Bosnia and Hercegovina · Country Report April 2004 Bosnia and Hercegovina April 2004 The Economist...

Country Report April 2004

Bosnia and Hercegovina

April 2004

The Economist Intelligence Unit15 Regent St, London SW1Y 4LRUnited Kingdom

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Bosnia and Hercegovina 1

Country Report April 2004 www.eiu.com © The Economist Intelligence Unit Limited 2004

Contents

3 Summary

4 Political structure

6 Economic structure6 Annual indicators7 Quarterly indicators

8 Outlook for 2004-058 Political outlook9 Economic policy outlook10 Economic forecast

13 The political scene

18 Economic policy

21 The domestic economy21 Output and demand25 Employment, wages and prices26 Financial indicators

27 Foreign trade and payments

List of tables10 International assumptions summary13 Forecast summary22 Federation: industrial production24 BiH: inter-entity turnover25 BiH labour statistics26 BiH: retail prices27 BiH: commercial bank lending28 Federation: foreign trade29 Federation: trading partners30 BiH: balance of payments

List of figures13 Gross domestic product13 Consumer price inflation30 Remittances, 200231 Net free reserves



Summary April 2004

The political scene in Bosnia and Hercegovina (BiH) is unstable, given thefractious relations between the leading parties, and early elections this year area distinct possibility. Significant reform was achieved in 2003, but continuedprogress in 2004-05 will be dependent on pressure from the internationalcommunity. The Central Bank of BiH will maintain its tight monetary policystance over the forecast period, in support of the country's currency boardarrangement. Large external deficits—which represent a risk to the currencyboard—are in the process of correction, but significant continued adjustmentwill be necessary in the coming years.

Relations between the leading political parties in BiH—both nationalist andmoderate—remain tense. In the Federation in particular, the government'sstability is in question, with calls for the resignation of the prime minister andthe Croatian Democratic Union of BiH (HDZ BiH) claiming that it is consideringleaving the coalition. The BiH government is currently attempting to meet theEU's set of criteria for the eventual opening of negotiations on a stabilisationand association agreement (SAA), but such negotiations are not likely to beginuntil the end of this year or in early 2005.

The IMF has lauded the reform progress achieved in 2003 and the significantfiscal consolidation registered in both entities, although on conclusion of BiH'sstand-by arrangement in March it noted that much work remains to be done incorporate restructuring and liberalising the labour market. The creation of acentralised Indirect Tax Administration (ITA) was hailed by the internationalfinancial institutions as a massive step forward in tightening the country's fiscalposition and improving the business environment in the country.

Output figures show a mixed picture for BiH in 2003; industrial productiongrew by some 5% in both entities, but this marked a deceleration in theFederation. Construction output grew in both entities, and retail sales growthwas driven largely by automobile sales. Employment trends are bleak, withunemployment rising in tandem with rapid wage growth. Inflation, however,has remained low, underpinned by exchange-rate stability.

BiH's external position consolidated somewhat in 2003, after a massive increasein trade and current-account deficits in 2002. Exports rose by almost 20% inlocal-currency terms, and import growth was kept much lower by tightmonetary policy and fiscal prudence during the year. Sales to the EUrebounded from very poor performance in 2002. The current-account deficit,however, is estimated to have remained large. Foreign direct investment (FDI)inflows in January-September were respectable, aided by greater public effortsto promote the country as a destination for investment.

Editors: Matthew Shinkman (editor); Laza Kekic (consulting editor)Editorial closing date: March 24th 2004

All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] report: Full schedule on www.eiu.com/schedule

Outlook for 2004-05

The political scene

Economic policy

The domestic economy

Foreign trade and payments

4 Bosnia and Hercegovina


Political structureThe state of Bosnia and Hercegovina (BiH) exists within the boundaries of the formerYugoslav republic of the same name. It includes two entities: the Federation of Bosniaand Hercegovina (which is often referred to simply as the Federation), set up by theWashington Treaty of March 18th 1994, and Republika Srpska (RS). It also includes a self-governing district, Brcko, under the sovereignty of the central state government

The central BiH government was granted limited responsibilities under the Dayton peaceagreement signed in the US in November 1995, including the establishment of aConstitutional Court, a Commission for Displaced Persons, a Human Rights Commission,a central bank, public corporations to manage and operate transport andtelecommunications, a Commission to Preserve National Monuments, and a system ofarbitration. Foreign trade is also managed by the BiH government. In recent yearsministries of justice, security and defence have been created at state level, and the statepresidency assumed central command of the armed forces in 2003. Tax and customsadministration is to be unified in 2006

BiH has a bicameral parliament comprising the House of Representatives and the Houseof Peoples, two-thirds of the members of which are elected from the Federation and one-third from the RS. A valid majority requires the support of at least one-third of themembers representing each entity. The Federation and the RS also have parliaments

General elections took place on October 6th 2002 to select a new three-member statepresidency, the RS president, and state, entity and cantonal parliaments. Next presidentialand parliamentary elections due in 2006

BiH has a rotating, collective, three-member presidency: Borislav Paravac (Serb; appointedApril 2003), Sulejman Tihic (Muslim; elected October 2002; current chairman) andDragan Covic (Croat; elected October 2002)

The Council of Ministers comprises ten ministers, one of whom is appointed chairman(prime minister) for a four-year term. The current government was formed after electionsin October 2002. The entities also have their own governments

Social Democratic Party (SDP), Party for BiH (SzBiH), New Croatian Initiative (NHI), Partyfor Democratic Action (SDA), Croatian Democratic Union of BiH (HDZ BiH), SerbDemocratic Party (SDS), Party of Democratic Progress (PDP), Party of Independent SocialDemocrats (SNSD)

The Dayton agreement established the Office of the High Representative (OHR), chargedwith monitoring the implementation of the agreement and co-ordinating the activities ofinternational organisations. Since December 1997 the High Representative has been ableto impose decisions in cases of disagreement and to dismiss obstructive officials

Chairman Adnan Terzic (Muslim)Foreign affairs & deputy chairman Mladen Ivanic (Serb)Security & deputy chairman Barisa Colak (Croat)Defence Nikola Radovanovic (Serb)Civil affairs Safet Halilovic (Muslim)Foreign trade & economy Dragan Doko (Croat)Human rights & refugees Mirsad Kebo (Muslim)Treasury Ljerka Maric (Croat)Transport & communications Branko Dokic (Serb)Justice Slobodan Kovac (Serb)

Peter Nicholl

Paddy Ashdown

Head of state

Main political parties

Legislatures

State competencies

National government

National elections

National government

International involvement

Central Bank governor

High representative

Official names



President Niko Lozancic (HDZ)Vice-president Sahbaz Dzihanovic (SzBiH)Vice-president Desnica Radivojevic (SDA)Prime minister Ahmet Hadzipasic (SDA)Deputy prime minister & minister of finance Dragan Vrankic (HDZ)Deputy prime minister & minister of sport & culture Gavrilo Grahovac (SzBiH)

Agriculture, water & forestry Marinko Bozic (HDZ)Defence Miroslav Nikolic (HDZ)Education and science Zijad Pasic (SDA)Energy, mining & industry Izet Zigic (SzBiH)Environment & urban planning Ramiz Mehmedagic (SzBiH)Health Tomo Lucic (HDZ)Interior Mevludin Halilovic (SDA)Justice Borjana Kristo (HDZ)Labour & social affairs Radovan Vignjevic (SDA)Trade Maid Ljubovic (SzBiH)Transport & communications Nedzad Brankovic (SDA)Veterans’ affairs Ibrahim Nadarevic (SDA)

President Dragan Cavic (SDS)Vice-president Ivan Tomljenovic (SDP)Prime minister Dragan Mikerevic (PDP)

Agriculture Rodoljub TrkuljaDefence Milovan StankovicEducation & culture Gojko SavanovicEconomy, energy & development Milan BogicevicFinance Branko KrsmanovicEconomic affairs & co-ordination Omer BrankovicHealth & social welfare Marin KvaternikInterior Zoran DericJustice Suad FilipovicTrade & tourism Boris Gaspara Officially, the party affiliations of ministers have not been revealed.

Federation

Key ministersa

Key ministers

Republika Srpska



Economic structure

Annual indicators1999 a 2000 a 2001a 2002 a 2003 b

GDP at market prices (KM bn) 8.6 9.6 10.2 11.6 12.1GDP at market prices (US$ bn) 4.7 4.5 4.8 5.6 7.0

Real GDP growth (%) 9.6 5.4 4.4 5.5 3.5Retail price inflation (av; %) 5.8 6.3 3.9 0.6 0.9 a

Population (m) 3.7 3.8 4.1 4.1 4.2

Exports of goods fob (US$ m) 831.8 1,173.6 1,131.2 1,115.1 1,150.0Imports of goods fob (US$ m) 4,128.7 3,795.9 4,091.4 4,518.8 4,900.0

Current-account balance (US$ m) -1,458.5 -1,192.3 -1,563.1 -2,138.6 -2,195.0International reserves (US$ m) 452.4 496.6 1,221.2 1,321.4 1,795.6Total external debt (US$ bn) 2.7 2.4 2.2 2.8 b 3.5

Exchange rate (av) KM:US$ 1.83 2.12 2.19 2.08 1.73 a

a Actual. b Economist Intelligence Unit estimates.

