THE WESTERN BALKANS REVVING UP THE ENGINES OF GROWTH AND PROSPERITY OVERVIEW The team was led by Ekaterina Vostroknutova and Trang Van Nguyen, and included Ashley Taylor, Jennifer Keller, Monica Robayo, Kazi Matin, Bojan Shimbov, Olasupo Olusi, Michelle Tejada, Suzana Petrovic, Georgia Harley, Sandra Hlivnjak, Alena Kantarovich, Johanna Jaeger, and John Burgess. Inputs from Lazar Sestovic, Sanja Madzarevic-Sujster, Dusko Vasiljevic, Hilda Shijaku, Agim Demukaj, Barbara Cunha, and other team members working on the Western Balkans are appreciated. The team is grateful for comments, at different stages of the report’s preparation, from Ron Hood, Andrew Dabalen, Edgardo Favaro, Jorge Araujo, Gonzalo Varela, Lada Strelkova, Maria Davalos, Cesar Cancho, Alexandru Cojocaru, Johannes Koettl, Timothy Johnston, Josefina Posadas, Zahid Hasnain, Tony Verheijen, Raymond Muhula, Srdjan Svircev, and Jonas Arp Fallov. Administrative support from Mismake Galatis is appreciated. The team was guided by Ellen Goldstein, Linda Van Gelder, Gallina Vincelette, Ivailo Izvorski, Luis-Felipe Lopez-Calva, Carolina Sanchez-Paramo, and John Panzer. © 2017 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included 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. 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Contents Introduction 3 Growth and global integration were stalled by the global financial crisis 9 Pre-crisis convergence with EU living standards faltered, calling for a new growth model 17 Increasing the welfare of all citizens will require more people to have jobs 23 Labor market barriers discourage employment and fuel emigration 29 Western Balkan economies have major potential to improve their productivity 35 With reforms, the state can help build a new growth model and deliver better services 41 Postscript 47 introduction The Yugo, a communist-era car from the former the 1990s and are likely to expand further with Yugoslavia, was widely ridiculed for shedding recovery of European and global growth.1 its parts on roads across Europe and the United States. Zastava, which made Yugo, fared Serbia’s emergence as a successful exporter of even worse than its product. After the Balkan competitive cars and parts is a symbol of a conflicts of the 1990s, the factory was reduced new era for the six countries of the Western to producing only 18,000 cars in 2002. Then Balkans: Albania, Bosnia and Herzegovina, Fiat entered the picture in 2008, investing more Kosovo, the Former Yugoslav Republic (FYR) than a billion euro to make Zastava one of its of Macedonia, Montenegro, and Serbia. As late most modern factories anywhere in the world. reformers, they can benefit from rising wages Now it is producing more than 100,000 cars in the rapidly reforming transition countries of a year and exporting to the European Union 1  This report uses official data available as of September and the United States. Bosch and more than 2016. This report draws on World Bank (2015) Albania: forty other international companies have set Systematic Country Diagnostic; World Bank (2015) Rebalancing Bosnia and Herzegovina: A Systematic Country up operations in Serbia to supply parts to this Diagnostic; World Bank (2016) Republic of Kosovo: factory and to other car producers in Europe; Systematic Country Diagnostic; World Bank (2016) Montenegro Systematic Country Diagnostic: Achieving domestic investors also started entering the Sustainable and Inclusive Growth amidst High Volatility; sector. Exports of the Serbian automotive World Bank (2015) Serbia’s Potential for Sustainable Growth and Shared Prosperity: Systematic Country industry have increased almost tenfold since Diagnostic. Revving Up the Engines of Growth and Prosperity 3 the European Union and from greater cost- Dramatic differences in growth trends and consciousness among firms adapting to lower in convergence to higher income levels are global growth. The six (of which all but Albania notable in the region before and after the global were born from the break-up of Yugoslavia) financial crisis. At a 5.6 percent average during largely missed out on earlier opportunities to 2000-08, living standards in the WB6 were thrive in the post-Cold War era. Today, with rising faster than world and EU averages, lagging peace and enhanced collaboration, coupled only slightly behind the 7STEE. The growth with future prospects of European Union also helped drive down poverty in most of the membership, the Western Balkan countries Western Balkan countries. In the early 2000s, have another opportunity to build prosperity. roughly one in three people in the region lived on less than $5 per day. In 2008, only about This report addresses the following question: one in five did. High structural unemployment, How can these countries raise economic growth a legacy of Yugoslavia, improved somewhat rates and ensure sustained improvement in during this period. Moreover, the Human welfare for their citizens? Finding the right Development Index—which aggregates key answer will help the countries’ aspiration for dimensions of human development such as a income convergence with the EU, where on long and healthy life, being knowledgeable, and average people enjoy incomes that are three having a decent standard of living—increased times higher. over this same period in the Western Balkans and is higher than in other countries with The six Western Balkan countries (WB6)— similar income. they are also called the SEE6, for the South East Europe Six—have already achieved strong After the global crisis in 2008, growth slowed growth and poverty reduction. The 1995-2015 precipitously, although it remained higher than period saw living standards increase (from a low the average in Europe. Unemployment has base) almost six-fold in Bosnia and Herzegovina, remained persistently high: in 2015, seven nearly triple in Albania, and almost double in years after the start of the global financial Serbia. But some of the neighboring countries crisis, it ranged between 17 and 33 percent, did better. This report seeks to catalogue the with youth unemployment almost double the reasons, as well as outline broad priorities for average. Today, the six countries remain among the future, using for illustration the comparison the poorest in Europe, with lower standards to the “seven small transition economies of of living on display in everyday life. The large Europe” (the “7STEE” group) that have entered numbers of people who pass their days in cafes the EU (Bulgaria, Croatia, Estonia, Latvia, and public squares give evidence of chronic Lithuania, Slovak Republic, and Slovenia). high unemployment and inactivity. For income, 4 Revving Up the Engines of Growth and Prosperity many families depend more on transfers inefficient and (in a large part of the region) (from government or from abroad) than state-heavy economies and link to regional and on their own labor. The decrepit towers of global markets to foster growth and productivity obsolete state-owned industrial plants reflect and provide high-quality jobs in societies where incomplete reforms, continued inefficiency, and too many people don’t work at all. over-reliance on government as a driver of economic activity. This is somewhat similar to the task that faced Eastern Europe after the fall of communist rule Despite these realities, the Western Balkan two and a half decades ago. Most of the 7STEE states have significant potential for growth. countries met it with notable success. But the They are located next door to the huge Western Balkan states emerged from their EU market and have made some progress socialist and communist pasts into the violence in integrating their economies into world and disruption of the ethnic conflicts of the markets in such fields as finance and trade. 1990s. Although not all countries were directly As Fiat’s success in Serbia shows, they have involved, the conflicts slowed the pace of comparative advantages in many products that economic transition and EU accession across are in demand in the EU and other export the region. markets. In a few of the Western Balkan countries, working-age populations are still increasing, which could yield a “demographic Figure 1: Starting from a similar level of per capita income dividend” in the form of a surge in growth as FYR Macedonia, Latvia was able to grow it much faster. and incomes through higher proportions of (GDP per capita as share of EU’s, international 2011 PPP US$, percent) people working. Substantial—albeit variable— progress has occurred in reforms to transition 80 to a market economy. 70 7STEE 60 Latvia Pre-crisis growth in the Western Balkans 50 was largely driven by consumption fueled by 40 FYR Macedonia remittances, aid, and real estate development. 