond reached an all-time low and the Ministry of Finance and Economy decided it would be beneficial to issue a Eurobond by the end of the year in order to finance budget expenditures. On 28 September 2012, Serbia entered the international financial market for the second time and successfully reopened the issue Serbia Reopening volume was USD 1 bn, with a yield rate of 6.625%. Bond price at reopening reached USD , meaning that the tap issue was issued with a premium. Even though Standard and Poor s downgraded the country s credit rating from BB to BB- with negative outlook in August and Fitch assessed its outlook for the forthcoming period as negative, Serbia has managed to issue a security with a yield higher than that achieved by some countries in the region with higher credit rating. Graph 26. Serbia s 2021 Eurobond price and yield trends from the issue date to 31 October $ $ $ $ $ $ $ $ $ $ 93 9,0 8,8 8,5 8,3 8,0 7,8 7,5 7,3 7,0 6,8 6,5 6,3 6,0 5,8 5,5 5,3 5,0 Closing price YTM Currency structure of Serbia s public debt in the period At year-end 2009, more than 66% of Serbia s public debt was denominated in euros, followed by debt denominated in US dollars (12.9%), while the share of debt denominated in local currency was 12.7%. For the purpose of financing the budget deficit, 2011 saw intensified issues of dinar-denominated securities, which increased the share of dinar-denominated public debt to approximately 16.2% at yearend At the end of October 2012, dinar-denominated debt accounted for nearly 18.9% of Serbia s public debt. 7

8 In percentages Table 35. Currency structure of public debt in the period 2009 October /X (RSD bn) % (RSD bn) % (RSD bn) % (RSD bn) % Special Drawing Rights EUR , USD CHF RSD Other Total , , , Graph 27.Currency structure of public debt in the period 2009 October ,0 2,7 2,1 1,9 4,7 7,7 6,6 5,9 12,7 12,9 14,8 16,2 18,9 14,4 17,8 20, ,7 60,4 57,3 52, X EUR USD RSD SDR Other According to the figures as at 31 October 2012, the bulk of Serbia s public debt remains denominated in euros 52.8% of total public debt stock. This is followed by public debt denominated in dinars and US dollars, with 18.9% and 20.4% respectively. The remaining debt is denominated in Special Drawing Rights (5.9%) and other currencies (2.0%). Interest rate structure of Serbia s public debt in the period The structure of public debt, including non-guaranteed local government debt of Serbia, according to interest rates is favorable, because the majority of debt is tied to fixed interest rates. The share of fixed-rate interest was even higher in 2009 (75.3%), but in 2010 it dropped sharply to 65.2%. According to figures as at 31 October 2012, debt with fixed interest rates accounted for 70.6% of public 8

9 debt. On the other hand, as regards variable interest rates, they were mostly linked to EURIBOR and LIBOR on EUR. The structure of interest rates on Serbia s public debt is showed in Graphs 28 and 29: 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Graph 28. Interest rate structure of public debt in the period ,7% 75,3% 34,8% 31,6% 29,4% 65,2% 68,4% 70,6% Х Variable interest rates Fixed interest rates The majority of Serbia s public debt (70.6%) is subject to fixed interest rates, while debt with variable interest rates accounted for 29.4% of total public debt. As regards variable interest rates, EURIBOR and LIBOR on EUR account for the highest share % combined of total public debt subject to variable interest rates. LIBOR on USD accounts for 12.0%, while LIBOR on CHF accounts for 2.0% of public debt subject to variable interest. Variable interest rates linked to LIBOR on GBP and JPY and other variable rates account for 13.3% of public debt subject to variable interest; of that number, interest rates on Special Drawing Rights account for 2.7% of total public debt. Graph 29.Structure of variable interest rates in the period % 90% 80% 70% 60% 5,4% 3,5% 3,6% 2,4% 11,6% 12,9% 12,9% 13,3% 2,1% 2,0% 11,5% 12,0% 50% 40% 30% 78,1% 82,5% 73,5% 72,7% 20% 10% 0% Х EURIBOR and LIBOR on EUR LIBOR on USD LIBOR on CHF Оther 9

