This paper assesses the extent to which data unreliability could alter the assessment of the macroeconomic challenges ahead. The contributions of the indirect tax authority (ITA) in remedying the flaws are highlighted, and the architectural agenda is discussed. Fiscal sustainability and the government’s bold initiatives to secure it by restructuring the domestic claims have been assessed and key implementation issues in realizing the government’s plans noted. A survey of selected tax policy issues in Bosnia and Herzegovina is also included in the paper.

Abstract

This paper assesses the extent to which data unreliability could alter the assessment of the macroeconomic challenges ahead. The contributions of the indirect tax authority (ITA) in remedying the flaws are highlighted, and the architectural agenda is discussed. Fiscal sustainability and the government’s bold initiatives to secure it by restructuring the domestic claims have been assessed and key implementation issues in realizing the government’s plans noted. A survey of selected tax policy issues in Bosnia and Herzegovina is also included in the paper.

IV. Domestic Claims on the Governments1

A. Introduction

1. The citizens of BiH have accumulated large claims on their governments. These claims accrued before, during, and after the 1992-95 war. They mostly relate to frozen foreign currency deposits, war damage claims, and government spending arrears. The claims could exceed 200 percent of GDP.

2. Though countries faced with such burdens have generally resolved them through hyperinflation, the authorities have committed to a uniquely ambitious solution which guards macroeconomic stability. They propose to do this by converting the claims into very long bonds and cash payments, both at large discounts in net present value (NPV) terms. This note describes the claims, outlines the problems they posed, assesses the authorities’ proposals, and notes the implementation challenges ahead.

B. Extent and Nature of the Claims

3. Current estimates of the domestic claims exceed 200 percent of GDP (Text Table 1). However, the exact magnitude of the claims depends on various legal and procedural issues. Also, other claims may yet emerge.

Text Table 1.

Potential Domestic Claims

(In percent of entity GDP or total GDP)

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Frozen foreign currency deposits

4. Residents of the former Socialist Federal Republic of Yugoslavia (SFRY) were allowed to hold their savings with domestic banks in foreign currency-denominated deposits. The counterpart assets to these deposits were held in the central bank in Belgrade and the deposits carried an explicit guarantee from the SFRY government.

5. The foreign currency deposits were frozen when, following the secession from the SFRY, BiH banks no longer had access to the counterpart foreign exchange reserves in Belgrade. Without such a freeze, commercial banks in BiH would have collapsed. A similar freeze was effected in Croatia and Serbia and Montenegro. The latter two countries have since put in place repayment schedules according to which depositors will receive their money back over an extended period of time (see Annex I). Until December 2003, this had not been done in BiH.

6. The BiH governments took over the guarantee on the frozen deposits. More than KM 2.2 billion (18 percent of GDP) in deposits are still outstanding, affecting more than a quarter of the population. The possibility to use frozen deposits as a means of payment in the divestiture of government-owned apartments and companies only led to a KM 0.3 billion reduction in the face value of the stock of frozen deposits during 1998-2003. Of the 1.3 million deposit accounts, some 800,000 do not exceed KM 100 (US$65).

War damage claims

7. A 2001 ruling by the RS Supreme Court allowed citizens to file claims for war damages against their own government. The court ruled that the Law on Obligatory Relations—inherited from the SFRY and designed to address claims of individuals against each other for damages—was applicable to war damage claims.2 Therefore, the use of the RS army in combat operations was considered an activity within the scope of the RS government’s obligations. This gave rise to lump sum benefits for damages caused by death of relatives and other non-material damages suffered by veterans and victims of war.

8. Thousands of claims have been filed in the RS courts. The total value of the claims on the RS government resulting from this are estimated at KM 4.5 billion (126 percent of RS GDP). This includes some KM 3 billion in accrued penalty interest.

9. So far, in the Federation, the procedures for filing non-material damage claims appear less well-established. However, claims for non-material damages have also been filed in the Federation courts. Given that combat operations during the 1992-95 war took place mostly on what is now the territory of the Federation, it could be expected that the damage claims arising would, if allowed to proceed, more than proportionally exceed those in the RS.

