Bosnia and Herzegovina: Staff Report for the 2001 Article IV Consultation

This 2001 Article IV Consultation highlights that after several years of double-digit growth rates, real GDP for Bosnia and Herzegovina increased by about 5.5 percent in 2001. The growth slowdown was particularly marked in the Republika Srpska, where output grew by just 2 percent. The slowdown—which is partly owing to lower aid-financed reconstruction spending—marks the end of the post-war economic rebound. Industrial production is still less than half its pre-war level and measured unemployment remains high at 40 percent.

Abstract

This 2001 Article IV Consultation highlights that after several years of double-digit growth rates, real GDP for Bosnia and Herzegovina increased by about 5.5 percent in 2001. The growth slowdown was particularly marked in the Republika Srpska, where output grew by just 2 percent. The slowdown—which is partly owing to lower aid-financed reconstruction spending—marks the end of the post-war economic rebound. Industrial production is still less than half its pre-war level and measured unemployment remains high at 40 percent.

I. Background

1. Six years after the Dayton Accords, the challenge facing Bosnia and Herzegovina is to make the transition from a post-conflict rebound, spurred by massive aid inflows, to durable growth spurred by a dynamic private sector. A lot has already been achieved: ethnic tensions have been reduced; much of the physical infrastructure has been rebuilt; the currency board arrangement has brought macroeconomic stability. The next steps are to lock in the macroeconomic stabilization by securing sustainable fiscal adjustment, and to create a business friendly environment by further structural reforms.

2. The governments that took power in early 2001 have made progress in macroeconomic stabilization and structural reforms.1 Nonetheless, their freedom of action is constrained by their weak positions in parliament. In the Federation, the Alliance for Change is a coalition with a razor-thin majority in parliament, while in the Republika Srpska (RS) the ruling coalition relies on the support of nationalist parties to secure a majority in parliament. In addition, the two-year electoral cycle makes for a short policy horizon: the next elections are scheduled for October 2002. The ethnic factor still interferes with policymaking.

3. BiH’s first stand-by arrangement expired shortly after the completion, on May 25, 2001, of the sixth and seventh reviews. A prior action for these reviews was misreported; on November 2, 2001, in light of the corrective measures taken by the authorities, the Executive Board granted a waiver which brought the purchases under the sixth and seventh reviews into compliance.

4. Article IV discussions overlapped with discussions of a possible program to be supported by a stand-by arrangement. The authorities hope that a second SBA-supported program will provide a framework for continued fiscal and structural reforms, serve as a catalyst for continued external finance, and help create a track record to allow an eventual move to a medium-term program supported by the PRGF and/or EFF. Program discussions have not yet been concluded because the RS authorities have not committed to keep the harmonized sales tax in place, potentially undermining a key reform under the previous program, and because the draft 2002 budget of the Federation is based on revenue estimates that the staff views as unrealistic and expenditure measures that have not yet been defined in sufficient detail. Discussions of these issues are ongoing. Agreement will also need to be reached on the next phases of the reform of treasuries and tax administration as well as other structural reforms.

II. Recent Economic Developments

A. Macroeconomic Developments

5. Real GDP growth slowed sharply in both Entities in 2000-2001 (Figure 1). For the country as a whole, the staff estimates that real GDP growth decelerated from 10 percent in 1999 to 6 percent in 2000 and 5½ percent in 2001. This slowdown appears to mark the end of the post-war economic rebound even though measured GDP is still little more than half its pre-war level. In 2000, the slowdown was exacerbated by a severe drought, which affected hydro electricity generation and agricultural output. In 2001, agricultural production revived but growth slowed in both Entities. The RS suffered a more pronounced slowdown than the Federation—a development confirmed by industrial production data, which strengthened in the Federation but declined sharply in the RS (Figure 1 and Table 1)).

Figure 1.
Figure 1.

Real GDP Growth, 1998-2001

Citation: IMF Staff Country Reports 2002, 052; 10.5089/9781451804799.002.A001

Sources: Entity statistics agencies; and IMF staff estimates.

6. Official statistics on production and employment are unreliable (Appendix III) and, owing to the pervasiveness of the gray economy, may underestimate the level of output and employment. Available data put the unemployment rate at about 40 percent but a large body of anecdotal information suggests that this figure substantially overstates the true unemployment rate. High social contributions and taxes are strong incentives to underreport employment and wages: in many establishments more than half the employees are in the gray economy.

7. The inflation rates in the two Entities are converging at a low level. In the Federation, inflation has been well below 2 percent for the last three years, while in the RS, inflation has steadily decelerated, reaching single digits in 2001 (Figure 2). Overall countrywide inflation rate declined from 5½ percent in 2000 to 3 percent in 2001, undoubtedly reflecting the stabilizing effect of the currency board.

Figure 2.
Figure 2.

Average Inflation by Entity 1997-2001

Citation: IMF Staff Country Reports 2002, 052; 10.5089/9781451804799.002.A001

Source: BiH authorities.1/ Through September 2001.

8. A factor in the narrowing inflation differential and convergence of price levels is increased economic integration between the Entities. In 1998, prices for basic foodstuffs were 20 percent higher in the Federation than in the RS. By 2001, the difference had been nearly eliminated. Over the same period, the nominal gross wage differential declined from 98 percent to 50 percent (Figure 3). Other evidence of closer integration is the widespread use of the KM in the RS, where the currency was initially accepted only slowly.

