III. The reform challenge posed at independence

A. Immediate changes on independence

Apart from Serbia, which still had federal structures after the former SFRY broke tip, the newly independent states were immediately faced with the need to create new functions that were previously federal functions, such as defense, foreign affairs, and customs. In addition, each new state inherited that part of the SDK operations which was physically within its territory, as well as the state branch of the Federal Central Bank. Given the conditions under which independence occurred, all of the new states were faced with particularly difficult financial conditions, with their share of federal assets denied them until much later.
           
Faced with these challenges, compounded in some cases by war, the new states had to take immediate steps to avoid chaos. The SDK was restructured to a state level operation and initially continued to perform most of its original functions. The state branch of the Federal Central Bank became the central bank of the new state. The role of the state MOF became more important as it took over Federal MOF functions, including fiscal policy and debt. Among the early policy initiatives was the reorganization of taxes, which introduced a more rational and manageable income tax to replace the multiple deductions, each earmarked for specific public services funded through EBFs. This led to the abolition of most of these EBFs soon after independence, with revenue instead being channeled through the State budget. In the climate immediately after independence, therefore, there was little choice but to hold on to those essential institutions which functioned, in particular the SDK, which was renamed the “payments bureau” (PB), but otherwise remained essentially unchanged. It has been argued that this move delayed fundamental reforms, in the financial sector and the management of public finances, although it is questionable whether adequate and appropriate capacity was available in the MOFs and the central banks (and even the commercial banks) to take over these functions immediately after independence.
           
The increased responsibility placed on the MOF raised its profile within government. However, it would take a number of years before it revised the legal budget framework, acquired the relevant institutional structure, and developed an appropriate internal capacity, essential elements to ensure sound financial management by other ministries. The immediate aftermath of independence was, to say the least, difficult for all the republics, and in some of them disastrous, as war broke out. Their economies contracted sharply, partly due to hostilities, partly due to the loss of internal markets as well as exports and tourism, and the uncertainties surrounding the division of assets. All of which led to significant declines in government revenues, hyperinflation, and loss of faith in the currency. As a result, the MOFs were faced with constant crisis management, and not surprisingly it would take some time before more deep rooted reforms could be undertaken. In addition, independence did not bring about immediate change in political leadership, in many cases it simply became nationalistic, which meant that old habits and attitudes dominated government operations.
           
The fiscal crises of the early nineties led the MOFs to introduce cash rationing as a main budgetary instrument, especially as they realized that the revenue targets set in the approved budget would not be met. In the absence of financial management reforms to improve oversight of ministry operations, and particularly for those countries engaged in war, it is not surprising therefore that significant arrears built up during this period. Key among the unpaid creditors were public enterprises, pensioners, public workers (salaries), and recipients of social welfare payments. Concurrently taxes were also not being paid by public enterprises. In the countries affected by war, in addition, substantial promissory notes were issued, to be paid after the war. Given these problems, the gap between budget and actual outturns progressively widened. This fiscal crunch led many spending units to understate (or even not report) revenues that they collected, in order to make ends meet. Unfortunately, the lack of ability to pay also had a “knock-on” effect on the banking system, creating a banking crisis, which was compounded by the lack of internal control within the banks due to the still dominant position of the PBs, in which secretive and old attitudes remained strong.

B. The challenge of budget system reform

Perhaps the biggest challenge to reform created by the SFRY heritage was the issue of what to do with the SDK system that survived independence under the recast “payment bureaus” (PBs). In this regard, reforming the budget system posed something of a dilemma. On the one hand, it was increasingly recognized that to develop the financial sector and the budget system on market-based lines would require dismantling the SDK system. On the other hand, it was also recognized that the SDK system was so central to the functioning of the financial sector and to government operations that these institutions would have to be restructured and their capacities developed before the dismantling of the PBs could safely take place. This resulted in an initial period where an attempt was made to develop viable capabilities in other institutions, not the least in the MOF, though these were often handicapped by the continued existence of the unreformed PB system. Box I describes the various functions of the PBs and the reforms needed.

Limitations of the SDK system for budget management

The development of MOF treasury and budget management functions were those most obviously held back by the existence of the PBs. Using the PBs giro accounts management system, the MOF transferred funds from its main budget account, to direct spending unit accounts of the main budget users accounts, which in turn distributed these funds to the indirect spending units, or its subordinate agencies that also maintained giro accounts in the PB system. There were obvious problems, however, with the fiscal information available to the MOF. The PB maintained information of the balances and movements in the giro accounts of all the government agencies, as a counterpart to deposits with banks. The PB reported back this information separately to each spending unit. The MOF received information from the PB about the movements in the main budget giro account, but not, in general, about the transactions on giro accounts of the spending agencies (except its own as a spending agency). Information on the general budget giro account was the basis for the final accounts of government. Government expenditure was recorded, as a result, on the basis of transfers from the general budget account to the budget institutions accounts, and not on the basis of real expenditure by each spending unit. Consequently, the MOF had only limited information on the outstanding balances of spending agencies, that is, on the government’s available cash resources.

Limited capacity in the Ministry of Finance

At the same time, the PB removed the incentive to develop MOF capacity in budget management. From the government’s viewpoint, its control over tax collection, which in any case was easier to enforce in the SDK system, meant that the MOF’s capacity in tax administration was extremely limited. At the same time, in executing government payments, and in accounting for, and reporting on, these transactions, the PB removed the need to develop treasury functions.5 The system described was a decidedly decentralized decision-making process, with important resource allocation powers resting within the planning agencies or in the main ministries, rather than the MOFs. In effect, the MOF acted merely as a distributor of funds, trying to balance incoming receipts with outlays, but often with real decisions made elsewhere. Information on budget execution resided firmly with the PB, only some of which was accessible to the MOF. The secrecy of the PBS also created difficulties for the MOFs. The MOF had no special status to the PB, it was largely treated as equivalent to other ministries who held their accounts in its giro system. Given this status, it was perhaps not surprising to find at the time of independence the republic MOFs not too well-staffed both in terms of numbers and quality, and existing under the shadow of a more powerful federal MOF. With independence, the republic MOFs had to assume some functions previously undertaken at a federal level, and also to develop the capacity to take over other functions residing in the PB or other government institutions. Needless is to say it was evident that initially they were rather unprepared for this role.