This Selected Issues paper examines the risks and structural weaknesses in Bosnia and Herzegovina. The paper provides an estimate of the current account adjustment required to stabilize net foreign liabilities. It uses the external sustainability approach of the Consultative Group on Exchange Rate Issues (CGER) methodology for exchange rate assessment. The paper analyzes the impact of the newly introduced borrowing rules on the longer-term debt dynamics. An overview of salient facts about unemployment in Bosnia and Herzegovina is also presented.

Abstract

This Selected Issues paper examines the risks and structural weaknesses in Bosnia and Herzegovina. The paper provides an estimate of the current account adjustment required to stabilize net foreign liabilities. It uses the external sustainability approach of the Consultative Group on Exchange Rate Issues (CGER) methodology for exchange rate assessment. The paper analyzes the impact of the newly introduced borrowing rules on the longer-term debt dynamics. An overview of salient facts about unemployment in Bosnia and Herzegovina is also presented.

I. Overview

1. On the basis of the strong performance of recent years, staff macroeconomic projections show that Bosnia & Herzegovina’s medium-term baseline outlook is stable (see accompanying staff report). The momentum of robust growth in 2006 is expected to continue in the coming years. Fiscal and external positions are projected to be in a comfortable zone in the medium term, even with recent spending pressures.

2. This baseline projection is reassuring, but two important questions arise: With current policies in place, will Bosnia & Herzegovina be able to keep this growth momentum in the longer term? And what are the risks to this outlook? Despite the recent good performance, Bosnia & Herzegovina still suffers from a number of structural weaknesses. Although weak policy coordination, the absence of a comprehensive fiscal strategy, and structural reform drift may not matter much in good times, they may become a drag to the economy in the longer run and gradually leave the country increasingly vulnerable to changes in the external environment. The Chapters in this Selected Issues volume examine the risks and structural weaknesses in Bosnia & Herzegovina.

3. Extending the analysis beyond the medium term, Chapters II and III explore risks to longer-term external and fiscal sustainability. On the external side, what would be the consequences of maintaining persistently high current account deficits? With no change in policies, the current account deficits would remain wide in the coming years and Bosnia & Herzegovina’s net foreign liabilities (NFL) will keep growing from today’s’ level, which is below the regional average. To keep the external position sustainable, the country’s NFL will have to stabilize at some point. Chapter II provides an estimate of the current account adjustment required to stabilize NFL. It uses the external sustainability approach of the Consultative Group on Exchange Rate Issues (CGER) methodology for exchange rate assessment, which is a debt dynamics accounting framework that takes into account all forms of foreign liabilities (both debt and equity). The adjustment is estimated in the order of 8 percentage points of GDP. The Chapter finds that if the adjustment were to start now and span the next 10 years, NFL would stabilize at a level below 60 percent of GDP. This seems feasible if the recent export trends were to persist. In contrast, if the adjustment is delayed, the paper shows that the level of NFL would reach about 90 percent of GDP before it stabilizes. The Chapter points to the need for an early start of the adjustment; postponing the reforms that would ensure recent export trends continue would leave the economy with very high NFL and thus vulnerable to changes in external environment.

4. On the fiscal front, could the newly-introduced borrowing rules help reverse explosive debt dynamics and ensure fiscal sustainability? Previous staff analysis indicated that growing primary deficits combined with the increasing share of non-concessional borrowing may lead to an explosive debt dynamics over the longer term. Debt laws recently adopted by the State and Entities introduce borrowing rules limiting future debt service as a percentage of last year’s revenue. Chapter III uses a stochastic method, which takes into account uncertainty about macroeconomic conditions, to assess the impact of these new borrowing rules on debt dynamics. The results show that the rules would indeed help maintain debt sustainability in the long term. However, implementing the borrowing rules without a comprehensive policy framework and a long planning horizon may result in inefficient expenditure compression and ultimately undermine the credibility of the borrowing limits.

5. Beyond external and fiscal sustainability concerns, rigidities in the labor market could make it difficult for the economy to adjust to a changing environment. Despite several years of robust growth, unemployment—a sign of inefficient use of resources—remains stubbornly high. What are the causes of high unemployment in Bosnia & Herzegovina? Although the lack of high quality statistics makes it difficult to answer the question in a definite way, Chapter IV explores the available data and possible hypotheses. It finds several signs pointing to the problems on the supply side and to structural rigidities. These include wage policies, heavy taxation of labor, and the limited portability of pension and health insurance systems, which may hinder labor mobility and discourage employment creation.

6. The lack of internal economic integration is another rigidity with potentially important political repercussions. Different policies and rules in the Entities make capital and labor mobility difficult and distort market incentives. After many years of actively promoting economic cohesion, have the authorities and the international community succeeded in doing so? Chapter V examines the degree of economic cohesion in Bosnia & Herzegovina. It finds strong evidence of economic convergence between the Entities, with the Republika Srpska (RS) catching up with the Federation. However, there is little evidence of increased economic integration between the two, or within the Federation. Promoting internal economic cohesion in Bosnia & Herzegovina will require accelerating structural reforms in the Federation and eliminating the remaining barriers to capital and labor mobility within and between the Entities.

7. In the context of rapid credit growth, which has accompanied economic growth in recent years, risks to financial stability cannot be ignored. These risks are explored in Chapter VI. Specifically, the Chapter empirically examines the relationship between credit growth, bank soundness, and banks’ foreign liabilities, and tests the effects of past policy measures to curb credit growth. The Chapter shows that the financial deepening process in Bosnia & Herzegovina has been in line with regional trends. It finds that policy measures to curb credit growth have not been effective, which points to the important role of prudential supervision to minimize the risks to financial stability. The Chapter also finds that foreign-owned banks appear to run a higher risk of insolvency. This finding highlights the importance of cooperation with home-country supervisors to closely monitor local subsidiaries or branches of foreign banks.

Bosnia and Herzegovina: Selected Issues
Author: International Monetary Fund