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Country Report

Bosnia and Hercegovina

April 2006

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

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Bosnia and Hercegovina 1

Country Report April 2006 www.eiu.com © The Economist Intelligence Unit Limited 2006

Contents

Bosnia and Hercegovina

3 Summary

4 Political structure

6 Economic structure 6 Annual indicators 7 Quarterly indicators

8 Outlook for 2006-07 8 Political outlook 9 Economic policy outlook 10 Economic forecast

13 The political scene

17 Economic policy

21 The domestic economy 21 Output and demand 24 Employment, wages and prices 26 Financial indicators

27 Foreign trade and payments

List of tables 10 International assumptions summary 12 Forecast summary 21 Federation: industrial production 23 Republika Srpska: industrial production 24 BiH: labour statistics 26 BiH: retail prices 28 BiH: imports of goods, 2005 28 BiH: goods exports, 2005 29 BiH: trading partners 30 Balance of payments 32 General government external debt by creditor

2 Bosnia and Hercegovina


List of figures

13 Gross domestic product 13 Consumer price inflation 25 Net wage growth 27 Credit growth



Bosnia and Hercegovina April 2006

Summary

The October 2006 general election is likely to see moderate parties in both entities make inroads against the three leading nationalist parties. The Economist Intelligence Unit expects the approach of the October election to mitigate the risk of significant political instability in the interim, although EU, and later IMF, requirements will sustain pressure on the election winners. The currency-board arrangement will stay in place in 2006-07, helping mitigate the inflationary impact of the introduction of VAT this year. We expect improving export performance to drive an upturn in real GDP growth to 5.8% by 2007.

In January 2006 the Republika Srpska (RS) government, led by the hardline Serb Democratic Party (SDS), lost a no-confidence vote, and a new coalition, led by the Alliance of Independent Social Democrats (SNSD) was formed. In the Federation, progress has been slow on agreeing a public broadcasting law that meets with EU requirements. Negotiations on a stabilisation and association agreement (SAA) with the EU are on course. A new High Representative, Christian Schwarz-Schilling of Germany, took over in January 2006.

In late 2005 the adoption of state and entity budgets for 2006 was delayed, forcing both entities to pass temporary funding measures. The IMF and the authorities have been unable to agree a new stand-by arrangement, primarily because of differences over fiscal plans for the year. A state-wide value-added tax (VAT) came into effect in January. The new government in the RS has pledged to review previously concluded privatisations.

Industrial output growth decelerated in the Federation in 2005, but remained robust in the RS. The introduction of VAT at the beginning of 2006 led to a sharp jump in prices in January, but the impact of the new tax had already weakened by February. Bank credit to the private sector had grown more slowly in the first part of 2005, but it accelerated towards the end of the year.

Import growth surged towards the end of 2005, leaving the merchandise trade deficit for the year at KM7.4bn (US$4.6bn), some KM700m (US$446m) larger than in 2004. Preliminary figures from the Central Bank of Bosnia and Hercegovina (CBBH) suggest that the 2005 current-account deficit widened by around KM500m, or 18%, compared with 2004.

Editors: Matthew Shinkman (editor); Richard Eames (consulting editor) Editorial closing date: March 29th 2006 All queries: Tel: (44.20) 7576 8000 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

The political scene

Economic policy

The domestic economy

Foreign trade and payments

Outlook for 2006-07



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 BiH government was granted limited responsibilities under the Dayton peace agreement signed in November 1995, including 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 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 6th 2002 to select a three-member state presidency, the RS president, and state, entity and cantonal parliaments. Next presidential and parliamentary elections are due in October 2006

BiH has a rotating, collective, three-member presidency. The current members are: Borislav Paravac (Serb; appointed April 2003), Sulejman Tihic (Muslim; elected October 2002, current chairman) and Ivo Miro Jovic (Croat; appointed May 2005)

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 was formed after elections in October 2002. The entities also have their own governments, and cantons within the Federation also have powerful local governments

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

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

Chairman Adnan Terzic (Muslim) Civil affairs Safet Halilovic (Muslim) Defence Nikola Radovanovic (Serb) Foreign affairs & deputy chairman Mladen Ivanic (Serb) Foreign trade & economy Dragan Doko (Croat) Human rights & refugees Mirsad Kebo (Muslim) Justice Slobodan Kovac (Serb) Security & deputy chairman Barisa Colak (Croat) Transport & communications Branko Dokic (Serb) Treasury Ljerka Maric (Croat)

Kemal Kozaric

National government

Central Bank governor

Legislatures

National elections

Head of state

National government

Main political parties

International involvement

State competencies

Official name



Christian Schwarz-Schilling

President Niko Lozancic (HDZ) Vice-president Sahbaz Dzihanovic (SzBiH) Vice-president Desnica Radivojevic (SDA) Prime minister Ahmet Hadzipasic (SDA) Deputy prime minister & minister of finance Dragan Vrankic (HDZ) Deputy prime minister & minister of sport & culture Gavrilo Grahovac (SzBiH)

Agriculture, water & forestry Marinko Bozic (HDZ) Defence Miroslav Nikolic (HDZ) Education & science Zijad Pasic (SDA) Energy, mining & industry Izet Zigic (SzBiH)a Health Tomo Lucic (HDZ) Interior Mevludin Halilovic (SDA) Justice Borjana Kristo (HDZ) Labour & social affairs Radovan Vignjevic (SDA) Trade Maid Ljubovic (SzBiH) Veterans' affairs Ibrahim Nadarevic (SDA)

President Dragan Cavic (SDS)

Vice-president Ivan Tomljenovic (independent) Vice-president Adil Osmanovic (SDA)

Prime minister Milorad Dodik (SNSD)

Agriculture Slaven Pekic (PDP) Economic affairs & co-ordination Jasna Brkic (independent) Economy, energy & development Milan Jelic (SNSD) Education & culture Anton Kasipovic (independent) Finance Aleksandar Dzombic (SNSD) Health & social welfare Ranko Skrbic (SNSD) Interior Stanislav Cadjo (SNSD) Justice Omer Visic (SzBiH) Trade & tourism Predrag Gluhakovic (SPRS)

a Outgoing.

Federation

Key ministers

High Representative

Key ministers

Republika Srpska



Economic structure

Annual indicators

2001a 2002a 2003 a 2004 a 2005b

GDP at market prices (KM bn) 10.5 11.6 12.3 13.5 b 14.7

GDP at market prices (US$ bn) 4.8 5.6 7.1 8.6 b 9.3

Real GDP growth (%) 4.3 5.3 4.0 5.7 b 5.3

Retail price inflation (av; %) 3.9 3.1 1.4 0.8 3.2

Population (m) 3.9 3.9 3.9 3.9 3.9

Exports of goods fob (US$ m) 1,134 1,110 1,478 2,087 2,589

Imports of goods fob (US$ m) -4,092 -4,449 -5,637 -6,656 -7,574

Current-account balance (US$ m) -750 -1,201 -1,745 -1,918 -2,110

International reserves (US$ m) 1,221 1,321 1,796 2,408 2,531

Total external debt (US$ bn) 2.3 2.8 2.9 3.1 3.5

Exchange rate (av) KM:US$ 2.19 2.08 1.73 1.58 1.57

a Actual. b Economist Intelligence Unit estimates.

Share in gross value added 2004a % of total Components of gross domestic product 2003b % of total

Agriculture 11.5 Private consumption 91.7

Industryc 22.1 General government consumption 22.3

Manufacturing 12.3 Exports of goods & services 25.1

Services 61.7 Imports of goods & services 59.1

Principal exports 2005 % of total Principal imports 2005 % of total

Base metals 26.4 Machinery 16.2

Wood & wood products 10.7 Mineral products 14.5

Mineral products 14.2 Foodstuffs 10.0

Chemicals 8.1 Chemicals 9.4

Main destinations of exports 2005 % of total Main origins of imports 2005 % of total

Croatia 20.5 Croatia 16.9

Serbia & Montenegro 15.5 Germany 14.4

Italy 13.1 Serbia & Montenegro 10.2

Germany 11.3 Italy 9.0

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



Quarterly indicators 2004 2005 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 QtrFinancial indicators Exchange rate KM:US$ (av) 1.564 1.624 1.601 1.511 1.488 1.554 1.604 1.646Exchange rate KM:US$ (end-period) 1.600 1.609 1.576 1.436 1.509 1.617 1.624 1.658Deposit rate (av; %) 3.64 3.50 3.79 3.96 3.81 3.49 3.37 3.59Lending rate (av; %) 10.55 10.33 10.15 10.10 9.95 9.85 9.56 9.08M1 (end-period; KM m) 3,428 3,590 3,799 3,788 3,763 3,985 4,228 4,426M1 (% change, year on year) 14.8 15.2 18.0 15.2 9.8 11.0 11.3 16.8M2 (end-period; KM m) 6,105 6,476 6,844 7,213 7,272 7,682 8,156 8,562M2 (% change, year on year) 15.7 19.2 21.2 22.5 19.1 18.6 19.2 18.7

Foreign trade & payments (US$ m) Exports fob 446.7 484.4 534.8 620.7 561.0 680.8 n/a n/aImports fob -1,314.1 -1,649.5 -1,752.3 -1,940.2 -1,502.1 -1,951.6 n/a n/aTrade balance -867.4 -1,165.1 -1,217.5 -1,319.5 -941.1 -1,270.8 n/a n/aServices balance 80.2 106.0 72.6 112.9 112.4 160.0 n/a n/aIncome balance 130.0 99.4 114.9 102.0 123.2 120.4 n/a n/aTransfer balance 371.7 431.1 502.0 528.3 384.4 442.0 n/a n/aCurrent-account balance -285.6 -528.5 -527.9 -576.4 -321.1 -548.4 n/a n/aReserves excl gold (end-period) 1,885 1,969 2,164 2,408 2,277 2,222 2,427 2,531

Sources: IMF, International Financial Statistics.



