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1 27 Inernaional Moneary Fund Augus 27 IMF Counry Repor No. 7/269 Bosnia and Herzegovina: Seleced Issues This Seleced Issues paper for Bosnia and Herzegovina was prepared by a saff eam of he Inernaional Moneary Fund as background documenaion for he periodic consulaion wih he member counry. I is based on he informaion available a he ime i was compleed on June 29, 27. The views expressed in his documen are hose of he saff eam and do no necessarily reflec he views of he governmen of Bosnia and Herzegovina or he Execuive Board of he IMF. The policy of publicaion of saff repors and oher documens by he IMF allows for he deleion of marke-sensiive informaion. To assis he IMF in evaluaing he publicaion policy, reader commens are invied and may be sen by o publicaionpolicy@imf.org. Copies of his repor are available o he public from Inernaional Moneary Fund Publicaion Services 7 19h Sree, N.W. Washingon, D.C Telephone: (22) Telefax: (22) publicaions@imf.org Inerne: hp:// Price: $18. a copy Inernaional Moneary Fund Washingon, D.C.

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3 INTERNATIONAL MONETARY FUND BOSNIA AND HERZEGOVINA Seleced Issues Prepared by Mali Chivakul, Milan Cuc, Graham Slack (all EUR), Samir Jahjah (PDR), and Wojciech Maliszewski (FAD) Approved by he European Deparmen June 29, 27 Conen Page I. Overview...4 II. Exernal Balance Shee and he Curren Accoun Adjusmen Required o Sabilize Ne Foreign Liabiliies...6 A. Inroducion... 7 B. The Exernal Balance Shee... 8 C. Mehodology and Assumpions... 1 D. Main Resuls E. Conclusion and Policy Implicaions...15 Tables 1. Exernal Balance Shee, Composiion of Ne Exernal Posiion Projeced Exernal Balance Shee (a end 212) Assumpions on Real Rae of Reurns and GDP Growh Exernal Balance Shee (a end 217) Exernal Balance Shee (a end 222)...15 III. Deb Susainabiliy and he New Borrowing Rules...17 A. Inroducion...18 B. Mehodology...19 C. Resuls...21 D. Conclusions...26 Tex Boxes 1. Deb Laws Fiscal Pressures and Financing Assumpions...21

4 2 Figures 1. Borrowing Rules wih Three-Year Planning Horizon Borrowing Rules Five-Year Planning Horizon Probabiliy of Exceeding limis in Borrowing Rules wih Three-Year Planning Horizon...25 Annex Projecion Model...27 IV. Unemploymen and Labor Marke...3 A. Inroducion...31 B. Basic Facs...31 C. Explaining Unemploymen...38 D. Policy Implicaions...46 Tables 1. Esimaes of Unemploymen Raes...33 Figures 1. Labor Marke Oucomes, Regional Comparison, GDP and GDP Gap, Labor Tax Wedge Comparison, V. An Assessmen of Economic Cohesion...49 A. Inroducion...5 B. Evidence of Economic Convergence...5 C. Evidence of Economic Inegraion...55 D. Insiuional and Legislaive Barriers o Inegraion...56 E. Conclusions...57 Figures 1. Eniy Convergence ULCs, and Financial Deepening Descripive Saisics for Canons Unemploymen Company Mobiliy...56 VI. Credi Growh, Bank Soundness, and Banks Foreign Liabiliies...58 A. Inroducion...59 B. Recen Developmens in he Banking Secor...6 C. Empirical Invesigaion...68

5 3 D. Conclusions and Policy Implicaions...77 Tables 1. Financial Soundness Indicaors, Main Foreign Banks Mauriy Maching Requiremens Changes in Reserve Requiremens Credi Growh Regressions Disance of Defaul Regressions, wih year-on-year Credi Growh Disance o Defaul Regressions, wih quarer-on-quarer Credi Growh Banks Foreign Liabiliies Regressions...76 Figures 1. Credi Growh, January Cenral and Easern Europe: Credi o GDP Raio and Credi Growh, Developmens in Marke Srucure Key Feaures of he Credi Expansion Financing of Credi Expansion...65 Appendices 1. Daa Sources and Definiion Regional Comparison of Empirical Resuls Prudenial Regulaion: Inernaional Examples...81

6 4 I. Overview 1. On he basis of he srong performance of recen years, saff macroeconomic projecions show ha Bosnia & Herzegovina s medium-erm baseline oulook is sable (see accompanying saff repor). The momenum of robus growh in 26 is expeced o coninue in he coming years. Fiscal and exernal posiions are projeced o be in a comforable zone in he medium erm, even wih recen spending pressures. 2. This baseline projecion is reassuring, bu wo imporan quesions arise: Wih curren policies in place, will Bosnia & Herzegovina be able o keep his growh momenum in he longer erm? And wha are he risks o his oulook? Despie he recen good performance, Bosnia & Herzegovina sill suffers from a number of srucural weaknesses. Alhough weak policy coordinaion, he absence of a comprehensive fiscal sraegy, and srucural reform drif may no maer much in good imes, hey may become a drag o he economy in he longer run and gradually leave he counry increasingly vulnerable o changes in he exernal environmen. The Chapers in his Seleced Issues volume examine he risks and srucural weaknesses in Bosnia & Herzegovina. 3. Exending he analysis beyond he medium erm, Chapers II and III explore risks o longer-erm exernal and fiscal susainabiliy. On he exernal side, wha would be he consequences of mainaining persisenly high curren accoun deficis? Wih no change in policies, he curren accoun deficis would remain wide in he coming years and Bosnia & Herzegovina s ne foreign liabiliies (NFL) will keep growing from oday s level, which is below he regional average. To keep he exernal posiion susainable, he counry s NFL will have o sabilize a some poin. Chaper II provides an esimae of he curren accoun adjusmen required o sabilize NFL. I uses he exernal susainabiliy approach of he Consulaive Group on Exchange Rae Issues (CGER) mehodology for exchange rae assessmen, which is a deb dynamics accouning framework ha akes ino accoun all forms of foreign liabiliies (boh deb and equiy). The adjusmen is esimaed in he order of 8 percenage poins of GDP. The Chaper finds ha if he adjusmen were o sar now and span he nex 1 years, NFL would sabilize a a level below 6 percen of GDP. This seems feasible if he recen expor rends were o persis. In conras, if he adjusmen is delayed, he paper shows ha he level of NFL would reach abou 9 percen of GDP before i sabilizes. The Chaper poins o he need for an early sar of he adjusmen; posponing he reforms ha would ensure recen expor rends coninue would leave he economy wih very high NFL and hus vulnerable o changes in exernal environmen. 4. On he fiscal fron, could he newly-inroduced borrowing rules help reverse explosive deb dynamics and ensure fiscal susainabiliy? Previous saff analysis indicaed ha growing primary deficis combined wih he increasing share of non-concessional borrowing may lead o an explosive deb dynamics over he longer erm. Deb laws recenly adoped by he Sae and Eniies inroduce borrowing rules limiing fuure deb service as a percenage of las year s revenue. Chaper III uses a sochasic mehod, which akes ino

