Mission Concluding Statement 

Republic of Kosovo: Concluding Statement of the 2011 Article IV Consultation Mission

June 1, 2011

Kosovo enjoyed robust growth in the 2000s and weathered the global financial crisis well. However, the economy depends on remittances and direct investment from the Kosovar diaspora, a growth model that is likely unsustainable. Strengthening competitiveness—through administrative and legal reforms, better infrastructure, and wage restraint—is needed to foster the emergence of a tradable sector and self-sustained growth. Fiscal policy addresses pressures to increase capital and social spending from a limited revenue base. In the short term disciplined budget execution is pivotal. In the medium term a re-orientiation of fiscal priorities is needed, including raising more revenue from direct taxes. The financial system has developed rapidly but maintained a sound funding structure.

Background

1. In the past decade, Kosovo made significant progress with building key social and economic institutions. The efforts to build core functions of a public administration and strengthen governance have benefitted from considerable external assistance.

2. Kosovo enjoyed robust economic growth in the 2000s, with the structure of growth tilted toward domestic demand. Remittances from Kosovars living abroad boosted consumption, while foreign direct investment fuelled construction activity. By contrast, the export sector has remained small. GDP per capita remains among the lowest in Europe. Social challenges loom large, with unemployment estimated at about 40 percent of the workforce.

3. Kosovo unilaterally adopted the euro as legal tender. While this supports stability by importing a strong monetary anchor and has generally served the economy well, it places a premium on disciplined macro-policies, competitive wage levels, and flexibility to adjust to external shocks through internal adjustment.

4. The financial system expanded rapidly in the past decade, but avoided the built-up of large funding imbalances. Banks are mostly foreign-owned and deposit funded. Supported by technical assistance, the central bank (CBK) has taken over the responsibility for financial supervision and is building the capacity to provide emergency liquidity assistance to the banking system.

5. Kosovo benefits from low public debt and sizeable government cash buffers, the result of a conservative fiscal policy for most of 2000s. Potential for expansion was constrained by a limited tax base and the government’s inability to issue debt. Public expenditure as a share of GDP is modest, owing in part to low spending on transfers, as many social security schemes were rebuilt entirely after 1999. More generally, Kosovo does not bear large burdens of long-term obligations to pensioners, veterans, or creditors.

Recent developments

6. The global financial crisis had only a modest impact on Kosovo, as limited integration into global financial and goods markets curbed contagion. Inflation follows price developments for food and gasoline imports, triggering deflation in 2009 and double-digit inflation in early 2011. Credit growth moderated, but banks’ portfolio quality deteriorated only modestly and profits remained solid. Large capital buffers suggest ample shock-absorbing capacity.

7. Since 2008, the government has adopted an increasingly expansionary fiscal stance, financing deficits from cash buffers, asset sales, and donor support. The general government balance shifted from a surplus of more than 7 percent of GDP in 2007 to a deficit of 2.6 percent in 2010. Capital spending has been the expansion’s main driver. In 2010, construction started on a highway linking Pristina with the Albanian border. Costs are estimated at more than 20 percent of annual GDP. This year, spending pressures spread to current expenditures, with large increases in public sector wages and war related benefits.

8. An 18-month Stand-By Arrangement (SBA) approved by the IMF Executive Board in July 2010 was interrupted in 2011. The program aimed at restoring fiscal sustainability and safeguarding financial stability, by exercising restraint on current spending and bolstering the government’s deposits with the CBK. Elements of the 2011 budget—in particular the large increase in the wage bill—deviated from program commitments. As a result, no program review could be completed. During this mission, staff and the authorities reached staff-level agreement on a Staff Monitored Program to establish a track-record that could lead to an IMF-supported arrangement in 2012.

Short-term macroeconomic outlook and risks

9. The short-term outlook is benign, even though high food prices are putting pressure on inflation. Remittances, robust credit growth, and public investment continue to support domestic demand. Exports are growing fast, although from a low base. Overall the economy is projected to grow by about 5 percent in both 2011 and 2012. High import prices are expected to push inflation to more than 8 percent (annual average) this year. However, core inflation remains benign, even though possible spillovers from higher public sector wages need to be watched. IMF staff projects the current account deficit to increase to
25 percent of GDP, financed by FDI and other non-debt creating inflows.

10. The outlook is subject to large downside risks, from both domestic and external sources. Domestic risks include economic policy missteps and political disturbances. External risksinclude weaker growth in Europe. This could reduce incomes of Kosovars living abroad, thus limiting remittances and capital inflows, and forcing a contraction in domestic demand. Lower remittances could also affect the banking system by reducing deposits as well as debtors’ capacity to service their debts.

Enhancing competitiveness and promoting sustainable growth

11. Kosovo’s growth model needs reorientation. To date growth relied on exceptionally high remittances and FDI from abroad, but longer-term prospects for these flows are subdued as diaspora Kosovars integrate more closely into their host countries. Going forward, the key challenge is fostering the emergence of a tradable sector that could drive economic development and growth.

12. Numerous constraints impede the development of a tradable sector. Infrastructure is lacking, notably in transport and energy supply. Limited administrative and judicial capacity impede the business climate. Skill levels of large parts of the work force are modest, reflecting inter alia disruptions in the provision of education prior to independence. Wages, while low in nominal terms, are not particularly competitive when scaled with a measure of productivity (such as per capita GDP).

