WESTERN BALKANS REGULAR ECONOMIC REPORT No. 22  |  Fall 2022 Beyond the Crises Western Balkans Regular Economic Report No.22 | Fall 2022 Beyond the Crises © 2022 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and permissions The material in this work is subject to copyright. Because The World Bank encourages dissemination of its knowledge, this work may be reproduced, in whole or in part, for noncommercial purposes as long as full attribution to this work is given. Any queries on rights and licenses, including subsidiary rights, should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; fax: 202-522-2625; e-mail: pubrights@worldbank.org. The cutoff date for the data used in this report was September 30, 2022. BEYOND THE CRISES 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, Christos Kostopoulos, and Richard Record (Task Team Leaders). This issue’s core team included World Bank staff working on the Western Balkan countries (with additional contributions to specific sections): Marc Schiffbauer, Natasha Rovo (Growth section), Sanja Madžarević-Šujster, Joana Madjoska, Klea Ibrahimi (Labor section), Leonardo Lucchetti, Carlos Gustavo Ospino Hernandez, Anna Fruttero, Zurab Sajaia, Jonathan Karver (Poverty section), Milan Lakićević, Besart Myderrizi (Fiscal section), Hilda Shijaku, Isolina Rossi (Monetary section), Alper Oguz, Jane Hwang (Financial sector section), Sandra Hlivnjak, Tihomir Stučka (External section), Richard Record, Lazar Šestović, Collette Mari Wheeler, Philip George Kenworthy, Shijie Shi, Sinem Kilic Celik (Outlook section), Alper Oguz, Jane Hwang, Ismail Fontan, Vahe Vardanyan (Spotlight). Research assistance was provided by Suzana Jukić. Diane Stamm provided assistance in editing, and Budy Wirasmo in typesetting. The cover image was created by Sanja Tanić. The dissemination of the report and external and media relations are managed by an External Communications team comprised of Paul Clare, Sanja Tanić, Lundrim Aliu, Anita Božinovska, Ana Gjokutaj, Jasmina Hadžić, Gordana Filipovic, 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.22 Contents Acknowledgementsv Abbreviationsx Beyond the Crises 1 1. Overview 2 2. Global headwinds weigh on the recovery 6 3. Labor market recovery hit by a new storm 9 4. Significant headwinds could hamper poverty reduction in 2022–23 16 5. Fiscal policy faces renewed pressures 23 6. Soaring inflation poses new policy trade offs 30 7. Financial sector resilience tested with new challenges ahead 34 8. External imbalances widened despite the export recovery 40 9. The region heads into another storm 43 10. Spotlight: Greening the Western Balkan Financial Sector 53 Country Notes 65 Albania66 Bosnia and Herzegovina 72 Kosovo77 Montenegro83 North Macedonia 88 Serbia94 Key Economic Indicators 99 vi Contents BEYOND THE CRISES Figures Figure 2.1. Real GDP growth started to decelerate but is projected at 3.4 percent for the year… 6 Figure 2.2. ...as consumption and investment remain strong in most countries. 6 Anti-competitive practices of competitors and access to technology are reported Figure 2.3.  as major growth constraints for businesses in the recovery. 8 Figure 2.4. Few Western Balkan firms report being environmentally friendly. 8 Figure 3.1. The employment rate reached a historical high in the Western Balkans… 9 Figure 3.2. …with services and construction having the highest job creation rates. 9 Figure 3.3. Employment prospects are solid in the Western Balkans… 11 ..but post-pandemic labor market challenges loom, including increased labor Figure 3.4. . shortages.11 Figure 3.5. Regional labor market is gaining importance… 11 ..but further measures are needed to to curb the problem of labour force Figure 3.6. . shortages and brain drain. 12 Figure 3.7. Unemployment rate declined in all countries. 13 Figure 3.8. More women returned to labor market than men in 2022. 13 Figure 3.9. Wages grew twice as fast as productivity before the pandemic… 14 Figure 3.10. …with productivity gaining strength from 2021. 14  overty likely decreased in 2021, but the region is experiencing significant Figure 4.1. P challenges for poverty reduction going forward. 16 Food and energy inflation would push a large share of vulnerable people into Figure 4.2.  poverty in the absence of government support measures. 18 Figure 4.3. Household welfare is expected to fall along the welfare distribution. 20 Figure 4.4. Intentions to upgrade heating technology and attitudes towards sustainable heating. 22 Figure 5.1. Fiscal deficits levels remain high against renewed pressures… 23 Figure 5.2. …remaining broadly unchanged from 2021 in Western Balkan biggest economies. 23 Figure 5.3. Expenditure levels remain high, marginally increasing in most countries. 24 Figure 5.4. Capital underspending helped contain expenditures in Kosovo and Albania. 24 Figure 5.5. Public and publicly guaranteed debt declined in most countries… 25 Figure 5.6. …and so did external debt. 25 Figure 5.7. Share of variable-rate debt is high in several countries. 28 Figure 6.1. Inflation has reached record highs globally. 30 Figure 6.2. Soaring energy prices are still driving up inflation. 30 Figure 6.3. Price pressures are increasingly broad-based… 31 Figure 6.4. …and the core inflation is rising globally. 31  estern Balkan countries experienced rapid increases in headline inflation Figure 6.5. W during 2022… 32 Figure 6.6. …as commodity and food price increases were amplified by the war in Ukraine. 32 Persistent commodity price shocks were transmitted to broader prices causing Figure 6.7.  core inflation to increase… 32 Contents vii WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Figure 6.8. …de-anchoring inflation expectations in the Western Balkans. 32 Figure 6.9. Central banks responded to inflation by tightening monetary policy. 33 Figure 6.10. Exchange rate pressures varied among Western Balkan countries. 33 Figure 7.1. Credit growth has been positive in all countries and is accelerating. 35 Figure 7.2. Corporate loan growth surpassed household loan growth in half of the countries. 35 Figure 7.3. NPLs continued a downward trend in all countries except Montenegro. 36 Figure 7.4. Banks’ capital buffers were preserved. 36 Figure 7.5. Stage 2 loans remain elevated in the post-Covid period. 39 Figure 7.6. Firm liquidity needs are surging in the post-COVID environment. 39 Figure 8.1. Current account deficits widened in most countries in the region… 40 Figure 8.2. …as trade deficits widened. 40 Figure 8.3. Services and remittances only partly help contain external deficits. 41 Figure 8.4. External debt is expected to decline in most Western Balkan countries in 2022. 41 Figure 9.1. Growth projections have been revised downward in 2023 since spring 2022. 43 Figure 9.2. Commodity prices may have peaked. 43 Figure 9.4. Financing costs have risen as advanced economies tighten monetary policy. 47 Figure 9.5. Trade is weakening as the global economy slows. 47 An increase in potential growth is needed for the Western Balkans to converge Figure 9.6.  with EU per capita income levels. 49 Figure 9.7. A large governance gap exists between the Western Balkans and EU peers. 49 Figure 9.8. Total factor productivity growth has been sluggish. 49 Figure 9.9. Labor force participation, particularly for women, is below that of EU peers. 49 Figure 9.10. Structural reforms are needed to boost potential growth in the Western Balkans. 52 Figure 10.1. Green Finance and the Role of the Financial Sector. 54 Figure 10.2. Scope and example of CERO Assessments: An illustrative example. 59 Figure 10.3. Overview of specific actions for regulating and supervising climate-related and environmental risks. 63 viii Contents BEYOND THE CRISES Boxes Box 2.1. What are firms struggling with in the Western Balkans region? 7 Box 3.1. Employment prospects improved but multiple challenges remain. 10 Box 3.2. Wages and productivity in the Western Balkans: call for reforms. 14 Box 4.1. Simulating food and energy price shocks. 19 Attitudes towards transition to more sustainable and efficient heating in the Box 4.2.  Western Balkans. 21 Box 5.1. High medium-term refinancing needs facing rising cost of capital. 26 Box 7.1. NPL resolution in the post-COVID environment. 38 Box 9.1. Global economy under continued shocks. 44 Box 9.2. Raising potential growth will be key to unlocking a medium-term recovery. 50 Tables Table 1.1. Western Balkans Outlook, 2019–2024 5 Poverty reduction at the country level is projected to slow in 2022, reflecting Table 4.1.  rising food and energy prices and impacts of the war in Ukraine. 17 Table 4.2. Simulation parameters and data sources. 19 Table 4.3. Coverage and generosity of social transfers programs is uneven. 20 Table 5.1. Country credit ratings are still at non-investment grades. 26 Table 5.2. Yields and spreads on outstanding Eurobonds surged. 28 Table 10.1. Selected Indicators from the INFORM Risk 2022 Index for Climate Risk Management.56 Table 10.2. Western Balkan commercial banks: Conclusions of the questionnaire/survey to the commercial banks regarding climate and environment risks. 62 Contents ix WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Abbreviations CAD current account deficit NPLs nonperforming loans CEE Central and Eastern Europe PMI Purchasing Managers Index CESEE Central, Eastern and pp percentage points Southeastern Europe PPG public and publicly guaranteed CIT corporate income tax PPP purchasing power parity CPI Consumer Price Index Q1 first quarter € euro rhs right-hand scale EBA European Central Bank SILC Survey of Income and Living ECAPOV Central Asia Regional Collection Conditions ECB European Central Bank SMEs small and medium-sized eop end-of-period enterprises EPS Elektroprivreda Srbije (Serbia) SOEs state-owned enterprises EU European Union UNCTAD United Nations Conference on FAO Food and Agriculture Trade and Development Organization VAT value-added tax FDI foreign direct investment y-o-y year-over-year FX foreign exchange GDP gross domestic product H1 first half Country abbreviations ICT information and communications technology ALB Albania IMF International Monetary Fund BIH Bosnia and Herzegovina KM convertible mark; the monetary KOS Kosovo unit of Bosnia and Herzegovina MKD North Macedonia LFS Labor Force Survey MNE Montenegro lhs left-hand scale SRB Serbia NBS National Bank of Serbia WB6 Western Balkans 6 x Abbreviations Beyond the Crises WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 1. Overview The economies of the Western Balkans now averages 46 percent, a 3-percentage point continue to face a turbulent external increase over mid-2021, although still low environment, placing households, firms, and compared to the EU27. All sectors contributed governments under acute stress. Just as the to the job market recovery, with services post-COVID recovery of 2021 began to fade (including tourism) playing an especially strong and the region returned to a normalized rate of role. As a result, labor shortages have emerged economic growth, the Western Balkan region as a key concern highlighted by businesses now faces a new combination of challenges. The across the region. The unemployment rate war in Ukraine, and the resultant sharp increase in the Western Balkans declined to a historic and energy prices and slowdown in global low of 13.5 percent by mid-2022, equivalent growth, is weighing on economic performance to a decline in unemployment of 151,000 in all six economies. Higher energy and food people. The broad-based recovery in the labor prices have pushed inflation to levels unseen market has also benefitted vulnerable groups, for many years, eroding purchasing power and with youth unemployment also seeing a business confidence. Monetary tightening in notable decline to 27.1 percent, albeit from a advanced economies is pushing up financing high level. Similarly, labor force participation costs and weakening external demand. among women has increased to 53.0 percent by mid-2022 (up 2.6 percentage points) as women Economic growth proved to be robust in the returned to the labor market. However, more first half of 2022, above expectations. Private recent data suggests that the labor market is consumption and investment were the key beginning to cool with employment slowing drivers of growth. Rising wages and remittances, amid high inflation and increased uncertainty. together with increasing private credit, have supported private consumption. Investment Poverty has continued to decline in 2022, was particularly strong in North Macedonia, but sharply higher inflation poses risks to Serbia, and in Bosnia and Herzegovina, partially poverty reduction going forward. Poverty as countries accumulated inventories to avoid in the Western Balkans is expected to fall by supply chain bottlenecks and accelerated approximately 1 percentage point in 2022, investment in the energy sector. Sustained considering the good performance in the first export growth, especially in Kosovo together half of 2022, and the anticipated slowdown. with Albania, Montenegro, and Serbia, has also This is equivalent to bringing about 144,000 acted as a key growth driver. However, growth people out of poverty. At the same time, momentum is beginning to slow in the face of inflation, particularly for food and energy, is mounting headwinds. negatively affecting the less well-off relatively more than other income groups as they Building on performance seen in 2021, tend to spend more of their budget on these employment levels reached historical highs products and have fewer coping mechanisms in several countries by mid-2022. The to maintain purchasing power. In the absence employment rate increased in all countries and of government support, the severity of the 2 1. Overview BEYOND THE CRISES energy and food price shocks could result in a During 2022, inflation in the Western 13-percent increase in the number of the poor Balkans has soared due to a combination in the region, according to the World Bank of supply- and demand-side factors. Food simulation. and energy prices were already rising before the outbreak of war in Ukraine accelerated Fiscal spending pressures following the upward pressures. Inflation is now expected to energy and food price shocks have offset remain in double digits for 2022 in all Western revenue buoyance brought by high inflation Balkan countries except for in Albania. Food and halted fiscal consolidation. The average inflation reached as much as 25 percent in fiscal deficit in 2022 is expected to increase Bosnia and Herzegovina, Montenegro, and by 0.4 percentage points as a share of GDP North Macedonia. While commodity price compared to in 2021. On the one hand, increases have been the most significant drivers high inflation has helped to boost revenue in of inflation, price pressures are increasingly nominal terms, especially for indirect taxes broad-based. such as VAT. But on the other hand, public expenditure has increased significantly as Financial sector stability has been governments have been taking measures in maintained, but a growth slowdown and response to rising inflation and the energy crisis. higher inflation will inevitably test the All Western Balkan countries have adopted financial sector. Non-performing loans remain policies to mitigate the impact of inflation on on a downwards trajectory (at 4.4 percent on the most vulnerable households, but the fiscal average in March 2022) and the direct impact impact of the energy price shock has been of the war in Ukraine on the region’s banking most significant in energy-importing Serbia, sector has been limited. Capital buffers have North Macedonia, and Kosovo. In some cases, held broadly stable, as has bank profitability. losses incurred by energy utilities are creating Loan growth has remained strong, averaging significant contingent liabilities, increasing 10.2 percent year-on-year by mid-2022, fiscal risks. In such an environment, public helping to propel growth. However, tighter debt remains elevated in the Western Balkan global financing conditions, a slowdown in economies, although nominal GDP growth is both domestic and external demand, as well as helping to bring debt burden indicators as a weakening business and consumer confidence share of GDP moderately downwards. Public will surely impact the region’s financial sector. and publicly guaranteed debt is expected to decline to 52.7 percent of GDP in 2022, from The region’s export boom has begun to slow, 56.4 percent in 2021, but still above the pre- just as imports have sharply increased due to COVID peak, while financing conditions the higher cost of food and energy, widening are tightening as global monetary policy current account deficits. Deficits are widening attempts to tame the inflation shock. Yields in all countries of the Western Balkans, and in on outstanding Eurobonds issued by Western some cases such as Kosovo, Montenegro and Balkan countries widened noticeably in 2022, Serbia have reached double digits. For the with some of them pushing close to as high as region, the current account deficit is expected 10 percent. to widen from 4.9 percent of GDP in 2021, to 8.7 percent of GDP in 2022. Exports, of both 1. Overview 3 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 goods and services, have remained strong across retention and reinvestment among foreign the region, but the pace of growth has begun investors, reduce barriers to female labor to slow. At the same time, import growth force participation, improve the quality of increased, largely determined by higher prices education, and raise standards of governance, for imported food, electricity, oil and gas. including digitalization. The ongoing crisis Foreign direct investment flows, along with also underpins the importance of accelerating remittances, have remained resilient during the green transition in the region away from the first half of 2022. However, the outlook volatile hydrocarbons toward cleaner electricity for trade and investment is inevitably tied to generation, as well as greener production, the economic outlook for the region’s primary finance, and consumption patterns. trading partners which are among Europe’s advanced economies. The transition towards a low-carbon, environmentally sustainable economy is While growth in the first half of 2022 proved not only good for longer-term growth, but to be relatively robust, it is clear that the also as a response to the current crisis. Such region is now heading into another storm. a transition requires significant investments. A confluence of indirect supply and demand The financial sector has an important role to shocks are expected to weigh heavily on the play in facilitating this transition. However, region’s outlook, keeping inflation high and so far green finance has fallen short in terms dampening consumer and investor confidence. of the required scale and scope, both globally Financing conditions are tightening, the risks and particularly in the Western Balkans. The of a winter COVID-19 flare-up remain, and Spotlight in this edition of the Western Balkans global supply chains continue to be stressed. Regular Economic Report sheds some light on Economic activity is also slowing sharply the agenda ahead of the region in order to in advanced economies, especially in the green its financial sector. Eurozone, which is a key source of demand for Western Balkans goods and services, and a source of investment and remittances. As a result, growth in the Western Balkans has been further revised downward for 2023 (by 0.3 percentage points) to 2.8 percent. In the short term, governments should prioritize policy support to the vulnerable, ensuring that measures are targeted and timebound to minimize fiscal risks. With limited fiscal space, no-regret reforms that would boost medium-term growth at limited fiscal costs should be a priority for policymakers. This would include measures to increase the level of market competition, remove entry barriers to business, increase 4 1. Overview BEYOND THE CRISES Table 1.1. Western Balkans Outlook, 2019–2024 2019 2020 2021 2022e 2023f 2024f Real GDP Growth (percent) Albania 2.2 -3.5 8.5 3.2 2.3 2.5 Bosnia and Herzegovina 2.8 -3.1 7.5 4.0 2.8 3.2 Kosovo 4.8 -5.3 10.5 3.1 3.7 4.2 North Macedonia 3.9 -6.1 4.0 2.1 2.7 2.9 Montenegro 4.1 -15.3 13.0 6.9 3.4 3.1 Serbia 4.3 -0.9 7.4 3.2 2.7 2.8 WB6 3.7 -3.2 7.6 3.4 2.8 3.0 Real GDP Components Growth (percent) Consumption 3.1 -1.3 5.3 3.1 2.6 2.6 Investment 2.4 -1.5 3.7 2.1 1.1 1.0 Net exports -1.6 -0.4 -1.3 -1.9 -0.9 -0.6 Exports 3.7 -5.9 9.9 4.8 3.2 3.2 Imports (-) 5.4 -5.4 11.2 6.8 4.1 3.8 Consumer Price Inflation (percent, period average) 1.5 0.9 3.3 10.9 6.4 3.0 External Sector (percent of GDP) Goods exports 28.5 27.6 31.8 32.6 32.7 33.1 Trade balance -13.6 -13.6 -12.7 -15.5 -15.0 -13.5 Current account balance -6.1 -5.6 -4.9 -8.7 -8.3 -7.1 Foreign direct investment 4.9 5.3 5.8 5.2 5.3 5.1 External debt 76.7 89.8 88.4 83.9 81.5 79.3 Public Sector (percent of GDP) Public revenues 35.5 34.9 36.3 35.4 35.3 35.4 Public expenditures 36.9 42.7 39.2 38.7 38.1 37.6 Fiscal balance -1.3 -7.9 -2.9 -3.3 -2.8 -2.2 Public and publicly guaranteed debt 50.3 60.8 56.4 52.7 52.7 52.9 Sources: National statistical offices; Ministries of Finance; central banks; World Bank staff estimates. Note: e = estimate; f = forecast. 1. Overview 5 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 2. Global headwinds weigh on the recovery Following a strong rebound in 2021, stepped up efforts to control inflation and growth, although still robust, was on a tame inflationary expectations by raising policy decelerating path in the first half of 2022. rates. In the current environment, however, In Q1 of 2022, the Western Balkan economies these important actions, taken at a time when remained resilient overall, supported by the recovery is losing strength, and when the sizable policy actions at the EU, euro area, economies are facing supply-side constraints and national levels. First-quarter growth was including labor shortages, have contributed particularly strong in tourism-based economies to the significant headwinds. Overall, growth and in Serbia. However, growth decelerated in the region is expected to reach 3.4 percent in Q2, as countries had to deal with the direct in 2022, 0.6 pp above the average growth consequences of the war and is projected to expected in the EU (Figure 2.1). continue decelerating in the second half of the year reflecting higher base levels of growth Private consumption and investment were in Q3 and Q4 2021 and the stronger global the key drivers of growth in the first half headwinds. 2022. Both business and consumer confidence remained strong, and despite increasing energy Rising prices, monetary policy tightening, and food prices, consumption contributed and supply-side constraints have created significantly to growth in the first half of headwinds to a stronger recovery. With the year (Figure 2.2). Rising wages and average inflation surpassing 13 percent in remittances, together with increasing private the Western Balkan region in July 2022, credit, have supported private consumption. consumers and firms have been faced with Investment was particularly strong in Bosnia rising costs and reduced purchasing power. As and Herzegovina where it has been mostly a response, central banks in the region have driven by infrastructure works and private Figure 2.1. Real GDP growth started to Figure 2.2. ...as consumption and investment decelerate but is projected at 3.4 percent remain strong in most countries. for the year… Percent Percent 16 10 8 12 6 7.6 8 4 5.3 2 3.4 2.8 4 0 0 -2 -4 -4 -3.2 -6 -5.6 -8 -8 -10 2012–19 2022 2012–19 2022 2012–19 2022 2012–19 2022 2012–19 2022 2012–19 2022 -12 -16 MNE ALB SRB KOS MKD BIH WB6 EU27 ALB BIH KOS MKD MNE SRB J 2020 J 2021 J 2022e J Consumption J Investment J Net exports Q Real GDP growth Source: National statistical offices; Eurostat; World Bank staff Source: National statistical offices; World Bank staff estimates. estimates. Note: Factor contributions to real GDP growth. 6 2. Global headwinds weigh on the recovery BEYOND THE CRISES investment, as well as North Macedonia and contributed on average 1 percentage point (pp) Serbia but mostly due to the rise in inventories. to GDP growth, the contribution of investment In contrast, in Kosovo, a slowdown in private to growth has been significantly higher in 2021 investment amid higher construction input and 2022, at 3.7 and 2.1 pp, respectively prices and a low capital execution rate in the (Figure 2.2). While total investment is playing a public sector is expected to lead to a negative stronger role in this post-COVID-19 recovery, contribution of investment to growth for 2022. the composition of investment is slow to change as most businesses seem to still be behind on the With investment playing a key role in digital and green investment agenda (Box 2.1). economic growth, the recovery seems In all Western Balkan countries, the higher structurally different from past experience costs of energy and materials are expected to and bodes well for the region despite the weigh on private investment going forward, global headwinds. Compared to the years leading to a potential delay in the execution after the 2008-09 global financial crisis, of planned investment, and overall muted between 2012 and 2019, when low investment contributions of investment to growth. Box 2.1. What are firms struggling with in the Western Balkans region? Several challenges constrain business growth, reflected in low productivity growth in the region. Challenges include access to finance, anti-competitive practices of competitors, lack of or expensive technology, and lack of skills (Figure 2.3). While access to finance has always been reported as a significant challenge in the region, the other growth constraints have become particularly acute in the recovery phase, with shortages of key inputs such as technology and skills becoming more severe, and still high regulatory barriers to entry and conduct, and weak competition policies unaddressed. Contrary to isolationist trends, economic integration emerges as a way ahead. The quality of regional cooperation is deemed important or very important by the majority of businesses within the region, with the majority of businesses confirming the benefits received from the regional free trade agreement (the 2006 Central European Free Trade Agreement). Businesses in the Western Balkans also continue to believe in the benefits of EU accession, even though they have become less optimistic regarding timelines, implementation, and competitiveness vis-à-vis other EU countries. Overall confidence remains well below pre-pandemic levels, with old and new challenges ahead. Despite the significant jump in 2021, overall confidence remains below the pre- pandemic level in four of the six Western Balkan countries, while for Albania and Kosovo, general confidence has returned to previous highs. However, firms report that economic development, unemployment, corruption, and emigration remain the top concerns in the region. In addition, new challenges lie ahead. With the green transition likely to pick up 2. Global headwinds weigh on the recovery 7 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 (Box 2.1 continued) speed in the next few years, most businesses would need to step up their efforts to adjust their operations toward more environmentally friendly operations and investments. As of now, however, the majority have taken no or only minor steps (Figure 2.4). Figure 2.3. Anti-competitive practices of Figure 2.4. Few Western Balkan firms competitors and access to technology are report being environmentally friendly. reported as major growth constraints for businesses in the recovery. 70 Others 7 8 60 Competition from 22 47 50 incumbents 40 Access to finance 46 50 30 Lack of technology/ 18 32 20 expensive technology 10 Lack of skills 7 20 0 0 10 20 30 40 50 ALB BIH KOS MKD MNE SRB WB6 J 2021 J 2022 J Yes, a lot J Yes, a little J No J DK/refuse Source: The 2022 Balkan Business Barometer survey was Source: Balkan Business Barometer 2022. conducted during mid-February to mid-March 2022 in Albania, Note: Share of businesses that reported taking steps to Bosnia and Herzegovina, Kosovo, Montenegro, North Macedonia, reduce their environmental impact, such as reducing energy and Serbia. The Business Opinion survey presented 177 questions consumption, waste reduction or switching to recycled/ to 1203 business owners, managers, or executives. More info is sustainable materials. available at: Balkan Barometer | Welcome (rcc.int). Note: Major constraints faced when trying to scale up, as reported by businesses. Albania, Kosovo, Montenegro, and Serbia, important for growth. The contribution of stand out for their export growth. Exports in agriculture to the region’s economies was Kosovo, particularly for manufactured goods, modest or negative, due to the rise of input increased by 29.4 percent y-o-y through July. prices and unfavorable climate conditions. All Diaspora-driven service exports also increased economic sectors were strongly affected by significantly, and travel data suggest that labor market tightening. This applies especially positive momentum continued during the to tourism, but also to other sectors, such as summer season in tourism-led economies, like information and communication technology Albania and Montenegro. In Montenegro, and agriculture. In Albania, a new wave of growth of exports outpaced that of imports, emigration among Albania’s youth is one of the supported not only by further tourism recovery main causes of labor shortages. but also by higher metal and electricity prices. On the production side, services have been the engine of the recovery. Both industry and construction have struggled in the region, owing in part to rising energy and materials costs; the exception have been construction in Albania and industry in Serbia, which remained 8 2. Global headwinds weigh on the recovery BEYOND THE CRISES 3. Labor market recovery hit by a new storm1 The region’s labor market recovered quickly The employment rate increased in all and by mid-2022, employment levels countries and the average for the Western reached historical highs in several countries. Balkans reached a historical high of 46 The growth recovery which began in 2021, percent in June 2022.2 Although still low led by demand for transport, trade, and when compared to 61 percent of the EU27, tourism workers, and included a booming ICT due to a spectrum of structural constraints,3 industry, brought employment to new highs, this is an increase by over 3 pp since mid-2021 surpassing pre-crisis levels. Between mid-2021 underscoring the magnitude of the recovery. and mid-2022, around 170,000 jobs were In Albania, the employment rate surpassed created in the region, of which Serbia had the 55 percent, while the largest increase in the strongest gains. This was followed by Kosovo, employment rate was recorded in Montenegro where the Pensions Savings Trust reported (Figure 3.1). In Kosovo, despite recent that the number of active pension contributors gains, only 31.7 percent of the working-age increased by 16 percent in Q2 2022 (y-o-y), population is employed. North Macedonia equivalent to about 50,000 jobs being added observed the smallest increase in the annual or formalized. The average annual employment employment rate. growth for the region was 2.7 percent since mid-2021. In fact, in 2022, labor shortages emerged as (Box 3.1). a key concern raised by businesses  Similar to advanced economies in Europe, the Figure 3.1. The employment rate reached a Figure 3.2. …with services and construction historical high in the Western Balkans… having the highest job creation rates. 15+ years, percentage change H1 2021–H1 22 Change in employment, percent, y/y WB6 2.2 12 1.4 8 KOS 1.2 BIH 4 0.1 MKD 0 10.3 MNE -4 2.8 SRB -8 2.5 ALB -12 General Agriculture Industry Construction Services government 0 9 18 27 32 45 54 J 2022 J 2021 J Q2-20 J Q3-20 J Q4-20 J Q1-21 J Q2-21 J Q3-21 J Q4-21 J Q1-22 J Q2-22 Source: National statistics offices; World Bank staff estimates. Source: National statistics offices; 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 employment, pension insurance, and unemployment data for Kosovo helped provide an approximate picture of the labor market in 2022. 2 The employment rate is the region’s simple average. 3 See for example for North Macedonia (https://documents.worldbank.org/en/publication/documents-reports/ documentdetail/809991603810854005/republic-of-north-macedonia-action-plan-for-recovery-of-growth-and-jobs) or Montenegro (https:// documents.worldbank.org/en/publication/documents-reports/documentdetail/787451545030793133/montenegro-growth-and-jobs). 3. Labor market recovery hit by a new storm 9 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 post-COVID growth recovery has resulted in in employment across countries, except in a sharp increase in unfilled vacancies, and a North Macedonia. Employment in agriculture widening of the skills mismatches that firms in continued to shrink, except in Albania and the region have reported for some time. Some Bosnia and Herzegovina. of the countries of the Western Balkans— Albania, North Macedonia, and Serbia—are However, more recent data suggests signs that looking at liberalizing the work permit regimes the labor market is cooling, as the effects of to enable cross-border labor mobility. the energy crisis are more widely felt. North Macedonia and Serbia observed a slowdown in All sectors except agriculture contributed employment growth in industry already from to the job market recovery  (Figure 3.2). Q1 2022 showing signs of the impact of the During the summer, a rebounding tourism global energy crisis on their export industries. sector boosted employment, followed by a Services show strong resilience and growth in rise in trade, ICT, as well as transport. The the post-pandemic period. construction sector also observed an increase Box 3.1. Employment prospects improved but multiple challenges remain. After experiencing the sharpest fall in 2020, public and business expectations regarding employment and economic opportunities have improved. In 2022, the Balkan Barometer expectation index for the Western Balkans increased for both firms and citizens but is still below 2019 except for in Albania and Kosovo. In addition, most firms expect to either keep the same workforce or increase employment levels in the next 12 months. Around 60 percent of firms in the Western Balkans expect that their workforce will remain unchanged; an outlier is Kosovo where around 78 percent of firms expect to increase the number of people employed (Figure 3.3). Yet, even though firms’ expectations have improved, they still face significant challenges related to staff availability and behavioral changes  (Figure 3.4). More than 43 percent of firms in the region have issues finding the right staff and 36 percent suffer staff behavioral changes (such as low productivity and absence) due to the pandemic. In Albania and Kosovo, the problem is more pronounced, with over half of firms dealing with these issues. Only Montenegro is an exception, where just 10 percent of firms report problems with the staff availability. Unable to fill vacancies domestically, firms reported a preference for hiring more foreign workers. More than 42 percent of firms in Montenegro and 74 percent of firms in Albania report a preference to employ workers from abroad; and half of the firms in the region are open to hiring workers from other countries of the region. Firms in North Macedonia are the least interested in hiring workers from abroad (Figure 3.5). 10 3. Labor market recovery hit by a new storm BEYOND THE CRISES (Box 3.1 continued) Figure 3.3. Employment prospects are Figure 3.4. ...but post-pandemic labor solid in the Western Balkans… market challenges loom, including increased labor shortages. Percent of firm respondents Problems affecting firms due to COVID-19, percent of respondents 70 SRB 60 MNE 50 MKD 40 KOS 30 BIH 20 ALB 10 WB6 0 0 20 40 60 80 100 ALB BIH KOS MKD MNE SRB J Decrease J Remain unchanged J Increase J Staff availability J Staff behavioral changes J No answer J Supply chain problems J Access to domestic customers J Access to customers abroad J Finances J Containment measures affecting sales, transport, etc. Source: Balkan Business Barometer 2022 survey. Source: Balkan Business Barometer 2022 survey. Figure 3.5. Regional labor market is gaining importance… Percent of firms employing workers from abroad Percent of firms employing workers from the region 100 100 90 90 80 80 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 ALB BIH KOS MKD MNE SRB ALB BIH KOS MKD MNE SRB J Not likely at all J Not likely J Neither likely nor unlikely J Not likely at all J Not likely J Neither likely nor unlikely J Likely J Very likely J DK/refuse J Likely J Very likely J DK/refuse Source: Balkan Business Barometer 2022 survey. While firms report labor force shortages, some 39 percent of Western Balkan citizens are considering leaving and working abroad. Thirty percent of the respondents who are thinking of leaving are actively taking steps to inform themselves about new opportunities, reviewing and applying to vacancies. In addition, five percent are in the process of leaving and will leave soon. There is a strong preference to migrate towards EU countries and less to the countries in the region. Almost 80 percent express that they would not consider migrating to other Western Balkan countries, even if their academic and professional qualifications were recognized and valued. This contrasts with firms’ attitude to being more open to hiring workers from within the region. Although wage differentials with the destination markets for migrants from the Western Balkans may explain some of the differences between the firms’ and workers’ sentiments, strengthening the education system and offering better job opportunities might help 3. Labor market recovery hit by a new storm 11 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 (Box 3.1 continued) with retaining the workforce and decrease Figure 3.6. ...but further measures are the brain drain (Figure 3.6). Almost needed to to curb the problem of labour force shortages and brain drain. 