30 WB6 This model proved unsustainable in the post- 20 crisis period—the accelerated growth, rising 10 living standards, and poverty reduction of the early 2000s came to an abrupt stop. To get 0 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 them going again, the countries must meet a set of common challenges: how to restructure Source: World Development Indicators and World Bank sta calculations. Revving Up the Engines of Growth and Prosperity 5 The experience of Eastern European transition Albania) are in low-productivity agriculture economies that were early reformers can be and informal employment, allowing for easy instructive for the Western Balkan countries productivity gains by reallocating labor. Current today. To varying degrees, their convergence export industries use relatively low skills and of per capita income was accompanied technology, meaning ample room exists to by convergence in functioning of markets raise export growth by upgrading the products and institutions to those of their western sold abroad. Only three of the six countries neighbors. As a result, though some of them are WTO members. While a slower global started from similar income per capita as the economy complicates the task of increasing Western Balkans, they achieved solid growth exports, it also creates opportunities because in income and employment through rapid international firms that have markets, gains in investment, exports, and productivity technology, and capital are looking even (see Figure 1 for GDP per capita). This was more carefully to relocate to improve their made possible by prudent macroeconomic competitiveness or find new niches. management and strong reforms that fostered integration with the world economy. For The Western Balkan countries need to example, like other successful transition act quickly to exploit these potentials. economies, Latvia was able to combine the The challenges posed by the aging of inflow of technology and capital with its corps their populations add fur ther urgency. of capable workers by adopting market policies The prolonged period of sluggish reforms, and institutions. Slovakia, a relative latecomer political uncer tainty, and slow convergence to transition, managed to catch up on market in living standards has left citizens dissatisfied reforms and achieve high growth rates, partly with government. They are increasingly thanks to connection to the supply chain of the asking for deeper reforms which would global automotive industry. also serve to accelerate the EU accession process. The prospect of EU membership For the Western Balkans, likewise, the continues to provide the strongest anchor potential for raising productivity through for reform, but implementation has been further integration with Europe and the rest slow. Levels of emigration from the Western of the world is large. For now, aggregate labor Balkans are high as young and educated productivity in the region is just half of that people look for oppor tunities elsewhere. in successful transition countries of Eastern The authorities understand the need to Europe and a fraction of that in Western create oppor tunities at home for the poor Europe. A large share of workers (about 25 and for the middle class in order to broadly percent on average and over 40 percent in improve living standards. 6 Revving Up the Engines of Growth and Prosperity In the absence of vigorous reform, the region more diversified opportunities for investment. faces a vicious cycle of high emigration, limited Reducing the regulatory burden and improving reforms, and below-potential growth, which the logistics and trade infrastructure would will further stimulate emigration of the best increase competitiveness and help domestic and brightest youth. The Western Balkan firms upgrade and expand exports. In this countries must make it easier for enterprises process, making better use of labor and human to grow and reach new markets. This will capital by enhancing relevant skills and bringing require reducing and modifying the role of the more people into the workforce will be key. state from a direct driver of economic activity Countries will need to address disincentives to a provider of effective policies, regulatory for work and barriers to employment that frameworks, governing institutions, and exist in their labor, tax, and social protection essential public goods. Improving the business systems, and support acquisition of the skills climate would facilitate firm entry and exit and that workers will need for new jobs created. the reallocation of factors of production to The countries must create a social services the most productive activities. Combined with system that achieves the goal of protecting the improved macroeconomic stability, this would vulnerable without hindering productivity or also help growth through increased returns and discouraging work. Revving Up the Engines of Growth and Prosperity 7 8 Revving Up the Engines of Growth and Prosperity Growth and global integration were stalled by the global financial crisis The Western Balkans economies grew despite strong export performance; external faster than the world average before debt also surged. When capital inflows fell the global financial crisis, and—even as precipitously, domestic demand declined as growth slowed in its aftermath—have well, leading to a contraction of imports and a remained among the best performers in reduction in external deficits. Since most capital Europe. Before the global crisis, the countries were expanding on average by 5.6 percent per Figure 2: GDP growth in the Western Balkans fell by more than year, only 0.3 percentage points lower than half after the global crisis. the 7STEE. But after the crisis, the Western (GDP growth rate, percent per annum) Balkans slowed to 2.4 percent a year. That was considerably behind emerging market 12 Median GDP growth economies in other parts of the world but still 8 6.0 5.9 5.6 faster than their harder-hit transition neighbors 4.9 3.8 4.7 4.6 4 2.7 in Europe (Figure 2). 2.2 2.4 1.6 1.3 0 Large capital inflows before the global crisis financed consumption-driven growth. -4 The strong pre-crisis growth was driven by -8 domestic demand—predominantly private and public consumption. This was accompanied -12 UMC 7STEE WB6 EAP World EU UMC EAP World WB6 EU 7STEE by high rates of import growth that resulted 2000-08 2009-15 in unsustainably large current account deficits, Source: World Development Indicators, Eurostat, national authorities and World Bank sta calculations. Revving Up the Engines of Growth and Prosperity 9 inflows went into non-tradable sectors, they in the world, with only several East Asian did little to expand the economy’s capacity to countries doing better. Export growth for grow sustainably in the long run and service its Kosovo, FYR Macedonia, and Serbia came in external debt. at 7-8 percent, for Bosnia and Herzegovina 5 percent, and Albania 3 percent. Montenegro’s After the global crisis, export growth goods exports grew only slightly in this period, slowed but still kept to levels well above although tourism was strong. The European world averages. Exports grew strongly at Union remained the dominant destination for 13-18 percent per year in 2000-08, albeit merchandise exports, ranging from just over 30 from a very low base, with the exception of percent for Kosovo and Montenegro to more Bosnia and Herzegovina and FYR Macedonia than 70 percent for Albania and Bosnia and (Figure 3). The global crisis stunted trade flows Herzegovina. all over the world; in the Western Balkans, export growth slipped to about 5 percent a Rapid export growth increased the share year. That was nonetheless among the highest of exports to GDP, but this share remains low by global standards. With exports of goods and services making up more than 40 Figure 3: The impact on export growth varied widely among percent of GDP, FYR Macedonia, Montenegro, Western Balkan countries. and Serbia are the most integrated, led by FYR (Real exports of goods and services, average annual growth rate) Macedonia (48.8 percent in 2015), which has 20 done the most to promote export-oriented 18 growth. Behind these three countries are 16 Bosnia and Herzegovina (34 percent), Albania 14 (27 percent), and Kosovo (19 percent). But 12 as a group, the Western Balkans’ performance 10 in this metric lags well behind the 7STEE. In 8 6 2000, Slovakia, Estonia, Lithuania, and Slovenia 4 had roughly the export/GDP ratios that the 2 Western Balkans states now have. By 2008 0 they had grown their shares to 80 percent 2000-08 2009-15 2000-08 2009-15 2007-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 or higher, typically the level necessary for a small country to become prosperous (Figure ALB SRB KSV MNE MKD BIH WB6 7STEE UMC EAP 4). Keeping Western Balkans exports on an Source: World Development Indicators, Eurostat, national authorities and World Bank sta calculations. Note: UMC stands for upper-middle-income countries; EAP is East Asia and Paci c region, as de ned in upward trajectory will be key for faster income the World Development Indicators. convergence. 10 Revving Up the Engines of Growth and Prosperity The Western Balkans countries have more Figure 4: The region has significant potential for further growth in exports. than doubled their share of exports to (Exports of goods and services, percent of GDP) the EU since 2005, as they became more deeply integrated into global value chains 120 and upgraded the technology of their SVK 100 exports. The increase in EU market share EST came from a low base, but was an important 80 SVN step in the ladder of technological upgrading BGR LTU 60 SRB LVA and participation in production networks. The MNEMKD HRV rise was partly due to strong performance 40 BIH BIH MNE in the parts and components trade, a key ALB MKD ALB 20 indicator of global value chains participation KSV KSV SRB (Figure 5). A catching up in the medium-skill 0 6 7 8 9 10 11 12 segment was another sign of integration into Log of GDP per capita (PPP, current international $) value chains at a technologically sophisticated All countries - 2015 WB6 - 2000 WB6 - 2015 7STEE - 2000 7STEE - 2015 level. The result was a general upgrading of the composition of exports, with potentially high Source: World Development Indicators, Eurostat, national authorities, and World Bank sta calculations. benefits for the regional economy as a whole: sophistication of exported goods of medium- skill technology intensity has nearly tripled in part to their rising participation in European since 2001 (Figure 6). This was mostly driven value chains, as manifest in the expanding share by the more manufacturing-oriented countries of parts and components in machinery and of Bosnia and Herzegovina, FYR Macedonia, transport exports. Still, the