Bosnia and Herzegovina
Request for Stand-By Arrangement: Staff Report; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Bosnia and Herzegovina

This paper discusses the request from the Bosnia and Herzegovina authorities for a Stand-By Arrangement. The global financial and economic crisis hit Bosnia and Herzegovina when the overheating was already raising doubts about the sustainability of the economic expansion. The authorities’ comprehensive financial sector strategy aims at strengthening the banking sector and improving crisis preparedness. IMF staff supports the authorities’ plans to enhance the monitoring of financial stability by establishing a standing committee in charge of crisis prevention and management, and by signing a formal memorandum of understanding on cooperation.

Abstract

This paper discusses the request from the Bosnia and Herzegovina authorities for a Stand-By Arrangement. The global financial and economic crisis hit Bosnia and Herzegovina when the overheating was already raising doubts about the sustainability of the economic expansion. The authorities’ comprehensive financial sector strategy aims at strengthening the banking sector and improving crisis preparedness. IMF staff supports the authorities’ plans to enhance the monitoring of financial stability by establishing a standing committee in charge of crisis prevention and management, and by signing a formal memorandum of understanding on cooperation.

I. Background and Recent Economic Challenges

1. Robust growth of recent years has been increasingly accompanied by macroeconomic imbalances. Benefiting from a favorable external environment, the currency board, and the effects of reforms in key sectors, output growth averaged 6 percent per year during 2003–08, while inflation remained low. Bank privatizations and reforms in the financial sector, along with improved growth prospects, attracted large capital inflows—FDI and long-term borrowing by foreign bank subsidiaries. The introduction of the VAT, income tax reforms, large privatizations in Republika Srpska (RS), and the establishment of the Fiscal Council strengthened public finances. All these achievements culminated in the signing of the Stabilization and Association Agreement with the EU in June 2008. However, with capital inflows driving a domestic demand boom, internal and external imbalances worsened recently: growth of bank credit to the private sector rose sharply, core inflation accelerated, and the current account deficit widened. Loose fiscal and incomes policies also contributed to the overheating of the economy (Figures 1 and 2). Meanwhile, economic policymaking has been complicated by a complex political setting (Box 1).

Figure 1.
Figure 1.

Bosnia and Herzegovina: Indicators of Economic Activity, 2003–09

Citation: IMF Staff Country Reports 2009, 226; 10.5089/9781451804980.002.A001

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

Bosnia and Herzegovina: Inflation Developments, 2005–09

Citation: IMF Staff Country Reports 2009, 226; 10.5089/9781451804980.002.A001

Sources: BiH authorities; and IMF staff calculations.

Bosnia & Herzegovina: Key MacroeconomicIndicators, 2005–08

(In percent of GDP, unless otherwise indicated)

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Sources: BiH authorities; and Fund staff estimates.

Political Background

The Dayton Peace Agreement that ended the war in 1995 created two largely autonomous Entities: Republika Srpska and the Croat-Bosniak Federation of Bosnia and Herzegovina (Federation), itself divided into ten largely ethnic cantons, which exercise most economic power; and a State government with a limited mandate. This structure causes duplication of many domestic policy functions and weakens incentives to cooperate. In recent years, policies have been 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. Moreover, the lack of political coordination is slowing progress toward closer integration with and eventual membership in the EU.

2. The global financial and economic crisis hit Bosnia and Herzegovina (BiH) when the overheating was already raising doubts about the sustainability of the economic expansion. The negative fallout from the global crisis started to become increasingly evident in late 2008. Stock market indices slumped, international reserves began to decline, bank credit growth came to a halt, and financial soundness indicators started to deteriorate (Figures 3 and 4). The banking system came under strain in October 2008, as the spate of negative news about parent banks of BiH subsidiaries triggered a mini-run on banks. The situation stabilized quickly, with the affected banks initially receiving emergency cash from their parents, and tapping their excess reserves with the Central Bank of Bosnia and Herzegovina (CBBH). To counter the liquidity pressures, the CBBH relaxed reserve requirements in several steps (Figure 5). The situation has remained stable since the October episode, but the CBBH lost part of its gross international reserves—by end-May, reserves were down by 16 percent relative to their peak at end-September 2008.

Figure 3.
Figure 3.

Bosnia and Herzegovina: Private Sector Credit Growth, December 2006–March 2009, Percent

Citation: IMF Staff Country Reports 2009, 226; 10.5089/9781451804980.002.A001

Sources: CBBH; and IMF staff calculations.
Figure 4.
Figure 4.