30 percent of workers feel that the education Percent of firm respondents system failed to provide the adequate skills 100 that their job needs and 62 percent express 90 80 that they are not learning new skills or 70 advancing their skills. However, more than 60 50 half of the respondents expressed that they 40 30 would be ready to improve and get additional 20 qualifications to get a job. From the firm 10 0 side, more can be done to offer training ALB BIH KOS MKD MNE SRB Region opportunities for their workers. Forty-five J Retain labour force J Encourage diaspora to return J Encourage diaspora to transfer knowledge percent of firms responded that they do J Incentivise private businesses to attract diaspora not regularly review the skills and training J Improve institutional effectiveness Source: Balkan Business Barometer 2022 survey. needs of individual employees, and only 21 percent of firms do. Further, policies to encourage the diaspora to either return home or contribute with their know-how should be encouraged, along with improving education system effectiveness. Unemployment fell in five Western Balkan the activity rate—its unemployment rate fell countries, resulting in an annual decline in to 14.5 percent in mid-2022, the lowest on unemployment of 151,000 people by June record. 2022. The unemployment rate in the Western Balkans declined by 2.2 pp to 13.5 percent in The broad-based recovery in the labor market mid-2022 as more people found employment has also benefitted vulnerable groups. Youth (Figure 3.7). This reflects a broad-based decline unemployment declined to 27.1 percent in in all countries, with Serbia reaching its pre- mid-2022, the lowest on record, and down by crisis low of 8.9 percent. The unemployment 5.5 pp y-o-y. Around 30,000 young people rate in Bosnia and Herzegovina and Kosovo also were moved out of unemployment over the dropped significantly, by 2.3 pp and 4.3 pp, year, with the largest improvements recorded respectively, compared to a year ago, although in Serbia and Bosnia and Herzegovina, remained the highest in the region at 15.7 and accounting for two-thirds of this success. Serbia 16.2 percent, respectively. In Montenegro, the now has the lowest youth unemployment rate late start of the tourism recovery will likely lead in the region—at 18.7 percent—while, despite to reduction in unemployment in the second improvements, the youth unemployment rate half of the year. A similar pattern is expected in Bosnia and Herzegovina is the largest in the in Albania, which also had a successful summer region—at above 36 percent. tourism season. North Macedonia observed a continued decline in the unemployment In parallel with increased employment, rate but largely on account of a decline in the labor force participation rate also 12 3. Labor market recovery hit by a new storm BEYOND THE CRISES Figure 3.7. Unemployment rate declined in Figure 3.8. More women returned to labor all countries. market than men in 2022. Unemployment rate, 15+ years, percent, and H1 2021–H1 22 change, Labor force participation, percentage change, latest 2022–2021 percentage points WB6 -2.0 80 -2.2 70 SRB 60 -0.5 ALB 50 -1.3 MKD 40 -2.6 30 MNE -2.3 20 BIH 10 Dec-19 Dec-21 Jun-22 Dec-19 Dec-21 Dec-19 Dec-19 Mar-22 Dec-21 Jun-19 Jun-22 Dec-21 Jun-22 Dec-21 Dec-19 Jun-22 Dec-20 Jun-21 -4.9 KOS 0 4 8 12 16 20 24 ALB MNE SRB MKD BIH KOS J 2022 J 2021 Q Female LFP Q Male LFP Source: National statistics offices; World Bank staff estimates. Source: National statistics offices; World Bank staff estimates. Note: LFP stands for labor force participation. rose due to the relatively larger number of (Box 3.2). As firms try to offset the impact women returning to the labor market. The of increased labor costs (amidst pressures participation rate increased to 53 percent from other input prices, including energy), for the region, up 2.6 pp compared to mid- defensive restructuring, like furloughs, can 2021. While the participation rate of women take place, as is already happening in the car is still lagging that of men, at mid-2022, the supply industry. The prolonged crisis will likely female participation rate stood at 43.1 percent hurt the industry even more as demand from (compared to men of 63.1 percent), an increase EU countries declines amidst recessionary of 0.6 pp from end-2021 (Figure 3.8). In developments. Weakened corporate balance Bosnia and Herzegovina, however, the female sheets after multiple crises could lead to a participation rate declined to 36.1 percent deterioration of the labor market trends from in June 2022. The largest improvement late 2022 and into 2023. was in Montenegro (4.7 pp) as the tourism sector recovered, but the female labor force participation rate is still the highest in Albania at 56.3 percent (another record). However, the recovery of the labor market is likely to slow later in 2022 and into 2023. Labor shortages and high inflation in the Western Balkans have created wage pressures, which may slow the pace of hiring by firms. The region’s economies are announcing increases in the minimum wages to offset the real income decline due to inflation. However, recent evidence suggests that wage growth in the region has been outpacing productivity growth, putting competitiveness at risk 3. Labor market recovery hit by a new storm 13 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Box 3.2. Wages and productivity in the Western Balkans: call for reforms. Sluggish productivity growth evidenced in the aftermath of the global financial crisis was pronounced in the Western Balkans. Most of the slowdown in labor productivity in the Western Balkans came from reduced total factor productivity growth, along with subdued investments.4 At the same time, despite considerable underreporting of wages and high informality, wage growth surpassed productivity growth across the region in the run-up to the COVID-19 crisis, contrasting trends observed for the EU27.5 Even with low levels of productivity6, real gross wages noted steady growth before the crisis in all the economies of the Western Balkans. During 2015–19, the gap between productivity and wage growth was most pronounced for North Macedonia, where minimum wage hikes and public sector pay rises spurred wages while average productivity growth went negative. In the same period, wages increased less than productivity in Montenegro which has the highest wage level in the Western Balkans. The wage–productivity differential for the region reveals that wages grew nearly twice as fast as productivity (Figure 3.9). Figure 3.9. Wages grew twice as fast as Figure 3.10. …with productivity gaining productivity before the pandemic… strength from 2021. Real gross wage and labor productivity growth (2015–2019) Real gross wage and labor productivity growth, 2021 3.5 14 3.0 12 2.5 10 2.0 8 1.5 6 1.0 0.5 4 0 2 -0.5 0 ALB BIH KOS MKD MNE SRB WB6 ALB BIH KOS MKD MNE SRB J Average real wage growth J Average real labor productivity growth Q Real wage growth Q Real productivity growth Source: Eurostat, national statistical offices, World Bank staff Source: Eurostat, national statistical offices, World Bank staff calculations. calculations. Post-pandemic, labor productivity picked up and outstripped wage increases in some Western Balkan countries (  Figure 3.10). The outbreak of the global pandemic in 2020 led to a region-wide drop in productivity of 6 percent, while the trend of rising wages continued undeterred by the severe contraction in economic activity. A surge in productivity growth in 2021 exceeded growth in wages for some of the countries in the region (Albania, Bosnia and Herzegovina and Montenegro). However, for North Macedonia, Kosovo, and Serbia, even in the first year after the emergence of the pandemic, the wages and productivity growth divide continued. 4 Dieppe, Alistair. 2021. Global Productivity: Trends, Drivers, and Policies. Washington, DC: World Bank. 5 ILO 2021. Global wage report 2020-21: Factsheet for the European Union. 6 Labor productivity is calculated as gross value added divided by total employment. 14 3. Labor market recovery hit by a new storm BEYOND THE CRISES (Box 3.2 continued) With productivity below the EU average7 and wages racing ahead, Western Balkan economies face a challenging roadmap to narrow income gaps with advanced economies. Repeated adverse shocks (epidemics, wars, financial crises) undermined productivity and hindered years of progress towards income convergence. Going forward, wage sprints amidst low productivity may dim external competitiveness and hamper private investment. With new crises looming on the horizon, sustained commitment to a strong reform agenda tackling education shortcomings, persistent informality, feeble investment, infrastructure gaps, weak governance, misallocation of resources, and lack of economic diversification can boost productivity and accelerate the convergence. 7 OECD 2021. Multi-dimensional analysis of development in the Western Balkans. 3. Labor market recovery hit by a new storm 15 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 4. Significant headwinds could hamper poverty reduction in 2022–23 Owing to a broad-based growth recovery, households by limiting remittances from the poverty is estimated to have resumed its diaspora. Finally, tighter fiscal space creates decline in 2021. Before COVID-19 hit in challenges in implementing government 2020, the region had made significant progress support measures to protect household in reducing poverty, based on the upper incomes. middle-income class poverty line of US$6.85/ day in 2017 Purchasing Power Parity (Figure Figure 4.1. Poverty likely decreased in 2021, but the region is experiencing significant 4.1).8 Between 2016 and 2019, the poverty rate challenges for poverty reduction going is estimated to have dropped by about 10 pp forward. Poverty headcount, percent of population living on less than $6.85/ to approximately 19 percent. Improvements in day 2017 PPP well-being came to a halt when the pandemic- 30 29.1 26.6 induced crisis pushed all six economies into 25 23.1 a recession in 2020. As a result, poverty is 19.0 20.2 20 estimated to have increased by over 1 pp, 16.7 15.7 14.9 14.1 15 equivalent to roughly 155,000 new poor that year. As economies in the region experienced 10 a robust economic recovery in 2021, poverty 5 is estimated to have decreased by 3.5 pp, 0 equivalent to lifting an estimated 547,000 2016 2017 2018e 2019e 2020e 2021e 2022f 2023f 2024f people out of poverty. Source: World Bank estimates and projections based on 2018 income data from the Survey of Income and Living Conditions (SILC) for Montenegro; 2019 for Albania, North Macedonia, and Serbia; and 2017 Household Budget Survey (HBS) for Kosovo. Poverty is projected to moderately decline in Note: Income measures in the SILC and consumption measures in the HBS are not strictly comparable. Welfare is estimated in U.S. 2022, although many challenges pose risks to dollars using 2017 PPPs. The regional estimate excludes Bosnia and Herzegovina (BiH) due to a lack of comparable data. Forecasts are poverty reduction going forward (  Table 4.1). based on GDP per capita in constant LCU, e = estimate, f = forecast. Just as the region was beginning to recover in 2021, the energy crisis and the war in Ukraine Given slower economic growth in 2022, cut short the recovery and generated additional poverty in the region is projected to fall inflationary pressures. First, the war in Ukraine by approximately 1 percentage point, could negatively affect the economic recovery equivalent to about 144,000 people. In of the EU and could also reduce the demand Albania, according to baseline projections, for exports from the Western Balkan countries poverty is projected to fall further in 2022 and thus affect jobs in such industries. Second, by 2 percentage points. However, persistent the slower economic recovery in the EU could inflationary pressures could severely reduce affect the non-labor income of Western Balkan real income growth especially among poor and 8 Poverty data are now expressed in 2017 PPP prices, versus 2011 PPP used in previous editions. As price levels across the world evolve, global poverty lines must be periodically updated to reflect the increase of the value of the lines in nominal terms. The new global poverty lines of US$2.15, US$3.65, and US$6.85 reflect the typical national poverty lines of low income, lower middle-income, and upper middle-income countries in 2017 prices. 16 4. Significant headwinds could hamper poverty reduction in 2022–23 BEYOND THE CRISES Table 4.1. Poverty reduction at the country level is projected to slow in 2022, reflecting rising food and energy prices and impacts of the war in Ukraine. Poverty estimates and projections (%) Year ALB KOS MKD MNE SRB 2017 37.3 34.2 23.1 17.8 22.1 2018 34.2 32.3 20.8 18.5 17.3 2019 29.6 28.9 19.1 17.9 12.1 2020 31.6 32.4 20.8 20.0 12.2 2021 25.4 26.4 16.1 18.0 10.5 2022 23.4 25.0 15.9 17.1 9.9 2023 22.3 23.3 15.4 16.7 9.3 2024 21.0 21.6 14.9 16.3 8.8 Source: Calculations based on ECAPOV (ECA Poverty database) harmonization using SILC-C data for Albania (ALB), North Macedonia (MKD), Montenegro (MNE), and Serbia (SRB), and HBS data for Kosovo (KOS). Note: Black=Actual. Orange=Nowcasted/projected. Income measures in the SILC and consumption measures in the HBS are not comparable. Poverty is defined as living on less than US$6.85 per day per person in revised 2017 PPPs. Bosnia and Herzegovina is excluded due to lack of comparable data. vulnerable households and dampen poverty Serbia, while employment continued to grow, reduction. In Bosnia and Herzegovina, lower and nominal wages increased, rising food and growth in the EU could affect the non-labor energy prices, together with phasing out of income of households by limiting remittances, government support programs are expected to on which the country is particularly dependent. raise the cost of living and weaken the gains In Kosovo, the strong 2021 recovery is estimated from economic growth leading to a much to have reduced poverty by 6 pp below its 2020 slower projected poverty reduction in 2022. level. In 2022, although poverty is expected to further decline to 25 percent, downside risks The increase in prices is now expected to be related to food and energy prices could hit long-lasting in some countries in the region. Kosovo especially hard as it is a net importer According to the 2022 Balkan Barometer of both—if diaspora travel remittances and perception survey, approximately 79 percent wages fall behind inflation, real incomes could of citizens in the region are mostly unsatisfied be significantly reduced, and poverty might not or completely dissatisfied with the price level fall as projected. In North Macedonia, partially in 2022, compared to 55 percent in 2021.9 because of government programs and partially Inflation, particularly in food and energy because of a strong labor market rebound, prices, affects the less well-off relatively more poverty is estimated to have resumed its decline than higher income groups as the less fortunate in 2021 and continued into 2022; yet, inflation tend to spend more of their budget on food and creates challenges for poverty reduction in 2022. energy and have fewer coping mechanisms to The tax reform in Montenegro contributed to maintain purchasing power.10 growth in disposable incomes, but the adverse impact of surging inflation is estimated to The substantial increases in food prices greatly slow further poverty reduction. In represent a major concern for the welfare of 9 Balkan Barometer | Welcome (rcc.int). 10 World Bank: Western Balkans Regular Economic Report #20 and #21. 4. Significant headwinds could hamper poverty reduction in 2022–23 17 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 households in the region, particularly those Figure 4.2. Food and energy inflation would at the lower end of the income distribution push a large share of vulnerable people into poverty in the absence of government scale, which have fewer means to offset support measures. these increases. By July 2022, food prices in Poverty headcount, percent of population living on less than $6.85/ day 2017 PPP the Western Balkan countries had increased 45 by 21.3 percent compared to July 2021 (the 40 increase varied between 13.9 and 25.5 percent 30 among countries, Table 4.2). The effects of 25 food price increases are disproportionally 20 greater for the less well-off: the share of food 15 expenditure for the first decile ranges from 10 approximately 68 percent in North Macedonia 5 to 34 percent in Bosnia and Herzegovina, 0 ALB BIH KOS MKD MNE SRB while the share of food expenditure for the J Preschock J Food shock J Energy shock top decile stood at 46 percent in Kosovo to 23 Source: World Bank staff simulations based on most recent surveys: 2019 income data from the SILC for Albania, North Macedonia, and percent in Montenegro. In the absence of any Serbia; 2018 Montenegro; 2017 for Kosovo; and 2015 HBS in BiH. Note: Preshock refers to actual or nowcasted poverty estimates in government response measures, the increase 2019 based on real GDP per capita growth. Except for BiH, welfare is estimated in U.S. dollars using 2017 PPPs in all countries. Poverty of food prices would significantly increase in BiH is based on a KM 205 per capita monthly threshold and the per capita welfare measure is reduced to 2007 prices. Therefore, the the estimated poverty rate (by upper middle- poverty rate in BiH is not strictly comparable with the rest of the countries. “Preshock” refers to poverty rates before shocks (food and energy prices increases), “Food Shock” refers to a simulated increase income standards)11 ranging from 1.5 pp in in poverty rates after food price increases; and “Energy Shock” refers to the simulated poverty rate increase after energy price increases. Montenegro to 3.8 pp in Kosovo, according to The figure does not assume government support. Shocks are actual food and energy price increases y-o-y in July 2022. The magnitude of the Bank simulations12 (Figure 4.2). the shock is described in Box 4.1. Energy prices have also surged in the region, in Albania to 7 percent in Kosovo; for the top though they have not increased as much as decile, from 19 percent in North Macedonia food prices. The average annual increase in to 6 percent in Albania. Hence, the impact of the price of energy for the region for July 2022 energy price increases on poverty is also expected was 13.1 percent (Table 4.2). Importantly, to be smaller and less regressive. Yet, higher the increase does not reflect the full effect of energy prices could contribute to increases in energy price increases in the global market poverty by more than a half percentage point as governments have cushioned the impact in some of the Western Balkan countries (not of these increases on their citizens through accounting for government support). fiscal outlays. The increases in energy prices have ranged from 4.5 percent in Albania to Higher food and energy prices are expected 18.2 percent in Bosnia and Herzegovina. The to negatively affect welfare along the entire share of the household budget spent on energy distribution in all six countries. The estimated is smaller and more evenly distributed than price incidence curve (Figure 4.3) depicts the share of the budget spent on food. For the percentage reduction in welfare at each the bottom decile, it ranges from 15 percent percentile of the distribution ranked by welfare 11 Because comparable data are lacking, poverty in Bosnia and Herzegovina is based on a KM 205 monthly threshold. 12 The results of the simulation should be interpreted as changes from a counterfactual welfare distribution, which has not been affected by high inflation or the COVID-19 pandemic, to a simulated distribution affected by a significant inflationary shock. The counterfactual year chosen is 2019, therefore the simulation uses the latest available data nowcasted up to that year. 18 4. Significant headwinds could hamper poverty reduction in 2022–23 BEYOND THE CRISES Box 4.1. Simulating food and energy price shocks. A distributional analysis of the welfare impact of rising food and energy prices and of government response measures was carried out for the six Western Balkan economies.13 We estimate the change in the overall consumption surplus in response to the y-o-y food  and energy price increases as of July 2022 and assuming an elasticity of -0.2514. The impact of higher food and energy prices is assessed separately, and the joint effect is the sum of both impacts. To assess the impact of higher prices on consumption, the analysis uses the latest harmonized Household Budget Survey (HBS) in each country, which provides granular information on consumption items. To measure the impact on internationally comparable income poverty rates and to model the mitigating effect of government transfers, the analysis uses the latest available EU Survey of Income and Living Conditions (SILC), which reports household income (including government transfers). To assess the combined effect of the two channels, we assume that the percentage change in welfare of each percentile is equal in the HBS and the SILC. Poverty is based on per capita household income in Albania, Kosovo, North Macedonia, Serbia, and Montenegro and on per capita household consumption in BiH. To simulate the impact of higher prices, poverty estimates are nowcasted in 2019 based on real GDP per capita growth. Table 4.2 shows all relevant parameters and data sources used in the simulations. Table 4.2. Simulation parameters and data sources. Country Average ALB BIH KOS MNE MKD SRB Household Budget Survey year 2018 2015 2017 2015 2019 2019 Income data from EU SILC-C year 2019 N/A 2017 2018 2019 2019 Food price increase (%, July 2022, y-o-y) 21.9 13.9 25.5 22.1 25.4 24.3 20.3 Energy price increase (%, July 2022, y-o-y) 13.1 4.5 18.2 15.3 15.7 15.8 9.1 per person due to rising food and energy prices 4.5 percent in the top decile of the distribution. combined. The average impacts measured in The share of people who are not beneficiaries of terms of welfare losses are substantial, ranging social transfer programs, but are a vulnerable from -4.9 percent in Albania to -10.2 percent in group without any kind of support who are North Macedonia. Behind these averages, the simulated to become poor due to higher food effects are markedly regressive in all countries; and energy prices—ranges from approximately they range from a decline between 13.2 and 76 percent in Albania to over 94 percent in 5.7 percent in the poorest decile to 7.8 and North Macedonia and Kosovo. 13 Based on Ferreira, F., A. Fruttero, P. Leite, and L. Lucchetti. 2013. “Rising Food Prices and Household Welfare: Evidence from Brazil in 2008.” Journal of Agricultural Economics. 64 (1), 151-176. and R. Laderchi, C., Olivier, A., and Trimble, C. 2013. “Balancing act: Cutting energy subsidies while protecting affordability.” Europe and Central Asia Reports No. 76820, Washington, DC: The World Bank. 14 The simulations only account households as consumers, and thus hurt by increases in the prices of the commodities they consume. They do not account for them as producers, who may benefit from increases in the prices of the commodities they produce. 4. Significant headwinds could hamper poverty reduction in 2022–23 19 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Figure 4.3. Household welfare is expected to increase in the number of poor in the region, fall along the welfare distribution. Simulations of income loss due to price shocks, percent with the highest increase of about 21 percent in 0 Bosnia and Herzegovina and North Macedonia, to the lowest of 8.4 percent in Albania (Table 4.3). Social transfer program15 coverage of the -5 overall population also varies across countries, ranging from 26.2 percent in Montenegro -10 to 3.4 percent in Kosovo. Most of the new poor would not be covered by the programs. Increasing benefits to existing beneficiaries -15 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 1 3 5 7 9 would be effective in supporting their income ▬ ALB ▬ BIH Deciles of welfare distribution ▬ KOS ▬ MKD ▬ MNE ▬ SRB but would leave a large percentage of the Source: World Bank simulations based on most recent surveys as in population unprotected, especially in Kosovo. Figure 4.2. Note: Welfare is estimated in U.S. dollars using 2017 PPPs. Income Moreover, the size of the average benefit in measures in the SILC and consumption measures in the HBS are not strictly comparable. The figure shows the simulated welfare Kosovo is extremely low relative to the size percentage changes after the combined food and energy price increases. The graph does not assume government support. Shocks of the welfare loss.16 A program targeting the are actual food and energy price increases y-o-y in July 2022. The magnitude of the shock is described in Box 4.1. new poor would be effective in containing the increase in poverty rates, as this vulnerable All countries have social transfer programs group is likely to be close to the poverty line. that can be used as a tool to mitigate the However, the expansion of coverage to the new impact of shocks, but their effectiveness poor would result in higher income inequality depends on the coverage and generosity among the poor (that is, worsening of poverty of the program and the specific size and gap and poverty gap squared).17 Moreover, regressivity of the shock. The impact of the traditional poverty-focused programs are energy and food price shocks on the number of difficult to expand horizontally, as shown poor is estimated to vary substantially across the during the COVID-19 crisis. Other tools region. Our simulations result in a 13-percent need to be considered to support the energy Table 4.3. Coverage and generosity of social transfers programs is uneven. Country ALB BIH KOS MNE MKD SRB Region Estimated percentage change of poor people 8.4 21.0 10.8 11.7 20.8 15.8 13.0 (%) Program coverage post shock (%) 25.4 - 3.4 26.2 14.8 22.0 17.7 Program benefit / Average income loss of the 66.3 - 6.2 139.7 52.4 74.1 55.3 poor (%) Source: World Bank estimates based on most recent surveys as in Figure 4.2. Note: Welfare is estimated in U.S. dollars using 2017 PPPs. Income measures in the SILC and consumption measures in the HBS are not strictly comparable. 15 Social transfers refer to government assistance programs targeted to the poor. These are typically captured in the EU-SILC surveys as “benefits specifically intended to combat social exclusion”. For example, these transfers include the Guaranteed Minimum Assistance program in North Macedonia, or the Ndihma Ekonomike program in Albania. 16 In some surveys, income data can be less reliable than consumption data and the two do not always align. For instance, in BiH, household income has systematically been about a third lower than household consumption in part because imputations are applied to consumption but not income measures (World Bank. 2015. Rebalancing Bosnia and Herzegovina: A Systematic Country Diagnostic. Washington, D.C.: World Bank Group). As such, we do not measure government income support in BiH. 17 The poverty gap index captures the depth or intensity of poverty and measures the extent to which individuals fall below the poverty line as a proportion of the poverty line. Compared to the poverty headcount, the poverty gap has the advantage of detecting changes among the income of the poor that are not enough for them to cross the poverty line. The squared poverty gap index captures the inequality among the poor by giving more weight to larger poverty gaps. 20 4. Significant headwinds could hamper poverty reduction in 2022–23 BEYOND THE CRISES vulnerable, such as subsidies to the energy bill and incentives to transition to more sustainable type of heating and to keep them from resorting to more polluting methods (Box 4.2). Box 4.2. Attitudes towards transition to more sustainable and efficient heating in the Western Balkans. The current state of residential heating across the six Western Balkan countries highlights a set of challenges that pose a direct threat to greening the economy in the medium and long term. On the one hand, residential heating—overwhelmingly favoring traditional heating sources relying on inefficient and heavily polluting solid fuels (very much the norm across the region)—is a large source of pollution emissions in the winter (as is combustion from residential cooking throughout the year). Ambient concentrations of particulate matter 2.5 (PM2.5) emissions are well above EU standards, in many cases leading to a disproportionate number of premature deaths relative to other countries in Europe. On the other hand, these residential heating practices can be explained by norms, culture, habit, and the tremendous sensitivity of many (especially poorer) households to energy prices and access to modern heating fuels, since traditional heating practices rely on access to cheap wood, coal, or other solid fuels to heat their homes. As a result, effectively shifting to cleaner, more sustainable (and energy efficient) practices where affordability concerns and reluctance to upgrade are high will require a deep understanding of both structural (e.g., financial, legal) and behavioral (e.g., psychological, cognitive, emotional, cultural, and social) factors, including rethinking the design and implementation of support programs. This transition will likely require holistic solutions that address attitudes, perceptions, beliefs, and knowledge about its costs and benefits. Understanding the non-financial barriers can help to improve the design and implementation of programs and policies to support these transitions by considering holistic engagement strategies and simplifying the journey for households at various stages. A behavioral diagnostic carried out in 2022 to better understand these challenges and explore policy solutions in a subset of countries looked at demand- and supply-side factors constraining changes in the behavior of households. The diagnostic centered around online and phone surveys was implemented in Bosnia and Herzegovina, Kosovo, North Macedonia, and Serbia to understand the barriers to and enablers of a change in behaviors and the role governments can play in facilitating this change (especially in the context of limited and/or fragmented subsidy and grant programs to support these transitions). The results from the diagnostic survey suggest that attitudes among respondents are quite progressive, but intentions to upgrade heating remain low, and key bottlenecks to behavioral change exist, complicating transitions to more sustainable heating practices. Among traditional heating user respondents (generally using inefficient and dirty 4. Significant headwinds could hamper poverty reduction in 2022–23 21 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 (Box 4.2 continued) stoves or boilers burning low-grade wood, coal, and/or waste), 41 percent are unwilling to upgrade their heating technology, while 21 percent are unsure about upgrades (Figure 4.4). Among 38 percent willing to upgrade, only half of these would do so in the next two years (similar results are found for intentions to thermally renovate dwellings). Despite these low intentions to upgrade soon, attitudes about sustainable heating practices are progressive: an overwhelming majority of respondents to the survey across the four countries are aware of the costs and benefits of upgrades and know someone who has upgraded, even among those using traditional technologies. Low intentions appear to be driven mainly by affordability concerns and competing priorities within the home (for example, structural investments not related to the heating technology), and by low trust in the institutions that are meant to support these transitions (financial institutions and local, regional, and national government actors). Focus group discussions among lower Figure 4.4. Intentions to upgrade heating income segments revealed similar attitudes technology and attitudes towards and preferences. sustainable heating. Share of traditional heating respondents, percent 100 Support programs provided by 90 80 70 governments in the Western Balkans 60 50 should be designed and implemented in 40 30 such a way that can influence the attitudes, 20 10 0 beliefs, and preferences of the target y to ve th sts e y to ed o up oul val ves de ea ves bi ces o h ad h ho Im rs) gr d a ue en R rs rs lth ow c d t Im lls gr s w <5 d =2 d ro Un h pro gy u e or (< n population toward investments in cleaner er ed n e te m p up er ad ff ta ad In e o more efficient technologies. This means C gr ha Kn up properly communicating the benefits (and J BIH J KOS J MKD J SRB costs) of the program, managing expectations Source: World Bank survey 2022. Note: This figure plots the share of respondents using traditional of participation, and simplifying the heating technologies that: (i) would be willing to upgrade their heating technology with a modern one at some point in the next choice architecture in a way that motivates two years (respondent are first asked if they plan to upgrade, and among those who say yes, are asked about the time frame action and persistence in terms of program for this upgrade); and (ii) somewhat or strongly agree with a set of statements capturing attitudes about sustainable heating participation and heating practices. Low (relative to somewhat or strongly disagree or don’t know enough about the issues). The six sets of bars on the right side of the graph capture the level of agreement with the corresponding awareness of support programs and perceived statements (shortened in the figure for improved visibility): (from left to right): “Upgrades of heating systems or ceiling or exclusion should be countered with holistic wall insulation improve the value of a home”; “I could afford to upgrade my heating system or ceiling or wall insulation in the engagement strategies, while lack of trust in next five years”; “A modern source of heating or ceiling or wall insulation reduces energy bills”; “A modern source of heating traditional messengers would benefit from improves the health of household members”; “I understand the costs associated with upgrading to a modern source of heating dialogue between early adopters and hesitant or ceiling or wall insulation”; and “Most people I know in my community have upgraded their heating technology to a modern households. one (e.g., a wood pellet stove/boiler or heat pump)”. 