Bosnia and Herzegovina: Selected Economic Issues

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.

VI. Fiscal Sustainability and Budget Spending1

A. Introduction

1. In 2004, a major restructuring of government domestic liabilities and strong budgets were adopted. The former, the “domestic claims plan”, envisaged lowering government domestic liabilities from over 200 percent of GDP to a NPV of 10 percent of GDP. And the 2004 budgets targeted an underlying primary surplus of 1 percent of GDP. These actions together were consistent with fiscal sustainability—i.e., with non increasing ratios of public debt to GDP and overall fiscal balances which can be financed. They therefore put in place a major ingredient for economic growth.

2. But fiscal sustainability is not secure.

  • First, the constitutional court has rejected the terms of the domestic claims plan in the Republika Sprska regarding war damages, and of that in the Federation concerning frozen foreign currency accounts.

  • Second, domestic liabilities of government may increase further due to restitution payouts now under discussion and in the context of write offs of corporate arrears for pension contributions.

  • Third, various public expenditure plans, including some sought by the International Community, would greatly increase public spending.

3. This note assesses the significance of these three issues and draws policy implications. To do so, it quantifies the permanent cuts in budget spending that these developments imply is necessary to reestablish fiscal sustainability.

4. The implications are stark. The necessary cuts in budget spending are large. If the court ruling on domestic claims means in NPV terms that a quarter of the current estimate of total claims must be paid, if restitution and pension arrears write-offs are moderate, and the priority projects proceed as now envisaged, permanent cuts in budget spending of at least 7 percent of GDP (KM 980 million) will be needed. That is almost exactly than the spending of one of the Entity Central Governments. These funds will be needed to pay the debt and pension payments and to fund the priority projects.

B. Domestic Claims

5. Several laws restructured domestic liabilities of governments in 2004: the Republika Sprska (RS) law of July 2004, the Federation law of November 2004, and parallel laws for the State and Brcko District. These were based on best—but inadequate—estimates of the various liabilities of government available at the time—for war damages, expenditure arrears, frozen foreign currency accounts, to banks, and so on. They anticipate “verification” processes now underway to check each individual claim. And they anticipate settlement of the claims in a mix of cash payouts, which have already begun, and zero coupon or submarket coupon bonds with maturities up to 50 years. Terms of the payouts were anticipted to reflect the verified claims.

6. The below market coupon long bond structures reflected legal advice from the authorities on what they anticipated might be accepted by the courts. Given a technical assessment that all claims could not be paid in full consistent with the authorities’ public expenditure ambitions, it was suggested that courts could accept payouts of nominal sums equal to the claims via long term sub-market interest bonds. This was anticipated to secure an acceptable balance between the rights of the claimants and the public interest in solvency of government in the assessment of the courts.

7. The structure of the domestic claims plans was the outcome of a complex negotiation. Within the constraints of fiscal sustainability and very different indebtedness of the two Entities, efforts were made to secure reasonably common treatment of classes of claims between the two Entities, notably in respect of frozen foreign currency holdings.

8. But the RS restructuring was struck down in court. On December 17, 2004, the Constitutional Court of Bosnia and Herzegovina heard an appeal against the Republika Sprska for failure to implement a ruling of the Basic Court in Banja Luka of 12 April 2002. The 2002 ruling was in respect of compensation of KM 24,000 (Euro 12,000) due from the Ministry of Defense to the widow and son of a man killed during the war as a reserve soldier in the RS army. The Constitutional court concluded, in respect of the “Law on Establishment and Manner of the Internal Debt of the Republika Sprska of July 2004”:

“Regardless of the evident public interest of the state to adopt this law, due to the enormous debt which was incurred as a result of the pecuniary and non-pecuniary damages caused by the war actions and which is contained in Article 18 of the Law in question, the Constitutional Court holds that by adoption of such law, an excessive burden was placed on the individuals and therefore the requirement of proportionality between the public interest of the community and fundamental rights of individuals was not met. The Constitutional Court sees the excessive burden which is placed on the individual in the fact that Article 21 paragraph 1 of this Law provides that claims which were established in the legally binding court judgments shall be settled “by issuing of bonds with the maturity date of up to 50 years” which justifiably imposes the question whether any of the citizens who will possess such type of bonds will live to charge these bonds and thus realize their rights. Moreover, the challenged law provides that the obligations shall be settled without interest rates being charged, which, considering the mentioned grace period, surely means that the amounts to be paid out to the individuals shall be considerably diminished.”

