Bosnia and Herzegovina: Selected Issues and Statistical Appendix

This Selected Issues and Statistical Appendix paper on Bosnia and Herzegovina provides background information for the 1999 Article IV Consultation with Bosnia and Herzegovina. The economy has been dominated by a small number of large state-owned enterprises. A central policy was settled during the preparation of the privatization framework under which the competence to privatize was assigned to the entities. Major tax policy reforms will be needed over the medium term to address the deficiencies of the present tax system, and to lay the foundation for long-term economic growth, driven mainly by private sector development.

Abstract

This Selected Issues and Statistical Appendix paper on Bosnia and Herzegovina provides background information for the 1999 Article IV Consultation with Bosnia and Herzegovina. The economy has been dominated by a small number of large state-owned enterprises. A central policy was settled during the preparation of the privatization framework under which the competence to privatize was assigned to the entities. Major tax policy reforms will be needed over the medium term to address the deficiencies of the present tax system, and to lay the foundation for long-term economic growth, driven mainly by private sector development.

Bosnia and Herzegovina: Basic Economic Indicators, 1995-99

article image
Sources: Data provided by the authorities; and IMF staff estimates.

Data refer to the entire country, unless otherwise indicated.

Growth in 1995 is given for BIH territory as a whole.

Data coverage not comparable before and after 1997. For estimated annual growth rates, see Table 21.

Data refer to average net wages paid in a particular period, not average earnings in that period; only firms paying wages in a particular month are included in the data.

Period average retail price index. Data for both Entities are affected by post-war adjustments to market pricing.

Up to June 1998, prices observed in Yugoslav dinars and converted to DM using the parallel market rate described in footnote 14.

Change in percent of opening M2.

Excludes municipal government operations for Republika Srpska. Data for 1996 and subsequent years exclude military expenditures financed by external grants.

No net domestic financing of the budget deficit, other than arrears, in 1996-99.

Excluding official transfers.

Data for 1995-99 are rough estimates for the whole territory of Bosnia and Herzegovina.

Excluding earmarked funds and blocked accounts; including foreign exchange held by the CBBH in Payments Bureaus.

Official rate. Parallel rate not collected by the National Bank of BIH.

YUD/DM exchange rate in the parallel market collected by National Bank of Yugoslavia. The official rate exchange rate in FR Yugoslavia was set at YUD 3.3=DM 1 from December 1995 - March 1998, and YUD 6.0=DM 1 since March 31, 1998.

I. Introduction and Overview 1

1. This document provides background information for the 1999 Article IV consultation with Bosnia and Herzegovina. The first chapter contains an overview of economic developments, particularly those since the last consultation in 1998, and outlines the authorities’ economic reform strategy in key areas. Subsequent chapters elaborate this reform strategy for the financial sector, privatization, fiscal sustainability, devolution of fiscal responsibilities, social benefits, and trade.

2. The country of Bosnia and Herzegovina is at an economic crossroads. During the last four years it has undertaken a massive reconstruction effort supported by substantial financial assistance from the international community. However, the international community’s financial commitment has not been matched by a similar commitment to structural reform from the authorities. This, combined with sustained high unemployment, has kept increases in public and private savings below the pace required to replace the anticipated decline in external assistance. These developments call into question the viability of the country’s economy in the medium term. In this context, the following chapters are a mix of retrospective and prospective components. The retrospective component intends to provide a succinct summary of where policy reforms stand in key areas. The prospective component assesses the agenda of unfinished business in each of these areas. This agenda will provide elements for discussion of a medium-term reform program with the authorities in Bosnia and Herzegovina.

3. In evaluating the progress of reform and assessing the prospects for Bosnia and Herzegovina, including required further reforms, the most striking conclusions of the paper are as follows:

  • The current fiscal policy stance is not sustainable. Under unchanged policies the public debt-to-GDP ratio could reach over 180 percent of GDP by 2014.

  • The government is too large. The tax burden is considerably larger than in comparable countries. Expenditures as percentage of GDP are similarly high and concentrate on the military, and on benefits for military invalids and their families. Allocations to priorities, such as health and education, are low.

