Mission Concluding Statement 

Kosovo: Staff Concluding Statement of the 2017 Article IV Mission

December 13, 2017

An IMF mission, led by Stephanie Eble, visited Pristina during November 29-December 12 to conduct the 2017 Article IV consultation discussions. The IMF mission is grateful to the authorities and all other counterparts for their excellent cooperation, frank and open discussions, as well as hospitality.

Kosovo has made significant progress during the last years, including under the recent Stand-by Arrangements in ensuring fiscal discipline, strengthening the health and resilience of the financial sector, and enhancing growth. Policies should now focus on reforms to improve competitiveness to close the gap, reduce income inequality, and achieve stronger and more inclusive growth. This will require measures to further improve productivity and private sector activity; further enhance the budget composition within the limits of the fiscal rule; and support financial deepening, while safeguarding financial sector stability.

Macro-economic developments and outlook

Growth is expected to reach 4.1 percent in 2017 , among the highest in the region, led by high investment and exports. Continued growth in remittance inflows and bank lending also give support to this development. Headline inflation has increased on higher international food and fuel prices and is expected to average 1.5 percent this year.

The medium-term outlook is favorable but subject to risks . Based on current policy objectives (fiscal discipline and gradual structural reforms), real GDP growth is expected to remain at 4 percent, driven by private consumption and investment, with exports making an increasing contribution to growth. Inflation is projected to remain slightly above the euro area average of 1.8 percent, reflecting moderate productivity gains. While this outlook is relatively favorable, higher growth is needed to accelerate job creation and lift incomes. Medium-term growth could surpass 4 percent should the planned new power plant project and reforms be implemented that attract more private sector foreign and domestic investments and mobilize large IFI financing for key capital projects. However, risks to political stability could undermine confidence and halt reforms. Also social spending pressures could crowd out productive spending. Furthermore, dependency on remittances continues to leave Kosovo vulnerable to potential external shocks.

Recent reform progress, but important challenges remain ahead

Kosovo has made significant progress in strengthening economic growth , containing the fiscal deficit while increasing infrastructure spending, and enhancing financial sector stability and deepening. Furthermore, there has been progress in structural reforms such as initiating more transparent public procurement (even though implementation is lagging), adopting a new bankruptcy law, and strengthening contract enforcement.

However, important structural challenges remain . Weak external competitiveness, informality, weaknesses in governance, low labor force participation and high unemployment rates particularly among young workers continue to constrain Kosovo’s growth potential. Resolving these structural problems is needed to develop a productive, export-oriented private sector to accelerate income-convergence with the European Union.

The mission discussed the following reform priorities:

Structural Reforms: Improving Investment Climate, Governance and Competitiveness

Kosovo needs to further improve its business environment . While Kosovo’s ranking on the World Bank’s “Doing Business Indicators” has improved significantly, in some areas, these improvements reflect legislative and regulatory changes, which need to be implemented in practice to further enhance the business environment. Implementation of recent legislative changes will reduce the costs of doing business and level the playing field between debtors and creditors.

Also, better governance and more efficient judiciary can help attract much needed investment . In this regard, the mandatory e-procurement platform should be used, the effectiveness of the anti-corruption agency and asset declaration strengthened, and large public investment projects should be subject to ex-post audits.

Addressing energy and infrastructure bottlenecks will help support private sector activity and strengthen competitiveness . This requires finally moving ahead with the much-delayed new power plant, and protecting the space in the budget for priority investments.

Plans to reduce inefficiencies in the public enterprise sector should be carried out and are critical to improve growth prospects and reduce fiscal risks . Reform priorities include improving governance by strengthening the independence of supervisory boards, timely publication of financial statements, external audits, and significantly reducing operating costs by rightsizing employment and reducing high wage bills. This should also pave the way for private sector involvement in the medium term, including privatization. The Privatization Agency’s institutional and governance structure should also be strengthened to accelerate the slow-moving privatization/liquidation process.

Planned reforms focused on increasing labor participation and addressing unemployment are welcome . To reduce the high unemployment rate, in particular amongst the youth and increase the low female labor market participation, the mission welcomes the government’s action plan that focuses on vocational training, active labor market polices, and increased availability of affordable child-care and urges for swift implementation.

In addition to these measures, any future increases in the minimum wage should be in line with the current rule-based minimum wage setting mechanism , given the still high level of unemployment, large competitiveness gap, and weak enforcement framework. Large discretionary increases in the minimum wage could, in the medium term, disadvantage low skilled workers and increase youth unemployment, as well as generate pressures to the already high social benefits, thus crowding out higher priority spending in the budget.

