WESTERN BALKANS REGULAR ECONOMIC REPORT No.20 | Fall 2021 Greening the Recovery Western Balkans Regular Economic Report No.20 Greening the Recovery Fall 2021   © 2021 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. Rights and Permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. The cutoff date for the data used in this report was September 29, 2021. Acknowledgements This Regular Economic Report (RER) covers economic developments, prospects, and economic policies in the Western Balkans region: Albania, Bosnia and Herzegovina, Kosovo, Montenegro, North Macedonia and Serbia. The report is produced twice a year by a team led by Sanja Madzarevic-Sujster and Richard Record (Task Team Leaders). This issue’s core team included World Bank staff working on the Western Balkan countries (with additional contributions to specific sections): Marc Schiffbauer, Asli Senkal, Yan Liu, Zenia Ann Rogatschnig, Harald Jedlicka (Growth section), Sanja Madžarević-Šujster, Joana Madjoska (Labor section), Trang Nguyen, Ana Maria Oviedo, Leonardo Lucchetti, Carlos Gustavo Ospino Hernandez, Sarah Coll-Black, Stefanie Brodmann (Poverty section), Milan Lakićević, Besart Myderrizi (Fiscal section), Hilda Shijaku, Christoph Ungerer (Monetary section), Alper Oguz, Jane Hwang (Financial sector section), Sandra Hlivnjak, Tihomir Stucka (External section), Natasha Rovo, Lazar Šestović, Collette Mari Wheeler, Julia Renee Roseman Norfleet (Outlook section) and Grzegorz Peszko, Richard Record, Simon David Ellis, Sameer Akbar, Penelope Ann Mealy, Esther G. Naikal, Katharina Gassner, Arno Behrens, Elena Merle-Beral, Claudio Protano, Klas Sander, Rhedon Begolli, Ramon Munoz-Raskin, and Alexis Rivera Ballesteros (Spotlight). Research assistance was provided by Suzana Jukić. Diane Stamm provided assistance in editing, and Budy Wirasmo assistance in designing. The cover image was created by Sanja Tanić. The dissemination of the report and external and media relations are managed by an External Communications team comprised of Paul A. Clare, Sanja Tanić, Lundrim Aliu, Anita Božinovska, Ana Gjokutaj, Jasmina Hadžić, Gordana Filipovic, Mirjana Popović, and Carl Hanlon. The team is grateful to Linda Van Gelder (Regional Director for the Western Balkans); Lalita Moorty (Regional Director, Equitable Growth, Finance and Institutions); Jasmin Chakeri (Practice Manager, Macroeconomics, Trade, and Investment Global Practice); and the Western Balkans 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 the Ministries of Finance and Central Banks in Western Balkans countries. This Western Balkans RER and previous issues may be found at: www.worldbank.org/eca/wbrer/. WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Contents Acknowledgementsv Greening the Recovery 1 1. Overview 2 2. The Western Balkans is experiencing a strong recovery 6 3. The labor market is struggling despite a growth recovery 11 4. Poverty reduction is resuming slowly due to an uneven labor market performance 16 5. Fiscal policy needs to strike a balance between maintaining stability and boosting growth 20 6. Stronger demand and higher global prices are creating inflationary pressures 25 7. Preserving financial stability is key in the post-COVID-19 recovery 28 8. External imbalances are set to moderate in most Western Balkan economies 33 9. Setting the course for a stronger and greener economic recovery 37 10. Spotlight: From a green recovery to green transition in the Western Balkans 46 References66 Country Notes 68 Albania69 Bosnia and Herzegovina 74 Kosovo80 Montenegro86 North Macedonia 92 Serbia97 Key Economic Indicators 103 List of Figures Figure 2.1. All Western Balkan countries have experienced a strong economic recovery in 2021. 6 Figure 2.2. The recovery is driven by a strong rebound in consumption and tourism. 6 Figure 2.3. Higher demand for commodities drove recent goods export growth. 7 Figure 2.4. Despite fewer projects, FDI inflows shrank much less than in other regions in 2020. 8 Figure 2.5. Manufacturing, financial services, transportation, and construction attract most FDI. 8 Figure 3.1. The employment rate is decreasing despite a robust rebound. 11 Figure 3.2. The public sector is leading the job creation, while agricultural job losses still loom. 11 vi  | Contents GREENING THE RECOVERY Figure 3.3. Unemployment rates increased except in Kosovo and North Macedonia. 13 Figure 3.4. Inactivity remains a challenge. 13 Figure 3.5. Employment expectations have reached a record low in late 2020… 14  yet, almost three-fourths of Western Balkan firms will either maintain Figure 3.6. … their current employment levels or even increase it. 14 Figure 3.7. Small and micro firms are more concerned about employment decline. 15 Figure 3.8. Is it lack of adequate skills or lack of jobs that drives unemployment? 15 Figure 4.1. The region’s poverty rate is expected to decline in 2021 to about its 2019 level. 16  ood price inflation could significantly affect the purchasing power of Figure 4.2. F poor households. 17 Figure 5.1. Fiscal deficits have narrowed in most Western Balkan countries… 20 Figure 5.2. …owing to robust revenue growth and lower expenditure 20 Figure 5.3. Expenditure is marginally contracting from its very high levels in 2020. 21 Figure 5.4. Capital expenditure has underperformed in Kosovo and Montenegro. 21 Figure 5.5. Public and publicly guaranteed debt (PPG) remains elevated… 22 Figure 5.6. …due to the rise in external debt. 22 Figure 5.7. The EU provided Macro-Financial Assistance to almost all countries... 23  while the IMF increased SDR allocations worth EUR 1.5 billion for Figure 5.8. … the Western Balkans. 23 Figure 5.9. Average nominal interest rate on public debt in 2012 and 2021. 23 Figure 6.1. Inflation is picking up in the Western Balkans. 25 Figure 6.2. Food and energy prices drove most of the increase in inflation. 25 Figure 6.3. Minimum wages have gone up in most COVID-19-affected countries. 26 Figure 6.4. The impact of demand pressures on core inflation shows a mixed picture. 26  n countries with a flexible exchange rate, anchored expectations have Figure 6.5. I enabled monetary stimulus to continue. 26  PL ratios increased slightly in Q1 2021 and are expected to increase Figure 7.1. N further as borrower relief measures expire. 28 Figure 7.2. Banks preserved capital buffers 28 Figure 7.3. Credit growth has been positive in all countries but with a slower pace in H1 2021. 29 Figure 7.4. Lending to households surged in 2021. 29  urrent account deficits will narrow or remain unchanged across most of Figure 8.1. C the Western Balkans. 34 Figure 8.2. Net FDI remained an important financing source of the current account deficit. 34 Figure 8.3. Total external debt and foreign exchange reserves rose sharply. 35 Figure 8.4. Net international investment positions worsened. 35 Figure 9.1. Growth is settling at pre-crisis levels from 2022. 37 Figure 9.2. Vaccination rates are lower than in the EU. 37  ercentage of the unvaccinated population that will take the COVID-19 Figure 9.3. P vaccine when available. 38 Figure 9.4. Global economic developments. 41 Figure 9.5. Western Balkan convergence. 44 Contents  |  vii WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Figure 10.1. Higher carbon intensity of GDP in the Western Balkan than in EU. 49 Figure 10.2. High reliance on fossil fuels in primary energy use. 49 Figure 10.3. Are the Western Balkans accumulating or depleting their wealth? 52 The structure and value of wealth per capita in Western Balkan and Figure 10.4.  selected comparators 53 Western Balkan countries have been slowly decreasing reliance on Figure 10.5.  exports from emission-intensive sectors, but it remains high except in Albania. 56 Figure 10.6. Green Complexity Index ranking, Western Balkans and selected countries. 57 Figure 10.7. Green competitive strengths and potential opportunities in the Western Balkans. 58 Direct subsidies provided to coal/lignite electricity producers in the Figure 10.8.  Western Balkans. 62 List of Tables Table 1.1. Western Balkans Outlook, 2019–2023. 5 Poverty reduction is projected to resume at a different pace across Table 4.1.  countries, reflecting the uneven labor market recovery. 17 Top 4 structural reforms needed to close the gap with Germany: Table 9.1.  Regulations, governance, financial development, and digitalization. 44 Table 10.1. Energy excise taxes in the Western Balkans and selected EU countries compared to proposed ETD tax rates. 63 List of Boxes The Western Balkans could benefit from realignment of global production Box 2.1.  networks in the post-pandemic context. 8 Box 3.1. Employment expectations of businesses and individuals remain grim. 14 Box 4.1. The COVID-19 crisis has initiated a series of social assistance systems reforms. 19 Well-designed Public Credit Guarantee Schemes are a useful instrument to Box 7.1.  support the economic recovery. 31 Box 8.1. Macro-financial indicators point to external vulnerabilities in the Western Balkans. 35 Box 9.1. Understanding COVID-19 vaccine hesitancy in the Western Balkans. 38 The global economy is expected to see a strong rebound, but continues to Box 9.2.  be subject to key downside risks. 40 Learning from each other would help to boost economic convergence in the Box 9.3.  Western Balkans. 44 viii  | Contents Greening the Recovery WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 1. Overview In 2021, the Western Balkans is seeing an Balkan countries, with Montenegro seeing accelerated rebound from the COVID-19- no improvement yet. The unemployment induced recession that all six economies rate increased in the first half of 2021 in experienced in 2020. The recovery is taking most countries, except Kosovo and North hold at a faster-than-expected pace, with strong Macedonia. While the employment support growth performances recorded across the region programs implemented in response to in the second quarter of 2021, in contrast to the pandemic helped blunt the impact of the subdued performance seen in the first COVID-19 on the labor market, a post-crisis quarter (and as noted in the Spring 2021 jobs recovery will not be easy. Furthermore, job Regular Economic Report). However, while the losses from the recession and its aftermath have recovery is broad-based—as a result of strength disproportionately affected women and youth, in both domestic and external demand—it is which may set back efforts to raise the region’s also fragile. perennially low rates of labor force participation. Experience from previous crises suggests that The rebound is being supported by a prolonged high youth unemployment could heady combination of domestic reopening, result in long-term labor force scarring. allowing for a recovery in consumption and tourism arrivals, and favorable external While the pace of vaccinations has picked conditions for the region’s exports. As a result up, the Western Balkans still lags more of falling infection rates, countries across the developed European neighbors. Vaccination region were able to loosen both domestic and rates1 are below 40 percent of the overall cross-border mobility restrictions during late population in most countries of the Western spring and summer. This saw a sharp rebound Balkans, except for Kosovo and Serbia. This in domestic consumption and in travel across lack of vaccination protection means that the Europe, boosting remittances as well as tourism region is less prepared than advanced economies inflows during the peak summer season. A to withstand the ongoing Delta wave or new strong recovery in advanced economies, due to variants that might emerge, with COVID-19 rapid vaccination and helped by fiscal stimulus, infectivity and mortality rates already rising also provided a welcome boost to demand for sharply across the region. Further, vaccine the region’s exports. hesitancy, which appears to be higher across the Western Balkans compared to European Union However, early warning signals from the (EU) averages, suggests that new approaches labor market call for close policy attention. will be needed to reach the levels of vaccination The labor force participation rate edged up needed to effectively suppress severe cases of during the first half of 2021 in several Western COVID-19. 1 Measured as a total number of people who received at least one vaccine dose divided by the total population of the country. 2  |  1. Overview GREENING THE RECOVERY Fiscal balances have started to improve as a continues to maintain resilience due to a result of a stronger economic performance, combination of COVID-19 support measures but it will take further effort to replenish and the growth rebound. Public measures buffers. The growth recovery is contributing to have helped to mitigate the impact of the buoyant revenue collection across the region, 2020 recession on bank asset quality, keeping particularly in value-added tax collections, as nonperforming loan ratios broadly stable. domestic consumption strengthens. Similarly, However, the health of the banking system will a leveling off of public spending in 2021 after be tested during the recovery, particularly as the countercyclical surge of 2020 is helping on remaining borrower relief measures are phased the expenditure side. As a result, all countries out. except Bosnia and Herzegovina expect to see a narrower fiscal deficit in 2021, with the The outlook for Western Balkan countries average deficit reduced by 2.7 percent of GDP has improved due to a stronger-than- year-on-year. However, the deficits across all expected economic performance in 2021. economies of the Western Balkans are still GDP growth is projected to reach 5.9 percent above pre-pandemic trends, and the legacy of in 2021, after a 3.1 percent contraction in the pandemic is a stock of public debt that 2020. Thereafter, a steadier pre-crisis growth has now reached historic highs in all countries path is expected to resume, with growth in the except Serbia and Bosnia and Herzegovina. region projected at 4.1 percent in 2022 and 3.8 As the recovery from COVID-19 takes hold, percent in 2023. Pre-crisis levels of output are greater efforts will be needed to mobilize and expected to be surpassed by the end of 2021 for diversify sources of revenue and to streamline all economies in the Western Balkans, except expenditure programs, which in turn would for Montenegro (by mid-2022). The 2020 help address fiscal vulnerabilities that have recession saw a reversal of previous reductions arisen during the crisis. in the level of poverty in the Western Balkans. With a full year growth recovery in 2021, In line with global conditions, inflationary the poverty rate for the region is projected to pressures in the Western Balkans are on an resume its historical downward trend and fall upward trajectory. Average inflation is projected by around 1 percentage point to 20.3 percent, to reach 2.3 percent in 2021 from 0.9 percent close to its 2019 level. in 2020. On the external side, strengthening demand in advanced economies is driving This more positive outlook is still marred by commodity prices upward and putting pressure risks clearly tilted to the downside, not least on COVID-19-strained logistics networks and of which is the further impact of domestic global value chains. Similarly, the faster-than- or international movement restrictions as a expected recovery in domestic consumption result of new pandemic flare-ups. Depleted across the region has placed upward pressure fiscal space and high debt levels will continue on domestic costs, particularly in labor markets to weigh on the region. Political uncertainty during the summer tourism season. would also delay a recovery in both domestic and foreign investment, which the region needs Financial sector conditions are supportive of to boost potential output. growth, but risks remain. The financial system 1. Overview  |  3 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 As the Western Balkans starts to look the many policy tradeoffs, will need to be a beyond the pandemic, the policy focus core focus of policy attention for the Western will need to shift back toward addressing Balkans in the years ahead. the key structural impediments to job creation and economic transformation. Many of these constraints, which among others include weak firm-level productivity, lack of market competition, limited regional economic integration, and weak institutions, have become even more apparent as a result of the stresses that COVID-19 has placed on the region. At a time when fiscal space has narrowed, structural reforms would help boost private investment as well as ease preparation toward EU membership. Furthermore, the six countries of the Western Balkans now find themselves at a key decision point regarding the impending green transition. The external environment is going through a fundamental structural change. Global strides toward action on climate change, biodiversity loss, air and plastic pollution, and other existential environmental crises are changing the foundations of economic activity, consumer choices, and investor behavior everywhere. Yet, the Western Balkans are currently characterized by a development model tilted toward familiar brown industries, supported by “sticky” brown skills and jobs, and established value chains and market infrastructure. Leapfrogging to a green growth pathway is far from easy, especially in the short term. However, despite myriad challenges, the green transition also offers opportunities for the Western Balkans, not least through closer integration into Euro-centric global value chains, as well as access to significant EU resources to help fund a green transition. Effectively managing this transition, including 4  |  1. Overview GREENING THE RECOVERY Table 1.1. Western Balkans Outlook, 2019–2023. 2019 2020 2021e 2022f 2023f Real GDP growth (percent) Albania 2.2 -4.0 7.2 3.8 3.7 Bosnia and Herzegovina 2.8 -3.2 4.0 3.0 3.2 Kosovo 4.8 -5.3 7.1 4.1 4.4 North Macedonia 3.2 -4.5 4.6 3.7 3.4 Montenegro 4.1 -15.3 10.8 5.6 4.8 Serbia 4.3 -0.9 6.0 4.5 4.0 WB6 3.6 -3.1 5.9 4.1 3.8 Real GDP components growth (percent) Consumption 3.4 -1.8 4.0 2.9 2.7 Investment 1.0 -2.4 1.3 0.4 1.5 Net exports -0.8 -1.9 1.2 0.8 -0.3 Exports 3.0 -10.3 10.9 4.4 3.3 Imports (-) 3.8 -8.5 9.7 3.6 3.6 Consumer price inflation (percent, period average) 1.5 0.9 2.3 2.1 2.1 External sector (percent of GDP) Goods exports 28.5 27.6 31.1 31.8 32.4 Trade balance -13.6 -13.8 -13.3 -12.2 -11.8 Current account balance -6.2 -5.7 -5.6 -5.1 -4.7 Foreign direct investment 4.9 5.4 4.8 4.9 5.0 External debt 76.5 90.6 93.9 91.5 90.8 Public sector (percent of GDP) Public revenues 35.6 35.0 36.6 36.4 36.3 Public expenditures 37.0 42.2 41.2 38.8 37.9 Fiscal balance -1.3 -7.3 -4.6 -2.4 -1.6 Public and publicly guaranteed debt 50.3 60.9 58.9 57.4 56.0 Source: State statistical offices; Ministries of Finance; central banks; World Bank staff estimates. Note: e = estimate; f = forecast. 1. Overview  |  5 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 2. The Western Balkans is experiencing a strong recovery The Western Balkan economies are that may lead to further mobility restrictions, rebounding strongly from the economic uncertainty around the recovery remains high. crisis caused by the COVID-19 pandemic, in line with global trends. While the human toll Consumption is driving growth in the of the pandemic continues to accumulate in region, contributing 4 percentage points the region, economies are recovering faster than to economic growth as social distancing previously projected as stringent containment measures eased compared to 2020  (Figure measures are being relaxed and external 2.2). Higher wages, credit growth, remittances, demand picked up. Following a contraction of a strong tourism season, and pent-up demand 3.1 percent in 2020, the Western Balkans are are pushing up private consumption despite the set to grow 5.9 percent in 2021, 1.5 percentage slow recovery in labor markets and increasing points higher than projected earlier (Figure consumer prices in all Western Balkan countries. 2.1). The uptick in the estimates reflects Public consumption is supporting growth, improved external conditions (with European except for Montenegro and Kosovo, where Union growth revised upward by 1 percentage spending decelerated. Public consumption point), higher commodity prices, recovery in growth is driven by higher public sector wages tourism exports, and improved business and in Albania, Bosnia and Herzegovina, and consumer sentiment. Economic activity in the Serbia; and spending on goods and services region is projected to bounce back to 2019 also contributes to the rise in Albania, North levels by year-end. Yet, with low vaccination Macedonia, and Serbia. rates across the region, and the continued race between the variants and vaccinations globally Figure 2.1. All Western Balkan countries have Figure 2.2. The recovery is driven by a strong experienced a strong economic recovery in rebound in consumption and tourism. 2021. Percent Contribution to growth, percentage points 12 10.8 12 8 7.2 7.1 10 6.0 5.9 4.6 4.0 8 4 3.7 6 0 4 -4 2 -8 0 -12 -2 -16 -4 MNE ALB KOS SRB MKD BIH WB6 EU27 MNE ALB KOS SRB MKD BIH J 2019 J 2020 J 2021e J Consumption J Investment J Net exports Q Real GDP growth (percent) Source: National statistical offices; World Bank staff estimates. Source: National statistical offices; World Bank staff estimates. 6  |  2. The Western Balkans is experiencing a strong recovery GREENING THE RECOVERY Private investment is recovering after a Kosovo, and Serbia. In Kosovo value of goods considerable drop in 2020. Investment is exports have marked a substantial increase contributing 1.3 percentage points to economic throughout the pandemic, driven by both base growth in the region driven by private and metals and minerals exports, but also across public investment in most countries. Private the board increases in other products reflecting investment is firming up in all Western Balkans further diversification in goods exports. Only countries, as business sentiment recovers, and in Montenegro, commodity exports have investment lending accelerates. In Albania, recently started to fall back below their 2019 North Macedonia, Serbia, and to a lesser extent level (Figure 2.3). As international travel in Bosnia and Herzegovina, higher public restrictions eased and vaccinations hastened investment is also supporting growth. Public in Europe, Kosovo, Montenegro, and Albania investment is expected to decline by yearend further benefitted from a strong recovery in in Kosovo and Montenegro due to delays in tourism revenues, boosting service exports. implementation. Net foreign direct investment Net exports are adding 1.2 percentage points (FDI) inflows to the region remain resilient to growth in the Western Balkan region. and have declined much less than in the EU The net export contribution is highest in and most other regions in the world since Montenegro (6.6 percentage points) driven by the start of the pandemic. While European a surge in service exports driven by a strong investors have long dominated FDI and tourism recovery. It is positive in all countries, stronger global value chain participation in the except for Serbia and North Macedonia where Western Balkans, the region has increasingly import growth outpaced export growth driven attracted new investors from North America by higher domestic demand or high import and East Asia. There has been discussion that component of exports. the pandemic may provide significant FDI opportunities for Eastern European countries Figure 2.3. Higher demand for commodities from nearshoring. While there is little evidence drove recent goods export growth. so far for massive FDI nearshoring taking place Commodities goods exports 190 in the region, the Western Balkan economies 170 could still benefit from a realignment of global 150 production networks in the post-pandemic 130 phase (Box 2.1). To take full advantage of these opportunities, the Western Balkan economies 110 need to embrace proactive policies to strengthen 90 their investment competitiveness. 70 50 r-19 -19 ep-19 ec-19 ar-20 n-20 p-20 ec-20 ar-21 un-21 Ma Jun Se Higher demand and prices for commodities ▬ ALB S ▬ BIH D M ▬ KOS Ju ▬ MNE D M ▬ MKD J ▬ SRB including metals and minerals have Source: National statistical offices; World Bank staff estimates. Note: index, 2019=100; 3 months moving average. driven the surge in goods exports in the Western Balkans since the start of the year. Commodity exports are between 30– Growth in services—the hardest-hit sector 80 percent higher than in the year before the in 2020—is spearheading the recovery. pandemic in Albania, Bosnia and Herzegovina, The recovery is broad-based across economic 2. The Western Balkans is experiencing a strong recovery  |  7 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 activities, except agriculture. The service sector earthquake reconstruction ensue. In Bosnia and is marking the fastest recovery, particularly Herzegovina, manufacturing is also picking up in tourism, as foreign tourist overnight stays, thanks to higher external demand. In North and diaspora travel have picked up. The Macedonia, the fastest recovery is occurring in contribution of agriculture to growth remains trade, transport, tourism, manufacturing, and limited in all countries and is negative in information and communications technology, Serbia due to weather-related shocks. In while construction activity contracted in the Albania, construction continues to add to second quarter. growth as infrastructure projects and post- Box 2.1. The Western Balkans could benefit from realignment of global production networks in the post-pandemic context. COVID-19 has presented an unprecedented shock to global FDI flows. Despite challenging circumstances, the Western Balkan economies fared relatively well in attracting foreign investment. FDI inflows shrank by 16 percent in 2020 compared to 2019 in the Western Balkans region, much better than the small transition European economies (STEEs)2 and EU countries, which suffered from a 43 percent and 73 percent decline in FDI inflows, respectively (Figure 2.4). The Western Balkan region, however, was bearing the brunt of a collapse in new investment announcements. The number of greenfield FDI project announcements plummeted to 65 in 2020, the lowest reading since the data became available in 2003. As a leading indicator, fewer greenfield project announcements may portend a slowdown in actual FDI inflows in the coming months. Proactive government policies might be warranted to restore investor confidence in the region. Figure 2.4. Despite fewer projects, FDI Figure 2.5. Manufacturing, financial inflows shrank much less than in other services, transportation, and construction regions in 2020. attract most FDI. 2020 vs 2019 (percent change) Million EUR 25 0 15–19 avg. 1,141 627 310 540 420 322 467 407 419 -25 -50 2020 819 760 460 445 408 343 324 201 395 -75 WB6 STEE7 SSA EAP LAC SA EU NA Developing Developed countries countries 0 1,000 2,000 3,000 4,000 5,000 J Change in FDI inflows J Manufacturing J Financial J Transportation J Construction J Change in number of greenfield FDI projects J Real estate J Mining J Utility J Wholesale J Professional J Others Source: National statistical offices; World Bank staff estimates. Source: National statistical offices; World Bank staff estimates. Note: Change in FDI inflows by region. EAP = East Asia and Pacific; Note: Sectoral composition of FDI. EU = European Union; LAC = Latin America and the Caribbean; NA = North America; SSA = Sub-Saharan Africa; STEE7 = small transition European economies; WB6 = Western Balkans 6. 2 STEE includes Bulgaria, Croatia, Estonia, Latvia, Lithuania, Slovak Republic, and Slovenia. 8  |  2. The Western Balkans is experiencing a strong recovery GREENING THE RECOVERY Box 2.1 continued Demonstrated FDI resilience in several sectors, global value chain diversification, and potential nearshoring could contribute to the much-needed sustainable and inclusive growth in the region in the post-pandemic era. Manufacturing, financial services, transportation, construction, and real estate were the top FDI receiving sectors in the region before the crisis (Figure 2.5). Manufacturing received the most FDI in Bosnia and Herzegovina, North Macedonia, and Serbia. FDI in Albania flows primarily to utilities, financial services, and mining, while FDI in Kosovo is concentrated in real estate. Official FDI statistics for the entire region show a 28 percent contraction in manufacturing FDI and an 18 percent decline in construction FDI in 2020 compared to the 2015–19 average, while FDI inflows in financial services and transportation grew by 21 percent and 48 percent, respectively. Both the official statistics and greenfield FDI announcement data reveal an uptick in FDI inflows in automotive components in 2020, driven by a huge investment in Serbia. In Serbia, for example, FDI inflows in the sector almost doubled from EUR 173 million in 2019 to EUR 301 million in 2020, with further significant investment announcements in the pipeline.3 Greenfield FDI in Business Process Outsourcing (BPO) and tourism also grew by 60 percent and 11 percent, respectively. The global shift toward electrical vehicles and digitalization holds potential for the region to integrate into automotive, electronics, and IT-BPO value chains by targeting FDI in these emerging sectors. European investors have long dominated FDI inflows in the Western Balkans region and continue to expand investment in many global value chain (GVC)-intensive sectors. Meanwhile, the region has increasingly attracted investors from North America and East Asia, attesting to the region’s global competitiveness. EU investors consistently accounted for about half of total FDI inflows into the region during 2013–19. Other Europe and Central Asian economies contributed to another 30 percent of FDI inflows. During 2014–19, FDI from the EU nearly quadrupled in North Macedonia, EU investment also more than doubled in Kosovo, and nearly doubled in Albania. FDI from the EU has boomed in a wide range of sectors in recent years, including automotive components, consumer products, electronic components, textiles, software, and IT services. Yet, recently, FDI inflows to the region from North America and East Asia have been growing more rapidly than FDI from the EU and remained resilient during the pandemic. Greenfield FDI data suggest that newly announced investments from the EU more than halved in 2020 relative to 2019, while new investments from East Asia declined only modestly, and FDI from North America recorded strong growth. Prompted by accelerated technology adoption, economic governance realignment, the push for sustainability and resilience-oriented restructuring, and unprecedented global shipping delays, multinational firms are diversifying their global production networks and creating new opportunities for the Western Balkan region. Investors seek to reduce overdependence on single locations for production and make their global value chains more resistant to external shocks. New technologies have enabled firms to adopt new modes of business operations and embrace more flexible and agile value chains. Delivery delays, congestion, and soaring freight rates during and post- COVID-19 have also prompted firms to rethink their supply chains. All these factors could result in diversification, reshoring, and nearshoring.4 Given the Western Balkan economies’ geographic and cultural proximity to EU member countries; its well-educated, young, and multilingual workforce; and relatively lower wages, the region is well positioned to benefit from potential nearshoring. Sectors such as automotive components, transportation, and BPO have also demonstrated resilience for 3 Japan’s Nidec for example plans a 200-billion-yen (1.6 billion euro) investment in Serbia. https://seenews.com/news/japans-nidec-plans- 200-bln-yen-16-bln-euro-investment-in-serbia-report-719343 4 UNCTAD. 2021. World Investment Report 2021: Investing in sustainable recovery. 2. The Western Balkans is experiencing a strong recovery  |  9 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Box 2.1 continued attracting FDI inflows, signaling strong momentum for value chain regionalization and nearshoring potential. Massive nearshoring may be unlikely soon, though the Western Balkans region could still benefit from realignment of global production networks, even if it turns out to be on a smaller scale. Various business surveys have painted a mixed picture of the likelihood and scale of nearshoring. While some surveys5 find significant potential for supply chain diversification, particularly in sectors such as precision mechanics, optics, medical technology, chemicals, pharmaceuticals, plastics, IT, electrical engineering, and automotive industries, some of the more recent studies point to limited evidence of significant changes to GVCs.6 The intention of firms to nearshore could also fizzle out over time. As the pandemic is still not over and uncertainty remains, many companies may prefer to avoid disruptive and costly relocations at this stage. However, there is a stronger appetite to reduce dependence on single or dominant source countries, and even small-scale nearshoring could have a significant impact on the Western Balkan economies due to their small sizes. To take full advantage of potential nearshoring opportunities, the region needs to embrace proactive policies to strengthen its investment competitiveness and implement targeted outreach programs to promote itself to potential investors based on the currently successful sectors and those with identified potential. The COVID-19 crisis and emerging megatrends mark a global inflection point for future FDI and GVC trends. They provide a unique opportunity for the Western Balkans region to undertake reforms to ensure it benefits from the shifting global context. Several countries have already undertaken efforts to review and realign their FDI attraction strategies. The region can leverage its proximity to the EU to attract more FDI, but to take full advantage of any potential nearshoring to the EU market, the Western Balkans governments should continue to review and realign their FDI and private sector development policies with post-COVID realities and address key binding constraints for FDI attraction. 5 AHK World Business Outlook, Spring 2021. Survey by the Network of German Chambers of Commerce Abroad; and WIIW. May 2021. Getting stronger after COVID-19: nearshoring potential in the Western Balkans. 6 EY Attractiveness Survey Europe. June 2021; and Saurav et al. June 2021. The impact of COVID-19 on Foreign Investors: Evidence from the Quarterly Global Multinational Enterprise (MNE) Pulse Survey for the First Quarter of 2021. 10  |  2. The Western Balkans is experiencing a strong recovery GREENING THE RECOVERY 3. The labor market is struggling despite a growth recovery While the labor market started rebounding the same in June 2021 at 45 percent, compared in late 2020, in line with the growth to 2020. The largest decline in the employment recovery, it remains fragile given the renewed rate was seen in Montenegro (4.2 percentage pandemic waves and the gradual withdrawal points), where closures and travel bans caused of government support measures.7 a serious impact on the critical tourism sector. Countercyclical and discretionary measures Meanwhile, in Kosovo, the employment rate undertaken in response to the crisis helped increased by 1.2 percentage points due to mitigate the impact of the pandemic on the gains in formal employment. According to the labor market; however, the duration of the Kosovo Pensions Savings Trust, the number pandemic and the winding down of government of active pension contributors increased by job retention programs are impacting the 13.6 percent during the second quarter (Q2) labor market recovery. Some countries (like of 2021, indicating an increase of about 40,000 North Macedonia and Montenegro) kept formal jobs compared to the same period of wage subsidies in place even in 2021, although 2020 and 2019. At 52.4 percent, Albania still narrowing the scope and targeting only the has the highest employment rate in the region; most affected sectors. The Western Balkan in Kosovo, at the other extreme, only about employment rate (for those age 15 and older) 30 percent of the working-age population is on a four-quarter rolling basis remained largely employed (Figure 3.1). Figure 3.1. The employment rate is decreasing Figure 3.2. The public sector is leading the despite a robust rebound. job creation, while agricultural job losses still loom. 15+ years, percentage change 2020–21 Change in employment, percent, YOY 0.0 6 WB6 4 1.2 KOS 2 MNE -4.2 0 -2 -0.3 BIH -4 -0.2 -6 MKD -8 0.4 SRB -10 -0.2 -12 ALB -14 Agriculture Industry Construction Services General 0 6 12 18 24 30 36 42 48 54 government J 2021 J 2020 J Q2-20 J Q3-20 J Q4-20 J Q1-21 J Q2-21 Source: Data from national statistics offices; World Bank staff estimates. Source: Data from national statistics offices; World Bank staff estimates. Note: 2021 is a four-quarter average to June 2021. 