II Recent Economic Trends, Short-Term Vulnerabilities, and Medium-Term Challenges

Rakia Moalla-Fetini; Shehadah Hussein; Heikki Hatanpaa; Natasha Koliadina

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Author: Rakia Moalla-Fetini, Mr. Shehadah Hussein, Mr. Heikki Hatanpaa, and Natasha Koliadina¹

¹ 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Language:: English

Keywords:: BOOK; bank; wage; rate of return; Kosovo economy; investment balance; employment growth; financing needs; Current account deficits; Employment; Labor force

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Abstract

Kosovo staged a very strong recovery after the end of the conflict. However, the economy’s heavy reliance on foreign inflows renders the gains achieved so far fragile and the economy vulnerable, while significant developmental challenges remain largely unaddressed. The economy is operating far below potential, with no more that one adult out of three holding a job and the ranks of job seekers swelling annually by an additional 30,000 young people. After years of exclusion from the job market and the steady decline of the education system, human capital has been severely eroded, with the majority of citizens lacking the necessary education and training to lead a robust economic growth. Despite extensive rehabilitation, major deficiencies in public utilities and infrastructure continue to be a serious drag on competitiveness and investment profitability. Finally, the large environmental liabilities will be extremely costly to tackle.

Recent Economic Trends

Following the end of the conflict, large amounts of foreign assistance and private inflows underpinned an exceptionally strong rebound in economic activity. The economy—which had relied on federal transfers equivalent to 40 percent of its GDP annually—witnessed a steady decline starting in the early 1980s with the drying up of these transfers and the subsequent disintegration of the former Federal Republic of Yugoslavia. GDP per capita declined from about €1,800 in 1981 to below €300 in the late 1990s and now stands at about €930 in constant 2003 euros (Figure II.1). During 2000–03, foreign assistance totaled €4.1 billion, equivalent to over twice Kosovo’s 2003 GDP,¹ and private inflows added another €2.4 billion.

A sharp decline in foreign assistance, the end of the postconflict construction boom, and the lagging impact of an unintended fiscal tightening in 2001 seem to have brought the economy to a grinding halt in 2002.² Reflecting a fall of over 20 percent in total foreign assistance, the demand for local goods and services originating from the donor sector is likely to have contracted by about €100 million, exerting a contractionary impact on output of some 4 percent (Figures II.2–II.3 and Statistical Appendix Tables 1–4). A sharp decline in housing investment due to the completion of most reconstruction, and the slowdown in expatriates’ demand for rental housing, exerted additional contractionary pressures. Lastly, the unexpectedly strong performance of the newly established tax system—which outstripped the pace of rising budgetary spending—may have slowed the economy further. Available evidence seems to support this assessment, including the sharp deceleration in the growth of recorded commercial imports, the fall of inflation—which had turned negative by end-2002—and reports of anemic growth in most sectors from business surveys and representatives of the banking community.³

In 2003, a sizable fiscal expansion may have offset further declines in foreign assistance and private investment, allowing some recovery. A large fiscal expansion in 2003—with an increase in spending contributing 7 percentage points to GDP growth—may have offset the impact of a further decline in foreign assistance and private investment. Together with some supply recovery in agriculture, this may have boosted growth to some 3 percent. Notwithstanding the acceleration of spending, the overall budget balance remained positive, leading by end-2003 to an accumulation of government assets of over €300 million, equivalent to about 17 percent of GDP (see Table II.1).

Table II.1

General Budget, 2000–03

(In percent of GDP, unless otherwise indicated)

Sources: Kosovo authorities; and Fund staff estimates.

Table II.1

General Budget, 2000–03

(In percent of GDP, unless otherwise indicated)

		2001	2002	2003
Revenues		19.8	28.8	32.8
	Percent increase in euros	150.1	55.5	18.0
Expenditure		15.1	23.2	30.3
	Percent increase in euros	20.6	63.7	35.5
Budget balance		4.7	5.6	2.5
Government assets		9.6	15.1	17.1
	In millions of euros	156	263	307

Sources: Kosovo authorities; and Fund staff estimates.

Table II.1

General Budget, 2000–03

(In percent of GDP, unless otherwise indicated)

		2001	2002	2003
Revenues		19.8	28.8	32.8
	Percent increase in euros	150.1	55.5	18.0
Expenditure		15.1	23.2	30.3
	Percent increase in euros	20.6	63.7	35.5
Budget balance		4.7	5.6	2.5
Government assets		9.6	15.1	17.1
	In millions of euros	156	263	307

Sources: Kosovo authorities; and Fund staff estimates.

Notwithstanding large current account deficits, the banking system in recent years accumulated sizable assets abroad—funded by a sharp increase in deposits—providing evidence of significant private inflows (Table II.2 and Statistical Appendix Table 5). By end-2003, the banking system’s foreign assets had reached a level equivalent to 40 percent of GDP, of which a little less than half reflected government assets deposited at the Banking and Payments Authority of Kosovo. About 15 percent of the buildup of net foreign assets is likely to have reflected a fall in the public’s cash holdings of euros and a commensurate increase in bank deposits.⁴ The remainder points to large private inflows, the nature of which is not fully clear.⁵ They may represent (i) workers’ remittances that are not properly captured by the “official” estimate, (ii) various forms of investment by the Kosovar diaspora, notably in housing, or (iii) export receipts from illegal activities—a possibility that cannot be precluded, given widespread concerns about organized crime in Kosovo.⁶

Table II.2

Balance of Payments, 2001–03

(In millions of euros, unless otherwise indicated)

Source: Fund staff estimates.

