Bosnia and Herzegovina: Staff Report for the 2017 Article IV Consultation, First Review Under the Extended Arrangement Under Extended Fund Facility, Requests for Extension of the Arrangement, rephasing of Purchases, and Waiver of Nonobservance of Performance criterion
Author: International Monetary Fund. European Dept.
Publication Date:
13 Feb 2018
eISBN:
9781484341353
Language:
English
Keywords:
ISCR; CR; Bosnia-Herzegovina; authority; wage bill saving; SDR; accounts payable; private sector; fiscal policy; job creation; balance of payments; Capital spending
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2017 Article IV Consultation, First Review Under the Extended Arrangement Under the Extended Fund Facility, Requests for Extension of the Arrangement, Rephasing of Purchases, and Waiver of Nonobservance of Performance Criterion-Press Release; Staff Report; and Statement by the Executive Director for Bosnia and Herzegovina

Abstract

2017 Article IV Consultation, First Review Under the Extended Arrangement Under the Extended Fund Facility, Requests for Extension of the Arrangement, Rephasing of Purchases, and Waiver of Nonobservance of Performance Criterion-Press Release; Staff Report; and Statement by the Executive Director for Bosnia and Herzegovina

Recent Developments, Outlook, and Risks

A. Context

1. Macroeconomic conditions in Bosnia and Herzegovina (BiH) remain stable, but job creation is inadequate and the income gap with the EU remains wide. BiH has been making progress in reducing internal and external imbalances in recent years, thanks to a prudent fiscal position, driven in part by financing constraints, and a strong monetary anchor provided by the currency board. However, job creation in the private sector has been limited, and unemployment remains high—particularly among the youth. A slowdown in productivity growth since the global economic crisis, and continued emigration, particularly of the young and educated—driven, in large part, by limited job opportunities at home—affect the country’s economic potential. BiH has one of the widest income gaps with EU among the countries in Eastern Europe; the gap has not narrowed significantly over the past decade and a half.

2. The authorities have recently made efforts to undertake structural reforms and advance on the path to EU accession. In 2015, the governments adopted a comprehensive Reform Agenda which sets out the main plans for socio-economic and related reforms of all levels of government. In September 2016, the EU Council accepted BiH’s formal application to become a candidate for EU membership. However, implementation of the Reform Agenda and progress toward EU accession (candidacy) have been slower than expected.

3. The first review of EFF has been delayed by a year, though the extended arrangement has been an anchor for the authorities’ economic policies during this period. In September 2016, the Executive Board approved a three-year extended arrangement under the EFF with BiH for an amount equivalent to SDR 443.042 million (167.06 percent of quota) to support the country’s economic program. The objective of the program is to raise BiH’s growth potential while maintaining macroeconomic stability. The lack of passage of the excise law amendment, which was to unlock external financing for significant multiyear growth enhancing infrastructure investment, became an important reason for the delay in completing the first review, till it was eventually passed in late 2017. While the implementation of some key policies has been slower than envisaged at the time of program request, the authorities have made notable progress in maintaining fiscal discipline, safeguarding financial stability, and improving the business environment.

4. The difficult political situation continues to hinder policy implementation and intergovernmental cooperation. Political gridlock in 2017 combined with BiH’s complex constitutional set-up and weak inter-government cooperation have made it difficult to effect policy changes and implement reforms. The IBiH and FBiH parliaments met sporadically in 2017 due to coalition infighting and ethno-nationalist tensions, slowing the reform momentum. The upcoming general election in late 2018 poses uncertainties.

B. Outlook and Risks

5. Economic growth is expected to pick up over the medium term. While private consumption will continue to be the main contributor to GDP growth over the medium term, public investment is expected to pick up significantly, and this combined with continued implementation of structural reforms are expected to promote private sector activity, allowing growth to rise to around 4 percent by 2022. The recent passage of the amendments to the excise law that increases the duty on fuel products is expected to unlock external financing for significant growth-enhancing infrastructure construction (Box 1). Inflation should moderate slightly to 1.6 percent in 2018 once second-round effects from higher commodity prices in 2017 dissipate, but is expected to pick up to about 2 percent with gradual narrowing of the output gap in medium term. While the current account deficit is expected to increase in 2018–2019 reflecting import needs of the heavy public investment, it should stabilize at around 5 percent of GDP by 2022. The external sector assessment suggests that developments are broadly in line with fundamentals (see Annex II).

