Bosnia and Herzegovina
Selected Issues

This Selected Issues paper provides background information for the 1998 Article IV Consultation with Bosnia and Herzegovina. The paper contains an overview of economic and political developments. It describes the establishment of the Central Bank of Bosnia and Herzegovina, developments in the financial sector, and external sector developments and policies. The paper highlights that in formulating their economic program for 1998–99, the authorities in all regions indicated their commitment to an economic strategy based on the maintenance of cautious macroeconomic policies, the rebuilding of public administration, market-oriented structural reforms, and a well-coordinated reconstruction program.

Abstract

This Selected Issues paper provides background information for the 1998 Article IV Consultation with Bosnia and Herzegovina. The paper contains an overview of economic and political developments. It describes the establishment of the Central Bank of Bosnia and Herzegovina, developments in the financial sector, and external sector developments and policies. The paper highlights that in formulating their economic program for 1998–99, the authorities in all regions indicated their commitment to an economic strategy based on the maintenance of cautious macroeconomic policies, the rebuilding of public administration, market-oriented structural reforms, and a well-coordinated reconstruction program.

I. Introduction and Overview

1. This document provides background information for the 1998 Article IV consultation with Bosnia and Herzegovina. The first chapter contains an overview of economic and political developments since the last consultation discussion, in August 1996, and outlines the authorities’ economic strategy. Subsequent chapters describe the establishment of the Central Bank of Bosnia and Herzegovina, developments in the financial sector, and external sector developments and policies.

A. The Political Context

2. Bosnia and Herzegovina declared independence from the former Socialist Federal Republic of Yugoslavia (SFRY) in March 1992. War in Bosnia and Herzegovina began the following month, as the country’s secession was challenged by the Yugoslav National Army and other internal and external forces. Conflict also took place between the Croat defense forces (HVO) and the Army of the Republic of BH from 1993 to early 1994. Hostilities between the Army of the Republic and the HVO were ended by the Washington Agreement of March 1994, which also created the Federation of Bosnia and Herzegovina (a political union of the Bosniac- and Croat-majority regions). The broader conflict was ended by the Dayton Treaty of December 1995.

3. Reflecting deep-seated mistrust among regions, the new Constitution enacted as part of the Dayton Treaty provided for a decentralized governmental structure. The Constitution confirmed that the Republic of Bosnia and Herzegovina continued in existence within its internationally-recognized borders, but would henceforth be known as “Bosnia and Herzegovina.” It stipulated that the country consists of two constituent Entities—the Federation with 51 percent of the territory (and, at least initially, about two-thirds of the population) and the Republika Srpska (RS) with the remainder. The central (“State”) government has limited powers and a balanced ethnic composition, with consensus required for most decisions. Under Article III of the Constitution, the State’s economic responsibilities are limited to monetary policy under a currency board arrangement, foreign trade and customs tariff policy, and external borrowing and debt service. In addition, the State is responsible for citizenship; foreign policy; immigration, refugee, and asylum policy; international and inter-Entity criminal law enforcement; common and international communications facilities; regulations of inter-Entity transportation; and air traffic control. Functions not explicitly assigned to the State are reserved for the Entities or their sub-units, except where they are necessary to carry out specific obligations under the Dayton Treaty or to preserve the sovereignty, political independence, and international personality of Bosnia and Herzegovina. The Entities, by mutual consent, may agree to expand the powers of the State.

4. The Federation also has a relatively decentralized system of government, in which substantial powers are devolved to the 10 cantons. The Federation is responsible for defense; economic policy, including planning and reconstruction within the Federation; refugees and displaced persons; and tax and customs administration. The Federation and cantons exercise joint responsibility in a number of areas, including health, environmental policy, communications and transportation infrastructure, social welfare policy, and interior affairs. The cantons are exclusively responsible for matters not allocated explicitly to the Federation, including education, culture, housing, public services, local land use, and social transfer expenditures. A canton may delegate responsibilities to municipalities within its territory, and municipalities are granted self-rule on other local matters. In the RS, where there is no system of cantons, responsibilities are divided between the Entity and municipal governments, with the latter responsible mainly for local matters. As a result, the RS government has jurisdiction over most matters that would be handled by cantons in the Federation, such as education.

