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Country Report January 2003

Bosnia and Hercegovina

January 2003

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

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Bosnia and Hercegovina 1

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

Contents

2 Summary

3 Political structure

5 Economic structure5 Annual indicators6 Quarterly indicators

7 Outlook for 2003-047 Political outlook9 Economic policy outlook11 Economic forecast

14 The political scene

19 Economic policy

21 The domestic economy21 Output and demand23 Employment, wages and prices25 Financial indicators

26 Foreign trade and payments

List of tables11 International assumptions summary13 BiH: forecast summary22 BiH: industrial production23 Inter-entity turnover, Jan-Sep24 BiH: labour statistics, 200225 BiH: retail prices26 Federation: commercial bank lending27 Federation: foreign trade, Jan-Sep28 Federation: trading partners, Jan-Sep29 Republika Srpska: trading partners, Jan-Sep30 South-east Europe: foreign direct investment inflows

List of figures14 BiH: gross domestic product14 BiH: current-account balance14 BiH: seats won by leading parties in Oct 2002 elections



Summary January 2003

The final outcome of complex and acrimonious negotiations over the form ofnew state-level and entity governments after the October 2002 elections is stilluncertain. It is nonetheless clear that the nationalist parties have regained thecontrol over the political process that they lost in the 2000 elections. The Officeof the High Representative has put a brave face on the results and has confirmedthat it will, nevertheless, move aggressively in 2003 to speed up the pace ofreform. Economic prospects have been aided by continued disinflation in bothentities, as well as evidence of fiscal tightening at the state and entity levels.Nonetheless, the outlook for 2003-04 bears significant risk. Prolonged politicalinstability could have a profound negative effect on the pace of vital reform,while persistent large current-account deficits and increasing external debtservice will coincide with declining international assistance inflows.

The three main nationalist parties trounced the moderate Alliance for Change inelections in October 2002. A coalition between the Croatian Democratic Unionof BiH (HDZ BiH), the Party for BiH (SzBiH) and the Party of Democratic Action(SDA) appears likely in the Federation, while the Serb Democratic Party (SDS)looks likely to co-operate with the more moderate Party for Democratic Progress(PDP) in the Republika Srpska (RS). Stability in the state and entity governments,given the history of conflict between the parties, appears far from assured.

Overall fiscal performance in 2002 by the entity governments is estimated tohave bettered IMF requirements and the government has committed to keepingdebt levels sustainable in the face of declining aid inflows. Privatisation hasbeen woefully slow and current conditions in both entities are still notconducive to improvement in this area. The currency board will remain in placebeyond the end of its mandate in 2003 as part of the IMF agreement.

Industrial production numbers indicate that the third quarter of 2002 reversedthe slowdown experienced in the first half of the year in BiH. Constructionoutput, an important indicator in the post-war regeneration economy, was up inthe first three quarters of 2002 on the corresponding period in 2001, and growthin new housing is a positive sign for 2003. Both entities experienced furtherdisinflation through 2002. Competition in the banking sector and increasedmacroeconomic stability have brought interest rates down significantly since2001.

The BiH trade deficit widened considerably in the third quarter of 2002, asexports to the EU continued to suffer from weak import demand in the BiH�slargest markets. External debt service is expected to double from 2001 levels in2003 and prospects for significant growth in FDI are slim, meaning thatconcessional funding will be required to make up the difference.

Editors: Matthew Shinkman (editor); Laza Kekic (consulting editor)Editorial closing date: January 13th 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, US on November 21st: theestablishment of a Constitutional Court, a Commission for Displaced Persons, a HumanRights Commission, a central bank, public corporations to manage and operate transportand telecommunications, a Commission to Preserve National Monuments, and a systemof arbitration between the two entities. Foreign trade is also supposed to be managed bythe government of BiH

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, Republika Srpska president, and state, entity and cantonal parliaments

BiH has a rotating collective three-member presidency: Mirko Sarovic (Serb; electedOctober 2002; current chairman), Sulejman Tihic (Muslim; elected October 2002) andDragan Covic (Croat; elected October 2002)

The Council of Ministers comprises six ministers, one of whom is appointed chairman(prime minister) for a four-year term (a recent change from the previous eight-monthrotating basis). The outgoing government was formed on February 22nd 2001 and anew government is in the process of being formed. The entities also have their owngovernments

Social Democratic Party (SDP), Party for BiH (SzBiH), New Croatian Initiative (NHI), BiHPatriotic Party (BPS), List for Progress (List), Party of Democratic Action (SDA), CroatianDemocratic Union of BiH (HDZ), Serb Democratic Party (SDS), Party of DemocraticProgress (PDP), Party of Independent Social Democrats (SNSD), Democratic Socialist Party(DSP), Serb People�s Alliance (SNS), Serbian Radical Party of Republika Srpska (SRSRS),Socialist Party of Republika Srpska (SPRS), Bosnian Party (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 operating in BiH. The HighRepresentative is advised by the Peace Implementation Council (PIC), which includes allthe signatories to the Dayton agreement. Since December 1997 the High Representativehas been able to impose decisions in cases of disagreement and to dismiss officials whoobstruct the Dayton agreement

Chairman Adnan Terzic (Muslim)Civil affairs & communications Safet Halilovic (Muslim)Foreign affairs Mladen Ivanic (Serb)Foreign trade & economy Milo Gadzic (Croat)Human rights & refugees Mirsad Kebo (Muslim)Treasury Ljerka Maric (Croat)

Peter Nicholl

Official names

Form of state

Legislatures

National elections

Head of state

National government

International involvement

National government (designates,subject to confirmation from theOfice of the High Representative)

Main political parties

Central Bank governor



Paddy Ashdown

President Safet Halilovic (SzBiH)Vice-president Karlo Filipovic (SDP)Prime minister Alija Behmen (SDA)Deputy prime minister & minister of finance Nikola Grabovac

Agriculture, water & forestry Behija Hadzihajdarevic (SzBiH)Defence Mijo Anic (NHI)Education, science, culture & sports Mujo Demirovic (SDP)Energy, mining & industry Hasan Becirovic (SDP)Environment Ramiz Mehmedagic (SzBiH)Interior Ramo Maslesa (SzBiH)Justice Zvonko Mijan (SDP) Trade Andrija Jurkovic (SDP)Transport & communications Besim MehmedicVeterans affairs Suada Hadzovic

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

Agriculture Rodoljub TrkuljaDefence Slobodan BilicEducation Gojko SavanovicEnergy & mining Bosko LemezFinance Simeun VilendecicForeign economic relations Fuad TuralicHealth & social security Milorad BalabanInterior Perica BundaloJustice Biljana MaricTrade & tourism Boro Babica Officially, the party affiliations of ministers have not been revealed.

Federation (outgoing, newgovernment under formation at

time of writing)

Key ministers

Key ministersa (outgoing, newgovernment under formation at time

of writing)

Republika Srpska (designates)

High representative



Economic structure

Annual indicators1998 a 1999a 2000 b 2001b 2002b

GDP at market prices (KM bn) 7,244 8,603 9,432 10,233 10,645GDP (US$ bn) 4,113 4,690 4,574 4,684 5,133

Real GDP growth (%) 9.9 10.6 4.5 2.3a 3.5Retail price inflation (Federation; %; av) 5.3 -0.6 1.5 a 1.7a 0.1Retail price inflation (Republika Srpska; %; av)c 2 15.1 14.6 a 6.5a 2.0

Population (m; mid-year; resident) 3.65 3.73 3.80 3.87 3.95Exports of goods fob (US$ m) 593 749 903 957 1,078

Imports of goods fob (US$ m) -2722.9 -3,077 -2,558 -2,750 -2,950Current-account balance (US$ m) -843.5 -758 -919 -1,126 -1,266

Reserves excl gold (US$ m) 175.0 452 497 a 1260a 1,225Total external debt (US$ bn) 3.0 3.1 2.9 2.6 2.7Exchange rate (KM:US$; av)d 1.76 1.83 2.12 a 2.18a 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 2000 % of total Components of gross domestic product 1998 % of totalAgriculture, fisheries & forestry 13.3 Public & private consumption 100.4Industry & utilities 23.1 Gross investment (incl stockbuilding) 38.0

Construction 5.9 Exports of goods & services 35.1Services 57.7 Imports of goods & services -73.5

Principal exports 2001 % of total Principal imports 2001 % of totalFederation Federation

Base metals 23.7 Food & beverages 15.2Clothing 18.0 Chemicals 10.7Wood products 11.1 Machinery & equipment 8.8

Leather products 7.3 Fuel 8.6

Main destinations of exports 2001 % of total Main origins of imports 2000 % of totalFederation FederationItaly 23.3 Croatia 17.1Germany 16.8 Italy 16.0Switzerland 12.6 Slovenia 13.0Croatia 11.3 Germany 12.5

