Bosnia and Herzegovina: Staff Report for the 2006 Article IV Consultation
Author: International Monetary Fund
Publication Date:
23 Oct 2006
eISBN:
9781451804911
Language:
English
Keywords:
ISCR; CR; government; authorities project; RS government's decision; deficit; Bosnia-Herzegovina; fiscal policy; entity government; government balance; labor market; federation government
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Bosnia and Herzegovina has enjoyed rapid growth and price stability in recent years, but stronger policy ownership, improved policy coordination, and meaningful progress in structural reform are needed to provide the basis for sustained, private sector-led growth. Ensuring the sustainability of public finances in the face of emerging spending pressures and still uncertain domestic liabilities is required. Improving fiscal governance and coordination, reducing financial sector vulnerabilities, and strengthening the private sector while improving competitiveness and the external position is required.

Abstract

Bosnia and Herzegovina has enjoyed rapid growth and price stability in recent years, but stronger policy ownership, improved policy coordination, and meaningful progress in structural reform are needed to provide the basis for sustained, private sector-led growth. Ensuring the sustainability of public finances in the face of emerging spending pressures and still uncertain domestic liabilities is required. Improving fiscal governance and coordination, reducing financial sector vulnerabilities, and strengthening the private sector while improving competitiveness and the external position is required.

I. Background

1. Growth has been strong and inflation low over the past several years, and there has been some progress in structural reforms. Growth has averaged 5 percent annually, and inflation has remained low, underpinned by the currency board. Financial deepening has continued and the banking system has been largely privatized. International reserves are high and rising (Tables 1-2). Customs and indirect tax policy have been unified and a VAT successfully introduced in January 2006. Finally, the general government balance has strengthened by 4 percentage points of GDP during 2001-05 while, at 32 percent of GDP at end-2005, public debt is relatively low. At the same time, an uncertain but potentially large amount of outstanding war damage and other claims against the government continues to be a major threat to fiscal sustainability. Recent steps toward restructuring some of these claims are mitigating these concerns, but risks remain.

Table 1.

Bosnia and Herzegovina: Selected Economic Indicators, 2002–06

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Sources: Bosnian authorities; and IMF staff estimates and projections.

Based on weighted averages for the Federation and Republika Srpska.

Broad money includes currency, demand deposits, time and savings deposits, bonds, and money market instruments.

Assuming 17 percent of GDP of debt to settle domestic claims against the government.

End-July.

Table 2.

Bosnia and Herzegovina: Selected Economic Indicators, 2002–06

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Sources: Bosnian authorities; and IMF staff estimates and projections.

2. These achievements, however, are hostage to fundamental political and economic imbalances:

  • Policy coordination is hampered by weak institutions and lack of political will. Several incidents highlight the ineffectiveness of current coordination mechanisms and the resistance against centralizing key policy functions, notably the controversy over unifying bank supervision and the continuing dispute over the allocation of indirect tax revenue among the Entities and Brcko District, which froze the transfer of funds from the treasury to their budgets for several months this year. In addition, the first attempt at amending the constitution to strengthen core State institutions (notably the Council of Ministers and the House of Representatives) with a view to facilitating policy-making at the State level was narrowly rejected in April.

  • The external imbalance, while likely much smaller than official estimates indicate (Box 1), is large, reflecting insufficient private savings (Tables 3-4). Poor current account data introduce greater-than-usual uncertainties in any quantitative assessment of the level of the real exchange rate. The CPI-based REER has been stable and exports have recently been rising fast and are projected to continue rising, suggesting that there is no major misalignment. But the export base is narrow and vulnerable to commodity price movements, and unit labor costs and other competitiveness indicators are mixed (Figure 1 and Section II.D).

  • Structural reforms lag behind neighbors’ and sustained private sector-led growth has yet to take root. Bosnia & Herzegovina ranks last among all European transition economies on the EBRD transition index, and the pace of reform is disappointing (Figure 2). In the World Bank’s Doing Business 2007 report, Bosnia & Herzegovina slipped from the 91st to the 95th position. The government is large, wide swathes of the corporate sector remain loss-making, and bankruptcy procedures are not effective. Unemployment is estimated by the World Bank at over 20 percent. Notwithstanding a few large foreign investments in metals and mining, FDI penetration, at less than US$600 per capita, is one of the lowest in the region.

