Public Information Notice No. 06/80

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Albania

July 26, 2006

On July 24, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Albania.¹

Background

Macroeconomic performance since the turn of this decade has generally been strong. Growth has been rapid and Albania is now emerging from the low-income country group. Together with large remittances, the rapid growth has significantly reduced poverty. The absolute poverty rate declined from 25½ percent in 2002 to 18½ percent in 2005 and the extreme poverty rate from 4¾ to 3½ percent. Macroeconomic stability has been maintained—evidenced by low inflation, increasing confidence in the currency and the banking system, and rising international reserves.

Fiscal policy has contained net domestic borrowing and lowered public debt from 67½ percent of GDP in 2001 to 55¼ percent in 2005. More recently, reforms in revenue administration have boosted revenues—which have been allocated in the 2006 supplementary budget between investment spending, tax relief, and continued debt reduction. The absence of fiscal dominance has supported the Bank of Albania's (BoA) monetary policy framework—a reserve money program with the repo rate as the main policy instrument, combined with a floating exchange rate regime.

However, progress with structural reform has been uneven and the business environment remains relatively uninviting. Despite advances, weak public institutions remain a source of vulnerability, particularly in the fiscal and financial areas. Together with infrastructure deficiencies—particularly in the electricity sector—these factors hinder growth and promote corruption and informal activities. While there is no indication of a significant exchange rate misalignment, the resulting lack of non-price competitiveness continues to hinder investment and exports.

Past accomplishments notwithstanding, recent macroeconomic developments pose new challenges:

• Credit growth has accelerated markedly. The stock of private sector credit increased from 9 percent of GDP at end-2004 to 17 percent of GDP by April 2006, creating a sizable demand impulse. So far, however, the resulting rise in nontradables prices has been offset by declining traded goods prices, with the result that headline inflation is still low and relatively stable.

• The current account deficit increased to an estimated 7¾ percent of GDP in 2005, up from 5½ percent in 2004, as a result of weakening demand in key trading partners and intensified competition in textiles (Albania's main product market). This, together with strong import demand-partly fueled by the credit expansion-and higher oil import costs, caused the trade deficit to widen in 2005, a trend that appears to have continued in the first quarter of 2006.

• Growth has slowed. The electricity crisis in October-November 2005 hit the economy hard and economic activity in the construction sector has weakened. Together with a slowdown in exports, these factors led to a slowing of growth from about 6 percent in 2004 to 5½ percent in 2005. The economy weakened further in the first quarter of 2006, reflecting the emerging capacity constraints in non-tradable sectors and the closing of a large metallurgy plant.

Executive Board Assessment

Directors commended the authorities for Albania's good macroeconomic performance in recent years. Strong, noninflationary growth, combined with large and sustained remittance inflows, have raised incomes significantly and lowered poverty. Directors considered that sound macroeconomic policies—including the maintenance of a flexible exchange rate regime—and a more competitive banking system had contributed to this success. In the period ahead, Directors emphasized the need for far-reaching structural reforms to enhance the business climate, secure long-term economic growth, and achieve the Millennium Development Goals.

Directors supported the authorities' fiscal strategy, which aims at maintaining a small government and the privatization of non-core activities. This approach is expected to improve efficiency, conserve scarce resources, and serve more effectively Albania's development needs. However, to be successful, it will require strengthened medium-term budgeting and better integration of the annual budget into the medium-term expenditure framework and the Poverty Reduction Strategy Paper.

Directors commended the authorities for their success in strengthening tax administration, and supported the planned disposition of the resulting revenue gains. However, if the revenue gains continue to exceed expectations, they recommended a more aggressive debt-reduction path than currently envisaged. Directors agreed that any future tax relief should focus first on reducing rates on taxes that most distort the labor market, but stressed that tax relief should be introduced at a measured pace, and only after making certain that other revenue increases that replace the taxes forgone are permanent.

Directors considered that the 2006 supplementary budget is fully consistent with the new fiscal strategy, and properly balances the need for infrastructure investment, tax relief, and debt reduction. The reduced call on domestic borrowing in 2006 will help reduce aggregate demand and provide appropriate support to monetary policy.

Directors commended the BoA for its prudent monetary policy implementation. They welcomed the recent increase in policy interest rates, which should help alleviate underlying price pressures and prevent possible second-round effects of the increase in the electricity tariff. Directors observed that the floating exchange rate regime has served Albania well, and recommended that it be maintained in order to help the economy withstand external shocks.

Directors viewed the recent growth of financial intermediation and increased dynamism of the financial sector as beneficial and necessary for continued rapid economic growth, but noted the attendant risks to macroeconomic and financial stability. In this regard, they commended the authorities for initiating early and proactive measures to strengthen banking and prudential supervision, and urged them to stand ready to take additional measures as warranted. They recommended that nonbank supervision be strengthened as well. Directors supported the planned creation of a unified supervisory agency for the nonbank financial sector, which should be independent, sufficiently funded, and properly staffed.

Directors supported the authorities' structural reform program, which will help to strengthen institutional quality and infrastructure and underpin growth at higher income levels. Better governance, the enforcement of property rights, and efforts to root out corruption will help to attract the high-quality private investment that is needed to further develop the export sector and increase the formal sector's share of economic activity. Directors supported the authorities' decision to privatize the distribution arm of the electricity company (KESH), and urged them to proceed in a timely manner with the remaining large-scale privatizations.

Directors encouraged the authorities to work toward eliminating the significant weaknesses that remain in the national accounts and balance of payments statistics.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.