Albania: First Review Under the Third Annual Arrangement Under the Poverty Reduction and Growth Facility and Request for Waiver of Performance Criteria

Executive Directors commended the authorities for their policies to maintain macroeconomic stability, which had resulted in favorable growth performance and zero inflation, and welcomed improvements in tax collection and encouraged the authorities to continue with their efforts to strengthen tax administration. The authorities are urged to proceed rapidly with structural reforms, in particular by improving governance further to ensure sustained growth and poverty reduction. Macroeconomic data, although adequate for program monitoring, continue to suffer from serious deficiencies, especially in the real sector.

Abstract

Executive Directors commended the authorities for their policies to maintain macroeconomic stability, which had resulted in favorable growth performance and zero inflation, and welcomed improvements in tax collection and encouraged the authorities to continue with their efforts to strengthen tax administration. The authorities are urged to proceed rapidly with structural reforms, in particular by improving governance further to ensure sustained growth and poverty reduction. Macroeconomic data, although adequate for program monitoring, continue to suffer from serious deficiencies, especially in the real sector.

I. Introduction

1. On June 9, 2000, the Executive Board concluded the 2000 Article IV consultation, approved the second review of the second annual arrangement under the Poverty Reduction and Growth Facility (PRGF), and endorsed the authorities’ Interim Poverty Reduction Strategy Paper (I-PRSP). On June 29, the Board approved the authorities’ request for a third annual arrangement under the PRGF, bringing the total amount of resources committed under the three-year arrangement to SDR 45.04 million. Discussions for the first review and a Supplementary Memorandum on Economic and Financial Policies took place in Tirana during October 19-31, 2000, and were preceded by a July 5-14 staff visit.1

2. At the time of Board approval of the arrangement, Executive Directors commended the authorities for their policies to maintain macroeconomic stability, which had resulted in favorable growth performance and zero inflation. They welcomed improvements in tax collection and encouraged the authorities to continue with their efforts to strengthen tax administration. Directors urged the authorities to proceed rapidly with structural reforms, in particular by improving governance further to ensure sustained growth and poverty reduction. In the financial sector, Directors pointed to the importance of accelerating preparations for the privatization of the Savings Bank.2

3. Confidence in Albania’s political stability has been bolstered by the peaceful conduct of the local elections, the second round of which was held on October 15 and resulted in a victory for the ruling Socialist Party. International monitors described the election process as generally orderly and smooth. The largest opposition party has, however, not recognized the results. Parliamentary elections are scheduled for June 2001.

4. In the attached letter and the Supplementary Memorandum on Economic and Financial Policies (Attachment I), the authorities report on the progress in realizing program objectives and describe policies they intend to pursue during the remainder of the third-year program. All quantitative performance criteria and indicative targets for end-September were observed. The authorities are requesting waivers for the nonobservance of three structural performance criteria. The measures envisaged under two of these criteria have in the meantime been enacted, and the authorities are making progress toward the third one (announcing the privatization tender for the Savings Bank), with a view to meeting the conditions by June 2001 (see ¶27).

5. Macroeconomic data, although adequate for program monitoring, continue to suffer from serious deficiencies, especially in the real sector (Appendix III). The report on Albania’s observance of standards and codes for data dissemination was submitted to the Executive Board on June 9, 2000. Two Article IV/Use of Fund Resources (UFR) staff reports have been published so far. The authorities have requested that this report be published as well.

II. Performance Under the Program

6. Available indicators of economic activity suggest that strong GDP growth continued into the second half of 2000. Stronger-than-expected private investment and consumption have been fueled by a swift rise in private remittances, reflecting improved confidence in the economic and political environment. On the supply side, available data indicate better results in agricultural production than previously expected, owing to the recent high levels of investment in machinery and the increasing use of fertilizers. This, in addition to the indicators of activity in construction, transportation, and state-owned industry, as well as indirect data on private sector manufacturing activity, has warranted an increase in the projected GDP growth rate to about 7¾ percent in 2000, compared with 7 percent at the time of the Board meeting in June 2000 (Table 1 and Figure 1). Financial and fiscal indicators, particularly on the transaction demand for money and tax collections, provide further evidence of rapid output growth.

Table 1.

Albania: Basic Indicators and Macroeconomic Framework, 1997-2001

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Sources: Albanian authorities and Fund staff estimates and projections.

Current account excluding official transfers.

Revenue minus current expenditure.

Excluding privatization revenues.

Including bonds for bank rettructuring (lek 7 bn for 1999; lek 24.4 bn for 2000).

For 1999 excluding imports of direct humanitarian aid related to the Kosovo crisis.

Figure 1.
Figure 1.

Albania: Monthly Economic Indicators, 1995-2000

Citation: IMF Staff Country Reports 2001, 029; 10.5089/9781451800647.002.A001

Sources: Bank of Albania, Ministry of Finance, INSTAT, and Fund staff estimates.1/ Against the currencies of Albania’s major trading partners. A rise in the graph indicates appreciation.2/ The decline in September 1995 reflects payments associated with rescheduling of Albania’s commercial bank debt.3/ Three-month t-bill rate; the real rate is the nominal rate minus annualized filtered inflation.

7. Electricity shortages, however, are threatening the sustainability of rapid growth. If adverse weather conditions continue in the months ahead, Albania may face very disruptive electricity shortages. Water reserves—the main source of power supply—are extremely low, despite the rationing of supplies to households.

