## 1bihea2024002

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### Remuneration Rates and Capital Outflows
- Key findings and overview:
  - Wider spread between domestic interest rates and euro area short-term rates associated with capital outflows of around KM 1.7 billion since the ECB started tightening monetary policy in July 2022, mostly in the form of money market placements in the euro area.
  - Excess reserves in KM declined by close to KM 800 million since monetary tightening started in mid-2022.
  - Regression evidence: a one percentage point increase in the spread (1-month Euribor vs. BiH weighted deposit rates up to 1 year) is associated with an average KM 630 million increase in bank net foreign assets (NFA), controlling for VIX, total remittances to BiH, and the inflation differential with the euro area.
  - Most capital outflows so far are callable deposits placed at euro area banks; holdings of non-resident securities other than shares in foreign currency have picked up recently, particularly in FBiH.
  - Capital outflows have been gradual; regulatory measures and limits have contained a larger exodus, but may conceal underlying dynamics.

- Global and euro-area context:
  - ECB deposit facility rate: -0.5 percent in July 2022; stands at 4 percent (as of text).
  - 1-month Euribor: -0.30 percent in July 2022 to 3.85 percent in December 2023 (monthly average).
  - Remuneration of vista deposits for households increased from around zero to 0.36 percent over the same period.
  - Excess liquidity in the euro area: €3,255 billion in April 2024 (ECB Economic Bulletin Issue 3/2024).

- BiH specifics and institutional context:
  - Currency board arrangement (CBA) pegging convertible mark (KM) to the euro; CBBH must hold euro reserves at least equal to KM in circulation.
  - Since mid-2022: banks’ foreign assets increased by close to KM 1.7 billion; excess KM reserves fell by close to KM 800 million.
  - Short-term rates used in analysis: 1-month Euribor and weighted deposit rates of BiH households and NFCs with maturity up to 1 year.
  - Controls in regressions: euro area volatility index (VIX), total remittances, inflation differential; spread explains most variability in NFA (high R2).

- Composition of outflows and regulatory constraints:
  - Predominant instrument: money market placements (callable deposits) in the euro area.
  - Recent uptick in holdings of non-resident securities (other than shares) in foreign currency, especially in FBiH.
  - Regulatory/administrative restraints:
    - Regulatory limits on residents’ placements of deposits abroad and on exposures to foreign sovereign bonds.
    - Private individuals must seek approval from the entity’s Ministry of Finance to open a bank account abroad; cash transport across border requires permission for amounts exceeding €10,000.
    - Banking agencies set the ceiling on banks' exposure to foreign sovereigns equal to the amount of regulatory capital, until end-2024.
  - Caveat: restrictive measures may hamper market functioning and conceal underlying dynamics.

- Domestic interest rates, funding costs, and credit:
  - Funding costs (CBBH reference rates) for 3-month tenor as of 2023Q2: KM: 0.28 percent; EUR: 0.66 percent.
  - Deposit composition between KM and EUR has remained stable despite external spread.
  - Credit to the private sector grew by 7.4 percent y-o-y in 2023.
  - CBBH Bank Lending Survey: strong loan demand, particularly from corporates; rejection rates for loans to households and enterprises increased in the last four quarters.
  - Lending rates remain flat and close to historical lows; borrowing costs for companies are now lower in BiH than in the euro area.
  - October 2022 banking agencies’ decision: for lending-rate increases greater than 200 bps for any loan, banks would have to increase the amount of provisions for such loan (initially until end-2023, subsequently extended to June 2024).
  - NPLs low at 3.8 percent as of end-2023.
  - Competition among many banks cited as another factor keeping lending rates low.

- Real estate market and investment alternatives:
  - Domestic financial markets underdeveloped; consumers have limited alternatives beyond deposits and real estate.
  - House prices increased significantly since 2019, accelerating since 2021.
  - Household lending for home purchase is the leading contributor to credit growth since 2019; some general-purpose loans may effectively finance home purchases and be undercounted as real-estate lending.
  - Banking agencies regulation: limit uncollateralized home-purchase loans to 50,000 KM per person and to a 10-year maximum maturity.
  - Risk: crowding of funds into real estate could pose long-term financial stability risks if housing prices accelerate abruptly or households overborrow; if real estate cannot absorb excess savings, excess liquidity could persist and depress interest rates.

- Policy measures and potential market responses:
  - Existing measures: limits on increases in lending rates (200 bps rule), ceilings on banks' exposure to foreign sovereigns through end-2024, administrative approval requirements for opening accounts abroad, cash movement permits above €10,000.
  - Potential initiative: Republika Srpska (RS) considering issuing retail bonds for individuals to participate in the market for sovereign debt.
    - Expected medium-term volumes: relatively low.
    - Possible market effects: could incentivize banks to raise deposit rates; some banks reportedly offered promotional deposit rates after announcement.

*Source: International Monetary Fund — “1. Remuneration Rates and Capital Outflows” (chapter content provided).*

### Deposit Elasticities, Funding Stability, and Policy Implications
- Deposit elasticities (Bayesian SVAR with sign restrictions):
  - Savings deposits are generally stickier than vista deposits.
  - For a 100 bps increase in remuneration:
    - savings deposit volumes grow by 1.4 percent in the month following the interest rate increase, with no significant further increases subsequently.
    - vista deposit volumes increase by 2.9 percent for the same change in remuneration.
  - Households prefer more liquid forms (vista deposits) because there are no early withdrawal penalties.
  - Households and NFCs hold most funds in checking accounts and make little use of savings accounts.
  - The predominance of vista deposits may have been exacerbated by compression of interest rate differentials between vista and term deposits since the beginning of the previous ECB loosening cycle.
  - Recent months show some reversal, but the interest rate differential remains low.

- Implications:
  - Bank funding becomes more short-term, with stability risks due to shorter maturities (affects maturity transformation).
  - To attract stable funding, banks would need to increase remuneration comparatively more on savings deposits.

### Conclusions on Remuneration Rates and Policy Recommendations
- Global context: interest rates have increased globally in response to inflation; pass-through to lending and deposit rates has been sluggish and heterogeneous.
- BiH vulnerabilities:
  - With a CBA linked to the euro, BiH is susceptible to euro area monetary policy changes.
  - Widening spread between local rates and euro area rates changes relative prices and affects capital flows; exchange rate cannot adjust.
  - Since July 2022, capital outflows amounted to around KM 1.7 billion.
  - Gap between CBBH remuneration of banks’ required reserves and the ECB’s deposit facility rate widened to 350 bps, leading banks to place funds in the euro area.
  - Domestic pass-through slow; low deposit remuneration and underdeveloped financial market limit investment alternatives beyond real estate.
  - Funding composition historically tilted toward short-term (little savings deposits).

