Report No. 104327-ECA South East Europe Regular Economic Report No.9 Rebalancing for Stronger Growth Spring 2016   Acknowledgments This Regular Economic Report (RER) covers economic developments, prospects, and economic policies in six South Eastern European countries (SEE6): Albania, Bosnia and Herzegovina, Kosovo, FYR Macedonia, Montenegro, and Serbia. The report is produced twice a year by World Bank staff economists working on the SEE6 countries. The team of authors comprises Gallina A. Vincelette (task team leader and lead author), Ekaterina Vostroknutova (task team leader and lead author), Ashley Taylor (lead author), Barbara Cunha, Agim Demukaj, Faya Hayati, Sandra Hlivnjak, Sanja Madžarević-Šujster, Suzana Petrović, Lazar Šestović, Hilda Shijaku, and Bojan Shimbov. Additional contributions were made by: Maria Davalos, Trang Van Nguyen, Cesar A. Cancho, Alexandru Cojocaru, William Hutchins Seitz, and Monica Robayo (regional poverty trends); Johanna Jaeger (financial sector); Raymond Muhula and Tony Verheijen (public wages). Anne Grant provided assistance in editing, and Budy Wirasmo in designing this report. Valentina Martinovic, Pegi Ylli, Helena Nejedla, Nejme Kotere, Samra Bajramovic, Ivana Bojic, Enkelejda Karaj, Hermina Vukovic Tasic, Jasminka Sopova, Boba Vukoslavovic, and Dragana Varezić assisted the team with logistics. Dissemination of the report and external and media relations are managed by an External Communications team of Lundrim Aliu, Anita Božinovska, Paul A. Clare, Ana Gjokutaj, Jasmina Hadžić, Elena Karaban, Artem Kolesnikov, Andrew Kircher, Vesna Kostić, John Mackedon, Mirjana Popović, Sanja Tanić and Artem Kolesnikov. The team is grateful to Ellen Goldstein (Country Director, South East Europe), Satu Kähkönen (Director, Macroeconomics and Fiscal Management Global Practice), Ivailo Izvorski (Practice Manager, Macroeconomics and Fiscal Management Global Practice) and the South Eastern Europe Country Management team for their guidance in preparation of this report. The team is also thankful for comments on earlier drafts of this report received from SEE6 Central Banks and Ministries of Finance. This and previous SEE RERs may be found at: www.worldbank.org/eca/seerer. Standard Disclaimer: This volume is a product of the staff of the International Bank for Reconstruction and Development/ The World Bank. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data presented in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Copyright Statement: The material in this publication is copyrighted. Copying or transmitting portions or all of this work without permission may be a violation of the law. The International Bank for Reconstruction and Development/The World Bank encourages dissemination of its work and will normally grant permission promptly to reproduce portions of the work. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978- 750-4470, http://www.copyright.com/. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522-2422, e-mail pubrights@worldbank.org. SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Contents 1. Overview 1 2. A Strengthening Economic Recovery 7 Growth Gains Momentum as Investment Revives 9 Higher Employment and Lower Inflation Helped Reduce Poverty 11 The External Environment Supported Exports 13 Higher External Volatility Affected Financing Availability 17 3. Supportive Policy Reforms Are Ongoing 19 Fiscal Adjustment Advancing 21 Public Debt Edging Up 28 Accommodative Monetary Policy  29 Some Concerns about Quality of Bank Assets 31 4. Sustaining the Rebalancing of Future Growth 35 Positive Near-Term Outlook with Downside Risks 37 Rebalancing the Drivers of Growth and Addressing Twin Deficits 38 Improving Productivity is Paramount for Boosting Potential Growth  41 5. SEE6 Country Notes 45 Albania47 Bosnia and Herzegovina 53 Kosovo59 FYR Macedonia 64 Montenegro70 Serbia76 6. SEE6: Key Economic Indicators 83 vi  | Contents REBALANCING FOR STRONGER GROWTH List of Figures Figure 2.1: SEE6: From stagnation to growth  9 Figure 2.2: Revival of investment was seen in 2015 in most countries 10 Figure 2.3: Previously, consumption was the dominant driver of growth in most countries 10 Figure 2.4: Private investment demand led growth in Serbia, Albania and Kosovo 10  rowth in 2015 created jobs, but employment is still below pre-crisis Figure 2.5: G levels in most countries 12 Figure 2.6: Unemployment remained high, despite the rebound of economic growth 12 Figure 2.7: CPI inflation remained subdued 13 Figure 2.8: SEE6’s share in the EU market doubled between 2005 and 2014 14 Figure 2.9: Serbia led the expansion of SEE6’s exports to the EU 14 Figure 2.10: Current account deficits mostly narrowed 16 Figure 2.11: Mixed performance on export sophistication 16 Figure 2.12: FDI inflows increased to SEE6 while other capital inflows declined 18 Figure 3.1: Fiscal deficits narrowed 21 Figure 3.2: Spending restraint contributed to large fiscal adjustments in Albania and Serbia 21 Figure 3.3: The burden of public wages and social spending remained high 24 Figure 3.4: The efficiency of public investment management needs improvement 24 Figure 3.5: SEE6 PPG debt has grown fast since 2007 28 Figure 3.6: Steady upward trend of SEE6 PPG debt threatens debt sustainability 28  e share of dollar-denominated external PPG debt is below most Europe Figure 3.7: Th and Central Asia countries 29 Valuation effects of public debt due to dollar appreciation in 2015 were Figure 3.8:  comparable to fiscal deficits in some countries 29 Figure 3.9: SEE6 currencies mostly followed the euro, with some recent divergence 30 Figure 3.10: Official policy rates are at historical lows 30 Figure 3.11: Tentative recovery of private credit growth 31 Figure 3.12: Mobilization of domestic deposits is increasing 32 Figure 3.13: After declining, credit risk moved up 32 Figure 3.14: Banks are well-provisioned 33 Figure 3.15: NPL ratios are improving, but remain far above pre-crisis levels 33 Figure 4.1: Current account imbalances narrowed somewhat in 2015, but remain high 39 Figure 4.2: Economic structures are rebalancing from domestic to external demand 39 Figure 4.3: Labor costs starting to move more in line with labor productivity 39 Figure 4.4: External debt ratios have risen 39 Weak growth, growing interest costs and high deficits put pressure on Figure 4.5:  public debt sustainability 40 Figure 4.6: Twin deficits restrict policy options in the face of deteriorating external conditions 40 Figure 4.7: Productivity subtracted from growth post-crisis in most countries 42 Figure 4.8: Total factor productivity levels have at best stagnated since 2008 42 Contents  |  vii SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 List of Figures (continued) Albania47 Figure 1. Real GDP, Annual Growth Rates and Economic Sentiment Indicator, 2012–15 47 Figure 2. Fiscal Balance and Public Debt, 2010–17 49 Figure 3. Unemployment and Employment, 2012–15 50 Figure 4. Current Account Balance, FDI and Other Investments, 2013–15 50 Figure 5. GVA Growth by Sector, 2013–15 50 Figure 6. General Government Revenues, Expenditures, and Deficit, 2009–17 50 Figure 7. Confidence Survey Indicators, 2010–15 51 Figure 8. General Government Debt, 2010–15 51 Figure 9. Monetary Aggregates, Annual Growth and NPLs, 2009–15 51 Figure 10. CPI Inflation, 2010–15 51 Bosnia and Herzegovina 53 Figure 1. Real GDP Growth, 2012–15 53 Figure 2. Growth in Industrial Production and Retail Trade 56 Figure 3. GDP Growth on the Production Side, 2012–15 56 Figure 4. Consumer Price Inflation 57 Figure 5. Real Indirect Tax Revenues 57 Figure 6. General Government Fiscal Balance 57 Figure 7. Growth in Exports and Imports, and the Goods Trade Balance 57 Figure 8. Real and Nominal Effective Exchange Rates 57 Figure 9. Banking Sector Performance Indicators 57 Kosovo59 Figure 1. Real GDP Annual Growth Rates, Kosovo, 2008–15 60 Figure 2. Growth in Aggregate Demand, 2012–15 62 Figure 3. Growth in the Economy by Sector, 2010–14 62 Figure 4. Current Account Balance and FDI, 2011–15 62 Figure 5. General Government Deficit, by Quarter, 2013–15 62 Figure 6. Annual Growth in Loans, 2012–15 62 Figure 7. General Government Debt, 2008–15 62 Figure 8. Nonperforming Loans, 2008–15 62 Figure 9. CPI and PPI, 2011–14 62 viii  | Contents REBALANCING FOR STRONGER GROWTH List of Figures (continued) FYR Macedonia 64 Figure 1. GDP Growth by Sector 65 Figure 2. Business Tendencies in Manufacturing 67 Figure 3. Labor Market Developments, 2004–15 67 Figure 4. The Main Components of the CPI, 2012–15 67 Figure 5. Current Account Balance, Trade Deficit and Private Transfers, 2006–15 67 Figure 6. Central Government Budget Execution, 2006–15 67 Figure 7. Public Debt by Government Level, 2006–15 67 Figure 8. Credit Growth and Contribution to Credit Growth, 2012–15 68 Figure 9. Nonperforming Loans, 1/2012–12/2015 68 Montenegro70 Figure 1. Real GDP Growth, 2011–15 70 Figure 2. Fiscal Balance and Public Debt, 2008–15 72 Figure 3. High Frequency Data, Trend-Cycle Adjusted Series, 2009–15 73 Figure 4. Current Account Balance 73 Figure 5. Labor Market, Administrative Data 74 Figure 6. General Government Deficit 74 Figure 7. Labor Market, Survey-based Data, 2012–15 74 Figure 8. General Government Debt, 2007–18 74 Figure 9. Loans: Annual Growth Rates, 2010–15 74 Figure 10. CPI and PPI, Annual Growth Rates, 2009–15 74 Serbia76 Figure 1. Real GDP Growth, 2011–15 77 Figure 2. Net Reduction of General Government Spending by Category, 2014–15 77 Figure 3. Strong growth of industrial output helped Serbia’s economy exit recession… 79 Figure 4. …with the recovery reflected in labor market conditions 79 Figure 5. Inflation remains low, despite the continued easing of the key monetary policy rate 79 Figure 6. Exports were growing throughout 2015, but imports started picking up as well 79 Figure 7. The fiscal deficit declined significantly in 2015… 80  although general government debt-to-GDP moved up notably, in part Figure 8. … due to currency movements 80 Contents  |  ix SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 List of Tables Table 1.1: Growth to pick up through 2017 3 Table 1.2: Fiscal deficits are projected to narrow but debt ratios will remain high 4 Table 4.1: Growth trend to continue through 2017 37 SEE6: Key Economic Indicators 85 List of Boxes Box 2.1: The Automotive Industry: Stimulating Growth and Exports 14 Box 3.1: Serbia’s Reform of the Public Wage System  22 Box 3.2: Strengthening the Management of Public Investment  25 Box 3.3. Albania: Arrears Clearance and Commitment Controls  27 Box 3.4: 2025 Western Balkans Financial Systems Structure: Scenarios 33 Figure B3.4.1: 2025 Financial Landscape Scenarios 34 x  | Contents 1. Overview REBALANCING FOR STRONGER GROWTH Growth in the six South East European Across the region, wages in manufacturing have countries (SEE6) rebounded to 2.1 percent also started moving in line with productivity, in 2015, as investment revived  (Table 1.1). a process that is vital for sustaining growth In Serbia, Kosovo, Montenegro, and Albania, though exports. A continued shift in the investment, both domestic and foreign, was sources of growth from the unsustainable pre- the main source of growth. The investment crisis model of consumption fueled by capital growth push built on a sustained positive inflows to private investments and exports is contribution from net exports. The external needed to ensure that the economic expansion environment and previous structural reforms is sustained. gave support especially to manufactured exports. The traditionally high contribution While higher growth in 2015 brought new from consumption took a back seat in 2015. jobs in the private sector, and helped poverty reduction to resume, unemployment is still Table 1.1: Growth to pick up through 2017 entrenched. In 2015, as growth rebounded Real GDP growth, in percent 2014 2015e 2016f 2017f across the region, job creation picked up in the Albania 2.0 2.6 3.2 3.5 private sector. Generation of more jobs and lower inflation have supported real income Bosnia and Herzegovina 1.1 2.8 2.6 3.1 dynamics, allowing poverty reduction to resume. Kosovo 1.2 3.6 3.6 4.0 In Albania, FYR Macedonia, Montenegro, Macedonia, FYR 3.5 3.7 3.7 4.0 and Serbia, the average estimated poverty rate Montenegro 1.8 3.4 3.7 3.1 declined by 2 percent between 2013 and 2015. Serbia -1.8 0.8 1.8 2.3 That means that some 140,000 people in those SEE6 0.3 2.1 2.6 3.0 four countries (or 1 percent of their combined Sources: Data from central banks and national statistical offices, World Bank staff projections. population) have escaped poverty, measured against the regional standardized benchmark of US$5 a day (in 2005 PPP). Despite an The SEE6 region is not only growing but expanding economy and employment that is also rebalancing to more durable sources finally responsive to economic growth, however, of growth. Like many other countries, the on average unemployment in the region is still tightening in external financing conditions 21.5 percent. during the global financial crisis led to a significant economic adjustment in the In 2015, fiscal deficits continued to narrow SEE6. Current account deficits declined in all SEE6 countries except Montenegro. substantially, from 18.5 percent of GDP in Expenditure consolidation was most effective 2007 to 6.5 percent in 2015, contributing to a in Albania and Serbia, but revenue gains were rebalancing of the sources of growth. Between supportive across the region. Fiscal 2007 and 2015 the share of consumption in consolidation efforts in the region are focused GDP in the region fell by 6 percentage points, on reforming entitlement programs, reducing while the share of exports rose by 10 percentage the public sector footprint, and improving points. Further rebalancing was seen in 2015 public sector performance. The fiscal challenges in Serbia, Albania, and Kosovo where growth are significant: sizable public wage bills that was increasingly driven by private investment. exceed 12 percent of GDP in Bosnia and 1. Overview  |  3 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Herzegovina and Montenegro; substantial and selective national bank interventions, helped poorly targeted social spending that averages keep currencies relatively stable against the over 13 percent of GDP; and inefficient public euro. investment that funds projects with low economic and social returns. For a sustained The near-term baseline outlook for the impact on deficits, shifting the composition of region is positive. Growth is forecast to rise public spending to more productive and from 2.1 percent in 2015 to 3 percent in 2017 equitable areas and mobilizing more revenue as domestic demand recovers. In the SEE, the are both important. Despite progress on cutting revival of investment is expected to continue, public spending and bringing in more revenue, and the economies are expected to benefit from public debt-to-GDP continued to increase in the support of consumption and exports. Over 2015 (Table 1.2). the medium term the dividends of continuing structural reforms in many SEE countries With inflation at historic lows, should also support growth. accommodative monetary policy supported growth, and credit to the economy slowly Downside risks threaten the recovery. The began to grow. Lending rates fell in all countries potential for higher external volatility in global and lending to households picked up. However, financial markets threatens financing options, NPLs averaging 14.7 percent of total loans still especially for countries with poor policy burden bank balance sheets and, combined environments and more significant imbalances. with concerns about collecting on collateral, Growth in major export markets, especially dampen credit growth. Restrictive fiscal policy the EU, and movements in global oil prices and reduced external imbalances, along with also pose risks to the outlook, both upside Table 1.2: Fiscal deficits are projected to narrow but debt ratios will remain high Percent of GDP unless otherwise stated 2014 2015e 2016f 2017f Real GDP growth (percent) 0.3 2.1 2.6 3.0 Consumer price inflation (percent, period average) 0.9 0.9 1.6 2.0 Public revenues 34.7 35.0 35.3 34.7 Public expenditures 38.8 38.8 38.5 37.5 Fiscal balance -4.1 -3.8 -3.2 -2.8 Public and publicly guaranteed debt 52.1 55.1 56.9 57.4 Goods exports 24.3 25.2 25.6 26.7 Trade balance -17.0 -15.8 -15.2 -16.1 Current account balance -7.2 -6.3 -6.6 -6.8 External debt 64.6 67.3 68.0 67.7 Non-performing loans (percent of gross loans) 15.8 14.7 .. .. Unemployment rate (percent, period average) 22.5 21.7 .. .. Sources: Data from central banks and national statistical offices, World Bank staff projections. 4  |  1. Overview REBALANCING FOR STRONGER GROWTH and downside. As elections processes unfold while improving quality of service delivery; in several countries in 2016, risks caused by Deepen trade and financial integration; and domestic political dynamics are also likely to Ensure that natural resource use is sustainable. rise. Fiscal and current account deficits must decline further to support growth. The rebound of growth in the SEE and improved near-term outlook is welcome news. But sustaining growth into the medium term will require further reduction in both fiscal and current account deficits, which are still sizable and contribute to significant financing needs, especially with the high levels of public and external debt. If not addressed, these imbalances could crowd out private investment, erode external financing options, and reduce policy space to respond to future economic shocks. Sustaining the nascent rebalancing requires unlocking the growth potential of the SEE6 economics by reversing productivity dynamics that have been deteriorating since 2008. Between 2000 and 2008 total factor productivity, i.e. how efficiently inputs of labor and capital are used in production, provided solid support for growth. Since the global financial crisis broke, across the region productivity has fallen, often subtracting from growth. While physical and human capital are vitally important to the region’s potential growth, boosting productivity is paramount, given potential headwinds for investment from financing costs, demographic factors and the time it takes to improve human capital. The agenda for reducing the structural rigidities that impede growth is broad- based and centered on five pillars: Eliminate disincentives and barriers to formal employment; Improve the business climate and governance; Reduce the size of government 1. Overview  |  5 2. A Strengthening Economic Recovery REBALANCING FOR STRONGER GROWTH Growth Gains Momentum as Investment Revives Growth in the six South East European Investment has notably revived as the SEE6 countries (SEE6) averaged 2.1 percent in economies expanded in 2015, which added 2015, significantly higher than the 2014 to the continued push from net exports. flood-impacted figure of 0.3 percent.1 The Although the moderate expansion in economic regional growth projection for 2015 was revised activity in 2015 in the European Union up initially from the 1.3 percent forecast in the (EU) was based on consumption, in SEE6 a January 2015 RER, a magnitude broadly in line main source of growth was investment, both with improvements in growth across Europe. domestic and foreign (Figure 2.2). This was After contracting by 1.8 percent in 2014, the the case for Serbia, Kosovo, Montenegro, and Serbian economy grew by 0.8 percent in 2015, Albania, a welcome change from previous in spite of continuing fiscal adjustment and years, when consumption was the common the drought that followed the 2014 floods. driver of growth in SEE countries (Figure The other SEE6 countries also grew faster 2.3). In 2015 in Serbia, broad-based growth compared to 2014: FYR Macedonia by an in manufacturing was accompanied by a estimated 3.7 percent, Kosovo by 3.6 percent, marked rise in private investment, supported Montenegro by 3.4 percent, Bosnia and by regulatory reforms, cheaper credit, and a Herzegovina by 2.8 percent, and Albania by 46 percent increase in foreign direct investment 2.6 percent (Figure 2.1). (FDI). In Kosovo, the pick-up in private investment was fueled by greater access to loans Figure 2.1: SEE6: From stagnation to growth and by FDI. In Albania, large energy projects Real GDP Growth, 2014 and 2015, percent were behind robust capital formation. The new 4 3.7 3.6 growth push from investment came on top 3.4 3 2.8 of a sustained positive contribution from net 2.6 2.1 exports; especially in Albania where net exports 2.0 2 were the strongest driver of growth in 2015. 1 0.8 Most notable expansion of exports linked to growing manufacturing exports in Serbia and 0 FYR Macedonia, and to tourism services in -1 Montenegro and Albania. -2 ALB BIH KOS MKD MNE SRB SEE6 EU28 Consumption contributed less to growth in JJ 2014 JJ 2015e 2015 than it did in the recent past. Only in Source: Data from national statistical offices and Eurostat (2015). Note: Growth values for 2015 are estimates. FYR Macedonia did consumption pull the most weight (fueled by employment and real wage increases) as healthy growth in construction, retail trade, and services was supported by expansion of credit and by 1 The SEE6 are Albania, Bosnia and Herzegovina, Kosovo, FYR Macedonia, Montenegro, and Serbia. government spending related to the political 2. A Strengthening Economic Recovery  |  9 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 cycle. In the rest of the region, it contributed account deficits have also declined substantially. less to growth than earlier. Consumption In 2015, there were also signs of a rebalancing subtracted from growth due to the fiscal towards growth driven increasingly by private adjustment that restrained nominal wages in investment in Serbia, Albania and Kosovo Serbia, and to the uncertainties in the labor (Figure 2.4). This in part reflects the ongoing market and reduction of remittances from fiscal consolidation efforts in Serbia and Figure 2.2: Revival of investment was seen in Figure 2.3: Previously, consumption was the 2015 in most countries dominant driver of growth in most countries Decomposition of real GDP growth, 2015 Decomposition of real GDP growth, 2012-14 6 5 5 4 4 3 3 2 2 1 1 0 0 -1 -1 -2 -2 -3 -3 -4 KOS ALB SRB MNE MKD BIH KOS ALB SRB MNE MKD BIH JJ Consumption JJ Investment JJ Net exports QQ Real GDP growth JJ Consumption JJ Investment JJ Net exports QQ Real GDP growth Source: World Bank estimates based on data from national statistical Source: World Bank estimates based on data from national statistical offices. offices. Greece and Italy in Albania. In Bosnia and Figure 2.4: Private investment demand led Herzegovina, consumption was supportive of growth in Serbia, Albania and Kosovo growth although much less so than in the recent Contributions to growth, pps, 2015 6 past. In Kosovo, growth in private consumption 5 remained strong as remittances, wages, and 4 pensions continued to rise. 3 2 1 The change in growth drivers in 2015 may be 0 the start of a broader rebalancing in SEE6. A -1 continued shift in the sources of growth from -2 unsustainable pre-crisis model of consumption -3 fueled by capital inflows and remittances, to -4 INV CON INV CON INV CON INV CON INV CON INV CON KOS ALB SRB MKD BIH MNE that driven by private investments and exports, JJ Private investment JJ Public investment is needed to ensure robust yet sustainable JJ Private consumption JJ Public consumption economic expansion. Consumption as a share Source: World Bank estimates based on data from national statistical offices. of GDP has declined by about 6 percentage Note: The public-private breakdown in investments is an estimation for most countries. Investment split is not available for MKD and BIH. points and exports have increased by 10 percentage points in the region on average Albania, while in Montenegro public between 2007 and 2015, suggesting slow but investment dominated private investment, visible progress on rebalancing. Current adding to already high fiscal pressures. FYR 10  |  2. A Strengthening Economic Recovery REBALANCING FOR STRONGER GROWTH Macedonia started a rebalancing process earlier domestic uncertainty one likely reason. The key than the rest of SEE6, driven by public question, addressed in more detail in Section 3 investment and improvements in the business of this report, is whether the rebalancing can be environment. But the contribution of sustained in the medium- and long-term. investment to growth fell to zero in 2015, with Higher Employment and Lower Inflation Helped Reduce Poverty Economic growth and labor market reforms points.2 Notwithstanding job creation in 2015, supported job creation in 2015, especially in employment remained below pre-crisis levels the private sector, in most SEE6 countries (Figure 2.5). (Figure 2.5). In Serbia, reform of the Labor Law in 2014 increased hiring flexibility, rationalized Employment growth reduced estimated severance payments (limiting employer’s poverty. In the immediate aftermath of the responsibility to years with the current 2008 crisis, slow economic growth caused a employer), reformed benefits, and intensified reduction in employment and a contraction of enforcement. Although overall employment fell consumption, reversing progress in reducing by 1 percent (y-o-y) in the last quarter of 2015, poverty. In 2015, as growth rebounded across these timely reforms supported creation of the region and job creation picked up, poverty private jobs at a time when public employment reduction resumed. Even though labor income fell by 5 percent as part of public sector reform constitutes only half of household income—a and SOE restructuring. Montenegro managed very low share compared to other middle- to reduce unemployment by 1 percent (y-o-y) income countries—improving labor market in September; but jobs were created mostly in outcomes facilitated poverty reduction. In services. In Albania, growth in employment, by Albania, FYR Macedonia, Montenegro and 1.9 percentage points (pp), was accompanied Serbia, the average estimated poverty rate3 by an increase in the labor force, leading to declined by 2 percent between 2013 and 2015.4 a modest decline in unemployment to an Put differently, one percent of population or average of 17.1 percent for 2015. In FYR some 140,000 people in these four countries Macedonia, increases in manufacturing and are likely to have escaped poverty, measured public administration jobs were among the against the regional standardized benchmark. key drivers of the unemployment reduction During this period, poverty is estimated to have from 28.1 to 26.1 percent in 2015. In Bosnia and Herzegovina, however, faster growth did not bring substantial employment benefits, 2 Based on LFS data. 3 Poverty line of $5/day in 2005 PPP is used henceforth. with unemployment rising by 0.2 percentage 4 The estimate for FYR Macedonia is based on an income aggregate, while estimates for the other three countries are based on consumption aggregates. Poverty data for Bosnia and Herzegovina and Kosovo using the international poverty lines is not available. 