Outlook for 2006-07

Political outlook

In early 2006 there was a considerable shake-up in the political scene in Bosnia and Hercegovina (BiH), including a change in government in Republika Srpska (RS), one of the two entities at sub-state level. The October 2006 state-wide general election is likely to see moderate parties in both entities make inroads against the three leading nationalist organisations—the Serb Democratic Party (SDS), the Croatian Democratic Union of BiH (HDZ BiH), and the mostly Bosnian Muslim Party for Democratic Action (SDA). However, the current ruling parties will remain significant forces in both entities, and it is unclear to what degree the introduction of less hardline parties into government will lead to an acceleration in the pace of reform or to improvements in relations with international actors in BiH. The risk of significant political instability in the period before the October election is relatively low, although outside demands to push forward with constitutional reform and EU integration requirements will maintain pressure on the election winners later in the forecast period.

The leading parties have recently agreed a series of constitutional reforms that will strengthen the central state government and make it more difficult for individual parties to block legislation. This will weaken the ability of the nationalist parties to obstruct reform, which, until now, has been one of the only common causes in their coalition. Christian Schwarz-Schilling, a German diplomat, took over as High Representative in early 2006, promising to adopt a more hands-off approach than his predecessor and to allow local authorities more autonomy in determining policy. This will also make life more difficult for the governments in both entities, as they will be less able to rely on the Office of the High Representative (OHR) to push through politically sensitive legislation that is required as part of the EU integration process. This process—focused currently on negotiating a stabilisation and association agreement (SAA)—will also place strong demands on the winners of the 2006 election. The EU is pressing for improved co-operation with the International Criminal Tribunal for former Yugoslavia (ICTY) in The Hague, reform of the public broadcasting system, and continued restructuring of the police—all of which face significant domestic opposition.

The installation of the new government in the RS, led by Milorad Dodik, marked a victory for the former opposition party, the Alliance of Independent Social Democrats (SNSD). The SNSD stands a good chance of winning the October election. Mr Dodik has set out an ambitious agenda centred on rooting out corruption and kick-starting the economy, while knowing that his govern-ment will probably be able to delay unpopular measures until after the vote. Mr Dodik’s government faces the difficult task of completing another phase in the country’s ongoing police reform—which is highly unpopular in the RS—before the election. Although it has been dealt a blow by recent events, the SDS remains strong, and the campaign is likely to feature heavy attacks by the SDS on the nascent SNSD-led government. Nevertheless, as of early 2006 it appears

Domestic politics

Election watch



that the next RS government will not include the SDS, barring a much stronger than expected performance or a collapse in support for the SNSD. Should the SNSD win, it is likely to form a similar government to the one that it currently leads, probably including the Party for Democratic Progress (PDP).

In the Federation of BIH (the second entity at sub-state level), the political geometry is also complicated. The HDZ BiH, which rules in coalition with the SDA and the Party for BiH (SzBiH), has been significantly weakened in recent months by in-fighting and an impending court case against its leader, Dragan Covic. However, there does not appear to be a credible alternative to the HDZ BiH on the Bosnian Croat political scene, and the period leading up to the election will see the parties of the Bosnian Croat political bloc working to develop a coherent coalition, most likely led by the HDZ BiH, that could take part in a new Federation government. The SDA remains the strongest party in the Federation and is likely to do well in the election. The SzBiH's reputation has been tarnished by its willingness to work with the nationalist parties in the Federation government, but the return to politics of its founder, Haris Silajdzic, could yet see its fortunes improve. The popularity of the Socialist Democratic Party (SDP), the strongest opposition party in the Federation, has recently improved, but it is unlikely to overtake the SDA, as did the SNSD in the RS. More likely is a government including both the SDA and the SDP, who acted in close concert in the recent constitutional amendment process.

EU representatives and local authorities have suggested that Bosnia’s SAA negotiations could be completed by the fourth quarter of 2006, although it is likely that the talks could last longer. The EU has set out a range of requirements for completion of the SAA, some of which will be politically sensitive. At the same time, current concerns within the EU over the pace of enlargement mean that the European Commission is likely to take a much firmer stance on full implementation of reforms than it did with previous potential candidate countries. The government is also aiming for membership in NATO's Partnership for Peace (PfP) programme, which will necessitate improved co-operation with the ICTY.

Economic policy outlook

Disagreements over fiscal plans for 2006 have held up the conclusion of a new stand-by arrangement with the IMF. The IMF has insisted on further fiscal consolidation, which it considers essential for maintaining macroeconomic stability, whereas the authorities insist that the budgets allow for financing an ambitious infrastructure programme. However, given the negative con-sequences of an IMF withdrawal, the Economist Intelligence Unit expects the authorities to work with Fund representatives in BiH to bring the entity budgets into line with IMF requirements—although, given upcoming elections, this is unlikely to take place until 2007. We therefore expect a stand-by arrangement to be completed sometime later in the forecast period. More broadly, the context for economic policymaking over the forecast period will be set by the national medium-term development strategy (MTDS). The MTDS envisages further progress on corporate restructuring, as well as strengthening of the business

Policy trends

International relations



environment in order to encourage more investment. The coming general election presents a significant risk to the pace of economic reform this year.

Several factors have led the entity governments to push for higher public expenditure in their 2006 budgets. Both governments are concerned about the potential disruption caused by the introduction of value-added tax (VAT), and have called for increased social expenditure to mitigate the impact. At the same time, the approach of the general election provides a strong incentive to boost current expenditure. Both entity budgets for 2006 rely on an expected improvement in tax revenue in line with the new VAT (preliminary data suggest that revenue was up strongly at the beginning of the year), but also on growth projections that we find implausible (7% real GDP growth in the RS and 8% in the Federation). There is thus a significant risk that fiscal deficits in the entities will be larger than budgeted this year. With the authorities already under pressure from the IMF to tighten the fiscal position, and the impact of VAT uncertain, it is likely that both governments will have to produce supplementary budgets this year. Additional risks to the fiscal position over the forecast period are posed by a significant debt-service burden, spending on police and defence reforms, and declining international assistance.

The Central Bank of Bosnia and Hercegovina (CBBH) has run a currency board regime in BiH since 1998, with the convertible marka fixed to the euro. In November 2005 the central bank increased the reserve requirement—one of its few monetary policy tools—in order to stem recent rapid growth in consumer credit, which it fears could destabilise the currency board arrangement. The large external imbalance and high unemployment remain long-term concerns for the CBBH, but foreign reserves have grown rapidly in recent years and more than cover the central bank’s monetary obligations. International reserves held by the CBBH rose strongly in 2005, and reached a historical high of KM4.2bn (US$2.6bn) in January 2006. Inward investment flows and large private remittances will keep foreign reserves on an upward trend over the forecast period. Nonetheless, the central bank has made clear its intent to keep monetary conditions tight in order to support the currency board arrangement. In the first half of 2006 the CBBH expects to issue BiH’s first short-term securities, pending the successful resolution of a domestic claims problem (the governments are working through how to pay off arrears for war damages, bank deposits seized during the war, and other expenditure), and may seek a second sovereign rating. BiH is currently rated B3 by Moody’s.