Infrastructure Quality and Recent Measures to Unlock Public Infrastructure Investments1

Infrastructure quality in BiH has been lagging regional peers and there is substantial gap compared to the EU. Survey-based indicators suggest that infrastructure in BiH today is of the poorest quality in the region, and that the country saw relatively limited improvement over the past decade. Quantitative indicators show that BiH’s infrastructure gap is substantial, particularly in the areas of transportation—highways and railways—and communication—broadband internet and telecommunications.

A01ufig1

Regional Peers: Infrastructure Gaps, 2015

(percent)

Citation: IMF Staff Country Reports 2018, 039; 10.5089/9781484341353.002.A001

Sources: WDI, EIA, IRF, Eurostat, and IMF staff calculations.Note: Infrastructure Gap Index calculates the gap between a country’s infrastructure and that of an average EU member. A value of Zero reflecting EU-28 average.

The declining share of public investment and weak governance affect infrastructure quality. Since the global financial crisis, public investment in BiH has dropped below the regional average. BiH’s government effectiveness is also much lower compared with regional peers, as per the World Bank’s Worldwide Governance Indicators. There has not been much improvement in these indicators over the past 15 years either and the gap with regional peers has widened.

A01ufig2

Infrastructure Quality Index

Citation: IMF Staff Country Reports 2018, 039; 10.5089/9781484341353.002.A001

Sources: World Economic Forum.
A01ufig3

Government Effectiveness: Percentile Rank

Citation: IMF Staff Country Reports 2018, 039; 10.5089/9781484341353.002.A001

Source : Worldwide Governance IndicatorsNote: Higher rank indicates better outcome.

Tackling BiH’s infrastructure gap through improvements in the efficiency of public investment should lead to higher growth potential. A concerted effort is needed for removing bottlenecks to enhancing domestically-financed capital spending, including through strengthening public investment management frameworks—i.e., to improve planning, allocation, implementation, and monitoring capacities. These measures would ultimately reduce waste and improve efficiency of investments. Budget planning could also be strengthened by using a medium-term approach to public investment, to ensure there is adequate and sustained funding for capital spending.

Recent amendments to the excise law would help mobilize resources for critical growth-enhancing infrastructure investments. Construction of highway Corridor 5C over the next 9 years, at a total cost of about 12 percent of 2017 GDP, will significantly improve transport connectivity within the country as well as with neighbors. The investment would significantly increase GDP growth in short term, with attendant job creation in the construction sector, while also expanding productive capacity and economic potential in the long-run. The excise amendments entail an increase in excise rates on fuel products, including LPG and biofuel, by 15 fenings per liter. The resulting additional tax revenue will be split between entities—FBiH (0.4 percent of GDP) and the RS (0.2 percent)—and would be earmarked to the entities’ highway and road funds to enhance their debt service capacity. A significant portion of the investment is expected to be financed by EBRD and EIB. While most of the 5C investment is expected in the geographical area of the FBiH, the additional revenue from excise tax would strengthen the financial position of the RS Highway Fund to carry out works on the RS sections of that highway, as well as on other roads.

1 “Public Infrastructure in the Western Balkans: Shifting Gears—Opportunities and Challenges,” European Department Paper Series, IMF (forthcoming).