^¹Adjusted to remove the impact of the one-off spike at end-2001 due to the euro cash changeover.

Table II.2

Balance of Payments, 2001–03

(In millions of euros, unless otherwise indicated)

		2001	2002	2003
Current account
	(after foreign assistance)	–140	–201	–284
	(in percent of GDP)	–8.6	–11.6	–15.8
Change in currency in
	circulation (increase)¹	–31	132	24
Change in banking system’s		–212	–315	–48
	NFA (end-of-period stock)¹	335	649	697
Other identified capital
	transactions	20	–39	–34
Unidentified inflows		363	423	341

Source: Fund staff estimates.

^¹Adjusted to remove the impact of the one-off spike at end-2001 due to the euro cash changeover.

Table II.2

Balance of Payments, 2001–03

(In millions of euros, unless otherwise indicated)

		2001	2002	2003
Current account
	(after foreign assistance)	–140	–201	–284
	(in percent of GDP)	–8.6	–11.6	–15.8
Change in currency in
	circulation (increase)¹	–31	132	24
Change in banking system’s		–212	–315	–48
	NFA (end-of-period stock)¹	335	649	697
Other identified capital
	transactions	20	–39	–34
Unidentified inflows		363	423	341

Source: Fund staff estimates.

^¹Adjusted to remove the impact of the one-off spike at end-2001 due to the euro cash changeover.

Trends in Kosovo’s real effective exchange rate seem to suggest that, following a strong initial appreciation, competitiveness was gradually restored, thanks to a significant slowdown in inflation (Figures II.4 and II.5).⁷ The initially strong real Appreciation reflected the foreign-inflows-driven high domestic inflation—which caused a strong real Appreciation vis-à-vis the euro area—and a significant real depreciation of the Yugoslav dinar and the Turkish lira.⁸ A gradual correction started in mid-2001 as price pressures subsided in response to the decline in aid flows and a weakening in domestic demand. These favorable price developments fully offset the impact of further nominal appreciation. The latter was much smaller than the effective appreciation in the euro zone, mainly because the currencies of Kosovo’s main trading partners are either linked to the euro or did not depreciate vis-à-vis the euro as much as the U.S. dollar did.

Aid Dependency and Short-Term Vulnerabilities

In Kosovo, as in other postconflict regions, the parallel structures created by the international presence complicate the analysis of foreign assistance. The international structures are best seen as a separate sector. This sector, which may be called the donor sector and whose budget is financed by taxpayers in donor countries, runs a parallel structure of public spending. Part of that spending is reflected in wages to a large community of international civil servants, foreign experts, international police and judges, and foreign peacekeeping soldiers (Statistical Appendix Table 6).⁹ Other public expenditures are covered by Kosovo’s general budget and are financed by taxes paid by the domestic sector, namely, Kosovar households and firms.

In such a context, the overall external current account deficit overstates the extent of the underlying imbalances, as foreign assistance is, in some sense, financing more than the “true underlying” deficit of the domestic economy. First, part of the deficit reflects the cost of activities related to the nonnormalized political situation, which will be phased out eventually. Second, the cost of the activities that would not be phased out and would simply be transferred to an eventual new political structure would be much lower, given the differential between expatriates’ and civil service wages.¹⁰ Third, some of the donor spending covered one-off expenditures related to postconflict reconstruction with a heavy import content and, hence, neither reflected a “structural” deficit nor made a significant contribution to domestic output.

In these circumstances, a more appropriate measure of the true underlying macroeconomic imbalances is the current account deficit of the domestic sector only. The analytical framework presented in Box II.1 shows that this deficit is consistent not with the entire amount of foreign assistance but with its contribution to the domestic economy only. In turn, foreign assistance’s contribution to the domestic economy is best seen as a “virtual export market” for Kosovar goods and services, which are in the form of local employees’ hiring and purchases of domestic goods and services for consumption by the community of expatriates and peacekeeping soldiers, as well as for donor-financed projects.

Using this framework reveals that, although the consolidated current account deficit of the economy as a whole was on the order of 77 percent of GDP in 2003, the fundamentals of the economy are best captured by the underlying current account deficit of the domestic sector only, which was on the order of 50 percent of GDP (Statistical Appendix Tables 7 and 8). The difference reflects the gap between total foreign assistance, which was about 40 percent of GDP, and its contribution to GDP, which was on the order of 13 percent only (Statistical Appendix Table 9).

Box II.1.

