Public Information Notice No. 05/76

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Bosnia and Herzegovina

June 15, 2005

On May 27, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Bosnia and Herzegovina.¹

Background

Economic activity strengthened in 2004, inflation remained low, and international reserves continue to increase reaching almost 6 months of imports by end-2004. Real GDP growth increased to an estimated 5.7 percent from 4.0 percent in 2003, buoyed by strong regional export market growth, recent large company restructurings in the mining and manufacturing sectors, and continued expansion of credit to the private sector of over 25 percent. Corporate profitability does not appear to have improved in 2004 as increased production was fully absorbed by employment in the Federation and by wages in the Republika Srpska. Domestic savings remain low. But unemployment and poverty rates remain in the mid-20s and over 30 percent respectively.

Alongside, the external current account deficit strengthened modestly. Despite strong export growth of over 15 percent, imports, fuelled by the continued growth of credit, remained buoyant.

The fiscal deficit is estimated at 0.6 percent of GDP, excluding recapitalization of a bank. This is slightly weaker than targeted due to lower than expected customs and excise duties, and slow progress on military demobilization.

Some significant structural fiscal reforms were advanced during 2004, including the unification of customs and indirect tax policies at the State-level, with part of indirect tax revenues pooled into a single account from 2005. These arrangements pave the way for the introduction of VAT from end 2005—with a single rate of 17 percent and an EU standard structure—to replace the dual-sales tax. And a "Fiscal Sustainability Working Group" has recently been established to identify spending efficiencies across all levels of government.

The broader fiscal challenges facing Bosnia and Herzegovina are deepening. Recent court rulings reject key elements of the laws adopted in 2004 aimed at restructuring unsustainable domestic claims on government of more than 200 percent of GDP. This raises the prospect of deep expenditure retrenchment to fund the associated court-mandated debt service on these claims. At the same time, plans to expand the State-level ministries imply significant increases in consolidated primary spending in the near to medium term, and the planned introduction of VAT from end-2005 presents revenue risks. These challenges arise in the context where there remains no domestic institution tasked with controlling the consolidated fiscal balance.

Executive Board Assessment

They welcomed the further advances in economic performance that Bosnia and Herzegovina has made during 2004: real GDP continued to grow strongly; significant fiscal consolidation was achieved; international reserves rose; and consumer prices were flat. There has also been progress in strengthening fiscal structures. This progress provided essential support for the currency board and a good basis to pursue ambitions for EU membership. Notwithstanding these achievements, Directors underscored that Bosnia and Herzegovina continues to face major challenges: persistent fiscal problems, a weak corporate sector, and a large current account deficit, in the context of a currency board. They noted that these challenges pose significant risks, and encouraged the authorities to work closely with the international community to address them. Directors emphasized the importance of institution-building, including self-sustained State institutions.

Directors emphasized that the current account deficit remains a matter of concern, even taking into account Bosnia and Herzegovina's special circumstances and data weaknesses. Thus, they underscored that policies should be geared toward ensuring that it moves toward a sustainable range. In the near term, this will require a continued tight fiscal stance. In the medium-term, maintenance of the tight fiscal stance alongside deep corporate restructuring will be required, the latter aimed at establishing profit seeking behavior and raising domestic savings and exports. Directors stressed that adequate fiscal structures will need to be further elaborated so as to secure the necessary policies. Despite the significant progress on fiscal consolidation, work should continue so as to formulate and administer a consolidated budget with an eye to achieving and underpinning sustainability.

Directors urged the authorities to achieve further fiscal consolidation by targeting a primary fiscal surplus in 2005 and 2006. This represents a minimum goal pending clarification of the additional debt burden implied by the court rulings on domestic claims. In this context, several Directors urged early action to address risks in the 2005 budgets, including unanticipated expenditure increases in the Cantons, plans to increase police pay, the delay in cutting State remuneration levels, and uncertainties in prospects for dividend receipts.