room for further and Serbia. gains in this field is large: FYR Macedonia’s exports still have a high import content, and Within manufactured exports, considerable Serbia is only starting to build backward linkages upgrading has occurred. Since 2008, the in its economy. region on average has moved towards a larger share of medium- and high-skill products as well Future progress will hinge on exploiting as technology-intensive ones, although Albania countries’ comparative advantages. Bosnia and Kosovo have barely registered in that and Herzegovina, FYR Macedonia, and Serbia upgrading. Serbia and FYR Macedonia raised have achieved strong growth in machinery their share in this category to 60-70 percent and transport, as well as in labor-intensive of manufactured exports and Bosnia and manufactured products such as garments and Herzegovina to about 40 percent. This is due footwear. Albania, Kosovo, and Montenegro Revving Up the Engines of Growth and Prosperity 11 Figure 5: Parts and components trade grew Figure 6: Medium-skill and technology goods faster than in other countries. are catching up to EU standards of sophistication. (Average annual growth rates of parts and components (Evolution of EXPY in manufacturing for medium-skill imports and exports, percent) technology intensity, index) 35 8000 30 7000 6000 25 5000 20 4000 15 3000 10 2000 5 1000 0 0 2000-08 2009-15 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 World 7STEE WB6 High-income countries WB6 Source: UN Comtrade and sta calculations based on B. Shimbov, M. Alguacil, and C. Source: B. Shimbov, M. Alguacil, and C. Suarez (2016). “International Production Suarez (2013). “Fragmentation and parts and components trade in the Western Balkan Networks and Economic Growth: The Case of the Western Balkan Countries.” Eastern countries.” Post-Communist Economies, 25:3, 371-391. European Economics, 54:1, 49-70. Note: EXPY is a measure of sophistication of a country’s export basket following R. Hausmann, J. Hwang, and D. Rodrik (2007). “What you export matters.” Journal of Economic Growth, 12(1): 1-25. have achieved relatively little growth in Financial integration has gone deeper machinery and transport; most of their than trade integration, helping to support gains were in metals, minerals, garments, and the rise of the private sector. For the past footwear. Metals have considerable potential two decades, major EU banks have invested for earning a larger share of downstream substantially in the Western Balkans and now highly-differentiated products. Albania, Bosnia own between two-thirds and four-fifths of and Herzegovina, FYR Macedonia, and Serbia banking assets in individual countries. They could also upgrade in agriculture by shifting have brought in new technology and better from primary agricultural exports to higher- banking and management practices, increasing value processed exports. Similarly, in services, efficiency. They have expanded arms-length the scope for expanding higher-value tourism banking, helping substantially reduce traditional and modern services exports remains links between the banking system and state- considerable. owned enterprises. Newer technologies have 12 Revving Up the Engines of Growth and Prosperity strengthened the infrastructure underpinning more growth than would otherwise have the banking system. Not only did firms get been possible. Similarly, trade integration better access to loans but households did too, that followed domestic liberalization and resulting in expanding credit. freer access to EU and Central European Free Trade Agreement markets accelerated Financial integration created new expor ts and employment. But high volumes sources for funding beyond traditional of funds arriving from abroad also created national savings, but resulting capital vulnerabilities in the banking system. This inflows fueled the consumption-based money generally went to finance excessive model of growth. The large foreign direct consumption or investment in non-tradable investment into banking and other sectors, as sectors such as real estate, in par ticular in well as cross-border funds inflows, supported Montenegro. As a result, growth created higher investment and consumption and thus by this consumption-based model was not higher domestic demand. This in turn fueled sustainable during and after the crisis. Figure 7: Domestic deposits are the main source Figure 8: Non-performing loans shot up after the of bank financing. crisis, but have begun declining in most countries. (Financing sources of domestic banks, 2015Q2, percent) (NPLs as percent of total loans) 100% 30 80% 25 20 60% 15 40% 10 20% 5 0% 0 ALB BIH KOS MNE MKD SRB 2007 2012 2013 2014 2015 Household deposits Corporate deposits Government deposits SRB MNE MKD KSV BIH ALB Foreign liabilities Capital and reserves Other Source: International Financial Statistics, Bank of International Settlements locational Source: National authorities, Financial Soundness Indicators (FSIs) and World Bank sta statistics, national authorities and World Bank sta calculations. calculations. Revving Up the Engines of Growth and Prosperity 13 Deeper financial sectors are needed to after the global financial crisis, non-performing support more private-sector and export- loans in 2015 comprised 18-22 percent of the driven growth in the future. As foreign total in Albania and Serbia, 10-14 percent in banks deleveraged after the global crisis, FYR Macedonia, Montenegro, and Bosnia and domestic deposits increasingly became the key Herzegovina, and about 6 percent in Kosovo source of financing for domestic banks (Figure (Figure 8). This burdens balance sheets, reduces 7). Loan-to-deposit ratios fell. This reduced profits, and suppresses lending, which remains vulnerability to external shocks, but the depth banks’ main activity, accounting for almost of the financial sector, measured by private two thirds of total banking sector assets in sector credit to GDP, remained somewhat the region. The non-banking sector has barely subdued, at an average 45 percent, with lower developed; deeper financial sector reform is levels in Kosovo and Albania. Almost a decade needed to develop capital markets. 14 Revving Up the Engines of Growth and Prosperity Revving Up the Engines of Growth and Prosperity 15 16 Revving Up the Engines of Growth and Prosperity Pre-crisis convergence with EU living standards faltered, calling for a new growth model High growth rates before the global crisis But after the crisis, convergence stopped. accelerated the catch-up to EU living Had the trends of the early 2000s continued standards, which nevertheless was slower after the crisis, the Western Balkans would than that of the transition economies have doubled their 1995 living standards already in the EU. Measured as income per to over 30 percent of Germany’s by 2015. capita in terms of purchasing power parity, But instead, they stagnated at around 26 the region’s living standards increased from percent between 2009 and 2015 (Figure 9). 19 percent of Germany’s level in 2000 to 25 The 7STEE, on the other hand, continued percent in 2008, a catch-up of 0.8 percentage to converge even after the crisis, albeit at a points of relative GDP per year (Figure 9). lower speed (0.6 percentage points per year This was the highest speed for the Western after 2008, compared to 1.9 points a year in Balkans ever, compared to the average of 0.4 2000-08). percentage points per year over the 1995- 2015 period. But other countries did even Lagging reforms are one reason for the better. The 7STEE countries consistently convergence gap with the European caught up by a whole percentage point faster transition countries. The Western Balkans per year than the Western Balkans, resulting and the 7STEE began their reforms at in an increase of their relative living standards approximately the same time with the break- from 42 percent of Germany’s in 2000 to 57 up of the Soviet Union and Yugoslavia, aiming percent in 2008, a 15 percentage point catch- to transform their planned public sector- up in just eight years. driven economies into open market models. Revving Up the Engines of Growth and Prosperity 17 The Western Balkans even had a higher starting crises: countries with weaker positions before point in 1989. But—initially due to conflict— a crisis suffer greater balance of payments they lagged significantly in this task behind the consequences and faster and more severe 7STEE, only now arriving at the level those withdrawals from capital markets. They lack countries had achieved in 1996 (Figure 10). ability to mitigate the immediate consequences Moreover, the speed of reform implementation through fiscal policy and take longer to recover slowed considerably after the financial crisis. once the crisis is over. Today the Western This means the Western Balkans have been Balkans have mostly completed reforms in consistently missing the opportunity for faster price and trade liberalization, but continue growth that comes from implementation of to lag on privatization, governance, public structural reforms. In addition, a poor reform administration, enterprise restructuring, labor record generally increases vulnerability to markets, and competition policy. Figure 9: Convergence to higher living standards Figure 10: Reforms in WB5 are now at where stalled after the global crisis. 