4 Policy Priorities for the Near Term

Davina Jacobs, and Johannes Herderschee
Dimitri Demekas
Published Date:
April 2002
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Despite the signs of vigorous private economic activity, Kosovo’s long-term economic prospects are clouded by considerable uncertainty-Revitalizing the province’s infrastructure and capital base after years of degradation and wartime damage would require significant up-front investments. One of Kosovo’s greatest assets, its young population, 7 would also require sizable investments in education to realize its full potential- Donor assistance has been critical in averting a humanitarian tragedy and getting Kosovo’s economy back on its feet, but it cannot be relied upon fully to finance these necessary long-term investments. At the same time, domestic and especially foreign private investors are unlikely to undertake major projects in Kosovo as long as uncertainty about the province’s final status persists.

In addition, regardless of the timing of the final political settlement, in the more immediate future Kosovo is facing the prospect of a rapid decline in foreign transfers (Figure 1). Humanitarian assistance has already started declining and is expected to drop to very low levels by 2003. In the same year, donor grants for recurrent budgetary spending are expected to end. Grants for reconstruction are likely to decline to DM 300-400 million by 2004 from DM 1.3 billion in 2001. While the current magnitude and medium-term outlook for private transfers are uncertain, these are unlikely to persist at their present level. In all, foreign transfers are expected to fall to 15-20 percent of estimated GDP by 2004 from 67 percent in 2001. This pattern is similar to that of Bosnia and Herzegovina after the war. Indeed, the experience of the latter suggests that the decline of foreign transfers to Kosovo might, if anything, be even steeper over the medium term. The presence of international staff in Kosovo is also likely to be reduced.

Figure 1.Kosovo and Bosnia and Herzegovina: Unrequited Transfers

(In percent of GDP)1

Source: IMF staff estimates and projections.

1 Data are subject to considerable uncertainty.

The near-term economic policy goal should thus be to develop the domestic productive capacity and further the integration of Kosovo’s economy into that of the region and the rest of Europe. This would mitigate the impact of the decline in foreign assistance. Moreover, given the longer-term uncertainties, it would maximize the chances of building a sustainable economy. To achieve this goal, UNMIK and the provisional institutions of self-government should focus on four broad policy priorities: fiscal sustainability, financial sector deepening, private sector development, and good governance. Each of these is discussed in turn below.

Fiscal Sustainability

The main fiscal challenge for 2002 and the medium term will be to keep spending growth in line with that of available resources. Despite better-than-expected revenue collection in 2001, local revenue growth will be unable to compensate for the drop in donor grants in the short to medium term. Spending needs, however, will remain high, even after reconstruction is over. Resolving the tension between resources and needs in a rational manner will require transparency, a medium-term vision, and the political courage on the part of UNMIK and the provisional institutions of self-government to make tough decisions.

Tax policy should aim at simplicity, low and uniform tax rates, and as broad a tax base as possible. Tax collection is likely to continue to grow rapidly as the economy expands, major new taxes are introduced (on wages and profits in 2002 and on all incomes in 2003), and tax compliance is improved. However, the capacity and human resources of the tax administration are likely to remain strained. The following measures would help maximize the contribution of the tax system to economic growth while, at the same time, keeping it manageable and equitable.

  • The planned wage tax should apply to all wage earners, including Kosovars employed by UNMIK.

  • The future income tax should be levied on all sources of personal income, including that from labor, interest, rents, pensions, and social transfers.

  • The import tariff rate should be reduced or, preferably, abolished altogether in order to eliminate the associated trade distortions. However, this step should only be taken if the associated revenue loss can be fully offset by other means, such as lowering the VAT threshold and improving domestic revenue collection.

  • Strengthening the tax and customs administration should continue to be a priority, and care should be exercised in creating customs warehouses.

  • UNMIK should resist the temptation to grant tax exemptions to certain categories of goods, regions, or groups of taxpayers. International experience has shown that such exemptions do not generate permanent benefits for the economy as a whole, but reduce the transparency of the tax system, hamper the efficiency of tax administration, and open the door to corruption.

On the basis of this tax policy, and without the possibility of borrowing, staff projections of revenue and the outlook for donor grants provide a tentative estimate of the envelope for public expenditures over the medium term. These projections suggest that the resources available to finance public spending will decline (Figure 2). Since reconstruction needs will naturally fall, however, the room for current spending within this overall envelope will actually increase over the medium term. The share of current spending to GDP in Kosovo—excluding interest and pensions, which have so far been zero—is broadly in line with that of other countries in the region, as well as that of a representative sample of low- and middle-income countries (Figure 3 and Table 7). This suggests that the medium-term expenditure envelope in Figure 2 is adequate for the needs of Kosovo without additional support by donors for current spending. It also underscores the need for UNMIK and the provisional institutions of self-government to put the emphasis on allocating the existing resources efficiently.

