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.


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.

IX. Consolidated Cantonal and Municipal Fiscal Balances1

A. Introduction

1. Consolidated fiscal balances at cantonal and municipal levels need to be controlled. This is one essential component of effective control of overall government balances, compatible with fiscal sustainability and macro economic stability and is key to the effective working of the National Fiscal Council (NFC).2 These concerns need to be met, however, in a manner which allows cantons and municipalities to apply resources prudently to their individual spending priorities as far as is possible.

2. Present arrangements do not meet these requirements. They neither secure control over consolidated balances, nor provide flexibility to individual cantons and municipalities. The potential for arrears accumulation, the ad hoc nature of borrowing embargoes, unrestricted use of resources from privatization, and the lack of restrictions on issuance of guarantees undermine control over the consolidated balance. And the same ad hoc restrictions on borrowing are inflexible and have prevented the development of a market for local government debt. Partly as a result of the latter, utility and other local infrastructure has been decaying for years.

3. This chapter discusses how these arrangements should be reformed.3 Its proposals are nested within arrangements to establish a NFC.

B. Background and Assessment

4. Central control over the consolidated fiscal balances of cantons and municipalities is not secure. Arrears accumulation and uncoordinated cantonal disposal of privatization and other one off receipts have undermined this in the past.4

5. Thus, arrears accumulation and use of privatization and other one off receipts by cantons and municipalities are not properly regulated. The former has, apparently, resulted in sizeable arrears, notably of wage payments and claims of suppliers. And the latter, notably in 2005, has resulted in emergence of a large planned fiscal deficit in Sarajevo Canton—KM 55 million, 0.4 percent of GDP—significantly larger than the deficits anticipated for either the State or the two Entity Central governments in 2005.

6. On the other hand, central control over borrowing has enjoyed some success. This is reflected in low indebtedness to domestic banks. But this has been secured, in part, by administrative measures which overrode the underlying legal framework regulating borrowing.

7. The underlying framework regulating Cantonal and municipal borrowing is expressed in by organic budget laws. In contrast, in the Brcko District, domestic borrowing is regulated by the Law on Domestic Debt adopted in July 2004, with its external borrowing regulated only by State legislation. Table 1 summarizes present provisions.

Table 1.

Summary of Present Sub-entity Borrowing Rules

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8. Arrangements for prior approval by Entity Central Governments of cantonal and municipal borrowing vary. In Republika Srpska, the ministry of finance must approve borrowing in excess of the indicated long term limit, but short term borrowing is not subject to this approval. In the Federation, there are no arrangements for prior approval. Instead, borrowing procedures differ across cantons. The individual cantonal assemblies endorse annual borrowing limits, whereas approval procedures differ for cities and municipalities in accordance with respective cantonal laws on self-government: in some cantons, municipal borrowing must be approved by the cantonal parliaments, while in others approval by the municipal councils suffice.

9. These frameworks have been applied in an ad hoc manner. In the Republika Srpska, in the context of previous Stand-by arrangements with the Fund, government decisions were adopted that strictly limited actual municipal borrowing. The government decision adopted in May 2003 limited the stock of central government and municipal debt to 9 million KM, and municipal borrowing (and issuance of guarantees) was allowed only upon approval by the minister of finance. This decision has been extended and is still in force. Similarly, in the Federation, in spite of the general borrowing provisions described above, recent budget execution laws, including for 2005, have banned any new commercial borrowing by sub-entity governments.5

10. A further factor inhibiting Cantonal and municipal borrowing is lack of creditworthiness. This reflects the lack of transparency, revenue autonomy, adequate financial management systems, and accountability of many of them.

11. But short term bank lending to cantons and municipalities does occur. As new treasury and payment systems are introduced at local level, alongside the general economic recovery, local banks have opened short term credit lines to their municipalities, in part to get the opportunity to manage their accounts.

12. And long-term bank lending to cantons and municipalities is also in evidence. There is anecdotal evidence of—albeit modest—breaches of the regulations. This may reflect the complex nature of those regulations, weak monitoring and enforcement, inadequate in-house auditing and controls, and incomplete or possible inaccurate statistics on local government borrowing that are needed for effective monitoring. And new lending projects of international donors—exempt from the general borrowing embargoes—involve intermediate or guaranteed bank lending to municipalities.

