bosnia report
New Series No:49-50 December - March 2006
The economy of Bosnia-Herzegovina – ten years on
by Azra Hadžiahmetovic

In an era of strong orientation towards integration and strengthening of the internal market in most parts of Europe in the second half of the eighties and the first half of the nineties, the region of South-East Europe - and particularly of the former Yugoslavia - was marked by processes of disintegration and massive war-related devastation. At the centre of these developments was the former Yugoslav republic of Bosnia-Herzegovina, with its territory of some 50,000 square kilometres, 20 kilometres of Adriatic coastline, population of 4,4 millions and GDP of 8,3 billion US dollars ($1,900 income per capita).

As part of a Yugoslav economy whose annual growth rate in the period from 1960 to 1990 was 5,5%, B-H used to be described as a republic endowed with abundant raw materials and a wealth of other natural resources: e.g. wood, coal, salt, manganese, silver, lead, iron and copper. Its economy was more open and more market-oriented than that of other Yugoslav republics, it had a highly educated work force, and over half its exports were oriented towards the EU market.

The B-H economy was diverse, with a large industrial base, and highly entrepreneurial. More than half of its production and employment were in the industrial sector, mainly focused on energy production and the production of raw materials. In the services sector, B-H had developed capacities in civil engineering that contributed to the creation of 7% of its GDP.

The dramatic political and economic situation in Yugoslavia at the beginning of the nineties brought B-H into an extremely difficult position. In 1990 and 1991, a huge decrease of industrial production, exports and imports was recorded, alongside massive disintegration of its market, and a blockade of movement of goods, payment operations and the monetary system. The result of all these developments was a dramatic decrease in the living standard of B-H’s population, an increase of unemployment to approximately 33%, monetary collapse and a blockade of foreign trade.

As it is widely known, the dissolution of Yugoslavia and the recognition of its former republics were followed by a four-year-long devastation of B-H. When the Dayton Peace Accords (DPA) were signed, they found B-H lacking one quarter of its prewar population and three quarters of its prewar economic potential. Overall war damage has been estimated at 50-70 billion dollars, illustrating what a huge task of reconstruction awaited the war-devastated country. Such a collapse had not been recorded in Europe since the end of World War II.

Dayton created the framework for a new structure of government in B-H; also for the engagement of the international community, with the aim of providing support for the settlement’s implementation and for realisation of a programme of reconstruction and legislative reform. The Office of the High Representative was established and granted broad competences, inter alia in the legislative process in B-H, in view of its obligation to realise the conclusions of the Peace Implementation Council (PIC). Immediately after the signing of DPA, B-H became a member of the IMF; thereby the door to membership in the WB and its group was opened for it. From the beginning of its involvement the IMF has played a key role in the creation and evaluation of economic policy in B-H. The World Bank, the European Commission, the OHR and others have monitored the status of B-H in the IMF, defining its monetary and fiscal policies, as well as structural and external measures.

Enormous war damage, one million internally displaced persons and 1,2 million refugees, 90% of the population unemployed, have confronted B-H with a triple challenge:

- reconstruction of its war-devastated economy;

- development of new administrative structures and institutions for economic management;

- reforms leading towards a market economy.

The international community pledged to provide assistance to the country amounting to 5,1 billion dollars for its reconstruction programme. In the first three postwar years, 4,4 billion dollars were invested into B-H. Immediately after accepting B-H into membership, the IMF approved 30 million dollars of special drawing rights (SDR) for emergency assistance that was partly used to repay the external debt (i.e. the debt related to the succession of the former Yugoslavia). The second part of these funds was spent by the IMF in order to establish the country’s budget, and somewhat later its currency board. Since 1998 the IMF has provided support - through its stand-by arrangements - for B-H’s budget, as well as for its monetary, fiscal and structural reforms. Out of overall funds invested into the programme of reconstruction, 25% was funded by the WB (directly or through various funds). In the first three years of reconstruction alone, the WB approved about 435 million dollars for priority reconstruction projects, 25 million dollars being non-repayable funds and the rest very favourable loans (under IDA terms). These projects received significant support from other donors, who together with the European Commission have coordinated and monitored the programmes of reconstruction and transition. In the first years of the country’s reconstruction, assistance was mainly invested into infrastructural programmes and projects. According to WB indicators for 1998, investment was made into reconstruction of the energy and housing sectors - 450 million dollars each - while for social assistance, transport and peace implementation efforts another 250 million dollars were spent.

