Western Balkans and Europe 2020 - Supporting Convergence and Growth Jane Armitage, Country Director and Regional Coordinator for South East Europe WORLD BANK March 2011

Outline Post-crisis macroeconomic framework Structural reforms for smart, sustainable, and inclusive growth Competitiveness Governance and rule of law Social sectors The World Bank’s engagement

Two years after the crisis started... The legacy of the crisis continues though economies are slowly improving Growth collapsed but is recovering tentatively, especially through growing export demand Private capital inflows fell sharply but very recently are beginning to trend upwards and formerly unsustainable CADs have shrunk sharply Fiscal deficits spiked in most countries but have begun to moderate as a result of a expenditure adjustments However, domestic demand remains weak and improvements in employment and poverty reduction remain elusive

Growth rates declined sharply and GDP shrank in most countries but there is now a gradual return to growth…

The momentum of poverty reduction slowed considerably…

Fiscal consolidation needed for macro sustainability, but… Ageing populations and increased longevity putting pressure on pension and health systems Need for reformed social safety nets with improved targeting to alleviate budgetary pressures and reduce payroll tax disincentives for employment creation Competitiveness requires greater access to higher education and improved quality at all levels Major infrastructure improvements needed in environment of reduced private finance

I. Promoting Growth and Competitiveness

The Region is improving ranking on “Doing Business”, but key areas need attention… Most difficult areas are construction licenses, property registration and contract enforcement Reforms are not that difficult: FYR Macedonia climbed from being 94th in 2006 to 38th in 2011

Lack of infrastructure is a major bottleneck for businesses in the Western Balkans… % of firms indicating transport is a major obstacle to doing business % of indicating electricity is a major obstacle to doing business Energy MONTENEGRO BiH SERBIA Source: Doing Business 2011 9

Lack of infrastructure cont’d Irrigation and Water Resources Western Balkan countries have strong potential for agricultural production which is unrealized due largely to inadequate irrigation (most countries are net importers of food but could be net exporters with adequate irrigation) Absence of River Basin Management Plans, inhibits balanced multi-purpose river use and leads to controversy (e.g. hydropower vs agriculture) Major vulnerability to floods (e.g. Dec. 2010, 6 casualties) due to inadequate dike protection, lack of maintenance, no integrated planning, poor cost recovery Going forward, climate change will continue to restrict areas that can produce rain- fed crops Urban Water and Sanitation Services Although coverage is generally good in the Western Balkans, services are unreliable affecting growth in key high-potential and water intensive industries such as tourism and food processing Water and sanitation are generally publicly funded putting pressure on limited budgetary resources in many instances Lack of adequate policy framework – low tariffs, weak collection rates and non-revenue water-- inhibits private sector investment

Transport Infrastructure Roads: Total road network in the SEE countries covers over 100,000 kms of which core network is 6,000km Road quality remains poor despite investments in the SEETO ‘Core Network’ All Western Balkan countries rank in the bottom half in a world economic forum ranking of 139 countries Rail: Western Balkan countries are in the bottom half of rankings for quality of rail infrastructure among 116 countries Serbia, Bosnia and Herzegovina, and Albania are among the bottom quarter Port and inland waterways : The inland water transport network in SEE has been neglected for far too long nearly no expenditure on Sava or Tisa since 1990

Better transport infrastructure is critical for Economic Development in the Western Balkans… The small size of the Western Balkan countries, and their favorable location vis-à-vis the EU market, underline the importance of trade facilitation for growth and poverty reduction, but: Road infrastructure below European standards: raises costs of trade Broader trade and logistics environment (transport services, border-crossings etc.) is also weaker than in EU-10 region Overall objective for transport sector development is to reduce ‘economic distance’ to the main markets A reduction in economic distance requires: improved physical infrastructure improvements in the institutional framework improved logistics multi-modal development strategy

Improving Transport: Priorities for Action Address increasing demand for road transport through continued development of the SEETO core regional road network Prioritize improved management of existing infrastructure through: better maintenance and establishment of professional management systems Focus on enhancing logistic chains and clearance procedures to reduce delays to international transport Revitalize the rail network through: rehabilitation of track to return line speeds to design speed, rolling stock rehabilitation rather than major upgrade in speed, further institutional reform. Improve financing sustainability through: Efficiency improvements and increased cost recovery Effective partnership with the private sector Ensure environmental and social sustainability: Improve road safety Reducing disbenefits (air pollution, noise etc…) through appropriate pricing Include environmental social cost in determining mode choice

Energy use in the Western Balkans is massively inefficient and investment needs are huge… SEE economies are characterized by high energy intensity and low energy efficiency: Conventional power generation structure, import dependent, and emerging severe shortages; National market generally dominated by one state owned generator and is subject to high losses (commercial and technical) Regulated tariffs cover costs but are generally low and insufficient to cover cost of new investments Energy generation is dirty, heavily dependant on petroleum and coal Meeting development and EU2020 goals will require Huge investments: 20-25 billion Euro over next 10 years Adoption of regional investment strategies Addition of new generation capacity and replacement of old plants Development of gas and renewable resources in conjunction with revamping of tariffs structures

