The main question addressed in this study is the performance of the labour markets in the Western Balkans. The aim was to find out whether they can deliver growth of employment and decline of unemployment in the medium run and whether they can withstand short- term shocks due to changes in demand or supply. These questions are particularly pressing in view of the monetary policy based on fixed exchange rates which is followed by the majority of the countries in this region. In terms of the theory of optimal currency areas, if the exchange rate is fixed, labour markets have to be flexible if there are adverse shocks. Otherwise, adjustment would work through a fall in employment levels and an increase in unemployment. The alternative of flexible exchange rates has been abandoned by most monetary authorities in the region for fears of risk of an exchange rate crisis.

It is assumed in this study that it would be rather difficult for the countries in the Western Balkans to abandon fixed exchange rate regimes and opt for a more flexible one. The example of Serbia, which is the one country that has been experimenting with exchange rate regimes, is not encouraging. Also, the example of Romania, which has switched to inflation targeting, is a rather new one and it is not clear whether it can be imitated even if it proves successful, which at this moment is still to be decided. We do not investigate these issues in depth here, but other studies and also the commitments of the monetary authorities in the Western Balkan countries are clearly in favour of one type or another of a fixed exchange rate regime. In practically all cases, the exit strategy is the euro (which is already used as legal tender in Kosovo and Montenegro) rather than more flexibility. Hence the study takes for granted that the West Balkan region finds itself largely in a fixed exchange rate regime with the eurozone.

This makes the study of the labour markets that much more important. Before summarizing the findings, brief comments are in order on the more important macroeconomic assumptions that can be relied on in view of the current state of these economies and having in mind the stylized facts about the transition in the peer countries (Bulgaria, Romania, Slovenia) and in other comparable transition economies.

Growth prospects are for the most part favourable in the medium run. The short-term risks of a slowdown are increasing in Serbia due to political instability. Other countries should see GDP growth rates in the range of 4% to 6% per year. Also, growth of industrial production should accelerate and export growth should remain strong.

The main shock in transition is that of productivity. Indeed, in this region, as in more advanced countries in transition, productivity growth is the main source of GDP growth. With employment stagnant or falling and recovering only in one or two cases, inflationary pressures should be quite moderate. Thus, if there is no policy mismanagement, fixed exchange rates should be sustainable except if productivity growth of the trading partners is even stronger. With the EU being the main trading partner, that risk is negligible.

Though OCA considerations are clearly important, labour market disequilibria seem to be mostly structural and connected with the characteristics of the process of transition (see section 3.1.1 for a detailed overview of labour market developments in the region). That means that low employment, high unemployment and market segmentation (i.e. a high share of informal employment) are not primarily the consequence of the wage setting process and practices. That is not to say that the flexibility of wages is not important for short-term adjustment, but medium-term developments are more subject to the change of structural factors.

Short-term risks are as a rule connected with the external balances. High trade and current account deficits make these countries vulnerable to short-term reversals in financial flows. These risks have been increasing recently due to unfavourable external developments and slow policy reaction in the countries in the region, but serious short-term risk is present only in the case of Serbia.

In the medium run, macroeconomic balances may prove to be sustainable if there are improvements in labour market outcomes. That will mostly depend on economic growth being strong and sustained and on the appropriate labour market policies.