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Republic of Kosovo: Staff Report for The 2017 Article IV Consultation

Author(s):
International Monetary Fund. European Dept.
Published Date:
February 2018
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Context

1. Since the last Article IV in 2015, Kosovo has taken important steps under the Stand-by Arrangement that expired in August 2017 to foster fiscal sustainability, further strengthen financial stability, and advance some structural reforms (Annex I). These have contributed to strengthening the recovery and improving confidence. Despite this progress, however, structural challenges remain significant. Kosovo is a small, unilaterally euroized economy characterized by high unemployment, extensive informality, and a narrow production and export base resulting in a large trade deficit—mainly financed by large and growing remittance flows. While the relatively high economic growth is helping to improve living standards, Kosovo remains one of the poorest European countries.

2. A new government was appointed recently, pledging to support investment, fight corruption, and improve relations with neighboring countries. Following early general election in June 2017 a new multi-party coalition government took office in September. However, its thin majority in parliament may affect the pace of reform implementation. Also, the impending issuance of indictments by a special war crimes tribunal expected to start in 2018 and the ratification of the border demarcation agreement with Montenegro—a key precondition for EU visa liberalization—may test the strength of the government coalition. Notwithstanding these risks, Kosovo has made some further progress in normalizing international relations, and is now recognized by almost two-thirds of UN member states.

Recent Developments, Outlook and Risks

3. Growth continues at a healthy pace, led by investment and, more recently, growth in exports. Real GDP growth has averaged about 4 percent per year since 2015, a relatively strong performance compared to Kosovo’s Western Balkan peers. Staff project growth to continue at 4.1 percent in 2017, led by continued strong investment, export growth, and higher remittance inflows. While declining recently, unemployment remains the highest in Europe at just above 30 percent, particularly among the youth (50 percent).

4. The policy framework has improved considerably. The fiscal deficit has been kept well below the 2 percent of GDP fiscal rule ceiling, despite spending pressures, and government bank balances are above the minimum level of 4.5 percent of GDP. Banks remain healthy and credit growth has increased (Table 1, Figure 1). Inflation remains subdued and although headline is expected to pick up to 1.5 percent (largely driven by higher food and energy prices), core inflation has turned negative due to falling input prices for some non-tradable and consolidation in the retail sector resulting in lower prices.

Table 1.Kosovo: Select Economic Indicators, 2014-22(Percent, unless otherwise indicated)
201420152016201720182019202020212022
Projections
Real GDP growth1.24.14.14.14.04.04.04.04.0
Contribution to growth (percentage points of GDP)
Consumption7.24.64.71.14.33.73.73.73.8
Private7.45.45.61.63.43.43.43.43.4
Public−0.5−1.1−1.0−0.50.90.20.30.30.4
Investment−1.32.82.03.43.13.43.43.33.4
Net Exports−5.5−3.9−2.6−0.3−2.1−1.8−1.9−1.7−1.4
Exports−2.1−2.80.53.61.21.61.51.71.6
Imports−3.3−1.1−3.2−3.9−3.3−3.4−3.4−3.4−3.0
Official unemployment (percent of workforce) 1/35.332.928.730.6
Price changes
CPI, period average0.4−0.50.31.51.01.92.12.22.2
GDP deflator3.30.20.41.51.21.71.81.92.1
Real effective exch. rate (average; -=depreciation)1.3−2.20.9
Real effective exch. rate (end of period; -=depreciation)−1.1−1.00.6
Terms of Trade8496100103104106108109109
General government budget (percent of GDP)
Revenues23.925.126.326.226.926.626.426.226.1
Primary expenditures26.326.727.327.129.630.028.929.028.7
Of which: Wages and salaries8.79.09.08.68.78.78.78.78.6
Subsidies and transfers6.67.48.07.97.87.87.87.87.8
Capital and net lending7.36.87.07.18.17.77.57.57.3
Overall Balance Ex-PAK ex-IFI capital projects (Fiscal rule) 2/−2.3−1.7−1.1−1.1−1.8−1.9−1.9−1.9−1.9
Overall balance excluding PAK current spending 2/−2.3−1.7−1.1−1.1−2.9−3.7−2.7−3.0−2.9
Stock of government bank balances1.83.53.54.94.55.05.05.05.0
Total public debt (percent of GDP)16.718.919.621.021.824.926.327.829.0
Of which: Debt of the former Yugoslavia 3/6.35.85.24.64.03.42.92.41.9
Balance of Payments (percent of GDP)
Current account balance, incl. official transfers−7.0−8.7−8.9−8.7−8.9−8.6−7.9−8.0−7.7
Of which: official transfers 4/5.23.53.42.62.62.62.52.52.5
Of which: remittance inflows11.211.511.411.211.111.010.910.710.5
Capital and financial account3.24.42.17.26.76.75.96.06.1
Of which: Net foreign direct investment2.24.73.05.05.05.05.25.25.0
Portfolio investment, net−0.2−0.8−6.10.4−0.3−1.3−1.5−1.5−1.2
Errors and Omissions3.94.36.81.42.21.91.92.01.7
Savings-investment balances (percent of GDP)
National savings13.515.214.817.618.821.321.422.022.6
Investment25.827.627.228.930.432.531.832.532.8
Current account, excl. official transfers−12.3−12.4−12.4−11.3−11.6−11.2−10.4−10.5−10.3
Non-performing loans (percent of total loans) 5/8.36.24.93.4
Bank credit to the private sector (percent change)5.37.310.310.510.110.49.49.18.7
Deposits of the private sector (percent change)4.07.38.77.77.37.57.88.28.4
Regulatory capital/risk weighted assets 5/17.819.017.918.7
Memorandum items:
GDP (millions of euros)5,5675,8076,0706,4146,7497,1357,5568,0118,508
GDP per capita (euros)3,0233,1603,3013,4363,5623,7103,8714,0444,231
GNDI per capita (euros)3,5253,6743,8323,9754,1134,2864,4774,6814,903
Population (millions)1.81.81.81.91.91.92.02.02.0
Sources: Kosovo authorities; and IMF staff estimates and projections.

As of Q2 2017.

For fiscal rule purposes, only projects post-July 2015 apply.

Kosovo neither recognizes nor services nor tracks this debt.

Total foreign assistance excluding capital transfers.

2017 as of November 2017.

Sources: Kosovo authorities; and IMF staff estimates and projections.

As of Q2 2017.

For fiscal rule purposes, only projects post-July 2015 apply.

Kosovo neither recognizes nor services nor tracks this debt.

Total foreign assistance excluding capital transfers.

2017 as of November 2017.

Figure 1.Kosovo: Recent Economic Developments

Sources: Kosovo Agency of Statistics; Central Bank of Kosovo; KPST; and IMF staff estimates.

5. Medium-term growth prospects remain positive, although more is needed to accelerate income convergence with regional peers and the EU. Under the assumption of a gradual pace of reform efforts, medium-term growth is projected at 4 percent, driven mainly by private consumption and investment, with exports (mainly minerals) making an increasing but still relatively minor contribution to growth. Reaching the authorities’ objective of sustained growth above 5 percent and accelerating income-convergence with the EU—GDP per capita in PPP terms was just 20 percent of the EU average in 2016—will require faster reforms to address major bottlenecks in Kosovo’s business climate, and to close physical and human capital gaps. With the economy growing at its current potential, inflation is projected to remain slightly above the euro area average of 1.8 percent throughout the projection period, reflecting productivity gains. The trade deficit is expected to remain large, though on a declining path, while largely funded by non-debt creating inflows, namely remittances and FDI. Even assuming a scaling up of donor-financed public investment to reduce the infrastructure gap, debt-to-GDP is projected to increase moderately over the next years, but will remain below the 30 percent threshold (Annex II).

GDP per Capita in PPP Relative to EU Average

(Index, EU = 100)

Sources: IMF, World Economic Outlook; and IMF staff calculations.

Selected Macroeconomic Indicators
2016201720182019202020212022
projections
Real GDP Growth (in percent)4.14.14.04.04.04.04.0
Contributions:
Consumption4.71.14.33.73.73.73.8
Investment2.03.43.13.43.43.33.4
Exports0.53.61.21.61.51.71.6
Imports−3.2−3.9−3.3−3.4−3.4−3.4−3.0
CPI inflation (in percent, average)0.31.51.01.92.12.22.2
in percent of GDP
Fiscal balance excluding PAK and donor projects−1.1−1.1−1.8−1.9−1.9−1.9−1.9
Stock of government bank balances3.54.94.55.05.05.05.0
Total public debt19.621.021.824.926.327.829.0
Current account balance, incl. official transfers−8.9−8.7−8.9−8.6−7.9−8.0−7.7
Source: IMF staff estimates; KAS.
Source: IMF staff estimates; KAS.

6. Risks to the outlook are balanced(see Risk Assessment Matrix—Annex III).

  • Weaker reform momentum, including on the back of political risks, could lower growth and keep unemployment and migration high. Tax compliance gains may fall short of target, and significant social spending pressures and low progress in mobilizing IFI and privatization financing could reduce productive spending.

  • Weaker-than-expected growth in the EU and lower remittance inflows could result in lower consumption and investment (largely housing), and therefore slower growth. Also, high current account deficits and heavy reliance on remittances make Kosovo vulnerable to external shocks.

  • At the same time, moving ahead with the new power plant and accelerated reform implementation that could help attract more FDI and possibly unlock large IFI financing for key capital projects are upside risks to the outlook.

Authorities’ Views

7. The authorities were more optimistic about the outlook and viewed staff’s baseline scenario as too conservative. In their view, growth could accelerate to 5.3 percent by 2020, and despite risks of further delays, moving ahead with the construction of a new power plant would provide a substantive boost to growth. They considered that the current coalition would be able to move ahead with important reforms to address structural challenges.