Economic forecast

International assumptions summary (% unless otherwise indicated)

2004 2005 2006 2007

Real GDP growth World 5.1 4.6 4.3 4.1

OECD 3.2 2.6 2.5 2.3

Euro zone 12 1.9 1.2 1.8 1.9

EU25 2.4 1.6 2.1 2.3

Monetary policy

Fiscal policy

International assumptions



International assumptions summary (% unless otherwise indicated)

2004 2005 2006 2007

Exchange rates ¥100:US$ 1.1 1.1 1.1 1.0

US$:€ 1.244 1.245 1.248 1.338

SDR:€ 0.84 0.84 0.85 0.87

Financial indicators € 3-month interbank rate 2.13 2.15 2.90 3.69

US$ 3-month Libor 1.62 3.56 5.32 4.95

Commodity prices Oil (Brent; US$/b) 38.5 54.7 60.0 55.3

Gold (US$/troy oz) 409.5 445.0 525.0 500.0

Food, feedstuffs & beverages (% change in US$ terms) 8.5 -0.2 -0.5 -2.3

Industrial raw materials (% change in US$ terms) 21.0 10.5 11.7 -15.8

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

BiH's economic growth is reliant on demand from its main trading partners in the EU and south-eastern Europe. GDP growth in the euro zone is forecast to accelerate moderately to around 2% by 2007. Germany and Italy (two of BiH's largest export markets) have been among the weakest euro zone economies, and we expect growth to remain sluggish in both countries over the forecast period. Economic growth and import demand in south-east Europe—BiH’s other main export market—will be faster in 2006-07. We expect the US dollar to weaken sharply against the euro in 2007, which could dent BiH’s export competitiveness later in the forecast period. We forecast that oil prices will decline significantly in 2007, but rising euro zone interest rates could offset this impetus to growth.

In line with slowing industrial output growth in the Federation—which accounts for two-thirds of BiH’s output—we estimate real GDP growth in 2005 at around 5.3%, a slight deceleration compared with 2004. Tight monetary policy and heavy pressure from the IMF to compress the public wage bill will dampen credit growth and household demand over the forecast period. However, recent strong growth in imports of investment goods will strengthen the country's export base, and significant export-oriented capacity has come on stream in the past 12 months. Along with rising import demand in several of BiH's leading export markets, this should underpin robust export growth over the forecast period. The government has opened several credit lines with foreign donors—most recently, with the Swiss and Japanese governments, aimed at providing finance for small and medium-sized enterprises (SMEs), which is expected to boost output in this sector. These factors will help to drive a steady acceleration in growth to 5.6% this year and to 5.8% in 2007.

An established trend of low and falling inflation in both entities was reversed in 2005 when retail prices in the Federation and the RS rose by 3% and 5.2%, respectively, in large part as a result of high fuel prices (the annual figures in the entities differ from the average of monthly figures reported during the course of the year). The introduction of VAT led to a large spike in price growth in

Economic growth

Inflation



January 2006, but by February inflation had decelerated significantly. We continue to expect inflation to be higher in both entities this year, in part as a result of looser wage policy in the run up to the election. Exchange-rate stability should dampen the impact of import prices on the consumer price index (CPI) later in the forecast period, and we expect global oil prices to fall sharply in 2007. Prices tend to rise more quickly in the RS, owing to the stronger links between its economy and that of Serbia.

The convertible marka is pegged to the euro at a rate of KM1.96:€1, so the exchange rate against the US dollar is determined by that of the euro to the US currency. Low inflation in BiH has tempered the pace of real effective appreciation in previous years, although rising inflation in 2005 and 2006 could put upward pressure on the real effective exchange rate and, consequently, on export competitiveness. The CBBH, however, is unlikely to consider any alteration to the currency board arrangement.

Import growth escalated in the fourth quarter of 2005, primarily as a result of pre-emptive buying ahead of the VAT introduction. This led to a sharp increase in the merchandise trade deficit, and so to a substantially larger full-year current-account deficit—although as a percentage of GDP it is expected to have increased only slightly compared with 2004. Over the medium term the introduction of VAT should see demand for some imported goods fall in response to their higher relative prices. We expect the pace of import growth to be affected by an easing of growth in household demand as monetary conditions tighten, although investment demand will expand robustly over the forecast period. At the same time, we expect export growth to be supported by strengthening demand in the euro zone, as well as improvements in export capacity driven by recent inflows of investment in heavy industry. Despite waning international assistance, net inward transfers will remain high, underpinned by large private remittances. We expect the current-account deficit to narrow as a percentage of GDP over the forecast period, falling to around 13% of official GDP by 2007.

Forecast summary (% unless otherwise indicated)

2004 a 2005 b 2006c 2007c

Real GDP growth 5.7 b 5.3 5.6 5.8

Industrial production growth 12.4 b 9.0 9.0 9.0

Average lending rate (%)d 10.3 9.6 9.4 9.6

Federation retail price inflation (av) -0.3 3.0 4.0 3.1

Republika Srpska retail price inflation (av) 1.9 3.4 5.5 3.8

Exports of goods fob (US$ bn) 2.1 2.6 3.6 4.6

Imports of goods fob (US$ bn) -6.7 -7.6 -8.5 -9.5

Current-account balance (US$ bn) -1.9 -2.1 -1.8 -1.6

Current-account balance (% of GDP) -22.4 b -22.6 -17.7 -12.8

External debt (year-end; US$ bn) 3.1 3.5 3.8 4.0

Exchange rate KM:US$ (av) 1.58 1.57 1.57 1.46

Exchange rate KM:US$ (end-period) 1.44 1.66 1.48 1.49

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

Exchange rates

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

1

2

3

4

5

6

7

2001 02 03 04 05 06 07

0

5

10

15

20

25

30

35

2001 02 03 04 05 06 07

The political scene

In late 2005 the Party of Democratic Progress (PDP), which had been the junior coalition partner in the government of the Republika Srpska—RS, one of the two entities in Bosnia and Hercegovina (BiH) at sub-state level—withdrew its support for the hardline Serb Democratic Party (SDS) and moved into opposition. The minority government immediately came under pressure from both the PDP and the moderate Alliance of Independent Social Democrats (SNSD), the leading opposition grouping and the second-largest party in the RS. Soon after the PDP left the coalition, the SNSD initiated a no-confidence vote in the government, following the parliament’s rejection on December 29th of the RS draft budget for 2006. The no-confidence vote took place in late January, and passed by 44 votes and to 29. The task of providing a mandate to form a new government fell to the president of the RS, Dragan Cavic, who is also the head of the SDS. This led to some speculation that Mr Cavic would offer the SDS another opportunity to put together a majority in parliament, but the balance of power had by that point swung in the SNSD's favour, leaving Mr Cavic little choice but to offer the mandate to the SNSD leader, Milorad Dodik. Mr Dodik's coalition government was confirmed in parliament in February with the backing of 45 of the 83 members of the RS parliament.

The new RS cabinet contains five members from the SNSD, three from the PDP, two from the centrist Party for BiH (SzBiH), one from the predominantly Bosnian Muslim Party of Democratic Action (SDA), three independent ministers, and one member each from two smaller parties. Mr Dodik's cabinet respected the stipulation of the RS constitution that the cabinet must have eight ethnic Serb members, five Bosnian Muslim members, and three “others”. Although the Social Democrat Party (SDP), the strongest opposition party in the Federation of BiH (the country's other entity), supported Mr Dodik as RS prime minister, it was not included in the government. This is because it would have proposed a Bosnian Serb for a ministerial post, therefore reducing the number of positions to be allocated to the RS-based ethnic Serb parties in the new coalition.

Government of Republika Srpska falls



Although confirming that his government would seek to improve co-operation with the International Criminal Tribunal for Former Yugoslavia (ICTY) in The Hague, and push forward with negotiations on changes to BiH's constitution, Mr Dodik suggested that the fight against corruption and organised crime would top his agenda. He announced that he would seek to establish a special prosecutor and court for dealing with organised crime, along with amendments to related legislation. Most controversially, he said that his government would initiate a review of privatisations that had taken place in the RS (it remains unclear exactly which transactions will be audited), claiming that many were conducted under non-transparent conditions. Mr Dodik also plans to establish a development bank for the RS—a move that was met with some concern from the international financial institutions in BiH.

Mr Dodik moved rapidly to implement his party's promises. He initiated a number of personnel changes across various institutions—most controversially, in the RS Ministry of the Interior and on the boards of several public enterprises, which had for some time been crucial levers of power for the SDS. The changes in interior ministry are likely to reduce the influence of the SDS over the government’s activities in fighting organised crime. This has raised some concern within the leadership of the SDS, given allegations that some of its senior members have links to criminal activity in the RS. Control over the public enterprises has been an important way of exercising power for all three nationalist parties, and the removal of SDS members from their management boards will also be a blow to the party. As part of the review of privatisation, Mr Dodik announced that the government would look especially closely at irregularities in asset sales in the banking sector. The controversial sales of Kristal Banka and Banjalucka Banka are expected to be among the first scrutinised, and both involve senior members of the PDP, so that these audits could raise tensions between the new coalition government's two main parties.

The state-level government also found itself under pressure in the early part of 2006. In the wake of the collapse of the RS government, the SDS announced in March that it would leave the central state government as well, and asked its two deputy ministers in the Council of Ministers (the state-level cabinet), as well as two other ministers elected with its support, to resign. At the time of writing, both of the deputy ministers look set to leave the state government, but the two SDS-backed ministers—at defense and justice—insisted that they would remain in their positions, as both were in the middle of completing sensitive reforms.

