Sarajevo, Bosnia and Herzegovina, February 23, 2000

Mr. Stanley Fischer
Acting Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Fischer:

1.  In the period since we wrote to Mr. Camdessus on June 14, 1999, the Bosnia and Herzegovina authorities have continued their efforts to consolidate financial stabilization and reinvigorate the structural reform process. We are pleased to report that the target for the stock of minimum free international reserves of the Central Bank for December 1999 was achieved with some margin, and a number of important structural measures have been taken. In the fiscal area, there was some borrowing from commercial banks by various levels of government during 1999, which reflected primarily pressures on budgets that arose from the conflict in FR Yugoslavia. We are committed to reversing this slippage. We also experienced some delays in clearing payments arrears to the European Investment Bank, but these were settled in early-November, 1999. The authorities remain dedicated to implementing measures to ensure continued financial discipline (Table 1).

2.  In the monetary area, strict implementation of currency board rules has contributed to low inflation in 1999, acceptance of the convertible marka (KM) throughout the country, and a sustained increase in international reserves of the Central Bank of Bosnia and Herzegovina (CBBH). In the fiscal area we are committed to improving revenue performance and controlling expenditures within the guidelines under the program. Due to the negative impact of the conflict in FR Yugoslavia, revenue collection in the Federation was lower than budgeted in 1999, although performance since May 1999 improved. The improvement reflected, inter alia, the termination of the preferential trade agreements with neighboring countries and the implementation of the common import surcharges. As a result of lower revenues, and also delays in the disbursement of external financing, wage and benefits payments were slower than envisaged, and the Federation Government lowered budget allocations for military expenditures and transfers to war invalids. The Republika Srpska (RS) 1999 budget was implemented virtually as originally passed by Parliament, although the RS Government carried out some tax offsetting transactions.

3.  We reaffirm the commitment of all levels of government to run balanced budgets on a cash basis with no borrowing from domestic sources and limited external borrowing, exclusively on concessional terms. The Governments of both Entities will avoid arrears on the basis of the 2000 budget execution laws, which permit reductions in all expenditure commitments other than transfers to the State to bring them in line with available resources. As for the 2000 budgets, both Entities and the State have adopted 2000 budgets that are broadly based on key parameters agreed with the IMF.

4.  The 2000 budgets of the State and Entity Governments are based on conservative revenue estimates and foreign financing projections. The State Administrative Budget, which is mainly funded by transfers from the Entities, will be based on an increase of 10 percent in the level of such transfers relative to their allocation in the 1999 State Budget. In 2000, the overall deficit-to-GDP ratios (before grants) in the Federation and the Republika Srpska are projected to be 1.6 percent and 3.4 percent, respectively, slightly lower than those estimated for 1999. Military expenditures will be cut substantially in Entity 2000 budgets, making room for increased allocations to priority sectors, such as education and infrastructure. Both Entities have included major fiscal activities that are currently recorded off-budget in their 2000 budget presentation.

5.  Both Entity Governments have recognized the need to implement measures that will correct the non-observance of the performance criterion for government borrowing and prevent future non-observance. The Federation Ministry of Finance has issued instructions to social funds that prohibit future borrowing. In addition, an explicit provision has been included in the 2000 Budget Execution Law to prevent local government borrowing. For the Republika Srpska, the Ministry of Finance has also issued instructions to local governments and social funds that prevent future borrowing. Moreover, in the new RS treasury system, social fund finances will be subject to direct central government control.

6.  Important progress has been made in implementing several fiscal measures envisaged under the stand-by arrangement. Since mid-May, 1999, when bilateral preferential trade agreements were abolished, imports from Croatia to the Federation and from the Federal Republic of Yugoslavia (FRY) to the Republika Srpska have been subject to standard tariffs under the State Customs Tariff Law. A unified list of import surcharges has been put in place in both Entities since July 1999. On February 9, 2000 the Council of Ministers approved draft amendments to the State Customs Policy Law to reduce the scope of exemptions, and restrict duty free shops to locations beyond customs checkpoints at international airports. In addition, legislation has been drafted to limit the number and locations of free zones.

