WESTERN BALKANS REGULAR ECONOMIC REPORT Testing Resilience No. 23  |  Spring 2023 Western Balkans Regular Economic Report No.23 | Spring 2023 Testing Resilience © 2023 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. The cutoff date for the data used in this report was March 31, 2023. TESTING RESILIENCE Acknowledgements This Regular Economic Report (RER) covers economic developments, prospects, and economic policies in the Western Balkans region: Albania, Bosnia and Herzegovina, Kosovo, Montenegro, North Macedonia, and Serbia. The report is produced twice a year by a team led by Sanja Madzarevic-Sujster, Richard Record, and Natasha Rovo (Task Team Leaders). This issue’s core team included World Bank staff working on the Western Balkan countries (with additional contributions to specific sections): Marc Schiffbauer, Natasha Rovo, Leonardo Iacovone, Matias Belacin (Growth section), Sanja Madžarević-Šujster, Joana Madjoska (Labor section), Leonardo Lucchetti, Carlos Gustavo Ospino Hernandez, Anna Fruttero, Zurab Sajaia (Poverty section), Milan Lakićević, Besart Myderrizi, Stefanie Brodmann, Sarah Coll-Black, Zoran Anušić, Cornelius Von Lenthe (Fiscal section), Hilda Shijaku, Isolina Rossi, Sergiy Zorya, Silvia Mauri (Monetary section), Alper Oguz, Jane Hwang (Financial sector section), Sandra Hlivnjak, Tihomir Stučka (External section), Richard Record, Christos Kostopoulos, Collette Mari Wheeler, Daria Taglioni, Roman David Zarate Vasquez (Outlook section), Anita Hafner, and Marissa Santikarn (Spotlight). Research assistance was provided by Suzana Jukić. Diane Stamm provided assistance in editing, and Budy Wirasmo assistance in designing. The cover image was created by Sanja Tanić. The dissemination of the report and external and media relations are managed by an External Communications team comprised of Christopher Walsh, Sanja Tanić, Lundrim Aliu, Anita Božinovska, Ana Gjokutaj, Jasmina Hadžić, Gordana Filipović, and Mirjana Popović. The team is grateful to Xiaoqing Yu (Regional Director for the Western Balkans); Lalita Moorty (Regional Director, Equitable Growth, Finance and Institutions); Jasmin Chakeri (Practice Manager, Macroeconomics, Trade, and Investment Global Practice); and the Western Balkans Country Management team for their guidance in preparation of this report. The team is also thankful for comments on earlier drafts of this report received from the Ministries of Finance and Central Banks in Western Balkans countries. This Western Balkans RER and previous issues may be found at: www.worldbank.org/eca/wbrer/. Acknowledgements v WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Contents Acknowledgementsv Abbreviationsx Testing Resilience 1 1. Overview 2 2. The recovery proved resilient despite global headwinds and unfavorable weather conditions7 3. Job creation decelerated in late 2022 amidst a growth slowdown 12 4. Protracted inflation poses a marked challenge to poverty reduction 18 5. Rebuilding fiscal buffers as financing costs rise 22 6. Inflation pressures soften, but prices remain elevated 31 7. Financial stability risks increase as macro-financial conditions continue to weaken 37 8. Current account balances deteriorate anew in the Western Balkans 43 9. Domestic reforms would help offset a more challenging external outlook 46 10. Spotlight: Towards carbon pricing in the Western Balkans 54 Country Notes 70 Albania71 Bosnia and Herzegovina 77 Kosovo83 Montenegro89 North Macedonia 95 Serbia101 Key Economic Indicators 107 vi Contents TESTING RESILIENCE Figures Figure 2.1. Real GDP growth slowed in 2022… 7 Figure 2.2. ...but it surpassed 2019 levels in all Western Balkan countries. 7 Figure 2.3. Growth was led by domestic demand in 2022. 8 Figure 2.4. Investment growth has been resilient. 8 Figure 2.5. Tourism outperformed 2019 levels in several countries. 9 Figure 2.6. Dry days and hydro production in Albania. 9 Energy-efficiency improvements have a large impact on reducing energy Figure 2.7.  consumption, while the impact on corporate profits is relatively small. 11  imulated impact of a large energy price shock on average corporate costs varies Figure 2.8. S substantially depending on firms’ improvements in energy efficiency. 11 Figure 3.1. Employment growth has slowed since mid-2022. 12 Figure 3.2. In all countries except North Macedonia, employment is above the pre-crisis level. 12 Figure 3.3. Public sector and agricultural employment declined in late 2022. 13 Figure 3.4. Yet, the employment rate increased compared to 2021. 13 Figure 3.5. Unemployment declined in all Western Balkans countries in 2022. 13 Figure 3.6. The youth unemployment is still high and double the overall unemployment rate. 13 Figure 3.7. Despite chronic skills shortages, regional unemployment differences remain high. 15  ore people joined the Western Balkan labor force, but progress slowed in Figure 3.8. M several countries. 16 Figure 3.9. The female-to-male labor participation gap narrowed to 16 percentage points. 16 Figure 4.1. Poverty is likely to have declined moderately in 2022, but many challenges lie ahead.18 Figure 4.2. Inflation varies significantly among product groups. 19 Figure 4.3. Consumption shares vary significantly among income deciles. 20 Figure 4.4. Cost-of-living inflation varies among households. 20 Figure 4.5. Poverty measures are systematically affected by the inflation method used. 21 Figure 4.6. Inequality measures are also affected by the inflation method used. 21 Figure 5.1. Fiscal deficits narrowed in most Western Balkan countries… 22 Figure 5.2. …but widened in Montenegro and Bosnia and Herzegovina. 22 Figure 5.3. The share of social benefit spending increased... 24 …while real public wages declined across the Western Balkans, except for Figure 5.4.  Bosnia and Herzegovina. 24 Figure 5.5. Public and publicly guaranteed debt declined in all countries… 25 Figure 5.6. …and so did government external debt. 25 Figure 5.7. The Western Balkan countries spend considerable resources on social protection. 28 Figure 5.8. Social assistance coverage of the poorest is low. 30 Figure 6.1. Inflation pressures are softening, but price pressures remain elevated globally. 31 Figure 6.2. Global energy and food prices remain above historical averages. 31 Figure 6.3. Food inflation in WB6 and EU27. 32 Figure 6.4. Share of food and non-alcoholic beverages in total household consumption. 32 Contents vii WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Figure 6.5. Growth in agricultural GDP in the WB6 and EU. 33 Figure 6.6. Budgetary support to agriculture in the WB6 and EU. 33 Figure 6.7. In the WB6 countries, inflation peaked at historic highs during 2022... 35 Figure 6.8. …with elevated food and energy prices continuing to fuel consumer price inflation. 35 Figure 6.9. Policy rates started to increase in line with monetary policy tightening in the EU… 36 Figure 6.10. …but real policy rates are negative. 36 Figure 6.11. Exchange rate management was different among the three countries. 36 Figure 6.12. Real exchange rates appreciated. 36 Figure 7.1. Share of government securities as a percentage of total banking sector assets. 39 Figure 7.2. Residential real estate loans to total gross loans. 39 Figure 7.3. Credit growth has started to decelerate since September 2022. 40 Figure 7.4. Household loans grew faster except in North Macedonia and Montenegro. 40 Figure 7.5. NPLs continued a downward trend in all countries. 41 Figure 7.6. Banks’ capital buffers were preserved. 41 Figure 8.1. Current account deficits widened in 2022… 43 Figure 8.2. …in most countries in the region. 43 Figure 8.3. External deficits were mostly met with robust FDI… 45 Figure 8.4. ...among else due to the nearshoring to some parts of the Western Balkans. 45 Figure 9.1. Growth projections have been revised downward in 2023 for three economies. 47 Figure 9.2. Commodity prices have receded from past peaks, but remain elevated. 47 Figure 9.3. Aggregate welfare gains: reducing waiting times at the border by three hours. 50 Figure 9.4. Global Developments and Growth Scenarios. 52 Figure 10.1. Western Balkans’ energy mix: Gross available energy by product, 2015 and 2020 55 Figure 10.2. Share of exports exposed to CBAM by sector and country, 2018–2022. 57 viii Contents TESTING RESILIENCE Boxes Energy efficiency gains imply large savings in energy consumption and greenhouse Box 2.1.  gas emissions by firms, but have only a relatively small impact on corporate profits. 10 Box 3.1. Regional unemployment disparities in the Western Balkans persist. 14 Boosting the efficiency, effectiveness, and equity of social protection in the Box 5.1.  Western Balkans. 28 Box 6.1. Food inflation in the Western Balkans. 32 Box 7.1. Western Balkans financial sector: Sovereign and real estate market exposure. 38 Trade facilitation reforms could help to accelerate growth in the Western Balkans, Box 9.1.  especially if countries take coordinated action. 49 Box 9.2. Global economy under large uncertainty. 50 Box 10.1. EU CBAM Exemptions.57 Box 10.2. Modeling results for impacts of domestic carbon pricing in Serbia. 62 Tables Table 1.1. Western Balkans Outlook, 2020–25 6 Table 5.1. Growth rates of key fiscal variables and inflation. 23 Table 5.2. Yields on Western Balkan countries’ outstanding Eurobonds. 27 Table 10.1. WB6 and EU27 energy mixes, GHG emissions, and renewables trends. 58 Table 10.2. CBAM selected sector effects by 2035 compared to BAU for Serbia. 59 Table 10.3. Overview of selected modeling results of CBAM impacts in WB6. 59 Table 10.4. WB6 Carbon pricing and MRV developments. 61 Table 10.5. Overview of carbon pricing modeling results in WB6. 63 Table 10.6. Fuel excise rates in WB6 and EU guidance. 63 Contents ix WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Abbreviations BAU business as usual MRV Measurement, Reporting and BoA Bank of Albania Verification CAD current account deficit MTRS Medium-Term Revenue CBAM Carbon Border Adjustment Strategy Mechanism NECPs National Energy and Climate CEE Central and Eastern Europe Plans CO2 carbon dioxide PMI Purchasing Managers Index COL cost of living pp percentage point CPI Consumer Price Index PPG public and publicly guaranteed ECAPOV Europe and Central Asia Q3 third quarter Regional Collection Q4 fourth quarter ECB European Central Bank R&D research and development EGD European Green Deal rhs right-hand scale ETD Energy Tax Directive SILC Survey of Income and Living ETS Emissions Trading System Conditions EU European Union SOEs state-owned enterprises FDI foreign direct investment 3mma three-month moving average FX foreign exchange WTO World Trade Organization GDP gross domestic product y/y year over year GFC global financial crisis GJ gigajoule H1 first half Balkan Country Abbreviations H2 second half HBS Household Budget Survey ALB Albania ICT information and BiH Bosnia and Herzegovina communications technology KOS Kosovo IMF International Monetary Fund MKD North Macedonia KM konvertibilna marka; the MNE Montenegro monetary unit of Bosnia and SRB Serbia Herzegovina WB6 Western Balkans 6 x Abbreviations TESTING RESILIENCE Other Country Abbreviations ARM Armenia AZE Azerbaijan BGR Bulgaria BLR Belarus CZE Czech Republic ECA Europe and Central Asia EST Estonia GEO Georgia HRV Croatia HUNG Hungary KAZ Kazakhstan KGZ Kyrgyzstan KSV Kosovo LTU Lithuania LVA Latvia MD Moldova MDA Republic of Moldova POL Poland ROU Romania RUS Russia SVK Slovakia TJK Tajikistan TUR Turkey UKR Ukraine UZB Uzbekistan Note: All comparisons are year on year unless otherwise stated. Abbreviations xi Testing Resilience WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 1. Overview The six countries of the Western Balkans now surpassed their pre-pandemic levels in have seen their resilience tested over the terms of GDP, although at different speeds. last three years. After the economic activity bounced back in 2021, economic performance Inflation surged to a two-decade high in has been buffeted by a challenging external 2022 in almost all economies, and price environment stemming from the fallout pressures remain elevated in early 2023. of Russia’s invasion of Ukraine, higher In most countries of the Western Balkans, energy and food prices, unfavorable weather consumer price inflation peaked in late 2022 conditions, tightening financial conditions, and now shows signs of easing. Energy and and significant uncertainty. That said, while food price increases have driven inflation growth continues to slow and prices continue upward throughout 2022, but with external to rise, the economies of the Western Balkans drivers now dissipating due to slowing global have shown resilience. Although risks remain growth. Trends in core inflation suggest that heavily tilted to the downside, the most price pressures remain broad-based and sticky. significant fears—such as persistent energy and In countries with an independent monetary food shortages or a recession in the Eurozone— policy, central banks have taken steps to tighten have not materialized. The region now faces the it. However, conditions remain accommodative challenges of rebuilding buffers in readiness as real policy rates remain negative due to rising for the next shock, and in undertaking supply- inflation and price expectations. side reforms to lay the foundations for more sustainable and greener growth. Higher food and energy prices have affected low-income households especially Growth in the Western Balkan economies severely, resulting in a much slower pace of started strong in early 2022, before poverty reduction in 2022 despite universal moderating toward year-end, but the government support. Due to lower economic impact of major shocks, such as electricity growth and higher inflation, poverty is estimated and heating outages, has been less severe to have decreased by just 1 percentage point in than expected. The economic performance 2022, a much lower poverty reduction pace than of the region reflects synchronization with in the pre-pandemic period. This is equivalent the European Union (EU), the effect of rising to 160,000 individuals moving out of poverty energy and food prices on consumption and in 2022. Households at the bottom end of the investment, and the weather-induced impact distribution of income spend a much higher on agriculture and energy production, due to proportion of their income on food and energy, a particularly dry year. Despite having avoided the two items in the consumption basket with a recession in the last quarter, the EU27 is the highest price increase, compared to those estimated to have grown at a pace of 3.7 percent at the top of the income distribution. This in 2022, leading to a pause in the Western means that the increases in the actual cost of Balkans convergence. All six economies have living faced by the poor in the Western Balkans 2 1. Overview TESTING RESILIENCE are much higher than official consumer price transfers were offset by declining real public inflation figures suggest. To design effective wages and under-execution of capital spending. policies to protect the less well-off and promote As a result, the Western Balkan average deficit economic growth, it is important to consider level remained constant from a year before at the variability of inflation rates across different 3.0 percent of GDP and still higher than its pre- household types. pandemic level. While public debt has declined below pre-pandemic peaks, except in Kosovo Despite seeing a positive rate of employment and North Macedonia, it remains elevated in growth, the pace of job creation lost general, amid tightening financing conditions. strength across all Western Balkan countries As the region begins to look beyond the in the second half of 2022. By year-end, crises, countries will need to shift away from employment in the Western Balkans contracted broad-based subsidies toward more targeted by over 1 percent, equivalent to 72,000 fewer approaches. Pent-up pressures on public sector jobs. Albania and Montenegro are the only wage bills are also expected to grow. countries where employment levels continued to grow. However, employment levels across The financial sector in the Western Balkans all countries except North Macedonia are still continued to be stable, but its resilience is above pre-crisis levels despite the slowdown. being tested by pressures on financial stability While the unemployment rate declined across posed by multiple factors. The ongoing war all countries to 13.2 percent by end-2022, the in Ukraine, sharply higher interest rates and youth unemployment rate is still double the inflation are now coupled with a deterioration overall rate, although it is declining. There of economic sentiment across the region. were 878,000 people unemployed in the While asset quality continues to improve, there region at end-2022, a contingent that needs are concerns that rising interest rates and the to be mobilized to address labor shortages tightening of credit supply might accentuate articulated by firms. The regional disparities in borrowers’ vulnerabilities. Credit risks from unemployment persisted throughout the crises energy-intensive corporate sectors, residential and recovery, suggesting low labor mobility. and commercial real estate, uncollateralized consumer finance, interest rate-sensitive Fiscal deficits have narrowed in most portfolios, and sovereign exposures will need Western Balkan countries despite persistent to be closely monitored. High frequency data social spending pressures against record points to signs of higher credit risk, despite inflation. In four of the six Western Balkan decreasing NPL ratios. countries, fiscal deficits narrowed by an average of 1 percentage point of GDP during 2022. Yet, In 2022, the regional current account in Montenegro and Bosnia and Herzegovina, deficit exhibited its highest level in the last fiscal balances deteriorated compared to 2021, decade, with the exception of the pandemic though less than previously expected. Across year. Specifically, the regional external deficit the six economies, nominal revenues have soared to 6.9 percent of GDP in 2022 from performed well, helped by higher inflation. 4.8 percent the year before. The widening As a share of GDP, public expenditure was of the external deficit was mainly driven by broadly stable, as higher social spending and Montenegro and North Macedonia, while 1. Overview 3 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Albania remained an exception. Merchandise compressing demand and raising financing trade deficits widened due to both the terms- costs for sovereigns, corporates and households. of-trade shock raising the cost of imports, and consumption and investment growth Against this backdrop, the resilience of outpacing export growth. Net service exports, growth in 2023 will be tested further. GDP including tourism, in particular, picked up in growth is expected to moderate to 2.6 percent 2022, helping in part to offset the widening in 2023 mainly driven by consumption, current account deficit. Remittances have also though public investment is expected to play held steady reflecting a continued tight labor an important role in Bosnia and Herzegovina, market in the EU. Regional external imbalances Montenegro, and North Macedonia. While were largely funded by net inflows of foreign several countries are expecting a continued direct investment. These rose by 1.2 percent of recovery in tourism revenues, as well as further GDP (to 7.0 percent of GDP) and may give growth in merchandise exports, external some credence to the argument of nearshoring demand may weaken, and domestic demand is of global value chains and/or relocation of expected to remain an important growth factor. businesses from Ukraine and Russia benefiting For the most part, GDP growth forecasts for the Western Balkans. 2023 have been revised downward since the last edition of the Western Balkans Regular The outlook for the Western Balkans remains Economic Report on account of the weaker subdued and uncertainty remains high. In the external environment, which affects export short term, growth outcomes are expected to be growth, inflation, and financing costs (Table driven by economic performance in the EU, the 1.1). course of energy and food prices, and the fight against inflation. All these factors are affected In the medium term, the Western Balkans by Russia’s invasion of Ukraine and persistent continues to have a positive outlook, but impacts of the pandemic, which prompted shifts reforms are needed to rebuild buffers, in demand and revealed supply bottlenecks. accelerate the green transition, and to The outlook for the EU remains challenging, address key structural challenges. The although the latest forecasts suggest that the ongoing energy crisis has highlighted the Eurozone will avoid a recession. Energy prices need to accelerate the green transition across are driven by continued supply uncertainty, Europe, including in the Western Balkans. A although price forecasts are now lower than key starting point in this regard is to accelerate anticipated last year owing to the milder the move toward carbon pricing and to increase European winter and receding fears regarding the use of environmental fiscal measures that gas storage stocks. However, natural gas prices incentivize households and firms to shift are proving sticky, especially in Europe, given toward lower carbon intensity with respect to the critical role Russia has played in this economic activity (the Spotlight in this edition market. Food prices are expected to remain of the Western Balkans Regular Economic Report high and look to be resulting in a pass-through investigates this issue in more depth). Further, to higher core inflation. Finally, monetary as governments across the region look toward tightening led by advanced economies is both rebuilding their fiscal buffers, there are high 4 1. Overview TESTING RESILIENCE returns to no-regret reforms that would boost productivity over the medium term, such as accelerating regional integration, increasing levels of market competition, attracting higher quality investments, and addressing barriers that limit labor force participation (especially among women). Finally, securing alternative energy resources, including through the acceleration of investment in renewables, needs to be a priority ahead of the next winter. 