How Emerging Europe Came Through the 2008/09 Crisis

Chapter 13. Bosnia and Herzegovina: Containing the Fallout with International Assistance

Bas Bakker, and Christoph Klingen
Published Date:
August 2012
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The global crisis exposed the fragility of Bosnia and Herzegovina’s growth, which relied on ample foreign-financed credit, inward remittances, and donor-financed reconstruction of the war-torn economy. The sudden stop of financial inflows from abroad zapped domestic demand and, together with contracting exports, opened sizable external and fiscal financing gaps. The authorities’ stabilization program supported under a stand-by arrangement (SBA) with the IMF stabilized public finances and shored up confidence in the currency board and the domestic banking system, thereby limiting the output loss. Looking beyond the past crisis, establishing strong sustainable growth and improving resilience against external shocks requires the implementation of ambitious structural reforms.


Bosnia and Herzegovina (BiH) lived through a traumatic transformation in the 1990s. Prior to the dissolution of Yugoslavia, its economy had been heavily industrialized and dominated by large-scale, export-oriented enterprises in the energy, raw materials, and military sectors. The 1992–95 war caused immense human suffering, destruction of physical infrastructure, and a decline in GDP by almost 80 percent. The 1995 Dayton Peace Agreement, which ended the war, created a complex political system designed to protect the interests of the different ethnic groups. BiH consists of two largely autonomous entities: the Republika Srpska and the Federation of BiH (hereafter the Federation), the latter divided into 10 cantons, each with substantial autonomy. The nation also has an overarching state government (referred to as the Institutions of BiH) with a limited mandate. In addition, there is the Brcko District, which is also a self-governing unit.

Growth in the period immediately following the war primarily reflected reconstruction financed by exceptionally large donor assistance. By 2003, progress had been remarkable. Real GDP tripled and exports grew 10-fold, although industry never recovered the breadth and dominance it once had. Inflation stabilized at low rates thanks to the introduction of a currency board arrangement that pegged the newly created convertible marka (KM) first to the Deutsche Mark and later to the euro. The banking system was privatized, recapitalized, and better regulated. Foreign banks would eventually account for close to 90 percent of system assets. The fiscal situation improved to the point where, after years of deficits, BiH recorded a small surplus. International reserves rose to three months of imports. On the downside, however, large external assistance allowed BiH to develop with less urgency to implement fundamental reforms than in other transition economies.

The Run-Up to the Global Financial Crisis

In the years preceding the crisis, BiH enjoyed robust but increasingly unsustainable growth. During 2003–08, GDP grew on average by over 5¼ percent per year. Domestic demand—supported by rapid credit growth, remittances from abroad on the order of 10–15 percent of GDP, hefty wage increases, and a sizable fiscal impulse—exceeded GDP by a substantial margin throughout. Much of the private sector credit growth, which averaged 19 percent in real terms, was funded by foreign parent banks that provided their local subsidiaries with loans and capital.

Public spending took off to unsustainable levels—increasing by 56 percent during 2005–08, well in excess of the 44 percent increase of nominal GDP. The increased spending was financed by the successful introduction of the value-added tax in 2006 and went mostly into nonproductive uses: boosting public wages by 54 percent and war-related benefits by 76 percent. In addition, the Republika Srpska used large privatization proceeds in 2007 to undertake an ambitious multiyear public investment program. This weakened public finances, with the consolidated general government balance deteriorating from a surplus of 2.2 percent of GDP in 2006 to a deficit of 3.7 percent of GDP in 2008.

By 2008, external and internal stability came under threat. The current account deficit hit 14 percent of GDP, well outside the sustainable range. However, given easy access to external financing, the large deficit failed to appreciably dent foreign reserves. Indeed, between 2003 and 2007, the import coverage ratio rose from 3 to 4.7 months, and the reserve buildup continued through the third quarter of 2008. The sharp increases in government spending on wages and social transfers in 2008 magnified the impact of booming food and energy prices on domestic inflation, which peaked at 10 percent in July 2008.

The robust growth performance in the precrisis years masked the economy’s structural weaknesses. BiH has consistently trailed its central and eastern European peers on most structural indicators. Following the 2000–01 voucher privatization, the sale of strategic enterprises moved forward only in 2007 in the Republika Srpska and is effectively stalled in the Federation. Official unemployment remained stubbornly high at well over 20 percent of the labor force, with employment generation held back by sizable skill gaps, an outdated collective bargaining system, widespread informality, and low labor force participation. On a positive note, the establishment of the Fiscal Council in August 2008 was an important step toward better fiscal coordination, and the signing of the Stabilization and Association Agreement with the European Union in June 2008 raised expectations for faster progress in critical structural areas.