Around the same time, and spearheaded by the SDS, a group of Bosnian Serb MPs in the state-level parliament called for a no-confidence vote in the Council of Ministers, which is led by Adnan Terzic of the SDA. The MPs suggested that their move had been motivated by certain shortcomings on the part of Mr Terzic's cabinet, including a failure to take action on a recommendation of the state parliament to dismiss of the head of the Indirect Tax Authority (ITA). The recommendation came in the wake of alleged irregularities in the allocation of tax revenue to the entities from the ITA's single account. The no-confidence vote is due to take place by mid-April 2006. The Council of

State government comes under pressure

New RS government pledges to clamp down on corruption



Ministers looks more likely to be reshuffled rather than to collapse, primarily because, even if it loses the confidence vote, the state government could remain in office under a "technical mandate" until the October 2006 general election.

The work of the Federation government has been blocked for the past several months by disputes over replacements for two ministers who resigned in late 2005. This prevented the resolution of a debate on the long-standing issue of aligning the Federation's public broadcasting law with state-level law, which is one of the main conditions for the eventual conclusion of a stabilisation and association agreement (SAA) with the EU. On January 31st the Federation government adopted a law on broadcasting that breached the state-level law by allowing the Federation broadcasting company to operate as a public company owned by the Federation parliament. As part of the SAA process, BiH is required to restructure its public broadcasting organisation so that the entity-level companies become part of a single public broadcaster at state level. The necessary changes to Federation law have been strongly opposed by the hardline Croatian Democratic Union of BiH (HDZ BiH) on the grounds that they would unfairly disadvantage Bosnian Croats and fail to protect the Croatian language.

The House of Representatives (the lower house in the Federation parliament) adopted an amended law in March 2006, but without the votes of the HDZ BiH. The party announced that, when the bill arrived at the House of Peoples (the upper house in the Federation parliament), it would invoke the “vital interest” constitutional clause, by which MPs from any of the three main ethnic groups can veto legal changes if they feel they violate the vital interests of their constituencies. The European Commission responded by insisting that failure to make the Federation law conform with the state-level rules in this area could result in the suspension of SAA negotiations.

Constitutional reform in Bosnia and Hercegovina

Delays centre on details election mechanisms

The leaders of the country's main political parties have been under heavy pressure from the US and the EU for some time to agree to a series of constitutional reforms intended to strengthen the central government and reduce the inefficiencies in the current highly decentralised structure. The EU has made clear for some time that Bosnia and Hercegovina (BiH) will be unable to gain EU membership with its governance structure as it is, and the US has taken the lead in pushing the parties to come to a negotiated solution on amending the constitution. The proposed amendments envisage two new state-level ministries (agriculture, and science and technology), the enlargement of the state-level parliament, the strengthening of the powers of the Council of Ministers, the establishment of a state ombudsman, and the replacement of the current three-member state presidency with a single president and two vice-presidents. By February agreement had been reached on most of the issues, with the main stumbling block being the process for electing the state president and the two presidential deputies. The Bosnian Serb and Bosnian Muslim parties wanted these positions to be filled through a direct election, whereas the Bosnian Croat parties insisted that they be chosen by the state parliament. Given that they represent the smallest of the three

Federation government fails to resolve broadcasting impasse



main ethnic groups in BiH, Bosnian Croat representatives worried that a direct election would rule out the chances of a Bosnian Croat candidate becoming president. In the end, with support from US interlocutors, the main parties agreed to back the selection of the president by the state parliament. The draft amendments were sent by the state presidency to the state parliament in late March, and a vote is expected in April. The US and the EU have been pressing the authorities to have the constitutional changes completed by May, so that they are in place for the general election in October 2006. The changes are expected to pass with the required two-thirds majority in the state parliament. However, the issue of the future role of the entity governments is now unlikely be addressed before 2007.

BiH officially opened talks with the EU on an SAA in late November 2005. A preliminary round of talks took place in January, and both EU and BiH authorities have publicly targeted the end of 2006 for completing the talks. However, Commission representatives insist that measurable progress in a number of areas will be necessary before they agree to recommend a completion of the SAA. Among the main conditions outlined by the Commission are the continuing implementation of police reform, reform of the public broadcasting service, and strengthening of the country’s legislative and administrative capacities. Above all, the EU has insisted on improved co-operation with the ICTY. The BiH authorities—in the RS in particular—have been under pressure for some time to take a more proactive role in the capture of Ratko Mladic and Radovan Karadzic, the two indictees at the top of the ICTY's list. The capture in late 2005 of another high-profile target, Ante Gotovina of Croatia, and the recent death of Slobodan Milosevic, a former Serbian and Yugoslav president, in his cell in the Hague have served to increase pressure on BiH to co-operate more fully with the tribunal.

On February 27th the International Court of Justice (ICJ) opened proceedings in BiH's genocide case against Serbia and Montenegro. The action was brought in 1993 by the government of BiH, which was led by Bosnian Muslims, in the midst of the country's 1992-95 war with what was then Yugoslavia. In the intervening years, the issue has been hotly disputed both within BiH, and between BiH and Serbia and Montenegro. The original lawsuit called for reparations to be paid to BiH should Serbia and Montenegro be found guilty of inciting genocide in BiH during the war, but the outcome is likely to be more important for domestic political reasons in both countries, as the Bosnian Muslim member of the tripartite state presidency, Sulejman Tihic, and his party, the SDA, have used the issue to rally political support from its Bosnian Muslim constituency.

Bosnian Serbs have been opposed to the action from the start, claiming that it is primarily an attempt on the part of the Bosnian Muslims to weaken their authority, to link them to the discredited Yugoslav regime of the time, and to gain a pretext for the weakening of RS political structures. The Bosnian Muslims have insisted that the case go forward and that a guilty verdict would provide justification for a more thoroughgoing reform to the entity system (a suggestion that is highly unlikely to take hold in the RS). The government of Serbia and Montenegro has also tried to find a way around the lawsuit, offering

SAA negotiations begin, but with conditions attached

Genocide trial against Serbia and Montenegro opens at ICJ



to settle the dispute by diplomatic means. The case is expected to run throughout May 2006.

A German diplomat, Christian Schwarz-Schilling, became BiH’s fifth High Representative—the international community's lead interlocutor in BiH—on January 31st, succeeding Paddy Ashdown of the UK. Mr Schwarz-Schilling is also the EU's special envoy to BiH (as Mr Ashdown too had been)—a role that is expected to take on increased importance as the Office of the High Representative (OHR) is phased out. As part of this process of winding-down, the new High Representative is expected to make less frequent use of the "Bonn powers" to force through legislation and sack obstructive officials; Mr Ashdown often exercised these powers, especially at the beginning of his tenure. More broadly, Mr Schwarz-Schilling is expected to be less controversial than was Mr Ashdown, who at times clashed with the local authorities in the RS in particular.

Economic policy

Bosnia and Hercegovina (BiH) instituted a state-wide value-added tax (VAT) in January 2006. The new tax came into effect after months of heated debate over the level at which to set the rate, and demands by some of the main opposition parties and the trade unions that the VAT system include more than one rate, as opposed to the single-rate system originally put forward by the government, which was favoured by the IMF and other international financial authorities. In late 2005 the opposition Social Democratic Party (SDP) proposed an amendment to the tax code to exclude basic food items, medicines, and printed material from the uniform rate, which the government proposed be set at 17%. The country's trade unions launched an initiative for the introduction of a dual-rate system, warning that the implementation of a single rate could have a negative impact on the small business sector and poorer households. The government rejected both proposals, but was able to gain the support of the opposition and the unions by promising that the system put in place would be able to handle the introduction of a variable-rate VAT should the need arise in the future.

Only days after the launch of the new tax, under pressure from local media companies, the Council of Ministers (the state-level cabinet) put forward a proposal to amend the VAT law to exempt printed material. The steering board of the state-level Indirect Taxation Authority (ITA) gave its seal of approval to the changes in the law, although in the past it had rejected a similar initiative. The ITA's approval cleared the way for parliamentary debate, which was ongoing at the time of writing. The opening of debate on a potential exemption for printed material led to growing calls from a range of other interest groups, including consumer groups and farmers, to exempt other products from the 17% VAT rate. Adnan Terzic, the chairman of the Council of Ministers, said that the government would review the impact of VAT in several months and, if it deemed it appropriate at the time, would introduce a zero rate on selected goods.

New High Representative takes office

New state-wide VAT comes into effect



In preparation for the introduction of the state-level VAT, in 2005 the responsibility for indirect taxation was transferred from the entity tax administrations to the ITA. According to preliminary figures from the ITA, indirect tax receipts in 2005 amounted to KM2.1bn (US$1.3bn), an increase of 10% year on year compared with the entities' collection of these taxes in 2004. Road taxes and "other taxes" contracted in annual terms, but other indirect tax revenue increased significantly. Excise tax revenue rose by 11.8% year on year, sales tax by 12.7%, and customs receipts by 10%. On January 1st 2006 the ITA took over the collection of VAT, and despite some concerns about staffing levels and preparedness, the switch did not cause any major problems. In January the ITA reported indirect tax receipts into its "single account" at KM270m (US$172m), representing an increase of 17% in annual terms and amounting to 7% of projected total indirect tax revenue for 2006. Excise tax receipts went up by 13% year on year and customs receipts by 4%. The ITA expects some KM500m in VAT receipts in 2006.

