March 19, 2024
Sarajevo, Bosnia and Herzegovina:
Growth has proven resilient despite the continued fallout from the war in Ukraine and is set to strengthen starting this year albeit to subpar levels. Inflation continues to decline, but wage pressures linger. Risks remain elevated, including from an intensification of regional conflicts and an abrupt slowdown in Europe, and domestically, from rising political tensions and more expansionary macroeconomic policies. On the other hand, opening of European Union accession talks could sustain the reform momentum and boost confidence.
Fiscal policy should focus on restoring sustainability by curbing current spending while preserving growth-enhancing investment expenditures. Both entities face large financing needs that are unlikely to be met solely in the domestic market and should prepare contingency plans in case of financing shortfalls. Reforms, including a review of public employment, wages, and social benefits are needed to return to a fiscal surplus over the medium term and rebuild buffers.
The authorities should continue to closely monitor financial sector risks and enhance crisis preparedness. The establishment of a financial stability fund, which would facilitate bank restructurings and provide liquidity on an exceptional basis, would substantially strengthen the financial safety net. The currency board remains an anchor of stability in an otherwise uncertain environment and should be preserved.
To accelerate growth, the authorities need to speed up reforms to improve fiscal governance, protect financial integrity, fight corruption, and step up digitalization. Transitioning from coal to green energy along with preparing for the introduction of EU carbon taxes is a major challenge ahead. Placing BiH on a higher growth path and providing its people with more opportunities will ultimately reduce emigration.
Economic outlook
The economy is showing resilience in a difficult environment. Growth decelerated to 1¾ percent in 2023 from 4¼ percent in 2022 but is projected to rise to 2½ percent this year. Demand will be helped by higher real wages, continued policy support, a mild recovery in private investment, and tourism, while goods exports to the EU will partially recover. Without substantially greater reform progress, we expect growth to remain subdued at around 3 percent in the medium term—too low for significant income convergence with the EU. The current account deficit narrowed in 2023 with lower oil prices and higher investment income and remittances, but will deteriorate in 2024 with increasing domestic demand.
We project inflation to continue to decline. Inflation has gradually decreased from a peak of 17½ percent in October 2022 to 6 percent, on average, in 2023 and is expected to further decline to 3 percent in 2024. However, inflation excluding food and energy prices is proving to be stickier reflecting persistent wage pressures.
Uncertainty around the outlook is high and downside risks outweigh. The intensification of regional conflicts, an abrupt slowdown in Europe, or increased commodity price volatility could disrupt trade and raise food and energy prices, lower BiH exports and remittances, and dampen domestic demand. Rising domestic political tensions could increase BiH economic fragmentation and weaken growth prospects.
There are also policy-induced risks. Public and minimum wage increases to mitigate the impact of the cost-of-living crisis have supported domestic demand but risk fueling inflation. Keeping interest rates low has prompted banks to place excess liquidity abroad, mainly in overnight deposits, while lending rates may not adequately reflect credit risk. Maintaining expansionary fiscal policies could undermine fiscal and external sustainability—financing needs have risen and proven challenging to meet. The materialization of financial sector risks could lead to more capital outflows and financial distress. By contrast, a positive decision by the EU to start accession talks could provide a reform boost, with positive spillovers.
Fiscal policy and reforms
The authorities should curb current spending in 2024. We project the overall fiscal deficit to widen to 2½ percent of GDP in 2024 from ¾ percent in 2023, reflecting the accumulated impact of several permanent increases in public wages and social benefits. The authorities should move to contain the public sector wage bill, avoid discretionary increases in social benefits, and revisit other current spending—while preserving growth-enhancing public investment outlays. The sizable minimum wage increase in the Republika Srpska (RS) and commitments by both entities to cap electricity price increases are creating fiscal risks through public enterprises. These risks should be properly assessed, monitored, and mitigated. To avoid a further deterioration of the fiscal position, the RS should avoid introducing new support measures, such as those being considered to mitigate the impact on companies of the recent minimum wage increase.
The authorities should prepare contingency plans in case financing cannot be secured. Fiscal buffers have been eroded due to increased budget deficits, large debt repayments, and drawdown of government deposits. Some budgetary payments from 2023 were deferred. Financing needs this year are therefore significant in both entities, but more pressing in the RS. The two entities’ budgets envisage large debt issuances, some of which are yet to be firmly identified. The RS is planning up to KM 810 million in external financing. The Federation of Bosnia and Herzegovina (FBiH) is planning to roll over up to KM 360 million maturing T-bills and raise KM 740 million from domestic and external sources. The authorities should reduce financing needs, as described above, firm up borrowing plans, and identify additional cuts to current spending to prepare for potential financing shortfalls.