Figure 2.Medium-Term Projections of Expenditure

(In percent of GDP)

Sources: UNMIK; and IMF staff estimates.

Figure 3.International Comparison of Current Expenditure 1

(In percent of GDP)1

Sources: IMF, Government Finance Statistics Yearbook (Washington, various years); and IMF staff estimates.

1 Estimated outcome for Kosovo consolidated budget, excluding budgets of the public enterprises. Subsidies and transfers include unallocated contingency reserves.

2Former Yugoslav Republic of Macedonia.

3Barbados, Botswana, Chile, Colombia, Costa Rica, Cyprus, Dominican Republic, Egypt, El Salvador, Fiji, Hungary, Islamic Republic of Iran, Jordan, Malta, Mauritius, Morocco, Panama, Paraguay, Peru, Romania, Swaziland, Thailand, Tunisia, Turkey, Uruguay, and Zimbabwe.

4Burkina Faso, Cameroon, Democratic Republic of Congo, Ghana, Kenya, Lesotho, Malawi, Mali, Sierra Leone, Sri Lanka, and Zambia.

Deciding on public resource allocation in an efficient manner will be a challenge. First, although reconstruction spending will naturally fall in the near future, the need for capital spending will continue to be high, especially in the energy sector. Second, social spending, such as education and health, together with the recent introduction of a pension system will require an increasing portion of budgetary resources. Third, new spending needs will arise, such as the possible burden from Kosovo’s share of former Yugoslav debt and several off-budget expenditures currently financed directly by donors. The special circumstances of ethnic minorities are also likely to generate expenditure pressures.

Against this background, it will be critical to set expenditure priorities over a medium-term horizon, rather than from one annual budget to the next, and to control current spending, especially the public wage bill. The wage bill already absorbs the bulk of the consolidated budget. UNMIK has not been able thus far to tackle widely acknowledged overstaffing in the public sector, notably among administrative staff in the health sector and in the Kosovo Protection Corps, relying instead on wage compression to keep the wage bill manageable. This policy deprives the public sector of qualified personnel. The review of medium-term staffing needs and pay, currently planned in the context of the 2002 budget, is a timely initiative. It should be accompanied by a plan to reduce and rationalize public sector employment starting in 2002, with the savings partly used to increase wage differentiation.

The public enterprise sector urgently needs better management, and greater transparency and accountability. It makes little sense to rely on donors for financing recurrent expenditures while, at the same time, public enterprises are accumulating large cash balances. Posts and Telecommunications of Kosovo must be brought under the Public Utilities Department, and its transactions—in particular its cash balances, which derive from its status as a state monopoly—must be accounted for with complete transparency. The telecommunications sector needs to be opened up to private sector competition as soon as possible. Kosovo Electricity Company requires new and professional management to reduce overstaffing, streamline operations, and improve service to the public.

The new pension system addresses an important need, but care should be exercised to ensure its financial viability. The main risk for the proposed system is setting the basic citizen’s pension at a level that is not fiscally responsible. This risk is considerable because, under the pension regulation, the assembly is responsible for setting the benefit level while taxation remains in the reserved powers of the Special Representative of the Secretary-General. A mechanism is thus required to ensure that the benefit level set by the assembly is low enough to be consistent with available resources and adjusted in a transparent, nonpolitical way. A relatively low basic pension would also strengthen the fully funded second and third pillars, which would then become the main components of the system. Furthermore, because the basic citizen’s pension is essentially a social safety net for the elderly, it should be subject to the future income tax, which would provide a method of means testing. Finally, pension funds should be managed for the benefit of their contributors, strictly supervised, and required to invest in low-risk instruments, which are unlikely to be available in Kosovo in the near future.

Financial Sector Deepening

Financial sector development in Kosovo is facing formidable obstacles. Financial intermediaries have a critical role to play in evaluating and pricing risk, allocating savings, financing investment, and enforcing good accounting and management practices, thereby bringing the “shadow economy” into the light. However, Kosovo’s financial sector is stunted by lack of confidence in banks; lack of trained, experienced managers and supervisors; and a weak legal framework for private business. In addition, political uncertainty deters potential foreign investors.

