Chapter

Chapter 1. Growth, Jobs, and Convergence1: Obstacles and the Roadmap for Reform

Author(s):
International Monetary Fund. European Dept.
Published Date:
March 2015
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After the collapse of socialist regimes in the early 1990s, ensuing conflicts in the region caused major disruptions, and income per capita fell. The pace of recovery was uneven in the second half of the 1990s: some countries such as Bosnia and Herzegovina and Croatia experienced a sharp turnaround in growth, while others such as Serbia and Albania faced high growth volatility. By the end of the decade, however, real GDP per capita in the region had recovered to its pre-1990 level, despite another recession around the turn of the century, when output in Albania, Montenegro, and Serbia shrank by over 10 percent in a single year.

After 2000, the Western Balkan countries enjoyed sustained economic growth up until the global financial crisis. During this precrisis period, real GDP per capita in the region increased by more than 40 percent on average, riding the tide of deeper financial and trade integration with the rest of Europe, high capital inflows, rapid credit expansion, and productivity growth. Poverty fell sharply—both in absolute numbers and in depth. Rapid growth brought uneven benefits, however, and the early 2000s saw large increases in inequality; while in absolute terms everyone became better off, disparities in income distribution increased.

The boom years came to an abrupt end in 2009, and per capita GDP growth has largely stalled since then. Reigniting convergence will not be easy. In the aftermath of the global financial crisis, growth in the euro area—a key export market for the region—has been weak, and could remain so over the medium term, creating a less than supportive external environment for the Western Balkan states. In addition, the end of a period of rapid global growth unmasked problems associated with stalled domestic reform agendas in the Western Balkans, which will continue to weigh on growth potential if left unaddressed. While economic transformation in the region is largely complete in some areas, notably with respect to price, trade, and foreign exchange liberalization, more effort is needed in upgrading institutions, improving the business environment, building infrastructure, and developing financing markets.

What policies can help address the Western Balkans’ high unemployment, which represents a unique regional challenge both in its importance and magnitude? The region was unable to generate significant employment gains during the boom years and registered large job losses during the global crisis. A comprehensive set of reforms will be needed to address the region’s persistently high unemployment, and this chapter’s findings of a significant positive impact of structural reforms on the probability of employment is worth highlighting.

Section A of this chapter surveys the historical growth and convergence track record of the Western Balkans, exploring both similarities and differences with respect to other emerging markets. Section B analyzes progress in transforming economic structures and also benchmarks the sequence and depth of reforms to the experience of the New Member States. With this background, and by underscoring lessons from the transition elsewhere in Europe, Section C presents a prioritization of reforms that should help generate a strong payback in growth and accelerate convergence. Section D explores the demographic, macroeconomic, and structural drivers of labor market outcomes in the region, offering insight into the likely effects of various possible reforms. Section E summarizes lessons for stronger convergence.

A. Growth and Convergence—A Cup Half Full or Half Empty?

All the Western Balkan countries enjoyed high and sustained economic growth starting with the turn of the century, in line with the rest of Emerging Europe. What were the main factors driving growth performance in the region?

Average Real GDP Growth

(Weighted average across countries, in percent)

Sources: Penn World Table; WEO; and IMF staff calculation.

Real GDP per Capita

(Simple average across countries; in PPP adjusted U.S. dollars per person)

Sources: Penn World Table; and IMF staff calculations.

A simple growth-accounting exercise suggests that capital accumulation and total factor productivity gains were the biggest growth drivers in both regions during the precrisis years (Annex 1.1). Indeed, both the Western Balkans and the New Member States experienced investment booms in the 2000s owing to substantial capital inflows and low global interest rates (see Chapter 2). The large productivity gains likely resulted from the transformation toward market economies, although the relatively small contribution of labor inputs and the consequent high importance of productivity—a residual—could be also partly explained by the large informal economies in the Western Balkan countries, which tend to be more labor-intensive (Gërxhani 2004). Nonetheless, similar patterns have been observed elsewhere—in particular, recent evidence suggests that the uptick in growth in emerging market economies during the 2000–12 period is mainly explained by higher total factor productivity (Tsounta 2014). In addition, the very low contribution of labor and human capital to GDP growth in the Western Balkans is in line with findings of other studies (Campos and Coricelli 2002; IMF 2009; and EBRD 2013).

Average Output Growth and Sources 2000–11

Sources: Penn World Table; Inklaar and Timmer (2013); University of Groningen Growth and Development Centre; and IMF staff calculation.

1/ Growth accounting uses measures of capital stocks from Penn World Table 8.0 and adjusts employment growth for years of schooling as in Barro and Lee (2013).

2/ The chart shows simple average growth rates for real GDP and the respective contributions of human capital, labour, physical capital and total factor productivity.

3/ Montenegro data starts in 2006.

4/ For EU countries, the contribution of labor has been adjusted for the change in average hours worked per person engaged.

Yet despite a limited contribution from labor, the impulse to growth from other factors was strong enough to generate substantial improvements in living standards, as well as a reduction in poverty (Box 1.1). By 2008, the Western Balkan countries had made impressive progress and reduced their gap in GDP per capita vis-à-vis advanced EU economies by 30 percent. But contrary to predictions of standard economic theory, the speed of convergence was slower in the poorer Western Balkans than that of the richer New Member States during the boom years.

Catching up with Advanced Europe

(Average country GDP per capita as percent of average EU17 GDP per capita)

Sources: Penn World Table; and IMF staff calculations.

