Bosnia and Herzegovina
First Review Under the Stand-By Arrangement and Request for Waiver of Nonobservance of a Performance Criterion —Staff Report; Press Release; and Statement by the Executive Director

Bosnia and Herzegovina’s (Bah) economy started to lose steam in early 2012 as growth slowed in Europe. Intensification of the euro area crisis further affected Bin's growth outlook. However, measures such as limiting the expenditure at the central government level and targeting overall general government spending by 1 percentage point of GDP in 2013 aim to improve the economy. Comprehensive reforms of rights-based benefits are also identified, which are imperative for both medium-term fiscal sustainability and improving the functioning of labor markets.

Abstract

Bosnia and Herzegovina’s (Bah) economy started to lose steam in early 2012 as growth slowed in Europe. Intensification of the euro area crisis further affected Bin's growth outlook. However, measures such as limiting the expenditure at the central government level and targeting overall general government spending by 1 percentage point of GDP in 2013 aim to improve the economy. Comprehensive reforms of rights-based benefits are also identified, which are imperative for both medium-term fiscal sustainability and improving the functioning of labor markets.

I. Recent Developments, Outlook, and Risks

1. High frequency indicators point to a further slowing of economic activity. A largely export-led recovery in 2010–11 started to lose steam in early 2012 as growth slowed in Europe, BiH’s largest trading block. Exports fell by 4 percent in the first nine months of 2012 relative to the same period last year, while imports have been flat. Industrial production and private sector employment have also continued to decline in recent months, while credit growth has remained subdued. Inflation is well contained at close to 2 percent, mostly reflecting higher food and energy prices while core inflation is low at around ½ percent. Central bank foreign reserves in recent months have recovered the earlier loss in the year and remain strong at 109 percent of base money. Staff now expects a mild recession in 2012, with real output contracting by ½–1 percent, followed by a modest recovery of around ½ percent in 2013. Inflation is expected to remain around 2 percent in 2013, reflecting weak demand (Table 1).

BiH: Selected High-Frequency Indicators, 2011-12

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Sources: BiH authorities; and IMF staff estimates.

Percent change over the same quarter in previous year.

uA01fig01

BiH: Central Bank’s Foreign Assets

(euro millions)

Citation: IMF Staff Country Reports 2012, 344; 10.5089/9781475583717.002.A001

Source: BiH authorities.

2. Risks are tilted to the downside. An intensification of the euro area crisis would significantly affect BiH’s growth outlook, mainly through its impact on exports, remittances, and capital inflows. Foreign bank subsidiaries’ parent banks could withdraw funding if conditions in home countries deteriorate significantly. A further worsening of credit quality could impede the fragile recovery in bank lending. Exports could also be hampered by a failure to harmonize quality standards ahead of Croatia’s EU accession (see para. 18). The difficult domestic political situation will continue to pose significant risks to program implementation.

II. Performance under the Program

3. All but one performance criteria for end-September 2012 were observed. Both the Institutions of BiH and the central government of the Republika Srpska (RS) met their respective fiscal balance targets with comfortable margins. However, the performance criterion on the Federation central government fiscal balance (the net lending of the Federation central government) was missed, mainly as payments of already planned agricultural support were advanced in light of a severe drought. The indicative target for the balance of the general government was also missed, caused by a faster-than-anticipated pace of spending by the Highway Fund in the Federation and the Health Fund and local governments in the RS ahead of local elections. The authorities request a waiver of the non-observance of the end-September 2012 performance criterion on the Federation central government fiscal balance, as the non-observance was entirely a timing issue. As corrective actions they re-affirmed that the annual spending envelope as defined in the approved budget will not be exceeded, while they will also take steps to strengthen cash management and expenditure controls (see below).