  • Fiscal reform over the next 3–4 years has to be directed to rationalizing and lowering taxes and social contributions drastically, curtailing spending on the military and military benefits, and streamlining a complex government structure.

  • Entitlements at current levels for social insurance and social assistance programs are not affordable. The social benefit systems in both Entities are caught between overly generous entitlements and a narrow resource base. Urgent measures are needed to simplify the systems, restrict the present scope for abuse, and bring entitlements in line with resources.

  • The sustainability of economic growth will require urgent private market development. This in turn will require an acceleration of financial sector reform and privatization. Although a well-defined strategy is in place, privatizations thus far have been confined to small enterprises, and the authorities must take immediate steps to privatize large enterprises.

  • Harmonization of economic policies in the two Entities to promote the development of a unified economic space in all of Bosnia and Herzegovina is critical to encourage private investment. In this regard, tax harmonization is essential to avoid wasteful fiscal competition between the Entities and eliminate opportunities for tax evasion.

  • Trade reform should be deepened. The strategy should contemplate the elimination of import surcharges, and lowering of tariff dispersion so as to converge to a low and fairly uniform tariff regime over the medium term.

A. Background 2

4. The pre-war economy of Bosnia and Herzegovina was fairly diversified, with a large industrial base and a highly educated labor force. The annual per capita GDP in 1990 was US$2,446, and nearly half the annual GDP was produced in the industrial sector of the economy, notably in energy and raw materials (electricity generation, wood production, and mining), and manufactured goods (textiles, footwear, machinery, and electrical equipment). Agriculture accounted for just about 10 percent of GDP. International trade was an important factor, with exports and imports accounting for 24 percent of GDP and 19 percent of GDP, respectively. Although closely integrated with the former Socialist Federal Republic of Yugoslavia (SFRY), and to a lesser extent with the socialist bloc, Bosnia and Herzegovina also exported a wide variety of goods, constituting nearly half of its total exports, to “hard currency” Western countries.

5. However, by the end of the war in 1995, GDP had contracted by about 80 percent from its pre-war level, and the annual per capita GDP had shrunk to just about US$500. The physical infrastructure of the country had been almost completely destroyed, and industrial activity in the country had contracted by 90 percent from its pre-war level. Trade had been virtually paralyzed during the war, and by the end of the war exports of nearly all products had dried up.

Bosnia and Herzegovina: Chronology of Key Events, 1992–1999

March 1992—Bosnia and Herzegovina declares independence from the Socialist Federative Republic of Yugoslavia (SFRY) and gains international recognition. A month later, armed conflict with the Yugoslav National Army and other internal and external forces begins.

March 1994—The Washington Agreement ends hostilities between the Croat forces and the BH Army, which had begun in early 1993, and creates the Federation of Bosnia and Herzegovina, a political union of the Bosniac-and Croat-majority regions.

November 1995—The Dayton Peace Agreement is initialed by representatives of Bosnia and Herzegovina, Croatia, and FR Yugoslavia, establishing peace and new constitutional foundations for the country (see Box 6 in Chapter VII). This is followed, by year’s end, with the country’s succession to a portion of the membership of the former SFRY in the international financial institutions. SDR 30.3 million were disbursed by the IMF, under the policy on post-conflict emergency assistance.

September 1996—First country-wide elections since secession from SFRY. Results legitimize war-time leaderships of all three ethnic groups.

January 1997—First meeting of the Bosnia and Herzegovina (State) Parliament at which it appoints a Council of Ministers, hence completing the establishment of key State-level government institutions. The three-member Presidency had begun regular meetings the previous October, and the governor of the new central bank, a foreign citizen, had been appointed the previous November.

June 1997—“Quick-start package” of economic laws on the central bank, the 1997 budget, external debt, trade and customs tariff policies is adopted by the State Parliament. A new Bosnian currency—the convertible marka—begins to be used as unit of account but not as unit of payment yet.

