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Country Report July 2003

Bosnia and Hercegovina

July 2003

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

Bosnia and Hercegovina at a glance: 2003-04

OVERVIEWThe political outlook for Bosnia and Hercegovina (BiH) remains uncertain, asthe three main nationalist parties continue to bicker and drag their feet overproposed reforms. The Office of the High Representative (OHR) is expected torely increasingly on its powers to impose legislation and fire obstructiveofficials. BiHs macroeconomic fundamentals have improved, but self-sustainability in the absence of international aid flows remains far off. Reformsto tax and customs administrations, and attempts to jump-start the moribundprivatisation process, could provide some desperately needed momentum tothe fragile recovery that is now under way. External performance, however,remains a concern!current-account deficits are massive and persistent as aresult of weak export performance.

Key changes from last month

Political outlook• Progress has been made in consolidating the government coalition, although

it still looks fragile. The governments decision to defy EU pressure againstsigning a treaty with the US exempting US peacekeepers from prosecutionby the International Criminal Court (ICC) could have negative repercussionsfor BiHs EU-related aspirations.

Economic policy outlook• New rules governing the reserve requirement ratio of the Central Bank of

Bosnia and Hercegovina (CBBH) should help to slow last years rapid creditgrowth, and ease pressure on the current-account deficit. New bankruptcylaws could put thousands out of work, and with social tensions runninghigh the government may lack the resolve to carry out further reforms.

Economic forecast• Weaker than expected external performance and the effects of fiscal and

monetary tightening have led the Economist Intelligence Unit to revise downits forecast for real GDP growth to 3.7% in 2003 and 3.9% in 2004. We haveraised our forecast for inflation in 2003-04 to reflect the effects of drought onagricultural prices. We now estimate a current-account deficit in 2002 ofaround 40% of GDP and expect deficits to stay large in 2003-04.

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Bosnia and Hercegovina 1

Country Report July 2003 www.eiu.com © The Economist Intelligence Unit Limited 2003

Contents

3 Summary

4 Political structure

6 Economic structure6 Annual indicators7 Quarterly indicators

8 Outlook for 2003-048 Political outlook9 Economic policy outlook10 Economic forecast

13 The political scene

17 Economic policy

21 The domestic economy21 Output and demand23 Employment, wages and prices26 Financial indicators

27 Foreign trade and payments

List of tables10 International assumptions summary13 BiH: forecast summary22 BiH: industrial production23 Inter-entity turnover25 BiH: retail prices26 BiH: commercial bank lending27 Federation: foreign trade, Jan-Mar28 Federation: trading partners, Jan-Mar

List of figures

13 Gross domestic product13 Consumer price inflation24 Net wages25 Retail price inflation30 FDI in BiH by sectors, 1994-2002



Summary July 2003

Over the forecast period, the international communitys Office of the HighRepresentative (OHR) is expected to rely increasingly on coercion to induce thethree nationalist parties!the Party for Democratic Action (SDA), the CroatianDemocratic Union of Bosnia and Hercegovina (HDZ BiH) and the SerbDemocratic Party (SDS)!into co-operating with the current reform programme.BiHs economic fundamentals are showing some signs of improvement.Nevertheless, the countrys self-sustainability as international aid flows declinewill depend upon the ability of the government to move forward rapidly withreform of the business environment. Large current-account deficits remain aserious problem, given the monetary straitjacket of the countrys currencyboard arrangement.

The political scene in BiH is fraught with uncertainty, and is bogged down bylack of co-operation among the leading parties and only grudging commitmentto reform. Eight months after the 2002 elections, the main nationalist partiesand the leading moderate parties are still consolidating their positions in thegovernment. The signing of an agreement with the US exempting its USpeacekeepers on BiH territory from prosecution by the International CriminalCourt (ICC) could damage relations with the EU.

In the second quarter Central Bank of Bosnia and Hercegovina (CBBH)announced a set of changes to its calculation of the reserve requirement ratio,intended to increase the its own flexibility in its attempts to quell the strongconsumer credit growth seen last year. This growth has led to an explosion inimports and the CBBH is expected to tighten liquidity, lest massive current-account deficits threaten the viability of the currency board.

Industrial production figures in the first quarter of 2003 suggest that the mildrecovery from the slowdown experienced in early 2002 continues. Changes toemployment statutes, along with the implementation of a new bankruptcy law,could lead to a jump in unemployment this year. Inflation remains low,underpinned by the consistent application of the currency board arrangement,but it is expected to rise in 2003-04 owing to the effects of drought.

First-quarter trade figures suggest a slight narrowing of the trade deficit com-pared to the same period of 2002. The improvement is occurring despite weakexpected import demand in the EU, which is the destination of roughly half ofBiHs exports. The current-account deficit in 2002 now appears to havebreached 40% of GDP as a result of a very sharp rise in imports, fuelled by therapid expansion of consumer credit. A tightening of monetary conditions by theCBBH will help to dampen import growth in 2003-04, but current-accountdeficits will remain large.

Editors: Matthew Shinkman (editor); Laza Kekic (consulting editor)Editorial closing date: June 19th 2003

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

Outlook for 2003-04

The political scene

Economic policy

The domestic economy

Foreign trade and payments

4 Bosnia and Hercegovina


Political structure

Bosnia and Hercegovina (BiH) has legal existence within the boundaries of the formerYugoslav republic of the same name. It comprises 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). Brcko District is underthe sovereignty of BiH

BiH has the following limited responsibilities under the Basic Principles agreed in Genevaand New York in September 1995, and confirmed at Dayton in the US on November 21st:the establishment of a Constitutional Court, a Commission for Displaced Persons, aHuman Rights Commission, a central bank, public corporations to manage and operatetransport and telecommunications, a Commission to Preserve National Monuments, and asystem of arbitration. Foreign trade is also supposed to be managed by the BiH government

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; current chairman), Sulejman Tihic (Muslim; elected October 2002) andDragan Covic (Croat; elected October 2002)

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), Serb DemocraticParty (SDS), Party of Democratic Progress (PDP), Party of Independent Social Democrats(SNSD), Democratic Socialist Party (DSP), Serb Peoples Alliance (SNS), Serbian RadicalParty of Republika Srpska (SRSRS), Socialist Party of Republika Srpska (SPRS), BosnianParty (BOSS)

The Dayton agreement called for the appointment of a High Representative, a seniorforeign diplomat charged with monitoring the implementation of the agreement and co-ordinating the activities of international organisations in BiH. The High Representative isadvised by the Peace Implementation Council (PIC), which includes the signatories to theDayton agreement. Since December 1997 the High Representative has been able toimpose 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)Civil affairs Safet Halilovic (Muslim)Foreign trade & economy Mila Gadzic (Croat)Human rights & refugees Mirsad Kebo (Muslim)Treasury Ljerka Maric (Croat)Transport & communications Branko Dokic (Serb)Justice Slobodan Kovac (Serb)

Peter Nicholl

Official names

Form of state

National elections

Head of state

National government

International involvement

National government

Main political parties

Central Bank governor

Legislatures



Paddy Ashdown

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.

Key ministers

Republika Srpska

High representative

Federation

Key ministersa



Economic structure

Annual indicators1998 a 1999a 2000 a 2001a 2002b

GDP at market prices (KM m) 7,244 8,603 9,432 b 10,233b 10,969GDP (US$ m) 4,113 4,691 4,536 b 4,795b 5,282

Real GDP growth (%) 15.6 9.6 5.6 4.5 3.8Retail price inflation (Federation; %; av) 5.3 -0.7 1.5 1.7 -0.2a

Retail price inflation (Republika Srpska; %; av)c 2.0 14.2 14.6 6.5 1.7a

Population (m; mid-year; resident) 3.65 3.73 3.80 b 3.87b 3.95Exports of goods fob (US$ m) 652 816 1,152 1,166 1,090

Imports of goods fob (US$ m) 2,612 2,658 3,109 3,118 3,300Current-account balance (US$ m) -1,256 -1,526 -1,274 -1,355 -2,271Reserves excl gold (US$ m) 175 452 497 1,221 1,321a

Total external debt (US$ bn) 3.0 3.1 3.0 b 2.6b 2.7Exchange rate (KM:US$; av)d 1.76 1.83 2.12 2.18 2.07a

a Actual. b Economist Intelligence Unit estimates. c KM-based index. d 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 13.0 Public & private consumption 100.4Industry & 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 FederationBase metals 25.8 Food & beverages 15.7

