Bosnia and Herzegovina: Third Review under the Stand-By Arrangement and Request for Waiver of Applicability of a Performance Criterion

This paper discusses Bosnia and Herzegovina’s Third Review Under the Stand-By Arrangement and Request for Waiver of Applicability of a Performance Criterion. Financial sector indicators through end-March 2013 suggest that the banking system remains profitable and adequately capitalized at the aggregate level. Foreign parent banks’ exposure to their Bongani Investments Holdings subsidiaries has broadly stabilized over the last several quarters. Industrial production and exports rose markedly in the first quarter of 2013 compared to the same period last year. It is found that while this reflected to a large extent a much milder winter, higher water levels that boosted electricity production, and exports, prospects for a modest economic recovery this year of approximately ½ percent have improved.

Abstract

This paper discusses Bosnia and Herzegovina’s Third Review Under the Stand-By Arrangement and Request for Waiver of Applicability of a Performance Criterion. Financial sector indicators through end-March 2013 suggest that the banking system remains profitable and adequately capitalized at the aggregate level. Foreign parent banks’ exposure to their Bongani Investments Holdings subsidiaries has broadly stabilized over the last several quarters. Industrial production and exports rose markedly in the first quarter of 2013 compared to the same period last year. It is found that while this reflected to a large extent a much milder winter, higher water levels that boosted electricity production, and exports, prospects for a modest economic recovery this year of approximately ½ percent have improved.

Recent Developments, Outlook, and Risks

1. The economy is showing tentative signs of recovery. Industrial production and exports rose markedly in the first quarter of 2013 compared to the same period last year. While this reflected to a large extent a much milder winter and higher water levels that boosted electricity production and exports, prospects for a modest economic recovery this year, by around ½ percent, have improved. Inflation continued to decline to ½ percent in April, owing to lower food and fuel prices. The unemployment rate, however, inched up further, to over 28 percent.

BiH: Selected High-Frequency Indicators, 2012–13

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Sources: BiH authorities; and IMF staff estimates.

Percent change over the same quarter in previous year.

2. Looking beyond 2013, growth is expected to pick up in line with a projected gradual recovery in Europe. Growth in BiH is expected to be driven by an increase in exports that combined with large and stable inflows of remittances will boost incomes and thus consumption and imports. Public investment in infrastructure projects should also support economic activity. Growth rates are expected to remain below pre-crisis levels, however, partly as bank lending will likely expand at a more modest pace than before the crisis and there is no room for fiscal stimulus. A faster pace of economic growth would require substantial progress in implementing structural reforms.

3. Downside risks to the outlook remain significant. A difficult political situation continues to pose significant risks to the timely implementation of policies envisaged under the program. Stalled attempts to reshuffle the cabinet in the Federation have created a political gridlock, making it difficult for the government to take major decisions. On the external side, a re-intensification of the euro area crisis or sustained weak growth in Europe would significantly affect BiH’s growth outlook. On the other hand, a faster recovery in Europe would boost external demand and private capital inflows.

Performance under the Program

4. All end-March 2013 performance criteria on fiscal balances were met. Despite slightly lower than forecasted indirect tax revenues due to unexpectedly high VAT refunds (see paragraph 7), tight control of current spending and delays in the execution of capital projects helped the entity central governments observe the end-March performance criteria on fiscal balances (net lending) by comfortable margins. The Institutions of BiH met its target as well, aided by higher than projected revenues and lower spending on wages. Nevertheless, the general government overall end-March deficit target—an indicative target—is estimated to have been missed due to faster than projected capital spending, mainly by the highway and road funds in the Federation and Republika Srpska (RS). This largely reflects the uncertainty about the implementation of major road construction projects, not only with regard to the timing of disbursements by the external financiers of these projects, but even more so with regard to the subsequent drawdown of these resources by the road and highway funds, which also depends on weather conditions. Nevertheless, oversight over these projects could be improved through better coordination with the highway and road funds. As reported at the time of the second review, the authorities did not contract or guarantee any new non-concessional short-term external debt, nor did they accumulate any external payment arrears.

Figure 1.
Figure 1.

BiH: Selected Economic Indicators, 2007–14

Citation: IMF Staff Country Reports 2013, 196; 10.5089/9781484366370.002.A001

Sources: BiH authorities; and IMF staff estimates and projections.