In February the central state-level House of Representatives adopted a 2006 budget that envisages spending of KM954.6m, a doubling of the estimated outturn in the 2005 state budget. The state budget has traditionally been much smaller than the entity budgets, as it had very limited revenue-generating capacity before 2006, as well as far fewer personnel. However, the larger 2006 budget reflects a significant increase in the intervening year in the responsibilities of the central state government, as a result of political and constitutional reforms aimed at strengthening the state-level institutions. The budget envisages a smaller allocation for the recently created state-level Ministry of Defence (KM287m), drawing strong opposition from Nikola Radovanovic, the defence minister, who argued that at least KM300m would be needed to implement the next phase of defence reform, which will see the demobilisation of numerous soldiers and the restructuring of the armed forces to bring them into compliance with NATO standards.

The government designated KM65m for the ITA, KM55m for the State Border Service, and KM42m for the Ministry of Foreign Affairs and Economic Relations. Out of some 30 proposed amendments to the budget, only one was adopted, allocating KM500,000 (US$320,000) from budgetary reserves to the Agency for Statistics of Bosnia and Hercegovina to prepare for the census that has been proposed for 2010. The budget also allocates KM288m for external debt servicing. The largest share of the projected revenue—some KM566m—is expected to come from indirect tax revenue. At the end of March a harmonised version of the budget produced by a joint parliamentary commission was approved by both houses of the state parliament.

In early March both houses of the Federation parliament adopted a balanced budget for 2006. The budget sets both revenue (including financing) and expenditure at KM1.14bn, marking a spending increase of 10% compared with the 2005 budget. Political squabbling over the selection of a minister of energy and industry to replace Izet Zigic delayed the parliamentary debate and led to a postponement of the budget’s planned adoption in December 2005. This forced the government to adopt a temporary financing scheme for the first quarter of

Federation adopts balanced budget

Indirect tax revenue rises strongly in 2005

State government adopts larger budget for 2006



2006, which envisages revenue and spending of KM259.7m (revenue in January came in at only KM17.9m, less than half the total collected in January 2005).

The Federation government based its increased expenditure projection on an expected rise in tax revenue as a result of the introduction of VAT in January. A KM4m increase in spending the final draft budget (compared with the draft submitted in late 2005, which was rejected by the lower house of the Federation parliament) will be used to fund increased transfers to three cantons—Podrinje, Livno and Posavina—for employment programmes, and to increase the entity's contribution to the ITA budget. The budget allocates KM30m to pay off a portion of the Federation government's arrears to pensioners from 2000 and 2001, and envisages spending of KM28m on agricultural support—an increase of KM12m compared with the 2005 budget. The spending plan also includes outlays of KM50m aimed at cushioning the effect of the introduction of the VAT. Ahmet Hadzipasic, the Federation prime minister, suggested that the budget would be rebalanced in July, after an assessment of the impact of the introduction of VAT. In the first 11 months of 2005 the Federation consolidated government recorded revenue of KM966.8m, ahead of a planned KM962.5m for the year. Expenditure in the same period was KM767m, slightly below the KM778m expected.

The RS parliament also struggled to agree a 2006 budget on time, forcing it to adopt a decision in late 2005 on temporary financing for the first half of 2006. In March the RS National Assembly adopted a full-year budget that envisages spending and revenue of KM1.09bn—each increasing by 15% compared with the 2005 RS budget. Domestic revenue is set at KM1.04bn, of which the bulk is expected to come from indirect tax revenue via the ITA. One of the main expenditure items envisaged in the 2006 budget is a KM140m transfer to the entity's pension and disability fund. The budget envisages KM20.7m to offset the expected impact of the VAT on the vulnerable segments of the population, and a significant wage increase for government employees—the first in five years, according to the new RS prime minister, Milorad Dodik. The budget has yet to be approved by the upper house of the RS parliament. The outgoing government in the RS reported that the fiscal outturn in 2005 was on target, despite an alleged KM40m revenue shortfall caused by operational problems in the ITA, and issues with the distribution of indirect tax revenue from the single account to the entities.

Both the budget-setting process for 2006 and the finalising of the VAT details became issues of contention between the BiH governments and the inter-national financial institutions in late 2005 and into 2006. The IMF and the BiH authorities have been negotiating a proposed 18-month, US$50m stand-by arrangement for over a year; as of mid-March 2006 the sides had been unable to bridge their differences and bring the stand-by arrangement into force. The IMF pressed the authorities to keep a tight rein on spending in 2006, insisting that the entity governments target primary budget surpluses, given the unpredictable effect of the introduction of the VAT at the beginning of the year, as well as a number of spending items that are difficult to predict accurately. These include pay-outs by the government to resolve significant domestic

RS government also completes 2006 budget

IMF talks fail to yield results in early 2006



claims that originated during the war; the cost of state-level institution-building envisaged in recent constitutional reforms; and ongoing defence and police reform programmes. The IMF also urged the authorities to develop and implement an action plan on strengthening the newly established Fiscal Council, a body tasked with co-ordinating fiscal policy for the country.

Sellers' markets: privatisation takes centre stage

Republika Srpska

In his inaugural speech to the Republika Srpska (RS) National Assembly, Milorad Dodik, the new RS prime minister, announced that his government would propose the abolition of the RS Directorate for Privatisation (it plans to absorb the function into a new development bank) and submit a bill to parliament calling for an audit of privatisation in the RS. The RS proceeded much more quickly with voucher privatisation than the Federation, but it has lagged behind in the sale of strategic companies. The pace of privatisation in the RS picked up in 2005 when the government sold stakes in 58 enterprises, bringing in receipts of KM40.2m (US$25.6m). A total of 661 enterprises, or 60% of the number of companies slated for privatisation, had been sold by the end of 2005. In 2006 a number of companies are scheduled for sale, including the Sava sugar factory in Bijeljina, a bauxite mine in Srebrenica, and a coal mine in Miljevina. The most high-profile privatisation target is Telekom Srpske (TS), the government-held fixed-line telecommunications operator whose sale has been under preparation for several years. Mr Dodik announced in mid-March that his cabinet would make a decision on issuing a tender for TS by the end of April. The government has hired Austria's Raiffeisen Investment to provide a valuation of the company’s assets and assist on the sale, which it hopes will be completed by July 2006. In March Nedzad Brankovic, the Federation's minister of communications, called for a synchronised approach to the sale of three state-held telecommunications firms in Bosnia and Hercegovina (BiH), claiming that a single privatisation would secure a higher price than three individual sales. Political considerations, however, seem certain to prevent a co-ordinated sale of the three companies. In 2005 the Federation government began preparations for the privatisation of BH Telecom and HT Mostar, the Federation's two telecommunications companies, and Mr Brankovic confirmed in early 2006 that the Federation government would soon choose a model for the sale of the two companies and send the proposal to parliament.

Federation

Following protracted negotiations over the sale of the Federation oil distributor Energopetrol to the Croatian-Hungarian INA-MOL consortium (Country report January 2006), on January 25th the House of Representatives (the lower house in the Federation parliament) rejected the government’s proposal on the sale of a 67% stake in the company, on suspicions that the state-controlled INA might seek to exert political influence in BiH via its participation in Energopetrol. The government's plan envisioned the state retaining a 22% stake, with 11% remaining in the hands of small shareholders. The INA-MOL consortium had offered to pay KM10.2m for the stake, KM60m for servicing of the company's debt, and some KM150m in additional investment over the next three years, while keeping on all of the company's 1,059 workers. Parliament's decision was not binding on the government, however, and efforts continued to be made at the cabinet level to find a way to resolve the main



unresolved issue between the government and the bidder—namely, Energopetrol's outstanding debt to the Federation government, which INA-MOL has been unwilling to assume. The government set up a commission to examine the finances of the company (which posted a KM5m loss in 2005) and to determine the options for recapitalisation. In late March the government decided to restart the talks, and INA-MOL agreed to extend the validity of its bid, which had expired in February, until May. Nonetheless, the difficulties in completing the Energopetrol sale threaten to weaken the government’s already poor image with respect to privatisation, which could have an impact on its prospects for success in forthcoming sales. In addition to continuing small-scale privatisation in the trade, catering, services and road transport sectors, the Federation government also plans to offer 24 sizeable companies for sale in 2006, including the food manufacturer Agrokomers and the aluminium smelter Aluminij Mostar.