Domestic spending arrears

10. Weaknesses in public expenditure management caused the accumulation of substantial government spending arrears in the post-war years through 2001. Concerted efforts were made in the first half of 2003 to establish the total stock of domestic spending arrears. With assistance from an expert from the IMF’s Fiscal Affairs Department, and after scrutiny by the Entities’ audit institutions, the arrears were estimated at 9 percent of entity GDP in the RS and 6 percent of entity GDP in the Federation (Text Table 2). Some legal issues are yet to be resolved in defining these arrears.3 Moreover, a systematic assessment of spending arrears of the Federation cantons is still to be completed.

Text Table 2.

Spending Arrears

(In percent of entity GDP)

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Claims on government resulting from the privatization of state-owned enterprises

11. In the process of privatization of banks and companies, the entity governments took over responsibility for their debts. The latest estimate of these claims on the RS government amount to KM 40 million. However, more work is needed regarding the verification of these claims, including in the Federation.

Claims on government resulting from the issuance of privatization vouchers

12. Privatization vouchers still represent potentially very large claims on the Federation government. Immediately after the 1992-95 war, the governments of both entities issued vouchers to their citizens. The amount of vouchers allocated depended on various parameters such as age, length of government service, length of military and government service during the war, unpaid pensions, unpaid wages, etc. These vouchers could be used, at face value, to purchase government-owned assets such as apartments and companies at inflated book values. In the RS these vouchers recently expired. However, in the Federation the use of the remaining outstanding stock of vouchers, some KM 5.8 billion (71 percent of Federation GDP), was extended in 2003.

Debts to domestic banks

13. The governments’ debts to domestic banks unrelated to the takeover of privatization-related claims are small. In November 2003, they amounted to KM 23 million (0.2 percent of GDP).

Other claims

14. Other claims may yet emerge. A key remaining source of possible additional claims is the restitution process—with citizens still pressing for compensation (and for property to be returned) following seizures after 1945. In addition, a recent judgment by the Human Rights Chamber of Bosnia and Herzegovina ordered the payment of KM 3.5 million to relatives of the Srebrenica massacre victims. The judgment reportedly related to the cases of 49 missing persons and the court has another 1,700 cases on its books relating to Srebrenica alone. The exact implications of this recent judgment by the Human Rights chamber have still to be determined. And the estimates for the identified claims may also be significantly amended.

C. Three Problems Raised by the Domestic Claims

15. Firstly, public indebtedness including the claims is, by standard measures, unsustainable—and hence an impediment to investment, employment, and growth. Pending a resolution of the claims, potential investors are deterred by the possibility that:

  • A costly settlement could require higher taxes or a cut in government services.

  • A default on the claims could undermine payment discipline throughout the economy.

  • And a fiscal crisis could develop if all creditors would stop lending to the government because it can not pay its obligations.

16. Secondly, policy towards restructuring public indebtedness including the claims has to take the external debts as given because they have already been written down substantially by external official and commercial creditors in the late 1990s. At the end of the war, external debt was unsustainable and was not being serviced. By end-1997, total external public debt, including outstanding external payment arrears and late interest exceeded US$4 billion (100 percent of GDP). As a result of a debt relief by the London Club group of commercial creditors, the Paris Club group of bilateral official creditors, as well as multilateral creditors, Bosnia’s external debt has been reduced to a sustainable level and further concessions from external creditors are unlikely (see Annex II for an external debt sustainability analysis). At end-2003 total external debt is estimated at US$2.6 billion (34 percent of GDP). Given that much of it is on concessional terms, the net present value of the debt, at 26 percent of GDP, is substantially lower than its face value. And the annual debt service burden, at 2.1 percent of GDP or less than 8 percent of the estimated value of exports of goods and nonfactor services in 2003, is manageable.

17. Third, the majority of the domestic claims are still unregulated in the sense that no formally agreed terms and conditions for interest and repayment exist—so citizens have no idea of when or how satisfaction will be provided. One of the few guidelines is that the governments of both entities have adopted moratorium laws which stipulate that the frozen foreign currency deposits and war damage claims will not be paid out until budgetary resources have been identified. However, holders of other claims have initiated court cases to obtain payments and attempted to seize government deposits to pay the court-ordered awards. Such court awards could therefore disrupt basic government operations.

18. Accordingly, the authorities took the view that efforts to secure public debt sustainability had to focus on restructuring the domestic claims and that their resolution was urgent.

D. Sustainability

19. The first challenge was to determine how much of the domestic claims to settle and how much to write off. A study published in the recent World Economic Outlook4 indicates that emerging market economies whose public debts exceed 50 percent of GDP face a high risk of economic crisis and that the sustainable public debt level for a typical emerging market economy may only be about 25 percent of GDP.

