Proposal for a COUNCIL DECISION providing macro-financial assistance to the Federal Republic of Yugoslavia

(presented by the Commission)

EXPLANATORY MEMORANDUM

1. Introduction

The long-awaited political changes in the Federal Republic of Yugoslavia (FRY) finally took place in October 2000. After a decade of confrontation with neighbouring countries and the international community that provoked complete isolation of the country and led to a conflict with NATO in 1999, the hard-line Milosevi regime collapsed on 5 October 2000 following federal presidential and parliamentary elections on 24 September. In Serbia, an extended transitional period of co-ruling of the former regime and the new democratic coalition ended after Serbian parliamentary elections on 23 December and with the establishment of the new Serbian Government in January 2001.

The departure of the old regime and the installation of a democratic reform-minded government was clearly an essential step in the process of setting the FRY on the path of sustainable political and economic development. The international community has supported the new regime in the FRY substantially, in particular with massive emergency assistance, to facilitate the consolidation of power during its first months of existence. The European Community (EC) in particular provided an emergency assistance package of some EUR200 million, as announced at the Biarritz European Council in October 2000. The package comprised food aid as well as medical and energy supplies to provide for the basic needs of the population during the winter 2000/2001.

During the past few months, the new FRY authorities were able to establish links with International Organisations and Financial Institutions. IMF membership occurred in December 2000 and a month later the FRY became a member of the European Bank for Reconstruction and Development (EBRD). Contacts with the World Bank and the European Investment Bank (EIB) have also been re-established with a view to getting these institutions operational in the FRY as soon as possible. The FRY was admitted to World Bank membership on 8 May 2001. This will pave the way for structural adjustment Bank lending in support of an economic stabilisation and reform programme. A precondition for new EC and EIB lending to the FRY is the acceptance and clearance of outstanding arrears (some EUR218 million as of beginning of April) stemming from relevant old loans to this part of the former Socialist Federal Republic of Yugoslavia. The FRY authorities have expressed their willingness to fulfil these obligations following the example of all the other former Yugoslav republics.

The FRY is currently facing important economic and financial challenges that are, for the greater part, those of a classic transition economy, although clearly compounded by war damages and sanctions. During the past ten years, economic and financial mismanagement have damaged the FRY economy, which went through a process of continuous de-industrialisation and international isolation. The economy became increasingly trapped in a vicious circle of negative savings, dis-investment and falling productivity. As a result, between 1990-1999, the FRY economy (excluding Kosovo) registered a negative average annual growth rate of 7 percent, reducing the estimated GDP in 1999 to half of that registered in 1990.

2. Recent Economic Performance

Following IMF membership in December 2000, the FRY received a loan under IMF's policy on emergency post-conflict assistance. In that context, the authorities agreed with the IMF a stabilisation programme that addressed the short-term needs and covered the period December 2000-March 2001.

Since the adoption of the programme, macro-economic policies have been in line with the agreed programme and, overall, conditions have been fulfilled. In particular, net domestic assets of the National Bank of Yugoslavia have been kept at a constant level and base money was only created on the basis of increases in net international reserves. Monthly inflation has come down considerably and has been maintained below 3.2 percent from December 2000 to March 2001. The exchange rate has been kept stable and foreign exchange reserves have increased since October from USD 380 million to the current level of about USD 580 million. On the other hand, real GDP growth in 2000 and in the first quarter of 2001 have remained below expectations.

Despite some improvement in tax and customs collection in the last quarter of 2000, the federal budget in 2000 was confronted with a shortfall in revenues and led to a compression of expenditures and arrears accumulation. In Serbia, revenue collection has also improved significantly since the last quarter of 2000 and the revenue targets under the programme have been fulfilled. However, for the year 2000 as a whole, the Serbian budget showed a consolidated deficit of some 10 percent, including a cash deficit of 1 percent of GDP, accumulated arrears during 2000 of 4 percent of GDP and quasi-fiscal deficits of 5 percent of GDP. Total stock of arrears at end-2000 amounted to 12 percent of GDP.

