WESTERN BALKANS REGULAR ECONOMIC REPORT No.15 | Spring 2019 Reform Momentum Needed Western Balkans Regular Economic Report No.15 Reform Momentum Needed Spring 2019   Acknowledgements Regular Economic Report (RER) covers economic developments, prospects, and economic policies in the Western Balkans’ region: Albania, Bosnia and Herzegovina, Kosovo, Montenegro, North Macedonia, and Serbia. The team was led by Marco Antonio Hernandez and Marc Tobias Schiffbauer (Task Team Leaders). This issue’s core team included World Bank staff working on the Western Balkan countries (with additional contributions to specific sections): Bojan Shimbov, Sandra Hlivnjak (External section), Edith Kikoni (Fiscal section), Johanna Jaeger, Christoph Ungerer (Financial sector section), Sanja Madžarević-Šujster, Gonzalo Reyes (Labor section), Asli Senkal (Growth section), Lazar Šestović, Milan Lakicević (Outlook section), and Hilda Shijaku (Monetary section). Additional contributions were made by: Stefanie Brodmann, Trang Van Nguyen, Ana Maria Oviedo, Monica Robayo, and Cesar A. Cancho (Labor section and Spotlight#2); Gunhild Berg, Alena Kantarovich, Blerta Qerimi, Ruvejda Aliefendic, Keler Gjika, and Alper Oguz (Financial sector section); Elwyn Davies, Graciela Miralles, Tania Begazo, Leandro Zipitria, and Tilsa Ore (Growth section and Spotlight#1); David Gould (Outlook section); David Duarte and Lorena Meco (Fiscal section). The Special Focus Section “Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion” was led by Jamele Rigolini, with contributions from Bojana Naceva, Boryana Gotcheva, Cem Mete, Dorothee Chen, Flora Kelmendi, Harry Patrinos, Ian Forde, Katia Herrera, Marijana Jasarevic, Mirey Ovadiya, Stefanie Brodmann, Tania Dmytraczenko, Marc Tobias Schiffbauer, and Marco Antonio Hernandez. Anne Grant provided assistance in editing, and Budy Wirasmo assistance in designing. Nejme Kotere, Samra Bajramovic, Ivana Bojic, Enkelejda Karaj, Hermina Vukovic Tasic, Jasminka Sopova, Boba Vukoslavovic, Dragana Varezić, and Leah Laboy assisted the team. The dissemination of the report and external and media relations are managed by an External Communications team comprised of Lundrim Aliu, Anita Božinovska, Paul A. Clare, Ana Gjokutaj, Jasmina Hadžić, Carl P. Hanlon, Vesna Kostić, John Mackedon, Mirjana Popović, Kym Louise Smithies, and Sanja Tanić. The team is grateful to Linda Van Gelder (Regional Director for the Western Balkans); Lalita Moorty (Director, Macroeconomics, Trade, and Investment Global Practice); Gallina A. Vincelette (Practice Manager, Macroeconomics, Trade, and Investment Global Practice); and the Western Balkans Country Management team for their guidance in preparation of this report. The team is also thankful for comments on earlier drafts of this report received from the Ministries of Finance and Central Banks in Western Balkans countries. This Western Balkans RER and previous issues may be found at: www.worldbank.org/eca/wbrer/. © 2019 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this work is subject to copyright. 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WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Contents Reform Momentum Needed 1 1. Overview 2 2.  Growth in the Western Balkans accelerated in 2018 5 3.  Fewer jobs were created in 2018 despite strong growth 10 Safeguarding the fiscal adjustment made in recent years is critical 4.  16 Inflation picked up and monetary policy stayed accommodative 5.  24 A wider range of financing instruments is needed to boost lending to businesses 6.  26 Although exports grew, in most of the region external deficits stayed high 7.  30 Stable outlook, rising risks, and growing public discontent—reform momentum is needed 8.  35 9.  Spotlight #1: Competitive Markets Needed 41 Spotlight #2: Labor Taxation in the Western Balkans 10.  44 Focus Section on Human Capital in the Western Balkans: A Missing Link to 11.  Growth and Inclusion 46 References57 Country Notes 59 Albania61 Bosnia and Herzegovina 66 Kosovo71 Montenegro76 North Macedonia 81 Serbia86 Key Economic Indicators 91 vi  | Contents REFORM MOMENTUM NEEDED List of Figures  conomic growth in the Western Balkans picked up in 2018 and the Figure 1.1. E outlook for 2019–20 is stable. 4 Figure 1.2. But limited private sector dynamism is reflected in slow job creation… 4 Figure 1.3. …and in low, and slow-growing foreign investment inflows. 4 With public spending dominated by wages and untargeted social Figure 1.4.  programs, fiscal policy needs reform. 4  dvancing reforms to ensure that private sector firms can compete on Figure 1.5. A equal terms will boost productivity and sustain higher growth rates. 4  nvesting more efficiently in human capital would allow Western Balkan Figure 1.6. I countries to expand their economic potential and ensure that growth is inclusive. 4 Figure 2.1. Growth accelerated in 2018. 5 Figure 2.2. Higher public spending supported consumption and investment growth in 2018. 6 Figure 3.1. Employment responded feebly to growth… 10 Figure 3.2. …and in Bosnia and Herzegovina it is still below the pre-crisis level. 10 Figure 3.3. Unemployment declined in all Western Balkans countries... 12 Figure 3.4. …but is still the most serious concern of Western Balkan citizens. 12 Figure 3.5. More people seem to be seeking and finding jobs, but the progress is slow. 14 Figure 3.6. In some countries inactivity is not only high but increased. 14 Figure 3.7. The female–male labor participation gap narrowed to 23 percentage points. 15  iscal consolidation reduced the deficit in Montenegro while Bosnia’s Figure 4.1. F budget returns to deficit. 16  pending restraint contributed to fiscal outcomes in Albania, North Figure 4.2. S Macedonia and Montenegro. 16 Figure 4.3. Higher spending went mainly to capital investment and social benefits. 18 Figure 4.4. Spending is dominated by public wages and social programs. 18 Figure 4.5. Public debt-to-GDP ratios fell in Serbia, Bosnia and Herzegovina and Albania. 19  xternal PPG debt rose in Montenegro, North Macedonia and Albania as Figure 4.6. E they tap international credit markets. 19 Figure 4.7. Full fiscal transparency is needed. 20 Figure 5.1. Inflation, though slowly building, is still contained. 24 Figure 5.2. Food and oil prices mainly drove inflation, but core inflation remains low. 24  entral banks further eased monetary policy in Albania, North Figure 5.3. C Macedonia, and Serbia...… 25 Figure 5.4. …and intervened in forex markets. 25 Figure 5.5. Appreciation pressures also intensified. 25 Figure 6.1. Credit outstanding continued to increase in most countries. 26 Figure 6.2. Credit to households grew rapidly and outpaced credit growth to firms. 26 Figure 6.3. Nonperforming loans are declining. 27 Figure 6.4. Banks are adequately capitalized. 27 Figure 7.1. CADs widened in Bosnia and Herzegovina, Kosovo, and Montenegro. 30 Contents  |  vii WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Figure 7.2. Goods imports were the main factor in changes to CADs. 30 Figure 7.3. FDI levels remain low and they are growing slowly. 33 Figure 7.4. External debt increased in 2018. 33 SOEs are sometimes controlled by line ministries rather than by Figure 9.1.  independent institutions… 42 Figure 9.2. …and SOEs have access to finance that is not available for private firms. 42 Strengthening competition in energy, water, transport, and telecoms can Figure 9.3.  accelerate growth. 43 Figure 10.1. Labor tax wedges for low-wage earners are high in several Western Balkan countries.44 Figure 10.2. Labor tax wedges are high for workers with dependents. 44 Figure 11.1. Disparities are growing among transition economies. 46 Figure 11.2. The Western Balkans face severe employment challenges, which result in a considerable waste of working years. 47 Figure 11.3. Human capital and development go hand in hand. 48 Figure 11.4. In some Western Balkan countries, education outcomes are well below those in peer countries. 50 Figure 11.5. There is room to improve Western Balkan’s health systems to properly insure people and deliver better outcomes. 51 Figure 11.6. Social assistance spending is relatively high but is not necessarily intended for the poor. 52 Figure 11.7. Spending on employment services and programs remains low in most countries in the Western Balkans. 53 Figure 11.8. Education outcomes among vulnerable Roma remain dismally low. 54 viii  | Contents REFORM MOMENTUM NEEDED List of Tables Table B3.1.1. Labor Market Characteristics, Western Balkans Youth, June 2018, Percent. 13 Table 8.1. The Growth Trajectory in the Western Balkans, 2017–20f. 35  ultidimensional connectivity has improved for the Western Balkans Table B8.1.1. M since the early 2000s. 38 List of Boxes Box 2.1. High-Growth Firms in the Western Balkans: Startups Wanted! 7 Box 3.1. Youth Employment in the Western Balkans. 13 Box 4.1. Balancing Efficiency and Equity in Revenue Collection with the Personal Income Tax. 20 Box 6.1. Diversification of Financial Systems for Greater Access to Finance. 28 Box 7.1. Export Sophistication in the Western Balkans. 31 Box 8.1. Enhancing Multidimensional Connectivity in the Western Balkans. 38 Contents  |  ix Reform Momentum Needed WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 1. Overview The Western Balkans economies are Despite stronger growth in 2018, the pace projected to continue to expand in 2019– of job creation slowed, reflecting limited 20, but this stable outlook is vulnerable to private sector dynamism. In 2018, 96,000 risks. In 2018 economic growth in the Western jobs were created in the Western Balkans Balkans reached 3.8 percent, supported by (mostly in industry and services), down increased public spending, and in Albania and considerably from 171,200 jobs created during North Macedonia also by a rise in net exports. 2017. The slower labor market response Growth is projected to average 3.7 percent for reflects to some extent the temporary effects 2019–20, faster than the EU and similar to the of the fiscal stimuli that pushed growth but average for Central and Eastern Europe (CEE). did not encourage private sector job creation. Growth will differ by country, accelerating in Unemployment fell in 2018 but remains high, Bosnia and Herzegovina, Kosovo, and North particularly for women and the youth; in some Macedonia while decelerating in Albania, countries the fall in unemployment stemmed Montenegro, and Serbia. Factors common to from increased labor inactivity and emigration all countries are the recent fiscal stimuli and rather than new jobs. Labor market distortions favorable external conditions that pushed at the country level remain evident in regional growth in 2018, beyond its potential in some and gender disparities. Reducing disincentives of them. The waning effects of these factors to employment and labor force participation, challenges the medium-term growth outlook such as the high burden of taxes on low-wage in the region. Moreover, there is growing earners, is critical to spur job creation and public discontent in several countries which growth. could lead to higher political uncertainty and a slower pace of structural reforms. In North Ensuring that firms can readily enter, compete Macedonia, by contrast, the resolution in early on equal terms, and efficiently exit the 2019 of the decades-long dispute with Greece market would support business development over the country’s name is an opportunity to and attract private investment in the Western advance reforms, accelerate EU accession, and Balkans. In recent years, inflows of foreign become more integrated in global markets. direct investment (FDI) have helped transform Western Balkan countries are also confronted industries and increase exports; but FDI is still with growing external risks from slower-than- low as a share of GDP and its growth is slow. projected growth in the EU, geopolitical and Regulatory barriers make it difficult for existing trade disputes, and a possible tightening of firms to expand, become more productive, or financing conditions in international capital exit the market, and for new firms to emerge markets. Against this backdrop, there is an and succeed, or fail fast and cheap. High- opportunity to advance reforms to mitigate growth firms—that grow on average by at risks and the demands for greater economic least 20 percent for three consecutive years— opportunities. create the most jobs in the Western Balkans, but there are few of these firms: in 2016 2  |  1. Overview REFORM MOMENTUM NEEDED only 1 in 33 formal sector firms in North (2) labor taxation; (3) the distributional impact Macedonia and, in 2017, only 1 in 20 in Serbia of personal income taxation; (4) financial sector had average growth of at least 20 percent for diversification; (5) export sophistication; and three consecutive years. Other small transition (6) economic connectivity. Advancing reforms economies in Europe, such as Latvia, Lithuania, in these and other areas would allow Western and Estonia, as well as other emerging markets Balkan countries to seize the opportunities have much larger shares of high-growth firms. that EU accession can bring, and to be able to Reinforcing the public institutions that ensure compete on an equal footing with EU peers. no one benefits from special treatment would encourage entrepreneurs to enter the market This report features a special focus section and innovate, expanding the pool of younger, on human capital development. The region more productive firms that grow and create has achieved notable progress in expanding jobs (Spotlight #1). access to basic education and health and setting up social protection systems to protect the Because public spending is dominated vulnerable. This Focus Section explores how by large public wage bills and untargeted Western Balkan societies can be better prepared social programs, the efficiency of fiscal to take advantage of the opportunities offered policy needs to improve. Countries that have by rapid technological changes, mitigate been committed to fiscal consolidation such risks, and create dynamic growing economies as Albania and Serbia are seeing their debt where young people can thrive and realize go down, and it is critical to safeguard these their aspirations. Unaddressed, the region’s gains. But public and publicly guaranteed debt human capital challenges will severely limit remains high in most countries, and rose in the region’s prospects for growth and poverty Montenegro, North Macedonia, and Kosovo in reduction. For instance, too little investment 2018. Fiscal risks related to pensions, municipal in early childhood development translates into finances, and state-owned enterprises are also poor performance in primary and secondary on the rise. Improving the efficiency and equity education in some countries. In school, of public spending as well as strengthening students in some countries do not acquire the revenue mobilization remain priorities for fiscal skills they need to function effectively as labor policy to reduce the high debt levels, create markets become ever more competitive. Poor- fiscal buffers to mitigate risks, and improve quality technical and university education the delivery of public services in the Western makes the transition from school to work Balkans. difficult; many graduates who suffer years of unemployment cannot build work experience. Harnessing the opportunity to build reform Social assistance programs also do not give momentum at a time of a stable outlook is vulnerable households the support they need to essential for strengthening the foundations prepare them for the labor market. Inefficient for future growth. This edition of the Western health systems are unable to address the rise Balkans Regular Economic Report discusses of noncommunicable diseases, and individual selected reform areas that will help boost out-of-pocket spending on health is high. In productivity for faster and sustained growth general, countries in the region must act boldly and jobs, namely (1) competition policy; to build human capital. 1. Overview  |  3 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Figure 1.1. Economic growth in the Western Figure 1.2. But limited private sector Balkans picked up in 2018 and the outlook for dynamism is reflected in slow job creation… 2019–20 is stable. Growth rates, 2017–20f, percent Two-quarter average y-o-y employment growth, percent 2017 2018e 2019f 2020f 12 20 Albania 3.8 4.2 3.8 3.6 10 15 Bosnia and Herzegovina 3.2 3.0 3.4 3.9 8 Kosovo 4.2 4.2 4.4 4.5 6 10 North Macedonia 0.2 2.7 2.9 3.2 4 5 Montenegro 4.7 4.4 2.9 2.4 2 Serbia 2.0 4.2 3.5 4.0 0 0 Western Balkans 2.6 3.8 3.5 3.8 -2 -5 EU28 2.6 2.1 1.8 1.7 -4 Central and Eastern Europe 4.9 4.3 3.6 3.2 -6 -10 -15 c-15 r-16 -16 -16 c-16 r-17 -17 -17 c-17 r-18 -18 -18 c-18 Sep De Ma Jun Sep De Ma Jun Sep De Ma Jun Sep De ▬▬ALB ▬▬BIH ▬▬MKD ▬▬MNE ▬▬SRB ▬▬WB6 ▬▬KOS, rhs Source: For the Western Balkans: World Bank estimates based on data Source: National authorities and World Bank estimates. from national authorities. For EU28 and Central and Eastern Europe: European Commission Winter Economic Outlook. Notes: Growth in the Western Balkans is a weighted average by population. EU28 comprises the 28 EU members countries. Central and Eastern Europe comprises Bulgaria, Croatia, Czech Republic, Hungary, Poland, and Romania. Figure 1.3. …and in low, and slow-growing Figure 1.4. With public spending dominated foreign investment inflows. by wages and untargeted social programs, fiscal policy needs reform. Net FDI-to-GDP ratio, and percent change Composition of estimated public spending, 2017 and 2018e, percent of GDP 13 4 50 11 9 2 40 7 5 0 30 3 1 -2 20 -1 -3 -4 10 2018e 2018e 2018e 2018e 2018e 2018e 2018e 2017 2017 2017 2017 2017 2017 2017 -5 -7 -6 0 ALB SRB MNE MKD KOS BIH WB6 MNE BIH SRB MKD KOS ALB WB6 JJNet FDI to GDP 2018e, percent QQ2017–18e change in net FDI to GDP, pps JJWage bill JJSocial benefits JJCapital expenditures QQTotal expenditures Source: National authorities and World Bank estimates. Source: National authorities and World Bank estimates. Figure 1.5. Advancing reforms to ensure that Figure 1.6. Investing more efficiently in human private sector firms can compete on equal capital would allow Western Balkan countries terms will boost productivity and sustain higher to expand their economic potential and ensure growth rates. that growth is inclusive. Estimated growth from more competition in key service sectors Average number of productive employment years lost 0.25 0.07 35 0.06 30 0.20 0.05 25 0.15 0.04 20 0.10 0.03 15 0.02 10 0.05 0.01 5 0 0 0 ALB BIH MKD MNE SRB WB6 Comparator countries JJExpected additional value added, 2017, current USD, billions JJ15–24 JJ25–54 JJ55–64 QQFemales QQEstimated impact on GDP, percent Source: World Bank estimates (see text for details). Source: World Bank estimates (see text for details). 4  |  1. Overview REFORM MOMENTUM NEEDED 2.  Growth in the Western Balkans accelerated in 2018 In 2018 growth accelerated in the region, energy surged and the construction of the Bar- reaching 3.8 percent, despite slower growth Boljare highway accelerated. in its main market, the EU area (  Figure 2.1). Serbia, the largest economy in the region, grew Figure 2.1. Growth accelerated in 2018. by 4.2 percent, significantly higher than the Percent 5 previously projected 3.5 percent when the Fall 2018 edition of this report was published. The 4.4 4 4.2 4.2 4.2 strong growth was driven by consumption and 3.8 investment, in part due to a temporary stimulus 3 3.0 2.7 from an increase in public sector wages and 2 2.1 pensions, and a recovery of the energy sector after a drop in production in 2017. In Kosovo 1 and Albania, growth reached an estimated 0 4.2 percent. In Kosovo, it was driven by a rise MNE KOS ALB SRB BIH MKD WB6 EU28 JJ2016 JJ2017 JJ2018e in public infrastructure investment and by a Source: National statistical offices data; Eurostat; World Bank estimates. consumption rebound due to higher public wages, remittances, and consumer lending. In Higher growth has been supported by Albania, a rise in energy production due to consumption  (Figure 2.2). Consumption exceptionally favorable hydrological conditions growth has been driven by an increase in explained half of total GDP growth, which public sector wages or social benefits including was further supported by growth in tourism pensions in Serbia, Kosovo, and Bosnia and services and household consumption driven Herzegovina. Higher consumer lending also by higher employment and wages. In Bosnia supported consumption in Albania, Kosovo, and Herzegovina, growth slowed marginally Montenegro, North Macedonia, and Serbia to 3 percent from last year’s 3.2 percent, as did employment in Albania, Montenegro, with domestic demand as the dominant and North Macedonia. However, while a rise driver of growth. In North Macedonia, the in untargeted social benefits may have spurred economy recovered from the political crisis consumption in some countries, it raises with consumption growth driven by rising concerns about the sustainability and efficiency employment, wages, and household lending of public spending (see Section 4). and higher net exports pushing up growth to 2.7 percent (2.5 percentage points (pp) higher Private and public investments were another than last year’s). Growth in Montenegro was a important driver of growth, especially solid 4.4 percent,1 0.6 pp higher than projected in Kosovo, Montenegro, and Serbia. In earlier, as private investment in tourism and Montenegro, private investments in tourism and energy and the construction of the Bar- 1 Following the closing date for data collection for this report the Boljare highway fueled investment growth, Statistical Offices of Montenegro and Serbia issued new GDP estimates for 2018 (see the country notes for more details). which contributed an estimated 5.8 pp to GDP 2. Growth in the Western Balkans accelerated in 2018  |  5 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 growth in 2018. In Albania, higher public exports added 1.7 pp, largely the product investment compensated for the deceleration of FDI-related exports. Net exports cut 1 pp of FDI-driven investment in energy, with total from GDP growth in Bosnia and Herzegovina investment contributing 1 pp to GDP growth.2 and subtracted 3.5 pp from GDP growth in In Kosovo, total investment contributed Kosovo, because a halt in nickel production 5.7 pp to GDP growth, driven by higher outweighed the effect of an increase in tourism- public spending on infrastructure financed related exports. by privatization proceedings and private investment, including FDI in real estate. Total Tourism, retail, and transport services as well investment was stable in Serbia, contributing as energy production were the main drivers 2.3 pp to growth, based on both higher of growth in the region, reflecting higher private and public investment. By contrast, public spending and external factors. A record the contribution of investment to growth was tourism season in Montenegro boosted service limited in Bosnia and Herzegovina (0.5 pp) exports and investment; tourism also supported due to project delays, and negative in North growth in Albania, Kosovo, and Serbia. Retail Macedonia (-2.2 pp) due to a combination of trade, the rebound of construction, and project delays and lower public investment. transport—in part driven by public spending— further contributed to growth, especially Except for Albania and North Macedonia, in Montenegro and North Macedonia. In the contribution of net exports in the region addition, exceptional events such as favorable was negative. Net exports contributed 1.3 pp weather conditions in Albania and the near to GDP growth in Albania, thanks to a weather- completion of the of underwater electricity related spike in exports of hydroelectric power, transmission cable between Montenegro and a strong tourism season, and a slowdown in Italy boosted energy production in these two imports as import-intensive FDI projects Western Balkan countries. were phased out. In North Macedonia, net Figure 2.2. Higher public spending supported consumption and investment growth in 2018. Factors in real GDP growth, percent 2017 2018e 11 10 9 8 7 6 5 4 3 2 1 0 -1 -3 -2 -5 -4 -7 -6 MNE KOS ALB BIH SRB MKD MNE KOS ALB SRB BIH MKD JJConsumption JJInvestment JJNet exports QQReal GDP growth JJConsumption JJInvestment JJNet exports QQReal GDP growth Source: National statistical office data; World Bank estimates. 2 Specifically, investments in the Trans Adriatic Pipeline and the Devoll Hydropower PowerPlant are phasing out. 6  |  2. Growth in the Western Balkans accelerated in 2018 REFORM MOMENTUM NEEDED Overall, growth in the Western Balkans was Western Balkan countries need to raise their higher in 2018 but it was also fragile as it long-term growth potential to sustain faster benefited from fiscal stimuli and favorable growth. The pattern of growth in the region external conditions. On the one hand, the raises concerns about its sustainability, and weather helped boost energy production in thus the need to build reform momentum Albania and agriculture production in Serbia. to raise growth potential. The one-off factors But weather conditions can change rapidly, noted above pushed growth in 2018 beyond and the experience of previous years shows its potential, especially in Albania, Kosovo, that growth in the Western Balkans is highly Montenegro, and Serbia. As further discussed vulnerable to weather shocks as evidenced, for in Section 8, growth is projected to revert to example, by the devastating effects that floods, its long-term potential in the coming years droughts, and harsh winters have had on as temporary fiscal stimuli phase out and production. On the other hand, fiscal stimulus external conditions become less favorable. supported growth in some countries, through Higher potential growth will require higher public investment, public wages, and macroeconomic sustainability, and advancing untargeted social benefits. Public investment reforms to strengthen governance, the business can support long-term growth, but it needs environment, skills, and resilience to climate to be accompanied by greater efficiency and change and natural hazards. For example, efficacy of public spending. Meanwhile, the Box 2.1 and Spotlight #1 on “Competitive effects of public wages and untargeted social Markets” highlight the need to reinforce benefits on growth are temporary and costly, policies and public institutions that promote and they can hinder fiscal sustainability. market competition to boost productivity in Furthermore, robust growth in tourism is a the region. welcome sign, but is partly driven by economic developments in other regions such as the EU. Box 2.1. High-Growth Firms in the Western Balkans: Startups Wanted! Challenges to firm productivity and job creation in the Western Balkans are rooted in a policy environment that favors a few dominant market players over startups. In the Western Balkans high-growth firms create most jobs. The OECD and Eurostat define high-growth firms as those that (1) grew by at least 20 percent annually for three consecutive years (measured by firm turnover, deflated using the producer price index), (2) have at least 10 workers, and (3) are at least 4 years old. In 2015–16 these firms created 56 percent of net new jobs in North Macedonia, 61 percent in Serbia, and 42 percent in Albania (Figure S1.1). In faster-growing or more developed countries, high-growth firms are even stronger job creators (World Bank, 2015 and 2018). For example, in 2015/16 in Croatia they created all the new jobs. But there are only few of them in the region. High-growth firms are relatively rare in the Western Balkans—only 1 in 50 formal sector firms in North Macedonia in 2014 and 1 in 33 in 2016 (Figure S1.2); in Serbia, the number was 1 in 25 in 2015 and 1 in 20 firms in 2017, and in Albania, 11 percent 2. Growth in the Western Balkans accelerated in 2018  |  7 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Box 2.1 continued in 2013 and 17 percent in 2016.3 Other Eastern European countries are doing substantially better: In Latvia in 2015, almost 50 percent of firms were high-growth firms, in Estonia about 33 percent, and in Lithuania, the Czech Republic, and Hungary, about 25 percent. Moreover, in 2018 in emerging markets about 20 percent of firms were high-growth (World Bank 2018). Figure B2.1. High-growth firms create over Figure B2.2. …but there are not many high- 50 percent in Albania, Serbia, and North growth firms. Macedonia... Net job creation by high-growth firms, percent Percent of high-growth firms 110 50 100 102 99 45 45 90 40 80 35 36 70 73 72 30 60 25 25 50 55 23 20 22 40 19 46 18 42 15 17 15 30 10 12 11 20 9 24 5 7 6 6 5 5 5 10 4 4 3 2 0 SWE 09 CZE 15 ALB 13 NLD 13 BGR 13 ROU 15 ALB 16 MKD 16 LVA 15 EST 15 LTU 15 HUN 15 SVK 15 PRT 15 ITA 15 NOR 15 LUX 12 SVN 12 SRB 15 HRV 17 SRB 17 MKD 14 0 ALB HRV MKD SRB JJ2015 JJ2016 Source: Registry and SBS data in the region, including firms with more than 10 employees; for other countries, OECD Business Demographics; World Bank calculations. Note: High-growth firms are at least 4 years old, with 10 or more workers, with growth of at least 20 percent a year for three consecutive years. In all three countries in the region, high-growth firms engage in a variety of activities and are not more common in high-tech industries. This is consistent with World Bank findings (2015, 2018). In Albania, they are a bit more common in manufacturing, construction, wholesale and retail, transport, and food and accommodation and less common in ICT and media. In Serbia and North Macedonia, they are more likely to emerge in manufacturing, construction, transport, and ICT. But unlike in most other regions, high-growth firms in the Western Balkans are not necessarily younger or more productive. They tend to be 10–12 years old, about the average for all firms in Albania, North Macedonia, and Serbia. In most other emerging economies, high-growth firms are younger (World Bank 2015, 2018). Moreover, also unlike comparators (World Bank 2015, 2018), high-growth firms in the region are not necessarily more productive, as measured by turnover or value added per worker. Startups wanted! It thus appears that in the region the dynamics that produce high-growth firms and thus jobs are distorted. More firms entering-—and leaving—would enlarge the pool of younger firms, which have been found more likely to become high-growth firms. Since these firms create most jobs, removing barriers to market entry can boost private sector job growth. Similarly, removing constraints that discourage firms from innovating or prevent a more effective allocation of capital and labor across firms, would unleash productivity growth and thus the number of high-growth firms and new jobs. In contrast, the firm dynamics in the Western Balkans point to the existence of barriers to firm entry and productivity growth that hold back job creation and appear to be rooted in a policy environment that insulates a few dominant market players from competition. 3 In Albania, the recent anti-informality campaign which encouraged formalizing employment likely contributed to the higher share of high- growth firms. 8  |  2. Growth in the Western Balkans accelerated in 2018 REFORM MOMENTUM NEEDED Box 2.1 continued References Davies, Elwyn. 2019 (forthcoming). “Productivity Drivers in Serbia: Opportunities for New Growth.” Background paper for the Serbia Country Economic Memorandum: The New Growth Agenda.” Washington, D.C.: The World Bank. World Bank. 2015. Jobs or Privileges – Unleashing the Employment Potential of the Middle East and North Africa. Washington, D.C.: The World Bank. World Bank. 2018. High Growth Firms: Facts, Fiction, and Policy Options for Emerging Economies. Washington, D.C.: The World Bank. 2. Growth in the Western Balkans accelerated in 2018  |  9 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 3.  