Fiscal Policy: Supporting Economic Growth through Macro-stability, and Structural Tax and Expenditure Policies

The fiscal stance remains appropriate from an economic stability and development perspective, and the “fiscal rule” is an appropriate anchor for fiscal policy . In line with the supplementary budget, the 2017 budget deficit (fiscal rule definition) is expected to be about 1.5 percent of GDP, well below the fiscal rule’s deficit ceiling of 2 percent of GDP. The draft 2018 budget targets a deficit of 1.8 percent of GDP, in line with the fiscal rule. The draft budget also keeps the wage bill constant as a share of GDP, in line with the wage bill rule. The authorities expect to start utilizing donor and privatization-financed investment (exempted from the fiscal rule’s deficit ceiling) to address the large infrastructure gap. Assuming past difficulties in mobilizing these resources are addressed, such project spending could reach 1 percent of GDP next year. Bank balances have been restored to a prudent level of 4.5 percent of GDP and are expected to stay at that level.

However, the overall budget composition should be improved over time . Pressures for higher social spending are high, and against revenue constraints, could crowd out needed scaling up of investments in education, health, and infrastructure which are critical to improve productivity and growth. In this regard, the mission recommends the following structural measures:

• The authorities should broaden the tax base by further strengthening the tax and customs administration to reduce informality . Collections should be reinforced by setting quantitative and strategic performance targets, widening the tax filing requirements, improving the efficiency and productivity of audits and significantly scaling up debt collection. To meet the 2018 budget revenue target (which includes gains from tax administration improvements), the authorities are preparing specific tax and custom administration reforms, which should start in earnest. Introduction of tax holidays or exemptions that could weaken the tax base should be avoided.

• Social benefit programs should be reformed to more effectively address inequality, poverty and unemployment within the existing spending envelope . This includes strengthening mechanisms to ensure no double dipping, better means-testing, removing disincentives to remain employed, tightly administering and enforcing eligibility of schemes, and making the system more equitable by e.g. aligning the disability threshold and payments for war veterans to the general disability benefits. Further, a credible re-classification and verification of war veterans, in line with the law, should be completed in early 2018, which is necessary for social spending to stay within the budget envelope. The mission urges not to introduce any non-contributory early retirement schemes for special groups (such as for the police) as this would undermine the fairness and financial soundness of the pension system.

• Efficacy of health and education spending should be improved . Healthcare and education spending levels and outcomes are poor. The mission welcomes the increased 2018 budget allocation and urges the authorities to accelerate efficiency improving reforms in the health care system to keep spending in check once the new insurance system is rolled out. Also, the contribution base must be broadened to secure sufficient revenue. Comprehensive education reforms should move ahead in earnest to upgrade skills and address mismatches, often quoted as one of the key impediments to growth.

• The wage bill should make space for hiring in priority sectors within the limits of the rule . The mission recommends that across the board wage increases be more restrained, given the already high public sector wage level. This would create space for priority hiring in the judiciary, health and education. It would also reduce pressure from public sector wages on private sector ones.

• The public investment framework needs to be strengthened to increase the efficiency of capital spending and improve the absorption of donor financing . This includes introducing a requirement for cost-benefit analysis of major capital projects, strengthening project appraisal, selection, preparation, and execution; adopting multi-year budgeting; and ensuring ex-post independent audit and assessment of large-scale projects.

Financing should be diversified, and its costs and roll-over risks reduced . The mission welcomes the continued extension of maturities, but urges to improve absorption of available IFI/EU financing (especially for investment) to minimize any crowding out once Euro area monetary policy normalizes. In line with the development of domestic debt market, the mission encourages the authorities to promote a diversified participant base on both primary and secondary markets.

Financial Sector: Supporting Economic Growth through Financial Deepening and Stability

Kosovo’s banks are well capitalized, liquid and profitable, but bank oversight could be further strengthened . In particular, the mission welcomes the low level of non-performing loans and adequate provisioning. Notwithstanding, the authorities should continue to strengthen their supervisory framework, for instance by advancing work on an off-site bank examination manual and further strengthening their macroprudential policy framework.

Further efforts are also needed to deepen financial intermediation . Credit penetration has increased in recent years, and interest rates have dropped significantly. However, at 38 percent of GDP, it is low relative to other CESEE and Western Balkan countries. Further, credit growth has been largest in mortgage and unsecured consumer lending, while lending to productive sectors remains low. Reform priorities to ensure larger and more balanced lending include the full implementation of the amended Law on Enforcement Procedures, addressing the still-large court backlog, establishing a fully-functioning property registry that covers all of Kosovo, and allowing banks access to the agriculture registry. It is also critical that the authorities continue to show supervisory vigilance amid strong and sustained consumer and construction lending.

Article VIII

Legal and financial experts that joined the mission found that Kosovo is free from multiple currency practices and restrictions on the making of payments and transfers for current international transactions, except for sanctions measures maintained solely for reasons of international or national security. The authorities expect to move shortly to Article VIII status from Article XIV (a transitional status available to new member countries in the Fund).