Bosnia and Herzegovina: Financial Sector Indicators, 2004–08

Citation: IMF Staff Country Reports 2009, 226; 10.5089/9781451804980.002.A001

Figure 5.
Figure 5.

Bosnia and Herzegovina: Central Bank’s Foreign Assets and Commercial Bank Reserves, 2008–09

Citation: IMF Staff Country Reports 2009, 226; 10.5089/9781451804980.002.A001

Sources: CBBH; and IMF staff calculations.

Bosnia and Herzegovina: Financial Soundness Indicators, 2004–08

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Source: CBBH.

Funding Deposit Withdrawals, October 2008–March 2009

(Cumulative, percent of GDP)

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Decline in FX Reserves, October 2008–March 2009

(Cumulative, percent of GDP)

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3. The strong growth momentum dissipated by end-2008, inflation pressures let up, and the trade deficit began to narrow. The squeeze came from both the domestic and external demand sides. With bank credit drying up, construction activity faltered, and a number of enterprises began to lay off workers. The worsening economic conditions in the EU pushed export growth into negative territory, and with imports dropping faster still, the trade deficit began to shrink (Figure 6). After peaking at 10 percent y-o-y in July 2008, headline inflation decelerated to zero percent y-o-y in April 2009. Core inflation also eased (from 4 percent to 1.8 percent over the same period), suggesting that spillovers from last year’s large public sector wage increases may have been neutralized altogether.

Figure 6.
Figure 6.

Bosnia and Herzegovina: External Trade, 2004–09

Citation: IMF Staff Country Reports 2009, 226; 10.5089/9781451804980.002.A001

Sources: CBBH; and IMF staff calculations.

4. With declining revenue and sharply increasing expenditure, fiscal policy loosened in 2008. The general government deficit widened to 4 percent of GDP from a nearbalance in 2007, with the structural balance deteriorating by 4 percentage points of GDP. Revenue performance weakened, as VAT refunds accelerated and customs duties on EU imports began to be phased out. Expenditure rose sharply, driven by increases in wages and social benefits. In the Federation, transfers to households almost doubled in nominal terms. Spending in the RS also expanded quickly as well following sharp wage increases—the RS central government’s wage bill rose by about 40 percent. To this end, public sector wage increases across BiH have drawn attention to the large government payroll and the relatively high level of public wages compared with the rest of the economy (Figure 7).

Figure 7.
Figure 7.

Bosnia and Herzegovina: Wage Developments, January 2005–March 2009

Citation: IMF Staff Country Reports 2009, 226; 10.5089/9781451804980.002.A001

Sources: BiH authorities; and IMF staff calculations.

Bosnia & Herzegovina: General Government Operations, 2005–08

(In percent of GDP)

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Sources: BiH authorities; and Fund staff estimates.

5. In contrast to the RS’s comfortable financial position, the Federation faced a fiscal crisis. Receipts from the privatization of Telekom and a petroleum refining and distribution company in 2007 allowed the RS to finance its additional spending and provide subsidized lending through the Investment and Development Bank. In the Federation, the inability of the government to come to grips with large unfunded spending legislation related to benefits for war veterans and demobilized soldiers (currently absorbing a third of the Federation’s budget), and the lack of progress with the privatization agenda undermined the Entity’s financial health. By end-2008, the Federation’s budget accumulated expenditure arrears of 1.4 percent of national GDP.

6. The authorities have started to address the impact of the crisis, but they recognize that there are limits to these efforts due to the severity of the downturn. In addition to measures to improve the liquidity situation in the banking sector, the deposit insurance limit was raised substantially (from KM 7,500 to KM 20,000). Moreover, in response to revenue shortfalls, Entity central governments and Cantons have begun to restrain spending. All governments recognize that financing constraints and the existing structural deficit mean that an easing of fiscal policy to cushion the downturn is unfortunately no longer possible—especially in the Federation.

II. The Program

A. Overall Program Objectives and Strategy

7. The authorities’ program is designed to safeguard the currency board and cushion the effects of the deteriorating external environment, while adopting policies to redress fiscal imbalances and strengthen the financial sector. Specifically, the program seeks to: (i) reduce the structural fiscal balance so as to limit the government’s financing needs and bring public finances on a sustainable medium-term path; (ii) re-establish public wage policy restraint; (iii) support adequate liquidity and capitalization of banks; and (iv) secure enough external financing and improve confidence. If fully implemented, the program should help position BiH’s economy for a strong recovery once the global economic environment improves. And, over the medium term, it would help set the stage for sustainable growth and convergence with the EU by providing a framework to launch longoverdue structural reforms to strengthen the economy’s supply side, safeguard competitiveness, and ensure the stability of the currency board.