External Stability Assessment

8. The external position is weaker than implied by the fundamentals and desirable policy settings, but there has been some progress in strengthening competitiveness since the last Article IV. Standard methodologies indicate that the real effective exchange rate remains stronger than justified by fundamentals and desired policies in the range of 12-14 percent (compared to 15-18 percent at the last Article IV). This modest improvement has been largely achieved by controlling public sector wages, consolidating the budget, and some progress with structural reforms (Annex IV).

9. Notwithstanding, the trade deficit remains substantial, but is largely financed by non-debt creating capital inflows. While the trade deficit has continued to remain at 28-30 percent of GDP at elevated levels, exports have been increasing steadily over the last three years, albeit from a very low base. However, the deficit is largely financed by FDI (5 percent of GDP), remittances (15 percent) and other non-recorded capital inflows. Despite a projected increase in IFI-financing, external debt is expected to remain low at around 25 percent of GDP.

10. International reserve coverage remains broadly adequate. Gross international reserves reached 12 percent of GDP in 2016 and are expected to increase to 13.5 percent in 2017. This covers more than 110 percent of a composite metric of reserve adequacy (ARA metric), important for a unilaterally euroized economy, like Kosovo, which needs liquidity buffers to mitigate the impact of external shocks on domestic absorption and pressures stemming from financial obligations and bank liquidity.

11. Progress has been made in improving qualitative competitiveness indicators. While recognizing measurement uncertainty, various indicators point to an improvement in Kosovo’s standing in various rankings since 2014. Kosovo’s improvement is more noteworthy in the areas of starting a business, registering property and trading across borders. This improvement however largely reflects the progress of adopting new legislation in line with EU directives, which has not been translated yet into de-facto improvement on the ground to support higher productivity and competitiveness.

Authorities’ Views

12. The authorities broadly concurred with the external sector assessment, but had a more sanguine view of reform implementation gaps. The authorities stressed that substantial progress has been made in improving the business environment, as for instance reflected in Kosovo being ranked among the top 10 reformers globally in the World Bank’s 2018 Doing Business Report, but noted that reform implementation is hampered by capacity constraints (in human capital, in particular). They welcomed the reduction in the overvaluation of the real exchange rate, but noted that the magnitude of this is unclear due to model uncertainty.

Policy Discussions

Discussions focused on measures to address the three key challenges facing Kosovo: (i) accelerating structural reforms to improve productivity and reduce high unemployment; (ii) improving the composition of the budget within the limits of the fiscal rule and the efficiency of spending; and (iii) safeguarding financial sector stability and financial deepening. All three areas are critical to improving competitiveness, achieving stronger and more equitable growth and supporting income convergence with regional peers and the EU.

A. Structural Reforms: Improving Investment Climate, Governance and Competitiveness

13. Several structural issues are impeding growth and are also contributing to inequality.1 These include the perception of a weak “rule of law”2 and a large informal sector that create an uneven playing field amongst businesses, deter investment, and support small-scale low value added production (instead of more competitive companies). Public enterprises remain relatively inefficient, with low productivity. High informality hampers access to bank financing and is associated with weak labor and working standards. These contribute to inequality, which is further exacerbated by the poor public health and education systems, as well as poorly targeted social benefits.

14. The authorities are making some efforts to improve governance, but further decisive steps are needed. The use of the e-procurement platform has been delayed and remains limited, although picking up in recent months. Therefore, efforts are needed to strengthen the system by expanding capacity and enforcing the mandatory use of e-procurement, while at the same time increasing the list of goods and services subject to centralized procurement. Also, the investigative capacity of the anti-corruption agency and the effectiveness of the asset declaration regime should be strengthened. Enhanced capacity of the anti-corruption agency would make its investigation capacity more effective in supporting law enforcement agencies to meet their obligations. Asset declaration requirements should be as comprehensive as possible and cover all assets owned both domestically and abroad. Large public investment projects should be subject to ex-post audit.

15. Plans to reduce the large inefficiency in public enterprises will improve governance, and should be fully carried out to put those companies into more productive use. 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 the excessively high wages. This should also pave the way for private sector involvement (e.g., PPPs, privatization) in the medium term, and developing a clear divestment strategy would be a first step. The Privatization Agency’s institutional and governance structure should also be strengthened significantly to accelerate the slowed-down privatization/liquidation process.3

16. Higher quality and better targeted education is needed to improve labor market outcomes. The 2015 Program for International Student Assessment (PISA) score (Kosovo’s first participation) ranks Kosovo low among participating countries. Decisive measures are needed to improve access and quality of education, including enhanced curricula for vocational programs. This would help to address the large skill mismatch, particularly among the most disadvantaged groups. The timely implementation, with the support of the EU, of the new Action Plans for increasing youth employment and for enhancing active labor market policies and job placement will also play a key role to increase labor participation and employment, including for women.

Government Secondary Education Spending and PISA Outcome, Latest Value Available

17. In addition, any increases to minimum wages should be in line with the current rules-based minimum wage setting mechanism. This rule links adjustments to developments in prices, private sector wages and competitiveness. While some increase in the minimum wage could reduce wage inequality, care should be given to avoid unwarranted increases beyond productivity gains. Against the backdrop of high unemployment, a large competitiveness gap, and widespread informality, large discretionary increases could disadvantage low-skilled workers and increase youth unemployment, leading to greater migration or increase in informal employment. In addition, it could generate fiscal pressures by e.g. raising expectations for higher social benefit amounts, thus crowding out higher priority spending in the budget.

18. Addressing energy supply constraints and shortages is key to support investments in the tradable sector. After several attempts over the last decade to replace one (Kosovo A) of the two aging lignite power plants, little progress has been achieved. The recent conclusion of the commercial agreement with a private firm is a first step to replace Kosovo’s existing plant with a more reliable and higher capacity plant that is projected to be completed in 2023, assuming no further delays.

Authorities’ Views

19. The authorities agreed with the need to accelerate structural reforms and felt that their reform priorities are well-aligned with staff recommendations. Strengthening the rule of law (including by new hiring in the judiciary), supporting private sector development, and closing skills and energy gaps are among their reform priorities. While agreeing that there is scope to further strengthen governance, including in public procurement and public enterprises, they felt that progress made in the 10 years since independence is not sufficiently recognized or captured in perception-based governance indicators.

20. There was also broad agreement amongst various stakeholders, including employer representatives and trade unions, that inequality should be addressed. It was agreed that improving public education and health, fighting informality, enforcing labor standards and better targeting social assistance are key priorities. Trade unions stressed that informal employees not only tend to get paid less but also risk being left without any other old age insurance except the basic pension benefits, and employers noted that the same standards and the rule of law should be applied to every company.

21. The authorities were not convinced that an increase in the minimum wage beyond those implied by the current rule could undermine competitiveness and efforts to improve labor market outcomes. Internal discussions on raising the minimum wage and changing the minimum wage setting mechanism are still ongoing. The authorities generally considered that the impact of higher minimum wages on the economy will be limited, and by reducing the underreporting of wages in the private sector it will increase revenue.

B. Fiscal Policy: Supporting Economic Growth Through Macro-stability, and Structural Revenue and Expenditure Policies

22. The existing “fiscal rule”4 provides an appropriate anchor for fiscal policy (see Figure 2, Table 2). The 2017 fiscal deficit is expected to be about 1 percent of GDP, and the 2018 budget targets a deficit (fiscal rule definition) of 1.8 percent of GDP, all below the fiscal rule’s deficit ceiling. The budget also keeps the wage bill constant as a share of GDP, in line with the wage bill rule. Assuming the authorities will be able to execute IFI and privatization-financed investment (exempted from the fiscal rule’s deficit ceiling) of about 1 percent of GDP to address the large infrastructure gap, this would bring the overall 2018 fiscal deficit to about 3 percent of GDP, from 1 percent in 2017. While this would result in a pro-cyclical stance, the high import-content of investment and the still high unemployment rate should keep domestic demand pressures broadly in check.

Figure 2.Kosovo: Fiscal Developments

Source: Country authorities; and IMF staff calculations.

1/ Overall balance excluding PAK spending.

Table 2.Kosovo: Consolidated Government Budget, 2014-22 1/(Excluding donor designated grants; millions of euro)
201420152016201720182019202020212022
Original BudgetProj.Budget 4/Proj. 5/Projections
Revenue and grants (excluding donor designated grants)1,3331,4551,5951,7131,6831,8171,8171,8961,9922,1022,218
Revenue1,3331,4551,5951,7131,6831,8101,8101,8961,9922,1022,218
Taxes1,1621,2691,4241,5121,4981,6071,6071,6861,7701,8661,967
Direct taxes188196234251241267267280294310326
Indirect taxes1,0071,1071,2291,3051,3151,3861,3861,4551,5271,6111,699
Tax refunds−33−34−39−44−58−46−46−49−52−55−58
Nontax revenues171187171201185202202210222236251
Grants00000770000
Primary expenditure1,4641,5521,6571,9891,7372,0812,0002,1392,1802,3222,443
Current expenditure1,0591,1561,2301,2751,2801,3871,3871,4631,5461,6371,738
of which: PAK-related current expenditures56611711111213149
Wages and salaries485525544572550590590621656693736
Goods and services206204202225224266266281297315335
Subsidies and transfers368427485473506526526556588623662
Pension and social assistance347399466486505534565599636
Other transfers and subsidies212919202122232426
Current reserves00050555555
Capital expenditure and net lending404395426715457695613677634685705
Budget-financed capital expenditure and net lending404395426523457546546550570600620
Budget-financed capital expenditure404395434534468546546550570600620
Expropriation21272730250000
Other capital spending289254249258454492570600620
Capital Reserves00000000
Net lending00−7−11−11000000
PAK-financed capital expenditure00087062420000
IFI-financed capital expenditure 2/00010508625127648585
Primary balance−131−97−61−276−54−264−183−243−187−221−225
Interest income, net−6−10−11−23−23−24−24−30−33−31−30
Overall balance−136−107−73−299−77−288−206−274−220−251−255
Ex-PAK ex-IFI capital projects (Fiscal rule)−131−101−66−96−70−123−123−135−143−152−161
Ex-PAK-related current expenditures−131−101−66−288−70−277−195−262−207−237−246
Statistical discrepancy−564
Financing136946270195262207237246
Foreign financing−1813−237455112−102966
Drawings, incl. official financing458104936223840
Amortization−22−28−66−37−19−50−96−94−59
Donor financing for new projects000025127648585
IMF financing0363510100000
Domestic financing971819697123206237231205
Domestic borrowing (net)1041091019786206237231205
Privatization revenues06100420000
Accumulation of Assets (- = increase)57−99−11−10112−56−20−23−25
Memorandum items:
Bank balance of the general government102201212329313301301357377400425
Of which: ELA4646464646464646464646
Total public debt9311,0991,1891,3501,4751,7771,9872,2262,465
Of which: Debt of the former Yugoslavia 3/351337316294271246219189158
Sources: Kosovo authorities; and IMF staff estimates and projections.