13. Contingent liabilities have been widely used. Guarantees have been provided to local enterprises, in particular utilities, owned by cantons and municipalities, posing a fiscal risk of unknown magnitude. And looming over all are possibly large liabilities for war claims and claims for restitution.7

14. None of this is satisfactory. Stronger discipline over arrears accumulation and use of privatization receipts is needed. A coherent framework for borrowing—not one which is overridden—needs to be established. And with cantons and municipalities increasingly gaining access to domestic and external credit, the threat of loss of control over the consolidated fiscal balance of government is rising. But in addition, the current borrowing frameworks, as applied, have impeded sensible borrowing potential by Cantons and municipalities for sound infrastructure and other projects. Reforms must therefore carefully balance the need for effective central control over the consolidated balances of cantons and municipalities with need for appropriate flexibility for these individual government units to apply resources prudently.

C. Issues

15. New arrangements are needed for arrears, use of privatization receipts, guarantees, and borrowing by cantons and municipalities. With new debt laws under preparation, consideration of these options is timely.

D. New Arrears and Use of Privatization Receipts

16. The key to combating arrears accumulation is enforcement and bankruptcy procedures. Municipalities and cantons have not faced the threat of bankruptcy when accruing arrears. And this is reflected in past lack of discipline on their part in this area. The new 2004 bankruptcy laws, however, exempt municipalities and cantons from these procedures. To secure discipline over accumulation of arrears, a way needs to be found to render them liable for these procedures.8 But this will have to be consistent with the broader resolution of the war claims and restitution issues. If these levels of government are made liable to bankruptcy and enforcement, this could result in many or all of them being placed into bankruptcy on account of potential war damage and restitution claims.

17. Cantonal and municipal use of privatization receipts raise various issues. Under current arrangements, they have substantial freedom to dispose of these resources. While only a small number are well endowed with such funds, they can impart large shocks to the consolidated fiscal stance, as seen in the case of Sarajevo Canton in 2005. At the least, a system of “advance warning” could be set up—so that the central Entity Ministries of Finance should be alerted of cantons’ or others’ intention to use these resources. Advance notice should be long enough to allow the central governments time to offset the fiscal effects in their own budgets—for example, to make matching expenditure cuts. But since, given a target for the consolidated fiscal balance, the corollary of cantonal and municipal use of these funds will be offsetting adjustments at Entity central government levels, there may also be a case to make use of these resources subject to some sort of prior approval by the central Entity governments. These steps would also reflect the need to improve the general reporting of cantonal and municipal operations.

E. Borrowing Rules9

18. These raise the more complex technical issues. Based on international experience, country approaches to the control of sub-national borrowing fall into four broad categories although many use a combination of them: reliance on market discipline; a cooperative approach; a rules based approach; and direct central government control of borrowing. These options, and their applicability to Bosnia and Herzegovina (BiH), are discussed in Box 1.

Approaches to Borrowing Rules for Sub-National Levels of Government

Sole reliance on market discipline has rarely been adopted. Canada is one case, but this resulted in steadily increasing provincial indebtedness despite clear deterioration in ratings of provincial bonds. Brazil is another, and a rapid accumulation of sub-national debt eventually prompted the government to institute such controls. But this approach has worked reasonably in Finland, France, and Sweden.

But it is unlikely to suit BiH. The benefits of full borrowing flexibility for local governments are outweighed by the absence of control over the consolidated fiscal balance. Its limited use reflects the stringency of conditions for success: free and open financial markets; no borrower privileges for governments; public information on a borrower’s debt and repayment capacity; and no possibility of bailouts. And without efficient financial management systems of lower levels of government in BiH, the approach will prove unworkable.

A cooperative approach to debt controls is an alternative. This is applied in Australia and Scandinavia and is based on annual agreements between different levels of government concerning fiscal projections and targets, including limits on borrowing. This approach maximizes local government borrowing flexibility while securing control over the consolidated balance of all governments. But it can be time consuming, may not work in countries with weak fiscal management, and where consensus is difficult to secure. For these reasons, it does not seem best suited to Bosnia and Herzegovina.

Many countries apply a rules based approach. Limits may be set on the level or the purpose of borrowing, and limits may refer to ceilings on the ratio of debt-service to revenue or on the total debt stock. Borrowing from central banks and for consumption is often disallowed (“golden rules”). This approach is transparent, uniform, avoids time-consuming bargaining processes, and can secure control over consolidated fiscal balances. But it may be inflexible and rule evasion may occur. It works best with clear, uniform, and enforceable accounting standards, minimal off-budget operations, and modern financial management systems. For Bosnia and Herzegovina, this approach could ensure control over consolidated fiscal balances, in a transparent and simple way, while mimicking market discipline.

