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.

II. External Balance Sheet and the Current Account Adjustment Required to Stabilize Net Foreign Liabilities1

At about 50 percent of GDP, Bosnia & Herzegovina’s net foreign liabilities today are close to the average of Eastern European countries. Gross official reserves are at a comfortable level, external public debt is low and largely at concessional terms, and foreign direct investment has recently been increasing. However, in the staff baseline macroeconomic framework (no policy change), the current account deficit remains high, and is projected to stay at a level that would imply a steady rise in net foreign liabilities over the medium term.

At some point, the country’s external balance sheet will have to stabilize if Bosnia & Herzegovina’s external position is to be sustainable. The only way to achieve this is a substantial adjustment in the current account. Although the current account has improved significantly over the last couple of years, a lot more will be needed to stabilize net external liabilities. In addition, although foreign direct investment inflows do not create debt, they do raise the foreign liabilities of the private sector and will generate an increasing outflow of income payments in the form of profit repatriation. This future outflow has to be taken into account when estimating the required current account adjustment that would stabilize the country’s external balance sheet.

This 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, which is a debt dynamics accounting framework that takes into account all forms of foreign liabilities (both debt and equity). This adjustment is estimated around 8 percentage points of GDP.

An adjustment of this magnitude can only happen gradually over time. Two key questions are: when will it start? and how long will it take? This paper assumes that the adjustment will take place over a 10-year horizon. Two scenarios are considered. The first scenario, “an early adjustment,” is based on the assumption that the adjustment would start in 2007. The second scenario, “a delayed adjustment,” is based on the assumption that the adjustment would start only in the next decade.

The results show that, in the early adjustment scenario, the NFL would stabilize at around 56 percent of GDP by 2017. This is still a relatively low level by international standards. In contrast, in the delayed adjustment scenario, the level of NFL would reach about 90 percent of GDP before it stabilizes. The two scenarios illustrate the importance of early adjustment, which is feasible if the recent export trends persist. Although a slower adjustment through a more gradual pace of reforms might be politically easier, the end result of a very high level of NFL would leave the economy vulnerable to changes in the external environment.

A. Introduction

8. Bosnia & Herzegovina’s net foreign liabilities (NFL) have been growing in recent years and reached about 50 percent of GDP at end-2006, close to the average of Eastern European countries. Similar to the experience of many Central and Eastern European (CEE) countries, Bosnia & Herzegovina has been running large current account deficits and accumulating external liabilities in recent years. Commercial bank borrowing and foreign direct investment (FDI) have been the main contributors to growth in NFL.

9. NFL relative to the size of the economy will have to stabilize at some point to ensure the sustainability of the country’s external position; this will require a much reduced current account deficit. Despite a recent decline, Bosnia & Herzegovina’s current account deficit remains high, and is projected to stay around the same level in the medium term. This implies increasing net external liabilities and income payments, both in the form of interest payment and profit repatriation. Taking this future outflow into account, the required adjustment in current account to stabilize NFL can be substantial.

10. This Chapter 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, which is a debt dynamics accounting framework that takes into account all forms of foreign liabilities (both debt and equity) to calculate the adjustment. The calculated adjustment depends on the outstanding stock of accumulated liabilities, output growth, and the expected returns on external assets and liabilities.

11. The methodology used in this Chapter involves three main steps. First, the composition of the external balance sheet of the country at end-2006 is estimated. Second, the external balance sheet at end-2012 is projected in line with the staff medium-term baseline macroeconomic scenario. Third, using simple debt dynamics accounting, the current account adjustment required to stabilize NFL is estimated.

12. Two scenarios are then considered. The level at which NFL stabilize depends on when Bosnia & Herzegovina will start adjusting and how long it will take. First, a scenario that assumes an early adjustment is estimated. This scenario assumes that the adjustment would start immediately and span a 10-year horizon. A “delayed adjustment” scenario is then considered. It assumes that the adjustment would only start at the end of the decade, and also span a 10-year horizon. A delayed and long adjustment period would imply continued build-up of liabilities before they stabilize.

13. The results illustrate the importance of an early start of the adjustment. Although a gradual adjustment would allow more time and might be easier politically, a high level of NFL could leave the economy vulnerable to changes in the external environment and could undermine the viability of the currency board. The case for an early start is even stronger if Bosnia & Herzegovina is to undertake ambitious infrastructure investments in the coming years, that would imply additional foreign liabilities to those assumed in the baseline.

