This Selected Economic Issues paper for Bosnia and Herzegovina reports that output, exports, and incomes have increased and inflation has stabilized. New modern banking laws have been passed in both entities, and the banking sector has been almost completely privatized, with the majority of assets now under foreign ownership. The reforms to the central bank and to the banking system have been aimed to secure stability and to build an efficient financial system.

Abstract

This Selected Economic Issues paper for Bosnia and Herzegovina reports that output, exports, and incomes have increased and inflation has stabilized. New modern banking laws have been passed in both entities, and the banking sector has been almost completely privatized, with the majority of assets now under foreign ownership. The reforms to the central bank and to the banking system have been aimed to secure stability and to build an efficient financial system.

I. Introduction and Overview

1. Since 1995, Bosnia and Herzegovina (BiH) has come a long way. Output, exports, and incomes are much increased, inflation has stabilized, the budgets are now close to balance, and the currency board has become an established part of the environment.

2. But a cursory glance at the major macroeconomic indicators suggests that much work still lies ahead. Staff estimates put the external current account deficit at well over 15 percent of GDP, unemployment at over 20 percent, government spending at half of GDP, and, following recent court rulings, government domestic indebtedness at well above levels anticipated in the 2004 domestic claims settlement laws. And output is still well below prewar levels and the IBRD assesses poverty at over 30 percent.

3. This Selected Economic Issues paper addresses two sets of issues arising from this evidence.

  • The first, discussed in Chapters 2–6, is whether the bleak impression conveyed by these headline macroeconomic indicators is correct.

  • The second, discussed in Chapters 7–10, concerns the implications for policies and policy-making frameworks in coming years.

4. Chapter 2 discusses market indicators of confidence in banks and in the currency. This provides immediate reassurance that with confidence in both strengthening, concerns which the headline macroeconomic data might arouse are not reflected in the behavior of the private sector in regard to their attitude to banks and the currency. Indeed, since 2000, the evidence suggests much increased confidence, with increased use of local currency and financial deepening. That said, the picture is not unqualified. Foreign currencies remain significant in bank deposits, banks continue to insist that loans longer than a year are indexed to foreign currencies, and bank intermediation is still well below comparator countries.

5. Chapter 3 situates BiH’s experience with a credit boom and a large external current account deficit in international experience. On both accounts, Bosnia and Herzegovina is an international outlier, including among transition, post-conflict, and currency board cases. Given evidence—summarized in the chapter—that such patterns have been associated with instability internationally, concerns remain. But that international evidence is not straightforward. Credit booms have not always been linked to instability, or vice versa, and the same is true of large external imbalances. Taken with the evidence from Chapter 2 that, thus far, private confidence in banks and the currency is holding, this suggests that Bosnia and Herzegovina has time to address these two issues, but that it should not delay unduly in doing so.

6. Chapter 4 turns to the domestic counterpart of the external deficit. Bosnia and Herzegovina is unusual in that its external deficit seems associated with an unusually low level of domestic—notably corporate—savings. This chapter considers the company-level evidence for this assertion, including providing a brief review of “how the corporate sector got to be this way.” It also considers lessons for future initiatives to correct the problems from the rich set of largely failed initiatives undertaken since 1995 in Bosnia and Herzegovina to address corporate ailments. It summarizes a set of principles arising from this experience. More concrete proposals await the conclusion of work now underway by the authorities and the World Bank to determine, in concrete terms, the way forward.

7. Chapter 5 sheds light on the extent to which the bleak impression given by the headline macroeconomic indicators reflects underestimation of nominal GDP. It reviews work on Bosnia and Herzegovina, including by IMF statisticians, on this question, and it notes that BiH is unusual in not making any adjustments for the unrecorded economy in its official published data. Accordingly, the chapter summarizes ongoing staff analysis to use data on GDP internationally, and its correlation with various indicators, to “estimate” what Bosnia and Herzegovina’s total––including unrecorded––GDP is. All this evidence suggests that, indeed, Bosnia and Herzegovina’s GDP is underestimated, likely up to 50 percent. But because all economies have some unrecorded activity even after statistical adjustments aimed to reflect it, the implication that the headline indicators in BiH exaggerate problems does not necessarily follow. It is only to the extent that unrecorded activity in Bosnia and Herzegovina is proportionately more pronounced than elsewhere, and that the indicators expressed relative to GDP are themselves correctly measured that this implication follows. On both, the evidence is cautionary. Bosnia and Herzegovina may have a disproportionately large unrecorded economy compared with similar — post conflict, and low middle income — countries. But it seems to have similar propensities to unrecorded activity as the CIS countries. And key macroeconomic indicators, including the current account deficit, are measured with significant error. For example, the external deficit estimated by staff—used throughout these papers—makes no correction for unrecorded merchandise imports. If, instead, the Central Bank estimate of the deficit—which makes this correction—is used, and its estimate is expressed relative to GDP inflated by 50 percent for unrecorded activity, the deficit in 2004 is 16 percent of GDP, close to the staff estimate of 17 percent of GDP.

