Press Release No. 02/35

The Executive Board of the International Monetary Fund (IMF) today approved an SDR 67.6 million (about US$89 million) stand-by arrangement for Bosnia and Herzegovina to support its economic program for the period August 2002-November 2003. The decision will enable Bosnia and Herzegovina to draw up to SDR 19.6 million (about US$26 million) from the IMF immediately.

Following the Executive Board discussion, Anne Krueger, First Deputy Managing Director and Acting Chair, said:

"The authorities have made progress toward achieving sustained non-inflationary growth over the past 18 months. The fiscal deficit has been lowered significantly, and fiscal reforms, including harmonization of sales taxes and the introduction of modern treasury systems, are being implemented. However, with economic activity recently decelerating, high unemployment rates, and large external current account imbalances, the need for further action is urgent.

"The authorities' economic program is timely. It focuses appropriately on prudent fiscal policy, maintenance of the currency board arrangement, and further structural reform. If strictly implemented, these policies should help achieve medium-term fiscal sustainability and access to foreign financing, thereby enhancing prospects for sustained economic and employment growth in an environment of low inflation.

"Fiscal discipline is a cornerstone of the program. A significant fiscal consolidation effort is to be undertaken in 2002-03, underpinned by military demobilizations and a prudent stance towards the execution of public spending during 2002. Fiscal structures will also be strengthened. The large stock of outstanding claims on the public sector will be addressed, and in that connection, all one-off receipts will be placed into escrow accounts in anticipation of a comprehensive domestic debt settlement.

"The strong fiscal stance will support the currency board arrangement, which has contributed to currency strength and stability, price stability, and a high level of international reserves. The banking system is sound, and efforts will be made to strengthen the role of bank credit in investment and enterprise activity.

"In the context of prospective declines in reconstruction aid inflows and high unemployment, strengthening the private sector will be critical for improving the business environment. To this end, the authorities are committed to harmonizing foreign investment regulations, strengthening bankruptcy procedures and the legislative framework for credit extension, and entrenching the rule of law. Efforts to accelerate the privatization of large strategic state-owned enterprises are also strongly encouraged.

"Finally, improvements in the quality of economic data will be essential for effective diagnosis and implementation of economic policies and program monitoring," Ms. Krueger said.

ANNEX

Recent Developments

Six years after the cessation of hostilities, normalization has yet to be secured. The currency board set up in 1997 has lowered inflation to industrial country levels, but the aid-financed post-conflict boom has lost momentum with output apparently still well below pre-war levels. Private investment and foreign direct investment remained mired in concerns over political risks, the hostile business environment, and infrastructure bottlenecks. In 2001, refugees continued to return to Bosnia and Herzegovina in significant numbers, swelling unemployment already likely in the low- to mid-20s. With internal resettlement also accelerating, many property rights disputes are coming to a head and personal security remains a concern for returnees, especially in rural areas. International peace-keeping and police forces—with a combined strength of 20,000—remain in place, though their numbers will be cut by a quarter immediately following the fall elections.

With aid declining, self-sustained growth has yet to take root. In 2001, activity decelerated—with the Republic of Srpska (RS) apparently in recession—and labor market and external imbalances remained sizable. Staff estimate that GDP in Bosnia and Herzegovina (BiH) slowed to around 2.3 percent in 2001 from 4.5 percent in 2000 with the Federation's GDP slowing to 4 percent in 2001 from 7 percent the previous year and the Republic of Srpska's GDP shrinking by 1.9 percent in both years. Nevertheless, in some key policy areas, prospects for growth have clearly improved. The currency board continues to anchor inflation and international reserves have risen strongly. Significant fiscal consolidation appears to have been achieved in 2001 and fiscal structures have been strengthened. But key blockages to growth remain, particularly in the area of fiscal policies.

Program Summary

The program primarily aims at strengthening activity and the external account balance in the near and medium terms as aid for post-conflict reconstruction, though still large, declines. The program supports good use of the reconstruction aid and continues laying the groundwork for life without it. As a first step towards its medium-term goals, the program targets real GDP growth to rise from 2.5 percent in 2002 to 4 percent in 2003, sizeable declines in the external current account deficit, and continued low inflation and strong international reserves.

A benevolent external environment alongside reduced aid-related imports is projected to lower the external current account deficit by some 4 percentage points of GDP over two years. Inflation, anchored by continued adherence to the currency board, is programmed to fall from just over 2 percent in 2002 to just under 2 percent in 2003 reflecting modest declines in imported manufactured price inflation and oil prices.

