Bosnia and Herzegovina –Economic Reform:Achievements, Challenges and Priorities

Consultative Group MeetingSarajevo

September 22-23, 2004

Outline of presentation 1. Main achievements to date and

key remaining weaknesses2. Major challenges for achieving

sustained growth and higher employment while increasingly integrating into European structures

3. Selecting/designing priority reforms for achieving these goals

MAIN ACHIEVEMENTS AND KEY REMAINING WEAKNESSES

Significant progress in reconstruction, macro policy and state-building…

Post-conflict reconstruction supported by large aid flows is nearing successful completion.The currency board, backed by debt restructuring and phased fiscal adjustment (to small surplus in 2003), laid the foundations for macro stability.Recent advances in public financial management (expenditure framework, tax policy) and state-building, including enhanced internal harmonization and state-level coordination.

…and in some important but difficult areas of structural reform…

Foreign trade extensively liberalized, including bilateral FTAs with sub-regional trading partners, and enhanced access to EU market (ATMs)Developed a largely privatized competitive banking system, including enforced regulatory and supervisory functions.SMEs privatized and faced with hard budget constraints.Reformed labor code.Social protection (first pensions, recently veterans benefits).MTDS and SAp.

…has already brought important positive results

GDP trebled since 1995, extreme poverty eliminatedMuch enhanced macro stability (inflation, reserves and debt indicators, confidence in currency)Some redirection of trade towards EU and CroatiaForeign direct investment doubled from 2000 to 2003, reaching close to 5 percent of GDP. Total FDI since the end of the war over US$1.6 billionSME sector shows increasing promise (behaving commercially, paying on time, creating new jobs)

However, significant vulnerabilities remain…

Slowing growth, declining aid flows and large/persistent current account deficit pose risks for sustained growth.After a rapid initial burst, export growth has stagnated and goods exports remain much too low (10% of GDP).External/government creditworthiness remains elusive.GDP still well below pre-war level, with 20% living below poverty line.Some 30% near-poor could slip into poverty were the economy hit by a negative shock.

…and reforms are far from completeLost decade of war plus the twin challenge of post-conflict reconstruction and transition still leave BH quite far behind the most successful Central and Eastern European countries.Notwithstanding achievements, the track record in structural policies is uneven, with partial reform in many areas.The agenda of integrating into European structures lies largely ahead.

KEY CHALLENGES

Challenges are well described in the MTDS

We focus on six:Deepening macroeconomic adjustmentReducing the size/improving the efficiency of governmentAccelerating export growth and deepening trade integrationRestructuring the enterprise sectorStrengthening the business environmentImproving the functioning of the labor market

Macroeconomic adjustment needs to be further deepened

Overarching challenge is increasing domestic savings to cut current account deficit without harming investment, economic efficiencyPublic savings can be raised by further containing current spending/GDPDomestic claims resolution plan needs to be implemented within agreed parametersIn the short-run, increasing private savings requires controlling credit growth, primarily to household sectorMedium-term challenge is boosting corporate savings, i.e. the profitability of BH companiesAttracting more FDI/other foreign savings also key to external sustainability

Governments need to become smaller/more efficient

Despite past gradual reduction, public spending still over 50 percent of GDP, one of the highest levels in the world. Post-DPA political/administrative structure plays a role, but much is inefficient spending.Need further rationalization targeted at current spending, esp. wage bill, making room for MTDS/SAp priorities.Transfers of responsibilities should be revenue-neutralWithin core public services, e.g. education or social protection, expenditure allocation should be driven by efficiency/equity considerations. Focus on education financing, welfare transfers to households. Also need to further enhance technical capacity and transparency, reduce complexity of government, and continue improving coordination between various levels of government (e.g. higher education reform)

Further trade integration and private sector reform are keys to export growth

Recent disappointing export performance can hardly be attributed to a policy of liberalization/integration. As nothing broken with the trade regime, BH should build on initial achievements and selectively advance the same agenda.Need further progress in removing ‘behind the border’ barriers to using extensive market access (technical, veterinary etc. standards; product certification; customs)Further developing single economic space will also stimulate cross-border trade.Key to faster export growth is enterprise restructuring, the business environment, and labor market (wage competitiveness) which we turn to next.