July 1997-January 1998—Republika Srpska (RS) institutions are essentially paralyzed by a political crisis that commenced with RS President Playsic’s dissolution of the RS National Assembly and ended with election of Milorad Dodik for Prime Minister by new Assembly elected in November. New leadership ends RS isolationist policy, begins economic reform, and foreign assistance to the RS intensifies.

December 1997—Rescheduling agreement with commercial bank creditors is signed.

June 1998—The convertible marka is put into circulation. A stand-by arrangement for BiH is approved by IMF Board.

September 12–13, 1998—General elections in BiH, which result in ethnically based parties maintaining substantial control of the political institutions in both Entities. In the RS, nationalists capture the presidency, but fail to secure the parliamentary majority required to form a government. After major delays in the formation of the Federation and State Governments, they assume office in December 1998 and February 1999, respectively.

October 1998—Rescheduling and debt-reduction agreement with the Paris Club is signed.

March 1999—High Representative removes Nikola Poplasen as President of RS. Position not filled to date. Dodik’s government continues to function, based on slender parliamentary majority support.

March—June 1999—NATO air campaign against FR Yugoslavia.

June 1999—The IMF Board approves completion of the first review under the stand-by arrangement.

July 30, 1999—The summit of the Stability Pact for South-Eastern Europe is held in Sarajevo, with the participation of heads of state and governments of 40 countries, and principals of international organizations, agencies, and regional initiatives. The main objective of the summit is to adopt a common agenda for stability and prosperity in South-Eastern Europe.

6. Growth in the period immediately following the war reflected primarily reconstruction of the country financed by the exceptionally large levels of donor assistance. In December 1995 the international donor community pledged nearly US$5.1 billion over a three-to four-year period to enable implementation of the Priority Reconstruction Program, and in 1996 alone donor disbursements for this purpose amounted to some US$1.9 billion. Donor support in the period 1997–98 averaged nearly US$1 billion annually. Jump-started by the reconstruction effort, real GDP grew at an annual average rate of some 36 percent during the period 1996–98. Industrial production nearly doubled, and was mainly concentrated in the production of wood products, textiles and apparel, and foodstuffs and beverages. Agricultural activity also recovered, with the production of food crops (mainly wheat) rising to about 80 percent of its pre-war levels. In the initial post-war period, growth was largely restricted to the Federation of Bosnia and Herzegovina, which began receiving donor assistance earlier, and in larger amounts, than the Republika Srpska (RS). During this period, growth in the Republika Srpska was generally less rapid than that experienced in the Federation, partly because it had a higher base owing to considerably less war devastation and dislocation experienced by the Republika Srpska than in the Bosniac areas of the Federation.

7. In the spring of 1999, the momentum of recovery that had been established in both Entities of Bosnia and Herzegovina was interrupted by the conflict in the former Republic of Yugoslavia (FRY). In particular, the disruption of economic links with the FRY had a severe impact on the economy of the Republika Srpska, which was heavily dependent on the FRY as a source of raw materials, and also as its chief market for finished goods. The recent, gradual emergence of inter-Entity trade has partially mitigated the adverse consequences of the Kosovo conflict on the Republika Srpska.

B. Policy Framework for Medium-Term Growth

8. Against this background the key challenges facing the economy of Bosnia and Herzegovina are to regenerate the momentum of growth that was interrupted by the crisis in the FRY, and to foster a favorable environment for private investment. Such an environment, and a substantial rise in private domestic savings, are necessary to compensate for the anticipated decline in donor assistance over the medium term.

Macroeconomic framework

9. The medium-term macroeconomic framework for Bosnia and Herzegovina is designed with a view to achieving annual average real GDP growth of more than 9 percent over the period 2000–05 (Table 1). Attaining such growth rates will entail nongovernment investment ratios to be maintained at about 16 percent of GDP during this period. Such investment ratios will have to be financed by an increase in private savings—excluding current official transfers—from 12 percent of GDP in 2000 to 16 percent in 2005. Reflecting the decline in external assistance, Bosnia and Herzegovina’s current account deficit will need to drop from about17 percent of GDP to 8 percent over the same period. To facilitate such a sharp adjustment in the current account, Bosnia’s exports will have to grow at an average rate of 14 percent during 2000–05. At the same time, non-reconstruction imports will have to grow by some 10 percent in order to support the rapid growth of private investment. However, imports of consumption goods will decline as the domestic industry recovers, and imports for reconstruction, that are projected to reach nearly $530 million in 2001, are expected to decline sharply to just about $150 million by 2005. Moreover, such an adjustment will be facilitated by radical fiscal reform (see Chapter VI). These parameters of macroeconomic adjustment imply that the savings rate of the public sector—excluding current official transfers—will have to rise from 2 percent of GDP to 5 percent on average over the period 2000–05.

