A quarterly magazine of the IMF

March 2002, Volume 39, Number 1

In the wake of the Kosovo crisis, the countries of Southeastern Europe have made great strides, although they still have to catch up with their neighbors in Central and Eastern Europe. What form should their reform agenda take, and what lessons can the international community draw for helping other postconflict regions?

The Kosovo conflict of 1999 was short, but it was painful and costly. Besides the many lives that were lost, nearly one million Kosovars (about 45 percent of the prewar population of the province) were displaced either inside Kosovo or in neighboring countries. There was extensive damage to property, especially the housing stock and public infrastructure, primarily in Kosovo but also in the rest of the Federal Republic of Yugoslavia. The conflict and attendant international sanctions on the Federal Republic of Yugoslavia also disrupted transportation and normal economic links among the countries of Southeastern Europe: Albania, Bosnia and Herzegovina, Bulgaria, Croatia, the Federal Republic of Yugoslavia, the former Yugoslav Republic of Macedonia, and Romania (see map).

For the international community, the immediate priority was to avert a humanitarian crisis, and it successfully did so. But by stepping back and taking a long-term regional approach, it also sought to develop solutions that could help achieve lasting peace and strengthen all of Southeastern Europe's economies. This approach went well beyond the reconstruction and upgrading of shared infrastructure, such as bridges and road networks. It also aimed at fostering "peace, democracy, respect for human rights and economic prosperity," in the words of the Cologne document of June 10, 1999, that created the Stability Pact for South Eastern Europe.

Although it is early days, the region is showing encouraging signs of economic recovery—in the form of higher growth, lower inflation, and reduced current account deficits. The priority now for policymakers is tackling major economic challenges if the region is to catch up with its European neighbors, and it is well positioned to do so. In retrospect, therefore, the Kosovo crisis and its aftermath were a defining time for Southeastern Europe. Can the international community draw lessons from it that will help it deal with regional conflicts elsewhere? The answer appears to be yes.

What happened

In purely economic terms, the conflict was not the catastrophic external shock that many had feared at the outset. Economic sanctions closed the borders of the Federal Republic of Yugoslavia and disrupted regional trade routes, with export receipts for the region as a whole declining by about 7 percent during 1999. But the slowdown in economic growth was short lived, although recovery was uneven (see chart). The Federal Republic of Yugoslavia was hardest hit, with real GDP declining by about 15 percent in 1999. Postconflict growth was also negative in Croatia and Romania, and it slowed considerably in Bulgaria, but the causes of these developments were principally domestic. The fiscal impact of the crisis was limited by the rapid return of refugees and the international community's considerable financial contribution toward meeting the humanitarian costs of refugee flows.

This generally benign picture of events, however, belies the risks that the Kosovo crisis presented to its neighbors. It could easily have triggered macroeconomic instability and a reversal in structural reform efforts. All countries in the region suffered from fragile market institutions and had rather checkered reform records during the 1990s.

What helped prevent this worst-case outcome? Certainly, the domestic policies of individual countries helped greatly. Policymakers avoided taking hasty short-term measures that might have temporarily boosted output but threatened long-term efficiency and stability. Although policy implementation varied from country to country, there was no significant backtracking in any of them. Indeed, most countries maintained macroeconomic stability and structural reform momentum throughout the crisis. The exception, of course, was the Federal Republic of Yugoslavia, where reforms did not start until after the fall of the Slobodan Milosevic regime.

The international community also played a vital role in keeping the region's economies stable—not least through generous contributions of almost 20 billion euros to the region during 1999-2001 for humanitarian assistance, reconstruction, economic development, and budgetary support (see table). In April 1999, donors asked the European Commission and the World Bank to coordinate all bilateral and multilateral aid for reconstruction and development in Southeastern Europe. In addition, the Group of Eight industrial countries created a high-level steering group to oversee this effort. In May 1999, the European Union (EU) established the stabilization and association process to provide a clear path for the integration of Albania and the countries of the former Socialist Federal Republic of Yugoslavia that did not already have candidate status agreements with the EU. In June 1999, the international community put in place the Stability Pact for South Eastern Europe, which provides a forum for cooperation among countries of the region, the major industrial countries, and the international financial institutions. Its work focuses on democratization and human rights, economic reconstruction, and security.