8. Against this backdrop, the program is based on strong policy measures, coupled with sizeable financial support.

  • Continued stability of the currency board will require a strengthening of domestic policies. Following the ongoing structural fiscal deterioration, there is a need to reverse the sharp increase in public spending. To this end, cuts in recurrent expenditure along with public-sector wage restraint will ensure stability in the short term, while structural fiscal reforms will bring public finances back on the path of medium-term sustainability. Public investment is programmed to increase and the social safety net will be reformed to protect the poor. Fiscal policy measures will be accompanied by a coordinated approach to enhance financial sector stability.

  • Large external financing support is needed to fill the external and budget financing gaps and ensure a smooth adjustment. With the Federation’s public finances coming under severe financing constraints, an external financial buffer will help governments avoid crowding out domestic lending to the private sector and shore up private investor confidence. Fund resources will thus support macroeconomic policies as the economy adjusts by helping fill the fiscal financing gap and by boosting the central bank’s reserves. At the same time, foreign parent banks have been encouraged to maintain their exposure to their subsidiaries in BiH.

B. The Currency Board

9. The program’s key objective is to ensure the stability of the Currency Board Arrangement (CBA). The CBA is probably among the strongest institutions in BiH: it has been immune to political interference, enjoys political support, and remains a key macroeconomic policy anchor. Staff’s updated external stability analysis (Box 2) has found no strong evidence of a significant real exchange rate misalignment. Moreover, the financial system has some cushions to draw on, as the CBBH and the commercial banks have built sizeable liquidity buffers. The authorities believe that all these considerations make a compelling case for retaining the CBA at the current juncture. Nevertheless, staff emphasized that possible sizeable exchange rate depreciations in BiH’s regional trading partners could have adverse implications for the CBA’s viability and for the stability of the financial system. To this end, it is important to safeguard the CBA through continued political commitment, wage flexibility, prudent macroeconomic and financial sector policies, and progress in structural reform to enhance competitiveness.

C. Macroeconomic Framework

10. The short-term macroeconomic outlook remains challenging. The deterioration in the global environment is undermining growth through two main channels: a drop in external demand and a tightening of external financial conditions. High frequency indicators show a deterioration in the first quarter of 2009. Staff projects that growth will remain negative throughout this year with a very mild recovery only beginning in the middle of next year. With foreign parent banks merely maintaining their credit lines to their subsidiaries, credit to the economy is unlikely to increase. That, along with lower FDI and the expected fiscal retrenchment—on a cyclically adjusted basis—will produce a sharp drop in domestic demand, roughly equally distributed between consumption and investment.

Leading indicators: Change, Percent

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Figures are affected by a startup of a large refinery in late 2008.

11. Against this background, the program includes cautious macroeconomic projections:

  • Real GDP is expected to contract by 3 percent in 2009. The contraction is projected to be higher in the Federation, where no fiscal space and tight financing conditions will not allow it to provide stimulus. The RS, on the other hand, with own financing available, will be able to somewhat mitigate the impact on domestic demand and growth through higher capital spending. Once confidence is restored and balance sheets begin to readjust, domestic demand is projected to slowly rebound in 2010 and output to grow moderately.

d21123511e1688

GDP Growth, 2001–14, Percent

Citation: IMF Staff Country Reports 2009, 226; 10.5089/9781451804980.002.A001

Bosnia & Herzegovina: Key Macroeconomic Indicators, 2007–10

(In percent of GDP, unless otherwise indicated)

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Sources: BiH authorities; and Fund staff projections.
  • Inflation is expected to remain low in line with inflation in the euro area. The opening of a large negative output gap over 2009–10 and wage restraint will help keep core inflation low as well.

  • The current account deficit is projected to decline to about 9¾ percent of GDP. The precipitous drop in domestic demand will help reduce the trade deficit by more than offsetting the projected worsening in the terms of trade. At the same time, some of the reduction in the trade deficit will be offset by a fall in remittances. The sharp contraction in the current account deficit over 2009–10 and the continued drop in subsequent years will bring it to a level considered sustainable over the medium term. Moreover, external competitiveness is projected to remain adequate with wage policy marked by restraint and progress on structural reforms.