7 5 accoun uncerainy abou macroeconomic condiions, o assess he impac of hese new borrowing rules on deb dynamics. The resuls show ha he rules would indeed help mainain deb susainabiliy in he long erm. However, implemening he borrowing rules wihou a comprehensive policy framework and a long planning horizon may resul in inefficien expendiure compression and ulimaely undermine he credibiliy of he borrowing limis. 5. Beyond exernal and fiscal susainabiliy concerns, rigidiies in he labor marke could make i difficul for he economy o adjus o a changing environmen. Despie several years of robus growh, unemploymen a sign of inefficien use of resources remains subbornly high. Wha are he causes of high unemploymen in Bosnia & Herzegovina? Alhough he lack of high qualiy saisics makes i difficul o answer he quesion in a definie way, Chaper IV explores he available daa and possible hypoheses. I finds several signs poining o he problems on he supply side and o srucural rigidiies. These include wage policies, heavy axaion of labor, and he limied porabiliy of pension and healh insurance sysems, which may hinder labor mobiliy and discourage employmen creaion. 6. The lack of inernal economic inegraion is anoher rigidiy wih poenially imporan poliical repercussions. Differen policies and rules in he Eniies make capial and labor mobiliy difficul and disor marke incenives. Afer many years of acively promoing economic cohesion, have he auhoriies and he inernaional communiy succeeded in doing so? Chaper V examines he degree of economic cohesion in Bosnia & Herzegovina. I finds srong evidence of economic convergence beween he Eniies, wih he Republika Srpska (RS) caching up wih he Federaion. However, here is lile evidence of increased economic inegraion beween he wo, or wihin he Federaion. Promoing inernal economic cohesion in Bosnia & Herzegovina will require acceleraing srucural reforms in he Federaion and eliminaing he remaining barriers o capial and labor mobiliy wihin and beween he Eniies. 7. In he conex of rapid credi growh, which has accompanied economic growh in recen years, risks o financial sabiliy canno be ignored. These risks are explored in Chaper VI. Specifically, he Chaper empirically examines he relaionship beween credi growh, bank soundness, and banks foreign liabiliies, and ess he effecs of pas policy measures o curb credi growh. The Chaper shows ha he financial deepening process in Bosnia & Herzegovina has been in line wih regional rends. I finds ha policy measures o curb credi growh have no been effecive, which poins o he imporan role of prudenial supervision o minimize he risks o financial sabiliy. The Chaper also finds ha foreignowned banks appear o run a higher risk of insolvency. This finding highlighs he imporance of cooperaion wih home-counry supervisors o closely monior local subsidiaries or branches of foreign banks.

8 6 II. EXTERNAL BALANCE SHEET AND THE CURRENT ACCOUNT ADJUSTMENT REQUIRED TO STABILIZE NET FOREIGN LIABILITIES 1 A abou 5 percen of GDP, Bosnia & Herzegovina s ne foreign liabiliies oday are close o he average of Easern European counries. Gross official reserves are a a comforable level, exernal public deb is low and largely a concessional erms, and foreign direc invesmen has recenly been increasing. However, in he saff baseline macroeconomic framework (no policy change), he curren accoun defici remains high, and is projeced o say a a level ha would imply a seady rise in ne foreign liabiliies over he medium erm. A some poin, he counry s exernal balance shee will have o sabilize if Bosnia & Herzegovina s exernal posiion is o be susainable. The only way o achieve his is a subsanial adjusmen in he curren accoun. Alhough he curren accoun has improved significanly over he las couple of years, a lo more will be needed o sabilize ne exernal liabiliies. In addiion, alhough foreign direc invesmen inflows do no creae deb, hey do raise he foreign liabiliies of he privae secor and will generae an increasing ouflow of income paymens in he form of profi repariaion. This fuure ouflow has o be aken ino accoun when esimaing he required curren accoun adjusmen ha would sabilize he counry s exernal balance shee. This paper provides an esimae of he curren accoun adjusmen required o sabilize ne foreign liabiliies. I uses he exernal susainabiliy approach of he Consulaive Group on Exchange Rae Issues (CGER) mehodology for exchange rae assessmen, which is a deb dynamics accouning framework ha akes ino accoun all forms of foreign liabiliies (boh deb and equiy). This adjusmen is esimaed around 8 percenage poins of GDP. An adjusmen of his magniude can only happen gradually over ime. Two key quesions are: when will i sar? and how long will i ake? This paper assumes ha he adjusmen will ake place over a 1-year horizon. Two scenarios are considered. The firs scenario, an early adjusmen, is based on he assumpion ha he adjusmen would sar in 27. The second scenario, a delayed adjusmen, is based on he assumpion ha he adjusmen would sar only in he nex decade. The resuls show ha, in he early adjusmen scenario, he NFL would sabilize a around 56 percen of GDP by 217. This is sill a relaively low level by inernaional sandards. In conras, in he delayed adjusmen scenario, he level of NFL would reach abou 9 percen of GDP before i sabilizes. The wo scenarios illusrae he imporance of early adjusmen, which is feasible if he recen expor rends persis. Alhough a slower adjusmen hrough a more gradual pace of reforms migh be poliically easier, he end resul of a very high level of NFL would leave he economy vulnerable o changes in he exernal environmen. 1 Prepared by Samir Jahjah.