Analytical Framework for an Analysis of Foreign Assistance in Kosovo

To analyze foreign assistance in Kosovo, it is useful to think of the Kosovo economy as consisting of three sectors: (i) the donor sector; (ii) the government (the Kosovo general government budget, or KGB); and (iii) households and firms, including socially owned enterprises (SOEs) and privately owned enterprises (POEs). Total direct spending by the donor sector can be decomposed into (i) expatriates’ wages, W_exp; (ii) wages of local employees, W_le; and (iii) spending on goods and services. Let G_UNMIK be UNMIK’s spending on goods and services, I_PIP be the PIP component of spending on goods and services, and G_KFOR be KFOR’s spending on goods and services. Letting FA be total foreign assistance, we would have

FA = W_{_exp} + W_{_le} + G_unmik + I_pip + G_kfor

Equilibrium in the goods market is given by adding the demand originating from these three sectors, plus regular exports X:

\begin{matrix} Y = & (C_{H} - M_{H}^{C}) + (I_{H} - M_{H}^{I}) + G_{g} + (I_{g} - M_{g}^{I}) \\ + (G_{U N M I K} - M_{U N M I K}^{G}) + (G_{K F O R} - M_{K F O R}^{G}) \\ + (I_{P I P} - M_{P I P}) + (C_{\exp} - M_{\exp}^{C}) + X; \end{matrix}

where C_H and $M_{H}^{C}$ are private consumption and its import content, I_H and $M_{H}^{I}$ are private investment and its import content, G_g is government’s consumption, I_g and $M_{g}^{I}$ are government investment and its import content, and $M_{UNMIK}^{G}$ , M_PIP, $M_{KFOR}^{G}$ , and $M_{\exp}^{C}$ are the import contents of the respective expenditure items.

Adding and subtracting (W_{_exp} + W_{_le}) to the right-hand side of the equation, the equation gives the following decomposition of GDP into the main expenditure items: private and public consumption, private and public investment, and net exports:

\begin{matrix} Y = & C_{H} + (G_{g} + G_{U N M I K} + G_{K F O R} + W_{\exp} + W_{l e}) \\ + (I_{H} + I_{g} + I_{P I P}) + N E X P_{T}, w h e r e \end{matrix}

\begin{matrix} N E X P_{T} = & (X + C_{\exp}) - ((M_{H}^{C} + M_{H}^{I} + M_{g}^{I}) \\ + (M_{\exp}^{C} + M_{U N M I K}^{G} + M_{K F O R}^{G} + M_{P I P}^{I}) \\ + (W_{\exp} + W_{l e})) . \end{matrix}

The above equations show that the direct contribution of foreign assistance to GDP is equal to the domestic component of UNMIK’s spending on goods and services, plus the domestic component of the PIP spending on goods and services (including designated donor grants), plus the domestic component of the local spending of the expatriates and KFOR.

Hence, if we call DCFA the direct contribution of foreign assistance to GDP, we have

\begin{matrix} D C F A_{G D P} = & (G_{U N M I K} - M_{U N M I K}^{G}) + (G_{K F O R} - M_{K F O R}^{G}) \\ + (I_{P I P} - M_{P I P}^{I}) + (C_{\exp} - M_{\exp}^{C}), \end{matrix}

and the direct contribution of foreign assistance to GNDI (gross national disposable income) is given by

DCFA_gndi = DCFA_gdp + W_{_le}.

Having defined down the budget constraints of the three sectors, it is easy to check that the financial savings of the economy is equal to the current account balance, CA, where CA is given by

CA = NEXP + WR + W_le + FA.

If we call NEXP_ds the net exports of the domestic sector only, it is easy to check that

\begin{matrix} N E X P_{D S} = & X - (M_{H}^{C} + M_{H}^{I} + M_{G}^{I}) \\ = & N E X P_{T} + (F A - D C F A_{G D P}) . \end{matrix}

This analysis reveals 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 which 20 percentage points are from foreign assistance. Through the hiring of local employees and the purchase of local goods and services, the donor sector is creating a €380 million (20 percent of GDP) “export” market for Kosovar goods and services. Total private inflows on the order of 30 percent of GDP are helping close the remaining deficit (see Table II.3).

Table II.3

Underlying Savings/Investment Balances, Domestic Sector, 2001–03

(In percent of GDP)

Source: Fund staff estimates.Note: GNDI = gross national disposable income.

Table II.3

Underlying Savings/Investment Balances, Domestic Sector, 2001–03

(In percent of GDP)

		2001 Est.	2002 Est.	2003 Est.
Current account balance		–60.1	–53.7	–50.4
	Regular exports	1.4	1.6	2.0
	Imports	61.5	55.3	52.5
Investment		25.6	24.1	22.3
Underlying domestic savings		–34.6	–29.6	–28.2
Current account financing		60.1	53.7	50.4
	Donors’ contribution to GNDI	38.2	28.2	21.2
	Private inflows	22.0	25.5	29.2
Memorandum item
Total foreign assistance		72.3	52.6	41.0
Total private inflows		35.7	38.3	32.4
Stock of net foreign asset
	position of the economy	24.5	38.3	41.3

Source: Fund staff estimates.Note: GNDI = gross national disposable income.

Table II.3

Underlying Savings/Investment Balances, Domestic Sector, 2001–03

(In percent of GDP)

		2001 Est.	2002 Est.	2003 Est.
Current account balance		–60.1	–53.7	–50.4
	Regular exports	1.4	1.6	2.0
	Imports	61.5	55.3	52.5
Investment		25.6	24.1	22.3
Underlying domestic savings		–34.6	–29.6	–28.2
Current account financing		60.1	53.7	50.4
	Donors’ contribution to GNDI	38.2	28.2	21.2
	Private inflows	22.0	25.5	29.2
Memorandum item
Total foreign assistance		72.3	52.6	41.0
Total private inflows		35.7	38.3	32.4
Stock of net foreign asset
	position of the economy	24.5	38.3	41.3

Source: Fund staff estimates.Note: GNDI = gross national disposable income.