  • The balance in the capital and financial account is projected to fall from a surplus of €1,530 million in 2008 to a €477 million surplus in 2009. Program assumptions for 2009–10 include: (i) foreign parent banks maintaining their exposure to BiH (thus a 100 percent rollover); (ii) zero net trade credit in 2009 and only a mild recovery in 2010; (iii) a halving of FDI in 2009 from the 2008 level, followed by a recovery in 2010, in line with commitments already in the pipeline; (iv) no privatization proceeds; and (v) a reduction in the net liability position of corporates.

A01ufig01

Commodity price outlook, 1999=100

Citation: IMF Staff Country Reports 2009, 226; 10.5089/9781451804980.002.A001

12. While there are upside risks to the baseline, the balance of risks is tilted somewhat to the downside. In the near term, output could be further compressed if the drop in external demand and the slowdown in capital inflows are larger than anticipated. Also, a bigger-than-envisaged credit crunch could cause a sharper contraction in domestic demand and thus a faster external adjustment. On the upside, stronger FDI, higher grants, and the economic stimulus measures in the RS could mitigate the decline in domestic demand. Moreover, measures to strengthen the financial sector and envisaged EBRD and World Bank support to banks and SMEs, respectively, could accelerate the recovery in the provision of credit.

13. The program projects a gradual economic recovery over the medium term. Easing of global deleveraging pressures should cause external financing to resume, which along with improving growth prospects should lead to a resumption of lending. Higher FDI, along with privatization in the Federation, will boost investment. Moreover, wage restraint, fiscal policy crowding in the private sector through medium-term fiscal consolidation, and ambitious structural reforms will deliver strong productivity gains, a gradual improvement in competitiveness, and better growth prospects.

D. Fiscal Policy

14. The sharp deterioration in the structural fiscal balance and tight financing constraints do not leave room for counter-cyclical fiscal policy. The general government is starting with a sizeable structural imbalance (4½ percent of GDP in 2008) and, under current policies, the headline deficit would widen to 7¾ percent of GDP thus implying an additional 1½ percentage points of GDP deterioration in the structural balance. Without a policy correction, the deficit would spiral over the medium term, thus worsening fiscal sustainability prospects. In addition, financing conditions have also deteriorated. Although the RS could meet its financing needs by tapping its privatization funds, the Federation government would be left unable to finance a large deficit at a reasonable cost.

15. Against this backdrop, the proposed program envisages a gradual fiscal adjustment (LOI, ¶14). The requested financing from the Fund will support a smooth return of fiscal policy back to the target path implied by a balance at full potential output by 2012–13. To this end, the fiscal targets of 4¾ percent of GDP in 2009 and 4 percent in 2010 strike a compromise between: (i) the need to reduce the structural balance and restore fiscal viability over the medium term; (ii) tight financing constraints, especially in the Federation; and (iii) the desire to crowd in the private sector. The composition of the adjustment between the entities reflects the need to reverse recent expenditure trends and tight financing constraints in the Federation. The adjustment by the State provides a strong signal for burden-sharing and public wage policy restraint. Finally, aware of the risks to the budget, the authorities stand ready to take compensatory measures, if needed, focusing mainly on the expenditure side.

Bosnia & Herzegovina: Fiscal Balance, 2008–10

(In percent of GDP)

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Sources: BiH authorities; and Fund staff estimates.

Proposed fiscal measures for 2009

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Includes measures of KM9 million for Brcko district.

16. The program focuses on measures to reduce recurrent spending and to strengthen revenue (LOI, ¶16 and 17) Specifically: (i) the State will reduce the wage bill and spending on goods and services; (ii) the Federation, through an Emergency Law, will reduce the wage bill, transfers, and other recurrent expenditure; and (iii) Republika Srpska will reduce the wage bill, transfers to individuals, and other recurrent spending. All these measures will be adopted and included in rebalanced budgets that will be submitted to the Entity Parliaments prior to Board consideration of the SBA. Finally, on the revenue side, increases in excises on tobacco, coffee, and petroleum products in line with commitments toward the EU aim at offsetting some of customs revenue loss. The full-year impact of these measures will also contribute to further fiscal consolidation in 2010.

17. The Entity governments are committed to safeguard public investment and to protect vulnerable groups. Capital spending is projected to increase from 6 percent of GDP in 2008 to 7 percent in 2009, while efforts will be made to improve the rate of absorption of EBRD and EIB funds for infrastructure, thus providing for stronger growth potential over the medium term. Moreover, the authorities are committed to cushion the effects of the fiscal adjustment and of the reforms of benefits system, by reforming the social safety net and thus protecting the poor (LOI, ¶20-21). To this end, a Development Policy Lending operation currently being discussed with the World Bank includes two components that focus on enhancing safety net design and the eligibility process, and providing income support and job creation to vulnerable unemployed persons.

