Bosnia and Herzegovina
2008 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Bosnia and Herzegovina
Author: International Monetary Fund
Publication Date:
06 Oct 2008
eISBN:
9781451804973
Language:
English
Keywords:
ISCR; CR; authority; BiH authorities; authorities of Bosnia and Herzegovina; RS government; private sector; State authorities; broad money; market share; financial market; Current account deficits; Global; indirect tax
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This Article 2008 IV Consultation highlights that Bosnia and Herzegovina’s economy has been exhibiting robust growth, but imbalances have emerged. The current account deficit has widened and underlying inflation has picked up. Procyclical fiscal policy has added to these imbalances. Moreover, large public-sector wage increases threaten to spill over to private sector settlements, thus exacerbating inflation pressures and weighing on competitiveness. Credit growth has started to slow down, and tightened financial conditions have resulted in a fall in bank profitability.

Abstract

This Article 2008 IV Consultation highlights that Bosnia and Herzegovina’s economy has been exhibiting robust growth, but imbalances have emerged. The current account deficit has widened and underlying inflation has picked up. Procyclical fiscal policy has added to these imbalances. Moreover, large public-sector wage increases threaten to spill over to private sector settlements, thus exacerbating inflation pressures and weighing on competitiveness. Credit growth has started to slow down, and tightened financial conditions have resulted in a fall in bank profitability.

I. Overview

1. The economy has been exhibiting robust growth, but macroeconomic imbalances have emerged. Benefiting from the currency board and the effects of past reforms in key sectors and the financial system, Bosnia & Herzegovina (BiH) has seen strong growth and low inflation in recent years. However, with capital inflows driving a domestic-demand boom, economic tensions have built up. The current account deficit has widened, and, while inflation accelerated mainly on account of global food and energy price shocks, underlying inflation pressures have also intensified. Procyclical fiscal policy has added to these imbalances. Unsettled global financial markets and a worsening economic environment in Europe pose risks to BiH’s stability and growth prospects.

2. Progress vis–à–vis the EU is encouraging, but the complex political system complicates policymaking. The SAA opens the road to EU accession and could help accelerate reforms. Also, the approval of the Fiscal Council law and agreement on a permanent indirect tax revenue allocation formula should help improve fiscal coordination. The Dayton Peace Agreement created two largely–autonomous entities, Republika Srpska (RS) and the Croat–Bosniak Federation of BiH (Federation) divided into ten largely–ethnic cantons, all held together by a central government (State) with a limited mandate. This structure causes duplication of many domestic policy functions and weakens incentives for cooperation. Moreover, policies are diverging between the two Entities, with the RS making steady progress on reforms and the Federation finding it difficult to mobilize action on needed reforms. Preparing BiH for eventual EU accession will require constitutional reform: a modest first attempt failed in 2006, and the conflicting views on the future makeup of the country suggest still little common ground.

II. Background

3. Despite robust economic performance in recent years, convergence to EU income levels has been slow. Considering its late start to transition and the devastating effects of the 1992–95 war, BiH’s current level of per capita income—which is above the Balkan average—is remarkable (Figure 1). Although real GDP increased by a cumulative 30 percent since 2002, BiH’s growth dynamics put it somewhat below the convergence path traced by other countries at a similar point in transition.1

Figure 1.
Figure 1.

Bosnia and Herzegovina: Income and Growth

Citation: IMF Staff Country Reports 2008, 327; 10.5089/9781451804973.002.A001

Sources: World Economic Outlook; BiH authorities; and IMF staff calculations.

4. The economy is experiencing an absorption boom, but capacity constraints are emerging. Solid output growth continued in 2007 supported by strong productivity gains, especially in the tradable sector. However, domestic demand—with broadly equivalent contributions from consumption and investment—took over as an engine of growth (Figure 2). It has been supported by robust real credit growth (22 percent), healthy wage increases (10 percent), and a sizeable fiscal impulse (1.2 percent of GDP). In 2008, leading indicators remain solid (Figure 3), but there are signs of capacity constraints. With most of unemployment structural, selected sectors (services and construction) are experiencing labor shortages—accentuated by workers seeking employment in neighboring countries. Moreover, wage and price pressures have been on the rise, with excess demand spilling over into a larger trade deficit. Although it is difficult to gauge the size of the output gap in a transition economy like BiH, staff estimates suggest that it has been narrowing (Figure 2)2.

Figure 2.
Figure 2.

Bosnia and Herzegovina: Growth Performance

Citation: IMF Staff Country Reports 2008, 327; 10.5089/9781451804973.002.A001

Sources: BiH authorities; and IMF staff calculations.
Figure 3.
Figure 3.

Bosnia and Herzegovina: Indicators of Economic Activity, 2003–08

Citation: IMF Staff Country Reports 2008, 327; 10.5089/9781451804973.002.A001

Sources: BiH authorities; and IMF staff estimates.
uA01fig01

Wage Growth: y-o-y, percent, January 2005–April 2008

Citation: IMF Staff Country Reports 2008, 327; 10.5089/9781451804973.002.A001

Bosnia & Herzegovina: Key Macroeconomic Indicators, 2003–07

(In percent of GDP, unless otherwise indicated)

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Sources: BiH authorities; and Fund staff estimates.

