Threats to external stability in the pre-crisis period have now been reduced substantially and foreign non-debt creating flows have declined, sufficient to support external stability. The global economic downturn has raised challenges for evaluating the countries’ fiscal stance and fiscal policy focus should be lowering support to debt sustainability, private sector development, and the currency board stability. The two entity pension funds have been under increasing financial pressures. Putting the public pension systems on a sound footing will encompass a number of complementary steps.

Abstract

Threats to external stability in the pre-crisis period have now been reduced substantially and foreign non-debt creating flows have declined, sufficient to support external stability. The global economic downturn has raised challenges for evaluating the countries’ fiscal stance and fiscal policy focus should be lowering support to debt sustainability, private sector development, and the currency board stability. The two entity pension funds have been under increasing financial pressures. Putting the public pension systems on a sound footing will encompass a number of complementary steps.

II. External Sector Stability and Competitiveness1

A. Introduction

1. Analysis and understanding of external stability and competitiveness are important, especially in the context of Bosnia and Herzegovina’s (BiH) currency board arrangement. Since its inception, in addition to being widely acceptable by the public and policymakers, BiH’s currency board has proved to be an efficient tool of macroeconomic management and has ensured macroeconomic stability. However, maintaining its stability requires strong fiscal discipline and flexibility of wages and relative prices. The 2008 Article IV consultation and the analysis of BiH competitiveness highlighted growing imbalances that required immediate attention. Following a procyclical loosening of fiscal and public wage policies during 2006–08, internal and external imbalances continued to grow: the current account deficit approached unsustainable levels and inflation picked up. These developments hampered BiH’s external competitiveness.

2. This chapter analyzes BiH’s external stability and competitiveness. First, we discuss various measures of the current account deficit; and then, in Section C, we look into a number of indicators of external price and cost competitiveness, including export market shares, profitability of export industries, labor rigidities impeding competitiveness, and FDI pattern. Section D focuses on theoretical underpinnings of exchange rate assessment and practical application to BiH; this section also provides a range of estimates of the equilibrium real effective exchange rate and required adjustment and some recommendations on improving the external stability and competitiveness in BiH. Finally, Section E concludes.

B. Factors Behind Large Current Account Deficit and Adjustment During the Crisis

Pre-crisis developments

3. Over the last decade, the current account deficit continued to remain high driven by policies stimulating rapid increase of domestic demand and credit boom. In the initial post-war era, BiH’s current account deficit remained at high levels for quite a few years. It was mostly driven by imports for rebuilding of the war-torn economy largely financed by government foreign grants and loans. In subsequent years, the current account deficit has declined (particualrly during 2003–2006) supported by prudent fiscal policies and significant improvement in the terms of trade.

uA02fig01

BiH: Current Account Components

(in percent of GDP)

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

4. However, the current account deficit began to widen again in 2007. Speedy credit growth financed by strong capital inflows, along with a procyclical loosening of fiscal and public sector wage policies, fuelled a domestic demand boom. These developments combined with deterioration in the terms of trade contributed to a sharp worsening in the current account deficit by about 6 percentage points of GDP; the deficit reached 15 percent of GDP in 2008. Exports growth moderated (15 percent in 2007 compared to an average of 30 percent during 2004–06), while the growth of imports accelerated (17 percent in 2007compared to an average of 7.1 percent during 2004–06).

uA02fig02

Components of Private Sector Spending Power, % of GDP

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

5. The boom in private consumption was a key contributor to the high savings-investment gap. The share of GDP allocated to private consumption in BiH is among the highest in the Western Balkans. In the aftermath of the 1992–1995 war, the boom in consumption reflected the catching up of living standards after years of suppressed spending. Later on, the increase in private consumption was fueled by high private transfers and factor income from abroad (which averaged around 25 percent of GDP during 2002–06) and external grants and loans. Further, limited saving opportunities and financial instruments, have also created a favorable environment for consumption growth. As a result, domestic private savings remained negative throughout the entire post-war era. While public savings have improved significantly during 2002–05, they started to deteriorate during 2006–09 contributing to demand for foreign savings, thus increase in current account deficit.