7STEE were in 1996. (GDP per capita as share of Germany’s, international (EBRD transition score) 2011 PPP US$, percent) 70 4.0 62 60 3.5 50 3.0 40 34 2.5 30 27 2.0 20 17 10 1.5 0 1.0 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 WB5 7STEE KSV SRB MNE MKD BIH ALB LVA Source: EBRD and World Bank sta calculations. Median WB6 Median 7STEE Note: WB5 is WB6 excluding Kosovo, due to a lack of data for that country. The score ranges from 1 (large transition gap, or challenge ahead), to 4+ (a negligible gap). The indicator is the average of six sub-indicators: large-scale privatization, small-scale privatization, governance and enterprise restructuring, price liberalization, trade and Source: World Development Indicators and World Bank sta calculations. foreign exchange system, and competition policy. Improvement in the indicator is measured as the di erence in the score between two points in time. 18 Revving Up the Engines of Growth and Prosperity Figure 11: Growth sources have tentatively begun Figure 12: …and from public to private sources. rebalancing from domestic demand to net exports… (change in private sub-component, as share of total (change between 2008 and 2016, percentage points of GDP) component, between 2008 and 2015, percentage points) 25 10 15 5 5 0 -5 -5 -15 -10 -25 -15 SRB BIH MKD KSV ALB MNE WB6 ALB KSV SRB MKD MNE BIH Change in private investment share (of total investment) Consumption Investment Exports Imports Change in private consumption share (of total consumption) Source: National statistics o ces and World Bank sta estimates. Source: National statistics o ces and World Bank sta estimates. Note: No data are available on the public-private investment split in BIH. Because the nature of growth in the early on consumption supported by transfers or 2000s was unsustainable, convergence inefficient public spending. tapered off after the global crisis. The adjustment after the crisis reduced the The global financial crisis forced adjustment current account deficit and drove savings up. in consumption and net exports, but the But in several Western Balkan countries, a region has achieved little rebalancing of deterioration of fiscal balances accompanied the sources of growth since then. The this realignment, resulting in a sharp increase in crisis brought on serious adjustments in the external debt as well as a fall in net investment region’s external accounts: current account position. Internal imbalances, such as high deficits contracted from 22 percent to about unemployment, also worsened. Clearly, the 8 percent on average. As part of this process, region needed a rebalancing towards a more net exports gained increasing prominence as a sustainable growth model—one based on source of growth. In Serbia, this was driven by a exports and the private sector rather than strong growth in exports, a first step towards a Revving Up the Engines of Growth and Prosperity 19 more sustainable model of growth. But in other states’ expor ts to GDP ratio would have to countries, such as Montenegro, adjustment of double to come up to the healthier level of the external account was due mostly to sharp the transition economies. The Western Balkan contraction of imports (Figure 11).The dynamic countries’ current account deficits are also between public and private sources of growth wider than in those countries. Their average was even more mixed (Figure 12). investment ratios, running the range from 18 percent of GDP in Bosnia and Herzegovina To ensure sustained expansion, a true to 28 percent in Albania in 2009-15, are solid, rebalancing of growth sources is vital— but still lower on average than the 25 percent from consumption to investment, from minimum that the World Bank Growth domestic demand to international, Commission recommends for sustained from public to private sector. Given the high growth. Given constrained fiscal space, countries’ level of income, consumption public investment will grow slowly, making it will likely continue to play a strong role, as imperative that the private sector (including happens in other transition or emerging through FDI) play a bigger role in investing in market economies. The Western Balkan the region’s economies. 20 Revving Up the Engines of Growth and Prosperity Revving Up the Engines of Growth and Prosperity 21 22 Revving Up the Engines of Growth and Prosperity Increasing the welfare of all citizens will require more people to have jobs Too few people in the Western Balkans participation rate of about 50 percent is only have jobs. This reflects low participation in slightly below averages for the broader set of the labor force and unemployment rates that transition economies and the 7STEE countries, are among the highest in the world. While its its unemployment rate is almost two times Figure 13: Low labor force participation rates… Figure 14: …compound high unemployment rates. (Labor force participation rate, percent of population (Unemployment rate, percent of the labor force, 2015, aged 15+, 2015, national estimates) national estimates) 80 40 60 30 40 20 20 10 0 0 7S A ac ni a gro ME 6 Ko IH o a A P C FY A TEE Se S NA nte ia P S C A A NA A EE nte ia Se o a ni a Ko IH o WB sov EC ace B6 LA SA rbi EA SS B LA SA gr rbi sov EA Mo edon SS EC Mo lban R M lba B ne T ME do RM W ne 7S FY Source: World Development Indicators, Labor Force Surveys and World Bank sta calculations. Source: World Development Indicators, Labor Force Surveys and World Bank sta calculations. Note: De nition of labor force may di er by country. Note: De nition of unemployment may di er by country. Revving Up the Engines of Growth and Prosperity 23 Figure 15: The old-age burden has increased shrinking population, compounding the burden from rates that were already high. of support on active workers (Figure 15). (Old-age dependency ratio, as percent of working age population, 2000 and 2015) Income from work plays too small a role in household finances. Labor and human capital 30 are typically the most important assets for poor 25 families. Jobs are a critical channel for poverty reduction and economic growth. Yet the typical 20 Western Balkan household derives only about 15 50 percent of its income from labor, compared to about 60 percent among EU countries and 10 70-80 percent in Latin America and East Asia and 5 the Pacific (Figure 16). Serbia and Montenegro have particularly low rates, followed by Bosnia 0 and Herzegovina and Albania. Meanwhile, ALB BIH KSV MKD MNE SRB Kosovo and FYR Macedonia—which have 2000 2015 done away with many institutions and social Source: World Development Indicators. entitlements from Yugoslavia times—have overall greater reliance on labor income. The higher (Figure 13 and Figure 14). As a result, scope for real wage growth and for deriving only about 40 percent of working-age people a larger share of income from labor is limited in the six countries actually work, compared to by low employment rates and by low labor more than 50 percent in the 7STEE. productivity growth in these countries since the crisis. The large reliance on state benefits and Low rates of employment mean a remittances can create a culture of dependency greater burden on people who do work and disincentive to work and is difficult to and on the government to support the sustain (Figure 17). Spending on social assistance unengaged, whose potential productivity in the Western Balkans should be geared more remains untapped. The fewer people toward reaching the poor and vulnerable. working, the fewer people there are to support family members and, through taxes, With low rates of working come stagnant vital government expenditures on schools, rates of poverty reduction and welfare pensions, and social programs targeted to growth. The region made steady progress the needy. The overall trend in the region against poverty in the early and mid-2000s, with is toward an aging and—in some cases— overall poverty (defined as life on US$5 per day 24 Revving Up the Engines of Growth and Prosperity Figure 16: Labor income makes up a low share Figure 17: ...while reliance on transfers is high. of household income in the Western Balkans… (Western Balkans household income, by source, percent) (Most recent year available, percent) 90 100 80 70 80 60 50 60 40 40 30 20 20 10 0 0 SRB MNE BIH ALB MKD KSV WB6 LAC EAP B40 ALL B40 ALL B40 ALL B40 ALL B40 ALL B40 ALL ALB 2012 BIH 2011 KSV 2013 MKD 2008 SRB 2013 MNE 2014 labor income pension social assistance remittances other Source: EU Surveys of Income and Living Conditions 2012, Household Budget Survey Source: World Bank sta estimates based on the harmonized Europe and Central Asia 2010-2013, LAC data lab, and World Bank 2014 “East Asia Paci c at Work.” poverty dataset (ECAPOV). Note: Selected countries for LAC and EAP. Note: B40 refers to the bottom 40 percent of the income/consumption distribution. or less) heading down from about 35 percent following the global financial crisis, incomes of of the population to about 25 percent (Figure their bottom 40 actually increased, possibly due 18). Economic growth generally benefitted the to the early start of reforms in FYR Macedonia poor and vulnerable at a faster rate than the and the destruction of the Yugoslav institutions population at large, promoting shared prosperity in Kosovo.) The region’s poverty rate has held and slightly narrowing income inequalities. basically constant in recent years and remains However, that progress stalled after the global higher than in the transition economies of financial crisis hit in 2008. Between that year Eastern Europe. and 2013, average household consumption declined by between 5 and 17 percent in The people of the Western Balkans yearn Albania, Bosnia and Herzegovina, Montenegro, for a better quality of life. Citizens are and Serbia (Figure 19). Welfare of the two particularly dissatisfied with job opportunities: bottom consumption quintiles also suffered, two out of three feel that lack of jobs is the disproportionately in Serbia and Montenegro. most important problem facing their economies. (Kosovo and FYR Macedonia were exceptions: Other factors that harm quality of life include Revving Up the Engines of Growth and Prosperity 25 lifestyle-related risk