Mission Concluding Statement 

May 12, 2015

An International Monetary Fund (IMF) mission, led by Ron van Rooden, visited Banja Luka and Sarajevo during April 28-May 12 to conduct the 2015 Article IV consultation discussions. The concluding meetings with the authorities also covered Bosnia and Herzegovina’s assessment under the IMF Financial Sector Assessment Program, conducted during November 2014 by a team led by Sònia Muñoz. The mission is grateful to the authorities and all other counterparts for their excellent cooperation and frank and open discussions. At the conclusion of the mission, Mr. van Rooden issued the following statement:

After difficult years, signs of an economic recovery

1. Bosnia and Herzegovina had experienced strong growth prior to the global financial crisis. Sizable inflows into the banking system fueled a credit boom, while the introduction of value added taxation in 2006 allowed for large increases in public sector employment and in public wages and social benefits. But while incomes rose, so did domestic and external vulnerabilities. When output collapsed in the aftermath of the global crisis, the current account and budget deficits rose sharply, and with that public debt. Growth was lackluster following the crisis, with several starts and stops, reflecting weak activity across Europe and deleveraging by foreign-owned banks.

2. External and internal imbalances have been gradually reduced in recent years, mainly through fiscal consolidation, but also reflecting lower investment and higher savings. The economy started to recover in 2013, with growth reaching 2.5 percent. This progress was interrupted by the natural disaster that hit Bosnia and Herzegovina in May 2014. However, the economy proved more resilient to the impact of the disaster than initially expected. Production and exports rebounded faster than anticipated, and despite the limited disbursements of donor assistance—beyond the immediate emergency assistance—growth is estimated to have reached over 1 percent in 2014. The current account and budget deficits widened, but much less than had been feared, while public debt rose to 45 percent of GDP by end-2014.

3. After these difficult years, the recovery is showing signs of taking a firmer hold. As economic activity is projected to pick up in Europe, growth in Bosnia and Herzegovina is expected to rebound to over 2 percent this year. Industrial activity and exports will gather momentum, and together with the decline in fuel prices, this will boost incomes and consumption. Reconstruction efforts could significantly support the recovery, provided that the authorities can speed up the absorption of assistance that donors have made available and projects can be gradually implemented. Meanwhile, deflation has been imported through the currency board arrangement and inflation is projected to remain low in the period ahead.

4. Looking ahead, growth could accelerate to 4 percent over the medium term, provided that sustained progress is made in structural reform implementation. Absent this, growth prospects are likely to be much weaker than before the crisis. Also, the outlook remains subject to substantial risks. On the external side, risks are balanced, as stagnation in Europe, possible financial market strains, or geo-political tensions could dampen growth, while a faster recovery in Europe or the resolution of trade issues between Bosnia and Herzegovina and the EU could spur exports. Domestic political risks, however, continue to weigh heavily on the outlook, as the risk of policy slippages is significant given the complex political set-up.

Lagging reform implementation holds back incomes and employment

5. Despite recent progress, Bosnia and Herzegovina still substantially lags its peers in income convergence to advanced European economies, with per capita income averaging only about a quarter of the average income level in advanced European economies. Unemployment is stuck at a very high level, and high youth and long-term unemployment are particularly worrisome. With few private sector jobs and high reservation wages as a result of sizable remittances and relatively high public sector wages, job seekers look for opportunities abroad or “wait” for a job in the public sector.

6. The poor labor market outcomes also reflect the low level of private investment, in particular foreign direct investment, compared to peers. This has limited potential output and private sector job creation, contributing also to a relatively low level of exports. This lack of investment reflects not only political risks, but notably the poor business environment and labor market rigidities. The complex governing structure with its multitude of regulations and a fragmented economic space create major obstacles to businesses.

An urgent need for reforms

7. An ambitious policy agenda is necessary to accelerate growth and reduce unemployment, while maintaining macroeconomic stability. Policies will need to focus on: (i) intensifying reforms to improve the business environment, attract investment, and raise the economy’s growth potential; (ii) resuming fiscal consolidation to place public debt on a steady downward path, while improving the quality of government spending; and (iii) safeguarding financial sector stability and reviving bank lending.

Advancing structural reforms to boost growth and job creation

8. Some progress has been made in the last few years to make it easier to start and operate a business, but much remains to be done. Similarly, it has proven difficult to achieve consensus between the social partners on new labor market legislation that would help create more jobs. To attract investment and boost job creation in the formal economy, it will be critical to:

• Improve the business environment by: (i) further reducing the administrative burden on businesses, including by harmonizing regulations between the entities and reducing para-fiscal fees; (ii) restarting privatization of state-owned companies; (iii) improving the court system; and (iv) finalizing the process of World Trade Organization accession and resolving trade issues with the European Union (EU).

• Enhance the functioning of the labor market by: (i) revitalizing the collective bargaining process; (ii) allowing wages to be better linked to performance; (iii) reducing disincentives for hiring; and (iv) increasing labor inspections to reduce informal employment and better protect workers’ rights. This will need to be accompanied by strengthening the system of unemployment benefits and active labor market policies, including by expanding training and education opportunities.

