Serbia and Montenegro—Letter of Intent, Memorandum of Economic and Financial Policies, and Technical Memorandum of Understanding

May 21, 2004

Ms. Anne Krueger
Acting Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Ms. Krueger:

Firm implementation of our medium-term economic program supported by the Fund under the Extended Arrangement (EA) has permitted good progress in stabilization and reform. To ensure continued progress, we have updated our economic and policy targets for 2004-05, as described in detail in the attached Memorandum on Economic and Financial Policies, to reflect the latest developments. On this basis, we request: (a) completion of the third review (including the sixth and seventh financing reviews) under the EA, (b) a waiver for the non-observance of the end-December, 2003 performance criterion on net bank credit to the government, (c) two purchases of SDR 50 million each corresponding to the end-September and end-December 2003 test dates, and (d) a reapportionment of the last five purchases originally envisaged under the arrangement into four equal purchases to be phased over the remainder of the arrangement.

We believe that the policies and measures described in the attached memorandum are sufficient to achieve our program objectives, but we stand ready to take timely additional measures and seek new understandings with the Fund, as necessary, to keep the program on track. We will remain in close consultation with the Fund on the adoption of these measures, and in advance of any revisions to the policies contained in the attached MEFP in accordance with the Fund's policies on such consultations. We will provide all information to the Fund that it requests to assess the implementation of the program. The program will continue to be reviewed by the Fund, with the discussions for the fourth review, in combination with the Article IV consultation, expected in September 2004. The fourth review will concentrate on the implementation of fiscal, monetary and exchange rate policy, progress in enterprise and bank reform (including issues related to connected lending) and the broad macroeconomic and policy parameters of the 2005 program, while the fifth review will focus on the annual budget and financial program for 2005. Moreover, each purchase under the arrangement will continue to be subject to a review of the financing of the program.

Yours sincerely,

/s/ Predrag Ivanovi Minister of Foreign Economic Relations Serbia and Montenegro
/s/ Miroljub Labus Deputy Prime Minister Republic of Serbia	/s/ Miroslav Ivaniševi Deputy Prime Minister Republic of Montenegro
/s/ Mladjan Dinki Minister of Finance Republic of Serbia	/s/ Radovan Jelaši Governor National Bank of Serbia
/s/ Igor Luksi Minister of Finance Republic of Montenegro	/s/ Ljubisa Krgovi Chairman Central Bank of Montenegro

Memorandum of Economic and Financial Policies

I. Introduction

1. This memorandum updates and supplements the Memorandum of Economic and Financial Policies (MEFP) attached to the Letter of Intent of July 11, 2003. It reports on recent developments under the program supported by the Extended Arrangement (EA) approved in May 2002 and updates the economic objectives and policy agenda for the remainder of 2004. Annexes A and B, attached to this memorandum, contain the quantitative performance criteria and indicative targets, while Annexes C and D list the structural performance criteria and benchmarks as well as prior actions. Annex E (Technical Memorandum of Understanding, TMU) defines the performance criteria and indicative targets and describes the reporting arrangements.

2. Although political developments impacted adversely on the pace of reforms, further progress has been made toward integration with Europe over the past year. The two states of the Union of Serbia and Montenegro have moved toward harmonizing their customs, trade and indirect tax regimes as a step toward a Stability and Association Agreement with the EU. Continued progress has also been made in stabilizing and restructuring the economy as described below. Meanwhile, following Serbian parliamentary elections in December 2003, a new government took office in March and began work to reinvigorate reforms and foster sustainable growth.

3. Economic performance has remained generally favorable but the current account deficit remains large. Twelve-month inflation was almost halved from a year earlier to 7.8 percent at end-2003—below the 9-11 percent target—notwithstanding currency depreciation. Real GDP growth in 2003 is estimated at about 3 percent—lower than the targeted 3½-4½ percent owing in part to the effects of drought on agricultural output. Gross industrial output declined by 2.7 percent, but this reflected the contraction of inefficient production and incomplete coverage of the most dynamic enterprises, with value added in industry performing better. The current account deficit (before grants)—at almost 12½ percent of GDP in 2003—exceeded the program target by about 1½ percentage points of GDP. A large fiscal deficit, rapidly rising euro wages, and continued albeit lower credit growth contributed to the 7½ percent import volume growth in 2003, while restructuring-induced losses in the export base and weak foreign demand dampened export volume growth to 3 percent, leaving export levels low by historical standards. Private remittances were buoyant at 11.2 percent of GDP. About ¾ of the 2003 current account deficit was financed by FDI (which reached 6¾ percent of GDP) and foreign grants. A surge in privatization proceeds helped raise official gross reserves by $1.3 billion in 2003 to $3.6 billion (4.4 months of 2004 imports) at end-year, although subsequent pressures on the foreign exchange market — triggered mainly by budgetary overspending in December — reduced official reserves to $3.3 billion by end-March.

4. Macroeconomic policies have remained broadly on track (Annex A). End-December 2003 performance criteria on credit and external sector targets were met, but the ceiling on net bank credit to the general government was exceeded by 0.4 percent of GDP. As regards indicative targets, the ceilings on banking system NDA and on the transfer of central government bank deposits to the central bank were met, but the ceiling on the wage bill of public enterprises (adjusted for spin-offs) was exceeded by a small margin and the zero limit on net new expenditure arrears was breached by the equivalent of 0.1 percent of GDP (on account of the social funds).

5. Fiscal developments have been broadly in line with the program, except for an expenditure slippage in December. The fiscal deficit excluding foreign-loan financed projects (FLFPs) amounted to 3.7 percent of GDP, 0.4 percent above the program target. This reflected election-related spending as well as "expenditure-smoothing" in late December before the onset of tight temporary financing arrangements for 2004 Q1. Revenue was in line with the program, with strong PIT and CIT receipts offsetting weaker-than-projected retail sales taxes and social contributions. The overall fiscal deficit, including FLFPs amounted to 4.2 percent of GDP. Temporary budget rules restricted spending in the first quarter of 2004 in Serbia while revenue performance was approximately as budgeted, leading to a broadly balanced general government position in 2004 Q1.

6. Privatization exceeded expectations, but other structural reforms were delayed. Serbian cash privatization receipts reached €729 million (4 percent of GDP) in 2003, more than twice the budget assumption. Other key structural reforms included the introduction of a new Serbian payments system, pension reform, and trade regime harmonization within the union. However, political developments since late 2003 delayed enterprise, bank and fiscal reforms (Annex C). Under a revised timetable, the resolution plan of the largest Serbian bank will be finalized by mid-May, 2004; the tender for the sale of the first bank to be privatized will also be launched by end-May, with two others to follow before end-2004; and, following a further step in early 2004, the debt-equity swap in banks associated with Paris and London Club related debt will be completed by end-June 2004.

7. Negotiations with foreign creditors will continue. Despite progress in discussions with London Club creditors—including the submission by the outgoing authorities of a detailed debt restructuring proposal to creditors on Paris Club terms—political developments precluded an agreement. The new government will: resume London Club discussions in June 2004, thereby demonstrating SM's continued good-faith efforts in the negotiations; sign the remaining Paris Club bilaterals in the coming months; and, complete the restructuring of other debt, including short-term debt to Russia and China.

