On behalf of our Albanian authorities we would like to express our appreciation to management and staff for the focused and valuable policy dialogue and for the technical assistance provided over the three years of the program. We welcome also the candid assessment of the main achievements realized under the EFF and of the key challenges ahead provided in the staff report.
General remarks on the performance under the program
A steadfast program implementation has been instrumental to rebuilding growth momentum. The fiscal position and the public finance management framework have been substantially strengthened, and ambitious reforms have finally addressed many of the structural constraints that have been piling up over the years. In particular, public debt has now been placed on a downward path after having reached an all-time high in 2016, while a bold pension reform will ensure its long-term sustainability; international reserves are sizable; inflation is on a converging path towards the central bank’s target; the financial system has proven its resilience and banks’ confidence in lending has been gradually restored. Acting as an anchor of stability, the EFF has contributed to catalyze international financing from private and official sectors partners.
Recent macroeconomic developments and outlook
Hard indicators point to a sustained economic recovery in 2016. A real growth of 3.1 percent y-o-y has been recorded in third quarter of 2016. Growth is gaining further traction with the quarter-on-quarter rate rising to 0.9 percent in Q3 from 0.3 in Q2, pointing at a likely increase of 3.4 percent for the whole year, which would represent the best performance since 2010. Employment is also rising: during the program period employment rate rose by 10 percent points and, while still high at 15.2 percent, the unemployment rate dropped by 3.4 percentage points. The growth cycle is being led by a pickup in domestic demand and by high tourism revenues. On the production side, a drop in the contribution from the mining industry has been more than offset by the increase in the contribution from information and communication services and from construction. On the other hand, trade continues to suffer from the impact of low oil and other commodity prices on the terms of trade. Net FDI are once again performing strongly also due to some large energy-related projects.
For 2017, the approved budget assumes a further acceleration of growth to 3.8 percent, on the back of the peak in the execution of two large projects in the energy sector and sustained private consumption. Nevertheless, the economy will still perform below potential. The current account deficit is projected to further widen to around 12.6 percent of GDP, then to gradually narrow to below 10 percent in 2020 as oil prices recover. FDI will continue to represent the most important source of finance.
The authorities agree on the medium-term outlook put forward by staff, although they consider that risks are broadly symmetrical. Downside risks stemming from a weakening of activity in major trade partners or from adverse trends in oil and financial markets appear now to be less pronounced than in the past. On the other hand, improvements in the labor market conditions, higher tourism inflows, and the implementation of the structural reforms might contribute to higher external and domestic demand.
Sizeable fiscal consolidation has been accomplished under the program. An inherited stock of commercial arrears amounting to 3.7 percent of GDP was repaid in just 2 years. Net of this effort, the average improvement in the primary balance-to-GDP ratio during the program period has been of 0.7 percentage points. Public debt has started to decreased in 2016 (-1.6 percent of GDP over the previous year) and is projected to approach 60 percent of GDP in 2019, while the primary balance is set to continue to improve over the projection period. It is remarkable that the decline in the public debt-to-GDP ratio has occurred in spite of a nominal GDP growth rate that fell short of initial expectations, with a negative impact on both the numerator and denominator of the ratio.
The strong commitment to fiscal consolidation has continued to pay off in 2016. The improvement in tax administration, the higher tax compliance and the non-distortionary basebroadening fiscal measures introduced in 2016 have led to a growth in tax revenues higher than that of nominal GDP. Coupled with a tight expenditure control, especially for current outlays, this has allowed the highest primary surplus recorded in Albania. Under the 2017 budget, priority is being given to: (i) continuing fiscal adjustment and ensuring the reduction of public debt through a further broadening of indirect taxes base; (ii) accommodating the cost of reforms in the justice and public utilities sectors, as well as of fiscal decentralization, reforms that are all critical for improving the business environment; (iii) ensuring adequate financing for much-needed infrastructure projects. The budget approved for 2017 aims to achieve a primary balance of 0.7 percent of GDP, while debt reduction will further benefit from one-off revenues measures generating savings not factored in the budget. Besides, in an effort to avoid any political budget cycle, the authorities and staff agreed to introduce quarterly ceilings on budget execution.
