Country Report October 2003 Bosnia and Hercegovina October 2003 The Economist Intelligence Unit 15 Regent St, London SW1Y 4LR United Kingdom Bosnia and Hercegovina at a glance: 2004-05 OVERVIEW The political situation in Bosnia and Hercegovina (BiH) remains unstable. The leading nationalist parties have concentrated on consolidating their power bases, rather than on pushing forward the long list of essential reforms to make the BiH economy self-sustaining. The Economist Intelligence Unit expects real GDP growth to decelerate this year to around 3.5%, but forecasts an acceleration in growth to around 4% in 2004-05, boosted by growth in domestic demand and improved export performance. Our forecast, however, is contingent upon continued piecemeal implementation of reforms, driven by pressure from the international communitys representatives in the country. Key changes from last month Political outlook • The governing coalitions!at state level and in both entities!between the main nationalist parties look fragile, and have made limited progress in pushing through vital reforms to revitalise the local economy. We are increasingly pessimistic about the current governments chances of surviving its four-year mandate. Economic policy outlook • The currency board arrangement will remain the centrepiece of BiH economic policy, and will underpin low inflation in 2004-05. The government has achieved rapid fiscal consolidation in recent months, but will be put under increasing pressure by the need to redress significant public-sector wage arrears. We expect only slow progress in improving the business environment, given the lack of co-operation so far between the nationalist coalition parties. Economic forecast • We have revised down our estimate for real GDP growth in 2003 from 3.7% to 3.5%, based on a deceleration in industrial production growth in the Federation and the expected effect of the measures of the Central Bank of Bosnia and Hercegovina (CBBH, the central bank) to control credit growth. We expect GDP growth to accelerate in 2004-05, in conjunction with a narrowing of the current-account deficit.
Transcript
Country Report October 2003
Bosnia and Hercegovina
October 2003
The Economist Intelligence Unit15 Regent St, London SW1Y 4LRUnited Kingdom
Bosnia and Hercegovina at a glance: 2004-05
OVERVIEWThe political situation in Bosnia and Hercegovina (BiH) remains unstable. Theleading nationalist parties have concentrated on consolidating their powerbases, rather than on pushing forward the long list of essential reforms to makethe BiH economy self-sustaining. The Economist Intelligence Unit expects realGDP growth to decelerate this year to around 3.5%, but forecasts an accelerationin growth to around 4% in 2004-05, boosted by growth in domestic demandand improved export performance. Our forecast, however, is contingent uponcontinued piecemeal implementation of reforms, driven by pressure from theinternational community�s representatives in the country.
Key changes from last month
Political outlook• The governing coalitions!at state level and in both entities!between the
main nationalist parties look fragile, and have made limited progress inpushing through vital reforms to revitalise the local economy. We areincreasingly pessimistic about the current government�s chances of survivingits four-year mandate.
Economic policy outlook• The currency board arrangement will remain the centrepiece of BiH
economic policy, and will underpin low inflation in 2004-05. Thegovernment has achieved rapid fiscal consolidation in recent months, butwill be put under increasing pressure by the need to redress significantpublic-sector wage arrears. We expect only slow progress in improving thebusiness environment, given the lack of co-operation so far between thenationalist coalition parties.
Economic forecast• We have revised down our estimate for real GDP growth in 2003 from 3.7%
to 3.5%, based on a deceleration in industrial production growth in theFederation and the expected effect of the measures of the Central Bank ofBosnia and Hercegovina (CBBH, the central bank) to control credit growth.We expect GDP growth to accelerate in 2004-05, in conjunction with anarrowing of the current-account deficit.
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With little to show for its first year in power, the coalition between the leadingnationalist parties faces hardening public opinion and increased attacks in themedia. The Economist Intelligence Unit does not expect it to survive its four-year mandate. We expect GDP growth to decelerate in 2003, because of thecredit-tightening measures of the Central Bank of Bosnia and Hercegovina(CBBH, the central bank), but we forecast an acceleration in GDP expansion in2004-05 as export growth picks up. Inflation will remain low, underpinned bythe country�s currency board arrangement. The greatest challenge facing thecountry, however, will be the reduction of the massive current-account deficit,which threatens to put unbearable pressure on the convertible marka (KM).
After just under one year in office, the coalition between the leading nationalistparties continues to suffer from in-fighting and lack of willingness to co-operate. Recent bomb attacks in the capital, Sarajevo, suggest that the securitysituation in the country cannot be taken for granted. Relations with formerYugoslav neighbours remain tense, but progress has been made towards entryinto NATO�s Partnership for Peace (PfP) programme, a step towards eventualNATO membership.
Following a long period of delay, significant progress has been made in recentmonths in the establishment of unified tax and customs structures. In themedium term this should both speed up the creation of a single economicspace in the country and combat fraud, which has cost the entity governmentslarge sums in lost revenue each year. Privatisation programmes in the entitieshave made only halting progress, despite redoubled efforts to improve thecountry�s image with investors.
Industrial production in the first half of 2003 grew by some 5% in theFederation and roughly 4% in Republika Srpska (RS). Unemployment figureshave levelled off in recent months. Inflation remains low, underpinned by thecurrency board arrangement. Interest rates continue to fall, prompted by theincreased competition and sophistication in the banking sector.
Revised data suggest that the current-account deficit in 2002 was smaller thanpreviously thought, but still large, at some 38% of GDP, and imbalancecontinues to put pressure on the ability of the monetary authorities to run thecurrency board. First-half data in the Federation suggest an upturn in exports,and both entities recorded moderate import growth. International reserves aresufficient to maintain the currency board, but more foreign direct investment(FDI) will be needed to bring in the foreign exchange necessary in 2004-05.
Editors: Matthew Shinkman (editor); Stuart Hensel (consulting editor)Editorial closing date: September 11th 2003
All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] report: Full schedule on www.eiu.com/schedule
The 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 the following limited responsibilities under the BasicPrinciples agreed in Geneva and New York in September 1995, and confirmed at Dayton inthe US on November 21st: the establishment of a Constitutional Court, a Commission forDisplaced Persons, a Human Rights Commission, a central bank, public corporations tomanage and operate transport and telecommunications, a Commission to PreserveNational Monuments, and a system of arbitration. Foreign trade is also supposed to bemanaged by the BiH government, there are state-level Justice and Security ministries
BiH has a bicameral parliament comprising the House of Representatives and the Houseof Peoples, two-thirds of whose members are elected from the Federation and one-thirdfrom the RS. A valid majority requires the support of at least one-third of the membersrepresenting each entity. The Federation and the RS also have their own parliaments
General elections took place on October 6th 2002 selecting a new three-member statepresidency, the RS president, and state, entity and cantonal parliaments
BiH has a rotating collective three-member presidency: Borislav Paravac (Serb; appointedApril 2003), Sulejman Tihic (Muslim; elected October 2002) and Dragan Covic (Croat;elected October 2002; current chairman)
The Council of Ministers comprises nine ministers, one of whom is appointed chairman(prime minister) for a four-year term (a recent change from the previous eight-monthrotating basis). The current government was formed after elections in October 2002. Theentities 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, charged withmonitoring 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
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.