II. Economic Objectives and Policies

8. The economic objectives for 2004 have been updated within a medium-term framework to take into account recent developments (Table). They are consistent with the achievement of sustainable growth, low inflation, and a viable external position over the medium term:

• Real GDP is projected to grow by 4-5 percent in 2004 supported by the recovery in agriculture this year, and reach 5 percent in subsequent years owing to further progress in privatization, large cumulative FDI inflows since early 2002, and declining restructuring-related output losses.
  
  
• Inflation is targeted to be contained at 8-9 percent through end-2004 and to converge toward EU levels over the medium term.
  
  
• The external current account deficit (before grants) is projected to narrow by 1½ percentage points to 11 percent of GDP in 2004 in line with progress toward external sustainability and consistent with expected financing; and to decline steadily thereafter based on a recovery of exports toward historical levels—reflecting improving domestic supply conditions and an upturn in foreign demand—and a containment of imports through prudent policies.
  
  
• FDI and grants will cover almost half of the 2004 deficit (based on cautious official privatization estimates), with official borrowing and other capital inflows covering the remainder. As the business climate improves over the medium term, FDI inflows will play an increasing role in financing the current account deficit, allowing a gradual decline in reliance on foreign assistance.
  
  
• Following a large over performance this year, import coverage of foreign reserves will remain broadly unchanged from end-2003, with a view to guarding against possible risks and preparing for the projected rise in external debt service in a few years following the expiry of grace periods under debt restructuring agreements.

9. Macroeconomic policies will be geared to support growth while narrowing the external current account deficit. Specifically, (a) the overall fiscal deficit (including FLFPs) will be reduced by 0.7 percentage points to 3.1 percent of GDP; (b) cost competitiveness and profitability in the traded goods sector will be enhanced in part through wage restraint in the state sector; and (c) dinar money growth will be kept broadly in line with targeted nominal GDP growth.

10. To safeguard medium-term objectives, structural reforms in the enterprise and banking sectors will be invigorated. With the pipeline of readily privatizable socially-owned enterprises drying up, focus will shift toward the accelerated restructuring of public utilities and insolvent socially-owned enterprises to facilitate their rapid privatization. Further structural reforms will include public expenditure and tax reform, bank restructuring and privatization, and the early passage and effective implementation of laws on bankruptcy and energy to harden enterprise budget constraints.

11. The PRSP process will continue to guide the development agenda and social policies. After consultations with and contributions by civil society, full PRSPs were adopted by the Serbian and by the Montenegrin governments in late 2003. Social spending will be protected to provide a safety net for those affected adversely by reforms, while its efficiency will be enhanced through the improved targeting of benefits.

A. Fiscal Policy

12. Fiscal policy will underpin the stabilization effort in 2004. The overall SM fiscal deficit will be lowered to 3.4 percent of GDP, of which 3.1 percent would be incurred by Serbia and the remainder by Montenegro (equivalent to 4.6 percent of its own GDP). Excluding foreign-loan financed projects (expected to rise by ½ percentage points of GDP), the deficit is projected to fall by 1.2 percentage points to 2.5 percent of GDP. Reflecting prudently budgeted privatization receipts (0.7 percent of GDP), the fiscal program in 2004 will be financed mainly domestically (0.9 percent of GDP) including a drawdown of privatization receipts from previous years, and by foreign assistance (1.8 percent of GDP). Excess privatization proceeds, after covering a shortfall in foreign assistance, will be used to reduce net government indebtedness and—if consistent with achieving program objectives and in consultation with the Fund in the context of program reviews—to cover investment and restructuring costs.

Serbia

13. The consolidated Serbian fiscal deficit will be limited to 2.3 percent of GDP (3.1 percent including FLFPs) to put the fiscal and current account deficits on sustainable paths.¹ In line with the new government's objectives to promote growth, create jobs, boost agricultural production, and maintain macroeconomic stability, the 2004 fiscal program will reduce the labor tax burden, increase capital expenditures, notably for road construction, channel assistance to the agriculture sector, and help accelerate enterprise restructuring and bank reform. These programs will be financed though higher taxes on consumption and cuts in recurrent expenditures, especially for goods and services. To avoid the accumulation of new arrears, the republican budget will provide adequate transfers to the social funds. Since the 2004 budget adopted by parliament last March provides for a deficit of 3.3 percent of GDP (excluding FLFPs), additional measures have been adopted or will be in place before Board consideration of the third review, as described below, to ensure achievement of the program's fiscal deficit target.

14. The tax policy package will raise budgetary revenues. In line with the 2004 fiscal program, consolidated revenue is projected to increase by 0.7 percentage points to 40.5 percent of GDP. First, several new measures were adopted in April, including: (i) amending the Excise Law, effective May 2004, with a total positive revenue effect of around (CSD 5.2 billion), including gains from additional retail sales tax receipts;² (ii) increasing the Tax on Use, Keeping and Carrying of Goods (tax on motor vehicles, vessels, and aircrafts) (CSD 0.7 billion); and (iii) securing an agreement with the Board of NIS (state-owned oil refinery enterprise) to make a cash dividend transfer of CSD 5 billion to the budget. Second, as prior actions for the Board discussion, in May the contribution rate to the Employee Pension Fund will be increased by 1.4 percentage points to 22 percent (CSD 3 billion) and excise on diesel will be raised by 3 dinars/liter (CSD 3.5 billion). These measures will more than compensate for the elimination of the wage-bill tax (3.5 percentage points, accruing fully to local governments) starting July 1, with an estimated cost, already included in the 2004 budget, of CSD 7½ billion this year (1.1 percent of GDP on an annualized basis). The republican budget will compensate local budgets by transferring a higher share (30 percent rather than 5 percent) of the personal income tax (PIT) with an amendment of the Law on Local Public Finance.

15. The expenditure share in GDP at the general government level is projected to remain broadly at its 2003 level of 44 percent. In line with the new government's objectives, the 2004 budget has increased allocations for road building, agricultural support (subsidies and a new bank-administered investment lending program), and enterprise and bank restructuring. The general government wage bill will rise somewhat in relation to GDP, reflecting mainly wage increases at the union level in late 2003, but spending on goods and services will be curtailed.

16. Expenditure cuts and reallocations in the 2004 budget will facilitate the realization of the deficit target while avoiding new arrears. Transfers to the social funds will be increased by about CSD 7 billion—CSD 3 billion for the Employee Pension Fund (EPF), CSD 2.5 billion for the Farmer's Pension Fund, and CSD 1.5 billion for the Labor Market Fund—to ensure timely payment of entitlements. Expenditure cuts relative to the 2004 budget, to be implemented in line with the organic budget law, include transportation (CSD 0.5 billion), the development fund and others (CSD 2 billion), subsidies to agriculture (CSD 1.5 billion), and bank restructuring (CSD 1.2 billion). These cuts will be complemented by reductions in (i) net lending to agriculture (CSD 0.5 billion); (ii) the general reserve (CSD 2 billion); (iii) projects for the Road Directorate (CSD 1 billion); (iv) Health Fund transfers (CSD 0.5 billion); and (v) goods and services (CSD 0.5 billion). To help ensure that the finances of the social funds are placed on a sustainable path, the government has started an audit of the EPF, which could generate savings in the medium term.

Fiscal reform

17. The government will present to Parliament a major tax reform package for implementation in 2005. Eliminating the wage bill tax was a first step in the new government's plan to improve the tax system. By mid-year, the parliament is expected to adopt a value-added tax (broad-based with no more than two rates) to replace the cascading retail sales tax (RST) with effect from January 1, 2005. In addition, the financial transaction tax on all transactions will be eliminated (taxes on secondary market transactions in securities were abolished recently). Finally, local property taxes will be placed on a progressive scale, raising revenues for local governments.