7 This analysis was affected by (1) delays in publishing Q4 2020 Labor Force Survey (LFS) data in Kosovo; (2) changes to LFS methodology in Montenegro in 2021, making 2021 data not comparable with previous LFS data; and (3) a sampling revision in Bosnia and Herzegovina that improved labor market indicators in 2020 but made them no longer comparable with previous LFS data. Using administrative employment and unemployment data helped approximate what happened with labor in Q1-Q2 2021 in Kosovo and in Q2 2021 in Montenegro. 3. The labor market is struggling despite a growth recovery  |  11 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Approximately 84,000 jobs were lost in the to a historical high. As some of the government first half of 2021 in the Western Balkans, support programs have been unwound, the compared to 2020 average, but a major unemployment rate in Serbia in H1 2021 recovery started since April. In Serbia, after increased to 11.9 percent (compared to a sluggish performance in Q1 2021, the labor 9.2 percent in the same period of 2020). As market rebounded back in Q2 2021, adding the support gradually declined, some of the more jobs than in 2020. The recovery has yet to foreign-owned large manufacturers decided to ignite the labor market in Montenegro: since the close their operations in Serbia, resulting in pandemic outbreak, there has been a persistent significant layoffs. The unemployment rates in decline in employment, with some 40,000 Montenegro and Bosnia and Herzegovina have jobs lost since mid-2020. Trade, construction, also been increasing in H1 2021, by 4.6 and and tourism have taken the biggest toll, 2.2 percentage points, respectively, compared though tourism recovery during the summer to a year ago. In Montenegro, the government is expected to increase employment. In North continued providing wage subsidies that helped Macedonia, employment rebounded in late avoid even larger layoffs, while the late start of 2020 and continued throughout 2021, with the tourism recovery might further improve the women contributing to the rise as they moved labor market. In Albania, the unemployment from unemployment to service sector jobs. rate declined to 11.6 percent in Q2 and has Employment increased marginally in Q2 2021 finally been coupled with an increase in the in Albania due to employment in construction participation rate to above 59 percent—the and manufacturing, while agriculture highest in the region. North Macedonia is the continued to shrink. Going forward, tourism only country in the region that has registered and post-earthquake reconstruction should a continued decline in the unemployment rate absorb earlier losses in manufacturing jobs. throughout the crisis—its unemployment rate While most of the earlier losses were in tourism declined below 16 percent in Q2, the lowest and construction, the rebound by mid-2021 since the measurement was introduced in was led by public sector employment, trade, 2007. However, this is partly due to a falling and tourism (Figure 3.2). Although the public participation rate and a rise in inactivity (Figure sector became the largest employer across most 3.4). of the Western Balkans, except in Kosovo, as the recovery takes hold, downsizing will likely Job losses have disproportionately affected be necessary in the medium term driven by young people and women. While the average fiscal sustainability concerns. unemployment rate in the Western Balkans increased to 17.3 percent, up 1.5 percentage Unemployment increased in the first half points from June 2020, youth unemployment of 2021 in most countries of the Western rose to 37.7 percent, up 5.4 percentage Balkans, except in Kosovo and North points from June 2020, further worsening Macedonia, partly led by improvement in youth employment prospects. Montenegro participation rates (Figure 3.3). There were registered the largest increase in youth 125,000 more job seekers than in H1 2020, unemployment, while even North Macedonia of which two-thirds were from Serbia also has not been spared. Only in Albania did supported by the rise in the participation rate youth unemployment decline—to below 12  |  3. The labor market is struggling despite a growth recovery GREENING THE RECOVERY Figure 3.3. Unemployment rates increased Figure 3.4. Inactivity remains a challenge. except in Kosovo and North Macedonia. Unemployment rate, 15+ years, percentage change 2020–21 Inactivity rate, 15+ years, percent, and 2021–20 change, percentage points 0.7 -0.4 WB6 WB6 1.3 0.2 SRB ALB 0.0 0.4 ALB MKD -0.3 -1.3 MKD SRB 1.1 3.7 BIH MNE 2.3 -0.2 MNE BIH -0.8 -1.2 KOS KOS 0 2 4 6 8 10 12 14 16 18 20 22 24 26 0 8 16 24 32 40 48 56 64 Source: National statistics offices data; World Bank staff calculations. Source: National statistics offices data; World Bank staff calculations. Note: 2021 is a four-quarter average to June 2021. Note: 2021 is a four-quarter average to June 2021. 20 percent—the lowest level on record. Among Macedonia, wage growth continued in H1, those disproportionally affected are also self- albeit at more subdued pace (6.3 percent employed and workers on non-standard year-on-year) compared to the previous year, contracts. when the minimum wage increased. The largest increases were observed in sectors The region’s labor force participation that were most affected by pandemic-related rate increased slightly compared to June restrictions, such as transportation, food and 2020. It increased by 0.4 percentage points accommodation, entertainment, and other to 50.3 percent in June 2021, with the services. Tightening the rules on holiday and participation rate of women lagging behind that Sunday work and increasing the wage rate could of men. The activity rate in North Macedonia add to existing wage pressures. In Montenegro, picked up from its low in summer 2020, mostly the Parliament adopted an increase in the net due to a rise in male labor force participation, monthly minimum wage of over 12 percent while female participation dropped. While the (from €222 to €250), effective October 2021, participation rate increased in Albania in Q2, and Albania negotiated a rise in the minimum Montenegro has not seen a recovery yet. The wage of around 15 percent, effective September largest decline of female participation was in 2021. Montenegro, where the service sector was hit hard. Female labor force participation increased As expected, government support packages in Albania to 51.7 percent in 2021, while it have prevented a more adverse crisis impact remains the lowest in Kosovo (with a peak of on the labor market, although extended 23.8 percent in 2020). adverse impact is being observed in 2021. While the labor market seems to be rebounding Wage rises may prevent faster recovery in in summer 2021, the speed of the recovery employment. In Serbia, wages increased by will depend primarily on the epidemiological 8.6 percent year-on-year in nominal terms in situation. Further, administrative actions that H1 2021, with private sector wages increasing are expected to increase wage pressures may faster than public sector wages. In North discourage formal employment, as well as the 3. The labor market is struggling despite a growth recovery  |  13 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 business expectations on hiring (Box 3.1). balance sheets may prevent a faster recovery of Employment support programs have been the labor market if risks to the growth outlook tightened across the region as fiscal space materialize. narrows, while pandemic-weakened corporate Box 3.1. Employment expectations of businesses and individuals remain grim.8 Perceptions of Western Balkan firms and citizens of economic and employment prospects remain grim, as the expectation index declines to the lowest level since first measured in 2014 (Figure 3.5). As governments across the region stepped in to cushion the impact of the pandemic on  the labor market, more than half of the firms managed to maintain the number of employees in 2020. Going forward, 61 percent of businesses expect the number of employees to remain unchanged, with an additional 15 percent hoping to increase staffing in the following year (Figure 3.6). Albania has the largest share of firms expecting an increase in employment (22 percent), while only 10 percent of firms in North Macedonia expect their staffing to increase. Montenegrin firms are less optimistic than their regional peers: 26 percent expect their employment to decrease in 2021, while 62 percent of Western Balkan citizens feel confident, they will be able to keep their job in 2021. Figure 3.5. Employment expectations have Figure 3.6. …yet, almost three-fourths of reached a record low in late 2020… Western Balkan firms will either maintain their current employment levels or even increase it. 75 60 SRB 16 63 16 6 55 70 55 MNE 26 60 13 3 71 50 65 MKD 20 65 10 7 45 60 40 KOS 9 58 18 16 55 35 BIH 21 60 13 7 28 50 30 ALB 11 63 22 5 45 25 44 WB6 17 61 15 7 40 20 2014 2015 2016 2017 2018 2019 2020 0 20 40 60 80 100 ▬ Balkan Expectation Index - Business sentiment (rhs) J Decrease J Remain unchanged J Increase J No answer ▬ Balkan Expectation Index - Public sentiment (lhs) Source: Balkan Barometer 2021 Survey. Source: Balkan Barometer 2021 Survey. Firms’ expectations for new hiring in the upcoming months vary by firm size. The large companies are most optimistic about new hiring: 42 percent expect that the number of employees will increase in the next 12 months, and almost the same percent plan to retain their current labor force. Small companies are relatively more pessimistic, with 21 percent believing that their employee count will decline. This is at the same time the largest pool of firms in the Western Balkans. Still, an overwhelming majority of micro and small companies (67 and 56 percent, respectively) are confident that the number of employees will remain unchanged in the next year (Figure 3.7). 8 Based on the 2021 Balkan Barometer surveys (https://www.rcc.int/balkanbarometer/home) that were conducted between December 2020 and February 2021 in the six Western Balkan countries. The Public Opinion survey posed 117 questions to 6000 citizens and the Business Opinion survey presented 110 questions to 1200 business owners, managers or executives. 14  |  3. The labor market is struggling despite a growth recovery GREENING THE RECOVERY Box 3.1 continued Figure 3.7. Small and micro firms are more Figure 3.8. Is it lack of adequate skills or concerned about employment decline. lack of jobs that drives unemployment? 7 60 Western 15 Balkans 61 17 50 51 5 50 46 42 44 45 44 Large 42 40 42 11 39 40 38 36 9 33 34 28 30 Medium 52 30 12 7 Small 16 56 20 21 7 11 10 Micro 67 16 0 0 10 20 30 40 50 60 70 WB6 ALB BIH KOS MKD MNE SRB J Decrease J Remain unchanged J Increase J No answer J Lack of adequate skills J Lack of adequate jobs Source: Balkan Barometer 2021 Survey. Source: Balkan Barometer 2021 Survey. Almost half of Western Balkan citizens continue to see unemployment as one of the most important challenges for the country. This is an increase from 45 percent in 2019, but a decrease from the peak of 68 percent in 2016. More than one-third of citizens across the region think a lack of adequate jobs is one of the main obstacles to finding a job (Figure 3.8). This issue concerns almost half of the respondents in Kosovo (46 percent) and one-third of respondents in Montenegro and Serbia. On the other hand, 44 percent of businesses in the region see lack of adequate skills by applicants as one of the main reasons for unfilled vacancies. For that reason, half the firms in North Macedonia and Montenegro cannot find employees to fill their vacancies. Yet, over the past 12 months, 70 percent of firms have not conducted any employee training that is not legally mandated, and 47 percent of firms in the region do not have or do not plan to have an internship or apprenticeship program. This number, however, has significantly decreased from 63 percent a year ago. The recovery of the labor market from the COVID-19 crisis, as well as reduced mobility, might have changed attitudes toward retraining and employment migration. Two-thirds of respondents are willing to get an additional qualification in order to get a job. Further, a growing number of respondents (about 38 percent) think that education and hard work are the main preconditions for finding a job, while a still-high 54 percent claim that knowing the right people is key to boosting your prospects in the Western Balkans. Importantly, there is a decline of 6 percentage points in the share of respondents who are seriously considering leaving their economy (now around one-third), while over half claim they have no intention of working abroad in the near future. 3. The labor market is struggling despite a growth recovery  |  15 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 4. Poverty reduction is resuming slowly due to an uneven labor market performance As the Western Balkan economies recover Figure 4.1. The region’s poverty rate is from the 2020 COVID-19 crisis, the region’s expected to decline in 2021 to about its 2019 level. poverty rate is expected to decline in 2021 Percent of population to levels similar to 2019. The severe impact of 30 the COVID-19 crisis on the region’s economies destroyed many jobs and slashed the incomes 25 25.6 of thousands of households. As a result, 22.9 previous poverty reduction came to a halt, and 23.3 poverty9 is estimated to have increased by 1.0 20 21.3 20.4 21.4 20.3 to 2.5 percentage points in 2020 (Figure 4.1). 18.8 As services and industry rebounded in 2021, growth has returned to the region, and in some 15 2016 2017 2018 2019e 2020e 2021f 2022f countries significantly. In 2021, the poverty ▬ Lower bound … Upper bound rate for the Western Balkans is projected to fall Source: World Bank simulations based on 2018 income data from the Survey of Income and Living Conditions (SILC) for North Macedonia; by around 1 percentage point to 20.3 percent, 2017 SILC income data for Albania, Montenegro, and Serbia; and 2017 Household Budget Survey (HBS) data for Kosovo. close to its 2019 level. A projected positive Note: Income measures in the SILC and consumption measures in the HBS are not strictly comparable. Welfare is estimated in US dollars using revised growth path beyond 2021 is expected to put 2011 PPPs. The regional estimate excludes Bosnia and Herzegovina due to lack of comparable data. Upper bound denotes the more conservative poverty back on its historical downward trend. estimates for Albania and North Macedonia. The projected impacts of the economic While it is expected that employment will rebound on poverty in 2021 vary across benefit from this rebound, the speed of labor countries, reflecting variations in sectoral market recovery has so far been uneven. growth and labor market recovery. GDP Employment in the first quarter of 2021 did not growth fell from 3.2 (Bosnia and Herzegovina) appear to recover in most of the countries, but to 5.3 percent (Kosovo) in 2020, with two many countries saw improvements in second outliers: in Montenegro, the decline in tourism quarter employment indicators. Montenegro services caused a contraction of 15.3 percent, still experienced rising unemployment in the whereas Serbia suffered a mild recession first half of 2021. Given the uneven labor (-0.9 percent). Economies throughout the market developments at this point, the impact region are projected to rebound in 2021 by of economic growth on poverty is expected between 4 percent (Bosnia and Herzegovina) to be positive but weaker than what it could and 10.8 percent (Montenegro) with exports be if its impact on jobs were more significant. and services being the major driver of the Continued uncertainty over the vaccine rebound. rollout and renewed restrictions have slowed 9 In this section, poverty is defined as a person living on less than $5.5/day in revised 2011 purchasing power parity (PPP), with the exception of Bosnia and Herzegovina due to lack of comparable data. In May 2020, the 2011 PPPs were revised (https://openknowledge.worldbank.org/ bitstream/handle/10986/33623/9781464815300.pdf ), resulting in revised estimates of poverty at $5.5/day. This revision reflects a reassessment of cost-of-living comparisons between countries but does not imply a real change in poverty within countries. 16  |  4. Poverty reduction is resuming slowly due to an uneven labor market performance GREENING THE RECOVERY labor market recovery, increasing the risks to significantly, from 40 to 32.4 percent of the sustainable poverty reduction over the medium population. The November 2019 earthquake, term. In addition, the rising inflation can also followed by the COVID-19 pandemic, dampen households’ purchasing power and hurt reversed this trend. After a modest decline in the poor, particularly for food and fuel prices, 2019, poverty is estimated to have increased since poor and vulnerable households often in 2020, reaching a similar level as in 2018. In spend a larger share of household expenditures 2021, the economy rebounded significantly, on these items (Figure 4.2). In addition to but labor force participation and employment the clusters of poverty before the pandemic have been slower to recover. At the same time, (e.g. geographic, ethnic, low education, etc), incomes are rising in part due to an increase in informal low-skill workers who lost jobs and the minimum wage, which has already pushed might not have received much formal-sector formal real wages up by 4.3 percent. Poverty is government support may still be at risk of projected to fall in 2021 by 1 percentage point poverty. Vulnerable households and individuals relative to the 2019 estimated value, and by who became poor during the pandemic may 1.5 percentage points in 2022, leaving income- have difficulty exiting poverty in places where based poverty at below 30 percent. the jobs recovery is still sluggish. Table 4.1. Poverty reduction is projected to Figure 4.2. Food price inflation could resume at a different pace across countries, significantly affect the purchasing power of reflecting the uneven labor market recovery. poor households. Poverty projections (percent) Year Percentage of final consumption expenditure of households: ALB KOS MKD MNE SRB Food and non-alcoholic beverages 70 2016 40.0 23.6 21.6 16.0 22.2 60 2017 35.8 24.4 19.5 16.0 19.8 50 2018 32.4 23.2 17.9 15.2 17.9 40 2019 31.8 20.9 16.9 14.5 17.3 30 2020 32.6 23.4 18.0 20.0 17.4 20 2021 30.8 20.9 16.9 17.7 17.1 10 2022 29.3 18.9 15.8 16.3 15.4 Source: Calculations based on ECAPOV harmonization using SILC-C data 0 for ALB, MKD, MNE, and SRB, and HBS data for KOS. KOS ALB MKD BIH MNE SRB EU27 Note: Black=Actual. Orange=Nowcasted/projected. Income measures J Total, 2019 J Poorest quintile, 2015 in the SILC and consumption measures in the HBS are not strictly comparable. Poverty is defined as living on less than $5.5/day per person Source: EUROSTAT and World Bank staff calculations using HBS. in revised 2011 PPPs. Bosnia and Herzegovina is excluded due to lack of Note: For Kosovo total and poorest quintile refer to 2015. The expenditure comparable data. shares are not methodologically comparable to those estimated for the Consumer Price Indices. As the economy recovers in Bosnia and Poverty in Albania, the highest in the region, Herzegovina, improvements in labor is projected to fall in 2021 below its 2019 market participation and employment will level (  Table 4.1). Albania has the largest remain crucial if growth is to translate into poverty headcount in the Western Balkans; poverty reduction. Economic growth has not about one-third of its population lives on less translated into more and better jobs in the past. than US$5.5 per day (in 2011 PPP). Between As such, the poverty rate does not seem to have 2016 and 2018, income-based poverty declined improved. The latest available data using the 4. Poverty reduction is resuming slowly due to an uneven labor market performance  |  17 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 national poverty line of KM 205 per capita The COVID-19 pandemic caused a severe per month is for 2015, when the poverty rate contraction of economic activity, reversing six was estimated at 16 percent, very close to the years of gains in poverty reduction. COVID-19 15 percent estimated for 2011. In 2020, the containment measures and the collapse pandemic caused substantial damage to the of tourism and related services depressed labor market, which did not appear to recover employment and earnings, especially for in the first quarter of 2021. The slowdown in poorer and low-skilled people, who are more the economy and the consequent loss of jobs likely to depend on seasonal and informal and earnings have likely eroded household employment. Targeted wage subsidies and welfare. The policy measures the government one-off cash assistance for vulnerable citizens introduced to protect firms and households helped the country avoid even larger layoffs prevented a worse impact on the labor market. and increases in poverty, but vulnerable workers in the informal sector might not Due to a rebound of the economy in 2021, have received much support. Simulation the poverty rate in Kosovo is projected to fall analysis suggests that poverty increased from back to its 2019 level. Thanks to a sustained an estimated 14.5 percent in 2019 to about positive economic performance (per capita 20 percent in 2020. Montenegro’s economy is growth averaged 3.7 percent annually for 2017– recovering in 2021, thanks to revived tourism, 19), the poverty rate fell from 24.4 percent in but unemployment remained high in the first 2017 to an estimated 21 percent in 2019. In half of the year, limiting the pace of resumed 2020, the crisis reversed this positive trend and poverty reduction. GDP per capita is estimated to have shrunk by 6.2 percent. Poverty in 2020 is estimated In North Macedonia, poverty in 2021 is to have increased by 2.5–5.2 percentage projected to decline back to pre-crisis levels. points mainly because of steep output losses The country has reduced poverty considerably in services (diaspora travel) and industry, since the 2008 global financial crisis. The despite the fiscal stimulus and a net increase in poverty rate was halved to 18 percent in 2018 remittances. Together with a strong projected compared to 2009, driven primarily by greater rebound in per capita GDP of 6.5 percent in employment opportunities and increased 2021, poverty is projected to fall back to its labor earnings. The adverse effects of the 2019 level; however, this is only a partial result COVID-19 crisis have reversed earlier poverty as no data are yet available regarding overall reduction gains: a simulation analysis predicts employment recovery. The government, along that poverty has likely increased between 1 to with several other countries in the Western 4 percentage points in 2020. The government Balkans, is undertaking a major reform of its provided support measures, such as subsidies social assistance system to expand the coverage and social security contributions to private in response to future shocks (Box 4.1). sector firms and cash benefits and vouchers for vulnerable people, which to some extent Poverty is projected to decline slowly in relieved the negative poverty impacts of the Montenegro in 2021 as tourism rebounds COVID-19 crisis. In the short term, a slow but remains higher than its 2019 level. rollout of the COVID-19 vaccine, coupled 18  |  4. Poverty reduction is resuming slowly due to an uneven labor market performance GREENING THE RECOVERY with continuous containment measures and a universal cash transfer, helped cushion the unresolved structural bottlenecks, represent immediate impacts on the population and challenges for a faster poverty reduction. the economy. The labor market held up, and agriculture grew by 4.9 percent. As a result, Poverty reduction is expected to resume it is estimated that poverty stayed at about with a lag in Serbia, depending on the pace 17.4 percent in 2020, close to its 2019 level. of labor market improvements as fiscal While economic growth is projected to pick stimulus programs expire. The COVID-19 up in 2021, the labor market recovery has been pandemic pushed the Serbian economy into a sluggish. Employment and unemployment mild recession in 2020, and interrupted poverty rates deteriorated early in the year, when some reduction. The government’s massive fiscal of the fiscal stimulus programs expired, and package of about 13 percent of GDP, including only started recovering in the second quarter. broad-based wage subsidies for all sectors and Box 4.1. The COVID-19 crisis has initiated a series of social assistance systems reforms. The pandemic has stimulated a variety of reforms to the design and delivery of social protection. Similar to other developing economies, social protection systems in the Western Balkans did not respond adequately to the poverty impacts of the pandemic. As a result, governments in some countries are considering structural reforms to make their systems more adaptable, while others are advancing innovations in delivery systems. The features of these reforms vary, informed by the initial conditions of the country and the experience of the social assistance response to COVID-19. North Macedonia has modified the eligibility criteria for its Guaranteed Minimum Income (GMI) program that allowed it to expand to people who lost their jobs and income because of the pandemic. The GMI law was amended to reflect this, and with the declaration of an emergency, the modified eligibility criteria can be rapidly rolled out. While these changes to the GMI program legal framework are an important step forward in terms of building the resilience of the social assistance system, the government is also considering operational changes that will help ensure this support reaches people in need quickly. This includes reviewing the legal requirement that people who apply to the GMI program must do so in person in a Center for Social Work and establishing new procedures that would allow applications to also be submitted online. In Kosovo, the Government is embarking on a broader reform of its Social Assistance Scheme (SAS) to eliminate strict categorical selection requirements, thereby focusing the SAS on the poorest. As part of this reform, the Government aims to set out the legal basis to enable the SAS to expand coverage in response to shocks, thereby eliminating the need to establish new emergency programs as was done during the initial months of the COVID-19 pandemic. Complementing such legal changes with investments in the systems and procedures to support such a response, through online applications, enrollment, recertification, and greater use of e-payments, for example, would help ensure that these legal changes lead to effective and timely support to the poorest in Kosovo. In other countries, such as Serbia, recent innovations will help improve the responsiveness of the social protection system to shocks. Serbia’s Social Card Registry, once fully operational, will enable the better identification of vulnerable groups. It will thus provide timely and reliable data for rapid identification of groups and individuals in need, as well as effective management of the social protection system response to a crisis. 4. Poverty reduction is resuming slowly due to an uneven labor market performance  |  19 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 5. Fiscal policy needs to strike a balance between maintaining stability and boosting growth A strong rebound in growth is narrowing a strong rebound in revenue collection. In fiscal deficits in most of the Western Balkans Albania, Kosovo, and Serbia, public revenues in 2021. The regional average10 deficit is increased nominally by more than 20 percent11 expected to drop by more than 2.7 percentage for the first seven months of 2021. By year-end, points of GDP compared to 2020 (Figure North Macedonia is expected to experience the 5.1). The sharpest declines are expected in most buoyant revenue collection performance Montenegro and Kosovo, followed by North in the region, with revenue increasing by Macedonia. Albania is expected to see only a 5.9 percentage points of GDP. The value- slight improvement in its fiscal balance. The added tax (VAT) is the greatest contributor exception is Bosnia and Herzegovina, which to revenue growth for most countries. Higher is expected to widen the fiscal deficit in 2021 international commodity prices and consumer compared to the previous year, despite some prices have also temporarily boosted VAT higher revenue collection. Yet, excluding collection. Revenue buoyancy is the key driver Kosovo, all Western Balkan countries are of fiscal consolidation in North Macedonia expected to run significantly higher deficits in and Albania, given the continued increase in 2021 compared to pre-pandemic levels. expenditures. Montenegro is experiencing strong revenue growth, but at a slower pace Buoyant revenue collection is reducing than GDP growth, thus contribution to fiscal deficits. With growth gaining momentum, deficit reduction comes mainly from the most Western Balkan countries are experiencing expenditure side. (Figure 5.2). In Kosovo, Figure 5.1. Fiscal deficits have narrowed in Figure 5.2. …owing to robust revenue growth most Western Balkan countries… and lower expenditure Percent of GDP Percent of GDP 3 8 é Reduced revenues, Increased spending 6 0 -0.9 4 -3 2 -3.1 -4.0 -4.6 0 -6 -5.9 -2 -6.9 -6.7 -4 -9 -6 ê Increased revenues, Reduced spending -12 -8 SRB ALB MKD MNE BIH KOS WB6 MNE KOS MKD SRB ALB BIH WB6 J 2019 J 2020 J 2021e J Expenditure J Revenue Q Change in fiscal deficit Source: National statistical offices; Ministries of Finance; World Bank staff Source: National statistical offices; Ministries of Finance; World Bank estimates. estimates. Note: pp = percentage points. 10 Unweighted average of fiscal deficit levels in Western Balkan countries. 11 From here on, comparisons are year-on-year unless otherwise indicated. 20  |  5. Fiscal policy needs to strike a balance between maintaining stability and boosting growth GREENING THE RECOVERY part of the expenditure consolidation is due support measures, such as the micro and small to the sluggish public investment execution. and medium-sized enterprise loan subsidy In Bosnia and Herzegovina, revenue growth is scheme in Montenegro, or even the withdrawal expected to be modest compared to the region, of some measures, such as Serbia. The high and pent-up current spending commitments cost of fiscal policy measures in the previous from 2020 together with an expected increase year, and the uncertainty over the persistency in capital spending should drive up expenditure of the pandemic, have also limited the scope in 2021 and lead to a higher fiscal deficit. for public expenditure growth in 2021 for more financially constrained Western Balkan After a significant jump in 2020, public countries. Against this backdrop, the average expenditure in the Western Balkans is level of public expenditure for the region is leveling off in 2021, as rescue measures are expected to decline by 1.1 percentage points scaled back and become more targeted. While of GDP, with the steepest drop expected for public expenditure is expected to increase in Montenegro and Kosovo, and a slight drop all Western Balkan countries during 2021, expected for Serbia (Figure 5.3). a faster-than-expected recovery in economic activity is expected to outpace expenditure Spending on wage bill and social benefits, growth in Montenegro, Serbia, and Kosovo. In is decelerating in relative terms in most Bosnia and Herzegovina, Albania, and North Western Balkan countries from the high Macedonia, the expenditure-to-GDP ratio is levels in 2020. At the regional level, spending set to further increase; in North Macedonia on social benefits is expected to decrease by due to the government Growth Acceleration an average of 0.6 percentage points of GDP. Plan, which aims to boost public and private Kosovo and Montenegro are expected to see investments. The relaxation in pandemic- a decline in social spending and wage bill related restrictions on economic activity and spending relative to GDP, but also in capital mobility in 2021 have enabled the adoption expenditure as Montenegro approaches of more targeted counter-pandemic policy the last phase of its highway construction Figure 5.3. Expenditure is marginally Figure 5.4. Capital expenditure has contracting from its very high levels in 2020. underperformed in Kosovo and Montenegro. Percent of GDP Contributions to change, in percent of GDP 60 4 50 2 40 0 30 -2 20 -4 10 -6 0 2020 2021e 2020 2021e 2020 2021e 2020 2021e 2020 2021e 2020 2021e 2020 2021e -8 SRB MNE BIH MKD ALB KOS WB6 MNE KOS SRB BIH ALB MKD WB6 J Wage bill J Social benefits J Capital expenditures Q Total expenditures J Wage bill J Social benefits J Capital expenditures Q Total expenditures Source: National statistical offices; Ministries of Finance; World Bank Source: National statistical offices; Ministries of Finance; World Bank estimates. estimates. 5. Fiscal policy needs to strike a balance between maintaining stability and boosting growth  |  21 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 project, while Kosovo has yet to progress on while other countries will see an increase. externally financed capital projects. Serbia, However, in nominal terms, a decline in PPG North Macedonia, Albania, and to a lesser debt is expected only in Montenegro, as the extent, Bosnia and Herzegovina, are expected country repays debt worth 10 percent of GDP to experience a significant increase in capital in 2021 from the 2020 Eurobond receipts. In expenditure. North Macedonia experienced a Albania, PPG debt is expected to rise further, 45 percent growth in public investment during as the fiscal rule was temporarily suspended in the first half of 2021, and Albania and Bosnia July 2021, to allow for additional infrastructure and Herzegovina are expected to see an increase projects to start in 2021. Fiscal rules, where in wage bill spending by 0.2 and 0.1 percentage exist, have, in effect, been suspended in all points of GDP, respectively (Figure 5.4). countries, but will need to be reinstated as the recovery takes hold. After a historically high increase in 2020, public and publicly guaranteed (PPG) debt Eurobond issuances as well as borrowing remains elevated. New borrowing to finance from international financial institutions the widening fiscal deficits in 2020 has pushed pushed external public debt up in all PPG debt to historical highs in all countries, countries. During 2020–21, Western Balkan except for Serbia and Bosnia and Herzegovina countries placed Eurobonds worth over EUR (Figure 5.5). Owing more to the denominator 7 billion, with proceeds used to finance swelling effect as nominal GDP rebounds faster than deficits and debt repayment. Consequently, the expected in all economies, the average PPG Western Balkan external PPG debt-to-GDP debt to GDP of the Western Balkan countries ratio reached its historic high of 41 percent in is estimated to decline from 61 percent of 2020 but is estimated to decline to 39 percent GDP in 2020 to 59 percent in 2021. The two in 2021 (Figure 5.6). In the first half of 2021, countries driving this decrease are Bosnia and Montenegro and North Macedonia repaid large Herzegovina and Montenegro, where PPG Eurobonds, which has helped reduce external debt-to-GDP ratio will decline by 1 percentage debt. In these two countries and in Bosnia and point and 18 percentage points, respectively, Herzegovina, external PPG to GDP is expected Figure 5.5. Public and publicly guaranteed Figure 5.6. …due to the rise in external debt. debt (PPG) remains elevated… Percent of GDP Percent of GDP 110 100 100 90 90 80 80 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 MNE ALB MKD SRB BIH KOS WB6 MNE MKD ALB SRB BIH KOS WB6 J 20201e ▬ 2020 Q Pre-pandemic peak J 20201e ▬ 2020 Q Pre-pandemic peak Source: National statistics offices; World Bank staff estimates. Source: National statistics offices; World Bank staff estimates. 