Consumption in Selected Neighbor Countries

(Averages, In percent of GDP)

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Sources: WEO, IMF Staff Estimates.

Domestic savings

(In percent of GDP)

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6. The above developments in economy have affected the structure and composition of the external financial flows. The financial account inflows in the pre-crisis period consisted mainly of FDI, which was primarily driven by privatization and external loans to banks and enterprises. Capital inflows helped finance the current account deficits and build foreign exchange reserves, which reached €3.2 billion or 5.7 months of imports at end-2008.

uA02fig03

BiH: Foreign direct investment relative to peers

(in percent of GDP)

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

uA02fig04

BiH: Capital and Financial Account Components

(in percent of GDP)

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

Developments during the crisis

7. The global crisis led to an unexpectedly large current account adjustment (6.4 percent of GDP in 2008–09), driven by a combination of retrenchment in domestic and foreign demands. The trade balance was the main source of this adjustment, with a steep contraction of imports counterbalancing the drop in exports. Exports of goods fell by about 17 percent, due to lower foreign demand and decline in export prices. Imports of goods plummeted by 24 percent driven by low domestic demand and a decline in global prices. The export contraction was mostly due to price decline driven by deterioration in global demand for aluminum, metals and steel (accounting for more than a quarter of BiH exports). The decline in imports was evenly distributed between prices and volumes effects. While price developments are a combination of exogenous decline in world prices of oil and food during 2009, the drop in volumes is a consequence of deteriorating domestic demand.

The breakdown of import and export value changes by prices and volume in KM 1/

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Export import prices percent change over year ago

Key components of exports price include metal, aluminium prices and component based export deflator for BiH for other exports (all WEO)Key components of imports price include oil, gas, food prices and euro area export deflator for other imports(all WEO)

8. The adjustment in the trade balance offset the decline in other elements of the current account, particularly the drop in private transfers. The significant adjustment in the services balance is related to a cut back in trade activities (widespread decline in exports of all types of services notably in transportation, freight and communication). Current transfers have also declined, mostly due to a worsening of economic conditions in EU countries, where most of migrants and seasonal labor from BiH are located.

uA02fig05

BiH: Monthly Exports and Imports

(y-o-y percent change)

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

uA02fig06

BiH: Monthly Trade Balance

(KM million)

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

9. The adjustment of the current account continued in the first half of 2010. Weak domestic demand contributed to further decline in real imports (3.7 percent decline year-on-year) and some increase in nominal terms (4.8 percent), driven by recovery of prices in international markets. The improved outlook for BiH’s key export commodity prices resulted in rapid recovery of key exporting industries (including metals, steel aluminum, and wood). Meanwhile, the decline continued in services, income and current transfers’ balances, thus partially offsetting the positive developments in the merchandise trade.

10. The crisis has significantly reduced capital inflows. The financial and capital account surplus in 2009 declined to 6.3 percent of GDP from 13.4 percent in 2008. Preliminary outturn for 2009 suggests that FDI more than halved, dropping from 5.0 percent of GDP to 1.4 percent. Non-bank private sector external borrowing also slowed down and banks’ foreign liabilities were slightly lower than suggested by the commitment of parent banks to maintain their overall exposure to BiH. Capital transfers and drawdown of loans by the public sector appeared to be somewhat lower mostly due to the limited implementation capacity in BiH and extended preparation processes among donors. As a result, gross international reserves declined to about 5.3 months of prospective imports of goods and services (111 percent of domestic currency outside banks) at the end-2009.

Bosnia and Herzegovina: Potential Foreign Exchange Liquidity Drains and Liquidity Buffers

(In percent of GDP)

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Sources: CBBH; and Fund staff calculations and estimates.

11. Nevertheless, the analysis of potential liquidity drains and buffers indicate that the deteriorating trend for risks at the end of 2008 has somewhat abated, and there is a steady recovery of potential buffers, bringing them closer to pre-crisis levels by end-2010.

