**1. Introduction**

What causes a fundamental lack of development in Western Balkan (WB) countries? The effectiveness of political and economic institutions is a vital determinant of long-run growth. Institutions constitute one of the underlying explanations for differences in growth across countries [1]. The structure of a societal organization is the central force behind differences in Albania, Bosnia and Hercegovina, Kosovo, Montenegro, North Macedonia, and Serbia [2]. The WB 6 shares a similar economic history. However, each of these countries has its differences. Today, the six Western Balkan countries are facing numerous economic and financial challenges and weak institutions, while future development dynamic is significantly dependent on the quality of economic governance.

Political institutions, which represent the governance structure, exercise public authority. Examining differences of the Western Balkan governance structures

assists us to feature the efficiency of each country's public administration. On average, most of the WB 6 fare poorly on public services, implementation of policies, enforcement of property rights, and corruption. The relationship among these dimensions of economic governance and growth has been studied in recent literature [3–5]. Each of the WB 6 has tendencies to converge towards the European Union (EU), and each is expected to join the EU. Early in the 1990s, these countries started the transition mechanism. Countries with efficient institutions, welladvanced property rights, and sound public policies have stronger will to employ more efficiently physical and human capital and achieve a higher growth rate. Since each of the WB 6 has set its national development strategies, it is valuable to examine how the government efficiency indicator impacts this set of economic growth dynamics. Besides, we are interested in observing the behavior of inflation, as the new Member States eventually have to fulfill the Maastricht price criteria.

The objective is to reveal the dynamic relationship between economic governance, growth, and inflation for each of the WB 6 in the specified period and forecast the economic growth and inflation dynamics using an SVAR approach. Specifically, we aim at exploring how economic governance shocks impact GDP growth and vice versa. To achieve that objective, we estimate recursively structural VAR identified models for each of the Western Balkan countries. On purpose, we included the years of the global crisis to observe, analyze, and explore changes in this vital relationship between the exogenous shocks of the economic integration of the WB 6 and growth. We have to keep in mind that foreign direct investments could not penetrate the WB 6 markets as they did in the EU members because of economic disintegration. The data for governance quality are collected from the World Bank database [8, 9]. We must identify purely exogenous (policy or another type) shock to be able to trace out its dynamic effects: identify the structural VAR. Impulse responses trace the effects of structural shocks on the endogenous variables. Besides, we use forecast error variance decomposition to observe the proportion of the movements of a variable due to shocks to itself and to shocks to other variables. Ceteris paribus, we hypothesize that shocks to government effectiveness positively affect economic growth and can be employed by the WB 6 governments as an anti-inflationary mechanism in the process of accessing the European Union. In short, this paper will show the impact of institutional strength on the development

*Governance and Growth in the Western Balkans: A SVAR Approach*

*DOI: http://dx.doi.org/10.5772/intechopen.91731*

Government effectiveness fosters growth and prosperity. The relationship between growth and government effectiveness in advanced countries has been

Papers that examine WB 6 economies are limited. To this end, various conceptual and empirical models are employed. The convergence of the WB 6 towards the EU-15 members has been examined by Siljak and Nagy, and they find the WB 6 converges faster, ranging from 1.3% to 3.6% [20]. Economic integrations, openness, and foreign direct investments impact growth based on recent literature in the EU [21]. EU membership prospect is the best trigger for foreign inflows [22]. Economic integration of CEE countries, between 1993 and 2001 and 1995–2007, revealed faster convergence towards the EU [23, 24]. The convergence patterns change

It looks like there is no integrated agreement in the empirical literature on the significance and the line or course on which it is moving. On the other hand, the economic catch-up integration of the WB 6 towards the EU still shows no convergence [26, 27]. Colak analyzed 33 EU (CEE 10, SEE 8, and EU 15) countries and found that economic governance has converged for each group of countries [28].