Population (m; mid-year; resident) 3.65 3.73 3.80 b 3.87b 3.95Exports of goods fob (US$ m) 664 831 1,173 1,137 1,114
Imports of goods fob (US$ m) 3,780 4,126 3,793 4,089 4,516Current-account balance (US$ m) -1,161 -1,458 -1,191 -1,556 -2,137Reserves excl gold (US$ m) 175 452 497 1,221 1,321a
Total external debt (US$ bn) 3.0 2.7 2.4 b 2.2b 2.7Exchange rate (KM:US$; av)c 1.76 1.83 2.12 2.19 2.08a
a Actual. b Economist Intelligence Unit estimates. c Convertible marka (KM) introduced in June 1998 and fixed at KM1:DM1; since January 2002,KM1.95583:�1.
Origins of gross domestic product 2001 % of total Components of gross domestic product 1998 % of totalAgriculture, fisheries & forestry 13 Public & private consumption 100.4Industry & utilities 32.7 Gross investment (incl stockbuilding) 38.0
Construction 8.2 Exports of goods & services 35.1Services 46.1 Imports of goods & services -73.5
Principal exports 2002 % of total Principal imports 2002 % of totalFederation Federation
Main destinations of exports 2002 % of total Main origins of imports 2002 % of totalFederation FederationCroatia 17.1 Croatia 17.9Germany 15.2 Germany 14.4Switzerland 14.6 Slovenia 11.3Italy 12.0 Italy 10.8
Republika Srpska Republika SrpskaSerbia & Montenegro 49.1 Serbia & Montenegro 25.6Italy 11.1 Slovenia 11.4Croatia 8.9 Austria 7.6Slovenia 6.0 Hungary 7.4
Ten months into its mandate, the coalition, which is spearheaded by the threenationalist parties!the Party for Democratic Action (SDA), the Serb DemocraticParty (SDS) and the Croatian Democratic Union of Bosnia and Hercegovina(HDZ BiH)!has made only modest progress in advancing a complex set ofeconomic and political reforms. Recent polls suggest that the public isincreasingly distrustful of politicians in the country, and is questioning the levelof genuine commitment to the reform programme, which was agreed understrong pressure from the international community. The progress that has beenachieved!some of which will prove extremely valuable to the country�seconomic and political outlook, such as the unification of the customsadministration and recent agreements on military reform!has been made withgreat difficulty, and largely thanks to the firm guidance of the maininternational body in the country, the Office of the High Representative (OHR).To the degree that reforms have been settled, the process has often involved alevel of compromise that the leading parties have been hesitant to show in thepast, suggesting that implementation of the changes in 2004-05 will bepainstaking and slow.
The leading parties have a strong external incentive to back the reformprogramme, as representatives of the international community have madefurther support, financial and otherwise, conditional upon reform of the taxsystem, acceleration of privatisation, and the movement forward of a raft ofchanges to improve the business environment in the country. It is thereforedifficult to make out the degree to which the parties share any real consensusover the central policy issues facing Bosnia and Hercegovina (BiH), and thepace at which reforms should be implemented. With the parties co-operatingonly grudgingly, however, it seems likely that the political scene in 2004-05will continue to be characterised by instability, the threat of coalition collapse,and gridlock.
Although the leading parties appear to be consumed with power politics, socialdiscontent looks to be on the rise, and several bombings in the summermonths in the capital, Sarajevo, show that the security situation is still an issue.The government has devoted insufficient attention to the daily grievances ofthe public, and has resorted to blaming the opposition for the deterioratingsocial conditions. The opposition has, in the meantime, tried to capitalise onthese developments and is becoming more vocal in its support for earlyparliamentary elections (which are currently not due before 2006). Nonetheless,the likelihood of the opposition parties mobilising early elections remainsremote in the short term.
A more immediate threat is likely to come from within the government itself,especially the moderate coalition partners, the Party for BiH (SzBiH) and theParty of Democratic Progress (PDP). Intra-coalition tensions, and the likelihoodof a coalition collapse, will probably increase, as the room for manoeuvre for
postponing politically and socially sensitive reforms, such as bankruptcylegislation and privatisation, is narrowing. The Economist Intelligence Unit thusbelieves that the present government stands little chance of staying together forits full four-year term and early elections remain a distinct possibility.
However, it seems certain that in 2004-05 the nationalist parties will use allpossible options to stay in power. These might include purges within someparties!most likely the SDS and the HDZ BiH!of their more radical factions, inorder to secure a more moderate image, with the aim of winning internationalacceptance for the current government. Such a scenario does not bode well forrapid reform progress in 2004-05.
The task of improving relations with BiH�s former Yugoslav neighbours hasbecome more difficult since the nationalist parties recaptured power in BiH.These parties tend to interpret historical events involving the two neighboursdifferently. A high degree of mistrust remains, as was recently illustrated by thefailure to complete an agreement on the joint use of the Croatian port of Ploce,and by the BiH government�s testy response to Croatia�s offer of assistance inthe construction of a major motorway. Thus, regional relations, whichimproved markedly with the departure of nationalist governments in Croatia,and in Serbia and Montenegro, look set to remain tense in 2004.
Relations with the US are strained, despite the government�s recent decision toexempt US nationals in BiH from prosecution by the International CriminalCourt (ICC), as BiH featured on a US list of countries with poor records ofcombating organised crime and trafficking in people. Nonetheless, BiH remainson course for membership of NATO�s Partnership for Peace (PfP) programme,which could take place as soon as the end of 2003, as efforts to unify theentities� separate armed forces and rationalise military structures have madegood progress in recent months. SFOR, the NATO force maintaining the securitysituation in the country, is set to remain in BiH throughout 2004, after which itwill probably be replaced by an EU force, as the EU seeks to expand its role inthe region.
Economic policy outlook
Nominally, the government�s agenda over the forecast period will includepreserving the initial successes in fiscal consolidation, tempering the macro-economic risks posed by a recent credit boom, and continuing with the broadagenda of structural reform. The evidence so far suggests that the currentgovernment is likely to drag its feet, especially on the reforms that are morepolitically sensitive, and the OHR will need to rely on the full weight of itspowers to push through change. The public sector is estimated to account forsome 50% of the country�s GDP, making it imperative to bring downgovernment spending and to extricate the state from ownership andmanagement of many of the country�s largest companies, if the economy is tobe revitalised.
The main structural reforms that the government has pledged to concentrate onover the forecast period include legal and regulatory reforms intended to
improve the business environment; further strengthening of the financialsystem; enterprise reform; and the revival of the privatisation programme. Thenext phase of reform of the enterprise and business environment involvesimplementation of recently adopted bankruptcy legislation. Politicalsensitivities and the country�s weak judicial system are likely to hamper theimplementation of the new legislation, which stipulates that firms that do notpay wage arrears in full within 60 days are to be declared legally bankrupt andliquidated (some observers have estimated that tens of thousands of jobs maybe lost because of the new laws).
Reform of the financial system, which has moved ahead much more rapidlythan structural reforms in other areas, will focus primarily on improvingbanking regulations and promoting further consolidation in the industry. Theauthorities have committed themselves to enforcing a new minimum capitalrequirement of KM15m (US$8.5m), although banks that are being restructuredunder the supervision of the World Bank are exempted. This has alreadyspurred several bank mergers in the Federation. Efforts to bring the entities�separate banking agencies under the direction of the Central Bank of Bosniaand Hercegovina (CBBH, the central bank) will also continue.
