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Country Report

Bosnia and Hercegovina

October 2006

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

Bosnia and Hercegovina at a glance: 2007-08

OVERVIEW The nationwide elections held on October 1st have shifted the balance of power between political parties in Bosnia and Hercegovina (BiH), but have failed to break the pattern of ethnically divisive politics, and may even have reinforced it. The main winners were the nominally moderate parties: the Alliance of Independent Social Democrats (SNSD) in Republika Srpska (RS), and the Party for BiH (SzBiH) in the Federation. However, both the SNSD and the SzBiH prospered by running on an ethnic agenda, and their leaders may struggle to establish a working relationship. The signing of an EU stabilisation and association agreement (SAA) is unlikely before 2007, reflecting slow progress on police reform and other EU prerequisites. The currency board arrangement will stay in place in 2007-08. The introduction of value-added tax (VAT) this year has seen inflation rise strongly, but it will fall back in 2007. The Economist Intelligence Unit expects strong investment and export performances to drive average real annual GDP growth of 5.4% in 2007-08. This will help to bring the current-account deficit down to around 12% of GDP by the end of 2008.

Key changes from last month

Political outlook • Both the SNSD leader, Milorad Dodik, and the SzBiH leader, Haris Silajdzic,

would have to retreat considerably from their current positions to develop a reasonable working relationship. The looming question of Kosovo!s future status may also make agreement between the two parties difficult.

Economic policy outlook • Increased spending pressures related to war veterans and to holders of

frozen foreign-currency deposits have led to international concern and could pose a risk to fiscal stability.

Economic forecast • We estimate real GDP growth of 5.3% in 2006, reflecting strong domestic

demand and export growth.

The Economist Intelligence Unit

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ISSN 1462-673X

Symbols for tables �n/a� means not available; �� means not applicable

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Bosnia and Hercegovina 1

Country Report October 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 2007-08 8 Political outlook 10 Economic policy outlook 11 Economic forecast

13 The political scene

19 Economic policy

23 The domestic economy 23 Output and demand 24 Employment, wages and prices 26 Financial indicators

27 Foreign trade and payments

List of tables 11 International assumptions summary 12 Forecast summary 23 Republika Srpska: industrial production 24 Federation: industrial production 26 BiH: retail prices 26 BiH: commercial bank lending, Aug 28 Balance of payments

List of figures

13 Gross domestic product 13 Consumer price inflation 25 Wages 29 Net free reserves



Bosnia and Hercegovina October 2006

Summary

The nationwide elections held on October 1st have shifted the balance of power between political parties in Bosnia and Hercegovina (BiH), but have failed to break the pattern of ethnically divisive politics, and may have reinforced it. The main winners were the nominally moderate Alliance of Independent Social Democrats (SNSD) in Republika Srpska (RS), and the Party for Bosnia and Hercegovina (SzBiH) in the Federation. However, both the SNSD and the SzBiH ran on an ethnic agenda, and their leaders may struggle to establish a working relationship. The signing of an EU stabilisation and association agreement (SAA) is unlikely before 2007. The currency board arrangement will stay in place in 2007-08. The introduction of value-added tax (VAT) this year has seen inflation rise strongly, but it will fall back in 2007. The Economist Intelligence Unit expects strong investment and export performance to drive average real annual GDP growth of 5.4% in 2007-08. This will also help to bring the current-account deficit down to around 12% of GDP by the end of the forecast period.

The SNSD!s strong showing reflected skilful campaigning by the party!s leader, Milorad Dodik, as well as falling support for the Serb Democratic Party (SDS). The SzBiH benefited from the return of Haris Silajdzic to the leadership. Reforms slowed ahead of the elections, amid jurisdictional disputes between governments at state and entry level.

Proposed payments to war veterans and holders of frozen foreign-currency savings deposits have raised concerns about fiscal stability. Indirect tax receipts have continued to grow strongly, reflecting buoyant revenue from VAT. The Federation government has sold an oil distributor, Energopetrol, and the RS government has called a tender for a 65% stake in Telekom Srpske.

Industrial output growth decelerated in the third quarter of 2006. A new labour force survey put the unemployment rate in BiH at about 30%. Wage growth eased during the third quarter, but inflationary pressure persisted. The growth of commercial bank credit has decelerated.

BiH ran a current-account deficit of KM828m (US$529m) in the first half of 2006, a 38.4% drop compared with the year-earlier period. Exports grew much faster than imports, partly because of methodological changes and the introduction of VAT. Net foreign direct investment in the first half was KM352m.

Editors: Richard Eames (editor); Laza Kekic (consulting editor) Editorial closing date: October 12th 2006 All queries: Tel: (44.20) 7576 8000 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

Outlook for 2007-08

The political scene

Economic policy

The domestic economy

Foreign trade and payments

4 Bosnia and Hercegovina


Political structure

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

The central 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 1st 2006 to select a three-member state presidency, the RS president, and state, entity and cantonal parliaments.

BiH has a rotating, collective, three-member presidency. The current members are: 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), Party for BiH (SzBiH), Social Democratic Party (SDP), Croatian Democratic Union of BiH (HDZ BiH), Alliance of Independent Social Democrats (SNSD), Serb Democratic Party (SDS), Party of Democratic Progress (PDP)

The Dayton agreement established the Office of the High Representative (OHR), charged with monitoring the implementation of the agreement and co-ordinating the activities of international organisations. Since December 1997 the High Representative has been able to impose decisions in cases of disagreement and to dismiss "obstructive" officials

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 Vahid Heco (SzBiH) 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)

Federation

Key ministers

High Representative

Key ministers

Republika Srpska



Economic structure

Annual indicators

2002a 2003a 2004 a 2005 a 2006b

GDP at market prices (KM bn) 11.6 12.3 14.6 15.7 17.9

GDP at market prices (US$ bn) 5.6 7.1 9.3 10.0 11.5

Real GDP growth (%) 5.3 4.4 6.2 5.0 5.3

Retail price inflation (av; %) 0.4 0.6 0.4 4.5 8.2

Population (m) 3.9 3.9 3.9 3.9 3.9

Exports of goods fob (US$ m) 1,110 1,478 2,087 2,580 3,500

Imports of goods fob (US$ m) -4,449 -5,637 -6,656 -7,534 -8,250

Current-account balance (US$ m) -1,190 -1,637 -1,784 -2,087 -1,730

International reserves (US$ m) 1,321 1,796 2,408 2,531 2,700

Total external debt (US$ bn) 2.5 2.6 3.2 3.4 b 3.9

Exchange rate (av) KM:US$ 2.08 1.73 1.58 1.57 1.56

a Actual. b Economist Intelligence Unit estimates.

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

Agriculture 9.8 Private consumption 91.7

Industryc 24.5 General government consumption 22.3

Manufacturing 11.2 Exports of goods & services 25.1

Services 65.7 Imports of goods & services 59.1

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

Base metals 26.4 Machinery 16.2

Mineral products 14.2 Mineral products 14.5

Wood & wood products 10.7 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 2006 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 QtrFinancial indicators Exchange rate KM:US$ (av) 1.601 1.511 1.488 1.554 1.604 1.646 1.627 1.557Exchange rate KM:US$ (end-period) 1.576 1.436 1.509 1.617 1.624 1.658 1.616 1.538Deposit rate (av; %) 3.79 3.96 3.81 3.49 3.37 3.59 3.71 3.65Lending rate (av; %) 10.15 10.10 9.95 9.85 9.56 9.08 8.44 8.20M1 (end-period; KM m) 3,799 3,788 3,763 3,985 4,228 4,422 4,473 4,772M1 (% change, year on year) 18.0 15.2 9.8 11.0 11.3 16.7 18.9 19.7M2 (end-period; KM m) 6,844 7,213 7,272 7,682 8,156 8,561 8,869 9,378M2 (% change, year on year) 21.2 22.5 19.1 18.6 19.2 18.7 22.0 22.1Foreign trade & payments (US$ m) Exports fob 534.8 620.7 561.0 680.8 652.9 685.4 679.7 n/aImports fob -1,752.3 -1,940.4 -1,502.2 -1,955.4 -1,940.8 -2,135.9 -1,349.2 n/aTrade balance -1,217.5 -1,319.7 -941.2 -1,274.6 -1,287.9 -1,450.5 -669.5 n/aServices balance 98.2 134.8 124.7 151.4 128.3 150.7 115.1 n/aIncome balance 117.8 105.4 136.2 117.6 118.9 99.9 91.6 n/aTransfer balance 511.4 537.4 395.1 444.3 501.3 498.5 326.6 n/aCurrent-account balance -490.0 -542.0 -285.2 -561.4 -539.3 -701.5 -136.1 n/aReserves excl gold (end-period) 2,164 2,408 2,277 2,222 2,427 2,531 2,747 3,016

Sources: IMF, International Financial Statistics.