Energy (cont’d) Regional integration is critical for energy security but must overcome the following challenge Lack of market price penetration to final consumers and no publicly available and trusted “reference price” for electricity Close relationship between incumbent generator and incumbent supplier which impedes open, competitive market Difference between regulated tariffs across countries are too low to allow market based investments in generation Market participants, regulators, and authorities have little or no experience of electricity market operation Perceived instability of energy policy constrains private involvement Strategic focus of Bank’s engagement in energy in the Western Balkans is Development of regional energy market (transmission, rehabilitation of generation, dam-safety) Promotion of energy efficiency and renewable resources Improvement of energy supply and infrastructure (including new generation) through PPP approaches Implementation of strategies for global and local environmental improvement

Western Balkan water and sanitation systems generate high water and financial losses… Generally high water and sanitation coverage masks weaknesses aging infrastructure results in high physical losses outdated water pumps translate into high energy costs continuity of service dips as low as 8 hours per day in some countries wastewater treatment limited with negative externalities Lack of operations & maintenance management & budgeting: accelerated depreciation of assets service disruptions Utility financial performance is weak: high Non-Revenue Water & low collection rates overstaffing inability to attract private sector financing Private sector participation low tariffs make concessions non-viable political interference undermines pricing weak regulatory oversight and enforcement

Water and Sanitation Sector: Priorities for Action Update Water Sector Legislation and Regulations to align with EU Directives Harmonize National Water and Sanitation Sector Strategies with EU Policies Link water supply distribution to water resource management goals Promote energy efficiency and water demand management Initiate utility reform programs Consolidate utilities to achieve better economies of scale Institute utility performance contracts against realistic benchmarks Set performance standards for utilities Support utility staff training and certification programs Devise subsidy programs that better target the poor: Wind down subsidies to poor performing utilities (perverse incentives) Target subsidies to the poor through social assistance programs Improve data collection and information systems: Empower regulatory oversight agencies to enforce reporting of sector data Standardize indicators and performance measurement Mainstream third-party verification of disclosed data

Despite tremendous potential, agricultural productivity is relatively low… Agriculture represents 9-20% of GDP Half the population (and most of the poor) lives in rural areas Agriculture has enormous potential: abundant land and low-cost labor, favorable climate, and proximity to EU Market Productivity is low: small farms, fragmented value chains, poor logistics, inadequate infrastructure, and low skills Need for shift from subsistence producers to commercial farms Align policies to access EU agriculture funds Prepare for climate change

Irrigation – Essential tool to generate income and jobs… Agriculture is 12-25% of countries’ GDP and 20-50% of jobs -- given major un- and under-employment it is critical to maintain agricultural employment Climatic conditions impose use of irrigation and drainage to produce marketable valuable crops (vegetables, fruits, grapes, oil seed crops, etc.) Climate will become drier and warmer  limits rain-fed agriculture, expands need for irrigation Investment needs in rural infrastructure amount to €5-6 billion. Most irrigation systems out of operation or vandalized, many drains not maintained. Most countries now prioritize modern agriculture including irrigation and drainage; plus bulk water supply (reservoirs, groundwater). World Bank focus in Agriculture/Rural Water: Institutional reform: (1) establish Water User Associations, (2) ensure market access for agriculture products, (3) realistic water fee to be paid by farmers, (4) partnership with local govt. O&M costs plus on-farm equipment to be paid by farmers, but “public good” investment in main reservoir, pump, piping, for the moment from national budget Combine irrigation, drainage, water storage, in river basin management

Improving water use and mitigating impacts of climate change… Climate change has contributed to increasing frequency and severity of floods throughout the Western Balkans Flood protection infrastructure is inadequate and poorly maintained Water management will be more critical over next 2 decades as Western Balkans become subject to more intense but less frequent rainfall Households and businesses need protection from the high cost of flood damage Key emphases of World Bank strategy: Provision of affordable insurance against losses from flooding and other catastrophic risks (Western Balkan Catastrophe Risk Insurance Fund) Early warning system, river flow forecasting, improve hydromet data system Localized emergency reconstruction and relief Better integrated planning of structural and non-structural measures, including recreation of floodplains Securing the supply of bulk water, including dams and reservoirs bulk water canals, pumping stations Support river basin management in line with EU Water Framework Directive, including analysis of trade-offs between environment, hydropower, other uses

II Governance: Governments are by and large gradually becoming more efficient, effective and transparent

EU Accession is Driving Clear Governance Improvements in the Western Balkans Western Balkans have made clear progress in key governance indicators in recent years But still lag the EU10 and Turkey in terms of governance quality Rule of law and control of corruption are the weakest aspects of governance Qualifying for decentralized management of IPA funds is a key driver of PFM reform

The rule of law has improved, but lags EU-10, Croatia, and Turkey WBI Rule of Law (percentile rank) Rule of Law (WBI Indicators, 2009)

Corruption in Courts is Down… BEEPS 2005-2008: % of firms saying that bribes in dealing with the courts are frequent

