THE WESTERN BALKANS REVVING UP THE ENGINES OF GROWTH AND PROSPERITY Report No. ACS22690 The Western Balkans: Revving Up the Engines of Growth and Prosperity © 2017 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The bound- aries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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Abbreviations and Acronyms 7STEEs Seven Small Transition Economies LITS Life in Transition Survey of EBRD of Europe LPI Logistics Performance Index ALB Albania LSMS Living Standards Measurement Study BEEPS Business Environment and Enterprise MENA Middle East and North Africa Performance Survey MICS Multiple Indicator Cluster Survey BIH Bosnia and Herzegovina MKD FYR Macedonia BIS Bank for International Settlements MNE Montenegro CAGR Compound Annual Growth Rate NACE Statistical classification of economic CEE Central and Eastern Europe activities in the European Community CEFTA Central European Free Trade Agreement (abbreviation of French name) CEQ Commitment to Equity NPL Non-Performing Loan CIT Corporate Income Tax OECD Organisation for Economic CMT Cut, Make, and Trim Co-Operation and Development CPI Consumer Price Index PAR Public Administration Reform CSC Citizen Service Center PEFA Public Expenditure and Financial DB Doing Business Accountability DVA Domestic Value Added PISA Programme of International Student EAP East Asia and the Pacific Assessment, OECD EBRD European Bank for Reconstruction PMI Purchasing Managers’ Index and Development PPG Public and Publicly Guaranteed (Debt) ECA Eastern Europe and Central Asia PPP Purchasing Power Parity ECAPOV Eastern Europe and Central Asia RER Regular Economic Report Poverty database SAA Stabilisation and Association ECFIN Directorate-General for Economic Agreements and Financial Affairs of the European SAS South Asia Commission SBS Structural Business Survey EU European Union SCD Systematic Country Diagnostic EXPY A measure of export sophistication SEE South East Europe FDI Foreign Direct Investment SEETO South East Europe Transport GCR Global Competitiveness Report Observatory GDP Gross Domestic Product SILC European Union Statistics on Income GFS Government Finance Statistics and Living Conditions GVA Gross Value Added SRB Serbia GVC Global Value Chain SSA Sub-Saharan Africa HBS Household Budget Survey UNDP United Nations Development ICT Information and Communication Programme Technology VAT Value Added Tax IFS International Financial Statistics WB6 The six countries of the Western ILO International Labour Organisation Balkans IMF International Monetary Fund WEF-GCR World Economic Forum’s Global KSV Kosovo Competitiveness Report LAC Latin America and The Caribbean WGI Worldwide Governance Indicators LCU Local currency unit WTO World Trade Organization LFS Labor Force Survey Contents Acknowledgements 7 EXECUTIVE SUMMARY 9 INTRODUCTION 13 A new beginning for the Western Balkans GROWTH Needed: A new, sustainable model to restore economic expansion 17 Despite past success, the six countries remain among the poorest in Europe and have grown more slowly after the global financial crisis. 19 Convergence to higher income is slowed by incomplete structural reforms. 19 Growth is volatile and vulnerable to external conditions. 20 Factors of production are under-utilized. 20 Low productivity is a high impediment to faster growth. 24 The region needs to shift to a more sustainable growth model. 24 The Western Balkans need faster structural change to rekindle growth. 28 WELFARE Greater affluence through more jobs, less dependence on state transfers 33 Economic growth before the global financial crisis was generally inclusive, but poverty reduction slowed post-crisis. 35 People in the Western Balkans need greater employment to drive sustainable welfare improvement, instead of relying on help from the state. 40 The poor and vulnerable need better access to health, education, and basic services if they are to improve their livelihoods. 43 LABOR Creating a place where more people work 51 Levels of employment are exceptionally low, driven by low labor force participation and high unemployment rates. 53 Informal employment is high. 53 Real wage growth has been constrained by low labor productivity growth in the post-crisis period. 54 The region lacks inclusive labor markets, resulting in widespread disparities in access to high-quality jobs across population subgroups. 54 Complex factors cause disappointing labor market outcomes. 55 High levels of non-labor income –remittances, pensions, and social assistance– can create disincentives to work. 56 Burdensome taxes and regulations discourage creation of formal jobs. 59 Workers in the Western Balkans often lack the skills needed in a modern integrated economy. 61 Disadvantaged groups face additional barriers to employment. 64 Labor markets need special policy attention. 66 INTEGRATION Taking a place in the world economy to drive growth and income convergence 71 Integration that was once brisk needs to accelerate again. 73 There is room to deepen integration among the Western Balkan countries, building on CEFTA. 74 The potential for upgrading quality and quantity of exports is high. 75 Western Balkan participation in global value chains is slowly rising. 79 To deepen trade integration, reforms should target bottlenecks to GVC participation. 83 Greater depth, stability, and efficiency in the financial sector would also facilitate trade. 84 Deepening regional integration will reinforce national reforms. 87 ENTERPRISE Creating an environment that nurtures private firms 91 An unfriendly business environment is holding back private sector development in the Western Balkans. 93 Stoking productivity is key to speeding up the Western Balkans’ economies. 94 The dynamics of labor allocation by sector or productivity is not efficient. 94 The business environment is improving, but private enterprise still needs and deserves better. 96 Modernizing old and unreliable infrastructure is crucial to helping private enterprise set up and prosper. 98 Further improvements in credit markets and regulatory environment will also help private enterprise. 100 THE STATE Building a state that enables, rather than impedes, a new growth model 103 The state needs to become a more effective enabler of private sector investment and growth. 105 Providing the right regulatory, legal and fiscal environment will spur business creation and growth. 106 Fiscal impediments are holding down private investment. 107 State funds should be spent more wisely and the quality of service delivery improved. 111 The state needs a higher capacity to deliver. 118 Can reforms succeed this time, and how? 119 CONCLUSION 123 BIBLIOGRAPHY 126 BOXES, FIGURES AND TABLES Box 1. The pace of reform: Comparing Latvia and the Western Balkans 21 Box 2. Structural change to date has not enhanced productivity 29 Box 2.1: Populations that are aging –and in some cases shrinking– mean challenges for economic growth 47 Box 3.1: Demand-side analysis is a critical knowledge gap, mostly due to lack of access to reliable firm-level data. 57 Box 3.2: Some lessons from Germany and Poland in supporting jobs for the bottom 40 percent 69 Box 6.1. Fiscal rules in the Western Balkans. 110 Box 6.2. Albania moves to clear arrears and establishing commitment controls 112 Box 6.3. Serbia is reforming its public wage system 114 Box 6.4. Albania moves toward e-government reform 118 Box 6.5. Tools allow weighing of the distributional impact of fiscal policy 119 Figure 1: Living standards increased two-to-six fold in 1995-2015, but they remain among the lowest in Europe 19 Figure 2: The economy grew fast, especially before the global crisis 19 Figure 3: The Western Balkans’ convergence to higher income per capita lags behind that of the 7STEEs 20 Figure 4: The 7STEEs overtook the Western Balkans in transition reforms early on 20 Figure 5: The structural component of growth is declining or, at best, stagnating across the Western Balkans 22 Figure 6: The structural component of growth declined or stagnated after the crisis, but the Western Balkans are not the only countries in this situation 23 Figure 7: The Western Balkans countries have trailed Europe and the global environment but with greater volatility 23 Figure 8: The region has low and poor-quality capital stock 23 Figure 9: Investment rates vary, and are generally below the 25 percent of GDP recommended for sustaining rapid economic growth 23 Figure 10: Savings have been broadly consistent with the countries’ level of income per capita 25 Figure 11: Reflecting high external deficits, countries have relied heavily on foreign savings 25 Figure 12: Output per employed worker is low compared to other transition economies 25 Figure 13: Consumption goods are over-represented in imports, an indication of poor investment quality 25 Figure 14: Total factor productivity is dragging down growth post-crisis 26 Figure 15: By country, TFP growth was either negligible or negative after the crisis 26 Figure 16: Strong consumption dominates GDP 26 Figure 17: In Kosovo, FDI is heavily concentrated in non-tradable sectors 26 Figure 18: The economies are rebalancing in the aftermath of the global crisis 27 Figure 19: Labor costs are starting to move more in line with productivity 27 Figure 20: Growth sources have only tentatively begun rebalancing from domestic demand to net exports in the countries that export manufactured goods 27 Figure 21: Evidence of public-private shifts is even more mixed 27 Figure 22: After the global crisis, unemployment grew or stagnated, except in FYR Macedonia, due to its active labor market policies 28 Figure 23: Fiscal balances mostly deteriorated 28 Figure 24: Public expenditure composition changed to accommodate the increase in current expenditures 28 Figure 25: New policies are needed in these four areas 31 Figure 26: Poverty declined pre-crisis but held steady post-crisis 36 Figure 27: Bottom 40 consumption often grew faster than consumption for all income groups 36 Figure 28: Growth was often the main contributor to poverty reduction prior to the crisis 37 Figure 29: Inequality remained stable in most Western Balkan countries 37 Figure 30: The Western Balkan countries have high rates of poverty relative to comparators 38 Figure 31: Life satisfaction is relatively low 39 Figure 32: Households that have escaped poverty are prone to becoming poor again during economic downturns 39 Figure 33: In Bosnia and Herzegovina, wages were the most important driver of income growth 40 Figure 34: In FYR Macedonia, increases in labor incomes at the bottom drove household income growth 40 Figure 35: Wages and pensions reduced poverty in Albania 41 Figure 36: Loss of employment and labor income drove poverty increase in Serbia 41 Figure 37: Share of labor income in the Western Balkans is relatively low 42 Figure 38: Transfers are an important source of household income 42 Figure 39: Only a fraction of the poor receive social assistance… 43 Figure 40: …even though more than half of social assistance spending reaches the poorest quintile 43 Figure 41: The Western Balkans have outstandingly high remittances compared to other regions 44 Figure 42: Roma people have particularly high levels of poverty 44 Figure 43: Stunting incidence is high among the Roma 44 Figure 44: Early childhood education attendance is low, particularly among the poor and Roma 45 Figure 45: Secondary education attendance is also low among the poor and Roma 45 Figure 46: The poorer the person, the lower the education 45 Figure 47: Poorer individuals also save less 45 Figure 48: High out-of-pocket health costs are sometimes the reason of falling into poverty 46 Figure 49: Many of the elderly are poor 48 Figure 50: Western Balkan employment levels are low and declining 53 Figure 51: Low employment rates reflect high inactivity and unemployment 54 Figure 52: Real wage growth slowed in the post-crisis period 55 Figure 53: Low growth of real wages since 2008 is primarily a concern in Albania and Serbia 55 Figure 54: Real wage growth has been even slower than productivity growth in the post-crisis period 55 Figure 55: Female, youth, and older workers (aged 40+) are particularly disadvantaged in accessing employment 56 Figure 56: There is a modest negative correlation between labor force participation and remittances 58 Figure 57: A strong positive correlation exists between remittances and unemployment 58 Figure 58: Pensions and remittances constitute a large share of GDP in the Western Balkans 58 Figure 59: Pensions are generous and many go to people below 65, creating potential disincentives to work 58 Figure 60: The public-sector wage premium varies by age groups 59 Figure 61: Public-sector employment has fallen in recent years, but remains high. 59 Figure 62: The tax burden is high for low-wage workers, suggesting low progressivity 60 Figure 63: Serbia and FYR Macedonia have the region’s least flexible labor markets 61 Figure 64: Protection of permanent workers against dismissal is strong in the Western Balkans, particularly in Montenegro 61 Figure 65: Temporary employment is closely regulated, especially in FYR Macedonia 61 Figure 66: The region has tough specific requirements for collective dismissal, especially Serbia and Montenegro 61 Figure 67: Minimum wages are binding in Albania 62 Figure 68: Lack of skills a particular problem for firms in Kosovo and FYR Macedonia 62 Figure 69: In human capital, Western Balkan education outcomes exceed other fast-growing, middle-income regions 63 Figure 70: But education quality leaves something to be desired 63 Figure 71: The Western Balkans have a large population living outside the home countries 64 Figure 72: Labor migration and brain drain are quite high in the Western Balkans, especially in FYR Macedonia and Bosnia and Herzegovina 64 Figure 73: The labor market demands workers with “new economy” skills; older workers risk skills obsolescence 65 Figure 74: Working-age populations are becoming smaller on average in the Western Balkan countries 66 Figure 75: The aging of the workforce is correlated with the lack of structural transformation 66 Figure 76: The share of young workers (15-24) in the working-age population is heading down... 67 Figure 77: …while the share of older workers (55-64) is rising 67 Figure 78: Stronger reformers benefit from increased employment and labor productivity, albeit with a lag 68 Figure 79: Rising labor productivity accompanies rising trade integration 73 Figure 80: The Western Balkans have achieved major financial integration, with room to grow further 74 Figure 81: The Western Balkans have broad potential to further expand trade 74 Figure 82: Strong export growth in the 2000-08 period slowed in the global crisis’ aftermath 75 Figure 83: The Western Balkan states doubled their combined share in the EU market between 2005 and 2014 75 Figure 84: Potential to increase regional integration 75 Figure 85: Western Balkan countries tend to export a small number of products to a small number of countries 77 Figure 86: In large countries of the region, manufactured exports dominate trade in goods… 78 Figure 87: …but upgrading to higher content of high technology and skill content is only starting. 78 Figure 88: High-skill technology-intensive exports remain low 79 Figure 89: Medium-skill technology-intensive exports have risen 79 Figure 90: Intermediate goods trade in Western Balkans and the 7STEEs: 2004 vs 2015 81 Figure 91: The Western Balkans’ parts and components trade grew faster than world and 7STEEs 82 Figure 92: The Western Balkans had mixed results in compound annual growth of gross exports and DVA growth embedded in gross exports in 2000-12 82 Figure 93: Real exchange rates were volatile in the 2000-15 period 84 Figure 94: Labor costs are lower than in the EU but higher than in low-cost Asia 84 Figure 95: Vigorous reforms in the Western Balkans... 85 Figure 96: ...still fell short of those in other small transition economies of Europe. 85 Figure 97: The Western Balkans are lagging behind 7STEEs on logistics performance 85 Figure 98: Financial sector assets are mostly in the banking sector 86 Figure 99: Credit and deposits vary country-to-country 86 Figure 100: Funding though deposits grew steadily… 87 Figure 101: …and now dominates the funding structure of banks 87 Figure 102: The transition from state to private ownership has been slow… 93 Figure 103: …yet private investment rates have remained robust. 93 Figure 104: FDI inflows have been strong, even during the crisis 94 Figure 105: In most Western Balkan countries, TFP has dwindled since the global financial crisis... 95 Figure 106: …subtracting from overall productivity growth. 95 Figure 107: Real labor productivity levels in 2015 were low compared to 7STEEs 95 Figure 108: And real annual labor productivity growth was slow 95 Figure 109: In Serbia, labor movement within sectors drove what productivity growth there was in 2009-14 96 Figure 110: The Western Balkans’ manufacturing sector is not cost-competitive or productive, even compared to the EU transition economies 97 Figure 111: Western Balkan countries remain a fair distance from the business environment frontier… 97 Figure 112: …and have sub-par rates of business entry density. 97 Figure 113: The Western Balkans states lag 7STEEs in ease of doing business. 98 Figure 114: The top five obstacles to doing business are similar in the Western Balkans and 7STEEs. 99 Figure 115: The 7STEE all outstrip the Western Balkan states in logistics quality 99 Figure 116: In other logistics indicators, the Western Balkans states are Europe’s low performers 99 Figure 117: Broadband penetration needs an upgrade 100 Figure 118: In quality of electricity, the Western Balkans rank behind most EU transition economies 100 Figure 119: The transition towards a market economy remains incomplete 105 Figure 120: For half the countries in the region, government spending to GDP is well above norms by income level 105 Figure 121: There is a long way to go on governance indicators. 107 Figure 122: Weak enforcement of contracts is dampening the business climate across the region 107 Figure 123: Fiscal deficits widened markedly in many countries after the global financial crisis 111 Figure 124: Government debt-to-GDP ratios have increased substantially, raising sustainability concerns. 111 Figure 125: Satisfaction with public services is low relative to spending levels 116 Figure 126: Satisfaction lags behind peer countries in social service delivery 116 Figure 127: Education spending to GDP lies within the range of regional peers 117 Figure 128: Health spending varies widely country-to-country 117 Figure 129: Concerns over corruption are high 120 Figure 130: At the current relative growth speed, it will take about 60 years for the Western Balkans to converge to the average EU level of income 130 Table 2.1: 2014 floods in Serbia increased poverty 39 Table 4.1: Composition of goods exported differs significantly among Western Balkan countries 78 Table 4.2: Western Balkan countries have a heavy burden of domestic regulation. 85 Table 6.1: Taxes on goods and services are relatively high as a share of GDP, and as a share of total revenues. 108 Table 6.2: Social security contribution rates are particularly high in Bosnia and Herzegovina, Montenegro, and Serbia. 109 Table 6.3: Wage bills account for a sizeable share of current spending, with social benefits also high in many of the countries 113 Table 6.4: The variation in overall spending levels corresponds closely to the size of social security spending 115 Acknowledgements The team was led by Ekaterina Vostroknutova and Trang Van Nguyen, and included Ashley Tay- lor, Jennifer Keller, Monica Robayo, Kazi Matin, Bojan Shimbov, Olasupo Olusi, Michelle Tejada, Suzana Petrovic, Georgia Harley, Sandra Hlivnjak, Alena Kantarovich, and Johanna Jaeger. Inputs from Lazar Sestovic, Sanja Madzarevic-Sujster, Dusko Vasiljevic, Hilda Shijaku, Agim Demukaj, Barbara Cunha, and other team members working on the Western Balkans are appreciated.The team is grateful for comments, at different stages of the report’s preparation, from Ron Hood, Andrew Dabalen, Edgardo Favaro, Jorge Araujo, Gonzalo Varela, Lada Strelkova, Maria Davalos, Cesar Cancho, Alexandru Cojocaru, Johannes Koettl, Timothy Johnston, Josefina Posadas, Zahid Hasnain, Tony Verheijen, Raymond Muhula, Srdjan Svircev, and Jonas Arp Fallov. Editing by John Burgess and administrative support from Mismake Galatis are appreciated. The team was guid- ed by Ellen Goldstein, Linda Van Gelder, Gallina Vincelette, Ivailo Izvorski, Luis-Felipe Lopez-Cal- va, Carolina Sanchez-Paramo, and John Panzer. N The Western Balkans: Revving Up the Engines of Growth and Prosperity EXECUTIVE SUMMARY The six countries of the Western Balkans region As the countries chart their future, they can draw today have a second chance for sustained growth inspiration and practical guidance from the so-called and prosperity. Albania, Bosnia and Herzegovina, 7STEE group —Bulgaria, Croatia, Estonia, Latvia, Kosovo, the Former Yugoslav Republic (FYR) of Lithuania, Slovak Republic, and Slovenia— the sev- Macedonia, Montenegro, and Serbia largely missed en small transition countries of Eastern Europe that their first. In the 1990s, as other small countries of are already members of the European Union. After Eastern Europe pressed forward with reforms and starting at income levels that were comparable, and began a rise toward affluence, parts of the West- sometimes even lower than those in the Western ern Balkans became embroiled in armed conflict. Balkans, they have achieved about 60 percent of After peace returned, the countries lagged in making Germany’s. structural changes to their legacy socialist systems and thus were vulnerable when the global financial The task ahead requires achieving the following crisis struck in 2008. Today their economies have broad goals: high unemployment and low growth. Poverty reduc- tion has stagnated. Per capita incomes stand on aver- 1. Government that is more efficient age at about a quarter of Germany’s. The region’s 18 and (in some countries) smaller. million people are yearning to restart convergence with the living standards of their neighbors in the The state retains an outsized role in Serbia, Monte- European Union. negro, and Bosnia and Herzegovina, both in spending and employment, a legacy of the old socialist order. They can do that with a comprehensive set of The private sector in the Western Balkans is smaller reforms. The fundamental challenges are to modify than that in the 7STEE countries. Operating behind the role of government in the economy, unleash the protective walls, state-owned enterprises crowd out potential of private enterprise, make better use of private initiative.They pay wages that are higher than labor and human capital, and integrate deeply with in the private sector, yet operate with lower produc- the EU and global economy, all the while maintaining tivity, distorting labor markets, rewarding subpar per- macroeconomic stability. Demand needs to rebal- formance, and indirectly strengthening the region’s ance away from inward and toward outward. With large informal economy. Privatizations have turned proper reforms, the region can raise productivity, some of these plants into successful companies— improve infrastructure, and foster an environment in Fiat’s revival of Serbia’s Zastava car maker is a prime which more people work (currently less than half of example—but more such conversions are needed. working-age people actually do). At the same time, the region needs to pay special attention to the wel- But most important, the state needs to become a fare of groups that suffer particular hardships —the more efficient and reliable provider of services. In poor, women, youths, older workers, and ethnic Albanian hospitals, for instance, about 35 percent minorities— so that growth is inclusive and pro-poor. of staff are non-medical personnel. Social spending E xec u t i v e S u m m a ry IX has remained at unsustainable levels. Better tar- access to education, health care, and public services geting would allow gross spending to come down is critical if the poor and vulnerable are to improve while protecting segments of society that are most their livelihoods. Better coverage of poverty-target- in need. In countries where state spending is large, ed social assistance would help more of them meet reductions in it would relieve pressure on strained basic needs and cope with shocks. Policies that could fiscal accounts and reduce debt. remove women’s barriers to employment include greater child and elderly care, flexible work arrange- This would help governments provide a stable mac- ments, and stronger labor market programs. roeconomic environment for the private sector to grow. The global financial crisis precipitated GDP 3. A friendly atmosphere for private contractions in several countries in the region, with enterprise. Serbia experiencing three separate recessions. As a result, fiscal accounts destabilized, deficits grew, and Government in the Western Balkans should be an debt levels increased. While in most countries stabil- enabler, not a driver of economic growth. It can ity has returned, continuing high levels of debt and achieve this new role by overhauling the many leg- often depleted buffers leave countries more vulner- acy policies and institutions that discourage private able to external shocks. enterprise. 2. Greater employment and A key constraint to operating a private firm in the opportunities for increasing people’s Western Balkans is finding the right employees. The well-being. allure of the higher wages and security of public employment keeps qualified applicants away from Better job opportunities, rather than reliance on the private companies—surveys show that a govern- state for support, is paramount for creating great- ment job is the preferred kind of employment for er affluence overall. It is especially important in a most people. The region’s schools and technical region whose population is aging rapidly, creating a colleges often teach outdated skills, while people progressively larger class of older citizens who are who do get a good education often emigrate due supported by the productive ventures of young- to the dim prospects at home. The region needs to er ones. Yet labor income in the Western Balkans pay added attention to creating an education system accounts for only about half of total household that equips graduates with the modern skills that income, reflecting low labor market engagement. today’s employers are looking for. Therefore, reforms need to remove a number of labor market barriers. The region’s extensive social Poor services are another important drag on devel- security programs often undermine formal employ- opment. Power failures are common in the Western ment, with its long-term better wages and greater Balkans countries; the region’s roads and bridges productivity. High payroll taxes, disproportionately need upgrading. Broadband Internet access, increas- affecting low-wage low-skill workers, may cause ingly an underpinning of economic efficiency, remains employers and employees alike to prefer informal well behind levels in the EU in many parts of the arrangements where those taxes go unpaid. Pension region. A sluggish and often unpredictable court sys- systems that allow early retirement and unemploy- tem makes many business people wary—in Serbia it ment programs that come with free health insur- takes about 635 days to enforce a contract. Overall, ance are among the region’s many potential dis- the region needs to shake up a bloated administra- incentives to work. Skill gaps and mismatches also tive system that impedes such basic economic activi- hold back employment. ties as registering a business and clearing a shipment through customs. Specific social groups suffer disproportionate hard- ship. Women consistently have higher rates of unem- 4. Greater integration. ployment than men. Members of the Roma com- munity rank far below populations at large in such The experience of the 7STEE countries has con- measures as income, education, and access to health firmed that the best route to prosperity for small care. The poor have lower access to education countries is to integrate with the global economy. It than the well-off. Going forward, ensuring equitable is not only a question of selling into overseas mar- X The Western Balkans: Revving Up the Engines of Growth and Prosperity kets, but tapping into overseas investment, expertise, er skill levels in the labor force, productivity could and economies of scale. also be enhanced by reforms that make it easier for workers to move between firms, sectors, and The Western Balkans states have made brisk prog- geographic regions where economic activity is more ress on integration in the financial sector. But in oth- efficient and remunerative. er sectors the region has a long way to go. This is especially true for trade in goods and services, which All told, a rebalancing away from domestic con- would thrive with deeper integration into global val- sumption and towards an increased role for invest- ue chains. While four countries in the region now ment and exports would create a more sustain- have trade equal to about 100 percent of GDP, that able growth model. But key to making any of these remains well below the 140 percent average rates reforms work will be improvements in the quality of among the 7STEEs. Western Balkans exports tend public administration. It is not only low efficiency that to be heavy on agriculture, minerals, and metals. The is the barrier. Corruption and malfeasance are com- region could increase the total value of goods and mon in the Western Balkans and are rarely punished services sent abroad by increasing export sophisti- in court. Public opinion polls show consistent worry cation. Becoming a more important part of global over the “capture” of state institutions by private or value chains would take them well along that path. political interests. Government must find the political will to build trust, both with the region’s own people A key challenge in the region is that aggregate labor and with those abroad who are eager to take part productivity is stuck at less than half the levels in the in an historic advance of prosperity. 7STEEs. Foreign partners’ technology and expertise can help drive these figures up. In addition to high- E xec u t i v e S u m m a ry XI XII The Western Balkans: Revving Up the Engines of Growth and Prosperity INTRODUCTION A New Beginning for the Western Balkans How can the countries of the Western Balkans resume high growth and ensure sustained improvement in welfare for all citizens? Answering this question is crucial to the future investment financed apartment blocks and shopping of the 18 million people who live in the six centers, not export factories and their attendant countries of the Western Balkans (the WB6)— higher productivity. Growth stagnated; large num- Albania, Bosnia and Herzegovina, Kosovo, the bers of people who had climbed out of poverty fell Former Yugoslav Republic (FYR) of Macedo- back into it. Nine years after the global crisis, unem- nia, Montenegro, and Serbia. They have achieved ployment holds stubbornly to rates between 17 and major gains in growth, poverty reduction, and struc- 35 percent, with youth unemployment nearly dou- tural reform since socialism ended in the 1990s, yet ble the average. now find this progress has stagnated. They live on incomes that are roughly 25 percent of what peo- The countries continue to lag on key reforms ple enjoy in Germany. They have far higher rates of to create durable, outward-looking growth and unemployment, and lower quality of health care and substitute private enterprise for the social- education. Electric power and Internet connections ist legacy of government as the key driver of are often haphazard. Corruption and inefficiency in the economy. State-owned enterprises retain an government are common. Economic crises are fre- outsized footprint in the economy. Bureaucracy and quent. All of these conditions have helped build in high social taxes discourage formal employment Western Balkans society a yearning for a new path and the launch of private companies. Skill sets that that would restore convergence toward the higher served workers well in socialist days have not been living standards of the EU. upgraded to fit today’s demands; broad social assis- tance programs and early pensions often encourage Following the armed conflicts of the 1990s, the dropping out of the labor force. Millions of people, countries achieved a burst of economic growth among them some of the best-educated, have cho- that outstripped rates of neighboring coun- sen to emigrate in search of better fortunes abroad. tries. The expansion was pro-poor, with people in the bottom 40 percent of the income distribution In charting their future, the Western Balkan rising faster than the average. But the financial crisis countries can look to the experience of seven that hit the globe in 2008 exposed the vulnerabil- of their neighbors, the so-called 7STEEs (seven ities of that growth model. It depended too much small transition economies of Europe): Bulgar- on inward-oriented consumption and not enough ia, Croatia, Estonia, Latvia, Lithuania, Slovak on global and regional integration. Too often, foreign Republic, and Slovenia. Several of these countries I n t ro d u c t i o n 13 started their transitions at roughly the same time state-owned enterprises to end the crowding as the Western Balkans but today are well ahead out of the private sector will be the most difficult in the convergence process. They have sustained tasks. Reforming labor markets, which are saddled strong gains in GDP and employment through effi- with high inactivity rates, widespread informality, cient integration into the world economy—vibrant and limited job mobility, will help raise productivity trade in goods and services and wise use of for- growth. Improving governance and transparency in eign capital. Using favorable external conditions to public institutions, particularly the courts, will make their advantage, the seven made strides in combin- foreign investors more willing to risk their funds in ing West European technology and investment with the region. A friendlier business climate for private their own capable workers. They adopted policies enterprise accompanied by deeper integration with and developed institutions that promoted economic EU and global markets will shrink unemployment integration and outward-oriented growth. and raise incomes. This report explores the mix of policies that Overall, the goal is to rebalance growth from will allow the Western Balkans states to fol- consumption to investment, from domestic low in their neighbors’ path.1 The region has demand to international, and from public to major potential that can bloom with the right private. Action is required on multiple fronts and reforms. Reducing the size of the state in several in many cases will be politically challenging. But each countries, to bolster fiscal sustainability, increas- reform will hold the potential to build on the others ing the quality of public services, and restructuring and after delays that have extended too long put the Western Balkans back on the path to convergence. 1 This report draws on the five World Bank Systematic Country Diagnostic (SCD) reports: World Bank. 2015. “Albania: Systematic Country Diagnostic.”; World Bank. 2015d. “Rebalancing Bosnia and Herzegovina: A Systematic Country Diagnostic.”; World Bank. 2016c. “Republic of Kosovo: Systematic Country Diagnostic.”; World Bank, 2016a. “Montenegro Systematic Country Diagnostic: Achieving Sustainable and Inclusive Growth amidst High Volatility.”; World Bank. 2015f. “Serbia’s Potential for Sustainable Growth and Shared Prosperity: Systematic Country Diagnostic.” 14 The Western Balkans: Revving Up the Engines of Growth and Prosperity 16 The Western Balkans: Revving Up the Engines of Growth and Prosperity GROWTH Needed: A new, sustainable model to restore economic expansion For small countries like the Western Balkans six, finding a place in global or regional production chains is fundamental for future growth and prosperity. Serbian car maker Zastava offers an example of what’s possible. Known in the ‘80s and ‘90s for the breakdown-prone Yugo sedan, Zastava was bought by the Fiat group in 2008. The new owner poured more than a billion euros of investment into the aging production lines destroyed by war, provided vital technical expertise, and hooked the company into its global network of supply and sales. Zastava is today producing more than 200,000 modern, reliable vehicles a year, and exporting to the European Union and United States. The impact extends far beyond Zastava. Bosch and other international companies set up in Serbia to supply parts to the factory and look set to expand and export to the rest of Europe and other foreign markets as well. Exports of the Serbian automotive industry have already increased almost tenfold since the 1990s. Openness to the outside world is driving this expansion, also indicating the upgrading of the sources of growth. Cumulative foreign direct investment in Serbia had reached 13.5 billion euros over 2009-16, helping accelerate GDP growth rates that had stagnated for a decade following the global financial crisis. Serbia can present challenges to foreign investors such as formidable paperwork. But the Zastava/Fiat experience shows that these can be over- come to reap major economic success. G ro w t h 17 1 How fast have Western Balkan countries converged to higher levels of income, and how has this performance compared to countries with similar backgrounds? The Western Balkans achieved fast GDP and exports growth before the global financial crisis, starting from very low levels. While this drove some convergence in income per capita, the levels have now stagnated at around 25 percent of Germany’s. This compares to about 60 percent in the seven small transition economies in Europe. 2 What progress have the six countries made to date in abandoning the legacies of the past and becoming efficient and modern open economies? The region’s growth model before the global financial crisis was based on consump- tion fueled by capital inflows. Rebalancing toward a more outward- and private invest- ment-oriented growth model is necessary to speed up convergence in income. Struc- tural reforms in that direction remain incomplete. 3 What are the key directions of further reform that could close the income and policy gaps with countries of the European Union? Reforms to support sustainable rebalancing concern governance, labor markets, busi- ness environment, and integration with the global and regional economies. Together these steps can reduce the importance of the state and harness the dynamism of the private sector to bring higher standards of living to the region. 18 The Western Balkans: Revving Up the Engines of Growth and Prosperity The Western Balkans have come a long way did better: in 1995 Latvia and FYR Macedonia both since the start of transition. Beginning from a low stood at about 24 percent of Germany’s income per level in 1995, living standards2 had by 2015 increased capita. In 2015, Latvia’s had caught up to more than almost six-fold in Bosnia and Herzegovina, nearly tri- 50 percent of Germany’s level while FYR Macedo- pled in Albania, and almost doubled in Serbia (Fig- nia’s remained at around 30 percent. Generally, the ure 1). Before the global financial crisis, the region’s 7STEEs have been more successful than the Western countries grew faster than world and EU averages Balkans in converging to higher standards of living. and lagged only slightly behind the 7STEE countries, leveraging favorable external conditions to advance Convergence to higher income is at a median 5.6 percent per year (Figure 2). slowed by incomplete structural reforms. Despite past success, the six countries remain among the poorest in Europe In transition economies, the pace of implemen- and have grown more slowly after the tation of the structural reform agenda has been global financial crisis. a key determinant of the speed of income con- vergence. Across Eastern Europe, the transition to Median growth in the region slowed to 2.4 per- a market economy has led to a smaller footprint for cent on average in 2009-15. Though they remain the state and to economic liberalization. But in the among the poorest countries in Europe, the Western Western Balkans, the necessary reforms have come Balkans aspire to membership in the European Union. into force later and at much slower speeds. In several countries, armed conflict and the subsequent struggle Overall, the Western Balkan region has been toward recovery delayed these important changes. converging to higher standards of living slow- In general, the Western Balkan states are now at the er than some of its neighbors. While the region’s same place in transition reforms as the 7STEEs were countries impressively raised their per capita income in 1996 (Figure 4). This has held them back: overall, from 17 percent of Germany’s in 1995 to 27 per- structural reforms and growth have had a strong cent in 2015 (Figure 3), other transition countries association during post-communist transitions.3 Figure 1: Living standards increased two-to-six fold Figure 2: The economy grew fast, especially in 1995-2015, but they remain among the lowest before the global crisis. in Europe. (GDP growth rate, percent per annum) (Income per capita, thousands of US$, 2011 PPP) OECD members Median GDP growth European Union 12 Czech Republic Poland Hungary 8 6.0 5.9 5.6 Romania 4.9 4.7 4.6 Estonia 3.8 4 2.2 2.7 2.4 Slovenia 1.6 1.3 Slovak Republic 7STEE Lithuania 0 Latvia Croatia Bulgaria -4 World Upper Middle Income -8 Montenegro Serbia FYR Macedonia WB6 -12 Albania UMC 7STEE WB6 EAP World EU UMC EAP World WB6 EU 7STEE Bosnia and Herzegovina Kosovo ARM, GEO, MDA, UKR 2000-08 2009-15 0 10 20 30 40 50 2015 1995 Source: World Development Indicators and World Bank sta calculations. Source: World Development Indicators, Eurostat, national authorities, and World Bank sta calculations. 2 Measured by per capita GDP in 2011 international purchasing 3 power parity terms, as shown in World Development Indicators. Falcetti et al. 2006. G ro w t h 19 Figure 3: The Western Balkans’ convergence to higher Figure 4: The 7STEEs overtook the Western Balkans income per capita lags behind that of the 7STEEs. in transition reforms early on. (GDP per capita as share of Germany’s, international (EBRD transition score, index) 2011 PPP US$, percent) 70 4.0 62 60 3.5 50 3.0 40 34 2.5 30 27 2.0 WB5 7STEE 20 17 10 1.5 0 1.0 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 Source: EBRD and World Bank sta calculations. KSV SRB MNE MKD Note: WB5 is WB6 excluding Kosovo, due to a lack of data for that country. The score BIH ALB LVA ranges from 1 (large transition gap, or challenge ahead), to 4+ (a negligible gap). The Median WB6 Median 7STEE indicator is the average of six sub-indicators: large-scale privatization, small-scale privatization, governance and enterprise restructuring, price liberalization, trade and foreign exchange system, and competition policy. Improvement in the indicator is Source: World Development Indicators and World Bank sta calculations. measured as the di erence in the score between two points in time. Today the Western Balkans have mostly com- in their economies, which are more prone to exter- pleted reforms in price and trade liberalization, nal shocks than their neighbors (Figure 7). This puts but continue to drag in privatization, gover- the Western Balkan states at a disadvantage that is nance, enterprise restructuring, and competi- bound to affect their income convergence in the lon- tion policy. In addition to slowing income conver- ger term. Continued anemic growth in the European gence, the incomplete state of reforms took another Union and globally will make it harder for economic toll during the financial crisis of 2008. Countries that activity to pick up in the Western Balkans. had implemented advanced structural reforms and prudent fiscal management suffered shorter and less Factors of production are under- severe currency depreciations and stock market crises. utilized. Growth is volatile and vulnerable to The stock of capital is low and investment is external conditions. below benchmarks. The wars and mismanage- ment of resources destroyed a significant pro- While growth has been high on average, it has portion of the region’s productive capital. Indirect also been volatile and vulnerable to external measures suggest the quality of capital stock is also conditions. The structural component of growth low, placing the former Yugoslav republics in the has been declining or stagnating in most Western lower-left quadrant of Figure 8. The rate of build- Balkan countries, a trend that started long before the up of this depleted capital stock has lagged behind global financial crisis (Figure 5). Kosovo and Monte- countries with comparable income per capita. negro’s potential output has become flat, with the Average investment ratios in 2009-15 ran the range crisis having had only minor role. Among the other from 18 percent of GDP in Bosnia and Herzegov- four countries, the decline in potential output since ina to 28 percent in Albania. On average, this was the early 2000s has only tentatively reversed itself in below the 25 percent of GDP minimum threshold Bosnia and Herzegovina and Serbia. The deceleration recommended for sustained high growth by the has impacted the middle-income countries of Europe World Bank’s Commission on Growth and Devel- more heavily than those in other regions (Figure 6). opment, and well below similar-income country But while this dynamic has not been unique to the averages of above 31 percent (Figure 9).4 These Western Balkans, unfavorable external conditions are inefficiencies hamper the usual positive correla- adding to the already weak domestic growth drivers 4 Commission on Growth and Development. 