7.  To enhance domestic tax collection, the Federation has enacted permanent legislation implementing the inter-Entity excise tax harmonization agreement of June 8, 1999, except for cigarettes. Excise tax legislation on cigarettes was passed by parliament, and will be gazetted before February 25, 2000. The Republika Srpska Government has issued a temporary decree introducing excise tax rates that are in line with the June 8, 1999 harmonization agreement, pending permanent legislation submitted to parliament in early February, 2000. It has also taken a decision to not carry out tax offsetting transactions or extend official guarantees for enterprise borrowing.

8.  During 2000, we will reform budget procedures to ensure better expenditure planning, and enhance tax administration. Plans for establishing treasury systems within the State and Entity governments have been prepared and detailed regulations on fiscal reporting were issued to budgetary Entities at all levels of government. Both the Federation and the Republika Srpska Ministries of Finance will establish a treasury department, and, with the technical assistance from the US Treasury and USAID, will develop and implement a medium-term plan for treasury systems. In the Republika Srpska, the Customs Administration, the Tax Administration, and the Financial Police have been integrated into the Ministry of Finance under the authority of the Minister of Finance, and a draft law establishing a centralized treasury system has been submitted to Parliament.

9.  The authorities of both Entities will strengthen the implementation of other agreed reforms in taxation and expenditure management. Both Entities will amend their sales tax laws to remove the discretionary power of governments to grant exemptions, eliminate non-standard exemptions, and further harmonize the tax rates and bases. The Federation's temporary sales tax exemption for domestically produced cars will be extended for another year, in keeping with prior commitments to a foreign investor. Temporary sales tax exemptions for specific users of diesel oil, and for meat and meat products, have expired, and the Federation government does not intend to renew them. To enhance the transparency of social funds' operations, the Governments of both Entities will require regular reporting of the social funds to the Ministries of Finance.

10.  Following a rather sluggish pace of structural reforms in 1998 and early 1999 we have taken a number of important steps over the last several months. The privatization of state enterprises has been launched in both Entities, with the sale of several small-scale enterprises. Substantial progress was made toward the liquidation of the National Bank of Bosnia and Herzegovina, the former central bank. As regards the payments system, the adoption of Internal Payments Laws in both Entities has eliminated payment bureaus' monopoly on the provision of payments services. We are aware that this measure has placed increased responsibility on commercial banks, and made it more urgent to undertake steps that will increase the public's confidence in the banking system. To this end, in August 1999, the Deposit Insurance Law was passed in the Federation and the law on commercial banks was passed in the Republika Srpska. A modern chart of accounts that will facilitate bank supervision in the Republika Srpska was implemented beginning January 1, 2000. In addition, both Entities have issued standards regarding commercial bank provision of payment services, and we expect that a number of banks will be licensed shortly to provide these services.

11.  We remain committed to strengthening the financial sector by fully implementing the undertakings provided in the Memorandum of Economic and Financial Policies of June 14, 1999. To this end, we have completed the solvency tests for nearly all state owned banks, and their liquidation or privatization will be completed by end 2000. In the Republika Srpska, a plan to separate the Development Bank from the payments bureau was completed in August 1999, and the Government will adopt by March 2000 a plan for its privatization.

12.  Enterprise privatization continues to be at the core of our program. Nevertheless, progress has been very slow, and the government will need to intensify efforts to clarify land ownership rights, and claims by previous owners and labor. More generally, the government will have to put its political weight behind a concerted effort to accelerate privatization.

13.  In other structural areas, there is an urgent need to eliminate labor market distortions and significantly improve the system of social benefits. As a preliminary step toward achieving a financially viable pension system over the medium term we will unify the two Federation pension funds in early 2000. Both Entities are in the process of amending their pension laws and laws on veterans' rights to bring entitlements in line with financial resources. As regards the labor market, Federation labor legislation is being amended to promote increased labor mobility and wage rate flexibility. The amended legislation will be submitted to Parliament by end-June 2000. The Entity Governments will continue to work with the staffs of the IMF, the World Bank, and other agencies during the coming months to elaborate the broad range of structural reforms needed to accelerate the transition to a market economy.

14.  We recognize the importance of eliminating trade restrictions, and establishing a transparent and non-discriminatory trade regime to promote the growth of private investment and a viable external sector. To this end, the protection accorded to domestic manufacturers, notably of cigarettes, was lowered by unifying the excise taxes imposed on domestic and imported products. The process of simplifying the trade regime, that was initiated with the passage of the State Customs Tariff Law in 1998, was continued in June 1999 with the implementation of a harmonized list of import tariff surcharges across the two Entities. We are committed to continued full implementation of these measures throughout the country.