Alongside reconstruction, the international community’s priority was to create employment possibilities and to meet the requirements of external financing. With such a significant presence of foreign aid, B-H succeeded in achieving an extraordinarily high rate of economic growth, e.g.: about 80% in 1996, 36,6% in 1997, 10% in 1998 and 1999. Since then, the average rate of growth has been stable at about 5% per year. Such a high growth rate, as well as its rapid decrease, indicates that the B-H economy is highly dependent on foreign aid, which is still an important part of budgetary support to B-H. It was thanks to foreign aid that high levels of imports, public consumption, public investment and public expenditure were made possible. Average annual growth of about 30%, unemployment halved in comparison with the period immediately after the war, a reconstructed basic infrastructure, and production that was doubled: these were only some of the ‘impressive’ results of the country’s reconstruction, which was made possible thanks to its macro-economic stability and fiscal management through strict monetary arrangements supported by IMF stand-by arrangements. The result of all this has been that annual GDP in B-H is about 60% of its prewar level; estimates nevertheless indicate that if average economic growth is as anticipated, the prewar GDP cannot be achieved before 2015.

What is shown by other features of our economic growth?

- An average annual growth rate of about 5% from 2000 until today shows that not all the significant inputs of foreign funds from the period of reconstruction have been used, and that B-H has failed to generate domestic development. Internal sources of growth have not been mobilised, particularly those in the private sector, nor were significant inflows of foreign direct investment (FDI) into the economy of B-H recorded.

- The consequence of this trend is an exceptionally high unemployment rate, estimated at approximately 45% of the work force. Although unemployment is one of the most important parameters of poverty assessment, meanwhile, the Living Standard Survey for B-H has shown that 60% of the population living in poverty consists of families with only one member employed. This, together with other poverty indicators, shows that the B-H population is highly vulnerable to the slow-down of economic growth that could be the consequence of recession and stagnation.

- What poses a special problem for B-H is the growing share of the informal sector – the so-called ‘grey economy’ – in its GDP. It is estimated that more than one third of GDP occurs in this sector of the economy, characterized by a different dynamic of economic growth and public revenue, just as there are different unemployment rate trends in the formal and the informal sector. This has resulted in an increase of per capita revenue - estimated on the basis of parity of purchasing power of the population - that amounts to about 6,000 dollars and the calculation of which also includes informal sources of revenue (unregistered money transfers made by B-H citizens living abroad, revenue of unregistered firms, unreported income, etc.).

Situation in the monetary sector of the B-H economy

As envisaged by Dayton, the Central Bank has functioned as the currency board since 1997. Since 1998, when a joint currency fully covered by foreign currency reserves was introduced, B-H has had a stable macro-economic environment with a very low inflation rate. However, such a position of B-H’s Central Bank significantly narrows its own functions, reducing it to a technical and operational mechanism, rather than an institution acting creatively in the sphere of monetary policy. No loans to either the government or to other banks are permitted. The rate of statutory reserves now amounts to 10% - two times less than in neighbouring countries. The primary funds of the Central Bank must be fully covered by convertible money. The Euro - to which foreign currency exchange is pegged - is used as a monetary ‘anchor’, and it is thanks to this that foreign currency exchange maintains stability. Let me also mention the automatic effects of the country’s balance of payments on changes in its monetary supply.