18. To put fiscal sustainability on a permanent footing, the authorities have proposed a series of structural fiscal reforms to improve public finance management and contain key expenditure pressures (LOI, ¶20). To this end: (i) the operational framework of the Fiscal Council will be strengthened, and the Council will take a lead role in the preparation of the 2010 budgets; (ii) the Federation, in consultation with the World Bank, will undertake a comprehensive reform of its rights-based benefits system with the objective of rationalizing and streamlining those benefits and improving targeting; (iii) steps will be taken by all governments to reform public administration and improve its efficiency; and (iv) the Federation government will adopt a comprehensive wage law, aimed at improving transparency by consolidating all allowances into the base wage. Finally, the Federation government is determined to move ahead with the privatization of state-owned companies.

E. Financial Sector Policies

19. BiH’s banking system has been resilient, but stresses are building up. As noted above, financial soundness indicators, although still healthy, have began to point to unfavorable trends, particularly in profitability, and the large volume of forex-linked lending raises the possibility of currency mismatches in household and corporate sectors. Stress tests conducted by an MCM TA mission in April 2009 indicate that the banking sector is generally resilient to various types of mild shocks. However, it is vulnerable to: (i) a large increase in nonperforming loans; (ii) a large shock in funding costs; (iii) the indirect effect of a large depreciation; and (iv) a deposit run. Aware of these vulnerabilities, over the next few months, the authorities will strengthen their capacity to conduct stress tests by improving data collection, the methodology, and the frequency of testing.

20. Financial sector policies will focus on enhancing the capability of monitoring financial stability. To this end, a Standing Committee for Financial Stability (SCFS) will be established comprising of representatives of the Fiscal Council, the CBBH, the two banking agencies, and the Deposit Insurance Agency (DIA). As a first step, the Committee will approve and sign a Memorandum of Understanding (MoU) to formalize the cooperative arrangements for financial stability, crisis preparedness and management. Moreover, the CBBH and the two banking agencies will monitor high-frequency data, and on the basis of such data prepare regular reports for the SCFS.

21. The authorities will improve the crisis management framework by strengthening the bank resolution and deposit insurance frameworks (LOI, ¶24 and 25). Specifically, they will prepare a contingency manual for a two-agency bank resolution strategy, make law amendments to broaden the banking supervisory agencies’ discretion to appoint a temporary administrator, and ensure irreversibility of supervisors’ decisions and seniority of the DIA’s claims for depositor reimbursements over the claims of general creditors. To ensure continued confidence in the deposit insurance scheme, the authorities plan to bring the coverage more closely in line with neighboring countries and prospective requirements under EU directives. To this end, the deposit insurance funding will be strengthened by a contingent credit line negotiated with the EBRD.

22. Foreign banks’ commitment to maintain exposures and to enhance capital if needed is a key element in improving financial stability. The BiH banking system is dominated by foreign-owned banks (accounting for 95 percent of total assets) whose parents are mostly in the euro area. The worsening of the global financial situation necessitates coordinated action, including support of parent banks and home country authorities. The authorities have thus sought pledges from foreign banks to maintain exposure to their BiH subsidiaries and to recapitalize those as needed over the program period (Box 3).

F. Other

23. The authorities and staff agreed on the need to improve the quality of statistics so as to strengthen policy analysis and program monitoring (LOI, ¶26-28). Specifically, the State and Entity Statistics Agencies will further harmonize the expenditure- and production-side GDP data and publish it in a timely manner, while the latter two Agencies will develop quarterly and/or semiannual GDP data. Strong efforts will be made to compile fiscal data harmonized with Eurostat and the IMF’s Government Finance Statistics guidelines. The authorities also intend to improve the coverage of fiscal statistics and to ensure timely submission of fiscal data by lower levels of government in the two entities. To this end, and under the umbrella of the Fiscal Council, a coordinating group will be set up, with the task of collecting and consolidating fiscal statistics from all levels of government in BiH. Finally, improvements will be made on the coverage and methodology of statistics on foreign grants.