15.  The full benefit of trade reform is best enjoyed in a multilateral context. Accordingly, in the period ahead we will focus our efforts in the area of trade reform toward achieving sustainable multilateral trade liberalization. As a preliminary step in this direction we have already requested technical assistance from donors to help prepare us during the process of our accession into the WTO. As regards external debt, we have finalized bilateral agreements with almost all Paris Club creditors, and have requested an extension of the period to complete such bilateral negotiations. We expect to finalize shortly bilateral agreements with the remaining Paris Club creditors, and will seek comparable terms to those received from the Paris Club from all of our other creditors. We will also facilitate timely negotiations of outstanding claims on the non-government sector. Furthermore, we will ensure that the outstanding foreign liabilities of the Privredna Banka Sarajevo do not generate any claims on the Federation budget, and seek, in the future, to treat in a comparable manner any similar liabilities of other public banks. We will also ensure that such liabilities are not absorbed by other public enterprises, and/or indirectly passed on to the Federation budget through lower privatization receipts.

16.   Bosnia and Herzegovina is committed to accepting the obligations of Article VIII, Sections 2, 3, and 4 of the IMF's Articles of Agreement following the clarification of some issues related to overlapping jurisdictions of relevant State and Entity laws and to nonresident foreign currency deposits, which are currently frozen. In addition, during the period of the arrangement, we will not impose or intensify restrictions on the making of payments and transfers for current international transactions, introduce multiple currency practices, conclude any bilateral payments agreements that are inconsistent with Article VIII of the Fund's Articles, impose or intensify any import restrictions for balance of payments purposes, or accumulate any new external payments arrears, except transitionally on amounts subject to rescheduling.

17.  We are aware that the balance of payments position of Bosnia and Herzegovina is fragile, and that it remains highly dependent on external assistance in support of the priority Reconstruction Program. In recognition of the large amounts of highly concessional resources that have been made available to Bosnia and Herzegovina, and of its limited debt service capacity, we will ensure that the State and Entities refrain from borrowing on nonconcessional terms. In particular, this will preclude "in kind" loans. This prohibition on nonconcessional external borrowing will also apply to the granting of domestic or foreign payments guarantees or the assumption of liabilities under existing contracts that are not specifically identifiable as liabilities of the State, Entities, Cantons, or other levels of Government. The sole exception to this policy will be projects financed by the European Bank for Reconstruction and Development, International Finance Corporation, European Investment Bank, the European Commission, or other donors in conjunction with World Bank lending.

18.  On the basis of recent policy performance and the policy objectives and commitments set forth in this letter we request the completion of the second and third reviews under the stand-by arrangement. The governments request a further extension of the arrangement through end-March 2001, augmentation of the program by SDR 16.91 million, and a waiver for the availability of the end-December 1999 performance criteria. As regards the latter, arrears to the Council of Europe Social Development Fund were settled in July, and to the European Investment Bank on November 30, 1999. The access and phasing of purchases are shown in Annex I. The extension of the arrangement would give the authorities the time needed to reach the objectives of the adjustment program.

19.  Under the program for 2000, the implementation of macroeconomic policies will be monitored on the basis of quarterly quantitative performance criteria on government domestic borrowing, on currency board operations, and on external borrowing. Quantitative performance criteria will be set for end-March and end-June, 2000, and indicative targets for end-September and end-December, 2000. Quantitative performance criteria for the latter dates will be set in the context of the fourth review, to be completed by end-May, 2000. This review will be based, inter alia, on the observance of the end-March, 2000 performance criteria. The review will also assess actions undertaken on the structural side, notably in the area of enterprise and bank privatization, progress in labor reform, and payments system reform. The fifth review, scheduled for completion by end-August, 2000, will be based on the observance of the quantitative performance criteria for end-June, 2000, as well as budgetary outcomes. The review will also focus on progress in reforming the payments system, full implementation of the labor reform, and implementation of key fiscal reforms. The sixth review, scheduled for end-November, 2000, will focus on preparation and steps toward promulgation of the budgets for 2001, progress implementing the enterprise and bank privatization programs and in reforming the payments system.