Origins of GDP 2002 % of total Components of gross domestic product 1998 % of totalAgriculture, fisheries & forestry 13.0 Public & private consumption 100.4

Industry & utilities 32.7 Gross investment (incl stockbuilding) 38.0Construction 8.2 Exports of goods & services 35.1

Services 46.1 Imports of goods & services 73.5

Principal exports 2002 % of total Principal imports 2002 % of totalFederation FederationManufactured goods 28.3 Machinery & transport equipment 25.2

Miscellaneous manufactured articles 23.5 Manufactured goods 20.9Crude materials, inedible, excl fuels 16.3 Food & live animals 14.9Machinery & transport equipment 17.2 Miscellaneous manufactured articles 11.9

Main destinations of exports 2003 % of total Main origins of imports 2003 % of totalFederation FederationCroatia 19.95 Croatia 19.32Germany 18.37 Germany 14.43

Switzerland 11.89 Slovenia 10.45Italy 14.34 Italy 10.67

Republika Srpska Republika SrpskaSerbia and Montenegro 41.5 Serbia and Montenegro 22.7

Italy 10.3 Slovenia 7.3Croatia 10.9 Croatia 11.9Slovenia 7.0 Austria 4.2



Quarterly indicators2002 20031 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr

Financial indicatorsExchange rate KM:US$ (av) 2.232 2.130 1.989 1.962 1.823 1.724 1.740 1.645Exchange rate KM:US$ (end-period) 2.242 1.961 1.984 1.865 1.795 1.712 1.679 1.549Deposit rate (av; %) 4.81 4.54 4.40 4.36 4.19 4.28 4.19 n/aLending rate (av; %) 13.25 12.98 12.36 12.19 11.40 11.04 10.51 n/aM1 (end-period; KM m) 3,028 3,117 3,217 3,154 2,987 3,115 3,220 3,298M1 (% change, year on year) 101.3 86.4 70.2 13.0 -1.4 -0.1 0.0 4.6M2 (end-period; KM m) 5,175 5,173 5,357 5,319 5,278 5,433 5,646 5,929M2 (% change, year on year) 94.0 81.3 70.1 8.1 2.0 5.0 5.4 11.5Foreign trade (US$ m)a

Exports fob 183.1 199.2 224.4 222.5 233.0 275.8 276.1 n/aImports cif -672.1 -823.7 -928.0 -938.9 -805.8 -984.1 -1,014.2 n/aTrade balance -489.0 -624.6 -703.5 -716.4 -572.8 -708.3 -738.1 n/a

Foreign reserves (US$ m)Reserves excl gold (end-period) 1,134 1,229 1,223 1,321 1,241 1,325 1,510 1,796

a DOTS estimates.

Sources: IMF, International Financial Statistics; IMF, Direction of Trade Statistics.



Outlook for 2004-05

Political outlook

The fourth quarter of 2003 was marked by the passage of long-awaited defenceand tax reforms in Bosnia and Hercegovina (BiH). Nonetheless, the tortuousprocess of agreeing the reforms suggests that major differences remain betweenthe three leading nationalist parties over a wide range of policy issues. Mostnotable are those relating to the strengthening of central institutions, which is thecurrent focus of the international community's conditionality policy. The threemajor reforms of 2003—centralising defence, indirect taxation and securityservices—encountered obstructions in both entity governments and from localparty representatives, and the international community had to apply heavypressure to ensure the completion of reforms.

The three largest political parties—the Party of Democratic Action (SDA), theSerb Democratic Party (SDS) and the Croatian Democratic Union of BiH (HDZBiH)—have put renewed energy into presenting themselves to the internationalcommunity as reform-minded moderates. However, significant doubts remainover their commitment to economic and political reform. Above all, thedifferent interests of the ethnic groups that these parties represent implysignificantly different views on the desirable degree of centralisation at the statelevel. The SDS continues to press for strong entity governments, ensuringpolitical dominance of the Serbs in Republika Srpska (RS); the HDZ BiH pressesfor devolution of power in the Federation from the entity government to thecantonal governments, in order to maximise its leverage in those smallerbodies; and the SDA, which represents the Bosnian Muslims, steadfastlysupports a strong central state at the expense of the entity governments.

Over the forecast period the Economist Intelligence Unit therefore anticipatescontinued friction between the leading parties, and expects that furtherprogress on reform—which was commendable in 2003—will not be internallydriven and will instead depend on continued heavy pressure from theinternational community, and from the Office of the High Representative (OHR)in particular. Recent attempts to force through a government reshuffle in theFederation failed, but the likelihood of such an occurrence in one or both of theentities this year remains high. Furthermore, the possibility of early elections atstate or entity level some time this year cannot be fully discounted.

The European Commission responded in late 2003 to BiH's application to beginnegotiations on a stabilisation and association agreement (SAA), outlining a listof key reforms that must be put in place before those talks can begin—includingimproving co-operation with the International Criminal Tribunal for formerYugoslavia (ICTY), strengthening the legal system, and implementing reforms toimprove the business environment in the country. As of March only a smallnumber of the 40-odd specific pieces of legislation requested by theCommission had been implemented, suggesting that negotiations are unlikelyto start before late 2004. Nonetheless, although the timing remains in question,we expect that negotiations will start within the next 12 months. Despite this,

International relations

Domestic politics



given that the EU is reticent to suggest a target date for eventual EUmembership for BiH, and that such membership is unlikely to occur in thisdecade, it is uncertain that the EU integration process will provide any strongincentive for change among the local political establishment. This raises doubtsas to how much leverage the EU will have in the country and the region morebroadly over the forecast period, especially as aid flows diminish.

It is now virtually certain that the NATO-led Stabilisation Force (SFOR), soon tobe sharply reduced in size, will be replaced by an EU-led force by the end of2004, although discussions are currently under way regarding the future role ofNATO in the country. Local authorities have expressed their desire to maintain aUS presence in BiH, and are pressing for a significant role in determining themandate of the EU force. Despite some delay in meeting several conditions formembership, we continue to expect BiH to receive an invitation to join NATO'sPartnership for Peace (PfP) programme at its summit in June.

Over the past few years BiH’s relations with its neighbours have improvedmarkedly, as all sides try to put wartime animosities behind them. Mechanismsfor an ongoing dialogue have been put in place, and have facilitated discussionover a broadening range of sensitive issues related to these countries' commonpast within the former Yugoslavia, their behaviour during the war, and currenteconomic development issues. The Kosovo issue could raise tensions inside BiHand between BiH and Serbia and Montenegro—especially given recent flare-upsof inter-ethnic violence in the province. In particular, the outcome of finalstatus deliberations on the future of Kosovo could stoke pressures within BiHfor a reconsideration of the status of the RS.

Economic policy outlook

In the past the OHR's primary efforts have focused on building the institutionalframework in BiH for conducting a country-wide economic policy. Withsignificant progress made in this respect in 2003, over the forecast period theOHR will press for implementation of the economic reforms needed for sus-tainable economic growth, including greater efforts in restructuring and sellingthe remaining state-owned enterprises. The government will look to build onthe progress made in 2003 in consolidating fiscal positions at the state and entitylevels, and the Central Bank of BiH will maintain its focus on narrowing thecurrent-account deficit through tighter monetary policy implementation.

Preliminary data indicate that in 2003 a small consolidated general governmentsurplus was recorded, mainly as a result of slow growth in public expenditure.The government has committed itself to maintaining a tight fiscal stance in2004, and has proposed further current expenditure cuts. Public-sector wagegrowth has been slow in the past year, and the government has committed tocontinued prudence in this respect, as well as to further efforts to reduce public-sector staffing levels. Cuts in benefits to war veterans, disability benefits, anddefence are expected to lead to a fall in the share of total expenditure in GDP tosome 46% in 2004 (down from 46.3% in 2003). Public revenue is projected at

Policy trends

Fiscal policy



46.1% in 2004, below the preliminary figure for 2003, largely owing to loss ofcustoms revenue as BiH implements its free-trade agreements with neighbours.

The government faces a difficult task in meeting its 2004-05 targets for smallgeneral government surpluses. Social tensions are high, and the prospect ofnew privatisation-related job losses will challenge the government'scommitment to the implementation of reforms. At the same time, publicpressure from unions and pensioners is expected to remain high, given theausterity programmed into the current budget with regard to public-sectorwages and pension payments. The introduction of value-added tax (VAT),which is expected to strengthen revenue performance, is unlikely to come intoforce before late 2005 at the earliest. We believe that upward pressure onexpenditure and slower than expected progress in implementing the reformsthat underpin revenue projections will keep the general government balance inslight deficit in 2004-05.

The Central Bank tightened monetary policy in 2003 via several adjustments toreserve and core capital requirements, in response to what had been rapidgrowth in imports in 2002, and a concurrent widening of the current-accountdeficit. Credit growth decelerated in 2003, in part owing to the Central Bank'smeasures and in part to market effects as the pool of creditworthy borrowers inBiH shrinks. Nonetheless, both the Central Bank and the IMF remain concernedabout the size of BiH's external deficits—and the potential pressure they couldexert on the currency board—and the Central Bank is expected to maintain atight monetary policy over the forecast period. At the same time, the CentralBank has maintained high levels of international reserves in recent years, whichprovide a safety net against potential threats to the currency board.