9. This was followed by a set of rulings on Frozen Foreign Currency Deposits. On April 6, 2005, the Human Rights Commission (HRC) of the Bosnia and Herzegovina Constitutional Court delivered a decision concerning the treatment of these accounts in the Federation. While the court found that interest due on the frozen accounts after January 1, 1992 could be validly written off in the public interest (para. 1243) and that the verified claims could be paid in the form of bonds, both as the 2004 law anticipated, other aspects of the restructuring were adjudged to violate the account-holders’ constitutional rights to property and to a fair trial. Notably, the court mandated that the maturity of the bonds should not exceed 15 years and that they should carry fair interest, i.e., the value that “would reflect the realistic value of invested foreign currency, including the average rate of inflation (paras. 1245 and 1246). The court also laid out a number of procedural requirements. These include that the State (rather than the Entities) should issue a law governing the frozen foreign currency accounts within six months, and that this law should provide explicit constitutional justification for any difference in treatment of claimants, including between the two Entities.

10. Much about these rulings is unclear. They both recognize that a balance has to be struck between the public and individual interest. But they find that this balance is not appropriately struck in by the July 2004 RS and November 2004 Federation laws. And the implication, in the last sentence of the December ruling, that “considerable diminishment” of the claims is unwarranted could imply that only “moderate” write downs would meet the criteria of the court. And though the December ruling refers to the RS law’s treatment of war claims only, it is likely that the Federation Law’s handling of war claims would be adjudged similarly if it was to be tested in court. Similarly, it is likely that the ruling on Federation Frozen accounts would affect the RS law on those accounts, given that it provided for even less generaous payouts than those envisaged in the Federation law.

11. But the implications are sobering. If, for illustration, the courts were to impose requirements implying that a 75 percent NPV write down of claims as “not considerably diminished”, that would leave Bosnia and Herzegovina (BiH) with domestic indebtedness with a NPV of some 50 percent of GDP. This assumes that the estimates of total claims are correct, at about 200 percent of GDP. Focus on this possible estimate of the NPV payout is helpful because under some assumptions—notably that the court approves cancellation of privatization vouchers still outstanding—it coincides with plausible interpretations of the court’s rulings on frozen foreign currency accounts.2 In particular, if the court mandate for “fair” interest rates means that “market” interest rates be paid, and that they be paid on all bonds to be issued as part of the domestic claims settlement with accrued interest to date on all claims written off (not just Federation frozen foreign currency accounts), then the NPV of the total payouts could amount to some 50 percent of GDP.

12. To assess the implications, the sustainability analysis underpinning the original domestic claims plan is repeated (Text Table 1). Column (a) shows the analysis underlying the domestic claims plan that recognition of new claims with an NPV of 10 percent of GDP is compatible with non-increasing government indebtedness in a long-term scenario. As before, it abstracts from the short term characteristics of the Bosnia and Herzegovina economy, and assumes real interest rates 2 percentage points above long term growth.3 A primary surplus of 1 percent of GDP yields non-increasing indebtedness and a financeable overall balance in this context.

Text Table 1.

Public Debt

(In percent of GDP)

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13. Column (b) derives the primary balance needed to secure sustainability if claims of 50 percent of GDP are recognized instead. It shows that the sustainable primary balance rises to a surplus of 1½ percent of GDP. But note that a budget primary surplus of 1½ percent implies an overall deficit of 4 percent of GDP—on account of the added burden of interest payments accruing from the court-mandated domestic debt of government. This overall balance could not be financed in an orderly manner—without arrears. Creditors cannot be found to supply that volume of credit annually, now, and would be even less willing to do so in the context of high debts.

14. So column C shows that the budget primary surplus would need to strengthen to 4 percent of GDP in 2010 to yield a financable path for the overall budget deficit upto then. And even a budget this strong, maintained throughout the medium term, would suffice only to lower the NPV of public debt to just over 60 percent of GDP by 2010.

15. Given budget revenue ratios to GDP, the implications for spending are stark. Increasing the primary surplus to 4 percent of GDP would require permanent reductions in public spending, compared to the 2005 budget levels, of 3 percent of GDP or some KM420 million. Even if the entire Federation Central Government program of benefits for war veterans was to be cancelled as part of efforts to realize this adjustment, this would not suffice. A further KM 120 million in savings would still be needed, equivalent to approximately one third of all administrative expenses of the State.