10 Structure of government securities and their duration in the period The Republic of Serbia began issuing Government bonds in Originally it issued only shortterm Government bills from 2003 to 2006; however, after a period of stagnation in the market for dinardenominated Government bonds, the Government began reissuing the bills in February Within four years, the balance of this debt exceeded RSD 400 bn. In other words, of the EUR 6 bn of absolute debt growth compared with year-end 2008, nearly one half was generated in the domestic market through issues of dinar- and euro-denominated government securities saw the introduction of new dinardenominated instruments such as inflation-indexed bonds and 2-year amortizing bond with variable coupon. A 5-year Government bond was also issued for the first time, in an effort to extend the maturity of dinar-denominated securities. As at 31 October 2012, about 83% of planned borrowing was achieved through issues of dinar-denominated government securities for The maturity structure of dinardenominated government securities is shown in Graph 30: Graph 30. Structure of Government securities by original maturity at the end of the observed period October Y Government Bonds - EUR denominated 2,8 5,0 3,8 17,6 8,4 2,0 0,7 1,1 1,5 10Y Government Bonds - inflation indexed 90 4,7 2, ,6 25,8 34,0 11,8 30,9 13,2 5,2 21,2 6,9 28,1 3,3 12,1 9,0 4,6 1,3 1, Х In 2011, the Republic of Serbia issued euro-denominated Government bills and bonds for the first time in the domestic market. It issued 53-week and 18-month Government bills with the total nominal value of EUR 350 mil and with a weighted interest rate of 4.9%. As regards bonds, the Government issued on two occasions 15-year Government bonds with a 5.85% coupon and 3-year Government bonds with a 5% coupon, with the total nominal value of about EUR 200 mil. In 2012 the government continued issuing euro-denominated instruments: a 2-year euro-denominated security with a 5.75% coupon was issued for the first time, in the total nominal value of EUR mil. In the total government securities portfolio at the end of October 2012, dinar-denominated government securities accounted for 77.5%. The remaining 22.5% of the portfolio are euro-denominated government securities. The maturity structure of euro-denominated government securities and an overview of accepted rates of government securities are given in Graphs 31 and 32, respectively: 16,5 2,9 1,5 14,2 9,1 16,2 5,3 19,0 5Y Government Bonds 3Y Government Bonds - EUR denominated 3Y Government Bonds - inflation 3Y Government Bonds 2Y Government Bonds - EUR denominated 2Y Government Bonts - amortising 24M Government Bills 18M Government Bills - EUR Denominated 18M Government Bills 53W Government Bills - EUR Denominated 53W Government Bills 12M Government Bills 6M Government Bills - EUR Indexed 6M Government Bills 3M Government Bills 10

11 Primary auctions accepted rates - RSD denominated Primary auctions accepted rates - EUR denominated Graph 31. Structure of euro-denominated government securities by original maturity at the end of October % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 16,6% 26,1% 6,8% 10,6% 12,9% 27,1% 40,1% 36,2% 23,6% Х 15 year Government Bonds- EUR Denominated 3 year Government Bonds-EUR Denominated 2 year Government Bonds-EUR Denominated 18 month Government Bills- EUR Denominated 53 week Government Bills-EUR Denominated Graph 32. Overview of accepted rates of government securities 16,5% 16,0% 15,5% 15,0% 14,5% 14,0% 13,5% 13,0% 12,5% 12,0% 11,5% 11,0% 10,5% 10,0% ,75% 7,50% 7,25% 7,00% 6,75% 6,50% 6,25% 6,00% 5,75% 5,50% 5,25% 5,00% Number of auctions of Government securities issued on domestic market from the 1st January 2012 Government Bills 3M Government Bills 6M Government Bills 53W Government Bills 18M Government Bills 24M Government Bonds 3Y Government Bonds 5Y Amortizing Government Bonds 2Y Government Bills 53W - EUR Government Bills 18M - EUR Government Bonds 2Y - EUR Serbia 2021 Considering that securities issued until 2010 were mostly 3-month Government bills, the duration, or average days to maturity, was low. With the introduction of new instruments with longer maturity and the lower share of short-term instruments in the total balance of dinar-denominated securities, duration was extended considerably. As at October 2012, the duration of dinar-denominated Government bonds was 391 days, while the average duration of total securities was 628 days. Trends in the duration of dinar-denominated government securities in recent years are shown in Graph 33: 11

