Nicholas Watson in Belgrade -

News on March 15 that Serbia had repaid early almost $1bn in loans to the IMF was yet more proof of how far the country has come since its international pariah status of the 1990s. Yet some of the foreign banks now rushing into Serbia could be pinning too much hope on the pace and scale of the country's development.

The banking sector is undoubtedly the most restructured part of the economy. In 2000, following the overthrow of the late dictator Slobodan Milosevic, the government threw open the doors to the sector, allowing foreign banks to open up affiliates in the country as well as enter the market through acquisitions, privatisations or green-field licences.

Though the government has since closed the window on banks opening affiliates, acquisitions have continued apace so that now around 80% of the banking sector is controlled by foreign institutions – a figure comparable to the more developed markets of neighbouring Central Europe.

National Bank of Serbia

Except for the state-controlled Komercijalna, the top-seven banks by assets are all foreign owned – Austria's Raiffeisenbank, Italy's Banca Intesa, Austria's Hypo Alpe-Adria and HVB Bank (part of Italy's UniCredit Group), France's Societe Generale, and Vojvodjanska Banka (which was bought by National Bank of Greece in September for €360m).

Initially, foreign banks were attracted by a banking system that still resembled that of Central and Eastern European following the collapse of communism in the early 1990s. Caught in a time warp, Serbia's bank system consisted of 80 quasi-state-owned banks that didn't offer credit to the general public and engaged in almost entirely politically motivated lending.

"It was in a disastrous state," says Oliver Roegl, chairman of the managing board at Raiffeisenbank in Belgrade, who arrived in the country in November 2000 to set up the Austrian banks' operations there. "But we had strong support from the government to reform the banking sector and the national bank was very supportive also."

In little more than six years, the situation has improved dramatically. Serbian banks had about €3.2bn in savings accounts at the end of 2006, up 44.6% from a year ago, and about €2.9bn more than at the end of 2001. According to central bank figures, the sector's assets hit €8.9bn in the third quarter of 2006, and the annual growth rate of the sector is 31.4% since the reforms were launched in 2001. Serbs have also taken to debt like ducks to water – private lending rose almost 40% in 2006 to stand at €2.4bn. There are more than 2.5m credit and debit cards in Serbia already.

Yet with assets at 43% of GDP and loans at 24% only, "Serbia offers plenty of growth," says Jiri Stanik, an analyst at the brokerage Wood & Co, and this is continuing to attract foreign banks.

Better late than never

So far this year Hungary's OTP Bank has increased its stake in Serbia's Kulska Banka to 92.6% from the 89% it held in December; Greek ATE Bank in February received approval from the central bank to retain its 20% share of AIK Banka that it has been building up since the beginning of the year; and in January, Belgian banking and insurance group KBC said it reached a deal to acquire a majority stake in Serbian bank A Banka.

Not all have been successful: in January, Bank of Moscow pulled out of a deal to buy Agrobanka, complaining that since it filed an application with the central bank the cost of Agrobanka had risen almost four-fold.

The rising price of these banks is causing some observers to wonder whether the market is getting ahead of itself. The highly acquisitive Greek bank EFG Eurobank last year completed its takeover of Nacionalna Stedionica, paying about 4.75 times book value for the bank.

"These banks have gone for increasingly high multiples, 3-5 times book value," says Raiffeisen's Roegl. "When you see the prices it's difficult to see how some investors will get their money back."

Added to this is that many of these Serbian banks need deep restructuring – closing of branches, firing of workers etc. – which is an expensive, time-consuming and politically fraught business. For those banks like Raiffeisen who didn't buy their way in, this isn't a problem; though on the flip side these banks also need to continually find staff to facilitate their organic growth.

Downtown Belgrade cleaned up

"Yes prices for banks and a lot of other companies have become very high, but provided they have a minimum asset, know-how, network and reasonable cleanliness value, it is better to buy than to start greenfield," reckons one Western banker based in Belgrade. "More important is probably the buyer's capacity to transform the purchased bank fairly quickly into a fully operational westernised entity. It is my feeling that this has been the secret of failure or success, not only in Serbia, but in the whole region."

The results of these transformations of local banks are expected to start being felt more profoundly this year and next as foreign banks that acquired Serbian ones in the earlier part of the decade finish their restructuring efforts and turn their attention to competing for a larger share of the market. This increasing competition is expected to cut margins significantly, which worries those analysts who feel that some foreign banks are paying too much for their Serbian acquisitions.

Lingering problems

The increasingly competitive banking market comes against a backdrop of economic and political transformation that is still far from complete. "There are, how should we say, lingering problems from the 1990s," says the Western banker.

The most prominent of these problems right now is of course Kosovo, which in turn is having a crippling effect on the politics, since no party wants to be in power when, as is almost certain, the UN-administered province heads off down the path that will ultimately lead to independence. A lack of any government some two months after an election won by the ultra-nationalist Radicals is disconcerting because failure to form a government over the next month means the country will have to go back to the polls.

"People are getting sick of elections – new polls could be catastrophic for the country," says the banker.

Raiffeisen's Roegl agrees that while macro-economically speaking Serbia is moving in the right direction, "we are missing the political stability." This lack of stability means the greenfield investment is going to EU newcomers Romania and Bulgaria rather than Serbia, he says..

Politics is also intruding on the central bank's independence. The National Bank of Serbia (NBS) wrote a letter to the European Central Bank and the European Commission in November last year complaining that a new law the Serbian Parliament adopted for choosing a new NBS governor after the January elections compromises the independence of the bank. And now the NBS is being pressured by both politicians and commercial banks to relax its tough measures taken to cool the lending market. The surge in retail loans is, the NBS argues, hurting the bank's efforts to bring the inflation rate below 10%.

The central bank raised the level of the mandatory reserves requirement to 40% in March, forcing many banks to carry out capital hikes to meet these requirements. Yet the commercial banks argue that the stubbornly high inflation is caused by public spending and a lack of structural reforms, while politicians are concerned the NBS' actions will choke off the recovery.

"I agree a certain fine-tuning should take place – there was a strong understanding that inflation of 17% at the beginning of last year was not acceptable," says Roegl. "But this reserve level is impacting [small and medium-sized enterprises] and corporates such as exporters."

Experts say hurting the SMEs would be especially pernicious, given that Serbia already struggles to produce more of these businesses, which are crucial to the long-term development of the country. Serbia fares poorly compared with the other states of the former Yugoslavia in the creation of SMEs for historical reasons – Serbia was traditionally the home of the large state-owned monopolies, while smaller businesses were found in places like Croatia and Slovenia.

A related issue to this is the overarching power of a few individuals in certain sectors of the economy – the Serbian oligarchs – who use their connections to dominate these industries and strangle competition. This also leads to rampant corruption, involving, whisper some sources, not only Serbian businessmen and politicians, but also often EU-based companies doing business in the country.

One vital sector that needs to be opened up more is the insurance sector - which lags behind the bank sector in terms of reform - as this would help develop the pensions industry and in turn revitalise the stock market. WTO members called on Serbia in January to do more to liberalise this sector, which has yet to see major privatisations though some 10 foreign companies and counting have set up there. Again, the poltical impasse is cited as to why there has been so little movement here.

Even so, Raiffeisen's Roegl believes the development of the stockmarket and an IPO market will happen over time. At the end of 2006, Raiffeisen introduced RZB Future, a voluntary pension fund, and the number of such pension funds could rise to five if the application of Slovenian Insurer Triglav on January 24 to set up a voluntary pension fund is approved by the central bank.

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