5. The Dayton Treaty provided a timetable and procedures for the early stages of the peace process. In the first weeks, an international peacekeeping force (initially the Implementation Force (IFOR), now the Stabilization Force (SFOR)), was deployed and the various local armies withdrew behind the inter-Entity boundary line. Since then military aspects of the treaty have proceeded in a generally satisfactory manner and there has been no recurrence of large-scale armed conflict. In the area of civilian implementation, however, there was relatively little cooperation between the Entities or toward the creation of State institutions in the period leading up to the first postwar elections. International organizations worked together very closely to maximize their joint effectiveness in dealing with this problem, under the leadership of the Office of the High Representative (OHR).1 The most important achievements in this period were the establishment of new institutions in the Federation; partially integrating the separate wartime administrations of the Bosniac- and Croat-majority areas; initial technical assistance to strengthen implementation capacity in the RS; and the convening of a number of inter-Entity working groups on future common institutions and policies.

6. Country-wide presidential and parliamentary elections were held in September 1996, holding out an opportunity to put civilian implementation on a stronger footing. In practice, the process continued to be very slow. The first of the new State institutions to begin functioning was the three-member Presidency of Bosnia and Herzegovina, which began to meet more-or-less regularly in October 1996. In late October the Presidency concurred in the appointment by IMF Management of an expatriate Governor of the new (and at that time nonexistent) Central Bank of Bosnia and Herzegovina, and named the other three members of the Central Bank’s governing board (see Chapter II). Finally, in January 1997 the State Parliamentary Assembly met for the first time to appoint a Council of Ministers. One of the first concrete actions of these two bodies was the adoption in June 1997 of the so-called “Quick-Start Package” (QSP) of key economic laws on the central bank, the 1997 budget, external debt, trade and customs tariff policies.

7. The implementation of most of the QSP laws did not begin until 1998, due in large part to a political crisis that emerged in the RS in late June, 1997. Following the resolution of this crisis and the appointment of a new RS government, there has been a marked improvement in inter-Entity cooperation and the functioning of the State institutions (though the latter still remain at an early stage of development). Also contributing to this sea-change was the decision of the December 1997 Peace Implementation Conference (PIC) that the mandate of the High Representative should be interpreted as giving him the authority to impose interim solutions for unresolved issues in State bodies. In subsequent months, the High Representative took decisions, inter alia, on the new State flag, the law on citizenship, currency designs, and a foreign investment law.

8. Another focus of the PIC has been on problems of governance in all regions of the country. During the war political and economic institutions of Bosnia and Herzegovina were severely disrupted and, even now, many public functions are carried out in an ad hoc manner inconsistent with existing laws. This is largely a consequence of the political and economic fragmentation of the country, which is being reversed only slowly. A preoccupation of fiscal authorities in both Entities has been to recover control of the tax base from organized criminal groups that became particularly active during the war. In cooperation with the OHR and international peacekeeping forces, the EU’s customs and fiscal advisory office (EC-CAFAO) is spearheading efforts to help address these problems. The OHR is also establishing an Anti-Fraud Unit to help the authorities prosecute cases of official corruption. The Entity authorities have made numerous changes in their tax and customs administrations in recent months, in response to internal investigations and EC-CAFAO reports. Donors have expressed concern about the diversion of some assistance to purposes for which it was not intended, but neither international nor domestic investigators have found evidence of systematic corruption in the management of donor funds.

B. The Economic Situation and Strategy

9. In formulating their economic program for 1998-99, the authorities in all regions of the country have indicated their commitment to an economic strategy based on the maintenance of cautious macroeconomic policies, the rebuilding of public administration, market-oriented structural reforms, and a well-coordinated reconstruction program. The strategy has three macroeconomic pillars: (i) the use of a fixed exchange rate as a nominal anchor, through the currency board arrangement; (ii) fiscal discipline, aimed initially at the avoidance of domestic borrowing by all levels of government; and (iii) large-scale external assistance on concessional terms. The highest priority structural measures for 1998-99 include banking reform; enterprise privatization and restructuring; pension and health system reform; implementation of a simplified customs tariff system; exchange and trade liberalization; and initial steps in the strengthening of economic statistics. To address governance issues, early in the postwar period the authorities have drawn upon the assistance of the IMF, World Bank, and US government to improve budgeting and treasury management techniques; EC-CAFAO to improve and monitor the workings of the customs administrations; and these and other donors to begin reorienting the legal framework and improving statistical systems. Under the program, the authorities are to intensify these efforts and also take more direct measures to address some of the specific governance problems described above. In addition to changes in personnel, the latter include the elimination of discretionary tax and customs tariff exemptions, more even-handed and transparent approaches to payment of social benefits, technical improvements of customs and excise tax administration, and placing the customs administration and financial police of the RS under the authority of the Ministry of Finance.

