## Selected Economic Issues — Bosnia and Herzegovina

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### Introduction and overview
- Since 1995: output, exports, and incomes increased; inflation stabilized; budgets close to balance; currency board established.
- Headline concerns:
  - external current account deficit "well over 15 percent of GDP";
  - unemployment "at over 20 percent";
  - government spending "at half of GDP";
  - government domestic indebtedness "at well above levels anticipated in the 2004 domestic claims settlement laws";
  - output still well below pre-war levels;
  - IBRD assesses poverty "at over 30 percent."
- Paper structure:
  - Chapters 2–6: assess whether headline indicators paint a bleak picture.
  - Chapters 7–10: implications for policies and policy-making frameworks.

### Market indicators of confidence in the KM and the banking system
- Key finding: "with confidence in both strengthening," private-sector behavior does not reflect worst-case implications of headline macro data.
- Evidence since 2000:
  - increased use of local currency and financial deepening; KM currency in circulation doubled between October 2001- December 2001 (reverse currency substitution);
  - KM deposits increased faster than foreign currency deposits until late 2004;
  - money multiplier: around 2;
  - spread between Euro and KM interest rates: still around 2 percentage points, fallen by ¾ percentage point since January 2003;
  - international reserves and net free reserves at end-2004: Euro 1,768 million (gross); Euro 88 million (net free);
  - currency board: set up 1997, pegged KM1=1 Deutsche Mark then KM 1.9558=Euro 1;
  - number of banks: declined from 72 in 1998 to 33 at end-2004; five under provisional administration at end-2004; 21 banks members of deposit insurance by end-December 2004.
- Caveats:
  - substantial foreign-currency indexing of loans (bulk over 50 percent of KM borrowing indexed to the Euro);
  - foreign currencies remain significant in deposits;
  - intermediation below comparator countries.
- Regulatory effects:
  - forex exposure limits: ~120 percent of capital in mid-2003 → 30 percent by mid-2004;
  - prudential liquidity matching up to 90 days with phased compliance through June/September 2004;
  - banks raised short-term KM deposits with the CBBH using foreign borrowing to meet rules, producing intra-month reserve swings up to KM 400 million by mid-2004; daily reporting implemented October 2004 reduced swings.
- Interpretation: strengthened confidence provides policy space but does not eliminate structural and contagion risks from external imbalances and credit growth.

### Confidence in the banking system — findings and prospects
- Findings:
  - public confidence in banks increased since 2000;
  - financial deepening: share of KM in circulation in M1 and broad money declined as deposits grew; velocity of bank deposits fell sharply in December 2001 and continued to drop;
  - time and savings deposits grew faster than demand deposits since December 2001; spreads between deposit and lending rates declined by over two percentage points since January 2002;
  - no bank runs despite consolidation; formal deposit insurance began in 2001.
- Risks and weaknesses:
  - money multiplier and deposit indicators still low by international standards;
  - over 60 percent of state-owned companies are lossmaking—indirect risk to banks;
  - weak borrower monitoring, absent functioning collateral and pledge registry, weak court enforcement.
- Signals to monitor:
  - shift from Euro notes into KM currency in circulation;
  - reduction in indexed lending by banks (would lower foreign borrowing and foreign deposit-taking);
  - development of an interbank market (unlikely soon);
  - changes in CBBH remuneration of excess reserves relative to ECB rates could affect reserve holdings.
- Policy recommendations:
  - early implementation of structural reforms to promote private sector growth and corporate restructuring;
  - strengthen bank supervision and regulation;
  - strengthen analytical capacity of the CBBH;
  - establish mechanisms for monitoring borrower quality and recovery (including collateral registry);
  - improve judicial capacity for enforcement; supervisors and CBBH to monitor credit boom closely and be ready to act.

### International experience with credit booms and large current account deficits
- BiH is an "international outlier" with a credit boom and large external current account deficit.
- Empirical evidence:
  - credit booms not always lead to instability, nor large external imbalances always precipitate crises, but correlation is substantive.
  - Caprio and Klingebiel (2003): 117 banking crises in 93 countries since late 1970s.
  - Definition: credit boom = three-year cumulative private credit-to-GDP rise ≥ 10 percentage points.
  - Of 140-country sample, 74 had banking difficulties; 22 of these had a >10 percentage point credit-to-GDP growth in preceding three years (these 22 account for almost 40 percent of credit boom cases).
  - Countries with private credit-to-GDP > 25 percent account for about half the sample but 75 percent of the 22 crisis cases.
  - Estimated likelihood of banking difficulties following lending boom: as high as 20 percent (depends on dataset/methodology).
- Currency-board comparisons:
  - BiH’s credit growth is atypical among currency boards; few analogues.
- Policy implication:
  - moderation of credit growth and reduction of external imbalance advisable to underwrite stability.

### Corporate sector performance and domestic savings
- National savings fell from about 8 percent of GDP in 2000 to about 3 percent in 2004.
- Private consumption expanded by more than 10 percent of GDP since 2000; investment stagnant at about 20 percent of GDP for four years.
- Bank credit to non-government rose by over 20 percentage points of GDP in 2001–04; credit to households rose by 14 percentage points of GDP since 2001.
- Corporate profitability (2002):
  - BiH: Profitability -1; Loss making 28 (percent of firms);
  - BiH SoEs: -13; 71;
  - BiH Private enterprises: 1; 25;
  - Federation: 1; 14; Federation SoEs: -7; 55; Federation Private enterprises: 2; 12;
  - RS: -5; 45; RS SoEs: -25; 80.
- Unit labor cost components (manufacturing, 2002=100):
  - Federation production: 100; 102; 120 (2002,2003,2004);
  - Federation wages: 100; 113; 114;
  - RS wages: 100; 111; 129; RS employment: 100; 86; 84.
- Liquidity and solvency:
  - Many enterprises illiquid: half of SoEs and 40 percent of private enterprises cannot repay current liabilities from current assets (Text Table 6).
  - Over one third of enterprise debts owed to suppliers; loans account for a further quarter; wage arrears ≈ 5 percent; tax/contribution arrears ≈ 10 percent.
  - Clearance of tax and labor debts would return only 15 percent of companies to liquid position; ~40 percent would remain illiquid/insolvent.
- Causes and constraints:
  - war-damaged capital stock, emigration, loss of markets;
  - policy decisions: SoEs used as social safety nets, restrictive labor laws, ineffective voucher privatization, weak bankruptcy procedures before 2003;
  - incentive problems: weak shareholder control, expectations of government bailouts, restrictive labor legislation and tripartite wage bargaining;
  - business environment: high start-up cost (46 percent of per capita income), high tax burden, corruption.

### Lessons from past revitalization efforts and core restructuring elements
- Voucher privatization (2000–2001): vouchers KM 15 billion issued; PIFs poorly designed; lack of management incentives and government retained effective control.
- Debt rescheduling: rescheduling in RS (end-2001) of KM 430 million; only 20 percent began repaying after grace; reschedulings without restructuring delayed adjustment.
- Strategic privatization: out of 108 strategic companies, 18 sold by end-2003.
- Sales to private owners show rapid gains with effective management and capital, but constraints include workforce skill shortages, restrictive labor law, infrastructure and bureaucracy.
- Core remedy elements:
  - make debt write-offs/reschedulings conditional on restructuring and management change;
  - ensure shareholders have effective control and ability to remove management;
  - credible bankruptcy enforcement capacity and procedures;
  - transparent, time-bound privatization free from political interference;
  - address social costs of restructuring given limited fiscal resources;
  - labor law reform to prevent future arrears and ease adjustment.

### Non-Observed Activity (NOA) and GDP measurement
- BiH unusual in making no NOA adjustment in official GDP.
- Estimates:
  - IMF Statistical Advisor: NOA ≈ 40 percent of unadjusted GDP in 1999–2002 (implies ~28 percent of total activity).
  - Direct-method study: NOA at 58 percent of official GDP in 2001 (≈40 percent of total activity); only ~7 percentage points of GDP of NOA estimate concerns illegal activities.
  - Staff panel regression approach (1999–2002) yields NOA estimates:
    - Based on All Countries: increases to official GDP of 26–33 percent by year (Average: 29 percent).
    - Based on Non-Transition Countries: increases of 39–50 percent by year (Average: 45 percent).
  - Staff summary: NOA likely 30–50 percent, bracketing other estimates.
- Regression pooled coefficients (selected, Text Table 3):
  - Currency in circulation per capita: 0.065 (0.033) **
  - Exports per capita: 0.272 (0.035) ***
  - Health care expenditures per capita: 0.489 (0.045) ***
  - R-Squared: 0.9574; Observations: 349; Countries: 96 (Excluding BiH)
- Caveats:
  - regressions show correlation, not causation; discrepancies could reflect measurement error, post-conflict X-inefficiencies, or understatement of GDP.
- Policy implications:
  - strong case to begin adjusting official data for NOA and to set up surveys for direct-method adjustments;
  - headline ratios (e.g., current account deficit, government spending) may be overstated if GDP understated, but other data (merchandise imports, consolidated spending) also have shortcomings.
- Numerical illustration:
  - staff estimate external deficit used = 17 percent of GDP;
  - using Central Bank adjusted deficit and inflating GDP by 50 percent for NOA gives deficit of 16 percent of GDP (2004), close to staff 17 percent.

### Restructuring of domestic liabilities, court rulings, and fiscal sustainability
- 2004 restructuring laws (RS July 2004; Federation November 2004; State and Brcko parallels): mixed cash payouts and zero/sub-market coupon bonds up to 50 years, with verification processes.
- Constitutional Court rulings:
  - RS law struck down December 17, 2004: concerns about disproportionate burden, 50-year bonds, and zero interest ("considerably diminished" payouts).
  - HRC decision April 6, 2005 on Federation frozen foreign currency deposits: interest due after January 1, 1992 could be written off; bonds permissible but maturities should not exceed 15 years and carry fair interest reflecting realistic value/inflation; State must issue law within six months and justify differential treatment.
- Fiscal implications (illustrative):
  - assumed total claims ≈ 200 percent of GDP;
  - if courts require NPV write-down leaving NPV domestic claims = 50 percent of GDP, NPV of public debt (2010) could be 76 percent of GDP under one scenario; alternative scenarios show NPV of public debt 61 percent with larger primary surplus.
  - sustainability table (selected items):
    - 2003 NPV public debt: 26 (percent of GDP)
    - 2010 under domestic claims plan (NPV domestic claims in 2004 = 10): NPV public debt 33; Primary balance 1; Overall balance -1; Real interest rates less real GDP growth 4
    - 2010 if NPV domestic claims = 50: NPV public debt 76; Primary balance 1½; Overall balance -4½; Real interest rates less real GDP growth 2
  - required permanent spending reduction to raise primary surplus to 4 percent of GDP: permanent reductions of 3 percent of GDP (KM420 million) relative to 2005 budget; cancelling entire Federation Central Government veterans program still leaves KM 120 million short.
- Immediate operational risks:
  - thousands of court cases could produce a "run on government deposits and assets" via execution proceedings; example: Trebijne municipality case.
- Recommended immediate actions:
  - promptly identify NPV of domestic debt courts would accept;
  - determine speedy legal processes to implement acceptable settlements;
  - examine options to reduce legal and fiscal uncertainty.
- Restitution and pension risks:
  - restitution commission must define scope and payouts consistent with fiscal sustainability; little scope for large restitution payouts given fiscal pressures;
  - pension contribution gaps: restoring full entitlements without revenue would increase future liabilities—recommend partial closure conditional on company restructuring.

### Consolidated government expenditure, priority projects, and trade-offs
- Priority projects (text table highlights): combined permanent spending increases ~4 percent of GDP or more.
  - Police reform: 0.6 percent of GDP permanently (with downsizing scenarios reducing cost);
  - Defense reform: 0.6 percent of GDP if no State-level wage cut and no downsizing; downsizing by 1/4 could reduce cost to 0.1 percent.
  - EBRD committed lending: ½ a percent of GDP for roads.
- Fiscal constraint:
  - fiscal revenue (including grants) ≈ 49 percent of GDP; limited scope for revenue expansion;
  - VAT yield uncertain and implementation challenging.
- Conclusion:
  - permanent savings in "other" spending of at least 4 percentage points of GDP required to offset high-priority plans and sustain fiscal balance;
  - if court rulings require a quarter of estimated outstanding claims paid in NPV terms, permanent cuts ~3 percent of GDP needed; if larger payouts mandated, cuts substantially more than 7 percent of GDP could be required.

### VAT implementation: design, challenges, and budgetary safeguards
- VAT introduction timing: VAT at end-2005.
- Registration threshold: KM50,000 (US$30,000); threshold covers about 90 percent of sales tax receipts; estimated ~4000 companies to register.
- VAT base: includes customs duties, excises, other import charges, indirect supplier costs, connection/installation charges.
- Returns and refunds:
  - VAT returns due by 10th day of month following accounting period; payment due by filing deadline; refunds within 60 days of submission.
- Administrative challenges:
  - IT development slow; software testing not started;
  - staffing/recruitment for VAT administration lagging;
  - taxpayer education and Regional Tax Centres preparation insufficient;
  - implementing regulations remain to be defined.
- Revenue allocation issue:
  - VAT does not record tax origin at sub-entity level, complicating allocation to Cantons/Municipalities; options include uniform minimum municipal share of new personal income tax plus entity-level equalizing grants.
- Distributional impact and compensation:
  - FAD TA: average increase KM 300 (2.4 percent of consumption spending) per household per annum;
  - absolute burden rises more on richer households; as a share of consumption, impact is regressive (2.6 percent for lowest deciles; 1.9 percent for highest deciles);
  - recommendation: Entity-level social welfare program to compensate poor; centralization of such programs favored.
- Budgetary recommendations given uncertainty:
  - establish a spending reserve ("delayed spending list") in 2005 budgets at State and Entity central government levels; reserve to be authorized only after observing collections for up to six months in 2006;
  - if VAT revenues prove a confirmed windfall, use permanent windfall to reduce labor taxes (current labor tax indicators cited: 52 percent of net wage in RS; 69 percent of net wage in Federation).

### Cantonal and municipal borrowing, arrears, and control frameworks
- Problems:
  - weak control over consolidated cantonal and municipal fiscal balances; arrears, ad hoc borrowing embargoes, and unrestricted use of privatization receipts undermine predictability.
  - Sarajevo Canton planned 2005 deficit KM 55 million (0.4 percent of GDP).
- Objectives for reform:
  - secure central control consistent with fiscal sustainability; allow prudent local borrowing; prevent arrears accumulation; regulate privatization receipts use.
- Recommended approach: rules-based borrowing limit (debt service ceiling) rather than sole market discipline, cooperative approach, or direct central control.
  - Draft test: ceiling on allowed future annual debt service = 10 percent of previous year's current revenue.
- Transitional risks and phase-in:
  - If all local governments immediately borrowed to 10 percent ceiling in 2005, potential borrowing volume ≈ 3.6 percent of GDP (based on projected 2005 current revenue of KM 1,714 million = 12½ percent of GDP).
  - Table 2 highlights 2005 projected current revenue: Cantons KM 1,295.2; Municipalities KM 472.5; Total KM 1,767.7.
  - Phase-in options: illustrative five-year schedule 2%-4%-6%-8%-10% or alternative phased/automatic schedules; Cantonal/Municipal Credit Board (CMCB) proposed to manage exceptions.
- Calibration: 10 percent debt service limit, if fully used, consistent with stable consolidated cantonal and municipal deficit ~0.3-0.4 percent of GDP.
- Recommendations:
  - enforce transparency, bankruptcy liability for sub-national governments, advance warning or prior approval for privatization receipt use, and stronger reporting and monitoring.