Table 1.

Bosnia and Herzegovina: Macroeconomic Scenario, 1996-2005

article image
Source: IMF staff estimates.

Negative of current account.

National disposable income includes net official current and private transfers.

General government revenue including grants for budget support less current general government expenditure.

Disposable national income excludes all official transfers (but includes private).

General government revenue excluding grants for budget support less current general government expenditure.

Imports of goods and non-factor services minus exports of goods and non-factor services

10. If Bosnia and Herzegovina is successful in growing at the targeted rates over the period 1998–2005, it will double its annual per capita GDP to US$2,000 in 2005, about 20 percent below its pre-war level. A recent study of 25 transition economies in East Europe and Central Asia provides some evidence that achieving such growth rates need not be beyond the country’s capacity.3 The study finds that beyond an output decline in the initial transition period of three to five years, the majority of countries experienced strong and sustained recovery. The study also finds that the impact of initial conditions recedes over time, and that macroeconomic stabilization and progress on market-oriented reforms are dominant determinants of recovery during the transition period.

11. For Bosnia and Herzegovina to realize its full potential, both the agricultural and the industrial sectors of the economy will have to experience sustained growth in the period ahead. This will entail the implementation of sound macroeconomic policies, and a determined effort to ease several structural impediments to private investment and real GDP growth.

Policies to promote growth

Macroeconomic policies

12. The key element of the macroeconomic strategy is based on the use of a currency board arrangement to establish a nominal anchor, with the use of supporting fiscal policies to prevent the need for domestic borrowing by the Entity governments. The currency board that was introduced in Bosnia and Herzegovina in August 1997 has been instrumental in lowering inflation to single digits in both Entities and in facilitating the rapid acceptance of the convertible marka throughout the country. Thus far, the fiscal policies adopted by the authorities and the generous donor support that Bosnia has received have been key to the successful implementation of the currency board. Given the ongoing structural constraints on fiscal policy, Bosnia and Herzegovina must meet its fiscal targets in the period ahead without borrowing domestically, which will entail continued high levels of donor support for budgetary operations.

13. Bosnia and Herzegovina’s present fiscal stance cannot be sustained without such donor support. Although revenue-to-GDP ratios are very high, Bosnia’s recurrent spending requirements under existing institutional arrangements far exceed available resources, owing in part to continued high levels of unemployment. The high tax burden in Bosnia discourages tax compliance and is a strong disincentive for private investment. Thus, immediate reforms directed at lowering the tax burden are essential to achieve the authorities’ real GDP growth target. In this setting, and faced with declining levels of donor support, the authorities can attain medium-term fiscal sustainability only by implementing politically difficult expenditure cuts, notably the demobilization of a large part of the military.

Structural reform

14. The viability of the social benefits system is threatened by overly generous entitlements and a narrow resource base resulting from the prevailing high rates of unemployment.4 The pressures on resources could intensify as a result of the emigration of a large number of working age citizens, and the return of older displaced persons. Moreover, an increasing amount of domestic resources will also be required to support a viable health care system and education requirements, as external reconstruction support declines. In particular, reforms will have to address the existing imbalance between benefits granted to military and war invalids, and to other vulnerable groups. In this regard, legislation recently adopted in the RS, and under consideration in the Federation, which seeks to expand benefits to military invalids and their families, is a step in the wrong direction. Neither Entity has been able to meet the entitlements provided by the previous legislation, and an expansion of entitlements only serves to undermine the credibility of the respective governments.