2. A Strengthening Economic Recovery  |  11 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 gone down in all SEE6 countries, but to a to this publication. Long-term unemployment varying extent, depending on the speed of is especially high: as many as 62 percent of the economic and labor market rebound as well as unemployed in FYR Macedonia and 82 percent the shape of the welfare distribution, with faster in Bosnia and Herzegovina have been without reduction in countries where concentration a job for over a year (Figure 2.6). High long- around the poverty line is higher. Going term unemployment in the presence of positive forward, poverty is expected to decline, but economic growth suggests structural issues that challenges for poverty reduction remain with constrain employment growth. A combination the high volatility of growth, limited fiscal of factors have been cited as examples of such space for mitigating adverse shocks, and still issues in the region, such as an unfinished low labor force participation and high market transition that makes for an inflexible unemployment rates. labor supply, high labor costs, and other Figure 2.5: Growth in 2015 created jobs, but Figure 2.6: Unemployment remained high, employment is still below pre-crisis levels in despite the rebound of economic growth most countries Employment Index, Q2 2008=100 2010–15, percentage points, percent, rate 130 4 40 2 20 115 0 0 100 -2 -20 85 -4 -40 70 -6 -60 -08 -09 -10 -11 -12 -13 -14 -15 ALB BIH SRB MNE KOS MKD Jun Jun Jun Jun Jun Jun Jun Jun ▬▬ ALB ▬▬ BIH ▬▬ MKD ▬▬ MNE ▬▬ SRB ▬▬ SEE6 JJ Change in unemployment rate (pps), lhs JJ Real GDP growth (annual average), lhs QQ Unemployment rate, rhs ‹‹ Long-term unemployment rate, rhs Sources: Data from national statistical offices. Sources: Data from national statistical offices. Note: The regional total excludes Kosovo. Note: Long-term unemployment is presented as percentage of the labor force, instead of the conventional percentage of the unemployed. June 2010 to June 2015 changes are used. Unemployment and long-term unemployment are for 2015. In the last five years, economic growth has rigidities. Without fundamental structural not always reduced unemployment, which reforms, a sustainable long-term decrease in remains entrenched  (Figure 2.6). Average structural unemployment is unlikely. unemployment in the region is still 21.5 percent. The average employment rate in SEE6 is Low inflation helped boost purchasing practically unchanged since 2006 at about power of the poorest households. In 2015 just 45 percent, compared with 64 percent in inflation in the SEE6 region remained the EU. The youth unemployment rate is subdued, in spite of the recovery in growth. generally about double that of the working-age After inflation of 0.9 percent in 2014, growth population, see the Special Topic supplement in the consumer price index averaged just 12  |  2. A Strengthening Economic Recovery REBALANCING FOR STRONGER GROWTH 1 percent in 2015, ranging from -1 percent considerably, however, although in Albania in Bosnia and Herzegovina to 1.9 percent in food price inflation reached 5.2 percent in Albania and Serbia (Figure 2.7). Meanwhile, December 2015. deflation persisted in FYR Macedonia and Kosovo, similar to that seen in EU members Figure 2.7: CPI inflation remained subdued in Central and Eastern Europe in 2015 where CPI inflation y-o-y, percent prices fell by 0.4 percent on average. Lower 15 prices bolstered real household incomes overall. However, the SEE6 region saw food prices rise 10 in the first half of 2015, from a low base in 2014, leading to inflation of food prices. The 5 largest contribution came from higher prices for seasonal agricultural products, especially 0 fruits and vegetables, but also oils and fats. The largest surge in food prices was in Montenegro; -5 it pushed the economy from deflation in 2014 Dec -11 un-12 J Dec -12 Jun -13 Dec -13 Jun -14 Dec -14 Jun -15 Dec -15 ▬▬ ALB ▬▬ BIH ▬▬ KOS ▬▬ MKD ▬▬ MNE ▬▬ SRB ▬▬ SEE6 to headline inflation of 1.5 percent in 2015. Source: National statistical offices. Toward the end of 2015 food inflation slowed Note: SEE6 is GDP-weighted average. The External Environment Supported Exports Faster expansion in the EU helped SEE6 share of SEE6 exports to the EU market has countries increase exports, which became doubled, though admittedly the base was very a large contributor to growth in several low (Figure 2.8 and Figure 2.9). Serbia was the countries. Real GDP in the EU recovered main driver of this trend; in 2015 its exports from a contraction in 2013 to growth of grew across the board, but industrial exports 0.9 percent in 2014 and then 1.5 percent took the lead: growth from new automotive in 2015. While world trade volume again parts exporters and from other medium-sized expanded by 3.6 percent in 2015 (the same companies more than compensated for a steep rate as in 2014), imports of the EU grew by drop of 13.6 percent in the exports of FIAT, a only 1.6 percent. Yet, the SEE6 countries major investor in the country; steel, tobacco, have shown remarkably consistent progress in food, and travel and professional services also increasing their exports to the EU, the region’s contributed to export growth (see Box 2.1). major trade partner.5 In the past decade, the Services boosted Montenegro’s exports in 2015 as tourism increased due to some diversion of tourists from other destinations like Greece 5 The EU accounts for about 65 percent of SEE6 exports, and and Turkey. For Bosnia and Herzegovina the less than 3 percent of the region’s exports go to China and the main contributors to export growth were food, USA. The majority of the remaining exports are accounted for by intraregional trade. textiles, and mechanical appliances. 2. A Strengthening Economic Recovery  |  13 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Figure 2.8: SEE6’s share in the EU market Figure 2.9: Serbia led the expansion of SEE6’s doubled between 2005 and 2014 exports to the EU Index 2005=100 Percent Share of EU market, percent 400 0.55 0.30 350 0.50 0.25 300 0.45 0.20 250 200 0.40 0.15 150 0.35 0.10 100 0.30 0.05 50 0 0.25 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 JJ Share of SEE6 exports in EU imports, rhs ▬▬ ALB ▬▬ BIH ▬▬ KOS ▬▬ MKD ▬▬ MNE ▬▬ SRB ▬▬ SEE6 exports to EU, lhs ▬▬ Total EU imports, lhs Source: Data from national statistical offices. Source: Data from national statistical offices. Box 2.1: The Automotive Industry: Stimulating Growth and Exports The automotive industry has a long history in Serbia, which began exporting automobiles in 1953 as a result of cooperation between Kragujevac-based Zastava and FIAT. It continued with the 2008 joint-venture agreement with FIAT to create FIAT Automobiles Serbia (FAS), which is 67 percent owned by FIAT and 33 percent by the Serbian government. Total investment in FAS has since exceeded €1 billion. In addition to FIAT, a lively supplier industry has since come into being, consisting of both local and foreign-owned firms. Total investments in these companies are estimated at over €200 million (1.2 percent of total foreign investment in Serbia), and they have created about 3,000 jobs (0.1 percent of total employment, and 0.5 percent of manufacturing employment). These companies have also created demand spillovers especially in services: transport services (rail in particular), as well as electricity, etc. Some of the largest foreign companies in this group are Magneti Marelli, Johnson Controls, Draxlmaier, Bosch, Lames, Yura, Leoni, Grundfos, Magna, Contitech, and Mecaplas. There are also about 20 domestic companies. As a result, in 2015 turnover in the Serbian automotive sector exceeded €2.7 billion, about 8 percent of GDP, having quadrupled since 2005. Production of vehicles accounts for almost 60 percent of the total turnover; tires and wiring systems account for about 10 percent each. Most of these companies are export-oriented; they accounted for 21 percent of total Serbian exports in 2015, of which FAS accounted for 12 percent. FAS grosses about €1.5 billion in turnover from the Fiat 500L but has capacity to produce other models as well. Other large exporters, which produce automotive supplies, are from France, Korea, Germany, and Denmark. FYR Macedonia also has a dynamic automotive sector, building on the country’s experience since it was part of Yugoslavia. The sector has been significantly reinforced as a number of companies began operating in the country in the last five years, including Johnson Matthey, Johnson Controls, Van Hool, Key Safety Systems, Draexlmaier, and Kromberg & Schubert. Their total investments 14  |  2. A Strengthening Economic Recovery REBALANCING FOR STRONGER GROWTH are estimated at €235 million, about 5.5 percent of total foreign investment, and they have brought about significant changes in FYR Macedonia’s export structure. In the last five years, automotive exports have expanded almost six-fold in nominal terms, reaching €1.7 billion in 2015, 20 percent of GDP. Johnson Matthey alone accounts for more than 40 percent of exports of foreign companies and about 20 percent of overall exports. Combined, these companies have since 2011 created an estimated 15,000 jobs, about 20 percent of all new jobs, of which one-third are skilled and two-thirds low-skilled (the latter are concentrated in two companies that produce wire harnessing). While this FDI segment has created spillovers in transport, logistics, tooling, and auxiliary services (including construction services) that were estimated at be worth €50 million in 2014, linkages to the local economy are still limited. In Bosnia and Herzegovina, Volkswagen has a factory near Sarajevo, and two factories in Banja Luka and Mostar produce buses. In addition, German company Car Trimm, a large maker of seat covers and leather upholstery for the car industry, has a factory in Zepce. The German group MANN+HUMMEL has a facility in Tesanj producing filter elements for the international automotive and mechanical engineering industries. Remus Innovation, an Austrian investor and a world market leader in sport exhausts, has a production facility in Sanski Most. The well-known SIAC Group from Italy, which produces cabins for agricultural machines, also has facilities in Bosnia and Herzegovina in Krupa Kabine. Other investments include those of Bosancar from Italy which produces vehicles for construction and agriculture sectors and of Novi Most, a Slovenian investor, which produces welded safety structures for the European producers of buses, trucks, mechanical equipment and other different machines for the company. Importantly, new local companies are emerging as major suppliers to world-renowned car producers, among them Prevent Group and Bekto Precisa. Prevent, which has been in operation for about 17 years, now has three factories in the automotive industry. It produces textile and leather seat covers for Volkswagen, BMW, Citroen, Peugeot, Ford, and others. Each year two million cars around the world are equipped with seats produced in Bosnia and Herzegovina. Prevent also produces brakes and other metal and plastic car parts. In its 10-year history Bekto Precisa has also grown rapidly. It now employs about 500 people and supplies metal and plastic parts to major car producers, such as BMW, Porsche, and Audi. Source: SIEPA, the Serbian Customs Administration, Directorate for Technological Industrial Zones of the Republic of Macedonia, the State Statistics Office, and IFC. Although improved external demand was services, logistics costs, and the investment the primary reason for export growth in climate will be essential to support any further 2015, real depreciation against trading sustained increases in exports. partners also helped export performance. With respect to trading partners, moderate real While commodity exporters suffered from effective exchange rate depreciation occurred lower prices, higher investment fed through over the year, ranging between 1 and 3 percent, into higher imports. Low prices for oil and supporting higher exports in 2015 (see base metals in international markets particularly Section 2). But it was the improved external affected the exports of Albania, Bosnia and demand that played the leading role in export Herzegovina, Montenegro, and Kosovo— performance. Addressing other drivers of countries where commodities constitute a fairly competitiveness, such as labor market and wage large share of their exports. In Albania, where rigidities, education systems, quality of public crude oil and base metals exports account for 2. A Strengthening Economic Recovery  |  15 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 nearly 40 percent of total exports, production on average and goods imports declined by was more than halved after oil prices dropped. 2.3 percent. In 2015, goods exports went down by 7.2 percent y-o-y, despite steady growth in Albeit still mainly low-tech, export exports of textiles and shoes. Because of the sophistication performance is improving. decline in base metal exports, Kosovo’s goods Within the region’s medium-term goods export exports stagnated, growing by only 0.2 percent, performance, there has been an increase in their and Montenegro’s fell by 7.3 percent. In sophistication mainly in the manufacturing- contrast, countries whose exports are exporting countries (Figure 2.11), largely on manufacturing-intensive, such as FYR the intensive margin. However, overall the Macedonia and Serbia, are benefitting from the SEE6 export basket remains predominantly current environment (Figure 2.10). Throughout low-tech. Figure 2.10: Current account deficits mostly Figure 2.11: Mixed performance on export narrowed sophistication Contribution to change in current account deficit in 2015, Share of high- and medium-tech goods exports, percent of total relative to 2014, percent of GDP 4 40 3 2 30 1 0 20 -1 -2 -3 10 -4 -5 0 KOS MKD ALB BIH MNE SRB MKD SRB BIH ALB MNE JJ Goods exports JJ Goods imports JJ Net services exports JJ 2001 JJ 2008 JJ 2014 JJ Remittances JJ Others QQ Change in current account Source: Data from central banks and national statistical offices. Source: World Bank staff calculations based on WDI, WITS, PWT8.0 and National Statistical Agencies data. Note: The classification is based on technological ranking of manufactured products as in Lall et al., .2006. The ‘Sophistication’ of Exports a New Measure of Product Characteristics. the SEE6, low oil prices suppressed import In sum, external imbalances continued growth. However, strong investment in almost to narrow in most SEE6 countries. In all SEE6 countries was reflected in higher 2015, Albania, Bosnia and Herzegovina, imports of machinery and equipment. While Montenegro, and Serbia reduced their current goods imports declined in many countries, a account deficits-to-GDP, while Kosovo and rebound in domestic demand explains some of FYR Macedonia saw them widen (Figure 2.10). the pickup in imports, by 5.6 percent y-o-y, The drivers of the narrowing external deficits in seen in Serbia. On balance, the SEE6 trade SEE6 were mixed. While imports contracted as deficit narrowed to 15.9 percent of GDP in a whole, in part due to lower oil prices, their 2015 as goods exports increased by 0.7 percent decline was muted in some countries due to 16  |  2. A Strengthening Economic Recovery REBALANCING FOR STRONGER GROWTH the supporting role of intermediate and capital the services side, such as transport and travel, goods in investment and manufactured export as well as from manufacturing shipments to production. The boost in exports came from Europe. Higher External Volatility Affected Financing Availability In 2015, heightened volatility in capital March 2016 Eurobond issue (€300 million inflows affected the ability of emerging and 5-year bond) was priced 200 basis points above developing economies to finance external the previous year’s issue. The rise reflects not imbalances. Most beneficial for the region has only global changes in investors’ risk aversion, been the gradual pick-up in activity in the EU, but also their reevaluation of Montenegro’s falling global oil prices, and the weakening of fundamentals with the increase in the fiscal the euro against the U.S. dollar. But as U.S. deficit. interest rates move to normalize, the outlook for capital flows to emerging markets weakened in Although FDI to the region has increased, 2015, with projections for inflows in 2016 and tighter international liquidity conditions 2017 also downgraded.6 In early 2016 global are likely to make it harder to compete market conditions have been more turbulent, for external financing. The projection of with markets reacting to global economic news sustained high current account deficits in and changes in expectations of the path of the region, combined with the uncertain future U.S rate increases. This uncertainty has international financial environment, suggest contributed to a reduction in U.S. Treasury and that external financing risks remain high. FDI German government benchmark yields (the in both euro terms has picked up through latter have moved into negative territory) while 2015 in a number of countries in the region emerging market spreads increased through (Figure 2.12). For example, in Montenegro the mid-February before falling back. Markets increase was driven by real estate projects, bank remain susceptible to further changes in risk recapitalizations, and the entry of banks; in appetite with potential impact for the future cost Albania by the construction of the Transadriatic and availability of financing for SEE6 countries pipeline and a hydropower plant; and in Serbia like Serbia, Albania, and FYR Macedonia that by FDI in manufacturing (motor vehicles), require significant gross fiscal financing. In the trade and baking sector. In terms of overall case of Montenegro, the interest rate on the financing risks, the basic external balance i.e. the sum of the current account balance and net direct investment inflows, was positive for 6 For example, the World Bank January 2016 Global Economic FYR Macedonia, Montenegro, and Serbia, Prospects report (GEP) projects capital flows to developing ECA to be 2.7 percent of GDP in 2015, down from 4.6 percent in 2014, and direct investment covered 61 percent of and rising slightly to 3.1 percent in 2016. The projections were Albania’s current account deficit as well. The revised downward from the June 2015 GEP by 2.3 pp for 2015 and by 2.7 pp for 2016. situation in Bosnia and Herzegovina raises 2. A Strengthening Economic Recovery  |  17 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 concern about external financing risks, because Figure 2.12: FDI inflows increased to SEE6 in 2015 FDI covered only 24 percent of the while other capital inflows declined projected current account deficit. Portfolio Four quarter rolling sum, euro million 4,500 inflows, which in the region are mainly driven 4,000 by sovereign bonds flows, were positive only 3,500 in Albania and Montenegro. Net portfolio 3,000 outflows were highest in Serbia (0.9 percent of 2,500 2,000 GDP), as government external bond financing 1,500 declined relative to 2014. Other investment 1,000 outflows were large in the banking sector in 500 Montenegro and in the non-banking sector in 0 FYR Macedonia. -500 -13 r-1 4 -14 -14 -14 r-1 5 -15 -15 Dec Ma Jun Sep Dec Ma Jun Sep ▬▬ FDI inflows ▬▬ Portfolio investment inflows ▬▬ Other investment inflows Policies will be key in competing for scarce Source: Data from central banks and national statistical offices. Note: Inflows = liabilities on the financial account. financing options. Countries with credible reform programs will be more attractive to investors, and are more likely to retain or receive financing when the sources of financing are scarce. The following sections discuss short- and long-term policies that are likely to matter for growth and for attracting capital in the near-term. 18  |  2. A Strengthening Economic Recovery 3. Supportive Policy Reforms Are Ongoing REBALANCING FOR STRONGER GROWTH Fiscal Adjustment Advancing Continued fiscal consolidation in 2015 Albania, Serbia, and Kosovo were combined narrowed deficits in all SEE6 countries with one-off gains. In Serbia, one-off factors except in Montenegro. The largest reductions amounted to 1.1 percent of GDP; they included in 2015 were in Serbia (from 6.6 percent of dividends and fees from public enterprises and GDP to 3.7 percent); followed by Albania payments on licenses for the 4G network. (from 5.9 to 4.8 percent, with public arrears Among the more lasting policy changes were clearance amounting to 1.3 percent); FYR a rise in the VAT rate in Kosovo; higher excises Macedonia (from 4.2 to 3.5 percent); and in Serbia and in Bosnia and Herzegovina; Kosovo (from 2.6 to 1.9 percent) (Figure 3.1). and reintroduction of the profit tax on non- Only in Montenegro did the fiscal deficit widen reinvested earnings in FYR Macedonia. Efforts significantly (from 3.1 to 7.0 percent of GDP) to improve tax collection also advanced; new IT after a spike in capital expenditures and a systems now support collection of 95 percent shortfall in revenues. In the region, the average of both individual and corporate taxes in Serbia deficit declined negligibly between 2014 and and of all corporate tax payments in FYR 2015, from 4.1 to 3.8 percent of GDP, while Macedonia. Offsetting these gains was revenue public debt moved up to average 55 percent of from VAT and excise duties, which came in GDP, revealing difficulties in overcoming lower than expected almost everywhere in the structural public finance shortcomings. region. The problems can likely be attributed to still inadequate tax collection processes, tax Revenue gains drove much of 2015’s fiscal concessions and exemptions for the foreign adjustment. Revenue increases throughout the segment of the economy, and lower retail oil region were related to policy changes, which in prices. Figure 3.1: Fiscal deficits narrowed Figure 3.2: Spending restraint contributed to large fiscal adjustments in Albania and Serbia Fiscal deficit to GDP, percent Contribution to annual change in fiscal deficit in 2015, percent of GDP 8 4 7 3 6 2 5 1 4 0 3 -1 2 -2 1 -3 0 -4 MNE ALB SRB MKD KOS BIH SEE6 MNE BIH MKD KOS ALB SRB SEE6 JJ 2014 JJ 2015 JJ Expenditure JJ Revenue QQ Change in fiscal deficit Source: Ministries of Finance. Source: Ministries of Finance. 