### Fiscal policymaking institutions and National Fiscal Council (NFC) proposal
- Problems:
  - fragmented Dayton fiscal structure with no institution charged with consolidated fiscal balance determination, implementation, or monitoring.
  - OHR coordinating role receding; domestic institutions must assume responsibilities.
- NFC central proposal:
  - build on Indirect Tax Authority (ITA) notion of "pooled sovereignty";
  - NFC functions: coordinate budget calendars, break fiscal deadlocks, control cantonal/municipal balances, strengthen macro analysis and statistics;
  - propose legal basis with binding calendar, joint sign-offs, data publication obligations, and deadlock-breaker (e.g., last year's numbers apply if no agreement by deadline).
- Institutional architecture:
  - Mutual surveillance among three Ministries of Finance; Joint Finance Committee (JFC) representing State and Entity parliaments for oversight;
  - MAU (macroeconomic analysis unit) role expansion; strengthen CBBH analytical capacity.
- Implementation path:
  - phased "learning by doing"; urgent steps include amending ITS law to require ITA board and State parliament endorsement for indirect tax policy changes and prior approval by Entity ministers for State drawings from single account; new laws for Cantons/Municipalities and bankruptcy liability for sub-entity tiers.
- Safeguards and amendment constraints:
  - NFC law could require NFC consent for amendments to borrowing rules, privatization receipts use, bankruptcy arrangements, budget calendars, data publication obligations, and tax/expenditure assignments; NFC assent and State Parliament approval could be required for changes.
- Administrative needs:
  - NFC requires administrative support (option: grow out of MAU, cooperative structure among three Ministries, or mixed approach); strengthen Ministries’ administrations.

### Synthesis of short- to medium-term outlook and policy priorities
- Short- to medium-term outlook:
  - strengthened confidence in KM and banking provides policy space;
  - BiH remains an outlier on credit growth and external deficits—downside risks elevated.
- Policy priorities:
  - address large external current account deficit and credit boom dynamics without undue delay;
  - improve measurement of GDP and external flows (particularly merchandise imports) to reduce uncertainty around headline ratios;
  - design corporate-sector revival measures informed by lessons from past initiatives and ongoing diagnostics with the World Bank;
  - secure fiscal sustainability in light of court rulings on domestic claims: ascertain acceptable NPV of claims, strengthen primary surplus through spending cuts and revenue measures, and protect cash flow from court execution risks;
  - implement VAT with careful administrative preparations and budgetary safeguards (spending reserve), and consider use of confirmed permanent VAT windfall to lower labor taxes;
  - strengthen fiscal architecture (NFC, JFC, integrated budget timetable, mutual surveillance, debt rules for sub-national governments) and statistical/analytical capacity.
- Institutional note: the currency board remains a central feature of the macro environment.

*INTERNATIONAL MONETARY FUND. BOSNIA AND HERZEGOVINA — Selected Economic Issues. Prepared by Peter Doyle, Daniel Kanda, John Norregaard, Graham Slack, Iva Petrova, Nombulelo Wandwasi, and Joerg Zeuner. Approved by European Department. May 11, 2005.*

### 2005. The views expressed in this document are those of the staff team and do not necessarily reflect

### Selected Economic Issues — Bosnia and Herzegovina

### Introduction and overview
- Since 1995, Bosnia and Herzegovina (BiH) has "come a long way." Output, exports, and incomes are much increased; inflation has stabilized; budgets are now close to balance; and "the currency board has become an established part of the environment."
- Nevertheless, headline macroeconomic indicators remain concerning:
  - external current account deficit "well over 15 percent of GDP";
  - unemployment "at over 20 percent";
  - government spending "at half of GDP";
  - government domestic indebtedness "at well above levels anticipated in the 2004 domestic claims settlement laws" (following recent court rulings);
  - output still well below pre-war levels;
  - IBRD assesses poverty "at over 30 percent."
- The paper addresses two sets of issues:
  - Chapters 2–6: whether the bleak impression from headline indicators is correct.
  - Chapters 7–10: implications for policies and policy-making frameworks going forward.

### Market indicators of confidence in the KM and the banking system (summary of Chapter 2)
- Key finding: "with confidence in both strengthening," private-sector behavior toward banks and the currency does not reflect the worst implications of headline macro data.
- Evidence since 2000 suggests:
  - much increased confidence, with increased use of local currency and financial deepening;
  - caveats: foreign currencies remain significant in bank deposits; banks continue to insist that loans longer than a year are indexed to foreign currencies; bank intermediation is still well below comparator countries.
- Implication: signs of strengthening confidence give some reassurance but do not fully offset structural and contagion risks associated with external imbalances and credit growth.

### International experience with credit booms and large current account deficits (summary of Chapter 3)
- BiH is described as "an international outlier" on two dimensions:
  - a credit boom; and
  - a large external current account deficit.
- International evidence indicates such patterns have often been associated with instability, but the evidence is nuanced:
  - credit booms have not always led to instability;
  - large external imbalances have not always precipitated crises.
- Combined with Chapter 2 evidence of maintained private confidence, the assessment is:
  - BiH "has time to address" the credit and external deficit issues;
  - but it "should not delay unduly."

### The corporate sector and domestic savings (summary of Chapter 4)
- The external deficit appears associated with "an unusually low level of domestic—notably corporate—savings."
- Chapter 4:
  - presents company-level evidence supporting weak corporate savings and investment performance;
  - reviews "how the corporate sector got to be this way";
  - reviews a "rich set of largely failed initiatives" since 1995 aimed at corporate revitalization and derives principles for future initiatives.
- More concrete proposals are deferred pending completion of concurrent work by the authorities and the World Bank.

### Non-observed activity and GDP measurement (summary of Chapter 5)
- BiH is "unusual in not making any adjustments for the unrecorded economy in its official published data."
- Staff analysis using international correlations suggests:
  - BiH’s GDP is underestimated, "likely up to 50 percent."
- However, policy implications are cautious:
  - all economies have some unrecorded activity even after statistical adjustments;
  - the fact that GDP may be underestimated does not automatically imply that headline ratios exaggerate problems.
- Two conditional points emphasized:
  - if unrecorded activity in BiH is proportionately more pronounced than elsewhere, headline ratios may be overstated;
  - measurement error in key magnitudes (for example, merchandise imports) affects the external deficit.
- Numerical illustration:
  - the staff estimate of the external deficit used throughout the papers is 17 percent of GDP (implicit in text);
  - if the Central Bank estimate of the deficit (which adjusts for unrecorded merchandise imports) is used, and GDP is inflated by 50 percent for unrecorded activity, "the deficit in 2004 is 16 percent of GDP," close to the staff estimate of 17 percent of GDP.

### Synthesis and policy implications (drawn from Chapters 2–5 and the overview)
- Short- to medium-term outlook:
  - Strengthened confidence in the KM and the banking system provides valuable policy space.
  - However, being an outlier internationally on credit growth and external deficits keeps downside risks elevated.
- Policy priorities signaled in the overview:
  - Address the large external current account deficit and the credit boom dynamics without undue delay;
  - Improve measurement of GDP and external flows (particularly merchandise imports) to reduce uncertainty around headline ratios;
  - Design corporate-sector revival measures informed by lessons from past initiatives and pending diagnostic work with the World Bank.
- Institutional note: the currency board remains a central feature of the macroeconomic environment.

*INTERNATIONAL MONETARY FUND. BOSNIA AND HERZEGOVINA — Selected Economic Issues. Prepared by Peter Doyle, Daniel Kanda, John Norregaard, Graham Slack, Iva Petrova, Nombulelo Wandwasi, and Joerg Zeuner. Approved by European Department. May 11, 2005.*

### 8.      Chapter 6 assesses the implications of the court rejection of the 2004 domestic

### Chapter 6 assesses the implications of the court rejection of the 2004 domestic claims restructuring laws

### Implications of the constitutional court rulings for public debt and fiscal policy
- Court rulings imply a much larger NPV of public debt than anticipated in the 2004 laws.
- This increases by a significant margin the primary fiscal balance associated with sustainability.
- Immediate policy implication: need to rein in primary spending sharply to secure a strong fiscal stance and support efforts to rein in the external deficit.
- Sharp reductions in primary spending may be needed within the overall fiscal envelope to provide room for interest payments on domestic debts.
- Tension noted between this fiscal priority and international-community–sponsored initiatives that will raise public spending; a balance between these imperatives must be found.

### Revenue-side responses and VAT
- External deficits and the domestic claims rulings call for strong fiscal policies and securing the tax base.
- Plans to introduce the VAT are key, including as a measure to help render the grey economy white.
- Implementation is unusually challenging in Bosnia and Herzegovina; key steps already taken and further steps lie ahead.
- Implementation risks remain significant; for 2006 there is no scope to anticipate a major revenue windfall.
- VAT implementation timing noted: VAT at end-2005.

### Spending-side issues: state building and fiscal costs
- “State building” initiatives aim to increase the role of the State, partly to pursue EU accession ambitions.
- Past implementation is criticized as proceeding slowly and at too high a fiscal cost.
- Major steps forward are imminent, including shifting security functions to State level.
- Given the need to find economies in primary spending (due to court rulings), past inadequacies in state building could exact a high macroeconomic price unless corrected promptly.
- Suggested remedies:
  - Prioritization among state building objectives.
  - Clear link between state-level steps and corresponding contractions in spending at other government levels.
  - Strengthening the “fiscal architecture” (rules governing budget preparation, etc.) to help ensure objectives are realized.

### Cantonal and municipal borrowing and budget balance control
- Past ad hoc embargoes on cantonal and municipal borrowing helped secure fiscal consolidation.
- These arrangements may be excessively restrictive, preventing strong and creditworthy cantons and municipalities from borrowing for local infrastructure.
- Proposal: strengthen the current ad hoc framework to allow greater flexibility for stronger Cantons and municipalities, drawing on international experience.
- Any new framework should:
  - Secure effective monitoring and control of the aggregate fiscal impact during transition and after completion.
  - Be implemented in close coordination with reductions in primary spending at other government levels to prevent deterioration of the consolidated fiscal balance.

### Fiscal policymaking institutions and the National Fiscal Council proposal
- Multiple fiscal challenges ahead:
  - to maintain a strong consolidated balance,
  - to secure a sizeable strengthening in the primary surplus and increases in public investment,
  - to provide a “social plan” for large numbers of workers to be dismissed from bankrupt firms,
  - to meet ongoing calls for increased pensions,
  - to engineer multiple shifts in functions between tiers of government and an expansion of State-level competencies in accord with EU-accession requirements,
  - to implement a host of tax reforms, starting with VAT at end-2005, and combat tax evasion.
- OHR’s coordinating role is receding sharply; strong fiscal policymaking institutions are essential.
- The Dayton-derived fiscal structure is fragmented and weak; no institution is charged to determine, implement, or monitor the consolidated fiscal balance.
- No consensus on broader constitutional change exists; progress must be made within the current framework.
- Chapter 10 proposes a comprehensive approach to strengthen fiscal coordination:
  - Build on the Indirect Tax Authority’s notion of “pooled sovereignty.”
  - Initiatives include coordination of budget calendars, devices to break fiscal negotiation deadlocks, controls on cantonal and municipal balances, strengthening macro analysis and statistics.
  - Central proposal: establish a National Fiscal Council charged with fiscal coordination, to be developed through “learning by doing.”

### Market indicators of confidence in the KM and the banking system (since 2000)
- Summary observation: currency board nearly 8 years old; international reserves stand at 6 months of merchandise imports; after 1998–2002 restructuring, banks are booming—signals of confidence in the KM and banking system, but confidence can shift quickly.
- Currency board and exchange-rate facts:
  - Currency board set up in 1997; KM introduced pegged at KM1= 1 Deutsche Mark.
  - Subsequently pegged at KM 1.9558=Euro 1 upon abolition of the DM.
- International reserves and net free reserves at end-2004:
  - Euro 1,768 million (gross international reserves).
  - Euro 88 million (net free reserves).
- Banking sector consolidation and privatization (1998 to end-2004):
  - Number of banks declined from 72 (55 in the Federation and 17 in the Republika Srpska (RS)) in 1998 to 33 (24 in the Federation and 9 in the RS) at end-2004.
  - Of the banks existing at end-2004, five were under provisional administration—four in the Federation and one in the RS.
  - By end-December 2004, 21 banks were members of the deposit insurance scheme.
- Evidence on confidence in the KM:
  - KM currency in circulation doubled between October 2001- December 2001 (reverse currency substitution).
  - Subsequent small decline in currency in circulation attributed to increased use of the banking system and financial deepening; KM deposits increased faster than foreign currency deposits until late 2004.
  - Banks’ KM-denominated lending: bulk (over 50 percent) of KM borrowing indexed to the Euro.
  - Anecdotal evidence: some merchants beginning to be less willing to accept Euro notes and coin for small transactions.
- Interest rate spreads and confidence:
  - Spread between Euro and KM interest rates used as a proxy (interpreted with caution); spread is still around 2 percentage points, but it has fallen by ¾ percentage point since January 2003.
  - Spread between Bosnian central rates and 3-month EURIBOR also declined through 2004 and early 2005, after being stable since mid-2002.
- Banks’ behavior and credit boom:
  - Banks often require KM loans indexed to foreign currencies; higher share of indexed loans at longer maturities.
  - Credit to the private sector increased by over 20 percentage points of GDP in the past three years (surge since 2002), reflecting a significant credit boom and competition for market share.
- Regulatory tightening and its effects (mid-2003 onward):
  - Forex exposure limits phased in: from about 120 percent of capital in mid-2003 to 30 percent of capital by mid-2004.
  - Forex exposure regulations amended from mid-2003 to include KM assets and liabilities indexed to foreign currencies.
  - Prudential liquidity regulations required liabilities of maturity up to 90 days to be matched 100 percent by assets of similar maturity, with compliance deadlines up to June 2004 (some allowed to comply by September 2004).
  - Banks increased borrowing from abroad (largely from parents), converting borrowed funds into short term KM deposits held with the CBBH to meet forex exposure and liquidity rules; this raised banks’ reserves at the central bank and increased international reserves and reserve money from mid-2003 to mid-2004.
- Evidence that increased reserves reflected regulatory compliance rather than KM confidence:
  - Banks exploited month-end application of new rules by borrowing in foreign currencies at month end and reversing transactions a few days later, causing intra-month swings in bank and international reserves from January 2004; swings reached as much as KM 400 million from peak to trough by mid-2004.
  - These within-month swings declined after banks were informed of forthcoming daily forex exposure reporting and were virtually eliminated after daily reporting was implemented in October 2004.
  - Remuneration changes: starting June 2003 all bank reserves with the CBBH were remunerated at market rates up to December 2003; thereafter remuneration of excess reserves was cut from the market rate (2 percent at the time) to a fixed one percent (the ECB deposit rate at the time). Despite the cut, excess and total reserves continued to grow through most of 2004 month-end to month-end.
  - Required reserve base was widened in June 2003 to include foreign currency liabilities (more than doubling the base) while required reserve rate was reduced from 10 percent to 5 percent; net effect modestly raised required reserves, but required reserves remained well below actual reserves throughout.