9 7 A. Inroducion 8. Bosnia & Herzegovina s ne foreign liabiliies (NFL) have been growing in recen years and reached abou 5 percen of GDP a end-26, close o he average of Easern European counries. Similar o he experience of many Cenral and Easern European (CEE) counries, Bosnia & Herzegovina has been running large curren accoun deficis and accumulaing exernal liabiliies in recen years. Commercial bank borrowing and foreign direc invesmen (FDI) have been he main conribuors o growh in NFL. 9. NFL relaive o he size of he economy will have o sabilize a some poin o ensure he susainabiliy of he counry s exernal posiion; his will require a much reduced curren accoun defici. Despie a recen decline, Bosnia & Herzegovina s curren accoun defici remains high, and is projeced o say around he same level in he medium erm. This implies increasing ne exernal liabiliies and income paymens, boh in he form of ineres paymen and profi repariaion. Taking his fuure ouflow ino accoun, he required adjusmen in curren accoun o sabilize NFL can be subsanial. 1. This Chaper provides an esimae of he curren accoun adjusmen required o sabilize ne foreign liabiliies. I uses he exernal susainabiliy approach of he Consulaive Group on Exchange Rae Issues (CGER) mehodology for exchange rae assessmen, which is a deb dynamics accouning framework ha akes ino accoun all forms of foreign liabiliies (boh deb and equiy) o calculae he adjusmen. The calculaed adjusmen depends on he ousanding sock of accumulaed liabiliies, oupu growh, and he expeced reurns on exernal asses and liabiliies. 11. The mehodology used in his Chaper involves hree main seps. Firs, he composiion of he exernal balance shee of he counry a end-26 is esimaed. Second, he exernal balance shee a end-212 is projeced in line wih he saff medium-erm baseline macroeconomic scenario. Third, using simple deb dynamics accouning, he curren accoun adjusmen required o sabilize NFL is esimaed. 12. Two scenarios are hen considered. The level a which NFL sabilize depends on when Bosnia & Herzegovina will sar adjusing and how long i will ake. Firs, a scenario ha assumes an early adjusmen is esimaed. This scenario assumes ha he adjusmen would sar immediaely and span a 1-year horizon. A delayed adjusmen scenario is hen considered. I assumes ha he adjusmen would only sar a he end of he decade, and also span a 1-year horizon. A delayed and long adjusmen period would imply coninued buildup of liabiliies before hey sabilize. 13. The resuls illusrae he imporance of an early sar of he adjusmen. Alhough a gradual adjusmen would allow more ime and migh be easier poliically, a high level of NFL could leave he economy vulnerable o changes in he exernal environmen and could

10 8 undermine he viabiliy of he currency board. The case for an early sar is even sronger if Bosnia & Herzegovina is o underake ambiious infrasrucure invesmens in he coming years, ha would imply addiional foreign liabiliies o hose assumed in he baseline. Curren siuaion B. The Exernal Balance Shee of Bosnia & Herzegovina 14. A end-26, he gross exernal liabiliies of Bosnia & Herzegovina are abou 9 percen of GDP (Table 1). Liabiliies are equally spread beween deb and equiies (porfolio and FDI-relaed liabiliies). The governmen exernal deb is small and mainly on concessional erms. Table 1 : BiH : Exernal balance shee (a end 26) (in percen of GDP) Asses Liabiliies Moneary auhoriy 3.6 Commercial banks Governmen 23.4 of which London Club 1.4 Privae Equiy Porfolio 18.4 FDI 27.9 Toal Source : CBBH 15. Deb asses are below he average of oher counries and are concenraed in he moneary auhoriy and he commercial banks. Deb asses are abou 44 percen of GDP, wo-hird of which belong o he moneary auhoriy. The average in he region is 3 percenage poins higher. Compared o oher currency boards, Bosnia & Herzegovina s level of inernaional reserves is relaively low (Table 2). 16. While equiy liabiliies are already above he average of oher counries in he region, hey are expeced o increase furher. Equiy liabiliies are esimaed a 46 percen of GDP, 4 percenage poins higher han he region s average, bu well below Esonia, Hungary, and Czech Republic. As he auhoriies pursue heir privaizaion effors and

11 9 srucural reforms, FDI is likely o increase in he medium erm. In he nex wo years, large FDI is expeced in he elecom, refinery, and elecriciy secor. 17. The level of ne foreign liabiliies is close o he average in Easern European counries. NFL sands a 48.6 percen of GDP, jus above he average of 48.2 in oher Easern European counries. Deb liabiliies are below he average. This low level of indebedness reflecs low fiscal deficis in he pas, bu also a weak implemenaion of donor-financed projecs. Table 2. Composiion of Ne Exernal Posiion (in percen of GDP) Deb Asses Equiy Asses Deb Liabiliies Equiy Liabiliies NFL Esonia Hungary BiH 1/ Croaia Lavia Poland Bulgaria Lihuania Slovak Republic Romania Czech Republic Slovenia Average (excl. BiH) / As of end 26, Saff Esimaes; 24 for he oher counries Source: Lane and Milesi-Ferrei, 26 Medium-erm projecion 18. The medium erm oulook (27-12), based on he baseline (unchanged policies) scenario in he accompanying saff repor, is sable, suppored by a relaively benign exernal environmen. Expors will coninue o grow, alhough he growh will slow down saring from 28. Falling meal prices will parly offse growing expor volumes. GDP growh will decline slowly, averaging 5.2 percen, and he curren accoun defici is expeced o remain around 13 percen of GDP. Significan FDI inflows are expeced over he nex wo years, bu hey will abae in subsequen years, reflecing a slowdown in srucural reforms. The fiscal posiion will deeriorae, bu would be offse by GDP growh. Afer an iniial jump due o he issuance of bonds o cover domesic claims, he public deb-o-gdp raio will decline over he projecion period. 19. A he end of he medium erm period in 212, NFL are projeced o reach abou 61 percen of GDP. This increase is mainly driven by FDI flows, a coninued increase in banks borrowing and declining foreign asses of he cenral bank (Table 3). The increase in FDI is relaed o he privaizaion of RS Telecom as well as oher projeced FDIs in refineries and oher indusries. During he medium erm, new governmen borrowings are assumed o be on marke erms. The srucure of exernal public deb, which was almos enirely concessional a end-26, will herefore become increasingly non-concessional.