8. The balance of payments improved in 2000 owing to higher-than-projected private remittances and privatization inflows, which more than offset the somewhat higher deficit for trade in goods and services. Measured in euro terms, exports are recovering rapidly from the Kosovo-related depressed levels in the second half of 1999, owing to the resumption of activity in the chromium and steel sectors, and the renewed strength of exports of textiles and shoes. The rise in recorded imports is even more pronounced, causing an increase in the trade deficit, but to a large extent this reflects more accurate import valuation and a reduction in smuggling. Owing to higher inflows of remittances, the current account deficit in 2000 is estimated to have declined by about 1 percentage point to 7 percent of GDP relative to 1999. Official transfers were 3 percentage points of GDP, while other capital flows amounted to about 5 percentage points of GDP. Official reserves in mid-December reached US$570 (about 4½ months of prospective imports of goods and services), comfortably above the program target.

9. Inflation, despite some pickup in recent months, remains tamed, owing to restrained monetary conditions and productivity growth. The annual inflation rate declined steadily from its peak in early 1998, and was persistently negative between mid-1999 and August 2000. Relative prices, however, continued to adjust. In particular, the CPI group comprising fuel, utilities, and rents rose during this period, while domestic food prices and prices of imported goods declined—the former reflecting rapid productivity growth in agriculture, and the latter, the steady appreciation of the lek against the euro. Inflation turned positive in September and rose to 1.9 percent in November (year-on-year), primarily as a result of higher oil prices. Electricity shortages could temporarily push the inflation rate higher in the coming months.

10. The budget has been on track, with commendable revenue performance continuing through November. Tax collections through November were about 28 percent higher than a year earlier, thanks solely to improvements in the efficiency of tax and customs administrations, as tax rates have remained unchanged or have been cut (maximum duty rate) (Table 1). Customs revenues have benefited from efforts to enhance valuation procedures and combat smuggling and corruption. The Internal Audit Unit reports, agreed under the program, have been produced regularly. Implementation of disciplinary measures has been delayed, but the authorities are trying to accelerate the process. The review of companies benefiting from special customs licenses, which revealed a large number of violations, has been expanded to all customs houses and was expected to be completed by end-2000. Tax evasion has also been reduced as a result of better cooperation between the two revenue administrations. In the area of internal tax collection, improved enforcement resulted in an increase in the number of registered active VAT and small business taxpayers by 17 percent and 28 percent, respectively, in the year to October 2000. The government decided to amend the law on profit tax holidays in future customs-free zones (as a prior action for the completion of the review). On the negative side, the high percentage of uncollected VAT revenues assessed at audits and delays in VAT refunds continue to be a major concern. The government is also coming under increasing pressures from potential investors for various tax breaks.

11. Expenditure execution in the first three quarters of 2000 was broadly in line with the budget and seasonal patterns. The supplementary budget (in October) reallocated resources from contingency reserves and from savings on interest payments for bank recapitalization to increased pensions and wages, and to a subsidy to the public electricity company, KESH—to increase electricity imports. The release in the last quarter of 2000 of the second tranche of the EU Kosovo-related grant was allocated for additional investment in infrastructure damaged during the Kosovo crisis, while investment in schools was higher as a result of the release of a foreign grant. To tighten budget execution, the government has contracted an international accounting firm, financed by a foreign grant, to undertake an expenditure-tracking exercise. However, insufficient progress has been made in improving coordination among ministries to enhance implementation and reporting of foreign-financed investment projects.

12. Monetary conditions have been eased in line with the program objectives (see Figure 1 and Table 3). The removal of the minimum interest rate on three-month deposits in September completed the phased elimination of direct monetary policy instruments. From July 2000 onwards the Bank of Albania increased liquidity by extending direct credit to the budget and purchasing foreign currency privatization receipts, while allowing its liquidity-withdrawing rate to decline to 4½ percent in October. As a result, the three-month T-bill rate dropped by 3 percentage points between June and October, to about 7¾ percent (about 5-6 percent in real terms), a development that was also helped by the much larger participation of private banks and nonbank investors in T-bill auctions—more than doubling from 1999. Deposit interest rates—which, given the low level of private credit, remain the most relevant for influencing macroeconomic conditions—fell less (by about 1½ percentage points), largely as a result of the Savings Bank’s efforts to defend its market share against increasing competition from private banks. In line with vibrant economic activity, transaction demand for money remained strong, with Ml expanding at an annual rate of 25 percent in October. Foreign currency deposits increased by 14 percent, while growth in time deposits slowed to 3 percent, in response to the decline in interest rates. Private sector credit has picked up, particularly in the construction sector and for housing. The exchange rate appreciated relative to the euro until October, but it has subsequently stabilized (Figure 2).

Table 2.

Albania: Government Revenues and Expenditures, 1997-2001

(In percent of GDP)

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Notes:

Incudes solidarity lax and nontax revenue collected by Customs Department.

In 2001 expenditure on work incentive programs (lek 400 miilicn) has been reclassificd under subsidies.

The expenditure figures based on the functional classification are highly provisional. The Albanian authorities have only recently started to work On the functional classification.

Table 3.

Albania: Monetary Aggregates

(In billions of leks unless otherwise indicated; end-period)

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Sources; Bank of Albania; and staff estimates.

According to the definition in the Technical Memorandum of Understanding.

Figure 2.
Figure 2.

Albania: Daily Exchange Rates, 1999-2001

Citation: IMF Staff Country Reports 2001, 029; 10.5089/9781451800647.002.A001

Source: Albanian authorities.