Does not yet reflect the GFSM 2001 methodology.

For fiscal rule purposes, only IFI projects post-July 2015 apply.

Kosovo neither recognizes nor services nor tracks this debt.

Assumes tax compliance gains of 0.7 percent of GDP, a timely and full implementation of the war veteran pension law, and tight administration for all other budgeted social schemes.

See footnote 4. Also, assumes a lower exectution of IFI and PAK financed investments, taking into account implementation capacity.

Sources: Kosovo authorities; and IMF staff estimates and projections.

Does not yet reflect the GFSM 2001 methodology.

For fiscal rule purposes, only IFI projects post-July 2015 apply.

Kosovo neither recognizes nor services nor tracks this debt.

Assumes tax compliance gains of 0.7 percent of GDP, a timely and full implementation of the war veteran pension law, and tight administration for all other budgeted social schemes.

See footnote 4. Also, assumes a lower exectution of IFI and PAK financed investments, taking into account implementation capacity.

23. Over the medium term, the authorities aim to maintain budget deficits below the fiscal rule’s ceiling, and—when including IFI and privatization-financed capital spending—at around 3 percent of GDP, on average. This would provide an appropriate balance between fiscal discipline and developmental needs, given the still low public debt of 22 percent of GDP (2017). It would also maintain bank balances at a prudent level of 4.5 percent of GDP. While the government debt is projected to increase in the medium term, the debt sustainability analysis shows that it is expected to remain within sustainable levels (Annex II).

24. However, the 2018 budget is subject to risks and efforts would be needed to reach the deficit target. The budget assumes about ¾ percent of GDP in gains from revenue administration reforms, which may not be realized. On the expenditure side, social spending could exceed the budget allocation by about ¾ percent of GDP, unless there is timely reclassification and verification of war veteran pension beneficiaries, and a tight administration of other social benefits. At the same time, there are pressures to move ahead with several new unbudgeted social spending initiatives, and while there might be scope to delay some investment, spending on Route 6 of some 2½ percent of GDP is expected to be needed in 2018.

25. Also, the composition of the budget and the efficiency of its spending could be improved to ensure better outcomes and make space for scaling up of investment in education, health, and infrastructure—critical to improve productivity and growth.

Possible Revenue Measures

26. There is considerable scope for improving revenue collection. While total revenue has increased to 26 percent of GDP, it is still some 10 percentage points below the EM Europe average (or 6 percentage points if contributions to the second pillar pension system are included) and collected from a narrow base. Low tax revenue mobilization is due to low tax rates and high informality combined with weak collection efficiency. The tax gaps for VAT and PIT are estimated at one-third and two-third respectively of potential taxes collected and the CIT gap close to 20 percent.5 Over three-quarters of Kosovo’s revenue comes from indirect tax (led by VAT and excise), making fiscal revenue highly vulnerable to consumption and imports.

Total Revenue, Kosovo and Comparator Average

(Percent of GDP)

Sources: IMF, World Economic Outlook; and IMF staff calculations.

Tax Structure Compared to Regional Average

(Percent of GDP)

Sources: IMF, Government Finance Statistics; and IMF staff calculations.

27. The focus should be on fighting informality by strengthening the tax administration. The 2018 budget ambitiously targets some ¾ percent of GDP in tax compliance gains. To achieve this objective, collections should be reinforced by setting publicly available quantitative and strategic performance targets for the tax administration, allocating resources to activities that generate the highest yields (e.g. risk-based audits), improving the efficiency and productivity of audits, significantly scaling up tax debt collection, and requiring filing a tax return by every registered taxpayer, even if no tax is due.

28. Tax policy, on the other hand, should seek to minimize exemptions and increase yields. As individual tax rates are broadly in line with peer countries in the region, the focus should be on broadening the tax base.6 The new property tax legislation paves the way towards higher yields—which is achievable if exclusions of taxable objects or other tax relief is kept to a minimum. As to indirect taxes, the VAT standard rate is regionally competitive. However, no new exemptions/reduced rate categories should be introduced as these tend to lower revenue (including by evasion), not reach the intended beneficiaries, and not increase growth. Continuing to increase excises on products, such as tobacco, in line with the current schedule are sound tax policies, especially since Kosovo has among the lowest tobacco excise rates in the region.

Possible Spending Measures

29. Pressures to increase current spending remain high. Current spending has increased from 17½ percent in 2011 to an estimated 20 percent in 2017, due to continued spending increases on social schemes and a higher wage bill, largely due to a wage hike in 2014. While as a share of GDP current spending remains below European EMEs, Kosovo spends relatively more on untargeted and work dis-incentivizing social benefits and public wages, which are key factors worsening competitiveness and inequality.7 Also, in terms of outcomes Kosovo ranks low in the poverty and inequality-reduction impact of benefit spending (Box 1).

30. The wage bill should make space for hiring in priority sectors within the limits of the rule. Staff recommends that across the board wage increases be restrained, given the already high public sector wage level. This would create space for priority hiring in the judiciary, health and education sectors, and to finance the health insurance scheme when it is eventually introduced. It would also reduce pressure from public sector wages on private sector wages, important for gaining price competitiveness and job creation, and reduce inequality between public-private sector employees.

31. Social benefit programs should be reformed to more effectively address inequality, poverty and unemployment within the existing spending envelope.8 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 those of the civilian disability scheme. 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 current spending to stay within the budget envelope.9 Staff urges not to introduce any non-contributory early retirement schemes for special groups as this would further weaken the fairness and financial soundness of the unfunded pension system.

32. Efficacy of health and education spending should be improved. Healthcare and education spending levels and outcomes are poor. While the 2018 budget allocation has increased, efficiency improving reforms in the health care system must also move forward 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.

33. While capital spending is already high, there is scope for scaling up by improving the absorption of donor financing and strengthening its efficiency. The authorities have ratcheted up spending including through large resources allocated to motorways (Routes 6 and 7). The implementation of other priority projects, however, has generally been limited by capacity constraints and low absorption of available IFI-financing. Scaling up public investment and improving its quality will raise potential GDP growth and accelerate income convergence toward EU levels (with an estimated growth dividend of up to 0.8 percent yearly).10 This includes introducing a requirement for cost-benefit analysis of major capital projects, strengthening project appraisal, selection, preparation, and execution, adopting multi-year budgeting for investment projects, and ensuring ex-post independent audit and assessment of large-scale projects.11

Box 1.Income Inequality and Social Benefit Performance

While income inequality is relatively low, spatial disparities remain, exacerbated by a weak labor market and high poverty. There is some regional variation in inequality, which is higher in urban areas. As of 2015, 18 percent of the population was below the national poverty line of €1.82 a day, and poverty is considerably worse than the EME Europe average. Poverty and distributional gains are constrained by high unemployment (31 percent in 2017) and low participation (57 percent inactive); both indicators are worse among youth and women.

Gini coefficient by region

A rapid expansion of social assistance in recent years, now high by regional standards, has skewed towards categorical benefits. Pension and social assistance as a share of current expenditure increased from 21½ percent in 2010 to 36½ percent in 2016, and social assistance spending is now above the Western Balkans average. However, the composition of benefits over time has shifted away from poverty and inequality-focused benefits towards war-related benefits.

Social assistance spending, percent of GDP

As such, high social benefit spending has not translated into above-average distributional outcomes. The impact of social benefits is constrained by a number of factors: (i) only around half of all households receive any benefit; (ii) adequacy is low, particularly for non-pension social benefits; and (iii) benefit and beneficiary incidence indicate a need to improve targeting.

Social benefit allocation in 2010 and 2017

Source: IMF staff calculations based on data from authorities.

Social benefit performance

Social benefit spending (percent of GDP) and Gini reduction (percent)

Source: IMF staff calculations based on HBS 2015 and World Bank ASPIRE database.

Notes: For social benefit performance, the Gini and poverty reductions are simulations are based on the current year. Coverage is the percent of the households receiving social benefits, while adequacy is the share of welfare that social benefits represent.

Financing

34. Financing so far has been readily available, but the investor base should be diversified to minimize roll-over risks and support market development. Financing of the fiscal deficit has been easily absorbed largely by banks operating in Kosovo and to a lesser extent by other institutional entities, despite the 100 percent risk-weightings on government paper for banks with EU-based parents (in the absence of a sovereign credit rating).12 The authorities are gradually extending the maturity of all outstanding public debt (2-year average maturity), with recent 7-year issuances, which should reduce roll-over risks. However, a normalization of the euro area monetary policy may make it more difficult to sell bonds in the domestic market. Therefore, the investor base should be expanded and diversified so that costs and roll-over risks will be reduced.

Authorities’ Views

35. The authorities broadly concurred with staff’s assessment. They agreed that the fiscal stance is appropriate given cyclical conditions, and that the fiscal rule continues to provide an important anchor to fiscal policy. In terms of risks to budget execution, they are confident that the revenue targets will be met, while any overspending related to social spending pressures could be offset by cutting capital spending to keep the deficit within the limits of the fiscal rule.