22 4. Significant headwinds could hamper poverty reduction in 2022–23 BEYOND THE CRISES 5. Fiscal policy faces renewed pressures Fiscal consolidation halted amid pressures Inflation is boosting revenue growth across to mitigate the impact of surging inflation the region. All Western Balkan countries and rising energy costs. After promising recorded strong nominal revenue growth of consolidation momentum in 2021, Western above 10 percent y-o-y during the first half of Balkan countries are facing renewed fiscal 2022, with Albania’s public revenues growing pressures and risks. The regional average18 fastest at 19.2 percent during this period. Given deficit is expected to increase by 0.4 pp of GDP the rise in international commodity prices, compared to 2021 (Figure 5.1), driven by a indirect taxation is providing the greatest boost deterioration in fiscal balances in Montenegro to revenue growth. In Montenegro, indirect and Bosnia and Herzegovina, which nonetheless tax revenues continued to grow despite the continues to run a low deficit level. Albania and reduction of the VAT rate for hospitality Kosovo should see the fiscal deficit declining services and the excise rate on fuel, but social by more than half a percentage point of GDP, security contributions and the personal while in Serbia and North Macedonia, fiscal income tax declined following the removal deficits are expected to maintain previous year of healthcare contributions and introduction levels. Nevertheless, the average fiscal deficit for of tax allowances. In North Macedonia, the the region remains double the pre-pandemic reduced VAT rate for energy was not renewed rate, and the risks of a further deterioration due in July to help contain the growing deficit. to higher energy subsidies during the winter Except for Kosovo, public revenue is expected season remain high. to only keep pace with the surging inflation, remaining broadly constant from a year before as a share of GDP. In Kosovo, and to a lesser degree in BiH, revenue growth is expected to Figure 5.1. Fiscal deficits levels remain high Figure 5.2. …remaining broadly unchanged against renewed pressures… from 2021 in Western Balkan biggest economies. Percent of GDP Contribution to change in balance, pp of GDP, 2022f 0 4 ↑Reduced revenues, increased spending -0.9 -0.8 3 -2 2 -3.3 -4 -4.0 -3.8 1 -4.9 -5.2 -6 0 -1 -8 -2 -10 -3 ↓Increased revenues, reduced spending -12 -4 MKD MNE SRB ALB BIH KOS WB6 MNE BIH SRB MKD KOS ALB WB6 J 2020 J 2021 J 2022e J Expenditure J Revenue Q Change in fiscal balance Sources: National statistical offices, Ministries of Finance and World Sources: National statistical offices, Ministries of Finance and World Bank estimates. Bank estimates. 18 Unweighted average of fiscal deficit levels in Western Balkan countries. 5. Fiscal policy faces renewed pressures 23 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 provide a positive contribution to containing Macedonia are increasingly spending on energy the level of the fiscal deficit (Figure 5.2). subsidies. In Serbia, support provided to energy companies for importing gas, coal, and Public expenditure continued to increase electricity was not entirely shown as a direct following the adoption of measures to budget expenditure, but rather as a below-the- respond to surging inflation and the energy line transaction. The upcoming electoral cycle crisis. After consolidating by 3.5 pp of GDP in Bosnia and Herzegovina is also exerting in 2021, in all Western Balkan countries but upward expenditure pressures. While the Kosovo and Bosnia and Herzegovina public automatic stabilizers, as noted in the earlier expenditure is expected to decrease by an edition,19 should automatically react to the average of 0.5 pp of GDP y-o-y during 2022 business cycle, with revenues decreasing and (Figure 5.3). In Albania, expenditure levels are some spending increasing in times of crisis, expected to decline by 0.9 pp of GDP driven their relatively small size observed in the 2020 by a significant drop in public investment. episode, points to the need to reinforce the In nominal terms, however, most Western automatic features of the tax and expenditures Balkan countries are experiencing significant systems. growth of recurrent expenditure. Bosnia and Herzegovina, and North Macedonia, and to Social protection spending continues to a lesser degree Montenegro, are also seeing a drive expenditure growth. Social protection significant increase in capital expenditure, with spending is expected to increase by a regional North Macedonia planning to embark on the average of 0.3 pp of GDP in 2022; however, construction of a major highway. All Western in Bosnia and Herzegovina, social benefits Balkan countries adopted measures to mitigate are expected to increase the fastest by 3.4 pp, the impact of inflation on the most vulnerable reaching the highest level in the region at households, while Kosovo, Albania, and North 18.7 percent of GDP (Figure 5.4). Budget Figure 5.3. Expenditure levels remain high, Figure 5.4. Capital underspending helped marginally increasing in most countries. contain expenditures in Kosovo and Albania. Percent of GDP Contribution to change, in percent of GDP 50 4 3 40 2 30 1 0 20 -1 10 -2 0 -3 2021 2022p 2021 2022p 2021 2022p 2021 2022p 2021 2022p 2021 2022p 2021 2022p -4 SRB MNE BIH MKD ALB KOS WB6 BIH MNE ALB MKD SRB KOS 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; and World Sources: National statistical offices; Ministries of Finance; and World Bank estimates. Bank estimates. Note: 2022p = 2022 projected. 19 World Bank Western Balkans Regular Economic Report #21, Spring 2022. 24 5. Fiscal policy faces renewed pressures BEYOND THE CRISES allocations for social assistance have increased denominator effect, given the strong growth across the region. In Albania, Montenegro, in GDP, but also because most of the 2022 and Kosovo pension benefits also increased financing needs are covered from the deposits in response to inflation. The governments in accumulated through the Eurobond issuance in Serbia and North Macedonia also announced 2020. Similarly, Albania’s PPG as a percent of an increase in pensions starting from November GDP is also expected to decline significantly, by 2022. At the same time, wage bill spending is 5.1 pp, as the country used its 2021 Eurobond increasing in nominal terms across the region. receipts to cover financing needs in 2022. In In Bosnia and Herzegovina and Serbia, the contrast, Serbia’s PPG as a percent of GDP is wage bill is expected to remain broadly the expected to increase by 1 pp to 58.1 percent of same as last year, while real public wages are GDP. Unlike other Western Balkan countries, expected to decline in Kosovo, Albania, and North Macedonia’s and Kosovo’s PPG debt North Macedonia. as a percent of GDP remain above their pre- pandemic levels. Particularly higher is PPG Public and publicly guaranteed (PPG) debt debt in North Macedonia—which increased remains elevated in most countries, despite by 10 pp—because of extensive COVID-19 the recent drop in the debt to GDP ratios. support during 2020–21. Despite lower-than-expected real growth in the region in 2022, high GDP deflators are resulting External PPG debt is expected to continue to in higher-than-expected nominal GDP. This decline in 2022 but to remain above the pre- translates into a reduction of PPG as a share of pandemic high  (Figure 5.6). The anticipated GDP in all countries in the region, but Serbia, decline of external PPG from 38.2 percent where it will increase marginally. The average of GDP in 2021 to 35.1 percent of GDP for PPG as a share of GDP is expected to decline the region is expected to mostly come from an to 52.7 percent in 2022 from 56.4 percent in increase in the nominal GDP. Serbia’s external 2021 (Figure 5.5). The decline will likely be PPG debt to GDP is the only one among the most prominent in Montenegro, where it is Western Balkan countries where an increase of expected to reach 11.3 pp, both because of the 1 pp is anticipated. Albania and Montenegro Figure 5.5. Public and publicly guaranteed Figure 5.6. …and so did external debt. debt declined in most countries… 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 ALB SRB BIH KOS WB6 J 2022p Q 2021 ▬ Pre-pandemic peak ▬ Pre-pandemic low J 2022p Q 2021 ▬ Pre-pandemic peak Sources: National statistics offices; World Bank staff estimates. Sources: National statistics offices; World Bank staff estimates. 5. Fiscal policy faces renewed pressures 25 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 are expected to recorded declines of 4.3 pp in 2022. The cost of financing has thus rapidly and 11 pp, respectively, as they use Eurobond increased. Most Western Balkan countries proceeds from previous years to service debt have a significant share of external debt and are in 2022. Given the appreciation of the U.S. vulnerable to these developments, particularly dollar against the euro and regional currencies, countries with high total debt burdens and countries with a higher share of U.S. dollar- limited fiscal space. S&P Global Ratings has, denominated debt that have not hedged against however, affirmed countries’ credit ratings the foreign exchange risk are more vulnerable and stable or positive outlooks; Fitch affirmed to the surging dollar. Serbia and Albania have North Macedonia’s BB+ rating with a negative the highest share of U.S. dollar-denominated outlook (Table 5.1). Yet, all countries have a debt among the Western Balkan countries, non-investment speculative grade, with North followed by Bosnia and Herzegovina. After a Macedonia’s and Serbia’s rated as speculative series of successful Eurobond placements in and other countries in the region rated as the past two years, none of the Western Balkan highly speculative. countries issued Eurobonds in 2022, amid high uncertainty and rapidly increasing financing Table 5.1. Country credit ratings are still at non-investment grades. costs. S&P Global Moody’s Fitch Ratings Financing conditions are rapidly tightening B1 B+ — Albania (Box 5.1). Surging inflation has triggered more  (stable) (stable) aggressive than expected monetary tightening Bosnia and B3 B — Herzegovina (stable) (stable) by the U.S. Federal Reserve and the European B1 B — Central Bank (ECB), which have increased Montenegro (stable) (stable) their policy rates by a cumulative 225 and North — BB- BB+ 50 basis points, respectively, between March Macedonia (stable) (negative) 2022 and mid-September 2022. It is expected Ba2 BB+ BB+ Serbia (stable) (positive) (stable) that both the U.S. Federal Reserve and the Note: — = not available. ECB will hike interest rates significantly again Box 5.1. High medium-term refinancing needs facing rising cost of capital. The synchronous tightening of monetary and fiscal policies across the globe, and particularly amongst major economies, is resulting in tightening financial conditions. These developments leave many emerging and developing countries highly vulnerable, among which are the Western Balkan countries, though the degree of vulnerability varies among countries. Over the past years, most Western Balkan countries have become increasingly reliant on external funding. By 2021, all countries but Kosovo and Bosnia and Herzegovina20 20 With the exception of its entity Republika Srpska, which has placed Eurobonds in 2018 and 2021. 26 5. Fiscal policy faces renewed pressures BEYOND THE CRISES (Box 5.1 continued) were exploiting the favorable financing conditions by issuing Eurobonds. These placements were part of countries’ debt management strategies to extend maturities and develop and diversify their investors pool. During the pandemic, countries relied heavily on international markets: in 2020 alone, Albania, Montenegro, North Macedonia, and Serbia raised a total of EUR5.1 billion in Eurobonds, which were used to refinance debt and finance widening deficits. In 2021, Serbia and Albania placed Eurobonds with longest maturities of 15 and 10 years, respectively, while Serbia also placed a green bond with a record-low interest rate of 1 percent. Nevertheless, the favorable financing conditions and increasing volumes of borrowing have kept public debt levels elevated for most countries, with North Macedonia’s public debt now well above the pre-pandemic high. The Western Balkan countries have relatively high medium-term refinancing needs at the time of financial tightening. Average time to maturity (ATM) for the region is estimated at 6.3 years,21 below the OECD average of 7.7 years. Countries’ external debt amortization in 2023–24 averages 2 percent of GDP per year; however, country level differences are significant. Serbia, with an ATM of 8.1 years on total debt and external debt amortization of 1.9 percent of GDP over 2023-24, faces lower refinancing risk. On the other hand, despite relatively low external debt amortization of 0.6 percent of GDP in 2023–24, Albania is most exposed to refinancing risk with an ATM of 4.7 years. Montenegro’s external debt amortization of 4 percent of GDP in 2023–24 is the highest in the region, while its ATM is 5.6 years. Kosovo, Bosnia and Herzegovina, and Albania have domestic debt ATMs of about 3 years, well below the regional average. North Macedonia faces a higher level of refinancing risk on external debt, with external debt amortization of 2.7 percent of GDP in 2023–24 and an ATM of just 4.7 years. The rapidly changing financing conditions are making Eurobond issuances much more expensive. As a result of aggressive tightening of the U.S. Federal Reserves in response to 40-year high inflation in the U.S., global investors are pulling money out of other markets to invest in higher-yielding U.S. assets. The widening of global financial pressures is leaving Western Balkan countries in a vulnerable position. Yields on outstanding Eurobonds issued by Western Balkan countries have widened in 2022, with some of them pushed close to 10 percent (Table 5.2). In all countries but Albania, yields on Eurobonds maturing in 3 years are higher than those maturing in 5 years, reflecting that markets price higher risks for bonds maturing sooner. Domestic cost of government financing is also increasing in the Western Balkans. In Kosovo, which does not issue Eurobonds, the average yield on a 5-year fixed coupon bond increased from 2.5 percent at end-March to 3.3 percent at end-August 2022. Domestic auctions have also shown a similar trend in Albania; the average yield for a 5-year fixed coupon 21 Based on 2020 and 2021 reported ATM. 5. Fiscal policy faces renewed pressures 27 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 (Box 5.1 continued) bond resulted at 3.43 percent by end-January 2022 and for the same type of instrument the yields went up to 5.14 percent at end-July 2022. North Macedonia issued mainly 15-year bonds during this part of 2022, and the yields on such instruments increased from 2.6 percent in January to 4.2 percent in early September 2022. In Serbia, 10-year bonds were auctioned at 6.8 percent during September in the domestic market; the last 10-year bond was auctioned in September 2021 with an accepted rate of 2.5 percent. Table 5.2. Yields and spreads on outstanding Eurobonds surged. Yield in % Spreads Coupon Maturity (last price) (basis points) Albania 3.5 16/06/2027 5.84 581.8 Albania 3.5 09/10/2025 6.33 631.4 Montenegro 2.785 16/12/2027 9.75 973.2 Montenegro 3.375 21/04/2025 8.20 818.8 North Macedonia 3.675 03/06/2026 6.17 615.2 North Macedonia 2.75 18/01/2025 5.95 593.0 Serbia 3.125 15/05/2027 6.43 641.5 Serbia 1.5 26/06/2029 7.67 765.5 Republic of Srpska 4.75 01/01/2023 6.18 616.7 Republic of Srpska 4.75 01/01/2026 6.55 652.8 Source: https://www.boerse-frankfurt.de/en, accessed on 20 September 2022. Note: Spreads refer to spreads with yields on German bonds with similar residual maturity. Notwithstanding higher cost of raising new debt and refinancing, the structure of debt will have an immediate impact on interest expenditures. On average, a quarter of total debt portfolios in the Western Balkans consists of variable interest debt agreements and instruments; with four out of six countries Figure 5.7. Share of variable-rate debt is having more than 1/5 of their sovereign high in several countries. debt portfolios tied to variable-rate interest Percent of total debt, 2021 60 (Figure 5.7). Serbia and Kosovo are the least 50 vulnerable to the immediate impact of the 40 surging interest rates. Surging dollar will also 30 translate into higher debt servicing costs of debt denominated in USD, where Albania 20 and Serbia are the most exposed among 10 Western Balkan countries, with 10.8 percent 0 BIH ALB MNE MKD SRB KOS WB6 and 12.6 percent of external debt. Source: Ministries of Finance, Bank staff estimates. 28 5. Fiscal policy faces renewed pressures BEYOND THE CRISES Limited fiscal space, elevated public debt, and increased cost of financing are straining governments’ abilities to respond to the current crises. All Western Balkan governments have implemented support measures to combat the cost-of-living crisis, and unlike COVID-19 support, most of it was not targeted. All countries except Bosnia and Herzegovina and Montenegro have provided subsidies to the energy state-owned enterprises and are expected to be under pressure for further support as the winter season approaches. Serbia, North Macedonia, and Montenegro reduced their excise rates on fuel, the latter by 50 percent for three months to combat the inflationary impact on households and businesses. A similar measure is under consideration in Bosnia and Herzegovina but is stalled in the Parliament. North Macedonia allocated an additional 0.6 percent of GDP for anti-crisis measures within the budget revision in May 2022. An increase in expenditure arrears in several countries is further narrowing governments’ fiscal space. For example, North Macedonia’s expenditure arrears reached 3 percent of GDP because of overdue payments of the health sector, state enterprises, and local governments. Similarly, repayment of Montenegro’s health expenditure arrears of 1.2 percent of GDP created additional pressures on spending. Further, contingent liabilities coming from state-owned enterprises and public-private partnerships pose significant fiscal risks in Albania, North Macedonia, and Serbia. Considering the narrow fiscal space most countries have, efforts should be made toward boosting tax compliance, optimizing spending, and revisiting tax exemptions and subsidies provided to ensure a reduction in debt and sustainability of their public finance. 5. Fiscal policy faces renewed pressures 29 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 6. Soaring inflation poses new policy trade offs Inflation has risen to record highs globally 2022 were still 11 percent higher than last year,23 on the back of rebounding demand, supply disproportionally affecting disposable incomes constraints, and surging commodity prices, of the poor, given that food items account for particularly, since the outbreak of the war in a higher share of their consumption basket. Ukraine in February 2022. In July 2022, the Food price increases have been partially made global median headline Consumer Price Index worse by the growing number of food trade (CPI) rose to 9.4 percent y-o-y, the highest restrictions put in place by many countries. As level since 2008 (Figure 6.1).22 Several factors of September 2022, at least 20 countries have are behind the increase in inflation. Rising implemented 29 food export bans, and at least energy costs are contributing significantly to seven have implemented 12 export-limiting mounting inflationary pressures (Figure 6.2). measures.24 The cutoff of natural gas to several European countries, including the shut-down of the Nord While commodity prices continue driving up Stream pipeline, has pushed the gas prices to headline inflation numbers, price pressures record highs. In September 2022, Brent crude are increasingly broad-based ( Figure  oil stood at US$90.2 per barrel, more than 6.3). Increases in prices were particularly 20 percent increase over a year. Global food pronounced for commodities of which Russia prices suffered sharp increases through June and Ukraine are large exporters, such as natural 2022, though they have been on a declining gas, fertilizers, grains and metals. Moreover, trend since, due to, among other factors, the pandemic-related effects linked to shortages resumption of exports from ports in the Black of materials, equipment and workers also Sea in Ukraine. However, food prices in August continue to impact price increases. While food Figure 6.1. Inflation has reached record Figure 6.2. Soaring energy prices are still highs globally. driving up inflation. Headline inflation, percent Dollar 10 140 8 120 100 6 80 4 60 2 40 0 20 -2 0 21 Oc 1 No 1 De 1 Ja 1 22 M 22 Ap 2 M 22 Ju 2 22 Au 2 22 De 8 18 Au 9 De 9 Ap 9 Au 0 De 0 20 Au 1 De 1 Ap 1 22 2 2 2 2 -2 -2 l-2 2 2 2 1 1 1 1 2 2 g- p- t- v- c- g- n- b- r- n- g- g- r- c- r- c- g- c- r- g- r- c- ay ar Ju Ap Ap Au Se Au Fe ▬ EMDE ▬ Advanced ▬ Crude oil, Brent ▬ Natural gas, Europe Sources: World Bank Global Economic Prospects 2022. Source: World Bank Commodity Price Data Note: Prices are US$ per barrel for oil and US$ per Metric Million British Thermal Unit (mmbtu) for gas. 22 July 2022 estimates of inflation may differ from other World Bank reports due to data release schedules. 23 World Bank Commodity Price Data. 24 World Bank Food Security Update, September 2022. 30 6. Soaring inflation poses new policy trade offs BEYOND THE CRISES and energy prices have mainly driven the sharp Monetary authorities are facing a few trade- rise in headline inflation, core inflation has also offs in calibrating their monetary policy risen globally (Figure 6.4). stance. Despite stagnant economic growth, mounting price pressures encourage central The degree of inflation persistence is banks to tighten their policy stance to reduce uncertain and the risk of higher inflation inflation expectations. At the same time, becoming further entrenched in expectations tighter monetary policy will inevitably have is significant. Mounting inflation prompted consequences for the economy, including central banks across the world to step-up those associated with the negative impact on policy interventions, withdrawing monetary bank’s balance sheets and on debt financing for support and raising interest rates faster to ease businesses and households. Countries without inflation pressures. In many emerging markets independent monetary policy have limited and developing economies that have adopted room to mitigate the impact of rising inflation, inflation targeting, inflation increased above exacerbated by the war in Ukraine. In such target. As a result, central bank monetary policy contexts, supply-side policies aimed at boosting tightening is taking place more rapidly than competitiveness and enhancing productivity, anticipated at the start of the year and faster and reducing energy dependence are critical. than in advanced economies. In the short term, expectations of further price increases could Between January and July 2022, inflation in become entrenched into price-setting behavior, the Western Balkans soared in all countries resulting in the greater persistence of inflation. in the region(Figure 6.5). A combination At the same time, raising interest rates and of supply- and demand-side factors played a tighter financing conditions could weigh on role in driving up price pressures. On the one economic activity. hand, supply constraints drove food and energy prices to record highs and they were amplified Figure 6.3. Price pressures are increasingly Figure 6.4. …and the core inflation is rising broad-based… globally. Euro area HICP, y-o-y percent change 5 20 20 18 16 15 14 12 10 10 8 6 5 4 2 0 18 8 19 9 20 0 21 1 22 2 0 l-2 l-2 l-1 l-1 l-2 n- n- n- n- n- Ju Ju Ju Ju Ju Ja Ja Ja Ja March 2022 July 2022 Ja J Food and non-alcoholic beverages J Alcoholic beverages ▬ Global ▬ Advanced economies ▬ EMDEs J Housing, water, electricity, gas and others J Furnishing, household equipment and others J Recreation and culture J Restaurants and hotels J Miscellaneous goods and services ▬ HIPC all items Source: World Bank staff calculations based on Eurostat data. Source: Global Economic Prospects. Note: HIPC = Harmonized Index of Consumer Prices. Note: EMDEs = emerging markets and developing economies. 6. Soaring inflation poses new policy trade offs 31 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Figure 6.5. Western Balkan countries Figure 6.6. …as commodity and food price experienced rapid increases in headline increases were amplified by the war in inflation during 2022… Ukraine. y-o-y, percent 18 22 16 20 14 18 12 16 10 14 8 12 6 10 4 8 2 6 0 4 -2 2 -4 0 Ap 19 Ju 9 Oc 9 Ja 19 Ap 20 Ju 0 Oc 20 Ja 0 Ap 21 Ju 1 Oc 21 Ja 21 Ap 22 Ju 2 2 Ap 19 Ju 9 Oc 9 Ja 19 Ap 20 Ju 0 Oc 20 Ja 0 Ap 21 Ju 1 Oc 21 Ja 21 Ap 22 Ju 2 2 2 2 2 l-2 2 l-2 1 l-1 1 l-1 2 2 2 2 r- l- t- r- l- t- n- r- t- n- r- t- n- n- r- r- n- n- r- l- t- r- l- t- n- n- Ja Ja ▬ ALB ▬ BIH ▬ KOS ▬ MKD ▬ MNE ▬ SRB ▬ WB6 ▬ CPI inflation ▬ Energy CPI inflation ▬ Food CPI inflation Source: National statistics agencies. Source: National statistics agencies. Figure 6.7. Persistent commodity price Figure 6.8. …de-anchoring inflation shocks were transmitted to broader prices expectations in the Western Balkans. causing core inflation to increase… y-o-y, percent Inflation expectations (12 months) 9 20 8 7 6 15 5 4 3 10 2 1 0 5 -1 -2 -3 0 Ap 19 Ju 9 Oc 9 Ja 19 Ap 20 Ju 0 Oc 20 Ja 0 Ap 21 Ju 1 Oc 21 Ja 21 Ap 22 Ju 2 2 2 2 l-2 1 l-1 2 2 Q2 9 Q3 9 Q4 9 Q1 9 Q2 0 Q3 0 Q4 0 0 Q2 1 Q3 1 Q4 1 Q1 1 Q2 2 2 r- l- t- n- r- t- n- r- n- r- l- t- n- -2 -2 -2 -2 -2 -2 -1 -1 -1 -1 -2 -2 -2 -2 Ja Q1 Q1 ▬ ALB ▬ BIH ▬ KOS ▬ MKD ▬ MNE ▬ SRB ▬ WB6 ▬ Serbia ▬ Albania ▬ North Macedonia Source: National statistics agencies. Source: Central banks’ surveys. by the war in Ukraine (Figure 6.6); on the on the rise, with growth reaching 15.7 percent other, lingering demand-supply imbalances in Montenegro to 18.1 percent in Bosnia and from the COVID-19 recovery continue to Herzegovina. Finally, since January 2022 core weigh on prices at the regional level. In July, inflation increased in almost all countries in annual headline inflation reached 7.5 percent the region (Figure 6.7). Higher increases were in Albania and up to 16.7 percent in Bosnia observed in Montenegro, Serbia, and Albania and Herzegovina. Energy tariff controls and a where in July 2022 core inflation reached mild currency appreciation prevented a similar 9.4 percent, 7.5 percent, and 7.3 percent, pickup of inflation in Albania. Food and energy respectively. inflation continue to represent key components of the overall increases. The Consumer Price In countries with flexible or managed Index (CPI) for food rose above 24 percent exchange rate regimes, central banks in Bosnia and Herzegovina, Montenegro, and responded by tightening monetary policy, in North Macedonia. Energy CPI trends were also line with the Eurozone. In Serbia, the central 32 6. Soaring inflation poses new policy trade offs BEYOND THE CRISES Figure 6.9. Central banks responded to Figure 6.10. Exchange rate pressures varied inflation by tightening monetary policy. among Western Balkan countries. Policy rate, percent Exchange rate to EUR, annual changes, percent 4.0 2 3.5 1 3.0 0 2.5 -1 2.0 -2 1.5 -3 1.0 0.5 -4 0 -5 Se 0 Se 1 Se 2 19 Se 9 19 M 0 20 M 1 21 M 2 22 Au -19 Oc -19 De t-19 Fe c-19 Ap -20 Ju -20 Au -20 Oc -20 De t-20 Fe -20 Ap -21 Ju -21 Au 21 Oc -21 De t-21 Fe -21 Ap -22 Ju -22 22 -2 2 -2 2 -1 -2 2 n- p- n- p- n- n- p- n- n- p- ay g b r ay n g c b r ay b r ay n g c Ja Ju Ja Ja Ja M ▬ ALB ▬ MKD ▬ SRB ▬ Eurozone ▬ ALB ▬ MKD ▬ SRB Source: Central banks. Source: Central banks. bank increased its key policy rate several times, reaching 3.5 percent at the end of the third quarter. The increase in inflation expectations (Figure 6.8) also prompted a faster monetary policy normalization in Albania, where the central bank raised its key policy rate to 1.75 percent in August 2022 (Figure 6.9). In North Macedonia, the policy rate was increased to 3 percent in five rounds by early September. Exchange rate pressures differed among the Western Balkan countries; while in North Macedonia the central bank intervened to keep the stability of the exchange rate, decreasing foreign exchange reserves by 20 percent, in Albania currency appreciation vis-à-vis the euro prevented a more rapid pass through from imported inflation. In Serbia, the nominal dinar exchange rate was stable throughout 2022 (Figure 6.10). 6. Soaring inflation poses new policy trade offs 33 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 7. Financial sector resilience tested with new challenges ahead Financial sector stability has been preserved However, while imposed sanctions had a throughout the pandemic shock while new negative impact on some European banking risks loom. Non-performing loans (NPLs) in groups26 with exposure to Russia and Ukraine, the region continued to decrease (4.4 percent on the European Banking Authority (EBA)27 and average as of March 2022), while profitability European Central Bank (ECB)28 announced and capital buffers were preserved. So far, the that this exposure was limited, and that Western Balkan financial sector navigated the European banking groups could withstand heightened uncertainty and volatility without any potential write-off of these positions. any significant disruptions, but challenges lie Furthermore, Western Balkans subsidiaries ahead, including the fallout from the war in of these groups remained more isolated from Ukraine, prolonged supply chain disruptions, the turmoil as they are predominantly funded inflationary pressures, tightening global by local deposits. Nevertheless, although liquidity, weak domestic political stability, and regional groups remain committed to their the energy crisis. exposures in the Western Balkans, with no sign of deleveraging, this channel still needs to The initial direct impact of the war in be monitored closely as strategies and growth Ukraine on the Western Balkan banking prospects in the Western Balkans may change sector has been limited and manageable. Two should additional pressures arise from exposures main transmission channels have been in effect. to Russia and Ukraine. The first comprises sanctioned banking groups with Russian capital that were operating in the Second-round impacts of the war in Ukraine Western Balkans. These groups faced liquidity are more concerning from a financial problems and were rapidly taken over by other stability perspective, especially under a local banking groups, thereby containing scenario of prolonged conflict. Under such a further negative financial sector impacts.25 scenario, increases in food and energy prices can The second comprises foreign banking groups add to inflationary pressures that were already with concentrated cross-border exposures and high, primarily due to a strong rebound in equity positions in Russia and Ukraine. These demand, supply-chain disruptions and record- triggered some concerns regarding whether high commodity prices. Multiple factors may they would face deterioration in loan quality lead to asset-quality deterioration and put and capital erosion due to declining ratings. pressure on corporate and household balance 25 Sanctions include freezing assets, exclusion from SWIFT which provides services related to the execution of financial transactions and payments between banks worldwide and prohibiting engaging in U.S. dollar activities. Sberbank Europe AG, a fully owned subsidiary of Sberbank Russia, faced a liquidity crisis, which impacted three Sberbank subsidiaries, one in Serbia and two in Bosnia and Herzegovina. All three subsidiaries were rapidly taken over by other local banking groups. 26 According to EBA French, Italian, and Austrian banks reported the highest volume of exposures to Russian counterparts while Austrian, French, and Hungarian banks had the largest exposure to Ukraine. 27 EBA Risk Dashboard: https://www.eba.europa.eu/eba-risk-dashboard-indicates-limited-direct-impact-eu-banks-russian-invasion-ukraine-also- points. 28 https://www.reuters.com/business/finance/all-large-euro-zone-banks-can-withstand-russian-write-off-ecb-says-2022-04-20/?utm_ source=newsletter&utm_medium=email&utm_campaign=global-investor&utm_term=Reuters%20Global%20Investor%20-%202021%20 -%20Master%20List. 34 7. Financial sector resilience tested with new challenges ahead BEYOND THE CRISES sheets. First, potential corporate vulnerabilities Despite the downside risks, loan growth remain from the global pandemic, which can continued to be strong in Western Balkans come from slow recovery in some sectors such countries, averaging 10.2 percent y-o-y as of as food, accommodation, and entertainment June 2022. Average loan growth in the region and weakened creditworthiness of borrowers, has been increasing continuously since March which may have been more difficult to detect 2021 (Figure 7.1), after registering its lowest during the pandemic when there was ample growth rate (4.5 percent y-o-y) in the post- public-sector support provided to the private pandemic period. The average loan growth rate sector. Second, increased costs for inputs, as of June 2022 was significantly higher than including energy and commodities, and in June 2019 (7 percent, y-o-y) and has been disruption of supply chains may contribute to accelerating since January 2022. Starting from an increase in corporate defaults, particularly March 2022, on average, corporate loan growth in those sectors that could not fully recover surpassed household loan growth in the region after the pandemic. In addition, a tightening for the first time since January 2013 in North of financing conditions and access to financing Macedonia, Montenegro, and Serbia while may exacerbate the situation for companies household loans still drive the loan growth in that are already highly leveraged. Third, the Albania, Kosovo, and Bosnia and Herzegovina impact on households of increasing inflation (Figure 7.2). Surging corporate loan demand and shrinking disposable income may put may be a sign of liquidity needs driven by pressure on consumer and mortgage loans. The price increases in energy, commodities, and mortgage loan channel is moving more slowly overall higher inflation. While all countries as price increases (energy, commodities) have have registered positive loan growth in 2022, not been fully passed on to consumers because strongest growth was registered in Kosovo government support programs have partially (17.3 percent y-o-y) and Albania (10.5 percent absorbed these costs. y-o-y), while the weakest was in Bosnia and Herzegovina (5 percent y-o-y). Figure 7.1. Credit growth has been positive Figure 7.2. Corporate loan growth surpassed in all countries and is accelerating. household loan growth in half of the countries. Change in nonfinancial private sector credit outstanding, June 2022, Change in credit outstanding, June 2022, percent, y-o-y percent, y-o-y 20 20 18 15 16 14 10 12 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. 7. Financial sector resilience tested with new challenges ahead 35 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Loan demand in the region is expected most of the region’s banking markets. In to remain strong in the next six months, addition, positive funding conditions—easy while supply conditions are predicted to access to retail and corporate deposits—will deteriorate, possibly creating a mismatch likely remain in the next six months, although, between credit demand and supply. According according to the CESEE Bank Lending Survey, to the results of the Central, Eastern and less favorable than before. Southeastern Europe (CESEE) Bank Lending Survey, loan demand is expected to remain The regional average NPL ratio continued to strong, favoring short-term liquidity needs of decline in March 2022, marking its lowest firms (working capital) at the expense of fixed level since both the pandemic and the post- investments. However, a tightening is predicted global financial crisis period (Figure 7.3). The on the supply side as a result of increased NPL ratio decreased by 0.1 percentage points uncertainty and a worsened economic outlook. from December 2021 to 4.4 percent in March The tightening is expected to be widespread 2022. The regional average of 4.4 percent across all segments but appears more relevant is slightly below the 5 percent threshold the for small and medium-sized enterprises (SMEs) European Banking Authority defines as a high and large corporates, as a worsening economic NPL ratio; nevertheless, NPL ratios are still outlook puts pressure on firm balance higher than the region’s average in Montenegro sheets and banks become more risk averse.29 (7.2 percent), Bosnia and Herzegovina Tightening of supply conditions will mostly (5.4 percent), and Albania (5.2 percent). NPLs be driven by increasing selectivity of banks in have continued to increase only in Montenegro search of credit-worthy customers rather than compared to its December 2021 level. Kosovo’s bank deleveraging or significant deterioration NPLs remained the lowest in the region, while in funding conditions for regional and local Albania registered the largest drop in NPLs in banks. Cross-border banking groups continue the post-COVID period (3 percentage points to see high or medium market potential in since March 2020). Figure 7.3. NPLs continued a downward Figure 7.4. Banks’ capital buffers were trend in all countries except Montenegro. preserved. NPLs as percent of total loans, March 2022 Percent, March 2022 9 25 8 7 20 6 15 5 4 10 3 2 5 1 0 0 MNE BIH ALB SRB MKD KOS SRB BIH MNE ALB MKD KOS J Mar-20 J Mar-21 J Mar-22 Q Pre-crisis level (end 2007) J Mar-20 J Mar-21 J Mar-22 Q Average (2006–08) Sources: IMF Financial Soundness Indicators; central banks. Sources: IMF Financial Soundness Indicators; central banks. 29 Central, Eastern and Southeastern Europe (CESEE) Bank Lending Survey. 