How the Western Balkans can catch up

By Peter Sanfey, Jakov Milatovic and Ana Kresic


The six countries of the Western Balkans – Albania, Bosnia and Herzegovina, FYR Macedonia, Kosovo, Montenegro and Serbia – face a major convergence challenge vis-à-vis the EU in terms of living standards. GDP per capita in the Western Balkans is roughly half that of the 11 central and Eastern European EU countries (EU-11), one-third that of Southern EU members and a mere one-quarter of the richest EU members in Western Europe (Chart 1).

A new EBRD working paper examines how the Western Balkans can close this gap in the coming years by highlighting the scale of the challenge, the advantages of the region for investors and the likely growth drivers, as well as the challenges and risks. This focus piece summarises the main points of the paper.

    Chart1: Convergence potential

    

   Source: IMF WEO. Note: Countries are ordered from highest to lowest. Luxembourg excluded

  1. How competitive is the Western Balkans relative to EU countries?

Western Balkan countries compare poorly with EU comparators on competitiveness measures; this is one of the main reasons behind the prosperity gap. The region’s average ranking is 86th place in the World Economic Forum’s Global Competitiveness Report (GCR) in comparison to an average 36th place for the EU (Chart 2). The failure to make efficient use of talent, the reliance on informal networks (i.e., family and friends) rather than on professional management, the lack of business sophistication, and inadequate transport infrastructure are among the main problems identified in the GCR.

But competitiveness is improving gradually. FYR Macedonia has experienced the biggest jump in its GCR score since 2007 and now ranks just behind the EU-11 average; notable advances have also occurred in Albania and Montenegro. In contrast, scores of the EU countries have remained on average almost the same as before. Governance scores are also improving (Chart 3), according to evidence from the World Bank. In an important sense, therefore, the region is converging towards the EU.

   Chart 2: WEF’s Global competitiveness Index        Chart 3: World Bank’s Governance Indicators

   

      Source: Authors’ calculations based on WEF’s Global Competitiveness Index and WB’s Governance indicatorsNote: Competitiveness score scale is [ 1, 7] and Governance     indicators scale is [-2.5, 2.5]. “EU-15” means the 15 members of the EU prior to the 2004 expansion.

  1. What can the region offer to investors?
  1. The region has an EU perspective. This is a unique quality in comparison to other emerging markets, as it helps to anchor market-oriented reforms and EU standards. However, full membership is not on the cards for any of the countries during the mandate of the present Commission (2014-2019).
  2. The region enjoys a high degree of macroeconomic stability. Inflation is uniformly low and stable, and exchange rates are closely linked to the euro through fixed pegs or managed floats, or through unilateral euro adoption. Fiscal and current account deficits are more problematic in some cases but are being addressed, with several countries currently in programmes with the IMF.
  3. Geographic proximity and tariff-free acess to EU markets is a strong advantage. China has recognised the importance of the region’s strategic location as a gateway to Europe in its “Belt and Road Initiative” and is planning to establish a rapid transport connection from the Greek port of Piraeus, the first major European container port for ships entering the Medditeranean from the Suez Channel, through the Balkans and further to EU markets – the “Balkan Silk Road”. The first operational move was made when the Chinese shipping giant Cosco Pacific took over half of the Piraeus port.  
  4. Economies in the Western Balkan region are quite diverse. As a result, they offer a wide range of opportunities for investors (Chart 4). “Domestic trade, transport and storage, accommodation and food services” is on average the largest sector of the Western Balkan economies, ranging from 18 per cent of value added in Albania and Serbia to 27 per cent in tourism-dependent Montenegro. Industry accounts for 20 per cent on average and varies significantly across the countries, with particular importance for Serbia. Agriculture also plays a vital role in the Western Balkans (12 per cent on average), both socially and in terms of employment.
  5. Taxes and labour costs are also favourable. During the past decade, tax rates in the Western Balkans have been relatively stable and there has been a fall in the administrative burden of submitting taxes. Although there are differences among the countries in the region, the total tax burden is lower in all cases than in any of the EU benchmarks (Chart 5). In addition, all Western Balkan countries have lower Unit Labour Costs compared to the EU average (Chart 6). This is important for export-oriented companies specialised in labour-intensive industries. The advantage of low labour costs is complemented by the relatively educated population.

      Chart 4: Structure of economy, per cent of gross value added (2014)

      

     Source: National Statistical Offices.

  1. Taxes and labour costs are also favourable. During the past decade, tax rates in the Western Balkans have been relatively stable and there has been a fall in the administrative burden of submitting taxes. Although there are differences among the countries in the region, the total tax burden is lower in all cases than in any of the EU benchmarks (Chart 5). In addition, all Western Balkan countries have lower Unit Labour Costs compared to the EU average (Chart 6). This is important for export-oriented companies specialised in labour-intensive industries. The advantage of low labour costs is complemented by the relatively educated population.