Fewer jobs were created in 2018 despite strong growth Although employment grew, job creation rate of 1.8 percentage points in 2018, despite slowed in most of the Western Balkans.4 the deceleration in job creation in comparison While employment rose in all countries to the previous year. Overall, if Western except Kosovo, the annual rate of job growth Balkan countries are to achieve the average was only 1.6 percent in 2018. By September employment rate of middle-income countries employment growth in the region was only worldwide (about 62 percent), the region would 1.5 percent y-o-y—the lowest rate since need to create 2.8 million additional jobs. December 2015—but it started to pick up in And to achieve the average employment rate the last quarter of 2018 (Figure 3.1). About of the EU28, the region would need to create 96,000 jobs had been created, a little more than 3.7 million additional jobs. In comparison, the half of the 2017 achievement. Employment Western Balkans region created only 755,000 growth in 2018 slowed in all countries additional jobs over the past 4 years. except Montenegro (3.6 percent) and North Macedonia (2.5 percent); job growth was led The labor market remained difficult in by construction, tourism, services, and the Kosovo and to a lesser extent in Bosnia public sector in Montenegro, and by services and Herzegovina. In Kosovo, employment and manufacturing in North Macedonia. The contracted, by a deep 3.4 percent in 2018, mostly employment rate in Montenegro reached a because employment in the manufacturing and historical high of 47.5 percent in 2018. Albania construction slackened. The employment rate has the highest employment rate in the region at had fallen from 29.8 in 2017 to 28.8 percent; 52.1 percent and saw the largest increase in the with male employment low at 45 percent and Figure 3.1. Employment responded feebly to Figure 3.2. …and in Bosnia and Herzegovina growth… it is still below the pre-crisis level. Employment growth, two-quarter averages, y-o-y, percent Employment index, quarterly 2008–18 12 20 130 10 15 120 8 6 10 110 4 5 100 2 0 0 90 -2 -5 80 -4 -6 -10 70 -15 c-15 r-16 -16 -16 c-16 r-17 -17 -17 c-17 r-18 -18 -18 c-18 -08 -09 -09 -10 n-11 r-12 c-12 -13 -14 r-15 c-15 -16 n-17 r-18 c-18 Sep De Ma Jun Sep De Ma Jun Sep De Ma Jun Sep De Jun Mar Dec Sep Ju Ma De Sep Jun Ma De Sep Ju Ma De ▬▬ALB ▬▬BIH ▬▬MKD ▬▬MNE ▬▬SRB ▬▬WB6 ▬▬KOS, rhs ▬▬ALB ▬▬BIH ▬▬MKD ▬▬MNE ▬▬SRB ▬▬KOS ▬▬WB6 Source: National statistics offices and World Bank estimates. 4 Labor Force Survey (LFS) data for the 15+ age group are used throughout the document, unless specifically referred to administrative data. For Kosovo, data refer to the age group 15–64. 10  |  3. Fewer jobs were created in 2018 despite strong growth REFORM MOMENTUM NEEDED female employment dismal at 12 percent. from tax exemptions and public subsidies on Employment in Bosnia and Herzegovina grew employment. In Montenegro, construction by 0.9 percent in 2018, with the rate for the and tourism were significant contributors to year rising slightly to 34.3 percent, second employment growth. In Kosovo, employment lowest in the Western Balkans (Figure 3.2). in industry fell, but it rose in trade, information and communication technology (ICT), and the In 2018 employment rates in both Serbia public sector. and North Macedonia reached historical peaks, but in Serbia employment growth was Unemployment rates declined in all Western less intense. At 47.6 percent, the employment Balkan countries in 2018  (Figure 3.3). In rate in Serbia hit a new high, having grown by 2018, 1.15 million people in the region were 0.9 percentage points. Serbia’s 38,300 new jobs unemployed—95,800 or 7.7 percent less in 2018 account for 40 percent of all new jobs than a year ago. Unemployment declined created in the Western Balkans. Employment most in Bosnia and Herzegovina (13 percent) growth in Serbia—of 1.4 percent in 2018— to a historical low of 18.4 percent. But the was particularly pronounced in the formal decline in Bosnia and Herzegovina and Kosovo private sector; informal employment, mostly was primarily driven by higher inactivity in agriculture, contributed 20.4 percent of new and likely emigration, reducing labor force jobs, while employment in the public sector participation. In contrast, inactivity declined narrowed by 1.1 percent. In North Macedonia, substantially in Albania and Serbia. Albania employment increased by 2.5 percent, pushing (12.3 percent), Serbia (12.7 percent), up the employment rate by 1 pp to 45.1 percent. Montenegro (15.2 percent), and North Macedonia (20.7 percent) reached historically Most jobs created were in industry and low unemployment rates in 2018. The lowest services, while employment in agriculture unemployment rate in the region is in Albania continued to decline. In Albania, employment while it is the highest in Kosovo at 29.5 percent. in industry went up by 3.9 percent in 2018 and in services by 2.5 percent; public sector Throughout the Western Balkans employment also rose, by 4.3 percent. In Bosnia unemployment continues to be a major and Herzegovina, manufacturing and wholesale concern of citizens  (Figure 3.4). About trade accounted for more than 70 percent of 70 percent of respondents in Kosovo and the employment increase according to the Bosnia and Herzegovina cited unemployment administrative data. Of the 18,000 new jobs as their top concern—more than triple the EU created in Bosnia and Herzegovina, about share. In the other Western Balkan countries, 72 percent were in manufacturing and trade, more than 33 percent of respondents still cite 11 percent in tourism, and 10 percent in the unemployment as the major concern, although public sector, especially education and health. edged out in Albania by the prevailing economic In North Macedonia, most new jobs were in situation; however, these are smaller percentages manufacturing, transport and storage, and than in the 2017 survey. A lack of adequate professional services (mainly call centers). The jobs is considered the biggest obstacle for gains in manufacturing and professional services securing employment in Albania (66 percent) were in FDI companies, which still benefit and Kosovo (48 percent); in neighboring 3. Fewer jobs were created in 2018 despite strong growth  |  11 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Figure 3.3. Unemployment declined in all Figure 3.4. …but is still the most serious Western Balkans countries... concern of Western Balkan citizens. Unemployment rate, 15+ years, percent, and 2017–18 change, Percent of respondents pp 32 80 -1.0 28 70 24 60 -1.7 20 -2.1 50 16 -0.9 -1.2 40 -1.4 -0.8 12 30 8 20 4 10 0 0 KOS MKD BIH MNE ALB SRB WB6 EU28 ALB MKD MNE SRB KOS* BIH* JJ2018 JJ2017 JJUnemployment JJEconomic situation JJCrime JJImmigration JJRising cost of living JJGovernment debt JJEducation system Source: National statistics offices and World Bank estimates. Source: Eurobarometer, Autumn 2018. *For Bosnia and Herzegovina and Kosovo: Balkan Barometer 2018, a public opinion survey by the Regional Cooperation Council, www.rcc.int. economies the biggest obstacle is thought to be unemployment in Montenegro from 32 percent not knowing the right people.5 In Serbia, about a year before. Bosnia and Herzegovina has seen 25 percent of respondents believe that inability the largest drop in youth unemployment— to get a job is related to age discrimination. Yet, by close to 7 pp to 38.8 percent—but this 42 percent of the Western Balkans population is likely to be due to rising inactivity or would still prefer working for a public employer. emigration. Youth unemployment is still very Public jobs are considered more secure and high in Kosovo at 55.3 percent and in North better paid, with better working conditions. Macedonia at 45.4 percent. In fact, in Kosovo The highest preference for public jobs is in youth unemployment has even gone up as Kosovo (62 percent) and the lowest in Serbia more young people entered the labor market (37 percent). About 39 percent of respondents and the pace of job creation slowed. Despite have considered moving abroad for work—far improvements, the labor market situation of fewer than a year ago. young people in the Western Balkan countries still features high inactivity, persistently Youth unemployment dropped to high unemployment, high share of informal 37 percent—about 2 pp below the 2017 employment, significant skills mismatches and rate. In the Western Balkans, about 280,600 continued emigration (Box 3.1). Since 2012, people between 15-24 years old—a contingent when about 50 percent of young people were at a highly productive age—are without jobs. unemployed, the rate fell to 37 percent in The lowest youth unemployment rates were 2018, but that is still more than double the EU in Albania (23.1 percent) and in Serbia and average. More than half of the young people Montenegro (about 30 percent in both). Robust are long-term unemployed (without a job for economic growth and a variety of occupational more than a year), which erodes skills, reduces and training programs have helped reduce youth motivation to seek employment, and raises the possibility of leaving the local labor market 5 Balkan Barometer 2018, www.rcc.int. 12  |  3. Fewer jobs were created in 2018 despite strong growth REFORM MOMENTUM NEEDED altogether (see the Focus Section on Human reached 59.4 percent in Albania—a record for Capital in the Western Balkans). the region. Employment dynamics encouraged job searching despite a decrease of the working- Through 2018 the regional average labor age population over the past four years. While force participation rate improved slightly, in Serbia the labor force participation rate but participation declined in Bosnia and increased slightly (up by 0.5 pp), in Bosnia and Herzegovina and Kosovo. In 2018, labor Herzegovina and Kosovo because the working- force participation in the region averaged age population was declining, so did labor force 51.6 percent—up 0.1 pp from the year before, participation. The lowest ratio of working-age with the largest gains in Montenegro by 1.3 pp population participating in the labor force is and Albania by 1.1 pp. Labor force participation 40.9 in Kosovo and 42.1 percent in Bosnia Box 3.1. Youth Employment in the Western Balkans. In the Western Balkans participation of young people in the labor force is low by European standards and stagnant. In June 2018, youth participation averaged 30.5 percent in general and only 22.5 percent for young women. In Kosovo only 12.5 percent of young women were active, probably because of family responsibilities, lack of child and elder care facilities, and too little education. For young people, the transition from school to work often takes two years (World Bank 2016). Table B3.1.1. Labor Market Characteristics, Western Balkans Youth, June 2018, Percent. WB6 ALB BIH KOS MNE MKD SRB AUT BGR HRV HUN Employment rate 20.0 25.6 19.7 9.7 27.4 17.0 21.5 50.1 20.6 25.2 28.7 (% of the age group) Unemployment rate 34.6 27.3 38.8 54.9 23.9 47.6 27.5 9.1 15.2 21.1 9.5 (% of labor force) Long-term unemployment 54.6 52.7 68.7 47.2 43.4 62.1 47.4 15.7 48.1 28.8 26.4 share (% of total unemployment) Temporary employment share 49.9 26.0 42.1 83.0 77.0 41.6 55.4 31.9 8.8 58.3 15.2 (% of total employment) Part-time employment share 12.8 19.1 8.3 4.3 12.4 5.0 14.2 24.0 6.8 9.6 7.5 (% of total employment) NEET rate 22.3 25.9 24.3 25.9 16.7 24.9 17.2 6.5 15.3 15.4 11.0 (% of the age group) Source: World Bank’s Western Balkans Labor Market Trends 2019, based on data provided by national statistics offices and Eurostat. Moreover, youth employment is mostly based on temporary contracts. In June 2018, the employment rate for people aged 15–24 years (Table B3.1.1) was 20 percent, compared with 35 percent in the EU. Only 13 percent of young women and 23 percent of young men had jobs. In Kosovo, just 5 percent of young women were employed. Regionally, about 50 percent of the young people working were on temporary contracts, with a range of 80 percent in Kosovo and Montenegro, but only about 25 percent in Albania. Although the rates are declining, almost 20 percent of young workers had informal jobs in Albania, and almost 33.3 percent in North Macedonia and Serbia (Djurić 2016; Marjanović 2016). 3. Fewer jobs were created in 2018 despite strong growth  |  13 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Box 3.1 continued Above-average unemployment rates for the highly educated suggest skills mismatches. According to regional Survey Towards Employability and Productivity (STEP) surveys for firms trying to recruit, lack of skills and experience are the major problem. Skill gaps cover both technical job-specific skills and broad socio-emotional and basic cognitive skills. The skills gap is higher for labor market entrants than for the current workforce; apparently the education system is not adequately preparing youth for the jobs available. Unemployment was higher for young men in Albania, Montenegro, and North Macedonia, and for young women in Bosnia and Herzegovina, Kosovo, and Serbia. The options of emigration and family support may have raised reservation wages and thus youth unemployment durations and inactivity rates. Youth inactivity is high. The rates of young people neither in employment nor in education and training (NEET) were substantially higher in Western Balkan countries than elsewhere in Europe. Despite a decline, in June 2018 the NEET rate in the region still averaged 22.3 percent, placing many young people at risk of poverty and social exclusion. Young people detached from jobs or education for long periods may find it difficult to penetrate the labor market. Due to degraded skills, they also earn about 20 percent less when they do find work, and the earnings deficit can persist for a long period. References World Bank. 2016. “Ten Messages About Youth Employment in South East Europe”, South East Europe Regular Economic Report No. 9, Special Topic. Washington, D.C.: The World Bank. Djurić. 2016. Labour market transitions of young women and men in Montenegro,” Work4Youth Publication Series No. 34. Geneva: International Labour Organization. Marjanović. 2016. “Labour market transitions of young women and men in the Republic of Serbia,” Work4Youth Publication Series No. 36. Geneva: International Labour Organization. and Herzegovina. Both countries have seen a Participation rates improved because more rise in their inactive population (Figure 3.5 and women entered the labor market (Figure 3.7). Figure 3.6). The largest increase was in Albania and Serbia. Although Albanian women’s participation in the Figure 3.5. More people seem to be seeking Figure 3.6. In some countries inactivity is not and finding jobs, but the progress is slow. only high but increased. Percent of population aged 15+ Inactivity rate, 15+ years, percent, 2017–18 change, pp 100 60 1.9 0.6 90 50 -0.2 80 -0.5 47.8 47.6 -0.1 -1.3 70 -1.1 40 60 50 8.8 8.2 30 40 20 30 43.3 44.2 20 10 2018 2018 2018 2018 2018 2018 2018 2017 2017 2017 2017 2017 2017 2017 10 0 0 KOS MKD BIH MNE ALB SRB WB6 KOS MKD BIH MNE ALB SRB WB6 JJEmployed JJUnemployed JJInactive JJ2018 JJ2017 Source: National statistics offices and World Bank estimates. 14  |  3. Fewer jobs were created in 2018 despite strong growth REFORM MOMENTUM NEEDED labor force grew less than men’s during 2018’s of about 13 percent y-o-y in real terms. The economic expansion, the female participation average wage in Serbia went up by 4.2 percent rate of 51 percent in Albania is the highest in the in real terms. Led by wage growth in mining, region. The rates in Serbia and Montenegro are ICT, tourism, manufacturing, and the public also above the regional median of 45.8 percent, sector, real wage growth in North Macedonia and in Serbia, the gender gap of 15.4 pp is the was 4.4 percent in 2018, compared to narrowest. The female to male participation gap 1.2 percent in 2017. The mandatory minimum declined by 2 pp from last year ‘s to 23 percent, wage increase continued to put pressure on although it is still at 43 pp in Kosovo. One labor-intensive industries, which sought factor explaining the low participation rates temporary government support to deal with is the relatively high labor tax wedges in the higher labor cost pressures. The low-earning Western Balkans, which discourage low wage labor-intensive sectors saw a nominal increase earners from actively seeking jobs (see Spotlight in wages of over 10 percent y-o-y, compared to #2 on Labor Taxation). negative labor productivity over the past several years. Further wage increases might erode the Figure 3.7. The female–male labor competitiveness of low-value-added industries. participation gap narrowed to 23 percentage In Bosnia and Herzegovina, real wages rose points. by 3 percent y-o-y in November 2018, with Labor force participation, percent, December or latest 2018 80 the highest increase in construction. In 70 Montenegro, real wages declined during 2018 60 as fiscal consolidation affected salaries in public 50 administration and manufacturing salaries fell. 40 A rise in the minimum wage is being discussed 30 in Montenegro. If the minimum wage is to 20 remain an instrument of labor market policy, 10 to avoid a surge in informal employment, and Dec-18 Dec-18 Dec-18 Dec-18 Dec-18 Jun-18 2015 2015 2015 2015 2015 2015 0 ALB SRB MNE MKD BIH KOS to maintain cost competitiveness, minimum QQFemale LFP QQMale LFP wage policy should be informed by assessments Source: National statistics offices and World Bank estimates. of labor productivity in the sectors where it mostly applies. Employment, wage growth, and low inflation further reduced poverty in the Western Balkans. In 2018, the average poverty rate for Albania, Montenegro, North Macedonia, and Serbia dropped by about 1 pp y-o-y, producing a regional poverty rate estimated at 21.6 percent.6 In other words, about 114,000 people escaped poverty in the past year. In Albania, rising wages in the private sector indicate strong growth 6 Poverty figures reflect the upper-middle-income-country standardized benchmark of living on less than US$5 a day in 2011 PPP terms. 3. Fewer jobs were created in 2018 despite strong growth  |  15 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Safeguarding the fiscal adjustment made in recent years 4.  is critical W  hile fiscal deficits remain relatively low public sector wages, and securing more revenue in all Western Balkan countries other than from raising excise duties and value-added tax Montenegro, the deficit increased in 2018 (VAT) rates. In contrast, the deficit reduction in some countries due to higher capital of 0.9 pp in North Macedonia was mainly spending. The average unweighted fiscal deficit due to under-execution of capital spending, in the region went up from 1.3 percent of GDP in while current spending grew by 6 percent. 2017 to 1.7 percent in 2018 as deficits widened In Albania, continued robust spending on in Bosnia and Herzegovina and Kosovo (Figure capital infrastructure was offset by restraint in 4.1). In Bosnia and Herzegovina, the fiscal spending on wages and social benefits, which position is estimated to have returned to deficit, reduced the deficit slightly. Still benefiting owing largely to an expansion in veterans’ from the fiscal adjustment of recent years, benefits in the Federation, wage increases in public finances in Serbia remained in surplus, Republika Srpska, and higher investment in though slightly lower than last year’s because infrastructure. In Kosovo, the widening deficit public sector salaries and pensions went up and is attributed to more current spending on social infrastructure capital spending, which has been transfers and goods and services and higher weak in recent years, was more vigorous. capital spending on infrastructure. In contrast, Montenegro, North Macedonia, and Albania With revenues generally holding steady, the narrowed their deficits. Montenegro achieved regional average revenue-to-GDP ratio was a consolidation of 1.8 pp after a series of 35.3 percent in 2018. Policy reforms and fiscal consolidation reforms, among them the efforts to improve revenue collection in 2018 abolition of mothers’ benefits, a reduction in raised the ratios in Montenegro (by 1.1 pp of Figure 4.1. Fiscal consolidation reduced the Figure 4.2. Spending restraint contributed to deficit in Montenegro while Bosnia’s budget fiscal outcomes in Albania, North Macedonia returns to deficit. and Montenegro. Fiscal deficits, percent of GDP Contribution to change in the fiscal deficit, 2018, % of GDP 6 4 5 3 ↑Reduced revenues, increased spending 4 2 3 2 1 1 0 0 -1 -1 -2 -2 ↓Increased revenues, reduced spending -3 -3 MNE KOS MKD ALB BIH SRB WB6 BIH KOS SRB ALB MKD MNE WB6 JJ2016 JJ2017 JJ2018e JJExpenditure JJRevenue QQChange in fiscal deficit Source: National statistical offices and Ministries of Finance; World Bank estimates. Notes: Data for North Macedonia presented in this section excludes finances of the Roads Agency which were taken off-budget in 2013. Unless otherwise specified, the regional average is calculated as the non-weighted average. 16  |  4. Safeguarding the fiscal adjustment made in recent years is critical REFORM MOMENTUM NEEDED GDP) and Bosnia and Herzegovina (0.9 pp). spending from 40.4 percent of GDP in 2017 As value added tax (VAT) receipts surged, to 44.3 percent in 2018. In Serbia, improved aggregate revenue in Montenegro was boosted economic and financing conditions have by the tax reforms adopted in 2017. In Bosnia attracted higher capital investment from both and Herzegovina, higher excise taxes on oil and foreign and domestic sources. This has been oil derivatives, introduction of a road tax, and supported by better capital budget execution, a tax on liquid gas brought in more revenue. mainly because backlogs have been reduced Livelier economic activity contributed to the and oversight is now more effective. In Kosovo, revenue gains in Kosovo (0.5 pp). Nominal spending on capital investment has gone up but revenues increased in Albania, Serbia, and North also untargeted social protection expenditures Macedonia, but at a slower pace than economic (pensions and benefits to war veterans) have growth, causing a decline in the revenue-to- been rising fast. Elsewhere in the region, total GDP ratio (see Figure 4.2). In Albania, the spending as a percentage of GDP contracted, estimated revenue fall of 0.5 percent of GDP though the reasons varied. Public spending in in 2018 results from VAT revenues that were Montenegro grew by 5.5 percent in nominal lower than expected, partly because they were terms but the spending-to-GDP ratio declined offset by VAT refund arrears being cleared. For by 0.8 pp thanks to higher GDP growth and a similar reasons, net VAT receipts as a share of reduction in social benefits and nominal public GDP fell. In North Macedonia, even though sector wages. In North Macedonia, political the revenue-to-GDP ratio fell, the collection of uncertainty before the referendum and the corporate income tax (CIT) and social security decision to scrutinize the existing portfolio contributions exceeded expectations, supported of construction projects contributed to by employment and wage growth. In Serbia, a exceptionally low capital spending in 2018. In solid rise in social security contributions and Albania, the authorities have prioritized capital personal income tax (PIT)—reflecting the spending—which strengthened to 4.7 percent growth in formal employment—was countered of GDP—and accelerated the use of public- by minimal growth in corporate and indirect private partnerships (PPPs) to address public tax receipts. infrastructure gaps. Capital investment and higher public PPPs can raise the efficiency of public wages and social benefits have pushed up spending and reduce the strain of large total spending in the region ( Figure 4.3). infrastructure projects on scarce public The largest increases in capital spending were finances, but they carry fiscal risks that must in Bosnia and Herzegovina (2.5 pp), Serbia be managed. PPPs often require government (0.8 pp), and Kosovo (0.7 pp). In Bosnia guarantees to attract private partners and and Herzegovina resumption of the capital opaque arrangements can create scope for investment plan is estimated to have produced corruption by guaranteeing revenues of private robust growth in capital spending in 20187; partners that exceed their risks. They can thus which combined with higher public sector reduce the strain on budgets in the short- wages and social transfers boosted overall term but expand medium-term contingent liabilities. The extent to which PPPs provide 7 Bosnia and Herzegovina Global Fiscal Framework 2019–2021. better value for money over the medium term 4. Safeguarding the fiscal adjustment made in recent years is critical  |  17 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Figure 4.3. Higher spending went mainly to Figure 4.4. Spending is dominated by public capital investment and social benefits. wages and social programs. Contribution to change in public spending, 2018e, percent of Composition of estimated public spending, 2017 and 2018e, GDP percent of GDP 6 50 5 4 40 3 30 2 1 20 0 -1 10 2018e 2018e 2018e 2018e 2018e 2018e 2018e -2 2017 2017 2017 2017 2017 2017 2017 -3 0 BIH KOS SRB ALB MNE MKD WB6 MNE BIH SRB MKD KOS ALB WB6 JJWage bill JJSocial benefits JJCapital expenditures QQTotal expenditures JJWage bill JJSocial benefits JJCapital expenditures QQTotal expenditures Source: National statistical offices and Ministries of Finance; World Bank estimates. depends on risk-sharing agreements and other to curb untargeted social benefits and public details set out in PPP contracts. Transparent sector wages, improving the quality of public reporting on the performance of active PPPs spending. Overall, in 2018 budgets in the and comprehensive monitoring and disclosure Western Balkans continued to be burdened by frameworks can help manage the risks and spending on wages, pensions, and untargeted ensure value for money.8 social benefits, highlighting that there is ample room to boost the efficiency of public spending There is ample room to improve fiscal balances and thus the quality public services. by curtailing unproductive or untargeted social benefits and transfers  (Figure 4.4). Countries with mature fiscal consolidation In Bosnia and Herzegovina and Kosovo the continued to see their debt fall, but in others increased spending in 2018 went mainly to a rise public and publicly-guaranteed (PPG) debt in pensions and public wages (and spending on has edged up; public debt is particularly high benefits to war veterans continued to be high); in Albania and Montenegro ( Figure 4.5). In public investment also increased. In North 2018 economic growth, fiscal consolidation, Macedonia, while overall spending went down and active debt management brought down due to lower public investment, spending on the share of PPG debt in Albania, Bosnia and social benefits continued to increase in 2018. Herzegovina, and Serbia. Between 2017 and Higher capital spending on the Bar-Boljare 2018, tighter fiscal policy helped to further motorway in Montenegro raised public debt reduce public debt as a share of GDP in Serbia levels in recent years which forced governments from 58.7 to 54.3 percent and in Albania from 71.8 to 68.6 percent.9 Montenegro’s overall 8 Comprehensive monitoring and disclosure frameworks for active PPG debt, which remains high due to the PPPs can help manage the risks, ensure value for money, and financing of highway construction, is projected support a range of objectives, including (1) better management of fiscal risks; (2) timely intervention in underperforming projects; to have reached 75.4 percent of GDP in 2018. (3) learning from PPP successes and failures; (4) increasing government accountability and value for money; and (5) building In North Macedonia, PPG debt rose from up market confidence. For more information see World Bank (2018), “Procuring Infrastructure Public Private Partnerships Report”, Washington, D.C.: The World Bank. 9 This includes general government arrears. 18  |  4. Safeguarding the fiscal adjustment made in recent years is critical REFORM MOMENTUM NEEDED Figure 4.5. Public debt-to-GDP ratios fell in Figure 4.6. External PPG debt rose in Serbia, Bosnia and Herzegovina and Albania. Montenegro, North Macedonia and Albania as they tap international credit markets. Public and publicly guaranteed debt, percent of GDP External PPG debt as a percent of GDP, and percent change in total external PPG debt, 2018 80 65 8 70 55 6 60 45 50 35 4 40 25 30 15 2 20 5 0 10 -5 0 -15 -2 MNE ALB SRB MKD BIH KOS WB6 MNE MKD ALB BIH SRB KOS WB6 JJ2018e ▬▬2017 QQ2007 JJExternal PPG debt QQChange in total PPG external debt, percent, rhs Source: National statistical offices and Ministries of Finance; World Bank estimates. 47.7 to 48.4 percent of GDP due to a new Against this background, North Macedonia Eurobond issue. Kosovo’s PPG debt—though recently reformed the social protection system still the lowest in the region—rose during to safeguard pension and health services by the year, reaching 17.7 percent of GDP due amending the pension indexation, limiting to higher social benefits and better execution early retirement options, and increasing social of public investment projects. External PPG contributions. And Montenegro centralized debt pressures rose in countries that tapped the procurement of pharmaceutical to reduce international financial markets (Figure 4.6). In costs while more needs to be done to contain Bosnia and Herzegovina and Serbia, external pharmaceutical spending. Fiscal risks also arise PPG debt fell in 2018. By contrast, external from inefficient SOEs, which cost the public PPG rose in Montenegro, North Macedonia, purse hundreds of millions of euros each and to a lesser extern in Albania. The growth year (for example, in terms of subsidies and of Montenegro’s external PPG debt was driven guarantees for loans for SOEs), when they could mainly by financing of the Bar-Boljare highway, in a different scenario produce revenue.10 The and the issuance of a large Eurobond. forthcoming World Bank’s Municipal Finance Review for the Western Balkans highlights that Reducing risks to fiscal sustainability local governments need more fiscal discipline requires reining in pension spending, and greater accountability, especially as related better controlling state-owned enterprise to budget arrears and municipal borrowing, (SOE) debt, increasing discipline in local as well as stronger capacity to deliver public government financial management, and services efficiently and effectively. Meanwhile, improving the efficiency of public spending more efficient public spending in areas and tax collection. Pension and health like education, health, infrastructure, and spending needs to be contained given that these are a large source of fiscal risk in several 10 Note that in some countries there is a strong presence of SOEs. countries in the Western Balkans, as spending For example, in Serbia, about 1 in 4 of the largest 100 companies is state-owned, including the largest companies in banking, is bound to keep rising as the population ages. insurance, and transportation, as well as all utility companies. 4. Safeguarding the fiscal adjustment made in recent years is critical  |  19 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 agricultural subsidies could yield significant transparency since 2010 (Figure 4.7). One area savings and growth dividends—in North to highlight is the need to capture and report Macedonia, for example, the World Bank’s fiscal risks arising from off-budget spending, forthcoming Public Finance Review notes SOEs, government arrears, and contingent that the country could save 13 percent of total liabilities from public-private partnerships so public spending by improving its efficiency. that they can be effectively addressed. In this Lastly, more tax revenue can be collected, for context, well-designed and implemented fiscal example, by modernizing tax administration, responsibility frameworks can promote policy encouraging formalization, and reviewing credibility, enhance investor confidence, and tax exemptions and tax rates—perhaps ‘sin contribute to sustained growth. taxes’ on items that have adverse health or environmental impact. Furthermore, there is Figure 4.7. Full fiscal transparency is needed. scope for improving the progressivity of the Open Budget Index, Score 90 personal income taxation, balancing efficiency 80 and equity in revenue collection (see Box 4.1). 