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Time for Hard Decisions

December 12, 2011

Anabela Abreu, World Bank Country Manager for Bosnia and Herzegovina

Growth in Europe and in the rest of the world is likely to be much lower than anyone expected even a few months ago. The effects of this are going to be felt very sharply in Bosnia and Herzegovina (BH) and the country needs to prepare. Both the political leaders and the social partners need to resolve some key policy differences in order to avoid a looming domestic crisis. Here is what is very likely to happen if they do not.

Exports will be hit. Domestic growth will slow and government revenues will fall. Access to finance will tighten sharply. As these flows are cut off the government will have very few options for funding its expenditures. Raising tax rates in a recession is not an attractive option and anyway the social contribution rates are so high already that many of the workers and firms have fled the formal economy and pay no taxes at all. The government will be forced to try to borrow to cover its widening deficit. But local capital markets are very thin. Bosnia and Herzegovina has had a heavy reliance of on foreign sources of finance flowing through the banking system. However, funding from foreign banks is going to be very difficult to tap further. The crisis unfolding in Europe is essentially a sovereign debt crisis that is threatening those very banks that have been providing funding up until now. Italian Banks, for instance hold claims on BH amounting to 20 percent of BH GDP. They have problems of their own now and will not be seeking to increase their exposure to BH. The Austrian central bank has just ordered that its banks make no further loans to countries in Europe’s periphery beyond what they can fund out of local deposits.

Other countries in the region face similar external challenges, but they have been taking steps to protect themselves. Macedonia recently took advantage of a new credit line facility from the IMF and also arranged a credit guarantee with the World Bank. Serbia completed a Standby Agreement series with the IMF and is just starting a new one. Serbia also got a credit guarantee from the World Bank. Other countries in the region have made similar arrangements and several, including Montenegro and Serbia, have issued Eurobonds to build up financing buffers. These preparations are not just about securing financing. Making these arrangements has involved some tough political decisions and reforms. But these countries have proved able to make them.

Against this backdrop it was especially disappointing that the BH Fiscal Council was unable, again, to agree on a macroeconomic framework for 2012 when it met on November 22. This is critical to gaining access to funding from the EC, the IMF and the World Bank - three of the rapidly dwindling sources of finance that still remain at this critical moment. Without agreement these will also disappear.

 The difficulty in coming to agreement is not entirely because of political differences between the Entity and State governments. There is, of course, a tension over the allocation of revenues and responsibilities between the three. But there is another more fundamental, and essentially political, problem that involves the social partners. BH has powerful groups representing the interests of particular blocks of the BH population. This does not make BH unique. All countries have interest groups and these are in fact part of a healthy democracy. But in BH the demands of these groups on the public purse are not adequately reconciled through an effective political process with the result that government is too large and budget commitments are larger than the country can afford. The public sector wage bill is far higher than in any other country in the region. Pension benefits to veterans and military personnel are more generous than the country can afford. The number of individuals receiving disability pensions is very high relative to other countries. There is a need to restructure benefits systems to allow for more for means-testing in order to direct limited public resources to the truly vulnerable and to avoid discouraging workers from participating in the formal economy. The current policies are not sustainable and the problem is likely to come to a head in the coming months as the external forces bring additional pressure to these points of internal political weakness. The inability to contain demands will cause budget deficits to swell. These deficits will be difficult to finance. Arrears will mount. Increased recourse will be made to the system of “coefficients” or rationing that is already strained to the limit and is in any event a blunt and inefficient instrument. Social partners will be tempted to turn again to the courts, generating further budget obligations that cannot be met. At some point the system will break completely, with consequences that are difficult to predict and unpleasant to contemplate.

It does not have to be this way. But for the future to be better there will need to be real progress on the political front. The entity and state authorities will have to come to a sensible and enduring compromise on the allocation of revenues and responsibilities, and leaders of all sorts, including those of the social partners, need to summon the courage to communicate frankly to their various constituencies the need to carry out important reforms and to temper collective demands fit fiscal reality.