As part of this international effort, the IMF and the World Bank stepped up their operations in the region. The IMF boosted its financial assistance to countries affected by the crisis in keeping with its continued support of macroeconomic stability and structural reforms. This assistance, which totaled $1.8 billion as of the end of 2000, has included Stand-By Arrangements in Bosnia, Croatia, Romania, and—beginning in June 2001, after an Emergency Post-Conflict Assistance program that was approved in December 2000—the Federal Republic of Yugoslavia; an Extended Fund Facility (EFF) Arrangement in Bulgaria; a Poverty Reduction and Growth Facility (PRGF) Arrangement in Albania; and, until the recent insurgency crisis, a PRGF/EFF Arrangement in the former Yugoslav Republic of Macedonia. The World Bank has increased its provision of policy advice, grants, and loans, with its financial assistance to date totaling $2.4 billion.

Following the end of the conflict in June 1999, the international community sought to provide humanitarian aid and establish a secure environment for returning refugees. Relief agencies distributed food aid to about 900,000 people in Kosovo—almost half of the population—throughout the winter of 1999-2000. Over 90,000 shelter kits and other materials were provided for home reconstruction, and emergency repairs were carried out to Kosovo's health facilities and its road, energy, and water-supply networks. These efforts were successful, and by July 2000, the humanitarian emergency in Kosovo was deemed to be over. This remarkable achievement was marred, however, by the postconflict expulsion of 210,000 people—Serbs and members of other non-Albanian ethnic minorities—from Kosovo. Although large numbers of displaced persons still remain, primarily in the Federal Republic of Yugoslavia, the priority has shifted from addressing their problems to achieving economic reconstruction.

Over time, the political climate in the region has improved considerably. Two and a half years later, free elections have taken place in all countries, and governments have changed in an orderly fashion. In some cases—notably Bosnia and Herzegovina, Croatia, and the Federal Republic of Yugoslavia—power has shifted from political groups offering inward-looking, nationalistic agendas to liberal groups committed to creating competitive market economies. Even so, significant political risks remain. The recent insurgency crisis in the former Yugoslav Republic of Macedonia reminds us that continuing ethnic conflict can wreck economic development. In Kosovo, despite the first democratic elections last November, ethnic tensions continue to challenge stability and recovery. In Bosnia and Herzegovina, state institutions still function poorly, and cooperation between the two subnational entities—the Federation of Bosnia and Herzegovina and the Republika Srpska—remains far too limited.

On the economic front, Southeastern Europe has benefited greatly from the restoration of peace and stability. Economic growth rebounded in 2000 and 2001—averaging some 4 percent annually during the first half of 2001—and inflation has edged downward in all countries. Current account deficits have remained high, but they did narrow somewhat during 2000. Moreover, countries have made great strides toward greater economic integration, both with the rest of the world and within the region, as they have embraced trade liberalization. In May 1999, the European Commission provided Southeastern European exporters with duty-free access to EU markets for virtually all of their products. In June 2001, all countries in the region signed a memorandum of understanding that will establish a network of bilateral free trade agreements by the end of 2002.

Challenges ahead

Yet the reality is that Southeastern European countries still lag far behind their Central and Eastern European neighbors. The transition in Southeastern Europe was slow getting off the ground; reforms were timid; and implementation was fitful. The successor states of Yugoslavia were war torn, and Albania was affected by internal strife. Consequently, per capita incomes in Southeastern Europe are less than half those in Central Europe. If the region hopes to catch up, its policymakers must aggressively tackle five key challenges.

Reducing external vulnerability. This is the single biggest macroeconomic risk. The current account deficits in Bosnia and Herzegovina, the former Yugoslav Republic of Macedonia, and the Federal Republic of Yugoslavia are too high to be sustainable in the long run. They are now financed largely by concessional capital flows, but these will gradually decrease over time. The global economic slowdown, especially in Western Europe, further clouds prospects.