- Policy recommendations:
  - Narrow the gap between CBBH remuneration of required reserves and the ECB’s deposit facility rate to avoid further capital outflows.
  - Allow interest rates to adjust to global conditions; interest rates should be free to adjust to market dynamics to avoid distortions, mispricing of risk, and capital misallocation.
  - Monitor developments in the real estate market by computing and publishing key indicators such as house price indices, credit growth in the mortgage sector, and measures of indebtedness.

*Source: IMF staff analysis (excerpt provided).*

### Minimum Wage Determination, Reform Proposals, and Impacts
- Timing, process, and institutional gaps:
  - Decisions are most often adopted late in the fourth quarter or in January.
  - In some years governments did not take decisions and the last adopted decision continued to be applied; in some years the MW was increased twice.
  - Law stipulates MW discussions in ESC, but often no agreement or no discussions occur; government then decides.
  - MW last determined based on ESC proposal in 2018 in RS, and never in the last 20 years in FBiH.
  - Some by-laws specified in labor law have not been adopted or are no longer in force.
  - In FBiH all decisions were made by the government; in RS ESC proposals used only in 2017 and 2018.

- Proposed reforms in FBiH (PIT, SSC, and MW law):
  - Drafts of PIT and SSC laws in parliamentary procedure since 2018.
  - Proposals (adopted in first reading) include:
    - SSC rate reduced from 41.5 to 33 percent.
    - Income tax base expanded so reform is budget neutral.
    - Non-taxable benefits (hot meals, vacation) and dividend income introduced in the tax base.
    - Progressive income taxation replacing the existing one rate.
    - Increase in the personal tax deduction from KM 300 to KM 700 per month.
  - PIT and SSC changes proposed together to offset revenue loss from lower SSC.
  - Proposed MW law (sent to parliamentary procedure in 2021) proposed:
    - MW at 75 percent of the average salary in 2022, 80 percent in 2023.
    - Annual adjustments thereafter based on changes in inflation, gross salary, and employment.
    - Specified MW exclusions (difficult working conditions, overtime, night work, Sundays/holidays).
    - Did not specify treatment of meal, transportation, and vacation allowances (estimated about KM 350 monthly).
    - Government estimates: including these benefits could raise MW to about KM 1,000 (or 77 percent of the current average salary).

- Incidence and potential impact:
  - In BiH (2022): about 22 percent of employees worked for minimum wage.
  - About 55 percent received a take home salary up to KM 1,000 per month (59.4 percent in FBiH and 44.2 percent in RS).
  - Estimated impacts on average wage:
    - RS 2024 MW increase of 28.6 percent could raise the average wage by 4.3 percent assuming no change in other wages; if other wages also increase by one fifth of the minimum wage increase (5.7 percent), RS average wage would increase by 8.8 percent.
    - FBiH potential further increase of 67.8 percent in the MW to KM 1,000 could lead to 17.5 percent increase in the average wage with no change in other wages, and 26 percent increase with an increase in other salaries.
  - Implied passthrough ranges: RS: 0.15 to 0.31; FBiH: 0.26 to 0.38.

- Employment, informality, and competitiveness considerations:
  - International evidence mixed: studies show higher MWs led to dis-employment in CESEE (Raei et al, 2016) and increased informality (Lotti et al, 2017); other estimates vary widely.
  - In BiH concerns that sizable MW increases will challenge utility companies and public enterprises with regulated prices.
  - Authorities argue MW increases could make employment more attractive and stem emigration.
  - Informality estimated around 30 percent in 2018 (Efendic, 2018); could rise with large MW increases.
  - Competitiveness risk: significant MW increases may erode external competitiveness unless firms raise prices or increase productivity; labor-intensive export sectors (wood-processing, textiles) most at risk.
  - Real wage growth has outpaced productivity: from 2019 Q4 to 2023 Q4, average real net wages increased by 13 percent while productivity growth was around 7.8 percent.

- Fiscal and social spending implications (direct estimates and narrative):
  - Direct fiscal impact estimates (assuming unchanged employment):
    - FBiH: MW increase 67.8 percent — SSC and PIT revenues: Percent change 18.8; KM 1,200 mn; Percent of GDP 3.6. Wage bill and social benefits table entries presented with fragmented formatting in source; preserved explicit numbers where shown.
    - RS: MW increase 28.6 percent — SSC and PIT revenues: Percent change 4.4; KM 115 mn; Percent of GDP 0.7.
  - Narrative: Increasing MWs by 28.6 percent in RS and 67 percent in FBiH could lead to an increase in PIT and SSC revenues by around 4 and 19 percent—KM 115 mn (0.7 percent of RS GDP) and KM 1.2 bn (3. 6 percent of FBiH GDP), respectively—based on the direct impact on wages and assuming unchanged employment.
  - In RS, close to 6 percent of general government employees receive MW and total allocations for wages would increase by 0.9 percent or 0.1 percent of RS GDP.
  - In FBiH, no direct impact on public sector wage bill since no budgetary beneficiary employees receive MW.
  - Indirect impacts may be significant if average wages rise; social spending would likely go up because some social benefits (particularly in FBiH) are determined as a percent of the minimum or average wage.

- Recommendations on MW policy:
  - Avoid high or frequent MW adjustments or indexation that would undermine competitiveness and weaken labor market outcomes.
  - Avoid minimum wage increases above inflation without an agreed methodology linked to productivity.
  - Delink social benefits from MW/average wage increases and link them to relevant macro indicators (e.g., backward-looking inflation).
  - Harmonize, strengthen, and enforce labor market legislation across the two entities, including the methodology to set MW, and strengthen consultation with economic partners.
  - Build capacity to closely monitor labor markets and poverty indicators and the impact of MW adjustments on outcomes; enhance Labor Force Survey quality and data collection capacity.
  - Encourage broader reforms: support flexible employment, expand childcare to increase female participation, tackle skill mismatches and long-term unemployment.

