This is the story of a country located next to the largest and most connected economic block in the world, with fairly low labor costs and a relatively well educated workforce. You would expect that country to do well. However, the state of Serbia’s economy is problematic. Today, Serbia’s output is below what it was in the 1980s (in the time of Yugoslavia) and only half of its working age population has a job in the formal sector.
At the heart of Serbia’s problems are two interconnected imbalances, which explain why the country appears to be stuck on its path to prosperity. First, the economy is running on domestic consumption, which was fueled by financial inflows since 2000, while exports remain well below potential. Second, employment is driven by the state, not the private sector, with almost half (45%) of all formal jobs in the government or State Owned Enterprises.
Serbia’s path to prosperity – and EU accession – will be about correcting these two imbalances. For a small, open, middle-income economy like Serbia there is only one path to higher growth and thus a higher income for all citizens: the country needs to integrate more successfully with the world, especially Europe. This is because a small domestic market is not enough for firms to expand and scale-up production and because trade generates technological spillovers and learning. Today, Serbia’s exports are below 40 percent of GDP while many of the world’s successful economies have rapidly grown in foreign markets. This includes transition economies and Serbia’s regional peers such as Slovakia and the Czech Republic (both doubling their exports from 40% to 80% of GDP since the mid-1990s) and countries as different as Panama, Ireland, Malaysia or Singapore, all of which have export levels close to or above 100% of GDP.
Serbia’s labor market imbalance is even more dramatic: Out of a population of 7.2 million, and a workforce of 4.6 million, only 2.2 million (48 percent) have a job to start with. In more successful countries of Central and Eastern Europe the ratio is above 60 percent. The EU average is around 65 percent. Moreover, almost half of those formally employed are working in the public sector. The main challenge, therefore, is a dearth of private sector jobs. If Serbia’s is to reach an employment rate of 65 percent – similar to the Czech Republic – it will need to create an additional 800,000 jobs.
Chart 2: Out of a workforce of 4.6 million, just over 1 million have a job in the formal private sector
And this is where the interconnectedness between Serbia’s two weaknesses becomes apparent. The private sector needs opportunities to expand in order to create jobs: given the limited domestic market such expansion needs to take place “abroad”.
Manufacturing exports are particularly promising: Serbia already has some traditional strengths and existing clusters, especially in the automotive sector. However, Serbia’s productivity in manufacturing is low, at just 40 percent of the level of new EU member states, which means that even with lower labor costs, Serbia is not competitive. Why is productivity so low? In short, the level and quality of investment was nowhere near adequate to upgrade the technology and processes used by many of Serbia’s companies. FDI is a good proxy as it contributed almost ¾ of Central and Eastern Europe’s growth during its first decade of transition. Yet Serbia’s accumulated stock of FDI is low, at less than US$ 4,000 per capita, while it is over US$ 11,000 per capita in the Czech Republic or Slovakia. Moreover, almost three quarters of Serbia’s (low) investments went to non-tradable sectors – telecoms, real estate, retail and wholesale trade, banking – reinforcing the economic imbalance. Manufacturing only attracted 20 percent of the FDI.
Why have Serbia’s export sectors not attracted more interest from investors? Most export industries, particularly manufacturing, are lumpy and entail large-scale commitments which will only pay-off in the medium-term. Therefore investors only come if they can expect a certain degree of stability with respect to economic fundamentals and a good and predictable business environment (smooth process of starting and expanding a business, especially if they need to construct buildings and factories). These are precisely the areas where Serbia is weak relative to its neighbors and peers. Excessive regulatory burdens add to the costs of production and exports, unclear land use policies inhibit investment, and the current tax system does not make it worthwhile to hire low-medium skilled workers.
Making a country more competitive requires a comprehensive reforms program and consistent implementation. Many factors need to come together to succeed: a well-trained workforce; an open and efficient trade regime; an environment in which investors can operate with ease; transport networks; energy costs and macroeconomic stability to name but a few.
Three priority areas stand out. First, the business environment needs to become more predictable: the business inspection system needs to be overhauled (in particular labor, trade and tax inspections), the system of para-fiscal charges reformed, and land administration and construction permits procedures streamlined. Second, Research and Development needs to play a more significant role: the funding for public R&D institutes needs to be allocated on a more competitive basis, and much more focus should be on commercialization. Third, the National Employment Service needs to be strengthened to become a modern service provider for the unemployed and for employers; and the minimum social security contribution needs to be reformed to reduce the labor costs of low-paying part-time jobs in the service sector.
This is a big agenda but a necessary one for Serbia to avoid remaining stuck in its current “middle-income trap”. By contrast, ambitious reforms will lead to more investments, higher productivity, and an invigorated private sector, so that Serbia’s export engine can run at its full potential.