12 Graph 33. Duration of Government securities issued in the domestic market in the period October Х Duration of dinar-denominated securities Duration of total securities Servicing of Serbia s public debt (central government 5 ) in the period The figures presented in this section relate to past repayments of interest and principal and projections for the forthcoming period. Table 36 shows the history of public debt servicing from 2009 to 2011, while Table 37 shows projected public debt servicing for the period : Table 36. Interest and principal repayment in the period in RSD bn Principal Interest Total Table 37.Projections of interest and principal repayment by p 2013p 2014p 2015p in RSD bn Principal Interest Total public debt as at 31 October Table 38. Projections of interest and principal repayment by 2015 (as a % of GDP) 2012p 2013p 2014p 2015p in RSD bn GDP 3, , , ,316.2 Principal 10.0% 11.0% 9.0% 6.9% Interest 2.0% 2.5% 2.5% 2.1% Total 12.0% 13.5% 11.5% 9.0% 5 Central government level includes the Budget of the Republic of Serbia, compulsory social insurance funds and the public enterprise Putevi Srbije (Serbian public roads company) 6 Principal repayment projection for 2015 includes the obligations based on restitution. 12

13 2. Projection of General Government Debt Balance in the Period Taking into account Serbia s projected primary budget deficit in the period , including the withdrawal of loans for project financing of budget beneficiaries, the effects of exchange rate changes between the dinar on the one side and the euro and the US dollar on the other side in the basic macroeconomic scenario, and considering the plan to finance future deficit primarily through long-term debt in the form of securities issues, the balance of Serbia s public debt excluding guaranteed liabilities (except for Železnice Srbije (Serbian Railways) and Putevi Srbije (Serbian public roads company)) and including local government debt should according to the basic scenario equal about 60% of GDP,on average. Table 39. Basic projection of general government debt by p 2013p 2014p 2015p in RSD bn GDP 3, , , ,316.2 Primary deficit Interest Public debt 2, , , ,391.2 Non-guaranteed local government debt Debt-to-GDP 63.2% 62.9% 56.0% 55.4% Local government debt-to-gdp 1.9% 2.3% 2.7% 3.0% According to the projections, local government debt will remain at a relative level of 2% to 3% as a share of GDP. Debt arising from guaranteed liabilities, which are not included in public debt balance according to the Maastricht criteria, is expected to be between 4% and 6% of GDP. Analyses underlying the Public Debt Management Strategy The Public Debt Agency based its Public Debt Management Strategy on the quantitative approach, identifying potential limitations by applying macroeconomic indicators, cost and risk analysis and market conditions that affect public debt management. The cost and risk analysis took into account all viable financing alternatives. The share of each instrument in the overall financing needs for a given year is determined on the basis of Strategy objectives. The following instruments available in domestic and international financial markets were used in the analysis. Sources of financing denominated in foreign currency Loans by foreign governments and international financial institutions are presented as two instruments denominated in euros, with fixed and variable interest rates; Domestic debt denominated in euros is presented through three instruments: loans by domestic commercial banks with variable interest rates, Government bills and bonds issued in the domestic financial market; Eurobond issued in euros or US dollars. 13

14 Sources of financing denominated in local currency All government securities denominated in dinars are categorized in a number of groups, including short-term Government bills (with maturity up to 53 weeks), 2-year government securities (Government bills and bonds with maturity of 18 months and 24 months) and 3- year and 5-year coupon Government bonds. Future market interest rates and scenario analysis The mid-term public debt management strategy for the period was developed using quantitative cost and risk analyses based on various scenarios and projections. The starting point was the basic scenario, developed using the most probable market conditions. We then proceeded to identify three groups of market variables: foreign exchange rate, reference interest rates in the international market and reference interest rate on dinars. The first two variables were readily available. Future market rates can be deducted from an analysis of available purchase power parity or interest rate parity forecasts. The analysis assumes an average depreciation of the dinar against the euro of 3.0% as well as of the dinar against the US dollar of 2.5% over the observed period. Another possibility is to use the forward exchange rate between EUR and USD, but in this case external influences ( background noises ) are limited and the EUR:USD exchange rate is assumed to be fixed, in order to gain a clear picture of the effects of the applied shock. Similarly, market forward rates are currently poor predictors of future interest rates. The analysis also used constant rates. The effects of market rate changes were fully tested in shock conditions. Interest rates on debt denominated in dinars cannot be real, constant or forward rates, because the projected curbing of inflation has not yet resulted in the reduction of projected interest rates. Among other issues, there is a lack of research of consumer prices and of structure rules that lead to very high interest rates. The approach used for interest rates in dinars is based on real rates that reflect the current situation, taking into account also the expected inflation rate reduction in the following years. Once the basic scenario was defined, four additional types of scenarios (shocks) were chosen. Macroeconomic shocks or shocks in the primary budget are examined separately in the debt sustainability analysis. 1. Depreciation of the dinar against the dollar by 25%. In this type of shock, all other exchange rates remain unchanged. This global scenario is not particularly related to the Serbian economy, but it can have a significant impact on Serbia s debt because of the portion of the debt denominated in dollars (which should account for more than 20% of Serbian central government public debt by the end of the year). In this scenario, the EUR/USD exchange rate would change from 1.30 to This scenario is likely to occur once the US economy recovers and sees a higher growth rate, as the European economy continues to suffer from effects of the current debt crisis. 2. Depreciation of the dinar against all currencies by 25%. In this scenario, exchange rates in the whole world would remain stable, while only the dinar would depreciate against them. Macroeconomic circumstances in this scenario would include a high balance of payments deficit and low inflow of foreign direct and portfolio investment. 3. Interest rate increase in the international market. At present, interest rates worldwide are at a historic low. Central banks keep low rates anchored, thus enabling governments to address the issue of debt and banks to profit from positive yield curves and recapitalization, as long 14

