Bosnia and Herzegovina—Letter of Intent, Supplementary Memorandum of Economic and Financial Policies

Sarajevo and Banja Luka, February 10, 2004

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler,

The new governments that were formed at the State and Entity levels following the October 5 elections began their work in earnest in the Spring of 2003. The policies implemented since then testify of our commitment to promote sustained economic growth and improved living standards through continued macroeconomic stability and further structural reforms necessary to create a fully-functioning market economy. Policy measures taken during the past few months also underscore our strong backing for the maintenance of the currency board arrangement, further fiscal consolidation, and continued structural reforms. In support of this program, we are requesting completion of the fourth review under the Stand-By arrangement (SBA).

Based on discussions with Fund staff for the fourth review, the attached Supplementary Memorandum of Economic and Financial Policies assesses economic developments and policy implementation under the arrangement. It also lays out the concrete policy measures to be taken during the remainder of the year.

As noted in the attached memorandum, overall policy implementation through June 2003 has been strong, but some policy objectives were not realized. While we regret that one structural performance criterion and a structural benchmark for end-June 2003 was not observed, we are pleased to note that corrective action has been taken. The amendment to the regulations on banks' foreign exchange exposures (structural performance criterion) was issued on July 29, 2003. In addition, the structural benchmark on the collection period for pensions in the RS was not observed in November, but this issue was corrected in December. In light of this, we request the Executive Board of the IMF to approve a waiver in respect of the non-observance of the structural performance criterion for end-June 2003. Although the early payment of wage arrears in the RS in November breached a structural benchmark, we are pleased to inform you that we have since adopted a comprehensive strategy to make appropriate arrangements for all domestic claims on government, thereby fulfilling a prior action for the review.

We are well aware that there is a substantial medium-term reform agenda ahead of us. Our governments are increasingly focusing on translating this agenda into concrete measures which we intend to implement during the remainder of the program and in the framework of a possible successor extended arrangement to the SBA.

The Governments of Bosnia and Herzegovina believe that the policies set forth in the attached SMEFP are adequate to achieve the objectives of their program, but they will take any further measures that may become appropriate for this purpose. Bosnia and Herzegovina will consult with the Fund on the adoption of these measures, and in advance of revisions to the policies contained in the SMEFP, in accordance with the Fund's policies on such consultation.

We are committed to transparency in our economic policies, and we authorize the Fund to publish this letter and the SMEFP following Executive Board consideration of the fourth program review.

Sincerely yours,

Supplementary Memorandum on Economic and Financial Policies
For Bosnia and Herzegovina

We have begun our work in Bosnia and Herzegovina in earnest. Since we took office following elections in the fall of 2002, we have:

• Secured a smooth transition to a new CBBH board, provided for the succession to a new governor at end-2004, rationalized reserve requirements, and firmly restated our commitment to the currency board arrangement;
  
  
• Strengthened banking regulations in regard to foreign exchange exposures and core capital requirements;
  
  
• Committed to implementation of wide ranging reforms under our six-month Action plan;
  
  
• Agreed a fundamental reform of indirect taxation which will underpin customs unification and preparations for a VAT;
  
  
• Prepared a reorganization of defense operations, anticipating rationalization, demobilization, and major cost savings;
  
  
• Maintained strong budget execution and published a plan for a comprehensive settlement of outstanding domestic claims on government (Table 1-3).

Though formulated in consultation with the international community, these are our policies, we will see that they are fully implemented, and they will form the basis for what follows.

2. The recent increases in international reserves of the Central Bank (CBBH) signal continued confidence in our policies and our commitments to reform and to the currency board. To ensure that confidence remains and deepens, our immediate focus is on two macroeconomic concerns: the continued rapid expansion of bank credit; and, looking further ahead, the need for sustained economic growth to raise living standards, combat unemployment, and respond to further declines in external reconstruction aid inflows.