Outlook for 2007-08

Political outlook

The nationwide elections held on October 1st have shifted the balance of power between political parties in Bosnia and Hercegovina (BiH), but have failed to break the pattern of ethnically divisive politics, and may even have reinforced it. The three traditionally ethnic nationalist parties"the Serb Democratic Party (SDS), the Croatian Democratic Union of BiH (HDZ BiH) and the mostly Bosnian Muslim Party for Democratic Action (SDA)"have emerged weakened from the elections. The main winners were the nominally moderate parties: the Alliance of Independent Social Democrats (SNSD) in Republika Srpska (RS), and the Party for BiH (SzBiH) in the Federation. However, both the SNSD and the SzBiH prospered by running on an ethnic agenda during an election campaign that was tense and at times inflammatory.

The SNSD!s convincing victory marks the first time that a party from the RS has emerged as the main political force, able to determine the make-up of the state-level government. The prospects for government stability depend on whether the SNSD leader, Milorad Dodik, and the SzBiH leader, Haris Silajdzic, can establish a working relationship.

Mr Silajdzic, who will represent Bosnian Muslims in BiH!s tripartite presidency, advocates a unitary BiH. Mr Dodik, by contrast, insists on preserving the semi-statehood that the RS was given under the terms of the Dayton peace agreement. Moreover, Mr Silajdzic has the strong backing of BiH!s Islamic community, which makes him an unlikely partner from Mr Dodik�s point of view. Forging a common position on the complex reform agenda that awaits the incoming government will therefore be a difficult task. There is thus a risk that the pace of reform will not accelerate once the new governments take office, leading to further tensions with international actors in BiH.

Both Mr Silajdzic and Mr Dodik are political pragmatists, and with some international cajoling a compromise may be possible. Mr Dodik, for example, would like the local authorities in BiH to take full responsibility for government matters, without international involvement. For this to happen, there has to be greater progress on reform, including the signing of an EU stabilisation and association agreement (SAA). This requirement may lead Mr Dodik and the SNSD to engage more constructively in state-level government than his pre-election rhetoric would suggest.

For a modus vivendi to emerge, however, both leaders would have to retreat considerably from their current positions. For example, whereas Mr Dodik!s reference to a secession referendum for the RS is probably rhetorical, his resistance to the abolition of the RS is not. The looming question of Kosovo!s future status may also make agreement between the SNSD and the SzBiH difficult.

Much will depend on the precise composition of governments at state and entity level, as well as on the real influence that the SzBiH will have, given the

Domestic politics



limited powers of the BiH presidency. The formation of an RS government will be straightforward, in view of the SNSD!s clear majority, but the closer result in the Federation means that coalition-building there is likely to be protracted. Forming a state-level government could also take some time, as the SNSD will insist on taking over the post of chairman of the Council of Ministers"the de facto government of BiH"which for the past four years has been held by a Bosnian Muslim. As expected, the elections showed that the Bosnian Croat political scene, which has traditionally been dominated by the HDZ BiH, has become increasingly fragmented following a split in the party earlier this year.

The political and economic reform agenda is so large that international actors will remain heavily involved in BiH over the forecast period. In mid-2006 the Peace Implementation Council (PIC), the body that oversees the work of the Office of the High Representative (OHR), announced plans to shut down the OHR by mid-2007, and to rescind the "Bonn Powers", by which the High Representative has had the authority to remove obstructive officials and impose legislation in BiH. The current High Representative, Christian Schwarz-Schilling, has suggested that the exact timing of the OHR!s closure will be determined by progress in vital areas of reform, including restructuring of the entities! police forces. Failure to make swift progress in these areas after the elections will render implausible the mid-2007 timeline for closing the OHR.

If the timetable does not slip, the closure of the OHR, which has for the past decade operated as the highest executive authority in BiH, will mark a turning-point on the domestic political scene. Although significant progress has been made in the past ten years in reducing inter-ethnic tensions in the country, relations between the leading political parties"most of which are still based on ethnicity"remain prickly. The political and reform outlook later in the forecast period will thus be strongly influenced by the degree to which the EU can provide incentives to keep the ruling parties co-operating with one another, and focused on the EU integration agenda.

EU representatives and the BiH authorities agree that talks on a stabilisation and association agreement (SAA) between BiH and the EU have proceeded smoothly from a technical perspective. However, progress has been slow in meeting many of the criteria for an SAA, including those on police reform, co-operation with the International Criminal Tribunal for former Yugoslavia (ICTY) in The Hague, reform of the public administration, and passing laws on higher education and broadcasting. The upcoming report of the European Commission on BiH!s progress in meeting EU requirements is therefore expected to be highly critical of the local authorities, so that the agreement will almost certainly not be signed until 2007. In the light of current concerns within the EU over the pace of future enlargement, BiH!s path towards membership is likely to be significantly longer than those of the most recent new EU entrants. Membership of NATO!s Partnership for Peace (PfP) programme continues to be delayed by inadequate co-operation with the ICTY.

International relations



Economic policy outlook

Negotiations with the IMF over a new stand-by arrangement have been on hold for some time. However, given the negative consequences that would ensue from an IMF withdrawal, and with the elections out of the way, the Economist Intelligence Unit expects the authorities to work with Fund representatives to resolve their differences over the fiscal position and conclude a new agreement at some point.

Privatisation will continue in both entities. In August 2006 the RS government announced a tender for the state!s 65% stake in the publicly held telecommuni-cations provider, Telekom Srpske, and it hopes to conclude the sale by the end of the year. However, there are risks to this timetable. Shortly after the announcement the outgoing state-level prime minister, Adnan Terzic, suggested that the sale of telecoms assets was the prerogative of the state, rather than entity governments, and asked the OHR for legal advice on the matter. More broadly, the possibility of fractious coalitions emerging after the elections, especially at state level and in the Federation, presents a significant risk to the pace of economic reform in 2007-08.

Revenue from the new state-wide value-added tax (VAT) remained strong during the third quarter of 2006, leading the entity governments to consider reducing other tax rates at some point during the forecast period. The entity governments are also working to reduce discrepancies between their tax systems in order to minimise complications for businesses operating across BiH. In 2007-08 we expect the IMF to influence fiscal policy more strongly. However, even in the absence of an IMF agreement, the governments have maintained relatively prudent fiscal stances. We therefore expect the general government budget to run modest deficits in 2007-08. Nonetheless, risks to the fiscal position include spending pressures related to BiH!s large internal debt-service burden, planned infrastructure investment, the reforms of the police and defence, as well as declining international assistance.

The introduction of a Fiscal Council consisting of the prime ministers and finance ministers of the state and entity governments was intended to strengthen fiscal co-ordination and to put a sustainable fiscal structure in place. However, the council!s work has been undermined by disputes over the sharing of VAT revenue between the entities, and its recommendations have not always been heeded.

The Central Bank of Bosnia and Hercegovina (CBBH) runs a currency board regime, whereby the convertible marka has been fixed to the euro since the introduction of the single currency in 1999. At the end of 2005 the CBBH raised the reserve requirement"one of the few monetary policy levers it has at its disposal"from 10% to 15%, but credit growth has remained strong so far in 2006. However, the Central Bank has suggested that it does not expect to raise the reserve requirement further in the short term. External imbalances and high unemployment remain long-term concerns for the CBBH, but substantial private remittances and several large foreign investments in the country have underpinned strong growth in foreign reserves in recent years, and net free

Policy trends

Monetary policy

Fiscal policy



reserves"that is, those that are surplus to the CBBH!s monetary liabilities"have risen apace. Efforts to centralise bank supervision at the state level have stalled, but progress may be more likely after the nationwide elections.