13. The government’s recently adopted competitiveness strategy contains important steps in the right direction, notably administrative and legal reforms to improve Kosovo’s rank in the World Bank’s “Doing Business” survey; the privatization of energy production and distribution to enhance the reliability of energy supply; and the government’s ambitious highway construction program, although related fiscal burdens require careful management.

14. Negative implications of government policies for labor costs should be avoided. The sharp increase in public sector salaries may trigger undesired spillovers to private sector wages. Minimum wages should be set at levels that avoid excluding employees from formal employment, especially younger workers.

Restoring fiscal sustainability

15. Fiscal policy should remain anchored by two complementing objectives: the maintenance of adequate liquidity buffers and the sustainability of public debt.

• Liquidity buffers consist primarily of the government’s balances with the CBK. They are needed not only to satisfy the government’s own liquidity needs, but also to extend resources to the CBK to provide emergency liquidity assistance to banks if needed. A useful yardstick for bank balance adequacy are one month of public expenditures plus one-tenth of banks’ non-equity liabilities, adding up to about
€300 million.

• Debt sustainability. IMF staff recommends targeting a medium-term primary deficit of about 0.5 percent of GDP. This would allow for a very gradual increase of public debt, stabilizing at about 30 percent of GDP in the long term. Kosovo’s public debt law prescribes a maximum public debt ratio of 40 percent of GDP, thus, the recommended deficit path leaves room to react to external or growth shocks.

16. Kosovo’s current fiscal stance conflicts with both objectives. Liquidity management is complicated by the large outlays on the highway that give rise to temporary deficits of around 5 percent of GDP, with limited financing options through debt issuance. As regards sustainability, staff estimates the primary deficit underlying the 2011 budget at
3½ percent of GDP, implying a fiscal adjustment need of close to 3 percent of GDP.

17. Specifically, while fiscal challenges in 2011 appear manageable, adjustment and/or external disbursements are needed to prevent bank balances from falling below prudent levels in 2012. Revenues have evolved well, reflecting in part progress with tax collection. However, the civil service wage hike raises current expenditures permanently by about one percent of GDP. In the 2011 budget this increase is partly compensated by lower capital spending. Receipts from the privatization of the post and telecom operator are expected to be the main source of deficit financing. While privatization appears on schedule to be finalized before end-year, a possible delay is a risk, and IMF staff recommends building a contingency reserve. In the second half of 2012, bank balances are projected to be depleted on unchanged policies.

18. Against this background, IMF staff recommends fiscal adjustment of ¾ of a percent of GDP annually over a period of four years, with a mix of revenue measures and restraint on current spending. Such a policy would safeguard both adequate liquidity buffers and a sustainable fiscal stance, provided international assistance resumes in 2012.

19. New spending initiatives need to be costed thoroughly, and their accommodation requires higher revenues or expenditure cuts elsewhere. Importantly, the government plans another highway from Pristina to Skopje/Macedonia, for which a sound financing plan is an indispensable prerequisite. Social priorities include a pension for war veterans and benefits for former political prisoners. Prior to designing such benefits, a comprehensive assessment of the number of eligible beneficiaries is needed.

20. More generally, the government’s ambitious spending plans suggest a need for a reorientation of fiscal priorities. Funding higher expenditures with one-off revenues is unsustainable if spending needs are permanent. In this case, more permanent revenues are required. One option is raising the low yield from direct taxes. An upcoming IMF technical assistance mission will develop recommendations in cooperation with the authorities.

21. Unorthodox funding measures should be avoided. Specifically, the government should not tap the assets of the pillar II pension fund, even though a modest part of new inflows could be invested in government paper within the limits of the current legal framework. Large-scale non-concessional borrowing should also be avoided. While such actions might alleviate short-term constraints, in the medium term they would make budget financing more difficult.

Safeguarding Financial Stability

22. While Kosovo’s financial system has evolved in a robust manner, further progress is impeded by limited judicial capacity and incompletely defined property rights. With assistance from the World Bank, the authorities are improving a cadastre to increase the use and enhance the quality of collateral in lending operations. Reforms to speed up contract enforcement by the courts are also needed.

23. Full institutional and operational independence of the CBK is critical for preserving financial stability. In this context, the appointment of a new central bank governor earlier this year was characterized by a clean implementation of the central bank law’s nomination rules.

24. Financial supervision has made progress. Following a based-risk supervision model under the framework of Basel I, the superintendency of banks conducts at least one comprehensive on-site inspection per bank each year. Advances are also being made in the area of stress-testing.

25. Passage of the new banking law will strengthen the institutional framework for banks and microfinance institutions. The draft law improves governance standards, tightens restrictions for lending to bank-related parties, and allows for consolidated supervision of banking groups. It also grants the authorities better tools for bank resolution. To this end, the deposit insurance law needs to be amended to allow funds of the deposit insurance fund to be used for purchase and assumption transactions. As regards microfinance institutions, the law should require a clearly defined ownership structure and assign to the CBK the responsibility for licensing.

26. A priority is enabling the CBK to provide emergency liquidity assistance (ELA) in needed. At the conceptual level ELA was introduced in 2010. Going forward, a memorandum of understanding between the government and the CBK needs to be completed to define duties and identify resources that the CBK can use for ELA.

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We wish to thank the authorities for their hospitality and for the open and constructive discussions.