The domestic economy

Output and demand

Industrial output in the Federation rose by 6.1% year on year in 2005, marking a significant deceleration from the 13.2% increase registered in 2004. The slowdown was in part the result of base-year effects. The energy sector, which accounts for a significant portion of industrial output, saw production contract in 2005, but this followed a 12% annual rise in 2004. Output of intermediate goods grew strongly, in line with heavy investment in the steel sector. In the first two months of 2006 industrial production growth rebounded to 10.4% year on year, led by continued robust growth of intermediate goods and rising output in the energy sector.

Federation: industrial production (% growth, year on year unless otherwise indicated)

% of total 2002 2005 Jan-Feb 2006Energy 39.9 -1.1 16.5Intermediate goods 25.0 16.6 20.4Capital goods 2.5 6.3 3.0Consumer durables 2.9 14.5 -3.3Consumer non-durables 24.5 6.5 6.5Other 5.2 -7.1 -12.7Total 100.0 6.1 10.4

Source: Federal Office of Statistics, Statistical data on economic and other trends.

One of the most prominent factors behind the Federation's deceleration in industrial output growth in 2005 was a 4.2% annual contraction of output in electricity, gas and water supply. Faltering electricity production was caused by the need for prolonged maintenance work at several power plants, including the Jablanica hydroelectric power plant, one of the Federation’s largest energy producers. Disruptions in gas supply further contributed to the sector’s overall poor performance. The sector recovered strongly in January-February 2006, increasing output by 13.8% year on year. Electricity, gas and water supply

Federation industrial output growth slows in 2005



accounts for over 30% of the total industrial output in the Federation and therefore has a strong influence on industrial performance overall.

Mining output growth decelerated from 5.8% in annual terms in 2004 to 4.2% last year. The slowdown was caused by weaker performance in the Federation's coal mines, reflecting stoppages in production caused by liquidity problems in several of the mining companies. Output of metal ore surged as a result of large-scale recent investment in the sector. The positive recent performance in the manufacturing sector was maintained in 2005, and output rose by 11.4% in annual terms as all of the leading manufacturing branches in Bosnia and Hercegovina (BiH) posted growth, with the exception of wood-processing. The logging and wood-processing sector is undergoing significant restructuring, and both entity governments have imposed restrictions on output in order to clamp down on illegal activity, which has depressed output in this sector. In the first two months of 2006 production of machinery and equipment rose by 14% in annual terms.

The significant expansion of intermediate goods output in the Federation in 2005 was driven by buoyant performance in the base metals sector, where output rose by 28.6% year on year, on the back of strong global demand and, consequently, high global prices for metal products. Steel and aluminium were the two main items driving this growth. Their output is concentrated in two of BiH's largest companies, BiH Steel and Aluminij Mostar.

The leading sectors for production of consumer non-durables in the Federation are clothing, and food and beverages, both of which recorded sluggish performances during 2005: clothing output contracted by almost 7% year on year, whereas output in food and beverages was up by just 1.3%; in the first two months of 2006, food and beverages output growth accelerated to 5%, but clothing production plummeted almost 25% year on year. Both industries have come under increased competitive pressure from imports as a result of trade liberalisation. Furthermore, as much of the clothing industry operates as part of outward-processing schemes, it relies on regular contracts with foreign manu-facturers and can therefore be subject to sharp fluctuations in output. Strong growth in manufacturing and equipment, motor vehicles and other transport equipment in 2005 underpinned the increase in output of capital goods, which nonetheless continues to account for only a modest proportion of total industrial output.

Industrial output in the Republika Srpska (RS), which had also been growing strongly in 2003-04, surged in 2005, rising by almost 20% year on year. Mining and quarrying, manufacturing and energy output all picked up strongly during the second quarter, and continued to grow robustly throughout the rest of the year. The fastest growth was in capital goods (up by 59.3% year on year) propelled by sharply rising production of electrical equipment and metals. Production of automobile parts rose strongly, to some extent owing to accelerating activity at TMD, a factory owned by Cimos, a Slovenian auto-mobile parts group. TMD recently opened a new facility in Srebrenica (in addition to its existing plant in Grabacac), which produced 4.5 tonnes of car parts in the six months following its opening in July 2005. Cimos recently

Intermediate goods drive Federation industrial growth

Industrial output surges in Republika Srpska



announced plans to invest in new production capacity at the Srebrenica factory, which it expects to create 100 jobs.

Republika Srpska: industrial production (% growth, year on year unless otherwise indicated)

% of total 2003 2005 Jan 2006Energy 34.4 4.4 -27.5Intermediate goods 30.8 17.0 13.5Capital goods 9.1 59.3 24.2Consumer durables 3.4 58.2 4.2Consumer non-durables 22.3 28.6 11.5Total 100.0 19.8 -6.5

Source: Republika Srpska Institute for Statistics, Industry statistics.

A sharp increase in the manufacture of furniture was the main factor behind strong growth in consumer durables output in the RS in 2005. Output of non-durable consumer goods rose by 28.6%, primarily as a result of robust performance of food and beverages, one of the RS's most important industries. Once one of Yugoslavia's largest processing plants for fruit and vegetables, Vitaminka, based in Banja Luka, recently announced plans to expand output by 40% in 2006, and in January it saw a 30% year-on-year increase. Intermediate goods output went up by 17% in the RS last year, reflecting similar trends in the main industries to those seen in the Federation. The aluminium smelter Birac has recently completed significant investment in expansion and modernisation of its production facilities, which boosted aluminium output significantly in 2005. In January 2006 industrial output contracted by 6.5%, mostly as a result of base-year effects (output rose by 36% year on year in January 2005).

Federation construction output increased by 16.1% in 2005, as a result of a robust expansion in roadbuilding and a pick up in house construction. House construction, which contracted sharply in 2004, rose fourfold in 2005 as increased availability of credit boosted demand and companies stepped up their activities ahead of the introduction of value-added tax (VAT) in January 2006. This was reflected in a shift in the composition of output in favour of new buildings and away from maintenance and repairs, which was the dominant form of construction output in the first half of 2005. The largest number of housing units went up in the Sarajevo and Tuzla cantons, which together accounted for 84% of the total. In the RS, the value of completed construction work increased by 18.8% year on year. At the same time the number of workers and hours contracted declined, suggesting improving productivity in the sector.

In 2005 retail sales in the Federation increased by 40.5% year on year, marking a second consecutive year of very strong growth. The retail sector's buoyant performance has been underpinned by the rapid rise in real wages, improving access to consumer credit, and high inflows of private remittances, which represent a vital source of income for large sections of the population. The most notable increases in sales in 2005 were of automobiles (up by 37.7%) and automobile parts (up by 66.6%), with the surge in the latter partly spurred by the impending introduction of VAT. Sales of fuel increased by 66.9%, reflecting

Construction performance improves

Federation retail trade is buoyant



the impact of high global oil prices. Strong growth was also registered in sales of pharmaceuticals, cosmetics and toiletries, which were boosted by govern-ment stockbuilding before the VAT increase. The main local manufacturer of pharmaceuticals, Bosnalijek, has steadily increased its share on the domestic market, which had traditionally been dominated by foreign brands, especially those from Croatia and Slovenia. The firm holds roughly one-third of the local market, and exports around 13% of its output to other former Yugoslav countries and those in the Commonwealth of Independent States (CIS).

Employment, wages and prices

Average registered employment in Bosnia and Hercegovina (BiH) declined by 1.5% year on year in 2005, according to the most recent labour data published by the Agency for Statistics of BiH; a small improvement in the number in employment in the Federation was offset by a sharp contraction in Republika Srpska (RS). The number of registered unemployed increased in both entities, pushing the country-wide number of jobless up by 7.4% year on year. Falling employment in the RS was the result of enterprise restructuring, as well as cutting staff numbers at the public administration and defence forces. None of the BiH's three statistics agencies publish official unemployment rates, but their employment and unemployment figures suggest very low participation in both entities, as well as extremely high unemployment.

BiH: labour statistics ('000 unless otherwise indicated)

2005 2006 Apr May Jun Jul Aug Sep Oct Nov Dec JanFederation Employment 390.0 390.3 388.9 387.6 387.1 387.0 387.3 387.1 386.6 n/aUnemployment 331.6 330.8 335.0 341.7 344 345.7 346.3 346.6 347.5 n/aNet wage (KM) 546.9 555.0 556.4 556.2 561.4 562.7 565.1 569.0 582.1 n/aRepublika Srpskab Employment 119.4 118.0 117.4 116.1 115.6 115.3 114.7 113.9 112.6 n/aUnemployment 153.5 153.6 154.2 153.7 155.1 154.9 156.3 151.6 142.3 n/aGross wage (KM) 689 687 706 717 719 718 725 721 745 735Net wage (KM) 452 452 464 471 472 472 476 474 490 483

a Unemployed divided by unemployed plus employed; includes waiting-list workers. b Employment and unemployment figures not reported.

Sources: Agency for Statistics of Bosnia and Hercegovina; Federal Office of Statistics, Statistical Data on Economic and Other Trends; Republika Srpska Institute of Statistics, Monthly

Statistical Review.