4. Progress in meeting structural benchmarks has been satisfactory. The continuous structural benchmarks pertaining to the adherence to the currency board and the prohibition of introducing new privileged retirement benefits were observed. Regarding the latter, the Federation authorities considered granting privileged pensions to a group of decommissioned soldiers of the army of BiH, whose benefits had been repealed at the level of the Institutions of BiH. Similar groups of veterans in the Federation already receive benefits and the authorities intended to ensure equal treatment. However, when the authorities realized this would violate their commitments under the program, they withdrew the proposal from parliament and agreed to consider this group only in the context of a comprehensive overhaul of the privileged pension system planned for early 2013 (see below), which would be consistent with the intentions of the original program. All structural benchmarks for end-September were met, albeit with delay in some cases. In addition, the required inter-entity payments to settle past disputes on indirect tax revenue allocation were initiated in early September and will continue until end-December 2012. The Federation has completed the payment of accrued rights to the decommissioned soldiers whose benefits were repealed at the level of BiH Institutions—funded from a transfer from the Institutions of BiH budget—and the RS has done so for most of eligible beneficiaries (an end-December 2012 structural benchmark).

III. Policy Discussions

A. Fiscal Policy

5. The authorities are broadly on track to meet the end-year overall deficit target of 3 percent of GDP. Despite the slowdown in economic activity, revenues collected through November have been on target, in part due to efforts to increase tax collection, including publication of the largest VAT debtors. On the expenditure side, the Institutions of BiH, and the Federation and RS central governments are firmly committed to stay within their respective expenditure envelopes, and some under-execution of (capital) spending is likely. Lower-level governments and public companies are also expected to largely stay within their respective budgets and financial plans, due to their very limited capacity to borrow without prior approval. Nevertheless, both entity governments will closely monitor spending outside the central budgets.

6. Fiscal consolidation will continue in 2013, balancing the need for supporting domestic demand with ensuring medium-term sustainability. The 2013 budgets have been based on conservative revenue assumptions, given the weak state of the economy. Despite the weaker growth outlook, a reduction in the general government deficit to 2 percent of GDP—a somewhat larger reduction than envisaged at the time of the program request—is targeted. This faster pace in fiscal consolidation is made possible by strictly containing—and in the case of RS even reducing—current spending at the central government level and owing to a sizable one-off dividend payment to the Entity budgets by the joint electricity company, Transco (equivalent to nearly 0.4 percent of GDP). Excluding this one-off operation, the budgets entail a reduction in the overall structural deficit of 1.1 percent of GDP, a slightly larger adjustment than had been originally envisaged. By firmly containing current spending, the combined State and Entity central government budgets are further moving into a primary surplus, creating room for meeting BiH’s sizable debt service obligations that peak in 2013 and 2014.

uA01fig02

BiH: Debt Services and Primary Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 344; 10.5089/9781475583717.002.A001

Sources: BiH authorities and IMF staff calculations.1/ Excluding foreign-financed investment projects.

BiH: General Government Operations, 2011–15

(Percent of GDP, unless otherwise noted)

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

7. By strictly containing current spending at the central government level, overall general government spending is targeted to shrink by 1 percentage point of GDP in 2013, relative to the projected outturn for 2012. Capital spending is projected to increase marginally. The Institutions of BiH and entity central governments will freeze employment at the 2012 level in 2013. This, along with unchanged base wages in the Institution of BiH and the Federation central governments, as well as a 10 percent cut in civil servants’ wages in the RS central government will reduce the public sector wage bill by 0.6 percent of GDP in 2013, to less than 12½ percent of GDP. In addition, both entities will continue with eligibility audits of recipients of war-related benefits, and ensure that social funds discharge all obligations without incurring arrears or budget overruns. By containing or reducing the wage bills, some room was made for an increase in social and private sector support, to help foster growth and increase social assistance.

8. To mitigate risks to the program, the 2013 budgets were adopted by the respective parliaments as prior actions for this review. This was the first time since the war that the budgets of the Institutions of BiH and the central governments of the Federation and the RS were all adopted before the start of the fiscal year.