3. Supportive Policy Reforms are Ongoing  |  21 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Several countries are moving to enhance Fiscal consolidation efforts have started to revenues. Efforts to widen the revenue base, deliver positive results as countries reform reduce the disproportionate reliance on labor entitlement programs, reduce the public taxes (notably social security contributions, sector footprint in the economy, and support SSCs), and professionalize tax administration public sector performance. Ingrained are necessary to support structural structural problems across SEE6 include high improvements in public finance management public consumption and unproductive public in SEE6. To that end, Albania has launched transfers. Serbia and Albania both reduced their an anti-evasion campaign that incorporates a expenditure-to-GDP ratio in 2015. Serbia was public awareness campaign, tougher penalties able to cut public spending by 1.7 percent of in the Tax Procedures Code, and hiring of GDP during 2015 thanks to savings on public more tax inspectors. Tax procedures are also wages and pensions, substantially reducing the being changed to close regulatory loopholes in fiscal deficit (Figure 3.2). The government’s VAT and excises, and the country is gradually ambitious fiscal consolidation program is now moving to risk-informed monitoring. In centered on wage bill reforms which, along Serbia, the tax administration has successfully with pension reforms, are expected to deliver adopted the Transformation Plan approved by three-quarters of the planned fiscal deficit the government in June 2015. reduction by the end of 2017 (see Box 3.1). Similarly, in Albania, restrained spending on wages, social services and interest helped reduce fiscal imbalances. Box 3.1: Serbia’s Reform of the Public Wage System Public sector reform was one of the first priorities for the government of Serbia appointed in 2014. Fiscal weaknesses in 2012–14 caused public debt to surge by 26 percentage points of GDP and heightened the urgency of fiscal adjustment. General government expenditures averaged 45.6 percent of GDP during that period, and the largest single spending category, the wage bill, accounted for 11 percent of GDP in 2013. Apart from wage bill expenditures being high, they were also non transparent, posing issues of fiscal predictability. The wage system included 5 different base salaries, 900 different job coefficients, 2,200 job titles, 71 different elements of remuneration, based on 19 laws and a plethora of by-laws. The payment of salary supplements under the different elements of pay was not rule-based, leading to significant distortions in the pay system. De facto, institutions have the incentive to maximize the use of wage bill resources. Establishment control principles were circumvented through the largely uncontrolled hiring of temporary employees. Since 2014, the government has targeted reducing the wage bill through a comprehensive reform designed to raise the quality and efficiency of public services; motivate and of public administration  better reward public employees; and build up the capacity of the Serbian Public Administration to manage the EU accession process. The reform is based on two strategic documents, the Public Administration Reform (PAR) Strategy and the Action Plan for Implementing the PAR Strategy. 22  |  3. Supportive Policy Reforms are Ongoing REBALANCING FOR STRONGER GROWTH To achieve its reform goals, the government has moved on two fronts, legislative and administrative. The Ministry of Finance (MoF) created a Registry of Employees in the core Public Sector (not including state-owned enterprises), which contains individual information on about 465,000 employees. While based on self-reporting, which poses risks of data quality, data in the registry are regularly cross checked with the data of the mandatory social insurance registry to reduce the scope for errors. In terms of cost control, the wage indexation formula was scaled down, followed by a nominal reduction in wages by 10 percent in November 2014, and the introduction of a ceiling on maximum public sector salaries. In addition to the employee registry, the MoF, in partnership with the Ministry of Public Administration and Local Self-Governance (MPALSG), established the Registry of Institutions in the Public Sector. Establishment control was strengthened through a hiring freeze established in January 2014, which allowed a maximum of 1:5 replacements. The hiring freeze is still in place, though is being phased out and replaced with a system of hard employment ceilings by institution, set under the Law on Maximum Number of Employees in the public sector, adopted in Summer 2015. Under this Law, ceilings for individual institutions are now being proposed and set by Government decree on a 6-monthly basis. Finally, the number of contract employees a ministry or agency could hire was limited to 10 percent of its total staff, and ministries were given 3 months to bring numbers in line with this ceiling. Other measures are underway to ensure that this reform is sustainable. In particular, in early 2016 the government enacted the Law on Public Sector Employees Salary System, which sets the parameters for the pay and grading system that apply across the public sector, to improve transparency and equity in the compensation structure. The Law addresses the unfairness caused by the large number of legislations on public sector compensation and the resultant discretion in setting salary levels. It provides for a uniform base rate and multipliers for each position and harmonizes about ten different base rates that existed before. The law creates a uniform pay structure for all categories of employment in the public sector, introduces a catalogue of positions, lays out the methodology for setting pay for various positions and grades, and provides a transparent criteria for bonus payments. In parallel, the government is conducting a thorough functional review of ministries and agencies to determine options for optimization, focusing on those ministries and agencies that employ most staff and deliver vital services, as well as on streamlining the more than 100 central state institutions that currently exist. Source: World Bank It is essential to further shift the composition bills of about 12 percent of GDP. Social benefits of public spending to more productive and have risen as a share of GDP in Albania, equitable areas. Although all SEE6 countries Kosovo, and Macedonia and remained flat in except Kosovo have reduced the public wage Bosnia and Herzegovina, Montenegro, and bill as a share of GDP over the past three years, Serbia; there is general concern about their wages still comprise a notably sizeable item in targeting and efficiency. Moreover, some recent SEE6 budgets. For example, in 2015, Bosnia policies will put added pressure on budgets. In and Herzegovina and Montenegro had wage Montenegro, amendments to the Law on 3. Supportive Policy Reforms are Ongoing  |  23 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Pension Insurance which allowed for a rise in spending, though it continued to be restrained pensions on average by 3 percent and the rise in in countries that traditionally had lower capital minimum pension by 20 percent, along with spending. For example, in Kosovo, construction the amendments to the Law on Social and of highways added 2 percent of GDP in Child Care that introduced lifetime benefits for spending and in Montenegro 4.7 percent, mothers of three or more children that amount and the level is expected to rise further in the to 70 percent of the average national net medium term. salary—would increase spending by 1.5 percent of GDP annually. In FYR Macedonia, pensions As in all countries, public capital spending have been rising for the last four years, reaching in SEE6 should be rigorously evaluated 9.0 percent of GDP in 2015. Reforming the to ensure that public money supports the amounts and targeting of pensions and related projects with the highest economic and social benefits is critical to effective medium- social returns. Bosnia and Herzegovina has term fiscal consolidation. made good progress in developing transparent evaluation criteria to state and entity public Large public investment projects prompted investment programs. Most SEE6 countries the rise in public spending seen in several are establishing a single pipeline of public countries in 2015. Their budget share ranged investment projects. Rigorous and transparent from 3 percent of GDP in Serbia to 7 percent in arrangements for appraisal, selection, Kosovo and 8.5 percent in Montenegro. Capital and approval of investment projects and spending was cut throughout the region as reinforcement of the institutions related to part of the fiscal adjustment immediately after funding, management, and monitoring of the 2008 global financial crisis. After growth projects will ensure quality delivery of public returned, this budget item continued to grow services, connect citizens and firms to economic in countries with traditionally high capital opportunities, and serve as a central catalyst for Figure 3.3: The burden of public wages and Figure 3.4: The efficiency of public investment social spending remained high management needs improvement Public spending, 2015e, percent of GDP Capital spending (2012–15) and latest PEFA scores related to Capital Expenditures, percent of GDP (lhs) and PEFA score (rhs) 60 A 10 50 B 8 40 C 6 30 D 4 20 2 E 10 0 0 MNE BIH SRB MKD ALB KOS SEE6 KOS MNE MKD ALB BIH SRB JJ Wage bill JJ Social benefits JJ P12(iii) Multi-year costing of recurrent & investment expenditure, rhs JJ Capital expenditures QQ Total expenditures JJ P12(iv) Linkages of investment budgets & expenditure estimates, rhs QQ Capital expenditures (2012–15 annual average), lhs Source: Ministries of Finance. Source: Ministries of Finance, PEFA. 24  |  3. Supportive Policy Reforms are Ongoing REBALANCING FOR STRONGER GROWTH economic growth (see Box 3.2). In all countries, informed decision-making that will ultimately improving medium-term fiscal planning and reinforce fiscal consolidation by raising the public investment decisions will also support long-term return on public spending. Box 3.2: Strengthening the Management of Public Investment Improving public investment management (PIM) has been found to have significant benefits for growth and the efficiency of public spending. Countries with the most efficient PIM systems tend to have higher growth per dollar spent on public infrastructure than the least efficient countries.7 While much of the literature confirms that public investment raises output, the magnitude of the impacts found varies due to uncertainties about fiscal multipliers on the demand side and inefficiencies on the supply side (Easterly and Rebelo 1993; and Warner 2014). The IMF (2014) found that in advanced economies public investment, defined as an unanticipated one percentage point of GDP rise in investment spending, shocks raise output by about 0.4 percent in the same year and 1.5 percent after four years; it also found that investment shocks have an even larger growth impact in countries with more efficient public investment, increasing output by 2.6 percent after four years. The lack of clear national regulations and guidelines in the SEE6 region jeopardizes the quality and efficiency of core PIM functions. Currently, there is little or no assurance that projects are effectively screened for consistency with government policies and strategies, using formalized appraisal tools and independently reviewed. The responsibilities of stakeholders are not clear, causing ambiguity about levels of approval because of the overlap of some functions. There are also gaps in formalizing the requirements for project management and monitoring, especially for projects funded by state budgets. A comparison with good international practice shows that in the region steps are being missed in the PIM cycle. A methodology developed by the World Bank8 makes it possible to compare current SEE6 practices with good PIM practices at various points; among them are: • Strategic guidance and preliminary screening. Lack of a national strategy that clearly articulates public investment priorities inhibits effective pre-screening of project ideas. Considerable emphasis should be given to filtering out bad project ideas at an early stage, so that only projects with a clear rationale based on government policies and strategies move forward and resources are not wasted on appraisal and design of less effective projects. Projects also tend to acquire their own planning momentum, which makes it more difficult to stop at a later stage. There needs to be a centralized process and guidelines for the format and for screening initial project proposals for consistency with national policy priorities. • Formal appraisal and independent review. Currently, there are no guidelines for appraisal of public investment projects that are to be financed by domestic revenue. While standardized 7 IMF, Making Public Investment More Efficient, 2015. The study defines the efficiency of public investment as the relationship between the value of the public capital stock and the measured coverage and quality of infrastructure assets. The level of efficiency in a given country is calculated as the distance from an efficiency frontier, which is defined by the countries with the highest coverage and quality of infrastructure (output) for a given level of public capital stock (input). See also, IMF (2014) “Is It Time for an Infrastructure Push? The Macroeconomic Effects of Public Investment,” in IMF World Economic Outlook, October 2014, pp. 75–114. 8 See, Rajaram et al (2010), A Diagnostic Framework for Assessing Public Investment Management, World Bank Policy Research Working Paper 5397. 3. Supportive Policy Reforms are Ongoing  |  25 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 appraisal tools are internationally recognized as important to ensure that projects chosen are feasible and of socioeconomic value, current regulations do not require feasibility studies. Similarly, there is usually no pre-feasibility study that incorporates cost-benefit analysis of a broader range of options contemplated for significant projects. Countries with good PIM practices typically formalize independent checks of any bias in project documentation. This is particularly important because line ministries do not always follow a stringent model for separating internally the roles of project “proposer,” “appraiser,” “reviewer,” and “approver.” For example, pre-feasibility and feasibility studies are often outsourced, with the contractor reporting to the same unit or authority that is proposing the project. • Selection and budgeting. A fundamental aspect of a well-functioning PIM system is an appropriate linkage between the appraisal and selection of projects and the budget cycle. Desirable features of such a system are transparent criteria for selecting projects; a well-structured budget preparation process that takes into account both current investment and recurrent project implications over the medium to long term; effective gate-keeping to ensure that only appraised and approved projects are financed; and ensuring that projects selected have adequate financing for not only construction but also operation and maintenance costs after completion. • Project implementation, finalization, and evaluation. Budget preparation and execution procedures appear to have mixed impact on how effectively projects are constructed. There is no evidence that allocation levels are insufficient to ensure timely completion of projects, and there are mechanisms in place to allow multiyear commitments when there may be spending consequences in future fiscal years. However, a skewed pattern of annual spending, with a large share of capital spending happening in the last month of the fiscal year or not executed at all, points to issues related either to timely initiation of project activities or insufficient flexibility during the budget year. Nor do most countries have any specific formal requirements or institutional arrangements in place to guide ex post evaluation of public investment projects, such as completion reviews. National audit offices have so far had only a limited role in the evaluation of public investments. Source: World Bank. Improving SEE6 fiscal positions would be and related public services. They are, however, impossible if risks are not successfully complex; they require not only careful risk managed. Increasing fiscal transparency and allocation and mitigation but also a well- strengthening budget management with thought-out procurement strategy to ensure credible fiscal rules, medium-term expenditure that the public sector gets value for money. frameworks, and more stringent management Often, inefficient PFM results in the of debt, guarantees, and contingent liabilities accumulation of arrears. Clearing arrears and are expected to reduce risks and improve the preventing their build-up is a serious challenge fiscal stance. All SEE6 countries would benefit for central and local governments in SEE6. from stricter oversight of public-private However, in just two years, Albania has been partnerships (PPPs) and better integration able to clear public arrears amounting to between national strategic plans and capital 5 percent of GDP and at the same time has budgeting and financing. PPPs and concessions been reinforcing its PFM institutions to limit might be useful for supporting infrastructure their accumulation (see Box 3.3). 26  |  3. Supportive Policy Reforms are Ongoing REBALANCING FOR STRONGER GROWTH Box 3.3. Albania: Arrears Clearance and Commitment Controls A combination of declining government revenues post-crisis and spending commitments consistently above budget ceilings led Albania to accumulate major arrears in 2008–13. Even as financial resources tightened and there was a large overhang of social spending, the government continued to spend heavily on infrastructure. The spending ceilings assigned to budget entities for the medium term were treated as a reference baseline for their plans, rather than an upper limit. New investment projects were approved with commitments well beyond the budget limits of a year and then often cut back during the year due to lack of resources. Where executions exceeded budgets, arrears accumulated. By the end of 2013, Albania’s arrears amounted to 5.3 percent of GDP, on works, goods and services, such as utility bills, VAT and CIT refunds, disability benefits, and special funds. In 2014 the government signed a Strategy for the Prevention and Settlement of Overdue Liabilities. It set procedures for (1) settling overdue debt in an accurate, transparent, and unbiased manner within three years, and (2) tightening financial discipline to prevent future accumulation of debt. Arrears were paid using the FIFO (first in, first out) principle. The Ministry of Finance (MoF) established special units to manage the process. Reports on the processing of arrears were published regularly. An external audit validated the amounts and the clearing process. Arrears were fully cleared by the end of 2015, slightly ahead of schedule. To prevent emergence of fresh arrears a number of controls were introduced. Budgeted entities were required to prioritize their activities within set limits and approved budget ceilings. Clear prioritization criteria ensure that poorly prepared and ill-conceived projects are not financed and that resources are applied where they will have maximum effect on the government’s fiscal and other objectives. To avoid over-commitments the MoF in March 2014 issued a budget circular notifying line ministries that commitments for 2015 to 2017 were not to exceed 30 percent of the medium-term fiscal ceilings for current expenditures and 50 percent for domestic capital expenditures. Parliament approved the 3-year spending limits in the Budget Law of 2015. The government plans to amend Albania’s Law on Management of the Budget System, in 2016 so that it reflects, among other things, the changes to the medium-term fiscal framework. These changes are also embedded in Albania’s PFM strategy, which was approved by the Council of Ministers and published in December 2014. To better control commitments, budget entities must now obtain authorization from the Treasury before commencing procurement for a project. The Council of Ministers in a regulation issued in January 2014 now requires all budget units to receive a Treasury stamp before procuring any goods or services. The MoF denies the stamp for buying goods for which funds are not available. This procedure has helped curtail the common practice of initiating procurement, particularly multiyear commitments, without sufficient consideration of the resources available, since the Treasury system is currently not capable of imposing hard controls on expenditure commitments. The Treasury system was also reinforced to provide greater control of commitments, including multiyear commitments. Budget units must record commitments in the Treasury District Office within three days of signing a contract. The Treasury performs periodic checks on budget users that have a high risk of incomplete compliance to ensure that the requirements are followed. Source: World Bank. 3. Supportive Policy Reforms are Ongoing  |  27 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Public Debt Edging Up Public debt rose further in 2015 despite the magnitude to its budget deficit, while in its fiscal consolidation and tax reforms neighbors the valuation effect was more muted underway in several SEE6 countries. Public (Figure 3.8). and publicly guaranteed (PPG) debt as a share of GDP rose in 2015 in all countries in the Because of heightened external uncertainty, region, with an average increase of 3 percentage exposure to environmental disasters, and points of GDP over 2014. Montenegro led the volatile political cycles, the SEE6 economies way with a 10 percentage point increase in its need healthy fiscal buffers to act as essential public debt in 2015, which reached a new high shock absorbers. The narrowing of fiscal of 78.8 percent of GDP. In addition to still- deficits is set against the background of high, sizable fiscal deficits, valuation effects due to and still rising, levels of public debt. Albeit the appreciation of the US dollar also pushed from different levels in 2007, PPG debt as a up debt for those those countries with a large share of GDP increased by end 2015 by at least share of debt held in US dollars (Figure 3.5 and 20 pp in Montenegro, Serbia, Albania and FYR Figure 3.6). In Serbia the contribution of the Macedonia. Moreover, the increase in the ratio valuation effect to PPG was more significant of PPG to GDP in SEE6 is almost double the than in other countries because the depreciation one in upper middle-income emerging markets against the dollar was more pronounced and (Figure 3.5). The room for fiscal maneuver more of its debt was denominated in dollars is therefore very limited. Faced with the than in other countries (Figure 3.7). As a result, risks of a less supportive future international in 2015 Serbia’s valuation effect was similar in environment, both for growth and financing Figure 3.5: SEE6 PPG debt has grown fast Figure 3.6: Steady upward trend of SEE6 PPG since 2007 debt threatens debt sustainability PPG debt to GDP change since 2007 to 2015, percentage PPG debt to GDP, percent points 60 90 80 79 50 77 73 40 70 60 55 30 50 46 20 44 40 10 30 0 20 13 -10 10 -20 0 L L A D B B O R R R S M N BIH M E Z V Y Y MNE BIH SRB MKD ALB KOS SEE6 PH BO TH KO MK AL SR PE MA JO GE SL BL PR GU MN TU GT AR JJ SEE6 JJ Comparators ▬▬ Upper-middle income average JJ 2015 QQ 2007 ‹‹ 2011 Source: Ministries of Finance. Source: Ministries of Finance. Note: Comparable countries are emerging markets with income per capita of $2,900–$6,400, non-oil exporters, non-island states outside of Africa. 