5. The assessment of the performance criterion on the non-accumulation of domestic arrears for entity general governments continued to be complicated by weaknesses in data reporting. While the Institutions of BiH, and the central governments of the Federation and the RS did not accumulate any new arrears through end-March 2013, data—neither for the period through end-December 2012, nor for the period through end-March 2013—are not yet available for lower levels of government, extra-budgetary funds, and public companies. Given that there is no indication that this performance criterion was not met, the authorities are requesting a waiver of applicability of this end-March performance criterion.1 Going forward, both entity authorities are taking steps to improve the monitoring of domestic arrears (see paragraph 10).

6. Steady progress continued to be made toward implementing structural reforms. All but one of the structural benchmarks were observed, although with delays in some cases:

  • The authorities continued to adhere to the currency board arrangement (a continuous structural benchmark);

  • The authorities did not introduce any new privileged or special rights for retirement (a continuous structural benchmark);

  • The consolidated general governments accounts for end-December 2012 and end-March 2013 were published on the website of the Institutions of BiH (a quarterly structural benchmark);

  • The eligibility audits of recipients of war-related benefits continued and the summary reports for the first quarter of 2013 have been posted on government web sites (a quarterly structural benchmark);

  • The new comprehensive law on privileged pensions for war veterans, adopted by the Federation parliament in April (a prior action for the second review), has become effective and the process of requalification of existing beneficiaries and screening of new entrants has started.

  • Amendments to the law on the Deposit Insurance Agency (submission of which had been a structural benchmark for end-March) have been approved by the BiH parliament, enhancing the coverage and effectiveness of the deposit insurance system.

  • The four tax agencies signed a Memorandum of Understanding on the exchange of taxpayer information (an end-May structural benchmark), with a view to facilitating the permanent, unfettered, and automated sharing of taxpayer records, starting January 2014.

  • The preparation of a new budget framework law in the Federation (an end-May structural benchmark), however, required further consultations with Fund staff before a revised draft that was consistent with staff recommendations was approved by the government in Mid-June (see paragraph 10). Parliamentary approval of this law is now expected by end-September 2013 (a new proposed deadline for this structural benchmark).

  • Amendments to the RS Banking Agency Law have been submitted to parliament and are expected to be adopted before end-June (an end-June structural benchmark), aligning treatment of confidential information with EU standards. With similar amendments already having been adopted in the Federation, this will help to enhance cooperation with foreign bank supervisors.

  • Amendments to the banking laws to limit the period of provisional administration to one year have also been submitted to the entity parliaments and are expected to be adopted by end-June as well (end-June structural benchmarks).

Policy Discussions

A. Fiscal Policy: Improving Revenue Collection and Continuing Fiscal Consolidation

7. With signs of the onset of a modest economic recovery, the gradual reduction in the general government deficit this year to around 2 percent of GDP—from an estimated 2.6 percent of GDP in 2012—remains appropriate. Nonetheless, while economic activity appears to be picking up, indirect tax collection has lagged behind so far this year, largely due to growing refunds and tax arrears. Meeting the fiscal targets will therefore require increased efforts to improve revenue collection, particularly by addressing VAT fraud and collecting tax arrears, by upgrading the Indirect Tax Authority’s (ITA) risk management and fraud detection framework, as well as by increasing excise rates on some tobacco products. Achieving the targets will also require continued expenditure restraint and securing the envisaged one-off dividend payment from the public electricity distribution company TRANSCO (equivalent to about 0.3 percent of GDP).

8. If downside risks to the economy were yet to materialize, automatic stabilizers could be allowed to work to some extent on the revenue side. In that case, in line with earlier policy advice, allowing the deficit of the consolidated general government to remain at around 2½ percent of GDP would not materially change BiH’s medium-term debt outlook. In the event of a sharper downturn, possible contingency measures include a reduction in those pensions and social benefits that exceed the social minimum—although this would be politically difficult—and delaying capital spending. On the other hand, should the economy grow faster than envisaged and revenues were to over-perform, adhering to the expenditure envelopes would allow for a faster reduction in the overall deficit.

9. Looking ahead, the authorities’ draft Global Fiscal Framework for 2014-16 envisages continued fiscal consolidation, mainly through expenditure constraints.2 This medium-term fiscal framework, which is expected to be adopted in the coming month, is mainly to determine the overall spending envelope and revenue share for the budget of the Institutions of BiH for 2014–16, but it also sets indicative key parameters for the entities’ budgets. The framework sets spending envelopes consistent with a further gradual reduction of the consolidated general government deficit by about ¾ percent of GDP in each the coming years, to reach a balanced budget by 2016.