2008. 20 The Western Balkans: Revving Up the Engines of Growth and Prosperity Box 1. The pace of reform: Comparing Latvia and the Western Balkans. In 1996, Latvia, a strong performer in the 7STEE group, had an income per capita close to that of FYR Macedonia (their GDP per capita in PPP terms was at around 30 percent of European Union’s). But unlike FYR Macedonia or other countries in the Western Balkans, Latvia front-loaded the critical mass of the most difficult reforms, allowing it to quickly unlock its growth potential. The reform package spanning over two decades included macroeconomic stabilization, trade and prices liberalization, and privatization. The first generation reforms included land restitution and enterprise reforms, to set up stage for a private-sector driven economy. Second generation reforms dealt with social security system, and were followed by legislative harmonization with the EU. The currency peg worked well in stabilizing inflation, maintaining monetary credibility, and facilitating trade with the EU. At the micro level, the authorities eliminated a number of enterprise and price subsidies and introduced a simplified tax system that consisted only of a value added tax, flat personal income and corporate taxes, and social security contributions. The investment climate improved significantly. Latvia harmonized many of its laws with EU legislation, streamlined business registration and construction permits, and improved business inspections. Year after year, the Doing Business report shows newly implemented reforms improving Latvia’s its business environment. In 2017, the country occupied 14th overall place in the ranking of 189 countries assessed, and 22nd on the ease of starting a business. As a result, Latvia doubled its GDP per capita between 2000 and 2015 as it became an open economy able to boost exports to achieve growth, and allowing it to catch up with EU levels of income faster than the average of the 7STEEs. Latvia is now continuing to make progress on reforms under the “Europe 2020” strategy. The countries of the Western Balkans have made significant progress, but deeper structural transformation is still needed to speed the catch-up. (Transition indicators and income convergence) (Selected transition indicators) 4.5 4.0 4.0 3.5 7STEE 1996 3.5 average 3.0 EBRD transition score 2.5 3.0 2.0 2.5 1.5 2.0 1.0 1.5 0.5 1.0 0.0 0 10 20 30 40 50 60 70 80 WB6 Latvia WB6 Latvia WB6 Latvia GDP per capita (percent of EU level) Competition Policy Governance and Large scale enterprise restructuring privatisation ALB (from 1990) BIH (from 1994) MKD (from 1990) MNE (from 1996) SRB (from 1995) LVA (from 1995) 1996 2014 7STEE 1996 7STEE 2014 WB5 (from 1996) 7STEE (from 1996) Sources: World Development Indicators, EBRD, and World Bank sta calculations. Note: The score ranges from 1 to 4+, where 1 represents a large transition gap (or challenge ahead), and 4 a negligible gap. The indicator is calculated as the average of six sub-indicators: large-scale privatization, small-scale privatization, governance and enterprise restructuring, price liberalization, trade and foreign exchange system, and competition policy. Improvement in the indicator is measured as the di erence in the score between two points in time. Two decades later, Latvia’s income per capita is 65 percent of EU’s, while that of FYR Macedonia is at 35 percent. In the Western Balkans, the pace of reforms has been much slower. The reforms have followed similar patterns as in the 7STEEs, but were not front-loaded and continued at a much slower pace. The biggest gains on price liberalization, trade, foreign exchange management, and small-scale privatization took place in the 1990s. However, the critical mass of reforms in competition policy, governance and enterprise restructuring, and large-scale privatization—which are more difficult to achieve—came later and are still incomplete. The privatization process was uneven across countries and while sectors such as telecommunication, banking, and energy moved faster, large public enterprises have been problematic to restructure. Progress was limited by unclear ownership rights, selling to insiders, weak governance, and price controls. While great strides have been made (notably, by FYR Macedonia), greater effort is needed to make the economies more business-friendly, with Doing Business ranking ranging between 10th (FYR Macedonia) and 81st place (Bosnia and Herzegovina). Source: World Development Indicators, EBRD, Doing Business, and World Bank staff calculations. G ro w t h 21 Figure 5: The structural component of growth is declining or, at best, stagnating across the Western Balkans. 10 Albania 10 Bosnia and Herzegovina 8 8 6 6 4 4 2 2 0 0 -2 -2 -4 -4 -6 -6 2001 2003 2005 2007 2009 2011 2013 2015 2001 2003 2005 2007 2009 2011 2013 2015 Structural Cycle Real GDP Structural Cycle Real GDP 10 Kosovo 10 Montenegro 8 8 6 6 4 4 2 2 0 0 -2 -2 -4 -4 -6 -6 2001 2003 2005 2007 2009 2011 2013 2015 2001 2003 2005 2007 2009 2011 2013 2015 Structural Cycle Real GDP Structural Cycle Real GDP 15 FYR Macedonia 10 Serbia 8 10 6 5 4 2 0 0 -2 -5 -4 -10 -6 2001 2003 2005 2007 2009 2011 2013 2015 2001 2003 2005 2007 2009 2011 2013 2015 Structural Cycle Real GDP Structural Cycle Real GDP Source: World Bank sta estimates based on World Development Indicators, Eurostat, and national authorities' data. Note: Growth components are calculated using Hodrick-Prescott (HP) lter. Structural component of growth presents a smoothed estimate of the long-term trend, while cyclical component refers to short-term uctuations. tion between investment and economic growth. Domestic savings have been growing in the Consequently, even in countries with relatively Western Balkans, but reliance on foreign high investment ratios, there is a need for strong financing has been exceptionally high. Average public investment to improve business-related and savings in the region have been broadly consistent connectivity infrastructure. But given the strain on with the countries’ level of income per capita (Figure the region’s national budgets, public investment 10). There has been growth in domestic savings, with will grow slowly. It is all fur ther evidence that the private savings playing an increasingly important role. private sector will need to play a bigger role in the Where domestic savings were not sufficient, foreign region’s economies. savings helped to fill the investment gap (Figure 11). 22 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 6: The structural component of growth Figure 7: The Western Balkans countries have declined or stagnated after the crisis, but the Western trailed Europe and the global environment but Balkans are not the only countries in this situation. with greater volatility. (Growth rates of structural component of GDP) (Average growth rates) 14 64 8 7 9 59 6 5 4 4 54 3 2 -1 49 1 0 -6 44 2002 2004 2006 2008 2010 2012 2014 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 WB6 average growth EU average growth KSV MKD BIH MNE ALB SRB 7STEE UMC average growth Global Composite PMI (+50=expansion, rhs) Source: World Bank sta estimates based on World Development Indicators, Eurostat, Source: World Development Indicators, Eurostat, Haver, and World Bank sta and national authorities' data. calculations. Figure 8: The region has low and poor-quality Figure 9: Investment rates vary, and are generally capital stock. below the 25 percent of GDP recommended for (Quality of infrastructure on scale of 1 to 7=best sustaining rapid economic growth. and capital stock as percent of GDP, 2013) (Gross fixed capital formation, in percent of GDP) 7 40 Quality of overall infrastructure (1 to 7, best) 6 35 UMC average (2009-15) LTU EST 5 HRV 30 UMC average (2000-08) SVK 25 4 MNE ALB SRB BRG 20 3 BIH 15 2 10 1 5 0 0 0 100 200 300 400 ALB KSV MKD MNE SRB BIH WB6 7STEE EAP LAC Capital stock (percent of GDP) All countries WB6 7STEE 2000-08 2009-15 Source: World Development Indicators, IMF, Global Competitiveness Index, and World Source: World Development Indicators, Eurostat, national authorities, and World Bank Bank sta calculations. sta calculations. Note: The dashed lines cross at the median on each axis. Large capital inflows in the pre-crisis period financed determining improvements of household per cap- investment that was substantially in excess of nation- ita income and standards of living. The ability of an al savings to generate higher growth, but this also economy to provide good, well-paying jobs for its meant high external borrowing, both by the private people is a key measure of overall development sector and governments. performance. In order to accelerate per capita income convergence, the Western Balkans need Labor force participation levels and demogra- well-functioning labor markets that make efficient phy have worked against growth. Labor is a key use of labor and enable all citizens to participate factor in production, with labor outcomes largely in the growth process. Yet today only half of the G ro w t h 23 working-age population in the Western Balkans To achieve high growth, the region would need on average participates in the labor market, and to overcome not only government capital con- a quarter of people seeking jobs fail to find them. straints and high labor inactivity, but also rising Most of the unemployed are idle long-term. Strict total factor productivity (TFP).5 It would take a employment rules protect insiders, make the labor long time and vigorous reforms to tackle the region’s market less competitive overall, and disproportion- high structural unemployment. Improvements in the ately hurt younger people and new entrants. The capital stock will also take time to bear fruit. It is social benefit systems may discourage people from clear that without improvements in the efficiency seeking low-wage and part-time work. A high labor with which the factors of production are utilized, tax “wedge” discourages creation of formal sector high growth will be very hard to achieve in the jobs. Early access to pensions, meanwhile, reduces Western Balkans. After the global financial crisis, the employment among older workers. All of these TFP dynamic actually subtracted from growth on constraints have considerable costs in efficiency and average in the region (Figure 14 and 15). equity, holding back economic growth, and are dis- cussed in more detail in the Labor chapter. The region needs to shift to a more sustainable growth model. Low productivity is a key impediment to faster growth. The current economic model in the Western Bal- kans relies heavily on consumption. Consumption Productivity is determined by the quality of represents close to 100 percent of GDP in the West- the factors of production and efficiency of ern Balkan states, compared to 78 percent in both the their use. We can think of productivity—output 7STEEs and the European Union as a whole. At the per worker—as growing from three elements: same time, exports are lower than what they could quality of human capital (the skills and health of have been, as the experience of neighboring countries workers), quality of physical capital (the tools shows (Figure 16). While consumption will continue to and facilities of production), and the efficiency play an important role in the Western Balkans, given in harnessing the two forms of capital. Efficiency, their level of economic development and their grow- or total factor productivity, reflects how well a ing middle class, overreliance on consumption limits country harnesses the physical and human capi- incentives to move up in the production chain and tal it has, through such processes as technology become competitive in international markets. Many adoption, product innovation, the sharing of know- factors have combined to create the current situation: how between firms and sectors, and the mobility the often unfriendly business environment, fiscal limita- of workers. If efficiency is slow, returns on capi- tions, fragile macro stability, paternalistic government, tal are low as well, reducing incentives to invest and reliance on social and foreign transfers. Prolonged in new equipment, infrastructure, and schooling. periods of high external deficits that are financed by Lower returns in turn slow capital accumulation. capital inflows tend to undermine future growth by In contrast, higher efficiency can raise productivity changing the incentive structure in the private sector. by improving returns on existing investments and For instance, overly large shares of pre-crisis foreign motivating investors to put increased capital into direct investment went to less productive sectors, such new factors of production. as real estate (Figure 17). 5 The growth accounting exercise is based on the Solow model Aggregate labor productivity in the Western and covers data for 2000–14. Despite its many well established Balkans is less than half that in other small tran- caveats, this simple exercise can provide some intuition about the main drivers of GDP growth during the last 15 years. Annual sition countries of Europe. Output per worker (a GDP is assumed to be a function of the aggregate physical capital proxy for labor productivity at the economy-wide stock (K) and labor (L), following a Cobb-Douglas technology. In the absence of consistent employment data for all countries, level) is substantially lower than in most 7STEE the working-age population (age 15–64) is used as a proxy for countries (Figure 12). Low quality of human capital labor. In the absence of data on capital stocks, physical capital is estimated through a highly simplified perpetual inventory method. is one factor contributing to this: PISA scores are 20 In this simple growth accounting exercise, TFP includes the main percent lower than those in the OECD. Investment component—efficiency with which the economy uses the main factors of production—but likely also hides the impact from a quality is also low, by some indirect measures, such combination of factors including skills and labor under-utilization as under-representation of consumption goods in (i.e. converting the working-age population into employed human capital).This enables factors that affect the overall efficiency of the imports (Figure 13). economy, as well as technological progress. 24 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 10: Savings have been broadly consistent Figure 11: Reflecting high external deficits, with the countries’ level of income per capita. countries have relied heavily on foreign savings. (GVA per worker, truncated, and gross capital formation (In percent of GDP) per worker, 2015) 15 30 13 25 (thousands of constant 2010 US$) 11 20 SVK 9 EST SVN Capital per worker 15 SVK SVN 7 HRV KSV 10 5 MKD MNE LVA LTU 5 3 ALB SRB BGR HRV EST 0 1 LVA BIH LTU -5 2008 2015 2008 2015 0 BGR -1 0 10 20 30 40 50 60 WB6 7STEE Output per worker (thousands of constant 2010 US$) Gross domestic savings Gross external savings Total WB6-2015 7STEE-2015 7STEE-1996 Source: IMF, World Development Indicators, Eurostat, national authorities, and Source: World Bank sta estimates, based on World Development Indicators, World Bank sta calculations. Eurostat, and national authorities' data. Figure 12: Output per employed worker is low Figure 13: Consumption goods are over-represented compared to other transition economies. in imports, an indication of poor investment quality. (GVA per employed worker 2015, in 2010 US$) (In percent of total goods imports) 100% 7STEE 90% WB6 80% 70% 60% KSV 50% MNE 40% 30% BIH 20% SRB 10% 0% MKD 2000-08 2000-08 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2009-15 2009-15 2000-08 2009-15 ALB 0 5 10 15 20 25 30 35 ALB BIH MKD MNE SRB WB5 7STEE consumption 7STEE intermediate 7STEE capital Consumption Intermediate Capital Source: World Development Indicators, Eurostat, national authorities, and World Bank Source: COMTRADE and World Bank sta calculations. sta calculations. Note: WB5 is WB6 excluding Kosovo. A rebalancing towards an increased role for and imports, which raised net exports (Figure 18). investment and exports in the economy would As a result of these shifts, labor costs moved more create a more sustainable growth model. The in line with productivity, improving competitiveness global crisis forced a rebalancing of the sources of (Figure 19). growth. As happened in many European countries, it led to a sudden stop in the flows of capital from But rather than by stronger export perfor- abroad. A subsequent waning of optimism led to mance, the rebalancing has been often driven slower growth and a reduction in domestic demand by a reduction in economic activity, imports, G ro w t h 25 Figure 14: Total factor productivity is dragging Figure 15: By country, TFP growth was either down growth post-crisis. negligible or negative after the crisis. (Contributions to growth, percentage points) (Contributions to growth, percentage points) 6 10 5 8 4 6 3 4 2 2 1 0 0 -2 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 -1 -4 2000-08 2009-14 ALB BIH KSV MKD MNE SRB WB6 Capital stock Working age population Capital stock Working age population Human Capital TFP GDP Human Capital TFP GDP Source: World Bank sta estimates, based on World Development Indicators, Eurostat, Source: World Bank sta estimates based on World Development Indicators, Eurostat, and national authorities' data. and national authorities' data. Figure 16: Strong consumption dominates GDP. Figure 17: In Kosovo, FDI is heavily concentrated (GDP composition in percent of total GDP, in non-tradable sectors. average 2009-2015) (Jobs created by FDI projects in Kosovo) 140 4000 120 3500 3000 100 2500 80 2000 60 1500 40 1000 20 500 0 0 KSV MNE BIH ALB MKD SRB WB6 7STEE IRL EU28 Real Estate Agribusiness Services Business Automotive & OEM Metals Financial Industrial Machinery Consumer Electronics Sevices Private consumption Public consumption Im Imports Public investment Private investment Exports E Source: World Development Indicators, Eurostat, national authorities, and World Bank Source: World Bank 2017a. "Kosovo Country Partnership Framework." sta estimates. and investment (Figure 20). Only the manufac- Internal imbalances also worsened after the turing exporters were able to increase exports, crisis, suggesting that the countries have yet especially in Serbia (by more than 20 percent over to implement proper policies to sustain the eight years). Serbia was also the only country to also adjustment. In a sustainable rebalancing towards increase imports, indicating a rebalancing in the right higher exports, domestic imbalances such as high direction. In the other countries, higher net exports unemployment and fiscal deficits should also fall as were due to a fall in imports, most likely driven by private firms grow, demand-side constraints in the lower consumption. Moreover, the fall in domestic labor market decline, and more revenues flow in. demand reflected, to a large degree, a fall in invest- But in the Western Balkans, unemployment either ment, except in FYR Macedonia. The evidence of a grew or stagnated at high levels, undermining the shift towards a more private-sector driven economy durability of the potential rebalancing of the sources has been even more mixed (Figure 21). of growth towards exports and the private sector 26 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 18: The economies are rebalancing Figure 19: Labor costs are starting to move more in in the aftermath of the global crisis. line with productivity. (Decomposition of structure of GDP, change (In percent) between 2008 and 2015, percentage points of GDP) 25 14 20 12 15 10 10 8 5 6 0 4 -5 2 -10 -15 0 -20 -2 2004-09 2010-15 2004-09 2010-15 2004-09 2010-15 2004-09 2010-15 2004-09 2010-14 -25 -4 MNE SRB MKD ALB BIH KSV WB6 MNE BIH MKD SRB ALB Change in domestic demand Change in net exports VA/worker growth Real wages growth Source: World Development Indicators, national authorities, and World Bank sta Source: World Bank sta calculations based on World Development Indicators and estimates. national authorities’ data. Figure 20: Growth sources have only tentatively begun Figure 21: Evidence of public-private shifts is even rebalancing from domestic demand to net exports in more mixed. the countries that export manufactured goods. (Change in private sub-component, as share of total (Change between 2008 and 2016, percentage points of GDP) component, between 2008 and 2015, percentage points) 25 10 20 15 5 10 5 0 0 -5 -5 -10 -15 -10 -20 -25 -15 SRB BIH MKD KSV ALB MNE WB6 ALB KSV SRB MKD MNE BIH Change in private investment share (of total investment) Consumption Investment Exports Imports Change in private consumption share (of total consumption) Source: National statistics o ces and World Bank sta estimates. Source: National statistics o ces and World Bank sta estimates. Note: No data are available on the public-private investment split in Bosnia and Herzegovina. (Figure 22). As output slumped and governments favorable external environment. After the global applied fiscal stimuli, fiscal deficits widened, social crisis, the average current account deficit in the West- spending increased, and public investment fell (Figure ern Balkans declined dramatically from 21.6 percent 23 and 24). FYR Macedonia was an exception, with in 2008 to 7.6 percent in 2015, mainly reflecting the unemployment declining. But the costs of the active change in the capital inflows, but in some countries labor market policies that helped bring this about aided by currency depreciation and improvement in may prove to have been too high and the labor mar- domestic savings levels. Most countries experienced ket results unlikely to carry into the long term. a fall in FDI and other investments. Keeping spending levels unchanged as the adjustment on the external The prolonged deterioration in the fiscal side continues has added to the pressures dating to accounts suggests that governments have been the pre-crisis period and led to soaring debt levels as acting to maintain high consumption in a less percentage of GDP. Instead of embracing adjustment G ro w t h 27 Figure 22: After the global crisis, unemployment and passing reforms to steer the region toward a remained high. more export- and private sector-driven economy, (Unemployment rate, in percent) governments have tended to contract more debt. For example, PPG debt went up by almost 20 per- cent of GDP in just six years to reach 55 percent of 60 GDP on average in 2016. 50 The Western Balkans need faster 40 36.1 structural change to rekindle growth. 30.0 30 26.9 20.1 Sustainable rebalancing that can generate 20 19.0 17.1 15.1 strong growth for the long term in GDP and 12.1 10 employment will require a significant realloca- tion of labor, credit, and investment (includ- 0 ing FDI) to the tradable sectors. Currently, the KSV MKD BIH SRB MNE ALB WB6 7STEE non-tradable sectors take the bulk of employment 2000-08 2009-15 and production, but their labor productivity is low. Source: World Development Indicators, Eurostat, national authorities, and World Bank sta The rebalancing must promote a more export- and calculations. private-sector driven growth model. However, with- Figure 23: Fiscal balances mostly deteriorated. Figure 24: Public expenditure composition changed to (Central government fiscal position, percent of GDP) accommodate the increase in current expenditures. (Percent of total expenditure) 120 8 100% 100 90% 6 80 80% 60 4 70% 40 2 60% 20 0 0 50% 0.7 -20 -2 40% -40 -1.1 -1.7 30% -60 -3.7 -3.4 -3.3 -4 -4.9 20% -80 -6 -100 10% -7.3 -8 -120 0% 2008 2015 2008 2015 2008 2015 2008 2015 2008 2015 2008 2015 2008 2015 2008 2015 2008 2015 2008 2015 2008 2015 2008 2015 2008 2015 2008 2015 BIH MNE SRB MKD ALB KSV WB6 7STEE KSV BIH SRB MKD MNE ALB R Revenue Expenditure Balance (rhs) Wage bill Social assistance Capital Interest Other Source: World Development Indicators, Eurostat, national authorities, and World Bank Source: Haver, national authorities, and World Bank sta calculations. sta calculations. Note: The split of capital expenditure for Bosnia and Herzegovina was not available and therefore not included in the chart. 28 The Western Balkans: Revving Up the Engines of Growth and Prosperity Box 2. Structural change to date has not enhanced productivity. Most Western Balkan countries have completed the bulk of the transition from agriculture to industry that naturally accompanies growth of income per capita. Overall, workers who are shed from the agriculture and industry sectors move to jobs in the slowly growing services sector, in line with countries’ income per capita. As Share of employment (1990-2015) a result, growth has been mostly driven by industry, with structural labor movements playing a marginal role (see 100 Agriculture figure below). Albania and Montenegro are two exceptions 90 from this pattern. Albania still has a high share of agriculture in GDP and a manufacturing sector that is growing its share 80 Share in total employment in the economy from a low base. Montenegro already has 70 a high share of services in GDP due to its tourism sector. 60 50 An analysis of sub-sectoral reallocation of labor using 40 labor force surveys (LFS) versus administrative data yields somewhat different labor shifts across sub-sectors in the 30 Western Balkans. These differences are the results of data 20 collection methodologies and especially the inclusion of 10 informal employment in LFS data. Then, although quantifying 0 labor shedding and labor productivity shifts are challenged 6 7 8 9 10 11 12 by these data shortcomings, common trends can be Log of GDP per capita (PPP, international US$) identified. Labor shed from agriculture and manufacturing finds its way into wholesale and retail, food, recreation, 70 Industry and to a lesser extent professional services. The decline of employment in the manufacturing industry is also common 60 in 7STEE countries, but the expansion of employment is more focused in professional and other higher-productivity Share in total employment 50 services. Moreover, government employment in the Western Balkans tends to compensate for lack of opportunities in 40 other sectors at a larger proportion than in 7STEE countries. 30 In the long term, labor movement from manufacturing 20 to less productive services could be accounted for by increased openness and a rise of the middle class. However, 10 in the Western Balkans this shift means less productive use of labor and slower growth. For that reason, increasing 0 6 7 8 9 10 11 12 labor productivity in the services sector becomes crucial to Log of GDP per capita (PPP, international US$) overall growth. Decomposition of labor productivity growth, 100 Services 2009-2015 90 5 80 4 Share in total employment 70 3 60 2 50 1 40 30 0 20 -1 10 -2 0 SRB MNE ALB BIH MKD WB6 7STEE LAC ECA developing EAP developing 6 7 8 9 10 11 12 Log of GDP per capita (PPP, international US$) Agriculture Industry Services Labor reallocation All countries 7STEE ALB KSV MKD MNE SRB Source: World Development Indicators, national authorities, and World Bank sta Source: World Development Indicators and World Bank sta calculations. calculations. G ro w t h 29 out a decline in the price of non-tradables, the real- bottom 40 percent of the income distribution. The location may stall, and without a fall in the unit labor floods of 2014, which hit growth hard in Serbia and cost (ULC) of tradables to enhance competitive- Bosnia and Herzegovina, are proof of these shocks’ ness, export performance may not improve. Fur- power. ther structural reforms are needed to enhance the competitiveness of tradables and increase invest- Rekindling growth dynamics will require ment in them. addressing deep-seated structural issues left unfinished during the transition to a market This is the type of sustainable rebalancing that economy. Structural issues are slowing progress many 7STEE countries accomplished in the towards convergence and EU accession. Faster post-crisis period through structural reforms, convergence will be achieved only when countries fiscal consolidation, and real devaluation.6 The put in place a coherent reform plan that address- external adjustment of the 7STEEs was aided both es the key bottlenecks holding back productivity by import reduction and export expansion, but improvements, a more conducive business environ- exports were particularly aided by wage adjustment ment, and well-functioning labor markets. Commit- in the tradable sector. While the emphasis and con- ment towards EU accession provides a clear path tent of actions differed among these countries, and for the difficult reforms needed to join the EU aspi- some acted more rapidly than others, they all aimed rational group, instead of those that are easier to at four objectives: large improvements in compet- implement but bring smaller gains. itiveness (ULCs fell); sizeable fiscal consolidation; maintenance of macro-financial stability; and repair Subsequent chapters of this report focus on of private corporate and household balance sheets. steps that are fundamental for establishing As a result, the countries enjoyed sustained increas- higher structural growth in the Western Bal- es in export growth despite an often adverse exter- kans. Reducing the footprint of the state, putting nal environment in the 2009-15 period. the fiscal house in order, increasing quality of public services, and reducing the dominance of inefficient On the financing side, speeding up convergence SOEs in the economy (thus reducing their crowd- will require putting the macro house in order. ing out of the private sector) are the most difficult Despite the higher growth that the Western Balkans tasks. Eliminating disincentives and barriers to formal countries achieved in 2000-08, they were unable employment in labor markets, which are saddled to converge in income per capita to the levels the with high inactivity rates, widespread informality and 7STEE countries achieved. This was partly because inflexible regulations is the first key step to higher the Western Balkans were starting from a much productivity growth. Alongside these, reforms to lower base, having fallen behind during the conflicts improve the business climate for the private sector of the 1990s. Today, to raise growth and investment, and deepen regional integration are necessary to especially private investment, they must not only sustain productivity growth. A cross-cutting theme improve the investment climate but increase domes- is ensuring sustainable use of energy and natural tic savings rates. If the investment climate improves resources and stewardship of the environment. Pol- substantially, a quickening of FDI inflows, especially to icies to support sustainable rebalancing would also export sectors, could help finance higher investment close gaps to comparator countries in the key areas without undermining debt sustainability. that this report looks at in more detail: governance and the role of the state, labor markets, the envi- In addition, output volatility and political cycles ronment for business, trade, and financial integration, result in lower average medium-term growth and migration (Figure 25). in the region. They affect resource allocation and private sector activity and hinder the development of productive investment needed to raise output. Volatility has also been heightened by environmen- tal shocks, which can derail improvements in struc- tural performance, and disproportionally harm the 6 See Atoyan et al. 2013, Aslund and Ivanova 2012, and Purfield and Rosenberg 2010. 30 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 25: New policies are needed in these four areas. Labor Integration (% of working age population not working) (Exports as % of GDP) 65 60 KSV ALB 55 BIH MNE 50 SRB MKD 45 HRV LVA 40 BGR LTU 35 SVN 30 EST SVK 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 0 20 40 60 80 100 WB6 7STEE Enterprise The State (Doing Business indicators distance to frontier, (Average of the six WGI governance indicators, 0 worst to 100 best) 2014, between -2.5, weak to 2.5, strong) 85 1.0 80 0.8 WB6's governance 75 0.6 0.4 gap 70 0.2 7STEE before and after each country gained 65 EU accession 0 60 -0.2 55 -0.4 T-5 Join EU T+5 50 BIH KSV ALB MNE SRB MKD HRV BGR SVK SVN LTU LVA EST Median 25 - 75th percentiles DB 2010 DB 2017 Median WB6 (DB 2017) Median 7STEE (DB 2017) Source: World Development Indicators, World Governance Indicators, Doing Business, and World Bank sta calculations. G ro w t h 31 32 The Western Balkans: Revving Up the Engines of Growth and Prosperity WELFARE Greater affluence through more jobs, less dependence on state transfers In the early 2000s, the people of the northern Kosovo town of Drenas had scant hopes for a better standard of living, whether for themselves or their children. With few jobs, their community seemed stuck in permanent economic lethargy. Then in 2004, a group of foreign investors stepped in with capital and technical know-how for an abandoned mining and metals complex. Reborn as NewCo Ferronikeli, the facility today employs close to 1,000 people. Now accounting for close to 40 percent of the country’s exports, Ferronikeli has raised welfare in other struggling communities of Kosovo as well by plac- ing orders with suppliers there and raising general skill levels. The privatization has met some rough waters along the way. The company faced complaints of pollution, and in 2015, a collapse of world nickel prices pushed it into financial crisis. But it has bounced back more healthy, and few people in Drenas miss its former derelict, neglected state. W e l fa r e 33 1 How far have the Western Balkans states come in raising their people’s welfare? The Western Balkan countries have achieved laudable gains in living standards since the turmoil of the 1990s. The biggest advances came in the first years of the new mil- lennium, as the region enjoyed boom conditions fueled by a favorable world economy. Poverty declined; living conditions rose overall, particularly for the less well-off. How- ever, minorities and poor and rural people still lag considerably in both monetary and non-monetary dimensions of welfare. They are vulnerable to economic and weather shocks. Compared to other parts of Europe, citizens of the Western Balkan countries still have limited employment opportunities to make their livings. 2 What impact did the global financial crisis have on welfare? Progress in welfare generally stalled. Poverty headcounts remained stagnant or edged up marginally. Only two countries—Kosovo and FYR Macedonia—continued to reduce poverty. The region remains well behind the former transition economies now in the EU on this measure. 3 What are the key steps toward future gains in welfare? For sustainable improvement, the people of the Western Balkans need greater opportu- nities for employment rather than reliance on transfers from the state. Equitable access to education, health care, and public services is critical if the poor and vulnerable are to improve their livelihoods. Improved coverage of poverty-targeted social assistance would help more of them meet basic needs and cope with shocks. 34 The Western Balkans: Revving Up the Engines of Growth and Prosperity Surrounded by wealthier neighbors in the to 15 percent in 2011. In Kosovo, the rate dropped European Union, the people of the Western from 50 percent in 2000 to 45.1 percent in 2006, Balkans aspire to better living standards. They and continued falling to 34.5 percent in 2009 and have enjoyed notable welfare improvements since 29.7 percent in 2011. FYR Macedonia was an excep- the end of the Yugoslav wars in the 1990s, as the tion among the region’s six countries: its economic Growth chapter has noted. The Human Develop- growth before the crisis was not pro-poor, for rea- ment Index—which aggregates such dimensions of sons related to lack of employment creation dis- the human experience as living a long and healthy cussed below. Poverty measured at $5 a day in 2005 life, having a decent standard of living, and being edu- PPP increased from 29.2 percent in 2002 to 35.1 cated—is higher than in other countries with similar percent in 2008, though it has been declining since. income levels.7 The average life expectancy in the Western Balkans has increased from around 71 to During the boom years, growth rather than 75 in the last 25 years. Poverty is in decline. In 2003, distribution effects was often the main con- one in three people lived on less than $5 a day; that tributor to poverty reduction. Pre-crisis poverty ratio has now narrowed to one in four. All in all, sur- reduction in Albania, Montenegro, and Bosnia and veys show, satisfaction with life has trended upward Herzegovina was in large part due to growth (Figure in the last decade. 28).9 Consumption growth accounted for more than 90 percent of the reduction in Montenegro in 2006- Despite these gains, income per capita in the 08 and Albania in 2002-08 of the fraction of the Western Balkans remains among the lowest in population living on under $5 a day. In Bosnia and Europe. Life satisfaction remains below levels in Herzegovina, consumption growth accounted for the post-transition EU neighbors. But these coun- three quarters of the downward trend in 2004-07. tries’ experience suggests that faster gains in living In Serbia, consumption growth and changes in the standard are possible in the Western Balkans. This welfare distribution both played a role in lowering chapter examines steps that would encourage an poverty before 2008. acceleration. Pre-crisis growth was not only pro-poor but Economic growth before the global also inclusive, that is, it improved welfare for financial crisis was generally inclusive, the bottom parts of the distribution. Their but poverty reduction slowed post- improvement was actually faster than for the pop- crisis. ulation as a whole (Figure 27). In Montenegro, for example, strong economic growth in 2005-08 creat- A spurt of economic growth in 2000-08 ed low-skill jobs in such fields as construction, min- improved welfare and drove down poverty in ing, and retail trade that helped lower poverty and the societies of the Western Balkans. Average promote welfare gains for the bottom 40. In Albania, household consumption increased by 1-6 percent construction and services were important drivers of per year in the years leading up to 2008 (Figure 27). economic and employment growth in 2000-08, con- Poverty reduction mirrored economic growth, with tributing to rising real wages, poverty reduction, and progress prior to the financial crisis, but since then household income growth including for the bottom poverty levels have held roughly steady (Figure 26). two quintiles. In Bosnia and Herzegovina, the bottom The share of the population living on under $5 a 40’s consumption grew a bit more than the aver- day in 2005 purchasing power parity8 fell steadily age during the country’s growth years. This reflected starting in the early 2000s, reaching its lowest level job creation and growth in sectors requiring low- in 2008. Bosnia and Herzegovina and Kosovo—the skill employment (mostly in services, wholesale and two countries where this international poverty rate retail trade, real estate, construction, and transpor- is not available—also reduced poverty as measured tation, with lesser growth in manufacturing and agri- by the countries’ own definitions of it. Bosnia and culture) and a large expansion of public and private Herzegovina reported a decline from 17.7 percent transfers. In Serbia in 2006-08, household welfare in 2004 to 14 percent in 2007 but with an uptick improved especially among people employed in agri- 7 UNDP: http://hdr.undp.org/en/content/human-development- 9 index-hdi Datt-Ravallion decompositions separate poverty changes 8 Excluding Kosovo and Bosnia and Herzegovina due to issues into a component caused by distributional-neutral growth and a with PPP measures. component caused by changes in the welfare distribution. W e l fa r e 35 Figure 26: Poverty declined pre-crisis but held Figure 27: Bottom 40 consumption often grew steady post-crisis. faster than consumption for all income groups. (Poverty headcount and annualized GDP per capita growth, %) (Annualized growth of bottom 40, national consumption measure, percent) 40 12 35 10 30 8 25 6 20 4 15 2 10 0 -2 5 -4 0 -6 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2006-08 2008-10 2005-08 2009-12 2007-08 2009-13 2004-07 2007-11 2003-08 2009-13 2006-11 WB-average-Poverty headcount $5/day in 2005PPP (pop weighted)- w/o KSV ans BIH SRB ALB MNE BIH MKD KSV WB-average-GDP per capita growth (annual %)- w/o KSV ans BIH All Bottom 40 Source: World Bank sta estimates based on the harmonized ECAPOV dataset and World Development Indicators. Source: SCDs, World Bank sta estimates, and FYR Macedonia poverty note. Note: Regional average excludes Kosovo and Bosnia and Herzegovina due to issues in Note: FYR Macedonia 2009-2013 based on income (SILC). calculating PPP welfare aggregates. culture, mining and construction, and services, but nomic downturn and rising unemployment hurt the also among the unemployed through social transfers. bottom 40’s consumption a bit less or the same as Inequality, as measured by the Gini index, remained the rate of the rest of the population (in Bosnia and stable during this period in most of the countries Herzegovina and Albania) or more (in Montenegro except for a notable increase in FYR Macedonia and Serbia). In post-crisis Bosnia and Herzegovina, (Figure 29). The reason is related to the lack of the average decline in consumption explained the overall job creation in the economy prior to 2009, overall increase in poverty, with the change in wel- with labor re-allocation to low-productivity jobs. The fare distribution slightly counteracting this increase. In sector with the most net job creation in 2002-06, Serbia between 2008 and 2010, average consump- agriculture, had minimal or negative contribution to tion decline and distribution effects both contributed value added growth.10 That tended to slow improve- significantly to that country’s rise in poverty. ments of the welfare of the poor and the bottom 40. Only FYR Macedonia and Kosovo managed However, living standards improvement and to make progress during the post-crisis peri- poverty reduction have stalled since the crisis. od. In Kosovo, the poverty rate as measured by Real per capita income today, measured as GDP per the national indicators continued falling from 45.1 capita in purchasing power parity, is not far from its percent in 2006 to 34.5 percent in 2009 and 29.7 2008 level. Between 2008 and 2013, household con- percent in 2011, thanks to continued economic sumption declined by 1-2 percent on average per growth. The bottom 40 percent of the consump- year in Albania, Bosnia and Herzegovina, Montene- tion distribution in Kosovo enjoyed consumption gro, and Serbia (Figure 27). Poverty headcounts in growth of 3.9 percent per year in 2006-11, higher these four countries circa 2013 all appear to have than the 2.4 percent rate among the top 60 percent remained close to 2008 levels or edged up slightly. of the distribution. This inclusiveness was mainly due Overall, the growth slowdown in the Western Bal- to increases in labor earnings, particularly among kans has kept the $5 per day poverty rate roughly the bottom groups. Movement of workers out of level, estimated at 25 percent in 2013 (Figure 26), agriculture and into construction, trade, and manu- but ending the reductions experienced during the facturing was particularly visible in the two lowest boom years. Depending on the country, the eco- quintiles. Similarly, the economy of FYR Macedonia 10 continued to grow through the crisis, and con- World Bank 2009. “FYR Macedonia Poverty, Jobs and Firms: An Assessment for 2002-2006.” trary to the earlier period, growth in 2009-13 was 36 The Western Balkans: Revving Up the Engines of Growth and Prosperity employment-generating and pro-poor—income of Life expectancy and infant and maternal mor- the bottom 40 increased much more than average tality rates in the Western Balkans are better and absolute poverty fell. Net job creation in ser- than in other countries with similar per-capita vices, followed by industry, particularly construc- income, but non-communicable diseases are tion, contributed to this progress. While there was a rising risk to health, compromising quali- growth in employment, a large share of employ- ty of life and productivity. Lifestyle-related risk ment creation was related to government efforts factors—such as smoking and alcohol consump- through public investment (construction), subsidies tion—compound the impact of non-communica- to industries (manufacturing) or costly active labor ble diseases that are already common due to aging market programs.11 populations. Bosnia and Herzegovina, for instance, has one of the highest rates of smoking in the Living standards in the Western Balkans remain world, with nine out of ten adults lighting up daily. below comparator countries. Real per-capi- Almost all of the country’s premature deaths are ta income is today about half of that in the 7STEE attributable to major non-communicable diseases. states. Figure 30 shows that the share of people living on below $5 per day is higher in the Western Bal- kans than the 7STEEs. This comparison comes with Figure 28: Growth was often the main contributor to poverty a caveat, however, because of different welfare mea- reduction prior to the crisis. sures that are not strictly comparable: 7STEE coun- (Contribution to poverty reduction measured at $5/day 2005 PPP, %) tries and FYR Macedonia use the EUSILC income aggregates while most of the Western Balkans use SRB 2003-07 consumption aggregates. But other measures com- monly applied in EU countries for monitoring wel- BIH 2004-07 fare and social inclusion also confirm the lower living standards in the Western Balkans. The share of pop- ALB 2002-08 ulation living in relative poverty (below 60 percent of median income) stands at around 25 percent in FYR Macedonia and Serbia. Rates of material depri- MNE 2006-08 vation (financial inability of a household to afford 0 20 40 60 80 100 some level of material conditions including housing Growth Distribution items, durable goods, and meals) in the two coun- Source: World Bank sta estimates based on the harmonized ECAPOV dataset. tries are also higher than in all of the transition econ- Note: Figures for Bosnia and Herzegovina are based on its own de nition of poverty. omies that have joined the European Union. The people of the Western Balkans desire bet- Figure 29: Inequality remained stable in most Western ter health and quality of life. The 2016 Life in Balkan countries. Transition Survey found that people in the Western (Gini index, using ECAPOV harmonized aggregate) Balkan countries report lower life satisfaction than in 0.50 the 7STEE countries and among transition countries 0.44 0.45 in general, even though all did enjoy an increase in 0.39 0.40 life satisfaction between 2006 and 2016 (Figure 31). 