36 7. Financial sector resilience tested with new challenges ahead BEYOND THE CRISES Capital buffers in the Western Balkan are supported by some signs of corporate countries remained broadly stable, while vulnerabilities such as elevated stage 2 loans31— bank liquidity has slightly decreased which is a good indicator of future NPLs, compared to December 2021. As of March vulnerable sectors (food, accommodations, and 2022, bank capital adequacy averaged hospitality), and increasing liquidity needs of 18.1 percent, far above the regulatory the companies. As of December 2021, regional minimum, and slightly lower compared to average stage 2 loans were at 10 percent, much December 2021, at 18.2 percent (Figure 7.4). higher than NPLs, at 4.4 percent. In addition, The ratio of liquid to total assets averaged results of the follow-up Enterprise Surveys32 28 percent, which is the lowest level in the conducted in the region post-COVID indicate post-COVID period, potentially reflecting that, on average, 63 percent of the firms liquidity needs of firms and households and surveyed reported decreased liquidity or cash increasing loan demand. The loan-to-deposit flow availability since the beginning of the ratios were well below 100 across the board pandemic (Box 7.1). (78.9 percent on average in March 2022) while increasing slightly, indicating a faster loan Regional average bank profitability has growth compared to deposit growth. remained stable since March 2021 but is still below pre-COVID levels. Profitability Although the impact of the pandemic on as measured by return on assets remained bank credit risk in the Western Balkans has unchanged at 1.4 percent in March 2022 been largely mitigated by the comprehensive compared to December 2021. In early 2021, government support measures, new bank profitability started to recover from the pressures on asset quality have been initial COVID impact, while it remained building up due to the war in Ukraine and stagnant since March 2021. As of March the possible economic consequences. While 2022, Kosovo had the highest profitability some sectors (for example, hospitality) have not (2.4 percent), while Albania had the lowest fully recovered from the effects of the pandemic (0.8 percent). The CESEE Bank Lending and some supply chain constraints persist, Survey also confirms this outcome, showing potential second- and third-round effects of that all the international banks operating the war in Ukraine may generate knock-on in Kosovo reported a higher return on assets effects across industries due to rising costs compared to their group profitability, while and put an additional burden on low-income in Albania this ratio was 50 percent. It households. Banks operating in the region are will be important to monitor profitability, expecting a deterioration of credit quality going considering the risks for the outlook. If asset forward, significantly affecting both the retail quality deteriorates as expected in the next six and corporate segments.30 These expectations months, this would put additional pressures on 30 Central, Eastern and Southeastern Europe (CESEE) Bank Lending Survey. 31 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.) 32 Additional rounds of Enterprise Surveys (ES) were conducted between June 2020 and January 2022 of five of the six Western Balkan countries to follow up the impact of the COVID-19 crisis on firms. Follow-up surveys were conducted of the companies surveyed during the regular ES cycles before 2020. Available follow-up surveys are for Albania (June 2020); Serbia, Montenegro, and BiH (February 2021); and North Macedonia (January 2022). 7. Financial sector resilience tested with new challenges ahead 37 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 profitability, with increasing impairment costs, control capacity, including robust early- and would jeopardize the economic recovery. warning systems to allow the identification of distressed borrowers, are of utmost importance. Going forward, authorities need to keep Loan classification and staging should be kept their focus on monitoring credit risks accurate, enabling the proper monitoring and and the evolution of distressed loans, on evaluation of bank risks, as well as sufficient the potential spillovers from the second- and timely provisioning. Banks should also be round effects of the war in Ukraine, and on prepared to act quickly in the case of new NPL increasing prices. Regulators and banks need inflows, by maintaining the capacity to allow to act in a timely manner and take the necessary early intervention, with sustainable measures to preemptive measures to prevent a new buildup support viable borrowers when necessary (Box of NPLs. In the current environment, with 7.1). high uncertainty, bank loan monitoring and Box 7.1. NPL resolution in the post-COVID environment. While it was expected that NPLs would spike in response to economic hardship caused by the pandemic, data show that the average NPL rate in the Western Balkans region continued to decrease during the last five years, falling from 11.6 percent in December 2016 to 4.5 percent in December 2021. One of the main reasons for the continuation of the downward trend in the NPL rate was an unprecedented response from authorities and regulators by introducing borrower relief and regulatory forbearance measures after the COVID-19 crisis. In most Western Balkan countries, these temporary measures had expired by the time of the writing of this report. Hence, the NPL rate might resume an upward trend in some countries, as banks will be able to apply the qualitative assessment of “unlikeliness to pay” criterion in a more precise manner. The assessment of a borrower’s unlikeliness to pay was one of the most difficult and controversial issues during the period when borrower relief and regulatory forbearance measures were in place. Anecdotal evidence shows that many banks in the region rescheduled eligible loans during this period by granting “grace” periods, thereby postponing the full payment of interest and principal by borrowers. This might delay the crystallization of NPLs for another six to 12 months. Additional economic headwinds stemming from current geopolitical tensions, the war in Ukraine, tightening of monetary policies by the major central banks, a substantial increase in inflation, and the energy crisis (particularly in Europe) may well cause an increase in NPLs in the coming quarters. The first indications of an upcoming new inflow of NPLs in banks are early warning signals of corporate financial vulnerabilities. A good early warning indicator of upcoming loan servicing problems by corporates is delayed payments to supply chains. Analysis of previous crises shows that usually after a steep increase in delayed 38 7. Financial sector resilience tested with new challenges ahead BEYOND THE CRISES (Box 7.1 continued) days for payables and receivables, companies start defaulting on their bank loans. Results of the follow-up Enterprise Surveys conducted in the region during the post-COVID period indicate that, on average, 58 percent of the firms surveyed reported delayed payments to suppliers, landlords, and tax authorities since COVID-19 began. Another good predictive indicator is the interest coverage ratio. Moody’s identified a strong correlation (0.75) between this ratio two quarters earlier and the default rate of U.S. high-yield corporate debt. In addition to these early warning indicators, close attention should be paid to the gap between stage 2 and stage 3 loans (for countries that have introduced IFRS 9a) (Figure B.7.1.1). Analysis of Western Balkan countries shows that this gap increased from 1.2 percentage points in December 2019 to 5.7 percentage points in December 2021, which indicates an increase in loans with a significant increase in credit risk. Figure 7.5. Stage 2 loans remain elevated Figure 7.6. Firm liquidity needs are surging in the post-Covid period. in the post-COVID environment. Stage 2 and 3 loans as percent of total loans, December 2021 Percent 12 80 70 10 60 8 50 6 40 6.3 5.7 30 4 20 2 10 1.4 1.2 0 0 MKD ALB MNE BIH SRB 2018 2019 2020 2021 Jan-22 Jun-20 Feb-21 Feb-21 Feb-21 J Stage II and III gap ▬ Stage II ▬ Stage III Percent of firms ever experienced decrease liquidity or cash flow J  availability since COVID-19 began Percent of firms ever delay payments to suppliers, landlords, tax J  authorities since COVID-19 began Sources: FITCH and World Bank staff calculations. Sources: Follow-up Enterprise Survey results. Authorities can be better prepared for the upcoming increase in NPLs by preparing in advance, as previous crises reveal the difficulty implementing tough but necessary reforms in the middle of a financial crisis. While many countries in the region are better positioned for the potential increase in NPLs due to reforms implemented after the global financial crisis, improvements needed in the enabling environment (that is, judicial systems, insolvency regimes, and enforcement frameworks) feature prominently in the analysis conducted by the World Bank. In addition, banks and policy makers can substantially benefit from a corporate financial viability analysis conducted at the national level. These studies can serve as early warning signs of potential upcoming NPL inflows in the banking system and inform authorities’ policy decisions in response. The corporate financial viability studies conducted by the World Bank in Europe and Central Asia and the Middle East and North Africa region countries provide useful insights and a solid foundation on which to calibrate a proper policy response. Note: a. International Financial Reporting Standard (IFRS) 9 specifies how an entity should classify and measure financial assets, financial liabilities, and some contracts to buy and sell nonfinancial items. 7. Financial sector resilience tested with new challenges ahead 39 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 8. External imbalances widened despite the export recovery The war in Ukraine and the persistence of 11.3 percent of GDP, is set to occur in Kosovo, COVID-19, including the ensuing supply which has a high merchandise trade deficit, shortages and inflation, have weakened the while Bosnia and Herzegovina, an electricity external sector in the Western Balkans. In exporter, represents the other extreme, with a net terms, the Western Balkans economies are projected CAD of only 3.1 percent of GDP. large importers of energy, raw materials and The most pronounced widening is likely to manufactured goods and are affected by the be in North Macedonia and Serbia, at about war in Ukraine and its impact on commodity 6.3 pp and 5.8 pp of GDP, respectively. Such prices, and by the impact of COVID-19 on a widening of external imbalances in a single global supply chains. These factors have had an year has not occurred since 2007 and provides adverse impact on energy trade, have created a window into the significance of the external inflationary pressures and food insecurity, and shock experienced by the countries in the have caused protectionist policies in many region. Overall, the average CAD for the region Western Balkan countries, such as export bans is expected to widen from 4.9 percent in 2021 on cereals, edible oil, and wood products (logs, to 8.7 percent of GDP in 2022 (Figure 8.1). firewood, pellets). Higher food, oil, and electricity prices have In 2022, the current account deficits (CADs) put pressure on structural merchandise trade in all Western Balkan countries are expected deficits. As import prices surge, the merchandise to widen. The broadened external imbalances trade deficit33 in the Western Balkans is are in some cases in double digits, as in Kosovo, expected to reach almost 31 percent of GDP in Montenegro, and Serbia. The largest CAD, at 2022, driving the widening CADs (Figure 8.2). Figure 8.1. Current account deficits widened Figure 8.2. …as trade deficits widened. in most countries in the region… Percent of GDP Percent of GDP 2017 2018 2019 2020 2021 2022e 2017 2018 2019 2020 2021e 2022p 0 0 -4 -5 -8 -10 -12 -15 -16 -20 -20 -24 -25 -28 -30 -32 ▬ ALB ▬ BIH ▬ KOS ▬ MKD ▬ MNE ▬ SRB ▬ WB6 Sources: Central banks; World Bank staff estimates. Sources: Central banks; World Bank staff estimates. Note: WB6 is the simple average of WB6 CADs. 2021e = 2021 Note: 2021e = 2021 estimated; 2022p = 2022 projected. estimated; 2022p = 2022 projected. 33 Exports and imports of goods, simple average of the six countries. 40 8. External imbalances widened despite the export recovery BEYOND THE CRISES The large merchandise trade deficit is the result the previous contract but significantly below of a large increase in imports, from 51.7 percent current market prices. Nonetheless, high prices in 2021 to 58.5 percent of GDP in 2022, for imported electricity mean that the Western alongside a strong increase in exports of goods Balkans feel the energy shock heavily. Two from 25.4 percent in 2021 to 27.6 percent of countries—North Macedonia and Kosovo— GDP in 2022. Although exports are expected to particularly feel the pinch—having declared an grow strongly in 2022—by 26.5 percent—the energy emergency, predicting shortages in the increase in imports (24.7 percent) is expected colder months. to be equally pronounced and characterized by a much larger base. Growth in exports remained strong in the region. Growth in exports is estimated to be The rise in imports is to a large extent owed the highest in Bosnia and Herzegovina, up to higher food and energy imports, such as by 6.1 pp of GDP compared to last year due electricity, oil, and natural gas. The price to windfalls from energy exports, followed by of crude oil rose on average about 50 percent North Macedonia with an increase of 4.4 pp by September 2022 compared to 2021. of GDP. In other countries, the expansion in Other energy imports were equally affected merchandise exports has been more moderate, by the war in Ukraine, which has weakened between 1.4 pp and 2.4 pp of GDP (Figure the Western Balkans’ already fragile energy 8.3). Serbia is the only country where exports security. However, while Serbia, Bosnia and of goods are expected to decline in GDP terms Herzegovina, and North Macedonia are compared to last year. largely dependent on Russia for natural gas, this energy source accounts for only a small Net services and remittances largely remain proportion of their energy mix. Moreover, at 2021 levels, which help only in part to Serbia has recently renewed its long-term gas offset the soaring merchandise deficits. Net contract with Russia at favorable financial services exports continue to be an important terms, which are about 30 percent higher than source of net inflows, especially in Montenegro Figure 8.3. Services and remittances only Figure 8.4. External debt is expected to partly help contain external deficits. decline in most Western Balkan countries in 2022. Contributions to changes in CAD, percent of GDP Percent of GDP Percent 16 200 48 12 38 150 8 28 4 100 0 18 -4 50 8 -8 0 -2 -12 -16 -50 -12 ALB BIH MNE KOS SRB MKD MNE BIH ALB MKD SRB KOS WB6 J Goods exports J Goods imports J Net services exports J Total external debt J External PPG debt J Remittances J Others Q Change in CA deficit Q Change in total external debt, rhs Sources: Central banks; World Bank staff estimates. Sources: Central banks; World Bank staff estimates. 8. External imbalances widened despite the export recovery 41 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 as tourism inflows are expected to have almost profit repatriation is expected to increase, and fully recovered in 2022 (Figure 8.3). Visits by are expected to finance only one-third of the workers living abroad account for most travel CAD, same as for North Macedonia. This is a inflows in Bosnia and Herzegovina, Kosovo, large shift for North Macedonia, which has seen and North Macedonia, whereas Albania and its external account deficit typically financed by Montenegro have a more prominent tourism net FDI inflows. Given the importance of FDI sector. In contrast to the net export of services, in supporting the current account, external remittances did not manage to keep up with borrowing remains a smaller—but no less nominal GDP. In sum, in four countries in important—source of financing. Total external the region, inflows of net export services and debt is on the decline for the region, projected remittances are projected to offset about two- at an average of 84.4 percent of GDP, after thirds of the merchandise trade deficit in 2022. peaking at close to 90 percent in 2020 (Figure The share of remittances is expected to decline, 8.4). in terms of GDP, across all Western Balkan countries, except North Macedonia. This Continued net financial inflows have slowdown in relative remittances may be driven supported the buildup of foreign exchange by high inflation and uncertainty in European reserves. By end-September 2022, foreign host countries. North Macedonia and Serbia exchange reserves remained strong for the are different, with much lower levels of net region, and prudent adequacy levels were export service and remittances inflows in 2022; maintained for all countries. This is despite thus, for North Macedonia the net export of some pressures on exchange rates in several services and remittances are expected to cover countries to defend their currencies, which was about 27 of the merchandise trade deficit while addressed through interventions at the foreign for Serbia they are expected to cover 42 percent exchange markets that initially reduced reserves. of the merchandise trade deficit. In the case of North Macedonia, a decline in reserves in spring 2022 was around 20 percent, External imbalances, on average, continue which has been partly recovered since. to be mainly funded by non-debt-creating flows. Net foreign direct investment (FDI) in the form of equity and reinvested earnings continue to drive the financing of the external shortfalls in the region. In Serbia, Albania, and Montenegro, this was especially pronounced, with estimated net FDI totaling 5.5 percent, 6.3 percent, and 10.3 percent of GDP, respectively, and financing on average about 78 percent of CADs. In Serbia and North Macedonia, intercompany loans, a debt-creating FDI, dominate as the countries continue integrating into EU-centric manufacturing value chains. In Kosovo, meanwhile, net FDI inflows decelerated somewhat as a share of GDP, as 42 8. External imbalances widened despite the export recovery BEYOND THE CRISES 9. The region heads into another storm The outlook for the Western Balkans and export rebound of 2021 was sustained into continues to be buffeted by global events, the following year. Initial fears that the region’s generating significant uncertainty and economies would be directly affected by the downside risks. After the strong post-COVID fallout of the war proved to be overblown. recovery of 2021 (Table 1.1), a growth Economies and sectors most exposed to slowdown was inevitable as economic expansion either Russian or Ukrainian demand, such as normalized. However, the start of the war in Montenegro’s tourism sector and investment Ukraine triggered a series of shockwaves that flows into Serbia, held up comparatively well. have weighed heavily on the growth outlook for 2022 and for 2023. Energy and food prices However, it is now clear that the region is have dramatically increased, pushing inflation heading into a perfect storm. By mid-2022 it upward to levels unseen for many years. became apparent that a confluence of indirect Similarly, monetary tightening and a slowdown supply and demand shocks would weigh heavily in growth in advanced economies present on the region’s outlook, pushing inflation the region with a challenging combination sharply upward and dampening consumer of higher financing costs and weaker external and investor confidence. Economic activity is demand. Meanwhile, the risks of a winter also slowing sharply in advanced economies, COVID-19 flare-up remain, and global supply especially in the Eurozone, which is a key chains continue to be stressed. source of demand for Western Balkans goods and services, and a source of investment and Growth in the Western Balkans during the remittances. As a result, growth in the Western first half of 2022 proved to be relatively Balkans has been further revised downward for robust. Growth momentum was sustained 2023 (by 0.3 percentage points) to 2.8 percent across the region through the first two quarters (Figure 9.1). This downgrade is in line with of the year as the consumption, investment, revisions to global growth (Box 9.1), including Figure 9.1. Growth projections have been Figure 9.2. Commodity prices may have revised downward in 2023 since spring 2022. peaked. Revisions to GDP forecast Index, 2010=100 4 160 1.3 3.3 140 3 120 2 100 80 1 0.3 60 0 0 0 0 40 -0.3 -0.3 -0.4 -0.6 -0.6 -1 20 -0.8 -1.2 -1.3 0 -2 Ja 0 Ja 1 Ja 2 13 Ja 4 Ja 5 16 Ja 7 18 Ja 9 20 Ja 1 22 1 2 1 1 1 1 1 1 n- n- n- n- n- n- n- n- n- n- n- n- n- ALB BIH KOS MKD MNE SRB Ja WB6 Ja Ja Ja Ja J 2022 J 2023 ▬ Food Price Index ▬ Metals & minerals ▬ Crude oil Source: World Bank staff calculations. Source: UN FAO and World Bank. 9. The region heads into another storm 43 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 a projected full-year recession in the Eurozone year to 103.8 points in August. Oil prices also in 2023. appear to have peaked due to increased fears for global growth, with the index dropping slightly Gas prices have increased dramatically to 121.4 in August. Most significantly for over the year, although prices for other Europe, prices for natural gas have multiplied commodities appear to have peaked due to Russian supply restrictions, raising also (Figure 9.2). Prices for traded commodities electricity and heating prices, placing energy increased rapidly as the world recovered from importing economies (including Kosovo, COVID-19, placing net importers under acute North Macedonia, and Serbia) under acute pressure. However, food prices (as measured pressure. This pressure is expected to intensify by the United Nations Food and Agriculture during the coming winter heating season, Organization Food Price Index) appear to have especially for those economies that either have peaked, stabilizing at 138.0 points in August. limited storage capacity or are dependent on Similarly, the index of international metals and spot-market purchases to meet their energy minerals has risen only marginally over the past import requirements. Box 9.1. Global economy under continued shocks. Two years after the onset of the Covid-19 pandemic, the global economy continues to be rocked by a series of large shocks34. Geopolitical tensions are casting a long shadow, with the Russian Federation’s invasion of Ukraine magnifying pre-existing supply-side challenges and intensifying volatility in commodity markets. China, the main engine of emerging markets (EMDE) expansion in the pre-pandemic decade, is facing another year of markedly weak growth under the strains of pandemic-related lockdowns and real estate sector stress. Meanwhile, stubbornly high, and persistent inflation across both advanced economies and EMDEs has given rise to a sharp and highly synchronized global monetary tightening cycle. Indeed, the aggregate number of policy rate hikes reached a record-high in July 2022. Alongside, the withdrawal of pandemic-related support programs has seen a precipitous decline in government spending-growth, from an unprecedented high of 18 percent of global GDP in 2020 to 3 percent in 2022, a level more in line with its 2010-19 average. The confluence of these factors has motivated sharp downward revisions to consensus forecasts for global growth in 2022 and 2023. In January 2022, consensus forecasts were for global GDP growth of 4.1 percent in 2022 and 3.3 percent in 2023. By August, these projections had been downgraded to 2.8 percent for 2022 and 2.3 percent for 2023. Consensus growth projections for 2022 and 2023 have been downgraded for most countries—more than 90 percent of advanced economies and 80 percent of EMDEs for 2023. In contrast, expectations for global inflation in 2023 have increased substantially. 34 This box is based on: Guénette, J.-D., M.A. Kose, and N. Sugawara. 2022. “Is a Global Recession Imminent.” EFI Policy Note 4, World Bank, Washington, DC. 44 9. The region heads into another storm BEYOND THE CRISES (Box 9.1 continued) With the growth outlook already weak, global recession risks have risen. The modest but positive growth envisioned by consensus forecasts would not necessarily be a bad outcome— the breakneck growth rate of 2021 was not sustainable, as demonstrated by the widespread evidence of overheating. However, a sharp slowdown into a period of weak growth leaves the global economy vulnerable to further shocks. Moreover, policy responses may be constrained by pandemic-era debt surge, which has curtailed fiscal policy space, and need for monetary authorities to curb inflation. In this context, additional large shocks could be the trigger for the next global recession, defined as negative global per capita growth (Kose, Sugawara, and Terrones 2020). The history of global recessions suggests reason to be concerned. There have been five global recessions since 1970, in 1975, 1982, 1991, 2009 and 2020. They have occurred when the world economy has experienced exceptionally large supply shocks (oil shock in 1973– 74; pandemic in 2020), financial turmoil, often linked to accumulated financial imbalances (1982, 1991, and 2009), or sharp shifts in policy (1982). The current circumstances share some key characteristics with periods preceding previous global recessions. Indicators of global economic activity, such as world industrial production, trade, and oil consumption have tended to slow down in the two years before global recessions. Resembling this experience, several high-frequency activity indicators have weakened over the past year, including manufacturing export orders, equity prices and consumer confidence. In the global recession scenario, more substantial increases in inflation expectations are countered with much larger-than-expected synchronous policy tightening, triggering financial stress that tips the global economy into recession. Core inflation would decline to 2.9 percent by 2024, close to target, but at a high cost. In 2023, the global economy would experience a recession similar in magnitude to 1982, with growth slowing to 0.5 percent. 2024 would see only a subdued recovery, to 2 percent growth, reflecting the absence of countercyclical policy support in advanced economies, and adverse spillovers combined with limited policy space in EMDEs. The global recession scenario illustrates the importance of the value of clarity and consistency in formulating and communicating monetary policy (Ha et al. 2022; Kose et al. 2019; Shin 2022). Transparency in the conduct of policy reduces the risk of abrupt market dislocations and financial stress. Heading into 2023, policymakers face a difficult challenge to successfully navigate an environment of weak growth and high inflation. Monetary policy must be employed consistently to restore, in a timely manner, price stability. The lesson from history is that making the necessary policy adjustments in a timely fashion is essential to contain inflation, and thus avoid the more severe output costs associated with larger policy interventions later. Fiscal policy needs to prioritize medium-term debt sustainability while providing targeted support to vulnerable groups. Policymakers need to stand ready to manage potential spillovers 9. The region heads into another storm 45 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 (Box 9.1 continued) from the globally synchronous withdrawal of policies supporting growth. On the supply side, measures can be put in place to ease the constraints that confront labor markets, energy markets, and trade networks. This should help combat inflation, while also improving long- term growth. Figure 9.3. Global Developments and Growth Scenarios. A. Global policy rate rises and cuts B.  Annual changes in global general government expenditures Number Percent of GDP 30 20 20 15 10 10 0 5 -10 0 -20 -5 -30 -10 1970 1983 1996 2009 2022 1991 1997 2003 2009 2015 2021 J Rises J Cuts J Advanced economies J China ▬ World J EMDE commodity importers (ex. CHN) J EMDE commodity exporters (ex. RUS) C.  Evolution of global growth and inflation D. Global growth forecasts Percent Percent 5 7 6 5 4 4 3 2 1 0 3 -1 -2 -3 -4 2 -5 1975 1982 1991 2009 Feb Mar Apr May Jun Jul Aug 1970 1980 1990 2000 2010 2020 ▬ Growth ▬ Inflation ▬ GDP ▬ Per capita GDP E. Global per capita GDP growth F. Global core CPI inflation (excluding energy) Percent Percent 3 6 5 2 4 1 3 2 0 1 -1 0 2022 2023 2024 2022 2023 2024 J Baseline ▬ Sharp downturn ▬ Global recession J Baseline ▬ Sharp downturn ▬ Global recession 46 9. The region heads into another storm BEYOND THE CRISES (Box 9.1 continued) Source: Bank for International Settlements; Consensus Economics; Haver Analytics; International Monetary Fund; Kose, Sugawara, and Terrones (2020); Oxford Economics; World Bank. A. Three-month average of the number of policy rate rises and cuts over the month for 38 countries including euro area. The last observation is July 2022. B. Nominal and real (CPI-adjusted) short-term interest rates (Treasury bill rates or money market rates, with the maturity of three months or less). Global interest rates are weighted by GDP in U.S. dollars. Sample includes 118 countries, though the sample size varies by year. Data for 2022 are based on the numbers in the first two quarters of the year. C. Consensus forecasts of global growth are weighted by GDP in U.S. dollars based on 86 countries, and consensus inflation forecasts are based on median based on 83 countries. The last observation is August 2022. D. Shaded areas indicate global recessions in 1975, 1982, 1991, 2009, and 2020. The last observation is 2021. E.-F. These scenarios are produced using the Oxford Economics Global Economic Model. Figure 9.4. Financing costs have risen as Figure 9.5. Trade is weakening as the global advanced economies tighten monetary economy slows. policy. Euribor, percent Merchandise exports, growth rate, year on year, percent 1.2 25 1.0 20 0.8 15 0.6 10 0.4 0.2 5 0 0 -0.2 -5 -0.4 -10 -0.6 -15 -0.8 -20 Ju 5 Ja 15 Ju 6 Ja 6 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 1 1 l-1 n- l- 0 1 2 3 4 5 6 7 8 9 0 1 2 n- l- n- n- n- l- n- l- n- n- l- -1 -2 -1 l -1 -2 -1 -1 -1 -1 -1 -1 -1 -2 Ja Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Source: Bloomberg. Source: UNCTAD. Inflationary pressures are expected to remain Tighter global financing conditions will raise elevated, with risks that higher energy and refinancing costs. As advanced economies, food costs translate into a sustained wage- led first by the United States and now the price spiral. Average inflation rose sharply Eurozone, look toward taming the global over the course of 2022, with all economies inflation shock, global monetary conditions are (except Albania) seeing inflation moving into tightening (Figure 9.4). This is expected to raise double digits by midyear. The trend is still the costs of financing for both sovereigns and upward as regulated energy price adjustments corporates, restricting access to the Eurobond in several countries have yet to be passed on market for Western Balkan economies with to end users. Low-income households, which market access. Euro Interbank Offered Rates spend a higher proportion of their income on (Euribor) have risen especially sharply. Where energy and food costs, have been particularly governments are unable to meet their financing affected by the inflation spike. Minimum wages needs in their domestic markets, there is have been increased across the region, and likely to be increased recourse to international labor market tensions have started to become financial institutions for budget support. apparent. Inflation is projected now to average 10.9 percent in the Western Balkans for 2022 Slowing global growth, especially in the as a whole before starting to trend downward Eurozone, will dampen demand for the in 2023. region’s exports. Strong export earnings, both for manufactures and for services (especially 9. The region heads into another storm 47 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 tourism) helped propel the recovery from in 2022, from 2.9 percent in 2021. After a COVID-19. However, with a slowdown (or decline in public and publicly guaranteed debt even a recession) in the Eurozone, which is by to 53 percent of GDP in 2022, debt is expected far the largest trading partner for the Western to stay roughly at the same level in 2023. Balkan economies, export growth is expected to slow sharply. Growth in global demand for External deficits are likely to widen due to merchandize exports dropped significantly in deteriorating terms of trade. Higher import 2022 (Figure 9.5). Remittance flows may also costs for energy and food will push current weaken, if advanced economies that host the account deficits wider, especially in those Western Balkan diaspora enter pronounced economies that are most import dependent. slumps. While suppressed global demand may For the Western Balkans as a whole, the current reduce stresses on global supply chains, this account deficit is projected to increase from will be partially offset by periodic COVID-19- 4.9 percent of GDP in 2021 to 8.7 percent related movement restrictions in China. of GDP in 2022, and to remain elevated into 2023. In such an environment, investor sentiment is expected to remain subdued. High- In the short term, governments should frequency data sources, such as the Purchasing prioritize policy support to the vulnerable, Managers Index (PMI), point toward sharply ensuring that measures are targeted and weaker business sentiment (Eurozone PMI timebound. The recovery of 2021 saw an data dropped below 50 in July 2022, indicating improvement in fiscal balances across all six a shift from manufacturing expansion to economies of the Western Balkans. However, contraction). Foreign direct investment flows, one year of positive growth was not enough as well as domestic investment decisions, are to see a significant increase in fiscal space. As likely to be put on hold amid considerable such, policy support should ideally be targeted uncertainty. Financial sector risks will also need toward low-income households and energy- to be closely monitored. While nonperforming vulnerable consumers, with a clear time period loan numbers remain low for the region, credit for the cessation of support. Income support is quality may deteriorate if there is a protracted preferable to blanket subsidies, allowing price growth slowdown. signals to drive consumer choice and efficient use of energy. Support to energy-vulnerable Governments will face acute fiscal pressures firms should be provided with caution, due to a combination of energy relief needs especially to state-owned enterprises, and be and higher financing costs. This occurs at a accompanied by reforms to boost transparency time when fiscal buffers are already depleted and strengthen market signals. due to COVID-19 policy support. Fiscal risks will need to be closely monitored as energy With limited fiscal space, no-regret reforms generation and distribution firms struggle to that would boost medium-term growth finance their operations and in several countries at limited fiscal cost should be a priority. are prevented from fully passing on higher Convergence with European peers is only costs to end users. Fiscal deficits are expected possible for the Western Balkans if the rate of to widen to an average of 3.3 percent of GDP potential growth is increased. At a time when 48 9. The region heads into another storm BEYOND THE CRISES Figure 9.6. An increase in potential growth Figure 9.7. A large governance gap exists is needed for the Western Balkans to between the Western Balkans and EU peers. converge with EU per capita income levels. GDP per capita in 2019 (PPP, constant 2017 international USD) EU 1.0 SVN LTU 0.8 EST 0.6 SVK LVA 0.4 Governance gap HRV BGR 0.2 MNE SRB 0 MKD BIH -0.2 ALB -0.4 5 years before 5 years after KOS 2019 joining EU Join EU joining EU 0 10,000 20,000 30,000 40,000 50,000 WB New EU member states ▬ Median - new EU member states ▬ 25–75th percentiles Source: World Bank. Source: World Bank. Figure 9.8. Total factor productivity growth Figure 9.9. Labor force participation, has been sluggish. particularly for women, is below that of EU peers. Growth rate of total factor productivity Female labor force participation rate, Q2 2022 6 60 4 50 2 40 0 -2 30 -4 20 -6 10 -8 -10 0 10 11 12 13 14 15 16 17 18 19 20 21 22 S H U B6 KD V B L EU R 27 E HU E N N K B PO CZ N HR KO SV BG SR AL RO BI SV 20 20 20 20 20 20 20 20 20 20 20 20 20 W M M ▬ ALB ▬ BIH ▬ MKD ▬ SRB Source: Total Economy Database. Source: Eurostat and National Statistical Offices. public sector resources are scarce, it would be importance of accelerating the green transition appropriate to prioritize reforms with limited in the region away from volatile hydrocarbons fiscal cost that would serve to accelerate toward cleaner electricity generation, as well as potential growth and convergence over the greener production, finance, and consumption medium term (Figure 9.6). This would include patterns. Greening the financial sector and measures to raise standards of governance, green finance offer new opportunities in the including digitalization (Figure 9.7), increase Western Balkans (see Section 10: Spotlight) at the level of market competition, remove entry lower financial and opportunity costs. barriers to business, and increase retention and reinvestment among foreign investors The medium-term outlook for the Western to boost factor productivity (Figure 9.8), Balkans remains positive, but short-term as well as improve skills and reduce barriers risks are heavily tilted to the downside. The to female labor force participation (Figure region’s fundamentals and the opportunity to 9.9). The ongoing crisis also underpins the achieve economic convergence and integration 9. The region heads into another storm 49 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 with Europe remain strong. However, increased countries in the Western Balkans remain high. intensification of the economic crisis as a result Finally, the risks of a flare-up of COVID-19 of the prolonged war in Ukraine would place remain acute, given the vaccination gap that the region under even further stress. Similarly, exists between the Western Balkans and the the risks of political polarization within rest of Europe. Box 9.2. Raising potential growth will be key to unlocking a medium-term recovery.35 To counter significant headwinds to long-term growth prospects, structural reforms are needed to reignite productivity growth, accelerate the convergence process with average EU incomes, and help reap dividends from the digital and green transition. Following years of weak growth in the aftermath of the global financial crisis and European debt crisis, potential growth in the Western Balkans is now anticipated to increase. Potential growth in Western Balkans is anticipated to strengthen from 2.2 percent over 2013–21 to an average of 3.2 percent over 2022–30 driven by the expected increase in contributions from investment, in particular the positive impact of EU investment funds, and related structural reforms that would boost the contribution from capital and total factor productivity (TFP) growth over the remainder of the decade.36 The contribution from labor is anticipated to become a drag on potential growth as the population continues to age and the labor force subsequently shrinks. Still, potential growth estimates remain subject to a high degree of uncertainty given overlapping negative shocks over the last few years from the COVID-19 and the Russian Federation’s invasion of Ukraine. Although potential growth in the Western Balkans is expected to firm over 2022–30, it is anticipated to remain subdued relative to peers. The average pace of potential growth is projected to remain weaker than the EMDE average, as lingering structural issues and adverse demographic trends weigh on growth prospects in the Western Balkans. Sluggish improvement in institutional quality, weak perception of government effectiveness and the control of corruption, lack of high-quality job opportunities, and elevated informality and inequality have exacerbated longer-term structural issues like a dwindling supply of labor amid ageing and emigration. These constraints also weigh on foreign investments, private- sector development, and firm productivity. Despite relatively high levels of average years of education, learning outcomes in all six Western Balkan economies trails the OECD average as measured by PISA test scores.37 35 Based on the forthcoming work in Kilic Celik et al., Kilic Celik, Kose, and Ohnsorge (2020) and World Bank (2018a). 