B. The External Balance Sheet of Bosnia & Herzegovina

Current situation

14. At end-2006, the gross external liabilities of Bosnia & Herzegovina are about 90 percent of GDP (Table 1). Liabilities are equally spread between debt and equities (portfolio and FDI-related liabilities). The government external debt is small and mainly on concessional terms.

Table 1.

BiH: External balance sheet (at end 2006)

(in percent of GDP)

article image
Source: CBBH

15. Debt assets are below the average of other countries and are concentrated in the monetary authority and the commercial banks. Debt assets are about 44 percent of GDP, two-third of which belong to the monetary authority. The average in the region is 3 percentage points higher. Compared to other currency boards, Bosnia & Herzegovina’s level of international reserves is relatively low (Table 2).

Table 2.

Composition of Net External Position

(in percent of GDP)

article image

As of end 2006, Staff Estimates; 2004 for the other countries

Source: Lane and Milesi-Ferretti, 2006

16. While equity liabilities are already above the average of other countries in the region, they are expected to increase further. Equity liabilities are estimated at 46 percent of GDP, 4 percentage points higher than the region’s average, but well below Estonia, Hungary, and Czech Republic. As the authorities pursue their privatization efforts and structural reforms, FDI is likely to increase in the medium term. In the next two years, large FDI is expected in the telecom, refinery, and electricity sector.

17. The level of net foreign liabilities is close to the average in Eastern European countries. NFL stands at 48.6 percent of GDP, just above the average of 48.2 in other Eastern European countries. Debt liabilities are below the average. This low level of indebtedness reflects low fiscal deficits in the past, but also a weak implementation of donor-financed projects.

Medium-term projection

18. The medium term outlook (2007–12), based on the baseline (unchanged policies) scenario in the accompanying staff report, is stable, supported by a relatively benign external environment. Exports will continue to grow, although the growth will slow down starting from 2008. Falling metal prices will partly offset growing export volumes. GDP growth will decline slowly, averaging 5.2 percent, and the current account deficit is expected to remain around 13 percent of GDP. Significant FDI inflows are expected over the next two years, but they will abate in subsequent years, reflecting a slowdown in structural reforms. The fiscal position will deteriorate, but would be offset by GDP growth. After an initial jump due to the issuance of bonds to cover domestic claims, the public debt-to-GDP ratio will decline over the projection period.

19. At the end of the medium term period in 2012, NFL are projected to reach about 61 percent of GDP. This increase is mainly driven by FDI flows, a continued increase in banks’ borrowing and declining foreign assets of the central bank (Table 3). The increase in FDI is related to the privatization of RS Telecom as well as other projected FDIs in refineries and other industries. During the medium term, new government borrowings are assumed to be on market terms. The structure of external public debt, which was almost entirely concessional at end-2006, will therefore become increasingly non-concessional.

Table 3.

BiH: Projected external balance sheet (at end 2012)

(in percent of GDP)

article image
Source: Staff Estimates

C. Methodology and Assumptions

20. To determine the current account that would stabilize net foreign liabilities, a simple accounting framework that takes into account all components of the external balance sheet is developed. The method differs from a standard debt sustainability analysis (DSA) in that the class of assets and liabilities and their respective rate of returns are explicitly distinguished. The analysis is also carried on beyond the medium term projection covered in the standard DSA.

21. The methodology, which is used in CGER assessments of exchange rate, provides the analytical foundation to estimate the current account balance that would stabilize the NFL. The approach, developed by Lane and Milesi-Ferretti (2006), links the net external position, the current account, the trade balance, and the rates of return on the external portfolio. The methodology allows, for a given structure of the external portfolio, to estimate the steady-state current account balance required to stabilize NFL. A country’s net external liabilities cannot continually increase relative to the size of the economy. The required adjustment depends on the accumulated stock of external liabilities, the cost of servicing them, and the GDP growth. The cost of servicing liabilities depends on the structure of the portfolio. Servicing will be low if liabilities are mainly at concessional terms. It will be higher if equity liabilities represent a higher share of the portfolio.

The accounting framework2

22. In this section an accounting framework that links the dynamics of external liabilities to the current account and economic growth is presented.

23. The change in the net foreign asset position B is given by

BtBt1=CAt+KGt+Et(1)

where CA is the current account balance, KG is the capital gain or loss on net foreign assets and E includes capital account transfers and error and omissions.