1. Overview 5 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Table 1.1. Western Balkans Outlook, 2020–25 2020 2021 2022e 2023f 2024f 2025f Real GDP Growth (percent) Albania -3.3 8.9 4.8 2.8 3.3 3.3 Bosnia and Herzegovina -3.0 7.4 4.0 2.5 3.0 3.5 Kosovo -5.3 10.7 3.5 3.7 4.4 4.2 North Macedonia -4.7 3.9 2.1 2.4 2.7 2.9 Montenegro -15.3 13.0 6.1 3.4 3.1 2.9 Serbia -0.9 7.5 2.3 2.3 3.0 3.8 WB6 -3.0 7.8 3.2 2.6 3.1 3.5 Real GDP Components Growth (percent) Consumption -1.1 4.6 3.3 1.9 2.1 2.6 Investment -1.6 2.0 2.5 0.9 0.9 1.2 Net exports -0.3 -0.1 -2.7 -0.2 0.2 -0.3 Exports -5.9 9.7 7.7 2.3 2.8 3.4 Imports (-) -5.6 9.8 10.4 2.5 2.6 3.6 Consumer Price Inflation (percent, period average) 1.0 3.3 11.8 7.0 3.4 2.9 External Sector (percent of GDP) Goods exports 27.2 32.5 36.8 37.0 37.0 37.1 Trade balance -14.0 -13.0 -15.3 -14.7 -14.1 -13.7 Current account balance -5.5 -4.8 -6.9 -6.3 -5.8 -5.5 Foreign direct investment 5.2 5.8 7.0 5.8 5.7 5.8 External debt 88.9 83.8 78.4 75.6 73.8 72.3 Public Sector (percent of GDP) Public revenues 34.7 36.0 35.6 35.9 35.6 35.7 Public expenditures 42.5 38.9 38.6 38.7 38.1 37.9 Fiscal balance -7.9 -3.0 -3.0 -2.7 -2.4 -2.0 Public and publicly guaranteed debt 60.5 56.6 51.0 50.9 51.3 50.7 Sources: National statistical offices; Ministries of Finance; central banks; World Bank staff estimates. Note: e = estimate; f = forecast. 6 1. Overview TESTING RESILIENCE 2. The recovery proved resilient despite global headwinds and unfavorable weather conditions Growth in the six Western Balkan Growth was driven by two countervailing economies started strong during the year forces: (i) a robust increase in domestic before moderating toward end-2022, but the demand owing to private consumption impact of major shocks, such as electricity and, in some countries, a surge in public and heating outages, has been less than investment; and (ii) an adverse terms-of- expected. The economic performance of the trade shock ( Figure 2.3). Private consumption, WB6 countries reflects synchronization with exports, and investment drove growth, despite the European Union (EU), which, having increasing energy and food prices. Part of avoided a recession in the last quarter, is it is policy induced—still accommodative estimated to have grown at 3.7 percent in 2022; monetary and fiscal policy in the first half and despite the effect of rising energy and food of the year; tightening that followed lead to prices on consumption and investment and the lower growth at the end of 2022. Increases weather-induced impact on agriculture and in remittances, credit growth, fiscal support energy production due to a particularly dry measures, minimum wage hikes, and public year. Overall growth for the year came in at sector wage increases helped support household 2.1 percent in North Macedonia, 2.3 percent consumption. Where real net wages softened, in Serbia, 3.5 percent in Kosovo, 4.0 percent such as in Bosnia and Herzegovina, this was in Bosnia and Herzegovina, 4.8 percent in offset by higher remittances and drawdowns Albania, and 6.1 in Montenegro (Figure 2.1). in household deposits, largely foreign currency All six economies have now surpassed their pre- long-term deposits. Public investment helped pandemic levels in terms of GDP, although at the recovery in Bosnia and Herzegovina, different speeds (Figure 2.2). largely supported by infrastructure works boosted by elections held in October 2022. In Figure 2.1. Real GDP growth slowed in 2022… Figure 2.2. ...but it surpassed 2019 levels in all Western Balkan countries. Percent Real GDP (2019=100) 16 115 12 110 8 105 3.7 3.2 4 100 0 95 -4 90 -8 -12 85 -16 80 MNE BIH ALB KOS SRB MKD WB6 EU27 2019 2020 2021 2022 J 2020 J 2021 J 2022 ▬ ALB ▬ BIH ▬ KOS ▬ MKD ▬ MNE ▬ SRB Sources: National statistical offices; IMF; World Bank staff. Sources: National statistical offices; World Bank staff. 2. The recovery proved resilient despite global headwinds and unfavorable weather conditions 7 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Figure 2.3. Growth was led by domestic Figure 2.4. Investment growth has been demand in 2022. resilient. Contributions to growth, 2022, pp Percent of GDP 15 30 25 10 20 15 5 10 5 0 0 -5 -5 -10 -15 -10 -20 10 11 12 13 14 15 16 17 18 19 06 20 7 08 09 20 21 0 20 20 20 20 20 20 20 20 20 20 20 20 20 MNE ALB BIH KOS SRB MKD 20 20 J Consumption J Investment J Net exports ▬ WB6 ▬ EMDEs excl. China ▬ EU Q Real GDP growth (percent) Sources: National statistical offices; World Bank staff. Sources: World Bank 2023; World Development Indicators. Albania and Montenegro, instead, gross fixed benefits of the proximity of the six countries capital formation slowed, due to a decline in to the EU, and opportunities associated with government capital spending and following the nearshoring of global value chains. completion of the first section of the highway, respectively. Imports, especially of electricity, On the supply side, the hospitality sector has offset export growth in almost all countries; rebounded strongly and even outperformed only in Kosovo was the net export contribution the pre-pandemic levels in Albania, Kosovo, to growth positive. and Serbia  (Figure 2.5). International tourism receipts accounted for up to more Investments in the Western Balkans have also than 50 percent of total exports in Albania (Figure 2.4). This contrasts with been resilient  and Montenegro in 2019, before COVID-19 a majority of emerging markets and developing hit, which led to a large fall in arrivals in the economies (EMDEs), where the investment two countries and across the region. In 2022, recovery following the COVID-19 pandemic tourism, proxied by the number of nights has proceeded slowly, especially compared to spent by nonresidents, has fully recovered the years following the global financial crisis and has surpassed the 2019 level in Kosovo, (GFC). In addition, the decline observed for followed by Albania and Serbia. In contrast, investment growth in EMDEs over the past in Montenegro, North Macedonia, and Bosnia two decades reflects in large part the path of and Herzegovina, even though tourism has output, changes in the capital flow-to-GDP continued to see a steady recovery, the number ratio, and low private sector real credit growth. of arrivals and nights spent have still not yet For the Western Balkans, the contribution of returned to the levels observed before the investment to growth was higher in 2021 and pandemic. 2022, at 2.0 and 2.5, respectively, compared to the years immediately after the GFC and The service sector continues to lead the differently from the EMDEs average, where growth recovery, while industrial activity the investment growth was sluggish in the lags, except in Kosovo. Construction has aftermath of the GFC. This may also reflect the subtracted from growth across the region, 8 2. The recovery proved resilient despite global headwinds and unfavorable weather conditions TESTING RESILIENCE Figure 2.5. Tourism outperformed 2019 Figure 2.6. Dry days and hydro production in levels in several countries. Albania. Number of nights spent by foreign tourists (2019=100) MWh (million) 180 10 350 160 9 300 140 8 7 250 120 6 200 100 5 80 4 150 60 3 100 40 2 50 20 1 0 0 0 10 11 12 13 14 15 16 17 18 19 20 21 22 20 20 20 20 20 20 20 20 20 20 20 20 20 2019 2020 2021 2022 ▬ ALB ▬ BIH ▬ KOS ▬ MKD ▬ MNE ▬ SRB ▬ Hydro (net domestic production) ▬ Number of days <0.3mm (rhs) Sources: National statistical offices; World Bank staff. Sources: www.meteotirana.al; INSTAT. Note: Dry days are days with precipitation less than or equal to 0.3 millimeters. except in Albania, where construction, together on firms’ profits, especially in Albania and with trade, have been the main drivers of Montenegro (Box 2.1). The agriculture growth. While in Montenegro an increase sector also suffered from unfavorable weather in the number of building permits issued conditions, with agricultural production toward the end of the year points to a likely declining in Serbia for the second year in a row, resumption of construction activity in the near while in Albania it grew by only 0.13 percent term, the 12 percent decline in construction in the second quarter. The agricultural sector permits issued in December suggests prolonged in Albania accounts for almost 18 percent of weaker construction activity in Serbia. Across GDP, more than double the average share for the six countries, industrial production also other Western Balkan countries. contracted in 2022, except in Kosovo, where it expanded. In Serbia, after a slowdown in the third quarter, industrial production bounced back in the last quarter, primarily supported by the mining sector. Unfavorable weather negatively impacted electricity production and agriculture across the region. Unfavorable hydrometeorological conditions in the region, with 2022 reaching a new record-high number of dry days (Figure 2.6), affected electricity generation, negatively impacting overall industrial production in Albania and Montenegro. Investments in energy efficiency would help cope with the increasing frequency and severity of such energy shocks and would significantly reduce the negative impact of energy price shocks 2. The recovery proved resilient despite global headwinds and unfavorable weather conditions 9 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Box 2.1. Energy efficiency gains imply large savings in energy consumption and greenhouse gas emissions by firms, but have only a relatively small impact on corporate profits. Substantial savings in energy-related greenhouse gas emissions would be generated by even moderate improvements in the energy efficiency of Western Balkan firms. Energy requirements vary among sectors and among firms within sectors. For example, in high energy-dependent sectors such as transport, energy expenses in electricity and fuels account for 45 percent of total costs, while in low energy-dependent industries such as textiles, the average share of energy in total costs is 7 percent. But there are also large differences in the energy efficiency among firms operating in the same sector, reflecting differences across firms in green technology investment and green management practices. That is, even in the least energy-intensive sector—textiles—differences range from 4 percent to 10 percent of total costs. If all energy-inefficient firms—namely, those below the 50th percentile in energy efficiency of their sector—adopted the industry’s median efficiency, energy consumption required for producing the same amount of output would decline between 14 percent and 36 percent for the average firm in the Western Balkans (Figure 2.7, Panel A). Improving energy efficiency has only modest effects on the average firm’s costs and profitability, given their low energy dependence and comparatively lower energy costs, yet the social benefits are large. Given that average energy expenses do not exceed 9 percent of firms’ total costs in Western Balkan countries, reflecting on average lower energy prices than in their EU peers, improving energy efficiency would have low impact on firms’ total costs and profitability. That is, enhancing the energy efficiency of less-efficient firms would reduce total costs (including labor, raw materials, costs of goods sold, and energy items) between 0.6 percent and 3.1 percent, which implies profit gains ranging from 0.4 to 3.9 percent (Figure 2.7, Panel B). The relatively small size of the expected profit gains from energy improvements may thus explain why investments in green technologies and environmentally friendly management practices have been relatively limited in Western Balkan countries; that is, as the expected gains from green technology investments are limited, firms are less prone to invest money in green technologies or management practices. However, social benefits from increased energy efficiency are large. Policy incentives should be designed such that firms internalize the social benefits from investing in green technology and management practices. Improving energy efficiency would, however, shield Western Balkans companies from future electricity and gas price shocks. Notably, during the energy crisis, firms in the Western Balkans have so far faced much lower electricity and gas price shocks than firms in the EU27 countries. If electricity and gas price shocks were as equally strong as those experienced by the average firm in the EU27 countries, total costs among Western Balkan firms would have risen between 3 percent and 9 percent. To quantify the extent to which energy efficiency improvements can reduce corporate costs after a surge in electricity and gas 10 2. The recovery proved resilient despite global headwinds and unfavorable weather conditions TESTING RESILIENCE (Box 2.1 continued) prices comparable to that observed in EU countries, Figure 2.8 reports the change in costs considering two scenarios: (a) there are no energy efficiency improvements; and (b) firms below the median energy-efficiency level compared to other firms of similar size in their sector are able to catch up to the efficiency level of the median firm. Moreover, as energy consumption depends on the price levels, we consider the average energy consumption of firms in the EU27 to simulate the impact of electricity and gas price changes at the country level. The results show that the rise in total corporate costs would be limited to only 1 to 2 percent instead of 3 to 9 percent if less energy-efficient firms improve their efficiency to the medium efficiency of their respective sector-size group. In Albania and Montenegro, for example, such energy efficiency improvements would reduce the electricity and gas price shock impact on total corporate costs from 9 percent to only 1.5 percent. Figure 2.7. Energy-efficiency improvements have a large impact on reducing energy consumption, while the impact on corporate profits is relatively small. Panel A. Energy savings Panel B. Profit gains and total cost savings Change relative to baseline, percent Change relative to baseline, percent Albania Albania Bosnia and Bosnia and Herzegovina Herzegovina Kosovo Kosovo Montenegro Montenegro North North Macedonia Macedonia Serbia Serbia 0 10 20 30 40 50 60 0 1 2 3 4 5 6 J Costs J Profits Source: Staff calculations based on World Bank Enterprise Surveys. Note: Energy costs are the sum of annual electricity and fuel costs. Total costs are defined as the sum of labor, energy, raw materials, and costs of goods sold. Value added results of subtracting raw materials costs from sales, while profits are calculated as total sales net of total costs. Baseline values are profits and costs before efficiency improvements. Figure 2.8. Simulated impact of a large energy price shock on average corporate costs varies substantially depending on firms’ improvements in energy efficiency. Change in costs relative to baseline, percent Albania Bosnia and Herzegovina Kosovo Montenegro North Macedonia Serbia -2 -1 0 1 2 3 4 5 6 7 8 9 Q Improvement to p(75) eff. ‹ Improvement to p(50) eff. Q No eff. improvement Source: World Bank staff calculations based on World Bank Enterprise Surveys and Eurostat. Note: No efficiency improvements consider the impact of the energy price shock on average firm-level total costs assuming the price increase is the average EU27 electricity and gas price changes. Improvement to the 50th percentile—p(50)—efficiency means that efficiency of firms below the median of the industry-by-size efficiency threshold is improved to the threshold value. The equivalent exercise if performed for the 75th percentile—p(75). Baseline costs are those under no efficiency improvements. 2. The recovery proved resilient despite global headwinds and unfavorable weather conditions 11 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 3. Job creation decelerated in late 2022 amidst a growth slowdown1 Despite employment growth, job creation Employment contracted the most in lost strength across all the Western Balkan agriculture and public administration, countries in the second half of 2022  (Figure while industry and services also observed 3.1). While employment in early 2022 increased a slowdown. In December 2022, the in all countries (except North Macedonia, due strongest employment growth was in services to the adjustment to the new census-informed (3.2 percent2) and construction (2.8 percent), sample) by year-end the situation had reversed. while industry observed a mild 0.5 percent By December 2022, employment dropped in rate of employment growth (Figure 3.3). In all countries except Albania and Montenegro Albania, Bosnia and Herzegovina, and Kosovo, compared to end-2021. At year-end, overall employment increased in agriculture as well, annual employment in the Western Balkans while in other countries, a decline continued had contracted by over 1 percent, equivalent despite increased subsidies to the agriculture to a net loss of 72,000 jobs. The largest annual sector to contain the impact of food inflation drop was observed in North Macedonia, and to increase import substitution. Albania, followed by Serbia and Kosovo. However, Bosnia and Herzegovina, and Serbia also employment levels across all countries except observed a rise in public sector employment. North Macedonia are still above pre-crisis Employment in construction, retail trade, levels (Figure 3.2). information and communications technology (ICT), and tourism in Montenegro increased by double digits compared to 2021. Service sector employment in Serbia also gained Figure 3.1. Employment growth has slowed Figure 3.2. In all countries except North since mid-2022. Macedonia, employment is above the pre- crisis level. Two-quarter averages 2019 to 2022, y/y employment growth, percent December 2019=100 10 40 115 30 110 5 20 105 0 10 100 -5 95 0 -10 90 -10 85 -15 -20 80 Ju 19 Se -19 De -19 M -19 Ju 20 Se -20 De -20 M -20 Ju 21 Se -21 De -21 M -21 Ju 22 Se 22 De -22 22 - - - n- c- - ar n p c ar n p c ar p ar n p c Dec-19 Dec-20 Dec-21 Dec-22 M ▬ ALB ▬ MKD ▬ SRB ▬ WB6 ▬ BIH (rhs) ▬ MNE (rhs)▬ KOS (rhs) ▬ ALB ▬ BIH ▬ KOS ▬ MKD ▬ MNE ▬ SRB ▬ WB6 Source: National statistics offices and World Bank staff estimates. Source: National statistics offices and World Bank staff estimates. 1 This analysis was affected by (1) delayed publishing of Labor Force Survey (LFS) data in Kosovo; and by (2) a sampling revision in Bosnia and Herzegovina, Montenegro, and North Macedonia that reduced comparability with previous LFS data. Using administrative unemployment, and tax administration data for Kosovo, helped provide an approximate picture of the labor market from Q2 2022. 2 All comparisons are year on year unless otherwise indicated. 12 3. Job creation decelerated in late 2022 amidst a growth slowdown TESTING RESILIENCE strength in late 2022, partially helped by 2022 (Figure 3.4). At 50.9 percent, Serbia migrant labor in ICT and professional services, registered a historically high employment rate as in Montenegro. in June 2022, and declined slightly by year- end, reflecting the growth slowdown. Although The Western Balkans employment rate (those the employment rate in Kosovo increased, it is aged 15 and over) reached a historic high of still a low 32 percent. 47 percent in September 2022, after which it began to decline. The largest annual increases Unemployment declined across all countries were registered in Albania and Montenegro at and reached 13.2 percent at end-2022 2.7 and 7.9 percent, respectively. Albania is still (Figure 3.5). As of December 2022, there  the front-runner in the Western Balkans, with were 878,000 people unemployed in the the highest employment rate of 56.3 percent, region—10.5 percent or 103,000 people fewer although Montenegro gained speed throughout than a year ago. Bosnia and Herzegovina, 2022, reaching 51.3 percent in December Kosovo, and North Macedonia recorded the Figure 3.3. Public sector and agricultural Figure 3.4. Yet, the employment rate employment declined in late 2022. increased compared to 2021. Employment level, 15+ years, percent, annual change Employment rate, 15+ years, percent, annual 8 WB6 1.6 6.4 6.2 6 5.4 1.6 4.7 KOS 3.7 3.7 4 3.3 3.2 2.8 0.6 2.3 2.3 BIH 1.9 1.7 1.6 2 1.5 1.5 1.4 1.4 1.2 1.2 0.9 0.9 0.5 0.2 0.0 0 MKD -0.2 -0.3 -0.8 -0.9 -1.5 -2 1.6 -2.0 SRB -2.7 -3.1 -4 -3.6 7.9 -4.2 -4.3 -4.4 -4.5 MNE -4.7 -4.9 -6 -5.9 2.7 -8 ALB General Agriculture Industry Construction Services government 0 10 20 30 40 50 60 J Q2-20 J Q4-20 J Q2-21 J Q4-21 J 2022 J 2021 J Q1-22 J Q2-22 J Q3-22 J Q4-22 Sources: National statistics offices and World Bank staff estimates. Sources: National statistics offices and World Bank staff estimates. Note: Employment growth is weighted average. Figure 3.5. Unemployment declined in all Figure 3.6. The youth unemployment is still Western Balkans countries in 2022. high and double the overall unemployment rate. Unemployment rate, 15+ years, percent, and 2022–21 change, pp Percent WB6 -1.8 60 -1.6 50 SRB -0.6 ALB 40 -1.3 MKD 30 -1.9 MNE 20 -2.0 BIH 10 -5.5 KOS 0 0 2 4 6 8 10 12 14 16 18 20 22 ALB BIH KOS MKD MNE SRB WB6 J 2022 J 2021 J 2019 J 2020 J 2022 Source: National statistics offices and World Bank staff estimates. Source: National statistics offices and World Bank staff estimates. 