*Source: Selected Economic Issues chapter text provided in the Content unit.*

### 17.      This combined evidence suggests that confidence in the KM has increased

### 17.      This combined evidence suggests that confidence in the KM has increased

### D. Confidence in the Banking System — key findings
- Confidence by the Bosnian public in the banking system has increased since 2000.
- Financial deepening is evident:
  - The share of KM currency in circulation in M1 and broad money has declined as Bosnians use bank deposits for an increasing share of their transactions.
  - The money multiplier remains on the low side (around 2).
  - Cross-country comparison suggests there is still room for more financial deepening.
- Velocity and deposits:
  - The velocity of bank deposits declined significantly in December 2001 and continued to drop thereafter.
  - Strong deposit growth has accompanied a steady decline in currency in circulation.
  - Note: “The true velocity is likely higher than presented in Figure 7, since official estimates of nominal GDP exclude the large non-observed economy.”
- Deposit composition and maturity:
  - Time and savings deposits have grown faster than demand deposits since December 2001.
  - A pickup in time and savings deposits in late 2004 may partly reflect banks’ efforts to meet prudential regulations on maturity matching.
  - Enforcement of these regulations appears to have caused an increase in spreads of time and savings deposit rates over demand deposit rates in 2004.
  - Depositors’ willingness to extend deposit maturity, even at a higher price, signals confidence in the banking system.
- Bank efficiency and interest spreads:
  - Competition has raised bank efficiency and led to a substantial decline in spreads between deposit and lending interest rates.
  - Spreads have declined by over two percentage points since January 2002.
- Stability and bank closures:
  - Despite substantial changes and consolidation there have been no bank runs.
  - Bank closures generally resulted from provisional administration by banking agencies rather than depositor runs.
  - Formal deposit insurance coverage began only in 2001 and has been limited to sound banks.
  - Possible explanations for absence of runs: depositors avoided weak banks, or public belief in an implicit government guarantee (particularly for state-owned banks).

### E. Prospects — signals to monitor and scenarios
- Signals that could indicate further increases in confidence in the KM:
  - If citizens shift from Euro currency in circulation into KM currency in circulation as settlement and store of value, KM currency will rise and this will be reflected in increased international reserves of the CBBH.
  - If banks reduce indexed lending of their own volition, this would signal a change in banks’ perception of exchange rate risk; it would be reflected in:
    - Less foreign currency external borrowing.
    - Less foreign currency deposit-taking.
    - Note: This favorable development could lower CBBH international reserves because banks’ need for KM deposits with the CBBH to meet prudential regulations would drop. The decline in the pace of growth of CBBH reserves in early 2005 could reflect this, but confirmation requires more data on loan indexation in 2005.
  - If an interbank market develops, it would provide an alternative short-term KM asset for banks and reduce reserves with the CBBH; however, given an existing excess of short-term assets, an interbank market is unlikely to develop soon.
  - Interest rate differential effects: With potential ECB rate declines (given European economic weakness and a strong Euro vs US dollar), the CBBH remuneration of excess reserves (one percent) could become more attractive and encourage banks to increase reserves; this would reflect an interest rate differential effect rather than a confidence effect.

### F. Risks, institutional gaps, and indicators to watch
- Main indicators of bank confidence to monitor:
  - Money multiplier.
  - Velocity of bank deposits.
  - Maturity composition of deposits.
  - These indicators have trended positively but have further to go by international standards.
- Indirect risks from the corporate sector:
  - Over 60 percent of state-owned companies are lossmaking and require deep restructuring; many others are only marginally profitable.
  - Banks face the risk of being caught up indirectly in corporate difficulties.
- Weaknesses in credit monitoring and recovery:
  - Framework to monitor borrower quality and recover nonperforming loans needs improvement.
  - Efforts to set up a collateral and pledge registry have not yet borne fruit.
  - Banks have relied on personal guarantors for consumer loans, but many guarantors have guaranteed loans for multiple borrowers and banks cannot satisfactorily track contingent liabilities.
  - The court system is not yet in a position to swiftly adjudicate bank suits against recalcitrant debtors.

### Concluding remarks — policy implications and recommendations
- Continued efforts are needed to strengthen confidence in the KM and the banking system, particularly because banks’ skepticism remains.
- Policies and reforms to pursue:
  - Early implementation of structural reforms to promote private sector growth and competitiveness, with particular emphasis on corporate restructuring.
  - Continued improvements in the quality of bank supervision and the regulatory environment.
  - Strengthening the analytical capacity of the CBBH.
  - Improvement and implementation of mechanisms to monitor borrower quality and recover nonperforming loans (including a functioning collateral and pledge registry).
  - Judicial capacity improvements to speed enforcement of creditor claims.
  - Supervisors and the central bank should monitor the credit boom closely and be ready to act decisively to maintain financial system stability.
- Important interpretative note: A drop in international reserves will not necessarily signal a loss of confidence—if it reflects changes in bank behavior (e.g., reduced need to hold KM deposits with the CBBH), it could in fact reflect increasing confidence in the KM.

### Contextual macro-financial statistics and trends cited
- Money multiplier: around 2.
- Spreads between deposit and lending rates: declined by over two percentage points since January 2002.
- Deposit insurance coverage began only in 2001.
- CBBH remuneration of excess reserves: one percent.
- Corporate sector: over 60 percent of state-owned companies lossmaking.
- Early-2000s macroimbalances and credit growth (from subsequent section):
  - External current account deficit (staff estimates): about 17 percent of GDP in 2004.
  - External current account deficit (official estimates): closer to 24 percent of GDP in 2004.
  - Current account deficit peaked at almost 22 percent of GDP in 2002 (staff estimates).
  - Bank credit to non-government relative to GDP increased by over 20 percentage points in three years and grew almost 120 percent in that period.
- Indexation: “Indexation remains high, though forex exposure has improved.”

*Source: IMF country report section titled “This combined evidence suggests that confidence in the KM has increased.”*

### 4.      The domestic counterparts to

### _cr05198 - 4.      The domestic counterparts to

### Domestic macroeconomic counterparts
- National savings have fallen from about 8 percent of GDP in 2000 to about 3 percent in 2004.
- The overall deficit of the general government has fallen from about 7 percent of GDP in 2000 to less than 1 percent in 2004.
- Private sector consumption has expanded by more than 10 percent of GDP since 2000.
- Investment spending has stagnated at about 20 percent of GDP for four years.

### Bank-financed consumption and credit dynamics
- Bank credit to non-government, relative to GDP, has increased by over 20 percentage points in 2001–04.
- The ratio of bank credit to households rose by 14 percentage points of GDP since 2001 (mainly for reconstruction and consumption).
- Credit to non-households accounts for most of the remaining one percentage point increase.
- Bank credit to the government sectors has changed only marginally.
- The rapid expansion of credit reflects many factors, including the strong restructuring of the banking sector (see Chapter 2 for details).

### International comparisons — credit booms and banking crises
- Caprio and Klingebiel (2003) report 117 banking crises that occurred in 93 countries since the late 1970s.
- Credit boom definition used: a three-year period during which the private sector credit-to-GDP ratio jumped by a cumulative 10 percentage points or more.
- Sample: private sector credit-to-GDP behavior for 140 countries over corresponding period.
- From the 140-country sample, 74 have had at least one episode of banking difficulties as defined by Caprio and Klingebiel (2003).
  - Of these 74, 22 countries experienced growth of private sector credit-to-GDP by more than 10 percentage points for three years preceding these events.
  - These 22 countries account for almost 40 percent of the credit booms, indicating a high frequency of banking instability in countries with credit booms.
- For the period 1990–2003:
  - Countries with private credit-to-GDP ratios of more than 25 percent account for about half of the sample of 140 countries but 75 percent of the 22 countries with both rapid credit growth and banking crisis.
  - The other half of the sample with private sector-to-GDP ratios of less than 25 percent account for only one quarter of the crisis countries.
- Transition countries: many experienced banking instability in the early-1990s before credit expanded; since then credit has boomed and three episodes of banking sector difficulties followed credit booms (Poland 1993, Bulgaria 1996, Slovak Republic 1997).
- The likelihood for banking difficulties to follow a lending boom is estimated to be as high as 20 percent, depending on dataset and methodology.

### Currency boards and Bosnia and Herzegovina’s outlier status
- Bosnia and Herzegovina’s credit growth is an outlier even among currency boards.
  - Among active currency board countries, only Bulgaria had rapid credit growth alongside an external deficit before introducing its currency board.
  - Hong Kong experienced rapid credit growth from 1993–97 but alongside current account surpluses.
  - Non-active currency boards (Argentina 1991–2001, Ireland until 1979, Malaysia 1967–73) had credit growth below the chapter’s threshold; Singapore (1967–73) exceeded the threshold in the two years before abandoning its currency board.
- Banks in Bosnia and Herzegovina have not typically funded domestic-currency lending with foreign-currency borrowing (see Chapter 2 for details), a route observed elsewhere in fixed exchange rate environments.

### External deficits and associated risks
- From a WEO sample of 180 countries, Nicaragua is alone in reporting a similar external deficit in 2003 and 2004 to Bosnia and Herzegovina.
- Except for Bosnia and Herzegovina, Jordan, and Lebanon, countries reporting annual current account deficits of more than 15 percent of GDP for at least 3 consecutive years since the mid-1980s are low-income (PRGF-eligible) countries with structural balance of payments deficits.
- Among active currency board countries, few other countries have exceeded the 15-percent of GDP current account deficit mark since 1990; small island economies in the East Caribbean Currency Union have sometimes exceeded 20 percent of GDP.
- Inactive currency boards generally did not exhibit high current account deficits during board years (examples cited in source).

### Other indicators of potential instability
- External imbalances are only one indicator of potential currency instability. Other indicators include:
  - poor export performance
  - financial sector instability
  - low or falling international reserves
  - rapid money and/or credit growth
  - low real GDP growth
  - domestic inflation
  - fiscal deficits
- Bosnia and Herzegovina scores well on some indicators: international reserves, inflation, the fiscal balance, and strong banks (see Chapter 2).
- Concerns remain on other fronts: the fiscal balance is structurally weak with significant risks attached, GDP growth has slowed since the early 2000s, and bank credit is booming (see Chapters 6 and 10).

### Conclusion and policy implication
- Bosnia and Herzegovina’s credit boom and external deficit are remarkable and render the country an outlier in international experience, though not completely unique.
- Countries elsewhere exhibiting similar characteristics have disproportionately, but not always, experienced subsequent periods of instability.
- Given the mix of indicators and the probability of instability associated with sustained credit booms, there appear to be sound grounds to:
  - moderate credit growth, and
  - lower the external imbalance in Bosnia and Herzegovina
  so as to underwrite the stability gained so far (see Chapter 5).

*Prepared by Joerg Zeuner. Sources: Authorities and Fund staff estimates.*

### 5.      These data are of uncertain quality. Balance sheets and income statements are not

### _cr05198 - 5.      These data are of uncertain quality. Balance sheets and income statements are not

### Data quality and scope
- Balance sheets and income statements are not subject to independent auditing; compliance with local audit requirements is weak, and most companies do not make their audited statements publicly available.
- The application of accounting rules varies across companies and there is liberal use of off-balance sheet accounts.
- The notable exception is the financial industry.
- Prepared by Graham Slack. This section builds on and extends work undertaken by Mr. Bob Etherington and colleagues at the World Bank.

### Corporate profitability (findings)
- The corporate sector is dominated by loss making and marginally profitable enterprises.
- Average gross profit margin (before tax): negative in RS and at breakeven in the Federation (Text Table 1).
- SoEs are considerably less profitable than private enterprises—70 percent of SoEs and 25 of percent of private enterprises are loss making.
- Only one in five private enterprises and one in twenty SoEs report profit margins above 5 percent.
- Profits may be incompletely recorded.

- Text Table 1: Profitability, 2002 (Profits/sales; % of firms)
  - BiH: -1; 28 (Loss making)
  - BiH SoEs: -13; 71
  - BiH Private enterprises: 1; 25
  - Federation: 1; 14
  - Federation SoEs: -7; 55
  - Federation Private enterprises: 2; 12
  - RS: -5; 45
  - RS SoEs: -25; 80
  - RS VPEs: -1; 40
  - RS Other private ent.: 0; 44

### Profit trends and employment/wage dynamics
- Profits have not increased in recent years despite increases in industrial production.
- Increased output was matched by wage and employment growth (Text Table 2).
- Profits declined by 10 percent in the Federation between 2002 and 2004.
- RS enterprises: profits increased somewhat in 2003 (helped by appreciation of the Serbian Dinar) and stagnated in 2004.

- Text Table 2: Unit Labor Cost Components 2002=100 (Manufacturing)
  - Federation (2002, 2003, 2004)
    - Production: 100; 102; 120
    - Wages: 100; 113; 114
    - Employment: 100; 100; 117
    - Prices/ ULCs: 100; 90; 90
  - RS (2002, 2003, 2004)
    - Production: 100; 99; 113
    - Wages: 100; 111; 129
    - Employment: 100; 86; 84
    - Prices/ ULCs: 100; 105; 106

### Costs, labor shedding simulations, and non-labor costs
- Reduced labor costs are not sufficient to restore profitability.
- In SoEs labor costs as a share of revenues are typically four times higher than in private enterprises.
- Shedding up to half the labor force, and assuming no consequential loss of output, would leave 40 percent of SoEs continuing to generate losses (Text Table 3).
- High non-labor related costs likely stem from:
  - outdated plant and machinery,
  - poor management,
  - weak corporate governance,
  - low sales volume,
  - corruption,
  - administrative and transportation costs from reliance on imported raw materials.

- Text Table 3: Federation: Profitability after Labor Shedding, 2002 (% reduction in labor costs)
  - % reduction in labor costs: 0, -10, -20, -30, -40, -50
  - SoE Profit/sales:
    - <0%: 55; 50; 48; 48; 41; 39
    - 0-2%: 34; 20; 11; 7; 9; 7
    - 2-5%: 5; 20; 9; 16; 11; 7
  - Private enterprises Profit/sales:
    - <0%: 12; 10; 9; 8; 7; 7
    - 0-2%: 54; 48; 42; 38; 34; 30
    - 2-5%: 182326282830

### Sales revenue to assets (organization of production)
- Low sales revenue to assets suggests inadequate organization of production.
- SoEs generate considerably less revenue from their assets than private enterprises across industries.
- It is uncertain if assets are realistically valued in company books.

- Text Table 4: Sales Revenue/Assets, 2002 (Sales revenue /assets; % of firms with sales/assets in bands 0-0.5, 0.5-1.0, 1.0-3.0, >3.0)
  - BiH overall: 0.66; 33; 16; 33; 17
  - BiH SoEs: 0.24; 81; 12; 7; 0
  - BiH Private enterprises: 0.89; 30; 17; 35; 19
  - Federation overall: 0.88; 10; 17; 44; 29
  - Federation SoEs: 0.28; 68; 18; 14; 0
  - Federation Traded goods sector SoEs: 0.26; 74; 21; 6; 0
  - Federation Private enterprises: 1.25; 7; 17; 46; 30
  - Federation Traded goods sector Private enterprises: 0.63; 18; 31; 40; 11
  - RS overall: 0.38; 60; 17; 19; 4
  - RS SoEs: 0.18; 87; 9; 4; 0
  - RS VPEs: 0.47; 55; 18; 22; 5
  - RS Other private ent.: 0.45; 65; 16; 17; 2

- Text Table 5: Sales Revenue/Assets, 2002 (by Sectors) — SoEs vs Private enterprises
  - Agriculture: 0.55; 0.23
  - Mining: 0.36; 0.28
  - Manufacturing: 0.23; 0.75
  - Construction: 0.32; 0.96
  - Wholesale/retail trade: 0.29; 2.35
  - Transport and communication: 0.58; 1.40

### Liquidity and solvency (findings)
- A large proportion of enterprises are illiquid.
- Half of the SoEs and 40 percent of private enterprises are unable to repay current (less than 1 year) liabilities from current assets (Text Table 6).
- The vast majority of companies are unable to repay current liabilities from current income even over a 10 year horizon, implying liquidation of fixed assets, securing outside financing, or accumulating arrears—thereby reducing solvency.

