General remarks

Not withstanding extreme complexities, stemming from its unique political and economic structure, Bosnia & Herzegovina (BiH) has made considerable progress in recent years. With assistance from the international community, including the Fund, the authorities have succeeded in restoring macroeconomic and financial stability, rebuilding policy-making institutions and reconstructing the infrastructure severely damaged from the three-year war. These policies have had a significant and positive impact on economic activity and stability. Over the past decade, GDP - although from a very low level -tripled; the high fiscal deficits turned into surpluses; inflation significantly declined and structural and state-building reforms were launched. These achievements paved the way to talks with the EU representatives toward the Stabilization and Association Agreement (SAA) at the end of 2005.

Having said that, the authorities acknowledge that much remains to be done and there are many risks up the road. The unemployment and poverty levels are still high, the current account deficit is large, the private sector continues to be weak and the financial system and business climate need to be enhanced. Additionally, the high internal debt threatens fiscal sustainability. Indeed, the economy is lagging behind other countries in the region in several transition indicators. Sharing the staffs observations and concurring with the main recommendations for policy priorities, the authorities stress that lack of political support exacerbated by fragmented institutions have prevented them from more forcefully moving forward with important reforms.

It is therefore regrettable that after two successful SBAs, the authorities and staff failed to agree on the third SBA, particularly in an election year, when budgetary pressures mount. The authorities hope that cooperation with the Fund will continue soon after the new government is formed. This would be highly important for the Bosnian authorities, to agree on a prudent consolidated budget for 2007 and to formulate an explicit reform agenda for strengthening the private sector and competitiveness. Moreover, close cooperation with the Fund would also be beneficial to facilitate public consensus on the required structural reforms as well as to improve the country’s image for investors.

Macroeconomic developments

Supported by favorable external conditions along with the growing interest of foreign investors, economic activity continues to record strong growth, making the country one of the fastest growing economies in the region. In 2005, GDP grew by 5 percent, and with the ongoing surge in exports and investment, the authorities project that the growth rate will accelerate to 6 percent in 2006 and further to around 7 percent in 2007-09. The current account balance has improved in the past year and together with high capital inflows, contributed to the economy’s external resilience. In this context, international reserves this year have reached the highest level in the post-war era, both nominally and in terms of months of import, and the external debt-to-GDP ratio is projected to slightly decline to below 30 percent. Following a moderate decline in 2005, Foreign Direct Investments (FDI) renewed their upward path and reached, in 2006, a record-high level.¹

The authorities welcome the staffs selected issues paper on BiH’s current account deficit, which shows that the “true” current account deficit is much lower than the official figure suggests. This estimation supports the authorities’ position in past discussions and shows that the external vulnerability of BiH is equivalent to that of other countries in transition, including some with a currency board arrangement. Going forward, the authorities concur with staff that the large current account deficit is still a matter of concern and requires sound policies to support its reduction. In this context, the authorities stress the importance of a combined policy action of fiscal and monetary instruments to improve the external position. They also believe that the growing external demand for Bosnian products with sustained strong growth will stimulate a continuous decline in the current account-to-GDP ratio.

Structural reforms

The authorities fully concur with staff that strengthening the private sector, widening the export base and improving competitiveness are beneficial to further reduce external vulnerabilities. The authorities also agree that the implementation of reforms is somewhat protracted; however, they stress that this is not a result of a lack of clear strategy. In this context, the private sector and the labor market reforms are properly addressed within the Mid-Term Development Strategy for 2004-07 (PRSP), which has been supported by the World Bank’s and the IMF’s Executive Boards. The current Mid-Term Development Strategy ends next year and the elected governments will have to prepare the new one by the end of 2007. The authorities believe that this will be an opportunity for the new governments to commit to speeding up structural reforms. Despite some delays, the authorities have continued to enhance private sector activity by moving forward with companies’ restructuring this year. However, following the amendment to the Republika Srpska (RS) privatization law, which allows greater flexibility in the privatization process, it gained greater momentum in RS than in the Federation. A development worth noting in that respect is the RS government’s decision to call for an international tender for the sale of the publicly held telecommunications provider, Telecom Srpska, which is the second largest telecom company in BiH. The authorities hope to conclude the sale by the end of the year. Preparations for the sale of the oil refineries at Brod and Modrica together with a fuel retailer, Petrol, are taking place as well. As for the Federation, the government sold 67 percent of Bosnia’s biggest fuel retailer Energopetrol (September), but its plan to sell 24 sizable companies in 2006 is somewhat lagging behind. The authorities expect that the adoption of the law that allows privatization of firms via the stock exchange (July) will speed up the process. Bosnia & Herzegovina remains committed to trade liberalization. Despite its high trade deficit, the authorities fully liberalized the trade of agricultural goods and reduced the average custom protection to the lowest in the region. The authorities also take active part in the current CEFTA discussions, aimed at establishing a free trade zone in Southeast Europe to replace the existing bilateral free trade agreements. The last round of CEFTA negotiations are supposed to be held by the end of October.