3. Job creation decelerated in late 2022 amidst a growth slowdown 13 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 largest declines in the number of unemployed, Balkans—a contingent in its highly productive by 13, 18, and 21 percent, respectively. In all age, some 36,000 less than in 2021. The lowest three countries, this is explained by a declining youth unemployment rate was in Albania, at labor force and an increase of inactivity, 21.5 percent, followed by Kosovo and Serbia, while in Montenegro, people moved to jobs. each under 25 percent. Robust economic Montenegro is the only country that experienced growth and diverse occupational and training a rise in both employment and unemployment, programs for the young helped reduce youth and where the regional differences are largest unemployment to 31 percent in Montenegro, (Box 3.1). Bosnia and Herzegovina, and compared to 37 percent a year before. Despite North Macedonia reached historically low improvements, the labor market situation for unemployment rates—14.3 percent and young people in the Western Balkan countries 14 percent, respectively, but largely as people is characterized by high inactivity, persistent moved to inactivity or migrated. Serbia has high levels of unemployment, a high share of the lowest unemployment rate in the region informality, significant skills mismatches, and at 9.2 percent in December 2022, while the continued emigration. Since 2012, when half highest unemployment rate is in Kosovo, at the young people were unemployed, the rate slightly under 17 percent. fell to 26 percent in 2022, but was still around 10 pp higher than the EU average. More than The youth unemployment rate in 50 percent of young people were long-term the Western Balkans is double the unemployed, which runs an increased risk of overall rate, although it declined to skill losses, reduced motivation to search for 27 percent—4.8 percentage points below the employment, and has the potential that youth December 2021 rate  (Figure 3.6). There are will exit the local labor market altogether. 202,000 young people unemployed in Western Box 3.1. Regional unemployment disparities in the Western Balkans persist. Regional unemployment in the Western Balkans was disproportionately affected by the pandemic, with most of the impact absorbed by service-intensive regions. Nearly 70,000 jobs were lost across Western Balkan countries in 2020,a largely in tourism-oriented economies such as Albania and Montenegro, where coastal regions were hit hardest as a result of movement restrictions. At the same time, unemployment rates in capital cities (Tirana, Belgrade, Skopje) evidenced a modest reduction in unemployment. Post-pandemic, the regional recovery proved uneven and altered regional unemployment patterns across countries in the Western Balkans. In 2019, the bottom of the regional unemployment rate distribution was held by Elbasan, Albania (5.4 percent in 2019), but by 2022, Montenegro’s coastal region took the lead (3.6 percent). Regions with high structural unemployment, such as the Northern region in Montenegro, the Federation of Bosnia and Herzegovina, and the Northeast region in North Macedonia, continued to struggle with unemployment rates of over 34 percent, largely unchanged compared to 2019. 14 3. Job creation decelerated in late 2022 amidst a growth slowdown TESTING RESILIENCE (Box 3.1 continued) Unemployment inequality within countries intensified, but the structure remained largely the same. In many Western Balkan countries, regions with the historically highest unemployment rates evidenced the largest hikes in unemployment relative to the pre- pandemic period, such as Lezhe and Diber in Albania (up by 5 pp and 7.6 pp to 22.7 percent and 17.7 percent in 2022) and the Northeast region in North Macedonia (up by 3.3 pp to 36 percent in 2021). Regional disparities also deepened as the gap among regions with the lowest and highest unemployment rates widened in most of the countries, particularly in North Macedonia, where the difference between the Northeast and the Southeast region increased by over 5 pp compared to 2019, and the unemployment rate gap between the two regions reached 32.5 pp in 2021.b The lack of mobility in Montenegro from the north to the coastal region is also pronounced; the unemployment rate gap between the two regions remained unchanged in 2022 compared to the pre-crisis 2019, at 30.6 pp. The coastal area’s unemployment rate is below the natural rate of unemployment and is relying on foreign workers from neighboring Kosovo, Albania, and Serbia, but also Asian markets. Figure 3.7. Despite chronic skills shortages, regional unemployment differences remain high. Unemployment rate by regions, ages 15+ 40 35 30 25 20 15 WB6 2022 average 10 5 0 AL the ër So kas l B Ko a AL Va ija M Du dar Vl e M MKD Lez t M ukë t B Be t S e B B S LB N th d st M B est M ALB en S Pe Tira al So ib S hë M B th g rt IH m uth hko th No FB n t ija nd ër AL Sko s a KD s b t B LB n A vo r SR lgr ë M go në ë AL thw r B es K s AL LB Eas as o SR LB din B pj KD B KO B ad C R KD IH er El ra j e u ë ë tr or B a Be rc an Ea KD ro t SR A asa u t SR SR A SRB ou Su o S or KD n No Pol M Gji oas ad a d Vo Fi KD rr W he NE IH B r D r B C l a AL NE M AL A NE M KD Sources. National statistical offices. Note: North Macedonia (2021), and Kosovo (Q1 2022). a. Western Balkans Regular Economic Report Spring 2021. The estimates exclude Bosnia and Herzegovina, which saw an increase in employment due to LFS sampling changes. b. The 2021 census data have not yet been reflected on the historical population data adjustment from 2001 onwards. This may lead to overestimation of the unemployment rates in 2019 as labor outmigration has not been adequately captured. 3. Job creation decelerated in late 2022 amidst a growth slowdown 15 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 The aggregate labor force participation rate The improvement in the labor force improved slightly over the last year for the participation rate is the result of women Western Balkans as a whole ( Figure 3.8). but also men entering the labor markets of The participation rate averaged 53.1 percent in Albania, Montenegro, and Serbia. The most December 2022—0.8 pp up since end-2021, pronounced increase of female participation with the gains coming only from Montenegro was in Montenegro at 4.3 pp in 2022, Albania and Albania (of 5.6 pp and 2.8 pp, respectively). at 3.5 pp, and North Macedonia at 3 pp. The labor force participation rate reached With 57.4 percent of female participation rate, 63.2 percent in Albania—a record for the Albania sets the record for the region (Figure region, but after the revised methodology, 3.9). Serbia and Montenegro have female Montenegro is following suit. In Bosnia and participation rates also above the regional Herzegovina, Kosovo, North Macedonia, and median of 48 percent, while in Albania, the Serbia the participation rate dropped in 2022 gender gap is the narrowest, at 11.8 pp. The as employment growth slowed in late 2022, female-to-male participation gap for the and people either moved to inactivity or to region declined by 4 pp over the last year to work abroad. The working age population 15.6 percent, with a stark difference of over over the past three years declined in Kosovo, 33 pp in Kosovo (Figure 3.9). Together with North Macedonia, and Serbia, reflecting the methodological improvements, the labor tax high outmigration flows. The lowest ratio wedge reduction that came along with an of the population participating in the labor increase in net wages as part of the Europe Now market is in Kosovo (at 37.7 percent), where program in Montenegro, likely contributed it has been declining since 2018. In Bosnia to the increased labor force participation, as and Herzegovina and Kosovo, a rise in inactive advances in male participation (at 67.4 percent) population has been observed, which also are also remarkable. reflects on pension outlay costs (Figure 5.3). Figure 3.8. More people joined the Western Figure 3.9. The female-to-male labor Balkan labor force, but progress slowed in participation gap narrowed to 16 several countries. percentage points. Percent of population aged 15+ Labor force participation, percent 63.2 80 ALB 70 54.9 MKD 60 55.1 SRB 50 60.0 40 MNE 30 47.5 BIH 20 37.7 10 KOS 0 Dec-20 Dec-21 Dec-22 Dec-20 Dec-21 Dec-20 Dec-22 Dec-21 Dec-20 Dec-20 Dec-22 Dec-21 Dec-22 Dec-21 Dec-19 Dec-22 Dec-20 Mar-22 53.1 WB6 0 10 20 30 40 50 60 70 ALB MNE SRB MKD BIH KOS J Dec-22 J Dec-21 J Dec-20 Q Female LFP Q Male LFP Source: National statistics offices and World Bank staff estimates. Source: National statistics offices and World Bank staff estimates. 16 3. Job creation decelerated in late 2022 amidst a growth slowdown TESTING RESILIENCE Wage pressures increased by end-2022 due to the inflation surge, and despite a slowdown in employment. In Montenegro, the average net monthly wage increased by 18.7 percent in real terms in 2022, due to the reduction in labor taxes and an increase in the minimum wage. In Albania, a nominal wage rise of 10.8 percent by December 2022 (or 3.4 percent in real terms) reflected the increased labor demand by the private sector. The average wage in Serbia increased by 13.8 percent in nominal terms or 1.7 percent in real terms, reflecting shortages of skills in the service sectors. The 2022 wage growth was more pronounced in the private sector, where the average net wage increased by 17 percent, whereas public sector wages increased by 7.3 percent. Led by a rise in the minimum wage, but also demand for workers in accommodation and recreation services, manufacturing, and the retail trade, nominal wages increased in North Macedonia by 11 percent in 2022. Yet, double-digit inflation meant that real net wages declined. In Bosnia and Herzegovina, nominal wage growth was 14.2 percent, and it was broad-based, with the highest increase in services, and the least in the public sector. But in real terms wages declined by 0.5 percent in December. 3. Job creation decelerated in late 2022 amidst a growth slowdown 17 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 4. Protracted inflation poses a marked challenge to poverty reduction Modest poverty reduction is expected in Figure 4.1. Poverty is likely to have declined 2022, although many challenges remain.3 moderately in 2022, but many challenges lie ahead. Prior to the pandemic, the region had witnessed Poverty headcount, percent of population living on less than $6.85/ a significant reduction in poverty, with the day 2017 PPP 40 poverty rate estimated to have decreased by around 10 percentage points (pp) between 30 2016 and 2019 (Figure 4.1), based on the upper 29.1 26.6 middle-class poverty line of US$6.85 per day 20 23.1 16.9 19.6 19.7 15.9 15.0 in 2017 purchasing power parity (PPP). This is 14.1 13.1 equivalent to almost 1.4 million people moving 10 out of poverty. The 2020 pandemic halted this positive trend. However, the economies of the 0 16 17 e e e e e f f f 23 24 25 18 19 20 21 22 20 20 20 20 region rebounded strongly in 2021, resulting in 20 20 20 20 20 20 Sources: World Bank estimates and projections based on 2018 an estimated poverty reduction of about 2.8 pp, income data from the Survey of Income and Living Conditions (SILC) for Montenegro; 2019 for Albania and North Macedonia, 2020 Serbia, equivalent to lifting more than 400,000 people and 2017 Household Budget Survey (HBS) for Kosovo. Note: Income measures in the SILC and consumption measures in out of poverty. Several risks pose challenges the HBS are not strictly comparable. Welfare is estimated in U.S. dollars using 2017 PPPs. The regional estimate excludes Bosnia for future poverty reduction. Poverty in 2022 and Herzegovina (BiH) due to a lack of comparable data. Forecasts are based on GDP per capita in constant local currency units. e = is estimated to have decreased by only 1 pp in estimate; f = forecast; PPP = purchasing power parity. 2022 due to lower economic growth, equivalent to around 160,000 individuals. However, Index (CPI), which typically measures the price going forward, lower external demand could changes for a fixed basket of goods and services. negatively affect exports and non-labor income However, each household’s consumption by limiting remittances, while tighter fiscal basket may differ from the CPI basket and space continues to constrain the support that from other households’ consumption patterns. can be provided to households. When prices do not vary much, this difference may not matter. However, when price High inflation affected all countries in 2022, variations are high or uneven (such as when but its impact varied among household the prices of some products increase more groups. Food and energy prices soared across than the prices of others), the overall change the region, reducing the purchasing power in the CPI basket may differ significantly from of households, particularly the poor and changes in the price of households’ actual vulnerable, as they spend a larger share of consumption baskets. Among all six Western their income on these items. Estimates of the Balkan countries, Albania had the smallest aggregate inflation impact on real incomes are between-group variation in inflation rate: a based on each country’s official Consumer Price difference of about 13.1 percentage points 3 This section largely relies on Lokshin, Michael M.; Sajaia, Zurab; Torre, Ivan. Who Suffers the Most from the Cost-of-Living Crisis? (English). Policy Research working paper; no. WPS 10377 Washington, D.C.; World Bank Group. 18 4. Protracted inflation poses a marked challenge to poverty reduction TESTING RESILIENCE Figure 4.2. Inflation varies significantly among product groups. 12-month price change across consumption groups, 2022 Panel A. Albania Panel B. Bosnia and Herzegovina 15 30 23.2 14.2 16.9 17.2 14.7 20 12.2 11.6 10 11.1 7.4 8.6 8.5 6.5 6.0 10 5.5 5.2 2.5 4.4 2.6 2.4 1.4 3.8 5 3.3 2.8 2.3 0 -7.3 1.3 1.3 1.1 0 -10 Recreation Recreation Communication Miscellaneous Clothing Alcohol and Clothing Communication Alcohol and Miscellaneous Tobacco Tobacco Health Education Housing Average Restaurants Transport House Equipment CPI Food and Beverages Education Health Average Restaurants House Equipment CPI Housing Transport Food and Beverages Source: World Bank staff calculations. Note: This figure plots the 12-month price change by December 2022 of the 12 Classification of Individual Consumption According to Purpose (COICOP) broad consumption groups in Albania (panel A) and Bosnia and Herzegovina (panel B). The light blue bars indicate the simple average of the 12-month price across these groups. The red bars indicate the 12-month price change of the official Consumer Price Index (CPI) in each country during the same period. (pp) between the largest-growing food and Macedonia presents the greatest dissimilarity beverages and health divisions (Figure 4.2, of consumption shares among deciles when panel A). In contrast, Bosnia and Herzegovina considering 12 consumption components experienced a 23.2 percent growth in food (Figure 4.3, panel B).4 prices compared to a deflation of 7.3 percent for clothing, resulting in a spread of 30.5 pp Given the significant price increases in 2022 (Figure 4.2, panel B). and the evidence of the difference in the share of household spending, the cost-of-living Household exposure to inflation depends (COL) inflation experienced among groups not only on the different price changes of households varies substantially. For all between the goods and services they six Western Balkan countries, the less well- consume, but also on their consumption off systematically experience higher inflation baskets. In countries where households rates compared to the better-off. On average, spend approximately the same proportions households in the lowest decile face inflation of their budget on each consumption group, that is about 2.3 pp higher than the inflation household-specific inflation rates will not vary rate faced by the households in the richest significantly across households. If households decile (Figure 4.4). In North Macedonia, the have very dissimilar consumption baskets, then inflation rate experienced by the poorest group the opposite is true. In the Western Balkans, is 3.8 pp higher than the average, and 6.6 pp the poorest households have a significantly higher than households in the top decile. On different expenditure composition from the the other extreme, the differences between the richest ones, and these differences vary among rates faced by the poorest and the richest is countries. At one extreme, Montenegro 1.6 pp for Albania. shows the smallest diversity (Figure 4.3, panel A), while at the other extreme, North 4 These groups correspond to two-digit divisions in the Classification of Individual Consumption According to Purpose (COICOP). 4. Protracted inflation poses a marked challenge to poverty reduction 19 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Figure 4.3. Consumption shares vary significantly among income deciles. Composition of consumption expenditure across deciles, Montenegro and North Macedonia, 2021 Panel A. Montenegro Panel B. North Macedonia Expenditure share in the total Expenditure share in the total 100 100 80 80 60 60 40 40 20 20 0 0 1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10 Decile Decile J Food and beverages J Alcohol and tobacco J Clothing J Housing J House equipment J Health J Transport J Communication J Recreation J Education J Restaurants J Miscellaneous Source: World Bank staff calculations. Note: These figures plot the composition of consumption expenditure across deciles in Montenegro (panel A) and North Macedonia (panel B). Montenegro has the lowest value in consumption diversity among households among the Western Balkans countries with decile data in our sample, while North Macedonia has the highest value in consumption diversity among the same group. The values for both countries were calculated from their respective Household Budget Survey for 2021. Figure 4.4. Cost-of-living inflation varies profiles of the poor derived from household- among households. specific inflation rates differ systematically from Cost-of-living annual inflation by decile across those based on the standard CPI approach Western Balkan countries Average in percentage points (Figure 4.5). Furthermore, the differences are 4 even larger during periods of high inflation, such as 2022. Holding income constant and 2 using COL inflation instead of official CPIs would result in a 0.7 pp higher poverty rate on 0 average, while the simulated results for Albania and Kosovo show a difference of more than -2 1.0 pp. When comparing Gini coefficients of per capita consumption expenditures, the -4 1 2 3 4 5 6 7 8 9 10 COL-based Gini coefficient is higher than the ▬ MKD ▬ MNE ▬ BIH Decile ▬ KOS ▬ SRB ▬ ALB CPI-based one for all countries (Figure 4.6). Source: World Bank staff calculations. Again, the difference is more pronounced Note: This figure plots the cost-of-living (COL) annual inflation by decile for December 2022. The inflation by decile is expressed as a for 2022, since price variations were high or difference with respect to the average COL inflation. The red line highlights the values for North Macedonia, the country with the uneven. North Macedonia’s Gini coefficient largest difference between the COL annual inflation in decile 1 and decile 10, and the green line highlights the values for Albania, changes the most (0.9 pp), while Serbia presents the country with the smallest difference between the COL annual inflation in decile 1 and decile 10. the lowest difference (0.3 pp). The estimates for poverty and inequality To design effective policies to protect the would be higher if household-specific less well-off and promote economic growth, inflation were used instead of the standard it is important to consider the variability of CPI method. Poverty and inequality rates and inflation rates across different household 20 4. Protracted inflation poses a marked challenge to poverty reduction TESTING RESILIENCE Figure 4.5. Poverty measures are Figure 4.6. Inequality measures are also systematically affected by the inflation affected by the inflation method used. method used. Difference between CPI- and COL-based poverty measures Comparison of CPI- and COL-based Gini coefficients (percentage points) 1.2 35 34 North 1.0 Macedonia Kosovo 33 0.8 Bosnia and North Herzegovina Macedonia Albania 32 Montenegro 0.6 31 0.4 30 Albania Bosnia and 0.2 Serbia Herzegovina 29 Kosovo Montenegro Serbia 0 28 1.00 1.05 1.10 1.15 1.20 1.25 28 29 30 31 32 33 34 35 CPI inflation rate, 2017=1 Gini based on CPI inflation Q 2021 ‹ 2022 J Gini based on 2021 COL inflation ‹ Gini based on 2022 COL inflation Source: World Bank staff calculations. Source: World Bank staff calculations. Note: This figure plots the differences in poverty rates between the Note: This figure plots the Gini coefficients of per capita CPI-based and COL-based measures for Western Balkans countries. consumption expenditures for the 6 Western Balkan countries. Each Each marker represents a value of corresponding poverty measure marker represents a value of Gini coefficient for a particular country for a particular country and year. Square markers show differences and year. Square markers show the Gini estimated based on 2021 between the poverty measures for 2021, and triangular markers COL inflation, and triangular markers show the Gini estimated based show the differences calculated for 2022. on 2022 COL inflation. Markers on the dashed 45-degree line indicate no difference between the CPI- and COL-based Gini coefficients. The further the estimate is from the 45-degree line, the larger the difference. types. The CPI may not be a reliable instrument for assessing to what extent household cost of living has increased in periods of high inflation, such as in 2022. As poorer households experience higher COL increases, using the CPI to measure inflation in such situations could also lead to policies with potentially unintended regressive consequences. As such, it is crucial that policies to protect vulnerable populations and promote economic growth consider the heterogeneity of inflation across households. For example, annual adjustments to benefit levels and eligibility criteria of government programs for poverty reduction are made based on inflation estimates. Thus, differences in inflation estimates could have significant implications for coverage, benefits, and budgets of such programs. Therefore, it would be important to employ inflation indicators that accurately capture the actual cost of living for different types of households to design efficient poverty alleviation policies. 