Making government finances sustainable and more efficient

9. Fiscal policy will need to strike a balance between ensuring medium-term sustainability and supporting the nascent recovery. This calls for a gradual resumption of fiscal consolidation, as public debt and notably debt service obligations are still high. The 2015 central government budgets that were adopted and which aim to contain current spending are consistent with this goal. The overall budget deficit is projected to decline to about 2.5 percent of GDP this year, although this also depends on the ability to control overspending by lower levels of government, extra-budgetary funds, and state-owned companies.

10. At the same time, comprehensive fiscal reforms are needed to make this consolidation sustainable, to create room for investment in infrastructure, and to improve the efficiency of public finances:

• Revenue collection and administration will need to be strengthened by: (i) enhancing the cooperation between the four tax authorities and strengthening the powers of the entity tax administrations to improve compliance; (ii) implementing risk-based tax audits and inspections, and (iii) increasing efforts to collect outstanding tax and social security contribution debts.

• The high tax burden on labor can be reduced over time by lowering social security contribution rates, offsetting this by broadening the base for taxes and contributions and through spending cuts.

• The single-rate value added tax that is applied to a broad base is highly effective and will need to be preserved.

• The size of public spending will need to be reduced, and its composition and quality improved through: (i) implementing public administration reform; (ii) initiating health care reform; (iii) ensuring the sustainability of the pension system by completing pension reforms; and (iv) improving the targeting of social assistance to protect the most vulnerable, while containing the costs of benefits to war veterans, including by completing the audit process.

• Controls over lower levels of government and extra-budgetary funds will need to be strengthened to fully account for and stop the increase in uncovered liabilities, and loss-making state-owned enterprises will need to be addressed. A comprehensive strategy is needed to tackle the issue of unpaid social security contributions.

Safeguarding a stable financial system that can support growth

11. The currency board arrangement is a cornerstone of economic policies in Bosnia and Herzegovina. It provides stability in an otherwise uncertain environment. Official foreign exchange reserves are adequate and the real effective exchange rate appears to be broadly in line with economic fundamentals.

12. The banking sector weathered the global financial crisis and the subsequent years of weak economic growth, as well as last year’s floods, relatively well. At the aggregate level, the banking system remains liquid and adequately capitalized, although some vulnerabilities remain. Some banks with governance and risk management shortcomings and high loan concentration ratios are likely to require additional capital.

13. Credit to the private sector is still stuck in low gear, as demand for new loans is weak and banks continue to repair their balance sheets. Banks’ asset quality and profitability have weakened since the crisis. This, together with an inadequate resolution and insolvency framework, has resulted in a persistently high level of non-performing loans—14 percent of total loans at end-2014, although these are largely provisioned for.

14. Further efforts are needed to ensure financial sector stability and to help revive bank lending:

• Stronger actions are needed to deal with weaker banks. This will require developing a comprehensive strategy—backed by a thorough diagnostic assessment—including a credible backstop to deal with any systemic cases. At the same time, with high liquidity ratios in the system, consideration could also be given to raising reserve requirements for banks, to rebuild financial buffers, while they could also be better tailored toward prudential purposes.

• Good progress has been made in preparing new banking laws to bring these in line with EU directives and Basel requirements, and this process is expected to be completed soon. These laws are expected to strengthen supervisors’ corrective and enforcement powers, introduce consolidated supervision, and improve crisis management and resolution frameworks. Contingency planning and crisis preparedness has improved, but should be strengthened further, and the macro-prudential framework should be broadened.

• Legislative and regulatory changes are also needed to improve the framework for recovering and resolving non-performing loans, including facilitating out-of-court restructuring of debts and the sale of non-performing loans by banks.

• Urgent action is needed to bring the legal and regulatory framework for combating money laundering and the financing of terrorism fully in line with international standards. While progress has been made, failure to complete this work could result in serious obstacles to cross-border transactions.

Future IMF engagement

15. IMF staff has also been discussing future IMF engagement with Bosnia and Herzegovina. The authorities’ main economic policy priorities are closely aligned with staff’s views and the mission expects to return to Bosnia and Herzegovina soon for more detailed discussions on a possible successor arrangement. Meanwhile, staff is also coordinating closely with other international institutions, including the EU, the European Bank for Reconstruction and Development, and the World Bank, regarding support for the authorities’ economic policies.

Bosnia and Herzegovina: Selected Economic Indicators, 2011–15                     2011 2012 2013 2014 2015             Proj.                   Nominal GDP (KM million) 25,772 25,734 26,282 26,595 27,193     (Percent change)   Real GDP 1.0 -1.2 2.5 1.1 2.1   CPI (period average) 3.7 2.0 -0.1 -0.9 0.5   Credit to the private sector 4.2 2.8 2.3 1.8 2.1     (In percent of GDP)   General government balance -2.8 -2.7 -1.9 -2.8 -2.4   Total public debt 39.7 43.6 41.6 45.1 46.1   Current account balance -9.6 -8.9 -5.7 -7.8 -8.7                   Sources: BiH authorities; and IMF staff estimates and projections.