10. Most of Bosnia and Herzegovina was devastated by the war and economic recovery is still in its early stages. National accounts statistics are unreliable and in the process of revisions, so that any statements about developments in national income and product are highly tentative; substantial revisions are likely in the coming year as technical assistance efforts take hold.2 Real GDP is estimated to have grown by about 30 percent in 1995, 50 percent in 1996, and another 30 percent in 1997 (see Basic Indicators, and Table 1). The leading sectors have been capital expenditures (mainly reflecting the donor-financed reconstruction program—see Chapter IV) and net exports. Despite these rapid growth rates, GDP in 1997 was estimated to be only half of its level in 1990. The pickup in economic activity has been much stronger in the Federation than in the RS, due to the relative access to external assistance and, until recently, constraints on merchandise trade with the RS through the Federation and the Republic of Croatia (Table 2). Employment has risen rapidly in the Federation (Table 3) and the unemployment rate has dropped from 70-80 percent of the labor force to perhaps 30-40 percent since the end of the war. Anecdotal evidence suggests that there has been less progress in the RS; country-wide unemployment is still estimated at around 40 percent of the labor force. The unemployment problem is being exacerbated throughout the country by demobilization and the return of refugees. Wages (Tables 4-5) and social benefits in the Federation have risen much more rapidly than those in the RS since 1995.

Table 1.

Bosnia and Herzegovina: Gross Domestic Product by Entity and Broad Sectoral Activity, 1994-97

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Source: Data provided by the authorities of the Federation and the Republika Sprska; and staff estimates.

GDP estimates for the Republika Srpska include staff adjustments to the official estimates, reflecting the widespread use of parallel market exchange rates in domestic transactions as well as sizeable unrecorded trade activities.

Table 2.

Bosnia and Herzegovina: Industrial Production, 1994-Feb 98 1/

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Sources: Data provided by State Statistical Office and Statistical Office of Republika Srpska.
Table 3.

Bosnia and Herzegovina: Employment in the Federation, 1994-Jan. 98

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Source: Federation Statistics Institute.

Data prior to September 1996 apply to the Bosniac-majority area only.

The category of “waiting” applies to personnel not actually working, but for whom contributions (pension, health) are paid; data distinguishing between those actually working, and those “waiting” are available beginning September 1996.

Includes government administration, education, health care, and other social services.

Table 4.

Bosnia and Herzegovina: Average Monthly Wages in the Federation, 1994-97

(In deustche marks) 1/

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Source: Data provided by State Statistical Institute.

Includes government administration, education, health care, and other social services.

Table 5.

Bosnia and Herzegovina: Average Monthly Wages in the Republika Srpka 1994-97

(In deutsche marks) 1/

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Source: Data provided by Statistical Office of the Republika Srpska.

Based on the average monthly parallel market exchange rate between the YUD and DM.

Includes government administration, education, health care, and other social services.

11. As described in Chapter II, the new Central Bank of Bosnia and Herzegovina (CBBH) began partial operations in August 1997, initially only in the Bosniac-majority area of the Federation. Five currencies are presently in use within the country: the BH dinar, which continues to circulate pending the introduction of banknotes in the new domestic currency, the convertible marka (KM) in June; the KM, which presently exists only as a unit of account for bank deposits and payments system transfers; the Croatian kuna (in the Croat-majority area of the Federation); the FR Yugoslavia dinar (in the RS); and the deutsche mark (DM) (throughout the country). Mirroring these arrangements, monetary developments in recent years have largely reflected developments in the balance of payments (see Chapter III). In 1996, the broad money supply expanded by over 96 percent, in connection with a surge in foreign financing, but slowed to 25 percent in 1997, as aid inflows moderated.

12. Following a wartime bout of hyperinflation, during 1994 the monetary authorities in all regions instituted policies of avoiding the use of central bank credit to finance the fiscal deficit. This policy was more immediately successful in the Federation, where the retail price index declined sharply during 1995-96, due not only to the tightening of monetary and fiscal policy, but also to the successful pegging of the domestic currency to the DM and improved access to imported consumer goods (Table 6). In the RS, inflation measured in Yugoslav dinars (YUD) continued to be affected during 1995-96 by the depreciation of the YUD exchange rate, owing mainly to economic policies in the FR Yugoslavia. However, inflation began to improve after the removal of economic sanctions on the RS and the FR Yugoslavia in early 1996.3 With currencies in both Entities largely stable in terms of the DM during 1997 (Figure 1), increases in retail prices were moderate and largely reflected adjustment in official utility charges and rent (moderated in the RS by diversification of import sources following an agreement on transit trade through the Federation).4

Table 6.