8. Chapter 6 assesses the implications of the court rejection of the 2004 domestic claims restructuring laws. The various rulings issued recently by the constitutional court — the precise interpretation of which is still to be finally clarified—will certainly imply a much larger NPV of public debt than anticipated in those laws. This increases by a significant margin the primary fiscal balance associated with sustainability, and hence it sets the stage for need to rein in primary spending sharply. This chapter notes the background to these developments and illustrates with examples the possible extent of necessary adjustments in primary spending. The implication is that along with need to secure a strong fiscal stance through expenditure restraint so as to support efforts to rein in the external deficit, sharp reductions in primary spending may be needed within that envelope to provide room for interest payments on domestic debts. This priority contrasts, however, with aspirations to realize a variety of initiatives sponsored by the international community which will raise public spending. A balance between these two sets of imperatives will need to be found.

9. Chapter 7, and those which follow, consider various policy responses starting with the revenue base. With the external deficits and the domestic claims rulings calling for strong fiscal policies, an immediate implication is the necessity to secure the tax base for governments. Plans to introduce the VAT are key here, including as a measure to help to render the grey economy white. However, this task, already underway for some years, is unusually challenging in Bosnia and Herzegovina, and this chapter lays out the key steps already taken, as well as those which still lie ahead. It underscores that notwithstanding considerable efforts so far, the implementation risks remain significant and that, certainly for 2006, there is therefore no scope to anticipate a major revenue windfall.

10. Chapter 8 turns to the spending side, focusing on “state building.” At issue is various initiatives to increase the role of the State, partly in order to prosecute ambitions to eventual accession to the EU. The chapter reviews past implementation of this agenda and finds much fault with it — including that state building is proceeding slowly and at too high a fiscal cost. But with major steps forward here imminent, including shifting security functions to State level, and given the imperative to find economies in primary spending due to the court rulings on domestic claims, the inadequacies in the past approach to state building are set to exact a high price in macroeconomic terms, unless corrected promptly. The chapter suggests that this requires prioritization among state building objectives, a clear link between such steps and corresponding contractions in spending at other levels of government, and a strengthening of the “fiscal architecture” — the set of rules governing budget preparation etc—to help ensure that these objectives are realized.

11. Chapter 9 extends discussion of necessary policies to issues concerning control over Cantonal and Municipal budget balances. With external and domestic debt considerations pressing for fiscal restraint, past ad hoc embargoes on cantonal and municipal borrowing have helped to secure fiscal consolidation in recent years. But these arrangements are, perhaps, excessively restrictive in so far as they impede even strong and creditworthy cantons and municipalities from borrowing to develop local infrastructure. This chapter considers how the current ad hoc framework could be strengthened so as to allow greater flexibility, notably for the stronger Cantons and municipalities, drawing on international experience. Consideration is given to how this can be done while securing effective monitoring and control of the aggregate fiscal impact, both in the transition to a new regime and when that transition has been completed. But, the chapter cautions that even with such control secured, the need to prevent a deterioration in the consolidated fiscal balance and to retrench and consolidate primary expenditure means that any new framework for cantonal and municipal borrowing should be implemented in close coordination with reductions in primary spending at other levels of government.

12. Chapter 10 draws out the implications of all these issues for development of fiscal policymaking institutions. There are a host of fiscal challenges in coming years:

  • to maintain a strong consolidated balance,

  • to secure a sizeable strengthening in the primary surplus and increases in public investment,

  • to provide a “social plan” for large numbers of workers to be dismissed from bankrupt firms,

  • to meet ongoing calls for increased pensions,

  • to engineer multiple shifts in functions between different tiers of government and an expansion of State-level competencies in accord with EU-accession requirements, and

  • to implement a host of tax reforms, starting with VAT at end-2005, and combat tax evasion.

All this has to be achieved in the context where the OHR’s coordinating role is receding sharply. Thus, strong fiscal policymaking institutions will plainly be essential.

13. But the fiscal structure bequeathed by Dayton is fragmented and weak. So much so that no institution is charged to determine, implement, or monitor the consolidated fiscal balance. Complicating matters further, there is no consensus on broader constitutional change within which efforts to address these institutional shortfalls could be embedded. Until that consensus is reached, progress is required within the current framework.

14. In this challenging context, chapter 10 proposes a comprehensive approach to strengthening fiscal coordination. It works within the spirit of the Dayton compromises, building on—but much extending and strengthening—the initiative of the Indirect Tax Authority and its notion of “pooled sovereignty.” A wide range of initiatives are suggested— encompassing coordination of budget calendars, development of devices to break fiscal negotiation deadlocks, controls on cantonal and municipal balances, the strengthening of macro analysis and statistics—all focused on establishment of a National Fiscal Council charged with fiscal coordination. This approach would need to be developed through “learning by doing.” But it heralds the prospect of creating mechanisms with which the authorities will be able to secure effective fiscal policy, and therefore the exercise of fiscal sovereignty, within the Dayton framework.

15. Drafts of most of these chapters were discussed with the authorities during the Article IV consultation mission. In that context, the drafts of Chapters 2, 3, 4, 8, 9, and 10 concluded with proposed “questions for discussion”. These questions are listed for the record in the annex to this Selected Economic Issues paper.