Why did the Western Balkans converge more slowly? One possible explanation is that the closer physical distance of the New Member States to advanced EU economies may have offered advantages in terms of access to markets and investments, and facilitated the transfer of knowledge.

These relative advantages are only recently partially offset by improvements in infrastructure links between the Western Balkans and Advanced EU economies. Yet even after controlling for the physical distance, econometric evidence suggests that, except for the postwar recovery period, the pace of convergence in the Western Balkans has been slower than in the New Member States (see Annex 1.2). This is partly due to the absence of convergence within the Western Balkan region, because poorer countries such as Albania and Bosnia and Herzegovina failed to grow significantly faster than the richer countries, such as Croatia.

What other factors may have constrained faster convergence? There is a growing literature on the impact of structural factors on convergence, though mostly on larger panels of countries. Findings suggest that domestic financial development speeds up convergence (Aghion, Howitt, and Mayer-Foulkes 2005; Fung 2009) and that human capital is more important to growth for countries that are less developed (Fung 2009; Ciccone and Papaioannou 2009). Better institutional infrastructure and selected labor market reforms have been shown to facilitate convergence at the regional level (Che and Spilimbergo 2012). Reform priorities for sustaining convergence have been found to vary with income levels. Empirical evidence suggests that in lower-middle-income countries, priorities should be reforming banking and agricultural sectors, reducing barriers to FDI, increasing competition in product markets for a more vibrant services sector, improving the quality of secondary and tertiary education, and alleviating infrastructure bottlenecks. In upper-middle-income countries, boosting productivity growth would require deepening capital markets, developing more competitive and flexible product and labor markets, fostering a more skilled labor force, and investing in research and development and new technologies (Dabla-Norris and others 2013). Finally, a survey of various studies that focus specifically on the transition process concludes that institutional quality and market liberalization policies to promote private sector growth have a positive impact on economic growth, despite their initially disruptive effect (Campos and Coricelli 2002).

In line with these findings, the analysis here shows that improving the quality of governance, and developing market-oriented institutions, a strong human capital base, and deeper financial systems help poorer countries catch up (Annex 1.2). In contrast, the dominance of the public sector in the economy hinders the catching-up process. And the Western Balkans have lagged behind the New Member States in these areas. In light of the critical importance of economic transformation, the next section explores progress to date.

Box 1.1.Inequality and Poverty in the Western Balkans

The boom years of the early 2000s brought steady increases in incomes across the region. Poverty fell sharply both in terms of absolute numbers (poverty headcount) and depth (as measured using the poverty gap).

Initially, rapid growth brought uneven benefits, and the early 2000s saw large increases in inequality (as measured by the Gini index). While in absolute terms all income groups were better off, disparities increased as the income share of the top quintile rose relative to the income share of the bottom quintile. Income inequality in the region has since declined, although it remains high, particularly in Bosnia and Herzegovina and FYR Macedonia.

Poverty, however, has increased since 2008, though with significant variation across countries, and to a lesser extent than in the New Member States. Albania and Montenegro have seen the sharpest increase in poverty since the global financial crisis, although poverty in Serbia also increased. Wage reductions, and importantly, a loss of remittances served to transmit the economic slowdown across Europe to poverty levels in the Western Balkans.

Gini Coefficient, 2010

Sources: Povcal; and World Bank, World Development Indicators.

Poverty Headcount 1/

(Percent)

Sources: Povcal; and World Bank, World Development Indicators.

1/ Share of population living below poverty line.

B. Progress in Economic Transformation

Structural Reforms—What Has Been Accomplished?

Structural reforms are an integral part of the process of transformation into a market economy. So how did the Western Balkans fare in their implementation? The sequence of reforms was similar to that in the New Member States. Specifically, price liberalization and reforms to trade and foreign exchange systems preceded privatization, and were followed only later by reforms to governance and competition policy. However, the pace of reforms was quite different, and the Western Balkans have not progressed as far as the New Member States along a critical set of structural reforms.

One notable feature of the early transition period was the unique economic system, known as “market socialism”, that was in place in the former Yugoslavia well before the 1990s, where heavy reliance on administrative controls coexisted with a vibrant private sector of small and medium enterprises without Soviet-style central planning (Boughton 2012). Albania, on the other hand, started the transition process as an isolated and autarkic state with virtually no elements of a market economy, but made swift progress, particularly in trade and foreign exchange liberalization, where reforms went further than in the rest of the Western Balkan states as early as 1992.

Transition Indicators

(WBS average)

Source: EBRD Transition Indicators.

Note: NMS average excludes Czech Republic.

Transition Indicators

(NMS average)

Source: EBRD Transition Indicators.

Note: NMS average excludes Czech Republic

Despite a difficult decade, by 1999 the Western Balkans as a group had reached a fairly advanced stage of transition (measured by a value of 3 or higher for the Transition Indicators of the European Bank for Reconstruction and Development) in the areas of price liberalization, trade and foreign exchange, and small-scale privatization by 1999, trailing the New Member States by only a few years. However, other reforms, such as large-scale privatization, were delayed, and the Western Balkans are yet to reach the advanced stage of transition in governance and competition policy areas. A key culprit was another Yugoslavia-specific feature—the “socially-owned” system of enterprise ownership, in contrast to state ownership in centrally planned economies elsewhere—which posed important challenges to large-scale privatization. The absence of a legal property owner required sorting out how to convert social to private ownership; the method of conversion varied across the different countries (Hashi 2001). The nature of the privatization process and the resulting stakeholder structure in those enterprises had implications for corporate governance and incentives to restructure:

Selected Transition Indicators, 2012

Sources: EBRD Transition Indicators; and IMF staff calculations.