Impact of the Global Financial Crisis

The crisis arrived in BiH in the fourth quarter of 2008—at a time when overheating concerns had already taken root. As the financial health of foreign parent banks with subsidiaries in BiH was called into question, a mini–deposit run ensued in October 2008. The outflow of household deposits was covered by emergency loans from parent banks and freed-up liquidity from the lowering of reserve requirements. Official foreign exchange reserves experienced the largest one-month decline in years, raising red flags with foreign investors. In addition, exports started to let up and private investment collapsed. Private consumption softened to a lesser extent, as the impact of rising unemployment was partly offset by moderate growth in wages and social benefits. Inflation decelerated sharply amid the economic malaise and falling international commodity prices. Faced with the worsening financial health of enterprises and households, banks cut back their loan portfolios. Financial soundness indicators started to deteriorate, reinforcing the downturn in private sector credit. The stock market slumped.

Balance-of-payments and fiscal pressures escalated in the first half of 2009. The leakage of official foreign exchange reserves continued because the improvement in the trade balance brought on by the weakness of domestic demand was overcompensated for by the decline of remittances and the sudden unwillingness of foreign banks and investors to provide the customary funding. On the fiscal front, cumulative indirect tax revenue reached a trough in July 2009, off by 15 percent relative to the same period in 2008, before recovering somewhat to finish the year 12 percent below the 2008 outcome. In the Republika Srpska, privatization proceeds helped soften the blow to public finances and ensured continued financing of the public investment program and subsidized lending through the Investment and Development Bank. The Federation, on the other hand, faced the full brunt of the fiscal crisis, accumulating expenditure arrears of 1.4 percent of national GDP at end-2008.

Policy Responses

Faced with increasing financing pressures in early 2009, the authorities turned to the IMF and requested financial support for their economic adjustment program. The idea of approaching the IMF was first raised by the Federation government, which was under tremendous financial strain; it was quickly endorsed by the Fiscal Council. An IMF negotiating mission was dispatched very quickly, and staff-level agreement was reached on May 5, 2009. Given BiH’s political structure, discussions were held with members of the Presidency, the Chairman of the Institutions of BiH, 12 prime ministers, 13 finance ministers, and the central bank. The original and subsequent letters of intent carried no less than seven signatures.

A three-year SBA in the amount of SDR 1.01 billion (US$1.57 billion) was approved in July 2009 by the IMF’s Executive Board. A US$111 million Development Policy Loan from the World Bank, to be followed by two additional such World Bank loans and a €100 million macroeconomic support loan from the European Union, completed the envisaged financing package. The program was designed to safeguard the currency board in a deteriorating external environment while redressing fiscal imbalances, strengthening the financial sector, and securing commitments from foreign parent banks to maintain exposure and keep subsidiaries adequately capitalized. In particular:

  • Roughly two-thirds of the resources made available under the SBA were envisaged for strengthening the reserves of the central bank should a need arise.1 The currency board had been the linchpin of macroeconomic stability for one and a half decades, the central bank and commercial banks had built sizable liquidity buffers to support the viability of the monetary regime, and the exchange rate was not significantly misaligned. However, depreciations in the exchange rate of regional trading partners were a distinct possibility, so continued external competitiveness needed underpinning from wage flexibility, fiscal restraint, prudent financial sector policy, and progress in structural reforms.
  • Fiscal policy tried to strike a balance between softening the economic downturn and achieving the necessary fiscal consolidation. Given the unsustainable fiscal starting position, applying a discretionary fiscal stimulus was out of the question. But there was room to allow automatic stabilizers to play out, primarily on the revenue side. The disbursements under the SBA, as well as the SDR allocation to the IMF membership, helped the authorities broadly maintain the provision of public services while initiating structural fiscal reforms. All levels of government were expected to contribute to the adjustment, but the burden fell disproportionately on the Federation, reflecting its tight financing constraints and larger contribution to the structural fiscal deficit. The Institutions of BiH, Republika Srpska, the Federation, and the Brcko District all committed to reducing the wage bill and rationalizing other expenses, including war-related benefits. Reforms, supported by the World Bank’s Development Policy Loan, aimed at better and more-targeted protection of the poor, through eligibility audits and conditioning on recipients’ income and ability to work.
  • Financial sector policies focused on enhancing the capacity to monitor financial stability, strengthening the health of the banking sector, and shoring up confidence. A Standing Committee for Financial Stability was established. Stress testing of individual banks was introduced with technical assistance from the IMF. To help reassure the public, the individual deposit insurance limit was raised from KM 7,500 to KM 35,000 (€17,000) and extended to all banks. In this context, BiH signed an agreement with the EBRD that enabled the Deposit Insurance Agency to access emergency credit of up to €50 million in case its funds turned out to be insufficient to cover a payment event. To support credit growth in a tightening credit environment, the authorities temporarily relaxed the prudential rules on restructuring. Moreover, reserve requirements, which had already been lowered from 18 to 14 percent in October 2008, were further cut from 10 percent to 7 percent for long-term bank liabilities.
  • The successful negotiation of the SBA allowed the authorities to secure commitments from nine foreign parent banks to maintain their exposure to BiH and recapitalize their subsidiaries under the European Bank Coordination Initiative arm of the Vienna Initiative (see Box 5.2). Follow-up meetings would be held in the context of program reviews.

