Alex Young in Belgrade -

Without a state-level government for almost a year, the extent of Bosnia-Herzegovina's economic woes continues to become ever more apparent.

Widespread protests by farmers' associations from the Federation of Bosnia-Herzegovina, the country's Bosniak-Croat entity, over changes to agricultural subsidies recently led to the blocking of four border crossings and the Federation government building. Workers from one of the country's oldest factories, meanwhile - the furniture manufacturer Konjuh - have descended on Sarajevo, requesting both financial assistance and investigations into alleged mismanagement. Though Bosnia's economy has returned to (marginal) growth, job creation and the position of domestic producers remain extremely weak.

Fiscal matters are increasingly proving to be one of the main sources - and manifestations - of inter-ethnic tension. The Republika Srpska, the country's other Serbian entity, is to pursue two lawsuits against the Federation - one relating to €35m of unpaid indirect taxation revenues; the other concerning some 25,000 pensioners, whose obligations the Federation should have assumed. In sum, the outstanding debts to the Republika Srpska amount to approximately €300m - roughly a third of the Federation's annual budget.

The Republika Srpska government has also called for reform of the state-level Indirect Taxation Authority (ITA) and the opening of separate accounts for the collection of revenues. Effective from 2006, the ITA administers the collection of VAT revenues from throughout Bosnia, providing the largest single source of government revenue. The two parts of Bosnia receive any surplus left over after state expenses have been covered, in accordance with their respective collection of VAT receipts. Given its significance, the ITA is likely to provide the next battleground in the heated dispute over Bosnia's future shape and form.

In addition, the Republika Srpska's Ministry of Finance has proposed amendments to the Law on the Central Bank of Bosnia-Herzegovina, arguing that - as a co-founder of the bank, having contributed a third of the initial loan - it should be entitled to one-third of the bank's revenues. At present, 60% the bank's revenues are paid to the budget of Bosnia's state institutions, with the remainder transferred to the bank's general reserves.

Budget battle

Once a government is established, approving a budget for Bosnia's state-level institutions for 2011 and 2012 will be a first priority.

The Republika Srpska has clearly indicated that it will reject any proposed increases, arguing that its budget cuts - particularly of government salaries - should be mirrored at the state level and in-line with austerity measures passed by other European countries. Even if the budget for 2011 were to remain the same as 2010 (at BAM1.028bn, which is approximately €514m), the share derived from indirect taxation revenues would increase by approximately €59m due to losses of other revenues. Such an arrangement is seen as detrimental to the entity's financial interests and is likely to spark heavy resistance that will threaten the sustainability of state institutions, which currently rely upon temporary financing.

Meanwhile, the governing coalition in the Federation - led by the much-vaunted Social Democratic Party (SDP) of Zlatko Lagumdzija - has been accused of nepotism in appointing hundreds of close associates to positions in public companies. Audit reports have revealed a distinct lack of transparency in the spending of almost all the Federation's institutions and ministries, particularly the Ministry of Agriculture, Water Management and Forestry, which apparently paid agricultural incentives to a manufacturer of ammunition and explosives. The same institutions have also been criticized for their excessive levels of spending on salaries and allowances, and travel expenses. Several state companies, such as BH Telecom and Elektroprivreda Bosnia-Herzegovina, which produces and distributes electricity, have also been accused of hiding some €500m in commercial banks that could instead be used for investment purposes.

Standard and Poor's has already warned that Bosnia's credit rating may be downgraded from 'stable' to 'negative' due to, in particular, political stalemate and public sector corruption. In addition, Bosnia could lose some €96m of support allocated for 2011 under the EU's Instrument for Pre-Accession As-sistance (IPA), due to a failure to reach agreement on which projects to support. With the EU pushing stronger conditionality as part of its bid to play a more assertive role in the country, such disputes are likely to intensify; particularly with the Republika Srpska largely opposed to projects designed to strengthen state-level institutions, such as the High Judicial and Prosecutorial Council and the Statis-tics Agency. Continued delays in the formation of the Council of Ministers may also deprive Bosnia of further international assistance - including the IMF's Stand-By Arrangement, World Bank credits and the EU's Macro-Financial Assistance - amounting to some €500m.

The shifting regional context, meanwhile, is creating new dilemmas. Kosovo's decision to impose a 10% customs duty on goods from Bosnia (which amounted to some €80m in the first six months of 2011) has further impacted its trade balance, with competitors from Macedonia and Montenegro taking over lucrative markets. Croatia's seemingly imminent membership of the EU, however, may open up new possibilities. Once it joins, Croatian manufacturers will no longer benefit from duty-free exports provided by the Central European Free Trade Agreement (CEFTA), but will instead have to pay a 15% levy to export to its most significant non-EU markets in the region. As such, many are considering relocating factories to Bosnia. Pre-empting such a move, the Croatian government has threatened to allow exports to pass through only two border crossings (Gradiska and Bijaca), thereby adding to the costs facing Bosnia's exporters.

If functionality is to be the key driver of constitutional reform, then the country's political elites, as well as the international community, may have to consider the creation of a third - and invariably predominantly Croat - entity within Bosnia as a replacement for the cumbersome and expensive cantonal system of government in the Federation. Indeed, given the contentiousness of constitutional reform issues at present, it makes a great deal of sense to shift the focus to economic development programmes at the entity and cantonal levels.

In the absence of consensus, however, Bosnia-Herzegovina's accelerating economic and fiscal fragmentation continues to pose the biggest threat to its future viability.