28  |  3. Supportive Policy Reforms are Ongoing REBALANCING FOR STRONGER GROWTH costs, policy measures to address structural space and can be important to strengthen public fiscal rigidities, including the management of finances to limit the adjustment required in the public debt, can help provide additional fiscal event of adverse shocks. Figure 3.7: The share of dollar-denominated Figure 3.8: Valuation effects of public debt external PPG debt is below most Europe and due to dollar appreciation in 2015 were Central Asia countries comparable to fiscal deficits in some countries Share of external PPG, percent of GDP, 2014 Percent of GDP Ratio 100 11 100 90 10 90 80 9 80 70 8 70 7 60 60 6 50 50 5 40 40 4 30 3 30 20 2 20 10 1 10 0 0 0 D U A R E R TJK MN R AR B M O BIH M R S Z MKE Z B B SRB BIH KOS MKD ALB MNE RO MD AZ UK BL BG UZ KA GE KG KO TU AL SR TK JJ USD share of external debt ▬▬ Europe and Central Asia average JJ USD valuation effects JJ Fiscal deficit QQ Change in total public debt ‹‹ Valuation effect as share of fiscal deficit, rhs Source: Ministries of Finance. Source: Ministries of Finance and WDI data. Note: Valuation effects calculated by comparing US$ denominated public debt in 2014 with the increase from the change in US$: local currency exchange rates in 2015. Accommodative Monetary Policy Restrictive fiscal policy and reduced external Central Bank lowering the reference rate, and imbalances, along with the interventions of global developments such as the decrease in national banks, helped to keep currencies flow to emerging markets. But differences in stable against the euro in SEE6(Figure 3.9). U.S. and Euro Area monetary policies and the Movements against the euro were limited for resulting higher U.S. bond yields contributed most of 2015, although the Albanian lek to a marked strengthening of the dollar against appreciated somewhat near the end of the year the euro in 2014 and most of 2015. From the as a result of higher seasonal demand coming end of 2014 to Feb 2016, nominal depreciation from migrants returning to the country. The against the U.S. dollar of local currencies with Serbian dinar, on the other hand, depreciated floating exchange rates or fixed rates to the euro slightly against the euro toward the end of 2015 was between 10 and 12 percent for Albania, and in early 2016 as a result of such seasonal Bosnia and Herzegovina, FYR Macedonia and factors as repayments of public debt, higher Serbia, with most of the drop occurring early in demand from importing companies, exchange rate swaps by commercial banks reacting to the 3. Supportive Policy Reforms are Ongoing  |  29 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 the year.9 Real effective exchange rate With policy rates at historic lows in SEE6, depreciation over the year was only moderate. lending rates declined, providing support to the tentative growth in private credit. Subdued inflation led central banks to keep Lending rates fell in all SEE6 and across the monetary policy accommodative. Overall, region, lending to households picked up. official policy rates held at historically low levels Overall credit growth headed upward in FYR in SEE6 (Figure 3.10). In November 2015, Macedonia, Kosovo, Montenegro, and Bosnia based on forecasts of low inflationary pressures and Herzegovina (Figure 3.11). Findings of in the medium term, the Bank of Albania a recent survey10 of banks highlights that the reduced its policy rate by 0.25 percentage drivers of credit on both the demand and the points, to 1.75 percent, a historic low. For the supply side: In Kosovo, supply conditions same reason, between March 2015 and have eased, demand for loans picked up and February 2016 the National Bank of Serbia cut nonperforming loans have fallen. In Serbia, the policy rate seven times, down to growing demand continues to be constrained 4.25 percent. Only FYR Macedonia kept its by a much slower improvement in lending policy rate unchanged; it had assessed that conditions. And in Albania, both demand and given economic and financial conditions, the supply are tepid. current monetary policy was adequate. Figure 3.9: SEE6 currencies mostly followed Figure 3.10: Official policy rates are at the euro, with some recent divergence historical lows Change from December 2014 to Feb 2016, percent Percent 14 12 12 10 10 8 8 6 6 4 4 2 2 0 -2 ALB BIH MKD SRB EU ALB BIH MKD SRB BIH KOS MKD SRB 0 USD Euro REER 2012 2013 2014 2015 2016 ▬▬ MKD ▬▬ ALB ▬▬ SRB ▬▬ Eurozone Source: Data from central banks and the IMF. Source: ECB, National banks. Note: Increase = depreciation. 9 Montenegro and Kosovo are fully euro-ized economies. 10 EIB CESEE Bank Lending Survey, H2 2015. 30  |  3. Supportive Policy Reforms are Ongoing REBALANCING FOR STRONGER GROWTH Figure 3.11: Tentative recovery of private credit growth Credit growth year-on-year, three month moving average, percent Albania Bosnis & Herzegovina Kosovo 30 25 20 15 10 5 0 -5 -10 -15 -09 ec-10 ec-11 ec-12 ec-13 ec-14 -09 ec-10 ec-11 ec-12 ec-13 ec-14 -09 -10 -11 -12 -13 -14 Dec D D D D D Dec D D D D D Dec Dec Dec Dec Dec Dec JJ ALB nominal ▬▬ ALB real JJ BIH nominal ▬▬ BIH real JJ KOS nominal ▬▬ KOS real FYR Macedonia Montenegro Serbia 30 25 20 15 10 5 0 -5 -10 -15 -09 ec-10 ec-11 ec-12 ec-13 ec-14 -09 -10 -11 -12 -13 -14 -09 -10 -11 -12 -13 -14 Dec D D D D D Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec JJ MKD nominal ▬▬ MKD real JJ MNE nominal ▬▬ MNE real JJ SRB nominal ▬▬ SRB real Sources: Central bank and IMF data. Note: Growth in real credit is calculated as ex post real growth based on CPI inflation. The three-month moving average is the average of growth rates year-on- year. Some Concerns about Quality of Bank Assets Banks in SEE6 remained generally well- reductions in foreign bank funding, though the capitalized and liquid, and are moving to pace of reductions is now slower. Regulatory increased domestic deposit mobilization. As reforms and tighter supervision under the external financing became scarce and parent European Banking Union are creating pressures banks started deleveraging from the region, on some parent banks to further shrink their local banks worked to attract domestic sources balance sheets, reduce the amount of capital of financing. The robust pace of the growth in held in subsidiaries, or even sell subsidiaries. deposits-to-GDP ratios since the crisis allowed Nevertheless, for the region as a whole claims on Bosnia and Herzegovina, Montenegro, and non-bank borrowers declined more than claims Serbia, which had high loan-to-deposit (LTD) on banks, likely reflecting continued weakness ratios, to lower them notably (Figure 3.12). in corporate balance sheets. Funding costs, on the other hand, after easing for almost two Deleveraging in SEE6 slowed in 2015. years, started increasing in Q2 2015, reflecting Most countries in the region continued to see uncertainties about the Greek crisis and other 3. Supportive Policy Reforms are Ongoing  |  31 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 external factors, such as the slowdown in capital continuing concern are the large stocks of flows to emerging markets (Figure 3.13). foreign exchange lending to unhedged borrowers. For example, in Albania and Serbia While the SEE6 banking sector reduced the foreign currency lending is at 60 percent of number of non-performing loans, there are total lending. differences in asset quality at the individual bank level. The region’s commercial banks are High NPLs burden bank balance sheets, reasonably healthy, but provisioning for high undermine profits and capital, and suppress NPLs may erode some bank earnings and bank consideration of new lending—and capital buffers (Figure 3.14). Still-high NPLs reduce the general ability of banks to boost continue to put significant pressure on SEE6 economic activity (Figure 3.15). All SEE6 banking systems, although recently all SEE6 countries have moved to better resolve NPLs, Figure 3.12: Mobilization of domestic deposits Figure 3.13: After declining, credit risk moved is increasing up Loan-to-deposit ratio US$ million CDS spread, basis point 180 2,000 900 160 1,500 800 140 1,000 700 120 600 500 100 500 0 80 400 -500 60 300 40 -1,000 200 20 -1,500 100 0 -2,000 0 1 -11 -12 -13 r-14 -14 -15 BIH SRB MKD MNE KOS ALB r-1 Dec Sep Jun Dec Sep Ma Ma JJ Dec-15 QQ Peak level since 2006 JJ Change in BIS reporting banks external position vis-à-vis SEE6, lhs ▬▬ SEE6 sovereign CDS spread, bps, rhs Source: National authorities. Source: National authorities, BIS. Note: Country CDS spreads are those for Albania, FYR Macedonia, Montenegro and Serbia. Change in BIS reporting bank external position are for claims on SEE6 excluding Kosovo. countries except Serbia have seen improvements. either through their own initiatives or through On average, NPLs across the region declined in regional cooperation, such as the Vienna 2015 by about 1 percentage point, with the Initiative. Supervisory authorities in Albania, biggest declines in Montenegro, Albania and Montenegro, and Serbia have launched Kosovo. In Serbia, NPLs are about 23 percent; comprehensive programs to provide incentives but this might be underestimated due to loan for banks to take specific actions to promptly classification, according to the recent asset recover viable loans and enforce collection quality review in 14 banks. Moreover, pockets against nonviable borrowers. The authorities in of vulnerability among domestically-owned Bosnia and Herzegovina, Kosovo, and Serbia banks in Bosnia and Herzegovina and have initiated reforms to build up their Montenegro need to be addressed. Also a insolvency regimes. In FYR Macedonia and 32  |  3. Supportive Policy Reforms are Ongoing REBALANCING FOR STRONGER GROWTH Albania, regulators now require banks to write for the region are significantly dependent on off fully provisioned NPLs that are older than external developments, an analysis of alternative two years in the former and three years in the scenarios was recently conducted to help latter. Montenegro has off-loaded large NPL financial sector policymakers and regulators portfolios to special purpose vehicles belonging prepare for a range of possible futures (Box 3.4). to parent banks operating in the country. The analysis, while hypothetical, demonstrates how external shocks would have an immediate The global financial market outlook, impact on SEE6 financial systems and that external borrowing risks, EU regulatory and moving to improve the health of the financial supervisory reforms, and parent bank capital sector is an important risk-mitigating strategy constraints may all negatively affect financial that countries in the region should employ. sectors in the SEE6. Recognizing that prospects Figure 3.14: Banks are well-provisioned Figure 3.15: NPL ratios are improving, but remain far above pre-crisis levels Capital adequacy ratio Percentage point change Nonperforming loans, percent of total loans 25 1.5 30 1.0 25 20 0.5 20 15 0 15 10 -0.5 10 5 -1.0 5 0 -1.5 0 SRB KOS MNE MKD ALB BIH SRB ALB BIH MNE MKD KOS JJ Dec-14 JJ Q3/Q4 2015 QQ Change since Dec-14 JJ Dec-14 JJ Dec-15 QQ Pre-crisis level (end 2007) ‹‹ Average (2006–08) ‹‹ Peak since 2008 Source: National authorities. Source: National authorities. Box 3.4: 2025 Western Balkans Financial Systems Structure: Scenarios11 Because prospects for the region depend heavily on external developments, a regional scenario analysis portrays possible futures for SEE6 financial sectors. The objective was to support policymakers and regulators discussing strategic challenges and policy responses, and increase their understanding of the critical uncertainties SEE6 financial sectors will confront. The World Bank through consultations with stakeholders from the region and international development partners prepared the building blocks for the scenarios by identifying 14 areas of uncertainty that might prove to be major drivers of change. These cover global economic dynamics, geopolitics, financial regulation and markets, and technology-based innovation, as well as uncertainties more specifically related to the EU. 11 The 2025 scenarios and their regional implications are discussed in World Bank. 2016. Western Balkans Financial Sector Outlook. (forthcoming). 3. Supportive Policy Reforms are Ongoing  |  33 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Each scenario sketches out a different Figure B3.4.1: 2025 Financial Landscape shape the world could be in in 2025 Scenarios (Figure B3.4.1). The dynamism of the global  5 Banking regulation economy in the Shifting Orange scenario 4 presents booming financial innovation, but 3 also raises issues of mandate adequacy for 2 financial regulators. With the center of gravity Financial service 1 0 Banking FDI no longer in the old advanced countries, innovation this scenario is characterized by growth of multidimensional capital flows and major new players in the banking FDI scene. The turmoil in the global economy reflected in the Capital markets depth ▬▬ Orderly Blue ▬▬ Unsettling Grey ▬▬ Shifting Orange Unsettling Grey scenario raises problems for the Source: World Bank (2016). financial system, stemming from low growth Note: On the scale from 0 to 5, 3 represents the 2015 baseline. Higher environment and assumed political fragility, numbers (4 and 5) represent growth in bank FDI, deepened capital markets, increased financial innovation and tightened bank regulation including in the EU. Piecemeal innovation is compared to the 2015 baseline; and vise-versa for lower numbers taking place in capital markets, financial services (1 and 2). The methodology relies on identification of uncertainties followed by determination of end-points for each uncertainty with and payment systems. The positive evolution the aim to define the range in which each of the 2025 scenarios can possibly play. Based on the uncertainties and their end-points, built into of the EU economy and integration that the internally coherent stories of the future, the four dimensions are rated. Orderly Blue scenario would offer countries in the region many opportunities for banking and capital markets integration. Strengthening of banking regulation and its consequences is a significant feature of the Orderly Blue scenario. The Basel-driven regulatory environment, however, would have unintended effects because compliance costs and capital requirements act as a disincentive for small banks and for exposure through foreign subsidiaries on which the region is quite dependent. Figure B3.4.1 is an illustration of how select financial sector uncertainties (bank FDI, financial services innovation, bank regulation and capital market depth) were combined into internally coherent, and both plausible and provocative scenario plots. The scenarios are intended to facilitate regional and national conversations about the possible policy responses to the implied challenges and opportunities. As a first step, a seminar was held in Vienna on November 13, 2015, for regional stakeholders and international partners. Central to the discussions were topics of regional integration, management capabilities and corporate governance, technology, and the building of efficient and stable financial system the structuring of robust economic and financial sectors. EU harmonization was recognized as an important anchor of reform in the region. Cross-country harmonization will continue to be vital both for attracting and facilitating investments and for transferring knowledge. The scenario analysis gave a sense of the importance of acting now to ensure that all countries in the region arrive at 2025 with financial systems that are prepared to make the best possible contribution to economic growth and prosperity. Source: World Bank. 34  |  3. Supportive Policy Reforms are Ongoing 4. Sustaining the Rebalancing of Future Growth REBALANCING FOR STRONGER GROWTH Positive Near-Term Outlook with Downside Risks The near-term growth prospects for the SEE6 the reduction in current account deficits in are positive. Growth in the region is forecast to 2015, which was supported by lower oil prices, rise from 2.1 percent in 2015 to 3.0 percent in on average they are not projected to narrow 2017 because of recovering domestic demand further over the projection period. Although (boosted by investment and support from the gradual improvement in growth should consumption) and continuing support of help to generate employment and wage growth, exports. The dividends of ongoing structural overcoming structural weaknesses in SEE6 reforms in many of the countries of the region labor markets will be necessary to help reduce should also support growth over the medium poverty sustainably. term. Table 4.1: Growth trend to continue through 2017 Percent of GDP unless otherwise stated 2014 2015e 2016f 2017f Real GDP growth (percent) 0.3 2.1 2.6 3.0 Consumer price inflation (percent, period average) 0.9 0.9 1.6 2.0 Public revenues 34.7 35.0 35.3 34.7 Public expenditures 38.8 38.8 38.5 37.5 Fiscal balance -4.1 -3.8 -3.2 -2.8 Public and publicly guaranteed debt 52.1 55.1 56.9 57.4 Goods exports 24.3 25.2 25.6 26.7 Trade balance -17.0 -15.8 -15.2 -16.1 Current account balance -7.2 -6.3 -6.6 -6.8 External debt 64.6 67.3 68.0 67.7 Non-performing loans (percent of gross loans) 15.8 14.7 .. .. Unemployment rate (percent, period average) 22.5 21.7 .. .. Sources: Data from central banks and national statistical offices, World Bank staff projections. Within the aggregate SEE6 growth picture, Even though growth projections were revised there is marked country diversity. The upwards, the risks to the generally positive Serbian economy is growing more slowly outlook are weighted to the downside. than the others (at 2.3 percent in 2017 versus Growth in the SEE6 region for 2015 was 3.1–4.0 percent for the other SEE6 countries) revised from 1.8 percent in the SEE6 RER but its growth pick up in 2016 is the largest September 2015 edition to 2.1 percent with in the region. The narrowing in fiscal balances upward revisions for all countries. The risks on is expected to continue, although public and the downside are notable. They include volatile publicly guaranteed debt will continue to move international financial markets, slower-than- up to 57.4 percent of GDP in 2017. Following projected growth in major export markets, 4. Sustaining the Rebalancing of Future Growth  |  37 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 especially the EU, and the movement of global currency mismatches, in both private and oil prices, which could provide upside support public sectors, there is the risk of adverse to trade balances and consumption if prices balance sheet effects impacting investment, for are below projections. In terms of other global example. risks, given their lower trade linkages countries in the region are relatively insulated from direct In addition to the external risks, domestic spillovers from the slowdown in China and political dynamics are also likely to come the problems of the other BRICS, but they to the fore because several countries in the could be impacted via second-round channels, region have elections scheduled for 2016. particularly international financing conditions. Parliamentary elections are due in FYR Macedonia and in Serbia in the first half of As the turbulence in international financial 2016 and in Montenegro later, and there will markets has risen, so have financing risks. be local elections in Bosnia and Herzegovina. Early 2016 saw a significant sell-off in many While the political context clearly differs by equity markets, particularly in Europe, and country, in general as elections approach the a rise in spreads on emerging market bonds. appetite for progress on reforms tends to wane. The mid-year referendum on a possible British Given the external conditions, the extent to exit from the EU and geopolitical factors are which either incumbent or new governments also weighing on market sentiment. Given sustain progress on necessary structural and significant external and fiscal financing needs fiscal reforms will be a key determinant of the international market volatility exacerbates growth outlook. refinancing risks. Furthermore, if there are Rebalancing the Drivers of Growth and Addressing Twin Deficits The global financial crisis forced an (Figure 4.1). In line with this adjustment, the adjustment in the region’s current account SEE6 economies saw shifts in the drivers of deficits that eventually led to a rebalancing growth from predominantly domestic to of sources of growth in SEE6 countries. Prior external ones. In the years after the 2008 crisis, to the global financial crisis, SEE6 economies with decreased inflows of remittances and large grew unsustainably: with consumption fueled contractions of domestic credit, consumption by public spending, remittances and excessive fell from 101 percent of GDP in 2007 to capital inflows. After the crisis, with drastically 95 percent in 2015. On average, domestic reduced capital inflows and private transfers demand fell by 9 percent of GDP in the same from abroad, the SEE6 economies were forced period, while net exports share in the economy to undertake adjustment to reduce their increased by 10 percent of GDP, leading to an external financing needs. As a result, the region’s increased role of net exports in growth (Figure average current account deficit fell from 4.2). 18.5 percent in 2007 to 6.6 percent in 2013 38  |  4. Sustaining the Rebalancing of Future Growth REBALANCING FOR STRONGER GROWTH Figure 4.1: Current account imbalances Figure 4.2: Economic structures are narrowed somewhat in 2015, but remain high rebalancing from domestic to external demand Current account deficit, percent of GDP 2009–17 Decomposition of structure of GDP, change between 2007 and 2015, percentage points of GDP 0 21 -5 15 -10 9 -15 -20 3 -25 -3 -30 -9 -35 -15 -40 -45 -21 MNE ALB KOS BIH SRB MKD SEE6 MNE SRB ALB BIH KOS MKD SEE6 JJ 2007 JJ 2009 JJ 2014 JJ 2015f JJ 2016f JJ 2017f JJ Change in domestic demand 2007–15 JJ Change in net exports 2007–15 Source: Data from central banks and national statistical offices, World Bank Source: World Bank staff calculations based on data from national staff projections. statistical offices. Figure 4.3: Labor costs starting to move more Figure 4.4: External debt ratios have risen in line with labor productivity Increases in real value added per worker and real wages in local External debt, percent of GDP currency, percent annually 14 160 12 140 10 120 8 6 100 4 80 2 60 0 40 -2 20 -4 2004–09 2010–15 2004–09 2010–15 2004–09 2010–15 2004–09 2010–15 2004–09 2010–15 0 MNE BIH MKD SRB ALB MNE SRB MKD BIH ALB KOS SEE6 JJ VA/worker growth ‹‹ Real wages growth JJ 2007 JJ 2009 JJ 2015 Source: Data from central banks and national statistical offices, World Bank Source: Data from central banks and national statistical offices, World Bank staff projections. staff projections. Rebalancing towards exports has been depreciation that was seen for some countries supported by wages moving more in line over 2014 and 2015, this fall in the relative with productivity. Before the global financial pace of labor costs increases compared with that crisis, real wages grew much faster than worker of productivity has allowed SEE6 to expand productivity, creating concerns about the exports and their contribution to growth. competitiveness of the SEE6 economies (Figure 4.3). As part of the rebalancing process, while But with low interest rates post-2008, value added continued growing at a modest external debt rose to finance still sizeable pace, real wages have been nearly flat during the current account and fiscal deficits. When 2010–15 period. In combination with the real countries grow fast or enjoy low interest rates 4. Sustaining the Rebalancing of Future Growth  |  39 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 on their debt, they can sustain relatively higher as governments and corporates took advantages debt levels. In 2008, the nominal growth rate of lower yields. As a result external debt has in the SEE6 countries was between 6 and risen in parallel with public debt for many 14 percent higher than the effective interest countries making them vulnerable on both rate on public debt, pushing down debt ratios. fiscal and external sides (Figure 4.6). The need In 2015 this differential was between 1.7 percent to raise resources to finance these twin deficits is and minus 2.3 percent.12 While primary fiscal intensifying pressure for structural reforms. On balances have narrowed since the global the external side, net current account financing financial crisis, the SEE6 have ended up with needs are in the order of 7 percent of GDP notably higher public debt-to-GDP ratios through the projection period. Gross external (Figure 3.6). Moreover, SEE6’s growth to financing needs are even higher (for example, effective interest rate differential worsened 26 percent of GDP in Bosnia and Herzegovina substantially compared to 2007 (Figure 4.5). and 13 percent of GDP in Serbia in 2016).13 Similarly, fiscal amortization requirements have Countries with both fiscal and external risen with the increase in the size of debt. For imbalances are at a particular disadvantage to example, Serbia’s gross fiscal financing needs compete for scarce financing options. While are estimated at 17 percent of GDP in 2016 FDI flows and remittances have increased, with a deficit projected at just under 4 percent debt-financing inflows also rose in recent years of GDP. Figure 4.5: Weak growth, growing interest Figure 4.6: Twin deficits restrict policy options costs and high deficits put pressure on public in the face of deteriorating external conditions debt sustainability Primary fiscal balance percent of GDP in 2015; nominal growth Fiscal balance, percent of GDP 2007 and 2015 rate minus effective interest rate on public debt 4 8 KOS 07 SEE6 2007 MNE 07 6 2 4 SEE6 07 0 2 MKD EMG 07 BIH 07 SRB 07 ECA 07 BIH 0 KOS BIH KOS 15 15 -2 SEE6 2015 -2 SRB 07 MKD ALB ECA 15 EMG 15 ALB 07 -4 MKD -4 ALB 15 SEE6 SRB 15 15 15 MNE -6 MNE 15 -6 -8 -5 0 5 10 15 -40 -35 -30 -25 -20 -15 -10 -5 0 Percent Current account balance, percent of GDP 2007 and 2015 Source: Ministries of Finance, World Bank, IMF. Source: World Bank calculations based on data from central banks and Note: Bubble size is total public debt (percent of GDP) and interest rate national statistical offices, IMF World Economic Outlook. is the nominal effective interest rate of public debt. For a given primary Note: EMG refers to the IMF’s Emerging and Developing economies balance, a higher nominal growth rate and lower effective exchange rate classification of countries and ECA refers to Europe and Central Asia will reduce the debt-to-GDP ratio. classification of countries by the World Bank. 13 See recent IMF Article IV reports. Gross financing needs include 12 Sample for 2008 excludes Kosovo. debt amortization. 