Table 3.

Bosnia and Herzegovina: Balance of Payments, 2003–07

(In millions of euros, unless otherwise indicated)

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Sources: Bosnian authorities; and IMF staff estimates and projections.

Errors and omissions are explicitly projected to capture unrecorded capital inflows.

Table 4.

Bosnia and Herzegovina: Vulnerability Indicators, 2003–06

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Sources: Bosnian authorities; and IMF staff estimates and projections.

Includes repayment of IMF loans.

Figure 1.
Figure 1.

Bosnia and Herzegovina: Competitiveness Indicators, 2000-06

Citation: IMF Staff Country Reports 2006, 371; 10.5089/9781451804911.002.A001

Sources: Bosnian authorities; and IMF staff estimates.
Figure 2.
Figure 2.

Bosnia and Herzegovina: Progress in Structural Reforms, 2003-05

Bosnia & Herzegovina still lags behind neighboring countries…

Citation: IMF Staff Country Reports 2006, 371; 10.5089/9781451804911.002.A001

Sources: EBRD Transition Reports, 2003 and 2005; and IMF staff estimates of unweighted regional and category averages. Indicators range from 1 (no reform) to 4+ (standards of an industrialized market economy).1/ The nine areas are large-scale privatization; small-scale privatization; governance & enterprise restructuring; price liberalization; trade & foreign exchange system; competition policy; banking reform & interest rate liberalization; securities markets & nonbank financial institutions; and infrastructure reform.

What is the True Current Account Deficit in Bosnia & Herzegovina?

Staff has explored, in consultation with the CBBH, two alternative approaches that provide more accurate estimates of the current account deficit than the official estimates (see accompanying Selected Issues paper). A range of plausible estimates is derived first by using alternative data for remittances—a key component of the current account—and second by estimating the current account from capital and financial account data.

The CBBH estimate of remittances underestimates receipts substantially. This estimate relies on a 2004 household survey. There are, however, indications that remittances are larger and have been increasing in recent years: the most tangible one is a substantial increase in remittances recorded through the banking system. Regional comparisons also suggest remittances in Bosnia & Herzegovina are underestimated. On this basis, staff estimates that remittances are likely to be 3-5 percent of GDP higher than reported by the CBBH. On account of this factor alone, the true current account deficit is lower than the CBBH estimate by at least this amount.

Capital and financial accounts statistics provide an alternative estimate of the current account deficit. Identified capital inflows in recent years amounted to 7-13 percent of GDP annually. This provides a lower-bound estimate of the current account deficit.

These two estimates suggest that the current account deficit is at the range of 7-18 percent of GDP. But the size of the current account deficit relative to the economy is exaggerated by the underestimation of GDP in the national accounts due to sizeable nonobserved activity. While this is a common problem in many economies, the evidence suggests that it is larger in Bosnia & Herzegovina, and may indeed have increased in recent years. Previous staff analysis (IMF Country Report No. 05/198) concluded that GDP in Bosnia & Herzegovina could be 30-50 percent higher than official national accounts suggest, although a recent upward revision in official GDP estimates (by about 10 percent) to capture imputed rent has shrunk this gap. Combining the range of current account estimates with an adjusted GDP suggests that the true current account deficit in Bosnia & Herzegovina has been in the range of 6-14 percent of GDP in recent years.

3. Recent macroeconomic trends, correcting for the effects of the VAT, underscore these concerns (Figure 3). Growth is projected to accelerate slightly in 2006 (to 5½ percent) on account of strong consumption, and the current account deficit to improve (from 21 percent of GDP in 2005 to 17 percent this year). The latter projection, however, reflects a large decline in imports in early 2006 following a surge late last year in anticipation of the VAT (Box 2). Correcting for this temporary shift, estimated at about 1¾ percentage points of GDP, as well as for the likely VAT-induced improvement in the statistical coverage of exports, which is harder to quantify, all but eliminates the current account improvement. Underlying inflation—excluding the impact of VAT and administrative price hikes—is estimated at 3-4 percent, slightly higher than last year.

Figure 3.
Figure 3.

Bosnia and Herzegovina: Selected Indicators, 2000-06

Citation: IMF Staff Country Reports 2006, 371; 10.5089/9781451804911.002.A001

Sources: Bosnian authorities; and IMF staff estimates and projections.