Figure 3.
Figure 3.

Nominal Gross Wages by Entity (KMs) 1997-2001

Citation: IMF Staff Country Reports 2002, 052; 10.5089/9781451804799.002.A001

Sources: BiH authorities; and IMF staff estimates.1/ Through September 2001.

9. Real effective exchange rates for 1998-2001 indicate a modest gain in competitiveness in the Federation and a more pronounced loss of competitiveness in RS. These trends are confirmed by wage data: during the same period, average gross wages, expressed in U.S. dollars, declined in the Federation and edged up in the RS. In 2001, dollar wages in the Federation were about 20 percent lower than in the advanced transition countries. The loss of competitiveness in the RS needs to be understood in light of the exceptionally low prices and wages at the beginning of the period and the catch-up in prices and wages described above. Indeed, even after significant rises, dollar wages in RS in 2001 were still 50 percent lower than in the Federation and were in-between those in Latvia and in Romania.

10. Exports grew strongly and aid-related imports contracted but there are conflicting data on overall imports and hence on the current account deficit in 2000-01. Following the end of the Kosovo war, export growth picked up strongly, from a low base, and strengthened further in 2001 as the free trade agreements with neighboring countries came into effect and the European Union granted free entry of goods (see below). Import figures provided by the authorities show a significant decline relative to GDP, while partner country data suggest continued buoyancy, in spite of reduced imports for donor-financed reconstruction. Estimates based on the authorities’ figures suggest that the current account deficit (excluding transfers) declined to 18 percent of GDP in 2001 (Table 7) while partner country data implies that the current account deficit was roughly unchanged at 24 to 25 percent of GDP. By either measure the current account deficit remained large. It is likely, however, that the deficit is overstated, possibly by a large amount, owing to unreported transactions.2

11. The external public debt ratio declined in 2001, owing to debt cancellation (Box 1). The stock of public sector external debt at the end of 2001 was estimated at 56 percent of BiH GDP. At end-2000 the largest creditor was the World Bank, which accounted for 42 percent of the debt stock (Table 9). Another 10 percent was owed to other international financial institutions including the IMF. The remainder was owed to Paris Club creditors (18 percent of the total), London Club creditors (4 percent) and “other” creditors (27 percent). External debt service, which is almost all on concessional terms, remains manageable, but it is projected to rise significantly in the next few years (Table 9).

Relations with External Creditors

Paris Club

The only Paris Club issue still outstanding is the signing of the bilateral agreement with Japan. The interest rate applied to debt service and the amount of penalty interest are both still under negotiation. It is expected that negotiations will be completed, and debt service resumed, in 2002.

London Club

The London Club agreement covers US$262 million of commercial bank debt. The agreement stipulates that if BiH’s per capita GDP reaches US$2,800 by 2006, an additional US$436 million in commercial debt will be rescheduled; otherwise, negotiations will begin for a debt write-off in 2007.

Other Debt

This consists of debt to former COMECON countries, meanly former Czechoslovakia, as well as trade credit and unassigned debt inherited from the former SFRY, The amount outstanding was estimated to be US$946 million at end-2000. The liability for “other debts” was allocated among the successor states on the basis of the geographical location of the end-user. A rescheduling or cancellation of such debt was to have taken place in 2000. By end-2000, only around US$350 million had been cancelled. To date, the debt owed by the Federation has been identified and is under discussion. The amount owed by the RS is estimated at US$300 million. Many of these credits were extended by now non-existent state-owned enterprises in former COMECON countries, which complicates their settlement.

B. Fiscal Developments in 2001

12. On the basis of projections made at the end of 2001, the general government deficit (on a commitment basis) declined from 20 percent of GDP in 2000 to 13 percent in 2001 (Table 2). Revenues are estimated to have declined by 2 percentage points of GDP (owing mainly to lower sales tax rates), but expenditure commitments are estimated to have dropped by as much as 11 percentage points, through belt-tightening by the Federation cantons and the RS government, a scale-back of pension entitlements, and a decline in (foreign financed) spending on reconstruction. A definitive assessment of the 2001 outcome is not yet possible, pending further information on budget execution by the Entities. Preliminary data received since December suggest that a significant part of the projected adjustment has in fact taken place but that the cantons, whose budgets were put under considerable strain in 2001, have accumulated arrears equivalent to 1-1 percent of GDP.3

13. The cut-back in expenditures in 2001 was intended to halt the accumulation of arrears which had reached 4 percent of GDP in 2000and to free up resources to start repaying arrears accumulated in previous years. In the Entities, large amounts of unfinanced and unbudgeted spending counter to understandings under the Fund program had led to a sharp increase in budgetary arrears in 2000.4 At the same time, pension arrears had swelled because benefit entitlements far exceeded the resources of the pension funds. The governments that took office in 2001 were determined to reverse this trend by implementing their budgets as passed and by enforcing laws which adjust pension entitlements to the amount of cash available. In addition, the RS budget and the Federation revised budget set aside resources to clear arrears equivalent to more than 1 percent of BiH GDP.

14. The commitment to clear arrears was underpinned by strengthened control over budget execution in the Entities. The Ministries of Finance began to control budgetary commitments. In the Federation, the practice of implementing the budget on ethnic lines was ended (except in the military), while the RS authorities stopped using tax offsets and operations of the Goods Reserve Directorate to circumvent budget ceilings. Finally, the new Supreme Audit Institutions, which began operation in 2001, assessed the stocks of arrears and provided an effective basis for improved parliamentary oversight of budget execution.