36 Potential growth is constructed from model-based estimates, which are intended to capture major long-term drivers of growth using a standard Cobb-Douglas production function, where growth of potential GDP can be decomposed into contributions from increased capital stock, labor supply adjusted for human capital, and gains in total factor productivity. Potential labor supply is derived from the labor force participation predicted by a panel regression of labor force participation in five age groups for each gender on education and health indicators, as well as cohort effects. Potential TFP growth is derived from the predicted value of a panel regression of trend TFP growth on education and health indicators, investment, and research and development spending. Potential capital is assumed to match actual capital. 37 OECD, 2018. 50 9. The region heads into another storm BEYOND THE CRISES (Box 9.2 continued) Compounding these long-standing structural issues are intense cyclical headwinds. Learning and job losses from the pandemic have weighed on the formation of human capital, with vulnerable populations the worst affected—in part reflecting digital constraints for online education for poorer and rural households and weaker labor market recoveries for lower-skilled workers. The war in Ukraine is exacerbating structural headwinds by denting confidence and disrupting regional value chains and energy supplies. As a result, output in the Western Balkans is anticipated to remain about 5 percent below its pre-pandemic trend in 2023.38 Over the longer term, the fragmentation of regional trade and finance networks from the war could interrupt the Western Balkans’ progress in global value chain (GVC) integration, which had already lagged regional and Asian peers prior to the pandemic.39 Given intense headwinds to long-term growth prospects, it will be critical for economies in the Western Balkans to advance structural reforms and accelerate economic transformation (  Figure 9.10). Significant EU investments over the remainder of the decade can provide an anchor for structural reforms in the Western Balkans. Improving institutional quality could yield large gains in potential growth by bolstering confidence, creating a more favorable business climate, and increasing government effectiveness—in turn strengthening the efficiency of public investment and attracting private investment. Deeper regional integration with the EU—including with digital, investment, innovation, and industrial policy—could boost investment and trade prospects, the regulatory environment, competition, and productivity.40 The EU investments over the remainder of the decade also include sizable funding for the green and digital transition in the Western Balkans—a key priority given these economies are among those in ECA farthest from the green transition frontier.41 Increasing R&D spending—which ranged from 0.2 to 0.9 percent of GDP in 2020 across the Western Balkans compared to 2.3 percent of GDP in the EU—could provide additional support to the digital and green agendas, further encouraging the acceleration of technological development and TFP. 38 World Bank Regular Economic Report for the Western Balkans, Spring 2022. 39 https://blogs.worldbank.org/psd/western-balkans-should-leverage-foreign-direct-investment-integrate-global-value-chains. 40 https://ec.europa.eu/info/sites/default/files/economy-finance/ip180_en_0.pdf. 41 EBRD 2021. https://www.ebrd.com/news/publications/annual-report/annual-review-2021.html. 9. The region heads into another storm 51 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 (Box 9.2 continued) Figure 9.10. Structural reforms are needed to boost potential growth in the Western Balkans. A. GDP growth B. Investment growth Percent Percent 10 16 8 12 6 8 4 4 2 0 0 -4 2003–08 2010–14 2015–19 2022–24 2003–08 2010–14 2015–19 2022–24 J WBK ▬ EMDE median ▬ Range for EMDE regions J WBK ▬ EMDE median ▬ Range for EMDE regions C. Labor force participation rate D.  Contributions to potential growth in Western Balkans Percent of working-age population Percentage points Percent 80 4 4 3 3 60 2 2 40 1 1 20 0 0 0 2000–10 2011–21 2000–10 2011–21 -1 -1 Male Female 2013–21 2022–30 J EMDEs J ECA J WBK J Labor J Capital J TFP Q Potential growth, rhs Sources: Penn World Tables; UN Population Prospects; World Bank; World Bank, WDI. Note: ECA = Europe and Central Asia; EMDEs = emerging market and developing economies; WBK = Western Balkans. Shaded area indicates forecasts. GDP weights are calculated using average real U.S. dollar GDP (at average 2010-19 prices and market exchange rates) for the period 2011–19. A. Bars show period averages of annual GDP-weighted averages. Markers denote medians, vertical lines denote min-max ranges. B. Bars show period averages of annual GDP-weighted averages. Vertical lines denote min-max ranges. Sample includes 14 ECA economies, including Türkiye, the Russian Federation, and Ukraine. C. Figure shows proportion of the population ages 15 and older that is economically active. Aggregates are calculated as simple averages. Sample includes Sample includes 145 EMDEs, 23 ECA economies, and 6 WBK including Albania, Bosnia and Herzegovina, Kosovo, Montenegro, North Macedonia, and Serbia. D. Period averages of annual GDP-weighted averages. Estimates based on production function approach. Sample includes 4 Western Balkans economies (Albania, Bosnia and Herzegovina, Montenegro, and Serbia). 52 9. The region heads into another storm BEYOND THE CRISES 10. Spotlight: Greening the Western Balkan Financial Sector The energy crisis is accelerating decisions on the required scale and scope that is required to green transition polices across the European address these challenges. Union countries. The external environment is going through a major structural change, Climate change and environmental and fundamental environmental pressures are concerns expose the financial sector to changing the foundations of economic activity, physical and transition risks which impact consumer choices, and investor behavior financial stability. Physical risks are risks in everywhere. Yet, the Western Balkans have so far terms of natural disasters/hazards related to been slow in moving away from legacy “brown” climate change—floods, droughts, landslides, industries, skills and jobs, and established earthquakes, hurricanes and/or climate change value chains and market infrastructure. And induced extreme events. Other potential furthermore, while leapfrogging to a “green” climate-related extreme events may be growth pathway is far from easy, especially in deforestation, heatwaves, water scarcity and the short term,42 the green transition offers wildfires which are becoming more frequent opportunities for the Western Balkans, and for and intense with climate change. Such the financial sector in particular. physical risks translate to financial exposure through the banking and insurance segments related to agriculture, industry, services, The financial sector has an important energy, and mining sectors, nearly all sectors. role to play in addressing climate Transition risks are risks related to sudden change and unanticipated climate policy, technology, Transition towards a low-carbon, and consumer preference changes. Transition environmentally sustainable economy risks could also emerge when other countries requires significant global investments to implement climate border adjustment measures deal with adaptation and mitigation costs, (e.g. EU imposing tariffs on imports of carbon and address other aspects of environmental intensive products to avoid carbon leakage degradation. High-level estimations suggest and encourage partner countries to introduce that supporting a green economic recovery carbon pricing). A rapid and unmanaged after COVID-19 will generate more than $10 transition to a low carbon economy could trillion in investment opportunities.43 The translate into significant transition risks for the global transition away from fossil fuels has financial sector, especially if there is a need for been estimated as a $50 trillion investment a rapid transition toward green investments to and financing opportunity.44 However, despite meet climate goals; and/or to mitigate large large financing gaps, greening the financial exposures of financial sector to carbon-intensive sector and green finance have fallen short of 42 World Bank Western Balkan Regular Economic Report #20, Fall 2021. 43 World Bank (2021): Toolkit for Policymakers to green the financial system. 44 World Bank (2021): Toolkit for Policymakers to green the financial system. 10. Spotlight: Greening the Western Balkan Financial Sector 53 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 and other transition-sensitive sectors. Both The nexus of climate change and the types of risks may impact financial stability. financial sector has prompted a growing body of international cooperation and To support financial stability, mitigating policy guidance. Volunteer networks have climate change and environmental risks been developed between central banks can be achieved by “greening” the financial and supervisors to share best practices and system, including through the development contribute to the development of environment of green finance instruments. Greening the and climate risk management in the financial financing system refers to increasing financing sector and to mobilize finance to support flows into sectors that contribute to climate transition towards a sustainable economy.47 and environmental objectives.45 It can be Likewise, a voluntary coalition of fiscal and supported by (i) enhancing prudential measures economic policy makers of over 70 countries to maintain the quality of financial sector have formed “the Coalition of Finance portfolios that may be subject to climatic shock Ministers for Climate Action” utilizing the (direct or indirect), and (ii) developing green Helsinki Principles to guide the coalition’s finance instruments and services which support commitment to combat climate change.48 households, firms and government in meeting International financial standard setting bodies, adaptation and mitigation actions (Figure 10.1). including the Financial Stability Board49 and Green finance is a narrower term and refers to the Basel Committee on Banking Supervision50 all lending and investment towards climate have published guidelines related to combating mitigation, climate adaptation and resilience, climate change within the financial sectors— and other environmental objectives—including Task Force on Climate-Related Financial biodiversity management and nature-based Disclosures and the Principles for the effective solutions.46 management and supervision of climate-related Figure 10.1. Green Finance and the Role of the Financial Sector. Ÿ Banking sector How can it contribute to Ÿ Capital markets de-carbonizing the economy? Ÿ Insurance sector Taxonomies Greenproducts Information Ÿ Risk of green bubbles - Financial sector How can banks (and other financial overfunding intermediaries) manage the climate Ÿ Risk of guided/directed lending - related and environmental risk underfunding without incurring in new risks? Ÿ Risk of greenwashing Prudential supervision Source: World Bank FinSAC. 45 World Bank (2021): Toolkit for Policymakers to green the financial system. 46 World Bank (2021): Toolkit for Policymakers to green the financial system. 47 NGFS: Central Bank and Supervisors: Network for Greening the Financial System. https://www.ngfs.net/en. 48 https://www.financeministersforclimate.org/. 49 https://www.fsb-tcfd.org/. 50 https://www.bis.org/bcbs/publ/d532.pdf. 54 10. Spotlight: Greening the Western Balkan Financial Sector BEYOND THE CRISES financial risks, respectively. The Principles should be included in the regulatory and seek to improve banks' risk management and supervisory frameworks for credit institutions supervisors' practices related to climate-related and investment firms.56 The European Central financial risks. Lastly, the International Capital Bank published guidelines on climate-related Market Association (ICMA) also published and environmental risks for banks.57 guidelines regarding the voluntary process for issuing green bonds. Specific implementation guidance for emerging markets, including the Western From a regional perspective, the European Balkan economies, have also emerged. From Commission (EC) has issued several a regional perspective, a working group on guidelines and policy measures to combat climate change was created under the Vienna climate change within the European Initiative with a task to come up with practical financial sector. It also adopted a set of policies recommendations for the Western Balkan to reduce greenhouse gas emissions to net- countries to address the topics of climate risk- zero through the European Green Deal51 and related data gaps, banking supervision issues, adopted an Action Plan to finance sustainable and transitional strategies. Furthermore, growth.52 Market guidance has been developed Guidelines for the Implementation of the and issued in the areas of: (i) European Green Agenda for the Western Balkans (Sofia Corporate Sustainability Report that requires Deceleration)58 and an Action Plan for the certain large companies to disclose information Western Balkan economies59 for 2021–2030 on how they operate and manage social and providing implementation guidelines and environmental challenges;53 (ii) Green Bond concrete actions of implementing the European Standards,54 which are voluntary standards Green Deal have been issued.60 to help scale up and raise the environmental ambitions of the green bond market; and (iii) Sustainable Finance Taxonomy,55 the The Western Balkan economies still EU taxonomy that is a classification system have some way to go when it comes to greening the financial sector that establishes a list of environmentally sustainable economic activities. From the Most of the Western Balkan economies prudential regulatory aspects, the European are at the initial stage of greening their Banking Agency provided a comprehensive financial sectors. While the carbon intensity proposal on how ESG factors and ESG risks of their growth is on decline, it is still several 51 https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal_en. 52 https://www.greenfinanceplatform.org/policies-and-regulations/european-commissions-action-plan-financing-sustainable- growth#:~:text=The%20Action%20Plan%20on%20Sustainable,3)%20To%20foster%20transparency%20and. 53 https://ec.europa.eu/info/business-economy-euro/company-reporting-and-auditing/company-reporting/corporate-sustainability-reporting_en. 54 https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/european-green-bond-standard_en. 55 https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/eu-taxonomy-sustainable-activities_en. 56 https://www.eba.europa.eu/eba-publishes-its-report-management-and-supervision-esg-risks-credit-institutions-and-investment. 57 https://www.bankingsupervision.europa.eu/press/pr/date/2020/html/ssm.pr201127~5642b6e68d.en.html. 58 https://ec.europa.eu/neighbourhood-enlargement/system/files/2020-10/green_agenda_for_the_western_balkans_en.pdf. 59 https://www.rcc.int/docs/596/action-plan-for-the-implementation-of-the-sofia-declaration-on-the-green-agenda-for-the-western- balkans-2021-2030. 60 For emerging economies, in general, the World Bank published: (i) the Toolkit for Policymakers to Green the Financial System—a practical, high-level guidance for public authorities that are exploring opportunities to green their financial sector; and (ii) Developing a National Green Taxonomy—the guide includes recommendations for drafting of national green taxonomies, as well as a comparison of several existing taxonomies, in order to support countries in their efforts to clarify to market participants the types of activities that are deemed environmentally sustainable. 10. Spotlight: Greening the Western Balkan Financial Sector 55 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 times above the EU levels.61 Collectively, the European market, there is an absence of Western Balkan countries are vulnerable to country-specific, comprehensive strategies several physical risks: floods, earthquakes, and roadmaps to tackle climate and landslides, wildfires, droughts, blizzards. environmental risks. In many Western Climate change will exacerbate the frequency Balkan economies, an initial taxonomy of their and intensity of such occurrences and associated economic activities has yet to be undertaken. vulnerabilities (e.g. energy production Transparency and disclosure standards and vulnerabilities associated to droughts which statements for sustainability for large corporate effected hydropower-reliant countries, food and financial institutions have not yet been security associated to agriculture production developed. Prudential supervision and oversight reliant upon climate stability) (Table 10.1). guidelines have yet to be drafted and enforced In terms of transitory risks, the countries face by financial regulators. substantial challenges in transitioning towards less carbon-intensive economic activities. These Despite growing public awareness of the role transition risks are likely to affect the banking, that the financial sector could play in reaching insurance, and pension sectors, particularly, as countries’ climate and environmental this is the case for the financing of construction, goals, the Western Balkan economies are transportation, energy, manufacturing, and still far from implementation of the actual agriculture sector credits and investments interventions required to greening their within their respective portfolios. The real respective financial sectors nor do they offer a sector is trailing in terms of adjusting their broad array of green finance products due to industries to meet the pending European several reasons. This delay could be associated market standards—part of the European Green to the misalignment of fiscal, economic, and Deal—and will ultimately need to be funded to environmental policies. For example, public ensure their decarbonization is in line with the subsidies are still being offered to sectors Paris Agreement. that are not low-carbon and there is low effective carbon taxation. There could also be Despite the presence of these risks and the uncertainty regarding long-term government proximity and economic linkages to the policy which in turn inhibits the development Table 10.1. Selected Indicators from the INFORM Risk 2022 Index for Climate Risk Management. Economic Lack of Coping Country Inform Risk Flood Drought Vulnerability Dependency Capacity Bosnia and 3.5 7.1 2.8 3.8 2.6 4.9 Herzegovina Albania 3.1 4.7 6.6 1.7 2.3 4.4 Serbia 2.8 8.9 2.9 2.4 1.4 3.7 Montenegro 2.7 4.4 1.9 2.6 2.5 3.2 North Macedonia 2.5 4.2 3.6 2.1 1.4 3.6 EU Average 1.9 4.4 1.8 2.6 0.3 2.0 Source: European Commission INFORM Risk Index 2022. 61 https://openknowledge.worldbank.org/bitstream/handle/10986/36402/Greening-the-Recovery.pdf?sequence=1&isAllowed=y. 56 10. Spotlight: Greening the Western Balkan Financial Sector BEYOND THE CRISES of a project pipeline; or there could be limited initial steps towards greening their financial motivation or capacity of financial institutions sectors. The presence of these institutions to identify and originate green assets and has supported initial efforts towards raising manage climate-related and environmental awareness of ESG and Sustainable Finance risks. Furthermore, the high upfront financing within the financial sector. Several banks costs, transactions costs, lack of track-record of operating across the Western Balkan region63 new technologies, and long payback periods are subsidiaries of EU-based banks (Austria, for some green projects could increase the Germany, Italy and Slovenia). These banking real and perceived riskiness of green projects groups are typically more familiar with the overall.62 Overall, these delays can indirectly relevant European legislations and guidelines influence the perceived level of risk which has a and have already faced consolidated prudential direct impact on investment decisions. Rather, and risk management requirements by the ECB. managing climate and environmental risks These banks effectively work as a key channel through financial supervision and increasing for cross-border knowledge and the transferring awareness can play an important role in of best practices. Likewise, the financial sector changing financial behavior and driving capital is currently supported by IFIs—EBRD, IFC, towards green goals. IBRD, KfW, USAiD—which have designed and implemented programs to support the One positive development is Serbia’s development of sustainable lending markets issuance of its first sovereign green bond in the Western Balkans. They regularly offer in 2021 of EUR1 billion. The sovereign concessional funding to partner banks in the green bond is envisaged to be used for Serbia’s region linked to sustainable lending products. financing and refinancing in the areas of renewable energy, energy efficiency, sustainable To ensure financial stability, central banks water management, pollution prevention and and banking supervisors in the region are control, protection of the environment and in the process of building their capacity, biodiversity and sustainable agriculture. The as they take their first steps towards the seven-year bond, three times oversubscribed, preparation and approval of Green Finance has a 1 percent interest rate, and the yield rate Strategies. These strategies are being developed is 1.26 percent. The interest rate was well below by the central banks in Albania, Kosovo, the rate for regular bonds and drew in a new Montenegro and North Macedonia, and the and wider class of investors. Serbia’s sovereign Banking Agencies of the Federation of BiH green bond issuance offers useful lessons for and the Republika Srpska. Most authorities other countries in the region. are also actively participating in international and regional fora, regularly engaging with Fortunately, there is a strong presence of international organizations to have a clear predominantly European-owned banks as understanding of what their role should be in well as international institutions which are greening the financial sector and what initiatives supporting the Western Balkans to take the they may adopt within a credible timeline. 62 World Bank (2021): Toolkit for Policymakers to Green the Financial System. 63 Such as RBI, OTP Bank, Unicredit Group, Intesa SanPaolo, ProCredit, and NLB Group, among others. 10. Spotlight: Greening the Western Balkan Financial Sector 57 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Furthermore, Western Balkans central banks funding or investment can also be earmarked and supervisory authorities coordinate with as such. The taxonomy should be interoperable the relevant competent government ministries with the EU's taxonomy practices; as well as, (Finance, Environment, Industry, etc.) to seek aligned with climate-related national strategies, synergies across domestic policies. laws, and action plans of each country. Albania and Montenegro’s national green taxonomy could also cover blue economy considerations The development of Green Finance such as sustainable fisheries given their access Strategies is a key priority to the Adriatic Sea. This would help with As a first step, each Western Balkan country the development of green and blue financial can develop a national strategy and a products and the avoidance of greenwashing. roadmap on green finance to prioritize Using this national green taxonomy, financial actions. To coordinate initiatives and activities sector regulators could develop climate- across different stakeholders such as policy related reporting and disclosure requirements, makers, regulators, supervisors, and financial enforceable for financial institutions and market participants, establishment of a national corporates. task force on green finance would be beneficial not only for advancing green finance but Subsequently, ministries of finance can also for further assessing and understanding consider issuing mandatory sustainability climate and environmental risks. Such a task disclosure requirements applicable to the force could build on and reinforce an inter- largest corporates.64 Disclosing regulated, institutional working group on the broader audited information on the sustainable green agenda established under the oversight of credentials of corporates will be essential the Cabinet. This may require legal mandates for banks and investors when assessing and responsibilities by different authorities to different elements of corporate sustainability. fulfill the objectives. Nonetheless the agile and Furthermore, market regulators can be engaged efficient coordination between institutions, to support the ministry of finance define the avoiding gaps, overlaps and inconsistencies in framework for Green Bonds. A Green Bond the process needs to be assured. Framework would enable both the state and private sector agents to issue green or social The ministries of finance would be bonds.65 responsible for creating the conditions for the development of the green financial Climate and Environment Risk and market by adopting a “green taxonomy.” Opportunity Assessments (Green Finance This would identify the criteria upon which Diagnostics) are useful tools to understand the economic activities can be identified (Figure the climate risks and opportunities  as sustainable or green, and therefore their 10.2). In 2021–22, the World Bank worked 64 Corporate sustainability plans may involve how corporates will align business plans to the Paris agreement, exposure to transition and physical risks from climate change, ESG management practices, own GHG emissions, etc. 65 The WB has issued guidance for public financial sector authorities in developing appropriate key performance indicators for sustainability linked bonds (https://documents1.worldbank.org/curated/en/935681641463424672/pdf/Striking-the-Right-Note-Key-Performance- Indicators-for-Sovereign-Sustainability-Linked-Bonds.pdf and https://documents1.worldbank.org/curated/en/099615001312229019/pdf/ P170336065a94c04d0a6d00f3a2a6414cef.pdf). 58 10. Spotlight: Greening the Western Balkan Financial Sector BEYOND THE CRISES Figure 10.2. Scope and example of CERO Assessments: An illustrative example. A. Climate Change and Environmental Context B. Vulnerabilities to Climate C. Supervisory Response D. Deepening Markets for E. Deepening Markets for and Environmental Risks Green Growth Climate Risk Resilience Impact of typhoons and pandemic on bank capital Table of Key Recommendations Responsible Recommendations (references to main text) Time authorities Total capacity adequacy ratio in percent Supervisory response (140-61) 18 1 Perform in-depth environmental risk assessments of the impact of climate and environmental BSP, IC NT risks on banks and insurers. 2 Improve information collection and monitoring of relevant climate and environmental risk metrics. BSP, IC NT 16 15.3 15.3 3 Develop capacity to stress test prudential impacts of climate change. BSP MT Typhoon, once 4 Issue guidelines for banks on environmental risk management, governance and disclosures taking BSP NT in 25 years account of FSB TCFD recommendations. 14 5 Integrate climate and environmental risks in off-site monitoring, on-site supervision and BSP MT supervisory ratings. October WEO 6 Consider applying for membership of the Central Banks and Regulators Network for Greening BSP MT 12 the Financial System. 7 Build capacity to monitor and supervise uptake of the Sustainability Reporting Guidelines for PLCs SEC MT and evaluate whether a mandatory approach is needed. 10.3 9.7 10.2 10 9.1 8.9 9.6 8 Conduct a study on how investors are integrating sustainability factors into investment decisions SEC MT and risk management. 9 Develop risk-based regulation and supervision methodologies that address insurers’ catastrophe IC MT 8 risk accumulation and transfer practices. 7.7 10 Introduce disclosure guidelines on reporting of environmental and climate risks for insurance IC NT companies, taking account of FSB TCFD recommendations. 6 6.8 Deepening Markets for Green Inclusive Growth (162-81) 5.4 11 Develop a strategy on green or sustainable finance. DOF, BSP NT 5.2 12 Set up a national platform for green or sustainable finance. BSP NT 4 13 Introduce a green finance taxonomy based on global best practices. DOF, BSP MT 14 Consider a mandatory labeling system for energy efficiency of buildings. DoE MT Typhoon, once 3.2 15 Explore the opportunity for further reprioritizing development banks for green growth. DOF, BSP MT 2 in 500 years 16 Consider issuing sovereign green bonds, performing a readiness and opportunity study as a DOF NT first step. 1.0 17 Explore the potential for blended finance instruments to stimulate green investments. DOF NT 0 18 Introduce a catastrophe insurance pool. DOF NT 2019 2020 2021 2022 t t+1 t+2 t+3 19 Launch an NDC implementation roadmap providing clarity on pathways and investments needed Current scenario Future scenario CCC, Congress NT for climate adaptation and mitigation. 20 Consider incentives to further price externalities, including a carbon tax. DOF MT Short Term (ST) = within one year; Near Term (NT) = 1–3 years; Medium Term (MT) = 3–5 years. Source: World Bank FinSAC. with the authorities in Albania, North 2020) estimates average future damage Macedonia, and Serbia to help draft Green from earthquakes and flooding alone at Finance Diagnostics; high-level observations US$147 million per year, while catastrophic are noted below. The diagnostics follows the and more unlikely events could cause FSAP Climate and Environment Risk and considerably higher damage. Albania shows Opportunity Methodology. The framework slow but steady greenhouse gas (GHG) looks at vulnerabilities in the climate and emission growth, of which transportation, environment within the macro-financial industrial and agricultural processes are context. It includes analysis regarding the the most influential drivers. The largest supervisory response, deepening green finance shares of current GHG emissions stem markets, and deepening markets for climate from agriculture, which has put a strong risk resilience by covering ways authorities can focus on livestock that accounts for over promote the development, access, and use of 50 percent of agricultural production value. climate-resilient instruments. Unlike many other countries in the region, Albania’s electricity generation contributes • Albania ’s greatest climate-related hazard only minor GHG emissions because its risk is flooding, as the country has multiple power sector is almost 100 percent fueled rivers and stream systems with significant by hydropower. The portfolio of Albanian downstream flooding potential. Other banks consists of multiple sectors that could potential climate-related extreme events are be directly or indirectly exposed to physical droughts, heatwaves, water scarcity, and risks such as droughts. Manufacturing, wildfires. A recent report on Albania by construction, electricity, accommodation, the Global Facility for Disaster Reduction mining, transportation, real estate, and Recovery (World Bank Group agriculture, and water sectors are identified 10. Spotlight: Greening the Western Balkan Financial Sector 59 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 as directly or indirectly exposed to climate This concentrated exposure makes banks physical risks. In addition, credit exposure more vulnerable to physical risks of that and economic activity in Albania show region, particularly flooding. Agriculture high levels of geographical concentration. is another key transmission channel for Over 74 percent of loans are granted to physical risks to the North Macedonia’s the Tiranë district. About one-third of the financial sector. In terms of transition risks, outstanding loans on the balance sheets of in total, about 51 percent of bank loans to Albanian banks are linked to transition- non-financial firms (USD 1.6 billion) are sensitive sectors. Exposures are highest in the exposed to Climate Policy-Related Sectors. manufacturing sector (15 percent of total Banks’ direct exposure to fossil fuels and credit exposure), followed by construction utilities appears limited, although transition (13 percent), mining (3 percent), risk exposures could differ strongly amongst transportation (2 percent), and agriculture individual banks, depending on their (1.5 percent). The investment portfolios of specialization. Pension funds and other Albanian insurers are very conservative and institutional investors as well as insurance transition risks appear to be manageable. sector face limited exposure to physical Institutional investors, mainly consisting and transition risks currently, while risk of of investment funds, could also be affected insurers from agriculture, property damage by climate-related risks if recurring climate- and business interruption has been growing. related impacts affect fiscal sustainability and thus put pressure on domestic sovereign • Serbia is particularly exposed to droughts bond holdings. and floods. Physical risks can materialize through the banking sector’s exposure to the • North Macedonia is characterized by agriculture, hydropower, and energy and a variable climate and is vulnerable to mining sectors, among others. According to floods, extreme temperatures, wildfires, high-level estimates, more than significant droughts, and landslides. Previous disasters of non-life insurers’ underwriting portfolios in North Macedonia highlight its historical could be exposed to physical risks through vulnerability to floods and extreme insurance products to cover natural temperatures which are representing 46 disasters. Transition risks could materialize and 25 percent of all disasters registered for the banking sector through exposure to between 1950–2021, respectively. Over activities related to building, transportation, the recent years, North Macedonia has energy, or agriculture. Although only shown relatively persistent levels of GHG assessed at high-level, these so-called emission, with energy being the largest climate-policy-relevant sectors make up the driver accounting for about 75 percent equivalent of nearly half of Serbia’s GDP. of the emissions. Total emissions in 2019 In the nonbanking sector, larger voluntary were estimated at 12.9 million metric tons, pension funds seem to be more exposed to which is a 15 percent increase on the average transition risks through equity exposure to emissions in 1990–2018. The region of climate policy-relevant sectors such as oil Skopje represents 53 percent of all loans to and gas compared to insurance companies non-financial firms in North Macedonia. and investment funds. 