Front Matter

Front Matter

International Monetary Fund. European Dept.
Published Date:
March 2015
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The Western Balkans: 15 Years of Economic Transition

Regional Economic Issues Special Report

Zuzana Murgasova, Nadeem Ilahi, Jacques Miniane, Alasdair Scott, Ivanna Vladkova-Hollar, and an IMF Staff Team

MAR 15

Cataloging-in-Publication Data Joint Bank-Fund Library

The western Balkans : 15 years of economic transition. – Washington, D.C. : International Monetary Fund, 2015.

pages ; cm. – (Regional economic issues special report)

Zuzana Murgasova, Nadeem Ilahi, Jacques Miniane, Alasdair Scott, Ivanna Vladkova-Hollar, and an IMF staff team.--Cover.

Includes bibliographical references.

ISBN: 978-1-49835-651-0

1. Economic development – Balkan Peninsula. 2. Balkan Peninsula -- Economic conditions. I. Murgasova, Zuzana. II. International Monetary Fund.

HC401.W47 2015

The Regional Economic Issues (REI) is a series published to review developments in Central and Eastern Europe. The policy considerations in this REI Special Report are those of the IMF staff and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Publication orders may be placed online, by fax, or through the mail:

International Monetary Fund, Publication Services

P.O. Box 92780, Washington, D.C. 20090, U.S.A.

Tel.: (202) 623-7430 Fax: (202) 623-7201


Approved By

Aasim M. Husain

Prepared by a staff team from the European Department led by Zuzana Murgasova, Nadeem Ilahi, Jacques Miniane, Alasdair Scott, and Ivanna Vladkova-Hollar; and including Pamela Madrid Angers, Nina Budina, Natasha Che, Chris Faircloth, Marc Gerard, Nikita Kannekanti, Zsoka Koczan, Ricardo Llaudes, Murad Omoev, Janyne Quarm, Jesse Siminitz, Dustin Smith, Eugen Tereanu, Ron van Rooden, Johannes Wiegand, and Zaijin Zhan (Washington, DC); Ruben Atoyan and Patrick Gitton (Resident Representatives to Bosnia and Herzegovina and FYR Macedonia, respectively); Irena Jankulov (Sarajevo Office); and Norbert Funke, Maksym Ivanyna, and Mikhail Pranovich (Joint Vienna Institute). Administrative and editorial assistance was provided by Joanna Swirszcz. Helpful comments on earlier drafts by country teams, other IMF departments, and others outside the IMF are gratefully acknowledged.



David Lipton, IMF First Deputy Managing Director

For the Western Balkan countries, the transition from communism to capitalism and democracy was less smooth than in other parts of Emerging Europe. But once the war ended and peace returned, these countries did more than rebuild: they began a transformation into market economies, liberalizing prices, privatizing many state and socially owned enterprises, and building the institutions needed to support a market economy. During my time at the U.S. Treasury in the 1990s, I was closely involved with the Western Balkans and saw first-hand how the seeds of this transformation were planted. The process that unfolded was not uniform across the region, as starting positions differed, and has not been complete. Moreover, each country’s political realities and social and cultural preferences all played a role in the approaches taken. Nevertheless, progress over the last two decades has been evident in every country, resulting in rising incomes and living standards. One objective of this book is to document this transformation, both the tangible achievements as well as the missed opportunities.

Perhaps the most tangible achievement of all lies in the fact that the Western Balkan countries are on a path towards European Union accession, something that seemed far off in the 1990s. It is incumbent upon us not to understate the serious challenges that lie ahead, both in terms of macroeconomic stability and even more so with regard to longer-term development. A key contribution of this book is to underscore the incomplete reform process in the region. We should be worried about this, as without further reforms the lackluster growth of recent years could become the norm, imperiling the convergence of living standards towards advanced European levels, and denying employment opportunities to many in the region.

Yet, I remain confident that the region will rise to the challenge, as happened time and again in the past. Western Balkan countries understand that, without macroeconomic stability, there can be no hope of durable growth. A new wave of elected leaders, and an increasingly vibrant civil society, are ready for a second reform wave, embracing private ownership and competition, and tackling vested interests while convincing electorates that the benefits of reform need not be for the very few. We at the IMF remain deeply committed to the region, through our policy advice, our capacity building support, and, if and where needed, our financing. Here’s hoping that the next 15 years will bring even more positive change than the last 15.