An extensive remaining agenda of enterprise sector reforms

Banking/SME successes not matched in broader enterprise sector, esp. SOEs. Early (MVP) privatizations led to diluted ownership and weak governance, soft budget constraints and weak profit drive. Large privatization painfully slow, and exit so far rare. Need:Faster, more transparent privatization to strategic owners. Changes to encourage concentration of ownership in PIFs/MVP firms.Range of corporate governance reforms to strengthen role of owners, create incentives for efficiency gains.Remove barriers to effective corporate restructuring.Implementation of new bankruptcy laws (a major positive reform), including active initiation of proceedings by government bodies/firms, control of subsidies.

The business environment needs to be significantly strengthened

While somewhat improved, it retains high barriers to entry and impediments to business operation. Priorities include:Complete new business registration system to smooth/lower cost of entry.Improve functioning of legal system (esp. commercial courts, including backlog) in protecting property rights and contracts.Reduce economic policy uncertainty and corruption as most powerful deterrents to business entry and development.To reduce administrative barriers, streamline business inspection, incl. via clear distribution of tasks across levels of government.VAT introduction/ITA as particularly crucial with far reaching implications; also level playing field in tax collection, follow by gradual reduction of tax wedge on labor.

The labor market needs to be made more flexible

Formal labor market is anemic, unemployment high (esp. for women and youth), and informal economy may be gaining ground.Despite relatively flexible labor laws, participation remains low, pay/separation practices rigid, and wages grow faster than productivity.Problems compounded by weak firm-level discipline (by workers, other creditors, management) and corporate governance. Role of employers in collective bargaining needs to be enhanced.A strict incomes policy needs to be applied in leading public companies.Minimum wage needs reform to promote competitiveness and employment of vulnerable groups (women, youth).Employment institutes/active programs also need restructuring.Over time, reduce tax burden on labor.

SELECTING/DESIGNING PRIORITY REFORMS

Reforms need to be selectively chosen, flexibly implementedThe authorities have already taken many initiatives to meet the noted challenges. BUT envisaged actions are often too numerous to be credible, starting with those in MTDS itself.The vast scope of challenges calls for selectivity, prioritization and sequencing.Reforms must in turn be linked to and consistent with MTEF and PIPThere is also a need to flexibly apply 4 different types of approaches to economic policy

1. ‘Staying the course’ Means keeping the same policy direction in areas

where policies are broadly adequate, with selective further deepening. For example:Macroeconomic policy (rely on CBA as solid anchor supported by continued fiscal consolidation and prudent debt/borrowing policy).Trade policy. Increased protectionism would backfire, so continue and deepen liberal policies and market integration.Banking. Continue strengthening of supervision while tightening credit policy.

2. Setting the right incentives for the private sector

Accelerating progress on 16 prior requirements set forth in the EC Feasibility Study, to open negotiations for a SAA (extensive impact on business climate).Tax reform (VAT, tax on labor) and creating level playing field in tax collection.Changing privatization/PIF laws to get core owners.Corporate governance reforms.Creating bankruptcy framework.More flexible wage determination.

3. Getting out of the way Proposed policies too often see a large and active

role of government. BUT government cannot fix everything and is already big. Large gray economy shows entrepreneurial activity which could flower if government got out of the way. This includes:Deregulation/streamlining the administrative framework around the private sector (e.g. business registration, licensing)Trade liberalizationReducing subsidiesLabor market flexibility

4. Intervening smartly in some areasAreas where government must act decisively include:

Adjusting size/composition of public spendingAddressing domestic debt overhangCreating institutions required to access export marketsPrivatization/initiation of bankruptcy for companies with large tax and contribution arrearsAnti-corruption effortsIncomes policy for public sector companiesReforming education systemCreating a new, more effective architecture for donor coordination

Summary of key challengesDeepening macroeconomic adjustmentReducing the size/improving the efficiency of governmentAccelerating export growth and deepening trade integrationRestructuring the enterprise sectorStrengthening the business environmentImproving functioning of the labor market