      Chart 5: Total tax burden as a % of profit (2015)       Chart 6: Unit labour cost (2014)

   

        Source: World Bank: Doing Business database. Source: National Statistical Offices and Eurostat.

  1. Where will growth come from in the coming decade?
  1. Attracting foreign direct investment (FDI) is crucial. Current levels of FDI are modest. The average FDI stock per capita in the Western Balkans is ca. €2,600 versus €14,300 in the EU (Chart 7). The catch up potential is obvious and will be likely driven by increase in FDI from non-traditional sources, such as Gulf countries and China, and going more into tradable sectors, and less so in sectors intended primarily for domestic consumption. Traditionally, the most important investors have been the Eurozone countries: Austria, followed by the Netherlands, Greece and Italy (Chart 8).

        Chart 7: FDI stock per capita, EUR (2014)                Chart 8: FDI stock owners in Western Balkans

      

       Source: UNCTAD.  Source: National central banks.

  1. Trade integration, within the region and with the rest of the world, is below potential. The region’s average trade openness (exports plus imports divided by GDP) is at 70 per cent of the EU-11 (Chart 9). This is due to different reasons. The cost and time to export tend to be higher in Western Balkan countries vis-à-vis EU members. The average share of manufactured goods in total exports is much lower in the Western Balkans compared to EU-11 (55 versus 71 per cent) which reflects the fact that the region is not well integrated into EU (or global) supply chains. Also, the sophistication of the exported manufactured goods is worse than in EU-11. Over 50 per cent of the regions’ manufactured goods are either labour- and resource- intensive or low-skill and technology intensive, in comparison to about 30 per cent in the EU-11 (Chart 10).

          Chart 9: Trade openness (2014)                         Chart 10: Share of manufactured goods in total exports and breakdown by the technology level (2014)

          

      Source: UNCTAD: International trade database

  1. Improvement of the transport infrastructure can be one of the key growth enablers. Years of neglect and under-investment have led to major investment needs in transport infrastructure: poor quality of roads, inadequate railway systems and ports, and limited air transport (Chart 11). But major financial assistance is at hand. The Western Balkans has been promised by the EU a financial envelope of up to €1 billion for key connectivity related investments over the period of 2015-2020. Chinese investment in infrastructure in the region is becoming increasingly important. The region may also benefit from private sector participation in the provision of new infrastructure, although to date there have been no successful public-private partnerships (PPPs) in the road or railway sectors.
  2. Exploiting the region’s energy sector is a clear opportunity. The strong potential for transforming the region’s power supply (Chart 12) comes from three directions. First, several significant energy projects are under construction or in the pipeline. Second, improvement in energy efficiency can be expected in the years ahead, especially in Albania and Kosovo where losses in distribution account for up to 30 per cent of gross electricity consumption. And third, regional cooperation through the Energy Community is yielding tangible benefits through increasingly coordinating energy needs and integration into the EU energy market. In addition, the region is gradually being viewed as a potential transit region of gas supplies to the EU. The key projects are: the Trans-Adriatic Pipeline (TAP), designed to bring in around 10 bcm of natural gas from Azerbaijan via the Trans-Anatolian Natural Gas (TANAP) pipeline through Greece and Albania, and across the Adriatic Sea to Italy; and the 5 bcm Ionian Adriatic Pipeline (IAP) from Albania through Montenegro and BiH to Croatia.

         Chart 11: Quality of transport infrastructure (2015)  Chart 12: Net maximum capacity of power plants in MW, 2014

          

       Source: WEF’s GCR Source: South-eastern Europe Energy Community

  1. Innovation is another area of potential growth. Although overall spending on R&D is close to negligible, innovation broadly defined – adopting and adapting to existing products and processes as well as introducing organisational and marketing changes (Chart 13) – is a feature of many companies.Further innovation could be enabled by easier access to finance and retaining skilled workers.

         Chart 13: Percentage of firms engaging in different types of innovation (weighted cross-country averages)

             

            Source: EBRD: BEEPS V, MENA ES and authors’ calculations, 2013.

  1. What are the long-term challenges and risks?

There are four main areas that require long-term vision and commitment to head off the risks: reform fatigue, financial sector fragility, inclusion and demographic trends and climate change. One risk is that further structural reforms are postponed or even reversed, leaving the region “stuck” in transition. EU approximation represents the best hope for structural and institutional reforms. However, convergence towards EU standards will require far-sighted politicians with a strong commitment to reform. Sustained cooperation and coordination among the countries themselves, as well as with the wider international community, will be key to tackling pressing issues such as financial sector fragility. Longer-term demographic and inclusion trends are also worrying and need to be addressed in order for the region to reach its growth potential. Lastly, the Western Balkan region is vulnerable to the negative consequences of global warming and climate change. The incidence of extreme weather events and climate-related hazards has increased noticeably during the past two decades, and these events are expected to continue and accelerate in the future. These problems will also require a cooperative and coordinated approach.