This situation is symptomatic of very weak underlying fundamentals: extremely low domestic savings and wide current account deficits. Excluding the net impact of the donor sector as a source of “export” earnings, the underlying domestic savings rates are largely negative, probably on the order of -30 percent of GDP—despite a substantial amount of public services provided for free by the donor sector. Also, large private inflows and the net contribution of the donor sector have allowed not only high consumption but also fairly high investment rates.

Such weak fundamentals are not a creation of the 1990s conflict but have been with the economy for many decades. Under the former Federal Republic of Yugoslavia, Kosovo used to receive sizable transfers from the Federal Fund, which was designed to provide long-term supplementary investment resources to stimulate economic development in the less developed regions. Additional current transfers helped defray some of the costs of basic social services. In 1980, total transfers amounted to 40.7 percent of Kosovo’s GDP.¹¹

The economy’s reliance on private inflows of a largely unidentified nature and untested stability is a main source of vulnerability. While pure workers’ remittances have proved to be a stable, and even a stabilizing source of external financing in other economies,¹² it is not clear how much of the private inflows in Kosovo are stable workers’ remittances or a form of foreign direct investment by the Kosovar diaspora.¹³ According to the official statistics,¹⁴ the level of workers’ remittances in 2003 is estimated at 13.7 percent of GDP, comparable to the highest levels in the region. Based on this estimate, the national savings rate would be largely negative and on the order of -15 percent of GDP, by far the lowest of all neighboring countries (Figure II.6). If workers’ remittances were about 25 percent of GDP—which may be supported by the evidence presented in Appendix II—the national savings rate would be higher but still negative.

Further declines in foreign assistance would continue to exert contractionary pressures on the economy and weaken the fiscal outlook. The shock to output from a full phase-out of foreign assistance is measured by the balance of payments gap it would generate, which, as estimated above, is tantamount to a loss of export earnings equivalent to 20 percent of GDP. The potential gap in the budget balance reflects both a decline in tax revenues and higher spending. As explained in Chapter III, foreign assistance not only is contributing indirectly to higher tax revenues—by sustaining a higher level of economic activity—but is also contributing about 3 percentage points of GDP to tax revenues from taxes on the local spending of the donor sector. On the expenditure side, the gap will not be as large as the actual size of the spending by the donor sector because of the exceptional nature of some of the spending and the wage differential, as explained above.

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—as previously saved surpluses are used up. Contractionary pressures from a fall in foreign inflows will be amplified by the fixed exchange rate regime. The latter would prevent, in the short run, an adjustment of the real exchange rate that could offset some of the impact of the shock. However, use of part of the foreign assets accumulated during the past 3 years could mitigate such an adversity.

Medium-Term Growth and Employment Challenges

The most pressing problem facing Kosovo today is the absence of sustained growth and job creation, which are essential to raising living standards. Although this problem is widely recognized, little work has been done to clarify the broad outlook of a macroeconomic framework to address these challenges. The aim of this section is to fill this gap. It uses a growth-accounting methodology¹⁵ to derive the investment requirement for a growth scenario anchored in an employment policy objective and draws implications for the financing needs and policy requirements.

Notwithstanding the severity of unemployment, it would be unrealistic for policymakers to aim at sharply reducing it. Although the seasonally unadjusted headline unemployment figure of 55 percent is likely to overstate the extent of the problem, given the size of the “gray” economy, unemployment is nonetheless rampant: it may be as high as 30 percent, with an employment rate of no more than 33 percent (Box II.2 and Statistical Appendix Table 10). However, high unemployment, like low domestic savings, is not a creation of the recent past; it has been an entrenched problem throughout Kosovo’s modern history.¹⁶ The experience of other transition economies in the fight against high unemployment shows that the task is far from easy, even if, in Kosovo, most of the labor shedding associated with the transition has already taken place. Also, a fast decline in unemployment may not be possible before labor productivity has been increased significantly. Indeed, the availability of large workers’ remittances may be acting as a mechanism that sets an implicit reservation wage well above market-clearing levels.

A reasonable macroeconomic framework could possibly target an employment growth rate of some 3 percent. Achieving this policy objective, while making a modest dent in the stock of unemployment, will, it is hoped, strengthen confidence and support a virtuous circle of self-reinforcing economic growth and political stability. As shown in the illustrative scenario in Statistical Appendix Table 12, a sustained annual employment growth rate of 3 percent over the next 10 years would create about 145,000 net additional jobs and would bring unemployment down to a more manageable rate of about 25 percent (Figure II.7).¹⁷ Other countries’ experience, as reported in Statistical Appendix Table 13, which shows employment growth never exceeding 2.8 percent per annum, provides an additional reality check for the employment objective.

