Abstract: This article gives an update on Serbia engagement to the European Union based on an analysis of the country’s exchange rate Serbian Dinar against the Euro. It gives a quick overview of the country’s macroeconomic situation, and the risk it faces if Serbia adopts the single currency in their regime.
Introduction
There are seven countries on the list of the EU enlargement, and Serbia is part of them. To review briefly its status, it applied for full membership in December 2009 and was confirmed as candidate at Brussels summit in March 2012. As far as we are concerned, there is no precise date when Serbian will potentially become a member of the European Union, however we heard from economist Dusan Reljic that 2025 could be the enter date based on the country’s economic parameters.
Review of the economic parameters
As you know, ten years from today is a long time and process, especially if we assume that there will be no external shocks during all these years. Although joining the European Union looks like a privilege still today, what are the benefits for Serbia?
First of all, we know that each country entering the European Union needs to meet a few Euro convergence criteria, also known as the Five Maastricht criteria. Here are the important ones to follow:
- Two of them requires ‘government discipline’: a debt-to-GDP ratio below 60% and a deficit-to-GDP below 3%. As you can see it on the table below, Serbia has constantly reported budget deficit over the past 9 years (exceeding 4% as a share of GDP in the past 3 years), sending its debt-to-GDP ratio to a new post-crisis high of 71%. It clearly shows us that Serbia needs to work on its fiscal adjustment, which means economic growth will be capped in the next decade.
(Source: Trading Economics)
- The next criteria is Price Stability, measured by the Harmonized Consumer Price Inflation rate (HCPI), which by definition ‘cannot exceeds the unweighted arithmetic average of the HCPI of the best EU members (lowest inflation rate) plus 1.5%’. First of all, with Europe now suffering from deflation (and Depression) in most of the countries, what sort of level do we expect from applicants now? Even though Serbia has never been a good student in managing its inflation rate, the country’s HCPI has been fluctuating around 2% over the past two years (See chart below). Its policymakers expect it to grow towards 4% for the period of December 2015 – December 2016, the core target based on the last National Bank of Serbia’s Memorandum of Inflation.
(Source: Bloomberg)
- Eventually, the last important condition to join the third EMU stage is the exchange rate stability, which basically means that the Serbian Dinar needs to be pegged to the Euro (within narrow bands) for at least two years before the final condition is met. If we look at the chart below, the Serbian Dinar has constantly been depreciating against the Euro since the Great financial crisis; EURRSD rose from a low of 75 in August 2008 to 120 today, which represents roughly a 60-percent devaluation. As you can see, the currency has been trading within a narrow range at around 120 over the past seven months.
(Source: Bloomberg)
What has happened with the Exchange Rate (EURSRD) over the past 6 months?
Let’s comment the chart below and try to understand why there is such no fluctuation on the exchange rate. When you look at it at, you would potentially believe that EURRSD is pegged at a central rate of 120 with a range band of +/- 1%. In order to protect this ‘hypothetical’ peg, the National Bank of Serbia would need to buy Euros and Sell Dinar if EURRSD trades below 118.80, and Sell Euros and Buy Dinars if EURRSD trades above 121.20.
(Source: Bloomberg)
Looking at the chart, it seems that the NBS had to react a few times in the April-June period (ellipse), therefore sell Euros and Buy Dinars, which could be explained in its balance sheet by the fall of its foreign exchange reserves between May and June as you can see it on the spreadsheet below.
(National Bank of Serbia)
Serbian Outlook within the EU
If we assume that Serbian Officials are trying to do ‘whatever it takes’ to enter the European Union, what can it expect in terms of growth and monetary policy?
As we said earlier, the country has only worked on its currency peg for the past few month, now the importance for the Serbia is to look at the economy outlook over the next 12 to 18 months. With more and more Emerging Markets entering into a crisis stage and most of the EM currencies collapsing (Brazilian Real, South African Rand, Russian Ruble…), it is important to learn from them and understand what factors could potentially hurt the Serbian economic outlook in the longer term. We mentioned earlier that Serbia has persistently recorded negative fiscal deficits over the past nine year, which is usually a negative sign for foreign investments. Another important variable that investors look at is the current account balance. The chart below shows that Serbia has also run a persistent current account deficit over the past 10 years, and the country recorded a current account deficit of 6% as a share of GDP.
(Source: Trading Economics)
When you look at the history of investments (Capital inflows and outflows), it doesn’t take to long for Foreign Investors to withdraw their money if the country runs a persistent twin-deficit (fiscal and current account deficits). When the market suddenly realizes that, the country suffers from violent market attacks and it can only count on its Central Balance Foreign Exchange Reserves to defend itself. NBS reported that it had approximately 1.3 trillion Serbian Dinars of Foreign Exchange Reserves, which corresponds to approximately 10.8bn Euros (i.e. very poor FX reserves). Therefore, it wouldn’t take the country to long to default in case of a market attack after a few years of speculation.
The problem with the EURRSD peg is that it is not the right time for it. Most of the countries in the World are facing severe issues based on the slowdown of EM market (especially China). Looking at the Serbian trade balance, which is an important component of the current account balance, it has constantly been on deficit over the past twenty years and was recorded at -10% as a share of the country in 2014. Therefore, if Serbia cannot devalue its currency in the middle of this EM meltdown, the country’s trade balance could even show worse figures in the coming years. Its agriculture industry, which accounts for 8.2% of its GDP and one fourth of the country’s total exports, won’t be enough to counter an asset price deflation and its banking sector’s exposure.
Nature of future investments…
When it comes to ‘investing in Serbia’, market participants have always been afraid of a potential new devaluation or a sudden loss of control of the inflation rate, in addition to geopolitical risks within the region. Serbia’s recent history has put aside foreign direct investments (FDI) during all these years. However, if the country joins the EU in a near future (near future in economics could mean a decade), officials need to be careful about the nature of investments and the banking exposure to those speculative waves. In the first part of the episode, in a period of low long-term rates, times look prosperous with equities and the property market reaching new historical highs and creating the so-called ‘wealth effect’, a process of reflexivity with the real economy (positive feedback loop). However, History showed the importance of a country’s balance of payments and its fiscal adjustments over the years. If exports continue to worsen based on a strong currency and a loss of competiveness, the government will first finance those imbalances by issuing more debt to the external investors. This will work for a number of years until the turning point when investors start to withdraw their money based on the economy conditions. This triggers the negative spiral and usually ends with an economy which GDP is lower than its initial state.
Conclusion
To conclude, fiscal adjustments combined with a currency peg will make it difficult for the country to generate a sustainable a healthy growth. The country just emerged from a dip recession with a negative 4% QoQ in the third quarter of last year. The economy is expected to grow by 0.5% in 2015 based on the last NBS report, but its long-term projection will steeply depend on the speed of the Euro Area. Therefore, the 3-percent target from some analysts seem very optimistic.
(Source: Trading Economics)