22  |  5. Fiscal policy needs to strike a balance between maintaining stability and boosting growth GREENING THE RECOVERY Figure 5.7. The EU provided Macro-Financial Figure 5.8. …while the IMF increased SDR Assistance to almost all countries... allocations worth EUR 1.5 billion for the Western Balkans. Million EUR Million EUR 250 SRB 200 BIH 150 MKD 90 250 80 ALB 100 50 KOS 50 90 30 80 50 MNE 30 0 ALB BIH KOS MNE MKD 0 200 400 600 800 1,000 1,200 1,400 J 2020 J 2021 J To be disbursed J Existing allocation J 2021 allocation Source: National statistics offices; World Bank staff estimates. Source: National statistics offices; World Bank staff estimates. to decline, while other countries will see an Figure 5.9. Average nominal interest rate on increase, most notably Serbia and Albania. public debt in 2012 and 2021. All Western Balkan countries except Serbia Percent 6 requested Macro-Financial Assistance (MFA) 5.4 5 from the European Union after having received 4.3 IMF support through the Rapid Finance 4.0 4.0 4 3.6 Instrument. Kosovo, North Macedonia, Bosnia 3 2.9 2.9 2.8 2.6 and Herzegovina, and Albania also received 1.9 2.3 2.3 2 significant support from World Bank fast- disbursing emergency COVID-19 operations 1 in response to the pandemic (Figure 5.7). In 0 ALB BIH KOS MKD MNE SRB August, the IMF approved the largest Special J 2012 J 2021 Drawing Rights (SDRs) allocation in history, Source: National authorities and World Bank staff calculations. Note: Average nominal interest rate is derived as nominal interest with the Western Balkans being credited about expenditure divided by previous period debt stock. EUR 1.5 billion (Figure 5.8). The increase provides additional liquidity, supplements by lower global financing costs on the back countries’ international reserves, and reduces of highly accommodative monetary policies. not only balance-of-payment risks, but also However, given a quick buildup in inflationary fiscal financing risks for the euroized Western pressures in the advanced economies during Balkan economies. the summer, there are now indications of a possible tightening of monetary policies by the Financing conditions have been benign U.S. Federal Reserve and the European Central for years, but tightening is expected going Bank. This would increase the cost of borrowing forward. Since 2012, most Western Balkan and impact capital inflows into emerging countries have turned to international markets, which in turn would adversely affect markets, which has helped extend maturities the Western Balkan countries, especially those and reduce interest rates (Figure 5.9) driven with high debt burdens and limited fiscal space. 5. Fiscal policy needs to strike a balance between maintaining stability and boosting growth  |  23 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Thus, the Western Balkan countries should discussed in the Chapter 10. Spotlight). Further, strengthen their own fiscal management to all countries need to significantly strengthen mitigate the potential risks from the increased public financial management and debt cost of financing. management. Managing fiscal risks, including those arising from state-owned enterprises, Stronger revenue performance and is important to ensure fiscal sustainability. availability of financing should be used to Addressing public investment management gradually consolidate fiscal balances. While challenges will be critical to ensure stronger government support was critical in preventing growth effects of capital spending, bearing in the adverse impact of the crisis, as the recovery mind the need for environmentally sustainable takes hold, governments should start phasing investment. Greening public investments out their support and creating buffers. could also be a catalyst for attracting private Some countries have already discontinued investment, while focusing on education and wage subsidies (Montenegro), while others health sector efficiency would help ensure more strengthened targeting to most affected sectors inclusive and sustainable growth. (North Macedonia), which has brought down the fiscal costs of support measures. Montenegro has additionally reduced spending on goods and services in an attempt to reduce fiscal imbalances. On the other hand, most countries have incorporated in their medium-term fiscal strategies measures to boost the recovery, such as Kosovo’s Economic Revival Plan and North Macedonia’s Growth Acceleration Plan, which may push fiscal expenditures up going forward. As part of the recovery plan, most Western Balkan countries plan to increase their capital spending in the medium term. To create sufficient fiscal space to weather any future crises and support growth in a sustainable manner, governments of the Western Balkan countries should consider widening the tax base and improving tax compliance. Environmental taxes are low in the Western Balkans and could be an important revenue source going forward. Gradually shifting tax burden from income to fossil fuels can raise domestic revenue in a way that makes growth environmentally sustainable while reducing economic distortions, improving equity and easing tax administrations (as 24  |  5. Fiscal policy needs to strike a balance between maintaining stability and boosting growth GREENING THE RECOVERY 6. Stronger demand and higher global prices are creating inflationary pressures Global inflation has accelerated in 2021 with With the recovery in aggregate demand, pandemic induced pressures linked to supply inflationary pressures in the Western constraints adding to the global demand Balkans are building up. Supply-side shocks, acceleration. While most central banks increased inflation in trading partners, and remained patient through the recent increase demand expansion drove an increase of average in prices, in emerging market economies, inflation to 2.6 percent in June 2021, up by interest rates are likely to increase, in order to 1.7 percent from 0.9 percent in June 2020. preserve policy credibility and keep expectation Food prices accounted for most of this growth, anchored. Global food prices rose during 2020, as did commodity prices as transmitted from as pandemic-related disruptions in distribution international markets, as reflected in higher chains, supply bottlenecks, and increased fuel prices. Electricity and transport prices also transportation costs affected food prices. Even increased. The increase in prices intensified as temporary supply and demand dislocations in the summer months and was most notable eased, the acceleration in food prices persisted in Kosovo (4.7 percent YOY in August as a result of the recovery in demand picking in 2021), Serbia (4.3 percent YOY), and North H1 2021. Across the world, as in the Western Macedonia (3.6 percent YOY). In Albania, Balkans, the rise in food prices is occurring exchange rate appreciation during the summer simultaneously with a pick-up in core inflation, mitigated some of the impact of imported thus increasing the likelihood of intensifying inflation, which reached 2.2 percent in July. In inflationary pressures in 2021 (Figure 6.1). Bosnia and Herzegovina, inflation jumped to 2.3 percent YOY in August, with food prices picking up pace since January (Figure 6.2). Figure 6.1. Inflation is picking up in the Figure 6.2. Food and energy prices drove most Western Balkans. of the increase in inflation. Headline CPI inflation, YOY percent Percent 4 5 3 4 2 1 3 0 2 -1 1 -2 -3 0 -19 -19 Jul-19 ct-19 n-20 pr-20 ul-20 ct-20 an-21 pr-21 Jul-21 -19 -19 Jul-19 ct-19 n-20 pr-20 ul-20 ct-20 an-21 pr-21 Jul-21 Jan Apr O Ja A J O J A Jan Apr O Ja A J O J A ▬ ALB ▬ BIH ▬ KOS ▬ MKD ▬ MNE ▬ SRB … WB6 ▬ CPI inflation ▬ Energy CPI inflation ▬ Food CPI inflation Source: Central Banks; World Bank staff calculations. Source: Central Banks; World Bank staff calculations. Note: WB6=Western Balkans 6. Note: CPI=Consumer Price Index. 6. Stronger demand and higher global prices are creating inflationary pressures  |  25 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Wage pressures also increased as the recovery September and October 2021, respectively, took hold and inflation picked up(Figure that will create potential cost pressures toward 6.3). In North Macedonia wage pressures were year-end. notable, with wages increasing by 6.3 percent YOY in the first half of 2021, partly due to the Despite the recent increase in headline minimum wage increase, and formalization inflation, core inflation has not increased in of envelope wages also incentivized by the all countries. Core inflation increased (Figure government support measures. In Montenegro, 6.4), reaching record-high in Montenegro of the pressure from producer prices was limited, 3.9 percent in July and 3 percent in North but a recovery of tourism boosted consumption, Macedonia. In Albania and Serbia, core inflation which was then reflected in rising prices was more stable, thus allowing monetary policy during the summer. Albania and Montenegro to continue to provide a stimulus to demand negotiated a rise in the minimum wage in through keeping the policy rates low. In North Macedonia, the central bank left the policy Figure 6.3. Minimum wages have gone up in rate low—at 1.25 percent, given a still fragile most COVID-19-affected countries. recovery path (Figure 6.5). Minimum wage as percent of average wage 60 The policy stimulus also translated into 50 increased money supply, and credit growth 40 in the first half of the year. In Albania, low 30 liquidity risk premia in the domestic financial market facilitated the transmission mechanism 20 to lower lending rates, leading to an expansion 10 of credit to the private sector by 7.7 percent 0 YOY by June 2021. In Serbia, the money KOS MNE SRB BIH MKD ALB J 2017 J 2019 J Sep-21 supply increased by 13.5 percent YOY in July Source: Statistical offices, authorities, World Bank staff calculations. 2021. Figure 6.4. The impact of demand pressures Figure 6.5. In countries with a flexible on core inflation shows a mixed picture. exchange rate, anchored expectations have enabled monetary stimulus to continue. Core CPI inflation, percent Policy rates, percent 4 3.5 3 3.0 2 2.5 1 2.0 0 1.5 -1 1.0 -2 0.5 -3 -4 0 -19 -19 Jul-19 ct-19 n-20 pr-20 ul-20 ct-20 an-21 pr-21 Jul-21 -19 pr-19 Jul-19 ct-19 n-20 pr-20 ul-20 ct-20 an-21 pr-21 Jul-21 Jan Apr O Ja A J O J A Jan A O Ja A J O J A ▬ ALB ▬ BIH ▬ KOS ▬ MKD ▬ MNE ▬ SRB … WB6 ▬ ALB ▬ MKD ▬ SRB … Eurozone Source: Central Banks; World Bank staff calculations. Source: Central Banks; World Bank staff calculations. 26  |  6. Stronger demand and higher global prices are creating inflationary pressures GREENING THE RECOVERY After a long period of low and stable inflation, the balance of risks for inflation has tilted upward. Imported inflation through commodity, oil, and food prices is likely to continue putting pressure on producer prices and in turn wages, while domestic policies on wage increase can intensify along. Food price increases are likely to erode the purchasing power of poorer households, given the large share of food in their consumption basket, and be a drag on overall consumption. Central banks need to be ready to tighten policy rates in case inflationary risks materialize. 6. Stronger demand and higher global prices are creating inflationary pressures  |  27 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 7. Preserving financial stability is key in the post-COVID-19 recovery The financial system remained resilient so need to continue to closely monitor bank far backed by continued COVID-19 support lending portfolios and potential vulnerabilities measures, and by the growth recovery that may arise after borrower relief measures across the Western Balkans. Public measures expire. Maintaining the health and financial implemented in most jurisdictions mitigated, stability of the banking system becomes ever at least temporarily, the negative effects of the more important during the recovery phase, as pandemic on bank asset quality. Most of these the provision of credit by the banking system temporary measures, including the borrower will play a central role in helping the economies relief and prudential measures, are gradually boost growth over the medium term (Figure expiring in 2021, while the few remaining 7.2). ones are expected to be phased out by yearend. Although the worst-case scenario—a major As of June 2021, the credit growth has been deterioration of asset quality—has been positive in all Western Balkan countries avoided so far, the ultimate impact of the (Figure 7.3), with household loans growing crisis on bank asset quality remains uncertain. faster than corporate loans. However, the According to the results of the Central, Eastern first six months of 2021 registered a slower and South-Eastern Europe (CESEE) Bank average loan growth compared to the second Lending Survey,12 banks in the region expect half of 2020, with loan growth decelerating an increase in nonperforming loan (NPL) in Serbia, Montenegro, and North Macedonia ratios in the remaining part of the year (Figure while accelerating in Kosovo, Bosnia and 7.1). Going forward, financial sector regulators Herzegovina, and Albania. Kosovo saw the Figure 7.1. NPL ratios increased slightly in Q1 Figure 7.2. Banks preserved capital buffers 2021 and are expected to increase further as borrower relief measures expire. NPLs as percent of total loans Percent and percentage points 12 25 10 20 8 15 6 10 4 2 5 0 0 ALB BIH MNE SRB MKD KOS SRB MNE BIH ALB KOS MKD J Jun-19 J Jun-20 J Mar-21 Q Pre-crisis level (end 2007) J Jun-19 J Jun-20 J Mar-21 Q Average (2006–08) Source: IMF Financial Soundness Indicators; central banks. Source: IMF Financial Soundness Indicators; central banks. 12 The CESEE Bank Lending Survey – Spring 2021. Banks in the region expect NPLs to rise in four of the five countries covered in the Western Balkans. 28  |  7. Preserving financial stability is key in the post-COVID-19 recovery GREENING THE RECOVERY strongest private sector credit growth, at and lending to corporates declined slightly by 12.2 percent year-on-year (YOY) in July 2021, 0.2 percentage points compared to end-2020 backed by a positive economic outlook leading (Figure 7.4). The largest decline in corporate to more favorable loan demand and supply lending was in Serbia due to tightened supply conditions. Loan growth in Albania was at conditions, especially for small and medium- around 7.4 percent YOY, while Bosnia and sized enterprises (SMEs) and corporate Herzegovina maintained low (1 to 2 percent) segments. but steady growth in the second quarter of 2021 after exiting from negative growth The NPL ratios deteriorated slightly in early territory. In both countries, this credit growth 2021, albeit less than anticipated. A negative was supported by a fast recovery in loan trend is expected to continue throughout 2021. demand and eased bank funding conditions. As of March 2021, the regional NPL average A deceleration of loan growth in Serbia, North was 5 percent of total loans, 0.1 percentage Macedonia, and Montenegro was driven points higher than in the previous quarter. by milder market outlooks, expiration or However, the March 2021 NPL ratio was still tightening of support programs, and tighter 0.2 percentage points lower than a year ago loan supply conditions. As of June 2021, when the pandemic hit the region. Kosovo’s annual household loan growth in all countries NPLs remain the lowest in the region, while except Montenegro was higher than corporate NPLs in Albania, Bosnia and Herzegovina, loan growth. Specifically, household loans grew and Montenegro remain high, at around 6 to on average by 8.2 percent, more than double 8 percent. Most of the borrower relief measures that of corporate loan growth at 3.9 percent, including moratoriums, relaxation of loan a trend that has continued since July 2020, classification standards for NPLs, and favorable indicating a return to pre-COVID-19 trends. loan restructuring schemes have expired in As of June 2021, Western Balkans lending to the first quarter of 2021 after several rounds households increased by 2.3 percentage points, of extensions. Remaining borrower relief Figure 7.3. Credit growth has been positive Figure 7.4. Lending to households surged in in all countries but with a slower pace in H1 2021. 2021. Change in nonfinancial private sector credit outstanding, Change in credit outstanding, June 2021, percent, YOY percent, YOY 14 16 12 14 10 12 8 10 6 8 4 6 2 0 4 -2 2 -4 0 -16 -16 -17 l-17 -18 -18 -19 -19 -20 -20 -21 -21 Jan Jul Jan Ju Jan Jul Jan Jul Jan Jul Jan Jul ALB BIH KOS MKD MNE SRB ▬ ALB ▬ BIH ▬ MKD ▬ MNE ▬ SRB ▬ KOS J Firms J Households Source: IMF International Financial Statistics; central banks. Source: central banks. 7. Preserving financial stability is key in the post-COVID-19 recovery  |  29 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 measures—a loan moratorium in Montenegro with particular attention to restructured loans, and a restructuring scheme in Albania—are will be key to the early detection of any buildup expected to expire by yearend. Therefore, of vulnerabilities. Authorities should continue the 2021 first quarter NPLs may not fully strengthening the NPL resolution capacity by capture the complete picture on asset quality. focusing on (i) robust banking regulation and The CESEE Bank Lending Survey indicates a supervision to ensure the proper identification deterioration of asset quality in the second half and classification of NPLs and provisioning of 2021, both in corporate and retail segments for credit losses; (ii) strengthening of banks’ of most of the financial markets in the region. operational readiness to work out rising volumes of problem assets; and (iii) a legal environment Capital buffers and bank liquidity in the (that is, insolvency and creditors’ rights) that Western Balkan countries stayed broadly enables banks to work out bad loans and thus stable. As of March 2021, bank capital avoids steering distressed but viable borrowers adequacy averaged 18.8 percent, far above toward liquidation. In addition, authorities the regulatory minimum, and slightly higher should also refocus on a medium- to long- compared to December 2020, at 18.6 percent. term reform agenda to align financial systems The ratio of liquid to total assets averaged in the region with international standards (that 28.9 percent, slightly lower than in December is, Basel Core Principles, European Union 2020 (29.2 percent), and loan-to-deposit ratios Banking Directives) that might have been were well below 100 across the board. interrupted due to other priorities related to the COVID-19 response. Bank profitability started to recover in the first quarter of 2021. Bank profitability is While many countries introduced financial showing signs of recovery after remaining support instruments to alleviate the liquidity depressed for four quarters following the shock faced by firms during the COVID-19 outbreak of the pandemic. Profitability as crisis, including Public Credit Guarantee measured by return on assets has increased to Schemes (PCGSs) with exceptional design 1.4 percent in March 2021 from 1.1 percent features, there is now a need to adapt the in March 2020, mainly due to expiring instruments to a recovery phase. Countries borrower relief measures, removal of additional in the Western Balkan region either scaled up provisioning, and declining impairment costs. already existing schemes (Kosovo), introduced However, if asset quality deteriorates toward new PCGSs (North Macedonia, Serbia, Bosnia the end of 2021, this would put additional and Herzegovina), or are still considering pressures on profitability, with increasing introducing one (Montenegro). The economic impairment costs. distress caused by the pandemic and the need to act swiftly to preserve economic stability As the recovery takes hold, maintaining have implied in many cases a departure from financial stability will be of the utmost the principles, especially on the legal and importance to preserve the ability of the institutional framework, risk sharing, and financial sector to play its key role in pricing PCGSs. The primary objective of these providing funding to support economic interventions has been to protect firms and recovery. Going forward, continued vigilance, jobs. As economies are now entering a recovery 30  |  7. Preserving financial stability is key in the post-COVID-19 recovery GREENING THE RECOVERY phase, PCGSs can still play an important role to “normal” to minimize moral hazard. This in enabling the flow of credit to the productive implies restoring international best practices,13 sector and supporting resource reallocation. including (i) revising eligibility criteria for However, compared to the exceptional target groups, (ii) lowering coverage rates to operational design features implemented during more traditional levels, and (iii) adopting risk- the outbreak phase, PCGSs should go back based pricing (Box 7.1). Box 7.1. Well-designed Public Credit Guarantee Schemes are a useful instrument to support the economic recovery. Public Credit Guarantee Schemes (PCGSs) have become a prominent policy response around the world to support the financing needs of firms in the context of the COVID-19 crisis. PCGSs are particularly relevant and effective when there is enough liquidity in the financial system, yet this liquidity does not flow to some sectors or segments because of higher credit risk. PCGSs can help mitigate the credit risk and therefore facilitate the flow of bank finance. The nature of the COVID-19 crisis is aligned with this situation, characterized by substantial liquidity due to support measures, and large uncertainty on the length and depth of the crisis, leading to a very high credit risk that is constraining credit activity. PCGSs are also preferred to other interventions because they are (i) among the most market-friendly interventions with minimal distortions; (ii) crowding in private capital as banks typically share some of the risk; and (iii) requiring much lower initial cash flow needs and, as such, represent a cost-effective government intervention to incentivize lenders to provide financing to firms. However, PCGSs may add limited value and prove costly when their design and implementation are flawed. As economies are entering into a recovery phase, restoring international best practices of PCGSs by revising exceptional operational design features implemented during the outbreak phase is critical to ensure PCGS’s role in enabling the flow of credit to the productive sector and supporting resource reallocation. The Principles for the Design, Implementation and Evaluation of Public Credit Guarantee Schemes for SMEs, a set of international best practices developed by the World Bank in 2015, identified important aspects for the success of public PCGSs. Among the most important ones are: • Legal and Regulatory Framework: A PCGS should be established as an independent legal entity, with a clearly defined legal and regulatory framework  that should encourage the private sector’s participation in the scheme, clarify the ownership policy of the government, and separate government control from day-to-day operations, ensuring the PCGS’s independence and accountability. The legal framework should specify the sources of funding of the PCGS. The PCGS should also be supervised by a financial sector supervisory authority, according to the risk posed by its products. • Corporate Governance and Risk Management: The PCGS should have a clearly defined mandate, strong internal controls, and a solid risk management framework. The mandate should be set in legislation and include the target market and any other services in addition 13 World Bank (2015). Principles for public credit guarantee schemes for SMEs. Washington, D.C.: World Bank Group. http://documents. worldbank.org/curated/en/576961468197998372/Principles-for-public-credit-guarantee-schemes-for-SMEs. 7. Preserving financial stability is key in the post-COVID-19 recovery  |  31 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Box 7.1 continued to the guarantees (such as technical assistance). Based on the mandate, the PCGS should develop strategies for different segments. The PCGS should have a sound corporate governance structure, set in legislation, with an independent board of directors appointed in accordance with defined criteria. Effective PCGSs have in place strong internal controls, and internal audit and compliance functions. An adequate risk management framework is also essential, with accurate information and timely reporting systems to enable adequate monitoring and management of risks, including credit, liquidity, market, and operational risks. A comprehensive management information system for loan tracking and a guarantee issuance system facilitates risk identification, monitoring, and remedial action in a timely manner. • Operational Framework: Eligibility criteria should be designed to target financially constrained SMEs, while providing for some flexibility. The coverage ratio refers to the percentage of the loan exposure by the PCGS and should be on a risk sharing basis to provide sufficient protection against the risk of default and moral hazard, while preserving incentives for effective loan origination and monitoring. A risk-based pricing policy should be adopted, with fees high enough to discourage banks from using guarantees for good borrowers, but not excessive to avoid adverse selection. The claim payout should be quick and predictable in order to build the credibility of the guarantee scheme, while encouraging loan collection. Guarantee schemes should be allowed to require collateral up to reasonable limits. • Monitoring and Evaluation: PCGSs should also have rigorous financial reporting requirements, have the financial statements externally audited, and undertake reviews to assess additionality, outreach, and financial sustainability. Periodic reviews are important to provide the checks and balances to evaluate operations and refine procedures with regard to operational efficiency, claim payout, design features, performance, client satisfaction, additionality, sustainability, outreach, new products, and others. 32  |  7. Preserving financial stability is key in the post-COVID-19 recovery GREENING THE RECOVERY 8. External imbalances are set to moderate in most Western Balkan economies In 2020, the Western Balkans saw a The rapid growth recovery in the United States bifurcation in external imbalances, with the and China strengthened Europe’s external current account deficits of Albania, Kosovo, demand, with positive spillover effects on and Montenegro widening, and those in Western Balkan countries. The rebound in other countries improving or maintaining economic growth resulted in higher commodity broadly unchanged. Travel restrictions and prices, with the price of Brent Crude oil rising labor market shocks in source countries led to a from US$18 per barrel recorded in April 2020 sharp drop in tourism receipts and remittances to US$71.60 per barrel in early September in many countries in the Western Balkans. 2021. The latter has increased pressures on the This caused a widening of the current account structural merchandise deficits in the Western deficit in some countries, despite the sizable Balkans, which ranged from close to 12 percent contraction in oil prices, and merchandise of GDP in Serbia to 46 percent of GDP in import volume compressions exceeding declines Montenegro in 2020. in export volumes. In Montenegro, which was hit hardest by the COVID-19 shock, the Higher tourism receipts and remittances current account deficit ballooned 12 percentage compared to the halt seen in 2020 will offset points to 26 percent of GDP, whereas in the higher oil import bill in 2021 and help Albania, the external shortfall widened to close either narrow current account deficits or to 9 percent of GDP. In Kosovo, despite the rise leave them broadly unchanged across most in merchandise exports to 6.9 percent of GDP of the Western Balkans ( Figure 8.1.). In the in 2020 compared to 5.6 percent the previous first half of 2021, exports of goods and services year, the current account deficit widened by rebounded, but so did merchandise imports. 1.4 percentage points to 7 percent of GDP. Nevertheless, the strong recovery in remittances Meanwhile, Bosnia and Herzegovina and North resulted in a broad-based improvement in Macedonia recorded a broadly unchanged external shortfalls. Specifically, in Bosnia current account deficit of 3.3 and 3.5 percent and Herzegovina, Montenegro, and North of GDP, respectively. With a current account Macedonia, external shortfalls are expected to deficit that shrank in 2020 by 2.7 percentage continue shrinking or remain at the same level points to 4.2 percent of GDP, Serbia stood out as a year ago, in GDP terms. In Bosnia and in the region. The contraction in the external Herzegovina, the improvement in the external shortfall is, on the one hand, a consequence imbalance is driven by a surge in manufacturing of the improvement in the merchandise and consumer durable goods exports rather deficit as imports were compressed more than than remittances, which reflects strong external exports, and on the other hand, a significant demand in predominantly Central European improvement in the primary income surplus Free Trade Agreement (CEFTA) countries. due to a fall in direct investment income Meanwhile, Serbia and Albania are expected outflows. to widen their current account deficit, with the increase in import exceeding the rise in export 8. External imbalances are set to moderate in most Western Balkan economies  |  33 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Figure 8.1. Current account deficits will Figure 8.2. Net FDI remained an important narrow or remain unchanged across most of financing source of the current account deficit. the Western Balkans. Contributions, 2021 projections, percent of GDP 2021 projections, percent of GDP 16 16 12 14 8 12 4 10 0 8 -4 6 -8 4 -12 2 -16 0 MNE BIH MKD ALB SRB KOS MNE ALB KOS SRB MKD BIH WB6 J Goods exports J Goods exports J Net services exports J CAD J Net FDI J Remittances J Others Q Change in CA deficit Source: Central banks; World Bank staff estimates. Source: Central banks; World Bank staff estimates. volumes. Remittances will remain an important 21.5 percent of GDP in Montenegro in 2020. source of secondary income surpluses, which in In Serbia, the sharp increase in intercompany part offset the merchandise trade deficits and loans and portfolio investment had to offset are likely to benefit further from the rebound weakened equity inflows, but also a substantial in the European Union (EU) in the second outflow of other investment resulting from half of 2021. The net inflow of remittances is an increase in bank deposits abroad and net especially significant for Albania, Bosnia and government debt repayments. In the first half Herzegovina, and Kosovo, where the primary of 2021, an uptick in direct investment equity source countries are Austria, Germany, Greece, inflows took place across all Western Balkan Italy, and Switzerland. countries compared to the same period last year, while intercompany loans slowed. While foreign direct investment (FDI) flows declined globally, equity inflows in the External debt increased by over 14 percentage Western Balkans remained robust in 2020 points in the Western Balkans in 2020, and in the first half of 2021, reducing external raising sustainability concerns ( Box 8.1). borrowing requirements ( Figure 8.2). That The largest increase is seen in Montenegro, said, direct equity investment and reinvested estimated at above 220 percent of GDP in earnings fell 50 percent in Serbia and close 2020, as it issued a Eurobond in late 2020 to 80 percent in North Macedonia but were to refinance debt in early 2021. The rise in largely offset by soaring intercompany loans. debt is largely attributable to the government Similarly, in Montenegro, FDI remained robust external debt increase (by 8.5 percentage points and was complemented by an acceleration to 40.9 percent of GDP in 2020), but private in intercompany loans that almost tripled sector did not deleverage either. Meanwhile, compared to 2019, as parent companies kept North Macedonia and Serbia issued new subsidiaries afloat through liquidity injections. Eurobonds in 2021 at historically low rates, The external borrowing requirement totaled reflecting an international landscape of low 34  |  8. External imbalances are set to moderate in most Western Balkan economies GREENING THE RECOVERY interest rates but also investor confidence. Serbia led to rise in foreign exchange reserves across all issued the inaugural green bonds in September Western Balkan economies in 2020 and 2021. 2021 as well. The increased external borrowing Box 8.1. Macro-financial indicators point to external vulnerabilities in the Western Balkans. Most Western Balkan countries seem to have weathered the impact of the COVID-19 crisis well when it comes to current account deficits. On average, the current account deficits did not deteriorate significantly in 2020 and 2021 compared to the pre-crisis years as import compression outpaced declines in exports. Foreign exchange reserves have risen across the board due to capital inflows exceeding external borrowing requirements. However, although net equity inflows remained robust, external borrowing accelerated, especially by the public sector, as fiscal revenues collapsed (Figure 8.3). Private external borrowing, in the meantime, rose marginally in some countries, supported by intercompany loans. As a result, from 2019 to 2021, total external debt is set to rise by about 17 percentage points of GDP, to an average for the Western Balkans of 94 percent of GDP. Thus, even though external buffers in the form of foreign exchange reserves rose since 2019, foreign liabilities increased at a higher pace. Figure 8.3. Total external debt and foreign Figure 8.4. Net international investment exchange reserves rose sharply. positions worsened. Percent of GDP Percent of GDP 100 37 0 95 35 -50 90 33 -100 85 31 -150 80 29 75 27 -200 70 25 -250 2017 2018 2019 2020 2021 ALB BIH KOS MKD MNE SRB ▬ Total external debt, lhs ▬ FX reserves, rhs J 2018 J 2019 J 2020 Source: Central banks; World Bank staff calculations. Total external debt, and more broadly net foreign liabilities to GDP, is a significant crisis predictor for emerging markets and high-income countries. Catão and Milesi-Ferretti (2014)14 estimate the probability of an external crisis using the Net International Investment Position (NIIP), which reflects the aggregate net financial assets of all agents in an economy and uses equity as well as debt as significant explanatory variables for crisis prediction. The NIIP threshold of -50 percent of GDP is derived from a large sample of countries and provides a common point of reference, which disregards country-specific characteristics. Turrini and Zeugner (2019)15 estimate such country- specific prudential benchmarks that aim at gauging the NIIP level beyond which there is higher risk 14 Catão, L.A.V., and G.M. Milesi-Ferretti (2014), “External liabilities and crises”, Journal of International Economics, 94, 18-32. 15 Turrini, A., and S. Zeugner (2019), “Benchmarks for Net International Investment Positions”, European Commission Discussion Paper No. 97, May. 8. External imbalances are set to moderate in most Western Balkan economies  |  35 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Box 8.1 continued of a balance-of-payments crisis. Such interaction of NIIP values with structural variables affecting the riskiness of a given NIIP stock allows for deriving country-specific thresholds. All Western Balkan countries except Kosovo deviate significantly from prudential NIIP levels (Figure 8.4). Turrini and Zeugner (2019) estimate prudential benchmarks for countries used here  as proxies for assessing the external risks stemming from the stock of assets and liabilities in each country. As expected, Montenegro is an outlier with an NIIP level roughly nine times the prudential benchmark,16 whereas Serbia, North Macedonia, and Bosnia and Herzegovina exhibit NIIPs about two to three times the prudential level. With such elevated levels likely to persist over the medium term, external vulnerabilities appear more pronounced in the Western Balkans from the perspective of NIIPs than when assessed based on current account deficit outcomes alone. 