40  |  4. Sustaining the Rebalancing of Future Growth REBALANCING FOR STRONGER GROWTH Going forward the availability and cost of the availability of financing could require a financing may be impacted by uncertainty sharper current account adjustment, either arising from the political cycle in a number through an adjustment in relative prices (i.e. of countries and by any downturn in the exchange rate) or volumes (contraction international financing conditions. As such, in domestic absorption). Put another way, in it will be important to ensure that domestic such a scenario a lack of significant further policy stances are supportive of financing fiscal consolidation would require a marked inflows, particularly more stable FDI which rise in private sector net saving, potentially has performed relatively strongly in 2015. dampening investment and growth. Otherwise, there is a risk that a tightening of Improving Productivity is Paramount for Boosting Potential Growth As SEE6 economies rebalanced post-crisis, Labor markets dynamics and human capital the contribution of total factor productivity accumulation seem to have contributed (TFP) to economic growth has fallen, often little to regional growth in the past 15 years. into the negative territory. Before the crisis, With activity rates at about 50 percent of the growth rates of capital accumulation had been population and persistently low employment, supported by large capital inflows, domestic human resources have been consistently under- credit expansion and low interest rates, and used in SEE6 during the last 15 years. Albania moderated as these inflows declined in the and Bosnia and Herzegovina have had stable post-crisis period. Labor, measured by the employment shares, while Serbia’s employment broad proxy of working age population, has declined in the pre-2008 period; only in played a minor but steady role, reflecting the FYR Macedonia employment expanded. The demographic dynamics in the region with low underutilization of labor had been aggravated birth rates and large out-migration. Total factor prior to crisis by increasing labor costs, as real productivity (TFP) growth provided strong wages grew faster than productivity gains in support during the pre-crisis period, most most countries of the region during the boom notably in Serbia, but it became negative in the years (Figure 4.3). While education attainment post crisis period (Figure 4.7).14 increased, particularly in tertiary education where enrollment rates more than doubled since the early 2000s, the quality of education 14 The growth accounting exercise is based on the Solow model and covers data for 2000–2014. Despite its many well established remains low compressing the returns to caveats, this simple exercise can provide some intuition about the main drivers of GDP growth during the last 15 years. Annual education and lowering the quality of human GDP is assumed to be a function of the aggregate physical capital stock (K) and labor (L), following a Cobb-Douglas technology. In the absence of consistent employment data for all countries, the working age population (age 15–64) is used as a proxy for factors of production—but likely also hides the impact from a labor. In the absence of data on capital stocks, physical capital is combination of factors including skills and labor market dynamics estimated through a highly simplified perpetual inventory method. (i.e. converting the working age population into employed human In this simple growth accounting exercise, TFP includes the main capital), enabling factors that affect the overall efficiency of the component—efficiency with which the economy uses the main economy, as well as technological progress. 4. Sustaining the Rebalancing of Future Growth  |  41 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Figure 4.7: Productivity subtracted from Figure 4.8: Total factor productivity levels have growth post-crisis in most countries at best stagnated since 2008 Contributions to annual average real GDP growth Estimated index of TFP level (2008=100) 10 110 8 105 100 6 95 4 90 2 85 0 80 -2 75 2000–08 2000–08 2000–08 2000–08 2000–08 2000–08 2009–14 2009–14 2009–14 2009–14 2009–14 2009–14 70 0 2 4 6 8 0 2 4 ALB BIH KOS MKD MNE SRB 200 200 200 200 200 201 201 201 JJ Capital stock JJ Working age pop. (15–64) JJ TFP QQ GDP ▬▬ ALB ▬▬ BIH ▬▬ KOS ▬▬ MKD ▬▬ MNE ▬▬ SRB Source: World Bank staff calculations. Source: World Bank staff calculations. capital. As an example, in Montenegro and Addressing structural rigidities is crucial to Albania, more than half of the students could unleashing SEE6 productivity performance not reach minimum proficiency in reading and and economic potential and for increasing math on the PISA test. Skill gaps have been living standards of the population. While identified as particularly severe in the region. cyclical factors such as lower oil prices and external recovery are expected to drive the SEE6 Boosting growth in SEE6 requires a reversal outlook in the near term, addressing structural of this deteriorating productivity dynamics. issues along five policy fronts are required to Productivity dynamics have deteriorated dismantle the key obstacles to productivity significantly since the global financial crisis performance and sustainable growth in SEE6:15 (Figure 4.8). Physical and human capital inputs clearly have very important roles to 1. Eliminate disincentives and barriers play in improving the region’s potential growth to formal employment. Labor markets (see, for example, the discussion on public across the region are anemic. They suffer investment management in the preceding from persistently high unemployment, section). But the need to enhance productivity low labor force participation, high levels performance is of particular importance, given potential headwinds for investment dynamics from financing costs and time 15 This section is based on several Systematic Country Diagnostics (SCD) reports prepared by the World Bank. lags for improving human capital and skills. The SCD for Albania can be found at http://www-wds. worldbank.org/external/default/WDSContentServer/WDSP/ Generating productivity gains consistently IB/2015/07/31/090224b083041523/2_0/Rendered/PDF/ faster than competitors is what will ensure the Next0generatio0m0country0diagnostic.pdf; the Bosnia and Herzegovina SCD can be found at http://www-wds. continuation of successful sources of growth worldbank.org/external/default/WDSContentServer/WDSP/ IB/2015/11/16/090224b0831becfd/1_0/Rendered/PDF/ rebalancing toward export and investment in Rebalancing0Bo0c0country0diagnostic.pdf; the Serbia SCD SEE6. can be found at http://documents.worldbank.org/curated/ en/2015/06/24559780/serbia-systematic-country-diagnostic. SCDs in other SEE6 countries are also in preparation. 42  |  4. Sustaining the Rebalancing of Future Growth REBALANCING FOR STRONGER GROWTH of informality and sluggish formal job state is also a priority for policy reform in creation. Sticky unit labor costs have the SEE6. undermined competitiveness, constraining the scope of external rebalancing of 3. Enhance the equity, quality and economies. Labor market outcomes are efficiency of public services and social particularly weak among some groups protection systems, while reducing of the population such as youth, Roma the governments’ footprint. In most and women. Reducing labor law rigidity SEE6 countries, the public sector tends would help to activate the most vulnerable to deliver public services that are too groups on the mostly dual labor markets expensive and can improve in quality. in the region; the laws overprotect insiders Addressing structural rigidities related to and largely exclude youths, females, and the efficiency, size, equity and quality of elderly from the labor force. Reforms to public service delivery, while maintaining education systems to better align them fiscal sustainability, is a key policy agenda. with skills the labor market demands and For example, improving the delivery of remove disincentives and barriers to formal health services is particularly important labor engagement are shown to have because it has potential spillovers to human meaningful impacts for growth. Increasing capital and productivity of workers. At income-generating opportunities in the the same time, ensuring that vulnerable labor market, including for the less well- groups are effectively and efficiently off and excluded, is critical to boost growth protected will remain central to addressing prospects and increase living standards issues of poverty and inclusion in the across SEE6. region. Efforts targeted at reinforcing pension systems, improving the targeting 2. Improve the business climate and and coverage of social protection systems, governance. Even though some progress modernizing benefits administration, and has been made in easing the problems making active labor market programs of the investment climate, including more effective would have important regulatory simplification (e.g., in FYR social impacts, while contributing to Macedonia and Montenegro), there is needed fiscal consolidation. still room for improvement. Applying the law in a non-discretionary and consistent 4. Deepen regional and global integration. manner and protecting rights to property Improving the physical and institutional (including land) and contracts are central connectivity of the SEE6 within and to ensure a level playing field. Regulatory across the region and the rest of the world reforms that simplify legislation, promote would help make these countries more e-governance, and establish one-stop competitive, supporting domestic and registration shops, are shown to reduce foreign firms in reaching beyond established business costs and encourage private markets and products. Advancing in sector development in countries around the EU accession process represents an the world. Improving the governance of opportunity for the SEE6 to pursue an EU SOEs and reducing their burden on the integration agenda that will have positive 4. Sustaining the Rebalancing of Future Growth  |  43 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 impact on potential growth through improved trade and export performance. For all SEE6 countries, strategically upgrading obsolete infrastructure would boost economic potential—provided such investments target projects with strong economic returns and do not threaten the sustainability of public debt. 5. Ensure sustainable use of energy and natural resources and stewardship of the environment. The energy sectors of SEE6 economies are inefficient. Persistent distribution losses, regulated tariffs that are below cost recovery, and low collection rates lead to recurrent energy shortages (especially, in economies that rely heavily on hydro generation) as well as either high costs for the private sector or an extra burden on public finances, or both. Addressing these issues would make the energy sectors financially viable, ensure reliable energy supplies, and support economic growth. The SEE6 are endowed with natural beauty, cultural heritage, and resources that, used well, can boost long- term national growth potential. However, SEE6 countries are also among those most vulnerable to natural hazards and weather changes, which necessitate efforts to build resilience against them. 44  |  4. Sustaining the Rebalancing of Future Growth 5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH Albania Albania’s economy grew by 2.6 percent in 2015, supported by robust private investment. The pace of expansion is expected to gradually continue at 3.2 percent in 2016, and 3.5 percent in 2017. Investment in the Trans Adriatic Pipeline and a hydropower plant in the Southern Albania will help expand domestic demand. As fiscal consolidation takes course, government spending will be limited. Public debt is expected to start heading down in 2016 as a result of the fiscal consolidation measures approved in the 2016 budget law. The medium-term outlook depends on the pace and depth of additional structural reforms in the energy and financial sectors and better management of public investment in infrastructure. Judicial reform is also crucial to make the investment climate more attractive and revive credit growth. Albania’s economy continued to recover Figure 1. Real GDP, Annual Growth Rates and in 2015, supported by robust private Economic Sentiment Indicator, 2012–15 investment. Real GDP grew by 3 percent in the In percent Right axis 6 120 third quarter, maintaining positive momentum, 5 and is estimated to have expanded 2.6 percent 4 100 for the full year. Growth was led by a recovery 3 80 in private investment; gross fixed capital 2 60 formation increased by 12.6 percent (y-o-y) in 1 the third quarter. Imports of machinery and 0 40 equipment expanded by 13.6 percent (y-o-y) -1 20 in the last quarter, a sign of robust investment -2 growth. After three consecutive quarters of -3 0 12 12 13 13 14 14 15 15 Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- decline, household consumption went up JJ Real GDP, annual growth rates, lhs ▬▬ Economic sentiment indicator, rhs 1.9 percent (y-o-y) in the third quarter. Growth Source: Bank of Albania, INSTAT. in consumer loans, higher trade, consumer confidence, and VAT receipts all reinforced the positive consumption trend in the last quarter. Growth in the first three quarters of 2015 was Affected by unfavorable international oil and led by construction (14.2 percent y-o-y) and mineral prices, real exports fell by 2 percent services (2.8 percent),especially health and (y-o-y), but because real imports also fell, net administrative services. In the last quarter, the exports contributed positively to growth. confidence of businesses in trade, construction, and industry improved, but fell for services other than trade. Industrial businesses increased capacity utilization and reported more export contracts. In construction, new permits for 5. SEE6 Country Notes  |  47 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 nonresidential buildings and investments in Sustained growth stimulated modest job hydropower and telecommunications went creation in 2015. Jobs increased in non-market up in the third quarter. Government capital services, and agriculture, the biggest employer. expenditures were concentrated in the last Growth in employment, by 1.9 percentage quarter, supporting an expansion of this sector. points (pp) was accompanied by more people moving into the labor force (1.9 pp), leading Inflation was below the target band. Average to a modest 0.4 pp decline in unemployment annual inflation reached 1.9 percent in 2015, to an average of 17.1 percent for 2015. Youth below the Bank of Albania’s target of 3±1 percent. unemployment (those aged 15–29) declined Because low external inflation and the negative by 1.7 pp from a year earlier but was still high output gap continue to put downward pressure at 32.2 percent. The disparity in labor force on prices, the Bank of Albania kept an participation by males and females remained accommodative monetary policy, reducing the high at about 20 basis points. main policy rate to a historic low of 1¾ percent in November 2015. Although T-bill yields and The current account deficit (CAD) is deposit rates responded quickly, rates on loans estimated to have narrowed in 2015. After are falling more slowly. In the fourth quarter declining for the first two quarters, the CAD the Albanian lek appreciated slightly against expanded by 10.1 percent annually in the the euro, up 1.4 percent (y-o-y). By yearend third quarter. The net result for the year is an the real effective exchange rate had appreciated estimated 11.4 percent, lower than in 2014. 2.5 percent. The deterioration was caused by worsening lower balance of trade in goods and services and Concerned about high NPLs, quality an 18.1 percent decline in remittances. Despite of projects, and difficulties in enforcing a large expansion in tourism exports, exports contracts, banks were reluctant to expand of goods and services dropped by 3.4 percent credit. The banking sector continued to be because of lower oil and minerals prices. Total profitable. The capital adequacy ratio held at imports contracted by 1.9 percent due to lower 15.7 percent in the fourth quarter, far in excess merchandise imports. In the third quarter of the regulatory minimum of 12 percent. capital controls on banks in Greece limited Risk aversion by banks that are still plagued the extent to which transfers could be made by high NPLs continues to suppress credit to Albanian families, which contributed to a growth, although policy initiatives such as drop in remittances. However, large inflows in write-off of old loans have brought NPLs down the same quarter that are identified as “errors to 18.2 percent from their peak of 25 percent and omissions” suggest that such transfers in September 2014. Lending requirements might have taken place through other means. for households relaxed in the second part of Despite declining in the third quarter by the year, but credit to business remains tight, 4.5 percent, net FDI financed about 70 percent partially because it is difficult to enforce of the current account deficit. Issuance of contracts and execute on collateral through the €450 million in Eurobonds in early November court system. complemented the external financing and helped build up international reserves, which 48  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH at year-end exceeded five months of goods and primary surplus of 0.3 percent—an adequate services imports. pace of consolidation. The budget proposes tighter control of expenditures and increased Figure 2. Fiscal Balance and Public Debt, revenues through more effective administration. 2010–17 Tax adjustments, which aim at broadening the In percent of GDP In percent of GDP tax base, will have only a minor role. 0 80 70 -1 On February 5, 2016, Standard & Poor’s 60 raised its long-term foreign and local currency -2 50 sovereign credit ratings on the Republic of -3 40 Albania from B to B+ and confirmed short- -4 30 term foreign and local currency sovereign 20 credit ratings at B, still below investment -5 10 grade like the rest of the region. S&P assessed -6 0 the outlook as stable, on the expectation that 2010 2011 2012 2013 2014 2015 2016 2017 fiscal performance will remain strong through JJ Public debt, rhs ▬▬ Overall balance, lhs Source: Ministry of Finance and INSTAT data. 2019 as authorities continue to make progress on an International Monetary Fund (IMF) program that targets fiscal and structural The budget deficit remained on track despite reforms. Earning a higher rating would require a shortfall in revenues. The budget deficit is continued structural reforms, more robust estimated to have reached 4.8 percent of GDP fiscal institutions, and more encouraging in 2015, down from 5.9 percent in 2014. The economic prospects. However, if government outturn in 2015 included arrears clearance of finances begins to deteriorate, potentially tied 1.3 percent of GDP. Revenues are estimated to noncompliance with conditions in the IMF to have underperformed by approximately arrangement, the rating will be lowered. 4.2 percent against the revised budget plan. The shortfall was greater in VAT and excise The Albanian economy is expected to duties, reflecting both problems in revenue accelerate gradually. Growth will emerge with administration and forecasting issues, such as a pickup in investment in large FDI-financed under-estimation of tax credits, and also lower infrastructure projects, such as the Trans than expected GDP growth, interest rates, and Adriatic Pipeline and a hydropower plant in oil prices. However, a spike in non-tax revenues Southern Albania, and with gradual recovery of due to one-off sales of mobile telecom licenses consumption. Net exports are expected to grow worth 0.4 percent of GDP, interest savings, and as the EU also gradually recovers. Improvement under-execution of spending by 1.2 percent of in the business climate and reforms to address GDP across the board kept the budget in line high NPLs could further strengthen private with expectations. Public debt continued to rise investment and consumption in the medium and is estimated to have reached 72.2 percent of term. Fiscal consolidation, supported by the GDP by yearend. In December, the Parliament 2016 budget exercise, limits the push from adopted the 2016 budget, which targets a the government side. Growth is projected to headline deficit of 2.5 percent of GDP and a reach 3.2 percent in 2016 and 3.5 percent in 5. SEE6 Country Notes  |  49 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 2017. Growth prospects for Albania hinge on Priorities are to address high NPLs, reinforce tax accomplishing the structural reform agenda administration and close loopholes, undertake on energy, management of public investment, additional reforms in the energy sector, improve and pensions. Reforms already in progress are public investment management, and mitigate expected to both promote growth and have the fiscal risks associated with local government positive distributional effects. Going forward, arrears, public-private partnerships, and claims it will be critical to maintain the momentum for compensation. on reforms and fiscal consolidation efforts. Figure 3. Unemployment and Employment, Figure 4. Current Account Balance, FDI and 2012–15 Other Investments, 2013–15 In percent In € billions 60 400 50 300 200 40 100 30 0 20 -100 -200 10 -300 0 -400 12 12 13 13 14 14 15 15 13 13 13 13 14 14 14 14 15 15 15 Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- Q1- Q2- Q3- ▬▬ Employment ▬▬ Unemployment JJ Current account JJ Direct investment JJ Other investment Source: INSTAT data. Source: CBCG and MONSTAT data. Figure 5. GVA Growth by Sector, 2013–15 Figure 6. General Government Revenues, Expenditures, and Deficit, 2009–17 In percent In percent of GDP In percent of GDP 6 35 0 4 30 -1 2 25 -2 20 -3 0 15 -4 -2 10 -5 -4 5 -6 -6 0 -7 12 12 13 13 14 14 15 15 Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- 2009 2010 2011 2012 2013 2014 2015 2016 2017 JJ Agriculture JJ Extractive industry JJ Manufacturing JJ Overall balance, lhs ▬▬ Total revenue and grants, rhs JJ Construction JJ Trade, hotels and restaurants, transport ▬▬ Expenditures, rhs JJ Communications JJ Other services Source: MOF and INSTAT data. Source: INSTAT data. 50  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH Figure 7. Confidence Survey Indicators, Figure 8. General Government Debt, 2010–15 2010–15 Differences of balances In percent of GDP 20 80 10 70 60 0 50 -10 40 -20 30 20 -30 10 -40 0 10 10 11 11 12 12 13 13 14 14 15 15 Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- 2010 2011 2012 2013 2014 2015 2016 2017 ▬▬ Trade ▬▬ Consumption ▬▬ Services ▬▬ Industry ▬▬ Construction ▬▬ Total PPG debt Source: INSTAT data. Source: MoF and INSTAT data. Figure 9. Monetary Aggregates, Annual Growth Figure 10. CPI Inflation, 2010–15 and NPLs, 2009–15 In percent In percent, y-o-y 35 5 30 25 4 20 3 15 10 2 5 1 0 -5 0 r-0 9 r-1 0 r-1 1 r-1 2 r-1 3 r-1 4 r-1 5 -10 Jul-10 an-11 Jul-11 an-12 Jul-12 an-13 Jul-13 an-14 Jul-14 an-15 Ma Ma Ma Ma Ma Ma Ma Jan J J J J J ▬▬ Broad money growth ▬▬ NPL ratio ▬▬ Credit growth Source: INSTAT data. Source: BoA data. 5. SEE6 Country Notes  |  51 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 ALBANIA 2012 2013 2014 2015e 2016f Real GDP growth (percent) 1.6 1.1 2.0 2.6 3.2 Composition (percentage points): Consumption 0.3 1.2 3.0 -2.3 2.2 Investment -2.3 -0.8 0.9 2.2 3.2 Net exports 3.7 0.7 -1.8 2.7 -2.2 Exports -0.3 3.5 -6.0 1.1 Imports (-) 4.0 -2.8 4.4 1.7 Consumer price inflation (percent, period average) 2.0 1.9 1.6 1.9 2.3 Public revenues (percent of GDP) 24.7 23.7 26.2 26.3 27.4 Public expenditures (percent of GDP) 28.2 29.2 32.1 31.1 29.6 Of which: Wage bill (percent of GDP) 5.2 5.2 5.1 5.0 4.7 Social benefits (percent of GDP) 9.0 9.5 9.9 9.9 10.0 Capital expenditures (percent of GDP) 4.6 4.8 4.3 4.3 3.9 Fiscal balance (percent of GDP) -3.5 -5.5 -5.9 -4.8 -2.5 Primary fiscal balance (percent of GDP) -0.3 -1.7 -3.1 -2.2 0.3 Public and publicly guaranteed debt (percent of GDP) 62.0 70.4 71.8 71.9 70.7 Of which: External (percent of GDP) 26.9 26.6 29.6 33.5 34.6 Goods exports (percent of GDP) 15.9 18.2 9.3 8.0 7.5 Goods imports (percent of GDP) 36.8 36.1 30.8 28.7 29.1 Net services exports (percent of GDP) 2.2 -0.2 2.7 3.8 3.5 Trade balance (percent of GDP) -18.7 -18.0 -18.8 -16.9 -18.1 Remittance inflows (percent of GDP) 9.2 7.1 7.2 6.9 6.7 Current account balance (percent of GDP) -10.1 -10.7 -12.9 -11.4 -13.1 Foreign direct investment inflows (percent of GDP) 6.8 9.6 8.1 7 7.9 External debt (percent of GDP) 35.7 34.7 36.9 42.3 42.9 Real private credit growth (percent, period average) 4.6 -3.5 -1.4 0.6 0.9 Non-performing loans 24 24.1 22.4 18.2 17.5 (percent of gross loans, end of period) Unemployment rate (percent, period average) 13.4 16 17.5 17.1 16.8 Youth unemployment rate (percent, period average) 28.5 29.7 35.6 32.3 32 Labor force participation rate 57.3 52.5 53.7 55.7 56 (percent, period average) GDP per capita, PPP (current international $) 10,517.94 10,947.65 11,390.71 11,872.41 12,484.42 Poverty rate at US$5/day, PPP 47.5 47.2 46.7 46.2 45.5 (percent of population) Sources: Country authorities, World Bank estimates and projections. Notes: Financial sector data for 2015 reflect year-to-date annual rolling averages unless otherwise stated. Youth unemployment rate is for labor force aged 15–29. 