Despite these obstacles, significant, albeit uneven, progress is being made. Kosovo’s nascent banking system is growing rapidly, as deposits and a small but healthy loan portfolio are rising. The early introduction of a sound regulatory framework and the work of the BPK in establishing and enforcing high supervisory standards have contributed to this development, as has the process of the introduction of the euro. Structural reforms in other areas, such as passage of bankruptcy legislation, introduction of a property registry, and payment of public employees and suppliers through direct bank deposit, would help accelerate banking system growth. Above all, however, the BPK should continue to exercise close oversight, as new banks with inexperienced management trying to acquire market share often take excessive risks if not properly supervised. Moreover, as the banking system develops it will be important to ensure adequate rules on loan-loss classification, provisioning, and connected lending.

TABLE 7International Comparison of Government Expenditures(Average as percent of GDP)
Kosovo 1AlbaniaBulgariaCroatiaMacedoniaRomaniaIncome 2Income 3
Expenditures by economic type (including net lending)17.331.436.831.037.735.627.725.6
Current expenditures16.424.934.225.435.132.621.918.6
Goods and services11.312.416.516.612.411.711.512.6
Other goods and services5.
Subsidies and transfers5.16.813.37.421.
Of which: pensions1.05.411.65.813.610.64.61.3
Capital expenditures0.
Net lending50.00.0-
Expenditures by function617.331.441.529.937.635.626.726.3
Military and civil defense2.
Social security and welfare2.78.411.65.813.610.64.61.3
Economic services2.
Other government services2.
Number of countries2611
Source: IMF,Government Finance Statistics Yearbook (Washington, various years); and IMF staff estimates.

Developments in the insurance sector, however, were a serious setback for the industry, as well as for UNMIK. The original regulation was hastily prepared by inexperienced staff; supervision was nonexistent; and once problems were identified, corrective action was delayed and there was no accountability. The resulting crisis was predictable, and could have been prevented with more timely action by UNMIK. The new insurance regulation, which assigned the BPK a supervisory role over insurance companies, is a welcome—albeit much delayed—step in the right direction. The magnitude of the problem and the possible costs arising from undercapitalized insurance companies, however, are yet to be fully assessed.

There are good arguments for extending the BPK’s supervisory role over new financial intermediaries. In the future, new financial intermediaries will be created, starting with the pension funds. It would normally be unusual for a quasi-central bank to supervise pension funds. But in the circumstances of Kosovo, given that the BPK has already amassed significant expertise in financial oversight, it would make sense to charge it with the supervision of these intermediaries, provided it has adequate resources to do so.

In order to perform its functions properly, the BPK should have not only operational autonomy but financial independence as well. UNMIK should consider a plan for the gradual capitalization of the BPK. Independence, however, ought to go hand-in-hand with good governance and accountability. The BPK’s resolution of its internal accounting problems and rationalization of its operations—notably the reduction of the number of its branches to two—are thus key priorities, as well as prerequisites for recapitalization.

Private Sector Development

Private activity in Kosovo today is vibrant but remains mostly limited to informal services. Therefore, it remains small scale, outside the official tax net, and vulnerable to crime. While this activity bears testimony to the entrepreneurial spirit of the Kosovars, it is unlikely to be sufficient as the basis for sustainable development.

The key to transforming the existing activities into a modern business sector is an appropriate legal framework and the institutional apparatus to enforce it. UNMIK has made significant progress in promulgating a basic package of laws, including a contract law, a company law, a foreign investment law, a customs and excise law, a foreign exchange law, a banking law, and a law for the pledging of mobile assets. This package now must be supplemented by legislation on bankruptcy, protection of competition, and mortgages, as well as a functioning cadastre and property registry. Equally important is the strengthening of the judiciary so that the new laws can be properly administered.

UNMIK has prepared a proposal for privatization, but legal and political obstacles have stalled implementation. There are currently some 300-350 socially owned enterprises in Kosovo. According to tentative UNMIK estimates, one-quarter to one-half are unlikely to be viable as going concerns—although they might still own potentially valuable assets. A small number (i.e., 20-40) are estimated to have competent management, working capital, and an established market that could attract outside investors. In between, there is a large number of enterprises that may be viable in some form, but are unlikely to attract investment. Box 4 outlines a proposal for a three-pronged approach to privatization that the re-construction pillar of UNMIK developed in early 2001. This plan, however, has raised a number of legal and political issues. UN legal services have interpreted UNSCR 1244 as not allowing UNMIK to make any change to the ownership status of socially owned enterprises in Kosovo that would prejudice the rights of former owners or claimants. Potentially, old Serbian claims or concession agreements with foreign companies could stop the sale of such companies in Kosovo. Although the proposal is designed to overcome these legal snags, UN legal services have yet to decide how and whether to proceed.