Note: The scales range from 1 to 4+, where 1 represents little or no change from a rigid centrally planned economy and 4+ represents the standards of an industrialized market economy. Data for Czech Republic and Kosovo not available. Analysis for Kosovo not included as the relevant data are not available.

  • The progress in large-scale privatizations was uneven across the region. While many Western Balkan countries had already initiated these privatizations in the late 1990s and early 2000s, Bosnia and Herzegovina, Serbia, and Montenegro joined the process at later stages. There was also considerable variation across sectors: privatizations in the banking, telecommunications, and in some cases energy sectors generally moved ahead, but large public enterprises in historically important industries—such as metals, shipyards, utilities, and railways—proved particularly difficult to privatize. Stalled privatizations often reflected large social opposition, high short-run costs, and few serious bidders.
  • Corporate governance and enterprise restructuring of former state-owned enterprises remained a challenge across the region and state support often continued. For example, in Bosnia and Herzegovina the management of privatized enterprises was hampered by diffuse or ill-defined ownership rights. In FYR Macedonia, most socially-owned enterprises were sold to insiders rather than to strategic investors with capital and know-how, and many firms thus survived with substandard performance. Progress in winding down a few large loss-making enterprises has been slow. In Serbia, weak governance and output price controls resulted in large enterprise losses at significant fiscal cost. In Croatia, sizable direct state aid persisted, particularly in agriculture and shipbuilding, up until EU accession. In Montenegro, privatized steel and aluminum enterprises continued to drain public finances.

The Western Balkans made substantial progress in reducing red tape and improving the business environment in the mid-2000s. Steps were taken across the region to lighten the regulatory burden. Several countries initiated “regulatory guillotines” to eliminate unnecessary regulations, set up one-stop-shops for starting a business and obtaining construction permits, reduced non-tax fees, strengthened bankruptcy procedures, improved investor protection, introduced or expanded the coverage of real estate cadastres, introduced or improved investment promotion laws, and set up entrepreneurial zones with good infrastructure and land free of ownership uncertainty. Large infrastructure projects were initiated to fill critical gaps. According to the World Bank’s Doing Business Indicators, significant progress across the region was made on some fronts: registering property is cheaper in the Western Balkans than in the Advanced EU countries, and the tax burden is lighter. Yet it is still time-consuming for businesses to trade, pay taxes, or resolve insolvency, and costly to start a business or enforce contracts. Most countries in the region continue to face large infrastructure needs in transportation as well as in energy. Overall, rigid business environments often continue to hamper foreign investment, though there are isolated success stories.

Selected Doing Business Indicators, 2012

Source: World Bank, Doing Business Indicators; and IMF staff calculations.

Note: A large positive gap signals large shortfalls in ranking relative to the EU17.

A formidable challenge facing the region is reforming governance. While better governance facilitates higher per capita incomes, empirical evidence does not point to a virtuous cycle whereby higher growth automatically brings about improvements in governance (Kaufmann and Kraay 2002). This underscores the need for a concerted effort to improve the quality of governance. The Western Balkans still lag far behind the EU and New Member States peers in rule of law, control of corruption, and political stability, according to the World Bank’s World Governance indicators. Cross-country analysis shows that the quality of such institutions depends on several factors, particularly openness—that is, countries with greater openness to trade and finance tend to have better economic institutions (EBRD, 2013).2

World Governance Indicators, 2013

Sources: World Bank, World Governance Indicators. and IMF staff calculations.

Note: Estimate of governance ranges from approximately -2.5 (weak) to 2.5 (strong) governance performance.

Global Competitiveness Index, 2014

Source: World Economic Forum Global Competitiveness Indicators; and IMF staff calculations.

Note: Scale 1-7, 7 is best. Data not available for Kosovo.

Gradual Increase in Openness

Given that greater trade openness is commonly associated with higher economic growth and efficiency, we now turn to an assessment of the progress of the Western Balkans in this area.

While the region has gradually moved toward greater openness, the Western Balkan’s average share of exports stands at under half of the New Member States average of 60 percent of GDP. The average share of exports to GDP increased by 8 percentage points between 2000 and 2013, albeit representing disparate cross-country dynamics: a twofold and threefold increase in export shares took place in relatively closed economies like Bosnia and Herzegovina and Albania, in contrast with limited gains in export shares in Montenegro.

Exports of Goods

(Share of total exports)

Sources: Direction of Trade Database; and IMF staff calculations.

1/ 2000 average uses Serbia and Montenegro data.

The EU has been the largest export market for the region for some time, and continues to absorb about 60 percent of Western Balkan exports, with the notable exception of Montenegro. Yet trade among the Western Balkan countries themselves has become more important as well since 2000. The strength of regional integration is confirmed by an econometric analysis of trade linkages: augmenting a standard gravity model of trade with regional groupings shows that for both exports and imports, membership in the Western Balkan group is a strong explanatory factor of the size of trade flows (Annex 1.3).

The evolution of the structure of export goods in the Western Balkans as a group has broadly mirrored the experience of New Member States, which saw a rise in higher-value-added exports accompanied by an increase in agricultural exports and minerals. However, this masks large heterogeneity across the region. Whereas FYR Macedonia and Serbia have augmented their shares of exports of machinery and transport, mineral exports have increasingly dominated the export structure in Albania, Bosnia and Herzegovina, and Montenegro. The latter lags behind the rest of its Western Balkan peers in export diversification, whereas Serbia has made significant progress, and Croatia has preserved its relatively more favorable starting point.