Direct central control is a further alternative. This may reflect central authorization provisions or centralized borrowing and on-lending to lower levels of government. While appropriate for external borrowing, the rationale is less compelling for domestic borrowing by sub-national governments, renders central government highly intrusive in local government matters, and may oblige bailouts when local governments are under financial stress. This “direct control” approach is what Bosnia and Herzegovina has applied to date. And while it has helped to secure control of the consolidated fiscal balance, it is overly restrictive.

19. On balance, a rules-based approach appears appropriate for Bosnia and Herzegovina now. While the conditions for a smoothly working cooperative approach do not appear to be present at the moment,10 and full reliance on market forces is not feasible, direct central control or a rules-based approach are the remaining options. While both approaches are conducive to securing control over consolidated fiscal balances, it may prove difficult to implement fully uniform nationwide direct controls in the context of the present and highly decentralized fiscal structure of the country. And direct controls leave no flexibility for local governments to meet their individual borrowing requirements. So a rules based approach would seem most appropriate as it can be calibrated to secure control over the fiscal balance and to allow a prudent degree of flexibility to Cantonal and Municipal governments.

F. Borrowing Rules in Steady State

20. The requirements for such rules are demanding. They must be transparent and easy to administer for the sub-national governments, and easy to monitor for higher levels of government, while being sufficiently flexible and able to deliver the appropriate volume of credit to local governments. And they must ensure that borrowing by Cantons and Municipalities is compatible with effective control over the consolidated balance of all governments. Administratively, they must be executed through transparent and efficient financial management systems that maximizes the probability of debt being serviced.

21. A rules based approach that mimics market discipline will appropriately address flexibility and transparency considerations. Setting limits for the amount of debt service costs expressed as a ratio of current revenue of individual local governments, possibly under “golden rule” criteria, constitutes a transparent and easily monitorable arrangement that provides the local governments with a sufficient degree of flexibility to issue debt consistent with local needs.

22. This approach has the considerable merit of “mimicking” market discipline. With debt service in any future year capped as a percentage of last year’s outturn revenue, Cantons or Municipalities can borrow more, year after year, as their revenue rises. They can also increase borrowing if they increase their creditworthiness, and therefore, the term over which creditors are willing to lend to them. This model is incorporated in the draft Federation organic budget law, and is envisaged also in the entity and State framework laws. The proposed borrowing test in these draft laws is defined as a ceiling on the allowed future annual debt service of individual cantons and municipalities of 10 percent of current revenue collections in the previous fiscal year.

23. A debt service limit of 10 percent of local government revenue is consistent with effective control of the consolidated fiscal balance over the medium-term.11 Under reasonable steady-state assumptions, a 10 percent debt service limit that is fully and permanently used would, ceteris paribus, be consistent with a stable consolidated cantonal and municipal deficit of around 0.3-0.4 percent of GDP.12 This is a magnitude small enough to allow manageable offsetting adjustments year by year in the central government balances so as to secure annual consolidated general government fiscal balances.

G. Transitional Issues

24. Transitional issues towards these permanent arrangements will be considerable. They arise from the very low level of outstanding debt and the expected expansion of local debt issuance to finance local infrastructure projects. The World Bank argues that

“Obviously, during an interim period, public indebtedness (including those of individual sub national governments) should be limited to lower levels, and only allowed to converge to that long-term general asymptotic maximum gradually, as macroeconomic conditions permit.”13

25. This raises the question of thepotential magnitude of borrowing in the short term that this regime could entail. Staff projections for 2005 (see Table 2) imply that if all cantons and municipalities immediately upon introduction of a 10 percent ceiling borrow to the limit, it would result in a borrowing volume (and, if immediately spent, an increase in the fiscal deficit) of about 3.6 percent of GDP.14 This estimate reflects projected current revenue of all cantonal and municipal governments in 200515 of some 1.7 billion KM, or 12½ percent of GDP, with close to 1.3 billion to the cantons (9.1 percent of GDP) and about 450 million to municipalities nationwide (3.2 percent of GDP). The existing and very modest debt service obligations would allow on the order of 1¼ percent of GDP in “new” annual debt service costs.

Table 2.

