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Country Report

Bosnia and Hercegovina

November 2007

The Economist Intelligence Unit 26 Red Lion Square London WC1R 4HQ United Kingdom

Bosnia and Hercegovina at a glance: 2008-09

OVERVIEW Bosnia and Hercegovina (BiH) is facing arguably its most serious political crisis since 1995, owing to escalating tensions between Bosnian Serb political leaders and the international High Representative in BiH, Miroslav Lajcak. BiH!s Bosnian Serb prime minister, Nikola Spiric, resigned on November 1st in protest at Mr Lajcak!s plans to simplify decision-making in state-level institutions. Other resignations could follow, raising the risk of further delays in passing the reforms needed for BiH to sign an EU stabilisation and association agreement (SAA). Prospects for amending BiH!s constitution to strengthen state-level institutions are also slim at present. The currency board arrangement will stay in place. Inflation fell sharply in 2007 and will remain low in 2008-09. Strong investment and private consumption will drive the economy, and annual average real GDP growth is projected at 6% over the two years of the forecast period. The annual current-account deficit will remain large, at an average of about 15% of GDP.

Key changes from last month

Political outlook • The worsening political situation in BiH, together with heightened concerns

about regional stability related to the issue of Kosovo!s future status, raise serious doubts as to whether the Office of the High Representative (OHR) will close in mid-2008, as planned.

Economic policy outlook • BiH!s consolidated budget was in surplus in the first half of 2007, but is

likely to swing into deficit by year-end as governments honour previous spending pledges.

Economic forecast • The Economist Intelligence Unit continues to forecast annual average real

GDP growth of 6% in 2008-09. However, the risks to this forecast have increased recently because of the turmoil on global financial markets and the worsening political situation in BiH.

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Bosnia and Hercegovina 1

Country Report November 2007 www.eiu.com © The Economist Intelligence Unit Limited 2007

Contents

Bosnia and Hercegovina

3 Summary

4 Political structure

6 Economic structure 6 Annual indicators 7 Quarterly indicators

8 Outlook for 2008-09 8 Political outlook 9 Economic policy outlook 10 Economic forecast

13 The political scene

17 Economic policy

20 The domestic economy 20 Output and demand 21 Employment, wages and prices 22 Financial indicators 23 Sectoral trends

23 Foreign trade and payments

List of tables 10 International assumptions summary

12 Forecast summary

24 BiH: Trade in goods, Jan-Sep

25 Balance of payments

List of figures

13 Gross domestic product 13 Consumer price inflation 22 Retail price inflation 22 Total commercial bank loans 26 Net free reserves



Bosnia and Hercegovina November 2007

Summary

Bosnia and Hercegovina (BiH) is facing arguably its most serious political crisis since 1995, owing to escalating tensions between Bosnian Serb leaders and the international High Representative in BiH, Miroslav Lajcak. BiH!s Bosnian Serb prime minister, Nikola Spiric, resigned on November 1st in protest at Mr Lajcak!s plans to simplify decision-making in state-level institutions. Other resignations could follow, raising the risk of further delays in passing the reforms needed for BiH to sign an EU stabilisation and association agreement (SAA). Prospects for amending BiH!s constitution to strengthen state-level institutions are also slim at present. The currency board arrangement will stay in place. Inflation fell sharply in 2007 and will remain low in 2008-09. Strong investment and private consumption will drive the economy, and annual average real GDP growth is projected at 6% over the two years of the forecast period. The annual current-account deficit will remain large, at an average of about 15% of GDP.

In mid-October Mr Lajcak reduced the state-level government!s ethnically-based quorum and warned that he would apply similar measures to the state-level parliament. Mr Spiric resigned after the main international powers engaged in BiH expressed their support for Mr Lajcak. Serbia and Russia have weighed in to the dispute, blaming Mr Lajcak!s plans for the worsening political situation. The main parties in BiH have reached a tentative agreement on police reform.

BiH!s consolidated budget was in surplus in January-June 2007, owing to strong tax revenue. The RS government has rebalanced its 2007 budget to allow for extra spending. The IMF has called on the BiH authorities to strengthen banking supervision in view of continued rapid lending growth.

Industrial output has continued to grow strongly in the Bosniak (Bosnian Muslim)-Bosnian Croat Federation and to stagnate in the RS. Construction remains strong across BiH. Inflation is low in both entities, reflecting strong base-period effects. Bank lending increased by 30% in the year to September.

The merchandise trade deficit totalled KM5.68bn (US$4.22bn) in January-September, a 31% year-on-year increase, as import costs rose sharply. The current-account deficit rose to KM1.29bn in January-June, but was covered by inflows of foreign direct investment (FDI), which reflected the sale of the leading RS telecommunications operator.

Editors: Richard Eames (editor); Joan Hoey (consulting editor) Editorial closing date: November 5th 2007 All queries: Tel: (44.20) 7576 8000 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

Outlook for 2008-09

The political scene

Economic policy

The domestic economy

Foreign trade and payments

4 Bosnia and Hercegovina


Political structure

The state of Bosnia and Hercegovina (BiH) exists within the boundaries of the former Yugoslav republic of the same name. It includes two entities: the Federation of Bosnia and Hercegovina (which is often referred to as the Federation), set up by the Washington Treaty of March 18th 1994, and Republika Srpska (RS). It also includes a self-governing district, Brcko, under the sovereignty of the central state government

The central state-level BiH government was granted limited responsibilities under the 1995 Dayton peace agreement. These included the establishment of a Constitutional Court, a Commission for Displaced Persons, a Human Rights Commission, a central bank, public corporations to manage and operate transport and telecommunications, a Commission to Preserve National Monuments, and a system of arbitration. Foreign trade deals are also negotiated by the BiH government. In recent years ministries of justice, security and defence have been created at state level, and the state presidency assumed central command of the armed forces in 2003. A unified indirect tax administration has been created and a state-wide value-added tax (VAT) was introduced in January 2006

BiH has a bicameral parliament comprising the House of Representatives and the House of Peoples, two-thirds of the members of which are elected from the Federation and one-third from the RS. A valid majority requires the support of at least one-third of the members representing each entity. The Federation and the RS also have parliaments

General elections took place on October 1st 2006 to select a three-member state presidency, the RS president, and state, entity and cantonal parliaments.

BiH has a rotating, collective, three-member presidency. The current members are: Nebojsa Radmanovic (Serb; elected October 2006), Haris Silajdzic (Bosniak; elected October 2006) and Zeljko Komsic (Croat; elected October 2006)

The Council of Ministers is BiH!s state-level cabinet, headed by a chairman who is the country!s de facto prime minister. Members serve four-year terms. The current government took office on February 9th 2007. The entities have their own governments, and cantons within the Federation also have powerful local governments

Party of Democratic Action (SDA), Party for BiH (SzBiH), Social Democratic Party (SDP), Croatian Democratic Union of BiH (HDZ BiH), Croatian Democratic Union 1990 (HDZ 1990), Alliance of Independent Social Democrats (SNSD), Serb Democratic Party (SDS), Party of Democratic Progress (PDP)

The Dayton agreement established the Office of the High Representative (OHR), charged with monitoring the implementation of the agreement and co-ordinating the activities of international organisations. Since December 1997 the High Representative has been able to impose decisions in cases of disagreement and to dismiss "obstructive" officials. In February 2007 the Peace Implementation Council (PIC), which oversees the work of the OHR, decided to delay the planned closure of the OHR by 12 months, until mid-2008