20. Two frameworks were used to assess sustainability of the domestic claims in the Bosnian context.

21. First, the status quo was assessed using a framework endorsed by the IMF’s Executive Board5 (Table 3 and 5). This indicates that Bosnia’s current public indebtedness—excluding these domestic claims—is comfortable, even in the face of the shocks examined in that framework, fundamentally because economic growth is projected well above real interest rates and because the primary fiscal balance is projected to remain firm over this short- to medium-term horizon. However, the public debt ratios are on an increasing trend in an alternative scenario in which it is assumed that the structural reforms necessary to sustain the growth rates of the past 5 years are not implemented. This suggests, with a qualification that the reform effort needs to be strong, that there is capacity to settle at least some of the domestic claims without compromising sustainability in the short-to medium term.

22. Second, a longer term framework was developed. This abstracts from “particular” features of the Bosnian economy currently—such as its current access to some concessional external credit and so on. This framework operates in NPV terms. In this context, if real interest rates are assumed at 2 percentage points higher than trend real growth,6 the debt ratio is on a declining path if a fiscal primary surplus of 1 percent of GDP is maintained, the 2003 outturn (base case scenario in the Text Table 3). This exercise therefore confirms the finding of the standardized debt sustainability analysis, that there is scope for a debt settlement.

Text Table 3.

Scenarios for Settlement of Domestic Claims

(in percent of GDP)

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23. Two alternative scenarios were prepared for sensitivity purposes. In scenario (a) with long-run growth of 3 percent and real interest rates of 5 percent, 25 percent of 2003 GDP of new claims are recognized in NPV terms, along with the primary surplus of 1 percent of GDP. Debt ratios do not fall in this scenario and reach 49 percent of GDP by 2010. The authorities viewed this strategy as too risky. Scenario (b) takes the same growth, interest rate and primary balance assumptions and considers recognition of 10 percent of GDP in new debt. Here debt ratios are on a declining trend, falling to 33 percent of GDP in 2010.7

24. Thus, with a long run growth-interest differential in the region of 2 percentage points, recognition of a NPV of 10 percent of claims could be sustainable with a primary balance of 1 percent of GDP. In NPV terms this would mean that public debt was some 36 percent of GDP and on a declining path. Recognition of claims in excess of that would require a strengthening of the path for the primary balance to retain sustainability. However, the authorities regarded this as undesirable.

E. Proposals to Restructure Domestic Claims

24. The authorities decided to limit the total cost of the plan to settle the vast amount of domestic claims on government to 10 percent of 2003 GDP in NPV terms. This requires large write-downs on the bulk of the claims as well as immediate action to place an embargo on the completion of court rulings on war damage claims to prevent new claims emerging and to remove the legal basis for the accrual of penalty interest on the war claims. Table 1 summarizes the plans to settle claims on the government of the Federation (top panel) and the RS (bottom panel). The authorities have made concrete proposals on the form of these write downs, but these proposals may be adjusted before implementation to the extent that new data become available on the stock of the claims. The authorities are committed to make any adjustments while retaining the cap of 10 percent of GDP in NPV terms for the settlement.

Table 1.

Bosnia and Herzegovina: Plans to Settle Domestic Claims on the Governments (in millions of KM)

Federation of Bosnia and Herzegovina (in millions of KM)

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25. A key element of the strategy to effect the required write-downs in a manner that is legally sound is to issue to the holders of the claims very long-term bonds which pay a very low or no interest. For instance, to settle the war damage claims for which finalized court decisions exist, the authorities in both entities plan to issue 50-year amortizing bonds with a 40-year grace period and which pay no interest. This would achieve a 94 percent reduction in the net present value of the claim (Text Table 4).

Text Table 4.

Summary of Bond Issues in the Context of the Domestic Debt Settlement Plan

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26. Legal advice, including from the OHR considers that these proposals are necessary to meet the requirements of the European Court of Human Rights in Strasburg. The advisors believe that this settlement which pays the face value of the claim over an extended period of time would be viewed as striking an appropriate balance between the rights of individual claimants and the public interest (e.g. preserving a sustainable fiscal position and maintaining macroeconomic stability).