13. The reform and privatization effort in the financial sector has continued. After all legal technicalities were resolved, the National Commercial Bank was transferred to foreign investors in November 2000. Progress in privatizing the Savings Bank has been slower than envisaged under the program. The chief operating and accounting officers for the Savings Bank were appointed in September, after delays caused by the World Bank’s procurement procedures, but the chief operating officer had to be replaced in November. Selection of the privatization advisor was delayed due to complications beyond the control of the government. Therefore, the privatization advisor could only be selected in December, breaching the end-September structural performance criterion, and postponing the announcement of the privatization tender (end-November performance criterion). On the positive side, the audit of financial statements for 1999 has confirmed that the bank’s accounting practices comply with international standards. Moreover, the bank has continued to collect outstanding classified loans and to streamline its operations. It has also identified branches and offices that could be closed or transferred to the Post Office, which the authorities intend to accomplish before the privatization tender is announced.

14. Enterprise privatization has proceeded well. The sale of Albania Mobile Communications (AMC) for the unexpectedly high amount of US$86 million was completed in July. The government has recently received bids for a second mobile phone license. The transfer of the cement factory to foreign buyers has been completed. The government has announced the winners of tenders for four mid-size companies, with the sale of one company completed on October 4, a few days later than the end-September performance criterion for privatization in the enterprise sector. The privatization of two other enterprises was completed in November. Regarding the fixed line telecommunications provider, Albtelekom, a contract has been signed with the privatization advisor, but the audit of the company’s 1999 results did not fully satisfy international standards because of problems in preparing an inventory of fixed assets. In the petroleum sector, the action plan for the privatization of the service company, Servcom, was approved in June and the law on its privatization was passed in December 2000. Privatization of the strategic part of the company could be finalized by mid-2001.

15. Other structural reforms have progressed more slowly. After months of delay, office space has been allocated for the registry of movable collateralized property. Land registration is lagging, as the registration of remote and less accessible areas is increasingly difficult. A working group to prepare amendments to the social security law has submitted recommendations, but legislative approval will not take place before early 2001. The Council of Ministers recently tightened the licensing procedures for private enterprises to enforce the payment of social security contributions.

16. The authorities are moving ahead with preparing a PRSP in mid-2001. In September 2000, a U.K.-based development institute submitted a background study outlining possible strategies to engage civil society in the consultative process. The authorities also reached agreement with the Carter Center, to assist in organizing participation of civil society. A qualitative poverty assessment and a rural development strategy is under preparation in cooperation with the World Bank. The Medium-Term Expenditure Framework (MTEF) 2001-03, also prepared with assistance from the World Bank, has identified broad fiscal policy objectives and budget envelopes; spending on health and education is expected to be substantially increased over these three years. Priorities include primary healthcare and family doctors, construction of new schools in densely populated areas, and more training for teachers. However, compiling a preliminary poverty profile has been delayed because the data from the household income survey currently conducted with the assistance of the EU are not adequate owing to limited geographical coverage. The quantitative poverty profile will be available after the results of the Living Standards Measurement Survey are ready in December 2001 or early 2002.

III. Report on the Discussions

17. Discussions with the authorities focused on progress in preparing the PRSP, reaching understandings on a draft 2001 budget, undertaking immediate measures to address problems in the electricity sector, and continuing the structural reforms.

A. Progress in Preparing the PRSP

18. The authorities were very enthusiastic about progress in preparing the PRSP. They briefed the mission on the consultative process, involving representatives of civil society, private business, and local governments. To improve the participation of groups that might be skeptical of government initiatives, the Carter Center, which recently opened its office in Tirana, had approached representatives from various civil society institutions and groups and invited them to several workshops and advisory meetings. A National Civic Society Advisory Group is also scheduled to be established by January 2001. The EU representatives welcomed the PRSP process and viewed it as consistent with the forthcoming Stabilization and Association Agreement. (The authorities invited all donors to a December conference at which a coordinating group of core donors was created under the auspices of the World Bank). The mission welcomed the authorities’ efforts and noted that, should data deficiencies require a delay in preparing the PRSP, a second I-PRSP or a progress report could provide the basis for continued concessional assistance from the Bretton Woods institutions. The authorities indicated that they remained committed to producing the PRSP by mid-2001, which would be based on an updated poverty profile that will draw on a range of sources, including the 1998 Living Conditions Survey, the 2000 Household Budget Survey, the 2000 Agricultural Survey, the on-going qualitative poverty assessment, and administrative information from Government agencies. The results of a comprehensive Living Standard Measurement Survey, with its quantitative estimates of poverty profile, would be incorporated in an updated PRSP in 2002. Following public discussions on the PRSP in November, the authorities have changed the title of their document to the Growth and Poverty Reduction Strategy (GPRS).

B. Macroeconomic Framework

19. The authorities and the mission agreed that the macroeconomic framework for 2001 envisaged under the program remained broadly appropriate, although the precarious electricity situation increased the risks. Real GDP growth is now projected at about 7¼ percent in 2001, while inflation is expected to rise to about 2½ percent (average), and the current account deficit is projected to remain broadly unchanged relative to 2000, at about 7¼ percent of GDP (Figure 3). This is consistent with fiscal consolidation of about ⅓ percentage point of GDP in 2001 (see Paragraph 21 below), and some further moderate relaxation of monetary conditions. The main parameters of the financial program are based on a conservative projection for velocity, sufficient scope for private sector credit growth, and a target for official reserves of about 4½ months of imports. These projections depend heavily on avoiding disruptive electricity shortages during the coming winter, and that, in case of adverse developments, the framework would need to be reviewed and appropriate corrective measures taken.