C. Non-Model Analysis of BiH External Stability

12. Both REER-CPI and REER-ULC indicate that external competitiveness of BiH remains largely stable with REER-ULC showing even some gain in cost competitiveness, likely driven by decline in employment and simultaneous increase in output and wages.

uA02fig07

BiH: REER

(2002=100)

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

uA02fig08

BiH: Decomposion of ULC

(2002=100)

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

13. Developments in bilateral real exchange rate vis-à-vis its trading partners/neighbors were broadly stable in the pre-crisis period. More recently, BiH’s real exchange rate appreciated somewhat compared to Serbia (on account of the nominal depreciation of the Serbian currency), while the REER in relation to Croatia and EU member partners remained broadly stable.

14. Analysis of the BiH export market share in the world and Euro area regional markets demonstrate that BiH’s export competitiveness has improved rapidly during 2003–08. Export growth has been strong, and both real export growth and market share gained especially over 2003–07. While the market share in world exports stabilized, the BiH lost some of its markets in the EU area, due to the impact of the global recession on the Euro area.

uA02fig09

Bosnia and Herzegovina exports market share In woild and EU area exports (%)

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

15. Developments in market share are further explained by the composition of exports in BiH. While there were some positive trends in pre-crisis period with a few capital and technology intensive industries, exports remained tilted towards raw-materials and unprocessed products that are not technology and labor-input intensive. As a result, BiH exports remain very much dependent on fluctuations in international commodity markets. The decline in exports is mainly driven by the contraction of global demand for iron, steel and aluminum. The positive trends in the first half of 2010 partly explained by recovery in a few export components is yet to appear in export composition (including, mineral products driven by launch of production of refined oil products in Republika Srpska, aluminum and metals).

uA02fig10

BiH:Composition of exports

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

16. Further improvement in exports composition and increase in capital and technology intensive industries might require fundamental changes in the labor market and business enabling environment. As discussed in the recent WB enterprise survey, the shortage of skills in export-related industries is significant and may constrain future economic growth. WB firm-level evidence also proves that shortage of skilled workers is becoming a serious impediment to growth of BH exporting companies (See also Chapter I of this paper for a detailed analysis of labor market rigidities).2

uA02fig11

Indexes of key commodity prices, 2000-2015, 2005=100

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

17. BiH chronically lags behind its peers in cross country competitiveness analyses, indicating the need for structural reforms to foster private sector led growth in BiH. The country has further lost standing in the Global Competitiveness Report (GCR) 2010/2011, ranking 102nd out of 139 evaluated countries. Moreover, the special publication of GCR on information and technology ranks BiH 110th, compared to Croatia 51st, FYR Macedonia 73rd and Serbia 84th.

The Global Competitiveness Index (GCI) 2010–2011

rankings and 2009–2010 comparisons

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© 2010 World Economic Forum

18. BiH was also downgraded in the six dimensional ranking of the World Bank governance indicators. It now ranks in 44th percentile on rule of law, 46th percentile on control of corruption, and 35th percentile on government effectiveness3. These results are in line with the ranking of World Bank Doing Business Report 2010, where a cross-country ranking of business environment indicators shows BiH’s sub-par performance relative to neighboring countries (116 out of 183 countries).

uA02fig12

World Bank, 2009 Doing Business Ranking

(183 countries)

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

19. These rankings are broadly consistent with the findings of IMF staff survey of private sector representatives and survey results of the World Economic Forum Competitiveness report. Two companies that were unaffected by the crisis and even managed to expand their business were part of international supply chains, in furniture and machinery production industries. Their success was driven by updates in technology and investment in human capital, milder interference with local bureaucracy due to being a part of supply chain, easy access to short-term working capital through intra-firm financing. Both IMF and World Economic Forum Competitiveness report surveys revealed that key impediments for companies to access foreign markets include: (i) political instability; (ii) complicated and “expensive” bureaucracy; (iii) lack of clear vision for economic development; (iv) corruption and weak legislative framework; and (v) poor quality control (i.e., local certification and standardization). Substantial opportunities lie in enhanced productivity via bigger investment in R&D and human capital.

uA02fig13
Note: From a list of 15 factors, respondents were asked to select the five most problematic fordoing business in their country/economy and to rant them between 1 (most problematic and 5. The bars in the figure show the responses weighted according to their rankings.