0.35 0.31 0.32 0.34 0.33 The large numbers of people who pass their days 0.30 0.29 0.31 0.32 0.30 0.30 0.29 0.29 0.30 0.27 in cafes and public squares give evidence of chronic 0.25 low employment. While air quality has improved in 0.20 Bosnia and Herzegovina and Serbia, certain environ- 0.15 mental practices such as waste management remain 0.10 0.05 behind EU standards. 0.00 2005 2008 2012 2005 2009 2013 2005 2008 2005 2008 2014 2007 2010 2004 2011 ALB KSV MKD MNE SRB BIH 11 World Bank 2017c. “Poverty Reduction, Shared Prosperity Source: ECAPOV database. and Inequality in FYR Macedonia in the Post Financial Crisis Period (2009-2013).” W e l fa r e 37 Figure 30: The Western Balkan countries have high rates of poverty relative to comparators (Poverty rate, percent of population living on below $5/day 2005 PPP) 50 45 40 35 30 25 20 15 10 5 0 2012 2013 2014 2013 2012 2010 2012 2012 2012 2012 2012 2012 ALB MKD MNE SRB BGR HRV HRV EST LVA LTU SVK SVN ECAPOV EUSILC ECAPOV ECAPOV EUSILC ECAPOV EUSILC EUSILC EUSILC EUSILC EUSILC EUSILC Source: Eurostat and ECAPOV database. Note: EUSILC welfare aggregates based on income and ECAPOV based on consumption are not strictly comparable. More than 20 percent of Montenegrins, meanwhile, of countries in the Europe and Central Asia region report health problems lasting 10 years or longer. (Figure 32). The incidence of chronic diseases—such as depres- sion, diabetes, high cholesterol, and hypertension— In the years following the onset of the global in Serbia showed a steady and significant increase financial crisis, more than 5 percent of non- from 2000 to 2013. Not surprisingly, the 2016 Life poor households in Montenegro and close to in Transition Survey data found that citizens of the 4 percent in Serbia fell back to living below $5 Western Balkan countries consider investments in per day, reversing earlier upward mobility out health or education, sometimes both, as the top of poverty. As a small state, Montenegro expe- two priorities for government spending. rienced a particular boom and bust with signifi- cant swings in the poverty rate in just a few years. Household welfare in many Western Balkan During the boom, the rate declined from 11.3 per- countries is vulnerable to macroeconomic vol- cent in 2006 to 4.9 percent in 2008, but climbed atility and weather shocks. The concentration of back up to 11.3 percent in 2012 as growth slowed people around the poverty line indicates not only and some low-skill jobs disappeared. Vulnerabili- that they have the potential to break out of pover- ty increased even more: the share of households ty during economic upturns but also that they risk with consumption below 1.5 times the poverty line falling back into it when the economy goes sour. increased from 16 percent in 2008 to 26 percent Two percent of the population in Bosnia and Her- in 2012. zegovina and Serbia live right above the respective national poverty lines (within a 5 percent increase In addition, countries in the region are over the line) and another 2 percent right under. exposed to extreme weather events. Heat, Nine percent live between the line and 1.2 times drought, and flooding undermine agricultural pro- the line, while 7 percent live within the same range duction, energy efficiency, and the general wel- below the line. The poor and the less well-off are fare of people. For example, simulations show often more vulnerable to setbacks than better-off that the floods of May 2014 in Serbia increased populations because they typically have fewer assets the at-risk-of-pover ty rate (people living below to help them cope with shocks. Therefore, some 60 percent of median income) by 1.7 percent- households that have escaped poverty may become age points, from a baseline of 24.6 percent. The poor again during downturns, as has happened not simulated impacts were higher in the less well-off only in the Western Balkans but also in a number regions of the countries (Table 2.1). 38 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 31: Life satisfaction is relatively low. (Percent of respondents who “agree” or “strongly agree”with the statement “All things considered, I am satisfied with my life now.”) 80 2006 2010 2016 70 60 50 40 30 20 10 0 Croatia Estonia Albania Slovenia Latvia Czech Republic Lithuania Slovakia Montenegro Serbia BiH WB6 Bulgaria FYR Macedonia Kosovo Source: World Bank sta estimates based on LiTS 2006, 2010, and 2016. Figure 32: Households that have escaped poverty are prone to becoming poor again during economic downturns. (Share of households leaving $5/day poverty or falling back into poverty) 0.5 Early time period (circa 2001 to 2008) Late time period (circa 2008 to 2010) 0.4 0.3 0.2 0.1 0.0 -0.1 BLR ROU UKR KAZ RUS TUR LTU MNE ALB POL ARM MDA SVK SRB HUN MKD GEO MDA TUR BLR KAZ SRB POL ROU UKR GEO RUS ARM SVK MNE Upwards mobility, share 5 USD line Downwards mobility, share 5 USD line Source: Cancho et al. 2015. Table 2.1: 2014 Floods in Serbia increased poverty. Estimates of damage due to 2014 floods # Employees # Farmers Baseline poverty Simulated increase affected affected % (2013) in poverty (% pts) Belgrade 4,879 4,492 11.4 0.7 Vojvodina 1,139 1,066 26.8 0.1 Šumadija and Western Serbia 41,817 21,641 28.4 4.1 Southern and Eastern Serbia 3,968 5,295 31.2 1.9 National 51,803 32,495 24.6 1.7 Source: Republic of Serbia, World Bank Group, United Nations and European Union. 2014. “Serbia Floods 2014.” W e l fa r e 39 People in the Western Balkans in Montenegro, where employment accounted for need greater employment to drive most of the decline in poverty in 2007-08. In Serbia, sustainable welfare improvement, loss of employment accounted for 71 percent of the instead of relying on help from the increase in poverty after the crisis. Declining wag- state. es accounted for 47 percent, while pensions largely counteracted this impact (Figure 36). Labor earnings drive income growth of the less well-off and, as a result, the dynamics of pov- Public transfers helped bring down pover- erty itself. Decompositions of per-capita house- ty during good times and cushioned the pain hold income growth and of changes in poverty can during bad times. The cushioning effect was often isolate the role played by different income sources. due to the pensions that are common and generous This analysis, conducted for the Western Balkans in most of the region. In Albania, pensions accounted except for Kosovo due to data concerns, illustrates for close to half of the poverty decline in 2005-08, the significant contributions that employment makes. 2.8 percentage points of the 5.9 percentage-point Specifically, unpacking per-capita household income reduction (Figure 35). In Bosnia and Herzegovina, growth by income source (Figure 33 and Figure 34) almost half of the income growth of the bottom 40 shows that labor earnings—from both wage and in 2004-07 was attributable to increases in social self-employment— were important for all groups assistance. However, throughout the crisis, pensions in Bosnia and Herzegovina and for the bottom two in that country played a larger role in mitigating the income quintiles in FYR Macedonia. In Bosnia and adverse impact of labor income losses. Similarly, in Herzegovina, about a third of the overall growth Montenegro, public transfers played a bigger role in incomes of the bottom 40 percent over 2004- than employment in offsetting the rise of poverty 07 came from wage income growth, and about a in the post-crisis period. In Serbia during the same quarter from self-employment income growth. In period, it was changes in pensions that countered FYR Macedonia as well, increases in labor income the upward pressure on poverty (Figure 36). at the bottom contributed the most to total income growth and helped lift people out of poverty in Employment prospects worsened overall after 2009-13. In Albania, wages and labor earnings the global financial crisis, including for the poor accounted for about half of the poverty decline in and low-income earners. Between 2008 and 2012, 2005-08—2.9 percentage points of the 5.9 percent- the unemployment rates in four of the six countries age-point fall (Figure 35). There was a similar pattern went up from already high levels, by 11 percentage Figure 33: In Bosnia and Herzegovina, wages were Figure 34: In FYR Macedonia, increases in labor the most important driver of income growth. incomes at the bottom drove household income growth. (Contribution of income sources to per capita (Contribution of income sources to per capita household household income growth 2004-07, percentage points) income growth 2009-13, percentage points) 1.5% 50 Hired Wages 3.1% 1.1% 40 Self-employed Waged -0.3% 0.2% 30 Pensions 0.8% 2.1% 20 Social Assistance 1.3% 0.7% 10 Remittances 0.3% 0.0% 0 Property -0.2% -0.5% -10 Other Income -0.6% 4,8% -20 Total Change 4,4% -30 -2% -1% 0% 1% 2% 3% 4% 5% Q1 Q2 Q3 Q4 Q5 Total Labor Income Pensions Other Income Out ow Bottom 40 Top 60 Unemployment Other Children/Social Total Net Income Bene ts Bene ts Allowance accumulated Growth Source: Bosnia and Herzegovina SCD based on World Bank sta estimates using HBS Source: FYR Macedonia poverty note based on World Bank sta estimates using SILC 2004 and 2007. 2009 and 2013. 40 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 35: Wages and pensions reduced poverty Figure 36: Loss of employment and labor income in Albania. drove poverty increase in Serbia. (Contribution of income sources to poverty (Contribution of income sources to poverty change change 2005-08, percentage points) 2008-2010, percent) 100% 100% Total -5.9 71% 80% Income from properties -0.3 60% 40% 47% Unemployment bene t -0.5 40% Pensions -2.8 20% 8% 3% 6% 1% 4% Private transfers -0.2 0% Social Assistance -0.1 -20% Wage & Earningss -2.9 -40% Other -0.2 -60% -80% Consumption/Income Ratio 1.1 -80% -100% -8.0 -6.0 -4.0 -2.0 0 2.0 Prop. Adult Agr. Income Other Ratio HH size factor Prop. Employed adults Wages Pension Social Total Assistance Source: Albania SCD based on World Bank sta estimates using LSMS 2005 and 2008. Source: Serbia SCD based on World Bank sta estimates using HBS 2008 and 2010. points in Serbia and 5 percentages points in Bos- jobs accounted for 51.7 percent of total employ- nia and Herzegovina. In Serbia, the unemployed and ment among the bottom 40, but only 31 percent of self-employed endured the greatest increases in employed individuals among the top 60.13 Across poverty between 2008 and 2010, while data from the countries, the bottom 40 percent are more con- 2012-13 indicate that informal workers in Serbia centrated in elementary occupations such as agricul- were more likely to move into unemployment or ture, crafts and related trades, and services and sales. inactivity than the formally employed. In Montene- gro, the percentage of poor households with two or For sustainable welfare improvements going more income earners decreased from an average forward, the Western Balkans will need stron- of 55 percent in 2007-08 to 40 percent in 2009-12. ger role for employment and labor income. Cit- izens of Western Balkan countries say that the most While labor market performance has slowly important problem facing their economies is lack of returned to pre-crisis levels, weaker employ- jobs—that was the view of 68 percent of respon- ment persists among the bottom income and dents in the 2016 Balkan Barometer.14 Labor income consumption quintiles. Individuals in the bottom in the Western Balkans accounts for only about half 40 percent of households are more likely to be of total household income on average. In many EU unemployed or, if working, to hold informal jobs. For countries, the figure stands at around 60 percent, example, unemployment is particularly prevalent while in Latin America and East Asia Pacific, it averag- among the less well-off in Montenegro and Kosovo, es 70-80 percent (Figure 37). The Western Balkans’ where more than 30 percent of the bottom 40 are low figure for labor income reflects low labor-force unemployed. That compares with just 16.7 percent participation and high unemployment, partly linked in the top 60 in Montenegro, and 23.2 percent in to disincentives to work, as discussed in a later chap- that group in Kosovo. Similarly, in Serbia, about 54.4 ter on labor. Labor and human capital are often the percent of the labor force in the bottom two quin- poor’s most important assets, so maximizing them is tiles was unemployed in 2013, compared to only important for long-term poverty reduction. 22.8 percent of the wealthier counterparts. In FYR Macedonia, while the unemployment rate in 2013 13 Here we use the “firm size and occupation” definition for was only 22.2 percent in the top three quintiles, it informality. A worker is considered informal if he/she works in a was 53.5 percent in the bottom quintile.12 Informal firm with five or fewer employees and works as self-employed. For the general concept of informality, we mean the “enterprise- 12 Serbia and FYR Macedonia calculations are based on the based” concept defined by the ILO which is defined as jobs in SILC, and Montenegro and Kosovo calculations on the Household unregistered and/or small unincorporated private enterprises. 14 Budget Survey. Balkan Barometer 2016. W e l fa r e 41 Figure 37: Share of labor income in the Western Balkans is relatively low. (Labor income, most recent year available, as share of household income) 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Cambodia Fiji Brazil Argentina Mexico POL SVK NLD CZE EST LVA SWE LUX BGR SVN ITA DNK HRV LTU AUT BEL ESP PRT FIN GBR HUN FRA GRC ROU IRL KSV MKD ALB BIH MNE SRB Chile Uruguay Vietnam Timor Leste Thailand Philippines Mongolia Source: EUSILC (2012), Household Budget Survey (2010-2013), LAC data lab, and Packard and Nguyen 2014. Reliance on public transfers, particularly pen- similar to the level in Albania. Among the Western sions and categorical transfers not targeted to Balkan countries, Kosovo and FYR Macedonia have the poor, is difficult to sustain. Pensions together relatively lower shares of government spending both with social assistance represent a significant share of at the aggregate and household level. The region’s household income across all segments of the welfare generally high reliance on public transfers is difficult distribution (Figure 38). Serbia and Montenegro, in to sustain because public debt in many countries is particular, have preserved many social entitlements reaching critically high levels and the societies are from Yugoslavia times, and today they have the rapidly aging. highest proportion of public transfers and lowest proportion of labor earnings in household income. Spending on social assistance should be geared Bosnia and Herzegovina also has high government more toward reaching the poor and vulner- spending as a share of GDP. Households’ reliance on able. Social assistance income is important for state benefits for their income is high in that country, those in need: it makes up a larger share of income among the bottom 40 than among the top 60 per- cent. However, social assistance overall and last-re- Figure 38: Transfers are an important source sort (poverty-targeted) assistance in the Western of household income. Balkans have relatively limited coverage of the poor. (Household income, by source, percent) The share of the poorest quintile that receives any 100% form of social assistance ranges between 15 and 35 percent (Figure 39), which is low compared to 80% countries in Europe and Central Asia in general and the post-transition EU members in particular. While 60% these programs have respectable targeting (Figure 40), with more than half of spending reaching the 40% poorest quintile in all countries but Bosnia and Her- 20% zegovina, their poverty impact is limited by the low coverage. Improving coverage while maintaining 0% good targeting of social assistance would help the B40 T60 B40 T60 B40 T60 B40 T60 B40 T60 B40 T60 ALB 2012 BIH 2011 KSV 2013 MKD 2008 SRB 2013 MNE 2014 poor and vulnerable protect basic needs and cope labor income pension social assistance remittances other with shocks. Source: World Bank sta estimates based on the harmonized ECAPOV dataset. Note: B40 refers to bottom 40 percent and T60 to top 60 percent of income/ consumption Large numbers of households also get help in distribution. the form of remittances from family members 42 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 39: Only a fraction of the poor receive Figure 40: …even though more than half of social social assistance… assistance spending reaches the poorest quintile. (Coverage of Q1, share of the poorest quintile, percent) (Targeting to Q1, share of expenditures received by the poorest quintile, percent) 40 90 35 80 30 70 25 60 50 20 40 15 30 10 20 5 10 0 0 KSV 2011 MKD 2010 ALB 2012 MNE 2015 SRB 2010 BIH 2007 KSV 2011 SRB 2010 MKD 2010 MNE 2015 ALB 2012 BIH 2007 Last resort Social Assistance All Social Assistance Last resort Social Assistance All Social Assistance Source: World Bank ECA SPEED database. Source: World Bank ECA SPEED database. who have moved abroad, income that bolster such as land and financial and social capital would welfare but can also lower the incentive to further enable people to access employment and work. Remittances as a share of GDP in the Western earn income as workers, farmers, and entrepreneurs. Balkans averaged around 9 percent in 2014, with the highest levels in Kosovo and Bosnia and Herzegovi- Yet disparities persist across geographical na (Figure 41). Remittances reach 20-25 percent of regions, income groups, and ethnic groups in households in Kosovo and are estimated to amount Western Balkan countries. Overall access to to more than 15 percent of GDP. Remittances as a basic health and education and services such as share of household income vary by country, with the sanitation and electricity is generally high in the highest levels in Kosovo, followed by Albania (Figure Western Balkans and in line with countries of simi- 38). While these flows can raise income, support lar income levels. However, access is weaker in rural small business development, and alleviate poverty, areas and for the Roma and RAE (Roma, Ashkae- their regular arrival may undermine the incentive to lia, and Egyptians) minorities, where poverty is also work. Remittances together with the already sizeable more concentrated. Poverty rates among Roma public transfers to households and individuals in the populations are estimated to be two to four times Western Balkans push up non-labor income and res- those of non-Roma living in similar neighborhoods ervation wages. The current study’s chapter on labor in Western Balkan countries (Figure 42). Poverty discusses further the impacts of outmigration and rates are also higher in rural than urban areas. The remittances on the level of human capital at home. share of the population living in urban areas has been steadily increasing in some countries, notably The poor and vulnerable need better Albania and Montenegro, over the past decade. In access to health, education, and basic Bosnia and Herzegovina, however, 60 percent of the services if they are to improve their population is still rural, making it among the least livelihoods. urbanized country in Europe. The cost of living in cities is high while access to public services in rural While economic growth is necessary, improving areas is at reasonable levels. Migration, especially the welfare of the poor and less well-off also after the wars, tended to be cross-border rather requires equitable opportunities to build criti- than toward the cities. cal endowments and generate income. Access to basic education, health, and public services is not only Inequities start early for Roma people. From a dimension of welfare in broad terms but also key birth and early childhood, children in Roma fami- to building human capital. Equitable opportunities to lies in all of the Western Balkan countries are more acquire human capital and other productive assets likely to be stunted, a sign of chronic malnutrition, W e l fa r e 43 Figure 41: The Western Balkans have outstandingly high long-lasting consequences that are difficult to make remittances compared to other regions. up for later in life. Therefore, early childhood devel- (Percent of GDP, 2015) opment is critical for addressing socio-economic disparities. Yet, rural children in Albania are twice as KSV likely to die before age one compared to children BIH born in urban areas, and the chance is four times WB6 MNE higher for children in mountainous regions. Stunt- ALB ing is more common among the poorest quintile SRB in FYR Macedonia and Serbia, while in Bosnia and 7STEE Herzegovina and Montenegro, the relatively higher MKD stunting among children in wealthy families is likely SSA MENA due to a decline in breastfeeding among mothers LAC in this group rather than food insecurity. Preschool ECA attendance is low overall, particularly for Roma and EAP children from poor families (Figure 44). Preschool OECD 0 5 10 15 20 net enrollment can be three to eight times as high among the richest quintile as among the poorest. Source: World Bank sta calculations based on World Development Indicators. Fewer than one in ten children from households in the poorest quintile attend preschool while four in five children from the richest quintile do. Similar gaps with serious implications for their cognitive develop- exist in secondary school attendance and in edu- ment and lifelong earning potential (Figure 43). They cational attainment across all the Western Balkan also have a significantly lower chance of receiving countries (Figure 46). early childhood education and attending secondary school (Figure 44 and Figure 45). Disparities carry over into adulthood, work and family life. Access to productive assets such Income and location also determine inequali- as finance is unequal, affecting income-generating ties during childhood, a stage of life in which opportunities (Figure 47). Labor force participation, investments are most critical for future suc- already low in the region, is worse for the poor, for cess. Global evidence shows that delays in cognitive Roma, and for women. For example, Bosnia and and overall development from birth to age six have Herzegovina has the second-lowest labor force par- Figure 42: Roma people have particularly high Figure 43: Stunting incidence is high among the Roma. levels of poverty. (Height for age stunted under 2 standard deviations (Percent with income below the absolute poverty below median, children under age 5, percent) line of $4.30 PPP) 50% 30% 40% 25% 20% 30% 15% 20% 10% 10% 5% 0% 0% BIH ALB MKD MNE SRB BIH FYR Montenegro Serbia Roma Non-Roma Roma Poorest Richest Source: Based on data from 2011 UNDP survey of Roma and non-Roma households living Source: MICS for Bosnia and Herzegovina (2012), Macedonia (2011), Montenegro in similar neighborhoods, using smaller sample and shorter consumption and income (2013), and Serbia (2014). module than typical household surveys. The estimates are not strictly comparable with o cial national poverty measures. 44 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 44: Early childhood education attendance is Figure 45: Secondary education attendance is also low, particularly among the poor and Roma. low among the poor and Roma. (Early childhood education attendance, age 36 - 59 (Secondary school attendance, percent) months, percent) 90% 100% 81% 72% 80% 63% 54% 60% 45% 36% 40% 27% 18% 20% 9% 0% 0% BIH FYR Macedonia Montenegro Serbia FYR Macedonia MNE SRB BIH Roma Poorest Richest Roma Poorest Q2 Top 60% Source: MICS for Bosnia and Herzegovina (2012), FYR Macedonia (2011), Montenegro Source: MICS for Bosnia and Herzegovina (2012), FYR Macedonia (2011), Montenegro (2013), and Serbia (2014). (2013), and Serbia (2014). Figure 46: The poorer the person, the lower Figure 47: Poorer individuals also save less. the education. (Share of individuals aged 15+ who saved any (Share of individuals aged 15+ with at most a primary money in the past year, bottom 40 and top 60, 2011) education) 70 30 60 25 50 20 40 15 30 10 20 10 5 0 0 ALB 2012 BIH 2011 KSV 2014 MKD 2010 MNE 2014 SRB 2013 ALB BIH KSV MKD MNE SRB Bottom 40 percent Top 60 percent Bottom 40 percent Top 60 percent Source: World Bank sta estimates based on the harmonized ECAPOV dataset. Source: Findex. ticipation among the Western Balkans. Furthermore, less likely to have four antenatal care visits.15 In Alba- the employment rate among its bottom two con- nia, only one third of poor women were informed sumption quintiles, at 40 percent, is even worse than by health providers of signs of pregnancy complica- the 50 percent employment rate among the top 60. tions, compared to 73 percent among more well- The unemployment rate is 44 percent among the off women. Lower-income groups in Serbia tend to country’s Roma, compared to 27 percent among have slightly higher unmet medical needs and lower non-Roma neighbors living in the same community. insurance coverage even though 94 percent of the The poor who do manage to find work are more population has health insurance. The poor are more likely to be farmers and unskilled professionals. Gen- likely to forego care: among the poorest quintile, 11 der gaps in labor force participation are particularly percent reported that they had skipped health ser- large in Kosovo and Bosnia and Herzegovina. vices in the past year for financial reasons, compared to 1.5 percent of the richest quintile. In 2010, about Similar gaps exist in access to health services. In 4 percent of poor households spent more than a child bearing, poor women and Roma in Serbia are 15 MICS 2014. W e l fa r e 45 Figure 48: High out-of-pocket health costs are sometimes Aside from impacts on growth and labor the reason of falling into poverty. force size and composition, aging puts pres - (Percent of population impoverished by out-of-pocket sure on the pension, health, and social care health spending) systems. A significant number of the elderly are poor, as shown in the age poverty pyramid (Fig- 5.0 ure 49). Ensuring sufficient income for them is 4.5 impor tant for avoiding poverty and hardship in old 4.0 age. Improved preventive and long-term care can 3.5 3.0 suppor t healthier aging. Yet the projected demo- 2.5 graphics strain the ability of the pension and health 2.0 care systems to deliver this suppor t. For example, 1.5 in Serbia, the pension beneficiary-to-contributor 1.0 ratio is projected to jump from the current 0.6:1 0.5 to 1:1. This implies that today’s workers’ average 0.0 24 percent rate of contribution to the pension sys- ALB KSV SRB MKD MNE BIH tem would translate into a benefit of just 24 per- Source: World Bank sta estimates based on household survey data. cent of average wage (assuming fiscal affordability of the system), far lower than the current benefit quarter of non-food expenditures on health. Out- of about 60 percent of the wage. Mobilizing more of-pocket expenditures can have an impoverishing resources for pensions and long-term care to sup- effect, highest in Albania and Kosovo. With every- port an aging population is especially challenging thing else unchanged, health spending in the six with the shrinking working-age population. Western Balkan countries pushes between close to 1 percent and 4.5 percent of the population below For the countries of the Western Balkans, the poverty line (Figure 48). speeding up poverty reduction and conver- gence of living standards toward the EU would Demographic trends add new challenges for require a growth rebound, an enhanced role economic growth and maintaining the welfare for labor, and equal opportunities. Sustained of older people in the Western Balkan states. economic growth would help resume the poverty Populations are rapidly aging, and in some countries reduction that the region enjoyed before the glob- even shrinking. The median age in the Western Bal- al financial crisis. The key role of labor in ensuring kans is 8.7 years higher than in the world at large, welfare improvements points to a need to improve and projections show this increasing even further. labor market outcomes. Ensuring equitable access The population was already shrinking in Albania, to schooling, healthcare, other basic services, and Bosnia and Herzegovina, and Serbia between 2005 employment opportunities would empower those and 2010, due to low or negative natural population at the bottom of the welfare distribution to improve growth and net outmigration. The UN World Popu- their livelihoods. Yet the current inequality of lation Prospects projects that population numbers in opportunities in access to basic endowments holds the Western Balkans will decline further. Aging and back this potential, and the low coverage of pov- stagnant populations will lead to a doubling of the erty-targeted social assistance limits the support old-age dependency ratio in the Western Balkans that those in greatest hardship receive. Subsequent (excluding Kosovo) between 2015 and 2050. This chapters on labor and on the state will elaborate would pose a serious obstacle to growth (Box 2.1) on what can be done to improve employment out- and the size of the labor force, already burdened with comes, health, education, and other public services. employment challenges for youth and the elderly (the Aging and, in some cases, shrinking populations add chapter on labor discusses this issue in more detail). urgency to the reform agenda that will allow the With the working age population declining over time, Western Balkans to resume their catch-up with the maintaining GDP expansion would require increasing EU in growth and living standards. labor productivity and keeping workers working until retirement age and beyond. 46 The Western Balkans: Revving Up the Engines of Growth and Prosperity Box 2.1: Populations that are aging –and in some cases shrinking– mean challenges for economic growth. The Western Balkan region is aging fast, with its population projected to continue declining. This trend is due to low fertility rates coupled with external migration. The regional fertility rate fell from 3.9 to 1.6 children per woman during 1965-2015. Emigration is projected to continue reducing the region’s population, though not by as much as in the past. Bosnia and Herzegovina, which has the highest median age among the six countries, expects to see its median age increase from 41.5 in 2015 to 53.9 in 2065—the second highest in the world. If there are no policy or behavioral responses or changes in labor productivity, simulations show that aging in the region will lower labor force participation and reduce average annual per-capita income growth by 0.4 percentage points over the next 50 years. As a result, the window of opportunity to grow based on the “demographic dividend” seems to be short, in particular for those countries with medium-term aging. Aging populations mean that to better use their labor assets to grow, these countries need to increase labor force participation to counter the shrinking workforce and need to raise worker productivity. Bosnia, FYR Macedonia, Montenegro, and Serbia do not have a youth bulge anymore. Aging and stagnant populations will lead to a doubling of dependency of the old on the working age from 2015 to 2050. By the time many countries in the region have exhausted their demographic dividend, they remain at relatively low incomes: GDP per capita in the Western Balkans is less than half of that in most of the new EU member states in the year when their total dependency ratio (ratio of children and elderly to the working age population) begins to rise. Old dependency ratios are on the rise (2015-2050). By the time many countries in the region have exhausted their (Expected old age dependency ratio, percent) demographic dividend, they remain at relatively low incomes. (GDP per capita, PPP constant 2011 international $, in year in which total dependency ratio begins to rise) 100 30,000 WB (ex. Kosovo) - Median Upper-middle income countries 25,000 High-income countries 20,000 50 15,000 10,000 5,000 0 0 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 BIH-2010 ALB-2015 MKD-2013 SRB-2010 BLG-2006 MNE-2014 ROM-2016 POL-2010 HUN-2005 GRE-1999 CZE-2005 SLV-2004 PRT-2000 Source: World Bank calculations based on 2015 UN Population projections. Source: World Bank. 2015c. “Growth Recovers, Risks Heighten.” South East Europe Regular Economic Report No. 8S, Fall 2015. Note: Albania GDP data are for 2014. Source: World Bank 2015c. “Growth Recovers, Risks Heighten.” W e l fa r e 47 Figure 49: Many of the elderly are poor. (Age-gender poverty population pyramids, millions, Left = Women, Right = Men; Red = below $2.50/day, Purple= between $2.50 and $5/day, Light blue = above $5/day) Albania 2012 Montenegro 2014 65-older 65-older 45-54 45-54 55-64 55-64 35-44 35-44 25-34 25-34 15-24 15-24 0-14 0-14 0.40 0.20 0 0.20 0.40 0.60 0.40 0.20 0 0.20 0.40 0.60 Serbia 2013 FYR Macedonia 2010 65-older 65-older 45-54 45-54 55-64 55-64 35-44 35-44 25-34 25-34 15-24 15-24 0-14 0-14 1.0 0.50 0 0.50 1.0 0.20 0.10 0 0.10 0.20 Source: ECAPOV. 48 The Western Balkans: Revving Up the Engines of Growth and Prosperity 50 The Western Balkans: Revving Up the Engines of Growth and Prosperity LABOR Creating a place where more people work With hot springs, untouched forests, and almost 300 kilometers of picturesque Adriatic coastline, Montenegro long knew it could be a magnet for foreign tourists—but not without the right infrastructure, accommodations, and work- er skill set. So through a combination of public and private development, the “Pearl of the Mediterranean” (as the country calls itself in marketing cam- paigns) has kept the numbers growing year after year since 2000. Today tour- ism directly employs about 15,000 people, a full 8 percent of formal workers, and has more than doubled its share of GDP to 22 percent. The Montenegro Tourism Development Strategy to 2020 calls for environ- mentally responsible expansion of an industry that in places has caused un- controlled building and pressure on natural resources. The hope is to integrate visits to coastal areas and the lesser-known hinterland to extend the tourism season beyond the short peak of summer months and help develop the coun- try’s northern and central regions. Supporting the tourism value chain will generate new jobs among local suppliers, including farmers. Employers and government are reaching out to potential workers to facilitate easy access to seasonal jobs and provide monetary and education incentives for youth to learn the necessary skills. At the website sezonac.com, employers can directly access the pool of available employees. Waiters, cooks, reception- ists, and maids are the workers most in demand. Lab o r 51 1 What are the most important challenges facing Western Balkan labor markets? The region has very low rates of employment—only about 40 percent of the work- ing-age population actually works. When people do work, it is too often in the informal economy. Low and slowly-growing labor productivity constrains the prospects for real wage growth. And certain groups, notably young and old workers, women, and ethnic minorities, bear burdens of disproportionately high unemployment and low income. 2 What factors impede the improvement of these markets? High levels of non-labor income—pensions, social assistance, and foreign remittances— may discourage people from seeking work. A high burden of taxes and regulations inhib- its job creation, particularly for the low-wage, low-skill segment. Skills that employers seek are sometimes in short supply, and workers’ mobility to take better jobs is limited. Disadvantaged groups face special barriers to economic advancement. 3 What types of policy initiatives would fix these problems? The region should recraft its labor markets to make them well-functioning, inclusive, and attentive to the demographic pressures that are reducing the number of workers. It needs a friendlier business environment to facilitate job creation by firms. It needs tax and social protection systems that encourage job creation and job seeking, not protec- tion of existing jobs. Building relevant skills, enhancing labor reallocation, and reducing search frictions would further raise employment and labor productivity. 52 The Western Balkans: Revving Up the Engines of Growth and Prosperity Jobs are a crucial mechanism both for gener- Figure 50: Western Balkan employment levels are low ating strong economic growth and translating and declining. that growth into shared welfare gains across (Percent of population aged 15+) the population. Yet today only half of the work- ing-age population in the Western Balkans partici- 70 pate in the labor market, and one in four people 60 are unemployed. The imperative to reduce unem- 50 ployment and inactivity is even more urgent as the 40 ratio of the working-age population to dependents starts to shrink. In parallel to improving the regulato- 30 ry environment to encourage business startup and 20 growth, the Western Balkans need labor market and 10 social protection structures by which firms create 0 more jobs, more people work and for longer, and 7STE TE EE 7STEE AFRICA AFRIC RIC CA AP P EAP ECA EC CA C A LA A AC C LAC MENA ME ENA E N SA SA 6 WB6 general prosperity rises. 2000 2015 Source: World Bank sta estimates using data from World Development Indicators for all countries except Levels of employment are low, driven Kosovo, weighted regional averages. by low labor force participation and high unemployment rates. force participation rates, means a shrinking labor Less than 40 percent of the available popula- force.17 While currently 2.2 working-age individuals tion of working age is actually engaged in work. in the Western Balkans support each dependent, This is about 15 percentage points lower than the this number is projected to decline to about 1.8 in world average and more than 10 percentage points the next 20 years.18 below the Europe and Central Asia region average (Figure 50). Employment in the Western Balkans Informal employment is high. has declined slightly in the last 15 years, while it has remained stable or increased in the 7STEEs and Between 25 and 33 percent of total employ- countries in other regions. Employment rates are ment in Montenegro is informal, about 33 per- depressed both by low labor force participation and cent in Bosnia and Herzegovina, between 30 high unemployment (Figure 51). and 60 percent in Albania, and about 43 per- cent in FYR Macedonia.19 High informality under- Low employment levels mean that a large mines workers, firms, and the economy at large. Peo- share of factors of production and sources ple working informally face barriers to work-related of income remain untapped, potentially jeop - legal rights and protection and insurance mecha- ardizing further growth and development. nisms against shocks such as illness, loss of a job, and Declining employment-to-population ratio places poverty in old age. Large firms face unfair competi- a greater burden on workers and the government tion while small firms have incentives to stay infor- to support the unengaged.16 Declining employment mal, both hindering efficient investment and growth. rates can create a culture of dependency on non-la- High informality rates can be a drag on long-term bor benefits such as remittances and pensions, cre- growth and prevent income convergence, since the ating perverse incentives and inhibiting the develop- informal sector is usually characterized by low edu- ment of a skilled and adaptable labor force. Finally, cational levels and lower productivity. A large infor- employment outcomes can be further harmed by mal economy also makes it harder and more costly a shrinking (or merely slowly growing) working-age population that, without significant changes in labor 17 This is already a challenge for Serbia. Working-age populations as part of total population have increased in Albania, FYR 16 The share of older workers (+64) relative to the working- Macedonia, Montenegro, and Bosnia and Herzegovina in the age population (15-64) is high in the Western Balkans when last 15 years, but the demographic dividend is expected to be compared to other regions and is increasing over time, as shown exhausted in the medium term. 18 in the Welfare chapter. This is especially the case in Serbia, Bosnia Onal 2015. 