Figure 3.
Figure 3.

Albania: Economic Developments and Prospects, 1993-2001 1/

Citation: IMF Staff Country Reports 2001, 029; 10.5089/9781451800647.002.A001

Source: Albanian authorities and Fund staff estimates.1/ Projected outcome for 2000 and program projections for 2001.

20. The problems in the electricity sector, which have been caused by the extremely weak management of the electricity company, the unacceptably low efficiency in collecting bills, and the exceptionally high level of electricity theft, need to be addressed immediately. The weak performance of the electricity company has also adversely affected donors’ assistance in this sector, and led to a suspension of a World Bank project in 1998. The authorities acknowledged that they had been slow to address these problems, but pointed out that firm action had now been taken by appointing a new general manager of the company, acting forcefully against electricity theft—including by amending the provisions in the penal code—and standing ready to implement the proposals of the recently hired foreign consultants (MEFP, ¶23).3 The mission urged the authorities to immediately seek an agreement with the World Bank on a strategy for the electricity sector as well as on emergency measures. Following the mission, the authorities invited a World Bank team to Albania, and in early December 2000 agreement was reached on a strategy, which includes specific quantitative targets for improving the main indicators of KESH’s performance. The Bank organized a meeting with the donors involved in the electricity sector in Brussels on December 15, 2000, where the donors endorsed the government’s strategy. To alleviate the shortages, the authorities have taken measures to boost electricity imports to the maximum technical level and to improve conditions for supplying liquefied gas, including by temporarily extending VAT exemption for gas in the January–April 2001 period. The government has also organized public awareness campaigns and decided to switch heating in all government offices to liquefied gas.

C. Fiscal Issues

21. The budget for 2001 incorporates additional revenue efforts, cuts in duty rates and profit tax, measures to reduce tax distortions, and substantial improvements in the structure and execution of expenditure. A reduction in the overall deficit is envisaged from 9.5 percent of GDP in the revised 2000 budget to 9.2 percent of GDP in 2001. Adjusted for the increase in the interest cost of bank restructuring, which reflects the recognition of the costs incurred in the past, the deficit will be reduced by about ½ percentage point. The proposed fiscal consolidation is appropriate in the context of the stable macroeconomic environment and the authorities’ ambitious objective of raising public investment—to 7½ percent of GDP, more than half of which would be foreign-supported projects—and sectoral spending that reflects poverty-alleviating priorities established in the I-PRSP and the MTEF. The deficit target implies a government domestic borrowing requirement of 2.7 percent of GDP, over ¾ percentage point less than previously envisaged, owing to higher privatization receipts and the use of the resources from World Bank SAC in 2001. The deficit target is consistent with a further decline in interest payments relative to GDP. Gross public debt-to-GDP ratio would increase somewhat to 72½ percent of GDP, but in present value terms it would decline, owing to the highly concessional foreign financing of the budget. (For a discussion of medium-term fiscal sustainability, see Box 1.) The 2001 budget, consistent with the understanding reached with the staff, was approved by parliament on December 20 (a prior action for completion of the review).

Medium-Term Fiscal Sustainability

The high economic and social returns of public expenditures combined with a still-limited capacity for taxation, are the key factors underlying Albania’s temporary reliance on relatively large fiscal deficits. Improving the dilapidated infrastructure is a prerequisite for the rapid growth of the private sector; the persistence of governance issues demonstrates the importance of strengthening basic public institutions, including those for public order; and abundant evidence highlights the detrimental effects of underspending in social sectors, in particular in public health (see I-PRSP, EBD/00/41). Despite recent progress, the capacity to tax the economy remains constrained by various shortcomings in the administrative and governance area, and by the large share of agriculture and small enterprises in the economy.

The focus on revenue generation and the increase in public investment resulted in prudent fiscal policy over the 1998-2000 period, although it accommodated relatively large deficits. The increases in the tax revenue of 3¼ percentage points of GDP and in investment expenditure of 1½ percentage points of GDP have strengthened the structure of the budget. The rise in the public debt-to-GDP ratio, which has raised concerns about debt sustainability, reflects to a large extent highly concessional foreign financing and the recapitalization of banks for losses incurred in the past. Finally, despite the increasing debt ratio, interest payments have declined rapidly, owing to the reduction in domestic real interest rates and foreign financing on highly concessional terms.

Table: Fiscal Sustainability

(In percent of GDP)

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The gradual fiscal consolidation envisaged over the medium term (2001-2004) will turn around the trend in the debt-to-GDP ratio. The ratio of the net present value of debt to GDP is projected to decline by 9 percentage points of GDP from 2000 to 2004 and the expensive domestic component would decline by about 5 percentage points of GDP. This projection assumes that rapid growth will continue as a result of macroeconomic stability and further progress in structural reforms. The projection assumes real domestic interest rates of about 7 percent, a level above the average for transition economies that have accomplished macreoconomic stabilization. Foreign financing will be restricted largely to loans on concessional terms and grants, in the recent ratio, keeping interest payments on foreign debt below 1/3 percent of GDP, and the debt service below 10 percent of exports. Privatization receipts are projected conservatively in light of the upcoming privatization of the telecommunications company and the Savings Bank. With the government deficit declining to about 6¾ percent of GDP in 2004, and an increase in the revenue-to-GDP ratio of 1½ percentage points, noninterest expenditure could grow by about 6½ percent in real terms. A lower GDP growth rate of 4 percent, with somewhat lower government deficits to keep the debt ratio unchanged, would still allow noninterest expenditure to grow by 3 percent annually. However, strong fiscal pressures, which would require expenditure cuts in real terms, would develop if (a) Albania loses its access to concessional foreign financing relative to recent levels, (b) GDP growth slows down, or (c) the target for improving revenue collections is not met.