52  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH Bosnia and Herzegovina Growth in Bosnia and Herzegovina (BH) is likely to have reached 2.8 percent in 2015. Growth was higher than earlier expected with a supportive external environment boosting net exports and domestic activity rebounding from the impact of 2014 floods. Reforms are being advanced in a number of key areas, supported by the medium-term Reform Agenda that the authorities agreed on in mid-2015. Among them are major changes in labor laws, a new insolvency law recently adopted in one of the constituent entities, Republika Srpska (RS), and continuing pension and social assistance reforms in the Federation of Bosnia and Herzegovina (FBH). Adoption of the Reform Agenda and progress on realizing it are also the basis for the country’s application for EU membership, which was submitted in mid-February 2016. However, the outlook for improved growth over the medium term is based on sustained implementation of long-standing reforms. Recent developments earnings were stagnant throughout 2015 across most sectors (up only 0.5 percent y-o-y in Economic growth was better than earlier nominal terms). expected in 2015, pushed up by a strong recovery from the impact of the previous Figure 1. Real GDP Growth, 2012–15 year’s floods. Net exports were the main driver In percent y-o-y of growth, with consumption also supportive 5 and investment a drag on growth. Real GDP 4 expanded by 4.3 percent year-on-year (y-o-y) in 3 Q2—the highest rate in the last five years—and 2 by 3.1 percent in Q3. On the production side, 1 manufacturing and retail trade contributed 0 around half the growth of real value added in -1 the first three quarters of 2015. High frequency -2 data suggest softening GDP dynamics in -3 late 2015, and we projected growth to be Q3 2012 Q4 Q1 Q2 2013 Q3 Q4 Q1 Q2 2014 Q3 Q4 Q1 Q2 2015 Q3 ▬▬ Federation of BH ▬▬ Republika Srpska 2.8 percent for 2015 as a whole. JJ BH overall Source: Statistical offices. The growth pick-up has not been reflected in labor market performance. Unemployment Lower commodity prices, particularly for remains high, at 27.7 percent, with the number oil, continued to affect the economy of BH of persons in paid employment rising by only through a number of channels, most notably 1.9 percent y-o-y in November 2015. Net the trade balance and the impact on domestic 5. SEE6 Country Notes  |  53 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 prices. Taken as a whole, the economic impact The reduction in the current account deficit seems to be net positive because lower prices (CAD) in 2015 was mainly the result of the supported real disposable income, reduced real declining trade deficit. The CAD is estimated input costs, and reduced net imports. However, to have narrowed from 7.8 percent in 2014 to price deflation and minimal income growth 6.3 percent of GDP in 2015. This was driven raised the real burden of debt, with potential by the reduction in the trade deficit for goods; impact on household and corporate financial in nominal US dollar terms, while the services health. surplus and remittances were relatively stable. In terms of net external financing, net FDI Consumer price deflation persists, driven inflows are estimated to have dropped from by lower prices for imported goods. The 3 percent of GDP in 2014 to about 1.5 percent, consumer price index (CPI) dropped by leaving significant dependence on debt- 1.3 percent y-o-y in December, the 13th creating inflows. This level of FDI does not consecutive month of declines, with the CPI provide much support for domestic investment now up only 3 percent from its 2010 average. rates (about 18 percent of GDP) or potential The biggest drivers were falls in prices of positive spillovers to economic growth. imported goods and goods linked to the H2 2015 declines in euro-denominated oil prices, Collections of gross revenue from indirect primarily food (down 1.5 percent y-o-y), taxes went up in 2015. Collections increased clothing and footwear (down 8.3 percent), by 1.7 percent y-o-y in 2015, led by higher and transport (down 6.1 percent). Meanwhile excise tax collections, which contributed alcohol and tobacco saw notable price rises, with 1.1 percentage points (pp) to the growth in smaller rises for education, health, housing, and indirect tax revenue; of this 0.6 pp was due to utilities. Given the limited growth in nominal the excise tax on petrol and 0.4 pp to the excise salaries, declining consumer prices provided tax on tobacco. some boost to real incomes. The net monthly salary in December 2015 averaged €421, down The fiscal deficit is expected to remain little by 0.1 percent y-o-y in nominal terms. changed at 2 percent of GDP in 2016. Nonetheless, there are some positive signs of The trade deficit continued to improve, improvements in budgetary processes and though at just under 30 percent of GDP it steps toward much-needed improvements is still significant. Lower oil prices brought in the quality and structure of spending. For down imports of related products, and example, a moratorium on public employment improved external demand supported exports. was introduced for 2016, and pension reforms Monthly data indicate that in 2015 imports fell continue in FBH. Given previous delays in by 2.1 percent y-o-y while exports, mainly to budget adoption, particularly following the neighbors and the EU, increased by 3.5 percent, need to form governments in 2015 for FBH although growth fell late in the year. The trade and the BH Institutions, adoption in late 2015 deficit, valued in euros, fell by 8.7 percent, to of all three 2016 budgets is a positive early sign €3.5 billion. of how fiscal policy will be implemented this year. 54  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH Still, 2016 budget allocations are considerably Financial sector support to economic activity higher than in 2015. Both Houses of the has been constrained by deleveraging and by BH Parliament Assembly adopted the 2016 rising concerns about asset quality. While the BH State Budget without amendments. banking sector remains stable and now relies That budget amounts to about €880 million less on foreign financing, many of the foreign- (approximately 6 percent of estimated 2016 BH owned banks that dominate the banking GDP), of which €486 million is for financing system have been gradually deleveraging. This state institutions and €394 million for servicing has contributed to falling credit growth, which foreign debt. While the former amount is the averaged only 3.0 percent y-o-y from 2009 same level as in the four previous years, foreign through December 2015; between 2003 and debt servicing is about 29 percent higher than 2008 credit had grown by 24 percent a year. was budgeted for 2015. Furthermore, the In addition, the share of nonperforming loans Federation parliament adopted a budget with (NPL) in commercial bank portfolios was expenditures of €800 million (5.5 percent high, reaching 13.7 percent as 2015 ended. of estimated 2016 BH GDP), up 11 percent High provisioning for NPLs has caused some over the 2015 budget, with net lending of deterioration in bank profitability. Asset €155 million (1 percent of estimated 2016 BH quality concerns make it hard to reestablish GDP). In the RS the overall budget increased bank profitability, mainly because the country’s to €1.6 billion (11 percent of overall GDP), corporate resolution and insolvency laws 40 percent higher than in 2015. The main are inadequate. In a positive development, difference is to the inclusion for the first time however, RS has recently adopted a new of the RS Pension and Disability Insurance insolvency framework. Fund in the RS Budget and Treasury System. At €31 million, net lending is unchanged from The entities have launched a number of 2015. The central government budgets do not reform initiatives as part of the Reform cover spending by lower levels of government; Agenda adopted in mid-2015. Both RS and general government spending for 2016 is FBH have new labor laws to address long- projected at about 46 percent of GDP). standing rigidities in their labor markets and to support job creation. However, the FBH In Bosnia and Herzegovina monetary constitutional court recently ruled that the policy continues to be run through a FBH law needed to return to Parliament to have currency board with the euro as the anchor procedural violations resolved and in March currency. International reserves in 2015 were a the labor law in FBH is returned to Parliament comfortable 6 months or so of imports. Given procedure. Other reforms underway include its linkage to the euro, the BH convertible mark reinforcing unemployment benefit systems (BAM) has seen sustained depreciation against and, in FBH, pension reforms. Addressing the dollar but nominal appreciation recently public sector arrears and reforming SOEs are against the currencies of some trading partners. also priorities. BH submitted its application for This contributed to some appreciation in both EU membership in mid-February 2016. the nominal and the real effective exchange rate in late 2015, although in recent years the latter has been restrained due to weak price growth. 5. SEE6 Country Notes  |  55 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Outlook depends, however, on sustained reforms, and the absence of adverse shocks to external trade Supported primarily by growth in and financial conditions. consumption, medium-term economic growth is likely to strengthen to above Achieving prudent, efficient, and effective 3 percent. Although the recovery in EU import fiscal policy within a highly decentralized demand will lead to a moderate rise in exports, fiscal system is central to BH’s multi- given the relative strength of import demand, dimensional reform agenda. Although net external demand will continue to be a drag deficits remain relatively moderate, the fiscal on growth. External conditions will, however, sector is still characterized by a high tax burden support a stable inflow of remittances, which, and inefficient patterns of spending. Fiscal combined with sustained lower oil prices, will consolidation will not be effective if structural promote a gradual pick-up in consumption, rigidities on the expenditure side are not keeping it a key driver of growth. Investments unaddressed, especially the large public wage in energy and tourism will support growth bill and sizeable and poorly targeted social in investment generally. As a result of these assistance. The proposed IMF program, and dynamics, real GDP growth is projected to support from other partners like the World strengthen gradually from 2.8 percent in Bank, can help the authorities to deliver on 2015 to 3.5 percent in 2018. This projection their challenging agenda. Figure 2. Growth in Industrial Production and Figure 3. GDP Growth on the Production Side, Retail Trade 2012–15 In percent y-o-y Real percent change y-o-y 20 3.5 3.0 15 2.5 2.0 10 1.5 5 1.0 0.5 0 0 -0.5 -5 -1.0 -1.5 -10 -2.0 -13 ep-13 ec-13 ar-14 un-14 ep-14 ec-14 ar-15 un-15 ep-15 ec-15 Jun S D M J S D M J S D 2012 2013 2014 2015f ▬▬ Industrial production ▬▬ Retail trade turnover JJ Agriculture value added JJ Industry value added Source: BH Agency for Statistics. JJ Services value added QQ Overall GDP growth Source: BH Agency for Statistics, World Bank. 56  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH Figure 4. Consumer Price Inflation Figure 5. Real Indirect Tax Revenues In percent y-o-y In euro In percent y-o-y 8 40 15 6 30 4 20 10 2 10 0 0 5 -2 -10 0 -4 -20 -6 -30 -5 -8 -40 -10 -50 -10 -12 Jul-12 an-13 Jul- 13 -14 Jul- 14 -15 Jul- 15 -13 -13 Jul-13 ct-13 an-14 pr-14 Jul-14 ct-14 an-15 pr-15 ct-15 Jan J Jan Jan Jan Apr O J A O J A O JJ BH overall CPI inflation ▬▬ BH transport CPI inflation ▬▬ Growth in total indirect revenues in 2010 prices, 3mma yoy ▬▬ Change in Brent oil price, rhs ▬▬ Growth in net indirect revenues in 2010 prices, 3mma yoy Source: BH Agency for Statistics. Source: Indirect Tax Office, World Bank. Figure 6. General Government Fiscal Balance Figure 7. Growth in Exports and Imports, and the Goods Trade Balance In percent of GDP 3mma percent y-o-y In KM billions 0 20 8 -1 10 4 -2 0 0 -3 -4 -10 -4 -5 -20 -8 -12 Jul- 12 -13 Jul- 13 -14 Jul- 14 -15 Jul- 15 2009 2010 2011 2012 2013 2014 2015f Jan Jan Jan Jan Source: Fiscal authorities, World Bank Staff est. JJ Trade balance ▬▬ Exports, rhs ▬▬ Imports, rhs Note: f=forecast. Source: BH Agency for Statistics, World Bank. Figure 8. Real and Nominal Effective Exchange Figure 9. Banking Sector Performance Rates Indicators 2009=100, ‘+’ denotes appreciation In percent 110 20 15 105 10 100 5 0 95 -5 90 -10 09 09 10 10 11 11 12 12 13 13 14 14 15 15 09 09 10 10 11 11 12 12 13 13 14 14 15 15 Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- ▬▬ NEER ▬▬ REER JJ Capital adequacy, tier 1 capital to risk weighted assets Source: Central Bank of BH, World Bank Staff calculations. ▬▬ Asset quality, NPL to total loans ▬▬ Profitability, return on equity Source: Central Bank of BH, World Bank Staff calculations. 5. SEE6 Country Notes  |  57 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 BOSNIA AND HERZEGOVINA 2012 2013 2014 2015e 2016f Real GDP growth (percent) -0.9 2.4 1.2 2.8 2.6 Composition (percentage points): Consumption 0.7 2.0 Investment 0.1 1.0 Net exports 2.0 -0.4 Exports 1.0 0.7 Imports (-) 0.9 -1.1 Consumer price inflation (percent, period average) 2.0 -0.1 -0.9 -1.0 -0.5 Public revenues (percent of GDP) 44.5 43.4 43.8 44.5 43.2 Public expenditures (percent of GDP) 46.6 45.6 45.8 46.3 45.2 Of which: Wage bill (percent of GDP) 12.9 12.5 12.0 11.7 11.4 Social benefits (percent of GDP) 17.1 16.8 17.1 17.1 16.9 Capital expenditures (percent of GDP) 3.2 4.0 4.3 4.4 4.4 Fiscal balance (percent of GDP) -2.0 -2.2 -2.1 -1.8 -2.0 Primary fiscal balance (percent of GDP) -1.5 -1.2 -1.3 -0.7 -1.0 Public debt (percent of GDP) 39.5 36.4 39.0 39.8 41.4 Public and publicly guaranteed debt (percent of GDP) 44.3 40.8 43.0 43.8 45.2 Of which: External (percent of GDP) 27.8 28.2 30.1 30.6 31.3 Goods exports (percent of GDP) 22.6 24.3 24.2 23.9 23.6 Goods imports (percent of GDP) 53.5 52.0 53.9 51.6 51.0 Net services exports (percent of GDP) 7.0 6.8 6.8 7.3 7.5 Trade balance (percent of GDP) -24.0 -20.8 -22.9 -20.4 -19.9 Remittance inflows (percent of GDP) 8.1 8.1 8.5 8.4 8.3 Current account balance (percent of GDP) -8.8 -5.7 -7.8 -6.3 -6.4 Foreign direct investment inflows (percent of GDP) 2.0 1.7 2.6 1.4 1.7 External debt (percent of GDP) 52.8 53.9 50.8 54.0 55.1 Real private credit growth (percent, period average) 1.0 1.9 4.0 2.2 2.5 Non-performing loans 13.5 15.1 14.2 14.1 14.0 (percent of gross loans, end of period) Unemployment rate (percent, period average) 28.1 27.5 27.5 27.7 27.5 Youth unemployment rate (percent, period average) 63.3 58.8 62.9 62.3 62.1 Labor force participation rate 44.0 43.6 43.7 44.1 44.3 (percent, period average) GDP per capita, PPP (current international $) 9,214.0 9,562.8 9,808.0 10,359.6 10,500.0 Poverty rate at US$5/day, PPP (percent of population) Sources: Country authorities, World Bank estimates and projections. Notes: Labor market data for 2015 are preliminary. Credit growth for 2015 reflect year-to-date annual rolling averages. Non-performing loans show year-to-date actuals. 58  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH Kosovo Fueled by domestic demand, real economic growth reached an estimated 3.6 percent in 2015 and is projected to remain little changed in 2016. Consumption and investment contributed positively to growth, but the contribution of net exports was negative due to weaker trade revenue in the last quarter driven by a fall in export of base metals, Kosovo’s main commodity. Foreign direct investment went up by 150 percent in 2015, with more originating in the EU after Kosovo signed the Stability Association Agreement. Despite solid revenue growth of 9.4 percent, fiscal adjustment was needed so that Kosovo could honor its fiscal rule that, with few exceptions, caps budget deficits at 2 percent of GDP. The IMF approved a 22-month, €184-million Stand-by Arrangement (SBA) on July 29, 2015. The first SBA review was concluded positively in January 2016. The country’s economic performance will be similar in 2016 subject to political stability and a successful start of FDI in the Brezovica Ski Resort. Recent developments and industry contributed 0.4 pp, mainly, as was expected, from significant growth in Despite political instability, the Kosovo electricity production in 2015—a leveling economy performed well in 2015. Growth effect after production was interrupted in 2014 for the year is estimated at 3.6 percent, driven by an explosion near the Kosovo A power plant. by domestic demand. Investment contributed Public administration continued to have a 4.1 percentage points (pp) to growth. Private negative effect on growth. investment was boosted by more foreign direct investment (FDI) and greater access to mortgage External imbalances widened in 2015. The loans; public investment also intensified at the current account deficit went from 7.9 percent end of the year. Private consumption added of GDP in 2014 to 9.4 percent because of large an estimated 0.9 pp, fueled by an increase of profits of foreign-invested companies, and as 9 percent in remittances and by higher wages the accelerated construction of the highway to and pensions since 2014. Net exports had FYR Macedonia (more funding was allocated a negative 1.3 pp contribution to growth during the fiscal year) required more imports as exports fell in the last quarter. Exports of of investment goods that pushed up transport goods contributed only 0.1 pp to growth for services by 47.3 percent. More Kosovars the year and the contribution of imports was traveled abroad, although visa liberalization has negative by 1.4 pp. On the production side, not yet been granted for Schengen countries, services were the main contributor to growth so that imports of travel services went up with 1.3 pp, mainly from private investment 7 percent. Exports of goods and services lost and public highway construction. Agriculture, their initial steam (11.3 percent growth y-o-y forestry, and fishing together added 0.7 pp, was recorded through June) and were flat 5. SEE6 Country Notes  |  59 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 by yearend compared to a year before. The fiscal adjustment. The initial budget, which slowdown in China brought down the prices of had been based on overoptimistic revenue base metals, Kosovo’s main commodity export, projections, was corrected through a fiscal and slashed exports of goods late in the year. consolidation in the mid-year budget review. Exports of telecommunication services were Among the revenue measures adopted were an depressed by 30 percent because of the spread increase in the VAT rate from 16 to 18 percent of new technologies. and improvements in tax collection, which produced 0.8 pp of GDP. Also helpful were Figure 1. Real GDP Annual Growth Rates, lower execution of the original budget (cuts Kosovo, 2008–15 on goods and services, the wage bill, and In percent war veteran benefits) by about 1 pp of GDP. 5.0 4.5 4.4 Better tax collection was a major factor in the 4.5 generation of 9.4 percent more revenue than 4.0 in 2014. One-off revenues of 1.1 percent of 3.6 3.6 3.3 3.4 3.5 2.8 GDP from partial liquidation of privatization 3.0 2.5 fund increased Kosovo’s yearend bank balances. 2.0 Spending grew by 8.5 percent, mainly due to 1.5 1.2 higher current spending on wages and pensions. 1.0 Almost half of public investment spending 0 was executed in the last quarter. At yearend 2008 2009 2010 2011 2012 2013 2014 2015 Kosovo was able to allocate more funding Source: Kosovo Agency of Statistics (SAK) data. Note: 2015 growth is an estimate based on data for Q1–Q3 from SAK. than originally budgeted for the highway to Macedonia by transferring resources scheduled for nonperforming capital projects. This will Financial account balances went up by also reduce the highway financing burden in 180 percent in 2015, with inflows of FDI coming years. recovering. Net FDI inflow in 2015 more than doubled to about 5.3 percent, reflecting in Deflation of 0.5 percent was recorded in substantial part reinvested earnings by foreign- 2015. Kosovo, a price taker, benefited from invested companies (this is part of the negative falling global fuel prices. The decline in global amount recorded in the current account deficit). prices for transportation fuel that began in Most FDI originates in the EU but in 2015 a the second half of 2014 continued, leading significant amount came from Turkey. This is to deflation in Kosovo throughout 2015. The a very positive development that complements costs of higher education and accommodation progress toward EU accession with the signing services also plunged. A slight decline in food of the Stabilization Association Agreement in prices in the second half of the year helped to 2015. Real estate, rentals, and business activities mitigate poverty very slightly. continued to attract most of the FDI. In 2015 Kosovo’s financial sector was The 2015 fiscal deficit was 1.9 percent of profitable and credit grew 7.3 percent. GDP (below the 2 percent fiscal rule cap), Commercial bank profits shot up by thanks to healthier revenues and a timely 56.5 percent y-o-y, driven by spending cuts. 60  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH Though improving, financial intermediation Macedonia. Net exports will continue to reduce in Kosovo is still underdeveloped. As rates fell, growth by 0.3 pp because, although both will interest rate spreads narrowed by an average increase, imports will have a larger base than of 2.9 pp to 7.1 percent. Lower interest rates exports. The near-term outlook assumes no heightened private credit by 7.3 percent (y-o-y) further political disruptions and preservation with credit growing faster to households of 2015’s positive trend in FDI inflows. The (10.6 percent, y-o-y) than to businesses countries economic performance will be (5.7 percent). Meanwhile, deposits grew similar in 2016 subject to political stability 6.4 percent. Transferable deposits, which are and successful start of FDI in the Brezovica Ski 60 percent of the total, grew more (23 percent); Resort. time deposits declined by 8.4 percent for households but went up 8.1 percent for The fiscal stability achieved by the corporations. consolidation efforts in mid-2015 is expected to be preserved in the near term. Nonperforming loans (NPLs) are coming The 2016 draft budget is in line with the down. After peaking at 8.8 percent in February IMF program, which should reinforce fiscal 2014, by January 2016 they were down to stability. The recent approval of the investment just 6.2 percent of total loans, with the trend amendment to the current fiscal rule will both continuing in the right direction. NPLs are open up additional fiscal room for productive now lower in Kosovo than in the other SEE6 investments in strategic sectors and boost countries. Both corporate and household NPLs public investments and economic growth in are dropping, mainly due to the successful work coming years. of private enforcement agents. Outlook Economic growth in Kosovo is expected to remain little changed in 2016 and 2017, assuming sustained consumption growth, rising exports, and starting investments of the FDI-financed Brezovica Ski Resort. Domestic demand is expected to drive positive growth but net exports will continue to be negative. Consumption is expected to contribute 2.4 pp to growth; private consumption should be up 2.6 pp, but public consumption will go down by 0.2 pp. Investments will add 1.4 percentage points to growth. Private investments will continue to be fueled by FDI, such as that for Brezovica. The public investments will benefit from higher spending on the highway to 5. SEE6 Country Notes  |  61 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Figure 2. Growth in Aggregate Demand, Figure 3. Growth in the Economy by Sector, 2012–15 2010–14 In percent In percent 8 5 6 4 3.4 3.6 4 2.8 3 2 1.2 2 0 1 -2 0 -4 -1 -6 -2 2012 2013 2014 2015 2011 2012 2013 2014 2015 JJ Consumption JJ Investments JJ Net exports ▬▬ Real GDP growth JJ Agriculture JJ Industry JJ Services Source: Statistics Agency of Kosovo and World Bank. JJ Taxes less subsidies ▬▬ Real GDP growth Source: Statistics Agency of Kosovo and World Bank. Figure 4. Current Account Balance and FDI, Figure 5. General Government Deficit, by 2011–15 Quarter, 2013–15 In percent of GDP In euros In percent of GDP 10 600 4 2 5 500 0 0 400 -2 -4 -5 300 -6 -10 200 -8 -10 -15 100 -12 -20 I II III IV I II III IV I II III IV I II III IV 0 -14 2012 2013 2014 2015 Q1-14 Q2-14 Q3-14 Q4-14 Q1-15 Q2-15 Q3-15 Q4-15 JJ CAD JJ FDI net JJ Revenues JJ Expenditures ▬▬ Fiscal deficit, rhs Source: Central Bank of the Republic of Kosovo and World Bank. Source: Ministry of Finance and World Bank. Figure 6. Annual Growth in Loans, 2012–15 Figure 7. General Government Debt, 2008–15 In percent In percent of GDP 20 14 18 12 11.9 16 10.6 10 9.3 14 8.6 12 8 10 6.1 6.3 5.9 8 6 6 4 4 2 2 0 0 -12 Jul-12 -13 Jul- 13 -14 Jul- 14 -15 Jul- 15 -16 Jan Jan Jan Jan Jan 2009 2010 2011 2012 2013 2014 2015 ▬▬ Total loans ▬▬ Loans to corporations ▬▬ Loans to households Source: Ministry of Finance. Source: Central Bank of the Republic of Kosovo. Figure 8. Nonperforming Loans, 2008–15 Figure 9. CPI and PPI, 2011–14 In percent of total loans In percent of growth 10 12 9 10 8 7 8 6 6 5 4 4 3 2 2 1 0 0 -2 r-0 -0 r-1 -1 r-1 -1 r-1 -1 r-1 -1 r-1 -1 r-1 -1 -16 9 9 0 0 1 1 2 2 3 3 4 4 5 5 11 11 12 12 1-13 3-13 1-14 3-14 1-15 3-15 Ma Sep Ma Sep Ma Sep Ma Sep Ma Sep Ma Sep Ma Sep Jan Q1- Q3- Q1- Q3- Q Q Q Q Q Q Source: Central Bank of the Republic of Kosovo. ▬▬ CPI ▬▬ PPI Source: Statistics Agency of Kosovo. 