36. They agreed with the need to strengthen the tax administration and reduce informality, but felt that staff’s revenue projections underestimate related gains. They also see room for improvement in the budget composition, but pointed out that it does not compare poorly to peers when adjusting for initial conditions, nothing that the high social benefit spending largely reflects legacies from the 1998-99 conflict. Nonetheless, they see scope to make the social benefit system more equitable, i.e. by improving the funding and eligibility for the social assistance and basic pension schemes. Laws are under preparation that would strengthen the administration, tighten eligibility, and improve the targeting and equity of social benefit schemes. Regarding the wage bill, they see limited space for additional priority hiring within the limits of the wage bill rule given the need to attract and retain skilled labor in the civil service by offering competitive salaries.

C. Financial Sector: Supporting Economic Growth Through Stability and Financial Deepening

37. Kosovo’s largely foreign-owned banking system is broadly sound (see Figure 3, Table 6). The banking sector remains well-capitalized and liquid, despite credit growth and a shift toward shorter deposit tenors with falling interest rates. It also remains profitable as lower interest income has been offset by higher fee income and lower operational costs. However, the implementation of IFRS9 will require more provisioning with little space to increase fees further. Aggregate asset quality is strong by international comparison – the system’s NPL ratio has halved in the past two years to below 3½ percent as banks have proactively collected on bad loans and the CBK has implemented stricter write-off standards.

Figure 3.Kosovo: Banking Sector Overview

Sources: Central Bank of Kosovo; and IMF staff estimates.

Table 3.Kosovo: Consolidated Government Budget, 2014-22 1/(Excluding donor designated grants; percent of GDP)
201420152016201720182019202020212022
Original BudgetProj.Budget 4/Proj. 5/Projections
Revenue and grants (excluding donor designated grants)23.925.126.326.726.226.926.926.626.426.226.1
Revenue23.925.126.326.726.226.826.826.626.426.226.1
Taxes20.921.823.523.623.423.823.823.623.423.323.1
Direct taxes3.43.43.93.93.84.04.03.93.93.93.8
Indirect taxes18.119.120.220.320.520.520.520.420.220.120.0
Tax refunds−0.6−0.6−0.6−0.7−0.9−0.7−0.7−0.7−0.7−0.7−0.7
Nontax revenues3.13.22.83.12.93.03.02.92.92.92.9
Primary expenditure26.326.727.331.027.130.829.630.028.929.028.7
Current expenditure19.019.920.319.920.020.520.520.520.520.420.4
Wages and salaries8.79.09.08.98.68.78.78.78.78.78.6
Goods and services3.73.53.33.53.53.93.93.93.93.93.9
Subsidies and transfers6.67.48.07.47.97.87.87.87.87.87.8
Pension and social assistance6.26.97.77.67.57.57.57.57.5
Other transfers and subsidies0.40.50.30.30.30.30.30.30.3
Current reserves0.00.00.00.10.00.10.10.10.10.10.1
Capital expenditure and net lending7.36.87.011.17.110.39.19.58.48.68.3
Budget-financed capital expenditure and net lending7.36.87.08.17.18.18.17.77.57.57.3
Capital expenditure7.36.87.18.37.38.18.17.77.57.57.3
Expropriations0.40.50.40.50.40.00.00.00.0
Other capital spending5.24.44.14.06.76.97.57.57.3
Net lending0.00.0−0.1−0.2−0.20.00.00.00.00.00.0
PAK-financed capital expenditure0.00.00.01.40.00.90.60.00.00.00.0
IFI-financed capital expenditure 2/0.00.00.01.60.01.30.41.80.81.11.0
Primary balance−2.3−1.7−1.0−4.3−0.8−3.9−2.7−3.4−2.5−2.8−2.6
Interest income, net−0.1−0.2−0.2−0.4−0.4−0.3−0.3−0.4−0.4−0.4−0.3
Overall balance−2.4−1.8−1.2−4.7−1.2−4.3−3.1−3.8−2.9−3.1−3.0
Ex-PAK ex-IFI capital projects (Fiscal rule)−2.3−1.7−1.1−1.5−1.1−2−2−1.9−1.9−1.9−1.9
Ex-PAK related current expenditures−2.3−1.7−1.1−4.5−1.1−4.1−2.9−3.7−2.7−3.0−2.9
Statistical discrepancy−0.10.10.1
Financing2.41.61.01.12.93.72.73.02.9
Foreign financing−0.30.2−0.41.20.81.6−0.10.40.8
Drawings, incl. official financing0.10.10.10.20.70.50.30.50.5
Amortization−0.4−0.5−1.1−0.6−0.3−0.7−1.3−1.2−0.7
Donor financing for new projects0.00.00.00.00.41.80.81.11.0
IMF financing0.00.60.61.60.00.00.00.00.0
Domestic financing1.73.11.61.51.82.93.12.92.4
Domestic borrowing (net)1.91.91.71.51.32.93.12.92.4
Privatization revenues0.01.10.00.00.60.00.00.00.0
Own-source revenue (- = increase)−0.10.2−0.10.0−0.10.00.00.00.0
Accumulation of Assets (- = increase)1.0−1.7−0.2−1.60.2−0.8−0.3−0.3−0.3
Memorandum items:
Bank balance of the general government1.83.53.55.14.94.54.55.05.05.05.0
Of which: ELA0.80.80.80.70.70.70.70.60.60.60.5
Total public debt16.718.919.621.021.824.926.327.829.0
Of which: Debt of the former Yugoslavia 3/6.35.85.24.64.03.42.92.41.9
Nominal GDP (millions of euros)5,5675,8076,0706,4146,4146,7496,7497,1357,5568,0118,508
Sources: Kosovo authorities; and IMF staff estimates and projections.

Does not yet reflect the GFSM 2001 methodology.

For fiscal rule purposes, only projects post-July 2015 apply.

Kosovo neither recognizes nor services nor tracks this debt.

Assumes tax compliance gains of 0.7 percent of GDP, a timely and full implementation of the war veteran pension law, and tight administration for all other budgeted social schemes.

See footnote 4. Also, assumes a lower exectution of IFI and PAK financed investments, taking into account implementation capacity.

Sources: Kosovo authorities; and IMF staff estimates and projections.

Does not yet reflect the GFSM 2001 methodology.

For fiscal rule purposes, only projects post-July 2015 apply.

Kosovo neither recognizes nor services nor tracks this debt.

Assumes tax compliance gains of 0.7 percent of GDP, a timely and full implementation of the war veteran pension law, and tight administration for all other budgeted social schemes.

See footnote 4. Also, assumes a lower exectution of IFI and PAK financed investments, taking into account implementation capacity.

Table 4.Kosovo: Balance of Payments, 2014-22(Millions of euros, unless otherwise indicated)
201420152016201720182019202020212022
Projections
Goods and services balance−1,610−1,665−1,726−1,730−1,824−1,908−1,970−2,105−2,224
Goods−2,059−2,109−2,291−2,463−2,594−2,762−2,910−3,138−3,300
Exports324322308390425454485524574
Imports−2,383−2,432−2,599−2,854−3,019−3,216−3,395−3,662−3,873
Services4484455657347708549391,0331,076
Receipts9049381,0381,2461,2971,3961,4991,6201,737
Payments−456−493−473−512−527−543−560−587−661
Income109868787888994105119
Compensation of employees (net)200206194198202206208209211
Investment income−91−107−107−111−114−117−114−104−92
Interest payments on public debt−10−11−10−13−16−20−21−18−16
Transfers1,1091,0621,0961,0881,1331,2031,2821,3621,447
Official transfers292203207168177186192204216
Other transfers (net)8178598899209561,0181,0901,1581,232
Current account−392−504−543−555−603−615−595−638−657
Capital and financial account176255128463452480448477516
Capital account−2−2−2−222301
Financial account, incl. CBK178257130465450478445477515
Foreign direct investment, net124272180321336360390414429
Commercial banks, excl. FDI752−581618159191−16
General government−1713−207455112−10−56−18
Drawings5414111174162863840
Repayments−22−28−61−37−19−50−96−94−59
Other000000001
Other sectors, excl. FDI 1/−485−2−2033662670146150
Central Bank of Kosovo481−2948−124−88−78−22−26−30
Reserve assets (- = accumulation)57−894−141−93−117−28−310
Government balances (program definition)57−99−11−10115−58−20−23−25
Program financing (- = increase) 2/0−36−35−10100000
Other reserve assets, incl. SDRs01015−40−109−59−7−825
Non-reserves assets42426342063954−30
Liabilities 3/03510−200000
Net errors and omissions 4/21624841492151135147161141
Overall balance000000000
(In percent of GDP)
Goods and services balance−28.9−28.7−28.4−27.0−27.0−26.7−26.1−26.3−26.1
Exports22.121.722.225.525.525.926.326.827.2
Imports−51.0−50.4−50.6−52.5−52.5−52.7−52.3−53.0−53.3
Income (net)2.01.51.41.41.31.21.21.31.4
Transfers (net)19.918.318.117.016.816.917.017.017.0
Official5.23.53.42.62.62.62.52.52.5
Other14.714.814.614.314.214.314.414.514.5
Current account, excl. official transfers−12.3−12.4−12.4−11.3−11.6−11.2−10.4−10.5−10.3
Current account, incl. official transfers−7.0−8.7−8.9−8.7−8.9−8.6−7.9−8.0−7.7
Capital and financial account3.24.42.17.26.76.75.96.06.1
Foreign direct investment, net2.24.73.05.05.05.05.25.25.0
Other sectors, excl. FDI 1/−8.70.0−0.30.51.00.40.91.81.8
Net errors and omissions 4/3.94.36.81.42.21.91.92.01.7
Overall balance0.00.00.00.00.00.00.00.00.0
Memorandum items:
Debt service to export ratio (percent)2.63.15.23.12.03.85.95.23.2
Debt service to exports and remittances (percent)1.72.03.42.11.42.74.23.72.3
External debt (percent of GDP)23.424.724.524.924.925.624.523.923.7
Of which: Debt of the former Yugoslavia 5/6.35.85.24.64.03.42.92.41.9
Net foreign assets of CBK1,0451,0731,0251,1481,2361,3141,3371,3631,393
Gross international reserves of the CBK 6/6457347308729651,0821,1101,1411,195
Gross international reserves in months of imports 6/2.73.02.93.13.33.53.43.23.2
Sources: Kosovo authorities; and IMF staff estimates and projections.