Chairman Nikola Spiric (SNSD)a Deputy prime minister & finance minister Dragan Vrankic (HDZ BiH) Deputy prime minister & security minister Tarik Sadovic (SDA) Civil affairs Sredoje Novic (SNSD) Defence Selmo Cikotic (SDA) Foreign affairs Sven Alkalaj (SzBiH) Foreign trade & economic relations Slobodan Puhalac (SNSD) Human rights & refugees Safet Halilovic (SzBiH)

National government

Legislatures

National elections

Head of state

National government

Main political parties

International involvement

State competencies

Official name



Justice Barisa Colak (HDZ BiH) Transport & telecommunications Bozo Ljubic (HDZ 1990)

Kemal Kozaric

Miroslav Lajcak

President Borjana Kristo (HDZ BiH) Vice-presidents Mirsad Kebo (SDA) Spomenka Micic (SzBiH) Prime minister Nedzad Brankovic (SDA) Deputy prime minister & minister of finance Vjekoslav Bevanda (HDZ BiH) Deputy prime minister & minister of sport & culture Gavrilo Grahovac (SzBiH)

Agriculture Damir Ljubic (HDZ 1990) Education & science Meliha Alic (SzBiH) Development, entrepreneurship & crafts Velimir Kunic (SNSD) Displaced persons & refugees Edin Music (SDA) Energy, mining & industry Vahid Heco (SzBiH) Environment & tourism Nevenko Herceg (HDZ BiH) Health Safet Omerovic (SzBiH) Interior Muhidin Alic (SzBiH) Justice Feliks Vidovic (HDZ BiH) Labour & social policy Perica Jelecevic (HDZ 1990) Physical planning Salko Obhodjas (SDA) Trade Desnica Radivojevic (SDA) Transport & communications Nail Seckanovic (SDA) Veterans' affairs Zahid Crnkic (SDA)

President Igor Radojicic (SNSD) b

Vice-presidents Davor Cordas (HDZ BiH) Adil Osmanovic (SDA)

Prime minister Milorad Dodik (SNSD)

Administration & local government Zoran Lipovac (independent) Agriculture, forestry & water management Radivoje Bratic (SNSD) Economic affairs & co-ordination Jasna Brkic (independent) Economy, energy & development Rajko Ubiparip (SNSD) Education & culture Anton Kasipovic (independent) Family, youth & sport Proko Dragosavljevic (SNSD) Finance Aleksandar Dzombic (SNSD) Health & social welfare Ranko Skrbic (SNSD) Interior Stanislav Cadjo (SNSD) Justice Dzerard Selman (SzBiH) Labour & veterans Bosko Tomic (PDP) Refugees & displaced persons Omer Brankovic (SDA) Science & technology Bakir Ajanovic (independent) Trade & tourism Predrag Gluhakovic (SPRS) Transport & communications Nedeljko Cubrilovic (DNS) Urbanism, civil engineering & ecology Fatima Fetibegovic (independent)

a Mr Spiric announced his resignation on November 1st. b Mr Radojicic, the speaker of the RS National Assembly, took over as acting president following the death of Milan Jelic (SNSD) on September 30th. A presidential election in RS has been scheduled for December 9th.

Federation

Ministers

Central Bank governor

High Representative

Ministers

Republika Srpska



Economic structure

Annual indicators

2003a 2004a 2005 a 2006 a 2007b

GDP at market prices (KM bn) 14.5 15.8 16.9 19.1 b 20.4

GDP at market prices (US$ bn) 8.4 10.0 10.8 12.3 b 14.2

Real GDP growth (%) 3.5 6.1 5.0 6.2 b 5.5

Retail price inflation (av; %) 0.6 0.4 3.7 7.5 1.4

Population (m) 3.9 3.9 3.9 3.9 3.9

Exports of goods fob (US$ m) 1,478 2,087 2,590 3,382 4,058

Imports of goods fob (US$ m) -5,637 -6,656 -7,545 -7,680 -9,753

Current-account balance (US$ m) -1,631 -1,794 -2,116 -1,322 -2,210

International reserves (US$ m) 1,796 2,408 2,531 3,372 4,500

Total external debt (US$ bn) 4.5 5.2 5.6 6.6 b 7.1

Exchange rate (av) KM:US$ 1.73 1.58 1.57 1.56 1.44

a Actual. b Economist Intelligence Unit estimates.

Share in gross value added 2005a % of total Components of gross domestic product 2003b % of total

Agriculture 10.3 Private consumption 91.7

Industryc 19.3 General government consumption 22.3

Manufacturing 10.9 Exports of goods & services 25.1

Services 65.4 Imports of goods & services 59.1

Principal exports 2006 % of total Principal imports 2006 % of total

Base metals 26.4 Mineral products 15.7

Machinery & mechanical appliances 12.2 Machinery 15.2

Mineral products 11.5 Base metals 9.9

Wood & wood products 8.8 Foodstuffs 9.6

Main destinations of exports 2006 % of total Main origins of imports 2006 % of total

Croatia 18.7 Croatia 16.7

Italy 13.8 Germany 12.3

Serbia and Montenegro 13.2 Serbia and Montenegro 9.7

Germany 12.9 Italy 8.9

a In real terms. b Economist Intelligence Unit estimate. c Not including construction.



Quarterly indicators 2005 2006 2007 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 QtrFinancial indicators Exchange rate KM:US$ (av) 1.604 1.646 1.627 1.557 1.535 1.517 1.493 1.451Exchange rate KM:US$ (end-period) 1.624 1.658 1.616 1.538 1.545 1.485 1.469 1.448Deposit rate (av; %) 3.30 3.59 3.71 3.60 3.80 3.50 3.50 3.48Lending rate (av; %) 9.30 9.00 8.30 8.20 7.70 7.65 7.47 7.14M1 (end-period; KM m) 4,228 4,422 4,473 4,772 5,226 5,553 5,783 6,630M1 (% change, year on year) 11.3 16.7 18.9 19.8 23.6 25.6 29.3 38.9M2 (end-period; KM m) 8,156 8,561 8,869 9,378 10,209 10,758 11,189 13,119M2 (% change, year on year) 19.2 18.7 21.9 22.1 25.2 25.7 26.2 39.9

Foreign trade & payments (US$ m) Exports fob 655 688 677 876 911 918 917 1,048Imports fob -1,944 -2,138 -1,363 -1,970 -2,117 -2,231 -1,946 -2,497Trade balance -1,289 -1,450 -686 -1,094 -1,206 -1,313 -1,030 -1,449Services balance 111 134 117 181 147 166 165 215Income balance 167 78 67 99 206 93 118 131Transfer balance 516 512 365 443 535 558 409 566Current-account balance -496 -726 -136 -371 -318 -497 -338 -538Reserves excl gold (end-period) 2,427 2,531 2,747 3,016 3,148 3,372 3,493 3,753

Source: IMF, International Financial Statistics.



Outlook for 2008-09

Political outlook

Bosnia and Hercegovina (BiH) is facing arguably its most serious political crisis since 1995, owing to escalating tensions between Bosnian Serb leaders and the international High Representative in BiH, Miroslav Lajcak. The political atmosphere has worsened considerably since mid-October, when Mr Lajcak proposed measures ostensibly aimed at making central state-level institutions function more efficiently"and, in particular, at breaking the deadlock over internationally backed plans to centralise policing in BiH. This provoked an outcry in Republika Srpska (RS), which believes that Mr Lajcak!s proposals will lead to the Bosnian Serbs being outvoted in central institutions, and even to the RS being destroyed or abolished. BiH!s Bosnian Serb prime minister, Nikola Spiric, resigned on November 1st, and the leading Bosnian Serb parties are threatening to withdraw their other representatives from state-level institutions. The stakes are high, with Serbia and Russia strongly criticising Mr Lajcak!s actions and the leading Western powers backing him.