factors—such as smoking While economic growth is necessary, and alcohol consumption—which compound a equitable access to basic services, health, non-communicable disease burden that is already and education is also critical if the poor high due to aging populations. While air quality and vulnerable are to access employment has improved in Bosnia and Herzegovina and and improve their livelihoods. Poor people Serbia, environmental practices such as waste are disadvantaged both in income and access management remain far behind EU standards. to services. In child bearing, for instance, poor The region is also exposed to extreme weather women in Serbia are less likely than better- such as heat, drought, and flooding, which off women to have adequate numbers of undermines agricultural production, energy medical care visits after a birth. Although 94 efficiency, and general welfare. Surveys indicate percent of the population in that country has that people in the Western Balkans are not as health insurance, lower-income groups have satisfied with their lives as their neighbors in the slightly higher unmet medical needs and lower 7STEE and Western Europe. insurance coverage. Similar disparities emerge Figure 18: Earlier poverty reduction stalled Figure 19: Pre-crisis growth benefited the bottom 40 after the crisis hit. percent of the populations, but welfare has declined since. (Poverty rate and GDP per capita growth, percent) (National consumption measures, annualized growth rates, percent) 40 12 All Bottom 40 10.1 35 10 30 8 6.8 6 5.0 25 4.0 4 3.5 3.3 3.7 2.6 2.4 20 2 1.5 1.3 1.1 0.7 15 0 10 -2 -1.2 -0.8 -1.3 -1.1 -1.4 5 -4 -2.9 -3.2 -3.8 -3.8 0 -6 2006-08 2008-10 2005-08 2009-12 2007-08 2009-13 2004-07 2007-11 2003-08 2009-13 2006-11 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 WB4-average - Poverty headcount $5/day in 2005PPP (pop weighted) - w/o KSV and BiH SRB ALB MNE BIH MKD KSV WB4-average - GDP per capita growth (annual %) - w/o KSV and BIH Source: World Bank Sta estimates based on the harmonized Europe and Central Asia Source: Systematic Country Diagnostics, based on World Bank sta estimates. FYR poverty dataset (ECAPOV) and World Development Indicators. Macedonia using poverty note, Kosovo using Europe and Central Asia poverty database Note: Regional average excludes Kosovo and Bosnia and Herzegovina due to issues in (ECAPOV). calculating PPP welfare aggregates. 26 Revving Up the Engines of Growth and Prosperity Figure 20: Bottom consumption quintiles Figure 21: Roma and poor children in Serbia are less educated. are disadvantaged in access to education. (Share of individuals aged 15+ with at most (Serbia, early child development or secondary school primary education) attendance, 2013, percent) 70 100 60 80 50 40 60 30 40 20 20 10 0 0 ALB 2012 BIH 2011 KSV 2014 MKD 2010 MNE 2014 SRB 2013 Roma Poorest Second Middle Fourth Richest Top 60 percent Bottom 40 percent Early Child Development Secondary Source: World Bank sta estimates based on the harmonized Europe and Central Source: Serbia Systematic Country Diagnostic, UNICEF Multiple Indicator Cluster Asia poverty dataset (ECAPOV). Survey, 2014. when comparing income groups on basic Some of the most dramatic differences in education (Figure 20 and Figure 21). poverty afflict the Roma minority. Poverty rates among Roma populations are estimated Living standards in cities are consistently to be two to four times that of non-Roma higher than in the region’s rural areas. living in similar neighborhoods in Western Concerning basic services such as health, Balkan countries. Roma children in Bosnia and education, sanitation, and electricity, access is Herzegovina have a 10 times higher chance of generally high in the Western Balkan states and malnutrition than non-Roma. In Serbia, only in line with countries of similar income levels, but one in eight Roma children has a chance of it is lower in rural areas than in urban centers. In receiving early childhood education (Figure addition, delivery of basic services is inefficient: 21). Disparities that begin in childhood carry governments in the region achieve the same over into adulthood, both in work and family outcomes as countries with similar income life, keeping groups down generation after levels, but sometimes at a much higher price. generation. Revving Up the Engines of Growth and Prosperity 27 28 Revving Up the Engines of Growth and Prosperity Labor market barriers discourage employment and fuel emigration With less than half of the working age would also ensure equity and inclusiveness of population actually seeking work, and a economic growth. quarter of job-seekers failing to find it, the need to reduce unemployment and Inflexible labor markets protect jobs inactivity is paramount. On the demand side, for a small number of people instead of improving the business and labor regulatory helping create jobs for large numbers of environment would enable firms to expand people. First, social security contributions their operations and create jobs. But for this and other labor taxes constitute the labor tax to bear full fruit, simultaneous action is needed wedge, the gap between the employer’s cost on the supply side to assure that workers of hiring and the worker’s take-home earnings. acquire the skills that firms need—better basic This wedge is particularly high for low-wage education and technical training, for example— earners in the Western Balkans (Figure 22). so that they can find and fill the new jobs that For example, in Serbia, around 37 percent of appear. Better chances of getting a job would the labor cost to the employer is taxed, placing bring discouraged workers back into the it among OECD countries with the highest labor force. More important still would be to tax wedge. The high minimum social security improve incentives—or eliminate disincentives contribution also does not depend on the that are embedded in the social protection hours worked, pushing low-skilled workers system—so that more people seek work. to low-paid and less-productive informal jobs. Clearing specific barriers to employment faced Overall, high taxes on labor make formal- by older workers, youth, women, and minorities sector jobs less attractive, for both employers Revving Up the Engines of Growth and Prosperity 29 and employees, pushing up unemployment and relatively low wages. Lengthy procedures by informality. Second, employment protection which companies register for social security measures such as restrictions on temporary create additional burden. work and high dismissal cost and severance pay remain stronger in the Western Balkans Search frictions and mobility constraints than in OECD countries and countries in result in low movement of workers other regions, despite reforms aimed at toward more productive jobs in other making markets more flexible while providing companies, sectors, or places. Compared adequate protection for workers (Figure 23). to other countries inside and outside Europe, Third, wage regulations in some countries the Western Balkans have the lowest rates of cause additional rigidity in the labor market. change in employment shares in each major For example, Albania’s high minimum wage, set sector (agriculture, industry, and services)— at 50 percent of the average wage, adds to even though low-productivity agriculture still already strong disincentives for firms to hire accounts for under 20 percent of employment workers formally, especially those who earn in all countries except Albania (where it is above Figure 22: High tax wedges and low progressivity Figure 23: Low labor market flexibility encourage unemployment and informality. impedes hiring. (Gap in tax wedge between high and low wage earners, 2012) (OECD Employment Protection Legislation Index) 25 Progressivity of tax wedge (percentage points) LAC (2014) IRL BEL Other non OECD (2012-15) 20 OECD av. (2013/14) FRA DEU WB6 (2013/14/15) 15 GBR AUT NLD ITA HUN BIH (2015) ESP SVN 10 KSV (2014) CZE NOR PR GRC SWE ALB (2015) USA EST MNE (2013) 5 LVA MKD SRB SRB (2015) JPN BIH MKD (2015) 0 BGR 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 0 0 0.0 05 0.5 1.0 10 15 1.5 20 2.0 2.5 25 30 3.0 3.5 Tax wedge for single at 33 percent of average wage OECD Employment Protection Legislation Index Source: World Bank based on OECD tax and bene t models. Source: OECD and World Bank sta calculations. 30 Revving Up the Engines of Growth and Prosperity Figure 24: Pensions are generous and too often Figure 25: Remittances are high available early, creating perverse incentives for and help drive up reservation wages. people in prime working age to retire. (In percent of GDP, 2015) (Pension spending per beneficiary as a share of GDP per capita and share of pensions going to people under age 65) 60 Kosovo BIH 50 WB6 Montenegro 40 Albania Serbia 30 7STEE FYR Macedonia SSF 20 MENA LAC 10 ECA EAP 0 OECD 0 5 10 15 20 Cze ia (2 4) Slo R. (2 4) ) ac IH 0) Slo ia ( ) EC i a ( 2 0 ) v 4) Lit i a 12) Alb R. (2 ) ia ) nte ia ( 9) a( ) gro 4) 14 4 on 011 4 an 014 rbi 14 k 1 an 1 ven 01 R M B (201 Aa 1 ch 01 Mo edon (200 ne 201 va 20 hu ( 2 0 20 Lat . (20 Se (20 Est v. (2 a v CD Percentage Points OE FY Pension spending as a share of GDP (%) Source: World Development Indicators and World Bank sta calculations. Proportion of pensioners eligible before age 65 (%) Note: Values might di er from national estimates. The same data source is used for international comparisons. SSF, MENA, LAC, ECA, EAP are regions of the world, Source: OECD, International Monetary Fund, Eurostat, and national authorities. as de ned in the World Development Indicators. 