Privatization of state-owned and socially owned enterprises is an important component of the transition to a market economy and should start as soon as possible, either in the proposed form or under another scheme. Some argue that, in the case of Kosovo, privatization would have limited benefits because many or most of these enterprises are not viable. The importance of privatization, however, should not be underestimated.

Box. 4The Proposed Privatization Plan

The proposed developed by the reconstruction pillar of UNMIK envisages three channels for previlization.

Spin-offs: Assets of enterprises that could attract new investment would be transfered to a company, fully owened by the old enterprise. The letter would retain all liabilities. The old enterprise would then be liquidated (volentarily or through bankreptcy) or transformed (see below), while the new company could seek new investers.

Transformation: Sharcs of enterprises that are able to meet minimum capital requirements but are unlikely to attract strategic investors would be distributed to employees (60 percent) and the rest to a newly created Kosovo Trust Agency(KTA). The KTA would be a public agency separate from UNMIK, thus shielding UNMIK from potential liabilities. The Agency would be governed by a board of governors appointed by the Special Representative of the Secretary-General, and would be in charge of promoting the restructuring and privatization of the enterprises in which it holds shares.

Liquidation: Nonviable companies would be liquidated or reorganized through bankruptcy.

  • It would unlock the potential of valuable assets that many of these enterprises hold, notably land.

  • It would eliminate a source of quasi-fiscal liabilities.

  • It would restore a level playing field between these enterprises and potential private sector competitors and reduce corruption.

  • It would send a powerful signal to domestic economic agents, as well as to the rest of the world, about the kind of economy Kosovo wants to build.

Good Governance

Governance is a major weakness. UNMIK and KFOR have been very successful in improving the security situation and reducing violent crime. However, the process of building new state institutions in an area devastated by war has inevitably created gaps in laws and law enforcement, some of which still persist. As a result, Kosovo is vulnerable to corruption, tax evasion, and other economic crime. An even bigger threat is international organized crime, which concentrates on the weakest links in international law enforcement. Establishing and enforcing the rule of law should thus remain one of the highest priorities in order to promote sustainable economic development and prevent Kosovo from becoming a pariah in the international community.

UNMIK has recently started focusing on economic crime. In November 2001, it initiated work on an anti-economic-crime strategy, which includes the creation of an Economic Crime Unit. The strategy will be aimed at establishing priorities, building institutions, and mobilizing resources in fighting economic crime. It will be important to ensure that this strategy cover anti-money-laundering legislation and infrastructure, and that it utilize the already considerable capacities and expertise of the customs administration in this area.

Good governance goes beyond law and order; it encompasses transparency and accountability in government decision making and in managing public resources. Key measures to improve governance and facilitate the implementation of power sharing under the new constitutional framework are the following:

  • Coordination and accountability in decision making. In a number of cases, notably insurance and privatization, important regulations took months of legal review, and budget decisions were not always implemented by spending agencies due to differences in policy priorities or interpretation within UNMIK. These delays have real economic costs for donors and Kosovars alike. Steps need to be taken to shorten review procedures, strengthen interdepartmental coordination, and enhance accountability.

  • Institutional structure of public finances. Under the new constitutional framework, the authority for fiscal policy in Kosovo is to be split between the Special Representative of the Secretary-General and the government that will emerge from the elections. This split responsibility risks weakening budgetary discipline and therefore needs to be carefully planned and implemented. In addition, accounting and reporting standards, and treasury operations should remain unified for both parts of government spending, as well as for local authorities.

  • Coverage of the Kosovo consolidated budget. The budget today covers only part of public expenditure: investment spending remains outside, as do many other donor-financed-off-budget activities. It is imperative to incorporate into the budget all public spending and all sources of financing in order to increase transparency and rationalize resource allocation.

Improving the statistical infrastructure is also an important step toward transparency and better policies. The lack of statistics—with the notable exception of public finances and the recently published monetary statistics—precludes the accurate assessment of the economic situation and hampers policy design. The importance of statistics has recently been fully recognized by UNMIK. It will be critical to continue efforts in this area, placing priority on national accounts and external trade statistics, and providing adequate resources to the Statistical Office of Kosovo.

With over half the population under 25 years of age, Kosovo has one of the youngest populations in Europe.

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