By choosing to force the issue at this time, Mr Lajcak has put his credibility and authority on the line. On paper, Mr Lajcak has practically unlimited authority, as well as the full support of all the Western powers, NATO and the EU"a point reiterated on October 31st by the Peace Implementation Council (PIC), an international body overseeing the implementation of the Dayton peace agreement. However, the PIC also expressed its �utmost concern� over the deterioration in the political situation in BiH, and recommended no specific sanctions against defiant RS officials.

The ferocity of the RS!s response appears to have taken Mr Lajcak by surprise, and it is not clear whether he would prevail in a head-on confrontation. The Bosnian Serbs are unusually united; in the RS prime minister, Milorad Dodik, they have a capable and popular leader with an indisputable democratic mandate; support from Serbia and Russia is stronger than at any time since 1995; and the international setting for the RS to make a stand is probably also more favourable than at any time in the past decade. In addition, with a potential crisis brewing over Kosovo, Mr Lajcak!s latest measures have given Serbia a reason to react and link the issue of Kosovo to BiH.

The options for the Office of the High Representative (OHR) and the EU are limited. The credibility of the incentive of possible EU membership has been gravely weakened. The international troop presence in BiH, once 60,000-strong, is down to 2,500"and these are EU rather than NATO troops. The OHR can call elections, but Mr Dodik!s Alliance of Independent Social Democrats (SNSD) would merely win again, but even more convincingly than in October 2006. And although Mr Lajcak could in theory dismiss Mr Dodik, the latter!s popularity makes such a scenario highly unlikely.

It may still be possible for the OHR and the RS to reach a compromise. There might be an agreement to interpret Mr Lajcak!s decisions in such a way as to say that representatives of the RS cannot be outvoted in state-level institutions.

Domestic politics



However, this would constitute a climbdown for Mr Lajcak, and would gravely erode his position. At the very least, the current stand-off between Mr Lajcak and RS officials has raised serious questions about the maintenance of the "Bonn powers", by which the OHR has the authority to remove officials it considers obstructive and to impose legislation in BiH. The worsening political situation in BiH, together with continued concerns about regional stability related to the issue of Kosovo!s future status, also raises serious doubts as to whether the OHR will close in mid-2008, as planned.

Technical negotiations on a stabilisation and association agreement (SAA) between BiH and the EU were concluded in December 2006, and the text of an agreement has largely been finalised. However, the worsening political atmosphere in BiH will make it hard for the main parties to reach a detailed agreement on police reform"especially if the EU refuses to accept an outcome that stops short of transferring real power to state level. BiH is therefore highly unlikely to initial an SAA in 2007. Furthermore, the subsequent signing of an SAA could be delayed by the EU!s likely insistence that the parties pass related enabling legislation, and by the fact that preparing the final agreement requires a few months of legal and translation work.

The main regional issue affecting BiH is the determination of the future status of Kosovo, whose ethnic Albanian majority is demanding independence from Serbia. Until recently Serb leaders had only hinted at the possibility that independence for Kosovo could trigger secessionist demands by the RS. Serbia has now seized the opportunity of the crisis in BiH to explicitly link the Dayton accords with the Kosovo status process. A unilateral declaration of independence (UDI) by the Kosovo Albanians would have far-reaching repercussions. In mid-2006 Mr Dodik threatened to hold a referendum on the entity!s secession from BiH in the event that Kosovo became independent. Recognition of a UDI by the US and the EU, or at least some leading EU member states such as the UK and France, would therefore have potentially serious political consequences in BiH.

Economic policy outlook

In its most recent Article IV consultation with BiH earlier in 2007, the IMF reiterated several of its long-standing economic policy concerns. The Fund is urging the local authorities to maintain a prudent fiscal policy, strengthen policy co-ordination between governments, and bolster financial stability by tightening supervision of the banking sector. Another priority for the IMF is completing the creation of a single economic space in BiH, in part by liberalising labour markets, and making pension and health benefits portable across BiH. The Fund is also keen for the local authorities, especially in the Federation, to accelerate structural reforms and privatisation, and to reduce regulations affecting business.

However, talks between the BiH authorities and the IMF over a new arrangement have been on hold for some time, and the Economist Intelligence Unit does not expect BiH to sign another agreement with the Fund for the time

Policy trends

International relations



being. The authorities in the RS would seem to have little need for an agreement for now, in view of the entity!s large privatisation receipts in 2007. There are also serious doubts as to whether the ruling coalitions at state level and in the Federation are willing or cohesive enough to push through IMF-backed reforms, especially in view of the current political turbulence. There is therefore a significant risk of further delays in economic reform in 2008-09.

We estimate that the general government budget moved from a healthy surplus in 2006 to a deficit of about 1% of GDP in 2007. This is partly because the state-wide value-added tax (VAT) has produced less of a boost to revenue in 2007 than it did in 2006, following the introduction of the levy at the start of last year. In addition, expenditure is likely to rise significantly towards the end of 2007, in part owing to commitments made by the leading parties ahead of the October 2006 elections.

Even if BiH remains without an IMF agreement, we assume that the Fund will have considerable influence on fiscal policy over the forecast period, and we forecast general government deficits of about 1.5% of GDP in 2008 and 2009. However, there are considerable risks to this scenario. These stem from the unresolved and potentially large domestic claims against the government; spending pressures exerted by public-sector workers, pensioners and war veterans; infrastructure investment; the costs of defence and (possibly) police reforms; uncertainty as to how effectively the RS authorities will spend the entity!s large privatisation receipts; and poor fiscal policy co-ordination between the state and entity governments in BiH. The IMF will also urge the entities to harmonise their respective systems of corporate taxation and social contributions, as part of efforts to create a single economic space.

The Central Bank of BiH (CBBH) runs a currency board regime, whereby the convertible marka is pegged to the euro at a rate of KM1.96:#1, so that the bank has relatively few monetary policy tools at its disposal. The real rate of year-on-year credit growth in BiH picked up in 2007 as price pressures eased, and commercial banks are continuing to fund much of their lending by borrowing from abroad. The CBBH has suggested that it does not expect to raise the reserve requirement"one of its few monetary policy levers"just yet. Nevertheless, the bank will leave open the option of tightening policy in the future; in October 2006 it removed the 20% ceiling on the required reserve rate. In addition, the IMF is calling on the local authorities to strengthen supervisory controls over the banking sector"for example, by tightening loan classification.

Economic forecast

International assumptions summary (% unless otherwise indicated)

2006 2007 2008 2009

Real GDP growth World 5.3 5.0 4.6 4.7

OECD 3.1 2.5 1.8 2.6

Euro area 2.8 2.4 2.0 2.1

EU27 3.0 2.7 2.1 2.3

Monetary policy

Fiscal policy

International assumptions



International assumptions summary (% unless otherwise indicated)

2006 2007 2008 2009

Exchange rates ¥:US$ 116.2 117.6 105.3 96.3

US$:� 1.256 1.361 1.445 1.328

SDR:US$ 0.680 0.652 0.626 0.646

Financial indicators � 3-month interbank rate 3.08 4.12 3.83 4.00

US$ 3-month Libor 5.19 5.33 4.72 4.89

Commodity prices Oil (Brent; US$/b) 65.3 70.0 69.5 63.8

Gold (US$/troy oz) 604.5 674.0 705.0 618.8

Food, feedstuffs & beverages (% change in US$ terms) 16.1 20.6 6.6 -2.5

Industrial raw materials (% change in US$ terms) 49.6 12.8 -3.1 -12.8

Note. Regional GDP growth rates weighted using purchasing power parity exchange rates.