40 percent). The right policies would facilitate legacy pension systems (Figure 24). Statutory efficient job matching and labor reallocation increases of the retirement age that many across firms, sectors, and places by removing countries have enacted have so far had limited obstacles to internal labor mobility, promoting effect, given lax rules for early retirement. the sharing of reliable and timely information Pension systems continue to pay benefits to on job vacancies, and enhancing employment large numbers of people who are below the services that government offers. official retirement age. For example, in Serbia, where a pension replaces over 50 percent of The social protection system discourages the average wage, about half of pensioners are work and suppresses labor force below 65, the official retirement age. As a result participation. Retirement at an early age of numbers like these, workers aged 40 and is common, made possible by generous older in most of the six countries have strikingly Revving Up the Engines of Growth and Prosperity 31 high inactivity rates. In addition, social assistance Women, young people, and minorities benefits can discourage efforts to find work. suffer particular disadvantage in finding Although Serbia’s last-resort benefit is not high jobs. A large gap in employment rates on average, for some low-income households exists between men and women. Female it can come close to the net minimum wage. unemployment is on average 20 percent In Montenegro, the newly introduced lifetime higher than male. Younger workers (aged 15- benefit for non-working mothers of three or 24) face unemployment of close to 50 percent. more children amounted to up to 70 percent Even higher rates are common among the of the average wage in 2016. Social assistance countries’ minorities, notably the Roma: 44 benefits in the Western Balkans are also percent of Roma in Bosnia and Herzegovina designed to fall one-for-one when income are unemployed, for example, compared to increases, acting as a labor tax and reducing 27 percent of non-Roma living in the same incentives to take up low-paid and part-time communities. Policies that could remove jobs in the formal sector. barriers to employment of disadvantaged Figure 26: Female workers are particularly Figure 27: Unemployment remains particularly disadvantaged and have fewer economic opportunities. high among youth. (Labor force participation, percent of population (Total youth unemployment, percent of total labor force, aged 15+, 2015, national estimates) ages 15-24, national estimates) 90 50 80 40 70 60 30 50 40 20 30 10 20 10 0 SAS EAP SSA LAC ECA 7STEE MENA WB6 ng . en do o Sw a n d Mo S e nia Est ar y La ia Cr t via Bu oatia rm a Slo any hu a Ice nia ni a Alb BIH ne a gro Hu ak R Ge lgari Lit veni nte r b i a c e sov on ed a a l R M Ko v Slo 2000 2015 FY Source: World Development Indicators, Labor Force Surveys and World Bank sta calculations. Source: World Development Indicators, Labor Force Surveys, and World Bank sta calculations. Note: De nition of labor force may di er by country. Note: De nition of unemployment may di er by country. 32 Revving Up the Engines of Growth and Prosperity groups include providing greater child Figure 28: Emigration of the most educated workers may and elderly care, promoting flexible work limit growth potential. arrangements, and strengthening labor market (Percent of the tertiary-educated population living abroad) programs. 35 29.4 Skill gaps and mismatches also constrain 27.6 26.7 30 employment. Sixty percent of 15-year-olds 23.3 25 in Albania and 50 percent in Montenegro 20.3 17.5 score below the threshold for functional 20 15.3 literacy. In Montenegro, at least 15 percent of 15 11.3 11.1 10.1 the unemployed could not benefit from job 9.2 10 6.8 6.7 5.9 growth due to insufficient education and 20 5.4 5 percent due to occupational mismatch. 0 EAP ECA MENA LAC ALB BIH MKD Facing scant opportunity at home, 1990 2000 2010/11 younger people often seek their fortunes Source: World Development Indicators (for 1990 and 2000) and OECD (for 2010/11). No data on emigration abroad—as of 2013, a quarter of the six by education level are available for Kosovo and Montenegro. countries’ population had emigrated. Note: De nitions of emigration rates vary due to di erent sources of data. Many of these people send remittances to family members who stay behind, providing another crutch for personal survival in a were living abroad in 2000 (Figure 28). These moribund economy. Taken together, these countries would benefit from developing payments account for a substantial por tion job oppor tunities at home while harnessing of GDP (Figure 25) and household income, benefits from emigration such as investment especially in Kosovo and Albania (Figure and knowledge transfers from people living 17). But emigration is a mixed blessing for abroad. development. A regular remittance can undermine the recipient’s incentive to work. In addition, when a high share of the well- educated are leaving, the resulting “brain drain,” makes it all the more difficult for the home economy to advance. This challenge is par ticularly visible in FYR Macedonia, where almost 30 percent of university graduates Revving Up the Engines of Growth and Prosperity 33 34 Revving Up the Engines of Growth and Prosperity Western Balkan economies have major potential to improve their productivity For almost half a century, the Western improving their allocation to most productive Balkan countries had state-directed areas, and thus to increasing overall productivity economies, and many features of that in the economy. system remain in place. Many mines and factories that were owned and operated by New firms have difficulty entering the government in the socialist years are still in public market, and structural rigidities slow down hands, particularly in Bosnia and Herzegovina, labor reallocation to more productive Serbia, and Montenegro. Their technology is sectors. With high disincentives for hiring, many generally outdated and their efficiency low, but workers who don’t get coveted state jobs end year after year they remain in business, often up in low-productivity informal employment, behind protective walls that dilute incentives for such as selling in the market or doing odd jobs. modernization. High wages in state employment, The countries’ tax structures often serve to lock as well as remittances from family members these people into that work. The generally low- abroad, tend to drive up the local economy’s productivity agriculture sector, which accounts reservation wage, the lowest wage that a worker for a sizeable portion of employment, holds is willing to accept. Statutory minimum wages the potential for important gains if significant that are sometimes set well above one third numbers of those workers were to move to of the actual average wages also hurt formal jobs in higher-productivity sectors. But outside employment. These legacies of the past stand in of Albania, which has the highest employment the way of modernizing factors of production, share in agriculture, very few have. Lack of new Revving Up the Engines of Growth and Prosperity 35 Figure 29: Serbia’s productivity is low and slow-growing. Figure 30: Reallocation of labor between sectors (Real labor productivity in constant 2010 EUR and its has lowered productivity in Serbia. growth rate in percent, 2014) (Contributions to productivity growth, percentage points, 2009-2014) 6% 8 LIT 5% Cummulative Annual Growth Rate 6 EST 4% SVN S 4 BGR 6.70 3% HUN 3.00 ROU 2 2% POL LAT 0.79 0.90 -0.04 -0.01 CZE 0 1% SRB HRV 0.09 -1.58 -1.20 -2.84 0% -2 0 5000 10000 15000 20000 25000 30000 35000 40000 -1% SVK -4 Overall Mining Manufacturing Construction Services Real Labour Productivity Economy & Quarrying (Excl. Agric) Source: World Bank sta calculations based on Eurostat data and Serbia’s Structural Contribution from Structural Change Business Surveys 2009 to 2014. Note: Lower left quadrant denotes the lowest productivity and productivity growth among countries depicted. Comparable data are available for only Contribution from within sectors productivity growth Serbia among the Western Balkans countries. Real labor productivity is measured as value Source: World Bank sta calculations based on Eurostat data and Serbia’s Structural added (at factor cost) per person employed. Real values are euro 2010-adjusted. Compound Business Surveys 2009 to 2014. Note: Comparable data for other Western Balkan countries annual growth rate is based on growth between 2009 and 2014 for each country. are not available. jobs is just part of the problem; people are often growth of about 0.87 percent annually is much reluctant to relocate for new employment. lower than the 2.75 percent recorded among Surveys find that less than 40 percent of people the 7STEE (Figure 29). This is caused in part ages 18-64 are willing to move internally for by labor shifts between sectors and industries employment reasons. Yet so many people are that have worked against productivity, although willing to move abroad. it is also related to the ongoing restructuring and privatization in several industries, such Labor productivity is low and slow- as pharmaceuticals, which could temporarily growing. Approximating the region’s reduce productivity (Figure 30). Some highly average labor productivity at firm level with productive sub-sectors such as computer estimates that are available only in Serbia programing, real estate, telecommunications, and FYR Macedonia shows that the Western and rental and leasing activities are also Balkans states are lagging behind most 7STEE emerging, having recorded increases in countries. Serbia’s average labor productivity employment between 2009 and 2014. 