5. The current account deficit is widening, but official reserves rose in 2007 as the balance of payments benefited from large long–term inflows. The absorption boom was mirrored by a widening external deficit, which reached 13 percent of GDP in 2007—an underlying deterioration of 1.5 percentage points of GDP.3 Export growth moderated to 15 percent (driven by strong volume growth), after a torrid pace in the preceding years, and imports resumed their faster growth following a temporary, VAT–related slowdown in 2006. The current account deficit was fully covered by FDI, largely reflecting privatizations in the RS, which together with bank borrowing and other unidentified inflows pushed gross official reserves to €3.4 billion (5.4 months of imports) at end–2007. Data for early–2008 point to a further widening of the external deficit, with still–robust export growth overshadowed by strong import growth, and higher food and energy prices contributing more than half of the increase in the import–to–GDP ratio.

uA01fig02

Contribution to Metal Export Growth

(In Percent)

Citation: IMF Staff Country Reports 2008, 327; 10.5089/9781451804973.002.A001

uA01fig03

Contribution to Non-Metal Export Growth

(In Percent)

Citation: IMF Staff Country Reports 2008, 327; 10.5089/9781451804973.002.A001

6. The real effective exchange rate has been stable and external competitiveness appears adequate. Staff calculations using various methodologies imply that the equilibrium current account deficit ranges between 7½–13½ percent of GDP, although a number of factors (e. g., underestimation of current inflows) merit consideration in making an assessment (Box 1). With the caveat of large uncertainties surrounding the estimates, the current account deficit has been moving toward unsustainable levels. At the same time, the real effective exchange rate has been stable, and, although some margin of overvaluation can not be ruled out, at present levels, does not raise significant external stability concerns. Indicators of price and cost competitiveness vis–à–vis neighboring countries remain benign, export growth has been strong, and export market share has steadily increased, amid robust productivity gains in the tradable sector (Figure 4). Finally, financing of the current account deficits remains tilted toward more stable sources—FDI and long–term bank–mediated inflows—and the external position does not indicate serious vulnerability risks (Figure 5).

Figure 4.
Figure 4.

Bosnia and Herzegovina: Competitiveness Indicators, 2000–08

Citation: IMF Staff Country Reports 2008, 327; 10.5089/9781451804973.002.A001

Sources: BiH authorities; Direction of Trade Statistics.; and IMF staff estimates.
Figure 5.
Figure 5.

Bosnia and Herzegovina: External Position

Citation: IMF Staff Country Reports 2008, 327; 10.5089/9781451804973.002.A001

Sources: CBBH, IMF, BIS and Fund staff estimates.

External Competitiveness

Staff analysis suggests that, while the external deficit currently exceeds sustainable levels, there is no strong evidence of a significantly overvalued real exchange rate (RER) at present that could result in future external instability. However, large uncertainties surround this assessment.

Equilibrium current account deficit (CAD) estimates are between 7%–13% percent of GDP.

  • The CGER macroeconomic balance approach suggests an equilibrium CAD—taking into account about 2 percent of GDP capital transfers—of 9 percent of GDP. However, this may underestimate it in a setting of EU convergence and rapid financial integration. Accounting for these effects (IMF WP/07/64), the equilibrium CAD is 13½ percent, thus implying no gap from the underlying deficit.

  • The external sustainability approach suggests that the CAD level required to stabilize net foreign liabilities (NFL) is 7½ percent, implying a 6 percent gap.

  • The CGER equilibrium RER approach suggests a RER undervaluation of 17 percent. This result is driven mainly by a favorable productivity differential against trading partners.

  • The consistently–large and positive errors and omissions (2 percent of GDP)—which may reflect underestimation of current inflows (Country Report 06/368)—also merit consideration in interpreting the above CAD gaps.

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Source: Staff estimates.

Based on Abiad, Leigh and Mody (2007).

Export and productivity trends suggest that competitiveness is adequate.

  • Export growth has been robust and export market share steadily increased. Constant–market–share analysis suggests that BiH’s export growth over 2003–06 can be mainly explained by the competitiveness effect. Recent data point to continued robust export growth in 2007–08 (15 percent), with import growth mainly driven by imports of machinery and base metals (29 and 43 percent, respectively).

  • Relative to nontradables, average labor productivity growth of BiH tradables over 2004–06 was much higher than that of the main trading partners.

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Sources: BiH Statistics Agency, Eurostat, and staff estimation.

Croatia’s data is only available for 2003-04.