The sustainability of BiH�s fiscal performance remains a major source ofconcern, even though substantial adjustment has recently been made on boththe expenditure and revenue sides. The reform of public finances has led tospending cuts, and stricter enforcement of existing legislation has led to animprovement in revenue collection. However, the fiscal position will faceincreased strain over the forecast period, as the entities are under pressure toclear large wage and payments arrears to public-sector workers and suppliers,estimated at as much as KM1bn (US$570m). Funding is needed to finance thegrowing role of the central state government, to repay public pre-war debt, andto cover costs associated both with returning refugees and with acceleratedreform of the public administration. Donor support, which has been instrum-ental in covering the fiscal deficit, is programmed to decline over the forecastperiod. Compensating for this decline through higher taxes is not possible, asthe country�s tax burden is already one of the highest in the region. Reform ofthe tax and customs administrations, a pillar of the fiscal adjustment effortduring the past year, is expected to strengthen revenue performance, with thecustoms service in Republika Srpska (RS) already reporting a dramatic increasein customs receipts in the first month under the newly unified customs system.Nonetheless, if the government is to meet the IMF target for a generalgovernment deficit of 2.2% of GDP in 2003, it will have to reduce expendituredecisively. We expect defence spending and social transfers to be the areas inwhich cuts are focussed.
In May the CBBH announced a set of policy measures aimed at addressing therapid growth in domestic credit in 2002, which led to a significant widening ofthe current-account deficit. The package of measures makes several changes tothe level and definition of the CBBH�s reserve requirement ratio, which is the
only instrument of monetary policy that the bank has at its disposal under therules of the currency board arrangement.
At the time of writing, no data were available to assess the effects of the centralbank�s measures. However, the measures are expected to help to slow importgrowth in the second half of this year, which had been fuelled by the boom inconsumer credit in 2002. The consequent deterioration last year in thecountry�s external account was considered by the CBBH to be a direct threat tothe currency board regime, which is the centrepiece of the government�smonetary policy and is the primary anchor of stability in the economy.
Economic forecast
International assumptions summary(% unless otherwise indicated)
in US$ terms) 12.7 2.1 1.8 3.0Industrial raw materials (% change in
US$ terms) 2.2 9.1 3.9 4.3
Note. Regional GDP growth rates weighted using purchasing power parity exchange rates.
Global economic growth remains sluggish and is unlikely to acceleratesubstantially this year. Euro zone activity has slowed considerably. EU GDPgrowth in 2002 was only 1%, and we expect a deceleration this year, to 0.7%. EUrecovery in 2004 will be weak, with growth now expected to be just 1.9%.
The main downside risk to our forecast concerns the pace of economicrecovery in the EU. BiH�s economic growth is in large part dependent on itsexport sector, which, in turn, is heavily reliant on demand from its main tradingpartners in the EU. EU weakness largely reflects restrained consumer spending!a particular concern for BiH�s exporters. Should economic growth in the EU beeven slower than expected this year and next, BiH�s export prospects couldsuffer, leading to a more pronounced deceleration in real GDP growth than iscurrently forecast. At the same time, fiscal constraints on EU governments couldlead international aid flows into BiH to decelerate more rapidly than forecast,which would also seriously dampen GDP growth, in addition to putting thestability of the economy as a whole at risk.
We have revised down our estimate for real GDP growth in 2003 to 3.5% (froman earlier 3.7%), compared with 3.8% in 2002. We expect that the effects of theCBBH�s monetary tightening will have taken hold by the second half of 2003;along with a strict fiscal policy, this will cut into domestic demand growth,which was an important source of expansion in 2002. This effect will becompounded by the recent completion of several ongoing reconstructionprojects financed by international donors, which have been the main source ofinvestment finance for the past six years. Industrial output data in theFederation, the larger of BiH�s two entities, suggest a slightly weaker first-halfperformance than in 2002. Furthermore, a severe drought, which gripped thecountry for most of the second quarter, will probably lead to some decelerationof overall output growth. Initial estimates of the cost of the drought in the RSalone are on the order of KM150m, or some 0.5% of GDP. In 2004-05, we expectreal GDP growth to accelerate to around 4% in both years. We do not expect theCBBH to allow monetary tightening to unduly affect growth, and thus forecastthat domestic demand will drive an acceleration of GDP growth in 2004-05.Narrowing current-account deficits will mean the external balance will act asless of a drag on growth in 2004-05 than in recent years.
A number of risks surround our forecast, with the political situation presentingthe greatest uncertainty. The country�s economy is still almost completelydependent upon state expenditure and international aid. The complex reformsneeded to create conditions for broad-based development led by the privatesector require political consensus and determination of a degree that theincumbent government has yet to show.
We have revised down slightly our estimates for inflation this year in bothentities, to 0.2% in the Federation and 2.2% in the RS. Pressure on prices in thesecond half of 2003 and into 2004 is likely to come from several sources,including the effects of the drought on agricultural prices and a likely short-termincrease in the prices of excisable goods, owing to the recent change in thepoint of collection for this tax. Overall, continuing strict implementation of thecurrency board will keep prices in check and we forecast only moderateinflation over the forecast period, with inflation in the RS continuing to surpassthat in the Federation, but with the gap between the entities narrowing.
The convertible marka (KM) is pegged to the euro at a rate of KM1.96:"1. Weanticipate a weakening US dollar against the euro in 2004, and thus acorresponding nominal appreciation of the KM against the US currency, beforethe US dollar rebounds in 2005. With inflation low, this implies a significantreal effective appreciation for next year, undermining BiH�s external compet-itiveness, which already suffers because of the low quality of the country�sexports, as well as the rapid rise in wages compared with productivity. Cheaperoil imports, however, are likely to offset this effect to some degree.
BiH�s trade deficit in the first six months of 2003, expressed in US dollars,increased by around US$170m. In local-currency terms, however, the figuressuggest a slight narrowing of the trade deficit, led by solid growth in Federationexports and tempered growth in imports in both entities. We thus expect a
narrowing of the trade deficit in 2003, driven by continued moderation inimport growth, which itself will be underpinned by the CBBH�s efforts to stemconsumer credit and by a slowdown in reconstruction-related imports. Exportslook set to grow more quickly in 2004-05, based on recovery in the EU (albeitgradual) and the improvement in regional prospects related to recent free-tradeagreements with BiH�s neighbours. In the context of moderating import growthand a strengthening of the US dollar in 2005, this should lead to a narrowing ofthe current-account deficit in 2004-05, despite declining remittances. We expectthe deficit to narrow sharply in 2003, and then to under 20% of GDP by 2005!which is still extremely large. This will put heavy pressure on the governmentto move forward rapidly with privatisation and other initiatives aimed atspurring foreign direct investment (FDI), in order to secure the inflows offoreign exchange necessary to support the currency board arrangement,especially in the context of declining aid flows. We expect that the initiativesalready under way will increase investor interest in BiH assets over the forecastperiod, and expect the country (with the help of the international community)to continue to finance its external deficit.