Cantonal and Municipal Revenue and Debt Service, 2003 and 2005

(KM millions)

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26. This represents a considerable risk to the consolidated fiscal balance. Even though this risk is mitigated by low creditworthiness, this mitigation is difficult to quantify. While external official creditors are cautious in their intentions to provide new credit, in part reflecting concerns with creditworthiness, domestic commercial banks have been engaged in a three year rapid expansion of credit to the private sector—indicative of a considerable appetite for risk. And they have indicated their desire to expand their lending to government, including municipal and cantonal governments, considerably. And some have negotiated considerable external commercial funding precisely for this purpose.

27. So the risks of a destabilizing fiscal impulse are significant, even if difficult to quantify precisely. And even a moderate fiscal weakening from this source would put serious pressure on a current account already in substantial deficit. These concerns would be compounded if initiatives to control arrears accumulation and use of privatization receipts are not secure. And they are compounded by other fiscal initiatives to increase expenditure.16 Hence, remedial measures for the transition period need to be developed.

28. There are various options to ensure that these “transitional” risks to the consolidated fiscal balance are addressed.

29. One of these is to follow the World Bank suggestion and phase the borrowing limit in. By gradually increasing annual ceilings for individual municipalities and cantons in terms of revenue—as an illustrative example, a five year 2%-4%-6%-8%-10% schedule—the risk of a surge of borrowing and the consequent increase in the fiscal deficit of consolidated government would be minimized. Hence, a 2 percent limit would allow a maximum of new borrowing of about half of one tenth of a percent of GDP. Under this proposal, the move from one ceiling to the next would not be automatic. It would occur only when individual cantons and municipalities have reached the preceding ceiling (to avoid abrupt credit expansions owing to “unused” credit ceilings of previous years).

30. The main advantage of this framework is that it ensures control over the consolidated fiscal balance throughout the phase in period. However, because of the low ceilings as the phase-in progresses, it could restrict individual well-prepared municipal borrowing projects, including those sponsored by donors, delay the development of a municipal debt market, and it would be complex to implement. These concerns could be alleviated in three different fashions.

31. First, a simplification of the phasing-in mechanism could be considered. If the move through the steps is automatic and simultaneous, then all Cantons and municipalities would reach the 10 percent ceiling in the 5th year, notwithstanding their actual borrowing during the period. Or, building on the fact that only some Cantons and Municipalities are creditworthy and hence able to obtain bank credit in any meaningful volume, the initial ceiling could be set higher than the 2 percent, for example at 4%-6%-8%-10% or 3 1/3 %-3 1/3 %-3 1/3 %, on an automatic and simultaneous basis. This could allow some municipalities to go ahead with financially sound projects while still limiting the macro risks from credit expansion. The basic question on this way forward is whether the marginal simplifications achieved are sufficient to address the concern, while not simultaneously loosening control of the consolidated fiscal balance.

32. Second, the approach above could be developed. A Cantonal and Municipal Credit Board (CMCB) could be established at entity level with participation of all stakeholders (entity ministries of finance, representatives of cantonal and municipal governments, donors, commercial banks, and possibly the central bank) to monitor and control overall local government borrowing volumes. The key objective would be to ensure that the consolidated borrowing of all cantons and municipalities combined is compatible with the consolidated fiscal balance target. Within this constraint, the CMCB could grant individual exemptions to cantons and municipalities from the phasing-in ceilings on borrowing. Where projects are sound, such exemptions would allow the individual cantons and municipalities to go straight to the 10 percent borrowing limit. But this flexibility would be allowed only if it was consistent with the target consolidated fiscal balance. While this proposed arrangement would ensure effective control over the consolidated fiscal balance, and allow significant flexibility for individual cantons and municipalities to borrow immediately up to the full 10 percent limit, it does require that the CMCB is an effective and appropriately neutral decision-making body.

33. A third approach would be to apply the phase-in rules differently between the Cantons on one hand and the municipalities on the other. Municipalities could be subjected, immediately and only, to the general 10 percent limit without any phase-in or exceptions arrangements. But alongside, cantons could be disallowed any borrowing, as under the present prohibition arrangement. Eventually, however, a phasing-in system (2%-4%-6%-8%-10% or some other schedule) could be envisaged for them, along, perhaps, with establishment of a Cantonal Credit Board to handle requests for exceptions.

