Bosnia and Herzegovina, 2007 Article IV Consultation, Preliminary Conclusions

May 22, 2007

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

Sarajevo, 22 May 2007

The economy performed strongly in 2006. Real GDP growth is estimated at 6 percent. Prices surged following the introduction of the VAT, bringing average annual inflation to 7½ percent last year, but underlying price pressures were low and inflation returned to an annual rate of about 1 percent in early 2007. The VAT yielded high revenues—a large part of which was one-off—leading to a consolidated general government surplus (including foreign-financed projects) of 3 percent of GDP. And although problems with statistics preclude an accurate assessment, strong export growth and subdued imports reduced the external current account deficit last year to an estimated 11-12 percent of GDP.

This strong performance reflected a benign external environment and the effects of past economic reforms. Growth in Bosnia & Herzegovina's trading partners was strong, creating opportunities for exports. World prices of metals—a key export—rose further. Low world interest rates facilitated the financing of the current account deficit. Industrial production and exports of key products, such as steel and alumina, benefited from past privatization and foreign investment in these sectors. And the successful introduction and administration of the VAT led to the good fiscal outcome.

Economic performance in 2007 will continue to be good, but some long-standing weaknesses of the economy of Bosnia & Herzegovina will re-surface. The international economic environment is projected to remain favorable. Inflation pressures will remain contained and the recent growth will continue for the third year in a row, although the composition of growth will be different: exports, though still strong, will slow down, while domestic consumption and investment will rise. In contrast to these positive trends:

• The external current account deficit is likely to widen somewhat this year, as higher consumption and investment will translate into higher imports, as is already evident in the data for the first four months.

• Economic growth is not likely to make a significant dent in unemployment and will not benefit all sectors and regions of the country equally. In particular, because labor mobility is limited, unemployment in depressed areas is likely to remain high.

• The government's failure to resist spending pressures will be reflected in a sharp deterioration of the government balance. The one-off effects of the VAT will disappear while the bill for populist pre-election spending increases—most notably by the Federation and cantonal governments—will come due this year. Therefore, as we had warned at the time of the 2006 Article IV consultation, unless bold measures are taken to control spending, the accumulated surpluses from 2006 will evaporate and the general government will register a deficit of 1-1½ percent of GDP in 2007.

Now is the time to start addressing these long-standing weaknesses, while the external environment is still positive and growth continues to be strong. Last year, this opportunity was missed because of the elections and the absorption of decision-makers with domestic politics. But the new governments have a fresh mandate and a long time horizon and should not let this opportunity slip again.

Improving statistical data is a prerequisite for successful economic management. Cooperation among statistical agencies and other data providers is inadequate. In the long run, the answer lies in unifying the separate agencies. In the meantime, the coordinating role of the Statistical Council should be strengthened and the managements of the three agencies should enhance cooperation. Improvements in national accounts and price statistics, under preparation for some time now, should be implemented as quickly as possible. Despite some progress, major problems in the timeliness and coverage of general government statistics persist. There has been very little progress in the area of balance of payments statistics, and we again urge the CBBH to improve these data, particularly for remittances.

Put order in the public finances

Fiscal policy is the only macroeconomic policy instrument under the currency board. During our discussions, it became clear that many of our counterparts see the budget mainly as an instrument for pursuing the government's social goals. The budget is, of course, all this, but it is also a macroeconomic policy tool—indeed the only such tool available to Bosnia & Herzegovina. And given the high external current account deficit, fiscal policy should be primarily aimed at ensuring macroeconomic stability.

• In the rest of this year, the governments should act urgently to minimize the deterioration in the general government balance from 2006. This would require (1) both Entities to stick to the spending plans in their original budgets; and (2) the Federation government to take measures to offset the deficits likely to arise in cantonal budgets, which could amount to KM 130 million. We support the consolidation of the various laws dealing with demobilized soldiers' and veterans' benefits in the Federation, but this may not be sufficient to yield the required savings.

• The general government should maintain a balance over the medium term. Keeping a balanced budget (including foreign financed investment projects) while reducing the tax burden and making room for priority infrastructure investment will require significant cuts in expenditures at all levels of government. There is ample scope for savings in social transfers, public administration, and subsidies, as identified in the recent World Bank Public Expenditure Review.

• Maintaining a prudent fiscal position will be all the more difficult if the VAT revenue is eroded.

The terms of settling domestic claims against the government should be consistent with fiscal sustainability. The proposed amendments to the law dealing with frozen foreign currency deposits should be rejected, the verification process accelerated, and the potential liability from enforceable judgments assessed. And a law on restitution should be adopted to limit financial compensation in line with the budget's long-term ability to pay.

Privatization receipts are both an opportunity and a challenge. The RS and—hopefully soon—the Federation will receive large amounts of privatization revenue. These funds should be used for the long-term benefit of the economy. Both Entity governments assured us they do not intend to use them to finance current spending. What should they use them for?

• The first best would be to use them to finance the introduction of fully-funded pension pillars, as planned in the RS.

• Using them for investment in infrastructure is a second best option and has risks: it is not clear that the Entities have the administrative capacity to ensure that these funds are invested wisely.

• Using them to finance private business development in "strategic sectors" is not a good option: if the business environment is improved, the private sector should be able to accomplish this without government support; if not, government support will make little difference and the money will be wasted.

In addition, sizeable privatization revenue may complicate liquidity management in the financial system and jeopardize macroeconomic stability. To avoid this, the Entity governments should deposit these receipts abroad or with the CBBH until it is time to spend them, and spread out their use over time.