Improving governance. The region suffers from extensive corruption and organized crime. Problems range from tax evasion to corruption, extortion, and money laundering. Although anticorruption initiatives have started in most countries, institutional development is rudimentary, administrative capacity is weak, and many countries have not yet adopted international conventions against corruption. Although the management of public finances has strengthened recently, some countries clearly lag behind their neighbors. Institutions are still fragile and good practices have not yet become ingrained. Southeastern European countries have also passed legislation to reform recruitment and performance standards in the civil service. Nevertheless, implementation remains weak and supporting institutions need to be created to train and manage the civil service.

Developing the private sector. Although the region has taken some major steps to develop the private sector, progress is uneven. Enterprise restructuring and privatization are now advancing, although certain countries are still privatizing small enterprises while others are planning sales of large state-owned enterprises and utilities. All countries have improved their legal frameworks for private economic activity, but implementation remains weak and corporate governance standards are low. Efforts to create an efficient regulatory framework for public utilities and attract private participation in the rebuilding and improvement of infrastructure also need to receive high priority.

Reforming the financial sector. After years of persistent banking crises, the region's financial sector has gradually revived. The entry of foreign banks, better supervision, and the creation of credible deposit-insurance schemes have all improved bank intermediation. State ownership in the banking sector is declining rapidly; some countries have yet to close insolvent banks, however, and the privatization of more viable state-owned banks is not complete. Efforts to strengthen financial sector supervision are under way in all Southeastern European countries. Achieving and maintaining high supervisory standards will be a challenge, but the internationally accepted standards—notably the Basel Committee's 25 Core Principles for Bank Supervision—and the EU Banking Directives provide a clear blueprint for reform. Developing the region's capital markets is an important goal for the medium term, but it will take time and require considerable external technical assistance.

Attracting foreign direct investment. The region has a poor record of attracting foreign direct investment: it received just over $300 per capita of such investment, compared with about $1,200 per capita in Central Europe and the Baltics, during 1989-2000. Despite an improving investment climate throughout the region, foreign investment inflows continue to be small. Even so, as political risk continues to diminish and reforms proceed, the region should become more attractive to foreign investors.

Lessons learned

What lessons can be drawn from the recent experience of Southeastern Europe?

First, the compassionate, swift, and far-reaching regional approach represented a major innovation in the international community's relationship with Southeastern Europe. Previously, crisis intervention had been overly reactive and tended to have a short time horizon. By adopting a regional approach, the international community is gradually encouraging development of a new mentality among policymakers and businesspeople in these countries. The EU has played a pivotal role in this process. By holding out the prospect of accession, it has provided all countries in the region with a strong incentive for reform.

Second, the crisis has emphasized the importance of institutions. Successful and democratic institutions can help Southeastern European countries deal with ethnic and political conflict and make effective use of both financial resources and technical assistance.

Third, the international community, and particularly the EU, needs to continue providing financial resources and technical expertise, but, in the end, the authorities' continued commitment and ongoing efforts will be decisive. The reform agenda for the region remains daunting. Existing institutions have not yet put down deep roots, and, as a result, Southeastern Europe is vulnerable to criminality, both domestic and international. More important, ethnic and political tensions are still high, and the risk of sliding back into violence and anarchy, though greatly diminished, has not been entirely eliminated.

Nonetheless, the maturing political environment has laid the foundation for greater economic progress. Since the end of the Kosovo conflict, countries have pursued market-oriented reforms and integration with the rest of the world. Furthermore, there are increasing signs of a deep and broad consensus in Southeastern Europe on both the ultimate goal of sustainable growth and the policy means to achieve it.

This article is derived from a joint IMF-World Bank paper by the authors entitled "Building Peace in South East Europe: Macroeconomic Policies and Structural Reforms Since the Kosovo Conflict," which was presented at the Second Regional Conference for South East Europe in Bucharest, October 25-26, 2001. This paper is available on the web at http://www.seerecon.org.