3. The credit boom has been a mixed blessing. Funded largely by surging deposits in the banking system, it has facilitated long-overdue refurbishment of the housing stock and boosted activity—with real GDP growth in 2002 estimated at some 5½ percent, though it has since fallen back somewhat reflecting drought. But the pace of credit expansion raises concerns about its quality. And the lending has further enlarged the open foreign exchange position of banks, has caused bank liquidity in some banks to drop well below prescribed limits, and has boosted imports and the already-high external current account deficit—which rose to 18½ percent of GDP in 2002 and now shows only the most tentative signs of stabilizing.

4. Our actions to rationalize and tighten reserve requirements in June and strengthen regulations on bank forex exposures and core capital in July in the context of a strong budget stance were our first steps to address these problems. With credit growth and bank forex exposures remaining strong through September, these steps will be implemented firmly:

• Banks not yet observing the forex and capital regulations were required to prepare plans with the banking agencies indicating how compliance would be secured. We propose that as prior actions for completion of this review (Table 3):
  
  
  1. Plans for those banks which exceeded their end-September ceilings would be finalized indicating how full compliance would be secured by end-December, and
     
     
  2. finalization of corrective plans for those banks which in September did not yet observe the end-December 2003 core capital requirements.
     
     
• In addition, liquidity regulations on banks will be reviewed and applied firmly. We will agree these regulations with IMF staff along with a phase-in period with monthly ceilings until full observance is achieved. This will be accompanied by a regime of escalating penalties for noncompliance. Preparation of plans for all non-compliant banks as at end-September indicating how compliance will be achieved throughout the phase in period will constitute a prior action for completion of the review.
  
  
• In the context of the application of the forex and liquidity regulations, the CBBH Board has reduced the rate of remuneration of excess reserves with the possibility of subsequent reductions.

In this context, the CBBH will maintain the present reserve requirements rate under close review with IMF staff and will adjust that rate as necessary in consultation with them.

5. Our fiscal stance in 2003 has been strongly supportive of these efforts to address the adverse effects of rapid credit growth on the external balance. With tax revenue broadly on track with program projections but somewhat below the original budget projections, we have observed our aggregate quarterly spending ceilings to September this year and all the sub ceilings under the performance criterion on borrowing from domestic banks. This has allowed us to reconstitute KM 18.3 million (0.2 percent of GDP) in succession monies used during 2002 to finance demobilization. Cantonal budgets have benefited in 2003 from a strong increase in sales tax collection, reflecting improved tax administration, and are on track to remain balanced this year without incurring new arrears, and the State budget has also performed strongly due to better than projected own revenue.

6. During the last quarter of 2003, we targeted to maintain spending below KM 268 million and KM 350 million in the RS and Federation central governments respectively. As disbursements of credits from the World Bank and the EU were delayed into 2004, we delayed completion of the reconstitution of succession monies until those disbursements occur. In addition, neither entity will take unilateral action regarding the Human Rights Chamber (HRC) decision that pensions should be paid from the entity in which they were earned. But we will hasten efforts to ensure rapid implementation of that decision in accordance with our "Action Plan." And following slippages in November, no repetition of the extension of the collection period for pension contributions in the RS will occur. On the basis of strong own revenues, the State rebalanced its 2003 budget at slightly higher spending levels than the original budget, without additional administrative transfers from the Entities, and with borrowing limited to the CIPS project. Accordingly, we estimate that we secured an overall fiscal consolidation of 2¾ percentage points of GDP from a deficit of 2.2 percent of GDP in 2002 to a small surplus in 2003.

7. By securing continued fiscal consolidation, this will maintain the necessary counterbalance to the effect of credit growth on imports, giving the monetary and regulatory steps outlined above time to moderate that credit expansion. And this consolidation will allow us to continue appropriate abstention from new borrowing from domestic banks and to place privatization receipts in escrow.

8. Alongside these steps, significant fiscal structural reforms will be taken forward. The Indirect Tax Authority (ITA) framework has been approved by the legislative authorities and its head has been nominated. The unified customs administration is expected to begin operations, funded from the State budget, in early 2004. The introduction of treasuries in the Federation cantons has broadly progressed as envisaged, and all Cantons are expected to have fully operational treasuries by February 2004. From October 2003 onward, the Federation Central Government and Cantonal Finance Ministers have met each month to discuss fiscal policy issues in the Federation. In the RS, we aim to implement treasuries in 5 pilot municipalities by early-2004. We are also committed to improve the transparency and financial management of RS Elekroprivreda, as agreed with the World Bank, and will review the quasi-fiscal subsidy program it provides with a view to abolishing this program.