4. Protracted inflation poses a marked challenge to poverty reduction 21 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 5. Rebuilding fiscal buffers as financing costs rise Fiscal deficits narrowed in most Western Revenue growth remained strong but slowed Balkan countries despite persistent social compared to 2021, while expenditures spending pressures against record inflation. moderated. In Albania, Kosovo, North In four of the six Western Balkan countries, fiscal Macedonia, and Serbia, nominal revenue deficits narrowed by an average of 1 percentage increased by an average of 13 percent point (pp) of GDP during 2022. Yet, in (Figure 5.2), boosted by record inflation.6 Montenegro and Bosnia and Herzegovina, In Montenegro, on the other hand, revenues fiscal balances deteriorated compared to increased by only 4.5 percent, while in Bosnia 2021, although less than previously expected. and Herzegovina they remained broadly While fiscal pressures heightened due to the constant. In Albania, Serbia, and Kosovo, needed social spending increases across the six intensified formalization efforts also bolstered countries to provide support during the energy revenue performance. Yet, compared to 2021, crisis and rising prices, the tax policy change revenue growth slowed (Table 5.1). As a share in Montenegro and election-driven spending of GDP, public revenues remained broadly in Bosnia and Herzegovina compounded this unchanged for the region, averaging close to impact and exacerbated fiscal balances. As a 36 percent of GDP, with Kosovo and Albania result, the Western Balkan average5 deficit staying below 30 percent of GDP and Serbia remained broadly constant from a year before and Bosnia and Herzegovina above 40 percent. (Figure 5.1) and still higher than its pre- pandemic level. As a share of GDP, public expenditure remained at the previous year’s level, mainly on account of lower real public wages and capital underspending. After consolidating by Figure 5.1. Fiscal deficits narrowed in most Figure 5.2. …but widened in Montenegro Western Balkan countries… and Bosnia and Herzegovina. Contribution to change in the fiscal balance, percent of GDP, 2022e 0 6 ↑Reduced revenues, increased spending -0.5 -1.0 -2 4 -3.0 -3.1 -4 -3.7 2 -4.5 -5.2 -6 0 -8 -2 -10 ↓Increased revenues, reduced spending -12 -4 MNE MKD ALB SRB BIH KOS WB6 MNE BIH KOS ALB SRB MKD WB6 J 2020 J 2021 J 2022e J Expenditure J Revenue Q Change in fiscal balance Sources: National statistical offices; Ministries of Finance; World Bank Sources: National statistical offices; Ministries of Finance; World Bank estimates. estimates. Note: e = estimated. Note: p = projected. 5 Unweighted average. 6 All comparisons are year over year unless otherwise indicated. 22 5. Rebuilding fiscal buffers as financing costs rise TESTING RESILIENCE Table 5.1. Growth rates of key fiscal variables and inflation. 2020 2021 2022 Cumulative 2020–22 Country Variable Percent y/y change nominal growth CPI Inflation, average 2.2 2.6 6.7 11.9 Revenues -7.5 20.0 13.9 26.4 Albania Tax revenues -6.5 19.3 14.7 27.9 Expenditures 9.0 11.2 9.0 32.1 Current expenditures 4.0 6.5 9.6 21.4 CPI Inflation, average -1.1 2.0 14.0 15.0 Revenues -4.8 13.3 -0.3 7.5 Bosnia and Tax revenues -5.1 24.4 -7.6 9.1 Herzegovina Expenditures 12.5 1.2 1.2 15.2 Current expenditures 10.0 10.3 -3.1 17.6 CPI Inflation, average 1.2 3.2 14.2 19.3 Revenues -7.8 16.8 10.1 18.6 North Macedonia Tax revenues -3.4 14.5 11.2 23.0 Expenditures 9.8 7.1 7.7 26.7 Current expenditures 12.2 3.5 7.4 24.7 CPI Inflation, average -0.3 2.4 13.0 15.4 Revenues -13.2 17.1 4.8 6.5 Montenegro Tax revenues -12.3 16.5 4.5 6.8 Expenditures 2 -2.1 13.7 13.5 Current expenditures 3.7 4.2 11.6 20.6 CPI Inflation, average 0.2 3.4 11.6 15.6 Revenues -8.8 26.9 13.7 31.6 Kosovo Tax revenues -9.5 30.0 14.0 34.1 Expenditures 6.7 2.5 10.6 21.0 Current expenditures 18.6 0.9 13.0 35.2 CPI Inflation, average 1.6 4.0 11.9 18.2 Revenues -1.0 20.3 13.6 35.3 Serbia Tax revenues -0.2 23.2 13.4 39.4 Expenditures 10.4 17.8 10.1 43.2 Current expenditures 8.4 11.7 7.3 29.9 Sources: National statistics offices; Ministries of Finance; World Bank staff estimates. almost 4 pp of GDP in 2021, average public expenditures also declined, by 0.5 and 1.6 pp expenditure remained broadly constant in of GDP, respectively. In contrast, expenditures 2022, at 38.6 percent of GDP (Figure 5.3). In increased by 3.5 percentage points of GDP in fact, public expenditure contracted by around Bosnia and Herzegovina, where the electoral 1 pp of GDP in North Macedonia, Serbia, cycle fueled increases in spending. All six and Montenegro. In Kosovo and Albania, countries adopted measures to mitigate the 5. Rebuilding fiscal buffers as financing costs rise 23 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 impact of rising inflation. At the same time, process. Partly owing to high inflation, capital Albania, North Macedonia, Kosovo, and spending increased in Montenegro and Bosnia Serbia (through off-budget fiscal operations), and Herzegovina, while it remained constant provided significant energy subsidies. All in North Macedonia. In both Kosovo and countries except Bosnia and Herzegovina North Macedonia, under-execution of the contained their public sector wage spending. planned capital budget remained significant. Inflationary pressures proved particularly With fiscal policy in a crisis mode for yet challenging for the implementation of another year, social protection spending multiyear capital projects, with limited scope continued to remain high and drive to adjust for changing input prices. expenditure growth. Social protection spending increased by 0.6 pp of GDP, on With persistent inflation, there are pent- average, in 2022; in Bosnia and Herzegovina, up pressures for public wage increases, social benefits increased the most, by 5.2 pp, while looming external uncertainties might reaching the highest level among the Western prevent a retraction of temporary measures. Balkans at 19.8 percent of GDP (Figure After the restraint demonstrated in 2022, most 5.4). In Albania, Montenegro, and Kosovo, countries granted public wage increases in early pension benefits also increased in response 2023. Serbia, for example, increased wages by to inflation. Real public wages declined in 12.5 percent in early 2023, while Montenegro Kosovo and Montenegro by more than 1 pp increased civil servant and education sector of GDP, and in Albania, Serbia and North net wages by almost 20 percent as health Macedonia by around 0.5 pp. Wage spending contributions got abolished and a minimum increased by 1.1 pp of GDP in Bosnia and wage increase led to a rise in public sector Herzegovina (Figure 5.4). Capital expenditure salary base. A new public wage law entered declined in Kosovo and Albania the most; in into force in Kosovo in 2023 that will see the latter due to slowing of the reconstruction total wage spending increasing by 15 percent. Figure 5.3. The share of social benefit Figure 5.4. …while real public wages spending increased... declined across the Western Balkans, except for Bosnia and Herzegovina. Percent of GDP Contribution to change, in percent of GDP 50 8 40 6 30 4 2 20 0 10 -2 0 2021 2022p 2021 2022p 2021 2022p 2021 2022p 2021 2022p 2021 2022p 2021 2022p -4 SRB BIH MNE MKD ALB KOS WB6 BIH KOS SRB MKD MNE ALB WB6 J Wage bill J Social benefits J Wage bill J Social benefits J Capital expenditures Q Total expenditures J Capital expenditures Q Total expenditures Sources: National statistical offices; Ministries of Finance; World Bank Sources: National statistical offices; Ministries of Finance; World Bank estimates. estimates. Note: p = projected. 24 5. Rebuilding fiscal buffers as financing costs rise TESTING RESILIENCE North Macedonia is working on a new public of fiscal consolidation if indexation mechanisms wage law, after continuous demands from the and budget rigidity is not addressed. Federation of Trade Unions. In parallel, the persistence of external uncertainties could slow In all countries except Kosovo and North plans for scaling down temporary inflation Macedonia, the public and publicly mitigation measures and energy subsidies. guaranteed (PPG) debt to GDP is below the pre-pandemic peak, but higher than the pre- In this context, a normalization path for fiscal pandemic low. Owing to the denominator policy might be challenging, but is necessary. effect, the PPG debt declined as a share of Moreover, capital spending has served as a GDP. While growth was slower than initially buffer to ensure fiscal agility, but this has come projected in all the Western Balkan countries, with important costs in addressing much- high GDP deflators resulted in much-higher- needed investments to close the infrastructure than-expected nominal GDP. This has led to a gaps and enhance competitiveness in Western reduction of PPG debt as a share of GDP in all Balkan economies. Elevated public debt countries (Figure 5.5). The average PPG debt amidst increasing financing costs and a slower to GDP declined to 51 percent of GDP from growth environment call for the adjustment 56.6 percent in 2021. Given that Montenegro of government spending. To that extent, had the highest nominal growth of GDP, and rigidity of indexation of pensions and wage since most of its financing needs in 2022 were bill with inflation need to be reviewed against serviced from deposits, the decline of PPG debt the narrower fiscal space. Serbia has recently to GDP was the strongest—from 86.8 percent amended the fiscal rules to increase the upper in 2021 to 72.5 percent in 2022. Albania’s and bound for pension and public sector wage bill Bosnia and Herzegovina’s PPG debt declined spending limits, but also increased the coverage by a strong 9.9 pp and 4.6 pp of GDP, while in of its general government. Kosovo is another the remaining countries, despite double-digit country which has expenditure rule for some growth of nominal GDP, PPG debt to GDP spending categories. Overall, there is a risk that declined by less than 2 pp. Going forward, capital spending will continue to bear the brunt slower growth and lower inflation will lead Figure 5.5. Public and publicly guaranteed Figure 5.6. …and so did government debt declined in all countries… external debt. Percent of GDP Percent of GDP 100 100 80 80 60 60 40 40 20 20 0 0 MNE ALB MKD SRB BIH KOS WB6 MNE MKD SRB ALB BIH KOS WB6 J 2022p Q 2021 ▬ Pre-pandemic peak ▬ Pre-pandemic low J 2022p Q 2021 ▬ Pre-pandemic peak Sources: National statistics offices; Ministries of Finance; World Bank Sources: National statistics offices; Ministries of Finance; World Bank staff estimates. staff estimates. 5. Rebuilding fiscal buffers as financing costs rise 25 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 to a lower nominal GDP growth, which may The higher cost of external financing requires lead to faster debt accumulation at the time of fiscal prudence. Countries have become increased debt servicing costs. increasingly reliant on external financing in recent years and are vulnerable to the rising In 2022, external PPG debt continued cost of financing resulting from monetary declining but remains above pre-pandemic policy tightening. This is particularly so for levels as countries relied on borrowing from countries with a high debt burden and limited multilateral banks  (Figure 5.6). The decline of fiscal space. After several successive years of the average external PPG debt from 38 percent Eurobond issuances, no Western Balkan to 34.5 percent was mostly driven by an increase country tapped the markets in 2022. However, in nominal GDP. Montenegro recorded the in early 2023, Serbia and North Macedonia strongest decline of 14.3 pp of GDP, followed turned to international investors. In January, by Albania at -6.5 pp of GDP and Bosnia and Serbia issued two Eurobonds—a five-year Herzegovina at -1.7 pp. Montenegro’s and Eurobond of US$750 million at a coupon rate Albania’s net external borrowing was negative, of 6.25 percent, and a 10-year Eurobond of considering both countries used Eurobond US$1 billion at a coupon rate of 6.5 percent. proceeds from previous years to cover a large In March 2023, North Macedonia issued a share of financing needs in 2022. In November four-year Eurobond of EUR 500 million at 2022, the International Monetary Fund a coupon rate of 6.95 percent to refinance (IMF) Executive Board approved a two-year a EUR 450 million Eurobond coming due arrangement of EUR 530 million for North in July. While no other countries tapped the Macedonia under the Precautionary and Eurobond market, Montenegro signed a three- Liquidity Line, of which EUR 110 million year loan agreement of EUR 100 million with has already been disbursed. A month later, the Deutsche Bank, at an interest rate of a six- IMF approved a EUR 2.4 billion Stand-by month Euro Interbank Offered Rate (Euribor) Arrangement for Serbia, of which EUR 1 billion plus 5.9 percent. The interest rates increased by has been disbursed. Both countries will use this more than 500 bp since Eurobond placements support to address the impact of the energy in 2021. Considering the unfavorable crisis. The World Bank provided additional market conditions, yields on the outstanding support through the development policy loans Eurobonds of the Western Balkans countries approved for Kosovo (EUR 50.6 million), have increased substantially (Table 5.2). And Albania (EUR 110 million), and Serbia (EUR while declining from their peaks in late 2022, 149.9 million), which aim to strengthen still high yields and widening spreads are an resilience of the countries’ economies and their indication of lasting unfavorable financing environmental sustainability. The EU has also conditions. allocated EUR 500 million of budget support to the Western Balkan countries to mitigate the Room for fiscal maneuver is expected to impact of the energy crisis and support energy shrink further, unless governments focus transition. on boosting their revenue base, improving tax collection, and strengthening spending (Box efficiency, particularly social spending  5.1). All Western Balkan governments have 26 5. Rebuilding fiscal buffers as financing costs rise TESTING RESILIENCE Table 5.2. Yields on Western Balkan countries’ outstanding Eurobonds. Yield in % Spreads Country Coupon Maturity (last price) (basis points) Albania 3.5 16/06/2027 6.5 421.6 3.5 09/10/2025 6.1 358.6 Montenegro 2.785 16/12/2027 8.4 615.2 3.375 21/04/2025 7.3 481.5 North Macedonia 3.675 03/06/2026 6.6 425.9 2.75 18/01/2025 6.4 391.9 Serbia 3.125 15/05/2027 5.8 349.4 1.5 26/06/2029 6.2 401.2 Bosnia and Herzegovina entity: 4.75 01/01/2023 9.0 650.6 Republic of Srpska 4.75 01/01/2026 7.0 463.5 Source: https://www.boerse-frankfurt.de/en. Note: Spreads refer to spreads with yields on German bonds with the same residual maturity. Republic of Srpska is one of the two entities of Bosnia and Herzegovina, the other being the Federation of Bosnia and Herzegovina. implemented support measures to combat term fiscal sustainability. Serbia is the only the cost-of-living crisis, but compared to country with an independent fiscal council, COVID-19 support, targeting of support and Montenegro and North Macedonia are measures worsened. All countries except working toward their establishment. Bosnia and Herzegovina and Montenegro have provided subsidies to the energy state- owned enterprises (SOEs), while government arrears increased in most countries, largely due to SOEs and the health sector. In North Macedonia, public sector arrears increased to 3.1 percent of GDP. Furthermore, contingent liabilities coming from SOEs and public- private partnerships are significant fiscal risks in Albania and Serbia. And while the impact of the energy crisis in 2022 proved to be milder than initially expected, it has highlighted the importance of shifting toward greener and more resilient drivers of economic growth and accelerating the green transition. This, however, would require unlocking energy efficiency and renewable private investments and incentivizing households and firm behavior through effective carbon pricing and removing fossil fuel subsidies (see Spotlight). Finally, all countries would benefit from strengthening fiscal transparency and establishing independent fiscal councils that would ensure longer- 5. Rebuilding fiscal buffers as financing costs rise 27 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Box 5.1. Boosting the efficiency, effectiveness, and equity of social protection in the Western Balkans. Social protection systems played a critical role in response to first the pandemic and then the energy crisis, but reforms are needed to place the systems in the Western Balkans on a better footing.a The major shocks of recent years have highlighted the critical importance of social protection systems to protect vulnerable households from falling into poverty. Several countries in the Western Balkans are currently working on reforms to enhance the equity, sustainability, effectiveness, and adequacy of their social protection systems. However, while some progress has been made, pension funding sustainability, benefits adequacy, and contribution rates remain an issue. Reforms in other areas such as social assistance, social services, and employment programs are progressing, albeit slowly and unevenly in many countries. Isolated reforms focusing on a specific program or aspect of the delivery system are unlikely to lead to satisfactory outcomes, either in terms of reducing poverty or promoting growth. Most of the Western Balkans’ comparatively high public spending on social protectionb goes toward pensions, suggesting that only a limited allocation reaches the poor and vulnerable households. Although the six countries spend between 8 and 13 percent of GDP on social protection (Figure 5.7), over 70 percent of this goes toward pensions, compared to the OECD countries, where median social protection spending on pensions is 40 percent. Pensions are based on contributions made by the formally employed, with social pensions tending to be very small in most countries. Wage employment is typically concentrated among people in the upper quintiles of the population, while those who are self-employed or unemployed are more likely to be at the bottom of income distribution, meaning that they are unlikely to qualify for pensions in the future.c Figure 5.7. The Western Balkan countries spend considerable resources on social protection. Percent 18 16 14 12 10 8 6 4 2 0 UZ - 2 7 A 17 7 19 SR - 2 9 M - 2 18 B6 - 9 UK era * RO - 2 * U 017 B 012 HR - 2 7 V 017 HU R - 014 KG - 20 7 Z 16 T 17 RU - 2 7 S 017 M -2 6 16 GE - 2 7 AR - 2 6 8 E 017 Z 19 K 17 K 017 M -2 1 EC Ave 020 B 02 L 01 01 Av ge R ge R 01 1 E 1 U 1 H 1 W KD 01 R 01 O 01 M 01 LV - 20 NG 20 ES - 20 CZ - 20 LT - 20 TJ 20 NE 0 BI - 20 KA 20 DA 0 B 0 PO - 2 -2 BG - 2 AZ - 2 SV - 2 AL - 2 BL - 2 TU - 2 A ra 2 - - V KS J Labor market programs J Social assistance J Social insurance J Social care services Source: World Bank Social Protection Expenditure and Evaluation Database (SPEED). Note: Percent of GDP as arithmetic average of latest year available. 