18. The strengthening of revenue administration will continue. An excise and retail sales tax enforcement program was revitalized recently, and a program of unannounced field audits targeting selected enterprises/activities traditionally associated with high tax evasion is being implemented. The newly adopted Customs Law will facilitate tighter control and the enforcement of duties collection, while the standardization of the business identification number will help reduce tax fraud and evasion. Following the VAT law adoption, the Ministry of Finance will immediately begin intensive training for tax officials, promote VAT registration, and increase taxpayer education. VAT administration will be centralized in the four regional offices and in 24 A-type branch offices with strong taxpayer services; VAT audit and refund audit programs will also be put in place. In the coming months, new legislation will harmonize the bases of the social security contributions and the personal income tax; and eliminate remaining nuisance taxes.

19. Treasury operations will be further strengthened. All remaining direct budget users (Serbian Parliament, President of the Republic, the Ministry of Interior, Agency for Security and Intelligence Service, Tax Administration, Public Payment Agency, Road Directorate, Geodesic Agency, and Tobacco Agency) will be brought into the Treasury Single Account (TSA) by end-2004 following a further expansion of the treasury's implementation capacity. In the interim, the treasury will ensure the daily transfer of cash balances of these sub-accounts to the TSA to minimize idle cash balances. Second, with FAD technical assistance, the Ministry of Finance will examine the role of the PPA and decide how to ensure centralized monitoring and control over all budgetary payments. In the medium term, all sub-accounts of indirect budget users will be closed, with their financial operations being brought under the TSA.

Montenegro

20. Fiscal adjustment continues in Montenegro. Following revisions in March-April, the 2004 general government deficit (before grants) is targeted at €67.1 million, representing a fiscal adjustment relative to 2003 by 0.6 percentage points to 4.6 percent of Montenegrin GDP (or by 1.2 percentage points to 3.4 percent of GDP excluding foreign loan-financed projects). In light of a projected shortfall in budget revenue, achievement of this target will require corrective measures of €10.2 million. Accordingly, as prior actions for the Board consideration of the third review, (a) new legislation in May raised cigarette excises and introduced new taxes on motor vehicles, insurance and gambling (with an expected yield of €4.5 million) and (b) the government adopted a decision to cut spending commitments on agricultural subsidies, net lending and public investment by €5.7 million. Over the medium term, the government is committed to continue lowering the deficit to ensure fiscal and external sustainability.

21. The government is implementing a tax reform package to reduce the currently high and distortionary payroll taxes that discourage job creation. The government, in consultation with the IMF and World Bank and in the context of a Supplementary Budget for 2004, envisages a phased lowering in social contribution and PIT rates, with a first 5 percentage point reduction effective July 1, 2004, and a subsequent reduction of equal size effective on December 1, 2004. The resulting revenue loss would be partly offset by a marked reduction in budgetary employment involving at least 4,200 government sector redundancies by end-2004, which is projected to generate savings in 2005 of €15 million. When preparing the revised 2004 and the 2005 budgets, the government, in consultation with the IMF and the World Bank staff, will adopt sufficient fiscal measures effective at the time of the first reduction in social contribution and PIT rates to ensure that the program's deficit targets in 2004 and beyond are achieved. In particular, the government will review revenue developments, and, if necessary to achieve the program's deficit target, adopt a one percentage-point increase in the VAT. Meanwhile, the government will refrain from extending new exemptions or differential VAT rates to any sector.

22. The government will also adopt key reforms in cash management, health sector financing and revenue administration. To improve cash management, central government deposits will be shifted gradually from commercial bank accounts to the Treasury Single Account held at the CBM by end-2004, except for balances held at the largest bank undergoing restructuring, where the amount of central government deposits would be halved by end-2004 and reduced to zero by end-2005. In the health sector, the government will work closely with the World Bank to ensure early implementation of an equitable system of co-payments for health care services to raise efficiency in the use of public resources. Finally, revenue administration will be enhanced with a stronger focus on collecting tax arrears and enforcing stricter compliance with current obligations. The government will avoid restructuring the tax debt in a manner that would undermine its tax collection over the medium term.

B. Monetary and Exchange Rate Policies

23. The 2004 monetary program is consistent with targeted inflation on the assumption of a slight increase in dinar broad money velocity. Reserve money is programmed to rise by 7½ percent, reflecting an expected reduction in banks' excess dinar reserves. With NFA broadly unchanged, reserve money growth would be driven by NDA. Dinar broad money and credit to the economy are projected to rise by 11½ percent. In accordance with the central bank law, the NBS will not extend credits to the government, except in limited amounts and for short periods.

24. The development of market-based instruments remains a key task. To expand its monetary instruments, facilitate the development of a money market, and manage bank liquidity, the NBS will introduce repo operations. To this end, the NBS and the Ministry of Finance will restructure the government's debt to the NBS and enhance NBS-Treasury coordination, in the context of new by-laws on the NBS' organizational structure. In addition, taxes on interbank security transactions will be phased out. To enhance public resources management and avoid implicit subsidies to banks, all republican government deposits will be transferred to the NBS by end-June 2004, and all NBS deposits in commercial banks will steadily decline and will be fully withdrawn by end-February 2005, while imposing market-based interest rates on remaining deposits in the interim. To make NBS monetary operations more effective, the fiscal-monetary committee will prepare a monthly operation plan for 2004 taking into account budget financing needs, the schedule of T-bill issuance, and treasury debt repayments.

25. Exchange rate policy in Serbia will continue to strike a balance between safeguarding the external position and containing inflation. The NBS will maintain a flexible exchange rate policy taking into account conditions in the interbank market and developments in trade, prices, and domestic costs, with a view to supporting external competitiveness, while continuing to provide a nominal anchor for price expectations.

C. Bank Reform

26. Bank restructuring and privatization will continue. A resolution plan for the largest bank, to be prepared in consultation with IMF and World Bank staff, will be adopted by the Board of the Bank Rehabilitation Agency (BRA) by mid-May 2004 as a prior action for Board consideration of the third review under the Extended Arrangement (Table D). The plan will provide a cost estimate for the chosen resolution option and involve: (i) no recapitalization or new liquidity support from the NBS, general government, or state-owned enterprises, prior to privatization; (ii) consolidation prior to recapitalization, including incentives and penalties for bank management to achieve downsizing targets; (iii) a reduction in operating costs in 2004 of at least 10 percent compared with 2003, along with clear incentives and penalties linked to management performance; (iv) no net new lending or launch of new business activities; and (iv) no significant capital investment. By end-June 2004, the government will adopt and publish a comprehensive strategy and timetable to divest the state's equity stakes in 16 banks based, inter alia, on diagnostic audit reports, annual audits, and supervisory reports. A tender notice offering a controlling stake in Jubanka will be published by end-June 2004. The tenders of state-owned stakes in Continental Banka and Novasadska Banka will be launched by end-September 2004. The tenders will seek to maximize the present value of the State's equity, notably through either ensuring that the new owners will retain responsibility for managing existing bank assets, or carving out and auctioning selected impaired assets. At the same time, the government will prudently evaluate and strictly limit the provision of indemnities or put options and warranties to new owners. As regards Niška Banka, a privatization advisor is expected to be appointed by end-July, and a tender for its sale issued by end-December, 2004.