70 60 Beyond sustainability, it is necessary to 50 strengthen fiscal transparency and build 40 strong fiscal institutions. Bosnia and 30 20 Herzegovina, North Macedonia, and Serbia 10 seem to be depriving taxpayers of information 0 about how their money is spent.11 The 2008 2015 2017 JJBIH JJMKD JJPRY JJSRB JJALB Open Budget Index (OBI), which measures JJHRV JJSVK JJBGR JJGEO transparency, shows limited improvement in Source: International Budget Partnership. Box 4.1. Balancing Efficiency and Equity in Revenue Collection with the Personal Income Tax. There is room for fiscal policy in the Western Balkans to become more progressive while allowing for higher revenue collection. Western Balkan countries need to collect higher revenues to ensure better service delivery and infrastructure investment in the coming years to accelerate their convergence towards EU living standards. At the same time, the nature of fiscal policy should become more progressive to avert rising inequality. In the absence of higher transfers to households at the lower end of the income distribution, governments should consider more progressive personal income taxation schemes with higher top rates for higher incomes, and to shift the composition of their revenues towards a larger share coming from direct taxation. This would bring their revenue composition closer to that of EU countries and also act as a powerful redistributive policy. In Western Balkan countries the personal income tax (PIT) contributes little to revenues. Instead, they generate a large share of their revenues from social security contributions (SSCs) and 11 The latest available OBI index uses information until 2017. Since then some countries in the Western Balkans have taken actions to increase the transparency of public finances. 20  |  4. Safeguarding the fiscal adjustment made in recent years is critical REFORM MOMENTUM NEEDED Box 4.1 continued indirect taxes like the value-added tax (VAT). For instance, the average Western Balkan country collects about 37 percent of GDP in revenues, of which less than 5 percent come from direct taxes (PIT and corporate income tax), a sizable 16 percent from indirect taxes (VAT and excises), and the rest from SSCs and other sources. The revenues of Western Balkan governments are similar to those of Eastern European EU member countries in terms of both total collection and general composition (Figure B4.1.1). But the new EU member countries rely more on direct taxes, especially PIT, and less on VAT revenues. Western Balkans PIT rates are also generally lower (Figure B4.1.2). As a result, PIT collection in the Western Balkans averaged 2.7 percent of GDP in 2017, compared to 3.0–6.6 percent in comparator countries. Figure B4.1.1. Taxes often constitute the largest public revenue category Government revenue structure, percent of GDP 50 40 30 20 10 0 LVA SVN EST LTU SRB SVK MNE HRV BiH* BGR WB6 av. MKD KOS ALB JJPIT JJCIT JJVAT JJExcises JJSocial contributions JJOther revenues Source: National accounts data, Eurostat, and World Bank calculations. Note: For Bosnia and Herzegovina, the PIT data combines both PIT and CIT for 2016. Figure B4.1.2. Top marginal PIT rates in the Western Balkans are lower than those of EU members Highest marginal tax rate and threshold 60 70,907 80 64,800 62,800 70 50 60 40 48,564 50 35,268 40 30 17,563 30 20 9,000 12,540 20 10 10 0 0 KOS BIH SRB MNE MKD ALB BGR LTU EST SVK LVA HRV SVN JJHighest MTR, percent, lhs QQThreshold (EUR), no threshold=flat, in thousands, rhs Source: Deloitte (International Tax) data; World Bank calculations. In addition, the PIT structure is often less progressive in the Western Balkans (  Figure B.4.1.2). New EU member states are more likely to apply progressive tax schemes (4 of 7 countries), with more than half having top marginal rates of 25 percent or more—Slovenia’s is 50 percent. Meanwhile, two Western Balkan countries have a flat 10 percent tax rate; Montenegro has a temporary PIT structure of 9 and 11 percent that is scheduled to return to a flat rate of 9 percent by the end of 2019.a All Western Balkan countries except Montenegro have personal tax allowances—which allows for some progressivity—and Bosnia and Herzegovina also has a family allowance. Of the Western Balkan 4. Safeguarding the fiscal adjustment made in recent years is critical  |  21 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Box 4.1 continued countries that apply progressive taxation, the top marginal rate are still relatively low compared to EU countries with 23 percent in Albania, 18 percent in North Macedonia, and 10 percent in Kosovo.C Income thresholds for top tax rates vary considerably and tend to grow with the top rate. For example, Slovenia has both a high top rate and the highest income threshold, about €70,000. However, Montenegro’s current top rate of 11 percent begins to apply at an annual income of €9,000 and North Macedonia’s at an annual income of €18,000. Kosovo’s PIT rates are compressed: income below €11,520 pays no tax, rates of 4 to 8 percent apply for incomes between €11,520 and €64,800, and higher earnings are taxed at 10 percent. This explains why the direct taxation share of total revenues is very low in Kosovo. In the Western Balkans the low progressivity of the PIT and the somewhat heavier reliance on indirect taxes limit the redistributive impact of fiscal policy. Recent analysis suggests that in Albania and Montenegro fiscal policy—both taxation structure and government transfers—tends to have relatively limited redistributive effects (Figure B4.1.3). For example, direct taxation in Albania reduces inequality only at the margin—inequality measure by the Gini coefficient falls from 0.37 at market income (income plus pensions) to 0.35 for consumable income (subtracting all taxes and contributions and adding direct transfers). But fiscal policy as a whole, especially the VAT, has a small poverty-increasing effect that is not sufficiently offset by direct social transfers. The analysis for Montenegro in 2015, when PIT rates were more progressive with a top rate of 15 percent, found that income inequality falls by 4 Gini points after the combined effect of taxes, contributions, and social benefits are taken into account (including a relatively well-targeted last resort social assistance program). But moving back to a flat PIT of 9 percent would reduce this redistributive impact significantly. Figure B4.1.3. Fiscal policy has a small redistributive effect in Albania and Montenegro Gini coefficient before and after taxes and transfers 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 15) 10) 10) 015 10) 12) 11) 11) 12) 13) 9) 10) 10) 14) 12) 14) 16) 9) 10) 10) (20 ia (20 n (20 nia 2 ia (20 ia (20 ia (20 es (20 a (20 le (20 u (200 a (20 o (20 y (20 (20 o (20 a (20 il (200 ia (20 a (20 gro a co ene t h iop Jorda Alb R uss dones rmen d Stat genti n Chi Per ta Ric Mexic ragua Mexi Mexic anam Braz lomb A fric ont E In A ite Ar Co s Pa P Co Sou t h M Un JJMarket income plus pensions JJConsumable income Source: Data from Lustig (2018) and Dávalos et al. (2017), and World Bank calculations. a. Early in 2013, Montenegro introduced a temporary “crisis” tax, when a higher PIT rate of 15 percent was introduced on net monthly wages exceeding EUR 480 (about the average wage level), otherwise 9 percent. The temporary “crisis” tax has been gradually reduced to currently 11 percent of monthly gross wages above EUR 750 (roughly the average wage. b. Macedonia Public Finance Review (2018). c. In 2014, Albania adopted a progressive income tax system from a flat tax rate system of 10 percent. In December 2018, North Macedonia moved from a flat rate of 10 percent to introducing a top PIT rate of 18 percent for incomes above DEN90,000 per month, effective January 2019. 22  |  4. Safeguarding the fiscal adjustment made in recent years is critical REFORM MOMENTUM NEEDED Box 4.1 continued References Dávalos, María E., Monica Robayo-Abril, Esmeralda Shehaj and Aida Gjika. 2018. The Distributional Impact of the Fiscal System in Albania. Washington, D.C.: The World Bank. Deloitte, 2019. International Tax Highlights. Lustig, Nora. 2018. Commitment to Equity Handbook. Estimating the Impact of Fiscal Policy on Inequality and Poverty. Brookings Institution Press and CEQ Institute, Tulane University. World Bank. 2019 (forthcoming). North Macedonia Public Finance Review. Washington D.C.: The World Bank. 4. Safeguarding the fiscal adjustment made in recent years is critical  |  23 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Inflation picked up and monetary policy stayed 5.  accommodative Inflation rose slowly in 2018 as tax rates due to excise tax increases. In Albania, North and prices for imported food and energy Macedonia, and Serbia, inflation during the rose. After picking up in the first half of the year mostly responded to food and oil price year, inflation dynamics softened toward the dynamics, with additional pass-through effects end of the year. Domestic demand pressures from appreciation of the exchange rate in on inflation remain low in most Western Albania. Balkan countries, with temporary hikes in food prices and rising oil prices contributing Monetary policy was eased to support credit the most to inflation (Figure 5.1). Core growth. In floating-exchange-rate countries inflation was stable, which suggests that (Albania and Serbia) and in North Macedonia, long-term inflationary pressures are under which has a de facto pegged exchange rate, the control (Figure 5.2). Kosovo experienced the central banks cut interest rates and intervened highest inflation in the region in 2018, driven in the foreign exchange (forex) market to ease by a rise in food price inflation which rose short-term currency fluctuations and related steadily since July and reached 5.5 percent in impacts on inflation (Figure 5.3 and Figure December—the 100 percent tariffs introduced 5.4). In Serbia, the policy rate was lowered in on imported goods from Serbia and Bosnia March to 3.25 percent and in April to 3 percent, and Herzegovina may have contributed to which prevailed through the year. The easing the acceleration of inflation at the end of the of monetary policy in Serbia is consistent year. In Bosnia and Herzegovina, inflation was with the somewhat more expansionary fiscal driven by higher prices for transport, housing, policy in 2018. In Albania, lower-than- alcoholic beverages, and tobacco, the latter two expected inflation associated with exchange Figure 5.1. Inflation, though slowly building, is Figure 5.2. Food and oil prices mainly drove still contained. inflation, but core inflation remains low. Headline CPI inflation, y-o-y percent Inflation rate, y-o-y percent 5 3.0 4 2.5 3 2.0 2 1.5 1 1.0 0 0.5 -1 0 -2 -0.5 -3 -1.0 -16 -16 v-16 -17 -17 -18 18 -18 -16 -16 v-16 -17 -17 -18 18 -18 Jan Jun No Apr Sep Feb Jul- Dec Jan Jun No Apr Sep Feb Jul- Dec ▬▬ALB ▬▬BIH ▬▬KOS ▬▬MKD ▬▬MNE ▬▬SRB ▬▬WB6 ▬▬WB6 headline inflation ▬▬EU28 headline inflation ……WB6 core inflation ……EU28 core inflation Source: Central banks and World Bank estimates. Note: Food and energy prices are included in headline but not core price indexes. Data for Western Balkans and EU28 are calculated as weighted averages. 24  |  5. Inflation picked up and monetary policy stayed accommodative REFORM MOMENTUM NEEDED Figure 5.3. Central banks further eased Figure 5.4. …and intervened in forex markets. monetary policy in Albania, North Macedonia, and Serbia...… Official policy interest rates, percent Exchange rate annual changes, percent 5 7 6 5 4 4 3 3 2 1 0 2 -1 -2 1 -3 -4 -5 0 -6 -16 -16 v-16 -17 -17 -18 18 -18 -14 un-15 -15 un-16 -16 un-17 -17 -18 -18 Jan Jun No Apr Sep Feb Jul- Dec Dec J Dec J Dec J Dec Jun Dec ▬▬ALB ▬▬MKD ▬▬SRB ▬▬Eurozone ▬▬ALB ▬▬MKD ▬▬SRB Source: Central banks and ECB estimates. Source: Central banks estimates. Note: Increase indicates depreciation. rate appreciation triggered a rate cut in June Pressures for exchange rate appreciation by 25 basis points, to 1 percent. In North were driven by foreign currency inflows from Macedonia, where prices were stable because exports and one-off factors. Appreciation of the narrowing output gap and the improved against the euro in Albania and Serbia were external position, the central bank lowered the highest, because demand for their exports is policy rate three times; in December it reached higher (Figure 5.5). With volatility higher a historically low 2.5 percent. While except in emerging markets, however, currency in Albania most of the policy easing was in appreciation may not last (see Section 8). monetary aggregates, its transmission through the credit channel was reduced by euroization Figure 5.5. Appreciation pressures also and structural bottlenecks in the credit market intensified. (see Section 6). Western Balkan countries are Exchange rate changes, Dec 2017 to Dec 2018, percent 4 engaging in de-euroization through, e.g., use 2 of macroprudential tools to reduce incentives for borrowing in foreign currencies. Keeping 0 inflation and inflation expectations low and -2 stable, building up the resilience of the financial -4 sector, heightening the transparency of financial services, and building a market for instruments -6 to hedge foreign exchange—together these -8 USD EUR REER can ensure effective transmission of monetary JJSRB JJALB JJBIH JJMKD JJKOS JJMNE policy to the real economy. Source: Central banks, Eurostat, and World Bank estimates. Note: Increase indicates depreciation. 5. Inflation picked up and monetary policy stayed accommodative  |  25 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 A wider range of financing instruments is needed to boost 6.  lending to businesses Credit outstanding12 continued to rise outstanding is still negative at -2 percent, partly in most Western Balkan countries, with because the recent exchange rate appreciation household lending again growing faster reduced the value of loans denominated in than corporate. In 2018 Kosovo continued foreign currency.13 As lending to households to show the fastest growth of credit to the continues to drive credit growth, lending to private sector at over 11 percent, thanks to corporations is more uneven, with write-offs improving credit terms, reforms to reinforce of NPLs still suppressing credit growth (Figure contract enforcement, and less bank risk 6.2). De-euroization strategies are pushing up aversion (Figure 6.1). In Montenegro and lending in domestic currencies, which reduces Serbia, credit to the private sector accelerated, currency risk for unhedged borrowers. Despite exceeding 9 percent in December 2018, as asset general progress in deepening credit markets quality continued to improve and deposits, a across the Western Balkans, domestic credit to major source of funding for local banks, grew the private sector is still far below EU levels. substantially. At 5–7 percent, lending was also robust in Bosnia and Herzegovina and North With NPLs declining in all countries, lending Macedonia. In Albania, however, total credit is gradually becoming more available. As of Figure 6.1. Credit outstanding continued to Figure 6.2. Credit to households grew rapidly increase in most countries. and outpaced credit growth to firms. Change in nonfinancial private sector credit outstanding, percent Change in credit outstanding, percent y-o-y in December 2018 y-o-y 12 14 12 10 10 8 8 6 6 4 4 2 2 0 0 -2 -4 -2 -6 -4 -8 -16 -16 v-16 -17 -17 -18 18 -18 Jan Jun No Apr Sep Feb Jul- Dec ALB BIH KOS MKD MNE SRB ▬▬ALB ▬▬BIH ▬▬MKD ▬▬MNE ▬▬SRB ▬▬KOS JJFirms JJHouseholds Source: IMF IFS, Central banks. Source: Central banks. Note: Consistent data on private sector credit growth in Albania, Bosnia and Herzegovina, Republic of North Macedonia, and Serbia are from the IMF International Financial Statistics (IFS). Data on household and corporate credit are from national central banks. Other depository corporations surveyed are expressed in local currency (except in euros for Kosovo). Data for Montenegro are based on central bank statistics for credit to residents but not to governments and financial institutions. 12 Credit here refers to the stock of nonfinancial private sector credit outstanding. Its growth reflects changes in both new credit (positive) and NPL write-offs (negative). In 2018, due to large write-offs in several countries (for which the data are not always 13 Excluding the impact of cleaning up bank balance sheets and current), the dynamic of credit outstanding did not match new exchange rate effects, in Albania credit to the private sector had credit growth. This effect is likely to ease by yearend as write-offs grown 5.9 percent by the end of 2018 (Bank of Albania Quarterly slow. Monetary Policy Report 2019/I). 26  |  6. A wider range of financing instruments is needed to boost lending to businesses REFORM MOMENTUM NEEDED Figure 6.3. Nonperforming loans are declining. Figure 6.4. Banks are adequately capitalized. NPLs as percent of total loans Percent and percentage points 30 25 25 20 20 15 15 10 10 5 5 0 0 ALB BIH MNE SRB MKD KOS SRB ALB MNE MKD KOS BIH JJSep-17 JJSep-18 ‹‹Peak since 2008 QQPre-crisis level (end 2007) JJSep-17 JJSep-18 QQAverage (2006–08) Source: IMF FSIs, Central banks. Source: IMF FSIs, Central banks. September 2018, the regional NPL average As of September 2018, bank capital adequacy was 7.3 percent of total loans, down 2 pp averaged 17.6 percent (Figure 6.4). Profitability, from a year earlier (Figure 6.3). While NPLs though low, is on the rise—as of September in Albania have declined steadily from over 2018 the regional average return on assets 20 percent at peak in September 2014 to was 1.7 percent. At the same time, domestic 12.9 percent in September and 11.1 percent in bank vulnerabilities continue to raise concerns December 2018, they are still the highest in the about asset quality and the health of specific region; at 2.7 percent Kosovo’s NPLs are the banks. In Montenegro, the regulator placed lowest. Recent reforms have helped to reduce two undercapitalized domestic banks under NPLs considerably as Albania, Montenegro, temporary administration in December 2018; North Macedonia, and especially Serbia where they are currently undergoing restructuring or NPLs continue to decrease due to selling and liquidation procedures. So far, Montenegro has write offs. New insolvency laws are in place in shown no visible signs of bank deposit declines Albania, the Bosnia and Herzegovina entity or liquidity pressures, but if bank resolution Republika Srpska, and Kosovo.14 Moreover, remains protracted, it may jeopardize the Central Bank of Albania is preparing a macro-financial stability, increase the cost of framework for voluntary bank out-of-court resolution, and erode confidence in the system. restructuring of large NPLs. And Montenegro In Serbia, despite improvements in the banking has expanded coverage of its credit registry to system as a whole, the quality of state-owned enhance the capacity of lenders to assess credit bank assets is a worrisome risk. Improvement risk; Montenegro is also working to reclassify in the operations of state development banks NPLs and revise its capital requirements to in Bosnia and Herzegovina is incomplete, comply with the EU Capital Requirements with some deficiencies in the governance and Directive. business model still unresolved. Given the size of Western Balkan economies and financial Banks in the Western Balkans are well- sectors, there is room for further consolidation, capitalized, but there is some vulnerability. entrance of reputable players, and banking sector efficiency gains. 14 In the Federation of Bosnia and Herzegovina a new insolvency law is being considered by Parliament. 6. A wider range of financing instruments is needed to boost lending to businesses  |  27 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Across the region corporate lending is still 17 percent in Bosnia and Herzegovina, and limited and would benefit from a wider 15 percent in Albania. Of those SMEs that range of financing instruments. On the found bank loans to not be relevant to them, demand side, access to financial services is a an average of 33 percent in the region saw high major obstacle for Western Balkan businesses. interest rates as the main obstacle, far more According to a recent survey by the European than the 8 percent in the EU28. Yet factoring, Commission,15 an average of 15 percent leasing, and capital market instruments are consider access to finance to be the most not frequently in use in the Western Balkans. important problem faced by their firms, Diversifying financial systems is important to compared to 7 percent in the EU28. Access broaden access to finance; and the availability to finance was cited as their biggest problem of term financing would foster investments— by 24 percent of SMEs in Montenegro, and ultimately economic growth (see Box 6.1). Box 6.1. Diversification of Financial Systems for Greater Access to Finance. Improving access to finance is a priority in the Western Balkans. A decade after the last global financial crisis, countries in the region are making progress on addressing NPLs but credit has not yet recovered much. Gradually improving asset quality is helping drive credit growth, but financial depth, measured by the ratio of private sector credit to GDP, averages only 44 percent (down from 48 percent in 2008), compared to 96 percent in the EU. Greater diversification of financial systems Figure B6.1.1. Financial systems in the can create opportunities for enhancing Western Balkans are not diversified. access to finance. In the Western Balkans, Bank assets to total financial sector assets, 2017 banks account for about 85 percent of financial 100 sector assets, considerably more than the Euro 90 80 area‘s 45 percent (Figure B6.1.1). Insurance, 70 pensions, mutual funds, leasing, factoring, and 60 capital markets are underdeveloped in all six 50 40 countries. Four of the six have stock markets- 30 -Albania and Kosovo do not—but the value 20 traded is small. Few companies are listed, and 10 there is no secondary market liquidity. Average 0 Euro ALB MNE SRB BIH MKD KOS Area stock market capitalization-to-GDP in the Source: Central banks. region is about 33 percent (48 percent in the EU) and government securities-to-GDP is about 22 percent, compared to 159 percent in the EU. Despite the high liquidity in Western Balkan banking systems, the private sector is not using nongovernment bond markets for its financing needs. Initial public offerings (IPOs) are rare; 2018 saw the first IPO in Serbia since 1940. Diversification of financial markets is crucial for term financing to foster investments, and ultimately economic growth. A wider range of financing instruments would supply the needs of both households and enterprises. 15 European Commission, Survey on the access to finance of enterprises - Analytical Report, 2018. 28  |  6. A wider range of financing instruments is needed to boost lending to businesses REFORM MOMENTUM NEEDED Box 6.1 continued By limiting alternatives to bank financing, the lack of financial sector diversification exposes the private sector to external shocks. Firms that want to grow must rely on bank financing, which is difficult for micro, small, and medium-sized enterprises (MSME) to access despite ample bank liquidity. Bank loans are also short-term, and usually accessible only to firms in business for several years, sufficient collateral, and good financial accounts, which disadvantages both start-ups and micro and small firms. Limited diversification also means that private firms are vulnerable to fluctuations in the credit cycle—as happened during the global financial crisis—and have few other sources to tap in funding shortfalls. Policies to promote financial sector diversification could stimulate long-term growth and job creation. Western Balkan countries increasingly recognize the importance of furthering integration and diversification of financial systems through, e.g., building up capital markets to boost investment, as envisaged in the 2017 Western Balkans Multi-Annual Action Plan (MAP) for a Regional Economic Area. Enacting supportive laws for leasing, factoring, venture capital, private equity, and microfinance can spur market development and financial system diversification. Governments can also invest in educating businessowners and managers about the advantages and disadvantages of different financing options. In general, the preconditions for building capital markets are not yet in place in the Western Balkans. It is therefore important to grow the institutional investor base, that is, insurance, pensions, mutual funds, and make it more attractive to companies to use capital markets. Policymakers can also improve the operation of government bond markets to establish a reliable yield curve for pricing financial instruments. 6. A wider range of financing instruments is needed to boost lending to businesses  |  29 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Although exports grew, in most of the region external 7.  deficits stayed high In 2018 external deficits widened in Bosnia 2018, ending the year at 0.3 percent of GDP, and Herzegovina, Kosovo, and Montenegro compared to 1 percent in 2017; the reduction but narrowed in Albania, North Macedonia, in the CAD deficit was mainly driven by a and Serbia ( Figure 7.1). Kosovo and rising exports which reduced the trade balance. Montenegro saw their current account deficits Though Serbia’s CAD did not change in 2018, (CADs) expand most, while in Albania the it is an elevated 5.2 percent of GDP because CAD narrowed by 1.2 pp. The change in Bosnia surpluses in trade in services and in net transfers and Herzegovina was relatively small, and in failed to compensate for rising imports and a Serbia the CAD was unchanged as a percent of still high primary income deficit. GDP. The high CAD in Montenegro—which widened in 2018 from 16.1 to an estimated Net goods exports grew in all countries 17.1 percent as construction-related imports except Kosovo and Serbia and net service rose—is a threat to external sustainability exports grew in all countries except Albania. because of both its size and its dependence Still, rising consumption and investment on foreign financing. A rise in investment- means that imports grew faster (Figure 7.2). In related imports was also the main cause of 2018, increased demand from the EU benefited the widening of the CAD in Kosovo, which Western Balkan exporters, and a pickup in registered the highest CAD deterioration in international prices benefited commodity the region (2.5 pp), hitting 8.4 percent of exporters Albania, Bosnia and Herzegovina, GDP. Bosnia and Herzegovina’s CAD deficit Montenegro, and North Macedonia. In most increased by 0.2 pp reaching 4.9 percent of WB6 countries net services exports also went up, GDP due to higher trade deficits. The CAD driven by tourism and transport. Montenegro in North Macedonia improved significantly in had the largest rise in net services exports, which Figure 7.1. CADs widened in Bosnia and Figure 7.2. Goods imports were the main Herzegovina, Kosovo, and Montenegro. factor in changes to CADs. Current accounts balances, percent of GDP Contribution to changes in current account deficit, 2018e, percent of GDP 0 5 ↑Reduced exports, increased imports -5 4 3 -10 2 -15 1 -20 0 -25 -1 -2 -30 -3 -35 -4 ↓Increased exports, reduced imports -40 -5 MNE KOS ALB SRB BIH MKD WB6 KOS MNE BIH SRB MKD ALB JJ2007 JJ2009 JJ2016 JJ2017 JJ2018e JJGoods exports JJGoods imports JJNet services exports JJRemittances JJOthers QQChange in CA deficit Source: Central banks, national statistical offices, World Bank estimates. Source: Central banks, national statistical offices, World Bank estimates. 30  |  7. Although exports grew, in most of the region external deficits stayed high REFORM MOMENTUM NEEDED went up 0.6 pp to reach 20.4 percent of GDP, in services exports of tourism and transport due to higher tourism receipts. Nonetheless, which compensated for the rise in construction- because exports and infrastructure construction related imports for large infrastructure projects. depend heavily on imports of intermediate In Albania, the trade balance improved because goods in the Western Balkans, imports also exceptionally favorable weather facilitated rose substantially in 2018. Throughout the hydropower generation, which translated region the rise in imports outpaced the rise into a significant rise in energy exports; and in exports of goods and services, worsening goods imports slowed as two large energy trade deficits in most countries. Kosovo’s trade infrastructure projects neared completion. In deficit went up by 3.1 pp of GDP, also because North Macedonia, improvement in the trade of lower exports of base metals and despite balance was driven by broad-based growth higher net services exports from tourism in exports from sectors led by foreign direct income from diaspora travelers. Serbia’s trade investment (FDI), mainly motor vehicle deficit increased by 1.9 pp as exports of goods manufacturing, and also in non-FDI-led including auto manufacturing rose less than sectors (iron and steel, furniture, and services). expected due to a slowdown of economic Goods exports have also become more skill- and activity in major trading partners, particularly technology-intensive in North Macedonia and Italy. In Bosnia and Herzegovina, the trade Serbia over the last decade as both countries deficit remained stable due to higher goods benefitted from FDI into the export-intensive exports of mineral products, base metals, car manufacturing sectors (Box 7.1). chemicals, and machinery and robust growth Box 7.1. Export Sophistication in the Western Balkans. As they have become better able to grow faster, transition countries can now produce goods that are more sophisticated and more competitive in international markets. Over time, they have been replacing low-value-added with high-value-added goods. Foreign direct investment (FDI) has enhanced the process and participation in global value chains (GVCs) allows for more knowledge spillovers, encouraging links with other domestic industries. In general, countries that produce more sophisticated products will benefit more and move faster up the technological ladder to higher economic growth. Over the past several years and to different degrees, the Western Balkan countries have benefitted from this nexus between sophistication and growth. During the transition period in general they have been increasing export-to-GDP ratios, largely because manufactures now constitute a larger share of their exports. North Macedonia and Serbia in particular are benefiting from rising FDI and active integration into GVCs, and to a lesser extent has Bosnia and Herzegovina. They have also improved the technology structure of their exports, at the expense of low-skill and technology- intensive ones (Figure B7.1.1). Higher skill-intensity has resulted in more sophisticated product exports16 (Figure B7.1.2), especially in North Macedonia and Serbia. The process of convergence to the manufactures of high-income countries has been advancing fast, but it is far from evenly distributed, with the other 16 The sophistication of production and exports index EXPY is constructed using the Hausmann et al., 2007 methodology. 