The second building block of the growth scenario is to gauge the minimum rate of capital accumulation needed to support the employment objective.¹⁸ Cross country evidence shows that any growth rate of employment has always been associated with a much higher rate of capital accumulation. Low labor costs relative to the rental cost of capital are likely to have favored more labor-intensive growth processes, but some increase in the capital-labor ratio has been the rule everywhere.¹⁹ The baseline scenario assumes an increase in the capital-labor ratio of 1.5 percent per year. This is somewhat optimistic but still realistic if appropriate wage and sectoral policies promote labor-intensive sectors.

Box II.2.

Unemployment: How Big a Problem?

The headline figure for the unemployment rate, although frighteningly high, is likely to overstate the extent of the problem. According to published statistics, in 2002 only 263,000 people had a job, 321,000 people were unemployed, and the remaining 623,000 people of working age were out of the labor force. These numbers suggest a dismal labor market performance, with an employment rate less than 22 percent, a participation rate of 48 percent, and an unemployment rate at a staggering 55 percent. However, because the two labor force surveys were conducted in winter, when labor demand in agriculture and in construction is relatively weak, and because of the high degree of informality in labor relations, it is likely that the official statistics overstate the problem.

Results of the Labor Force Surveys (LFS), 2001–02

(In thousands, unless otherwise indicated)

Sources: Statistics Office of Kosovo LFS 2001 and LFS 2002; and Fund staff estimates.

Results of the Labor Force Surveys (LFS), 2001–02

(In thousands, unless otherwise indicated)

		2001	2002
Working-age population		1,144	1,207
	Employed	229	263
	Unemployed	305	321
	Not in the labor force	610	623
	Labor force participation rate (in percent)	46.7	48.4
Unemployment rate (in percent)		57.2	55.0

Sources: Statistics Office of Kosovo LFS 2001 and LFS 2002; and Fund staff estimates.

Results of the Labor Force Surveys (LFS), 2001–02

(In thousands, unless otherwise indicated)

		2001	2002
Working-age population		1,144	1,207
	Employed	229	263
	Unemployed	305	321
	Not in the labor force	610	623
	Labor force participation rate (in percent)	46.7	48.4
Unemployment rate (in percent)		57.2	55.0

Sources: Statistics Office of Kosovo LFS 2001 and LFS 2002; and Fund staff estimates.

Staff team estimates of informal employment suggest a figure on the order of 150,000 (Statistical Appendix Table 13). The methodology combines available data on households’ total wage incomes and subsistence agriculture with officially recorded employment and salary data. The estimation method (i) converts employment in subsistence agriculture into full-time employment equivalents by assuming that wages in this sector are equal to 85 percent of average net wages in the budget sector, in order to reflect the presumably somewhat lower productivity; and (ii) subtracting the wage remuneration in the formal sector from the household budget survey’s estimates of total wage remuneration, it derives employment in the informal nonagricultural sector as a residual using three different levels of wages, ranging from 85 percent to 115 percent of average net wages in the budget sector.

Factoring in informal employment, unemployment is still very severe. Assuming the same participation rate and the same share of active-age population as in the labor force survey of 2002 yields an unemployment rate in the range of 22–30 percent. Considering some biases are inherent in the estimation method (e.g., the fact that some of the officially employed persons are likely to work occasionally in subsistence agriculture) and in the available information on minimum acceptable salaries for unemployed persons, it would seem that the lower end of the employment range (415,000) and, consequently, the higher end of the unemployment range (30 percent) are more plausible.

Labor Force Surveys 2001 and 2002, and Illustrative Scenarios for 2003¹

Sources: Statistics Office of Kosovo (SOK) LFS, Dec. 2001 and Nov. 2002; SOK 2002/03 Household Budget Survey (HBS); and Fund staff estimates.

^¹Scenarios incorporate subsistence and informal employment, converted into units of full-time employment equivalents.

Labor Force Surveys 2001 and 2002, and Illustrative Scenarios for 2003¹

		2001 LFS	2002 LFS	2003
		2001 LFS	2002 LFS	Scenario 1	Scenario 2	Scenario 3
Total population (in thousands)		1,868	1,900	1,932	1,932	1,932
Total working-age population 16–64 (in thousands)		1,144	1,207	1,227	1,227	1,227
	Employed	229	263	465	436	415
	Unemployed	305	321	129	158	179
	Not in the labor force	610	623	633	633	633
Working-age population by status (in percent)
	Employed	20.0	21.8	37.9	35.6	33.8
	Unemployed	26.7	26.6	10.5	12.8	14.6
	Not in the labor force	53.3	51.6	51.6	51.6	51.6
Share of working-age population in total population (in percent)		61.2	63.5	63.5	63.5	63.5
Unemployment rate (in percent)		57.2	55.0	21.7	26.5	30.1
Participation rate (in percent)		46.7	48.4	48.4	48.4	48.4
Dependency ratio		63.3	57.5	57.5	57.5	57.5

Sources: Statistics Office of Kosovo (SOK) LFS, Dec. 2001 and Nov. 2002; SOK 2002/03 Household Budget Survey (HBS); and Fund staff estimates.

^¹Scenarios incorporate subsistence and informal employment, converted into units of full-time employment equivalents.