Exports of Goods and Services

(Percent of GDP)

Sources: World Economic Outlook; and IMF staff calculations.

1/ 2003 data uses Serbia and Montenegro data.

2/ 2000 average uses 2004 data for Macedonia, 2003 data for Serbia and Montenegro.

Herfindahl-Hirschman Product Concentration Index, 2013

Sources: UN Comtrade Database; and IMF staff calculations.

Note: This indicator is a measure of the dispersion of trade value across an exporter’s products. A county with a preponderance of trade value concentratedin a very few products will have an index value close to 1. Thus, it is an indicator of the exporter’s vulnerability to trade shocks. Measured over time, a fall in the index may be an indication of diversification in the exporter’s trade profile. HS6 classification was used when creating the Herfindahl-Hirschman Product Concentration Index.

Total Exports of Goods

(Percent of GDP)

Sources: UN Comtrade Database; and IMF staff calculations.

1/ 2000 average uses Serbia and Montenegro data.

Note: SITC Rev. 4 commodity codes from Comtrade were used to create aggregations.

C. Ranking Structural Reforms Priorities for Faster Growth3

It is generally accepted that ambitious structural reforms can boost economic growth. But which specific reforms would deliver the strongest growth dividend in each of the Western Balkan countries? This question is tackled here by first identifying country-specific reform gaps, and then comparing the performance of the Western Balkan economies along a wide set of competitiveness indicators with the performance of New Member States and the average EU country.4 Growth regressions are then used to rank reforms according to their importance for growth. The results allow for proposing country-specific reform priorities in areas where both the competitiveness gap is large and the estimated growth impact of reform is high (see Annex 1.4 for methodological notes).

We first analyze the aggregated set of factors that determine productivity and growth, encompassing 10 broad areas such as institutions, infrastructure, and innovation, among others.5 Along a few dimensions the Western Balkan states have closed the distance with New Member states, but those most gaps are still negative. When assessed against EU averages, however, the pending reform agenda looms large. Where do the main gaps lie?

  • Relative to NMS, Montenegro and, to a lesser extent, FYR Macedonia compare relatively favorably: most of the estimated gaps are small, and a few are slightly positive—meaning that in these specific areas the competitiveness profile of these two countries is similar to that of NMS (Figure 1). The results for Albania, Bosnia and Herzegovina, and Croatia are more mixed—while the gap is relatively small in some areas, in others they lag behind significantly. For Albania and Bosnia and Herzegovina, the notable gaps are in infrastructure and financial market development; for Croatia, the gaps are in goods and labor market efficiency. Serbia generally faces more formidable structural challenges, as it compares unfavorably to NMS along all 10 indicators.
  • Relative to the EU average, the gaps in all Western Balkan countries tend to be wider, highlighting significant structural reform needs in almost all areas. This is also true for Montenegro and FYR Macedonia, which compare reasonably well to the New Member States. Overall, the major gaps throughout the region are in institutions, infrastructure, goods market efficiency, and financial market development. The estimated gaps in business sophistication and innovation are particularly large compared to the EU, both relative to other reform areas and in contrast to generally good performance of the region along this dimension relative to New Member State peers.

Figure 1.Main Reform Gaps in the Western Balkans

(Standard deviations)

Sources: World Economic Forum, Global Competitiveness Report; and IMF staff calculations.

Note: Global Competitiveness Report Pillars: 1 - Institutions, 2 - Infrastructure, 4 - Health and Primary Education, 5 - Higher Education and Training, 6 - Goods Markets Efficiency, 7 - Labor Markets Efficiency, 8 - Financial Markets Development, 9 - Technological Readiness, 11 - Business Sophistication, 12 - Innovation. Excluded are Macroeconomic Environment (pillar 3) and Market Size (pillar 10). Analysis for Kosovo not included as the relevant data are not available.

If all structural reforms were equally important for growth, the size of the reform gap would signal reform priorities. However, the growth impact of reform areas differs. The analysis of this study (see Annex 1.4) suggests that while reforms in all areas are expected to have a positive impact on growth, reforms in institutions, financial markets, and infrastructure have, on average, a larger impact on growth. Results also suggest that the growth impact of reforms varies with income levels—institutions and infrastructure are estimated to be relatively more important for lower- and middle-income countries, whereas innovation and business sophistication appear relatively more important for high-income countries.

Leaning on these findings by combining reform gaps and the relative importance of each reform area for growth, we can identify reform priorities. According to our methodology, the reform priority is higher the more important the specific reform area is for growth and the larger the corresponding reform gap is. This derived structural reform map serves to provide an indicative overview of where reform priorities may be (Annex 1.4).6

Top 5 Reform Priorities for Each of the WB States

Note: Reform priorities are assessed relative to the NMS in each of the 10 main pillars of the Global Competitiveness index. Larger bubbles represent reform areas that receive a higher rank ordering. Analysis for Kosovo not included as the relevant data are not available.

Our results suggest that, compared to New Member States, reforms across the Western Balkans are particularly needed in the areas of institutions, infrastructure, goods market efficiency, labor market efficiency, and financial market development. Each of those areas is found to be among the top five reform priorities for at least four of the six Western Balkan states; infrastructure was identified as a top reform priority in all six countries.