7. Although exports grew, in most of the region external deficits stayed high  |  31 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Box 7.1 continued countries far behind North Macedonia and Serbia. By 2017 the sophistication of North Macedonia’s exports of manufactured goods was on a par with high-income countries, with Serbia not far behind. Their participation in GVCs stimulates the upgrading of exports, and thus potentially also economic growth. Shimbov et al. (2019) found that an increase of 10 percent in FDI or in trade in parts and components (as a proxy for participation in GVCs) is accompanied by an improvement in the export sophistication index of more than 1.6 percentage points. The rise of export sophistication in North Macedonia and Serbia are primarily driven by FDI from high income countries into the export- intensive motor vehicles manufacturing industries. While these foreign firms boost both countries’ exports, many of these firms import a high share of their inputs and source only few goods and services domestically. Figure B7.1.1. Exports from the Western Figure B7.1.2. In North Macedonia Balkans have become more skill- and and Serbia exports have become more technology-intensive. sophisticated, while other countries are lagging. Manufacturing exports by skill and technology intensity, avg. Export sophistication in manufacturing, in thousands 1995–97/2015–17, percent 100 18 90 16 80 14 70 12 60 10 50 8 40 30 6 20 4 1995–97 1995–97 1995–97 1995–97 1995–97 1995–97 2015–17 2015–17 2015–17 2015–17 2015–17 2015–17 10 2 0 0 5 7 9 1 3 5 7 9 1 3 5 7 ALB BIH MNE SRB MKD WB6 199 199 199 200 200 200 200 200 201 201 201 201 JJLow-skill JJMedium-skill JJHigh-skill ▬▬High-income ▬▬MKD ▬▬SRB ▬▬Other WBC Source: Shimbov et al. (2019) and World Bank calculations. The extent to which FDI in export-intensive industries boosts productivity and growth, however, also depends on the creation of linkages between foreign and domestic firms. Such linkages with the domestic economy would facilitate knowledge and technology transfer to domestic suppliers (Javorcik, 2004, 2008). It is thus critical that the extent of knowledge spillovers to the Figure B7.1.3. The increased export domestic economy is analyzed in more detail sophistication was driven by medium skill and that Western Balkan countries review the and technology manufacturing. incentives and costs for foreign firms to source Export sophistication in medium skill and technology more domestic goods and services. manufacturing, in thousands 9 8 Examining the skill and technological 7 intensity of manufacturing exports in the 6 region reveals the same picture ( Figure 5 B7.1.3). North Macedonia and Serbia achieved 4 convergence in this segment, with Serbia’s 3 2 sophistication topping the average for high- 1 income countries. They have expanded their 0 production frontier over time and acquired 5 7 9 1 3 5 7 9 1 3 5 199 199 199 200 200 200 200 200 201 201 201 201 7 new skills and technologies. Shimbov et al. ▬▬High-income ▬▬MKD ▬▬SRB ▬▬Other WBC (2019) found that a rise of 10 percent in the Source: Shimbov et al. (2019) and World Bank calculations. 32  |  7. Although exports grew, in most of the region external deficits stayed high REFORM MOMENTUM NEEDED Box 7.1 continued sophistication in a country’s manufactures entails a rise in the growth of its GDP per capita of 0.1 percentage points. However, they also found that the influence of human capital on growth and the quality of economic institutions also has a robust influence on the sophistication of production and subsequent growth in the Western Balkans. References Smarzynska Javorcik, Beata. 2004. Does foreign direct investment increase the productivity of domestic firms? In search of spillovers through backward linkages. American Economic Review, 94, 3, 605-627. Javorcik, Beata Smarzynska, and Mariana Spatareanu. 2008. To share or not to share: Does local participation matter for spillovers from foreign direct investment? Journal of Development Economics, 85, 1-2, 194-217. Shimbov, Bojan, Maite Alguacil, and Celestino Suarez. 2019. Export Structure Upgrading and Economic Growth in the Western Balkan Countries. Emerging Markets Finance and Trade, DOI: 10.1080/1540496X.2018.1563538. Figure 7.3. FDI levels remain low and they are Figure 7.4. External debt increased in 2018. growing slowly. Net FDI to GDP, percent External debt dynamics, percent of GDP and percent 13 4 200 20 11 15 9 2 150 7 10 5 0 100 5 3 1 -2 50 0 -1 -5 -3 -4 0 -10 -5 -7 -6 -50 -15 ALB SRB MNE MKD KOS BIH WB6 MNE MKD ALB BIH SRB KOS WB6 JJNet FDI to GDP 2018e QQ2017–18e change in net FDI to GDP (pps) JJTotal external debt JJExternal PPG debt ‹‹Change in total external debt, rhs QQChange in total PPG external debt, rhs Source: Central banks, national statistical offices, World Bank estimates. Source: Central banks, national statistical offices, World Bank estimates. FDI and remittances helped finance external in Montenegro large net FDI-financed imbalances in 2018, despite a slight decline infrastructure projects are near completion, in FDI  (Figure 7.3). Remittance inflows were and because other countries, e.g., Bosnia and relatively unchanged in all countries except for Herzegovina, were slow to improve the business increases of 0.7 percent of GDP in Serbia and environment. In 2018 the FDI-to-GDP ratio 0.5 percent in Kosovo, where they financed was highest in Albania at 7.8 percent of GDP significant portions of the trade deficits. (fully financing the CAD), driven by FDI in On average, for 2018 FDI into the Western energy infrastructure and manufacturing. The Balkans was an estimated 5.5 percent of net FDI-to-GDP ratios of Serbia (7.4 percent regional GDP, slightly less than the 5.7 percent of GDP) and Montenegro (7.1 percent) are average of the past three years, mainly because quite sizable and do much to explain their 7. Although exports grew, in most of the region external deficits stayed high  |  33 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 large external financing needs. FDI in Kosovo declined slightly in 2018 but was enough to finance the CAD. In North Macedonia FDI inflows increased sharply following the resolution of the political crisis and are estimated at around 5.8 percent of GDP in 2018; the highest level since 2008. Bosnia and Herzegovina has the least FDI, mainly because the political environment is difficult and the country’s reforms have not progressed much. Although growth in Western Balkan countries has enjoyed substantial support from FDI, current investment levels are too low to sustain growth over the long term (see Section 8). Sources of external financing in the Western Balkans need to be closely monitored(Figure 7.4). After peaking at 82.1 percent of GDP in 2015, average external debt in the region declined in 2016 and 2017 to 78.9 percent, but it is estimated that in 2018 external debt went up to 80.7 percent—mainly because of higher external public debt, which countries are using to finance either large infrastructure projects or budget deficits—with more being used to finance current spending than for investment (see Section 4). The exception is Serbia, where it is estimated that both public and private external debt declined by 7.7 pp of GDP. The growth of exports and FDI inflows in recent years should be positive for the external positions in Western Balkan countries, but in several countries the CAD is sizeable and worsening. If CADs continue to rise, they will put pressure on official foreign currency reserves, which would intensify external debt and make countries more vulnerable to shocks in foreign investment flows. In 2018, however, all Western Balkan countries had foreign currency reserves of more than 4 months of imports. 34  |  7. Although exports grew, in most of the region external deficits stayed high REFORM MOMENTUM NEEDED Stable outlook, rising risks, and growing public 8.  discontent—reform momentum is needed The Western Balkans region is projected to slow by 0.7 pp as the temporary stimulus of grow by 3.5 percent in 2019 and 3.8 percent public sector wages and pensions in 2018 fades in 2020 (Table 8.1). Regional growth in 2019 and EU demand for Serbian exports slows. In is projected to moderate, as growth slows in contrast, growth in Bosnia and Herzegovina Albania, Montenegro, and Serbia, and then and North Macedonia is expected to accelerate recovers gradually in 2020. The region is by 0.4 and 0.2 pp in 2019, driven by public expected to grow faster than the EU through investments in the energy sector in Bosnia and 2020, and at a similar pace as the average for Herzegovina and higher domestic demand in Central and Eastern European (CEE) countries. North Macedonia as investor and consumer confidence improves now that the country’s Table 8.1. The Growth Trajectory in the long-standing name dispute with Greece is Western Balkans, 2017–20f. resolved. Real GDP growth, percent 2017 2018e 2019f 2020f Expected drivers of growth for 2019–20 also Albania 3.8 4.2 3.8 3.6 vary by country. In Kosovo, where growth is Bosnia and Herzegovina 3.2 3.0 3.4 3.9 expected to be stronger thanks to large capital Kosovo 4.2 4.2 4.4 4.5 investment projects, the economy is expected to North Macedonia 0.2 2.7 2.9 3.2 expand by 4.5 percent on average during 2019– Montenegro 4.7 4.4 2.9 2.4 20. In Albania, as energy production returns Serbia 2.0 4.2 3.5 4.0 to normal and two large energy infrastructure Western Balkans 2.6 3.8 3.5 3.8 projects are completed, growth is expected to EU28 2.6 2.1 1.8 1.7 moderate to 3.8 percent in 2019 and 3.6 percent Central and Eastern Europe 4.9 4.3 3.6 3.2 in 2020, with domestic demand a major Source: For the Western Balkans: World Bank estimates based on data from national authorities. For EU28 and Central and Eastern Europe: contributor. In Serbia, increasing investment European Commission Winter Economic Outlook (https://ec.europa.eu/info/ publications/european-economic-forecast-winter-2019_en). activity and a steady rise in consumption will Notes: Growth in the Western Balkans is a weighted average by population. feed growth. In Bosnia and Herzegovina, solid EU28 comprises the 28 EU members countries. Central and Eastern Europe comprises Bulgaria, Croatia, Czech Republic, Hungary, Poland, and consumption and investment is expected to Romania. bring growth of 3.9 percent in 2020. In North In 2019 the dynamics of growth will differ Macedonia, the recent resolution of diplomatic by country, with growth accelerating in disputes with Greece has significantly reduced Bosnia and Herzegovina, Kosovo, and North political uncertainty, facilitating higher Macedonia and decelerating in Albania, investment and consumption and ultimately Montenegro, and Serbia. Deceleration will a brighter economy. In Montenegro, however, be worst in Montenegro (1.5 pp relative to the completion of large public investment 2018), where private investment is expected projects and fiscal consolidation is expected to to level off after rising steeply in 2018, in part slow growth to 2.4 percent. because higher uncertainty may dent investor confidence. Growth in Serbia is projected to 8. Stable outlook, rising risks, and growing public discontent—reform momentum is needed  |  35 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 The region’s stable economic outlook is, Further tightening of monetary policy in the however, vulnerable to interacting external US and the EU would increase the region’s and domestic risks, the materialization of borrowing costs and crowd out productive which could significantly hurt growth, job domestic spending. Western Balkan creation, and poverty reduction. Externally, economies—especially Albania, Montenegro, geopolitical risks are adding to an increasingly and North Macedonia—have high PPG debt volatile environment. Prolonged trade disputes that has increasingly been financed from foreign between the United States and China, potential sources. A rise in global interest rates would trade restrictions between the United States raise their financing costs enough to crowd out and the EU, and uncertainty about Brexit talks productive public investment in infrastructure between the EU and the United Kingdom and social services. The underdevelopment of are generating anxiety about protectionist domestic sovereign bond markets also amplifies policies that would ultimately hurt global, and their exposure to hikes in global interest rates. If therefore Western Balkan growth prospects. the real economy in the United States weakens, For instance, United States tariffs on European the Federal Reserve may not increase interest cars could have significant impact on exports rates in 2019. And as the European Central from the auto industries in North Macedonia Bank stopped quantitative easing at the end and Serbia. If regional trade tensions in of 2018, it may postpone raising interest rates the Western Balkans remain elevated—like at least until the end of 2019. Nonetheless, it Kosovo’s tariffs on imports from Serbia and would be wise for Western Balkan countries to Bosnia and Herzegovina—this would affect prepare for higher global interest rates. economic prospects. In contrast, resolution of the dispute with Slower-than-projected growth in the EU is a Greece over its name has significantly risk to the outlook for the Western Balkans. improved North Macedonia’s economic Economic growth slowed in the EU in the last outlook. Its economy, which averaged growth two quarters in 2018, somewhat disrupting car of just 1.9 percent in the previous three years, production in several Eurozone members, and has begun to pick up and through 2020 growth in the last quarter EU industrial production is expected to reach 3.2 percent. Resolution contracted by 1.1 percent. By yearend, Italy, one of the name issue—which has been inflicting of the largest trading partners of the Western political and economic damage on the country Balkans, had fallen into recession. The Global since 1991—is an opportunity to advance its Economic Prospects issued by the World Bank accession to the EU and to become more deeply in January 2019 revised down its June 2018 integrated into regional and global markets. projections for 2019 EU growth by -0.4 pp for the EU28 and -0.6 pp for the Euro area; any Growing public discontent over the slow pace further slowing would have negative spill-over of reforms in some Western Balkan countries effects on Western Balkan countries because of carry not only domestic risk but also a both lower external demand for their exports unique opportunity to build momentum and lower inflows of remittances and FDI. for reforms. Dissatisfaction with the economic and political situation is reflected in recent anti-government protests in Albania, Bosnia 36  |  8. Stable outlook, rising risks, and growing public discontent—reform momentum is needed REFORM MOMENTUM NEEDED and Herzegovina, Montenegro, and Serbia. The of law and battle corruption. Western Balkan public discontent is also reflected in increasing countries have improved the connectivity of political polarization in Albania, Montenegro, their economies with the rest of the world, but and Serbia; in all three, opposition parties they still trail most other Eastern European recently rejected the European Commission’s countries though the potential gains from more appeal to end their boycotts and return to economic integration in the region are large. For their parliaments. These developments may example, Box 8.1 highlights policies to enhance worsen the growth outlook because political economic connectivity, which could boost instability erodes the confidence of investors annual growth in the Western Balkans. Labor and consumers. The rising public discontent market reforms should thus be accompanied by over the lack of economic opportunities is continuous improvements to trade connectivity also rooted in incomplete or slow-moving and to the business environment to enhance reforms. These developments therefore also competitiveness and create conditions for vital provide an opportunity to advance structural private sector-led growth. This will not be reforms to boost potential growth in the possible without building the public institutions medium term. In all countries in the region, that enforce fair market competition to ensure large and unreformed public sectors have that no one benefits from special treatment built-in inefficiencies that have undermined and to encourage entrepreneurs to adopt new the quality of education, health, and public technologies and innovate. Western Balkan infrastructure and reduced competitiveness. In countries with high debt levels must show a several countries, governance and rule of law firm commitment to rebuild fiscal buffers to indicators have deteriorated17; growth could guard against downside risks. It is therefore well have been faster if the corresponding crucial for Western Balkan countries to make reforms were given more priority. public spending more efficient so that resources can be freed for high impact investments in In summary, the economic outlook for infrastructure and social services. More effective, the Western Balkans is vulnerable to accountable, and transparent policymaking is risks and rising public discontent which also necessary to regain citizens’ trust and to make it imperative for countries to reduce the emigration of skilled young people. accelerate structural reforms. This report highlights policy options in selected reform This report features a focus section titled areas: (1) deepening trade integration and “Human Capital in the Western Balkans: connectivity; (2) unshackling firms by changing A Missing Link to Growth and Inclusion” a policy environment that favors a few dominant which highlights the need to invest more market players over startups; and (3) investing efficiently in people. The Focus Section notes in people. Reforms in these and other areas will the need to improve education, health, and help mitigate risks and sustain faster growth. social protection systems to allow workers and The prospects of EU membership remain a firms in the Western Balkans to be prepared to major reform anchor and should embed a take the opportunities that new technologies heightened commitment to improve the rule are creating. 17 As evidenced by recent rankings by internationally recognized think-tanks and NGOs. 8. Stable outlook, rising risks, and growing public discontent—reform momentum is needed  |  37 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Box 8.1. Enhancing Multidimensional Connectivity in the Western Balkans. The benefits of connectivity accrue not only from opening to greater trading opportunities but also, and perhaps more important, from knowledge transfers between countries. Trade, investment, and the movement of people, among other forms of connectivity, lead to exchanges of information and ideas. A recent World Bank report, Critical Connections: Promoting Economic Growth and Resilience in Europe and Central Asia (Gould 2018), examines connectivity measures not typically considered that matter for the transfer of knowledge and thus influence on long-term economic growth. This includes the interconnected networks of trade, FDI, transport, migration, and ICT. Much of the transfer of knowledge gained from connectivity comes from tacit knowledge— learning by doing and face-to-face interactions. Unlike explicit knowledge, tacit knowledge cannot be transferred in texts and blueprints. Being part of regional or global supply chains, where firms invest in other firms and where people migrate for jobs or study abroad, can transfer useful tacit knowledge. Many channels of connectivity interact to support higher economic growth. It is hard to imagine new forms of trade emerging without people traveling to discover new markets, or e-commerce growing without transport and high-speed internet. Countries therefore need to balance different types of connections. Such complementarities are particularly important for building supply chains, where the exchange of producers with countries of intermediate inputs, investment, managerial talent, and transport is central. Being well-connected to countries that are well-connected to other countries can enhance knowledge spillovers. For example, Serbia’s trade with Germany provides additional knowledge spillovers compared to trade with Italy, because Germany has wider global connections. Table B8.1.1. Multidimensional connectivity has improved for the Western Balkans since the early 2000s. Early 2000s Multidimensional Trade FDI Migration ICT Airlines Portfolio Connectivity Flows North Macedonia 70 65 67 108 45 72 83 Bosnia and Herzegovina 85 80 86 114 117 91 108 Serbia 83 82 100 25 42 80 NA Albania 101 95 105 111 49 79 113 Latest Period Multidimensional Trade FDI Migration ICT Airlines Portfolio Connectivity Flows Serbia 57 74 37 49 54 74 NA Bosnia and Herzegovina 60 60 63 88 49 63 82 North Macedonia 61 52 58 83 65 58 69 Albania 75 79 75 37 60 48 75 Source: Gould (2018). Note: The table shows global rankings, from best (1) to worst (113), in combined per capita connectivity. FDI=foreign direct investment; ICT=information and communication technology; NA=not available. Earliest and latest period available for connectivity varies by country and channel of connectivity; the most common start date is 2000 and end-date is 2014. 38  |  8. Stable outlook, rising risks, and growing public discontent—reform momentum is needed REFORM MOMENTUM NEEDED Box 8.1 continued Though Western Balkan countries have improved the connectivity of their economies with the rest of the world, they still trail many other European countries. Table B8.1.1 shows how Western Balkan countries (data not available for Kosovo and Montenegro) are ranked in the Multidimensional Connectivity Index (MDC); rankings range from 1 (highest connectivity) to 113 (lowest), which is the number of countries in the sample. Serbia currently ranks highest in the region with a ranking of 57, up from 82 in the early 2000s, and is in the middle of the global sample of countries. Albania ranks 75, down from 10, close to the bottom of the sample. Overall, the Western Balkans rank in the middle globally but low compared to the average for Europe and Central Asia (ECA), which ranks in the upper 25 percent. However, average FDI connectivity has increased in most of the Western Balkans, particularly Serbia, which is ranked 37 globally in the MDC sub-index for country connections and FDI per capita. Though migration connectivity has also improved, the measure must be taken with a degree of skepticism, because many citizens of the former Yugoslavia are classified as “foreign born” in census data of recipient countries, despite never migrating. Connectivity has also improved in trade, ICT, airline, and portfolio financial flows. The potential gains from more economic Figure B8.1.1. Raising multidimensional integration in the region are large. Figure connectivity to EU averages could boost B8.1.1 shows what could happen to overall annual growth in the Western Balkans from growth if countries in the region improve their about 0.5 to 0.7 percent. connectivity to the EU average, which is in Annual long-term contribution to growth by increasing Multidimensional Connectivity to the EU28 average, the top 15 percent globally. Because Albania is percentage points ranked lowest in connectivity, it has the most 0.8 to gain: improving its connectivity to the EU 0.7 average could generate 0.7 pp of additional 0.6 GDP growth per year. Serbia, the most 0.5 connected country in the Western Balkans, 0.4 would gain over 0.5 pp annually. 0.3 0.2 How can Western Balkan countries become 0.1 better connected? Since 2008, the number of 0 SRB BIH MKD ALB bilateral investment treaties signed by Western Source: Gould (2018). Balkan countries is among the highest in ECA, Note: Annual long-term contribution to growth by raising MDC to the EU28 average. MDC impact on growth is estimated based on initial but FDI is still modest. This suggests a need to levels of income, education, investment, size of government, inflation, deepen trade and investment treaties to further and quality of governance. reduce tariffs and attract FDI; perhaps more important is to make the investment environment more attractive. The 2017 Western Balkans Multi- Annual Action Plan to develop a Regional Economic Area (MAP-REA) provides a roadmap for expanding connectivity in trade, investment, labor mobility, and the digital economy, and aligning regulation in preparation for eventual EU accession. A firm commitment to advance such reforms will help Western Balkan countries achieve balanced connectivity (Gould 2018). With regard to trade, besides upgrading physical infrastructure and aligning tariffs, the Western Balkans need to establish national Single Windows to reduce nontariff barriers to trade and streamline border crossings. On investment, policies to attract FDI need to be supported by measures to strengthen competition (see Box 2.1). On mobility, policy options are mutual recognition of academic qualifications and reforms to build human capital (see Focus Section). On digital connectivity, priorities are elimination of regional roaming charges, a unified approach to digital security and data protection, affordable and accessible high-speed broadband, and promotion of digital skills. A comprehensive agenda 8. Stable outlook, rising risks, and growing public discontent—reform momentum is needed  |  39 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Box 8.1 continued is necessary to facilitate transfers of knowledge and technology for faster and sustained economic growth in the Western Balkans. Reference Gould, David Michael (2018). Critical Connections: Promoting Economic Growth and Resilience in Europe and Central Asia. World Bank, Washington, DC. https://www.worldbank.org/en/ region/eca/publication/critical-connections 40  |  8. Stable outlook, rising risks, and growing public discontent—reform momentum is needed REFORM MOMENTUM NEEDED 9.  Spotlight #1: Competitive Markets Needed Markets with active competition are give the Energy Regulatory Entity guidance central to the growth in productivity in its decisions. In telecommunications, that supports sustainable growth. Lack of the enforcement of rules to curb potential competition between firms pushes up prices, anticompetitive practices by operators with reduces production, and limits incentives for significant market power has improved. innovation. The World Bank Group and the However, there are still issues regarding OECD are currently preparing Product Market spectrum policy that could restrict competition Regulation assessments for Albania, North in wireless services and network constructions, Macedonia, and Serbia, to analyze policy for example in Bosnia and Herzegovina and options to further strengthen competition Serbia. policy. Hindering competition in professional In recent years, Western Balkan countries services can undermine the affordability have started to align their competition policy and quality of services to the rest of the to EU standards but the implementation of economy. In North Macedonia, the number these policies is lagging. Restrictive regulation of lawyers and notaries is limited by law and of services still hinder competition in, e.g., energy industry barriers to entry; and in Serbia there and telecommunications, and in professional are territorial restrictions on notaries. In North services (e.g., lawyers, accountants, engineers). Macedonia and Serbia, restrictions on activities Furthermore, enforcement of state aid control persist for lawyers, including limitations on is poor and adherence to competitive neutrality advertising and additional barriers for other principles limited. Institutional capacity needs professionals qualified to provide some types of to strengthen to ensure a “level playing field” lawyer services. Price regulation further limits where firms can compete on their merits; the ability to compete, such as binding prices currently weak implementation of competition for lawyers in North Macedonia and Serbia and laws and anemic competition authorities do for accountants in North Macedonia. not act to discourage anticompetitive business practices. Rules that guarantee neutrality in markets where state-owned enterprises (SOEs) Policies to facilitate market competition and operate with state aid would help firms to firm entry could help to raise productivity. enter the market, compete, and expand For example, some countries now allow based on productivity and innovation. In competition in electricity generation and public utilities, governments interfere directly supply. Often, however, rules to make entry in SOEs, undermining their governance and effective are missing—for example, terms of commercial independence, as by the political access to the grid: in North Macedonia, the appointment of CEOs in Serbia and North Energy Regulatory Commission cannot apply Macedonia, and control of SOEs by line penalties; and in Albania, the government may ministries rather than by a dedicated office in 9. Spotlight #1: Competitive Markets Needed  |  41 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Serbia, North Macedonia, and Albania (Figure independent. Finally, there is evidence from 9.1). Finally, even though SOEs are subject to Kosovo, Montenegro, Serbia, and Bosnia and antitrust rules across the Western Balkans, they Herzegovina that grants of state aid are not tend to enjoy privileges that may distort market monitored (World Bank Group 2019). outcomes. For instance, in North Macedonia and Serbia SOEs can receive financing not Failure to act against anticompetitive available to private companies (Figure 9.2). practices undermines competition policy Moreover, in Albania and North Macedonia and discourages firms from following the SOEs participate in both commercial and law. Western Balkan laws are aligned to noncommercial activities with no legal Articles 101 and 102 of the Treaty of the requirement to separate the activities. Functioning of the European Union but only Albania, Montenegro, and Serbia have made All Western Balkan countries have EU- unannounced inspections; North Macedonia, based state-aid regulations, but there are Serbia, and Montenegro have moved against implementation gaps. The laws in Albania, cartels; and Bosnia and Herzegovina and North Macedonia, Kosovo, Montenegro, and Albania have sanctioned anticompetitive Serbia are largely aligned with the EU; Bosnia practices, but fines are too low for deterrence. and Herzegovina lacks clear criteria for state And while all Western Balkan countries have aid. There are also significant shortcomings ex ante controls of mergers, authorities tend in secondary legislation, and few resources for to approve all and rarely move to remedy enforcement. The Albanian State Aid Unit, part anticompetitive effects. Proactive use of of the State Aid Commission (SAC), has only structural or behavioral remedies is crucial two technical staff; and Kosovo’s SAC has one to minimize the anticompetitive effects on staff member though six are planned. Moreover, consumers. Furthermore, fees for merger the authorities charged with scrutinizing state reviews are seen as a source of revenue, creating aid in Albania, Montenegro, and Serbia are not an undue burden on the private sector—in Figure 9.1. SOEs are sometimes controlled Figure 9.2. …and SOEs have access to finance by line ministries rather than by independent that is not available for private firms. institutions… Management of state equity holdings in publicly-controlled firms SOEs financing not available for private firms 69% 70% including Albania, North Macedonia, including and Serbia North Macedonia, and Serbia including 20% Albania 30% 11% JJMinistry JJIndependent holding entity JJOther JJYes JJNo Source: World Bank Group (WBG) Product Market Regulation (PMR) assessment; 2019 preliminary data for Albania, North Macedonia, and Serbia; for other countries: OECD and OECD–WBG PMR data. 42  |  9. Spotlight #1: Competitive Markets Needed REFORM MOMENTUM NEEDED 2018 Bosnia and Herzegovina doubled fees Simulations for Western Balkan countries for mergers to raise up to the elevated levels of show potential for positive effects of reforms Serbia and Montenegro. in services t hat could have positive effects on value-added growth and productivity Figure 9.3. Strengthening competition in (Arnold et al.2008; Barone and Cingano energy, water, transport, and telecoms can 2011; Conway et al. 2006; and De Rosa et accelerate growth. al. 2009). In particular, Barone and Cingano Impact on annual value added, % Billions USD, current 0.25 0.07 (2011) suggest that liberalizing regulated input 0.06 services generates gains in value-added growth 0.20 0.05 in service-dependent industries in OECD 0.15 0.04 countries. A simulated scenario for the Western Balkans, where countries, other things being 0.10 0.03 equal, undertake pro-competition reforms 0.02 0.05 in services suggests that annual GDP growth 0.01 could rise from 0.14 to 0.23 percentage points 0 ALB BIH MKD MNE SRB 0 (Figure 9.3). JJExpected additional value added, 2017, rhs QQEstimated impact on GDP Source: World Bank calculations based on Barone and Cingano (2011), EORA-country Input-Output tables 2015, and World Development References Indicators. Arnold, Jens, Giuseppe Nicoletti, and Stefano Notes: Calculations based on Input-Output (I-O) tables for 2015, which have information on 26 sectors for the region except North Macedonia, for Scarpetta. 