Structure and Focus of the Report

This report analyses the main economic developments and achievements in the Western Balkan countries, and lays out the key macroeconomic policy challenges for the future. While the collapse of communism 25 years ago marked the start of the transition to market economics for all Emerging Europe, the economic transformation of the Western Balkans really got going only after the conflicts that engulfed the region in the 1990s subsided. Hence, the past 15 years are the main focus of this report.

The report is structured as follows. The overview chapter surveys the key findings and policy recommendations. Individual analytical chapters then focus in depth on the following key thematic issues: growth and structural reforms, macroeconomic developments and policies and the role of the IMF in the economic transformation, and the financial sector. Each analytical chapter concludes by outlining the key challenges that the Western Balkans face and suggests possible policy responses.

Given that the Western Balkan countries are following the path previously taken by New Member States to become members of the European Union, the analysis relies heavily on comparisons between these two subregions. In compressing the experience of more than 17 countries over 15 very eventful years, the report inevitably focuses on broad themes, and cannot do justice to the nuance and diversity of individual country narratives.

While the report highlights the role of the IMF during the economic transition, the Fund is only one of a number of agencies that have supported these countries over the past 25 years. In particular, the IMF may have taken a lead role in the early phases of transition, but for some Western Balkan countries the prospect of accession to the European Union has also been an important catalyst for reform. Other key players include the European Bank for Reconstruction and Development, European Central Bank, European Investment Bank, and World Bank, as well as bilateral country donors and private and voluntary sector institutions. But whether external assistance comes from the IMF or others, its impact pales in significance to the importance of domestically driven reform and development, which is the principal subject of the report.

The report was prepared by a team from IMF headquarters in Washington DC, IMF offices in the region, and the IMF’s Joint Vienna Institute (JVI). The views presented are those of the authors.

Country Coverage and Acronyms

In order to have reasonably consistent country groupings for analytic purposes, the report broadly follows the division of countries used within the IMF’s internal organizational structure. The regional aggregates are defined and country acronyms are used as follows:

  • - Western Balkans (WBS, red): Albania (ALB), Bosnia and Herzegovina (BIH), Croatia (HRV), Kosovo (UVK), FYR Macedonia (MKD), Montenegro (MNE), Serbia (SRB)
  • - New Member States (NMS, blue), which are countries that joined the EU during the 2004 and 2007 enlargement: Bulgaria (BGR), Czech Republic (CZE), Estonia (EST), Hungary (HUN), Lithuania (LTU), Latvia (LVA), Poland (POL), Romania (ROU), Slovak Republic (SVK), Slovenia (SVN)
  • - Central Europe CEE5, green): Czech Republic (CZE), Hungary (HUN), Poland (POL), Slovak Republic (SVK), Slovenia (SVN)
  • - Baltics (orange): Estonia (EST); Latvia (LVA), Lithuania (LTU)
  • - Southeastern Europe (SEE, light blue): Bulgaria (BGR), Romania (ROU)
  • - Emerging Europe: Albania (ALB), Bosnia and Herzegovina (BIH), Bulgaria (BGR), Croatia (HRV), Czech Republic (CZE), Estonia (EST), Hungary (HUN), Kosovo (UVK), Lithuania (LTU), Latvia (LVA), FYR Macedonia (MKD), Montenegro (MNE), Poland (POL), Romania (ROU), Serbia (SRB), Slovak Republic (SVK), Slovenia (SVN)
  • - Advanced European Union (EU17, purple): Austria (AUT), Belgium (BEL), Cyprus (CYP), Denmark (DNK), Finland (FIN), France (FRA), Germany (DEU), Greece (GRC), Ireland (IRL), Italy (ITA), Luxembourg (LUX), Malta (MLT), Netherlands (NLD), Portugal (PRT), Spain (ESP), Sweden (SWE), United Kingdom (GBR)

The Western Balkans: 15 Years of Economic Transition: Executive Summary

March 10, 2015

The countries of the Western Balkans have undergone a major economic transformation over the last 15 years, and many are unrecognizable compared with where they stood at the turn of the century. Following the conflict-ridden 1990s, these countries set out to comprehensively rebuild and reform their economies. They opened up to global trade and became increasingly export-oriented, expanded the role of the private sector, dismantled regulations that stifled business development, and began to build institutions needed to support a market system. Banking systems were built up—literally from scratch in some cases—with the aid of foreign capital and know-how. The result of these efforts has been robust economic growth, a significant rise in incomes and living standards, and enhanced macroeconomic stability.