Private sector involvement in road building should be encouraged but has risks. Concessions and public-private partnerships are a good way to improve the road infrastructure utilizing private sector resources. But these agreements can result in significant future liabilities for the government. We recommend caution and—as elsewhere in the region—are ready to assist Bosnia & Herzegovina with our technical expertise in building the appropriate accounting and institutional framework for public-private partnerships.

Fiscal policy will not achieve its goals unless institutions and management are improved. Fiscal institutions in Bosnia & Herzegovina are fragmented and do not promote policy coordination. The laws on government debt and borrowing are a welcome step forward, but there is major unfinished business in this area.

Provide a firm legal basis for the Fiscal Council. Adoption of the draft law seems to be delayed by procedural disagreements. We urge the governments to address the shortcomings of the draft (expand the definition of the primary balance to cover capital spending, and strengthen the penalties in case of noncompliance), resolve procedural issues, and adopt the law as quickly as possible.

Agree on a revenue allocation formula that respects the three principles put forward by the Chairman of the Governing Board of the Indirect Tax Authority: simplicity, clarity, and fairness (upside and downside fluctuations in tax revenue should be shared equally by all). The recent OHR decision on the revenue share of the District of Brcko is not consistent with these principles.

Stop the proliferation of extra-budgetary funds and off-budget agencies. Entity governments' plans to expand or create new funds or agencies off-budget would reduce the transparency and accountability of these operations, as well as the government's control over the use of taxpayers' money. In any event, the activities of these agencies should be included in the statistics of the general government sector.

Strengthen financial stability

While the pace of credit expansion per se is not a major concern, certain aspects of this phenomenon need the close attention of policy-makers. The extension of the credit registry to individuals is a welcome step. But under the pressure of competition, commercial banks may be taking on higher credit risk. While this risk still appears to be relatively small, it may be concentrated in some banks. The fact that some large banks are repeatedly fined for violations of prudential rules also suggests that the fines are too low. Moreover, current regulations create a bias in favor of bank borrowing from abroad to finance credit expansion. To address these concerns, we recommend the two Entity supervisory agencies to:

Tighten loan classification by moving loans with payments overdue more than 30 days to category C, in line with best international practice. This measure should be introduced gradually over the next 12-18 months to provide sufficient time to commercial banks to adjust their practices.

Raise the fines for noncompliance with prudential regulations.

Relax gradually the maturity matching requirement between banks' assets and liabilities in order to weaken the link between credit expansion and foreign borrowing by allowing banks to finance the former with shorter-term domestic deposits.

A unified bank supervision agency is necessary. No-one in Bosnia & Herzegovina disagrees with the principle that unifying supervision is needed for what is increasingly a country-wide banking system. A single, independent, and effective supervisor, either at the CBBH or in a separate agency, would strengthen the financial sector and benefit the economy of each Entity. It would also allow the conclusion of Memoranda of Understanding with key foreign supervisors. But like other economic policy measures, this decision is hostage to domestic politics. We urge the authorities to consider this issue primarily on technical and economic grounds. As we noted at the conclusion of last year's Article IV consultation, we will continue providing assistance as needed to make progress in this area.

Until supervision is unified, we encourage the CBBH to play a more active role in coordinating supervision. The CBBH, with assistance from the IMF and the European Central Bank, is upgrading its monitoring and analysis of the financial sector. Together with the supervisors, it should set up a systematic way to share information and establish regular dialogue at a senior level. It should also use this upgraded analytical capacity, as well as its authority, to inform the authorities, the banks, and the public about issues of financial stability. While these steps are necessary, they do not remove the need for unified bank supervision.

Complete the creation of a single economic space

The last few years have seen significant economic convergence between the two Entities but little real integration. The economy of the RS has broadly caught up with that of the Federation in terms of income per capita, prices for basic goods, and wages. While this convergence is a natural development, there are few signs of economic integration between the two Entities, and even across the cantons of the Federation. Labor mobility is very limited, leading to persistent unemployment differentials between regions, and there is a myriad of regulatory and administrative barriers to the mobility of companies and services across the country. This not only perpetuates the differences between regions but also holds back the development of the country as a whole. To redress this, the authorities should:

Harmonize corporate and personal income taxes. Corporate income taxes are 10 percent in the RS but 30 percent in the Federation, and the tax base is different. This makes it hard to do business in both Entities.

Harmonize the base for employers' contributions on wages and enforce vigorously compliance in both Entities.

Facilitate labor mobility by (1) amending labor legislation to stop the accumulation of wage claims in cases where workers are not effectively employed by the company and allow workers to switch employers without first having to settle existing claims; and (2) harmonizing and ensuring the portability of pension and health benefits. In the process, reform the pension and health systems to ensure their long-term viability.

Improve the business environment by streamlining the processes for obtaining permits, reducing the regulatory burden, and simplifying inspections. This is a major obstacle to private sector development and job creation, and pushes activity into the informal sector. The RS has started making progress in this area assisted by USAID.

Harmonize the laws on securities and companies to facilitate capital mobility and capital market development.

The recent positive economic trends highlight the resilience of the private sector in Bosnia & Herzegovina. To sustain this development and help the economy realize its full potential, policy-makers should take advantage of their new mandate from the electorate to start addressing the imbalances and inefficiencies in the public sector. The policies outlined above could form the basis of the governments' economic program.


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