*Source: IMF staff report (excerpt provided).*

### Electricity Price Liberalization, ETS Design, Modeling, and Policy Recommendations
- Motivation and current situation:
  - Electricity prices regulated below cost-recovery for households and small businesses; each entity can limit price increases.
  - FBiH: EPBiH reported a loss of KM 140 million in 2023 (€72 million). EPBiH proposed a new block tariff implying an increase in average prices of 10 percent from June 2024 within an entity government cap of 20 percent; regulator rejected proposal in April 2024.
  - Average cost of supply in FBiH approximately €70/MWh; average price €57/MWh; household consumption (~40 percent of total supply) pays approximately €38/MWh.
  - RS: lowest household tariff (applied to over 50 percent of total consumption) reported as €33/MWh.
  - Liberalization rationale: allow ETS-inclusive price signal to pass to consumers, reduce emissions, incentivize low-carbon investment and efficiency; combine with increased social protection if end-user prices rise significantly.

- ETS design and phasing recommendations:
  - Gradual phase-in of an ETS with initial relief for EITE firms.
  - Allowances could be issued to maintain a price floor increasing over time at pre-determined increments.
  - Allowances should be allocated by auction each year on a paid basis; initially free allowances could be provided to vulnerable EITE firms and phased out as EU phases out free allowances under CBAM.
  - EU context highlights:
    - Minimum emissions price €24 per ton of CO2.
    - Existing EU ETS cap decreases by 4.3-4.4 percent per year from 2024 onward.
    - Emissions price hovered around EUR 90 per ton since late-2021.
    - Inclusion threshold 25,000 CO2 tonnes.
    - Separate EU ETS for buildings, transport, and small industry planned in 2027 with price stabilization at EUR 45 per tonne and cap decline of 5 percent per year from 2024 levels; exemption until 2031 for member states with national carbon tax equal to or above ETS price.
    - CBAM initial scope: iron and steel, cement, fertilizers, aluminum, electricity and hydrogen through 2030; tax rate equals effective EU ETS price less carbon price paid in producer country.
    - CBAM Article 2(7) conditions for electricity export exemption include application of EU law for electricity, commitment to carbon neutrality by 2050, roadmap and progress toward EU-aligned ETS by 2030.

- Interim carbon pricing via fuel excises:
  - Current state-level fuel excise system: fuel excise plus a ‘toll’ fee of KM 0.4 per liter, of which KM 0.15 goes to the budget and KM 0.25 to road and highways public enterprises.
  - No excise applied to coal use or electricity consumption or gas consumption for heating purposes.
  - Current excise taxes diesel less than gasoline despite higher carbon emissions intensity.
  - Introducing an additional carbon price of KM 30 per ton (EUR 15 per ton) implies an additional excise between KM 0.05-0.08 per liter of fuel.
  - A coal excise equivalent to 30KM/tCO2 would amount to approximately 43KM/ton of coal.
  - Reported arrears related to coal mines: Elektroprivreda Republike Srpske mines: approximately €6 million; Elektroprivreda Bosne I Hercegovine: approximately €257 million.

- Quantitative modeling approach and reform scenario (CPAT):
  - Model: IMF and World Bank Climate Policy Assessment Tool (CPAT), a reduced-form model covering several sub-sectors and fuels.
  - Baseline: no new policies.
  - Illustrative reform scenario components:
    - Removal of electricity price controls to align with market prices over 5 years, starting in 2025.
    - An ETS with an emissions cap corresponding to an allowance price of €5 per ton from 2026, rapidly aligning with EU price levels (approximately €90 per ton by 2030).
    - No free allowances assumed in the base analysis.
  - Modeling caveats:
    - ETS assumed to cover all sectors including those under the second EU ETS and all activities regardless of firm size.
    - Impact of CBAM not estimated; outcomes depend on export mix, EU exposure, emissions-intensity relative to EU producers, and alignment of BiH ETS prices with CBAM phase-in.
    - Rapid renewable energy investment assumption: approximately USD 1.4 billion in renewable energy investment over 2026-2030 is predicated for modeled outcomes.

- Emissions, pollution, and mitigation outcomes:
  - Introducing an ETS in line with the reform scenario would put BiH’s unconditional NDC target within reach.
  - Model suggests overall decrease in energy consumption across sectors, most notably power and industrial sectors.
  - Assumes investment in abatement technology and rapid switch from coal to renewables.
  - ETS introduction has positive impact on local air pollution due to phase-down in coal use.

- Fiscal and macroeconomic implications:
  - Revenue potential: ETS may raise over 3 percent of GDP in 2030.
  - Deregulation of electricity prices generates savings of about 0.5 percent of GDP in 2030, largely benefiting two energy SOEs that currently absorb revenue loss from regulated prices.
  - ETS revenue primarily from coal use through auctioning allowances.
  - GDP impact and revenue recycling:
    - Without revenue recycling, potential negative impact on GDP growth in 2030 is 1.9 percentage points.
    - Illustrative revenue-recycling scenario (20 percent cash transfers, 50 percent labor tax reductions, 30 percent public investment) offsets negative GDP impact; extent depends on fiscal multipliers.

- Pricing and sectoral impacts (CPAT model table of price impacts by 2030):
  - Gasoline: Baseline US$ per liter 1.4 → Price Liberalization 1.4 (0% change) → Price Liberalization + ETS 1.6 (16% change)
  - Diesel: Baseline US$ per liter 1.2 → Price Liberalization 1.2 (0% change) → Price Liberalization + ETS 1.5 (18% change)
  - LPG: Baseline US$ per liter 0.6 → Price Liberalization 0.6 (0% change) → Price Liberalization + ETS 0.8 (23% change)
  - Kerosene: Baseline US$ per liter 1.0 → Price Liberalization 1.0 (0% change) → Price Liberalization + ETS 1.2 (23% change)
  - Oil: Baseline US$ per barrel 65.4 → Price Liberalization 65.4 (0% change) → Price Liberalization + ETS 103.4 (58% change)
  - Coal: Baseline US$ per gigajoule (GJ) 2.2 → Price Liberalization 2.2 (0% change) → Price Liberalization + ETS 10.0 (358% change)
  - Natural gas: Baseline US$ per gigajoule (GJ) 14.2 → Price Liberalization 16.8 (18% change) → Price Liberalization + ETS 21.45 (18% change)
  - Electricity: Baseline US$ per kwh 0.1 → Price Liberalization 0.17 (7% change) → Price Liberalization + ETS 0.22 (9% change)

- Sectoral and distributional impacts:
  - Aviation, mining, cement, shipping, and iron and steel face significant production cost increases.
  - Energy-intensive trade-exposed industries require gradual phase-in (initial free allowances phased out in line with EU) and conditional relief tied to firm-level investments in energy efficiency.
  - Household consumption: average reduction close to 3 percent relative to baseline, with largest effects on bottom four deciles.
  - Revenue recycling to increase progressivity: illustrative allocation of 20 percent targeted cash transfers to bottom four deciles, 50 percent to reduce labor tax burden (tax-free allowance), and 30 percent to public investment would make reform more progressive.
  - Urgent needs: strengthen social safety net for targeted transfers, allocate revenue to address livelihood losses in coal-producing regions.