B. Fiscal Structural Reforms: Advancing Entitlement Reform and Strengthening Public Financial Management

10. The authorities continue to move ahead with reforms of entitlement programs and efforts to strengthen public financial management, to underpin the fiscal consolidation process:

  • The Federation authorities have started with the implementation of the new law on privileged pensions for war veterans. The new law was designed to improve social fairness, contain the fiscal costs, and provide stronger safeguards for the financial health of the old-age pension system. The process of requalification of existing beneficiaries and screening new entrants has started, and benefit levels of existing beneficiaries are being substantially reduced. It will be important to ensure that sufficient administrative resources are allocated to make sure that these processes can be completed within the prescribed deadlines. Strong political will continues to be required to ensure the full implementation of this law.

  • Further progress has also been made in the reform of old-age pensions in the Federation. Given the challenging demographics, pension reform is imperative to ensure the longer-term sustainability of the system. The key objective of the reform is to encourage workers to stay longer in the labor force—including by raising the retirement age3—and increase the number of contributors. In this context, the Federation government has approved a pension reform strategy, developed with the assistance of the World Bank, consistent with these objectives, and plans to submit this strategy, together with an action plan, to parliament in July 2013.

  • The RS authorities have started to address the rising costs of health care. A number of cost-cutting measures are being implemented, including reduced sick leave, wage cuts for health fund staff, lower prices for prescriptions and expansion of e-prescriptions, negotiations with Serbia over the cost of services provided to RS residents, and reducing staffing levels in the health sector.

  • Controls over and reporting by lower levels of government are being improved. The Federation government has approved a new draft law on budgets, with the assistance of Fund staff, aimed at strengthening control over—and monitoring of—spending by lower levels of government, extra-budgetary funds, and public companies. Parliamentary approval of the law is expected by end-September 2013 (the new proposed deadline for this structural benchmark). Key improvements in the new law include: (i) a new coordination and consultation process between the various levels of government; (ii) the requirement that budgets of lower levels of government include an opinion by the Federation finance ministry; (iii) a new fiscal rule for all levels of government, requiring a balanced current budget, and enhancing the Federation finance ministry’s control over all borrowing; (iv) enhanced spending controls; (v) the inclusion of financial plans and outcomes of public companies and extra-budgetary funds in key budget documents; and (vi) improved cash management procedures. In addition, treasury systems in both entities will continue to be gradually expanded to cover all cantons, municipalities, and extra-budgetary funds. Also, the Institutions of BiH and entity governments will establish a common definition of spending arrears and require that all due dates of invoices be entered into the treasury system.

  • A new law on public procurement will be submitted to the BiH parliament by end-September 2013 to strengthen governance and enhance transparency. The draft has been prepared with the assistance of the EU and the OECD, and will bring procurement practices in BiH in line with those in the EU.

C. Ensuring Financial Sector Stability

11. The banking system is showing the effects of subdued economic activity as lending remains muted and non-performing loans (NPLs) continue to creep up. Financial sector indicators through end-March 2013 suggest that the banking system—predominantly owned by Austrian and Italian banks—remains profitable and adequately capitalized at the aggregate level. Foreign parent banks’ exposure to their BiH subsidiaries has broadly stabilized over the last several quarters. However, NPLs have edged up to around 14 percent and are likely to rise further in the near future, although provisioning stands unchanged at around 65 percent of non-performing assets. With credit growth expected to pick up only modestly, reflecting banks tightening of credit standards and weak credit demand, profitability in the sector will be adversely impacted. In this context, the banking agencies have engaged some smaller banks that exhibited tighter capital positions under the stress tests with more severe shock scenarios. A number of these banks already increased their capital. One bank in the RS, however, failed to meet minimum capital requirements after writing down non-performing loans, and the RS authorities are considering options to deal with this bank, including ways to attract new capital. While the bank is relatively small—accounting for less than 4 percent of RS banking system assets—the authorities are concerned about possible spillover effects on the system from a depositors’ loss in confidence. Fund staff has been actively engaged with the authorities providing a strategy that would limit the potential fiscal costs without creating undue risks to the banking system.

Figure 2.
Figure 2.

Financial Indicators in SEE

Citation: IMF Staff Country Reports 2013, 196; 10.5089/9781484366370.002.A001

Sources: BIS Locational Statistics, BiH authorities and IMF staff calculations.1/ Based on 2007 values.

12. The authorities are taking further measures to strengthen bank supervision and the crisis resolution framework. Specifically:

  • The Central Bank of Bosnia and Herzegovina (CBBH) and the Banking Agencies completed the identification of systemically important banks with a view to closely monitoring financial sector developments and better assessing potential risks. The design and implementation of bottom-up stress tests for this set of banks is also envisaged.