Including trading companies, insurance companies, and pension funds.

Includes only program financing under the 2015-17 SBA.

Includes SDR allocations and IMF account at historical value.

Errors and omissions are thought to be mostly comprised of unidentified private remittances and unidentified FDI.

Kosovo neither recognizes nor services nor tracks this debt.

When calculating reserves, the CBK excludes claims on the government related to IMF financing.

Sources: Kosovo authorities; and IMF staff estimates and projections.

Including trading companies, insurance companies, and pension funds.

Includes only program financing under the 2015-17 SBA.

Includes SDR allocations and IMF account at historical value.

Errors and omissions are thought to be mostly comprised of unidentified private remittances and unidentified FDI.

Kosovo neither recognizes nor services nor tracks this debt.

When calculating reserves, the CBK excludes claims on the government related to IMF financing.

Table 5.Kosovo: Central Bank and Commercial Bank Survey, 2014-17(Millions of euros, unless otherwise indicated)
2014201520162017
Proj.
Depository Coporations
Net foreign assets1,5791,6091,6231,595
Net domestic assets1,2751,4501,6841,872
Central Bank
Net foreign assets1,0451,0731,0251,148
Foreign assets1,2661,3291,2911,413
Of which: Securities121127568588
Deposits9831,046403504
Foreign liabilities222256266264
Net domestic assets−1,045−1,073−1,025−1,148
Net claims on commercial banks−316−316−296−306
Claims on commercial banks0000
Liabilities to commercial banks−316−316−296−306
Net claims on the central government−629−626−623−744
Claims on central government102128114172
Liabilities to central government−731−754−737−916
Of which: KTA (privatization) fund−558−487−461−455
Of which : Government balances (program definition)−102−201−212−313
Net Claims on other sectors−52−82−58−51
Claims on other sectors0−30−62
Liabilities to other sectors−52−52−52−52
Other items, net 1/−48−48−48−47
Commercial banks
Net foreign assets534536598446
Assets716740775663
Liabilites−182−204−177−217
Net domestic assets2,3202,5242,7093,021
Claims on the CBK316316295306
Net claims on the central government187221234304
Claims on central government193226239304
Liabilities to central government−5−6−60
Net claims on other public entities−65−31−46−49
Claims on other public entities1133
Liabilities to other public entities−65−32−49−52
Credit to private sector1,8812,0182,2272,460
Deposits of the private sector2,3782,5502,7732,987
Demand deposits1,1311,3811,6241,750
Time deposits1,2471,1701,1501,236
Other items, net 1/476509534495
Memorandum item:
Gross international reserves 2/645734730872
Deposits of the private sector (12-month percent change)4.07.38.77.7
Credit to the private sector (12-month percent change)5.37.310.310.5
Deposits of the private sector (Percent of GDP)42.743.945.746.6
Capital Expenditure and Net Lending of GDP)33.834.836.738.3
Sources: Kosovo authorities; and IMF staff estimates and projections.

Includes shares and other equity.

When calculating reserves, the CBK excludes claims on the government related to IMF financing.

Sources: Kosovo authorities; and IMF staff estimates and projections.

Includes shares and other equity.

When calculating reserves, the CBK excludes claims on the government related to IMF financing.

Table 6.Kosovo: Selected Financial Soundness Indicators, 2012-17 1/(percent, unless otherwise indicated)
201220132014201520162017
Structure
Number of banks99101010
Foreign77888
Share of total assets (percent)89.690.289.988.788.1
Domestic22222
Share of total assets (percent)10.49.810.111.311.9
Capital adequacy
Regulatory capital to risk weighted assets 2/14.216.717.819.017.918.2
Tier 1 capital to risk weighted assets 2/11.612.814.616.715.916.3
Capital to assets10.09.710.812.212.112.9
Asset quality
NPL to total loans 3/7.58.78.36.24.93.4
NPL net of provisions to capital7.47.84.73.02.21.3
Large exposures to capital80.4107.497.163.566.981.1
Sectoral breakdown of loans
Agriculture2.52.62.43.02.72.3
Manufacturing9.59.710.010.010.09.8
Trade37.836.935.834.934.332.3
Other services11.612.412.813.311.713.2
Construction7.26.66.04.94.65.2
Households31.431.833.034.035.836.5
Liquidity
Liquid assets to total assets 4/34.337.838.337.836.032.4
Deposits to loans122.6130.8129.4130.4125.8117.5
Liquid assets to short-term liabilities 5/40.847.141.037.341.536.3
Profitability
Return on average assets 6/0.81.01.92.92.22.0
Return on average equity 6/8.310.820.226.418.516.9
Interest margin to total income55.654.362.268.669.364.9
Non-interest expense to total income 7/23.922.212.91.514.39.7
Interest margin to gross income 8/74.773.176.176.275.970.1
Non-interest expense to gross income 7/8/87.884.566.851.862.856.1
Market risk
Net open currency position to tier 1 capital0.72.31.81.84.40.9
Source: Central Bank of the Republic of Kosovo, institutional public balance sheets, staff estimates.

2017 as of November 2017.

As of December 2012, new capital adequacy rules include an additional requirement for operational risk, higher risk-weights for assets rated B- or less, and a deduction for related party

Loans classified as doubtful or loss.

Siquid assets are cash and balances with the CBK, balances with commercial banks, and securities. maturity).

Profits are before taxes and extraordinary items.

Non-interest expense including general and administrative costs.

Gross income is net interest income plus non-interest income.

Source: Central Bank of the Republic of Kosovo, institutional public balance sheets, staff estimates.

2017 as of November 2017.

As of December 2012, new capital adequacy rules include an additional requirement for operational risk, higher risk-weights for assets rated B- or less, and a deduction for related party

Loans classified as doubtful or loss.

Siquid assets are cash and balances with the CBK, balances with commercial banks, and securities. maturity).

Profits are before taxes and extraordinary items.

Non-interest expense including general and administrative costs.

Gross income is net interest income plus non-interest income.

NPL Ratio

(Latest Available)

Source: Country authorities, IMF staff estimates

38. The authorities should continue efforts to refine bank oversight to bolster bank safety and soundness. Most of the 2012 FSAP recommendations have been implemented (Annex V). Specifically, the authorities have adopted emergency liquidity assistance and macroprudential policy (MPP) frameworks in line with international best practice and adopted risk-based bank supervision. Current efforts to publish manuals for recovery and resolution and crisis management are also important, and the authorities should continue to operationalize their MPP framework. They should also move to complete work on an off-site bank examination manual, which can serve as an additional element of the CBK’s analytic toolkit and help to alert the authorities to banking system risks.

39. Credit growth has increased in recent years, following several years of weak lending, but credit penetration and lending to productive sectors remain low.13 Credit growth has averaged 9½ percent y/y since January 2016, with strong contributions from both the corporate and, especially, household sectors (about two-thirds and one-third of the system loans, respectively). This has been driven by plummeting interest rates (thanks to increased competition), healthier bank balance sheets, excess liquidity, reforms to strengthen contract enforcement (see below) and less risk aversion among EU subsidiaries’ parent banks. However, at 38 percent of GDP, credit depth remains low relative to Kosovo’s Western Balkan and income-level peers, as well as to its own macroeconomic fundamentals. Further, credit growth has been largest in unsecured consumer lending, while lending to productive sectors remains low.

Western Balkans: Credit Depth

Bark credit to the private sector in CESEE (Ihs) and at similar income levels (rhs) in percent of GDP, 2016 1/

Citation: 2018, 30; 10.5089/9781484340431.002.A001

Source: IFS, Conference Board TED, and Staff calculations.

1/ The rhs chart plot WBS against other countries across the world with a similar per capita income level (ranging 19,000 to 114,000 in constant 2014 PPP dollars) in 2016 or latest (2015).

40. Further progress on structural reforms is needed to support more productive financial deepening. The authorities have made significant progress in recent years to reduce structural impediments to lending, with a focus on strengthening the contract enforcement system. The authorities should now:

  • Maintain momentum in implementing the amended Law on Enforcement Procedures, particularly regarding the reform of the PEA tariff structure and the establishment of an independent PEA inspection unit at the Ministry of Justice;

  • Adopt pending legislation to automatically send certain types of property rights cases through an official arbitration process, thus clearing up more space in the court system;

  • Accelerate the reduction of the still-large court case backlog and prioritize large commercial cases. Consideration could be given to establish a commercial court, the efficiency of which would benefit from smaller caseloads and specialized judges;

  • Establish a fully functioning cadaster system that covers all of Kosovo; and provide banks access to the recently-established agriculture registry.

Contribution to Corporate Credit Growth

(Percent_y-o-y)

Source: CBK, staff estimates.

41. It is also important that the authorities maintain supervisory vigilance amid strong and sustained consumer and construction lending. While data is unavailable, anecdotal evidence suggests that a significant amount of unsecured consumer loans are used to purchase property given the inability to obtain a mortgage. The authorities should continue to closely monitor this sector and be vigilant of any pockets of vulnerability in view of possible excess supply in the market. They should also work toward developing a housing price index or creating a centralized registry of property valuations populated by real estate appraisers. This should be a priority, as 79 percent of the strong FDI inflows since 2015 have been directed toward the real estate and construction sectors (although construction loans comprise only about 5 percent of bank loans).

42. Policy measures have helped to improve the insurance sector’s health and performance. The sector, while small (3 percent of system assets) and no systematic risk, in aggregate posted losses in recent years and experienced liquidity and capital shortfalls. However, the sector has returned to profitability this year following the adoption of Solvency I rules and regulation to limit distribution costs; the establishment of an arbitration procedure to resolve claims out of court; and the start of a gradual phasing-in of regulations on internal controls and risk management.