22. The authorities’ main revenue objectives include: (i) continuing efforts to enhance tax administration; (ii) reducing the import duty and profit tax rates; and (iii) improving the VAT refund system. The revenue target reflects the assessment further scope exists to upgrade the efficiency of tax administration, which, together with some increase in excises on alcohol and taxes on property transfer, should increase tax revenues by about 1¼ percentage points of GDP, more than compensating revenue losses of about ¾ percent from other tax-reducing measures. In this context the authorities expressed strong commitment to implementing the recommendations of the recent FAD technical assistance mission (¶13). In particular, the authorities expected substantial revenue effects from the strengthened large taxpayer unit; the upward adjustment in the VAT threshold, coordinated with an appropriate adjustment in the ceiling for turnover-based small business tax; and the introduction of fiscal stamps (banderoles) on excisable products, combined with extensive action to suppress the evidently persistent smuggling of cigarettes. The mission, in consultation with the EU Customs Assistance Mission (CAM Albania), also identified further measures in the customs area (¶14). Moreover, as a prior action to complete this review, the profit tax holiday included in the recently approved Free Zones law would be removed to avoid possible adverse effects on tax morale, and to discourage rent-seeking and pressures for further exemptions. In a similar vein, the authorities agreed to resist pressure for special tax incentives from businesses. Instead, they have decided to reduce the profit tax from 30 percent to 25 percent, in line with the downward trend among other transition economies in the region. To address legitimate concerns of investors and exporters, the authorities will also change the procedures for VAT refunds (¶3). As previously agreed under the program, they will liberalize foreign trade further by reducing the maximum and minimum tariff rates from 18 percent to 15 percent, and from 5 percent to 2 percent, respectively, as of January 1, 2001.

23. On the expenditure side, priorities in the 2001 draft budget reflect the objectives set out in the MTEF, in particular in relation to the sectors identified as important for growth and poverty alleviation (¶15-17). Investment expenditures are set to rise substantially to about 7½ percent of GDP, reflecting higher spending on the network transport infrastructure and public utilities. (The involvement of foreign construction companies in the main infrastructure projects alleviates risks of capacity constraints for investment activity). On a functional basis, real resources for health and education are set to increase by 23 percent and 8½ percent, respectively. After extensive discussions, the rise in public sector wages and pensions was limited to 8 percent as of July 1, 2001 and a somewhat higher rise in military and police pay as of January 1, 2001, while the number of public employees would be cut by 2,400 positions (about 2 percent of total public employment). Overall, the budget wage bill will decline by 0.1 percentage point of GDP in 2001. The authorities based their support for the public sector wage adjustment on a substantial wage differential relative to the private sector—in the absence of private sector wage statistics, the mission confirmed this in contacts with the private sector—and difficulties in retaining qualified staff, confirmed by the high turnover at the level of central government public servants. In the context of the next MTEF (2002-04), the authorities will conduct a wage survey and use the results for setting principles for a medium-term wage policy. The draft budget allocates a Lek 3.4 billion subsidy for KESH—consistent with the understanding reached with the World Bank on a strategy for the electricity sector—with a view to ensuring conditions for the functioning of this company until its performance is improved by the implementation of the envisaged measures. It also allows for Lek 1.5 billion in interest costs in 2001 to recapitalize fully the Savings Bank by issuing T-bills at the end of 2000, in an amount of Lek 17 billion, to create conditions for successful privatization and to satisfy minimum capital requirements under the banking laws. Regarding the pension system, the authorities have requested assistance from the World Bank to develop their planned reform by end-2001. In response to the mission’s concerns regarding the need to strengthen foreign-financed project implementation, the authorities enhanced the frequency and timeliness of information on foreign-financed capital expenditures. Given the uncertain environment in the period ahead, however, the authorities intend to use the fiscal reserve and contingency funds sparingly and make the execution of specified expenditure items, in particular investment expenditure, conditional on revenue performance.

D. Monetary and Exchange Rate Policy

24. The mission and the Bank of Albania (BoA) agreed that some further, albeit modest, scope for relaxing monetary conditions existed. In the context of below-target inflation and overperformance in official reserves, the mission welcomed the relaxation in monetary conditions that has led to a significant decline in T-bill rates since July, but expressed concerns about the slow response of the deposit rates. In the BoA’s view, the T-bill rate was set to decline further to about 7½ percent, a level broadly consistent with projected inflation in the 2-4 percent range (¶18). The mission did not dispute this view but noted that lower than targeted expected inflation would call for a further easing of interest rates. The BoA expected that the deposit rates would respond with some lag—an expectation that was confirmed by subsequent developments—but the BoA was not in favor of further large declines in deposit rates. This view was strongly supported by private banks. They pointed to the squeeze in the spreads over the U.S. dollar deposit rates, which were seen as important in the Albanian retail market, particularly at a time when the U.S. dollar was appreciating. Accordingly, developments in the currency composition of deposits and term-structure of interest rates would be monitored closely to provide indicators a further decisions on monetary policy.

