1.  Since the eruption of the crisis in Kosovo in March 1999, the staff of the Fund, in consultation with World Bank staff, has provided assessments of the regional economic impact of the crisis and helped to develop a coordinated strategy for external financing to countries most affected by the crisis.¹ The response of the international community focused initially on two fronts: provision of humanitarian relief to alleviate the suffering of the large number of refugees displaced from Kosovo; and the mobilization of adequate external financing to the most affected countries in the region to help them deal with the adverse macroeconomic consequences of the crisis. With the cessation of hostilities in June 1999, the focus of the international community's response has begun to shift to economic reconstruction and support for sustainable recovery in the region. The Fund will continue to play a key role in coordinating this response. In Kosovo itself, which is a province of the Federal Republic of Yugoslavia (Serbia-Montenegro) (FRY), and not a member of the Fund, Fund staff are also providing substantial technical assistance at the request of the United Nations Interim Administration in Kosovo (UNMIK).²

2.  Against this backdrop, this paper provides an updated assessment of the economic prospects for the region and external financing requirements for 1999-2000. In doing so, the paper reviews the policy responses of the most affected countries and examines some of the key intra-regional links, including the importance of FRY to regional development.

3.  Despite the quick end to hostilities and resolution of the refugee crisis, the Kosovo crisis was a major setback to the region's economies.³ The crisis is estimated to have reduced output in the six most affected countries by about 2 percentage points in 1999 and significantly raised budget and current account deficits. As a result, growth in 1999 is estimated to be minus one percent for the region (Table 1). Coming on top of a similar output decline in 1998, the region will thus have fallen further behind the rest of Europe in terms of income levels. Policy responses to the crisis in the affected countries were mixed, but on the whole helped to produce relatively orderly adjustment and reduce some of the potential costs. These policy responses, together with the generosity of the international community, have helped to close external financing gaps in 1999.

4.  The swift return of refugees certainly helped to ease the strains on the neighboring countries. The burden fell largely on Albania and the FYRM, which at the peak of the crisis together were host to about 700,000 refugees. By end-July, almost all the refugees from the neighboring countries had returned to Kosovo, even earlier than assumed in the Fund staff's more optimistic "Scenario B" (see EBS/99/59, Supplement 1). The cost of humanitarian relief to the refugees was largely borne by international donors. Nevertheless, the presence of refugees put a heavy strain on the economic and social infrastructures of these two countries, as well as on their budgets and balance of payments. With their already weak administrative capacity even more thinly stretched by the burden of hosting the refugees, they barely avoided a breakdown of law and order.

5.  The damage to the region's transportation network and disruption of trade routes continues to have an adverse influence on the economies in the region, although in some cases trade has been surprisingly quick to resume. In addition to bringing most of trade with FRY to a halt, the military campaign inflicted considerable damage on the transport and storage infrastructure in FRY and impaired navigation along the Danube, the region's major waterway. While restoration work is under way, some transit trade through FRY will continue to have to be diverted well into next year at a cost to traders in FYRM, Bosnia and Herzegovina, Bulgaria, and, to a lesser extent, Romania. Nevertheless, preliminary data suggest that, at least in the case of the FYRM, exports to FRY rebounded sharply immediately after the conflict ended.

6.  The crisis did not help the region improve its poor record in attracting inward investment, but indications are that, for the most part, there was no widespread collapse. This was particularly the case with privatization-related FDI, where a number of countries (e.g., Bulgaria and Croatia) pushed ahead with sales of telecommunications companies and major banks in order to secure foreign financing to cover budget and external financing gaps. The crisis also deterred tourists from visiting the region, although this should prove to be short-lived. Thus, a rebound in tourism has already been reported in Bulgaria following the end of the conflict. Croatia, however, is still suffering from earlier widespread cancellations by tour organizers.