12 1 Table 3 : BiH : Projeced exernal balance shee (a end 212) (in percen of GDP) Asses Liabiliies Moneary auhoriy 28.7 Commercial banks Governmen 15.8 of which London Club.2 of which non concessional 3. Privae Equiy Porfolio 18. FDI 44.2 Toal Source : Saff Esimaes C. Mehodology and Assumpions 2. To deermine he curren accoun ha would sabilize ne foreign liabiliies, a simple accouning framework ha akes ino accoun all componens of he exernal balance shee is developed. The mehod differs from a sandard deb susainabiliy analysis (DSA) in ha he class of asses and liabiliies and heir respecive rae of reurns are explicily disinguished. The analysis is also carried on beyond he medium erm projecion covered in he sandard DSA. 21. The mehodology, which is used in CGER assessmens of exchange rae, provides he analyical foundaion o esimae he curren accoun balance ha would sabilize he NFL. The approach, developed by Lane and Milesi-Ferrei (26), links he ne exernal posiion, he curren accoun, he rade balance, and he raes of reurn on he exernal porfolio. The mehodology allows, for a given srucure of he exernal porfolio, o esimae he seady-sae curren accoun balance required o sabilize NFL. A counry s ne exernal liabiliies canno coninually increase relaive o he size of he economy. The required adjusmen depends on he accumulaed sock of exernal liabiliies, he cos of servicing hem, and he GDP growh. The cos of servicing liabiliies depends on he srucure of he

13 11 porfolio. Servicing will be low if liabiliies are mainly a concessional erms. I will be higher if equiy liabiliies represen a higher share of he porfolio. The accouning framework In his secion an accouning framework ha links he dynamics of exernal liabiliies o he curren accoun and economic growh is presened. 23. The change in he ne foreign asse posiion B is given by B B 1 = CA + KG + E (1) where CA is he curren accoun balance, KG is he capial gain or loss on ne foreign asses and E includes capial accoun ransfers and error and omissions. 24. By expressing (1) in raio o GDP (represened wih lower-case leers), and assuming zero capial gain 3, equaion (1) becomes b b ca 1 1 (1 + g )(1 + π ) g + π b + ε (2) where g is he growh rae of real GDP, π is he inflaion rae, and ε he raio of capial ransfers and errors and omissions o GDP. Ignoring he laer erm, he equaion relaes he curren accoun balance needed o sabilize he nex exernal posiion and he nominal GDP growh. 25. The curren accoun balance ha would sabilize b is derived by seing b = b -1 in ss ss equaion (2). This yields ca ( g + π ) b. For example, in a counry running a 7 percen curren accoun defici and growing a 8 percen in nominal erms, NFL would sabilize a abou 9 percen of GDP. A growing counry can susain a permanen curren accoun defici, and his defici can be larger he larger he growh rae and he larger he sock of exernal liabiliies. However, larger exernal liabiliies require a sronger balance of goods and services o offse he higher income paymens associaed o he liabiliies. 26. Equaion (2) can be furher expanded by decomposing he exernal porfolio ino is asses A and liabiliies L. Doing so yields 2 This secion is based on Lane and Milesi-Ferrei (26) Capial Flows o Cenral and Easern Europe, IMF Working Paper 6/ Given he currency board arrangemen of he KM wih he euro, and given ha mos asses and liabiliies are in euro, we can ignore capial gains wihou affecing he conclusion of he analysis.

14 12 L A b g g Y L i A i bgs b b ε π π ) )(1 (1 (3) where bgs is he balance of goods, services, and ransfers, A and L are exernal asses and liabiliies, and i A and i B heir respecive nominal yields. 27. Equaion (3) can be expressed in funcion of real rae of reurn on foreign asses and liabiliies: L A l g g r a g g r bgs b b ε (4) where r represens he real rae of reurn, defined as = A A i r π and = B B i r π. 28. If reurns on asses and liabiliies are idenical, equaion (4) becomes he sandard deb accumulaion equaion ( ) = b g r bgs b b. To preven he raio of exernal liabiliies o GDP o grow indefiniely, a ne debor (b<) mus achieve a rade surplus if he rae of reurn exceeds GDP growh (r>g). If reurns on asses and liabiliies are differen, as i is mos ofen he case, he srucure of he balance shee will affec he esimaion of he rade balance required o sabilize ne exernal liabiliies. For example, if he sock of asses and liabiliies is abou 1 percen of GDP and a counry pays a rae of reurn on is liabiliies which exceeds he reurn on is asses by 1 basis poin, he rade surplus necessary o sabilize he ne exernal posiion will be 1 percenage poin of GDP higher han in he absence of reurn differenial. 29. A furher refinemen is o decompose asses and liabiliies ino heir deb and equiy componens. Expeced reurns on deb and equiy are likely o differ subsanially as exernal financing in Bosnia & Herzegovina is shifing away from concessional deb o privae equiy. Equaion (4) becomes: D DL EQ EQ D DA EQ EQ l g g r l g g r a g g r a g g r bgs b b ε (5) where EQ and D idenify he deb and equiy componens of exernal asses and liabiliies and heir respecive raes of reurn. 3. Once equaion (5) is parameerized, he curren accoun balance needed o sabilize he ne exernal posiion is derived by seing b = b -1. This sabilizing curren accoun balance depends on he assumpions on economic growh, real reurns on deb and equiy asses and liabiliies and heir respecive levels in percen of GDP.