- Text Table 6: Liquidity, 2002 (Current assets/current liabs; % of firms current assets/current liabs <1)
  - BiH overall: 1.09; 42
  - BiH SoEs: 1.08; 53
  - BiH Private enterprises: 1.09; 41
  - Federation overall: 1.26; 31
  - Federation SoEs: 1.32; 43
  - Federation Private enterprises: 1.24; 31
  - RS overall: 0.86; 53
    - Exc. tax and labor debt: 1.05; 41
  - RS SoEs: 0.81; 58
    - Exc. tax and labor debt: 1.05; 46
  - RS VPEs: 0.85; 54
    - Exc. tax and labor debt: 1.03; 41
  - RS Other private ent.: 1.00; 50
    - Exc. tax and labor debt: 1.19; 35

- Text Table 7: Debt Structure, 2002 (in Percent) — composition of LT and ST liabilities for SoE, VPEs, Other (columns include o/w loss making)
  - LT liabilities: SoE 25 (o/w loss making 26); VPEs 16; Other 21 (o/w loss making 16); Loans 23; Loans o/w loss making 24; Other 2 (o/w loss making 2)
  - ST liabilities: SoE 75 (o/w loss making 74); VPEs 84; Other 79 (o/w loss making 84); Affiliate loans 1 (o/w loss making 0); Affiliates other 1 (o/w loss making 2); Loans 7 (o/w loss making 7) / 12 (o/w loss making 10) / 10 (o/w loss making 12) respectively; Advance payments 3 (o/w loss making 3) / 12 (o/w loss making 7) / 9 (o/w loss making 3); Suppliers 39 (o/w loss making 36) / 38 (o/w loss making 29) / 32 (o/w loss making 28); Wage arrears 6 (o/w loss making 7) / 5 (o/w loss making 9) / 5 (o/w loss making 11); Tax and contribution arrears 11 (o/w loss making 10) / 9 (o/w loss making 14) / 8 (o/w loss making 15); Other 6 (o/w loss making 6)

- Over one third of enterprise debts are owed to suppliers; a further quarter are loans. Wage arrears reportedly account for only 5 percent of total enterprise debts, and tax and contribution arrears a further 10 percent.
- Loss making SoEs have accumulated proportionately more arrears to suppliers than loss making private enterprises; loss making private enterprises have accumulated proportionately more wage and tax arrears than loss-making SoEs.
- Uncertainty remains whether total labor debts are correctly recorded due to accrual rules for “fictitious” workers.

- Clearance of tax and labor debts would return only 15 percent of companies to a position of being able to pay current liabilities from current assets, leaving some 40 percent of enterprises illiquid and effectively insolvent.

### Historical and structural causes
- Initial conditions in 1995 were unfavorable: civil war disruptions left plant and machinery outdated or destroyed; large-scale emigration and internal displacement caused loss of know-how; vertically integrated enterprises lost traditional local markets and access to Former Yugoslav Republics markets.
- At end-2004 manufacturing output had recovered less than half of its pre-war contribution to GDP.

- Policy choices that aggravated difficulties:
  - SoEs were treated as a social safety net—pressured into hiring veterans, inflating payrolls and benefiting from generous wage and benefit packages beyond SoEs’ ability to pay.
  - Labor regulations required clearance of unpaid wage and contribution arrears prior to dismissal, effectively preventing shedding of labor.
  - Voucher privatization failed to transform SoEs into profit seeking enterprises.
  - Government mandates lasted only 2 years, reducing political will to tackle reforms.
  - Bankruptcies were rare prior to 2003: procedures were protracted and ineffective in the Federation and non-existent in the RS, leading to interenterprise arrears, barter systems, and bilateral creditor-enterprise negotiations.
  - Unconditional debt write-offs and reschedulings in the RS prolonged life expectancy of unprofitable enterprises and reduced profitability of others.
- Price stability under the currency board meant enterprises’ real debt burden was not significantly reduced.

### Why revitalization has proved difficult (institutional and incentive constraints)
- Profit seeking for shareholders is not a core motive for many enterprises; incentives do not prioritize maximizing shareholder returns or full payment of wages and contribution obligations.
- Hard budget constraints are not enforced because creditors (including workers) are reluctant to file bankruptcy proceedings.
- Voucher-privatized enterprises are not under effective control of private shareholders.
- Enterprise managers and workers often expect government fixes, sheltering from foreign competition, or boosts to aggregate demand rather than internal restructuring.
- Labor legislation impedes adjustment:
  - Tripartite collective bargaining sets contracted wage rates above firms’ ability to pay; contracted wage rates at least 20 percent higher than paid wage rates have led to unpaid wage, pension, health, and unemployment benefit contributions.
  - Requiring clearance of all wage, benefit, and contribution arrears before a worker can be released prevents shedding of “excess” and “fictitious” workers.
  - Wage and benefit rates are inflexible downward due to fixed coefficient systems and, in the Federation, indexation of the minimum price of labor to the average price of labor.
- Business environment discourages firm entry:
  - EBRD Transition Report 2004 places Bosnia and Herzegovina among the lowest-performing five out of 27 transition countries in small and large scale privatization.
  - It costs 46 percent of per capita income to start a business in Bosnia and Herzegovina (regional average cited as 16 percent).
  - Bosnia and Herzegovina has one of the highest tax burdens in the region.
  - Corruption levels are ranked among the top five obstacles to doing business.
  - Political considerations affect foreign investor participation in tenders for SoEs.
  - High world steel and aluminum prices have increased attractiveness of mining and steel industries to foreign investors.
- Bankruptcy procedures introduced in 2003 are new and largely untested:
  - Legal administration to enforce 2003 bankruptcy laws is being developed with USAID assistance; initial indications are that bankruptcy cases move through courts without major delay up to point of asset sale.
  - Sale of assets impeded by poor land registry records.
  - Potential large volume of bankruptcy cases may overwhelm limited capacity of courts and trustees.

### Social and political challenges of corporate restructuring
- Revitalization will often initially result in job losses, sometimes in single-company towns.
- Limited resources are available to ameliorate social effects.
- A balance is needed between addressing wage arrears and gaps in pension contributions for workers, and maintaining fiscal solvency.

*Source: Bosnian authorities and staff estimates (compiled in the IMF staff report section).*

### 21.      Faced with these realities, corporate restructuring has been neglected by the

### _cr05198 - 21.      Faced with these realities, corporate restructuring has been neglected by the

### Lessons from earlier revitalization initiatives — voucher privatization
- Voucher privatization (2000–2001) transferred ownership of about 1000 enterprises in the Federation and 600 enterprises in the RS, covering around a quarter of SOE assets.
- Vouchers equivalent to some KM 15 billion (150 percent of 2000 GDP) were issued.
- Most voucher holders exchanged vouchers for shares in Privatization Investment Funds (PIFs) which pooled holdings in Voucher Privatized Enterprises (VPEs).
- Key strategic enterprises (56 in the RS and 72 in the Federation) were excluded from the voucher scheme.
- PIF institutional design problems:
  - PIFs received a fixed management fee based on the book value of company assets and were limited by regulation to 30 percent of VPE capital.
  - PIF incentives did not encourage demanding profitability improvements or forcing management change.
  - Governments retained effective control over many VPEs via direct shareholdings and holdings by pension and restitution funds.
- Finding: Private ownership must secure control by a competent and financed owner with effective control over the enterprise and the ability to remove management.

### Debt rescheduling — experience and effects
- Following voucher privatization, some 500 VPEs in RS were granted rescheduling of liabilities (as of end-2001) owed to the RS government totaling some KM 430 million (14% of 2001 RS GDP).
- Rescheduling design flaws:
  - After a 2 year grace period on tax and contribution arrears, only 20 percent of participating VPEs began repaying rescheduled liabilities.
  - Authorities failed to file bankruptcy proceedings against VPEs that did not pay current tax and contribution obligations (as required), undermining incentives to restructure.
  - When the grace period expired in mid-2004, 80 percent of participating VPEs did not make payments on their rescheduled liabilities; bank accounts were initially blocked and later unblocked pending review and possible additional rescheduling.
- Lesson: Without a tight link between debt write-offs/rescheduling and restructuring (including credible bankruptcy), rescheduling delays structural adjustment and encourages expectations of future reschedulings.

### Strategic privatization and tender processes
- Out of 108 strategic companies, only 18 had been sold by end-2003 (mostly from the Federation).
- Constraints:
  - Privatization agencies often lacked effective control over SoE assets.
  - Tender processes were subject to interference from line ministries; failed tenders frequently reverted to one-on-one negotiations.
  - Federation privatization was fragmented: cantons privatize companies in their jurisdiction while central government handles companies spanning cantons.
- Lesson: Privatization must be transparent, time bound, free from political interference, and under the effective control of a single agency in each entity.

### Sale to private owners — outcomes and constraints
- Managers of recently restructured large companies reported rapid expected gains:
  - Exports of surveyed firms relative to 2003 BiH outturns (percent): 2003: 13; 2004: 26; 2005: 39; 2006: 106; 2007: 139.
  - Imports (percent): 2003: 4; 2004: 6; 2005: 9; 2006: 22; 2007: 29.
  - Nominal GDP (percent): 2003: 0.9; 2004: 1.5; 2005: 2.3; 2006: 4.0; 2007: 4.8.
- Evidence: With effective management and fresh capital, enterprises can be turned around relatively quickly; industrial output increased strongly in both entities in 2004.
- Constraints to sustained expansion:
  - Aging workforce and lack of skilled engineers and mid-level managers.
  - Restrictive labor legislation.
  - Infrastructure and supply issues: lack of rail capacity, unreliable electricity supply.
  - Government bureaucracy causing delays (e.g., import document signings) that can lead firms to consider relocation.

### Conclusions and core policy elements
- Situation:
  - An estimated 60 percent of enterprises in Bosnia and Herzegovina have debts they cannot repay.
  - Bosnian enterprises started poorly after the war and subsequent policy neglect worsened outcomes.
- Quick fixes are unlikely to rejuvenate the corporate sector; indiscriminate write-offs of tax arrears will not suffice.
- Core elements of a remedy (drawn from BiH experience):
  - Debt write-offs and reschedulings must be made conditional on restructuring and management change.
  - Shareholders must have effective control over the enterprise, including the ability to remove management.
  - Governments must demonstrate commitment to bankruptcy proceedings to establish a credible threat to enterprises that do not restructure; this includes addressing capacity and administrative constraints in bankruptcy procedures.
  - The process of privatization must be free from political interference, transparent, and strictly timebound.
  - The social aspects of corporate restructuring need to be addressed in the context of limited fiscal resources.
  - Labor legislation must be reformed to prevent future accumulation of wage and contribution arrears and to alleviate frictional unemployment during corporate restructuring.
- Political economy: Implementation requires substantial administrative, social, and political effort; emerging consensus exists on the need for broad-based restructuring but political will to implement decisively is unclear.

### Non-Observed Activity (NOA) — measurement context and BiH estimates
- International context:
  - Average NOA adjustments incorporated in official GDP data for transition economies amount to 21 percent of officially published GDP.
  - Ratios by region: CIS about 26 percent; SEE about 13 percent.
- BiH specifics:
  - BiH makes no adjustment for NOA in official published GDP.
  - IMF Statistical Advisor estimates NOA around 40 percent of unadjusted (official) GDP in 1999–2002 (on a declining trend).
  - This implies NOA is some 28 percent of total activity (officially published GDP plus NOA), placing BiH proportionately close to the CIS group and above other transition and former Yugoslav countries.

*Source: IMF country report content provided in the input.*

### 9.      A more recent study, applying the “direct method” to BiH assessed NOA at

### _cr05198 - 9.      A more recent study, applying the “direct method” to BiH assessed NOA at

### Major findings on non-observed activity (NOA) in Bosnia and Herzegovina (BiH)
- A direct-method study assessed NOA at 58 percent of official GDP in 2001 (Text Figure 1).
- This corresponds to some 40 percent of total activity.
- The decomposition in that study finds only around seven percentage points of GDP of their NOA estimate concerns illegal activities, implying that shortcomings in the statistical system, rather than illegal activity, overwhelmingly account for difficulties in reflecting NOA in official data (Text Figure 1).
- Enterprises underreporting revenue, companies using false registration numbers, and small merchants produce:
  - a third of BiH’s officially published GDP, and
  - more than 40 percent of Republika Srpska’s (RS) officially published GDP.

### Indirect (latent variable) estimates and comparison with direct methods
- Two latent-variable indirect estimates for BiH (1999–2003) put the grey economy at 30–37 percent of officially published GDP, lower than the direct-method estimates for BiH.
- The two indirect estimates differ on trends:
  - Schneider (2005) indicates an increasing trend,
  - Dell’Anno and Piirisild (2004) suggest a slight decrease since 2002.

### Staff “panel regression” approach: method and key variables
- Approach: extend one-variable methods (currency in circulation, electricity consumption) using international panel data to estimate typical correlations between such variables and GDP; insert BiH values to predict an “estimated GDP for BiH”; difference with official GDP yields implicit NOA estimate.
- Steps:
  - Identify variables available for BiH after 1999 (telephone lines, health, macro indicators).
  - Assemble corresponding data for a panel of some 193 countries; calculate bivariate correlations with nominal GDP; discard variables with low correlations.
  - Include remaining variables in a large regression and apply step-down procedure to reach a parsimonious regression (Text Table 3).
- Key result: health care expenditures, exports, and currency in circulation “account for” more than 90 percent of the variation in GDP.

### Pooled regression (1999–2002) — coefficients (Text Table 3)
- Dependent Variable: GDP per capita (in logarithm of US dollar value)
- Currency in circulation per capita (in logarithm of US dollar value): 0.065 (0.033) **
- Exports per capita (in logarithm of US dollar value): 0.272 (0.035) ***
- Health care expenditures per capita (in logarithm of US dollar value): 0.489 (0.045) ***
- Cereal production (in logarithm of kilograms per hectare): 0.070 (0.040) *
- Number of air passengers per capita (in logarithm): 0.031 (0.019)
- Population below 14 years of age (in percent of total population): 0.005 (0.003)
- Rural population (in percent of total population): 0.003 (0.002)
- Debt service of public an publicly guaranteed debt per capita (in logarithm of US dollar value): 0.005 (0.028)
- Constant: 2.712 (0.454) ***
- R-Squared: 0.9574
- Number of Observations: 349
- Number of Countries: 96 (Excluding BiH)
- Note: Standard errors in parenthesis. *** - significant at 1% level, ** - significant at 5 % level, * - significant at 10 % level.