BiH: forecast summary(% change year on year unless otherwise indicated)
2002a 2003 b 2004c 2005 c
Real GDP growth 3.8b 3.5 3.8 4.0Industrial output 8.2b 5.5 6.0 6.2
Retail price inflation (av)Federation -0.2 0.2 0.4 0.5Republika Srpska 1.7 2.2 2.3 2.4Merchandise exports fob (US$ m) 1,114 1,280 1,450 1,660Merchandise imports fob (US$ m) -4,516 -4,400 -4,450 -4,500
Current-account balance (US$ m) -2,137 -1,725 -1,600 -1,580 % of GDP -38.2 b -24.7 -20.7 -20.2Exchange rate (av; KM:$) 2.07 1.74 1.65 1.72
a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts.
A wave of protests swept through Bosnia and Hercegovina (BiH) between Juneand September. Miners and workers in the largest steelworks in the Federationwent on strike in August and September, protesting against non-payment ofsalaries (which were months overdue), perceived irregularities in theprivatisation process, and the government�s limited progress in addressing thecountry�s growing economic and social problems. Pensioners in both entitiesalso protested, demanding an increase in pensions and clearance of pensionarrears. In Republika Srpska (RS), healthcare trade unions demanded that thegovernment adopt a social-assistance programme and agree to changes in arecently negotiated wage agreement that stipulated a minimum monthly wageof KM90 (US$53), and they threatened to call for the government�s resignationand early elections should it fail to meet their demands.
Public perception of the government�s ineffectiveness in dealing with thecomplex situation in the country was accentuated by a deterioration in thesecurity situation over the summer. A series of explosions in Sarajevo, thecapital, as well as in other parts of the country, has raised public concerns overpersonal security and further underlined the instability that continues to facethe country. The perpetrators of the attacks have thus far remained un-identified. The government accused the opposition of being behind theincidents, and of using the explosions as part of a strategy to force earlyelections. These accusations fuelled the suspicion among the public, andespecially within the media, that the government was not ready to come togrips with the country�s real problems and was instead resorting to scandal-mongering and politicking in order to deflect attention from its inaction.Growing public discontent coincided with a decision in August to increasesignificantly the salaries of the deputies in the state parliament and in the RSgovernment, in spite of suggestions that there was insufficient funding for someof the state and entity institutions.
In the context of rising social discontent, the state-level government faced asetback in July when the BiH Council of Ministers (CoM) failed to adopt a six-month action plan for the implementation of urgent economic reforms. TheCoM opted to delay the process, selecting a committee to prepare a moredetailed proposal, establishing a sequence for the implementation of measuresproposed by the government and the Office of the High Representative (OHR),and identifying the personnel to carry them out. The action plan contains some130 reforms necessary for BiH to integrate further with the structures of the EUand the World Trade Organisation (WTO) in the areas of public finance, thebusiness environment, the financial sector, public administration, statistics, andthe labour market. The implementation of the action plan, together with theadoption of the poverty reduction strategy paper (PRSP), is a pre-condition for aUS$120m World Bank credit.
The delay of the reform package is indicative of the deep political divisionsbetween the members of the governing coalition, as well as of the strongdisincentive they face for co-operation, which could weaken their respective
power bases. It comes as no surprise, then, that since its election in October thecurrent coalition!at both state and entity levels!has focused its efforts on re-opening the debate on a number of reforms that were started under theprevious administration, thus dramatically slowing down their implementation.
The lack of co-operation at the state level is mirrored at the entity level. Inanother indication of the priorities of the ruling coalition in the Federation atthis stage in its mandate, in July the Federation government passed a decisionto replace the chairmen and the members of the management boards of23 state-controlled companies. The decision was taken in the aftermath ofseveral high-profile scandals and resignations in the state electricity companiesearlier this year. Although the removal of the boards at state companies wasthus justified as an attempt to improve the professionalism of those runningthe entity�s largest organisations, it was also probably an attempt to supplantloyalists of the previous, moderate Alliance for Change government withsupporters of the current government.
The Muslim nationalist Party for Democratic Action (SDA) and the Croatnationalist Croatian Democratic Union of Bosnia and Hercegovina (HDZ BiH)have claimed that, since they took office in October 2002, the stance taken onministerial and government appointments by the Office of the HighRepresentative (OHR, which conducts a time-consuming vetting process for allcandidates for top government positions) has allowed the cadre appointed bythe former government to keep their posts. The legality of the Federationgovernment�s decision to oust the management of state-owned enterprises wasquestioned by the OHR, and the case was forwarded to the Federation Officeof the Human Rights Ombudsman, along with a strongly-worded commun-ication from the OHR suggesting that the procedure violated establishedprinciples of legality and transparency.
The political scene in the RS was also highly fractious in the third quarter. TheMuslim member of the BiH (state-level) tripartite presidency, Sulejman Tihic,suggested that the creation of the RS was a result of genocide and questionedthe future of the entities and of the Dayton agreement. His comments met withstrong criticism from all RS parties. Tensions were raised further in the RSparliament when the SDA parliamentary caucus launched an initiative tochange the insignia of the RS and to restore a number of street names that werealtered because of the war. Some members of the Serb nationalist SocialDemocratic Party (SDS) questioned whether the SDA should be allowed tocontinue to participate in the RS government, given the behaviour of itsdeputies. The SDA responded by saying that it was already debating internallythis issue, owing to the poor record of reform so far. The moderate Party for BiH(SzBiH), which co-operates with the nationalists in both entities, all suggestedthat the future of its co-operation with the government was uncertain.
The friction between the SDS and the moderate Muslim Party for DemocraticProgress (PDP)!the two main RS coalition partners!was exacerbated by reportsof a meeting between Dragan Mikerevic, the RS prime minister, andMilorad Dodik, the leader of the main opposition Party of Independent SocialDemocrats (SNSD). The meeting took place amid recurrent threats that the
SNSD was considering leaving the RS parliament in an attempt to trigger earlyelections. The SDS has been relentless in its criticism of RS institutions, partlybecause of policy disagreements, but largely because of personal animositiesbetween Mr Mikerevic and the leadership of the SNSD.
Formally, the SDS and the PDP have confirmed that problems exist in theirrelationship within the parliament, but the two parties have attempted toquash speculation over an imminent reshuffle of the government. Instead, theyvowed to try to overcome their differences by developing a proposal for a long-term development strategy for the RS, although the chasm between themsuggests that common ground will be difficult to identify.
The complex structure of government in BiH has led to the politicisation ofvirtually all aspects of public life in the country. Efforts by the internationalcommunity to reform the education system, with the aim of streamlining thestructure of the school system and minimising ethnic segregation at the schoollevel, met with stiff resistance in August. Education officials in both entities andin the separate Brcko district signed an agreement, sponsored by theOrganisation for Security and Co-operation in Europe (OSCE), to begin theprocess of replacing the three ethnically-based education systems in BiH with aunified one. This is to start with the unification of administrative structures in52 schools in the Federation, in which Muslim and Croat students have so farbeen taught different curricula, from different textbooks, and used schoolfacilities separately. The reform programme, which would bring Muslim andCroat pupils in the schools concerned under a single administration andestablish a single budget for all pupils, was immediately attacked byrepresentatives of the HDZ BiH. The HDZ BiH, in a resolution against thereform, stated its concern that the unification of the three parallel systemswould disadvantage Croat students, and it called on fellow ethnic Croat groupsto �safeguard� Croatian-language education. The OSCE and OHR were quick topoint out that the initial reforms were intended only to minimise wastefulduplication at the administrative level, but further progress in eliminatingethnic segregation from the education system looks unlikely to be rapid.