In what follows, we apply the same approach used above to disentangle reform priorities at a more disaggregated level. Specifically, the subcomponents of the four most common broad reform areas discussed above are analyzed by looking at more granular reforms within institutions, infrastructure, goods market efficiency, and labor market efficiency (Box 1.2).7

Box 1.2.Reform Gaps in Institutions, Infrastructure, Goods Market Efficiency, and Labor Markets

Institutional Reforms1

The protection of property rights is a common problem in most of the Western Balkan countries, particularly relative to the EU average, though to a lesser extent in FYR Macedonia.

Indicators related to corruption and government inefficiency also point to reform gaps in most countries. Compared to NMS, inefficient government spending appears to be an important constraint in Serbia, Albania, Croatia, and Bosnia and Herzegovina.

In Serbia, and to a lesser extent in Croatia, Bosnia and Herzegovina, Albania, and Montenegro, reform needs are large in areas linked to corporate sector performance. Specifically, this includes the strength of reporting standards, efficacy of corporate boards, and protection of minority shareholders.

Encouragingly, Albania, Bosnia and Herzegovina, FYR Macedonia, and Montenegro score relatively well in terms of burden of government regulation, even compared to the EU average. For Croatia and Serbia, however, the gaps in this area remain large.

Infrastructure2

The analysis of specific reform gaps within the broader infrastructure pillar suggests that the Western Balkan countries have had a mixed performance when assessed vis-à-vis their peers. In terms of overall quality of infrastructure, Croatia ranks better than its New Member State peers, while the largest overall quality gaps exist in Bosnia and Herzegovina and Serbia. All Western Balkan countries, except Croatia, lag behind the EU by a wide margin.

The gap analysis points to important reform potential in railroad infrastructure in Albania, FYR Macedonia, and Serbia. Compared to the average EU country, road and air transport infrastructure gaps are large in all countries, though to a lesser extent in Croatia.

Goods Markets Efficiency3

The results of the analysis suggest that the Western Balkan countries impose a relatively low tax burden on businesses. Total tax rates4 are well below those of NMS and EU average in FYR Macedonia, Montenegro, and Bosnia and Herzegovina. Similarly, all countries but Bosnia and Herzegovina perform well or are broadly at par in terms of procedures and time to start a business.

Gaps in competition policy, measured by the intensity of local competition and the effectiveness of anti-monopoly policy, point to potential reform needs in this area, in line with the findings in Section B of this chapter.

Gaps in trade barriers, tariffs, and impediments to foreign ownership and foreign direct investment (FDI) are relatively moderate in most Western Balkan countries, but almost always negative. Rules on FDI and foreign ownership seem to be stricter in Croatia and Serbia.

Agricultural policy cost seems to be a significant burden for the economy in Croatia and Serbia, and to a lesser extent in Albania.

Labor Market Efficiency5

Performance of regional labor markets, when benchmarked against New Member State peers, is relatively mixed, as measured by indicators on the flexibility of setting wages, flexibility of hiring and firing, and redundancy costs. All of the Western Balkans lag behind their peers in at least one of these three areas. Croatia has relatively more inflexible hiring and firing rules, and stronger tax disincentives to work but relatively more flexible wage setting. The labor tax wedge is also relatively large in Serbia. In contrast, Albania and Bosnia and Herzegovina score lower in terms of flexibility of wage setting.

Most of the Western Balkan countries (except Albania and Montenegro) compare less favorably to the New Member States in terms of retaining and attracting talent, contributing to skilled labor shortages. In these areas, as well as in professional management and cooperation on labor-employer relations, gaps tend to be larger vis-à-vis the EU. In other areas, differences with respect to the EU are less important, reflecting significant labor market rigidity in both sets of countries.

1 See Annex Figure 1.4.3 in Annex 1.4.2 See Annex Figure 1.4.4 in Annex 1.4.3 See Annex Figure 1.4.5 in Annex 1.4.4 As defined in the World Economic Forum’s Global Competitiveness Report, the total tax rate is “a combination of profit tax (% of profits), labor tax and contribution (% of profits), and other taxes (% of profits).”5 See Annex Figure 1.4.4 in Annex 1.4.

To identify overall reform priorities at the more granular level, we combine the analysis of reform gaps with their estimated growth impact, focusing on the 10 most important reform priorities for four subpillars.8 Reform priorities remain broadly the same whether New Member States or EU countries are taken as the comparator. In most countries reforms related to the quality of institutions dominate the priority list, followed by goods market efficiency and infrastructure. Of the labor market indicators, pay and productivity enters the top 10 reform priorities in half of the Western Balkan countries.

Top 10 Reform Priorities For Each of the WB States 1/2/

1/ These are assessed relative to the NMS along four sub-pillars of the Global Competitiveness Index (Institutions, Goods Market Efficiency, Labor Market Efficiency and Infrastructure).

2/ Numbers indicate the priority, with 9 pointing to the highest priority (see Annex IV).

Note: Analysis for Kosovo not included as the relevant data are not available.

Box 1.3.Structural Reform in Kosovo: Past Achievements and Future Priorities

Kosovo has undergone a significant economic transformation since 1999. Following the sequence seen elsewhere, one of the first major reforms was to liberalize previously administered prices in conjunction with the shift away from the Serbian dinar and towards a peg with the deutsche mark. Later, Kosovo embarked on widespread privatization. A key milestone in that regard was the privatization in 2006 of the Ferronkeli mining complex, which accounts for about half of Kosovo’s exports and employs over 1,000 workers. More recently, with the shift towards a market economy well under way, Kosovo has focused on improving its business environment as well as its labor market regulations:

  • Business environment In recent years, the authorities streamlined business regulations to reduce the cost of doing business, passed new laws to protect investors, and initiated projects to support the financial and technical needs of small and medium enterprises. These measures helped Kosovo move from 119th to 75th in the World Bank’s Doing Business rankings (although it still lags most Western Balkan States). Kosovo has also improved some of its ratings in the World Bank’s World Governance Indicators, including Rule of Law and Accountability, where it stands at about the 40th percentile for both.
  • Labor market measures: The authorities have recently adopted a rules-based framework for setting minimum wages that should help to contain excessive labor cost increases.