62  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH KOSOVO 2012 2013 2014 2015e 2016f Real GDP growth (percent) 2.8 3.4 1.2 3.6 3.6 Composition (percentage points): Consumption 2.7 2.3 3.8 0.9 2.4 Investment -4.4 -0.1 -1.4 4.1 1.4 Net exports 4.5 1.2 -1.2 -1.3 -0.3 Exports 0.1 0.4 3.0 0.1 0.3 Imports (-) 4.4 0.8 -4.2 -1.4 -0.7 Consumer price inflation (percent, period average) 2.5 1.8 0.4 -0.5 0.5 Public revenues (percent of GDP) 25.9 25.2 24.4 25.4 26.6 Public expenditures (percent of GDP) 28.5 28.1 27.0 27.3 28.4 Of which: Wage bill (percent of GDP) 8.1 7.9 9.1 9.3 9.2 Social benefits (percent of GDP) 3.7 4.2 6.1 6.9 7.4 Capital expenditures (percent of GDP) 10.8 10.1 7.5 7.4 7.8 Fiscal balance (percent of GDP) -2.6 -2.9 -2.6 -1.9 -1.8 Primary fiscal balance (percent of GDP) -2.4 -2.5 -2.4 -1.6 -1.5 Public debt (percent of GDP) 8.2 9.0 10.6 11.9 15.2 Of which: External (percent of GDP) 6.7 6.1 6.0 6.4 7.5 Goods exports (percent of GDP) 5.6 5.5 5.9 5.6 5.7 Goods imports (percent of GDP) 46.3 43.1 43.5 42.3 41.7 Net services exports (percent of GDP) 6.4 5.9 6.1 5.6 5.6 Trade balance (percent of GDP) -34.3 -31.8 -31.5 -31.2 -30.4 Remittance inflows (percent of GDP) 12.0 11.7 12.7 13.2 13.5 Current account balance (percent of GDP) -7.5 -6.9 -8.1 -9.4 -9.6 Foreign direct investment inflows (percent of GDP) 4.2 4.7 2.8 5.2 5.5 External debt (percent of GDP) 7.3 6.5 6.4 6.5 7.4 Real private credit growth (percent, period average) 5.8 1.9 3.0 7.3 Nonperforming loans (percent of gross loans, end of 7.5 8.7 8.5 6.2 period) Unemployment rate (percent, period average) 30.9 30.0 35.3 33.3 Youth unemployment rate (percent, period average) 55.3 55.9 61.0 60.0 Labor force participation rate (percent, period 36.9 40.5 41.6 42.6 average) GDP per capita (US$) 3,600.7 3,877.2 4,052.7 3,551.0 3,629.0 Sources: Country authorities, World Bank estimates and projections. Notes: Credit growth for 2015 reflects year-to-date annual rolling averages. Non-performing loans show year-to-date actuals. 5. SEE6 Country Notes  |  63 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 FYR Macedonia FYR Macedonia’s economic growth remained robust at 3.7 percent in 2015, despite the political turmoil. Growth was driven by rising private consumption and higher public spending. Net exports made a small contribution to growth. The trade deficit narrowed in 2015, but net FDI inflows declined. The fiscal deficit was slightly lower than the budget had projected but still higher than that in the Medium Term Fiscal Strategy. Growth is expected to accelerate gradually in the medium term, but a prolonged political turmoil would affect this outlook negatively. GDP growth remained robust in 2015, also picked up toward the end of 2015. Exports despite the political turmoil. Preliminary (mostly FDI related) continued to perform well data indicate that FYR Macedonia’s economy growing by 4.6 percent y-o-y. Imports growth expanded by 3.7 percent in 2015. Growth was was almost flat in the first three quarters, but largely driven by construction (16.8 percent), a significant increase in FDI related imports wholesale and retail trade (7.3 percent) in the last quarter propelled imports growth and services (3.4 percent), particularly real to 2.4 percent for the full year. Net external estate, fueled by buoyant credit growth. demand contributed favorably (although Manufacturing output contracted by 2 percent modestly) to GDP growth (0.7 percent y-o-y). as the recovery in the second half of 2015, partially compensating for the slowdown earlier Deflation persisted in 2015. Falling global in the year. Finally, agriculture production has food and oil prices influenced domestic price slowed down, despite receiving increasing movements and led to a general price decline of subsidizes. 0.3 percent. Meanwhile, core inflation went up slightly, by 0.5 percent, driven by higher prices On the demand side, growth was largely for pharmaceuticals and IT equipment. driven by consumption, both private and public. Increasing employment combined Widespread job creation caused with higher real wages, pensions, and social unemployment to fall further in 2015. transfers, led to a 3.2 percent increase in Employment rose by nearly 1 percent in private consumption in 2015. Government 2015, due to new hires in manufacturing, consumption also increased sharply in 2015 public administration and services (especially (4.6 percent), especially in the second half of the accommodations and financial and real year. Gross investment rebounded in the third estates). Labor force participation remained quarter, propelled by increased public outlays stable at 57.2 percent. Unemployment dropped on highway construction. Growth in long-term to an average of 26.1 percent in 2015, from credit to firms suggests that private investment 28.1 percent in 2014. Youth unemployment 64  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH also eased significantly, from 53.1 percent in by 19 percent (y-o-y), to about 17 percent of 2014 to 47.3 percent in 2015, helped by costly GDP. youth employment programs. Still, long-term unemployment remains a problem: 61 percent The current account deficit widened slightly of the registered unemployed report having in 2015, and net FDI inflows declined. Private been without a job for more than a year. transfers, though slightly lower than in 2014, were still enough to cover the trade deficit, Figure 1. GDP Growth by Sector alleviating external financing pressures. The In percent current account deficit widened to 1.4 percent 14 of GDP, up from 0.8 percent in 2014. The 12 deficit is mainly financed by FDI. Net FDI 10 decreased by 14 percent (y-o-y) in 2015, falling 8 to 1.9 percent of GDP from 2.3 percent in 2014. 6 This was largely due to capital outflows in May 4 2015 (the height of the political uncertainties 2 in the country and the Greek crises) and later in 0 September and November. As in 2014, reserves -2 covered 4.6 months of imports. -4 13 2-13 3-13 4-13 1-14 2-14 3-14 4-14 1-15 2-15 3-15 4-15 Q1- Q Q Q Q Q Q Q Q Q Q Q JJ Manufacturing JJ Construction JJ Wholesale & retail, transp., accomm. Credit continued to expand and the financial JJ Other services JJ Mining, electricity, gas supply JJ Agriculture ▬▬ Real GDP growth sector is sound. Non-performing loans (NPLs) Source: State Statistics Office data. fell to 10.6 percent in December, thanks to a decline in corporate NPLs. The banking sector remains highly liquid (28.5 percent on average Exports grew faster than imports in 2015, in Jan-Sep 2015). Profitability increased in the narrowing the trade deficit. Exports increased first three quarters of 2015, and the capital by 9.0 percent (y-o-y) in euro terms in 2015, adequacy ratio held at 16 percent, well above though they declined by the same amount in the mandated 8 percent. Credit growth reached US dollar terms as the denar, which is pegged 9.5 percent (y-o-y) in 2015, slightly below to the euro, depreciated against the dollar. the 9.8 percent in 2014; household lending Most of the growth was driven by FDI-related accounted for 57 percent of the expansion. exports, which account for almost 40 percent of total exports. Exports from traditional The fiscal deficit narrowed in 2015, in part segments, such as iron and steel, ores and slag, due to some payments that were deferred to and tobacco, declined. Export destinations 2016. Total revenues amounted to 28.8 percent became more concentrated: 44 percent of of GDP in 2015, up from 27.8 percent in 2014. exports (mainly parts and components related The increase was driven by reintroduction of to the automobile sector) went to Germany, up a profit tax on non-reinvested earnings (not from 41 percent in 2014. After declining in the collected since 2009), and by higher social third quarter, imports rebounded as the year contributions linked to the improved labor ended, leading to 2015 growth of 5.5 percent market. VAT, which accounts for almost one- (y-o-y). As a result, the trade deficit narrowed third of tax revenues, underperformed despite 5. SEE6 Country Notes  |  65 higher growth and consumption. This result in the first two months, €57 million in new is probably due to a combination of factors, domestic debt was issued. among them declining oil prices, weaknesses in revenue collection, and a growing VAT-exempt FDI segment. Expenditures increased less than Outlook revenues in 2015, but at 32.3 percent of GDP, this represents an increase from 32 percent in Growth is expected to remain robust at 2014. This increase largely reflects higher public 3.7 percent in 2016 and increase to 4 percent wages, pensions, social transfers, and spending in 2017. Public investment will continue on goods and services, especially in the second to be an important driver of growth as the half of 2015. The central government under- construction of the two highways is scheduled executed capital spending despite increases to end by 2018. Private consumption should projected in the mid-year budget revision. continue to be strong, supported by increasing However, capital spending by nongovernment employment and possibly higher public wages, public agencies compensated for government pensions, and social transfers. FDI exports underperformance. The central government are expected to continue increasing as the EU deficit reached 3.5 percent of GDP in 2015, market gradually recovers, but the contribution lower than the revised budget (3.7 percent) and of net external demand will continue to be the result of 2014 (4.2 percent). The difference modest. between actual and projected deficits mainly reflects transfers of contributions by the state- The political uncertainty and refugee funded pension fund to private funds (about crises are the primary risks to the economy 0.1 percent of GDP) that were related to 2015 over the coming year. General elections are but deferred to January 2016. currently scheduled for June 5, 2016, subject to satisfactory resolution of issues related to the After declining in the first half of the year, voters registry, and the law on media. Prolonged public debt rose in the second half to a level political uncertainties could affect investment higher than a year earlier. Public debt fell decisions and slow economic activity. Escalation from 46 percent of GDP in December 2014 to of the current refugee crises may also be a risk, 43.7 percent in July 2015 following prepayment especially if the EU decides to close its borders of debt to the IMF (€154 million). Government or significantly limit the inflow. issuance of a €270 million Eurobond and increased domestic net borrowing by € 94 million caused debt to rise in 2015. State guarantees associated with large investment projects, including two highways, added another 0.8 percent of GDP, which by year-end brought total public debt to 46.4 percent of GDP. Debt is expected to continue to expand in 2016 driven by increasing financing needs for the still high deficit level and the sizable State Owned Enterprises investment portfolio; REBALANCING FOR STRONGER GROWTH Figure 2. Business Tendencies in Figure 3. Labor Market Developments, Manufacturing 2004–15 Index In percent In percent 25 65 70 64 20 63 60 62 15 61 50 10 60 40 59 5 58 30 57 0 56 20 1 3 1 3 1 3 1 3 1 4 1 4 1 4 1 4 1 5 1 5 1 5 1 5 4 5 6 7 8 9 0 1 2 3 4 5 - - - - - - - - Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct - - - - 200 200 200 200 200 200 201 201 201 201 201 201 JJ Average level of capacity utilization of the business entities, rhs ▬▬ Unemployment rate ▬▬ Employment rate ▬▬ Assessment of the current business situation of the business entity ▬▬ Activity rate ▬▬ Youth unemployment ▬▬ Confidence indicator Source: State Statistics Office (Labor Force Survey). Source: State Statistics Office data. Figure 4. The Main Components of the CPI, Figure 5. Current Account Balance, Trade 2012–15 Deficit and Private Transfers, 2006–15 Period average yoy, percent change In percent of GDP 20 30 15 25 10 20 5 0 15 -5 10 -10 5 -15 0 -20 -5 -25 -30 -10 -35 -15 12 12 12 12 13 13 13 13 14 14 14 14 15 15 15 15 Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 ▬▬ CPI total ▬▬ Food & beverages JJ Trade deficit JJ Private transfers ▬▬ Current account balance ▬▬ Electricity, gas & other ▬▬ Fuels & lubricants Source: National Bank data. Source: State Statistics Office data. Figure 6. Central Government Budget Figure 7. Public Debt by Government Level, Execution, 2006–15 2006–15 In percent of GDP In percent of GDP In percent of GDP 36 1 50 45 34 0 40 32 -1 35 30 30 -2 25 20 28 -3 15 26 -4 10 5 24 -5 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 JJ Budget balance, rhs JJ Upward budget balance revisions JJ Central government JJ Funds ▬▬ Revenues, lhs ▬▬ Expenditures, lhs JJ Municipalities JJ Guaranteed debt of SOEs Source: Ministry of Finance and WB staff estimates. Source: National Bank data. 5. SEE6 Country Notes  |  67 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Figure 8. Credit Growth and Contribution to Figure 9. Nonperforming Loans, 1/2012– Credit Growth, 2012–15 12/2015 In percent y-o-y In y-o-y percent change In percent of total by category 100 12 20 90 18 80 10 16 70 8 14 60 12 50 6 10 40 8 30 4 6 20 2 4 10 2 0 0 0 12 12 13 13 14 14 15 15 -12 Jul-12 -13 Jul-13 an-14 Jul- 14 -15 Jul- 15 Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Jan Jan J Jan JJ Contribution of household loans, lhs JJ Contribution of corporate loans, lhs ▬▬ Corporate NPLs ▬▬ Household NPLs ▬▬ Total NPLs ▬▬ Credit growth, rhs Source: National Bank data. Source: National Bank data. 68  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH MACEDONIA, FYR 2012 2013 2014 2015e 2016f Real GDP growth (percent) -0.5 2.9 3.5 3.7 3.7 Composition (percentage points): Consumption 1.4 1.4 1.6 3.0 1.7 Investment 3.0 0.1 3.8 0.0 1.7 Net exports -4.2 1.3 -1.7 0.7 0.3 Exports 0.9 2.6 8.0 2.3 2.2 Imports (-) -5.1 -1.3 -9.7 -1.6 -1.9 Consumer price inflation (percent, period average) 3.3 2.8 -0.3 -0.3 0.9 Public revenues (percent of GDP) 32.1 30.2 29.8 30.9 31.1 Public expenditures (percent of GDP) 36.0 34.2 34.0 34.4 34.5 Of which: Wage bill (percent of GDP) 7.7 7.2 7.0 6.9 6.8 Social benefits (percent of GDP) 16.6 17.5 17.3 17.5 17.7 Capital expenditures (percent of GDP) 5.2 4.4 4.3 4.4 4.1 Fiscal balance (percent of GDP) -3.8 -3.9 -4.2 -3.5 -3.4 Primary fiscal balance (percent of GDP) -2.9 -2.9 -3.2 -2.3 -2.3 Government debt (percent of GDP) 33.7 34.2 38.2 37.9 39.6 Public and publicly guaranteed debt (percent of GDP) 38.3 40.5 45.9 46.4 48.9 Of which: External (percent of GDP) 25.6 25.6 31.9 31.2 33.0 Goods exports (percent of GDP) 30.4 29.1 32.5 33.5 34.4 Goods imports (percent of GDP) 56.9 51.9 54.2 53.4 54.1 Net services exports (percent of GDP) 4.1 4.6 4.2 3.8 4.0 Trade balance (percent of GDP) -22.4 -18.2 -17.5 -16.3 -15.7 Remittance inflows (percent of GDP) 2.4 2.2 2.2 2.1 2.1 Current account balance (percent of GDP) -3.2 -1.6 -0.8 -1.4 -1.7 Foreign direct investment inflows (percent of GDP) 1.7 2.8 2.3 1.9 2.1 External debt (percent of GDP) 66.1 64.0 69.8 69.7 70.1 Real private credit growth (percent, period average) 3.7 1.0 8.5 9.4 9.6 Non-performing loans 10.3 11.3 11.1 10.6 10.3 (percent of gross loans, end of period) Unemployment rate (percent, period average) 31.0 29.0 28.0 26.1 25.2 Youth unemployment rate (percent, period average) 54.0 51.9 53.1 47.3 46.0 Labor force participation rate 56.5 57.3 57.5 57.2 57.4 (percent, period average) GDP per capita, PPP (current international $) 11,874 12,468 12,938 13,330 13,797 Poverty rate at US$5/day, PPP 19.2 19.1 18.7 17.3 16.4 (percent of population) Sources: Country authorities, World Bank estimates and projections. Notes: Labor market indicators and credit growth for 2015 reflect year-to-date annual rolling averages. Non-performing loans show year-to-date actuals. Poverty rates are based on FYR Macedonia survey on income and living conditions (SILC). 5. SEE6 Country Notes  |  69 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Montenegro Economic growth is likely to have nearly doubled to 3.4 percent in 2015, fueled by investment—especially of the Bar-Boljare highway—and exports of tourism services. Although activity and employment rates reached historical highs, unemployment was also high at 17.6 percent. Stronger tourism receipts also helped narrow external imbalances, despite struggling goods exports, lower metal prices and Russian trade sanctions. After consolidation measures reduced the fiscal deficit to 3.1 percent of GDP in 2014, a rise in highway- related capital expenditures and revenue underperformance in 2015 pushed the general government deficit back up to 7 percent. As a result, public debt headed up toward 68 percent of GDP . Highway construction and tourism Figure 1. Real GDP Growth, 2011–15 underpinned economic recovery in 2015. In percent 8 After growing 1.8 percent in 2014, real GDP 5.9 6 expanded by an estimated 3.4 percent in 5.2 4.2 4.2 2015 (ESA2010 methodology). Growth was 4 3.6 3.1 3.2 3.0 3.7 2.5 supported by investment, both public and 2 2.1 1.6 private, especially in the second half of the 0 0.7 0.3 year as tourism projects and construction of -0.5 -2 a priority motorway section took off. Healthy -2.1 -2.5 -3.0 growth in exports of services, particularly -4 -3.6 tourism, supported the economy: tourist arrivals -6 11 11 12 12 13 13 14 14 15 15 expanded by 12.9 percent and overnight stays Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Source: MONSTAT. by 15.7 percent. Government consumption also grew, and higher household consumption boosted retail trade, which surged by 2 percent Although growth recovered, the labor market in 2015. response was sluggish. Survey data pointed to 1 percent fewer unemployed by September A recovery of domestic demand spurred compared to the same period of 2014; inflation in 2015. After increasing throughout agriculture and service-related activities helped 2015, 12-month consumer prices grew by increase employment by 2.7 percent year- 1.4 percent in December. On average, although on-year (y-o-y). As a result, the four-quarter oil prices continued to drop, annual inflation unemployment rate dropped to 17.6 percent amounted to 1.5 percent, up from negative though that was still high. Administrative 0.7 percent in 2014, driven by higher prices for employment data in the last quarter of 2015 food and clothes. showed a decline, and unemployment increased again, pushing the year-end unemployment 70  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH rate to 18.8 percent—1.9 percentage points Net FDI surged in 2015. Net FDI amounted more than in December 2014. to 17.2 percent of GDP largely because of surge in investments in companies and banks, mostly Labor inactivity remains high. The activity from Austria and Ukraine. Two more banks rate rose to 53.5 percent and the employment were given licenses during the course of 2015, rate to 44.1 percent, but both are very low with one more becoming operational in early compared to EU peers. A new law introduced 2016, resulting in a total of 15 banks for a small a limited quota of work permits for foreign market of 620 thousand citizens. workers, with the strict requirement to employ those available through the local unemployment Lending gradually recovered in 2015. After bureau. Further, amendments to the Law on falling by 1.9 percent in 2014, total lending Social and Child Care introduced lifetime grew by 0.8 percent in 2015. While corporate benefits for women giving birth to three or and household borrowing grew by 3 percent, more children in the amount of 70 percent of government and financial institutions reduced the average net wage. Women qualifying are also their borrowing from the banking sector. With entitled to health insurance (with a condition of total deposits surging by 13.7 percent annually, having 25 years of service for mothers of three driven mostly by corporate savings, the loan- or 15 years of service for mothers of four or to-deposit ratio reached 90.9 percent by end- more children). The right cannot be exercised 2015—the lowest level since 2007. As lending during active employment or while exercising grew, the share of non-performing loans pension rights; early developments suggest that dropped from 15.9 percent at the end of 2014 around 15,000 women have applied for this to 12.5 percent. entitlement, resulting in the withdrawals from the labor market. In 2015, the general government deficit grew to a preliminary 7 percent of GDP. The central Tourism helped narrow the external government cash deficit reached 8 percent of imbalance in 2015. The current account deficit GDP, against a budgeted 6.7 percent. The rise declined to 13.4 percent of GDP in 2015, in capital spending (advances for construction compared to 15.2 percent for the same period of the Bar-Boljare highway) and repayment in 2014. The drop was led by a historically high of arrears amounting to 2.2 percent of GDP current account surplus, pushed up by surging (pension debt, resolution of court cases, tourism revenues (19.1 percent y-o-y). Another and utilities) led to a surge in expenditures positive contribution came from the improved (10.9 percent y-o-y). Meanwhile, revenues income balance underpinned by increase in dropped by 1.9 percent y-o-y, especially workers’ remittances, reduced interest and from VAT, as tax relief authorized for new dividend payouts. On the other hand, goods investments eroded the tax base. exports again struggled, especially meat exports suppressed by Russian trade sanctions, and led Public debt is estimated to head up to to a rise in the trade deficit to 40.6 percent of 68 percent of GDP in 2015. By September GDP. 2015, public debt already reached 67.9 percent of GDP, and grew 18 percent in nominal terms from the end of 2014. With guarantees 5. SEE6 Country Notes  |  71 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 included, it reached 78.8 percent of GDP. requirement in 2016 will be about 18 percent The main impetus for the rise in public debt of GDP to repay €390 million in Eurobonds, was external: the €500 million Eurobond allocate €255 million for the highway, finance and the €169 million Chinese EXIM Bank the budget cash deficit, and settle health fund disbursement. arrears. In early March, the government issued a €300 million 5-year Eurobond with a coupon In November, Standard & Poor’s (S&P) of 5.75 percent—some two percentage points affirmed Montenegro’s long-term and short- above the last year’s issue. term B+/B ratings with stable outlook. S&P estimated annual average economic growth The authorities have revised up the fiscal of 3.1 percent for 2015–18, supported by deficits for 2017–18 from the estimates higher investment, predominantly in tourism presented in the September 2015 Fiscal and energy. However, the rating was tentative Guidelines. The Guidelines shelved plans because the high deficit and public and external to get rid of the primary deficit by 2018. In debt, especially for highway construction, raise November 2015, Albania and Montenegro risks to public finances. signed a Memorandum of Understanding with a private Chinese company, Pacific, to Figure 2. Fiscal Balance and Public Debt, start preparing the construction project for the 2008–15 Adriatic–Ionian Highway to connect the two In percent of GDP In percent of GDP countries along the coast. The estimated cost to 90 0 Montenegro is €550 million, or 14.5 percent of 80 -1 GDP, which will further strain public finances. 