3. Medium Term Economic Policy Framework

3.1. Outline of the main policy objectives in 2001

The FRY authorities recently reached agreement ad referendum with the IMF staff on most policy aspects of a comprehensive stabilisation and reform programme for 2001 that could be supported by the Fund under a stand-by arrangement covering the period until end-March 2002. IMF Board approval of the programme is expected for June, although the timing will depend on the resolution of some outstanding issues, including the question of financing assurances from other donors and in particular from Paris Club creditors.

The main elements of the programme can be summarised as follows:

* Lowering 12-month inflation, by end-2001, to 30-35 percent in Serbia (from 115 percent at end-2000); and to 6½ percent in Montenegro (from about 25 percent at end-2000).

* Real GDP growth of around 5 percent.

* Containment of the current account deficit to about 16½ percent of GDP in 2001, consistent with a foreign reserve build-up by USD 0.2 billion, to USD 0.7 billion (equivalent to 1.3 months of imports).

3.2. Fiscal Policies

In Serbia, the general government cash deficit is envisaged to be contained to around 3.2 percent of GDP in 2001, to be financed through domestic bank financing of up to 0.6 percent of GDP, privatisation proceeds (1.4 percent of GDP), and foreign grants and loans (around 1.2 percent of GDP). The program includes a wage policy in the government and large state enterprises, consistent with keeping the annual wage bill broadly constant in real terms on the basis of the targeted rate of inflation. It also comprises large increases in the electricity prices (by 60 percent on 1st April , 40 percent on 1st June , and 40 percent on 1st October 2001) to limit the need for related budgetary subsidies. Moreover, the programme contains a major fiscal reform in Serbia, including a reduction in the number of taxes, a lowering of tax rates, and a widening of the tax base through elimination of exemptions. It also foresees the abolition of a large number of extra-budgetary programs with earmarked revenues and a reduction of military spending in relation to GDP, as well as its subjection to civilian control.

In Montenegro, the fiscal deficit should be contained to the equivalent of 0.4 percent of FRY's GDP, consistent with available foreign grants, on the basis of expenditure cuts in the areas of subsidies, investment, and other discretionary spending and no further increases in public sector wages. Various reform measures have been undertaken in the area of public finance (improvement in accounting standards, adoption of an organic budget law and measures to enhance revenue collection). These steps were largely enforced through conditionality attached to the exceptional Community financial assistance provided in 2000. The next step on the reform agenda will be the gradual introduction of a Treasury system to improve expenditure control.

3.3. Monetary and Exchange Rate Policies

It is the intention of the authorities to broadly maintain the monetary and exchange rate policy stance adopted by end-2000 under the short term IMF stabilisation programme through end-2001.

In Serbia such a policy would be based on the absence of any credit extension by the National Bank of Yugoslavia (NBY), i.e. no change in net domestic assets of NBY, and on creation of base money strictly limited to the purchase of foreign exchange. The authorities' main objectives are to stabilise the rate of the Dinar at the current level of around YuD30/D-mark, to reduce inflation to 30 percent (year-on-year) by end-2001 (from the 120 percent end-2000 level), and to consolidate the current foreign exchange reserve position (around USD 580 million) in the framework of the IMF stand-by programme. Further steps will be taken to liberalise interest rates and exchange transactions.

The Montenegrin authorities unilaterally adopted the D-mark/EUR as a sole legal tender at the end of 2000. They consider that this has contributed to stabilisation of the economy, and for the time being they do not intend to change the policy stance.

3.4. Structural Policies

The authorities have already implemented first structural reform measures, in particular in the area of trade and customs, privatisation and banking and financial sector.

As for trade, a federal draft law on trade liberalisation has been prepared and is expected to be adopted soon. According to the new law, enterprises engaged in foreign trade will no longer be required to register in the foreign trade register or to report to federal agencies on import and export contracts with foreign partners. Some quantitative restrictions will be abolished and transformed into tariff rates; minimum export prices for some products will be removed and the total amount of custom tariffs will be reduced from 40 to 6. The average protection rate will be reduced from 14.4 to 9.3 percent. Restrictions on advance payments for imports, which were established in the past to prevent capital flights, were recently partly removed as far as capital goods and raw material are concerned; they are still in place for imported consumables. In Montenegro, progress has been made as the number of items subject to trade restriction has been reduced significantly and as of now 95 percent of categories are subject to free trade. Customs rates range between 0 and 15 percent; the average customs rate is 2.5 percent and thus lower than in FRY/Serbia.