- Conclusions and policy recommendations:
  - Gradually phase-in an economy-wide ETS to promote GHG emissions reductions, with offsetting support to households and firms.
  - Complementarities and sequencing:
    - Deregulate electricity prices over 5 years starting in 2025 to allow carbon prices to pass through.
    - Introduce an ETS starting in 2026 that rapidly aligns with EU levels by 2030 to meet mitigation targets and reduce local air pollution by switching away from coal.
    - Provide initial relief to energy-intensive trade-exposed industries (free allowances phased out in line with EU).
    - Recycle a portion of ETS revenues for targeted support to vulnerable households and measures that offset negative GDP impacts.
    - Consider interim use of state-level fuel excise to implement an equivalent carbon price while ETS established.
  - Implementation caveats:
    - Rapid ETS price increases will raise input and output prices, may be politically challenging, harm competitiveness of energy-intensive industries, and have negative distributional impacts.
    - Actual outcomes depend on renewable investment speed and scale, institutional and transmission upgrades, and careful design of compensatory measures.

*Source: Excerpt from the IMF staff analysis in the provided Bosnia and Herzegovina country report content.*

### 1. Remuneration Rates and Capital Outflows ___________________________________________ 5

### 1. Remuneration Rates and Capital Outflows

### Key findings and overview
- Wider spread between domestic interest rates and euro area short-term rates associated with capital outflows of around KM 1.7 billion since the ECB started tightening monetary policy in July 2022, mostly in the form of money market placements in the euro area.
- Excess reserves in KM declined by close to KM 800 million since monetary tightening started in mid-2022.
- Regression evidence: a one percentage point increase in the spread (1-month Euribor vs. BiH weighted deposit rates up to 1 year) is associated with an average KM 630 million increase in bank net foreign assets (NFA), controlling for VIX, total remittances to BiH, and the inflation differential with the euro area.
- Most capital outflows so far are callable deposits placed at euro area banks; holdings of non-resident securities other than shares in foreign currency have picked up recently, particularly in FBiH.
- Capital outflows have been gradual; regulatory measures and limits have contained a larger exodus, but may conceal underlying dynamics.

### Global and euro-area context
- ECB tightening timeline and key figures:
  - ECB deposit facility rate: -0.5 percent in July 2022; stands at 4 percent (as of text).
  - 1-month Euribor: -0.30 percent in July 2022 to 3.85 percent in December 2023 (monthly average).
  - Remuneration of vista deposits for households increased from around zero to 0.36 percent over the same period.
  - Excess liquidity in the euro area: €3,255 billion in April 2024 (ECB Economic Bulletin Issue 3/2024).

### Interest rate differentials and capital flows (BiH specifics)
- BiH operates under a currency board arrangement (CBA) pegging the convertible mark (KM) to the euro; the CBBH must hold euro reserves at least equal to KM in circulation.
- Since mid-2022:
  - Banks’ foreign assets increased by close to KM 1.7 billion.
  - Excess KM reserves fell by close to KM 800 million.
- Data and regression:
  - Short-term rates used: 1-month Euribor and weighted deposit rates of BiH households and NFCs with maturity up to 1 year.
  - Controls: euro area volatility index (VIX), total remittances, inflation differential.
  - Control variables’ coefficients relatively small; the spread explains most variability in NFA (high R2).

### Composition of outflows and regulatory context
- Predominant outflow instrument: money market placements (callable deposits) in the euro area.
- Recent uptick: non-resident securities (other than shares) in foreign currency, especially in FBiH.
- Regulatory and administrative restraints:
  - Regulatory limits on residents’ placements of deposits abroad and on exposures to foreign sovereign bonds have constrained outflows.
  - Private individuals must seek approval from the entity’s Ministry of Finance to open a bank account abroad; cash transport across border requires permission for amounts exceeding €10,000.
  - Banking agencies set the ceiling on banks' exposure to foreign sovereigns equal to the amount of regulatory capital, until end-2024.
- Caveat: restrictive measures may hamper market functioning and conceal underlying dynamics.

### Domestic interest rates, funding costs, and credit
- Funding costs (CBBH reference rates) for 3-month tenor as of 2023Q2:
  - KM: 0.28 percent
  - EUR: 0.66 percent
- Deposit composition between KM and EUR has remained stable despite external spread.
- Credit dynamics:
  - Credit to the private sector grew by 7.4 percent y-o-y in 2023.
  - CBBH Bank Lending Survey: strong loan demand, particularly from corporates; rejection rates for loans to households and enterprises increased in the last four quarters.
- Lending rates and policy measures:
  - Lending rates remain flat and close to historical lows; borrowing costs for companies are now lower in BiH than in the euro area.
  - In October 2022, banking agencies published a decision to effectively limit the increase of lending rates: for increases greater than 200 bps for any loan, banks would have to increase the amount of provisions for such loan (initially until end-2023, subsequently extended to June 2024).
  - NPLs low at 3.8 percent as of end-2023.
  - Competition among many banks cited as another factor keeping lending rates low.

### Real estate market and investment alternatives
- Domestic financial markets underdeveloped; consumers have limited alternatives beyond deposits and real estate.
- House prices:
  - Increased significantly since 2019, accelerating since 2021 after a long period of subdued activity.
  - Low deposit returns and limited investment options have increased demand for real estate.
- Household lending for home purchase:
  - Leading contributor to credit growth since 2019; some general-purpose loans may effectively finance home purchases and thus be undercounted as real-estate lending.
  - Banking agencies issued regulation limiting uncollateralized home-purchase loans to 50,000 KM per person and to a 10-year maximum maturity.
- Risk considerations:
  - A crowding of funds into real estate could pose long-term financial stability risks if housing prices accelerate abruptly or households overborrow.
  - Conversely, if real estate cannot absorb excess savings, excess liquidity could persist and further depress interest rates.

