Directors noted that attaining the program’s 2010 and 2011 fiscal targets will pave the way to restoring fiscal sustainability. Directors encouraged the expenditure restraint demonstrated to be maintained, stressing that meeting the 2010 fiscal target hinges on steadfast implementation of reforms of war-related benefits and a reduction of current expenditures by the Federation’s cantons. Directors welcomed the authorities’ confirmation of the program’s overall fiscal deficit target for next year, and encouraged them to finalize discussions on the 2011 budgets in the Fiscal Council expeditiously.

Directors underscored that medium-term fiscal consolidation needs to be accompanied by a shift from recurrent to capital expenditures. This will require perseverance with the reforms of rights-based benefits to improve their efficiency through better targeting of the poor and the most vulnerable, reining in the public wage bill, and putting the pensions systems on a sustainable footing. Directors welcomed the authorities’ commitment to carry out comprehensive expenditure reviews at the State and Entity levels. They noted that the resources freed-up by these reforms would help finance much-needed infrastructure investments.

Directors commended the authorities for vigilant financial sector policies which helped the financial system weather well the spillovers from the global financial crisis. They also welcomed the commitments by foreign parent banks to maintain their exposure vis-à-vis Bosnia and Herzegovina and keep their subsidiaries well capitalized. Directors noted that rising nonperforming loans and declining profitability in the banking sector require continued vigilance and close monitoring of developments in credit quality and spillover risks from regional developments.

Directors underscored that medium-term prospects depend critically on the implementation of structural reforms to improve the country’s growth potential. Reforms aimed at addressing labor market rigidities, speeding up the pace of technological change, and improving the business environment would set the stage for robust, sustainable growth.

Directors called on the authorities to take the necessary steps to accept the obligations under Article VIII. They also encouraged further efforts to address data quality issues.

Background

After several years of strong growth, increasingly accompanied by external and internal imbalances, the economy of Bosnia and Herzegovina fell into recession in 2009. Like elsewhere in the region, Bosnia and Herzegovina’s pre-crisis growth relied on booming domestic demand financed from abroad. Sharp increases in government spending on wages and social transfers in 2008 added to demand pressures, which manifested in widening current account deficits and a spike in inflation. The global economic and financial crisis triggered a collapse in the demand for Bosnia and Herzegovina’s exports and severely curtailed cross-border financial inflows. Private investment and spending on consumer durables collapsed, while private consumption softened to a lesser extent, on the back of moderate growth of wages and social benefits. The pre-crisis credit boom came to a sudden stop.

Faced with increasing financing pressures in early 2009, the authorities put together a comprehensive program supported by an IMF Stand-By Arrangement. The program was designed to safeguard the currency board and cushion the effects of the deteriorating external environment, while adopting policies to redress fiscal imbalances and strengthen the financial sector. The authorities’ approach included: (i) gradual fiscal consolidation accompanied by structural fiscal reforms to bring public finances on a sustainable path; (ii) steps to strengthen the resilience of the financial sector alongside commitments from foreign parent banks to maintain their exposures to BiH and keep their subsidiaries capitalized; and (iii) substantial financing from the IMF along with funds from the World Bank and the European Union (EU).

Bosnia and Herzegovina’s stabilization program has helped mitigate the impact of the global financial crisis on the economy. The IMF’s financial support package has helped minimize the impact of revenue shortfalls on government spending, thus limiting output losses. It has also helped stem the loss of foreign reserves by the central bank and shore up investor confidence. Confidence building steps, including Bosnia and Herzegovina’s participation in the European Bank Coordination Initiative, and the increase of the scope and limit of deposit insurance coverage helped restore depositors’ confidence in the banking system. Performance under the program has been encouraging: fiscal restraint is addressing large imbalances of recent years and structural fiscal reforms have advanced, albeit at a slower pace than initially envisaged.

The economy appears to have bottomed out and is projected to stage a modest recovery in 2010, paving the way for a rebound in 2011. Domestic demand will remain subdued, held in check by stagnant real wages and ongoing fiscal consolidation. This will contribute to a further narrowing of the current account deficit. Underlying inflation is projected to remain low. Private sector credit will pick-up slowly, as banks have yet to absorb the full losses due to non-performing loans in their portfolios. The program targets a general government deficit of 4.5 percent of Gross Domestic Product (GDP) in 2010.