2008, Regulation, Allocative which it has information on 61 markets. Impact calculations are additional value-added as percentage of the GDP at current local prices, generated by Efficiency and Productivity in OECD improvements in a specific sector. Following Barone and Cingano (2011), Countries: Industry and Firm-level Evidence. the estimate assumes a multiplier effect of 0.75 percentage points in all service-intensive sectors due to joint reforms of selected services. The Paris: Organisation for Economic Co- estimates assume that the structure of the economies remain constant, meaning that the estimated relative impact of changes on GDP were the operation and Development. same in both 2015 and 2017. (*) The impact calculation also covers Barone, Guglielmo. and Federico Cingano. reforms of professional services, which could be identified in a specific country due to a larger and more disaggregated I-O table. 2011, “Service Regulation and Growth: Evidence from OECD Countriesi.” Economic Journal 121 (555): 931–57. Finally, inability to integrate competition Conway, Paul, and Giuseppe Nicoletti. 2006, principles into design of legislation deters Product Market Regulation in the Non- competition. Although most competition Manufacturing Sectors of OECD Countries authorities are mandated to conduct market Measurement and Highlights. Paris: assessments and advise the government on OECD. De Rosa, Donato. 2009. “Barriers to how to promote competition, their resources Competition in Croatia: The Role of and powers are inadequate. Moreover, Government Regulation.” Washington, they are often sidelined—the competition DC: World Bank. authority of Montenegro was not consulted OECD. 2018, Competitiveness in South on the competition principles in the new East Europe. A Policy Outlook. Paris: procurement law before public consultations Organisation for Economic Co-operation and Development started. A formal system could help assess the World Bank Group. 2019, “Underlying impact of proposed legislation on markets and Data for Calculation of Product Market competition, but there is little collaboration Regulation Indicators for Albania, North between competition authorities and other Macedonia, and Serbia.” Washington, institutions. DC: WBG. 9. Spotlight #1: Competitive Markets Needed  |  43 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Spotlight #2: Labor Taxation in the Western Balkans18 10.  A larger difference between the total costs tax wedges in the region are significantly higher of an employee for a firm and the net take than in most developing countries. Wedges home wage for a worker—referred to as the on the average wage are high in Montenegro labor tax wedge—implies less incentives for (40.3 percent), Serbia (39.6 percent), and individuals to work and higher costs for Bosnia and Herzegovina (Federation of Bosnia firms to hire employees. The labor tax wedge and Herzegovina—41.7 percent; Republika measures the difference between the costs of a Srpska—38.2 percent). In these three countries worker to her employer and the employee’s net wedges are comparable to those of the EU and (take home) wage. It therefore measures both OECD wedges for high-wage earners, but they incentives for individuals to work (labor supply are much higher for low-wage earners due to side) and the costs for firms to hire employees low progressivity. (labor demand side). Specifically, the higher the labor tax wedge, the larger are the disincentives The relative lack of tax-free family allowances for individuals to work and for firms to hire suggests that in the Western Balkans the workers. effective tax burden per employee is even higher than in the EU. In Albania, Kosovo, In the Western Balkans, labor tax wedges Montenegro, and Serbia, personal income tax are relatively high, especially for low-wage (PIT) rates are levied on gross wage (minus earners. There is some diversity of labor tax the personal allowance, which does not exist burdens within the region (Figure 10.1), but in Montenegro). In both entities in Bosnia compared to EU and OECD countries, labor and Herzegovina and in North Macedonia, Figure 10.1. Labor tax wedges for low-wage Figure 10.2. Labor tax wedges are high for earners are high in several Western Balkan workers with dependents. countries. Labor tax wedges for a single worker at 67%, 100%, and 167% Tax wedges of a single worker (100%) and a one-earner couple of average wage with two children (100+0%) 50 9 55 8 50 40 45 7 40 6 35 30 5 30 4 25 20 20 3 15 10 2 10 1 5 0 0 0 OECD EU22 ALB FBIH RS KOS MKD MNE SRB average in OECD BEL DEU FRA AUT FBIH SVK MNE SRB RS DNK MKD GBR ALB KOS JJ67% JJ100% JJ167% QQProgressivity ‹‹Single 100% QQOne earner couple 100%, 2 children Source: For Western Balkans countries: World Bank (2019), “Western Balkans Labor Market Trends 2019.” For others, OECD. 18 Based on World Bank (2019). 44  |  10. Spotlight #2: Labor Taxation in the Western Balkans REFORM MOMENTUM NEEDED the PIT base is lower since, following common Reference international practice, the PIT rate is levied after deduction of employee social security World Bank (2019). Western Balkans Labor contributions (SSCs) and, in the Bosnia and Market Trends 2019, Special Topic “Labor Herzegovina entity Republika Srpska, after Costs, Labor Taxes and Low-Wage Earners an additional deduction of family benefits for in the Western Balkans.” Washington, dependents. Figure 10.2 shows the difference D.C.: The World Bank. between the tax wedge for a single worker earning 100 percent of the average wage and that of a worker with a non employed spouse and two children. For the latter family Montenegro shifts from the 7th highest labor tax wedge to the top one. Similarly, Serbia moves from 8th highest to 4th highest. International comparisons based on single-worker wedges underestimate the true differential for Western Balkan workers with dependents. The relatively high labor tax wedges for low- wage earners and those with a family imply higher raise their hiring costs and reduce their take-home wages and employment. A major simultaneous reform of the entire system of labor taxation and social insurance in the region may be the most promising way to revitalize its labor markets. Introducing progressivity through personal deductions or family allowances and levying PITs after SSC deductions would improve the labor market position of low-wage workers with dependents. A rebalance between PITs and SSCs would require deep discussion and a strenuous effort to reform the design and ensure the sustainability of social security regimes in the region. 10. Spotlight #2: Labor Taxation in the Western Balkans  |  45 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Focus Section on Human Capital in the Western 11.  Balkans: A Missing Link to Growth and Inclusion Introduction Other human development indicators, such as life expectancy, literacy, and access to public Too often countries do not give priority to services also improved. investments in human capital; their payoffs are not realized immediately, so there are Yet the six Western Balkan countries are still no ribbon-cutting ceremonies on near- among the poorest in Europe, and the pace of term achievements. But the hard reality is income convergence to European standards that neglecting to invest in human capital has slowed. Other small transition economies dramatically erodes a country’s competitiveness in Europe, such as Slovenia, Croatia, Slovakia, and growth prospects. Improving education and Estonia, Latvia, and Lithuania, have converged health is central to ensuring that people benefit much faster. For instance, in 1995, per capita from job opportunities now and in the future. incomes in both Latvia and the Republic of A healthy, well-educated, skillful population North Macedonia were about 25 percent of provides the foundation for a prosperous Germany’s (Figure 11.1). Today Latvia’s GDP society. It enables workers to compete in the per capita is twice that of North Macedonia. dynamic labor markets of technologically fast- After the global financial crisis, growth changing economies, and it allows firms to stagnated in the Western Balkans, but early hire the skilled workers they need to handle accession countries quickly caught up with the increasingly complex production processes. rest of the EU. Endowing a country’s most vulnerable citizens with quality human capital also helps them Figure 11.1. Disparities are growing among escape poverty by giving them a much higher transition economies. chance of landing a stable job that pays better— GDP Per Capita in PPP, 2011 Prices, As a Share of Germany’s 65 and thus contribute to national prosperity. A country that fails to invest in human capital is 55 failing its citizens. 45 Since 1995 Western Balkan countries have 35 achieved significant economic growth while 25 reducing poverty. Between 1995 and 2017 living standards increased almost six-fold in 15 5 7 9 1 3 5 7 9 1 3 5 7 199 199 199 200 200 200 200 200 201 201 201 201 Bosnia and Herzegovina19, nearly tripled in ▬▬Median of 7 small transition economies in Europe ▬▬Latvia Albania, and almost doubled in Serbia. In the ▬▬North Macedonia ▬▬Median of the Western Balkans early 2000s, about 33 percent of the people Source: World Bank calculations based on data from national authorities, World Development Indicators, and Eurostat. in the region lived on less than US$5 a day; by 2008, that was true of just 20 percent. Lagging economic growth has led to a persistent jobs challenge, which results 19 Albeit from a low base due to war. in a considerable waste of working years. 46  |  11. Focus Section on Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion REFORM MOMENTUM NEEDED Figure 11.2. The Western Balkans face severe employment challenges, which result in a considerable waste of working years. Average Years of Productive Employment Lost, 2016 50 45 40 35 30 25 20 15 10 5 0 LVA L D AUT EST CZE LTU HU N SVN PO SVK BG R RO U ALB HR V SRB MN E MK BIH KO S JJ15–24 JJ25–54 JJ55–64 QQFemales Source: World Bank (2018d). Note: Methodology based on Arias et al. (2014). The average years of employment potentially lost is equal to the share of total working years for the age group, multiplied by one minus the employment rate for the same age group. Only 44 percent of working-age people in the low- and middle-income countries (limited Western Balkans have jobs. Unemployment is access to education, malnutrition, low high (about 17 percent), and inactivity even life expectancy), but a new generation of higher (47 percent). Labor market outcomes challenges is now affecting them. The human for youth, minorities, and the vulnerable capital challenge starts early in life and builds are even worse. In all six Western Balkan throughout the life cycle. Minimal investment countries many youths are not engaged in in early childhood development (ECD) employment, education, or training (NEET), translates into poor performance in primary with the highest rates being 24 to 26 percent and secondary education, so students are in Bosnia and Herzegovina, North Macedonia, not prepared to acquire the skills they need Kosovo, and Albania. Structural labor market to operate effectively in today’s increasingly deficiencies also cause a considerable loss of competitive labor markets. Poor-quality working years. The average male worker in the technical education and universities also Western Balkans loses more than 20 years of his affect the transition from school to work. As productive lifetime because of unemployment a result, many graduates are unemployed for a and inactivity. For women, the loss is over long time and cannot build work experience. 30 years (Figure 11.2). The jobs challenge Meanwhile, social assistance programs do not also adds to the incentives to migrate: in adequately alleviate poverty and give vulnerable some countries, the share of emigrants outside households sufficient support. Moreover, the region is close to a third of the resident inefficient health systems are not addressing population. the dramatic rise of noncommunicable diseases (NCDs) and inadequate health insurance Poor human development outcomes are coverage heightens the risk of impoverishment contributing to lagging growth and dim due to the catastrophic costs of sickness. employment prospects. Western Balkan countries have for the most part mastered the human development challenges common to 11. Focus Section on Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion  |  47 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Human capital is essential for growth and having the type of human capital that promotes development.20 Human capital consists of productivity (Figure 11.3). the knowledge, skills, experience, and health that people accumulate throughout their lives Human capital also helps a country’s most that enables them to realize their social and vulnerable citizens to escape poverty. Better- economic potential as members of society. educated workers have a much higher chance of Without human capital, societies cannot landing a stable and better-paid job. Education function. Social norms, the sharing of common is among the best predictors of a person’s values, the ability to interact with other labor market performance. On average, one members of society and to resolve conflicts, all year of additional schooling raises income by hinge on citizen human capital. A healthy, well- 9 percent; returns are higher for women and educated, and skillful population is vital to a in low-income countries (Psacharopoulos and prosperous society because qualified workers can Patrinos 2018). But formal schooling is only better compete in the dynamic labor markets of one of several factors that influence human technologically fast-changing economies, and capital. ECD is also very important. Proper firms can hire the skilled workers they need nutrition and adequate stimulation and brain to operate in increasingly complex production development during pregnancy and from processes. It has been estimated that 10 to birth to formal school age have been shown to 30 percent of the differences in per capita significantly affect labor market outcomes and income between countries can be attributed to a child’s ability to assimilate knowledge once in human capital (Hsieh and Klenow 2010).21 school (Berlinski and Schady 2016). The close association between human capital Figure 11.3. Human capital and development and development is reflected in the World go hand in hand. Bank’s recent Human Capital Index (HCI). Human capital index, scale 0–1 KOR JPN The HCI captures the productivity that a child 0.8 SVN PRTCZE FIN GBR AUS SWE CANNLD DEU AUT DNK ITA NZL ISR FRA SRB CYP BEL born today can expect to achieve in view of 0.7 KAZ RUS HRV POL LVA ESTESP LTU MLT HUN ISL GRC SVK SYC the risks of poor health and poor education VNM UKR CHN BGR CHL BHR GEO ALB MNG BIH MNE CRI MUS ARG MEX TUR MYS TTO OMN currently prevailing in its home country (World 0.6 MDA ARM JOR ECU COL PER LKA KOS LBN AZEIRN BRA THA URYROU SAU PHL JAM Bank 2018f ). The index combines measures of NIC PRY IDNMKD DZA PAN 0.5TON SLV MAR TUN DOM GUY MMR GTM EGY education attainment and quality with labor- LAO IND TLS NAM GAB BWA 0.4 SWZ ZAF IRQ market-relevant health outcomes like stunting PAK NGA AGO and child and adult survival rates. There is a 0.3 5 10 20 50 strong association between GDP per capita GDP per capita PPP, 2017, in thousands and the HCI, with more advanced economies ▬▬GDP-adjusted average ……EU average Source: World Bank calculations based on World Bank data. 20 This section draws on Flabbi and Gatti 2018. Health also influences how well people 21 Although nobody disputes the importance of human capital for long-term development, its precise contribution is difficult to perform in society and their productivity, assess because the data limitations are severe—macroeconomic studies face challenges in capturing the quality of the learning which in turn affects a country’s growth received and its relevance for the labor market, or how the quality prospects. Chronic malnutrition, for of human capital affects firms’ ability to adopt new technologies and otherwise innovate (Caselli and Ciccone 2013). instance, affects children’s brain development: 48  |  11. Focus Section on Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion REFORM MOMENTUM NEEDED Stunting, a measure of height for age that is At almost every stage, with few exceptions, closely associated with malnutrition, has been education systems in the Western Balkans associated with less time in school, lower test fail to provide the skills the labor market scores, lower incomes, and a higher likelihood requires. Systems also fail to provide students of poverty (Hoddinott et al. 2013). Disability with the skills they need to successfully and workplace accidents also undermine complete each stage and move confidently to long-term earnings potential, as does obesity the next. These challenges persist all the way up (Campolieti and Krashinsky 2006; Brunello, the education ladder, from preschool education Michaud, and Sanz-de-Galdeano 2009; to graduate university degrees. Gilleskie and Hoffman 2014). Preprimary enrollment in the Western Western Balkan countries need to invest Balkans is far below EU averages. Investing more efficiently in human capital. In in young children—especially those from education, the quality, relevance, and inclusion disadvantaged backgrounds—is essential to of current systems need attention. In health, ensure proper brain development as a solid efforts should focus on addressing the lifelong basis for children to learn. It has been shown consequences of poor ECD, the rise of NCDs, to reduce inequalities and raise the productivity and exceedingly high out-of-pocket spending of the entire society (Heckman and Masterov on health. And social assistance systems should 2007). In Bosnia and Herzegovina, Kosovo, give more priority to poverty alleviation and and North Macedonia, preprimary enrollment the employability of the poor, integrating is close to the average for low-income countries case management to ensure effective support and far below the average of countries with throughout the lifecycle. similar incomes; and except in Albania, preprimary enrollment is far below the average for EU member states (Figure 11.4, left panel). Education systems that fail many Nor is much known about the quality of early students in the labor market childhood education, although that is crucial to generate positive net returns to early education Education is lifelong. Education starts with (Elango et al. 2016). Albania, for instance, does adequate stimulation at a very early age, which not have national standards for early childhood promotes brain development. It continues with education for children between 0–3 years old. early childhood education to lay the foundation for solid socioemotional development and Poor-quality basic education systems fail to cognitive learning. Basic education then equips endow many students with the basic skills students with general skills that will help them they need to function in society. Except throughout their lives. In higher education and in Serbia, learning outcomes are far below technical and vocational education and training the EU-member averages; and for Albania, (TVET), students deepen skills that allow them Kosovo, North Macedonia and Montenegro, to integrate effectively into the labor market; they are below the average of peers with similar and throughout adulthood, lifelong learning income levels (Figure 11.4, right panel)—in helps people switch careers and stay current some cases, close to the scores of low income with progress. countries. Poor-quality basic education is a 11. Focus Section on Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion  |  49 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Figure 11.4. In some Western Balkan countries, education outcomes are well below those in peer countries. Pre-Primary net enrolment rates, % Learning outcomes, harmonized test scores 100 ISR FRA MLT BEL ISL KOR JPN MUS SYC ESPGBR KOR ITA NLD SWE 550 FIN URY PRT NZL AUSDNK RUS KAZ EST POL CAN PER MNG RUS LTU SVN EST LVA SVN DNK NLD DEU LVA JPN FIN VNM SRB PRT CZE SWE AUT AUS BEL MDA PHL LBN BRA HUN MYS HUN NZL LTUESP GBR ITA 80 VNMGUY ALB CRI BGR CHL ROU 500 BGR HRV SVK ISR CYP FRA ISL JAM ARG DZA MEX UKR ECU POL TTOCYP CAN AZE MUS MYS MLT GRC CHL 60 SRB M NE HRV BIH CHNGAB SYC TURTTO NIC PAK THA 450 ROU BHR AGO SLV KAZ BHR MDA SWZ GEO ARM MNG CRITHA URY COL MMR ALB MNE IRN MEX MAR GTM GEO DOM IRNPANGRC OMN ECU COL ARG OMN 40 LAO IDN PHL GTMJOR PER NAMIDN BRA LBN SAU GAB 400 NIC LKA PAN PRY JOR JAM PRY TUN BWA EGY MKD TUR TONLAO TLS KOS MKD DZA MMR SAU MAR SLV IRQ 20 TON KOS NAM TUNZAF 350 IND EGY DOM SWZ BIH BWA AZE GUY ZAF TLS PAK AGO NGA IRQ 0 300 5 10 20 50 5 10 20 50 GDP per capita PPP, 2017, in thousands GDP per capita PPP, 2017, in thousands ▬▬GDP-adjusted average ……EU average ▬▬GDP-adjusted average ……EU average Source: World Bank calculations based on World Development Indicators and World Bank data. Note: For details about the methodology used to build Harmonized Test Scores see Altinok, Angrist, and Patrinos (2018). fragile basis upon which to build the higher- for reading (OECD 2016; World Bank 2017). level skills needed for productive jobs. And trends are often not encouraging: in North Macedonia, average learning outcomes The educational quality challenge, declined between the last two waves of PISA ubiquitous in the Western Balkans, should assessments. There is a need for Western Balkan not be underestimated. An analysis based on countries to move promptly to boost education 2015 PISA assessments, which test the skills quality: calculations based on PISA data and knowledge of 15-year-old students,22 suggest that at the current rate of progress, it found that at age 15 about 70 percent of the would take Western Balkan countries 29 years students in Kosovo and North Macedonia, to reach today’s EU reading average. and about 50 percent of Albanian students are still functionally illiterate, which means Higher education and TVET systems are they cannot comprehend the text they read, failing to instill in students the technical and are therefore not qualified for good jobs. and socioemotional skills they need to Nearly 50 percent of Montenegrin students are be productive in jobs. Surveys to capture not attaining basic proficiency in science and workforce skills consistently show a mismatch mathematics, and 40 percent are not proficient between the skills with which graduates leave in reading. And even in Serbia, the top technical and higher education, and expressed performer in the Western Balkans, 40 percent private sector needs (World Bank 2018a, of students are functionally innumerate and 2018b, and 2019, among others). The gaps are about 30 percent are functionally illiterate, not only in job-specific technical skills but also compared to an OECD average of 20 percent in higher-order cognitive and socioemotional skills like communication and people skills (for 22 The Programme for International Student Assessment (PISA) is managers and professionals) and basic cognitive a triennial international survey evaluating education systems and time management skills. Firms in the region worldwide by testing the skills and knowledge of 15-year-old students. See http://www.oecd.org/pisa/. also find it hard to find workers with soft skills 50  |  11. Focus Section on Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion REFORM MOMENTUM NEEDED Figure 11.5. There is room to improve Western Balkan’s health systems to properly insure people and deliver better outcomes. NCD burden, in thousands Out of pocket health expenditures 40 80 ARM UKR AZE IRQ MMR NGA BGR PAK IND 35 LVA LTU EGY 60 GEO RUS ROU GTM GEOALB MDA SRB HUN PHL MAR MUS IDN 30 BIH HRV EST MDAVNMLAO UKR ECU DOM BGR MNEMUSGRC DEU 40 GUY TUN MNG SRB MEX IRN LVA CYP KAZ MKD POL SVK PRT CZE NIC PRY LKA MKD MYS RUS GRC TTO KORMLT 25 ARM TTO MLTFINDNK AGO LBN PER MNE CHL PRT CHN LTU AZE URY KAZ SVNITA GBRBELNLD AUT SLV KOSBIH BRAGAB PAN HUN DZA MMR GUYMAR ALB MNG CHN SYC ESP JPN SWE CAN JOR JAM POL EST ITA BHR ISR ESP TON FRA NZL 20 CRI ROU FIN AUS 20 LAO IND JAM PHL EGY IDN BRA THAARGCHL CYP AUS COL ARG URY TUR SVK HRV CZE GBR AUT BELISL SWE CANSAU PAK VNM SLV TUN LKA DOM IRN TUR KOR ISL TON TLSSWZ NAM ZAF THA SVN JPN NZL DNK DEUNLD SWZ ZAF MEX DZAGAB TLS PRYECU LBNCRI MYS ISR BWA FRA OMN GTM PAN BHR SYC 15 AGO NAM COL 0 NIC NGA JOR PER BWA IRQ OMN SAU 5 10 20 50 5 10 20 50 GDP per capita PPP, 2017, in thousands GDP per capita PPP, 2017, in thousands ▬▬GDP-adjusted average ……EU average ▬▬GDP-adjusted average ……EU average ……WHO recommended threshold Source: World Bank calculations based on World Development Indicators. Note: Disability-Adjusted Life Years (DALY) capture lost years of “healthy” lives. For details, see https://www.who.int/healthinfo/global_burden_disease/metrics_daly/en/. like reliability, resilience, adaptiveness, problem six countries is still pervasive, and overweight solving, and teamwork. in the adult population is prevalent (North Macedonia and Montenegro) or increasing rapidly (Albania and Serbia). Health systems that impoverish people and fail to address new diseases Health systems in the region have not yet been reformed to address these new NCDs are rising dramatically in all Western challenges, leading to poor outcomes. Health Balkan countries except Kosovo. In all except systems are costly but ineffective because they Kosovo an aging population is contributing are overwhelmingly hospital-centric. There is to a rise in NCDs, especially cardiovascular little health promotion or preventive care in diseases, diabetes, and cancers. Across the communities or workplaces. Funding of cost- Western Balkans, the burden of NCDs is effective primary health care, which is more already higher than the average for their level of efficient in preventing and treating NCDs, has development, and in Bosnia and Herzegovina, not kept up with the speed with which NCDs Montenegro, and Serbia it is higher than are growing. Substantial gains in population the EU average (Figure 11.5, left panel). health could also be achieved by controlling This directly affects the ability of citizens to tobacco use and improving air quality (Fuchs, contribute economically and socially to their Orlic, and Cancho 2019). Without reforms, country’s prosperity. In North Macedonia, for premature mortality caused by NCDs will example, almost 20,000 productive years are remain much higher in the Western Balkans lost annually due to premature deaths from than in the EU. NCDs, and many more from disability or early retirement (World Bank 2018d). Among other Western Balkan countries are also facing substantial risk factors associated with NCDs difficulties in addressing children’s early are the fact that tobacco consumption in all health and development, and a few also 11. Focus Section on Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion  |  51 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 face high rates of maternal and child Out of focus social assistance mortality. The number of women dying in childbirth in Albania is estimated to be more Western Balkan countries spend heavily on than double that in many EU countries, and social assistance, ranging from 1.2 percent in North Macedonia rising child mortality of GDP in North Macedonia to 2.8 percent rates are more than triple the EU average in Kosovo  (Figure 11.6). In Bosnia and (World Development Indicators). Almost one Herzegovina, Kosovo, and Montenegro it in five Roma children in Serbia, Kosovo and exceeds the average social assistance spending North Macedonia are stunted, a sign of long- of countries in Eastern Europe and Central standing malnutrition (compared to around Asia, the region that spends the most on social one in twenty non-Roma children). Some assistance; and in all Western Balkan countries of the most basic health care activities, such it is also higher than regional averages for South as immunization against infectious diseases, Asia, the Middle East and North Africa, and are also not reliably performed. Only around East Asia. 90% of children in the poorest wealth quintile in Serbia, Kosovo and North Macedonia are Figure 11.6. Social assistance spending is vaccinated against measles, for example—less relatively high but is not necessarily intended for the poor. than the number required to reliably prevent Social assistance spending, including social pensions, outbreaks (UNICEF 2019). percent of GDP 3.0 Impoverishment due to the catastrophic cost 2.5 of severe illness is also a major threat. While 2.0 except for Kosovo all Western Balkan countries 1.5 have public health insurance, coverage tends 1.0 to be low or inadequate. The share of out- of-pocket payments in total spending on 0.5 health ranges from 29 percent in Bosnia and 0 SA MNA EAP LAC SSA ECA MKD ALB MNE SRB BIH KOS Herzegovina to 57 percent in Albania (Figure JJLast resort social assistance 11.5, right panel). The recommended WHO Source: World Bank (2018g); World Bank (2018c) for LRSA; and World threshold is 20 percent. High out-of-pocket Bank calculations for Montenegro (2017) and Bosnia and Herzegovina (2017). expenditures also make it likely that the poorest Note: Latest year available. Figures include social pensions but not all social protection expenditures such as pension transfers. The ECA average households forego needed health care because does not include the Western Balkans. for them it is unaffordable. Soaring NCDs are bound to make financing health even more However, most social assistance spending is problematic. Making public spending on health not designed to support the poor. Programs more efficient has become even more urgent. specifically designed to support the poor (Figure 11.6) represent only a small proportion of total spending on social assistance, from 4 percent in Bosnia and Herzegovina to 17 percent in Albania and Serbia Most social assistance spending in the region is distributed to specific categories of people, not all of whom are poor. 52  |  11. Focus Section on Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion REFORM MOMENTUM NEEDED An incidence analysis shows that the percentage last-resort social assistance programs may in of individuals receiving social assistance, fact discourage beneficiaries from seeking directly or indirectly, in the poorest income employment. And despite the region’s massive quintile varies from 44 percent in Bosnia and unemployment problem, apart from Serbia and Herzegovina to 22 percent in Montenegro; for Montenegro spending on employment services comparison, coverage of the poorest quintile is and active labor market programs (ALMP) is close to 90 percent in Romania, and more than far below the OECD average of 0.56 percent 60 percent in Bulgaria and Ukraine (World of GDP (Figure 11.7). Employment programs Bank 2018c, latest year available). and intermediation services are also often tailored to the profiles of formal sector and In some Western Balkan countries, poverty middle-class workers, rather than the needs of alleviation programs are massively outspent the poor. More could be done to enhance the by grants to groups falling beyond the scope employability of the poor to help them escape of social assistance. Grants to war veterans, poverty. In North Macedonia, for example, the for instance, amount to 1.9 percent of GDP in World Bank’s Public Finance Review notes that Bosnia and Herzegovina (against 0.8 percent for in the last decade social assistance did little to disability, families with children, and poverty reduce poverty and improve labor outcomes, alleviation programs; World Bank 2018e); and mainly due to the low and fragmented coverage Kosovo spends about 2 percent on war-related of social assistance programs. schemes and pensions (World Bank 2018c). Introducing means-testing in these programs would free up large amounts that could be used A pressing and persistent lack of to better alleviate poverty. inclusion In most Western Balkan countries there Poor human development outcomes can be is also a weak link between the social linked to a persistent lack of inclusion: some assistance system and employment services vulnerable groups have significant gaps in and programs. Eligibility rules for some human capital that affect countries’ ability Figure 11.7. Spending on employment services and programs remains low in most countries in the Western Balkans. Spending on employment services and programs, % GDP 1.0 0.9 0.8 0.7 0.6 OECD average 0.56% 0.5 0.4 0.3 0.2 0.1 0 9 1 3 2 3 2 3 4 4 4 2 3 4 6 6 4 4 4 2 4 4 ia 0 R. 1 nia 1 tvia 1 rbia 1 atia 1 egro 1 aria 1 aine 1 stan 1 ania 1 rkey 1 ania 1 BIH 1 ovo 1 onia 1 ova 1 enia 1 arus 1 ijan 1 stan 1 uan Kyrgyz Esto La Se Cro nten Bulg Ukr zakh Rom Tu Alb Kos aced Mold Arm Bel zerba Tajiki Lith M o K a M A rth No Source: World Bank (2018c), and World Bank estimates for Bosnia and Herzegovina. 