Clothing 8.6 Chemicals 8.8Wood products 12.8 Machinery & equipment 10.0

Leather products 4.2 Fuel 6.6

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



Quarterly indicators2001 2002 20032 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr

Financial indicatorsExchange rate KM:US$ (av) 2.243 2.199 2.186 2.234 2.131 1.990 1.964 1.824Exchange rate KM:US$ (end-period) 2.306 2.142 2.219 2.242 1.961 1.984 1.865 1.795Deposit rate (av; %) n/a n/a n/a 4.81 4.54 4.40 4.36 n/aLending rate (av; %) n/a n/a n/a 13.25 12.98 12.36 12.19 n/aM1 (end-period; KM m) 1,672 1,890 2,790 3,028 3,117 3,217 3,154 2,988M1 (% change, year on year) 33.4 38.8 90.7 101.3 86.4 70.2 13.0 -1.3M2 (end-period; KM m) 2,853 3,150 4,922 5,175 5,173 5,357 5,319 5,279M2 (% change, year on year) 20.5 29.3 92.0 94.0 81.3 70.1 8.1 2.0Foreign trade (US$ m)a

Exports fob 184.0 187.3 177.6 184.8 200.6 226.6 218.9 n/aImports cif -680.2 -718.6 -802.7 -659.6 -798.3 -892.7 -899.2 n/aTrade balance -496.2 -531.3 -625.1 -474.8 -597.7 -666.1 -680.3 n/a

Foreign reserves (US$ m)Reserves excl gold (end-period) 497 588 1,221 1,134 1,229 1,223 1,321 1,241

a DOTS estimates.

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



Outlook for 2003-04

Political outlook

Politically, Bosnia and Hercegovina (BiH) faces a turbulent period in 2003-04,given the continued low level of co-operation among the three nationalistparties, and between them and their moderate counterparts. Eight months after2002 elections, with the coalition at the state level still in a process ofconsolidation, the new BiH government remains focused on the distribution ofpolitical appointments at all levels!state, entity and canton. The internationalcommunitys lead institution in BiH, the Office of the High Representative(OHR), has insisted on granting approval of all political appointments and hasprevented new appointees from taking office before a new civil code, designedto govern the recruitment of administration staff, is adopted. In addition to thenatural antagonism between the coalition parties, this obstruction to thehandover of power to the nationalist parties!the Party for Democratic Action(SDA), the Croatian Democratic Union of BiH (HDZ BiH), and the SerbDemocratic Party (SDS)!has further heightened tensions among them, andbetween them and the OHR. The nationalist parties, and their leadingmoderate counterparts, the Party for BiH (SzBiH) and the Party for DemocraticProgress (PDP), consider it vital that their members and supporters be installedinto important posts in the government and the public administration in orderto safeguard and consolidate their position. Although the handover is nearingcompletion, it looks increasingly unlikely that the coalition will be capable ofpushing forward a programme of reform effectively without heavy-handedcoercion from the OHR.

The ruling coalition lacks a unified programmatic orientation!which mightotherwise provide an incentive to reach agreement on the civil code. Thisleaves the High Representative, Paddy Ashdown, as the most likely protagonistin trying to move forward the economic reform agenda. In doing so,Mr Ashdown is expected to rely increasingly on the full extent of his powers ofimposing legislation and removing from important posts public officialsdeemed obstructive.

Although in their first six months in office the three nationalist parties haveoften seemed to behave in ways reminiscent of the past, their position in thecurrent government is different than it was during their period in power before2000. Several factors are likely to lead them to maintain some momentum inthe reform programme. In contrast with the situation of their former coalition,the nationalists now have no strong majority in the government, andconstitutional changes to the constitutive status of all three main ethnic groupsin BiH have weakened the nationalists position. Additionally, BiHs inter-national patrons are tightening the conditions for their continued support, uponwhich the country is still critically dependent. According to the results of arecent survey, conducted by the UN, of public perceptions of the government,the public is increasingly dissatisfied with the efficacy, transparency andaccountability of the government, creating the potential for even deeper socialunrest. In addition, the three nationalist parties are vulnerable to pressures from

Domestic politics



within the uneasy coalition that was hammered out following the elections.Early into its mandate the SzBiH has shown that it is ready to challenge theother coalition members on matters that it considers to be against the interestsof BiHs state-level institutions.

Despite these pressures, the leading parties will probably take a highly scepticalapproach to any attempt to move reform along quickly. Thus, the most likelyscenario for the forecast period is one in which the nationalist parties will tryto extend their term in office for as long as possible, adapting their strategies toaccomplish the minimum necessary to comply with the conditions set by theinternational community.

BiH has found itself in the middle of two transatlantic rows in recent months,both of which had the potential to damage relations with the EU and the US.The Bosnian governments recent agreement with the US to grant US soldierson BiH territory immunity from prosecution by the International CriminalCourt (ICC), despite pressure from the EU not to sign the agreement,accentuated BiHs delicate position as a recipient of both US and EU assistance.In the end, the continuing role of US peacekeepers on BiH territory proveddecisive, and the government was left hoping that the EU, aware of BiHsspecific position, would not retaliate by refusing to go ahead with its plannedfeasibility study for a stabilisation and association agreement (SAA).

At the same time, NATO and the EU appeared to be in some confusion over aproposed handover of peacekeeping duties in BiH to an EU rapid reaction force,with NATO officials surprising their EU counterparts in June by insisting thatsuch a move would be premature. Maintaining good relations with both theUS and the EU is vital to BiH, and the state-level government is likely to seek astance on these and other issues that is most likely to secure continued inflowsof foreign assistance.

Economic policy outlook

Maintaining prudent fiscal policies and sustaining structural reforms will be themain economic policy priorities over the forecast period. Reforms intended tostrengthen the business environment will continue, having received a boostfrom the successful completion of the first phase of the OHRs BulldozerInitiative. Progress has been made in creating a modern tax system in BiH, butadditional reforms are needed to simplify tax structures, further rationalise taxrates, and improve tax compliance and collection. The introduction of a single,state-wide value-added tax (VAT), which is the responsibility of a commissionon taxation established in June, will be the centrepiece of the forthcomingpackage of tax reforms.

In addition to streamlining and standardising of the tax system, creation of aunified customs system remains one of the leading policy challenges in theperiod ahead. Officials in Republika Srpska (RS) in particular had expressedstrong opposition to the establishment of a single customs administration, butappear to have accepted this reform as inevitable. Both the customs and taxadministrations are expected to begin functioning some time in 2005.

Policy trends

International relations



The government has made a nominal commitment to step up the privatisationprocess, although this will not be an easy task, given the institutionalweakness of the privatisation commissions and the overall lack of politicalwill on the issue. The reforms envisaged over the medium term carrysignificant negative social implications, for which the government at themoment lacks adequate solutions.

The sustainability of BiHs fiscal performance remains a major source ofconcern, despite considerable fiscal adjustment both on the expenditure andrevenue sides. Public finance reform has led to spending cuts, and, by enforcingexisting legislation more strictly, an improvement in revenue collection.However, the entities are under pressure to continue to clear wage andpayments arrears to public-sector workers and suppliers. In the past, allowingarrears to build up was an important method of deficit financing, so thatattempts to clear them will put further pressure on the fiscal position. Moreworryingly, upward pressure on expenditure is expected from several sources in2003-04. Funding is needed to finance the growing role of the central state, torepay public pre-war debt, and to cover costs associated with returning refugeesand reform of the public administration. Donor support, which has beeninstrumental in covering the fiscal deficit, is programmed to decline in 2003-04.Compensating for this decline through higher taxes is not possible, as thecountrys tax burden is already high. Thus, if the government is to meet thetargets agreed with the IMF, it will have to move decisively towards reducingexpenditure, with defence spending the likely candidate for further cuts.

In May the Central Bank of Bosnia and Hercegovina (CBBH) announced a setof policy measures aimed to address the rapid growth in domestic credit in2002. The package makes several changes to the level and definition of theCBBHs reserve requirement ratio, which is the only instrument of monetarypolicy that the bank has at its disposal under the rules of the currency boardarrangement. The changes, although not expected to lead to any immediate risein interest rates, will enable the CBBH to move more decisively to tightenliquidity in the country, should further credit growth put pressure on thecurrent-account deficit and therefore also the currency board arrangement itself.The CBBH forecasts a slight drop in international reserves in 2003 as part of itsmonetary tightening.