Reforms are needed to rebuild fiscal buffers by returning to a fiscal surplus over the medium term while improving spending quality. Resources should be reallocated from current to capital spending, primarily on infrastructure, green energy, and digitalization. A review of public employment and wages is needed to identify redundancies and reduce the wage bill. Annual pension increases pose risks in both entities given unfavorable demographics. Pension eligibility and indexation should be reviewed to align with best practices, and pension increases should be limited to those legislated. Social benefits adjustments should be de‑linked from wage increases. To better target social spending, the authorities should establish or link beneficiary registries, conduct a review of benefits, and introduce a social-card system. The FBiH should maintain formula-based minimum wage increases. It should also reduce the social security contribution (SSC) rate and broaden the bases for calculating personal income tax and SSCs in a budget-neutral way. Ultimately, in both entities, additional revenue must be mobilized, including by reducing tax exemptions and introducing a tax on dividends. A single VAT rate and threshold should be maintained.
Currency board arrangement and financial sector policies and reforms
The currency board arrangement has served the country well and must be preserved. Pressure for the central bank (CBBH) to finance government budgets or to provide credit to banks should be strongly resisted.
The CBBH should further strengthen the reserve requirement framework, including by increasing remuneration rates on bank reserves. The CBBH has increased remuneration rates only marginally since the ECB began its hiking cycle, despite the currency board arrangement and peg. Narrowing the gap with euro area rates would reduce incentives for banks to place funds abroad, thus containing capital outflows. Should this change be passed through to lending rates, it could help further reduce inflation. We also recommend continuing fulfillment of required reserves on foreign exchange deposits in foreign exchange beyond the transitional period.
Banks have sizable buffers, but risks are high. The banking sector in aggregate is well capitalized and liquid and had record profits last year, while non-performing loans are declining. However, exposure to interest-rate risk may be rising, as rates for new loans are mostly fixed at low levels over long maturities, while deposits are increasingly short term; banks could experience upward pressures in financing costs. The risk that banks conducting business with individuals and entities sanctioned by the U.S. could also fall under sanctions poses concerns. Finally, an incomplete regulatory framework for virtual assets continues to be a source of legal uncertainty.
The authorities should continue to closely monitor the financial sector and enhance crisis preparedness. They should eliminate measures that aim to contain increases in lending rates, and ensure that bank asset classifications and loan-loss provisions accurately reflect credit risk and losses. We welcome the introduction of Systemic Risk Buffers (SRB). Introducing additional capital buffers, such as Countercyclical Capital Buffers (CCyB), buffers for Domestic Systemically Important Banks (D-SIBs), and borrower-based measures, such as Loan-to-Value (LTV) and Debt-Service-to-Income (DSTI) limits, would further enhance the macroprudential toolkit. We continue to call for a country-wide financial stability fund that could facilitate bank restructuring and provide liquidity on an exceptional basis. In addition, all institutions with a role in preserving financial stability should meet regularly to review developments, prospects, and risks, exchange information, and update and strengthen contingency plans. The deposit insurance scheme, including its investment modalities, should be preserved. We encourage the authorities to request an IMF-World Bank Financial Sector Assessment Program (FSAP).
Governance, digitalization, and energy reforms
Reforms to improve fiscal governance, protect financial integrity, and fight corruption are critical. The authorities need to improve the oversight, transparency, and operations of public enterprises and address weaknesses in public procurement. We welcome the recent adoption of the AML and conflict of interest laws and urge the authorities to effectively implement them, including by stepping up the identification of politically exposed persons and beneficial owners. Legal amendments to strengthen the effectiveness of the access-to-information framework and to ensure judicial and prosecutorial independence and integrity are also critical. We encourage the authorities to request a comprehensive IMF governance diagnostic assessment to help inform and prioritize reforms.
The authorities should step up digitalization efforts. The lack of digitalization is severely holding back the economy. A law on electronic identity and trust services would lay the foundation for e-government, increasing efficiency and transparency. It would also boost private sector e-services.
The authorities should step up efforts to decarbonize the economy by gradually liberalizing electricity prices, introducing carbon pricing, and facilitating a transition to renewables. Despite being a relatively small emitter in a global context, BiH has a highly carbon-intensive economy with severe air pollution from coal-fired power generation. The authorities should seek to liberalize electricity prices and establish an EU-equivalent emissions trading system (ETS), albeit gradually and with due regard to the distributional impact. This would remove price distortions, correct economic incentives, and promote decarbonization, helping to lower emissions and air pollution. An ETS would also allow BiH to retain carbon pricing revenues domestically as the EU Carbon Border Adjustment Mechanism (CBAM) is phased in from 2026, as well as secure an initial CBAM exemption for electricity.
The mission thanks the authorities and all other counterparts for the constructive and insightful discussions in Sarajevo and Banja Luka. We regret not having had the opportunity to meet with the Fiscal Council, a key counterpart in previous consultations.
A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF’s Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.
The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.
Source – IMF