36 Revving Up the Engines of Growth and Prosperity Figure 31: In most Western Balkan countries, productivity Figure 32: Total Factor Productivity has reduced levels have dwindled since the global financial crisis. growth more recently. (Total factor productivity, 2008 = 100) (GDP growth accounting decomposition, 2000-2014) 105 10 100 8 95 6 90 4 85 2 80 0 75 -2 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 70 -4 2000 2002 2004 2006 2008 2010 2012 2014 ALB BIH KOS MKD MNE SRB WB6 KOS SRB MNE BIH ALB MKD Capital stock Working age pop (15-64) Human Capital TFP GDP Source: World Bank sta calculations based on World Development Indicators, Eurostat Source: World Bank sta calculations based on World Development Indicators, Eurostat and national authorities' data. and national authorities' data. Figure 33: Western Balkan states are still far from Figure 34: And they are not very cost-competitive. the investment climate frontier. (Median cost of input per US$ of sales) (Doing Business scores, 0 worst to 100 best) 80 0.50 Median 7STEE (DB 2017) 75 0.45 Median WB6 Median WB6 (DB 2017) 70 0.40 Median 7STEE 65 0.35 60 0.30 55 0.25 50 0.20 ALB BIH KSV SRB MNE MKD HRV BGR SVN SVK LVA LTU EST ALB MKD KSV SRB BIH MNE ROU EST LTU SVN HRV BGR LVA DB 2010 DB 2017 Source: World Bank Doing Business and World Bank sta calculations. Source: World Bank Enterprise Surveys 2013 and World Bank sta calculations. Revving Up the Engines of Growth and Prosperity 37 Table 1. Western Balkan countries have a heavy burden of domestic regulation. ALB BIH KSV MKD MNE SRB 7STEE Doing Business rank (2017) - WB 58 81 60 10 51 47 27 Corruption Perception Index score (2016) - TI 39 39 n.a. 37 45 42 55 Intensity of local competition (2016-17) - WEF 116 119 n.a. 41 124 128 51 Extent of market dominance (2016-17) - WEF 124 108 n.a. 67 89 129 64 Effectiveness of anti-monopoly policy (2016-17) - WEF 112 105 n.a. 49 85 118 64 Business impact of rules on FDI (2016-17) - WEF 59 127 n.a. 32 95 102 50 Sources: Doing Business; Transparency International, and World Economic Forum’s Competitiveness Index. Making it easier to set up and grow private Without these, productivity-enhancing labor enterprises will accelerate the reallocation reallocation will advance very slowly. of resources to higher-productivity sectors and firms. In view of structural Despite recent reforms, the Western unemployment and emigration, productivity Balkans remain at considerable distance gains are the only sure means of improving from the business environment frontier competitiveness and growth. Yet total factor and are less competitive than their peers productivity levels dwindled in the Western (Figure 33). Competition from informal firms, Balkans after the global crisis, and in some political instability, poor access to finance, countries actually subtracted from growth high tax rates, and problems with electricity (Figure 31, Figure 32). But when they have service are the five main obstacles that formal occurred, gains of reallocation of resources enterprises identify. Among these factors, to more productive activities have been informal competition, poor access to finance, substantial. However, such reallocation does not and political instability appear to be more occur automatically. It needs such enticements severe obstacles in the Western Balkans than as a better business environment—rule of law, in the 7STEE countries, where tax rates are easier business entry and exit, better access cited as the biggest problem. Trade, customs, to finance, improved infrastructure, a skilled and transport-related infrastructure also workforce, and greater labor market flexibility. require attention—their current quality 38 Revving Up the Engines of Growth and Prosperity undermines export potential. Moreover, with Figure 35: The region can do much more to enable trade. low productivity levels, manufacturing firms in (Global Enabling Trade rankings, 2016) Western Balkans countries are generally less cost-competitive than those in the 7STEE BIH (Figure 34). There is an exception in the region, MKD however: FYR Macedonia, which was an early ALB WB5 reformer in improving its business environment. SRB MNE BGR Reforming burdensome competition HRV restrictions and high connectivity costs SVK 7STEE could upgrade and expand exports. Even LTU as cross-border banking flows dried up after LVA SVN 2008 and global demand remained low, FDI 0 20 40 60 80 100 120 140 inflows and export growth have continued to provide hope for a GDP growth revival, if Availability and use of ICTs Availability and quality of transport services E ciency and transparency of border administration only these countries could accelerate reforms Source: World Economic Forum. Note: The lower the rank, the better the situation. to become more attractive to business. Table 1 highlights the sizeable restrictions that exist on domestic competition and Figure 35 puts the region’s high connectivity costs in sharp relief. Revving Up the Engines of Growth and Prosperity 39 40 Revving Up the Engines of Growth and Prosperity With reforms, the state can help build a new growth model and deliver better services The state has a key role to play in used, and services delivered is paramount to reorienting the growth model of the rekindling growth. Across the board, the state’s Western Balkans towards one that is role should be to regulate and facilitate private- private sector-dominant, productivity- sector dynamism, not over-burden or distort driven, and export-led. Reforms must now investment and employment decisions. focus on creating a nimbler, and in some cases smaller state that will be a more effective State institutions and policies need to enabler of this new growth model. Currently provide the right regulatory, legal, and the state often has too much of a footprint fiscal environment for business creation in the wrong places, and too little in the right and growth. Reforming the legal and regulatory ones. This varies country to country. In Bosnia systems is crucial. Enhancing the quality, and Herzegovina, Montenegro, and Serbia, reliability, and timeliness of the state’s legal and the ratio of government spending to GDP regulatory systems is at the heart of improving remains well above norms of countries of the business environment to allow a dynamic similar income level; government wage bills private sector to drive growth, employment, and range from moderate to some of the largest poverty reduction. The quality of courts is poor among regional peers (Figure 36). In countries across the region, with inconsistent rulings and with outsized public sectors, reforms reducing high appeal rates. Procedural abuses go largely the size of the state are necessary, including unchecked. Delays are endemic—in Serbia addressing the legacy of often still-large state- and FYR Macedonia, it takes approximately owned enterprises. Improving the efficiency 635 days to enforce a contract, followed by of the way public money is spent, assets are Bosnia and Herzegovina, Montenegro and Revving Up the Engines of Growth and Prosperity 41 Albania, which are all at above 500 days. The security also distort labor markets. In a 2016 EU accession process has created incentive survey in the region, 79 percent of respondents for large-scale legislative reform but effective said they would prefer to work in the public implementation is very often lacking. Business sector given the choice, with levels reaching operations suffer in this complex and in some almost 90 percent in Bosnia and Herzegovina cases fragmented legal environment. Intellectual and Kosovo. property rights are a particular issue in Albania and Kosovo, where piracy is widespread. If Addressing structural rigidities in unable to enforce contracts, firms are less expenditures, such as relatively high likely to expand their collection of suppliers, shares of spending on wages and pensions, take on credit, and expand their business. is also necessary for restoring the macro- Enhanced independence, accountability, and fiscal stability which is a pre-requisite for professionalism of the judiciary would ensure sustained private investment. Ongoing that laws and regulations are implemented in reforms of fiscal regimes have helped restore an efficient and nondiscretionary way. Finally, stability since the global financial and euro governments should strive to ensure that crises. As growth declined, fiscal accounts access to the courts and to social services is deteriorated. As revenues shrank and interest equitable. costs rose, structural rigidities prevented changes in spending patterns—for example, Current fiscal regimes often distort reductions in pension and government wage incentives and undermine dynamism in bills. These spending rigidities did, however, the private sector. Fiscal policy can better support household incomes, mitigating the support private-sector growth and job creation, impact of the economic downturn (Figure particularly in those countries in the region 37). Most governments in the region were where the fiscal burden on the private sector able to use their fiscal space pragmatically is high. Countries might investigate lowering to manage the crisis impact. But debt levels high marginal tax and social contribution rates are now much higher than before the global that serve to keep people in the region’s large financial crisis (by around 20 percentage informal sector and stifle creation of formal points of GDP in some countries). Restoring jobs. In Bosnia and Herzegovina, social security macro-fiscal stability and debt sustainability contributions on the order of 35-40 percent has been a priority for countries such as of gross wages, the highest in the region, may Albania and Serbia, so as to rebuild confidence make the cost of bringing a worker into the among domestic and foreign investors and formal sector prohibitive. The large public- consumers. Public financial management has sector employment and its higher pay and job received considerable