Under our central forecast, the economic impact on BiH of the recent global financial market turmoil is likely to be minimal, but the threat of a global liquidity crunch has increased. BiH�s economic growth in 2008-09 will be partly reliant on demand from its main trading partners in the EU and in south-eastern Europe. Growth in the euro area has been solid in 2007, but we have lowered our growth forecast in 2008 to 2% from 2.2%, largely owing to weaker than expected expansion in the US. However, rapid expansion elsewhere in south-eastern Europe should boost import demand in several of BiH�s main regional export markets. We now anticipate that the US dollar will depreciate against the euro in 2008 to an average of US$1.45:#1 (from US$1.38:#1 previously). This could dent BiH�s export competitiveness, since the marka is pegged to the euro. However, the US dollar is set to recover in 2009 as the US economy starts to grow more rapidly. We continue to believe that international oil prices will remain high over the forecast period. This will put upwards pressure on BiH�s import costs and could have some inflationary impact.

Real GDP growth in 2007 is estimated at a relatively buoyant 5.5%. This reflects a generally favourable external environment and strong private consumption, which is being driven by rapid growth in real wages and consumer borrowing. Nominal wages are rising by about 10% year on year, inflation remains in the low single digits, and bank lending is growing by about 30% year on year in nominal terms. We forecast further strong real GDP growth in 2008-09, of 6% a year.

The rapid increase in capital goods imports in the first half of 2007 supports our belief that investment will continue to grow strongly in 2008-09. Large infrastructure projects will boost construction, and further investment in the corporate sector (some of it from abroad) will support solid growth in foreign sales. Private consumption growth will also stay strong, reflecting continued growth in bank lending and real wages. However, the risks to this forecast have increased recently, owing to turmoil on the global financial markets and the worsening political situation in BiH.

Economic growth



Inflation slowed significantly in both entities in 2007, owing to the strong base-period effect caused by the introduction of VAT at the start of 2006. High international oil prices and rising food costs"the latter a consequence of a drought and higher world grain prices"will exert some inflationary pressure. Nevertheless, we anticipate that price growth across BiH during the forecast period will remain well below that of 2006. This reflects the absence of any further tax increases, as well as more modest wage growth and the continued stabilising influence of BiH�s currency board arrangement.

The marka is pegged to the euro at a rate of KM1.96:#1. In 2007 we estimate that the marka depreciated in real effective terms by a modest 1.3% against a basket of currencies of BiH!s main trading partners. This is because the sharp decline in inflation in BiH outweighed the depreciation of the US dollar against the euro. We forecast that the marka will remain stable in real effective terms in 2008-09 as the rate of inflation stays low. The marka appears to be considerably overvalued, but the likelihood of a change in the exchange-rate regime over the forecast period is remote. The CBBH maintains sufficient reserves to cover the whole of its monetary liabilities. Its free reserves"that is, those above and beyond these liabilities"remain relatively low, despite strong growth in recent years. However, the chances of a speculative attack on the marka are low.

We estimate that BiH!s current-account deficit rose to 15.5% of GDP in 2007, from 10.8% in 2006. This was largely the result of a strong base-period effect related to the introduction of VAT, which caused the merchandise trade deficit to contract in 2006. We expect the external imbalance to remain large in 2008-09. Strong growth in private consumption and investment demand will drive up import costs, and will be only partly offset by slower wage growth. Export expansion will be supported by reasonably strong external demand, and by productivity gains stemming from recent investment in heavy industry. However, BiH�s export base will remain relatively narrow and vulnerable to swings in international commodity prices. We forecast large annual current-account deficits in 2008-09, equivalent to about 15% of GDP.

Forecast summary (% unless otherwise indicated)

2006 a 2007 b 2008c 2009c

Real GDP growth 6.2 b 5.5 6.0 6.0

Industrial production growth 11.5 b 8.0 10.0 10.0

Average lending rate (%)d 8.0 7.3 6.5 6.0

Federation retail price inflation (av) 6.9 1.8 2.5 2.5

Republika Srpska retail price inflation (av) 8.4 1.3 2.0 2.0

Exports of goods fob (US$ bn) 3.4 4.1 4.6 5.2

Imports of goods fob (US$ bn) -7.7 -9.8 -10.7 -11.4

Current-account balance (US$ bn) -1.3 -2.2 -2.5 -2.4

Current-account balance (% of GDP) -10.8 b -15.5 -15.0 -14.9

External debt (year-end; US$ bn) 6.6 b 7.1 7.7 8.2

Exchange rate KM:US$ (av) 1.56 1.44 1.35 1.47

Exchange rate KM:US$ (end-period) 1.48 1.37 1.41 1.51

a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts. d Period average.

Exchange rates

Inflation

External sector



BiH Balkans (a)

Gross domestic product(% change, year on year)

BiH Balkans (a)

Consumer price inflation(av; %)

(a) Albania, Bosnia and Hercegovina, Bulgaria, Croatia, Macedonia, Romania, Serbia and Montenegro.

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

20

03

04

05

06

07

08

09

0.0

2.0

4.0

6.0

8.0

10.0

12.0

20

03

04

05

06

07

08

09

The political scene

Dramatic developments in Bosnia and Hercegovina (BiH) in recent weeks have plunged the country into possibly its most serious political crisis since the end of the war in 1995. The latest incident came on November 1st, when Nikola Spiric resigned as prime minister of BiH!s central state-level government. Mr Spiric, a Bosnian Serb, resigned in protest at measures announced by the international High Representative in BiH, Miroslav Lajcak, aimed at stream-lining decision-making in state-level institutions. Mr Spiric resigned after the Peace Implementation Council (PIC), an international body overseeing the implementation of the Dayton peace agreement, expressed its support for Mr Lajcak on October 31st.

Whereas most parties in the Bosniak (Bosnian Muslim)-Bosnian Croat Federation welcomed the proposals, as did most Western ambassadors in BiH, Bosnian Serb parties objected strongly. Public protests against Mr Lajcak, who is also the EU!s Special Representative in BiH, were held throughout the Republika Srpska (RS) entity on October 29th. The following day, the RS parliament condemned Mr Lajcak!s reforms and called for his powers to be curbed sharply.

On October 19th Mr Lajcak, a Slovak diplomat who took over as High Representative in July, unveiled proposals to simplify BiH!s complex decision-making process. Using the so-called Bonn powers, by which the Office of the High Representative (OHR) has the authority to impose legislation on BiH, Mr Lajcak reduced the state-level government!s ethnically-based quorum. Furthermore, he warned that he would apply similar measures to the state-level parliament if lawmakers did not make the changes themselves by December 1st. Finally, Mr Lajcak requested that the ruling parties at state level form a co-ordination council to speed up legislative activity.

Mr Lajcak said that his decisions were aimed at making it harder for laws to be blocked in state-level institutions through non-attendance or the invocation of vital national interests. In particular, the measures aim to cut through a long-running political deadlock that has blocked certain reforms in BiH that are

BiH's prime minister resigns in protest at Mr Lajcak's decisions

Mr Lajcak says he was trying to break the political deadlock



backed by the international community. The most important of these is the highly sensitive issue of the organisation and control of the entities! police forces, which the EU has deemed a necessary precondition for BiH to sign a stabilisation and association agreement (SAA).