19 and Herzegovina, and Montenegro. Albania, Kosovo, and FYR Estimates for all countries except FYR Macedonia from Macedonia have relatively younger populations, but the share of ILO 2011. FYR Macedonia statistic from World Development the young as a proportion of the working-age population is also Indicators. These estimates may not be strictly comparable since diminishing over time. they may not adhere to the ILO standard definition of informality. Lab o r 53 Figure 51: Low employment rates reflect high inactivity and unemployment. Labor force participation rates (national estimates), 2015 Unemployment rates (national estimates), 2015 80 40 60 30 40 20 20 10 0 0 SSA EAP LAC ECA 7STEE ALB MKD MNE SAS SRB WB6 MENA BIH KSV EAP SAS LAC SSA ECA MENA 7STEE ALB MNE SRB WB6 MKD BIH KSV Source: World Development Indicators, Labor Force Surveys and World Bank sta calculations. Note: De nition of labor force and unemployment may di er by country. to establish social risk pools and effective systems for Albania, real wages almost doubled before the crisis, tax, transfer, and public service delivery. but after 2009 slowed down significantly. In Serbia, this growth dropped off significantly in response to Jobs in the public sector are a significant por- the nominal public wage freeze introduced in 2009- tion of total formal employment. In 2010, about 10 and a cap that was imposed on indexation of 45 percent of all salaried jobs in Kosovo were still in wages in the public sector in 2012-13. However, this the government and SOEs. In the rest of the West- trend has started to change in recent years: real wage ern Balkan countries, the share was only about 10 growth was more than 1 percent between 2014 percentage points lower. and 2016. In FYR Macedonia, salaries decreased by 1.9 percent annually on average post-crisis, and the Real wage growth has been decrease was more pronounced in services. constrained by low labor productivity growth in the post-crisis period. Disparities in access to jobs weaken labor market outcomes. Low labor productivity growth in the post-cri- sis period has limited the scope for real wage Disadvantages that Roma people face in access increases in some Western Balkan countries. to education and jobs are well documented,20 Real wage growth in the region was relatively strong but there are also relatively high differences in over the 2002-09 period, averaging more than 5 per- jobs outcomes by gender and age (Figure 55). cent annually. In Albania, Serbia, and Montenegro, it Females have significantly poorer work opportunities outpaced labor productivity growth before the cri- compared to males, exceeding the gender dispari- sis, eroding competitiveness. However, this trend has ties in the broader Europe and Central Asia region. reversed itself since then as Western Balkan econ- In 2014, the gender gap in labor force participation omies exhibit low and slow-growing productivity, a ranged from 14.4 percentage points in Montenegro topic discussed in greater detail in this report’s chap- to 40.4 points in Kosovo. While the ECA region had ters on growth and enterprise. Real wage growth relative parity in the female and male unemployment was even slower than productivity growth after the rates, in the Western Balkans, the female unemploy- crisis hit (Figure 54). It was more than halved over the ment rate was 20 percent higher on average. 2009-14 period compared to before the crisis, limit- ing earnings convergence with comparator countries Young and older workers are particularly dis- (Figure 52). The lack of real wage growth was par- advantaged (Figure 55). Young workers face dismal ticularly evident in Albania and Serbia (Figure 53). In 20 Kahanec, 2014. 54 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 52: Real wage stagnated in the post-crisis Figure 53: Low growth of real wages since 2008 is period. primarily a concern in Albania and Serbia. (Real wage index, 2008=100) (Real wage index, 2008=100) 130 120 120 115 110 110 100 105 90 100 80 95 70 60 90 50 85 40 80 2008 2009 2010 2011 2012 2013 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 ECA EAP WB6 ALB MKD SRB OECD Europe OECD Non-Europe 7STEE BIH MNE WB6 Source: Sta calculations based on ILO Global Wage Database (Nominal Wage Adjusted Source: Sta calculations based on ILO Global Wage Database (Nominal Wage Adjusted by IMF CPI In ation). No data for Kosovo. by IMF CPI In ation). No data for Kosovo. employment outcomes, with unemployment rates Figure 54: Real wage growth has been even slower than approaching 50 percent on average for the 15-24 productivity growth in the post-crisis period. age group. Kosovo and Bosnia and Herzegovina had (Annualized percentage change, 2009-2013) the highest youth unemployment rates at 57.7 and 62.3 percent, respectively, in 2015. The rate of idle SRB youth —young people not in employment, educa- tion, or training— stood at 27 percent in the West- MNE ern Balkans, not only lowering the labor supply but MKD likely undermining the future stock of human capital.21 Except for Albania, participation in the labor force BIH peaks at age 35-39 or earlier (i.e. 25-29 in Kosovo), a much younger age than the 45-49 peaks common ALB in other European countries. Serbia’s high inactivity -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% rates among older workers may partially reflect labor market discouragement. Eighty percent or more of Labor Productivity Growth 2009-2013 Real Wage Growth 2009-2013 people looking for jobs after age 40 have done so for more than a year. Source: Sta calculations using nominal wages from ILO Global Wage database adjusted by CPI, labor productivity measured as GDP per person employed in constant LCU from World Development Indicators. Complex factors cause disappointing labor market outcomes. The analysis in this chapter focuses on four Market frictions hold back firms’ creating major supply-side factors that prevent the jobs, workers’ supplying their labor, and effi- development of better labor markets. They are: cient matching between them. Analysis of labor (1) high levels of non-labor income, (2) burden- demand in the region often faces a knowledge gap some labor tax and regulations, (3) gaps between caused by lack of access to reliable firm-level data. workers’ skills and those demanded by employers, Box 3.1 summarizes this issue and the limited evi- and (4) barriers to employment and segmented dence that exists, and the chapter on enterprise labor markets for disadvantaged groups. In addition, discusses the specific demand-side constraints to geographic constraints may impede internal labor private sector development and job creation. movement. Estimates based on the 2010 Life in Transition Surveys suggest that less than 20 percent of the population 18 or older in the Western Balkans 21 Vincelette et al. 2016. Lab o r 55 Figure 55: Female, youth, and older workers moved to a different city within the same country in (aged 40+) are particularly disadvantaged the previous 20 years. Less than 40 percent of peo- in accessing employment. ple aged 18-64 say they are willing to move internal- Labor force participation, % population aged 15+, ly for employment reasons. Weak national employ- by sex, 2015 ment services, struggling with high caseloads, have 90 trouble providing effective job matching assistance 80 and promoting labor mobility. % of population ages 15 to 64 70 60 High levels of non-labor income 50 –remittances, pensions, and social 40 assistance– can create disincentives to 30 work. 20 In several countries in the Western Balkans, 10 cross-border labor migration has become a NAC SSA ECA EAP WB6 LAC SA MENA MNE SRB ALB BIH MKD KSV vital strategy for improving household welfare. Male Female In 2010, more than 20 percent of the Macedo- Source: World Development Indicators and national authorities' data. nian-born population was living outside the coun- try. In Bosnia and Herzegovina and Albania, this figure was closer to 40 percent. The region’s very Youth unemployment, 2015, % of force (15-24) large outward migration has resulted in remittance MNE income averaging 10 percent of GDP in affected economies. Cross-country data shows a statistically ALB significant negative correlation between labor force SRB participation and remittances (Figure 56), although MKD the relationship is not particularly strong. The cor- KSV relation is stronger when we restrict the sample to middle-income countries, and even more so by BIH looking just at the Western Balkans. As we noted in WB6 the welfare chapter, remittances may impact both 0 10 20 30 40 50 60 70 the willingness to work and willingness to take cer- Source: World Development Indicators and national authorities data. tain types of jobs, leading to higher unemployment and possibly longer spells of unemployment. Over- Labor force participation rates, by age all, there is a positive relationship between remit- 90 tances and unemployment in the Western Balkans (Figure 57). 70 Pensions can also serve to lower employment, 50 because they have high coverage and are often more generous than unemployment benefits 30 and social assistance. Although several countries 10 have introduced reforms,22 pension benefits in Serbia, for example, amount to about 70 percent of aver- -10 age wage and 66 percent of GDP per capita (Figure 15–19 20–24 25–29 30–34 35–39 40–44 45–49 50–54 55–59 60–64 59). Early retirement is still common too. In Serbia ALB 2013 KSV 2014 SRB 2013 and Albania, for example, about half of pensioners MKD 2013 BIH 2010 MNE 2015 are below the age of 65. Pensions and remittanc- Source: O cial reports from national statistical o ces based on LFS statistics (Montenegro, FYR Macedonia, and Kosovo). Sta estimates based on LFS es together can account for more than 20 percent Statistics (Serbia and Albania). of GDP, higher than in most comparator countries 22 Serbia, for instance, introduced a new pension law in 2014 reducing early retirement and lowering the pay-outs of high- benefit pensions. 56 The Western Balkans: Revving Up the Engines of Growth and Prosperity Box 3.1: Demand-side analysis is a critical knowledge gap, mostly due to lack of access to reliable firm-level data. Evidence on job creation and job destruction for the Western Balkans is still limited compared to that available for other countries, in part due to lack of access to reliable firm-level data and information about job vacancies. Using firm-level data to analyze firm dynamics, barriers to entry for potential new firms, and barriers to growth for incumbent firms is fundamental to understanding the main constraints on job creation. Disaggregated job creation and job destruction rates are key to understanding which types of firms are responsible for the majority of the job creation (whether small or large firms, high or low productivity firms, and in which sectors). Also unavailable are data on job vacancies, which are necessary to understand the tightness of the labor market, or how well the existing stock of vacancies matches the inflow of unemployed workers (the “matching” process). Previous empirical analysis has used enterprise-level data to shed some light on these issues. These include two datasets: (1) Amadeus, a cross-country database on enterprise performance and operations, covering some EU-10 countries, some Western Balkan countries, Moldova, the Russian Federation, and Ukraine, and (2) the Business Environment and Enterprise Performance Survey (BEEPS), a cross-country database collecting data on perceptions of the business environment, among other things, covering 29 countries. Earlier studies, such as Arias and Sanchez-Paramo 2014, that used Amadeus have found that net job creation in the region in the pre-crisis period was usually led by a few high-growth firms. In Bosnia and Herzegovina and Serbia, about 20 percent of firms accounted for over 70 percent of net job creation in the pre-crisis period (2006-08).These firms tended to be young and small (so-called “gazelles”), and were more likely to operate in labor-intensive sectors, such as market services. A number of studies using the BEEPS conclude that the key binding constraints against entry of productive firms as well growth of existing firms are a weak regulatory environment, limited access to finance, and tax regulations that favor capital over labor. In Albania, large regulatory barriers may have harmed firm growth and job creation. Poor access to financial services also constrains accumulation and use of financial assets by firms in Albania, and affects relatively more the firms with the most rapid employment growth. Barriers to firm registration and high personal income taxes also discourage formal-sector job creation. In Serbia, net job creation in the few years after the onset of the crisis occurred mostly in the informal sector, particularly in part-time work. The often unfriendly business environment seems to be an important constraint impeding job creation. The formal private sector created few jobs. Exporters and importers do not seem to have different patterns of job creation. In recent years, smaller firms have had higher rates of employment growth but, since they started from a low base, they seem to have contributed less than large firms to overall employment growth. Gross job losses have been concentrated among the transition generation—people 40 and older. About 25 percent of firms perceive corruption as a major constraint on doing business, according to the 2013 BEEPS. Informal employment, poor access to finance, and corruption are also cited as important constraints by SMEs (small and medium enterprises).This segment of firms is important since its members provide 58.7 percent of total formal employment in Serbia. In Kosovo, net job creation has been concentrated in higher-productivity sectors, mainly construction and other services. Job creation in the tradable sector has been quite limited, in particular in the private sector. Labor costs that rise faster than productivity erode competitiveness and seem to be the most important constraint. Lack of skills appeared to be a binding constraint for large and fast-growing firms. In Montenegro, most new jobs have been created in skilled labor-intensive sectors. Employment of tertiary educated labor had increased by over 40 percent by 2014 compared to 2008, while the employment of workers with at most primary education faltered by over 40 percent during the same period. Skills per se are generally not identified as an important constraint on firm growth in employment surveys, except by new and innovative firms. Firms complain that they cannot fill vacancies, suggesting that supply side factors may be more important. In FYR Macedonia, the lack of dynamic private-sector job creation and of structural transformation and labor reallocation from low to high productivity sectors have limited the creation of better jobs. Most formal private employment is in small and less dynamic firms, with limited turnover, low innovation, and limited growth prospects. Gross job flows indicate a significant level of job churning in the enterprise sector, which in turn points to an unfinished transition process. As in other countries in ECA, a small share of firms (gazelles) accounted for a significant share of job creation. Larger firms are not necessarily more productive, signaling that resource reallocation is a significant issue. Two dimensions are identified as the major constraints on doing businesses: access to financial and human capital, and weak institutions. Credit restrictions, skills shortages, and corruption and unfair competition from informal firms are the more salient areas hampering the business climate. Source: Arias et al. 2014 and World Bank. 2016. “Firms Dynamics and Job Creation in FYR Macedonia: An Overview,” and World Bank Systematic Country Diagnostics. Lab o r 57 Figure 56: There is a modest negative correlation Figure 57: A strong positive correlation exists between labor force participation and remittances. between remittances and unemployment. (As percent of working-age population and GDP, (As percent of GDP and labor force, respectively) respectively) Avg Labor Force Participation Rate (percent) (2000-2015) Avg Unemployment Rate (percent) (2000-2015) 90 50 KSV MWI NPL MOZ TZA RWAKHM FRO ISL MDG BMU 80 40 CMRGINGHAUGA BEN VNM CHN NOR ETH THA EAPPER NGA MKD EAS KAZ ZMBSYC UMC 70 CAN CHE IDN MAC NZL BOL PRY BRBMLI LBR 30 RUS BRA VEN SWE ABW NAC USA BTN NLD DNK COL LCAECU DOM BIH AUS MYS WLD LAC LMY LCNAZE MIC CYP SLE CSS BLZ GEO GTMPHL JAM KGZ HTI NAM ZAF PSE LSO PAN ISR GBR TTO URY KOR HIC PRT FIN IRL UKR BGDNIC ARM SLV KIR ARM JPN OED ARG BLR AUTSVK MUSCRIMNG EST MEX LMC HND 60 NAM HKGCZE DEU ECS SVN ESP EUU MDV BWA EMU FRA ECA ROU LTULVATLS LUX SAS ALB IRQ LCA MNE 20 BWA SRB CHL ZAF CEB POL IND MKD KIR DZA ETH ESP YEM ALB DOM GRC BEL PAKMAR BGR LKA SEN LSO GRCSVK POLSTP SDN HRV TUN NGA GEO JOR SAU IRQHUNHRV MLT MNE IRN ZMB COL MNA LTU ARB LVA BGR BLZ JAM 50 TURITA ARB EGY MEA FJI ARG VEN URY TUR EMU MDV MEA CEB EST ECA BRB CSS EGYMAR SEN SRB KSV MDA EUU FRA PRT ITA FIN ECS MNATUN MUS IRL CHL 10 ABW DEU BRA SUR KAZ HIC ISR TTO RUS MWI CAN ROU OED SWE PAN AFG IDN HUN BEL LCN CZE SVNLAC CYPAZE CRI MLTUKRMLI ECU MNG FJI TLS NICPHL KGZ SLV IRN SDN YEM MHL WSM LBN NAC USA WLD GBR SAU DNK AUS UMC NZL AUT HKG CMR JPN EAS EAP NLD CHN MAC CHE KOR TZA NOR MYS SYC PRY GHA PER MIC LMY ISL MDG MEX PAK LMC BOL SAS LUX INDFRO LKA BGD LBRHND NPL BMU MDA WSM PSE BIH BTN RWA UGA GTM 40 DZA JOR THA BENVNM KHM 0 0 10 20 30 40 0 10 20 30 40 Avg Personal remittances, received (% of GDP), 2000-2015 Avg Personal remittances, received (% of GDP), 2000-2015 Source: World Development Indicators and World Bank sta estimates. Source: World Development Indicators and World Bank sta estimates. Figure 58: Pensions and remittances constitute Figure 59: Pensions are generous and many go to people a large share of GDP in the Western Balkans. below 65, creating potential disincentives to work. (Pensions plus remittances as percent of GDP, (Pension spending as a share of GDP and share of pensions 2014 or latest year) going to people under 65, latest year available) MNE 30 ALB BIH 25 FYR SRB 20 EST 15 LTU EST 10 SVK OECD 5 LVA CZE 0 ECA SVN EST SVK LTU CZE MKD SVN ALB LVA BIH KSV SRB MNE 0 10 20 30 40 50 60 Pensions/GDP Remittances/GDP Proportion eligible before age 65 Pension spending as a share of GDP Source: World Development Indicators, IMF 2015, IMAD 2015, Mukesh et al. 2007, Source: World Development Indicators, IMF 2015, IMAD 2015, Mukesh et al. 2007, Schwartz and Arias 2014, and World Bank sta estimates. Schwartz and Arias 2014, and World Bank sta estimates. (Figure 58). This may generate a strong supply-side nia, where the effective tax rate (income tax plus disincentive for older people to work. lost benefits of gross labor income) for these earn- ers is more than 65 percent.23 In Serbia, people who Social assistance may have generated disin- register as unemployed also get free health insur- centives for potential low-wage and part-time ance, a potential incentive to remain unemployed. In earners to shift from inactivity or from infor- Montenegro, social assistance programs create dis- mal to formal-sector jobs. Since social assistance incentives to take up part-time, temporary, and sea- generally subtracts a euro from the benefit amount 23 The effective tax rate is measured as the share of gross income for each euro earned, the cost of moving out of of the accepted formal job—including in-work benefits—that social assistance can be high (the “inactivity trap”). is taxed away through personal income tax, social security contributions, and lost benefits (social assistance, family, and This is particularly true in Serbia and FYR Macedo- housing benefits). Source: Arias et al. 2014. 58 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 60: The public-sector wage premium varies Figure 61: Public-sector employment has fallen in by age groups. recent years, but remains high. (Public sector wage/earnings premium, controlling (Percent of total employment) for worker characteristics) 1.0 100 Public Sector Share of Total Employment 0.8 0.6 80 Wage premium in percent 0.4 60 0.2 -0.0 40 -0.2 -0.4 20 -0.6 -0.8 0 (15-19) (20-29) (30-39) (40-49) (50-59) (60-69) (70+) Croatia Estonia Albania Latvia Lithuania Slovakia Slovenia Montenegro Serbia Bulgaria Kosovo BIH age groups Albania BIH Montenegro 2006 2010 Source: Sta estimates based on LFS data. Note: Speci cation includes the following controls: education, sector of employment, urban/rural, sex, age, and age squared. No controls for sample selection. Source: Sta calculations based on Life in Transitions Survey. sonal employment due to a high marginal effective about 8 percent.25 Public-sector employment in the tax rate for earnings below social assistance levels. region is decreasing over time (Figure 61), but still represents a significant share of total employment. Reservation wages (the lowest pay at which people are willing to work) are high. Remittanc- Burdensome taxes and regulations es, large social protection systems, and high pub- discourage creation of formal jobs. lic-sector wage premiums in the Western Balkans are creating disincentives to work. High non-labor High labor taxes may hinder job creation and income can create perverse increases in inactivity work incentives by making vacancy creation by increasing the reservation wages, unemployment and acceptance of jobs in the formal sector less rates, and duration of unemployment.24 The higher appealing. Social security contributions and other wages and job security of the public-sector may labor taxes contribute to the wedge between the have pushed reservation wages up as well and creat- cost of hiring a worker and the wage the worker ed disincentives to take up jobs in the private sector. receives. If these costs cannot be passed to the worker as lower wages, employers will likely adjust Incentives for working can be further ham- by limiting job creation or eliminating jobs, pushing pered by a large public sector that pays signifi- up the unemployment rate.26 On average, labor tax- cantly more than the private sector, reducing es constitute 37 percent of labor costs in the ECA the attractiveness of private-sector jobs, espe- region.27 The figures are significantly higher in the cially among high-skilled workers. FYR Mace- Western Balkans (Figure 62). Serbia has one of the donia has a significantly large public-private sector highest tax wedges at 42.2 percent,28 while Kosovo wage gap, and it has widened in recent years. The has one of the lowest,29 due to low pension contri- premium is higher for younger and more educated butions and personal income taxes.30 High taxes in workers, lowering their probability of accepting pri- vate-sector jobs. Even after controlling for worker 25 26 Winkler 2014. Alesina and Perotti 1997. characteristics, a public sector wage premium exists 27 Arias et al. 2014. in Bosnia and Herzegovina and Albania (Figure 60). 28 Serbia has not only the highest tax wedge in the region but also high severance payments linked to the employee’s entire work The premium in Kosovo, meanwhile, is estimated at history, not just to tenure with the firm. 29 Other estimates of the tax wedge are 41.4 percent for FYR Macedonia, 34.9 percent for Bosnia and Herzegovina, 40.2 percent for Montenegro, and 33.4 percent for Albania. 24 30 Blanchard et al. 2013 and Cahuc and Zulbebberg 2004. Though Kosovo has a very low tax wedge, other benefits such Lab o r 59 Figure 62: The tax burden is high for low-wage Stringent labor market regulations—including workers, suggesting low progressivity. restrictions on temporary work, protection (Percentage points) of workers against dismissals, and mandato- ry severance payments—can harm employ- 20 ment, but recent reforms in the region have Progressivity of tax wedge (percentage points) Ireland Belgium 18 France moved in the right direction. While evidence 16 Switzerland Austria Germany suggests limited impacts of labor market regulations 14 Italy Hungary United Kingdom Netherlands (unless at the extremes) on overall labor outcomes, 12 Norway Spain Slovenia there are distributional effects that have stronger 10 Finland 8 Portugal Czech Republic impacts on potential low-wage or part-time work- United States Slovak Republic Greece 6 Estonia Latvia Lithuania Sweden ers and on new and young entrants. The overall FYR Macedonia Poland Romania OECD employment protection indicator puts the 4 Japan BIH-Federation 2 BIH- Serbia Western Balkans on par with EU comparators but Republika Srpska Bulgaria 0 more restrictive than economies in other regions 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% (Figure 63). The degree of employment protection Tax wedge for single at 33 percent of average wage varies across the countries in the region. The World Source: World Bank based on OECD Tax and Bene t Models. Economic Forum labor market efficiency indicator, Note: Tax wedge is measured as personal income tax and social security contributions paid by combining labor flexibility and talent utilization effi- workers and employers as a share of total labor costs. The y axis shows progressivity of labor ciency, ranks the Western Balkan countries between taxation, as the tax wedge di erence between average and low-wage earners (for a single person with no children at 100 percent or 33 percent of average wage, respectively). Progressivity refers position 33 and 101 (1 is the most efficient), with to the increase of the tax wedge in percentage points. The x axis shows the tax wedge for FYR Macedonia and Montenegro the most efficient low-wage earners (here de ned as earning 33 percent of average wage). among them. Strong protections for permanent workers in Serbia, FYR Macedonia, and Montenegro these countries are mostly driven by social security make it significantly difficult to reduce employment contributions, though reforms in some countries are levels when an employer’s circumstances change. bringing these contributions down. In FYR Macedo- Kosovo has some of the region’s loosest controls on nia, the social security contribution rate was lowered hiring and firing of workers. The 2013 BEEPS sur- from 32.5 percent in 2008 to 27 percent in 2011, vey in Kosovo shows that only 4.9 percent of firms mainly due to reduction in pension and health con- there consider labor regulation to be a problem for tributory rates.31 doing business. Recent reforms across the region have probably made labor regulation more flexible Progressivity of labor taxes is low, discourag- and a less important obstacle to doing business. ing people at the bottom of the earning dis- tribution from seeking formal employment. The “Binding” minimum wages33 may hinder job labor tax wedge is especially high among low-wage creation for low-skilled workers. The ratio of and/or part-time earners (Figure 62).32 This means the minimum wage to the average wage is a com- that women, low-skilled workers, and youth, all of mon proxy used to measure the restrictiveness of whom tend to be more represented in low-wage minimum wages. In countries with high unemploy- and part-time employment, face disproportionate ment among young and low-skilled workers, this disadvantage. Formal-sector matches between firms ratio should not surpass one-third.34 By this rule and unskilled workers are less attractive as a result of thumb, all Western Balkan states, like their small of higher non-wage labor costs, leading to a high- transition economy comparators, have relatively er fraction of unskilled workers moving to either high minimum wages (Figure 67). High minimum unemployment or informality as they wait for better wages may also have distributional effects, resulting formal-sector opportunities to come. in increased earnings for employed workers but job losses among young and older unskilled workers. as maternity leave (currently 12 months) may impose a high cost on employers, which may hinder creation of jobs for women. 31 World Bank 2015b. “FYR Macedonia Public Expenditure 33 Review: Fiscal Policy for Growth.” A “binding” or effective minimum wage is a minimum wage set 32 In Serbia, for instance, the tax wedge is constant across all above the equilibrium wage in a competitive labor market. When wage levels, making it highly regressive. This is because there is minimum wages are binding, a large fraction of employees are at a mandatory minimum base for social security contribution set or close to the statutory minimum wages, and the distribution of at 35 percent of the average wage. It is not adjusted by hours wages is truncated. 34 worked, which has particular effect on part-time workers. Rutkowski 2003. 60 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 63: Serbia and FYR Macedonia have Figure 64: Protection of permanent workers against dismissal the region’s highest protection in terms is strong in the Western Balkans, particularly in Montenegro. of dismissal and hiring procedures. (Protection of permanent workers against individual (OECD Employment Protection Legislation Index) and collective dismissals, index) LAC LAC Other non OECD OECD Average OECD Avg. Other non OECD Western Balkans Western Balkans BIH Kosovo Kosovo Serbia Albania FYR Macedonia Montenegro Albania Serbia BIH FYR Macedonia Montenegro 0 1 2 3 4 0 0 0.0 0.5 0 5 1 0 1.0 1.5 1 5 2.0 2 0 2.5 2 5 3 3.0 3.5 4.0 Source: World Bank calculations based on OECD data. Scale from 0 (least restrictions) Source: World Bank calculations based on OECD data. Scale from 0 (least restrictions) to 6 to 6 (most restrictions), latest year available. For Albania (2015), Bosnia (2015), FYR (most restrictions), latest year available. For Albania (2015), Bosnia (2015), FYR Macedonia (2015), Kosovo (2014), Montenegro (2013), Serbia (2014). Macedonia (2015), Kosovo (2014), Montenegro (2013), Serbia (2014). Figure 65: Temporary employment is closely Figure 66: The region has tough specific regulated, especially in FYR Macedonia. requirements for collective dismissal, especially (Regulation on temporary forms of employment, index) Serbia and Montenegro. (Specific requirements for collective dismissal, index) OECD Average LAC Other non OECD Other non OECD LAC OECD Average Western Balkans Western Balkans BIH Kosovo Albania FYR Macedonia Montenegro Serbia FYR Macedonia Montenegro 0 1 2 3 4 0.0 0 0 0.5 0 5 0 1 1.0 1 5 1.5 2 0 2.0 2 2.5 5 3 0 3.0 3 5 3.5 4.0 Source: World Bank calculations based on OECD data. Scale from 0 (least restrictions) Source: World Bank calculations based on OECD data. Scale from 0 (least restrictions) to to 6 (most restrictions), latest year available. For Albania (2015), Bosnia (2015), FYR 6 (most restrictions), latest year available. For Albania (2015), Bosnia (2015), FYR Macedonia (2015), Kosovo (2014), Montenegro (2013), Serbia (2014). Macedonia (2015), Kosovo (2014), Montenegro (2013), Serbia (2014). Workers in the Western Balkans often a growing demand for new skills (not only mea- lack the skills needed in a modern sured by educational attainment, but also by other integrated economy. proxies that capture cognitive and non-cognitive skills). But the supply of those skills did not keep up, Skill gaps and skill mismatches may constrain despite the fast expansion of tertiary education. By employment in some countries. There exist large constructing a skill match index based on variance differentials between the types of skills demanded by of unemployment rates across different education firms and the skills available in the Western Balkan groups, signs of possible mismatches in Montenegro economies.35 Skill shortages and surpluses emerged and Kosovo have been found. In Montenegro, at early in the process of economic transition in the least 15 percent of the unemployed will not ben- Western Balkans as a consequence of privatization efit from job growth due to insufficient education and economic restructuring. The transition induced attainment and 20 percent due to occupational 35 mismatch. However, firms’ perception of skills as a Arandarenko and Bartlett 2012. Lab o r 61 Figure 67: Restrictive minimum wages can hinder job creation. (Percentage of average wage) Minimum Wage (% Average Wage) 60 2010 2000 50 40 30 20 10 0 Croatia Estonia Macedonia Slovak Rep Albania Moldova BIH Serbia Montenegro Ukraine Poland Romania Hungary Georgia Armenia Lithuania Kyrgyz Rep Belarus Russia Azerbaijan Turkey Slovenia Latvia Czech Rep Kazakhstan Bulgaria Tajikistan Source: Arias et al. 2014. Calculations using 2013 data from ILO. Figure 68: Lack of skills a particular problem for firms in Kosovo and FYR Macedonia. (Percentage of firms identifying an inadequately educated workforce as a major constraint, ECA countries, 2013) 45 % of rms identifying skills as a constraint 40 35 30 25 20 15 ECA Regional Average: 14.8 10 5 0 Kosovo FYR Macedonia Albania Serbia BIH Montenegro Croatia Uzbekistan Slovak Republic Kyrgyz Republic Ukraine Georgia Estonia Latvia Armenia Tajikistan Belarus Moldova Slovenia Hungary Turkey Poland Czech Republic Romania Lithuania Kazakhstan Bulgaria Source: World Bank calculations based on BEEPS 2013. major constraint is mixed. But on average, the share Balkans fare relatively well in international student of firms reporting skills as a major obstacle to doing assessments (such as PISA scores) and have relatively business is lower in the Western Balkan countries high tertiary gross enrollment rates compared to oth- than in other countries in Europe and Central Asia er middle-income countries (Figure 69). Still, many chil- (Figure 68). dren are not acquiring minimum generic skills, espe- cially when compared to OECD and EU countries. People in the Western Balkans have high access About 77 and 71 percent of 15-year-olds in Kosovo to tertiary education, but the schools seem inad- and FYR Macedonia scored below the threshold for equate for equipping workers with generic skills. functional literacy, which measures the ability to read Generic skills include cognitive skills (literacy, numeracy, and write (Figure 70). This may be one of the drivers and problem solving) and non-cognitive ones (behav- of the region’s high youth unemployment rates. ior and socio-economic attributes). These skills help workers make use of their human capital flexibly and Tertiary education delivers high average enhance job mobility. Most countries in the Western returns in the Western Balkans, and, with the 62 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 69: In human capital, Western Balkan education outcomes exceed other fast-growing, middle-income regions. (PISA Scores in math test, 2012 left and tertiary gross enrollment rate, % of tertiary school-age population, 2014 right) 480 467 60 460 50 440 40 Percent Scores 418 420 407 30 397 400 20 380 10 360 0 LAC Developing Asia Western Balkans ECA ECA LAC EAP SA SSA MNE SRB ALB MKD BIH Source: PISA, UN, Human Development Report. No data available for Kosovo. Note: Developing Asia consists of Indonesia, Malaysia, and Thailand. Western Balkans consists of Albania, Montenegro, and Serbia. Figure 70: But education quality leaves something to be desired. (Percentage of 15-year-olds who are functionally illiterate, scoring below level 2 on PISA reading test, 2015) 90 80 70 60 50 40 30 20 10 0 Croatia Switzerland Finland Cezch Republic Kosovo Estonia Sweden FYR Macedonia Netherlands Bulgaria Ireland d a d Poland d Norway y Denmark k Slovenia a Germany y Spain n Russia a Portugal al Latviaa United Kingdom m s n Belgium m a d OECD D Italy y e c Iceland d Austria a Luxembourg g e Hungary y Slovak k Serbia a Romania a Turkey y a Montenegro o Moldova a Albania a Georgia a a o France Greece Source: Vincelette et al. 2016. exception of Albania, there is no systematic evi- ployment rate for those with no schooling was 64.6 dence that the expansion of tertiary education percent, but only 18.9 for the tertiary-educated.37 has driven down the college wage premium. The earnings premium over secondary education, People who do have good skills often leave the often a proxy for a skills premium, was close to 60 country—as of 2013, a quarter of the six coun- percent in 2002 in FYR Macedonia and 55 percent tries’ population had moved abroad (Figure in Albania. In 2009, while those returns remained 71). The emigration rate among the highly educat- constant in FYR Macedonia, in Albania they fell by ed is high all over the Western Balkans (Figure 72), about 10 percentage points.36 The wage premium is particularly in Albania, Bosnia and Herzegovina, and also significant across the wage distribution. In addi- FYR Macedonia (it was almost 30 percent in that tion to receiving higher wages, individuals with high- country in 2000). If it exceeds a certain threshold, er education are rewarded with higher probability this measure of “brain drain”38 decreases the stock of employment. In Kosovo, for example, the unem- 37 Kosovo LFS 2014. 38 Emigration rate of skilled workers is widely used as a measure 36 Arias et al. 2014. of brain drain. The emigration rate is defined as the ratio of Lab o r 63 Figure 71: The Western Balkans have a large Figure 72: Labor migration and brain drain are quite high population living outside the home countries. in the Western Balkans, especially in FYR Macedonia and (Migrant stock, % source region population) Bosnia and Herzegovina. (Emigration rate of tertiary educated, as % of total tertiary educated population, age 25 and older) 25% 40 30 29.4 27.6 23.3 % 13% 20.3 20 17.5 15.3 7% 11.3 6% 6 9.2 10.1 11.1 10 6.7 6.8 7.3 7.1 3% 3% 0 W t nB Western Balkans Rest of Southern Southe thern Europe Eur est o Rest off the th W ld World ECA EAP MENA LAC ALB BIH MKD 1990 2013 1990 2000 Source: World Bank 2015a. “Coping with Floods, Strengthening Growth.” Source: World Development Indicators. No data on emigration available for Kosovo, World Bank sta calculations based on UN International Migrant Stocks Montenegro, and Serbia. data, 2013 revision. of human capital in the country of origin and can return on education, therefore inducing more invest- produce occupational distortions. ment in human capital, and financial, knowledge, and technology linkages with the diaspora. We noted in To understand the sources of the brain drain, it the welfare chapter that remittances from emigrants is useful to look at the schooling gaps between make an important contribution to household emigrants and natives, measured as the propor- income in the Western Balkans, but may have also tion of skilled relative to unskilled among emigrants lower incentives to work. All in all, the region would relative to the same proportion among native-born benefit from developing more job opportunities at individuals. On average, Albanian emigrants tend to home, while at the same time harnessing the bene- be more educated than the resident population, fits of emigration such as investment and knowledge since the share of secondary and tertiary among transfers from the people abroad. emigrants is quite high, suggesting that a dispropor- tionate share of high-skilled Albanians tend to emi- Aging exacerbates the problems of skills short- grate. In Bosnia and Herzegovina and FYR Macedo- ages. The skills of older workers are becoming nia, the share of individuals who completed primary obsolete, making it more difficult for them to tran- education or have incomplete secondary education sition to new jobs. In FYR Macedonia, the demand is higher for emigrants, suggesting that the high for new-economy cognitive skills (usually the types skill emigration rate cannot be attributed to higher needed in manufacturing or services) has increased schooling gaps.39 across younger cohorts, while older cohorts are employed in occupations that require routine man- For the migrant-sending country’s develop- ual skills, typically in agriculture and low-productivity ment, a brain drain can have both negative sectors (Figure 73). and positive impacts. On the negative side, the country suffers a reduction in the human capital Disadvantaged groups face additional that remains in the country and loses the economic barriers to employment. spillovers from that more educated workforce. Pos- itive effects might include increased expectations of Gender gaps in the labor market reflect dif- ferences in access to income-enhancing assets emigrants with certain school level, to natives with the same such as education, but also differences in school level (residents and emigrants). See Docquier 2006 and Docquier et al. 2006. returns to those assets, barriers to transition 39 World Bank 2015a. “Coping with Floods, Strengthening into the work force, and cultural norms. In Growth.” 64 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 73: The labor market demands workers with “new economy” skills; older workers risk skills obsolescence. (Percentile of the skill distribution for jobs held by each cohor t) FYR Macedonia, Cohort born after 1955 FYR Macedonia, Cohort born after 1974 65 65 Mean Skill Percentile of 2007 60 60 Skills Distribution 55 55 50 50 45 45 40 40 2007 2008 2009 2010 2011 2007 2008 2009 2010 2011 New Economy Skills Routine Skills Manual Skills New Economy Skills Routine Skills Manual Skills Source: Arias et al. 2014. Note: Y-axes plot the percentile of the skill distribution for jobs held by each cohort in any given year, with respect to the corresponding median skills intensity of jobs held by that cohort in the initial year. Kosovo, which has the region’s highest gender gap employees often lack the socio-emotional skills nec- in labor force participation, gender disparities are essary for a smoothly functioning workplace.43 As primarily driven by observable differences, nota- discussed before, labor regulation and labor taxation bly levels of upper secondary education.40 In other may also constrain youth employment. Low-wage countries, including Serbia and Albania, the causes earners bear a relatively high burden of labor tax- tend more to be unobservable factors and discrimi- es, so youth are more heavily taxed when working nation. In Serbia, it is women with low levels of edu- formally (often in part-time and low-wage positions). cation who face the greatest challenges in the labor The youngest labor market entrants tend to be over- market. On average, their inactivity rates are 19 represented in informal work. percentage points higher and unemployment rates are 2 percentage points higher than those of their Low employment rates among the old are male counterparts. Lack of working experience is mostly driven by low rates of participation in a contributing factor: about 55 percent of primary the labor force, resulting from work disincen- school-educated women who are inactive have no tives such as early retirement, disability, dat- paid working experience. In Albania, women face ed skills, and low labor mobility. In Serbia, the difficulty making the transition from family care-giv- share of 40-64-year-olds who are inactive due to ing or unpaid farm work to the commercial labor being discouraged or other reasons unrelated to markets. Lack of child-care options and cultural education are two to three times higher than the norms also play an important role—in traditional share of younger workers. In addition, the share of society, the priority for women is family.41 discouraged and inactive persons who are not in education or training increases with age, pointing Poor labor market outcomes among younger to growing problems of finding a proper job in old- workers are associated with skill gaps, labor er age. Preliminary evidence for Serbia shows that taxes, and regulations that particularly affect older people are less likely to find a formal-sector low-wage and part-time earners.42 Youth unem- job and exit unemployment than are prime-age and ployment has been associated with skill gaps, difficult younger workers. Mobility from the public to the transitions from school to work, and vocational pro- private sector among older workers is also limited, grams that are under-resourced and use outdated considering the generally longer employment dura- curriculum. In addition, many firms report that young tion in public-sector jobs.44 40 Pastore et al. 2013. 41 43 Western Balkan Gender Assessments. World Bank 2010 “FYR Macedonia Labor Demand Study.” 