Economic Outcomes in 2009–11

BiH’s stabilization program was successful in mitigating the impact of the global financial crisis on the economy. The IMF and World Bank external financial support helped minimize the impact of revenue shortfalls on government spending, thus limiting output losses. The economy bottomed out in 2009 and has since stabilized, paving the way for a gradual rebound in 2010–11. The multilateral support package has also helped stem the loss of official foreign exchange reserves, shoring up investor confidence (Figure 13.1).

Figure 13.1Bosnia and Herzegovina: Central Bank’s Foreign Assets

(Percent change since end-September 2008)

Sources: Central Bank of Bosnia and Herzegovina; and IMF staff calculations.

Note: DPL = Development Policy Loan; RS = Republica Sprska; SBA = stand-by arrangement; SDR = special drawing right; WB = World Bank.

The economy turned the corner in 2010 on the back of recovering export demand. Real GDP growth reached 0.7 percent in 2010 and 1.7 percent in 2011. However, the expansion has failed to spread to domestic demand amid rising unemployment, falling real wages, weak foreign direct investment inflows, and stalled bank lending. The strength of external demand, in conjunction with a slow recovery of imports, further narrowed the current account deficit, while official foreign exchange reserves increased. Core inflation is low, while headline inflation is driven by higher oil prices and tobacco excises.

Fiscal performance has so far been broadly in line with the program. Despite expenditure reduction measures initiated under the SBA, revenue shortfalls in 2009 led to a breach of the deficit ceiling by 1 percentage point of GDP and necessitated an easing of the deficit target for 2010 from 4 to 4.5 percent of GDP in the context of the first review. The revised 2010 target was comfortably met. Stopgap measures kept the 2011 fiscal deficit in line with the target of 3 percent of GDP. However, while overall spending stayed within the program envelope, its composition is a source of growing concern. The consolidated general government wage bill grew in 2009–11 despite programmed moderation, and savings from war-related benefits have fallen short of expectations amid stalled reforms. The overruns on wages and transfers have been offset by strict control over other current spending and by underperformance of the capital budget. Fiscal structural reforms have advanced very slowly. Both entities have approved legislation to reform war-related benefits, but implementation has been slow.

The banking sector has stabilized. Household deposits have fully recovered and are now above the levels reached prior to the October 2008 deposit run. But bank credit to the private sector has stabilized below its precrisis peak amid tightened lending standards. Nonperforming loans reached 11.8 percent of total loans at end-2011. As a result of the higher provisioning against nonperforming loans and the slump in lending activity, the banking sector recorded an overall loss in 2010, but it returned to profitability in 2011.

The first three program reviews were completed through October 2010, but the inability to form a new state government following the October 2010 elections has not allowed (as of end-2011) the resumption of program discussions.

Challenges Ahead

Going forward, BiH needs to see through the quantitative fiscal consolidation envisaged under the program. Lasting medium-term macroeconomic stability also requires structural fiscal reform to free up resources for much-needed infrastructure investment. This in turn requires persevering with the reforms of war-related benefits to improve their efficiency, reining in the public wage bill, and putting the pension systems on a sustainable footing.

With the government deficit and current account on track to return to sustainability and inflation in check, attention should increasingly be paid to addressing long-standing labor market rigidities and impediments to entrepreneurship. Chief among the labor market reform priorities are the need for: better alignment of the systems of collective bargaining and wage determination with the principles of a market economy; restraint in public sector hiring and benefits; and a refocusing of the work of employment agencies from providing welfare to active job placement policies. Speeding up the pace of technological change would require increasing the efficiency of the regulatory framework to allow quicker business startups, fewer authorizations for business operations, and a reduction in the number of different tax payments. Corporate sector performance could be boosted by privatization of the large strategic enterprises in the Federation and of the remaining medium-sized public companies in both entities. Legislative and institutional reforms aimed at creating a single economic space within the country will be needed to attract foreign direct investment and promote further integration of the local economy in the larger European marketplace.