16 While external public debt is projected to decline to 82 percent of GDP in 2021 from 97 percent the year before, total external debt is expected to decline to 196 percent of GDP in 2021 from 224 percent in 2020. Turrini and Zeugner (2019) list benchmarks, among others, for North Macedonia (22.8 percent of GDP) and Croatia (37.4 percent of GDP). We use the simple average of the two countries (i.e. 30 percent of GDP) as a proxy for the threshold of other Western Balkan countries. Over the medium term, external imbalances labor markets in Europe fully recover from the are set to moderate across most Western COVID-19 shock. Balkan economies, but external debt will remain elevated. Assuming that new The rebound in exports will in part be COVID-19 variants do not cause widespread offset by an acceleration in merchandise containment measures in the EU, the recovery imports driven by a recovery in private of exports in goods and services seen in the first consumption and public investment in the half of 2021 is expected to continue over the Western Balkans. Remittances, meanwhile, medium term. Bringing COVID-19 infections are likely to recover sooner than tourism under control through accelerated vaccinations incomes, helping to some extent soften the re- and managing cluster outbreaks is paramount emergence of widening structural merchandise to reducing external imbalances in Western deficits. Overall, a broad moderation in current Balkans economies that are tourism dependent. account deficits is expected over the medium Many Western Balkan countries are struggling term largely financed by direct investment in to secure sufficient vaccine supplies and fight equity and reinvested earnings. Intercompany vaccination hesitancy and are thus unlikely to loans could decelerate, while external financing achieve widespread inoculation before 2022. of gradually adjusting fiscal deficits is likely to The major tourism season has been successful ensure a further buildup in foreign exchange in Albania, Montenegro, and to some extent reserves. in Bosnia and Herzegovina, which helped keep external financing needs manageable. Tourism and travel inflows are, nevertheless, likely to reach pre-crisis levels only in 2022, as inoculations become more widespread and 36  |  8. External imbalances are set to moderate in most Western Balkan economies GREENING THE RECOVERY 9. Setting the course for a stronger and greener economic recovery The outlook for Western Balkan countries has growth in the region is expected to stabilize overall improved due to an overall stronger- closer to the pre-crisis potential output (Figure than-expected economic performance in 2021, 9.1). Yet, economies in the Western Balkans but early indicators point to moderating have been among those most impacted by the momentum in the second half of 2021. The spread of the Delta variant in the third quarter pre-crisis growth path is expected to resume, of 2021, with the number of new COVID-19 with growth in the Western Balkans expected to cases approaching or surpassing previous be 4.1 percent in 2022 and 3.8 percent in 2023. peaks. Vaccination rates lag the world average Three main factors are behind the stronger- of 47 percent (Box 9.1), with the exception than-expected recovery: (i) the recovery of key of Kosovo (Figure 9.2), and clearly lag the sectors, like tourism and trade, as countries EU average of 68 percent. In addition, global adjusted to the “new normal” and have reduced disruptions in trade due to delays in shipments, stringency measures; (ii) strong domestic low capacity of ports, and disruptions in value demand, fueled primarily by government chains, will likely contribute to a deceleration support, remittances, household credit, and, in trade. While the growth in the first half of investments especially in Serbia and North the year have been driven by external forces, Macedonia; (iii) the stronger-than-expected going forward, domestic factors, in particular recovery in the EU and key trading partners, consumption and investment, are expected to which gave a boost to manufacturing industries sustain the recovery. linked to the value chain. In 2022 and 2023, Figure 9.1. Growth is settling at pre-crisis Figure 9.2. Vaccination rates are lower than in levels from 2022. the EU. Real GDP growth, percent Share of population, percent 12 50 47 44 10 40 40 38 34 8 30 5.9 6 23 4.1 3.8 20 4 2 10 0 0 2021 2022 2023 BIH ALB MKD MNE SRB KOS J ALB J BIH J KOS J MKD J MNE J SRB ▬ WB6 Source: World Bank staff calculations. Source: Our World in Data, accessed on October 15, 2021. Note: Total number of people who received at least one vaccine dose divided by the total population of the country. 9. Setting the course for a stronger and greener economic recovery  |  37 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Box 9.1. Understanding COVID-19 vaccine hesitancy in the Western Balkans. As the COVID-19 vaccine rollout gains momentum globally, many countries struggle to effectively communicate the importance of vaccines in preventing the spread of the virus, saving lives, and reviving economic activity. Social, economic, and behavioral barriers to vaccine take- up can slow the progress toward herd immunity. A detailed understanding of perceptions of the COVID-19 vaccines can help governments take effective steps to increase vaccine take-up. To that end, the World Bank has collected data on vaccine perceptions among Facebook users in 15 countries.17 In each country, 5,000 to 10,000 Facebook users whose age, gender, region, and education levels aim to align with the national population, are surveyed about their attitudes toward vaccines and sources of information. Teachers and health workers are identified in the survey due to their importance as trusted messengers on COVID-19-related information. Results from these surveys have shed light on the drivers of vaccine hesitancy, such as safety concerns, low trust in institutions, and lack of understanding of the need for vaccines. The survey tests the impact of different messages on people’s intention to get vaccinated by randomly varying the framing of questions. Experimental test from several countries18 highlights the power of framing: messages that incorporate relevant information to specific subgroups by differentiated messengers can increase the intention to get the COVID-19 vaccine by about 20 to 40 percent. While vaccination has recently accelerated in Figure 9.3. Percentage of the unvaccinated the Western Balkans, fully vaccinated rates population that will take the COVID-19 range from only 23 percent in Bosnia and vaccine when available. Herzegovina to 47 percent in Kosovo. To 19 support the vaccination progress in the region, SRB 23 36 41 the World Bank conducted a survey during July–August 2021 in Kosovo (6,078 responses), MKD North Macedonia (4,554 responses across four 37 43 20 regions, Polog, Skopje, Vardar, and Pelagonia) and Serbia (13,992 responses). Preliminary KOS 57 33 10 results show that, among the unvaccinated, an important proportion of respondents are 0 20 40 60 80 100 unsure about getting the COVID-19 vaccine, Percent underscoring a need for behaviorally informed J Yes J Unsure J No messaging to encourage uptake among this Source: World Bank survey. group (Figure 9.3). People are more likely to Note: Because the survey only reaches Facebook users, certain demographic groups (men, young adults, and more educated individual) be hesitant if they do not believe it is important are overrepresented. Due to advertising targeting, only four regions to vaccinate to protect others, do not believe (Polog, Skopje, Vardar, and Pelagonia) were included in the North Macedonia sample. Thus, the surveys are not nationally representative. friends and family will get vaccinated, and do not think the government response has been effective. People who are hesitant because of low trust in institutions are more likely to be male, while those hesitant because of concerns about the safety or efficacy of the COVID vaccine are more likely to be female. 17 As of September 2021. World Bank, Behavioral Science Support to COVID19 Vaccine Distribution. 18 Earlier experiments were carried out in Lebanon, Iraq, West Bank, Gaza, Tunisia, Libya, and Honduras. 19 Data as of October 15, 2021. Mathieu, E., Ritchie, H., Ortiz-Ospina, E. et al. A global database of COVID-19 vaccinations. Nat Hum Behav (2021). https://ourworldindata.org/explorers/coronavirus-data-explorer 38  |  9. Setting the course for a stronger and greener economic recovery GREENING THE RECOVERY Box 9.1 continued The most common concern among the vaccine-hesitant—27 percent of respondents in North Macedonia and Serbia, 38 percent in Kosovo—is long-term side effects. The most trusted source of information for health advice is family members: trusted by 51 percent of those who do not intend to get vaccinated in North Macedonia, 44 percent in Serbia, and 41 percent in Kosovo; and by 45 percent of the uncertain in North Macedonia, 37 percent in Serbia, and 29 percent in Kosovo. Scientists and epidemiologists are the second most trusted source. Hesitancy among health and education workers mirrors the general population, with similar proportions indicating they do not intend to get vaccinated in North Macedonia and Kosovo, and slightly lower but still important proportions in Serbia. Messaging that highlights the fact that studies from around the world confirm that COVID-19 vaccines are effective in protecting individuals, families, and friends increases the intention to get vaccinated by 39 percent in North Macedonia and 10.5 percent in Kosovo. In Serbia, messaging that highlights that other people are getting vaccinated against COVID-19, including how many have done so in the past two weeks, increases the intention to vaccinate by 20 percent. These findings provide useful insights about the drivers of hesitancy and how communications can be customized to appeal to specific concerns related to the COVID-19 vaccines. Inflationary pressures are expected to expenditure rationalization will have to lead a moderate as the economies settle closer fiscal consolidation effort in order to bring the to their potential growth, but to remain elevated debt levels down. Public and publicly elevated due to inevitable energy price guaranteed debt is expected to decline from its hikes. As the economies have recovered faster, peak in 2020 of 61 percent of GDP to below inflationary pressures have started to build 56 percent of GDP in 2023. This is well above up. Supply-side shocks, increased inflation in the pre-crisis debt levels, suggesting further trading partners, and strong demand have led efforts will be needed to restructure spending to an increase of the average inflation in the and improve tax compliance across most of region to a projected 2.3 percent in 2021, from the region. Bosnia and Herzegovina and Serbia 0.9 percent in 2020. However, inflationary are the only exceptions, where consolidation expectations are still anchored, and wage efforts in the pre-COVID-19 period managed growth is kept moderate, which will keep core to bring public debt down considerably, thus inflation subdued over the medium term. The creating fiscal space to respond to such shocks. necessary energy price adjustments as countries align excises and reform their energy sectors With resumed trade activity, external deficits may keep the consumer prices elevated. are also expected to narrow, assuming inflows from remittances and tourism remain stable Fiscal deficits are expected to decline in the medium term. Inflows from remittances gradually, but public debt will not return to and a surplus in services compensated the the pre-crisis level over the medium term. higher demand for imported goods coming Improved revenue collection and the reduction from increased investment and consumption. in relative spending led to a reduction of With exports and remittances bouncing the average fiscal deficit by 2.7 percentage back, the current account deficit is expected points of GDP in 2021. Yet, beyond 2021, to gradually narrow in the Western Balkans, 9. Setting the course for a stronger and greener economic recovery  |  39 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 leading to a slow reduction in historically high socioeconomic program needed to address the external debt. country’s development challenges and pave the way for EU accession. The deterioration The outlook is subject to a series of risks, in performance of state-owned enterprises, as mostly geared to the downside  (Box 9.2). seen recently in Serbia with Telekom Srbija A prolonged pandemic and the rise of new and Air Serbia, could also add new fiscal variants domestically and internationally pressure. Yet, positive developments may also could adversely affect growth and confidence. emerge around EU accession and around the International travel bans and further disruption substantial new EU funding envelope focused in global trade may weaken domestic production on investments for green and digital transition, and export of goods and services. In the absence and implementation of structural reforms. of fiscal consolidation, especially for countries with high debt, like Albania, Montenegro, and North Macedonia, refinancing risks could arise if external financial market demand tightens. Debt sustainability may become a concern, while access to finance may become more expensive as monetary tightening starts. In the financial sector, risks are linked to the increase in nonperforming loans. Political polarization risk also remains high. In Bosnia and Herzegovina, the current political deadlock could be further amplified in the pre-election period, adversely affecting implementation of the adopted Box 9.2. The global economy is expected to see a strong rebound, but continues to be subject to key downside risks. The global economy is experiencing a strong rebound but the continued spread of COVID-19 weighs on the near-term outlook. Following a collapse in global economic activity from the pandemic, a cyclical recovery has been underway since the trough in 2020Q2. Global activity has been supported by improving domestic demand on the back of vaccination progress, especially in major economies. In emerging market and developing economies (EMDEs), including those in the Western Balkans, a generally supportive external environment has further propelled the rebound. According to the June 2021 edition of Global Economic Prospects, global output is projected to expand 5.6 percent in 2021 and then moderate to 4.3 percent in 2022 (Figure 9.4A). The forecast assumes that activity in major economies stabilizes, including in the euro area, and macroeconomic support continues to be withdrawn. The spread of more transmissible variants, however, has prompted renewed mobility restrictions and casts a long shadow over the strength and durability of the recovery. For EMDEs, obstacles from the pandemic, including highly unequal vaccine access, are partly offsetting some of the benefits of firming demand. 40  |  9. Setting the course for a stronger and greener economic recovery GREENING THE RECOVERY Box 9.2 continued Figure 9.4. Global economic developments. A. Global GDP B. Economic Surprise Index Percent Index 6 200 5 150 100 4 50 3 0 2 -50 -100 1 -150 0 -200 -20 -20 -20 -20 -20 -20 -21 r-21 -21 l-21 -21 2021 2022 2023 Jan Mar May Jul Sep Nov Jan Ma May Ju Sep J Baseline ▬ Scenario range ▬ World ▬ Advanced economies ▬ EMDEs C. Global shipping times and costs Consensus GDP growth forecasts for the euro D.  area Index, 50+=faster Index, 100=Jan 2020 Percent 90 550 5 80 450 4 70 350 3 60 250 2 50 150 1 40 50 0 -20 -20 -20 -20 -20 -20 -21 r-21 -21 l-21 -21 Jan Mar May Jul Sep Nov Jan Ma May Ju Sep 2021 2022 ▬ Delivery times ▬ Container shipping rates (rhs) J September Q June E. Global financing conditions F. Inflationary pressures Index, 100=January 1, 2021 Percent Percent 101.5 2.8 2.0 2.6 101.0 1.6 2.4 100.5 2.2 1.2 2.0 100.0 1.8 0.8 99.5 1.6 1.4 0.4 99.0 1.2 98.5 1.0 0 -21 eb-21 ar-21 pr-21 ay-21 un-21 21 21 Jul- Aug- Sep- 21 -19 -19 -19 -19 -20 -20 -20 -20 -21 -21 l-21 Jan F M A M J Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Ju ▬ World ▬ Advanced economies ▬ EMDEs ▬ United States ▬ Euro area (rhs) Source: Bloomberg; Consensus Economies; harperpetersen.com; Haver Analytics; World Bank; WTO; Bolt et al. (2018); Kose, Sugawara, and Terrones (2020); Oxford Economics; World Bank. A. Blue bars show baseline data from Global Economic Prospects June 2021 database. Yellow whiskers indicate the scenario ranges from Oxford Global Economic Model simulations compared to the baseline scenario. B. Citi’s Economic Surprise Index measures the degree to which economic data are either beating or missing expectations. Last observation is September 28, 2021. C. Global manufacturing suppliers’ delivery times, Purchasing Managers’ Index (PMI), and the HARPER PETERSEN Charter Rates Index (HARPEX) for container shipping rates. PMI data are inverted by subtracting data from 100; therefore, increasing (decreasing) PMI data indicate faster (slower) delivery times. Container shipping rates are monthly averages of weekly data and reflect price developments on the charter market for container ships. Dashed lines indicate long term averages over the period January 1998–December 2019 for delivery times and February 2018–December 2019 for container shipping rates. Last observation is August 2021 for delivery times and September 17, 2021 for container shipping rates. D. The average forecast for the months indicated from Consensus Economics. E. Goldman Sachs country-specific financial conditions indexes, which track borrowing costs, exchange rates, and equity valuations. GDP-weighted aggregates are calculated using 2021 GDP measured at average 2010-19 prices and market exchange rates. Sample includes 10 advanced economies, the euro area, and 14 EMDEs (excluding China). A reading above 100 indicates tightening of financial conditions. Last observation is September 17, 2021. F. Last observation is September 21, 2021. 9. Setting the course for a stronger and greener economic recovery  |  41 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Box 9.2 continued Global activity, while robust, likely plateaued in the first half of 2021. Many countries’ recoveries have faltered in the second half of 2021, with incoming economic data pointing to a loss of momentum amid the ongoing effects of the Delta variant (Figure 9.4B). This slowdown has been most evident in countries with severe COVID-19 outbreaks; in EMDEs, this has been compounded by low vaccination rates, partly owing to highly unequal vaccine access. The expansion in the global composite Purchasing Managers’ Index (PMI) has been dampened by the subsequent rise in global new COVID-19 cases in 2021Q3, with services activity in EMDEs particularly affected. The recovery in global goods trade has eased with growth in 2021Q2, slowing to about a third of its pace in the previous quarter, and has continued to lose momentum at the start of 2021Q3. Survey data point to further softening moving forward, with the manufacturing PMI for new export orders slipping in 2021Q3 due to substantial supply bottlenecks and strains in global value chains. Ongoing shipping delays and shortages of raw material have resulted in record-high backlogs (Figure 9.4C). The euro area—a key trading partner for the Western Balkans—continues to experience a sustained recovery. Following two consecutive quarters of contraction, GDP growth in the euro area bounced back in the second quarter of 2021, expanding 9.2 percent (QOQ, saar), prompting an improvement in private-sector forecasts for 2021 growth (Figure 9.4D). Despite this strong rebound, output in 2021Q2 remained about 2.5 percent below its 2019Q4 level. Nevertheless, the recovery has been underpinned by firming services activity following the relaxation of mobility restrictions and an accelerated vaccine rollout. Although incoming composite PMI data indicate that activity in the euro area continued to be strong in the third quarter, mounting supply and shipping bottlenecks have weighed on manufacturing production. These record-high backlogs have also contributed to the increase in prices, with inflation reaching a decade high of 3 percent in August.20 The outlook continues to be subject to key downside risks, particularly in the context of the pandemic and its scarring effects on the economy. In a downside scenario of a protracted pandemic, global growth over the next two years would falter to a pace similar to the anemic recovery that followed the global financial crisis. A lingering pandemic could further exacerbate the unevenness of the recovery, as limited vaccine access and hesitancy would continue to hinder widespread vaccination. As a result, years of hard-won gains in per capita income growth and poverty reduction could be further lost. Even in the relatively robust baseline, per capita income catch-up with advanced economies has slowed and even reversed in some cases. By end-2021, about 100 million people are expected to have fallen back into extreme poverty globally. The risk of financial market stress also remains pronounced, especially following last year’s rapid buildup of government and corporate debt. In an environment of elevated debt, financial stress could be triggered by any of a number of shocks that unexpectedly increase borrowing costs (Rogoff 2021).21 Although global financial conditions have remained relatively benign in 2021, they have tightened for EMDEs since June (Figure 9.4E). Conditions could abruptly tighten if major economies began to remove monetary policy accommodation faster than expected. Throughout the year, pockets of market volatility have been triggered by concerns over above-target inflation in the euro area and United States—both of which have announced tentative plans to start tapering 20 The European Central Bank (ECB) shifted its monetary policy strategy in July 2021, raising its inflation target to 2 percent—compared to its previous target of close to but below 2 percent—and affirming it would tolerate moderately higher, transitory inflation. Nevertheless, the ECB recently announced plans to start slowing its pandemic emergency bond purchases. 21 A sudden increase in interest rates could stem from a rise in risk aversion, inflation, or expectations of faster monetary tightening. 42  |  9. Setting the course for a stronger and greener economic recovery GREENING THE RECOVERY Box 9.2 continued bond purchasing programs at the end of this year—which has led to an increase in market-based forecasts on inflation and in expectations of further rate hikes in the near future for the United States (Figure 9.4F). For the Western Balkans, a sudden tightening in external financing could generate risks associated with debt rollover and currency mismatches, especially in those economies that have substantial upcoming redemptions or borrowed heavily in foreign currency. A resilient recovery, and sustainable growth with shrinking fiscal space going forward going forward, would require regionwide and would reorient spending toward growth- efforts on advancing structural reforms and enhancing items. Learning from each other accelerating the low-carbon transition. When by implementing those structural reforms to compared to EU peer countries, key areas in close the gap with the best performer among which the Western Balkans lags behind, and that the Western Balkan countries in each of the would bring the bulk of growth, are business key dimensions, would raise average growth in regulation and the quality of institutions—that the region by almost 2 percentage points in the is, governance (Box 9.3). If business climate next decade (Box 9.3). reforms are implemented, together with the necessary policies to support labor market A region-wide effort is also required to participation and formal employment, private promote green growth. This could be done investment could provide further support to by, for example, promoting efficiency gains, growth and would allow for growth to translate expanding green industries and technologies, into poverty reduction. Further strengthening supporting green jobs, and proactively building the independence of public institutions, up resilience to climate and disaster risks. especially the judiciary, would not only Adequately pricing carbon would not only improve countries’ prospects of joining the EU, provide incentives to focus on green recovery but would ensure a level playing field for all but would also offset the adverse impact of the businesses and entrepreneurs, hence favoring EU Carbon Border Adjustment Mechanism a more equitable recovery. Digitalization and the Western Balkan exports competitiveness boosting internet penetration are also expected (Chapter 10). to open new growth avenues for the six countries. The structural reform agenda should be accompanied by a firm commitment to prudent fiscal management. On the revenue side, it is of the utmost importance to improve compliance, incentivize formalization, and boost revenues, especially for Albania, which has the lowest revenue collection in the region. On the expenditure side, enhancing targeting and efficiency of spending would help deal 9. Setting the course for a stronger and greener economic recovery  |  43 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Box 9.3. Learning from each other would help to boost economic convergence in the Western Balkans. Structural reforms can boost GDP growth through their impact on the three standard inputs of a production function: capital, labor, and productivity (or efficiency). Structural determinants of potential GDP growth are identified by separately studying capital, labor, and productivity—the channels through which these determinants may work. The analysis builds on the approach introduced by Bouis and Duval (2011), Barnes et al. (2013), and Johannson et al. (2013), and elaborated on by Egert and Gal (2016) and recently applied for Argentina by Lusinyan (2018) and for Serbia by Rovo (2020). Cross-country reduced-form panel data regressions are estimated for the capital-to-output ratio and the employment rate. Efficiency is estimated through stochastic frontier analysis, which allows for the computation, for a given sample of countries, of the maximum amount of output, given the factors of production and technology available and conditional on structural and macro variables. The analysis highlights the role of crucial structural characteristics in accelerating growth, including institutional quality, labor market rigidities/regulations, product market regulations and competition, digital economy, and human capital. Table 9.1. Top 4 structural reforms needed to close the gap with Germany: Regulations, governance, financial development, and digitalization. Bosnia and North Albania Kosovo Montenegro Serbia Herzegovina Macedonia REG REG GOV REG GOV REG GOV GOV FIN GOV REG GOV DIG DIG DIG DIG DIG DIG Note: DIG refers to digitalization as proxied by the share of individuals using internet in the previous three months (WDI, 2018); FIN refers to financial development as proxied by credit to the private sector (as a share of GDP – WDI, 2018); GOV refers to governance as proxied by the governance effectiveness index (WDI, 2018); REG refers to regulations as proxied by the business regulatory quality index (Fraser, 2018). Reforms in the business environment, governance, and digitalization would contribute the most to growth and close the gap with the EU best-performing countries. Based on the assumption that the six countries have the capacity—in terms of plans and resources—to implement reforms promptly and simultaneously, it is possible to simulate the change in annual GDP growth from closing the gap in critical structural areas relative to one of the best-performing countries in Europe (namely, Germany) over a period of 10 years. All six countries would benefit from improving the regulatory environment for businesses and the quality of institutions, that is, governance. In addition, advancing digitalization is critical for Figure 9.5. Western Balkan convergence. boosting growth (Table 9.1). Average real GDP growth: reform vs. no-reform scenarios, Real GDP (index, 2007=2007) 220 Learning from the Western Balkans best 210 performer in each dimension would add 200 2 percentage points to the average real GDP 190 180 growth for the region. Closing the gap with 170 the best performer among the Western Balkan 160 countries in each dimension, would speed the 150 140 recovery process, boost the average economic 130 growth in the region by about 2 percentage 120 9 0 1 2 3 4 5 6 7 8 9 0 points, and accelerate convergence with the EU 201 202 202 202 202 202 202 202 202 202 202 203 ▬ WB6 no reform … WB6 reform (Figure 9.5). 44  |  9. Setting the course for a stronger and greener economic recovery GREENING THE RECOVERY Box 9.3 continued References Barnes S., R. Bouis, P. Briad, S. Dougherty, and M. Eris. 2013. “The GDP Impact of Reform.” Economics Department Working Papers No. 834, OECD, Paris. Bouis R., and R. Duval. 2011. “A quantitative assessment of the potential gains from various structural reforms in the OECD area and beyond.” OECD Economics Department Working Papers No. 835 Egert, B., and P. Gal. 2016. “The Quantification of Structural Reforms in OECD Countries: A New Framework.” Economics Department Working Paper No. 1354, OECD, Paris. Johansson, A., Y. Guillemette, F. Murtin, D. Turner, G. Nicoletti, C de la Maisonneuve, P. Bagnoli, G. Bousquet, and F. Spinelli. 2013. “Long-term Growth Scenarios.” Economics Department Working Papers No. 1000, OECD, Paris. Lusinyan, L. 2018. “Assessing the Impact of Structural Reforms through a Supply-side Framework: The Case of Argentina.” IMF Working Paper 18/183, International Monetary Fund, Washington, DC. Rovo, N. 2020. “Structural Reforms to Set the Growth Ambition”. Policy Research Working Paper;No. 9175. World Bank, Washington, DC. 9. Setting the course for a stronger and greener economic recovery  |  45 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 10. Spotlight: From a green recovery to green transition in the Western Balkans Environmental sustainability is a The post-pandemic policy environment pressing global concern has changed Across the world, environmental Having just suffered sharp economic sustainability is moving from the periphery downturns during the COVID-19 pandemic, to the mainstream of the growth and the six countries of the Western Balkans macro-fiscal stability agenda. Multiple now find themselves rethinking their environmental crises, including climate long-term development strategy. Do they change, biodiversity loss, and pollution, pose continue with a brown recovery, using existing existential risks to humanity and immediate means of production, or fundamentally shift systemic risks to the prosperity, sustainability, their economies to a green growth model? and resilience of nations. The preferences of Leapfrogging to green growth is far from easy, global consumers and investors are changing, especially in the short term. Traditional, brown and green technologies and business models industries are familiar, supported by “sticky” are disrupting more markets. Green policies are brown skills and jobs, established value chains, reshaping economic landscapes and greening and market infrastructure. Reliable, local, and the environmental footprint of economies and cheap coal (when externalities are excluded) are becoming a decisive factor in international combined with cheap labor gives the industry competitiveness and in the ability to attract of the region a competitive advantage and international finance and investment. undoubtedly contributes to the attraction of foreign direct investment. Green alternatives to The small, open economies of the Western business-as-usual drivers of short-term recovery Balkans are no exception. As a neighbor of the from COVID-19 and long-term growth are European Union (EU), an unequivocal leader not that obvious, especially as fiscal space has in global climate action, both access to the EU narrowed, and the higher debt burden after market and expected EU financial assistance will the crisis has restricted the set of choices that crucially depend on the progress made by the governments can make when it comes to large Western Balkans in greening their economies. investments. Pursuing a business-as-usual Therefore, this spotlight highlights the macro- growth model post-COVID-19 carries the fiscal challenges and drivers of greening the risk of locking in growth on an unsustainable region’s growth in the rapidly changing world. (brown as opposed to green) trajectory. Sector greening challenges and opportunities will be highlighted in the next edition of the Furthermore, business-as-usual is no longer Regular Economic Report. available to the countries of the Western Balkans. The external environment is going through a fundamental structural change. Global strides toward action on climate change, biodiversity loss, air and plastic pollution, 46  |  10. Spotlight: From a green recovery to green transition in the Western Balkans GREENING THE RECOVERY and other existential environmental crises are the imported goods, the corresponding cost can changing the foundations of economic activity, be fully deducted for the EU importer. Since, as consumer choices, and investor behavior mentioned, the EU is the largest trading partner everywhere. And closer to home, the European for the Western Balkan countries, the CBAM is Green Deal is providing a new set of markers for expected to eventually affect the terms of trade the region’s future growth trajectory, especially for carbon-intensive goods exported to the EU, in the context of the countries’ EU accession unless Western Balkans levy comparable carbon aspirations. The EU accounts for almost pricing to producers at home. 70 percent of the region´s total trade, which makes it the largest trading partner for each of The EU CBAM was designed to have a the Western Balkan countries. Trade between targeted and limited impact, but what comes the EU and the region has risen by almost 130 next could be a game changer. Initial World percent over the past 10 years, with the total Bank analysis suggests a small overall impact of trade between these two partners reaching EUR the CBAM proposal on the Western Balkans, 55 billion before the crisis. Old choices will not although some manufactured goods exported work in the new environment. to the EU could be significantly affected. The current CBAM proposal covers only direct The EU Carbon Border Adjustment emissions of carbon from the production Mechanism (CBAM) proposed by the processes of the selected goods. Going forward, European Commission is the first tangible however, the EU is likely to expand the CBAM manifestation of the costs that could be to cover more sectors and more products after faced by countries that continue a business- 2030.22 In future, import tariffs could also as-usual growth model. The July 2021 EU cover emissions from electricity and heat used CBAM legislative proposal applies to the import during production and eventually all emissions of selected goods from the most emission in the value chain of exporting companies. intensive and trade exposed sectors covered When this happens, the emissions intensity by the EU’s Emissions Trading System (EU of the power grid will have a decisive impact ETS), such as electricity, cement, fertilizers, on the competitiveness of the Western Balkan steel and aluminum. The proposal stipulates products in the EU and other countries that may that, from 2026, EU importers of these goods decide to apply CBAM alongside EU. More will be required to buy carbon certificates countries, like Japan and Canada, are already corresponding to the carbon price that would contemplating similar trade measures as part have been paid, had the goods been produced of a more ambitious climate policy packages. in the EU under the EU ETS. The price of these This would limit opportunities for the Western certificates will gradually approach full EU Balkans to redirect exports of carbon-intensive ETS price over 10 years, as free allowances in goods away from the EU towards other EU are phased out by 10 percent a year. Once markets. The World Bank carried out global non-EU producers show that they have already simulations that showed that a larger group of paid for the carbon used in the production of countries introducing CBAM covering value 22 Publicly stated by Gerassimos Thomas, Commission’s Director General for the Taxation and Customs Union. 10. Spotlight: From a green recovery to green transition in the Western Balkans  |  47 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 chain emissions would significantly influence structural funds, could help pave the way for global trade flows, incentives to cooperate on closing this environmental infrastructure gap. climate action, stranded assets, as well as GHG emissions.23 Western Balkan exporters with Investments in climate-resilient high carbon footprints may also face other infrastructure are also needed to protect barriers in accessing markets and finance, as against flooding and drought, and to ensure global consumers, investors, and financiers are water security. In 2014, historic flooding greening their preferences. caused over EUR 2 billion in damage and loss in Bosnia and Herzegovina (equivalent to nearly 15 percent of the country’s GDP), and Shifting to a green growth pathway will over EUR 1.5 billion in damage and loss in require new and different investments Serbia (nearly 5 percent of Serbia’s GDP). In in hard and soft infrastructure 2017, record temperatures buckled train tracks; fueled dozens of fires across the Balkans; caused Catching up with the infrastructure a drought in Serbia, which led to a drop in investment backlog and compliance with agricultural output of nearly 10 percent; and the EU environmental acquis is a known forced Albania to spend EUR 200 million on and manageable challenge of EU accession. energy imports amidst a devastating drought. The costs of alignment with the EU climate These extreme events serve as a reminder of just policy package and implementing the EU how vulnerable the region is to climate-related environmental acquis will be high, and massive shocks. As weather patterns become more infrastructure investments are needed. It is uncertain in the region, governments need to indisputable, however, that the benefits to take increasingly proactive approaches to ensure accession countries are higher than the costs. the safety and prosperity of communities. Crumbling municipal and environmental infrastructure make Western Balkan cities less Given the region’s legacy of energy- and livable than their EU counterparts. Under- emission-intensive infrastructure, with sticky provisioned and poor-quality basic municipal “brown” skills and jobs, the green growth services, such as water, sanitation, transport, trajectory looks for many stakeholders and waste management in many cities drive like a tall order. Energy intensity in the people away and deter both domestic and region remains three times higher than in EU foreign investment. Unaccounted water losses, countries, on average. The gap is the highest for example, in capital cities of the Western in Bosnia and Herzegovina and the lowest in Balkans are strikingly high, particularly Albania, although the energy intensity gap has in Tirana (73.6 percent) and Sarajevo been narrowing over the past two decades. (75.2 percent). Wastewater coverage is well below 100 percent in most of the capital cities For all Western Balkan countries, except and well below that of countries overall. EU Albania, CO2 emissions per dollar of GDP are pre-accession funds and, later, cohesion and significantly higher than in EU countries24 23 Peszko et al. 2020; Peszko, van der Mensbrugghe, Golub 2020; Peszko et al 2021. 