11. Focus Section on Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion  |  53 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 to improve overall human development 30 percent of new labor market entrants will outcomes. At age 15, for instance, children in be from vulnerable and minority backgrounds rural areas are on average a full year behind in (World Bank 2015). Failure to address the their learning compared to children in urban inclusion challenge will affect not only the areas; and children from the poorest 20 percent well-being of the poor, but also national of households are almost three years behind competitiveness and economic performance. children from the richest 20 percent (PISA data and World Bank 2017). Figure 11.8. Education outcomes among vulnerable Roma remain dismally low. For some minority groups, such as the Upper secondary completion rates, % 100 Roma, human development outcomes 90 remain dismally low. A recent EU-UNDP- 80 70 WB survey of vulnerable communities in the 60 Western Balkans found that only 20 percent 50 of Roma youth aged 22–25 had completed 40 upper secondary school, compared to 30 20 80 percent of non-Roma youth in the same 10 neighborhoods (Figure 11.8). Differences 0 ALB BIH KOS MNE MKD SRB in human development outcomes extend QQRoma QQNon-Roma beyond education, to labor market and health Source: Robayo-Abril and Millán (2019). Note: Vulnerable groups aged 22–25. outcomes, among others. The proportion of youth not in employment, education, or training averages 68 percent in vulnerable The way forward: More and better Roma communities, against 34 percent for investments in human capital their non-Roma neighbors; and stunting is three times more prevalent among Roma Western Balkan countries need to invest children under 5 than among majority children more efficiently in human capital. The region in Montenegro, North Macedonia, and Serbia. has achieved notable progress in expanding Roma women and minorities women are at access to basic education and health, and even more disadvantageous position (Robayo- setting up social protection systems to protect Abril and Millán 2019). the vulnerable. With stronger human capital Western Balkan societies would be better Addressing the inclusion challenge matters prepared to take advantage of the opportunities not only for poverty reduction but also for offered by rapid technological changes, mitigate growth. Without appropriate human capital risks, and create dynamic growing economies endowments, vulnerable youth cannot realize where young people can thrive and realize their their full potential to contribute to economic aspirations. Digital technologies (robotics, ICT, activity. And with populations aging in most of artificial intelligence) will transform the world the region and fertility rates higher among the of work, but could increase inequality as some poor, more and more new labor market entrants workers see wages stagnate or jobs displaced. will be from relatively deprived backgrounds. Investments in people are thus needed so that In Serbia, for instance, by 2030 an estimated citizens are positioned to flourish. 54  |  11. Focus Section on Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion REFORM MOMENTUM NEEDED Improving human capital requires deep pocket health expenditures. Reforms should reforms that build on one another; be directed to reproductive health and antenatal significant investments; and time—a care services and children’s health care. Health considerable amount of time. Meaningful care at all levels also needs to better adapt to improvements in the quality of education can aging populations and the dramatic rise of take from 10 to 30 years23; In Brazil and Chile, NCDs. As a first step, primary care should be it took 15 years and continuous efforts to enhanced and expanded into the places where integrate social assistance programs and build people live and work. Health insurance systems a comprehensive social registry; and for Peru also need to be broadened and optimized to to achieve one of the world’s most successful reduce out-of-pocket spending, in particular reductions in stunting (15 percentage points), among poorer households, for whom health it took 11 years of sustained effort (Marini care is significantly worse and payments higher, and Rokx 2016). Given the magnitude of the which leaves them with the dreadful choice of human development challenges in the Western not seeking treatment or falling further into Balkans—especially from the perspective of EU poverty. accession—it is imperative for countries to act quickly. Social assistance systems should concentrate on alleviating poverty and vulnerability In education, there is a need to improve the and integrating case management to ensure quality, relevance, and inclusion of existing effective support throughout the lifecycle. systems. In the early ages, access to quality Social assistance systems should not only childcare centers needs to be expanded—with support people suffering from poverty but children from poor and vulnerable backgrounds also promote acquisition of human capital given priority. In basic education, teacher and the employability of the poor throughout and curriculum reforms and better school the active life cycle. Integrating programs and management could go a long way in ensuring case management and tailoring social services that students acquire solid foundational to the vulnerabilities of different types of skills. And in TVET and higher education households have consistently proven to be institutions, ensuring quality certification and effective in reducing poverty, ensuring that accreditation and closer links with the private poor children learn and remain in good health, sector could boost the labor market relevance and promoting employment. Social assistance of the teaching and training that is imparted. must be refocused to address actual needs and At all levels of education, there is also a need vulnerabilities, rather than covering broad to more carefully monitor student performance categories of beneficiaries whether or not they and outcomes, and to give more support to need it. Programs and case management can also poor and low-performing students. be better integrated: only two Western Balkan countries have a well-established social registry Health reforms should concentrate on (the basis for integrated case management), addressing the lifelong consequences of poor although others are currently developing it. ECD, the rise of NCDs, and excessive out-of- And more efficient investment in ALMPs, as well as better integrating employment 23 That is, increasing learning outcomes by half a standard deviation; see Hanushek and Woessmann (2008). 11. Focus Section on Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion  |  55 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 programs with social assistance, could enhance the employment prospects of the poor. Even if all goes smoothly, improving human capital will take several political cycles, hence consensus-building and evidence- based policy making should be integral to any reform. Progress is too often impeded by a lack of coherence and consistency across reform cycles. Sustainable improvements in human capital require broad political consensus and willingness of the entire polity to maintain reform momentum and ensure that future governments will build upon the foundations laid down by past ones—rather than dismantling achievements and starting from scratch. Solid, gradual progress may be better at times than major but controversial reforms. Evidence-based policy making, with reforms adapting international best practices to the local context and their success assessed against carefully defined, measurable objectives helps shield reforms from political cycles. These reforms will take time. But there is an urgent need to agree on a clear path forward to boost human capital in the region and, even if in small steps, start acting now. 56  |  11. Focus Section on Human Capital in the Western Balkans: A Missing Link to Growth and Inclusion REFORM MOMENTUM NEEDED References Programs in the United States, edited by Robert Moffitt. Chicago, IL: University of Chicago Press. Flabbi, Luca, and Roberta Gatti. 2018. “A Altinok, Nadir, Noam Angrist, and Harry Primer on Human Capital.”World Bank Anthony Patrinos. 2018. “Global Data Policy Research Working Paper 8309, Set on Education Quality (1965–2015).” Washington, DC. World Bank Policy Research Working Fuchs, Alan, Edvard Orlic, and Cesar A. Paper 8314. Washington, DC. Cancho. 2019. “Time to Quit  : The Arias, Omar S., Carolina Sánchez-Páramo, Tobacco Tax Increase and Household María E. Dávalos, Indhira Santos, Erwin Welfare in Bosnia and Herzegovina.” R. Tiongson, Carola Gruen, Natasha Washington, DC: World Bank. de Andrade Falcão, Gady Saiovici, and Gilleskie, Donna, and Denise Hoffman. 2014. Cesar A. Cancho. 2014. “Back to Work: “Health Capital and Human Capital as Growing with Jobs in Europe and Central Explanations for Health-Related Wage Asia.” Washington, DC: World Bank. Disparities.” Journal of Human Capital. Berlinski, Samuel, and Norbert Schady. 2016. doi:10.1086/677855. The Early Years: Child Well-Being and the Hanushek, Eric A., and Ludger Woessmann. Role of Public Policy. Washington, DC: 2008. “The Role of Cognitive Skills in Inter-American Development Bank. Economic Development.” Journal of doi:10.1057/9781137536495. Economic Literature 46 (3): 607–68. Brunello, Giorgio, Pierre Carl Michaud, and Heckman, James J., and Dimitriy V. Masterov. Anna Sanz-de-Galdeano. 2009. “The 2007. “The Productivity Argument for Rise of Obesity in Europe: An Economic Investing in Young Children.” Review of Perspective.” In Economic Policy. Agricultural Economics, 29: 446–93. doi:10.1111/j.1468-0327.2009.00226.x. Hoddinott, John, Jere R. Behrman, John Campolieti, Michele, and Harry Krashinsky. A. Maluccio, Paul Melgar, Agnes R. 2006. “Disabled Workers and Quisumbing, Manuel Ramirez-Zea, Wage Losses: Some Evidence from Aryeh D. Stein, Kathryn M. Yount, Workers with Occupational Injuries.” and Reynaldo Martorell. 2013. “Adult Industrial and Labor Relations Review. Consequences of Growth Failure in Early doi:10.1177/001979390606000107. Childhood.” American Journal of Clinical Caselli, Francesco, and Antonio Ciccone. Nutrition. doi:10.3945/ajcn.113.064584. 2013. “The Contribution of Schooling in Hsieh, Chang Tai, and Peter J. Klenow. 2010. Development Accounting: Results from “Development Accounting.” American a Nonparametric Upper Bound.” Journal Economic Journal: Macroeconomics. of Development Economics. doi:10.1016/j. doi:10.1257/mac.2.1.207. jdeveco.2013.02.006. Marini, Alessandra, and Claudia Rokx. 2016. Elango, Sneha, Jorge Luis García, James Standing Tall: Peru’s Success in Overcoming J. Heckman, and Andrés Hojman. Its Stunting Crisis. Public Disclosure. 2016. “Early Childhood Education.” doi:10.1109/CCDC.2013.6561448. In Economics of Means-Tested Transfer OECD, (Organisation for Economic Co- References  |  57 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 operation and Development). 2016. Targeting, and Poverty Impact of Social PISA 2015 Results (Volume I): Excellence Assistance in Bosnia and Herzegovina.” and Equity in Education. PISA. Washington, DC. doi:10.1787/9789264266490-en. ———. 2018f. “The Human Capital Project.” Psacharopoulos, George, and Harry Anthony Washington, DC. https://openknowledge. Patrinos. 2018. “Returns to Investment worldbank.org/handle/10986/30498. in Education: A Decennial Review of the ———. 2018g. “The State of Social Safety Global Literature.” Education Economics. Nets 2018.” Washington, DC. https:// doi:10.1080/09645292.2018.1484426. openknowledge.worldbank.org/ Robayo-Abril, Monica, and Natalia Millán. handle/10986/29115. 2019. “Breaking the Cycle of Roma ———. 2019. “Skills for More and Better Jobs Exclusion in the Western Balkans.” in Serbia.” Washington, DC. Washington, DC: World Bank. UNICEF, (United Nations International Children’s Emergency Fund). 2019. “UNICEF Multiple-Indicator Cluster Surveys.” World Bank. 2015. “Serbia  : Systematic Country Diagnostic.” Washington, DC. https://openknowledge.worldbank.org/ handle/10986/23104. ———. 2017. “PISA 2015: Europe and Central Asia.” Washington, DC. http:// documents.worldbank.org/curated/ en/944801487709204308/pdf/112950- BRI-PUBLIC-ADD-SERIES- PISA2015ECA-regionreportV18.pdf. ———. 2018a. “Demand for Skills in Albania: An Analysis of the Skills Towards Employment and Productivity Survey.” Washington, DC. ———. 2018b. “Kosovo Country Report: Findings from the Skills Towards Employment and Productivity Survey.” Washington, DC. ———. 2018c. “Kosovo Social Assistance Scheme Study.” Washington, DC. ———. 2018d. “Seizing a Brighter Future for All: Former Yugoslav Republic of Macedonia Systematic Country Diagnostic.” Washington, DC. ———. 2018e. “Technical Note on Coverage, 58  | References Country Notes REFORM MOMENTUM NEEDED Albania • In 2018, a rise in energy production helped to push economic growth in Albania to 4.2 percent. • Unemployment has declined due to job creation and increased labor force participation in recent years. • A primary fiscal surplus resulting from fiscal consolidation and appreciation of the exchange rate have helped to reduce public debt, but off-balance-sheet risks are mounting. • Strong services exports helped narrow the current account deficit to 6.3 percent of GDP. • Growth is projected to moderate to 3.7 percent through 2020 as economic dynamism gradually closes the output gap. The positive outlook is subject to external and domestic risks, though these can be mitigated by a firm government commitment to macroeconomic sustainability and structural reforms. Recent Economic Developments dynamics encouraged job searchers and entry into the labor force, despite a four-year Growth accelerated in 2018 to an estimated drain on the working-age population due to 4.2 percent. With hydrological conditions emigration. However, labor force participation exceptionally favorable, energy production is still low at 59.4 percent, and there are major more than doubled in the first nine months, gaps between male and female participation making up for nearly half of the GDP growth rates. The unemployment rate, after declining for that period. Tourism boosted growth of for 11 consecutive quarters, slightly increased services; the number of foreign citizens visiting by 0.1 p.p at 12.3 percent at the end of the year. the country for leisure rose by 15.9 percent Youth unemployment rate fell by 2.3 pp y-o-y. year-on-year (y-o-y) in 2018. On the spending The average real wage increased by 1.6 percent side, consumption contributed 1.9 percentage at the end of 2018. points (pp) to estimated growth, supported by higher employment and wages. Net exports, Minimal inflationary pressures prompted especially of energy and services, contributed an easing of monetary policy, in line with 1.3 pp. Private investment moderated due to the Bank of Albania’s (BoA) price stability the winding down of two large energy projects framework. Headline inflation of 1.8 percent financed by foreign direct investment (FDI), at year-end 2018 was below the BoA’s 3 percent but public investments in infrastructure target. Inflation dynamics during the year speeded up; by year-end the contribution of reflected mostly food prices, with some pass- investment to growth was 1 pp. through effects resulting from the exchange rate appreciation in the second half of the Growth supported job creation in all sectors, year. Inflationary trends as indicated by core and with more Albanians participating inflation (0.4 percent at year-end) show little in the labor force, unemployment went demand pressure. After the exchange rate down. Average employment growth in 2018 appreciation, the BoA intervened in the foreign was strongest in industry (4.7 percent y-o-y) exchange market and in June eased monetary and services (4.2 percent). The labor market policy by taking the policy rate to a record Albania  |  61 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 low of 1 percent; the change was transmitted underperforming, curbs on the wage bill and to short-term government securities and, to social benefits brought current spending as a lesser extent, deposit and lending rates.1 a share of GDP down from 25.3 percent Through 2018 the lek appreciated by about in 2017 to 24.3 percent. Capital spending 5 percent against the euro. went up slightly, by 0.3 pp of GDP as new infrastructure projects were launched—PPPs The banking system is well-capitalized for infrastructure projects rose rapidly. Though and liquid, but credit to the private sector PPPs do alleviate funding constraints in the continued to contract. As the BoA continued short term, they increase contingent liabilities its efforts to reduce nonperforming loans, that may narrow the fiscal space for new they had fallen to 11.1 percent of total loans investments in later years. Thus PPPs need to by December 2018. Despite monetary easing, be continuously re-evaluated. Budgetary arrears credit to the private sector as a share of GDP (e.g., VAT refunds and road infrastructure and fell by 2 percent (y-o-y). The main cause was local government arrears) amounted to about the decline of credit in foreign currency and 1.5 percent of GDP in 2018, thwarting budget related exchange rate dynamics; credit in execution and undermining the credibility of local currency mostly went to households and the fiscal consolidation, with negative effects SMEs. Deleveraging by EU-owned banks is on private sector growth. The stock of public constraining credit supply, and on the demand debt and arrears declined to 68.6 percent of side, BoA surveys indicate that firms and GDP in 2018, mostly due to the exchange- households have little interest in borrowing. rate appreciation, but that is still high and carries risks for debt sustainability in case of Fiscal consolidation has helped to reduce adverse shocks. The government successfully public debt; now there is a need to address placed a seven-year €500 million Eurobond at such fiscal risks as contingent liabilities 3.5 percent in October and used €200 million from public-private partnerships (PPPs) to buy back a portion of its €450 million 2015 and from state-owned enterprises (SOEs). Eurobond expiring in 2020. Fiscal consolidation efforts continued in 2018 in the form of spending restraints. Revenues Strong exports and slowing growth in declined from 27.7 percent of GDP in 2017 imports improved the external position in to 27.2 percent, partly due to the clearance of 2018. The current account deficit (CAD) accumulated value added tax (VAT) refund narrowed from 7.5 percent of GDP in 2017 to arrears and to the effect of the exchange 6.3 percent in 2018. The trade deficit narrowed rate appreciation on VAT on imported to 13.5 percent of GDP, as rising exports of goods. However, personal income tax (PIT) electricity and services, supported 16.7 percent revenue and social security contributions export growth. FDI grew by 6.4 percent, which rose slightly, supported by wage increases and fully financed the CAD. Year-end foreign measures to reduce informality. With revenue reserve coverage of 6½ months of imports mitigated the risks posed by high external debt 1 Forex interventions were temporary introduced in June, to prevent excessive fluctuations in the exchange rate following capital of 62.1 percent of GDP. conversions of some commercial banks to domestic currency, and as announced, without compromising the commitment to maintain exchange rate flexibility. 62  | Albania REFORM MOMENTUM NEEDED Outlook and Risks Medium-term growth projections depend on the pace of structural reforms and Albania’s economic growth is expected to progress with EU accession. Efforts to moderate to 3.7 percent through 2020, with sustain fiscal consolidation, mitigate fiscal the return of energy production to normal risks from contingent liabilities, and accelerate and the completion of major investment energy sector reform are needed to safeguard projects. Services and construction are macroeconomic sustainability. Improving the expected to lead growth, which will be business climate and the rule of law remain supported by private consumption fueled priorities for EU accession and such efforts by labor income gains, further government should be complemented by investments in investment in infrastructure, and improvement infrastructure and human capital. That would in the business environment. Medium-term reap the benefits of EU accession and ensure projections assume that consumption will poverty reduction and shared prosperity. Given continue to grow at about 3.4 percent a year Albania’s limited resources, investments will and fixed capital formation at 3 percent. Net need to be prioritized. exports are also expected to support growth as market access expands, but their contribution Albania is vulnerable to a slowdown in is expected to be smaller as imports respond to Europe, particularly in its neighboring main domestic demand. trading partners. A lack of growth in these countries could mean lower Albanian exports, By 2020 the fiscal deficit is projected to remittances, and FDI. The expected tightening increase to 2.1 percent. The rise will be of monetary policy in advanced economies driven by government efforts to clear arrears would also raise financing costs given the and the adoption of fiscal incentives such as country’s high public debt, which is increasingly VAT exemptions, lower income tax rates, and being refinanced through foreign sources. A a higher ceiling for the high-income PIT tax slower-than-expected pace of reforms would bracket. Current expenditures on wages, social also affect economic and social prospects. transfers, and operation and maintenance are expected to be contained as a share of GDP, but capital spending will rise to 4.8 percent. PPPs are expected to finance an increasing share of public projects, some of them already signed in 2018 or in the pipeline, which will increase contingent liabilities. Albania  |  63 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Growth accelerated in 2018, driven by net The labor market improved. exports and investment. Contribution to GDP growth, percentage points Percent 6 60 50 4 40 2 30 0 20 -2 10 -4 0 201 1 201 2 201 3 201 4 201 5 201 6 201 7 8e 2019f 020f 12 13 14 15 16 Q1- 17 18 201 2 Q1- Q1- Q1- Q1- Q1- Q1- JJInvestment JJNet exports JJConsumption ▬▬Real GDP growth, % ▬▬Employment rate ▬▬Unemployment rate Source: Instat and World Bank staff projections. Source: Instat. Fiscal consolidation is helping reduce public Exchange rate appreciation helped keep debt. inflation low. Fiscal balance and public debt, percent of GDP CPI inflation, percent, y-o-y 80 0 6 70 -1 5 60 -2 4 50 -3 40 3 -4 30 2 -5 20 -6 1 10 0 -7 0 0 1 2 3 4 5 6 7 e f 201 201 201 201 201 201 201 201 2018 2019 2020 f -10 -12 -14 -16 -18 ec-18 Jan Jan Jan Jan Jan D JJPublic debt ▬▬Fiscal balance, rhs Source: Ministry of Finance and Economy and World Bank staff Source: Instat. projections. External imbalances were reduced. Private sector credit declined. € million Credit to the private sector, percent 1,600 1.0 1,400 0.5 1,200 0 1,000 -0.5 800 -1.0 600 -1.5 400 -2.0 200 -2.5 0 -3.0 13 13 14 14 15 15 16 16 17 17 18 18 -16 -16 v-16 -17 -17 -18 18 -18 Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Jan Jun No Apr Sep Feb Jul- Dec JJFDI inflows JJPortfolio inflows JJOther inflows ▬▬Current account deficit Source: Bank of Albania. Source: Bank of Albania. 64  | Albania REFORM MOMENTUM NEEDED ALBANIA 2014 2015 2016 2017 2018e 2019f 2020f Real GDP growth (percent) 1.8 2.2 3.4 3.8 4.2 3.8 3.6 Composition (percentage points): Consumption 4.5 -0.9 0.1 2.3 1.9 2.8 2.5 Investment -0.9 0.7 1.4 2.2 1.0 1.3 0.9 Net exports -1.8 2.4 1.9 -0.7 1.3 -0.2 0.2 Exports 0.9 0.5 6.5 4.6 3.0 3.3 3.4 Imports (-) 2.7 -1.9 4.6 5.3 1.7 3.5 3.2 Consumer price inflation (percent, period average) 1.6 1.9 1.3 2.0 2.1 2.5 2.9 Public revenues (percent of GDP) 26.3 26.6 27.6 27.7 27.2 27.2 27.1 Public expenditures (percent of GDP) 32.3 31.5 29.4 29.8 29.0 29.4 29.2 Of which: Wage bill (percent of GDP) 5.1 5.1 4.6 4.7 4.5 4.6 4.4 Social benefits (percent of GDP) 9.9 9.9 10.3 10.4 10.2 10.4 10.3 Capital expenditures (percent of GDP) 4.3 4.4 4.0 4.4 4.7 4.9 4.8 Fiscal balance (percent of GDP) -6.0 -4.9 -1.8 -2.0 -1.8 -2.1 -2.1 Primary fiscal balance (percent of GDP) -3.1 -2.2 0.5 0.0 0.4 0.1 0.1 Public debt (percent of GDP) 66.1 69.1 68.7 67.8 64.6 63.0 62.1 Public and publicly guaranteed debt 72.0 72.7 72.3 71.8 68.6 65.8 64.7 (percent of GDP) Of which: External (percent of GDP) 29.6 34.2 32.6 32.6 32.8 31.9 31.9 Goods exports (percent of GDP) 9.3 7.5 6.6 6.9 7.4 6.2 6.3 Goods imports (percent of GDP) 31.6 29.9 30.9 31.3 30.1 31.6 32.2 Net services exports (percent of GDP) 3.2 5.1 7.4 9.4 9.2 11.8 12.6 Trade balance (percent of GDP) -19.0 -17.3 -16.8 -15.1 -13.5 -13.6 -13.3 Remittance inflows (percent of GDP) 5.9 5.8 5.7 5.5 5.3 5.3 5.3 Current account balance (percent of GDP) -10.8 -8.6 -7.6 -7.5 -6.3 -6.4 -6.2 Net foreign direct investment inflows 8.1 8.0 8.7 8.6 7.8 6.8 6.8 (percent of GDP) External debt (percent of GDP) 69.5 74.4 73.4 68.7 62.1 59.8 59.1 Real private credit growth (percent, period average) -1.3 -1.8 -2.1 -2.3 -3.0 n.a. n.a. Nonperforming loans 22.4 18.2 18.3 13.2 11.1 n.a. n.a. (percent of gross loans, end of period) Unemployment rate (percent, period average) 17.5 17.1 15.2 13.7 12.3 n.a. n.a. Youth unemployment rate (percent, period average) 32.5 33.2 28.9 25.9 23.1 n.a. n.a. Labor force participation rate 53.7 55.7 57.5 58.3 59.4 n.a. n.a. (percent, period average) GDP per capita, PPP (current international $) 10,645 10,926 11,276 11,693 n.a. n.a. n.a. Poverty rate at US$5.5/day, PPP n.a. 37.4 36.7 35.9 35.2 34.4 33.5 (percent of population) Sources: Country authorities, World Bank estimates and projections. Note: Youth unemployment rate is for labor force aged 15-29. Albania  |  65 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Bosnia and Herzegovina • In 2018 Bosnia and Herzegovina (BiH) maintained steady growth estimated at 3 percent. The pace of growth is projected to pick up slightly in 2019, but this outlook rests largely on a rise in infrastructure investment and the timely formation of new governments and their advancement of structural reforms. • Modest job creation helped to decrease unemployment slightly, but it is still high. • Given the time it is taking to form the new government of the Federation of BiH and the BiH Council of Ministers, planned reforms to enhance the efficiency of public investments and to make the tax system and social security contributions more efficient and equitable—critical to sustainable and equitable growth—are likely to be delayed. • The economic outlook is stable, but vulnerabilities related to both domestic and external factors remain high. Slower-than-expected growth in the EU, tighter financial conditions internationally, and domestic political turmoil and divided views about BiH’s program for NATO accession are the main downside risks. To mitigate them will require a faster pace of structural reform. Recent Economic Developments Though trending upward, BiH’s employment rate is still low for the Western Balkans. With In 2018, BiH’s economy continued to growth stable over the last three years, there grow at a stable pace, but it remains highly have been modest gains in employment rate, dependent on consumption. Growth reached which reached 34.3 percent in 2018. Most an estimated 3 percent in 2018, down slightly jobs created were in industry and services; by 0.2 percentage points (pp) from 2017. agricultural employment fell in absolute terms. Domestic demand remained the dominant Combined with a fall in the activity rate, the driver, with consumption adding 3.6 pp and slight rise in the employment rate reduced investment 0.5 pp. Greater external demand the unemployment rate from 20.5 percent in has supported export growth, but imports 2017 to 18.4 percent in 2018, though that is offset this momentum so that net exports still high.2 Long-term unemployment went subtracted 1.0 pp from growth. Growth in down by nearly 2 pp but is still at 80 percent. exports was mainly in the same commodities The minimal improvements in the labor as a year earlier: mineral products, base market highlights the need for BiH to address metals, chemical products and machinery, structural rigidities if it is to stimulate private which totaled 50.7 percent of export growth; sector job creation and reduce disincentives to similarly, as in 2017, growth in imports was employment and labor market participation. driven by the same four categories as exports plus transportation equipment—together Prices continued to rise in 2018. Inflation as they explain 47.7 percent of import growth. measured by the consumer price index (CPI), BiH trade flows clearly need more diversified grew by 1.6 percent y-o-y in December 2018, exports. For production, the main contributors driven by higher prices for transport, tobacco, to growth in 2018 were services (2.1 pp), and rental housing. Core inflation remained industry (0.9 pp) and agriculture (0.1 pp). 2 According to the latest Labor Force Survey (2018). 