ATTACHMENT_1__Development_Challanges.docx

ATTACHMENT 1: DEVELOPMENT CHALLENGES

USAID’s understanding of the following development challenges underlies the selection of objectives and results under this contract.

Serbia has made improvements in its macroeconomic framework and has begun to accelerate positive GDP growth following the global financial crisis. However, the competitiveness of the Serbian economy, while improving, continues to lag behind other countries in the western Balkans region. Losses and inefficiencies associated with state owned enterprises slated for privatization continue to imperil macroeconomic stability. Realistically, the privatization of Serbia’s remaining state owned enterprises will entail restructuring or bankruptcy, which presents an additional challenge to stability in terms of the capacity of the private sector to absorb those rendered redundant by these processes. While employment levels are slowly rebounding, decreasing to 15.3% in 2016, employment growth remains unstable. Thus, Serbia needs to grow its private sector as an essential prerequisite for long-term economic development and stability.

Yet Serbia’s private sector is not yet equal to this challenge. Serbia’s private sector is small by international standards and dominated by SMEs--SMEs account for 99.8% of all enterprises--yet the productivity of these firms is considerably lower than in Europe. Average Gross Value Added per employee in the average European SME is 41.3, while it is 10.9 in Serbia. Despite the overwhelming presence of SMEs in the Serbian economy, the SME sector generates only 55.2% of gross value added; 34% of the country’s GDP; and 9% of exports. Turnover and profit per employee is equally low compared to the EU average, making the Serbian SME sector uncompetitive and diminishing its contribution to the economy. In order to improve these figures, SMEs must invest in modernizing existing equipment, production methods and processes. In this respect the Serbian economy is almost 30 years behind the EU, a result confirmed by a representative survey of companies in textile, food processing, pharmaceutical, machinery, chemical and building material industries.[footnoteRef:1] [1: Dejan Djordjevic, Dragan Cockalo, Savina Djurin, Serbian Enterprises and Global Competition Challenges (October 2011)]

A key contributing factor to Serbia’s low levels of economic growth and competitiveness is an insufficient level of investment. Serbia’s share of investment as a percentage of GDP has averaged 18% since 2010, which is one of the lowest levels in Central and Eastern Europe. While inefficient and insufficient public investment has contributed to Serbia’s investment gap, private sector investment as a percentage of GDP has been particularly weak.[footnoteRef:2] [2: Fiscal Council of the Republic of Serbia, Fiscal Consolidation and Growth in Serbia, 2015-2017: Program, Accomplishments and Drivers (March 2017), available at http://www.fiskalnisavet.rs/english/istrazivacki-radovi.php.]

At the same time, Serbia’s business environment continues to provide several disincentives for investment. While Serbia has made several significant improvements in its business enabling environment over the past few years, due at least in part to USAID’s support for key reforms such as the labor law, construction permitting and reform of Serbia’s inspections regime, much work remains to be done to improve the predictability and transparency of government interactions with the private sector. Several surveys and indices note that administrative inefficiency and policy instability remain key challenges for the private sector. Weak linkages between the public and private sectors have limited opportunities for public-private dialogue that could have facilitated the development of policies responsive to private sector needs, perpetuated mutual mistrust between the public and private sectors and undermined private sector confidence in the equitability and effectiveness of economic governance. The complexity and unpredictability of regulation also provides significant scope for government discretion and rent seeking. Moreover, unclear and burdensome regulation continues to exact significant financial and opportunity costs on firms, especially SMEs. Although Serbia managed to reduce administrative costs by 15% from 2010 to 2014 (as measured by the Standard Cost Model), the costs of regulatory compliance remain high, and are estimated at 3.5% of Serbian GDP. This also continues to provide a powerful incentive to SMEs to remain within the shadow economy. By some estimates unregistered businesses represent 28% of all business entities in the country, and weak enforcement, restructuring and bankruptcy systems incentivize businesses operating in the shadow economy to stay there.[footnoteRef:3] [3: Foundation for the Advancement of Economics, The Shadow Economy in Serbia: New Findings and Recommendations for Reform (March 2013), available at http://policycafe.rs/documents/loop/the-shadow-economy-in-serbia-executive-summary.pdf]

It is also the case that a number of regulatory areas have not seen significant improvement over the past few years, including tax regulation and access to finance. Serbia remains the most commercial bank-centric financial system in Europe, and the only country in Europe where SMEs/companies rely almost exclusively on commercial banks for external financing. At the same time high interest rates, unfavorable banking terms and conditions, collateral requirements and persistent weaknesses in credit enforcement limit SME access to commercial lending, and almost no alternative channels for financing have emerged, including different capital market products, and non-banking financial institutions. As a result, only 27% of SMEs use external sources of funding. The government has continued to grant state aid to unprofitable public companies or in a non-transparent manner, and administrative capacity to manage subsidies at local and central levels remains weak. Investment aid, in particular, is not granted on the basis of predictable criteria in line with the European Union state aid rules.

The Government of Serbia (GoS) has recognized the importance of support to small and medium-sized enterprises (SMEs) and their integration into local and regional economies as critical to Serbia’s socioeconomic development as well as its integration into the European Union (EU).[footnoteRef:4] To drive these efforts, the Serbian Ministry of Economy has developed a strategy for support to the development of SMEs, entrepreneurship and competitiveness from 2015 to 2020 (the “Strategy”). In it, the GoS recognizes that the engine of Serbia’s economic growth will be SMEs. The Strategy identifies six key issues/obstacles that need to be addressed and improved to support the development of SMEs and entrepreneurship. These include: [4: ]

1) improving the business environment;

2) providing better access to sources of financing;

3) continued development of human resources/workforce development;

4) strengthening the sustainability and competitiveness of SMEs;

5) better access to new markets; and

6) enhancing entrepreneurship and encouraging women and youth entrepreneurs and social entrepreneurship.

The Activity has been designed to respond to several of these obstacles, and support Serbian efforts to improve its business enabling environment to be better able to stimulate the competitiveness of Serbian businesses.

The approach set forth in this statement of work was developed in response to findings from a Business Enabling Environment Assessment conducted by USAID/Serbia between March and April of 2017. One major finding of the Business Enabling Environment Assessment was that while Serbia’s business enabling environment has improved over the course of the last five years, Serbia’s competitiveness still lags behind the surrounding region. Thus, improvements in the business enabling environment to accelerate private sector growth and job creation and strengthen private sector management to advance public service delivery to businesses and citizens remain important GoS objectives for achieving sustainable growth.