Nearly 5 years into the postconflict transition, Kosovo finds itself at a critical juncture. While there are many positive signs, including progress in institution building and noteworthy macroeconomic stabilization, there are also reasons for concern. First and foremost, the pace of recovery has been too slow to meet people’s demands and expectations. The episodic ethnic flare-ups serve as a warning that the achievements of the past few years are still fragile, and that the economy could fall into a vicious circle where the lack of economic development hampers political stability and the lack of political stability undermines economic development.
For Kosovo to make the right choices, the authorities should take stock of the achievements so far, deepen the understanding of the challenges ahead, and develop appropriate policy responses—also the broad aims of this paper. With most rehabilitation work nearly completed and a basis for macroeconomic stability in place, the most pressing challenge is to achieve economic growth that is sufficiently (i) strong to make a dent in unemployment, and (ii) regionally and socially inclusive to foster national reconciliation. This challenge is all the more daunting in the face of declining foreign assistance and private inflows, on which the economy is still heavily dependent. The underlying message of this paper is that Kosovo’s deeply rooted problems will not be solved by any one “quick-fix” solution but require instead concerted initiatives and sustained efforts across a range of areas to kick-start a process of self-generating growth. Resolution of Kosovo’s final status would provide the right enabling environment to the extent that political uncertainty may hinder investment and economic activity more generally.
Economic Structure and Long-Term Prospects
Under the impetus of a massive infusion of foreign assistance and private inflows, the Kosovo economy staged an exceptionally strong recovery immediately after the end of the conflict. However, the very dependence on such foreign inflows renders the gains achieved so far fragile and the economy vulnerable.
The analysis of the underlying macroeconomic structure and the role of the donor sector suggests that today’s level of economic activity is being propped up by foreign assistance and external private inflows to the tune of 50 percent of GDP. By hiring local employees and purchasing local goods and services for consumption by the community of expatriates and peacekeeping soldiers, as well as for donor-financed projects, the donor sector is creating an artificial “export” market for Kosovo goods and services equal to about 20 percent of GDP. Also, the nature and stability of private inflows on the order of 30 percent of GDP, which are financing the remainder of the current account deficit, are still largely unclear, as the officially estimated flow of workers’ remittances is much smaller.
Behind the large current account deficit of the domestic sector lie extremely weak fundamentals, as evidenced by large domestic dissavings, which were also characteristic of the Kosovo economy during the 1970s and early 1980s. A sudden reversal in private inflows or an overly rapid withdrawal of foreign assistance would lead to a painful retrenchment. The near-term outlook, even under a more benign scenario, does not look promising if further declines in foreign assistance were to compound the waning of the ongoing fiscal stimulus.
The gains achieved so far not only are fragile but have left major developmental challenges largely unaddressed. These include entrenched high structural unemployment, a depleted stock of human capital, and dilapidated main public utilities and infrastructure. Although the headline unemployment figure of 55 percent overstates the extent of the problem, unemployment is nonetheless likely to be very severe. The staff team estimates that the employment rate is about 33 percent and the unemployment rate about 30 percent, even after factoring in informal employment.
It would be unrealistic for policymakers to aim to reduce unemployment sharply. However, this paper argues that a reasonable macroeconomic framework should target an employment growth rate of at least 3 percent, which will make some inroads in tackling unemployment. Achieving this objective is likely to require investments of 25–27 percent of GDP per annum over the next decade, which, together with the increase in employment and solid gains in total factor productivity, could sustain growth at about 5–5½ percent.
However, given the extremely low domestic savings, Kosovo’s own resources are not sufficient to finance the required investment, and relying on foreign borrowing to fill the gap would be imprudent. This paper develops a financing scenario that could underpin the above macroeconomic framework. It assumes prudent borrowing that aims to limit the buildup of external debt to no more than 30 percent of GDP over the next 10 years—from the technical working assumption of zero today, pending clarification of the issue of liabilities and assets from the former Federal Republic of Yugoslavia. The scenario reveals that a financing gap of about €300 million annually would persist over the medium term, albeit on a declining trend. To the extent that the inherited debt is not zero, as may indeed be likely, Kosovo’s financing needs will be affected accordingly.
Addressing Kosovo’s problems would therefore require sustained and combined efforts by both the authorities and the donor community. On the part of the authorities, strong policies will be required to preserve macroeconomic stability, speed the reform of the public enterprise sector, and accelerate the overall pace of market reform. As for the donors, their continued involvement could support the authorities’ policies until the economy’s fundamentals strengthen, and governance and market institutions reach maturity. To that end, achieving clarity about policies and financing needs will be essential, albeit difficult—a task partially attempted in this paper. To increase foreign assistance’s contribution to the domestic economy and improve its developmental impact, an increasing share should be channeled through the budget. This will allow it to play a greater role in boosting growth and will reinforce both ownership and transparency.
The Fiscal Framework
Kosovo has made strides in building institutions for autonomous fiscal management, and, although still at a formative stage, the Kosovo General Budget (KGB) is rapidly approaching maturity. The nearly fivefold increase in tax revenues since 2000 and the slower expansion of expenditures have laid the basis for a strong fiscal position, offering a unique opportunity for fiscal policy to help address Kosovo’s developmental challenges. However, liberal carry-forward of unused appropriations and unhealthy competition between reserved and transferred-power agencies have impeded progress in elaborating a clear fiscal strategy.1 In the context of plentiful resources and weak capacity for expenditure management, this approach carries the risk of setting fiscal policy on a wasteful and unsustainable course.