Thanks to this monetary arrangement, the country’s foreign currency reserves have recorded significant growth, especially since 2001. This has enabled significant results in reform of the banking sector – particularly in terms of privatisation and the liquidation of insolvent banks. Today private banks - predominantly with foreign (mainly Austrian) capital - dominate the banking system of the country and represent more than two thirds of overall privately owned capital. Consolidation of the banking sector, competition, and an improved legal, regulatory and supervisory framework, have all contributed to renewed confidence in the system as such. In the period from 2001 to 2005 alone, citizens’ savings have been doubled. However, they still represent only 3,5% of GDP. Why is this so important? In a study on the financial viability and creditworthiness of B-H, the World Bank estimated that the growth of savings should already have represented 10% of GDP. Besides, and despite significant banking potential, lending to the private sector is still low, due to the short-term nature of deposits. It is worth mentioning that the successes in reforming the banking sector have brought about a decrease in interest rates, which are unfortunately still fairly high compared with the European average. Furthermore the difference between deposits and interest rates on loans is four times higher than in the EU, while high banking charges still reflect a considerable fear of risk. Although ‘consumer’ loans’ expansion has slowed down, according to IMF’s estimates it is still one of the key challenges and problems facing the economy of Bosnia-Herzegovina.

The situation in the fiscal sector has been recording significant improvement. Since 2001, and after a huge fiscal deficit, B-H has been registering marked fiscal consolidation. However, the share of the public sector in GDP is evidently high. In the last three years alone, public expenditure has increased its share in GDP from 50% in 2002 to more than 60% today. This is not the only problem though. Dayton created the framework for a complex and very expensive state organisation, such as could not be funded by the budgets of even the most highly developed countries in the world. In B-H, moreover, there are the following levels of government: the national level, two entity levels, ten cantonal levels, a specific district one (Brčko), and finally those of towns and municipalities. Thus one of the two entities – the Federation of B-H – has legislative competence in ten cantons. Each segment of this structure of government has a complex model of political organisation, which naturally functions at the expense of both rationality and efficiency. Another way of putting it is that, with fourteen governments in place, B-H with its population of 3,8 million has more ministers, deputy ministers, advisors, secretaries and drivers than any other country in the world. The total cost of B-H institutions (at both state and entity levels) now amounts to more than 50% of GDP. Simply in economic terms, such an excessive expenditure is unsustainable even in the mid-term perspective. And there are other forms of public expenditure too. For example, education – a strategic interest for the country – is regulated at the cantonal level. The result of such an arrangement is that seven universities exist in a country with a population of 3,8 million. That the problem does not stop there, moreover, is evident from the fact that per capita income is very low, the poverty level very high and illiteracy steadily increasing.

The biggest issue relates to the balance of payments, which shows a high deficit on both current and trade accounts. The continuous presence of a current-account deficit - which in the period of reconstruction amounted to 25% of GDP on average - has continued over the past several years. The trade deficit until 1999 was about 50% of GDP; since then it has slowed down slightly, now showing an unstable average annual growth of up to 45% of GDP. In the period of reconstruction during the first postwar years, with its related imports, this deficit was explicable; but the continuation of such an imbalance indicates serious structural problems. Today the balance of payments deficit amounts to 24% of GDP, caused to a great extent by the expansion of credit and by lack of reorganisation of the private sector. If we know that investment in capital funds in B-H amounts to 18% of GDP, which is little compared with international standards, then we know too that a deficit is not the way to finance investment in the future. Therefore, the issue of the sustainability of this deficit clearly arises.

B-H did not register any significant FDI inflow until 2001 (roughly 100 million Euro per year). In 2002 FDI doubled, and from 2003 on there was again a slow growth recorded. For comparison, among sixteen countries of central and eastern Europe B-H occupies thirteenth position in terms of overall inflow of FDI. Viewed in per capita terms, FDI in B-H is twenty time slower than in Hungary or the Czech Republic, more than ten times lower than in neighbouring Croatia. Only Moldova has a lower FDI inflow per capita than B-H. Having in mind B-H’s needs for financing its balance of payments deficit and repayment of foreign debt, it is of particular importance for the country to see an increase of FDI and private capital.

B-H’s foreign debt amounts to about 54% of its GDP. Thanks to the advantageous terms under which most B-H debt was contracted, as well as to favourable agreements for restructuring the debt, the amount of repayment of foreign debt to date, expressed as a percentage of overall exports, has been pretty low - only 8%. However, in the next mid-term period we need to reckon with significantly increased annual instalments, representing a service rate of about 9%. Given other macro-economic indicators, particularly the country’s high deficit - which has exceeded the sustainability threshold - we may expect this problem to impose a need for emergency harmonisation.