Economic forecastInternational assumptions summary(% unless otherwise indicated)

2001 2002 2003 2004Real GDP growthWorld 2.1 2.9 3.0 3.7OECD 0.9 1.8 1.6 2.2EU 1.5 1.0 0.8 1.8

Exchange ratesUS$: 0.90 0.94 1.15 1.18US$:SDR 1.27 1.30 1.41 1.42

Fiscal policy

Monetary policy

International assumptions



International assumptions summary(% unless otherwise indicated)

2001 2002 2003 2004Financial indicatorsUS$ 3-month Libor 3.78 1.80 1.13 1.85 3-month interbank rate 4.26 3.33 2.18 2.06Commodity pricesOil (Brent; US$/b) 24.5 25.0 25.5 18.3Natural gas (Europe; % change in

US$ terms) 5.2 -24.8 22.8 -14.7Food, feedstuffs & beverages (%

change in US$ terms) -1.9 12.7 2.1 1.8Industrial raw materials (% change

in US$ terms) -9.7 2.2 10.2 3.5

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

Global economic growth remains sluggish and is unlikely to acceleratesubstantially this year. Activity in the euro zone in particular has slowedconsiderably and is forecast to stay weak in 2003. The Economist IntelligenceUnit estimates that EU GDP growth in 2002 was only 1%. We now forecast adeceleration to 0.8% in 2003, and then a gradual acceleration in 2004, to 1.8%.The outlook for Germany!BiHs most important trading partner!is particularlybleak. We expect Germanys real GDP to grow by only 0.1% this year, withgrowth accelerating to 1.2% next year. With Germany facing EU-related fiscalconstraints, its chances of a strong pick-up this year or next are remote.

The two main downside risks to our forecast concern the valuation of theUS dollar and the pace of economic recovery in the EU. We have recentlyrevised our forecast for the US dollar in 2003-04, and now expect it to weakensignificantly against the euro in both years. However, a sharper than expecteddepreciation would eliminate any chance of an EU recovery in 2004. BiHsprospects for economic growth are heavily dependent on improved exportperformance, which, in turn, will rely on demand from the countrys largesttrading partners in the EU. Should economic growth in the EU be even slowerthan expected this year, the prospects for any export revival in BiH could suffer,potentially leading to a deceleration in real GDP growth in 2003-04.

BiHs post-war GDP growth has been primarily underpinned by large inflowsof international assistance. These inflows, and the overall macroeconomicstability brought about by the currency board, have provided the basis for rapidshort-term regeneration of economic activity. At the same time, aid flows haveallowed the postponement of the type of reforms that would support broad-based sustainable growth. For such growth to be achieved, accelerateddevelopment of the private sector will be critical. Wide-ranging reforms to thatend, however, are still to be implemented, and it will take some time beforethey have an impact on the overall macroeconomic picture. This makescontinuing international support vital for maintaining the economicmomentum created by the post-war reconstruction efforts. We expect that thissupport, although largely scaled down from earlier levels, will continue,providing for modest growth over the next couple of years. Nonetheless, weakexternal performance, our pessimistic view for EU growth, expected monetarytightening and the effects of this years severe drought have led us to revise

Economic growth

International assumptions



down our forecast for real GDP growth to 3.7% this year (from 4%) and 3.9%(from 4.3%) next year.

We expect inflation to remain low, underpinned by continued strictimplementation of the currency board. We have raised our forecast for inflationin both entities for 2003, owing to the effects of drought on the prices ofagricultural products. Our forecast assumes that the currency board will remainin place and that recent fiscal discipline will be maintained. The introduction ofVAT, which will also boost inflation in both entities, was previously expectedin 2004, but now is likely to take place in early 2005.

The convertible marka (KM) is pegged to the euro at a rate of KM1.96:"1. Weanticipate a weakening US dollar against the euro through 2003-04 and thus acorresponding nominal appreciation of the KM against the US currency. Withinflation low, the significant real effective appreciation that this implies willundermine BiHs external competitiveness, which already suffers because ofthe low quality of the countrys exports, and the rapid rise in wages comparedto productivity.

BiHs external performance is difficult to determine with any precision, as dataon foreign trade are poor. Data for the Federation in the first quarter of 2003suggest that exports grew faster than imports and that, in local-currency terms,the trade deficit has narrowed. Boosting exports remains a priority if economicself-sustainability is to be achieved, and some modest improvements are likelyover the next couple of years. Discussions are under way to transform the BiHdeposit insurance agency into an export-import agency, that would, in additionto issuing guarantees, secure export loans and loans for the imports of materialfor export-oriented production. Overall, however, we expect the large foreign-trade deficit to persist, giving rise to large current-account deficits, especially asinward current transfers continue to decline. We now estimate that BiHscurrent-account deficit was as much as 43% of GDP in 2002, caused by to aflood of imports sucked in by dramatic growth in consumer credit. Over theforecast period, we expect current-account deficits to narrow slightly as theCBBH moves to dampen import growth, although they will remain large as apercentage of GDP. The country has so far relied on international aid flows tofinance its current-account gap; as these flows decline, the revitalisation of theprivatisation programme will become increasingly critical in order to stimulatelarger inflows of foreign direct investment (FDI).

It will take time for the positive effects of structural reforms, and subsequentincreases in inflows of foreign capital as another source of funding the current-account deficit, to be felt. In this respect, an important factor in improvingforeign investors perceptions of BiH will be the stance that the EU takestowards the region as a whole regarding eventual EU membership. If the EUmakes a firm commitment to the future accession of Balkan countries to the EU,it may increase investors confidence and strengthen capital inflows into theregion, including BiH, relieving to some extent the dependence of BiH on thegenerosity of international donors.

Inflation

Exchange rates

External sector



BiH: forecast summary(% change year on year unless otherwise indicated)

2001a 2002 b 2003c 2004 c

Real GDP growth 4.5b 3.8 3.7 3.9Industrial output 5.0b 8.2 7.5 7.5

Retail price inflation (av)Federation 1.7 -0.2 a 0.5 0.7Republika Srpska 6.5 1.7 a 2.4 2.5Merchandise exports fob (US$ m) 1,166 1,090 1,150 1,210Merchandise imports fob (US$ m) -3,918 -4,625 -4,300 -4,100

Current-account balance (US$ m) -1,355 -2,271 -1,757 -1,472 % of GDP -28.3b -43.1 -26.0 -20.1

Exchange rate (av; KM:$) 2.18 2.07 a 1.70 1.65

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

The political scene

The first cracks in the ruling coalition, comprised of the three nationalistparties!the Party for Democratic Action (SDA), the Serb Democratic Party (SDS),and the Croatian Democratic Union of Bosnia and Hercegovina (HDZ BiH)!and supported by the moderate Party of Democratic Progress (PDP) and Partyfor BiH (SzBiH), began to appear in the first several months after the 2002parliamentary elections. A major dispute over the election of the new deputyspeaker of the state-level House of Representatives provided a characteristicexample of the fractious relations between the parties and their grudgingwillingness to work together. Following the resignation of Mirko Sarovic, theSerb member of the BiH tripartite state presidency, based on his role in ascandal over illicit defence contracting between Republika Srpska (RS) and Iraq,the former deputy speaker of the House of Representatives, Borislav Paravac ofthe SDS, was appointed to take his place. This move necessitated the election ofa new deputy speaker. The SDS put forward Momcilo Novakovic, the head ofits caucus in the House of Representatives, and the Party of Independent SocialDemocrats (SNSD), the largest RS opposition party, proposed Nikola Spiric as itscandidate. The opposition parties in the BiH parliament voted for Mr Spiric. In

Cracks begin to surface amongnationalists in the coalition



the end, however, his narrow victory was decided by the votes of deputiesfrom two coalition members!the SzBiH and the PDP!and the abstention ofseveral PDP and SDA MPs.

Mr Spirics election thus highlighted the growing disunity among the coalitionparties and the coalitions vulnerability to the whims of the SzBiH and the PDP.The SzBiH strategy since it reluctantly joined the nationalist parties coalitionhas been to support policies and candidates selectively, with an eye towardsstrengthening the state-level institutions of BiH, as a stronger state wouldimprove the position of its Croat constituency vis-à-vis a relatively weakenedRS. In this sense, the partys vote for Mr Spiric, who in his former capacity as achairman of the BiH House of Peoples was acclaimed for his work in strength-ening the BiH state government, was not a surprise.