### Policy measures and potential market responses
- Existing measures that have affected dynamics:
  - Limits on increases in lending rates (200 bps rule with higher provisioning).
  - Ceilings on banks' exposure to foreign sovereigns through end-2024.
  - Administrative approval requirements for individuals opening accounts abroad and cash movement rules (permits above €10,000).
- Potential initiative:
  - Republika Srpska (RS) is considering issuing retail bonds for individuals to participate in the market for sovereign debt to provide an alternative to deposits and real estate.
    - Expected medium-term volumes: relatively low.
    - Possible market effects: presence of retail sovereign bonds could incentivize banks to raise deposit rates; some banks reportedly offered promotional deposit rates after announcement.

*Source: International Monetary Fund — “1. Remuneration Rates and Capital Outflows” (chapter content provided).*

### 16.      Estimates show that the relative elasticities of demand and savings deposits, together

### 16.      Estimates show that the relative elasticities of demand and savings deposits, together 

### Deposit elasticities, recent interest rate developments, and implications for bank funding
- Elasticities estimated using a Bayesian SVAR model with interest rates and volumes as endogenous variables and sign restrictions.
- Savings deposits are generally stickier than a vista deposits.
- For a 100 bps increase in remuneration:
  - savings deposit volumes grow by 1.4 percent in the month following the interest rate increase, with no significant further increases in the subsequent months.
  - vista deposit volumes increase by 2.9 percent for the same change in remuneration.
- Households prefer more liquid forms (a vista deposits) for the same remuneration increase because there are no early withdrawal penalties.
- Households and NFCs in BiH hold most of their funds in checking accounts and make little use of savings accounts.
- The long-term tendency toward a predominance of vista deposits may have been exacerbated by the compression of interest rate differentials between a vista deposits and term deposits since the beginning of the previous monetary policy loosening cycle by the ECB.
- The recent trend has somewhat reversed in recent months, but the interest rate differential remains low.
- Implications:
  - Bank funding becomes more short-term, which can have financial stability implications because short-term funding is generally less stable than longer-term funding.
  - Affects maturity transformation.
  - To attract stable forms of funding, banks would need to increase remuneration comparatively more on savings deposits.

### Conclusions and policy recommendations (D)
- Global context:
  - Interest rates have increased globally in response to inflation; however, pass-through of policy rates to lending and deposit rates has been sluggish and heterogeneous across countries.
  - Excess liquidity following unconventional monetary policy is dampening pass-through in many countries.
- BiH specific vulnerabilities and effects:
  - With a CBA linked to the euro, BiH’s economy is susceptible to changes in euro area monetary policy.
  - A widening of the spread between local interest rates and the euro area changes relative prices, with potential effects on capital flows.
  - Exchange rate cannot adapt to close the gap because the local currency is pegged to the euro.
  - Since July 2022, when the ECB started hiking interest rates, capital outflows have amounted to around KM 1.7 billion.
  - The gap between the CBBH’s remuneration of banks’ required reserves and the ECB’s deposit facility rate has widened to 350 bps, leading many BiH banks to place funds in the euro area, mostly in overnight deposits, in search for yield.
  - Domestically, pass-through has been slow with possible effects on capital allocation: low remuneration of deposits and an underdeveloped financial market leave households and firms with few investment alternatives beyond real estate.
  - Composition of bank funding in BiH has historically been tilted toward short-term deposits, with little savings deposits, making funding less stable.
  - Current compression of the spread between a vista and savings deposits incentivizes households and firms to hold their funds in the former.
- Policy recommendations:
  - Narrow the gap between CBBH remuneration of required reserves and the ECB’s deposit facility rate to avoid further capital outflows.
  - Allow interest rates to adjust to global conditions; interest rates should be free to adjust to market dynamics to avoid distortions, mispricing of risk, and capital misallocation.
  - Monitor developments in the real estate market:
    - Compute, monitor, and make available key indicators such as house price indices, credit growth in the mortgage sector, and measures of indebtedness.
    - Rationale: real estate is the primary domestic investment alternative and could overheat if households and firms borrow at very low rates to invest in this market.

### Labor market overview and wage developments (selected findings from subsequent section)
- Employment and recovery:
  - BiH employment surpassed its pre-pandemic level in early-2022.
  - By end-2023, employment had risen by 2.7 percent above the end-2019 level.
  - Only private sector employment declined during the pandemic, while public sector employment continued to grow largely in line with trend.
- Sectoral employment patterns:
  - Science and technology sectors (including information and communication, professional, scientific and technical activities) grew steadily, rising by 10 to 30 percent relative to 2019 levels by end-2023.
  - Traditional sectors experienced declines: by December 2023, employment in real estate and mining had contracted by around 13 percent relative to end-2019.
- Public sector employment and shares:
  - Public sector employment rises mainly in education and health.
  - Employment in public administration, defense, and security services increased by 1.6 percent.
  - Education and health sector employment rose by 4 and 10 percent, respectively.
  - Public sector continues to employ around 25 percent of total employment versus 75 percent for the private sector (9 percent in public administration, defense, and security services, and 16 percent in education and health).
  - Including public enterprises’ employment would increase the public-sector share to over 35 percent.
- Gender and unemployment:
  - Female labor market outcomes lag male outcomes:
    - Female participation and employment stood at 37.0 percent and 31.0 percent, respectively, in 2023 Q4.
    - Male participation and employment were 60.7 percent and 54.4 percent, respectively.
    - Female unemployment was 16.2 percent compared with 10.4 percent for male.
  - Overall unemployment:
    - Unemployment rate declined to 12.7 percent in 2023 Q4 from 15.4 percent in 2022 and 19.1 percent in 2021 Q1.
    - Youth unemployment was 35 percent in 2022.
- Wages and minimum wage developments:
  - Average nominal wages were 24.5 percent higher in December 2023 compared to end-2021.
  - Real average wages increased by around 6 percent over the same period.
  - Average net wages increased more rapidly in RS than in FBiH.
  - Wages in the public sector were 18-25 percent higher in December 2023 compared to end-2021.
  - Private sector wages were 20-40 percent higher, except in electricity and gas and financial activities, where salaries increased by 14 and 5 percent, respectively.
  - In December 2023, the ratio of private sector wages to total average net wages stood at around 89 percent; public administration and defense at 130 percent; health and education at 112 percent.
  - Minimum wages (MW):
    - Cumulative increase in MWs reached 52 and 100 percent in FBiH and RS, respectively, between December 2019 and January 2024.
    - RS MW measured as a share of average net wages is 69 percent (46 percent for FBiH), the highest in the region and around 10 percentage points higher than the Western Balkans average (61 percent).
  - Wages increased more than productivity:
    - From 2019 Q4 to 2023 Q4, average real net wages increased by 13 percent while productivity growth was around 7.8 percent.
- Legal and institutional framework for MW:
  - MW legal basis in labor laws in both entities; entity governments determine MW annually after consultation with their respective Economic and Social Councils (ESC).
  - ESC composition: 18 members in FBiH and 9 members in RS (representatives of government, trade unions, and employers’ associations).
  - Employment allowances (hot meals, transportation, vacation, premia, seniority increases) are common and not considered part of the (minimum) salary in most cases; exceptions exist for RS public sector where hot meal and vacation allowances are included in the salary.
  - FBiH decree methodology for determining MW (in force since 2022):
    - The increase for a given year cannot be lower than the sum of 50 percent of the increase in consumer prices and 50 percent of the increase in GDP for January – September of the previous year.
    - The increase of MW can be higher than the formula-based amount, but cannot be lower than the latest regulated MW.
    - MW should be greater than or equal to 55 percent of average wage (interpretation ambiguity noted).