27. The plans approved by the Federation government allow for the continued use of privatization certificates, but on a limited basis. The outstanding stock of these vouchers remains large and their continued unlimited use in the privatization process, at face value, could significantly erode the net worth of the government. Accordingly, the authorities propose to allow continued use of these certificates through June 2007 only. However, in any bid by an individual for the privatization of a garage, a business premises, or shares in a company, the share of certificates shall not exceed 10 percent of that individual’s bid.12

28. The settlement plan also envisages cash payments of some 4 percent of BiH GDP (Text Table 5). In addition to the issuance of long-term bonds with a face value of 28.5 percent of GDP and a NPV of 6 percent of GDP, the plans of the Federation and the RS call for the settlement of some claims in cash to be paid out over a number of years:

Text Table 5.

Cash Payments Under the Plan

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  • Some government arrears to suppliers, pensioners, and civil servants will be paid in cash

  • Cash payments will also be made to individuals holding small frozen foreign currency deposits.

F. Implementation Challenges

29. The implementation of the plans is likely to prove even more challenging than their preparation.

30. Several tasks in the legal area are crucial:

  • There is need for immediate embargos on the completion of court rulings on war damage claims.

  • Determination of how the writing off of interest on finalized court decisions regarding war claims can be effected and secured in a legally sound way.

  • The preparation, for each entity, of one comprehensive law governing the settlement of all claims for each entity government (not separate laws for each class of claims on government). This should make clear to any court to which appeal is subsequently made that the settlement of individual claims is part of a large overall settlement and that the (partial) write-off is necessitated by the large total amount of the claims.

  • A possibly protracted verification process. If the verification of the claims is not completed by mid-2004 as envisaged in the governments’ decisions, the exact terms of the settlements may have to be adjusted at a later date to ensure that the final settlement is still consistent with sustainability.

  • Before the verification process begins, the standards of proof required for each of the categories of claims on government have to be determined.

Procedural and logistical challenges are substantial. They are posed by the following:

  • In view of the number of claimants involved, the verification of claims will be logistically demanding. Outside technical assistance may be necessary.

  • Databases need to be established in both entities to track the valid claims that have been identified for each class of claims and to improve monitoring mechanisms to track the current use of privatization vouchers and frozen foreign currency deposits.

  • More work is needed to verify the claims on government resulting from the privatization of state-owned enterprises. This will require a cooperative effort, in both entities, of the ministry of finance, the privatization agency, the banking agency, and the CBBH.

  • Procedures need to be established to track the arrears of the federation cantons. These arrears remained largely a blind spot in the plan to settle claims on government and this needs to be corrected.

  • Technical work needs to be initiated in both entities to prepare for the issuance of government bonds. The staff sees merit in the issuance of registered bonds—which would require the drawing up of modalities and requirements for a registry—and believes that the bonds should probably include collective action clauses to facilitate their future reorganization. The authorities should make good use of technical assistance that is being offered to facilitate this work, including from the U.S. Treasury.

  • The biggest challenges are political—gathering support for these plans among the public and in the respective National Assemblies. Many citizens’ aspirations will be disappointed in this initiative to secure fiscal sustainability.

G. Conclusion

31. The authorities have taken a bold step, without international precedent in terms of its scale and ambition. In large part, the claims on government are the result of earlier policy errors and attempts to pay them in full would simply compound those mistakes—putting macro stability and prosperity at further risk. The authorities will need to be equally bold in implementing their plans.

1

Prepared by Geert Almekinders.

2

Appellate case No. 28/01 dated June 22, 2001.

3

For instance, successive budget laws in the RS appear to have virtually ruled out government arrears. These laws stated that, to the extent that budgetary assets were not available, sublegal regulations (such as the labor law or the pension law) could not create obligations of the government. Similarly, the pension laws in both entities indicate that average monthly pensions are to be adjusted to the financial means available to the pension fund in a given month.

4

See “Public Debt in Emerging Markets: Is it Too High?”, Chapter III in the IMF’s World Economic Outlook of September 2003

5

See Assessing Sustainability (www.imf.org) and Sustainability Assessments—Review of Application and Methodological Refinements (www.imf.org).

6

In the very long run, BiH’s external debt will be rolled over into debt instruments with a market-based interest rate and real growth will have converged to industrial country levels.