The program further promotes fiscal consolidation of 3.3 percentage points of GDP between 2001 and 2003, helped by two sets of measure. First, the demobilization of over 10,000 Federation soldiers, which has already begun, will yield annual savings on current expenditure of over 1.3 percent of BiH GDP once severance payouts are completed during 2002. Secondly, a series of steps to strengthen the fiscal system will be taken, including measures which attenuate tax competition, strengthen tax policy and administration (including strengthening its legal framework and applying taxpayer identification numbers), and steps to improve budget execution.

The budgets envisaged under the program for 2003 anticipate unchanged policies from 2002. Grant aid declines by 4 percentage points of GDP in the two years to 2003, offset by a rise in tax revenues of 1 percent of GDP. The overall fiscal outlook for 2002 reflects the policies of the various fiscal authorities and prospects for off-budget foreign investment projects: In the RS, the consolidated deficit on a commitment basis is programmed to fall from 1.2 percent of BiH GDP to 0.2 percent in 2002. In the Federation, the consolidated deficit on a commitment basis is programmed to rise to 1.8 percent of BiH GDP in 2002; and at the State level, the 2002 budget anticipates a deficit of 0.1 percent of BiH GDP. Receipts of funds from the Entities for debt service are matched by corresponding outflows to external creditors to service that debt. Revenues and expenditures will increase from 3 percentage points in 2001 to 4.6 percentage points of BiH GDP as commitments to the State Border Service and the new State institutions rise. The 2003 budgets will be prepared by incoming administrations after the fall elections. The program assumes unchanged policies from 2002. This secures a further deficit reduction of consolidated general government budget from 5.5 percent of BiH GDP in 2002 to some 3 percent in 2003 largely because of carry-over effects of policies implemented during 2002, notably the savings yielded by the military demobilization effected in 2002.

Public debt remains on a sustainable trajectory. At end-2003, public debt (excluding frozen foreign currency deposits and war claims) is projected at 71 percent of GDP, compared with 68 percent of GDP at end-2001. The increase reflects further reconstruction aid and donor-financed activities and the prospective takeover by the State government in 2002 of 2.1 percent of BiH GDP of state enterprise debt. Finally, the first essential steps will be taken to resolve the issues posed by the stock of public debt. Given that arrears cannot be settled in full without compromising fiscal sustainability and that a total default is neither desirable nor politically feasible, settlement must occur at a discount. The stand-by arrangement will secure the necessary foreign financing required to address the balance of payments need. Debt service rises in 2002-03 largely due to obligations to the IMF and World Bank, and the current account deficit is projected to remain large. Financing from the EU and the World Bank is contingent on formal IMF endorsement of policies.

Regarding monetary policy for 2002-03 period, the strict currency board arrangement will remain as the Dayton constitution requires that it remain until at least mid-2003, after which changes are subject to the approval of the State Parliament. Administrative changes to the currency board are envisaged, including the reanchoring to the euro at the final DM:euro rate. The permissible range for the reserve requirements imposed on commercial banks will be widened from the current 10-15 percent to 10-20 percent, providing some flexibility for monetary policy. The reserve requirement will remain unchanged at 10 percent during the stand-by arrangement.

Under the program, key steps will be taken to strengthen the operations of the private sector. In 2002, privatization initiatives will focus on selling large strategic enterprises long slated for sale. In the Federation, the authorities plan to sell at least 8 such enterprises, including several large industrial and telecommunications firms. Following several bank sales to foreign investors and bank closures in 2001, the privatization and/or restructuring of remaining state owned banks will proceed as follows. Of the eight remaining Federation state-owned banks, four will be privatized in 2002; one will be merged with a foreign bank, and one is under administration. Of the RS's eight state-owned banks, two are ready for privatization by mid-2002, two are at an advanced stage of preparation for privatization, and four are undergoing bank resolution procedures. By mid-2002, free trade agreements will be in operation in all of the former Yugoslav republics to be accompanied by bilateral free trade agreements with Bulgaria and Turkey.

Further ahead, investment-and savings-friendly policies will be required. Activity growth is projected to rise to 6 percent, stable low inflation, and a decline in the external account balance by 7 percentage points of GDP between 2003 and 2006 as aid inflows decline. On this basis, public debt ratios are projected to decline by 7 percentage points of GDP. This will require strengthened structural policies, lower taxes, and improved governance to stimulate corporate savings and private investment; a comprehensive domestic debt settlement to secure fiscal sustainability; and labor market and benefit reforms to encourage job-rich and poverty reducing growth.