15. In the fiscal area, a complex set of issues arises out of the structure of fiscal federalism in Bosnia and Herzegovina. The present assignment of revenue sources and expenditure responsibilities are mismatched across local governments, and between local and Entity governments. The Entities’ autonomy in tax policy also causes problems in coordinating fiscal policy between the two Entities. In the last year, the emergence of harmful fiscal competition among the Entities has contributed to instability of the structure of domestic taxes, and because of a failure to implement uniform tax systems, has slowed the development of a unified domestic market. The Entities are aware that both of these developments are detrimental to the growth of private investment. For this reason they have requested assistance to develop simple and transparent tax systems that will prevent such competition in the future.

16. The establishment of a sound and modern financial sector in Bosnia and Herzegovina is a priority of the structural reform program. Bosnia’s financial sector has been dominated traditionally by the payments bureaus that have had a monopoly on clearing all banking sector payments, collecting and processing tax revenues, maintaining a wide range of public sector accounts, and collecting statistics. The presence of the payments bureaus has curtailed the flow of funds to the banking system, thus preventing the emergence of banking institutions capable of financial intermediation.5 These constraints have been exacerbated by some recent bank failures, and the freezing of some assets held in the banking system. Thus, the public at large has lost confidence in the banking system. As a result of these constraints, the industrial sector of the economy has been faced with high interest rates, often as high as 3 percent a month, while loans exceeding three months in duration are uncommon.

17. To address these problems, financial sector reform—based on a two-pronged strategy—has been initiated in both Entities. In the first instance, reforms are underway to eliminate the payments monopoly of the payments bureaus, with a view to phasing out the bureaus entirely by end-2000. At the same time, efforts to place sound private banks at the core of the financial system are also in progress. In this regard, the strategy is to reduce the number of banks in Bosnia and Herzegovina through mergers, or to liquidate insolvent banks. In addition, all state-owned banks are to be privatized or liquidated by August 2000. Finally, there has been a significant improvement in the quality of bank supervision, and efforts to introduce deposit insurance are currently proceeding.6

18. A key means of encouraging private investment is to accelerate the privatization of the public sector enterprises that still dominate the economy. These enterprises are inefficient almost across-the-board, drain resources that could be utilized more efficiently, and are resented by private entrepreneurs that view the state sector as not subject to the same level of market discipline. In addition, the privatization of the main utilities, which remain in the state sector, is an important step to complement efforts under the reconstruction program to modernize economic infrastructure. To this end the program to privatize state enterprises has been initiated in both Entities. A well-structured legal framework has been adopted, and some small enterprises have already been privatized. The goal set under the World Bank’s Enterprise and Bank Privatization Credit (EBPC) is to complete the privatization of small enterprises by end-June 2000.7 The take-off of large enterprise privatization, originally envisaged by end-1999, is unlikely to take place before mid-2000. The privatization of the largest enterprises, including utilities, is envisaged for 2001.

19. The role of an open and liberal trading system in promoting the development of competitive, outward-oriented domestic industries, and in promoting the growth of foreign direct investment is now well understood. In Bosnia and Herzegovina, good progress has been made recently toward establishing a liberal and transparent trade regime (see Chapter IX). Further trade reform has to be directed at an early stage to unifying the specific import tariff surcharges at a single ad valorem rate. Thereafter, import tariff surcharges will have to be eliminated according to a well-specified timetable.

20. In other areas, important impediments to growth include the weak judicial system that precludes the timely enforcement of contracts and agreements. The court system is viewed as slow and inefficient, and since court decisions are often not based on precedent, skepticism exists as to whether decisions are fair or just. Furthermore, high taxes on civil suits discourage bringing claims to court. Reform efforts in this area have been led by the Office of the High Representative and some donors. However, a comprehensive strategy to address these problems still remains to be formulated.