15. In spite of generally tight spending policies, tensions on the spending side remained: (i) both Entity authorities found it difficult to resist political pressures for increased wages; (ii) large unbudgeted commitments (notably for the State Border Service) distorted the execution of the State budget; and (iii) pension entitlements, which are a major indirect threat to the Entity budgets, were brought down only with difficulty.5

16. In addition, as in previous years, the seasonality of tax revenues and delays in policy-linked disbursements by international financial institutions further complicated the execution of the Entity budgets. For the most part, adjustments were made on the expenditure side. The RS authorities scaled back expenditures in some areas and cleared fewer expenditure arrears than budgeted. In the Federation, a resource shortfall relative to the amounts in the revised budget was covered by clearing fewer pension arrears than planned.

17. Next to improved budgetary discipline, the most significant fiscal development in 2001 was a sales tax reform that completed the unification of indirect taxes across the Entities.6 The sales tax was simplified, virtually all exemptions were eliminated, and effective tax rates were lowered from an excessively high level. The two Entity sales taxes now have a simple rate structure (20 percent and 10 percent), nearly identical bases, and a small number of exemptions. The reform was put in question in late 2001 when discussions were reopened with proposals for deeper cuts in tax rates, changes in the point of collection, and changes in excise taxation. Progress towards full harmonization was also marred by the Entities double imposition of excise taxes on inter-Entity trade and delays by the RS authorities in implementing a mechanism that allocates excise tax revenues to the Entity of final consumption.7 Finally, divergences in customs valuation and differences in taxation between the Entities and Brčko District have been a source of friction (Box 2).

Brčko Special District

Brčko District (90,000 inhabitants), a small special administrative unit under international supervision, has become a focal point of discontent for the Entity authorities. One issue stems from the fact that a significant amount of imports clears customs in Brčko, channeling revenues to the Brčko budget. Allegations of customs under-valuation in Brčko are widespread, and increase the incentive to route trade through the District. The Brčko customs authorities assert that the high customs revenues are due to the District’s location at a transport node and the efficient District customs administration. Other areas of dispute include the District’s unregulated and untaxed “Arizona” trading area (the District authorities are gradually bringing Arizona into the tax net), privatization receipts and pension contributions.

Regarding sales tax reforms, the Brčko District authorities have agreed in principle to full harmonization but have put their reform on hold, pending finalization of the Entity sales taxes.

C. Monetary and Financial Sector Trends and Policies

18. At the beginning of 2001 BiH’s payments bureaus (government-run interbank clearing systems inherited from the former SFRY) were shut down and replaced by a commercial bank-based clearing system, the first in any successor state of the former SFRY. Teething problems were quickly overcome and the system is now functioning well, though transactions fees are higher than had been anticipated and role of the payments bureaus in compiling statistics has not been replicated.

19. The gross foreign assets of the central bank increased further in 2001, as residents continued to move their cash holdings from deutsche marks into KM. This trend, which reflects growing confidence in the KM, was mirrored and reinforced by a gradually diminishing role of the deutsche mark as a medium of exchange. The shift from deutsche mark cash into KM cash accelerated strongly late in the year in the run-up to the introduction of euro notes; consequently, gross reserves more than doubled from June to December.8 It is too early to say whether the shift into KM will continue in 2002 or be partly reversed. Since the euro is not one-to-one against the KM, however, it is unlikely to have as important a role in BiH as the deutsche mark once did.

20. The development of private sector banking is well advanced in the Federation, but still at an early stage in the RS. Since 1999, foreign banks have opened branches in the Federation and become dominant in the markets for deposits and consumer loans. In addition, the privatization of large state-owned banks is moving ahead. An agreement on the privatization of PBS, the largest banking group in the Federation, was signed in December 2001. After the PBS privatization is completed, an estimated 90 percent of the Federation banking sector (by assets) will be privately held, with 70 percent foreign-owned. In the RS, the financial condition of the three largest state-owned banks deteriorated in 2000 and 2001 owing in part to the poor performance of loans to the public sector. Two of the three became illiquid in September 2001 and were suspended by the RS Banking Agency. The authorities have since been working with the World Bank on a plan to privatize or liquidate these banks.

III. Discussions with the Authorities

21. The authorities see rapid economic growth as the key to their fundamental goals of reducing poverty and unemployment, but delays in reforms to improve the business environment have put growth at risk just when the aid-driven post-war economic boom is coming to a close. There are significant administrative and legal hurdles to starting a business in BiH. New businesses find it difficult to navigate the legal and administrative systems of the State, two Entities, and ten cantons (plus Brčko District). The fragmented regulatory system offers incentives for corruption by government officials. The courts and other institutions do not have sufficient resources to apply commercial law quickly and efficiently. Finally, the market for land does not function well, which discourages green field investment and prevents enterprises from using property as collateral for loans.

22. The growth outlook is also undermined by demands on public resources which, if not contained, may threaten macro economic stability.9 New and growing State institutions are absorbing resources but offsetting spending cuts are not always made at lower levels of government. Foreign aid for reconstruction is declining but the public sector has not yet taken over development efforts. The Entities are burdened with multiple financial obligations, including frozen foreign currency deposits, domestic expenditure arrears and war debts, but they have not yet decided how much they can afford to pay. Finally, large entitlements to pensioners and veterans have not yet been scaled back in a definitive manner. Public debt (including domestic arrears) is estimated at 62 percent of GDP at end-2001; in addition, frozen foreign currency deposits are equivalent to about 30 percent of GDP.