The authorities recognize that a reduction of contingent fiscal risks is key to ensuring long-term fiscal sustainability. The PPPs framework has been strengthened through the creation of a new unit in the Ministry of Finance dealing with PPPs’ financial aspects. This enables the Ministry of Finance (MoF) to comprehensively review the value for money of the PPPs and the related possible fiscal risks, as well as to exercise its veto power right. Moreover, the decision to launch PPPs will be taken under the framework valid for public investment management, and only if it is proven that they represent the most suited instrument to implement specific priorities. The MoF has legally gained a complete and direct oversight on the Regional Development Fund eliminating a primary source of new arrears and unbudgeted projects. Other administrative measures, some of them implemented as prior actions, aim to ensure that only prioritized and fully funded projects will advance, and to avoid the recurrence of arrears.
The implementation of all the EFF’s conditionality has enabled an effective modernization of the tax administration. A new organizational structure and a strategic plan, incorporating Fund’s TA recommendations, are now operational with the double goal of boosting tax compliance while providing more efficient services to taxpayers. A fully staffed risk management unit has developed a new methodology for compliance risk-based audits. Compliance costs will be lowered through an improved communication and by increasingly automatized procedures, including for processing of VAT refunds (indeed, tax refunds paid in 2016 already over-performed the targets).
Further structural fiscal reforms will strengthen the budget framework. The fiscal decentralization law will provide municipalities with resources needed to perform their new functions. Municipalities’ arrears clearing is ongoing as it constitutes a prerequisite for transfers. First steps towards the introduction of a value based property tax have been taken as prior action. After some delays, the implementation of a new fiscal cadaster is ongoing. Moreover, according to the action plan approved by the Prime Minister the new property tax law, including a new valuation methodology replacing the current flat rate system, is expected to be enacted in the second half of 2017.
Monetary policy and financial stability
The acceleration of growth reflects also the transmission of the accommodative monetary policy stance. In the absence of fiscal space, the reduction of financing costs and the supply of liquidity to the financial markets have played a primary role in sustaining domestic activity. As a result, inflation is recovering towards the target, reaching 2.8 percent in January. This pick-up reflects the recovery in the domestic environment and the reduction of external disinflationary pressures, as well as base effects from last year dips and the higher unprocessed food prices due to severe weather conditions (core inflation was almost unchanged). However, inflation is expected to remain below target during 2017, with a durable convergence towards the 3 percent target achieved only in 2018.
The central bank concurs with staff on the importance to stick with this accommodative stance. The authorities remain committed to maintaining the current stance at least until the end of the third quarter of 2017. The expected baseline scenario of a continued economic recovery and a gradual convergence of inflation to the target will require a gradual normalization of monetary policy. However, in undertaking this path, the Bank of Albania (BoA) will exert due caution, so as to avoid disrupting the recovery or destabilizing inflation expectations. As this policy has been effectively and extensively communicated, at the moment there are no market expectations of an increase in the policy rate and inflation expectations remain well-anchored. The same forward guidance will be provided well ahead any decision of policy normalization takes place. For 2017, the authorities’ more recent forecast of average inflation is of 2.3 percent, up from 1.3 percent in 2016.
The credit cycle is starting to react to this stimulus. Excluding the effect of loan writeoffs, the credit to the private sector in December stood 3.2 percent higher than in the previous year, led by lending to households. Credit in domestic currency increased in the same period by 10.2 percent. The BoA expects a further improvement as credit demand recovers in line with the economic activity, while the supply side will benefit from the implementation of the legislative reforms aiming at reducing the non-performing loans (see below). Final data for 2016 show that, after a spike due to two large borrowers’ insolvency, the ratio of nonperforming loans to total loans fell from above 25 percent at end-2015 to 18.2 percent. 70.5 per cent of NPLs are fully provisioned, with net NPLs at 5.4 percent. This reduction reflects the combined effects of the improvement of the economic situation, credit restructuring and non-performing loans write-off from balance sheets.