15 13 Main assumpions 31. The curren accoun required o sabilize he NFL is derived using equaion (5) and he following assumpions: All deb insrumens carry he Euro Libor as he base ineres rae. Exernal liabiliies are assumed o carry a sovereign risk premium of 2 basis poins. These assumpions are consisen wih he assumpion in he Deb Susainabiliy Analysis (DSA) in he saff repor. The rae of inflaion is se a 2 percen, boh in Bosnia & Herzegovina and in Europe. Reurns on equiy, mosly FDI-relaed, is assumed o move ogeher wih GDP growh. A an aggregae level, reurns on FDI will be correlaed wih he overall performance of he economy. Higher GDP growh ranslaes ino more profis and repariaion. Conversely, in a slowing economy, declining profis will reduce repariaion. The expeced real reurns on privae equiy are hus assumed o be equal o he projeced real GDP growh plus a consan spread of 1 basis poins over he growh rae 4. Transfers and non-financial income is assumed o remain sable. Therefore, mos adjusmen in he curren accoun have o originae in he balance of goods and services. Table 4. Assumpions on Real Rae of Reurns and GDP Growh Real GDP Growh LIBOR Euro 1/ Governmen liabiliies FDI 2/ Concessional Non-concessional / WEO (average over ) 2/ Following Lane and Milesi-Ferrei (26) we suppose a 1 poin spread over he growh rae 32. In an early adjusmen scenario, a ransiional pah is derived saring in 27 so ha NFL would be sabilized in 217. The adjusmen would span a 1-year period and is assumed o come mainly from coninued growh in expors. 33. To consider a delayed adjusmen scenario, a ransiional pah is derived so ha, NFL would be sabilized a end-222. In his case, he adjusmen would also span a 1-year period, saring in 212. During he ransiion, he curren accoun defici, while on a declining pah, will hover above is NFL-sabilizing level, and exernal liabiliies will coninue o 4 The spread of 1 bps over he GDP growh is similar o he assumpion used in Lane and Milesi-Ferrei (26).

16 14 increase. As liabiliies coninue o build up, he sabilizing curren accoun is esimaed again, in a recursive way. 34. A series of assumpions perain o he financing of he curren accoun during he ransiion period for boh scenarios. The curren accoun defici is financed eiher by deb accumulaion, foreign direc invesmen or drawing down of inernaional reserves. During he ransiion, FDI is se a 3.3 percen of GDP, heir level projeced a he end of he medium erm period. Ne public deb accumulaion is se a 1.5 percen of GDP, in line wih he projeced public defici a he end of he medium erm. Ne exernal borrowing by commercial banks is linked o GDP. If hese sources are insufficien o finance he curren accoun, inernaional reserves will decline. Lasly, a depreciaion rae of capial of 5 percen is assumed. Real GDP growh is 5.2 percen. D. Main Resuls 35. In he early adjusmen scenario, NFL would sabilize a 56 percen of GDP by end-217 (Table 5). The curren accoun defici needed o sabilize NFL in 217, given an early adjusmen, is around 5.5 percen of GDP, compared o he projeced defici of 13.5 percen in 27. The required adjusmen is hus abou 8 percenage poins of GDP. Table 5 : BiH : Exernal balance shee (a end 217) (in percen of GDP) Asses Liabiliies Moneary auhoriy 46.4 Commercial banks Governmen 23.3 Privae Equiy Porfolio 18. FDI 49.3 Toal Source : Saff esimaes 36. In he delayed adjusmen scenario, NFL would coninue o build up, o reach abou 9 percen of GDP by end-222 (Table 6). Higher liabiliies ranslae ino higher ne income paymens a abou 5.7 percen of GDP, compared wih 4 percen of GDP a end The required adjusmen in he curren accoun would also be abou 8 percen of GDP in his case. The curren accoun defici required o sabilize exernal liabiliies a his

17 15 level would be around 5.7 percen of GDP, compared wih average projeced curren accoun of 13.5 percen beween A delayed and long duraion of adjusmen will leave he counry in a more vulnerable posiion (Table 6). A level of NFL as high as 9 percen of GDP, way above he regional average, increases he vulnerabiliy o shocks in ineres raes, overall liquidiy condiion, and marke senimen. Governmen exernal deb will be abou 4 percen of GDP. Reserves of he cenral bank would end up a a much lower level han a he onse of he adjusmen, weakening he capaciy o susain he currency board. Table 6 : BiH : Exernal balance shee (a end 222) (in percen of GDP) Asses Liabiliies Moneary auhoriy 22.8 Commercial banks Governmen 3. Privae Equiy Porfolio 18. FDI 53.2 Toal Source: Saff esimaes. E. Conclusion and Policy Implicaions 39. This Chaper provides an esimae of Bosnia & Herzegovina s exernal porfolio. In he medium-erm baseline, he exernal posiion of Bosnia & Herzegovina remains sound, wih large exernal inflows supporing invesmen and growh. However, ne foreign liabiliies coninue o grow. 4. The only way o sabilize ne exernal liabiliies is o lower he curren accoun defici. The curren accoun adjusmen required o sabilize exernal liabiliies is esimaed using a seady-sae deb dynamics framework. This is similar o he exernal susainabiliy

18 16 approach of he CGER mehodology for exchange rae assessmen. The adjusmen in he curren accoun defici needed o sabilize NFL is esimaed a abou 8 percen of GDP. 41. This magniude of adjusmen can only ake place gradually over ime, bu a delayed adjusmen would leave he counry wih a very high NFL level. If he adjusmen were o sar now, he NFL would no increase much unil i sabilizes a a level below 6 percen of GDP in 217. This is sill a relaively low level by inernaional sandards. A delayed adjusmen period, however, will increase NFL o a very high level, leaving he counry vulnerable o changes in exernal environmen. 42. The Chaper illusraes he imporance of early adjusmen, which is feasible if he recen expor rends persis. This would be condiional on furher srucural reforms o increase compeiiveness of he economy and is araciveness o foreign invesors. The case for an early sar of he adjusmen is even sronger if Bosnia & Herzegovina is o underake ambiious infrasrucure invesmens in he coming years. Large invesmens, like he corridor Vc road projecs, will generae sizeable addiional foreign liabiliies, be i deb or equiy, which would require an even larger curren accoun adjusmen.