24 Consistent data for Kosovo were not available. 48  |  10. Spotlight: From a green recovery to green transition in the Western Balkans GREENING THE RECOVERY  Figure 10.1). Bosnia and Herzegovina stands ( average. Coal and lignite (46 percent of the out in particular as being more carbon- total) dominates in the power generation and intensive economy than any EU member state. heavy industry, and oil (29 percent of the Interestingly, carbon intensities of output for total) dominates in transport. The penetration Bosnia and Herzegovina and Montenegro of natural gas for power generation is low have been quite stable over the last 20 years, (8 percent of the total). Renewable energy while all other Western Balkan countries saw a accounts for only 17 percent of gross available consistent decrease. energy and is dominated by biomass used in residential heating (10 percent of the total), About 83 percent of gross available energy and hydro (6 percent). Investment in new (primary energy use) in the Western Balkans renewables, such as wind and solar, has been comes from fossil fuels (Figure 10.2). This negligible. The energy mix is similar across compares with 70 percent in the EU, on Western Balkan countries, with the exception Figure 10.1. Higher carbon intensity of GDP in the Western Balkan than in EU. Carbon dioxide (CO2), kilograms of CO2/USD, 2000–2018 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 ▬ ALB ▬ BIH ▬ MNE ▬ MKD ▬ SRB Source: https://data.oecd.org/air/air-and-ghg-emissions.htm. Note: Thin grey lines represent carbon intensity of individual EU members states. Figure 10.2. High reliance on fossil fuels in primary energy use. Gross available energy by source, 2019, kilotons of oil equivalent, ktoe 2.386 7.230 2.669 1.112 2.844 15.437 31.678 100 9 7 1 2 2 6 1 5 1 1 6 1 14 4 90 6 13 7 7 10 17 80 19 13 9 13 8 3 70 28 7 23 25 60 2 38 29 50 37 40 30 53 56 50 49 46 20 33 37 10 5 0 Albania Bosnia and Kosovo Montenegro North Serbia WB6 Herzegovina Macedonia J Coal and lignite J Oil J Natural gas J Biomass J Hydro J Other RE J Other Source: Eurostat. 10. Spotlight: From a green recovery to green transition in the Western Balkans  |  49 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 of Albania, where the contribution of coal is factor affecting the export competitiveness more limited, and oil and hydro have a larger of Western Balkan products, because all share.25 producers use electricity from the grid. In the past, preferences for local coal and All Western Balkan countries (except resistance to imported gas have been driven by Albania) rely on domestic coal (lignite) for energy security concerns, which traditionally power generation, and they are producing were equated with energy self-sufficiency. their own lignite to fuel power plants. In A new concept of energy security based on 2019, Kosovo generated about 95 percent of diversification of energy sources, molecules, its electricity from domestic lignite, followed technologies, and trade routes is the essence by Serbia, Bosnia and Herzegovina, North of the EU energy policy and is slowly being Macedonia (about 60–70 percent), and internalized by decision makers in the Western Montenegro (44 percent). Of all types of coal, Balkans. lignite has the lowest energy density, a low heating value and a high moisture content. For Perhaps one of the most pressing issues this reason, it is uneconomical for long-distance in the cities of the region is poor air transport and export. It is mainly used in the quality, which is commonly the leading power plants that are integrated with the nearby environmental contributor of death and mines. In such a configuration, it represents a disability. The extreme population exposure reliable power source with low generation cost to fine particles—PM2.5—that occurs every (assuming externalities are excluded). Fuel winter is principally the result of emissions prices are predictable and unaffected by global from domestic heating (coal and wood-fired market volatility. The commercial viability stoves and boilers, and the domestic burning of of lignite, however, deteriorates dramatically waste) and, to a lesser extent, coal power plants when the costs of environmental damage and industrial installations. The transport (both local and global) are added to the fuel sector’s contribution is relatively smaller but price. Therefore, electricity systems based on persists throughout the year and is exacerbated lignite are strongly exposed to the risks of local by an aging vehicle fleet (especially old diesel environmental regulations, citizen protests, and vehicles) and congestion. Agriculture is also carbon pricing, both on domestic and export a seasonal contributor due to the burning of markets. Albania is the only producer of crude agricultural waste. Other major factors include oil and small amounts of natural gas in the dust from industry, quarrying, and poor waste region and has a coal-free power grid. management practices. It is estimated that as a result of exposure to ambient PM2.5 air If the EU extends the CBAM to scope pollution, 3,300 people die prematurely every 2 emissions,26 the carbon footprint of year in Bosnia and Herzegovina, 1,600 people electricity generation will become a critical in North Macedonia, and 760 people in 25 Source: Eurostat. 26 So that, for example, an exporter of vehicles would need to pay a carbon tax at the border for carbon content of electricity used to produce these vehicles. 50  |  10. Spotlight: From a green recovery to green transition in the Western Balkans GREENING THE RECOVERY Kosovo.27 According to World Bank estimates, the relative stringency and urgency of climate annual economic costs of ambient air pollution and air pollution policies, the operators of the in these three Western Balkan countries ranged coal power plants will face incentives either to from US$240 million to US$1.38 billion retrofit coal units and install highly efficient in 2016.28 The PM2.5 concentrations in end-of-pipe air pollution control installations some region’s cities rival that of big cities like or retire coal plants earlier and switch to less- Beijing, Mumbai, and New Delhi.29 Western polluting fuels, such as natural gas or renewable Balkan countries (especially Serbia) are also in energy. Therefore, integrated calibration of violation of the emission limits on the sulphur multiple climate, air pollution and fiscal policy oxide (SO2), nitrogen oxides (NOX) and instruments is important to steer firms’ choices dust (PM) emissions embodied in the Energy toward socially cost-effective outcomes. Community Treaty. According to the European Commission Economic and Investment Plan,30 the 16 coal-fired electricity plants in the region Reforms will be needed to make the emit more SO2 than all 250 similar plants in trajectory of growth in the Western the EU. Balkans most sustainable There are some tensions between While income indicators, such as GDP, decarbonization strategies and the reduction measure the annual production generated of air pollution and GHG emissions. For by a country’s use of its assets, they do not example, removing SO2 emissions warms inform whether this production level can be the climate, investing in filters for coal-fired sustained in the future because they do not power plants significantly reduces air pollution capture the changes to its productive asset but slightly increases GHG emissions; the base. Income can be understood as the annual introduction of electric vehicles will not return that a country derives from its wealth. necessarily reduce GHG emissions if the source Therefore, the key to increasing economic well- of the electricity is coal; and putting a price on being in the future lies in building national carbon encourages households to switch from wealth. The World Bank developed the world’s clean gas and LPG to biomass and waste which most comprehensive, government balance are the key sources of population exposure to sheet-compatible accounts of the collective air pollution. These tensions do not justify wealth of nations, known as the Changing inaction on any of these major market failures Wealth of Nations.31 but require joint application of coherent air quality and climate policy instruments to Creation and maintenance of wealth requires ensure that one environmental problem is not savings in order to finance investment solved by aggravating another. Depending on in assets, as well as good institutions, 27 The World Bank country assessments of air quality management in the Western Balkans: Bosnia and Herzegovina, Kosovo, and North Macedonia: https://openknowledge.worldbank.org/handle/10986/33557. 28 Western Balkans Regular Economic Report No 17, Spring 2020. 29 In Skopje (North Macedonia), PM2.5 levels are more than four times the safe level recommended by the World Health Organization (WHO), over eight times the safe level in Tetovo (North Macedonia), and three times the safe level in Sarajevo (Bosnia and Herzegovina). 30 An Economic and Investment Plan for the Western Balkans, the European Commission, 6.10.2020. 31 Lange, Wodon, and Carey. 2018; World Bank 2021. 10. Spotlight: From a green recovery to green transition in the Western Balkans  |  51 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 policy incentives, and governance to make of, assets. Serbia had been losing wealth until productive use of those assets. One of the 2018 but started accumulating asset value since indicators the World Bank uses is adjusted 2018 due to the increased gross savings rate. net savings (ANS), developed originally by Hamilton and Clemens (1999). It tracks The ANS alone does not inform whether the sustainability of development over time as a depreciated and accumulated assets are green proxy for the change in wealth.32 ANS does or brown, and hence whether a country not capture all wealth components but its is becoming better or worse prepared to interpretation is simple: if ANS as a percentage manage a transition risk. The green transition of gross national income is negative, it indicates can be viewed as a supply shock with accelerated that the country is consuming more than it obsolescence of the capital stock. This should is saving, which will undermine long-term be offset by investment in new greener asset sustainability; if ANS is positive, then it is classes. Therefore, accelerated capital turnover adding to wealth and future economic well- can be an indicator of green transition, but being. Albania stopped accumulating wealth more detailed information about the type of around 2015 and has been depleting the basis of fixed assets formed and written off would be its future growth in 2019, mainly due to a drop needed to make this statement. Western Balkan in savings and investments with simultaneous countries may want to start monitoring the accelerated write-offs of the aging produced portfolio in their national balance sheets to assets (Figure 10.3). In contrast, North track whether their net fixed capital formation Macedonia has been accumulating wealth at an is green or brown. increasing rate since 2009, due to an improving ratio between investments in, and depreciation Figure 10.3. Are the Western Balkans accumulating or depleting their wealth? Adjusted net savings (ANS) as a percentage of Gross National Income Albania North Macedonia Serbia 40 40 40 30 30 30 20 20 20 10 10 10 0 0 0 -10 -10 -10 -20 -20 -20 -30 -30 -30 7 9 1 3 5 7 9 7 9 1 3 5 7 9 7 9 1 3 5 7 9 200 200 201 201 201 201 201 200 200 201 201 201 201 201 200 200 201 201 201 201 201 J G savings J Education J CFC J Energy dep J Min dep J Net forest dep J CO2 damage J Part damage … Adjusted net savings Source: World Bank Changing Wealth of Nations. Notes: CFC: Consumption of fixed capital. The complete data set available to calculate ANS was not available for Bosnia and Herzegovina, Kosovo and Montenegro. 32 ANS is measured as gross national savings minus depreciation of produced capital, depletion of subsoil assets and timber resources, and air pollution damage to human health, plus a credit for expenditures on education. 52  |  10. Spotlight: From a green recovery to green transition in the Western Balkans GREENING THE RECOVERY While Western Balkans energy systems producers, coal deposits represent a negligible depend on fossil fuels, their economies share of total wealth. do not. The wealth structure in the Western Balkans is typical of diversified, middle- The wealth structure of the Western Balkans income net fuel importers, although the value is in stark contrast to those of the fossil fuel- of wealth per capita is much lower than in EU dependant countries. For example, Azerbaijan, member states (Figure 10.4). Human capital33 which represents a typical asset portfolio of a dominates total wealth per capita (usually in fossil fuel-dependent country, has 44 percent of the range of 50 to 60 percent), followed by total wealth embedded in oil and gas and only produced assets (buildings, infrastructure, 23 percent in human capital (Figure 10.4). machines, intellectual property, and so forth), Export data confirm this pattern. Across the which account for 35 to 50 percent of total region, the share of fossil fuels in total exports wealth on average in the region. The value of is negligible for all coal producers in the region natural capital is usually below 10 percent in and reached around 8 percent in 2019 in EU member states and 10 to 15 percent in Albania due to its crude petroleum exports. the Western Balkan countries, but in all of them renewable assets (forests, agricultural The value of natural capital in the Western land, and protected areas) have much higher Balkan region has been dominated by value than the value of subsoil assets (fossil renewable assets (forests, agricultural fuels and minerals), the latter accounting for land, and protected areas), rather than a mere 2 percent or less of total wealth per underground resources. Per capita, the value capita across continental Europe, including of renewable natural capital during 2010–18 the Western Balkans. Even for the largest coal increased in Albania, slightly decreased in North Figure 10.4. The structure and value of wealth per capita in Western Balkan and selected comparators Wealth per capita in 2018, constant 2018 USD, in thousands 400 350 300 250 200 150 100 50 0 -50 Albania Bosnia and Montenegro North Serbia Bulgaria Croatia Slovenia Italy Azerbaijan Herzegovina Macedonia J Produced capital J Human capital J Renewable natural resources J Sub-soil assets J Net foreign assets Source: World Bank Changing the Wealth of Nations 2021 database. 33 CWON uses the lifetime earnings approach to estimate the value of human capital. According to this approach, human capital is estimated as the total present value of the expected future labor income that could be generated over the lifetime of the women and men currently living in a country, including those self-employed (Jorgenson and Fraumeni 1989; Fraumeni 2008; Hamilton and Liu 2014). The calculation of the lifetime income approach uses data by age and gender on population, employment and labor force participation, education, earnings profiles, and survival rates. 10. Spotlight: From a green recovery to green transition in the Western Balkans  |  53 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Macedonia, and remained more or less constant be large, with non-trivial political cost and in Bosnia and Herzegovina, Montenegro, and inflationary pressure of increasing taxes on fossil Serbia. In high-income economies, renewable fuel-based energy. Managing the just transition natural wealth per capital was increasing.34 of workers and communities in the mining regions, and shifting capital from stranded Better management can evoke more value assets in coal power plants and mines to new from abundant natural resources in the productive green assets, may be a significant Western Balkans. These would require policy though managable challenge. The most difficult incentives to improve resource management process will be to deal with social distributional practices in agriculture, forestry, and fisheries.35 and political economy issues, although several Tourism in the Western Balkans is already a new EU member states went through this key generator of income derived from natural process. The large part of additional revenue assets, such as beautiful coastlines, rivers, and from higher energy and carbon taxes may need mountain ranges. Subsoil natural assets (fossil to be used as transfers to ease the impacts of fuels and minerals) have not only represented higher energy prices instead of increasing green a small share of natural wealth per capita, investments or lowering taxes on income. but were also losing their value and hence Furthermore, the support of the EU funds significance as the basis for future growth. can significantly enhance opportunities for the affected communities. The next section explores The ambitious climate policies in the Western how well the Western Balkans are positioned Balkans will have important implications to harness green transition opportunities and for coal-related assets and labor, but are develop new sources of comparative advantage unlikely to represent a systemic macro-fiscal in a rapidly greening world. risk to their economies. The Western Balkan countries score high on the World Bank index The decision whether to stay brown or go of preparedness for low-carbon transition, green is a risk management problem. Signing with relatively low exposure and relatively up for the green transition is like joining a high resilience to transition risk. The key free trade area. Even if there is a multitude of determinant of relatively low exposure is the evidence to show the benefits, these are hard insignificant share of fossil fuel rents in GDP to estimate and will appear at an unspecified and fossil fuel exports in total export revenue.36 time in the future, whereas the costs (in Therefore, parting with the legacy of the brown terms of assets, jobs, and livelihoods) are growth model should not create the same tangible and specific and occur in the short systemic disruption in the Western Balkans, as term. Nonetheless, for the Western Balkans in the countries which derive over half of their external pressures like the EU CBAM; the EU exports and budget revenues from exports of oil accession process, with its financial assistance; and gas. The macro-fiscal challenge can however and the visible market preferences for a low 34 World Bank, 2021. 35 For example, overfishing reduced the value of marine fisheries in Albania from US$37 million in 2005 to US$6 million in 2018 (in constant 2018 USD). At the same time better management of protected areas increased their value from US$85 million in 2005 to US$4.6 billion in 2018 (CWON 2021). 36 Peszko et al. 2020. 54  |  10. Spotlight: From a green recovery to green transition in the Western Balkans GREENING THE RECOVERY environmental footprint of traded goods and not just a large market for goods and services, services make the expected benefits more but also access to investment, technology, and tangible, specific, and time bound. Therefore, know-how, to say nothing of pre-accession and embarking on a green transition for the structural funds. The 2019 European Green Western Balkans is not a problem of decision Deal is not just another environmental strategy, making under deep uncertainty, as for some of but, according to EU authorities, it is a new the world’s large fossil fuel exporters,37 but a long-term growth model that provides the risk management problem with probabilities of broad markers for an economic development external green drivers easier to assign, although trajectory for EU member states and their not always easy to agree on internally. trading partners. In the last decade most countries in the The economies of the Western Balkans Western Balkans maintained relatively high need to accelerate the shift towards reliance of exports from carbon-intensive green, complex, and competitive sectors, suggesting exposure to the low- products carbon transition risk. Figure 10.5 shows that only Albania made a major shift away from Greening the product and export mix will be carbon-intensive exports—from 60 percent an important condition of future economic in 2013 to just 10 percent of total exports in growth, especially given the economic 2019. Albania was also the only country in geography of the Western Balkans. With a the region which reduced the absolute value growing number of countries making net-zero of exports from carbon intensive sectors in emission pledges, global demand is beginning constant USD. This hedges the risk of the to shift away from fossil-fuel based production EU CBAM and other potential future “green” and toward cleaner technologies and more barriers to foreign market access. Other environmentally friendly products. As new countries have made some progress but remain growth opportunities in green product markets more vulnerable to transition risk. The share open, cultivating competitiveness in these areas of carbon-intensive exports in total exports is a fundamental way for countries to harness in 2019 was less than a decade ago, but still benefits from the transition to the green over 60 percent in Montenegro, 40 percent in economy. The region’s geographic proximity to North Macedonia, and 30 percent in Serbia European markets offers particularly attractive Bosnia and Herzegovina. Except Albania, and avenues for export-driven economic growth, Kosovo, the remaining countries reversed the provided that countries follow sustainable trend in the last three years and became even development trajectories that meet the more dependent on carbon-intensive exports. environmental and other standards of the EU Furthermore, each of them also increased the market and the increasingly green preferences value of exports from carbon-intensive sectors of European consumers and investors. Europe, in absolute, constant USD between 2016 and a global leader in the green transition, offers 2019. 37 Peszko et al. 2020. 10. Spotlight: From a green recovery to green transition in the Western Balkans  |  55 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Figure 10.5. Western Balkan countries have been slowly decreasing reliance on exports from emission-intensive sectors, but it remains high except in Albania. Exports, carbon intensive, percent of total exports, in constant 2010 USD 70 60 50 40 30 20 10 0 0 3 6 9 6 9 5 6 9 0 3 6 9 0 3 6 9 0 3 6 9 201 201 201 201 201 201 201 201 201 201 201 201 201 201 201 201 201 201 201 201 201 J ALB J BIH J KOS J MNE J MKD J SRB Source: World Bank staff using UN Comtrade 2-digit SITC for all but Kosovo. Note: Emission-intensive sectors include production of coal, coke and briquettes, petroleum, petroleum products, gas, fertilizers, minerals, chemicals, rubber, plastics, iron and steel, ferrous and non-ferrous metals, non-metallic minerals, pulp and paper. Despite a carbon intensive energy mix, the green (meaning they have potential use or Western Balkan countries are relatively well applications in the green transition such as endowed to manage a low-carbon export renewable energy generation, air pollution transition, but the export product mix monitoring, or waste management, but not will have to change significantly to stay necessarily a low carbon footprint in their competitive. This section applied the Green production), and complex (meaning they tend Transition Navigator38 to explore what existing to involve more technologically sophisticated and potential green competitive strengths are capabilities). Competitiveness in complex in global markets the region can rely on. The products is important as product complexity findings suggest that while the wealth structure enhances countries’ overall economic growth in the Western Balkans is conducive to a green and diversification prospects.39 Serbia, the economic transition, the product and export highest ranked country in the Western Balkans, structure will need to be significantly changed is ranked 33rd on the GCI followed by Bosnia to stay competitive in the green global economy, and Herzegovina which ranks 41st (Figure and particularly in the EU market. 10.6). Both held relatively stable ranks over the past two decades. The ranking of other While posing important challenges, for Western Balkan countries is much lower and example, via the EU CBAM, the green volatile, with Montenegro 71st, Albania 75th, transition also presents opportunities for the and North Macedonia 96th in recent years. Western Balkans to discover new products Close EU neighbors: Bulgaria, Croatia, and and new markets. The Green Complexity Index Romania rank above Serbia, at 15th to 22nd (GCI) tracks countries’ historical capacity place. Germany has consistently held the top to competitively export products that are GCI rank, with its strong manufacturing 38 The Green Transition Navigator (Andres and Mealy 2021) is an online tool (https://green-transition-navigator.org/) that draws on over 20 years of detailed data to showcase new metrics of green competitiveness and future green diversification potential across 231 countries and territories. Due to lack of data, Kosovo is not included in this analysis. 39 Hidalgo and Hausmann, 2009; Hausmann et al., 2014. 56  |  10. Spotlight: From a green recovery to green transition in the Western Balkans GREENING THE RECOVERY capabilities for green technologies, while China which measures a country’s competitiveness in rapidly increased its GCI ranking to 5th during specific green products and is calculated as the 2015–19. share of a country’s exports in a given product divided by the share of that product in global Figure 10.6. Green Complexity Index ranking, exports. GCS reveals the green competitive Western Balkans and selected countries. strengths of a country at the product level.42 GCI rank Serbia and Bosnia and Herzegovina are 0 20 currently competitive in a greater number 40 of green products, mainly those used in 60 renewable energy and wastewater management, 80 compared to the rest of the Western Balkans 100 (Figure 10.7). Across the region, comparative 120 advantage in green products is low, however— 140 barely above 1—indicating that the countries 160 9 1 3 5 7 9 11 3 5 7 9 will need to make an extra effort to become 5–9 997–0 999–0 001–0 003–0 005–0 2007– 009–1 2011–1 013–1 015–1 199 ▬ ALB 1 1 ▬ BIH 2 2 2 ▬ BGR 2 ▬ CHN 2 ▬ HRV 2 competitive in the international green product ▬ DEU ▬ MNE ▬ ROU ▬ SRB ▬ MKD space. Furthermore, most of Albania’s and Source: Bennet Institute40. Montenegro’s competitive green products tend to be less complex, with few exceptions, such as components for hydropower plants, There is significant potential for new spectrometers, optical instruments, and green competitive opportunities chromatographs. Interestingly, North Macedonia has fewer green competitive Green Competitive Strengths (GCS) and products overall, but relatively more green Green Potential Opportunities (GPO) products with a higher revealed comparative indicators can help identify each country’s advantage (RCA>30), such as air equipment potential to develop international for pollution control and rail transport. competitiveness in specific green and complex products. Both indicators rely Green Potential Opportunities (GPO) partly on the Product Complexity Index (PCI), provides an indication of green products which measures technological sophistication that each Western Balkan country is not of specific products,41 and hence technological yet competitive in (RCA<1) but might and knowledge spillovers they provide to the be able to develop competitiveness in the rest of the economy. For the Green Competitive future, because of their proximity to current Strengths (GCS) the PCI is combined with capabilities, including skills, know-how, or Revealed Comparative Advantage (RCA), factors of production.43 The proximity measure 40 https://www.bennettinstitute.cam.ac.uk/media/uploads/files/Economic_Complexity_and_the_Green_Economy.pdf 41 Hidalgo and Hausmann, 2009; Mealy et al 2019. 42 The bubbles represent green products each country is currently competitive in (RCA > 1). The y-axis plots each product’s PCI, and the x-axis plots the RCA. Products that have higher RCA values are more competitively exported by the country. Products are colored by the environmental category and sized by the country’s current proximity (measuring the product’s similarity to the country’s current productive capabilities). The data are based on trade values averaged over the 2015-2019 time period. 43 Hidalgo et al 2007; Neffke et al, 2011; Hidalgo et al 2018. 10. Spotlight: From a green recovery to green transition in the Western Balkans  |  57 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Figure 10.7. Green competitive strengths and potential opportunities in the Western Balkans. Albania: Green Competitive Strengths… …and Green Potential Opportunities. PCI PCI Renewable energy plants: iron/steel Hydroelectric power: hydraulic structures and parts turbines, water wheels Wind renewable energy: iron/steel towers and lattice masts Biodegradable, sustainable, natural materials RCA Proximity Bosnia and Herzegovina: Green Competitive Strengths… …and Green Potential Opportunities. PCI PCI Cleaner technology: Renewable energy: domestic appliances heat exchange units with electric motor Hydroelectric power: hydraulic turbines, water wheels Renewable energy: heat exchange units Wind renewable energy: iron/steel towers and lattice masts Wastewater management: Wind turbines: aluminum hydroxide, used in iron/steel towers, chemical recovery systems lattice masts RCA Proximity Montenegro: Green Competitive Strengths… …and Green Potential Opportunities. PCI PCI Heat/energy savings: Hydroelectric power: multiple-walled parts of hydraulic turbines insulating glass and water wheels Environmental monitoring: Biodegradable/sustainable surveying instruments products: jute fibers RCA Proximity 58  |  10. Spotlight: From a green recovery to green transition in the Western Balkans GREENING THE RECOVERY Figure 10.7. Green competitive strengths and potential opportunities in the Western Balkans (continued) North Macedonia: Green Competitive Strengths… …and Green Potential Opportunities. PCI PCI Rail transport: air brakes, Environmental monitoring/ parts for railway vehicles equipment: manostats Air pollution control: gas filtering/purifying machinery Electricity, power sector: electric transformers RCA Proximity Serbia: Green Competitive Strengths… …and Green Potential Opportunities. PCI PCI Environmental/ Electricity generation in waste management: renewable energy plants: mechanical appliances AC generators Parts for electric generating Electricity, power sector: sets for renewable resources liquid dielectric transformers RCA Proximity 10. Spotlight: From a green recovery to green transition in the Western Balkans  |  59 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 is calculated on the basis of the conditional environmental applications. Although currently probability of developing competitiveness brown skills and capabilities dominate, the in a product, given all the other products a educated and dynamic population in the country is currently competitive in. In the region, manufacturing sophistication, and GPO figures (Figure 10.7, right-hand panels), tighter integration with EU green innovation the downward slope across all Western Balkan and demand engines create an environment countries indicates that the more proximate conducive to quick transition to specialization green products tend to be less complex.44 This in competitive green and complex products. is a common trend for less developed countries with more limited technological capabilities. In This experimental analysis with a new contrast, the same figure for Germany would and still evolving tool (Green Transition have a positive slope, with high proximity to Navigator) should not be misinterpreted as high-PCI green products, reflecting its advanced a call for the government to initiate vertical manufacturing base and significant existing industrial policies to push specific products. expertise in green products. Green potential It is, rather, an initial effort to map the existing outlooks for Bosnia and Herzegovina and Serbia and potential strengths and weaknesses that look relatively strong, with manufacturing parts should inform the importance and urgency of for the renewable electricity generation being improving the incentives for the private sector most proximate to their current production to innovate and develop new green and complex capabilities. Montenegro’s current capabilities products rather than continue pushing brown seem to be furthest from the competitive products onto increasingly reluctant markets. green and complex products. The potentially competitive green products that are close Greening growth drivers can be an important to current capabilities in Albania have low incentive for much-needed innovation and complexity. productivity-driven growth. It also looks like a condition to stay competitive, especially in The green competitiveness analysis showed the EU market, and expand access to finance that Western Balkan countries have some and investors. competitive strengths in a mix of green and complex products. While Serbia and Bosnia and Herzegovina have stronger revealed Policy priorities for a green transition in comparative advantage in more green complex the Western Balkans products than the rest of the Western Balkans, this analysis has highlighted several key green Increasing savings and investments to make competitive strengths in each country. Looking growth more sustainable and resilient to ahead, new strengths can be developed in external shocks may be a challenge in the the region to take further advantage of the aftermath of the COVID-19. The pandemic likely rise in demand for products with left countries with the limited fiscal space and 44 The y-axis plots each product’s PCI, and the x-axis plots the proximity of each new product to existing capabilities. Products that have higher proximity to the country are likely to be easier for it to transition into in the future. Products are colored by the environmental category and sized by the country’s current RCA in them. The data are based on trade values averaged over the 2015–2019 time period. 60  |  10. Spotlight: From a green recovery to green transition in the Western Balkans GREENING THE RECOVERY elevated debt. Therefore, it is essential that the seek low-carbon supply chains, but this is not policy incentives attract investors to productive enough. and green fixed assets that are resilient to the risk of climate change and to the impact of A comprehensive environmental regulatory low-carbon transition, such as the EU CBAM. system that comes with the EU accession Investments in softer assets, such as creative, provides coherent incentives to facilitate productive, and healthy citizens; mutual trust, alignment with the multiple dimensions of better governance and institutions; and in the EU Green Deal. The EU’s environmental region’s natural endowment will be as important legislation consists of about 300 acts: regulations, as investments in produced “hard” assets. Such directives, decisions, and recommendations. diversification of comprehensive wealth is They are joined by numerous communications essential to boost productivity, sustainability, and policy guidelines drawn up by the and attractiveness to investors who bring new Commission. Eventually, a full compliance capabilities, skills, and good jobs.45 with the acquis is essential for accession, but transitional arrangements are always agreed for While the leaders of the Western Balkans made new member states. concrete environmental policy commitments in the 2018 Sofia Declaration,46 the incentives Before the full compliance with EU on the ground for firms and consumers are environmental acquis, interim incentives still lagging behind. The Western Balkans will be needed to attract investors in will require significant investment, both modern green assets and prevent further public and private, foreign and domestic, to accumulation of brown assets. Fiscal policy unlock growth potential and decarbonize their will be central to making green investments economies. The demand for green investments attractive in the short term. Together with is latent rather than effective, however. Policy expected future compliance with EU laws, and institutional incentives still favor “brown” it would prevent further accumulation of rather than “green” activities. The legacy of polluting assets. The key will be to correct often the close relationship between the government distorted prices for energy to ensure that they and fossil-fuel-dependent industrial interest convey incentives to reduce carbon emissions, groups and political patronage weakens the and air and water pollution, and enhance the institutions needed to navigate green structural sustainable use of natural resources. The fiscal transformation. Without reforming policy strategy in some countries, for example, Serbia, incentives, economic agents may not be willing includes the goal of lowering the fiscal burden to invest in low-carbon technologies, services, on labor. This opens the opportunity for green and business models and to seek financing fiscal reforms by gradually shifting the tax for them. Some motivation for greening the base from economic goods, like income, to private sector is generated by the demand economic “bads”, like pollution and wasteful pressure from EU importers and investors who use of resources. 