24. By expressing (1) in ratio to GDP (represented with lower-case letters), and assuming zero capital gain3, equation (1) becomes

btbt1catgt+πt(1+gt)(1+πt)bt1+εt(2)

where g is the growth rate of real GDP, π is the inflation rate, and ε the ratio of capital transfers and errors and omissions to GDP. Ignoring the latter term, the equation relates the current account balance needed to stabilize the next external position and the nominal GDP growth.

25. The current account balance that would stabilize b is derived by setting bt = bt-1 in equation (2). This yields cass ≈–(g + π)bss. For example, in a country running a 7 percent current account deficit and growing at 8 percent in nominal terms, NFL would stabilize at about 90 percent of GDP. A growing country can sustain a permanent current account deficit, and this deficit can be larger the larger the growth rate and the larger the stock of external liabilities. However, larger external liabilities require a stronger balance of goods and services to offset the higher income payments associated to the liabilities.

26. Equation (2) can be further expanded by decomposing the external portfolio into its assets A and liabilities L. Doing so yields

btbt1bgstt+itAAt1itLLt1Ytgt+πt(1+gt)(1+πt)bt1+εt(3)

where bgst is the balance of goods, services, and transfers, A and L are external assets and liabilities, and iA and iB their respective nominal yields.

27. Equation (3) can be expressed in function of real rate of return on foreign assets and liabilities:

btbt1bgstt+rtAgt1+gtat1rtLgt1+gtlt1+εt(4)

where r represents the real rate of return, defined as rtA=1+itA1+πt1andrtB=1+itB1+πt1.

28. If returns on assets and liabilities are identical, equation (4) becomes the standard debt accumulation equation btbt-1 = bgstt + (rtgt)bt-1. To prevent the ratio of external liabilities to GDP to grow indefinitely, a net debtor (b<0) must achieve a trade surplus if the rate of return exceeds GDP growth (r>g). If returns on assets and liabilities are different, as it is most often the case, the structure of the balance sheet will affect the estimation of the trade balance required to stabilize net external liabilities. For example, if the stock of assets and liabilities is about 100 percent of GDP and a country pays a rate of return on its liabilities which exceeds the return on its assets by 100 basis point, the trade surplus necessary to stabilize the net external position will be 1 percentage point of GDP higher than in the absence of return differential.

29. A further refinement is to decompose assets and liabilities into their “debt” and “equity” components. Expected returns on debt and equity are likely to differ substantially as external financing in Bosnia & Herzegovina is shifting away from concessional debt to private equity. Equation (4) becomes:

btbt1bgstt+rtEQgt1+gtat1EQ+rtDAgt1+gtat1DrtEQgt1+gtlt1EQrtDLgt1gtlt1D+εt(5)

where EQ and D identify the debt and equity components of external assets and liabilities and their respective rates of return.

30. Once equation (5) is parameterized, the current account balance needed to stabilize the net external position is derived by setting bt = bt-1. This stabilizing current account balance depends on the assumptions on economic growth, real returns on debt and equity assets and liabilities and their respective levels in percent of GDP.

Main assumptions

31. The current account required to stabilize the NFL is derived using equation (5) and the following assumptions:

  • All debt instruments carry the Euro Libor as the base interest rate. External liabilities are assumed to carry a sovereign risk premium of 200 basis points. These assumptions are consistent with the assumption in the Debt Sustainability Analysis (DSA) in the staff report.

  • The rate of inflation is set at 2 percent, both in Bosnia & Herzegovina and in Europe.

  • Returns on equity, mostly FDI-related, is assumed to move together with GDP growth. At an aggregate level, returns on FDI will be correlated with the overall performance of the economy. Higher GDP growth translates into more profits and repatriation. Conversely, in a slowing economy, declining profits will reduce repatriation. The expected real returns on private equity are thus assumed to be equal to the projected real GDP growth plus a constant spread of 100 basis points over the growth rate4.

  • Transfers and non-financial income is assumed to remain stable. Therefore, most adjustment in the current account have to originate in the balance of goods and services.

Table 4.

Assumptions on Real Rate of Returns and GDP Growth

article image

WEO (average over 2006–2011)

Following Lane and Milesi-Ferretti (2006) we suppose a 100 point spread over the growth rate

32. In an early adjustment scenario, a transitional path is derived starting in 2007 so that NFL would be stabilized in 2017. The adjustment would span a 10-year period and is assumed to come mainly from continued growth in exports.