Bosnia and Herzegovina: Principal Economic and Financial Indicators, 2003–11
Real Sector Indicators
GDP (real growth in percent)−
Domestic demand (real growth in percent)−−6.4−1.71.2
Net exports (real growth contribution in percent)−−
Exports of goods and services (real growth in percent)18.312.−
CPI (end-of-period change in percent)
Employment (growth in percent)−−3.5−1.9−3.2
Unemployment rate (percent)
Public Finances
Fiscal balance (percent of GDP)−−3.7−5.5−4.2−2.6
Government revenue (percent of GDP)47.045.646.648.
Government expenditure (percent of GDP)47.245.545.846.046.850.050.650.749.4
Government primary expenditure (percent of GDP)46.544.945.245.346.249.450.150.148.7
Government primary expenditure (real growth in percent)−1.70.8−1.2
Public debt (percent of GDP)27.625.625.621.432.931.236.139.640.6
Of which foreign held27.325.325.321.
External Sector
Current account balance (percent of GDP)−19.2−16.2−17.1−8.0−10.7−14.1−6.3−6.1−8.3
Net capital inflows (percent of GDP)112.514.017.511.314.810.
Other investment8.
Exports (percent of GDP)25.929.132.636.537.437.032.337.641.1
Exports (€, growth in percent)12.722.420.425.715.612.1−15.018.912.9
Global export market share (basis points)
Remittances (percent of GDP)13.514.613.512.912.810.
Imports (percent of GDP)70.970.172.865.668.970.155.559.464.7
Imports (€, growth in percent)6.07.311.81.418.515.1−22.99.312.5
External debt (percent of GDP)54.452.249.649.351.647.755.952.546.6
Gross international reserves (€ billions)
Gross international reserves (percent of GDP)18.921.724.528.030.825.525.926.425.4
Reserve coverage (GIR in percent of short-term debt)304.2550.4351.7395.7276.6175.1195.1168.7182.4
Monetary Sector
Broad money (end of period, growth in percent)9.924.318.222.620.
Monetary base (end of period, growth in percent)
Private sector credit (end of period, percent of GDP)34.336.543.344.351.054.854.554.755.1
Of which foreign currency denominated
Of which foreign currency indexed
Cross-border loans to nonbanks (Q4, percent of GDP)
Private sector credit (end of period, real growth in percent)19.514.922.39.924.017.6−3.4−0.81.3
Financial Sector
Assets (percent of GDP)52.258.969.276.590.085.487.586.586.6
ROA (percent)−0.60.7
ROE (percent)−5.55.9
CAR (percent of risk-weighted assets)20.318.717.817.717.116.316.116.217.2
NPLs (percent of total loans)
Loan-to-deposit ratio1.
Cross-border claims by foreign banks (all sectors, percent of GDP)8.710.720.822.828.625.429.124.121.2
Financial Markets
Interest rates (end of period, one-year government bond, percent)
CDS spreads (sovereign, end of period, basis points)
EMBIG spread (sovereign, end of period, basis points)
Exchange rate (end of period, domestic currency/€)
NEER (index, 2003 = 100)100.0101.3101.2101.0101.8102.9104.8102.3102.9
REER (CPI-based, 2003 = 100)100.098.898.1100.9100.1103.9104.0101.5102.0
REER (ULC-based, 2003 = 100)
Memorandum Items
GDP (nominal, in billions of domestic currency)151617192225242425
GDP (nominal, in billions of €)
Source: IMF staff.Note: CAR = capital adequacy ratio; CDS = credit default swap; CPI = consumer price index; EMBIG = Emerging Markets Bond Index Global; FDI = foreign direct investment; GIR = gross international reserves; NEER = nominal effective exchange rate; NPLs = nonperforming loans; REER = real effective exchange rate; ROA = return on assets; ROE = return on equity; ULC = unit labor cost.

Financial and capital account balances excluding EU balance-of-payments support, use of IMF resources, and SDR allocations.

Source: IMF staff.Note: CAR = capital adequacy ratio; CDS = credit default swap; CPI = consumer price index; EMBIG = Emerging Markets Bond Index Global; FDI = foreign direct investment; GIR = gross international reserves; NEER = nominal effective exchange rate; NPLs = nonperforming loans; REER = real effective exchange rate; ROA = return on assets; ROE = return on equity; ULC = unit labor cost.

Financial and capital account balances excluding EU balance-of-payments support, use of IMF resources, and SDR allocations.

The main authors of this chapter are Costas Christou, Milan Cuc, and Plamen Iossifov.


As of end-2011, these funds remained undrawn, as public and foreign investors’ confidence in the financial system was quickly restored.

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