42 44 Vincelette et al. 2016. World Bank 2013. “Serbia’s Job Challenge Updated.” Lab o r 65 Figure 74: Working-age populations are becoming Figure 75: The aging of the workforce is correlated smaller on average in the Western Balkan countries. with the lack of structural transformation. (Percentage of population 15+) (Labor movement across sectors and share of working age population over age 40) Change in Population 15+ 2010-2030 (Percentage) 10 4.0 5 3.5 Albania of employment in sectors 2000-2014 3.0 Sum of Coe of variation : shares 0 2.5 -5 2.0 -10 1.5 1.0 Montenegro -15 FYR Macedonia 0.5 Serbia BIH -20 0.0 LTU BGR LVA EST SRB 7SEE HRV BIH WB6 SVK SVN MKD MNE ALB 15% 20% 25% 30% 35% 40% 45% 50% Share of working age population older than 40 Source: United Nations 2015. Note: Sector transition index calculated as sum of the coe cients of variation between 2001-15 in the shares of (a) agricultural employment/total employment, (b) industrial employment/total employment, and (c) services employment/total employment. Source: Employment shares from World Development Indicators. Share of working age population over age 40 calculated from Population Pyramids of the World (populationpyramid.net). Labor markets need special policy formation including labor reallocation, which is more attention. difficult for older workers. Across the region, there is strong negative relationship between the age of In the years ahead, demographic factors will the workforce and the degree of inter-sectoral labor alter the size of future labor markets in the reallocation (Figure 75). Western Balkans (Figure 74). Countries in the region can be divided into two groups based on In view of structural and demographic challeng- their projected population dynamics over the next es, policy priorities in the region must focus on 20 years: those with growing working-age popula- creating more and better jobs by promoting tions (Albania, Kosovo, Montenegro, and FYR Mace- well-functioning and inclusive labor markets. donia) and those with rapid aging in the medium While making it easier for firms to grow and create term that will decrease the working-age population jobs, the Western Balkans also need labor market (Serbia and Bosnia and Herzegovina). Countries and social protection systems that encourage job with aging populations need to increase labor force creation and offer incentives to raise labor force participation to counter the effects of the shrink- participation by all population groups. Building rel- ing workforce and, at the same time, need to raise evant skills, enhancing labor mobility, and reducing worker productivity. search frictions would raise employment and labor productivity. The jobs agenda should focus on the Demographic pressures appear also to influ- following five objectives:45 ence the composition of the working-age pop- ulation in the Western Balkans. Projections sug- • Addressing work disincentives by reducing gest that while the share of young workers in the labor taxation for low-wage earners and re- working age population will decline (Figure 76), the forming elements of social protection that share of older workers will increase in all countries encourage early retirement and discourage except Montenegro (Figure 77). On average in 2010, beneficiaries from seeking work. Bosnia and about 14 percent of the region’s working-age popu- Herzegovina, for example, would benefit from a lation was between 55 and 64 years old. That com- phased modification of the social assistance sys- pares with a projected 15.3 percent in 2030. This tem to encourage employment among poorer is an important challenge since the transition to a market economy requires intensive structural trans- 45 The country-level recommendations are drawn from the country SCDs. 66 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 76: The share of young workers (15-24) in Figure 77: …while the share of older workers the working-age population is heading down... (55-64) is rising. (Percent of working-age population, 15+) (Percent of working-age population, 15+) 30 20 25 15 20 15 10 10 5 5 0 0 SRB MNE BIH ALB MKD LVA LTU BGR EST HRV SVN SVK WB6 7SEE SRB MNE BIH ALB MKD LVA LTU BGR EST HRV SVN SVK WB6 7SEE 2010 2030 2010 2030 Source: World Bank calculations using United Nations. 2015. Source: World Bank calculations using United Nations. 2015. groups. In Serbia, it is important to address the workforce skills as a major obstacle to business. high minimum social security contribution and Education systems will need to focus on provid- redesign benefits to incentivize transition to ing skills that allow workers to enter these sec- work—for example, by requiring able-to-work tors. In Serbia, expanding access to education for beneficiaries to register with the National Em- the Roma is critical; in Kosovo, increasing female ployment Services and search for jobs. enrollment in secondary education is a vital goal. • Making labor market regulations less strin- • Removing obstacles to internal labor mo- gent to support a more flexible system of hir- bility by implementing policies that reduce ing and layoffs, while maintaining an adequate the cost of internal migration, promote the level of worker protection. Recent changes in sharing of reliable and timely information of labor regulations in Serbia promote a more flex- job vacancies across sectors and geography, ible system of hiring and firing by reducing sever- and encourage immigration of young talent. ance pay, raising the maximum duration for term In Bosnia and Herzegovina, increasing private employment, abolishing obligations to pay higher provision of employment services can be useful salaries for shift work, and changing provisions in to supplement the coverage, breadth, and qual- collective agreements. There is still room for im- ity of services provided by public employment provement, however. For example, the maximum agencies. length of a fixed-term contract in the country’s services sector is only 24 months.46 In Albania, • Removing barriers to employment of disad- the severance pay for redundancy dismissal (for a vantaged groups, by enlarging child care and worker with 10 years of tenure) in the services eldercare options, promoting flexible work or manufacturing sector is 21.4 weeks of salary, arrangements, and strengthening labor mar- the highest in the Western Balkans, and fixed-term ket programs that facilitate the transition of contracts are prohibited for permanent tasks. minorities, youth, old workers, and women from inactivity to employment. In Montenegro, • Helping workers acquire market-driven strengthening efforts to attract FDI in labor-in- skills, with special attention to younger new tensive, low-skill sectors could alleviate the large entrants to the labor market, older work- differences in labor market participation and un- ers, and disadvantaged groups. In Monte- employment among population groups. Kosovo negro, 10 percent of firms in the modern and may need reforms of its rules on maternity leave, innovating sectors consider the lack of desired whose current 12-month duration may be leading employers to avoid hiring women. 46 Doing Business 2016. Lab o r 67 Figure 78: Stronger reformers benefit from increased As the Western Balkan countries move toward employment and labor productivity, albeit with a lag. a new growth model, an important goal will (% of years in each decade when both labor productivity be to assure inclusion by providing adequate and employment increased) income opportunities for the less well-off. While higher private sector investment and trade 100% are expected to support income growth of the bot- tom 40 percent through direct and indirect job cre- ation, this type of change is not always labor-neutral. Should investments filter primarily into capital-inten- 50% sive sectors, few jobs will be created. Should invest- ments expand mainly in technology-driven sectors, the result could be little job creation for the poor and higher skill premiums, potentially exacerbating wage inequality. 0% 1990s 2000s 1990s 2000s 1990s 2000s Poland FYR Macedonia Belarus Therefore, to support inclusion and boost Advanced Reformers Intermediate Reformers Late Reformers employment for those at the bottom, it is Source: Arias et al. 2014. important to raise their skills and productivity and continue removing the remaining pockets of labor market rigidity that affect them dis - Fostering labor mobility and effective social proportionately. While export-oriented growth protection systems are essential to minimize could create jobs in higher-productivity sectors and job losses along the transition path. Market-ori- bring spillovers to other sectors in the economy, ented structural reforms promise to pay off in terms promoting opportunities for the poor and vulnera- of productivity growth and higher employment, but ble build human capital and skills could allow them often with a lag. The experience of past reforms to expand their employment opportunities and (Figure 78) shows that some employment losses obtain some of these jobs. In addition, labor and tax and labor shedding may occur in the short run. In reforms will make low-wage formal jobs (including fact, ongoing fiscal consolidation efforts in a num- casual and part-time) more viable so that the less ber of Western Balkan countries, which are neces- well-off can also find work in supporting services sary for macroeconomic stability, need to take into as new businesses enter and grow. Lastly, consider- account distributional and social impacts of large ing the high share of employment among the less lay-offs. Labor and social security reforms must con- well-off in small firms and self-employment, policies tribute to the flexibility and efficiency of the labor should strive to eliminate barriers for small and markets while maintaining a level of protection for medium enterprises (SMEs) and self-employment, workers displaced in changes that are necessary for and attract investments in agriculture and services the future prosperity of the region. In the process of to raise productivity in these sectors. The Western labor reallocation across different sectors, younger Balkans can learn from the experiences of certain and older workers, women, and ethnic minorities EU countries (see Box 3.2). are likely to bear a particular burden of losing jobs. For that reason, policies that eliminate their bar- riers to work, enhance employability, address skill mismatches, and improve labor matching are critical. 68 The Western Balkans: Revving Up the Engines of Growth and Prosperity Box 3.2: Some lessons from Germany and Poland in supporting jobs for the bottom 40 percent. Germany offers a strong example of effective reforms of labor markets as shown by their resilience after the Great Recession. Germany’s high structural and persistent unemployment over the 1980s and 1990s was often linked to high levels of employment protection and labor costs as well as strict labor market regulation. Labor market reforms implemented between 2003 and 2005 supported a flexible management of working time (through overtime and short-time work, time accounts, and labor hoarding). Reforms also promoted social cohesion, controlled unit labor costs, and a rigid incentive-oriented labor policy supported by effective program evaluation. As a result, unemployment and employment remained largely unaffected by the economic shock, since most of the employment adjustments were done at the intensive margin and part-time work arrangements. More importantly, the employment outcomes of some vulnerable groups that are often over-represented in the bottom 40 percent (i.e. female workers between 25 and 54, low-skilled workers between 20 and 64, older workers between 55 and 64, and younger workers between 15 and 24 years) improved after the reforms were introduced. In Poland, strong and steady economic growth was accompanied by higher employment and rising earnings for all income groups, including those in the bottom 40 percent of the distribution. Most of the country’s success in generating inclusive growth was due to labor income growth, largely reflecting improved education levels underpinned by well- functioning labor markets and gains in overall productivity. Policy reforms concentrated on three key areas. First, they promoted flexibility in the labor market by loosening employment protection. Second, they endorsed increases in access to education (in particular the proportion of workers with tertiary education) and in education quality, which led to across-the-board gains in educational outcomes, raising labor productivity.Third, at the lower end of the market, a national minimum wage policy regularly and significantly increased the minimum wage to enable low-wage earners to share in the productivity gains. As a result, incomes grew across the entire income distribution. Source: Rinne and Zimmermann 2013 and World Bank. 2017b. “Lessons from Poland, Insights for Poland: A Sustainable and Inclusive Transition to High-Income Status.” Lab o r 69 70 The Western Balkans: Revving Up the Engines of Growth and Prosperity INTEGRATION Taking a place in the world economy to drive growth and income convergence Textile and garment production has been at the core of economic life in the FYR Macedonian town of Stip since as long ago as 1883. But in the 1990s, the mills withered in the face of international competition brought on by the demise of Yugoslavia and communism. Today Stip is again a vibrant apparel producing and exporting town, following the country’s decision to liberalize trade and the private sector and close or privatize parts of two Yugoslavia-era companies in the town, Makedonka and Astibo. A Turkish investor now operates a former denim plant of Makedonka; Astibo has been born again as a successful private fashion company. Swiss and German investors have relocated garment production to Stip. Foreign direct investment inflows combined with the town’s managers and workers to create vibrant plants that employ nearly a third of the country’s industrial workforce. FYR Macedonia now exports more clothing per capita than any country in the Western Balkans. Integration with the value chains of foreign companies has given birth to new local ones as well. Fersped Skopje and Deni Internacional are among other enterprises that set up to provide cost-effective transport, logistics, and trade facilitation ser- vices. Goce Delchev University in Stip, meanwhile, offers degrees and diplomas in textile and apparel production, design, and management to meet rising demand for skilled staff. I n t eg r at i o n 71 1 Have trade and financial integration increased in the Western Balkans and have they led to income convergence? The pace of trade and financial integration was fairly rapid between 2000 and 2008 but has slowed since. The Western Balkan countries’ speed of convergence to higher per capita income has closely followed the pace of integration. There is room to deepen global integration to help speed up income convergence with the European Union, as the experience of the 7STEE countries has shown. 2 How can the region more effectively expand trade integration? The surest way to improve competitiveness is to raise productivity faster than costs. Policy reforms in this direction in the Western Balkans have created better incentives for firms, but remain short of EU transition economies’ levels. Lackluster reforms con- cerning SOE restructuring and regulations that impede domestic competition and labor reallocation have reduced firms’ ability to enhance productivity. The region’s relatively small labor force makes upgrading of exports key to sustained growth of exports. This upgrading would generate economy-wide productivity growth by moving resources to more sophisticated products. There is still major room to lower costs and improve quality of logistics and other services to reduce order-delivery turn-around times and expand participation in global value chains (GVCs). A greater role in European GVCs is crucial to facilitating overall global integration. 3 Can deeper integration between the Western Balkan countries help their global integration? For small open economies, greater regional integration brings economies of scale and enhances global integration by making them larger, more efficient, and diverse compet- itors for places in GVCs. Greater regional integration has many dimensions that would create positive spillovers for global integration. These include trade, the financial sector, transport, regulatory and investment policy, and macroeconomic and fiscal policy. 72 The Western Balkans: Revving Up the Engines of Growth and Prosperity Trade and financial integration proceeded Figure 79: Rising labor productivity accompanies rising briskly in the Western Balkans in 2000-08 but trade integration. suffered a serious blow with the onset of the (GDP/employed, and percent of GDP, 2014) global financial crisis. The crisis sharply reduced 250 financial inflows as well as external demand. The fall GDP per employeed person (PPP, constant 2011 All countries in inflows squeezed imports and consumption pre- 200 WB6 cipitously, while the global economic slowdown let 7STEE the air out of the region’s export growth. The West- international $) 150 ern Balkan countries slowed the pace of reforms, especially concerning regulatory restrictions and domestic competition, resulting in a general slow- 100 down in integration and income convergence. Nev- HRV SVN SVK ertheless, both trade and financial integration have SRB LVA 50 LTU EST continued to make progress on various fronts. There ALB BIH MNE MKD BGR is evidence to suggest that countries that imple- 0 mented structural reforms and increased public 0 50 100 150 200 250 investments after 2008 performed better than oth- Trade (percent of GDP) ers in the efforts to keep the economy, exports, and Source: World Development Indicators and World Bank sta calculations. productivity growing. Integration that was once brisk needs Most of this integration was achieved by 2007, with to accelerate again. financial flows falling off precipitously in 2008-09 and recovering gradually since. Given that comparators No small country can become rich without such as Estonia and Latvia have exceeded 300 per- accelerating its exports and deepening its inte- cent of GDP, further financial integration is possible. gration into the international economy—this is a basic fact that faces the Western Balkan Most of the cross-border financial flows into countries today as they seek income conver- the Western Balkans were FDI by European gence with the European Union. Exports face commercial banks in 2000-08. Between two- intense global competition that compels firms to thirds and four-fifths of Western Balkans banking allocate resources efficiently,47 adopt better tech- assets are currently foreign-owned. This has reduced nologies, tap economies of scale,48 and improve the historically high connectedness of the banking imported inputs,49 thus generating higher productiv- system with state-owned enterprises, making lend- ity growth. At the same time, domestic reforms that ing more arms-length, a welcome development in open up trade and investment flows and facilitate SOE-dominated economies. Foreign ownership firms’ ability to move labor and other resources to also helped banks channel offshore funds into faster new activities can raise productivity growth, reduce expansion of domestic credit, supporting growth of costs, and make exports more competitive. These private-sector firms. virtuous cycles explain the positive association between greater trade integration and higher labor The greater availability of foreign funds helped productivity (Figure 79). underwrite greater investment than would have been possible with national savings alone, In the Western Balkans, financial integration but also created new concerns. Higher invest- has been successful, rising from once negligi- ment supported growth but also created vulnerabil- ble levels. Measured as the sum of foreign financial ities in the banking system when investments proved assets and liabilities as a share of GDP, all five coun- to be less productive and resulted in non-perform- tries for which there are data had attained financial ing loans. Where these inflows financed excessive integration levels close to 170 percent by the end of consumption, they created vulnerabilities too. 2015, with Serbia reaching 190 percent (Figure 80). In parallel, these countries made significant 47 Helpman and Krugman 1985. strides in trade integration in 2000-08, though 48 Aghion et al. 2005. 49 Atkin et al. 2016. it was not as rapid as financial integration. Total I n t eg r at i o n 73 Figure 80: The Western Balkans have achieved Figure 81: The Western Balkans have broad poten- major financial integration, with room to grow tial to further expand trade. further. (Exports plus imports of goods and services as % of GDP) (Foreign assets and liabilities, % of GDP, 2015) 350 175 Average 7STEE (2015) 300 150 250 125 Average WB6 (2015) 200 100 150 75 100 50 25 50 0 0 KSV ALB BIH MNE SRB MKD BIH KSV MKD ALB SRB WB5 7STEE LTU SVK HRV BGR SVN LVA EST 2008 2015 Source: Haver and World Bank sta calculations. Note: Data for Serbia is for 2013. Source: World Development Indicators and World Bank sta calculations. trade (the sum of exports and imports of goods and cent from a relatively low level, meaning all countries services) reached almost 100 percent of GDP and retain considerable room for greater trade integration. more in Serbia, FYR Macedonia, and Montenegro, Kosovo is the least integrated, followed in order by but 90 percent in Bosnia and Herzegovina and only Albania, Montenegro, Bosnia and Herzegovina, Serbia, around 70 percent in Albania and Kosovo (Figure and FYR Macedonia. By contrast, Slovakia, Estonia, Lith- 81). By comparison, small transition countries such uania, and Slovenia have export shares in GDP that as Lithuania, Estonia, and Slovakia have considerably equal or exceed 80 percent. In terms of per-capita higher trade ratios of 155 to 185 percent of GDP. exports, the Western Balkan countries achieve only a fraction of levels in 7STEE countries. Exports have been an important driver of trade integration. In the last decade and half, exports of There is room to deepen integration goods and services grew by more than 10 percent among the Western Balkan countries, a year in Serbia, Albania, and Kosovo but less than building on CEFTA. 10 percent in FYR Macedonia and Montenegro, with Bosnia and Herzegovina averaging only 5 percent As countries strive to integrate globally, the a year. Exports grew much faster in 2000-08 in all small size of their economies suggests that countries despite a domestic demand-driven growth regional integration would be a good first step. strategy, because of the peace dividend following the While not all countries would be able to attract lead 1990s conflicts, the liberalization of trade, finance, firms like Fiat, this will not be necessary if an integrat- and the private sector, and, of course, a booming ed regional economy is built. Eliminating barriers to global economy. The global slowdown of 2009-15 trade and flow of factors of production within the lowered their export growth to 0.5 to 8 percent region would help the Western Balkans to expand a year, which was nevertheless commendable in a market size and enter European and global produc- difficult external environment.50 tion networks, participation in which is crucial for increasing productivity in manufacturing. The export orientation of these economies has increased, some more than others, but they con- The region increased its export share in glob- tinue to lag the 7STEEs. The GDP share of goods al and EU markets over the last 15 years. The and services exports rose to between 25 and 45 per- countries’ share in the EU market rose by nearly 100 percent between 2005 and 2015 (Figure 83), 50 Only five East Asian countries—China, Vietnam, Thailand, accompanied by a four-fold increase in total exports Cambodia, and Lao PDR—did better. 74 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 82: Strong export growth in the 2000-08 Figure 83: The Western Balkan states doubled their period slowed in the global crisis' aftermath. combined share in the EU market between 2005 (Real exports of goods and services, average annual growth rate) and 2014. (Exports to EU and EU imports, index 2005=100 and percent) 20 18 Index 2005=100 Percent 16 400 0.40 14 0.35 12 300 0.30 10 0.25 8 200 0.20 6 0.15 4 100 0.10 2 0.05 0 0 0.00 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2000-08 2009-15 2000-08 2009-15 2007-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 Share of WB6 exports in EU imports (RHS) ALB SRB KSV MNE MKD BIH WB6 7STEE UMC EAP WB6 exports to EU (LHS) EU imports (LHS) Source: World Development Indicators, Eurostat, national authorities, and World Bank sta calculations. Source: World Bank. 2016b. “Rebalancing for Stronger Growth.” to the EU. Western Balkan countries raised their Figure 84: Potential to increase regional integration. share in world goods exports too, by around 25 per- (Percent of exports) cent, with all countries except Montenegro increas- ing their individual shares. The lessons of this period 100 can be very helpful in the coming years because in the more subdued global and EU economy, strong 80 export growth depends on taking a greater share of 60 a slow-growing market. 40 There is room to use existing regional agree- ments to scale up participation in major Euro - 20 pean value chains. Albania, Bosnia and Herzegov- ina, FYR Macedonia, and Serbia depend on the EU 0 2000 2014 2003 2014 2006 2014 2000 2014 2000 2014 for 60-70 of their exports (Figure 84). The Central European Free Trade Agreement, CEFTA,51 accounts ALB BIH MNE MKD SRB for about 30 percent of the exports of Montene- WB5 EU* Turkey Rest of ECA Rest of Asia Other countries gro and Kosovo but only 10 percent of the rest of the Western Balkans. Less than 15 percent of the Source: World Integrated Trade Solution and World Bank sta calculations. region’s top exports go to CEFTA countries and Note: EU excluding Luxembourg, Malta and Netherlands. only plastics, and iron and steel, have a CEFTA share of about 25 percent. The GVCs operating in cloth- The potential for upgrading quality ing, footwear, machinery, and automotive subsectors and quantity of exports is high. export an even smaller share to CEFTA and source around 90 percent of their intermediate imports Successful upgrading of exports can drive from non-CEFTA countries. Most GVC-related FDI growth in productivity, employment, and GDP comes from non-CEFTA countries. This is not sur- as well as faster income convergence. The rela- prising given the relative size of the CEFTA and EU tively small labor forces in these economies52 make markets, and the latter is likely to play the dominant 52 The working-age population ranges from about 500,000 in role in future integration. Kosovo and Montenegro to 1-1.5 million in FYR Macedonia, Albania, and Bosnia and Herzegovina to 3 million in Serbia. The labor chapter highlights structural and some intractable factors 51 The CEFTA countries consist of Albania, Bosnia and Herzegovina, that reduce the participation rate of the working-age population FYR Macedonia, Moldova, Montenegro, Serbia, and Kosovo. in these countries to unusually low levels. I n t eg r at i o n 75 expanding exports by upgrading the best route to some indication of the progress made in the val- higher wages and income convergence. The man- ue-added upgrading that brings increases in produc- ufacturing sector has managed to generate higher tivity and therefore faster convergence in income productivity gains and convergence53 and thus a shift per capita. to higher-skill and technology-intensive products. But productivity increases can also come in agricul- The variety of export items in the Western ture from a rise in the share of processed exports, Balkans is smaller, and both product and mar- in metals from a move towards more differentiated ket concentration higher. Diversification has a downstream products,54 and in services from a shift different meaning when applied to small countries: to modern business services including more skill- and specialization in high-value added exports could be ICT-intensive ones.55 The low current shares of these more productivity-enhancing than a more diversi- types of goods and services suggest a potential for fied export structure (for example, a highly devel- higher export growth through upgrading. oped automotive industry connected to global value chains could be a stronger engine of growth The 7STEE countries increased market share than a more diversified but less sophisticated and productivity through continuous upgrad- export basket). That said, high value added indus- ing of exports.56 The pace and timing of the tries also tend to increase the variety of products upgrading of manufactured exports varied among as backward linkages develop in the economies. countries, starting with an expansion of low-tech- There is therefore some value in looking at indi- nology, labor-intensive products such as clothing ces of diversification and sophistication of exports. and footwear to mostly medium-technology ones Albania and Montenegro export the smallest vari- such as consumer electronics, auto, and machin- ety of items (500-1,000), with FYR Macedonia and ery, and then more slowly to the production and Bosnia and Herzegovina having about 3,000. Serbia, export of high-technology items within those sub- which inherited a relatively developed manufactur- sectors. Quality of products within each technology ing sector from the former Yugoslavia, comes close segment rose as well. The continual upgrading and to 7STEE averages, followed by the other two man- the accompanying rise in productivity raised mar- ufacturing-exporting countries, Bosnia and Herze- ket share in the face of the region’s appreciating govina and FYR Macedonia (Figure 85). On product real exchange rates.57 The same feat was accom- concentration, the top five exports account for 50 plished in modern services. percent of earnings in Montenegro, 40 percent in Albania and FYR Macedonia, but less than 20 per- There is room in the Western Balkans for cent in Serbia and Bosnia and Herzegovina. Market increasing export sophistication. The region concentration of exports is significantly greater: the exports resource-based items, low-technology, top five export destinations account for 70 percent labor-intensive manufactures, and higher-technolo- of export earnings in Albania, 60 percent in Bosnia gy products. While all countries could benefit from and Herzegovina and FYR Macedonia, and less than upgrading, differences in their export characteris- 50 percent in Serbia. tics and future policies will influence how individual export structures evolve. All countries have a less Agriculture, minerals, and metals comprise diversified and less sophisticated export basket in substantially higher shares of exports than both goods and services relative to the 7STEEs. But in the 7STEE countries. These products form the shares of agriculture, minerals, and metals versus about a third of merchandise exports in Albania, manufactures differ greatly among them, with some Bosnia and Herzegovina, FYR Macedonia, and Ser- having a low proportion of medium- and high-skill, bia, and two-thirds in Kosovo and Montenegro technology-intensive exports within manufactures. (Table 4.1). In addition, most agricultural exports While export sophistication is an imperfect mea- consist of primary unprocessed items, ranging from sure of the quality of exports,58 it nevertheless gives 7-12 percent in Albania, Bosnia and Herzegovina, and FYR Macedonia to 17-21 percent in Monte- 53 Rodrik 2012. negro and Serbia. Similarly, metal exports consist 54 Mandel 2011. 55 Fernandes 2008. mostly of ores and unwrought items, counting for 56 Fabrizio et al. 2007 and Raiser and Gill 2012. more than 50 percent of total exports in Kosovo 57 Fabrizio et al. 2007. 58 Lederman and Maloney 2012. and Montenegro and a smaller but still substantial 76 The Western Balkans: Revving Up the Engines of Growth and Prosperity 20-25 percent in Albania, Bosnia and Herzegovina, Figure 85: Western Balkan countries tend to export a Serbia, and FYR Macedonia. small number of products to a small number of countries. (Number of products and destination countries, 2015) Exports of processed fruits and vegetables remain small despite easy access to EU mar- 5000 All countries kets and their high demand for such products. WB6 Bosnia and Herzegovina exports fresh plums and 7STEE SLV SVK frozen raspberries, and FYR Macedonia apples, 4000 EST LTU BGR peaches, sour cherries, and plums, while Serbia is Number of products SRB HRV the third-largest producer of berries in Europe. LVA BIH 3000 Albania, FYR Macedonia, and Serbia have exported MKD some processed vegetables such as ketchup based on tomatoes, spiced tomato paste from pepper, and 2000 chips from potatoes. Such exports have stagnated, MNE apparently because current production, yield, and consistency of quality are not scaleable for export 1000 ALB operations, and storage, transport, and logistics sys- tems are inadequate. 0 50 100 150 200 250 Manufactures dominate goods exports in FYR Number of countries Macedonia, Serbia, Bosnia and Herzegovina, Source: World Integrated Trade Solution and World Bank sta calculations. and Albania, but they remain at the lower end in skill-technology intensity and quality (Figure 86). Labor-intensive low-technology manufactures that their global value chain (GVC) participation is such as clothing and footwear account for most mainly at the assembly and lower-skill end of the of Albania’s manufactures exports but only about subsector, suggesting considerable room to upgrade. a fifth of FYR Macedonia’s and Bosnia and Herze- govina’s and a tenth of Serbia’s. On the other hand, Services account for 70 percent of total export machinery and automotive items account for two- of goods and services in Albania, Kosovo, and fifths of Serbia’s, a third of FYR Macedonia’s, and a FYR Macedonia but only 25 percent for the fourth of Bosnia and Herzegovina’s manufactured other three countries. Travel and transport62 exports.59 dominate service exports in all six countries, with considerable scope for expanding tourism nonethe- Export sophistication of Western Balkans less. But there is even greater potential for increas- manufactures remains low, but there has been ing exports of higher-productivity business and ICT considerable progress in medium-skill tech- services as the 7STEE countries did.63 Serbia, Koso- nology exports.60 While the high-skill technolo- vo, and FYR Macedonia have a head start because gy intensity of the region’s exports has remained they have a significant nucleus of firms and skilled largely unchanged since the 1990s (Figure 88), high- workers that are already providing communica- skilled manufacturing in several countries in the tion, information, and computer services for their region has recently matured as its share of produc- domestic markets as well as export, albeit at a low tion increased to the level expected at their income level; in 2012-14 these services averaged about 15 per capita.61 Serbia, FYR Macedonia, and Bosnia and percent of total service exports for each of the Herzegovina probably account for most of the rise three countries. Such services contribute to value in medium-skill technology exports, given the coun- added in GVC exports and are thus exported indi- tries’ success in machinery and auto sector exports rectly too. Enhancing the efficiency of these services (Figure 89). But Figure 87 and Figure 88 also show can contribute to expanding GVCs. 59 Montenegro and Kosovo also have high shares of machinery 62 Traditional services consist mainly of transport, travel, and auto parts in their manufactured exports, but manufactures construction, and personal, cultural, and recreational services. comprise only 20 percent of their total exports. Modern services include communications, insurance, finance, 60 Shimbov et al. 2016. computers and information, and other business services as well 61 World Bank 2017d. “Trade in Transition: Europe and Central as royalties and license fees. Asia Economic Update.” 63 Fernandes 2008 and Raiser and Gill 2012. I n t eg r at i o n 77 Table 4.1: Composition of goods exported differs significantly among Western Balkan countries. (two-digit level, 2014) Albania Bosnia and FYR Montenegro Serbia Kosovo Herzegovina Macedonia 01-05 Animal 1.0 2.0 0.6 2.4 1.5 0.1 06-15 Vegetable 4.0 3.5 3.9 3.1 11.6 2.2 16-24 Foodstuffs 2.3 3.2 7.4 11.5 8.3 4.0 25-27 Minerals 15.9 8.2 5.1 21.0 3.3 7.4 23-38 Chemicals 0.5 7.7 21.6 3.9 5.4 0.5 39-40 Plastic/rubber 0.5 3.1 1.9 0.5 8.6 4.4 41-43 Hides, skins 0.9 1.8 0.2 1.2 0.6 5.2 44-49 Wood 3.4 10.4 0.6 11.3 4.7 1.2 50-63 Textiles, clothing 16.7 5.5 13.2 0.3 5.2 7.9 64-67 Footwear 17.7 7.1 1.3 0.2 1.9 0.2 68-70 Stone/glass 0.4 0.6 0.8 0.3 1.0 5.2 71-83 Metals 9.9 17.8 15.3 32.8 12.8 51.0 84-85 Machin/electr 2.3 11.3 21.5 6.5 16.6 6.9 86-89 Transportation 0.5 4.5 5.2 2.9 12.7 1.9 90-97 Miscellaneous 1.2 11.3 3.4 2.2 4.4 1.8 98-99 Special 23.0 3.1 0.0 0.0 1.5 0.1 Source: Comtrade. Note: Data for 2014 for all countries except Kosovo, which is 2012-13. Figure 86: In larger countries of the region, manu- Figure 87: …but upgrading to higher content of high factured exports tend to dominate trade in goods… technology and skill content is only starting. (Manufactures as share of exports, percent, 2000-15) (Manufacture exports by level of skill and technology intensity, 2015) 90 100% 80 70 80% 60 60% 50 40 40% 30 20% 20 10 0% ALB BIH SRB MKD MNE WB5 7STEE HRV BGR SVN SVK EST LVA LTU 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Labour & resource-intensive + low-skill and technology-intensive ALB BIH MKD MNE SRB Medium-skill and technology-intensive High-skill and technology-intensive Source: UNCTAD and World Bank sta calculations. Source: UNCTAD and World Bank sta calculations. 78 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 88: High-skill technology-intensive exports Figure 89: Medium-skill technology-intensive remain low. exports have risen. (Evolution of EXPY in manufacturing for high-skill technology (Evolution of EXPY in manufacturing for medium-skill technolo- intensity, index) gy intensity, index) 9000 8000 8000 7000 7000 6000 6000 5000 5000 4000 4000 3000 3000 2000 2000 1000 1000 0 0 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 High income countries WB6 High income countries WB6 Source: Shimbov et al. 2016. Source: Shimbov et al. 2016. Note: EXPY is a measure of sophistication of a country’s export basket following Note: EXPY is a measure of sophistication of a country’s export basket following Hausmann et al. 2007. Hausmann et al. 2007. Western Balkan participation in global Poland, Lithuania, and Slovenia increased theirs by value chains is slowly rising. between 5 and 10 percentage points.66 This was all accomplished through expanded participation in Expanded and deeper GVC participation facili- European GVCs. Productivity growth in manufac- tates upgrading and diversification and contrib- turing firms that were part of GVCs was found to utes to overall growth of exports and produc- be higher than those that were not.67 tivity.64 Export upgrading is especially effective in driving growth in productivity, employment, and GDP Exports typically upgrade along two avenues, in countries with relatively small labor forces. Western one from low-to-medium-to-high skill and Balkan firms’ participation in GVCs has risen for more technology intensive subsectors and another than a decade because they are able to produce and from lower-to-higher quality segments68 within export a slice of the product value chain at a large each of these subsectors. Successful EU transi- enough scale to be globally competitive without hav- tion countries started with mostly low-technology ing to build the entire value chain in the country. Also, products such as clothing and footwear, moved on upgrading products and functions along the export to mostly medium-technology items in consumer value chain is easier because lead GVC firms provide electronics, auto, and machinery, and then as policies, technical advice and support when such help makes skills, and infrastructure improved, moved increasing- the final GVC product more competitive. ly to exports of high-technology items within the auto, machinery, and ICT subsectors.69 At different The experience of EU transition countries points in time, countries simultaneously exported shows that expanding and upgrading final and both low-technology clothing in the high-quality seg- intermediate exports through GVCs is a potent ment and medium-technology electronic and auto- means of trade integration.65 Hungary and Slova- motive items in the low-quality segment. kia upgraded and expanded their share of domestic value added exports in GDP at double-digit rates 66 Rahman and Zhao 2013. between 1995 and 2008, while Czech Republic, 67 Taglioni and Winkler 2016. 68 For example, within the electronic and optical equipment category, a simple radio alarm differs in quality from advanced 64 Taglioni and Winkler 2016. scientific equipment, and within the food products, beverages, 65 GVCs can “compress” development experience, making non- and tobacco category there are large quality differences between linear catch-up possible as China did. See Whittaker et al. 2010, champagne and simple foodstuffs. Breznitz and Murphree 2011, and Raiser and Gill 2012. 69 Fabrizio et al. 2007. I n t eg r at i o n 79 Participation of Western Balkan countries in University in Skopje to ensure a continued supply of GVCs has been growing for more than a decade, skilled workers for the automotive sector. but they remain well behind levels of the 7STEE countries. Western Balkans firms have joined GVCs In 2015, more than half of gross exports were in clothing, footwear, machinery, and autos but not intermediate products in all Western Balkan yet in processed agriculture or ICT services. FYR countries but Albania. Figure 90 provides an Macedonia and Serbia have the highest share of GVC economy-wide view of the share of intermediates in exports participating in all four subsectors, with Alba- total exports and imports of Western Balkan coun- nia and Bosnia and Herzegovina coming next, though tries, compared to the 7STEEs, in 2004 and 2015. Albania’s participation is limited mainly to clothing Montenegro had the highest share of intermediates, and footwear. In these products there is relatively lit- though it declined from 85 to 70 percent between tle backward integration of firms assembling inputs the two comparison years and nearly 50 percent of imported mainly from the EU into final products the country’s intermediate exports in 2015 consist according to designs provided by lead GVC firms in of alumina, iron, and steel generated by mines that the EU. Cars, buses, and machinery are assembled are unrelated to GVCs. Bosnia and Herzegovina, FYR mainly from imported components but increasing- Macedonia, and Serbia were the most integrated in ly from parts being made by foreign-invested tier 1 European value chains in clothing, footwear, machin- and 2 suppliers operating in Serbia, FYR Macedonia, ery, and automotive products, with more than half of and Bosnia and Herzegovina—for assemblers in the their gross exports as intermediates, most of them country as well as for export. These foreign tier 1 GVC-related. and 2 suppliers are still importing a lot of their inputs because there are only a few local tier 3 firms able to The share of intermediate exports was much supply quality inputs, but that is exactly where there higher in 2015 than in 2004 in FYR Macedo- is considerable room for upgrade. nia and Bosnia and Herzegovina, but lower in Serbia and Montenegro. Serbia’s figure declined Rising GVC participation generates growing because car parts and components that were pre- intermediate exports and imports and the lat- viously exported appear to now be increasingly ter in turn raise growth in both productivity and incorporated into Fiat cars that are assembled in the GDP. This is not only because access to better-quality country and exported in ever-larger numbers. The inputs improves competitiveness70 but because when share of intermediates in Montenegro declined due intermediate parts are part of a long GVC supply to issues with the aluminum plant KAP. In the 7STEE chain, relationships among producers become much countries, half or more of gross exports are inter- closer, providing many more opportunities for trans- mediates, with the exception of Lithuania. fers of know-how. When Zastava makes car parts that will be combined with imported parts for assem- Annual growth in the Western Balkans coun- bling into Fiat cars for export, it cannot rely only on tries’ machinery and transport parts and com- existing Serbian expertise. It imports Fiat technology, ponents trade exceeded those of the world management, logistics, and other bits of knowledge and of the EU transition countries (Figure 91). not available locally, so that the Serbian-made parts This is due mainly to the Western Balkans’ rising fit seamlessly with imported parts from Italy or else- participation in machinery and transport GVCs and where. The same is true when the U.S. firm Johnson corresponding growth in output and exports. The Controls invests in FYR Macedonia to produce elec- expansion in FDI-financed production capacity in tronic dashboard components; the components must Serbia, FYR Macedonia, and Bosnia and Herzegovina fit with other parts that are produced in a second explains most of the growth in parts and compo- country and assembled in yet another. For this reason, nents trade.71 GVC investors often work to upgrade technical and engineering skills in the host country, as in FYR Mace- Growth in domestic value-added (DVA) that donia, where the Johnson Controls Training Center is embedded in gross exports of intermediate was established as a joint venture with the Faculty of and final goods is important for the domestic Mechanical Engineering of Saints Cyril and Methodius economy.72 Increases in DVA capture the gains to 71 Shimbov et al. 2016. 70 Aitken et al. 1997. 