### Staff estimates of NOA (1999–2002) and sensitivity to sample
- Based on the full sample (96 countries), fitting available indicators suggests official GDP estimates in BiH should be increased by 30–33 percent (Text Table 4, Text Figure 3a).
- Reestimating the regression excluding all transition economies and predicting BiH GDP yields a higher implied discrepancy: official GDP in BiH would be expected to be some 45–50 percent higher than reported (Text Table 4, column 2).
- Comparing forecasts with published GDP for all transition countries suggests systematic underreporting (Text Table 4, column 3).
- Results by year and grouping (Text Table 4, In percent of official GDP):
  - Bosnia and Herzegovina (Based on All Countries): 1999: 33, 2000: 30, 2001: 26, 2002: 26, Average: 29
  - Bosnia and Herzegovina (Based on Non-Transition Countries): 1999: 50, 2000: 50, 2001: 41, 2002: 39, Average: 45
  - Transition Economies (Based on Non-Transition Countries): 1999: 30, 2000: 29, 2001: 27, 2002: 23, Average: 28
  - Former Yugoslav Republics (Based on Non-Transition Countries): 1999: 30, 2000: 34, 2001: 29, 2002: 21, Average: 29
- Within transition-economy cluster, BiH’s NOA increased in 1999–2002 relative to peers (Text Figure 3b).
- BiH exhibits high NOA estimates relative to low middle income and conflict/post-conflict economies (Text Figures 3c–3d).
- Note: Grey lines in figures represent two standard deviations around NOA estimates.

### Interpretational caveats and alternative explanations
- The regression yields correlations, not causation; causality is not inferred (see footnote).
- Two considerations affecting interpretation of the 30–50 percent staff estimate:
  - International evidence that GDP is generally underestimated implies the implied NOA in BiH could be a higher proportion of BiH published GDP.
  - The discrepancy could reflect factors other than NOA—e.g., post-conflict complications or X-inefficiencies—so that “potential GDP” suggested by indicators exceeds actual GDP; therefore the discrepancy may exaggerate NOA.

### Concluding observations and policy implications
- Considerable evidence points to understatement of activity in official BiH national accounts: direct, indirect, and staff methods all indicate understatement.
- Staff estimates of NOA: 30–50 percent, which straddle the IMF Statistical advisor’s and other direct estimates for BiH.
- The methodology cannot distinguish NOA from deviations of actual from potential output; this qualification weakens definitive interpretation.
- Policy recommendations:
  - Strong case to commence efforts in BiH to make adjustments to official data for NOA.
  - Even modest initial adjustments (as seen in regional practice) would strengthen national accounts statistics.
  - Efforts to set up surveys to form the basis for direct-method adjustments are appropriate.
- Implications for macro indicators:
  - Economic indicators for BiH measured as ratios to GDP (including current account deficit and government spending) are likely overstated if GDP is understated.
  - Caution: other data (e.g., merchandise imports, consolidated spending) also have shortcomings.
  - Example: using the Central Bank measure of the current account balance in euros and expressing that relative to “adjusted” GDP 50 percent higher than official yields a deficit of 16 percent of GDP, close to staff estimate of 17 percent of GDP.
  - Consolidated government spending accounts for some 50 percent of GDP on staff data, but this excludes road funds and extra budgetary funds below entity central government level and quasi-fiscal activities.
- Overall: need to strengthen statistics to provide better guidance for policymaking and surveillance; this is part of BiH’s strengthened fiscal architecture.

### Annex 1 — Decomposition of NOA (Dell’Anno and Piirisild, 2004; 2001 estimates)
- Non-response:
  - Non-response evaluated around 10 percent of surveyed units (assumed same in RS).
  - Non-response accounted for 5.9 % of official GDP.
- Underreporting of value added:
  - Undeclared sales amounted to seven percent of large taxpayers’ declared sales, or roughly 21 percent of declared sales of all taxpayers.
  - Underreporting, adjusted with an estimate for restaurant tips, evaluated at 12.7 percent of official GDP.
- Unregistered activities:
  - Estimated using Federation tax audit data as ratio of discovered underground businesses to active legal entities.
  - Underground value added amounted to 2.3 percent of official GDP.
- Informal sector:
  - Estimated by reducing labor productivity in formal sector and multiplying by number of informal workers (World Bank (2002) data), by branch and entity; with additional assessment of actual and imputed rents.
  - Size of the informal sector estimated at 29.4 percent of official GDP.
- Illegal production:
  - Based on average bribe amount, percentage of population having paid bribes, and CBBH’s assessment of value added of prostitution.
  - Illegal production evaluated at 7.3 percent of official GDP.

*Source: IMF Staff estimates; Dell’Anno and Piirisild (2004).*

### 5.      Several laws restructured domestic liabilities of governments in 2004: the

### 5.      Several laws restructured domestic liabilities of governments in 2004: the

### Restructuring laws, verification, and instruments
- Republika Sprska (RS) law of July 2004, Federation law of November 2004, and parallel laws for the State and Brcko District restructured domestic liabilities for war damages, expenditure arrears, frozen foreign currency accounts, to banks, and so on.
- Laws were based on “best—but inadequate—estimates” of liabilities available at the time.
- They anticipate verification processes to check each individual claim.
- Settlements were to be a mix of cash payouts (already begun) and zero coupon or sub-market coupon bonds with maturities up to 50 years.
- Terms of payouts were anticipated to reflect the verified claims.

### Legal rationale for long-dated, below-market coupon bonds
- Authorities’ legal advice suggested courts might accept payouts of nominal sums equal to claims via long-term sub-market interest bonds, given that not all claims could be paid in full consistent with public expenditure ambitions.
- Intended rationale: balance claimants’ rights and public interest in solvency when assessed by courts.

### Court rulings and immediate legal constraints
- RS restructuring struck down by the Constitutional Court of Bosnia and Herzegovina on December 17, 2004 (case concerning a KM 24,000 (Euro 12,000) compensation order from April 12, 2002).
  - Court conclusion on the “Law on Establishment and Manner of the Internal Debt of the Republika Sprska of July 2004”:
    - Adoption placed an excessive burden on individuals; proportionality between public interest and fundamental rights was not met.
    - Article 21 paragraph 1’s provision to settle legally binding claims “by issuing of bonds with the maturity date of up to 50 years” raised concern whether claimants would live to realize rights.
    - Law provided that obligations be settled without interest rates, which “surely means that the amounts to be paid out to the individuals shall be considerably diminished.”
- Human Rights Commission (HRC) of the Constitutional Court decision on April 6, 2005 concerning Federation Frozen Foreign Currency Deposits:
  - Interest due after January 1, 1992 could be validly written off in the public interest (para. 1243).
  - Verified claims could be paid in the form of bonds.
  - Other aspects violated constitutional rights to property and a fair trial.
  - Court mandated bond maturities should not exceed 15 years and should carry fair interest reflecting the realistic value of invested foreign currency, including the average rate of inflation (paras. 1245 and 1246).
  - Procedural requirements: the State (not the Entities) must issue a law governing frozen foreign currency accounts within six months, and that law must justify any differential treatment of claimants, including between the two Entities.

### Uncertainties and likely cross-effects of rulings
- Both rulings recognize need to balance public and individual interest but find the July 2004 RS and November 2004 Federation laws did not appropriately strike that balance.
- Implication: the December ruling’s comment that “considerable diminishment” is unwarranted could imply that only “moderate” write downs would meet court criteria.
- Federation rulings likely affect RS provisions (e.g., frozen foreign currency accounts) given RS provided for even less generous payouts than the Federation law.

### Quantified fiscal implications and scenarios
- Assumed estimate of total claims: about 200 percent of GDP.
- Illustration: if courts impose requirements implying a 75 percent NPV write down of claims as “not considerably diminished”, Bosnia and Herzegovina (BiH) would be left with domestic indebtedness with an NPV of some 50 percent of GDP (assuming total claims ~200 percent of GDP).
- Alternative interpretation: if “fair” interest means market interest rates paid on all bonds and accrued interest to date on all claims written off, NPV of total payouts could amount to some 50 percent of GDP.
- Sustainability analysis summary (Text Table 1, Public Debt In percent of GDP):
  - 2003 NPV of public debt: 26
  - 2010 under domestic claims plan (NPV domestic claims in 2004 = 10): NPV of public debt 33; Primary balance 1; Overall balance -1; Real interest rates less real GDP growth 4 (assumes real interest rates 2 percentage points above long term growth)
  - 2010 if NPV domestic claims = 50: NPV of public debt 76; Primary balance 1½; Overall balance -4½; Real interest rates less real GDP growth 2
  - 2010 alternate column: NPV of public debt 61; Primary balance 4; Overall balance -½; Real interest rates less real GDP growth 2
- Key interpretation:
  - Recognition of claims with NPV of 10 percent of GDP compatible with non-increasing government indebtedness under assumptions (primary surplus 1 percent of GDP).
  - If claims of 50 percent of GDP recognized, sustainable primary surplus must rise to 1½ percent of GDP, which implies overall deficit of 4 percent of GDP—difficult to finance without arrears.
  - To yield a financeable overall budget deficit path up to 2010, primary surplus would need to strengthen to 4 percent of GDP; even then NPV of public debt would be just over 60 percent of GDP by 2010.
- Spending implications:
  - Increasing primary surplus to 4 percent of GDP requires permanent reductions in public spending of 3 percent of GDP or some KM420 million relative to 2005 budget levels.
  - Cancelling the entire Federation Central Government program of benefits for war veterans would still leave a further KM 120 million in savings needed—approximately one third of all administrative expenses of the State.
- Sensitivity and upward risks:
  - If court rulings require payouts with NPV > 50 percent of GDP (e.g., 75 percent of GDP), larger permanent spending cuts would be required.
  - Analysis assumes the differential between interest rates and real GDP growth is unaffected by debt level; in reality higher debt would likely raise credit risk premia and lower GDP growth, increasing required spending cuts.
  - Verification processes could reduce or increase total claims; only lower verified claims would ease fiscal implications.

### Immediate operational risks from court awards
- Without a court-endorsed overall framework, lower courts can mandate immediate execution of awards, threatening normal government operations via seizure of cash and assets.
- Several thousand court cases amount to a “run on government deposits and assets” through the courts; an RS Municipality, Trebijne, case already realized this threat.
- Immediate cash-flow burden from awards could require spending cuts greater than those estimated, depending on flow of cases and awards.

### Recommended immediate actions and options
- Authorities need to identify promptly the level of NPV of domestic debt that courts would accept as constitutionally valid.
- Determine how such determinations can be done speedily within the legal system to minimize iterative delays from amending restructuring laws and further judicial review.
- Examine options promptly to reduce legal and fiscal uncertainty.

### Restitution, pension claims, and other new claims on government
- A commission is examining restitution issues, likely focusing on post 1945 claims. It must define valid claim types, enforcement via courts, compensation amounts and forms, and liable tiers of government. Potential sum of claims is very large but currently unknown.
- Commission needs to specify payouts consistent with fiscal sustainability:
  - Given prior sustainability analysis and assuming reversal of court rejection of 2004 domestic claims laws, there is room for payouts with NPV of some two percent of GDP.
  - Larger settlements would require offsetting cuts in budget spending as noted above.
  - Given court rejection of 2004 laws, little scope exists for restitution payouts because outstanding claims already require large offsetting spending cuts.
- Pension contribution “gaps” (arrears of pension contributions) present a major risk:
  - Ignoring contribution gaps and restoring full entitlements would increase government’s future pension liabilities without additional revenue.
  - Under current cash-rationing pension system, offsetting such a shock would necessitate pro-rata reductions in average pensions—a socially difficult adjustment.
  - Recommended resolution: provide at most partial closure of contribution gaps, conditional on fundamental restructuring of companies involved to provide resources for corresponding pension payouts.

### Consolidated government expenditure and priority projects
- Sustainability concerns imply need for large permanent spending reductions.
- Many plans and international partners propose more public spending, including raising public investment and other priority projects.
- Text Table 2 (Costs of Priority Projects) indicates anticipated increases in budget spending in percentage points of GDP for several projects:
  - Police reform: 0.6 permanently, even including downsizing of 17 percent; somewhat higher including transitional and costs of meeting civil service laws.
  - Defense reform: 0.6, if there is no wage cut at the State level and no downsizing from end 2004 levels. Downsizing by 1/4 could bring the cost down to 0.1.
  - Civil service reform: new civil service laws implemented requiring ethnically diverse composition according to the 1991 census; potential for more radical—and expensive—steps.
  - Expansion of Cantonal and municipal spending: proposed borrowing cap to prevent debt service exceeding 10 percent of revenues could accommodate increased borrowing of up to 4 percent of GDP; flows of up to 2 percent of GDP are likely under this rule.
  - Expansion of state institutions: permanent costs not yet available but list of institutions is long and many require additional staff.
  - Increased budget investment and operations and maintenance spending: consensus that on-budget investment should increase significantly; EBRD committed lending of ½ a percent of GDP for road repair and building.
- Aggregate effect:
  - As configured, priority projects will raise public spending by some 4 percent of GDP or more permanently, with transitional costs above that in a number of cases.
  - These increases cannot be funded from additional revenue: fiscal revenue (including grants) is some 49 percent of GDP and scope for expansion is limited.
  - The coming VAT’s yield is highly uncertain given poor quality of data and potential severe transitional implementation difficulties.

*Source: IMF country report content (section on domestic liabilities, courts, fiscal sustainability, and expenditure priorities).*

### 28.      So permanent savings in “other” spending of at least 4 percentage points of GDP

### 28.      So permanent savings in “other” spending of at least 4 percentage points of GDP

### Required fiscal adjustment and scope
- Permanent savings in “other” spending of at least 4 percentage points of GDP are required—equivalent to half of the RS central government budget—to offset high priority plans.
- Even large adjustments eliminating “wasteful” spending will be insufficient alone; there is need to economize in proposed new spending programs.
- Coordination is needed within the international community and between the international community and the authorities to address this challenge.

### Impact of government excess liabilities and judicial rulings
- The impact of BiH government excess liabilities—long hidden—is increasingly visible and has discouraged new private investment.
- Courts have, until now, often not pressed claims or have been impeded by laws postponing enforcement; with courts increasingly processing claims the risk to operations is materializing.
- Increased activism by pensioners is bringing the contribution gap issue into the open.

### Domestic claims laws, budget implications, and monitoring needs
- The 2004 domestic claims laws were intended to address the problem; the 2004–05 budget spending plans were consistent with them.
- The court’s rejection of the RS and the Federation laws represents a major challenge.
- If court rulings require even one quarter of the estimated outstanding claims to be paid in NPV terms, then permanent cuts in budget spending of some 3 percent of GDP will be necessary.
- Urgent need to clarify exactly what would meet the court’s prescriptions; the cuts necessary will depend on which domestic claims settlements the court accepts as valid.
- Securing government operations from threats to cash flow arising from execution proceedings requires:
  - a short-term remedy for awards already court-mandated, and
  - a strategy to address cases still in the courts, with effective monitoring so government lawyers can be fully prepared in each court.

### Limits on restitution, pension accommodation, and additional claims
- Additional domestic claims on government should be minimized.
- Compensation for restitution and accommodation of old pension arrears must be strictly limited.
- Recommendations from the restitution commission must reflect limits and include appropriate legal underpinnings.
- If mandated restitution claims are large, sizeable cuts to public spending could be required to reestablish fiscal sustainability.

