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Sovereign Bankruptcy: Serbia and Montenegro

Tania Jakobi

The introduction of democratic changes in 2000 and sweeping economic reforms have earned Serbia and Montenegro high praise from the International Monetary Fund (IMF), the World Bank, and the European Bank for Reconstruction and Development (EBRD).

Nevertheless, the country is facing the prospect of joining those highly indebted countries unable to keep making payments on their debt. This is due to the large amount of its sovereign debt in comparison with the slow recovery of the country’s Gross Domestic Product (GDP) and exports. By 2005, the situation might become especially dangerous, due to the structure of debt repayment. Sluggish domestic growth, a common problem among most countries in the early stages of a transition to a market economy, is a factor. But Serbia and Montenegro is mainly suffering from the failure of its major creditors to agree on restructuring its debt.

The Paris club of creditors, which groups national governments that have lent money to Serbia and Montenegro, along with multilateral institutions such as the IMF, World Bank, and European Investment Bank (EIB), have agreed to allow a generous writedown, or rescheduling of sovereign debt, because they acknowledge that the local economy is in a poor state. But the London club of creditors, which groups commercial banks, believes that the country is not so badly off and can make a smaller write-off of its debt.

If, in the next two years the country fails to persuade the London club of creditors that the present ratio of debt service won’t be sustainable in the long run, the country may follow the new IMF policy proposal, introduced in November 2001, known as a sovereign debt restructuring mechanism (SDRM), a procedure akin to bankruptcy. In that case, Serbia and Montenegro may request a temporary standstill on its debt repayments while it negotiates a restructuring acceptable to a majority of creditors. It is not clear that that will solve Serbia and Montenegro’s problems, however. Most of the major creditors have already agreed on debt relief. The obstacle lies with one member of the London club of creditors: Credit Agricole Indosuez which holds 40% of the London Club debt and consequently refuses to change its stand.


Serbia and Montenegro was once part of Yugoslavia, a country formed by a federation of six republics. Yugoslavia was torn apart by a series of bloody civil wars in the early 1990s. In 1992, the two republics that remained within the federation were Serbia and Montenegro, and they formed what was called the Federal Republic of Yugoslavia (FRY) for a time, until the country was renamed Serbia and Montenegro.

The roots of the unsustainable mountain of debt that this country is now struggling with lie in its history since World War II. In local media this aspect is often overlooked, and many people perceive the 1970s as the golden years, without realizing that that economic boom was built on loans that the country was eventually unable to repay.

In fact, there were three defaults on Yugoslavian debt since the 1950s and these economic events were among the factors that led to the collapse of Yugoslavia. Shortly after World War II, in order to avoid the strong hand of the former Soviet Union, the Yugoslav communist leader, President Tito, introduced some elements of democracy and market economics to Yugoslavia. Citizens were free to travel abroad and to open foreign currency accounts in domestic banks. The Yugoslav government abolished central planning in favor of a more liberal management policy, as long as it was loyal to the Communist Party.

Tito’s politics were widely welcomed by Western countries and rewarded by generous financial grants and loans. Those countries wanted to encourage Yugoslavia’s moves towards capitalism, especially because of its geostrategic position between the East and the West. From 1945 to 1954 the former Yugoslavia received some $400 million in grants and an almost equal amount in soft loans. The extremely high growth of the GDP in the 1950s was to a large extent the result of this inflow of foreign capital. Money disbursement was under strict federal government control. However, in the early 1960s, the inflow of foreign cash became insufficient to cover the intrinsic problems in the economy.

Mirko Canadanovic, a young liberal communist politician at the time, says: “We found out that every company had a large surplus of workers and that almost half the employees were not sufficiently educated for the position they held.”

Further market-oriented reforms in 1965 were stopped after the first signs of worker disappointment. After that, it became almost impossible for any employee to be sacked, or for a company or bank to face bankruptcy. “The Communist Party realized that reforms may sweep them out of their positions. However, if they wanted to stay in power they would need more foreign cash, and that’s how the sovereign debt went up dramatically,” says Canadanovic.

By the early 1970s, the Yugoslav debt stood at $1.8 billion. It was then that the seeds were sown for the eventual debt crisis. Under strong political pressure, the federal government granted each of the six Yugoslav republics autonomy in taking fresh foreign loans. The central banking system was reorganized in the same way: banks in the republics were in charge of distributing loans, while the federal central bank was in charge of debt repayment. The use of foreign loans became subject to pure political will. The political elite channeled foreign loans into consumption to gain public support while the domestic economy declined steadily.