Bosnia and Herzegovina: Retail Price Developments, 1995-Feb 98

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Sources: Federation and Republika Srpska Statistical Offices; and staff estimates.

Index based on prices denominated in FR Yugoslavia dinars.

YUD-based index, converted into DM using parallel market exchange rate.

Parallel market exchange rate.

Figure 1.
Figure 1.

Bosnia and Herzegovina: Bilateral Nominal Exchange Rates, January 1994 - April 1998

Citation: IMF Staff Country Reports 1998, 069; 10.5089/9781451804768.002.A001

Sources: Data provided by the authorities of Bosnia and Herzegovina, the Federal Republic of Yugoslavia, and Croatia.1/ Prior to the introduction of the convertible marka (KM) in August 1997, the domestic currency was the Bosnian dinar with a fixed official exchange rate of 100 BHD per deutsche mark (DM) as from August 1994.2/ FR Yugoslav dinar per DM.3/ Croatian kuna per DM.

13. With its export capacity largely inoperative and facing a need for substantial imported consumer and capital goods, Bosnia and Herzegovina has experienced large current account deficits in recent years, financed mostly through official transfers and private remittances (see Chapter IV). Donors have been supportive of the authorities’ US$5.1 billion priority Reconstruction Program, but disbursements slowed somewhat during 1997, owing mainly to donors’ concerns about slow implementation of civilian aspects of the Dayton treaty.

C. Fiscal Policy and Institutions

14. In support of the monetary arrangements, fiscal policy at all levels of government has been based on avoiding domestic borrowing (Tables 7-10). Within this constraint, both Entities attempted during 1996-97 to restore civilian expenditure to the extent possible. In the case of the Federation, this policy was facilitated by a rapid increase in tax revenue, especially from sales, customs and excise taxes. In the RS, revenue shortfalls and lack of access to external assistance led to a decline in on-budget spending. In both Entities the balancing of the budget on a cash basis also required the accumulation of domestic and external arrears. In the context of the 1998 budgets, a wide range of domestic arrears and other claims on governments will be resolved, mainly in conjunction with the privatization process, and legislation on budget execution and the operations of the social funds is being revised to avoid further domestic arrears. In the coming years, the focus will be on improving systems of budget planning and control, defining equitable and sustainable social expenditure policies, and growth-oriented tax reform. Tax reform will be guided by the principles of: (i) applying low tax rates to broad bases, thereby minimizing distortions; (ii) harmonizing policies and administrative procedures between the two Entities; (iii) enhancing the buoyancy of the tax system; and (iv) eliminating unnecessary complexities that hinder tax administration.

Table 7.

Bosnia and Herzegovina: Consolidated Fiscal Position, 1996-97

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Excludes local government and district operations.

Cash basis.

Includes district, canton, and municipal expenditures, for which insufficient data is available to permit allocation among the categories.

Table 8.

Bosnia and Herzegovina: State Budget, 1997-98

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Source: Council of Ministers of Bosnia and Herzegovina; and staff estimates for 1997.
Table 9.

Bosnia and Herzegovina: Federation Budget, 1996-98

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Sources: Federation Ministry of Finance.

Domestic financing for 1998 represents budgeted privatization revenue.

Table 10.

Bosnia and Herzegovina: Republika Srpska Budget, 1996-98

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Source: Data provided by authorities, and staff estimates.

Converted at average parallel market rate of DM 1 = YD 3.5

15. The new fiscal institutions required under the peace treaty at the level of the State and within the Federation are not yet fully in place, although there has been progress. The Parliamentary Assembly of Bosnia and Herzegovina has adopted laws on the 1997 and 1998 State budgets, external trade, customs tariffs, and debt. In the Federation a unified customs administration and tax administration have been established. The customs administrations of the Entities have begun cooperating, with assistance from EC-CAFAO, and are preparing to implement the new State customs policy.

16. The first State budget under the postwar structure of government was adopted in 1997, but served mainly as a mechanism for channeling resources from the Federation to holdover bodies from the previous Republic of BH. In 1998 the new State institutions will become operational. The 1998 State budget provides for overall expenditures of KM 183 million, consisting of administrative costs (KM 57 million) and external debt service (KM 126 million). State government expenditures will be financed mostly by transfers from the budgets of the two Entities. For administrative costs, the respective transfers from the Entities to the State are to be paid 2/3 by the Federation and 1/3 by the Republika Srpska. The respective contributions to external debt service have been determined by a working group, by allocating debt service according to the location of the final beneficiary of the loan, insofar as such an allocation was possible. Debt that could not be allocated in this fashion was split between the two Entity budgets in the same proportions as total allocated debt.