*Source: IMF staff analysis in the provided content unit.*

### 16.      The authorities are generally late in determining the MW. Decisions are most often

### 1bihea2024002 - 16.      The authorities are generally late in determining the MW. Decisions are most often

### Minimum wage determination: timing, process, and institutional gaps
- Decisions are most often adopted late in the fourth quarter or in January (Text Figure 1).
- For certain years, governments did not take decisions on the MW for the following year, and the last adopted decision continued to be applied.
- In some years, the MW was increased twice.
- Law stipulates discussions on the MW are to be conducted within the ESC, but often:
  - there is no agreement between the social partners, or
  - discussions within the ESC are not conducted at all; in those cases, the government takes a decision.
- The MW was last determined based on the proposal of the ESC in 2018 in RS, and never in the last 20 years in the FBiH.
- Some by-laws specified in the labor law (e.g., the labor rulebook in both entities or the general collective labor agreement in the RS) have not been adopted or are no longer in force.
- In FBiH, all decisions were made by the government.
- In the RS, the decisions were made based on the ESC proposals only in 2017 and 2018.

### Proposed reforms in FBiH: PIT, SSC, and minimum wage law
- Drafts of new laws on personal income tax (PIT) and social security contributions (SSC) have been in parliamentary procedure since 2018.
- Proposals (adopted in first reading) include:
  - SSC rate reduced from 41.5 to 33 percent.
  - Income tax base expanded so that the overall reform is budget neutral.
  - Non-taxable benefits (hot meals, vacation) and dividend income introduced in the tax base.
  - Progressive income taxation replacing the existing one rate.
  - Increase in the personal tax deduction from KM 300 to KM 700 per month.
- The PIT and SSC changes were proposed together to ensure revenue loss from lower SSC rate is partially or fully compensated by revenue gains from expansion of the PIT base; the package had not received parliamentary majority at the time of the text.
- A proposed MW law (sent to parliamentary procedure in 2021) proposed:
  - MW at 75 percent of the average salary in 2022, 80 percent in 2023.
  - Annual adjustments thereafter based on changes in inflation, gross salary, and employment.
  - Specified that MW would not include benefits based on difficult working conditions, overtime and night work or work on Sundays and holidays.
  - Did not specify treatment of meal, transportation, and vacation allowances (estimated at about KM 350 monthly).
  - Government estimates: including these benefits could raise the minimum wage to about KM 1,000 (or 77 percent of the current average salary).

### Potential impact of minimum wage (MW) reforms on wages and distribution
- Key factors determining impact: whether MW is binding, share of minimum-wage earners, and wage distribution.
- In BiH (2022):
  - about 22 percent of employees worked for minimum wage.
  - about 55 percent received a take home salary up to KM 1,000 per month.
    - 59.4 percent in FBiH and 44.2 percent in RS (Text Figure 2).
- Estimated impacts on average wage:
  - RS 2024 MW increase of 28.6 percent could raise the average wage by 4.3 percent assuming no change in other wages.
  - If other wages also increase by one fifth of the minimum wage increase (5.7 percent), RS average wage would increase by 8.8 percent.
  - In FBiH, a potential further increase of 67.8 percent in the minimum wage to KM 1,000 could lead to:
    - 17.5 percent increase in the average wage with no change in other wages.
    - 26 percent increase with an increase in other salaries.
- Implied passthrough ranges:
  - RS: 0.15 to 0.31.
  - FBiH: 0.26 to 0.38.
- Prior pass-through estimates cited:
  - slight negative in Romania (Andreica et al, 2010).
  - 0.01-0.15 in CESEE countries (Raei et al, 2016).
  - 0.8 in US (Neumark et al, 2005).

### Potential impact on employment, informality, and competitiveness
- Assessing employment impact is difficult; international evidence varies:
  - Raei et al (2016) (CESEE) found higher MWs led to dis-employment.
  - Lotti et al (2017) found higher MWs increase informality in a cross-country study.
- In BiH:
  - Concern in RS that sizable MW increases will pose challenges to utility companies and public enterprises, particularly those with regulated prices.
  - Authorities argue MW increases could make employment more attractive and stem domestic labor emigration.
  - Concerns exist (including in private sector) that large, ad hoc MW changes could lead to job losses, particularly during low demand for exports from Europe.
  - Informality was estimated at around 30 percent in 2018 in BiH (Efendic, 2018); informality could rise.
  - Informality reportedly includes envelope payments, underreporting of hours, and fully operating in the shadow economy.
- Competitiveness:
  - Significant MW increases may erode external competitiveness via higher wage costs unless firms can raise prices or increase productivity (reduce employees/hours, automate, or save in non-wage costs).
  - Labor-intensive export-oriented industries (wood-processing, textiles) are likely most affected.
  - Such firms cannot easily change prices in short term due to competition, contract renegotiation needs, and depressed demand from Europe.
  - Real wage growth in BiH has already surpassed productivity since 2023.

