On behalf of the Kosovar authorities, we would like to thank the mission team, led by Ms. Eble, for their constructive engagement and productive discussions during the Article IV mission in Pristina. We also express our appreciation for the helpful assessment of the Kosovar economy, the policy findings, and recommendations reflected in their in-depth reports. The authorities broadly agree with staff’s assessment and look forward to continued close dialogue and cooperation with the Fund.
Kosovo has made significant progress in recent years, including under recent Fund arrangements, in preserving fiscal discipline and maintaining low debt levels, strengthening the health and resilience of the financial sector, and moving forward with the structural reform agenda. However, the low labor participation rate and high unemployment rate, specifically among women and youth, and structural impediments to growth and investment continue to weigh on long-term growth prospects. The multi-party coalition government formed in September is committed to accelerating the implementation of structural reforms with the aim of expediting the process of income and institutional convergence with the European Union (EU), as well as moving from a growth model driven by remittances and consumption to one driven by investment and the tradable sector. In this vein, key objectives of the government’s policy strategy include safeguarding fiscal and financial stability while strengthening the rule of law, fighting corruption, enhancing the business and investment environments, and creating the conditions conducive to private sector-led growth.
Recent economic developments and outlook
Kosovo continues to enjoy the highest economic growth in the region. Initial estimates indicate that GDP growth reached 4.3 percent in 2017, higher than projected by staff and the authorities, driven primarily by investment and supported by consumption, remittances, and a steady recovery in exports. Stronger Euro Area growth and a broad-based surge in the production of tradable goods and services are stimulating export growth, albeit from a small base. Average inflation increased to 1.5 percent in 2017 on the back of a surge in prices for fuel, tobacco, food products, and household items, while the core inflation is projected to remain subdued due to falling input prices and consolidation in the retail sector.
The authorities are more optimistic than staff on the outlook assuming the current pace of reforms. They expect growth to reach 4.6 percent of GDP this year and increase to 4.9 percent and 5.3 percent of GDP in 2019 and 2020 respectively, fueled by stronger investment and export growth as donor-financed capital projects and measures to improve competitiveness begin to bear fruit. The current account deficit (CAD) remains elevated at 8.8 percent of GDP, financed by non-debt creating capital inflows, including remittances and net foreign direct investment.
The CAD is expected to hover around 9 percent of GDP in the medium-term as the increase in demand for imported capital goods, driven by the scaling up of capital investment, will weigh out the positive contribution of exports of goods and services.
While the authorities concur that risks to the outlook are balanced, they point out important upside risks to the baseline scenario. The recently signed contract with a private investor to build a 500-megawatt thermal power plant “Kosova e Re” (an investment valued at approximately 20 percent of GDP) could boost Kosovo’s growth by up to 2 percent of GDP in the medium-term. At the same time, the reforms being implemented to attract more private sector foreign and domestic investments and mobilize large international financial institution (IFI) financing for key capital projects could provide an important impetus to growth going forward.
The authorities are fully committed to safeguarding macro-financial stability while preserving the credibility of the fiscal rule and keeping public debt low. At the same time, concerted efforts are being made to improve the composition of the budget by containing unproductive current spending.
The implementation of a gradual and growth-friendly fiscal consolidation strategy in the last three years has kept current spending in check, while creating room for high priority spending and growth-enhancing capital investments. The positive fiscal performance continued through the end of 2017, although there is still room to improve the execution of the capital budget. According to provisional data, the fiscal deficit was lowered to 0.7 percent of GDP in 2017, well below the fiscal rule’s deficit ceiling, on the back of healthy tax and non-tax revenues, and the containment of spending. At the same time, bank balances increased to 5.3 percent of GDP, way above the prudent level of 4.5 percent of GDP.
The 2018 budget approved by Parliament in December is fully in line with the fiscal rule and staff’s suggestions, and strikes a good balance between fiscal prudence and development needs. The budget builds on conservative revenue projections and targets a deficit of 1.8 percent of GDP (excluding the Privatization Agency of Kosovo and IFI capital projects), while keeping the public wage bill constant as a share of GDP, in line with the wage rule. The public wage rule, which entered into force in January and represents an important achievement during the last Fund arrangement, ensures that public sector wages grow in line with productivity dynamics and prevents large discretionary increases in the public wage bill.
The budget structure has improved and on-budget capital spending is high (planned to increase to 8 percent of GDP this year). The authorities nonetheless acknowledge pressures to increase current spending. In this context, they concur that social benefit schemes need to be better targeted and means-tested to enhance spending efficiency and improve outcomes, including their distributional effect. In this vein, they are committed to strengthening mechanisms to eliminate double dipping, improve means-testing, remove disincentives to employment, and tightly administer and enforce eligibility criteria while making the system more equitable. The reform of war veteran pensions has proven socially sensitive and politically difficult. Nonetheless, the authorities recognize that the timely completion of the reclassification of war veterans, in line with the amended Law of War Veterans, is essential to ensure the scheme’s fiscal sustainability and eliminate labor force participation disincentives. At the same time, they fully acknowledge the risks stemming from the introduction of non-contributory early retirement schemes for special groups and will refrain from introducing such schemes, therefore preserving the financial soundness of the pension system.
Despite low tax rates and a low labor tax wedge, total revenues have increased steadily in recent years, reaching over 26.6 percent of GDP in 2017. Notwithstanding the progress, there is scope to further mobilize domestic revenues by broadening the tax base, including through addressing existing tax gaps for value-added tax and personal income tax, and continuing to fight informality. Against this backdrop, specific tax and custom administration reforms are being implemented in line with the recent Fund’s technical assistance mission report, including improvements in the areas of organization and performance management, compliance risk management, filing enforcement, debt collection, and tax audit.
