Mission Concluding Statement 

Bosnia and Herzegovina -- 2005 Article IV Consultation, Concluding Statement of the IMF Mission

April 14, 2005

April 14, 2005

1. Fifteen years after the Berlin Wall fell, and a decade into peace, it is remarkable how much has changed in Bosnia and Herzegovina—and how little:

• Socialist planning, war, economic collapse, and inflation have long gone.

• But peacekeepers, the OHR, unemployment, a swathe of state-owned companies, domestic claims, external deficits and the fractured constitution remain.

If aspirations to prosperity and EU membership are to be realized, those matters which have changed need to be entrenched and those which have not need to be transformed.

2. In moving ahead, the choice is not between development and stability. You will not develop without stability. The strong growth realized in recent years reflects the stability that has been secured. And equally, stability requires growth and development, appropriately pursued. The issue, looking ahead, is how to continue to keep the emphasis on both right, simultaneously, even as external financial support continues to decline and as refugees continue to return in numbers.

3. This is not easy, but it can be done. Given exceptional external deficits and fiscal pressures, and imminent governance changes vis-à-vis the international community, development and stability require, above all, strengthened coordination amongst yourselves.

4. You already have an essential public symbol of this coordination, the credibility of which is well established in the public mind: the currency board. Because it is anchoring price expectations, it is minimizing the burden on the budget and structural reforms to do so. Any other monetary and exchange regime would increase those burdens. In this context, we welcome your commitment to the currency board. And we urge you to reflect that commitment with continued strong fiscal and much strengthened structural policies, and to make the case for your chosen monetary framework expressly on the grounds of its role in anchoring prices and, therefore, its essential contribution to economic development here.

5. But no monetary and exchange rate regime, even one as successful as yours, is sufficient to secure stability. This also requires a strong financial system, fiscal and external sustainability, effective policy-making institutions, a vibrant corporate sector, and sound public services—all equally requirements for development.

6. The financial system—especially the banking sector—has many strengths. It is largely privately owned and enjoys the confidence of the public, as reflected in increasing bank deposits and their lengthening maturity.¹ But given the difficulties of enforcing collateral, scrutinizing guarantors, and banks' sustained competition for market share, credit risks should be monitored closely, particularly given some signs of increased loan rescheduling (ever-greening) recently. An IMF technical assistance mission in April will assist with this, anticipating a subsequent Financial Sector Assessment Program (FSAP).

7. In this context, banking supervision needs to be effective, with regulators continuing to apply the rules uniformly everywhere. Thus, we strongly urge early completion of the process embarked upon last year to bring the banking agencies into the CBBH. This will consolidate the supervisory process, ensure it remains appropriately funded, will reflect and encourage the increasing integration of the banking system, and it will secure improved coordination between your prudential and credit policies.

Fiscal Policy

8. What is the contribution necessary from the budgets?

9. The immediate and most serious challenge here is domestic claims.² The December 2004 Constitutional Court ruling against one part of the RS claims plan revives the specter of heavy excess indebtedness of the governments and risk of a flow of court awards against various levels of government disrupting their operations. Several steps are appropriate:

• to clarify the December Constitutional Court ruling, notably through further direct consultation with the court and consideration of its subsequent rulings;

• to continue with the procedures to "verify" claims now underway so as to ascertain as soon as possible an accurate—and legally endorsed—value for the total of claims on each entity;

• to contest effectively individual suits for awards, case by case, mobilizing and briefing lawyers for the defense effectively;

• then, assuming that the court embraces some sort of claims payout arrangement, to institute a stay on proceedings against awards on RS municipalities pending preparation of a "municipal domestic claims plan" for them;

• to establish that government officers are not personally liable for non-execution of awards;

• and to stop all budgeted payments, except if in execution of court awards, scheduled under the existing domestic claims plan until its status with the courts is clarified. Funds held in escrow should be fully available to meet ongoing court awards as they are made, thereby protecting ongoing government operations from these developments to the fullest extent possible.

As these matters are complex and highly sensitive, we strongly recommend that all parties, local and international, engaged with this issue should coordinate all related activities directly and only through the OHR, avoiding any steps not cleared with them first.

10. And if the court insists on large payouts to claimants, major permanent adjustments to budget spending will be needed. This will secure fiscal sustainability, stability, and therefore—to the extent possible in this difficult context—development. In this event, financial restitution may prove to be unaffordable, ever, and any social plan for workers as part of the corporate restructuring agenda will need to be strictly limited.