  • The changes to Banking Agency laws to bring the treatment of confidential information in line with EU practices will help the authorities enhance cooperation with foreign bank supervisors, including by signing of Memoranda of Understanding. In addition, to facilitate information exchange among home and host country supervisors and parent banks, the authorities are planning to host a cross-border forum this fall.

  • To further strengthen the crisis preparedness toolkit, the authorities, with the assistance of Fund staff, will agree on a set of detailed procedures describing the responsibilities of and the coordination between responsible institutions in the event of a systemic financial crisis (a new structural benchmark for end-December 2013). The members of the Standing Committee on Financial Stability will be responsible for the development of such over-arching contingency plans for financial stability.

13. Addressing high levels of NPLs in BiH will require a comprehensive strategy, including changes to the legal and regulatory frameworks. The authorities, together with Fund staff, have conducted a thorough review of the NPL resolution framework, including an evaluation of laws and regulations as well as current practices. The review has identified a number of measures to be implemented over time with further support from IMF staff. In particular:

  • Maintaining adequate provisioning levels is key to absorbing possible deteriorations in asset quality. A new law on corporate income tax in the Federation should clarify the tax treatment of loan loss provisioning by banks with a view to encouraging such provisioning. The RS will also review and enhance its tax treatment of loan loss provisioning to achieve the same objective.

  • The sale of NPLs to third parties, an effective method to improve liquidity management in banks and cleaning banks’ balance sheets, will be facilitated by submitting legislation, in line with Fund staff recommendations, regulating the establishment and supervision of asset management companies to the respective entity parliaments (new structural benchmarks for end-June 2014). This new legislation will fill the vacuum that currently exists and clear up the uncertainty that currently surrounds loan sales.

  • Other legislation influencing the NPL resolution framework will also be reviewed and amended as needed. In particular, the corporate insolvency laws should be revised to: (i) strengthen restructuring provisions so that companies that are viable can be quickly reorganized; (ii) reduce barriers to entry into bankruptcy, as these delays lessen both the chances of a successful reorganization and creditors’ recoveries; and (iii) speed up bankruptcy proceedings which can currently extend for many years.

  • Consideration should also be given to establishing an out-of-court restructuring mechanism so that viable companies have a better chance of remaining productive.

  • Finally, the law on protection of consumers of financial services under preparation in the Federation should clarify the rights and obligations of such consumers with a view to ensuring well-balanced rights and obligations of both lenders and borrowers.

14. A comprehensive overhaul of both entities’ banking laws is needed to keep up with ever more complex financial markets. Financial sector developments in BiH have highlighted the need to further strengthen financial sector legislation and regulation. Thus, the entities’ Ministries of Finance and Banking Agencies, and the Deposit Insurance Agency, with assistance of the Fund staff, will prepare and submit to the respective entity parliaments new laws on banks and other lending institutions in line with Fund staff recommendations (new structural benchmarks for end-June 2014). These laws, meant to replace the existing banking laws, will represent a significant step toward modernizing and harmonizing BiH’s legal and regulatory framework on banks with EU legislation and will also further expand the toolkit for dealing with problem banks. The Deposit Insurance Agency Law will also be reviewed and amended as needed to guarantee full consistency with the new laws. Moreover, the establishment of a bank restructuring agency should also be considered.

D. Enhancing Private Sector Development

15. Creating a vibrant private sector is key to foster job creation and reduce unemployment. Unemployment remains persistently high at around 28 percent, with youth unemployment exceeding 60 percent. In recent months, despite some tentative signs of an economic turnaround, employment prospects have not improved. The authorities are mindful of the need to take bold steps and are taking a multi-pronged approach in advancing labor market and regulatory reforms so as to improve job creation and enhance competitiveness. These include:

  • Simplification of business registration and regulation. The authorities are pressing ahead with facilitating the start-up of new businesses. The establishment of a one-stop shop for business registration in the RS is on-track to become operational late this year (a structural benchmark for end-September 2013). Similarly, the Federation is preparing a new law on companies with a view to simplifying business registration and improving corporate governance.

  • Streamlining the tax and contribution payment procedures. The authorities of the BiH Institutions continue to work on enabling laws and regulations for digital signature and expect its application throughout BiH by early 2014. Similarly, the Federation authorities, with help from USAID, are testing a more centralized collection and reporting system for social contributions, with a view to streamlining this process and reducing compliance costs for businesses.