7

The assumption of a 2-percentage point differential between real growth and real interest rates is important. If that differential was 4 percentage points, either because growth was weak or risk premia were high or both, BiH sustainability considerations would plead for settling even less of the domestic claims. However, the case for basing an assessment on a 4-percentage point differential between interest and growth rates is not strong. If long run growth was 3 percent, this differential would imply nominal KM rates of 9 percent, compared with euro rates currently around 4.2 percent. This spread of 450-500 bps compares with spreads for Bulgaria and Romania, countries with risk profiles similar to Bosnia, of around 250 bps.

12

In the privatization of housing, individuals may make up to 100 percent of their payment in certificates.

ANNEX I Frozen Foreign Currency Deposits in Croatia and Serbia and Montenegro

1. In Croatia, the government assumed responsibility for the foreign currency denominated-deposits in 1992. At the time, they amounted to about US$3 billion. The government issued to the banks “counterpart bonds” which were denominated in domestic currency and indexed to the German mark. In order to prevent the withdrawal of these deposits from the banking system—which would have precipitated the failure of the banks—these deposits were blocked for a period of three years (until July 1995), and thereafter unfrozen at the minimum rate of 20 semi-annual installments.1 The government also issued bonds (called JDA and JDB bonds) to finance the first two installments of principal of the counterpart bonds. The stock of frozen deposits was reduced considerably early on, partly due to the fact that banks were permitted to reduce the deposits more rapidly at their own discretion, but mainly due to budgetary repayments, which have amounted to about ½ percent of GDP per annum. Interest payments on these deposits have been made twice annually, and in a timely fashion

2. In Serbia and Montenegro, the government suspended withdrawals from households’ foreign exchange balances with domestic banks in 1991. The deposits were redeposited with the central bank of Serbia and Montenegro, whose foreign reserves were run down. A 1998 law converted the deposits into public debt, capitalized the interest (based on a government-set interest rate of 2 percent per annum) and established an ambitious repayment schedule for these deposits. The total public debt assumed by this law amounted to DM 7.4 billion, equivalent to 35 percent of GDP in 2001. Based on this law, the repayment started in 2000 and the federal government issued a decree in January 2001 on two special state bonds to be issued to the holders of such deposits. The servicing of these bonds would have placed a heavy burden on the budget starting in 2005. With a view to alleviating these pressures, the federal and Serbian governments decided to modify the original repayment schedule to ensure that annual payments would be limited to no more than 0.9 percent of projected GDP in 2005 and subsequent years, compared to over 2 percent of projected GDP in 2005-11 on average under the original repayment schedule. Uncertainty arose over the overall size of the obligation as withdrawals were more limited than expected.

Notes

1

In addition, during the three-year period the deposits were blocked, individuals were permitted to buy back their blocked deposits at a 30 percent discount or to exchange them for government bonds which could be used to purchase socially-owned apartments or enterprises. These proved to be attractive alternatives and, as a result, frozen foreign currency deposits fell from HRK 13.9 billion at end-1993 to HRK 10.8 billion in June 1995.

ANNEX II Bosnia and Herzegovina—External Debt Sustainability Analysis

A. Summary

1. The debt sustainability analysis (DSA) presented in this annex includes three components:

  • a medium-term baseline scenario which sets out assumptions on economic policies and key parameters;

  • a set of stress tests around the baseline, which are intended to explore the robustness of baseline projections to alternative assumptions on key parameters and macroeconomic performance. The stress tests are based on BiH’s performance during 1999-2003; and

  • an alternative scenario which illustrates debt dynamics in the absence of policy reforms aimed at restructuring the corporate sector and the labor market.

2. Partly reflecting data availability, the analysis focuses on the sustainability of public and publicly-guaranteed external debt. As a result of creditworthiness problems, private sector external debt is small.1 And so far, domestic debt of the general government is negligible.2 The prospective issuance of bonds under the governments’ plan to settle domestic claims will obviously increase the face value of the outstanding stock of public debt. However, the NPV of these bonds is about 6 percent of GDP and because the bonds are envisaged to have very long maturity and grace periods and pay no or very little interest, the implementation of the domestic debt plan will only affect BiH’s sustainability and vulnerability to shocks over the very long term.3

3. The baseline scenario shows a continuing steady improvement in debt indicators. This fundamentally reflects that economic growth is projected well above real interest rates and because the primary fiscal balance is projected to remain firm through 2009. Under those circumstances, Bosnia’s current and projected indebtedness is comfortable, even in the face of the common array of shocks.