11. Therefore, reforms now anticipated—State building, expansion of municipal and cantonal activities, new public investment, civil service reforms, etc.—require refocusing to minimize their impact on total budget spending.³ This underlies our assessment that early reductions in state remuneration rates are needed—we have suggested immediate reductions of 10 percent including benefits, and by 15 percent if benefits are unchanged—with further adjustments to follow the anticipated review of the State budget remuneration structure. These steps are key to reconciling your State building and EU accession aspirations with fiscal sustainability. And given the domestic claims uncertainties, plans to proceed with the expansion of cantonal and municipal activities should be contingent on identifying prior offsetting spending cuts.

12. Accordingly, we welcome the establishment of the "Fiscal Sustainability Group" to coordinate efforts to identify spending efficiencies. We suggest that it should be provided with a mandate jointly by the State and the Entities—to identify a menu of cuts summing to at least 10 percent of consolidated tax and nontax budget revenue—to be fully effective in this task. And we hope that spending on war veterans and the wage bill will feature prominently in its considerations. If all reform processes which raise spending are matched by pro rata implementation of measures from this menu, then reform can be rendered consistent with fiscal sustainability. And the group could also constitute a constructive voice encouraging strengthening of the fiscal system so as to more systematically bear down on inefficiencies in spending.

13. Similarly, policy on taxation also needs to be strong, particularly given the spending and prospective domestic claims pressures. Thus, we welcome the establishment of the single account in the ITA. And we urge your mutual provision of full confirmation to each other that all revenues assigned to it are routed there and agreement soon that all arrears of taxes from before 2005 will also be routed there. We welcome the Council of Ministers' decision, following an IMF request, to schedule implementation of VAT from end-2005 and urge early adoption of this schedule in the VAT law. This will allow time for completion of administrative preparations—which remain most urgently required in the areas of computers, software, recruitment, registration, and public information. And maintenance of the continued effectiveness of the sales tax administration during 2005 while the VAT administration is being built, and the early transfer of excise administration to the ITA, will be essential.

14. However an increase in the tax burden is not warranted. Raising the tax burden relative to GDP, including the grey economy, will set back efforts to encourage growth, employment, fiscal sustainability, and development. Thus, expansions in tax bases through improved tax enforcement, would best be matched by pro rata reductions in tax rates, leaving the overall tax burden on the economy unchanged. In this context, increasing revenue should come from increasing GDP only, with the broader fiscal pressures dealt with through exploiting the ample scope for efficiencies in spending.

15. Thus, we applaud your preparations for VAT, but emphasize need for further efforts in this area:

• Your intention to apply a broadly revenue-neutral single VAT rate at 17 percent remains appropriate in our view at this stage. But given data and administration uncertainties, the associated revenue projections are fraught with uncertainty. If, in early 2006, VAT receipts are above projections, and are assessed to remain so, we suggest application of such a surplus to finance reductions in labor taxation, to encourage employment and labor tax compliance. And to address the risk of revenue lower than anticipated, we suggest that your 2006 budgets incorporate sizeable formal "delayed current spending lists," including at State level. Items on these lists should only be executed during 2006 if revenues, including those from VAT, are on track.

• In any event, a targeted effort to offset the adverse effects of the shift from a dual sales tax to a single VAT rate on some of the poorer segments of society is warranted, as suggested by a recent IMF technical assistance mission.

• And with VAT replacing the sales tax, new arrangements will be required to fund cantons and municipalities from 2006. We will assist you in your efforts to design such new systems of local government financing.

Fiscal Coordinating Structures

16. Given these fiscal pressures, a significant strengthening of your fiscal policymaking structures is needed to strengthen coordination. Accordingly, we recommend amendment of the provision in the ITS law allowing the State unilateral determination of its annual administrative expenditures so as to require prior Entity assent. Further, the provisions in the same law which, in practice, have allowed the State parliament an unfettered role in determining indirect tax policy—at odds with the spirit and intention of the ITS law—should be amended to provide that such changes require the full formal approval of both the State parliament and the ITA board. These steps, establishing State accountability for expenditure and tying responsibility for revenue policy more closely to that for spending, will strengthen coordination amongst yourselves and therefore your ability to cope with the fiscal challenges ahead.

17. And in this light, steps to avoid a recurrence of the delayed preparations of the 2005 budgets are needed. We recommend that you schedule determination of your 2006 consolidated budget balance target, its subdivision amongst yourselves, revenue projections, the outline delayed spending arrangements, and the determination of State administrative expenditures for 2006 by end-July 2005—just some three months from now. This will allow timely preparation of your individual 2006 budgets within this agreed broad framework. But it will require early decisions on your plans for 2006 on the whole spectrum of State building initiatives now under consideration.