4. The persistently large current account deficit and the uptick in underlying inflation reflect strong domestic demand. Demand pressures are fueled by wage growth (7.5 percent in the year to July) and continuing robust credit expansion: following a VAT-related surge in December 2005, private sector credit grew at an annualized rate of 19 percent through July.

The Impact of the VAT

On January 1, 2006 the sales tax was replaced by a VAT at a standard 17 percent rate with very limited exemptions. VAT revenue accrues to the Indirect Tax Authority (ITA). The successful introduction of the VAT had manifold effects on the economy.

Consumer prices in July were 8.5 percent higher than their level a year earlier. Staff estimates that the VAT accounts for 3-3½ percentage points of the increase, and the rest reflects underlying inflation and the impact of administrative price increases in late 2005 and 2006.

Imports spiked in December 2005 in anticipation of the VAT and fell drastically in January. This shift in imports, which raised the external current account deficit in 2005 and reduced it in 2006, is estimated at 1¾ percent of GDP.

Exports increased strongly in early 2006 (43 percent in the first seven months relative to the same period last year). Some of this increase probably reflects stronger incentives for accurate reporting by exporters due to the VAT, but the precise extent of this factor is hard to estimate.

VAT collection through July amounted to 9½ percent of GDP compared with 6 percent for the sales tax in the same period last year. However, collection of delayed sales tax from December 2005 was 1 percent of GDP, which will not be repeated next year; and outstanding 2006 VAT refunds and credits another 0.5 percent of GDP, which will be refunded in 2007. The permanent gain from the VAT is thus estimated at about 1 percent of GDP.

5. After years of successful consolidation, the underlying fiscal stance weakened this year and spending pressures are rising. After achieving a general government surplus for the first time in 2005, the adopted 2006 budgets—the first to be prepared without intervention by the Office of the High Representative (HR)—targeted a deficit of ½ percentage point of GDP, despite the concerns about fiscal sustainability arising from the outstanding domestic claims against the government (also flagged at the conclusion of the last Article IV consultation). In the event, given the substantial unexpected temporary VAT windfall (Box 2)—and assuming the Entities will not revise their budgets to raise spending—staff estimates that the consolidated general government will again register a surplus in 2006, overperforming the budget targets by a substantial margin. Adjusted for the transitory gains from VAT, however, the outcome would be a small deficit, implying an easing of 1 percentage point of GDP from 2005 (Tables 5-6). Moreover, the VAT windfall and the pre-election environment are generating spending pressures at all levels of government, the impact of which will be felt mostly next year (Section II.A).

Table 5.

Bosnia and Herzegovina: General Government, 2003–07

(In percent of GDP)

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Sources: Ministries of Finance; and IMF staff estimates and projections.

Corrected for temporary effects of VAT refunds by replacing actual refunds and tax credits with requests for refunds and tax credits.

Table 6.

Bosnia and Herzegovina: Elements of General Government, 2003–07

(In percent of GDP)

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Sources: Ministries of Finance; and IMF staff estimates and projections.

Consolidated General Government

(in percent of GDP)

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6. The financial sector is dominated by foreign banks that, while resilient to a variety of shocks, have contributed to demand pressures by aggressively expanding credit (Figure 4 and Tables 7–9). The recent FSAP found that foreign banks may be underestimating credit risk and relying on low-cost foreign funding from their parent institutions, and identified weaknesses in supervision and corporate governance (Box 3).

Figure 4.
Figure 4.

Bosnia and Herzegovina: Money and Financial Sector Developments, 2001-06

Citation: IMF Staff Country Reports 2006, 371; 10.5089/9781451804911.002.A001

Sources: Bosnian authorities; and IMF staff estimates.
Table 7.

Bosnia and Herzegovina: Monetary Survey, 2002–06 1/

(In millions of marka, unles otherwise indicated)

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Sources: Central Bank of Bosnia and Herzegovina; and IMF staff estimates and projections.

Because data for March 2005 onward are based on the upgraded classification of general government, there is a structural break in March 2005.

The jump in broad money growth in 2004 reflects banks’ efforts to mobilize foreign currency deposits, following a tightening of end-month forex exposure limits. Further regulatory changes in late 2004 dampened these efforts.

Table 8.