Republika Srpska Republika SrpskaYugoslavia (Serbia-Montenegro) 50.6 Yugoslavia (Serbia-Montenegro) 24.3Italy 17.8 Slovenia 13.7Germany 6.0 Croatia 9.6Slovenia 4.5 Hungary 8.6



Quarterly indicators2000 2001 20024 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr

Financial indicatorsExchange rate KM:US$ (av) 2.252 2.121 2.243 2.199 2.186 2.234 2.131 1.990Exchange rate KM:US$ (end-period) 2.252 2.121 2.306 2.142 2.219 2.242 1.961 1.984Deposit rate (av; %) 14.67 16.50 n/a n/a n/a n/a n/a n/aLending rate (av; %) 30.50 30.99 n/a n/a n/a n/a n/a n/aM1 (end-period; KM m) 1,463 1,504 1,672 1,890 2,790 3,028 3,117 3,217M1 (% change, year on year) 27.3 26.1 33.4 38.8 90.7 101.3 86.4 70.2M2 (end-period; KM m) 2,564 2,668 2,853 3,150 4,922 5,175 5,173 5,357M2 (% change, year on year) 10.2 17.1 20.5 29.3 92.0 94.0 81.3 70.1

Foreign trade (US$ m)a

Exports fob 184.1 192.9 184.0 187.3 177.6 190.0 205.1 n/aImports cif -695.5 -630.2 -680.0 -719.1 -802.5 -663.3 -772.1 n/aTrade balance -511.4 -437.3 -496.0 -531.8 -624.9 -473.3 -567.0 n/aForeign reserves (US$ m)Reserves excl gold (end-period) 497 478 497 588 1,221 1,134 1,229 1,223

a DOTS estimates.

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



Outlook for 2003-04

Political outlook

Following the October 2002 elections, the three nationalist parties�the Party ofDemocratic Action (SDA), the Serb Democratic Party (SDS) and the CroatianDemocratic Union of BiH (HDZ BiH)�have taken over control of the BiH entityand state parliaments from the outgoing moderate Alliance for Change.Although there is still a chance of moderate parties playing a significant role inthe Republika Srpska (RS) and central state governments, this is unlikely to havea major influence on the way domestic politics will be played out over theforecast period, for two reasons. First, the powers of the central stategovernment, where the moderate parties are most likely to receive most of theirspoils in the post-election negotiations, are limited compared to those of theentities. Furthermore, the reintroduction of the nationalists into the entitygovernments is likely to further entrench those governments with respect to thecentral government. Second, the more moderate party in the RS, the Party ofDemocratic Progress (PDP), has been informally working in concert with theSDS since the PDP�s victory in elections in 2000. As further co-operationbetween the parties appears likely, the presence of the PDP is unlikely to lead tomuch divergence from the political agenda of the more powerful SDS.

The record of the three nationalist parties� co-operation is a poor one; in the pastimportant reforms have been blocked and the work of joint bodies obstructedas each of the three parties has concentrated on preserving and consolidating itspower among its own ethnic group. Under pressure from the internationalcommunity, and especially after losing the 2000 general elections, the threeparties have tried hard to shed their hardline-nationalist image, includingchanging their leadership. In reality, however, their political aims have largelyremained at odds with an agenda�supported by the international community�of rebuilding BiH as a functioning economy and society.

Bosnia and Hercegovina (BiH) is entering a period of heightened politicaluncertainty. The international community, via the High Representative, PaddyAshdown, will press ahead with the implementation of complex reforms, whichinclude strengthening the central state institutions and creating a functioningsingle market. Despite their declared commitment to reform, which some tend tointerpret as a sign of their recognition of the country�s precarious economicsituation, the strongest unifying bond among the nationalist parties is theirdesire to prevent the moderate parties from having any significant say ingovernment matters. Parties from the Federation and the RS have held sharplydifferent views regarding integration between the two entities and strengtheningthe central state government. This has led to the potential for gridlock in theimplementation of a number of planned reforms, including the new Law on theCouncil of Ministers, the creation of a state-level defence body and a host ofrecently introduced legislation viewed as weakening the position of the twoentities. Dragan Cavic, on the occasion of his inauguration as president of theRS, said that he believed the preservation of Republika Srpska�s autonomy was a�holy task� and that his priority was to prevent any further deterioration in the

Domestic politics



power of the RS government vis-à-vis the central state. Thus, securing the RSparties� co-operation in implementing the current reform agenda�with itsemphasis on administrative integration and strengthening the central stategovernment�will not be easy. The High Representative has responded to theelectoral developments by pledging to wield his powers to impose legislationeven more forcefully. He will now be monitoring and approving appointmentsof key ministers from cantonal to state level. This is a step back from theapproach during the Alliance for Change�s term in office, when the two sidestried to move towards an approach based on partnership and sharedresponsibilities for governing the country. The result is likely to be a highlystrained relationship between the international community and the localauthorities, which will slow down the reform process.

Another source of pressure for the government could yet come from theopposition. At the moment, it is not yet clear which parties will form thegovernment opposition, and much will depend on the stance of the Party forBiH (SzBiH) since the Social Democratic Party (SDP), once the strongest moderateparty, has split following its election debacle. At the time of writing, it appearsthat the SzBiH will play some role in the central state and Federationgovernments, although exactly what its relation to the other parties (whetherformalised in a coalition or more informal) will be in these bodies is stillunclear. Its presence alone, however, would narrow the government�s room formanoeuvre and render the decision-making process even more difficult.

Given the poor state of the country�s economy and growing populardiscontent�with protests by workers, teachers and war veterans alreadyspreading across the country�the government will have a difficult job ahead.This should play into the hands of the international community, which, as hasbeen the case thus far, will likely continue to rely on the carrot of internationalassistance to pressure the parties in government to deliver on their electionpromises. However, with the combination of a strong opposition and thelikelihood of halting co-operation between the new government and the HighRepresentative, early elections are a distinct possibility.

More broadly, there is an increasingly likelihood that the international com-munity will be forced to rethink its protectorate-style engagement in BiH,especially as it nears the inevitable point of (at least partial) military and politicaldisengagement, and as responsibility increasingly passes from the US to the EU.The failure to use administrative reform to spur development of moreresponsible local leadership has been the main shortcoming of the internationalcommunity�s existing approach to BiH�s post-war reconstruction. The HighRepresentative�s ability to improve the quality of local government at all levelswill be crucial in ensuring that the future legacy of the international com-munity�s engagement is a positive one.

The nationalist parties� takeover of the BiH government has been accepted withreservations in international circles, which was exacerbated by the fact that theelection results came in amid the backdrop of an international scandal over thediscovery of arms sales to Iraq originating in the Republika Srpska. NATOpeacekeepers uncovered documents during a raid in late 2002 suggesting that a

International relations



Bosnian aviation firm, Orao, had for years been supplying equipment to theIraqi military. While the investigation of the affair continues, a report completedin December 2002 appeared to exonerate the civilian leadership of theRepublika Srpska and lay blame on a network of Bosnian Serb military officials.The international community is likely to review the findings of the report withsome scepticism, but the RS government�s co-operation in the affair should bringthe RS back from the brink of international sanctions, which had been mootedwhen the scandal first broke.

The EU officially began its first policing mission under its European Security andDefence Policy (ESDP) at the beginning of January 2003 in BiH, taking over froma UN policing mission which had been put in place as part of the Daytonagreement. The EU policing mission (EUPM) comprises over 500 officers and 50advisors from over 30 countries, and will cost the EU �38m (US$39.5m) per yearuntil its mandate expires in 2005. The new mission, while itself trumpeted as amajor breakthrough for the EU in its attempts to establish a co-ordinatedEuropean defence capability, is considered a precursor to an eventual takeoverof the military role played in BiH by NATO forces.

Relations with neighbours will continue to feature prominently in BiH politics.There are signs of an improvement in relations with Croatia and Yugoslavia(Serbia-Montenegro); agreements on dual citizenship with the two countrieswere concluded in late 2002 and early 2003 with the intervention of the HighRepresentative. Recent statements by Croatian leaders indicate a desire toimprove co-operation among the western Balkan countries. Relations with bothcountries nonetheless remain prickly, with high-ranking Croatian and Yugoslavofficials incurring the rebuke of the BiH government in late 2002 and early 2003over comments that appeared to question the future of BiH and its borders.

Economic policy outlook

The outgoing BiH government had set an ambitious economic reform agenda,which aims at deepening structural reforms while maintaining macroeconomicstability. Despite some progress achieved in recent years, BiH lacks a functioningsingle market and is still in the process of building the legal and administrativeframework conducive to business development. In October 2002, eager tomaintain reform momentum, the High Representative imposed a package of 12economic laws, which aim at removing the remaining obstacles to the creationof a single market. The 12 laws include reforms to business and land registrationprocesses, and a law to strengthen the influence of the state government overeconomic decision-making in the entities. The absence of clear and harmonisedstandards and processes across the entities has created an opaque businessenvironment, which has worked as a strong deterrent to both local and foreigninvestment. This has caused gaps in tax and customs collection, costing thegovernment millions of convertible marka (KM) in lost revenue every year.

