Press Release No. 18/481

IMF Executive Board Concludes 2018 Article IV Consultation with Kosovo

December 18, 2018

On December 17, 2018, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation [1] with Kosovo, and considered and endorsed the staff appraisal without a meeting. [2]

Following three years of robust economic growth, the economy is expected to continue to grow at 4.0 percent in 2018, led by investment, consumption, and services exports. Inflation is projected to remain subdued at 0.9 percent. The budget deficit under the fiscal rule definition is expected to be around 1½ percent of GDP, well within the fiscal rule ceiling of 2 percent. Adding investment exempted from the deficit rule, the overall deficit is expected to reach 3 percent of GDP, which is also accompanied by a widening of the current account deficit to 7 percent of GDP. The banking system remains sound and financial deepening continues.

For 2019, growth is expected to increase to 4.2 percent supported by a temporary increase in public investment, and over the medium term to remain at its potential of 4 percent on the back of robust domestic demand and exports. Stronger reform progress, especially in labor market and governance areas, could lead to higher growth. However, there is an increased risk that spending pressures and tax revenue shortfalls could further crowd out productive spending or potentially increase the fiscal deficit and undermine confidence. Although the proposed new power plant would alleviate energy bottlenecks and provide an impulse to growth, it would widen the current account deficit during the construction phase and—depending on its financial arrangements—could significantly increase public debt.

Executive Board Assessment

Prudent fiscal and financial policies helped preserve macro-financial stability, while growth remains robust. The economy continues to grow at a healthy clip, outpacing Kosovo’s neighbors. Fiscal discipline has been maintained, reflected in a 2018 budget deficit that is expected to remain well-below the fiscal rule’s ceiling, while financial soundness indicators continued to improve. Despite some progress in regaining competitiveness, the external position remains moderately weaker than implied by fundamentals and desirable medium-term policy settings. Reserves are low in regional comparison, but at comfortable levels using standard metrics. Together with a government bank balance of 4.5 percent of GDP at the CBK they provide sufficient cushion for external, fiscal or liquidity shocks.

However, structural challenges remain largely undented, and should be at the forefront of the policy agenda. An underdeveloped private and export sector, widespread informality, reliance on remittances are mirrored in high unemployment and inactivity rates, and a large trade deficit. Tackling these deep-rooted challenges through structural fiscal, financial sector, product and labor market reforms remain a priority to create the jobs and growth needed to reduce unemployment, outward migration, and the still wide income gap with the rest of Europe. However, in a complex political environment important structural reforms have stalled and pressures to introduce fiscally costly, populist initiatives have increased.

The fiscal rule remains an appropriate anchor for fiscal policy and underpins the 2019 budget, though execution risks are significant. It accommodates large pension increases and space for other wage and social benefit initiatives, relying on large and uncertain gains from reforms in tax administration and war veteran benefits. While the authorities are committed to adjust spending in case of revenue shortfalls, this should be reinforced by limiting specific non-priority spending until the targeted revenue gains have been realized. Financing needs to be diversified to reduce roll-over risks and avoid crowding out credit to the private sector, while the central bank’s holdings of government securities are to be gradually reduced.

Revenue administration reforms should be accelerated to strengthen revenue collection and improve the business environment. Revenue remains some 10 percent below the regional average and the tax base is narrow, limiting the space for productive spending. In line with earlier Fund advice, the tax and customs administration need to be overhauled to reduce the high informality and large tax gaps and tax debts. The ambitious revenue targets included in the 2019 budget lend more urgency to these reforms. Further, to protect tax revenues, any changes to the import VAT collection should include strong safeguards, and the granting of new tax expenditures be avoided, and existing ones reviewed. There is also room to increase tax rates in the medium term, given that they are still low by regional standards.

Fiscal risks need to be contained to avoid crowding out pro-growth spending within the limits of the fiscal rule. To contain social benefit pressures, it is essential to move ahead with war veteran reforms and resist introducing new benefits schemes, such as for teachers, the police, and other types of benefits, while any pension increase should be limited to the basic pension only. To contain wage bill pressures, public administration and health care reforms should be (re-) designed to fit within the limits of the wage bill rule. To contain contingent liabilities, plans to restructure public enterprises need to move ahead and any government support for the new power plant through guarantees or financing need to be consistent with the fiscal rule and public debt sustainability. Planned pension reforms need to protect the second pillar and be carefully designed to avoid creating sizeable unfunded liabilities in the medium term.

Spending efficiency needs to be significantly enhanced to improve outcomes and support growth, including through strengthening fiscal institutions and governance. Social benefit reform would create space for much-needed investment to reduce human and physical capital gaps. Yet, any additional space for spending on education, health, the judiciary, active labor market policies, and infrastructure needs to be complemented by efficiency-enhancing reforms to improve outcomes in these areas. In addition, accelerating reforms to strengthen fiscal institutions, such as tax administration, public procurement, public investment and public enterprise management will be important not only to improve spending efficiency, but also to enhance transparency and accountability as well as reduce corruption vulnerabilities.

Policies should pivot from spending initiatives to removing structural constraints to growth and job creation. To lower wage and non-wage cost and improve productivity, it is critical to restrain wage and social benefit growth and implement policies to promote female labor force participation; to upgrade skills and reduce mismatches through better access and quality of education and vocational training; and to reduce infrastructure bottlenecks. Reforms to strengthen the rule of law and reduce red tape should also help in this regard. Fiscal initiatives such as the public salary law and excessively generous maternity/parental benefits, as well as a large minimum wage hike, would not only be costly but also undermine these efforts, providing another reason why they should be avoided or redesigned.

The financial sector remains sound, but access could be further improved. With double-digit credit growth, the authorities need to remain vigilant for possible pockets of risk and differentiate between healthy financial deepening and potentially excessive credit growth. While improving, credit depth remains low in regional comparison. Structural impediments to lending should be further reduced, including by fully implementing the law on enforcement procedures, accelerating the resolution of commercial cases, and strengthening property rights.

It is recommended that the next Article IV consultation takes place on the standard 12-month cycle.