9. In the event that downside risks to the economic outlook materialize during 2013, the authorities agreed to continue to adhere to the expenditure envelope, while automatic stabilizers could be allowed to work to some extent on the revenue side. Possible contingency measures on the expenditure side could include a reduction in social benefits and delaying capital spending. Similarly, should the economy grow faster than envisaged and revenues were to over-perform, staff advised the authorities also to continue to adhere to the expenditure envelope, allowing for a faster reduction in the overall deficit.

B. Advancing Public Sector Reforms

10. The authorities agreed that sustainable fiscal consolidation calls for progress in structural public expenditure reforms. The overall fiscal deficit has been brought down substantially in recent years, but this achievement largely reflects across-the-board cuts in the wage bill, benefits, and (privileged) pensions (the latter by lowering the coefficient that links benefit levels to the available financing envelope). While this approach is understandable in the short term, given the urgent need to stabilize public finances, it may not be sustainable over the medium-term as it does not address the need to reduce the size of the government and to stop the expansion of war-related benefits and better target benefits to the most vulnerable. Against this backdrop, staff and the authorities agreed that structural savings should be generated by moving ahead with benefit and payroll reforms. In addition, better control over lower-level governments, extra-budgetary funds, and public companies, together with tax administration reforms, would also help improve government finances.

11. Comprehensive reforms of rights-based benefits are imperative both for medium-term fiscal sustainability and for improving the functioning of labor markets. Notably, benefits to veterans and demobilized soldiers, so-called privileged pensions, which on average are substantially higher than regular old-age pensions, have ballooned in recent years. These benefits not only absorb a sizable share of budget resources, and at times also resources from the regular pension funds—to the extent that pension funds were asked to help fund privileged pensions from their collections of regular pension contributions, thus undermining their own financial viability—but they also adversely affect labor participation. Some progress in reining in these benefits has been made, particularly in the RS, but more remains to be done. Specifically:

  • The Institutions of BiH and the RS will refrain from introducing any new privileged or special retirement benefits. The Federation will do so too, at least until it adopts a new law on privileged pensions (see below). The Institutions of BiH provided funds to the Entities to settle the accumulated benefits of decommissioned army personnel of the Armed Forces of BiH whose benefits were repealed earlier this year.

  • The RS implemented a comprehensive reform of war veterans’ pensions in early 2012, separating the subsidy portion of the privileged pensions from that of regular contributory pensions and making the subsidy portion an allowance to be paid directly from the RS budget. At the same time, these allowances were substantially reduced for many beneficiaries. However, yielding to strong pressure from veteran groups, the government agreed to provide an additional payment to veterans to partially compensate for these reductions. This compensation will remain in place in 2013, but will be gradually phased out in subsequent years.

  • The Federation is preparing a comprehensive pension reform strategy, with the assistance from the Fund and the World Bank, aimed at keeping people longer in the active workforce. Given the challenging demographics, pension reform will need to focus on raising the retirement age, discouraging early retirement, and rewarding later retirement. The authorities expect to adopt this strategy by March 2013.

  • The Federation is also preparing a new law to consolidate the different types of privileged pensions in a single law, and with the aim to establish a system that is financially sustainable and socially fair. As has been done in the RS, the contributory portion of pensions will be separated from the privileged portion. Pension fund obligations would cover only pension entitlements based on years of contributions and age, while any form of special benefits would be paid from the central government budget. The new law will also harmonize privileged pension levels across similar groups and, more importantly, reduce the average level of privileged pensions and introduce penalties for early retirement. The number of beneficiaries is expected to increase somewhat—to ensure equal treatment of similar categories as noted above—but the total budgetary costs will be reduced relative to the 2012 level; the new law will continue to allow for the use of the rationing coefficient to guarantee that privileged pension payments will remain within the overall amount allocated in the central government budget. The adoption of the law incorporating these elements is a new structural benchmark for end-January 2013.

  • Both entities are continuing with the eligibility audits, which have resulted in some structural savings and which will help contain the number of beneficiaries.