### Priority projects, domestic debt, and required cuts
- Scope for priority projects will be limited if domestic debt of government is higher than anticipated in the 2004 domestic claims plans.
- Even if the 2004 plans are reinstated and additional liabilities capped at low levels, major cuts in budget spending may be necessary because priority projects require equal and offsetting cuts in other spending.
- These ambitions currently imply need for 4 percentage points of GDP or more in spending cuts.
- If estimates of total claims are broadly correct, if the court ruling implies that quarter of these must be paid in NPV terms, if restitution and closure of gaps in pension contributions are no more than symbolic, and if priority projects are implemented as now configured, then permanent budget spending cuts substantially more than 7 percent of GDP are required.
- That amount is equivalent to the annual spending of one of the Entity Central Governments; the spending would be cancelled entirely—not shifted to other levels of government—and resources released would be needed for the additional burden of government domestic debt, pension payments and the priority projects, consistent with fiscal sustainability.

### IMF advice and institutional responses
- Recent IMF advice to Bosnia and Herzegovina has been informed by these matters and has included:
  - encouragement to adopt the domestic claims plan to secure fiscal sustainability;
  - adopt it with a NPV of only 10 percent of GDP to reflect budget ambitions and legal advice on court acceptance;
  - placement of one-off receipts into escrow to fund court awards and other payouts;
  - establishment of the “Fiscal Sustainability Group” to identify expenditure cuts needed for priority spending;
  - encouragement for those developing priority spending plans to coordinate and rationalize them.

*Source: Excerpt from IMF staff report chapter on fiscal sustainability and VAT implementation (text provided).*

### 13. A registration threshold of KM50,000 (US$30,000) will be applied. The

### _cr05198 - 13. A registration threshold of KM50,000 (US$30,000) will be applied. The

### Registration threshold and expected registration impact
- A registration threshold of KM50,000 (US$30,000) will be applied.
- Threshold design objective: balance administrative and compliance costs against the need for additional revenue.
- In determining whether a threshold of KM50,000 is met, turnover of companies and other bodies under common direct or indirect control (through possession of shares or in any other way) will be taken into account.
- The turnover threshold of KM50,000 accounts for about 90 percent of the receipts reported on sales tax returns.
- It is estimated that about 4000 companies not currently registered for the sales tax will be required to register for the VAT.

### VAT base, imports, and place of supply of services
- The BiH VAT base includes customs duties and excises.
- The VAT on imports is collected at the time when goods are entered for customs purposes.
- The VAT base also includes:
  - other import charges as well as other public revenues;
  - any indirect costs charged by the supplier to the recipient of goods and services (such as commission, packaging costs, transport and insurance, etc.);
  - any costs of connection, installation charges, and other amounts charged to the purchaser by the supplier as a condition of supplying goods and services.
- The VAT law contains clear rules for the place of supply of services consistent with international practice:
  - Supply of services will be deemed to have taken place in BiH if the taxpayer has a permanent base in BiH from which services are provided; or, in the absence of such a base, if the taxpayer has his permanent address or usual place of residence in BiH.

### Tax returns, payment, and refunds
- All taxpayers should submit a VAT tax return for each accounting period by the 10th day of the calendar month following the end of the accounting period.
- Taxpayers must pay the tax for each accounting period by the deadline for filing the return.
- VAT refunds will be paid within 60 days of submission of a VAT return.
- Note: Administration is new and expected to be weak initially; dealing with refunds for all taxpayers may be difficult.

### Next steps — major challenges before VAT implementation
- Five major challenges identified before VAT implementation can proceed:
  - various technical preparations, including development of Information Technology (IT);
  - incorporation of excise tax administration into the ITA;
  - a comprehensive reform of arrangements to distribute indirect tax receipts among cantons and municipalities;
  - arrangements to offset the impact of the VAT on the poor;
  - steps to anticipate uncertainty in collections in the initial period of VAT implementation.

### Administrative preparations (tasks still to be completed)
- Preparation of the information technology systems has been slow.
  - Development of software for VAT returns and payment processing has just started.
  - Computer software testing has not started and should start well in advance of implementation.
- Staffing and recruitment for the new VAT administration has lagged and progress is needed urgently.
  - A number of recruitment-unfriendly rules in labour legislation, the inadequate quality of applicants, and a non-transparent recruitment process have hindered progress.
- Taxpayer education has started but should be much strengthened.
- Preparation of Regional Tax Centres is lagging and needs to be ready in time for VAT introduction.
- Implementing regulations remain to be defined, including guidelines on taxpayer registration and guidelines on enforcement procedures.

### Incorporation of excise administrations into the ITA
- Excise administration will be incorporated into the ITA for administrative efficiency.
  - Rationale: ensure indirect taxes with closely related tax bases (customs duties, excises, and the VAT) are collected and controlled by the same administrative entity at the State level (as foreseen by the ITS law and the nationwide excise tax law adopted at end-2004).
  - Expected benefits: help prevent tax-induced distortions of production and trade, and reduce companies' compliance costs.
- Status:
  - Integration has already taken place for excises on imported goods.
  - Deadline for integration into the ITA of the administration of domestic excisables is July 1 this year.
  - Deadline is expected to be met in part because very few companies are involved and the precondition is that no further excise taxes will be introduced.

### Revenue allocation for Cantons and Municipalities
- Current situation:
  - Under the sales tax, collections were administered by the central government in the Federation and allocated to the Cantons and Municipalities.
  - In the RS, collections were administered by the central government and shared between the central government and the municipalities.
  - In the current “intermediate” stage—where the sales tax on excisables is pooled in the single account—this allocation rule remains viable because sales tax data are still collected and provide a basis to distribute those funds within each Entity.
- Issue with VAT:
  - Once the VAT is introduced, tax origin will not be recorded under the VAT at the sub-entity level, so the existing allocation key will not be available.
- Policy responses under consideration:
  - Introduction of a uniform minimum municipal share of the new personal income tax (expected to replace the wage and citizen taxes by January 1, 2006), possibly combined with general equalizing revenue grants from the entity central governments directly to the municipalities, calculated as fixed amounts per capita.
  - For the Cantons, different models involving general revenue grants are being analyzed.
- Note: The authorities are receiving technical assistance in this area.

### Impact of VAT on the poor and compensation options
- FAD TA mission (March 2005) findings:
  - The average increase in the tax burden is estimated at KM 300 (2.4 percent of consumption spending) per annum per household.
  - The absolute increase in the tax burden falls disproportionately on richer households: households in the upper income deciles would pick up about 16 percent of the increase in the total burden, while those in the lower deciles only about 4 percent.
  - As a proportion of household consumption, the additional tax burden (compared with the sales tax) is regressively distributed:
    - It amounts to 2.6 percent of consumption spending for the lowest deciles.
    - It amounts to 1.9 percent of consumption spending for the highest deciles.
  - Important inter- and intra-entity differences: households in the Federation will bear a higher burden than those in the RS; urban households will be more adversely affected than households in rural municipalities.
- FAD mission advice:
  - An Entity-level social welfare program is the most appropriate instrument to compensate households adversely affected by the VAT.
  - Challenges: existing programs are poorly targeted and their separate policy formulation, financing, and implementation has resulted in wide variation of service provision across cantons and municipalities.
  - The mission favored centralization of these social programs at Entity level; laws to this effect are being drafted with assistance from the World Bank.

### Collection uncertainty immediately following implementation and budgetary recommendations
- Revenue uncertainty:
  - Estimates of the “revenue neutral” rate (16 percent) are based on BiH macroeconomic data, which are less than completely reliable; errors in the estimate could go both ways.
- Preparations for the 2006 budgets should anticipate this uncertainty to ensure continued control over the consolidated fiscal balance.
- Recommended measures to address lower-than-expected revenues:
  - Establish a spending reserve—a “delayed spending list”—in the 2005 budgets, with spending in the reserve only authorized during 2006 in light of actual collections.
  - The spending reserve should be created at the State level, and at the Entity central Government level.
  - Arrangements for revenue allocation from the Single Account will need to be set up to implement this approach.
  - Reserves should be in place for at least six months to allow appropriate analysis of collections data in the early months of 2006.
- Recommended measures if revenue exceeds expectations:
  - If revenue exceeds expectations and this trend is confirmed after an appropriate period, consideration should be given to the appropriate use of the “permanent windfall” receipts.
  - Given considerable inefficiencies in government spending, proposals to apply the windfall to additional programs should be resisted.
  - A better option would be to apply the “permanent windfall” to reductions in labor taxes.
    - Current labor tax indicators cited:
      - 52 percent of the net wage (including benefits) in the RS.
      - 69 percent of the net wage (excluding benefits) in the Federation.
    - Rationale: these tax levels discourage tax compliance and job creation; using a permanent VAT windfall to lower labor taxation would secure an appropriate shift from direct to indirect taxation and prevent further expansions in the size of government.

### Annex summary — Advantages of a VAT compared with a sales tax
- Main VAT features cited as best practice: production efficiency and absence of cascading.
- VAT characteristics:
  - As a tax on consumption, VAT meets the production efficiency criterion: VAT paid in intermediate production is refunded, so it does not distort the production process.
  - VAT does not cascade: refunds on inputs ensure VAT is ultimately only levied on final consumption.
- Retail sales tax (to be replaced by VAT in BiH):
  - Also production efficient but involves cascading because sales tax charged on inputs is not refunded, generally resulting in a much higher tax burden.
  - Cascading in BiH is limited because the retail sales tax is primarily collected at the retail stage (except for excisables taxed at import and manufacturing stages).
  - Raw materials and semi-finished goods used in the production of excisable products are exempt.

*Source: _cr05198 - 13. A registration threshold of KM50,000 (US$30,000) will be applied. The*

### 8.      Looking ahead, further State-building is anticipated. This will reflect expansion in

### 8.      Looking ahead, further State-building is anticipated. This will reflect expansion in

### Overview
- Further State-building is anticipated through: expansion in capacity and staffing for existing mandates; adoption of new mandates not executed by any level of government yet; and further shifts in functions from lower levels of government.
- Initial State spending goals for the 2005 budget doubled 2004 expenditures, although these were reined back in the face of Entity resistance.
- Administrative spending is targeted to rise by about 60 percent from 2004.
- BiH aspirations to enter NATO and the EU imply additional expansion well beyond 2005, including integration of the entity police and army forces into two single State-level forces.

### Assessment of current State-building
- State remains a small part of government; many State institutions can carry out functions in name only because of staff shortages.
- Growth of actual State level employment has been well below the “full complement” specified in State institution rule books.
- The lack of an independent revenue source has played only a minor role; transfers to the State have risen steadily over the years.
- State-building has been haphazard: institutions established with scant regard to overall coherence or cost; target staffing rationales in rule books are not apparent; office space is short; hiring processes are protracted; some recruitment restrictions exist (e.g., SIPA can currently only recruit from other police forces).
- International community priorities have tended to drive uncoordinated State initiatives (e.g., State Border Service and Judicial functions).

### Remuneration and cost implications (findings)
- Average remuneration in 2004 for a State government employee was almost 50 percent higher than in the Federation government and 180 percent higher than the RS government.
- SBS remuneration is more than 22 percent above that of the Federation Police force and 130 percent above the RS police.
- SIPA employees enjoy a pay premium of some 80 percent and 250 percent over the Federation and RS police respectively.
- In the State judicial system, average remuneration of employees in the Prosecutors office for 2004 was more than KM 4,500 per month. This is over 16 times the average per capita income in Bosnia and Herzegovina. By comparison, Italian High Court judges earn only 3 times the average per capita income of Italy.
- Compared to remuneration outside government (allowing for data quality and possible underreporting), State employees’ wages and benefits are estimated to exceed those of workers outside the budgets by 90 percent in the Federation, and some 125 percent in the RS in 2004.
- There is little evidence that the generosity of State remuneration is warranted given service-quality differentials.

### Specific examples of cost escalation
- Consolidated wage bill of customs in 2004 (entity level): a little under KM 30 million, or 0.2 percent of GDP.
- 2005 budget for the ITA (State-level customs administration) anticipates a wage bill (excluding severance) of KM 46 million and 0.3 percent of GDP — an increase of over 50 percent.
- Remuneration increases upon shifting to State status: some 160 percent for former RS customs officers, and 60 percent for former Federation officials, despite performing the same tasks.
- Consolidated expenditure relative to GDP fell from above 55 percent of GDP to about 50 percent between 2000 and 2004.
- To achieve that, a cumulative 11½ percent reduction in real public spending outside of State government (excluding Entity spending on transfers to the State) was required over this period.
- Macroeconomic risks: with nominal GDP growth slowing from early 2000 rates and real State spending set to rise sharply, further State-building will require additional sharp real cuts in Entity spending if consolidated government expenditure is to remain on a downward track and the consolidated fiscal deficit is not to grow.

### Police and Defense reforms (Box 2) — scenarios and quantification
- Police and defense reforms alone will increase total employment in the State budget from some 5,600 in 2004, to 33,000, an increase of almost 6 times.
- Estimated fiscal impact of envisaged police reforms: raise consolidated Entity and State government expenditure on police by 0.6 percent of GDP permanently.
- Box 2 modeled phased police reform implementation in the RS and the Federation over two years (including Cantonal Police), assuming efficiency gains yield a reduction of the police force of 17 percent by end-2007.
- Modeled assumption: as employees move from the Entity to the State, their remuneration increases to the average SBS level.
- Average SBS remuneration of KM 1807 per month in 2004, increasing annually at the rate of GDP growth.
- Total wage bill projected to swell by KM 142 million (61 percent) in 2005-07.
- Wage bill projected to rise from 1.8 percent of GDP to 2.4 percent, and stay there afterwards — a permanent increase of 0.6 percentage points of GDP.
- Transitional costs (severance, new equipment) will add to the burden.
- Alternative scenario: if unified State police pay were set at the current level of the Federation Central Government police force (a 20 percent cut in assumed pay relative to SBS level), Police reform would raise BiH spending on Police by only 0.2 percent of GDP.

Selected figures from the Box 2 numerical exercise:
- Republika Srpska Average wage (in KM) 1/ 782 809 847; Employees 7,772 6,477 1,295 0; Wage bill (in KM million) 736 313 0 30
- Federation Central Government Average wage (in KM) 1/ 1,479 1,523; Employees 1,278 959 0 0; Wage bill (in KM million) 231 800 0 0
- Cantons Average wage (in KM) 1/ 1,300 1,346 1,419; Employees 8,890 7,938 3,175 0; Wage bill (in KM million) 139 128 540 0
- State Average wage (in KM) 1/ 1,905 1,993 2,106; Employees 0 2,439 11,988 14,890; Wage bill (in KM million) 0 56 287 376
- Total Average wage (in KM) 1/ 1,088 1,236 1,792 2,106; Employees 17,940 17,812 16,458 14,890; Wage bill (in KM million) 234 264 354 376
- Memorandum items: Nominal GDP 13,021 13,865 14,697 15,579; Annual wage bill (in percent of GDP) 1.8 1.9 2.4 2.4
- 1/ Gross, and including benefits.

### Funding arrangements and macro-fiscal risks
- From 2005, under the Indirect Tax System law, discretionary monthly cash transfers to the State by the Entities ended, replaced by automatic transfers from the ITA single account to the State for administrative and debt servicing obligations.
- The annual amount of these funds is determined by the State alone, without formal reference to Entity budgets.
- This removes reliance on Entity goodwill but also removes the requirement for the State to coordinate its annual spending plans with the Entities.
- Risk: absence of coordination can remove incentive for the State to economize and can produce disorderly macroeconomic outcomes.
- The change in funding arrangements, coinciding with a large planned expansion in State functions, risks compromising macro and fiscal goals and inflaming domestic political sensitivities.