34. This approach would cap aggregate borrowing in a different manner to the approaches described above (¶29–32). Based on the data and projections presented above (¶24 and Table 2), this would cap new municipal borrowing at some 0.7 percent of GDP assuming that all 137 municipalities immediately borrow the full amount allowed under the ceiling. Clearly, a number of them will not be sufficiently creditworthy to borrow to the full extent allowable under this regulation. But given need to curb aggregate expenditure of consolidated government considerably, even this approach in regard of municipalities would require support of other expenditure-cutting measures elsewhere and an appropriate regime to control Cantonal use of their privatization receipts to make room for even a modest expansion in municipal activities. And given various uncertainties in future revenue prospects for the municipalities, including the impact of the VAT on them, the rule adopted for them should be reviewed in light both of their actual borrowing activity and the revenue shocks.

35. The simplicity, flexibility, and control over consolidated borrowing in this third approach commends it. But it might be viewed as discriminating in the treatment of local borrowing rules between the two entities. This follows because Federation Cantons are responsible for tasks that are the responsibility of the central government and municipalities in the RS. But with the structure of governments in the two entities so different under Dayton, fully equal treatment is likely not feasible. But this issue also highlights that the case for differential treatment of cantons and municipalities should also reflect their relative needs to borrow.17, 18


Prepared by Peter Doyle and John Norregaard.


See Chapter 10.


The establishment of a legal framework has commenced at the State level with the draft Law on Debt and Guarantees of Bosnia and Herzegovina with the dual purpose of establishing legal frameworks for sovereign debt creation and for a national securities market. The draft State debt law prescribes that, following adoption of the law, the entities must adopt their debt framework laws within 90 days to regulate entity central government debt as well as cantonal and municipal borrowing. Also, a State organic budget law has been adopted with provisions aimed at preventing expenditure arrears.


Payment arrears to suppliers have apparently been used mainly for utility services, leading to barter arrangements to settle the arrears such as tax off-sets between local governments and companies with claims on local budgets.


Article 39 of the 2005 Federation budget execution law states that “Cantons, cities, and municipalities can not borrow under commercial terms domestically and abroad to finance current expenditures and capital and investment costs.”


According to the new draft Federation organic budget law (Articles 52 and 53) now in procedure, cantons, cities, and municipalities can borrow only domestically and subject to a ceiling on total debt service costs (including on guaranteed borrowing) equal to 10 percent of the revenue collections in the previous fiscal year (note that the new limit applies to debt service as opposed to borrowing volumes under present provisions).


See Chapter 7.


Alternatively, provisions could be introduced in the entity organic budget laws pertaining to cantons and municipalities similar to those introduced in the State organic budget law (see footnote 3).


This section is based on Teresa Ter-Minassian and Jon Craig, Control of Subnational Government Borrowing, in Fiscal Federalism in Theory and Practice, ed. T. Ter-Minassian, (Washington, International Monetary Fund, 1997).


Although the associated benefits in terms of cooperation and exchange of information should be promoted in other ways.


In Croatia, the debt service ratio to revenue is 20 percent, while in Poland and the Czech Republic the limit is 15 percent. In Hungary it is 70 percent of own current revenue, while in Romania it is 20 percent of current revenue. However, the significant differences across countries in the level and structure of local government revenue, in the relative size of local governments subject to the ceilings, as well as in the specific definitions of the limits applied practically render cross country comparisons meaningless.


The actual deficit could be higher if projects are also financed from escrow accounts.


See draft IBRD report op cit, page 90.


Assuming projected current revenue of 1,714 million KM, 5 year average maturity and 10 percent average interest rate.


Adjusted for the impact of the Single Account and based on data for 2003 actual outcome (2004 execution data will be available only in May, 2005).


See Chapters 8 and 10.


Within the Federation, total cantonal revenue is about 3½ times higher than total municipal revenues, or about 78 percent of total Federation sub-entity revenue.


While these are the main options available for BiH, international approaches provide some further scope for refinements. For example, a system of local government debt control that has been applied in some US States constrains borrowing by local governments to those with an efficient financial management system. In effect, this allows borrowing only by larger municipalities which are, however, assumed to have the largest borrowing needs. Applied to BiH, this would entail a phasing-in of local borrowing contemporaneously with the gradual improvement of local financial management systems. Also, while most countries, including BiH, restrict sub-national borrowing in accordance with golden rule principles, i.e., borrowing is allowed only or mainly for capital investment purposes, some go further and limit borrowing only for well-specified types of capital projects (for example environmental or energy saving). Applied to BiH, the list of eligible investment purposes could be gradually expanded to secure a controlled credit expansion in the same manner as provided by the systems described above.