  • A centralized database of all beneficiaries of social benefits will be established in the Federation by end-January 2013.

12. Replacing ad-hoc wage restraints with sustainable structural measures in the RS will help contain the wage bill in the medium term:

  • The RS authorities are amending the various laws and regulations that govern wages in different parts of the public sector, with a view to harmonizing them by end-2012.

  • Following this, a centralized payroll system for all employees in the public sector will be set up for improved recording, control, and planning.

  • The RS authorities will amend the legislation to eliminate the take-home pay protection for public sector employees, to ensure that future changes in income tax rates and social contributions do not automatically lead to changes in the gross pay of public employees (a new structural benchmark for end-December 2013).

13. Stepping up control over lower levels of government, extra-budgetary funds, and public companies is needed to help safeguard fiscal sustainability. Expenditure control over lower levels of government is particularly weak in the Federation, given its heavily decentralized structure. In this area:

  • The Federation authorities, with the assistance from the Fund, are preparing a new law on budgets aimed at strengthening control over—and monitoring of—spending by lower levels of government, extra-budgetary funds, and public companies. The new law is expected to be adopted by March 2013 (a new structural benchmark).

  • In addition, the Federation Ministry of Finance will strengthen the unit responsible for the collection and consolidation of lower-level government data, and seek technical assistance from the Fund to improve its cash management.

  • The Federation authorities also plan to accelerate the introduction of treasury systems at lower levels of government and link them to the central government treasury system.

  • Highway funds in both entities have ambitious investment plans. While external borrowing for road projects—as all external borrowing—is subject to strict controls in both entities, the authorities agreed that the spending envelope of these funds should be realistically set, and they need to step up the monitoring and reporting of investment spending by extra-budgetary funds and public companies. Moreover, the authorities will work with Fund staff to strengthen their capacity to conduct debt sustainability analyses and to incorporate the findings more into the decision-making process for new projects.

14. While most structural reforms focus on the expenditure side, the authorities are also taking steps to improve tax administration. Given an already high tax and social contribution burden, the authorities plan to keep the rate structure broadly stable. They will continue to maintain a single VAT rate and refrain from introducing any form of tax expenditure. To strengthen tax administration:

  • The Institutions of BiH and the Entities will improve the exchange of information between the tax administration agencies to help improve compliance. In particular, the four tax administrations will sign a joint Memorandum of Understanding on data exchange by end-May 2013 (a new structural benchmark), with automated systems of information exchange becoming operational in the remainder of 2013.

  • All tax administrations are taking steps to strengthen the large-taxpayer units to ensure that they capture the largest taxpayers and employers.

  • The Indirect Taxation Authority (ITA) will establish a unit in its headquarters with the responsibility for detection and coordination of activities for the prevention of VAT fraud.

C. Mitigating Financial Sector Risks

15. BiH’s banking system has remained relatively stable. Banks have a large deposit base, and the sector as a whole is profitable and has improved its capital adequacy through capital injections and profit retention. Stress tests using end-June 2012 data did not reveal major weaknesses. Nonperforming loans (NPLs) have remained at around 12½ percent, but provisioning stands at 67 percent of non-performing assets, broadly in line with the regional average. BiH banks’ parents are committed to maintain their exposure to BiH, and the data for the first two quarters of 2012 show that parent banks’ exposure to BiH banks has remained broadly stable.

16. The authorities are taking measures to strengthen bank supervision, and will seek further technical assistance from the Fund on practical steps and procedures in the event of banking sector difficulties. Specifically:

  • Given the dominance of foreign ownership in the BiH’s banking system, cooperation with home supervisors is essential. In this context, the Federation authorities have amended the legal framework related to the treatment of confidential information to align it with EU requirements and the RS authorities plan to do this soon (an existing structural benchmark for end-December 2012). This would help to pave the way for the signing of Memoranda of Understanding with the Austrian and Italian banking supervision authorities.