6. Domestic politics poses downside risks while external risks are more balanced. There are elevated risks that political support for sound policies may falter in the run up to general elections in October 2018. With ethno-nationalist politics expected to continue to take center stage in the election season, the risk of a widening chasm in the single economic space and deterioration of regulatory coherence cannot be discounted. Uncertainties surrounding the electoral law in the Federation (FBiH) and formation of governments in the post-election period exacerbate the downside risks. As the extended arrangement serves as an external anchor of economic policies and reforms, a lack of progress in program implementation could lead to deterioration in budget quality and slippages in implementation of structural reforms to reorient the economy toward the private sector, and ultimately compromise BiH’s ability to achieve the medium-term growth objective. On the external front, adverse shocks in Europe could pose spillover risks to BiH, though conversely, a stronger-than-projected growth in Europe or the US would have an upside in BiH (Annex I).

Article IV Policy Discussions

7. Macroeconomic and financial policies should aim to enhance growth potential and address structural weakness, while maintaining economic and financial stability. The economy is experiencing a cyclical recovery but a poor business environment and inadequate infrastructure investment continue to be constraints on private sector development and job creation. Discussions focused on overcoming BiH’s key economic and structural weaknesses with an overarching objective of strengthening the country’s single economic space:

  • structural reforms to boost growth potential and employment by improving the investment climate;

  • reorienting the composition of public spending from wage bill to capital investments;

  • and improving financial regulation framework and enhancing financial stability.

Implementation of Past Fund Surveillance Advice

The 2015 Article IV consultation focused on policies and structural reforms needed to accelerate private sector-led growth and job creation, while ensuing macroeconomic sustainability. The objectives of the extended arrangement under the EFF, approved in 2016, were also consistent with these policy recommendations.

  • Structural Reforms. The authorities have made some progress in improving the business environment and enhancing the functioning of labor market, including by lowering the regulatory burden on enterprises and harmonization of tax laws across the entities. However, the reduction of high labor tax wedge is delayed, and progress in SOE reforms has been slower than expected.

  • Fiscal Policies. Fiscal stability has been maintained, mainly through continued restraint on current government spending. However, progress in improving the composition of government spending has been mixed. There has been limited progress in strengthening controls and quality of spending in lower levels of government, and the problem of arrears has come to light recently.

  • Financial Sector Policies. Measures undertaken to strengthen and safeguard financial stability include modernization of banking sector legislations and addressing banking weakness indicated by asset quality reviews. Coordination and cooperation, including information sharing among financial sector regulators and supervisors has also been enhanced. However, the adoption of the new deposit insurance law is delayed, and reforms of entity development banks has lagged.

A. Structural Reforms to Improve Investment Climate

Background

8. BiH has significant structural deficiencies that put a drag on growth and economic convergence. BiH’s low rate of investment reflects its poor business environment and institution quality. Infrastructure bottlenecks are particularly severe and undermine the country’s attractiveness to foreign investment and private sector development, and thus pose constraints on growth potential (Box 1). Complex and inefficient administrative structures, a fragmented economic space, and high political and regulatory uncertainty exacerbate the high cost of doing business. Unless these structural deficiencies are effectively addressed, the economy’s medium and long term growth prospects will remain weak, and the population’s living standards are unlikely to catch up with those in Western Europe.

A01ufig4

BiH and Western Balkans: Doing Business Overall Rank 1/

Citation: IMF Staff Country Reports 2018, 039; 10.5089/9781484341353.002.A001

Source: World Bank1/ Ranking out of 190 countries. The higher the rank - the less business-friendly the country.

9. Not surprisingly, job creation is weak and emigration has affected economic potential. Despite emigration, the unemployment rate is persistently high (over 20 percent), with youth unemployment above 40 percent. Female labor participation rate is among the lowest in the region, particularly in rural BiH. The low fertility rate, coupled with high rate of emigration of the young and skilled to advanced Europe, worsen demographic pressures and seriously affect economic potential and costs of service delivery (Figures 2 and 3).

Figure 1.
Figure 1.

Bosnia and Herzegovina: Selected Economic Indicators

Citation: IMF Staff Country Reports 2018, 039; 10.5089/9781484341353.002.A001

Figure 2.
Figure 2.

