Bosnia-Herzegovina Business Forecast Report Q2 2008

Improved Outlook For Reforms We believe that the surprise breakthrough on police reforms by Bosnia's ethnic political parties in December 2007, and the consequent signing of the Stabilisation and Association Agreement (SAA) with the EU, will be supportive of generally positive fiscal dynamics over the medium term.

Providing a crucial policy anchor going forward, the initiation of formal ties with the EU will likely see increased progress on structural and much-needed institutional reforms in the Balkan country, which continues to suffer from social and political divisions along ethnic lines. We expect this to provide a platform for more sustainable reductions in public spending commitments going forward, and to increase the incentive to maintain fiscal discipline. While Bosnia's central government budget is forecast to post a surplus of BAM40.8mn (EUR20.8mn) in 2008, we expect the fiscal balance to slip into a slight deficit of 0.1% of GDP in 2009, and likely remain at that level over a five-year horizon.

Our view reflects the ongoing lack of central government control of Bosnia's public finances, with independent entity budgets continuing to present key risks to Bosnia's fiscal environment. Indeed, we have previously highlighted that the recently established spending watchdog, the National Fiscal Council (NFC) remains largely ineffective. The continuation of Bosnian institutional reforms and increased centralised control of public spending programmes will be crucial to keeping the anticipated fiscal shortfall within a narrow range.

Concerns over the autonomy of the Republika Srpska (RS) will remain at the forefront of Bosnian Serb politics for the foreseeable future. Bosnian Serb Prime Minister Milorad Dodik's political mandate was reaffirmed, by the election of fellow Alliance of Independent Social Democrats (SNSD) party member Rajko Kuzmanovic to the largely ceremonial post of RS president, with 42% of the vote. The election comes on the back of the sudden death of the late RS president, Milan Jelic, in September, and is the first time that the Bosnian Serb president has been elected directly, and not through parliament. While the new president is unlikely to bring about a policy shift in the RS, the election outcome reaffirmed the political backing for the SNSD party and the RS prime minister.

We expect economic growth to largely be driven by exports to the eurozone going forward. Despite the fact that the export sector is relatively underdeveloped, we believe that there is substantial room for expansion. Furthermore, in light of rising wages elsewhere in the CE4 and parts of southeastern Europe, Bosnian exports will start to look increasingly competitive. However, the ability to capitalise on lower production costs will depend largely on Bosnia's ability to raise output levels to meet external demand. This will require building new production plants, as well as expanding capacity at existing plants. So far, the gains in industrial production have been encouraging.

Bosnia ranks 84th out of 179 countries in Transparency International's 2007 Corruption Perceptions Index, alongside Gabon and Macedonia. Corruption is a major problem in most aspects of business and society, with companies required to pass through a complex network of regulatory processes in order to obtain the necessary permits, providing numerous opportunities for the taking of commissions. Many are forced to pay bribes to ensure approval of their applications. Red tape is burdensome, with the World Bank estimating it takes an average of 54 days to complete registration for a new business.