The Central Bank is also expected to become increasingly proactive in its use ofits few policy tools. Current efforts to improve supervision of the bankingsector are expected to continue, in order to ensure the soundness of the sectorin the wake of its massive expansion in 2001-02. The entities currently haveseparate banking agencies, but have agreed to centralise supervision andregulation under the umbrella of the Central Bank.

Economic forecast

International assumptions summary(% unless otherwise indicated)

2002 2003 2004 2005Real GDP growthWorld 2.9 3.8 4.6 4.1OECD 1.6 2.1 3.2 2.6EU 1.0 0.7 1.9 2.1Exchange rates¥:US$ 125.3 115.9 105.5 106.5US$:€ 0.945 1.132 1.300 1.377SDR:US$ 0.772 0.714 0.660 0.644

Financial indicators€ 3-month interbank rate 3.33 2.33 1.93 2.23US$ 3-month Libor 1.80 1.21 1.26 3.24

International assumptions

Monetary policy



International assumptions summary(% unless otherwise indicated)

2002 2003 2004 2005Commodity pricesOil (Brent; US$/b) 25.0 28.8 27.0 22.1Gold (US$/troy oz) 310.3 362.8 421.3 375.0Food, feedstuffs & beverages (% change in US$

terms) 12.7 6.6 6.4 2.5Industrial raw materials (% change in US$ terms) 2.2 12.7 19.1 -3.1

Note. Regional GDP growth rates weighted using purchasing power parity exchange rates.

BiH’s economic growth is reliant on demand from its main trading partners inthe EU and in south-eastern Europe. A strong upturn in economic performancein the euro zone is likely to emerge only gradually over the forecast period,since an investment and debt overhang will hold back most euro zoneeconomies for some time. Should BiH’s largest EU trade partners fail to recoverduring the forecast period, its export and GDP growth would be lower thanforecast. Slower growth in these countries would also be likely to reduceinflows of aid and private investment, as well as significant private remittancesfrom citizens living abroad, which could have a negative impact on thecountry’s ability to finance its large current-account deficit. We expect healthygrowth in south-eastern Europe over the forecast period, but any faltering onreform progress could also leader to slower growth and weaker demand forBiH exports. Global oil prices are expected to fall gradually during the forecastperiod, providing a potential boost to industrial output in the form of lowerinput costs.

We expect the deceleration of real GDP growth seen last year to be reversedthis year, and see prospects for a consolidation of growth patterns in BiH overthe forecast period and beyond, should the current pace of reform be sustained.We anticipate weaker household consumption growth this year, driven by theeffects of the Central Bank's monetary measures from 2003 and restrainedpublic- and private-sector wage growth. Public-sector contribution to growthwill also be modest this year and next, with governments at all levelscommitted to fiscal tightening. However, these declines will be offset byincreased investment, both public and private. Investment growth will bedriven by the continuation of a number of ongoing reconstruction-relatedprojects and increasingly affordable credit for those actors in the corporatesector that are able to convince the banks of their creditworthiness. Progress incorporate restructuring should also boost investment. We also expect exports todrive growth, in view of our forecast for an economic upturn in the euro zone,despite halting progress in implementing free-trade agreements with several ofBiH's neighbours.

Several sectors are set for recovery this year. We expect manufacturing outputto recover, as domestic and foreign investment increases productive capacityand the expected pick-up in external demand boosts output in export-orientedindustries. The exceptional circumstances that led to a contraction in electricitygeneration in 2003 will not be repeated, making a return to growth likely. Thereis scattered evidence to suggest that construction activity, which decelerated in

Economic growth



the Federation in 2003, could pick up in 2004. The Federation government haspledged to invest some portion of its telecommunications company's profitsinto road-building, and several large new residential and commercialdevelopments are in the pipeline. A number of measures undertaken recentlyto boost agricultural production should reflect positively on the output of thissector, which has been subdued throughout the post-war recovery period andhas also been affected by two consecutive years of severe draught.

Based on the above assumptions we have adjusted upwards our forecast forreal GDP growth in 2004 from 3.8% to 4.3%. In 2005 we expect to see the initialresults of current initiatives to improve governance of state-owned enterprises,more progress in privatisation, and the implementation of a range of measuresto improve the business environment. Together these efforts will create spacefor accelerated expansion in output, and we forecast real GDP growth of 4.8%.

In 2003 prices in the Federation were up by just 0.1% year on year and those inthe RS by 1.8%. Inflation in the RS has traditionally been higher than in theFederation, owing to its stronger links to the economy of Serbia andMontenegro, although the gap between the entities' inflation rates will continueto narrow over the forecast period as the economic cycles come further intoalignment. In view of our forecast of falling oil prices, and under the assumptionof continuing strict implementation of the currency board, we expect inflationfor the country as a whole to remain low over the forecast period.

The convertible marka is pegged to the euro at a rate of KM1.96:€1, so themovement of the exchange rate is determined by movements of the euro to theUS dollar. The convertible marka has appreciated strongly against the US dollarin the past two years, and this trend is expected to continue in 2004, as theUS currency continues to weaken against the euro. BiH's inflation, however, ismuch lower than in the euro zone and the US, which along with slowerUS dollar depreciation against the euro in 2005 will temper the pace of realeffective appreciation over the forecast period. Nonetheless, upward pressureon the marka is a worrying trend, given that competitiveness in BiH’s exportsector is already low.

In 2003 BiH's US dollar-term trade deficit widened, despite improved exportperformance and slackening import growth, and thus the current-account deficitis estimated to have been wider than in 2002. In view of our forecast of agradual recovery in the EU in 2004-05, and the expected effects of BiH's free-trade agreements with its neighbours, exports look set to grow steadily over theforecast period. At the same time we expect to see a continued mild decelerationin import growth this year, in line with tight monetary policy, and over the restof the forecast period, as a result of slowing consumer demand and the windingdown of reconstruction-related activities. This should arrest the recent growth inthe trade deficit and bring the current-account deficit under 20% of GDP by theend of 2005, in spite of the ongoing decline in inward official transfers.

We expect growth in foreign investment in 2004-05, based on the assumptionof accelerated privatisation of several of BiH’s largest enterprises and publicutilities. BiH is set to receive a sovereign credit rating from one of the major

Inflation

Exchange rates

External sector



credit-rating agencies later this year, which will improve its image with foreigninvestors, and the state-level Foreign Investment Promotion Agency (FIPA) hasbecome increasingly proactive in marketing the country's investmentopportunities to overseas investors.

Forecast summary(% unless otherwise indicated)

2002a 2003 b 2004c 2005c

Real GDP growth 5.5 3.5 4.3 4.8Industrial production growth 7.5b 5.0 6.0 6.2

Average lending rate (%) 12.7 10.8 10.0 9.8Federation retail price inflation (av) -0.2 0.1 0.4 0.7Republika Srpska retail price inflation (av) 1.7 1.8 2.0 2.2

Exports of goods fob (US$ bn) 1.1 1.1 1.6 1.9Imports of goods fob (US$ bn) -4.5 -4.9 -4.9 -4.8

Current-account balance (US$ bn) -2.1 -2.2 -1.9 -1.6Current-account balance (% of GDP) -38.2 -31.3 -22.3 -17.1

External debt (year-end; US$ bn) 2.8b 3.5 3.9 4.2Exchange rate KM:US$ (av) 2.08 1.73 a 1.50 1.42Exchange rate KM:US$ (end-period) 1.87 1.55 a 1.41 1.46

a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts.

The political scene

Following a meeting of its leadership to assess the progress of the Federationgovernment, the nationalist Party for Democratic Action (SDA) launched anofficial initiative to reshuffle the Federation government in February 2004. Themeeting was convened at the request of the main board of the SDA at itssession in October, a week after the death of Alija Izetbegovic, the party's long-time leader. Elaborating on the decision, Sulejman Tihic, the incumbent SDAleader and the Bosniak member of the tripartite presidency of Bosnia andHercegovina (BiH), stated his party's concern that the government had failed todeliver on many issues that the SDA had pledged to tackle in its electionplatform. He highlighted the government’s inadequate response to highunemployment; its failure to revive the moribund privatisation programme;

The SDA asks for a Federationgovernment reshuffle



delays in the adoption of 2004 budget; the need for healthcare reform; and,above all, the poor communication and lack of consultation between thegovernment and parliament.

The proposal for the reshuffle was rejected by the other two coalition partners,the moderate Party for BiH (SzBiH) and the nationalist Croatian DemocraticUnion of BiH (HDZ BiH). The SzBiH, which had in the past criticised thegovernment and hinted that it would press for the resignation of the entityprime minister, Ahmet Hadzipasic, decided not to back the SDA proposal.Instead, the party used the opportunity to criticise the two main parties—theSDA and the HDZ BiH—over their style of government, which has relied heavilyon political deals struck outside the confines of the entity's governmentstructures. This has kept the SzBiH marginalised. The strife between the leadingcoalition partners was considered by some sections of the SzBiH to be anopportunity to assert itself in order to gain a better position within thegovernment. A meeting of the party's board, however, exposed tensionsbetween a faction that remains favourably predisposed to the SDA and a groupthat is critical of the SDA—and, indeed, of its own party’s participation in thegovernment. In the end, the SzBiH's statements shied away from demandingany resignations, preferring to emphasise the need to restructure the decision-making process.