7.  The crisis elicited generally appropriate macroeconomic policy responses from most of the affected countries. Several countries (Albania, Bosnia and Herzegovina, Croatia, and Romania) confronted weaknesses in budget revenues with increased efforts to control expenditures, and they reduced underlying fiscal deficits.⁴ In the case of Bulgaria, where revenues remained strong, the fiscal stance was tightened in response to an increased current account deficit through strict expenditure control. Some expenditure slippage did, however, occur in the FYRM, although efforts to strengthen revenues provided some offset. Monetary discipline--in the case of Bosnia and Herzegovina and Bulgaria, imposed by the currency board arrangements--also broadly held in most countries. Inflation was noticeably low in all the countries, with the exception of Romania, where it remained stable but in double figures.

8.  The crisis had a mixed impact on structural reform programs and efforts to strengthen governance. Most notably, in part because of the social and economic strains of the refugee crisis, the FYRM was unable to deliver on commitments under its ESAF-supported Fund program to address fundamental weaknesses in the enterprise and banking sectors. And in Croatia reforms remained slow, although this does not appear to be directly related to the Kosovo crisis. By contrast, Bulgaria and Romania continued, and even accelerated, some difficult reforms during the course of 1999. Albania also continued with reforms, but the refugee crisis and associated flood of humanitarian aid weakened efforts to confront serious problems of corruption and fraud in customs collection.

9.  The adjustment efforts of some countries helped to close external financing gaps in 1999, albeit with some negative impact on growth. The closure of external financing gaps assumes that some US$2 billion in committed official financing will be fully disbursed by the end of this year (Table 2). Financing is being provided on terms broadly consistent with the earlier agreed principles. In particular, the financing being provided to countries that hosted a large number of refugees (especially Albania and the FYRM) includes a high grant element.

10.  The Fund's own response to the crisis also followed the principles envisaged at the outset. The Fund provided financial support to countries where policies, including the response to the crisis, remained appropriate. In particular, access under Albania's ESAF-supported arrangement was augmented, Bulgaria (extended fund facility) and Bosnia and Herzegovina (standby arrangement) continued to make purchases under their existing arrangements, and a new standby arrangement was approved for Romania. And while the review of the FYRM's second year ESAF arrangement was not completed because structural reforms could not be implemented, the Fund did provide financing under the Compensatory and Contingency Financing Facility (CCFF). The Fund was also instrumental in providing regular policy advice to the affected countries.

11.  The economic impact of the conflict has been considerably more severe in Kosovo and the rest of the FRY. In Kosovo, the NATO bombing campaign, acts of local sabotage, and ethnic reprisals brought economic activity to a virtual standstill and wrought considerable physical damage to the social and economic infrastructure. The greatest destruction was to the housing stock.⁵ Damage to communications--especially the telephone system--was also considerable, and some damage to power supply and distribution is adding to continuing problems of electricity blackouts. For the most part, factories were not targeted by the bombing campaign, but many are no longer in functioning condition. There is a problem of land mines in several rural areas. Estimates of the cost of the physical damage are currently being finalized by the European Union and the World Bank.

12.  The massive population movements that occurred during and after the conflict also carry implications for immediate and medium-term economic recovery. First, the sheer size of the exodus between March and June 1999 of ethnic Albanian refugees--as many as 900,000 or about half the population of Kosovo--and their subsequent return has been extremely destabilizing. Moreover, many people within Kosovo remain displaced because their housing has been destroyed. This has contributed to the neglect of agriculture, a key economic activity and the missing of planting periods--although a lack of seed was also a major factor in this regard. Second, the departure of the majority of the ethnic Serbs, who for the previous 10 year had reserved most of the key administrative and management positions for themselves, has left Kosovo with a vacuum of experienced workers.

13.  The post-war economic situation in Kosovo needs to be seen in the context of more than a decade of economic decline and neglect. There had been little in the way of investment either in the infrastructure or economic sectors during this period and virtually no progress in reforming institutions. Banks were technically bankrupt before the war and the payments system was not suited to a modern market economy. Nor were legal and social institutions. Enterprises had been starved of investment and were in vital need of restructuring and more appropriate ownership structures. Finally, because of discrimination, social organization--schools, health care, welfare--among the ethnic Albanian community had gone underground. The ethnic Albanians funded their parallel system through a series of taxes on local residents and the diaspora. Clearly, trust in official systems will take time to rebuild.

