Current Account Sustainability: the case of Bosnia and Herzegovina

This research investigates whether the persistent current account deficit in Bosnia and Herzegovina (BH) is sustainable. Initially current account sustainability is investigated by using the concept of a stationary condition and the mean reversion proposition. It is argued that stationarity of the current account presents a minimum requirement for current account sustainability assessment based on less strict intertemporal solvency conditions. It was found that four out of the five Western Balkan countries investigated have a stationary current account to GDP ratio and therefore met this minimum requirement for sustainability. In order to develop an empirical model to assess current account sustainability in BH, next the Fundamental Equilibrium Exchange Rate is estimated. The conclusion drawn from this analysis was that BH‟s high and persistent current account deficit was not caused by exchange rate misalignment, thus there is no need to adjust the peg. The main reason behind the BH current account deficit is its trade deficit. In the absence of previous analyses of trade deficit sustainability in the WB the next question assessed was whether forming an free trade agreement is a helpful policy for BH utilising an ex post empirical analysis. The analysis of the new Central European Free Trade Agreement concentrates upon three effects: on trade flows using gravity equations; on Bosnia and Herzegovina‟s trade potential and on future deficit sustainability in BH. It was found that although BH trade flows were affected by the CEFTA agreement, the net effect was to contribute to a further widening of the trade deficit in BH. Given the finding that BH‟s current account deficit cannot be attributed to (real) exchange rate misalignment the main conclusion is that current account sustainability analysis must be based on understanding the reasons why BH has a persistent trade deficit. The main reason behind BH current account deficit is its trade deficit. The main factor underlying trade deficit in BH is strong demand for imported goods and also BH‟s supply side weaknesses. Policy-makers need to create an environment for the private sector to develop. Hence both micro and macroeconomic conditions would have to be considered by BH policy-makers in order for this country to improve its export competitiveness and its trade position, which could reduce high BH current account deficit.