25. Further measures to improving the effectiveness of indirect monetary policy instruments and to broaden the T-bill market were agreed. The authorities confirmed that the central bank law would be amended to eliminate the restriction on repo operations with government paper, as such repos currently count as direct credit to government (¶8). The authorities also noted that, in consultation with MAE, they intended to move to a fixed repo rate system in early 2001. Reflecting concerns raised by commercial banks, the BoA will keep interest rates in its repo operations more stable. On broadening the T-bill market, the Ministry of Finance explained that more time was necessary to organize sales through post offices, but noted the success in increasing the participation of nonbank investors in auctions. To compensate for the delay in sales through post offices, small quantities of T-bills would be sold through the stock exchange at prices linked to the last primary auction. As for other areas, remuneration of required reserves has been implemented and the conversion of the government’s nonmarketable obligations held by the BoA is expected to be completed by early 2001. In the context of relatively rapid private sector credit expansion, albeit from a low base, the BoA assured the mission that private banks satisfied prudential ratios with large margins and that the quality of their portfolios was effectively monitored by banking supervision.

26. Revised financial targets for end-December 2000 and end-March 2001 were agreed, and monetary projections for the rest of 2001 were discussed. According to the revised framework, broad money is projected to expand at an annual rate of about 11¾ percent by end-2001, on the assumption that velocity will cease to decline further, reflecting the effect of interest rate cuts on demand for time deposits. In line with the government’s projected domestic borrowing requirement of about 2.7 percent of GDP, the monetary program allows private sector credit expansion at a rate of about 32 percent. The target for official reserves is an increase to US$620 million by end-2001, equivalent to about 4½ months of imports and about 66 percent of reserve money.

E. Structural Policies

27. The timetable for the privatization of the Savings Bank has been revised in light of recent delays and complications. To ensure that the conditions for bank privatization were in place, two prior actions for completing this review were set: (i) to appoint the privatization advisor for the bank, and (ii) to recapitalize the bank fully by end-2000, which is also required by the banking law (¶21). (Both of these have now been met.) The authorities will also transfer the bank’s fully provisioned bad loan portfolio to the appropriate agency by March 2001. The recent delays arising from the need to replace the chief operating officer and other complexities noted by investment banks make an extension in the timetable for announcing the privatization tender unavoidable (now set as a structural performance criterion for end-June 2001). In relation to other areas of financial sector reform, the law on deposit insurance has been drafted and is expected to be approved by March 2001. The establishment of a credit information bureau has now been postponed to end-2001, reflecting delays in finding a consultant.

28. In the enterprise sector, the mission urged the authorities to maintain the privatization drive of recent months. Following the conclusion of the privatization of the remaining medium-size companies by end-2000, the authorities are now negotiating with potential new investors in the copper sector and the remainder of the chromium sector (¶22), Plans for a concession to build and operate the passenger terminal at the Tirana airport are proceeding, and the process of privatizing Albtelekom is expected to be completed in the second half of 2001. In the oil sector, the sale of some of the smaller units in Servcom will be completed in early 2001, and progress with privatizing ARMO, the refinery is moving ahead (¶22).

29. With regard to other areas, the mission urged the authorities to push ahead with establishing the investment-advisory office and reviewed progress in establishing a mediation center for the resolution of commercial disputes. The preparation of the law on offices for the execution of court decisions and the bankruptcy law are on track and are scheduled for parliamentary approval by January 2001. The schedule for registering the remaining, less accessible, lands was revised.

30. The authorities are continuing to make efforts to improve the quality and coverage of economic statistics. The 2001 budget allocates another 20 permanent staff positions to INSTAT to enhance its capacities, including its ability to conduct the upcoming population census in April 2001 (¶25). Having started to publish a unit value index and a retail trade index, INSTAT intends to publish the PPI in early 2001, at which time the weights in the CPI basket are also slated to be revised. Preliminary estimates of the national accounts for 1996-98 are expected to be completed in the coming months, and published by June 2001. The law on statistics, which has been drafted with assistance from the European Union, is expected to be ready for submission to parliament in early 2001.

F. External Sector

31. The balance of payments position is expected to remain sustainable. With foreign donors continuing to support exceptionally high investment needs for infrastructure, and foreign private investment responding positively to economic and institutional reforms, the current account deficit over the next several years is expected to decline only gradually from 7¼ percent of GDP in 2001 to 5¾ percent of GDP in 2004 (Table 4). Private remittances are expected to continue to grow steadily, while exports will rise as a result of foreign investment and integration of Albania into the regional economy, providing for gradual improvement in the trade account. Owing to the highly concessional terms of bilateral and multilateral support, foreign-debt-service payments will remain very low, below 10 percent of exports of goods and services. The resources required annually to close financing gaps in the period 2001-04, consistent with keeping the foreign reserves level at about 4½ months, are expected to be in the range of US$10-20 million. The current program is fully financed through the end of the program period (end-March 2001).

Table 4.

Albania: Balance of Payments, 1998-2004

(In millions of U.S. dollars)

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Sources: Ministry of Finance; Bank of Albania; donors; and Fund staff estimates and projections.

Excluding IMF.

The figure for 1998 corresponds to the clearance of arrears to Russia and Italy as a result of the rescheduling of Paris Club debt in July 1998.

The figure for 1999 corresponds to the deferral of interest payments granted by Paris Club creditors because of the Kosovo crisis.

Excludes imports (official transfers) related to the Kosovo crisis.