Labor Force Surveys 2001 and 2002, and Illustrative Scenarios for 2003¹

		2001 LFS	2002 LFS	2003
		2001 LFS	2002 LFS	Scenario 1	Scenario 2	Scenario 3
Total population (in thousands)		1,868	1,900	1,932	1,932	1,932
Total working-age population 16–64 (in thousands)		1,144	1,207	1,227	1,227	1,227
	Employed	229	263	465	436	415
	Unemployed	305	321	129	158	179
	Not in the labor force	610	623	633	633	633
Working-age population by status (in percent)
	Employed	20.0	21.8	37.9	35.6	33.8
	Unemployed	26.7	26.6	10.5	12.8	14.6
	Not in the labor force	53.3	51.6	51.6	51.6	51.6
Share of working-age population in total population (in percent)		61.2	63.5	63.5	63.5	63.5
Unemployment rate (in percent)		57.2	55.0	21.7	26.5	30.1
Participation rate (in percent)		46.7	48.4	48.4	48.4	48.4
Dependency ratio		63.3	57.5	57.5	57.5	57.5

Sources: Statistics Office of Kosovo (SOK) LFS, Dec. 2001 and Nov. 2002; SOK 2002/03 Household Budget Survey (HBS); and Fund staff estimates.

^¹Scenarios incorporate subsistence and informal employment, converted into units of full-time employment equivalents.

Achieving the employment objective could sustain growth at some 5–5½ percent but would require annual investments of 25–27 percent of GDP over the next decade (Statistical Appendix Table 14). If supportive macroeconomic and structural policies help achieve annual gains in total factor productivity (TFP) of 2 percent—a reasonable performance based on other countries’ experience—growth could be sustained at 5½ percent, with labor contributing 1.6 percentage points, capital 1.8 percentage points, and TFP 2 percentage points. The increase in the stock of remunerated capital (both private capital and the capital invested in POEs and SOEs) would necessitate an investment rate of some 20 percent of GDP, assuming 5 percent depreciation. This investment rate would need to be complemented with public investment to support the assumed gains in TFP. To estimate the latter, a bottom-up approach would be required to determine the cost of remedying the deficiencies in the main public infrastructure and rebuilding the stock of human capital. Such a bottom-up approach, which is a critical underpinning for the elaboration of an appropriate fiscal strategy, has yet to be developed (see Chapter III). A tentative estimate of the necessary public investment could be in the range of 5–7 percent of GDP. Box II.3 presents a sensitivity analysis around the main parameters.

The high negative domestic savings rate is, obviously, the main financing constraint to achieving such growth, and attempting to address this issue by relying on foreign borrowing would be extremely imprudent. In the recent past, the economy was able to finance broadly similar levels of investment, thanks to foreign assistance and private inflows equivalent to 50 percent of GDP. Attempting to close any significant share of the gap through foreign borrowing would be imprudent, as it would lead to a very rapid accumulation of a large stock of external debt. This would repeat the experience of many former Soviet Union countries, which, after 10 years of heavy borrowing, are now facing severe debt-repayment problems. For the economy to continue to grow, foreign assistance needs to continue to supplement available non-debt-creating private inflows until the economy’s capacity to generate its own domestic savings phases out, gradually and over time, the need for such support. Withdrawing foreign assistance prematurely and letting the economy fend for itself run the risk of deepening the unemployment problem and renewing the fraying of the social fabric.

The scenario in Statistical Appendix Table 15 illustrates the following broad parameters of a financing strategy that would maintain external solvency while supporting the needed growth:

Private savings. Increased productivity, improved competitiveness, and better access to foreign markets should allow the economy to gradually expand its production possibility frontier and increase savings. Although the speed of such a process is hard to predict, the scenario envisages an increase in domestic savings from -28 percent of GDP in 2003 to about -10 percent by 2013, reflecting an expansion of regular exports to some €600 million.²⁰ Such a level of exports would not be unrealistic if Kosovo were able to revive its mining and power sectors—which used to generate significant foreign exchange earnings—and discover new export niches.

Box II.3.

Sensitivity Analysis of GDP Growth and Investment Requirements

A more rapid increase in the capital-labor ratio would lead to higher economic growth, but it would also require more investment. If the annual growth rate of the capital-labor ratio were 2 percent, rather than 1.5 percent, economic growth would be 0.3 percent points higher than in the baseline, but that condition would also require a larger additional investment of 1.4 percent of GDP.

A higher initial level of the capital-output ratio would imply a lower underlying rate of return on capital, and would require larger volume of investment. If the capital-output ratio in 2003 were 3.3, rather than 3 percent as in the baseline, implying a net rate of return on capital of 7.8 percent rather than 9.1 percent, additional investment of almost 2 percent of GDP would be required to achieve the same rate of economic growth, as in the baseline.

Lower TFP gains weaken GDP growth, and would imply higher investment in relation to GDP. If TFP gains were limited to 1 percent per year, growth would be limited to 4.5 percent and the investment-to-GDP ratio would rise to 25.2 percent.