60 10. Spotlight: Greening the Western Balkan Financial Sector BEYOND THE CRISES Prudential management of climate to the transition and physical risks from and environment risks is essential climate change. This can be done by engaging To support prudential management of in simple, static exercises that maximize the climate-related and environment risks, available data sources and methodologies (i.e. Western Balkan financial sector public sensitivity analysis). authorities—central banks, ministries of finance, financial sector supervisors and Based on the assessment, high-level regulators—should develop an approach to supervisory guidance and more technical climate and environment risk assessment guidelines could benefit Western Balkan and management of the financial sector. financial institutions. Based on the results First, a qualitative climate risk assessment of the of these assessments and better knowledge financial institutions should be completed. The of the exposures of the financial sector to the qualitative assessment should be supplemented risks, supervisory recommendations67 and/ with a granular quantitative assessment. The or requirements on managing climate-related authorities should have a comprehensive risks can be drafted.68 Supervisors should understanding of the situation of the banking also integrate climate and environmental risk sector’s climate and environmental risks. To this considerations into their supervisory review end, authorities can prepare surveys addressed process and other regular supervisory activities. to the banking sector and organize climate risks Ongoing developments of regulatory and conferences with the participation of financial supervisory frameworks by the European institutions. Albania, Bosnia and Herzegovina, financial sector authorities—European Central Kosovo and North Macedonia are in the initial Bank and the European Banking Authority stages of issuing these surveys/questionnaires could guide the Western Balkan authorities.69 to the commercial banks; BiH and North Macedonia have begun drafting a Strategy Once supervisory recommendations are for Green Finance. General conclusions of issued, requesting banks to conduct a the surveys and questionnaires are referenced self-assessment against them and define below and are applicable to the majority of remediation plans would be the next step.70 the Western Balkan financial sectors (Table The outcome from this process should be a clear 10.2). Moreover, authorities can improve their commitment from the banking sector to fully understanding66 of the banking sector exposure meet the recommendations. WB6 Supervisors 66 For example, by assessing the transition risk by breaking down the corporate loan portfolio of the banking sector by NACE, identifying the credit exposures for the most sensitive economic sectors. Furthermore, the geographical location of the exposures of the banking sector can be linked to the physical risks (hazards) that affect those locations. 67 Many European and worldwide authorities have issued a comprehensive set of principles that banks are expected to follow when managing the climate-related risks that they are exposed to. In most cases, the regulatory acts are soft instruments, instrumented as recommendations (such as the 2020 ECB Expectations of Climate-related and environmental risks or the 2020 MNB’s Recommendations on Sustainability, updated in July, 2022). Importantly, the Basel Committee on Banking Supervision have issued a similar document, outlining the key principles that banks should follow in managing these risks. 68 The documents can outline several key principles on (i) business model and strategy, (ii) governance framework, (iii) risk strategy and risk appetite, (iv) the role of the internal control functions, (v) principles for credit, operational, market and liquidity risks triggered by climate-related risks, (vi) scenario analysis and stress testing and (vii) data issues. 69 European supervisors are actively working towards ensuring the integration of the risks towards the ordinary supervisory framework. For example, supervisors should work on the integration of the assessment of climate risks into the supervisory rating. For example, supervisors are complementing the assessment of banks’ internal governance and risk management, credit risk, or business model by introducing in their methodologies questions and dimensions that are directly related to sustainability. Moreover, supervisors should identify in their supervisory planning process the climate-related issues as an emerging priority and define specific actions to fully ensure the focus on them. 70 For example, after being published in a draft version (2019), the ECB Expectations were approved in the last quarter of 2020. In 2021, banks were requested to engage in self-assessments and to submit credible remediation plans. 10. Spotlight: Greening the Western Balkan Financial Sector 61 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Table 10.2. Western Balkan commercial banks: Conclusions of the questionnaire/survey to the commercial banks regarding climate and environment risks. 1 Banks exhibit an uneven level of progress in the management of climate risks 2 The first contact by banks with green finance has been broadly provided by the engagement with International Financial Institutions 3 Foreign-owned banks, especially those included in EU banking groups, are benefitting from the group expertise by starting the implementation of the group corporate policies 4 Some banks have been making progress towards the development of green products, both for corporates and individuals. Typically, these green loans are provided to improve the energy efficiency of buildings 5 The implementation of sustainability into the bank’s risk culture is uneven, with some banks already starting to promote mandatory training programs, updating their codes of conduct to consider aspects related to sustainability. Some banks have also identified their own targets for addressing their own footprint 6 Banks are making very preliminary steps to integrate climate-related risks into credit risk appetite. Typically, banks define “exclusion lists” by enumerating the economic activities that are considered unsustainable by the bank and therefore banks are unwilling to fund. Banks mostly identify coal-related activities 7 Some banks have started to allocate the roles and responsibilities on sustainability and, more concretely, on the management of climate related risks throughout the organization, although the practices are still at a nascent stage. Some banks have explicitly allocated responsibilities in one specific area and provide the supervisory board and management with specific information on climate risks 8 In some banks, the risk management function is actively involved in assessing climate risks, particularly for the corporate clients. Some banks are planning to have their internal audit units involved in assessing climate-related risks. No banks report any involvement by the compliance monitoring units in sustainability. 9 A small proportion of banks have already begun to integrate sustainability into their credit risk underwriting decisions, by requesting from their borrowers specific information on their sustainability when assessing the solvency of their corporate clients when making their credit risk underwriting decisions. Most banks are not ready to start embedding climate risks into their credit risk management framework 10 Banks do not have a process for systematically collecting client data for assessing their carbon footprint (i.e., GHG emissions, alignment plans with the NDC and the Paris Agreement, etc.) 11 Most banks have made progress in integrating the climate risks into the operational risk management framework, mainly to the consideration and, where applicable, insurance coverage of the most relevant physical risks that they are exposed to 12 No banks have made any relevant progress on integrating climate-related risks in market and liquidity risks. No banks have reported to have conducted any stress test or scenario analysis 13 No bank has reported the issuance of any green bond to the market. Source: World Bank FinSAC. should also be aware of the limitation faced by further supervisory steps can be taken to banks when addressing the recommendations, ensure risks are transparent and mitigated. such as data availability, lack of developed Authorities may consider the possibility of methodologies or the country’s legal gaps including rule-based requirements like the (i.e., lack of green taxonomy, of disclosures forced implementation of Pillar 3 prudential on sustainability, labelling system for building disclosures related to sustainability71 or credit energy efficiency, etc.). risk underwriting rules to force banks to assess the sustainability of the activities of a client After banks have made significant advances before any lending decision. on the management of climate risks, 71 For example, by introducing the new European requirements on prudential sustainability disclosures, that involve specific rules on publishing data on ESG risk management practices, on the exposure to transition risks, on the physical risks that the bank is exposed to, etc. 62 10. Spotlight: Greening the Western Balkan Financial Sector BEYOND THE CRISES Supervisory bottom-up stress testing should loans and investments. Regulatory authorities only come once banks and authorities have are reluctant to introduce such factors in the made significant progress in addressing absence of evidence of “green risk differentials,” climate risks. These exercises require according to which green assets are assessed to significant data gathering capabilities, and the be less risky than non-green assets. Therefore, development of sophisticated methodologies to the inclusion of capital requirements should project long-term climate scenarios. As they are only happen at a very late stage (Figure 10.3). likely to demand significant efforts by both the banking sector and the authorities, they should Authorities, and especially central banks, only come as the climate risk management can complement their approach with other practices have been properly anchored in the activities. Central banks should steer their country’s banking system72, especially for research and macro analysis departments to micro-prudential bottom-up exercises. prepare risk assessments on sustainability, such as the assessment of climate data sources or the Decisions such as setting up climate- analysis of the “green factor”, or the existence sensitive capital requirements can be made at of a certain risk differential73 across different a later stage. The current international debate portfolios. Finally, authorities can lead with over the imposition of capital requirements their own example by creating a sustainability is currently at its inception. Supervisors and culture across their organization by setting policymakers are debating the possibility of specific targets for emission reductions, actions introducing green supporting factors that that promote the circular economy, etc.74 can reduce the capital requirements for green Figure 10.3. Overview of specific actions for regulating and supervising climate-related and environmental risks. Ÿ Risk Assessment Exercises Stage 1 Ÿ Survey/questionaries to the bank sector Capacity building Ÿ Preparation of a Regulation/guidelines on management Stage 2 environmental risks Ÿ Request for strategic plans for assessing climate risks Ÿ Update of the supervisory methodologies to assess Risk analsis climate risks Stage 3 Ÿ Development of specific tools for assessing climate change risks Ÿ On-site activities for assessing climate change On-site activities Ÿ Pillar 3 reporting requirements for banks Stage 4 Ÿ Climate change stress testing Off-site monitoring Stage 5 Ÿ Setting capital requirements for climate change risks Source: World Bank FinSAC. 72 Although some top-down macroeconomic climate stress testing can be undertaken by the central bank without the intervention of banks. In this regard, and considering other relevant supervisory experience, performing bottom-up micro-prudential exercise is a much more challenging and complex exercise with requires substantial preparations and to which banks will need to undertake significant steps. 73 The green factor or the risk differential seeks to identify the impact on the sustainability of an asset in its risk profile. Many comprehensive studies have been trying to identify the existence of such differential and quantify it. 74 World Bank’s Financial Sector Advisory Center (FinSAC), based in Vienna, Austria, offers tailored expertise for the overall objective financial stability and via macroprudential frameworks and microprudential supervision and regulations. For example, FinSAC has commenced work with the Bosnia and Herzegovina financial sector authorities on designing a green finance strategy, roadmap and taxonomy regarding the management and supervision of climate-related financial risks in the financial sector for 2022-2025 and is also engaged with the Central Bank of Albania, the National Bank of the Republic of North Macedonia and, more recently, with the Central Bank of Kosovo. 10. Spotlight: Greening the Western Balkan Financial Sector 63 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 The development of green finance external reviews and enhance comparability. instruments presents an opportunity Because the corporate bond market is very for the region nascent amongst the Western Balkan financial Aside from Serbia’s sovereign green bond, sector, the governments might want to consider other Western Balkan governments could introducing incentive mechanisms to reduce explore opportunities to issue sovereign transaction costs such as external reviews on green and/or blue bonds. The development a green and blue bond/loan framework to of green finance instruments presents an stimulate green finance in the private sector. opportunity for the region in the future; however, credit to private sector is currently Western Balkan Ministries of Finance very low and non-bank financial sector is almost may want to explore options to introduce non-existent beyond sovereign bond markets. industry-level risk pooling mechanisms To this end, the government might want to for natural disaster insurance. A risk form an interdepartmental working group on pooling mechanism for natural disasters (e.g. green bonds comprising stakeholders from earthquake, flood, agriculture insurance) can be multiple ministries tasked with establishing introduced. Financial incentives could also be a governance and green bond framework and an option to promote natural disaster insurance facilitating coordination and consultation (e.g. agriculture insurance). For overall capacity among stakeholders in both government and building and knowledge exchange purposes financial markets. A sovereign green and blue beyond risk pooling mechanisms, the Coalition bond issuance could also create momentum of Finance Ministers for Climate Action could for corporate entities, including commercial be a useful initiative for the Ministry of Finance banks, to consider issuing corporate green and and Economy to join in order to learn about blue bonds. other countries’ experience and knowledge. To further mobilize private capital toward climate mitigation and adaptation, additional policy actions should be explored. Public financial authorities could cooperate with financial institutions, large companies, and market participants to develop green finance principles, standards, and guidelines for both green and blue corporate bonds and loans. With green finance expanding toward sustainability-linked instruments, robust key performance indicators for these instruments need to be developed. Financial sector regulators could also consider disclosure requirements for large corporates, establishing minimum entry requirements for private entities that provide green assessments, ratings, or verification services to ensure quality 64 10. Spotlight: Greening the Western Balkan Financial Sector Country Notes WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Albania • Following robust growth in early 2022, GDP is likely to decelerate in the remaining part of the year, as rising inflation affects real disposable income, and a slowdown in the global economy translates into tighter financing conditions and lower foreign demand. • High food and energy inflation have prompted additional government support to households and SMEs, which are already benefitting from regulated electricity prices. This adds to the fiscal pressures. • Medium-term prospects hinge on the global recovery and structural reforms, and on the launch of fiscal consolidation. • Poverty is expected to continue declining but the continuation of inflationary pressures will decelerate the recent gains. Recent Economic Developments Labor market conditions improved in early 2022. Annual employment growth accelerated Following a strong rebound in 2021, to 3.4 percent in Q1 2022, from 2.7 percent Albania’s economy expanded by 6 percent in in the previous quarter. At the same time, Q1 2022. Albania’s GDP growth rebounded unemployment fell to 11.3 percent, while to 8.5 percent in 2021, reflecting economic labor force participation increased. Business resilience following two exceptionally Surveys indicators suggest firms were expecting large shocks: the 2019 earthquake and the sustained employment growth from April to COVID-19 pandemic. Growth continued to July,2 with indicators being above historical be strong in Q1 2022; private consumption, averages. However, expected employment exports and investment expanded, as business growth started to slow down in August for and consumer confidence remained strong businesses operating in industry and services. despite increasing energy and food prices. Given the strong growth in GDP per capita Household consumption rose by 8.6 percent,1 in 2021, poverty is estimated to have dropped outpacing growth of the previous quarter. from 33 percent in 2020 to 23.1 percent in Net foreign demand contributed positively to 2021. growth as exports surged by 25.3 percent while imports increased by 17.6. After driving growth Following the war in Ukraine, inflation in 2021, gross fixed capital formation slowed to pressures that started in H2 2021 intensified. 15.5 percent (versus 16.9 percent in Q4 2021) The war in Ukraine and the sanctions imposed as government capital expenditures declined. on Russia disrupted supply chains and were On the supply side, trade and construction led reflected in surging prices of food, energy, growth in Q1 2022. Business surveys indicate and key minerals used in various industries. continued growth in the following trimesters These developments gradually affected on account of tourism, although business Albania’s inflation: the annual inflation rate confidence indicators started to decline in the rose to 7.5 percent in July 2022, the highest second half of the year. since March 2002. Food price inflation 1 All comparisons are year-on-year, unless otherwise stated. 2 The question refers to business employment expectations for the three upcoming months. 66 Albania BEYOND THE CRISES and transport inflation for the same month Credit to the private sector continued its increased at 13.2 percent and 19.7 percent, strong positive trend from 2021 for both respectively. Such increases are adversely enterprises and households. Outstanding impacting the poorest citizens given the higher credit to the private sector increased by weights these items have in the consumption 13.8 percent in Q2 2022. Non-performing basket of the poor. The exchange rate against loans stood at 5.3 percent, reflecting sound the euro appreciated by 3.7 percent in July, asset quality. However, the lending survey which restrained the transmission of imported conducted by the central bank indicates that inflation into the domestic economy. In banks have started to follow more prudent addition, regulated prices of energy for business policies for lending to enterprises in the Q2 and consumers as well as temporary controlled 2022. For the same period, total deposits grew prices for transport fuels and key food items by 10.2 percent, decelerating by 0.4 percentage have redistributed the burden of global price points from Q1 2022. The growth of foreign increases and prevented a full transmission currency deposits reflected higher service export to domestic inflation. Yet, these also had a inflows and a good performance of remittances negative fiscal impact. in Q2 2022. Persistent supply-side shocks have created The current account deficit narrowed by second round effects, raising prices of all 21.8 percent in Q1 2022as compared to the items in the consumption basket. In July same quarter in 2021, mainly driven by an 2022, core inflation stood at 7.3 percent increase in exports (by 58 percent) in particular against its long-term average of 0.8 percent tourism inflows (by 70 percent). Merchandise during 2015-2021. Inflation expectations also exports (especially minerals, metals, have started to reflect these trends: expected construction materials, energy, and crude oil), inflation for the 12 months ahead reached also recorded a high growth of 82.9 percent, 9.6 percent for businesses and 10.6 percent for largely explained by increased international consumers, the highest value recorded since prices. Imports grew by 32.1 percent, largely 2016. Longer term inflation expectations are driven by the increase in imports of goods, still anchored at below 4 percent. of minerals, energy, refined fuels, and food. Remittances increased by 9.2 percent. Total The increase in inflation expectations direct investment inflows increased by prompted a faster monetary policy 16 percent in Q1 and a double-digit increase normalization. The central bank raised its key was observed in real estate, extractive industries, policy rate by 50 basis points to 1.75 percent in energy, the financial and insurance sectors, and August, marking the third hike since the start manufacturing. The foreign exchange reserve of the war in Ukraine. As a result, government stock remained robust at the end of Q1 2022, securities yields’ have followed an upward covering 8.2 months of imports of goods and trend since March, also reflecting expectations services, or 394 percent of short-term gross for a faster normalization of monetary policy. external debt. Albania 67 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 The budget balance was positive in H1, increase inflation, disrupt supply chains, and at about 1.5 percent of GDP, reflecting, disturb financial markets; all of which could higher revenues, and cautionary spending further dim Albania’s growth prospects. In given the uncertainties ahead. Fiscal turn, a sluggish labor market combined with revenues increased by 19.2 percent in H1 diminished purchasing power could dampen 2022 on account of robust growth, increased progress on poverty reduction. inflation, formalization efforts, and higher profit tax revenues. VAT revenues contributed While the government plans to contain 10 percentage points to total growth. Revenues spending in line with fiscal consolidation from profit tax generated the second highest plans, higher costs of public service provision contribution to total growth. Investment create additional pressures on growth. Higher spending declined by 16.4 percent. In response spending may be needed to guarantee the energy to higher food prices stemming from the war supply through more costly energy imports and in Ukraine the government increased budget support to the fragile energy SOEs. Public debt allocations for support to vulnerable groups is expected to decline to 68.9 percent of GDP and increased subsidies to the energy SOEs, in 2022 from 74 percent in 2021, and more while keeping the tariffs for households and significantly over the medium term. However, SMEs unchanged. Support for the energy the fiscal balance could further deteriorate in sector since January to June reached 7.9 billion a worsening international context, forcing the Albanian leks, out of the 28 billion Albanian government to cut public spending to prevent a leks planned for the year. hike in the debt-to-GDP ratio. Given Albania’s growing reliance on external financing, interest rate and refinancing risks remain elevated. Outlook and Risks Contingent liabilities in the form of guarantees to cover energy purchases also represent a Growth for the current year is expected to significant risk. decelerate towards the fourth quarter of the year, despite the strong performance in Regarding the external account, services the first quarter. Sustained price increases are exports, including tourism and fast- likely to lead to a decline in domestic private expanding business-process operations, demand while the government contribution should gradually recover. Following a is expected to be affected through the post- reduction of the trade deficit on the first earthquake reconstruction program winding quarter, the current account deficit is expected down. Foreign demand is likely to decelerate to slightly expand for the year 2022 reaching affecting net exports contributions. 7.9 percent of GDP on account of lower remittances and incomes. The current account The baseline scenario projects economic deficit is expected to reach 7.7 percent of activity to expand at an average of 2.7 percent GDP in 2024, reflecting high demand for over 2024 following global conditions infrastructure-related imports. and persistent supply side shocks. This is below the pre-earthquake historical rate. Enduring geopolitical tensions could further 68 Albania BEYOND THE CRISES In the medium term, private consumption is projected to return as a key driver of growth. Private investment could provide further support to growth if business climate reforms are implemented. After a significant reduction in 2021, poverty is expected to continue declining in 2022, but persistent inflationary pressures could lead to smaller declines in the future or to reversals of past gains. Albania 69 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Growth continued to expand in early 2022, Labor markets improved. and surveys signal a slowing down in Q2 and Q3. Economic Sentiment Index (lhs) and GDP growth (rhs) Percent 120 20 63 14.0 15 61 13.5 100 59 13.0 10 80 57 12.5 5 55 60 12.0 0 53 40 11.5 -5 51 49 11.0 20 -10 47 10.5 0 -15 10.0 45 7 17 8 19 19 20 20 21 22 22 -1 l-1 c- n- b- p- 7 8 8 9 9 0 0 1 1 2 g- n- r- v- ay -2 -2 -1 -2 -1 -1 -1 -1 -2 -2 Ju De Ap Au Ju No Fe Se Ja Q3 Q1 Q3 Q1 Q3 M Q1 Q3 Q1 Q1 Q3 ▬ GDP growth (rhs) ▬ Economic Sentiment Index (lhs) ▬ Labor force participation rate ▬ Employment rate ▬ Unemployment rate (rhs) Source: INSTAT and Bank of Albania. Sources: INSTAT. Fiscal revenues grew strongly largely The current account deficit narrowed in Q1 reflecting high transaction prices and 2022. formalization efforts. Contribution in total annual revenue growth EUR million 50 7 7 8 8 9 9 0 0 1 Q1 1 2 -2 -2 -1 -1 -2 -1 -1 -1 -1 -2 -2 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 40 0 30 -100 20 -200 10 0 -300 -10 -400 -20 -500 -30 7 7 8 8 9 9 0 0 1 1 2 -2 -2 -1 -1 -2 -1 -1 -1 -1 -2 -2 -600 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q1 Q3 J VAT J Tax revenues, excl. VAT J Grants + non-tax revenues ▬ Revenues, annual change Source: Ministry of Finance. Source: Bank of Albania. Credit to the economy has supported Headline and core inflation have growth. accelerated since April. Percent change, yoy Percent, y-o-y 12 4 10 3 8 2 6 4 1 2 0 0 -1 -2 -4 -2 Ju -13 Ja l-13 Ju -14 Ja l-14 Ju -15 Ja l-15 Ju -16 Ja -16 Ju -17 Ja l-17 Ju -18 Ja l-18 Ju -19 Ja l-19 Ju -20 Ja -20 Ju -21 Ja l-21 Ju -22 2 16 6 17 Ja 7 18 Ja 8 19 Ja 9 20 Ja 0 21 Ja 1 22 l-2 l-1 l-2 l-1 l-1 l-1 l-2 n- n- n- n- n- n- n- n n n n n n n l n n n l Ju Ju Ju Ju Ju Ju Ja Ja Ja ▬ Inflation (CPI) ▬ Core inflation Source: Bank of Albania. Source: Bank of Albania. 70 Albania BEYOND THE CRISES ALBANIA Selected Economic Indicators 2019 2020 2021 2022e 2023f 2024f Real GDP growth (percent) 2.2 -3.5 8.5 3.2 2.3 2.5 Composition (percentage points): Consumption 2.5 -2.6 4.5 1.6 1.6 1.9 Investment -0.9 -0.9 4.8 1.0 0.0 0.0 Net exports 0.6 0.0 -0.9 0.5 0.7 0.6 Exports 2.0 -9.4 11.5 2.2 2.0 2.0 Imports (-) 1.4 -9.3 12.4 1.7 1.3 1.4 Consumer price inflation (percent, period average) 1.4 1.6 2.6 6.7 4.0 3.5 Public revenues (percent of GDP) 27.2 25.9 27.0 26.8 27.4 27.6 Public expenditures (percent of GDP) 29.2 32.6 31.6 30.7 32.1 31.4 Of which: Wage bill (percent of GDP) 4.6 4.7 4.4 4.1 4.4 4.4 Social benefits (percent of GDP) 11.9 12.7 11.8 10.4 10.8 10.8 Capital expenditures (percent of GDP) 4.5 6.2 6.8 5.1 4.7 4.0 Fiscal balance (percent of GDP) -1.9 -6.7 -4.5 -3.8 -4.6 -3.8 Primary fiscal balance (percent of GDP) 0.1 -4.6 -2.6 -1.3 -1.1 0.0 Public debt (percent of GDP) 63.7 74.0 72.1 67.0 65.5 65.0 Public and publicly guaranteed debt (percent of GDP) 67.4 75.9 74.0 68.9 67.4 66.9 Of which: External (percent of GDP) 29.1 35.3 36.1 31.8 30.6 29.7 Goods exports (percent of GDP) 6.6 6.0 8.2 10.2 9.8 9.7 Goods imports (percent of GDP) 29.7 28.4 33.0 36.6 35.1 34.5 Net services exports (percent of GDP) 9.3 8.1 11.5 14.8 14.0 13.8 Trade balance (percent of GDP) -13.8 -14.3 -13.3 -11.6 -11.3 -11.0 Net remittance inflows (percent of GDP) 5.2 5.1 4.9 4.7 4.4 4.4 Current account balance (percent of GDP) -8.0 -8.5 -7.7 -7.9 -8.1 -7.7 Net foreign direct investment inflows (percent of GDP) 7.6 6.7 6.4 6.3 6.4 6.4 External debt (percent of GDP) 60.0 60.5 62.7 55.5 51.6 49.3 Real private credit growth (percent, period average) 1.5 5.2 5.5 — — — Nonperforming loans (percent of gross loans, end of period) 8.4 8.1 5.7 — — — Unemployment rate (percent, period average) 11.5 11.7 11.5 — — — Youth unemployment rate (percent, period average) 21.5 20.9 20.9 — — — Labor force participation rate (percent, period average) 60.4 59.5 59.8 — — — GDP per capita, PPP (current international $) 15,393 14,888 16,183 16,733 17,118 17,546 Poverty rate (percent of population) 29.6 33.0 23.1 20.4 17.8 15.5 Sources: Country authorities, World Bank staff estimates and projections. Note: Youth unemployment rate is for labor force aged 15–29. Statistical discrepancy contribution is divided at the ratio of 80 percent and 20 percent between Consumption and Investment respectively. Change in inventories is included in Investments. e= estimate; f = forecast; — = not available. Albania 71 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Bosnia and Herzegovina • Robust economic activity continued in the first half of 2022. Nevertheless, employment improved only marginally; unemployment remains elevated and is especially high among youths. • Headline inflation accelerated fueled by food and transport prices, raising inflation to 12 percent by July 2022. Fiscal revenues benefited from strong growth and inflation, with the deficit expected to reach 1 percent of GDP in 2022, on election year. • Real output growth is expected to decelerate in the second half of 2022 as private consumption slows due to the erosion of real disposable income caused by high inflation, and a deterioration in net exports. • Elections took place on October 2, 2022, potentially setting the scene for a return to much- needed and delayed structural reforms to boost potential growth in the medium term. Recent Economic Developments Price increases accelerated in the first half of 2022, with a disproportionate impact on the Growth in the first half of 2022 remained poor. In July 2022, headline inflation surged robust at 5.9 percent and was buoyed to 16.7 percent, which elevated inflation to by strong investment and higher private over 12 percent during January–July 2022 consumption. Domestic demand grew at a due to soaring food and transport prices. Food rate of 5.5 percent, while negative net exports prices continued rising to 25.5 percent in July, decelerated somewhat compared to the first half resulting in a food inflation rate of 19.3 percent of the previous year. Domestic demand surged during January–July 2022. In parallel, transport on the back of a boost in investment supported prices accelerated to over 26 percent during the by infrastructure works and higher private same period as, for example, the price of diesel consumption. The latter was driven by rising fuel grew 52 percent between January and nominal net wages totaling 10.7 percent in the July, with spillover effects to other products, first half of 20221 (or a decline of 0.7 percent bolstering inflationary pressures during the first in real terms) and higher remittances, which half of 2022. The sharp increase in food and expanded by 2.6 percent, in real terms. On the transport prices places disproportionate stress production side, industrial production slowed on lower-income groups and generates risks for to 3.1 percent during the period January poverty reduction in 2022. to July 2022, from 11.6 percent the year before. Meanwhile exports grew a remarkable Labor market conditions improved, 20.5 percent in H1 2022, outpacing imports, especially for women, but the unemployment which grew 18.5 percent. This resulted in rate remains elevated. The labor market a compression of the net foreign deficit by tightened somewhat, with the employment rate 1.2 percentage points of GDP to 2.1 percent of increasing to 40.1 percent in Q1 2022 from GDP in H1 2022. 38.4 percent a year ago, despite the concomitant rise in the labor force participation rate. This means that 42,000 individuals found work in 1 All comparisons are year-on-year, unless otherwise stated. 