72 Gross exports of Western Balkan countries have three 80 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 90: Intermediate goods trade in Western Balkans and the 7STEEs: 2004 vs 2015. (Intermediate imports as % of gross imports) (Intermediate exports as % of gross exports) 39 28 MNE 36 ALB 32 45 61 ALB 39 SRB 52 37 46 BIH 54 MKD 58 54 61 SRB 56 BIH 66 52 85 MKD 63 MNE 70 45 38 LVA 37 LTU 40 EST 50 SVK 55 44 45 49 56 CRO 51 EST 48 LTU 57 LVA 62 51 49 57 42 SVN 54 CRO 52 47 55 BGR 58 SVN 53 66 50 SVK 59 BGR 57 0 10 20 30 40 50 60 70 0 20 40 60 80 100 2004 2015 2004 2015 Source: UN Comtrade and World Bank sta calculations. Note: Data for Montenegro compare 2015 with 2006 instead of 2004. a country’s labor and its entrepreneurs. DVA grows contribution to employment, productivity, and when gross exports grow, even if the DVA share per income. Figure 92 shows the compound annual unit of gross exports is low, as in clothing exports, growth rate (CAGR) of gross exports and of DVA and not rising. Countries can increase DVA per unit in five of the six Western Balkan countries for which of gross exports by undertaking backward integra- there are data.74 Serbia surged in DVA to 52 percent.75 tion and/or product and functional upgrading. This The annual growth of DVA in the other four countries, is the route available to Western Balkan countries. ranging between 12 and 17 percent, is respectable For example, producing garments by assembling relative to the 10-20 percent range of the 7STEEs, imported inputs implies low DVA per unit of gar- given the latter’s head start. In most cases, annual ment exports, as happens often in Western Balkan growth of DVA has nicely tracked the growth in gross countries. But if garment exports through GVCs exports. The only exception is Montenegro, where grow, their DVA could grow even more if export- export growth has been faster than DVA growth, ers procure imported fabrics and accessories and/or suggesting that exports from sectors with lower rates produce them domestically before assembling them of domestic value addition have been growing more into garments, as long as they can do such backward rapidly.This may reflect a changing composition of the integration competitively. export basket as well as increased GVC participation using more foreign inputs. Growth of gross exports and DVA embedded in gross exports73 are useful indicators of GVCs’ While raising growth of total DVA in gross components. The first is foreign value added (FVA) that is exports is an appropriate goal, maximizing imported from foreign suppliers, the second is domestic value the DVA share per unit of a subsector’s gross added (DVA) of gross exports of final goods that are consumed in the foreign destination countries, and third is DVA of gross exports is not. Excessive focus on the latter has led exports of intermediates that enter as inputs in foreign countries’ gross exports. Total DVA is the sum of DVA from gross exports of final and intermediate goods. to transfer non-proprietary technical know-how to countries and 73 Value addition is a function of productivity and is associated firms if they have potential to upgrade competitively. 74 There is anecdotal information on Kosovo’s participation in with breadth, variety, and sophistication of tasks and activities in which a country specializes. GVCs have a built-in mechanism to GVCs in garments and in metals. outsource tasks and activities to countries that can meet brand 75 Serbia is a clear outlier, suggesting a need for further quality competitively, because lead firms/tier-1 suppliers are willing examination of the Serbian database used by the EORA database. I n t eg r at i o n 81 Figure 91: The Western Balkans’ parts and components Figure 92: The Western Balkans had mixed trade grew faster than world and 7STEEs. results in compound annual growth of gross (Average annual growth rates of parts and components, imports and exports and DVA growth embedded in gross exports, percent) exports in 2000-12. (Exports and domestic value added, annual growth rate, 2000-12) 35 SVN 10% 10% 30 World SVK 16% 12% 25 7STEE 20% LTU 15% WB6 21% 20 LVA 15% 12% EST 13% 15 HRV 19% 13% 10 18% BGR 14% 5 16% SRB 52% 0 2000-08 2009-15 10% MKD 12% MNE 14% Source: UN Comtrade and sta calculations based on Shimbov, Alguacil, and Suarez 2013. 12% 11% BIH 16% ALB 17% 17% countries to restrict firms’ access to the often higher 0% 10% 20% 30% 40% 50% 60% quality and more competitive intermediate inputs Exports DVA available abroad. Such actions undermine competi- tiveness, GVC participation, and ultimately growth in Source: EORA database and World Bank sta calculations. total DVA.76 GVCs require trade regimes that make imports available at close to world prices, allowing firms to make choices based on market demand and local workers. The scope for functional upgrading competitiveness. Backward integration and product and product upgrading is high in this sector and suc- or functional upgrading are highly desirable when cess in that effort can generate significant increases they make the GVC product more competitive. in DVA share per unit of clothing exports. This can consist of upgrading products (for instance, shifting The Western Balkans countries can increase from shirts to suits) and upgrading functions (local DVA by either raising the DVA share per-unit in firms procuring fabrics and accessories, for example, existing GVC exports or by attracting GVC lead or preparing clothing samples for buyers). But this firms in new subsectors. Existing GVCs in clothing, requires skilled labor. If clothing exports are large footwear, machinery, and transport offer considerable enough, backward integration in terms of producing opportunities for backward integration and product fabrics and accessories domestically may be feasible. and functional upgrading, as well as simple expan- Similar upgrading possibilities exist in footwear. sion of existing intermediate and final good exports. Entering GVCs that have little local participation, as FYR Macedonia, Serbia, and Bosnia and Her- in processed agriculture or ICT services, is another zegovina have expanded automotive exports option. This is the way the 7STEE countries did it. through GVCs but FDI-invested exporters of intermediate and final goods have few linkages All the Western Balkan countries except Mon- to domestic suppliers. FYR Macedonia and Serbia tenegro export clothing through GVCs using have already begun efforts at further backward inte- mainly cut, make, and trim (CMT) contracts gration by encouraging local tier 3 suppliers. They by which imported materials are assembled by are working with procurement managers of FDI-in- vested assemblers and tier 1 and 2 suppliers in the 76 DVA and FVA are seen as complements in the context of two countries to identify parts of the value chain GVC integration because access to greater variety and/or to higher quality of imported intermediates embodying foreign that local suppliers might fill.77 technology and know-how increases productivity. See Grossman and Helpman 1993. 77 In FYR Macedonia’s bus manufacturing value chain, for instance, 82 The Western Balkans: Revving Up the Engines of Growth and Prosperity Attracting lead GVC firms in processed fruits The trading regime of the region is already and vegetable into the Western Balkans could very open. Albania, FYR Macedonia, and Montene- expand the region’s gross exports and DVA. gro are members of the World Trade Organization Albania, Bosnia and Herzegovina, FYR Macedonia, (WTO), while Bosnia and Herzegovina and Serbia are and Serbia have high production capacity78 and sev- at advanced stages of the WTO accession process. eral Western European supermarkets chains have Stabilisation and Association Agreements (SAA) have set up retail stores there.79 But competition from entered into force in all six countries, giving them free Greece, Italy, Spain, and Turkey, which have similar access to the EU market.81 However, current levels climates but more modern production processing of tariff on agricultural products and intermediate and logistics systems, makes it challenging to attract imports are affecting GVC competitiveness because GVCs in processed fruits and vegetables. In export- intermediate items have to cross borders more than ing fresh tomatoes, for example, Albania has many once, making the cumulative impact of tariffs high. missing links and poor coordination across the value chain, suggesting a need for government collabora- But the domestic regulatory environment tion with the right private investors to fill the gaps remains quite restrictive. These restrictions in the chain.80 increase the cost of domestic transactions relating to private investment and firm operations and reduce Steady progress so far in integrating into GVCs the competitiveness of exports. Though the regula- suggests they are a good base from which to fur- tions impinge on local citizens and foreigners alike, ther accelerate exports, employment, and pro- foreigners feel a greater impact because they have ductivity. Without comparable data on intermedi- less access to and understanding of local process- ate trade, gross exports, and domestic value added es. Reducing the domestic regulatory burden would in participating subsector GVCs, overall conclusions enhance competitiveness and facilitate further inte- have to be tentative. Nevertheless, the analysis above gration with the rest of the world. shows that the base is strong for future gains. Finding ways to increase competitiveness is To deepen trade integration, reforms critical as countries seek to expand exports should target bottlenecks to GVC in a time of global and European slowdown. participation. The currencies of the Western Balkans countries appreciated substantially in 2000-08 and remained Appropriate changes in policies and public high in the post-crisis period despite the shocks of investments to expedite trade integration the global slowdown (Figure 95). Serbia and Mon- through exports will be critical for reviving the tenegro experienced real appreciation of about 80 Western Balkans countries’ growth in produc- percent and others of 10-15 percent. Policies to tivity and GDP. Higher export growth through smooth out exchange rate volatility would raise the upgrading calls for greater GVC participation by region’s competitiveness. Though the cost of labor reducing tariffs on intermediate imports, increasing in the Western Balkan is lower than in the rest of domestic competition by reforming regulations and Europe, it is higher than in low-cost Asia. Lowering restructuring SOEs, investing in power and trans- high social security taxes in the region would also port, enhancing efficiency of connectivity in terms of be helpful (Figure 96). While these steps would aid trade facilitation and logistics, expanding availability competitiveness, far more important is removing the of industry-specific skills, and targeting development structural and regulatory barriers that harm produc- of domestic-suppliers in existing machinery and tivity (see Enterprise chapter). transport export sectors. To export more, the Western Balkans must interiors, exteriors, and tooling are currently made locally. Efforts also deliver goods cost-effectively. Moving goods are underway to create a critical mass of bus manufacturers in across borders efficiently requires high-quality logis- FYR Macedonia as a regional hub for final assembly. 78 These countries have substantial arable land, and more than tics and transport connectivity. It also requires efficient a quarter of their labor force is in agriculture, with many farms and fair border and customs processing. Likewise, producing fruits and vegetable annually. 79 Intermarche (France), Conad and Pam (Italy), Delhaize (Belgium), and Veropoulus (Greece) are operating there, as well 81 SAAs entered into force in FYR Macedonia in 2004, Albania as Turkish, Slovenian, and Hungarian chains. in 2009,  Montenegro in 2010,  Serbia in 2013,  Bosnia and 80 Ajennman 2014. Herzegovina in 2015, and Kosovo in 2016. I n t eg r at i o n 83 Figure 93: Real exchange rates were volatile in the Figure 94: Labor costs are lower than in the EU but 2000-15 period. higher than in low-cost Asia. (Real exchange rate index, 2000 = 100, increase is appreciation) (Nominal average wage, US$, 2010) 240 1200 220 1000 200 800 180 160 600 140 400 120 100 200 80 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 India Indonesia Philippines Thailand Albania China Serbia FYR Macedonia Bosnia and Herzegobina 7STEE ALB BIH MKD SRB MNE KSV Sources: Bruegel, IMF, national statistics o ces, and World Bank sta estimates. Sources: World Development Indicators and World Bank sta calculations. moving service products requires up-to-date digital and behind-the-border processes and infrastruc- communications networks. Figure 97 details deficien- ture. Many reforms will be horizontal in nature and cies in logistics relative to other European countries.82 include leveling the playing field between diverse set of enterprises, an agenda more thoroughly Despite considerable investments in the South described in the next chapter. This chapter has so far East Europe Transport Observatory (SEETO) advised focusing efforts in trade facilitation and cus- Comprehensive Network to create reliable toms, transport and logistics, and retaining qualified transport, the region needs significant fur- labor. Better financial services and a more integrated ther efforts to ensure competitive delivery of regional economy would help facilitate such reforms export goods. Such efforts may need to develop at the national level. “intelligent” transport systems for railways, improve risk management systems, and simplify border cross- Greater depth, stability, and efficiency ings.The challenge is to increase reliability in the time in the financial sector would also and cost of transportation and the moving of goods facilitate trade. across borders. Global financial integration has increased sub- An ambitious at-the-border and behind-the- stantially over the last two decades, including in border reform agenda would help cut costs the Western Balkans. In Europe, financial integration to increase productivity and competitiveness has been unique as private capital in all its forms— and facilitate cross-border trade. More analyti- cross border flows and FDI—has flowed from richer cal work is needed to identify specific constraints to to poorer countries, and from low- to high-growth increasing exports from the Western Balkans, as well economies. Since the early 2000s, transformation and as to faster climb on the technological ladder. Based transition have been particularly deep in the region’s on the diagnostic in this chapter, an ambitious agen- banking sector. Removal of nationality restrictions, the da is shaping up for reforming both at-the-border liberalization of market access, the EU enlargement process, and the sale of most state-owned banks have 82 A one-day delay reduces the export value of most goods brought about a round of banking consolidations and by 1 percent. For agricultural products, which are critical for development in the Western Balkans, a one-day delay may a large increase of foreign bank participation. translate as 7 percent. The unpredictability at border crossings coupled with a “culture of control” in these economies contribute to high logistics cost, which are estimated at 16 percent of GDP Financial deepening has been uneven across compared to about 8 percent in the EU and the United States. countries and sectors. In terms of size, on average, See Fengler 2016. 84 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 95: Vigorous reforms in the Western Balkans... Figure 96: ...still fell short of those in other small (EBRD transition score, index) transition economies of Europe. (EBRD transition score, index) 4.0 4.0 3.5 3.5 3.0 3.0 2.5 2.0 2.5 1.5 1.0 2.0 0.5 1.5 0.0 WB5 7STEE 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1995 2008 2014 ALB BIH MNE SRB Source: EBRD and World Bank sta calculations. Source: EBRD and World Bank sta calculations. Figure 97: The Western Balkans are lagging behind 7STEEs on logistics performance. (Logistics performance index 2014, Overall, 1=low to 5=high) 3.8 Median (Rest of EU) 3.6 3.4 Median (7STEE) 3.2 3.0 Median (WB6) 2.8 2.6 2.4 2.2 2.0 LVA SVN EST SVK LTU BGR HRV SRB MNE ALB BIH MKD Rest of EU 7STEE WB6 Source: World Development Indicators and World Bank sta calculations. Table 4.2: Western Balkan countries have a heavy burden of domestic regulation. ALB BIH KSV MKD MNE SRB 7STEE Doing Business rank (2017) - 58 81 60 10 51 47 27 WB Corruption Perception Index 39 39 n.a. 37 45 42 55 score (2016) - TI Intensity of local competition 116 119 n.a. 41 124 128 51 (2016-17) - WEF Extent of market dominance 124 108 n.a. 67 89 129 64 (2016-17) - WEF Effectiveness of anti-monopoly 112 105 n.a. 49 85 118 64 policy (2016-17) - WEF Business impact of rules on FDI 59 127 n.a. 32 95 102 50 (2016-17) - WEF Source: Doing Business (DB), Transparency International (TI), and World Economic Forum’s (WEF) Competitiveness Index; latest year available. I n t eg r at i o n 85 Figure 98: Financial sector assets are mostly in the Figure 99: Credit and deposits vary banking sector. country-to-country. (Financial and banking sector assets, as a share of GDP, 2014) (Private sector credit and deposits, as a share of GDP) 120 80 100 60 80 60 40 40 20 20 0 0 ALB BIH KSV MNE MKD SRB ALB BIH KSV MNE MKD SRB Financial Sector Assets/GDP Banking Sector Assets/GDP Private Credit 2008 Private Credit 2015 Deposits 2008 Deposits 2015 Source: International Financial Statistics (IFS), national authorities, and World Bank sta Source: International Financial Statistics (IFS), World Economic Outlook, national calculations. authorities and World Bank sta calculations. the region’s financial sector assets are equal to 93 per- of GDP. While this deleveraging impacted all coun- cent of GDP. Levels of financial sector depth vary across tries in the region, Bosnia and Herzegovina and Mon- the region ranging from 81 percent of GDP in Kosovo tenegro felt the heaviest blow. However, the general to 103 percent in Albania and FYR Macedonia (Figure absence of riskier instruments, and the launch of the 98). While the banking sector has been growing rapidly Vienna Initiative helped the region’s financial systems over the last two decades, the non-bank financial sec- weather the global crisis relatively well; deposits take tor remains shallow, with relatively minor capital mar- up a major share of the funding structure (Figure 100, ket activity, negligible penetration of insurance products, Figure 101). and generally insignificant non-bank financial institu- tions. Overall, financial intermediation in the Western To support sustained growth going forward, the Balkans remains low when compared to countries of Western Balkan financial systems need reforms the 7STEE group. The depth of the domestic finan- to increase efficiency, improve access to finance, cial sector, measured by private sector credit to GDP, and strengthen their own stability. Financial inte- stands at an average of 45 percent, with particularly gration brings important benefits to the extent that low levels in Kosovo and Albania (Figure 99). policymakers address existing vulnerabilities: While foreign bank penetration brought deep • Across the region, high levels of non-perform- and more efficient financial intermediation, ing loans need further urgent policy attention it also increased exposure to external vulner- to strengthen regimes for corporate and per- abilities. Commercial banks had access to larger sonal insolvency and creditors’ rights. Regulatory cross-border flows of funds. This supported great- classification and provisioning standards must be er financial deepening than was possible based on strengthened. domestic deposits, though those deposits contin- ued to dominate banks’ funding sources. Fueled by a • Deleveraging remains a risk as some parent favorable global environment and ample lending sup- banks plan to further scale back their presence ported by foreign parent banks’ funding and capital, in the region as a result of continued market credit to the private sector grew at rates exceeding and regulatory pressures. Shifts in banks’ funding 30 percent a year in the pre-crisis years.The associat- models, increased competition, and low bank ed risks became clear during the global financial crisis profitability in some countries in the region may when capital inflows came to a halt. Between 2008 bring about further bank consolidation. and 2015, Bank of International Settlements-report- ing banks reduced their cross-border exposure in the • Given the high dependency on foreign curren- Western Balkans by an average of almost 6 percent cy lending and borrowing, governments would 86 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 100: Funding though deposits grew steadily… Figure 101: …and now dominates the funding struc- (Percent of GDP) ture of banks. (Q2 2015) 60 100 50 80 40 60 30 40 20 10 20 0 0 2008 2009 2010 2011 2012 2013 2014 2015 ALB BIH KSV MNE MKD SRB International claims (WB6 average) Deposits (WB6 average) Household deposits Corporate deposits Government deposits Foreign liabilities Capital and reserves Other Source: IFS, BIS locational statistics, national authorities, and World Bank sta Source: IFS, BIS locational statistics, national authorities, and World Bank sta calculations. calculations. do well to pursue policies that increase the use Regional cooperation will reinforce of local currencies. This would both strengthen national efforts to deepen integration financial stability and afford greater policy free- into the world economy.83 dom to monetary authorities. Regional integration is a crucial component of • Moreover, it is essential to further strengthen the entering European GVCs. Once trade and trans- financial safety net by building up the financial portation costs between countries are reduced and and institutional capacity of the deposit insur- distances collapse, GVC entry will be easier. Firms from ance systems and by developing a comprehen- any country in the region will be able to offer goods sive resolution regime to deal with the weakest and services to the developing GVCs, such as the auto- banks. motive industry. Some progress has been achieved on this front, with increasing numbers of Serbian and • In terms of crisis prevention, macro-prudential regional suppliers connecting to the automotive val- supervision needs strengthening across the re- ue chain through the Serbia-based Zastava plant. An gion. This is particularly relevant in Montenegro, ambitious agenda to cut trade costs between countries Kosovo, and Bosnia and Herzegovina, which have would also include reforms to improve connectivity and limited monetary policy tools. eliminate trade policy barriers, behind-the-border con- straints to trade, and frictions that may arise at border • Banking regulation and oversight have improved control agencies such as customs.To the extent individ- over the last decade, but a number of import- ual Western Balkans countries implement reforms and ant shortcomings remain. Further progress is investments to foster regional ties, the steps are likely to needed in risk-based regulatory and superviso- fit well into EU integration as well. Reducing cross-bor- ry practices as well as linking regulatory capital der costs within the region will be crucial to help a large requirements to commercial banks’ market and investment in one given country cause ripple effects in credit risks. Regulation in corporate governance the rest. Several directions of regional cooperation will and identification of ultimate beneficiary own- provide the necessary support for this agenda. ers and related-party lending should also be strengthened in some Western Balkan countries. Continuing efforts to maintain macroeconomic The EU Banking Union aims for stronger super- stability will benefit the region as a whole. Having vision, a level playing field across borders, and weathered the global financial crisis, there is a com- simplified “home-host” interactions. Achieving these goals will require close cooperation and 83  Concerning specific dimensions of regional integration, this section draws on World Bank. 2017e. “Western Balkans: Regional communication. Economic Integration Issues Notes.” I n t eg r at i o n 87 mon need in the Western Balkans to ensure macro- ductivity and thus the return on new investments, it is economic stability by consolidating public finances, critical that the right skills for the technology available reducing debt levels, and enhancing the quality and are both available and well used. Mobility of people is equity of public spending. Fiscal sustainability is par- one of the key driving forces of regional integration and ticularly important in small open economies like the growth, as it allows for a more efficient allocation of Western Balkans that have limited monetary policy resources, thus raising productivity; it would also alle- flexibility and that are highly exposed to external viate the problem of local unemployment. A regional shocks. A regional commitment to macroeconomic labor market observatory could help balance the reali- stability—for example, such as the European Union’s ty of high unemployment while preparing for increased Stability and Growth Pact—can help improve con- mobility of people. It could include a body of research- sumer and investor confidence, thereby promoting ers and policy makers who identify data needs, perform trade, investment, and financial market development. analysis, and communicate evidence to policy makers And while some countries in the Western Balkans in each of the countries and in the economic bloc.This have strengthened their fiscal positions in the last body could help coordinate country labor market poli- few years, achieving fiscal sustainability would require cies to prepare for free mobility of people across coun- improvements in fiscal transparency, revenue mobi- tries, maximize the benefits of economic integration, lization, as well as public financial (including invest- and manage unintended consequences of integration ment and debt) management to better prioritize in national labor markets (see priority areas for action). and target spending based on economic and social returns, and better monitor and limit fiscal risks. Finally, there is a compelling case for region- al integration of financial and capital markets. Regional integration can also accelerate Even with success in integration, financial deepening through reforms in investment and competi- has been uneven across countries and sectors and tion policy. Investors look at the region and the lacks diversity. Nonbank financial intermediaries and potential of its markets as a whole. Though the capital markets in the region are shallow and some- economies do compete to create the most appeal- times nonexistent. Stock markets exist in four out of ing business environment, joining forces in removing the six Western Balkan countries (Albania and Koso- barriers to regional investment would help every vo are the exceptions), but the value traded is small: country. While some basic elements of a regional stock market capitalization in the Western Balkans investment agenda already exist in the Western Bal- is at about 20 percent of GDP, compared to more kans, a comprehensive framework aligning key poli- than 60 percent in Western Europe. Equity markets cies is missing. Such framework could promote the remain underdeveloped with only a limited number of region as a unique investment destination. Increased companies listed, and there is no liquidity of the sec- coherence of regional investment policies would cut ondary markets. For small countries whose domestic the time and cost to invest within a region, reduce financial markets lack the necessary diversification of fragmentation of production and transaction costs investment opportunities or funding sources, regional for investors, and attract multinational companies. integration is often a solution. Regional markets can It would also foster development of regional value play a key role in complementing bank-centric financ- chains and lead to increased diversification and sus- ing and help bring in investment and make the financial tainability of economic growth. Such policy agenda system more stable.The proposal for a capital markets will increasingly include technical areas of regulation, union for the Western Balkans highlights the need for such as investment promotion, entry and establish- more action to efficiently link investors and savers with ment, retention through protection, and develop- companies and to unlock the potential of capital mar- ment of linkages with the local economy and its kets for long-term investment.84 Although the EU has value chains. Modernized competition policy would achieved regional integration at deepest levels, other help the same goals, in addition to bringing unilateral regions have projects of capital markets integration, benefits to the implementing economies. such as Latin America, East Asia, and East Africa. 84  On September 30, 2015, the European Commission Countries attract FDI to take advantage of local adopted an action plan setting out 20 key measures to achieve a true single market for capital in Europe. See at http://ec.europa. resources—including natural resources, labor, eu/finance/capital-markets-union/index_en.htm. The SEE Link and skills. These new investments may shift firms’ project, which connects stock exchanges of several countries in the Western Balkans and beyond, is also a step in the right demand for skills. For new firms to maximize pro- direction (www.see-link.net). 88 The Western Balkans: Revving Up the Engines of Growth and Prosperity I n t eg r at i o n 89 90 The Western Balkans: Revving Up the Engines of Growth and Prosperity ENTERPRISE Creating an environment that nurtures private firms How important is free movement of people within a country? How can compa- nies expand and build value chains if their sales and procurement people are reluctant to travel more than a few kilometers from the home office? That was a serious constraint to enterprise development in Bosnia and Herzegovina following the wars of the 1990s. But the Office of the High Representative came up with a simple initiative to facilitate travel between different zones: automobile license plates that did not include the vehicle’s home jurisdiction. Today, people can drive the length and width of Bosnia and Herzegovina without concern that they will immediately be identified as outsiders. Analysts call the “uniform license plate” an important security aid in the reconstruction of a single economic space in a country where divisions remain but are declining over time. A similar measure was implemented in Kosovo. Bosnia and Herzegovina must overcome many obstacles to create an environ- ment in which private firms can be born and flourish. But with the simple and clever device of the uniform license plate, one key obstacle—concerns over secu- rity of travel—has been substantially addressed. E n t e r p r ise 91 1 Why is the growth of the private sector lagging in the Western Balkans? An often unfriendly business environment and competition from protected state-owned enterprises hamper the birth and growth of private firms. Overall, private enterprise in the region accounts for lower shares of investment and output than in other transition economies. 2 What is driving productivity growth in the Western Balkans’ work places? Is fac- tor allocation contributing to productivity growth? Within sectors, productivity growth is largely driving overall productivity increases. The potentially more powerful effect of workers moving from sectors of low productivity to more dynamic and productive ones generally has subtracted from overall productivity growth in countries for which data is available, reflecting the status quo with state- 3 owned enterprises and high informality. What can be done to make the Western Balkans more business-friendly? Improvement of basic infrastructure such as transportation networks, electrical power, and mobile broadband would encourage companies to enter the market. Easier registra- tion and reduction of administrative burden would further help, as would higher access to finance and better enforcement of property rights. 92 The Western Balkans: Revving Up the Engines of Growth and Prosperity The private sector’s share of GDP has grown foreign direct investment have been robust more slowly in the Western Balkans than in the throughout the last decade and a half. Private other transition economies, now in the European investment (including purchases of SOEs) has hov- Union. The Western Balkans’ average private sector ered at around 15-17 percent of GDP in Montene- share—66 percent—compares to a 74 percent aver- gro and FYR Macedonia, 20 percent in Serbia, and 25 age in the 7STEE countries.85 Serbia and Bosnia and percent in Albania (Figure 103). FDI inflows averaged Herzegovina have the Western Balkans’ lowest levels 7 percent of GDP during the 15-year period (Fig- at 60 percent each. Low share of private enterprises ure 104) but with considerable year-to-year volatility in investment, employment, and GDP generally works because they were driven mainly by privatizations. against long-term growth of the economy as a whole. These are generally strong figures, but lack of data makes it impossible to calculate precisely what role Improving the business environment private investment has played in the overall perfor- will boost private sector development mance of the economy. in the Western Balkans. Too high a share of foreign direct investment The slow pace of privatization and restructur- has gone into non-tradable sectors such as real ing of large state-owned enterprises accounts estate and retailing, which do not contribute for much of this slower growth of private directly to exports. The non-tradable shares of enterprises (Figure 102). The SOE sector not only FDI in 2007 were 80 percent in Albania, 70 percent remains large in terms of GDP and employment, but in Bosnia and Herzegovina, 65 percent in Serbia, draws substantial fiscal subsidies, diverting resources and 50 percent in FYR Macedonia. Large inflows to from more productive uses. In several manufacturing these sectors can be a net drag on development, subsectors such as energy, utilities and telecommu- because they tend to starve the tradable sectors, nications, and pharmaceuticals, SOEs are dominant, reducing export capacity and competitiveness and meaning private enterprises face a non-level playing creating external account imbalances. Generally, field. Bosnia and Herzegovina and Serbia have been capital inflows into non-tradable sectors in Eastern the slowest to privatize large SOEs. Europe have had a greater role in unsustainable consumption, investment surges, and collapses in Despite the state’s overly large role in the GDP growth than have capital inflows into tradable regional economy, private investment and sectors.86 Figure 102: The transition from state to private Figure 103: …yet private investment rates have ownership has been slow… remained robust. (Evolution of enterprise-related transition indicators) (Private investment as share of GDP, including SOEs) 4.0 35 3.5 30 3.0 25 2.5 20 2.0 15 1.5 10 1.0 0.5 5 0.0 0 1995 2008 2014 2000-08 2009-14 2000-08 2009-14 2000-08 2009-14 ALB MKD MNE WB5 7STEE Source: EBRD and World Bank sta calculations. Note: WB5 is WB6 excluding Kosovo. Source: World Development Indicators and World Bank sta calculations. 85 EBRD 2010. 86 European Commission 2014. E n t e r p r ise 93 Figure 104: FDI inflows have been strong, even during the crisis. (FDI gross inflows as percent of GDP, including public finance inflows) 120 100 90 100 80 80 70 60 60 50 40 40 30 20 20 10 0 0 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 2000-08 2009-15 BIH ALB KSV MKD SRB WB6 7STEE IDN KOR MYS Percent of GDP (rhs) Per capita (in hundreds of current US$) Source: World Development Indicators and World Bank sta calculations. Stoking productivity is key to speeding is much lower than the 2.75 percent average in the up the Western Balkans’ economies. 7STEEs (Figure 108). At the macro level, this trans- lated into slow convergence in output per worker, Western Balkan economies face a challenge compared to other regions. Average growth in the of low and slow-growing productivity. In this Western Balkans’ real output per employed per- chapter, we look at various measures of productivity, son was about 2.9 percent per year, lower than the mostly derived from firm-level surveys aggregated Europe and Central Asia (ECA) region average of into industry level, including total factor productivity 5.2 percent and the East Asia and the Pacific (EAP) (TFP).87 All these measures agree that productivity developing country average of 3.2 percent. Over the is low, with little progress to date. TFP’s levels dwin- 2009-14 period, productivity growth fell to an aver- dled after the global financial crisis (Figure 105), to age of 1.7 percent per year, again below ECA and the point that TFP actually subtracted from growth EAP developing country averages. While this perfor- in most countries, or contributed very little (as in mance was stronger than the Latin American (LAC) Albania)—this is shown by the growth accounting developing country averages, that is not surprising as decomposition of GDP (Figure 106).88 Labor pro- the LAC region has been long struggling with con- ductivity in Serbia and FYR Macedonia89 lags behind vergence and productivity growth.90 most 7STEE countries (Figure 107). In addition, labor productivity growth of about 0.87 percent annually The dynamics of labor allocation by sector or productivity is not efficient. 87 The growth accounting exercise is based on the Solow model and covers data for 2000–2014. Despite its many well established caveats, this simple exercise can provide some intuition about A lack of transformation—growth of new jobs the main drivers of GDP growth during the last 15 years. Annual in higher-productivity firms, economic sectors, GDP is assumed to be a function of the aggregate physical capital stock (K) and labor (L), following a Cobb-Douglas technology. and regions—has impeded overall productivity In the absence of consistent employment data for all countries, growth. This disappointing performance stems in the working age population (age 15–64) is used as a proxy for labor. In the absence of data on capital stocks, physical capital is part from a lack of labor reallocation to new and estimated through a highly simplified perpetual inventory method. more productive activities, which can be influenced In this simple growth accounting exercise, TFP includes the main component—efficiency with which the economy uses the main by the aging of the population. This is partly due to factors of production—but likely also hides the impact from a legacy protections in the labor markets, which favor combination of factors including skills and labor market dynamics (i.e. converting the working age population into employed human older workers (see Labor and State chapters). But capital), enabling factors that affect the overall efficiency of the other distortions are also at work, such as those in economy, as well as technological progress. 88 The accounting method for estimating TFP has a number of factor and product markets, as well as reduced geo- drawbacks that are discussed in detail in the literature. See Caselli graphical mobility. 2016 in Araujo et al. 2016, for an overview. 89 Countries that have made the data available. 90 Araujo et al. 2017. 94 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 105: In most Western Balkan countries, TFP Figure 106: ...subtracting from overall productivity has dwindled since the global financial crisis... growth. (Total factor productivity, 2008=100) (GDP growth accounting decomposition, 2000-2014) 10 110 8 6 Growth (Percentage %) 100 4 2 90 0 -2 80 ALB BIH MKD -4 MNE SRB KSV 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 00-08 09-14 70 2001 2004 2007 2011 2014 2000 2002 2003 2005 2006 2008 2009 2010 2012 2013 ALB BIH KSV MKD MNE SRB SRB Capital stock Working age population Human Capital TFP GDP Source: World Bank sta estimates, based on World Development Indicators, Eurostat, Source: World Bank sta estimates, based on World Development Indicators, Eurostat, and national authorities' data. and national authorities' data. Figure 107: Real labor productivity levels in 2015 Figure 108: And real annual labor productivity were low compared to 7STEEs. growth was slow. (GVA per person employed, constant 2010 US$) (Compound annual growth rate, percent, 2009-2015) 50,000 3.5 45,000 3.0 40,000 35,000 2.5 30,000 2.0 25,000 20,000 1.5 15,000 1.0 10,000 5,000 0.5 0 0.0 SVN SVK HRV EST LTU LVA KSV MNE BGR BIH SRB MKD ALB LTU BIH SVK EST SVN BGR LVA ALB HRV MKD MNE SRB Source: World Bank sta calculations based on Eurostat data and Serbia’s SBS. Source: World Bank sta calculations based on Eurostat data and Serbia’s SBS. Within industries improvements were the in the mining and quarrying industry, pushing pro- main driver of productivity growth, while ductivity up by an average 0.9 percent annually, it labor shifts between sectors and industries, was negative in manufacturing. This curtailed pro- have often harmed productivity growth.91 In ductivity by 2.84 percent annually, caused in part the non-agricultural economy, productivity in min- by labor shifts between sectors and industries, but ing and quarrying and manufacturing grew between could also be linked to the ongoing restructuring 2009 and 2014 at an annual average of 3.9 percent and privatization in several industries, such as phar- (Figure 109). The within-sector component was pri- maceuticals, which could temporarily reduce pro- marily responsible for this rise. While the contribu- ductivity. Some highly productive sub-sectors such tion of the structural change component—the role as computer programing, real estate, telecommu- of labor movement between sectors—was positive nications, and rental and leasing activities are also emerging, having recorded increases in employment 91 These conclusions are based solely on data from Serbia and (in some variables) from FYR Macedonia. between 2009 and 2014. E n t e r p r ise 95 Figure 109: In Serbia, labor movement within sectors er than in most comparator countries. High costs, drove what productivity growth there was in 2009-14. combined with low productivity, mean that only few (Compound annual growth rate, CAGR) firms survive; those that do must be making up the difference through other means, such as engaging in 8 6.70 unfair competition in the informal economy. 6 3.00 Barriers to formalization reduce labor reallo- 4 cation. Over the past decade, informality has fallen 2 0.79 only slightly. At the level of the individual worker, the 0 0.09 0.90 -1.20 ability to move from informal to formal employment -1.58 -2 -2.84 -0.04 -0.01 is extremely low. Preliminary estimates in Serbia show that an informal worker has a very low proba- -4 Overall Economy (excl. Agric.) bility of finding a formal-sector job, just 11.2 percent Mining & Quarrying Manufacturing Construction Services in 2013. Likewise, a recent study93 in that country found that the implicit cost of formalization is quite high: a single person with no children who earns less Contribution from within sectoral than the minimum wage in the informal sector has Contribution from structural change to give up between 40 and 75 percent of income to formalize. Geographical constraints are also dis- Source: World Bank sta calculations based on Eurostat data and Serbia’s Structural Business cussed in the Labor chapter. Surveys 2009 to 2014. Note: Real labor productivity is measured as value added (at factor cost) per employee at NACE 2 digit level. Real values are euro (2010) adjusted. Manufacturing covers NACE 2 digit There is broad room for improving productivi- level codes 10 to 33. Services cover codes 45 to 82. ty and competitiveness in the Western Balkans. Recent research on firm-level productivity94 shows that in most countries in Eastern Europe, the impact For the construction and services industries, of reallocation of resources on productivity growth productivity decreased. The fall was by about is quite strong. However, such reallocation does not 1.62 percent and 1.21 percent per year respectively occur automatically. It can be facilitated by improv- over the period. This was largely due to declining ing the business climate to provide easier business productivity within sectors and to a much lesser entry and exit, better access to finance, upgraded extent, labor reallocation, that is, structural change. infrastructure, a higher-skilled workforce, and great- While in general labor moved into less-produc- er labor market flexibility. Without these factors, the tive service sectors, some workers broke with the region will have to wait many years for a productivi- pattern, migrating to highly-productive sub-sectors. ty-enhancing reallocation of labor to take place. These included computer programing, real estate, telecommunications, and rental and leasing activities, which all recorded gains in employment between The business environment is 2009 and 2014. improving, but private enterprise still needs and deserves better. Manufacturing firms in the Western Balkans Western Balkans countries have already made are less cost-competitive than those in other important inroads in improving the business small transition economies of Europe.92 Gener- environment. Figure 111 presents individual coun- ally, costs of factor inputs are higher in the Western tries’ distance to the efficient business environment Balkans than in comparator countries (Figure 110). frontier of the World Bank’s Doing Business Indica- Higher costs accompanied by higher productivity tors. FYR Macedonia moved from a score of 65.8 to would not necessarily place the manufacturing sec- 81.7 on the efficiency scale (0 worst, 100 best). But tor in the Western Balkans in an inferior competitive the region still lags behind the 7STEE countries. Sim- position. However, even though labor productivity is ilarly, entrepreneurial activity is lower in the West- lower in countries such as Serbia, manufacturing unit ern Balkans. The number of newly registered firms labor costs—the ratio of real cost of wages and sal- with limited liability is lower in Albania, Bosnia and aries to real value added at factor costs—are high- 93 Randelovic et al. 2013. 