Doing Business Rankings: Kosovo

Source: World Bank, Doing Business Indicators.

Despite clear progress, the structural reform agenda is far from complete. Insufficient energy supply—the result of aging power plants and significant distribution losses—imposes a major constraint on growth.1 A decision on a new power plant is forthcoming. In addition, significant assets remain under the umbrella of the privatization agency, but momentum for privatization has stalled due to well-organized vested interests as well as shifting political preferences. Finally, Kosovo will need to complement its de jure improvements in business regulations and the rule of law with de facto progress. Perceptions of weak governance remain widespread and continue to hamper private sector development.

1 Energy imports are significantly more costly than domestic production even at lower global prices, hence the widespread use of power cuts to bridge demand and supply.

Given the critical importance of raising employment in the region, the next section turns to an in-depth examination of what policies would help improve labor market outcomes in the Western Balkans.

D. The Quest for Jobs

In the Western Balkans, high rates of unemployment and low rates of employment predated the global financial crisis, pointing to deep structural problems.

Unemployment Rate

(Unemployed as a percent of total labor force)

Sources: Country authorities; OECD; Haver; Eurostat; and IMF staff calculations.

1/ 2007 data used in place of 2006 data.

The New Member States—and particularly the Baltics—experienced large cyclical swings of both employment and unemployment during the 2000s, but in a qualitatively different context of markedly lower unemployment and higher employment. In contrast, workers in the Western Balkans failed to significantly benefit from employment gains during the boom years, while still registering significant job losses in the aftermath of the crisis (ILO 2012).

Labor Market Trends, 2000-2012

Source: WEO.

The persistence of unemployment in the Western Balkans regardless of cyclical conditions is confirmed through econometric analysis of contemporaneous responses of the unemployment rate to changes in economic growth, which suggests that responses of labor market outcomes to swings in economic cycles are smaller and statistically insignificant. This is in sharp contrast with larger and statistically significant response coefficients found in most Central European and Baltic economies.9 Looking ahead, this implies that unemployment is likely to persist in the Western Balkans even as economic growth picks up and output gaps close in the postcrisis period.10

Labor Market Cyclicality: Change in Unemployment Associated with 1 Percent Increase in Real GDP Growth 1/

(Percent)

Source: IMF staff estimates.

1/ Values of the response coefficient of unemployment to 1 percent increase in economic growth estimated over country-level data from the period of 1993-2013.

Note: Added country codes are for Belerus (BLR), Moldova (MDA), Russia (RUS), Ukraine (UKR).

So why have labor market outcomes been so much worse in the Western Balkans than elsewhere? One reason is that the Western Balkan countries are latecomers to the transition process, and hence FDI stocks, diversification from traditional sectors, and private sector job creation are still lagging compared with New Member States. At the same time, the countries have experienced very large emigration and brain drain, resulting in high remittance inflows that likely raise reservation wages, hamper external competitiveness, and contribute to long unemployment duration (Kovtun and others 2014; IMF 2013).11

Distribution of Firms that Consider Worker Skills a “Major” or “Very Severe” Constraint

Sources: EBRD-World Bank, Business Enironment and Enterprise Performance Surveys; and IMF staff calculations.

While significant, skill gaps were not as binding in the Western Balkans as in the New Member States, which are more integrated into European supply chains and have a greater presence of large manufacturing firms. According to EBRD-World Bank Business Environment and Enterprise Performance Surveys (BEEPS), skilled labor shortages are considered a major or severe constraint by about one in five companies in the Western Balkan countries, just behind infrastructure and corruption. Nevertheless, anecdotal evidence from employer associations and individual companies seems to suggest that in the Western Balkans, skill mismatches, which existed prior to the recent global economic slowdown, have become more prominent in the aftermath of the global financial crisis.

Strong employment and social protection systems were important features of centrally planned economies.12 These labor markets were shaped by the particular legacy of the “self-management” system for enterprises, and the existence of so-called “social ownership” (Kuddo 2013). This led to a high level of job protection for the “insiders” and to overall rigidity.13

Since the disintegration of the socialist economies, substantial labor market reforms have been undertaken, with the reform momentum having picked up since the middle of the 2000s, particularly in the areas of flexibility of wage determination and redundancy costs. Nonetheless, increased labor market flexibility in the Western Balkan countries is a recent phenomenon that will likely take some time to manifest itself in improved labor market outcomes.

In addition, the region still ranks less favorably—relative to its more dynamic peers—in terms of a number of competitiveness indicators capturing labor market flexibility. Specifically, as foreshadowed in Section C of this chapter, Western Balkan labor markets are characterized by feeble links between work compensation and labor productivity, as well as by low efficiency of using available talents, particularly in terms of low reliance on professional management and low female participation in the labor force.

Global Competitiveness Indicators by Region and Ranking

Source: World Economic Forum Global Competitiveness Indicator database, 2014-15 edition.

Note: First four indicators assess labor market flexibility and last three indicators assess efficient use of talent. Lower rank means better competitiveness.

