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Bosnia and Herzegovina

Report: Bosnia and Herzegovina - Country economic memorandum, May 2005

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EXECUTIVE SUMMARY
1. This Country Economic Memorandum (CEM) has three main objectives. First, it takes stock of economic developments in Bosnia and Herzegovina (BH) since the end of the war in 1995, with a particular focus on the most recent period. Second, the report discusses potential sources of high and sustained growth that BH could exploit, as European Union integration is advanced. Finally, the report formulates policy recommendations that would help maximize the potential of BH economy to achieve higher real GDP growth and generate more jobs. In doing so, the CEM focuses on four priority policy areas: macroeconomic management, international trade policy, business environment and enterprise reform, as well as labor market policies. The latter includes an assessment of BH's education policies.

2. The report conveys three key messages. First, ten years after the end of the war, BH still suffers from the legacy of a conflict that destroyed a significant part of the country's physical productive capacity, depleted human resources and shattered institutions and social capital. Time lost during the war, combined with subsequent difficulties in coping with the double challenge of post-conflict reconstruction and the transition to a market economy have left BH far behind the most successful countries of central and eastern Europe (CEE). While post-conflict reconstruction has been successful, mainly because of large aid flows, the analysis in the report shows that BH lags on many of the structural reforms that have accompanied economic transition in the region. These include strategic privatization, product and labor market liberalization and enterprise restructuring.

3. As the recent decline in aid flows is likely to continue, delays in advancing structural reforms constrain BH's self-proclaimed goal of emerging as a vibrant, productive economy integrated in global markets. The outstanding challenges are many. Strong and sustainable economic growth is yet to be established after the post-conflict recovery. The job market is anemic and unemployment is high, and the informal economy appears to be gaining further ground. The country's external imbalances remain large and need to be corrected to limit long-term risks. Many companies, especially those that are state-owned or mass-privatized, continue to operate under soft budget constraints, leaving space for inadequate managerial behavior that can range from a weak profit motivation to asset stripping. BH's most precious resource, its people and especially its young population, is still longing to leave the country. The uncertainties surrounding the country's economic future and the related apparent lack of opportunities are an important cause of continuing brain drain. However, the mindset in decision - making, be it at the political level, within the public administration or inside many companies, is still geared towards preserving short-term privileges over establishing grounds for sustained output expansion.

4. As an important caveat, the political and administrative structure which emerged from the Dayton Peace Accords (DPA) makes the task of catching up more complex. Although it is outside the purview of this report or the mandate and expertise of the World Bank to make any assessment of the political and institutional relevance of the DPAs, which the report takes as given, it should be noted that these arrangements carry a significant cost. The level of complexity underlying administrative arrangements throughout the country brings direct fiscal costs. It also results in less tangible economic costs because major reforms have to be sanctioned by a mandatory consensus among BH's constituent peoples. Reforms which may appear to put one or another group at a disadvantage often cloud the policy debate and crowd out the reform's likely larger, longer-term development impact. This problem is compounded by weak technical capacity and policy coordination failures across the various levels of government. The recent vacillations over higher education reforms provide a telling case of the complexities of BH's political economy. Not anticipating or suggesting any profound modification to the DPA, this reports signals that the political commitment for achieving reforms in a reasonable time frame needs to be even stronger in BH than elsewhere in the region in order to overcome the system's inherent inertia.

5. The report's second key message is that BH can indeed catch up with the more advanced economies in central and Eastern Europe. Opportunities for growth exist and the authorities have in several instances demonstrated the political will and persistence to engage in difficult reforms. Some very important institutional reforms been achieved with a measurable initial impact, even if not on the scale and at the pace that would be desirable. BH firms can export, foreign investors see business prospects in BH, and new jobs are being created. In order to scale up these initial results, however, a number of critical challenges need to be addressed. These mainly relate to the business environment, enterprise reform and labor market reform. The authorities' Medium -Term Development Strategy (MTDS) identifies most of these challenges and provides a vision consistent with that of this CEM: the objectives are not necessarily higher growth and investment than the fast pace in the aftermath of the war, but a different type of growth and investment, where the private sector is in the driver's seat. To achieve this objective, the MTDS recommends a wide array of policy measures. Unfortunately, the MTDS fails to prioritize policy actions in terms of their likely impact for boosting real GDP growth. The CEM attempts to fill in this gap by singling out the most pressing issues requiring an urgent policy response in these areas.

6. The third key message relates to the optimal characteristics of the policy response: selectivity in the choice of priority actions, and flexibility of the policy stance, ranging from holding firm in some policy areas to intervening smartly in others. As noted, BH authorities have not waited for this CEM to identify pressing policy issues and have even made plans in several areas requiring action. Often, however, the envisaged policy response is biased towards active and wide-ranging intervention by government. Moreover, envisaged actions are too numerous to be credible and to serve a signaling function, including those prescribed in the MTDS. The CEM, by contrast, takes a more nuanced view. The underlying policy objective to stimulate the "new" type of growth is primarily to set the right incentives for efficiency and effectiveness. In some areas, such as the trade regime or exchange rate policy, this translates into staying the course. In many other cases, setting the right incentives requires governments to minimize their presence or even get out of the way. Finally, there are opportunities for active policy intervention, in particular with respect to reorganizing public expenditure in order to reform the education system or provide more adequate safety nets for those who need them the most now and in the future as the economy transforms. Within this framework, the remainder of this summary reviews the most salient conclusions of the report.

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