28 5. Rebuilding fiscal buffers as financing costs rise TESTING RESILIENCE (Box 5.1 continued) Despite absorbing most of the social protection funding, pension systems in the Western Balkans struggle with financial sustainability and adequacy. Each country faces different tradeoffs among sustainability, adequacy, and coverage. Albania has made efforts to improve the fiscal sustainability of its pension system but has a low support ratio (meaning that the share of employed who contribute to a pension plan is low compared to the share of the elderly population who receive a pension). Montenegro has improved pension adequacy but faces projected deficits. North Macedonia has slightly improved financial sustainability, but this has been offset with increased benefits. Serbia’s low birth rates, outmigration, and informal employment threaten its pension system. Pandemic-related measures have widened pension deficits in Bosnia and Herzegovina. Finally, Kosovo’s pensions, which cost 6 percent of GDP, are mostly government-funded, and the nascent contributory system requires adjustments to maintain sustainability, as it covers only a few years of pension outlays before individual pension accounts are depleted. High inflation poses additional risks across the Western Balkans, and clear rules for indexation of pension benefits play an important role in protecting the purchasing power of retirees. The COVID-19 pandemic and the high inflation episodes induced interventions, largely through temporary supplements to pensions and one-off payments. The Western Balkan countries generally refrained from addressing short-run pension challenges through measures that could worsen long-run sustainability. With stabilization of inflationary trends, a growing contribution base, and diminished demographic pressure, the focus of pension policies is turning to long-term policies for improving pension adequacy through core pension measures aiming to prolong the length of service and raise more contributions. Low allocations for poverty-targeted policies, together with fragmented and poorly designed programs, lead to low coverage of the poorest families with social assistance. The six countries spend an average of only 0.3 percent of GDP on poverty-targeted income support for the poor. Throughout the Western Balkans, eligibility for social assistance is predominantly tied to categorical criteria, such as children being present in the household, dependency status (people with disabilities, orphans, caregivers, out-of-work), or military service (war veterans), but not to actual welfare status (such as income and assets). The outcome of this categorical targeting in combination with low overall funding for social assistance is that the coverage of the poorest families is much lower across the Western Balkans than in the rest of the emerging and developing countries of Europe and Central Asia (Figure 5.8), leaving poor people vulnerable to shocks. At the same time, cash benefits from poverty- targeted programs offer inadequate support and often create work disincentives. Rebalancing social spending more toward poverty-targeted social assistance and social services strongly linked to employment policies is critical to effectively reduce poverty and improve living conditions. All countries in the Western Balkans face a dual challenge to 5. Rebuilding fiscal buffers as financing costs rise 29 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 (Box 5.1 continued) better protect the livelihoods of the poor, while encouraging greater labor force participation, especially among women. Better protecting the poor and reducing poverty would be achieved through increasing the budget and scope of poverty-targeted programs and better linking them with social and employment services. North Macedonia is an example of a country undergoing a comprehensive reform of its social protection system. As part of the reform, the untargeted and costly parental allowance was reformed into an income-tested program, meaning that more vulnerable families are eligible for the benefit. Also, a means-tested social pension for the elderly was introduced, and all other means-tested schemes were consolidated into one means-tested guaranteed minimum assistance scheme. This scheme was central to the government’s response during the pandemic. By relaxing the eligibility criteria and simplifying the procedures, North Macedonia’s authorities easily extended coverage of social assistance to newly poor families during the pandemic. These can be lessons for other countries. Figure 5.8. Social assistance coverage of the poorest is low. Coverage (poorest quintile) 100 90 80 70 60 50 40 30 20 10 0 R 16 Z 17 U 18 8 0 8 16 8 9 M 15 8 B 15 KD 18 7 8 NE 17 TJ 015 R 11 8 9 O 07 R 08 7 8 KS 201 M 200 AZ 201 00 LV 201 1 1 BI 201 AL 201 01 01 KA 200 BL 20 KG 20 M - 20 AR 20 SR 20 UK 20 HR 20 RO 20 PO 20 TU 20 M 20 GE 0 BG 20 -2 -2 -2 -2 -2 - - - - - - - - - - - - - - - - - - K V B E H R L D Z A N K U V SV HU LT Source: World Bank Social Protection Expenditure and Evaluation Database (SPEED). a. This summary of the key issues on social protection is based on detailed social protection situational analyses for Albania, Bosnia and Herzegovina, Kosovo, Montenegro, North Macedonia, and Serbia. b. Includes social assistance, social services, social insurance, and employment and labor market programs. c. See, for example, World Bank 2021, “Albania Country Economic Memorandum: Background Note on Supporting an Adaptive and Resilient Labor Force”; https://documents.worldbank.org/en/publication/documents-reports/documentdetail/099845001312217227/ p1752090acdb7604a0918d0aa310774d0ea. 30 5. Rebuilding fiscal buffers as financing costs rise TESTING RESILIENCE 6. Inflation pressures soften, but prices remain elevated Inflation continued to rise in 2022 in almost domestic food price inflation7 remains high, all economies, and price pressures remain and many vulnerable countries still face high. Global median headline inflation heightened food insecurity (Box 6.1). New exceeded 9 percent in the second half of 2022, export restrictions could lead to additional its highest level since 1995 (Figure 6.1). In price pressures.8 emerging markets and developing economies (EMDEs), inflation reached a record high of Price pressures during 2022 reflected a close to 10 percent, and in advanced economies combination of both demand and supply over 9 percent. Although inflationary pressures factors. On the demand side, the persistence of started to abate toward the end of 2022, price price pressures was associated with accelerating pressures remain elevated and above central growth and lagged effects of crisis support bank targets. Commodity prices have eased measures provided by governments in the first from their peaks in the aftermath of the part of the year. At the same time, demand Russian invasion of Ukraine, with fears about pressures encountered capacity and supply a growth slowdown intensifying. However, constraints, contributing to further price individual commodities have seen divergent growth. On the supply side, high energy and trends, reflecting distinct demand and supply food prices associated with Russia’s invasion of conditions (Figure 6.2). Energy prices declined Ukraine continued to contribute significantly to 7.3 percent in February 2023 led by coal rising price pressures, along with wage pressures (-34.8 percent) and natural gas in the United associated with tighter labor market conditions. States (-27.2 percent). Food price surges Inflation remains high across a broad range of recorded in early 2022 subsided. However, goods and services, with detrimental impact on Figure 6.1. Inflation pressures are softening, Figure 6.2. Global energy and food prices but price pressures remain elevated remain above historical averages. globally. Global Consumer Price Index (CPI) inflation Energy and food indexes 10 200 180 8 160 140 6 120 100 4 80 60 2 40 20 0 0 M 19 Se 9 Ja 9 M 0 Se 0 Ja 0 M 21 Se 1 Ja 1 M 2 Se 2 Ja 2 23 -2 2 2 -2 2 -1 1 2 -2 2 Q1 -19 Q2-20 Q3-20 Q4-20 Q1 20 Q2-21 Q3-21 Q4-21 Q1 -21 Q2-22 Q3-22 Q4-22 Q1-22 Q2-23 Q3-23 Q4-23 Q1-23 Q2-24 Q3-24 Q4-24 4 n- p- n- p- n- p- n- n- p- -2 ay ay ay ay - Ja Q4 ▬ January 2023 ▬ 2015–19 average ▬ Energy ▬ Food Source: World Bank Global Economic Prospects, 2023. Source: World Bank Commodity Price Data, March 2023. 7 Measured as year-over-year change in the food component of a country’s Consumer Price Index (CPI). 8 In February 2023, 101 export restrictions—including quotas, licenses, and outright bans—were still being enforced, contrary to World Trade Organization principles that the limits should be temporary. 6. Inflation pressures soften, but prices remain elevated 31 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Box 6.1. Food inflation in the Western Balkans. Global food prices, which reached a record high in 2022 caused by the COVID-19 outbreak and amplified by the Russian invasion of Ukraine, have increased food insecurity and added to the cost-of-living crisis. They have also strained household budgets struggling with rising food prices, which required government intervention to fund extra social protection measures for the most vulnerable after their budgets were strained due to the energy crisis. In 2022, annual food inflation ranged from 12 percent in Albania to 23 percent in Montenegro. For the six Western Balkan countries, it averaged 20 percent in 2022, a large increase from 2 percent in 2019–20 and 10 percent in 2021. Except in Albania, annual food inflation in the Western Balkans countries exceeded that in the EU27 (Figure 6.3). Figure 6.3. Food inflation in WB6 and EU27. Figure 6.4. Share of food and non- alcoholic beverages in total household consumption. Annual change, percent Percent 35 40 30 35 25 30 20 25 15 20 10 15 5 0 10 -5 5 9 Aun-19 9 De t-19 Fe -19 Apb-29 0 Aun-20 0 De t-20 0 0 1 Aun-21 1 De t-21 Fe c-21 Apb-2 1 2 Aun-22 2 De t-22 c- 2 22 Apb-2 Ju r-2 Ocg-2 Ju r-2 Ocg-2 Apb-1 Ju r-1 Ocg-1 Ju r-2 Ocg-2 Fec-2 0 c Fe ALB BIH KOS MKD MNE SRB ▬ EU ▬ ALB ▬ BIH ▬ KOS ▬ MKD ▬ MNE ▬ SRB ▬ WB average ▬ EU average Sources: Statistical offices; World Bank staff calculations. Sources: Statistical offices; World Bank staff calculations. Food prices in the Western Balkans increased across all food subgroups,  with the largest increases recorded for meat (17 percent), bread and cereals (26 percent), dairy products (29 percent), and oils and fats (32 percent). The prices for these food subgroups rose in all countries in the range of around the regional average. Together they accounted for more than 70 percent of food inflation. In comparison, the price increase of fruits, fish, and beverages was relatively moderate, from 8 to 13 percent. Given that food and beverages account for 36 percent of average household consumption in the Western Balkans, compared to 16 percent in the EU, for example (Figure 6.4), high food inflation stalled poverty reduction in 2022. A rise in food inflation in the Western Balkans has been a result of not only a passthrough of high global prices to domestic prices, but also local factors. These local factors include the slowdown in agricultural growth in Albania and Bosnia-Herzegovina in 2020–21 compared to 2018–19, and the decline in agricultural growth in Kosovo, Montenegro, North Macedonia, and Serbia (Figure 6.5), driven by supply chain disruptions triggered by the COVID-19 outbreak and climate events such as drought. For comparison, EU agriculture weathered 32 6. Inflation pressures soften, but prices remain elevated TESTING RESILIENCE (Box 6.1 continued) the recent multiple shocks much better, which helped contain its food inflation. Another reason for high food inflation in the Western Balkans was the exchange rate depreciation in some countries, which increased local prices of imported food, upon which the Western Balkan countries depend, being net food importers, especially of processed food products. The oligopoly of some food processors and retailers also added to inflation, although a lack of a consistent and accurate time series of farmgate, wholesale, and retail prices precludes a more conclusive analysis in this regard. Figure 6.5. Growth in agricultural GDP in Figure 6.6. Budgetary support to the WB6 and EU. agriculture in the WB6 and EU. 2017–19, percent 8 30 26.1 6 25 4 20 15.6 2 15 11.6 10.5 10.5 8.6 0 10 7.7 -2 5 1.6 1.3 0.9 0.5 0.5 0.6 0.4 0.4 0.3 -4 0 ALB SRB BIH MKD KOS MNE EU ALB BIH KOS MKD MNE SRB EU-28 EU-NMS J 2018–19 J 2020–21 J Percent of GDP J Percent of GVA ag. Sources: Statistical offices; World Bank staff calculations. Sources: Statistical offices; World Bank staff calculations. Policy responses in the Western Balkans focused on reducing food inflation for all consumers through food price caps (all countries, except Kosovo), tax reductions (Montenegro and North Macedonia), export bans (North Macedonia and Serbia), import tariff reductions (North Macedonia), and mitigation of its impact on the poor (through social protection). However, most measures were weakly targeted to the poor, while they worsened long-term incentives for farmers, thereby depressing agricultural growth potential and increasing long-term food price levels. Bosnia and Herzegovina and Kosovo provided significant extra funding to farmers, averaging 0.33 percent of GDP. The support to farmers in Albania and Montenegro was smaller, at about 0.05 percent of GDP. In North Macedonia and Serbia, farmers received no extra support, largely because they were already well supported through regular budget programs. The agricultural budget support as a share of GDP in the Western Balkans (0.3 to 1.3 percent) is generally higher than that in the EU (0.4 percent), while farmers in most countries, except Albania, receive comparable support as a share of gross value added to that in the EU New Member States (Figure 6.6). The existing agricultural support in the Western Balkans, however, favors direct and coupled farm measures over the support to delivery of general services (for example, research and extension services under the Agricultural Knowledge and Innovations System, soil nutrient management, sanitary and phytosanitary measures, and public infrastructure), the investments in which have globally proven to be of high impact for climate resilience, agricultural productivity, and agricultural diversification. 6. Inflation pressures soften, but prices remain elevated 33 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 (Box 6.1 continued) Global and local food prices are projected to stay elevated in 2023 and 2024. Although the World Bank’s Food Price Index declined by 12 percent in the third quarter of 2022 after reaching an all-time high in April 2022, it remains almost 20 percent higher than a year ago, which is high by historical standards. War, climate change, and the cost of inputs could keep food prices elevated for longer. The continuation of the war in Ukraine could create an export gap of 35 million tons of grains and oilseeds in the 2022/23 marketing year. The weather phenomenon El Niño could cause droughts in south and southeast Asia and Australia, and floods in Latin America. The International Monetary Fund estimates that globally a 1 percent increase in fertilizer and oil prices, which have climbed recently and remain high, boosts food prices by 0.45 percent and 0.2 percent, respectively. All these risks put upward pressure on food inflation globally and in the Western Balkans in the foreseeable future. the poor and most vulnerable. During 2022, strong labor markets, wage pressures have also global core inflation rose, reaching 6 percent on increased. average for the Western Balkans. At the global level, the persistence of inflation has been In the Western Balkan region, inflation higher than expected and several factors such as remains elevated. In most countries, consumer short-term inflation expectations and elevated price inflation peaked in 2022, and has shown core inflation suggest that inflation may remain signs of easing in the last months of the year above central bank targets for longer than (Figure 6.7). Between July and November initially expected. 2022, Consumer Price Index (CPI) inflation reached 17.4 percent in Bosnia and Herzegovina Rising price pressures have triggered (October 2022), 19.8 percent in North synchronized and rapid monetary policy Macedonia (October 2022), 17.5 percent in tightening across advanced economies and Montenegro (November 2022), 14.2 percent in most EMDEs. Although monetary policy Kosovo (July 2022), and 8.3 percent in Albania tightening has been necessary to contain (October 2022). Energy and food prices price increases, the consequent restrictive continue to fuel consumer inflation (Figure global financial conditions are exerting a 6.8). At the regional level, food CPI inflation drag on activity, including consumption reached 24.6 percent in October 2022, 16.8 pp and investment. In the Eurozone, inflation higher than the previous year. Similarly, energy remains significantly above target but started CPI inflation has been on an increasing trend decelerating to 8.5 percent in February 2023, during 2022, reaching 19.7 percent in January reflecting a renewed sharp drop in energy prices. 2023. Trends in core inflation suggest that price Underlying price pressures in the Eurozone pressures remain broad-based. Since mid-2022, economy remain high. Inflation, excluding core inflation increased in almost all Western energy and food, increased to 5.6 percent in Balkan countries. Those with the highest February. Similarly, service inflation remains increases were North Macedonia, Montenegro, high (4.8 percent in February) reflecting pent- and Albania, where core inflation reached up demand and wage pressures. On the back of 11 percent (December 2022), 10.3 percent 34 6. Inflation pressures soften, but prices remain elevated TESTING RESILIENCE Figure 6.7. In the WB6 countries, inflation Figure 6.8. …with elevated food and energy peaked at historic highs during 2022... prices continuing to fuel consumer price inflation. CPI inflation CPI inflation 24 28 20 24 16 20 12 16 8 12 4 8 0 4 -4 0 No 19 Fe 19 M 20 Au 20 No 20 Fe 20 M 21 Au 21 No 21 Fe 21 M 22 Au 22 No 22 22 No 19 Fe 19 M 20 Au 20 No 20 Fe 20 M 21 Au 21 No 21 Fe 21 M 22 Au 22 No 22 22 - g- - g- g- b- v- g- b- v- v- v- - g- - g- b- v- b- v- - g- - g- b- v- b- v- ay ay ay ay ay ay Au Au ▬ ALB ▬ BIH ▬ KOS ▬ MKD ▬ MNE ▬ SRB ▬ WB6 ▬ WB6 food ▬ WB6 energy Sources: Statistical offices; World Bank staff calculations. Sources: Statistical offices; World Bank staff calculations. (November 2022), and 8.6 percent (October policy normalization and further expectations 2022), respectively. of monetary policy tightening, domestic yields on Albanian government securities started In countries with an independent monetary to increase, and auctions, particularly in the policy, authorities have responded with longer-duration segment, were for a short time a gradual tightening of monetary policy undersubscribed. Auctions started to normalize throughout 2022. The exchange rate toward October 2022. management was different, however, reflecting the strength of the passthrough, direction of In North Macedonia, rising inflation pressures during the year, and competitiveness expectations triggered a continuous concerns in a context of dampened demand. In monetary policy tightening during the year. Serbia, successive policy rate increases since April By early February 2023, the central bank aimed to contain the larger-than-expected rise had raised the key policy rate by 3.5 pp to in inflation and dampen inflation expectations, 5.25 percent in nine consecutive rounds and which, due to moderate wage and pension increased overnight loan and deposit rates. In increases, remained broadly consistent with the all three countries the authorities were able projected declining inflation path. In addition, to preserve and expand their international efforts were made to stabilize the exchange reserves: in Albania, reserves covered about rate in order to contain inflationary pressures 6.9 months of imports at year end. Similarly, emerging from high international energy and in Serbia, reserves increased to a historic high of food prices. In Albania, the central bank raised EUR 19.4 billion in December 2022, covering its key policy rate again by 50 basis points to close to 5.5 months of imports of goods and 2.75 percent in November, the fifth hike in services. In North Macedonia, reserves covered 2022. The Albanian authorities did not try to about 3.7 months of imports, recovering from manage the exchange rate, with the exception earlier losses at the start of the Russian invasion of a short-lived intervention at the start of the of Ukraine. Russian invasion of Ukraine. With monetary 6. Inflation pressures soften, but prices remain elevated 35 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Figure 6.9. Policy rates started to increase in Figure 6.10. …but real policy rates are line with monetary policy tightening in the negative. EU… Percent Percent 6 10 5 5 4 0 3 -5 2 -10 1 -15 0 -20 Ap -19 Ju 9 Oc 19 Ja -19 Ap 20 Ju 20 Oc 20 Ja 20 Ap -21 Ju 21 Oc 21 Ja 21 Ap -22 Ju 22 Oc 22 22 Ju -13 Ja l-13 Ju -14 Ja l-14 Ju -15 Ja l-15 Ju -16 Ja l-16 Ju -17 Ja l-17 Ju -18 Ja l-18 Ju -19 Ja l-19 Ju -20 Ja l-20 Ju -21 Ja l-21 Ju -22 Ja l-22 23 1 r- l- t- r- l- r- l- t- n- n- r- l- t- n t n n n n n n n n n n n n Ja Ja ▬ ALB ▬ MKD ▬ SRB ▬ Eurozone ▬ ALB ▬ MKD ▬ SRB Source: World Bank staff calculations based on central bank data. Source: World Bank staff calculations based on central bank data. Figure 6.11. Exchange rate management was Figure 6.12. Real exchange rates different among the three countries. appreciated. Index, 2010=100 2 115 1 110 0 105 -1 100 -2 95 -3 90 -4 85 -5 80 Se 19 De 19 M -19 Ju 20 Se 20 De 20 M 20 Ju 21 Se 21 De 21 M -21 Ju 22 Se 22 De 22 22 Ju 14 Ja -14 Ju 15 Ja -15 Ju 16 Ja -16 Ju 17 Ja -17 Ju 18 Ja -18 Ju 19 Ja -19 Ju 20 Ja -20 Ju 21 Ja -21 Ju 22 2 l-2 n- - n- p- n- p- n- - n- n- p- c- n- n- n- n- n- - n- p- c- n- c