Public Information Notice No. 04/17

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Bosnia and Herzegovina

March 5, 2004

On February 25, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Bosnia and Herzegovina.¹

Background

Economic activity weakened somewhat in 2003 while inflation remained low. Real GDP growth slowed to an estimated 3.5 percent from 5.5 percent in 2002 and 4.4 percent in 2001, as manufacturing has all but stood still and drought has cut agricultural output by one-fifth. Profitability appears to have strengthened in the Republika Srpska while deteriorating further in the Federation. Consumer prices, anchored by the currency board, were unchanged in January-September 2003 compared to the same period of 2002.

Credit to households soared in 2002, fueled by a rapid increase in bank deposits following bank privatization and reverse currency substitution as euro notes were introduced on January 1, 2002. This boosted imports and raised the current account deficit by about 2.5 percentage points of GDP towards 19 percent. After a policy tightening in 2003—a reform of required reserves regime, strengthened application of bank liquidity, and foreign exchange exposure regulations—credit to the private sector has begun to decelerate and the current account to strengthen. With slower growth in credit, the lagged impact of a real appreciation of the Serbian dinar in 2002, and further fiscal consolidation, the external balance strengthened by at least 1 percentage point of GDP in 2003.

Fiscal consolidation continued by about 2.5 percent of GDP in 2003, taking the balance to a small surplus. With revenue on track, both Entity governments kept a tight lid on spending. Spending at State, Cantonal, and extra-budgetary fund levels has also remained under control, with the latter two on track to achieve balanced budgets. The Entities continued to reconstitute into the escrow accounts funds spent in 2002 for severance payments under the demobilization program.

An impressive reform agenda is underway. First, a framework law on indirect taxation was recently adopted that will strengthen the fiscal system by providing for immediate establishment of a single indirect tax and customs administration and for indirect tax harmonization throughout BiH. It also establishes joint Entity and State decision-making for indirect tax policy. This package underlies plans to replace sales tax with value-added tax in 2005-06. Second, a plan has been announced to restructure unsustainable domestic claims on the government of more than 200 percent of GDP. Third, major defense reforms are anticipated for 2004, centralizing command and control structures, continuing demobilization, and facilitating accession to North Atlantic Treaty Organization's partnership for peace. Fourth, the judicial system is being overhauled, including a nearly completed exercise to selectively reappoint judges and a new system of commercial courts. Fifth, since mid-2003, bank regulators have stepped up enforcement of key liquidity and foreign exchange exposure regulations, with full enforcement expected by mid-2004. At the same time, the authorities' six-month "Action Plan" of structural reforms signals their increasing capacity to take the lead in economic policymaking. Furthermore, a European Union feasibility study has been completed, setting the stage for EU accession negotiations to commence.

Executive Board Assessment

Directors commended Bosnia and Herzegovina's progress during 2003 in maintaining growth despite a severe drought, as well as the maintenance of price stability, the achievement of a sizable fiscal consolidation, a decline in the external current account deficit, and an increase in international reserves; all of which signaled the increasing strength of the currency board. They also noted progress in institutional and structural reform, including the installation of a new central bank board, the development of plans to reform indirect taxes and defense spending, and to restructure domestic claims on the government. Directors cautioned, however, that many challenges remain in maintaining macroeconomic stability and deepening structural reforms, in particular in strengthening governmental institutions and corporate revitalization. These challenges are compounded by an eventual decline in aid inflows and the need to continue absorbing refugees.

Directors welcomed the authorities' commitment to maintain a strong fiscal stance in 2004, which they viewed as contributing to a sustainable fiscal position and a reduction in the external current account deficit, and bolstering the viability of the currency board. They cautioned, however, that further fiscal tightening might be required in view of uncertain trends in the balance of payments and domestic savings. They regretted the political and procedural difficulties in approving the 2004 budget that had led to a significant delay in completing the fourth review under the Stand-By Arrangement, and pointed to the challenges associated with improving fiscal policy coordination and containing current spending, especially on wages and pensions.

Directors were encouraged that a rapid expansion in bank credit is being contained, but stressed that further restraint is necessary for macroeconomic stability. In this respect, they highlighted the importance of firm implementation of monetary policies and regulations introduced in mid-2003 that altered reserve requirements, and tightened bank core capital requirements and foreign exchange exposure regulations. They noted that if the central bank's responsibilities are extended to banking supervision, the authorities should ensure that the quality of regulation is maintained during the transition period. They encouraged the authorities to put in place effective AML/CFT legislation.

Directors emphasized the critical importance of progressing on a broad range of structural reforms in the private and public sector. They endorsed steps to improve governance of state enterprises, including by reinvigorating privatization, and to put in place commercial legislation, including a bankruptcy code, and commercial courts. They called for the authorities to move quickly to structure voluntary debt workouts for state enterprises involving all creditors, and to curb regulatory, legal, and tax impediments to business development. They also saw a need simultaneously to reform labor market institutions to induce a more efficient use of labor. In this context, they strongly encouraged reviewing wage and severance arrangements in order to moderate wage growth and attain a higher rate of employment growth.

Directors emphasized the importance of strengthening fiscal policy and institutions. A top priority is to develop the Indirect Tax Authority, which would administer the planned value added tax, and to consider extending its responsibilities to coordinate fiscal policy in general. They also supported tax reform to reduce the burden of taxation, especially on labor, and stressed the need for greater efficiency in current spending to make room for public investment. They welcomed the authorities' plans to restructure domestic claims on government and to reduce their net burden, and stressed the importance of implementing debt restructuring without delay, thus paving the way for accession to Article VIII status.

Directors observed that deficiencies in statistics hindered macroeconomic policy making and analysis, including in running the currency board, and the analysis of broader economic developments. They highlighted the need for diligent attention to strengthening data collection.

Directors regretted the unilateral decision to delay, even briefly, full implementation of the regional Free Trade Agreements, and underscored that this might impede the country's accession to the World Trade Organization. A few Directors also noted the importance and possible revenue consequences of reducing tariffs.