IMF after visit to BiH: Both entities need borrowing, authorities should limit current spending in 2024!

(Patria) - The concluding statement presented the preliminary findings of the IMF mission members at the end of their official visit to BiH. The IMF published a statement reflecting the views of the IMF mission members, which do not necessarily reflect the views of the IMF Executive Board.

Based on the preliminary findings of this mission, IMF experts will prepare a report which, after approval by management, will be presented to the IMF Executive Board for discussion and decision-making.

"Growth has proven resilient despite the ongoing negative impacts of the war in Ukraine
and is on track to strengthen starting this year, although the growth rate will be below
average. Inflation has continued its downward trend, but pressures caused by
wage increases persist. Risks remain elevated, including risks from the intensification of regional conflicts and a sharp slowdown in growth in Europe, as well as domestic risks from rising political tensions and a greater prevalence of expansionary macroeconomic policies. On the other hand, the opening of accession negotiations with the
European Union could support reform momentum and increase confidence.
Fiscal policy should focus on restoring sustainability by curbing current spending, while preserving investment allocations that will stimulate growth.

Both entities face significant financing needs that are unlikely to be met solely by the domestic market and should prepare contingency plans for underfunding. In order to return to a fiscal surplus in the medium term and rebuild reserves, reforms are needed, including a review of public sector employment, wages, and social benefits.

Authorities should continue to closely monitor financial sector risks and improve
crisis preparedness. The establishment of a financial stability fund, which would facilitate bank restructuring and ensure liquidity in exceptional circumstances, would significantly strengthen the financial safety net. The currency board remains a cornerstone of stability in an otherwise uncertain environment and must be preserved.

To foster growth, authorities should accelerate reforms aimed at improving
fiscal management, protecting financial integrity, combating corruption, and speeding up
the digitalization process.

The transition from coal to green energy, along with preparations for the introduction of the EU carbon tax, is a major challenge for the future. Putting BiH on a path of higher growth and ensuring greater opportunities for its citizens will ultimately reduce emigration.

According to our projections, inflation will continue to decline. Inflation, from a record high of 17.5 percent reached in October 2022, has gradually decreased to an average of 6 percent in 2023, and is expected to further decline to 3 percent in 2024. However, inflation excluding food and energy prices is proving more persistent, reflecting continued pressures from wage increases.

Uncertainty regarding the economic outlook is high, and downside risks
prevail. Intensification of regional conflicts, a sharp slowdown in growth in Europe, or
increased commodity price volatility could cause trade disruptions and result in higher food and energy prices, reduced exports from BiH and remittances, and weaker domestic demand. Rising political tensions within the country could increase economic fragmentation in BiH and weaken growth prospects.

There are also policy-induced risks. Increases in public sector wages and minimum wages to mitigate the impact of the high cost of living crisis have stimulated domestic demand but also risk fueling inflation.

Maintaining low interest rates has encouraged banks to invest excess liquidity abroad, mainly in overnight deposits, while loan interest rates may not adequately reflect credit risk. Continued implementation of expansionary fiscal policy could jeopardize fiscal and external sustainability—financing needs have increased, and meeting them is proving challenging. Materialization of financial sector risks could lead to greater capital outflows and financial difficulties. Conversely, a positive decision by the European Union to start accession negotiations could boost reforms and have a broader positive impact.

Authorities should limit current spending in 2024. Our projection is that the overall fiscal deficit will increase to 2.5 percent of GDP in 2024 from 0.75 percent in 2023, reflecting the cumulative impact of several permanent increases in public sector wages and social benefits. Authorities should take steps to limit spending on public sector wages, avoid discretionary increases in social benefits, and reconsider other current spending, while continuing to allocate funds for growth-promoting public investments.

A significant increase in the minimum wage in Republika Srpska (RS) and promises from both entities to limit electricity price increases create fiscal risks through public enterprises. These risks should be adequately assessed, monitored, and mitigated. To avoid further deterioration of the fiscal position, RS should avoid introducing new support measures, such as those being considered to mitigate the impact of the recent minimum wage increase on businesses.

Authorities should prepare contingency plans for the inability to secure financing. Fiscal reserves have been depleted due to increased budget deficits, large debt repayments, and withdrawals of government deposits. Some budget payments from 2023 have been deferred. Financing needs this year are therefore large in both entities, but particularly pronounced in RS. Entity budgets envisage significant issuances of debt instruments, some of which have yet to be precisely identified. RS plans external financing of up to KM 810 million.

The Federation of Bosnia and Herzegovina (FBiH) plans to renew treasury bill redemptions totaling KM 360 million and raise KM 740 million from domestic and external sources. Authorities should reduce financing needs, as described above, specify borrowing plans, and identify additional cuts in current spending to prepare for potential financing shortfalls.