Economic forecast

International assumptions summary (% unless otherwise indicated)

2005 2006 2007 2008

Real GDP growth World 5.0 5.3 4.7 4.7

OECD 2.6 3.1 2.2 2.4

Euro zone 12 1.4 2.4 1.8 2.0

EU25 1.7 2.6 2.1 2.2

Exchange rates ¥:US$ 110.1 115.1 102.3 97.5

US$:� 1.245 1.255 1.363 1.338

SDR:US$ 0.677 0.679 0.643 0.644

Financial indicators � 3-month interbank rate 2.15 3.06 3.86 3.90

US$ 3-month Libor 3.56 5.20 4.90 5.33

Commodity prices Oil (Brent; US$/b) 54.7 69.3 69.3 66.0

Gold (US$/troy oz) 445.0 631.5 700.0 650.0

Food, feedstuffs & beverages (% change in US$ terms) -0.5 8.9 -4.5 0.7

Industrial raw materials (% change in US$ terms) 10.2 49.1 -3.7 -10.5

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

BiH!s economic growth is partly reliant on demand from its main trading partners in the EU and in south-eastern Europe. GDP growth in the euro zone is estimated at 2.4% this year"compared with 1.4% in 2005"but to fall below this level in 2007-08. Growth in Germany and Italy, two of BiH!s largest export markets, is expected to remain sluggish over the forecast period. In addition, policy tightening in several of BiH!s key export markets in south-eastern Europe could dampen import demand in those countries. We expect the US dollar to fall sharply against the euro in 2007, which could dent BiH�s export competitiveness. International oil prices will remain high, putting upward pressure on BiH!s import costs. Rising euro zone interest rates in 2007-08 present some risk to investment growth.

Recent rapid 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 year. We expect further inward investment to support an upturn in foreign sales, as conditions in several of BiH!s leading export markets improve gradually. The recent expansion of consumer borrowing should keep household spending buoyant in 2006 and push real GDP growth to an estimated 5.3%. Credit growth is likely to slow in 2007-08, which, along with public-sector wage restraint, is likely to weaken domestic demand growth. However, we expect strongly rising investment to keep annual real GDP

Economic growth

International assumptions



growing at around the same pace as in 2006, although the potential for political instability presents some risk to this forecast.

The introduction of VAT led to a sharp spike in price growth in both entities in early 2006, and inflation remained well above trend levels in the first half of the year. We anticipate a slowdown in inflation in both entities towards the end of 2006 as the impact of VAT dissipates and base-year effects take hold, although we continue to expect annual average inflation in both entities to be several percentage points higher than in 2005. In 2007-08 the absence of any further tax increases, together with more modest wage growth, will see inflation ease in both the Federation and the RS.

The marka is pegged to the euro at a rate of KM1.96:#1. Low inflation in BiH has tempered the pace of real effective appreciation in previous years, although rising inflation in 2006 and a weakening US dollar in 2006-07 will see the real effective exchange rate appreciate by about 4% in 2006 and by 2% next year. The marka appears to be considerably overvalued, although the likelihood of a change in exchange-rate regime over the forecast period is remote. The CBBH maintains sufficient reserves to cover the whole of its monetary liabilities. Its free reserves"that is, those above and beyond these liabilities"remain relatively low, despite strong growth in recent years. However, the chances of a speculative attack on the marka are also low.

The introduction of VAT in 2006 has led both to strong export growth, as more exporters reported their sales in order to claim VAT refunds, and to much slower growth in import costs, following the rush of imports in late 2005. We therefore estimate the current-account deficit in 2006 to be significantly lower in US dollar terms, and as a percentage of GDP, than in 2005. Over the medium term the introduction of VAT should see demand for some imported goods fall in response to their higher relative prices. In 2007-08 we expect the pace of import expansion to be affected by tight monetary conditions and slower wage growth, but this will be offset in part by strong investment demand and high oil prices. Export growth will be supported by improvements in export capacity driven by recent inflows of investment into heavy industry. We forecast a narrowing of the current-account deficit to around 12% of GDP by 2008.

Forecast summary (% unless otherwise indicated)

2005 a 2006 b 2007c 2008c

Real GDP growth 5.0 5.3 5.3 5.5

Industrial production growth 10.0 b 9.0 10.0 10.0

Average lending rate (%)d 9.6 8.3 8.2 8.0

Federation retail price inflation (av) 3.0 6.5 3.0 3.0

Republika Srpska retail price inflation (av) 5.2 9.0 5.0 4.0

Exports of goods fob (US$ bn) 2.6 3.5 4.4 5.2

Imports of goods fob (US$ bn) -7.5 -8.3 -9.4 -10.3

Current-account balance (US$ bn) -2.1 -1.7 -1.9 -1.8

Current-account balance (% of GDP) -20.8 -15.0 -13.8 -12.3

Exchange rates

Inflation

External sector



Forecast summary (% unless otherwise indicated)

2005 a 2006 b 2007c 2008c

External debt (year-end; US$ bn) 3.4 b 3.9 4.5 5.1

Exchange rate KM:US$ (av) 1.57 1.56 1.44 1.46

Exchange rate KM:US$ (end-period) 1.66 1.50 1.43 1.49

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

BiH Balkans (a)

Gross domestic product(% change, year on year)

BiH Balkans (a)

Consumer price inflation(av; %)

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

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

20

02

03

04

05

06

07

08

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

20

02

03

04

05

06

07

08

The political scene

The Alliance of Independent Social Democrats (SNSD) has emerged as the clear winner in the fifth post-war nationwide elections in Bosnia and Hercegovina (BiH), which were held on October 1st. The SNSD won the largest share of the vote in Republika Srpska (RS; one of the two sub-state entities) for both the BiH House of Representatives and the RS National Assembly. The party is expected to win an absolute majority of seats in the RS assembly, and to be the single largest party in the BiH parliament. In addition, the SNSD!s Nebojsa Radmanovic was elected as the Serb member of BiH!s rotating, collective, three-person presidency, and Milan Jelic won a similarly convincing victory in the race for the RS presidency against the incumbent, Dragan Cavic of the Serb Democratic Party (SDS).

Although final results had yet to be released at the time of writing, preliminary returns indicated that the SNSD had won more than 48% of the vote in the RS for the BiH House of Representatives. Its main rival, the SDS, won about 20%. The SNSD!s electoral success reflects a decline in support for the SDS and the skilful electoral strategy of Milorad Dodik, the SNSD leader and RS prime minister.

The SDS, which has traditionally taken a hard line on issues of Bosnian Serb identity and sovereignty, has been undermined by a series of measures of the international community in response to previous SDS-led governments! failure to co-operate in implementing the Dayton peace agreement. In 2002 some 80

The SNSD is the clear winner in national elections

Support for the SDS falls



SDS members were banned from active politics, and the party�s bank accounts have been frozen, weakening its activity on the ground, especially in the eastern RS.

At the same time, the SDS!s domestic popularity has suffered because of a perception that its leaders have been too willing to succumb to international pressure to help implement the Dayton agreement. In particular, much of the RS electorate believes that the progress made towards strengthening central state institutions in BiH when the SDS was in office is directly undermining the entity!s survival. The president of the SDS, Mr Cavic, has been criticised for agreeing to abolish the RS Ministry of Defence and for publicly accepting the Bosnian Serbs! responsibility for the Srebrenica massacre. The involvement of SDS members in privatisation irregularities has also significantly lowered the party�s standing.