27. The operations of the Serbian Bank Rehabilitation Agency (BRA) will be strengthened. A government decision will clarify the mandate of the BRA in managing and divesting the government's shareholdings in all banks. Concurrently, the BRA will strengthen its reporting requirements, control mechanisms, and governance in nationalized banks to preserve their value prior to resolution. The BRA will resolve the remaining bank under its administration, Pirotska Banka, by end-June 2004. By the same date, it will also complete the conversion into state equity of the bulk of London Club obligations (e.g., principal and interest accruing through end-May 2004), in compliance with the PLC law in a manner that maximizes the value of the State's equity.

28. Strengthening financial sector supervision and regulation remains a top priority in Serbia. After a delay due to management changes, the NBS resumed the implementation of the Supervisory Development Plan. Monthly liquidity indicators on banks were developed and a CAEL (capital, assets, earnings, and liquidity) system has been put in place. The large-debt registry was enhanced to include information on rating, provisions, and industry. As of early 2004, 5 banks have undergone full-scope on-site examinations, while on-site examinations of another 5 non-bank financial institutions have led to the closure of 3 such institutions. An early warning system will be broadened and the full CAMEL rating system will be finalized by mid-2004 with a view to developing a risk-based NBS examination schedule. Work is also underway to identify banks' ownership structure so as to enforce regulations on lending to connected parties. The official translation of IAS standards and the corresponding chart of accounts have been published, enabling financial institutions to prepare and publish IAS-conform financial statements for 2003 and to fully implement IAS from 2004; the same schedule, delayed by a year, will apply to non-financial institutions. Building on this progress, the NBS will intensify the enforcement of asset classification and provisioning through risk-based on-site and off-site supervision. In addition, the government will implement a more robust, pro-active framework for the supervision of non-bank financial institutions—involving comprehensive audits and the consistent enforcement of minimum capital requirements for insurance companies—following the enactment of a new law on insurance expected by end-June 2004.

29. Bank reform in Montenegro will continue to focus on privatization, asset resolution, and government deposit management, with banking supervision remaining vigilant. An international tender will be launched by end-2004 to sell the government's holdings in Podgoricka Banka, aiming to maximize cash privatization proceeds. Building on progress so far, a strategy to divest all state holdings from the banking system will be prepared by end-2004. Meanwhile, the state will cease to increase its stake in the banking system both directly and indirectly, through capitalizing banks by state-owned enterprises. While the CBM had made good progress in banking supervision-including implementing most of the Basel Core Principles, working towards consolidated risk-based supervision, and tightly enforcing prudential regulations—it will continue to be vigilant in light of the rapid credit expansion in 2003. A recently established Financial Investigation Unit has taken the lead responsibility for implementing the Anti-Money Laundering law, and, in cooperation with the CBM and the MOF, for continuing to identify remaining illegally operating offshore banks and recommend actions to close them if any are identified. To safeguard public resources and instill financial discipline, the Ministry of Finance intends to classify assets carved out from the banking system according to collectibility in the coming months. On this basis, by end-September 2004 the government will contract out—through an international tender procedure—the collection of assets deemed most collectible; and adopt a clear policy by year-end regarding the early resolution of the remainder. A draft Law on Insurance will be submitted to Parliament by end-June 2004, requiring insurance companies to be supervised by an independent authority in line with international best practice. Building on notable progress to date and forthcoming technical assistance, enhanced balance sheets for the central bank and for deposit money banks will be developed to improve the monitoring of banking and fiscal developments.

D. Enterprise Sector

State enterprises

30. The Serbian government will continue restructuring public utilities based on strategic plans. The forthcoming new Company Law will considerably simplify the spin-off and subsequent privatization of non-core activities. To ensure continued financial viability of EPS (electricity company), the average electricity price will be raised by at least 10 percent effective July 1, 2004 (PC-monitored)—part of the increase will be in the form of a change in the block tariff structure, namely a reduction in the first block tariff structure from 600 kWh to 300 kWh per month. EPS will reduce its core employment (relative to end-September 2003) by 3,400 by end-2004 in line with its business plan; service all its debt to the government in full except for the Kosovo-related debt; and, as in 2003, not receive any budgetary subsidy in 2004. To facilitate energy sector restructuring, the government will submit the draft Energy Law to Parliament by end-May. To enhance the collection rate and strengthen enterprise budget constraints, utilities will enforce penalties on late payments, cut off supplies to nonstrategic users with large arrears, or initiate their bankruptcy. Preparations will also continue to implement an operational regulatory framework for natural monopolies by end-December, 2004. Finally, the government will adopt a revised railway transport strategy based on profitability benchmarks involving substantial reductions in core employment, the closure of nonprofitable lines, and opening competition with alternative service providers on an equal footing to enable a reduction in government support to ZTP, which claims massive budgetary subsidies.

31. Wage bills in state enterprises will continue to be controlled to contain inflation pressures and encourage labor shedding. The wage bills in monitored state enterprises in 2004 will be allowed to grow by 8 percent on an annual average basis in line with the inflation target. Serbia's Ministry of Finance and Economy will monitor closely wage bill developments and ensure that the program's wage bill targets are met. In the list of monitored enterprises, Srbija Telekom will replace Srbija Voda to better reflect the macroeconomic importance of monitored enterprises in 2004. In the event of spin-offs as a result of future restructuring, the monitored wage-bill envelope will be adjusted downward for the wage-bills of the spun-off units.

Socially-owned enterprises

32. The pace of privatizing socially-owned enterprises is expected to slow, reflecting the lesser quality of the enterprises remaining in the pipeline. About 10 large socially-owned enterprises will be offered for sale through tenders, and 300 small and medium-sized ones through auctions during March-December 2004. Following a setback stemming from legal complications during the first quarter of 2004 in the sale of residual state-owned shares in socially-owned enterprises, share sales will resume from June 2004. A large transaction involving a state-owned company in the telecom sector will be prepared during the year, with the sale expected to be completed in 2005. The government will ensure that all asset sales are carried out in accordance with international best practice, including the competitive hiring of investment advisors and transparent international tenders. In addition, at least 2 large conglomerates undergoing restructuring, or core parts thereof, should be offered for sale by end-September, and 2 more by end-December 2004. The success rate in both auctions and tenders is expected to decline, reflecting the lower average quality of enterprises offered for sale (first attempts at selling many of these firms failed). In total, cash receipts from enterprise privatization are expected to amount to some €150 million in 2004. This compares with privatization receipts of about €230 million assumed in the budget, which includes receipts from expected bank sales. To ensure fiscal transparency, all privatization proceeds will be channeled through the budget and spending will follow normal budgetary procedures.

33. Rapid restructuring and privatization of remaining large socially-owned enterprises remains critical for enhancing the supply response and strengthening the external position. In this regard, the indebtedness of insolvent enterprises has become a critical impediment to the privatization process, which needs to be addressed without creating moral hazard. To this end, further write-offs of arrears on taxes, contributions or other enterprise liabilities to the government, public utilities or state-owned banks will be conditional on privatization or irreversible bankruptcy. With World Bank assistance, the extensive network of claims and liabilities will be tackled through coordinated agreements of state creditors (government and state-owned enterprises and banks) on haircuts; experience to date shows that private creditors are willing to accept similar haircuts in return for prompt payment. Recent progress in this area included the government decree enabling the Privatization Agency and the BRA to negotiate with creditors on the state's behalf, and the establishment of an inter-ministerial negotiating group with the right to propose haircuts on public utilities' claims on enterprises to be privatized. This approach will be prudently, transparently, and expeditiously implemented for socially-owned enterprises under restructuring.