45 Gill et al. 2014; Peszko et al. 2020; World Bank 2021. 46 https://www.consilium.europa.eu/media/34776/sofia-declaration_en.pdf 10. Spotlight: From a green recovery to green transition in the Western Balkans  |  61 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Scarce fiscal space in many Western Balkan to fossil fuels can raise domestic revenue in countries is wasted by the simultaneous a way that makes growth environmentally subsidization of renewable and coal- sustainable while reducing economic based electricity. According to the Energy distortions. Collecting excise taxes is easier 49 Community Secretariat, direct subsidies to than income taxes. It would incentivize energy electricity production from coal and lignite in efficiency, clean technology innovation, and five Western Balkan countries fell significantly facilitate transformation of the Western Balkan between 2017 and 2019, but still cost the public countries into modern, complex, resource- approximately EUR 73 million in 2019.47 The efficient and competitive economies. Integrated highest coal subsidies in absolute and per kWh with explicit taxation of carbon emissions and of electricity produced were in Bosnia and local pollution, such a fiscal reform would Herzegovina and in Serbia48 (Figure 10.8). align national tax policy with incentives to implement EU environmental legislation and Figure 10.8. Direct subsidies provided to coal/ help negotiate a reduced CBAM and facilitate lignite electricity producers in the Western access to EU markets. Balkans. Million EUR 90 The Western Balkan countries benefit from 80 a template green fiscal reform. In July 2021, 70 the EC announced a legislative proposal to 60 revise the EU Energy Taxation Directive 50 40 (ETD), 2003/96/EC, with the main objective 30 of aligning the taxation of energy products 20 and electricity with EU energy and climate 10 policies. In the legislative proposal of new ETD 0 BIH KOS MNE MKD SRB published in July 2021, the minimum tax rates J 2017 J 2018 J 2019 were significantly increased, especially for the Source: World Bank staff based on Miljević (2020). most carbon-intensive fuels. The rates of diesel taxes were increased to the level of petrol taxes Excise taxes on polluting fuels and per energy unit (GJ). This translates into a products provide the most obvious avenue much higher tax rate per liter. Most exceptions, for aligning fiscal incentives with green especially for energy and carbon-intensive transition aspirations. Increase of energy uses, were eliminated. In the Western Balkans, tax rates, combined with a reduction of more excise taxes on petrol and diesel in transport distortionary payroll taxes, could also improve and electricity in the region are more or less fiscal efficiency and mobilize resources for a comparable with the minimum rates of the post-COVID-19 recovery in a less disruptive existing and new Directive, although except manner. International experience and literature in Serbia, the diesel tax per liter is equal to or suggest that shifting the tax base from income lower than on petrol, incentivizing the use of 47 Albania does not use coal for electricity generation. 48 Miljević 2020. 49 IMF 2019; Pigato 2019. 62  |  10. Spotlight: From a green recovery to green transition in the Western Balkans GREENING THE RECOVERY Table 10.1. Energy excise taxes in the Western Balkans and selected EU countries compared to proposed ETD tax rates. Herzegovina* Montenegro Bosnia and Macedonia New ETD proposal Old ETD Albania Kosovo Serbia North Unleaded petrol €/liter 0.301 0.383 0.385 0.549 0.352 0.492 0.359 10.75 € (10.53 € per GJ /GJ) Diesel as a motor fuel 0.301 0.357 0.36 0.44 0.294 0.506 0.330 10.75 € €/liter (8.55 € per GJ /GJ) Diesel heating .. 0.230 0.36. 0.207 0.102 0.066 0.021 0.9 € (non-business) €/liter (0.54 € per GJ /GJ) Natural gas as a motor 0.065 0.230 0.150 0 0 0.216 2.6 7.17 fuel €/Gj Natural gas for heating 0.065 0.230 0.150 0 0 0 0.15 0.6 € and electricity (for business) €/Gj Natural gas for heating 0.065 0.204 0.150 0 0 0.056 0.3 0.6 and electricity (for non-business) €/Gj Coal and coke 0 0 0 0.3 0 0 0.15 0.9 (for business) €/Gj Coal and coke 0 0 0 0.3 0 0 0.3 0.9 (for non-business) €/Gj Source: World Bank staff calculations, based on data from European Commission Ministries of Finance. Note: *includes road fees; Gj=gigajoule. more polluting fuel. Other fuels, especially coal alone would not be enough to incentivize green and gas, are not taxed in the region or are taxed transition in the power and heating sector. The at low rates, especially compared to the new ETD is based on the principle that taxation high minimum rates proposed in the revised should be levied on end products, regardless of ETD (Table 10.1). inputs used in their production. If electricity is the end product, then the energy products Gradual reforms of energy taxation need to used as inputs, such as coal or gas are exempt. be complemented by explicit carbon pricing. The exemption is not mandatory, however, The proposed ETD aligns the relative rates of and member states may choose to tax both the energy taxes more closely with their climate coal used in a thermal power station and the impact but does not fully reflect the costs of ensuing electricity for environmental reasons carbon emissions, especially for fuels used for (Article 13).50 Most member states exempt generation of electricity. Without additional coal and gas used for power generation because carbon pricing the implementation of ETD their carbon content is covered by explicit 50 Vasques 2021. 10. Spotlight: From a green recovery to green transition in the Western Balkans  |  63 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 carbon prices under the EU ETS, but during To enable a green transition, public the transition to the EU ETS, the efficient expenditure and EU financing will play alternative is to gradually increase coal and gas an important role. The EU’s Economic and taxes in proportion to their carbon content. Investment Plan will not be enough to deliver So far, Montenegro is the only country in the green transition. The challenge will be to the region with an explicit carbon price. In rebalance public spending from brown to 2020, the country adopted legislation on an green economic activities and redefine the Emissions Trading System (ETS) to smooth role of a state from the system of patronage the transition of combustion installations to to infrastructure provider, market regulator, the EU ETS. The allowance prices will equal and guarantor of a level playing field among the average price of EU allowance prices from economic agents. Future competitive position the previous year with a minimum price of of the Western Balkans in the integrated EU EUR 24 per ton of CO2. There are large market will depend on early innovation and benefits for Western Balkan countries of acting entry of new disruptive firms. In line with EU regionally in harmonizing energy and carbon state aid rules, public finances will increasingly prices with EU. Doing so would help address need to reduce the effect of crowding-out the risk of carbon leakage and tax competition private finance and leverage private investments within the region if energy and carbon taxes and financing. There is considerable room differ significantly between individual Western for more efficient and effective use of public Balkan countries connected by the same power environmental expenditures in line with the grid. international good practice.51 Some Western Balkan countries apply A green energy transition will be challenging fiscal instruments, such as taxes and fees, socially and politically, and stranded to manage local pollutants of air and water assets will have to be managed. Accelerated and to encourage circularity of products and retirement of coal power plants and closure of materials that are harmful as waste, such as coal mines is a task facing all Western Balkan plastics. An initial review of current practices, countries except Albania. The costs of stranded conducted by the World Bank, identified assets will need to be transparently and fairly opportunities to significantly improve design of allocated between asset owners and the public. these instruments to make them more effective Workers and communities depending on coal and raise more revenues. This includes aligning mining and coal-intensive industries will need their incentive effect with the “polluter pays” to be assisted in making a smooth transition to principle, improving administrative efficiency new and green jobs. The government’s role in of tax collection, reducing distortionary impact the transition process needs to be multifaceted on business, and mitigating regressive burden and proactive. A well-planned and systematic on households. process of coal mine closure and layoffs is essential for supporting the reallocation of affected workers to alternative jobs and at the 51 E.g. OECD. 2021. Recommendation of the Council on Good Practices for Public Environmental Expenditure Management. OECD/ LEGAL/0345 https://legalinstruments.oecd.org/public/doc/175/175.en.pdf 64  |  10. Spotlight: From a green recovery to green transition in the Western Balkans GREENING THE RECOVERY same time mitigating the economic, social, green investments, but longstanding barriers and political costs of transition. Governments to private sector job creation such as human do not have to deliver everything themselves, capital weaknesses; governance challenges; but they do need to provide strategic direction and regulatory barriers to the flow of goods, and leadership, coordinate across stakeholders, services, and ideas. If ever there was a time arbitrate competing interests, and provide to prioritize reforms to stimulate growth and adequate financing that represents an investment, then this is it. And if ever there investment in transition.52 The green transition was a time to make the structural change away in the Western Balkans is manageable, if from a business-as-usual, unsustainable, brown incentives are aligned, social, distributional and development path toward a greener future, political economy issues are addressed, and the then now is the time. costs of stranded assets is smoothed over time and allocated without creating systemic risks or large contingent fiscal liabilities. Financing can play a pivotal role in navigating green transition. The region has access to facilities like the Economic and Investment Plan for the Western Balkans, providing EUR 9 billion between 2021 and 2027, or the Western Balkans Investment Framework, as well as long-term financing provided by financial and capital markets and multilateral financial institutions. Aligning the growth strategy of the Western Balkan countries with the European Green Deal is an investment in igniting a completely new growth strategy—more productive, sustainable, inclusive, and resilient to external shocks. This is no longer about making mainstream growth more environmentally friendly. It is about putting the core of the economy on a green and sustainable track. Many of the key fault lines and key structural barriers that were holding back growth across the economies of the Western Balkans before the crisis have become even more apparent today. These include not just the challenge of re-orienting the growth model from brown to 52 Bulmer et sl. 2021. 10. Spotlight: From a green recovery to green transition in the Western Balkans  |  65 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 References Andres, P and Mealy, P (2021) Green Transition Navigator. Retrieved from www.green-transition- navigator.org. Bolton, Patrick & Marcin Kacperczyk. 2021. Global Pricing of Carbon-Transition Risk. NBER https://www.nber.org/papers/w28510 Bulmer, Elizabeth Ruppert, Kevwe Pela, Andreas Eberhard and Jimena Montoya. 2021. Global Perspective on Coal Jobs and Managing Labor Transition out of Coal: Key Issues and Policy Responses. World Bank, forthcoming Energy Community Secretariat. 2019. Rocking the Boat: What is Keeping the Energy Community’s Coal Sector Afloat? Gill, I. S., I. Izvorski, W. van Eeghen, and D. De Rosa. 2014. Diversified Development in Eurasia: Making the Most of Natural Resources in Eurasia. Washington, DC: World Bank. Hausmann, R., Hidalgo, C. A., Bustos, S., Coscia, M., & Simoes, A. (2014). The atlas of economic complexity: Mapping paths to prosperity. Mit Press. Hausmann, R., Rodrik, D., & Sabel, C. (2008). Reconfiguring industrial policy: a framework with an application to South Africa. Hidalgo, C. A., & Hausmann, R. (2009). The building blocks of economic complexity. Proceedings of the national academy of sciences, 106(26), 10570-10575. Hidalgo, C. A., Balland, P. A., Boschma, R., Delgado, M., Feldman, M., Frenken, K., ... & Zhu, S. (2018, July). The principle of relatedness. In International conference on complex systems (pp. 451-457). Springer, Cham. Hidalgo, C. A., Klinger, B., Barabási, A. L., & Hausmann, R. (2007). The product space conditions the development of nations. Science, 317(5837), 482-487. International Monetary Fund. 2019. Fiscal Policies for Paris Climate Strategies—from Principle to Practice. Policy Paper No. 19/010. Lange, G., Q. Wodon, and K. Carey. 2018. The Changing Wealth of Nations 2018: Building a Sustainable Future. Washington, DC: World Bank Mealy, P., & Teytelboym, A. (2020). Economic complexity and the green economy. Research Policy, 103948. Mealy, P., Farmer, J. D., & Teytelboym, A. (2019). Interpreting economic complexity. Science advances, 5(1), eaau1705. Miljević, Damir. 2020. Investments into the past. An analysis of Direct Subsidies to Coal and Lignite Electricity Production in the Energy Community Contracting Parties 2018–2019. Energy Community Secretariat, December 2020. file:///C:/Users/WB114293/Downloads/Miljevi__ Coal_Report_122020.pdf Neffke, F., Henning, M., & Boschma, R. (2011). How do regions diversify over time? Industry relatedness and the development of new growth paths in regions. Economic geography, 87(3), 237-265. Peszko, G., D. van der Mensbrugghe, and A. Golub. 2020. “Diversification and Cooperation Strategies in a Decarbonizing World.” Policy Research Working Paper 9315, World Bank, 66  | References GREENING THE RECOVERY Washington, DC. https://openknowledge.worldbank.org/handle/10986/34056 Peszko, G., D. van der Mensbrugghe, A. Golub, J. Ward, D. Zenghelis, C. Marijs, A. Schopp, et al. 2020. Diversification and Cooperation in a Decarbonizing World: Climate Strategies for Fossil Fuel-Dependent Countries. Climate Change and Development. Washington, DC: World Bank. https://openknowledge.worldbank.org/handle/10986/34011 Peszko Grzegorz, Dominique van der Mensbrugghe, Alexander Golub, and Maksym Chepeliev. 2021. Low-Carbon Transition, Stranded Fossil Fuel Assets, Border Carbon Adjustments, and International Cooperation. In World Bank. Changing Wealth of Nations 2021, forthcoming. Pigato, Miria A.. 2019. Fiscal Policies for Development and Climate Action. International Development in Focus;. Washington, DC: World Bank. © World Bank. https://openknowledge. worldbank.org/handle/10986/31051 License: CC BY 3.0 IGO.” Vasques Sérgio. 2021. Challenges of EU energy taxes and double taxation. In: International Tax Review. https://www.internationaltaxreview.com/article/b1r3q0x1xlbqpr/challenges-of-eu- energy-taxes-and-double-taxation World Bank. 2021. The Changing Wealth of Nations 2021: Managing Assets for the Future, forthcoming. References  |  67 Country Notes GREENING THE RECOVERY Albania • Albania’s economic recovery in 2021 is stronger than anticipated, as travel, construction, and extractives bounced back and private investment, consumption, and public spending surged. • Macroeconomic policies have supported the recovery, although higher public spending has led to a further rise in the debt-to-GDP ratio. • Employment and labor force participation recovery was slower and real wages are increasing. • Economic uncertainty remains high as COVID-19 cases are increasing again amidst low vaccination rates. Recent Economic Developments Investments contributed the most, expanding by 21.1 percent, and public consumption grew Growth has rebounded in 2021, after the by 5.2 percent YOY. Private consumption, pandemic hit the Albanian economy hard. while recovering, is still below its pre-pandemic GDP in 2020 fell by 4 percent, and the level and in line with the slower recovery in the government incurred additional public debt to labor markets. For 2021, GDP is projected to mitigate the economic losses through increased increase by 7.2 percent. spending. Growth rebounded by 5.5 percent in the first quarter (Q1) of 2021. Although most The labor market started its recovery in Q2. sectors experienced economic recovery, energy As of Q1 2021, the labor market, continued to and construction contributed the most, by 1.7 shrink in terms of employment and labor force and 1.1 percentage points, respectively, the latter participation, largely due to employment in partly related to reconstruction efforts following agriculture. Employment increased marginally the 2019 earthquake. Among services, only by 1.1 percent in Q2 due to employment trade remained subdued. Business sentiment in construction and manufacturing, while indicators, an increase in construction permits agriculture continued to shrink. Labor force issued, and growth in foreign trade and fiscal participation also increased, by 1 percent; revenues suggest the rising growth trajectory is around 34,000 workers left the labor force in likely to continue in Q2. Tourist arrivals for the Q2 2021 compared to a pre-pandemic Q2 first seven months of 2021 were only slightly 2019. The unemployment rate declined to lower than those during the same period in 11.6 percent from 11.9 percent in the same 2019, suggesting a strong rebound of tourism quarter of 2020. Formal real wages rose by in the summer months. 2.9 percent in Q2 2021, partially because of an increase in the minimum wage. Increased vaccination rollout, remittances, credit growth, and recovery in the economic Inflationary pressures have started to build activity in trading partners boosted up. Supply-side shocks, increased inflation in consumer and business sentiment and trading partners, and demand expansion drove domestic demand, w hich expanded by an increase of average inflation of 1.8 percent in 4.8 percent year-on-year (YOY) in Q1 2021. Q2 from 0.9 percent in Q1. Food and oil prices contributed the most. With employment yet to Albania  |  69 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 recover, domestic pressures remain subdued53 the Organic Budget Law, and postponed the but are expected to intensify with the expansion target of reaching a positive primary balance to of demand and continuing monetary and 2024.55 fiscal stimuli. While inflation is picking up, inflation expectations are still anchored, hence, Public debt is set to rise again. The government monetary policy continued to support demand successfully met its financing needs by issuing through keeping the policy rate at its historical Eurobonds in 2020, which increased debt56 to a minimum. Low liquidity risk premia in the new high of 78.6 percent of GDP. At the same domestic financial market ensured a smooth time, the country’s buffers remain low in case of transition of the monetary stimulus into lower a new pandemic wave. In the absence of fiscal interest in the money market, government consolidation, refinancing risks could arise if securities, and credit to the private sector. external financial market demand tightens and Consumer mortgages and investment loans interest rates increase. for businesses led an expansion of credit to the private sector by 7.7 percent YOY by June External imbalances narrowed in the first 2021. half of 2021. Inflows from remittances and a surplus in trade of services compensated the Despite higher revenues, the fiscal deficit higher demand for imported goods, a reflection remains elevated. Budget revenues in H1 2021 of increasing investment and consumption. were 20.1 percent higher YOY and 3.6 percent The current account narrowed by 9.6 percent above the same period in 2019. To a large in the first half of the year. Remittances grew by extent, this increase reflects a statistical base 24.4 percent YOY. Foreign direct investment effect, as the second quarter of 2020 marked (FDI) declined slightly, by 1.7 percent, but the peak of restrictions on movement and the tendency was upward in Q2, particularly economic activity. The increase in excise goods in hydrocarbons. The stock of reserves, imports and, to a lesser extent, the increase estimated to cover 8.4 months of imports, of commodity prices, has also affected value- further increased in August as the International added tax (VAT) revenues, which contributed Monetary Fund released EUR160.7 million 5.2 percentage points to total revenue growth. in Special Drawing Rights to the country’s The deficit for the first half of the year was reserves. 25 percent lower than the same period in 2020. The government also reduced VAT reimbursement arrears of 10 billion lek.54 An Outlook and Risks increase in revenue collection and new debt allowed the government to increase spending. The strong projected growth rebound to Through a normative act, in July 2021, the 7.2 percent in 2021 i s subject to a smooth government temporary suspended the fiscal vaccination rollout, no further lockdowns, rule of a declining debt to GDP specified in and continued recovery in services, led by 53 Core inflation stood at a stable 1.4 percent. 54 VAT arrears reimbursement net out gross revenues and are not recorded as a separate item in the government accounts. 55 The fiscal rule includes an escape clause in the case of an emergency, which applied in 2020. 56 Includes arrears to the private sector. 70  | Albania GREENING THE RECOVERY tourism, and construction. Over the medium is to boost revenue collection and achieve fiscal term, private consumption is projected to consolidation while creating space for growth- become again the primary driver of GDP enhancing spending. growth. Private investment could provide further support to growth if business climate reforms are implemented. Meanwhile, the current account deficit is expected to expand to 9.4 percent of GDP, as high infrastructure investment demand brings imports growth to 29 percent in 2021. With exports bouncing back, the current account deficit should gradually shrink to 7.0 percent by 2023. Service exports, including tourism and fast-expanding business process operations, should narrow the current acount deficit over the medium term. Strong growth is expected to help boost public revenues to 27.4 percent of GDP during 2022–25. Beyond 2021, spending will likely be constrained by limited fiscal space, as public debt is projected to increase to 78.6 percent of GDP in 2021, before declining gradually over the medium term. However, economic prospects remain uncertain as daily cases have started increasing again. Further, by August 2021, the vaccination rate stood at only around 20 percent. If reinstated, new containment measures would delay the recovery of activity and employment, especially in services and manufacturing. Fiscal space could further deteriorate in such a downside growth scenario and in the absence of strengthened revenue collection. In this scenario, the government may need to cut capital spending to prevent an increase of the debt-to-GDP ratio. Moreover, with more reliance on external financing, exchange rate, interest rate, and refinancing risks remain elevated. A key medium-term reform priority Albania  |  71 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Economic activity is expected to rebound in The labor market is yet to recover. 2021. Contributions to growth, percent Percent 8 60 6 50 4 40 2 30 0 20 -2 -4 10 -6 0 11 012 013 014 015 016 017 018 019 020 21e -12 -13 -14 -15 -16 -17 -18 -19 -20 Q1-21 20 2 2 2 2 2 2 2 2 2 20 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 J Consumption J Net exports J Investment ▬ Real GDP growth ▬ Employment ▬ Unemployment Source: INSTAT and World Bank staff calculations. Source: INSTAT. Strong fiscal stimulus was used to support the Inflationary pressures are building up. economy, but at the cost of increasing public debt. Percent of GDP Percent 90 0 3 80 -1 -1.7 -1.9 -2.0 -2.0 2 70 -2 60 -3.1 -3.5 -3.4 -3 1 50 -4 40 -5 0 30 -5.0 -4.8 20 -6 -6.0 -6.7 -1 10 -7 -6.8 0 -8 -2 6 10 11 12 13 14 15 16 17 18 19 0 1e -1 l-16 -17 l-17 -18 l-18 -19 l-19 -20 -20 -21 l-21 20 20 20 20 20 20 20 20 20 20 202 202 Jan Ju Jan Ju Jan Ju Jan Ju Jan Jul Jan Ju J PPG debt including arrears ▬ Fiscal balance, rhs ▬ Inflation (CPI) ▬ Core inflation Source: INSTAT, MoFE and World Bank staff calculations. Source: Bank of Albania; World Bank staff calculations. Credit growth supported demand expansion. The current account deficit narrowed and was partially financed by FDI and government borrowing. Percent In million EUR, 4q rolling sum 10 2,000 8 1,500 6 1,000 4 500 2 0 0 -500 -2 -1,000 last obs: Jan-21 -4 3 4 4 5 5 6 6 7 7 8 8 9 9 0 0 -1,500 c-1 n-1 c-1 -1 c-1 n-1 c-1 -1 c-1 n-1 c-1 -1 c-1 -2 -2 -13 -13 -14 -14 -15 -15 -16 -16 -17 -17 -18 -18 -19 -19 20 20 -21 De Ju De Jun De Ju De Jun De Ju De Jun De Jun Dec Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1- Q3- Q1 J Net FDI inflows J Net portfolio inflows J Net other inflows ▬ Current account deficit Source: Bank of Albania; World Bank staff calculations. Source: Bank of Albania; World Bank staff calculations. 72  | Albania GREENING THE RECOVERY ALBANIA 2018 2019 2020 2021e 2022f 2023f Real GDP growth (percent) 4.1 2.2 -4.0 7.2 3.8 3.7 Composition (percentage points): Consumption 3.1 2.5 -3.8 3.9 1.9 2.7 Investment 0.7 -0.9 -1.0 3.1 -0.4 0.5 Net exports 0.2 0.6 0.8 0.2 2.3 0.5 Exports 1.4 2.0 -8.6 6.6 3.9 2.1 Imports (-) 1.1 1.4 -9.4 6.4 1.6 1.6 Consumer price inflation (percent, period average) 2.1 1.4 1.6 2.4 2.8 3.0 Public revenues (percent of GDP) 27.5 27.2 26.3 27.8 27.4 27.4 Public expenditures (percent of GDP) 29.2 29.2 33.2 34.4 30.2 30.4 Of which: Wage bill (percent of GDP) 4.5 4.6 4.8 5.0 4.5 4.4 Social benefits (percent of GDP) 11.6 11.9 12.9 12.6 12.0 11.8 Capital expenditures (percent of GDP) 4.8 4.5 6.3 7.5 5.6 5.1 Fiscal balance (percent of GDP) -1.7 -1.9 -6.8 -6.7 -2.8 -3.0 Primary fiscal balance (percent of GDP) 0.5 0.1 -4.7 -4.6 -0.7 -0.6 Public debt (percent of GDP) 64.9 63.7 75.1 75.4 74.9 73.1 Public and publicly guaranteed debt (percent of GDP) 69.5 67.4 77.2 78.6 76.7 74.9 Of which: External (percent of GDP) 30.4 29.1 35.9 38.6 35.3 32.4 Goods exports (percent of GDP) 7.7 6.6 6.1 7.6 7.5 7.5 Goods imports (percent of GDP) 30.1 29.7 28.9 33.9 33.5 33.1 Net services exports (percent of GDP) 8.7 9.3 8.1 10.6 13.0 13.6 Trade balance (percent of GDP) -13.7 -13.8 -14.7 -15.7 -13.0 -12.0 Net remittance inflows (percent of GDP) 5.2 5.2 5.1 4.7 4.7 4.7 Current account balance (percent of GDP) -6.8 -8.0 -8.8 -9.4 -8.1 -7.0 Net foreign direct investment inflows (percent of GDP) 8.0 7.6 6.8 6.6 7.4 7.0 External debt (percent of GDP) 65.2 60.5 64.7 59.3 53.9 52.9 Real private credit growth (percent, period average) -3.0 1.5 5.2 — — — Nonperforming loans (percent of gross loans, end of period) 11.1 8.4 8.1 — — — Unemployment rate (percent, period average) 12.3 11.5 11.7 — — — Youth unemployment rate (percent, period average) 23.1 21.5 20.9 — — — Labor force participation rate (percent, period average) 59.4 60.4 59.5 — — — GDP per capita, PPP (current international $) 15,101 15,433 14,816 — — — Poverty rate (percent of population) 32.4 31.8 32.6 30.8 29.3 — Sources: Country authorities, World Bank estimates and projections. Note: Youth unemployment rate is for labor force aged 15–29. Statistical discrepancy contribution is divided at the ratio of 80 percent and 20 percent between Consumption and Investment respectively. Change in inventories is included in Investments. Poverty rate calculations based on ECAPOV harmonization using SILC-C data. Nowcasted/projected values start at 2019. Income measures in the SILC and consumption measures in the HBS are not strictly comparable. Poverty is defined as living on less than $5.5/day per person in revised 2011 PPPs. Albania  |  73 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Bosnia and Herzegovina • Real GDP contracted 3.2 percent in Bosnia and Herzegovina in 2020 and rebounded by 1.5 percent in the first quarter (Q1) of 2021 driven by a surge in exports and robust growth in final consumption. • While a full recovery to the 2019 real income level is expected in 2021, the economy is unlikely to catch up with the pre-pandemic growth trajectory unless political bottlenecks are resolved. • After several years of budgetary consolidation and running surpluses, fiscal deficits are expected until 2023. Public debt is on an upward trajectory. • Medium-term prospects are mixed. External risks include a slower-than-expected recovery in the European Union (EU), while domestic risks include a prolonged paralysis in governing and, together with upcoming general elections in 2022, is likely to prevent the implementation of much-needed structural reforms. Recent Economic Developments Stronger household consumption and higher international oil prices lifted headline The economy rebounded in 2021 on the inflation to 1.9 percent in July (YOY). Last back of higher consumption and external year, deflation of 1.1 percent was mainly demand recovery. According to the latest driven by a drop in the prices of clothes and official estimates, real GDP growth contracted transportation as oil prices collapsed during 3.2 percent in 2020 compared to the previously the pandemic. However, the strong rebound in published 4.3 percent as manufacturing, transportation prices since April 2021 reflects wholesale, and retail trade declined less than spillovers from the recovery in international oil initially estimated. On the demand side, a prices as the price of Brent oil rose from a low larger compression of imports than exports of US$18 in April 2020 to US$75 in July 2021. in 2020 helped soften the sharp decline in Together with robust household consumption, household consumption and plummeting the change in food prices also picked up pace investments that resulted from the lockdown since January, resulting in higher headline during the pandemic, but also from political inflation of 0.4 percent during January–July deadlock. Nevertheless, real GDP grew an 2021 compared to -0.7 percent during the estimated 1.5 percent in Q1 of 2021 (year- same period last year. However, adjusting for on-year [YOY]) driven by a pickup in private food, energy, and administratively regulated and public consumption and a surge in exports prices, as well a tobacco prices, core inflation of goods. The surge in exports of goods was totaled -0.8 percent YOY during January–July caused by higher external demand triggered by 2021. a rebound in industrial production in Croatia, Italy, and Serbia, which in turn accelerated The fiscal imbalance continues in 2021. growth in manufacturing and production of A slump in revenues and higher current consumer durables. The increase in private spending led to a fiscal deficit of an estimated consumption, meanwhile, could be attributed of 1.8 percent of GDP in 2020, after a surplus to a combination of pent-up demand including e-commerce, and higher lending to households. 74  |  Bosnia and Herzegovina GREENING THE RECOVERY  f close to 2 percent of GDP the year before.57 o narrowed to 1.2 percent of GDP in the first This fiscal shortfall stands in sharp contrast to quarter of 2021 compared to 3.2 percent of the authorities’ planned deficit of 5.4 percent GDP during the same period last year. In of GDP in 2020, envisaged to result from 2020, despite the collapse in investment and measures counteracting the economic impact decline in household consumption due to of the pandemic, in the form of paying COVID-19 that reduced imports more than minimum wages and contributions to workers exports, the current account deficit slightly in companies severely affected by the pandemic, increased to an estimated 3.3 percent of GDP and from spending through special fiscal funds from 3.2 percent in 2019. The acceleration to stabilize the economy. Instead, current in exports totaling almost 17 percent during spending declined by 2 percent nominally January–March 2021 reflects higher external in 2020 compared to the growth of almost demand for base metals, machinery, and 11 percent in 2019. Thus, the fiscal response to furniture. In the meantime, imports grew the crisis in 2020 was more pronounced on the just below 3 percent, which reduced the revenue side than spending. The fragmented merchandise trade deficit to 16 percent of institutions led to inefficiencies and delays in GDP in the first quarter of 2021 compared to implementation, resulting in the slow release 20 percent during the same period last year. This of funds. In 2020, tax revenues fell 7.5 percent reduction in the merchandise deficit accounts in nominal terms, the result not only of a for the narrowing of the external shortfall as sharp decline in indirect taxes, but also due to the services and income surpluses remained deferred tax payments. In 2021, the rebound robust, at 3.4 percent and 9.7 percent of GDP, in economic activity led to an estimated rise in respectively. Adjusted for capital transfers, the revenues of 3.8 percent (YOY), while delayed external shortfall amounted to 0.6 percent of spending implementation from 2020 led to GDP, which was financed by non-debt-creating total spending increasing 4.5 percent, largely foreign direct investment inflows (that is, equity on account of higher public wages and higher and reinvested earnings). social benefits. The pandemic interrupted the ongoing fiscal Outlook and Risks consolidation that placed the public debt trajectory on a declining trend. Public debt Medium-term prospects are mixed. In the declined from 42.4 percent of GDP in 2016 to short term, the outlook is positive with real 32.8 percent of GDP at the end of 2019, yet GDP set to expand by 4 percent in 2021. Over it increased to 37 percent of GDP at the end the medium term, however, these prospects of 2020, of which roughly four-fifths represents are dampened by an expectation of growth external public debt. deceleration to around 3 percent in 2022 and 2023. The shape of the growth trajectory will Despite increased economic activity and in part depend on the authorities’ success in rising oil prices, the current account deficit accelerating the share of the vaccinated adult 57 BiH Global Fiscal Framework for 2022–2024. Bosnia and Herzegovina  |  75 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 population, which currently stands at around planned, the central bank board has not been 27 percent, while the number of infections is approved, and some other economic measures, on the rise again. If the health situation does such as reducing social contributions, are not deteriorate significantly over the next on hold. While a full recovery to the 2019 few months, the policy focus could shift to real income level is expected in 2021, the addressing priorities for EU accession and, country is unlikely to catch up with the pre- thus, implementation of the Socio-Economic pandemic growth trajectory unless political Program58, which in turn would allow for more bottlenecks are addressed soon. A full and prominent growth over the next few years. In timely implementation of the Socio-Economic this context, announced investments in energy Program would allow for a more rapid and infrastructure could solidify a sharper convergence to the EU27 average. increase in economic activity, supported by a further pickup in private consumption fueled The implementation lag of spending measures by remittances, a tightening labor market, approved in 2020 will spill over into 2021 and domestic lending. Intensified trade with and lift the fiscal deficit to around 3 percent neighbors could keep merchandise export of GDP. The combination of a partial recovery growth rates elevated and, together with a full in tax revenues, which are projected to grow by recovery of travel income and remittances, allow around 2.5 percent in 2021 after dropping by for a current account deficit in the range of 0.5 7.5 percent in 2020, and higher spending on to 2 percent of GDP over the medium term, goods and services, the wage bill, and capital which is significantly below the pre-pandemic expenditures, will broaden the overall fiscal level of above 3 percent of GDP. deficit in 2021. Financing from international financial institutions, especially the allocation Low investment rates in Bosnia and of US$300 million in Special Drawing Rights Herzegovina resulted in per capita GDP from the International Monetary Fund, will hovering around one-third of the EU27 help meet the larger gross financing need. average, a gap significantly larger than other peers in the Western Balkans, such as As the economy rebounds in 2021, Montenegro, North Macedonia, and Serbia. improvements in labor market participation Reducing this income gap will be challenging and employment will remain key for given the overall health situation and, more growth to translate into poverty reduction. importantly, the political deadlock, which is Addressing bottlenecks causing persistent fueled by the current policy paralysis of the long-term unemployment, such as enhancing presidency and council of ministers, and the formal labor market participation, especially upcoming parliamentary elections expected for women, and reducing skills mismatches for to take place in the second half of 2022. youth, will be key. Institutional and governance As a consequence of the political stalemate, reforms remain important challenges on the the country may not join the World Trade country’s development path and road to EU Organization in November 2021, as initially membership. 