  • In addition, to further strengthen the bank resolution frameworks, the authorities plan to shorten the provisional administration period and to redraft the law governing the Deposit Insurance Agency in line with Fund staff recommendations (existing structural benchmarks for end-December 2012 and end-March 2013, respectively).

  • The authorities are also working to improve their coordination in conducting top-down stress tests and will agree upon a joint Memorandum of Understanding on the stress-testing procedures by end-March 2013.

  • The authorities are in the process of identifying financial institutions that are considered systemically important, and will increase their focus on these institutions, including by conducting bottom-up stress tests.

17. Improving the NPL resolution framework would further enhance BiH’s capacity in crisis resolution. NPL resolution is currently hindered by legal, tax, and institutional shortcomings. The authorities will conduct a comprehensive review of the legal and institutional frameworks, with the assistance from the Fund, in order to create a system that encourages NPL resolution. As part of these efforts, the authorities plan to adopt legislation on factoring—allowing banks to sell loans—and review personal bankruptcy legislation in light of the high level of indebtedness of individuals.

D. Encouraging Private Sector Development

18. Urgent actions are required to harmonize export quality standards ahead of Croatia’s EU accession. Without coordinated efforts by all levels of governments, exports to Croatia, one of BiH’s largest export markets for agricultural products, could be adversely affected when Croatia joins the EU in mid-2013. Against this backdrop, the authorities are working to ensure that a unified set of rules and procedures to guarantee food and animal safety, consistent with EU requirements, is in place by end-May 2013.

19. The authorities will also take further steps to improve the business environment.

The RS authorities are amending a number of laws to create a one-stop-shop for business registration by end-September 2013 (a new structural benchmark). Similarly, the Federation authorities are preparing a new Law on Companies, for adoption also by end-September 2013, and also with the aim to streamline the business registration process. In the meantime, both entities will ensure that business registries will be harmonized and easily accessible.

IV. Program and Data Issues

20. The attached supplementary Letter of Intent describes the authorities’ progress in implementing their economic program and additional policy measures for the remainder of 2012 and 2013 to ensure that program objectives will be met. Quarterly performance criteria through end-2013 and additional structural conditionality are proposed in Tables 1 and 2 attached to the letter.

21. BiH’s capacity to repay the Fund remains good. By the end of the SBA, the level of Fund credit outstanding is projected to be slightly above 3 percent of GDP (13 percent of gross international reserves), and Fund repurchases and charges would peak at 43¼ percent of total debt service in 2013 (Table 10). The country’s good record of meeting Fund financial obligations, and the expectation that the program will lay the foundations for the return to a sustainable medium-term growth path, provide assurances that BiH should be able to discharge its Fund obligations in a timely manner. In addition, while the institutional arrangements in BiH already attach a high priority to meeting foreign debt service obligations, the authorities are amending the Law on Financing of BiH Institutions (a structural benchmark for end-December 2012), to ensure that these obligations can continue to be met in the absence of an adopted budget. Moreover, within one month of these amendments coming into force, the Ministry of Finance and Treasury of BiH and the Central Bank of Bosnia and Herzegovina (CBBH) will sign an agreement to ensure the timely payment of all external debt service obligations.

22. A safeguards mission that visited the CBBH during November 2012 found no major weaknesses. The safeguards assessment of the CBBH is substantially complete. The mission found that the CBBH maintains strong financial reporting and transparent publication of its annual and quarterly financial statements. The CBBH’s foreign reserves management practices and currency operations are well controlled and managed. Internal audit is in compliance with international standards, although the effectiveness of the internal audit function could be further enhanced by adding additional qualified staff. An area with room for improvement is the external audit process, where the CBBH should strengthen its process for the selection of the external auditor and enhance quality control of the audit. In line with the Fund’s safeguards policy requirements for direct budget financing, the Ministry of Finance and Treasury of BiH, the Ministry of Finance of the Federation, the Ministry of Finance of the RS, and the CBBH will sign a Memorandum of Understanding to regulate the disbursements from and servicing of all related obligations to the IMF (a new structural benchmark for end-December 2012).