23. BiH’s decentralized governmental structure and the sometimes divergent views of Entity governments on the role of State institutions have also been obstacles to reform. The difference of views has delayed the introduction of a value added tax (VAT) and the identification of a reliable source of revenues for the State budget. It also limits the scope for creating country-wide regulatory and supervisory agencies.

24. Against this background, discussions focused on the need to speed up structural reforms that enhance the development of the private sector, put government finances on a sounder footing, and allow the attainment of sustainable high rates of growth over the medium term.

A. Medium-Term Scenario

25. Staff and the authorities agreed that private investment would have to increase strongly in order to keep real GDP growth at 5 or 6 percent per year. In turn, the investment take-off would require both a stable macroeconomic environment and far-reaching structural reforms to remove impediments to private sector activity. On this basis, the staff prepared an illustrative medium-term scenario covering 2002-06 (Table 11). In this reform scenario, reduced foreign-financed reconstruction is replaced by strongly growing private investment and domestically financed government investment. The external current account deficit shrinks significantly owing to a rise in domestic savings, roughly equally divided between the public and private sectors. Increased competitiveness of domestic producers, improved access to the EU markets, the completion of the Balkan free-trade area, and various structural reforms enhance profitability and hence corporate savings. The reform scenario envisions a modest reduction in the public debt ratio during the period. The authorities largely agreed with the overall framework but worried that domestic savings could not rise so sharply and felt therefore that BiH would need a larger inflow of foreign savings. The staff preferred conservative projections for official flows and noted that private flows would depend on the progress in improving the business environment.

26. The “reform” scenario underscores the need for further fiscal adjustment. The government will have to mobilize domestic resources to replace, in part, aid flows that have in the past financed reconstruction and infrastructure investment. Given the already high public debt ratio, however, BiH’s capacity to borrow commercially during the projection period will be severely limited.10 The needed financial resources will therefore have to be released by restraining current spending. At the same time, tax reforms will be necessary to ensure high levels of revenue on a sustained basis.

27. An alternative, status quo, scenario illustrates how delays in reform could reduce the growth rate and lead to an unsustainable fiscal position (Table 11). In the status quo scenario it is assumed that private investment remains sluggish owing to inadequate measures to improve the business environment. At the same time public investment declines since falling aid-financed investment is not replaced by domestically funded investment. Consequently the growth rate would be lower than in the reform scenario and the public debt ratio would rise unsustainable

B. Budget Discussions11

28. Budgetary policy in BiH is made against the backdrop of unresolved issues in taxation, including the distribution of revenues among the levels of government, and changes in the structure of spending. The creation of new State institutions (such as the State Border Service) is causing a rapid expansion of spending but the State does not yet have a reliable source of own revenues and thus remains dependent on grants from donors and transfers from the Entities. The finances of the State will remain fragile until the size of the State budget has stabilized and a reliable source of own revenue has been secured. The Entity budgets are burdened by high spending on defense and veterans benefits. They are coming under further pressure from rising administrative transfers to the State and rising external debt service and will eventually need to take on a larger part of infrastructure investment and maintenance. The Entity governments therefore need to resist expenditure pressures; they must also improve tax administration and put a VAT in place in order to strengthen their revenue base. They also need to take difficult decisions on the clearance of arrears. Finally, the Federation cantons and municipalities, which came under pressure in 2001 from a mid-year cut in tax rates, will feel the full year effect of those cuts this year. The cantons will thus need to implement difficult spending measures.

29. The three draft 2002 budgets currently under discussion maintain a tight fiscal stance (Tables 36). The budgets bring a slight reduction in the debt ratio but they do not make the needed start in shifting budgetary resources from recurrent spending to investment. Taken together, the 2002 budgets of the State and the Entities the consolidated central government show a deficit of 0.9 percent of GDP on a commitment basis compared with 1.3 percent in 2001.12 The three budget deficits are roughly equal in size; each is equivalent to about 0.3 percentage points of BIH GDP.

30. As in 2001, the tighter fiscal stance reflects a decision not to borrow from private financial markets and the resolve to repay expenditure arrears. External financing is thus limited to borrowing from selected international financial institutions, while domestic financing is limited to privatization receipts. The authorities explored the possibility of issuing government bonds to finance the budget but it was agreed that commercial borrowing should wait until modern treasuries were functioning and a broader debt strategy had been agreed.

31. Staff noted that revenue projections in the Federation 2002 budget were optimistic, raising concerns that the deficit target may be exceeded. The budget assumes that indirect tax revenues will rise twice as fast as nominal GDP (Table 3).13 The staff urged the Federation authorities to project revenues more conservatively, as in the past, to create a safety margin for errors in forecasting. The authorities preferred to base their budgets on high, possibly unrealistic, revenue estimates. In the staffs view this approach is risky, particularly in an election year and in light of a past history of accumulating arrears.