58 The country’s medium-term development plan adopted in January 2020 to tackle key structural reforms and respond to EU accession priorities. 76  |  Bosnia and Herzegovina GREENING THE RECOVERY Several risks dominate the outlook. First, a prolonged adverse impact of the pandemic domestically could adversely affect growth in consumption and investment; and second, a prolonged adverse impact of the pandemic in the region or the reintroduction of movement controls if vaccination slows or the vaccine proves ineffective against new variants could dampen external demand for the country’s exports. In both cases, this could place Bosnia and Herzegovina on a lower growth trajectory over the medium term. Finally, the current political deadlock could be further amplified in the pre-election period, adversely affecting implementation of the adopted socioeconomic program needed to address the country’s development challenges and pave the way for EU accession. Bosnia and Herzegovina  |  77 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Growth rebounded in 2021 as services and The rebound in industrial production was led industrial production recovered. by manufacturing and consumer durables. Contributions to growth, percentage points Percent y-o-y 4 40 3 30 2 20 10 1 0 0 -10 -1 -20 -2 -30 -3 -40 -4 e -50 18 19 20 21f 22f 23f -18 -18 -18 -18 -19 -19 -19 -19 20 20 20 20 -21 20 20 20 20 20 20 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1- Q2- Q3- Q4- Q1 J Agriculture J Industry J Services Q Real GDP growth rate, percent ▬ Manufacturing ▬ Consumer durables Source: BiH Agency for Statistics and World Bank staff estimates. Source: BiH Agency for Statistics. Inflationary pressures increased. Fiscal imbalances will likely persist until 2022. Percent y-o-y Percent of GDP 2.5 3 2.0 2 1.5 1.0 1 0.5 0 0 -0.5 -1 -1.0 -2 -1.5 -3 -2.0 -2.5 -4 20 18 20 19 20 20 21 20 16 20 17 20 18 20 19 20 e 20 21f 22f 20 20 20 ▬ Headline inflation ▬ Core inflation J General government fiscal balance Source: BiH Agency for Statistics. Source: Fiscal authoritie and World Bank staff estimates. Nonperforming loans in commercial bank Unless the political deadlock is resolved, the portfolios remain high but are on a downward country will remain on a permanently lower trend. growth trajectory. Percent y-o-y Real GDP 20 38 18 16 36 14 12 34 10 8 32 6 4 2 30 0 -2 28 -13 -13 -14 -14 -15 -15 -16 -16 -17 -17 -18 -18 -19 -19 20 20 -21 20 18 19 20 e 21f 22f 23f Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1- Q3- Q1 20 20 20 20 20 J Capital adequacy (tier 1 capital to risk weighted assets) ▬ Pre-COVID trajectory (projection based on average real GDP growth 2015–19) ▬ Asset quality (NPLs to total loans) ▬ Profitability (return to equity) ▬ Projected post-COVID trajectory Source: Central Bank of BiH and World Bank staff calculations. Source: BiH Agency for Statistics and World Bank staff estimates. 78  |  Bosnia and Herzegovina GREENING THE RECOVERY BOSNIA AND HERZEGOVINA 2018 2019 2020 2021e 2022f 2023f Real GDP growth (percent) 3.7 2.8 -3.2 4.0 3.0 3.2 Composition (percentage points): Consumption — — — 4.5 2.8 3.0 Investment — — — -2.5 -0.6 0.8 Net exports — — — 1.9 0.7 -0.6 Exports — — — 10.1 4.0 3.3 Imports (-) — — — 8.1 3.2 3.9 Consumer price inflation (percent, period average) 1.4 0.6 -1.1 -0.2 0.5 0.7 Public revenues (percent of GDP) 42.7 43.0 42.2 41.2 41.8 42.0 Public expenditures (percent of GDP) 40.2 41.1 44.0 44.3 42.7 41.6 Of which: Wage bill (percent of GDP) 10.2 10.9 11.5 11.5 11.4 11.1 Social benefits (percent of GDP) 17.8 18.1 20.0 19.4 18.9 18.8 Capital expenditures (percent of GDP) 2.8 3.1 3.2 3.7 3.1 2.7 Fiscal balance (percent of GDP) 2.5 1.9 -1.8 -3.1 -0.9 0.4 Primary fiscal balance (percent of GDP) 3.2 2.6 -1.1 -2.3 0.0 1.2 Public debt (percent of GDP) 34.2 32.8 36.6 35.8 35.9 37.2 Public and publicly guaranteed debt (percent of GDP) 35.6 34.5 38.8 38.0 38.1 39.1 Of which: External (percent of GDP) 29.9 28.4 30.8 30.0 29.8 30.6 Goods exports (percent of GDP) 31.2 28.8 27.5 33.6 35.4 36.5 Goods imports (percent of GDP) 53.6 51.4 45.9 52.3 53.6 55.9 Net services exports (percent of GDP) 7.8 7.8 4.0 5.9 6.9 7.6 Trade balance (percent of GDP) -14.7 -14.7 -14.5 -12.7 -11.3 -11.7 Net remittance inflows (percent of GDP) 8.5 8.4 7.4 7.7 7.6 7.5 Current account balance (percent of GDP) -3.5 -3.2 -3.3 -2.0 -0.6 -1.1 Foreign direct investment inflows (percent of GDP) 3.0 2.0 1.9 2.0 2.1 2.2 External debt (percent of GDP) 66.8 64.1 71.6 70.0 70.3 70.5 Real private credit growth (percent, period average) 5.1 5.2 1.3 — — — Nonperforming loans (percent of gross loans, end of period) 8.8 7.4 6.1 — — — Unemployment rate (percent, period average) 18.4 15.7 15.9 — — — Youth unemployment rate (percent, period average) 38.8 33.8 36.6 — — — Labor force participation rate (percent, period average) 42.1 42.1 47.7 — — — GDP per capita, PPP (current international $) 13,200 13,775 13,424 14,100 14,700 15,250 Sources: Country authorities, World Bank estimates and projections. Bosnia and Herzegovina  |  79 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Kosovo • Kosovo’s economy is recovering rapidly from the COVID-19 pandemic, with output in 2021 expected to exceed 2019 levels by year-end, but risks to the outlook remain high as the country continues to grapple with the pandemic. • Economic activity in 2021 is expected to expand by 7.1 percent on the back of a stronger-than- expected rebound in diaspora visits, restored consumer confidence, and higher consumer lending. Exports of merchandise continued their expansion and gradual diversification from 2020. • However, significant inflationary pressures, primarily from higher import prices, may undermine a stronger recovery in private investment. • Public revenue is experiencing an unprecedented rebound due to higher economic activity, but also due to higher inflation and tax compliance measures. As a result, and against sluggish public investment execution, the fiscal deficit is expected to decrease in 2021. • Management of the fourth wave of the pandemic, including through accelerating vaccinations, remains a priority in the near term. In the medium term, Kosovo needs to transition to a more productivity-oriented growth model. Recent Economic Developments The key driver behind a faster recovery is the rebound in diaspora visits that fuel Kosovo’s Kosovo is experiencing a much faster recovery service exports and informal remittances. than previously expected. After merely Exports of services exceeded 2019 levels by returning to positive territory during the last June 2021, and by year-end are estimated to quarter of 2020, growth gained momentum exceed 2019 levels by 9.5 percent. Exports during the first quarter (Q1) of 2021, reaching of merchandise goods have also maintained a 5.6 percent.59 Firm sales and trade flows until strong pace of growth, but their share of total July 2021 exceeded 2019 levels, suggesting output remains relatively low at 8.4 percent. a further acceleration in growth for the remainder of the year. As vaccinations hasten in Limited restrictions on economic activity, Europe and Kosovo, economic activity is now fiscal support measures, and strong credit projected to expand by 7.1 percent in 2021, growth have bolstered private consumption. up by 3.1 percentage points from the spring Limited containment measures until end- forecast. Exports and private consumption are August 2021 enabled the uninterrupted expected to provide the highest contribution to resumption of economic activity and, despite growth. Private investment is also expected to significant delays, improved access to vaccines add to growth. On the production side, services have enhanced firm and consumer confidence. continue to be the main driver of growth, while In addition to social transfers and targeted the contribution of agriculture remains limited. wage subsidies, the allowed withdrawal of a fraction of pension savings from end-2020, 59 All comparisons are year-on-year unless otherwise stated. 80  | Kosovo GREENING THE RECOVERY amounting to almost 3 percent of GDP, is Exports are recovering rapidly in 2021. likely to have boosted private consumption, Imports are expected to increase by over especially during the Q1 of 2021. Significant 30 percent in 2021 to meet the rebound growth in household credit, which reached in consumption, exports, and investment, 16.2 percent by July 2021, also bolstered with exports of merchandise increasing by private consumption. 35 percent. Though growth in exports is expected to outpace the rebound in imports, The recovery has been accompanied by gains as imports grow from a higher base, current in formal employment. According to the account deficit is projected to reach 8.5 percent Kosovo Pensions Savings Trust, the average of GDP, up from 7 percent in 2020. At the quarterly number of active pension contributors same time, foreign direct investment, driven increased by 13.6 percent during Q2, indicating by higher dividend repatriation, is expected to an increase of about 40,000 in the number drop from 4.1 to 3.8 percent of GDP. of formal jobs compared to the same period in both 2020 and 2019. At the same time, The fiscal deficit is expected to narrow the average quarterly number of registered significantly in the context of a strong public jobseekers also dropped significantly—by more revenue performance and sluggish public than 30 percent compared to the same period investment. Public revenues are expected to in 2020. However, it is still higher than in the increase by almost 24 percent in 2021, thanks same period of 2019. to a considerable increase in firm turnover and the strong rebound in imports. By end-August Inflationary pressures heightened 2021, public revenue collection increased significantly during 2021, in line with by more than 30 percent, with the highest global trends, creating challenges for contribution from the value-added and excise private investment. Consumer price inflation, taxes and is likely to exceed current budget driven primarily by higher import prices, is projections. In addition to the expansion expected to reach an annual average of close to in economic activity, heightened inflation, 3.5 percent in 2021. Import prices increased intensified tax debt collection, and some by 2.5 percent in Q1 and 7.7 percent in Q2 formalization incentivized by fiscal stimulus and are expected to accelerate during the rest of measures have also added to revenue growth. the year, mostly driven by commodity imports. The government has announced an ambitious Production prices also increased, followed with Economic Revival Package amounting to a marked increase in the construction price 5.7 percent of GDP, mostly consisting of index (17 percent during the Q2 of 2021), current expenditures, which is expected to driven by higher commodity prices and wages. be implemented during 2021 and 2022. Construction comprises almost 60 percent of Public expenditure is expected to decrease by private investment activity60 in Kosovo. 1.8 percent compared to 2020, driven mainly by public investment underspending. The fiscal deficit is estimated at 0.9 percent of GDP; a 60 According to Firm Investment Statistics, Kosovo Statistics Agency. Kosovo  |  81 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 significant drop from last year, and lower than over the past two years. Private investment, and the level planned with the 2021 budget. Public public investment, in particular, are expected and publicly guaranteed debt is expected to to pick up and make a higher contribution increase from 22.4 percent of GDP in 2020 to to growth alongside consumption. Credit 23.2 percent in 2021. Thanks to good revenue growth is projected to continue supporting performance, domestic debt accumulation will private consumption increases. Against this slowdown and fiscal buffers are expected to backdrop, imports are projected to rise further; accumulate. hence, the current account balance is expected to deteriorate. Net exports, in line with pre- The financial sector is experiencing strong pandemic trends, are expected to subtract credit and deposit growth. Credit growth from growth. Remittances are projected to until July 2021 reached 12 percent, with credit maintain their increase in nominal value and to households increasing by 16.2 percent. will continue be the main source of financing Deposits increased by 14.5 percent for the same for the trade deficit. Inflationary pressures are period, with deposits of other nonfinancial projected to subside, with consumer inflation corporations increasing by 31.7 percent. stabilizing at an average of 1.8 percent. Capital adequacy remained above regulatory requirements until July, while nonperforming Higher fiscal deficits are likely due to a loans hovered between 2.5 and 2.7 percent from possible acceleration of public expenditure January to July 2021, according to the Central growth in the medium term. Public revenue Bank. The Kosovo Credit Guarantee Fund and public expenditure are projected to increase continued to expand its coverage, including by an average of 4 percent and 7.6 percent per through government-subsidized guarantee fees. year in the medium term, fueling an increase Its capital is expected to be further bolstered by in the level of fiscal deficit compared to 2021. government grants. Public revenue growth will decelerate, mainly because of the absence of one-off contributors, such as dividend income, and because of a Outlook and Risks slowdown in import growth and inflation compared to 2021. Expenditure growth will be Kosovo is expected to grow over 4 percent in fueled by an acceleration in public investment the medium term, contingent on the global spending, but also increased current expenditure course of the pandemic and its successful driven by the implementation of the Economic management. Although growth is expected Revival Plan. As a result, fiscal deficit levels are to decelerate in 2022 from the peak in 2021 expected to increase from 2021 to an average of of 7.1 percent, over the medium term, growth 2 percent of GDP over the medium term. With rate will stabilize at its potential of 4 percent. limited availability of privatization proceeds Given the level reached in 2021, service exports over the medium term, the deficit is projected are expected to increase, but at a slower pace. to be financed primarily through new domestic At the same time, with international prices debt and concessional external debt. Public and stabilizing in the medium term, Kosovo’s publicly guaranteed debt relative to output is commodity exports will also experience slower projected to rise from 23.2 percent in 2021 to growth, but maintain the gains experienced 27.8 percent by end-2023. 82  | Kosovo GREENING THE RECOVERY However, the outlook is marred by substantial COVID-19 risks. Given the rise of new virus variants and vaccination trends, both in Kosovo and globally, the pandemic risks remain high. Kosovo was hit with a fourth wave of infections in late August 2021, but the pace of vaccinations has accelerated. Given Kosovo’s high reliance on diaspora visits, reaching the vaccination coverage target at 60 percent of the eligible population by yearend remains important for mitigating pandemic-related risks and avoiding the imposition of further rounds of strict containment measures that restrict economic activity. Due to the inherent uncertainty of the course of the pandemic, policymakers need to have contingency plans, especially given the high impact of containment measures on public revenue collection, expenditure composition, and financing. Reimposition of international travel restrictions in diaspora-hosting countries could also weigh on growth and the fiscal position. In the medium term, there is a pressing need to focus policies on tackling constraints to higher productivity growth and investing in human capital. Kosovo needs to grow beyond its current potential to achieve higher living standards and more inclusive development. Thus, reforms should focus on (1) entrenching macroeconomic stability and sound governance; (2) increasing firm productivity; (3) raising farm productivity; (4) enhancing human capital; and (5) boosting exports, competition, and private investment, especially foreign direct investment. Kosovo  |  83 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Economic activity is recovering faster than Exports of services are experiencing a strong expected in 2021. rebound. Contributions to growth, percentage points Exports of goods and services, in EUR millions 8 2,000 1,800 6 1,600 4 1,400 1,200 2 1,000 0 800 600 -2 400 -4 200 0 -6 2019 2020 2021e 2019 2020 2021e 20 19 20 20 21e 22f 20 20 Exports of services Exports of goods J Consumption J Investment J Net exports ▬ Real GDP growth, percent Source: Kosovo Statistics Agency and World Bank staff calculations. Source: Central Bank of Kosovo; World Bank staff calculations. Strong recovery of revenues and under- Inflationary pressures increased in 2021. execution of capital investment are narrowing the deficit in 2021. Percent of GDP CPI inflation, percent 35 3.5 30 3.0 2.5 25 2.0 20 1.5 15 1.0 0.5 10 7.6 0 5 2.9 -0.5 0.9 2.0 0 -1.0 9 9 9 9 9 9 0 0 0 0 0 0 1 1 1 1 -1 r-1 -1 l-1 -1 -1 -2 -2 -2 -2 -2 -2 -2 r-2 -2 l-2 2019 2020 2021e 2022f Jan Ma May Ju Sep Nov Jan Mar May Jul Sep Nov Jan Ma May Ju J Public revenues J Public expenditure ▬ Budget deficit Source: Ministry of Finance and World Bank staff calculations. Source: Kosovo Statistics Agency. The recovery is accompanied by robust growth Credit growth is supporting the recovery. in formal employment. Quarterly average of pension contributors, in thousands Credit growth, percent 350 18 300 16 250 14 200 12 150 10 100 8 50 6 0 4 2019 2020 2021 2019 2020 2021 -18 -18 -18 -19 -19 -19 -20 -20 -20 -21 -21 Q1 Q2 Jan May Sep Jan May Sep Jan May Sep Jan May ▬ Total loans ▬ Loans to nonfinancial corporations ▬ Loans to households Source: Kosovo Pensions Savings Trust. Source: Central Bank of Kosovo. 84  | Kosovo GREENING THE RECOVERY KOSOVO 2018 2019 2020 2021e 2022f 2023f Real GDP growth (percent) 3.4 4.8 -5.3 7.1 4.1 4.4 Composition (percentage points): Consumption 3.9 6.2 2.2 5.2 2.8 2.7 Investment 2.6 -1.1 -2.4 1.9 2.3 2.3 Net exports -3.1 -0.3 -5.1 0.1 -1.0 -0.7 Exports 2.5 2.2 -8.4 13.7 2.5 2.2 Imports (-) 5.6 2.5 -3.3 13.6 3.5 2.9 Consumer price inflation (percent, period average) 1.1 2.7 0.2 3.5 1.8 1.6 Public revenues (percent of GDP) 26.3 26.8 25.4 28.9 28.8 28.8 Public expenditures (percent of GDP) 29.2 29.7 33.0 29.8 30.8 31.0 Of which: Wage bill (percent of GDP) 8.9 8.7 9.8 8.9 8.9 8.9 Social benefits (percent of GDP) 6.2 6.3 7.7 7.5 7.4 7.1 Capital expenditures (percent of GDP) 7.9 7.5 5.6 5.3 6.4 7.0 Fiscal balance (percent of GDP) -2.9 -2.9 -7.6 -0.9 -2.0 -2.2 Primary fiscal balance (percent of GDP) -2.6 -2.6 -7.2 -0.4 -1.5 -1.6 Public debt (percent of GDP) 16.4 17.0 22.0 22.7 25.9 27.6 Public and publicly guaranteed debt (percent of GDP) 17.0 17.6 22.4 23.2 26.2 27.8 Of which: External (percent of GDP) 6.2 5.8 7.8 7.8 10.1 11.1 Goods exports (percent of GDP) 5.6 5.6 6.9 8.4 8.6 8.8 Goods imports (percent of GDP) 46.7 45.8 44.2 55.9 56.3 57.2 Net services exports (percent of GDP) 12.8 13.1 5.7 14.8 14.0 14.7 Trade balance (percent of GDP) -28.2 -27.1 -31.6 -32.7 -33.7 -33.7 Net remittance inflows (percent of GDP) 11.4 11.6 13.8 14.3 14.0 13.6 Current account balance (percent of GDP) -7.6 -5.6 -7.0 -8.5 -9.6 -9.2 Net foreign direct investment inflows (percent of GDP) 3.4 2.7 4.1 3.8 4.1 4.5 External debt (percent of GDP) 30.5 31.2 37.5 — — — Real private credit growth (percent, period average) 10.1 7.9 7.6 — — — Nonperforming loans (percent of gross loans, end of period) 2.5 2.0 2.7 — — — Unemployment rate (percent, period average) 29.5 25.7 — — — — Youth unemployment rate (percent, period average) 55.4 49.4 — — — — Labor force participation rate (percent, period average) 40.9 40.5 — — — — GDP per capita (US$) 4,388 4,432 4,295 4,560 4,757 5,005 Poverty rate (percent of population) 23.2 20.9 23.4 20.9 18.9 17.0 Source: Country authorities, World Bank estimates and projections. Note: Poverty rate calculations based on ECAPOV harmonization using HBS data. Nowcasted/projected values start at 2018. Income measures in the SILC and consumption measures in the HBS are not strictly comparable. Poverty is defined as living on less than $5.5/day per person in revised 2011 PPPs. Kosovo  |  85 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Montenegro • After the deep 2020 recession, Montenegro’s economy is recovering faster than anticipated. • Progress with vaccinations, health protocols, and open borders has helped revive tourism. • Unemployment remains high despite the tourism rebound. • The large Eurobond issuance in December 2020 has relieved financing pressures in 2021, along with reduced fiscal deficit. Still, careful fiscal and debt management remains critical, as uncertainties loom. Recent Economic Developments July, with overnight stays reaching 90 percent of the 2019 level. Data from the national tourism While tourism was the main culprit for the organization point to an equally robust tourism economic downturn in 2020, it is now driving demand in August (July and August usually the economic revival. After a historic recession account for almost half of annual overnight of 15.3 percent in 2020, the economy has been stays). Retail trade strengthened by 6 percent62 showing signs of a robust recovery. It is estimated in the first half of 2021. In the same period, an that GDP will bounce back by 10.8 percent in increase of 10 percent in industrial production 2021, stronger than previously estimated. This was largely driven by electricity generation, is due to swifter tourism recovery—we now while construction was at the same level as a assume that tourism revenues will rebound year ago. to 75 percent of their 2019 levels, from 55 percent previously estimated. This rebound The recovery has yet to ignite the labor will boost exports, which are expected to lead market. Since the pandemic began, the the economic recovery in 2021. Despite lower administrative data show a persistent decline employment, tourism and household lending in employment, which reached a record low are expected to boost private consumption of 149,371 registered jobs in June (compared growth. However, government consumption to 178,178 in June 2020 and 213,488 in is estimated to decline, while investments are June 2019). Loss of jobs was recorded in all expected to increase only slightly due to delays sectors, but trade, construction, and tourism in public investment projects, supply-chain have taken the biggest hit, though tourism disruptions, and higher cost of materials. jobs are expected to have partly recovered due to intensifying tourism activity. Registered High-frequency indicators point to a unemployed rose from 41,890 in June 2020 to recovery but also show the economy’s scars 55,703 in June 2021, of which over 60 percent from the pandemic. In the first seven months of newly registered unemployed were women. of 2021, the number of overnight stays in tourist The government has continued paying wage collective61 accommodations were 56 percent of subsidies and one-off transfers, including the 2019 levels, but the peak season started in incentives for formalization of employment. 61 This includes hotels, holiday facilities, boarding houses, tourist resorts, hostels, and motels. 62 All comparisons are year-on-year unless otherwise stated. 86  | Montenegro GREENING THE RECOVERY This support has helped to avoid worse labor September and may reveal vulnerabilities that market outcomes. The Parliament has adopted would require decisive action by the Central an increase in the net monthly minimum wage Bank. from €222 to €250, effective October 1. External imbalances are expected to narrow Stronger demand and higher oil prices have as net exports and net income accounts pushed up inflation. As economic activity has strengthen. In the first half of 2021, exports picked up, so has inflation, and in the eight of goods and services increased by 40 percent, months it averaged 1.7 percent, with July and supported by a recovery in tourism and August inflation rates reaching 3.1 percent. transport services, but also stronger merchandise The increase in inflation was led by rising food, exports—primarily of electricity, minerals, and beverage, and transportation prices. Producer metals. In contrast, import growth was more prices grew more moderately, and by June moderate, edging up by 3 percent, largely the Producer Price Index had increased by driven by imports of food, beverages, and 1.3 percent. In the first seven months, nominal oil. Net primary and secondary incomes have wages increased by 1.3 percent, but real wages further reduced the current account deficit, fell marginally by 0.2 percent. primarily due to strong net remittances, which increased by 75 percent compared to the same The financial sector has so far been resilient. period last year. The current account deficit In the first seven months of 2021, outstanding was financed by drawing down reserves and loans were up by 7.3 percent, driven by net foreign direct investment (FDI), although household and non-resident lending. At the the latter declined by 20 percent. By July, same time, deposits were up by 16 percent, international reserves increased to €1.4 billion, most notably for firms, households, and covering 7.7 months of merchandise imports. non-residents. The lending-to-deposits ratio declined to 89 percent, back to its pre- The 2021 budget was adopted only in June pandemic level. By July, new lending surged by and introduced more meaningful program 57 percent, though it remained below its 2019 budgeting. The budget defines objectives level. The June average capital adequacy ratio and key performance indicators, although was at a healthy 19.2 percent, well above the not for all programs. Until the 2021 budget regulatory minimum. Nonperforming loans was adopted, the Ministry of Finance and increased to 6.3 percent of total loans from Social Welfare was issuing monthly temporary 5.6 percent in June last year. The full impact of decisions on financing. The budget proposed the crisis on bank asset quality will only be clear by the government initially planned a fiscal once the generous loan moratoriums expire in deficit of 3 percent of GDP but was eventually December and if corporate bankruptcies rise increased to 3.8 percent of GDP due to the after government crisis response programs are allocation of €25 million for reintroducing phased out. The Central Bank has commissioned mothers’ benefits transfers. The 2021 budget an Asset Quality Review (AQR) to identify also introduced child benefits for all children stressed assets and make necessary provisions until the age of six and financing of textbooks in banks’ balance sheets. After delays due to for all primary school students. There is room to the pandemic, the AQR shall be published in raise the inclusiveness and spending efficiency Montenegro  |  87 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 by reviewing the current social protection for the construction of the first section of the system to increase its effectiveness and targeting Bar-Boljare highway. and minimize potential adverse labor market participation effects. Outlook and Risks Stronger revenues are supporting fiscal deficit reduction. In the first seven months of The pandemic continues to pose challenges, 2021, central government revenues increased as new virus variants raise doubts about the by 11.3 percent, primarily supported by pace of the global recovery. In the second stronger value-added tax (VAT) and non-tax week of September, Montenegro had the fifth- revenue collection (including dividends from highest number of cases in seven days in the state-owned enterprises). In June, the Law world and is ranked third in the total number on E-fiscalisation entered into force and is of infected people per million inhabitants. The expected to further support VAT collection. vaccination process started at a fast pace in Expenditures declined by 4.5 percent, mainly May, and by mid-September 43 percent of the driven by under-execution of capital spending adult population has been fully vaccinated. The (due to delays in adopting the budget), but evolution of the pandemic will largely shape also lower spending on goods and services. the near-term economic outlook. The government has continued supporting the private sector and households through wage Assuming a full recovery in tourism in 2022 subsidies and one-off support until July. To and 2023, growth is expected to remain further support the recovery, the government strong at 5.6 and 4.8 percent, respectively. has also provided €40 million for subsidized Investments are expected to level off in 2022 loans for micro and small and medium-sized as the construction of the first section of the enterprises, which will be administered through highway is expected to be finalized by end- commercial banks. 2021. Investment is projected to grow in 2023 supported by projects in the energy sector. The After peaking at 105 percent of GDP in government announced stronger public capital 2020, public debt is expected to decline spending starting in 2022, which would further to 88 percent in 2021. Securing financing support medium-term growth. However, public through issuance of €750 million in Eurobonds investment management challenges should in December 2020 has significantly relieved be addressed to ensure stronger economic financing pressures in 2021. By July, the effects. Private consumption will continue to central government net debt was reduced by support growth as employment gradually starts over €300 million, including a repayment of recovering as a result of improved economic €227 in Eurobonds in March. Fiscal surpluses activity. The pace of the recovery of low-skills in June and July supported the buildup of jobs will determine how quickly poor and government deposits, which are expected to vulnerable households can recover their pre- cover the remaining financing needs for 2021. crisis income levels. Addressing long-standing The government has reduced fiscal risk by job and low labor participation challenges signing a hedging agreement to protect against is critical for robust job growth and welfare exchange rate risk as it started repaying the loan improvements in the recovery. 88  | Montenegro GREENING THE RECOVERY Strong fiscal and debt management are also remains high. Acceleration of structural needed to accelerate debt reduction. The reforms and a firm commitment to careful fiscal fiscal balance is expected to turn into a surplus management, however, can reduce investment in 2023, due to lower capital spending and uncertainty and improve the outlook. Further contained expenditures on goods and services strengthening the independence of public and stronger revenues due to the economic institutions, especially the judiciary, would recovery. The projections do not assume that not only improve Montenegro’s prospects the remaining sections of the highway will start of joining the European Union, but would by 2023, as fiscal space is projected to remain also support a resilient economic recovery by limited. The government’s medium-term plan ensuring a level playing field for all businesses foresees a primary fiscal surplus of almost and entrepreneurs. 2 percent of GDP in 2022. Running a primary fiscal surplus over the medium term will be critical for debt reduction and will require a sustained consolidation on the spending side. Public debt is expected to decline to 77 percent of GDP in 2022 and further to 70 percent of GDP in 2023, as about €500 million of debt is due for repayment in 2022–23. External imbalances are expected to narrow and return to pre-highway levels. The finalization of the import-dependent motorway section and stronger exports led by tourism recovery are projected to reduce the current account deficit to 11.2 percent and 9.5 percent of GDP in 2022 and 2023, respectively. Net FDI will continue to largely finance the current account deficit and is expected to remain moderate at around 7.5 percent of GDP. The outlook is subject to multiple downside risks. Looking at external risks, a new wave of COVID-19 infections in Europe could slow Montenegro’s economic recovery. Moreover, inflationary pressures in the United States and European Union may accelerate monetary tightening, which could translate into more expensive external financing. Domestic risks stem from lower vaccination rates and hesitancy, where possible new containment measures could delay the recovery. Political polarization Montenegro  |  89 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 The economy is recovering faster than …as tourism recovered. anticipated… Real GDP growth, percent International tourists overnight stays, in thousands 12 1,000 900 8 800 4 700 0 600 500 -4 400 -8 300 200 -12 100 -16 0 06 08 10 12 14 16 18 20 1e r r l t 20 20 20 20 20 20 20 20 202 Jan Feb Ma Ap May Jun Ju Aug Sep Oc Nov Dec J 2015–19 average J 2020 J 2021 Source: MONSTAT and World Bank staff calculations. Source: MONSTAT and World Bank staff calculations. Employment continued falling… …while inflation surged. Administrative data, thousands, Jan 2015–Jun 2021 Administrative data, Jan 2015–Jul 2021 220 60 6 550 5 500 210 50 450 200 4 400 40 3 350 190 2 300 180 30 1 250 170 200 20 0 160 150 -1 10 100 150 -2 50 last obs: Jun-21 140 5 5 6 6 7 7 8 8 9 9 0 0 1 0 -3 5 5 6 6 0 -1 g-1 b-1 g-1 b-1 g-1 b-1 g-1 b-1 g-1 -2 -2 b-2 -1 l-1 -1 l-1 -17 l-17 -18 l-18 -19 l-19 -20 -20 -21 l-2 1 Feb Au Fe Au Fe Au Fe Au Fe Au Feb Aug Fe Jan Ju Jan Ju Jan Ju Jan Ju Jan Ju Jan Jul Jan Ju ▬ Employment, lhs ▬ Employment_tc, lhs ▬ PPI, percent ▬ CPI, percent ▬ Real net wage (EUR 2015), rhs ▬ Unemployment, rhs ▬ Unemployment_tc, rhs Source: MONSTAT and World Bank staff calculations. tc=trend cycle. Source: MONSTAT data and World Bank staff calculations. Outstanding loans have been increasing… …while the fiscal position improved. Outstanding loans, Jan 2012–Jun 2021, in EUR millions 2015–21, percent of GDP 4.0 60 0 3.5 50 -2 3.0 2.5 40 -4 2.0 30 -6 1.5 20 -8 1.0 0.5 10 -10 last obs: Jul-21 0 0 -12 -12 -13 n-14 n-15 n-16 n-17 n-18 n-19 n-20 n-21 15 16 17 18 19 20 21e Jan Jan Ja Ja Ja Ja Ja Ja Ja Ja 20 20 20 20 20 20 20 J Private corporate J Government J Households J Financial sector J Total revenues and grants J Total expenditure and net lending J Other ▬ Accrual deficit, rhs Source: Central Bank and World Bank staff calculations. Source: MoF and World Bank staff calculations. 