23. Data provision is improving, but further efforts are needed to address remaining shortcomings. The authorities have notified the Fund of their intention to participate in the GDDS, and a national coordinator has been appointed, a major obstacle that had forestalled progress in this area. With help from STA, BiH should be able to meet the GDDS requirements in the near future. Significant progress has been made—with extensive technical assistance from the Fund—in improving fiscal reporting, but more efforts will be needed to ensure accurate reporting by lower levels of government and extra-budgetary funds, especially in the Federation. Similarly, the authorities have completed the transition of balance of payments data to BPM6, also with assistance from the Fund.

V. Staff Appraisal

24. Bosnia and Herzegovina’s early performance under the SBA has been encouraging. Fiscal restraint continued and policy measures have appropriately targeted expenditure categories that led to large imbalances in recent years. Financial sector policies are focusing on strengthening contingency planning and crisis preparedness. Confidence in the currency board has been maintained, and the international reserve position has strengthened. All but one of the quantitative performance criteria for end-September 2012 were met, as well as the structural benchmarks, albeit with some delay in a few cases.

25. Strict expenditure control remains critical to ensure medium-term fiscal sustainability. The 2013 budgets strike a good balance between supporting growth and the need for medium-term consolidation. With revenue performance still weak and strong expenditure pressures from stakeholders, the authorities are to be commended for their strong commitment to fiscal restraint, as witnessed by their efforts to strictly contain or even reduce current spending in the 2013 budgets.

26. Sustainable consolidation also requires continuing with structural fiscal reforms. Although the government deficits have declined, strong efforts continue to be needed to ensure fiscal sustainability, including by moving ahead with the reform of the privileged pension system in the Federation, and by the streamlining of government ministries and agencies in all of BiH. Additional areas of focus are enhanced control over lower-level governments, extra-budgetary funds, and public companies, as well as steps to improve tax administration. Successful implementation of these reforms will require strong political will.

27. It is essential to remain vigilant to any sign of stress in the financial sector. Staff welcomes steps already taken by the authorities to enhance the monitoring of banks, and to improve crisis preparedness and management. In this context, continued close coordination and cooperation between the CBBH, the banking supervision agencies, and the deposit insurance agency will be crucial to help ensure financial sector stability.

28. Risks to the implementation of the program remain high. Risks range from a fragile domestic political situation and a possible weakening of support for key fiscal structural reforms, to a further worsening of the external economic environment.

29. Despite the risks, in light of the authorities’ actions to date and their policies for 2013 expressed in the supplementary Letter of Intent, staff supports the authorities’ request for the completion of the first review under the Stand-By arrangement. In this context, staff also supports the authorities’ request for a waiver of the non-observance of the end-September 2012 performance criterion on the Federation central government fiscal balance, given the authorities’ corrective actions and commitment to adhere to the end-2012 fiscal targets. Continued adherence to the program will help BiH to achieve fiscal sustainability and a resumption of economic growth.

Table 1.

Bosnia and Herzegovina: Selected Economic Indicators, 2009–17

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Sources: BiH authorities; and IMF staff estimates and projections.
Table 2.

Bosnia and Herzegovina: Real Sector Developments, 2009–17

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Source: BiH, FBiH and RS Statistical Agencies, and Fund staff estimates.Notes: Nominal and real GDP series are based on the production approach.

Based on the BiH Labor Survey. The unemployment rate based on the number of unemployed persons registered in Unemployment Offices is significantly higher.

Table 3.

Bosnia and Herzegovina: Balance of Payments, 2009–17 1/

(In millions of euros, unless otherwise indicated)

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

Based on BPM6.

Table 4.

Bosnia and Herzegovina: General Government Statement of Operations, 2009-17

(Percent of GDP)

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