The decision by a prominent SDA deputy to abstain from the vote wasindicative of growing tensions within the SDA over co-operation with the othercoalition parties. The abstentions of PDP deputies Petar Kunic andJelina Djurkovic were even more problematic were. Their refusal to support theSDS candidate provoked an angry reaction from the SDS, with the partypresident, Dragan Kalinic, suggesting that the PDP and SDA were to blame forthe election of the SNSD candidate, which had allowed the moderate parties tostrengthen their position in the government.

The SDS faced several blows to its position in the government in the first halfof 2003, first when the Office of the High Representative (OHR) removed theSDS-led board of Elektroprivreda RS, the Serb entitys electricity firm, followingan internationally sponsored audit that uncovered pervasive corruption andmismanagement within the firm (as well as in two electricity companies in theFederation). The board selected to replace the ousted group is led by a PDPrepresentative. The atmosphere became even more heated when Mr Sarovic,the vice-president of the SDS, was forced to resign from the BiH presidency, andthe SDS-dominated Supreme Defence Council was dismissed by the OHR overits involvement in arms sales to Iraq and allegations of espionage.

The combination of these incidents has placed a deep strain on relationsbetween the SDS and the PDP. Although it is the strongest party in the RSparliament, the SDS has become increasingly concerned about losing out ininfluence to the PDP, which it has always considered to be submissive to thedictates of the international community. Reflecting this concern, the SDS hasbeen pressing to be given the post of RS finance minister ever since it becamevacant, following the resignation of the PDPs Simeun Vilandecic. The ongoingfriction between the PDP and the SDS, which make up the backbone of the RSgoverning coalition, thus looks set to continue.

The struggle over political appointments and the various scandals mentionedabove have dominated the first months of the new RS governments term inoffice, preventing it from dealing with difficult but critical economic reforms.Dragan Mikerevic is the RS prime minister, and his cabinet consists mostly ofmembers of his own PDP party, although the SDS holds the majority inparliament, making it difficult for the government to carry forward any

Gridlock in RS governmentthreatens reform progress

Election of deputy speakerexposes coalition rifts

Relations between SDS andPDP deteriorate



coherent agenda. At the same time as deciding not to participate in thegovernment, the SNSD pledged to be its harshest critic. Six months into itsterm, the governments record has been modest at best, providing the SNSDwith ample ammunition for its campaign. The SNSD has relentlessly criticisedthe RS governments poor record, especially in dealing with the escalation inthe foreign trade deficit, the failure to accelerate privatisation, the alleged fraudin the tax administration, and the proliferation of organised crime and poverty.The SNSD was quick to seize on revelations of links between certain SDSmembers and some suspects in the assassination of Zoran Djindjic, the Serbianprime minister, in an attempt to add weight to its accusations that criminal-isation within SDS ranks is pervasive and that this is having a damaging effecton RS interests.

Relations between the two leading parties in the Bosnian Federation, the SDAand the HDZ BiH, have also suffered in the second quarter of 2003, withparticular tension surrounding reforms to the intelligence services and theFederation pension administration. The parties squabbles reflect the deepmistrust that still exists between them, and which continues to undermine thefunctioning of joint institutions within the Federation.

Control over the intelligence services has been instrumental to the nationalistparties hold on power in BiH. Although efforts to unite the public componentof the police force started earlier, it was only when the moderate Alliance forChange entered office in 2000 that progress was made in uniting in theFederation the secret police establishments of Bosnian Croats and Muslims.Unsurprisingly, the Federation security service (FOSS) has become a flashpointfor conflict between the two nationalist parties. The acting director of the FOSSis from the HDZ BiH, and his party has insisted that the permanent head anddeputy head of the service be appointed simultaneously. This has furthercontributed to the delay in finding a replacement and has secured for the HDZBiH control of this important post, temporarily at least. At the same time, theSDA requested in April the removal of the FOSS acting director, following anannouncement that the Federation Ministry of Interior was conducting aninvestigation into his involvement in orchestrating violence against the NATO-led Stabilisation Force (SFOR) during its action in western Hercegovina in 1991.

At the April annual convention of the HDZ BiH, Barisa Colak was elected asparty president. Mr Colak and Dragan Covic, the Croat member of the BiHpresidency and an HDZ BiH leader, represent a moderate faction of the party.Before the convention, there was speculation that the hardline nationalist wingwould leave to set up a new party, which is what happened with the HDZ inCroatia. Although Mr Colaks election was hailed by some as the end of thedomination of the hardline faction, he won only just over half of the votes,indicating that the membership remains highly polarised over the direction inwhich the party should proceed. The overall tone of the discussion at theconvention was more moderate than in the past, but the address ofGeneral Ljubo Cesis Rojs, a Bosnian Croat representative in the Croatianparliament, suggested that the HDZ war-time agenda of uniting Croats acrossthe region still has support among some sections of the Bosnian partys

Co-operation of SDA andHDZ BiH remains strained

The HDZ BiH elects a moremoderate leadership



membership. Recent polls reveal growing support for the HDZ in Croatia, whichis bound to strengthen hardliners within its sister party in BiH.

The Muslim nationalist SDA has faced growing difficulty in maintaining partydiscipline, with a divide between a more technocratic faction and the partyshardliners beginning to emerge. Recent co-operation between Adnan Terzic, thechairman of the BiH Council of Ministers, Ahmet Hadzipasic, the Federationprime minister, and the OHR directly conflicts with the stance taken bySulejman Tihic, the leader of the SDA and the Muslim member of the BiHpresidency, who represents the hardline faction of the party. On taking up hispost, Mr Tihic vowed to strengthen the role of the presidency, which in hisview had been weakened by the increasingly assertive role of the Council ofMinisters under the previous moderate government. The OHR, however, hascontinued to work closely with the Council of Ministers, thus furtherundermining the attempts of SDA hardliners to assert the partys control overthe new government.

Mr Tihic has also been in open confrontation with the OHR over its insistencethat, before any changes in the staffing of the public service is undertaken, alaw establishing greater transparency in recruitment procedures for governmentpositions be adopted. Mr Tihic has argued that the OHRs position has enabledthe appointees of the former Alliance for Change to remain in posts that shouldbe filled by candidates from the ruling coalition. Mr Terzics co-operation withthe High Representative, Paddy Ashdown, is perceived by the SDAs hardlinersas weakening Mr Tihics position in securing the SDAs interests. Mr Terzic andhis moderate faction seem to be better positioned as, having been in charge ofthe SDAs personnel policy, he has managed to install like-minded partymembers in a number of important party and government positions.

The leaders of the three largest opposition parties from both entities!the SNSD,the Social Democratic Party (SDP) and the New Croatian Initiative (NHI)!haveagreed to work on a platform for co-operation, with the aim of mobilising partyactivists and other forces to call for early elections, which they argue arenecessary in the light of the catastrophic economic situation, impending socialrebellion and the failure of the Federation government to ensure fair partic-ipation of Bosnian Serb representatives. The agreement marked the first jointinitiative of the opposition parties since their defeat in the October 2002elections. Nonetheless, on the whole the opposition remains disorganised andpresents no serious threat to the government for the moment.

Following several years of intense pressure from the international community,an agreement on the formation of a joint state-level, civilian-led commandstructure for BiHs armed forces was reached in May. The agreement marks animportant step in the goal of comprehensive reform of BiHs defence structures,which the international community has insisted is vital both as part of fiscalconsolidation (by some estimates BiH spends as much as 10% of its governmentbudgets on defence) and as a precondition for BiHs eventual membership inNATOs Partnership for Peace Programme (PfP). Bosnian Serb political partieshad strongly opposed reforms that would lead to the unification of the entity

Tensions within the SDA rise

Progress is made on BiHmilitary reform

Opposition parties agree onco-operation



armed forces (each entity currently has its own army, with separate commandstructures), which they see as a direct threat to the autonomy that the entitieswere granted under the Dayton agreement after the conclusion to the war inBiH. However, after the OHRs dismissal of the RS Supreme Defence Council,the discovery of illegal weapons trading with Iraq and a spying scandal, RSrepresentatives had little choice but to succumb to pressure to fall in line withthe proposed reforms. Even then, the SDS, voicing the view of most otherBosnian Serb parties, argued that they would not allow the unification of theentities armies.