In addition to the reform programme�s emphasis on streamlining decision-making, a central pillar of the package is job creation. As part of the reformsintroduced to simplify the business registration procedure, the Office of the HighRepresentative (OHR) has started a Quick Impact Facility, which offers financial

Policy trends



and consulting assistance to small businesses. The reform package aims also tostimulate competition in sectors that remain slow to develop, and is intended tocrack down on official corruption and improve transparency and accountability.

The focus of the reform agenda put forward by the OHR has met with theapproval of the business community in BiH, and the parties that are likely tohead the new government have also pledged their support for both the currentreform package and the broader objectives of integration with Westernstructures. Nonetheless, the sheer fact that the legislation had to be imposedsuggests that its implementation will not be easy, and that the internationalcommunity will need to sustain strict conditionality in its dealing with thegovernment. This is likely to affect the pace of reform implementation.

BiH has made significant progress in fiscal consolidation in the past two years,closing the fiscal gap faster than expected (although the budget deficit is stilllargely covered by international assistance inflows). Public finance reform hasresulted in public spending cuts and an improvement in revenue collectionthrough tightening the tax collection system. But the overall fiscal position willremain a serious source of concern, primarily because of the risks inherent ingrowth projections and the speed of implementation of new value-added tax(VAT) and customs administrations.

Sustaining economic growth remains the key issue, as the revenue forecast isbased on a broadened tax base rather than on an increase in taxes�already highin comparison with other countries in the region. Declining foreign assistance,which, especially at the state level, has provided an important source of fundingto cover the revenue shortfall, is another source of concern. Privatisation receiptshave so far been minuscule and the prospects for the sale of the remainingstrategic companies are not clear. However, the entity and cantonalgovernments� decision to put privatisation receipts into escrow accounts to payoff public debt in 2003 should benefit the fiscal outlook in the long term.

The new government is likely to continue to adhere to the principles of fiscalprudence, not least because the current IMF stand-by arrangement hinges on it.But it is facing a difficult job, as the demand for public resources remains high.In December Federation administration workers and teachers in RepublikaSrpska demanded an increase in wages, although a central tenet of the IMF�sagreement with the government is a strict cap on public-sector wage rises. Thedispute over the introduction of the new VAT administration will prolonguncertainty over the funding of the central state institutions, which is becomingall the more critical in view of the expanded role for the central governmentenvisaged in the new Law on the Council of Ministers.

The currency board regime, which was initially scheduled to run until mid-2003,will remain in place at least for the duration of the current IMF stand-byagreement, as the IMF has made it one of the structural performance criteria forcontinuance of the agreement. The local currency is tied to the euro atKM1:�0.51. Successful implementation of the currency board since its inceptionhas provided a stable and credible currency, helping to keep inflation undercontrol.

Fiscal policy

Monetary policy



After growing strongly in 2001, gross international reserves are expected to finish2002 slightly down, although still covering almost five months of imports. Thecentral bank forecasts a slight decline in overall reserves for 2003, with prospectsfor significant foreign direct investment (FDI) inflows in the year fairly limited.

Economic forecastInternational assumptions summary(% unless otherwise indicated)

2001 2002 2003 2004Real GDP growthWorld 2.0 2.7 3.7 4.0OECD 0.7 1.6 2.3 2.7EU 1.5 0.9 1.6 2.2

Exchange ratesUS$:� 0.896 0.955 1.073 1.053SDR:US$ 0.785 0.768 0.734 0.745

Financial indicatorsUS$ 3-month Libor 3.78 1.87 2.19 4.57� 3-month interbank rate 4.26 3.36 3.25 3.83

Commodity pricesOil (Brent; US$/b) 24.5 25.2 24.7 19.7Natural gas (Europe; % change in US$ terms) 5.2 -10.8 -2.3 -2.4Food, feedstuffs & beverages (% change in US$ terms) -1.9 14.6 13.6 0.4Industrial raw materials (% change in US$ terms) -9.8 0.2 6.1 9.8

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

The global economic recovery is continuing, but after a strong start to 2002 ledby the US, the world recovery, and that of the euro zone in particular, slowedconsiderably in the second half of the year. World GDP growth is estimated at2.7% (at purchasing power parity weights) for 2002 and will be only 3.7% in 2003.With weakening in the US in the second half of 2002, the slowdown in demandfor European exports combined with weak domestic demand in Europe has leftestimated euro-zone growth for 2002 at only 0.9%. We expect slow accelerationof growth in 2003 and 2004, at 1.6% and 2.2%, respectively.

The performance of BiH�s small economy is closely tied to developments in theEU, the destination of over 40% of BiH�s exports in 2001. It is particularlystrongly affected by Italy (22% of BiH�s exports) and Germany (14% of exports), inboth of which economic recovery has been more sluggish than in other EUcountries. With both countries (Germany in particular) facing EU Growth andStability Pact constraints on fiscal stimulus in 2003, import demand in Italy andGermany is not expected to rebound as quickly in 2003-04 as initially believed.

There are two main risks to our global forecast. The first is the prospect for rapidcorrection of long-standing imbalances in the US economy, and the second isthat US military action in the Middle East leads to a prolonged oil price spike.Both scenarios would almost certainly extend the current global malaise, furtherdamaging prospects for BiH�s exports and its access to foreign capital. Theworsening outlook for the US has led us to revise our forecast for the US dollar,with the euro now expected to average around US$1.04:�1 in 2003-04. Oil priceshave risen sharply as the markets react to the perceived risks of a US attack on

International assumptions



Iraq, and are likely to spike even higher if the US does launch a military strike.However, assuming there are no sustained disruptions to supply, average oilprices in 2003 will be slightly lower than in 2002, and prices will fall backfurther in 2004 as the fundamental excess supply in the market reasserts itself.

In the second half of 2002, Federation industrial performance improved,construction activity picked up and transport and telecommunication servicesrecorded growth. Preliminary figures for Republika Srpska industrial productionsuggest that the steep decline seen in the first half of the year was reversed inthe third quarter of 2002, on the back of strong growth in raw and intermediategoods production driven by demand for construction inputs. There is no officialdata on private consumption from either entity but healthy increases inFederation and RS wages, taken together with a boom in consumer credit in thefirst half of 2002, would suggest that it is an increasing contributor to overalleconomic growth.

These data suggest higher real GDP growth in 2002 than previously expected.Based on preliminary data from the entities and the IMF, the EconomistIntelligence Unit now estimates BiH GDP growth in 2002 at 3.5%.

BiH GDP growth since the Dayton agreement has been largely underpinned byreconstruction-related activities and foreign assistance in financing thoseactivities. The decline in international assistance, and the potential for delays inits reimbursement in light of the country�s potentially fragile political situation,will have a major influence on BiH�s growth dynamics during the next twoyears. However, we expect the shortfall in future assistance to be at least partlymade up by continued improvements in underlying growth fundamentals(enterprise restructuring, industrial production growth, retooling of exportindustries). Thus we forecast modest acceleration in real GDP growth to 4% in2003, rising to 4.3% in 2004. The forecast is based on the assumptions that theprocess of economic reform continues, and that macroeconomic stability and astill-substantial inflow of foreign assistance are maintained.

The average annual rate of retail price inflation is estimated to have fallen to0.1% in the Federation in 2002 and to 2.0% in Republika Srpska. We forecastnear-zero inflation in the Federation in 2003 and further disinflation inRepublika Srpska, and a rise in 2004 in both entities following the expectedintroduction of VAT.

From January 2002 the euro replaced the D-mark as the currency board�sreference currency. The convertible marka is fixed at KM1.95583:�1, and willfollow the euro�s fortunes. The euro gained strongly against the US dollar in2002, and thus in 2002 the KM to strengthened to a full-year average exchangerate of KM2.07:US$1, a nominal appreciation of 5.3% against the US dollar. In2003 the marka is expected to appreciate nominally by approximately 11%against the dollar to KM1.82:US$1, which will tend to erode BiH competitivenessin non-euro markets in spite of lower inflation in BiH than in the US or the eurozone. Although official data are unavailable, it is unlikely that productivity gainsin 2002 outstripped significant nominal wage increases, jeopardising thepotential competitiveness gains achieved with real depreciation in 2001. Unless

Economic growth

Inflation

Exchange rates



a significant slowdown in wage growth can be achieved, BiH exportcompetitiveness and the external position in general could be threatened duringthe forecast period.