34. An effective bankruptcy process is critical for strengthening enterprises' financial discipline. The bankruptcy process will become operational by end-November 2004, following Parliamentary adoption of the new bankruptcy law and related legislation (including on the establishment of an agency to license and regulate bankruptcy trustees) by end-June 2004 (performance criterion-monitored), and the establishment of supporting institutions by end-November 2004 (structural benchmark-monitored). In collaboration with the World Bank, intensive work-including training courses—will continue to address existing limitations in the judiciary and in the availability of qualified trustees. The bankruptcy process for all enterprises will be under the authority and supervision of the courts, with trustees preparing each case for judges to rule on a handful of remaining key issues, such as unresolved creditor seniority, and the timing of asset sales or closure. The implementation of bankruptcy proceedings for socially-owned enterprises will also be facilitated by creating a specialized bankruptcy trustee agency for these enterprises.

35. Privatization in Montenegro is proceeding. The large aluminum company (KAP) and a steel company are in the process of privatization. For the former, a financial advisor has been hired and an international tender will be announced by end-June. In addition, Montenegro Telecom is expected to be offered for sale later this year. Privatization proceeds have been conservatively budgeted at €15 million.

E. Foreign Trade System

36. The foreign trade system is being harmonized internally and liberalized through regional agreements. Agreement on a timetable to harmonize the trade, customs, and indirect tax regimes of the two republics was adopted in August 2003, with 93 percent of harmonized tariff rates applied immediately, and the remaining 7 percent—with the exception of 56 agriculture products, for which harmonization will take up to 5 years—applied in 18-24 months. The special import fees for agricultural products will also be harmonized in 5 years. All export and import quotas have been eliminated, and the two republics intend to harmonize customs and trade laws and their implementation. Discussions on bilateral Free Trade Agreements with neighboring countries within the initiative of Stability Pact—aimed at facilitating trade through harmonized rules and standards, and simplified customs procedures—have progressed well. A Free Trade Agreement with Bosnia and Herzegovina is already in force, while the agreements with Bulgaria, Croatia and Romania have been ratified. It is envisaged that the first meeting of the Task Force of Serbia and Montenegro for the WTO accession will take place in the second half of 2004. Customs operation is expected to be further strengthened, including at the Union level. To avoid backtracking on reforms and maintain a competitive market environment, both Serbia and Montenegro will refrain from introducing or intensifying import restrictions.

III. Program Monitoring

37. Macroeconomic policy performance under the EA will continue to be monitored on the basis of quarterly quantitative performance criteria and indicative targets (Annex B). Progress in structural reform will be monitored through structural performance criteria and benchmarks on key policy measures (Annex D). Quarterly performance criteria are proposed for end-June, end-September, and end-December, 2004. Parliamentary (or when sufficient, government) approval of selected fiscal measures for Serbia and for Montenegro, as well as the adoption of a resolution plan for the largest domestic bank in Serbia in line with policies described in this memorandum, will constitute prior actions for Board consideration of the third review under the Extended Arrangement (Annex D).

Annex A

Annex B

Annex C

Annex D

Serbia and Montenegro: Technical Memorandum of Understanding

I. Introduction

1. This memorandum replaces the Technical Memorandum of Understanding attached to the Memorandum of Economic and Financial Policies of July 11, 2003. It sets out the understandings regarding the definitions of quantitative and structural performance criteria, benchmarks, and indicative targets for the program supported by the Fund under an Extended Arrangement (EA), as well as the related reporting requirements. The key changes in this updated memorandum include definitional changes in the external debt ceilings, and data revisions.

2. To monitor developments under the program, the authorities will provide the data listed in each section below to the European Department of the Fund, in accordance with the indicated timing. The quantitative performance criteria and indicative targets will be monitored on the basis of the methodological classification of monetary and financial data that was in place on December 31, 2002, except as noted below. Quantitative performance criteria and indicative targets for end-June, end-September and end-December 2004 are specified in Annex A of the Memorandum of Economic and Financial Policies (MEFP).

3. For program purposes, the public sector consists of the consolidated general government (comprising union operations, Serbian state and local governments, the Montenegrin state government, the Serbian and Montenegrin social security funds, and the Serbian special budgetary programs), the National Bank of Serbia (NBS), and the Central Bank of Montenegro (CBM). The authorities will inform the Fund staff of any new funds or special extrabudgetary programs that may be created during the program period to carry out operations of a fiscal nature as defined in the IMF's 2001 Manual on Government Financial Statistics, and will ensure that these will be incorporated within the definition of consolidated general government.

II. Quantitative Criteria: Definitions and Reporting Standards

A. Floor for Net Foreign Assets of the NBS and Program Exchange Rates

4. Definition. Net foreign assets (NFA) of the NBS consist of foreign reserve assets minus foreign reserve liabilities.

• For purposes of the program, foreign reserve assets shall be defined as monetary gold, holdings of SDRs, the reserve position in the IMF, and NBS holdings of foreign exchange in convertible currencies. Any such assets shall only be included as foreign reserve assets if they are under the effective control of, and readily available to, the NBS. In particular, excluded from foreign reserve assets are: frozen assets of the Union of Serbia and Montenegro (SM), undivided assets of the former Socialist Federal Republic of Yugoslavia (SFRY), long-term assets, NBS claims on resident banks and nonbanks, as well as subsidiaries or branches of SM commercial banks located abroad, any assets in nonconvertible currencies, encumbered reserve assets (e.g., pledged as collateral for foreign loans or through forward contracts), and precious metals other than monetary gold. For program purposes, all euro and foreign currency-related assets will be evaluated at program exchange rates; for 2004, the program exchange rates are those that prevailed on December 31, 2003. In particular, US$1 = DIN 54.6372, €1 = DIN 68.3129, and SDR1 = US$ 1.4806. Monetary gold shall be valued at an accounting price of US$ 416.85 per ounce. On December 31, 2003, the NBS's foreign reserve assets as defined above amounted to US$3,550.1 million, including gold valued at US$139.3 million.
  
  
• For purposes of the program, foreign reserve liabilities shall be defined as any foreign currency-denominated short-term loan or deposit (with a maturity of up to and including one year); NBS liabilities to residents and nonresidents associated with swaps (including any portion of the NBS gold that is collateralized) and forward contracts; IMF purchases; and loans contracted by the NBS from international capital markets, banks or other financial institutions located abroad, and foreign governments, irrespective of their maturity. Undivided foreign exchange liabilities of SFRY are excluded. On December 31, 2003, the NBS's foreign reserve liabilities, as defined above, to nonresidents were US$1,013.4 million and to residents were US$790.0 million.
  
  
• All assets and liabilities denominated in convertible currencies other than the U.S. dollar shall be converted at their respective exchange rates against the U.S. dollar prevailing on December 31, 2003. All changes in definition or in valuation of assets or liabilities, as well as details of operations concerning sales, purchases or swap operations with respect to gold shall be communicated to the Fund staff within one week of the operation.

5. Reporting. Data on foreign reserve assets and foreign reserve liabilities of the NBS shall be transmitted to the European Department of the Fund on a weekly basis within four business days of the end of each business week. To facilitate program monitoring, the NBS will provide the data at the indicated constant prices and exchange rates, as well as at current exchange rates. The NBS will report if any of the reported foreign reserve assets are illiquid, pledged, swapped, or encumbered.