66  |  Bosnia and Herzegovina REFORM MOMENTUM NEEDED low. Given that growth in nominal salaries was have a high import content that reduces the 4.9 percent y-o-y, the effect on real incomes positive impact on the CAD of export growth, was positive. although the import content has been growing in recent years, even if at a slower rate. Base The fiscal position is estimated to have metals and mineral products represented returned to deficit in 2018. The BiH 2018 fiscal 51 percent of total exports in 2018, but also deficit was an estimated 0.5 percent of GDP, 49 percent of total imports, which have compared to a surplus in 2017 of 2.6 percent.3 1.6 times more value than exports. The services In 2018, revenues rose due to collection of surplus from transport, travel, construction, more in indirect taxes. However, the rise in and remittances was almost unchanged and was revenues was offset by higher public spending, enough to finance a significant part of the trade mainly current spending related to social deficit. The rest was financed by the capital benefits, wages (i.e., the one-time increase for account, mainly through other investment and demobilized veteran benefits in the Federation FDI. Estimated net FDI inflows increased in and a wage rise in Republika Srpska), and nominal terms but decreased in terms of GDP capital projects. Though capital spending went by 0.1 pp, financing 42 percent of the CAD. up, it is still not sufficient and there are also long-standing project implementation delays. Total public and publicly guaranteed debt was Outlook and Risks estimated at 36.7 percent of GDP4 (down by 1.3 pp from 2017), of which 29.8 percent of Economic growth is projected to strengthen GDP is concessional debt to international gradually to 3.9 percent by 2020, supported financial institutions. mainly by domestic demand. This pickup in growth is hinged on timely formation of The banking sector is liquid and well- a new government and advancement of the capitalized. Though again declining, the BiH Reform Agenda. In the medium term, system-wide NPL ratio in Q3 was still a growth would be driven by higher investment high 9.4 percent. Profitability, however, went in energy, construction, and tourism, and by down, with return on equity at 11.1 percent higher exports, although demand for imports in Q3, down from 12.1 percent in Q2 but up for infrastructure projects would outpace from 10.2 percent in 2017 Q4. The capital export growth. While some rebalancing away adequacy ratio is still relatively stable at 15.5 from public consumption is expected, private in 2018 (Q3). Capital buffers are within legal consumption is forecast to remain a major requirements. driver of growth, driven by steady remittance flows. The current account deficit (CAD) widened slightly in 2018 as both imports and exports The fiscal balance is expected to improve started to pick up. It went from 4.7 percent in 2019, rebalancing to capital spending. of GDP in 2017 to 4.9 percent. BiH exports, As the planned construction of highways particularly machinery and chemical products, moves forward, the share of capital spending is expected to grow faster than the average of 3 See the CBBiH web portal panorama for data on GFS. 4 See the CBBiH web portal panorama for debt data. the previous three years. The share of recurrent Bosnia and Herzegovina  |  67 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 spending is expected to fall in the medium- There are notable risks to the outlook, term, given the authorities’ commitment not to both domestic and external. The main increase the wage bill further. Sustaining this domestic risks are the challenging political commitment will be important to reverse BiH’s environment and the slow pace of structural public expenditure patterns which remain reform. Externally, delays in NATO accession, concentrated current spending including slower-than-expected growth in the EU, and wages, pensions and social transfers. In 2019 tighter financial conditions in global markets the stock of public debt should continue to are of concern. On the positive side, in 2019 decline, falling to 35.6 percent. However, fiscal BiH could receive a ruling from the European risks will remain significant, including from Commission accepting its candidacy status, arrears and other SOE-related liabilities. which could help to accelerate reforms. Central to the BiH reform agenda is addressing persistent unemployment, boosting growth, and maintaining macroeconomic stability. Although fiscal deficits and debt levels continue to be moderate, the tax burden is high and public spending is inefficient, as evidenced by the poor targeting of benefits. Planned fiscal reforms are designed to reinforce the social contribution system and introduce a progressive income tax. In combination with others, these reforms will help structure a fairer and more growth-enhancing tax system. Provision of a safety net, however, will not be effective if structural rigidities in spending are not addressed—especially the high public wage bill. A strong and sustained commitment is needed to advance reforms in entity governments called for in the Economic Programs. Support from partners can help the authorities to deliver on their challenging reform agenda. 68  |  Bosnia and Herzegovina REFORM MOMENTUM NEEDED GDP growth slowed moderately in 2018. Consumer price inflation stabilized in the second part of 2018. Contributions to growth, percentage points of GDP Percent y-o-y 4 2 1 3 0 2 -1 1 -2 -3 0 -4 -1 -5 -2 -6 201 2 201 3 201 4 201 5 201 6 201 7 8e -15 -15 -15 -16 -16 -16 -17 -17 -17 -18 -18 -18 -18 201 Jan May Sep Jan May Sep Jan May Sep Jan May Sep Dec JJAgriculture JJIndustry JJServices QQOverall GDP growth JJOverall CPI inflation Source: BiH Agency for Statistics, World Bank. Source: BiH Agency for Statistics, World Bank. Collection of indirect gross tax revenues The fiscal balance is expected to remain in improved at year-end. surplus in the medium term. Real 3 months moving average (3mma), percent y-o-y Percent of GDP 14 3 12 10 2 8 6 1 4 2 0 0 -2 -4 -1 -15 -15 -15 -16 -16 -16 -17 -17 -17 -18 -18 -18 -18 201 5 201 6 201 7 8e 9f 0f Jan May Sep Jan May Sep Jan May Sep Jan May Sep Dec 201 201 202 ▬▬Growth in total indirect revenues (in 2010 prices, 3mma yoy) JJGeneral government fiscal balance ▬▬Growth in net indirect revenues (in 2010 prices, 3mma yoy) Source: BiH Indirect Tax Office, World Bank. Source: Fiscal authorities, World Bank estimates. The deficit in the goods trade continued to Nonperforming loans in commercial bank widen. portfolios remain high but trending down. 3 mma, percent y-o-y, and the goods trade balance in KM Percent billions 30 8 18 6 16 20 14 4 12 10 2 10 0 0 8 -2 6 -10 4 -4 2 -20 -6 0 -30 -8 -2 -15 -15 -15 -16 -16 -16 -17 -17 -17 -18 -18 -18 13 13 14 14 15 15 16 16 17 17 18 18 Jan May Sep Jan May Sep Jan May Sep Jan May Sep Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- JJTrade balance (12m sum, rhs) ▬▬Exports (3mma y/y, lhs) JJCapital adequacy (tier 1 capital to risk weighted assets) ▬▬Imports (3mma y/y, lhs) ▬▬Asset quality (NPLs to total loans) ▬▬Profitability (return on equity) Source: BiH Agency for Statistics, World Bank. Source: Central Bank of BiH, World Bank calculations. Bosnia and Herzegovina  |  69 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 BOSNIA AND HERZEGOVINA 2014 2015 2016 2017 2018e 2019f 2020f Real GDP growth (percent) 1.1 3.1 3.1 3.2 3.0 3.4 3.9 Composition (percentage points): Consumption n.a. n.a. n.a. n.a. 3.6 2.7 3.1 Investment n.a. n.a. n.a. n.a. 0.5 0.9 0.8 Net exports n.a. n.a. n.a. n.a. -1.0 -0.2 0.0 Exports n.a. n.a. n.a. n.a. 1.7 1.8 1.4 Imports (-) n.a. n.a. n.a. n.a. 2.7 2.0 1.3 Consumer price inflation (percent, period average) -0.9 -1.0 -1.6 0.8 1.4 1.1 1.1 Public revenues (percent of GDP) 43.7 43.1 42.7 43.0 43.8 42.0 41.4 Public expenditures (percent of GDP) 45.8 42.5 41.5 40.4 44.3 41.7 40.2 Of which: Wage bill (percent of GDP) 11.9 11.5 11.0 10.6 11.0 10.6 10.2 Social benefits (percent of GDP) 17.0 16.5 15.9 15.2 18.0 16.7 16.2 Capital expenditures (percent of GDP) 4.3 2.0 2.4 2.4 4.9 4.2 3.9 Fiscal balance (percent of GDP) -2.0 0.7 1.2 2.6 -0.5 0.3 1.2 Primary fiscal balance (percent of GDP) -1.2 1.6 2.1 2.6 0.5 1.2 2.1 Public debt (percent of GDP) 42.0 41.9 42.4 36.1 35.1 34.0 33.2 Public and publicly guaranteed debt 43.1 43.2 43.3 38.0 36.7 35.6 34.8 (percent of GDP) Of which: External (percent of GDP) 34.7 35.0 35.9 30.6 29.8 29.0 28.4 Goods exports (percent of GDP) 25.0 25.2 25.7 29.8 29.9 31.2 32.1 Goods imports (percent of GDP) 53.8 50.3 49.4 53.3 53.5 55.3 56.5 Net services exports (percent of GDP) 6.1 6.7 7.0 7.2 7.4 7.7 7.7 Trade balance (percent of GDP) -22.7 -18.5 -16.7 -16.3 -16.2 -16.4 -16.6 Remittance inflows (percent of GDP) 10.3 9.0 9.1 8.4 8.3 8.3 8.0 Current account balance (percent of GDP) -7.3 -5.3 -4.7 -4.7 -4.9 -5.3 -5.5 Net foreign direct investment inflows 2.9 1.8 1.7 2.1 2.0 2.1 2.1 (percent of GDP) External debt (percent of GDP) 77.1 72.2 71.0 67.6 70.5 67.4 66.7 Real private credit growth (percent, period average) 4.1 2.3 4.7 5.3 5.1 n.a. n.a. Nonperforming loans 14.0 13.7 11.8 10.0 n.a. n.a. n.a. (percent of gross loans, end of period) Unemployment rate (percent, period average) 27.5 27.7 25.4 20.5 18.4 n.a. n.a. Youth unemployment rate (percent, period average) 62.7 62.3 54.3 45.8 38.8 n.a. n.a. Labor force participation rate 43.7 44.1 43.1 42.6 42.1 n.a. n.a. (percent, period average) GDP per capita, PPP (current international $) 11,164 11,526 12,173 12,875 13,200 13,775 14,258 Poverty rate at US$5/day, PPP n.a. n.a. n.a. n.a. n.a. n.a. n.a. (percent of population) Sources: Country authorities, World Bank estimates and projections. Note: Nonperforming loans show year-to-date actuals. 70  |  Bosnia and Herzegovina REFORM MOMENTUM NEEDED Kosovo • In 2018 the economy continued to grow at an estimated 4.2 percent, driven by higher service exports and private and public investment. • The 2018 fiscal deficit is estimated at 2.7 percent of GDP, (in line with the fiscal rule) and was driven by higher infrastructure spending. • Kosovo continues to experience economic growth without job creation. The recovery in employment in the second half could not compensate for the job losses in the first half, despite strong economic growth. • The outlook is positive, with average growth projected at 4.5 percent through 2020, but is subject to risks from political uncertainty, proliferation of untargeted social benefits, the new law on public salaries, and dilatory execution of infrastructure investments. Recent Economic Developments declined by 1 pp in 2018, however this was driven by a decrease in labor force participation Growth in 2018 remained solid at 4.2 percent. by 1.9 pp. Youth unemployment increased Public and private investment contributed by 2.6 pp y-o-y, adding to social pressures. 5.7 percentage points (pp) to growth, up from Labor force participation is also chronically 1.5 pp in 2017. Private investment continued low at 40.9 percent as a share of working age to increase, through higher investment population. lending and partly by a recovery of FDI in the second half of the year. Public investment also The fiscal deficit was 2.7 percent in 2018 but accelerated, financed by privatization proceeds. was in line with the fiscal rule.6 Higher growth Consumption contributed 2 pp, drawing on supported a rise in revenues of 4.5 percent, higher public wages, remittances, and consumer despite the lower than expected performance lending. Net exports subtracted 3.5 pp from of excise tax revenues. Indirect tax revenues real GDP growth; imports were higher to meet grew by 2.2 percent thanks to growth in VAT the demand for capital goods. Exports added a revenue of 8.1 percent, and nontax revenues mere 1.8 pp to growth due to lower exports of grew by 5.6 percent. Direct tax revenues base metals, but there was encouraging growth grew 12.1 percent, as corporate income tax in tourism services, due mainly to higher collection went up 15.7 percent and personal spending by the Kosovar diaspora.5 11.1 percent. Spending went up 9.8 percent driven by an 8.8 percent increase in current Higher growth did not translate into job expenditure and 13 percent growth in capital creation. The recovery in the number of expenditures which pushed up capital spending employed during the second half of 2018 to 8.1 percent of GDP. The absorption of could not compensate for the job losses in IFI-financed capital investments under the the first half. Employment rate declined by investment clause, however, was weak for the 1 pp in 2018 and employment at 28.8 percent second consecutive year. While overall capital remains low. The unemployment rate also 6 Overall fiscal balance per fiscal rule definition excludes PAK- 5 2018 GDP figures are estimate; fourth quarter 2018 GDP statistics financed capital spending; and IFI financed capital spending will be released on April 4, 2019. through the investment clause. Kosovo  |  71 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 spending increased, capital spending declined in investment-driven imports. Remittances in nominal terms by 4.3 percent, not counting and FDI inflows continued to finance the the spending financed by privatization CAD, even though net FDI inflows were proceeds. This allowed for reallocation of down by 10.5 percent in 2018. Most FDI spending for underbudgeted items. Spending (85.8 percent) continued to be in real estate, for war veterans’ benefits in 2018 exceeded the driven by investments from members of the cap of 0.7 percent of GDP set by law. Increases diaspora in Switzerland and Germany. in social transfers and spending on goods and services were the main reasons for growth in current expenditure: social transfers-including Outlook and Risks veteran’s benefits, were up 12 percent and goods and services spending by 9.6 percent. The 2018 High capital spending is expected to keep deficit was 2.7 percent of GDP, but the deficit economic growth strong in 2019, w  ith a subject to the Kosovo’s fiscal rule definition was growth forecast of 4.4 percent, primarily driven only 1.3 percent as it excludes capital spending by higher investment, both public and private. financed by privatization receipts. Public and Several large public investment projects are publicly guaranteed debt reached almost expected to be commence implementation, 18 percent of GDP by end-2018. notably railway and regional road projects financed by IFIs. Private investment is expected Credit growth fueled both investment and to increase, driven by favorable lending consumption. By year-end nonperforming conditions and by FDI in the energy sector loans (NPLs) were down to 2.7 percent of total and in real estate. However, given the large loans. Improved market conditions and lower number of new entrants into the labor market, interest rates again spurred growth in private higher public spending will not be sufficient credit, by 10.8 percent. Loans to households to significantly reduce chronically high grew by 11.2 percent, and deposits grew by unemployment. 8.7 percent. The positive outlook is vulnerable to domestic For most of 2018 consumer prices went up political uncertainty, less IFI investment only slightly but the pace began to accelerate than expected, and slower growth in the EU. at the end of the year. Average inflation was only Moreover, the expansion of public investment 1.1 percent but also picked up late in the year: as a driver of growth through 2020 may suffer In December, y-o-y inflation was 2.9 percent from Kosovo’s limited capacity to carry out the due to increases in prices for fuel, food, tobacco, investment program. alcohol, and transportation. Tariffs imposed on goods imports from Serbia and Bosnia and Fiscal risks are on the rise. The new law Herzegovina may have contributed to the rise on public salaries, if not regulated through in consumer price inflation. prudent secondary legislation, could result in higher deficits that the fiscal rules or lead to The current account deficit (CAD) widened a deterioration in the composition of public to 8.4 percent of GDP as higher service spending. Because the law comes into force exports could not compensate for the surge only at the end of 2019, the full impact 72  | Kosovo REFORM MOMENTUM NEEDED will not be felt until 2020. Higher wages in the public sector can also put pressure on private sector wages, which could undermine the competitiveness of Kosovar exporters. Additional fiscal risks might arise from increases in untargeted social protection spending. By 2025 public and publicly guaranteed debt could reach 30 percent of GDP if growth in recurrent spending continues to exceed growth in revenue. To counterbalance the risks,reforms should be directed to preserving fiscal stability; shifting resources toward tradable sectors; investing more in education and health to realize the benefits of the demographic dividend and to improve skills; engaging and employing youth and women by reducing disincentives to labor market participation; increasing productivity by addressing the regulatory burden on businesses, improving the judicial system; addressing corruption; and building up environmental sustainability. Kosovo  |  73 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Investment and consumption were the main Services were the main engine of growth in reasons growth accelerated in 2018. 2018. Growth contributions, percent Growth contributions, percent 8 5 6 4 4 3 2 2 0 1 -2 -4 0 201 7 8e 9f 0f 201 6 201 7 8e 9f 0f 201 201 202 201 201 202 JJConsumption JJInvestments JJNet exports ▬▬Growth JJAgriculture JJIndustry JJServices JJTaxes less subsidy ▬▬Real GDP growth Source: Statistics Agency of Kosovo and World Bank. Source: Statistics Agency of Kosovo and World Bank. Despite fiscal pressures, the overall budget Consumer price inflation accelerated late in balance (right) stayed within the fiscal rule. 2018 and into 2019. Percent of GDP Percent y-o-y growth 32 0 3.5 31 3.0 30 -1 2.5 29 -1.2 -2 2.0 28 1.5 27 -3 1.0 26 -2.7 25 0.5 -4 -3.6 0 24 -3.9 23 -5 -0.5 7 201 7 8e 9f 0f -1 -17 Jul- 17 -17 -18 -18 18 -18 201 201 202 Jan Apr Oct Jan Apr Jul- Oct ▬▬Public revenues ▬▬Public expenditure ▬▬Budget balance, rhs Source: Ministry of Finance and World Bank. Source: Kosovo Agency of Statistics and World Bank. For three quarters employment declined Credit growth continues to spur private quarters but started recovering in Q3. investment. Number of employed, in thousands Percent y-o-y growth 370 18 360 16 350 14 12 340 10 330 8 320 6 310 4 300 2 290 0 16 16 16 16 17 17 17 17 18 18 18 18 -16 -16 -16 -16 -17 -17 l-17 t-17 -18 -18 -18 -18 Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- Jan Apr Jul Oct Jan Apr Ju Oc Jan Apr Jul Oct ▬▬Total loans ▬▬Loans to corporations ▬▬Loans to households Source: Statistics Agency of Kosovo, LFS. Source: Central Bank. 74  | Kosovo REFORM MOMENTUM NEEDED KOSOVO 2014 2015 2016 2017 2018e 2019f 2020f Real GDP growth (percent) 1.2 4.1 4.1 4.2 4.2 4.4 4.5 Composition (percentage points): Consumption 3.8 2.5 4.7 1.5 2.0 2.4 2.0 Investment -1.4 2.9 2.1 1.5 5.7 4.4 3.8 Net exports -1.2 -1.3 -2.7 1.2 -3.5 -2.4 -1.3 Exports 2.9 0.5 0.5 4.0 1.8 2.0 2.4 Imports (-) 4.1 1.8 3.2 2.8 5.2 4.4 3.7 Consumer price inflation (percent, period average) 0.4 -0.5 0.3 1.5 1.1 2.6 1.9 Public revenues (percent of GDP) 24.0 25.1 26.3 26.4 26.9 27.4 27.4 Public expenditures (percent of GDP) 26.6 27.1 27.7 27.6 29.6 31.3 31.0 Of which: Wage bill (percent of GDP) 8.7 9.0 9.0 8.6 8.8 8.9 8.9 Social benefits (percent of GDP) 5.0 5.4 6.1 6.1 6.3 6.5 6.4 Capital expenditures (percent of GDP) 7.4 7.0 7.2 7.3 8.1 8.8 8.4 Fiscal balance (percent of GDP) -2.6 -2.0 -1.4 -1.2 -2.7 -3.9 -3.6 Primary fiscal balance (percent of GDP) -2.4 -1.7 -1.1 -0.9 -2.4 -3.5 -3.2 Public debt (percent of GDP) 10.4 12.7 14.1 15.6 16.9 18.6 20.0 Public and publicly guaranteed debt 10.6 12.8 14.4 16.3 17.7 19.3 20.7 (percent of GDP) Of which: External (percent of GDP) 5.8 6.2 6.2 6.6 6.4 7.1 7.5 Goods exports (percent of GDP) 5.8 5.6 5.1 5.9 5.6 5.7 5.7 Goods imports (percent of GDP) 42.8 41.9 42.8 44.3 46.4 48.3 49.3 Net services exports (percent of GDP) 8.3 7.9 10.5 12.4 11.6 13.1 14.1 Trade balance (percent of GDP) -28.7 -28.5 -27.2 -26.1 -29.2 -29.4 -29.5 Remittance inflows (percent of GDP) 11.2 11.5 10.5 11.3 11.8 12.0 12.8 Current account balance (percent of GDP) -6.9 -8.6 -7.9 -6.0 -8.4 -8.9 -10.3 Net foreign direct investment inflows 2.2 4.7 2.9 3.4 2.8 4.0 4.5 (percent of GDP) External debt (percent of GDP) 31.2 33.3 33.2 32.6 33.9 34.2 34.8 Real private credit growth (percent, period average) 3.3 7.8 8.7 8.8 10.1 n.a. n.a. Nonperforming loans 8.5 6.2 4.9 3.1 2.7 n.a. n.a. (percent of gross loans, end of period) Unemployment rate (percent, period average) 35.3 32.9 27.5 30.5 29.5 n.a. n.a. Youth unemployment rate (percent, period average) 61.0 57.7 52.4 52.7 55.3 n.a. n.a. Labor force participation rate 41.6 37.6 38.7 42.8 40.9 n.a. n.a. (percent, period average) GDP per capita (US$) 4,055 3,745 3,698 3,957 4,108 4,442 4,619 Poverty rate at US$5/day, PPP n.a. n.a. n.a. n.a. n.a. n.a. n.a. (percent of population) Sources: Country authorities, World Bank estimates and projections. Kosovo  |  75 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Montenegro • In 2018 strong investment activity, another record-high tourism season, and a surge in industrial production drove up GDP growth to an estimated 4.4 percent.7 • The labor market responded to higher economic growth, with the unemployment rate hitting a historic low and participation and employment rates reaching historic highs. • Gradual fiscal consolidation is reducing the deficit, but because of higher than planned growth in public spending, the objective of balancing the budget is not likely to be met until 2020. • The financial sector has so far been stable during the ongoing resolution process for two ailing banks. • The outlook is positive but with significant downside risks, both domestic and external. Mitigating the risks will require firm commitment to fiscal consolidation, rapid resolution of vulnerable banks in accordance with the relevant laws and regulations, and an acceleration of structural reforms. Recent Economic Developments Montenegro to export more electricity. By year-end, manufacturing was ahead of 2017, In 2018, economic growth in Montenegro but mining contracted. A surge in construction was again better than expected. GDP growth financed by investments in energy, tourism, is estimated to have been 4.4 percent, supported and transport recorded 25 percent growth for by higher private and public investment and the sector and retail trade contributed another another strong tourism season: foreign tourist 3.4 percent to growth. arrivals were up 10.6 percent year-on-year (y-o-y). Because of strong employment growth, The labor market improved in 2018. an easing of credit, and the influx of tourists, Employment grew by 4.3 percent, mostly in consumption contributed an estimated construction, tourism, services, and the public 3 percentage points (pp) to GDP growth. sector. The registered unemployment rate Heavier investment in tourism and energy was 17.8 percent in December 2018, down and acceleration of construction of the Bar- from 22.4 percent a year earlier, with a youth Boljare highway fueled total investment, which unemployment rate about double the national contributed an estimated 5.8 pp to growth. average. The survey-based unemployment Because many investments are highly import- rate, which is lower because it better captures dependent, negative net exports continued informal employment, declined to a historic to weigh on economic activity, subtracting low of 15.2 percent in 2018. The decline was 4.4 pp from growth. Meanwhile, a surge in more pronounced for women; as a result, the industrial production was led by energy, where unemployment rates for women (15.1 percent) production grew by 62.1 percent, allowing and men (15.2 percent) are quite close. Moreover, there were record highs in the 7 During the process of preparing this report the Statistic Office of survey-based activity rate (56 percent) and Montenegro issued a new GDP estimates for 2018. Based on those the employment rate (47.5 percent). Strong preliminary estimates growth in 2018 reached 4.9 percent due to higher than previously estimated private consumption. economic activity has also had a positive effect 76  | Montenegro REFORM MOMENTUM NEEDED on youth unemployment, which declined to of them, and the establishment of interim 29.7 percent. But despite the strong economic administration on a second one, along with activity in 2018 nominal wages increased by a moratorium on deposit withdrawals. only 0.1 percent while real wages declined by While this situation has not translated into a more than 2 percent. significant decrease in deposits, a protracted resolution has the potential to erode confidence The external deficit widened in 2018 to from depositors and investors and increase the an estimated 17.1 percent of GDP. Solid cost of resolution. On a systemic basis, key growth of exports of goods and services was figures of the financial sector are largely stable. led by rising exports of tourism, transport, The capital adequacy ratio of 16.5 percent electricity, and chemical products. Export as of October 2018 is above the 10 percent growth, however, was outpaced by real import regulatory minimum. Credit to the private growth, largely because investment was highly sector grew by 9.4 percent in 2018, mostly import-dependent. Leading the import surge driven by lending to households. Deposits were machinery and equipment, oil, steel, iron, grew by 5.9 percent y-o-y from both corporate minerals, and furniture. The primary income and households. Non-performing loans (NPLs) account surplus declined because of higher increased somewhat in absolute terms (by dividend and interest payments. In 2018, net 3 percent) in 2018 but less than total loans so FDI inflows declined from 11.3 percent of GDP that the share of NPLs of total loans declined to in 2017 to 7.1 percent as FDI outflows surged 7.7 percent in December 2018 from 8.0 percent because of repayment of intercompany debt a year earlier.8 The banking sector is somewhat and government repurchases of shares of the moderately profitable overall, but profitability power utility company. By December foreign is unevenly distributed among banks, and net exchange reserves had risen to €1.1 billion, interest margins narrowed compared to 2017. covering 5.2 months of merchandise imports. By yearend, external debt had reached an The gradual fiscal consolidation program estimated 168 percent of GDP. has reduced the deficit, but higher than planned public spending is delaying the Higher inflation in 2018 eroded real gross goal of balancing the budget. After reaching wages. Average annual CPI inflation rose from 5.6 percent of GDP in 2017, it is estimated 2.4 percent in 2017 to 2.6 percent, primarily that the fiscal deficit fell to 3.8 percent in 2018. driven by an increase in the VAT rate. Higher Revenue growth of 10.1 percent (1.1 pp of excises and the cost of oil and pharmaceutical GDP) was supported by higher VAT, income products pushed up producer prices by tax, and non-tax revenues, though excise 1.7 percent. With nominal wages flat, inflation revenues dropped. Public spending went up by caused real gross wages to decline by more than 5.5 percent—but declined by 0.8 pp as a share 2 percent. of GDP given higher nominal GDP growth— due to higher capital spending and spending Vulnerabilities in the financial sector remain 8 NPLs include interest receivables and accrued fees, as reported by after a protracted resolution of ailing the Financial Stability Reports. The Central Bank of Montenegro banks. Three banks have faced vulnerabilities does not include those items and reports a share of NPLs of total loans of 6.9 percent in December 2018, down from 7.29 a year since 2015, leading to the bankruptcy of one earlier. Montenegro  |  77 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 on goods and services. Public sector wages Though the outlook is generally positive, also went up due to additional hiring early in there are significant downside risks. Among 2018. Despite the declining fiscal deficit, it is external factors that could affect Montenegro estimated that public debt peaked at 71 percent are weaker growth in the EU, tightening of of GDP in 2018 and public and publicly financial markets, and a heightening of trade guaranteed debt is now 75.4 percent. tensions. Among emerging domestic risks are increasing political uncertainty, further motorway cost overruns, the vulnerability of Outlook and Risks some smaller banks, and possible pressures on public spending in the run-up to the 2020 In 2019–20, the Montenegrin economy is elections. Mitigating these risks will require the expected to grow on average by 2.7 percent. government’s firm commitment to the fiscal Growth is expected to slow in 2019/20 as consolidation plan and the implementation of private investment levels off after the strong critical structural reforms in the labor market, increase in 2018 and with a gradual phasing- social sectors, and public administration. It out of large infrastructure projects, such as will also be necessary to reinforce the public the submarine electricity transmission cable institutions that enforce fair market competition between Montenegro and Italy and the first to ensure that no one benefits from special phase of the Bar-Boljare highway. Consumption treatment which would force entrepreneurs and employment are expected to moderate to compete by innovating. This will not only somewhat in 2019 due to the impact of fiscal mitigate the risks but also help unleash private consolidation and the implementation of the sector-led growth in Montenegro. government’s ambitious plan to reduce public administration staff. The growth slowdown will also be in part a response to the political and overall uncertainty weighing on consumption and investments. External imbalances are projected to moderate gradually in 2020 as investment-dependent infrastructure projects are finalized. 78  | Montenegro REFORM MOMENTUM NEEDED Another record-breaking tourism season and …supported robust growth, which is mainly strong industrial production led by energy… led by intensified investment activity. High-frequency data, trend-cycle, index 2011=100 Percent 200 last obs. 12/18 20 6 16 180 5 12 160 8 4 4 140 3 0 120 -4 2 -8 100 1 -12 80 -16 0 -12 -12 -13 -13 -14 -14 -15 -15 -16 -16 -17 -17 -18 -18 I-16 II-16 III-16 IV-16 I-17 II-17 III-17 IV-17 I-18 II-18 III-18 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul ▬▬Total industry_tc ▬▬Retail trade_tc ▬▬Tourism_tc JJNet exports JJGross investments JJGovernment consumption JJHousehold consumption ▬▬Real growth, rhs Source: MONSTAT data, tc = trend cycle. Source: MONSTAT. Strong growth is finally reflected in labor Inflationary pressures eased in the second half market performance. of 2018 due to lower excises on tobacco and oil prices. Administrative data, thousands Annual growth rates, percent 200 55 4 195 50 3 190 45 2 185 40 180 1 35 175 0 30 170 25 -1 165 160 last obs. 12/18 20 -2 last obs. 12/18 -12 -12 -13 -13 -14 -14 -15 -15 -16 -16 -17 -17 -18 -18 -14 Jul-14 an-15 Jul-15 an-16 Jul-16 an-17 Jul-17 an-18 Jul-18 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul J a n J J J J ▬▬Employment ▬▬Employment_tc ▬▬CPI ▬▬PPI ▬▬Unemployment, rhs ▬▬Unemployment_tc, rhs Source: MONSTAT data, tc = trend cycle. Source: MONSTAT data. Although the government deficit fell by an …public debt rose to a peak of 71 percent of estimated 1.8 percentage points compared to GDP. 2017… Percent of GDP EUR bn and percent of GDP 50 1 4 75 0 40 -1 70 3 -2 30 65 -3 2 -4 20 60 -5 -6 1 10 55 -7 0 -8 0 50 201 4 201 5 201 6 201 7 8e 201 4 201 5 201 6 201 7 8e 9f 201 201 201 JJTotal revenues and grants JJTotal expenditure and net lending JJGuarantees JJForeign public debt (EUR bn) ▬▬Cash deficit, % of GDP, rhs ▬▬Accrual deficit, % of GDP, rhs JJDomestic public debt (EUR bn) ▬▬Public debt, % of GDP, rhs Source: MOF data. Source: MoF data. Montenegro  |  79 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 MONTENEGRO 2014 2015 2016 2017 2018e 2019f 2020f Real GDP growth (percent) 1.8 3.4 2.9 4.7 4.4 2.9 2.4 Composition (percentage points): Consumption 2.6 2.2 4.5 3.0 3.0 1.5 1.9 Investment 0.5 1.9 6.3 7.3 5.8 2.8 -1.2 Net exports -1.3 -0.7 -7.9 -5.6 -4.4 -1.4 1.8 Exports -0.3 2.2 2.3 0.7 2.6 1.5 1.8 Imports (-) 1.0 2.9 10.2 6.3 7.0 2.8 0.1 Consumer price inflation (percent, period average) -0.7 1.5 -0.3 2.4 2.6 2.0 1.9 Public revenues (percent of GDP) 44.6 41.5 42.5 41.4 42.5 42.5 41.8 Public expenditures (percent of GDP) 47.7 48.8 45.3 47.0 46.2 45.4 41.6 Of which: Wage bill (percent of GDP) 13.5 12.9 12.7 12.3 11.7 11.7 11.7 Social benefits (percent of GDP) 15.1 13.9 14.6 13.0 12.1 11.6 11.5 Capital expenditures (percent of GDP) 6.1 8.7 4.2 8.3 8.5 9.2 6.9 Fiscal balance (percent of GDP) -3.1 -7.3 -2.8 -5.6 -3.8 -3.0 0.2 Primary fiscal balance (percent of GDP) -0.9 -4.9 -0.7 -3.2 -1.8 -0.9 2.0 Public debt (percent of GDP) 59.9 66.2 64.4 64.2 70.8 67.2 64.3 Public and publicly guaranteed debt 67.1 73.7 71.4 70.0 75.4 71.6 68.6 (percent of GDP) Of which: External (percent of GDP) 47.9 55.7 52.8 53.4 61.2 55.0 51.9 Goods exports (percent of GDP) 10.3 9.1 8.9 8.9 9.5 9.8 10.1 Goods imports (percent of GDP) 50.1 49.5 50.8 52.2 53.9 53.1 51.1 Net services exports (percent of GDP) 20.0 21.8 19.4 19.8 20.4 19.5 19.1 Trade and services balance (percent of GDP) -19.8 -18.6 -22.5 -23.4 -24.1 -23.7 -21.9 Remittance inflows (percent of GDP) 4.2 4.1 3.7 3.7 3.8 3.4 3.3 Current account balance (percent of GDP) -12.4 -11.1 -16.2 -16.1 -17.1 -17.1 -14.9 Net foreign direct investment inflows 10.2 17.1 9.4 11.3 7.1 8.7 8.4 (percent of GDP) External debt (percent of GDP) 162.3 171.0 162.5 160.5 168.3 162.1 159.0 Real private credit growth (percent, period average) -1.5 0.3 3.5 4.4 5.9 n.a. n.a. Nonperforming loans 16.8 13.4 11.1 8.0 7.7 n.a. n.a. (percent of gross loans, end of period) Unemployment rate (percent, period average) 18.0 17.6 17.7 16.1 15.2 15.4 15.0 Youth unemployment rate (percent, period average) 35.8 37.6 35.9 31.7 29.7 n.a. n.a. Labor force participation rate 52.7 53.7 54.5 54.7 56.0 n.a. n.a. (percent, period average) GDP per capita, PPP (current international $) 15,371 16,337 17,866 19,352 19,584 19,819 20,057 Poverty rate at US$5.5/day, PPP 4.8 4.6 4.2 4.4 4.8 4.7 4.6 (percent of population) Sources: Country authorities, World Bank estimates and projections. Note: Nonperforming loans show year-to-date actuals (including interest and accruals). 