As of January 2004 the tripartite BiH presidency will assume the role of thecivilian commander of BiH armed forces, with the running of the military to beoverseen by a Standing Committee on Military Matters (SCMM), although thejurisdictions of the presidency, the SCMM, and military leaders within theunified command structure remain to be determined. There are still majordifferences between the main parties as to the eventual form of the BiH army.Bosnian Serb and Bosnian Croat representatives favour keeping three separatearmy components, with each component still based on one of the main ethnicgroups; the RS leadership insists that a unified army is both unconstitutionaland impossible practically; and the Muslim representatives support the form-ation of a completely unified BiH army. Proposals tabled by NATO expertsenvisage significant downsizing of the size of the armed forces, with the currentlevel of around 20,000 personnel to be reduced by about half. Again, the ethniccomposition of the new force in likely to be contentious, as current proposalsenvisage Muslim, Bosnian Serb and Bosnian Croat components of equal size.NATO insists that the reforms should be completed by the end of this year ifBiH is to stay on track for membership in the PfP programme in 2004.

On May 7th the BiH presidency initialled a treaty to grant immunity fromprosecution by the International Criminal Court (ICC) to US peacekeepersserving on its territory. The agreement followed months of pressure from theUS, which had threatened to suspend military assistance to BiH and to rejectBiHs membership in NATOs PfP programme. Pressure came as well as fromthe EU, which has repeatedly warned EU aspirants in the western Balkans thatfailure to ratify the treaty could jeopardise their progress towards membership.In BiHs case, however, the imperative of maintaining a good relationship withthe US and NATO appears to have won, perhaps because the extendedtimeframe facing the country in its path towards EU membership talks gives itmore leeway for patching up later any possible short-term deterioration inrelations. The treaty was ratified by the BiH House of Representatives in June,and the ratification by the House of Peoples is considered a formality.

Economic policy

In May the Central Bank of Bosnia and Hercegovina (CBBH) introduced apackage of measures to adjust its methodology for calculating the commercialbanks reserve requirement, in order to improve its own flexibility in adjustingthe reserve requirement. This was also an initial step towards potential

BiH to grant US soldiersimmunity from ICC

Central bank introduces newreserve requirement regulation

Military structures are to beunified



monetary tightening, in response to the strong growth in bank credit seen in2002 and the effect this had of widening current-account deficit. The reformpackage, which required an amendment to the Law on the Central Bank,included four main changes. First, the bank decided to broaden the reservebase to include both local and foreign currency (previously it had included onlyforeign-currency deposits). After six years under the currency board arrange-ment, the CBBH judged that trust in the convertible marka (KM) has risensignificantly. This development has made it unnecessary to exclude thecurrency from the reserve base as an incentive for holding it. In addition, thebank concluded that adding the currency to the base would bring it into equalposition with foreign currency in the banking sector.

Second, the CBBH decided to disallow local currency cash held at the CentralBank from counting as an asset for the purpose of meeting the reserverequirement. Third, it updated the Law on the Central Bank to allow the CBBHto provide compensation to banks for their reserve deposits held in its ownvaults. Finally, the CBBH widened the range of potential reserve ratios. Underthe previous regime, the Central Bank was allowed to set the ratio between 10%and 20%, whereas the reforms envisage a range of 0-20%. Upon passage of thenew regulation, the CBBH cut the reserve ratio from 10% to 5%, thus making itthe lowest in south-eastern Europe.

Under the rules of the currency board, making adjustments in the reserverequirement is the CBBHs sole monetary policy lever. The decision to enhanceits capacity in this area came in response to the strong escalation of consumercredit over the past 18 months, which could have negative long-term con-sequences on the local economy. By fuelling import demand, consumer creditgrowth could contribute to a further deterioration in the balance of paymentsand thus undermine the currency board. Although the cut in the reserve ratiothat was implemented along with the reforms should offset the impliedmonetary tightening of the reforms themselves, the CBBH made clear in Junethat it would continue to assess closely the countrys external performance. Thebank also made clear that it had enacted the reforms specifically to allow it torespond decisively should future credit growth further undermine the countrysexternal position. The CBBH will thus monitor on a regular basis the dynamicsof bank credit and its effects on the balance of payment and adjust the reserveratio accordingly. The banks governor, Peter Nicholl, stressed that the reformsshould not lead to interest rate rises, in view of the offsetting cut in the reserveratio and the fact that the market in Bosnia and Hercegovina (BiH) issignificantly underbanked.

At the end of March the Federation government asked all budget users to cuttheir expenditures by 10% in order to maintain fiscal targets, as revenue take sofar this year has been weaker than expected. Exempted from the order are thefollowing: payments to the BiH central government and cantons; financing offoreign debt; transfers for disability benefits, and benefits for displaced personsand refugees; and gross salaries and contributions. The government expects themeasure to achieve savings of around KM31m (US$18.7m). Another KM10m insavings will come from improvements to revenue collection in the Federation

Federation government ordersexpenditure cuts

Need for monetary tighteningdrives regulatory change



Pension and Disability Fund, and KM4.2m in savings on the servicing of itsforeign debt as a result of favourable exchange-rate movements. The total cut inexpenditure, of KM45.2m, should enable the governments budget in the firstsix months of 2003 to remain within the framework agreed with the IMF. Themeasures are temporary and their effects will be analysed every month.

In contrast with the difficulty that the Federation has had this year in achievingits revenue targets, the tax administration in Republika Srpska (RS) announcedin June that it had achieved 99% of its revenue target for the first five months ofthe year, collecting KM344m (US$207m).

The fiscal programmes of both entities have long been criticised by inter-national observers for their high proportion of spending on social transfers andother current expenditure, arguing that this prevents the government frombeing able to invest in projects that will have a long-term impact on economicgrowth and stability. However, attempts to reduce these transfers haveinvariably met with stiff resistance. The implementation a new Federation lawon war veterans and invalids has become bogged down by the need toreconcile the demands of the representatives of Bosnian Croat and Muslimveterans. Currently, there are two separate systems of payments to thesebeneficiaries. The new law aims to unify these systems and would result in alarge reduction in entitlements, particularly to the Bosnian Croat component.Entitlements for war veterans in BiH are among the most extensive andgenerous in Europe. Expenditure for war veterans and invalids constitutes thesingle largest social transfer in the entity budgets, amounting to roughly 4% ofGDP and almost 10% of the entire RS budget, thus providing not only a sourceof fiscal pressure but also a constraint on other social assistance programmes.

In November 2002 the High Representative, Paddy Ashdown, launched theBulldozer Committee initiative, to help BiH politicians and business people toco-operate in identifying major barriers to business in the country, and fromthis, to develop a set of proposals to the government on how these barriersmight be removed. A part of the Justice and Work agenda agreed betweenMr Ashdown and local authorities, the Bulldozer initiative aimed at initiating50 reforms in 150 days by working closely with the business community. Bythe end of May 2003 a range of reforms had been proposed to the legislativebodies, covering various issues such as double taxation, administrative barriersto entry and exit, and compulsory fees to professional associations. In additionto trying to identify and eradicate obstacles to business effectiveness, theinitiative was intended to engage wide sections of BiH society in discussionand formulation of proposals to address opaque business practices, theremoval of which has often been obstructed by the interest groups close tolocal authorities.

Upon finalisation of a first set of reforms, the second phase of the BulldozerCommittee programme was launched in early June this year. In this phase, theinitiative will be pushed out by the Office of the High Representative (OHR) toregional and local authorities in order to improve local advocacy and bring thebulldozer process closer to local businesses. At the same time, the secondphase envisages continuous monitoring of the progress in implementation of

Negotiations on entitlementreforms remain deadlocked

Business environmentinitiatives enter a new phase



the 50 reforms set out in the first phase and continuation of the public-privatedialogue that started in November 2002.

The privatisation process in both entities has been torturously slow, with theresults after two years deemed unacceptable by the OHR. The sell-off ofsmall companies has been moderately successful, with almost 80% in theFederation and 55% in the RS having been sold. However, privatisation of largerenterprises, and those deemed strategic by the entities, has been held back bya combination of ineffective privatisation commissions, lack of investorappetite, and, most of all, an absence of will among the political leadership tosell off the countrys crown jewels in the energy, telecommunications, trans-port, and mining sectors.

