Bosnia and Herzegovina: 2008 Article IV Consultation, Preliminary Conclusions of the Mission

June 26, 2008

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.

Preliminary Conclusions of the Mission
June 24, 2008

1. Following several years of robust economic performance, Bosnia & Herzegovina (BiH) is facing new challenges. Accelerating inflation, a widening external deficit, and a worsening external environment amid rising fiscal and wage pressures, are combining to complicate policymaking in the period ahead. With the risks to macroeconomic stability and growth rising, progress on fiscal and structural reforms is assuming added urgency. The welcome signing of the Stabilization and Association Agreement (SAA) opens the road to EU accession and holds the promise of becoming a catalyst for accelerating much needed reforms.

Recent Developments

2. Strong economic performance in recent years is giving way to macroeconomic imbalances. Real GDP increased by a cumulative 30 percent since 2002, somewhat below the convergence path traced by other central and eastern European countries at a similar point in transition. Continued strength in private sector credit growth has been associated with a widening external deficit, which reached 13 percent of GDP in 2007. The deficit was fully covered by FDI, and gross official reserves increased to the equivalent of 5½ months of imports. Inflation has emerged as a new concern, with underlying inflation—excluding food and energy prices—picking up since late 2007.

3. Expansionary fiscal policy has added to these imbalances. The general government registered a deficit of 0.3 percent of GDP in 2007, compared with a 2.2 percent surplus in 2006. As a result, fiscal policy added further stimulus to already strong domestic demand. With spending on wages and transfers to households rising sharply, total government expenditure increased by 4 percentage points of GDP to reach almost 50 percent of GDP in 2007. In the Federation of Bosnia & Herzegovina (Federation), mounting spending pressures have led to liquidity problems.

4. Progress on structural reforms has been slow and BiH trails its best-performing peers on most structural indicators. On the fiscal side, recent income tax reforms represent a welcome step toward greater harmonization and transparency. Progress has been mixed on the broader range of structural reforms. In addition, fiscal policy coordination has been weak and creation of a single economic space remains elusive. Privatization advanced in the Republika Srpska (RS) last year, but has yet to take off in the Federation.

Looking Ahead

5. Growth in 2008 is accompanied by increasing vulnerabilities. Output growth is projected at 5½ percent and headline inflation will average 7½ percent, with underlying inflation pressures continuing. The envisaged loosening of fiscal policy (from a 0.3 to a 2 percent of GDP deficit) and incomes policy will exacerbate demand pressures, and contribute to a further widening of the current account deficit to 16 percent of GDP. The private sector is coming under pressure from both an expanding government sector and tightening credit conditions. These trends, in the context of an uncertain external economic environment, pose risks to the country's medium-term stability and growth prospects.

6. This underscores the urgency for tightening fiscal and incomes policies, and accelerating reforms. In the currency board setting, tight demand management policies will help keep inflation under control and safeguard competitiveness. Moreover, raising potential growth will require increased investment and efficient government spending. Higher investment will increase capital's contribution to output growth, while enterprise restructuring and privatization will help sustain strong productivity gains and underpin a dynamic export performance. With the right policies in place, output growth could accelerate to levels seen in the best EU performers.

Fiscal and Incomes Policies

7. There is agreement that fiscal policy is key for ensuring macroeconomic stability and promoting growth. However, mounting commitments for transfers to households in the Federation and rapidly increasing public sector wages are at odds with these objectives. Alongside, we understand that the signing of the SAA will imply customs revenue losses that will not be fully offset by increases in excises. Thus, unless current spending is rationalized, capital expenditure will likely be squeezed (to keep the deficit under control), curtailing the country's growth potential. In the mission's view:

• The adopted budgets imply a general government deficit of 3 percent of GDP for 2008. On account of continued strong revenue performance and the historical pattern of underexecution in investment projects, the mission projects a slightly lower deficit outturn of 2 percent of GDP. Nonetheless, this represents a significant and ill-timed fiscal expansion.

• The rising external imbalance calls for strong efforts to keep the overall fiscal accounts in balance in 2008. This will mean: (i) the RS government saving as much as possible from its revenue overperformance; (ii) in the absence of legislative changes, the Federation government cutting other spending to accommodate increases in social and war-related benefits; and (iii) the lower levels of government taking measures to support the balanced budget target.

• The general government should target at least a balance in 2009 and over the medium term. Such a fiscal target would keep public debt under control, leave room for the private sector to operate, and gradually improve BiH's external position.

• Achieving this target will require reductions in current spending, including rationalizing the wage bill, reducing subsidies, and, most importantly, curtailing social spending in the Federation, as set out in the World Bank's PEIR.

• Addressing ever-increasing social and war-related transfers in the Federation is urgent. The government should strengthen its efforts to reform the plethora of benefits, including those to war veterans, demobilized soldiers, and civil victims of war. The reform should aim at consolidating the various elements into a single system with more effective eligibility tracking. Earmarking of funds should be avoided.