20.  If necessary, we stand ready to take any additional measures and seek new understandings with the Fund to keep the program on track. We will remain in close consultation with the Fund, in accordance with the Fund's policies on such consultations, and will provide the Fund with any information that it requests on the progress made in policy implementation and on the achievement of program objectives. We would be grateful if you could arrange for this document to be posted on the IMF website, subsequent to Board approval.

21.  In closing, we wish to thank you for the valuable support provided by the Fund, especially for the timely assistance that contributed to cushioning the economic impact of the conflict in the FR Yugoslavia on Bosnia and Herzegovina.

The Presidency of Bosnia and Herzegovina:

Representing the Entities of Bosnia and Herzegovina:

Annex I

Bosnia and Herzegovina: Schedule of Purchases
Under Proposed Stand-by Arrangement Extension, Rephasing and Augmentation¹

Annex II

The general government is defined to include the State, Entity (Federation, and Republika Srpska), cantonal and municipal budgets, together with their respective extrabudgetary funds. Extrabudgetary funds include, but are not limited to, the pension funds, health funds, unemployment funds, and invalids and surviving family insurance funds in the two Entities.

Banking system claims on the general government for the purposes of program monitoring are defined as the sum of: (i) claims from the monetary authorities (the Central Bank of Bosnia and Herzegovina and the payment bureaus); and (ii) loans, advances, securities or bills issued (or guaranteed) by the general government and held by commercial banks.

For program purposes, those components of gross claims on the general government that are denominated in foreign currencies will be converted into convertible marka at the agreed accounting exchange rate prevailing on December 31, 1999.

The limits will be monitored from the accounts of the banking system, supplemented by information provided monthly by the Entity Ministries of Finance, and payment bureaus.

Annex III

Under the Central Banking Law and the program, the CBBH (acting as a currency board) is required to ensure that its domestic liabilities do not exceed the convertible marka counter-value of its net foreign exchange reserves. Net foreign exchange reserves of CBBH are defined as the difference of the following foreign assets and liabilities, both in convertible currencies and denominated in convertible marka.

Under the Central Banking Law and for the purposes of the program, foreign assets include: (i) gold, and other precious metal and stones; (ii) convertible foreign exchange notes held by the CBBH; (iii) credit balances in convertible foreign exchange—including SDRs—due to the CBBH on the books of foreign central banks or other financial institutions; (iv) liquid debt securities issued by the government and the central bank of the country in whose currency the securities are denominated and held by the CBBH on its own account; and (v) officially guaranteed forward and repurchase contracts of different types providing for future payments in convertible foreign exchange to the CBBH by non-residents.

Under the Central Banking Law and for the purposes of the program, foreign liabilities include: (i) foreign exchange and convertible marka balances on the books of the CBBH due to non-residents, including foreign central banks and international financial institutions; (ii) credit balances due to foreign central banks, governments, international organizations, and foreign financial institutions; (iii) forward and repurchase contracts of different types providing for future payments in foreign exchange by the CBBH to non-residents; and (iv) any other liabilities due to non-residents.

"Free reserves" of the CBBH are foreign exchange reserves not utilized as backing for the currency. They therefore consist of the CBBH net foreign exchange reserves in excess of the currency board liabilities. The program calls for quarterly minimum levels of free reserves. Foreign currency holdings will be converted into convertible marka at fixed exchange rates of December 31, 1999 (exchange rates other than that of the Deutsche mark will be those published in the IMF International Financial Statistics). Valuation changes will be excluded from cumulative changes in free reserves. The above limits will be cumulative from the actual level as of December 31, 1998 and will be monitored from the accounts of the CBBH, with information on net foreign assets provided monthly by the CBBH. The information will be made available to the Fund within two weeks following the end of each month throughout the program period. As the stock of free reserves as of December 31, 1998 is equivalent to the initial capital of the CBBH, the implication is that the capital cannot be drawn upon to finance operational expenditures or the acquisition of physical assets.

Annex IV

Annex V

The limit on the change in external payments arrears applies to the change in the stock of overdue payments on medium- and long-term debt contracted or guaranteed by the State, the Federation, the Republika Srpska, and the CBBH. The limit also applies to the change in the stock of short-term debt in convertible currencies with an original maturity of up to and including one year. The limit excludes reductions in connection with rescheduling of official and commercial debt and debt buy back. Accumulation of new external arrears is prohibited.