As far as the global economic crisis of 2008, different countries have had differ-

The WB 6 are heterogeneous, lacking similar convergence. Based on Zuk and Savelin (2018) the most successful central, eastern, and southeastern Europe

Badinger does not find a strong relationship between economic freedom and long-term growth [29]. The relationship between EU integrations and economic growth showed to be of positive and strong significance [30].

ent sensitivities [31–33]. Matkowski et al. examines the convergence of EU-11 towards the EU-15 during the period 1993–2015 and reveals that a greater extent of convergence was before the financial crisis [34]. The convergence before the crisis

was at a higher rate in the EU [35–37]. Western Balkans have continually

underperformed compared to the average of the EU.

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dynamics and dynamics of the EU integration process.

a topic of many empirical and theoretical studies [10–19].

across the WB 6 in different periods [25].

**2. Literature review**

Based on the requirements of the Maastricht criteria for entering the EU, the inflation rate must be stabilized as a prerequisite to joining. The WB 6 has to bring its national legislation in line with EU law and meet price stability to ensure economic convergence. Convergence criteria explicitly report: "A price-performance that is sustainable and average inflation not more than 1.5% above the rate of the three best performing Member States [6]". The Union carefully monitors the progress in the alignment with and implementation of the *acquis* throughout the process of negotiating. For instance, in the case of Montenegro, one of the benchmarks for the chapter Economic and Monetary policy is the Country has adopted the required constitutional change. It has to ensure that the primary objective of price stability is defined in compliance with Articles 127 (1) and 282 (2) of the Treaty on the Functioning of the European Union—Article 143 of the Constitution [7].

Even though economic governance has been analyzed to a moderate extent within the EU, we find there is still sufficient space for enhancement using the WB 6 as an example. The novelty of this paper is that it uses a structural vector autoregressive approach for the economies of Albania, Bosnia and Hercegovina, Kosovo, Montenegro, North Macedonia, and Serbia to analyze the impact of economic efficiency to growth. This paper suggests examining time series data from January 2006 to December 2018 for WB 6. It evaluates and compares the empirical performances of forecasts of inflation, GDP, and economic governance effectiveness.

The annual economic reform program exercise led by the European Commission with all Western Balkan countries is a crucial tool for supporting the modernization of their economies and achieving closer economic coordination with the EU. The Commission will strengthen this exercise, bring it even closer in line with the current European semester for the EU Member States, and provide more advanced technical assistance.

In the context of the EU framework to support economic governance, all candidate countries and potential candidates are invited to submit a three-annual Economic Reform Programme (ERP) which comprises of the following components: macroeconomic framework, fiscal framework, and structural reforms. The ERPs contain medium-term macroeconomic projections and budgetary plans for the next 3 years, as well as a list of priority structural reform measures aiming at boosting competitiveness and inclusive growth. The ERP process has helped to focus on governments' attention to addressing urgent structural reform needs and to improve coordination. However, the tangible results of such reform efforts on people's lives still need to materialize. Awareness of the policy guidance by the relevant stakeholders and commitment to their implementation needs to be strengthened by the WB 6.

#### *Governance and Growth in the Western Balkans: A SVAR Approach DOI: http://dx.doi.org/10.5772/intechopen.91731*

The objective is to reveal the dynamic relationship between economic governance, growth, and inflation for each of the WB 6 in the specified period and forecast the economic growth and inflation dynamics using an SVAR approach. Specifically, we aim at exploring how economic governance shocks impact GDP growth and vice versa. To achieve that objective, we estimate recursively structural VAR identified models for each of the Western Balkan countries. On purpose, we included the years of the global crisis to observe, analyze, and explore changes in this vital relationship between the exogenous shocks of the economic integration of the WB 6 and growth. We have to keep in mind that foreign direct investments could not penetrate the WB 6 markets as they did in the EU members because of economic disintegration. The data for governance quality are collected from the World Bank database [8, 9]. We must identify purely exogenous (policy or another type) shock to be able to trace out its dynamic effects: identify the structural VAR. Impulse responses trace the effects of structural shocks on the endogenous variables. Besides, we use forecast error variance decomposition to observe the proportion of the movements of a variable due to shocks to itself and to shocks to other variables.

Ceteris paribus, we hypothesize that shocks to government effectiveness positively affect economic growth and can be employed by the WB 6 governments as an anti-inflationary mechanism in the process of accessing the European Union. In short, this paper will show the impact of institutional strength on the development dynamics and dynamics of the EU integration process.