Privatisation is expected to make significant progress both in Serbia and Montenegro in 2001. In Serbia, the preparation of a new privatisation law is well advanced and is expected to be adopted in May 2001. The new law puts emphasis on privatisation through public tenders to strategic investors which shall obtain majority shares (up to 70 percent). Two tenders for cement companies will be launched very soon, to be followed by tenders for another cement company, a food processing company and a rubber and chemical company.

In Montenegro, the authorities are committed to transform all state property into private ownership. The authorities estimate that 25 percent of total capital has been privatised so far and project a further 35-40 percent this year on the basis of the Mass Voucher Privatisation programme. In addition, tenders for the privatisation of 20 companies will be under procedure or published by end-March 2001.

The restructuring of the banking sector is another area where prompt and comprehensive action is necessary. The FRY/Serbian authorities are currently engaged in a review of the banking sector to identify banks with financial problems and to examine the possibility of restructuring and rehabilitation of insolvent banks, as well as their closure. According to preliminary estimates of the authorities, the cost of the restructuring and rehabilitation of the banking sector would amount to some USD150-200 million in 2001. In Montenegro, a new law on the Central Bank of Montenegro and a law on the Banking System, which are in compliance with international standards, have been adopted by end-2000. These laws should provide the basis to transform the current cash economy to a market oriented system of financial inter-mediation. However, it still remains to be seen to what extent the 14 domestic banks which are currently operating in Montenegro, can be transformed into viable financial institutions. A new foreign bank has started operations in Montenegro and requests from three other foreign institutions are under review by the authorities.

4. External Financing Requirements of the FRY in 2001

According to IMF estimates, the FRY is facing a huge financing gap in 2001, reflecting both large import needs and external debt servicing obligations. FRY's current account deficit (before official transfers) is projected to widen to around USD 1.7 billion or 16.5 percent of GDP in 2001, reflecting a surge in foreign-financed imports and the resumption of debt servicing, in conjunction with a relatively modest increase in exports. Taking into account official grants and capital account inflows on the basis of already existing commitments, the overall balance of payments is projected to register a deficit of around USD 0.8 billion. Taking further into account a targeted increase in foreign reserves by USD 0.2 billion and external debt arrears of USD 10.1 billion as of mid-2001, the overall external financing gap is estimated at about USD 11.1 billion.

According to IMF projections, the financing gap could be in part filled by IFI programme and project assistance worth USD 287 million to be disbursed in 2001, including purchases from the Fund (USD 192 million), a programme loan from the World Bank (USD 85 million) and project-related loan disbursements from the EBRD (USD 10 million). The residual financing gap of some USD 10.8 billion is projected to be reduced by around USD 10.3 billion through rescheduling of arrears and current maturities and capitalisation of moratorium interest. Contacts are under way with the Paris Club and FRY external debt issues are expected to be discussed among Paris Club creditors in mid-May.

The IMF estimates the remaining financing gap at USD 530 million, of which USD 300 million are assumed to be in the form of balance of payments support. The IMF has not yet provided projections for the year 2002, however, the Fund expects a need for continued balance of payments support as the external financing needs will remain large partly due to increasing debt service payments.

5. Possible Community Macro-Financial Assistance and main Characteristics of this Assistance

The Commission is proposing that the Community would make available to the FRY a macro-financial assistance in the amount of up to EUR300 million. The proposed amount appears to be consistent with the IMF projections of the financing gap and the funding requirements.

The Community macro-financial assistance would contribute to bolstering the country's economic, social and political stability, as well as enhancing its important role as a factor of stability in the region after the political and democratic changes that occurred in the FRY in the last quarter of 2000. In particular, it is considered an appropriate measure to help ease the country's external financial constraints, support the balance of payments and strengthen the reserve position. The Community macro-financial assistance would complement resources being made available by International Financial Institutions and bilateral donors. Pledges for international financial support are expected at the FRY Donor's Conference that has tentatively been scheduled for 1st of June 2001. There is a risk that if sufficient official financing is not forthcoming, there would be adverse consequences for overall growth prospects, the level of employment and the standard of living. In this context, the probability of a policy reversal in economic and structural reforms would also increase substantially.