Nonetheless, the problems within the Federation government neared crisis inMarch, when the SDA's main coalition partner in the Federation, the HDZ BiH,announced that it would sever all relations with the SDA and would consideritself an opposition party. The HDZ BiH leadership's complaints mirrored thoseof the SDA: the party complained of poor working relations between coalitionpartners, and obstructionist behaviour by high-ranking officials in the SDA. Atthe time of writing, however, the situation remained unclear, as the HDZ BiHannounced that it would allow some time for a "compromise" solution to bereached, suggesting that the current fragile coalition will remain in place.

Only weeks after the SDA initiative for the Federation government reshufflefailed, in early March Niko Lozancic, the president of the Federation and a mem-ber of the HDZ BiH, requested that the entity's prime minister, Mr Hadzipasic,be removed from his post. Mr Lozancic said his move was motivated by theproblems in the work of the government, and laid the blame squarely withMr Hadzipasic. Barisa Colak, the president of the HDZ BiH, put the initiative inthe context of his party’s dissatisfaction with its position in the government. Hecomplained that Bosnian Croat ministers in the government were constantlyoutvoted by SDA members, and proposed a new system by which governmentdecisions would require at least one member of each ethnic group to vote infavour. However, both the SDA and the SzBiH refused to support eitherMr Lozancic’s motion or Mr Colak's plans to reshape the government.

Mr Hadzipasic faced criticism not only from his coalition partners in early 2004,but also from within his own party, as the SDA leadership stepped up criticismof his leadership style and the ineffectiveness of the government under hiscontrol. The main problem for the party leadership, however, seems to be theincreasing frequency with which Mr Hadzipasic has bowed to pressure from

Coalition partners reject theSDA proposal

The HDZ BiH moves to deposethe Federation prime minister



the international community, which in many cases has meant straying from theparty line. Within party circles, similar criticism has been made of the work ofAdnan Terzic, the chairman of the BiH Council of Ministers (and also an SDAmember). The party's membership, which holds significant power within theentity's canton-level governments, appears to have become increasinglyconcerned at the close relationship that Mr Hadzipasic and Mr Terzic have builtwith the international community, as improving relations have led to theincreasing centralisation of power in the BiH capital, Sarajevo.

The lack of trust between the two main parties in the Federation is wellillustrated by the eight-year battle over the final status of the city of Mostar(January 2004, The political scene), during which the two parties have failed toreach an agreement on how to govern the divided city (following an initialperiod of international administration, it has consisted of six self-governing andethnically divided municipalities). Since 1996, despite intensive internationalinvolvement, the two leading Federation parties have proven incapable ofagreeing to any power-sharing arrangements that would not guarantee thepolitical dominance of their respective ethnic group.

In February 2003 the Office of the High Representative (OHR) imposed apermanent statute for Mostar, under which the six municipalities wereabolished and Mostar was reorganised as one municipality with six electoralunits. The new statute abolishes parallel Croat and Muslim structures,establishes a single town mayor, budget and administration, and providessafeguards against the accumulation of power in the hands of either ethnicgroup. Both parties fought the proposal until the very end, suggesting that itwill not be easy to implement. The reorganisation of Mostar will result in manyjob losses because of the rationalisation of the former municipalities' numerousparallel structures, which will in itself work to the detriment of ethnicreconciliation, at least in the short term.

Political relations in the Republika Srpska (RS) government have also beenfractious in recent months. On March 1st Mirko Sarovic, the deputy chairmanof the Serb Democratic Party (SDS), withdrew from the party leadership inresponse to a demand from the OHR for his resignation from public posts andfrom politics after the US included his name on a list of people charged withaiding Radovan Karadzic, a fugitive war crimes suspect. In 2003 Mr Sarovicresigned from BiH's tripartite presidency over his involvement in a scandalinvolving the shipment of arms to Iraq.

In protest against the OHR’s request, the six deputy chairmen of the SDSoffered their resignation to the main board of the party. A debate then ensuedbetween the faction of the RS president, Dragan Cavic, and the faction close toDragan Kalinic, the RS parliamentary speaker, over whether either, or both, ofthe men should resign. Mr Kalinic said that any resignations would necessitatea new round of distracting party elections, and Mr Cavic—who claimed that hisopponent was also involved in behind-the-scenes dealings with theinternational community—pressed for the SDS to make a stand against theongoing international pressure on the party to give in to the efforts tostrengthen central state structures. In the end, the party leadership decided that

OHR pressure drives deal onthe final status of Mostar

Departure of leader revealsSDS power struggle



it had no power to discuss the resignation of Mr Kalinic and Mr Cavic andrejected the resignations of the six deputy chairmen. The fraying of allianceswithin the party, however, is symptomatic of the problems facing the politicalestablishment in the RS, as the OHR increases pressure to bolster the centralBiH state as part of the country's EU integration process.

The SDS in particular has come under heavy criticism from the OHR and theBiH government over its obstruction of reforms aimed at transferring powersfrom the entity to the state level. These reforms are a condition for BiH’sprospective membership of NATO’s Partnership for Peace (PfP) programme andfor opening negotiations with the EU on a stabilisation and associationagreement (SAA), which are the opening steps in processes towards eventual fullmembership of these bodies. In February the RS Assembly—in which the SDS isthe largest party—failed to authorise the government to establish a state-levelHigher Judicial and Prosecution Council (HJPC). The establishment of the state-level HJPC, a body intended to centralise the appointment and training of judgesand prosecutors in the entities, is one of the conditions set by the EuropeanCommission for the opening of negotiations on an SAA. In addition, theAssembly also attempted to obstruct the eventual adoption of a law on the StateIntelligence and Security Agency, as well as the appointment of a new state-leveldefence minister—also a condition for the opening of SAA negotiations.

NATO and the OHR set a deadline of February 15th for the defence minister tohave been confirmed if BiH were to receive an invitation to join the PfPprogramme, which the local authorities hope will come at the NATO summit inIstanbul in June. The two candidates initially accepted by the chairman of theBiH Council of Ministers—Adnan Terzic, BiH's de facto prime minister—wereeventually rejected by either the Council of Ministers or the OHR. BrankoStevic, the first nominee, was rejected because of questions over his wartimerole as a high-ranking police official. Dragomir Dumic, the second choice,withdrew his candidacy amid speculation that the OHR would not approve hisappointment, largely because of his lack of experience and credibility withinthe defence establishment in Europe. On March 9th Nikola Radovanovic, aWestern-educated non-party candidate with a background in military studies,secured the appointment as defence minister, with the blessing of the OHR.

The SDS has also played a role in obstructing the hunt for war crimes suspects.The OHR and NATO have put growing pressure on the RS government to acton its promises to help in the search for suspects by joining the troops of theNATO-led Stabilisation Force (SFOR) in operations, threatening sanctionsotherwise. The first such joint NATO-RS operation took place in January 2004at Pale, when evidence was gathered to help in the search for Mr Karadzic andhis helpers. In March the RS security services conducted their first independentoperation, although the 150-man raid failed to net any suspects. The issue of thearrest of indicted war criminals has come to prominence again recently, as theEU has made it clear that without the apprehension of the two leadingsuspects—Mr Karadzic and Ratko Mladic (the former commander of the BosnianSerb army)—BiH's further progress in Euro-Atlantic integration will not bepossible. Under growing pressure from all sides, Mr Kalinic confirmed in the RS

SDS is criticised for obstructingreform in the RS

New defence minister isfinally appointed

War crimes suspects remain akey obstacle



Assembly in February that the RS had a duty to assist in the arrest of warcrimes suspects, which could signal a possible change in the RS's approach.

The Party of Independent Social Democrats (SNSD), the main RS oppositionparty, continues its campaign against the RS government. Its leader,Milorad Dodik, has relied on a strategy of organising demonstrations across theRS to protest against the poor performance of the government, in the hope thatpublic pressure will give credence to calls for a government reshuffle. He hasaccused the government of protecting suspected war criminals, thus exposingthe RS to the risk of international sanctions, but he is at the same time criticalof the approach of the SDS to transferring powers from the entity to the statelevel. The SNSD claims that the SDS lacks any vision of what the impact on theRS's eventual status will be.

In co-operation with the Democratic People’s Alliance and the Socialist Party ofRepublika Srpska, the SNSD has launched an initiative inviting other BiHparties to talks on changing the constitutional set up of BiH to create anasymmetric confederation. The SNSD made clear its goal of establishing aconstitutional structure that would enable the RS to survive in the event thatthe Federation were to be dissolved into its individual cantons—a possibilityrecently raised by the European Stability Initiative, a political think-tank.According to a recent poll conducted by the UN Development Programme(UNDP), the SNSD's popularity is rising in the RS.