32. On the expenditure side, the draft Federation budget incorporates a 40 percent demobilization of the army but also sets up costly and iil-advised incentives for employment, small enterprises, and agriculture. The reform of the military, which has not yet been fully articulated by the authorities, would have its main financial impact in future years since part of the wage savings would be spent on severance packages. As regards the proposed incentive schemes, the staff viewed them as too costly (1½ percent of Federation GDP), and noted that the proposed subsidies and tax credits are unlikely to have a durable effect on employment and will therefore prove difficult to reverse in the future. The staff urged the authorities to consider reallocating these resources to finance severance packages for military demobilization or to increasing the amount of arrears clearance. In other areas, the draft budget freezes the government salary scale but the wage bill rises owing to larger employment. The budgeted increase in capital expenditure is modest and is viewed by the staff as insufficient.

33. Overall, the projected increase in revenues in the proposed RS budget for 2002 is smaller than GDP growth. The projections are subject to exceptional uncertainty, however, because a complete overhaul of direct taxes and social contributions—in late 2001entails a large cut in rates and a large assumed base-broadening effect. In light of the staffs concerns in this area, the authorities agreed to review revenue collection six months after the reform and to raise the tax and contribution rates if revenue is less than projected.

34. In discussing expenditures in the 2002 budget, the staff agreed with the broad outlines of the authorities proposals but considered that capital spending was too low. The authorities responded that expenditure ceilings throughout the budget were tight. The wage bill would be reduced by freezing the wage rate and cutting employment, including by a 10 percent reduction in military personnel. The limit on wages would help make room for a significant rise in debt service obligations and an increase in the budgetary transfer to the State. Military spending on goods and services would also rise above the 2001 level: the authorities explained that they viewed that level as grossly insufficient. In other areas, the draft 2002 budget was not significantly different from the 2001 budget.

35. The 2002 draft State budget provides for a steep rise in spending but the State lacks the recurrent revenues it needs for its new, larger, role. State spending, other than external debt service, nearly doubled in 2001 and is projected to increase by a further 45 percent in 2002.14 In spite of rising transfers from the Entities, however, resources have been found for only 85 percent of the States proposed spending, and the authorities have made the rest contingent on receiving additional external grants. Since the State budget is already highly dependent on nonrecurrent external grants, the present level of spending is unsustainable unless new revenue sources are found. The authorities and staff agreed that the difficulties in financing the 2001 budget underline the need for an overhaul of intergovernmental finances which would put the State budget on a secure footing. In the interim, the State authorities proposed introducing new taxes or fees to finance the higher levels of spending but the staff argued that it was important first to identify cuts in areas where known redundancy and overstaffing exist.

36. The 2002 budgets will be the first to be executed through the Entities newly created treasury systems. The new treasuries, which began operations in January 2002, give the authorities control over budget commitments and expenditures through the use of a treasury general ledger and treasury single account (TSA).15 The staff urged the authorities to put their TSAs in the central bank, mainly for prudential reasons. The accounts were initially opened in commercial banks, however, since the authorities were concerned about the impact on banks of loss of government business and since discussions were still underway on the terms and conditions for opening TSAs in the central bank. The mission urged the State to press ahead with the implementation of its own TSA, projected for mid-2002. In the Federation, it is also important that treasury reform be extended to the cantons.

C. Medium-Term Fiscal Issues

37. Expenditure pressures in a number of areas make it important to set medium-term spending priorities, including in the context of the World Bank Public Expenditure and Institutional Review (PEIR). Areas where the fiscal position is subject to pressures include:

  • Veterans’ benefits. The existing benefits are unaffordable. A reform underway, with World Bank support, should set up a well targeted and affordable veterans benefits.

  • Pensions. The indexing of pension entitlements under the existing pension laws should be strictly implemented. Consideration should be given to a next stage of pension reform in which entitlements and funding are defined in a definitive and transparent way.

  • Public investment. The authorities may need to increase their public investment programs in light of the decline in external assistance.

  • Debt management. The Entities need a strategy to repay arrears and meet obligations arising from war damages and frozen foreign exchange deposits.

38. In discussing the size of State institutions, the staff emphasized the need to identify a stable and predictable source of finance for the State. In the next year or two, while the State institutions are growing, the existing mechanism of a negotiated transfer from the Entities provides a natural way to ensure that the increased spending by the State is offset by expenditure restraint in the Entities. Transfers are not, however, a good basis for State financing over the medium term. Instead, the State will need a predictable source of own revenue to serve as a basis for rational, medium-term, budget planning. In addition, Entity transfers to the State are frequently late, which makes budget execution by the State difficult. Both problems would be solved by remitting a fixed share of one or more taxes directly to the State budget.

39. A future VAT could at one stroke resolve the issue of financing the State and place BiH’s indirect tax system on a sound footing, but preparations have stalled over a fundamental design issue whether the tax should be at the Entity or at the State level. Federation and State authorities favor a State-level VAT while the RS authorities consider that the Dayton Accords place taxation under the authority of the Entities. The staff emphasized two points. First, a well functioning VAT system would be a more reliable revenue source for the State as well as the Entities than the existing sales tax system.16 Second, robust enforcement of a VAT would require an integrated tax administration or closely cooperating tax administrations with access to a common database. The staff urged the authorities to try and agree on a model for an integrated country-wide VAT that meets the political and constitutional concerns of both Entities.