The proposed assistance would cover the whole one-year IMF stand-by programme period (tentatively 1st April 2001 - 31st March 2002). The implementation of this assistance would be conditional upon agreement between the FRY and the IMF on a macro-economic programme that is supported by an upper credit tranche stand-by arrangement and upon up-front full clearance of FRY's outstanding arrears towards the EC and the EIB. The assistance would be disbursed in at least two tranches and would be subject to appropriate macroeconomic and structural conditionality in line with the main elements of the IMF stand-by arrangement.

Given the overall level of indebtedness of the FRY and its limited borrowing capacity, the proposed Community macro-financial assistance foresees a substantial grant element of up to EUR120 million. As the macro-financial assistance operation would cover the period until end-March 2002, the grant element would thus partly be financed from the 2001 budget and partly from the 2002 budget.

The loan element of up to EUR180 million of this assistance would have a maturity of up to 15 years, comparable to recent macro-financial assistance packages to other Western Balkan countries. The Community would provide the funds through market borrowing with a guarantee by the general budget. The FRY would subsequently borrow from the Community. The borrowing and lending operations would be perfectly matched and would be without any commercial risk for the Community. In accordance with the Guarantee Fund mechanism, the budgetary implications of a decision to make available a loan of up to EUR180 million to the FRY would imply a EUR16.2 million provisioning of the Guarantee Fund.

The Council is therefore requested to adopt the attached draft Decision providing macro-financial assistance to the FRY.

2001/0112 (CNS)

Proposal for a COUNCIL DECISION providing macro-financial assistance to the Federal Republic of Yugoslavia

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community, and in particular Article 308 thereof,

Having regard to the proposal of the Commission [1],

[1] OJ

Having regard to the opinion of the European Parliament [2],

[2] OJ

Whereas:

(1) the Commission consulted the Economic and Financial Committee before submitting its proposal;

(2) political changes in the Federal Republic of Yugoslavia and the Republic of Serbia have taken place leading to new democratic governments and the Federal Republic of Yugoslavia is making efforts to establish a well-functioning market economy;

(3) within the Stabilisation and Association process, the framework for EU relations with the region, it is desirable to support efforts made to ensure a stable political and economic environment in the Federal Republic of Yugoslavia, with a view to evolving towards the development of a full co-operation relationship with the Community;

(4) financial assistance from the Community shall be instrumental in bringing the Federal Republic of Yugoslavia closer to the Community;

(5) the Federal Republic of Yugoslavia has reached an understanding with the International Monetary Fund (IMF) on a comprehensive set of economic stabilisation and reform measures to be supported by a 12-month upper credit tranche stand-by arrangement (SBA);

(6) the Federal Republic of Yugoslavia has reached an understanding with the World Bank on a set of structural adjustment measures to be backed by Structural Adjustment Loans and Credits in the areas of public finance reform, enterprise privatisation and banking restructuring;

(7) the authorities of the Federal Republic of Yugoslavia have requested financial assistance from the international financial institutions, the Community, and other bilateral donors;

(8) over and above the estimated financing which could be provided by the IMF and the World Bank, an important residual financing gap remains to be covered in the coming months in order to strengthen the country's reserve position and to support the policy objectives attached to the authorities' reform efforts;

(9) the authorities of the Federal Republic of Yugoslavia have committed themselves to fully discharge all outstanding financial obligations of all public entities of the Federal Republic of Yugoslavia towards the European Community and the European Investment Bank, and to accept the responsibility by way of guarantee of those obligations that are not yet due;

(10) a Community macro-financial assistance to the Federal Republic of Yugoslavia is an appropriate measure to help ease the country's external financial constraints, supporting the balance of payments and strengthening the reserve position;

(11) the Federal Republic of Yugoslavia is temporarily eligible for highly concessional loans and facilities from the World Bank,

(12) financial assistance from the Community in the form of a combination of a long-term loan and a straight grant is an appropriate measure to support the balance of payments and help ease the country's external financial constraints in the current exceptionally difficult circumstances;

(13) the inclusion of a grant component in this assistance is without prejudice to the powers of the budgetary authority;

(14) this assistance should be managed by the Commission in consultation with the Economic and Financial Committee;

(15) the Treaty does not provide, for the adoption of this Decision, powers other than those of Article 308,

HAS DECIDED AS FOLLOWS:

Article 1

1. The Community shall make available to the Federal Republic of Yugoslavia a macro-financial assistance in the form of a long-term loan and a straight grant with a view to ensuring a sustainable balance-of-payments situation and strengthening the country's reserve position.