6. Adjustors. For program purposes, net foreign assets will be adjusted upward pari passu to the extent that: (i) after December 31, 2003, the NBS has recovered frozen assets of the FRY, assets of the SFRY, long-term assets, and foreign-exchange-denominated claims on resident banks and nonbanks, as well as SM commercial banks abroad; and (ii) the restructuring of the banking sector by the Bank Restructuring Agency (BRA) involves a write-off of NBS foreign-exchange-denominated liabilities to resident banks. The net foreign assets floor will be adjusted downward by the shortfall relative to the programmed level of net external budgetary financing cumulative from December 31, 2003 (US$119.0 million through end-June 2004, US$ 148.2 million through end-September 2004, and US$217.4 million through end-December 2004) with a maximum adjustment of US$100 million. The net foreign assets floor will also be adjusted by the amount that the end-December, 2003 outcome is revised.

B. Ceiling on Net Domestic Assets of the NBS

7. Definition. For purposes of the program, net domestic assets (NDA) of the NBS are defined as the difference between reserve money (as defined in section E) and net foreign assets (as defined in section A), with the latter being converted from U.S. dollars into dinars at the program exchange rates as specified above. The ceiling is established as the monthly average of each month with an end-month test date (i.e., the averages of June, September, and December 2004, respectively). The monthly average of NDA for program purposes will be calculated as the difference of the monthly average of reserve money and monthly average of NFA. The monthly average of NFA will be adjusted so that the disbursements of World Bank program loans and EU macro-financial assistance are counted as if they occurred on the first day of the month in which they were effected. As of December 31, 2003, NDA of the NBS so defined were valued at DIN-25,412 million (Annex B).

8. Adjustors. The NBS's NDA ceiling is subject to the same adjustor for excess or shortfall in combined budgetary external financing and privatization proceeds for the consolidated Serbian government as defined in Section C, except that the limit for upward adjustment is DIN 2.5 billion. The adjustment for excesses/shortfalls in combined budgetary external financing and privatization proceeds is asymmetric: (a) it applies to the NDA ceiling but not to the NFA floor (except that shortfalls in budgetary external financing trigger an equal downward adjustment in NFA up to a limit of US$100 million); and (b) upward adjustments in NDA are capped at the equivalent of 0.2 percent of programmed annual GDP, while no limits apply to downward adjustments. This treatment takes into account that: (a) privatization proceeds reflect partly sales to residents (i.e., not directly affecting NFA), so that a downward adjustment in NDA in response to higher than programmed privatization proceeds may not necessarily lead to a corresponding increase in NFA or may do so with a considerable lag (money demand is not stable in the short run); and (b) the need to safeguard foreign reserves.

9. Reporting. The ceilings will be monitored on the basis of daily data on NBS foreign reserve assets and liabilities as defined under section A, and reserve money (as defined under section E), supplied to the European Department of the Fund by the NBS within four business days of the end of each business week. To facilitate program monitoring, the NBS will provide daily its foreign reserves liabilities, as well as the amounts and dates of World Bank and EU macro-financial assistance disbursements at the current and the program exchange rates.

C. Ceiling on the Net Credit of the Banking System to the Consolidated General Government

10. Definition. The banking system comprises the NBS and commercial banks licensed by it in Serbia, as well as the CBM and commercial banks licensed by it in Montenegro. The consolidated general government was defined above.

• For program purposes, net credit of the banking system to the consolidated general government is defined as all claims other than frozen foreign currency deposit (FFCD) bonds (i.e., credits, securities, and other claims in both dinar and foreign currencies) of the banking system on the consolidated general government less all deposits of the consolidated general government with the banking system, including foreign currency deposits. Foreign currency deposits and foreign-currency-denominated credits to the general government will be reported at the program exchange rates. Net bank credit to the consolidated general government in Montenegro will be monitored on the basis of data supplied by the Montenegrin authorities; at end-December 2003, net credit of the banking system in Montenegro to the consolidated general government in Montenegro amounted to €5.1 million (equivalent to DIN 348.4 million). At end-December 2003, net credit of the banking system to the consolidated general government so defined was DIN-24,036 million.

11. Reporting. The ceilings will be monitored using end-month data on the accounts of the banking system supplied to the European Department of the Fund with a lag not to exceed three weeks.

12. Adjustors. For program purposes, the ceilings on net credit of the banking system to the consolidated general governments will be adjusted downward by the cumulative increase in the stock of government debt held by the nonbank public (other than that related to the frozen foreign currency deposits), starting from January 1, 2003, and upward for any decrease. These performance criteria will be adjusted by the amount that the end-December 2003 outcome is revised. In addition, in the event of a shortfall in the sum of net foreign budgetary financing and privatization proceeds, the ceilings will be adjusted upward by 75 percent of the shortfall subject to the total adjustment limit of DIN 5 billion for Serbia's and €6 million for Montenegro's consolidated government. The ceilings will be adjusted downward for the excess of combined net external budgetary financing and privatization proceeds relative to budgeted levels that are not used (1) to reduce the government's external indebtedness by more than envisaged under the program, or (2) to cover investment and restructuring costs in consultation with the Fund in the context of reviews under the EA. Privatization receipts are defined to include all cash privatization receipts (defined as cash received by the government including the privatization agency), including those channeled to extrabudgetary funds. Net external budgetary financing is defined to include all budgetary (i.e., non-project) grants and loans, less amortization (on a cash basis). The estimation of the shortfalls (excesses) in the sum of net foreign budgetary financing and privatization receipts will be based on the following projections (cumulative from the beginning of 2004) with the actual inflows evaluated at the average exchange rates of the month when funds are received:

Serbia (In billions of dinars)

Montenegro (In € million)

D. Ceiling on Change in Domestic Arrears

13. For program purposes, indicative targets will be set on the change in domestic arrears. Separate indicative targets will be set for the consolidated general government of Serbia (including union-level spending), and the consolidated general government of Montenegro.

14. Definition

• For the purpose of establishing compliance with this indicative target, union-level expenditure is defined to comprise all budgetary activities specified in the Constitutional Charter, including the SM army and the SM pension fund for retired military personnel. The consolidated general government of Serbia is defined to comprise all budgetary institutions financed from the Serbian state budget, the Republican Pension and Invalidity Insurance Fund for Employees, the Republican Pension and Invalidity Insurance Fund for Self-employed, the Republican Pension and Invalidity Insurance Fund for Agricultural Workers, the Republican Health Insurance Fund, the Republican Labor Market Agency, all republican special directorates, and all other budgetary and extrabudgetary funds created by the government of Serbia existing before or created during the period of the program. The consolidated general government of Montenegro is defined to comprise all budgetary institutions financed from the state budget, the Republican Pension and Invalidity Insurance Fund, the Republican Health Insurance Fund, the Republican Labor Market Fund, and all other budgetary and extrabudgetary funds created by the government of Montenegro existing before or created during the period of the program.
  
  
• The outstanding stock of domestic arrears comprises wage and pension arrears; arrears with respect to accrued tax and social security contribution obligations, including personal income tax and social security contributions of employees withheld at source; arrears on social entitlement benefits (apart from pensions) to households; arrears incurred with respect to the purchases of goods and services from suppliers; arrears related to the servicing of domestic debt and nonpayment of budgeted transfers to finance union-level expenditures.
  