III. Program Modalities

A. Access

24. BiH faces large balance of payments financing needs over the next three years. Under the program’s rollover assumptions and maintenance of official foreign exchange reserves at the end-May 2009 level, gross financing needs of €1,411 million in 2009 will produce a financing gap of approximately €433 million. For 2010, a strong adjustment program will reduce the budget’s financing needs substantially, thus allowing to maintain reserves to the equivalent of 4.5 months of prospective imports of goods and services. With the current account continuing to adjust and rollover rates and FDI improving due to enhanced confidence in economic policies and the projected recovery in the world economy, gross financing needs during 2011 and the first half of 2012 are projected to decline substantially. The total financing gap under the program would amount to €1,488 million, with commitments from the World Bank of €189 million and indications for support from the EU of €100 million filling some of the gap. Filling the remainder of the gap will require about €1,145 million (600 percent of quota) from the Fund during the program period.

B. Capacity to Repay

25. BiH’s capacity to repay the Fund is expected to be good. Its excellent record of serving its Fund obligations, the expectation that the program would lay the foundations for the return to a sustainable medium-term growth path, and a strong political commitment to the Fund-supported program provide assurances that BiH will be able to discharge its Fund obligations in a timely manner. By the end of the SBA, Fund credit outstanding is projected to be 7.5 percent of GDP (31.8 percent of gross reserves).

26. Notwithstanding the strength of the authorities’ commitment, this program entails significant risks. These risks pertain to domestic policy implementation and the global economic environment. While policymakers at all levels agreed on the need for a comprehensive program to deal with the crisis, and the Fiscal Council signed off on the program, political developments over the coming months could test their commitment to the program. If adjustment is incomplete, higher balance-of-payments and fiscal disequilibria could lead to capital outflows and raise risks to BiH’s ability to repay the Fund. As for the global environment, a deeper and more prolonged global recession could lower trade and capital flows more sharply than projected in the program scenario. And, if global financing conditions do not improve, financing needs may be higher, thus highlighting the need to be ready to adjust the program as needed. Moreover, a loss of depositor confidence could trigger a deposit run, increase pressures on the currency board, and lead to a deeper and more prolonged recession. While the CBA enjoys strong political and public support, the needed multi-year policy adjustment could prove controversial, and it could thus test the governments’ political commitment. It is possible that foreign banks will be unable to maintain their exposure to BiH, given the regional dimensions of the financial sector crisis and of their operations. The authorities recognize all these risks and stand ready to adjust their policies as circumstances change.

27. The program’s design aims at mitigating some of the above risks to the Fund. Approval of the key fiscal adjustment measures by the State and the Entities needed to bring the 2009 fiscal deficit down and re-balanced Entity budgets by governments are prior actions for Board consideration of the request for the program. In addition, parliamentary approval of the fiscal measures and re-balanced budgets for 2009 will be obtained by the time of the first review of the SBA. To achieve sustained lower fiscal deficits, the program includes structural benchmarks on adopting a reform plan for rights-based benefits (Federation), on prohibiting passage of unfunded legislation (Federation), and on fiscal reporting. For the financial sector, structural benchmarks include the establishment of a standing committee of financial stability and signing of the MoU on financial stability and crisis management.

C. Program Monitoring, Conditionality, and Safeguards Assessment

28. The SBA will run over 36 months from July 2009 to June 2012 (Box 4). The size and timing of the disbursements should ensure that the program is able to support BiH’s economic policies during the current period of global deleveraging. Given the high level of access and uncertainty surrounding the projections under the program, the authorities will consult with staff on evolving risks and agree on policy adjustments needed to achieve the program’s goals.

29. Program performance will be monitored by quarterly reviews. The first review under the program will be based on end-September 2009 targets and the second review on end-December 2009 targets. Structural conditionality is consistent with the program’s focus on the fiscal and financial sectors (Table 13). The quantitative performance criteria, benchmarks, and prior actions are indicated in Tables 1 and 2 of the Letter of Intent.

Table 1.

Bosnia and Herzegovina: Selected Economic Indicators, 2005–10

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

2009 based on program.

Increase in 2007 reflects the recognition of domestic claims (mainly frozen foreign currency deposits and war damages).

Table 2.

Bosnia and Herzegovina: Balance of Payments, 2006–14

(In millions of euros, unless otherwise indicated)

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

30. Staff has initiated an update safeguards assessment of the CBBH, which needs to be completed no later than by the first review under the SBA. This assessment will update the assessment completed in January 2005, which made recommendations to address weakness identified in the CBBH’s safeguards. Based on the information received from the authorities all of these recommendations have been implemented. Staff has requested from the authorities the documentation necessary to complete the update assessment and will hold initial discussions with the central bank’s external auditors.