7. Accelerating inflation raises concerns. Headline inflation increased to 8.2 percent y–o–y in May, reflecting mainly food and energy price shocks (Figure 6). However, underlying inflation has also picked up, and producer price inflation has remained high (6.7 percent) suggesting that price setters, faced with higher input costs, are trying to maintain their markups. The authorities have resisted calls for reducing the VAT on food and, with the deregulated petroleum market, the pass–through of international to domestic prices has been instantaneous. To alleviate somewhat the impact of inflation on the poor, RS authorities increased targeted transfers, while both entities raised agricultural subsidies. The recent rise in inflation has been partially contained by the spillover of demand pressures into higher imports, and BiH’s inflation performance compares favorably with that of its peers (Figure 6).

Figure 6.
Figure 6.

Bosnia and Herzegovina: Inflation, January 2006–May 2008

Citation: IMF Staff Country Reports 2008, 327; 10.5089/9781451804973.002.A001

Sources: BiH authorities; Eurostat; and IMF staff calculations.

8. Fiscal policy has become procyclical. The general government registered a deficit of 0.1 percent of GDP in 2007, compared with a 2.2 percent surplus in 2006, adding further stimulus to an already–strong domestic demand. Driven mainly by sharp increases in transfers to households, capital spending, and wages, government expenditure approached 50 percent of GDP. Strong revenue performance has continued this year, but mounting transfers to households in the Federation (associated with unfunded legislative changes at end-2006) have led to liquidity problems that threaten its fiscal position.

General Government Operations, 2005–07

(In percent of GDP)

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Adjusted for cycle and transitory factors.

9. Although public debt is currently low, there are uncertainties about the size of the government’s contingent liabilities. At end–2007, gross public debt stood at 31 percent of GDP and general government deposits amounted to 15 percent of GDP. This favorable picture is clouded by: (i) the constitutional controversy over the issuance of bonds to cover frozen foreign–currency deposit (FFCD) obligations, which risks reopening court challenges to the size of the compensation;4(ii) uncertainty regarding the ultimate size of restitution claims and settlement terms; and (iii) the unknown size of government contingent liabilities to cover debts of loss–making state–owned enterprises.

10. Financial deepening accelerated in 2007, but remains in line with regional trends. Benefiting from a low interest rate environment (Figure 7), robust credit growth brought the credit–to–GDP ratio to 56 percent in 2007. Concerns about the speed of credit expansion prompted the Central Bank of Bosnia and Herzegovina (CBBH) to increase reserve requirements at end–2007—from 15 to 18 percent. Long–term borrowing by the largely foreign-owned banking sector is the key factor underpinning rapid credit growth, because tight maturity–matching requirements limit banks’ reliance on local deposits (Figure 8). Banks’ open positions are limited but the large volume of FX–linked lending raises the possibility of currency mismatches in household and corporate sectors.5 Despite several measures taken in 2007 (Table 11), banking supervision remains hampered by fragmentation into two Entity-based agencies and limited cooperation with foreign banking supervisors.

Figure 7.
Figure 7.

Bosnia and Herzegovina: Financial Market Indicators, 2003–08

Citation: IMF Staff Country Reports 2008, 327; 10.5089/9781451804973.002.A001

1/ SASX–10 is the stock market index of the Sarajevo Stock Exchange and BIRS is the stock market index of the Banja Luka Stock Exchange.Sources: BiH authorities; European Central Bank; and IMF staff calculations.
Figure 8.
Figure 8.

Bosnia and Herzegovina: Financial Sector Developments, 2004–08

Citation: IMF Staff Country Reports 2008, 327; 10.5089/9781451804973.002.A001

Source: CBBH; and IMF staff calculations.
Table 1.

Bosnia and Herzegovina: Selected Economic Indicators, 2004–09

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

Increase in 2007 reflects the estimated recognition of domestic claims, and in 2008–09 the projected recognition of domestic claims.

Table 2.

Bosnia and Herzegovina: Balance of Payments, 2004–13

(In millions of euros, unless otherwise indicated)

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

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

Table 3.

Bosnia and Herzegovina: Selected Vulnerability Indicators, 2004–08

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

Simple average between short–term and long–term rates.

Long–term rates.

Banja Luka Stock Exchange’s BIRS index.

Sarajevo Stock Exchange’s SASX–1 0 index.

Moody’s foreign currency sovereign rating.

Table 4.

Bosnia and Herzegovina: General Government, 2004–13

(In percent of GDP)

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Sources: Ministries of Finance; and IMF staff estimates.

Estimate of 2007 is based on Federation cantonal and municipality data as submitted by the Ministry of finance, and the receipts of VAT revenue as reported by the ITA.

Not included in the calculation of the overall fiscal balance.

Table 5.

Bosnia and Herzegovina: Elements of General Government, 2004–13

(In percent of GDP)

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Sources: Ministries of Finance; and IMF staff estimates.
Table 6.

Bosnia and Herzegovina: Monetary Survey, 2003–08 1/

(In millions of KM, unless noted otherwise)

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Sources: CBBH; and IMF staff estimates.

Data for March 2005 onward are based on the upgraded classification of general government, so 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.