Mr Dodik capitalised on these criticisms and adopted an increasingly nationalist tone, making the preservation of the RS�s semi-statehood the centrepiece of his electoral campaign. The BiH election campaign was fought against the backdrop of internationally mediated talks on the future status of Kosovo, a crucial issue of national identity for many Serbs. Mr Dodik!s strong line"including a repetition of his earlier pledge to hold an independence referendum in the RS"struck a chord with many RS voters. In addition, since taking office in early 2006 Mr Dodik has emphasised economic development and tried to build an image of the RS as the economically more progressive and stable of BiH!s two entities. This has won him the support of a large section of the RS electorate.

In BiH!s other entity, the Federation, the mostly Bosnian Muslim Party of Democratic Action (SDA) received the highest number of votes in the October 1st elections to the BiH House of Representatives, with about 25% of the total. The Party for BiH (SzBiH) came a close second, with 22-23%, and the Social Democratic Party (SDP) came third with about 15%. Although the SNSD!s success in the RS had been widely expected, that the SzBiH has become the second-largest party in the Federation was a surprise.

The main factor in the SzBiH!s success was the return of its founder, Haris Silajdzic, to the helm of the party. Bosnian Muslim voters in the Federation regard Mr Silajdzic as having more charisma than the SDA leader, Sulejman Tihic, and as more able to stand up to a strong RS leader such as Mr Dodik. In contrast to Mr Dodik in the RS, Mr Silajdzic ran on a platform to strengthen BiH!s central state institutions. Earlier in 2006 the SzBiH prevented the adoption of the constitutional reform proposal on the grounds that it was a poor compromise that could eventually lead to BiH�s disintegration, and this stance won over some former SDA supporters in the October elections.

Mr Silajdzic had the backing of the head of BiH�s Islamic community, reis effendi Ceric, which raised the SzBiH leader�s support among the Federation!s rural and refugee populations, which traditionally vote for the SDA. The SDA was also hurt by internal disputes between reformists and the party!s more nationalistic founders, which damaged the organisations image as a unified

Mr Dodik takes a nationalist line

The SzBiH performs strongly in the Federation



political force fighting for the interests of Bosnian Muslims. Mr Tihic was criticised for his performance as the Bosnian Muslim member of the BiH presidency, including the unsuccessful constitutional reform proposal, and lost the presidency to Mr Silajdzic.

The Bosnian Croat vote was split between two coalitions: the Croatian Coalition, led by the Croatian Democratic Union of BiH (HDZ BiH); and Croatian Unity, led by HDZ 1990, which broke away from the HDZ BiH earlier in 2006. Zeljko Komsic from the SDP was elected as the Croat member of the BiH presidency.

A number of incidents over the mid-year period raised tensions in BiH and contributed to one of the most inflammatory election campaigns since the end of the 1991-95 war in BiH. In mid-August the grave in the BiH capital, Sarajevo, of Alija Izetbegovic, the founder of the SDA and a former member of the BiH presidency, was damaged by an explosion. At the time of writing, no suspects had been charged, but the incident led to a series of sharp exchanges between Bosnian Serb politicians and their Bosnian Muslim counterparts. Around the same time, video footage was released in Serbia and the RS purporting to show a Bosnian Muslim commander, Atif Dudakovic, ordering his troops to burn a Bosnian Serb village during the war, prompting an uproar among RS politicians.

The current SDA president, Mr Tihic, accused Bosnian Serbs of collaborating with Serbia to incite ethnic tensions in BiH in order to highlight the potential for regional instability in the event that the leading international powers propose independence for Kosovo. Mr Cavic responded by demanding that Mr Dudakovic be charged with war crimes. The speaker of BiH!s House of Representatives, Nikola Spiric, raised tensions further by suggesting that the explosion at Mr Izetbegovic!s grave was masterminded by Muslim extremists. In addition, Mr Tihic�s meeting with Mr Dudakovic, at which the SDA leader praised the commander for his service to the country during the war, was seen by Bosnian Serbs as a provocative act.

The public exchange of accusations among leading political and religious figures in BiH dominated the media for several weeks and helped to rekindle ethnic sensitivities ahead of the October 1st elections. Some RS parlia-mentarians said that one of the entity government�s priorities after the elections should be to redefine the role of the Council of Peoples (an RS parliamentary body charged with protecting the national interests of BiH�s three constituent peoples), or even to abolish it. These calls came after the council blocked the RS law on higher education; before that, the council had tried to block the sale of the RS telecommunications operator, Telekom Srpske, evoking the so-called vital interest clause. In another move, which indicated the fragility of internationally backed progress in establishing joint institutions, Mr Dodik threatened to review a decision to transfer competences to the state-level prosecution chamber over the latter!s failure to file charges against Mr Dudakovic. Although the escalation in tensions should be seen in the context of the election campaign, it could complicate the return to more a constructive style of politics after the vote.

The Bosnian Croat vote is split

Tensions rise in the run-up to the elections



The governments of the RS and Serbia have become closer in recent months, culminating in Banja Luka on September 26th with the renewal of an intergovernmental agreement. The pact dates from 2001 and is permitted by the Dayton agreement, which allows the RS and the Federation to form "special parallel relationships" with Serbia and Montenegro, and with Croatia, respectively, in recognition of the ethnic links between their respective populations (July 2006, The political scene). Nevertheless, Bosnian Muslims in particular claimed that the decision by the RS government to renew the agreement, as well as its timing, could undermine the central state, and showed Serbia!s desire to intervene in BiH!s internal affairs.

The timing of the agreement, just a few days before BiH!s elections, was significant. Mr Dodik saw the signing as a chance to reaffirm his nationalist credentials with Bosnian Serb voters, in line with his calls for an independence referendum in the RS. Serbia!s leaders, meanwhile, are fighting a rearguard action over Kosovo and are keen to stress the possible negative implications for the region should the province be declared independent. Serbia!s prime minister, Vojislav Kostunica, and its president, Boris Tadic, both attended the signing ceremony.

Croatia�s prime minister, Ivo Sanader, also raised tensions before the elections by calling for another Dayton-style international conference to agree on the political reorganisation of BiH. Apart from the Bosnian Croats, most political parties in BiH criticised the proposal on the grounds that the matter should be decided by the people of BiH.

Thinking the unthinkable?

The RS prime minister raises the secession issue

In mid-September 2006 the High Representative for Bosnia and Hercegovina (BiH), Christian Schwarz-Schilling, said that he would sack Milorad Dodik, the prime minister of Republika Srpska (RS; one of BiH!s two entities) if the latter continued to insist on the right if the RS to hold a referendum on secession from BiH. Mr Dodik responded defiantly, arguing that any proposals for constitutional changes in BiH implied a right for the RS to decide its future for itself, �possibly in a referendum�. The issue of a referendum on secession for the RS has become hotter since Montenegro voted in May 2006 to separate from Serbia. If Montenegro has the right to self-determination, RS politicians have argued, then so too should the RS.

Not just electioneering

Mr Dodik is not a radical within the RS. His party, the Alliance of Independent Social Democrats (SNSD), had generally been regarded as moderate in comparison with the hardline Serb Democratic Party (SDS). However, Mr Dodik sought to position his party ahead of the BiH-wide elections on October 1st as the defender of RS interests in the face of international pressure. In June Mr Dodik�s government in effect brought a halt to efforts to integrate the police forces of the RS and the Muslim-Croat Federation, even though this is likely to delay the conclusion of a stabilisation and association agreement (SAA) between BiH and the EU. The RS government has also balked at the transfer of banking sector supervision to the Central Bank of Bosnia and Hercegovina (CBBH), in spite of IMF backing for this move. Mr Dodik�s insistence on the right of the RS to decide its own future"including the right to consider independence from BiH"is by far the most controversial element of his new, more assertive stance. Although Mr Dodik�s more strident approach may have been designed to outmanoeuvre the SDS in the election campaign, it may also be sincere. Montenegro has secured independence from Serbia, and Kosovo, with an overwhelming majority of

Regional relations add to internal tensions



ethnic Albanians, seems set to follow down a similar path. If Montenegro and Kosovo are to be allowed the right of self-determination, why should the RS be denied? The Serb majority�s disinclination for deeper integration with the Muslim-Croat Federation is plain. The RS leader has gone too far for this new development to be seen as mere electioneering, and he may find it difficult to back away from the position. At the very least, his secession threat looks like a device aimed at heading off the erosion or abolition of the RS. If Mr Dodik is serious, and his party stands behind him, Mr Schwarz-Schilling could face a difficult situation. Were the High Representative to dismiss Mr Dodik, even after the latter!s election win, and for expressing a point of view that is shared by both of the RS�s main Serb parties, he may struggle to find a credible successor with much support in the entity. Dismissing Mr Dodik, moreover, would raise a broader question over internationally backed plans to create a stronger central state in BiH: it is conceivable that the RS would bring to a halt all integration moves. In this context, the Western powers might be forced to reconsider their decision to close the Office of the High Representative (OHR) in mid-2007 and to rescind the OHR�s �Bonn Powers�"including the power to dismiss local officials"that the High Representative currently holds. This would be a setback for international efforts to bring Bosnia towards full sovereignty.