43. The authorities continue to refine their AML/CFT framework. The authorities adopted an AML/CFT law in June 2016 and supplementary regulations in November 2016. Since then, the CBK has made progress with its implementation, including issuing further guidance to banks on beneficial ownership. Also, the CBK is moving towards a risk-based approach to AML/CFT supervision. In the absence of membership in a FATF-style regional body, an AML/CFT assessment under PECK (a project established to strengthen capacities and sustainability of anti-economic crime efforts) will be carried out in 2018 to assess whether the AML/CFT regime is in line with best practice.

Authorities’ Views

44. The authorities shared staff’s view of the soundness of the banking system and do not see any major pockets of vulnerabilities. The CBK’s stress tests suggest resilience to most types of shocks, with some sensitivity to a further steep fall in lending rates. The authorities viewed the strong growth in consumer and construction loans as reflective of pent-up demand, and emphasized that banks have strengthened their risk management. Given ample capital buffers, they are confident that banks can absorb losses from a potential real estate shock, even when accounting for indirect exposures through consumer credit. They consider that the expansion of the credit guarantee fund will be key to support an acceleration of credit for productive sector with an emphasis for SMEs. While credit has been growing at a healthy clip, the authorities agreed that significant scope for further credit deepening remains, and see improving access to finance as a priority. In terms of the main structural bottlenecks to credit provision, they see the contribution from demand and supply side constraints as balanced.

Other Issues

45. Article VIII acceptance. Kosovo accepted Article VIII obligations on January 11, 2018. Kosovo notified the Fund at the time it became a member in 2009 that it intended to avail itself of transitional arrangements under Article XIV, Section 2. Staff has completed an assessment of the foreign exchange system and found that Kosovo does not maintain multiple currency practices or exchange restrictions, except for restrictions maintained solely for reasons of international or national security, which have been notified to the Fund pursuant to Decision No. 144. Staff will circulate a staff report to the Board noting Kosovo’s acceptance of Article VIII obligations. The acceptance of Article VIII obligations will send a positive signal to the investor community about the liberalized foreign exchange system and thus help facilitate a favorable business climate.

46. Data remain adequate for surveillance purposes. Fiscal and financial sector data are of good quality and are timely and available. The authorities need to make further efforts to implement recommendations provided in the recent past to improve the quality and timeliness of real sector data. The authorities should also begin to publish donor inflow data for the national accounts.

Staff Appraisal

47. Kosovo has made significant progress in recent years and sound financial and fiscal policies have helped to further strengthen the economy. Since the 2015 Article IV consultations, the medium-term growth outlook has improved. While some progress in regaining competitiveness has been made, the external position remains weaker than implied by the fundamentals and desirable policy settings, and the key priority is to accelerate the implementation of structural reforms to increase productivity. Current levels of international reserves and the government’s bank balance are adequate, which should help mitigate external and liquidity shocks, and the public-sector debt is low. Notwithstanding, given Kosovo’s unilateral euroization maintaining macroeconomic and financial stability is key.

48. But important structural challenges remain. This includes an external competitiveness gap, high informality, weaknesses in governance, low labor force participation and high unemployment rates which continue to constrain Kosovo’s growth potential. Resolving these structural problems should be a priority to reduce inequality and achieve stronger and more inclusive growth to reduce the still large income gap with regional peers and the EU.

49. Reforms to improve the productivity of the economy to support private sector and export-led growth should be at the forefront of the policy agenda. Kosovo needs to improve its governance and business climate, including by implementing the laws on procurement and bankruptcy procedures, strengthening the effectiveness of the anti-corruption regime and making large public investment projects subject to ex-post audits. Also, by moving ahead with the new power plant and prioritizing investment spending in the budget with multi-year commitments should help to address energy and infrastructure bottlenecks. Public enterprises should be restructured and their governance improved to pave the way for private sector involvement. To improve labor productivity and address high unemployment, planned reforms focused on addressing skill-mismatches by upgrading education should move ahead. On the other hand, any increases in the minimum wage should be in line with the current rule-based minimum wage setting mechanism and large discretionary increases avoided, given the still high level of unemployment, competitiveness gap and weak enforcement.

50. The fiscal rule has served Kosovo well and should be maintained. It has established an anchor for fiscal policy, and provides an appropriate balance between fiscal discipline and developmental needs, given the still low public debt and large infrastructure gap. Even though it allows for some pro-cyclical easing in 2018, given the openness of the Kosovo economy, this will have limited demand pressures.

51. However, the composition of the budget and the efficiency of its spending should be improved over time. This will help improve outcomes and make space for higher and more productive investment in education, health and infrastructure which are critical to increase productivity and ensure stronger and inclusive growth. To this end, social benefits should be better targeted to improve the distributional effect and pressures to introduce new schemes that further increase spending resisted. Therefore, finalizing the reform of the war veteran pension, in line with the law, and avoiding the introduction of unfunded early retirement schemes that undermine the fairness and financial soundness of the system is essential. Wage increases within the wage bill rule should be limited to make space for priority hiring and the introduction of the new health insurance scheme. Scaling up public investment, and improving its quality are essential, including making better use of IFI financing and strengthening the public investment framework.

52. Revenue administration reforms should move ahead in earnest to mobilize domestic revenue by broadening the tax base and reducing the large informality, given the low revenue to GDP ratio. Introducing tax holidays or new exemptions should be avoided, while there is scope for additional revenue from excises and property taxes.

53. The financial sector remains healthy but access is still limited. Credit growth has increased in recent years, but credit penetration remains low and certain sectors, such as agriculture and SMEs, remain underserved by the banks, while the bulk of credit goes toward less productive sectors. The authorities should maintain the strong reform momentum of recent years in reducing structural bottlenecks to lending. They should also maintain vigilance for pockets of vulnerability in the context of strong credit growth, and continue to strengthen the supervisory framework.

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

Annex I. Implementation Status of the 2015 Article IV Recommendations
AreasRecommendationsStatus
Structural reforms to improve growth and competitivenessWeak compliance
Improve governance and business environment.The PAK Board was nominated, but with 3 out of the 5 board members whose mandate has expired not yet replaced, the board does not currently have a quorum. The vacant seats of the Procurement Review Board (PRB) were also filled and the new legislation making e-procurement mandatory has been adopted, but only implemented in full yet. Laws on contract enforcement and bankruptcy procedures were passed, but implementation remains pending. Improvement in doing of business indicators. However, some of the improvements in the ranking on reflect changes to laws that have not been implemented yet. A new AML/CFT law was adopted in 2016 and its implementation is ongoing.
Reduce labor skill mismatching.No particular measures have been undertaken. With regard to education, the 2016 PISA assessment (the first one conducted in Kosovo) shows very weak results.
Replace and upgrade energy infrastructure.No substantial progress in this area yet. Discussion is ongoing between authorities, the winning bidder and the World Bank. The 400 Kv interconnection between Albania and Kosovo, which would help mitigate temporary supply fluctuations, was completed but not activated yet for political obstacles between Serbia and Kosovo.
Fiscal policyGood compliance
Fiscal consolidation by compressing current spending and VAT reform.The fiscal deficit has been reduced from 2.3 percent of GDP in 2014 to 1.1 percent in 2016 and it is expected to remain within the fiscal rule ceiling (below 2 percent) in 2017. However, despite GDP growth, current spending has increased by about 1 percent of GDP because of untargeted war veteran pension and other social benefits. The standard VAT rate was increased from 16 to 18 percent, while a reduced rate of 8 percent for a limited category of goods was introduced.
Limit public wage growth by linking it to macroeconomic indicators.The wage bill has remained fairly constant as a share of GDP during 2015-17. A rule-based mechanism to limit any future increases to nominal GDP growth was adopted in 2015 and has become effective with the 2018 budget.
Financial sectorStrong compliance
Improve bank supervision, strengthen Emergency Liquidity Assistance (ELA) framework.On-site supervision of all banks following the risk-based manual has been completed. A new ELA regulation, in line with the best international practices, is in place. A macroprudential framework has been also adopted and the authorities are in the process of operationalizing it.
Remove bank lending impediments.An amended Law on Enforcement Procedures was passed, which should improve court operations, reduce existing bottlenecks to contract enforcement, and fully establish a unique account registry but still requires implementation; a manual on PEA supervision has been adopted; and the number of PEAs has been increased, although the number is still at 38 (compared to a target of 72). Regulations have been updated to facilitate NPL write-offs. Kosovo still lacks a fully functioning property registry.
Annex II. Debt Sustainability Analysis

The general government debt is projected to gradually increase, but remain well within sustainable levels, largely driven by the primary deficit and IFI financing for large infrastructure projects within the WBIF context. Further increases in the average maturity of the outstanding debt will reduce gross financing needs while containing roll-over risks, when monetary policy in the euro area normalizes. Continued compliance with the fiscal rule remains the key anchor to preserve fiscal sustainability.

A. Key assumptions in the DSA

1. The assumptions are fully in line with the macroeconomic framework baseline. The fiscal deficit, excluding IFI-financed projects and projects financed by non-debt creating financial flows (privatization proceeds), is expected to remain within the 2-percent of GDP fiscal deficit rule ceiling throughout the projection period. A gradual increase (up to three years) in the average maturity of outstanding domestic debt is also assumed. IFI financing reflects the financial terms currently provided.

B. Public DSA

2. The general government debt covers both contracted and guaranteed debt of the general government. Debt stock contracted by the state-owned enterprises are not included, given the lack of SOEs budgetary information. The share of the domestic debt is close to two-third of the total (large bank loans) The external debt is largely owed to multilaterals, namely the IDA, EIB and EBRD.

3. General government debt is projected to slightly increase over the projection period but remain well within sustainable levels. The debt stock is expected to increase from 20 percent of GDP in 2016 to 29 percent of GDP by 2022, assuming a rapid increase in absorption of IFI-financing for new capital investments, particularly to implement regional connectivity projects within the WBIF context.