Includes imports (official transfers) related to the Kosovo crisis.

Includes arrears.

32. The authorities briefed the mission on regularizing relations with external creditors. Bilateral agreements were concluded with Paris Club creditors, Austria, France, Italy, and the Netherlands, an agreement in principle was signed with Japan, while arrears estimates were reconciled with Germany and Russia. Negotiations are also under way to clear arrears with non-Paris Club creditors, including Greece, Turkey, and some former CMEA members. The External Debt Committee has prepared a timetable and has formed working groups for reconciliation and rescheduling debt in arrears. It will continue to meet on a monthly basis to monitor progress toward regularizing relations with external official and commercial creditors so that the remaining restrictions subject to IMF approval under Article VIII, Section 2(a) can be removed. The government actively aims to reconcile and reschedule debt in arrears with its remaining creditors and will seek at least comparable treatment from non-Paris Club creditors with similar outstanding claims on Albania.

G. A Successor Arrangement

33. The authorities indicated their intentions to request a possible successor arrangement following the expiration of the current PRGF in July 2001. The authorities expressed their appreciation for the cooperation of the Fund over the last several years, which had helped them create stable macroeconomic conditions, put the economy on a rapid growth path, and implement far-reaching structural reforms. They also reiterated their commitment to develop and implement a comprehensive poverty-reduction strategy that could be supported by a PRGF. The staff noted that with Albania’s rising per capita income access under new possible arrangements would likely be a blend of PRGF and GRA resources.

IV. Staff Appraisal

34. The authorities are making good progress in preparing a comprehensive poverty reduction strategy. In particular, they have achieved commendable results in developing the consultative process; moreover, preparations for a qualitative poverty assessment and a rural development strategy are proceeding well. Regarding the timing of the PRSP, the authorities and the World Bank strongly believe that the benefits of completing the process in 2001—which is synchronized with the timing of the budget and would then provide a basis for more comprehensive policy formulation in 2002—outweigh the possible gains from waiting for higher quality poverty data that would be available from the household living standard survey in early 2002. Fund staff concurs. The authorities’ proposal for changing the title of the document to Growth and Poverty Reduction Strategy, with a view to improving its public acceptability and strengthening the focus on growth, is welcome.

35. Macroeconomic performance under the PRGF-supported program has continued to be strong and tax collection performance has been excellent. The authorities have managed to keep inflation very low during the past three years, while the economy has grown rapidly and the official reserves position has improved. The agreed tax and customs measures are bearing fruit, with tax revenues increasing by about 2½ percentage points of GDP in 2000, owing to notable progress in fighting smuggling and corruption. All quantitative performance criteria and indicative targets for end-September 2000 were met, and indicative targets for end-December 2000 are also estimated to have been met.

36. Failure to address problems in the electricity sector in a timely manner, however, has put the favorable macroeconomic performance at risk. While the authorities have so far managed to minimize the adverse effects of these shortages, particularly for the enterprise sector, the situation is tenuous and it is essential that they implement forcefully and speedily all the measures envisaged in the revised strategy for the sector, as agreed with the World Bank. In particular, the efficiency in collecting electricity bills and eliminating theft needs to be improved.

37. The draft 2001 budget sets appropriate targets for further strengthening tax administration and improving the structure of expenditure. To address the concerns of the business community and improve relations with investors, the authorities will change the VAT refund system and reduce the profit tax rate consistent with the recent trend in transition economies, and reject pressures for the extension of various tax exemptions. The expenditure structure will improve as a result of increasing the highly needed investment in dilapidated public infrastructure and providing additional resources for public health. Over the medium term, the authorities will need to remain vigilant in further increasing revenue collection. Moreover, Albania’s fiscal sustainability over the next three years will crucially depend on continued access to concessional foreign financing, the prospects for which currently appear very favorable. The authorities should make every effort to assure that all the measures on their side, required for the disbursement of foreign assistance are implemented on a timely basis.

38. The recent relaxation in monetary conditions is consistent with the 2-4 percent inflation target, which creates sufficient scope for needed relative price adjustments. The reduction in interest rates has also helped to mitigate appreciation pressures and stabilize the real effective exchange rate. If new information points to expected inflation falling below the target range, the BoA should consider some further reductions in interest rates. Regarding the conduct of monetary policy, the BoA should continue to improve the effectiveness of its indirect instruments of monetary policy.

39. The authorities should persist in their preparations for the privatization of the Savings Bank and remain fully committed to the revised timetable. A successful privatization will require close cooperation between the management of the Savings Bank and the Ministry of Finance to complete all the necessary preparatory work on time. Notably, the authorities should transfer bad loans to the collection agency as envisaged, and closely collaborate with the privatization advisors so that the tender for privatization can be announced by end-June.

40. Regarding other structural reforms, the authorities need to maintain the privatization drive of recent months and complete the legislative reforms. Indeed, they should move expeditiously and forcefully to privatize the telecommunications and oil sectors. The implementation of the new bankruptcy law and the law on the organization of offices for executing court decisions in civil cases will be crucial for making further progress in establishing the institutional framework required for a modern market economy.

41. Overall, despite some delays in structural reforms and privatization in the financial sector, the authorities’ policies continue to be on the right track. The staff, therefore, recommends the approval of the authorities’ request for waivers for nonobservance of three structural 2000 performance criteria and the completion of the first review of the third-year program under the PRGF.