  • Revamping labor laws. The current labor laws make it difficult for businesses to adjust staffing levels to changing economic circumstances and provide little incentives to provide job opportunities especially to the younger generation. The authorities in both entities have started the process of drafting new labor laws with a view to creating an environment more conducive to job creation, while providing adequate safeguards for workers’ rights. Close consultation with the social partners will be crucial to achieve these objectives. The authorities aim to have these new labor laws adopted by the respective parliaments by end-December 2013 (new structural benchmarks for end-December 2013).

16. The authorities have been making progress in harmonizing agricultural export standards ahead of Croatia’s accession to the EU and in WTO accession. While the value of the affected agricultural exports is relatively limited, the sector provides many jobs. After some initial delays, it is expected that the harmonization of standards on agricultural products with EU requirements and the preparation of border control points will proceed, thereby limiting disruptions of trade flows. Meanwhile, the authorities have already signed bilateral agreements with many WTO members, including the EU, and hope to conclude membership negotiations later in the year. This is expected to boost external trade and further integrate BiH’s economy with the rest of the world.

E. Program Issues

17. BiH has sufficient capacity to discharge its obligations to the Fund in a timely manner. By the end of the SBA, the level of Fund credit outstanding is projected to be slightly below 3 percent of GDP (12¼ percent of gross international reserves), and Fund repurchases and charges would peak at 44 percent of total debt service in 2013. The country so far has an excellent record of meeting Fund financial obligations. With the expectation that strong performance under the program will continue, BiH will return to a sustainable medium-term growth path. This provides assurances that BiH should continue to be able to service its obligations to the Fund on time.

Staff Appraisal

18. The authorities continue to make good progress under the SBA. The economy is showing signs of recovery, fiscal policy is on track, and steady progress is being made in implementing structural reforms. Still, some reforms are faced with delays and accelerating the pace of reforms will be crucial if BiH is to achieve higher rates of economic growth and the high level of unemployment is to be brought down. In this context, the authorities’ plans to enhance the functioning of the labor market and improve the business environment are welcome.

19. With signs of an economic recovery, continuing on the path of fiscal consolidation remains appropriate given the need to ensure medium-term fiscal sustainability. Increased efforts are urgently needed the improve revenue collection, however, in order to be able to achieve the 2013 deficit targets. And while risks to the outlook have become more balanced, downside risks remain significant. If these were to materialize, a slightly slower pace of fiscal adjustment could be temporarily warranted, by allowing automatic stabilizers to work to some extent on the revenue side. On the other hand, should the economy grow faster than envisaged, adhering to the spending envelopes would allow for a faster pace of fiscal consolidation.

20. The further rise in non-performing loans calls for continued close supervision of the banking system. The authorities’ increased efforts to strengthen banking supervision, improve their readiness to deal with any banking sector difficulties, and enhance the NPL resolution framework are crucial to ensure financial sector stability. Closer coordination and cooperation with home country supervisors also remains of particular importance given the ownership structure of the banking sector.

21. Risks to the program remain broadly unchanged. Any delay in Europe’s overall economic recovery will directly affect BiH’s economic outlook through its adverse impact on exports, remittances, and capital flows. In addition, domestic political risks continue to loom large and political instability could hamper program implementation and weaken support for key structural reforms.

22. Despite these risks, in view of the authorities’ strong performance so far and their policies for the remainder of 2013 as summarized in the attached supplementary Letter of Intent of June 12, 2013, staff supports the authorities’ request for the completion of the third review under the Stand-By Arrangement. Staff also supports the authorities’ request for a waiver of applicability of the end-March 2013 performance criteria on the ceiling on the accumulation of domestic arrears, as data are not yet available while there is no evidence that it was not met.

Table 1.

Bosnia and Herzegovina: Selected Economic Indicators, 2010–18

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Sources: BiH authorities; and IMF staff estimates and projections.
Table 2.

Bosnia and Herzegovina: Real Sector Developments, 2010–18

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Source: BiH, FBiH and RS Statistical Agencies, and Fund staff estimates.Notes: Nominal and real GDP series are based on the production approach.

Based on the BiH Labor Survey. The unemployment rate based on the number of unemployed persons registered in Unemployment Offices is significantly higher.

Table 3.

Bosnia and Herzegovina: Balance of Payments, 2010–18 1/

(In millions of euros, unless otherwise indicated)

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Sources: BiH authorities; and IMF staff estimates and projections.

Based on BPM6.

Table 4.

Bosnia and Herzegovina: General Government Statement of Operations, 2010–18

(Percent of GDP)

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Sources: BiH authorities; and IMF staff estimates and projections.