19 17 III. DEBT SUSTAINABILITY AND THE NEW BORROWING RULES 5 Previous saff analysis indicaed ha he resuls of he medium-erm public deb susainabiliy analysis in he 26 saff repor are poenially misleading. Even large primary deficis sabilize he deb raio over he medium erm since he exising deb is highly concessional. Bu growing primary deficis combined wih he increasing share of non-concessional borrowing migh lead o an explosive deb dynamics over he longer erm. This paper exends he previous analysis by assessing he impac of he newly-inroduced borrowing rules on deb dynamics. The rules limi governmen borrowing by resricing allowable deb service as a percenage of pas year s revenue. The paper assumes ha he adjusmens required o mee hese ceilings are underaken by slowing cerain caegories of expendiures when he limi is expeced o be exceeded. Wih hese new rules in place, he behavior of he deb raio is analyzed using a sochasic mehod. Uncerainy abou macroeconomic condiions complicaes he assessmen of deb susainabiliy: while a policy may look susainable under he mos likely macroeconomic scenario, downward risks o he cenral projecion may be subsanial, poenially leading o cosly policy adjusmens in he fuure. The paper simulaes fuure pahs for he main macroeconomic variables aking ino accoun heir volailiy and co-movemens, and summarizes risks o deb dynamics using he frequency disribuion of he fuure deb-o-gdp raio ( fan chars ). The implemenaion of he borrowing rules pus he deb raio on a firmly declining pah. Deb raios iniially increase, bu hey are quickly reversed when he governmens adjus o avoid breaching he rules. The consolidaed budge improves afer an iniial decline. Bu implemening he borrowing rules wihou a comprehensive policy framework may resul in inefficien expendiure cus. The projecion horizon in he exising medium-erm expendiure framework (MTEF) is oo shor o fully assess he implicaions of new borrowing on fuure deb servicing coss. In he absence of a longer planning framework, ad hoc adjusmens would be necessary, which could be a odds wih governmen spending prioriies and compromise efficiency. 5 Prepared by Wojciech Maliszewski.

20 18 A. Inroducion 43. An exended-horizon deb susainabiliy analysis (DSA) (see for example Chaper II in IMF Counry Repor No. 6/368) shows longer-erm vulnerabiliies no revealed in a sandard medium-erm deb susainabiliy analysis. Over a 5-year horizon, public deb would remain sable even wih relaively large primary deficis, due o high concessionaliy of he ousanding deb. Bu growing primary deficis and he increasing share of nonconcessional borrowing would lead o explosive deb dynamics over he longer erm (15-2 years). 44. This paper analyzes he impac of he newly-inroduced borrowing rules on he longer-erm deb dynamics. Deb laws adoped (or close o being adoped) in he Sae and Eniies inroduce borrowing rules limiing fuure deb service as a percenage of las year s revenue (see Box 1). Since he limi is imposed on oal deb service in any year afer he loan is conraced, full implemenaion of he rules requires projecions of fuure deb service coss. A precise framework for he implemenaion has no ye been esablished, hence he paper compares wo possible ways of applying he rules: using a hree-year planning horizon (consisen wih he curren MTEF) and a five-year planning horizon (sipulaed in he Sae Deb Law). The scope for possible adjusmens o comply wih he limis is assumed o be in line wih pas adjusmen effors limied o slowing down cerain caegories of expendiures. The analysis, however, does no specify how hese adjusmens are underaken when he limi is expeced o be breached. 45. The analysis uses a sochasic mehod o evaluae risks o deb dynamics semming from macroeconomic uncerainy (see similar examples in Celasun, Debrun, and Osry (26), and Garcia and Rigobon (24), Tanner and Samake (26)). Uncerainy abou macroeconomic condiions complicaes he assessmen of deb susainabiliy: while a policy may look susainable under he mos likely macroeconomic scenario, downward risks o he cenral projecion may be subsanial under oher less likely, bu sill plausible scenarios. The sochasic mehod simulaes fuure pahs for macroeconomic and fiscal variables aking ino accoun heir volailiy and co-movemens, summarizes he risks o deb dynamics using he frequency disribuion of he fuure deb-o-gdp raio pahs ( fan chars ), and shows a probabiliy ha borrowing rules limis will be breached. 46. Borrowing rules reduce bu do no eliminae he impac of macroeconomic shocks on deb dynamics. For insance, in case of negaive shock o revenue, he rules could limi spending financed by borrowing o a cerain exen. Because he expendiure adjusmen is by assumpion consrained, i may no be sufficien o ensure compliance wih he rules and susainabiliy.

21 19 Box 1. Deb Laws Laws on Deb and Borrowing ( Deb Laws ) have been adoped by he Sae and he RS. The adopion of he Federaion draf law has been slowed down by parliamenary procedures, bu is expeced soon. Borrowing rules The deb service limi in any fuure year in he Federaion is se a 18 percen of he previous year s consolidaed revenue. Wihin his limi, he maximum value for canons is 5 percen of heir previous year s revenue. The limi for municipaliies is iniially igher, a 3 percen of revenues for he firs wo years afer he law is passed, bu increases o 5 percen for he wo following years, and o 1 hereafer. All limis cover deb guaranees. The deb service limi in he RS is se a 18 percen of he previous year s consolidaed revenue. Municipal limi is also se a 18 percen. Sae deb service canno exceed 18 percen of he previous year s revenue. The limi is se for a period of hree years from he day he law becomes effecive, and will be subjec o annual review. Sae guaranees canno exceed 3 percen of Sae revenue. Insiuional framework The Sae Minisry of Finance prepares a five-year Sae Deb Managemen Sraegy in cooperaion wih Deb Commiee. The Deb Commiee is an advisory body composed of wo represenaives of he Council of Minisers (including a Miniser), a represenaive of he Cenral Bank, wo represenaives of he Federaion (including he Miniser of Finance), wo represenaives of he RS (including he Miniser of Finance), and he Direcor of Revenue Adminisraion of he Brcko Disric. The Deb Commiee in he Federaion is composed of he Federal and canonal Minisers of Finance and coordinaes deb managemen in he Eniy. RS municipaliies mus reques an agreemen from he Minisry of Finance o borrow in firs hree years afer he adopion of he law. Afer he ransiion period, agreemens will be required for foreign currency borrowing or if projeced deb service exceeds 1 percen B. Mehodology 47. Sochasic projecions o assess deb dynamics wih borrowing rules are consruced as follows: (1) for a given year, macroeconomic variables are simulaed using a simplified model of he Bosnian economy wih sochasic shocks (see Annex); (2) unadjused fiscal projecions are consruced for he same year, assuming based on he simulaed macro-variables ha revenues and expendiures grow in line wih he GDP or respecive ax bases, and aking ino accoun known fiscal pressures and financing assumpions (see Box 2); (3) he projecion is exended eiher 3 or 5-years ahead using a non-