40. In the area of direct taxation, the RS has moved ahead with a reform that is based on tax rates that the staff argued are too low. Rates were lowered to 10 percent for both personal and corporate income tax, while the base for the personal income tax was broadened to include non-wage compensation.17 The staff argued that the low tax rates would reduce revenues and, in the case of the corporate income tax, provoke tax competition with the Federation and neighboring countries. The staff urged the RS authorities to take advantage of the upcoming income tax reform in the Federation to review its own income tax rates. In the Federation where comprehensive new income tax legislation is still under preparation, the corporate income tax rate is still at 30 percent. However, the Federation did reduce the wage withholding tax rate, in stages, from 15 percent in 1999 to 5 percent in 2001.

41. Given the weak collection of customs, excises, and sales taxes, the staff welcomed the restructuring of the tax and customs administrations underway in both Entities.18 The staff urged the Federation authorities to move for rapid enactment of the new tax administration law (already approved in the RS), and urged both Entities to appoint, on the basis of merit, strong directors and regional directors, to issue unique taxpayer identification numbers, and to take steps to improve the cooperation between and within revenue and tax administrations.

42. The staff also urged the authorities to strengthen tax collection, particularly in the RS where customs and excise collections were disappointing. The authorities agreed to intensify efforts to control contraband trade in excisables. In the area of customs, the authorities in both Entities cited customs under-valuation by Brčko District as a main source of losses (Box 2). The staff noted that recent studies by the ECs Customs and Fiscal Assistance Organization (CAFAO) suggested that under-valuation was also a problem in the two Entities and urged all the authorities to tighten controls.

D. Structural Policies

43. The staff emphasized the importance of promoting the private sector by improving the business environment rather than by fiscal incentives. The staff supported the authorities efforts to develop, with the support of the World Bank, institutions that would encourage new entrants and reduce obstacles to day-to-day operations. Key steps needed are to introduce a country-wide business registration system, harmonize company law, eliminate duplication over the different levels of government, modernize bankruptcy and liquidation laws, and strengthen the courts. The authorities understand the importance of fundamental reforms of the business environment, but emphasized that they also feel under pressure to introduce quick-acting fiscal measures to cut unemployment and support agriculture.

44. The staff stressed the need to remove the obstacles that remain to completing the privatization of non-financial public enterprises. The authorities reported that mass privatization the sale of small-scale enterprises (SSE) for cash or vouchers had progressed satisfactorily, though the management of these enterprises was hampered by diffuse or ill-defined ownership rights. The first privatizations of strategic enterprises were completed in 2001, after enterprise-specific technical assistance had been mobilized in 2000 through the International Advisory Group for Privatization (IAGP).19 In discussions with the authorities it emerged that nontransparent bidding practices and the absence of up-to-date information on enterprise debts have often delayed or blocked privatization. Another obstacle has been unrealistic expectations on the part of the authorities. The staff urged the authorities to move quickly to privatize key enterprises in the manufacturing and public utilities sectors.

45. Staff and the authorities agreed that the creation of a viable private sector had to be supported by broader institution building, including a strengthening of social safety nets. While work on Bills poverty profile is still underway, the authorities view is that the main causes of poverty are high unemployment and the lasting repercussions of the war. The staff urged the authorities to create social safety nets that were well targeted and affordable. To that end, the authorities were encouraged to continue implementing the assistance programs supported by the World Bank which help building social sustainability by reforming health and social protection programs, (Appendix II).

E. Financial Sector Issues

46. The Central Bank of Bosnia and Herzegovina (CBBiH), as well as the State and Entity authorities, reaffirmed their commitment to the currency board arrangement. The staff concurred. Given BiH’s underlying fiscal problems and its complex politics the discipline of the currency board was needed in order to resist pressures to monetize fiscal deficits. Over the medium term, however, the currency board arrangement would only be sustainable if fiscal policy was disciplined: from this perspective the maintenance of fiscal adjustment and the freeze in wages were welcome features of the proposed 2002 budgets. The staff endorsed the continued strict adherence to currency board rules and urged the central bank to continue building its capital up to 10 percent of liabilities, in line with the Central Bank Law.

47. The staff urged the RS authorities to move quickly, with the support of the World Bank, to privatize or close the three largest state-owned banks. Negotiations are now underway for the privatization of two of the three banks; the third has been placed under conservatorship and will be liquidated or privatized. In the Federation, where the banking system has been strengthened by far-reaching privatization, the staff noted that the amount of commercial lending was still negligible in spite of the liquid position of many banks. Staff noted that the dearth of viable commercial borrowing proposals underscored the need to strengthen the enforcement of creditors rights.

48. The staff urged the CBBiH and the Entities to strengthen the central banks role in bank supervision. At present, supervision is carried out by Entity-level banking agencies. The mission took the view that centralizing bank supervision would bring economies of scale, greater independence, and a better capacity to supervise banks with branches in both Entities. The RS authorities expressed reservations regarding centralizing bank supervision, however, and considered that the RS Banking Agency was capable of effective supervision.

F. Other Issues

49. Under the framework of the June 2001 memorandum of understanding signed by the countries in South East Europe, BiH has concluded free trade agreements with Macedonia, Slovenia, and FRY. It had previously negotiated a free trade agreement with Croatia. An agreement with the European Union in 2000 has led to free access of BiH goods into the European Economic Area. BiH is currently involved in WTO accession negotiations, and appears to have the strong support of the European Union and the United States. The authorities explained that they expect to enter the WTO in the first half of 2002.