Rigid labor market regulations may constrain the development of new industries in some countries in the Western Balkans. Business surveys show that even prior to the global financial crisis, many younger and more vibrant firms considered existing labor market regulations a major or very severe impediment to their economic activity and growth, particularly in Bosnia and Herzegovina and Serbia, as well as in Romania and Bulgaria.

Factors Driving Labor Market Outcomes

As discussed above, cyclical, structural, and institutional considerations all play a role in determining poor labor market outcomes in Western Balkan countries, but their interplay is far from clear. What are the key macroeconomic and country-level structural and institutional indicators that determine the overall labor force dynamics in the region? The empirical analysis in Annex 1.5 offers several important insights:

  • The Western Balkan countries are fairly similar in terms of the importance of demographic characteristics of individuals for determining labor market transitions. For instance, previously unemployed persons are more likely to remain unemployed, and higher levels of education are generally associated with better chances of finding employment. There are, however, a few notable differences.14 Specifically, younger people seeking employment face significant headwinds in all countries, but have a somewhat better chance of finding a job in FYR Macedonia and Serbia. Similarly, while females seeking employment appear to have a lower probability of finding a job in all countries, this seems to be particularly pronounced in Bosnia and Herzegovina and Kosovo.
  • Macroeconomic indicators have an important bearing on the dynamics of labor market transitions. Higher real GDP growth and more buoyant investment-to-GDP ratios are generally associated with better chances of finding a job, but in the absence of other reforms improvements in either indicator yield fairly limited results.15 Similarly, higher rates of private credit growth seem to encourage more people to seek employment, but the impact on the probability of employment is also rather muted. Fiscal stimulus (for example, higher general government fiscal deficits expressed as a percent of GDP) is associated with more people joining the labor force and with higher probabilities of finding employment, particularly if not associated with higher government-expenditure-to-GDP ratios, which offers evidence in favor of a smaller role of the state in the economy.16,17 Finally, there is strong evidence that higher remittance inflows discourage people from seeking employment and are associated with longer unemployment spans.18
  • Stronger labor market institutions are critical for better outcomes. The analysis shows that a more decentralized wage bargaining processes, more flexible hiring-firing practices, and lower redundancy costs are all strongly associated with not only additional people joining the labor force but also with a greater probability of employment.19 Similar results hold for an environment with greater reliance on professional managers chosen based on merit and qualifications. In contrast, our analysis confirms that an environment where pay is only weakly related to worker productivity is more likely to discourage people from seeking employment. Finally, as one would expect, higher female participation in the labor force is found to moderately increase competition among the job seekers.
  • Broader structural reforms are also very important. The empirical evidence suggests that countries that are more advanced in overcoming the legacies of centrally planned economies and completing transition to a market-based economy are also the ones that generate significantly higher chances for job seekers of finding employment. This finding holds irrespective of whether the stage of transition to market-based economy is measured by the EBRD Transition Index or proxied by the per capita FDI stock.

Distribution of New Firms that Consider Labor Regulations a “Major” or “Very Severe” Constraint 1/

Sources: EBRD-World Bank, Business Enironment and Enterprise Performance Surveys; and IMF staff calculations.

1/ New firms are those which operated for five years or less.

No Silver Bullet

What would it take to improve the labor market outcomes in the Western Balkans? The empirical model presented above offers an opportunity to design an illustrative counterfactual experiment that may help answer this question. We next simulate the cumulative impact of a number of policy changes on employment probabilities on a cross-country subsample of individuals holding university degrees and calculate the impact on the unemployment rate for each subsample. The findings include the following:

  • Enhancing labor market flexibility—An improvement by 25 positions in relevant rankings in the World Economic Forum’s Global Competitiveness Indicators is likely to generate a notable decline in the probability of unemployment across all age groups and for both men and women, reducing the estimated sample unemployment rate by about 5 percentage points on average, and notably more (about 8¼ percentage points) for young women. However, in the absence of other reforms, and particularly when not coupled with an improved macroeconomic environment that would support job creation, simulations show a simultaneous increase in the probability of inactivity (workers staying out of the labor force).
  • More supportive macroeconomic environment—Should the general macroeconomic environment improve, with real GDP growth, credit, and investment rates returning back to their respective 2007 levels, both labor market participation and the probability of finding employment would rise, with the greatest gains accruing to young female workers.
  • Reigniting structural reform efforts—If, in addition, structural reforms are advanced to the average level observed in Central Europe—as measured by the EBRD Transition Index—our model suggests that the probability of finding employment rises by about 20 points relative to the baseline for the most vulnerable groups, resulting in an average decline of almost 10 percentage points in the sample unemployment rate.

Illustrative Effect of Reforms on Employment Outcome Probabilities and Unemployment Rate

Sources: National Labor Force Surveys; and IMF staff estimates.

1/ Calculated for a married (if 25 or older) person with university degree; and with macroeconomic indicators, labor market characteristics, and EBRD transition indicators at Western Balkan average levels in 2013.

2/ Based on a 25 position improvement in the World Economic Forum’s GCI ranking.

3/ Based on real GDP growth, credit, and investment rates as in 2007.

4/ Based on EBRD transition indicator as in CEE5 countries.

5/ Unemployment rate effects are calibrated by estimating frequencies of individual outcomes based on simulated probabilities.

E. Lessons for Stronger Convergence

Boosting employment and productivity, and ultimately converging to EU income levels are among the key objectives for policymakers in the Western Balkans. What will it take to achieve them, particularly in the current challenging external environment where demand from Advanced Europe is weak?

