Bosnia and Herzegovina--2006 Article IV Consultation, Preliminary Conclusions

July 12, 2006

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.

June 26, 2006

How will 2006 be remembered? As a year of economic progress?...

In the year since the last Article IV consultation, Bosnia & Herzegovina has made good economic progress in certain areas. At an estimated 5-5½ percent in 2005 and 2006, real GDP growth has been satisfactory. Despite higher oil prices and the impact of the VAT, underlying inflation has remained relatively low, underpinned by the currency board. Export performance has been strong. Some progress has been made in containing the financial burden of domestic claims. And financial intermediation has deepened while, at the same time, the credit registry will help strengthen bank risk management.

The most notable development was the successful introduction of a VAT. The VAT is having a major impact on the economy and, not surprisingly, has generated different reactions. It is too early to draw definite conclusions about the magnitude of this impact. Our assessment, based on the information available so far, is summarized in Box 1. But beyond its economic impact, the VAT has had two major, though less tangible, benefits: (i) it is already helping reduce the grey economy; and (ii) it has been an important step toward the creation of a single economic space and, through the Single Account, toward state building in Bosnia & Herzegovina.

Box 1. The impact of the VAT

On prices: Consumer prices in May were 8.6 percent higher than their level a year earlier. We estimate that the VAT accounts for 3-3½ percentage points, and the rest reflects underlying inflation and the impact of administrative price increases in late 2005 and 2006.

On imports: Imports spiked in December 2005 in anticipation of the VAT and fell drastically in January. This forward shift in imports, which raises the external current account deficit in 2005 and reduces it in 2006, is estimated at 1½ percent of GDP.

On exports: Exports increased strongly in early 2006 (33½ percent in the first four months relative to the same period last year). Some of this increase probably reflects stronger incentives for accurate reporting by exporters due to the VAT, but the precise extent of this factor is hard to estimate.

On tax collection: The VAT and sales tax collection through May amounted to 6.4 percent of GDP compared to 4.5 percent of GDP in the same period of last year. However, collection of delayed sales tax from December 2005 was 1 percent of GDP and outstanding VAT refunds and credits another 0.6 percent of GDP; these will not be repeated next year. The permanent gain from the VAT is thus estimated at around ¼ of a percentage point of GDP.

... or as the year when policies took a wrong turn?

The increasing focus on the forthcoming elections is causing policy paralysis and, in some areas, policy reversals. And this at a time when the role of the OHR is declining and Bosnians are finally taking full responsibility for running their country.

Budgetary coordination and discipline are breaking down. The 2006 targets agreed by the National Fiscal Council late last year were abandoned by the RS in March. New spending commitments have been made, such as the Federation legislation for the civilian victims of war that could add up to KM 90 million to expenditures. Widespread wage increases are planned at lower levels of government. And there are calls for weakening the VAT with various exemptions and for spending the "extra revenue" although, as Box 1 shows, most of this extra revenue is temporary.

Structural reform efforts have atrophied. Key legislation, such as the Law on Obligations, is delayed. The State Wage Law has been left to drift for so long that its passage this year is now unlikely. And privatization has stalled in the Federation.

If this paralysis is allowed to continue, the next State and Entity governments will be faced with a significant fiscal problem in 2007. Our preliminary estimates suggest that, if current policies continue, the consolidated general government balance will decline from a surplus of 1 percent of GDP in 2005 to a deficit of ¼ percentage point this year and to a deficit of about 1 percent of GDP in 2007, a cumulative deterioration of 2 percentage points of GDP over two years.

There is still time for government leaders to take action and focus on a few key goals before the elections.

Resist pre-election fiscal pressures. This requires keeping spending in line with the 2006 budgets, especially on wages and defense; maintaining discipline on borrowing by lower levels of government; enforcing cut-off dates for Entity pension funds; and rejecting zero rates and exemptions for the VAT.

Maintain the integrity of the Single Account. First, Entity governments must resolve the dispute on the distribution of revenue as soon as possible. Otherwise, their budget execution will again be disrupted and, more importantly, the credibility of the ITA and the Single Account—key components of state building—will be shaken. For this solution to be sustainable, the Entities must arrive at it by themselves. And second, proposals to earmark any part of revenues of the Single Account must be resisted.

Set the stage for a sound 2007 budget. This requires adhering to the harmonized budget calendar of the Intergovernmental Coordination Group; consolidating foreign-financed projects in the budget; agreeing on an appropriate overall general government target; and passing the State wage law.

Create a strong National Fiscal Council (NFC). A good NFC law should draw on the lessons from international experience, summarized in Box 2. But the most important lesson is that no system can work without the political will to cooperate. In addition, for the NFC to work effectively, the technical cooperation between the Finance Ministries should be formalized and the law establishing the EPPU as part of the public administration should be adopted.