  
• The outstanding stock of wage arrears at a particular date are defined as total accumulated unpaid wages of all employees on the regular payroll of all units belonging to the parts of the general government as defined above, up to the latest preceding regular pay date, which have not been settled by the test date. The total stocks of wage arrears, thus defined, are on a gross basis and are calculated by summing the wage arrears of all units of government with regard to their own employees; transfers between different levels of government for making wage or other payments are excluded from the estimates of these wage arrears.
  
  
• Pension arrears are defined as total accumulated pensions due but not disbursed by the pension funds concerned to all pensioners in the pension rolls up to the latest preceding pension disbursement date.
  
  
• The outstanding stocks of tax and social contribution arrears at a particular date comprise total accumulated accrued tax obligations of the parts of the general government as defined above that have not been paid by the test date. The total stocks of such arrears are on a gross basis.
  
  
• Social entitlement payments, apart from pensions, are defined as all cash payments due directly to, or on behalf of, the population in accordance with stipulations in the law and which are not contingent upon the provision of any services or sale of any goods or assets to the general government by such members of the population in return for these payments. The stock of such entitlement arrears are defined as total accumulated payments due but not disbursed by all units of government up to the test date. Thus defined, these arrears are also on a gross basis and do not include the netting out of any transfers made between different units of the general government for the payment of such entitlements.
  
  
• Arrears to suppliers comprise payments delayed beyond what was explicitly specified in relevant contracts, or in the absence of such specification, for two months from the date of submission of bills, for already-effected purchases of goods or services by the government concerned. These include, inter alia, arrears to utility companies, arrears incurred with respect to service and maintenance contracts, and payments for capital goods. These arrears are also defined on a gross basis. Thus, overdue tax and other obligations to the government of relevant enterprises are not included in the calculation of the arrears of the government, and netting out of any transfers made between different units of the general government for the payment of such arrears and obligations are also not taken into consideration.
  
  
• Arrears to domestic banks and nonbank lenders comprise all overdue payments related to financial contracts between the government and domestic banks, nonbanks, and private lenders.
  
  
• € denominated claims on government will be converted at the program exchange rate; claims denominated in currencies other than the € will first be converted at their respective program exchange rates against the € . The change in arrears is defined as the change in the end-period stock of arrears. Changes in wage and pension arrears will be adjusted for the changes in the average wage and average pension in the economy relative to their respective values in December 2003.
  

15. Reporting. Before the last business day of each month following the end of a quarter, data on end-period stocks of arrears for the previous quarter will be supplied to the European Department of the Fund by the Ministry of Finance of Serbia, and the Ministry of Finance of Montenegro.

E. Definition of Reserve Money

16. Definition. Reserve money is defined as the sum of currency in circulation (NBY Bulletin, September 2000, Table 3A, column 8) and dinar reserves banks are required to hold at the NBS, plus excess reserves of the commercial banks. Shortfalls in reserves that banks are required to hold will be included in required reserves (and therefore in reserve money), as well as in bank borrowing from the NBS. As of December 31, 2003, the required reserve ratio was at 18 percent of the base as defined in NBS Decision of March 28, 2002. Subsequent changes in the reserve requirement will be reflected in program definitions. The amounts that banks are permitted to hold in securities to satisfy the statutory reserve requirement will be limited to the amount that banks were holding as of December 31, 2000 (DIN 174.1 million). Excess reserves include commercial banks' (1) balances in Giro accounts 620, 621, 623, and 625, (2) overnight deposit in account 205 at the NBS, (3) excess balances above required reserves on account 201 at the NBS (with the shortfall in required reserves counted as negative excess) and (4) cash in vaults.

17. Data on reserve money will be monitored from the daily monetary indicators of the NBS, which will be supplied to the European Department of the Fund weekly by the NBS with a three-day lag. The end-month data is based on the NBS balance sheet, which will be provided to the Fund with a lag of less than three weeks. On December 31, 2003, currency in circulation amounted to DIN 43,712 million, while required reserves amounted to DIN 15,662 million, and excess reserves to DIN 10,644 million. For program and projection purposes, monthly averages of reserve money and its components were used. Data on effective reserve requirements and the deposit base used in reserve requirement calculations will be supplied to the European Department on a ten-day basis with a lag of less than a week.

18. Adjustors. For program monitoring purposes, reserve money will be adjusted as follows. Should the standard reserve requirement increase (decrease) from the level prevailing on December 31, 2003, the ceiling on net domestic assets would be increased (decreased) by an amount equivalent to the change in the standard reserve requirement ratio multiplied by the programmed deposit base used in the calculation of required reserves. Before making any changes to the reserve requirement, the NBS will consult with Fund staff. Required reserves of banks placed under BRA administration or liquidation will remain part of reserve money for program purposes. Similarly, the CBM will consult with Fund staff before making any changes to the reserve requirement.

F. Ceiling on External Debt-Service Arrears

19. Definition. External debt-service arrears are defined as overdue debt service arising in respect of obligations incurred directly or guaranteed by the public sector, except on debt subject to rescheduling or restructuring. The program requires that no new external arrears be accumulated at any time under the arrangement on public sector or public sector-guaranteed debts.

20. Reporting. The accounting of nonreschedulable external arrears by creditor (if any), with detailed explanations, will be transmitted on a monthly basis, within two weeks of the end of each month. This accounting will include, separately, arrears owed at the union level, by the Serbian and Montenegrin governments, and other public sector entities; arrears owed by Yugoslav Airlines; and arrears owed to Paris Club creditors, London Club creditors, and other creditors. Data on other arrears, which are reschedulable, will be provided separately.

G. Ceilings on External Debt

21. Definitions. The ceiling on contracting or guaranteeing of new nonconcessional external debt by the public sector with original maturity of more than one year applies not only to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt adopted on August 24, 2000 (Decision No. 12274-(00/85), see attachment to this Annex) but also to commitments contracted or guaranteed for which value has not been received. Excluded from this performance criterion are loans from, or other indebtedness to, the EBRD, the EIB and EU, the IBRD, the IMF, and the IFC. However, cumulative from December 31, 2003, contracting or guaranteeing by the public sector of new nonconcessional external debt from the EBRD, the EIB and EU, the IBRD, and the IFC will not exceed US$500 million by end-June 2004, US$500 million by end-September 2004, and US$500 million by end-December 2004 (Annex A defines the separate ceilings applicable for Serbia and for Montenegro). Contracting or guaranteeing of new debt will be converted into US$ for program purposes at the cross exchange rates implied by the official NBS exchange rates in effect on the day of the transaction. Concessionality will be based on a currency-specific discount rate based on the ten-year average of the OECD's commercial interest reference rate (CIRR) for loans or leases with maturities greater than 15 years and on the six-month average CIRR for loans and leases maturing in less than 15 years. Under this definition of concessionality, only debt with a grant element equivalent to 35 percent or more will be excluded from the debt limit. Second, with regard to the ceiling on new external debt with original maturity of up to and including one year owed by the consolidated general government or guaranteed by the public sector, the term "debt" has the meaning set forth in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt adopted on August 24, 2000 (Decision No. 12274-(00/85). Excluded from this performance criterion are normal short-term import credits.

22. Reporting. A debt-by-debt accounting of all new concessional and nonconcessional debt contracted or guaranteed by the public sector, including the original debt documentation, details on debt service obligations, as well as all relevant supporting materials, will be transmitted on a quarterly basis within four weeks of the end of each quarter.