However, the process of structural transformation began to stall in the mid-2000s, in the face of vested interests and as reform fatigue set in, and remains incomplete. By the time of the global financial crisis, growth in the Western Balkans was driven more by ample global liquidity and unsustainable capital inflows than by real progress in economic reform. Clear evidence of the weakness in the region’s economic model can be found in the extremely high unemployment rates, which remained above 20 percent in many countries even at the height of the precrisis boom.

Growth in the postcrisis period in the Western Balkan countries has been lackluster. The external environment has been weak, but it is the incomplete reform process that is holding back convergence to income levels of richer European Union economies. And faster growth, in itself, may not be enough. The Western Balkan countries also need to generate jobs to reverse the weak labor market outcomes that are leaving so many behind.

What, then, needs to be done? Preserving macroeconomic stability is paramount for durable growth. Previous gains in terms of low inflation should be safeguarded. Countries that are facing high fiscal deficits and public debt need to tackle them urgently; others should gradually rebuild fiscal buffers. Everywhere in the region, investment in the tradable sectors is needed to boost exports and reduce large trade and current account deficits. In addition, high levels of nonperforming loans need to be addressed so that credit can grow again and facilitate the recovery. The development of nonbank financial markets would help diversify sources of funding.

Embarking anew on deep structural reform is a key policy priority for the region. Many inefficient state- or socially-owned enterprises remain to be privatized; competitiveness problems, including red tape and weak governance, will have to be addressed if the private sector, the key engine of growth, is to flourish; and legacy practices that prevent the expansion of employment and distort labor markets outcomes will need to be dismantled.

Overview: Economic Transformation in the Western Balkans

After spending much of the 1990s mired in conflict, the Western Balkan countries have experienced a notable transformation over the last 15 years. They have transitioned toward market-based systems, privatized many inefficient state- and socially-owned enterprises, rapidly adopted modern banking systems, and enhanced the external orientation of their economies. The result has been a significant catch-up in living standards relative to their richer neighbors in advanced European Union economies. However, the pace of structural reform has been disappointing, owing to a combination of reform fatigue, resistance from vested interests, difficult politics that have constrained reform efforts, and delayed membership in the European Union. And in hindsight, part of the process of catching up was driven by unsustainable inflows in the years leading up to the global financial crisis. The region is thus still coping with the legacies of the boom period and incomplete transition. As a result, the Western Balkan countries still lag well behind the New Member States of the European Union in terms of economic transformation and income levels, which are around one-third those in Advanced EU economies. Vigorously reviving the reform momentum will be essential to improve living standards and revive income convergence.

The Western Balkans, New Member States, and Advanced European Union

The Western Balkan economies have experienced a notable transformation. While the rest of Emerging Europe transitioned peacefully out of communism and into democracy, many Western Balkan countries spent the better part of the 1990s engulfed in a devastating conflict. Yet, while the conflict caused widespread devastation and put the region’s economic transformation on hold, significant structural reforms were initiated during this decade that were then carried forward once the conflicts abated. Since then, the Western Balkan countries have made impressive gains in rebuilding their war-torn economies and moving forward with the transition to market economies. Vast swathes of state- or socially-owned enterprises have been privatized, tripling the share of the private sector in economic activity. Countries have eliminated many legacy regulations, while large projects have completely redrawn the infrastructure landscape in the region.

As they transitioned toward market-based systems, the region’s economies opened up to the world. Economies have become increasingly export-oriented, with FYR Macedonia and Serbia experiencing particularly noticeable gains. And this has been accompanied by increasing diversification of their export markets, with greater trade within the region and with the New Member States, and, concomitantly, lesser reliance on exports to Advanced EU economies. And just as Western Balkan firms were discovering new markets, foreign direct investment (FDI) into the region also took off.