In August the BiH presidency failed to endorse a protocol on amendments tothe agreement with Croatia on its port at Ploce and the BiH stretch of Adriaticcoast at Neum. Following months of difficult negotiations, the CoM and theCroatian government reached an agreement to regulate transit through Ploce!which had been BiH�s the only point of access to a deep-water port throughoutformer Yugoslavia!and Neum. The delay in completing the agreement willhave economic and political repercussions. The bulk of activity at Ploce isconducted by BiH companies. Thus, free access to the port!which can process5m tons of freight per year!is of paramount importance for the BiH economy.
The deal, signed in 1998 but never ratified by the Croatian parliament, initiallyenvisaged the establishment of a commission in charge of implementing theagreement, to be made up of three Bosnian members, three Croatian members,and one international representative. The Croatian parliament objected to themake-up of the commission, and an amended version was agreed thatexcluded the international member, except in the case of dispute among the six
Relations with Croatia arestrained by failure of port deal
Efforts to reform educationagain expose ethnic tensions
commission members. When the protocol was forwarded to the BiHpresidency, Mr Tihic vetoed it, suggesting that the agreement was too vague inestablishing a precise time frame for ratification by the Croatian parliament andin stipulating who would nominate the international arbiter.
Edgy relations with Croatia have also been hindered by the government�sselection of a vendor to construct a major motorway running from theCroatian border in the north to Ploce in the south, as part of the EU�s pan-European transport network. The Croatian government has expressed aninterest in playing a role in the construction of the 330-km Bosnian section ofthe �Corridor V� motorway, stretching from Budapest, through Croatia and BiH,and which is estimated to cost around US$2.5bn. The BiH government,however, has suggested that it is likely to award the construction of the Bosnianportion of the road, known as Corridor Vc, without a tender to Bosmal, aBosnian-Malaysian joint venture. Although the construction of the corridorcommands broad support among the leading parties, several have raisedobjections over the selection procedure. Opposition parties have raisedconcerns that the selection of Bosmal was driven by informal connectionsbetween some government figures and the company�s owners rather than bythe company�s professional credentials.
The tension surrounding the project increased when Croatia offered to provideUS$7m towards the preparation of the documentation for the project, oncondition that after the feasibility study was completed, an international tenderwould be opened for the construction project. The Croatian prime minister,Ivica Racan, intervened personally in the debate, arguing that Croatianparticipation would be natural, given that the Corridor V also runs throughCroatian territory. The Croatian offer of support for the feasibility study receiveda mixed reception in BiH, as it was seen by some as an attempt by the Croatiangovernment to secure lucrative contracts for its own construction industry(Bosmal has pledged to engage mainly local BiH companies). Adnan Terzic, thechairman of the BiH Council of Ministers (CoM), brushed away accusationsthat the government had unfairly favoured Bosmal by refusing to open aninternational tender. However, recent government statements suggest that theCoM may be pulling back from its initial commitment to Bosmal and might bewilling to consider other vendors.
Despite a programmed decline in aid flows to BiH, the international com-munity insists that it remains strongly committed to supporting stability in thecountry and the region. At a NATO meeting in July, the organisation confirmedthat its forces will remain in BiH until the end of 2004 at least. At the sametime, the meeting rejected the transfer of responsibility from NATO to an EU-ledforce, a proposal first tabled in December 2002. The EU currently runs a policeoperation in BiH, and EU forces have replaced the small NATO force inMacedonia. Although the transfer of the security arrangements to the EU is stilllikely to go ahead either in 2004 or 2005 as part of an overall broadening of theEU�s role in Balkan security affairs, NATO officials expressed concerns over EUforces� capacity to deal effectively with the range of security threats in thecountry, particularly the ongoing search for indicted war-crimes suspects. The
Selection process for roadproject causes concern
SFOR mission is to stay in BiHuntil the end of 2004
decision to extend the presence of troops from SFOR, the NATO security force,was made shortly after the US had published a list of BiH citizens who werebarred from entering the US, and a list of 15 countries, including BiH, whichface serious problems with human trafficking within their borders.
Economic policy
On concluding the second and third reviews of its stand-by agreement withBosnia and Hercegovina (BiH) in July, the IMF warned the authorities that,despite achieving a better than expected fiscal outturn in 2002, further fiscalconsolidation should remain a priority. This reflects the significant recentdeterioration in the external position caused by the very rapid growth ofconsumer credit, and the lack of monetary policy instruments to contain suchgrowth as a consequence of the country�s currency board arrangement. Early in2003, the Central Bank of Bosnia and Hercegovina (CBBH) unveiled measuresto tighten liquidity in the banking sector and slow consumer credit growthfrom the rapid rates seen last year (see Country Report July 2002, page 17). First-quarter data on the lending of commercial bank in both entities showed acontinued rise in the volume of credit extended, compared with the end of2002, suggesting that the CBBH�s measures will take some time to take hold,and that fiscal prudence remains critical in the short term in order to keep thecountry�s current-account deficit financeable, as the country currently dependsheavily on inflows of foreign direct investment (FDI) and international aid tofund its current-account gap.
Preliminary data on fiscal performance in the first half of 2003 were notencouraging in this respect. They suggested that revenue underperformed in theFederation, despite rising by 10% year on year in nominal terms, and that stateinstitutions� expenditures exceeded budget allocations. The pressure on thestate-level budget arises primarily because of the expanded role of the centralstate, which now includes responsibilities not envisaged in the Dayton accords,in conjunction with its lack of revenue-raising capacity. At the same time, thestate budget faces pressures of current expenditure, such as the recent decisionto increase the salaries of MPs in the state parliament, which will stretch thebudget, given the state�s limited revenue-raising capacity. The move met withheavy criticism from the public, opposition parties, and some deputies withinthe coalition. Meeting in July, the Council of Ministers (CoM) thus concludedthat the 2003 state budget would need to be rebalanced, and approached theIMF for approval, as stipulated by the stand-by agreement. However, the IMF isunlikely to grant the authorities permission to increase budgeted expenditure.The results of the negotiations are expected in September.
Although fiscal consolidation efforts have recently been geared primarilytowards cutting and restructuring public expenditure, reforms to increaserevenue through tax policy changes and improved tax collection haveadvanced apace. The international community�s representatives in BiH have forsome time been pushing for the introduction of single state-level value-addedtax (VAT) and customs regimes as the most appropriate solution to theproblems of central state finance and pervasive tax evasion.