c l ar l l ar l l l l ar l Ju Ja ▬ ALB ▬ MKD ▬ SRB ▬ BIH ▬ KOS ▬ MKD ▬ SRB Source: World Bank staff calculations based on central bank data. Source: World Bank staff calculations based on central bank data. Monetary conditions are still accommodative, all-time high of 41.3 percent at end-2021, to as real policy rates remain negative, reflecting 36.9 percent in August 2022, driven by higher rising inflation and inflation expectations. risk aversion connected to Russia’s war in Despite monetary tightening, real policy rates Ukraine. Because of the stable exchange rate (in remained negative for all three countries in the Serbia and North Macedonia) and appreciation Western Balkans that have own currencies. On of the Albanian lek, and given high inflation, one hand, the authorities have further room for the real exchange rate appreciated, raising maneuver in case global conditions and external competitiveness concerns. A prompt response energy prices prevent domestic inflation to curbing inflation and allowing for some from returning to target and fuel inflation flexibility of the exchange rate should provide expectations. On the other hand, negative real for less costly adjustments through the trade rates may trigger further euroization of deposits channel, and could help limit risks from the and cause mismatches in bank balance sheets. buildup of unhedged foreign exchange loans. In Serbia, deposit dinarization fell from an 36 6. Inflation pressures soften, but prices remain elevated TESTING RESILIENCE 7. Financial stability risks increase as macro-financial conditions continue to weaken The financial sector in the Western Balkans While regulators and banks in the region continued to be stable, but its resilience is maintain increased prudence, current market tested by pressures on financial stability conditions require vigilance regarding the posed by the ongoing war in Ukraine, concentration of risky assets and remaining overall deterioration of economic sentiment vulnerabilities. Credit risks from energy- and the growth outlook, and a surge in intensive corporate sectors (Box 2.1), residential interest rates and inflation. Nonperforming and commercial real estate, uncollateralized loans continued to follow a downward trend, consumer finance, interest rate-sensitive declining to a historical low (3.9 percent), while portfolios, and sovereign exposures must be profitability recovered to pre-pandemic levels monitored closely. Pressure on both household and capital buffers were preserved. The current and corporate borrowers will likely continue financial sector outlook demonstrates the to intensify, as their income and earnings strong resilience of the financial sector on the will be impacted by both inflation and lower one hand, while indicating the need for caution growth expectations. As banks are expected to against elevated risks on the other. The strong continue tightening financial conditions and resilience is mostly owed to the robust financial credit standards, highly indebted households position banks achieved by decisive reforms and and corporates may come under stress. Bank restructuring in the last decade (after the global exposure to residential and commercial real financial crisis) and strong government support estate and sovereign debt instruments are during the pandemic. In contrast, despite the particularly relevant to monitor in the Western demonstrated resilience, elevated risks remain Balkan region (Box 7.1). and require continued focus and vigilance on any emergence of vulnerabilities. Credit growth started to slow with the expectations of worsening economic outlook Deteriorating macroeconomic conditions and tighter credit supply conditions. Average increase the pressure on risky asset classes credit growth in the Western Balkans had and expose the weaknesses generated by flattened by June 2022 before starting to pockets of vulnerabilities. The high interest slow down in September 2022. Although still rate environment, which is expected to last positive and strong, credit growth decelerated longer than anticipated, is triggering asset to 8.5 percent, almost 2 pp below its peak in repricing, and changing investor sentiment and June 2022 (10.4 percent) in the post-pandemic asset allocations. Therefore, risky assets and period. Corporate loan growth decelerated remaining vulnerabilities are coming under faster than the household loan growth since stress, evidenced by the recent Silicon Valley October 2022, indicating that banks tightened Bank (SVB) failure, together with a few other standards more for SMEs and corporate clients. regional lenders in the United States and the The most pronounced slowdown of credit Credit Suisse crisis in Europe. growth compared to June 2022 was in Serbia 7. Financial stability risks increase as macro-financial conditions continue to weaken 37 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Box 7.1. Western Balkans financial sector: Sovereign and real estate market exposure. Macro-financial risks remain high in the Western Balkan countries. In 2021–22, the combined pressures of high global inflation and the continued impacts of the war in Ukraine resulted in a fragile economic growth outlook. In the Western Balkan countries, average inflation ranged from slightly above 6 percent in Albania to above 14 percent in Bosnia and Herzegovina and North Macedonia. The short-term outlook for economic growth has slowed to approximately 2 to 3 percent for the region, with convergence with the European Union stalling in 2022. This macroeconomic outlook comes on top of the fiscal impacts of the 2020 pandemic, which led to historically high public and private debt. Due to tighter macro-financial conditions, many governments were left with lower access to affordable, external financing, including Eurobonds and bilateral financing; thus, they have become increasingly reliant upon the local financial sector. The Western Balkan countries are directly or indirectly impacted by the recent European Central Bank’s and global interest rate increases, which have made external financing increasingly expensive for governments (Table 5.2). At the same time, sovereign budgets are tighter due to large post-pandemic or inflation support measures introduced between 2020 and 2023. As a result, governments increased their domestic bond issuances, while local insurance, pension, and banking sectors have increased their investment in this asset class. Elevated volatility, repricing risks, and liquidity planning may expose banks to potential disorderly adjustments in government bond markets. While pension funds and insurance companies are long term, buy and hold type, banks need a more liquid security portfolio. Banks in the region have low loan to deposit ratio around 75 percent on average while they place this liquidity largely in government bonds which exposes the banks to sovereign risks. Due to the relatively small size of the financial markets and shallow capital markets, the government bond markets are typically illiquid in the region. In the case of a liquidity stress scenario, banks could end up with the less liquid bond portfolio. While banks in the region keep on average around 15 percent of their assets in government bonds this ranges between as high as 36 percent in Albania to 8 percent in Bosnia and Herzegovina (Figure 7.1). Another important market segment that needs to be monitored closely is the real estate market. Credit-fueled real estate booms can pose financial stability risks due to the important direct and indirect linkages among real estate markets, the economy, and the financial system. Real estate markets are systematically important as they influence economic activity (investment, consumption), financed primarily by banking sectors and they are an important form of wealth storage for households. As real estate is typically acquired by high leverage, 38 7. Financial stability risks increase as macro-financial conditions continue to weaken TESTING RESILIENCE (Box 7.1 continued) even small declines in real estate prices may lead to a significant decline in household wealth and in the net worth of firms who own a property with broader implications for demand, economic activity, and creditworthiness. Figure 7.1. Share of government securities Figure 7.2. Residential real estate loans to as a percentage of total banking sector total gross loans. assets. Percent Percent 0.40 40 0.35 35 0.30 30 0.25 25 0.20 20 0.15 15 0.10 10 0.5 5 0 0 2018 2019 2020 2021 2022 2018 2019 2020 2021 Q3-22 ▬ ALB ▬ BIH ▬ KOS ▬ MNE ▬ MKD ▬ SRB ▬ KOS ▬ MNE ▬ SRB ▬ BIH ▬ MKD ▬ ALB Source: Central banks websites. Source: IMF FSI and Central Banks. Residential real estate price growth has accelerated sharply since 2020 reaching its highest growth rate in decades coupled with increased mortgage lending. This has led to concerns about overvaluation and household indebtedness. Exposure to real estate asset class is elevated in the region due to: (i) growing real estate and mortgage loan portfolio in recent years; (ii) mortgages forming most of the commercial bank’s collateral portfolio; and (iii) acquired and unliquidated real estate assets remaining on balance sheet as a legacy since the global financial crisis. In the region average exposure to residential and commercial real estate loans is around 25 percent of the gross loans. However, this goes up to 37 percent in Albania and 33 percent in North Macedonia (Figure 7.2). Due to the increasing exposure of the banking sector to both sovereign and real estate markets, policymakers should increase their vigilance against risks that can be transmitted from these channels. Regulators and central banks should intensify monitoring of exposure to real estate and sovereign and strengthen onsite and offsite supervision capacity to detect any buildup of risks or vulnerability. The main objective should be to identify early on any potential systemic risks that could endanger financial stability if they materialized. Macroprudential policy tools should be ready to contain any further build-up of the risks identified. 7. Financial stability risks increase as macro-financial conditions continue to weaken 39 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Figure 7.3. Credit growth has started to Figure 7.4. Household loans grew decelerate since September 2022. faster except in North Macedonia and Montenegro. Change in nonfinancial private sector credit outstanding, December Change in credit outstanding, December 2022, percent, y-o-y 2022, percent, y-o-y 20 18 16 15 14 12 10 10 5 8 6 0 4 -5 2 16 Ja 6 17 Ja 7 18 Ja 8 19 Ja 9 Ju 0 Ja 0 Ju 1 Ja 1 22 0 2 l-2 l-1 l-1 l-1 l-1 2 l-2 n- n- n- n- n- n- n- Ju Ju Ju Ju Ja ALB BIH KOS MKD MNE SRB ▬ ALB ▬ BIH ▬ MKD ▬ MNE ▬ SRB ▬ KOS J Firms J Households Sources: IMF International Financial Statistics; central banks. Source: Central banks. and Albania (4.8 percent and 3.5 percent, by corporate and retail deposits is expected to respectively). continue in the next six months. Continued strong loan demand from The regional average NPL ratio continued firms and households and tightened credit to decline, recording its historical low conditions are expected to widen the value (Figure 7.5). The regional average NPL mismatch between credit demand and supply ratio decreased by 0.6 percentage points from in the next six months. According to the December 2021 to 3.9 percent in December results of the Central, Eastern and Southeastern 2022. NPL ratios are higher than the region’s Europe (CESEE) Bank Lending Survey9, credit average in Montenegro (6.3 percent), Albania demand has remained strong and is expected to (5.0 percent) and Bosnia and Herzegovina follow a similar pattern in H1 2023. Working (4.5 percent). Kosovo’s NPLs remained the capital loans reflecting firms’ liquidity needs lowest in the region (2.0 percent), while are expected to be the main driver of demand Albania registered the largest drop in NPLs in while fixed investments and retail segments the post-COVID period (3.2 pp since March are expected to contribute negatively. On the 2020). supply side, tightening of loan standards and costs are expected to continue in all segments While asset quality continues to improve as a result of increased uncertainty, worsened in the region, concerns remain as sharply economic outlook, and increased costs of rising interest rates to curb the soaring financing. While banks continue their selective inflation and the tightening of credit supply approach in search for creditworthy customers, may accentuate borrowers’ vulnerabilities. cross-border banking groups do not foresee a Deterioration in the macroeconomic outlook significant deleveraging or strategy change in including high inflation and low growth the region. Positive funding conditions driven may expose firm, household, and sovereign vulnerabilities, increase stress on their balance 9 EIB Central, Eastern and Southeastern Europe Bank Lending Survey, Autumn 2022. 40 7. Financial stability risks increase as macro-financial conditions continue to weaken TESTING RESILIENCE Figure 7.5. NPLs continued a downward Figure 7.6. Banks’ capital buffers were trend in all countries. preserved. NPLs as percent of total loans Percent 9 25 8 7 20 6 15 5 4 10 3 2 5 1 0 0 MNE ALB BIH SRB MKD KOS SRB BIH MNE ALB MKD KOS J Mar-20 J Dec-21 J Dec-22 Q Pre-crisis level (end 2007) J Mar-20 J Dec-21 J Dec-22 Q Average (2006–08) Sources: IMF Financial Soundness Indicators; central banks. Sources: IMF Financial Soundness Indicators; central banks. sheets, and ultimately negatively affect their growth in recent months. The loan-to-deposit debt servicing capacity. Signs of higher credit ratios were well below 100 across the board risk remain despite decreasing NPL ratios. (77 percent on average in September 2022) Elevated stage 2 loans10—a good indicator of while declining slightly, indicating a slower future NPLs—point to a higher share of loans loan growth compared to a deposit growth. with significant increase in credit risk. As of December 2021, Western Balkans’ regional Regional average bank profitability has average stage 2 loans were at 10.5 percent, recovered to pre-pandemic levels as of much higher than NPLs, at 4.6 percent. The September 2022—for the first time in CESEE Bank Lending Survey also indicates the post-pandemic period. Profitability as that given the unfavorable economic outlook, measured by return on assets has recovered banks expect an increase in non-performing to 1.8 percent in December 2022 from loans in the next six months11. 1.4 percent in December 2021, supported mainly by the rising interest rates. Kosovo had Capital buffers in the Western Balkan the highest profitability (2.5 percent), while countries remained broadly stable, while Albania had the lowest (1.4 percent). The bank liquidity is slightly lower compared CESEE Bank Lending Survey also shows that to December 2021. As of December 2022, all the international banks operating in Kosovo bank capital adequacy averaged 18.3 percent, reported a higher return on assets compared far above the regulatory minimum, and slightly to their group profitability, while in Albania higher compared to December 2021, at a return on assets of the banking groups is 18.2 percent (Figure 7.6). The ratio of liquid to not different than their group profitability. total assets averaged 29.8 percent in December Going forward, it will be important to monitor 2022, recovering from its lowest level in June profitability, considering the risks for the 2022, potentially reflecting slowing loan outlook. A weaker economy and increased 10 Stage 2 Assets, in the context of IFRS 9, are financial instruments that have deteriorated significantly in credit quality since initial recognition but that offer no objective evidence of a credit loss event. (The International Financial Reporting Standard [IFRS] is published by the International Accounting Standards Board. IFRS 9 specifies how an entity should classify and measure financial assets, financial liabilities, and some contracts to buy and sell nonfinancial items.) 11 Central, Eastern and Southeastern Europe (CESEE) Bank Lending Survey, Autumn 2022. 7. Financial stability risks increase as macro-financial conditions continue to weaken 41 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 credit risk may weigh on bank profitability prospects in the medium term through increasing provisioning and impairment cost. Authorities need to keep their focus on monitoring any remaining pockets of vulnerability in the banking sector, including the risk concentration and macro financial channels that can increase the pressure on banks. Higher funding costs and less fiscal space are putting pressure on sovereign fiscal balances. High inflation, energy prices, and interest rates put pressure on corporates and households balance sheets with growing recession risk. Increasingly volatile financial markets are more prone to disorderly adjustments especially in riskier and less liquid asset classes such as bonds, or real estate market. Regulators and banks need to take the necessary preemptive measures to prevent a new buildup of risks, and monitor exposure to sovereign and real estate market adjustment. 42 7. Financial stability risks increase as macro-financial conditions continue to weaken TESTING RESILIENCE 8. Current account balances deteriorate anew in the Western Balkans The negative terms-of-trade shock and widening of the external deficit is mainly supply chain disruptions caused by Russia’s driven by Montenegro (4.2 pp) and North invasion of Ukraine adversely affected the Macedonia (2.9 pp), although deficits widened external sector in the Western Balkans in in other countries as well, with the exception 2022. The food and energy crises continued of Albania, which reduced its deficit in 2022 to spread through the external sector to the to 6 percent of GDP. Montenegro and Kosovo Western Balkans. The effects were initially exceeded the deficit level of 10 percent of GDP most evident in the disruption of commodity in 2022. While not unusual for Montenegro, and energy trade; an increase in commodity which consistently recorded external deficits prices, particularly food and oil; and sizable averaging 15.5 percent of GDP over the last inflationary pressures not seen in decades. These decade,12 it is the first time Kosovo exceeded market volatilities and geopolitical insecurities 10 percent of GDP since 2011, despite strong spilling over into the region are further growth in net service exports and remittances. intensifying uncertainties for consumers and investors alike, aggravated by tightening global The deterioration in the regional current financing conditions. account deficit was driven by further worsening of the merchandise trade deficit In 2022, the regional current account deficit (Figure 8.2). The merchandise trade deficit  exhibited the highest level in the last decade, grew to around 15.3 percent of GDP in with the exception of the pandemic year 2022 from 13 percent of GDP in 2021, or (Figure 8.1). The regional external deficit soared  2.3 percentage points. The continued increase to 6.9 percent of GDP in 2022 from 4.8 percent in the merchandise trade deficit was caused by the year before. The 2-percentage point (pp) two broad factors: first, on the demand side, Figure 8.1. Current account deficits widened Figure 8.2. …in most countries in the region. in 2022… Percent of GDP Contributions, 2022 preliminary, percent of GDP MNE ALB KOS SRB MKD BIH WB6 12.5 0 10.0 -5 7.5 -10 5.0 -15 2.5 -20 0 -25 -2.5 -30 -5.0 -7.5 -35 -10.0 -40 ALB KOS BIH SRB MKD MNE J 2007 J 2009 J 2020 J 2021 J Goods exports J Goods imports J Net services exports J 2022e J Remittances J Others Q Change in CA deficit Sources: Central banks; World Bank staff estimates. Sources: Central banks; World Bank staff estimates. 12 2011 to 2021. 8. Current account balances deteriorate anew in the Western Balkans 43 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 by the continued strong regional growth in 2022 compared to 2021, exhibiting a secular investment and private consumption fed by rise since 2016. Two countries stand out in this the steady inflow of remittances; and second, context: Kosovo and Bosnia and Herzegovina, by surging commodity prices such as oil, both with flourishing outmigration flows. electricity, and food, as well as higher import Kosovo’s remittance inflows amounted to volumes due to purchases to store reserves nearly 13 percent of GDP, while Bosnia and of food and other commodities. For some Herzegovina registered an inflow of 9 percent countries, such as Kosovo, the acceleration in of GDP. Other countries, such as North electricity prices has added significantly to the Macedonia, Albania, and Serbia, show a more widening of the trade deficit. The worsening subdued outcome in remittances flows, totaling of the merchandise trade balance was most 2.7 percent, and 5.5 percent of GDP for both, substantial in Montenegro (7.5 pp), followed respectively. by and North Macedonia (6.5 pp), Bosnia and Herzegovina and Kosovo, where it totaled Regional external imbalances were largely about 5 pp (for the former despite being an funded by net inflows of foreign direct electricity exporter). investment (FDI). Regionally, net FDI inflows rose by 1.2 pp of GDP in 2022 to 7.0 percent Net service exports picked up in 2022, of GDP and helped finance over 80 percent of softening the widening of the current account the regional external imbalance (Figure 8.3). (Figure 8.2). Net services in part offset deficit  However, the level of this mostly non-debt- the structurally high merchandise trade deficits creating financing inflow varies significantly in the region, by 2.2 percent of regional GDP. across countries. Bosnia and Herzegovina at In 2022, net service inflows grew most in 2.9 percent of GDP exhibited the lowest net Bosnia and Herzegovina, to 9.3 percent of FDI inflows in 2022 which increased by only GDP from 7.4 percent, and in Montenegro to 0.3 percent of GDP compared to the year before. 