A qualitative and quantitative review of the structural reform landscape presents an extensive policy agenda. The wave of reforms that brought liberalization of prices and trade and foreign exchange systems, as well as privatization in all but a few industries, started the critical process of economic transformation. But the transformation is incomplete. Improvements in various areas, including, critically, the business environment, will help strengthen the role of the private sector. However, a sustained, comprehensive, and coordinated push is needed to complete the structural transformation process that began two decades ago. Momentum for structural reform is lacking; there is a sense that reforms have under-delivered, and that the benefits of growth have not been felt widely. However, it is the insufficiency of the reform process over the last 10 years, rather than the nature of the reforms undertaken, that seems to be holding the region back.

What elements should the near-term structural reform agenda in the Western Balkans contain? A disaggregated analysis of structural reform measures has helped identify the most critical country-specific reform area, where addressing large performance gaps would yield large payoffs to growth. Despite heterogeneity among the Western Balkan countries, a number of reforms emerge as clear regional priorities and may benefit from coordinated regional solutions, notably in infrastructure. Institutional reforms—particularly the protection of property rights, fighting corruption and government inefficiency, and improving corporate sector performance—rank high across much of the region.

One caveat to this approach to prioritization is that it does not make it possible to identify synergies between reform areas, nor does it offer guidance on sequencing of reforms. It is likely that parallel implementation of critical reforms will lead to additional synergies, and the overall positive impact should be larger than the sum of the effects of individual reforms. Indeed, the need for a comprehensive effort is nicely highlighted in the examination of policies that strengthen labor market indicators—partial reform along any of the key policy areas leads to only limited improvements in employment probabilities.

1

Prepared by Nina Budina and Natasha Che (Growth and Convergence), Zsoka Koczan (Progress in Structural Transformation), Dustin Smith and Eugen Tereanu (Openness), Norbert Funke and Maksym Ivanyna (Ranking Structural Reform Priorities), and Ruben Atoyan, Irena Jankulov, and Ron Van Rooden (The Quest for Jobs), under the supervision of Ivanna Vladkova-Hollar.

2

The EBRD’s 2013Transition Report notes that openness is a particularly powerful tool to improve institutional quality, as it is achievable across a wide range of political systems. The report posits that international integration may help institutions through several channels. The increased presence of international firms helps to disseminate international business practices and standards. It may also put pressure on national and local authorities to improve the quality of government services. Dual listing of company shares may contribute to improved corporate governance.

3

Kosovo could not be included in the empirical analysis of reform priorities in the Western Balkans given data constraints. Structural reforms in Kosovo are described in detail in Box 1.3.

4

The analysis is based on data from the World Economic Forum’s Global Competitiveness Report. Competitiveness is defined as the set of institutions, policies, and factors that determine the level of productivity of a country. The database covers 144 countries, including six of the seven Western Balkan countries under consideration. Data for Kosovo are not available.

5

While the Global Competitiveness Report covers 12 reform areas (pillars), we omit two: Macroeconomic Environment and Market Size. The macroeconomic environment is analyzed in Chapter 3.

6

The methodology is appealing in its simplicity and tractability, but with the caveat that the calculated impacts are only partial and not part of a fully elaborated equilibrium framework. While this approach does not make it possible to identify synergies between reform areas and does not say much about the timing of reforms, it is likely that improvements in institutions and parallel implementation of various reforms in other areas will lead to additional synergies.

7

As Chapter 3 is devoted to financial market developments, we abstract from this otherwise critical reform area in this section.

8

The detailed analysis at the disaggregated level is indicative. Results at this level are more sensitive to the quality of data, potential measurement errors, estimation results, and the classification scheme.

9

It is important to recognize that high (structural) unemployment could coexist with relatively flexible labor markets (IMF 2013).

10

In the postcrisis environment, sluggish responsiveness of job creation to growth is likely aggravated by weakened balance sheets affecting financing conditions (ILO 2013). Also, job creation is impaired by a need for firms to build up new collateral to finance their activities (Calvo, Coricelli, and Ottonello 2012), while concurrently, fiscal consolidation could have depressed aggregate demand (ILO 2014).

11

Migration can also occur as a response to growth shocks, thus dampening their impact on unemployment. However, the remittance-reservation wage channel is likely to be dominant, because in contrast to the New Member States, most of the Western Balkans did not have easy formal access to labor markets in Advanced European economies for most of the sample period.

13

These are particularly relevant to those with jobs in state-owned enterprises and the public sector in the form of strict rules for terminating employment and generous severance payments.

14

While cultural and religious factors may have a bearing on the variety of cross-country trends, these differences likely also reflect significant heterogeneity of labor market institutions observed across the region.

15

The marginal impact of a 1 percent increase in either indicator is only 0.01 on the probability of employment.

16

One explanation for this finding could be that the fiscal impulse is picking up the statistical effect of a lower tax burden; higher fiscal deficits mean lower tax burdens for any given level of government expenditure. With low-tax countries shown to grow faster than high-tax countries (see Easterly and Rebelo 1993), this implies more employment opportunities for potential job seekers.

17

Loosening the fiscal stance by 1 percent of GDP would increase employment probability and reduce the probability of being inactive by about 0.025 and 0.035, respectively.

18

Our analysis shows that 1 percent of GDP higher remittance inflows are associated with a 0.03 increase in probability of being inactive.

19

A 25 position improvement in each of the corresponding Global Competitiveness Indicators is estimated to increase employment probability by about 0.05.

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