This brief overview of the B-H economy ten years after Dayton poses several logical questions.

- Why, despite a considerable inflow of foreign funds and the involvement of the international community, have no significant results been achieved in terms of generating domestic development?

- Why have internal sources of growth not been mobilised?

- Why did does B-H ten years after the war register an unemployment rate equal to almost half its labour-capable population?

- What has been the cause of the growing share of the grey economy in its GDP?

- How is it that, despite strict rules imposed by monetary arrangements, the issue still arises of the financial sustainability and creditworthiness of the B-H economy?

- At what cost has B-H’s fiscal consolidation been achieved, since its economy records a 60% share of public expenditure in overall GDP; or why is 50% of GDP spent on financing the country’s colossal administration?

- Why were there no structural changes or reorganisation of the private sector, resulting in such a high rate of deficit - amounting to 24% of GDP?

- What has been the reason for the absence of any significant inflow of FDI in the B-H economy?

- How is it that, in a situation of moderate indebtedness, B-H is still faced with the issue of its external solvency and creditworthiness?

- Is it not the case that, despite enormous involvement of the international community in B-H, there is a ‘construction error’ in the economic system of the country?

Economic aspects of the governmental structure of Dayton B-H

1. The economic space of B-H - with its small market, weak economic potential and huge war devastation - is fragmented by the entity political set-up and structure of the country. With respect to regional development and the fundamental criteria and principles of regionalisation, it is obvious that - when it comes to defining regions as areas determined primarily by economic, geographical, urban, industrial, transport, historical, cultural and other factors - the existing regional physiognomy of B-H shows all the weaknesses of the mechanisms upon which it is based. From a developmental point of view, the economic situation regarding our regions (entities and cantons) is that in B-H there are only depressed and undeveloped regions. They are ‘depressed’ because of their lack of mobilising activities for development, ‘undeveloped’ because they lag behind the rest of the world in the area of infrastructure, and because they do not have a network of development centres. Applying the criteria for assessing developmental effects, if we maintain our current state it would result only in further lagging behind in economic development, revenue growth, employment and investment.

2. Besides the complexity of the structures that make B-H an asymmetric state, the DPA drew the powers and competencies for issues vital to economic and social development - and for transition in general - down to lower, entity levels of government. Thus, for example, industry, agriculture, transport, natural resources, the labour market, the social sector, health care, education, etc. are all in the administrative competence of bodies which - in the spirit of the DPA - act totally independently from the state. The result of the system of territorial collectivities, conceived in such a way, is an absence of institutionalised coordination and subordination in the key issue of development. These are left to the political will of participants in the process. That alone makes B-H susceptible to obstructions made possible by the DPA institutional framework. The most obvious examples are those we see emerging whenever efforts are made to establish a single economic space in B-H: in the practice of ‘administering’ small doses of functioning to the state institutions, through a kind of charity provided by the two entities to the state budget; in two completely different and politically dubious models of privatisation, which have resulted in delays in the process and an absence of positive effects; and so on.

3. The existing constitutional framework and the complex state structure are not just inefficient, they generate a costly state apparatus and administration that could not possibly be afforded even by a much richer country. With fourteen governments and as many parliaments, over 150 ministers and their offices, B-H represents a unique example of over-institutionalisation. Yet there are no positive effects of such a hyper-organisation. Once again, the framework for such a high degree of institutionalisation in B-H lies in the DPA.

4. Yet, despite its high degree of institutionalisation, in B-H there is an acute absence of the institutionalised economic society that should mediate between the state and the market. This has had an impact on the manner and dynamics of implementation of reform in the country. It is only thanks to the involvement of the international community, particularly the High Representative, that results have been achieved in the domain of economic stability. Nevertheless, the issue of the economic sustainability - and particularly the ‘self-sustainability’ - of such a system is ever more obvious in key economic areas in B-H.