14.  Despite a lack of independent and reliable information, there is little doubt that, in addition to the terrible human consequences and psychological costs, the Kosovo conflict has had a catastrophic effect on the rest of the FRY economy, and in particular on Serbia. The damage to infrastructure and the productive capacity of the country has been extensive. Large swathes of the transport and communications infrastructure have been destroyed, the electric power grid has been severely damaged, and entire industries have effectively collapsed.⁶ In addition, environmental damage has been considerable and will be hard to remedy. According to an independent group of Yugoslav economists, Group-17, the economic losses are estimated to be roughly $30 billion.⁷ The same group puts the decline in industrial production for 1999 at around 45 percent and estimates that the level of per capita income for 1999 will be only one third of its level in 1989. Owing to the destruction of infrastructure and production capacity, unemployment has also increased, thus posing a number of socio-economic consequences, including a possible wave of emigration.

15.  Although there is very limited information on the status of the reconstruction process in FRY, reports indicate some progress in re-establishing transit routes. Road traffic through Serbia has been restored. With the exception of some stations that remain closed, railway traffic is also returning to normal. As for the transit of vessels along the Danube, although the river remains blocked, there is an inland channel that is being used by ships. However, relations between FRY and some of its neighbors (including Bulgaria and Romania) have been strained over the granting of passes to use the channel. The restoration of transit routes is important not only from a regional perspective, but also for the fee income it generates for FRY.

16.  The costs of financing operations related to the Kosovo conflict have put pressure on the budget and money growth, adding to concerns about macroeconomic instability. Inflation was already over 40 percent at the outset at the crisis, and is estimated by some analysts to have subsequently risen. At the same time, the dinar has weakened in the informal market to YUD 13 per DM in early September compared with an official rate of YUD 6 per DM. Moreover, structural reforms--which were being implemented at an already very slow pace--have very likely stalled, and could even have regressed.

17.  Finally, the "outer wall of sanctions", which intensified during the Kosovo crisis, is continuing to hinder FRY's economic and financial relations with the rest of the world. Some countries have reimposed a freeze on the financial assets of FRY, and FRY remains excluded from the main international financial organizations. Major donor countries have indicated that the wall will remain in place as long as there is no substantial political change in the country.

18.  With normalcy rapidly returning to the region, the immediate prospects for the six most affected member countries should be relatively favorable. The countries should benefit from the quick repair to transit routes that appears to be already underway, a more favorable environment for foreign direct investment, a return of tourists to the region, and the demand and trade creating impact of reconstruction in Kosovo. Success in macroeconomic stabilization during 1999 will also provide a solid base for recovery in 2000.

19.  An important consideration for the countries in the region will be to ensure the quality and sustainability of any recovery in 2000. The region already lags considerably behind the rest of Europe owing in part to the slow progress in addressing the economic distortions of central planning and lack of market-related institutional structures. Growth will prove fragile unless vigorous efforts are made to address the key structural weaknesses. In the provisional projections of the Fund staff, it is assumed that the countries in the region adhere at least to structural reform commitments under Fund-supported arrangements, where applicable, or carry though domestic programs to address the most serious structural imbalances and problems of poor governance.

20.  Provisional projections show average growth for the six countries in the region recovering to about 3¼ percent in 2000. While this would be a substantial improvement on the performance of the last few years, it would still fall short of what is required to begin the process of catching up with the more advanced transition economies in Europe. Moreover, performance is far from uniformly spread among the six countries (Table 3). Growth is projected to be brisk in Bosnia and Herzegovina and Albania, although this to a large extent reflects catch up from a low base due to earlier war and civil unrest. Reflecting some reward for reforms and good fiscal management, projected growth in Bulgaria would pick up to its highest level since transition began--although at 4 percent, this is still a relatively modest beginning. Likewise, the FYRM is projected to grow rapidly by the standards of its post-independence history, but major imbalances in its banking and enterprise sectors will likely inhibit a more robust supply side response to what should be a sharp improvement in export demand. The two largest economies, Romania and Croatia, are projected to grow considerably more slowly owing to the weak state of their enterprise and banking systems and the associated need for essential restructuring.

