Ian Bancroft in Belgrade -

Amidst much conjecture about the direction that Serbia's new president wants to take the country, it is the state of the country's public finances that is causing most concern domestically - expediting the usually lengthy process of forming a government after the May elections.

On June 7, the Serbian central bank was forced to raise interest rates by a half point to 10% as a way to halt the precipitous decline of the dinar, which is down around 11% this year on a combination of a deteriorating economy and a lack of government in place since the inconclusive elections.

The direst warning yet about the economy came on May 30 from the country's Fiscal Council, which monitors budget performance, which said that Serbia will require an additional €2.5bn to finance its liabilities this year. With its year-to-date deficit totalling some €687m (equivalent to 7-8% of its GDP), Serbia's budget deficit remains considerably higher than that agreed with the International Monetary Fund (IMF), whilst its public debt now stands at 46.7% of GDP, above the IMF-stipulated limit of 45%. As a result, the IMF's €1bn standby loan deal is now on hold.

According to Miroslav Prokopijevic, a Belgrade-based professor of economics, Serbia will face a debt crisis in 2012-2013, as the public debt in real terms is probably "close to 60%, because GDP is heavily overestimated in 2012".

As Dr Danica Popovic, from the Faculty of Economics in Belgrade, tells bne, "with an estimated 0% growth rate for 2012, the odds are that things could get even worse...[unless] strong and decisive measures [are] implemented immediately after the inauguration of the new government."

Limited options

Serbia's room for manoeuvre, however, remains limited. As Prokopijevic warns, the country cannot borrow on the international market, because yields would surpass 9% for 10-year bonds. Though "Serbia has a much lower debt than nearly all Eurozone countries, it is nevertheless on the Greek path."

Not that Serbia is the only country in the region facing such challenges. "Slovenia, as an EU and Eurozone member, faces similar problems with a debt of only 45% of GDP," Prokopijevic points out.

A quick fire sale of remaining state assets is unlikely given the unfavourable market conditions. The Serbian government was last year forced to cancel the sale of a 51% stake in Telekom Srbija after failing to secure the €1.4bn minimum asking price (the sole bidder, Telekom Austria Group, offered only €1.1bn). This comes on the back of failed efforts to privatize Jat Airways, the national airline. The proposed sale of Komercijalna Banka, meanwhile, has caused a great deal of controversy and there is a general reluctance to relinquish other strategic assets - such as Elektroprivreda Srbije and Srbijagas - in the current economic climate. Indeed, Serbia was recently forced to renationalise the former US Steel plant to prevent its closure.

In the short term, Popovic believes that Serbia will need to adopt "fire-extinguishing measures," such as raising VAT (from 18 to 20-21%) and freezing pensions and public sector wages. Serbia will also have to cut back the subsidies and sovereign guarantees provided to inefficiently state-run companies, lay off some 5% of public sector workers and raise the retirement age for women to 63 (up from 60). Looking ahead, however, "reforms of the tax administration and of the pension system seem to be the only long run remedy in this situation," claims Popovic.

The foreseen spending cuts - which could bring €1bn in savings - will further fuel socio-economic tensions in a country where unemployment stands firmly above 20%. The deficits have already driven Serbia's currency to a record low against the euro, despite the National Bank of Serbia having sold some €1.18bn this year to prop up its value. Whilst those with borrowings in foreign currencies feel the strain, Popovic insists that, "a feasible strong depreciation might well reduce labour costs and thus raise competitiveness, which could make foreign investors more interested in coming to Serbia than would otherwise be the case."

Against the backdrop of Europe's debt crisis, however, the prospects for sizeable foreign direct investment remain bleak. For Prokopijevic, "without profound pro-market reform, including the rule of law - and this is highly unlikely to happen - Serbia will remain a relatively poor business environment able to attract €0.8bn to €1.5bn in FDI per year... even less if the Eurozone crisis worsens."

With Tomislav Nikolic of the Serbian Progressive Party (SNS) having defeated previous presidential incumbent Boris Tadic of the Democratic Party (DS), Serbia faces a period of cohabitation, with the latter expected to serve as prime minister in a government containing, amongst others, the Socialist Party of Serbia (SPS).

Attempts to redefine the relationship between the post of prime minister and the constitutionally weak office of the presidency - through which Tadic had previously consolidated power - is likely to result in severe political instability, as politicians jostle to assert blame and attribute responsibility. Facing a disparate governing coalition, internal factions within the DS jockeying for influence and questions about his political legitimacy, Tadic may soon wish that he'd retired gracefully.

Whilst many presume that cohabitation between a president and government of different political shades will allow Serbia's politicians to take tough political decisions on Kosovo, the escalating public finance crisis will provide a more severe challenge of a very different sort. Indeed, in order to distract from the rising social tensions that await, a slightly tougher stance on Kosovo - plus renewed impetus for ties with Russia - may prove ever more appealing. First, however, as Popovic notes, Serbia's politicians and public will need to understand and appreciate just "how grave the situation is."