The first stage of reforms to unify the tax and customs rates and regimes of theentities and of the Brcko district have been largely completed, under strongpressure from the Office of the High Representative (OHR) and the inter-national community. A major breakthrough occurred in July, with the passageof a series of amendments to the Law on Excise and Sales Tax by the entityparliaments. The updated law, which entered into force on August 1st, containsseveral key changes. Foremost is the redefinition of the point of collection forthe sales tax for excisable goods. The tax, formerly paid at the retail point ofsale, will now have to be paid by the importer or at the wholesale level.Evidence gathered by international institutions supporting BiH in tax reformsuggest that large-scale tax evasion was being facilitated by the old system, asfirms failed to report the �final sale� of many excisable goods, particularly foralcoholic beverages, tobacco, and petroleum products. In a separate attempt tocrack down on the most likely sources of customs fraud, the entitygovernments agreed that, as of September 1st, oil and oil derivatives importedinto the country can now only be transported by rail. Restriction of roadtransport will thus ease the government�s work in regulating the flow of oil andoil derivatives into the country, with some 400 companies registered to tradeoil and oil derivatives in BiH. At the same time, the government established inJuly a central Indirect Tax Authority, tasked with the collection of customsduties and administration of tariffs, as well as collection of VAT revenue whenit is introduced some time in 2005.
Policy achievements to date have come about largely as a result of incessantpressure from the OHR and of the strict conditionality imposed by theinternational financial institutions at work in BiH. Relations between theleading parties in the negotiations over economic reform remain highlyfractious, and much of the decision-making has tended to degenerate intopolitical horse-trading. The selection of a director for the planned state-levelcustoms service was considered to be an example of this. The list of potentialcandidates was narrowed down to Fuad Kasumovic, a representative of theParty for Democratic Action (SDA), and Miodrag Kudic, representing the SocialDemocratic Party (SDS), in what was widely seen as an orchestrated move todisqualify Zelimir Rebac, the current Federation customs office director.Mr Rebac, who took on his current job when the previous government was inpower, is credited with making significant improvements in the work of theFederation customs service, and was tipped by many as the most suitablecandidate for the job. In short-listing the candidates, both Mr Rebac andSefika Hafizovic of the moderate Party for BiH (SzBiH) were eliminated fromthe running, and Mr Kasumovic emerged as the most likely candidate.Mr Rebac and his family reportedly received death threats when he initiallyrefused to resign from his post. The OHR has begun its vetting process, and atthe time of writing no decision had been made.
After almost a year of inactivity, in July the programme to privatise BiH�s powerinfrastructure took a step forward, when an action plan for restructuring andprivatisation of BiH�s power supply and distribution systems was presented foradoption to both entity parliaments, under threat from international donors ofa cessation of financial support for the project. The development of the plan
was part of the Power III project, which is supported by the World Bank andwhich is aimed at the reform of the country�s energy sector. The plan has beenstrongly criticised by the local business community, particularly over the lack ofco-ordination between the Power III plan and pending privatisation of BiH�smines. Critics have argued that the proposed model will result in the closing ofBiH�s thermal power plants, which would imply closures in the miningindustry; it would also put pressure on the government�s plan to sell off itsmining assets. Another point of concern is the potential loss of some 15,000jobs. The action plan will reach parliament�s agenda after its energy committeesissue their verdicts. These verdicts are unlikely to come swiftly, and furtherdelay of the privatisation process is to be expected.
A numbers game
The need to lure investors spurs improvements in official statistics
In their attempts to draw a clear picture of the economic situation in Bosnia andHercegovina (BiH), financial analysts have long been frustrated by the paucity andinaccuracy of official statistics coming from the country. That frustration looks set toease to some extent, as the authorities have recently devoted increased attention toproviding higher-quality data in a more transparent format.Balance-of-payments figures present a case in point. As of April 2003 the gapbetween annual figures reported by the Central Bank of Bosnia and Hercegovina(CBBH, the central bank) and the IMF for merchandise trade, services, and currenttransfers varied by as much as 20% during the period 1998-2002. By September thetwo sources were in virtual alignment, both historically and for the most recentquarter�s data. The CBBH has also begun to post a wide range of monetary andfinancial statistics on its website, dramatically improving the timeliness and usabilityof these figures. The CBBH plans to create a Statistics Council, which will overseeefforts to improve co-operation with local banks and the international monetaryauthorities, widen the scope of coverage, and ensure that figures are reported in linewith international standards.At the same time, other official bodies have been hard at work trying to improve theeconomy�s image to investors. The website of the Foreign Investment PromotionAgency (FIPA), a new institution, features a slick intro screen, which presents BiH inthe centre of Europe. Subsequent screens provide a range of industry profiles (filledwith familiar Western management-speak), detailed breakdowns of inflows offoreign direct investment (FDI), and an online matchmaking service for investors andfirms seeking capital.As BiH�s current-account deficit has grown perilously large, the need to draw in moreFDI has become urgent. Progress has been made, but further improvement in thequality and breadth of statistical coverage, at the level of both the central state andentities, will be necessary to help sceptical investors assess the macroeconomic risksto doing business in BiH.
Federation industrial output picked up in May and June as a result of improvedperformance in mining, driven by increased output in the Ugljevik mines innorthern Bosnia. The improved mining performance was, as is usually the case,accompanied by accelerating manufacturing output in those months. Second-quarter industrial output was thus up by 7.5% year on year. As growth was only2% in the first quarter, industrial output in the first six month of 2003 in theFederation thus rose by 4.9%, a mild slowdown in compared with the sameperiod in 2002 (when industry grew by 5.3% year on year).
BiH: industrial production(% change, year on year)
2002 20032 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr
Federation 5.8 11.8 15.7 2.0 7.5
Republika Srpska -12.3 1.4 10.5 -1.6 10.6
Sources: Federal Office of Statistics (FOS), Statistical Data on Economic and Other Trends; The Republika Srpska Institute of
Statistics, Monthly Statistical Review.
The slowdown was most pronounced in manufacturing output (despite therapid growth seen in May and June), which in the first half rose by only 1.5%year on year, whereas growth in electricity, gas and water sectors was strong.The main reason behind the slowdown in manufacturing output growth was acontraction in food-processing and wood-processing output in the first quarter,which underpinned the poor external performance seen in this period (woodand food products are two of BiH�s largest export sectors). Broken down byindustrial groupings, output data show that, in the first half of 2003 theproduction of intermediate goods grew fastest (up by 11.8%), followed closelyby capital goods (up by 11.5%), suggesting that some re-equipping of thecountry�s capital base is under way and portending continued medium-termimprovement in industrial performance.
Following a first-quarter contraction, industrial output in Republika Srpska (RS)recovered in the second quarter, pushing overall first-half growth to 4.3% yearon year. The recovery was driven by an expansion in electricity and watersupply output, as both mining and manufacturing production contracted inthe first half. RS manufacturing output in the first half fell by 0.9%, with strongperformance from several leading industries (food and beverages output wasup by 15.5%, and metal products by 4.1%) offset by a sharp contraction inwood production, one of the largest industrial sectors in the RS. As in theFederation, first-half output of capital goods grew rapidly in the RS, up by11.7% year on year.
Following a sharp first-quarter decline, Federation construction outputrecovered to some degree in the second quarter, but first-half output was stilldown by 1% on the same period of 2002. Repair and maintenance workaccounted for most of the completed work in the first half, with construction ofnew structures slowing compared with January-June 2002. Residential
Industrial output growthdecelerates in the federation
Industrial performanceimproves in Republika Srpska
Construction performancediffers between the entities
construction, however, shot up in 2003, with completed houses up over 50%year on year, and the backlog of unfinished dwellings falling by over 300.Employment in the industry rose from 6,050 in January to 7,988 in June, but isstill down from the 8,553 employed in June 2002, as the industry has failed torecover completely from the sharp contraction in the beginning of this year.