15 as inflation is kept at bay. If global economy recovers, interest rates will probably increase by about 2-3 percentage points. 4. Interest rate increase in the domestic market by 5%. This scenario would be possible if inflation remained high (above 10%) and the RSD:EUR exchange rate were highly volatile. Each of the above stress tests or risk scenarios was used to examine the cost effects of the strategies considered. 2.1 Alternative Borrowing Strategies for the Period In cooperation with World Bank experts, the Public Debt Agency of the Serbian Ministry of Economy and Finance applied the WB Medium Term Debt Strategy Model (MTDS) as a cost and risk analysis for the purpose of portfolio optimization and more efficient public debt management. The optimum choice of costs and risks defined the basic borrowing strategy for the following mid-term period. The following alternative borrowing strategies were analyzed: Basic strategy (S1): a strategy that largely covers the financing need with existing financial debt instruments. The majority of new borrowing is based on issuing government securities in local and foreign currencies in the domestic market and issuing Eurobonds denominated in US dollars. S2 Strategy: unlike the S1 Strategy, Eurobonds are issued in euros with five-year maturity. Supplementary dinarization strategy with extended maturity (S3): relying on increased issuing of dinar-denominated government securities (from 58% to 73% of gross financing needs until 2015), while maintaining the existing package of standardized dinar-denominated instruments, with a higher preference for long-term instruments. Strategy of financing through a Eurobond issue (S4): a strategy that fully covers financing needs in the period through an issue of Eurobonds denominated in US dollars, without borrowing in the domestic market or in local currency. All strategies envisage financing of national budget expenditures primarily through government securities issues in international and domestic capital markets. The debt covered by this analysis is central government debt, including debt arising from indirect liabilities serviced by the Republic, but excluding non-guaranteed local government debt. The balance of public debt thus calculated is estimated to be 57.7% of GDP at 2012-end. Cost and risk analysis of alternative borrowing strategies Quantitative analysis presents the performance of each of the four alternative borrowing strategies. The vertical axis shows debt as a share of GDP in the basis macroeconomic framework defined by the Fiscal Strategy and it is the basic measure of each individual borrowing strategy, while the horizontal axis shows the potential cost of each individual borrowing strategy (stress test result). Two different cost ratios were used: public debt-to-gdp and nominal interest-to-gdp. The first ratio is a balance indicator, while the second is a flow indicator. For the sake of comparison, the analyses focus on the results of examined strategies at year-end

