Statement by Age Bakker, Executive Director for Bosnia and Herzegovina And Miroslav Tomic, Advisor to Executive Director

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.

1. Introduction

July 8, 2009

The economy of Bosnia and Herzegovina (BiH) did not escape the impact of the global crisis. After several years of strong growth, supported by foreign investments and capital inflows and reflected in an increase in employment, the deterioration in the external environment and increase in domestic imbalances, threaten to challenge these achievements. The global crisis put the spotlight on the good policies done in the past (e.g. direct tax reform, establishment of a national fiscal council), but, more importantly, exposed the consequences of the unfinished agenda (public wage bill, reform of social sector rights-based untargeted benefits). In order to minimize the negative consequences and further strengthen economic development potential, the authorities have prepared strong adjustment measures explained in the Letter of Intent. Required prior actions have been met with wide margins, signaling strong determination to implement further measures.

2. Macroeconomic update: from the threat of overheating to reduced activities

The year 2008 saw transition from overheating-increase in (CPI) inflation to 7.4% from 1.5%, widening current account deficit by 2% of GDP to 14.7%, credit growth by 30% etc., to deposit withdrawal, credit tightening, interest rate increase, export reduction, unemployment increase, and threats to financial stability. Although the annual growth rate estimated at 5.5% still was satisfactory, revenue growth slowed in Q4 and, together with increase in public wages that occurred in the first part of the year, contributed to the widening fiscal deficit to a record high. For the first time after several years the primary balance turned into deficit.

The fiscal deterioration manifested asymmetrically in the two entities: while successful privatization of RS Telekom provides a cushion and allowes a development-related spending stimulus, the Federation BiH’s central government budget, burdened with unfunded war related social entitlements, ended last year with expenditure arrears. In addition, the privatized oil refinery commenced with production in November 2009, contributing to growth in industrial production in the Republika Srpska (RS), while the privatization process in the Federation BiH was stalled.

3. Financial and external sector: impact of the crisis

The financial sector so far weathered the impact of the financial crisis relatively well. At the beginning of 2008, in order to limit credit growth that contributed to the overheating, the Central Bank of BiH (CBBH) increased reserve requirements from 15% to 18%. At the first sign of increased deposit withdrawals, the CBBH promptly relaxed reserve requirements strengthening the liquidity position of the banks. The reserve requirement was decreased in stages closely monitoring bank activities and the relationship with mother banks. In order to allow branches to have cheaper access to mother banks, new capital was exempt from reserve requirements. To strengthen the deposit security, the authorities increased deposit insurance from 7500 KM to 20000 KM. Financial soundness indicators did deteriorate, but still remain far above the regulatory requirement. The situation stabilized with the effect that 11% of deposits was withdrawn and foreign exchange reserves were reduced by 16% from their peak level in 2008. Despite the increase in wages and relatively high recorded CPI inflation, there is no evidence of an overvaluation of the BiH currency. Although the share of BiH exports to the EU has been growing, the authorities are closely monitoring the real effective exchange rate behavior, particularly in light of the depreciation by some countries in the region, and stand ready for corrective measures in the wage policy.

4. Outlook: 2009 and beyond

Confronted with reduced revenues, the authorities at all levels limited non-mandatory expenditures in Q1 2009. While inflation pressures have abated and although the external position is expected to improve due to a faster drop in imports compared to exports, the sluggish recovery in major trading partners leaves no room for complacency. With a projected sharp fall in the GDP growth rate of 3% and an expected fall in revenue collection that could exceed 10%, the authorities are aware that a more serious effort, including external support, is needed.

5. SBA program: crisis as an incentive

The program is designed to preserve confidence in policy making, and particularly the currency board arrangement, a backbone of macroeconomic stability. The proposed duration of program (36 months) is based on the awareness that implementation of structural reforms is time consuming and complex and that results may come only with the lag. The authorities believe that the interest of the country would be better served by close cooperation with international financial institutions, as envisaged under the SBA, over a longer rather than shorter time period. This is not only because of the financing provided, but, more importantly, because of the guidance on and conditionality of the adjustments. The sheer process of the program negotiations contributed to an improvement in intergovernmental fiscal policy coordination through the National fiscal council (NFC), as all levels of government accepted to share the burden of adjustment.

Fiscal sector: immediate adjustment and structural improvements

At the outset, it should be stressed that the adjustment under the program is frontloaded, exceeding 3.1% of the GDP already in 2009, with the bulk of measures on the expenditure side. The reduction in expenditures on wages, allowances, transfers, etc. could be challenged and has been challenged from different perspectives, including social sensitivity and goals of macroeconomic stabilization.