9. We have also been concerned at reported double-digit wage growth in the non budget sector in the Federation and by recent demands for unsustainable 30 percent increases in budgetary wages in the Republika Srpska and large increases in other sectors. Pending a more thorough review of wage determination arrangements and the quality of the wage statistics, the Federation government will issue instructions through parent ministries to all state-owned enterprises to moderate wage awards, while the Republika Srpska will accommodate moderate budget wage increases largely funded from a mid-2004 restructuring of the salary structure and downsizing the civil service and the army.

10. To secure a sustained strong fiscal stance in 2003-04:

• The RS will maintain civil service wage rates unchanged until after a civil service reform including employment reductions, revision of wage scales, and reductions in nonwage benefits for civil servants is fully implemented in April 2004. Any savings generated by this reform can be used to increase wage rates, subject to ceilings on the wage plus benefits bill (excluding severance pay) of KM 373 million (a 3 percent increase over the 2003 outturn) in the 2004 budget, and subject to dismissals not exceeding 4,000 people during 2004. To the extent that dismissals exceed 4,000, the savings will be allocated to non-remuneration items. These figures imply that the increase in average remuneration (wage and non-wage benefits excluding severance pay) once the reform is implemented will not exceed 9 percent with respect to pre-reform remuneration.
  
  
• The RS National Assembly passed a 2004 budget which anticipates excess spending. In executing the 2004 budget, we will target a deficit on a commitment basis excluding payments under the domestic debt settlement smaller than KM 26 million (less than 0.7 percent of RS GDP). This will be achieved by delaying spending authorization for some 0.7 percent of RS GDP until a mid-year review of revenue performance (See Annex I). Delayed spending commitments will only be authorized after that time to the extent that revenue excluding financing is on track to overperform the budget estimates.

And we propose as prior actions:

• The collection period for the November RS pension will not be extended beyond the 10th of December, a requirement we have observed.
  
  
• An agreement will be reached between the RS, Federation, and State on entity transfers to the State for 2004, to be incorporated in all three budgets.
  

11. With monetary, regulatory, budget and wage policies thus calibrated to provide strong support to the currency board, we intend to resolve a remaining public finance challenge to it—namely the overhang of domestic claims on the government. Our commitment to prepare a plan for this by end-June was frustrated by the complexity of the issue—pertaining to war damages, various spending arrears, and frozen foreign currency deposits. Accordingly, and to respond to the flow of lawsuits for settlement and the broader impediment the overhang constitutes to our economic prospects, we have adopted—by publishing in our official gazettes—a plan to achieve this goal. It specifies how court awards and pending cases will be treated, commits to pay no more than 10 percent of GDP (KM 1.2 billion) of all claims in order to secure fiscal sustainability—settling these with long bonds and cash from escrow—and to write off the remainder, and anticipates adoption of the necessary legislative framework by mid-2004 and to complete implementation of the plan thereafter. It has been designed in accordance with the Conventions of the Strasbourg Court and the arrangements under the plan reflect the priorities of the Entity governments. Execution of the plan has begun in respect of budget wage arrears in the RS and pension and war invalid benefit arrears in the Federation. The payment of cash for the admitted claims will be up to 1 percent of GDP in 2004. The phasing of the cash payments in 2004 and thereafter will be determined in consultation with staff in light of financing availability and macroeconomic considerations.

12. We intend that 2004 will mark a decisive turning point in Bosnia's economic development. With the reconstruction phase coming to an end, stable governments with long mandates, and the currency board secured by policies described above, it is time within that framework to confront the key impediments to stability, growth, and employment. Doing so will, we hope, set us securely on the path for eventual accession to the European Union.