Of the 63 strategic companies in the RS, only 25 have been sold!and of theseonly four were sold in the 18 months up to May 2003. None of its strategiccompanies in energy, telecommunication, oil, gas, water or postal services hasbeen sold yet, reflecting the ongoing reluctance of local authorities to part withcontrol over firms that tend to be an important source of funding for politicalparties. In 1999 the RS government wrote off the debts, estimated at KM2bn(US$1.2bn), of some of the large, strategic firms in an effort to make them moreacceptable to investors. In the meantime, however, these firms have failed torestructure and privatise

Given the dismal privatisation progress made so far in the RS, the changes tothe RS privatisation law adopted in May this year provide little hope for rapidimprovement. The initial proposal put forward by the Bulldozer Committeeasked that the parliament be excluded from the privatisation procedure, but thiswas rejected by the deputies, who passed amendments to the law stipulatingthat the government must consult parliament on the sales of strategic enter-prises. The government made 22 changes to the privatisation law, of which onlysix correspond to the Bulldozer Committees recommendations, which wereaimed at expediting the procedure. Unsurprisingly, the most vocal opponents ofthe initial proposal were the trade unions at the electricity company that wasone of the prime targets for privatisation. They demanded that the state blockany attempt to bring in a private majority shareholder.

Similar to the situation in the RS, the Federation authorities have shown a lackof will to proceed with privatisation of strategic companies. The parliamentaryprocedure regarding a World Bank loan to assist privatisation of these firmsdragged on for almost two years, because Federation MPs were unhappy thatmost of the funds would go to foreign experts, who they believed might notnecessarily work in the best interests of local companies. Under sustainedpressure from the international community, the US$11.5m credit was finallyagreed in May, unblocking the privatisation of some ten enterprises, includingthe national air carrier Bosna Air. The funds will also be used for a review ofthe privatisation of Agrokomerc, one of BiHs largest food-processing firms, andto support arbitration over the privatisation of Aluminij Mostar, the countryslargest aluminium processor and also its largest exporter.

Privatisation in both entitiesremains woefully slow

Federation moves to unblockprivatisation of strategic firms

New law in RS is unlikely tolead to rapid improvement



In May chemical workers seeking payment of back wages staged a protest, andthe countrys largest trade union is currently contemplating a general strike.Against this backdrop of rising social tension, the entities governments arefacing the prospect of an additional 100,000 workers being made redundant bythe implementation of a bankruptcy law adopted at the beginning of 2003. Thelaw, intended to force the closure of unviable firms (the majority of which arestill in state hands), stipulates that firms that do not pay wage arrears in fullwithin 60 days are to be declared legally bankrupt and liquidated. In the RS,the authorities estimate that with full implementation the law could affect upto 30% of all firms.

Many of the state-owned firms that will be affected by the law have keptworkers nominally employed but not paid them wages, keeping them on thewaiting list category for the purposes of official employment statistics. Underthe new law, these workers will become officially unemployed, and their firmswill be sold off or partitioned among creditors, so that workers may not receivethe pension and other benefits that they had been expecting during theirwaiting list period. Government officials publicly hope that the law will senda strong signal to potential foreign investors that the country is serious aboutestablishing a viable business environment; at the same time, they will need tobe wary of the social effects of an overly rapid implementation of the law.

The remaining portion of the commercial debt that BiH inherited from theformer Yugoslavia was rescheduled in May, when the government of Japanagreed to write off 33% (roughly US$10m) of the countrys outstanding debt toJapan. At the same time, the Japanese government committed itself to donatingUS$8m to build two bridges in RS.

The BiH government pressed forward with liberalisation of the countrys tradepolicy in the second quarter of 2003, signing free-trade agreements withAlbania, Romania and Moldova as part of the process initiated under theStability Pact for South-eastern Europe initiative. BiH has already signed free-trade agreements with all of the successor states of former Yugoslavia, withwhich it conducts a large portion of its international trade. Trade with Albania,Romania and Moldova, however, has been modest so far, and the new dealshould boost BiHs trade balance with these countries, as well as stimulatingmore intense co-operation in other areas.

The domestic economy

Output and demand

Following a period of strong expansion in the second half of 2002, industrialoutput growth in the Federation continued in the first half of 2003, rising by4.8% year on year in the first five months. This growth represents a slightslowdown compared to the same period of last year, when industrial outputwas up by 5.1% year on year, although this is largely due to base-year effects, asindustrial production was very weak in 2001. Holding back the overallindustrial performance so far this year has been a year-on-year contraction of

Japan writes off BiHsremaining Yugoslav-era debt

BiH signs free-trade deals withthree neighbours

Federation registers moderateindustrial growth up to May

New bankruptcy law couldlead to significant lay-offs



0.4% in mining output, which accounts for roughly 12% of all industrialproduction in the Federation. Manufacturing, which accounts for over half ofindustrial production, fared little better, expanding by only 0.9% year on year inthe period from January to May. The production of electricity, gas and waterrecovered in the second quarter of 2003 and after five months had risen byover 7% on the same period of 2002, although this branch of production islikely to face slowed growth later this year and in 2004 as a result of theongoing inquiries into pervasive mismanagement and corruption in the twomain electricity providers in the Federation, Elektroprivreda Mostar andElektroprivreda BiH.

BiH: industrial production(% change, year on year)

2002 20031 Qtr 2 Qtr 3 Qtr 4 Qtr Jan-Apr

Federation 4.8 5.8 11.8 15.7 2.8

Republika Srpska -12.3 -12.3 1.4 10.5 0.9

Sources: Federal Office of Statistics (FOS), Statistical Data on Economic and Other Trends; The Republika Srpska Institute of

Statistics, Monthly Statistical Review.

In January construction output in the Federation fell by 36% year on year, andthe number of workers in the sector had contracted by almost 20%, from 7,351in January 2002 to 6,050 this year. By March, however, seasonal effects broughta pick-up in construction activity and a subsequent rise in the number ofconstruction workers to 8,807. The value of construction work completed,however, was down by 16.1% year on year, reflecting strong growth in 2002.

Year-on-year industrial output in Republika Srpska (RS) in the first quarter wasdown by 1.6%, suggesting that the recovery observed in the fourth quarter of2002 remains fragile. In April, despite a further month-on-month fall, outputwas up by 7.5% compared to the same month in 2002, leaving January-Aprilindustrial output up by 0.9%. This modest performance was underpinned bystrong growth in electricity, gas and water supply (up by 18.5%), which offsetdeclines in mining (down by 15.3%) and manufacturing (down by 5.5%).

Composition of output by final use reveals that, except for output inintermediate goods, which in January-April contracted by 4% year on year (alsoin line with external trends), the other major industrial groupings recorded risesin output: capital goods by 12%, consumer durables by 10%, non-durableconsumer goods by 2% and energy by just under 1%. Output trends for early2003 were in line with weak RS external performance experienced through thefourth quarter of 2002, with industries accounting for the bulk of RS exports(raw and semi-processed materials and other low value-added goods) faring theworst. Of the 23 manufacturing branches, output contracted in 12, of whichwood-processing, rubber-processing, and coke and refined petroleum productsexperienced the largest contractions. Coke and refined petroleum production,which account for just under 5% of all industrial production, were down almost80% year on year to the end of April 2003.

Growth was strong in food-processing (9.4%); metal products, except machinery(6%); and furniture (5.7%). Manufacture of pulp, paper and paper products,

Construction output contractsconsiderably

RS industrial performanceremains sluggish



which before the war was an important industrial sector, recorded a ten-foldincrease, although from a very low base (in 2002 it accounted for just 1.4% ofthe total manufacturing output), thus suggesting the potential revival of thissector in which the RS used to have significant production capacity. The sectorhas been the recipient of significant foreign direct investment (FDI) in the pasttwo years.