5. All these examples show that this system, and the entire legal and economic set-up of B-H, are impediments to significant economic, social, cultural and political progress. This system without a system can only generate grey economy, crime and corruption. It particularly emphasises the ‘free rider problem’: i.e. the philosophy that what needs to be done will be done by someone else. A system that does not imply responsibility, subordination, sanctions for non-implementation, represents a sum of autisms – political, ethnic and entity – and closed systems playing only for and by themselves.

This country has been transformed - from a socialist economy, through a donor-dependent economy, to a ‘waiting-for-Godot’ economy. B-H society has grown tired of waiting. However, the problem lies neither in the cultural nor in the economic system. It lies in the political system. Even the most important area of human activity – the so-called public sphere – is fragmented. That is where the erroneous belief that the economy could reintegrate B-H fails us, since it is a fact that the B-H economy is only a reflection of the political structure and set-up established by Dayton.

Even if we could subscribe to the thesis that such a complex state structure of B-H is not by itself an obstacle to democratisation and progress, the issue immediately arises of why it has not been implemented. I am sure that the ‘construction error’ I am talking about is the reason underlying the incomplete implementation of the DPA. It is also the reason for all those who delude themselves that the political set-up of B-H is reduced to a re-definition of the role of international community and of the High Representative. It is only the change of political configuration in B-H that can open up a space for a reduced role of the High Representative and international community in the functioning of B-H society. That is why claims that we hear that we should be given the opportunity to resume the ownership over our country and our future seem so self-deluding. For that we need to have a mechanism that is much more efficient, less costly, able of eliminating the levers of obstruction from the system, and ready not to leave merely to political will of the leaders the thing that should never be left to anyone’s political will – the mechanism that has the instrument of implementation built in its very structure.

This imperative requirement is particularly evident in the ‘European’ context of the future of B-H. Let me remind you of the South-East Europe Stability Pact and its most important part – the Stabilisation and Association Process. The European Commission has defined the steps of this process, whose final stage is the Stabilisation and Association Agreement (SAA). These steps, together with the ‘initial conditions’ determined earlier for all the countries of Central and Eastern Europe and for regional cooperation, imply political and economic reforms. The method for which the European Commission has opted is the so-called ‘middle road’ – an assessment of the degree of fulfilment of minimal criteria for the start-up of negotiations on the SAA. Its elements were contained in the Road Map with its eighteen conditions, and in the Feasibility Study with its eighteen conditions. Thanks to the heavy involvement of the international community – and particularly the High Representative - today, five years later, B-H is awaiting a positive assessment of the progress achieved and of its capacity to negotiate an SAA with the EU. Out of the five countries included in the stabilisation and association process, B-H is last so far as assessment of all the steps that the process implies is concerned.

Since the SAA is B-H’s first contractual relation with the EU, the country - as a contracting party – should both assume its obligations and define a transitional period within which they are to be fulfilled. The next step – negotiations on EU membership – implies the fulfilment of political and economic obligations, as well as the application of the Acquis criteria. That means the incorporation of what already amounts to over 100,000 pages of EU legislation. One high EC official has remarked in this connection that, if the process continues at the present pace and in the present way, B-H would need 500 years to bring it to a successful conclusion.

Without challenging the European orientation and perspective for B-H, several important questions seem to be logical and unavoidable:

- Although we have been positively assessed by the EC, are we in B-H - with such a political structure - really prepared, economically and institutionally, for these negotiations?

- Is B-H – as a party to the SAA – capable of taking up its obligations in fields where it does not have yet instruments of implementation available?

- Can B-H, with such a political structure, take up its obligations related to the dynamics of implementation of reforms - something that forms an integral part of its contractual obligations towards the EU?

- Given the vulnerability of its economy, can B-H stand the ever growing price of further delays in this process?

- Can anyone even imagine how much any conceivable alternative option would cost?

Any response to these questions must take into account the fact that what we have here is a system with no system: a system with an in-built ‘construction error’.

Dr Hadžiahmetović teaches at the faculty of economics of the University of Sarajevo. This is the text of her contribution to a seminar marking the tenth anniversary of the Dayton Peace Agreement, organized by The Bosnian Institute in London on 7 November 2005 at the University of Westminster


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