On March 5th the BiH House of Peoples passed a law forming a StateIntelligence and Security Agency. The agency will be responsible for thecollection, analysis and distribution of intelligence material, uniting the formerintelligence services of the RS and the Federation. The House of Representatives(the lower parliamentary body at the state level) adopted the law onFebruary 25th, but it was rejected on first reading in the House of Peoples. TheHDZ BiH demanded that the head of the agency be nominated by the statepresidency, and not by the chairman of the Council of Ministers, and itsproposal was accepted in the final draft of the law. The passage of the law wasone of the main conditions set by the European Commission for the opening ofnegotiations on an SAA, and also a criterion for PfP membership.

The issue of the eventual expiry of the mandate of the SFOR peacekeepingforce, and its replacement by EU troops, appears to have been resolvedamicably by NATO and the EU, despite several changes of heart by the USregarding its willingness to hand over control to the EU. A NATO-led force hasbeen deployed in BiH since the war ended in 1995, and, at its peak, numbered60,000 troops. The withdrawal of SFOR, which is expected by the end of 2004,will not mean the complete disengagement of NATO from BiH. Talks are underway regarding the establishment of a small NATO mission in BiH, a move thathas the strong support of the BiH government as a way of securing continuedUS interest in the country. The mission’s main task would be to assist in thesearch for war crimes indictees. BiH officials expressed an interest in beingmore closely involved in the discussion over the future mandate of the EUcontingent, which they expect to follow broadly the current mandate of SFOR.

The SNSD continues to rallyfor early elections

New law removes key obstacleto SAA negotiations

Planning for transfer of powerfrom SFOR to EU is under way



It is likely that a formal decision on ending the SFOR mandate will beannounced at the NATO summit in Istanbul in June.

Economic policy

At the end of December 2003 the IMF extended its US$101m stand-byagreement with Bosnia and Hercegovina (BiH) for two months (following asimilar extension in October 2003), allowing the BiH government to withdrawthe final tranche of US$18m. The IMF completed its fourth and final review ofthe programme in February this year, agreeing to overlook the non-observanceof one of the agreement's structural criteria, which dealt with improving theregulation of the banking sector.

The review was conditional on the government's agreeing a plan to deal withthe large amount of domestic claims on it (estimated at as much as 200% ofGDP), which are mostly wage and pension arrears and wartime claims. Thegovernment now plans to issue a combination of cash payments and long-termbonds to the value of around 10% of the net present value of these claims.

The IMF commended the government's progress under the stand-by agreement,noting in particular the continuing macroeconomic stability and the growingconsensus on major reform initiatives due to be implemented in 2004. The IMFcontinued to insist on faster progress in implementing a new framework forindirect taxation, restructuring the domestic claims on the government, anddecommissioning military personnel. At the same time, the IMF expressedconcern over the pace of structural reforms aimed at reviving the corporatesector, which it considers the key for consolidating and sustaining macro-economic stability. A recent study by the World Bank suggested that an increasein domestic savings to the level of 8-14% of GDP over the next five years wouldbe needed to provide for the necessary increase in fixed investment, in view ofdeclining aid inflows, to maintain growth of around 5%.

Another condition for the release of the last tranche of the IMF stand-by agree-ment was for the entity and state budgets to be agreed within the expenditurelimits prescribed by the IMF. According to preliminary IMF estimates, a smallconsolidated budget surplus was recorded in 2003, following a 4.3% deficit in2002. The improvement in fiscal performance was achieved despite problemsboth entities encountered in keeping up with budget projections during thesecond half of 2003, which led to new expenditure arrears. Under pressurefrom the IMF, the governments at all three levels—state, entity and cantonal—appear to have kept spending under control, and even extrabudgetary funds forhealth, employment and pensions achieved balanced budgets.

In February the Federation government adopted a 2004 budget that anticipatedexpenditure of some KM1.25bn (US$862m). Revenue is expected to reacharound KM1bn, and the small deficit is to be covered by funds from the IMF,the World Bank and other international financial institutions. The new budgetenvisages further cuts in expenditure after a year of heavy consolidation in2003, of which reducing military spending remains one of the key goals. A newround of demobilisation, involving some 5,200 troops, is planned for 2004 as

IMF extends its stand-byagreement

Federation budget includescuts in defence and spending



part of downsizing the armed forces in preparation for BiH's accession toNATO's Partnership for Peace (PfP) programme.

Towards the end of 2003 the Federation government's pension and disabilitybenefits arrears grew significantly. In January it thus adopted a decision ontemporary budget funding for the first quarter of 2004, in order to allow for aone-off payment of KM41.15m (US$28m) to cover the growing arrears. Thefunding was partly secured from an escrow fund into which privatisationproceeds and frozen assets from the dissolution of Yugoslavia have been paid.The Federation will be required to replenish the fund.

In December the Republika Srpska (RS) government adopted the entity's 2004budget, which envisaged an increase in expenditure of roughly 7.5% comparedwith the 2003 budget. The adoption of the budget followed a heated debate overthe projected allocation of funding. MPs from the moderate Party for DemocraticProgress (PDP) and the more nationalist Serb Democratic Party (SDS) demandedincreased expenditure for war invalids, families of dead soldiers, refugees anddisplaced persons, to which the government agreed. However, the governmentrefused requests to increase funds for public-sector salaries, disability benefits,pensions and social security, in line with its agreement with the IMF.

The BiH presidency adopted a draft budget for the BiH state government in2004 at an emergency session on March 3rd. The delay in the budgetaryprocedure was caused by prolonged negotiations over the establishment ofnew state-level institutions—the Indirect Tax Administration, State Intelligenceand Security Agency, and a Ministry of Defence—which had been thecentrepiece of economic policymaking in 2003 and which awaitimplementation this year. Of the KM480.5m earmarked in the budget forexpenditure, KM211.9m was assigned to support the function of BiH's stateinstitutions and KM268.6m (some 56% of the total) for servicing external debt.An annex to the budget stipulates that an additional KM5m will be set aside forthe new state institutions, with the Federation to provide KM3m from itsbudget, the RS KM1.5m, and Brcko district KM0.5m. In order to avoid political orprocedural difficulties in securing the funds for the work of the newinstitutions, the budget laws of the entities and Brcko district providemechanisms for the automatic transfer of funds to the central state budget.

In 2003 the RS government faced heavy pressure from the representatives ofworkers and pensioners who are unhappy with the level of compensation theyreceive from the government and the low standard of living in the entity. InOctober, in breach of the IMF stand-by agreement, the RS government gave in tothe demands to increase pensions and agreed to a gradual rise in the minimumwage. In early March this year the RS government again came under pressurefrom the trade unions over the signing of a social agreement on employmentand wages. The government agreed to pay a 20% portion of outstanding wagesowed to public-sector workers, along with regular wages, in early 2004, andcommitted itself to the protection of workers' rights in the future.

The Federation government faced a similar battle in March, holding meetingswith unions, the Office of the High Representative (OHR), and the World Bank.

RS 2004 budgetaryexpenditure increases

BiH adopts state budget inemergency procedure

RS government feels pressurefrom unions and pensioners



The unions pressed for the adoption of amendments to the entity's bankruptcylaw, which would give workers priority status over other creditors in therestructuring of bankrupt companies, in the hope that this would lead to fewerliquidations and improved conditions for workers in technically bankrupt firms.

In December 2003 the BiH parliament adopted the long-awaited law on indirecttaxation, by which a unified state-level Indirect Taxation Authority (ITA)replaced the entities' customs administrations. Under the BiH constitutionadopted as part of the Dayton accord, customs administration comes underentity jurisdiction. The establishment of the ITA was thus hailed as the firstinstance of the entities' transferring responsibility to the state level—a move thathas since been followed by centralisation of defence and intelligence capacities.

Implementation of customs policy at the entity level has caused enormouslosses in tax revenue in recent years. Given that customs make up the majorityof both entities' budget revenue, there was strong opposition from bothgovernments initially over the potential loss of direct control over this source ofincome. The new law explicitly guarantees both entities the receipt of their fullshare of customs revenue, while centralising the collection of customs dutiesand administration of the process, with the intention of reducing fraud andslippage along the borders. The next step in the process of modernisation andreform of the country's tax system is expected to be the implementation of astate-wide value-added tax (VAT). A team of experts from both entities, withclose support from the European Commission and the World Bank, has begunwork on a plan for eventual implementation of state-wide VAT by early 2006.The OHR and the World Bank have insisted for the past two years thatestablishment of single VAT and customs administrations is a necessary steptowards the creation of a single economic space in BiH.

In late December, under pressure from the agricultural lobby, the BiH Councilof Ministers decided to suspend until March 31st 2004 the implementation ofsome sections of the free-trade agreements that it had signed with Croatia andwith Serbia and Montenegro. The agreements, signed in 2001 and 2002,respectively, are asymmetric, allowing tariff-free exports from BiH withimmediate effect, and delayed and gradual elimination of import tariffs ongoods from Croatia and from Serbia and Montenegro. Full liberalisation oftrade in agricultural products was due from January 1st 2004. However, inPosusje the BiH farmers' association blocked the border crossing with Croatia,protesting against the terms of the agreement (which make the export of somegoods to Croatia difficult because of differences in veterinary andphytosanitary standards). The farmers threatened to block all border crossingswith Croatia if the government failed to react, and the government was forcedto bow to the association's demands.

