Boston - On June 30, Serbia officially became a part of the JPMorgan Government Bond Index - Emerging Markets (JPM GBI-EM) index family — a substantive acknowledgment of the large strides the country has made over the past decade in taming inflation, fiscal consolidation and other major reform initiatives.
For the Eaton Vance emerging markets (EM) team, Serbia also represents a case study in the tremendous potential that we see in countries outside the major EM benchmarks for managers willing to devote the time, resources and expertise required for such investments. We believe it is useful to recap some of the milestones of Serbia's journey as a guide to investors seeking value in the sector.
A decade ago, when the EM team first established a position in Serbian assets, the country was struggling with an unreformed socialist economy and rebuilding society following the Balkan and Kosovo wars of the 1990s. With an unloved reputation in the West, and given issues like high and volatile inflation, weak growth, and a small and illiquid local debt market, most investors passed over Serbia in favor of the larger names found in the GBI-EM benchmark.
But there were a number of reasons why the Eaton Vance EM team, which had "feet on the ground" building a burgeoning local contact network, saw the potential for fundamental reform.
The political spectrum had narrowed and most Serbs found themselves in favor of moving toward a market economy and leaning toward Western Europe. Global manufacturers began making small but consistent investments in production capacity onshore. The central bank began to take inflation more seriously, instituting a policy of high real interest rates and encouraging more trust in the local currency. Policymakers were eager to engage with the few foreign debt investors attracted by the double-digit yields.
The Commitment to Reform
In the early years, Serbia provided a classic frontier-market wild ride, including an unexpected political changeover in 2012 that ushered in the rule of the Serbian Progressive Party (SNS). After a few years of fits and starts, toward the middle of the decade, the government, led by then Prime Minister (now President) Aleksandar Vučić embarked on an economic liberalization program, backed by successive IMF programs, with concrete reforms such as:
- Closing or privatizing failing state-owned enterprises
- Restructuring and downsizing large public utilities
- Consolidating the fiscal deficit, from 6.4% of GDP in 2012 to a surplus of 1.37% in 2017
- Reducing the bloated public sector wage and pension bills
- Reforming various pieces of legislature to encourage foreign investment
Concurrently, the National Bank, led by Governor Jorgovanka Tabaković was:
- Cleaning up the banking sector, including a reduction of nonperforming loans
- Pursuing a policy of international reserve accumulation and FX stability relative to the euro
As the risk premium of the country fell, the nascent market rewarded these steps by taking long-end yields on Serbian debt from about 12% in 2015 to just under 5% by the end of 2018.
As these measures were put in place, better macroeconomic outcomes soon followed. Growth reached 4.0% in 2019, public debt fell from 71% in 2015 to 53% in 2019, and foreign direct investment grew to 7.73% of GDP that same year, helping boost the auto sector, among other industries. When COVID-19 hit, Serbia had generated enough macroeconomic space to respond quickly and decisively and is expected to be among the fastest countries in the world to rebound, having already regained its pre-COVID level of GDP in Q1 this year.
In the past three years, Serbia has begun to enjoy a reputation as a well-managed, stable Central European country. More and more, investors have been forced to take notice, helping create sufficient liquidity to allow for GBI-EM inclusion. We expect this achievement to increase demand and continue to boost local asset prices, even as yields have fallen to 3.25%.
Bottom line: Serbia serves as an example of the importance of policy and the idea that economies can reform themselves with time and consistent effort. Just as importantly, the country illustrates the potential for alpha in the EM debt sector for those willing to invest the time and effort to go beyond the narrow confines of common indexes.