50. As is the case with other successor republics of the former SFRY, BiH, at the time of independence, imposed restrictions on withdrawals and transfers from certain foreign exchange accounts held by residents and non-residents. The staff has now clarified that the rules which presently apply to these accounts give rise to exchange restrictions subject to approval under Article VIII. The authorities, in consultation with Fund staff, are currently considering ways to address the problems that arise from these accounts.

51. The staff urged the authorities to focus on improving the quality and coverage of basic economic data. The authorities agreed that the statistical base was weak (see Appendix III), and said that they had allocated more resources to the statistical institutes in the 2002 budgets. The staff welcomed that decision and urged that priority be given to producing, quickly, reliable data on the national income and product accounts, consumer and producer prices, and the balance of payments. The staff also urged the authorities to improve coordination among the three statistical institutes.

IV. Staff Appraisal

52. Progress was made on several fronts in 2001, particularly in the area of fiscal discipline and transparency. Budget implementation was improved, the growth of the stock of arrears was halted and important steps were taken in the areas of treasury reform and tax administration reform. These gains now need to be consolidated and extended.

53. Looking forward, the priority is now to allow the private sector to become the main engine of growth. Privatization of strategic enterprises needs to be accelerated in both entities. In the RS the privatization of the largest state-owned banks should be brought to a rapid conclusion. More broadly, BiH should move ahead quickly with reforms supported by the World Bank to remove impediments to investment and business registration and improve the environment for day-to-day business activities. Budgets should provide sufficient resources to the courts and other legal institutions affecting economic structures.

54. The authorities at ail levels should resist pressures to try and jump start the economy with subsidies or employment incentives. Such schemes are typically ineffective, costly, and prone to mismanagement.

55. The currency board arrangement has served BiH well and remains the best way to maintain a low inflation environment. By removing monetary policy from the political arena, the arrangement has brought inflation down and fostered a remarkable degree of confidence in the KM. BiH’s stable currency is now possibly the most positive feature of its business climate. The currency board rules should therefore continue to be implemented strictly.

56. A sustainable fiscal position is a second essential precondition for low inflation in the long run. The fiscal adjustment that began in 2001, if sustained and extended in 2002 (as planned), would be a welcome first step, but large debts (including domestic expenditure arrears) and entitlements, declining donor support, and weaknesses in the tax system cloud the medium-term fiscal outlook. For 2002, if revenues fall short of optimistic estimates, governments will have to hold expenditures below the approved budgetary ceilings in order to prevent the emergence of new arrears.

57. A broader public finance reform agenda also requires the Entities attention. This could include:

  • Ending permanently the double-imposition of excise taxes and fully implementing a mechanism to allocate excise revenues to the Entity of consumption.

  • The Federation moving quickly to enact legislation for a well designed, modern, tax administration, and both Entities providing their new tax administrations with adequate resources and effective, independent, leadership.

  • Making every effort to reduce customs under-valuation and launching sustained campaigns to remove smuggled excisable goods from the market.

  • Using the new treasury systems to further strengthen fiscal control. In the Federation, the cantons reinforcing their treasuries and providing full and timely reports of budget execution to the Federation authorities.

  • Indexing pension entitlements strictly to available resources.

58. The composition of public spending should be reviewed in light of the decline in aid-financed investment. BiH will need to increase the share of its budgetary resources devoted to capital spending and identify areas where recurrent spending can be restrained.

59. On the revenue side, the authorities are strongly urged to overcome the political and constitutional obstacles to implementing a harmonized VAT, collected by an integrated tax administration. The alternative options—Entity-level VATs or another round of reforms of the sales tax would also be difficult to agree, and would be a weaker basis for providing revenues over the medium term.

60. Outstanding fiscal federalism issues need to be addressed. Once definitive decisions have been made about the relative size and financial needs of the State the present system of Entity transfers to the State should be replaced by a more stable and predictable source of own revenues. In addition, the State authorities need to strengthen budget management and eliminate wasteful expenditures.

61. The overhangs of expenditure arrears and frozen deposits seriously threaten medium-term fiscal sustainability. Efforts are needed to put an end to the accumulation of new arrears, including by local governments. In clearing existing arrears, it will be important to recognize only claims that are documented and supported by law or contract, and repay the claims on terms that do not overburden the budget.

62. Although bank supervision has improved over recent years, it is weakened by the fact that supervision is based at the level of the Entities. Centralizing supervisory responsibility at the central bank would strengthen the financial system.

63. Published economic data on BiH is still too weak to provide a sound basis for policy–making. The three statistical institutes should improve coordination and cooperation. The strengthened statistical institutes should focus, in priority, on producing reliable and timely data on the main macroeconomic aggregates and prices.

64. The staff does not recommend approval of the exchange restrictions arising from the rules governing frozen foreign currency deposits, since there is at present no clear time-table for the removal of these restrictions.

65. It is proposed that the next Article TV consultation be held on the standard 12-month cycle.

Figure 4.
Figure 4.

Bosnia and Herzegovina: Indicators of Competitiveness, 1998-2001

Citation: IMF Staff Country Reports 2002, 052; 10.5089/9781451804799.002.A001

Sources: International Financial Statistics (IFS); and IMF staff estimates.1/ Data on real effective exchange rate (REER) for Bulgaria, Croatia, and Macedonia are from the IFS. For the Republika Srpska and the Federation, the REER is calculated using cost of living indices and bilateral trade data reported in the statistical bulletins of the two Entities, and CPI and bilateral exchange rate data from the IFS. Estimates for 2001 are based on January to September data.
Figure 5.
Figure 5.