Dreams of independence

What of the RS�s aspirations to secede? Formally, independence for Montenegro offers little support for those who wish to see an independent RS. The international powers have made it clear that there should be no changes to the borders of the former Yugoslav republics, and although Montenegro was a Yugoslav republic in its own right, the RS is merely a construct of the Dayton peace agreement. Two developments complicate the picture, however. First, the international powers are preparing to revise the Dayton agreement in order to strengthen the BiH state. Although this runs counter to RS aspirations for sovereignty, the act offers some encouragement because it shows, contrary to an earlier international position, that the Dayton agreement is open to revision. Mr Dodik�s most recent comments on the secession issue allude to the right of the RS to decide on any changes in its status. Second, moves are afoot on the part of some Western states"in particular, the US and UK"to set Kosovo on the road to independence. A decision on Kosovo�s future status could be taken in a matter of months, although some delay is likely, since Serbia is expected to hold a parliamentary election in late 2006 or early 2007. The political imperatives behind the push for independence for Kosovo seem to have trumped the legal distinctions, for such a move would undermine the insistence that the boundaries of the former Yugoslav republics are inviolate.

Balkanisation revisited

On current trends, it looks likely that independence for Kosovo would strengthen the resolve of pro-secession elements in the RS. The problem for the Western powers is that this could trigger other demands for independence, including from more radical ethnic Albanians in Macedonia, and leave the Balkans further fractured and with one or more barely viable states. Seeking to head off these problems, Mr Schwarz-Schilling has drawn a distinction between the case of Kosovo"which he describes as a �historically long-standing region�"and the RS, which is not. This is a less compelling and much less clear-cut argument than the one on the inviolability of the borders of the Yugoslav republics, on which the international community has relied up to now. Mr Schwarz-Schilling�s more immediate problem is how to deal with Mr Dodik. If the RS prime minister does not moderate his line, the Western powers will face what may be their toughest challenge in BiH since the end of the war.

Over the summer it became clear that there would be no more progress on key reforms, including those that BiH must adopt in order to sign an EU stabilisation and association agreement (SAA), until after the October 1st elections. Despite pressure from the international authorities in BiH to return to the talks on police reform, RS representatives refused to participate in the sessions of the steering board of the Police Reform Directorate and attended only as observers (July 2006, The political scene). The directorate is charged with implementing the agreement on police reform that the BiH government adopted in October 2005.

Police reform stalls



The RS government is unhappy about both the details of the police reform proposal and the simple majority voting system of the directorate, since this ensures that Bosnian Serb members can be outvoted. Mr Dodik says that police reform will have to start afresh. He insists that the RS Ministry of the Interior be preserved and financed out of the entity budget, even if this jeopardises the chances of BiH signing an SAA.

The international authorities, however, have publicly ruled out the possibility of new negotiations. Mr Schwarz-Schilling called on Bosnian Serb members of the steering board to take part in the work of the directorate. The deadline for reaching agreement on the new organisation of the police force has been put back to November 30th. However, there are doubts as to whether this will be met, since the most sensitive issue"the boundaries of the policing regions"has yet to be discussed.

Progress on broadcasting legislation, another precondition for signing an SAA, suffered another setback after the Federation!s Constitutional Court ruled that the proposed entity law breached the vital national interest of Bosnian Croats. Bosnian Croat deputies in the Federation parliament criticised the proposed law for ignoring their demand to have a Croatian-language TV channel as part of the transformation of the public broadcasting network in BiH. Since the broadcasting reform requires entity laws to be aligned with those at state level, the failure to adopt a public broadcasting law in the Federation means that the EU!s condition has not been met.

International representatives expressed concern at the pre-election reform deadlock, which they said risked undoing some of the progress made to date in making BiH!s governing structures more functional. Mr Schwarz-Schilling criticised local parties for obstructive behaviour and the failure to pass relevant legislation to allow BiH to move toward signing an SAA. He said that the lack of progress could delay the international community�s plan to close down the Office of the High Representative (OHR), the leading international interlocutor in BiH, by July 2007. The Peace Implementation Council (PIC), which oversees the implementation of the Dayton agreement, will take a decision in February 2007 regarding the closure of the OHR.

In a resolution adopted at the end of June, the Council of Europe criticised the obstruction of key reforms and said that because the proposed constitutional reform was rejected earlier in 2006, the October 1st elections in BiH would be held in violation of the country!s Council of Europe commitments. The council urged the parties to resume talks promptly on constitutional reform, but there was little enthusiasm on their part as the election campaign gathered speed.

The pre-election period saw an increasing number of jurisdictional disputes between the RS and state-level governments. Although these arguments in part reflected the tension of the election campaign, they also raised questions about whether BiH!s local political institutions are capable of coherent policymaking.

In July 2006 Bosnian Serb MPs in the state-level parliament refused to support a draft law allowing for the establishment of two new state-level ministries: the

Broadcasting reform is on hold in the Federation

Reform delays cloud prospects for signing an SAA

The state and RS governments argue over competencies



Ministry of Agriculture, Food and Rural Development, and the Ministry of Science, Technology and Environment. The enlargement of the Council of Ministers will transfer more responsibilities from entity to state level, but Bosnian Serb MPs insisted that the two ministries should only have a co-ordinating role and that the entity ministries would remain in charge of the two portfolios. The establishment of a state-level agriculture ministry has been advocated by BiH!s farming lobby for some time as a means of improving the country�s agricultural policy. Having a state-level ministry is also one of the requirements for receiving EU structural funds, once BiH becomes eligible. The law was adopted without Bosnian Serb participation, but the RS president, Mr Cavic, said that no change in the law was possible before state-wide constitutional amendments are agreed.

Another dispute over competencies was sparked by the RS government!s decision in August to call a tender for the privatisation of Telekom Srpske (see Economic policy). The chairman of BiH!s Council of Ministers, Adnan Terzic, claimed that privatisation of public utilities was a state competency under an annex of the Dayton agreement and asked Mr Schwarz-Schilling for a legal opinion, but the RS government went ahead and called the tender. It is unclear whether this disagreement will have any influence on the sale.

A similar problem arose in relation to the RS government�s demand that it take over a project to build a segment of a pan-European highway passing through the RS. Road transport remains under entity jurisdiction because of delays in establishing a state-level road directorate, which would be in charge of motorway construction.

BiH�s aspirations to join NATO�s Partnership for Peace (PfP) programme remain on hold owing to the failure of the local authorities to co-operate in the arrest and transfer of Radovan Karadzic and Ratko Mladic, the two highest-profile indictees wanted by the International Criminal Tribunal for former Yugoslavia (ICTY) in The Hague. BiH�s defence reform, the key precondition for PfP membership, has proceeded successfully and the country has met technical and military requirements. The main obstacle is now the RS government!s lack of co-operation with the ICTY.

In August the State Intelligence and Protection Agency, in co-operation with NATO and EUFOR forces, arrested two Bosnian Serbs charged with being part of the network protecting Mr Karadzic and Mr Mladic. In September Nikola Krajsinik, one of the indictees! closest political allies, was sentenced to 27 years in prison by the ICTY for his involvement in the ethnic cleansing of the non-Serb population in what is now the RS.