IV. Staff Appraisal

31. Bosnia and Herzegovina faces a difficult economic situation. The recent global economic and financial crisis has hit the economy hard at a time when macroeconomic imbalances were already evident. With capital inflows driving a domestic demand boom, credit expanded sharply, core inflation accelerated, and the current account deficit widened. Looser fiscal and incomes policies in 2008 further exacerbated these imbalances, limiting the

space for maneuver when the crisis hit. Since the onset of the global crisis, net capital inflows dried up, exports and imports plunged, international reserves began to decline, and budget revenues tumbled. Staff welcome the authorities’ steps to address the impact of the crisis, although their efforts are dwarfed by the severity of the downturn.

32. At this critical juncture, the return to fiscal and external sustainability through an orderly macroeconomic adjustment hinges on the adoption of appropriate policies and adequate financing. The authorities’ program centers on safeguarding the currency board—which enjoys broad political support and has served the country well—and cushioning the effects of the deteriorating external environment. Staff support this approach which will address fiscal imbalances, strengthen the financial sector, and facilitate a return to sustainable economic growth and thus improve living standards.

33. Strong domestic policies will be required for this strategy to be successful. The program envisages a speedy return to the fiscal consolidation path, structural fiscal reforms, and measures to strengthen the financial system and enhance crisis preparedness. Staff believe that this policy package addresses the areas of BiH’s main vulnerabilities and should therefore contribute to enhanced market confidence. Public spending and wage restraint will also help improve competitiveness, support external adjustment, and bring the current account to a sustainable range. However, implementation of these policies will be challenging and calls for broad political support. To this end, the authorities will need to communicate the benefits of this approach and engage the public on the importance of reforms.

34. The fiscal policy package strikes a balance between the need for fiscal adjustment and the desire to adopt reforms to ensure medium-term sustainability. The authorities’ plans envisage a substantial improvement in the structural balance between 2009 and 2011. Thus, the need to support the currency board and bring public finances to a sustainable path does not allow automatic stabilizers to work in full. The fiscal adjustment focuses on recurrent expenditure cuts that reverse sharp recent increases, to be supported by structural fiscal reforms, most importantly of the system of nontargeted social benefits, public administration, and public finance management. In this regard, staff welcome that the program ensures that public investment will increase and that the social safety net will be reformed to protect vulnerable groups. While the short-term expenditure cuts and the reforms to the system of benefits are likely to be difficult, staff agree that they have important long-term benefits.

35. The authorities’ comprehensive financial sector strategy aims at strengthening the banking sector and improving crisis preparedness. Staff support the authorities’ plans to enhance the monitoring of financial stability by establishing a standing committee in charge of crisis prevention and management, and by signing a formal memorandum of understanding on cooperation. The crisis management framework also needs to be improved by strengthening the bank resolution and deposit insurance frameworks, while the capacity to conduct stress tests be enhanced. Finally, by seeking to secure commitments by the main foreign parent banks to maintain exposures to their BiH subsidiaries and to capitalize them as needed, the program helps contain external financing gaps and ease the impact of the global crisis. Although all these steps are welcome, staff urge the supervisory authorities to remain vigilant and proactive.

36. Yet considerable risks remain. The political support for key fiscal reforms may fade and the economic deterioration may be more serious. Also, while the currency board enjoys broad political and public support, the needed multi-year adjustment may challenge the political commitment by all governments, and its strength could be tested in the case of sizeable exchange rate depreciations in BiH’s regional trading partners. To minimize risks, the program includes strong safeguards, namely approval of key fiscal measures and of rebalanced budgets prior to Board consideration of the request for the program. Moreover, staff take note of the commitment by the authorities at all levels to strongly support implementation of the program and to adjust policies as circumstances change. In view of this, staff support the authorities’ request for a 36-month Stand-By Arrangement.

External Competitiveness

An updated analysis finds no strong evidence of a misaligned real exchange rate (RER) at present that could result in future external instability. However, the estimates are subject to large uncertainties.

The CGER macroeconomic balance approach suggests an equilibrium current account deficit (CAD) of 7.4 percent of GDP after taking into account about 1.8 percent of GDP capital transfers. The external sustainability approach also suggests the same level of equilibrium CAD. Once we account for rapid financial deepening and integration that are notable particularly in Europe (Abiad, Leigh, and Mody (ALM), 2007), however, the equilibrium CAD is estimated at 11.7 percent of GDP.