Bosnia and Herzegovina: Selected Financial and Economic Indicators

(1996-2001)

Citation: IMF Staff Country Reports 2002, 052; 10.5089/9781451804799.002.A001

Sources: Data provided by Bosnian authorities; and IMF staff estimates.
Table 1.

Bosnia and Herzegovina: Main Economic and Financial Indicators, 1997-2002 1/

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

Data refer to the entire country, unless otherwise indicated.

Staff estimates until 2000.

Annual production, percent change over previous year. In 2001, estimates for the RS are up to September 2001.

Gross wages. In 2001 data for the Federation are up to November and in the RS up to July.

Data as of October 2001 for the Federation and up to September 2001 in the RS.

Country-wide monetary aggregates. In percent of beginning of year broad money stock.

Cash basis, after grants.

Excludes municipal government operations. Ratios for 2001 are based on budget.

Table 2.

Bosnia and Herzegovina: Consolidated General Government.

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Sources: Ministries of Finance; and IMF staff estimates.

Authorities’ Revised Plans, projected before the end of the year. Therefore, foreign financing numbers are subject to change, with a shortfall of 31.4 million KM for the Federation and 15.7 million KM for the RS.

For 2001, IMF staff estimate.

Pension Fund, Health Fund, and Employment Fund.

IMF staff estimates.

Data for 2000 are incomplete. The Brčko District started collecting revenue in March 2000.

External debt and stock of arrears. The decrease in 2001 is related to a large debt-relief operation.

Table 3.

Bosnia and Herzegovina: Federation Fiscal Operations, 1997-2002

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

For 2002, contribution from PTT to roads construction brought on budget

Does not include wages from the Army, the Ministry of Defense and the Intelligence service, counted elsewhere in the table.

Army and Ministry of Defense. Does not include off-budget assistance from oiher countries. Includes 50 million KM of severance payments in 2002.

Includes allocation for railroads and other capital expenditures.

Transfers from the Federation budget to clear penstion arrears of previous years.

In 2002, to be used to clew budgetary arrears or makt an extraordinary transfer tu tht pans ion funds

In 2001, includes KM 17.7 million of revenues frozen in Harcegovacka Bank, ind got back in 2002

Disbursement Amortization is included in the debt service transfers to the State.

Excludes the clearance of budgetary arrears to the pension fund, includes extraordinary transfers to the pension fundi to char arrears.

Table 4A.

Bosnia and Herzegovina: Republika Srpska Fiscal Operations (Old presentation), 1997-2001

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Sources: Data provided by authorities; and IMF staff projections.

Adjustments made to the cash outcome comprise: (i) elimination of unrealized revenue gains (losses) due to a depreciation (appreciation) of the domestic currency (KM 16.3 million and KM 34.9 million, respectively); (ii) inclusion of expenditures related to government lending (KM 7 million); and (Hi) removal of a KM 84 million item recorded under expenditure, but which was in fact an accounting error with no correspondence to real or committed expenditure.

Including railway surcharges.

Including fees, fines, and other special revenues (excluding railways).

Including materials costs and investment maintenance.

Including railway and other capital expenditure.

Including transfers to health insurance funds, refugees and displaced persons, students, and social institutions.

Disbursement. Amortization is included in the debt service transfers to the State.

Table 4B.

Bosnia and Herzegovina: Republika Srpska Fiscal Operations (New presentation), 2001-2002

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Sources: Data provided by authorities; and IMF staff projections.

Taxes on the personal use of special goods such as motor vehicles, mobile phones, boats, aircrafts and weapons.

Includes other fees (on water, on use of forests), own revenues from administrations and other non-tax revenues.

Outside subsidies to the railroads.

Disbursement. Amortization is included in the debt service transfers to the State.

Table 5.

Bosnia and Herzegovina: State Fiscal Operations, 1997-2002

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Sources: State Ministry of Treasury; and IMF staff estimates.

Does not include non-cash grants.

Includes new sources of revenues from the institute for standards, institute for accreditation, regulatory agency, department of civil aviation and CRA.

Communication Regulatory Agency, Archives, Civil Aviation, Institute for Standards and Meausres, Institute for Acreditation, Veterinary Services, and Foreign Investment Promotion Agency.

Includes 6.2 million KM of arrears to international organizations in CoM Rebalanced budget in 2001.

Includes 11.4 million KM for the Commission in charge of elections in 2002

Projects that would be implemented only if additional resources are found during the budgetary year (among which 7.4 million KM for the State Border Service, 11.3 million KM for refugees, and 7.7 million KM for the Information Agency)

Table 6.

Bosnia and Herzegovina: Consolidated Central Government, 1998-2002

(In millions of KM)

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Sources: Ministries of Finance; and IMF staff estimates.

Own revenues for the State, outside transfers from the Entities.

Does not include the foreign financed investment projects.

If arrears are accumulated on a net basis, this corresponds to a positive financing on a commitment basis. Includes Extrabudgetary Funds’ arreras, as the central government authorities started making transfers to the Funds to have them clear their a

Authorities’ Revised Plans, projected before the end of the year. Therefore, foreign financing numbers are subject to change, with a shortfall of 31.4 million KM for the Federation and 15.7 million KM for the RS.

Budget agreed with the authorities for the RS, authorities’ draft budget for the State and the Federation.