### Recommended policy actions (A Better Approach)
- The EU should clarify and prioritize institutional development requirements tied to EU accession, including sequencing for formal establishment and de facto staffing completion of new institutions; a coherent roadmap is needed.
- Prioritization and phasing should acknowledge administrative constraints on the State to build itself and reexamine the analytical basis for target staffing levels in ministries’ rule books.
- Identify specific cuts in sub-State spending to offset State-building that raises consolidated spending; the OHR fiscal sustainability group is timely and should focus on areas such as war veterans’ benefits.
- Establish mechanisms to ensure delivery of identified savings (e.g., use of coefficients allocating revenue from the single account within the Federation to draw resources from Cantons rather than the Central Government), coordinated with Cantonal budgeting.
- Lower State-level remuneration rates toward Entity rates to prevent sharp cost rises when functions shift to the State; a 20 percent cut in State wage and benefit rates could reduce the projected police-reform spending increase from 0.6 to 0.2 percent of GDP.
- The proposed 10-percent wage rate cut for State level employees in 2005 is too small and has yet to be implemented; benefits remain untouched.
- DFID consultant initiative to examine State remuneration structure is timely; the exercise should rationalize remuneration across State, Entity, and non-budget sectors.
- Large reforms (Police and Defense) should be designed and phased to cut, not increase, costs; conduct close examination of scope, phasing, and combined impact of reforms on consolidated budgets year by year.
- Change funding arrangements: require formal endorsement of the State annual administrative budget by the Entities before funds can be withdrawn from the single account; introduce processes to break negotiating deadlocks between Entities and the State. These elements form part of the proposed “fiscal architecture” for Bosnia and Herzegovina, including arrangements for the proposed National Fiscal Council.

*Source: IMF country report section "8. Looking ahead, further State-building is anticipated."*

### 1.      Consolidated fiscal balances at cantonal and municipal levels need to be

### 1.      Consolidated fiscal balances at cantonal and municipal levels need to be controlled.

### Background and assessment
- Central control over consolidated fiscal balances of cantons and municipalities is not secure.
- Key weaknesses identified:
  - Arrears accumulation and uncoordinated disposal of privatization and other one-off receipts have undermined control.
  - Potential for arrears accumulation, ad hoc borrowing embargoes, unrestricted use of privatization resources, and lack of restrictions on issuance of guarantees.
  - Ad hoc restrictions on borrowing have been inflexible and have prevented development of a market for local government debt.
  - Utility and other local infrastructure has been decaying for years.
- Specific episodes and figures:
  - Sarajevo Canton planned a large fiscal deficit in 2005—KM 55 million, 0.4 percent of GDP—significantly larger than deficits anticipated for either the State or the two Entity Central governments in 2005.
  - Government decision adopted in May 2003 limited the stock of central government and municipal debt to 9 million KM.
  - The Law on Domestic Debt (Brcko District, July 2004) sets a ceiling on debt service at 5 percent of budget revenues of the previous year for short-term domestic commercial borrowing.
- Application of existing frameworks:
  - Organic budget laws express the underlying framework for cantonal and municipal borrowing.
  - Arrangements for prior approval by Entity Central Governments vary:
    - Republika Srpska: ministry of finance must approve borrowing in excess of indicated long-term limit; short-term borrowing is not subject to this approval.
    - Federation: no arrangements for prior approval; borrowing procedures differ across cantons; individual cantonal assemblies endorse annual borrowing limits; municipal approval procedures differ by cantonal laws on self-government.
  - In practice, frameworks have been applied ad hoc (e.g., Federation budget execution laws, including for 2005, banned new commercial borrowing by sub-entity governments).
    - Article 39 of the 2005 Federation budget execution law states that “Cantons, cities, and municipalities can not borrow under commercial terms domestically and abroad to finance current expenditures and capital and investment costs.”
- Creditworthiness and lending:
  - Lack of transparency, revenue autonomy, adequate financial management systems, and accountability undermines creditworthiness.
  - Short-term bank lending to cantons and municipalities occurs as new treasury and payment systems are introduced.
  - Long-term bank lending exists with anecdotal evidence of modest breaches of regulations.
  - New donor lending projects (exempt from general borrowing embargoes) involve intermediate or guaranteed bank lending to municipalities.
- Contingent liabilities:
  - Guarantees provided to local enterprises, in particular utilities, pose a fiscal risk of unknown magnitude.
  - Possibly large liabilities for war claims and claims for restitution loom over sub-national governments.

### Issues and objectives
- New arrangements are required for:
  - Arrears,
  - Use of privatization receipts,
  - Guarantees,
  - Borrowing by cantons and municipalities.
- Objectives for reform:
  - Secure central control over consolidated balances compatible with fiscal sustainability and macroeconomic stability.
  - Allow cantons and municipalities appropriate flexibility to apply resources prudently to individual spending priorities.
  - Prevent arrears accumulation and properly regulate use of privatization and other one-off receipts.
  - Establish a coherent borrowing framework that is not overridden and that enables sensible borrowing for infrastructure.

### New arrears and use of privatization receipts
- Primary policy point:
  - The key to combating arrears accumulation is enforcement and bankruptcy procedures.
- Observations:
  - Municipalities and cantons have not faced bankruptcy threat when accruing arrears.
  - The new 2004 bankruptcy laws exempt municipalities and cantons from these procedures.
- Reform implications:
  - To secure discipline, cantons and municipalities should be rendered liable to enforcement and bankruptcy procedures, consistent with broader resolution of war claims and restitution issues.
  - Making them liable could result in many being placed into bankruptcy on account of potential war damage and restitution claims.
- Privatization receipts:
  - Cantonal and municipal freedom to dispose of privatization receipts can impart large shocks to consolidated fiscal stance (example: Sarajevo Canton, 2005).
  - Options:
    - Establish a system of “advance warning” so Entity Ministries of Finance are alerted to intentions to use these resources, with sufficient lead time for central governments to offset fiscal effects (e.g., make matching expenditure cuts).
    - Consider prior approval by central Entity governments for use of such resources, given consolidated balance targets and offsetting adjustments at Entity central government levels.
    - Improve general reporting of cantonal and municipal operations.

### Borrowing rules — approaches and assessment
- Four broad approaches to control of sub-national borrowing (internationally observed):
  - Reliance on market discipline.
  - A cooperative approach (e.g., annual agreements between levels of government).
  - A rules-based approach (limits on level, purpose, debt-service-to-revenue ratios, or total debt stock).
  - Direct central government control (authorization or centralized borrowing and on-lending).
- Applicability to Bosnia and Herzegovina (BiH):
  - Sole reliance on market discipline is not feasible given current conditions.
  - Cooperative approach conditions do not appear present now.
  - Direct central control is overly restrictive and leaves no local flexibility.
  - On balance, a rules-based approach appears appropriate now for BiH because it can be calibrated to secure control and allow prudent local flexibility.
- Requirements for rules:
  - Transparency, ease of administration, ease of monitoring by higher-level governments, flexibility, and ability to deliver appropriate credit volumes.
  - Must be executed through transparent and efficient financial management systems to maximize probability of debt being serviced.
- Recommended model:
  - A rules-based approach that mimics market discipline by setting limits for debt service costs expressed as a ratio of current revenue of individual local governments, possibly under “golden rule” criteria.
  - This provides transparent and easily monitorable arrangements while allowing local borrowing consistent with local needs.
- Draft law provisions and proposed test:
  - The draft Federation organic budget law and envisaged entity and State framework laws propose a borrowing test defined as a ceiling on allowed future annual debt service of individual cantons and municipalities of 10 percent of current revenue collections in the previous fiscal year.
  - Footnote: According to the new draft Federation organic budget law (Articles 52 and 53) now in procedure, cantons, cities, and municipalities can borrow only domestically and subject to a ceiling on total debt service costs (including on guaranteed borrowing) equal to 10 percent of the revenue collections in the previous fiscal year (note that the new limit applies to debt service as opposed to borrowing volumes under present provisions).

### Borrowing rules in steady state — calibration and steady-state implication
- Features of an appropriate steady-state rule:
  - Transparent and easy to monitor.
  - Allows local governments to increase borrowing as revenue rises or creditworthiness improves.
- Calibration example and implication:
  - A debt service limit of 10 percent of local government revenue is stated as consistent with effective control of the consolidated fiscal balance over the medium-term.
  - Under reasonable steady-state assumptions, a 10 percent debt service limit that is fully and permanently used would, ceteris paribus, be consistent with a stable consolidated cantonal and municipal deficit of around 0.3-0.4 percent of GDP.
  - This magnitude is small enough to allow manageable offsetting adjustments year by year in the central government balances to secure annual consolidated general government fiscal balances.

### Transitional issues
- Transitional challenges:
  - Very low current level of outstanding local debt and expected expansion of local debt issuance to finance infrastructure projects complicate transition.
- World Bank argument cited:
  - “Obviously, during an interim period, public indebtedness (including those of individual sub national governments) should be limited to lower levels, and only allowed to converge to that long-term general asymptotic maximum gradually, as macroeconomic conditions permit.”

*Prepared by Peter Doyle and John Norregaard; excerpted content as provided in the source unit.*

### 25.      This raises the question of the potential magnitude of borrowing in the short

### _cr05198 - 25.      This raises the question of the potential magnitude of borrowing in the short

### Short-term magnitude of local government borrowing
- Staff projections for 2005 imply that if all cantons and municipalities immediately upon introduction of a 10 percent ceiling borrow to the limit, it would result in a borrowing volume (and, if immediately spent, an increase in the fiscal deficit) of about 3.6 percent of GDP.
- This estimate reflects projected current revenue of all cantonal and municipal governments in 2005 of some 1,714 million KM, or 12½ percent of GDP, with close to 1,300 million to the cantons (9.1 percent of GDP) and about 450 million to municipalities nationwide (3.2 percent of GDP).
- The existing and very modest debt service obligations would allow on the order of 1¼ percent of GDP in “new” annual debt service costs.

- Table 2. Cantonal and Municipal Revenue and Debt Service, 2003 and 2005 (KM millions)
  - Cantons
    - 2003 Current revenue: 1,250.0
    - 2003 Debt service: 9.5
    - 2005 Current revenue: 1,295.2
    - 2005 Debt service: 9.5
  - Municipalities
    - 2003 Current revenue: 440.0
    - 2003 Debt service: 6.0
    - 2005 Current revenue: 472.5
    - 2005 Debt service: 10.0
  - Total
    - 2003 Current revenue: 1,690.0
    - 2003 Debt service: 15.5
    - 2005 Current revenue: 1,767.7
    - 2005 Debt service: 19.5

### Risks to the consolidated fiscal balance
- The potential surge in local borrowing represents a considerable risk to the consolidated fiscal balance.
- Risk mitigation from low local creditworthiness is difficult to quantify.
- Domestic commercial banks have engaged in a three year rapid expansion of credit to the private sector and have indicated a desire to expand lending to government, including municipal and cantonal governments; some have negotiated considerable external commercial funding for this purpose.
- Even a moderate fiscal weakening from this source would put serious pressure on a current account already in substantial deficit.
- Concerns are compounded if initiatives to control arrears accumulation and use of privatization receipts are not secure, and by other fiscal initiatives to increase expenditure.
- Remedial measures for the transition period need to be developed.

### Phase-in of borrowing limits (options and illustrative schedules)
- Option: Phase the borrowing limit in (World Bank suggestion). Illustrative five year schedule: 2%-4%-6%-8%-10%.
  - A 2 percent limit would allow a maximum of new borrowing of about half of one tenth of a percent of GDP.
  - Progression from one ceiling to the next would occur only when individual cantons and municipalities have reached the preceding ceiling (to avoid abrupt credit expansions owing to “unused” credit ceilings of previous years).
- Advantages: ensures control over the consolidated fiscal balance throughout the phase-in period.
- Disadvantages: low ceilings during phase-in could restrict well-prepared municipal borrowing projects, delay municipal debt market development, and be complex to implement.

### Possible refinements to the phase-in
- Simplified automatic and simultaneous phase-in: all Cantons and municipalities reach the 10 percent ceiling in the 5th year regardless of actual borrowing.
  - Alternative initial schedules cited: 4%-6%-8%-10% or 3 1/3 %-3 1/3 %-3 1/3 % (automatic and simultaneous).
  - Purpose: allow some municipalities to undertake financially sound projects while limiting macro risks.
- Cantonal and Municipal Credit Board (CMCB) at entity level:
  - Participation: entity ministries of finance, representatives of cantonal and municipal governments, donors, commercial banks, and possibly the central bank.
  - Objective: ensure consolidated borrowing of all cantons and municipalities combined is compatible with the consolidated fiscal balance target.
  - CMCB could grant individual exemptions to allow sound projects to go straight to the 10 percent limit, but only if consistent with the target consolidated fiscal balance.
  - Requirement: CMCB must be an effective and appropriately neutral decision-making body.
- Differential treatment between Cantons and Municipalities:
  - Municipalities could be subject immediately to the general 10 percent limit without phase-in.
  - Cantons could be disallowed any borrowing initially (as under present prohibition), with a phasing-in system later (e.g., 2%-4%-6%-8%-10%) and possibly a Cantonal Credit Board to handle exceptions.
  - Under this approach, new municipal borrowing would be capped at some 0.7 percent of GDP assuming all 137 municipalities immediately borrow the full amount allowed under the ceiling.
  - Given varying creditworthiness, not all municipalities would borrow to the full extent; but even this level would require support from other expenditure-cutting measures and control of Cantonal use of privatization receipts.
  - The rule for municipalities should be reviewed in light of actual borrowing activity and revenue shocks (including the impact of the VAT).

### Trade-offs and international precedents
- The third approach (municipalities immediate 10 percent, cantons phased) offers simplicity, flexibility, and control but may be viewed as discriminatory between entities given different responsibilities under Dayton.
- Within the Federation, total cantonal revenue is about 3½ times higher than total municipal revenues, or about 78 percent of total Federation sub-entity revenue.
- International refinements noted:
  - Some US States constrain local borrowing to those with an efficient financial management system, effectively allowing borrowing only by larger municipalities.
  - Many countries restrict sub-national borrowing to capital investment purposes; some limit borrowing to well-specified types of capital projects (e.g., environmental or energy saving). Applying such eligibility lists could secure controlled credit expansion.

### Fiscal sovereignty and need for a coordinating body
- Bosnia and Herzegovina lacks an institution responsible for aggregate fiscal policy; required functions include:
  - Secure fiscal sustainability, including management of total public debt and liabilities;
  - Determine the target aggregate annual fiscal balance and secure its realization;
  - Set the aggregate tax burden and its structure;
  - Determine policy on the economic composition of consolidated public expenditure;
  - Set policy on financing the annual consolidated fiscal balance, and the public debt structure;
  - Publish data and reports on general fiscal developments and plans.
- Under Dayton there are 14 autonomous Ministries of Finance (State, the Entities, Brcko District, and the 10 Cantons) plus some 140 municipalities and many extrabudgetary funds and off-budget operations; the absence of disciplined coordination leads to free-riding and weak aggregate outcomes.
- Fiscal sustainability and aggregate fiscal balances are particularly susceptible to free-riding distortions and are essential to support the currency board arrangement.
- Current arrangements:
  - The ITA Board and a nascent macroeconomic analysis unit (MAU) provide a kernel for coordination, but the ITA Board is not suited to oversee execution of consolidated budgets due to limited data sharing, narrow focus, and limited authority vis-à-vis the State parliament.
  - Budgets are typically adopted late; there are no domestic arrangements for monitoring and execution of consolidated fiscal policy; Cantons can spend privatization receipts (Sarajevo Canton planned spending of some 0.4 percent of BiH GDP from this source in 2005).
  - No domestic executive or parliamentary body is charged with oversight of aggregate fiscal policy; considerable external input from the OHR and the IMF is currently required.
- Proposal: establish a National Fiscal Council (NFC) or similar pooled-sovereignty body to coordinate the two Entities and the State in determination and supervision of aggregate fiscal policy; preparations of annual consolidated budgets would be jointly managed.