One sector that has been entirely transformed by foreign investment is banking, which has facilitated a more efficient allocation of capital. Starting in the early 2000s, foreign investment into banking, combined with increased deposit bases, boosted private sector credit. In fact, with deposits and credit rising by more than 30 percent of GDP since the early 2000s, financial sectors in the Western Balkans have deepened more than those in the New Member States at comparable stages of transition. Beyond deepening, there has been an increase in financial inclusion—access to banking services for poor and remote populations—as well as banking sector efficiency, although they remain below levels in the New Member States.

The IMF was closely engaged in the Western Balkan’s economic transformation from the start. In addition to providing advice on economic matters, the IMF has had financial arrangements with almost every country in the region, often more than once. These arrangements have typically aimed at preserving macroeconomic stability in the face of major economic transformation, which the Fund was simultaneously trying to advance. In addition, the IMF has provided significant technical assistance and training to the region. This, together with efforts from other donors, has helped the region build and gradually improve key institutions for economic policymaking, be it public finance laws or bank regulatory and supervisory regimes, among others.

Altogether, the region experienced significant gains in terms of incomes and living standards, although perhaps not as much as could have been expected. With average economic growth across the region exceeding 5 percent per year over 2000–08, income per capita increased significantly and partially closed the gap with the standards of living of Europe’s richest countries. Still, income convergence of the Western Balkans cannot be seen as entirely satisfactory. In particular, the New Member States caught up with Advanced EU economies significantly faster at similar stages of transition, which raises the question why the Western Balkans did not advance at the same rate. Part of the explanation lies in the closer physical distance of the New Member States to Europe’s core, allowing some of them to integrate into the German supply chain. But another, more troubling, part of the explanation is that income convergence in the Western Balkans was slower because structural reforms proceeded more slowly and did not advance as far as in the New Member States, particularly in the area of reducing state ownership and improving governance.

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.

In hindsight, abundant global liquidity channeled into the Western Balkan countries through equity investment in their domestic banking systems facilitated some of the growth catch-up and masked the incomplete structural transformation. In the years leading up to the global financial crisis, the increase in capital flowing into the Western Balkans was as significant as that into Central and Southeastern Europe. These capital inflows were intermediated by domestic banks, and the resulting extension of credit went beyond what fundamentals would have warranted. Indeed, according to some metrics, only half of the precrisis increase in credit-to-GDP ratios in the Western Balkans could have been explained by economic fundamentals. This was similar to the experience in other Emerging European economies, although in the Baltics and Bulgaria credit expansions were both significantly greater than in the Western Balkans (with the exception of Montenegro, and perhaps Kosovo), and significantly less driven by fundamentals. But the experience of the Western Balkan countries did differ from the New Member states in one key respect—the inflows into the banking system of the former were largely in the form of FDI and equity investment, rather than borrowing from parent banks and wholesale funding markets.

In the years leading up to the global financial crisis, current account deficits increased on average by more than 10 percent of GDP. Montenegro, in particular, experienced one of the sharpest current account deteriorations in the world. While some of this reflected capital formation, much of the increase was directed into nontradable sectors, where the scope for productivity growth tends to be lower. This exacerbated the region’s competitiveness problems, relatively narrow export bases, and concomitant dependence on imports. The preference of most Western Balkan countries for fixed or near-fixed exchange rates made the needed adjustment to the competitiveness challenge more difficult.

Perhaps the biggest flaw in the Western Balkan economic model has been the chronic underutilization of human resources. In 2008, at the tail end of the growth spurt, the unemployment rate in the region still averaged more than 20 percent. Employment levels tell an equally disappointing story, hovering between 40 and 45 percent on average since 2000, a full 10 percentage points lower than in the New Member States. Employment is particularly low among women and the young, strikingly so in Bosnia and Herzegovina and Kosovo. Why has this been so? According to available evidence, skill gaps have been particularly severe in the Western Balkans, more so than in the Baltics or Central Europe. Moreover, in some countries, failure to tackle the legacy of self-management and so-called social ownership has contributed to labor market rigidity and de facto protection for insiders. These problems have, in turn, been compounded by the region’s heavy reliance on remittances, which tend to raise reservation wages (i.e., the wage at which people are willing to work) above what productivity levels can sustain.