D. Model-Based Analysis of External Stability Analysis

20. Model-based analyses of external stability focus on identifying deviations of the current account balance and the real effective exchange rate from their equilibrium values. In practice, arriving at a model that could produce well-specified equilibrium values for both the current account balance and the exchange rate has proven to be a difficult task. There is a vast literature on the subject; however economists agree that each of the suggested methodologies has certain advantages and disadvantages, often resulting in different estimates.

21. The concept of external stability is particularly difficult to benchmark for economies like Bosnia and Herzegovina. This is in part due to the difficulty of pinning down the notion of equilibrium in relatively short historical time series for a country that has operated under market socialism in the past and experienced the devastating effect of the 1992–95 war. In addition, data quality continues to be an issue, introducing further uncertainties to statistical inference. In these circumstances, the judgments about the exchange rate assessments, i.e., estimates of whether or not a country’s exchange rate is over-or under-valued or broadly in line with macroeconomic fundamentals, becomes an important part of analysis and conclusions.

22. In this section we employ a number of methodologies and approaches, including by IMF’s Consultative Group of Exchange Rate Issues (CGER)4. We start by discussing the results of three different concepts of equilibrium-the macroeconomic balance approach (MB), the external sustainability approach (ES) and the (reduced form) equilibrium real exchange rate approach (ERER). We also discuss the notion of purchasing power parity in the context of competitiveness. We provide relevant estimates for BiH by adopting the coefficients from different studies and applying them to data for BiH and its trading partners.

BiH: Macroeconomic Balance Approach

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23. The preliminary analysis of macroeconomic balance approach suggests that the current account deficit slightly exceeds the sustainable level. Equilibrium current account estimates are between 0.33 percent surplus to 0.16 percent of GDP deficit5. However, we adjust the current account norm estimates by the level of fiscal foreign grants, which allow for higher level of sustainable current account deficit. The adjustment yields estimates of the sustainable current account deficit from 1.7 to 2.2 percent of GDP compared to underlying current account deficit proxied by the medium term projection of 5 percent of GDP. However, taking into account financial integration factor and potential EU convergence (based on Abiad, Leigh and Mody (AML) (2007) we arrive at equilibrium current account deficit of 4.0 percent of GDP, implying a gap from current account medium-term projection of about 1.0 percent of GDP.

24. Under the baseline scenario of BiH-specific parameters, the external sustainability approach suggests that the equilibrium current account deficit stabilizing the net foreign liability position at around 8 percent of GDP (average of the previous 5 years) is about 4.4 percent of GDP, implying 0.6 percent gap towards its medium-term estimate and 2.4 percent in GDP gap compared to the outcome of 2009. The alternative scenarios, i.e., higher interest rates, lower NFA and lower real growth, suggest need for higher adjustment in current account.

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25. The Equilibrium Real Exchange Rate approach evaluates the relationship between the real exchange rate and a set of fundamentals. Given data-related issues, the estimates provided in the paper are based on the CGER methodology, which estimates a panel regression of CPI or ULC-based REER on a number of fundamentals, including (NFA), productivity differential, and commodity terms of trade, government consumption, trade restriction index, and price controls.6 For Central and Eastern European (CEE) countries, the regression specifications allow for a stronger Balassa-Samuelson effect, compared to the global sample. The paper uses regression coefficients for both with and without CEE. Depending on using CPI-based or ULC-based REER the estimates fluctuate between 4.4 percent undervaluation to 8.8 percent overvaluation.