21. Against the background of the generous labor policy of the socialist era, the absence of a new, clearly articulated, labor policy constitutes not only an obstacle for the privatization process, but also a significant disincentive for private investment. The existing labor laws in both Entities provide for generous vacation and maternity leave benefits, and extensive sick leave, while mandatory payroll contributions for pension, health, and unemployment insurance are high by international standards. Moreover, the process of hiring and terminating workers is cumbersome and expensive.8 In the absence of quick and decisive reform, all these factors are likely to emerge as a major impediment to the smooth functioning of the privatization process and the growth of private investment.

22. For these reasons, a new labor law was approved in October 1999 by the parliament in the Federation of Bosnia and Herzegovina. However, the new law is inappropriate for labor market conditions in Bosnia. The law would not further the goal of promoting employment in the formal sector, but would undermine workers’ rights by making compliance virtually impossible. Specifically, the law offers vastly more generous maternity benefits than even the most protective labor laws in the European Union. It also sets forth a procedure to terminate surplus workers that would be prohibitively expensive. Among other changes, modifications of these two key aspects of the labor policy should be undertaken before it is enacted into law. In the Republika Srpska, labor policy is still governed by the old law inherited from the FRY. As a priority, it would need to be replaced by a modern labor law. The donor community is working with the governments of both Entities to ensure that the needed reforms are taken at an early date. In the Federation, a working group comprising government officials and experts in the area of lab or legislation has been appointed to prepare amendments to the law. In view of the high unemployment, the final labor laws in the two Entities should be positioned at the lower end of the EU protection-spectrum to enable more flexibility in the hiring and firing of workers by the developing private sector.

23. A strategy to renew growth in the agricultural sector has been developed with the assistance of the Food and Agriculture Organization of the United Nations (FAO). With the recovery of food production to close to its pre-war levels, policies should be directed at returning industrial crop production—oilseeds, tobacco, and sugar beets, whose recovery is lagging—as well as livestock production, to their pre-war levels. Furthermore, some agricultural products could have good prospects for export. In this regard, the production of medicinal crops and fruits needs to be encouraged, because of the high international demand for these products as well as of the favorable soil and climatic conditions in Bosnia and Herzegovina. The strategy for the agricultural sector, in addition to technical steps to raise the profitability and efficiency of production, should improve the marketing and processing of agricultural products, land use, and inter-Entity trade and cooperation. The agricultural strategy shares some key elements with the strategy for industrial growth. In particular, it is based on the swift privatization of state-owned marketing agencies and agro-processors, the creation of market-oriented rural credit institutions, and the promotion of inter-Entity trade. In addition, the reclamation of agricultural land through landmine removal programs needs to continue, in the process offsetting to some degree the impact of the currently fragmented land holdings.

1

Prepared by Juan J Fernández-Ansola, Bhaswar Mukhopadhyay, and Kari Udovički.

2

Box 1 presents a chronology of key events in Bosnia and Herzegovina since 1992.

3

Havrylyshyn, Oleh, Ivailo Izvorski, and Ron van Rooden, 1998, “Recovery and Growth in Transition Economies 1990-97: A Stylized Regression Analysis,” IMF Working Papers WP/98/141. Also see Berg, A., E. Borenzstein, R. Sahay, and J. Zettlemeyer (1999), “The Evolution of Output in Transition Economies—Explaining the Differences,” IMF Working Papers WP/99/73.

4

As an example, pending legislation in the Federation would link disability benefits for military invalids and surviving family to prevailing military wages, which are well above average wages. These benefits could instead be aligned to benefits provided for civilian work-related injuries or disabilities.

5

Money (narrow) amounted to 14 percent of GDP at end-1999, 50 percent of which was held in the form of cash outside the banking system. Domestic currency demand deposits held by households, private enterprises and other were equivalent to only 1 percent of GDP.

6

The authorities will need to ensure that the banking system is suitably strengthened before the introduction of deposit insurance.

7

Large enterprise privatization, originally envisaged to begin by end-1999, is unlikely to start before mid-2000.

8

In the Federation, a major issue in this regard concerns the existence of “waiting lists” for employees that were declared redundant by their employers as a result of the effects of the war. As the Federation Labor Law stands, it places a burden on employers equivalent to a severance payment of at least nine months for each of the 70,000 workers on waiting lists.