Public Information Notice No. 98/49

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

July 14, 1998

On May 29, 1998, the Executive Board concluded the Article IV consultation with Bosnia and Herzegovina¹.

Background

War began in Bosnia and Herzegovina in early 1992, shortly after independence, and ended with the signing of the Dayton peace treaty in December 1995. The new Constitution enacted as part of the Dayton treaty provides for a decentralized governmental structure. The central ("State") government has limited powers and a balanced composition among the three major national groups. The State’s economic responsibilities are confined to monetary and exchange rate policy, external borrowing and debt service, and foreign trade and customs tariff policy. Functions not explicitly assigned to the State are reserved for the country’s two constituent Entities--the Federation and the Republika Srpska (RS)--or their sub-units.

The economic and social situation in Bosnia and Herzegovina is difficult. The war caused widespread damage to infrastructure and productive capacity and much of what remains is obsolete. Out of a pre-war population of over 4 million, an estimated 250,000 persons are missing or dead, more than 1 million are refugees overseas, and about half the remaining inhabitants have been displaced from their homes. Economic recovery has been based largely on the reconstruction effort, buttressed by external financial assistance. Real GDP is estimated to have grown by about 50 percent in 1996 and 30 percent in 1997, but remains only about half its level in 1990. The pickup in economic activity has been stronger in the Federation than in the RS, owing mainly to the Federation’s relatively greater access to foreign aid. Country-wide unemployment is estimated at around 40 percent of the labor force.

The Dayton treaty provided a timetable and procedures for the early stages of the peace process, including the deployment of an international peacekeeping force, the withdrawal and partial demobilization of each Entity's armed forces, and elections. These events generally proceeded on schedule. In contrast, the implementation of civilian aspects of the treaty has been slow and incomplete. Country-wide presidential and parliamentary elections were held in September 1996, and the State Council of Ministers was named in January 1997. In June 1997 the Parliament adopted the so-called "Quick-Start Package" (QSP) of key economic laws on the central bank, the 1997 budget, external debt, trade and customs tariff policies. However, the implementation of most of these laws did not begin until 1998, owing to a political crisis that emerged in the RS in June 1997.

Following the resolution of this crisis in January 1998, there has been a marked improvement in inter-Entity cooperation and the functioning of the State institutions. This has enabled the authorities to adopt a country-wide economic program, based on the maintenance of cautious macroeconomic policies, the rebuilding of public administration, market-oriented structural reforms, and a well-coordinated reconstruction program financed by large-scale external assistance on concessional terms.

The central macroeconomic element of the program is a currency board arrangement, as mandated under the Dayton treaty. The Central Bank of Bosnia and Herzegovina (CBBH) will act as a currency board for at least its first six years, issuing a new domestic currency, the convertible marka (KM), in exchange for deutsche marks (DM) at the fixed exchange rate of one KM per DM. The CBBH began partial operations in August 1997 and its functions have recently been extended to all regions. The choice of a currency board arrangement for the immediate postwar period was motivated by the need to restore trust, which militated against monetary arrangements requiring frequent decision-making on sensitive matters; concerns over the lack of administrative capacity; and recognition of the role that transparency could play in reinforcing fiscal discipline. In support of the currency board arrangement, budgets in all regions are designed to avoid domestic borrowing.

Priority structural measures under the program include banking reform; enterprise privatization and restructuring; pension, health system, and social safety net reforms; development of the legal framework for a market economy; implementation of a simplified customs tariff system; exchange and trade liberalization; and the strengthening of economic statistics. The authorities are drawing upon the assistance of the EU, Office of the High Representative, World Bank, IMF, US government, and other governments and institutions to address governance issues.

Since late 1994 monetary policy in all regions, even prior to the establishment of the new Central Bank, has been based on avoiding the use of bank credit to finance budget deficits and limiting access to central bank liquidity facilities for commercial banks. The growing success in implementing this policy, along with improved access to imported goods following the cessation of hostilities, led to a sharp improvement in inflation performance. Until recently both monetary and fiscal policy were fragmented into three regional arrangements, operating with the Bosniandinar, the Croatian kuna, and the FR Yugoslav dinar. The deutsche mark circulates widely in all parts of the country.

With the assistance of the World Bank, EU Commission, IMF, and EBRD staffs, the authorities formulated a US$5.1 billion priority Reconstruction Program for 1996-99. Aid commitments in support of this program during 1996-98 have totaled US$4.3 billion, with disbursements of over US$1.8 billion in 1996-97.