A large foreign trade deficit and declining concessional funding will result inrecurring and large current-account deficits in BiH during the forecast period.Foreign assistance inflows have been a key driver of import demand since theDayton agreements. The dampening effect on demand of declines in theseinflows will be partially offset in 2003-04 by remittances and further growth indomestic demand. Boosting exports will remain the main challenge but onlymodest improvements can be expected during the next couple of years. BiH hasa narrow export base, and rising wage costs, along with the expected real KMappreciation against the US dollar and the euro, could undermine itscompetitiveness in important labour-intensive export industries such asfurniture-making.

For 2002 we have revised our estimate for the current-account deficit toUS$1266m, based on weaker than expected export performance. In 2003 weexpect a large but slightly reduced current-account deficit, narrowing further in2004 as domestic demand-led import growth is offset by stronger export growthas euro-zone import demand recovers.

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

2001 a 2002 b 2003c 2004 c

Real GDP growth 2.3 b 3.5 4.0 4.3Industrial output 9.0 b 8.0 8.0 7.0Retail price inflation (av)Federation 1.7 0.1 0.1 1.3Republika Srpska 6.5 2.0 1.6 2.5Merchandise exports fob (US$ m) 957 1,078 1,280 1,500

Merchandise imports fob (US$ m) -2,750 -2,950 -3,075 -3,227Current-account balance (US$ m) -1,126 -1,266 -1,204 -1,164 % of GDP -24.0 b -24.5 -19.9 -18.2Exchange rate (av; KM:$) 2.18 2.07 1.85 1.86

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

External sector



The political scene

The three nationalist parties that dominated the political scene in Bosniabetween 1990 and 2000�the Serb Democratic Party (SDS), the Party ofDemocratic Action (SDA) and the Croatian Democratic Union of BiH (HDZBiH)�polled the most votes among their respective ethnic groups in the October2002 elections. This has secured them outright control of the state presidencyand a strong bargaining position in both the state and entity parliaments. TheSDA performed best, managing to regain a large portion of the votes it lost to theoutgoing Alliance for Change in the 2000 elections. It emerged as the singlelargest party in both the state parliament and the Federation lower house ofparliament. The SDS and the HDZ BiH remained strong, although in absoluteterms neither was able to improve on their number of seats in the RepublikaSrpska (RS) and Federation parliaments, respectively, compared with the 2000election results. The SDS lost one seat in the state House of Representatives andthe HDZ BiH�s number of seats (won in alliance with the Croatian ChristianDemocrat Party) remained the same.

Nationalist parties sweepparliamentary elections



The biggest fall was recorded in the number of votes won by the SocialDemocratic Party (SDP), the largest party in the now defunct Alliance forChange, which led the outgoing government. The SDP recorded a 52.4% drop invotes for the state House of Representatives and a 50.7% fall in votes for theFederation House of Representatives compared to its results in 2000. The Partyfor BiH (SzBiH), the second largest Alliance for Change member, also recorded afall in votes for the Federation House of Representatives, although the declinewas of a much smaller magnitude than that of the SDP. The SzBiH increased byone its number of seats in the state parliament. Among the moderate parties inRepublika Srpska, the Party of Independent Social Democrats (SNSD) emergedtriumphant, having increased its share of votes for the entity�s house ofparliament by 36.5%, and by 71.8% for the state House of Representatives. TheParty of Democratic Progress (PDP), which led the outgoing RS government,recorded a fall in the number of votes for both the entity as well as the stateparliaments.

Although the nationalist parties performed well and moderate parties lost agreat deal of votes overall, the distribution of votes was such that no party wasable to form a government on its own. Given the distribution of votes across theparliamentary bodies, a coalition among the nationalist parties seems mostlikely, with support from one or more of the moderate parties. The interventionby the High Representative, allowing a number of parties which had failed topass the election threshold to win representation, has made coalition-buildingall the more critical. The state House of Representatives will consist ofrepresentatives of 14 parties and two coalitions; similarly, the Federationparliament will consist of representatives of 16 parties and two coalitions, andthat of the RS will include 15 parties.

The SDA and the HDZ won just under 50% of the seats in the Federation Houseof Representatives, which in principle should have made coalition buildingmore straightforward than in the other BiH entity. In the past, the two partieshave been consistently at loggerheads, and have effectively blocked the work offederal institutions for months on end. The nationalist strategy has been to relyon the perceived threat posed by other ethnic groups, as well as the fragility ofrelations between the entities themselves, as the main instrument in main-taining respective ethnic group allegiances to the parties. This has allowed themto maintain firm control during the economic and political life of theirconstituents. Although ostensibly staunch enemies, the two parties have in factfunctioned in an informal coalition during their years out of the government inorder to support one another�s firm grip over their respective ethnic group.However, their clear ideological differences made the process of explaining thecoalition to the electorate a delicate one.

It was apparently most difficult for the SDA, which initially went as far as to saythat it was not considering the HDZ as a coalition partner; instead, it stated thatits preferred coalition partner was the Party for BiH (SzBiH). But the SzBiH at firstdid not respond to the SDA proposal to set up a joint parliamentary majority,which would have had to include several other smaller parties. The relationshipbetween the two parties has always been complex and, at times, openly con-frontational. The SDA has always considered the SzBiH its direct competitor in

Coalition-building is based onpragmatism



the fight for Bosnian Muslim votes. But the closeness of the founders of the twoparties�Alija Izetbegovic and Haris Silajdzic (one-time leading member of theSDA), respectively�has kept the links between the parties strong, with the pres-ervation, or rather creation, of BiH as a unified multi-ethnic state being theircommon goal. Among large sections of BiH�s non-Muslim electorate, the SzBiH isperceived as a moderate alternative to the SDA, despite the drive by the SDA tosoften its public image and become recognised as a mainstream political actor.

As part of the negotiations to sway the SzBiH, the SDA pledged to support MrSilajdzic as the central state prime minister-designate, although the SzBiHremained undecided. When, by the end of November, no clear answer to itsproposal for a coalition came from the SzBiH, the SDA announced it would gointo coalition with the HDZ BiH. By this point its support for Mr Silajdzic asprime minister designate had become moot, as Mr Silajdzic had declined theposition. His choice to stay out of the government again indicates both theideological gap between the SzBiH and the nationalists as well as politicalmanoeuvring by the SzBiH and Mr Silajdzic. The SDA and the HDZ BiH decidedthey could form a majority in all the Federation cantons except the Sarajevocanton�in which the SDP and the SzBiH remain the two strongest parties.

Throughout the fourth quarter of 2002, the SDA and HDZ BiH made clear theirview that they would welcome the SzBiH to join their coalition and providethem with a clear and stable majority, but considered its demands for share ingovernment posts excessive. The possibility of the SzBiH entering this coalition,however, appears to have split the party among those siding with its president,Safet Halilovic, who is in favour, and Beriz Belkic, one of the most prominentmembers, who insists on SzBiH co-operating with the moderate parties.

The SzBiH, throughout the negotiations (which were ongoing at the time ofwriting), was firm in its support of a model of government that would reflect aunited BiH and represent the whole country. It firmly rejected several proposalsoffered to it by both the SDA in the Federation and by the SDS in the RepublikaSrpska. These rejections, however, were largely political posturing, as the SzBiHis likely to be included in both the Federation and central state governments.Such a stance reflects the position of the party as something of a kingmaker inthe post-election political constellation of BiH. It also shows how the party ismaintaining a healthy dose of pragmatic caution over how it associates itselfwith what looks increasingly like a Federation government run by the two largenationalist parties.

In the RS, the two moderate parties, the Party of Democratic Progress (PDP) andthe Party of the Independent Social Democrats (SNSD), won enough votes toenable them to build a coalition which would sideline the Serb DemocraticParty (SDS), the single largest party in the parliament. However, following itsstrong election showing, the SNSD announced its interest in forming a�partnership agreement for development and change�, inviting all moderateparties to join ranks and create a strong political block in the RS parliament.Three smaller parties, the Democratic National Alliance (DNS), the Serb People�sAlliance (SNS) and the Alliance for National Revival (SNP), accepted theagreement, arguing that it was a way to overcome the political fragmentation

RS coalition-building exposesdeep conflicts between parties



which had blocked reform in Republika Srpska in the past. The PDP, whichemerged as the third-largest party in the parliament after the SDS and the SNSD,had reservations about the initiative, proposing that a minority government beformed instead. Such a government would be led by the PDP and include theSocialist Party of Republika Srpska (SPRS); it would be open to all other partiesand would most likely have the support of the SDS.

Shortly before the final election results were announced, the US ambassador toBiH said that his country would reconsider its assistance to Republika Srpskashould the SDS take over the government (although this stance wassubsequently softened as the outcome of the elections became clear), and thePDP complained of tremendous pressure from the international community notto co-operate with the SDS. This was the most likely reason why negotiationsover a possible coalition between the SNSD and the PDP eventually wentahead, despite mutual animosity between the two party presidents, MiloradDodik and Mladen Ivanic, respectively. The SNSD demanded the post of the RSprime minister, offering in return the post of the speaker, the first choice of theposts in the Council of Ministers and four ministerial posts in the RSgovernment to the PDP. At the same time, the SNSD made clear that if the PDPrefused to agree to its candidate for the post of the RS prime minister, it wouldnot participate in the government and would remain in opposition.