92 See Cusolito et al. 2016. 94 See Alam et al. 2008. 96 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 110: The Western Balkans’ manufacturing sector is not cost-competitive or productive, even compared to the EU transition economies. Median cost of input per US$ of sales, in US dollars Manufacturing (real) labor productivity (2014) and unit labor cost 0.50 0.45 40,000 0.6 35,000 0.5 0.40 30,000 25,000 0.4 0.35 20,000 0.3 0.30 15,000 0.2 0.25 10,000 5,000 0.1 0.20 0 0 Albania FYR Macedonia Kosovo Serbia Montenegro Romania Estonia Lithuania Slovenia Croatia Bulgaria Latvia BIH Slovenia Hungary Czech R. Slovakia Estonia Croatia Lithuania Latvia Romania Serbia Bulgaria Real labor productivity Unit labor costs (rhs) Source: World Bank Enterprise Surveys 2013 and World Bank sta calculations. Source: Eurostat’s Structural Business Survey (SBS) and World Bank sta Calculations. Note: The cost of input per US$ of sales is the cost of raw materials and intermediate goods Note: Unit labor cost is real cost of salaries and wages to (real) value added (at factor cost). used in production. Figure 111: Western Balkan countries remain a fair Figure 112: …and have sub-par rates of business distance from the business environment frontier… entry density. (Ease of Doing Business, 2010 vs 2017) (New business density and GDP per capita) 85 80 16 New business density (new registrations per 14 75 12 LVA 1,000 people ages 15-64) 70 10 BGR 8 EST 65 MNE 6 SVK LTU 60 4 MKD SVN 2 HRV KSV SRB 55 ALB 0 BIH 50 -2 6 7 8 9 10 11 12 13 BIH KSV ALB MNE SRB MKD HRV BGR SVK SVN LTU LVA EST DB 2010 DB 2017 Natural log of GDP per capita PPP Median WB6 (DB 2017) Median 7STEE (DB 2017) (constant 2011 international $) Source: World Bank’s Doing Business Report 2017. Source: World Development Indicators and World Bank sta calculations. Herzegovina, Serbia, and FYR Macedonia than in the electricity. In Bosnia and Herzegovina and Serbia, the 7STEE countries, according to the Entrepreneurship issue is the slow pace of SOE privatization, and in Database of the World Bank’s Doing Business Indi- Albania contract enforcement and property rights. cators (Figure 112). At the other, higher-performing end of the scale, FYR Macedonia has made relatively early progress on a On ease of doing business, Western Balkan number of business environment indicators, with countries lag the 7STEE countries. But the for- highest payoffs in credit provision.This progress is also mer also differ dramatically among themselves in reflected in the latest ranking of Eastern European this indicator (Figure 111). Bosnia and Herzegovina, countries based on the Doing Business and Global Kosovo, and Albania are below the region’s average, Competitiveness Indicators (Figure 113), which high- largely because of poor quality and availability of lights the contrasts within the region: Albania ranks E n t e r p r ise 97 Figure 113: The Western Balkans states lag 7STEEs in Modernizing old and unreliable ease of doing business. infrastructure is crucial to helping (Global Competitiveness Index 2016-17 and Ease of Doing Business private enterprise set up and prosper. 2017) 4.9 All private enterprises suffer in competitive- Global Competitiveness Index (score, 1-7 best) EST 4.7 ness due to the generally high cost and low LTU quality of infrastructure. This includes logis- 4.5 BGR SVN LVA tics, transport, telecommunications, and electricity. 4.3 SVK According to WEF’s Global Competitiveness Report MKD HRV (GCR), all six Western Balkans countries lag behind 4.1 MNE the 7STEEs and the rest of the EU on the logistics ALB SRB 3.9 performance index, a measure that comprises six BIH 3.7 indicators including efficiency of the customs clear- ing process, and competence and quality of logis- 3.5 60 65 70 75 80 85 tics services. Figure 115 presents the WEF-GCR’s Logistics Performance Index (LPI). Serbia’s overall Ease of Doing Business (DTF, best=100) score is 2.96, the highest among Western Balkan Source: World Economic Forum and Doing Business databases. countries, but still lower than the 3.05 scored by the worst-performing 7STEE country, Croatia, and well below the median score of 3.7 for the rest of 58th in the world versus FYR Macedonia’s standing the EU. Figure 116, which breaks down the various of 10th. The figure also places the 7STEE countries to indicators comprising the LPI, shows that all West- the right (meaning they perform better) of all of the ern Balkans countries score lower than the 7STEEs Western Balkans countries except FYR Macedonia. and the rest of the EU on every indicator. This is a serious constraint to exports, which are a prime Key areas where reform is needed for bet- source of economic growth in many Western Balkan ter productivity and competitiveness include countries.95 informal competition, electricity, and access to finance. Figure 114 compares the top five obsta- In spite of its potential benefits, the ICT sector cles to enterprise in the Western Balkan counties in the Western Balkans is less developed than and the 7STEE countries, using data from the World in the 7STEE countries and requires significant Bank Enterprise Surveys. The top four obstacles to investment. There is consensus across the EU that enterprises are similar for both sets of countries. extension of broadband infrastructure, particularly However, informal competition, finance access, to rural areas, may promote economic diversification and political instability appear to be more severe and address a number of development bottlenecks obstacles in the Western Balkans than in the 7STEE, through skills enhancement and job creation. Extension where respondents call tax rates the biggest prob- may also attract FDI and boost such sectors as agri- lem. The quality and quantity of electricity supply is culture and tourism. Figure 116 shows that broadband a major challenge for Western Balkan enterprises, penetration is much weaker in the Western Balkans unlike for their counterparts in the 7STEE coun- than in the 7STEEs. Kosovo stands out as a particularly tries, which list an inadequately skilled workforce as low performer: only 5.74 percent of the population a top-five obstacle. use mobile broadband services, almost seven times lower than the Western Balkans average and twelve In the Western Balkans, unfair competition times lower than the 7STEE average. Similarly, the from informal enterprises and lack of access to number of dedicated data cards/wireless modems per finance rank in the top five in all six countries. 100 people in Kosovo stands at only 2.78, whereas the Informality is the biggest obstacle in Albania, Kosovo, Western Balkans average is 4.5 and EU-27 average is and FYR Macedonia. Electricity supply is reported as 9. Kosovo was one of the last countries in Europe to a top-five obstacle in all countries except Serbia and launch commercial 3G services. Inefficient spectrum Bosnia and Herzegovina. In those two countries, polit- 95 See, for example, World Bank 2014a. “Rebalancing Serbia’s ical instability is reported to be the biggest constraint. Economy: Improving Competitiveness, Strengthening the Private Sector, and Creating Jobs.” 98 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 114: The top five obstacles to doing business are similar in the Western Balkans and 7STEEs. Western Balkans 7STEE Informal Competition 17.4 Tax rates 26.2 Political Instability 16.9 Informal Competition 14.0 Access to Finance 16.2 Access to nance 13.6 Tax Rates 11.8 Political instability 9.5 Electricity 6.4 Skills 8.3 0 5 10 15 20 0 10 20 30 % of Enterprises Responding % of Enterprises Responding Source: World Bank Enterprise Surveys 2013 and World Bank sta calculations. Figure 115: The 7STEE all outstrip the Western Balkan states in logistics quality. (2014, overall index, 1=low to 5=high) 3.8 Median (Rest of EU) 3.6 3.4 Median (7STEE) 3.2 3.0 Median (WB6) 2.8 2.6 2.4 2.2 2.0 LVA SVN EST SVK LTU BGR HRV SRB MNE ALB BIH MKD Rest of EU 7STEE WB6 Source: World Economic Forum Global Competitiveness Report and World Bank sta calculations. Figure 116: In other logistics indicators, the Western Balkans states are Europe’s low performers. (Logistics Performance Index, 2014) SRB MNE ALB BIH MKD Rest of EU 7STEE E ciency of customs clearance process 4.5 4 Ability to track and trace 3.5 Quality of trade and consignments 3 transport-related 2.5 infrastructure 2 1.5 1 0.5 0 Frequency with which Ease of arranging shipments reach consignee competitively priced within scheduled or shipments expected time Competence and quality of Overall logistics services Source: World Development Indicators. E n t e r p r ise 99 management (for example, slowness in freeing up and band offerings, which are of particular importance in issuing additional frequency bands) appears to have mountainous and sparsely populated rural areas of the been the major cause of delay in the mobile broad- country where deployment of fixed broadband net- band roll-out. The underdeveloped wireless market in works is not commercially viable. turn holds back arrival of high-speed mobile broad- Unreliable electricity supply is dragging down the productivity of Western Balkans firms, Figure 117: Broadband penetration needs an upgrade. according to the BEEPs survey—the pow- (Fixed broadband household penetration and mobile penetration per capita, latest year available) er sector is in urgent need of reform and investment. The World Economic Forum’s Global 90 Competitiveness Index ranks the Western Balkans countries among the lowest in Europe for quality 80 of electricity (Figure 118). The six countries’ 4.6 70 median (out of a possible 7) ranks well below the Percentage of population 60 5.7 score of the 7STEEs. Power infrastructure in 50 countries such as Kosovo and Montenegro is aging and inefficient, resulting in high energy intensity 40 and low energy productivity. In Montenegro, the 30 system suffers high transmission and distribution 20 (T&D) losses due to an under-maintained grid, sig- nificant non-payment by consumers, and theft of 10 electricity. Transmission losses range from about 0 4 percent of total power and distribution losses ALB SRB MNE BIH KSV MKD HRV LTU LVA SVN EST to about 15 percent, compared to average 6 to Fixed household penetration Mobile penetration per capita 8 percent in the past. In Albania, whose grid had been besieged by power losses, favorable weath- Source: EC 2014b; GlobalComms Database, TeleGeography, Washington, DC, https://www.- telegeography.com/research-services/globalcomms-database-service /index.html. er and improved billing and payment enforcement Note: Higher value for the xed broadband household penetration in Kosovo is attributed to helped reduce the fiscal costs of the sector. In par- the high number of inhabitants per household (~6); xed broadband penetration per capita is among the lowest in the region. ticular, a decline in non-technical losses from 45 percent in 2013 to 28 percent in 2016 helped the grid’s financial recovery and reduced the need for Figure 118: In quality of electricity, the Western central government grants and guarantees. Alba- Balkans rank behind most EU transition economies. nia and FYR Macedonia have launched reforms (Global Competitiveness Index, Quality of electricity supply, to improve distribution efficiency and ensure full 2016-17) liberalization of the sector in line with EU practic- 7 Median WB5 Median 7STEE es. However, connectivity must be improved both internally and within the region. Strengthened tar- 6 iff policy and institutions, new investments, and 5 expanded supply are necessary. WEF score (1-7 best) 4 Further improvements in credit markets and regulatory environment 3 will also help private enterprise. 2 Credit availability was adequate to support 1 the sustained expansion of output and exports 0 in 2000-08, but after that lenders pulled back because of the high stock of non-performing BIH Slovenia Slovak R. Croatia Estonia Lithuania Latvia Bulgaria FYR Macedonia Serbia Albania Montenegro loans (NPLs) and weaknesses in property rights. Banks in the Western Balkans are carrying a higher Source: World Economic Forum’s Global Competitiveness Index and World Bank sta stock of NPLs today than in the new EU member calculations. states, even though the post-crisis credit correction 100 The Western Balkans: Revving Up the Engines of Growth and Prosperity in the region was less severe.96 Unresolved NPLs plifying planning and construction permits procedure, constrain economic activity of overextended bor- and reducing labor market rigidities. For its part, Bos- rowers and disrupt the allocation of capital to pro- nia and Herzegovina has made significant progress ductive activities. Banks troubled by customers’ weak with the introduction of a one-stop shop for business balance sheets become more risk-averse. Unless the registration and a new inspections law that removed NPL problem is addressed, credit availability is likely some obstacles to exports to the EU. But business- to remain sluggish and undermine enterprise per- es in that country still face a regulatory maze: The formance. At the same time, financial intermediation Federation of Bosnia and Herzegovina, one of the is weak due to high collateral requirements, ranging two political entities that make up the country, still from 160 percent to 230 percent of loan value in has 355 separate business-related licenses, permits, Kosovo to 216 percent for small and medium enter- approvals, and consents on the books, while the oth- prises in Bosnia and Herzegovina. Lenders have diffi- er entity, Republika Srpska, has 319. Added to those culty realizing the value of collateral due to weakness- are another 102 at the national level. In a similar pat- es in property rights—executing collateral warrants tern, FYR Macedonia98 has improved firms’ access to can take long periods of time, up to seven years in manufacturing-ready land with the creation of Tech- Bosnia and Herzegovina. The financial sector needs nological Industrial Development Zones (TIDZs) and reforms to facilitate NPL resolutions (loan workouts, industrial zones and the transfer of land management loan write-offs, collateral execution), reduce inef- to municipalities. But the agricultural land market in ficiencies, strengthen stability of banks, and expand that country remains complex and continues to hin- credit access. Action is also needed to improve the der productivity. These developments also need to contract enforcement regime and promote the non- expand beyond the special economic zones. bank financial sector, so as to diversify sources of credit for enterprises. Some countries have already The challenge in the Western Balkans going moved forward with these types of reforms, such as forward is to promote growth in investment, the Kosovo Credit Guarantee Fund to help SMEs jobs, exports, and productivity in existing pri- gain access to credit. vate enterprises and grow the number of new ones. This will be critical to bringing down the cur- Western Balkan countries have begun concert- rent high rates of unemployment in these countries. ed efforts to improve the business environment Privatization and restructuring of SOEs, necessary but need to keep with the job, because many for sustained growth of private sector, will require challenges remain. In Serbia, for instance, the gov- careful management to avoid redundancies that ernment is implementing the Strategy for Enhancing might aggravate unemployment. Overall, the region Entrepreneurship and Competitiveness for 2014–20. needs acceleration of reforms to encourage new So far, 212 out of 304 recommendations, rang- business registrations, support growth of exist- ing from comprehensive regulatory reform to the ing private firms, and promote inflows of FDI into streamlining of administrative requirements, have competitive tradable sectors. Careful sequencing of been implemented.97 The country would do well to reforms and restructuring will be important for both also focus on improving contract enforcement, sim- growth and employment. 96 As mentioned in the Integration chapter, the median level of NPLs in Western Balkan countries, at 13.1 percent in 2015, is still close to its post-crisis peak of 16.3 percent in 2013. Montenegro, however, has been an exception, significantly bringing down the burden of bad loans, after the adoption of the “Podgorica approach” to NPL resolution. 97 World Bank 2014a. “Rebalancing Serbia’s Economy: Improving Competitiveness, Strengthening the Private Sector, and Creating 98 World Bank 2012.“Unlocking FYR Macedonia’s Competitiveness Jobs.” Potential.” E n t e r p r ise 101 102 The Western Balkans: Revving Up the Engines of Growth and Prosperity THE STATE Building a state that enables, rather than impedes, a new growth model In 2013, finance officials in the government Albania were grappling with a very un- welcome line item in their spreadsheets—overdue bills of more than $700 million, amounting to about 5 percent of the country’s GDP. Different wings of government had accumulated the arrears through years of uncoordinated, undisciplined spend- ing. Even as tax revenues were declining and heavy social spending continuing, agencies had pressed ahead with big infrastructure projects. As liabilities mounted, the government had taken to holding back payment of a wide range of bills, in- cluding procurements, utilities, VAT refunds, and disability benefits. What followed was a textbook example of how a state can reform itself to clear roadblocks to development, growth, and income convergence. In 2014 the govern- ment signed a Strategy for the Prevention and Settlement of Overdue Liabilities. Arrears were paid on a first in, first out principle, overseen by special units in the Ministry of Finance and detailed in public reports. To prevent future arrears, gov- ernment agencies are now required to prioritize activities within approved budget ceilings. Clear criteria ensure that poorly prepared and ill-conceived projects don’t receive financing and that resources go where they will have maximum effect on advancing the government’s objectives. Arrears were fully cleared by the end of 2015, slightly ahead of schedule. This was beneficial not only for fiscal accounts but Albania’s business environment at large. A government that pay its bills on time fosters private enterprise and employment across the country, as well as investors’ confidence in the economy. The S tat e 103 1 How can the state better support economic growth in the Western Balkans? The state’s role must shift to become a more effective enabler of private sector-led, productivity-driven, and export-led growth. A number of countries in the region have oversized public sectors - including state-owned enterprises, legacy of socialist times - that tend to crowd out private firms. In these countries, reducing the economic foot- print of the state where necessary would open up space for companies both domestic and foreign to hire and expand, raising incomes and promoting convergence with EU standards of living. 2 What do governments need to do to create an environment that can spur expan- sion in the economy? To become an enabler of private enterprise the state needs to create the right reg- ulatory, legal, and fiscal environment for business creation and growth. Enhancing the quality, reliability and timeliness of the state’s legal and regulatory systems is crucial. Throughout the Western Balkans, courts are tied up in red tape, creating opportunities for malfeasance and constraining private sector businesses. Fiscal policy also has a role. Reduced social taxes would make it easier for workers in the region’s large informal sector to shift to higher-productivity jobs in the formal sector. Reforms in pension and social welfare systems could curb disincentives to work, while protecting the vulnerable. Prudent fiscal policy would provide an atmosphere of stability and predictability condu- cive to investment and the laying of plans for the future. 3 How can the delivery of social services support the new growth model? Does the state have the capacity to deliver on these reforms? Better spending on education and health would address skill gaps and enhance human capital and economic opportunities for all. If the benefits of future growth are to be shared across the population, social safety nets will also need to become more com- prehensive and, in view of fiscal constraints, better-targeted. Enhancing the capacity to deliver these reforms requires independent, efficient, and honest public administrations that are in line with European standards. Public servants must be empowered to par- ticipate in the design and implementation of reforms. Policy processes will also need to be streamlined, the center of government strengthened to improve coordination and accountability and oversight enhanced. 104 The Western Balkans: Revving Up the Engines of Growth and Prosperity How can the state help support the reorienta- remains incomplete. While transition began in tion of the growth model of the Western Balkans the 1990s in several countries, in others it did not towards one that is private sector-dominant, get underway until the 2000s, due to the conflict productivity-driven, and export-led? This chapter and turmoil of the previous decade. Since then, offers answers to this question, focusing on three main the region has achieved substantial progress (Fig- dimensions. The first (and overarching) requirement is ure 119) but there remain important areas to be that state institutions and government policies become addressed. Notable is that for half the countries more effective enablers of private sector investment (Bosnia and Herzegovina, Montenegro, and Serbia), and growth. Particularly in those countries in the government spending to GDP is well above norms region with outsized public sectors, this will require by income level (Figure 120). These countries still the state to exit from roles that it should not play. Sec- have large state-owned and public enterprises. As ond, state institutions and policies need to provide the a result, employment in the public sector can be right regulatory, legal, and fiscal environment for busi- large, relative to overall formal sector jobs, and pub- ness creation and growth. This includes not only their lic wage bills sizeable. Roughly one-third of all for- direct impact on firms’ investment decisions, but also mal jobs in Serbia and Montenegro are in the public their indirect effects, for example, by ensuring the mac- sector, almost half in Bosnia and Herzegovina, and ro-fiscal stability which is a pre-requisite for sustained more than half in Kosovo. private investment. Third, the state needs to improve the effectives of public spending and the quality of ser- The legacy of socialism shapes public expecta- vice delivery in support of private sector-led inclusive tions of the state’s role in the economy. The growth.With many of these objectives long unattained, size of the public sector and the weight of pensions the chapter concludes with a discussion of how, this and public administration costs in overall government time, the reforms can finally succeed. expenditure are an important hold-over in the unfin- ished transition from socialism. A related factor is the The state needs to become a more public perception of the proper role of the state in effective enabler of private sector the economy. In countries which are aging rapidly, investment and growth. such as Serbia, and Bosnia and Herzegovina, where the ratio of workers to dependents is falling, can the In half the countries of the Western Balkans, private sector bear the costs of meeting a public per- the state continues to loom large in the econ- ception that access to all government services should omy, as the transition to a market economy be universal? If young adults entering the labor market Figure 119: The transition towards a market econo- Figure 120: For half the countries in the region, my remains incomplete. government spending to GDP is well above norms (Average EBRD transition indicator, higher value indicates a by income level. more functioning market economy) (Expenditures as percent of GDP average 2012-2016) 7STEE range ALB 60 BIH KSV 4.5 MKD MNE 50 SRB BIH MNE 4.0 SRB 40 3.5 30 3.0 KSV ALB MKD 2.5 20 2.0 10 1.5 0 1.0 6 7 8 9 10 11 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Ln GDP per capita 2012 (PPP international dollars) Source: EBRD and World Bank sta calculations. Source: World Development Indicators, IMF World Economic Outlook April 2017, and World Bank sta calculations. Note: Line indicates non-parametric nearest neighbor smoothing with dashed lines con dence intervals at +/- 2 standard deviations. Y-axis truncated at 60 percent. The S tat e 105 perceive a job in the public sector as more attractive thought the government takes account of business than one in a private company, how can start-ups hire concerns quite a lot, with the governments of FYR the workers they need to grow or mature firms bring Macedonia and Albania getting the highest marks at in the new skills they need to reinvigorate their busi- just above 20 percent. nesses?99 An evolution in public perceptions of the role of the state will be central to supporting reforms Quality of justice services—a key determinant to create a nimbler, and in some cases smaller state of the business environment—is low across the that would enable a new growth model. region. This includes, for example, inconsistent juris- prudence, and high appeal rates. The EU accession Providing the right regulatory, legal process has created incentives for large-scale legis- and fiscal environment will spur lative reform but, as noted by the European Com- business creation and growth. mission, “across the board effective implementation is very often lacking.”101 Business operations suffer Enhancing the quality, reliability and timeliness in this complex and in some cases fragmented legal of the state’s legal and regulatory systems is environment. at the heart of improving the business envi- ronment to allow a dynamic private sector Throughout the Western Balkans, courts are to drive growth, employment, and poverty tied up in red tape, creating opportunities for reduction. The scope for better performance in malfeasance and constraining private sector the Western Balkans is clear. Governance indicators businesses. Weak enforcement of commercial in the Western Balkan region—looking at an aver- decisions and contracts and the related monetary age of perceptions of performance on voice and and time costs are dampening the business climate accountability, political stability and lack of violence, across the region (Figure 122). Of the businesses government effectiveness, regulatory quality, rule of examined in the World Bank 2013 Enterprise Sur- law, and control of corruption—remain behind the veys, the share identifying the courts system as a 7STEEs at the time they joined the EU, and in the major constraint was particularly high in Serbia (13.9 five-year period before membership (Figure 121). percent), Kosovo (13 percent), and Bosnia and Her- Measures of these different dimensions of gover- zegovina (8.2 percent). These figures compare to 5 nance are highly correlated, with, for example, better percent on average in surveyed countries in Europe regulatory quality going hand-in-hand with improved and Central Asia. rule of law. Unsurprisingly, they also relate closely to the ease of doing business for the private sector. Delays are endemic. In Serbia and FYR Macedo- nia it takes approximately 635 days to enforce a Concerning average time and cost of enforc- contract.102 If they can’t enforce contracts quickly ing contracts, the countries of the region have and reliably, firms are less likely to expand their been improving but still lag the 7STEE coun- reach of suppliers, take on credit, and expand their tries, as discussed in the Enterprise chapter. Across businesses. Property rights are a particular issue in the region, government’s sensibility toward business- Albania and Kosovo. Enforcement of decisions is es is perceived to be low. A 2016 survey of business often unpredictable and intermittent in Bosnia and opinion100 found 39 percent of respondents did not Herzegovina. Businesses there consider judicial pro- think the government takes into account at all the ceedings to be “very slow, too complex and decid- concerns of business with only 45 percent thinking edly ineffective.”103 In Serbia, over one-third of busi- there was “a little” taking into account. Put anoth- nesses with recent experience in court cases report er way, on average only 12 percent of respondents that the judiciary is a great obstacle for their basic operations, and an additional third call the courts a 99 Indeed, a 2016 survey found that on average 80 percent of respondents in the six countries of the Western Balkans would moderate obstacle.104 prefer to work in the public sector (public administration or public companies) rather than the private. This share was 87 percent in Kosovo and 82 percent in Bosnia and Herzegovina, 101 European Commission 2015. “EU Enlargement Strategy” with a low of 75 percent in Albania. Across the region, the main 102 Doing Business 2017. reasons cited were a safer job (53 percent of respondents on 103 World Bank 2015e. “Report on the Observance of Standards average), better working conditions including overtime and and Codes Insolvency and Creditor/Debtor Regimes (ROSC workload (36 percent), and better salary (35 percent). See Balkan ICR) Bosnia and Herzegovina.” Barometer. 2016a. 104 See World Bank 2014b. “Serbia Judicial Functional Review”, 100 Balkan Barometer 2016b. pp 135-136. 106 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 121: There is a long way to go on governance Figure 122: Weak enforcement of contracts is damp- indicators. ening the business climate across the region. (Average Worldwide Governance Indicators) (Cost and time for enforcing contracts) 1.0 Time to enforce contract (days), LHS Cost of claim (percent of claim), RHS 0.8 1,600 40 1,400 35 WB6's governance 0.6 1,200 30 0.4 gap 1,000 25 7STEE before and after each country gained 0.2 EU accession 800 20 0 600 15 -0.2 400 10 200 5 -0.4 T-5 Join EU T+5 0 0 KSV ALB MNE BIH MKD SRB LTU EST LVA BGR HRV SVK SVN Median 25 - 75th percentiles Source: Worldwide Governance Indicators and World Bank sta estimates. Source: World Bank Doing Business 2017. Note: Average of six WGI governance indicators. The estimate ranges from approximately -2.5 (weak) to 2.5 (strong) governance performance. Western Balkans data are for 2014. This is not due to a lack of resources in the judi- Enhanced independence, accountability, and ciary; most of these countries have an excessive professionalism of the judiciary would ensure court network and comparatively high ratios of that laws and regulations are implemented in judges and court personnel per capita. Yet back- an efficient and nondiscretionary way, helping logs are common. Across the region, the judicial sector to improve the business environment in the tends to have adequate resources compared with EU region. Countries in the Western Balkans can look member states, but resources are not allocated nor to good practices in the new member states of the used efficiently.105 Staffing is mismatched with needs. European Union, particularly the Baltic countries For example, most countries in the region, especial- and Croatia, as they work toward these objectives. ly the former Yugoslav countries, have an excessive number of judges at the top and low-skilled ancillary Fiscal impediments are holding down staff at the bottom, but a “missing middle” of specialist private investment. staff that is necessary to support judicial moderniza- tion.106 From a perspective of equity, access to justice Current fiscal regimes also often distort incen- is often constrained by generally high fees charged tives and undermine dynamism in the private by the courts and lawyers. In general, legal aid for the sector. As highlighted above, the aggregate fiscal poor deserves to be greatly improved. Meanwhile, burden on the private sector—as proxied by the there is also inadequate access for everyone to basic aggregate revenue to GDP ratio—is particularly legal information, such as consolidated legislation and high in Bosnia and Herzegovina, Serbia, and Mon- easily-understandable formats of basic laws. The pros- tenegro, standing at comparable levels to the EU’s. pect of alternative dispute resolution holds promise Indeed, for the period 2000-10, revenue collections but is not available in the countries of the region. in Bosnia and Herzegovina were about 6.3 percent higher than the level predicted by an economic model based on country characteristics.107 Across 105 For example, in Bosnia and Herzegovina, court expenditures are higher than EU averages, with 0.85 percent of GDP allocated all countries in the Western Balkans, the reliance to courts and prosecutors and the High Judicial and Prosecutorial on taxes on goods and services is high (Table 6.1: Council in 2015. However, budgets are deeply fragmented, with courts and prosecutors’ offices receiving funds from 14 different Taxes on goods and services are relatively high as budgets, which tends to destabilize the capacities and resources a share of GDP, and as a share of total revenues., of the courts. See European Commission. 2015. Bosnia and Herzegovina Report, p. 14. ranging from a low of 35 percent of total revenues 106 Serbia and Montenegro (at 42.4 and 40.5 judges per 100,000 in FYR Macedonia to 44 percent in Bosnia and Her- inhabitants respectively) have more than twice the number of judges per capita than the average in the Council of Europe countries. 107 Khwaja and Iyer 2014. The S tat e 107 Table 6.1: Taxes on goods and services are relatively high as a share of GDP, and as a share of total revenues. ALB BIH KSV MKD MNE SRB 7STEE av. 2015 2015 2015 2015 2015 2015 2015 As share of GDP Total revenue 26.6 43.2 26.1 31.0 41.9 40.4 40.5 Taxes 19.0 22.6 22.8 17.9 25.5 23.7 22.0 Taxes on income, profits, and capital gains 1.7 3.1 1.2 2.2 4.9 1.5 6.8 Taxes on payroll and workforce 2.1 0.0 1.2 2.3 0.0 3.6 0.0 Taxes on property 0.3 0.4 0.3 n.a. 0.4 1.0 0.9 Taxes on goods and services 11.5 19.0 10.6 11.0 17.3 16.1 14.3 Taxes on international trade and transactions 0.4 0.0 8.3 0.8 0.6 0.8 0.0 Other taxes 2.9 0.1 1.2 1.6 2.3 0.6 0.1 Social contributions 5.0 15.2 0.0 8.6 12.1 10.9 11.5 Grants 0.8 0.2 0.0 1.0 0.4 0.2 0.6 Other revenue 1.8 5.3 3.3 3.5 3.9 5.6 6.3 As percent of total revenue Taxes 71.4 52.2 87.4 57.7 60.9 58.6 54.4 Taxes on income, profits, and capital gains 6.6 7.2 4.6 6.9 11.7 3.8 16.7 Taxes on payroll and workforce 7.8 0.0 4.6 7.5 0.0 9.0 0.0 Taxes on property 1.0 0.9 1.1 n.a. 1.0 2.5 2.2 Taxes on goods and services 43.5 44.0 40.6 35.5 41.3 39.9 35.2 Taxes on international trade and transactions 1.5 0.0 31.8 2.5 1.5 2.0 0.0 Other taxes 10.9 0.2 4.6 5.3 5.5 1.4 0.2 Social contributions 18.9 35.1 0.0 27.7 28.8 27.1 28.5 Grants 3.0 0.4 0.0 3.4 0.9 0.4 1.5 Other revenue 6.8 12.2 12.6 11.3 9.4 13.8 15.6 Source: National authorities’ data, Eurostat, and IMF Government Finance Statistics (GFS). Note: Government Finance Statistics revenue classification. zegovina. Income taxes are much lower than in the top rates of corporate and personal income taxes in 7STEEs, with the exception of Montenegro. These the region are relatively low (Table 6.2: Social security figures suggest an opportunity for diversification of contribution rates are particularly high in Bosnia and the revenue base, accompanied by improvements in Herzegovina, Montenegro, and Serbia.), at 10 per- revenue administration to support compliance and cent for both corporate and personal in Bosnia and collection rates. Herzegovina, Kosovo, and FYR Macedonia. The top corporate income tax rate in Montenegro is even Countries might also investigate lowering high lower, at 9 percent. In part these low rates aim to marginal tax and social contribution rates that discourage tax evasion, in the context of high levels serve to keep people in the region’s large infor- of informality in many economies.108 However, social mal sector and stifle creation of formal jobs. The 108 For further discussion, see the World Bank’s Kosovo SCD. 108 The Western Balkans: Revving Up the Engines of Growth and Prosperity Table 6.2: Social security contribution rates are particularly high in Bosnia and Herzegovina, Montenegro, and Serbia. VAT Social security contributions (2015) Top Top (2015) corporate individual Threshold Current income tax income tax Employer Employee Total (euro) standard rate (2015) rate (2015) rate rate rate rate ALB 35,672 20 15 23 16.7 11.2 27.9 BIH 25,524 17 10 10 10.5 31.0 41.5 KSV 30,000 18 10 10 5.0 5.0 10.0 MKD 32,462 18 10 10 13.5 13.5 27.0 MNE 18,000 19a 9 15a 9.8 24.0 33.8 SRB 68,099 20 15 15 19.9 17.9 37.8 WB6 unweighted average 34,960 18.6 11.5 13.6 12.6 17.1 29.7 Selected others: Austria 0 10 25 50 21.7 18.1 39.8 Croatia 30,077 25 20 40 17.2 20.0 37.2 Germany 17,500 19 15 45 19.5 19.5 38.9 Greece 0 23 26 42 28.0 16.5 44.5 Italy 0 22 27.5 43 30.0 10.0 40.0 Slovenia 50,000 22 17 50 16.1 22.1 38.2 Source: National authorities data, Eurostat and IMF GFS. Note: The VAT rate is increased to 21 percent in 2017. The top personal income tax rate in Montenegro is a so-called “crisis” tax that was already reduced in 2016 to 13 percent and further to 11 percent in 2017. security contribution rates are relatively high in Bos- bills—prevented changes in spending patterns.These nia and Herzegovina, Montenegro, and Serbia, reach- rigidities did, however, support household incomes, ing similar levels to those of the EU. In Bosnia and mitigating the downturn’s harm to the region’s peo- Herzegovina, these contributions are on the order ple. Overall, governments in the region used their of 35-40 percent of gross wages, the highest in the fiscal resources pragmatically to manage the impact region. As we noted in the Labor chapter, rates like of the crisis. However, debt ratios shot up (Figure these may make the cost of bringing a worker into 124), raising concerns in many countries over unsus- the formal sector prohibitive. tainable debt trajectories. In the wake of the global financial crisis, fiscal Fiscal reforms to put public debt onto a more management and policies indirectly under- sustainable footing are high priorities, partic- mined the business environment through spill- ularly in Albania and Serbia, and have helped overs to macro instability. Starting in 2008, the restore macro-fiscal stability. Internation- global financial crisis and later the euro zone crisis al partners (IMF, EC, WB) have supported these rattled the region, tamping down its growth perfor- efforts. Some countries have also adopted fiscal mance. Fiscal accounts deteriorated (Figure 123). rules, albeit with inconsistent enforcement (Box Revenues shrank and interest costs rose, but struc- 6.1). Expenditure reforms have been a particular tural rigidities—for example, due to social spend- focus of fiscal consolidation in Serbia, with an aim ing, particularly on pensions, and government wage to address spending pressures from public sector The S tat e 109 Box 6.1. Fiscal rules in the Western Balkans. Four of the six countries in the Western Balkans—Kosovo, Montenegro, Serbia and Albania—have adopted fiscal rules aimed at achieving aggregate fiscal discipline and medium-term sustainability, with both entity governments within Bosnia and Herzegovina also putting in place such rules. However, as Koczan 2015 and Murgasova et al. 2015 note, enforcement and commitment have been generally weak. In Serbia, the 2009 Budget System Law adopted fiscal responsibility provisions including fiscal rules effective from 2010. These included a general budget balance rule setting the medium- to long-term deficit at 1 percent of GDP and a 45 percent of GDP ceiling for general government debt, excluding the liabilities arising from restitution. In addition, a Fiscal Council was established in 2011 to assess compliance with the fiscal rules. The Council has actively contributed to the debate on the government’s fiscal consolidation program. While Serbia’s debt has far exceeded its debt rule, Kosovo has faced the opposite situation with a debt limit of 40 percent of GDP introduced in 2010, which is above the current level of debt. This was supplemented by a consolidated central and municipal budget deficit ceiling of 2 percent of GDP from 2013, with capital spending exempt if financed from privatization and if the government’s bank balance is above certain levels. Kosovo had had an expenditure rule from 2006 to 2008, with a ceiling on real current expenditure growth of 0.5 percent per year, but this was not held to. The fiscal rule was also amended in 2015 to allow for an “investment clause” enabling productive capital investments in excess of the 2 percent deficit limit, subject to being financed by development partners and keeping the public debt below 30 percent of GDP. Montenegro introduced budget balance and debt ceilings from 2014 in line with the EU Stability and Growth Pact levels of 3 percent and 60 percent of GDP respectively. However, given the highway that pushed up capital spending, Montenegro’s rules remove from the budget deficit figure the cost of projects of national importance endorsed by Parliament. In December 2016, the government adopted a rehabilitation plan for public debt and deficit, aiming to bring the debt back to 60 percent of GDP within a five-year period. In Bosnia and Herzegovina, both entity governments have also introduced legal fiscal rules. In Albania, the 1998 Organic Budget Law included a rule that the debt stock not exceed 60 percent of GDP. This rule was revised in June 2016 to mandate that debt decrease every year until it reaches 45 percent of GDP. There is also a “buffer” clause mandating that 0.7 percent of total budgeted expenditures be allocated to a budgetary reserve that can be used to compensate for forecasting errors and unforeseen changes in macroeconomic variables. The law also introduces the “golden rule” of borrowing and limits the use of privatization receipts to debt reduction or the financing of capital investments. While fiscal rules in the Western Balkans have yet to build credibility and effectiveness, they should be viewed within the broader objective of putting in place fiscal institutions and mechanisms to improve medium-term fiscal budgeting and planning and fiscal risk management and control. For more information, see World Bank 2017b. “Faster Growth, More Jobs.” and IMF 2015, Koczan 2015, Murgasova et al. 2015, IMF Fiscal Rules Dataset, EU Montenegro 2015 forecasts. wages and pensions. Reducing fiscal pressures from The Western Balkan countries need to sus- state-owned enterprises has been another priority, tain progress on fiscal consolidation and on through reducing direct subsidies to the enterpris- improvements in public financial management es as well as the costs of debt guarantees that the to better monitor and limit the risks of future government provides. The fiscal deficit in Serbia has fiscal slippages. This includes improving control narrowed markedly through such measures, as well on spending commitments and addressing sourc- as better revenue performance. In Albania, where es of arrears.109 Absent effective monitoring and spending levels to GDP are lower, the focus has 109 For example, in recent assessments using the PEFA tool, the been on improving revenue mobilization. On the effectiveness of payroll controls was ranked at most at B+ in whole, fiscal deficits in the region had narrowed or Albania and Montenegro and as low as D+ for entities of Bosnia and Herzegovina (a score of A means good performance at an stabilized by 2015, but debt levels remained elevated internationally-recognized level while D means performance (Figure 124). The exception was Montenegro, where below the basic level). The scores for control of non-payroll spending and effectiveness of internal audit were even weaker, deficits and public spending are on the rise on the ranging from C+ to D. The most recent PEFA assessments are back of a significant increase in outlays for a major 2012 for Albania, 2013 for Montenegro, 2014 for Bosnia and Herzegovina state and entities, 2016 for Kosovo, and 2015 for highway investment. FYR Macedonia and Serbia. 