33. To consider a delayed adjustment scenario, a transitional path is derived so that, NFL would be stabilized at end-2022. In this case, the adjustment would also span a 10-year period, starting in 2012. During the transition, the current account deficit, while on a declining path, will hover above its NFL-stabilizing level, and external liabilities will continue to increase. As liabilities continue to build up, the stabilizing current account is estimated again, in a recursive way.

34. A series of assumptions pertain to the financing of the current account during the transition period for both scenarios. The current account deficit is financed either by debt accumulation, foreign direct investment or drawing down of international reserves. During the transition, FDI is set at 3.3 percent of GDP, their level projected at the end of the medium term period. Net public debt accumulation is set at 1.5 percent of GDP, in line with the projected public deficit at the end of the medium term. Net external borrowing by commercial banks is linked to GDP. If these sources are insufficient to finance the current account, international reserves will decline. Lastly, a depreciation rate of capital of 5 percent is assumed. Real GDP growth is 5.2 percent.

D. Main Results

35. In the early adjustment scenario, NFL would stabilize at 56 percent of GDP by end-2017 (Table 5). The current account deficit needed to stabilize NFL in 2017, given an early adjustment, is around 5.5 percent of GDP, compared to the projected deficit of 13.5 percent in 2007. The required adjustment is thus about 8 percentage points of GDP.

Table 5.

BiH: External balance sheet (at end 2017)

(in percent of GDP)

article image
Source: Staff estimates

36. In the delayed adjustment scenario, NFL would continue to build up, to reach about 90 percent of GDP by end-2022 (Table 6). Higher liabilities translate into higher net income payments at about 5.7 percent of GDP, compared with 4 percent of GDP at end-2012.

Table 6.

BiH: External balance sheet (at end 2022)

(in percent of GDP)

article image
Source: Staff estimates.

37. The required adjustment in the current account would also be about 8 percent of GDP in this case. The current account deficit required to stabilize external liabilities at this level would be around 5.7 percent of GDP, compared with average projected current account of 13.5 percent between 2007–12.

38. A delayed and long duration of adjustment will leave the country in a more vulnerable position (Table 6). A level of NFL as high as 90 percent of GDP, way above the regional average, increases the vulnerability to shocks in interest rates, overall liquidity condition, and market sentiment. Government external debt will be about 40 percent of GDP. Reserves of the central bank would end up at a much lower level than at the onset of the adjustment, weakening the capacity to sustain the currency board.

E. Conclusion and Policy Implications

39. This Chapter provides an estimate of Bosnia & Herzegovina’s external portfolio. In the medium-term baseline, the external position of Bosnia & Herzegovina remains sound, with large external inflows supporting investment and growth. However, net foreign liabilities continue to grow.

40. The only way to stabilize net external liabilities is to lower the current account deficit. The current account adjustment required to stabilize external liabilities is estimated using a steady-state debt dynamics framework. This is similar to the external sustainability approach of the CGER methodology for exchange rate assessment. The adjustment in the current account deficit needed to stabilize NFL is estimated at about 8 percent of GDP.

41. This magnitude of adjustment can only take place gradually over time, but a delayed adjustment would leave the country with a very high NFL level. If the adjustment were to start now, the NFL would not increase much until it stabilizes at a level below 60 percent of GDP in 2017. This is still a relatively low level by international standards. A delayed adjustment period, however, will increase NFL to a very high level, leaving the country vulnerable to changes in external environment.

42. The Chapter illustrates the importance of early adjustment, which is feasible if the recent export trends persist. This would be conditional on further structural reforms to increase competitiveness of the economy and its attractiveness to foreign investors. The case for an early start of the adjustment is even stronger if Bosnia & Herzegovina is to undertake ambitious infrastructure investments in the coming years. Large investments, like the corridor Vc road projects, will generate sizeable additional foreign liabilities, be it debt or equity, which would require an even larger current account adjustment.

1

Prepared by Samir Jahjah.

2

This section is based on Lane and Milesi-Ferretti (2006) “Capital Flows to Central and Eastern Europe”, IMF Working Paper 06/188.

3

Given the currency board arrangement of the KM with the euro, and given that most assets and liabilities are in euro, we can ignore capital gains without affecting the conclusion of the analysis.

4

The spread of 100 bps over the GDP growth is similar to the assumption used in Lane and Milesi-Ferreti (2006)