Executive Board Assessment

Executive Directors welcomed the progress that had been made in establishing the common institutions of Bosnia and Herzegovina, including the central bank, the state budget, and laws on external debt, investment, trade, and customs tariffs. Directors noted that, along with the recent strengthening of cooperation between Bosnia’s two constituent Entities—the Federation and the Republika Srpska—the establishment of these common structures had made it possible for the authorities to formulate a credible country-wide program of macroeconomic and structural reform. In that context, Directors welcomed the measures that had been adopted at the beginning of the program, which gave evidence of the authorities’ commitment to its sustained implementation.

Directors endorsed the authorities’ economic strategy, which is based on (i) the use of a fixed exchange rate as a nominal anchor, through the currency board arrangement; (ii) a fiscal policy that avoids domestic borrowing while being as supportive as possible of reconstruction and social needs; (iii) acceleration of the transition to a market economy through structural reforms; and (iv) the mobilization of large-scale external assistance on concessional terms. They considered that the choice of a currency board arrangement is appropriate in the case of Bosnia and Herzegovina, in view of the difficulty of establishing trust in discretionary policy actions in the postwar environment, and given the country’s limited administrative capacity. Directors considered that the new central bank and domestic currency could play a major role in political and economic reintegration and help to establish an environment more conducive to economic recovery. In this regard, they welcomed the various measures that have recently been taken to ensure that the financial transactions of the National Bank of Bosnia and Herzegovina (NBBH) will no longer pose further risks to the operation of the currency board, and they stressed the importance of full and timely implementation of the liquidation plan for the NBBH. Directors also urged the authorities in all regions to show strong support for the operation of the currency board.

At the same time, Directors stressed that adoption of a currency board arrangement places a high premium on the maintenance of fiscal discipline, wage moderation and labor market flexibility, and additional structural reforms to promote sustainable growth. The structural agenda will need to cover tax policy and administration, budget procedures, the trade regime, the financial and enterprise sectors, and other legal and institutional underpinnings of a market economy. Both to forestall further difficulties in the banking sector and to help put commercial banks in a position to serve as effective financial intermediaries, Directors considered it essential that the strategy for banking reform and the strengthening of supervision be implemented quickly in both Entities—in part through the timely adoption of new banking laws—and that a fundamental restructuring of the payments system be readied for adoption inthe coming year. Directors also stressed the importance of prompt implementation of a complementary framework for enterprise reform and privatization. They underscored that actions in these and other structural areas should be implemented on a consistent basis in all areas of the country. They expressed the hope that the authorities will approach the structural reform agenda in a comprehensive and determined manner, to establish a track record of policy implementation that could pave the way for the adoption of a program supported by arrangements under the Enhanced Structural Adjustment Facility.

While welcoming the progress made so far in putting in place the new fiscal structures called for under the Dayton and Washington peace treaties, Directors stressed the importance of making them fully operational and eliminating the vestiges of temporary wartime administrations. They also noted the urgent need for harmonization of tax policies and mutual assistance in tax and customs administration, which would require more effective inter-Entity cooperation on fiscal matters. While balancing budgets on a cash basis had helped to secure a major improvement in inflation performance, Directors agreed that sustaining fiscal discipline would require growth-oriented tax reforms, the restructuring of the pension and health systems, a more effective and targeted social safety net, and measures to avoid further domestic arrears and to eliminate existing arrears.

Directors noted the actions that had been taken, with the support of the international community, to address problems of governance such as tax and customs tariff fraud and the diversion of revenues into parallel political structures. They nevertheless were of the view that governance issues posed risks to the implementation of the program, and called upon the authorities to intensify their efforts to promote transparency, establish a more adequate legal framework, and detect and prosecute official corruption.

Directors welcomed the decision to embrace exchange and trade liberalization as a key to increased economic efficiency and competitiveness. They called upon the Entities to implement fully the common customs tariff regime, abolish inconsistent surcharges, and align preferential trade agreements with neighboring countries with the country-wide trade policy.

Directors noted that Bosnia and Herzegovina faced substantial balance of payments financing requirements, associated with its depressed export capacity, urgent reconstruction projects, and the need to reconstitute foreign exchange reserves and normalize relations with external creditors. In this regard, they welcomed the assistance pledged by the international community in support of the peace and reconstruction processes. They noted, however, that balance of payments assistance fell short of the amount sought under the program, and they called on external donors and creditors to help address the remaining financing gap on appropriately concessional terms and in a timely manner.