• Action is required to change the practice of approving legislation that creates unfunded future spending commitments. Any new spending proposals should be accompanied by identified funding or offsetting measures.

• Private sector involvement in infrastructure is welcome, but carries risks. Concessions and private-public partnerships are a good way to improve infrastructure utilizing private sector resources. However, we recommend caution as these agreements could result in significant future liabilities for the government.

8. Privatization proceeds should be used to support BiH's growth objectives without compromising macroeconomic stability. We are encouraged by the commitment of the RS authorities to use most of the funds for infrastructure and pension reform. In the Federation, plans have been drawn up to use most of the proceeds for public investment but we remain concerned that a large part will be used for recurrent spending. We also continue to have concerns about the effectiveness of subsidized lending through the Development Banks. Not to compromise macroeconomic stability, the mission urges the authorities to proceed cautiously and to engage in a systematic evaluation of alternative uses of privatization proceeds.

9. A strict public sector wage policy is needed. In addition to helping contain inflation, prudent wage policy in the government sector will help preserve competitiveness and support private sector development. To this end, the public wage reforms in the central government (State) and the RS, which seek to simplify the wage structure and consolidate some allowances with wages, are welcome. Although public sector wages in the RS have increased sharply, the government's commitment to improve efficiency and to freeze wages for the next three years is expected to keep its wage bill under control. The wage indexation mechanism in the State wage law raises concerns about increases in the wage bill next year and beyond; this underscores the role of the State administration in containing the wage bill pressures. The mission has similar concerns about wage indexation mechanisms in the Federation and in lower levels of government, and about the risk that public sector wage competition will spill over to private sector settlements. To minimize the risk of a feedback loop between public and private sector wages, future government wage increases should not be automatically linked to those in the private sector.

10. Better coordination among all levels of government remains key.

• The mission welcomes the establishment of the Fiscal Council and encourages the authorities to make it operational as soon as possible. This will require putting in place a number of important elements, including harmonizing the budget calendars; establishing a comprehensive, timely, and transparent reporting of budget and execution data; and mandating all levels of government to provide such data to MAU on a uniform and consistent basis. Moreover, the Central Bank of Bosnia & Herzegovina's (CBBH) observer status gives it a critical role in providing policy advice to the Council in the context of the currency board setting.

• Agreeing on a permanent indirect tax revenue allocation formula should also be a priority goal to bring stability and predictability to budget planning and to end time-consuming negotiations.

• A speedy resolution should be reached on the issuance of all frozen foreign currency deposit bonds.

Financial Sector Issues

11. In an environment of rising costs and interest rates, financial supervisors need to closely monitor credit risk. Higher consumer price inflation and input costs are beginning to put pressure on the budgets of households and enterprises, raising concerns about their ability to service loans. Dominated by subsidiaries of foreign banks, the financial system has already felt pressure from the global liquidity squeeze and risk repricing. As a result, bank profitability in the first quarter of 2008 registered its lowest level in the past few years. Although the CBBH's stress tests based on end-2006 data show that the banking system is resilient to shocks, supervisors should not hesitate in encouraging banks to strengthen their capital positions.

12. Progress in policy coordination between the CBBH and the banking agencies should continue. The signing of the Memorandum on coordination between the CBBH and the banking agencies is a good step towards advancing the financial stability work program at the technical level. Better coordination, however, is also needed at the policy level. We encourage the CBBH and the banking agencies to inform each other of monetary policy and major prudential decisions. Improved coordination should extend to plans to modify asset classification and provisioning rules that take into account the credit cycle and the banking system's health.

13. Further enhancing supervisory oversight of risk management is important and will require strengthening the capacity of supervisors. We are encouraged by measures taken to mitigate risks such as the introduction of regulation on effective interest rates to improve transparency, and the relaxation of the maturity matching rules to ease pressures to borrow from abroad. Moreover, the two banking agencies have introduced new regulations on liquidity, market, and operational risk management, and have recently begun to take on supervision of leasing companies and micro-credit organizations. While this progress is commendable, it also presents a challenge to supervisors in handling new tasks.

Capacity Building

14. Strengthening administrative capacity and improving macroeconomic statistics are prerequisites for successful economic management. To this end, it is important to upgrade expertise and capacity at various relevant institutions (e.g., the CBBH, DEP, and MAU). The CBBH is encouraged to expand and publish its analytical work, including the preparation of a medium-term macroeconomic framework. Significant problems still exist in the timeliness and coverage of general government statistics. The mission urges the authorities to strengthen their efforts to improve the quality of fiscal data, to enhance the effectiveness of the Fiscal Council.

We would like to thank the authorities for the close cooperation with the mission and we look forward to continuing the dialogue. We also stand ready to support the authorities through technical assistance and policy advice.


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