Two decades later, in the early 1990s, that easing of control over the sovereign debt played a significant role in the final disintegration of the former Yugoslavia, when the richer republics began to refuse to finance the poorly maintained economies of the poorer republics.

First default. But through the 1970s, money continued to pour into Yugoslavia. By the early 1980s the total sovereign debt was nearly $20 billion. In one year alone - 1976- Yugoslavia borrowed $8 billion, much of it from the major Yugoslav creditors at that time, such as Kuwait and other rich oil-exporting countries with a huge surplus of cash.

Then, in 1979, one of the state banks authorized to channel foreign loans declared its inability to repay the debt. Soon, all foreign banks were demanding the urgent repayment of their claims. The Yugoslav central bank was forced to repay the loan immediately, but failed to restore its credibility among foreign banks.

Second default. In the early 1980s, the country faced high inflation, recession and a negative capital inflow. This sharp decline in the living standard, combined with a political crisis, became fertile ground for growing nationalism that would eventually spark wars between the nations of the former Yugoslavia.

It also forced the federal government, in spite of all its efforts, to stop servicing the debt to the London Club, and in 1988 the former Yugoslavia defaulted on $15 billion of debt.

After negotiations with the London Club, the country and creditors signed two agreements, of which the New Financial Agreement (NFA) treated debt rescheduling, while the other agreement allowed former Yugoslavia to take a fresh $300 million syndicated loan. The NFA introduced a secondary market where investors could buy and sell Yugoslav debt bonds. It also introduced debt-equity swaps and allowed the Yugoslav central bank and companies to buy back their debt.

Since the flow of foreign cash into the country had practically dried up, the political elite in all republics started abusing the domestic currency. Since the central banks in the republics were outside the control of the federal central bank, all of them began to print their own money, which was not backed by either foreign currency reserves, or goods.

Failure of the second market-oriented reform. In the early 1990s, the three largest republics, Serbia, Croatia and Slovenia undermined another reform effort at the federal level. The former Yugoslavia fell apart soon after, in a number of civil wars from 1990 to 1994.

In 1990, Slobodan Milosevic (currently indicted for war crimes and genocide by The Hague Tribunal) took power over what was left of the former Yugoslavia, Serbia and Montenegro. In 1992, the EU, followed by the UN, imposed tough sanctions against the new Yugoslavia (the Federal Republic of Yugoslavia - FRY) composed of the two republics, in order to punish its rebellious leader.

In 1990, the overall outstanding sovereign debt of the new Yugoslavia was $7.5 billion or a quarter of the GDP, which equaled $28.5 billion. Even though the sovereign debt was not too high, the economy did not have the liquidity required to service the debt.

During that period, all six republics went into the secondary Yugoslav bond market and tried to buy their own, and each others’, NFA debt. This created a huge mess and later led to disagreement on the debt level of each republic. Such trading created the term "connected persons.". Connected persons are creditors suspected of buying debt on behalf of the FRY and with funds from the National Bank of Yugoslavia’s (NBJ) reserves, at the time still not divided among the successor countries of the SFRY.

It is believed that among conected persons are close cronies of the former FRY President Slobodan Milosevic, both businessmen and politicians and foreigners. However, it is hard to track the real owners due to the fact that Serbian owners used cover firms with foreign origins. Some of these trades were not properly registered by either the London Club of commercial banks or by the central bank of the former Yugoslavia, which produced even worse bookkeeping problems.

During that time the overall price of the NFA debt trading on the secondary market was between 25 and 28 cents to the dollar.

After four of the six former-Yugoslav republics declared independence, the London Club of creditors entered into separate agreements with each newly-created state and agreed to exclude the debt held by "connected persons."

Third compulsory default. The third default was effectively caused by the sanctions, and by Yugoslav law. In June 1992, the UN and EU sanctions forbade the FRY to make any financial payments abroad, while the FRY authorities adopted a law that temporarily canceled foreign debt repayment.

The economic sanctions on the FRY lasted from 1992 to 2000, and, combined with the NATO bombing in 1999, literally crippled the FRY economy. Industrial output fell to a third of the pre-war level and the same was true for the GDP, which dropped to $9 billion at the beginning of 2000.