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26. The purchasing power parity (PPP) approach relies on the concept that, over time, a country’s nominal exchange rate will tend to approach its PPP-determined level. This takes place as a country’s per capita income moving toward more developed country’s per capita income. However, the convergence in emerging economies is not a smooth process and may imply many impediments that keep convergence process slow. The most common factor is the Balassa-Samuelson effect. The PPP GDP per capita is generally used as a proxy for the relative productivity differential. Real exchange rate undervaluation (overvaluation) is observed if the country’s price level is too low (high) compared with the price level implied by its relative income level. The undervaluation of 8.2 percent under Balassa-Samuelson is consistent with the hypothesis that the real exchange rate should appreciate in line with relative productivity differential.

uA02fig14

Balassa-Samuelson, 2008

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

uA02fig15

Balassa-Samuelson, 2014

Citation: IMF Staff Country Reports 2010, 347; 10.5089/9781455212705.002.A002

27. Based on the above equilibrium current account norms, the estimated REER misalignment ranges from undervaluation of 4.2 (implying CPI REER) under the equilibrium REER approach to about 18 percent overvaluation under the macroeconomic-balance approach. The undervaluation based on Balassa-Samuelson implies that the convergence to developed partners is underway. These analyses do not suggest a strong evidence for real exchange rate overvaluation that could result in future external instability. The estimates are also subject to large uncertainties reflecting the large variations in macro-fundamental variables across the countries and over time and limits of the specifications imposed across a set of countries used for the development of CGER analysis.

BiH: External Stability Analysis

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Undervaluation (-) and overvaluation (+).

28. These findings differ from the analysis under the 2008 article IV consultations, when the range of equilibrium current account deficit varied between 7.5–13.5 percent of GDP. The likely explanation is in the shifts of macroeconomic fundamentals resulting from the global crisis in BiH and partner countries. The consequent adjustment resulted in relative narrowing of the estimated range of the equilibrium current account deficit to 1.7–4.4 percent of GDP.

E. Conclusions

29. The analysis in this chapter suggests that there is no case for significant overvaluation of the real exchange rate. Threats to external stability in the pre-crisis period—associated with a current account deficit that reached unsustainable levels—have now been reduced substantially; and while foreign non-debt creating flows have declined, they remain sufficient to support external stability. Risks related to foreign bank liabilities rollovers remain benign. Nevertheless, it is important to note that preserving external sector stability requires short-and medium-term policy measures aimed at removing bottlenecks and factors potentially risking external sustainability. These measures include but not limited to maintaining fiscal discipline, enhancing external competitiveness through addressing long-standing labor market rigidities, further improvement of productivity and removing impediments to entrepreneurship and good governance.

F. Appendix

30. The first two methods, the Macro-Balance and the External Sustainability approaches, are close to Williamson’s (1994) concept of Fundamental Equilibrium Exchange Rates, which is defined “…as the real exchange rate that allows for the simultaneous attainment of the internal and external balances, i.e., when output is set to its potential level and when the current account is financed through long-term capital flows….and as an exchange rate that is expected to be indefinitely sustainable on the basis of existing policies”. It should therefore be real effective exchange rate that is expected to generate a current account surplus or deficit that matches the country’s underlying capital flow over the business cycle, of course assuming that the country is pursuing internal and external balance. According to Edwards (1991), “…internal equilibrium means that the non-tradable goods market clears in the current period and is expected to be in equilibrium in future periods. External equilibrium means that the current account balances (current and future) are compatible with long-run sustainable capital flows”. The basic idea then is in estimating the required exchange rate adjustment to close the gap between the so-called underlying current account, i.e., adjusted for the economic cycle, and the “current account norm”, which represents an equilibrium value over a medium term horizon.