Inter-entity turnover(KM m unless otherwise indicated)

Apr 2002 Apr 2003 % changeFederation sale to RSTotal 17.44 18.02 3.3 Food products 4.54 6.00 32.2 Electrical engineering 3.20 4.07 27.1

Federation bought from RSTotal 4.82 4.41 -8.6 Food products 1.78 1.46 -18.2 Industrial and craft products 0.66 0.94 42.0

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

Inter-entity trade has been buoyant over the past three or four years as a resultof continuing normalisation of political relations between the two entities andthe gradual removal of various obstacles to crossborder transactions. Trade hasbeen consistently unbalanced, in that sales from the Federation to RS havesignificantly surpassed sales in the other direction. This imbalance is largelyexplained by differences in economic performance of the two entities, but alsoto the fact that the RS economy has retained strong links with that of Serbiaand Montenegro, which continues to act as a substitute destination forexports from the RS to the Federation. In the first quarter of 2003 the recentrecession in the RS, and the sluggishness of its recovery in early 2003, wereunderpinned by a slump in Federation purchases from the RS; year-on-yearpurchases from the RS contracted by 8.6% in April. Sales from the Federation toRS continued to grow, however, although at a slower rate than in 2002!in April2002 sales were up by 9.4% compared to the same month in 2001.

Employment, wages and prices

The trend of falling employment and increasing unemployment in theFederation, which started in the third quarter of 2002, continued in the firstquarter of 2003. Registered unemployment rose from 290,715 people inDecember to 293,204 in March, bringing the official unemployment rate to43.1%. Compared to March 2002, there were over 20,000 more peopleunemployed. At the same time, overall employment declined from 402,608 inMarch 2002 to 387,13!a fall of 3.9%. This fall was driven by several factors,including the ongoing demobilisation of sections of the Federations armedforces and the curtailment of the status of waiting list workers!those whohad been kept on the payrolls of state-owned enterprises, while not actuallyworking!in conjunction with the implementation of the countrys newbankruptcy law.

Imbalance in intra-BiH traderemains

Federation unemployment ratecontinues to rise



The confluence of these factors!combined with the poor job-creation recordthat has characterised post-war recovery in Bosnia and Hercegovina (BiH) andthe slow return of refugees (most of whom immediately join the ranks of theunemployed)!has contributed to a stubbornly high unemployment rate in theFederation. Real unemployment, however, is estimated at roughly one-half ofthe official figure, reflecting the large grey economy in the Federation andweaknesses of statistical collection techniques. Of particular concern withrespect to the prospects for cutting into the high rate of unemployment is theskills composition of the unemployed. Some 39% of the total number ofregistered unemployed were semi-skilled in March 2003, with unskilledworkers accounting for a further 37%.

Having increased by 9.2% in 2002 year-on-year, average nominal wages in theFederation continued to rise in the first quarter of 2003, and were 10.2% higherthan in the same period of 2002. The average nominal net monthly wage in theFederation thus reached KM515 (US$310) in March. The highest wage was in thefinancial services sector (KM1,029), traditionally one of the best-paid sectors,which in the Federation in particular has been recently buoyed by the entry offoreign banks offering higher remuneration, with wages in public admin-istration next highest.

First-quarter wages in the Republika Srpska (RS) also went up, albeit at a lowerrate, in line with the entitys poorer growth performance. In March the averagenominal wage amounted to KM371 (US$223), an increase of 8.4% year-on-year,but still less than three-quarters of the average wage in the Federation. As in theFederation, financial services recorded the highest wage, of KM760, and publicadministration wages next highest, with a net wage that was more than 50%higher than the national average in March.

With upwards of 60% of the entities government budgets being spent oncurrent expenses rather than capital expenditure, restrictive public-sector wagepolicy has been a leading target of the international communitys reformprogramme, both in terms of bringing down both entities large fiscal deficits,but also in order to release funds for desperately needed long-term investment.

Wages in both entities rise in2003



The recent disinflationary trend in the Federation continued in 2003 with first-quarter retail prices falling steadily in year-on-year terms, before picking upslightly in April. Price dynamics through the latter months of the first quarterand into the second are traditionally underpinned by seasonal factors, primarythe growth in prices of fresh agricultural products, which this year rose by 3.4%year on year in April, and by 11.2% compared to December 2002. Overallhowever, prices continued to decelerate; in the first fourth months of the yearretail prices were down a cumulative 0.3%. More broadly, low inflation in theFederation (and relatively low inflation in RS as well) has been underpinned bythe successful implementation of the currency board arrangement of theCentral Bank of Bosnia and Hercegovina (CBBH).

BiH: retail prices(% change)

2002 2003Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr

FederationMonth on month -1.0 0.7 -0.9 -0.1 0.0 -0.3 0.6 0.0 0.3 0.0 0.2 0.3 -0.3Year on year -0.2 -0.2 -0.9 -0.1 0.3 -0.2 -0.1 -0.5 -0.2 -1.3 -0.8 -0.2 0.7Republika SrpskaMonth on month -1.6 0.7 0.0 -0.5 -0.2 0.1 1.7 0.3 1.3 0.1 0.2 0.1 -1.1Year on year 3.0 2.7 0.7 0.2 0.0 0.1 0.8 1.1 2.4 1.7 2.0 2.1 2.6

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

Retail prices in the RS started creeping up in the second half of 2002 and year-on-year growth has remained steady around 2% since December 2002, drivenprimarily by the prices of agricultural products. Severe draught, which hit theRS in April, caused prices of agricultural products to soar by over 20% in annualterms, thus pushing inflation through the first four months of 2003 to 2.6%.Another factor contributing to the acceleration of the RS inflation rate was ahealthy rise in the prices of services, which were up by 5.7% year-on-year inJanuary-April, mainly owing to a steep rise in the prices of postal andtelephone services. Upward pressure on prices in the first quarter also camefrom the price of fuel, which rose in the wake of the war in Iraq.

Federation inflationdecelerates

RS prices continue to edgeupwards



Financial indicators

Commercial bank lending expanded strongly in 2002 as a result of improvedconfidence in the banking sector and strong growth in bank liquidity,underpinned by the publics conversion of foreign-currency savings into euros.Total loans extended in 2002 amounted to KM3,213m (US$1.9bn) an increase of53% year on year. Loans to households expanded sharply!up 120%, and loansto private enterprises recorded an increase of 32%. Out of the total stock ofloans, 44% went to households, up significantly from a 31% share in 2001. Thisgrowth was offset by declines in the proportion of commercial bank lending tothe private sector and to public enterprises.

The RS experienced explosive growth of lending to households!the total stockof loans to this sector grew more than sixfold in 2002, pushing its share in thetotal stock of credit from 6% in 2001 to 30% by the end of 2002. Nonetheless,because of continued lack of public trust in the banking sector, and its lowerlevel of sophistication compared with the Federation, commercial lending inthe RS remains only a declining fraction of that in the Federation.

Consumer credit is one of the main drivers of import demand in Bosnia andHercegovina (BiH). Considered against BiHs precarious balance-of-paymentsposition, recent developments in commercial lending represent a serious causeof concern. The rapid growth in both entities was thus the primary causebehind the decision of the Central Bank of Bosnia and Hercegovina (CBBH) toact to tighten liquidity in the market, despite the potential for slowed economicgrowth should private consumption be curtailed too rapidly.

BiH: commercial bank lending(KM m, end-period)

FederationRepublika

Srpska2001 2002 % change 2001 2002 % change

To government 26 30 16.7 2 14 686To public enterprises 246 249 1.2 104 112 8To private enterprises 770 1,079 40.1 216 225 4To households 623 1,260 102.2 21 155 656To others 59 73 23.5 30 15 -50Total 1724 2,691 56.1 375 521 39

Source: Derived from 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.

Equally worrying in both entities is the banks unbalanced term structure ofdeposits. In the RS, long-term deposits represented only 21% of the total in2002, which is insufficient to balance the term structure between credits anddeposit, posing a risk to bank liquidity: in the first quarter of 2003 two RSbanks had problems in maintaining the required level of reserves with theCBBH. The situation in the Federation was no better at end-2002, as under 25%of deposits were long term, and almost 70% of all loans were long-term loans.The mismatch represents a potential problem for the sector, but the rising shareof longer-term lending!long-term loans in the Federation at end-2002 were upfrom 62% of the total at end-2001 and 53% in 2000!suggests that the banks are

Expansion in commerciallending causes concern



benefiting from improved sophistication in scoring credit risk and are able tobring an increasing range of products to their clients.