Bosnia and Herzegovina, effective December 14, 1992, succeeded as one of five successor republics to the IMF membership of the former Socialist Federal Republic of Yugoslavia. Its quota¹ is SDR 169.1 million (about US$223 million), and its outstanding use of IMF credits totals SDR 85.3 million (about US$109 million).

Bosnia and Herzegovina: Main Economic and Financial Indicators, 1997-2003 1/
	1997	1998		1999		2000		2001 Est.		2002 Proj.		2003 Proj.
Population (millions)	4.2	4.2		4.3		4.3		4.3		...		...
Nominal GDP(millions of KM)
BiH	6,310	7,336		8,323		9,433		9,940		10,402		11,033
Federation 2/	4,942	5,602		6,142		6,698		7,086		7,421		7,978
Republika Srpska 2/	1,368	1,734		2,181		2,735		2,855		2,981		3,056
Real GDP growth (annual average)	36.6	9.9		9.9		4.5		2.3		2.3		4.1
Federation	36.2	8.3		10.4		7.0		4.0		3.2		5.6
Republika Srpska	37.9	15.8		11.3		-1.9		-1.9		0.0		0.5
Industrial production (percent change) 3/
Federation	36	24		11		9		12		...		...
Republika Srpska	27	23		2		10		-14		...		...
Wages (KM/month) 4/ 5/
Federation	493	506		551		606		651		679		...
Republika Srpska	174	256		314		384		442		516		...
CPI (twelve-month average)
Federation	14.4	5.2		-0.7		1.9		1.7		1.5		1.6
Republika Srpska	-7.3	-14.0		14.1		14.6		7.3		4.4		2.5
	(Change in percent of opening broad money)
Money and credit 6/
Broad money         (year-on-year)	-100	31		40		14		89		11		14
Domestic assets (net)	-384	31		-2		12		0		8		8
Foreign assets (net)	255	6		41		11		95		13		8
Other items (net)	29	-5		1		-9		-5		-11		-2
	(In percent of BIH, commitment basis, Consolidated General Government)
Federation
Revenue	...	36.4		34.7		34.2		33.2		33.5	34.4
Expenditure	...	39.5		38.0		37.7		34.5		35.3	34.4
Balance	...	-3.1		-3.2		-3.5		-1.3		-1.8	0.1
Republika Srpska
Revenue	...	9.4		12.5		12.6		12.4		12.3	12.0
Expenditure	...	10.7		14.4		45.0		13.6		12.5	11.9
Balance	...	-1.3		-1.9		-2.4		-1.2		-0.2	0.0
	(In percent of Entity GDP, commitment basis, Consolidated General Government)
Federation
Revenue	...	47.7		48.7		48.2		46.6		46.9	47.6
Expenditure	...	51.7		53.2		53.1		48.5		49.5	47.5
Balance	...	-4.1		-4.5		-4.9		-1.8		-2.5	0.1
Republika Srpska	...	39.9		43.7		43.5		43.2		43.0	43.3
Revenue	...	45.2		50.4		51.7		47.5		43.8	43.1
Expenditure	...	-5.3		-6.8		-8.2		-4.3		-0.8	0.1
Balance	...
	(In millions of U.S. dollars; unless otherwise indicated)
External current account balance (excluding official transfer)	-1,482	-873	-975		-971		-1,044		-1,015		-948
As a percentage of GDP	-43.3	-20.9	-20.8		-21.6		-23.1		-21.3		-18.7
Exports	575	702	744		903		1,002		1,165		1,388
CBBH gross reserves	80	175	455		488		1,193		1,570		1,620
In months of merchandise         imports	0.4	0.8	2.1		2.1		5.2		6.4		6.3
External Debt 1/
(In percent of GDP)	119.0	68.1	69.6		67.4		57.7		62.0		61.4
External debt service (in        percent of exports of goods        and nonfactor services)	16.0	9.2	8.5		5.4		5.1		7.5		7.6
Sources: Data provided by the authorities, and IMF staff estimates. 1/ Data refer to the entire country, unless otherwise indicated. 2/ Starting in 1997 in the Federation, and in 2000 in the RS, GDP is estimated based on 1993 SNA methodology. 3/ Manufacturing, mining, and electricity. 4/ Average gross wages in the economy as a whole. 5/ In 2002, first quarter only. 6/ Country-wide monetary aggregates. In percent of beginning of year broad money stock. 1 A member's quota in the IMF determines, in particular, the amount of its subscription, its voting weight, its access to IMF financing, and its allocation of SDRs.