Throughout the negotiations, Mr Ivanic, the PDP president, held that it would beunacceptable to offer the post of prime minister to the SNSD, given that thisparty was the fiercest critic of his government�s programme. At the same time,he stated that the SDS was ready to offer the PDP the post of the prime minister.The premiership is of paramount importance for the PDP in its desire tocomplete the reform programme it started under the outgoing government,making eventual co-operation increasingly likely between the PDP and SDS.Weakening the likelihood of co-operation between the SNSD and the PDP wastheir differing stance toward the SDS�the main bone of contention between thetwo parties. While the SNSD remained against participation of the SDS in thegovernment, the PDP saw it as unavoidable, either overtly or covertly. In theend, no agreement between the SNSD and PDP was reached, and the PDP�sDragan Mikerevic was proposed as prime minister designate with the support ofthe SDS although formally the two parties did not form a coalition. Mr Dodikcommented by saying that his party would go into opposition and will argue forearly elections.

By the time the new RS National Assembly was sworn in, a parliamentarymajority had thus not yet been defined. The outcome of the vote forparliamentary speaker, selecting the SDS�s Dragan Kalinic, appeared to confirmthat the PDP had effectively joined forces with the SDS and the SDA, thusreturning the RS to its pre-war political situation, when the two nationalistparties were in coalition.

The negotiations over the parliamentary majority at the state level have provenequally tough. Neither of the two blocks�the nationalists or the moderates�would have a majority of seats in the House of Representatives, but if themoderate parties joined forces they would command half of the seats. The

Untenable moderate coalitionbrings back SDS

State parliament negotiationsprove difficult as well



international community had been pressing the moderate parties to form acoalition, but the SzBiH and the PDP, on whom such a coalition would depend,remained undecided. By December 3rd, when the parliament was sworn in, thefinal shape of the majority coalition was still not defined. However, the refusalof Haris Silajdzic to accept the nomination for prime minister designate led thetri-partite state presidency to appoint Adnan Terzic from the SDA to the position,suggesting a likely consolidation of power among the nationalist parties at thestate level (with the support of several of the smaller parties, and the SzBiHlikely to end up in opposition).·

The SDP, BiH�s largest multi-ethnic party, emerged as the biggest loser in theOctober elections, and went into a state of virtual freefall in the aftermath. Theeventual outcome of a tumultuous post-election party congress was a split in theparty. The eventual fault-line emerged between reformers intent on using theelectoral debacle to spur by-law changes to re-invigorate and democratise theparty and a more conservative group loyal to Zlatko Lagumdzija, the long-standing and generally respected party president.

The form of the central state�s institutions, as well as their role in relation tothose of the entities, has consistently been the key point of difference betweenboth nationalist and moderate parties from the Federation and those from theRS. This has stymied attempts at coalition-building at the state level. The issuehas become even more sensitive in light of the High Representative�s decision tocarry on with reforms of the Council of Ministers�intended to bring it closer tobeing a truly executive authority. Some of the reforms envisaged by the new lawon the Council of Ministers include making the prime minister�s post a full four-year term instead of the current rotating chairmanship (Mr Terzic will be the firstprime minister to be granted office for the full four years). This will reduce thenumber of issues to be decided by consensus, and lead to the formation of newstate-level ministries of justice and security (so far they have been exclusivecompetencies of the two entities).

While the Federation parties are by and large in favour of the new law, theparties from Republika Srpska are strongly opposed to any changes in the roleand organisation of the Council of Ministers as it would undermine the semi-statehood status that the two entities currently enjoy. When the HighRepresentative imposed the law on December 2nd, the members of theRepublika Srpska state parliament walked out in protest during the inauguralsession of the assembly, drawing a harsh condemnation from the HighRepresentative�s office. Thus, while the prospects of maintaining internationalfinancial assistance and out-manoeuvring the nationalists remain the primeincentives for the moderates to co-operate among themselves, differentconceptions over the medium and long-term vision of a common state of BiHhave proved the strongest deterrent to building a workable coalition.

The reform of the Council of Ministers is one of three areas earmarked by theHigh Representative as the highest short-term priorities (the other two are theintroduction of VAT and the reform of customs services). While initial reformswere largely focused on establishing the rule of law and a functioning

Role of BiH state is the centralissue dividing the parties

The SDP splits over poorelection results

Reforms to entityadministrations are a priority



administration, the emphasis of the High Representative (as evidenced by thecurrent high priority reforms) has shifted to the implementation of measures tostimulate the moribund BiH economy and minimise corruption and fraud.

Another area, equally important if BiH is to evolve into a unified state (andtherefore equally controversial), is the establishment of a central defence body.The need for such a body became particularly clear following the recentdiscovery of the involvement of both the Federation and the RS defenceministries in the sales of arms to Israel and the US, breaching domestic andinternational regulations. BiH also almost came under sanctions when anAmerican intelligence report disclosed that the RS aviation company Orao inBijeljina had, for a number of years, had a contract with Iraq to refurbishmilitary jets and supply equipment and arms, thus violating the United Nations�embargo. In both cases, the fragmentation and overlapping responsibilities ofthe state and entity-level bodies were cited as key factors leading to thebreakdown in proper oversight.

The RS government has, of course, opposed the establishment of a joint state-level defence body, insisting that defence should remain an entity prerogative asstipulated by the Dayton peace agreement. Because of the sensitivity of thematter, the High Representative�s reform package aimed at strengthening stateinstitutions does not include the defence establishment. But in reaction to the�Orao� scandal, the message from the international community wasunambiguous�reform in this area will be essential for the BiH both in terms ofsecuring continued international assistance and as a prerequisite for joiningNATO�s Partnership for Peace programme, to say nothing of its interest inmaintaining an effective defence establishment.

Economic policy

The state budget of KM530m (US$282m) was adopted by the BiH House ofRepresentatives on December 11th 2002, beating by one day the deadline it hadto meet to secure the release of the most recent instalments of ongoingarrangements with the IMF, EU, and the World Bank (in this case thedisbursements in question totalled approximately US$55m). Of the total budget,KM58m will be provided by the Federation, KM29m by the RS and KM39m bythe Brcko district, while the rest will be covered by foreign funds and the state�sown revenue. Some 60% of the budget has been earmarked for servicing BiH�sforeign debt, while the remaining KM205m is to go to financing the central stateinstitutions.

The 2003 budget is the first to which the Brcko district will contribute. Thedecision to formalise the relationship between the Brcko district and the centralstate, including fiscal matters, was taken following a crisis in the funding of thestate border service, for which insufficient funds were allocated in the statebudget. The Brcko district is a self-governing unit within the state of BiH and itsrelations with the central state in fiscal matters were not defined in the originalDayton peace agreement.

State parliament adopts budgetwith first Brcko contribution



The funding of the central state, which has no revenue-raising powers apart fromfees, remains a problem which, in the view of the Office of the HighRepresentative (OHR), can only be permanently resolved by the introduction ofvalue-added tax (VAT) at the state level. Responses within the entities to theinternational agencies� proposed single centralised VAT administration hasfollowed the typical ideological division seen in virtually every attempt to shiftpower from the entities to the central government. While Federation authoritiesby and large agree with the proposal, strong opposition has been registered byall the RS political parties, who see it as a direct blow to the entities� fiscalsovereignty. Mr Dodik, the SNSD leader, said that if the decision were made tocollect VAT at the state level, his party would call for civil disobedience. Thus thefuture implementation of VAT remains uncertain and we expect it to bepostponed to 2004 (the original plan was to have it in place by the end of 2003).

The other key area identified by the High Representative for harmonisationacross the entities is customs administration. The High Representative, in astatement in December 2002, warned that the international community hadmade it �crystal clear that it is not prepared...to hand over their taxpayers� moneyto fund BiH criminals�. Predictably, the response to the creation of a single,centralised customs administration was met with scepticism by the RS politicalleaders. Nonetheless, the completion in December of a set of recommendationsfrom an EU team tasked with the design of the customs reform programme,along with the High Representative�s enthusiasm for the project, are likely tolead to an imposed reform sometime in 2003.

On November 14th 2002 the Federation government adopted a draft 2003budget totalling KM1.217bn (US$647m). The 2003 budget is KM110.4m smallerthan in 2002, projecting a 9% decline in tax revenue as a result of lower tax rates.More than one-third of the budget is earmarked for defence and disabilitybenefits. Federation current expenditure have been cut from KM1.214bn in 2002to KM1.058m in 2003, thus allowing for some capital expenditure such as roadbuilding. The bulk of capital expenditure has so far been financed byinternational donors. One of the aims of the internationally sponsored publicfinance reform programme has been to address the present imbalance betweencurrent and capital expenditure so that future government outlays areincreasingly allocated toward investment areas more likely to contribute to long-term growth potential in the country.