22 2 sochasic version of he model (wihou shocks) o check if he borrowing rules limi is exceeded; (4) if he limi is exceeded, he curren year s budge is reduced by slowing expendiures, bu sill accommodaing fiscal pressures described in Box 2. Projecions are consruced for every year beween 28 and 22, and he exercise is repeaed several imes o consruc a random sample of possible macro- and fiscal-oucomes. Each oucome is associaed wih a cerain deb pah, and frequency disribuions of he deb-o-gdp raio are derived for each year of he projecion. 48. Fiscal adjusmens, when needed, are assumed o be in line wih previous episodes. A subsanial adjusmen on he expendiure side beween 23 and 26 equivalen o 4½ percen of GDP was broad-based, bu wih pronounced reducions in capial expendiures (4 percen of GDP) and he wage bill (1½ percen of GDP). We analogously assume ha when he borrowing limi is binding, fuure adjusmens will resric wage increases o he rae of inflaion and keep capial expendiures unchanged in nominal erms. In addiion, pension increases will be indexed o inflaion, and ransfers o households will remain unchanged in nominal erms. These adjusmens are no necessarily opimal. Indeed cus in invesmen spending may have adverse consequences on growh given he need for infrasrucure improvemens. Bu in he absence of a clear longer-erm expendiure plan and a fiscal policy coordinaion mechanism beween he Eniies and he Sae, he only possible assumpion abou fuure adjusmens o mee he deb servicing ceilings is ha hey will follow he paern of pas experience. 49. Deb dynamics are summarized by fan chars, represening he frequency disribuion of he deb raio. Differen shades on he char delineae deciles in he disribuions of he raio, wih he zone in black represening a 2 percen confidence inerval around he median projecion, and progressively ligher grey zones respecively showing 4, 6 and 8 percen inervals. If he upper bound of he 8 percen inerval is above he iniial deb raio for some projecion years, i may be inerpreed as an over 2 percen probabiliy ha he deb-o-gdp will increase above he iniial level in hese years. 5. Probabiliies of exceeding he borrowing limi are also derived, consruced for all years as a frequency of exceeding he borrowing rules limi in he sample simulaed using he same sochasic framework.

23 21 Box 2. Fiscal Pressures and Financing Assumpions Revenues gradually decline due o rade liberalizaion and a slowdown in impor and consumpion growh (affecing rade axes and VAT revenue), and worsening demographics (affecing social securiy conribuions, wih pension funds operaing on curren basis). Grans are also on decline. Expendiures increase wih he unificaion of Miliary and Police wages, and worsening demographics affecing social securiy benefis under he curren pension sysem. Domesic claims are assumed o add 18 percenage poins of GDP o he deb level in 27, and an addiional 1 and 5 percenage poins in 28 and 29 respecively. The 27 jump is due o he selemen of frozen foreign currency deposis (FFCD), war claims, and general governmen obligaions. The average gran elemen is 25 percen. Addiional increases in 28-9 are assumed o cover he possible recogniion of addiional domesic claims (losses of sae enerprises, resiuion claims, and oher poenial claims) on erms similar o hose for he selemen of FFCDs. Concessional exernal borrowing shrinks, alhough gran suppor remains significan. IDA disbursemens are assumed o fall from ½ percenage poin of GDP in 27 o zero afer 211. Grans decline gradually. Borrowing on commercial erms (wih a projeced mauriy of five years and ineres rae a LIBOR a 5 percen + 2 basis poins and) is assumed o cover any addiional financing needs. Domesic borrowing on commercial erms (five year mauriy and ineres rae equal o euro LIBOR simulaed from he model as described in he Annex + 2 basis poins) o cover addiional financing needs. Privaizaion receips amoun o 7½ percen of GDP in 27 in he RS (from he sale of he RS Telecom and refining operaions) and of 1½ percen in he Federaion (from he sale of Aluminij Mosar and Energoinves). No furher receips are assumed afer 27. C. Resuls 51. The resuls indicae ha he new borrowing rules would preven he adverse deb dynamics under boh hree-year and five-year planning horizons. 6 Deb would iniially increase, bu reurn firmly ono a declining pah from 29 in boh Eniies (Figures 1 and 2). 6 Resuls wihou borrowing rules in place (no repored) are similar o hose repored in IMF Counry Repor No. 6/368 Chaper II and show an explosive dynamics of deb driven by growing primary deficis combined wih increasing coss of servicing he exising deb.

24 22 Deb reducion would be faser in he RS, where he iniial 27 fiscal posiion is sronger and subsanial privaizaion receips reduce borrowing needs. Possible macroeconomic shocks do no seem o have he poenial o deflec deb from he declining pah. 52. The hree-year planning horizon iniially produces relaively high deficis, which recede slowly, leading o a high probabiliy of exceeding he borrowing rules limis. A firs, he governmens do no fully anicipae he impac of a new borrowing on fuure deb service coss and increase expendiures. The resuling subsanial increase in he defici is difficul o reverse, as he paper assumes ha adjusmens are underaken only hrough slowing down spending and ha idenified expendiure pressures are accommodaed. In effec, he consolidaed budge posiion improves slowly o achieve a close-o-balance posiion only a he end of he simulaion period, and he borrowing rules limis are likely o be exceeded. The probabiliy of exceeding he limis increases o one in he Federaion and o ¾ in he RS afer 215 (Figures 3). Despie breaching he limis, he assumed adjusmen effor is sill sufficien o ensure deb susainabiliy. 53. The five-year planning horizon also generaes an iniial fiscal relaxaion, bu i is less pronounced han under he shorer horizon and reverses faser o a balance. In his case, he exended planning horizon limis iniial expendiure increases and allows governmens o achieve a sronger fiscal posiion, which faciliaes meeing he borrowing rules limis. The fiscal posiion improves from a small defici a he beginning of he period o close-o-balance in 215 and beyond. The probabiliy of exceeding he limis is lower han under he hree-year horizon: i slowly approaches ¾ in he Federaion in 219 and hen sars declining; and is negligible hroughou he simulaion period in he RS. The lower iniial deficis, he faser adjusmen o a balance, and he lower probabiliy of exceeding he limi reflec he governmens abiliy o beer anicipae consequences of increased expendiures on fuure deb service coss.