Fiscal issues

With the successful implementation of the VAT and the fiscal discipline kept throughout 2006, the authorities are pleased to note that the country will record a fiscal surplus in 2006 following the surplus recorded in 2005. The authorities do not share the staff’s view that the growing spending pressures in 2006 have not been resisted. To the contrary, they underscore that neither the state nor any of the entities rebalanced their budgets despite the elections and the strong growth in VAT revenues. They are aware that some deterioration occurred at the canton level and by approval of the new war-veteran legislation in the Federation; however, given the strong VAT revenues, they project that fiscal consolidation will be even stronger in 2006 than over the previous year. The authorities are pleased to note that this outcome will occur in the absence of the IMF’s SBA - an evidence of the authorities’ continued commitment to strong and prudent fiscal policies.

The BiH state government has recently approved the Budget Framework Paper (BFP) for the next three years (2007-2009). The BFP adheres to the principle that the demand for increased spending on priority projects should be covered by savings in low priority areas, and it envisages explicit recommendations for a higher level of fiscal sustainability through fiscal consolidation and fiscal reforms, particularly in the areas of revenue collection, social services systems, public investment and public expenditure management. The BFP needs to be approved by the National Fiscal Council (NFC), and should be seen, at this point, as the authorities’ commitment to prudent fiscal policy. In view of rising spending pressures, including from diminishing donor assistance, the settlement of domestic claims and the EU integration process, which requires building new state institutions, the authorities are not convinced that the staffs proposed fiscal targets are appropriate. According to their view, fiscal targets should remain close to balance to ensure fiscal sustainability, and at the same time provide sufficient resources to overcome increasing needs.

The authorities note with satisfaction that the introduction of the VAT went smoothly, and attempts to adopt VAT exemptions were successfully blocked by the parliament. So far, VAT revenues are significantly higher than previously expected and the authorities project that further improvement of tax collection will boost revenues even more. The authorities plan to spend a share of total VAT revenues to decrease direct taxes, particularly labor taxes, which will promote creation of new jobs in the private sector, and reduce the currently large informal sector of the economy. Accordingly, in 2006 the authorities continue with preparations of direct taxation system reform, including taxes on capital, labor and property.

The authorities agree with staff that inadequate fiscal co-ordination remains a serious weakness. To enhance coordination of budget design and execution among various levels of government, the authorities have agreed on a draft of the NFC law, which is consistent with the staffs key recommendations. The draft contains clear and well-designed mechanisms for fiscal coordination and envisages the maximum enforcement possible under the current constitution of BiH. Many political parties have expressed commitment to continue discussion on constitutional changes after the elections and are of the view that any constitutional changes should address positioning the NFC within the Constitution in order to strengthen the enforcement mechanism under the existing draft law.

Like staff, the authorities perceive the domestic claim settlement a priority. The plans for settling the war-related claims have been approved by the both entities and the work on settlement of restitution and frozen deposits claims is underway. Indeed, these claims envisage large fiscal pressures; however, the authorities reiterated their commitment to approve the new legislation prudently and in a fiscally sustainable manner.

Monetary issues

The high credibility of the currency board has served the economy well in keeping inflation under control and maintaining financial stability. In 2006 inflation has somewhat accelerated due to the VAT introduction, the increase in oil price and the continuous reform in the energy sector, however, from 2007 onwards the authorities project that inflation will revert to low levels. The Central Bank of BiH (CBBH) intervened several times in the past by raising the required reserves (RR) rate in order to slow down credit growth. To that end, in December of 2005 the CBBH raised the RR to 15 percent and succeeded to somewhat suppress the rapid credit growth.² At this juncture, the current level of RR is seen by the CBBH as appropriate, yet it is closely monitoring credit developments and is prepared to adjust its policy if needed. The CBBH confirm that, in line with the staffs advice, the statutory 20 percent cap on RR has been removed (as of early October).

Financial stability and supervision

The authorities are committed to thoroughly analyze the FSAP recommendations and to address the identified shortcomings. In this context, the CBBH is developing its own capacities to better assess potential risks and weaknesses within the financial sector. The Fund’s continued help in this regard is of great importance and the authorities hope to be able to rely on it in the future as well.

The authorities are well aware that the current organization of banking supervision is not adequate and it hinders further development. In this regard, a unified supervision system at the state level seems to be more effective in safeguarding financial stability and will be in line with the general approach of building a single economic space in BiH. However, since this issue is politically charged, further discussions on the supervision’s coverage, institutional setup and location are expected to take place after the newly elected governments are formed.

The authorities agree that the leasing sector needs better supervision; however they do not share the staffs view that this should be done under the umbrella of banking supervision, particularly given that the leasing companies are not deposit taking institutions and do not affect the functioning of the banking sector in a material way. The authorities stress that, in view of the multiple assignments together with the limited resources, the banking supervision agencies should focus, at this point, on improving their risk assessments and bank oversight.