According to preliminary reports, the implementation of the 2002 Federationbudget has bettered the IMF projection by a full 1% of GDP (an expected deficitof 0.8% of GDP including foreign grants as against the planned 1.8%), as a resultof the implementation of the new Tax Administration Law and a number ofother tax reforms. Encouragingly, this fiscal consolidation took place within thecontext of a major one-off cost of demobilising 10,000 military personnel.

The RS National Assembly adopted a draft 2003 budget on December 9th 2002.The 2003 budget amounts to KM999.7m, an increase of 25.8% compared with thedraft 2002 budget. The new budget is based on a GDP growth forecast of 2.1% inthe RS, and assumes continued favourable trends in tax collection and main-tenance of tight financial control. Taxes are the single most important source of

Federation plans fiscalconsolidation for 2003

Republika Serpska adoptsincreased budget for 2003



RS revenue, accounting for around 50% of the total. This is one reason why theauthorities are unwilling to pass on the administration to the state-levelauthority should VAT be introduced at that level.

The RS fiscal gap is projected to meet government and IMF estimates for 2002,according to latest estimates, although both revenue and expenditure werehigher as a percentage of GDP than planned. High revenue figures, like in theFederation, reflect successful tightening of the tax administration, while theexpenditure overshoot relates to faster than expected clearance of public wagearrears and large transfers to the social funds.

The pace of privatisation of strategic companies in the RS has lagged wellbehind the Federation and virtually ground to a halt in the first half of 2002.Despite assistance from several international agencies, only four strategicenterprises had been sold in Republika Srpska by mid-2002. There are severalreasons for a lack of progress in the sales of strategic enterprises in the RS: thepoor state of the RS economy, lack of transparency and the difficulty ofascertaining accurately the financial structure and debt obligations of the largestfirms, obstruction by political elites hostile to the prospect of losing �familysilver� to foreigners, and problems with the Privatisation Agency, owing toinadequate staffing and funding.

Privatisation of small, medium-sized and �non-strategic� enterprises hasproceeded at a faster pace, because it is less complex and the amounts of capitalinvolved are smaller. By the first quarter of 2002, around 50% of small andmedium-sized companies and 40% of large non-strategic companies had beensold. However, future prospects for rapid privatisation in this area are less clear�with voucher privatisation completed remaining assets will be sold for cash,which may prove problematic as the existing privatisation framework is notparticularly favourable to prospective strategic buyers of minority shares.

The third and the final round of a public share offering for privatisation voucherholders is under way in the Federation. Predictably, the response from citizenshas been lukewarm, in part because the most attractive enterprises have alreadybeen offered and partly owing to the country�s depressed economy. It isexpected that about 70% of small and 40% of large enterprises will have beensold by the end of 2003. Although privatisation of strategic companies in theFederation has been more successful than in the RS, the total number soldremains modest�only 13 by July 2002. Overall privatisation in both entities hasbeen difficult and its financial effects meagre, with only 30% of the overall BiHstate assets earmarked for privatisation so far sold.

The domestic economy

Output and demand

Following a slowdown in the first half of 2002, industrial output growth in theFederation accelerated in the third quarter and was up by 11.8% year on year.Strong industrial performance continued in October as industrial output rose by

Pace of privatisation remainssluggish in Republika Srpska

Interest is low in final phase ofvoucher privatisationtion

Federation industrial outputrecovers in the third quarter



18.6% compared with the same month in 2001, thus bringing January-Octoberindustrial output growth to 8.5%. Among the main industrial groupings, thefastest growth was in durable consumer goods (44%), with slow growth only inenergy (3.2%), and a decline in production of capital goods. Despite the overallrecovery, full year industrial output growth for 2002 is set to fall below the 12.2%increase recorded in 2001, which in part reflects a return to a more sustainablegrowth trajectory, following high growth rates in the late 1990s related to post-war reconstruction activities.

The third-quarter recovery in industrial output was primarily fuelled by stronggrowth in manufacturing, which rose by 14.3% compared with the same quarterin 2001. Following a further strong year-on-year increase in October, ten-monthmanufacturing output grew by 13% year on year in the first ten months of 2002.The food and beverages industry, the largest industry in the Federation,expanded strongly in 2001 as a number of new privately owned firms enteredthe market, and this expansion continued throughout 2002, with year-on-yearsectoral growth of 14.9% in the first ten months of the year. Manufacturing ofother non-metal mineral products (the second largest industry) recorded annualgrowth of 21.3% in the same period owing to a sharp increase in demand forconstruction material. Base metals, one of the Federation�s leading exportindustries, recovered in July and grew strongly in the following months but inthe period January-October grew by only 1.2%. At present, the bulk ofproduction in this industry comes from one steelworks (BiH Steel Zenica) andone aluminium plant (Aluminium Mostar), providing an overall capacityconstraint, which, to a large extent determines the dynamics of the sector.

Latest figures, although subject to revision and of varying quality, indicate thatRS industrial production in the third quarter of 2002 appears to have arrestedthe steep declines experienced in the first two quarters of the year. Overallproduction figures for the third quarter were, in particular, buoyed by stronggrowth in mining and non-metal mineral production, owing to similar demandfor construction inputs as experienced in the Federation. Food and beverageproduction also grew rapidly in the third quarter, with production up over 50%from the 2001 average.

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

2001 20023 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr

Federation 13.7 6.6 4.8 5.8 11.8

Republika Srpska 8.2 9.3 -12.1 -13.1 -1.4

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

Statistics, Monthly Statistical Review.

Construction output in the Federation grew in the third quarter of 2002, pushingtotal January-September output up by 4.7% compared with the year-earlierperiod. Comparative data for January-September suggest that the number ofcompleted residential buildings declined by 13.7% year on year, suggestingstronger growth in the construction of commercial properties. At the same timethe number of unfinished new housing starts was almost 6% higher during the

Recovery is driven by strongmanufacturing performance

Construction output is up

Third-quarter RS industrialproduction up slightly



same period in 2001, indicating that the overall residential construction sectorremains fairly strong.

Inter-entity turnover, Jan-Sep(KM m unless otherwise indicated)

2001 2002 % changeFederation sale to RSFood products 20.8 55.5 166.8Textile products 1.7 2.5 45.1Leather products 1.7 1.5 -10.9Fuel materials 2.9 1.5 -48.3Metal products 16.3 10.7 -34.5Glass, ceramics & porcelain 2.2 3.4 54.5Electrical engineering 43.0 34.1 -20.8Chemicals 7.9 13.7 73.6Wood products 7.7 9.7 25.9Liquid fuel & lubricant oil 0.1 1.9 1844.0Non-metal building materials 10.2 9.9 -2.8Other 23.9 21.6 -9.7Total 138.4 165.9 19.9Federation bought from RSFood products 14.3 15.0 4.9Textile products 0.46 0.7 58.1Leather products 0.4 0.6 57.9Fuel materials 0.9 0.5 -40.1Metal products 2.8 3.3 17.6Glass, ceramics & porcelain 0.29 0.3 15.4Electrical engineering 1.7 1.2 -28.2Chemicals 5.1 9.4 82.6Wood products 2.1 3.4 63.1Liquid fuel & lubricant oil 2.3 1.5 -34.9Non-metal building materials 1.5 1.7 11.1Other 8.5 8.3 -2.6Total 40.3 45.9 14.0

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

Trade between the entities grew healthily in the first three quarters of 2002, asthe process of removing barriers slowly progressed, although Federation sales tothe RS continue to dwarf sales in the other direction. Improvements in efficiencyand quality brought on by privatisations and new entrants in the food andbeverage industry in the Federation led to a dramatic year-on-year gain in thesale of foodstuffs from the Federation to the RS, while construction inputs andlow value-added products made the highest gains among RS sectors.

Employment, wages and prices

The number of unemployed persons in the Federation has been edging upwardssince December 2001 and reached a total of 287,055 registered unemployed inSeptember 2002, which represents a 7.1% increase compared with the 2001average. From January to September the jobless figure increased by about16,000, thus surpassing by 3,000 the decline in the number of employed duringthe same period (official employment fell from around 405,000 to 392,000).

Official unemployment isrising



This gap, along with the skills structure of unemployed persons (roughly one-third are listed as �non-skilled workers�) suggests that the increase inunemployment is partly related to the loss of jobs and partly to the rise innumbers of new entrants to the labour market. The international agenciesworking in Bosnia and Hercegovina (BiH) have repeatedly pointed out that theofficial figures are not indicative of the real unemployment situation in BiH.Official statistics do not include certain categories of employment such ascraftsmen and self-employed persons, and the grey economy is believed to bewidespread, suggesting that the real unemployment figure is significantlylower�perhaps by half�than the official figure of around 40%.