Progress in government effectiveness is slow and uneven WBI Government Effectiveness (percentile rank) Government effectiveness WBI Indicators, 2009

The Western Balkans have seen a sharp drop in bribe incidence, but still fare worse than the EU-10 BEEPS 2005-2008: The % of firms reporting that bribes are frequent has dropped sharply

Procurement capacity is still weak and corruption is a concern Public Financial Management and Procurement Systems are improving gradually, but reforms still needed… PEFA assessments show that PFM systems are now more efficient, effective, and accountable PFM reforms have improved budget planning, allocation, implementation and review Procurement capacity is still weak and corruption is a concern EU acquis and certification requirements for decentralized management of IPA funds (PIFC standards) are very strong incentives

III. Social Spending Challenging Balancing Act: Improving Social Protection, Education and Health w/tight budgets Quality, Coverage Efficiency, Cost Recovery, Targeting Social & Financial Sustainability Increasing Needs: Increased poverty & unemployment (crisis) Demographic changes Converging to EU standards Fiscal constraints: Large fiscal deficits and increasing public sector debt (crisis) Social Sectors = large share of public spending Growing pensions deficits

Pensions: Demographic => Fiscal Crisis Aging population (Doubling by 2050) Shrinking Workforce (Fewer contributors) = Rising Pension Deficits + Population Structure in 2005 Population Structure in 2050

How Can Countries Prepare for the Demographic Crisis? Raise retirement ages, particularly for women Reduce early retirement exemptions Index pensions to inflation only Start preparing for elderly without pension rights

Social Safety Nets: Increasing Needs with Tighter Budgets Dual challenge Higher unemployment + poverty => increasing needs. Tighter budgets given fiscal situation Reform priorities: Focus limited spending on the most “needy” Shift away from “rights-based” benefits that largely go to the non-poor (e.g., war veterans benefits in BiH, Croatia, Kosovo) Strengthen targeting (adopting means-testing) Eliminate filters which cause disincentives to work and exclude working poor

Education Sector Challenges School rationalization: demographic shifts have left too many schools, with too many staff Improve quality and increase participation in international standard testing Increase access to poor and minorities (e.g.Roma) Skills mismatch with labor market needs For higher education: pursue sub-regional approach to quality assurance, links to businesses, compliance with Bologna Process, and cost recovery

Health Sector Challenges and Reforms Cost pressures due to structural trends (e.g. technology, pharmaceuticals)—plus high rate of exemptions exacerbate mismatch between benefits and revenues Health Insurance Funds lack capacity to allocate resources efficiently Informal Out-of-Pocket expenditures are increasing (impact on poverty) Reform priorities: enhance efficiency and equity in a fiscally constrained environment Define Benefits Package, using evidence-based decision making in selecting interventions Link Payment to Performance Rationalize Infrastructure shifting resources to primary care Strengthen Institutional Capacity Tackle structural Cost Pressures (e.g. revising pharmaceutical pricing and reimbursement policies)

World Bank Engagement In Western Balkans

The World Bank Group is Active in the Region Over 20 years experience in the Western Balkans Total Lending 1995-2010 US$7.3 billion Pipeline of projects FY11-14 US$2.5 billion Our work reinforces and supports the EU accession process Significant country presence and sectoral knowledge

World Bank Lending to Western Balkans Total Lending 1995-2010 – US$ 7.3 billion Does not include IFC lending

World Bank Lending to Western Balkans Pipeline of projects – FY 11-14 (US$ 2.5 billion) Does not include IFC lending

Analytical and Advisory Assistance (AAA) AAA , including non-lending technical assistance (NLTA), is central to World Bank program; AAA services to Western Balkans average USD 3-5 million annually; US$46 million provided since FY2000; Does not include IFC AAA

Country Specific and Regional AAA Recently Completed and Underway ALBANIA: Country Governance and Anticorruption, Accountability for Better Governance, Public Expenditure and Financial Accountability, Social Protection TA, Country Economic Memorandum (CEM) BOSNIA AND HERZEGOVINA: Pension Technical Assistance, Report on the Observance of Standards and Codes on Fiscal Transparency, Public Expenditure Review (PER) KOSOVO: Country Economic Memorandum Follow up; Transport ; Comprehensive Water Sector Assessment; Environment Policy Note, Transport Sector Review FYR MACEDONIA: Comprehensive Water Sector Assessment, Higher Education, Green Growth and Climate Change, Science/Technology TA, Labor TA, Energy Policy Note MONTENEGRO: Public Expenditure and Institutional Review Follow up, Transport Sector Work, Public-Private Partnerships for Electricity SERBIA: Pension TA, Innovation Promotion, Capital Markets, CEM, Education, Policy Notes on Growth REGIONAL: REPARIS (The Road to Europe: Program of Accounting Reform and Institutional Strengthening); Programmatic Financial Sector Development; Study on Science, R&D and Innovation; Public Financial Management; Programmatic Poverty Assessment and Gender Monitoring; Labor market, Education Skills and Social (MILES), Energy Efficiency and Renewables.