70 -2 The January 2016 amendments to the Law on 60 -3 Pension and Disability Insurance will increase 50 -4 40 -5 all pensions by at least 3 percent in July 2016, 30 -6 and the lowest pensions will be 20 percent 20 -7 higher. Added to the new social spending 10 -8 on lifetime benefits for mothers of three and 0 -9 more children this means spending of another 2008 2009 2010 2011 2012 2013 2014 Sep-15 1.5 percent of GDP in 2016 alone. The savings JJ Domestic debt JJ Foreign debt JJ Guarantees ▬▬ Fiscal balance, rhs from the planned staff rationalization, given Source: Ministry of Finance (MoF) and MONSTAT data. the severance pays that would add to the costs in the near term, would hardly offset wage rise expected from the new Law on civil service Fiscal policy will continue to be wages. expansionary in 2016–18. The 2016 general government deficit is budgeted at 6.2 percent EU accession negotiations with Montenegro of GDP, with the expectation that growth will have advanced. In 2015, the EU opened six new reach 4.1 percent. The government plans to chapters; so far, 22 of 35 negotiating chapters allocate as much as €334.9 million for capital have been opened. However, if the negotiation investments, with public debt expected to process is to advance further, according to rise to 72.3 percent of GDP. The borrowing the 2015 EC Report on Montenegro and 72  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH Enlargement Strategy, the entire rule of law Economic growth is projected to continue system of Montenegro needs to deliver results, at the same pace in 2016 and 2017, with in particular establish a track record in the fight investment in public infrastructure and against corruption and organized crime and tourism as the main drivers of economic complete implementation of the new electoral activity. However, the risks to the outlook legislation. In terms of economic criteria, are again tilted to the downside. Slowing or Montenegro is assessed as moderately prepared stagnating growth in the Euro Area and globally in developing a functioning market economy. and volatility in financial markets affected Its public debt needs to be reduced and the by gradual monetary tightening are the main competitiveness of industrial production and external risks for budget financing and growth agriculture improved. prospects. Montenegro’s debt exposure to the US dollar (a highway loan amounting to €688 In January 2016, the Montenegrin million in 2014) and borrowing needs over the parliament passed a vote of confidence in medium term that exceed 17 percent of GDP the government. The government was backed present substantial risks to public finances. by members of leading party DPS, ethnic Risks on the domestic side include not only still minority parties, Positive Montenegro, and high NPLs and delays in the structural reforms the Social Democrats of Montenegro. The vote necessary to stabilize finances and increase came after Prime Minister Djukanovic invited competitiveness but also instability in domestic all opposition parties to join his government, politics, which could reduce the confidence of offering the posts of ministers or assistant foreign investors and cause them to pull back ministers of interior, finance, social welfare, on their investments in Montenegro. and agriculture. Figure 3. High Frequency Data, Trend-Cycle Figure 4. Current Account Balance Adjusted Series, 2009–15 Index, 2011=100 In US$ billion In percent of GDP 140 350 20 300 15 130 250 120 200 10 150 5 110 100 100 50 0 0 -5 90 -50 -100 -10 80 -150 -15 -200 70 -250 -20 60 -300 -25 last obs: 12/15 -350 50 -400 I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV -30 - 0 9 l-09 -10 l-10 -11 l-11 -12 l-12 -13 l-13 -14 l-14 -15 l-15 Jan Ju Jan Ju Jan Ju Jan Ju Jan Ju Jan Ju Jan Ju 2010 2011 2012 2013 2014 2015 ▬▬ Total industry_tc ▬▬ Retail trade_tc ▬▬ Tourism_tc JJ Current account balance, lhs ▬▬ Current account balance, rhs Source: MONSTAT and WB staff calculations. Source: CBCG and MONSTAT data. 5. SEE6 Country Notes  |  73 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Figure 5. Labor Market, Administrative Data Figure 6. General Government Deficit In thousands In thousands In percent of GDP In percent of GDP 200 42 60 1 195 40 0 190 38 50 36 -1 185 40 -2 180 34 32 -3 175 30 30 170 -4 28 20 -5 165 26 160 24 -6 10 155 last obs: 12/15 22 -7 150 20 0 -8 -10 -10 -11 -11 -12 -12 -13 -13 -14 -14 -15 -15 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul 2008 2009 2010 2011 2012 2013 2014 2015 ▬▬ Employment, lhs ▬▬ Employment_tc, lhs JJ Total revenues and grants JJ Total expenditures and net lending ▬▬ Unemployment ▬▬ Unemployment_tc ▬▬ Cash deficit, rhs ▬▬ Accrual deficit, rhs Source: MONSTAT and WB staff calculations. Source: MoF and MONSTAT data. Figure 7. Labor Market, Survey-based Data, Figure 8. General Government Debt, 2007–18 2012–15 In percent In percent In euro billions In percent of GDP 60 25 3.5 90 3.0 80 50 20 70 40 2.5 60 15 2.0 50 30 10 1.5 40 20 1.0 30 5 20 10 0.5 10 0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 0 0 0 1 5 e 16f 17f 18f 2012 2013 2014 2015 2007 2008 2009 2010 2011 2012 2013 2014 20 20 20 20 JJ Participation rate JJ Employment rate JJ Foreign public debt JJ Domestic public debt ▬▬ Unemployment rate, rhs ▬▬ Public debt, rhs Source: MONSTAT data. Source: MoF and MONSTAT data. Figure 9. Loans: Annual Growth Rates, Figure 10. CPI and PPI, Annual Growth Rates, 2010–15 2009–15 In percent In percent 15 5 4.1 10 4 3.4 3.1 3.2 5 3 1.9 2.2 2 1.7 1.5 0 1 0.5 0.2 0.3 -5 0 -10 -1 -0.7 -0.7 -15 -2 -3 -20 -4 last obs: 12/15 -3.8 -25 -5 - 1 0 l-10 -11 l-11 -12 l-12 -13 l-13 -14 l-14 -15 l-15 Jan Ju Jan Ju Jan Ju Jan Ju Jan Ju Jan Ju 2009 2010 2011 2012 2013 2014 2015 ▬▬ Total bank loans ▬▬ Loans to corporates ▬▬ Loans to households JJ CPI JJ PPI Source: CBCG data. Source: MoF and MONSTAT data. 74  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH MONTENEGRO 2012 2013 2014 2015e 2016f Real GDP growth (percent) -2.7 3.5 1.8 3.4 3.7 Composition (percentage points): Consumption -2.7 1.6 2.6 0.6 1.5 Investment 0.5 0.5 0.5 1.6 3.0 Net exports -0.5 1.5 -1.2 1.2 -0.8 Exports -0.1 -0.5 -0.3 2.4 0.6 Imports (-) -0.4 2.0 -1.0 -1.2 -1.4 Consumer price inflation (percent, period average) 4.1 2.2 -0.7 1.5 1.9 Public revenues (percent of GDP) 40.9 42.3 44.6 42.4 43.7 Public expenditures (percent of GDP) 46.8 46.9 47.7 49.4 49.9 Of which: Wage bill (percent of GDP) 13.2 12.4 12.7 12.2 12.4 Social benefits (percent of GDP) 15.2 14.4 14.3 13.9 14.1 Capital expenditures (percent of GDP) 4.3 3.6 5.3 8.5 11.1 Fiscal balance (percent of GDP) -5.8 -4.6 -3.1 -7.0 -6.2 Primary fiscal balance (percent of GDP) -4.0 -2.4 -0.8 -4.8 -4.1 Public debt (percent of GDP) 53.4 57.5 59.9 68.0 72.3 Public and publicly guaranteed debt (percent of GDP) 65.4 66.8 68.8 78.8 82.6 Of which: External (percent of GDP) 49.8 49.5 56.0 68.2 74.7 Goods exports (percent of GDP) 12.3 11.8 10.3 9.0 8.8 Goods imports (percent of GDP) 56.0 51.3 50.1 49.7 49.5 Net services exports (percent of GDP) 19.2 19.4 20.0 21.9 21.5 Trade and services balance (percent of GDP) -24.4 -20.1 -19.8 -18.7 -19.2 Remittance inflows (percent of GDP) 2.3 2.4 2.3 2.3 2.3 Current account balance (percent of GDP) -18.5 -14.5 -15.2 -13.4 -14.2 Foreign direct investment inflows (percent of GDP) 14.5 9.6 10.2 17.2 11.0 External debt (percent of GDP) 144.8 142.3 145.2 147.7 149.2 Real private credit growth (percent, period average) -9.3 2.6 -2.5 1.2 1.4 Non-performing loans 16.5 17.5 15.9 12.5 11.8 (percent of gross loans, end of period) Unemployment rate (percent, period average) 19.8 19.5 18.0 17.6 17.3 Youth unemployment rate (percent, period average) 42.6 41.7 36.3 38.5 38.1 Labor force participation rate 49.8 50.1 52.7 53.5 54.0 (percent, period average) GDP per capita, PPP (current international $) 13,729.7 14,286.0 14,338.0 14,395.4 14,524.9 Poverty rate at US$5/day, PPP 19.3 18.7 13.3 11.9 11.1 (percent of population) Sources: Country authorities, World Bank estimates and projections. Notes: Labor market indicators and credit growth for 2015 reflect year-to-date annual rolling averages. Non-performing loans show year-to-date actuals. 5. SEE6 Country Notes  |  75 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Serbia In 2015 Serbia’s economy returned to growth and unemployment declined, despite fiscal consolidation that reduced the fiscal deficit by more than earlier expected. Fiscal and structural reforms continued to make progress, the IMF program stayed on track, and there was a major breakthrough in the EU accession process so that the first negotiation chapters opened in early 2016. Continued work on structural reforms and fiscal discipline through this period are crucial to support growth and ensure that public debt stays sustainable. Growth in 2015 turned out to be much compared to 2014 the number of employed better than had been earlier projected. After rose by 0.6 percent in 2015, slightly below rebounding in Q3 to 2.3 percent y-o-y, initial real GDP growth for the year. Importantly, estimates of real GDP growth in Q4 were the net increase in the number of employees 1.2 percent y-o-y. Growth for 2015 as a whole came from the private, formal sector; the was an estimated 0.8 percent, considerably government hiring freeze continued and state- above the contraction of 0.5 percent expected owned enterprises (SOEs) released about earlier in the year. If not for drought, growth 15,000 people. As a result, employment in 2015 could have been even better. Agricultural output averaged 42.2 percent, the highest level since (accounting for 8 percent of GDP) declined Q3 2008. During the year, the most significant by an estimated 8 percent y-o-y in real terms improvement in the labor market was in in 2015. With services value-added posting Q3, when unemployment hit 16.7 percent. a small decline (0.2 percent y-o-y), the main However, in Q4 it turned around and reached driver of the growth recovery was industry, 17.9 percent (it had been 17.3 percent in Q4 where real value-added grew by 5.8 percent 2014). Aggregate real wages continued to y-o-y, supported by improving external slip in 2015, down 2 percent, following falls conditions and recovery from the disruption of 1.5 percent in 2013 and 0.8 percent in of the floods. Consumption fell less than had 2014. However, according to the most recent been projected as private sector wages began aggregate data, real wage growth y-o-y was to head upward. Investment also did well, up 1.5 percent in December 2015 and 0.6 percent 8.4 percent, contributing 1.6 percentage points in January 2016. The latest data for public (pp) to growth, and construction was boosted and private wages suggest that nominal public by reforms to the permitting procedure. Export sector wages in 2015 were down by 5.5 percent growth reached 8.2 percent in real terms, y-o-y. y-o-y, while private sector wages went up by 3 percent. As growth returned, unemployment fell but picked up slightly towards the end of 2015. Having peaked at 24 percent in 2012, unemployment has since declined. On average, 76  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH Figure 1. Real GDP Growth, 2011–15 quarters of the necessary structural adjustment In percent through 2017 comes from wage and pension 4 reforms and the rest from lower subsidies and 3 additional revenues. The deficit was reduced 2 in 2015 by both restrained spending (down 1 1.9 percent y-o-y in nominal terms) and higher 0 revenues (up 4.6 percent). Additional tax -1 -2 revenues of 1.7 percent were almost entirely -3 the result of higher excise income, an excise -4 tax on electricity having been introduced in -5 August 2015. Nominal expenditures were 11 11 12 12 13 13 14 14 15 15 Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- reduced by major savings from wage bill Source: Statistics Office. and pension reforms. Partially offsetting the savings (see Figure 2), spending on several Inflation continues to undershoot the categories increased, especially social assistance, target band due to lower oil prices and lack investments and interest payments. Despite of domestic demand. Despite substantial lower net financing needs, over 2015 general monetary easing, consumer price inflation government debt, including guarantees, still averaged 1.9 percent for 2015, below the shot up, from 72.3 percent of GDP at the end National Bank of Serbia (NBS) target band of 2014 to 76.8 percent, in part because of of 4 ± 1.5 percent. After picking up in August valuation effects from the appreciation of the to 2.1 percent y-o-y, primarily as a result of US dollar against the dinar. the electricity price increase, inflation held at about 1.4 percent for the rest of the year. With Figure 2. Net Reduction of General inflation low, since May 2013 the NBS has Government Spending by Category, 2014–15 lowered its policy rate continuously, cutting Percentage points of GDP 1.5 rates seven times in 2015 alone, from 8.0 to Other transfers to households 1.0 4.5 percent between January and October. In 0.5 Capital expenditures February 2016, in a surprise move, the policy 0 Interest payment rate was cut another 0.25 percentage points, -0.5 Wage bill because of minimal inflation pressures both -1.0 domestically and from global developments. -1.5 Pensions Cumulative net change -2.0 in expenditures In January inflation reached 2.4 percent y-o-y, Subsidies -2.5 pushed up by higher food prices, but it went -3.0 Goods and services down to 1.5 percent in February. -3.5 Net lending Amortization of activated guarantees Source: Ministry of Finance. Fiscal consolidation activities, along with one-off revenue gains, managed to reduce the general government fiscal deficit from In euro terms, in 2015 Serbia’s exports 6.7 percent of GDP in 2014 to 3.7 percent rose by 6.6 percent y-o-y and imports in 2015. In the government’s fiscal plan, by 4.1 percent. The goods trade deficit at as supported by the IMF program, three- €4 billion declined slightly compared to 2014 5. SEE6 Country Notes  |  77 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 and accounted for 12.1 percent of GDP. for the banking sector: nonperforming loans The current account deficit of €1.6 billion, (NPLs) had gone up from 11.3 percent in 4.8 percent of GDP, was 21 percent lower than 2008 to 22.3 percent by November 2015 and in 2014, due mainly to an improved services bank profitability had fallen. True NPLs may balance but also to higher net transfers. For the be higher: a recent NBS Asset Quality Review same period net foreign direct investment (FDI) of 14 major banks led to upward revision of was up 46 percent y-o-y in euro terms. Net FDI their estimated NPLs as of Q1 2015 from reached €1.6 billion, which more than covered 22.6 to 27.4 percent. The NBS has also moved the current account deficit. One-third of total to intensify oversight of banks and has been FDI went to automotive and related industries. more active in resolving the longstanding NPL By the end of September 2015, external debt problem thanks to the Action Plan for NPL stood at €26.3 billion (79.5 percent of GDP). Resolution approved in August 2015. Banks and businesses continued to reduce their external debt but the government’s rose by Credit activity, though recovering, is still €728 million in the year through September. tentative. Lending rates have declined, tracking the trend in policy rate changes but at After a period of stability in the second a slower pace. On average, interest rates on new half of 2015, the exchange rate came under business loans declined by 192 bps in 2015, pressure in early 2016 as international and on new loans to households by 224 bps. By markets became more turbulent. In 2015 year-end 2015 loans to the private sector were improvement in the current account supported up 3 percent y-o-y (not adjusted for currency the dinar against the euro, and the National movements). Loans to enterprises, both private Bank of Serbia (NBS) became a net purchaser and SOEs, were up 2 percent, supported by of euros to prevent appreciation of the dinar. the recovery in investment as well as the lower While flat against the euro, in 2015 the dinar interest rates. While growth in loans to private depreciated significantly against the US dollar, enterprises had turned positive by yearend, for particularly early in the year, and by December most of the year they were declining. Loans to it was down by 11.8 percent. In January 2016 households were up 4.7 percent in December the dinar again depreciated by 1.3 percent (y-o-y), although growth has been slowing in against the euro despite significant and frequent recent months. NBS foreign exchange market interventions. In February and early March the exchange rate stayed relatively flat against the euro. Official Outlook reserves were €9.9 billion at the end of February 2015, down €526 million since December. Growth in Serbia is projected to rise from 0.8 percent in 2015 to 1.8 percent in 2016 The financial system seems to be stable, and to 3.5 percent by 2017, based on although asset quality remains a concern and rising investment, a gradual recovery of some state-owned banks are problematic. consumption, and growing external demand. The Serbian financial system weathered the Fiscal consolidation will continue to limit near- global financial crisis and successive recessions term domestic demand but will benefit Serbia relatively well, but not without consequences in the medium term by supporting investment 78  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH and enhancing the business climate. The main is expected to contract from 46 percent of GDP domestic risk to growth is delays in structural in 2014 to 42 percent by 2017, mostly from reforms, due for example to the impact of the cutting recurrent spending. The 2016 budget early elections, which may also deter foreign as approved aims to consolidate further the investors. Another risk to growth in 2016 are significant fiscal adjustments made in 2015. the effects of recent floods; their impact has Debt sustainability analysis, in a baseline yet to be estimated. With domestic demand scenario, projects that the public debt-to- recovering only gradually and import prices GDP ratio will peak at 78.6 percent in 2016, low, inflation is expected to return to the target after which it will begin to edge down. Early band only in mid-2016. elections, possible delays in resolution of SOEs, and public sector rightsizing might put The current fiscal consolidation program additional pressure on the 2016 budget. A more is expected to put the public debt-to-GDP significant depreciation of the dinar could add ratio on a downward trajectory by 2017. further risks to debt sustainability. Over the medium term, government spending Figure 3. Strong growth of industrial output Figure 4. …with the recovery reflected in labor helped Serbia’s economy exit recession… market conditions Industrial output growth y-o-y, in percent Unemployment and employment rate, in percent 35 50 25 40 15 5 30 -5 20 -15 10 -25 -35 0 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 -12 -13 -13 -14 -14 -15 -15 Dec Jun Dec Jun Dec Jun Dec 2009 2010 2011 2012 2013 2014 2015 JJ 3m/3m, SA, ann ▬▬ y-o-y, 3m MA JJ Employment rate JJ Unemployment rate Source: Statistics Office. Source: LFS, Statistics Office. Figure 5. Inflation remains low, despite the Figure 6. Exports were growing throughout continued easing of the key monetary policy 2015, but imports started picking up as well rate y-o-y, percent; percent per year In euro billion, 12m sum Growth of 3m sum, y-o-y, percent 14 10 50 12 9 40 8 30 10 7 20 8 6 10 5 0 6 4 -10 4 3 -20 2 -30 2 1 -40 0 0 -50 -13 Jul- 13 -14 Jul- 14 -15 Jul- 15 -16 - 07 n-08 n-09 n-10 n-11 n-12 n-13 n-14 n-15 Jan Jan Jan Jan Ja n Ja Ja Ja Ja Ja Ja Ja Ja ▬▬ CPI total ▬▬ Key policy rate JJ Trade deficit, lhs ▬▬ Exports, rhs ▬▬ Imports, rhs Source: National Bank of Serbia. Source: Statistics Office. 5. SEE6 Country Notes  |  79 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 Figure 7. The fiscal deficit declined Figure 8. …although general government significantly in 2015… debt-to-GDP moved up notably, in part due to currency movements Fiscal balance as percent of annual GDP, 12-month sum Government debt-to-GDP, percent 2 80 1 70 0 60 -1 -2 50 -3 40 -4 30 -5 20 -6 -7 10 -8 0 -05 -06 -07 -08 -09 -10 -11 -12 -13 -14 -15 Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec 2009 2010 2011 2012 2013 2014 2015 Jan-16 Source: Ministry of Finance. JJ External direct debt JJ Domestic direct debt ▬▬ Guarantees Source: Ministry of Finance – Public Debt Administration. 80  |  5. SEE6 Country Notes REBALANCING FOR STRONGER GROWTH SERBIA 2012 2013 2014 2015e 2016f Real GDP growth (percent) -1.0 2.6 -1.8 0.8 1.8 Composition (percentage points): Consumption -1.2 -0.6 -1.1 -0.9 0.3 Investment 0.6 -1.5 -0.1 1.7 1.5 Net exports -0.4 4.8 -0.6 0.1 0.0 Exports 0.3 7.4 2.3 3.6 3.7 Imports (-) -0.7 -2.6 -3.0 -3.5 -3.6 Consumer price inflation (percent, period average) 7.3 7.7 2.1 1.9 2.2 Public revenues (percent of GDP) 39.4 37.9 39.7 40.9 40.0 Public expenditures (percent of GDP) 46.6 43.5 46.3 44.6 43.6 Of which: Wage bill (percent of GDP) 10.5 10.1 10.0 8.9 8.9 Social benefits (percent of GDP) 18.1 17.7 17.8 17.8 17.2 Capital expenditures (percent of GDP) 3.3 2.1 2.5 2.9 2.9 Fiscal balance (percent of GDP) -7.2 -5.6 -6.6 -3.7 -3.6 Primary fiscal balance (percent of GDP) -5.3 -3.2 -3.7 -0.5 -0.1 Public debt (percent of GDP) 49.2 52.6 64.6 69.5 73.2 Public and publicly guaranteed debt (percent of GDP) 57.4 60.9 72.3 76.8 78.6 Of which: External (percent of GDP) 33.2 35.7 43.1 45.8 49.2 Goods exports (percent of GDP) 26.5 30.7 31.9 34.3 36.0 Goods imports (percent of GDP) 44.3 42.8 44.3 46.4 47.3 Net services exports (percent of GDP) 0.4 0.9 1.4 2.2 2.6 Trade balance (percent of GDP) -17.5 -11.2 -10.9 -9.9 -8.7 Remittance inflows (percent of GDP) 6.1 6.3 5.6 6.3 6.2 Current account balance (percent of GDP) -11.6 -6.1 -6.0 -4.8 -4.6 Foreign direct investment inflows (percent of GDP) 2.4 3.8 3.7 4.8 4.7 External debt (percent of GDP) 81.2 75.1 78.4 83.4 83.3 Real private credit growth (percent, period average) 6.3 -9.2 -4.0 -2.2 -0.7 Non-performing loans 18.6 21.4 23.0 22.8 22.0 (percent of gross loans, end of period) Unemployment rate (percent, period average) 24.0 22.1 19.4 17.9 17.5 Youth unemployment rate (percent, period average) 51.0 49.4 47.0 42.9 42.0 Labor force participation rate 47.7 48.4 51.8 51.4 52.0 (percent, period average) GDP per capita, PPP (current international $) 12,790.8 13,404.8 13,378.0 13,576.8 13,944.3 Poverty rate at US$5/day, PPP 14.8 14.5 14.7 14.4 14.0 (percent of population) Sources: Country authorities, World Bank estimates and projections. Notes: Labor market indicators and credit growth for 2015 reflect year-to-date annual rolling averages. Non-performing loans show year-to-date actuals. 5. SEE6 Country Notes  |  81 6. SEE6: Key Economic Indicators REBALANCING FOR STRONGER GROWTH SEE6:  Key Economic Indicators 2012 2013 2014 2015e 2016f 2017f Real GDP growth (percent) Albania 1.6 1.1 2.0 2.6 3.2 3.5 Bosnia and Herzegovina -0.9 2.4 1.1 2.8 2.6 3.1 Kosovo 2.8 3.4 1.2 3.6 3.6 4.0 Macedonia, FYR -0.5 2.9 3.5 3.7 3.7 4.0 Montenegro -2.7 3.5 1.8 3.4 3.7 3.1 Serbia -1.0 2.6 -1.8 0.8 1.8 2.3 SEE6 -0.3 2.5 0.3 2.1 2.6 3.0 Consumer price inflation (percent, end of period) Albania 2.4 1.9 0.7 1.9 Bosnia and Herzegovina 1.7 -1.4 -0.5 -1.2 Kosovo 3.7 0.5 -0.4 -0.3 Macedonia, FYR 4.7 1.4 -0.3 -0.3 Montenegro 5.1 0.3 -0.3 1.4 Serbia 12.2 2.2 1.7 1.5 SEE6 7.0 1.2 0.7 0.7 Public expenditures (percent of GDP) Albania 28.2 29.2 32.1 31.1 29.6 28.4 Bosnia and Herzegovina 46.6 45.6 45.8 46.3 45.2 44.1 Kosovo 28.5 28.1 27.0 27.3 28.4 28.2 Macedonia, FYR 36.0 34.2 34.0 34.4 34.5 34.0 Montenegro 46.8 46.9 47.7 49.4 49.9 48.4 Serbia 46.6 43.5 46.3 44.6 43.6 41.8 SEE6 38.8 37.9 38.8 38.8 38.5 37.5 Public revenues (percent of GDP) Albania 24.7 23.7 26.2 26.3 27.4 27.3 Bosnia and Herzegovina 44.5 43.4 43.8 44.5 43.2 42.1 Kosovo 25.9 25.2 24.4 25.4 26.6 26.3 Macedonia, FYR 32.1 30.2 29.8 30.9 31.1 31.2 Montenegro 40.9 42.3 44.6 42.4 43.7 42.1 Serbia 39.4 37.9 39.7 40.9 40.0 39.1 SEE6 34.6 33.8 34.7 35.0 35.3 34.7 6. SEE6: Key Economic Indicators  |  85 SOUTH EAST EUROPE REGULAR ECONOMIC REPORT NO.9 SEE6:  Key Economic Indicators 2012 2013 2014 2015e 2016f 2017f Fiscal balance (percent of GDP) Albania -3.5 -5.5 -5.9 -4.8 -2.2 -1.1 Bosnia and Herzegovina -2.0 -2.2 -2.1 -1.8 -2.0 -2.0 Kosovo -2.6 -2.9 -2.6 -1.9 -1.8 -1.9 Macedonia, FYR -3.8 -3.9 -4.2 -3.5 -3.4 -3.0 Montenegro -5.8 -4.6 -3.1 -7.0 -6.2 -6.4 Serbia -7.2 -5.6 -6.6 -3.7 -3.6 -2.6 SEE6 -4.2 -4.1 -4.1 -3.8 -3.2 -2.8 Public debt (percent of GDP) Albania 58.0 66.6 67.7 67.8 65.8 62.9 Bosnia and Herzegovina 39.5 36.4 39.0 39.8 41.4 42.0 Kosovo 8.2 9.0 10.6 13.0 14.9 16.3 Macedonia, FYR 33.7 34.2 38.3 37.9 39.5 40.3 Montenegro 53.4 57.5 59.9 68.0 72.3 76.4 Serbia 49.2 52.6 64.6 69.5 73.2 73.3 SEE6 40.3 42.7 46.7 49.3 51.2 51.9 Public and publicly guaranteed debt (percent of GDP) Albania 62.0 70.4 71.8 71.9 70.7 68.1 Bosnia and Herzegovina 44.3 40.8 43.0 43.8 45.2 45.6 Kosovo 8.2 9.0 10.6 13.0 15.2 16.7 Macedonia, FYR 38.3 40.5 46.0 46.4 48.9 50.3 Montenegro 65.4 66.8 68.8 78.8 82.6 86.3 Serbia 57.4 60.9 72.3 76.8 78.6 77.6 SEE6 45.9 48.1 52.1 55.1 56.9 57.4 Goods exports (percent of GDP) Albania 15.9 18.2 9.3 8.0 Bosnia and Herzegovina 22.6 24.3 24.2 23.9 Kosovo 5.6 5.5 5.8 5.6 Macedonia, FYR 30.4 29.2 32.5 34.4 Montenegro 12.3 11.8 10.3 9.0 Serbia 26.5 30.7 31.9 34.3 SEE6 22.5 24.7 24.2 25.0 86  |  6. SEE6: Key Economic Indicators REBALANCING FOR STRONGER GROWTH SEE6:  Key Economic Indicators 2012 2013 2014 2015e 2016f 2017f Trade balance (percent of GDP) Albania -18.7 -18.0 -18.8 -16.9 Bosnia and Herzegovina -24.0 -20.8 -22.9 -20.4 Kosovo -34.1 -31.6 -31.0 -31.1 Macedonia, FYR -22.5 -18.5 -17.6 -16.8 Montenegro -24.4 -20.1 -19.8 -18.7 Serbia -17.5 -11.2 -10.9 -9.9 SEE6 -21.1 -16.9 -17.2 -15.9 Current account balance (percent of GDP) Albania -10.1 -10.7 -12.9 -11.4 -13.1 -12.6 Bosnia and Herzegovina -8.8 -5.7 -7.8 -6.3 -6.4 -7.1 Kosovo -7.5 -6.9 -7.9 -9.4 -9.6 -9.8 Macedonia, FYR -3.3 -1.6 -0.9 -1.4 -1.7 -2.2 Montenegro -18.5 -14.5 -15.2 -13.4 -14.2 -14.9 Serbia -11.6 -6.1 -6.0 -4.8 -4.6 -4.5 SEE6 -9.8 -6.6 -7.2 -6.3 -6.6 -6.8 External debt (percent of GDP) Albania 35.7 34.7 36.9 42.3 42.9 42.2 Bosnia and Herzegovina 52.8 53.9 50.8 54.0 55.1 54.3 Kosovo 7.3 6.5 6.4 6.5 7.4 7.3 Macedonia, FYR 66.1 64.0 69.8 69.7 70.1 69.8 Montenegro 144.8 142.3 145.2 147.7 149.2 149.6 Serbia 81.2 75.1 78.4 83.4 83.3 82.9 SEE6 64.6 62.8 64.6 67.3 68.0 67.7 Unemployment rate (period average, percent) Albania 13.4 16.0 17.5 17.1 Bosnia and Herzegovina 28.1 27.4 27.5 27.7 Kosovo 30.9 30.0 35.3 35.3 Macedonia, FYR 31.0 29.0 28.0 27.4 Montenegro 19.8 19.5 18.0 17.6 Serbia 24.0 22.1 19.4 17.9 SEE6 23.9 23.3 22.5 21.7 Source: World Bank estimates and projections based on data from national authorities. 6. SEE6: Key Economic Indicators  |  87