4. The main contributor to debt accumulation remains the primary balance and, to a lesser extent, higher real interest rates. The primary deficit, including IFI-financed projects, is the large contributor to the debt accumulation. In line with the baseline of the macroeconomic framework, the DSA assumes a gradual increase in the domestic debt average maturity.

5. The continued efforts to increase the average maturity of domestic debt stock should continue. This would help the reduce the annual gross financing needs of currently 8 percent of GDP, and contain roll-over risks. However, the recent sharp increase in CBKs’ holdings of public debt1 may limit this risk. Alternative scenarios (historical and constant primary balance) show a more favorable debt profile.

C. External DSA

6. Total external debt, which covers both public and private debt is expected to decline to 24 percent of GDP after having peaked at 25½ percent of GDP in 2019. The large gross financing needs reflect the assumption that all private debt is of a short-term nature, largely short-term credit from foreign parent banks. It is also assumed a gradual decline of neither recognized nor serviced of the portion of the former Yugoslavia debt.

7. The shock scenarios highlight the potential risks to the current account deficit. A sharp contraction in remittances could have an adverse impact on the current account. However, any decline in remittances will be largely offset by a contextual decline in imports. In addition, sizable unrecorded remittances, now included in errors and omissions, would also substantially reduce the actual current account deficit if assumed as remittances.

Figure 1.Kosovo: Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(in percent of GDP unless otherwise indicated)

Source: IMF staff.

1/ Public sector is defined as general government.

2/ Based on available data.

3/ Long-term bond spread over German bonds.

4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.

5/ Derived as [(r - π(1+g) - g + ae(1+r)]/(1+g+n+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate;

a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1+g) and the real growth contribution as -g.

7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).

8/ Includes asset changes and interest revenues (if any). For projections, includes exchange rate changes during the projection period.

9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Figure 2.Kosovo: Public DSA – Composition of Public Debt and Alternative Scenarios

Source: IMF staff.

Table 1.Kosovo: External Debt Sustainability Framework, 2014-2022(In percent of GDP, unless otherwise indicated)
ActualProjections
201420152016201720182019202020212022Debt-stabilizing non-interest current account 6/
1Baseline: External debt23.424.724.524.924.925.624.523.923.7−6.2
2Change in external debt−0.11.3−0.20.40.00.7−1.1−0.6−0.2
3Identified external debt-creating flows (4+8+9)682.8845.0874.22.73.02.61.81.91.8
4Current account deficit, excluding interest payments685.8848.2878.08.48.78.47.67.77.5
5Deficit in balance of goods and services28.928.728.427.027.026.726.126.326.1
6Exports22.121.722.225.525.525.926.326.827.2
7Imports51.050.450.652.552.552.752.353.053.3
8Net non-debt creating capital inflows (negative)−2.2−4.7−3.0−5.0−5.0−5.0−5.2−5.2−5.0
9Automatic debt dynamics 1/−0.81.5−0.9−0.8−0.7−0.7−0.7−0.7−0.7
10Contribution from nominal interest rate0.20.20.20.20.20.30.30.20.2
11Contribution from real GDP growth−0.3−1.1−1.0−1.0−1.0−0.9−1.0−0.9−0.9
12Contribution from price and exchange rate changes 2/−0.72.4−0.1
13Residual, incl. change in gross foreign assets (2-3) 3/−682.9−843.7−874.4−2.3−3.0−1.9−2.8−2.4−2.0
External debt-to-exports ratio (in percent)105.8113.8110.697.797.598.693.289.487.2
Gross external financing need (in millions of EUR) 4/903.11060.21176.01181.21245.31321.61384.01465.61494.8
in percent of GDP16.218.319.419.219.319.419.119.218.5
Scenario with key variables at their historical averages 5/10-Year10-Year24.923.223.122.322.122.2−6.9
Key Macroeconomic Assumptions Underlying BaselineHistorical AverageStandard Deviation
Real GDP growth (in percent)1.24.14.14.01.84.14.04.04.04.04.0
GDP deflator in EUR (change in percent)3.3−16.30.29.130.6−2.60.81.71.91.71.6
Nominal external interest rate (in percent)0.80.90.70.80.20.91.01.21.11.00.8
Growth of exports (in percent)7.42.66.812.210.221.55.27.57.28.07.8
Growth of imports (in percent)7.93.05.07.18.09.65.46.05.27.46.7
Current account balance, excluding interest payments−685.8−848.2−878.0−8.23.2−8.4−8.7−8.4−7.6−7.7−7.5
Net non-debt creating capital inflows2.24.73.04.41.65.05.05.05.25.25.0

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Derived as [r - g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock. r increases with an appreciating domestic currency (e > 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

Figure 3.Kosovo: External Debt Sustainability Bound Tests 1/2/

(External debt in percent of GDP)

Sources: International Monetary Fund, Country desk data, and staff estimates.

1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

2/ For historical scenarios, the historical averages are calculated over the ten-year period, and the information is used to project debt dynamics five years ahead.

3/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.

4/ One-time real depreciation of 30 percent occurs in 2010.

Annex III. Risk Assessment Matrix 1/
Source of RisksRelative LikelihoodExpected ImpactRecommended Policy Response
Downside RisksExternal Risks
Weaker-than-expected growth in key advanced economy. Low productivity growth, a failure to fully address crisis legacies and undertake structural reforms, and persistently low inflation undermine medium-term growth.HighMedium

Weaker growth in Germany or Switzerland could reduce consumption and investment and/or increase the current account deficit, given the large amounts of remittance/FDI inflows from the Diaspora.
The authorities should adopt structural reforms that improve competitiveness, and increase exports and domestic production to reduce the dependency from remittances.
Intensification of the risks of fragmentation/security dislocation in part of the Middle East, Africa, Asia, and Europe.HighLow

The previous EU refugee crisis bypassed Kosovo, as Kosovo is not a popular destination country.
The authorities should closely monitor the situation and be ready to collaborate with the EU and neighbor countries to design and implement any response.
Domestic Risks
Political instability, including early elections: Slim majority of the new coalition government could hamper the reform process or lead to early elections.MediumMedium/High

Political uncertainty would translate into loss of confidence, slow reform progress and economic uncertainty.
The authorities should strengthen political credibility by moving forward with key measures that would promote job creation, increase transparency and fight corruption.
Pressure on the budget, through increases of social benefits, such as through categorical social assistance programs and unfunded early retirement schemes, and lower fiscal revenue.MediumMedium

Poorly designed social benefits and revenue underperformance would undermine fiscal sustainability and labor market incentives. Also, revenue collection could fall short should gains from tax administration reforms not materialize.
Reform social benefit system. Tighten the war veteran pension schemes, and resist to new categorical social schemes and introduction of unfunded pension schemes. Move ahead with tax administration reforms.
Unaddressed energy issues. The two aging power plants are beyond their economic lifespan, operate significantly below installed capacity, and will not be able to provide a reliable supply of electricity without adding new generation capacity.Medium/HighMedium/High

Additional power cuts will further disrupt economic activity, while further undermining the weak business environment.
Following more than a decade of discussions, the authorities should accelerate protracted negotiations with its partners to replace Kosovo A to enable starting the groundwork as soon as possible.
Domestic Risks
Upside RisksGovernment implements and ambitious reform agenda, including a comprehensive reform of social benefits, decisively tackling corruption, improved capacity for higher IFI financing for capital projects, and starting the implementation of the new power plant.Low/MediumLow

Impact would be low in the next 12-24 months, but could be significant in the medium term.
The authorities should build social and political consensus for reforms. Focus on the actual implementation of laws.

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path. (The scenario most likely to materialize in the view of IMF staff.) The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“Low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent.) The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path. (The scenario most likely to materialize in the view of IMF staff.) The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“Low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent.) The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

Annex IV. Competitiveness, Exchange Rate and Reserve Adequacy Assessment

Large current account deficits and real exchange rate overvaluation indicate a competitiveness gap, even though lower than that estimated in 2015. Some progress in regaining competitiveness has been made since the 2015 Article IV by controlling public sector wages, which are closely correlated to private compensations, consolidating the budget, and moving ahead with structural reforms. Going forward, the priority is to accelerate the implementation of structural reforms, improve the composition of the budget, reduce the infrastructure gap and deepen access to financing to raise productivity. Reserves have remained at an adequate level.

1. The trade deficit has remained large, but funded by remittances and FDIs. The trade deficit has remained in the range of 28-29 percent of GDP in the last 3 years. Exports of raw material have been increasing steadily, albeit from a very low base. Imports have continued to grow at the same pace of GDP, remaining close to 50 percent of GDP, fueled by large and stable remittances and FDIs. Both recorded and unrecorded (included in errors and omissions) remittances have been at around 14-17 percent of GDP in the last 3 years.

2. The financial accounts have continued to improve, even though remaining limited. FDIs is expected to reach 5 percent of GDP in 2017, up from 3 percent recorded in 2016. Disbursements from new IFI-financed projects have been zero in 2017. However, they are expected to accelerate in the coming years when the implementation of IFI-funded investment projects is expected to accelerate.

I. Real Exchange Rate Assessment

3. Standard methodologies indicate that the real effective exchange rate has remained overvalued. In the Kosovo’s case, the assessment relies on two methodologies, the current account and external sustainability approaches.1 The current account EBA-lite model estimates the current account norm from a sample of emerging market economies; the external sustainability model assesses the CA deficit (surplus) needed to stabilize the NIIP at a certain level.

4. Both analytical tools are slightly adapted to better fit Kosovo’s case. To take account of the large unrecorded remittances, the underlying current account has been adjusted to include one-third of errors and omissions, acknowledging that a large share of these flows is associated with remittances.

5. The results of the two methodologies point to a relatively stronger external position than in the 2015 Article IV.2 This improvement is achieved thanks to the timely implementation of fiscal adjustment and structural reform envisaged under the SBA-supported program 2015-17.