Economic policy

International representatives in Bosnia and Hercegovina (BiH) have expressed concern at the decision by the BiH House of Representatives to amend the law on frozen foreign-currency savings so that deposit holders will be fully repaid within five years, rather than 13 years, as currently envisaged. Deposit holders have long been critical of the law, which regulates the procedure for repaying

The IMF and World Bank warn of fiscal instability

NATO integration is delayed



BiH citizens! pre-war foreign-currency deposits. They say that the repayment period is too long, and that the plan envisages only small cash payments.

However, the IMF, World Bank and the Office of the High Representative (OHR; the leading international interlocutor in BiH) are afraid that the House of Representatives! decision could undermine the internationally backed strategy for settling BiH!s large internal debt. The debt arising from frozen foreign-currency deposits is estimated at about KM2bn (US$1.28bn).

Peter Nicholl, the former governor of the Central Bank of Bosnia and Hercegovina (CBBH) who is now chairman of the governing board of BiH!s Indirect Taxation Authority (ITA), said that he was alarmed by the proposal. The amendment will entail a substantial increase in spending, and Mr Nicholl said that he doubted whether funding would be available in view of BiH!s current fiscal position. He said that, were the law were to be implemented, the rate of value-added tax (VAT) might have to rise by as much as 3 percentage points from the current level of 17%. However, the BiH House of Peoples, the other chamber of the state-level parliament, has yet to vote on the amendments.

Shortly before the October 1st elections the Federation government adopted a proposal to increase pension payments to war veterans, which, if implemented, would require a large increase in budgetary spending from 2007. The opposition parties criticised the adoption of the law as a pre-election stunt and claimed that the package was not financially sustainable. The Federation prime minister, Ahmet Hadzipasic, said that the law had been on the government�s agenda and that the timing of its adoption was a coincidence. Under the proposal, roughly one-third of social security transfers in the Federation budget would go to war veterans, but the government is adamant that an additional KM70m (US$45m) stipulated by the law could be secured in the light of improved revenue performance. Mr Hadzipasic has also said that strong revenue collection means there is no need to rebalance the Federation!s 2006 budget in view of costs related to the retirement of a larger than projected number of army personnel.

The ITA reported KM435m in indirect tax revenue in August 2006, the highest for any month so far this year. Consumption in BiH tends to peak in July and August, the height of the tourist season. Indirect tax revenue for January-August amounted to KM2.78bn, or 79.4% of the full-year projection of KM3.5bn. In August the ITA began issuing VAT refunds for January and February, and further refunds later in the year will slow the rate of net revenue growth. Nevertheless, the eight-month revenue figures reinforce earlier indications that the authorities will exceed the target for 2006 (July 2006, Economic policy).

Privatisation in BiH

Asset sales in the two entities have mixed results

In recent months the two entities making up Bosnia and Hercegovina (BiH) have had mixed fortunes in privatising state assets. The Federation government has reached agreement to sell an oil distributor, Energopetrol, but is moving more slowly in privatising its telecommunications sector. Republika Srpska (RS), in contrast, is further

The Federation government adopts a war veterans' law

Indirect tax revenue surges in the third quarter



ahead in disposing of its telecoms operator, Telekom Srpske, but is struggling to sell three oil companies.

The Federation government sells Energopetrol

The long and complicated process of selling Energopetrol ended in September 2006 when Hungarian-Croatian consortium MOL-INA and the Federation government signed an agreement on the sale of a 67% government stake. The government will keep a 22% stake, with the remaining 11% staying with small shareholders. The Federation prime minister, Ahmet Hadzipasic, decided to handle the final negoti-ations himself, in this way sidelining the minister of energy, mining and industry, Vahid Heco, who insisted that the ownership of petrol stations be transferred from Energopetrol to the government before the deal was signed. This would have led to further delays and complications, in Mr Hadzipasic!s view. The MOL-INA consortium will invest KM150m (US$96m) in Energopetrol and will provide an additional KM60m to pay off the company�s debts. The House of Representatives (the lower house in the Federation parliament) had rejected a similar deal in January 2006, for fear that state-controlled INA might seek to exert political influence in BiH through its participation in Energopetrol. However, this decision was not binding on the Federation government, which continued to negotiate with MOL-INA (April 2006, Economic policy).

Telecoms privatisation commences

In August the RS government called a tender for the sale of a 65% stake in Telekom Srpske, the second-largest telecoms company in BiH, with about 345,000 fixed-line and 572,000 mobile users. The government has set a minimum price of KM400m. Bidders must have at least 800,000 fixed-line customers, 1.5m mobile phone users, and 2005 revenue of #500m (US$630m). By early September, 11 foreign companies had expressed an interest in acquiring the stake. They include Telekom Austria, Telenor (Norway), France Télécom, Magyar Telekom (Hungary) and Telekom Srbije (Serbia). The RS government has decided to extend the bid deadline from October 4th to November 4th. The Federation government is worried that the privatisation of Telekom Srpske could undermine prospects for selling its own telecom operators, BiH Telecom and HT Mostar. In early August the government presented parliament with two alternative plans for the sale of the operators, but parliament decided to block the sales on the grounds that the proposal was rushed and ill-prepared.

The sale of RS oil companies falls through

Shortly after announcing the decision to sell its telecoms operator, the RS govern-ment made fresh efforts to sell the Bosanski Brod and Modrica oil refineries, together with Petrol Banja Luka, a fuel retailer (July 2006, Economic policy). The government has offered its stakes in the three companies to Zarubezhneft (Russia), which is reportedly willing to invest #300m to rehabilitate the Bosanski Brod refinery and a further #34m in the Modrica refinery, as well as to rebuild stations owned by Petrol Banja Luka. Zarubezhneft also said it was interested in building a railway line between Modrica and Bosanski Brod. However, the Russian firm withdrew from negotiations in mid-August after the RS government failed to resolve the issue of some #190m that the Bosanski Brod refinery owes to Vitol, its London-based former partner.



The problematic contract between Bosanski Brod and Vitol is a hot political issue in the RS. A former RS finance minister, Svetlana Cenic, says that the deal has been detrimental to the Bosanski Brod refinery, which has the capacity to meet around 80% of BiH!s fuel needs, but has been hampered by irregular supplies of crude oil. The problems experienced with Vitol prompted the RS government to look for a strategic partner such as Zarubezhneft, which has its own oil reserves. As of mid-October the RS authorities were trying to resolve the debt issue in order to conclude a deal with the Russian company.

In July 2006 the Federation House of Peoples (the entity!s upper house) adopted amendments to its law on privatisation in an attempt to facilitate the sale of remaining state-owned companies, especially large conglomerates. The Federation!s minister of energy, mining and industry, Vahid Heco, has said that recent tenders for companies such as the furniture manufacturer, Krivaja Zavidovici, and a leather producer, KTK Visoko, were unsuccessful because the authorities were unable to sell their core businesses separately. The amended law therefore allows the Federation to privatise a company!s core business without including other assets such as catering, transport facilities and holiday resorts. The exception is the energy sector, where such restructuring will not be allowed as part of a privatisation procedure, and the Federation has yet to propose separate legislation for the sale of the energy sector.

The amended law also permits the sale of state-owned capital through the stock exchange. Unlike in Republika Srpska (RS), where around 500 blocks of state-owned shares have been sold through the exchange, the Federation has so far relied exclusively on tenders for selling state shares in large companies. The first company to go on sale following the passage of the legislation was a logistics firm, InterSped Sarajevo, and in mid-September the government decided to offer 12% of the company�s capital on the stock exchange.

In addition, the law gives the Federation government a greater role in privatisation. The government will play a part in determining a company!s ownership structure in cases in which this is not clear, and will have to seek approval from parliament. The Federation government has also initiated parliamentary discussion on a law aimed at ensuring that privatisation contracts are implemented. Shareholders owning at least 5% of a company will be entitled to request monitoring of the sale contract by a special department in the Federation Privatisation Agency.