13. Our immediate reform agenda in this regard is reflected in our six-month "Action Plan" to be completed by March 2004. Accordingly, we have focused our efforts on:

• Passing the framework legislation for the ITA;
  
  
• Accelerating privatization towards goals of issuing tenders for at least 5 strategic enterprises in each Entity by the end of 2003;
  
  
• Passing draft amendments of our bankruptcy laws to limit the priority given to labor claims. We will accelerate efforts to complete the restructuring of the judiciary, including the establishment of 16 commercial departments in the courts. Training modules for judges, trustees and other managers of the bankruptcy courts are being developed and we anticipate that intensive training will start in early 2004;
  
  
• Appointing a Director and a Statistical Council for the State Agency for Statistics, and pressing on with efforts to reduce red tape on business under the Bulldozer II initiative;
  
  
• Removing impediments to agricultural exports by strengthening the Veterinary Office and Institute for Standardization.

These initiatives are only the first steps of a much more ambitious reform agenda that lies ahead and which we are preparing.

14. But these immediate structural reforms will take time to finalize and take effect. In the meantime, our preparations for financial policies in 2004 reflect current structural constraints on economic growth and the risk that some of these reform actions to slow credit growth could be activity-impairing in the short-run. In this context, the key upside influences will be the prospective recovery of agriculture from the 2003 drought and a strengthening in the international economy. Accordingly, we project GDP growth in 2004 to strengthen from 3½ percent in 2003 to 5 percent, inflation to remain low at one percent and the external current account deficit to decline by 2 percentage points of GDP, a first step towards an ongoing correction anticipating declining aid inflows.

15. With the monetary, regulatory, wage and structural initiatives getting to grips with the external imbalance, our strong consolidated fiscal stance will be maintained in 2004. In particular, the Republika Srpska and the Federation will execute budgets which reflect total revenue, spending and balances on a commitment basis (excluding payments under the domestic debt settlement) at or below those agreed with the staff, which cover our policy commitments in the assessment of IMF staff. Thus, excluding one-off items, we anticipate a small consolidated fiscal deficit in 2004, with this target being assured, in part, by maintenance of the prohibition on new bank borrowing by cantons. With domestic financing providing a bridge to foreign financing, reconstitution of succession monies used in 2002 will be completed, and privatization and succession receipts will continue to be placed and held in escrow in anticipation of the settlement of domestic claims.

16. Alongside, we plan significant expenditure reforms.

• Defense and other reforms will yield, at a minimum, 1 percentage point of GDP in structural fiscal savings with severance packages funded from escrow. Severance packages for the police and military will be at most an average of KM 6,000.
  
  
• Customs administration and intelligence and key parts of defense operations will shift to the state. Accordingly, the Entities and Brcko will transfer at least KM 94.3 million to the State for its administrative functions during 2004, executed from the ITA once the single revenue account is established. Additional administrative transfers may be agreed as arrangements to transfer spending functions to the state are finalized Spending at Entity level on these shifted functions will be terminated—ensuring that consolidated spending does not rise as the functions shift. But savings from rationalization of those functions will be returned to the Entities and Brcko in proportion with their contributions. The State will freeze all new hiring for SIPA until full agreement is reached between the Entities, Brcko, and the State on the transfer of staff and funds.
  
  
• In line with our resolve to curb wage growth and maintain a strong fiscal stance, average budgetary wage rises in 2004 will not exceed 2 percent in the Federation, and will be determined as discussed in paragraph 10 for the RS.
  
  
• In the RS, we will review the funding arrangements for the health sector by mid 2004. In the Federation, we will ensure fully transparent use of funds in the Road Directorate, including the Cantonal directorates.

17. Building on progress under the Stand-By since its initiation, a sea change in the economic affairs of Bosnia and Herzegovina has begun. The challenges immediately ahead nevertheless remain daunting. We have signaled by our actions in office our intent to address them. In taking those efforts further forward, we anticipate a continued close relationship with the IMF.

Annex I

Pursuant to Chapter II, Article 7, Point 1 of the Law on Foreign Debt and Article 14, Point b of the Treasury Law, and in the context of the fourth review of the program supported by a Stand-By Arrangement from the IMF, the entity Ministers of Finance and the Minister of the Treasury of the BiH Institutions have reached the following

Agreement on the Time Schedule for the Payment of Respective
Amounts for Foreign Debt Servicing and Entity Contributions for
the Financing of the 2004 Budget of the BiH Institutions

I

In order to ensure timely payment of foreign liabilities and 2004 liability projections arising from foreign debt, in a total amount of KM 268.6 million, out of which KM166.6 milion is the Federation liability and KM 102 million is the Republika Srpska liability, the Federation of Bosnia and Herzegovina and the Republika Srpska shall pay the required amounts against each due liability, 5 days ahead of the respective maturity date.