Sensitivity of Growth and Investment Rates to Changes in Assumptions

(In percent, unless otherwise indicated)

Sensitivity of Growth and Investment Rates to Changes in Assumptions

(In percent, unless otherwise indicated)

	Baseline Scenario	Sensitivity Analysis Around Baseline
	Baseline Scenario	ΔK/L=2	K/Y=3.3	TFP=1 percent
GDP growth	5.4	5.7	5.4	4.5
Total investment in percent of GDP	24.3	25.7	26.2	25.2
Net capital share in net output	32.0	32.0	30.8	32.0
Net rate of return on capital	9.1	9.1	7.8	9.1
Assumptions
Capital-output ratio	3.0	3.0	3.3	3.0
Change in capital-labor ratio	1.5	2.0	1.5	1.5
Contribution to growth by TFP	2.0	2.0	2.0	1.0

Sensitivity of Growth and Investment Rates to Changes in Assumptions

(In percent, unless otherwise indicated)

	Baseline Scenario	Sensitivity Analysis Around Baseline
	Baseline Scenario	ΔK/L=2	K/Y=3.3	TFP=1 percent
GDP growth	5.4	5.7	5.4	4.5
Total investment in percent of GDP	24.3	25.7	26.2	25.2
Net capital share in net output	32.0	32.0	30.8	32.0
Net rate of return on capital	9.1	9.1	7.8	9.1
Assumptions
Capital-output ratio	3.0	3.0	3.3	3.0
Change in capital-labor ratio	1.5	2.0	1.5	1.5
Contribution to growth by TFP	2.0	2.0	2.0	1.0

Private inflows. Their behavior is hard to predict, given the still largely undefined nature of these inflows. Genuine workers’ remittances could be expected to remain stable, but their contribution to financing the current account deficit would decline, as their growth may not keep up with the growth of the economy, unless additional emigration is allowed. The rest of the inflows may decline, but regular foreign direct investment could replace it as structural reforms are deepened and as part of the uncertainty about Kosovo’s unresolved final status is cleared up. All in all, the scenario assumes that these factors may contribute to keeping the level of private inflows broadly constant at some €550 million over the next 10 years. The economy could also use some of the assets it has accumulated in the past. This would add an extra €70 million of external financing per year.

Foreign borrowing. Borrowing needs to be consistent with the economy’s capacity to service debt. Several studies suggest that, beyond a debt-to-GDP ratio of 40–50 percent, the likelihood of a debt correction rises and the impact on growth turns negative, as the deterioration in the perceived creditworthiness of the country discourages domestic and foreign investment.²¹ Depending on the magnitude of the debt that Kosovo may inherit from the former Federal Republic of Yugoslavia the amount of new borrowing should be calibrated accordingly. The scenario takes the technical working assumption that the inherited debt is zero and allows a gradual buildup of debt to some 27 percent of GDP in 10 years.²² This could provide €70 million additional financing per year. To the extent that the inherited debt is not zero, as may indeed be likely, Kosovo’s financing needs will be affected accordingly. To ensure that debt service obligations remain sustainable, new borrowing should be made at concessional terms.²³

The above analysis shows that, although a financing gap is likely to persist over the medium term, it can be hoped that it is on a declining trend. Today’s level of foreign assistance is about €750 million, of which only €380 million finances the current account deficit of the local economy. As political normalization allows a gradual move toward more traditional forms of foreign assistance, the total level of foreign assistance could converge to the level of its current net impact on the domestic economy. This would imply that the level of total foreign assistance could also decline from about €750 million today to some €280 million by 2013.

Addressing Kosovo’s problems will therefore require sustained and combined efforts, such as the following, by the authorities and the donor community.

On the part of the authorities, it requires strong policies aimed at (i) an efficient and effective structure of public spending that promotes development and creates an enabling environment for productive private investment, while maintaining fiscal stability; (ii) a speedy reform of the state enterprise sector; and (iii) an acceleration of the overall pace of market reform and of the establishment of the rule of law. Achieving these goals will help achieve strong total factor productivity, a high rate of return on investment, and high growth—which, in turn, will expand the economy’s production possibility frontier and strengthen its fundamentals. Together with policies targeted at raising labor productivity, ensuring a better skill match, lowering labor cost, and maintaining labor market flexibility, these reforms will encourage and promote a labor-rich growth.

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. Given the emergence of donor fatigue, it is important to reinvigorate the virtuous circle through which foreign assistance supports good policies and good policies provide a basis for continued donor support. To do so, clarity about policies and financing needs will be essential, albeit difficult—a task partially attempted in this chapter. To increase foreign assistance’s contribution to the domestic economy and improve its developmental impact, a growing share should be channeled through the budget. This will allow foreign assistance to play a greater role in boosting growth and will reinforce both ownership and transparency.

This amount excludes the salaries of the UN peacekeeping soldiers (Kosovo Force, KFOR) and of many expatriates seconded by the administrations of their respective countries. Soldiers’ salaries alone could double the amount; during the 4-year period 2000–03, the KFOR presence amounted to about 143,000 soldier-years.

Owing to severe data deficiencies, assessment of recent economic trends is only tentative. Recent improvements in the range and quality of data provide a firmer basis—albeit still weak—for an analysis of the most recent past (see Appendix I).

Half of the 300 large enterprises surveyed by UBO Creations for EURECNA (February 2003) reported a decline in their output in 2002, with the decline exceeding 30 percent in one-third of the cases. Using survey data on 600 enterprises Appearing in SME Development in Kosova–Annual Report 2002, prepared by Riinvest, the staff team estimates that business turnover is likely to have declined by close to 10 percent. The rapid credit expansion in 2002 is interpreted, partly, as a sign of weakness, reflecting the squeeze on companies’ profit margins and their need to turn to banks to finance their working capital.