Like elsewhere, boom times came to an end, imperiling income convergence. With the onset of the global financial crisis and the associated pull-back in global liquidity, capital flows reversed in the Western Balkans as they did elsewhere. As a consequence, credit growth slowed sharply, and current account deficits contracted by more than 10 percent of GDP on average. With the exception of Croatia, these current account contractions were not mirrored by GDP contractions, as happened elsewhere in Europe. Rather, growth simply slowed down in most Western Balkan countries. The problem is that seven years after the onset of the crisis, growth remains lackluster in the region, and hence income convergence has stalled. At currently projected growth rates, Western Balkan economies will only close a small fraction of the gap with Advanced EU economies’ income per capita levels by 2030. And it is not just about incomes: faster growth is also needed to provide employment opportunities to the large surplus of unutilized labor in the region.

In some countries, the growth and jobs challenge is compounded by the need to pursue fiscal consolidation. As happened elsewhere in Europe, a substantial share of the rise in tax revenues during the boom years proved in hindsight to be cyclical, and this share disappeared once economic growth slowed or went into reverse. The boom had also prompted some countries in the region to lower tax rates. Once the crisis hit, Western Balkan countries found it hard to scale back spending to match the decline in revenues, not least because their share of precommitted spending is higher than in the New Member States or Advanced EU economies. As a result, some of the countries, notably Serbia and Croatia, now have very high public debt levels, exacerbated by ongoing fiscal deficits that need to be brought down.

Important financial sector reforms remain to be done. Tackling the large stock of nonperforming loans (NPLs) is a priority if credit is to support the economic recovery. NPLs rose significantly more following the global financial crisis in the New Member States than in the Western Balkan countries. However, in the former NPLs have started to come down, while in the latter they remain at postcrisis peaks, and in some countries they are still increasing. While financial stability risks are mitigated by comfortable levels of bank capital and provisioning, NPLs will continue to weigh on profitability and credit growth if left unresolved. A multi-pronged effort is needed to tackle the problem, including better collateral enforcement, improved frameworks for going-concern and out-of-court restructurings, and the clearing of bottlenecks in overloaded court systems. Reforms to strengthen supervision and regulation of financial institutions have to be redoubled. Lastly, it is critical to create an environment where nonbank financial development can take place.

The key challenge facing the region going forward is to complete the structural transformation process that began two decades ago. The impressive reform process born out of the ashes of socialism had largely stalled by the mid-2000s and was left incomplete, a victim of reform fatigue, a difficult political economy, vested interests that had grown in power and sophistication, and disillusionment with the way some reforms were executed. The process of accession to EU membership—arguably a main catalyst of reforms in the New Member States—remained a distant prospect for most of the Western Balkans. But abundant global liquidity gave the illusion, albeit temporarily, that fast economic growth was possible without reforming. Today, the region lags well behind the New Member States in terms of structural transformation. In some Western Balkan countries, resistance to private ownership has meant that many inefficient state or socially owned enterprises have survived and continue to impose a drag on public finances and resource allocation. Throughout the region, red tape and corruption continue to hamper economic activity, while corporate governance reform remains a long overdue promise. Importantly, wide political support for far-reaching reform—a crucial element in the transformation in the New Member States—has been elusive in most Western Balkans countries. There is a sense in the Western Balkans that reforms have underdelivered, and that the spoils of growth have benefited only a few.

Top 5 Reform Priorities for Each of the WB States1/2/

1/ These are assessed relative to the NMS in each of the 10 main pillars of the Global Competitiveness Index.

2/ Larger bubbles represent reform areas that receive a higher rank ordering.

Note: For Kosovo, a different methodology was used as GCI data is not available for the country.

As this report will make clear, however, it is the inadequacy of reform over the last 10 years, rather than the nature of the reforms undertaken, that is holding the region back. Without a courageous reform push, Western Balkan countries cannot expect to attract the scale of investment flows that is needed to finance rapid sustained growth, and they risk staying stuck at income levels less than one-third of those of their richer European neighbors.

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