72 Bosnia and Herzegovina BEYOND THE CRISES Q1 2022, more than two-thirds of whom were in the same period a year ago, in part due to women. High unemployment, nevertheless, an increase in net travel receipts of 1.1 percent persists at 16.7 percent.2 of GDP in 2022. The primary and secondary income accounts remained broadly unchanged Fiscal data were revised, substantially in H1 2022 at around 9.5 percent of GDP, increasing the consolidated fiscal deficit helping keep the external balance in check, in 2020. The latest consolidated data suggest with remittance inflows just below 8 percent a consolidated fiscal deficit of 5.3 percent of of GDP. Net FDI inflows covered roughly GDP in 2020 and only 0.3 percent in 2021, one-third of the external deficit in the H1 up from the previously published deficit of 2022, nominally the smallest amount since 1.8 percent of GDP and a surplus of 0.5 percent 2016. Foreign borrowing by the government in 2021. In 2022, stronger tax revenues and private sector, together with a drawdown supported by high inflation were more than on reserves, more than offset net portfolio offset by higher spending, which is expected outflows and helped finance the remainder of to result in a fiscal deficit of 0.9 percent of the borrowing requirement. GDP in 2022.3 Expenditures in 2022 are mainly driven by social measures softening the In 2022, the external deficit is projected inflationary impact on households, which are to widen to 3.1 percent of GDP from estimated to result in social benefits expanding 2.6 percent the year before. It is expected that 3.4 percentage points to 18.7 percent of GDP the merchandise trade deficit will increase to in 2022. Higher expenditures also reflect pre- 25.1 percent of GDP for the year as a whole. election spending, including wage hikes and Meanwhile, services inflows should improve sizable growth in capital expenditures. Public significantly to 12.5 percent of GDP, in part debt hovers around 35 percent of GDP. based on the doubling of overnight stays during January–July this year. At the same time, Despite the deceleration in merchandise remittances are set to disappoint somewhat as imports, the current account deficit widened net inflows are set to remain below 8 percent sharply to 4.8 percent of GDP in the first of GDP in 2022. The resulting net borrowing half of 2022, from 2.8 percent of GDP in H1 requirement is largely going to be financed by 2021. Adjusted for the capital account inflows net FDI inflows of about 69 percent of CAD, of 0.7 percent of GDP, the external financing which are expected to pick up during the requirement amounted to 4.1 percent of GDP remainder of the year, and external borrowing in the first half of 2022, two times larger than a by the government and private sector, year ago. Adverse terms of trade developments, supporting a mild buildup in foreign exchange among others, caused the sharp increase in the reserves by the end of 2022. merchandise deficit by 48 percent in H1 2022 in nominal terms, or a widening of 4.6 percentage The banking sector is well capitalized, and its points, in GDP terms. Nevertheless, the deficit profitability has further improved in 2022. in goods and services narrowed to 14.3 percent Asset quality has further improved compared of GDP, which is 2.2 percent of GDP less than to the previous years and pre-pandemic 2 The methodology of the Labor Force Survey was changed in 2021, which makes direct comparisons between 2021 and 2020 data difficult. 3 BiH draft Global Fiscal Framework for 2022–2024 and World Bank staff estimates. Bosnia and Herzegovina 73 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 period, with nonperforming loans to total current account deficit to over 5.3 percent of loans declining to 5.2 percent at the end of GDP in 2023 and just below 4.5 percent of Q2 2022 from 5.7 percent in same period last GDP in 2024, despite a shift to fiscal surpluses year and 8 percent in 2019. Capital adequacy, over the medium term. As general elections are meanwhile, remains robust compared to last completed, fiscal policy is expected to result year as the Tier 1 capital ratio is steady at in a balanced budget in 2023 and a fiscal around 18.6 percent. The profitability of the surplus of close to 1 percent in 2024. Public banking sector has improved given the rise debt is, nevertheless, expected to hover around in the net interest income to gross income to 35 percent of GDP due to the rollover of 56.6 percent in Q3 2022 from 53 percent last amortization payments coming due. Following year, and a modestly higher return on equity the elections, the attention of policy makers by 1.6 percentage points to 11.8 percent could turn to the structural reform agenda for compared to last year. Lastly, foreign currency EU accession. risk exposure has been reduced, with the share of indexed and foreign currency loans declining Considering energy market disruptions from 6.9 percentage points to 45.7 percent compare the war in Ukraine, inflationary pressures to last year’s outcomes. are now assumed to last longer than initially expected. Hence, inflation is projected at 11 percent in 2022, stabilizing in 2023–24 Outlook and Risks at rates seen prior to the pandemic, at around 2 percent and lower. Phased out pre-election Real output growth is expected to decelerate spending and one-off expenditures in response to 4 percent in 2022 as private consumption to the price shock will be in part offset by slows due to the erosion of disposable income higher interest payments. However, a return to because of high inflation, and a deterioration fiscal surpluses is expected by 2024. in net exports significantly softening the rise in aggregate demand. By 2024, real output Downside risks dominate the outlook. growth is projected to reach 3.2 percent driven Protracted effects of the war in Ukraine largely by a pickup in private consumption could have a negative impact on aggregate supported by remittances and a tightening demand through depressed consumer and labor market. Investment in energy and business confidence. Furthermore, war-related infrastructure (such as windmills and Corridor uncertainties and sanctions can dampen the Vc4) will add to the growth stimulus over the recovery in the EU, adversely impacting medium term, although not to the same extent demand for BiH exports, except for energy. as in 2021 and 2022. Adverse labor market developments across the EU could also limit remittance inflows, Strong exports are likely to be offset by which support private consumption. Finally, higher imports in part for infrastructure geopolitical risks could further aggravate projects, keeping the trade balance to domestic political frictions, with adverse around 25 percent of GDP over the next consequences for the much-needed structural two years. This, in turn, is likely to widen the reform push. 4 Corridor Vc is a major north-south transit road between the countries of the region through Bosnia and Herzegovina. 74 Bosnia and Herzegovina BEYOND THE CRISES GDP growth slowed in 2022. Yet, postcrisis growth trajectory is unlikely to close the gap with respect to the precrisis growth path. Contributions to growth, percentage points of GDP In 2015, thousand KM 8 37 36 6 35 4 34 33 2 32 0 31 30 -2 29 -4 28 2019 2020 2021e 2022f 2023f 2024f 2016 2017 2018 2019 2020 2021 2022 2023 J Agriculture J Industry J Services Q GDP growth ▬ GDP pre-pandemic … GDP post-pandemic Sources: BiH Agency for Statistics; World Bank. Source: World Bank staff estimates. Note: e = estimate; f = forecast. Consumer price and food inflation surged ...and despite higher revenues due to to double digits in 2022... inflation, the fiscal deficit widened in 2022, an election year. Percent y-o-y General government fiscal balance, percent of GDP 16 3 2 12 1 0 8 -1 4 -2 -3 0 -4 -5 -4 -6 17 18 18 19 19 20 20 21 21 22 c- n- c- n- c- n- c- n- n- c- De De De 2016 2017 2018 2019 2020 2021e 2022f De De Ju Ju Ju Ju Ju Sources: BiH Agency for Statistics; World Bank. Sources: BiH fiscal authorities; World Bank staff estimates. The merchandise trade deficit widened. Nonperforming loans in commercial bank portfolios declined steadily. Real 3-month moving average (3mma), percent y-o-y 60 0 20 50 -1 18 40 -2 16 30 -3 14 20 -4 12 10 -5 10 0 -6 8 -10 -7 6 -20 -8 4 -30 -9 2 -40 -10 0 M -18 Se 18 Ja 8 M -19 Se 19 Ja 19 M -20 Se 20 Ja 0 M -21 Se 21 Ja 21 M -22 2 -2 1 2 Q3 5 Q1 5 Q3 6 Q1 6 Q3 7 Q1 7 Q3 8 Q1 8 Q3 9 Q1 9 Q3 0 Q1 0 Q3 1 Q1 1 2 - - p- p- - p- - p- -2 ay -2 ay n -1 -1 n ay n -2 -1 -1 ay n -1 -1 -1 -1 -1 -1 -2 -2 ay n Ja Q1 ▬ Exports (lhs) ▬ Imports (lhs) ▬ Trade balance (12m sum) (rhs) J Capital adequacy (tier 1 capital to risk weighted assets) ▬ Asset quality (NPLs to total loans) ▬ Profitability (return on equity) Sources: BiH Indirect Tax Office; World Bank. Sources: BiH Central Bank; World Bank calculations. Bosnia and Herzegovina 75 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 BOSNIA AND HERZEGOVINA Selected Economic Indicators 2019 2020 2021 2022e 2023f 2024f Real GDP growth (percent) 2.8 -3.1 7.5 4.0 2.8 3.2 Composition (percentage points): Consumption — — 4.2 2.0 1.9 1.7 Investment — — 5.4 4.3 0.9 0.5 Net exports — — -2.0 -2.3 0.0 0.9 Exports — — 1.8 3.5 2.7 2.8 Imports (-) — — 3.8 5.8 2.7 1.9 Consumer price inflation (percent, period average) 0.6 -1.1 2.0 11.0 2.0 0.5 Public revenues (percent of GDP) 42.5 42.1 43.0 41.4 41.9 41.9 Public expenditures (percent of GDP) 40.6 47.4 43.3 42.3 41.8 41.1 Of which: Wage bill (percent of GDP) 10.6 11.4 10.8 10.8 11.1 10.8 Social benefits (percent of GDP) 14.8 16.1 15.3 18.7 18.5 18.6 Capital expenditures (percent of GDP) 2.9 5.2 3.7 4.1 3.4 3.0 Fiscal balance (percent of GDP) 1.9 -5.3 -0.3 -0.9 0.1 0.8 Primary fiscal balance (percent of GDP) 2.6 -4.5 0.3 -0.2 1.0 1.7 Public debt (percent of GDP) 32.8 36.6 35.4 31.9 32.7 33.8 Public and publicly guaranteed debt (percent of GDP) 34.5 38.8 37.6 33.0 34.0 35.5 Of which: External (percent of GDP) 28.4 30.8 30.8 27.4 27.8 28.3 Goods exports (percent of GDP) 28.8 27.5 34.1 40.2 41.6 42.1 Goods imports (percent of GDP) 51.4 45.9 53.3 65.3 66.7 67.2 Net services exports (percent of GDP) 7.9 4.4 6.9 12.4 10.3 11.1 Trade balance (percent of GDP) -14.7 -14.0 -12.3 -12.7 -14.8 -14.0 Net remittance inflows (percent of GDP) 8.5 7.4 8.2 7.3 7.1 7.0 Current account balance (percent of GDP) -2.9 -3.9 -2.3 -3.1 -5.3 -4.4 Net foreign direct investment inflows (percent of GDP) 1.5 1.7 2.1 2.2 2.1 2.1 External debt (percent of GDP) 65.6 70.7 65.4 57.2 55.9 54.8 Real private credit growth (percent, period average) 5.2 1.3 -0.3 — — — Nonperforming loans (percent of gross loans, end of period) 7.4 6.1 5.8 — — — Unemployment rate (percent, period average) 15.7 15.9 17.4 — — — Youth unemployment rate (percent, period average) 33.8 36.6 38.2 — — — Labor force participation rate (percent, period average) 42.1 47.7 48.0 — — — GDP per capita, PPP (current international $) 13,775 13,424 14,110 14,710 15,260 15,800 Sources: Country authorities, World Bank estimates and projections. Note: e = estimate; f = forecast; — = not available. 76 Bosnia and Herzegovina BEYOND THE CRISES Kosovo • Kosovo’s economic growth moderated in early 2022, with activity affected by broad-based price increases. Risks to the outlook remain high as the country continues to grapple with rising inflation pressures. • The price shock will inevitably continue affecting demand and economic activity in 2022, and growth is expected to moderate to 3.1 percent, mainly on account of higher real exports. • Strong tax revenue collection continues to favor the fiscal position, supported by higher inflation and tax compliance measures. The fiscal deficit is expected to reach 0.8 percent of GDP in 2022, amid significant capital underspending. • In a context of high uncertainty, maintaining buffers to respond to the changing macroeconomic environment, particularly in the context of an ongoing energy crisis, is vital. Over the medium term, it is imperative to advance structural reforms to enhance competitiveness and private sector development in support of the current export growth momentum. Recent Economic Developments performance, and key seasonal indicators on border crossings and flight travel suggest a After experiencing a stronger-than-expected positive trend of services exports. However, recovery in 2021, Kosovo’s economic growth imports surged led by a rise in commodity moderated in early 2022. Real output grew at a prices, substracting from growth. Capital record high of 10.5 percent in 2021, supported execution stood at 17 percent of the original by a rebound in domestic demand and strong plan by August, leading to a lower contribution export growth. During the first months of of investment to growth. The supply side was 2022, economic growth lost momentum, as marked by continued support from the services the spike in inflation and the energy shock sector, whereas the contribution of agriculture weighed significantly on economic activity. As and industry was modest, due among other a net importer of food and energy, Kosovo is factors to the negative impact of a double-digit particularly vulnerable to imported inflation, rise of input prices. which in the current context started eroding consumer purchasing power and private sector The labor market continues to reflect chronic competitiveness. weaknesses. Low labor force participation and employment, especially among women, is Growth in H1 2022 reached 3.2 percent, one of the key binding constraints to growth driven by domestic demand and exports. and poverty reduction. Although information Consumption, which rose 5.2 percent, was on labor markets remains limited to 2021, the main contributor to growth, supported administrative data for H1 2022 show an by credit growth, remittances inflows, and acceleration in formal employment and a crisis-related fiscal support. Exports growth— decreasing trend in registered unemployment, particularly of manufactured, plastic, and reflected in a decrease of 32 percent1 of the mineral goods—continues to record a positive number of job-seekers registered at employment 1 All comparisons are year-on-year, unless otherwise stated. All comparisons are year-on-year, unless otherwise stated. Kosovo 77 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 centers. Moreover, the labor market continues Tax revenue growth and capital to be characterized by significant gender underspending outpaced increases in current imbalances (a 44 percent employment rate for transfers by the summer of 2022. By August males and 16 percent for females) and skills 2022, higher social transfers and expenditure mismatches and labor outmigration, as firms associated with crisis-response measures and increasingly report difficulties filling vacancies. energy subsidies fueled a 17.6 percent increase in current expenditure. However, for the Crisis-induced commodity price increases same period, total tax revenue—particularly led to a persistent increase in consumer VAT collected at the border—increased by inflation in 2022. The Harmonized Index 15.4 percent and, together with a considerable of Consumer Prices reached a historic high underexecution of public investment, kept the of 13 percent in August 2022, a rise from budget balance positive to date. Yet, a new 7.1 percent in January 2022, fueled by increases package of inflation mitigation measures— in the price of food (21 percent), energy worth 1.7 percent of GDP—announced in (16.7 percent), and transport (25 percent) early September, and half of committed energy and disproportionally impacting the poor and subsidies, remain to be implemented by year most vulnerable. Import prices increased by an end. average of 21.8 percent between Q1 2021 and Q1 2022. Similarly, data from the agriculture Total public and publicly guaranteed (PPG) sector show that in Q2 2022, the price of debt remains moderate. PPG debt stood goods and services consumed in agriculture at 20.7 percent of GDP in June 2022, on a increased by 45 percent. Core inflation reached decreasing trend from 21.9 percent of GDP 4.5 percent in August, from 2.6 percent in at end-2021. The total stock of public and January, signaling a gradual increase in inflation publicly guaranteed debt consists mostly of expectations. domestic debt (65 percent of total PPG debt), and is held predominantly by the Kosovo Despite a sizable increase in exports, the Pension Savings Trust, commercial banks, and current account deficit (CAD) deteriorated the Central Bank of Kosovo. in 2022. Growth of merchandise exports reached 29.4 percent in July. In the meantime, The financial sector continues to be resilient. the value of merchandise imports grew by In July 2022, the annual change in loans 26 percent until July, whereas import volumes, was 18 percent, supporting consumption particularly for fuel, followed a declining trend and investment activity. During the same during Q2 2022, signaling weakened demand period, deposits recorded double-digit growth against the spike in prices. Remittances (10.6 percent). Bank capital buffers and asset inflows have slightly declined (-0.3 percent), quality remain adequate, with the ratio of moderating their pace of growth after a record regulatory capital on risk-weighted assets peak in 2021. In terms of financing sources, the standing at 15.8 percent and non-performing CAD was financed primarily by FDI inflows, loans remaining stable at 2.1 percent in July concentrated predominantly toward real estate 2022. and banking, and loans and trade credit to the private sector. 78 Kosovo BEYOND THE CRISES Outlook and Risks High import dependency exposes Kosovo to significant inflation risk, in a context of Growth is expected to slow to 3.1 percent rising international food and energy prices. in 2022, affected by reduced purchasing Consumer price inflation is expected to reach power and higher input costs for households a record 12.1 percent in 2022, as impaired and firms. Real exports and government supply chains and rising international prices consumption are expected to be the main of food and energy continue to add pressures drivers of economic activity. On the domestically. Upward wage pressures could production side, services—supported by higher also lead to further increase in prices. Moreover, diaspora demand, credit growth, and public high import dependence on several agricultural transfers—are expected to be the main driver products such as vegetable oils and cereals, of growth. Reflecting broad-based inflationary also exposes Kosovo to significant risks. As a pressures, private consumption and investment result of the significant rise in the import bill, are expected to provide a modest contribution the trade deficit is expected to deteriorate and, to economic growth. Investment activity, coupled with stalling diaspora remittances, particularly in the construction sector, could be could lead to a temporary deterioration of the impacted by the postponement of investment current account balance. In the medium term, projects due to rising input prices. In the the current account deficit is expected to be meantime, public investment, impaired by financed primarily by non-debt creating FDI among others factors, the inability to adjust for and external private and public lending. higher input costs in multi year contracts, is expected to subtract from growth. Over the medium term, the fiscal deficit is expected to increase and surpass 2 percent Over the medium term, the outlook of GDP by 2024, but stay within the fiscal remains highly uncertain and risks are rule limit. After a low deficit in 2022 due to skewed to the downside. Real GDP growth improved tax revenues and controlled spending, is expected to pick up and reach 4.2 percent the increase in the deficit over the medium by 2024, assuming inflationary pressures term will be driven by spending associated and associated uncertainties subside, but the with compensation of employees amid new outlook could deteriorate further as a result legislation on public wages, a rise in transfers of the continuation of the energy crisis and and a gradual pick up in capital investment. rising inflationary pressures. Higher energy Public debt is expected to reach 23 percent of consumption during the winter months and GDP over the medium term, remaining below rising energy costs could add further pressure to the 40 percent legal debt ceiling. both the import bill, as the outdated domestic capacity is unable to cover the country’s While financial sector deepening continues, needs, and the fiscal balance. Rising inflation financing costs are expected to rise in light in the European Union could also erode the of tighter financial conditions in Europe income of the diaspora residing abroad, with a and rising inflation. This is increasing the detrimental impact on remittances inflows and vulnerability of sectors that have been highly construction-related investment. exposed, such as construction, which may lead Kosovo 79 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 to a rise in nonperforming loans. Credit growth is expected to continue over the medium term, supporting consumption and investment. The post-pandemic recovery has stressed the need to address key structural bottlenecks to enhance competitiveness and sustain inclusive growth over the medium term. Moreover, in the current context of high uncertainty maintaining adequate fiscal buffers to respond to the changing macroeconomic environment is key. Over the medium-term, advancing structural reforms is essential. Priority reforms should focus on increasing productivity growth and boosting competition; enhancing human capital development and closing the infrastructure gap. 80 Kosovo BEYOND THE CRISES Growth in 2022 will moderate. Export growth momentum continues. Contributions to growth, percentage points Exports of goods as a percent of GDP 12 2022 9 2021 6 2020 2019 3 2018 0 2017 -3 2016 2015 -6 2019 2020 2021 2022e 2023f 2024f 0 2 4 6 8 10 12 J Consumption J Investment J Net exports ▬ Growth Sources: Kosovo Statistics Agency; World Bank staff calculations. Source: Central Bank of Kosovo; World Bank staff calculations. Higher revenue collection and capital Inflationary pressures increased in 2022. underspending will offset a continued increase in current spending. Percent of GDP 2015=100 35 8 135 30 6 130 4 25 125 2 20 120 -0.8 0 -1.3 15 -2.9 -2 115 -4 110 10 -6 105 5 -7.6 -8 100 0 -10 Ap 19 Ju 9 Oc 19 Ja 19 Ap 20 Ju 0 Oc 0 Ja 0 Ap 21 Ju 1 Oc 21 Ja 21 Ap 22 Ju 2 2 2 2 l-2 1 2 l-2 2 n- l- n- r- l- t- r- t- n- r- n- r- t- 2019 2020 2021 2022e Ja J Public revenues J Public expenditure J Capital expenditure ▬ Total HICP ▬ HICP: Food and non-alcoholic beverages J Current expenditure ▬ Budget deficit (rhs) Sources: Ministry of Finance; World Bank staff calculations. Source: Kosovo Statistics Agency. After their 2021 peak, remittances have Financial sector performance remains plateaued. sound. Monthly remittance inflows, in million euros Key financial soundness indicators, in percent 120 45 40 100 35 80 30 25 60 20 40 15 10 20 5 0 0 19 9 19 M 0 0 20 M 1 1 21 M 2 2 Ju -18 Se -18 De -18 M -18 Ju -19 Se -19 De -19 M c-19 Ju -20 Se -20 De -20 M -20 Ju -21 Se -21 De -21 M c-21 Ju -22 22 2 -2 2 -2 -1 2 -2 n- p- n- p- n- n- n- p- ay ay ay ar n p c ar n p ar n p ay ar c ar n p Se Ja Se Ja Ja Se Ja M M ▬ Total remittance inflow ▬ Banking channel ▬ Capital adequacy ratio ▬ Liquidity ratio ▬ NPLs (eop) ▬ Money transfer operators ▬ Other channels Source: Central Bank of Kosovo. Source: Central Bank of Kosovo. Kosovo 81 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 KOSOVO Selected Economic Indicators 2019 2020 2021 2022e 2023f 2024f Real GDP growth (percent) 4.8 -5.3 10.5 3.1 3.7 4.2 Composition (percentage points): Consumption 6.2 2.2 8.0 0.8 2.2 2.9 Investment -1.1 -2.4 3.7 -0.8 2.6 1.9 Net exports -0.3 -5.1 -1.3 3.1 -1.2 -0.6 Exports 2.2 -8.4 16.9 4.0 2.3 3.1 Imports (-) 2.5 -3.3 18.1 0.9 3.4 3.7 Consumer price inflation (percent, period average) 2.7 0.2 3.4 12.1 4.0 3.0 Public revenues (percent of GDP) 26.8 25.4 27.9 29.3 28.9 29.0 Public expenditures (percent of GDP) 29.7 33.0 29.3 30.1 30.6 31.2 Of which: Wage bill (percent of GDP) 8.7 9.8 8.5 8.0 8.6 8.4 Social benefits (percent of GDP) 6.3 7.7 7.4 7.2 6.5 6.2 Capital expenditures (percent of GDP) 7.5 5.6 5.4 3.8 5.6 6.3 Fiscal balance (percent of GDP) -2.9 -7.6 -1.3 -0.8 -1.6 -2.1 Primary fiscal balance (percent of GDP) -2.6 -7.2 -0.9 -0.4 -1.1 -1.6 Public debt (percent of GDP) 17.0 22.0 21.5 20.9 21.9 23.2 Public and publicly guaranteed debt (percent of GDP) 17.6 22.4 21.9 21.2 22.1 23.4 Of which: External (percent of GDP) 5.8 7.8 7.4 7.1 7.2 7.7 Goods exports (percent of GDP) 5.6 7.0 9.3 10.7 11.3 11.4 Goods imports (percent of GDP) 45.8 45.1 53.4 58.9 58.3 57.8 Net services exports (percent of GDP) 13.1 5.8 13.4 15.5 11.8 11.2 Trade balance (percent of GDP) -27.1 -32.3 -30.7 -32.7 -35.2 -35.2 Net remittance inflows (percent of GDP) 11.6 13.8 13.9 12.9 13.4 13.6 Current account balance (percent of GDP) -5.6 -7.0 -8.3 -11.3 -13.1 -12.3 Net foreign direct investment inflows (percent of GDP) 2.7 4.2 3.9 3.7 4.9 5.0 External debt (percent of GDP) 31.2 37.2 37.3 — — — Real private credit growth (percent, period average) 7.8 7.6 7.5 — — — Nonperforming loans (percent of gross loans, end of period) 1.9 2.5 2.3 — — — Unemployment rate (percent, period average) 25.7 25.9 — — — — Youth unemployment rate (percent, period average) 49.4 49.4 — — — — Labor force participation rate (percent, period average) 40.5 38.3 — — — — GDP per capita (US$) 4,433 4,295 5,209 5,212 5,381 5,706 Poverty rate (percent of population) 28.9 32.4 26.4 25.0 23.3 21.6 Sources: Country authorities; World Bank staff estimates and projections. Note: Poverty rate calculations based on ECAPOV harmonization using Household Budget Survey (HBS) data. Nowcasted/projected values start at 2018. Income measures in the SILC and consumption measures in the HBS are not strictly comparable. Poverty is defined as living on less than US$6.85/day per person in revised 2017 PPP. e= estimate; f = forecast; — = not available. 82 Kosovo BEYOND THE CRISES Montenegro • While still recovering from the pandemic, the economy is facing renewed headwinds. • Growth remains very strong, estimated at 6.9 percent in 2022, led by private consumption and a tourism recovery. • Inflation surged to new highs, but its adverse impact on the cost of living was largely mitigated by an increase in real disposable income. • The fiscal deficit is estimated to widen to 4.9 percent of GDP in 2022, due to the forgone revenues of the recent tax reform and increased social spending. • High public debt and the deteriorating global environment require near-term fiscal consolidation. Recent Economic Developments of stays in July alone reaching their 2019 level. Tourism in turn supported retail trade, Private consumption is driving growth. which expanded by 16 percent in real terms GDP growth was remarkably strong in the through July. However, in the same period, first half of 2022 at 10.3 percent,1 driven by industrial production declined by 3.6 percent, surging private consumption, underpinned by as unfavorable hydrological conditions affected increases in real disposable income, household electricity generation. Similarly, construction credit, employment, and remittances. Private declined by 3 percent,3 but an increase in the consumption, further supported by a stronger- number of building permits issued points to than-expected tourism season, is expected to a likely resumption of construction activity in lead growth in 2022, which is estimated to the near term. reach 6.9 percent. Despite a decline in the number of Russian and Ukrainian tourists, The labor market shows continuous tourism continued recovering in 2022, improvement. Labor Force Survey data reveal boosting exports. However, an increase in a 30 percent increase in employment in Q2 imports alongside stronger domestic demand is 2022, which equally benefited male and female expected to turn net exports negative for the employees. The activity rate rose to 59.5 percent year. Government consumption is projected to in Q2 from 46.8 percent a year ago, while in support growth, while investment is estimated the same period the unemployment rate fell to to grow only marginally, still affected by higher 14.6 percent from 17.1 percent in Q2 2022. costs of materials, supply-chain disruptions, The administrative data show record-high and completion of a first section of highway. employment in July of 235,343 employees, exceeding the July 2019 employment by Reviving tourism is stimulating economic 9.4 percent, with all sectors but public activity. In the first seven months of the year, administration registering double-digit growth the number of international tourist overnight rates. The registered unemployment rate fell to stays in accommodation facilities2 reached 16 percent in July 2022 from 22 percent in July 93 percent of the 2019 level, with the number 2021. In the first seven months, the average net 1 All comparisons are year-on-year, unless otherwise stated. 2 Accommodation facilities include hotels, holiday facilities, boarding houses, tourist resorts, hostels, and motels. High-frequency private accommodation data are not available. 3 Measured as the number of effective hours worked on construction sites. Montenegro 83 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 monthly wage increased by 21 percent in real External imbalances are expected to widen terms, due to the reduction in labor taxes and from their 18-year low in 2021. In the first an increase in the minimum wage. half of 2022, exports of goods and services grew by 72 percent, based on equally strong Inflation has been galloping in 2022. Global performance on both goods and services. inflationary pressures and higher wages have Transport and tourism services led service been driving a surge in prices. In the first eight export growth, while exports of electricity months, inflation averaged 11 percent, peaking and metals, benefiting from higher prices, in August at 15 percent. Most of the inflation supported merchandise exports. In the first is explained by increases in the price of food seven months of 2022, Montenegro exported and non-alcoholic beverages (19.4 percent) and 62 percent more in value of electricity and fuel (30.5 percent). The cost-of-living crisis has metals than in all of last year. Owing to higher been largely mitigated so far by an increase in demand, import growth was also strong, real disposable income through the tax reform, expanding by 52 percent by June. Net primary which resulted in an increase in the net average and secondary incomes strengthened, primarily monthly wage of 21 percent in real terms in due to strong net remittances, which increased the first seven months. The tax reform reduced by 23 percent. Net FDI increased by 73 percent labor taxes from a flat 39 percent of total labor in the same period and financed more than half cost to an average of 22 percent.4 of the current account deficit. In July 2022, international reserves stood at €1.7 billion, The financial sector is well capitalized covering seven months of merchandise imports. and liquid. In July 2022, outstanding loans were up by 4.4 percent, driven by lending Lower revenues as a share of GDP and higher to the private sector and households. At the social spending are estimated to widen the same time, deposits were up by 20.4 percent, fiscal deficit to 4.9 percent of GDP. Total similarly led by increases in the private sector revenues as a share of GDP are projected to and households, but also nonresidents. As a drop from 44.4 percent of GDP in 2021 to result, the loan-to-deposits ratio declined to 40 percent in 2022. There was a solid increase 77 percent, its lowest level ever. In the first in VAT and excise collection in the first eight seven months of 2022, new loans surged by months of 2022 despite the reduced VAT rate 37 percent, outpacing new lending in the of 7 percent for the hospitality industry and same period in 2019. The June average capital a 50 percent reduction of the excise on fuel adequacy ratio was a healthy 18.9 percent, as a cost-of-living mitigation measure. But well above the regulatory minimum, while revenues from social security contributions nonperforming loans increased to 6.9 percent and the personal income tax declined as part of total loans from 6.3 percent in June last of the government’s tax reform that removed year. Overall, the financial sector seems to be healthcare contributions, which was planned to in a good position, though at a time of high be financed by progressive income taxation and economic uncertainty and vulnerabilities to higher excises. At the same time, expenditures global shocks, added vigilance on the side of increased, led by higher social and capital bank supervision is warranted. spending. In December 2021, the Parliament 4 The labor tax wedge starts at 20 percent for the minimum wage and slowly increases with the rise of income. 84 Montenegro BEYOND THE CRISES increased minimum pensions by 36 percent, The current account deficit is projected to followed by another increase of 10 percent to be decline gradually until 2024. While higher implemented in September. These adjustments, energy prices are disproportionally affecting without complementary reform measures, are the poor, they are also supporting a reduction significantly increasing the pension costs and in the trade deficit as Montenegro’s growing threatening pension system sustainability and electricity capacity is used for energy exports. equity. The Ministry of Finance has prepared These, together with exports of tourism and a revision of the 2022 budget to account for transport services, are projected to support new expenditures, including pensions, higher- a reduction in the current account deficit than-planned social spending, and clearance of to 9.7 percent of GDP in 2024. Inflation is health arrears. projected to decelerate to 5.9 percent in 2023 and further to 2.6 percent in 2024 as global In August, there was a vote of no confidence in supply shortages ease. the government—the second government to collapse in 2022. The complexity and fragility The fiscal balance is expected to moderate over of the political landscape in Montenegro the medium term but will remain elevated. exacerbates already high uncertainties, slows The fiscal deficit is projected at 4 percent of the reform process, and diverts the focus GDP in 2023 and 2.7 percent of GDP in from imminent economic challenges. Prudent 2024, unless additional measures compensate fiscal policy based on continuous public debt for the decline in revenues as a share of GDP. reduction and policies to support growth are of As a result, public debt is expected to stay high critical importance in such an environment. at 73 percent of GDP. Given the tightening of global financial conditions and Montenegro’s sizable financing needs of around 9 percent of Outlook and Risks GDP per year in 2023–24, Montenegro will require careful debt management and stronger The unfavorable global economic outlook control over its expenditures. and high uncertainty are weighing on Montenegro’s recovery prospects. Growth is The outlook is clouded with multiple expected to moderate to 3.4 percent in 2023 downside risks. Prolongation of the war in and further to 3.1 percent in 2024, as private Ukraine would further amplify geopolitical consumption growth slows. The projections uncertainties and reduce growth prospects do not assume that the remaining sections of in Montenegro and its trading partners. the highway will start by 2025, as fiscal space Inflationary pressures are accelerating is limited. The projections do assume that monetary tightening, which translates into investments will be recovering, driven by the more expensive external, but also domestic energy and tourism sectors, but at a slower financing. Political instability and delays in pace, as major public investments are finalized. government formation are major domestic Tourism is expected to continue improving in risks. The severity of challenges ahead requires 2023, although deteriorating growth prospects strong political commitment and actions to in the EU and the region can slow its recovery. mitigate these risks. Montenegro 85 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 GDP growth remains strong at 6.9 percent… ...supported by continuous tourism recovery. Real GDP growth, percent International tourist overnight stays, in thousands 16 1,000 12 900 800 8 700 4 600 0 500 -4 400 300 -8 200 -12 100 -16 0 10 20 1 12 20 3 14 20 5 16 20 7 18 20 9 20 6 20 7 08 20 9 20 20 1 22 n b ar r ay n l g p t v c 1 2 1 0 1 1 1 0 0 Ju Oc Ap No De 20 Au 20 20 20 20 Fe Se Ja Ju 20 20 20 M M J 2019 J 2021 J 2022 Sources: MONSTAT data; World Bank staff calculations. Sources: MONSTAT; World Bank staff calculations. Employment reached a record high in July... ...as did inflation. Administrative data, thousands, Jan 2016–Jul 2022 Administrative data, thousands, Jan 2017–Jul 2022 250 70 16 700 60 14 600 200 12 50 500 10 150 40 400 8 30 6 300 100 4 20 200 50 2 10 0 100 0 0 -2 0 Ju 6 Ja 6 Ju 7 Ja 7 Ju 8 Ja 8 Ju 9 Ja 19 Ju 0 Ja 0 Ju 1 Ja 1 Ju 2 2 17 7 18 8 19 Ja 9 20 0 21 Ja 1 22 2 2 l-2 l-2 1 l-1 l-1 2 l-2 l-2 1 l-1 1 l-1 1 l-1 l-1 2 l-2 l-2 n- n- n- n- n- l- n- n- n- n- n- n- n- n- Ju Ju Ju Ju Ju Ju Ja Ja Ja Ja Ja ▬ Employment (lhs) ▬ Employment_tc (lhs) ▬ CPI (percent) (lhs) ▬ Real net wage (EUR 2015) (rhs) ▬ Unemployment (rhs) ▬ Unemployment_tc (rhs) Source: MONSTAT data. Source: MONSTAT data; World Bank staff calculations. Note: tc=trend cycle. Outstanding loans are also at a record high. The fiscal deficit is widening again. Outstanding loans, Jan 2012–Jul 2022, in millions 2015–22, percent of GDP 4.0 60 0 3.5 50 -2 3.0 2.5 40 -4 2.0 30 -6 1.5 1.0 20 -8 0.5 10 -10 0 Ju -12 Ja l-12 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 2 0 -12 l-2 n- n- n n n n n n n n n 2015 2016 2017 2018 2019 2020 2021 2022 Ja J Private corporate J Government J Households J Total revenues and grants J Total expenditure and net lending J Financial sector J Other ▬ Fiscal balance (rhs) Sources: Central Bank; World Bank staff calculations. Sources: Ministry of Finance; World Bank staff calculations. 