In July the RS authorities announced a review of all bank privatisations in the entity as part of a general examination of state asset sales initiated earlier in 2006 by the RS prime minister, Milorad Dodik. The RS auditor general, Bosko Ceko, said that he had received 98 requests to review privatisations of banks and enterprises, and the sales of some 670 enterprises and seven banks are likely to be reviewed (July 2006, Economic policy). Mr Dodik had said that the review process would focus on the few cases in which genuine fraud is likely to have taken place, but the latest figures suggest that the review may be broader than previously anticipated.

The RS has amended its privatisation law to enable the sales of companies through direct negotiations with potential buyers in an attempt to speed up the

The RS reviews sales

The Federation amends its privatisation law



process. The recently adopted law on debt restructuring in strategic enterprises, which allows for the write-off of some interest payments and rescheduling of the principal repayment, is also aimed at facilitating sales.

The final round of talks concerning BiH!s membership in the Central European Free-Trade Agreement (CEFTA) is scheduled to take place later in October, after the main text of BiH!s accession agreement was discussed in September. The expansion of CEFTA into south-eastern Europe is intended to replace the patchwork of 31 bilateral free-trade agreements that the countries in the region signed in recent years under the auspices of the EU!s Stability Pact for South Eastern Europe. The most sensitive issue for BiH is trade in agricultural products, since, unlike other CEFTA members, the country has no system of agricultural subsidies. In June 2006 the BiH Council of Ministers (the state-level cabinet) decided to introduce 40% customs duties on a number of dairy and meat products from Serbia, following protests from local farmers (July 2006, Economic policy). BiH!s priority is to renegotiate trade arrangements with Serbia and Croatia before finalising the CEFTA accession treaty.

The domestic economy

Output and demand

Industrial output growth in Bosnia and Hercegovina (BiH) decelerated in the third quarter of 2006, especially in the Federation, suggesting that for the year as a whole industry is unlikely to match the expansion rate of 10% recorded in 2005. In January-August industrial output rose by 10.7% year on year in Republika Srpska (RS) and by 6.9% in the Federation.

The main reason behind the better industrial performance in the RS was a surge in mining, which was up by 27.6% year on year in January-August, propelled by a sharp rise in coal output. The RS coal industry has benefited from the reconstruction of some of the entity!s largest mines, such as Gacko and Ugljevik, as well as strong demand from both BiH!s reviving metallurgical sector and overseas markets. In contrast, Federation mining output rose by a modest 4.9% in this period, the strongest expansion coming from the mining of metal ore.

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

% of total in 2003 2005 Jan-Aug 2006Energy 34.4 4.4 -17.7

Intermediate goods 30.8 17.0 32.8Capital goods 9.1 59.3 19.6

Consumer durables 3.4 58.2 37.4Consumer non-durables 22.3 28.6 8.4

Total 100.0 19.8 10.7

Source: Republika Srpska Institute for Statistics, Industry statistics.

Negotiations on CEFTA membership near completion

Industrial output growth decelerates in the third quarter

The mining sector boosts industrial growth in the RS



Electricity and gas was the second-strongest industry in the RS, with output rising by 13.9% year on year in the first eight months, and was the fastest-growing sector in the Federation, rising by 9.6%. This reflected the combined influence of output and price increases. Manufacturing performance was much stronger in the RS (up by 9.2%) than in the Federation (up by 6.3%). Base metals (up by 48.8%), wood-processing (up by 144.6%), furniture (up by 39.2%) and textiles (up by 26.3%) all grew rapidly in the RS, and the fastest growth in the Federation was in base metals, non-metallic mineral products and chemicals.

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

% of total in 2002 2005 Jan-Aug 2006Energy 39.9 -1.1 9.7

Intermediate goods 25.0 16.6 13.5Capital goods 2.5 6.3 8.0Consumer durables 2.9 14.5 10.1

Consumer non-durables 24.5 6.5 -1.4Other 5.2 -7.1 -8.8

Total 100.0 6.1 6.9

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

By product type, intermediate goods grew most rapidly in the Federation in January-August, rising by 13.5% year on year, compared with an 8% increase in capital goods production and a 10.1% rise in consumer durables. In the RS consumer durables production, which went up by a striking 37.4% year on year, outpaced intermediary goods (up by 32.8%) and capital goods (up by 19.6%).

The strong recovery in construction output across BiH in the second quarter of 2006 continued over the mid-year. In January-July the value of construction output surged by 18.7% year on year in the Federation and by 11.9% in the RS. At the same time, the number of workers on construction sites and the number of hours contracted declined in both entities, suggesting an improvement in productivity. Construction growth in the Federation came from housing and commercial buildings, although the RS authorities do not publish a comparative breakdown. In view of both entities! ambitious programmes of infrastructure investment, civil engineering, and road construction in particular, is likely to overtake housing and commercial buildings as the main source of growth.

Employment, wages and prices

In July 2006 the Agency for Statistics of Bosnia and Hercegovina published a labour force survey. Since it takes some account of the large grey economy in the country, the survey provides the most reliable unemployment data so far. The survey puts the rate of unemployment in Bosnia and Hercegovina (BiH) at about 30%, which is still high by regional standards, although it is below the figure of 40-42% reported by employment offices. According to the survey, a total of 811,000 people were in paid employment as of April 2006, compared with 366,000 without work. The bulk of those in paid employment (48.7% of the total) work in services, followed by industry (30.7%) and agriculture (20.6%). The main problems highlighted by the survey were a low participation rate (of

Construction is buoyant

New labour force data show lower rate of unemployment



42.9%), long-term unemployment, youth unemployment and skills shortages. The agency also reported that the number of registered unemployed in July was up by just under 1% year on year to 516,000, some 150,000 more than the jobless figure in the labour force survey.

By the end of August there were signs that wage growth was subsiding, following strong growth in the early months of 2006. In January-August the average net monthly wage in BiH amounted to KM574 (US$367), an increase of 6.7% year on year, compared with a year-on-year rise of over 8% in the first quarter. During the first eight months wages grew more quickly in the RS (by 8.1%) than in the Federation (where they went up by 6.2%). Although wages in the Brcko District contracted by 0.5% in January-August, the district!s average net wage of KM668 was the highest in the country. Stronger wage growth in the RS has narrowed the gap with the Federation, where wages are now only 18% higher than in the RS.

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Source: Entity statistical agencies.

Since the end of 2005 retail price inflation in BiH has been accelerating under the influence of several factors: the rise in global oil prices, increases in excise duties on tobacco and alcohol, and the introduction of value-added tax (VAT) in January 2006. The IMF, which uses a different methodology for calculating inflation than the statistics agency, suggested that the inflationary effect of VAT should peter out by mid-2006. Whether this has happened is difficult to tell from the eight-month inflation data, since retail price inflation remained high in the third quarter. In January-August prices were up by 9.5% year on year in the RS and by 7% in the Federation, compared with 9.2% and 6.9%, respectively, in January-June. In the RS, prices of manufactured goods grew more strongly than the overall price index in January-August, propelled by a 13% surge in the prices of foodstuffs. The fastest-growing category was tobacco, where prices went up by 18.1% year on year. Prices of services also rose sharply, up by 9.2% in annual terms. Retail price growth in the Federation was fuelled by an 8.1% rise in the cost of agricultural goods. Prices of manufactured goods went up by 6.5% and prices of services rose by 8.6% year on year.

Wage growth subsides

Price pressures rise in the third quarter



BiH: retail prices (% change)

2005 2006 Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul AugFederation Month on month -0.1 0.6 0.5 0.9 0.1 3.9 0.2 0.1 -0.1 1.5 0.4 -0.6 -0.4Year on year 3.3 3.8 3.6 4.3 4.4 6.7 6.2 6.0 6.5 7.8 8.2 7.5 7.1Republika Srpska Month on month -0.2 1.7 1.8 1.2 0.2 5.1 -0.7 0.1 -0.8 0.8 0.0 -0.5 0.0Year on year 2.3 3.9 3.9 4.3 4.1 9.5 8.5 8.5 8.8 9.8 10.1 9.7 9.8

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

Financial indicators

The mild slowdown in commercial bank credit growth in Bosnia and Hercegovina (BiH) continued in the third quarter of 2006. At the end of August the stock of commercial bank loans stood at KM8.5bn (US$5.43bn), an increase of 24.3% year on year. This represents a slight slowdown compared with 2005, when bank loans grew by about 27% in annual terms. Lending to households continues to outpace lending to private enterprise, with loans in these two categories rising by 29.7% and 25.3%, respectively, in August 2006, compared with the same month in the previous year. Commercial credit has risen strongly, owing to the relatively stable macroeconomic environment, rising incomes, falling interest rates, and the entry of several large foreign banks into BiH.