The estimates from the adjusted CA gap point to no strong evidence of a misaligned RER at present. Depending on the methodology, estimates range from a slight overvaluation of 4½ percent to undervaluation of 17 percent. One should caution, though, that these estimates are subject to large uncertainties due to the large forecast errors of regression-based estimates, and other assumptions regarding BiH’s business cycle, the import and export elasticities, and RER movements.

Current Account Gap and Estimated Real Exchange Rate Misalignment

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Source: Staff estimates.

Abiad, Leigh and Mody (2007)”International Finance and Income Convergence: Europe is Different”(IMFWP/07/64)

Export trends suggest that competitiveness remains adequate: the value of goods exports grew at an average 20 percent per year during 2000-08, and BiH has being gaining market share in EU markets. Also, the CPI-based real effective exchange rate has been stable during the same period. Finally, relative to nontradables, average labor productivity growth of BiH tradables has been much higher than that of the main trading partners.

The European Bank Coordination Initiative

The banking system in BiH is dominated by subsidiaries of foreign-owned banks (mainly from Austria, Italy, and Slovenia). Being the primary source of credit growth in recent years, those banks have been instrumental in BiH’s strong economic performance. Moreover, foreign parent banks have a declared long-term interest in BiH as well as in the region. However, uncertainty about other banks’ strategies may tempt risk-averse agents to cut back on lending or abandon the region. Coordination of continued foreign parent bank commitments for rollover and capital is therefore crucial for financial stability as well as for balance of payments sustainability.

To secure the support from parent banks, a meeting is scheduled to take place in Vienna on June 22, 2009. The meeting will be hosted by the Joint Vienna Institute and chaired by the Fund. It will include six largest foreign bank groups incorporated in BiH, their parent banks, the European Commission, the World Bank group, the EBRD, the EIB, the BiH authorities, and representatives of the home country authorities.

After a discussion on the current economic situation of BiH and the authorities’ program, commitments will be sought from foreign parent banks to maintain their exposure to their subsidiaries in BiH and to recapitalize them as needed.

Stand-By Arrangement

Access: SDR 1,014.6 million, 600 percent of quota.

Length: 36 months.

Phasing: SDR182.6 million will be made available upon the Board’s approval of the arrangement to address fiscal and balance of payment needs during the rest of the year. The eleven subsequent quarterly tranches, starting from December 2009 and ending in June 2012, will equal SDR 832 million.

Conditionality

Quantitative Performance Criteria

- Ceiling on accumulation of net credit of the banking system to:

  • ✓ the general government

  • ✓ the State government

  • ✓ the RS government

  • ✓ the Federation government

- Ceiling on new guarantees and the assumption of enterprise debt to banks by the State, Federation, and RS governments

- Ceiling on accumulation of external payment arrears

- Ceiling on contracting new short-term external nonconcessional debt

- Ceiling on accumulation of domestic arrears of:

  • ✓ the State government

  • ✓ the RS Government

  • ✓ the Federation government

Prior Actions for Board consideration of the program request

- Adopt rebalanced budgets by Entity governments and submit to Parliament

- Adopt amendments to the wage bill legislation by the Council of Ministers

- Adopt the Intervention law in the Federation.

- Adopt a new Excises Law

- Adopt the Global Framework by the Fiscal Council

Structural Benchmarks

- Adhere to the Currency Board Arrangement as constituted under the law (Continuous)

- Approve the rebalanced budgets by the Entity Parliaments (End-August 2009) - Agree on an action plan acceptable to the World Bank and IMF staffs to reform the system of rights-based transfers in the Federation (end-November 2009)

- Submit to the Federation Parliament a Law forbidding passing of unfunded legislation (end-November 2009)

- Publish on the State government’s web site quarterly consolidated general government accounts with a 5 week lag (Continuous)

- Form a standing committee of financial stability and sign the MoU on financial stability, crisis preparedness and crisis management (end-November 2009)

- The Deposit Insurance Agency to impose a principle of universal membership requirements, including for partially state-owned banks (end-February 2010).

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-10 index

Moody’s foreign currency sovereign rating.

Table 4.

Bosnia and Herzegovina: General Government, 2006–14

(In percent of GDP)

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Sources: Ministries of Finance; and IMF staff estimates.
Table 5.

Bosnia and Herzegovina: Elements of General Government, 2008–14

(In percent of GDP)

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Sources: Ministries of Finance; and IMF staff estimates.