Bosnia and Herzegovina: Jobs and Growth

Citation: IMF Staff Country Reports 2018, 039; 10.5089/9781484341353.002.A001

Sources: Eurostat; country authorities; ILOSTAT; OECD International Migration Database; and UN population estimates.1/ Youth unemployment rate is unemployed (15-24) in percent of active population (15-24). Long-term unemployment is defined as unemployment longer than 1 year in percent of active population.
Figure 3.
Figure 3.

Bosnia and Herzegovina: Investment and Business Environment

Citation: IMF Staff Country Reports 2018, 039; 10.5089/9781484341353.002.A001

1/ Unweighted average of Bulgaria, Croatia, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovak Republic and Slovenia.Sources: BiH authorities; World Bank, World Development Indicators; and IMF WEO.

10. There has been some progress toward strengthening the business environment and reforming the labor market. Harmonization of tax laws across the entities with the aim to improve the business climate has been progressing. To foster inter-entity consistency, the Republika Srpska (RS) parliament adopted amendments to the Corporate Income Tax Law, after the FBiH parliament had done so earlier. The FBiH government has submitted to parliament amendments to the laws personal income tax (PIT) and social security contributions (SSC), which is expected to more closely align labor tax laws with that in RS and reduce the high tax wedge on labor. A new general collective agreement, consistent with the new labor laws adopted in 2015, has been reached in FBiH, and most branch agreements have been concluded in both entities. There has been some effort to improve corporate governance in SOEs, with the FBiH government selling its minority shares in pharmaceutical and tobacco companies and the RS government adopting a restructuring plan for the troubled railway company, in line with World Bank advice. The FBiH government has taken measures to improve the management and cut the operational cost of its railway company, including by reducing employment. Progress in restructuring and/or privatizing large telecom SOEs in FBiH has been slow. Both entities also published the lists of para-fiscal fees, with the aim of reducing the fees and lowering the burden of enterprises.

Policy Advice

11. Achieving high sustained economic growth is critical for job creation and economic convergence, and strong structural reform efforts are needed to achieve these objectives.

  • Upgrading physical infrastructure, particularly in transportation, to address perhaps the biggest constraint on BiH’s economic growth. There is need to reverse the declining trend of public investment in highways and roads infrastructure, including by ensuring timely implementation of the Highway 5C project (Box 1). While financing constraints are binding for public infrastructure investment in BiH, strengthening the efficiency of public investment, and overcoming implementation-capacity bottlenecks to public capital investments could also yield substantial benefits. An improvement in the mechanism of coordinating infrastructure investments within FBiH—central government, cantons and municipalities would be welcome.

  • Lowering the fiscal and administrative burden on businesses. The fragmented administration structure in BiH puts an added burden on businesses through excessive regulation, taxes and local fees. The authorities are encouraged to continue to strengthen the single economic space—through harmonizing regulations and tax laws and better policy coordination between the two entities and lowering the burden of para fiscal fees emanating from overlapping administrations. There is an important need to streamline the process of starting and running a business, an aspect in which BiH fares particularly poorly.

  • Notwithstanding the progress made in reforming the labor market, further measures are needed. The tax on employment, or tax wedge, is a major deterrent in enhancing employment in the formal sector and is ultimately harmful for growth. The FBiH government’s plans to lower the excessively high tax wedge on labor and align it with that in the RS is welcome, and both entities should aim to reduce these taxes further over the medium term. Swift implementation of the bylaws of the new labor laws would also help boost employment. Lastly, the demographic crunch in the labor market is a real threat to BiH’s long term growth prospects. The authorities are encouraged to formulate policies to boost female labor force participation.

  • Improving governance of SOEs and enhancing competition, by advancing SOE reforms including reviving the restructuring process and/or privatizing them.