22.7 percent of GDP, an increase of 3.4 percent Continuous political frictions and a complex of GDP, similar to Kosovo. In all countries, institutional setup are likely to have adversely higher net services are accounted for by larger affected foreign investor confidence. Kosovo, tourism inflows. The same applies to Albania, with FDI inflows at 6.6 percent of GDP, mostly where, however, net service exports growth was for construction, and North Macedonia, with limited, and recorded an increase of 1.7 percent FDI inflows at 5.2 percent of GDP, are trailing of GDP, to 13.4 percent of GDP. In Kosovo the rest of Western Balkan countries in terms and North Macedonia, visits by workers living of FDI inflows. Montenegro had the strongest abroad account for the majority of travel inflow of FDI in 2022, at 13.5 percent of inflows. GDP, mainly driven by tourism, followed by Serbia at 7.1 percent of GDP, largely in highly Net remittance inflows remained steady in productive manufacturing subsectors. Overall, 2022 supported by, among others, a strong the sharper rebound in net FDI inflows since labor market in the European Union, with 2019 may give some credence to the argument an all-time low unemployment rate of of nearshoring benefiting the Western Balkans, 6.1 percent. The regional inflow of remittances but also relocation of businesses from Ukraine remained constant at 7.1 percent of GDP in and Russia (Figure 8.4). 44 8. Current account balances deteriorate anew in the Western Balkans TESTING RESILIENCE Figure 8.3. External deficits were mostly met Figure 8.4. ...among else due to the with robust FDI… nearshoring to some parts of the Western Balkans. 2022 preliminary, percent of GDP Net FDI, 2007 to 2022 preliminary, percent of GDP 14 12 12 10 10 8 8 6 6 4 4 2 2 0 0 10 11 12 13 14 15 16 17 18 19 20 7 08 09 20 20 1 22 2 0 20 20 20 20 20 20 20 20 20 20 MNE SRB ALB KOS MKD BIH 20 WB6 20 20 20 J CAD J Net FDI Sources: Central banks; World Bank staff estimates. Sources: Central banks; World Bank staff estimates. Even with a small drop in external debt in an exception, where both private and public 2022, the Western Balkan countries continue external debt declined in 2022 compared to to depend on external financing. In 2022, the 2021, together totaling 8.4 percent. A sudden average external debt was estimated at 78 percent halt to FDI inflows in the Western Balkan of GDP, a reduction of around 5 pp compared countries, or a persistent reliance on higher to 2021. Most of the countries reduced external imports, particularly consumption goods, could indebtedness, except for Kosovo and North amplify dependence on external financing and Macedonia, which increased total external debt endanger foreign currency reserves. At end- by 0.6 and 5.6 percent of GDP, respectively, 2022, Western Balkan countries maintained driven by private external borrowing. In fact, stable reserves exceeding five months of overall private external borrowing rose since imports, yet uncertainties are running high, end-2020. In other countries, the decline in and stronger regional cooperation could go total external debt is the result of the reduction a long way toward strengthening the gains in external public debt more than offsetting in the external sector since the decline of the higher private external borrowing. Albania is COVID-19 pandemic. 8. Current account balances deteriorate anew in the Western Balkans 45 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 9. Domestic reforms would help offset a more challenging external outlook The outlook for the Western Balkans remains in the Western Balkans matched world GDP subdued and subject to high uncertainty. In growth and was just under the growth of the the short term it is expected to be driven by euro area. In short, the Western Balkans proved the economic performance of the European resilient in 2022 during a highly uncertain Union (EU), the course of energy and food period. prices, and the fight against inflation. All these factors are affected by Russia’s invasion Against this backdrop, growth in 2023 of Ukraine and the persistent impacts of the is expected to remain resilient, but that pandemic, which prompted shifts in demand resilience will be tested further. GDP growth and revealed supply bottlenecks. The outlook is expected to moderate to 2.6 percent in 2023, for the EU remains challenging, although the mainly driven by consumption, though public latest forecasts suggest that the Eurozone will investment is expected to play an important avoid a recession. Energy prices are driven by role in Bosnia and Herzegovina, Montenegro, continued supply uncertainty, although price and North Macedonia. While several forecasts are lower than anticipated last year countries are expecting a continued recovery owing to the milder European winter and in tourism revenues as well as further growth receding fears regarding gas storage stocks. in merchandise exports, external demand may However, natural gas prices are proving sticky, weaken, and domestic demand is expected to especially in Europe, given the critical role remain an important growth factor. For the Russia has played in this market. Food prices most part, GDP growth forecasts for 2023 have are also expected to remain high and appear to been revised downward since the last edition of be resulting in a pass-through to higher core the Western Balkans Regular Economic Report inflation. Finally, monetary tightening, led by on account of the weaker external environment advanced economies, is compressing demand (Figure 9.1), which affects export growth, and raising financing costs for sovereigns, inflation, and financing costs. These factors, corporates, and households. together with the preponderance of downside risks (discussed below), will test the resilience The Western Balkans economies had a of the Western Balkans. good 2022, although growth decelerated sharply over the course of the year. Their Inflation is projected to moderate in 2023, average GDP growth rate was 3.2 percent, though monetary authorities are expected on the back of 7.8 percent GDP growth in to maintain an aggressive stance, putting a 2021, which reflected a recovery from the dampener on growth. The average inflation previous year’s contraction. However, growth rate for the Western Balkans is expected to slowed significantly in the second half of the drop to 7 percent, about 5 percentage points year as sharply higher food and energy prices, lower than the previous year. Nevertheless, along with elevated uncertainty, weighed on monetary authorities are expected to remain economic performance. Growth for the year vigilant as several authorities are committed to 46 9. Domestic reforms would help offset a more challenging external outlook TESTING RESILIENCE Figure 9.1. Growth projections have been Figure 9.2. Commodity prices have receded revised downward in 2023 for three from past peaks, but remain elevated. economies. Revisions to GDP forecast Index, 2010=100 0.8 160 0.8 140 0.6 0.6 120 0.4 100 0.2 0.2 80 0.2 0.2 60 0 0 0 40 -0.2 20 -0.2 -0.2 -0.2 0 -0.4 -0.3 -0.3 -0.4 Ja 0 Ja 1 12 Ja 3 14 Ja 5 Ja 6 Ja 17 Ja 8 Ja 19 Ja 0 Ja 21 Ja 2 23 1 2 1 1 1 1 1 2 n- n- n- n- n- n- n- n- n- n- n- n- n- n- ALB BIH KOS MKD MNE SRB WB6 Ja Ja Ja J 2023 J 2024 ▬ Food Price Index ▬ Metals & minerals ▬ Crude oil Source: World Bank staff calculations. Sources: UN Food and Agriculture Organization; World Bank. return inflation to about 2 percent by 2025. prices. Authorities also need to carefully review After surging in 2022, commodity prices have the tradeoffs between measures to protect the receded from their peaks, although prices purchasing power of households against high remain significantly above their pre-crisis levels inflation and energy prices and the need for (Figure 9.2). breaking inflation-wage spiral that feed into entrenched inflation. In this context the role Management of fiscal balances is expected of indexation, collective wage bargaining, and to remain challenging in 2023. Fiscal deficits income policies would need to be synced with are expected to narrow for Albania, Bosnia and the monetary policy objectives. Herzegovina, and Montenegro in 2023, but may widen in Kosovo and North Macedonia. Caution will be needed on debt management For Albania, Bosnia and Herzegovina, and and the management of fiscal risks, Serbia, the fiscal strategy is to phase out large including state-owned enterprises. While crisis-response spending programs and intensify the Western Balkans have low to moderate revenues, with a view toward reducing public debt, the external environment is precarious as debt, rebuilding fiscal buffers, and improving borrowing costs have increased in light of the resilience. For Kosovo, Montenegro, and North monetary tightening taking place on a global Macedonia, recent increases in the public scale. Rollover risks are expected to be high, as sector wage bill, other recurrent spending, and will the cost of new borrowing in the domestic significant public investment commitments or Eurobond markets. Increased access to will drive larger fiscal balances in 2023. For quick-disbursing resources from international countries with independent monetary policy, financial institutions will help partially fill authorities need to carefully review the policy financing needs. However, in an environment tradeoffs: while raising the policy rates will still marred by uncertainty, countries will need dampen the growth, it will at the same time to ensure that their social spending is well strengthen currencies, reducing the cost of targeted and efficient and that they are getting imported commodities and thus the need for value for money in their capital investments. mitigation measures for high energy and food 9. Domestic reforms would help offset a more challenging external outlook 47 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 The Western Balkans’ current accounts are Serbia and Kosovo offers the opportunity to expected to improve only modestly in 2023. attract greater investments and accelerate the Given the importance of the EU market, EU accession process. countries are expecting only a modest recovery in their exports of goods and services and in The most appropriate response is to return the flow of remittances. The current accounts to fundamentals and to emphasize growth- of the countries with the most expansionary enhancing structural reforms. The Western fiscal policies will also be affected as higher Balkans now looks to be exiting a period of levels of investments will attract higher levels overlapping external shocks, but with sluggish of imports. growth and depleted fiscal space. In such an environment, with elevated uncertainty, the The preponderance of risks to the outlook Western Balkans will need to pay attention to remains on the downside, although the three kinds of policies: (i) domestic revenue aggregate level of risks appears to have mobilization, (ii) productivity-enhancing receded somewhat. Energy prices remain reforms, and (iii) debt management. Meanwhile, elevated, but prices have fallen significantly the region continues to face an impending green since their peak in mid-2022. Similarly, transition that will require structural reforms, concerns surrounding the security of energy including the need to put a price on carbon (see supplies have partially receded. However, the Spotlight section). Several countries are actively region remains vulnerable to an extended energy exploring revenue options including increasing and food price shock. A weaker-than-expected progressivity in direct taxes, expanding direct performance in the EU would naturally affect tax coverage to previously excluded categories both the demand for exports from the Western (such as dividends and interest) and increasing Balkans and the flow of investments and the use of excise taxes. Similarly, no-regret remittances. The effects of monetary tightening reforms that would boost productivity over in advanced economies could also spill over the medium-term, such as to accelerate to impact the financial sector, as recent events regional integration (Box 9.1), increase levels in the United States and Switzerland have of market competition, attract higher quality shown. Domestic investor sentiment remains investments, and to address barriers that limit vulnerable to all these factors, as do domestic labor-force participation (especially among political developments and the electoral cycle women) should be a priority. Finally, there is in several countries in the region. On the a risk that the counter-cyclical fiscal response upside, should EU growth slowdown prove to to the pandemic and subsequently the energy be shallower than expected, or if a sustained crisis will leave lasting scars on public debt. decline in inflation leads to greater monetary This necessitates a careful review of public debt accommodation, then the Western Balkans may policy and management with a view towards see better-than-expected growth performance. rebuilding buffers in readiness for the next Similarly, high-frequency indicators of FDI shock. suggest that reshoring of global value chains continues to offer the region an opportunity to The medium-term outlook for the Western better integrate into Eurocentric supply chains. Balkans continues to be positive but shaded Further, normalization of relations between with large uncertainty (Box 9.2); growth 48 9. Domestic reforms would help offset a more challenging external outlook TESTING RESILIENCE acceleration is needed to close the gap However, at that rate it will take many decades with its EU peers. In the medium term, the before living standards converge with today’s countries of the Western Balkans will likely EU averages. Reforms to boost potential see growth reverting toward pre-crisis levels of growth would bring this convergence forward. annual potential growth of 2.5 to 3.5 percent. Box 9.1. Trade facilitation reforms could help to accelerate growth in the Western Balkans, especially if countries take coordinated action. Trade facilitation and regional integration are crucial for the economic growth and competitiveness of the Western Balkan countries, which currently face challenges due to fragmentation and their being small economies. The Common Regional Market initiative, which covers the four freedoms (digital, investment, innovation, and industry policy) is an essential step towards integrating these economies with each other and with the EU economy. Recent efforts have focused on improving trade facilitation, upgrading transport and connectivity infrastructure, and leveraging deep trade agreements within the region and with the EU. New World Bank research quantifies the economic and social benefits of regional economic integration in the Western Balkans u  sing a general equilibrium model, and assesses the impacts of trade facilitation reforms, accession to the EU, and new infrastructure (Gomez, Taglioni and Zarate 2023). The region's economic integration is essential for fully integrating with the EU, which is already the largest trading partner, with over 70 percent of exports from the region going to EU member states. The EU is also the biggest source of foreign direct investment (FDI) in the region, similarly, accounting for around 70 percent of total FDI, and it offers access to a market of more than 500 million high-income consumers. The study suggests that coordinated policies and investments for regional integration can generate significant economy-wide benefits. For example, reducing waiting times at the border has the same impact on exports as lowering tariffs in the EU market. • A simple reduction of the waiting time at the border by three hours would be similar to lowering ad valorem tariffs by around 2 percent across all countries in the Western Balkans. • The study also found that implementation of trade facilitation reforms can generate up to 8 percent additional gains with coordination among economies, equivalent to as much as 3 percent of per capita GDP in some cases. • Meanwhile accession to the EU can amplify gains by an additional 6 percent. Furthermore, neighboring countries such as Romania, Hungary, and Bulgaria can experience gains of around 0.2 percent due to trade with the Western Balkans. • Continued investment in transport infrastructure remains a regional priority as well. Past improvements in infrastructure, particularly roads, have increased real income by around 9. Domestic reforms would help offset a more challenging external outlook 49 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 (Box 9.1 continued) 5 percent, with the potential to further boost real income by 7 percent in the case of EU accession. Hence coordination of infrastructure and trade policies can lead to additional synergies and economic growth. Figure 9.3. Aggregate welfare gains: reducing waiting times at the border by three hours. Percent increase in welfare 3,500 3,000 2,500 2,000 1,500 1,000 500 0 ALB BIH MKD MNE SRB KOS J Independent policies J Cross-country coordination J Cross-country coordination + full EU accession Source: Gomez M., Taglioni D., Zarate R., “The Economic Effect of Market Integration Policies in the Western Balkans”, World Bank, (forthcoming) 2023. Note: This figure plots the aggregate welfare gains after implementing trade facilitation reforms which consist of reducing border times by three hours. The blue bar corresponds to the counterfactual in which each economy implements the policy independently, the red bar when countries coordinate with each other, and the orange bar when countries coordinate with each other and are also part of the European Union. Box 9.2. Global economy under large uncertainty. Global growth is projected to slow sharply in 2023, the third weakest pace of expansion in nearly three decades after the global recession caused by the COVID-19 pandemic and  Figure 9.4A).13 The slowdown reflects ongoing monetary policy the global financial crisis ( tightening to contain very high inflation, fiscal adjustments, worsening financial conditions, and continued disruptions from the Russian Federation’s invasion of Ukraine. The world’s three largest economies—the United States, the euro area, and China—are expected to face continued weakness in economic activity, with the resulting spillovers exacerbating other headwinds faced by emerging markets and developing economies. Global activity, especially on the services side, appears to have stabilized in early 2023, reducing the likelihood of a global recession(Figure 9.4B and 9.4C).14 After contracting for six months, the global composite Purchasing Managers’ Index (PMI) returned to expansion in February 2023, reflecting a strong pickup in services activity. Services trade is likely to continue to benefit from the recovery in international tourist arrivals, which remained about 25 percent below pre-pandemic trends in December 2022. In contrast, global manufacturing 13 Based on the World Bank’s January 2023 edition of Global Economic Prospects, the February 2023 “Global Monthly,” and Consensus estimates from Consensus Economics. Data are as of March 13, 2023. 14 Defined as a contraction in annual global per capita income. 50 9. Domestic reforms would help offset a more challenging external outlook TESTING RESILIENCE (Box 9.2 continued) activity has continued to be subdued after global goods trade volumes and industrial production experienced renewed weakness in late 2022. The recovery in the global manufacturing PMI in early 2023 has lagged that of services, with manufacturing activity dampened by an ongoing contraction in new export orders. China’s economic reopening is likely to boost headline global growth, but the positive spillovers to other economies and global trade could be modest given that the rebound has been less manufacturing- and trade-intensive relative to previous recoveries. More broadly, global demand for manufactured goods is likely to remain muted amid the ongoing and accumulating effects of tighter monetary policy. Nevertheless, weak goods demand and continued normalization of shipping conditions have helped ease global supply chain pressures, with suppliers’ delivery times falling to pre-pandemic levels in February 2023. The outlook for the global economy appears to have improved in early 2023, with Consensus forecasts for global growth in 2023 rising  from 1.5 percent in late December to 1.9 percent in mid-March  (Figure 9.3D).15 Various economic indicators suggest that particularly in large economies, activity was more resilient in late 2022 than earlier expected, implying that the drag from a weak fourth quarter in 2022 will weigh less on activity going forward. In the United States, continued strength in the labor market has supported services activity and underpinned a pickup in consumption in early 2023, with Consensus forecasts edging up from 0.2 percent in late December 2022 to a still modest 0.8 percent in March 2023. Nevertheless, the Consensus forecast for US growth in 2024, which is about 1 percent, points to sluggish activity as tighter monetary policy weighs on domestic demand. For the euro area, Europe and Central Asia’s largest economic partner, Consensus forecasts for 2023 growth remain subdued at about 0.5 percent, an improvement from the contraction envisioned in December 2022. The upward revision for euro area growth in 2023 is largely due to better-than-expected growth outturns in Q4 2022, with activity benefiting from a warmer winter and the decrease in energy prices. Incoming survey data point to an ongoing recovery in sentiment, particularly in the service sector, with the services PMI rising to its highest level in February 2023 since June 2022, amid a pickup in new business and improving expectations. In contrast, the manufacturing PMI in February 2023 contracted for the eighth consecutive month, with the decline in new export orders mirroring the weakness in global goods trade. Inflationary pressures also continue to weigh on euro area activity—although Harmonised Index of Consumer Prices inflation has decelerated in early 2023, core inflation continues to reach new record highs. This points to the possibility of more European Central Bank (ECB) policy rate hikes than currently envisioned by the market. The Consensus forecast for 2024 growth in the euro area remains subdued at 1.1 percent, as continued tightening of monetary policy to rein in inflation is expected to hold down domestic demand. 