18. And timely collation and publication of detailed consolidated monthly fiscal outturn data is long overdue. This simple step would constitute a key signal of your initiative and of your intention to coordinate fiscal policy effectively with each other. We have provided you with a format and resident technical assistance on this and related matters.

19. Difficult as some of these fiscal steps may be, they will also constitute essential progress in your assumption of effective fiscal sovereignty—a key part of the governance transition vis-à-vis the international community which we strongly support. We suggest a variety of initiatives to consolidate this—from adoption of an integrated formal calendar for all budgets, rules on sub Entity central government borrowing, development of macro-analytical capacity, much improved macro statistics, adoption of devices to break budget negotiation deadlocks, and formal liaison with the parliamentary finance committees and the CBBH—anticipating eventual establishment of a formal National Fiscal Council.⁴ Such a body could form the core of your internal fiscal coordination over the medium- to long-term. Many aspects of this proposal will have to be designed by learning by doing. But the inadequacies of current fiscal coordinating structures mean that early steps in this direction appear essential—including prompt publication of detailed consolidated monthly fiscal outturn data-whatever the final shape of the formal fiscal coordinating arrangements you adopt eventually.

The Fiscal Stance

20. With these fiscal matters thus attuned to stability and development, how should the fiscal stance—reflected in the consolidated fiscal balance-be set? We suggest that two concerns should guide this:

• First, if the NPV of court mandated payouts is higher than anticipated in the domestic claims laws, the sustainable primary balance of your consolidated budgets will be higher than its current level, possibly significantly so. This could require sharp and deep expenditure retrenchment to make room for interest and payouts on domestic claims. Ahead of clarification of the court's determination of these matters, there is no room for a weakening of the fiscal stance—this would simply amplify the necessary adjustment afterwards.

• Second, with domestic savings so low, the first task of the fiscal sector is not to draw on them, but to leave them available to the private sector where their developmental impact is greatest.

21. Thus, a consolidated budget close to balance or in surplus anticipates the court's decision and maximizes the fiscal contribution to development. Your 2005 budgets target a consolidated deficit of 0.7 percent of GDP and a primary deficit of 0.1 percent of GDP, therefore falling short of this requirement. To secure fiscal sustainability even under the earlier envisaged restructuring of domestic claims to a NPV of 10 percent of GDP, the target primary balance needs to strengthen towards 1 percent of GDP. This adjustment would be largely achieved by spending only half of anticipated GSM receipts, as earlier advised, and by executing your anticipated adjustment to the Sarajevo canton deficit. And adjustments even to the targeted primary surplus of 1 percent of GDP can only go in one direction—tightening—and possibly significantly so, largely depending on the outturn on domestic claims. In this event, GSM receipts, along with other one-off receipts, should go fully into escrow to fund individual court-mandated awards as these are finalized.

Corporate Restructuring

22. Apart from the domestic claims concerns, the recommendation for a fiscal surplus reflects the depth of the malaise in the corporate sector, where lossmaking decimates domestic savings. A deep and decisive corporate restructuring program is thus essential, both for stability and development. Privatization, bankruptcy, labor law changes, and a social plan are key to this—the latter necessarily strictly limited given uncertainties on domestic claims.⁵ Financial engineering—debt reschedulings, debt equity swaps, and the like, not linked to sale to strategic investors—and trade protective initiatives, including suspension of elements of the free trade area agreements, prolong but do not end the agony. Evidence from company restructurings that have taken place show that the beneficial impact—on profitability, employment, and exports—can be large and swift. Hence, we strongly encourage an early conclusion to your discussions with the IBRD on corporate restructuring and commencement of the program. And we urge a prompt return to full implementation of the FTA arrangements in consultation with your regional trading partners. This would also establish the credibility of your intentions to seek membership of the WTO.

23. Labor and restitution policy should support corporate restructuring. Arrangements in current labor laws whereby worker rights accrue indefinitely, regardless of attendance for work, need to be abolished promptly to prevent further accrual of wage and contribution arrears in companies. Alongside, shifts towards firm level bargaining, including termination of the link in the Federation between average and minimum wages, would increase efficiency and end the bias to contracted wage inflation. And following the initiative of the RS government, statutory wage and benefit structures should be established throughout governments to end the indexation of remuneration. And with large swathes of business property subject to possible claims for restitution in kind, your intentions in this regard should be determined on as limited a basis and as soon as possible so as to avoid further uncertainty. This will be a key element, along with other efforts to strengthen land registries, of steps necessary to clarify property rights—an essential requirement for new investment.