16. These are “low range” estimates of the permanent budget spending cuts required. If the constitutional court rulings necessitate payouts with an NPV of more than 50 percent of GDP, say 75 percent of GDP, to avoid “considerable diminishment”, then even larger permanent cuts in spending will be required. And further, in quantifying the necessary cuts, the differential between interest rates and real GDP growth has been assumed to be unaffected by the level of debt. But with the much higher debt burden than was anticipated under the domestic claims plan, this differential would likely be higher: credit risk premia would be higher; and GDP growth would be lower for lack of the contribution of public spending to the structural strengthening of the economy. Both factors would increase yet further the estimates of the budget spending cuts necessary to maintain fiscal sustainability— non increasing public debt ratios, and overall fiscal balances which can be financed. Only if verification processes yielded total claims below those currently estimated would these implications for spending be overstated. Verification could do that, as well as the reverse. And since these are “low range” estimates—assuming that the estimates of total outstanding claims are approximately correct—adjustment even on this magnitude would not necessarily be sufficient for a program with the Fund.

17. Primary surpluses on this order of magnitude are not without international precedent. Other highly indebted and distressed economies run similar surpluses, including Turkey (primary surplus 7 percent of GDP in 2004) and Argentina (primary surplus of 5½ percent in 2004). But the adjustment would be challenging.

18. In addition, without a court-endorsed overall framework, lower courts can mandate immediate execution of awards to litigants. These awards threaten normal government operations which depend on the cash and assets seized. And given that the total of litigants’ claims is too large to be met, the several thousand cases now in the courts amount to a “run on government deposits and assets” through the courts. This threat has already been realized in the case of a RS Municipality, Trebijne. Other government units are similarly exposed. With a large number of court cases coming through, the immediate cash flow burden to settle court awards could be heavy—requiring immediate cuts in spending. Depending on the flow of cases and awards, these demands to implement awards—the cash flow effect—could require spending cuts even greater than those discussed above.

19. What are the options? The authorities will need to identify as soon as possible the level of NPV of domestic debt that would be accepted by the courts as constitutionally valid. That will require prompt identification of how this determination can be done speedily in this legal system, so as to minimize delays thet would be inherent in an iterative process of amending the restructuring law and waiting for further judicial review of the amended laws in the context of dispute submitted to the courts. These options need to be examined promptly.

C. Restitution and Other New Claims on Government

20. Challenging as the issues above are, they are compounded by additional domestic claims on government. A commission is examining restitution issues, likely focusing on those post 1945. It will need to consider which type of such claims shall be deemed valid, which kinds will be enforced by the courts, how much and in what form compensation shall be paid, and which tier (s) of government shall be liable for such payments. With claims dating back so far—and possibly including property seizures occurring during the 1992–95 war—the sum of potential claims is very large indeed, albeit unknown now.

21. There is need for the Commission to specify payouts consistent with fiscal sustainability. Given the sustainability analysis completed by Fund staff in the context of preparations for the 2004 Domestic Claims Plan, and assuming that the Court rejection of that plan were to be reversed, there is room for payouts with a NPV of some two percent of GDP. Larger settlements would require the sort of offsetting cuts in budget spending noted above. And given the court rejection of the 2004 domestic claims laws, there would appear to be little scope for any payouts under restitution as the outstanding claims on government already require such large offsetting budget spending cuts.

22. For similar reasons, claims emanating from prospective corporate restructuring need to be minimized.4 The most difficult issue in this context is arrears of pension contributions—the so called “gaps” in worker contribution histories. These gaps diminish affected pensioners’ monthly pensions, which are determined in relation to paid, not accrued, contribution histories.

23. Social pressure to ignore these contribution gaps in determining monthly pensions is strong. But accommodating this demand would increase the stock of claims of citizens on government yet further in the form of future pensions, without any corresponding increase in revenue to pay for them. Under the current pension system, which operates on a cash-rationing basis, such a shock to eligibility could—theoretically—be handled by lowering the average pensions of all other pensioners pro-rata until monthly total pension payouts again matched monthly collections. But such a radical adjustment (cut) in the monthly pensions of existing pensioners would be socially difficult to absorb. So, if pension contribution gaps were to be simply ignored, this would represent yet a further claim on government, driving it even more deeply into debt. A resolution here needs to provide at most partial closure of these gaps, conditional on fundamental restructuring of the companies involved so as to provide resources for the corresponding pension payouts from economic growth borne of that profound restructuring.

D. Consolidated Government Expenditure

24. The sustainability concerns above could imply need for large permanent spending reductions.

25. But many plans to strengthen Bosnia and Herzegovina imply more, not less, public spending. There are many aspirations to raise public investment. And various other priority spending projects are also under consideration (Text Table 2). These include shifting security functions from the Entities to the State, efforts to ensure ethnic diversification at all levels of the governments’ civil service, expansion of Cantonal and municipal activities in infrastructure and provision of public services, and establishment and expansion of many institutions at State level in order to meet the requirements of eventual EU accession.5 These priority projects are strongly backed by the International Community and by many amongst the authorities.