On the one hand, while a reduction in public expenditures when both domestic and external demand is shrinking, could appear as pro-cyclical and counterproductive, the financing limitations and composition of the reduction reveals a different story. First, borrowing by the public sector from commercial banks, which the Federation BiH government was forced to do in order to cover 2008 arrears, would further limit availability and increase the cost of borrowing for the private sector. Second, a reduction in public wages, apart from its contribution to the fiscal balance, will have a positive effect on competitiveness and is supportive of the currency board arrangement. Third, immediate savings in non-targeted benefits for war veterans and civil victims, and initiation of the (long overdue) revision process under the auspices and guidance of the World Bank are expected to strengthen the structural fiscal balance that will positively reflect in the country’s credit rating.

On the other hand, one could argue that the adjustment is insufficient. Attempts to further reduce expenditures in the current juncture may, however, be politically unfeasible. In a nutshell, non-reduction in public expenditures when multiplier effects are unknown and financing is either expensive or nonexistent, will certainly decrease the quality of the public finances. Insistence on additional reductions could well be impossible for political economy reasons and therefore jeopardize the tangible improvements expected under the proposed SBA. The measures under the program, such as introduction of means-testing for all civilian and war related benefits, revisions of existing legislation granting the entitlements, and adoption of the fiscal responsibility law, beyond any doubt will strengthen the structural fiscal balance. On the revenue side, the adoption of the excise law (a prior action) is not only expected to increase the revenue but is also a step forward in harmonizing the tax legislation with that of the EU. The enactment of this law was also a precondition for the EBRD highway construction project loan, a major and longawaited capital investment.

Financial sector: expected improvements under the SBA

The financial sector is dominated by the banking sector, characterized by a huge share of foreign capital. Most banks operating in BiH are subsidiaries of mother banks from Austria, Italy and Slovenia. Foreign banks operating in BiH pledged their continued presence and exposure at a meeting chaired by the IMF in Vienna on June 22, 2009. The SBA is envisaging further institutional improvements in monitoring and crisis preparedness. The authorities will, as part of financial sector strengthening under the SBA, establish a Standing Committee for Financial Stability (SCFS) consisting of the CBBH, entity banking supervision agencies, and the Deposit insurance agency (DIA). Cooperation under the umbrella of the SCFS will secure more efficient collection of high-frequency data and also raise awareness of the interdependences of policy decision in different sectors through timely dissemination of financial sector data and reports. Based on recent MCM technical assistance recommendations, among other things a contingency manual for a bank resolution strategy will be prepared, while amendments to the law increasing banking supervision agency discretion in appointing temporary administrators will be enacted. DIA membership principles will be harmonized with banking licensing, allowing universal membership in DIA (currently possible only if the bank is at least in 90% private ownership). Finally, the authorities will use a credit line from the EBRD (50 million Euros, final approval expected on July 14, 2009), to further increase deposit guarantees to 50 000 KM. Given that the SCFS is modeled on successful intergovernmental cooperation within the NFC, it is expected to contribute to financial sector stability. A strong currency board arrangement and privatization of the banking system are considered the most successful reforms in the post-war period. The authorities are aware of the importance of the stability of the financial sector, will refrain from any unilateral decision and stand ready to consult with the Fund if further actions are required during the program.

Statistics

The program will bring additional quality to macroeconomic management through the harmonization in relevant macroeconomic data as the entities and the state agency will harmonize expenditure and production GDP. The precondition for successful monitoring, not only of the program targets but also of NFC targets, requires improvements in reporting metodology and frequency of fiscal data availability. The authorities look forward to technical assistance in this area.

6. Conclusion

The authorities learned the lesson of the importance of structural reforms during good times through the financial squeeze in bad times. The proposed program is an optimal combination of what should and can be done in order to secure the currency board arrangement and stability of the financial sector. The program strikes a feasible balance between the need to keep public debt at a comfortable level, while it improves the quality of public expenditure, through improved targeting in the social sector and infrastructure spending. The relationship with the Fund and other international institutions will help focus the policy effort in a direction beneficial for economic development and the Euro-Atlantic integration process.

More than a courtesy

Finally, the authorities would like to express sincere gratitude to the IMF staff headed by Head of Mission Mr. Christou for the beneficial, useful and fruitful discussion, including occasional disagreements and misunderstandings, and look forward to continued cooperation.

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
Author: International Monetary Fund