### Fiscal and social spending implications (direct estimates)
- Estimated fiscal impacts of MW increases (direct impact on wages, assuming unchanged employment):
  - FBiH: MW increase 67.8 percent
    - SSC and PIT revenues: Percent change 18.8; KM 1,200 mn; Percent of GDP 3.6
    - Wage bill: Percent change --- ; KM --- ; Percent of GDP 31.6 23? (table formatting in source ambiguous; preserved numbers as presented)
    - Spending for social benefits: Percent change 23?; KM 320?; Percent of GDP 0.7? (source table presentation partially fragmented; numbers preserved where explicit)
  - RS: MW increase 28.6 percent
    - SSC and PIT revenues: Percent change 4.4; KM 115 mn; Percent of GDP 0.7
    - Wage bill: Percent change 1.5?; KM 20?; Percent of GDP 0.1? (source table presentation partially fragmented; numbers preserved where explicit)
- Narrative fiscal estimates:
  - Increasing MWs by 28.6 percent in RS and 67 percent in FBiH could lead to an increase in PIT and SSC revenues by around 4 and 19 percent—KM 115 mn (0.7 percent of RS GDP) and KM 1.2 bn (3. 6 percent of FBiH GDP), respectively—based on the direct impact on wages and assuming unchanged employment.
  - In RS, close to 6 percent of general government employees receive MW and total allocations for wages would increase by 0.9 percent or 0.1 percent of RS GDP.
  - In FBiH, there is no direct impact on the public sector wage bill since no employees at the budgetary beneficiary institutions receive MW.
  - Indirect impacts may be significant if average wages rise; social spending would likely go up because some social benefits (particularly in FBiH) are determined as a percent of the minimum or average wage. In RS, some social benefits are determined as a percent of MW, but the percent is defined every year by the government.

### Recommendations
- Enhance labor market transparency and encourage more orderly wage negotiation by:
  - Avoiding high or frequent MW adjustments or indexation that would undermine competitiveness and weaken labor market outcomes.
  - Avoiding minimum wage increases above inflation without an agreed methodology linked to productivity.
  - Delinking social benefits from MW/average wage increases and linking them to movements of relevant macroeconomic indicators, such as backward-looking inflation.
  - Harmonizing, strengthening, and enforcing labor market legislation across the two entities—including the methodology to set MW, and strengthening consultation with economic partners.
  - Building capacity to closely monitor labor markets and poverty indicators and the impact of MW adjustments on labor market outcomes, including by enhancing the quality of Labor Force Survey data, and strengthening data collection and technical capacity.
- Encourage broader reforms to enhance labor market participation and stem emigration, including by:
  - Supporting flexible employment.
  - Expanding childcare to encourage higher female participation.
  - Tackling skill mismatches and long-term unemployment.

*Source: IMF staff report (excerpt provided in the supplied content).*

### 5.      Electricity price liberalization would allow for more effective carbon pricing. Currently

### 5.      Electricity price liberalization would allow for more effective carbon pricing. Currently

### Electricity price liberalization: motivation and current situation
- Electricity prices are regulated at below cost-recovery levels for households and small businesses, with each entity able to limit the scope of price increases.
- In the FBiH:
  - EPBiH reported a loss of KM 140 million in 2023 (€72 million).
  - EPBiH proposed a new block tariff implying an increase in average prices of 10 percent from June 2024, within the entity government’s price increase cap of 20 percent; the regulator rejected the proposal in April 2024.
  - Average cost of supply is approximately €70/MWh; average price is €57/MWh; household consumption (approximately 40 percent of total supply) pays approximately €38/MWh.
- In the RS:
  - Authorities reported the lowest household tariff (applied to over 50 percent of total consumption) as €33/MWh.
- Rationale:
  - Liberalization would allow an ETS-inclusive price signal to be passed onto consumers and therefore reduce emissions.
  - Liberalization would incentivize investment in low carbon electricity generation and more efficient electricity supply, which would reduce the impact of carbon pricing on electricity prices over the medium term.
- Policy complement:
  - Liberalization could be coupled with increased social protection to vulnerable households and small businesses if it leads to significantly higher end-user prices.

### ETS design and phasing recommendations
- Gradual phase-in of an ETS with initial relief for energy intensive trade-exposed (EITE) firms:
  - Allowances could be issued to maintain a price floor which increases over time at pre-determined increments to provide price certainty for firms investing in abatement technology.
  - Allowances should be allocated by auction each year on a paid basis.
  - Initially, free allowances could be provided to EITE firms particularly vulnerable to competitiveness issues; these free allowances would be phased out as the EU phases out free allowances under CBAM implementation.
- EU context (Box 1 summaries preserved):
  - Minimum emissions price was set at €24 per ton of CO2, with initial free allowances for energy intensive industries and coal plants to be phased out gradually.
  - Existing EU ETS cap decreases by 4.3-4.4 percent per year from 2024 onward.
  - Emissions price hovered around EUR 90 per ton since late-2021.
  - Inclusion threshold under current ETS is emissions of 25,000 CO2 tonnes.
  - Separate EU ETS for buildings, transport, and small industry planned in 2027 with a price stabilization mechanism to keep allowance prices at EUR 45 per tonne and an allowance cap set to an annual, linear decline of 5 percent per year from 2024 emission levels; exemption until 2031 for member states with a national-level carbon tax equal to or above the ETS allowance price.
  - CBAM initially applies to imports of iron and steel, cement, fertilizers, aluminum, electricity and hydrogen through 2030; tax rate equals effective EU ETS price less any carbon price paid in the producing country.
  - CBAM Article 2(7) conditions for electricity export exemption include: application of EU law for electricity including on renewable energy and electricity market coupling with the EU; commitment to carbon neutrality by 2050; roadmap and substantial progress toward implementation of an EU-aligned ETS by 2030.

### Interim carbon pricing via fuel excises
- Current BiH fuel excise system (state level) comprises a fuel excise plus a ‘toll’ fee of KM 0.4 per liter, of which KM 0.15 goes to the budget and KM 0.25 to road and highways public enterprises.
- No excise applied to coal use or electricity consumption or gas consumption for heating purposes.
- The current excise system taxes diesel less than gasoline despite higher carbon emissions intensity.
- Introducing an additional carbon price of KM 30 per ton (EUR 15 per ton) implies an additional excise of between KM 0.05-0.08 per liter of fuel.
- A coal excise equivalent to 30KM/tCO2 would amount to approximately 43KM/ton of coal.
- Reported arrears related to coal mines:
  - Elektroprivreda Republike Srpske mines: approximately €6 million.
  - Elektroprivreda Bosne I Hercegovine: approximately €257 million.