16 Cost (%) Cost (%) Comparison between alternative strategies Debt-to-GDP at year-end ,1 48,0 47,9 47,8 47,7 47,6 47,5 47,4 47,3 47,2 47,1 47,0 S3 S1 S4 S2 9,50 10,00 10,50 11,00 11,50 Risk Interest-to-GDP at year-end ,5 2,0 1,5 S2 S4 S1 S3 1,0 0, ,20 0,40 0,60 0,80 1,00 1,20 Risk The declining debt-to-gdp ratio is a result of lower financing needs in the forthcoming period and privatization of state-owned property in industries where there is competition. The graph clearly shows costs associated with each of the examined strategies: the S1 Strategy has a significant interest rate risk, given the relatively high share of dinar-denominated securities in the financing of budget needs, and historical figures show this shock is justifiable; furthermore, this strategy of financing from foreign sources is based on dollar-denominated securities and the effect of volatility of the dollar is seen as a significant shock. The S2 Strategy, as opposed to the S1 Strategy, considers a swap of dollar-denominated securities for euro-denominated securities; the results require further analysis of the need for applying hedging techniques and swapping dollars for euros, taking into account the lower volatility of the RSD:EUR exchange rate compared with the RSD:USD exchange rate. The reason for hedging instead of direct euro-denominated issues lies in the fact that many banks have reported that the international financial market is currently not open to Serbian securities denominated in euros. The S3 Strategy is shown to be the relatively priciest of all, but its advantage is that the relatively high share of dinardenominated debt would improve the stability of the debt-to-gdp ratio. The S4 Strategy carries a lower risk compared with S1 and S3 in terms of interest cost, but it has a relatively high risk associated with the debt-to-gdp ratio compared with other strategies, due to the high share of dollar-denominated debt in the total debt, which is the result of total elimination of dinar-denominated securities. 16

17 In this model, the analysis of the public debt-to-gdp ratio shows that the S4 Strategy is the riskiest choice, while the analysis of the interest-to-gdp ratio shows that the S3 Strategy is the most expensive one. The basic strategy (S1) carries a relatively low risk, but it is associated with relatively high interest costs due to the high share of dinar-denominated securities. The most advantageous solution appears to be the S2 Strategy, which has both low risk and low costs; however, as this strategy is based on an issue of euro-denominated Eurobonds, it should be taken into account that Serbia s current credit rating (BB-) prevents the country from borrowing in the international market by issuing eurodenominated securities. As the S2 Strategy is currently unviable, the basic strategy is the best solution for the time being; however, efforts will be made whenever possible to borrow through issuing eurodenominated securities in the international market or, if market conditions are favorable, to swap dollardenominated debt for euro-denominated debt. Table 40. Public debt-to-gdp at year-end 2015 Scenarios S1 S2 S3 S4 Basic scenario Exchange rate shock (25% all currencies) Interest shock (scenario 1) Interest shock (scenario 2) Combined shock (25% USD and interest shock 1) Maximum risk Table 41. Interest-to-GDP at year-end 2015 Scenarios S1 S2 S3 S4 Basic scenario Exchange rate shock (25% USD) Interest shock (scenario 1) Interest shock (scenario 2) Combined shock (25% USD and interest shock 1) 3, Maximum risk The following table shows the trends in basic parameters of public debt in each of the four examined strategies, which reflect the characteristics of each strategy explained above: Table 42. Risk indicators for alternative strategies Risk indicators Year-end 2015 S1 S2 S3 S4 Nominal debt (% of GDP) Net present value (% of GDP) Applied interest rate (%) Refinancing risk ATM 7 external portfolio (in years) ATM domestic portfolio (in years) ATM total portfolio (in years) Interest rate risk ATR 8 (in years) Refixing (% of total debt) Debt at fixed rates (% of total debt) Foreign exchange risk Debt in foreign exchange (% of total debt) АТМ - Average Time to Maturity 8 АТR - Average Time to Refixing 17