86 Montenegro BEYOND THE CRISES MONTENEGRO Selected Economic Indicators 2019 2020 2021 2022e 2023f 2024f Real GDP growth (percent) 4.1 -15.3 13.0 6.9 3.4 3.1 Composition (percentage points): Consumption 2.9 -3.9 4.1 8.2 2.9 2.7 Investment 0.9 -5.9 -4.7 1.4 1.1 1.5 Net exports 0.3 -5.5 13.7 -2.7 -0.6 -1.1 Exports 2.9 -24.2 25.7 13.7 3.1 2.5 Imports (-) 2.6 -18.7 12.0 16.4 3.7 3.6 Consumer price inflation (percent, period average) 0.4 -0.3 2.4 12.3 5.9 2.6 Public revenues (percent of GDP) 43.3 44.4 44.0 40.0 39.0 38.8 Public expenditures (percent of GDP) 46.0 55.5 45.9 44.9 43.0 41.5 Of which: Wage bill (percent of GDP) 11.0 13.5 12.2 11.1 10.7 10.1 Social benefits (percent of GDP) 11.2 13.4 11.5 12.0 12.1 11.7 Capital expenditures (percent of GDP) 8.7 7.5 5.7 6.2 5.6 5.8 Fiscal balance (percent of GDP) -2.7 -11.0 -1.9 -4.9 -4.0 -2.7 Primary fiscal balance (percent of GDP) -0.5 -8.3 0.5 -3.3 -2.2 -0.6 Public debt (percent of GDP) 76.5 105.3 84.0 73.4 72.7 71.9 Public and publicly guaranteed debt (percent of GDP) 80.0 108.7 86.8 75.5 74.7 73.8 Of which: External (percent of GDP) 68.1 97.3 78.3 67.3 66.1 67.1 Goods exports (percent of GDP) 9.4 9.8 10.6 13.0 12.6 12.0 Goods imports (percent of GDP) 51.1 49.0 49.3 57.6 57.1 57.1 Net services exports (percent of GDP) 20.6 4.2 19.3 25.7 26.8 28.1 Trade and services balance (percent of GDP) -21.1 -35.0 -19.4 -18.9 -17.7 -17.0 Net remittance inflows (percent of GDP) 4.0 5.3 6.1 5.4 4.4 4.1 Current account balance (percent of GDP) -14.3 -26.1 -9.2 -10.2 -10.3 -9.7 Net foreign direct investment inflows (percent of GDP) 6.2 11.2 11.7 10.3 9.0 7.9 External debt (percent of GDP) 169.0 224.1 — — — — Real private credit growth (percent, period average) 5.5 6.4 -0.2 — — — Nonperforming loans (percent of gross loans, end of period) 5.1 5.9 6.8 — — — Unemployment rate (percent, period average) 15.1 17.9 16.6 — — — Youth unemployment rate (percent, period average) 25.2 36.0 37.1 — — — Labor force participation rate (percent, period average) 57.4 53.3 50.9 — — — GDP per capita, PPP (current international $) 23,073 19,990 22,795 26,143 28,280 29,878 Sources: Country authorities; World Bank staff estimates and projections. Note: e= estimate; f = forecast; — = not available. Montenegro 87 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 North Macedonia • As the war in Ukraine and the energy crisis dim growth prospects, inflation is racing toward an all-time high, disproportionately eroding real incomes of the poor. • With limited fiscal space, elevated public debt, and increased cost of financing, fiscal support needs to target the most vulnerable households and firms. At the same time, monetary policy tightening needs to strike a balance between containing inflation and avoiding stifling economic activity. • The output growth over the medium term is expected to moderate and downside risks remain elevated, dampening growth and lifting inflation at the same time. Disruptions related to the war in Ukraine, overstretched global supply chains, mounting inflationary and wage pressures, and the intensifying energy supply crisis continue to weigh on the outlook and the economic prospects of the country. Recent Economic Developments but tourist arrivals are still hovering below pre- pandemic levels. The beginning of 2022 saw output growth slow to below potential as the recovery With soaring imports owing partly to higher momentum of the previous year waned and energy prices, the merchandise trade deficit the energy crisis loomed. After 4 percent GDP deteriorated, further widening external growth in 2021, output increased by 2.6 percent imbalances. The current account deficit in H1 2022, driven by continued recovery worsened to 6.3 percent of GDP (on a four- in investment and robust consumption. At quarter rolling basis to June 2022), owing the same time, imports surged by 25 percent, largely to a deterioration in the trade balance leading net exports into negative territory. On as import prices surged. The merchandise the production side, growth in H1 was driven trade deficit widened to 22.8 percent of GDP, by services, as the industry struggled (owing in mainly because of the negative contribution of part to rising energy costs), and construction the energy balance, while the services surplus saw a further decline. decreased to 3.7 percent of GDP, largely due to weaker travel and manufacturing services. Recent high-frequency indicators point to Remittances declined very slightly, while net a further deceleration of growth during the FDI stood strong at 3.4 percent of GDP. summer. Industrial production recorded a At the end of Q2 2022, gross external debt weak 0.2 percent growth in August 2022, as stood at 77.4 percent of GDP, down from energy production dropped amidst a moderate 81.6 percent at end-2021, with the decline increase in mining and manufacturing. At the coming from higher nominal GDP in the same time, real retail trade growth increased denominator, lower public sector debt, amidst by 3.1 percent in August 2022, following two rising intercompany debt. months in a row of a real decline, something last observed during the Covid-19 pandemic. The labor market recovery is slow and Tourism improved as travel demand surged, fragile despite government support. After the release of the 2021 census data that revealed an 88 North Macdonia BEYOND THE CRISES approximately 9 percent decline in population decelerated. The cumulative inflation stood and a smaller labor force, the participation at 11.6 percent by August. The cost-of-living rate settled at 55.3 percent in Q2 2022, crisis unraveled, disproportionately eroding drawn down by the low female participation real incomes of the poor. Regulated heating rate that stood at 44.5 percent. At the same and electricity prices were increased, but they time, the employment rate remained below remained below market prices. To respond the pre-pandemic peak at 47.3 percent. The to the rise in consumption and to widening unemployment rate decreased to 14.5 percent,1 electricity company losses, from July, the but the youth unemployment rate remained government introduced a block tariff system by high at 30.9 percent despite active labor market progressively increasing the cost of electricity policies that target youth employment. Rising consumption across four consumption blocks economic uncertainty lowered the share of for households and it increased the tariffs fixed-term contracts to only 60 percent of all for small consumers that are supplied by the new employment contracts. universal electricity provider. Nominal net wage growth averaged 9 percent To tame inflationary expectations, the by June 2022, but domestic inflation central bank further tightened monetary outpaced wage gains, and the real net wage policy. The policy rate was increased by turned negative. Nominal wage growth 1.75 percentage points to 3 percent in five spread across all sectors. The growth for retail, rounds to early September. The stability of accommodation, and entertainment services, the pegged exchange rate was preserved with in particular, was fueled by the 18.5 percent regular FX interventions that led to a more than minimum wage hike agreed in February 2022. 20 percent loss of reserves since mid-2021, but In addition, intensified pressures from labor signs of stabilization were visible by the end unions prompted the government to agree of the summer. The banking sector remained on public sector pay increases (to align with stable despite a decline in the liquidity ratio the minimum wage increase) over the fall of to 20.5 percent. The capital adequacy ratio 2022. Relatedly, the country agreed to open increased to 17.3 percent in Q2 2022. Credit its labor market to the Open Balkan Initiative growth continued at 9.7 percent in July 2022, countries,2 which might lead to further upward led by accelerated corporate and mortgage wage pressures as workers start exploiting lending. To strengthen the resilience of the opportunities across the border. banking system, the central bank announced a countercyclical capital buffer rate of 0.5 percent Headline inflation surpassed a decades-long to be applied from August 2023. In September peak with food, energy, and core inflation 2022 the central bank increased the 7-day and all contributing to the rise. Consumer price overnight deposit rates to stimulate savings in inflation reached a 25-year high at 16.8 percent domestic currency, and it reduced the RR base in August 2022, as food and energy prices for new loans that secure financing for domestic soared, with more than 20 percent annual renewable energy production. growth, although the monthly increase 1 The 2022 data are not fully comparable to previous labor data due to the change in the Labor Force Survey (LFS) sample based on the 2021 census. 2 Albania, North Macedonia, and Serbia. North Macdonia 89 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 A revised fiscal plan for 2022 left the fiscal toll on the domestic economy. Disruptions deficit largely unchanged compared to 2021; related to the war in Ukraine, overstretched deficit reduction is now postponed to 2023. global supply chains, mounting inflationary By June 2022, the general government deficit pressures, and the intensifying energy supply stood at 1.2 percent of GDP as revenues crisis continue to weigh on the outlook. surged by 13.6 percent y-o-y, current spending As companies, including the electricity decelerated to 8 percent y-o-y, and capital production company, build stocks to prevent spending increased by 16 percent. Still, the production outages, imports are forecast to capital spending realization rate is at one-third rise substantially, further deteriorating the of the revised annual plan and will likely be current account balance. The baseline scenario rationed as the government needs resources to is built on the assumption that the impact of further support the energy sector. Continued the energy crisis and the war in Ukraine on the calls for fiscal support by households and firms domestic economy will gradually subside while led the government to allocate an additional inflationary pressures tail off over the medium- EUR76 million euros (0.6 percent of GDP) term forecast horizon. However, underlying for anti-crisis measures within the 2022 budget assumptions of the forecast are significantly revision in May. There is a plan to close the tilted to the downside, simultaneously 2022 financing gap with short-term external dampening growth and lifting inflation. borrowing, the IMF’s Precautionary and Liquidity Line, and domestic financing. The With looming stagflation risks, the country issuance of a new Eurobond has been delayed needs to start delivering on reforms that due to the high interest rate. can reinvigorate the potential growth momentum over the medium term. Policy Public and publicly guaranteed and non- efforts need to be geared toward restoring guaranteed debt dropped to 55.4 percent fiscal sustainability while building social of GDP by the end of H1 2022. Nominal and climate resilience that will reduce the public debt remained elevated compared to the country’s vulnerability to shocks and revamp pre-crisis period, but it stabilized close to the the country’s long-term growth prospects. end-2021 level. Expenditure arrears were high Specifically, the focus of the country’s reform at 3 percent of GDP on account of overdue agenda needs to be geared toward creating fiscal payments of the health sector, state enterprises, space to reduce debt (through boosting tax and local governments, limiting fiscal space for compliance, restructuring and reprioritizing crisis response going forward. spending), ensuring resilience of the financial sector, launching the green transition, and improving efficiency of public investment Outlook and Risks management. The output growth over the medium term Given limited fiscal resources, widespread is expected to moderate and downside risks state aid through direct budget transfers, remain elevated. The 2022 growth forecast temporary subsidies, and broad tax is further adjusted down to 2.1 percent as the exemptions should be revised and redirected energy and Ukraine crises continue to take a toward long-term, growth-supportive 90 North Macdonia BEYOND THE CRISES spending. Efficient social protection will be critical in this transition. The draft Tax Reform Strategy is headed in the right direction in terms of keeping the tax system attractive while at the same time removing tax exemptions to increase progressivity. And while crisis support measures narrow, the launch of new highway construction from 2023 may stretch finances in the medium term and increase public debt. At the current juncture, a rising political divide makes policy coordination and implementation increasingly difficult, including on energy, climate, and fiscal sustainability issues that are critical for economic growth. Heightened political uncertainty and a parliamentary impasse following the results of the local elections, and a removal of obstacles for opening the EU accession negotiations, may lead to delays in reforms implementation needed to boost potential growth and consolidate public finances. Moreover, lower domestic and external demand, high input costs, and liquidity shortages could lead to layoffs and increase poverty, stretching already tight public finances. Finally, tightening financial conditions may affect financing options and costs going forward. North Macdonia 91 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Economic growth slowed as new crises ...and high-frequency indicators point to a emerged... renewed slowdown ahead. Percent Trade cycle (tc) adjusted, 2011=100 15 180 220 10 160 200 5 140 180 0 120 160 -5 100 140 80 -10 60 120 -15 40 100 -20 M -18 Se -18 Ja 18 M -19 Se -19 Ja 19 M 20 Se -20 Ja 20 M -21 Se -21 Ja 21 M 22 2 -2 p- p- p- n- Q2 18 Q3 18 Q4 18 Q1 18 Q2 19 Q 3 19 Q 4 19 Q1 19 Q2 20 Q3 20 Q4 20 Q1 20 Q2 21 Q3 21 Q4 1 Q1 21 Q2 22 2 n- p- ay ay n n ay n ay ay -2 -2 - - - - - - - Ja - - - - - - - - - Q1 ▬ Industry_tc ▬ Retail trade_tc ▬ Tourism_tc ▬ Construction_tc (rhs) Source: State Statistics Office. Source: State Statistics Office and World Bank staff calculations. The labor market recovery is still fragile as Domestic inflation reached a 25-year high... activity rate continues to decline. Percent Percent, yearly change 60 22 25 55 21 20 50 20 15 45 19 40 18 10 35 17 5 30 16 0 25 15 20 14 -5 18 8 19 9 20 0 21 1 22 2 l-2 l-2 l-1 l-1 l-2 Q2-18 Q3-18 Q4-18 Q1 18 Q2-19 Q3-19 Q4-19 Q1 -19 Q2-20 Q3-20 Q4-20 Q1 20 Q2-21 Q3-21 Q4-21 Q1 -21 Q2-22 2 n- n- n- n- n- -2 - Ju Ju Ju Ju - Ju Ja Ja Ja Ja Q1 Ja J Activity rate J Employment rate ▬ Unemployment rate (rhs) ▬ CPI total ▬ PPI total Source: State Statistics Office. Source: State Statistics Office. Note: LFS 2022 makes use of the 2021 census data, making a break in the series. ...and external imbalances widened But public debt stabilized in early 2022 in significantly led by energy and food response to tightened financing costs. imbalances. Percent of GDP Percent of GDP 25 1 70 1 20 0 0 60 15 -1 -1 10 50 -2 5 -2 -3 40 0 -3 -4 -5 30 -5 -4 -10 20 -6 -5 -15 -7 -6 10 -20 -8 -25 -7 0 -9 2018 2019 2020 2021 H1 2022 2018 2019 2020 2021 H1 2022 J Goods J Services J Income J Current transfers J Domestic debt J Foreign debt J Guarantees ▬ Current account balance (rhs) ▬ Fiscal deficit with PESR (rhs) Source: Central bank. Sources: Ministry of Finance and World Bank estimates. Note: H1 balance of payments is a rolling average. Note: *Deficit of the general government on a 12-month rolling basis. 92 North Macdonia BEYOND THE CRISES NORTH MACEDONIA Selected Economic Indicators 2019 2020 2021 2022e 2023f 2024f Real GDP growth (percent) 3.9 -6.1 4.0 2.1 2.7 2.9 Composition (percentage points): Consumption 3.1 -2.4 5.0 4.9 2.4 2.3 Investment 3.3 -5.3 2.2 5.1 2.4 2.5 Net exports -2.4 1.7 -3.3 -7.9 -2.1 -1.9 Exports 5.8 -7.4 7.9 7.7 5.5 4.8 Imports (-) 8.2 -9.1 11.2 15.6 7.5 6.7 Consumer price inflation (percent, period average) 0.8 1.2 3.2 12.1 6.1 3.0 Public revenues (percent of GDP) 31.4 30.5 32.3 32.0 31.7 32.1 Public expenditures (percent of GDP) 33.5 38.9 37.7 37.2 35.8 35.7 Of which: Wage bill (percent of GDP) 6.3 7.3 6.9 6.5 6.3 6.1 Social benefits (percent of GDP) 15.6 18.0 16.9 16.1 15.3 15.1 Capital expenditures (percent of GDP) 3.4 3.2 4.2 5.2 5.3 5.6 Overall fiscal balance (percent of GDP) -2.1 -8.3 -5.4 -5.2 -4.1 -3.6 Primary fiscal balance (percent of GDP) -1.0 -7.1 -4.1 -3.9 -2.6 -2.2 Overall fiscal balance with the Public Enterprise for State Roads -3.1 -8.8 -5.8 -6.2 -5.0 -4.5 included Public debt (percent of GDP) 40.4 51.9 51.8 50.4 50.9 52.4 Public and publicly guaranteed debt (percent of GDP)* 49.2 61.0 60.8 59.4 59.9 61.4 Of which: External (percent of GDP) 32.7 40.7 39.8 39.0 38.5 37.8 Goods exports (percent of GDP) 47.5 44.4 51.3 55.7 57.0 57.9 Goods imports (percent of GDP) 64.8 61.0 71.6 81.5 78.4 77.5 Net services exports (percent of GDP) 3.0 3.9 4.2 4.2 4.7 5.1 Trade balance (percent of GDP) -14.3 -12.7 -16.0 -21.6 -16.7 -14.5 Net remittance inflows (percent of GDP) 2.0 3.1 2.9 2.9 2.9 2.9 Current account balance (percent of GDP) -3.0 -2.9 -3.1 -9.5 -4.7 -2.7 Net foreign direct investment inflows (percent of GDP) 3.2 1.4 3.3 3.0 3.0 3.1 External debt (percent of GDP) 72.4 78.7 81.9 79.2 82.4 84.9 Real private credit growth (percent, period average) 6.5 5.6 2.8 — — — Nonperforming loans (percent of gross loans, end of period) 4.6 3.3 3.1 — — — Unemployment rate (percent, average)** 17.3 16.4 15.7 14.4 13.7 13.6 Youth unemployment rate (percent, period average) 35.6 35.7 36.3 — — — Labor force participation rate (percent, period average) 57.2 56.4 56.0 — — — GDP per capita, PPP (current international $) 14,230 13,360 13,890 14,181 14,564 14,987 Sources: Country authorities; World Bank estimates and projections. Note: *Includes non-guaranteed debt as well. **Data from 2022 are not fully comparable to previous labor data due to the change in the LFS sample based on the 2021 census. Youth unemployment rate is for labor force aged 15–24. f = forecast; — = not available. North Macdonia 93 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Serbia • Growth continued to be strong in H1 2022, despite major domestic and external challenges. • Inflation accelerated more rapidly than projected, and in line with developments in the region, reaching 13.2 percent y-o-y in August, driven by food and energy prices. • The fiscal deficit turned lower than anticipated, thanks to a strong performance of revenues, while public debt plateaued at around 57 percent of GDP. • While growth projections over the medium term (2022-2024) remain unchanged, risks to the outlook are clearly tilted to the downside. • The most significant deterioration is expected on the external side, with the CAD widening to around 10 percent of GDP due to the major increase in imports. Recent Economic Developments in the first half of the year compared to the same period of 2021. Conversely, industry The Serbian economy continued to grow at a performed well over the first seven months of solid pace in H1 2022. At 4.1 percent y-o-y, 2022. Industrial production increased output economic growth was almost entirely driven by 2.7 percent (y-o-y), driven by improvement by a surge in private consumption, with only is several sectors including pharmaceuticals, oil, a marginal contribution from investment. A tobacco, and electronics and paper industry— substantial increase in salaries and in lending which all grew between 5 and 15 percent, y-o-y. to households, as well as transfers from the Value added in services sectors increased by budget, helped private consumption to grow 5.7 percent (in real terms/y-o-y) in the first half 5.3 percent (y-o-y, in real terms). In the first of the year. Over the same period construction half of the year, total investment increased by sector posted a decline of 6.6 percent in real mere 1.4 percent (y-o-y) despite a significant terms. increase in government investment.1 Although the export performance was strong (up The labor market continued to improve 19.9 percent in real terms), the increase in in 2022. As a result of a solid growth in imports was even higher (up 22.3 percent in H1, the employment rate reached a record real terms, and from a higher level) primarily high level of 50.9 percent, well above pre- related to the import of energy (electricity, coal, COVID levels of 47 percent (average in oil, and gas). Thus, the net balance in goods and 2019).2 Meanwhile, unemployment gradually services made a negative contribution to growth declined to 8.9 percent in Q2 2022. The of 3.8 percentage points. On the production activity rate increased from 55.2 percent in Q1 side, agriculture output shrank again in H1 to 55.8 percent in Q2 2022.3 Overall, wages 2022 due a major drought (the second summer continued to increase, by a further 13.5 percent in a row) and significantly higher input prices. in nominal terms in the first half of the year Agriculture output was 5.3 percent lower compared to the same period of 2021. Unlike 1 Up by 43.8 percent in nominal terms over the first seven months of 2022 compared to the same period of 2023. 2 This was to some extent supported by increase in informal employment (up by 54,200 person), which is typical for this part of the year when the construction and agriculture season start. 3 Activity rate was around 53 percent in years prior to COVID pandemic. 94 Serbia BEYOND THE CRISES in previous years, private sector wages increased eventually opted to direct sale of bonds to faster than public sector wages. The former qualified investors, thus bypassing the market.4 went up by 16.3 percent in nominal terms, compared to a 7.9 percent increase in public Soaring imports, primarily related to sector wages. energy, led to a significant deterioration in the current account deficit (CAD). Imports The consolidated budget shifted to a small of energy increased by 278 percent (or EUR surplus of 0.3 percent of GDP over the 2.2 billion) over the first seven months of first seven months of 2022. Revenues posted 2022, compared to the same period of 2021. a strong performance (up 14.4 percent in This increase, equivalent to 3.7 percent of nominal terms, over the first seven months, annual GDP, was driven by oil (up by EUR y-o-y), thanks to the major increases in value 1 billion), gas (up by EUR 0.9 billion), coal (up added tax (VAT), corporate income tax (CIT), by EUR 0.2 billion) and electricity (up by EUR and social contributions. High inflation and 0.1 billion). As a result, the trade deficit nearly the surge in imports drove VAT revenues; doubled to reach 7.7 percent of annual GDP while improved collection under CIT reflects in the first half of the year, while the CAD the advances made during the previous fiscal reached 4.4 percent of GDP.5 The CAD is now year. Social contributions increased on the projected to increase to around 10 percent of back of raising formal employment and wages. GDP in 2022 (compared to 4.4 percent of Expenditures have been kept under control (up GDP in 2021). Net foreign direct investment by 12.7 percent over the same period) despite inflows declined by 9 percent of GDP in euro major pressures to provide financial support terms in the first half of 2022, compared to the to energy companies. To date, the support same period of 2021, and stood at 2.4 percent provided to energy companies for importing of GDP, still covering a significant portion of gas, coal and electricity was not shown as the external shortfall. direct budget expenditures, rather as below the line items. However, as the winter season Inflation increased sharply, in line with approaches, energy companies might require developments in other CEE countries. additional direct budget support, which could The consumer price index (CPI) peaked at lead to a significant increase in the fiscal deficit 13.2 percent (y-o-y) in August, the highest level (it is currently projected at 4 percent of GDP of inflation since January 2013. Food prices, for 2022). Public debt remained broadly notwithstanding the selective government stable throughout 2022 and stood at around price controls, drove this trend, increasing 57 percent of GDP. The cost of financing by 20.9 percent (y-o-y) in August 2022. In debt increased significantly, and some of the response to mounting inflation pressures, recent T-bill auctions remain significantly the National Bank of Serbia (NBS) increased undersubscribed. As a result, the government the key policy rate several times, reaching 3.5 percent in September. The nominal dinar 4 Serbian government started using this option as of August by issuing three bonds: a 53-weeks bond worth EUR 350 million with fixed interest rate of 2.4 percent; a three-year bond worth EUR 250 million with interest rate of: 3.75 percent + 6-month Euribor, and a four-year bond worth EUR 90 million with interest rate of: 3.95 percent + 6-month Euribor. In September the government secured another loan from the UAE to serve as a budget support in the amount of 1 billion dollars with 3 percent interest. 5 The CAD reached EUR 2.7 billion in the first half of 2022, compared to EUR 0.6 billion in the same period of 2021. Serbia 95 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 exchange rate was stable throughout 2022, the medium term, the economy is expected to with only a minor depreciation in late February grow steadily at around 3 percent annually. 2022.6 NBS official foreign currency reserves declined by EUR 2.6 billion over the first five The outlook also crucially depends on months of 2022, before recovering to close to the domestic reform agenda and its EUR 15.9 billion by the end of August, which implementation. The ongoing crisis in covers 4.9 months of imports. the domestic energy sector has once again emphasized the urgency of improving the The performance of the banking sector management of SOEs. In addition, contingent continued to be robust. Based on 2022 Q2 liabilities (currently covered by guarantees data, banks remained profitable and liquid. issued by the central government) could affect The share of liquid assets in total assets stood public finances, particularly those related to the at 33.1 percent, while capital adequacy ratio deterioration in the performance of SOEs, as stood at 19.8 percent at the end of June. Non- demonstrated recently by EPS and Srbijagas. performing loans (NPLs) stood at 3.3 percent As a remedy, the government should embark in June. Nevertheless, credit growth has slowed on a comprehensive and thorough reform of down in 2022. The total stock of loans in July SOEs to make them financially viable while was only 6.4 percent higher than a year earlier. improving corporate governance. In addition The highest increase in credit growth relates to to growth-oriented reforms, the government SOEs (up by over 50 percent, y-o-y) while loans should reassess the effectiveness of the anti- to private companies increased by 8.3 percent inflationary measures used so far and to prepare (y-o-y) and to households by 9.1 percent. the legal framework for assistance to energy vulnerable customers. Outlook and Risks The risks to the baseline macroeconomic outlook that could materialize in 2022 and The growth outlook remains positive with 2023 are numerous. First, although the peak risks tilted to the downside. Before the of inflation is expected in Q3 2022, it could outbreak of the war in Ukraine, the Serbian increase further depending on changes in economy was expected to grow at around international food and energy prices. Second, 4–4.5 percent annually. However, the war in the 2022 fiscal deficit could be higher than Ukraine, increase in international prices and the one projected under the base case scenario, breakdowns in operations of EPS in winter notably if additional support to energy 2021/22 brought projected growth downwards. companies is provided. Consequently, public Considering the impact of these shocks, debt could start rising again as a share of GDP. growth for 2022 is projected at 3.2 percent. Third, possible disruption in energy supply Further downward revision may be warranted (electricity and gas in particular, e.g., power depending on: (i) the performance of the outages) could slow down growth. Finally, the energy sector and energy availability; and (ii) CAD might deteriorate faster than projected if the impact of the poor agriculture season on the international prices of energy continue to rise, sectoral output, exports and food prices. Over rendering its financing more expensive. 6 Since May the NBS is net-purchaser of FX, buying EUR 1.4 billion. 96 Serbia BEYOND THE CRISES Growth remained strong in H1 2022... ...but started to lag behind other CEE countries. Contribution to growth, percentage points Growth rates, y-o-y 25 15 20 12 9 15 6 10 3 5 0 -3 0 -6 -5 -9 -10 -12 Q2 9 Q3 9 Q4 9 Q1 9 Q2 0 Q3 0 Q4 0 Q1 0 Q2 1 Q3 1 Q4 1 Q1 1 Q2 2 2 6 6 7 7 8 8 9 9 0 0 1 1 2 -2 -2 -2 -2 -2 -2 -1 -1 -1 -1 -2 -2 -2 -2 -2 -2 -1 -1 -2 -1 -1 -1 -1 -1 -1 -2 -2 Q1 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q1 Q3 J Consumption, final J Investment ▬ Serbia ▬ CEE8 average J Net exports ▬ Real GDP growth, percent Source: Statistics Office of the Republic of Serbia. Source: Statistics Office of the Republic of Serbia and Eurostat. Inflation is on rise... ...mainly because of food prices. Annual change in percent Contribution in pp 14 14 12 12 10 10 8 8 6 6 4 4 2 2 0 0 -2 Fe -21 a 1 Apr-21 ay 1 Ju -21 Ju -21 1 p- 1 Oc 21 1 Dev-21 Ja 21 Fe -22 a 2 Apr-22 ay 2 Ju -22 Ju -22 g- 2 22 Ju 5 Ja 15 Ju 6 Ja 6 Ju 7 Ja 17 Ju 8 Ja 8 Ju 9 Ja 19 Ju 0 Ja 0 Ju 1 Ja 21 Ju 2 2 M b-2 M r-2 Au l-2 Se g-2 No t-2 M b-2 M r-2 Au l-2 2 1 2 l-2 1 c- 1 1 l-1 1 l-1 2 l-2 n- l- n- l- n- l- n- l- n- n- n n n- n n n- Ja Ja ▬ CPI, total ▬ Target, upper bound ▬ Target, lower bound J Food and beverages J Clothes and footwear J Rents, furniture and communal services J Energy J Fuel for vehicles J Health product and services, education J Transport (passengers, vehicles) J Leisure and other service Source: Statistics Office. Source: Statistics Office. The CAD and trade deficit recently started …but reserves recovered as of June. to increase... Percent of GDP, 12-months sum Official foreign currency reserves, EUR million 0 16,500 -2 16,000 -4 15,500 -6 15,000 -8 14,500 -10 14,000 -12 -14 13,500 -16 13,000 -18 12,500 M 18 Se 18 Ja 8 M 19 Se 19 Ja 19 M 20 Se 20 Ja 0 M 21 Se 21 Ja 21 M 22 2 22 22 2 22 2 22 2 22 -2 1 2 -2 -2 l-2 - - n- p- n- p- - n- p- n- - n- p- g- n- b- r- n- ay ay ay ay ay ay ar Ju Ap Ja Au Fe Ja Ju M M ▬ CAB ▬ Trade balance Source: National Bank of Serbia. Source: National Bank of Serbia. Serbia 97 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 SERBIA Selected Economic Indicators 2019 2020 2021 2022e 2023f 2024f Real GDP growth (percent) 4.3 -0.9 7.4 3.2 2.7 2.8 Composition (percentage points): Consumption 2.9 -0.9 5.7 3.5 3.2 3.1 Investment 4.0 -0.1 3.8 1.5 0.9 0.9 Net exports -2.6 0.1 -2.1 -1.7 -1.4 -1.2 Exports 4.1 -2.3 10.3 4.7 3.3 3.4 Imports (-) 6.7 -2.4 12.4 6.4 4.7 4.6 Consumer price inflation (percent, period average) 1.9 1.6 4.0 11.5 9.2 3.7 Public revenues (percent of GDP) 42.0 41.0 43.3 43.1 43.0 42.9 Public expenditures (percent of GDP) 42.2 49.0 47.4 47.1 45.7 44.6 Of which: Wage bill (percent of GDP) 9.5 10.5 10.0 10.0 10.2 10.3 Social benefits (percent of GDP) 14.4 14.7 13.6 14.0 14.0 14.2 Capital expenditures (percent of GDP) 4.9 5.3 7.4 7.2 6.7 6.6 Fiscal balance (percent of GDP) -0.2 -8.0 -4.1 -4.0 -2.7 -1.7 Primary fiscal balance (percent of GDP) 1.8 -6.0 -2.4 -2.2 -0.7 0.2 Public debt (percent of GDP) 48.8 53.9 53.9 52.8 53.2 51.8 Public and publicly guaranteed debt (percent of GDP) 52.8 57.8 57.1 58.1 58.1 56.5 Of which: External (percent of GDP) 30.3 33.4 37.0 38.0 40.0 40.0 Goods exports (percent of GDP) 35.7 34.4 38.9 36.2 35.6 36.1 Goods imports (percent of GDP) 47.9 45.5 50.0 51.7 50.0 48.5 Net services exports (percent of GDP) 2.3 2.4 2.7 2.3 1.9 2.3 Trade balance (percent of GDP) -9.9 -8.8 -8.5 -13.2 -12.5 -10.1 Net remittance inflows (percent of GDP) 5.6 4.5 4.7 4.3 4.0 3.8 Current account balance (percent of GDP) -6.9 -4.1 -4.4 -10.2 -9.4 -7.9 Net foreign direct investment inflows (percent of GDP) 7.7 6.3 6.8 5.5 5.8 5.6 External debt (percent of GDP) 61.8 65.8 68.5 67.1 63.2 61.0 Real private credit growth (percent, period average) 6.9 9.2 3.7 — — — Nonperforming loans (percent of gross loans, end of period) 4.1 3.7 3.6 — — — Unemployment rate (percent, period average) 11.2 9.7 11.0 9.0 9.1 9.0 Youth unemployment rate (percent, period average) 28.6 27.3 26.6 — — — Labor force participation rate (percent, period average) 52.9 52.2 54.7 — — — GDP per capita, PPP (current international $) 19,025 19,168 21,243 22,901 24,599 26,271 Poverty rate (percent of population) 10.1 10.2 9.8 9.6 9.3 9.1 Sources: Country authorities, World Bank estimates and projections. 98 Serbia Key Economic Indicators WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Key Economic Indicators 2019 2020 2021 2022e 2023f 2024f Real GDP growth (percent) Albania 2.2 -3.5 8.5 3.2 2.3 2.5 Bosnia and Herzegovina 2.8 -3.1 7.5 4.0 2.8 3.2 Kosovo 4.8 -5.3 10.5 3.1 3.7 4.2 North Macedonia 3.9 -6.1 4.0 2.1 2.7 2.9 Montenegro 4.1 -15.3 13.0 6.9 3.4 3.1 Serbia 4.3 -0.9 7.4 3.2 2.7 2.8 WB6 3.7 -3.2 7.6 3.4 2.8 3.0 Consumer price inflation (percent, period average) Albania 1.4 1.6 2.6 6.7 4.0 3.5 Bosnia and Herzegovina 0.6 -1.1 2.0 11.0 2.0 0.5 Kosovo 2.7 0.2 3.4 12.1 4.0 3.0 North Macedonia 0.8 1.2 3.2 12.1 6.1 3.0 Montenegro 0.4 -0.3 2.4 12.3 5.9 2.6 Serbia 1.9 1.6 4.0 11.5 9.2 3.7 WB6 1.5 0.9 3.3 10.9 6.4 3.0 Public expenditures (percent of GDP) Albania 29.2 32.6 31.6 30.7 32.1 31.4 Bosnia and Herzegovina 40.6 47.4 43.3 42.3 41.8 41.1 Kosovo 29.7 33.0 29.3 30.1 30.6 31.2 North Macedonia 33.5 38.9 37.7 37.2 35.8 35.7 Montenegro 46.0 55.5 45.9 44.9 43.0 41.5 Serbia 42.2 49.0 47.4 47.1 45.7 44.6 WB6 36.9 42.7 39.2 38.7 38.1 37.6 Public revenues (percent of GDP) Albania 27.2 25.9 27.0 26.8 27.4 27.6 Bosnia and Herzegovina 42.5 42.1 43.0 41.4 41.9 41.9 Kosovo 26.8 25.4 27.9 29.3 28.9 29.0 North Macedonia 31.4 30.5 32.3 32.0 31.7 32.1 Montenegro 43.3 44.4 44.0 40.0 39.0 38.8 Serbia 42.0 41.0 43.3 43.1 43.0 42.9 WB6 35.5 34.9 36.3 35.4 35.3 35.4 Fiscal balance (percent of GDP) Albania -1.9 -6.7 -4.5 -3.8 -4.6 -3.8 Bosnia and Herzegovina 1.9 -5.3 -0.3 -0.9 0.1 0.8 Kosovo -2.9 -7.6 -1.3 -0.8 -1.6 -2.1 North Macedonia -2.1 -8.3 -5.4 -5.2 -4.1 -3.6 Montenegro -2.7 -11.0 -1.9 -4.9 -4.0 -2.7 Serbia -0.2 -8.0 -4.1 -4.0 -2.7 -1.7 WB6 -1.3 -7.9 -2.9 -3.3 -2.8 -2.2 Source: World Bank calculations and projections on data from national authorities. 100 Key Economic Indicators BEYOND THE CRISES Key Economic Indicators (continued) 2019 2020 2021 2022e 2023f 2024f Public debt (percent of GDP) Albania 63.7 74.0 72.1 67.0 65.5 65.0 Bosnia and Herzegovina 32.8 36.6 35.4 31.9 32.7 33.8 Kosovo 17.0 22.0 21.5 20.9 21.9 23.2 North Macedonia 40.4 51.9 51.8 50.4 50.9 52.4 Montenegro 76.5 105.3 84.0 73.4 72.7 71.9 Serbia 48.8 53.9 53.9 52.8 53.2 51.8 WB6 46.6 57.3 53.1 49.4 49.5 49.7 Public and publicly guaranteed debt (percent of GDP) Albania 67.4 75.9 74.0 68.9 67.4 66.9 Bosnia and Herzegovina 34.5 38.8 37.6 33.0 34.0 35.5 Kosovo 17.6 22.4 21.9 21.2 22.1 23.4 North Macedonia 49.2 61.0 60.8 59.4 59.9 61.4 Montenegro 80.0 108.7 86.8 75.5 74.7 73.8 Serbia 52.8 57.8 57.1 58.1 58.1 56.5 WB6 50.3 60.8 56.4 52.7 52.7 52.9 Goods exports (percent of GDP) Albania 6.6 6.0 8.2 10.2 9.8 9.7 Bosnia and Herzegovina 28.8 27.5 34.1 40.2 41.6 42.1 Kosovo 5.6 7.0 9.3 10.7 11.3 11.4 North Macedonia 47.5 45.3 51.1 55.5 56.7 57.7 Montenegro 9.4 9.8 10.6 13.0 12.6 12.0 Serbia 35.7 34.4 38.9 36.2 35.6 36.1 WB6 28.5 27.6 31.8 32.6 32.7 33.1 Trade balance (percent of GDP) Albania -13.8 -14.3 -13.3 -11.6 -11.3 -11.0 Bosnia and Herzegovina -14.7 -13.9 -12.3 -12.7 -14.8 -14.0 Kosovo -27.1 -32.3 -30.7 -32.7 -35.2 -35.2 North Macedonia -14.3 -13.0 -16.0 -21.5 -16.7 -14.5 Montenegro -21.1 -35.0 -19.4 -18.9 -17.7 -17.0 Serbia -9.9 -8.8 -8.5 -13.2 -12.5 -10.1 WB6 -13.6 -13.6 -12.7 -15.5 -15.0 -13.5 Current account balance (percent of GDP) Albania -8.0 -8.5 -7.7 -7.9 -8.1 -7.7 Bosnia and Herzegovina -2.8 -3.4 -2.6 -3.1 -5.3 -4.4 Kosovo -5.6 -7.0 -8.3 -11.3 -13.1 -12.3 North Macedonia -3.3 -3.4 -3.5 -9.8 -5.0 -3.0 Montenegro -14.3 -26.1 -9.2 -10.2 -10.3 -9.7 Serbia -6.9 -4.1 -4.4 -10.2 -9.4 -7.9 WB6 -6.1 -5.6 -4.9 -8.7 -8.3 -7.1 Source: World Bank calculations and projections on data from national authorities. Key Economic Indicators 101 WESTERN BALKANS REGULAR ECONOMIC REPORT NO.22 Key Economic Indicators (continued) 2019 2020 2021 2022e 2023f 2024f External debt (percent of GDP) Albania 60.0 60.5 62.7 55.5 51.6 49.3 Bosnia and Herzegovina 65.6 70.7 65.4 57.2 55.9 54.8 Kosovo 31.2 37.2 37.3 40.3 42.1 41.3 North Macedonia 72.4 80.3 81.4 78.9 82.0 84.5 Montenegro 169.0 224.1 214.9 204.7 194.4 184.7 Serbia 61.8 65.8 68.5 67.1 63.2 61.0 WB6 76.7 89.8 88.4 83.9 81.5 79.3 Unemployment rate (period average, percent) Albania 11.5 11.7 11.5 - - - Bosnia and Herzegovina 15.7 15.9 17.4 - - - Kosovo 25.7 25.9 - - - - North Macedonia 17.3 16.4 15.7 14.4 13.7 13.6 Montenegro 15.1 17.9 16.6 - - - Serbia 11.2 9.7 11.0 9.0 9.1 9.0 WB6 16.1 16.3 - - - - Source: World Bank calculations and projections on data from national authorities. 102 Key Economic Indicators Western Balkans Regular Economic Report No.22 | Fall 2022 View this report online: www.worldbank.org/eca/wbrer