In the RS, more encouraging figures were recorded. The value of contractedconstruction work rose by 5.2% in January-June. Improved prospects werefurther shown by other construction indicators, such as the number ofconstruction workers and total effective hours performed, which rose by 8.4%and 9.1%, respectively.
The difference in construction output between the two entities is largely theresult of a lag in the construction cycle in the RS, which is a result of the slowereconomic recovery there compared with that of the Federation. The Federation,which saw much larger-scale physical destruction than the RS during the 1992-95 war, also received the bulk of reconstruction aid early in the post-war period,spurring strong growth in construction activity, which is now tailing off.
In January-July Federation sales to the RS rose by 2.2% year on year,representing almost three times the volume of sales from the RS to theFederation. Federation purchases from the RS rose just over 10% in the sevenmonths to the end of July, mainly because of increased purchases of food, inline with improved performance of this sector in the RS. This rapid growth keptthe Federation trade surplus with the RS around KM90m (US$51m), roughly thesame level as a year ago. The composition of inter-entity trade also remainedbroadly similar to last year; food sales between the two entities are by far thelargest category of trade.
Inter-entity turnover, Jan-Jul(KM m unless otherwise indicated)
Source: Federal Office of Statistics (FOS), Statistical Data on Economic and Other Trends.
Employment, wages and prices
Employment in the Federation fell steadily in 2001 and the first half of 2002,but, barring a significant drop in early 2003, has been largely stagnant since.Total employment plummeted by almost 4,000 in January this year. This fallwas driven by several factors, including the ongoing demobilisation of sectionsof the Federation�s armed forces and the curtailment of the status of �waitinglist� workers!those who had been kept on the payrolls of state-owned firms,while not actually working!in conjunction with the implementation of thecountry�s new bankruptcy law.
The number of registered employed in June 2003 was up by roughly 1,000from the end-January figure, marking an increase of only 0.3%. In absoluteterms, the largest net growth was in education, as the educational systemgradually recovers from the impact of war. This trend looks set to reverse,however, with the latest reforms of the education system intended tostreamline the parallel administrative structures of the main ethnic groups.Manufacturing and public administration, the two largest employers in 2002,cut employment by 5.5% and 5%, respectively, compared with the end of 2002.Both sectors remain vulnerable to further cuts; the former because of theexpected impact of the implementation of the bankruptcy legislation and theprofit squeeze caused by falling productivity, and the latter because of theongoing reform of public administration.
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.
Alongside stagnating employment figures, the number of unemployed in theFederation continued to rise, albeit at a much slower pace than in 2002. Duringthe first half, the number of unemployed rose by over 3,200, or 1.1%, comparedwith an increase of almost 20,000 (or 7.5%) for 2002 as a whole.
In Republika Srpska (RS) the slow economic revival led to a reversal ofunemployment trends. The number of registered unemployed in June was143,666, or some 1,124 less than in December 2002. Official unemploymentfigures thus suggest an unemployment rate in both entities of some 40% of thelabour force, although these figures are widely considered to overestimate thesituation. A large percentage of the workforce participates in the country�s greyeconomy, which accounts for as much as one-third of official GDP according tosome estimates.
Nominal wages continued to grow strongly in both entities in the first half of2003. In the Federation, the average nominal wage in June rose by just under10% compared with the average 2002 wage. Growth was a little slower in theRS, both compared with the Federation and in relation to strong first-quarterwage growth of 8.4% in annual terms, with the June average nominal wage upby 7% from the 2002 average. Despite strong growth in RS wages, which hasresulted in a narrowing of the entity wage gap, Federation wages remainsignificantly higher than those in the RS. The Federation average net monthlywage amounted to KM525 (US$298) in May compared to KM379 in the RS inJune. The highest monthly wage in the Federation was recorded in tobaccomanufacturing (KM1,609), while in the RS the highest wage was recorded infinancial services (KM804).
Inflation in Bosnia and Hercegovina (BiH) has been low and falling for the pastseveral years, underpinned by the strict application of the country�s currencyboard arrangement. In the Federation, first-half average prices fell by 0.1%compared with the first half of 2002, with a decline in food prices largelydriving the fall, despite the drought conditions. Food prices were down by 1.4%year on year in the first half, although a sharp 10.4% year-on-year increase inJune suggests that the effects of the drought are beginning to be felt.
Sources: FOS, Statistical Data on Economic and Other Trends; Republika Srpska Institute of Statistics, Monthly Statistical Review.
In the RS, inflation decelerated towards the end of the second quarter, andcontinued to fall in July, thus bringing the annual inflation rate to 1.6% throughthe first seven months of the year, compared to an average inflation rate of 1.9%in the first quarter. The largest increase in the period was in the prices ofservices, which grew by 5.9% in the first half of 2003. Prices of industrialproducts were up by 0.7% over the same period, while for agricultural products,prices fell by 0.5%. Inflation in the RS has historically been higher than in theFederation, as the RS economy has tended to follow the business cycle inneighbouring Serbia and Montenegro more closely. The gap between theentities� inflation rates, however, has fallen rapidly from approximately16 percentage points in 1999 to around 2 percentage points in 2002.
Financial indicators
Lending in Bosnia and Hercegovina (BiH), especially to households, grewrapidly in 2002 as a result of strong growth in bank liquidity, underpinned bythe public conversion of foreign-currency savings into euros and the entranceof several well-capitalised foreign banks into the domestic market. Total loansextended went up by 53% year on year last year, and by a further 6% in thefirst quarter of 2003. Lending to households has also risen as a percentage oftotal lending.
Federation household lending rose from some 36% of total lending at the endof 2001 to almost 50% by the end of the first quarter of 2003. Householdlending in Republika Srpska (RS) was virtually non-existent as late as 2001,accounting for only 5% of all credits, but has risen very sharply during the pastyear, and now accounts for almost one-third of all lending. This rapid growthsuggests both increasing sophistication in the banking sector and also thesignificant latent demand for credit that is just now beginning to be uncovered.Steady growth in household deposits!up by 15% from end-2001 through thefirst quarter this year!also suggests increasing confidence in the banking sectoras a whole.
Lending decelerates slightlyafter explosive growth in 2002
Commercial lending has also been rising over the past several quarters.According to data from the Central Bank of Bosnia and Hercegovina (CBBH, thecentral bank), lending in the Federation by commercial banks in the firstquarter was KM1.2bn (US$680m), an increase of 6% compared with the end of2002. Long-term lending continues to account for the bulk of all credit, makingup over 90% of all lending to households and roughly 70% of total lending.Maturity structure in Federation banks continue to be a source of concern, withlong-term assets largely financed by short-term liabilities, and a significantportion of non-performing assets remaining on the banks� balance sheets.
BiH: lending by the commercial banks(KM m, end-period)
Federation RSDec 2002 Mar 2003 % change Dec 2002 Mar 2003 % change
To government 30 40 32 14 n/a n/aTo public enterprises 249 243 -2 112 94 -16
Source: Federation Banking Agency, Information on Banking System of the Federation of Bosnia and Herzegovina, March 2003, Republika Srpska Banking Agency, Information on Banking
System of RS, March 2003.