110 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 123: Fiscal deficits widened markedly in many Figure 124: Government debt-to-GDP ratios have countries after the global financial crisis. increased substantially, raising sustainability concerns. (General government net balance as percent of GDP) (Change in general government gross debt from 2007 to 2016, percentage points of GDP) 2 75 0 Change in debt in pp of GDP from 2007 to 2016 50 -2 SRB MNE 25 BIH -4 MKD ALB -6 0 KSV 50 100 150 ALB BIH KSV MNE MKD SRB -8 -25 Average 2002-2007 2008 2010 2012 2014 2016 -50 General government gross debt as percent of GDP, 2016 Source: IMF World Economic Outlook April 2017. Source: IMF World Economic Outlook April 2017. Note: Data for upper- and middle-income countries only. Y-axis range truncated between -50 to 75 and x-axis truncated at 150. controls on spending commitments, expenditure focus on improved public investment management, arrears may re-emerge. Arrears to suppliers can and related medium-term fiscal planning, is required, hinder the creditor firm’s financial health and future irrespective of levels of public investment.110 The investment decisions. Furthermore, without appro- agenda for improving the quality of spending is priate accounting of arrears, the picture from the broad-ranging.111 The discussion below focuses on reported budget deficit or debt figures can be mis- two transformative areas for reform–spending on leading as they may not capture real spending levels public wages and social benefits, and quality of ser- or fiscal liabilities. Albania, faced with general govern- vice delivery in social sectors. ment arrears reaching 5.2 percent of GDP in 2013, took steps to clear them and prevent their future Public sector wage bills make up a major share accumulation (see Box 6.1). The two entity govern- of current spending. Government expenses ments of Bosnia and Herzegovina are also placing an (that is, total expenditures excluding capital invest- increasing focus on arrears, for example, related, to ments) represent 85 to 90 percent of total general the health sector and SOEs. government expenditures in Bosnia and Herzegov- ina, Albania, FYR Macedonia, and Serbia. In Koso- State funds should be spent more vo and Montenegro, where government capital wisely and the quality of public service spending was higher, its share in 2015 was 74 and delivery improved. 82 percent respectively. Within expenses, outlays for social benefits and wages dominate (Table The region urgently needs better patterns and 6.3). Social benefits accounted from 35 percent quality of state spending to support a re-orien- of expenses in Kosovo and Montenegro, up to 50 tation of the growth model. Given the fiscal con- percent in FYR Macedonia, and about 40 percent straints that many countries face, governments will need to improve the allocation, efficiency, and effec- 110 Capital spending levels of the government in 2014 ranged from 2.5 percent of GDP in Serbia to the comparatively tiveness of public spending. Improved public services high levels, relative to 7STEE peers, of 5 percent or more in in education and health are needed to address skills Montenegro and Kosovo, which have focused on major transport infrastructure projects. In recent PEFA assessments, countries in gaps and enhance human capital and economic the region scored poorly on the existence of sector strategies opportunities. Better coverage of last resort social with multi-year costing of recurrent and investment expenditures and on the linkage between investment budgets and forward assistance would cushion the impact of shocks on expenditure estimates the vulnerable. Higher-quality infrastructure would 111 See recent World Bank public expenditure and finance reviews, for example, Albania 2014, FYR Macedonia 2015, and facilitate access to markets. Here, a cross-cutting Serbia 2015. The S tat e 111 Box 6.2. Albania moves to clear arrears and establishing commitment controls. Declining government revenues after the global financial crisis and spending commitments that were consistently above budget ceilings led Albania to accumulate major arrears in 2008–13. Even in the face of tightening financial resources and a large overhang of social spending, the government continued to spend heavily on infrastructure. The spending ceilings assigned to budget entities for the medium term were treated as a reference baseline for their plans, rather than an upper limit. New investment projects were approved with commitments well beyond the budget limits of a year and then were often cut back during the year due to lack of resources. Where executions exceeded budgets, arrears accumulated. By the end of 2013, Albania’s arrears amounted to 5.3 percent of GDP, on works, goods, and services, including utility bills, VAT and CIT refunds, disability benefits, and special funds. In 2014 the government signed on to a Strategy for the Prevention and Settlement of Overdue Liabilities. It set procedures for settling overdue debt in an accurate, transparent, and unbiased manner within three years, and for tightening financial discipline to prevent future accumulation of debt. Arrears were paid using the FIFO (first in, first out) principle. The Ministry of Finance established special units to manage the process. Reports on the processing of arrears were published regularly. An external audit validated the amounts and the clearing process. Arrears were fully cleared by the end of 2015, slightly ahead of schedule. To prevent emergence of fresh arrears, a number of controls were introduced. Budgeted entities were required to prioritize their activities within set limits and approved budget ceilings. Clear prioritization criteria now ensure that poorly prepared and ill-conceived projects are not financed and that resources go to where they will have maximum effect on the government’s objectives. To avoid over-commitments, the Ministry of Finance in March 2014 issued a budget circular notifying line ministries that commitments for 2015 to 2017 were not to exceed 30 percent of the medium-term fiscal ceilings for current expenditures and 50 percent for domestic capital expenditures. Parliament approved the three-year spending limits in the Budget Law of 2015, and approved the New Budget law in 2016. These changes are also embedded in Albania’s public financial management strategy, which the Council of Ministers approved in December 2014. To better control commitments, budget entities must now obtain authorization from the Treasury before commencing procurement for a project, and permission is denied if funds are not available. This procedure has helped curtail the common practice of initiating procurement, particularly multiyear commitments, without sufficient consideration of the resources available. The Treasury system was also reinforced to provide greater control of commitments, including ones with multi-year terms. Budget units must record commitments in the Treasury District Office within three days of signing a contract. To ensure that requirements are followed, the Treasury performs periodic checks on budget users that have a high risk of incomplete compliance. Source: World Bank. 2016. “Rebalancing for Stronger Growth.” in the three other countries. This compares to just formance (see Box 6.3 for Serbia’s strategy on this under 40 percent on average in the 7STEEs. Wag- issue).112 es as a share of expenses in Kosovo reached 45 percent in 2015, and around 19-33 percent in all Social sector spending dominates government other countries. In the 7STEEs, the wage bill to spending in most countries of the region. Gen- current spending averaged around 25 percent in eral government spending on health, education, 2015. But these figures may understate the true and social protection ranges from 12-16 percent size of the Western Balkans’ wage bill. For example, of GDP in Albania, Kosovo, and FYR Macedonia to Bosnia and Herzegovina finances health workers 24-28 percent in Bosnia and Herzegovina, Monte- through transfers from the Health Insurance Fund, negro, and Serbia (Table 6.4: The variation in overall which is an extra-budgetary fund. Including them spending levels corresponds closely to the size of would add approximately 4 percent of GDP to social security spending.). The higher levels are com- the wage bill. Thus wage bill reform is a priority in these countries to free up fiscal space and improve 112 See also the World Bank 2015g.“Serbia Public Finance Review” the quality of civil service management and per- and World Bank project documentation for the Modernization and Optimization of Public Administration Program Project for Serbia. 112 The Western Balkans: Revving Up the Engines of Growth and Prosperity Table 6.3: Wage bills account for a sizeable share of current spending, with social benefits also high in many of the countries. General government expenditures, ALB BIH KSV MNE MKD SRB 7STEE av. percent of GDP, 2015 Expenditure 31.5 42.6 27.2 49.2 34.4 44.0 42.2 Expense, o/w 27.0 40.6 20.2 40.2 30.2 41.2 38.3 Compensation of employees 5.1 11.5 9.0 13.2 7.0 8.8 10.4 Use of goods and services 3.0 7.5 3.7 4.9 4.6 7.5 6.1 Interest expense 2.7 0.9 0.3 2.4 1.2 3.2 1.8 Subsidies 0.9 1.3 0.2 1.4 2.4 3.3 0.9 Social benefits 9.9 16.6 7.0 14.3 14.9 17.6 15.0 Other expense 5.5 2.7 0.0 4.0 0.3 0.8 4.2 Investment in nonfinancial assets 4.4 2.0 7.0 8.9 4.2 2.8 3.9 Source: National authorities data, Eurostat and IMF GFS. Note: Note also that the wage bill numbers underestimate the actual wage bill in some countries where, for example, a sizeable share of health workers are financed by extra-budgetary funds. parable to the average spending in the 7STEE peers, ing disability benefits and early retirement. Where and slightly below the EU28 average of 31 percent. pension spending was greatest—in Serbia, Mon- As a share of total spending, the figure ranges from tenegro, and the Republika Srpska entity of Bosnia a low of 46 percent in Kosovo to the highs of 60 and Herzegovina—governments have reformed the percent in Serbia and 63 percent in Bosnia and systems to sharply reduce future spending, but have Herzegovina, again similar to the 7STEE peers and grandfathered existing retirees who enjoy high bene- just below the EU28 average. At a minimum, social fits and early access to them. The Federation of Bos- protection accounts for just under 20 percent of nia and Herzegovina (the other entity of Bosnia and spending in Kosovo, and up to 35-40 percent for Herzegovina) has yet to implement a pension reform. Bosnia and Herzegovina and Serbia. As discussed in While FYR Macedonia’s situation is better, its reform the Welfare chapter, this social protection spending was more structural, involving both the public pay-as- is an important source of income for poorer house- you-go pillar and a savings pillar. These four countries holds. However, overall social assistance spending also face the issue of uncovered informal workers, and last-resort (poverty-targeted) assistance does which puts further strain on their social assistance have relatively limited coverage of the poor, and systems. By contrast, Kosovo and Albania have insti- improvements in targeting are needed to make this tuted universal social pensions that give all elderly spending more effective. people, regardless of contribution history, a benefit at or above the social assistance level. The reforms Despite recent reforms, high pension spending in place are forecast to reduce spending consider- driven largely by early retirement and high ben- ably, but at the cost of sharp reductions in benefits. efits adds to fiscal pressures in Serbia, Bosnia This may not be politically sustainable. All six coun- and Herzegovina, and Montenegro. With the tries’ pension systems are experiencing pressure to exception of Albania, the countries of the West- restore higher benefits. ern Balkans inherited fiscally unsustainable pension systems from the former Yugoslavia. Falling pension High spending in social sectors in the region system revenues (mostly as a result of low employ- is often not matched by high-quality and ment, as detailed in the Labor chapter) caused fur- equity-enhancing service delivery. Public per- ther pressure in combination with the rising pension ceptions of the quality of public services often spending. The same factors that subdued growth and do not reflect the levels of spending. In the 2016 employment increased the number of people seek- LITS study, respondents in countries in the region The S tat e 113 Box 6.3. Serbia is reforming its public wage system. Public sector reform was one of the first priorities for the government that took office in Serbia in 2014. The fiscal consolidation agenda placed a particular focus on the largest single spending category, the wage bill, which accounted for 11 percent of GDP in 2013. In addition, wage bill spending was non-transparent, posing issues of fiscal predictability. The wage system included five different base salaries, 900 job coefficients (multipliers), 2,200 job titles, 71 elements of remuneration, all based on 19 laws and a plethora of by-laws. The payment of salary supplements under the different elements of pay was not rule-based, leading to significant distortions in the pay system. The effect has been to give institutions an incentive to run up wages and staffing to maximize the use of wage bill resources. Establishment control principles are routinely circumvented through the largely uncontrolled hiring of temporary employees. Since 2014, the government has targeted reducing the wage bill through a comprehensive reform of public administration designed to raise the quality and efficiency of public services, motivate and better reward public employees, and build up the civil service’s capacity to manage the EU accession process. The reform is based on two strategic documents, the Public Administration Reform (PAR) Strategy and the Action Plan for Implementing the PAR Strategy. To achieve its goals, the government has moved on two fronts, legislative and administrative. The Ministry of Finance created a Registry of Employees in the core public sector (not including state-owned enterprises), which contains information about 465,000 employees. Based on self-reporting, which poses risks of data pollution, data in the registry are regularly cross-checked with data from the mandatory social insurance registry to reduce errors. To control costs, the wage indexation formula was scaled down, followed by a nominal reduction in wages of 10 percent in November 2014, and the introduction of a ceiling on public sector salaries. In addition to the employee registry, the Ministry of Finance, in partnership with the Ministry of Public Administration and Local Self-Governance, established the Registry of Institutions in the Public Sector. Establishment control was strengthened through a hiring “freeze” that began in January 2014. This allowed a maximum ratio of 1:5 for replacements (for every five employees who leave the public sector, one employee may be hired). The freeze is being replaced with a system of strict employment ceilings by institution, set under the Law on Maximum Number of Employees in the public sector, adopted in Summer 2015. Under this law, annual ceilings for individual institutions are set by government decree. Finally, the number of contract employees a ministry or agency can hire was limited to 10 percent of its total staff, and ministries were given three months to bring numbers in line with this ceiling. Other measures are underway to make this reform sustainable. In particular, the government has adopted a new Law on Wages and Salaries in the Public Sector, which sets parameters for the pay and grading systems that apply across the public sector. The law dramatically reduces fragmentation in the wage system and ensures to the maximum extent possible the “equal pay for equal work” principle across the core public sector. In parallel, the government is conducting a thorough review of the functions of ministries and agencies to determine policies for optimization. With an overall goal of streamlining the more than 100 central state institutions that currently exist, the review is giving special attention to ministries and agencies that employ most staff and deliver vital services. Source: World Bank. 2016b. “Rebalancing for Stronger Growth.” 114 The Western Balkans: Revving Up the Engines of Growth and Prosperity Table 6.4: The variation in overall spending levels corresponds closely to the size of social security spending. (General government expenditures by functional classification, percent of GDP, 2015, unless indicated) ALB BIH KSV MKD MNE SRB* 7STEE av. EU28 Total, o/w 31.5 42.6 27.2 34.4 49.2 46.3 42.2 47.2 General public services 6.4 6.2 5.5 3.7 10.3 6.1 5.6 6.2 Defense 0.7 1.0 0.6 1.1 0.9 1.3 1.3 1.4 Order and public security 1.8 4.4 1.5 2.5 3.6 2.7 2.1 1.8 Economic Issues 4.1 2.1 5.5 9.4 8.4 6.0 5.1 4.3 Environment 0.1 0.0 0.2 0.2 0.3 0.3 0.7 0.8 Housing and communities 2.0 1.2 0.5 0.4 0.5 1.3 0.9 0.6 Health 2.7 6.7 2.8 5.5 5.9 5.7 5.9 7.2 Recreation, culture and 0.5 0.7 0.6 0.8 1.5 1.1 1.6 1.0 religion Education 3.1 5.5 4.5 4.1 4.3 4.2 5.2 4.9 Social protection 9.3 14.8 5.1 6.8 13.5 17.7 13.8 19.0 Other expenses 0.9 n.a. 0.5 n.a. n.a. n.a. n.a. n.a. As share of total spending General public services 20.3 14.6 20.1 10.7 20.9 13.2 13.4 13.1 Defense 2.4 2.3 2.2 3.2 1.8 2.8 3.0 3.0 Order and public security 5.6 10.3 5.3 7.2 7.3 5.8 4.9 3.8 Economic Issues 12.9 4.9 20.0 27.2 17.1 13.0 12.2 9.1 Environment 0.3 - 0.9 0.6 0.6 0.6 1.8 1.7 Housing and communities 6.2 2.8 1.8 1.2 1.0 2.8 2.0 1.3 Health 8.6 15.7 10.4 16.0 12.0 12.3 13.9 15.3 Recreation, culture and 1.5 1.6 2.1 2.4 3.0 2.4 3.7 2.1 religion Education 9.9 12.9 16.5 11.9 8.7 9.1 12.4 10.4 Social security 29.5 34.7 18.9 19.7 27.4 38.2 32.6 40.3 Other expenses 2.8 n.a. 1.8 n.a. n.a. n.a. n.a. n.a. Source: National authorities data, Eurostat and IMF GFS. Note: Data for 2015 for all but * which are 2014. The S tat e 115 Figure 125: Satisfaction with public services is low Figure 126: Satisfaction lags behind peer countries relative to spending levels. in social service delivery. (Percent of respondents satisfied with quality and efficiency of (Percent of respondents satisfied with quality and efficiency of public service delivery, average across indicators) public service delivery) 90 e ciency of public service delivery), simple average, 2016 LITS (percent of respondents satis ed with quality and 100 TUR 80 EST 90 ROM LVA SVK SVN 80 70 LTU UZB 70 BGR GEO RUS POL HRV 60 HUN 60 ARM MNG ALB UKR 50 50 KAZ SRB MNE TJK MKD KYR BLR BIH 40 40 MDA 30 20 30 20 25 30 35 40 45 50 55 10 General government expenditures to GDP (percent), 0 average 2012 to 2016 Public health Primary / Vocational Social security Unemployment system Secondary education bene ts bene ts Source: EBRD Life in Transition Survey 2016, IMF World Economic Outlook April 2017 and Education World Bank sta calculations. Note: Respondents who are “satis ed” are those who report that they were “very satis ed” ALB BIH KSV MKD or “satis ed” with the quality and the e ciency of the given public services in the 12 MNE SRB Min 7STEE Max 7 STEE months preceding the survey. Average of indicators for Public health system; primary/se- condary education; tra c police; o cial documents; vocational education; social security bene ts; unemployment bene ts; civil courts. Source: EBRD Life in Transition Survey 2016 and World Bank sta calculations. were less satisfied than those in other countries Study (TIMSS) declined significantly between 1999 with the same levels of overall government spend- and 2011, and are below those of other European ing (Figure 125). Looking at different social ser- countries. In Serbia, there are similar concerns on vices (Figure 126), satisfaction levels are generally education outcomes, based on PISA results. Alba- below the range of the 7STEE countries. Satisfac- nia, which spends much less on education than its tion with public health services is around 50-60 neighbors, has consistently improved its scores on percent and for social security and unemployment international student assessments. However, learning benefits roughly 20 to 40 percent. Improving the outcomes remain stubbornly low even relative to quality, efficiency, and equity of social services will neighboring countries with similar levels of income. require reinforcing systems for monitoring service More than 60 percent of Albanian 15-year-olds are quality and efficiency. Further gains could come functionally illiterate in math and about 50 percent from introducing performance-based financing and in reading. In Kosovo, where education spending is enhancing the mechanisms for citizen engagement relatively low, the quality of education remains weak and accountability of service providers, such as per- and inequitable with significant disparities between formance scorecards. municipalities, girls and boys (especially in language tests), and rural and urban students. Education spending in the region is broadly in line with regional peers (Figure 127) but out- Providing greater coverage of pre-school edu- comes are not keeping up.113 In FYR Macedo- cation would raise educational outcomes. nia, education outcomes have deteriorated despite Quality preschools can have a significant impact increased spending. The countries’ scores on the on later achievement in school and lifetime earn- Trends in International Mathematics and Science ings, particularly for low-income and disadvantaged 113 See, for example, World Bank 2015b. “FYR Macedonia Public children. Serbia has generally high access to primary Expenditure Review: Fiscal Policy for Growth.” and World Bank and secondary education, but still needs to enhance 2014. “Albania Public Finance Review Part II: Improving the the coverage of preschool education. At present, Efficiency and Quality of Public Spending.” 116 The Western Balkans: Revving Up the Engines of Growth and Prosperity Figure 127: Education spending to GDP lies within Figure 128: Health spending varies widely coun- the range of regional peers. try-to-country. (Government education spending to GDP and as a share of (Government health spending to GDP and as a share of general general government spending, percent) government spending, percent) 8 As share of GDP As share of total expenditures 20 8 As share of GDP As share of total expenditures 20 6 15 6 15 4 10 4 10 2 5 2 5 0 0 0 0 SVK EU28 BIH SVN HVR MNE LTU SRB* MKD EST BGR LVA KSV ALB EST LVA SVN BIH LTU EU28 HRB KSV MNE SVK SRB* MKD BGR ALB Source: National authorities, IMF GFS, and Eurostat. Source: National authorities, IMF GFS, and Eurostat. Note: Functional classi cation of general government spending. Data for 2015 for all but Note: Functional classi cation of general government spending. Data for 2015 for all but *, *, which are 2014. which are 2014. early childhood development programs reach only and provide greater transparency on resource allo- 52 percent of boys and 49 percent of girls—very cation decisions. In FYR Macedonia and Montenegro, low in comparison to the EU 2020 target of 95 per- tertiary education could benefit from setting budget cent—and are much lower for Roma at 5 percent levels based on the headcounts of individual institu- for boys and 7 percent for girls. Similarly in Albania, tions. Across the region there is a need for improved while access to basic education is relatively equitable strategic frameworks and information management across income groups, significant disparities remain systems to measure learning outcomes and their link- in access to preprimary and higher education. In age to employment outcomes, so as to better inform Bosnia and Herzegovina, on average only 13 percent policy decision-making and resource allocations. of children aged 3–5½ attend preschool, and atten- dance falls to 8 percent among the poor, Roma, and Government health sector spending varies people living in rural areas. Serbia also faces falling more widely across the region but countries pupil numbers and a need to consolidate the school face a number of common challenges. Health network and reduce excess teachers in primary and spending by government is higher in Bosnia and Her- secondary education. In FYR Macedonia and Mon- zegovina, Serbia, FYR Macedonia, and Montenegro tenegro, enrollment in tertiary education has been and lower in Albania and Kosovo (Figure 128). At increasing rapidly in recent years, but the efficiency the macro-level, those countries with more rapidly of the higher education system remains low. Tertiary aging populations face a higher burden of chronic education could improve by coordinating curricu- disease and a shrinking health insurance contribu- la with the needs of the private sector. In Albania, tion base. Arrears accumulation and spending ineffi- strengthening the regulation of higher education ciencies relating to pharmaceutical procurement and would also help assure quality and guarantee align- staffing composition are common. For example, in ment with population trends. Bosnia and Herzegovina, despite the high outlays, the public health sectors in both Republika Srpska and Across the region, reforms to education financ- the Federation have accumulated large debts and ing and information management systems arrears. In Serbia, roughly 25 percent of public health would further improve quality and equity of care expenditures in 2013 were on pharmaceuticals, outcomes. Recent expenditure reviews in Albania, compared to an EU average of 12.3 percent, while FYR Macedonia, and Serbia have highlighted that the share of nonmedical hospital staff is particular- moves to more equal per-student financing could ly high in Serbia and Albania.114 As with education, help address inequities in resources across schools 114 Recent World Bank public finance reviews in Albania and The S tat e 117 Box 6.4. Albania moves toward e-government reform. In June 2014, the Government of Albania began a bold reform program of public service delivery, entitled “Innovation against Corruption.” Elected in 2013 with a mandate to reduce corruption, the government’s aim was to change fundamentally how public services are provided through a variety of interventions, including creation of a one-stop shop for administrative services; regulatory reform; re-engineering how services are approved; increasing the number of services provided online; and implementing performance management measures. Through these reforms, the scope for corruption could decline, enhancing the business environment, and the citizen-focus and timeliness of public service provision improved. A one-stop shop citizen service center (CSC) in Tirana, regulatory reform, process re-engineering, and automation are key elements of this strategy. Establishing mechanisms for citizen feedback on the quality and timeliness of service delivery will provide the necessary data to manage performance. The medium-term goal is to automate 90 percent of selected government services for online provision by 2020. This reform is in parallel with other initiatives to automate public service delivery, such as the e-Albania portal (www.e-albania.al) along with online procurement, modernized business registration and licensing. These have helped support an improved environment for private sector dynamism and growth. Source: World Bank. For more information on the World Bank project supporting Albania’s Citizen Centric Service Delivery, see http:// www.projects.worldbank.org/P151972?lang=en. sound health information systems are needed to Administration Reform Strategy 2011-2016 identi- inform sector strategies and resourcing. For exam- fies capacity as a key binding constraint. In some cas- ple, Bosnia and Herzegovina already has a relatively es, the public sector is aging rapidly. For example, in good primary care health information system, but it Serbia, the average age in the Veterinary Service is 56. needs to be better networked, linked to hospitals As technically capable staff members retire, govern- and institutes of public health, and monitored sys- ments will need to develop innovative ways to find tematically. Again, performance-based financing for qualified replacements. In the short to medium term, health has the scope to support efficiency improve- there is a risk that these dynamics may undermine ments in the sector. the capacity of the state to function fully. The state needs a higher capacity to With these goals in mind, public administration deliver. reforms are rightly receiving strong priority in the region. Comprehensive strategies for public Delivering on the reform agenda outlined in administration reform have been adopted—such as the sections above will require a strengthening in Serbia and Montenegro—and across the region of capacity within public administrations. Insti- this is an important area for support from interna- tutional reforms across the region will only succeed tional institutions, in particular the EU in connection if rank-and-file public sector employees take part in with the accession process. Reforms to develop an the design and implementation of these reforms. This independent, professional, and efficient public admin- will require streamlining the policy process to ensure istration in line with European standards can improve alignment and consensus, strengthening the center of the quality of policy formulation, coordination, and government to improve coordination, and ensuring implementation. This includes reforms to civil ser- continuity in leadership in an environment of peren- vice administrations and the judiciary to improve the nially fluid politics. In many countries, the very capaci- selection, professionalism, and management of staff. ty of the public sector to perform its core mandate is Serbia, for instance, has recently attempted to over- a key challenge. For example, the Montenegro Public haul its legal frameworks and reduce public sector head count through right-sizing and strengthening Serbia have highlighted the relatively high share of non-medical policy coordination and implementation. Enhanced staff in those countries’ health sectors. In Serbia, non-medical staff accountability and oversight mechanisms are also make up 25-30 percent of the health workforce (twice as high as in OECD countries), rising to 42 percent in specialized hospitals. needed. E-government (such as the Albania e-ser- In Albania, around 35 percent of staff in hospitals are non-medical vices reform, see Box 6.4) is one entry point to while in FYR Macedonia the 17 percent figure is also relatively high. improve accountability and governance, promote 118 The Western Balkans: Revving Up the Engines of Growth and Prosperity Box 6.5. Tools allow weighing of the distributional impact of fiscal policy. Fiscal incidence analysis is a tool that policymakers and other stakeholders in developing and emerging economies increasingly use to measure the impact of a country’s revenue and spending on poverty and inequality and how fiscal reforms might alter the well-being of different segments of the population. The Commitment to Equity (CEQ) methodology is one such approach. Poland offers a recent example of its application. There the analysis was able to cover 62 percent of tax revenue and 51 percent of government spending. It concluded that the combined effect of taxes and social spending substantially helped to reduce poverty and inequality in Poland in 2014, in line with the findings in other European Union countries, with pensions achieving most of the reduction. The caveats for the CEQ methodology, as noted in the Poland analysis, are important to highlight. For example, no behavioral, lifecycle, or general equilibrium effects of policy reforms are applied. The quality of services is not captured, and some important revenue and spending items (including infrastructure investments and corporate profits) are not covered. But CEQ insights can still help to inform design of policy, mitigation measures of reforms, and communication strategies. Where fiscal policy reforms affect particular segments of the population, for example in the case of public administration right-sizing, other approaches can provide important insights. This includes examining the resilience of potentially affected households through analysis of household and labor force surveys as well as more targeted quantitative and qualitative surveys. Source: among others, The Commitment to Equity Project http://www.commitmentoequity.org/ and Goraus and Inchauste 2016 and World Bank 2015g. “Serbia Public Finance Review.” transparency, and reduce the scope for such corrup- raised, convergence in incomes reignited, and sus- tion.The incentives of EU accession show up not only tained improvement in welfare delivered for the cit- in public administration and judicial reforms, but in izens of the region. decentralization and efforts to strengthen the center of government through establishment of “delivery The level of political support for reform of the units” to push through improvements in performance state varies across the countries of the region. in critical areas. Finally, there is a need to strengthen For example, in Albania, the government is making fiscal controls and management information systems efforts to improve service delivery while in Serbia, for expenditures and personnel. Even if the political the government is moving forward on a wide range will is there, reform can lag if there is zero or very of challenging reforms to the state administration, limited basic data about areas of government spend- public enterprises, and SOEs, supported by the ing such as personnel costs or there is significant EU and international financial institutions. In Bosnia spending outside of the budget. and Herzegovina, while authorities put in place the Reform Agenda, backed by the international com- Can reforms succeed this time, and munity, institutional fragmentation still poses daunt- how? ing constraints even to reform-minded leaders. Until recently, FYR Macedonia has also been facing pro- Changing the role of the state is not easy; longed political uncertainty. Across the region, there reforms in this direction will succeed only if is also the risk that anti-EU sentiments could reduce backed by political will. Delivering a set of state political appetite for pushing EU-related reforms of institutions and government policies that are more the public sector. effective enablers of private sector investment and growth is no simple task. Short- and medium-term Building understanding of the positive distribu- political dynamics, concerns over the distributional tional consequences of state reforms can help impact of reforms and capture of state institutions mobilize political support for their adoption. The by private interests have all impeded reforms over prospects of enhanced future growth and prosper- the past decades. However, the need for reforms is ity for society as a whole must be weighed against becoming more pressing if growth rates are to be the interests of those who benefit most from the The S tat e 119 Figure 129: Concerns over corruption are high. (43 percent) and Serbia (42 percent), followed by Percent of respondents agreeing with statements that corruption Kosovo (34 percent) and Montenegro (29 percent). or bribery is one of the three biggest problems facing the country This reflects the fact that corruption and capture of in the public sector in this country. (percent of respondents) state institutions remain a concern in many coun- ties in the region. This capture can include politicized Corruption or bribery is one of the three biggest problems facing the country public administrations, discretionary application of Rate their government "badly" at ghting corruption in government the law, and limited parliamentary and state audit 90 oversight. Public perceptions that government is 80 corrupt and prone to control by private interests 70 remain high (Figure 129), although they are also high 60 in the 7STEEs. Perceptions of governments’ effort 50 in fighting corruption remain relatively weak, partic- 40 ularly in Bosnia and Herzegovina and Kosovo. Per- 30 ceived political interference in the judiciary raises 20 10 particular concerns among citizens, firms, and poten- 0 tial foreign investors about the credibility of contract ALB SRB MKD MNE KSV BIH Median enforcement. While the Western Balkan countries 7STEE have made reforms to protect the integrity of the Source: Transparency International, Global Corruption Barometer 2016. legislative framework, corruption is rarely pun- ished in courts anywhere in the region. Enhanced accountability and oversight, including through inno- status quo. These include the usual issues of winners vations such as e-government, can help businesses and losers (reflecting demographics and the current and workers alike to feel secure in committing their bias of spending towards the old). The distributional funds and futures to the region. implications of fiscal reforms, on both the revenue and expenditure side, are increasingly a focus for pol- Notwithstanding the challenges we have dis- icy makers across the world, and can be examined cussed, there is a growing understanding that through methodologies such as the Commitment to the time is now for sustaining and expanding Equity (CEQ) analysis (Box 6.5). Such analysis may be the necessary reforms. There can be no more of particular interest for the Western Balkans, given postponing. Looking outwards, the countries of the the importance of the state, and the need in many of region can see the results of the “EU convergence the six countries for reforms of social spending.Transi- machine,” which has supported improvements in tional costs of reforms are also important, particularly economic governance and higher incomes. Aspiring where they are heightened by fragmented institutional for the same results, all Western Balkan countries structures and overlapping authorities, such as in Bos- but Kosovo have submitted formal applications to nia and Herzegovina. the EU. The context for European enlargement has indeed shifted in recent years, due to the euro zone Even with stable politics and a willingness to crisis, experience of previous enlargements, political reform, the “capture” of state institutions by pressures from migration into the EU, and “Brexit.” private interests can impede the quality of pub- The European Commission has reaffirmed a strong lic services and obstruct the implementation of focus on the principles of “fundamentals first” in the reforms. Many people in the region view knowing accession process, prioritizing reforms related to the right people in government as essential for mov- the rule of law and the functioning of democratic ing ahead. In the 2016 Life in Transition Survey,115 institutions including public administration. All in all, 46 percent of respondents in FYR Macedonia chose the Commission is emphasizing that fundamental “political connections” as the most important factor changes like these require time, and accession will for success in life. This was the highest rate in the too. Looking inwards, many governments are taking survey, ranking above “effort and hard work” (34 on such tough reforms, motivated by a growing view percent) and “intelligence and skills” at 15 percent. that today the opportunity is better than it has been Bosnia and Herzegovina was not far behind with 45 in years for countries to deliver on their potential, percent choosing political connections, then Albania to raise economic growth and to ensure sustained 115 EBRD 2016. improvement in welfare for their citizens. 120 The Western Balkans: Revving Up the Engines of Growth and Prosperity 122 The Western Balkans: Revving Up the Engines of Growth and Prosperity CONCLUSION The six countries of the Western Balkans large- Figure 130: At the current relative growth speed, it will take ly missed out on earlier opportunities to thrive about 60 years for the Western Balkans to converge to the in the post-Cold War era. Today, with peace and average EU level of income enhanced collaboration, coupled with future pros- (GDP/capita relative to EU, international 2011 PPP dollars) pects of European Union membership, the coun- 100 tries have another chance. With the right package of 90 reforms, they can raise economic growth rates and 80 ensure sustained improvement in welfare for all cit- izens. As late reformers, they can benefit from rising 70 wages in the rapidly reforming transition countries 60 of the European Union and from greater cost-con- 50 sciousness among firms adapting to lower global 40 growth.The potential for raising productivity through further integration with Europe and the rest of the 30 world is large. The experience of Eastern European 20 transition economies that were early reformers can 10 provide valuable guidance for the Western Balkan 0 countries today. 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50 52 54 56 58 60 62 Years to converge It is crucial to act now. If the countries keep to WB6@5% WB6@3% WB6@average their current rates of per capita income growth, it 7STEE@5% 7STEE@3% 7STEE@average will take about 60 years to catch up with their EU neighbors (Figure 130). As things stand now, too Source: World Development Indicators and World Bank sta calculations. Note: Growth rates are relative to the EU. Median relative growth rates 1995-2015 are 1.8 percent for few people in the Western Balkans have jobs. Levels WB6 and 3.2 percent for 7STEE. of emigration are high as young and educated peo- ple look for opportunities elsewhere. Investment is low and private sector firms find it difficult to start ship continues to provide the strongest anchor for up and thrive. Productivity remains largely stuck deeper reforms, but implementation has been slow. at long-standing low levels. Populations are rapidly aging. The broad policy challenges are similar across the six nations. To speed up convergence, the The prolonged period of sluggish reforms, Western Balkan countries need to deepen reforms political uncertainty, and slow convergence to raise productivity and economic growth through in living standards has left citizens dissatisfied further integration into regional and world markets. with government. The prospect of EU member- They need higher employment and equity in access C o nc l u si o n 123 to services. They must make it easier for private In sum, Western Balkan countries’ highest pri- enterprises to grow and reach new markets. orities are to: This will require reducing and modifying the • Foster macroeconomic stability. role of the state from a direct driver of eco- • Remove disincentives and barriers to work. nomic activity to a provider of effective poli- • Strengthen the business environment and pri- cies, regulatory frameworks, governing institu- vate sector development. tions, and essential public goods. Improving the • Improve governance and institutions and deep- business climate will facilitate firm entry and exit and en public sector reform. the reallocation of resources to the most produc- tive activities. Improved macroeconomic stability will In pursuing these policy priorities, coordination at provide further aid to growth. Reducing the regula- the regional level would heighten integration within tory burden and improving the logistics and trade the region and with the rest of the world. Lasting infrastructure will increase competitiveness and help development results would also require ensuring domestic firms upgrade and expand exports. sustainable use of energy and natural resources and stewardship of the environment.116 Making better use of labor and human capital by enhancing relevant skills and bringing more people into the workforce will be key. Countries need to address disincentives for work and barri- ers to employment that exist in their labor, tax, and social protection systems, and support acquisition of the skills that workers will need for new jobs created. 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