### Quantitative modeling approach and reform scenario (CPAT)
- Model: IMF and World Bank Climate Policy Assessment Tool (CPAT), a reduced-form model covering several sub-sectors and fuels.
- Baseline scenario: no new policies introduced.
- Illustrative reform scenario components:
  - Removal of electricity price controls to align with market prices over 5 years, starting in 2025.
  - An ETS with an emissions cap corresponding to an allowance price of €5 per ton from 2026, rapidly aligning with EU price levels (approximately €90 per ton by 2030).
  - No free allowances are assumed in the base analysis.
- Important modeling assumptions and caveats:
  - ETS assumed to cover all sectors including those under the second EU ETS and all activities regardless of firm size.
  - Impact of CBAM is not estimated in the modeling; actual impact depends on export mix, proportion of exports to the EU, emissions-intensity relative to EU producers, and alignment of BiH ETS prices with CBAM phase-in.
  - Rapid renewable energy investment assumption: approximately USD 1.4 billion in renewable energy investment over the 2026-2030 period is predicated for modeled outcomes.

### Emissions, pollution, and mitigation outcomes
- Introducing an ETS in line with the reform scenario would put BiH’s unconditional NDC target within reach.
- Model suggests an overall decrease in energy consumption across all sectors, most notably in the power and industrial sectors.
- Assumes investment in abatement technology and a rapid switch away from coal towards renewable sources in the medium term.
- The ETS introduction has a positive impact on local air pollution levels due to phase-down in coal use.

### Fiscal and macroeconomic implications
- Revenue potential:
  - The ETS may raise over 3 percent of GDP in 2030.
  - Deregulation of electricity prices generates savings of about 0.5 percent of GDP in 2030, largely benefiting the two energy SOEs that currently absorb revenue loss from regulated electricity prices.
  - ETS revenue would be generated primarily from coal use through auctioning allowances.
- GDP impact and revenue recycling:
  - Without revenue recycling, potential negative impact on GDP growth in 2030 is 1.9 percentage points.
  - Illustrative revenue-recycling scenario: 20 percent of revenues recycled through cash transfers, 50 percent through labor tax reductions, and 30 percent through public investment; in that scenario the negative impact on GDP growth is offset.
  - The extent of reversal depends on the size of fiscal multipliers of policies chosen to recycle revenues.

### Pricing and sectoral impact
- An ETS will put upward pressure on energy prices, with the highest impact on coal.
- Tabled price impacts by 2030 (from CPAT model):
  - Gasoline: Baseline US$ per liter 1.4 → Price Liberalization 1.4 (0% change) → Price Liberalization + ETS 1.6 (16% change)
  - Diesel: Baseline US$ per liter 1.2 → Price Liberalization 1.2 (0% change) → Price Liberalization + ETS 1.5 (18% change)
  - LPG: Baseline US$ per liter 0.6 → Price Liberalization 0.6 (0% change) → Price Liberalization + ETS 0.8 (23% change)
  - Kerosene: Baseline US$ per liter 1.0 → Price Liberalization 1.0 (0% change) → Price Liberalization + ETS 1.2 (23% change)
  - Oil: Baseline US$ per barrel 65.4 → Price Liberalization 65.4 (0% change) → Price Liberalization + ETS 103.4 (58% change)
  - Coal: Baseline US$ per gigajoule (GJ) 2.2 → Price Liberalization 2.2 (0% change) → Price Liberalization + ETS 10.0 (358% change)
  - Natural gas: Baseline US$ per gigajoule (GJ) 14.2 → Price Liberalization 16.8 (18% change) → Price Liberalization + ETS 21.45 (18% change)
  - Electricity: Baseline US$ per kwh 0.1 → Price Liberalization 0.17 (7% change) → Price Liberalization + ETS 0.22 (9% change)
- Sectoral impacts:
  - Aviation, mining, cement, shipping, and iron and steel face significant production cost increases.
  - If firms are price takers, they may not be able to pass on higher costs, affecting competitiveness.
  - Energy-intensive trade-exposed industries could be offered a more gradual phase-in via initial free allowances, phased out at the same rate as the EU; relief can be conditional on firm-level investments in energy efficiency.

### Distributional impacts and social mitigation
- Household consumption:
  - Average reduction in household consumption close to 3 percent relative to the baseline, with largest effects on the bottom four deciles of the income distribution.
- Revenue recycling to increase progressivity:
  - Illustrative allocation: 20 percent of revenue for targeted cash transfers to the bottom four deciles, 50 percent to reduce labor tax burden (through the tax-free allowance), and 30 percent for public investment would make the reform more progressive.
- Urgent policy needs:
  - Strengthen social safety net to allow for targeted transfers to clearly identified and registered vulnerable households.
  - Allocate some revenue to address loss of livelihoods in coal producing regions and communities.

### Conclusions and policy recommendations
- Gradually phase-in an economy-wide ETS to promote GHG emissions reductions, possibly with offsetting support to households and firms.
- Key complementarities and sequencing:
  - Deregulate electricity prices (over 5 years starting in 2025 in the illustrative scenario) to allow carbon prices to pass through.
  - Introduce an ETS starting in 2026 that rapidly aligns with EU levels by 2030 to meet mitigation targets and reduce local air pollution by switching away from coal.
  - Provide initial relief to energy-intensive trade-exposed industries (e.g., free allowances phased out in line with EU).
  - Recycle a portion of ETS revenues for targeted support to vulnerable households and for measures that offset negative GDP impacts.
  - Consider interim use of the state-level fuel excise system to implement an equivalent carbon price while the ETS is being established.
- Implementation caveats:
  - Rapid increase in ETS prices will raise input and output prices, may be politically challenging, harm competitiveness of energy-intensive industries, and have negative distributional impacts.
  - Actual outcomes depend on the speed and scale of renewable energy investment, institutional and transmission upgrades, and careful design of compensatory measures.

*Source: Excerpt from the IMF staff analysis in the provided Bosnia and Herzegovina country report content.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2024/english/1bihea2024002.pdf_