Interest rates in BiH have been falling steadily for several years, driven both bycompetitive pressures, with foreign banks entering into the sector en masse.Rates have also been brought down by improvements in the credit-scoringcapabilities of local banks. In addition to a falling average interest rate, thedispersion of rates offered by BiH banks has also narrowed considerably. Theaverage short-term lending rate in the country has fallen from 13.6% in January2002 to 10.7% in June 2003, although comparable deposit rates have fallen moreslowly, from 1.9% to 1.1%.
Exports of goods continued to grow healthily in the second quarter of 2003,following the strong performance recorded in the first quarter. In January-Juneexport receipts totalled US$490m, representing a year-on-year increase of 60%.However, the strong growth partly reflects exchange-rate effects, linked to theweakness of the US dollar against the euro for most of 2002 and the fact thatmost of the exports of Bosnia and Hercegovina (BiH) are euro-denominated.The value of exports in the local convertible marka (KM), which is tied to theeuro, nonetheless confirms strong export performance in this period!exportsamounted to KM869m, an annual increase of 22%. Imports in US dollar termswere over US$1.5bn, up by 31% year on year in January-June.
The six-month trade deficit thus amounted to US$1bn, an increase of almost20% compared with a year earlier. Local-currency figures, however, give aclearer picture of real trends: growth in imports in marka terms was only 3.4%,suggesting a 2.6% contraction in the January-June trade deficit. The size of thetrade deficit in the Federation remains a concern, but the structure of importssuggests that an increased portion are going toward productivity-enhancingcapital investment, which will be to the longer-term benefit of the country.
Federation: foreign trade, Jan-Jun(US$ m unless otherwise indicated; by NACE production classification; fob-cif)
Source: Federal Office of Statistics (FOS), Statistical Data on Economic and Other Trends.
Exports in the first six months grew in line with a strong first-half manu-facturing performance. Out of 22 industrial branches, all but two recordedgrowth in exports, and the Federation�s three most important export sectors!base metals, wood products and clothing!all registered vigorous growth. The
Federation trade deficitappears to have narrowed
Export growth is spread acrossthe manufacturing sector
textiles industry has benefited from its historical role as supplier to the clothingindustries in Italy and Germany, but has recently suffered from a lack ofinvestment, leaving it in an increasingly uncompetitive position internationally.In contrast, the timber-processing industry, by far the Federation�s largest exportsector, has benefited from significant inward investment from Austria andprivatisation of some of the industry�s largest firms.
The growth in Federation imports appears to have been driven by a continuingrise in buys from abroad of machinery and transport equipment, which grewby about 7% year on year in the first six months of 2003 in local currency, andaccounted for roughly 10% of all imports. This development was more thanoffset by a drop of almost 8% in imports of food products, as the local food andbeverage industry appears to have successfully ramped up local production.
Federation exports by country bucked the overall economic trends in the EU,registering strong growth in sales to some of the most anaemic markets inEurope. Exports to Germany rose by 36% in local-currency terms in the firsthalf. Many Federation exporters have benefited from long-term supply contractswith EU partners, shieldeding them from the EU downturn. Federation exportsto Croatia, however, amounted to KM154m, an increase of 30%, thus puttingCroatia ahead of Germany as the Federation�s largest trading partner.
Federation: trading partners, Jan-Jun(US$ m unless otherwise indicated)
Exports to Italy, which grew by more than 60% year on year in local-currencyterms, totalled KM145m. The EU remains the Federation�s most important tradepartner (42% of its exports went to EU markets in the first half of 2003), but therespective shares of Croatia, Slovenia, and Serbia and Montenegro allcontinued to rise, and in the first half accounted for 37% of all exports.Normalisation of political relations in the region has contributed to improvingcommercial ties as well. This tightening of commercial links is particularlyimportant for BiH, as it is likely to remain more competitive in these markets(than it is in the EU, for example) for some time to come.
Most of the Federation�s first-half imports originated in Croatia. Imports fromCroatia amounted to KM500m, representing an increase of 11% year on year.Closely behind was Germany with purchases worth KM374m, up by 6% fromlast year�s first-half imports. With Italy as another important supplier, the EUshare in the Federation imports amounted to some 37% of the total. In January-June the strongest increase was in imports from Serbia and Montenegro, whichwent up by 40% in local-currency terms.
Republika Srpska: trading partners, Jan-Jun(US$ m unless otherwise indicated)
Source: Derived from Republika Srpska Institute of Statistics, Monthly Statistical Review.
In the Republika Srpska (RS), first-half export receipts in marka contractedsharply, falling by 12% year on year, and amounting to KM230m. Growth inimports was much slower than in the Federation, rising by only 0.7%. Despitethe slow pace of growth, the volume of imports remained much larger thanexport volume, at around KM1bn (US$568m), resulting in a half-year local-currency trade deficit roughly 5% larger than in the first half of 2002.
The decline in exports in local-currency terms was caused primarily by aplunge in sales to Serbia and Montenegro, which is the largest export market for
the RS. RS exporters, having focused for most of the past decade on exportingto their natural market in Serbia and Montenegro, have recently been trying tomove into other markets, notably the former Soviet Union, although withoutsignificant success thus far. Although imports from Serbia and Montenegrocontinued to account for the largest share of total imports in January-June,imports from Germany and Croatia increased rapidly, by 42% and 18%,respectively, when valued in the local currency. The growth in imports fromGermany is probably associated with the signing of several large outward-processing contracts in the clothing and leather industries.
The country�s massive trade deficit has driven persistently large current-accountdeficits over the past seven years, although the merchandise deficit has tendedto be partly offset by services and net transfers. First-quarter figures from theCentral Bank of Bosnia and Hercegovina (CBBH, the central bank) suggest thatthe current-account deficit narrowed in local-currency terms, with servicesexports increasing and the merchandise trade deficit narrowing significantlycompared with the first quarter of 2002. The CBBH�s recent measures to tightenliquidity!and thus credit and import growth!should help to control the recentrapid growth in the current-account deficit in the medium term. The deficitremains very large though, equivalent to some 25-30% of first quarter GDP.
In its second and third reviews of its stand-by arrangement with the BiHgovernment, the IMF presented revised historical data on private inflows, withprivate transfers in 2001 now estimated at some 11% of GDP, compared with3.4% previously. Although private inflows in 2002 are likely to have beensmaller than in the previous year, owing to the slow down in Europeaneconomies, the revision suggests that the current-account deficit for last yearwas slightly lower than previously estimated.
Facing a decline in international aid flows, there remain serious questions overthe country�s ability to continue to finance its external deficit. Recent data onforeign direct investment (FDI) inflows into BiH provide some positive news.Inflows in 2002 rose by KM200m (US$113m), or 120%, according to the ForeignInvestment Promotion Agency (FIPA). Nonetheless, this only covered some 15%of the current-account deficit, with the rest funded by international transfers.The majority of FDI thus far has been associated with the privatisationprogrammes in the entities, with greenfield investment remaining low.However, while the impending privatisation of utilities in the RS and theFederation, and of a number of large companies, is bound to attract furtherforeign capital, early in 2003 there were encouraging signs of increased investorinterest in greenfield investment. Foreign investment in real estate grew rapidlyin the past year, and Mercator, one of Slovenia�s largest retailers, has announcedit will build a large shopping centre in Sarajevo, in addition to the one it hasalready built in Tuzla.