BiH: labour statistics, 2002('000 unless otherwise indicated)

Jan Feb Mar Apr May Jun Jul Aug Sep OctFederationEmploymenta 404.7 404.3 402.6 390.7 390.4 391.0 390.7 390.6 391.6 391.5Unemployment 270.7 271.8 272.9 277.7 281.4 282.8 287.3 287.4 287.1 289.0Rate (%)b 40.1 40.2 40.4 41.5 41.9 42.0 42.4 42.4 42.3 42.5Net wage (KM) 457 467 470 475 476 471 484 491 499 500

Republika SrpskaEmployment n/a n/a 232.7 n/a n/a n/a n/a n/a n/a n/aUnemployment 146.6 147.6 147.7 147.1 144.9 143.8 143.5 142.9 143.3 n/aNet wage (KM) 342 334 342 349 350 340 353 348 351 n/a

a Registered employment; includes waiting-list workers on stand-by but not actually working (system discontinued in 2002). b Unemployeddivided by unemployed plus employed; includes waiting-list workers.

Sources: FOS, Statistical Data on Economic and Other Trends; OHR, Economic newsletter; CBBiH, Bulletin (various issues); BiH Foreign Investment Promotion Agency, Recent economic trends

(website); Republika Srpska Institute of Statistics, Monthly Statistical Review.

In the period January-September the largest job losses were recorded in publicadministration and defence (18.6%), as the government completed its de-commissioning of 10,000 military service personnel. The sector still rankssecond to manufacturing in terms of overall employment, however. Employ-ment in manufacturing fell by 2.8% compared with average 2001 employment.

The Federation average nominal wage grew strongly in the third quarter of 2002and was up by 10.9% compared with the same period of 2001. The September2002 average nominal wage was KM499.34 (US$265)�an increase of 9.1% fromJanuary 2002, suggesting that the full-year growth figure could surpass that of2001, when the average nominal wage rose by 7.4% in annual terms.

Much of this growth was fuelled by wage increases in the tobacco, chemicaland base metal industries and financial services. Wages in the public sector,especially in education and health, increased sharply in spite of IMF pressure tocap public-sector wage growth. In September and October school teachers wenton strike in the Hercegovina-Neretva canton and the threat of industrial actionof wider proportions is looming in the Federation as well as in Republika Srpska(RS), further complicating the High Representative�s plans for rapid structuraladjustment in 2003. The two industries with traditionally the highest averagewage�electricity and telecommunications�recorded falling average nominalwages in the third quarter of 2002; nonetheless their average nominal wagesremained more than twice the Federation average.

Wages rise sharply in the thirdquarter



Whereas figures from the RS indicate slower growth (less than 1%) in the thirdquarter, the overall level of nominal net wages remains strongly up in year-on-year terms, by 13.3%.

Retail prices in the Federation fell consistently in the fourth quarter of 2002, withyear-on-year disinflation from September to November. Overall averageinflation for the first 11 months of 2002 was reported at �0.2% during the sameperiod in 2001, although the Economist Intelligence Unit estimates the full-yearaverage figure to be 0.1%, as official figures have tended to slightly under-reportprice growth. The biggest fall during the 11-month period was recorded in theprices of non-food manufactured products, attributed mainly to a drop in theprices of textiles, leather products and fuel. Prices of food and agriculturalproducts rose by 2.4% during the same period, while the prices of servicesremained unchanged.

Although prices fell throughout mid-year in the RS, the trend was reversed in thefourth quarter of 2002, with prices up by 2.1% year on year during the fourthquarter of 2001. Preliminary figures for December indicate annual averageinflation for the RS of 2%, with a significant (2.8%) drop in agricultural goodsprices offset by growth of over 2% in industrial goods and services prices.

Retail price levels and growth rates between the Federation and the RS havebeen steadily converging since 2000. Price levels had initially been higher in theRS following the Dayton agreements, and before the introduction of the con-vertible marka (KM) the RS economy tended to follow that of Yugoslavia(Serbia-Montenegro) more closely than that of the Federation, accounting for therecent disparity in price levels and growth rates. However, with the introductionof the KM and increased integration between the two entities, inflation levelshave converged significantly in the past few years, a process that is expected tocontinue.

BiH: retail prices(% change)

2001 2002Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

FederationMonth on month 0.6 0.5 -0.2 -0.3 -1.0 0.7 -0.9 -0.1 0.0 -0.3 0.6 0.0 n/aYear on year 0.3 0.2 -0.1 -0.2 -0.2 -0.2 -0.9 -0.1 0.3 -0.2 -0.1 -0.5 n/aRepublika SrpskaMonth on month 0.0 0.6 0.0 0.0 -1.6 0.7 0.0 -0.5 -0.2 0.1 1.7 0.3 1.3Year on year 3.0 3.6 4.7 4.7 3.0 2.7 0.7 0.2 0.0 0.1 0.8 1.1 2.4

Sources: FOS, Statistical Data on Economic and Other Trends; OHR, Economic newsletter; CBBiH, Bulletin (various issues); Republika Srpska Institute of Statistics, Monthly Statistical Review.

Financial indicators

The volume of credit extended by Federation commercial banks rose sharply inthe first half of 2002. The total stock of loans held by Federation banksamounted to KM2.2bn (US$1.2bn), an increase of 30% compared with the end of2001. The term structure of bank lending continued to shift in favour of long-term credit, which accounted for 66% of the total at the end of June. Loans tohouseholds remain the single largest item�growing by 54% from January to June

Retail price inflation continuesto fall

Lending in the Federation risesstrongly

Inflation levels continue toconverge between the entities



2002. Over 90% of household lending is now long-term, while lending toenterprises is more evenly balanced, with half of the total loan structureconsisting of short-term loans. Lending to enterprises also rose by 22% inJanuary-June 2002, but it continues to fall behind the household sector as banksremain wary of business-sector creditworthiness.

The expansion of long-term credit, given the nascent state of the BiH bankingsector, carries significant risks to the banks, and has been singled out by both theIMF and local officials as an area of concern in 2003. The overall risks toFederation banks� balance sheets increased significantly in the first half of 2002,both as a function of the increase in credit and owing to the effect of thegrowing maturity mismatch between assets and liabilities on the overall sector�sbalance sheet (long-term lending being funded largely by short-term deposits). Ina more positive development, the Federation banks have made significantprogress since the end of 2000 in reducing the total value and proportion ofpoor quality assets on their balance sheets, from almost 70% at the end of 2000to about 55% by June 2002.

Federation: commercial bank lending(KM m; end period)

2001 Jan-Jun 2002 % changeTo government 26 34 30.8To public enterprises 246 245 -0.4

To private enterprises 770 942 22.3To households 623 959 53.9

To others 57 60 5.3Total 1,722 2,240 30.1

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

September 2002.

Interest rates have fallen sharply across BiH since the start of 2001. Increasedcompetition in the banking sector has brought down the overall average lendingrate by some 15% between the first quarter of 2001 and June 2002. Slowlyimproving attitudes towards the banking sector have reduced the rate needed toinduce households to deposit savings by roughly 10% during the same period.

Foreign trade and payments

Preliminary data suggest that the Federation foreign trade deficit continued towiden in US dollar terms in the third quarter of 2002, rising by US$503m.Following a 22.4% fall in the first half of 2002 year on year, exports rose by 67%in the third quarter, but were followed closely by an increase in imports, whichgrew by 61%. This brought the cumulative trade deficit for January-September2002 to US$1.35bn, an increase of 15.2% compared with the same period of 2001.

Federation nine-month exports reached US$511m�a contraction of 15.6% year onyear�caused mainly by an 18.9% fall in manufacturing. Exports of base metal,the single largest export item, fell by 13.3% compared with the year-earlier period.The decline was even larger in clothing (68%), textiles (80%) and leather (48%), agroup that in 2001 accounted for almost one-third of total exports. The slow-

Exports remain modest

Foreign trade balancedeteriorates sharply

Across BiH interest ratescontinue to fall



down in EU growth in 2002 compared with 2001 has led to a cut in orders fromthe euro zone, which is the principal market for the majority of firms in thesethree industries, who tend to operate mainly under outward processingagreements as part of the Association Agreement with the EU.