Food makes up around one-quarter of BiH's imports, which has put strongcompetitive pressure on local producers. Both the Croatian and Serbiangovernments protested against BiH's unilateral decision, and high-level talkswere held to resolve the issue, but the suspensions remained in place. Thegovernment had been expected to bring BiH into the World Trade Organisation(WTO) this year—another significant step in reintegrating the country's

Free-trade agreementstemporarily suspended

The law on indirect taxationcomes into force



economy with those of its neighbours and European trading partners—but theback-tracking that the government showed with respect to its free-tradeagreements could have significant negative repercussions in that process. As yet,the status of the free-trade agreements remains certain.

For the past two years the privatisation process in the Federation has been at avirtual standstill. In February the Federation House of Representatives adopteda report on privatisation, claiming that around one-third of the state capital onoffer has been sold, KM3.6bn through the public offering of shares andKM1.4bn through tenders. However, of the 1,450 firms earmarked forprivatisation, most of those in which stakes have been sold are small or "non-strategic" companies, leaving the remaining sales as both the most complex andpotentially the most valuable to the state's coffers.

The sale of large companies and public utilities has long met with politicalobstruction, and the Federation government is now looking at a strategy forkick-starting the process. The government is currently preparing a plan for theprivatisation of utilities, including in the energy sector, telecommunications androad infrastructure, as well as changes to some privatisation-related laws toincrease the emphasis on employment protection and job creation.

In January Donald Hays, the principal deputy high representative, met withprime ministers of several of the largest cantons in the Federation—each ofwhich has its own privatisation agency in competition with the entity agency—in an attempt to reach agreement on transferring authorisation for the sales ofstrategic state-owned enterprises from local agencies to the entity privatisationagency. However, no agreement was reached, as the prime ministers insistedthat they would have to refer the proposal to their own governments.

Despite objections from the World Bank and the IMF, in March the Federationgovernment announced that it would attempt to revive the defunct Air Bosnaairline, which was forced to suspend operations in 2003 because of unpaiddebts amounting to €8m (US$10m). The government intends to close a €5.5mcommercial loan to help the company to restart the operation, and to increaseper-customer taxes on flights. The World Bank, however, suggested that theintervention would also require significant public subsidy, at a time when fiscalconsolidation remains the watchword in both entities.

The domestic economy

Output and demand

Industrial output in the Federation rose by 4.8% year on year in 2003—adeceleration compared with the strong performance recorded in the previousseveral years. The main reason for the slowdown last year was a moderation inthe growth of manufacturing, despite improving export figures, as the post-warreconstruction-related upsurge in activity appears to have come to an end.Bearing in mind that the recovery in the Federation has remained confined toseveral industries, the slowdown is primarily the result of a return to more

Federation government aimsto save bankrupt airline

Federation governmentdiscusses privatisation strategy

Federation industrialproduction slows in 2003



sustainable growth rates than the double-digit output gains registered in theearly years after the war.

Output growth in some of the Federation’s most important industries—foodand beverages, wood-processing, furniture manufacture and tobacco—wasbelow the overall growth rate in manufacturing last year, and much lower thanin most of the two-year period prior to 2003. In part, weak performance in thewood sector was the result of public-sector interference, as the governmentdecided to limit exports of raw and processed wood products in order toconcentrate on development of the higher value-added and higher marginfurniture sector. Output in textiles, apparel and leather-processing, anothertraditionally important cluster of industries in the Federation, contracted inannual terms in 2003—and these industries are likely to find the going muchmore difficult in years to come, given the likely acceleration in implementationof free-trade agreements and the uncompetitiveness of many of the firms inthese more traditional sectors. By contrast, non-metallic minerals and basemetals continued in 2003 to be the fastest-growing industrial sectors, growingby 8.5% and 13.3%, respectively.

Another factor contributing to the 2003 slowdown in industrial output growthin the Federation was a contraction in electricity output. Electricity output,which accounts for about one-third of the Federation's industrial output, fell by1% year on year. Contraction in electricity output was caused by technicalproblems and a shortage of coal in the Kakanj and Tuzla thermoelectric powerplants. As this statistical category also includes gas, steam and hot water supply,some of the fall in output is also likely to be attributable to disruptions in thesupply of gas, in response to an accumulation of payment arrears for gaspurchased from Russia.

Federation: industrial production(% change year on year unless otherwise indicated)

% of total 2002 2002 2003Energy 39.9 4.2 1.6Intermediate goods 25.0 8.8 12.7Capital goods 2.5 3.3 14.2

Consumer durables 2.9 36.9 0.1Consumer non-durables 24.5 16.4 -7.6

Other 5.2 -2.9 0.8

Source: Federal Office of Statistics (FOS), Statistical Data on Economic and Other Trends.

Growth in the manufacture of intermediary and capital goods was sustained in2003—up by 12.7% and 14.2%, respectively. No data on the overall compositionof industrial output by use for 2003 was available at the time of writing, butstrong performance in these two industrial groupings is likely to have arrested atrend of falling share in total output recorded in 2000-02. This improved sharefor investment-related goods production is a positive sign for an economydesperate for increased investment and improved competitiveness.Nonetheless, capital goods' share in total output remains low in absolute terms:electricity accounted for almost 40% of total output in 2002, whereas the shareof intermediary goods was around 25% and capital goods 2.5%. Thiscomposition of industrial output suggests that widespread industrial recovery



still has not taken place, as enterprises struggle to overcome difficulties causedby war-inflicted damages, unsustainable cost structures, uncompetitiveproducts and the weak international economic environment.

Following a recovery in the second half of 2003, industrial output in RepublikaSrpska (RS) posted 5.7% annual growth. This healthy growth figure is, however,primarily attributable to a base-year effect, given very poor industrialperformance in 2002. The main impetus to industrial growth in 2003 camefrom the electricity sector, which expanded by 16.3% year on year, combinedwith a 22.4% increase in mining—the third-largest industrial sector in the RS. Atthe same time manufacturing output declined by 0.5% year on year, owing to acontraction in output in 13 out of the 23 industrial branches covered by the RSInstitute of Statistics. Contraction in the manufacture of wood, coke and refinedpetroleum products and the manufacture of other non-metallic minerals hadthe greatest impact on the decline in total manufacturing output.

In contrast to the Federation, electricity was the fastest-growing industrialcomponent in the breakdown of industry by final use. Electricity output roseby 10.1% year on year, followed by capital goods (6.5%), non-durable consumergoods (3.8%) and intermediary goods (2.7%). In the RS the composition ofindustrial output by final use has been more favourable than that of theFederation, with capital goods accounting for a much larger percentage of totalproduction, although that trend was reversed in 2003.

Improved performance in the last quarter of 2003 pushed the Federation's full-year construction output growth to 4.1% year on year, although this figurerepresents a slowdown compared with the 6% annual increase in 2002. Therewas a pronounced shift in the composition of output in favour of work on newbuildings, which represented some 60% of the total, compared with theprevious year, when the split was roughly equal between construction of newhouses and maintenance and repair of existing buildings. Although theproportion has declined slightly since 2000, a large proportion of new buildingconstruction is still residential, with the most buoyant housing growth in theSarajevo canton. A significant boost to the sector’s performance is likely thisyear and next if a number of road-building projects currently underdiscussion—especially the long-awaited Corridor Vc—materialise.

In the RS the construction sector posted a strong performance by all indicatorsin 2003. The value of work contracted rose by 12.1% year on year. The numberof workers on construction sites was up by 13.8% and this led to a 13.3% increasein the number of hours worked. Although the RS is the smaller of the twoentities, its construction sector is only slightly smaller than that of theFederation in terms of output. In 2003 the value of work completed in theFederation amounted to KM392m (US$230m), compared with KM300m in theRS, suggesting much more buoyant construction activity in the latter entity.

In 2003 Federation retail sales increased by 12.7% year on year, underpinned bycontinuing growth in wages as well as widening access to consumer credit,thanks to the increasing competitiveness and soundness of the banking sector.Another important driver of consumer spending is remittances, which,

Construction performance ismixed across entities

Car sales boost Federationretail trade performance

RS industrial output postshealthy growth



according to the latest IMF estimates, amount to around 10% of GDP in Bosniaand Hercegovina (BiH). The most notable growth in 2003 was a 60% increase inthe sales of motor vehicles. A trebling of stocks between December 2002 andDecember 2003, however, may be indicative of a coming slowdown inconsumer demand, as a result of the measures taken by the Central Bank ofBiH to arrest the expansion in the household credit.

The entities' trade with one another followed traditional patterns in 2003—theFederation's sales to the RS were almost four times as large as flows in theother direction, and food products made up the largest portion of trade in bothdirections. Very slow growth in trade flows between the entities in 2003provide some discouraging evidence that the efforts of the Office of the HighRepresentative (OHR) and the entity governments to reduce barriers to tradeacross the entities and establish a single economic space did not pay greatdividends in 2003.