Interest rates across BiH have been falling for some time, in both nominal andreal terms, as a result of increasing competition in the banking sector and theentry of well-capitalised foreign owners. In March the average nominal lendingrate on short-term loans stood at 11.5%, compared with 13.1% a year previously.Over the same period interest rates on long-term loans also fell from 11.6% to10.7%. Deposit rates, which exhibit far less uniformity across individual banksthan lending rates, ranged from 1.3% to 4.2% in March 2003.

However, the effect on private-sector lending of falling interest rates has so farbeen muted (private-sector lending was up only some 30% in 2002, comparedwith 120% growth in household lending), since the banks continue to perceiveit as being more risky than lending to households. The adjustment to thereserve requirement that was recently announced by the CBBH, although likelyto rein in liquidity growth, are not expected to lead to a reversal of recentinterest rate trends, given the major portions of both the commercial andhousehold sectors that remain underbanked.

Foreign trade and payments

The first-quarter Federation trade deficit increased in US dollar terms by 22%year on year, totalling US$449m. Exports grew by 47% to US$204m in January-March 2003, compared with US$139m in the year-earlier period, but thisperformance was accompanied by strong growth in imports, which rose fromUS$506m to US$653m!an increase of 29% on the year-earlier period. Much ofthis change, however, can be attributed to currency effects: in the interveningperiod the US dollar weakened significantly against euro (to which the localcurrency is tied), and most of the trade of Bosnia and Hercegovina (BiH) is withthe euro zone.

The balance of trade in local-currency terms!which provides a more accuratepicture of real changes!improved. First-quarter exports rose by 10.4% year onyear and imports by just 0.4%, bringing the trade deficit down by 3.6%compared with the same period of 2002. At the time of writing, no 2003foreign trade data were available for Republika Srpska (RS).

Federation: foreign trade, Jan-Mar(US$ m unless otherwise indicated; by NACE production classification; fob-cif)

2002 % of total 2003 % of total % changeExports (incl unclassified)Agriculture & fisheries 2.5 1.8 1.0 0.5 -59.3Mining 2.5 1.8 3.5 1.7 38.7Manufacturing 122.4 88.1 190.1 93.1 55.3Electricity, gas & water supply 9.2 6.6 6.7 3.3 -27.3Other 2.3 1.7 2.9 1.4 26.7Total 138.9 100.0 204.2 100.0 47.1

Competition and foreign entrydrive interest margins lower

Federation trade balanceshows positive signs



Federation: foreign trade, Jan-Mar(US$ m unless otherwise indicated; by NACE production classification; fob-cif)

2002 % of total 2003 % of total % changeImports (incl unclassified)Agriculture & fisheries 29.4 5.8 37.4 5.7 27.1Mining 0.9 0.2 1.9 0.3 120.7Manufacturing 447.5 88.5 592.7 90.8 32.4Electricity, gas & water supply 12.4 2.5 12.6 1.9 1.1Other 15.5 3.1 8.2 1.3 -47.1Total 505.7 100.0 652.8 100.0 29.1Balance -366.9 - -448.6 - 22.3

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

For the first time, Federation imports of machinery and transport equipmentsurpassed the share of consumer goods. Post-war economic recovery, and, morerecently, strong growth of consumer credit have fuelled demand for consumerimports, as domestic production has stayed subdued and of relatively lowquality. Imports of machinery and transport equipment still grew in 2002,accounting for 26.4% of total imports in January-March, suggesting that theretooling of Federation industry is continuing. Food and beverages, the secondlargest import category, accounted for 15.8% of the total over the same period.

Federation: trading partners, Jan-Mar(US$ m unless otherwise indicated)

2002 % of total 2003 % of total % changeExports fobCroatia 21.8 15.7 32.0 15.7 46.6Switzerland 22.3 16.0 28.3 13.9 27.3Germany 20.3 14.7 39.3 19.2 93.1Italy 19.0 13.7 34.8 17.0 82.9Serbia & Montenegro 10.5 7.6 15.5 7.6 46.7Slovenia 11.3 8.1 17.4 8.5 54.0Austria 6.9 4.9 8.7 4.3 27.4UK 5.2 3.7 1.1 0.6 -78.1US 2.5 1.8 2.5 1.2 0.6France 4.1 2.9 1.7 0.8 -58.0Other countries 15.1 10.9 22.9 11.2 52.0Total 138.9 100.0 204.2 100.0 47.0Imports cifCroatia 84.3 16.7 124.8 19.1 47.9Germany 71.0 14.0 82.2 12.6 15.7Slovenia 57.0 11.3 69.9 10.7 22.6Italy 46.2 9.1 71.0 10.9 53.7Austria 26.5 5.2 31.1 4.8 17.3Hungary 16.2 3.2 22.8 3.5 40.2Switzerland 13.1 2.6 13.8 2.1 5.9US 17.1 3.4 15.9 2.4 -7.0Czech Republic 11.3 2.2 14.4 2.2 27.3Serbia & Montenegro 6.8 1.3 9.7 1.5 42.4Other countries 156.1 30.9 197.2 30.2 26.3Total 505.7 100.0 652.8 100.0 29.1Balance -366.9 - -448.6 - 22.3

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

Capital goods importsovertake consumer goods



In contrast with the situation for imports, where some positive long-termdevelopments were observed in early 2003, exports remained dominated byindustrial products classified as raw materials, reflecting an industrial structurethat remains skewed towards lower value-added goods and commodities.

The EU remained the Federations most important export market, accountingfor just under half of all first-quarter exports. Sales to Germany accounted forroughly 20% of the total, followed by Italy (17%). Exports to the EU expressed inlocal currency increased by 24% year on year, more than twice as fast as theoverall export growth rate, partly reflecting a low 2002 base caused by theeconomic slowdown in the euro zone, which had fully taken hold by thebeginning of 2002. Sales to Croatia, which in 2002 amounted to 17% of totalexports, making it the Federations most important export destination, slippedto third place, to just under 16% of the total in January-March 2003. BiH exportsto Croatia come primarily from industries which have registered falteringgrowth over the past year, including electricity, wood products, and aluminium.

In the first quarter of the year Croatia increased its share in total imports to justover 19%, from approximately 18% at the end of 2002. This increased portionwas offset by a smaller role played by imports from Germany, accounted foraround 13% of the total!down from 15% in 2002. Purchases from Slovenia alsofell compared with 2002. Along with the deterioration in Federation exports toSlovenia, trends between the countries suggest that, despite a recent steppingup of political contacts, economic relations between the two countries arefailing to follow suit.

BiH has registered current-account deficits in the region of 30% of GDP since1998. Although current-account data are of questionable accuracy, owing to thelow level of sophistication in gathering of statistical information and the largeamount of trade that goes unreported, IMF figures for 2002 suggest that thecurrent-account deficit in 2002 was considerably larger than previous estimateshad suggested. In contrast with expectations of a deficit of roughly US$1.3bnthat were prevalent as late as January of this year, preliminary figures suggestthat the deficit was as much as US$2.3bn, equal to 43% of GDP for the year,despite a small size of the services surplus. This strengthened the justificationfor the moves by the Central Bank of Bosnia and Hercegovina (CBBH) to restrictimport growth. Current transfers into BiH have also fallen by almost 40% since1999. Preliminary figures from the CBBH for the first quarter of 2003 (whichtend to differ from the figures reported by the IMF by between 5% and 10%),show a deficit of KM840m (US$506m), suggesting that this years deficit willagain be very large.

On a more positive note, foreign direct investment (FDI) in BiH increasedsharply in 2002, according to the Foreign Investment Promotion Agency (FIPA),from KM130m in 2001 to KM321m in 2002. A cumulative total of KM1.1bn(US$660m) was invested in the Federation in the period from 1994-2002, whilethe RS received KM566m. Croatia was the largest investor in BiH during thisperiod, with investments valued at US$124m, the largest of which was in thewood-processing company Finvest. FIPAs sectoral breakdown of FDI reveals

Germany takes most of theFederations exports

Croatia remains the largestimporter to the Federation

Current-account deficit soars

2002 marks a positive year forFDI in BiH



that some 55% of the total FDI has been invested in manufacturing, followed by16.5% in banking, of which Hypo Alpe Bank and Croatias Zagrebacka Bankahave been the two largest investors. Most of the FDI has come via privatisation,with greenfield investment representing much smaller share. The largestgreenfield investment in 2002 came from a Malaysian firm, Bosmal, whichinvested KM100m in commercial real estate.

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