Public Information Notice No. 02/29

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Bosnia and Herzegovina

March 22, 2002

On February 25, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Bosnia and Herzegovina.¹

Background

After several years of double-digit growth rates, real GDP increased by about 5.5 percent in 2001. The growth slowdown was particularly marked in the Republika Srpska, where output grew by just 2 percent. The slowdown—which is partly due to lower aid-financed reconstruction spending—marks the end of the post war economic rebound. Industrial production is still less than half its pre-war level and measured unemployment remains high at 40 percent. Inflation, which has been close to zero in the Federation for several years, declined in the Republika Srpska in 2001, reaching 8 percent.

Strong export growth and a reduction in aid-financed imports helped reduce the external current account deficit in 2001. While the deficit remains large, it continues to be financed largely by non-debt creating flows, primarily grants. Debt cancellation in 2001 helped lower the external debt burden: the external public debt ratio declined to 54 percent of GDP at end-2001.

In 2001 the two entities started to reverse fiscal imbalances that had worsened in previous years. Fiscal discipline was improved in both entities. The net accumulation of arrears was halted in spite of lower-than-anticipated external assistance and some arrears were repaid, although public sector wages rose more than planned. Pension entitlements were reduced to affordable levels in both entities, ending the accumulation of pension arrears, and a start was made in clearing pension arrears accumulated in the past. Lower sales tax rates put the canton budgets under pressure, however, and the cantons encountered expenditure arrears. Expenditure by the State budget increased significantly in 2001, to about 3 percent of GDP, reflecting an increase in the role of State institutions (including the State Border Service).

Tax and structural fiscal reforms moved ahead in 2001. A reform of the sales tax brought full harmonization of indirect taxes and was a step towards creating a single economic space. The reform also eliminated virtually all sales tax exemptions, and significantly reduced the effective indirect tax rates. However, the entities continue to impose excise taxes on inter-entity trade, and work on a VAT remains stalled. In the fall, the Republika Srpska overhauled the system of direct taxes. In both entities, new treasury systems came on line in January 2002 and the tax administrations are being modernized.

The currency board arrangement has continued to deliver low inflation. Confidence in the Konvertibilna Marka (KM) has continued to increase, as shown by the trend increase in demand for the KM at the expense of foreign currency. The prospect of the introduction of euro notes accelerated the increase in the demand for KM in late 2001, though this may be temporary. The changeover to the euro has been managed smoothly by the Central Bank of Bosnia and Herzegovina.

Banking sector development is well advanced in the Federation but still at an early stage in the Republika Srpska. In the last three years, foreign banks have opened branches in the Federation and bank privatization has moved ahead. An agreement reached in December 2001 sets the stage for the privatization of PBS, the Federation's largest banking group. In the Republika Srpska, three large state-owned banks experienced difficulties in 2001. One has been privatized and discussions on the resolution of the other two are ongoing.

Bosnia and Herzegovina has continued to liberalize its trade regime. Under the framework of the June 2001 Memorandum of Understanding signed by the countries of South East Europe, Bosnia and Herzegovina signed free trade agreements with Macedonia, Slovenia, and the Federal Republic of Yugoslavia. Moreover, an agreement with the European Union has given Bosnia and Herzegovina goods free access to the European Economic Area.

Executive Board Assessment

Directors welcomed the continuing decline in inflation in Bosnia and Herzegovina the stability of, and increased demand for the local currency, the convertible marka, and the return of confidence in the banking system. However, they expressed concern about the slower real GDP growth and continued high unemployment. Noting the need to attain sufficient and sustainable growth and a reduction in poverty, and taking into account the anticipated decline in foreign aid, Directors urged the authorities to take further measures to strengthen the private sector, which would need to be the engine of growth in the future. In that connection, a dynamic private sector would require sustained macroeconomic stability with a sound fiscal footing. It would also require a strengthened business environment, including a consistent and transparent legal framework in both entities that encouraged good governance and created a level playing field. Directors also considered such measures to be key to fostering foreign investment. The harmonization of the administrative and legislative rules and regulations between the two entities toward European Union and international standards, would help support the business environment, foster economic integration, and facilitate the country's eventual membership in the EU.

Director emphasized that the currency board arrangement remains important for macroeconomic stability. It had created a strong and stable currency, and important positive feature of the business climate. Directors therefore urged the authorities to continue to implement currency board rules strictly and to strengthen the capital of the Central Bank of Bosnia and Herzegovina.

The viability of the currency board depends crucially on a sound fiscal policy, Thus, Directors urged that fiscal consolidation be continued in 2002. The reduction in the general government deficit, the efforts to halt the accumulation of arrears, and the improvements in budget management and transparency should all be sustained. In this context, Directors urged the authorities to base their 2002 budgets on realistic projections of revenue and financing, and to take into account the likely short-term costs of the planned military demobilization. The entities' new treasuries needed to tightly control budgetary commitments, and local government budgets, including in the Federation cantons, needed to be monitored closely.

Directors noted that the medium-term public expenditure outlook was clouded by expensive entitlement programs, by sizeable public debts (including arrears and frozen foreign currency deposits), and by the need to substitute domestic resources for donor-financed reconstruction. They urged the authorities to reform veterans' benefits, and to develop plans to clear arrears and frozen deposits on terms that do not overburden the budget.

Directors stressed that an integrated, country-wide value-added tax was needed in order to put budget finances on a sound footing, and they urged the authorities to work with the staff in its design, including with technical assistance. The entities needed to end the double-imposition of excise taxes, and to begin allocating excise revenues to the entity in which the taxed product was consumed.

Directors welcomed the increasing role of State institutions, and noted that the system of intergovernmental transfers would need to be changed to accommodate a larger State. The present system of entity transfers to the State should be replaced by a more stable and predictable source of "own" revenues for the State. Meanwhile, the States authorities needed to strengthen budget management and eliminate redundancy and overstaffing.

Directors stressed the importance of modernizing the entity tax administrations, and ensuring they were adequately financed and given effective and independent leadership.

However, they noted that the Federation still needed to enact the relevant supporting legislation for those administrations. Also, a more forceful anti-smuggling effort on excisable goods was needed.

Directors urged the authorities to improve conditions for private sector-led growth, concluding removing administrative obstacles to running a business, enforcing property rights, and keeping labor markets flexible. Privatization of strategic enterprises in both entities should also be accelerated. Directors, urged the authorities to resist pressures to jump-start the economy with inefficient fiscal measures, such as subsidies or employment incentives.

Directors noted that the banking system in the Federation had been strengthened by privatization and the increasing presence of international banks. They urged the authorities of the Republika Srpska to close problem banks or sell them to qualified investors. Directors considered bank supervision would be strengthened by centralizing supervision at the national level. The authorities' efforts to eliminate funding sources for terrorism and to prevent money-laundering were welcomed, and further steps in this area were encouraged.

Directors expressed concern that published economic data, including basic macroeconomic data, was still too weak to form a good basis for policymaking. They urged the authorities to provide the statistical institutes with sufficient resources, to improve cooperation between the institutes, and to use available technical assistance effectively.

Directors welcomed the lowering of trade barriers through participation in free trade agreements in the region.

Directors encouraged the authorities to work closely with the staff to prepare the ground for a future Fund-supported program.