BiH: inter-entity turnover(KM m unless otherwise indicated)

2002 2003 % changeFederation sales to the RSFood products 72.3 72.2 -0.1Textile products 5.3 7.2 36.3Leather products 2.2 2.9 34.3Fuel materials 1.8 6.1 236.6Metal products 14.2 11.7 -17.7Glass, ceramics & porcelain 5.3 4.1 -22.4Electrical engineering 48.3 51.3 6.3Chemicals 17.1 11.4 -33.3Wood products 13.2 8.2 -38.1Liquid fuel & lubricant oil 2.1 0.3 -86.5Non-metal building materials 12.8 16.1 25.3Other 31.7 45.5 43.6Total 226.3 237.0 4.7Federation buys from the RSFood products 21.1 23.3 10.5Textile products 1.2 0.9 -23.7Leather products 0.8 0.6 -31.5Fuel materials 0.9 0.5 -43.0Metal products 4.4 5.4 24.5Glass, ceramics & porcelain 0.5 0.5 -3.2Electrical engineering 1.6 2.1 31.3Chemicals 12.6 11.3 -10.4Wood products 4.4 4.1 -5.1Liquid fuel & lubricant oil 1.6 0.6 -60.2Non-metal building materials 2.5 2.3 -4.6Other 11.7 12.3 5.2Total 63.2 64.0 1.3

Source: FOS, Statistical Data on Economic and Other Trends.



Employment, wages and prices

Federation employment remained stable throughout 2003; total registeredemployment rose by less than 1,000—only 1%—between January andDecember. Most of the newly created jobs were in the food and beveragesindustry—one of the entity's largest—despite increasing competition fromregional imports. At the same time, unemployment continued to edge upwards.In December the number of registered unemployed was up by 4.8% comparedwith a year earlier, and reached its highest level in years. The greatest job losseswere in manufacturing, of which in turn the largest losses were in the textiles,apparel and leather-processing industries.

Nonetheless, manufacturing continues to be the single largest employer in theFederation, providing 26% of all registered jobs. Given the increasingcompetition that the sector faces as trade barriers in the region fall, and growingpressure on firms to begin much-delayed corporate restructuring procedures, itis unlikely that unemployment in the Federation will fall significantly in thenear future—especially as the new bankruptcy law enters into force. In an eventstaged to coincide with the labour unions' review with the government ofamendments to the bankruptcy law, metal workers in Sarajevo canton stageddemonstrations, claiming that at least 10,000 jobs would disappear if the lawwere adopted in its current form.

BiH: labour statistics, 2003('000 unless otherwise indicated)

Mar Apr May Jun Jul Aug Sep Oct Nov DecFederationEmployment 387.1 387.4 387.5 387.9 387.8 388.1 387.5 387.2 387.7 387.3Unemployment 293.2 292.8 292.6 294.0 297.5 299.3 302.3 303.1 303.5 304.8Rate (%)a 43.1 43.1 43.0 43.1 43.4 43.5 43.8 43.9 43.9 44.0Net wage (KM) 516.0 523.4 524.9 526.8 530.8 527.1 526.9 528.4 528.2 530.5Republika Srpskab

Unemployment 135.3 135.0 134.8 135.4 136.4 137.2 138.2 138.6 139.1 138.1Net wage (KM) 371 369 373 379 374 381 376 386 394 385

a Unemployed divided by unemployed plus employed; includes waiting-list workers. b Employment figures not reported.

Sources: FOS, Statistical Data on Economic and Other Trends; Republika Srpska Institute of Statistics, Monthly Statistical Review; OHR, Economic Newsletter.

The RS does not regularly publish employment data. According to the mostrecent data from the RS Employment Bureau, there were 145,000 registeredunemployed in the RS in December—a slight fall from the latest available datafrom the Institute of Statistics—and the officially recorded rate ofunemployment was around 38%. The official figure for the country as a wholesuggests an unemployment rate at just under 40%, but the most recent IMFestimates suggests that it could be much lower—perhaps around 20%—in partowing to the pervasive and growing shadow economy. Unemploymentremains a concern in the medium term, with significant redundancies expectedin the defence sector and the public administration as a result of theimplementation of the bankruptcy law.

Unemployment rises in theFederation

Unemployment remains aconcern in the RS



Despite a deceleration in the second half of 2003, full-year nominal wagegrowth in BiH was strong—some 9% in both the Federation and the RS. Theaverage net wage in 2003 amounted to KM523 (US$302) in the Federation andKM379 in the RS. Given the entities’ low rates of inflation, these trends implystrong growth in real wages, which against the trend of rising unemploymentsuggests that rigidities in the labour market remain one of the key obstacles toaddressing the problem of unemployment in BiH. More broadly, rapid realwage growth is likely to have outstripped productivity growth, thusundermining the competitiveness of the country’s industry. Recently, this areahas been highlighted by the IMF as requiring urgent attention; the Fundreserved particular criticism for the entities' collective wage-setting agreements,which lock in rigid wage structures and distort the market wage determinationprocess. The prevalent method in place in the Federation, of setting theminimum price of labour as a percentage of the average wage, reinforcesupward pressure on wages, and could spur faster inflation.

In spite of rising wages, inflationary pressures remain very subdued in BiH. Inthe Federation, prices rose by only 0.1% year on year in 2003. An annual rise inagricultural prices of 1.5%, driven in part by the severe drought experienced inthe first half of the year, was offset by a decline in the prices of manufacturedfoodstuffs, and other prices remained broadly unchanged. In the RS, followinga rise in the third quarter, the medium-term disinflationary trend was re-established at the end of the year, bringing the overall 2003 increase in pricesdown to 1.8% year on year. Services prices increased by 6% year on year, withagricultural prices rising by 4.4%, also owing to the effects of the drought.

BiH: retail prices, 2003(% change)

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec JanFederationMonth on month 0.0 0.3 0.3 -0.3 0.3 -0.4 -0.5 -0.5 0.4 0.6 0.0 0.2 n/aYear on year -1.3 -0.8 -0.2 0.7 0.3 0.7 0.4 -0.2 0.5 0.5 0.4 0.3 n/aRepublika SrpskaMonth on month 0.1 0.2 0.1 -1.1 -0.2 -0.1 -0.7 0.0 0.3 2.1 0.0 0.1 0.4Year on year 1.7 2.0 2.1 2.6 1.8 1.7 1.4 1.7 1.9 2.2 1.2 1.3 1.6

Sources: FOS, Statistical Data on Economic and Other Trends; Republika Srpska Institute of Statistics, Monthly Statistical Review.

Financial indicators

Consumer credit rose dramatically in 2002, in part owing to the introduction ofwell-capitalised foreign banks into the local banking sector, but also because ofthe introduction of the euro, as citizens brought savings that had previouslybeen held outside the sector into their banks for conversion. In the first threequarters of 2003, the Central Bank's tightening measures—it adjusted reserverequirements for banks and stepped up enforcement of minimum capitalrequirements—led to a slowdown in credit growth, although lending in bothentities still rose by over 20% compared with the end of 2002. In line with thesignificant fiscal consolidation experienced in the year, credit to governmentand public enterprises was down in both entities, whereas consumers made up

Wage growth is buoyant inboth entities

Inflation is low across BiH

Consumer credit growth slows



the bulk of the credit growth, taking out loans to finance purchases ofautomobiles and consumer goods, as well as continued housing improvements.

BiH: commercial bank lending(KM m unless otherwise indicated; end period)

Federation RS2002 3 Qtr 2003 % change 2002 3 Qtr 2003 % change

To government 30.2 30.3 0 14.5 4.6 -68To public enterprises 247.6 222.5 -10 112.4 60.7 -46

To private enterprises 1,078.8 1,329.3 23 225.5 289.4 28To households 1,262.1 1,597.6 27 155.5 253.4 63To others 72.9 89.2 22 15.2 22.7 49

Total 2,691.6 3,268.8 21 523.1 630.8 21

Source: Derived from Federation Banking Agency, Information on Banking System of the Federation of Bosnia and Herzegovina, Republika Srpska Banking Agency, Information on Banking

System of RS.

Interest rates have been falling steadily for some time in BiH, as a result of bankprivatisation, increased competition and foreign entry, and the introduction ofdeposit insurance. Both short- and long-term lending rates have fallen below10%—still well above euro zone averages—from around 30% in 2000. Similarly,deposit rates have also been declining, and in September 2003 stood at 3.9%and 1% for time and sight deposits, respectively. The interest rate spread has alsonarrowed significantly since the wave of bank privatisations in 2001 and 2002,and the consequent increase in competition among the banks. 2003 was a tightyear for monetary policy, with the Central Bank of BiH raising the banks'reserve requirement, tightening core capital requirements, and strengtheningforeign-exchange exposure regulation. However, rates fell steadily throughout2003, with the exception of a minor upturn in December.

Foreign trade and payments

After a weak external performance in 2002, preliminary data suggest that theexternal position in the Federation in 2003 consolidated to some extent. TheFederation posted a trade deficit of US$2.3bn, an increase of some US$300myear on year. Exports rose by 43.5% and imports by 23.2% in US dollar terms,although a large part of the increase was driven by exchange-rate effects, as aresult of significant US dollar depreciation against the euro—the currency inwhich most of the trade of Bosnia and Hercegovina (BiH) is conducted. Inconvertible marka terms, which provide a better picture of volume trends, thetrade deficit narrowed slightly, falling by some KM100m (US$56m) to KM3.9bn.Merchandise exports performed strongly, rising by 19.7%. At the same time,imports grew by just 2.8%, partly because of the impact of measuresundertaken by the Central Bank of BiH halfway through the year. The coverageof imports by exports, although rising, remained low at 31%.