18 Reducing public debt as a share of GDP in the period According to the fiscal rule laid down by the Budget System Law of the Republic of Serbia, general government public debt may not exceed 45% of GDP. If debt exceeds that level, the Government must adopt a program to reduce public debt as a share of GDP, i.e. to restore debt to the level permitted by the law. At year-end 2011, central government debt reached 48.7% of GDP and general government debt reached 50.3% of GDP. The upward trend of the public debt-to-gdp ratio continued and at the end of October 2012 general government debt reached 57.5% of GDP. It is expected to continue growing until the end of the year, reaching about 63% of GDP. It should be noted that, in addition to public debt operations (net withdrawals), the increase in public debt in the first ten months of this year was largely due to the increasing exchange rate of the euro and US dollar against the dinar. In the past year, the dinar has depreciated against the euro by more than 10%,. Due to the high share of debt denominated in foreign currencies (more than 80%), foreign exchange risk will obviously determine the trends of the public debt-to-gdp ratio in the future and influence the success of fiscal policy measures aimed at consolidating public finance and reducing public debt. Taking into account the planned macroeconomic framework, provided that potential risks (primarily foreign exchange risk) do not materialize, public debt (excluding liabilities arising from restitution and non-guaranteed local government debt) should drop to 55.4% of GDP by The key factors of public debt-to-gdp ratio reduction include GDP growth, primary deficit, exchange rate of the dinar against foreign currencies and interest levels. The planned fiscal policy measures provide for a reduction of primary deficit, which means that the key factor of debt growth will be eliminated as of Interest levels are expected to stagnate in the period , while nominal GDP should increase by 8-10%. All these factors combined are expected to reduce the level of public debt serviced by the Republic of Serbia to a level of about 49.5% of GDP in Local government debt as a share of GDP is expected to increase to 3%, while guaranteed debt serviced by guarantee beneficiaries will increase to around 6.0%, in the next three years. The key measure of public debt-to-gdp ratio reduction in 2014 will be the sale of state-owned property (enterprises) in tendering procedures, in industries where such enterprises have competition and are not the so-called state monopolies, as well as the sale of minority interest packages held by the government in certain enterprises. One of the sources of proceeds that will contribute to public debt-to- GDP ratio reduction is also the sale of disused state-owned resources (buildings, other constructions, agricultural land etc.). Proceeds from the sale of state-owned assets will contribute to public debt reduction because they will be available for debt repayment. This will directly reduce interest burden in the coming budget years and increase primary budget deficit. It should be noted that another contributing factor to public debt-to-gdp reduction will be more adequate control of guarantee issuing and improved prioritization of investment projects eligible for funding from credit lines approved by multilateral and bilateral creditors. Also, basic definitions of the debt will be redefined and harmonized in the Budget System Law and Public Debt Law for the purpose of adequate statistical reporting of the government debt. 18

19 2.2 Public Debt Management Principles Pursuant to the Public Debt Law, the primary objective of Serbia s borrowing and public debt management is to ensure funds needed to finance budget expenditures, with minimum mid- and longterm financing costs and with acceptable risk levels. Minimization of long-term costs of public debt services is limited by the structure of debt and actual cost reductions will depend on a number of factors and risks. Taking this into account, Serbia s public debt management strategy identifies the following overall objectives and principles: 1) It is necessary to ensure financing of Serbia s fiscal deficit, including both short-term (liquidity) and long-term deficit, as part of the policy aimed at maintaining public finance system stability; 2) It is necessary to define the acceptable level of risk, which should be determined as a targeted debt portfolio structure in terms of currency structure of debt, interest rate structure, maturity structure and debt structure by types of financial instruments; 3) Support should be provided for the development of a market for government securities issued in domestic and foreign markets in order to utilize the developed markets as a means of cutting borrowing costs in the mid and long term, in line with the high-quality diversification of the debt portfolio; 4) The borrowing process should be transparent and predictable. The Public Debt Management Strategy should be supported by and consistent with the Government s general mid-term macroeconomic framework. Serbia s financing strategy needs to take into account a number of limiting factors. As a middleincome country, sources of finance available to it in domestic and international financial markets available to it are limited, especially at a time when developed EU Member States are facing difficulties in their efforts to secure financing for their fiscal deficits and refinancing for their mature debt. There are also strict conditions under which the country may borrow from bilateral and multilateral loan facilities. Taking into account the above limitations and potential risks, it was nevertheless decided that public debt management strategy in the following mid-term period should focus on financing national budget expenditures mainly through issues of government securities in international and domestic capital markets. The existing debt structure is rather heterogeneous, taking into account the inherited debt of the former Yugoslavia, the limited availability of market instruments in the past period and the specific status in terms of project financing by international financial institutions. The market for government securities is still in its infancy. One of the tenets of public debt management is the requirement for flexibility, to ensure financing for national budget expenditures. Flexibility will be reflected in the choice of markets in which the country will be borrow, the currency of borrowing and the financing instruments. The choice of financing structure will take into account the current situation and development trends in domestic and foreign financial markets (interest rate levels, risk premiums, yield curve, exchange rates of reference currencies) and acceptable levels of exposure to financial risks. The aim is to finance debt in the following period through issues of mainly dinar-denominated securities in the domestic market. However, given the present circumstances, much as the government is determined to develop the domestic market for government securities, a large share of financing in the mid-term will have to be ensured in the international financial market. Guidelines for borrowing in foreign currencies in the international market will be to ensure access to a large number of investors in different segments of the international financial, to match borrowing in foreign currency with repayment of debt denominated in foreign currency (including interest) where possible and to allow borrowing in 19

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