III. Other Reporting Requirement for Program Monitoring

A. Macroeconomic Monitoring Committee

23. A macroeconomic monitoring committee, composed of senior officials from the Union Government, Serbian and Montenegrin Ministries of Finance, the NBS, and other relevant agencies, shall be responsible for monitoring the performance of the program, informing the Fund regularly about the progress of the program, and transmitting the supporting materials necessary for the evaluation of performance criteria and benchmarks.

B. Developments on Structural Performance Criteria and Benchmarks

24. The authorities will notify the European Department of the Fund of developments on structural benchmarks as soon as they occur. The authorities will provide the documentation, according to the dates in Annex C, elaborating on policy implementation. The authorities will also notify the European Department of the Fund expeditiously of any economic developments or policy measures (prior to taking such measures in the latter case) that could have a significant impact on the implementation of this program.

C. Data Reporting

Production and prices

25. Any revision to macroeconomically relevant data will be transmitted within three weeks of the date of the revision.

Public finance

26. Monthly data on public finance will include a consolidated budget report of the state governments (including union level operations), transmitted within four weeks of the end of each month comprising:

• The revenue data by each major item, including that collected by the state and local governments, as well as the social funds (also including "own revenue" of direct budget users);
  
  
• Details of current and capital expenditure at the union, state, and local levels, as well as those of the social funds (also including "own expenditure" of direct budget users); and
  
  
• Details of budget financing, both from domestic, and external sources, including total privatization receipts and Treasury bill issues and repayments (in the format described in paragraph 27).
  
  
• Montenegro will report quarterly arrears data starting from end-December 2003 for the consolidated general government in Montenegro, separating out normal float, and providing end-quarter stocks of arrears and gross repayments of outstanding arrears during each quarter.

Monetary sector data

27. The following data will be transmitted on a daily/weekly/biweekly basis within one/five working days of the end of each day/week.

• Daily movements in gross foreign reserves of the NBS at current and program exchange rates and gold prices, indicating amounts sold/bought at the auction, in foreign exchange offices and on the interbank market, inflows of foreign grants, inflows of foreign loans, and repayments of frozen foreign currency deposits.
  
  
• Daily movements in foreign exchange-denominated liabilities of the NBS to (i) non-residents; (ii) SM resident banks; and (iii) other SM residents.
  
  
• Daily movements in liquid foreign exchange assets of SM resident banks as reported by these banks to the NBS.
  
  
• Daily movements in reserve money, indicating currency in circulation, the basis upon which required reserves are calculated, required reserves, reserves held, and excess reserves.
  
  
• Outstanding stocks of Treasury bills, Treasury bill repayments made during the reporting period, and auction details (yields, amounts per maturity and number of banks participating in the auction per maturity).
  
  
• Interbank foreign exchange rates and volume of transactions, including rates and volume of trading outside the fixing session.
  
  
• Ten-day report on public sector borrowing and lending from commercial banks and the NBS.
  
  
• Ten-day report on required reserves and the reserve base.

28. The balance sheet of the NBS and the consolidated balance sheets of the commercial banks, including all banks in Montenegro, will be transmitted on a monthly basis within three weeks of the end of each month. The stocks of government and mandatory and voluntary NBS securities held by banks and by non-banks, as available to the NBS, detailed information on interbank money market transactions (terms, duration, and participating institutions), and interest rate developments will be transmitted on a monthly basis within two weeks of the end of each month. Credit to government by the banking system is provided with detailed breakdowns on the union, state, and local governments.

29. The following data will be transmitted on a monthly basis:

• NBS foreign exchange reserves held in accounts abroad, foreign banknotes, and foreign securities as well as interest income on foreign assets.
  
  
• Individuals' foreign exchange savings in top ten banks.
  
  
• Grants and loans disbursement as well as debt amortization and interest payments.

External data

30. The data below will be transmitted as follows:

• The interbank market exchange rate, as the simple average of the daily-weighted average buying and selling rates, will be transmitted on a weekly basis within five business days of the end of the week;
  
  
• Balance of payments data on services, private transfers, and capital account transactions will be transmitted on a quarterly basis within four weeks of the end of each quarter; and
  
  
• Detailed monthly data on the volume and prices of exports and imports, separating out imported petroleum products.
  
  
• The CBM will provide quarterly updates of the Montenegro balance of payments, including projections for the current and subsequent year.

Executive Board Decision No. 6230-(79/140) (Guidelines on Performance Criteria
with Respect to Foreign Debt) adopted August 3, 1979, as amended by Executive
Board Decision No. 11096-(95/100) adopted October 25, 1995, and as amended on August 24, 2000

Point No. 9

(a) For the purpose of this guideline, the term "debt" will be understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows:

(i) loans, i.e., advances of money to the obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans and buyers' credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements);

(ii) suppliers' credits, i.e., contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and

(iii) leases, i.e., arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the lessor retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property.

(b) Under the definition of debt set out in point 9(a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. However, arrears arising from the failure to make payment at the time of delivery of assets or services are not debt.

Supplement

June 2, 2004

Ms. Anne Krueger
Acting Managing Director
International Monetary Fund
Washington, DC 20431

Dear Ms. Krueger:

This letter updates the Serbia and Montenegro authorities' letter of intent dated May 21, 2004 and the accompanying Memorandum of Economic and Financial Policies (MEFP) with information on: Serbia's implementation of prior actions; new policy understandings on health sector wages and economy-wide minimum wages; and recent progress in Serbia-Montenegro's discussions with the London Club of creditors.

Serbia has implemented all its prior actions for Board consideration of the third review under the Extended Arrangement. Specifically: (a) on May 21, 2004, Serbia's Parliament adopted a law raising diesel excises by 3 dinars per liter with effect from June 1, 2004 (3.5 billion expected yield in 2004), (b) on May 29, 2004, the Serbian cabinet adopted a decision raising the pension contribution rate by 1.4 percentage points to 22 percent effective July 1, 2004 (3 billion dinars expected yield in 2004), and (c) on May 14, 2004, the Bank Rehabilitation Agency adopted a restructuring plan for the largest domestic bank in line with Bank and Fund staff recommendations. In connection with the latter, the government will not assume or guarantee any foreign debt obligations of this bank, in line with program commitments on nonconcessional borrowing.

To motivate health care workers and help retain them in the public sector, the wage structure for the health sector will be decompressed. In July 2004, wages for nurses and doctors will, on average, be increased by 7 percent and 14 percent respectively, in addition to the 7.5 percent general pay raise during 2004 that is envisaged under the program. With these added increases, the wage ratio between the highest grade (medical specialists) and the lowest grade (nonprofessional workers in the health sector) will increase from 3:1 to 3.5:1. To cover the associated net fiscal cost of about 1.4 billion dinars (0.1 percent of GDP in 2004), existing health fund contribution rates (ranging from 0.8 percent to 17.7 percent, with a weighted average of 11.5 percent) will be unified at 12.4 percent effective July 1, 2004. We will not implement a second wage increase for nurses and doctors currently envisaged for December, before consulting with the Fund staff during the September program review discussions.

We will not change the method of setting the minimum wage before consulting with the Fund staff on its macroeconomic implications in the context of the September discussions on the next program review. The increase in the minimum wage on July 1 will not exceed the rate of inflation over the past 6 months.

Negotiations on the restructuring of Serbia and Montenegro's debt to the London Club of creditors resumed recently with the submission to the creditors of a detailed debt restructuring proposal on terms comparable to those offered by the Paris Club. The creditors' response to this proposal is expected by mid-June 2004.

Sincerely yours,