21.  Without adequate official external financing, the countries in question would be forced to make additional macroeconomic adjustment, growth prospects would be poorer, and there would be a risk of a popular backlash against reform. Some reduction in current account deficits is expected for many of the six countries in 2000. This should be accompanied by a pickup in private inward investment. Nevertheless, the projections still foresee a need for additional official external financing of about US$850 million over and above current commitments from bilateral creditors and the multilateral financial institutions. It should be stressed that this financing gap is qualitatively very different from the gaps discussed in previous Fund reports on the impact of the Kosovo crisis. It does not arise primarily out of the direct cost of the Kosovo crisis, but rather is a provisional estimate of the short-term balance of payments need arising from the cost of supporting reforms and macroeconomic adjustment in the six countries. Moreover, there is a strong case for supporting more ambitious reforms, assuming this would also find the requisite political support in the countries themselves, and for providing official loans to finance infrastructure and other projects. This could substantially raise required financing needs. The financing needs of Kosovo will also be substantial.⁸

22.  While the Fund can play an important role in helping to close external financing gaps, support from bilateral creditors and donors will be essential. The projected residual financing gap already assumes that countries with Fund-supported programs will receive the amount of resources available under current arrangements. These resources could in principle be augmented to support stronger macroeconomic adjustment or reform programs, and non-program countries could choose to enter into arrangements with the Fund. Nevertheless, as currently projected, the financing gap exceeds what can be covered under normal rules of access to Fund resources. Finally, the Fund will continue to play its traditional role of the provider of advice to the countries of the region. In this context, it can help to ensure that countries maintain low inflation and sustainable financial policies if commitments made at the Sarajevo Summit in July to mobilize additional financing for regional development are realized.

23.  The projections assume that FRY (principally Serbia) will not make much of a contribution to regional recovery in 2000. FRY is assumed to remain marginalized in the international community and, other than humanitarian aid, is not assumed to receive the international support needed for recovery from the destruction of the Kosovo crisis and for restructuring of the economy.

24.  Nevertheless, the FRY occupies a pivotal position in southeastern Europe and the region would have much to gain from its recovery. Although its GDP has fallen sharply owing to the breakup of former Socialist Federal Republic of Yugoslavia, followed by several years of conflict and economic sanctions, FRY retains its regional importance owing to its large size (measured both in terms of population and land area) and its strategic geographical location on several of the main transport routes to western Europe for countries in the eastern part of the Balkans. In the event that political developments were to permit it, neighboring countries could benefit from recovery and reform in FRY through three main channels:

• Restorations of previous trade linkages. While intraregional trade declined during the 1990s, reflecting political turbulence and increased orientation to the west, this trade could be reestablished relatively quickly owing to the short interval since the links were severed. Moreover, in conjunction with trade liberalization and structural reforms in FRY, the benefits from intraregional trade could be well above that implied by earlier trade shares.

• Making the region a more attractive destination for foreign direct investment. This would be a bi-product of the "Stability Pact for South-Eastern Europe", an EU initiative aimed at fostering peace and stability in Southeastern Europe.⁹ It could also be effected through increased cooperation on trade, simplifying border crossings, and addressing problems of common interest-including environmental issues and coordination of regional transportation infrastructure and regulation.

• Increased demand from a major reconstruction effort in FRY. This could have multiplier effects on the level of activity in the region as well as spillover benefits from working with advanced technologies supplied from outside the region.

25.  The analysis of policies and prospects in the region in the aftermath of the Kosovo conflict leads to the following conclusions:

• The region, apart from Kosovo and the FRY, has weathered the worst effects of the conflict and is on the way to recovery.

• The governments in the region need to persevere in implementing sound macroeconomic policies and accelerate structural reforms to benefit from the improving economic environment in the region.

• The international community needs to ensure that external financing gaps for 1999-2000 are filled in a timely manner: donors should make good on their generous pledges of support made during recent months and should stand ready to provide additional financing for 2000 to support good policies. Access to Fund resources should be related to the strength of adjustment and reform programs.

• Kosovo faces difficult challenges to restore economic stability and rebuild its economic base and will require substantial support from the donor community.

• The long-term development of the region would benefit substantially from reform and integration of the FRY into the region's economy.