Mr Lajcak!s apparently innocuous, technocratic measures, designed to increase the efficiency of the state-level government, touch on the complex, quasi-federalist relationships in BiH. In particular, the Bosnian Serbs believe that these measures will allow the Serb entity to be outvoted. The RS prime minister, Milorad Dodik, offered to resign as premier and as the head of the Alliance of Independent Social Democrats (SNSD), but this was turned down by the SNSD!s main board. Mr Dodik then sharply criticised Mr Lajcak, and the SNSD threatened to boycott BiH!s state-level institutions unless the High Representative rescinded his decisions. Bosnian Serb parties regard the measures as a violation of the 1995 Dayton agreement that ended the war in BiH, and ultimately as a threat to the existence of the RS, which is one of the two semi-autonomous entities that make up BiH.

Serbia has also entered the fray, making its most direct intervention into BiH!s politics since 1995. On October 25th Serbia!s prime minister, Vojislav Kostunica, elevated the preservation of the status of the RS to one of Serbia!s two national priorities, alongside the maintenance of Serbian sovereignty over Kosovo. Serbia!s president, Boris Tadic, weighed in on October 27th, stating that the Dayton agreement required any constitutional changes to be confirmed by a consensus of all three constituent peoples.

On October 25th Haris Silajdzic, the Bosniak member of BiH!s presidency, condemned Serbia!s support for the RS as flagrant interference in Bosnian affairs. The Bosnian Croat member of the three-member presidency, Zeljko Komsic, warned Mr Kostunica to "keep his hands off BiH", because he "might receive a rap on his wrist and nose", and said that Mr Kostunica "should not forget how his predecessor [Slobodan Milosevic] ended up".

On November 1st Mr Kostunica blamed Mr Lajcak for the crisis and called for his resignation. The vehemence of Mr Kostunica!s attacks on Mr Lajcak may also be linked to the latter!s role as the EU mediator ahead of the independence referendum in Montenegro in 2006.

So far Serb leaders have only occasionally hinted at the possibility that independence for Kosovo could trigger secessionist demands by the RS. Western diplomats routinely repeat the mantra that these are separate issues, but the Serbs do not see it that way. Serbia has now seized the opportunity of the crisis in BiH explicitly and loudly to link the Dayton accords with the Kosovo status process. Mr Kostunica has alleged that Mr Lajcak!s measures and the plan proposed by the UN envoy, Martti Ahtisaari, which recommends supervised independence for Kosovo, have the aim of annulling the Dayton agreement and UN Resolution 1244, which recognises Serbia!s sovereignty over Kosovo. The US, the UK, France, Germany and Italy issued a démarche to Serbia on October 30th in protest at the way it has been portraying Mr Lajcak!s actions.

Serbia enters the fray

Serbs try to link RS and Kosovo issues

Bosnian Serbs threaten to boycott state institutions



Although Russia has given Serbia strong support on Kosovo, it had until recently kept in step with the West on BiH. Now Russia has also taken sides on the Bosnian dispute, blaming Mr Lajcak for the deterioration in the political situation. Although Russia did not block the PIC!s statement of support for Mr Lajcak on October 31st, it did not sign the statement and expressed concern about the possible consequences of the High Representative!s actions.

Police reform in BiH

Parties reach a tentative agreement

Amid the recent political turbulence, the main Bosniak (Bosnian Muslim), Bosnian Serb and Bosnian Croat parties agreed to the EU!s three principles for reforming the country!s police forces. The deal reached on October 28th seemingly meets the EU!s demands that the police in Bosnia and Hercegovina (BiH) be centrally financed, free from political interference, and organised on the basis of operational requirements. The High Representative, Miroslav Lajcak, described the deal as "extremely useful", and EU officials also welcomed the breakthrough. The RS prime minister, Milorad Dodik, said that party leaders in BiH intended to meet again in late November to discuss the details of police reform. Should the main parties reach a final agreement, the final major obstacle to BiH signing a stabilisation and association agreement (SAA) with the EU would be removed. However, it was the parties! failure to agree on police reform that prompted Mr Lajcak to introduce his measures for speeding up state-level decision-making, and the subsequent political fallout will make it hard to reach a consensus on the details of the reform.

The devil is in the detail

BiH!s two entities currently each have their own police force, and the basic disagreement between the country!s politicians concerns the future of the RS force. Bosniak politicians point to the actions of Bosnian Serb forces in the 1992-95 war and say that they will not agree to a deal that preserves the RS police in any form. At the same time, Mr Dodik has said that he would rather forgo an SAA than give up his entity!s police force (May 2007, The political scene). Since taking office Mr Lajcak had made police reform a priority, and he had hoped that local parties would reach agreement by end-September. However, this deadline was missed, as was another deadline of October 15th. The main disagreement was between Mr Dodik!s Alliance of Independent Social Democrats (SNSD) and the predominantly Bosniak Party for BiH (SzBiH), which is led by Haris Silajdzic. The SzBiH refused to endorse a proposal tabled by Mr Lajcak in August. The party argued that it was biased towards the Bosnian Serbs by allowing for the preservation of entity-level policing, and that it did not provide for state-level financing of the police. The Party of Democratic Action (SDA), the SzBiH!s main coalition partner in the Federation, also rejected Mr Lajcak!s proposal initially, but then stated that it was willing to endorse the plan with some modifications. The Croatian Democratic Union of BiH (HDZ BiH) and the Croatian Democratic Union 1990 (HDZ 1990) backed the proposal, and reportedly played a prominent role in brokering the October 28th agreement. It remains to be seen whether the agreement will prompt Mr Lajcak to end his threat to impose sanctions against local political leaders, which he had made during the lengthy impasse on police reform.

Russia gets involved



Relations between the Party for BiH (SzBiH) and the Party of Democratic Action (SDA), the leading Bosniak parties in the Federation and state-level govern-ments, remain poor. This reflects tensions between Mr Silajdzic, the SzBiH leader, and his counterpart at the SDA, Sulejman Tihic. Their relations worsened during multiparty talks on police reform, in which Mr Tihic complained of being sidelined. Mr Silajdzic said that the real reason behind Mr Tihic�s criticism was the failure of an alleged attempt by the latter to break with the SzBiH and switch to a coalition with the Social Democratic Party (SDP). Mr Tihic denied these allegations, but acknowledged that on some issues he was closer to the SDP than to the SzBiH.

The relationship between the two leaders has been fragile ever since Mr Silajdzic defeated Mr Tihic in the October 2006 election to become the Bosniak member of BiH!s tripartite state-level presidency. Mr Tihic survived as SDA leader, but had to accept a coalition with the SzBiH at Federation and state-level, since this was favoured by much of his party. Mr Tihic has also angered the SzBiH recently by calling for an end to the monopoly that the SDA and the SzBiH enjoy over Bosniak appointments to ministerial posts and managing boards of public enterprises. For example, the SzBiH heads the Federation Ministry of Energy, Mining and Industry, and its officials are in charge of the main public companies and relevant agencies in this segment. Similarly, the SDA heads the Ministry of Transport and Communications and controls the telecommunications sector. Mr Tihic suggested that these posts should be opened to individuals other than SzBiH and SDA members. In view of the current political situation, however, an immediate collapse of the SzBiH-SDA coalition seems unlikely, and the parties have recently drafted a common platform for reforming BiH!s constitution.

In July the Federation House of Peoples, one of the entity!s two parliamentary chambers, adopted a public broadcasting law, after rejecting several amend-ments that had been previously approved by the House of Representatives. The law stipulates that the Federation!s radio and television broadcasting service is established by the entity!s parliament, has one television and one radio channel, and is managed by a four-member board. It also contains provisions for ensuring the balanced ethnic composition of the broadcaster!s staff. Bosnian Croat MPs boycotted the vote, invoking a "vital interest", and continue to insist on having separate Croatian-language television and radio channels. Whether the law adopted by the House of Peoples will remain in its present form depends on the Constitutional Court�s verdict, which had yet to be issued at the time of writing.