From 1992 to 2000, the FRY part of the NFA debt was traded for between 10-25 cents for the dollar.

Sanctions were finally lifted toward the end of 2000, following the fall of Milosevic and democratic changes. Although Milosevic had not received a dime from Western countries for a whole decade, the sovereign debt rose to $12.5 billion and exceeded the GDP by 136% and annual exports by 480%.According to World Bank data, about 90% of the total debt sum to both the Paris and London Clubs consisted of accumulated interest arrears and penalty interest.

Third market oriented reform. In October 2000, the Western community welcomed the new democratic Yugoslavia, offering generous financial treatment. The FRY repaid a small old debt to the IMF at once, while its huge debt to IBRD worth $1.8 billion and a smaller debt to the EIB were rescheduled.

Two scenarios of sovereign debt restructuring. The FRY had considered two options for restructuring the burden of its sovereign debt.

First, it considered declaring bankruptcy in a scenario relatively similar to that of Ecuador, and then negotiating, first with the London Club, and then with the Paris Club of creditors. This approach was highly recommended by Schroder Salomon Smith Barney (SSSB) and partly by JP Morgan, which once led the Ecuador debt relief program. The FRY decided against that option, afraid that such a move might frighten off potential investors.

The second option was to use international support first to reach a favorable agreement with the Paris Club, and then to ask for the same treatment with the London Club of creditors. This approach was advised by UBS Warburg and Hampshire Partners, a specialist advisory firm on the FRY side.

In November 2001, strongly backed by the U.S. administration, the FRY persuaded the Paris Club of creditor-countries to write off 66% of the total $4.5 billion debt in two steps. The Paris Club decided to write off 51% of the debt at once and another 15%, if the FRY fulfills all the conditions set out in the three-year IMF-FRY agreement, which expires in 2004. The FRY’s main sovereign creditors were Germany, the UK, France and the US.

At the end of November 2001, the FRY asked the London Club for a 67% write-off of its $2.8 billion debt, $600 million of which is known to be in the hands of "connected persons". While some “connected persons” could be traced, Yugoslavia’s central bank (NBJ) believes that a further huge portion, 40% of the debt, which is held by the French-based Credit Agricole Indosuez Bank is also actually ultimately owned by close allies of former Yugoslav president Slobodan Milosevic. However, both the bank creditors and the FRY side are aware that it would be almost impossible to prove that fact. In addition, many NFA bonds changed hands too many times to be tracked.

Even though in November 2001 some influential foreign investment banks such as Merrill Lynch, one-time owner of the FRY’s NFA bonds, and SSSB were almost fully convinced that the FRY would repeat its success story, the London Club offered a write-off that was far less than 50% and has remained firm in its stand so far, despite the fact that anything below this would be unsustainable for FRY’s debt servicing potential, according to IMF and World Bank calculations.

But the stand of the NBJ, which is in charge of negotiations, has also not changed. The NBJ points to a clause in its write down agreement that says that the debtor-country should insist on receiving the same write-off terms from other creditors as it has received from the Paris Club.

Lessons learned

Countries making economic progress have a harder time restructuring their debt

The NBJ points to the fact that Serbia and Montenegro at present fulfills criteria for a mixed IDA status with the World Bank. The International Development Association (IDA) is an arm of the World Bank, and helps the world’s poorest countries reduce poverty by providing "credits," which are loans at zero interest with a 10-year grace period and maturities of 35 to 40 years. In three years from 2001 to 2004, Serbia and Montenegro will receive $540 million. IDA status is to expire in 2004, but Yugoslav authorities have already put forward a motion to try to prolong this for three years more.

But it seems that the secondary market and creditors have a different opinion. At present, Serbia and Montenegro’s NFA principal debt is traded at 40 to 48 cents to the dollar, while the cumulated price of NFA bonds on the principal debt and interest rates is below 30 percent, with more than a shallow trade.

“Cynically, we are the victims of our own success”, says Radovan Jelasic, NBJ vice-governor and since November 2002, head of the Serbia and Montenegro mission in negotiations with the London Club. The EBRD has said the Serbia and Montenegro was among the most successful in reforms among transition countries in 2000 and 2001, albeit because of its very low base start.