Directors underscored that plans for the 2006 budget should be adjusted as appropriate following clarification of the court rulings. With regard to tax revenues, particular care would be required in addressing VAT implementation and collection risks. In the event that collections exceed expectations, the "permanent windfall" should be applied to reductions in labor taxation. Directors also agreed that the authorities should seek improvements in tax administration, rather than tax increases, as the tax regime is already burdensome.

Directors called for a rapid resolution of the internal debt settlement, with a settlement structure that minimizes the impact on the budget. They cautioned, however, that public expenditure adjustments will be needed in the near to medium term, if as now expected, the court-mandated payouts on domestic claims significantly exceed the 10 percent of GDP in Net Present Value terms anticipated in the 2004 domestic claims laws. This issue, alongside aspirations for a variety of international community supported initiatives, underscores the need to identify offsetting economies in budget expenditure. In this context, Directors welcomed the establishment of the "Fiscal Sustainability Group" to identify such savings. Directors urged that efforts to build State-level institutions should proceed, with close attention to the budgetary implications so as to secure fiscal sustainability.

Directors noted that fiscal challenges also require a marked strengthening of coordinating mechanisms, particularly given the complex governing structure. They noted the establishment of the Indirect Tax Authority (ITA) as an important step in this direction. Directors welcomed as also an important step the establishment of the BiH Fiscal Council with representatives from the State and Entity governments, charged with determining and guiding overall fiscal policies. Directors looked forward to its development into an effective entity to execute budgetary policy. They emphasized that the Fiscal Council will need considerable elaboration to secure coordination and effective decision making in practice. In this context, some Directors noted that the Council would also require legal underpinnings and appropriate deadlock-breaking mechanisms. The Council would also require the support of much-improved and timely macroeconomic data. Directors considered that this should form part of a broader effort to address the serious deficiencies in the quality of macroeconomic data.

Directors welcomed the continued public confidence in the banking system and the authorities' commitment to the currency board. At the same time, they noted with concern the persistence and strength of the growth of credit which, while being supportive of reconstruction efforts, raises prudential concerns. Directors therefore urged the authorities to conduct frequent reviews of credit data and firmly enforce prudential regulations. Banking supervision should be strengthened alongside, notably through early completion of plans to bring the banking agencies into the central bank.

Directors emphasized that the recommended fiscal and external adjustment in 2005-06 is contingent on decisive progress in restructuring the corporate sector and increasing the flexibility of labor market structures. They regretted the slow progress recorded in both areas, emphasizing that this compromises aspirations to curb unemployment and poverty, but they welcomed efforts under way, with the help of the World Bank, to design a comprehensive corporate reform package. Directors urged early completion of these design efforts, paving the way for implementation. They cautioned that the authorities should avoid providing debt relief not linked to sale of companies to strategic investors as this would only prolong corporate sector difficulties.

Directors considered that labor market institutions also need to be transformed to encourage job creation during and after the corporate reforms. In this context, regulations allowing the indefinite accrual of wage rights, regardless of attendance for work, should be rationalized, and restrictions on the dismissal of workers relaxed. Directors were of the view that wage indexation should also cease, so as to moderate wage growth and engender a better balance between wage and employment growth.

Directors urged the authorities to move swiftly to fulfill their intentions to reinstate the regional trade agreements partially abrogated in 2004-05, and, in that context, to intensify their efforts to pursue WTO membership.

Directors welcomed the authorities' interest in a further program arrangement with the IMF and suggested early engagement to that end. Given the external and fiscal challenges ahead, and the ambition of and need for the authorities of Bosnia and Herzegovina to progressively take over responsibilities from the OHR and the IMF, they noted that an adequate fiscal stance, improved fiscal coordinating structures, and significant progress on corporate restructuring would be key. They noted that the objectives of the Fiscal Council and the modalities of its functioning would need to be clearly set out in any program, and that further steps of formal implementation as needed could subsequently be taken as part of program conditionality. Directors also considered that the PRSP should be the focus of reform and development efforts. These efforts should continue to be supported by the Fund working closely with other parts of the international community carrying responsibilities in Bosnia and Herzegovina.