The adoption of the law is one of the remaining conditions for the EU and BiH to sign an SAA, although the broadcasting debate has been overshadowed by the issue of police reform. The difficulty in adopting a public broadcasting law in the Federation has delayed the implementation of a law on BiH!s public broadcasting service.

SDA-SzBiH coalition is shaky

Bosnian Croats vote against a public broadcasting law



Economic policy

Bosnia and Hercegovina (BiH) ran a consolidated government budget surplus of KM537m (US$399m) in January-June 2007, an increase of 16.2% year on year, according to data from the Central Bank of BiH (CBBH). This implies that the consolidated budget showed a surplus in the second quarter, having recorded a surplus of KM324m in January-March (August 2007, Economic policy). The surplus reflected strong revenue growth at the level of the central state and in the entities, as well as lower than expected spending. The fastest pace of revenue growth in the first six months was in the Brcko District, where it grew by 40% year on year, followed by Republika Srpska (up by 17.2%) and the Bosniak (Bosnian Muslim)-Bosnian Croat Federation (up by 13.7%).

The main revenue boost came from continued healthy growth in indirect tax receipts, which account for the largest share of total revenue. Indirect tax receipts amounted to KM2.1bn (US$1.5bn) in January-June, an increase of 4.5% year on year against a very strong base period, following the introduction of value-added tax (VAT) at the start of 2006 (VAT receipts contribute about 60% of indirect tax revenue). Customs receipts rose by 21.9% year on year in January-June, in line with a surge in imports to BiH. Receipts from customs duties on oil and oil derivatives rose particularly strongly, owing to higher international oil prices. Data for July point to a further increase in indirect tax revenue. VAT receipts grew by 26.5% year on year in that month; for the first seven months of 2007, customs receipts went up by 22.2% year on year, and excise revenue was 10.3% higher.

The Federation government has reported consolidated budget revenue of KM3.7bn in January-August, an increase of 16% compared with the year-earlier period. The largest increases were recorded in non-tax revenue (up by 30%), followed by income tax (21%), contributions (17%) and indirect taxes (16%). The rise in direct tax receipts reflects higher wages, especially in the public sector, as well as more effective tax collection by the Federation authorities. The latter development may be related to the Federation government!s recent initiative aimed at reducing informal employment. Whereas indirect taxation in BiH is administered at the level of the central state, direct taxation is under the entities! jurisdiction.

At the time of writing, the Federation parliament was discussing draft laws that would reduce the rates of tax on personal income and corporate profits, and would move towards harmonising payroll contributions with those in the RS. The changes are intended to improve the business environment in the Federation, reduce informal employment and harmonise taxation across BiH. The different tax systems in BiH!s two entities are one of the main obstacles in the way of creating a single economic space across the country, and may be hurting the Federation!s ability to attract investment. The Federation!s corporate profit tax rate of 30% has prompted a number of companies to relocate to the RS, where the rate is just 10%.

The consolidated budget remains in surplus

Federation government discusses cutting tax rates

Federation reports strong revenue growth



The law on personal income tax envisages the abolition of the current 30% rate and its replacement with rates of 10% and 15%. The Federation government aims to lower the corporate tax rate to 10%"the same as in the RS"and to offer targeted tax breaks. Beneficiaries would include companies investing at least KM20m over a five-year period, and companies in which export earnings account for at least 30% of total revenue. Despite pressure from the employers� association, the Federation government has decided to stick with the current rate of payroll contributions for another two years, and to decide on a possible reduction following a review. The draft law instead aims to improve the collection of contributions by strengthening the role of the entity!s tax administration.

In October the RS government"which had previously adopted a balanced budget for 2007, with revenue and spending projected at KM1.25bn"decided to revise the budget. This reflects stronger than anticipated revenue from indirect taxes, income tax and corporate profit tax. As a result, the government increased both revenue and expenditure by 12.2% to KM1.39bn, allocating extra money for the health insurance fund, the judiciary, culture, education and the Ministry of the Interior.

The monthly minimum wage in the RS will rise to KM250 (US$185) from January 1st 2008, in line with a government proposal. This represents an increase of 22% compared with the previous minimum wage of KM205 per month. The increase comes on top of strong wage growth over the past couple of years, with nominal wages rising by more than 10% year on year so far in 2007 (see The domestic economy: Employment, wages and prices).

The RS minimum wage has lagged behind that in the Federation, as the two entities have different legislation. According to the 2005 General Collective Agreement, the minimum wage in the Federation is set at 55% of the average wage, and is one of the highest in the region. The minimum wage in the RS is significantly lower, amounting to some 40% of the average wage in 2006. Nonetheless, relatively high minimum wages in BiH help to explain the country!s low wage flexibility, despite the high rate of unemployment.

In October the prime ministers of the state- and entity-level governments agreed to adopt a law on the National Fiscal Council (NFC) by the end of the year. The NFC, a body that is strongly backed by international financial institutions such as the IMF, is charged with co-ordinating budgetary policy across BiH, with the aim of mitigating the risks posed by the country!s complex fiscal structure. However, the NFC has so far met only at the behest of the IMF, and a law setting out its responsibilities has yet to be passed. In addition, although new debt laws have introduced borrowing limits at all levels of government, it remains to be seen how strictly the local authorities in BiH will adhere to the statutory borrowing limits.

Besides expressing concern about fiscal co-ordination across BiH, the IMF has called on the local monetary authorities to strengthen banking supervision in response to continued rapid lending growth. The IMF has long been concerned

RS rebalances the budget

Governments pledge to adopt fiscal council law by end-2007

The IMF calls for tighter banking supervision

RS minimum wage is to rise



at weaknesses in loan classification and provisioning in BiH, and has reiterated its concerns in the light of recent turbulence in global financial markets. Part of the problem, according to the IMF, is that banks are currently supervised by separate agencies in BiH!s two entities, presenting logistical complexities and the risk of unequal treatment.

In its Macroeconomic Newsletter for October, the IMF called on the entity banking supervision agencies to tighten loan classification standards and levy larger fines on banks that do not comply with prudential regulations. The IMF also called for bank supervision in BiH to be unified, although the RS authorities in particular want banking oversight powers to remain at entity level. The importance of improving banking supervision has been highlighted by the European Central Bank (ECB), which recommended that the CBBH strengthen its supervisory role in co-ordination with other domestic and international bodies.

The Federation government has forwarded to the Federation parliament a long-awaited privatisation plan, covering the remaining companies that are due to be sold. The privatisation of the entity!s two main telecommunications operators (BiH Telecom and the smaller Hrvatske Telekomunikacije Mostar) are expected to secure the bulk of the receipts, which are estimated at KM4.1bn, although the timing of the sales remains uncertain. In mid-2007 the RS authorities sold a 65% stake in Telekom Srpske, the leading operator in that entity, for #646m (US$938m).

The sale of large companies in the Federation has been slower than in the RS, owing a weaker legislative framework and more complex political structure. A case in point has been the delayed sale of an 88% state-owned stake in the aluminium smelter Aluminij Mostar, BiH�s largest exporter. The Federation government has now pushed back from November 2007 to February 2008 its deadline for completing the sale.