It has long been considered that the official data do not provide an accurate reflection of real trends in the labour market, given the high number of workers and firms in the grey economy. In December 2005 the World Bank published an update of its 2002 Labour Market Study, which uses data from its Living Standards Measurement Survey (LSMS) and a number of other surveys. The World Bank's study largely confirmed what the official figures suggest: that widespread and growing informal employment, persistent high unemployment and high unit labour costs in the formal sector represent considerable challenges to BiH authorities.

Unemployment remains a serious problem

World Bank study confirms labour market deficiencies



However, the World Bank also found that job creation since 2002 may have been more buoyant than the official data suggest. This is because much of the job creation not captured by official statistics appears to have taken place in the informal sector, which the World Bank estimates accounted for 42% of total employment in 2004, compared with 37% in 2001. Job creation appears to have been more dynamic in the Federation than in the RS, although the LSMS data suggest that labour force participation is higher in the RS. The updated figures also confirmed that young and unskilled workers face the stiffest challenges among the unemployed. The World Bank also warned that the continuing large share of public-sector jobs (40%) in formal employment presents further risk, in view of the desperate need for deep restructuring of the public administration.

Little data for 2006 is available so far, but the authorities hope that the introduction of value-added tax (VAT) at the beginning of the year will help to address the problem of the grey economy by providing firms with strong incentives to register themselves, and to conduct business with other registered firms. As this process evolves, a clearer picture of real activity rates in BiH should emerge.

Following three consecutive years of deceleration, wage growth began to speed up again in 2005, with the average net monthly wage in BiH up by 5.9% year on year to KM535 (US$340). The main reason for this turnaround was a sharp acceleration in the growth of wages in the Federation, which was the result of rising wages in public administration, and in the transport and communications sectors. The net average wage in the RS grew faster than in the Federation, rising by 9.9% during the year, but this represented a slowdown from the 11.6% increase registered in 2004. Over the past eight years the net average wage in the RS has been rising faster than in the Federation, narrowing the gap that existed between the entities' average wages in the wake of the conflict of the early 1990s. According to the World Bank's labour market study, wage growth in BiH has consistently outstripped productivity growth, with the gap more pronounced in the RS than in the Federation.

Wages grow faster than productivity



An established trend in both entities of low and falling inflation was reversed in 2005 when retail prices in the Federation rose by 3% and in the RS by 5.2% (the annual figures for inflation in 2005 produced by both entities' statistical agencies do not correspond exactly with their monthly figures for the year). Excise tax adjustments pushed up the prices of tobacco and alcohol in both entities, and high global fuel costs drove a sharp increase in the average prices of services (via transportation costs). Services prices went up by 6.8% in the Federation and by 12.5% in the RS; tobacco prices were up by 20.8% in the Federation and by 28.7% in the RS. The prices of agricultural products also rose at a quickened pace and were up by 3% in the Federation and by 3.5% in the RS.

BiH: retail prices (% change)

2005 2006 Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan FebFederation Month on month 0.5 0.4 -0.6 0.3 -0.5 0.1 -0.1 0.6 0.5 0.9 0.1 3.9 0.2Year on year 1.2 1.7 2.1 2.2 2.6 3.4 3.3 3.8 3.6 4.3 4.4 6.7 6.2Republika Srpska Month on month 0.3 0.2 -0.9 -0.3 -0.5 -0.1 -0.2 1.7 1.8 1.2 0.2 5.1 -0.7Year on year 3.1 3.4 3.8 3.1 2.4 2.8 2.3 3.9 3.9 4.3 4.1 9.5 8.5

Sources: Federal Office of Statistics, Statistical Data on Economic and Other Trends; Republika Srpska Institute of Statistics, Monthly Statistical Review.

Prices shot up further in early 2006 under the impact of the VAT, which came into effect on January 1st at a rate of 17%. In January prices rose by 3.9% in the Federation and by 5.1% in the RS. In the first two months of the year, prices in the Federation were up by 6.4% year on year, with agricultural products prices rising by 9.1% in annual terms and services prices up by almost 10%. In January-February, price growth in the RS soared to 9%, driven by an annual increase of almost 20% in the prices of beverages.

Financial indicators

Following a slowdown in 2004, commercial bank lending accelerated in the second half of 2005. The stock of commercial bank loans in Bosnia and Hercegovina (BiH) rose to KM7.5bn (US$4.8bn) at end-2005, representing an increase of 27.3% year on year, only slightly below the record-high annual credit growth of 30% in 2002. The growth of credit to consumers slowed by several percentage points during the first nine months of the year, but households took out significantly more loans in the fourth quarter, pushing annual household credit growth back up above 30% at end-2005. Growth of credit to private enterprises quickened mid-year, but slowed in the second half. Consumer credit accounted for 46% of the commercial banks’ portfolio at end-2005, compared with a 43% share of corporate credit. Interest rates declined slightly in 2005. Long-term interest rates charged to household borrowers averaged 9.9% (down from 10.78% in 2004) according to data from the Central Bank of Bosnia and Hercegovina (CBBH), and corporates paid an average of 7.7% for financing (down from 8.23% in 2004).

Consumer credit growth accelerates in late 2005

Price growth accelerates strongly after VAT introduction



Deposits are estimated to have grown by 23.3% in 2005, a slight deceleration compared with 2004. Household deposits accounted for the largest share of the total, and foreign-currency deposits surpassed those in local currency. The term structure of the bank credit portfolio remains a source of concern, as a significant share of long-term loans is funded out of short-term deposits. This increases banks’ operational costs and prevents a more substantial decline in interest rates.

Foreign trade and payments

Merchandise import growth accelerated in the latter part of 2005, according to the Agency of Statistics for Bosnia and Hercegovina (BiH). A surge in December of 43% month on month pushed total imports to KM11.2bn (US$7.1bn), an increase of 18.6% year on year. The substantial increase in imports was in part the result of high global oil prices, but volume trends were driven by a spate of pre-emptive imports ahead of the introduction of value-added tax (VAT) in January 2006. Although the value of merchandise exports rose by 25.6% in 2005, the merchandise trade deficit increased by some KM700m (US$446m) to KM7.4bn.

The majority of BiH's exports are of intermediate goods: these accounted for roughly two-thirds of export revenue in 2005. Intermediate goods (mostly imports to the metals processing sector) are also the largest import category by main industrial grouping, but they account for a smaller portion of total imports. Capital goods imports and consumer non-durables each accounted for around 20% of total imports last year.

BiH's imports are more diversified than its exports. Food and beverages account for the largest portion of the total (12.1% in 2005), but chemicals, oil and oil derivatives, motor vehicles and machinery each also make up 9-10% of all imports. In 2005 machinery imports grew strongly, rising by 29.5%, driven by robust investment growth in the industrial sector, activity on several road-building and railway reconstruction projects, and rapid growth in the mining industry. Machinery import growth last year was also heavily influenced by

Import growth pushes full-year trade deficit up by 15.3%

Machinery purchases drive import surge



companies' increasing their stocks in anticipation of the introduction of VAT; in December alone, machinery imports rose by 86% month on month. Sharp rises in imports of vehicles (which were up by 71% month on month), pharmaceuticals (105%), and raw materials (23%) in December had the same motivation behind them. Raw materials had previously been exempt from sales tax, whereas pharmaceuticals, food, machinery and spare parts were taxed at zero rates. With the introduction of VAT, these goods are all taxed at 17%.

BiH: imports of goods, 2005 (KM m, unless otherwise indicated)

Jan-Dec % of total % growth, year on

yearAgriculture & forestry 473.6 4.2 -1.9Mining 288.9 2.6 47.7Food & beverages 1,357.4 12.1 2.0Textiles 344.1 3.1 15.2Leather goods 276.2 2.5 15.8Wood & wood products 124.3 1.1 24.2Coke & refined petroleum 1,043.8 9.3 29.3Chemicals & products 1,060.0 9.5 19.7Base metals 563.6 5.0 -1.3Metal products 379.1 3.4 6.4Machinery & equipment 1,000.5 9.0 29.5Motor vehicles 1,004.8 9.0 28.2Furniture 220.1 2.0 9.6Electricity, gas, water 164.5 1.5 72.6Total incl others 11,178.5 100.00 18.6

Source: Agency for Statistics of Bosnia and Hercegovina.

BiH's exports are less diversified. The bulk of the country's exports are base metals (22.5% of the total in 2005), mainly steel and aluminium, the majority of which is produced by one company, Aluminij Mostar. Motor vehicles made up 9.5% of all exports last year, and wood and wood-processing, 9.2%. Except for this last category, which contracted by some 15% year on year, in line with a decline in output in the sector, most of BiH's leading export sectors saw robust growth in sales abroad in 2005. By far the fastest growth was in foreign sales of metal ore, which rose tenfold as a result of increased global demand for steel inputs and rising global commodity prices. Several recently privatised mines have boosted output significantly, and announced plans for further expansion. Exports of higher value-added products remain low as a portion of BiH's total sales abroad, although recent investments in the motor vehicles and equipment sectors have enabled these industries to raise their profile and raise exports considerably.