31. Macro-economic balance approach (MB)-calculates the difference between the medium term projection of current account balance at current exchange rate and an estimation of current account norm. In the MB, first the current account norm7 is derived from panel regressions, attempting to establish an equilibrium relationship between the current account and a set of credible fundamentals across the time and cross-country dimensions. The standard CGER methodology (Lee and others, 2008) is based on a pooled OLS regression using the data from 54 industrialized and emerging markets between 1973 and 2004. Secondly, it estimates an underlying current account balance, i.e., current account balance that would materialize at a zero output gap for domestic and partner countries. Finally, a real exchange rate adjustment that would close the gap between the estimated current account norm and the underlying current account balance is calculated. The estimate is computed by implying elasticity of the current account to the real exchange rate calculated as export elasticity*(export/GDP)-(import elasticity-1)*(import to GDP)8.

32. External sustainability approach (ES)-estimates the differences between the actual current account balance and the one that will stabilize countries International Investment (IIP) or net foreign assets position at some sustainable benchmark level. This is built on the idea of intertemporal budget constraint for the economy as a whole. The MB and the ES approaches belong to the same group of models and differentiate themselves only from the way the current account norm is defined. Unlike MB, in the ES approach, the current account norm is defined as the current account balance that is required to stabilize the net external indebtedness of a country. It is assumed that changes in net international investment or net foreign assets of economy (Bt) are assumed to be due either to net financial flows (net purchases of foreign assets minus net foreign purchases of domestic assets) or to changes in the valuation of outstanding foreign assets and liabilities: Bt -Bt-1 =CA+Et -where CAt is the current account balance and Et includes factors that represent the difference between the current account balance and net financial flows (including capital grants and/or errors and omissions). By expressing all variables in GDP, the current account that stabilizes IIP at any given level cas=g+π(1+g)(1π)bse,

where g and π are growth rate of real GDP and inflation, respectively.

Likewise, the level of trade balance of goods and services consistent with IIP or NFA stabilizing level istb=(rg)1+gbgrant,

The suggested adjustment for grants implies similar logic used in estimation of macroeconomic-balance approach.

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1

By Armine Khachatryan (SPR).

2

Based on results from 2009 Enterprise Survey, World Bank. One third of managers of exporting firms in Bosnia indicated skills as a problem for doing business in 2009

3

Percentile ranks indicate the percentage of countries worldwide that rate below the selected country. Higher values indicate better governance ratings

4

In mid 90s, the IMF Consultative Group on Exchange Rate issues (CGER) (IMF economists internal working group) has been conducting exchange rate assessments for a number of countries from a multilateral perspective. Initially for the G-7 economies, further expanded to 27 advanced and 27 emerging market economies

5

We do not discuss the fixed effects results, given that the GGER estimates do not have a fixed effect for Bosnia, which eliminates any advantage that this method has.

6

Some interpretation of the economic substance behind the implied variables and their coefficients is provided here. A country with smaller NFA (or larger debt) needs larger CA surplus (or more depreciated real exchange rate) to service its debt. Productivity differential is included to account for the Balassa-Samuelson effect. Through real income or wealth effects, higher commodity terms of trade lead to an appreciation of the RER. Higher government consumption is likely to appreciate the RER as such consumption generally falls more on nontradables than tradables. Trade restriction is included as it may lead to higher domestic prices and more appreciated real exchange rates. Finally, a lower number of administered price categories are expected to be associated with a more appreciated real exchange rate in transition economies as prices rise towards market levels

7

Current account norms are equilibrium estimates arising based on a theoretical macroeconomic model. There is a large literature, including theoretical and empirical that discusses the l factors that can influence the dynamics of the current account including: demographics, government fiscal policy, closing the GDP gap, as well as various institutional characteristics that may influence the country’s ability to borrow abroad. An important aspect is that the current account - through an accounting identity, is linked to the difference between domestic saving and investment. This identity highlights the intertemporal nature of the current account and the role of consumption smoothing (see Sachs, 1981, and Obstfeld and Rogoff, 1994). The rationale of this approach is that a current account deficit does not necessarily imply an imbalance: it can make sense, for a country that is growing, to borrow against future income. Therefore, the current account norm may be non-zero.

8

For purposes of current analysis CGER elasticities are applied, i.e., -0.71 for exports and 0.92 for imports.

Bosnia and Herzegovina: Selected Issues
Author: International Monetary Fund