Public debt remains low at 16.6 percent of GDP and the authorities continue to strengthen public debt management. The new public debt management strategy 2018-2022 approved by the Ministry of Finance last year aims at diversifying the investor base, extending the maturities, and minimizing roll-over risk. In view of the ramp-up in public investment, targeted policy measures are also being taken to enhance the public investment management framework through the implementation of recommendations from the Public Financial Management Assessment. Concurrently, the National Investment Committee is being strengthened, including through improving project selection and management processes in close collaboration with line ministries, and enhancing coordination between central and local authorities, with the aim of improving the absorption of donor financing and increasing public investment efficiency.
The largely foreign-owned banking sector remains well-capitalized, profitable, and liquid, owing to robust macroeconomic fundamentals and very strong prudential policies. The capital adequacy ratio increased to 18.2 percent by end-November, above the regulatory minimum of 12 percent, while non-performing loan ratio declined to a historical low of 3.4 percent of total loans with high provisioning coverage. At the same time, banking sector profitability remains high, with returns on equity and assets at 22.1 percent and 2.7 percent in November, respectively. Improved market conditions, lower interest rates, and advancements in tackling structural impediments to credit provision, which have started to bear fruit, have been the main forces behind the acceleration of credit growth to 11.2 percent last year aided by higher demand from both corporate and household sectors.
The Central Bank of Kosovo (CBK) has advanced financial sector reforms aimed at strengthening the financial safety net and banking supervisory framework, including through adopting the emergency liquidity assistance framework, rolling out the risk-based supervision, developing and operationalizing the macroprudential policy framework, and addressing weaknesses in the insurance sector. Thus, almost all the 2012 Financial Sector Assessment Program recommendations have been implemented. Going forward, the authorities are committed to further strengthening the supervisory framework, including by advancing the work on an off-site bank examination manual and refining the macroprudential policy framework. Concurrently, the CBK is moving towards a risk-based approach to AML/CFT supervision based on the recently adopted law, and is closely collaborating with staff on further improving the financial health and performance of the insurance sector.
Notwithstanding healthy credit growth, the authorities concur that at 38 percent, the credit-to-GDP ratio is lower than predicted by fundamentals, and better access to credit and financial deepening is needed to sustain the economic growth and support income convergence with the regional countries and the EU. Against this backdrop, notwithstanding the improvements in strengthening the insolvency regime, enhancing the credit registry, improving contract enforcement, and reducing the interest rate spreads, concerted efforts are under way to address other non-banking structural obstacles to credit, including slow court procedures, the large court case backlog, the weak cadaster system, and the nascent private contract enforcement mechanism. All in all, the authorities believe that these efforts will play a critical role in increasing credit penetration as well as channeling lending to productive sectors, including to manufacturing and agriculture.
The authorities welcome staff’s focus on structural reforms. While Kosovo’s external position has somewhat improved in recent years, as confirmed by staff’s External Sector Assessment, important structural bottlenecks continue to stifle competitiveness and productivity. In this regard, the authorities are cognizant that an accelerated implementation of structural reforms is essential to raise potential growth, reduce the trade deficit, boost job creation, improve the living standards, and eradicate poverty. The authorities’ National Development Strategy (2016-2021) provides the blueprint for the structural reform agenda and its top priorities include fostering a business-friendly environment; improving governance; reforming the education sector; enhancing the functioning of the labor market; ensuring a close alignment of wages to productivity dynamics; and guaranteeing a sustainable supply of energy. Ultimately, the authorities believe that these measures will lead to reducing the high unemployment rate specifically among youth and women, reducing poverty, and supporting a private sector-led growth.
Kosovo has made substantial progress in improving its business environment as the country has moved up over 70 positions in the World Bank’s Doing Business Index in the last five years, and is now ranked 40th overall and one of the top 10 reformers globally. The adoption of a comprehensive insolvency law and establishment of a clear, priority rules inside bankruptcy for secured creditors helped strengthen creditor rights. Going forward, the authorities agree that there is a need to bolster the anti-corruption framework, including by strengthening the Anti-Corruption Agency’s capacities. Similarly, improving the public procurement process necessitates that the recent public procurement reform is fully rolled out and that the mandatory use of e-procurement is enforced at all levels of government.
While Kosovo’s number of public-owned enterprises is very small and they play a limited role in the economy, they remain inefficient and policy measures are required to improve their corporate governance, enhance fiscal discipline, and seek greater private sector participation. While the labor market is flexible, a lack of a skilled supply of workers persists. Against this backdrop, the authorities are in process of upgrading all curricula for pre-university education and are working on reforming the vocational school system in cooperation with development partners, in particular for the IT and agricultural sectors. Similarly, efforts are being made to remove barriers to employment and reducing high rates of inactivity, especially among women, including through plans to provide greater and more affordable childcare and ensuring adequate maternity leave in the new labor law. The authorities agree with staff that increases to the minimum wage should be in line with the current rule-based minimum wage-setting mechanism to preserve economic competitiveness and support job creation, especially for the less skilled part of the labor force.
The construction of a supercritical thermal power plant “Kosova e Re,” while addressing all environmental and social externalities, as well as the implementation of several other projects related to enhancing energy efficiency and renewable energy, aim to improve the reliability of the energy supply and removing one of the biggest constraints to growth and investment.
Acceptance of obligations under Article VIII
The authorities have decided to move from Article XIV status (a transitional status available to new member countries in the Fund) to Article VIII, and subsequently accepted Article VIII obligations on January 11, 2018. They welcome staff’s findings that Kosovo is free from multiple currency practices and restrictions on the making of payments and transfers for current international transactions, except for sanction measures maintained solely for reasons of international or national security. The authorities trust that the acceptance of Article VIII obligations will send a positive signal to the investor community about the liberalized foreign exchange system and help facilitate a favorable business climate.