BiH: goods exports, 2005 (KM m, unless otherwise indicated)

Jan-Dec 2005 % of total % growth, year on

yearAgriculture & forestry 32.7 0.9 14.0Mining 185.1 4.9 222.4Food & beverages 245.7 6.5 24.2Apparel 126.1 3.3 -2.8

Metal sector is central to BiH's export performance



BiH: goods exports, 2005 (KM m, unless otherwise indicated)

Jan-Dec 2005 % of total % growth, year on

yearLeather goods 111.1 2.9 0.8Wood & wood products 349.5 9.2 -14.8Coke & refined petroleum 133.4 3.5 124.8Chemicals & products 125.9 3.3 70.6Base metals 852.7 22.5 25.0Metal products 222.5 5.9 25.2Machinery & equipment 197.7 5.2 25.3Motor vehicles 358.8 9.5 46.2Furniture 218.7 5.8 26.8Electricity, gas, water 147.4 3.9 -14.6Total incl others 3,783.3 100.0 25.6


Exports to Croatia and to Serbia and Montenegro were important drivers of overall export growth in 2005. Sales to Croatia rose by 27.7% year on year in local-currency terms. Classified manufactures were the largest export on this line of trade in 2005 (and Croatia was also the leading purchaser of these goods). Purchases of raw materials (except fuel) were the single largest import item from Croatia. A 29.7% year on year rise in exports to Serbia and Montenegro pushed its share of BiH's exports up to 15.5%, ahead of Italy. The commodity structure of exports to Serbia and Montenegro, and to Croatia, was more broad-based than with other leading trading partners in 2005. This was largely explained by the fact that BiH's trade links with these regional markets are much better developed than with many of its partners elsewhere, in which single large contracts can skew the export structure significantly.

The EU was BiH’s main market in 2005, purchasing exports amounting to KM2bn—an increase of 20.6% year on year. The main boost to EU-bound exports came from a sharp rise in sales to Slovenia, which went up by 42.5% year on year (largely as a result of rising output at the TMD factory, which makes automotive parts). Slovenia has for some time been one of the leading foreign investors in BiH, which has helped to boost trade flows between the two countries.

BiH: trading partners (KM m)

Jan-Dec

2004 % of total Jan-Dec

2005 % of total % changeExports fob Croatia 607.2 19.9 775.4 20.5 27.7Italy 492.9 16.2 496.3 13.1 0.7Serbia & Montenegro 453.4 14.9 588.0 15.5 29.7Germany 351.1 11.5 429.0 11.3 22.2Slovenia 256.3 8.4 365.2 9.7 42.5Hungary 115.6 3.8 142.6 3.8 23.4Austria 140.6 4.6 163.4 4.3 16.2Other countries 631.7 20.7 823.4 21.8 30.4Total 3,048.6 100.0 3,783.3 100.0 24.1

Intra-regional trade grows faster than trade with the EU

Strong growth in sales to Slovenia boosts EU trade



BiH: trading partners (KM m)

Jan-Dec

2004 % of total Jan-Dec

2005 % of total % changeImports cif Croatia 1,732.3 17.6 1,886.5 16.9 8.9Germany 1,318.4 13.4 1,605.8 14.4 21.8Serbia & Montenegro 972.8 9.9 1,135.2 10.2 16.7Italy 876.9 8.9 1,000.5 9.0 14.1Slovenia 815.8 8.3 779.9 7.0 -4.4Hungary 426.7 4.3 409.6 3.7 -4.0Austria 439.3 4.5 488.1 4.4 11.1Other countries 3,240.8 33.0 3,872.9 34.6 19.5Total 9,822.9 100.0 11,178.5 100.0 13.8Balance -6,774.3 - -7,395.2 - -


Trends in BiH exports to its leading EU partners were mixed. The country registered rapid growth in sales to Germany (22.2%)—the bulk of which consisted of machinery and miscellaneous manufactured products—and to Austria. However, sales to Italy remained almost unchanged in annual terms, whereas imports from Italy rose by 14.1% year on year. Although rising exports to Germany have helped to reduce the large trade deficit between the two countries, BiH’s imports from Germany remain almost four times the value of exports. Most of BiH’s exports to Italy are manufactured goods classified by material, while chemicals make up the bulk of imports.

Preliminary figures from the Central Bank of Bosnia and Hercegovina (CBBH) suggest that the 2005 current-account deficit widened by some KM500m, or 18%, compared with 2004. The merchandise trade deficit, which in the fourth quarter increased by almost 9% year on year, was only partly offset by surpluses on the three invisibles accounts. Net services exports of KM874m were underpinned by robust growth in transportation services credits, whereas tourism (travel services exports) rose by 9% year on year in 2005. The income surplus rose slightly in 2005, primarily as a result of strong rise in investment income inflows, which were mirrored by a fall in inflows of foreign direct investment (FDI) into the financial account. Net inward transfers were virtually unchanged compared with 2004.

Balance of payments (KM m)

Year 4 Qtr 2004 2005 2004 2005Merchandise exportsa 3,280 4,067 938 1,128Merchandise importsa -10,473 -11,901 -2,933 -3,515Net services 727 874 206 248Net income 718 741 159 165Net transfers 2,937 2,902 812 820Current-account balance -2,810 -3,316 -817 -1,154

Full-year current-account deficit widens significantly



Balance of payments (KM m)

Year 4 Qtr 2004 2005 2004 2005Capital account 769 705 198 201Financial account 1,104 1,651 458 689 Net direct investment 954 469 414 112 Other investment 827 1,921 91 830Reserve assets -677 -738 -48 -253Net errors and omissions 936 960 162 264

a Including coverage and valuation adjustments by central bank.

Source: Central Bank of Bosnia and Hercegovina.

Net foreign direct investment (FDI) in 2005 fell to KM469m, some 51% less than in 2004, according CBBH figures (which vary from those published by other government institutions, including the Ministry of Economy). In 2004 BiH received a record FDI inflow of KM1.2bn, primarily reflecting large investments by Mittal Steel in the Zenica steel foundry, and a Lithuanian investment group in the Zvornik-based aluminium oxide factory Birac; the combined value of these two investments was approximately KM840m. The largest foreign investor in BiH in 2005 was Slovenia, which accounted for around one-third of total FDI inflows. Croatia has been the leading investor in BiH for the past decade, followed by Austria, Lithuania and Slovenia.

Following several years in which the largest proportion of FDI inflows were to service industries (in particular, the banking sector), by 2005 the largest share of went into manufacturing, led by a KM90m purchase by a Slovenian company, Livar, of the steel foundry Jelsingrad Livnica Celika in Banja Luka, and a KM27.6m investment by the British firm EFT in the lignite mine Rudnik Lignita Stanari. EFT announced plans in late 2005 to invest as much as €300m (US$372m) in expanding extractive capacity at the mine in order to bring coal output up to 2m tonnes of per year. Privatisation continues to be the main channel through which FDI enters BiH. In 2005 the economy ministry estimated that around 69% of FDI inflows were linked to privatisation. Whereas in other countries in the region the process has begun to slow, leaving them increasingly dependent upon greenfield and brownfield investors, in BiH privatisation-related inflows are likely to remain robust over the short term. A number of strategic companies are up for sale in 2006, including the tele-communications operator in Republika Srpska (RS), Telekom Srpske, which had been scheduled for sale by the end of 2005.

In 2005 the external debt stock of BiH's general government increased by 6.3% year on year to KM4.3bn, according to CBBH data. Outstanding debt to the European Investment Bank (EIB) and the World Bank rose by KM96m and KM190m, respectively, and these two creditors together accounted for 40% of the government's total external debt stock at end-2005. The government paid down a portion of its outstanding debt to the European Bank for Reconstruction and Development (EBRD) and reduced its debt to the London Club of private creditors by some KM5m (private creditors account for just 6% of the general

Foreign direct investment inflows drop

External debt rises slightly



government external debt stock). In 2006 a further portion of the government's debt to the London Club of private creditors is due to be repaid.

General government external debt by creditor (KM m, end-period)

2000 2001 2002 2003 2004 2005International financial

organisationsa 2,618 2,952 2,864 2,608 2,650 2,885Governments and government

agencies 1,176 1,206 1,164 1,143 1,120 1,146Private creditorsb 262 262 262 262 262 257Total 4,056 4,421 4,290 4,014 4,032 4,287

a Mostly World Bank, IMF, EBRD and EU financial institutions. b London Club debt.

Source: Central Bank of Bosnia and Hercegovina.

The CBBH held KM4.2bn (US$2.5bn) in foreign-exchange reserves at the end of 2005, equivalent to around four months of imports. Debt service is estimated at KM232.9m in 2005, and was paid without problems.

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