2. The loan component of this assistance shall amount to a maximum principal of EUR 180 million with a maximum maturity of 15 years. To this end, the Commission is empowered to borrow, on behalf of the European Community, the necessary resources that will be placed at the disposal of the Federal Republic of Yugoslavia in the form of a loan.

3. The grant component of this assistance shall amount to a maximum of EUR120 million.

4. The Community financial assistance shall be managed by the Commission in close consultation with the Economic and Financial Committee and in a manner consistent with any agreement reached between the IMF and the Federal Republic of Yugoslavia.

5. The implementation of this assistance is conditional upon clearance in full by the Federal Republic of Yugoslavia of the outstanding due financial obligations of all public entities towards the Community and the European Investment Bank and upon the acceptance by the Federal Republic of Yugoslavia of responsibility by way of guarantee of those obligations that are not yet due.

Article 2

1. The Commission is empowered to agree with the authorities of the Federal Republic of Yugoslavia, after consultation with the Economic and Financial Committee, the economic policy conditions attached to the Community macro-financial assistance. These conditions shall be consistent with the agreements referred to in Article 1(4).

2. The Commission shall verify at regular intervals, in collaboration with the Economic and Financial Committee and in co-ordination with the IMF, that economic policies in the Federal Republic of Yugoslavia are in accordance with the objectives of this macro-financial assistance and that its conditions are being fulfilled.

Article 3

1. The loan and grant components of this assistance shall be made available to the Federal Republic of Yugoslavia in at least two instalments. Subject to the provisions of Article 2, the first instalment is to be released after the full settlement of the outstanding financial obligations of the Federal Republic of Yugoslavia towards the Community and the European Investment Bank and on the basis of an agreement between the FRY and the IMF on a macro-economic programme that is supported by an upper credit tranche arrangement.

2. Subject to the provisions of Article 2, the second and any further instalments shall be released on the basis of a satisfactory track record in the FRY's adjustment and reform programme and not earlier than three months after the release of the first instalment.

3. The funds shall be paid to the National Bank of the Federal Republic of Yugoslavia.

Article 4

1. The borrowing and lending operations referred to in Article 1 shall be carried out using the same value date and must not involve the Community in the transformation of maturities, in any exchange or interest rate risks, or in any other commercial risk.

2. The Commission shall take the necessary steps, if the Federal Republic of Yugoslavia so requests, to ensure that an early repayment clause is included in the loan terms and conditions and that it may be exercised.

3. At the request of the Federal Republic of Yugoslavia, and where circumstances permit an improvement in the interest rate of the loan, the Commission may refinance all or part of its initial borrowings or restructure the corresponding financial conditions. Refinancing or restructuring operations shall be carried out in accordance with the conditions set out in paragraph 1 and shall not have the effect of extending the average maturity of the borrowing concerned or increasing the amount, expressed at the current exchange rate, of capital outstanding at the date of the refinancing or restructuring.

4. All related costs incurred by the Community in concluding and carrying out the operation under this Decision shall be borne by the Federal Republic of Yugoslavia, if appropriate.

5. The Economic and Financial Committee shall be kept informed of developments in the operations referred to in paragraph 2 and 3 at least once a year.

Article 5

At least once a year the Commission shall address to the European Parliament and to the Council a report, which will include an evaluation on the implementation of this Decision.

Article 6

This decision expires on 30 June 2003.

Done at,

For the Council

The President

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FINANCIAL RECORD

1. Title of Operation

Macro-financial assistance to the Federal Republic of Yugoslavia.