Bosnia and Herzegovina: Monetary Authorities’ Balance Sheet 2002–06

(In millions of marka, unless otherwise indicated)

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Sources: Monetary authorities; and IMF staff estimates and projections.
Table 9.

Bosnia and Herzegovina: Survey of Domestic Money Banks, 2002–06 1/

(In millions of marka, unless otherwise indicated)

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Sources: Monetary authorities; and IMF staff estimates and projections.

Because data for March 2005 onward are based on an upgraded classification of general government, there is a structural break in March 2005

Starting in June 2003, cash in vaults are excluded from assets eligible to meet reserve requirements.

2002-03 data are adjusted to correct for the structural break due to the RS govt, takeover of KM 463 million of old bank claims on RS enterprises in June 2004.

FSAP Key Findings

The financial sector is dominated by banks, with total assets at 75 percent of GDP. Foreign-owned banks are the main players, with the six largest holding 65 percent of bank assets.

The dominance of foreign banks minimizes solvency risk and—as stress tests show—enhances the system’s resilience to shocks, but raises other concerns. These include possible underestimation of credit risk, as these subsidiaries strive to meet high return on equity targets set by their parents, and reliance on low-cost foreign funding, which diminishes the incentive to mobilize long-term local deposits and raises the risk of contagion from adverse developments in other countries

Supervision is fragmented and has important gaps. The two Entity-based supervisory agencies are weak and subject to political interference. Strengthening is needed in consolidated supervision, loan evaluation, provisioning, and cooperation with foreign supervisors to enhance oversight of foreign-owned banks.

Institutional capacity and corporate governance are poor, even in comparison to neighboring countries. Despite progress in establishing the legal framework for insolvency, contract enforcement, and creditors’ rights, implementation is weak. Corporate governance suffers from opaque ownership, lack of accountability of boards and managers, and poor financial reporting and, according to the EBRD, is the least effective in the region. This is evident in the Privatization Investment Funds, which control a substantial share of corporate sector assets.

II. Report on the Discussions

7. Discussions focused on the need to create the basis for sustainable and dynamic private sector development and broad-based growth. Bosnia & Herzegovina’s growth so far has come mostly from postwar reconstruction and expansion of public consumption and investment financed by international assistance; public enterprise restructuring and private sector development have been neglected. While this approach has supported living standards and spurred much-needed institutional development during the last decade, it has left the economy well behind other countries in the region, with an overweight and inefficient government, chronically loss-making state enterprises, distorted factor markets, high unemployment, and a weak private sector—except in a few pockets, that have been successfully transformed by foreign investment.

8. Staff’s medium-term scenario highlights the risks of continuing on present trends (Table 10). The main driving force in the baseline (no policy change) scenario is the projected increase of exports, driven by a near doubling of output and exports of aluminum and steel as a result of a few large foreign investments in these sectors during 2003-04. High world prices of metals projected in the near term reinforce the impact on the current account. Hence, with unchanged policies, growth could accelerate to 5½-6 percent annually and the current account deficit decline by some 3 percentage points of GDP by 2009. This outlook seems reassuring: without major additional policy effort, the external imbalance would decline and, toward the end of the decade, the true current account deficit would be in the single digits. Staff, however, pointed out four important downside risks. First, this improvement in the baseline current account would be temporary and hostage to world steel and commodity prices: indeed in the outer years, when metal prices decline according to the latest WEO projections, exports would fall, the current account deficit start increasing, and reserves decline. Second, absent reforms to improve the business climate, private investment would remain low and income and consumption growth could not be sustained if exports slowed or in the event of other shocks. Third, vulnerabilities in the financial sector, which is now underwriting the growth in private consumption, could, if left unaddressed, amplify the impact of possible shocks. Fourth, without expenditure adjustment, the fiscal deficit would slowly rise and public debt would remain stuck at relatively high levels. Far from reassuring, the baseline scenario underscored, in staffs view, the fragility of the gains achieved so far and the vulnerability of the economy.

Table 10.

Bosnia and Herzegovina: Staff Illustrative Medium-Term Framework, 2003–11

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Sources: Bosnian authorities; and IMF staff estimates and projections.

Reflects a structural break in 2006 due to a change in statistical coverage.

Data from 2006 onwards include an estimate of debt assumptions to settle domestic claims on government.

Grants and disbursements of foreign loans.