*Source: Excerpt from IMF Country Report content unit _cr05198 - 25.*

### 14.      For this purpose, the Entities and the State will need to work to a strict

### _cr05198 - 14.      For this purpose, the Entities and the State will need to work to a strict

### Integrated budget timetable
- Require a strict integrated budget timetable that will:
  - formally integrate all budget calendars;
  - incorporate a specific date for finalization of macroeconomic assessments for the year ahead;
  - a date for the derivation from those macro assessments of the associated consolidated budget balance target;
  - a date for the subdivision of that consolidated balance target into the budget balances for the various components of Bosnia and Herzegovina’s fiscal system;
  - a date for the determination of indirect tax policy changes so that these may be properly reflected in year ahead revenue projections;
  - a date by which the year ahead total administrative expenditures of the State are determined in order that this can be reflected in the State and Entity budgets;
  - dates for presentation of the Entity and State budgets to their respective governments and into Parliament.

### Mutual surveillance and Joint Finance Committee (JFC)
- Annual execution monitored through “mutual surveillance”: the three Ministries of Finance monitor each others’ execution of individual budgets to assure adherence to the package of policies securing the overall fiscal stance.
- NFC should provide full reports to a body representing the State and the two Entity parliaments—possibly drawn from the members of the Finance committees of the three parliaments—forming a Joint Finance Committee (JFC).
- JFC functions:
  - accountability of the executive to the legislative within the Dayton framework;
  - encourage Ministers of Finance to resolve negotiating difficulties jeopardizing the budget calendar or budget execution;
  - provide direct oversight over NFC operations for all parliaments.

### Key calendar stages for JFC reporting
- JFC should receive public reports at:
  - (i) the overall macro assessment and the related agreement on the appropriate overall fiscal balance for the year ahead;
  - (ii) when agreement has been reached on the subdivision of the year ahead aggregate fiscal balance between the various parts of the fiscal system, and the agreement on the State administrative expenses at the same time.
- Both dates should occur well before budgets for the Entities and State are submitted into their governments.

### Data, analysis, and financing considerations
- Requirements for effective target fiscal balance determination:
  - good quality macroeconomic data from statistics agencies;
  - strengthen research capacity of the MAU in the ITA and similar analytical capacity in the CBBH;
  - reflect assessments of available financing, notably external financing, with donor conditionality requiring compliance by all governments;
  - MAU could collate anticipated disbursements from donors once compliance secured;
  - scope for borrowing by each participant government could be circumscribed by overall borrowing ceilings set in individual borrowing laws, as envisaged in the draft State debt and Entity debt laws.

### Subdivision of the consolidated fiscal balance
- Critical matters:
  - need effective control exercised from the central governments of each Entity over the consolidated balance of the Cantons, municipalities, extrabudgetary funds, and Brcko District.
    - A rules-based system governing the balances of these other parts of consolidated general government is required to render their consolidated balances predictable one year ahead.
    - Possible measures: require advance warning of intentions regarding their balance; controls over their borrowing and use of privatization receipts.
    - Risk of expenditure arrears at cantonal and municipal levels undermining subdivision; proposed remedy: render these levels subject to bankruptcy procedures so creditors can enforce claims in court.
  - reform the ITS law arrangement that allows the State to determine annual drawings from the single account without consulting the Entities.
    - State annual drawings from the Single account should require the formal prior approval of the entities to avoid unilateral reductions in the “residual” left to Entities.

### Revenue projections, joint sign-off, and JFC scrutiny
- Risk: Entities artificially boost revenue estimates, weakening balance outturn relative to budget.
- Proposed safeguards:
  - require agreement on subdivision of the year ahead consolidated fiscal balance to reflect precise estimates of the revenues of the budgets concerned;
  - all three ministers of finance jointly sign off on both the budget balance allocation and the revenue estimates in all budgets;
  - revenue projections submitted to the JFC with full explanations for differences from MAU estimates, enabling public scrutiny and verdict;
  - the JFC would require appropriate technical support to analyze proposed revenue estimates each year;
  - the CBBH to provide public assessments of proposed fiscal stance, revenue estimates, and budget outturns at critical stages.

### Deadlock-breaking mechanism
- A “strong” option: if a specific change from previous year’s agreement on consolidated budget balance, its subdivision, and annual State drawings from the single account is not secured by a specific date, then last year’s agreement shall apply to the coming year—the identical KM numbers.
  - This would also apply to the estimates used for year ahead revenue (excluding privatization).
  - Imposes deficit consolidation and a counter-cyclical bias into the system.
  - Requires parallel commitments to leave non-indirect tax structures unchanged from the previous year and clearly defined accounting rules.
  - Oversight by the JFC.

### Medium-term planning and fiscal year timing
- An integrated budget calendar supports medium-term fiscal planning and reduces “ad hoc” annual decisions, aiding the medium-term budget framework and the work of the Economic Policy Planning Unit.
- Consider shifting the fiscal year from calendar year to August 1 to July 31 to maximize continuous working months and set the deadline for adoption of annual budgets at July 31 each year.

### Execution of annual consolidated budgets: transparency and shock management
- Execution requirements:
  - full data and policy transparency through publication of detailed monthly fiscal outturn data from the treasury systems for all levels of government on revenue, expenditure, and financing (IMF proposed template referenced).
  - regular—perhaps quarterly—reports on all outturns to the JFC for cross questioning.
- JFC as a “whistle-blower”: timely submission of detailed outturn reports provides public signaling of deviations and disciplines governments.
- Dealing with fiscal shocks:
  - mutual surveillance alerts NFC members to force majeure developments allowing coordinated adjustments;
  - mid-course adjustments should be minimized; cautious revenue estimates are essential;
  - if unexpected macroeconomic shocks are significant, rebalance the whole consolidated budget framework including consolidated budget balance target, State drawings from ITA single account, and allocation among component parts of general government, sharing burdens across levels.

### ITA Board, NFC lodging, and membership
- ITA Board must shift focus from detailed indirect tax administration minutiae to policy issues, including indirect tax policy; operational minutiae should be handled within ITA administration.
- Require more organized political input into Board deliberations; Ministers of Finance should act as delegates from their governments.
- Formal process needed to determine dates and agenda of meetings so member governments can debate issues in advance.
- If NFC lodged in the ITA:
  - experts’ role may be restricted to indirect tax matters only, with no role in wider fiscal matters;
  - merit in lodging NFC in ITA because ITA encompasses formal voting procedures usable to break deadlocks.
- Recommendation to avoid inclusion of the two Prime Ministers and the Chair of the Council of Ministers in the NFC to keep the body small and functional; they could constitute a “Court of final appeal” for unresolved NFC deadlocks.

### Legislative basis for the NFC
- NFC cannot be informal; many steps in the calendar for integrated budgets and execution must be mandatory with no right of unilateral withdrawal.
- NFC members must make formal legal commitments to adhere to processes, with legal obligation to publish data in an agreed format without unilateral suspension.
- The JFC will also require a legal basis to provide essential discipline and parliamentary oversight.
- NFC should be established in State level law, with competencies only shifting there on the basis that subsequent changes to the NFC law can only be adopted with formal prior Entity assent to prevent unilateral State parliament changes.

*Source: _cr05198 - 14.      For this purpose, the Entities and the State will need to work to a strict*

### 35.      And more ambitiously, the NFC law could provide that the broader framework

### _cr05198 - 35.      And more ambitiously, the NFC law could provide that the broader framework

### NFC law and amendment constraints (paragraph 35)
- Proposal: the broader framework underpinning the NFC could only be amended with formal consent of the NFC.
- Areas specified that would require NFC assent before alteration:
  - arrangements for borrowing rules at State and Entity levels;
  - use of privatization receipts;
  - bankruptcy arrangements for sub Entity Central government tiers;
  - Entity or State budget calanders;
  - data publication obligations;
  - tax and expenditure assignments in the Entities or the State.
- Additional safeguard: changes in the framework arrangements and procedures supporting the NFC could also require the approval of the State Parliament to prevent unilateral alterations.
- Parallel with ITA governing board arrangements: similar approval/consent mechanisms proposed.

### Administration (paragraph 36)
- The NFC will require administrative support; options discussed:
  - NFC having its own administration, growing out of the MAU;
  - a cooperative administrative structure set up between the three Ministries of Finance;
  - a mixed approach is likely best.
- Imperative: strengthen greatly the quality of the administrations in the three Ministries of Finance due to the unusually complex fiscal architecture in Bosnia and Herzegovina.

### Implementation (paragraphs 37–38)
- Phasing:
  - No need to implement all reforms at once; system can and should be built over time through a process of “learning by doing”.
- Urgent steps (explicit list preserved):
  - The ITS law should be amended to provide that changes to indirect tax policy require the formal endorsement of both the ITA board and the State parliament;
  - The ITS law should also be amended to provide that annual drawings from the single account by the State require the formal prior approval of the Entity ministers of finance;
  - New laws governing the Cantons and municipalities are required, along with arrangements to control their discretion over use of privatization receipts; and
  - Cantons and municipalities should be rendered liable to bankruptcy proceedings.

### Conclusion (paragraphs 39–44)
- Framework objective (paragraph 39):
  - Strengthen fiscal sovereignty within the Dayton framework by embodying pooling of competencies rather than shifts in them, designed to function when political circumstances are adverse.
  - System effectiveness improved by determined coordination among authorities; not all contingencies can be fully addressed by the framework alone.
- Trade-off (paragraph 40):
  - Aim: secure effective domestic sovereignty over aggregate fiscal policy.
  - Cost: loss of unfettered sovereignty over components of that policy; discretion of the Entities and the State becomes subject to engagement by each other within the NFC.
- NFC role (paragraph 41):
  - NFC would not be just a “budget-making” body; it would have powers and technical support to address fiscal sustainability and broader fiscal matters.
- Legislative and central bank voice (paragraph 42):
  - Inclusion of legislatures via the JFC, and a parallel role for the CBBH, are key elements to help the NFC system function, not mere courtesies.
- Risks and mitigation (paragraph 43):
  - Success is challenging; non-cooperative behavior can undermine any system, and timetables alone cannot prevent it.
  - Potential souring of relations between NFC and JFC could create complications.
  - NFC/JFC system “leans in the cooperative direction,” encouraging intergovernmental cooperation.
  - Technical assistance (TA) support for the MAU, the CBBH, the Ministries of Finance, etc., will reduce administrative hiccoughs and strengthen input quality over time.
- Workload implications (paragraph 44):
  - NFC will assume policy-making functions currently carried out by the OHR and the IMF, increasing domestic authorities’ workload.
  - Offsets: current budget workload is aggravated by lack of formal coordinating or deadlock-breaking mechanisms; increased coordination is essential and is part of the price of acquiring sovereignty over aggregate fiscal matters in the Dayton context.

### Annex — Issues for Discussion (selected chapter questions)
- Chapter II. Market Indicators of Confidence in the KM and the Banking System since 2000
  - Why is such a high proportion of bank lending still indexed?
  - Should indexation of loans be discouraged? If so, how?
  - Are households really so confident in the KM? Or is confidence increasing but still low? Do trends—however informally measured—in household holdings of Euro notes and coin shed any light on this?
  - Why has confidence in the KM not been shaken by elections or more recent political uncertainty?
  - Has confidence in the KM been secured?
  - Why have there been no bank runs in Bosnia and Herzegovina?
  - Is continued depositor confidence in banks consistent with the current pace of credit expansion?
  - What needs to be done to safeguard credit quality? Is there scope for further prudential regulation, such as on provisioning requirements?

- Chapter III. International Experience with Credit Booms and Large Current Account Deficits
  - What comfort does international experience provide in regard to Bosnia’s credit boom and external deficit?
  - To what extent are concerns in Bosnia mitigated by underrecording of GDP, or are the same mismeasurements apparent in other countries also?
  - Is evidence of growing confidence in the KM and the banking system (see companion paper) inconsistent with this international evidence, or does it reflect the low public awareness of the macroeconomic imbalances?
  - What accounts for the uniqueness of Bosnia’s credit growth and external deficits among currency boards?
  - What about transition, or about Bosnia’s experience of transition, suggests that rapid credit growth and large external deficits are of less concern than they would be in other contexts?

- Chapter IV. Corporate Sector Issues
  - Is the condition of the corporate sector as bad as suggested by the data, or is it worse?
  - Is there a need for a comprehensive corporate restructuring strategy, or is the ad hoc company-by-company approach adopted in recent years adequate?
  - Are there alternatives to bankruptcy for unprofitable companies?
  - Is excess and or fictitious labor the key impediment to rejuvenating enterprises? If so, how should it be tackled?
  - Is the current labor legislation and wage bargaining process a key impediment to realizing corporate revitalization?

- Chapter VIII. State-Building
  - Will State-building, if implemented as in the past, undermine fiscal and macroeconomic sustainability?
  - Is the level of State remuneration rates per capita the key problem?
  - If State remuneration rates per capita are not lowered significantly, should State building aspirations be curtailed or delayed?
  - How can savings be found, within the Police and Defense reforms, given State level remuneration rates?
  - Which, in the view of the EU, are the three most important State institutions which must be fully functional by end 2006?
  - Should veterans benefits be the main focus of expenditures which are cut to offset the expansion of State activities? If not, what other spending should be cut, and at which levels of government?
  - Does fiscal stability without OHR supervision require prior Entity agreement on annual State administrative expenditures?

- Chapter IX. Consolidated Cantonal and Municipal Fiscal Balances
  - How can arrears accumulation of cantons and municipalities be prevented? Through a tightening of bankruptcy procedures? Through provisions in the entity organic budget laws? Or in some other way?
  - How could an “early warning system” or direct controls over the use of escrow resources best be developed?
  - Is a rules-based approach to cantonal and municipal borrowing appropriate?
  - If yes, is a debt-service to revenue ratio the appropriate form of the limit?
  - What procedures should govern the appointment of a CMCB to ensure its technical effectiveness and political neutrality?
  - Should cantons and municipalities be treated differently in the transitional arrangements?

- Chapter X. Fiscal Sovereignty
  - What are the three main problems in the current arrangements for budget design and execution?
  - Will the proposals in this note improve matters, or make them worse?
  - Sovereignty over aggregate fiscal policy requires a diminution in the autonomy now enjoyed by component governments. Is it worth it?
  - How can deadlocks in negotiations over fiscal matters be resolved without the intervention of the OHR or the IMF?
  - Will public scrutiny by the JFC and the CBBH be able to provide a useful discipline on budget preparation and execution?
  - What, apart from regular and complete fiscal data publication, is required to make “mutual surveillance” work?
  - What arrangements to control Cantonal, Municipal, and extrabudgetary funds deficits are necessary to ensure that the NFC has effective control over the consolidated fiscal balance of governments in Bosnia and Herzegovina?
  - What should the relative roles of the MAU and the EPPU be?

*Source: _cr05198 - 35.      And more ambitiously, the NFC law could provide that the broader framework*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05198.pdf_