4. However, the alternative scenario indicates that substantial risks remain if structural reforms are not implemented as envisaged in the baseline scenario. In the “no policy change” scenario growth slows, essentially because the “peace dividend” has been exhausted and the structural reforms necessary to underpin medium-term economic development are not implemented. In this scenario it is also assumed that the governments are unable to contain pressures to increase spending. In conjunction with the modest growth of the tax base, this would cause a reversal of the recent gains in fiscal consolidation. Under those circumstances, and since the governments do not have access to central bank credit, public debt ratios would increase to unsustainable levels and the country would become very vulnerable to shocks.

B. Background on BiH’s External Public Debt

5. The substantial improvement in Bosnia’s debt indicators over the past six years is the result of a concerted effort. Following the breakup of the former SFRY and during the war, BiH accumulated substantial arrears towards all of its external creditors. At end-1997, total external public debt, including outstanding external payment arrears and late interest exceeded €3.6 billion (100 percent of GDP). As a result of a concerted effort by the authorities of BiH, the London Club group of commercial creditors, the Paris Club group of bilateral creditors, and multilateral creditors, the external debt at end-2003 is estimated at €2 billion (34 percent of GDP) (Text Table 6).

Text Table 6.

External Public Debt by Creditor at end-2003

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6. Policy measures implemented by the governments of BiH contributed to the improvements in the debt and debt-servicing ratios in four ways:

  • Despite sometimes difficult conditions, the authorities made efforts, beginning in 1996 and 1997 to normalize the country’s relations with all creditors (see below).

  • Fiscal consolidation led to an improvement in the primary balance by almost 9 percentage points of GDP between 1999 and 2003.

  • Sound macroeconomic policies contributed to real GDP growth rates averaging 5½ percent over the same period.

  • Almost all of Bosnia’s new borrowing has been on concessional terms.

7. Commercial and official bilateral and multilateral creditors also helped BiH to make a fresh start by spreading out debt service payments over time:

  • Following clearance of arrears to the Fund, membership in the IMF was achieved in December 1995 and Bosnia immediately became the first member to make use of Fund resources under the institution’s policy on emergency assistance for post-conflict countries.

  • Clearance of arrears to, and membership in the World Bank was accomplished in 1996 through the consolidation of IBRD obligations into three loans.

  • In December 1997, a rescheduling agreement with the London Group of commercial bank creditors was signed, reducing eligible debt by 73 percent in NPV terms.4

  • In October 1998, a rescheduling and debt-reduction agreement was signed with the Paris Club group of sovereign creditors. Under the agreement, Bosnia’s eligible debt was reduced by 67 percent in NPV terms.

8. With high concessionality and a relatively long maturity structure, and against the backdrop of continued high government revenues, the debt-servicing burden of BiH’s external debt is manageable. The rescheduling agreements with the Paris Club and London Club groups of creditors in 1998-1999 substantially reduced the burden of the relevant debts. Also, Bosnia continues to receive concessional loans from the World Bank and more than half of total debt is now owed to the World Bank (Text Table 6). Reflecting the concessionality of much of the external debt, the NPV of the total debt amounts to about 26 percent of GDP and the annual debt service burden, at 2.1 percent of GDP or less than 8 percent of the estimated value of exports of goods and nonfactor services in 2003, is manageable.

C. Baseline Medium-Term Scenario

9. The baseline scenario is predicated on maintenance of a stable macroeconomic environment and accelerated implementation of structural reform. It assumes an annual average real GDP growth rate of 6 percent of GDP during 2004–2009, about equal to growth during 1999-2003 (Table 2). The current account deficit would decline progressively, with export and imports assumed to grow at an average annual rate of 13 percent and 5 percent, respectively, in euro terms, about equal to the growth rates estimated for 2002–03.

10. On the financing side, aid, including new concessional borrowing, is assumed to decline further. This is in line with recent trends and indications from key donors who plan to scale down assistance to Bosnia and/or provided more in the form of technical assistance rather than direct general financial assistance. Given that Bosnia’s creditworthiness assessment is expected to improve only slowly, commercial borrowing is not expected to fill the void soon. Instead, foreign direct investment in Bosnia is projected to increase somewhat, to an average of 5% percent of GDP over the medium term.

11. The baseline scenario shows a steady further improvement in external debt indicators (Table 3). The debt to GDP ratio is projected to fall to 22 percent by 2009. Reflecting the assumed strong growth of exports, the external debt to exports ratio is projected to be cut in half, from 136 percent in 2003 to 67 percent in 2009.