15 Consensus Economics, https://www.consensuseconomics.com. 9. Domestic reforms would help offset a more challenging external outlook 51 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 (Box 9.2 continued) Figure 9.4. Global Developments and Growth Scenarios. A. Global growth B. Global growth under different scenarios Percent Percent 6 5 4 4 3 2 2 0 1 -2 0 -4 -1 2023 2024 2023 2024 2023 2024 20 0 20 2 20 4 20 6 20 8 19 0 19 2 94 19 6 20 8 20 0 20 2 20 4 20 6 20 8 20 0 20 2 24 1 9 0 2 1 1 0 9 0 1 9 0 1 9 0 2 World AEs EMDEs 19 19 J Baseline ▬ Sharp downturn ▬ Global recession C. Global manufacturing and services PMIs D. Consensus forecasts for 2023 Index, 50+=expansion Percent 60 6 5 50 4 40 3 2 30 1 0 20 Ap -19 Ju 19 Oc -19 Ja -19 Ap -20 Ju 20 Oc -20 Ja 20 Ap -21 Ju 21 Oc -21 Ja 21 Ap -22 Ju 22 Oc -22 Ja -22 23 -1 r- t- r- r- n- r- t- t n l n l t n l n l Ja Global United States Euro area China ▬ Manufacturing ▬ Services J October 2022 J March 2023 Sources: Consensus Economics; Haver Analytics; World Bank 2023; World Bank. Note: AEs = advanced economies; EMDEs = emerging markets and developing economies; GDP = gross domestic product; PMI = Purchasing Managers’ Index. a. Aggregate growth rates are calculated using real US dollar GDP weights at average 2010–19 prices and market exchange rates, as published in World Bank (2023). The shaded area indicates forecasts. The sample includes up to 37 advanced economies and 144 EMDEs. b. Growth aggregates computed by Oxford Economics using 2015 market exchange rates and prices. c. PMI readings above (below) 50 indicate expansion (contraction). The last observation is February 2023. d. The figure shows growth projections from the last Continuous Consensus Forecast survey of the month indicated. Data are through March 15, 2023. Risks to the global outlook remain tilted to is substantial uncertainty about the impact of the downside, including from sustained high central bank policy in terms of both magnitude inflation, financial stress, Russia’s continued and timing. To bring inflation under control, war in Ukraine, and rising geopolitical central banks, including those in Europe and tensions. Inflation remains high in many Central Asia and the ECB, may need to hike economies. In the euro area, core inflation policy rates more than is currently expected. continues to rise amid strong momentum Financial stress among sovereigns, banks, in the goods and services categories and and nonbank financial institutions may second-round effects from earlier energy price result from the combination of additional increases. As a result, market participants monetary tightening, softer growth, and falling expect the ECB to raise policy rates to higher confidence in an environment of elevated levels compared to late 2022. Moreover, there debt. Given the already weak global growth, 52 9. Domestic reforms would help offset a more challenging external outlook TESTING RESILIENCE a combination of sharper monetary policy tightening and financial stress could result in a more pronounced slowdown this year. 9. Domestic reforms would help offset a more challenging external outlook 53 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 10. Spotlight: Towards carbon pricing in the Western Balkans Slow decarbonization progress is hard by the rising cost of imported energy. increasingly hurting Western Balkan Across the region, energy prices increased by economies an average of 13.1 percent annually by July The transition toward a low-carbon, 2022, ranging from 4.5 percent in Albania to environmentally sustainable economy has 18.2 percent in Bosnia and Herzegovina.18 In begun in the Western Balkan countries addition to high prices of electricity imports, (WB6), but progress has been slow and not quadruple energy crisis refers also to the parallel without setbacks. Despite recent progress on occurrence of a series of technical problems wind and solar capacity additions, as well as at coal power plants and mines (primarily the increased availability of renewable energy in Kosovo, North Macedonia, and Serbia), finance, the primary source of energy in the unfavorable conditions for hydropower WB6—with the exception of Albania— production (impacting all WB6 countries but is domestic lignite and coal (64 percent of mostly Albania), and an increase in biomass electricity in the WB6 was produced from prices in all countries. Overdue investments lignite and coal in 2020 and 47 percent of into modernizing the power sector, including gross available energy in 2020, down from scheduled decommissioning of several coal 49 percent in 2015) (Figure 10.1).16 Material- power plants19 and planned energy sector policy and energy-intensive modes of production reforms, were further delayed, and the backlog in industry are driving up production costs continues to aggravate the impact of the energy and emissions. Though declining, large fossil crisis. The destabilizing impact of Russia’s fuel subsidies17 and electricity tariffs below invasion of Ukraine has added the pressures of generation cost reduce incentives to achieve high food prices and inflation in the last year. energy savings, improve energy efficiency, and With significant differences in primary energy switch to greener fuels. mixes and import dependencies, the WB6 were hit by the same challenges, but to varying A quadruple energy crisis has hit WB6 degrees (Figure 10.1). countries hard in the past year, stalling progress and investment in key strategic The negative consequences of high fossil areas but also highlighting the need for more fuel dependency, high energy intensity and diversified energy sources and strengthened outdated technology use on the WB6 are cross-border interconnections. With clearly visible beyond the direct economic average annual net energy imports equaling impacts. On the supply slide, ageing coal up to 52 percent of energy consumption by power plants and the use of biomass cause country, the WB6 countries have been hit significant air pollution. Equally on the demand 16 IEA Electricity Information 2022 and Eurostat. 17 With the exception of Bosnia and Herzegovina, subsidies for coal and coal production have been continuously declining since 2016. Direct subsidies to coal mines and power plants amounted to EUR 73 million in the region in 2019 (Energy Community 2022). 18 World Bank 2022a; 2022b. 19 See Enervis (2021) for an overview of lignite plants in the Western Balkans as of 2021 and the schedule of phaseouts. 54 10. Spotlight: Towards carbon pricing in the Western Balkans TESTING RESILIENCE Figure 10.1. Western Balkans’ energy mix: Gross available energy by product, 2015 and 2020 Percent 100 80 60 40 20 0 2015 2020 2015 2020 2015 2020 2015 2020 2015 2020 2015 2020 2015 2020 ALB BIH KOS MNE MKD SRB WB6 J Solid fossil fuels (coal and lignite) J Natural gas J Oil and petroleum products J Renewables and biofuels J Electricity Source: Eurostat. Note: Gross available energy is defined as the overall supply of energy for all activities on the territory of the country. Note that for derived products (electricity), the chart shows only stock changes and international trade, as the original primary form of supply is accounted for in the form of the respective primary product. Resulting small negative balances for electricity, where applicable, are excluded from the chart for better overview. side, poor energy efficiency in buildings and The EU is incentivizing trading partners heating also contribute to poor air quality. All to act on the climate WB6 countries have failed to comply with air This mode of power generation and fossil- pollution limits set in their National Emission fuel intensive economic production leaves Reduction Plans (NERPs) where applicable, the region vulnerable as the European Union also due to a lack of enforcement of pollution (EU) decisively shifts to a cleaner and more limits outlined in those plans. A majority of resilient economic model. The European the WB6 power fleet is over 40 years old, with Green Deal (EGD)25 outlines a 2030 target few plants scheduled for decommissioning and of reducing emissions at least 55 percent and new plants in the pipeline.20 Specifically, legal a 2050 net zero emissions target.26 Under limit values for sulfur dioxide (SO2) from coal the EGD, carbon pricing plays a central role, power plants are frequently breached.21 Coal alongside phasing out of environmentally combustion is the second largest source of PM harmful subsidies: The European Union 2.5 emissions in the region22. In 2019, annual Emissions Trading System (EU ETS) will mortality rates due to PM2.523 air pollution in be strengthened and expanded, the Energy the Western Balkans were more than double Tax Directive will be reformed to improve the EU-27 average, with mortality rates in incentives for switching fuel, and a Carbon Bosnia and Herzegovina 140 percent above Border Adjustment Mechanism (CBAM) will those in the EU-27 average.24 impose a fee on the carbon content (direct and embedded CO2, N2O and PFC emissions) of 20 OECD (2022). 21 For quantitative country-level analyses on the apportionment of sources for Bosnia and Herzegovina, Kosovo, and North Macedonia, see https:// www.worldbank.org/en/region/eca/publication/air-quality-management-in-western-balkans. 22 OECD (2022), Multi-dimensional Review of the Western Balkans: From Analysis to Action, OECD Development Pathways, OECD Publishing, Paris, https://doi.org/10.1787/8824c5db-en. 23 PM2.5 refers to particulate matter 2.5 micrometers and smaller. It is particularly harmful to health because it can travel deeply into the lungs. 24 Belis et al. 2021, Figure 4. 25 The EGD, a provisional agreement reached by the Council of the European Union and the European Parliament, is pending formal adoption by both institutions. 26 EU Climate Law; https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32021R1119. 10. Spotlight: Towards carbon pricing in the Western Balkans 55 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 covered emissions-intensive imports (iron and The CBAM aims to incentivize coordinated steel, cement, fertilizers, aluminum, electricity, climate action in trading partner countries, and hydrogen, as well as selected articles of iron including the Western Balkan economies. or steel).27 The Green Deal Industrial Plan28 has The CBAM proposal as of December 2022 since been added to the EU policy framework encourages third countries to introduce carbon on green transition, covering measures to pricing, as the amount of CBAM certificates support the deployment of clean technologies to be surrendered for a given product would in the EU, also in response to the U.S. scheme be corrected for any carbon price paid in the of subsidies for green investment under the country of origin (Article 9). Full CBAM Inflation Reduction Act. This sends a strong exemptions would apply to countries linking to signal to its trading partners about the potential the EU ETS, partial CBAM exemptions could financial risks of a fossil fuel-centric economic apply to third countries that integrate with the model. EU through electricity market coupling—a process WB6 countries are going through The CBAM is a key tool for the EU to help with the support of the Energy Community level the playing field for domestic industries (Box 10.1). Clarifications on how the EU will covered by increasingly ambitious carbon determine these exemptions are needed in pricing. By expanding the carbon pricing the form of bylaws and additional guidance signal to imported carbon-intensive products, documents.30 the risk of carbon leakage—that is, relocation of carbon-intensive production to countries outside of the carbon pricing coverage—will Emissions intensive sectors in WB6 be reduced. Should the regulation come into would be negatively affected by CBAM but have time to adapt effect as planned, starting from 2023, importers of materials covered by the CBAM will have The CBAM’s impact on third countries that to start reporting embedded emissions of their do not qualify for exemption or join the products. From 2026, the CBAM fee will EU by the time CBAM becomes effective gradually be phased in (reaching average EU depends on their exposure and ability to ETS allowance price levels by 2034) while adapt. Exposure can be measured as share of the free allocation of allowances to EU ETS GDP from trade in CBAM goods with the EU entities29 will be phased out over the same time and carbon intensity. Ability to adapt depends period. This gradual implementation provides on characteristics such as export diversity, time and opportunity for WB6 economies to pace of decarbonization, and capacities for adapt and prepare for the CBAM. Measurement, Reporting and Verification, among other aspects.31 27 CBAM scope as of December 13, 2022 (Council of the European Union and European Parliament provisional agreement). 28 The Commission is expected to outline a draft proposal in March 2023. 29 “The free allocation of allowances deals with the risk of carbon leakage by reducing the costs of compliance faced by the operators covered by the EU ETS. These allowances thus help them to remain competitive against producers based in third countries”(https://op.europa.eu/webpub/eca/ special-reports/emissions-trading-system-18-2020/en/#:~:text=The%20free%20allocation%20of%20allowances%20deals%20with%20the%20 risk%20of,producers%20based%20in%20third%20countries.). 30 A list of questions and considerations these exemptions raise for the WB6 is included in Karova (2022). 31 For more details, see the total relative risk indicator based on vulnerability and exposure to the CBAM developed by Eicke et al. (2021). 56 10. Spotlight: Towards carbon pricing in the Western Balkans TESTING RESILIENCE Box 10.1. EU CBAM Exemptions.a  roposed Article 2(5) exempts third countries and territories from CBAM under the P conditions that the EU ETS applies in the country or territory (or alternatively full linking of a domestic trading scheme to the EU ETS applies) and that the carbon price is effectively charged without rebates beyond those applicable in the EU ETS. A  rticle 2(7) applies to third countries integrating with the EU electricity internal market through market coupling. If technical solutions cannot be found in time to impose CBAM on electricity exported into the EU, then a limited CBAM exemption will be granted until 2030 at the latest for the export of electricity if certain criteria are satisfied. These relate to commitments and implementation of policies relating to climate neutrality and development of renewables, among others.b a. This is based on the draft text from the December 2022 proposal. The final CBAM regulation still needs to be finalized and adopted, as such, it may change. b. For an outline of WB6 progress in achieving these conditions, see Energy Community. 2022. Energy Transition Tracker. Figure 10.2. Share of exports exposed to CBAM by sector and country, 2018–2022. Annual exports of CBAM products to EU, million USD Albania Bosnia and Herzegovina Montenegro 40 10 1,200 10 160 10 8 1,000 8 8 30 120 800 6 6 6 20 600 80 4 4 4 400 10 40 2 200 2 2 0 0 0 0 0 0 2018 2019 2020 2021 2022 2018 2019 2020 2021 2022 2018 2019 2020 2021 2022 North Macedonia Serbia Kosovo 600 10 2,500 10 15 10 500 8 2,000 8 12 8 400 6 1,500 6 9 6 300 4 1,000 4 6 4 200 100 2 500 2 3 2 0 0 0 0 0 0 2018 2019 2020 2021 2022 2018 2019 2020 2021 2022 2018 2019 2020 2021 2022 J Aluminium J Iron and steel products J Iron and steel J Fertilizer J Fertilizer (nitric acid and ammonia) J Electrical energy J Cement Q Share of CBAM exports in total exports (rhs) Source: COMTRADE, WDI and Kosovo Agency of Statistics. Note: Kosovo data only includes EX1 exports. Total exposure is therefore underestimated in the chart. 10. Spotlight: Towards carbon pricing in the Western Balkans 57 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.23 Given that the EU is the main trading partner of further carbon lock-in34 in the power sector of the WB6, and the carbon-intensive modes is high in all WB6 countries except Albania and of production in the region, the CBAM North Macedonia. is a tangible transition risk for the WB6. Exposure to CBAM depends on the amount Macroeconomic impacts are not large in of the specified product exported and the aggregate but emissions-intensive sectors relatively emissions intensity of that product. will be impacted significantly unless Looking at regional trade, 1 to 10 percent of domestic policy adjustments or changes in total exports by country would be covered by the production process are made. Modeling the CBAM based on 2018–22 data, with an done for Serbia shows CBAM leading to in a average of 4 percent covered across countries decline in exports, output and employment for and assessed years (Figure 10.2). Bosnia and electricity, ferrous metals, chemicals, and non- Herzegovina and Montenegro show the largest ferrous metals in the absence of supporting exposure, partly driven by large power exports. policy measures (Table 10.2). However, The carbon intensity of production processes in this does not translate into a significant the WB6 is also much higher than in the EU. macroeconomic impact as cleaner sectors, like According to the Energy Community Energy consumer goods and electronics, increase their Tracker, GHG in manufacturing in the WB6 output due to labor and capital shifts away is 10 times higher than the EU-27 average.32 from CBAM-targeted sectors. Carbon intensity of power is three times higher in the WB6 than in the EU-27, leading Despite the WB6’s high vulnerability to relatively higher embedded emissions in and exposure to the CBAM compared to electricity-intensive products produced in the other countries,35 the expected aggregate WB6 (Table 10.1).33 Looking at trends for macroeconomic impact for WB6 countries renewables’ shares in power generation, the risk is small as economies are expected to adjust Table 10.1. WB6 and EU27 energy mixes, GHG emissions, and renewables trends. RE in power generation Carbon intensity of power Trend for RE 2020 (percent) (grams CO₂e / kwh) in power mix Albania 100 24 (2020) → Bosnia and Herzegovina 28.5 489 (2021) ↘ Kosovo 5.2 778 (2020) → Montenegro 52.2 336 (2021) ↘ North Macedonia 24.4 487 (2021) ↗ Serbia 21.9 549 (2021) → EU27 38.0 265 (2020) → Source: IEA; BP Statistical Review of World Energy; Ember; Eurostat. Note: The third column indicates how the share of RE in power generation has changed in the last 10 years. Changes within +/-3pp are marked as ->. 32 Kantor, E3M 2021. 33 Based on the December 2022 CBAM draft, indirect emissions would be included but the final scope and timeline is yet to be determined. 34 “Carbon lock-in refers to the concern that investments in carbon-intensive infrastructure today will delay or foreclose a clean energy future by making it too difficult or too expensive to transition to alternative energies, thereby ‘locking’ a country into a fossil fuel-dependent development pathway” (https://www.energyforgrowth.org/memo/untangling-stranded-assets-and-carbon-lock-in/#:~:text=Carbon%20lock%2Din%20 refers%20to,fossil%20fuel%2Ddependent%20development%20pathway.). 35 A global assessment put five of the WB6 countries in the top two quintiles in terms of relative CBAM risk (Eicke et al. 2021). 58 10. Spotlight: Towards carbon pricing in the Western Balkans TESTING RESILIENCE Table 10.2. CBAM selected sector effects by 2035 compared to BAU for Serbia. Annual percent change Exports Output Employment Electricity -27.01 -3.96 -3.97 Ferrous Metals -30.55 -28.95 -28.92 Chemicals -6.53 -5.63 -5.35 Non-ferrous metals -3.47 -3.44 -3.53 Note: Results stated are for a scenario assuming scope 2 emissions are priced in CBAM from 2030, and price level is EUR110/tCO2e in 2035. Table 10.3. Overview of selected modeling results of CBAM impacts in WB6. CBAM IMPACT Estimated total annual Change in on GDP CBAM revenues GHG emissions Albania Up to -1.3% [2]