• Strengthen financial sector supervision by ensuring parliamentary confirmation of the management of the Federation Banking Agency, agreeing on the modalities for unifying bank supervision, and approving a leasing law at the State level.

Box 2. Fiscal coordination mechanisms: lessons from the international experience

Our research on fiscal coordination mechanisms, drawing on the experience of Austria, Australia, Belgium, Brazil, South Africa, Switzerland, and the EU, shows that there are different approaches to fiscal coordination, but all involve fiscal rules or independent fiscal institutions or a combination of the two.

Countries with fixed exchange rates require stricter rules and stronger institutions than those with flexible exchange rates.

Successful coordination requires a unified budget calendar, consistent accounting rules, and regular fiscal reporting across all levels of government.

The effectiveness and credibility of any coordination mechanism depends on the existence of penalties, as well as the ability and willingness to enforce them. The strongest mechanisms impose penalties automatically on those who violate the agreed policies. Such penalties can be waived only by a majority vote.

In all cases, the total level of public spending and the aggregate balance are decided at the national level and the responsibility for enforcement of penalties rests with the national government. The distribution of revenue, spending, and the aggregate balance is negotiated between national and sub-national governments.

Fiscal rules and independent fiscal institutions are necessary but not sufficient to guarantee good fiscal policies; political will to coordinate is a central requirement.

A four-point agenda for the new governments after the elections

1. Competitiveness and development

The key goal for Bosnia & Herzegovina is to reduce the current account deficit while stimulating self-sustained growth. This requires strengthening competitiveness, which in turn will increase exports, economic activity, jobs, and domestic savings. Domestic savings are currently low because of weak corporate profitability and low foreign investment. And while exports are expected to rise rapidly in the near term, primarily as a result of past investments in the metal sector, their growth will not be sustained and their base will remain narrow and vulnerable to world commodity price movements unless structural reforms are advanced.

What needs to be done is well-known. Bosnia & Herzegovina ranks last in Central and Southeastern Europe in terms of structural reforms and needs to catch up. Otherwise, growth and job creation will be held back and the currency board, which has been the foundation of monetary stability during the last decade, will increasingly be questioned.

• Bankruptcy procedures should be enforced and privatization stepped up, particularly in the Federation.

• Debt write-offs for companies should only take place in the context of privatization. The recent Federation law needs to be amended to make this link explicit. Alongside, the collection of current taxes and contributions should be strictly enforced.

• Re-opening past privatizations can damage investor confidence and should be avoided.

• Labor and other legislation should be amended to stop the accumulation of wage claims in cases where the workers are not effectively employed by the company and to allow workers to switch employers without first having to settle existing claims.

• Collective wage negotiations should only apply to the signatories to the agreements and, in the private sector, should take place without interference by the government.

Comparison of EBRD transition indicators
  Enterprises Markets and trade Financial institutions Infrastructure
  Private sector share of GDP EBRD mid-year estimate (%) Large-scale privatization Small-scale privatization Governance & enterprise restructuring Price liberalization Trade & foreign exchange system Competition policy Banking reform & interest rate liberalization Securities markets & nonbank financial institutions Infrastructure Reform
BiH 55 2.7 3.0 2.0 4.0 3.7 1.0 2.7 1.7 2.3
CE/Baltic 1/ 76 3.8 4.3 3.4 4.3 4.3 2.9 3.8 3.3 3.2
SE Europe 2/ 67 3.3 3.8 2.4 4.2 4.2 2.1 3.1 2.1 2.6
Sources: EBRD Transition Report, 2005; IMF staff calculations of (unweighted) regional averages.

1/ Eight new EU member states: Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic, and Slovenia.
2/ Southeastern Europe (excluding Bosnia and Herzegovina): Albania, Bulgaria, Croatia, Romania, FYR Macedonia, and Serbia and Montenegro.

2. Macroeconomic stability

Fiscal policy is essentially the only macroeconomic policy instrument under a currency board. It should be aimed at both short-term stabilization and long-term sustainability.

• The 2007 budgets should reverse the deterioration in the consolidated general government balance that, under current policies, is likely to arise. They should target at least a balanced budget position (including foreign-financed projects), underpinned by credible measures to achieve it.

• Over the medium term, fiscal policy should contribute to the increase in total domestic savings and should offset the burden of various domestic claims against the government. These two factors require maintaining a small overall general government surplus (¼-½ percentage point of GDP). This target may need to be adjusted as the terms of settling domestic claims are clarified in the period ahead.