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

2001 % of total 2002 % of total % changeExports (incl unclassified)Agriculture & fisheries 8.4 1.4 10.4 2.0 23.8Mining 5.9 1.0 8.6 1.7 46.7Manufacturing 561.2 92.6 455.6 89.1 -18.8 Base metals 157.1 25.9 136.2 26.6 -13.3 Wood products 69.8 11.5 68.3 13.4 -2.1 Furniture 30.9 5.1 46.3 9.1 49.9Electricity, gas & water supply 27.1 4.5 28.7 5.6 6.2Other 3.7 0.6 3.7 0.7 1.9Total 606.2 100.0 511.5 100.0 -15.6Imports (incl unclassified)Agriculture & fisheries 67.4 3.8 86.5 4.6 28.3Mining 6.6 0.4 3.9 0.2 -41.1Manufacturing 1,641.2 92.3 1,698.8 91.3 3.5 Food & beverages 265.7 14.9 291.0 15.6 9.5 Machinery & equipment 144.4 8.1 291.0 15.6 101.5 Chemicals 198.8 11.2 168.6 9.1 -15.2Electricity, gas & water supply 14.7 0.8 14.2 0.8 -3.2Other 47.5 2.7 45.6 2.5 -3.9Total 1,777.4 100.0 1,860.7 100.0 4.7Balance -1,171.2 - -1,349.2 - 15.2

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

Boosted by the boom in consumer credit, strong domestic demand combinedwith limited and poor quality domestic production continue to drive importvolumes up. Imports amounted to US$1.86bn cumulatively from January toSeptember 2002�an increase of 4.7% (in US dollar terms) compared with thesame period of 2001. Of the ten sectors classified by the Standard InternationalTrade Classification (SITC), imports increased in seven. Imports of machineryand transport equipment rose by 21.1% in the period from January to Septemberand were the single largest import item, driven largely by strong growth inimports of automobiles.

After falling in the first half of the year, imports of manufactured goods were upstrongly in the third quarter of 2002. Imports of food and beverages, which roseby 9.5% year on year in the first three quarters, remained the single largestmanufacturing import item. Although local capacity in this industry has beenexpanding, it still falls significantly short of domestic demand and risingcustomer expectations for quality. Imports of base metals rose sharply in thesame period in year-on-year terms (45.7%), followed by machinery andequipment (25.7%), suggesting that some re-equipping of the Federation�sindustrial base is under way.

Import demand is buoyant



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

2001 % of total 2002 % of total % changeExports fobCroatia 66.6 10.7 86.1 16.8 29.2Switzerland 82.9 13.3 75.8 14.8 -8.6Germany 114.1 18.2 78.4 15.3 -31.3Italy 135.9 21.7 62.5 12.2 -54.0Yugoslavia (Serbia-Montenegro) 52.8 8.4 45.2 8.8 -14.4Slovenia 53.3 8.5 45.7 8.9 -14.3Austria 23.1 3.7 23.9 4.7 3.4UK 3.5 0.6 15.7 3.1 349.4USA 7.4 1.2 9.2 1.8 25.3France 4.7 0.7 16.0 3.1 242.0Other countries 81.0 12.9 52.9 10.3 -34.6Total 625.3 100.0 511.5 100.0 -18.2Imports cifCroatia 304.1 18.1 335.4 18.0 10.3Germany 210.3 12.5 261.5 14.1 24.3Slovenia 230.9 13.7 222.1 11.9 -3.8Italy 254.7 15.1 201.8 10.8 -20.8Austria 89.5 5.3 98.4 5.3 10.0Hungary 54.2 3.2 70.5 3.8 30.1Switzerland 47.4 2.8 50.8 2.7 7.3USA 34.8 2.1 38.6 2.1 10.7Czech Republic 33.7 2.0 47.0 2.5 39.7Yugoslavia (Serbia-Montenegro) 20.4 1.2 28.8 1.5 40.8Other countries 402.8 23.9 505.9 27.2 25.6Total 1,682.7 100.0 1,860.7 100.0 10.6Balance -1,057.5 - -1,349.2 - 27.6

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

Exports to the EU, which had contracted for two consecutive quarters, recoveredin the third quarter of 2002 but the overall January-September figure was stilldown by 30.4% year on year. Exports to Italy and Germany, two of theFederation�s principal export markets, fell by 54% and 31% respectively. Theslowdown in growth in these two economies in 2002 has significantlydampened import demand.

Imports of goods from the EU increased in the first three quarters by 0.3% yearon year, widening the trade gap with the region from US$399m in the first ninemonths of 2001 to US$493m in the same period of 2002. A sharp fall in importsfrom Italy was offset by a large rise in German imports as well as increases inseveral smaller markets.

Among neighbouring countries, trade results for the third quarter were mixed.Exports to Croatia, which is the Federation�s largest single market, rose by almost30% year on year in the first three quarters, totalling US$86m for the period.Exports to Slovenia, with which the Federation continues to run a large tradedeficit, recorded a 14.3% fall year on year, followed by a slightly smaller drop inexports to Yugoslavia (Serbia-Montenegro; 12.5%). BiH has signed free-tradeagreements with all three countries. The agreements are asymmetric, allowing

Trade deficit with the EUwidens

Trade balance with neighboursimproves



BiH customs-free exports for a number of years, meaning that future pressure ontrade and current-account balances is likely as those asymmetric agreementsexpire. In 2002, however, in the case of Federation trade with Croatia, the agree-ment appears to have had a positive effect on Federation export performance,suggesting that there is the potential to replicate the positive developments inthe Slovenian and Yugoslav markets.

Croatian imports rose by 7%, which, against the sharp increase in exports, cutthe Federation�s trade deficit with Croatia from US$296m in the first threequarters of 2001 to US$249m in the same period of 2002. The Federation�s tradedeficit with Slovenia, which amounted to US$187m in January-September 2001,was also cut by around US$10m in the same period of 2002 as a result of an8.2% contraction in imports.

Republika Srpska: trading partners, Jan-Sep(US$ m unless otherwise indicated)

2001 % of total 2002 % of total % changeExports fobYugoslavia 104.8 50.8 96.8 51.5 -7.6Slovenia 9.0 4.4 11.7 6.2 30.8Germany 11.9 5.8 11.2 5.9 -6.3Austria 4.2 2.1 3.8 2.0 -9.1Italy 36.9 17.9 24.4 13.0 -33.9Croatia 11.3 5.5 19.1 10.1 69.0Hungary 1.1 0.5 1.5 0.8 39.7Other countries 27.1 13.1 19.5 10.4 -27.9Total 206.4 100.0 188.2 100.0 -8.8Imports cifYugoslavia 134.7 24.0 181.2 25.0 34.6Slovenia 74.3 13.2 86.4 11.9 16.3Germany 29.3 5.2 51.9 7.1 76.8Austria 38.7 6.9 60.5 8.3 56.3Italy 33.3 5.9 53.5 7.4 60.5Croatia 52.3 9.3 77.0 10.6 47.2Hungary 47.9 8.5 54.8 7.6 14.4Other countries 151.2 26.9 160.8 22.2 6.4Total 561.7 100.0 726.0 100.0 29.3Balance -355.3 - -537.9 51.4

Source: Derived from Republika Srpska Institute of Statistics, Monthly Statistical Review.

Trends in the Republika Srpska (RS) largely followed those of the Federation�theUS dollar trade deficit was up by more than 50% year on year in the first threequarters of 2002, and similar dynamics were seen between the RS and its largeeuro-zone markets, as in the Federation. By far the largest market for the RS isYugoslavia, and the increase in the trade gap between Yugoslavia and the RS inthe first three quarters of 2002 made up almost one-third of the entire year-on-year change from 2001. The RS does not report trade figures by industry.

Revised IMF data published in January 2003 suggest that the BiH current-account deficit in 2002 will have widened slightly from revised full-year figuresfor 2001. A slight widening of the merchandise trade deficit caused most of thedifference, with little change expected in services or income balances. As official

Current-account deficit wasstable in 2002



capital transfers for reconstruction have declined in 2002 from 2001, the gap willhave been covered by increased foreign direct investment (FDI), up by anestimated 84% from 2001 at US$240m, as well as an expected slight decline ingross official reserves at the central bank. As most FDI in BiH is privatisation-driven, political uncertainty and the lack of a unified legal and regulatoryframework for business remain the strongest deterrents to further growth inforeign investment in BiH. The minimal success achieved in the privatisation ofstrategic companies in either entity in 2002 suggests that covering growingfinancing gaps, while still comfortable, will become increasingly difficult unlessprivatisation is speeded up and steps are taken to reduce the current-accountdeficit.

Although BiH is a moderately indebted country, deterioration in the currentaccount driven by expected mounting trade deficits in 2003-04 could present aserious threat to the country�s external debt repayment capacity. Recent IMFprojections indicate external debt service doubling in US dollar terms from 2001to 2003, just as BiH enters a period of declining foreign assistance. Other sourcesof funding the external gap are far from reliable�foreign investment inflows intoBiH have been among the lowest in the region.

South-east Europe: foreign direct investment inflows(US$m unless otherwise indicated)

1999 2000 2001 2002aFDI stock, end-

2002aFDI stock per head,

end-2002a

Albania 41 143 207 160 943 297BiH 149 132 150 256 740 178

Bulgaria 806 1002 692 620 4,616 586Croatia 1,479 1,115 1,447 950 7,336 1,652

Macedonia 30 176 443 70 946 464Romania 1,041 1,025 1,157 1,200 8,903 411

a Estimates.

Source: Economist Intelligence Unit.

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