The Federation Ministry of Development, Entrepreneurship and Crafts has unveiled plans to support small and medium-sized enterprises (SMEs) through the establishment of additional business zones in the entity, in co-operation with cantonal and municipal governments. The document will be forwarded to the entity parliament by end-2007 and covers the period until 2010. A number of business zones have already been established in BiH; one of the most successful is Gracanica in the northern part of the Federation, which has been developed as a public-private partnership.

Federation government develops privatisation plan

Federation government plans business zones to help SMEs



The domestic economy

Output and demand

During the third quarter of 2007 industrial output continued to grow much faster in the Bosniak (Bosnian Muslim)-Bosnian Croat Federation than in Republika Srpska (RS). Industrial production in the Federation increased by 11.6% year on year in January-September. The main driver of growth was the buoyant manufacturing sector, where output rose by 18.3% and mining output climbed by 10.8%. Growth in these sectors outweighed a 7.9% contraction in utilities output.

By contrast, industry remained sluggish in the RS, and output crept up by just 0.1% year on year in January-September, compared with full-year growth of 19% in 2006. The sharp slowdown reflected a decline in utilities output, which fell by 11.8% year on year in the first nine months of 2007. Severe drought has affected output in RS!s hydroelectric power plants; in addition, repair and maintenance work on the Gacko thermoelectric power plant has been delayed. Manufacturing output increased by 5% year on year, and mining output rose by a modest 1.4%.

The most notable feature of the manufacturing sector in the Federation has been the strong performance by a number of smaller industries. Year-on-year growth in January-September was particularly strong in chemicals (up by 54%), rubber and plastic (27%), metal products (57%), motor vehicles (51%), and electrical machinery (21%), reflecting increased capacity utilisation, as well as new capacity. With the exception of furniture-makers, who saw output shoot up by 34%, the Federation!s leading manufacturing sectors, such as food and beverages, basic metals, and non-metallic minerals, generally grew by about 8-10% year on year. However, output in the textile, wood and tobacco sectors was lower than in the year-earlier period.

The textile sector in the RS has been far more vibrant, with output more than doubling year on year in January-September. There was also strong growth in office machinery and equipment, furniture, and non-metallic minerals. The sharpest falls were in radio and telecommunications equipment, leather and leather manufacturing, rubber and plastic, and tobacco.

Construction remained buoyant across Bosnia and Hercegovina (BiH) during the third quarter, maintaining the trend established earlier in the year. In January-August construction output grew by 39.6% year on year in the RS and by 29.2% in the Federation. In the Federation, building construction accounts for more than 50% of the total value of work performed, but infrastructure projects, especially roadbuilding, have been catching up fast. Although the RS does not publish data on the breakdown of construction output by the type of work, the trends are likely to be similar, since the entity has recently stepped up its roadbuilding programme (see The domestic economy: Sectoral trends).

Industrial output grows faster in Federation than in the RS

Federation's manufacturing base broadens

Construction continues to expand strongly



Employment, wages and prices

Employment trends have continued to improve modestly in Bosnia and Hercegovina (BiH). The number of those in work totalled almost 675,000 in August, according to the Agency for Statistics of BiH, representing an increase of 2% year on year. Employment growth was particularly strong in hotels and catering, financial intermediation, mining, real estate and trade.

At the same time, the growth in the number of registered unemployed, which had until recently outpaced growth in official employment, has slowed down. Unemployment across BiH in August was up by about 1% year on year to 521,620. This increase was entirely explained by higher unemployment in the Federation, which rose by 3.4% year on year in August. By contrast, registered unemployment in the RS and the Brcko District declined in year-on-year terms by 3.6% and 7.3%, respectively. The official rate of unemployment in BiH remains above 40%, but the actual jobless total is likely to be lower, not least because of the country!s large grey economy.

Wage growth in BiH has accelerated sharply since May. The average net monthly wage in August was KM651 (US$483), representing a nominal year-on-year increase of 10.2%. Wages grew faster in the RS, where the net average wage in August was 13.7% higher than the 2006 average for the entity. This reflected a sharp rise in public-sector wages, particularly in public administration (up by 18.7%), health (21%) and education (10.2%), as well as a 20.6% increase in construction wages. The net monthly wage in the Federation in August was 10.8% higher than the 2006 average; the fastest growth was in mining (up by 19.1%) and agriculture (14.9%). As in the RS, public-sector wages also posted strong growth and were significantly above the national average of KM651.

Inflation remained low in both entities in the third quarter of 2007, in part because of the continued strong base-period effect related to the introduction of value-added tax (VAT) at the start of 2006. In January-September retail prices rose by 1.6% year on year in the Federation and by just 1% in the RS. Services saw the largest price increase in both entities, rising by 2.8% in the Federation and by 2.4% in the RS. Prices of agricultural products went up by 2.3% in the Federation and by 2.2% in the RS. These higher than normal increases reflected severe and prolonged drought in BiH, which affected the supply of seasonal fruit and vegetables; and higher prices of some basic foodstuffs related to rising world grain prices.

The RS government has announced its intention to increase electricity prices by as much as 42.5%, which, if followed through, will have an impact on the overall price level. Another potential source of inflationary pressure is the proposed introduction of a tax on the price of petrol, which would help to finance the construction and maintenance of roads in BiH. The proposed tax has yet to be approved by the Indirect Taxation Authority (ITA), a state-wide body responsible for administering VAT and other indirect taxes in BiH.

Employment picks up

Wage growth accelerates

Inflation is low



-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Jan

2005

Mar May Jul Sep Nov Jan

06

Mar May Jul Sep Nov Jan

07

Mar May Jul Sep

Federation

RS

Retail price inflation(%, year on year)

Source: Entity statistical agencies.

Financial indicators

Credit growth in Bosnia and Hercegovina (BiH) continued to accelerate in the third quarter of 2007. At the end of September the total stock of commercial bank loans was KM11.2bn (US$7.8bn), an increase of 29.8% compared with the same point in 2006, up from 27.5% growth in May and 22.3% in December 2006. The stock of loans to private enterprises rose by 31.8% year on year in September, and household credit rose by 29.9%. Credit to private enterprises now accounts for about 43% of total bank credit, compared with 33% in 2002.

Increasing competition in BiH!s banking sector has improved access to credit for households and companies, and contributed to a moderation in interest rates. However, the rapid growth in bank credit has raised some concerns among international financial institutions, which fear that BiH!s external deficit could worsen further and that banking supervision is not rigorous enough.

0

2,000

4,000

6,000

8,000

10,000

12,000

Jul

2006

Aug Sep Oct Nov Dec Jan

07

Feb Mar Apr May Jun Jul Aug Sep

Total commercial bank loans(KM m)

Source: Central Bank of Bosnia and Hercegovina.

Growth of bank lending continues to accelerate



Sectoral trends

Both entities in Bosnia and Hercegovina (BiH) are moving ahead with ambitious investment plans for the energy sector. One large project in the RS is the planned construction of a 420-mw lignite-fired power plant near Stanari, about 70 km east of Banja Luka, which is being led by the energy company EFT. Another crucial project in the RS is a joint venture with CEZ (Czech Republic) to expand the Gacko thermal power plant. This will involve the construction of a new 600-mw thermal plant, along with an upgrading of the existing plant and the opening a new mine. A feasibility study for upgrading RS!s third main thermoelectric power plant at Ugljevik is currently being prepared by AES (US); the entity government is interested in upgrading the existing plant and building a new 600-mw plant. At the same time, the RS government has decided to develop the entity!s hydroelectric power sector and at the end of August it approved the construction of several hydroelectric plants on the Bosna River under a #152m (US$221m) agreement with Technor Energy (Norway).