Authorities’ Views

12. The authorities agreed that structural reforms were critical to enhance growth prospects and recognized the importance of boosting private sector development. They are mindful of the time needed to generate consensus over these reforms, considering the fragmented political and administrative systems and uncertainties related to the upcoming general elections. They reaffirmed their commitment to deepen reforms and address infrastructure gaps and pointed to their recent efforts to boost domestically financed spending on roads and highways. To enhance public investment efficiency, IBiH and FBiH authorities also requested Fund TA on Public Investment Management Assessment. On strengthening the single economic space, they underscored the need to respect constitutional competencies of entities and subnational governments. On SOE reforms, the authorities pointed out that measures to improve governance and management in some companies had started to bear fruit.

B. Making Fiscal Policy More Growth Enhancing

Background

13. There has been larger-than-expected fiscal consolidation since 2014, but progress toward improving the quality of public spending has been mixed. A strong revenue performance helped reach an overall fiscal balance in 2015, compared to a deficit close to 3 percent of GDP in 2014 (Table 4). Since then the fiscal position has turned into surplus, largely a consequence of external financing constraint. Current expenditure has been on a declining trend as a share of GDP, thanks to a general wage freeze and continued hiring restraint (agreed under the EFF). However, capital spending at the entity level has not risen as envisaged mainly reflecting financing constraints. In the RS, fiscal resources were devoted to bringing the pension funds into the treasury system. In FBiH, capital spending has been constrained as the bulk of it is undertaken by the highway company which, until the recent increase in excise revenues earmarked for it, had exhausted its borrowing capacity.

Table 1.

Bosnia and Herzegovina: Selected Economic Indicators, 2013–22

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

Bosnia and Herzegovina: Real Sector Developments, 2013–22

article image
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, 2013–22 1/

(In millions of euros, unless otherwise indicated)

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

Based on BPM6.

Table 4.

Bosnia and Herzegovina: General Government Statement of Operations, 2013–22

(In percent of GDP)

article image
Sources: BiH authorities; and IMF staff estimates and projections.
A01ufig5

Public Investment

(in percent of GDP)

Citation: IMF Staff Country Reports 2018, 039; 10.5089/9781484341353.002.A001

1/ SEE-XEU includes ALB, MKD, MNE, SRB, and UVK.Sources: WEO and IMF staff calculations.

14. The 2018 budgets envisage continued current spending restraint and measures to boost public capital spending. These budgets continue to maintain fiscal discipline and move away from current spending—the wage bill will continue to fall as share of GDP—and, in the case of FBiH, move towards raising growth-enhancing capital spending. As part of the FBiH government’s objective to increase domestically-financed investment in public infrastructure, the authorities plan to allocate resources towards investment in high-use roads and highway projects. Financing for these projects will come mainly from special dividends of a few SOEs with accumulated surplus.

15. Near term fiscal risks appear limited, but public sector arrears pose significant challenges. The BiH public sector is accumulating sizable arrears. In the RS these stem mainly from the health sector. The documentation of arrears in FBiH is more difficult because of its heavily decentralized fiscal structure (Box 3). While BiH’s overall public debt level is relatively low, health sector and SOE arrears ultimately pose large contingent claims on budget resources.

Policy Discussions

16. A broadly balanced structural fiscal position over the medium term is warranted. As the output gap closes, this will also enable the debt-to-GDP ratio to stay comfortably below 40 percent over the medium term, thus rebuilding fiscal buffers. During 2018–19 this would entail running down part of the modest fiscal surpluses, with domestically-financed public investment starting to scale up in line with implementation capacity limitations. The unused fiscal space should be preserved in the form of a temporary structural surplus.

17. Fiscal policy should continue to focus on further lowering current spending and raising growth-enhancing capital expenditures in a sustainable manner. The government is encouraged to continue with public sector employment reforms, including by conducting functional reviews of employment at ministerial and departmental levels. Wage bill savings should be channeled to boost capital spending (Annex III). Unlocking the external financing for highway construction, through the recently adopted increase in the excise tax on fuels, is essential to upgrade infrastructure. The sweeping of surplus of SOEs in FBiH to finance such investment in 2018 provides a welcome infrastructure boost. But the lack of clarity about maintaining such funding beyond 2018 and the administration of these funds outside the single treasury account, argue for caution when implementing this approach.