17. In the context of the Federation budgets for 1998, the Federation fiscal system is being developed further and the remaining vestiges of the two separate wartime fiscal systems are to be eliminated. During 1996-97 unified Federation tax and customs administrations became operational, cantonal governments and administrative structures were defined, and an assignment of revenues was agreed upon among the Federation, cantonal, and municipal governments. The unification and modernization of the tax systems also has begun, with unified tax rates adopted for wage, sales, excise, and—most recently—profits taxes. The base for the wage tax has been broadened, the number of sales tax rates reduced from 5 to 4, and collection of sales taxes on excisable goods shifted to the wholesale level. To reduce disincentives for employment, a 10 percent surcharge on wages in one part of the Federation has been eliminated and contribution rates for pension, health, and unemployment insurance are being reduced and unified. The Federation government recently discontinued ad hoc exemptions that have been granted to a number of state-owned firms for the payment of social contributions and import duties, and most other exemptions to import duties are to be eliminated as part of the implementation of the new State customs tariff regime.

18. On the expenditure side, new procedures for budget preparation and the classification of expenditures, consistent with IMF Government Finance Statistics definitions, have been introduced by the Federation and most cantonal governments in the preparation of the 1998 budget. In light of the importance of cantonal fiscal operations in the fiscal system, most cantons have been voluntarily reporting budget results to the Federation Ministry of Finance on a regular basis. Under the 1998 budget execution law, all Cantons will be required to report quarterly on their fiscal operations, with substantial penalties for non-compliance. The transparency of the fiscal system has been increased by bringing a substantial part of military expenditures on-budget in 1997 and 1998.5

19. In the RS, the 1998 budget is focusing both on ways to strengthen the revenue base and on the prioritization of expenditures. Revenue increases are expected to stem mainly from a strengthening of economic activity and improvements in tax and customs administration, drawing on technical assistance from EC-CAFAO, the IMF, World Bank, and US government. Toward this end, the RS government changed the management of the customs administration and financial police and placed them under the control of the Minister of Finance. The RS is committed to increased collection efforts for monthly tax payments and greater enforcement and auditing of tax returns. As part of this effort, the payment of excise taxes and sales taxes on excisable goods has been shifted to the wholesale level. To further improve the administration of excise taxes, tax stamps have been introduced for alcohol, cigarettes, and other excisable goods. The sales tax base has been broadened through the elimination of most exemptions and the sales tax rate has been reduced from 24 to 18 percent for goods and 7 to 4 percent for services. During 1998 the Entity also has begun to benefit from external assistance to the budget, which is essential to the success of the reform effort.

II. The Establishment of the Central Bank of Bosnia and Herzegovina 6

20. The Central Bank of Bosnia and Herzegovina (CBBH) began partial operation on August 11, 1998. Its establishment followed two years of intense internal debate over how to organize the new institution and define its prerogatives in policy making. While a broad consensus has been reached on these matters, the institution-building process is still under way as the CBBH continues to consolidate its credibility and expand its area of activity. This chapter presents a compact overview of the institution—its legal framework, organization, and modalities of operation.

A. The Legal Framework

21. At the time of the signing of the Dayton Treaty in December 1995, monetary policy was under the control of three distinct monetary authorities with no overlapping jurisdictions. One domestic currency and three foreign currencies were in widespread use. The domestic currency, the BH dinar issued by the National Bank of Bosnia and Herzegovina (NBBH), circulated only in the Bosniac-majority area of the Federation. The Croatian kuna and FR Yugoslavia dinar were widely used in the Croat-majority area of the Federation and the Republika Srpska (RS), respectively. The deutsche mark (DM) was widely used throughout the country.

22. The new Constitution enacted as part of the peace accords sought to restore monetary integration by mandating that:7

  • There will be a Central Bank of Bosnia and Herzegovina, which shall be the sole authority for issuing currency and for monetary policy throughout Bosnia and Herzegovina.

  • 1. The Central Bank’s responsibilities will be determined by the Parliamentary Assembly. For the first six years after the entry into force of the Constitution, however, it may not extend credit by creating money, operating in this respect as a currency board; thereafter, the Parliamentary Assembly may give it that authority.

23. Thus, the Constitution not only defines a broad mandate for the CBBH but provides a framework for the conduct of monetary policy.

24. The choice of a currency board arrangement in the Dayton/Paris Treaty was motivated by the importance attached to the credibility of a nominal anchor in the uncertain postwar environment. Moreover, it reflected the need to avoid—in a fragile political system—frequent decision-making in matters of great economic sensitivity, as it would happen under an alternative arrangement with signi