80  | Montenegro REFORM MOMENTUM NEEDED North Macedonia • Growth rebounded to 2.7 percent in 2018, driven by consumption and net exports; and investment began a recovery. • Unemployment fell to a historical low, and wage pressure continues, led by labor shortages in some sectors. • The fiscal deficit narrowed in 2018 as revenue grew and capital spending was significantly under- executed. Nevertheless, public debt increased. • As the political outlook improved, the emphasis should be on economic reforms to reignite the EU convergence process. Recent Economic Developments in manufacturing, transport and storage, and professional services. Even though the In 2018 the economy grew by 2.7 percent. employment rate improved to 45.1 percent Supported by consumption and net exports, in 2018, more than half of working-age economic activity picked up in 2018 after population is still either unemployed or not stagnating in 2017. Private consumption looking for work. The unemployment rate was the main driver of growth, contributing fell to a historical low in 2018 averaging 2.4 percentage points (pp) because of rises 20.7 percent throughout the year. in employment, wages, and lending to households. Net exports, mainly FDI-related, Wage pressures continue to be high in labor- contributed 1.7 pp. The remaining 0.8 pp. intensive sectors. The higher mandatory came from government consumption as minimum wage continued to put pressure on investments deducted from growth 2.2 pp. labor-intensive industries, which requested On the production side, wholesale and retail temporary government support to deal with trade and transportation services were the the increased labor cost. Led by agriculture, main drivers of growth, contributing 2.3 pp. manufacturing, trade, and the public sector, The manufacturing contribution of 0.6 pp was real wage growth was 4.4 percent in 2018— driven by higher production, mainly of motor more than double the 2017 level. Low-wage vehicles and electric machinery, by foreign- labor-intensive sectors saw real wages grow owned firms and by domestic producers of, for by over 10 percent in 2018, far exceeding the example, food and beverages, pharmaceuticals, growth in labor productivity over the past and basic and fabricated metal products. several years. Further mandated wage increases Construction rebounded from October, adding may erode the competitiveness of low- value- 0.02 pp to growth, thanks to the launch of added industries. public investment projects and a continued recovery of private investment. In 2018 external imbalances improved. The current account deficit (CAD) declined The labor market again improved in 2018. to 0.3 percent of GDP in 2018, compared Employment grew by 2.5 percent y-o-y in to 1 percent in 2017. The continued solid 2018. Most of the new jobs created were export performance of FDI-related industries North Macedonia  |  81 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 like motor vehicles and electrical machinery favorable developments in the foreign exchange was supplemented by growth of exports in market, moderate inflation, and continued such traditional products as iron and steel, solid deposit growth. Inflation in 2018 was and furniture. This helped to bring down the just 1.5 percent, although prices were higher goods trade deficit to 16.2 percent of GDP. for beverages and energy (including oil). Core Net services exports surplus remained solid at inflation in December 2018 was 1.4 percent. 3.3 percent of GDP, driven by transport and services for processing manufactured goods. Revenue growth and under-execution Though net private transfer inflows continued of capital investments brought the fiscal increasing, they were more than sufficient to deficit down in 2018. General government cover the entire goods and services deficit. Net revenues rose 4.9 percent, tracking rises in FDI inflows picked up in the second half of social contributions, excises, and corporate and the year, reaching 5.8 percent of GDP in 2018, personal income tax revenues. Net VAT revenues due to significant investments coming from also increased, despite a surge in refunds to clear UK. Gross external debt, excluding central arrears to businesses. Spending went down by bank transactions, increased in September 0.4 percent because the historically largest drop to 77.6 percent of GDP (up 4.5 pp y-o-y), in capital spending made up for higher current reflecting the January 2018 issuance of spending by 4.6 percent caused by a surge in Eurobonds. social transfers and higher subsidies to firms. The general government deficit declined from Credit growth increased in 2018. Household 2.7 percent in 2017 to 1.8 percent. (Adding credit grew by 10.3 percent and corporate in the financing of the Public Enterprise for lending to the private sector accelerated from State Roads raises the deficit to an estimated 2.3 percent in 2017 to 4.5 percent in 2018 as 2.3 percent of GDP.) investment picked up. Lending should further increase because bank assets have improved; Although the deficit was lower, public debt corporate NPLs declined from 9.8 percent in increased. Public and publicly guaranteed 2017 to 7.8 percent in 2018, and total NPLs (PPG) debt increased from 47.7 percent in from 6.1 percent to 5.1 percent. The loan- 2017 to 48.4 percent. The increase is due to-deposit ratio was kept at 86.2 percent, to issuance of a new Eurobond—a 7-year suggesting that banks have additional space to €500 million bond at 2.75 percent (the lend more. A survey of credit activity found best terms ever)—that covered government that in 2018 credit requirements had gone borrowing requirements for 2018 with a reserve down and corporate credit demand had gone for early 2019. Meanwhile, guaranteed debt up, implying that there is room to expand declined, from 8.3 to 8.0 percent of GDP, as corporate lending. disbursement of the Chinese loan for highway construction slowed. Monetary policy was even more accommodative than it had been in 2017. In 2018, in three steps the Central Bank lowered the key interest rate by 25 bps, to a historic low of 2.5 percent. The easing was based on 82  |  North Macedonia REFORM MOMENTUM NEEDED Outlook and Risks The economic outlook is positive, and growth is expected to gradually rise to 3.2 percent in 2020. The resolution of the name issue is expected to accelerate EU accession negotiations, strengthening investor confidence, and stimulating growth in the next few years. Large infrastructure projects, in particular roads, and the lifting of the moratorium on local government issuance of building permits will further boost investments. Consumption is expected to remain a stable source of growth, sustained by rises in employment, wages, and household lending. Net exports, especially those that are FDI-related, are expected to contribute positively to growth. With the political outlook improved, emphasis should now turn to economic reforms. The main challenges to growth will be the low and declining productivity of local firms, weak state institutions, low human capital, a mismatch between skills and the evolving labor market demands of a modern economy, and policy barriers to competition and investment. The more competitive legal framework for businesses has yet to translate into a vibrant private sector that drives growth and jobs. More efficient public spending and a broader tax base would help stabilize public debt and rebuild fiscal buffers against future shocks. In the government baseline fiscal scenario, by 2020 the PPG debt-to-GDP ratio is expected to rise to 54.4 percent, which underscores the need for strong and frontloaded structural reforms to stabilize debt. North Macedonia  |  83 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Economic growth strengthened during 2018… …and was broad-based. Percent Index 2008=100, trade cycle 6 160 300 140 250 4 120 200 2 100 80 150 0 60 100 40 -2 50 20 -4 0 0 16 16 16 16 17 17 17 17 18 18 18 18 0 1 2 3 4 5 6 7 8 Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- 201 201 201 201 201 201 201 201 201 JJAgriculture JJMining, electricity, gas supply JJManufacturing ▬▬Industry_tc ▬▬Retail trade_tc ▬▬Tourism_tc ▬▬Construction_tc, rhs JJConstruction JJWholesale & retail, transportation, accomodation JJOther services ▬▬Real GDP growth Source: State Statistics Office. Source: State Statistics Office and World Bank calculations. The external deficit was kept low by rising A brighter labor market brought unemployment exports. to a historic low. Percent of GDP Percent 30 60 57 55 20 5052 10 45 0 40 37 36 -10 35 30 -20 21 -30 20 0 1 2 3 4 5 6 7 8 6 7 8 9 0 11 12 13 14 15 6 17 8 201 201 201 201 201 201 201 201 201 200 200 200 200 201 20 20 20 20 20 201 20 201 JJCurrent transfers, net JJGoods trade balance JJIncome ▬▬Unemployment rate ▬▬Employment rate JJServices trade balance ▬▬Current account balance, rhs ▬▬Activity rate ▬▬Youth unemployment Source: National Bank. Source: State Statistics Office. Corporate lending recovered in 2018. Although the deficit declined, public debt went up slightly. Percent, and RHS: yearly change, percent Percent of GDP 100 9 50 90 8 80 7 40 70 6 60 30 5 50 4 40 20 3 30 20 2 10 10 1 0 0 0 16 16 16 16 17 17 17 17 18 18 18 18 200 2 200 4 200 6 200 8 201 0 201 2 201 4 201 6 201 8 Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- JJContribution of household loans JJContribution of corporate loans JJDomestic debt JJForeign debt JJGuarantees ▬▬Credit growth, rhs Source: National Bank. Source: Ministry of Finance and World Bank estimates. 84  |  North Macedonia REFORM MOMENTUM NEEDED NORTH MACEDONIA 2014 2015 2016 2017 2018 2019f 2020f Real GDP growth (percent) 3.6 3.9 2.8 0.2 2.7 2.9 3.2 Composition (percentage points): Consumption 2.1 3.5 2.0 0.1 3.2 1.9 1.6 Investment 2.8 2.9 3.9 0.7 -2.2 1.1 1.3 Net exports -1.3 -2.5 -3.2 -0.5 1.7 0.0 0.2 Exports 7.3 4.2 4.7 4.5 9.1 5.0 5.7 Imports (-) 8.6 6.7 7.9 5.0 7.4 5.0 5.5 Consumer price inflation (percent, period average) -0.2 -0.3 -0.2 1.3 1.5 1.8 1.9 Public revenues (percent of GDP) 29.7 31.0 30.6 31.0 30.2 32.2 32.2 Public expenditures (percent of GDP) 33.9 34.4 33.2 33.9 32.0 35.2 34.5 Of which: Wage bill (percent of GDP) 7.0 7.0 6.8 6.6 6.4 6.6 6.4 Social benefits (percent of GDP) 14.9 14.8 15.0 15.4 15.2 15.9 15.6 Capital expenditures (percent of GDP) 4.2 4.2 3.8 4.2 2.5 4.3 4.3 Fiscal balance (percent of GDP) -4.2 -3.4 -2.7 -2.7 -1.8 -3.0 -2.4 Overall Fiscal Balance with the Public Enterprise -5.3 -4.1 -3.8 -3.5 -2.3 -3.5 -2.9 for State Roads* Primary fiscal balance (percent of GDP) -3.2 -2.3 -1.5 -1.5 -0.6 -1.6 -1.0 Public debt (percent of GDP) 38.0 38.1 39.8 39.5 40.5 44.2 45.3 Public and publicly guaranteed debt 45.8 46.6 48.7 47.7 48.4 53.4 54.4 (percent of GDP) Of which: External (percent of GDP) 32.1 31.6 34.2 32.0 32.9 36.1 35.8 Goods exports (percent of GDP) 32.5 33.6 36.5 40.7 45.5 47.5 49.2 Goods imports (percent of GDP) 54.2 53.7 55.3 58.5 61.6 64.9 66.6 Net services exports (percent of GDP) 4.5 3.8 3.5 3.8 3.3 3.5 3.8 Trade balance (percent of GDP) -17.2 -16.2 -15.2 -14.1 -12.8 -13.9 -13.6 Remittance inflows (percent of GDP) 2.4 2.3 2.0 1.9 1.9 1.9 1.9 Current account balance (percent of GDP) -0.5 -2.0 -2.9 -1.0 -0.3 -1.4 -1.8 Net foreign direct investment inflows 2.3 2.2 3.3 1.8 5.8 4.4 4.6 (percent of GDP) External debt (percent of GDP) 70.0 69.3 74.7 73.6 77.4 80.4 81.0 Real private credit growth (percent, period average) 8.6 9.5 4.3 1.2 5.0 n.a. n.a. Nonperforming loans 10.8 10.3 6.3 6.1 5.1 n.a. n.a. (percent of gross loans, end of period) Unemployment rate (percent, period average) 28.0 26.1 23.7 22.4 20.7 19.4 18.0 Youth unemployment rate (percent, period average) 53.1 47.3 48.2 46.7 45.4 n.a. n.a. Labor force participation rate 57.3 57.0 56.5 56.8 56.9 n.a. n.a. (percent, period average) GDP per capita, PPP (current international $) 22,002 22,514 22,998 23,493 23,998 24,514 25,041 Poverty rate at US$5/day, PPP 24.8 23.2 21.9 21.0 20.7 20.5 20.5 (percent of population) Sources: Country authorities, World Bank estimates and projections. Note: *The general government balance as presented by the government with the state road agency finances included. Poverty rates are based on the North Macedonia survey on income and living conditions (SILC). North Macedonia  |  85 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 Serbia • Growth in 2018, estimated at 4.2 percent,10 was stronger than projected but began to slow late in the year. • As the labor market responded to higher growth, unemployment fell. • A surplus of 0.5 percent of GDP in the general government budget helped reduce public debt. • Because growth was to a large extent consumption-driven, the current account deficit went up by 8.4 percent (in euro terms). • The recent slowdown of the economy could be exacerbated if external conditions for emerging markets tighten, EU growth slows, and local and regional political uncertainty worsens. Recent Economic Developments 9 output estimated at 15.6 percent, adding about 1 pp to growth. The Serbian economy expanded by 4.2 percent in 2018, well above the projected The labor market continues to improve. 3.5 percent.10 Investment rose by an estimated According to Labor Force Survey data, 11 percent in real terms, contributing unemployment again declined, to an estimated 2.3 percentage points (pp) to GDP growth. annual average of 12.7 percent, and employment Consumption increased by 3.4 percent in real rose by 0.9 percentage points compared to terms, adding 2.9 pp to growth. The negative 2017, which suggests that 38,275 more jobs net contribution of foreign trade to growth were created in 2018. As a result, employment subtracted about 1 pp. Economic growth was among the population over 15 years old reached noticeably stronger in the first half of the year, a record high of 47.6 percent.11 In 2018, too, reaching 4.9 percent year-on-year (y-o-y), average wages went up by 4.4 percent in real but slowed in the second half to 3.7 percent; terms. the contributions of all components of GDP began to wane, led by a slowdown in private The 2018 consolidated general government investment and lower-than-expected export budget showed a surplus of 0.5 percent of growth as economic activity slowed in Serbia’s GDP by year-end. However, although there was major trading partners, particularly Italy. a strong increase in revenues from all sources, expenditures also went up significantly, leading Services were the main drivers of growth. to a smaller surplus than 2017’s 1.1 percent of All services contributed in 2018, but the GDP. Total revenues increased by 6.7 percent in leaders were trade, transport, and tourism, nominal terms but social security contributions which together added 1.1 pp to GDP growth. went up by 9.2 percent, explaining nearly Agriculture also did well, with real growth of half of the total revenue increase. Public spending rose by 7.9 percent in nominal terms, 9 During the process of preparing this report the Statistic Office corresponding to an increase of 152 billion of Republic of Serbia issued a new set of estimates of national accounts for 2018. Based on those preliminary estimates growth in dinars or (corresponding to 3 percent of GDP), 2018 reached 4.3 percent. 10 World Bank databases now include revised data on national 11 Looking at quarterly data, the peak in employment was in Q3 accounts from the Serbian Statistics Office. 2018 when employment rate stood at 49.2 percent. 86  | Serbia REFORM MOMENTUM NEEDED despite the fact that there were savings of about The banking system is still performing well. 0.5 percent of GDP on interest payments and Gross nonperforming loans (NPLs) declined activated guarantees. The main drivers of higher considerably, from 9.8 percent in December spending were capital investments (up 48.9 2017 to 5.7 percent at year-end 2018.13 Banks percent), wages (up 10 percent), and goods and have been more aggressive, writing off bad services (up 13.9 percent). The fiscal surplus loans or selling them to specialized investors. and GDP growth helped reduce PPG debt as a NPLs total about €1.1 billion, of which about share of GDP from 60.1 percent in 2017 to an €500 million is owed by active businesses and estimated 55.5 percent in 2018.12 €200 million by enterprises now in bankruptcy proceedings. The value of household NPLs is Inflation was generally quite stable about €400 million. The number of NPLs is throughout 2018, peaking in August at just expected to continue down over the medium 2.6 percent. The recovery in food and oil prices term, although probably not as fast as in the pushed up CPI inflation in the second half, but past two years. by year-end inflation had stabilized, bringing down the 2018 average to 2 percent. With The current account deficit (CAD) did not inflationary pressures low and the inflation change. Exports of goods rose by 7.7 percent outlook stable, the central bank (NBS) lowered in euro terms in 2018; but imports went up its policy rate to 3.25 percent in March and by 12.6 percent, from a much higher base. to 3 percent in April. In 2018, the dinar held Consequently, the trade in goods deficit reached steady in nominal terms. The NBS intervened 12.2 percent of GDP. The surplus in trade regularly in the foreign exchange market to in services rose in euro terms by 13 percent, smooth excessive short-term exchange rate countering the CAD impact of the widening volatility. For the year it was a net purchaser of goods trade deficit. It is estimated that the foreign currency, buying €1.6 billion. Foreign CAD, as in 2017, was still 5.2 percent. In 2018 currency reserves reached €11.3 billion by year- net FDI was much higher, by 31.8 percent, end, up €1.3 billion y-o-y. and was sufficient to finance the CAD. Total external debt started to go up in nominal terms, Credit activity recovered in 2018 but its reaching €26.5 billion in the third quarter, structure is somewhat unfavorable. Credit but continued to decline as a share of GDP, grew by 7.6 percent, with most of the increase reaching an estimated 61.3 percent at year-end. in the household sector (12.5 percent); loans to private businesses were up by 6.9 percent. A high proportion of household loans were short- Outlook and Risks term “cash” loans to individuals. The stock of those loans is 18.7 percent higher in euro terms Growth is expected to be slightly lower in than a year ago; loans to private enterprises were 2019 but to recover to about 4 percent over just 6 percent higher than loans to households. the medium term. Economic activity in 2019 is projected to grow by only 3.5 percent because external developments are less favorable and 12 Total public debt includes nonguaranteed debt of local governments. 13 Preliminary figures. Serbia  |  87 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 the one-off effects from higher consumption are exhausted. The medium-term projections are based on the assumptions that consumption will keep growing at about 3–4 percent annually and that investment will have annual growth of 5–6 percent in real terms. That would bring the share of investment in GDP to about 23 percent—still below the levels of other fast-growing Central and Eastern European countries. Net exports are projected to regularly make a small negative contribution to growth of about 0.3 pp a year. The medium-term growth projections depend heavily on the pace of structural reform. Serbia has a large unreformed public sector with inefficiencies in the SOEs sector. The sub-optimal performance of SOEs directly affects growth of the economy through lower than planned investment and occasional disruption in operations which leads to increase in imports. The lack of reforms not only has high fiscal costs but also makes Serbia less competitive (for example because of a slow pace of reforms in the energy, transport and other infrastructure sectors).  e downside risks are mainly political: The Th constant public expectation of early elections; increasing public discontent; unstable work on resolving relations with Kosovo; slower than expected opening of chapters of the acquis for EU accession; and deterioration of indicators of the rule of law and governance14, all suggest that growth could have been faster if these issues had been resolved. 14 Recent rankings by international think tanks and NGOs. 88  | Serbia REFORM MOMENTUM NEEDED Growth began to slow. However, the labor market improved. Contribution to GDP growth, percentage points Percent 9 50 7 40 5 3 30 1 20 -1 10 -3 -5 0 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 H1 H2 15 15 16 16 17 17 18 1 8 Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 JJConsumption, final JJInvestment JJNet exports ▬▬GDP, real growth JJEmployment rate JJUnemployment rate Source: Statistics Office of Serbia. Source: Statistics Office of Serbia. Credit recovered, mainly because loans to Short-term loans may be rising too fast. households increased. € billion Stock of loans, € billion 12 4.0 3.5 10 3.0 8 2.5 6 2.0 1.5 4 1.0 2 0.5 0 0 -06 -06 -07 -08 -09 -10 l-11 -12 y-13 r-14 r-15 -16 -17 c-17 -18 -15 -15 -15 -16 -16 -16 -17 -17 -17 -18 -18 -18 Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan Dec Nov Oct Sep Aug Ju Jun Ma Ap Ma Feb Jan De Nov ▬▬Private enterprises ▬▬Government ▬▬Households ▬▬SOEs Source: National Bank of Serbia. Source: National Bank of Serbia. Though the trade deficit widened, the CAD is High FDI is helping to push up reserves. under control. 12-month cumulative, percent of GDP € billion 0 12 800 -2 10 -4 600 -6 8 -8 6 400 -10 -12 4 -14 200 2 -16 -18 1 0 0 -1 -11 -12 -12 -13 -13 -14 -15 -15 -16 -16 -17 -18 -18 15 15 16 1 6 17 17 18 18 Jan Aug Mar Oct May Dec Jul Feb Sep Apr Nov Jun Jan Aug Q1- Q3- Q1- Q3- Q1- Q3- Q1- Q3- ▬▬Trade balance ▬▬CAD JJDirect investment, net, rhs ▬▬Reserves Source: National Bank of Serbia. Source: National Bank of Serbia. Serbia  |  89 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 SERBIA 2014 2015 2016 2017 2018e 2019f 2020f Real GDP growth (percent) -1.6 1.8 3.3 2.0 4.2 3.5 4.0 Composition (percentage points): Consumption 0.1 -1.0 1.1 1.9 2.9 2.4 2.9 Investment -0.9 0.8 0.4 2.2 2.3 1.5 1.3 Net exports -0.8 1.9 1.9 -2.1 -1.0 -0.3 -0.3 Exports 1.7 4.0 5.4 4.0 5.4 5.0 5.0 Imports (-) 2.5 2.0 3.5 6.1 6.4 5.3 5.3 Consumer price inflation (percent, period average) 2.1 1.4 1.1 3.2 2.0 2.6 3.0 Public revenues (percent of GDP) 39.0 39.3 40.8 41.5 41.1 39.9 39.7 Public expenditures (percent of GDP) 45.2 42.7 41.9 40.4 40.6 40.4 40.2 Of which: Wage bill (percent of GDP) 11.0 9.7 9.2 9.0 9.2 9.3 9.2 Social benefits (percent of GDP) 16.7 16.5 15.8 15.1 14.7 14.5 14.4 Capital expenditures (percent of GDP) 2.3 2.7 3.1 2.8 3.6 4.0 3.9 Fiscal balance (percent of GDP) -6.2 -3.4 -1.2 1.1 0.5 -0.5 -0.5 Primary fiscal balance (percent of GDP) -3.4 -0.4 1.7 3.6 2.6 1.4 1.6 Public debt (percent of GDP) 58.2 64.0 62.8 55.6 50.1 51.3 49.0 Public and publicly guaranteed debt 65.4 70.6 68.6 58.7 54.3 55.8 53.0 (percent of GDP) Of which: External (percent of GDP) 39.0 42.4 42.7 35.5 33.6 37.0 36.0 Goods exports (percent of GDP) 30.0 32.1 34.9 35.9 35.5 38.6 39.6 Goods imports (percent of GDP) 41.6 42.3 43.4 46.1 47.7 49.4 50.0 Net services exports (percent of GDP) 1.3 2.0 2.5 2.4 2.5 2.6 2.9 Trade balance (percent of GDP) -10.3 -8.2 -6.0 -7.8 -9.7 -8.2 -7.5 Remittance inflows (percent of GDP) 5.3 5.8 5.1 5.2 5.9 5.1 5.1 Current account balance (percent of GDP) -5.6 -3.5 -2.9 -5.2 -5.2 -5.1 -4.9 Net foreign direct investment inflows 3.5 5.1 5.2 6.2 7.4 5.7 5.5 (percent of GDP) External debt (percent of GDP) 72.4 73.5 72.1 68.9 61.3 57.4 53.2 Real private credit growth (percent, period average) -3.8 -1.2 5.0 1.9 3.7 n.a. n.a. Nonperforming loans 21.5 21.6 17.0 9.8 5.7 n.a. n.a. (percent of gross loans, end of period) Unemployment rate (percent, period average) 19.2 17.7 15.3 13.5 12.7 12.5 11.5 Youth unemployment rate (percent, period average) 47.5 43.2 34.9 31.9 29.8 n.a. n.a. Labor force participation rate 51.9 51.6 53.3 54.0 54.5 n.a. n.a. (percent, period average) GDP per capita, PPP (current international $) 13,398 13,454 13,773 15,000 15,942 16,925 18,020 Poverty rate at US$5.5/day, PPP 24.1 24.0 23.1 22.4 21.7 20.9 19.7 (percent of population) Sources: Country authorities, World Bank estimates and projections. Note: Nonperforming loans show year-to-date actuals. 90  | Serbia Key Economic Indicators WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 2014 2015 2016 2017 2018e 2019f 2020f Real GDP growth (percent) Albania 1.8 2.2 3.4 3.8 4.2 3.8 3.6 Bosnia and Herzegovina 1.1 3.1 3.1 3.2 3.0 3.4 3.9 Kosovo 1.2 4.1 4.1 4.2 4.2 4.4 4.5 North Macedonia 3.6 3.9 2.8 0.2 2.7 2.9 3.2 Montenegro 1.8 3.4 2.9 4.7 4.4 2.9 2.4 Serbia -1.6 1.8 3.3 2.0 4.2 3.5 4.0 WB6 0.4 2.6 3.3 2.6 3.8 3.5 3.8 Consumer price inflation (percent, period average) Albania 1.6 1.9 1.3 2.0 2.1 2.5 2.9 Bosnia and Herzegovina -0.9 -1.0 -1.6 0.8 1.4 1.1 1.1 Kosovo 0.4 -0.5 0.3 1.5 1.1 2.6 1.9 North Macedonia -0.2 -0.3 -0.2 1.3 1.5 1.8 1.9 Montenegro -0.7 1.5 -0.3 2.4 2.6 2.0 1.9 Serbia 2.1 1.4 1.1 3.2 2.0 2.6 3.0 WB6 1.0 0.7 0.4 2.2 1.8 2.2 2.4 Public expenditures (percent of GDP) Albania 32.3 31.5 29.4 29.8 29.0 29.4 29.2 Bosnia and Herzegovina 45.8 42.5 41.5 40.4 44.3 41.7 40.2 Kosovo 26.6 27.1 27.7 27.6 29.6 31.3 31.0 North Macedonia 33.9 34.4 33.2 33.9 32.0 35.2 34.5 Montenegro 47.7 48.8 45.3 47.0 46.2 45.4 41.6 Serbia 45.2 42.7 41.9 40.4 40.6 40.4 40.2 WB6 38.6 37.8 36.5 36.5 37.0 37.2 36.1 Public revenues (percent of GDP) Albania 26.3 26.6 27.6 27.7 27.2 27.2 27.1 Bosnia and Herzegovina 43.7 43.1 42.7 43.0 43.8 42.0 41.4 Kosovo 24.0 25.1 26.3 26.4 26.9 27.4 27.4 North Macedonia 29.7 31.0 30.6 31.0 30.2 32.2 32.2 Montenegro 44.6 41.5 42.5 41.4 42.5 42.5 41.8 Serbia 39.0 39.3 40.8 41.5 41.1 39.9 39.7 WB6 34.5 34.4 35.1 35.2 35.3 35.2 34.9 Source: World Bank calculations and projections on data from national authorities and World Economic Outlook (2017) 92  | Key Economic Indicators REFORM MOMENTUM NEEDED 2014 2015 2016 2017 2018e 2019f 2020f Fiscal balance (percent of GDP) Albania -6.0 -4.9 -1.8 -2.0 -1.8 -2.1 -2.1 Bosnia and Herzegovina -2.0 0.7 1.2 2.6 -0.5 0.3 1.2 Kosovo -2.6 -2.0 -1.4 -1.2 -2.7 -3.9 -3.6 North Macedonia -4.2 -3.4 -2.7 -2.7 -1.8 -3.0 -2.4 Montenegro -3.1 -7.3 -2.8 -5.6 -3.8 -3.0 0.2 Serbia -6.2 -3.4 -1.2 1.1 0.5 -0.5 -0.5 WB6 -4.0 -3.4 -1.4 -1.3 -1.7 -2.0 -1.2 Public debt (percent of GDP) Albania 66.1 69.1 68.7 67.8 64.6 63.0 62.1 Bosnia and Herzegovina 42.0 41.9 42.4 36.1 35.1 34.0 33.2 Kosovo 10.4 12.7 14.1 15.6 16.9 18.6 20.0 North Macedonia 38.0 38.1 39.8 39.5 40.5 44.2 45.3 Montenegro 59.9 66.2 64.4 64.2 70.8 67.2 64.3 Serbia 58.2 64.0 62.8 55.6 50.1 51.3 49.0 WB6 45.8 48.6 48.7 46.4 46.3 46.4 45.7 Public and publicly guaranteed debt (percent of GDP) Albania 72.0 72.7 72.3 71.8 68.6 65.8 64.7 Bosnia and Herzegovina 43.1 43.2 43.3 38.0 36.7 35.6 34.8 Kosovo 10.6 12.8 14.4 16.3 17.7 19.3 20.7 North Macedonia 45.8 46.6 48.7 47.7 48.4 53.4 54.4 Montenegro 67.1 73.7 71.4 70.0 75.4 71.6 68.6 Serbia 65.4 70.6 68.6 58.7 54.3 55.8 53.0 WB6 50.7 53.3 53.1 50.4 50.2 50.2 49.4 Goods exports (percent of GDP) Albania 9.3 7.5 6.6 6.9 7.4 6.2 6.3 Bosnia and Herzegovina 25.0 25.2 25.7 29.8 29.9 31.2 32.1 Kosovo 5.8 5.6 5.1 5.9 5.6 5.7 5.7 North Macedonia 32.5 33.6 36.5 40.7 45.5 47.5 49.2 Montenegro 10.3 9.1 8.9 8.9 9.5 9.8 10.1 Serbia 30.0 32.1 34.9 35.9 35.5 38.6 39.6 WB6 23.8 24.5 26.0 27.6 28.1 29.7 30.5 Source: World Bank calculations and projections on data from national authorities and World Economic Outlook (2017) Key Economic Indicators  |  93 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.15 2014 2015 2016 2017 2018e 2019f 2020f Trade balance (percent of GDP) Albania -19.0 -17.3 -16.8 -15.1 -13.5 -13.6 -13.3 Bosnia and Herzegovina -22.7 -18.5 -16.7 -16.3 -16.2 -16.4 -16.6 Kosovo -28.7 -28.5 -27.2 -26.1 -29.2 -29.4 -29.5 North Macedonia -17.2 -16.2 -15.2 -14.1 -12.8 -13.9 -13.6 Montenegro -19.8 -18.6 -22.5 -23.4 -24.1 -23.7 -21.9 Serbia -10.3 -8.2 -6.0 -7.8 -9.7 -8.2 -7.5 WB6 -16.4 -14.4 -13.0 -13.3 -14.0 -13.5 -13.1 Current account balance (percent of GDP) Albania -10.8 -8.6 -7.6 -7.5 -6.3 -6.4 -6.2 Bosnia and Herzegovina -7.3 -5.3 -4.7 -4.7 -4.9 -5.3 -5.5 Kosovo -6.9 -8.6 -7.9 -6.0 -8.4 -8.9 -10.3 North Macedonia -0.5 -2.0 -2.9 -1.0 -0.3 -1.4 -1.8 Montenegro -12.4 -11.1 -16.2 -16.1 -17.1 -17.1 -14.9 Serbia -5.6 -3.5 -2.9 -5.2 -5.2 -5.1 -4.9 WB6 -6.4 -5.1 -4.9 -5.5 -5.5 -5.7 -5.7 External debt (percent of GDP) Albania 69.5 74.4 73.4 68.7 62.1 59.8 59.1 Bosnia and Herzegovina 77.1 72.2 71.0 67.6 70.5 67.4 66.7 Kosovo 31.2 33.3 33.2 32.6 33.9 34.2 34.8 North Macedonia 70.0 69.3 74.7 73.6 77.4 80.4 81.0 Montenegro 162.3 171.0 162.5 160.5 168.3 162.1 159.0 Serbia 72.4 73.5 72.1 68.9 61.3 57.4 53.2 WB6 80.4 82.1 81.0 78.9 80.7 78.6 77.2 Unemployment rate (period average, percent) Albania 17.5 17.1 15.2 13.7 12.3 n.a. n.a. Bosnia and Herzegovina 27.5 27.7 25.4 20.5 18.4 n.a. n.a. Kosovo 35.3 32.9 27.5 30.5 29.5 n.a. n.a. North Macedonia 28.0 26.1 23.7 22.4 20.7 19.4 18.0 Montenegro 18.0 17.6 17.7 16.1 15.2 15.4 15.0 Serbia 19.2 17.7 15.3 13.5 12.7 12.5 11.5 WB6 24.3 23.2 20.8 19.4 18.1 15.8 14.8 Source: World Bank calculations and projections on data from national authorities and World Economic Outlook (2017) 94  | Key Economic Indicators Western Balkans Regular Economic Report No.15 | Spring 2019 View this report online: www.worldbank.org/eca/wbrer 1001 Windows by Markel Capo Capo is the author of different exhibitions that conjoin modern and traditional elements. His latest exhibition entitled ”Ku(k)llat” is a tribute to the strength and values of women. The painting “1001 Windows”, the winner of Albanian Contemporary Art Competition organized recently by the World Bank, is part of an ongoing project called “Wreath Stone”, inspired by castles, stones, and Albanian women strength. In another ongoing project Capo paints Albanian national costumes on plates, jewelry, and wooden spoons. Capo uses his art as a tool for communication, also using his art to raise awareness of people with Down syndrome. He volunteers with the foundation “Down Syndrome Albania”, teaching young children how to paint. Capo has expressed his dedication for those who have what he calls the “Love Syndrome” through music and photography. People forge ideas, people mold dreams, and people create art. To connect local artists to a broader audience, the cover of this report and following editions will feature art from the Western Balkan countries.