attention, with notable 42 Revving Up the Engines of Growth and Prosperity progress achieved on the comprehensiveness, to date. While consolidation efforts in Serbia transparency, and classification of budgets, for and Albania have helped bring fiscal deficits example, and the assessment of medium-term back in check, the situation in Montenegro raises fiscal risks. Procurement reform, such as in concerns. Efforts should continue to ensure Serbia, and internal financial controls, such as that policy makers can better monitor and in Montenegro, have also been areas of focus. limit the risks of future fiscal slippages, through such steps as improved control of spending Going forward, governments will need to commitments and reduction of arrears. Albania, redouble efforts toward fiscal consolidation for example, faced with general government and improved management of public arrears exceeding 5 percent of GDP in 2013, finances. Keeping the macro environment took steps to clear them and prevent a future stable for investment will require sustaining and accumulation. Bosnia and Herzegovina is now deepening the fiscal consolidation and public increasing its focus on stock-taking, monitoring, financial management improvements achieved and future resolution of public arrears. Figure 36: For half the countries in the region, Figure 37: Restoring macro-fiscal stability remains the ratio of government spending to GDP is well a priority for many countries following deterioration above norms by national income level. in the global crisis period. (Expenditures as percent of GDP, average 2012-2016) (General government net balance as percent of GDP) 60 2 50 BIH MNE 0 40 SRB -2 30 MKD KSV ALB -4 20 10 -6 0 -8 6 7 8 9 10 11 ALB BIH KSV MNE MKD SRB Ln GDP per capita 2012 (PPP international dollars) Average 2002-2007 2008 2010 2012 2014 2016 Source: World Development Indicators and IMF World Economic Outlook April 2016. Source: IMF World Economic Outlook (April 2017) and World Bank sta calculations. Note: The solid line indicates non-parametric nearest neighbor smoothing, with dashed lines showing con dence intervals at +/- 2 standard deviations. Y-axis is truncated at 60 percent. Revving Up the Engines of Growth and Prosperity 43 Figure 38: Satisfaction with public services is low Figure 39: Concern over corruption is high. relative to spending levels. (Percent of respondents agreeing with statements that corruption (Percent of respondents satisfied with quality and efficiency or bribery is one of the three biggest problems facing the country of public service delivery, average across indicators) in the public sector in this country, percent of respondents) e ciency of public service delivery), simple average, 2016 LITS (percent of respondents satis ed with quality and 90 90 TUR EST 80 80 LVA SVK SVN 70 70 M UZB ROM UZ 60 GEO LTU TU T LT U POL HRV ARM S BGR RUS BGG 50 60 HUN H ALB 40 MNG RB SRBB MN M MNE 50 30 KAZ KYR R UKR UKR TJK MKD B BLR BIH 20 40 MDA 10 30 0 20 25 30 35 40 45 50 55 ALB SRB MKD MNE KSV BIH Median 7STEE General government expenditures Corruption or bribery is one of the three biggest problems facing the country to GDP (percent), average 2012-2016 Rate their government "badly" at ghting corruption in government Source: EBRD Life in Transition Survey, 2016, and IMF World Economic Outlook, April 2017. Source: Transparency International: “People and Corruption: Europe and Central Asia,” Global Corruption Barometer 2016. Improvements in the effectiveness of Bosnia and Herzegovina account for at least public spending and quality of service 10 percent of GDP, almost two times higher delivery would support a new growth than in the European Union, and 1.5 times model and promote equity. Use of public higher than in an average upper middle income resources can become more effective by country—yet without higher health outcomes. improving the allocation of spending. In Geographic and socio-economic disparities in particular, rigid recurrent spending and the the delivery of public services put the poor need for special fiscal response to the recent and rural dwellers at particular disadvantage. crises have limited the fiscal space available for Better targeted and more effective spending productive investment. Enhancing social service on education and health would address skill delivery would also be beneficial. Satisfaction gaps and enhance human capital and economic with public services in the Western Balkans opportunities. Higher-quality infrastructure is generally low relative to spending levels in transportation, supported by improved (Figure 38). Health expenditures in Serbia and quality and, for some countries, higher levels 44 Revving Up the Engines of Growth and Prosperity of public investment spending, would facilitate such as e-government, can help businesses and the shipping of goods to markets. If the benefits workers alike to feel secure in committing their of future growth are to be shared across the funds and futures to the region. population, social safety nets will need to become more comprehensive and, in view of Reforms will succeed only if backed by fiscal constraints, better targeted. political will. This transition is not easy. Government will need to manage the potential Improving service delivery and making distributional disruptions of reforms (for the policy reforms outlined above will example, if pensions are changed) and weigh require a strengthening of capacity within prospects of enhanced future growth against public administrations. This includes moving the interests of those who benefit from the towards independent, efficient, and honest status quo. Corruption and the capture of state public administrations that are in line with institutions by private interests pose a serious European standards. Public servants must be impediment to reform. However, as seen in the empowered to participate in the design and difficult fiscal reforms moved forward in some implementation of reforms. Policy processes countries in recent years, there is a growing need streamlining and central government understanding that there can be no more strengthening to improve coordination. postponing. Looking outwards, the countries Corruption and political interference in of the region can see the results of the “EU government agencies, especially the judiciary, convergence machine” which has supported must be tackled to allay concerns among improvements in economic governance and citizens, firms, and foreign investors that set higher incomes. Looking inwards, the stalling of back broad objectives of national development improvements in living standards in the Western (Figure 39). While some countries have passed Balkans since the global financial crisis has also reforms aimed at protecting the integrity of helped to crystallize the view that now is the their legislative systems, the enduring pattern time to deliver on the region’s potential. The across the region is that corruption is rarely region owes it to its people to move ahead with punished in courts. Enhanced accountability reforms to raise economic growth rates and and oversight, including through innovations ensure sustained improvement in welfare for all. Revving Up the Engines of Growth and Prosperity 45 46 Revving Up the Engines of Growth and Prosperity Postscript The six Western Balkan nations face Figure 40: At the current relative growth speed, it will take similar policy challenges. If they maintain about 60 years for the Western Balkans to converge to the the status quo and continue to grow per average EU level of income. capita income relative to the EU at the (GDP/capita international 2010 PPP dollars relative to EU, percent, average rate they achieved in 1995-2015, years to achieve convergence) it will take about 60 years to catch up with their neighbor (Figure 40, compare to Figure 100 1). To speed up convergence, they need to 80 deepen reforms to raise productivity and economic growth through fur ther integration 60 into regional and world markets and to raise living standards through higher employment 40 and equity in access to services. 20 To aid in these tasks, the World Bank has 0 produced Systematic Country Diagnostic 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 reports for five of the countries (all but WB6@5% 7STEE@5% FYR Macedonia, whose report is still in WB6@3% 7STEE@3% WB6@average 7STEE@average progress). These diagnostics identify four Source: World Development Indicators and World Bank sta calculations. Note: Growth rates are relative to top policy priorities that are common across the EU. Median relative growth rates 1995-2015 are 1.8 percent for WB6 and 3.2 percent for 7STEE. all the countries: Revving Up the Engines of Growth and Prosperity 47 • Foster macroeconomic stability. the Western Balkans. Poor infrastructure, • Remove disincentives and barriers to including roads and railways, workers who did work. not always have the right skills, and a lack of • Strengthen the business environment and experienced local managers—Fiat’s success private sector development. in overcoming these and other challenges • Improve governance and institutions and to create a large-scale employer and point deepen public sector reform. of technology transfer is encouraging. The company can take pride in raising the Coordination at the regional level would also region’s sophistication of expor ts, providing heighten integration within the region and jobs to a young and educated labor force, with the rest of the world. and placing orders with many suppliers in Serbia and across the region. There is plenty As for Fiat, today it offers proof of of room in the Western Balkans for others what other private firms could do in to do the same. 48 Revving Up the Engines of Growth and Prosperity