IMF Survey: Bosnia and Herzegovina: On the Road to EU Accession

November 12, 2008

  • Door opened to EU membership after 12 years of successful reform
  • Getting ready for EU accession will be difficult at time of global economic turmoil
  • Complex political setup complicates decision making

A new agreement signed by Bosnia and Herzegovina opens the door to membership of the European Union (EU).

Bosnia and Herzegovina: On the Road to EU Accession

New car on sale in Sarajevo, Bosnia and Herzegovina, where rapid credit expansion has driven booming domestic demand (photo: Elvis Barukcic/AFP)


But after years of solid growth and sound policies the country has to prepare for EU accession during a time of global economic crisis.

Bosnia and Herzegovina signed a Stabilization and Association Agreement (SAA) with the EU on June 16, 2008, opening the door for EU membership. This agreement represents a watershed for the country. It marks the end of a period of about twelve years, during which the country made significant strides toward rebuilding its economy after the ravages of the 1992-95 war.

But the new agreement also means that after years of economic growth underpinned by sound macroeconomic policies, reforms in key sectors, and a favorable external environment, Bosnia and Herzegovina is facing a fresh test: how to get ready for EU accession at a time of extreme turmoil in the world economy

Achievements so far

Bosnia and Herzegovina has made great strides. Postwar reconstruction and expanded public consumption and investment have boosted living standards, with real wages rising 44 percent between 2000 and 2007. The country's currency board has been instrumental in bringing down inflation to a level close to that of the euro area (see Chart 1). The banking system has been largely privatized, and international reserves have been boosted substantially.

But economic imbalances have begun to emerge, with capital inflows and rapid credit expansion increasingly driving the domestic demand boom. The current account deficit rose to 12.7 percent of GDP in 2007, and is set to widen further in 2008.

Until now, the real effective exchange rate has been stable, and export growth has remained strong (see Chart 2). But inflation accelerated to 10 percent in July 2008. While this largely reflects the effects of global food and energy price shocks, underlying inflation has crept up as well, to about 4 percent. A procyclical fiscal policy has added to these imbalances.

Bosnia and Herzegovina also lags other countries in the region when it comes to creating a friendly business climate. At close to 50 percent of GDP, the public sector is large, and many companies still need restructuring. Privatization has been uneven, and the labor market is characterized by high, mostly structural, unemployment (amounting to 23 percent of the labor force) and low participation rates.

The complex political system complicates decision making. The Dayton Peace Agreement created two largely autonomous entities, Republika Srpska (RS) and the Croat-Bosniak Federation of Bosnia and Herzegovina (Federation) divided into 10 largely ethnic cantons, all held together by a central government (State) with a limited mandate. This structure leads to the duplication of many domestic policy functions and weakens incentives for cooperation.

Partly cloudy outlook

The need to reduce Bosnia and Herzegovina's vulnerabilities has become even more urgent because of the global financial crisis. Deterioration in the financial health of European banks active in Bosnia and Herzegovina, and a marked slowdown in Europe pose risks for a small, open economy.

For now, the impact of the crisis has been limited. The central bank moved quickly to loosen reserve requirements, allowing commercial banks to meet a sudden surge in deposit withdrawals and helping to restore public confidence unsettled by a spate of negative economic news from abroad.

But there are signs of tightening financial conditions for foreign banks active in the country, which could lead to a scaling back of lending. Some slowing of credit growth would in fact be welcome, as it would help cool domestic demand, but an abrupt halt in foreign lending could undermine growth and external stability. The projected decline in export prices relative to import prices will add to pressures on the current account, raising concerns about external competitiveness (see Chart 3).

Doing the right thing at home

The IMF's recent country assessment focused on the need to safeguard macroeconomic stability and strengthen the supply side of the economy. Domestic demand will need to be reined in to contain inflation and reduce the current account deficit.

Because of its currency board, Bosnia and Herzegovina cannot use monetary policy to lean against rising demand, which means it must use fiscal and income policies instead. Aiming for a balanced budget would ensure fiscal sustainability and would be a simple rule to follow in Bosnia Herzegovina's complex political and economic setting.

Keeping public wage increases in check will also be important: public wages directly affect the overall fiscal position, and set the tone for wage setting in the rest of the economy. On the structural front, top priorities include restructuring the corporate sector, streamlining business regulation, strengthening the rule of law (including by reforming the judicial system and reducing the backlog of cases), and making government smaller and more efficient.

In sum

All this adds up to an ambitious policy agenda. To make it happen, closer policy coordination will be needed. Although domestic political tensions have frequently distracted governments from the task of policy reform, there have been encouraging signs this year. The Fiscal Council (a body charged with coordination of fiscal policy) has been established, and agreement has been reached on a permanent indirect revenue allocation formula. And the recently signed SAA promises to become a catalyst for a renewed push for reform.

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