25 23 Figure 1. Bosnia & Herzegovina: Borrowing Rules wih Three-Year Planning Horizon (% of GDP) BIH Public Deb Federaion Public Deb RS Public Deb BIH Balance 4 3 Federaion Balance 4 3 RS Balance BIH Primary Balance Federaion Primary Balance RS Primary Balance Source: Saff calculaions. Noes: Chars presen perceniles of projeced oucomes. Black area corresponds o a 2 percen confidence inerval

26 24 Figure 2. Bosnia & Herzegovina: Borrowing Rules wih Five-Year Planning Horizon (% of GDP) BIH Public Deb Federaion Public Deb RS Public Deb BIH Balance 4 3 Federaion Balance 4 3 RS Balance BIH Primary Balance 5 4 Federaion Primary Balance 5 4 RS Primary Balance Source: Saff calculaions. Noes: Chars presen perceniles of projeced oucomes. Black area corresponds o a 2 percen confidence inerval

27 25 Figure 3. Bosnia & Herzegovina: Probabiliy of Exceeding Limis in Borrowing Rules wih Three-Year Planning Horizon Federaion RS Source: Saff calculaions. Figure 4. Bosnia & Herzegovina: Probabiliy of Exceeding Limis in Borrowing Rules wih Five-Year Planning Horizon Federaion RS Source: Saff calculaions.

28 26 D. Conclusions 54. The borrowing rules are a useful ool o ensure susainabiliy, bu heir full implemenaion may be difficul due o capaciy and poliical consrains. The simplified rules considered in his paper can sop he adverse deb dynamics, alhough weak planning may make heir implemenaion in Bosnia & Herzegovina difficul. The hree-year horizon, hough consisen wih curren MTEF, is oo shor o fully assess he impac of new borrowing on fuure deb service coss. Moreover, he MTEF does no ye guide he annual budge process: alhough MTEF arges should form a basis for annual budge plans, "las-minue" spending iniiaives ofen overrule MTEF arges, poining o a weak ownership of his exercise by policymakers. In he absence of a longer-erm expendiure plan, ad-hoc adjusmens o mee he rules will herefore likely be a odds wih he counry s needs and he governmen s spending prioriies. A well-planned adjusmen on he oher hand, in line wih he World Bank Public Expendiure Review recommendaions, would be more efficien and would furher reduce risks of unsusainable deb dynamics hrough deeper and poenially more durable adjusmens. 55. The balanced budge recommended by saff as a medium-erm fiscal anchor avoids large fiscal swings generaed by he simplified rules analyzed in his paper. A sharp iniial increase in expendiures would be complian wih he borrowing rules, especially when assessed using a shor planning horizon. Bu increasing borrowing coss semming from he increase in expendiures bu also from increasing coss of servicing he exising deb would require subsequen adjusmens. These adjusmens would be poliically difficul as hey would be esing governmens commimens o he newly esablished rules. Mainaining a balanced-budge posiion would help avoid hese problems. 56. While he sochasic mehodology is beer a assessing risks han he sandard deerminisic approach, he resuls sill need o be inerpreed wih cauion. There is subsanial uncerainy surrounding he srucure of he model (very simplified for he purpose of his exercise), esimaed parameers, and assumpions abou fuure policies. These facors are no refleced in he repored fan chars, so he uncerainy surrounding deb dynamics is likely o be larger han repored on he graphs.

29 27 Annex Projecion Model The model used in he projecion is a simplified version of he saff macroeconomic framework wih sochasic shocks. Macroeconomic variables are projeced as follows: GDP growh. Real GDP growh is governed by Cobb-Douglas funcion wih sandard coefficiens for labor and capial inpus (.7 and.3 respecively) and exogenous produciviy growh. Invesmen rae is fixed a 2 percen of GDP, wih privae invesmens deermined residually. Capial depreciaes a an annual rae of 5 percen. Iniial capial sock (in 2) is a 15 percen of GDP. Labor grows in line wih projeced working-age populaion growh (implying a gradual decline afer 215 due o adverse demographics). Average produciviy growh is 1.4 percen per year (average for he 2-5 period). Ne Expors. Expors of meals depends on exogenous producion assumpions (gradually expanding ill 212 and fla aferwards) and projeced meal prices. Oher expors grow in line wih EU-wide GDP. Impors of peroleum producs are posiively relaed o Bosnia & Herzegovina s GDP growh and negaively o real KM oil prices (wih an elasiciy of -.2). Impors of inpus for meal processing is proporional o meal expors. Impors for public invesmen projecs are he sum of exernal (off-budge) projec loans and grans. Oher impors grow in line wih GDP. Consumpion. Consumpion is deermined residually from projeced GDP, invesmens, and ne expors. Privae consumpion is he residual from oal minus public consumpion. Exernal environmen. Exernal variables in he model are euro-area GDP and CPI, euro LIBOR, euro/usd exchange rae, oil prices, WEO meal price index, and WEO euro-area impor price index. Projecions are consruced from a vecor auoregression model (VAR) wih one lag, esimaed on he sample (in some equaions coefficiens are adjused o mach he WEO projecion). Exchange rae and prices. The real exchange rae vis-à-vis he euro is consan, and consumer and impor prices follow he euro-area level. Expor prices are deermined as a weighed average of meal prices and he euro-area CPI. Invesmen deflaor is an average of impor prices and he CPI. GDP deflaor is an average of expor and impor prices, consumpion deflaor (CPI) and invesmen deflaor, weighed by heir respecive shares in GDP. Shocks. Sochasic shocks affec exernal variables and Bosnia & Herzegovina s GDP growh rae. Shocks o exernal variables are esimaed as residuals from he VAR model. Domesic produciviy shock is esimaed as a residual from he oal 2-5 GDP