2. Budget heading involved

a) Grant component of the assistance

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(1) This internal transfer in PA is subject to the adoption by the budgetary authority of the BRS4/2001 requesting additional payment appropriations for the Chapter 54 (Western Balkans).

b) Loan component of the assistance

B0-215 reflecting the European Community guarantee for borrowing programmes contracted by the Community to provide financial assistance for the Western Balkans. The amount drawn on the reserve is up to EUR16.2 million.

3. Legal basis

Article 308 of the Treaty

4. Description and justification of the action

a) Description of the action

Provision of a Community loan (to be financed by Community borrowings in the international capital markets) in the amount of up to EUR180 million and a Community grant of up to EUR120 million (to be financed from the General Budget) to the Federal Republic of Yugoslavia with a view to supporting the government's reform efforts and ensuring a sustainable balance-of-payments situation.

b) Justification of the action

The sustainability of the beneficiary country's economic stabilisation and reform achievements heavily depends on external financial assistance from official sources at concessional terms.

5. Classification of the expenditure

a) Grant component : non compulsory, differentiated.

b) Loan component : compulsory.

6. Nature of the expenditure

a) Straight grant (100% subsidy), which would be released in at least two successive instalments.

b) Potential activation of budget guarantee for the Community borrowing aimed to fund the loan.

7. Financial impact

a) Method of calculation

The evaluation of the amount of the assistance deemed necessary is based on the present estimates of the beneficiary country's residual external financing needs. For the loan component of the assistance, it is expected that the budget guarantee will not be called.

b) Effect of the action on intervention credits

The budget entry corresponding to the grant component of the assistance will be activated subject to compliance with a number of policy conditions to be agreed with the authorities of the Federal Republic of Yugoslavia.

The budget entry reflecting the budget guarantee for the loan component of the assistance will be activated only in the case of an effective call on the guarantee.

c) Financing of intervention

(i) Grant

The following schedule of appropriations to be financed within the limits of Category 4 of the present Financial Perspective is proposed (in million EUR):

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(ii) Eventual call on the budget guarantee

- Recourse to the Guarantee Fund established by Council Regulation (EC, EURATOM) no. 2728 of 31 October 1994, most recently amended by Regulation no. 1149 of 25 May 1999.

- In case the Guarantee Fund did not contain sufficient resources, additional payments would be called up from the budget by transfer: of any margin remaining in the Reserve for guarantees; of any late payments to the budget for which the budget guarantee has been activated (under Article 27(3) of the Financial Regulation); of any margin available under the ceiling of category 4 of the financial perspectives or redeployment therein.

- In order to fulfil its obligations, the Commission can provisionally ensure the debt service with funds from its treasury. In that case, Article 12 of the Council Regulation (EC, EURATOM) n°1552/89 of 29 May 1989 will apply.

8. Fraud prevention measures

The funds will be paid directly to the Central Bank of the beneficiary country only after verification by the Commission services, in consultation with the Economic and Financial Committee and in liaison with the IMF services, that the macro-economic policies implemented in these countries are satisfactory and that the specific conditions attached to this assistance are fulfilled.

The assistance will be subject to verification, control and auditing procedures under the responsibility of the European Court of Auditors and the Commission, including the European Antifraud Office (OLAF).

9. Elements of cost-effectiveness analysis

a) Grounds for the operation and specific objectives

By supporting FRY's macro-economic reform efforts and complementing financing by the International Community provided to this country in the context of the IMF-supported programme, this assistance would underpin its transition towards a market economy.

The present assistance will only be mobilised on the proviso that the beneficiary country fully discharges its outstanding due financial obligations towards the Community and the European Investment Bank.

b) Monitoring and evaluation

This assistance is of macro-economic nature and its monitoring and evaluation is undertaken in the framework of the IMF-supported stabilisation and reform programme that the beneficiary country is implementing.

The monitoring of the action by the Commission services will take place on the basis of a genuine system of macro-economic and structural policy indicators to be agreed with the authorities of the beneficiary country. The Commission services will also remain in close contact with the IMF and World Bank services to benefit from their assessment of the recipient country's stabilisation and reform.

An annual report to the European Parliament and to the Council is foreseen in the proposed Council decision, which will include an evaluation of the implementation of this operation.

10. Administrative expenditure

This action is exceptional in nature and will not involve an increase in the number of Commission staff.