Reforms are needed to ensure the rebuilding of fiscal reserves, returning to a fiscal surplus in the medium term while improving the quality of spending. Resources should be reallocated from current to capital expenditure, primarily for infrastructure, green energy, and digitalization.

A review of public sector employment and wages is needed to identify surpluses and reduce wage spending. Annual pension increases pose a risk in both entities due to the unfavorable demographic structure of the population. Pension rights and indexing should be reviewed to align with best practices, and pension increases should be limited to what is provided for in the legal framework.

Adjustment of social benefits should not be linked to wage increases. To better target social spending, authorities should establish or link beneficiary registries, review benefits, and introduce a social card system. FBiH should maintain the formula-based minimum wage increase method, reduce contribution rates, and broaden the base for income tax and contribution calculations in a budget-neutral manner. Ultimately, both entities must mobilize additional revenues, including by reducing tax reliefs and introducing dividend taxes. A single VAT rate and VAT threshold should be maintained.

The currency board arrangement has served the country well and must be preserved. Pressures on the Central Bank (CBBH) to finance government budgets or lend to banks should be strongly resisted. CBBH should further strengthen the mandatory reserve framework, including by increasing the remuneration rates for reserves held by commercial banks with CBBH. CBBH has only slightly increased remuneration rates since the ECB initiated its interest rate hike cycle, despite the currency board arrangement and the domestic currency's peg to the euro.

Reducing the gap between CBBH remuneration rates and Eurozone interest rates would reduce the incentive for banks to invest funds abroad, thereby curbing capital outflows. If this change were passed on to loan interest rates, it could help further reduce inflation. We also recommend continuing to apply the mandatory reserve fulfillment rule to foreign currency deposits in foreign currency even after the transitional period.

Banks have significant buffers, but risks are high. The banking sector as a whole is well-capitalized and liquid, achieved record profits last year, and non-performing loans are on a downward trend. However, exposure to interest rate risk may be increasing, as rates for new long-term loans are mostly fixed at low levels, while deposits are increasingly short-term, which could lead to higher funding costs for banks. The risk that banks operating with individuals and entities sanctioned by the US could also be subject to sanctions is concerning. Finally, the incomplete regulatory framework for virtual assets continues to be a source of legal uncertainty.

Authorities should continue to closely monitor the financial sector and improve crisis preparedness. They should abolish measures aimed at controlling loan interest rate increases and ensure that bank asset classifications and loan loss provisions accurately reflect credit risk and losses.

We continue to call for the establishment of a country-wide financial stability fund that could facilitate bank restructuring and ensure liquidity in exceptional circumstances. In addition, all institutions involved in maintaining financial stability should meet regularly to analyze trends, outlooks, and risks, exchange information, and update and strengthen crisis preparedness plans. The deposit insurance system, including its investment modalities, should be preserved. We encourage authorities to request the IMF and World Bank's Financial Sector Assessment Program (FSAP).

Governance, digitalization, and energy reforms Reforms to improve fiscal management, protect financial integrity, and combat corruption are crucial. Authorities should improve oversight, transparency, and the functioning of public enterprises and focus on addressing shortcomings in public procurement. We welcome the recent adoption of laws on preventing money laundering and conflict of interest and encourage authorities to implement them effectively, including through enhanced identification of politically exposed persons and beneficial owners.

Amendments to laws aimed at strengthening the effectiveness of the access to information framework, and ensuring the independence and integrity of judges and prosecutors, are also crucial. We encourage authorities to request a comprehensive IMF diagnostic assessment of governance to help identify and prioritize reforms. Authorities should intensify digitalization efforts. The lack of digitalization seriously hinders the economy.

The Law on Electronic Identification and Trust Services would lay the foundation for e-governance, increasing efficiency and transparency. It would also stimulate private sector e-services. Authorities should intensify efforts towards decarbonizing the economy by gradually liberalizing electricity prices, introducing carbon pricing, and facilitating the transition to renewable energy sources.

Although a relatively small emitter in a global context, BiH has a carbon-intensive economy and significant air pollution from coal-fired power generation. Authorities should strive to liberalize electricity prices and establish an EU-equivalent Emissions Trading System (ETS), albeit gradually and considering the distributional impact. This would remove price distortions, correct economic incentives, and promote decarbonization, helping to reduce emissions and air pollution. The ETS would also allow BiH to retain carbon pricing revenues domestically as the EU's Carbon Border Adjustment Mechanism (CBAM) is gradually introduced from 2026, as well as to secure an initial CBAM exemption for electricity," the IMF statement reads.