The Central Bank of Bosnia and Hercegovina (CBBH) is particularly keen to control growth in household lending using the limited monetary instruments at its disposal under BiH!s currency board rules. The CBBH last took a significant step in 2005, when it raised the banks� reserve ratio from 10% to 15%. An encouraging sign in 2006 has been the marked improvement in deposit growth, which has outpaced commercial credit growth; deposits rose by 28.9% year on year in August.

BiH: commercial bank lending, Aug (KM m, end period)

2005 2006 % changeClaims on governmenta 45.6 62.9 38.1 State government 0.0 0.0 - Entity governments 19.3 17.0 -12.1

Claims on public enterprises 665.6 636.5 -4.4Claims on private enterprises 2,960.8 3,709.2 25.3

Claims on households 3,139.4 4,071.0 29.7Otherb 73.8 84.9 15.0Total c 6,904.6 8,581.7 24.3

a Includes municipal governments, social security funds. b Includes non-bank financial institutions, non-profit organisations. c As in source.

Source: Central Bank of Bosnia and Hercegovina.

Interest rates in BiH have remained relatively low and stable by recent historical standards. Long-term corporate lending rates averaged 7.8% in August, an

Credit growth decelerates

Borrowing costs fall



increase of 0.1% compared to the average 2005 rate, and average short-term lending rates for corporates dropped from 9% in 2005 to 8.2% in August. Lending rates to households averaged 9%, slightly lower than in 2005. Stable or lower interest rates, coupled with rising inflation, mean that real borrowing costs have fallen substantially in 2006.

Foreign trade and payments

The merchandise trade deficit of Bosnia and Hercegovina (BiH) amounted to KM3.7bn (US$2.37bn) in January-August, which represents a 13.4% decrease on the deficit in the year-earlier period. Goods exports amounted to KM3.3bn in the first eight months, an increase of 38.7% in annual terms. Imports of goods in the same period rose by just 5.1% year on year to KM7bn, narrowing the trade deficit substantially.

Although export performance continues to improve, this partly reflects the change in methodology for recording outward-processing, which now includes the value of both raw materials and services. This has increased the value of exports in those industries in which there is a large share of outward-processing, such as textiles (almost 95% of which is outward-processing), shoes, metal furniture and some base metals. The export boom, as well as the modest growth in imports in 2006, also reflect base-period effects related to the introduction of value-added tax (VAT) in BiH at the start of this year.

Manufacturing exports increased sharply in January-August, growing by 37.7% year on year. The strongest growth was in sales of furniture and electricity, the latter in part as a result of an increase in prices. Furniture was BiH!s third-largest earner of export receipts in the first eight months, trailing only base metals and motor vehicles. Sales growth was strong in BiH!s most important export industries, driving the overall trend. Exports of base metals grew by 51% year on year, followed by chemicals (up by 43.3%), non-metallic minerals (up 40%), motor vehicles (up by 20.2%), and wood and wood-processing (up 16.9%).

Imports of electricity, crude oil, coke and refined petroleum products surged in January-August, boosted by the combined effect of high international commodity prices and strong economic activity in BiH. These goods accounted for 14.7% of the total value of imports in the first eight months of 2006. Imports of food and beverages remained BiH!s leading import item and rose more slowly than exports in this category. However, the country!s trade deficit in food and beverages is second in size only to the deficit on crude oil, coke and refined petroleum.

The EU remained BiH!s main export market in January-August, accounting for 57.8% of total exports in the first eight months. Exports to the EU rose by 48.6% year on year, with sales to Slovenia growing particularly strongly (by 73.6%), followed by Germany (62.7%) and Italy (46.1%). The sharp rise in exports to Slovenia reflects the entry of a Slovenian-owned company, Prevent, which operates in the Visoko free-processing zone, into the records of the Indirect Taxation Authority (ITA). The change in methodology for outward-processing

Manufacturing narrows the trade deficit

Furniture and electricity drive export growth

Exports to the EU rise strongly

Energy imports surge



has helped to raise the share of BiH!s exports going to the EU, since a significant proportion of contracts that BiH companies have in EU markets are linked to this activity.

Imports from the EU grew much more slowly in January-August, by 5.1% year on year, in line with BiH overall modest import growth. Imports from Germany, which is BiH!s second-largest supplier in absolute terms, fell by 6.3%. The fastest growth in the first eight months was in imports from other countries, which doubled year on year because of increased purchases of oil and refined petroleum from Bulgaria and Romania. BiH has a highly concentrated import structure, with purchases from Croatia, Slovenia, Serbia, Germany and Italy accounting for 55% of the total.

Trade with BiH!s main partners in the western Balkans grew more slowly than trade with the EU. Export sales to Croatia rose by 21.6% year on year in January-August, and exports to Serbia rose by 12.2%.

The Central Bank of Bosnia and Hercegovina (CBBH) has reported that BiH ran a current-account deficit of KM828m (US$529m) in the first half of 2006, a reduction of 38.4% compared with the deficit reported in the year-earlier period. The improvement in the external balance in January-June was driven primarily by the reduction in the trade deficit, as well as a year-on-year increase of almost 20% in the services surplus, to KM500m. The services balance was underpinned by receipts from construction work abroad, tourism and communications. The improved picture in trade and services was partly offset by a decrease in the surpluses on income and current transfers.

Balance of payments (KM m)

2005 2006 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year 1 Qtr 2 QtrMerchandise exportsa 838 1,061 1,051 1,132 4,082 1,106 1,368Merchandise importsa -2,239 -3,041 -3,118 -3,518 -11,917 -2,195 -3,043Trade balance -1,401 -1,979 -2,067 -2,386 -7,834 -1,089 -1,676Net services 185 235 205 247 871 209 290Net income 181 156 149 149 634 116 135Net transfers 590 692 804 820 2,906 547 638Current-account balance -446 -897 -909 -1,171 -3,424 -216 -612Capital account 147 172 194 205 718 127 142Financial account 293 484 405 847 2,029 52 342 Net direct investment 158 226 163 275 821 170 182 Other investment 112 417 591 826 1,947 127 360Reserve assets 23 -158 -349 -254 -738 -245 -200Net errors and omissions 6 240 310 119 676 37 128

a Including coverage and valuation adjustments by central bank.


Net foreign direct investment (FDI) inflows totalled KM352m in the first half of 2006, according to the CBBH, a drop of 8.3% compared with the year-earlier period. Privatisation remains one of the most important channels for inward FDI in BiH, and several large privatisation deals, including the sale of the oil distributor, Energopetrol, and the telecommunications operator, Telekom Srpske,

The current-account deficit falls by 38% in the first half

FDI falls slightly



will significantly boost FDI inflows in 2006. Nevertheless, there is also evidence of growing interest in foreign greenfield investments. In addition, BiH!s Foreign Investment Promotion Agency (FIPA) will soon submit a new, more specific action plan following criticism that it has not been sufficiently active in promoting foreign investment, given the modest capacity in this area of BiH�s diplomatic network abroad.

At the end of August the CBBH reported record foreign reserves of KM4.9bn, an increase of 22.5% compared with the end of 2005. This represents the equivalent of over five months of goods and services imports. The growth in net free reserves over the same period was much more modest, at 6.8%. This reflected a strong increase in monetary liabilities, in line with continued credit growth in BiH.

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(a) Net foreign-exchange reserves, less monetary liabilities.


Foreign reserves increase

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