The important steps taken recently to reform budgeting procedures will, it is hoped, allow a much-needed debate on an appropriate fiscal strategy. The strategy should, in the short to medium term, be based on two pillars:
Reining in the expansion of current spending to preserve a comfortable current budget surplus, to help finance public investment, and to ensure long-term sustainability; and
Stepping up work on medium-term strategies for education, health, and basic infrastructure, and elaborating on a well-prioritized public investment program directed at enhancing physical and, especially, human capital.
The medium-term fiscal framework should thus be anchored on a rolling 3-year growth rate for current expenditures. At the same time, the level of capital expenditures and the related overall budget balance should be consistent with a sustainable financing strategy—making prudent use of accumulated government assets and eventual borrowing, and taking into account the likely paths of foreign grants and donor-financed investment.
Kosovo has been remarkably successful in rebuilding its tax system, with a tax-to-GDP ratio already close to 30 percent, surpassing initial expectations and tax performance of countries at a similar stage of development. The system relies on traditional broad-based taxes with low nominal rates and few exemptions, which limits its distortionary effects. Further development of the tax system should ensure cost-effectiveness and avoid the risk that poor implementation will weaken tax compliance.
However, and paradoxically, this strong tax performance reflects, in part, the main structural weaknesses of the economy. First, foreign assistance not only provides an indirect support to the tax base by sustaining a higher level of economic activity, it also directly contributes some 3 percentage points of GDP to tax revenues through taxes on the implicit “exports” created by the donor sector. Second, private inflows, which currently allow an unusually high level of domestic absorption, boost the level of expenditure-based taxes commensurately.2 Further risks to tax revenues may arise from political pressures to lower rates and/or grant exemptions, and a phasing out of the peacekeeping forces’ mission.
The very limited scope for further expansion of the civil service wage bill underscores the need for prudent wage and employment policies. The proposed pay scale reform is a step in the right direction, with several associated benefits justifying the expected cost. However, the cost of the proposed meal allowance to all civil servants is significant and unwarranted. The pension and social transfer system is well designed and provides adequate minimum protection to the most vulnerable citizens. To ensure its sustainability, coverage should be expanded only cautiously, the real level of benefits kept broadly stable, and the eligibility criteria strictly enforced.
Monetary and Financial Frameworks
The monetary framework, anchored by the use of the euro, has served Kosovo well. The use of an external anchor for domestic policies has imposed financial discipline, securing a low-inflation environment. It is also likely to have played a major role in achieving a high level of monetization by avoiding the credibility problems that would have been associated with a domestic currency. For long-term development—the main challenge facing Kosovo today—the financial stability and facilitation of trade with Europe promoted by the use of the euro are likely to outweigh the costs of losing a stabilization instrument. To improve this trade-off, it will be important to further enhance labor and goods market flexibility.
Most of the perceived shortcomings in the performance of the financial sector—low credit volume, short maturities, and high lending interest rates—reflect, to a large extent, its short life span and its still nascent institutional capacity. A faster expansion of domestic credit would have compromised the quality of banks’ loan portfolios, given the still weak risk management capacity, the enterprise accounting and corporate governance shortcomings, and the weakness of the judicial processes. It would also have exacerbated inflationary pressures and inflicted greater damages on competitiveness. A more aggressive push for maturity transformation would have been imprudent, given the untested stability of bank deposits, and the absence of a lender of last resort and of ties to world financial markets.
The authorities should continue to focus their efforts on maintaining the soundness of the banking sector, strengthening the legal system to protect creditors’ rights and nurture a credit culture, and establishing a regulatory framework for external auditing and accounting standards. Enforcing the anti–money laundering law will reinforce the public’s growing trust in banks.
However, some policy intervention may be justified because Kosovo’s unresolved political status creates negative externalities that individual banks and financial institutions cannot absorb on their own. Political uncertainty exacerbates credit and liquidity risks, affects the growth of a stable deposit base, and complicates long-term investment decisions. This paper notes possible policy options, and the authorities are encouraged to carefully weigh their pros and cons.
Structural Reforms
While the achievements in the fiscal and financial areas have been remarkable, progress in structural reforms has been limited and has held back self-generating growth.
Even though privatization of socially owned enterprises (SOEs) was resumed recently—after changes to operating policies to increase transparency and ensure medium-term viability—the long pause has damaged prospects to attract investment, and the highly politicized disagreements between the PISG and UNMIK have undermined investors’ confidence. Privatization should proceed without further delay, and legislation defining land-use rights for liquidation cases should be promulgated promptly.
Limited progress in restructuring the publicly owned enterprises (POEs) has entailed significant economic costs. The de facto closure of the main mining company has virtually shut down an important sector of the economy, and the current social transfers to some of its workers are inefficient, onerous, inequitable, and a source of ethnic tensions. Similarly, faltering progress in restructuring the electricity company is depriving the economy of a reliable supply of electricity—a most serious impediment to private sector development—and generating quasi-fiscal losses of about 7 percent of GDP annually. Incorporating POEs and endowing them with strong and stable corporate governance will be critical to stemming their losses, unleashing their economic potential, and attracting much-needed private capital in would-be subsidiaries. Meanwhile, much greater transparency and closer monitoring are required, particularly of budgetary resources used by POEs.
Steady progress has been made in putting in place the main building blocks of the legal framework for private sector development; the main challenge is to develop the implementation capacity to enforce it. After years of neglect, policies to support an export-friendly environment need to be pursued more actively in the future.
The government functions transferred to the Provisional Institutions of Self-Government (PISG) following the adoption of the Constitutional Framework in 2001 are called transferred powers, whereas powers reserved for the Special Representative of the Secretary-General (SRSG) are called reserved powers.
A decrease in domestic absorption of 15 percent of GDP, which might correspond to a more stable level of private inflows, would translate into a loss of expenditure-based tax revenues equivalent to about another 3 percent of GDP, in addition to the indirect negative impact from lower economic activity.