Text Table 2.

Costs of Priority Projects

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26. Even under the now rejected domestic claims laws, these priority projects would have been difficult to accommodate within the fiscally sustainable primary surplus of 1 percent of GDP consistent with those laws. As currently configured, they will raise public spending by some 4 percent of GDP or more permanently, with transitional costs above that in a number of cases.

27. These increases cannot be funded from additional revenue. With fiscal revenue (including grants) some 49 percent of GDP and the tax authorities hard pressed to raise even that amount, scope for expansion is limited. Even the coming VAT may not provide relief.6 Its yield is highly uncertain—given the poor quality of data on which estimates for the yield are based—and as with any major tax reform, the transitional implementation difficulties may prove to be severe.

28. So permanent savings in “other” spending of at least 4 percentage points of GDP are required—equivalent to half of the RS central government budget to offset these high priority plans. This will be a considerable challenge. There is certainly need and scope for a concerted effort by the authorities to eliminate low quality spending. But even if large adjustments in “wasteful” spending are secured—as they should be—there is need to economize in the proposed new spending programs. Coordination within the international community and between the international community and the authorities is needed to address this challange.

E. Conclusion

29. The impact of BiH government excess liabilities—long hidden—is increasingly visible. While this has been one of many factors discouraging new private investment, the fact that courts have, until now, not pressed the claims—or have been impeded from doing so by the various laws postponing enforcement—has limited the visible impact of insolvency on government operations. But with the courts increasingly processing such claims, the risk to operations is materializing. And increased activism by pensioners is also bringing the contribution gap issue into the open.

30. The 2004 domestic claims laws were intended to address this problem. And the 2004–05 budget spending plans were consistent with them. The court’s rejection of the RS and the Federation laws therefore represents a major challenge. If those rulings require even one quarter of the estimated outstanding claims to be paid in NPV terms, then permanent cuts in budget spending of some 3 percent of GDP will be necessary. In this context, there is urgent need clarify exactly what would meet the court’s prescriptions. The cuts in budget spending that will eventually be necessary will depend on exactly what domestic claims settlements the court accepts as valid.

31. Securing government operations from threats to cash flow arising from execution proceedings is also necessary. This requires both a short-term remedy for the cases where awards have already been court-mandated, and a strategy to address cases still in the courts. The key element here will be effective monitoring of the latter, so that government lawyers can be fully prepared to make their case in each court.

32. In this context, additional domestic claims on government should be minimized. Thus, compensation for restitution and accommodation of old pension arrears must be strictly limited. This will need to be reflected in the recommendations from the restitution commission, as well as appropriate legal underpinnings for those recommendations. If such mandated restitution claims are large, then sizeable cuts to public spending could be required to reestablish fiscal sustainability in that context.

33. Scope for the priority projects will be limited if the domestic debt of government is higher than anticipated in the 2004 domestic claims plans. And even if those plans are reinstated and additional liabilities on government capped at low levels, major cuts in budget spending may be necessary to make room for the priority projects—because they require equal and offsetting cuts in other spending. These ambitions currently imply need for 4 percentage points of GDP or more in spending cuts.

34. These matters have informed much recent IMF advice to Bosnia and Herzegovina. They underlie the encouragement given to adoption of the domestic claims plan in the first place—to secure fiscal sustainability; to adopt it with a NPV of only 10 percent of GDP—to reflect the authorities’ budget spending ambitions and legal advice that the courts might accept such arrangements; placement of one-off receipts into escrow—to fund court awards and other payouts; and the establishment of the “Fiscal Sustainability Group”—to identify expenditure cuts that will be needed to facilitate priority spending. And they account for encouragement given to those developing the priority spending plans to coordinate and rationalize them.

35. But major budget adjustment may now be necessary. If the estimates of total claims are broadly correct, if the court ruling implies that quarter of these must be paid in NPV terms, if restitution and closure of gaps in pension contributions are no more than symbolic, and if priority projects are implemented as now configured, then permanent budget spending cuts substantially more than 7 percent of GDP are required. But as noted at the outset, that amount is equivalent to the annual spending of one of the Entity Central Governments. This spending would be cancelled entirely—not shifted to other levels of government. Instead, the resources released by these actions would be needed for the additional burden of government domestic debt and pension payments and the priority projects, consistent with fiscal sustainability.

1

Prepared by Peter Doyle.

2

Such interpretations will need to be confirmed by the authorities and the courts.

3

See Chapter 4, Domestic Claims on the Governments, IMF Country Report No. 04/54, March 9, 2004..

4

See Chapter 4.

5

See Chapter 7.

6

See Chapter 8.