But Jelasic believes that an objective assessment of Serbia and Montenegro’s debt servicing potential is Serbia and Montenegro’s strongest argument. “We can sign any agreement under any circumstances. But what is the purpose of that if in three years we default again, as Russia has done three times so far,” argues Jelasic.

However, "We should speed up our negotiations with the London Club. Otherwise it might cost us a lot", says Djunic, former federal deputy prime minister and head of the Serbia And Montenegro delegation in negotiations with the London Club. In 1997, Djunic requested a 70% write-off from commercial banks but the Serbia And Montenegro was almost in ruins at the time. According to NBJ calculations, the debt is gaining $100 million annually, or $ 250,000 per day.

Countries that aren’t attractive for future investment have difficulty persuading lenders to restructure debt.

While Serbia And Montenegro’s need solve the problem is becoming more urgent every day, the big commercial banks which form the London Club, are not very interested in any further engagement in Serbia and Montenegro in the coming years.

While the overall macroeconomic success of the reform is visible - both in terms of the monetary policy, liberalization of trade and prices and the reconstruction of the banking system - the economy has been slow in its recovery after having hit rock bottom under Milosevic.

Even though the privatization process is very much oriented toward foreign investors, they are hesitant, apprehensive of the local political turmoil within the ruling democratic coalition, the endless election cycles, public dissatisfaction with the low standard of living and, above everything, the overall world recession. Possible scarce privatization proceedings combined with a weak export potential might lead to an even more complicated situation then one is able to estimate. This leaves commercial banks with little incentive to make sacrifice repayment on outstanding debt in the hopes of making money in Serbia and Montenegro in the future.

Serbia and Montenegro’s case illustrates limitations of sovereign debt restructuring if there is absence of coordination between major creditors

If the London club of creditors stays firm in its stand to write off just a small amount of principal loan and accumulated arrears, the overall burden of Yugoslav sovereign debt will be unsustainable already in a short run.

This may lead to a new default, and debt restructuring which will be undertaken under even worse circumstances. The first fruits of reforms such as monetary stability, liberalization of prices, liberalization of trade and privatization investors might be seriously jeopardized or halted altogether by growing macroeconomic instability caused by high expenditures for debt service.

The cumulative heritage of careless borrowings, five decades of sluggish domestic growth and unresolved problems in domestic policy have already pushed Serbia and Montenegro to the bringk of joining that group of highly indebted poor countries (HIPC).

The timing of the debt restructuring was not well designed.

It might be argued that the strategy of debt restructuring was set in a wrong way even at the beginning. Mixed IDA status will expire at the end of 2004 exactly as Serbia and Montenegro starts to pay both principal debt and accumulated interest rates to Paris Club, and a huge portion of debt to the IBRD. And even a little success in its reforms is likely to make Serbia and Montenegro ineligible for IDA loans.

If, in the meantime, the economic situation worsens, and Serbia and Montenegro does fulfill criteria for renewed IDA status, it is questionable whether IDA sources would be sufficient for all countries in need.


Success of possible SDMR strategy is doubtful

In calculation of the future Yugoslav debt ratio published at the end of 2001, the IMF and World Bank presumed a scenario in which the London Club would be willing to follow the Paris Club solution.

In that case, Serbia and Montenegro debt to GDP ratio would be between 70% and 80%. On that presumption, annual repayment of the debt is estimated at $1 billion up to 2004 and $1.5 billion from 2005. Debt servicing would account for 17% of total Serbia and Montenegro budget revenue from 2005.

“This indicates potential serious problems with the country’s foreign liquidity in this period if GDP growth is below 8% and if export growth is less than 15%”, says Danko Djunic, a partner at Deloitte & Touché and former deputy prime minister. He was the first to warn of a new potential bankruptcy. At first the story was published in monthly publication of one NGO, disseminated by email to small number of readers. Two months after that both central bank and World Bank, and EBRD warned that the deal with the London Club must be reached as soon as possible, otherwise the ratio of debt service to export and GDP might touch the red zone.

After an annual GDP growth rate of 5% and 6% in 2000 and 2001, GDP growth slowed to just 3% due to the state of the local economy and the world recession. Even though exports in 2002 rose by 15%, experts have warned this it is far from enough, given that in the same period the foreign trade deficit registered a 24.5% increase relative to 2001 while topping exports by as much as 71.3%.

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