The reduction of the euroization of the economy ranks among the very top priorities of the BoA. The BoA is envisaging a set of measures on the banks’ liabilities side, including the establishment of different reserve remunerations for euro and lek deposits and higher requirements for highly liquid assets to be held against FX deposits. Foreign exchange reserves at the end of January stood at around 3 bn euros, covering slightly below 6 months of imports. Still, the monetary authorities consider that additional buffers may be appropriate. Therefore, a schedule of foreign exchange auction purchases for 2017 has been duly and transparently communicated to the market. This operation may also contribute to counteract any possible upward pressure on exchange rate coming from the success of the deeuroization strategy, while maintaining a fully market determined exchange rate.
During 2016, banking sector liquidity and capitalization indicators remained at high levels and the financial results are positives. The BoA has recently amended the regulatory framework for consolidated supervision of banking and financial groups in order to aligning it with the European regulations and directives and the core principles of the Basel Committee. Moreover, the regulatory and supervisory frameworks have been strengthened by the approval of a new bank resolution law that, in line with the European Bank Recovery and Resolution Directive, foresees the creation of a fund with mandatory contributions from financial institutions for the purpose of covering funding needs in the event of a crisis.
A coordinated approach among several Albanian institutions has allowed to successfully implement a fully-fledged strategy for a smooth further reduction of the NPL overhang. A very comprehensive legal package has been approved in the second half of 2016. It includes, among other legal instruments, a new bankruptcy law and amendments to the Private Bailiff law and civil procedural code in order to increase the efficiency of the execution process. Encouraging advancements in collateral execution have already been observed in recent months, especially for what concerns the transfer of land ownership. Finally, credit institutions are asked to elaborate detailed recovery plans for riskier clients.
The reform of the energy sector could be judged as a leading example of successful macro critical reform. As a result, a source of fiscal risks has been considerably reduced and the sector’s performance has clearly improved. At the onset of the program, sizeable unbudgeted support to the energy sector was not sufficient to prevent a considerable risk of bankruptcy for the SOEs of electricity sector. Nowadays, the country’s energy balance is positive as a result of the increase of energy production from private hydropower plants and the sensible reduction of distribution losses. Collection rates and revenues have significantly increased, budget allocations in 2017 amount to just 0.1 percent of the GDP, medium term sustainability has been restored, no new intercompany arrears have emerged while increased liquidity has allowed to repay the arrears to independent producers, reducing the existing debt in the sector and contributing to investments needed to further reduce distribution losses. The Power Sector Law has transposed the provisions of the EU Third Energy Package, containing the principles for the liberalization of the electricity market. In July 2016 the Council of Ministers has adopted an action plan for the progressive phasing out of price regulation.
The adoption of the judiciary reform has represented a cornerstone of a strengthened institutional framework. This reform has been long awaited by international partners, as deemed necessary to improve the business climate. Seeking to overcome inherited problems of inefficiency and corruption, it substantially improves independence and accountability of justice institutions. The business climate will benefit also from the simplification of procedures introduced by the reform of the Tax Procedures Code and from the recently approved DPL from the WB focused on establishing a friendlier environment for attracting and retaining investors. To improve medium term growth perspectives, the government has launched a reform of the education system, with a focus on vocational training. An ongoing project financed by the EBRD aims to improve railway interconnectivity in the region.
Building on these important achievements, our Albanian authorities remain committed to a comprehensive strategy aiming to promote growth and job creation in a context of fiscal and financial stability. The engagement with the Fund has provided valuable support to the formulation and implementation of the authorities’ economic policy, thus contributing to the country’s strong performance in recent years. Our authorities look forward to continuing their engagement with the Fund in the same constructive spirit of close cooperation that has inspired their relationships so far.