In late July the Federation parliament authorised Vahid Heco, the entity!s minister for industry, mining and energy, to finalise negotiations on the construction of eight power plants, four thermal and four hydroelectric. The construction of these plants by 2020 is part of the Federation government�s energy reconstruction programme.

BiH!s Ministry of Transport and Telecommunications has invited 15 consortiums to submit project documentation for the construction of a 130-km section of the pan-European Corridor Vc motorway, which is expected to start in 2009. The feasibility study for the 300-km section of the motorway that passes through BiH was completed in 2006. The government has identified three priority routes and started the procedure for the land acquisition.

Meanwhile, the RS authorities are currently negotiating a concession agreement with Strabag (Austria) for the construction of 420 km of roads, including 50 km of Corridor Vc. Work on parts of the road network is expected to start before the end of 2007, and the full programme should be under way by mid-2008.

Foreign trade and payments

Bosnia and Hercegovina (BiH) ran a merchandise trade deficit of KM5.68bn (US$4.22bn) in January-September 2007, an increase of 31.1% compared with the year-earlier period. Imports rose by 24.1% year on year in the first nine months to reach KM10.09bn, according to the central state-level Agency for Statistics of BiH, whereas exports increased at the slower rate of 16.3% and totalled KM4.41bn. The strength of import growth continues to reflect in part a weak base period"imports barely increased in 2006 following a rush of foreign buys ahead of the introduction of value-added tax (VAT) at the start of that year. At the same time, by encouraging greater reporting, the introduction of VAT gave a one-off boost to exports in 2006, and hence has created a strong base-period effect during 2007.

The trade deficit increases by almost one-third

Entity governments have ambitious energy sector plans

Roadbuilding continues



BiH: Trade in goods, Jan-Sep (KM m unless otherwise stated)

2006 2007 % changeExports fob 3,791 4,411 16.3Imports cif -8,123 -10,091 24.1

Balance -4,332 -5,680 31.1

Source: Agency for Statistics of BiH.

Machinery and base metals posted the strongest import growth among the main product categories in January-September, rising by 52.1% and 52.6%, respectively. The surge in machinery imports reflects retooling by industrial firms, as well as capital goods imports related to infrastructure projects in BiH. There was also rapid import growth in sectors that operate mostly on the inward-processing principle, such as wood and wood-processing (up by 47%), metal-processing (48%), and furniture (41%). Imports of food and beverages, which remains the single largest manufacturing import item, rose by 10.3% year on year in January-September.

The share of energy and non-durable consumer goods in the January-September import bill was lower than in the year-earlier period. At the same time, the share of capital goods increased from 17.4% in January-September 2006 to 20.4%, in line with expanding industrial and construction investment in BiH. The share of intermediate goods edged upwards by 1.5 percentage points, to account for 36.9% of the total value of imports in January-September.

Growth in manufacturing exports in January-September 2007 was slightly slower than in the year-earlier period, but still reached a healthy 20% year on year. Exceptionally strong growth in exports was recorded in several sectors, including metal processing (up by 57%), non-metallic minerals (51.8%), rubber and plastic (49.7%), and machinery (42.2%). Although these sectors account for a relatively modest share of total exports, strong growth in their foreign sales points to the improving competitiveness and increasing penetration of these companies in a number of key markets. Healthy growth was also recorded in wood and wood-processing (26%), leather (22.2%), and food and beverages (19.4%). Base metals, mainly aluminium and iron, remain BiH!s key export and accounted for 23% of total exports in January-September. However, export growth in this sector was just 4.8% year on year.

The EU is BiH�s main trading partner, accounting for 58.2% of the value of exports and 47.7% of imports in January-September 2007. Exports to the EU rose by 12.8% year on year, and imports increased by 11%. This represents a continuation of a trend seen in 2006, when faster export growth led to a decrease in BiH!s trade deficit with the EU. However, BiH!s trade deficit with Germany, its largest EU trade partner, widened in January-September. Exports to Germany, which represented 13% of BiH!s total exports in the period, grew by 16.3%, and imports increased by 22.2%.

BiH!s main trading partners outside the EU are Serbia, Croatia and Montenegro, which accounted for about 33% of exports and 27% of imports in January-September. (The Agency for Statistics of BiH is now reporting separate trade

Imports of machinery and base metals surge

Manufacturing exports remain strong

The EU is still the main trading partner for BiH



figures for Serbia and Montenegro, following the dissolution of their joint state in 2006.)

The sharp increase in the merchandise trade deficit was the main reason for the deterioration in BiH!s current-account deficit in January-June. The Central Bank of BiH (CBBH) has reported that the current-account deficit in January-June amounted to KM1.29bn, an increase of more than 60% compared with the KM800m (US$556m) deficit recorded in the year-earlier period.

The increase in the trade deficit was only partly offset by larger surpluses on the other parts of the current account. The strongest improvement was in the income surplus, which rose by 39% year on year to KM365m. This reflected growth in investment income and an increase in compensation paid to BiH citizens working in international organisations in BiH, which accounts for the bulk of income receipts. The services surplus rose by 18% year on year in the first half of 2007, reflecting strong receipts from travel and other services. Transfers, which are driven primarily by remittances from Bosnian citizens working abroad, were up by 11.5% year on year.

Balance of payments (KM m)

2005 2006 2007 2006 2007 Year 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year 1 Qtr 2 Qtr Jan-Jun Jan-JunMerchandise exportsa 4,082 1,102 1,364 1,399 1,392 5,256 1,368 1,521 2,466 2,889Merchandise importsa -11,917 -2,217 -3,067 -3,249 -3,383 -11,917 -2,905 -3,623 -5,284 -6,528Trade balance -7,834 -1,116 -1,703 -1,851 -1,992 -6,661 -1,537 -2,102 -2,819 -3,639Net services 774 191 282 225 252 950 245 313 473 558Net income 712 109 154 317 141 721 176 189 263 365Net transfers 2,991 594 690 821 846 2,949 610 821 1,283 1,431Current-account balance -3,357 -222 -578 -489 -753 -2,041 -505 -780 -800 -1,285Capital account 646 111 127 146 150 532 110 140 237 250Financial account 2,028 49 378 -167 456 715 369 477 426 846 Net direct investment 821 169 183 170 138 661 272 1,484 352 1,756 Other investment 1,944 124 394 280 462 1,259 233 -693 518 -460Reserve assets -738 -245 -200 -616 -144 -1,205 -135 -312 -444 -447Net errors and omissions 684 63 74 510 148 793 26 163 137 189

a Including coverage and valuation adjustments by central bank.


Net foreign direct investment (FDI) to BiH reached KM1.76bn in January-June, more than covering the current-account deficit. The strong FDI inflows reflected the sale of a 65% stake in Telekom Srpske, the leading operator in Republika Srpska (RS), for #646m (US$880m). Future FDI inflows will depend in part on the speed of privatisation in the RS and the Bosniak (Bosnian Muslim)-Bosnian Croat Federation, as well as on greenfield investments.

These privatisation receipts also boosted BiH!s net foreign-currency reserves, which reached an all-time high of KM6.5bn at the end of September, compared with KM5.3bn at the same point of 2006. Apart from the proceeds from the Telekom Srpske sale, higher tourism receipts and remittances also boosted reserves. BiH!s reserves are currently equivalent to about five months of

Merchandise trade deficit fuels the current-account deficit

FDI covers the deficit

Steady growth in foreign-currency reserves is sustained



imports. Net free reserves"those that are surplus to the CBBH!s monetary liabilities"stood at KM348m at end-September, up from KM245m a year earlier.

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