18. Strengthening PFM framework will be crucial for mitigating fiscal risks and ensuring fiscal sustainability. Arrear accumulation in the public-sector reflects a lack of fiscal discipline and accountability in subnational governments, extra-budgetary funds, healthcare systems, and SOEs. The authorities should strengthen the PFM framework to tackle these issues. Measures in RS should include cutting cost, improving efficiency, and rationing the health network. The FBiH should enhance its capacity to document and monitor arrears, improve the treasury system, and strengthening implementation of commitment control. While bringing arrears accumulation to a stop and clearing existing arrears is likely to be a multi-year process, reforms should commence promptly.

Public Sector Arrears

The ongoing arrear accumulation reflects structural problems in the health sector and weakness in the public financing management (PFM). In the RS, spending on public health is high and is not yielding good value-for-money. Improving efficiency is therefore high priority. While the RS Health Insurance Fund has already made progress in reducing outstanding arrears, the main underlying cause of health facility arrears is fragmented accountability, and lack of incentives for and monitoring of facility and manager performance. Moreover, the network of facilities is inefficient and has overlaps in service provision while health facilities are overstaffed with an excess of nonmedical workers. In FBiH, SOE reform should be the cornerstone of arrears reduction. In the FBiH general government, the starting point is improving arrear reporting and monitoring, followed by PFM reforms that strengthen commitment controls, improve cash management, upgrade the treasury financial management information system, reduce delays in processing of payments, and close gaps in the PFM legal framework and regulations.

The authorities have initiated various measures. The RS authorities have undertaken substantial work that aims at expanding the treasury system to health centers, thereby improving commitment controls in the health sector. In the Federation, the authorities are introducing budget information systems at the cantonal and municipal level, and the focus is currently on improving documentation and reporting of the stock and flow of overall public sector arrears.

Authorities’ Views

19. The authorities reconfirmed their commitments to maintain a prudent fiscal position and improve the composition of fiscal expenditure. The FBiH government emphasized that the planned domestically-financed road projects reflect its commitment to reduce the infrastructure gap. The authorities view the risks of using SOEs retained earnings to finance the projects as manageable and do not expect the operation to affect the financial health of SOEs. Regarding the administration of these funds outside the single treasury system, these funds will be subject to audits and be handled similar to externally-financed project accounts.

20. The authorities also agreed that decisive measures are needed to tackle the issue of public sector arrears. The RS government recognized that the arrears of the health sector are serious and could pose significant fiscal risks, but see a solution to the problem as part of larger health sector reform. The FBiH government views the arrears problem as outside its immediate mandate, since the majority of arrears is in public enterprises of cantons on which it has limited control. They also emphasized that the documentation of arrears, which is difficult for the FBiH, should be completed with IMF and WB assistance before a strategy to lower arrears creation can be formulated.

C. Safeguarding Financial Stability and Improving Regulatory Framework

Background

21. The banking system is broadly stable, but vulnerabilities remain. The sector is adequately capitalized and liquid at the aggregate level. Credit to the private sector has grown strongly at 7.5 percent in 2017 (to October), with a pickup in lending to corporates as well. The quality of bank loan portfolios continues to improve, but the non-performing loans (NPLs) to total loan ratio remains elevated at about 11 percent in 2017:Q3. The recently completed detailed bank AQRs revealed some shortcomings in banks’ risk management and supervisory practices. A fragmented market and high regulatory costs also pose constraints on the country’s banking sector; not surprisingly, bank profitability is the lowest in the region. Low profitability and balance sheet weakness have hindered banks’ ability to support economic recovery (Annex IV).

A01ufig6

Capital Adequacy Ratio

Citation: IMF Staff Country Reports 2018, 039; 10.5089/9781484341353.002.A001

A01ufig7

Liquid Assets to Total Assets Ratio

Citation: IMF Staff Country Reports 2018, 039; 10.5089/9781484341353.002.A001