90  | Montenegro GREENING THE RECOVERY MONTENEGRO 2018 2019 2020 2021e 2022f 2023f Real GDP growth (percent) 5.1 4.1 -15.3 10.8 5.6 4.8 Composition (percentage points): Consumption 5.2 2.9 -3.9 3.2 2.8 2.7 Investment 4.9 0.8 -5.8 1.0 -1.2 2.1 Net exports -5.0 0.4 -5.6 6.6 4.1 0.0 Exports 3.4 2.7 -24.0 21.0 6.8 3.5 Imports (-) 8.4 2.3 -18.4 14.3 2.7 3.5 Consumer price inflation (percent, period average) 2.6 0.4 -0.3 1.9 1.6 1.2 Public revenues (percent of GDP) 42.0 43.3 44.4 43.9 42.2 41.7 Public expenditures (percent of GDP) 46.6 46.0 55.4 47.9 43.1 40.7 Of which: Wage bill (percent of GDP) 11.2 11.0 13.5 12.1 11.3 10.7 Social benefits (percent of GDP) 11.7 11.2 13.4 12.3 11.6 11.0 Capital expenditures (percent of GDP) 8.5 8.7 7.5 6.3 3.8 3.7 Fiscal balance (percent of GDP) -4.6 -2.7 -11.0 -4.0 -0.9 1.1 Primary fiscal balance (percent of GDP) -2.4 -0.5 -8.3 -1.6 1.4 3.2 Public debt (percent of GDP) 70.1 76.5 105.3 87.7 77.0 69.9 Public and publicly guaranteed debt (percent of GDP) 74.1 80.0 108.7 90.7 79.8 72.5 Of which: External (percent of GDP) 64.6 68.1 97.3 82.2 72.8 65.8 Goods exports (percent of GDP) 9.4 9.4 9.8 9.5 9.6 9.8 Goods imports (percent of GDP) 53.3 51.1 49.0 49.7 47.8 47.3 Net services exports (percent of GDP) 20.1 20.6 4.2 16.4 20.0 21.3 Trade and services balance (percent of GDP) -23.8 -21.1 -35.0 -23.8 -18.2 -16.2 Net remittance inflows (percent of GDP) 4.0 4.0 5.3 6.4 5.1 4.8 Current account balance (percent of GDP) -17.0 -14.3 -26.1 -15.2 -11.2 -9.5 Net foreign direct investment inflows (percent of GDP) 6.9 6.2 11.2 7.8 7.4 7.4 External debt (percent of GDP) 163.7 169.0 224.1 — — — Real private credit growth (percent, period average) 6.8 5.5 6.5 — — — Nonperforming loans (percent of gross loans, end of period) 7.4 5.1 5.9 — — — Unemployment rate (percent, period average) 15.2 15.1 17.9 — — — Youth unemployment rate (percent, period average) 29.4 25.2 36.0 — — — Labor force participation rate (percent, period average) 56.0 57.4 53.3 — — — GDP per capita, PPP (current international $) 21,547 23,344 20,505 22,363 23,978 25,442 Poverty rate (percent of population) 15.2 14.5 20.0 17.7 16.3 — Sources: Country authorities, World Bank estimates and projections. Note: Poverty rate calculations based on ECAPOV harmonization using SILC-C data. Nowcasted/projected values start at 2018. Income measures in the SILC and consumption measures in the HBS are not strictly comparable. Poverty is defined as living on less than $5.5/day per person in revised 2011 PPPs. Montenegro  |  91 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 North Macedonia • A robust recovery is underway in North Macedonia despite the continued adverse impact of the pandemic. However, the improved outlook is subject to downside risks: vaccine hesitancy and the pace of immunization, the appearance and intensity of new virus variants, disrupted supply chains, increased inflationary pressures, and tightening financial conditions. • The labor market is slowly recovering, creating wage pressures in fast-growing sectors. • Continued government support measures have helped mitigate the impact of the crisis on households and firms but have further increased public debt. • Policymakers should gradually shift their focus to policies supporting a sustainable, inclusive, and green recovery that complement and further strengthen the EU accession reform agenda. Recent Economic Developments spiked as travel opened up during the summer season, which might contribute to further After declining in the first quarter (Q1) by growth in retail trade. The most recent data on 1.9 percent, domestic output surged at a the number of issued construction permits in double-digit rate in Q2. As a result, GDP June 2021 points to a prolonged upward trend growth in the first half of the year turned in the construction sector. positive at 5.2 percent. Private consumption picked up and investment grew, while The activity rate in the first half of 2021 government consumption resumed growth in picked up from its low in summer 2020, Q2 after dropping early in the year. Exports driven by an increase in male labor force and imports increased, as well, with imports participation. The activity rate increased to growing faster, thereby worsening the trade 56.2 percent or 0.4 percentage points (pps) balance. On the production side, growth was since Q3 2020. The unemployment rate observed in nearly all sectors, given the low base decreased by 0.2 pps to 15.9 percent since Q4 effect, with the fastest recovery occurring in 2020, while the employment rate increased trade, transport, tourism, manufacturing, and by 0.5 pps, with women contributing to the ICT. Construction surprisingly saw a decline in rise as they moved from unemployment to output in Q2. service sector jobs. The youth unemployment rate remains high at 37.8 percent, up 4 pps High-frequency data for the second half compared to the same quarter of 2020. of 2021 point to a moderation in growth. Industrial production turned negative in July Wage growth continued in the first half (0.6 percent year-on-year [YOY]) as energy of the year, albeit at a relatively more and capital goods production turned negative subdued pace compared to the previous despite a 13 percent YOY rise in exports in year. Wages increased by 6.3 percent YOY, July. Car supply firms are experiencing reduced with the largest increases seen in sectors most orders as supply delivery delays are mounting. affected by pandemic-related restrictions such Real retail trade remains strong but slowed to as transportation, food and accommodation, 8.9 percent YOY in July. Tourism numbers entertainment, and other services. For the 92  |  North Macedonia GREENING THE RECOVERY first six months, strong wage growth was also payment of dividends to banks and savings observed in manufacturing, trade, and the houses’ shareholders that was introduced in ICT sector. In addition, in June 2021, the February 2021. government adopted changes to trade and labor laws that increase the hourly pay for Sunday In the first half of 2021, external imbalances and holiday work and reduce the number of narrowed as current transfers grew. The working Sundays in the trade sector, thereby trade deficit in the first half of 2021 stood at adding to existing wage pressures. 13.2 percent of GDP (on a 4-quarter rolling basis), down from 13.9 percent in the same Consumer prices continued the upward period of 2020, while the services balance trend that started at the end of 2020. The improved to 4.4 percent of GDP mainly thanks inflation rate reached 3.6 percent in August to telecommunication and IT services. The 2021—the highest growth rate since July current account deficit declined to 2.7 percent 2013. The cumulative inflation rate reached of GDP (on a 4-quarter rolling basis) in the 2.7 percent YOY for the first eight months first half of the year. It is projected to increase of the year which is still largely within central to 3.6 percent by yearend, largely remaining bank forecast. The increase was primarily unchanged compared to 2020. With the driven by electricity, fuel, and food (mainly rising borrowing needs from the government, edible oil) prices, the latter reflecting global external debt increased to 84.8 percent of price hikes. In July 2021, regulated electricity GDP by March 2021, though it is expected prices were again on the rise, with this year’s to stabilize at 80.8 percent of GDP in light of increase being offset by a temporary reduction the repayment of Eurobonds in July. This is a of the VAT rate, which is set to gradually expire marginal increase compared to the 2020’s level. by July 2023. Fiscal deficit almost halved in the first half The performance of the banking sector of the year but is set to rise by yearend as per remained strong in the first half of 2021. the 2021 budget revision. For the first half Credit growth remains solid (6.4 percent (H1), the general government deficit stood YOY in August), providing support to both at 2.1 percent of GDP; at one-third of the households and firms. Nonperforming loans, planned deficit in the 2021 budget revision. currently at 3.5 percent, could see an upward Total revenues surged by 17 percent YOY, correction, as last loan moratoriums are being mostly on the back of buoyant VAT collection. phased out and the duration of crisis takes a toll In the second part of the year, the collection on some firms. However, the capital adequacy will be under the impact of the reduced VAT ratio remained high at 17.3 percent, as did the rates for electricity in addition to the already banking sector liquidity ratio, which stood at lowered rate for catering services early in the 22 percent in Q2, with minimal adjustments year. Expenditures have increased at a slower since the start of the pandemic. Considering pace (4 percent YOY) given more targeted the recent positive momentum of the economy, COVID-19 support, and despite an uplift in in August 2021, the central bank removed capital spending of 45 percent YOY. the temporary limit on the distribution and North Macedonia  |  93 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Public and publicly guaranteed debt63 exemptions, and subsidies remains high. While increased to 64.4 percent of GDP in H1 this helps protect employment in the near term, given the new Eurobond issuance amid it also derails fiscal sustainability. a retained sovereign issuer default rating of BB- with a stable outlook. In July the Fiscal deficit is expected to decline but only government repaid the seven-year EUR 500 gradually, following the latest government million Eurobond issued in 2014, which plans to ramp up capital spending. Over reduced debt to 60.5 percent of GDP. In August the medium term, public and publicly 2021, the IMF allocated EUR 134.5 million in guaranteed debt will continue its rising path Special Drawing Rights in an attempt to boost reaching 65.5 percent of GDP by 2023. liquidity across the world. The government Countercyclical fiscal policies put in place to aims to use this allocation for budgetary mitigate the impact of COVID-19 will need financing purposes. to be gradually withdrawn to address these sustainability concerns. Improving public investment management to help implement Outlook and Risks the government’s Growth Acceleration Plan, which eyes energy, environment, and transport Economic growth is expected to rebound investments, will be critical to support growth to 4.6 percent in 2021, returning to the as well as avoid fiscal sustainability concerns. pre-pandemic output level by yearend. The As the recovery takes hold, the country will baseline scenario is built on the assumptions need to boost tax compliance, restructure that the pace of immunization continues, there and reprioritize spending, address long-term are no further lockdowns in 2021, consumer bottlenecks, and enhance public finance and investor confidence remain high, and management efficiency. external demand continues to be supportive. Growth is expected to continue in 2022 as the To boost potential growth, the authorities economy gradually starts to stabilize. Poverty need to redirect their attention to structural is projected to resume its modest decline as and institutional reforms,  which can unlock expected economic growth rebounds in 2021. growth by addressing the legacies in state- owned companies and network infrastructure; Yet, while the outlook for the near term investing in human capital; strengthening the remains positive, continued containment accountability and independence of public measures, a slow vaccine rollout, and institutions, as well as commitment to the rule unresolved structural bottlenecks pose of law; and promoting private sector innovation challenges. Weak human capital development and competitiveness. Efforts to boost potential and a low labor force participation rate have output through structural reforms will need to led to underutilized labor resources amidst a occur in the context of region-wide efforts to demographic decline. Further, state involvement accelerate the low-carbon transition and reduce in the market through direct ownership, tax greenhouse gas emissions. 63 It also includes some non-guaranteed debt by SOEs. 94  |  North Macedonia GREENING THE RECOVERY The economy is on a recovery path from the …which is confirmed by high-frequency 2020 recession… indicators. Percent 2011=100, trade cycle adjusted 14 180 220 12 10 160 200 8 6 140 180 4 2 120 160 0 100 -2 -4 140 80 -6 -8 120 60 -10 -12 40 100 -14 -16 20 7 80 -17 3-17 1-18 3-18 1-19 3-19 1-20 3-20 1-21 -1 ul-17 n-18 ul-18 n-19 ul-19 n-20 ul-20 n-21 Q1 Q Q Q Q Q Q Q Q Jan J Ja J Ja J Ja J Ja ▬ Industry ▬ Construction, rhs ▬ Retail trade ▬ Tourism Source: State Statistics Office. Source: State Statistics Office and World Bank staff calculations. The labor market resumed positive trends. Inflationary pressures are on the rise as demand surges. Percent Percent, yearly change 60 15 24 55 10 50 22 45 5 20 40 35 0 18 30 16 -5 25 last obs: Jul-21 20 14 -10 2 -17 3-17 1-18 3-18 1-19 3-19 1-20 3-20 1-21 -1 -13 -14 -15 -16 -17 -18 -19 -20 -21 Q1 Q Q Q Q Q Q Q Q Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan J Activity rate J Employment rate ▬ Unemployment rate, rhs ▬ CPI total ▬ PPI total Source: State Statistics Office. Source: State Statistics Office. External imbalances narrowed… …while public debt is still on the rise. Percent of GDP Percent of GDP 30 1 70 1 0 20 60 0 -1 50 -2 10 -1 40 -3 0 -4 -2 30 -5 -10 20 -6 -3 -7 -20 10 -8 -30 -4 0 -9 20 15 16 20 17 18 19 20 21* 14 2015 016 2017 018 019 020 1-21 2-21 20 20 20 20 20 20 2 2 2 2 Q Q J Goods J Services J Income J Current transfers J Domestic debt J Foreign debt J Guarantees ▬ Fiscal deficit, rhs ▬ Current account balance Source: National Bank and World Bank staff calculations. Source: Ministry of Finance and World Bank staff estimates. Note: *2021 is a 4-quarter moving average to June 2021. Note: 2021 deficit is a 4-quarter moving average. North Macedonia  |  95 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 NORTH MACEDONIA 2018 2019 2020 2021e 2022f 2023f Real GDP growth (percent) 2.9 3.2 -4.5 4.6 3.7 3.4 Composition (percentage points): Consumption 2.9 2.4 -2.5 4.1 2.9 1.9 Investment 0.6 3.3 -3.7 1.4 1.7 2.1 Net exports -0.6 -2.5 1.7 -0.9 -1.0 -0.6 Exports 7.6 4.7 -7.3 5.0 4.7 4.9 Imports (-) 8.2 7.2 -9.0 6.0 5.7 5.5 Consumer price inflation (percent, period average) 1.5 0.8 1.2 2.4 2.0 1.8 Public revenues (percent of GDP) 30.4 31.5 30.2 36.1 36.8 36.5 Public expenditures (percent of GDP) 31.5 33.7 38.4 42.0 41.7 40.6 Of which: Wage bill (percent of GDP) 6.3 6.4 7.2 7.3 7.1 6.9 Social benefits (percent of GDP) 15.2 15.7 17.7 17.3 17.0 16.8 Capital expenditures (percent of GDP) 2.5 3.4 3.1 6.1 5.9 5.0 Fiscal balance (percent of GDP) -1.1 -2.2 -8.2 -5.9 -5.0 -4.0 Overall Fiscal Balance with the Public Enterprise for State Roads -1.7 -3.1 -8.7 -6.4 -5.2 -4.1 Primary fiscal balance (percent of GDP) 0.1 -1.0 -7.0 -4.3 -3.6 -2.6 Public debt (percent of GDP) 40.4 40.7 51.4 53.9 55.9 56.7 Public and publicly guaranteed debt (percent of GDP)* 48.4 49.4 60.2 62.7 64.7 65.5 Of which: External (percent of GDP) 32.9 32.7 40.2 39.0 38.0 37.0 Goods exports (percent of GDP) 45.4 47.5 44.7 46.0 47.1 48.3 Goods imports (percent of GDP) 61.6 65.1 61.5 63.0 63.5 64.0 Net services exports (percent of GDP) 3.5 3.1 4.0 4.1 4.3 4.6 Trade balance (percent of GDP) -12.7 -14.5 -12.8 -12.9 -12.1 -11.1 Net remittance inflows (percent of GDP) 1.9 1.7 2.6 2.5 2.3 2.2 Current account balance (percent of GDP) -0.1 -3.3 -3.5 -3.6 -3.0 -1.8 Net foreign direct investment inflows (percent of GDP) 5.6 3.2 1.9 2.5 2.6 2.7 External debt (percent of GDP) 73.0 72.8 80.2 80.8 78.7 78.9 Real private credit growth (percent, period average) 5.0 6.5 5.7 — — — Nonperforming loans (percent of gross loans, end of period) 5.0 4.6 3.3 — — — Unemployment rate (percent, period average) 20.7 17.3 16.4 15.5 14.3 13.5 Youth unemployment rate (percent, period average) 45.4 35.6 35.7 — — — Labor force participation rate (percent, period average) 56.9 57.2 56.4 — — — GDP per capita, PPP (current international $) 16,518 17,815 17,007 17,790 18,448 19,075 Poverty rate (percent of population) 17.9 16.9 18.0 16.9 15.8 — Source: Country authorities, World Bank estimates and projections. Note: Youth unemployment rate is for labor force aged 15-24. Poverty rate calculations based on ECAPOV harmonization using SILC-C data. Nowcasted/ projected values start at 2019. Income measures in the SILC and consumption measures in the HBS are not strictly comparable. Poverty is defined as living on less than $5.5/day per person in revised 2011 PPPs. *Includes also non-guaranteed debt of SOEs.  96  |  North Macedonia GREENING THE RECOVERY Serbia • Serbia’s growth recovery in 2021 at 6 percent is projected to be stronger than expected, supported primarily by a strong rebound in private consumption. • Despite the economic recovery, there was an increase in unemployment rate averaging 11.9 percent in the first half (H1) of 2021. • The fiscal deficit is gradually decreasing in 2021, despite the continuation of the government’s fiscal stimulus program. • Even though inflation has increased as of late, reaching 4.3 percent in August, the highest level in eight years, it is still within the National Bank of Serbia target band. • The current account deficit has been lower than projected in 2021, mainly thanks to a strong export performance. • A return to the previous growth path of around 4 percent is expected to start in 2022 and to continue over the medium term. Recent Economic Developments points to GDP growth. The economic recovery in 2021 is broad based, except for the agriculture After the pandemic-caused recession in sector, where output declined by 1.8 percent in 2020, the economy experienced a recovery real terms in H1. The agriculture sector output in H1 2021. Economic growth resumed in suffered from weather-related shocks, which the first quarter (Q1)—with GDP growth up had an impact across different agricultural by 1.8 percent, year-on-year (YOY)—but the subsectors and a significant increase in costs of real recovery was seen in Q2, when output food used in livestock breeding. increased by 13.7 percent YOY. Looking at the expenditure side of GDP, consumption and Countercyclical measures helped mitigate investment pushed the economy, while net the impact of the pandemic on the labor exports had a negative contribution to growth. market in 2020; however, the situation has Consumption was pushed by a large increase in somewhat deteriorated in 2021, as some of private consumption (up 17.6 percent in real the government support programs have been terms YOY), while government consumption unwound. According to the Labor Force Survey in fact decreased in Q2 in real terms. Although (LFS) data, in H1 2021, the unemployment the export performance was very good recently rate increased to 11.9 percent (compared to (up 36.5 percent in Q2, YOY in real terms) 9.0 percent, the average unemployment rate the increase in imports was even higher (up in 2020). The labor market improvement in 42.9 percent in Q2); thus, the net balance in 2020 (when unemployment rate went down goods and services made a negative contribution to 9.0 percent from 10.4 percent in 2019) to GDP in Q2 of 7.1 percentage points. Total was primarily the result of the fiscal stimulus investment is estimated to have increased by program, since one of the requirements for 44.4 percent in real terms in Q2, YOY, thanks firms to receive government support was to an increase in both public and private to ensure that total employment remained investment, thus contributing 9.3 percentage unchanged or decreased by a maximum of Serbia  |  97 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 10 percent. However, despite these measures, the maturity of fifteen years and the yield of the pandemic-related shocks to the economy 2.3 percent. had an impact on some of the foreign-owned large manufacturers who decided to close their The current account deficit (CAD) has operations in Serbia, resulting in significant continued to narrow. The CAD is estimated layoffs. Wages continued to go up, increasing at 4.1 percent of GDP for 2020, down from by 8.6 percent in nominal terms in H1 of the 6.9 percent in 2019. Over the first seven year. Unlike in previous couple of years, private months of 2021, the CAD narrowed further sector wages increased faster than public sector and reached 1.5 percent of GDP as a result of wages (up by 9.4 percent in nominal terms, improvements in the trade in services and in compared to a 7.5 percent increase in public secondary income. While the surplus in trade sector wages). Despite this, on average, in 2021 in services increased by 48.5 percent over the wages in the public sector were still about first seven months of 2021 (in euro terms), the 19 percent higher than in the private sector. deficit in trade in goods increased by 4.1 percent. Despite an increase in trade deficit, export The consolidated fiscal deficit decreased performance in 2021 was much better than significantly over recent months as revenues expected as large exporters resumed operations, recovered. General government revenues and exports thereafter. In addition, Serbia saw increased by 25.7 percent in nominal terms terms-of-trade improvement in 2021—export over the first seven months of 2021 (compared prices increased by 6.4 percent, as did import to the same period of 2020). All sources of fiscal prices, but by a lesser amount at 2.4 percent revenue increased with tax revenues going up (over the first eight months of 2021 compared 26.8 percent YOY over the first seven months to the same period in 2020). The CAD is again and non-tax revenues up by 15.1 percent. fully financed by foreign direct investment At the same time, government expenditures (FDI). Net FDI accounted for 3.9 percent of decreased slightly (down 0.6 percent), leading annual GDP, after growing 25.1 percent in the to a much better fiscal result. The consolidated first seven months of the year. Fitch Ratings fiscal deficit was just 0.1 percent of GDP by affirmed Serbia’s sovereign issuer default rating end-July. The central government deficit was at BB+, with a stable outlook. 0.7 percent of GDP, while local governments ran a significant surplus over the first seven Inflation increased gradually over the months. Public debt at end-July 2021 stood recent months, in line with the recovery in at 58.8 percent of GDP, thus only marginally consumption and the pressures from global increasing since end-2020.64 In September energy and food prices. Inflation in 2020, as 2021, Serbia issued its first green bond (along in Q1 2021, was low and stable, with prices with the new euro bond). The green bond of having increased by just 1.4 percent YOY in EUR1 billion was issued with the seven years Q1. However, since April, there was a gradual maturity and the yield of 1.26 percent, while increase in consumer prices with the consumer the euro bond is of EUR750 million, with price index (CPI) reaching a peak of 4.3 percent 64 This is a share of public debt in a 12-month moving average GDP. The nominal amount of debt is provided by the Ministry of Finance. 98  | Serbia GREENING THE RECOVERY (YOY) in August. This was the highest level of fiscal stimulus program is smaller and different inflation since September 2013. The National in structure compared to last year’s program Bank of Serbia (NBS) remains committed to (guarantees dominate in this year’s package, inflation targeting (3 percent +/–1.5 percent), and there are no further tax deferrals), thus and the key policy rate has been left unchanged the impact on the economy and labor market since December 2020, at 1 percent. The money performance could be different. This year, supply increase was also notable: in July 2021, the main drivers of growth are expected to M1 was 13.5 percent higher than a year before. be consumption and investment. Over the After a small appreciation in 2019, the dinar medium term, the economy is expected to grow held steady in 2020 and throughout 2021. At steadily at around 4 percent annually, similar to the end of August, the NBS had official foreign levels before the pandemic, as the economies of currency reserves of EUR 15.6 billion, up EUR main trading and investment partners recover 2.1 billion since the beginning of the year, fully from the pandemic. The main driver of which covers more than six months of imports. GDP growth over the medium term will be consumption, while net exports will make a Banking sector performance continued to negative contribution to growth. It is expected be robust. Based on preliminary data, banks that services sector will remain the main driver remained profitable in 2020 although both of economic growth going forward. return on assets (ROA) and return on equity (ROE) decreased. In 2021, ROE increased to Going forward, the focus of policymakers 7.3 percent in H1 2021. Liquidity indicators should be not only on accelerating growth also improved in the first half of the year. through further structural reforms, but Nonperforming loans (NPLs) hit a historic also on greening it. The Serbian economy annual low of 3.7 percent in December 2020 cannot unleash its growth potential in full primarily because of the resolution strategy unless structural bottlenecks related to introduced in 2015 and the recent crisis governance, labor market, infrastructure, and mitigation measures. NPLs stood at 3.5 percent the tax system are resolved. Green—clean and in July 2021. resilient—growth could be supported by, for example, promoting efficiency gains in use of raw materials and energy, expanding green Outlook and Risks industries and technologies, emphasizing less polluting and more energy-efficient industries, Growth is expected to reach 6 percent in and proactively building up resilience to climate 2021, and to return to about 4 percent over and disaster risks. Such growth strategy would the medium term. Based on the latest data, not only accelerate GDP growth but would GDP is expected to rebound in 2021 (up by create new, high-quality jobs. 6 percent), which is a revision compared to the previous projection of 5 percent. Growth Macroeconomic stability will be maintained in 2021 is being pushed up by the stimulus over the medium term. This year the fiscal package of about 4.5 percent of GDP deficit could be significantly lower than the announced in February, and all components one projected under the base-case scenario. of GDP are expected to increase. The new Consequently, public debt could start falling Serbia  |  99 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 as a share of GDP earlier than anticipated. Inflation pressures are mounting as in other countries, but inflation is expected to remain within the NBS target. External debt will be kept sustainable; the CAD is expected to increase only marginally over the medium term and will primarily be covered by FDI inflows. This relatively positive outlook could be affected by numerous risks. The main risks relate to external developments—that is recovery of the European and global economies—since those will impact the evolution of exports and FDI, which are both critical for the growth of the Serbian economy. They could be amplified by the ongoing disruptions in global value chains. There are, however, also internal risks to the baseline scenario. The new wave of the COVID-19 pandemic could have an impact on the economy as well, although new lockdowns are not foreseen. Contingent liabilities could affect public finances, particularly those related to the deterioration in the performance of state-owned enterprises, as demonstrated recently by Telekom Srbija and Air Serbia, in addition to other state-owned enterprises that have long been financially troubled. Political developments could distract the government from undertaking necessary reforms, the most important from a growth perspective being those related to improving the business environment, education, and environmental management. 100  | Serbia GREENING THE RECOVERY The GDP recovered well in 2021… …in line with developments among CEE countries. Contribution to growth, percentage points Real GDP change, y/y 24 15 20 12 16 9 6 12 3 8 0 4 -3 0 -6 -4 -9 -8 -12 last obs: Q2-21 -19 2-19 3-19 4-19 1-20 2-20 3-20 4-20 1-21 2-21 -16 -16 -17 -17 -18 -18 -19 -19 20 20 -21 Q1 Q Q Q Q Q Q Q Q Q Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1- Q3- Q1 J Consumption J Investment ▬ Serbia ▬ CEE8 average J Net exports ▬ Real GDP growth, percent Source: Statistics Office of Republic of Serbia. Source: Statistics Office of Republic of Serbia and Eurostat. The fiscal deficit has been reduced and public Total budgetary expenditures decreased even debt stabilized. though capital expenditures increased. Share in GDP Share in GDP 10 80 8 8 7 70 6 6 4 60 2 5 0 50 4 -2 3 40 -4 2 -6 30 -8 1 last obs: Jul-21 -10 8 9 0 1 2 3 4 5 6 7 8 9 0 1 20 0 -0 -0 n-1 n-1 n-1 n-1 -1 n-1 -1 n-1 -1 -1 -2 n-2 Jan Jan Ja Ja Ja Ja Jan Ja Jan Ja Jan Jan Jan Ja 2017 2018 2019 2020 2021f ▬ Fiscal balance ▬ Public debt as percent moving average GDP (rhs) Source: Ministry of Finance. Source: Ministry of Finance. The CAD and trade deficit started to increase Inflation has been increasing since April. recently. Percent of GDP, sum of 12 months CPI, yoy 0 6 -2 5 -4 4 -6 -8 3 -10 2 -12 1 -14 last obs: Jun-21 last obs: Aug-21 -16 8 0 5 -1 -18 -18 -19 -19 -19 -20 -20 -20 -21 -21 -1 -16 -17 -18 -19 -20 -21 Jan May Sep Jan May Sep Jan May Sep Jan May Jan Jan Jan Jan Jan Jan Jan ▬ CAB ▬ Trade balance ▬ CPI, total ▬ Target, upper bound ▬ Target, lower bound Source: National Bank of Serbia. Source: National Bank of Serbia. Serbia  |  101 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 SERBIA 2018 2019 2020 2021e 2022f 2023f Real GDP growth (percent) 4.4 4.3 -0.9 6.0 4.5 4.0 Composition (percentage points): Consumption 2.8 2.9 -0.9 3.4 4.2 3.2 Investment 4.2 4.0 -0.1 3.2 0.8 1.3 Net exports -2.6 -2.6 0.1 -0.5 -0.6 -0.5 Exports 4.3 4.1 -2.3 9.0 4.3 4.0 Imports (-) 6.9 6.7 -2.4 9.5 4.9 4.5 Consumer price inflation (percent, period average) 2.0 1.9 1.6 3.0 2.6 2.6 Public revenues (percent of GDP) 41.5 42.0 41.0 41.7 41.4 41.4 Public expenditures (percent of GDP) 40.9 42.2 49.0 48.7 44.4 43.2 Of which: Wage bill (percent of GDP) 9.2 9.5 10.5 10.4 10.0 9.9 Social benefits (percent of GDP) 14.7 14.4 14.7 14.5 14.0 13.9 Capital expenditures (percent of GDP) 3.9 4.9 5.3 7.2 6.3 6.1 Fiscal balance (percent of GDP) 0.6 -0.2 -8.0 -6.9 -3.0 -1.8 Primary fiscal balance (percent of GDP) 2.8 1.8 -6.0 -5.0 -1.1 0.2 Public debt (percent of GDP) 50.8 49.7 53.3 56.3 55.4 52.6 Public and publicly guaranteed debt (percent of GDP) 54.4 52.7 57.8 60.3 58.9 56.1 Of which: External (percent of GDP) 31.4 30.3 33.4 37.0 38.0 40.0 Goods exports (percent of GDP) 35.2 35.7 34.4 39.1 39.7 40.3 Goods imports (percent of GDP) 47.1 47.9 45.5 50.2 50.4 50.7 Net services exports (percent of GDP) 2.3 2.3 2.4 2.3 2.1 2.2 Trade balance (percent of GDP) -9.5 -9.9 -8.8 -8.9 -8.5 -8.2 Net remittance inflows (percent of GDP) 6.1 5.6 4.5 4.9 4.8 4.7 Current account balance (percent of GDP) -4.8 -6.9 -4.1 -5.0 -5.0 -4.9 Net foreign direct investment inflows (percent of GDP) 7.4 7.8 6.3 6.1 6.1 6.0 External debt (percent of GDP) 61.3 61.8 65.8 63.7 60.5 58.3 Real private credit growth (percent, period average) 3.7 6.9 9.3 ― ― ― Nonperforming loans (percent of gross loans, end of period) 5.7 4.1 3.7 ― ― ― Unemployment rate (percent, period average) 13.7 11.2 9.7 ― ― ― Youth unemployment rate (percent, period average) 29.7 27.5 26.3 ― ― ― Labor force participation rate (percent, period average) 52.9 52.9 52.2 ― ― ― GDP per capita, PPP (current international $) 17,842 18,972 19,146 20,545 22,044 23,534 Poverty rate (percent of population) 17.9 17.3 17.4 17.1 15.4 ― Source: Country authorities, World Bank estimates and projections. Note: Poverty rate calculations based on ECAPOV harmonization using SILC-C data. Nowcasted/projected values start at 2018. Income measures in the SILC and consumption measures in the HBS are not strictly comparable. Poverty is defined as living on less than $5.5/day per person in revised 2011 PPPs. 102  | Serbia Key Economic Indicators WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Key Economic Indicators 2016 2017 2018 2019 2020 2021e 2022f 2023f Real GDP growth (percent) Albania 3.3 3.8 4.1 2.2 -4.0 7.2 3.8 3.7 Bosnia and Herzegovina 3.1 3.2 3.7 2.8 -3.2 4.0 3.0 3.2 Kosovo 5.6 4.8 3.4 4.8 -5.3 7.1 4.1 4.4 North Macedonia 2.8 1.1 2.9 3.2 -4.5 4.6 3.7 3.4 Montenegro 2.9 4.7 5.1 4.1 -15.3 10.8 5.6 4.8 Serbia 3.3 2.0 4.4 4.3 -0.9 6.0 4.5 4.0 WB6 3.4 2.7 4.0 3.6 -3.1 5.9 4.1 3.8 Consumer price inflation (percent, period average) Albania 1.3 2.0 2.1 1.4 1.6 2.4 2.8 3.0 Bosnia and Herzegovina -1.6 0.8 1.4 0.6 -1.1 -0.2 0.5 0.7 Kosovo 0.3 1.5 1.1 2.7 0.2 3.5 1.8 1.6 North Macedonia -0.2 1.4 1.5 0.8 1.2 2.4 2.0 1.8 Montenegro -0.3 2.4 2.6 0.4 -0.3 1.9 1.6 1.2 Serbia 1.1 3.2 2.0 1.9 1.6 3.0 2.6 2.6 WB6 0.4 2.2 1.8 1.5 0.9 2.3 2.1 2.1 Public expenditures (percent of GDP) Albania 29.6 29.8 29.2 29.2 33.2 34.4 30.2 30.4 Bosnia and Herzegovina 41.5 41.4 40.2 41.1 44.0 44.3 42.7 41.6 Kosovo 27.9 27.8 29.2 29.7 33.0 29.8 30.8 31.0 North Macedonia 35.3 33.8 31.5 33.7 38.4 42.0 41.7 40.6 Montenegro 45.3 47.0 46.6 46.0 55.4 47.9 43.1 40.7 Serbia 41.9 40.4 40.9 42.2 49.0 48.7 44.4 43.2 WB6 36.9 36.7 36.3 37.0 42.2 41.2 38.8 37.9 Public revenues (percent of GDP) Albania 27.6 27.8 27.5 27.2 26.3 27.8 27.4 27.4 Bosnia and Herzegovina 42.7 43.8 42.7 43.0 42.2 41.2 41.8 42.0 Kosovo 26.4 26.5 26.3 26.8 25.4 28.9 28.8 28.8 North Macedonia 31.5 31.0 30.4 31.5 30.2 36.1 36.8 36.5 Montenegro 42.5 41.4 42.0 43.3 44.4 43.9 42.2 41.7 Serbia 40.8 41.5 41.5 42.0 41.0 41.7 41.4 41.4 WB6 35.3 35.3 35.1 35.6 34.9 36.6 36.4 36.3 Source: World Bank calculations and projections on data from national authorities and World Economic Outlook. 104  | Key Economic Indicators GREENING THE RECOVERY Key Economic Indicators (continued) 2016 2017 2018 2019 2020 2021e 2022f 2023f Fiscal balance (percent of GDP) Albania -1.8 -2.0 -1.7 -1.9 -6.8 -6.7 -2.8 -3.0 Bosnia and Herzegovina 1.2 2.4 2.5 1.9 -1.8 -3.1 -0.9 0.4 Kosovo -1.4 -1.4 -2.9 -2.9 -7.6 -0.9 -2.0 -2.2 North Macedonia -2.7 -2.8 -1.1 -2.2 -8.2 -5.9 -5.0 -4.0 Montenegro -2.8 -5.7 -4.6 -2.7 -11.0 -4.0 -0.9 1.1 Serbia -1.2 1.1 0.6 -0.2 -8.0 -6.9 -3.0 -1.8 WB6 -1.4 -1.4 -1.2 -1.3 -7.3 -4.6 -2.4 -1.6 Public debt (percent of GDP) Albania 68.7 66.9 64.9 63.7 75.1 75.4 74.9 73.1 Bosnia and Herzegovina 42.4 36.1 34.2 32.8 36.6 35.8 35.9 37.2 Kosovo 14.1 15.7 16.4 17.0 22.0 22.7 25.9 27.6 North Macedonia 39.9 39.4 40.4 40.7 51.4 53.9 55.9 56.7 Montenegro 64.4 64.2 70.1 76.5 105.3 87.7 77.0 69.9 Serbia 62.8 55.6 50.8 49.7 53.3 56.3 55.4 52.6 WB6 48.7 46.3 46.1 46.7 57.3 55.3 54.2 52.9 Public and publicly guaranteed debt (percent of GDP) Albania 72.3 71.9 69.5 67.4 77.2 78.6 76.7 74.9 Bosnia and Herzegovina 43.8 37.7 35.6 34.5 38.8 38.0 38.1 39.1 Kosovo 14.5 16.4 17.0 17.6 22.4 23.2 26.2 27.8 North Macedonia 48.8 47.7 48.4 49.4 60.2 62.7 64.7 65.5 Montenegro 70.4 69.1 74.1 80.0 108.7 90.7 79.8 72.5 Serbia 68.6 58.7 54.4 52.7 57.8 60.3 58.9 56.1 WB6 53.1 50.2 49.8 50.3 60.9 58.9 57.4 56.0 Goods exports (percent of GDP) Albania 6.7 6.9 7.7 6.6 6.1 7.6 7.5 7.5 Bosnia and Herzegovina 25.7 29.8 31.2 28.8 27.5 33.6 35.4 36.5 Kosovo 5.1 6.0 5.6 5.6 6.9 8.4 8.6 8.8 North Macedonia 36.5 40.6 45.4 47.5 44.7 46.0 47.1 48.3 Montenegro 8.9 8.9 9.4 9.4 9.8 9.5 9.6 9.8 Serbia 34.9 35.9 35.2 35.7 34.4 39.1 39.7 40.3 WB6 26.3 27.9 28.5 28.5 27.5 31.1 31.8 32.4 Source: World Bank calculations and projections on data from national authorities and World Economic Outlook. Key Economic Indicators  |  105 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.20 Key Economic Indicators (continued) 2016 2017 2018 2019 2020 2021e 2022f 2023f Trade balance (percent of GDP) Albania -16.8 -15.1 -13.7 -13.8 -14.7 -15.7 -13.0 -12.0 Bosnia and Herzegovina -16.6 -16.2 -14.7 -14.7 -14.5 -12.7 -11.3 -11.7 Kosovo -27.4 -25.8 -28.2 -27.1 -31.6 -32.7 -33.7 -33.7 North Macedonia -15.2 -14.1 -12.7 -14.5 -12.8 -12.9 -12.1 -11.1 Montenegro -22.5 -23.5 -23.8 -21.1 -35.0 -23.8 -18.2 -16.2 Serbia -6.0 -7.8 -9.5 -9.9 -8.8 -8.9 -8.5 -8.2 WB6 -12.8 -13.1 -13.4 -13.6 -13.7 -13.3 -12.2 -11.8 Current account balance (percent of GDP) Albania -7.6 -7.5 -6.8 -8.0 -8.8 -9.4 -8.1 -7.0 Bosnia and Herzegovina -4.8 -4.8 -3.5 -3.2 -3.3 -2.0 -0.6 -1.1 Kosovo -8.0 -5.5 -7.6 -5.6 -7.0 -8.5 -9.6 -9.2 North Macedonia -2.6 -0.9 -0.1 -3.3 -3.5 -3.6 -3.0 -1.8 Montenegro -16.2 -16.1 -17.0 -14.3 -26.1 -15.2 -11.2 -9.5 Serbia -2.9 -5.2 -4.8 -6.9 -4.1 -5.0 -5.0 -4.9 WB6 -4.8 -5.5 -5.1 -6.2 -5.7 -5.6 -5.1 -4.7 External debt (percent of GDP) Albania 73.5 68.8 65.2 60.5 64.7 59.3 53.9 52.9 Bosnia and Herzegovina 79.1 70.6 66.8 64.1 71.6 70.0 70.3 70.5 Kosovo 33.2 32.6 30.5 31.2 37.5 n.a. n.a. n.a. North Macedonia 74.7 73.4 73.0 72.8 80.2 80.8 78.7 78.9 Montenegro 161.8 159.9 163.7 169.0 224.1 195.5 194.0 193.5 Serbia 72.1 68.9 61.3 61.8 65.8 63.7 60.5 58.3 WB6 82.4 79.0 76.7 76.5 90.6 93.9 91.5 90.8 Unemployment rate (period average, percent) Albania 15.2 13.7 12.3 11.5 11.7 n.a. n.a. n.a. Bosnia and Herzegovina 25.4 20.5 18.4 15.7 15.9 n.a. n.a. n.a. Kosovo 27.5 30.5 29.5 25.7 n.a. n.a. n.a. 0.0 North Macedonia 23.8 22.4 20.7 17.3 16.4 n.a. n.a. n.a. Montenegro 17.7 16.1 15.2 15.1 17.9 n.a. n.a. n.a. Serbia 16.4 14.5 13.7 11.2 9.7 n.a. n.a. n.a. WB6 21.0 19.6 18.3 16.1 n.a. n.a. n.a. n.a. Source: World Bank calculations and projections on data from national authorities and World Economic Outlook. 106  | Key Economic Indicators Western Balkans Regular Economic Report No.20 | Fall 2021 View this report online: www.worldbank.org/eca/wbrer