In both 2007 and the medium term, new spending should be accommodated by reducing existing expenditure, especially on public administration and transfers. Bosnia & Herzegovina needs to upgrade public infrastructure and prepare the economy for EU membership in the long run. But with an already large share of the government in GDP, which should be reduced, and the need to lower the tax burden, especially on employment, these additional expenditures can only be accommodated by finding savings elsewhere. There is ample scope for savings: public administration suffers from duplication of functions and inefficiency; and spending on wages and social transfers is much higher than in similar economies, and indeed has risen rapidly in the last two years. These two categories alone account for almost two-thirds of total public spending.

Until the terms of settling all domestic claims against the government are finalized in a legally sound and financially sustainable manner, this issue will continue to hang like Damocles's sword over the public finances. Some progress has been made in recent months: the law on frozen foreign currency deposits has set out terms that are fiscally sustainable; likewise the law on internal debt in the RS. But the law on internal debt in the Federation is a step in the wrong direction: not only is the maximum amount much higher than necessary, but the terms appear to be more generous than required by the Constitutional Court ruling, and the law may not prevent a claimant simultaneously pursuing his claim through both administrative channels and the courts.

The law on restitution currently in preparation should be consistent with fiscal sustainability. Political pressures to broaden the scope of restitution should be resisted; restitution in kind should be limited so as not to generate uncertainty about property rights; and monetary compensation should be capped in line with the budget's long-term ability to pay. Last but not least, all restitution should be undertaken in the framework of the law.

The Central Bank has an important supporting role to play in ensuring macroeconomic stability. The reserve requirement has limited effectiveness as an instrument of macroeconomic policy. Nonetheless, although its current level seems broadly appropriate, the Central Bank should stand ready to adjust it if needed. In this connection, we support the removal of the 20 percent cap. In addition, the Central Bank should continue monitoring the economic situation and bringing independent macroeconomic analysis to the NFC.

Sound macroeconomic policies depend on sound statistics. With the exception of monetary and central government data, the coverage and quality of statistical data are very poor. The Central Bank should urgently work on improving balance of payments estimates; cantons and municipalities should report their budget execution regularly; and to foster cooperation and exploit synergies, the State- and Entity-level statistical agencies should as a first step be brought under a single budget.

3. A sound and well-supervised financial system

The recent Financial Sector Assessment Program (FSAP) mission identified several shortcomings in bank supervision. These include the lack of consolidated supervision; inadequate loan classification and provisioning rules; lack of adequate legal protection for supervisors; and insufficient cooperation with foreign supervisors.

We believe that a single banking supervisory agency for what is now a national banking system is necessary. Several countries have tasked the central bank with bank supervision, while others have independent supervisory agencies. Given that Bosnia & Herzegovina already has a strong and independent central bank, it would make sense to unify bank supervision there. But creating a separate agency would also work—although it would demand greater effort to ensure its independence and effectiveness. The unified supervisor should initially concentrate on banking and leasing, and could gradually assume oversight of the rest of the financial sector.

Leasing and insurance activities are growing fast but supervision is weak or nonexistent. This creates significant risk for these sectors and, ultimately, for the public. A law setting up the legal framework for leasing and giving supervisory authority to the unified supervisor is urgently needed. And technical regulations and capacity in insurance supervision need to be built up.

4. Efficient and accountable fiscal structures

Public finances should not only serve the goal of macroeconomic stability but also promote economic efficiency and accountability in the use of public resources. These broader objectives will require far-reaching reforms. Although the timetable for these reforms is longer, it is important that the necessary political debate be started soon on:

Reforming and coordinating direct taxes to reduce distortions and promote tax compliance, labor market participation, and investment.

Harmonizing the provisions of the social safety net and pension systems in order to develop a single labor market. In the process, reform the systems to ensure their long-term viability. The pension reform plans currently discussed in the RS could stimulate a wider debate in the country, which should also draw on international experience.

Rationalizing inter-governmental fiscal relations to provide incentives for cooperation, align taxing authority with spending responsibility at each level, and facilitate the shift of competencies from Entities to State.

* * * * *

It is often easy to overlook the progress that has been made in Bosnia & Herzegovina and focus only on the problems, both political and economic, that remain. We are aware of this risk and strive to be as balanced as possible. At the same time, it is also easy to derive a false sense of security from the monetary stability and satisfactory growth record of the last few years. But monetary stability alone does not guarantee sustainable development and rising living standards. Achieving these goals requires tough political choices. It may be tempting to want to lean on the international community for a little longer. But there is nothing in the policy agenda we outlined above that requires intervention by the OHR or that Bosnians themselves cannot tackle. Most of the counterparts we met here during the last two weeks are ready to do so, and the IMF is ready to assist as necessary.

Banja Luka, 26 June 2006


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