Manufacturing exports grew by 23.8% year on year in 2003, despite difficulttrading conditions in the EU, the Federation’s main market. This was a sharpimprovement on 2002, when the value of manufactured exports contracted by11%. Growth was particularly strong in motor vehicles (foreign sales more thandoubled), furniture (up by 20.9% with the help of government intervention),

Interest rates continue to edgedownwards

Federation foreign trade deficitwidens in 2003

Manufacturing exportsperform well



and machinery. Exports of base metals, the single most important exportindustry, fell by just over 1% year on year. The deterioration is likely to havebeen caused by difficulties experienced by the key exporter, AluminiumMostar, in keeping up with its production schedule because of interruptions inits electricity supply. A lengthy dispute over the price of electricity supplied toAluminium Mostar by a German intermediary, Debis, was reflected in acontraction in the exports of electricity, which fell by 20.5% year on year.

Imports of machinery and transport equipment grew by 22% and accounted for25% of total imports. Although purchases of passenger cars, underpinned byeasy access to consumer credit, accounted for a large share of total machineryand transport imports, purchases of capital equipment also grew. Combinedwith a rise in intermediate goods, the fastest-growing import category, thisindicates a continuing upward trend in investment-related imports. Imports offood products, the third-largest import item, declined by 5.8% year on year.

Federation: foreign trade(KM m unless otherwise indicated; by NACE production classification; fob-cif)

2002 % of total 2003 % of total % changeExports (incl unclassified)Agriculture & fisheries 27.6 1.8 15.0 0.8 -45.6Mining 26.7 1.8 35.6 2.0 33.4Manufacturing 1,331.8 87.9 1,648.8 90.9 23.8 Base metals 392.9 25.9 388.6 21.4 -1.1 Wood products 194.5 12.8 213.8 11.8 9.9 Furniture 128.4 8.5 155.2 8.6 20.9Electricity, gas & water supply 102.1 6.7 81.2 4.5 -20.5Other 10.1 0.7 31.1 1.7 209.0Total 1,514.5 100.0 1,812.9 100.0 19.7Imports (incl unclassified)Agriculture & fisheries 223.2 4.0 264.0 4.6 18.3Mining 12.1 0.2 25.7 0.4 113.2Manufacturing 4,308.7 76.8 5,360.0 92.9 24.4 Food & beverages 743.5 13.2 823.8 14.3 10.8 Machinery & equipment 457.5 8.2 558.2 9.7 22.0 Chemicals 425.0 7.6 553.3 9.6 30.2Electricity, gas & water supply 32.1 0.6 57.6 1.0 79.2Other 99.2 1.8 35.2 0.6 -64.5Total 5,612.5 100.0 5,769.6 100.0 2.8Balance -4,097.9 – -3,956.7 – -3.4

Source: Federal Office of Statistics (FOS), Statistical Data on Economic and Other Trends.

After a decline in sales in 2002, Federation exports to the EU in 2003 rose by19.5% year on year, on the back of a sharp increase in sales to Italy andGermany (of 42.3% and 41.5%, respectively). However, total EU-bound exports ofKM742.7m were still below the corresponding figure for 2001. Imports from theEU in 2003 increased at a much slower pace of 2.4% year on year, with importsfrom Austria contracting by almost 10%. Nonetheless, the Federation continuedto import roughly three times as much from its EU partners as it was able to sellin their markets.

Federation exports to the EUrebound in 2003



Federation: trading partners(KM m)

2002 % of total 2003 % of total % changeExports fobCroatia 256.5 16.9 361.6 19.9 41.0Germany 235.3 15.5 333.0 18.4 41.5Italy 182.7 12.1 260.0 14.3 42.3Serbia & Montenegro 111.9 7.4 136.6 7.5 22.1Slovenia 139.1 9.2 189.8 10.5 36.4Austria 71.7 4.7 71.1 3.9 -0.8Hungary 8.0 0.5 9.7 0.5 21.0Other countries 509.3 33.6 451.2 24.9 -11.4Total 1,514.5 100.0 1,812.9 100.0 19.7Imports cifCroatia 1,021.8 18.2 1,114.8 19.3 9.1Germany 805.0 14.3 832.3 14.4 3.4Slovenia 646.4 11.5 603.1 10.5 -6.7Italy 604.6 10.8 615.5 10.7 1.8Austria 288.2 5.1 261.4 4.5 -9.3Hungary 244.3 4.4 220.8 3.8 -9.6Serbia & Montenegro 89.0 1.6 111.7 1.9 25.5Other countries 1,913.2 34.1 2,010.0 34.8 5.1Total 5,612.5 100.0 5,769.6 100.0 2.8Balance -4,097.9 – -3,956.7 – -3.4

Source: Agency for Statistics of Bosnia and Hercegovina, Statistical Bulletin.

Sales to Croatia rose by 41% over the same period. Despite this strong exportperformance and an only moderate increase of 9% in imports from Croatia, thetrade between the two countries remains unbalanced, with imports fromCroatia almost four times the size of exports to that country. This imbalanceled to pressure from local agricultural and food-processing lobbying groups inlate 2003, and the state government consequently suspended temporarily thefree-trade agreement with Croatia under which BiH was to cut tariffs onagricultural imports from that country as of January 2004. The Federation alsoruns a large trade deficit with Slovenia, but it managed to reduce this in 2003,as a result of an expansion of 36.4% in exports coupled with a 6.7% decline inimports, as more Slovenian companies began to operate in BiH and ship goodsback to Slovenia.

Following a modest year-on-year narrowing in the first quarter, the current-account deficit expanded in annual terms in the second and third quarters of2003. The January-September current-account deficit amounted to KM2.5bn, anincrease of some 7% year on year. Despite healthy growth in exports andslowing import growth, the large trade deficit remains the primary source ofBiH’s large current-account deficit, which grew to over 38% of GDP in 2002. InJanuary-September current transfers rose by only 1.9%, marking a significantslowdown compared with previous years, primarily owing to a decline inofficial transfers from international donors. However, stronger exportperformance in the second half of the year suggests that the full-year current-account deficit for 2003 is likely to have been roughly in line with that of 2002,which would suggest a reduction of 7 percentage points as a share of GDP.

The current-account deficitremains wide

Intra-regional trade remainshighly unbalanced



Current-account data in BiH are notoriously unreliable, and massivediscrepancies between those reported by the Central Bank and the IMF havebeen the norm. The two bodies have recently improved their co-ordination andnow report more consistent figures, but both continue to advise treating thedata with caution, because of chronic under-reporting of trade at the borderand significant unrecorded of capital inflows. IMF data suggest that remittancesfrom Bosnians living abroad represent as much as 10% of GDP, but the Fundhas warned that the real value of remittances is difficult to ascertain.Nonetheless, there is little doubt that these unofficial, mostly unrecorded flowshave been instrumental in keeping private consumption buoyant in thecountry, and in keeping external deficits sustainable.

BiH: balance of payments(KM m)

2001 2002 2003Year Year 3 Qtr 3 Qtr

Merchandise exportsa 2,480 2,296 612 672Merchandise importsa -8,950 -9,319 -2,401 -2,574Net services 381 288 101 118Net income 692 524 132 108Net transfers 2,546 2,668 648 729Current account balance -2,851 -3,544 -908 -947Capital account 503 566 135 145Financial account 1,627 2,010 501 498 Net direct investment 274 604 108 118 Other investment 3,018 1,161 408 647Reserve assets -1,665 245 -15 -268Net errors & omissions 720 967 272 304

a Including coverage and valuation adjustments by central bank.

Source: Central Bank of BiH.

According to Central Bank data, in January-September 2003 foreign directinvestment (FDI) amounted to KM366m, down by 3.4% year on year. BiHreceived a record KM604m in FDI in 2002, although on the basis of FDI perhead the performance in the first nine months of 2003 still comparesunfavourably with most other countries in the region. The government has

FDI is disappointing



embarked on a proactive policy of foreign investment promotion in an attemptto attract potential investors. In March the Foreign Investment PromotionAgency organised a conference in the southern city of Mostar, attended byheads of state from around the region and several hundred investors. Despitean inauspicious start to the conference—the Macedonian president,Boris Trajkovski, was killed in a plane crash—it was deemed a success in thegovernment's concerted effort to shed BiH's poor international image.Privatisation had been stalled for almost two years, but has now restarted, andis another channel through which the government is hoping to entice FDI,which is becoming increasingly vital as foreign aid inflows dwindle.

BiH's external debt has remained manageable in recent years, despite weakexternal performance, thanks to a combination of write-offs, favourable debtrestructuring and concessionary borrowing. Although the country's externaldebt service has increased from 4.5% of exports in 1998 to 8.1% in 2002, itremains very low in a regional context. The Central Bank reported steadygrowth in international reserves throughout 2003, which resulted in a 30%increase in its net free reserves—that is, those reserves left over after accountingfor the Central Bank's monetary liabilities resulting from the currency boardarrangement.

Debt-service burden increases,but does not pose a problem

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