D. Stress Tests

12. Standard sensitivity tests were applied to gauge the robustness and ambitiousness of the baseline projections. The tests assume that key macroeconomic variables (e.g. growth, interest rates, and the current account balance) are above or below their recent historical averages by a factor reflecting their historical volatility. Historical averages are computed for the last five years (1999-2003) and volatility is measured through standard deviations.

13. The stress tests show that the medium-term debt dynamics can be quite sensitive to common shocks to key macroeconomic variables. As expected, lower growth causes the debt to GDP ratio to worsen compared to the baseline (stress test B2). The largest adverse effect on the debt ratio is from a worsening in the current account balance (stress test B4) and a 30 percent nominal depreciation of the KM (stress test B6). However, given that the shocks are assumed to be only temporary, the debt ratio starts to improve again beyond 2006 because of the projected strong growth and continued concessional interest rates on the external debt.

Table 2.

Bosnia and Herzegovina: Macroeconomic Framework, 2000–09

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

Includes disbursements of foreign loans, and grants.

Table 3.

Bosnia and Herzegovina: External Debt Sustainability Framework, 2000–09

(In percent of GDP, unless otherwise indicated)

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Derived as [r - g - ρ(l+g) + εα(l+r)]/(l+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(l+g) + εα(l+r)]/(l+g+ρ+gρ) times previous period debt stock, ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

E. “No Policy Change” Scenario

14. The steady worsening of the public debt ratio under a “no policy change” scenario highlights the risks associated with possible delays in implementing reforms of the corporate sector and the labor market. The expansion of exports and total output since 1997 is in large part related to the “peace dividend”. However, the corporate sector may soon find itself unable to extend the rebound it has enjoyed since the war. Corporate lossmaking, high unemployment, and limited progress in privatization suggest that comprehensive structural reforms are necessary to sustain the recovery of exports and total output. The projected course of key macroeconomic variables in the absence of necessary reforms is summarized in Table 4. The expansion of export, required to sustain overall growth in the economy, would come to a halt. Compared to the baseline scenario, this would give rise to permanent output losses and a commensurately smaller tax base. As a result, government revenues would be insufficient to satisfy the demands for additional public spending. Given that the government has no recourse to borrowing from the central bank, new domestic spending arrears would be accumulated, adding to the outstanding stock of domestic debt and exacerbating vulnerabilities to external and domestic shocks.

Table 4.

Bosnia and Herzegovina: “No Policy Change” Scenario, 2003–09

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Sources: Data provided by the Bosnia and Herzegovina authorities; and IMF staff estimates and projections.
Table 5.

Bosnia and Herzegovina: Public Sector Debt Sustainability Framework, 2000–09

(In percent of GDP, unless otherwise indicated)

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General government gross debt. The steep increase in 2004 reflects the issuance of long-term bonds as part of the settlement of domestic claims on government.

Derived as [(r - π(1+g) - g + αε(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε(1+r).

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

1

At end-2003, the EBRD’s and the EIB’s lending portfolio to the private sector amounted to €38.7 million and €12.5 million, respectively. BIS data suggests that private sector credit from foreign commercial banks has been available mostly only to BIH’s commercial banks.

2

The governments of BiH have not yet issued any domestic debt instruments. General government debt to the banking system, which is denominated in domestic currency, amounted to less than ¼ percent of GDP at end-2003

3

The stress tests consider the impact on medium-term debt sustainability of a hypothetical government takeover of sizable contingent liabilities; the experiment is a standardized one and not tailored to the estimated size of domestic claims on the governments or other contingent liabilities.

4

The agreement with the London Club group of creditors stipulates that of the total amount of restructured obligations (€357 million) a “basic amount” equivalent to 37.5 percent of the total will be subject to servicing over 20 years with 7 years grace and graduated amortization payments, with interest rates starting at 2 percent per year during the first four years, 3½ percent per year during the next three years, and LIBOR plus 13/16 thereafter. For the “performance amount”, equivalent to the remaining 62.5 percent of the restructured obligations to the London Club group of creditors, bonds will be issued to the creditors if GDP per capita exceeds US$2,800 (measured at 1997 prices) in two consecutive years by 2017. This would therefore add €223 million to BiH’s external debt (Text Table 6). The staff presently estimates per capita GDP at US$1,822. Adjusted for inflation, the threshold now amounts to about US$3,000.