  • (i) The CA norm under the EBA-lite model is estimated at −4.4 percent of GDP (a fitted value of −2.5 percent of GDP plus an additional 1.9 percent of GDP to account for policy factors). The macroeconomic balance approach points to an overvaluation of 15.2 percent. However, these external imbalances are expected to decline in the medium-term, due to the projected expansion of the export base and slower import growth as domestic production expands.

  • (ii) The external stability also indicates an overvaluation of the real exchange rate, but slightly lower than the CA model. Given that Kosovo is likely to continue to receive FDI inflows and borrow from IFIs to implement the priority infrastructure projects (see SIP on Public Investment), a realistic benchmark is to reach an NIIP level at around −60 percent of GDP in 2035. This is in line with the current level of Albania, but well below the average regional level. Stabilizing the NIIP at −60 percent of GDP implies a CA norm of −5 percent of GDP and a real exchange rate overvaluation of 12.4 percent.

Net IIP: Actual & Projected

(in percent of GDP. based on IIP data from EWN database

Source: Lane and Milesl-Ferretti’s E*ternal Wealth of Nations Dataset. IMF WEO

Table 1.Kosovo: Exchange Rate Assessment Summary(in percent, except for elasticity)
CA NormAdjusted Underlying CACA GapRER Gap
EBA-lite (CA Approach)−4.4−7.5−3.115.2
External Sustainability−5−7.5−2.512.4
RER Elasticity0.20.20.20.2
Source: Fund staff calculations.
Source: Fund staff calculations.

II. Reserve Adequacy Assessment

6. Reserves play a crucial role in mitigating external risks and reducing the likelihood of balance of payments crises. The reserve adequacy (RA) models have been developed to better frame the discussion about the amount of foreign reserves needed to prevent risks and/or mitigate external shocks impact when they materialize. Fully euroized (dollarized) economies need liquidity buffers to support domestic financial institutions, but also as a cushion for government financing.

7. Adjusted RA metric for Kosovo shows that international gross reserves are adequate. The following adjusted metric;34

puts Kosovo’s reserve adequacy at about 12 percent of GDP by end-2016 and 2017 (estimated). Gross international reserves reached 12 percent of the GDP in 2016 and are expected to increase to 13.5 percent of GDP in 2017. Therefore, reserves would remain at comfortable levels, covering 97 percent of the norm in 2016 and 110 percent (estimated) in 2017.56

Table 2.Kosovo: Reserve Adequacy(in percent of GDP, unless stated otherwise)
20162017
(actual)(projected)
Gross International Reserves (GIR)1213.5
Adjusted Norm12.412.3
GIR as a ratio of the Adjusted Norm (in percent)97110
Source: Fund staff calculations.
Source: Fund staff calculations.
Annex V. Status of Implementation of the 2012 FSAP Recommendations
RecommendationsStatus
Short Term (within 12 months of FSAP):
  • Ensure that costs associated with the legal defense of CBK employees sued while carrying out their official responsibilities are carried out ex ante.

  • Completed. CBK developed instructions for legal representation when staff is sued for carrying out official duties in good faith.

  • Subject ELA granted to potentially insolvent systematically important institutions to very strict conditions.

  • Completed. CBK operationalized this understanding, including by modifying the tripartite MOU on financial stability cooperation to clarify the responsibilities of the CBK and MOF in ELA.

  • DIL should raise the DIFK target level to 8-9 percent of insured deposits and should only introduce higher deposit coverage as the fund increases. It should also clarify that all past and future contributions made by the government and KfW can be used to repay insured deposits. Banks’ premiums should not be reduced or discontinued.

  • Completed. In January 2013, DIFK set a working range of the DIF to 8-9 percent to be reached within 14 years.

  • Legislation was passed clarifying that contributions by the government and KfW can be used to repay insured deposits.

  • Amend the Banking Law to address the identified shortcomings in the bank resolution framework and obstacles to competition and development of the MFI sector.

  • In progress. A new Banking and Microfinance Law was passed in 2012 to enhance the CBK’s supervisory and resolution powers. Kosovo has in place a good legal framework for problem bank supervision and resolution. The CBK also coordinates with other safety net providers (for instance, DIFK) as necessary.

  • Obstacles to competition for the microfinance sector remain. The CBK is working on draft legislation in this area.

  • Reinstate Solvency I for all insurers; establish an investment regulation for life and non-life companies for their own surplus and reserves, as well as mandatory annual actuarial audit of provisions by a certified actuary; and retain two in-house actuaries.

  • Completed. Solvency I has been adopted.

  • One actuary has been appointed in the CBK.

Medium Term (within one to three years of FSAP):
  • Institute a bank premium to fund ELA needs.

  • Incomplete. The authorities consider a bank premium unnecessary given ELA’s sufficient coverage of domestic bank deposits and comfort letters from foreign subsidiaries’ parent banks.

  • Put in place extraordinary funding arrangements for the DIFK.

  • Adopt a legal framework for crisis management, contingency plans, and perform crisis simulations.

  • In progress. DIFK has concluded a series of agreements with the EBRD for credit lines.

  • Kosovo has created a National Financial Stability and Crisis Management Committee (FSC), which includes an MOU for guidance, although it does not meet regularly, and conducted a crisis simulation with the assistance of the World Bank. The CBK is currently drafting a crisis management framework to be finalized by end-June 2018.

  • Conduct a comprehensive review of the financial system legal and regulatory framework to remove inconsistencies, close gaps, and ensure coherence.

  • Completed. Several legislative and regulatory initiatives have been adopted in the last few years.

  • Revise the AML legislation to address its technical weaknesses.

  • Completed. A new AML/CFT law was passed in May 2016, with subsequent regulation adopted by the CBK in November 2016. An AML/CFT assessment will be carried out in 2018 under the PECK II project.

  • Introduce risk-based supervision with attention to those risks resulting from systemic banks and their relation with their parent banks and groups, and enhance further the supervisory capacity of the CBK.

  • Completed. The CBK’s Bank Supervision Department received extensive TA over 2014-16 that helped to roll out risk-based supervision to all banks in Kosovo, bring regulations in line with international standards, and enhance its staff’s supervisory capacity.

  • Enact and implement a regulation to introduce an out-of-court insurance dispute resolution mechanism (e.g., private arbitration with binding decision powers), to address the growing volume of consumer complaints against insurers and the lack of technical capacity of local courts to properly address insurance-related disputes.

  • Completed. A new regulation to address this was introduced in March 2017, and implementation is in progress.

  • Enhance the stress testing framework to include macro scenario analysis as well as models specifying macro-financial linkages.

  • In progress. The CBK utilizes such stress testing in its semiannual financial stability report. The CBK is also currently working, with the help of IMF TA, in further strengthening the stress testing framework as well as incorporating stress testing into its macroprudential policy framework.

  • Develop and implement macroprudential policy using quantifiable indicators and policy instruments.

  • Completed. The CBK adopted, with the assistance of IMF TA, a macroprudential policy framework, including quantifiable indicators and policy instruments.

While inequality as measured by the Gini coefficient is currently not very high, there is considerable scope for reducing it through policies that will have positive growth impetus and improve income distribution.

In successive progress reports, the EC has pointed to weaknesses in the rule of law, judging Kosovo’s justice system, and the fight against corruption and organized crime to remain at an early stage (EU Commission Staff Working Document Kosovo 2016 Report). Kosovo continues to perform poorly in rankings of perceptions-based governance indicators (e.g., Transparency International).

More than 50 percent of identified assets (around 10 percent of GDP) remain to be liquidated after almost a decade.

The fiscal rule places a cap of 2 percent of GDP on the fiscal deficit, excluding capital projects financed by privatization proceeds and donors. The exemption for donor-financed investments can be invoked until 2025, provided that debt remains below 30 percent of GDP.

IMF staff estimates and World Bank. 2014. “Republic of Kosovo Public Sector Revenues: Tax Policies, Tax Evasion, and Tax Gaps”. Washington, DC.

The top PIT and CIT rates of 10 percent are roughly in-line with Western Balkan countries, except Albania and Serbia (both having higher levels of economic development) .

Some social benefits (e.g. war veteran pensions) require the recipient to be unemployed.

Selected Issue Paper – Improving Social Benefit Effectiveness.

Spending on war veteran benefits in 2017 was 1 percent of GDP (compared to the 0.7 percent targeted), and may increase to 1.2 percent of GDP in 2018 in the absence of reform.

Selected Issue Paper – Public Infrastructure: Challenges and Opportunities.

Public Investment Management Assessment Reports April 2016 and May 2017 see for example https://www.imf.org/external/pubs/ft/scr/2016/cr16100.pdf

The CBK currently holds €190 million (35 percent of total government securities) on its balance sheet, purchased in the secondary market. The main reason for the CBK to buy T-bills is to have positive returns on its assets and, therefore, to mitigate the impact of euro area negative interest rates.

Selected Issue Paper – Financial Deepening in Kosovo.

The CBK started purchasing Kosovo government securities in the secondary market in mid-2015. Now, it holds close to €190 million, about 35 percent of the outstanding stock and high ly concentrated (up to 96.5 percent of a single T-bond).

The REER approach cannot be conducted given the limited time series availability.

The following RA metric formula (RA = 10%X + 30%STD + 15%OPL + 10%M2) was suggested for an economy with fixed exchange rate (IMF, 2011, Assessing Reserve Adequacy, IMF Policy Paper). Specifically, X indicates export revenues, SDT indicates external short-term liabilities, OPL indicates other external medium- and long-term liabilities.

IMF Country Report N. 15/131.

Gross international reserves include: (i) reserve assets, (ii) SDR allocation, and (iii) IMF net disbursement, minus deposits of the privatization agency and pension funds, which are not under the control of government and CBK.

Reserves in the range of 100-150 percent of the composite metric are considered broadly adequate for precautionary purposes (see IMF Policy Paper 2011, “Assessing Reserve Adequacy”).

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