A decline of some €110 million in currency in circulation, following the changeover to the euro in 2002, explains part of the €315 million increase in the banking system’s net foreign assets in 2002. Euros in circulation are a foreign asset held by the private sector. A shift from the private sector’s preference for cash to a preference for deposits leads, ceteris paribus, to a change in the holdings of foreign assets from the private to the banking sector, with no impact on the balance of payments.

Present estimates of the balance of payments suggest that, in addition to €700 million of workers’ remittances and pension receipts from abroad, the economy attracted €1.2 billion in other private inflows during the past 3 years (equivalent to 65 percent of GDP in 2003).

The authorities have recently adopted an anti–money laundering law to start addressing this problem. Better border controls and measures to curb cigarette smuggling will also help.

No data are available on Kosovo’s competitiveness in terms of unit labor costs. Anecdotal evidence suggests that unit labor costs are relatively high due to particularly low labor productivity. Evidence of wages above marginal productivity abounds in loss-making POEs where sales receipts barely cover wages and intermediate input.

Serbia and Montenegro and Turkey account, respectively, for 16 percent and 9½ percent of Kosovo’s trade.

The donor sector budget includes the budget of UNMIK and KFOR, as well as spending by the rest of the international community, under the umbrella of the so-called public investment program (PIP). PIP covers direct donor spending on reconstruction and rehabilitation projects, technical assistance and training, and capital participation in local commercial banks.

Expatriates’ wages are 20–25 times higher than civil service wages and explain, in part, the higher cost of the public services provided by the donor sector. Compared with a GDP per capita of €930 in 2003 and budgetary expenditures by the KGB of €280 per person—covering most areas of traditional government spending, such as education, health, and social protection—public expenditures by the donor sector amount to €380 per person. If KFOR soldiers’ wages are included, public spending by the donor sector would be about €680 per person—which is equivalent to more than 70 percent per capita GDP.

World Bank, “Yugoslavia: Adjustment Policies and Development Perspectives” Report No. 3954-YU, Volume II: The Main Report, 1982.

During economic downturns, workers’ remittances may go up as immigrants transfer larger sums of money to their relatives at home to help them through the recession.

This, too, can be expected to be a stable and even increasing source of external financing, as long as the improved business climate continues to expand investment opportunities.

An estimate based on the Household Budget Survey run by the Statistical Office of Kosovo (see Appendix I).

The methodology uses rough estimates of the factor income decomposition of GDP, which show a labor share in GDP of some 58 percent and a capital share of 42 percent. Assuming a capital-output ratio of 3 and a depreciation rate of 5 percent we get a net rate of return on capital of 9 percent, which indicates low capital efficiency. Capital efficiency is unlikely to be much higher, as these figures are consistent with a capital stock of €4 billion. This is already on the low side, considering that the estimated housing capital stock is on the order of €3 billion, with imputed rent estimated at €300 million (Statistical Appendix Table 11).

Unemployment in Kosovo was always the highest in all the regions of the former Socialist Republic of Yugoslavia (on average, 79 job seekers for every vacancy, compared with 1.7 in Slovenia). A number of factors contributed to this poor performance, including stronger demographic pressures; poorer labor skills; a regional policy, during the 1960s and 70s, that kept regional income differentials within narrow limits—weakening incentives to migrate; and an industrialization policy that favored capital-intensive sectors, such as energy and mining. During the 1990s, discriminatory layoffs of Kosovar Albanian workers, together with reduced access to formal education, contributed to further deterioration of the situation and to a degradation of workers’ skills.

The scenario assumes no decline in the population growth rate (1.7 percent per annum) and a modest 0.5 percent per annum increase in the labor participation rate, as labor market prospects improve.

Of course, the rate of capital accumulation will ultimately depend on the expected rate of return on new investment. Experience in other countries has shown that high growth has unequivocally been associated with high rates of return on investment and high rates of total factor productivity (TFP) improvement. These are, indeed, the main elements in the creation of attractive investment opportunities, which, when acted upon, bring about high investment and high growth.

The evidence presented in Statistical Appendix Table 13 shows rates of increase of the capital-labor ratio varying from 1.7 percent in sub-Saharan Africa to 6.9 percent in East Asia.

Of course, the same improvement in the domestic savings rate could also reflect a decline in imports and smaller expansion of exports. But given the size of the domestic market, it is likely that, if Kosovo were to maintain an outward-oriented policy, an improvement in its current account deficit would mainly reflect export growth rather than import substitution.

See Policy Development and Review Department, Official Financing: Recent Developments and Selected Issues (Washington: IMF, 2003), p. 61; “Sustainability Assessments—Review of Application and Methodological Refinements,” http://www.imf.org/external/np/pdr/sustain/2003/061003.pdf (Washington: IMF, 2003), p. 36; and Catherine Pattillo, Helene Poirson, and Luca Ricci, “What are the Channels Through Which External Debt Affects Growth?” IMF Working Paper, 04/15 (Washington: IMF, 2004), p. 6.

Information is not available with regard to the amount of debt Kosovo may inherit. Clarification of this may need to await resolution of Kosovo’s final status.

In the baseline scenario, the debt stock of 27 percent of GDP by 2013 represents 135 percent of exports.

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