II

Total transfers in 2004 for the administrative segment of the budget of the BiH institutions amount to KM 90.48 million out of which KM 60.32 million is to be paid by the Federation and KM 30.16 million is to be paid by the Republika Srpska. Brcko District will transfer KM 4.056 million to the State in 2004.

The transfer to the budget of the BiH institutions shall be paid on a monthly basis, ensuring that 1/12 (one-twelfth) of the total transfer shall be remitted for every current month. Payments will be made at the latest by the 15th of each month for the liability of the previous month. Any delay in payments shall be treated as violation of the conditions under the Stand-by arrangement.

III

By the 20th day of each month, the Minister of Finance and Treasury of the BiH Institutions will provide a written report to the IMF indicating developments in transfers from the Entities to the State for administrative and debt service purposes during the previous month, noting their consistency with the commitments made in this agreement.

IV

Both Entity governments and the State government agree that the expenditure functions for customs administration and intelligence service will be transferred fully to the State government together with Entity budget allocations for these functions during 2004. The Federation government agrees to transfer amounts budgeted for 2004 for customs and intelligence, respectively to the State pro-rated on a monthly basis starting with the month the transfer of expenditure functions becomes effective. The RS government agrees to transfer amounts budgeted for 2004 for customs and intelligence, respectively to the State pro-rated on a monthly basis starting with the month the transfer of expenditures functions becomes effective. Both Entity governments and the State government agree that the central command structure of the military will be established at State-government level and that the Federation and the RS will provide transfer to finance State-level central command. Transfers from the entities related to the establishment of State-level central command will be executed in respect of the limits of the total expenditure envelope envisaged in each entity budget for 2004.

Brcko District agrees to transfer amounts budgeted for 2004 for customs to the State pro-rated on a monthly basis starting with the month the transfer of expenditure functions becomes effective.

Before the transfer of the expenditure function for customs and intelligence services as well as the military central command becomes effective, the Entities and the State government will sign a separate protocol which will determine the modalities of staff transfers, including remuneration, employment status, and other issues that the signatories deem relevant.

Republika Srpska government and the Brcko District agree to maintain the current arrangement on provision of customs service, based on the signed Agreement between Republika Srpska and Brcko District (No.01-483-1316/01, dated August 13, 2001) until the adoption of the Indirect Taxation Administration (ITA) budget. The final solution for the financing of customs service will be established in the context of the adoption of the ITA budget, and a protocol terminating the Agreement between Republika Srpska and Brcko District will be signed in that occasion.

The State will freeze any new employment for SIPA until the State, Entities and Brcko District reach an agreement on transfer of staff and funds for this institution.

Other Technical aspects of the realization of earmarked transfers to the institutions mentioned in the previous paragraphs will be agreed among the BiH Minister of Finance and Treasury, Entity ministers of finance, and the Brcko District.

V

BiH Council of Ministers, Federation BiH and the RS government will include explicit statements in their 2004 budget documents that will reflect the substance of the agreements mentioned in Article IV of this agreement. The appropriate allocation of expenditure on transfer of responsibilities and functions from the entities to the state will be recorded through a rebalancing of the 2004 budgets. The State government will seek a written agreement with Brcko District on the transfer for customs services and its budget to the State.

In Sarajevo and Banja Luka,

Annex II

Delayed Spending List in the RS, 2004

The total of spending in the following treasury codes will be restricted KM 26 million below the annual totals authorized by the RSNA during 2004. This will be subject to a mid-year review. If domestic revenue, excluding financing items, is clearly on track to exceed the budget estimate of KM 1,004 million, then these delayed spending items may be authorized up to the extent that this domestic revenue exceeds the budget estimate—thereby preserving the targeted budget balance.

Delayed Spending List