24. Without this range of bank regulatory, fiscal, and structural reforms, increasing credit to enterprises may herald bad debts, rather than stability or development. But decisive action in all these areas will be reflected in further reductions in the country risk premium on Bosnia, further lowering interest rates corporates have to pay for credit.

Recent Macroeconomic Developments

25. Recent macro trends reflect these issues. The momentum of economic growth appears strong. Assuming that the CPI is accurately gauging price trends, evidence from the velocity of money, tax ratios, and sectoral output indicators suggest that real output expanded in the upper end of the 5-6 percent range in 2004, buoyed by some 20 percent export growth and a continued expansion of credit to the private sector of somewhat over 25 percent, with mining in the RS, and manufacturing and electricity in the Federation growing quickest. But, partly as a result of the buoyancy of demand, imports—including consumption goods—have surged. In this context, the external current account deficit strengthened by just ½ a percent of GDP in 2004. Given structural constraints on supply, demand is growing as fast as it can consistent with avoiding a deterioration in the external balance.

Fiscal and Credit Policy for 2005-06

26. Policy on aggregate demand for 2005-06 should be set in this context. If imports and exports continue growing through 2005 at their pace of the past year, a further moderate consolidation of the current account deficit is in prospect. This would be consistent with continued growth of credit to the private sector at annualized rates around our suggested guideline range of "the low 20s." It is also consistent with our recommendations for the budget balance targets for 2005 which imply a further moderate withdrawal. Certainly, with Bosnia an outlier in international experience with regard to its external deficits, we see no room for external slippage.⁶ But on current external trends, and assuming that your current credit and our budget targets are realized, demand is set to grow at an appropriate pace relative to output, which we project to grow by 5½ percent.

27. With the momentum of economic growth so strong, you should emphasize need to secure external consolidation in the event of adverse developments during 2005. While output remains constrained by structural factors, this emphasis will serve the interests of stability and development. But this constraint should encourage further efforts to relax the structural impediments to supply—notably by deep corporate restructuring.

28. But this overall favorable assessment depends on the strengthening of your 2005 budget targets and elimination of several risks to their execution. On the revenue side, threats to the sales tax as officers shift to the VAT should be minimized, teething problems with the ITA single account should be addressed, and the dividend from telecom to the Federation budget needs to be assured. On the spending side, State wage and benefit rates need to be reduced promptly, along with reductions—at least to levels agreed with the IBRD—in war veterans programs. And risks to police pay in the RS need to be headed off with firm matching reductions in other wage spending.

Medium-term Macroeconomic Outlook

29. Our medium term projections assume strong corporate and fiscal reforms, and, pending clarification, the earlier anticipated domestic claims restructuring (Table 1). This will raise new investment, productivity, and output, as well as increase exports and domestic savings and provide a basis to maintain the strong momentum of growth realized in 2004 in the range of 5-6 percent. With aid flows declining sharply, we estimate that an increase in domestic savings of some 10 percentage points of GDP is needed over 5 years to sustain corporate fixed investment—and hence growth—and to lower the current account balance to below 10 percentage points of GDP by 2009. To support private sector led growth, a consolidated government budget of close to balance or stronger will need to be maintained, and the share of consolidated government revenues and grants in GDP should be reduced to 40 percent of GDP, or lower, over the medium term. If, however, the domestic claims burden is heavier than earlier anticipated, the primary balance will have to be strengthened, possibly considerably, through reductions in anticipated primary expenditure, and growth prospects may be diminished. And the latter is inevitable if reform is limited.

Concluding Remarks

30. Many—including citizens—looking at what has not changed in Bosnia over the past decade say that neither development nor stability can be secure here. But we have seen how far you have come. So without in any way understating the scale and urgency of the challenges ahead, including on domestic claims, we reject this pessimism.

31. But given the challenges, stability and development will require much more effective coordination amongst yourselves. That, and deep corporate restructuring, are essential to your prosperity.

* * * * *

We are grateful for the assistance and for the convivial welcome that is always accorded to us during our visits to Bosnia and Herzegovina.

¹ See "Market indicators of confidence in the KM and the banking system since 2000."
² See "Fiscal sustainability and budget spending."
³ See "State building" and "Consolidated cantonal and municipal fiscal balances."
⁴ See "Fiscal sovereignty."
⁵ See "Corporate Sector Issues."
⁶ See "International experience with credit booms and large current account deficits."