V. Proposed Decision

The following proposed decision is proposed for adoption by the Executive Board:

1. Albania has consulted with the Fund in accordance with paragraph 2(d) of the third annual arrangement for the Republic of Albania under the Poverty Reduction and Growth Facility (PRGF) (EBS/00/111; 06/29/00) and paragraph 33 of the Memorandum of Economic and Financial Policies attached to the letter dated May 24, 2000 from the Prime Minister, the Minister of Finance and the Governor of the Bank of Albania to review the implementation of the program of economic and financial policies supported by the third annual arrangement under the PRGF.

2. The letter dated January 12, 2001 from the Prime Minister, the Minister of Finance and the Governor of the Bank of Albania (the “Letter”), together with the attached Memorandum of Economic and Financial Policies (the “Memorandum”), and the Technical Memorandum of Understanding (the “TMU”), shall be attached to the third annual arrangement under the PRGF for the Republic of Albania, and the letter dated May 24, 2000 from the Prime Minister, the Minister of Finance and the Governor of the Bank of Albania, together with its attached Memorandum on Economic and Financial Policies, shall be read as supplemented and modified by the Letter with its attached Memorandum and the TMU.

3. Accordingly,

(a) the performance criteria in paragraph 2(a)(i)-(vi) of the third annual arrangement for end-March 2001 shall be as set out in Table 1 attached to the Memorandum and as further specified in the TMU.

(b) a new paragraph 2(bb) shall be added to read as follows: “(bb) if the Managing Director of the Fund finds with respect to the third loan that, by June 30, 2001, Albania has not carried out its intentions with regard to the announcement of a privatization tender for the Savings Bank as specified in paragraph 21 of the Memorandum”.

4. The Fund decides that,

(a) the first review contemplated in paragraph 2(d) of the third annual arrangement for Albania is completed; and

(b) Albania may request the disbursement of the second loan referred to in paragraph 1(b) of the third annual arrangement under the PRGF for Albania, notwithstanding the non-observance of the structural performance criteria in paragraph 2(b)(i) to (iii) of the third annual arrangement, on the condition that the information provided by Albania on performance under these criteria and on the implementation of the measures specified under A. of Table 2 of the Memorandum is accurate.

APPENDIX I Albania: Fund Relations

As of November 30, 2000

I. Membership Status: Joined: 10/15/1991; Article XIV

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans:

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V. Financial Arrangements:

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VI. Projected Obligations to Fund: (SDR Million; based on existing use of resources and present holdings of SDRs):

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VII. Exchange Rate Arrangement

On July 1, 1992 the Albanian authorities announced the removal of virtually all exchange and quantitative trade restrictions, unified the exchange markets, and adopted a floating exchange rate system (an independent float). The unified exchange rate stood at 149.5 lek per U.S. dollar on November 30, 2000.

VIII. Resident Representative

A Fund resident representative has been posted in Tirana since April 1993; Mr. Volker Treichel has held this position since January 1999.

IX. Technical Assistance

The Fund, other multilateral organizations and donors have provided extensive assistance for institutional development in Albania. The Fund alone has sent over 75 technical assistance missions to Albania since 1991. However, further institutional development is required in virtually every sector.

APPENDIX II Albania: Relations with the World Bank Group

Background

1. Albania joined the World Bank Group in October 1991. Since then, the Bank has been actively involved in the design and implementation of Albania’s reform program through its policy advice, lending operations, and technical assistance in various sectors. Beginning with the Critical Imports Project in 1992, the Bank to date has approved a total of 40 operations amounting to US$549.6 million in credits, of which 18 are completed now. Under the current Bank portfolio (USS323.6 million), 14 percent of the credits support adjustment, 18 percent agriculture, 43 percent infrastructure, 9 percent social sectors, and 16 percent technical assistance.

Current and medium-term initiatives

2. The Bank has been actively supporting Albania’s economic recovery efforts after the 1997 crisis. The Rehabilitation Credit, approved by the Bank Board in December 1997, provided support for priority structural measures (resolution of the pyramid schemes and reform of the banking sector), and for alleviating the increased poverty and unemployment generated by the crisis. The Rehabilitation Credit was approved in parallel with the Recovery Program TA Project which is financing the implementation of the policy measures supported by the Rehabilitation Credit. In February 1998, the Bank Board approved the Private Industry Recovery Project, which provides political risk cover for commercial financing of productive activities. An Urban Land Management Project and Durres Port Project were also approved in 1998, and support priority infrastructure development. In addition, the Health Recovery and Development Project provides support in a priority area of the social sectors after the 1997 crisis.

3. The Bank’s Country Assistance Strategy (CAS) for Albania was approved in 1998 and covers the period of 1998-2001. The CAS focuses on 3 strategic priorities: (i) Governance and institution building to help to establish an accountable, transparent and efficient state. The Bank will address these issues through a judicial and public administration reform project to be approved this fiscal year; (ii) Private sector development (including maintenance of macroeconomic stability, financial sector and enterprise reforms, and infrastructure improvement); and (iii) Human development and poverty alleviation. The Community Works Project was approved in January 1999, to assist rural communities with infrastructure and social infrastructure development. A CAS Progress Report was presented to the Board on March 21, 2000. While the CAS Progress Report continues to focus on the three strategic priorities outlined above, it places a renewed emphasis on poverty reduction, and in particular on its social underpinnings. At the same time, the Government has launched a participatory process to prepare a full scale Poverty Reduction Strategy Paper (PRSP) by mid 2001.

4. Since the Kosovo crisis and the large influx of refugees, the Bank has put more immediate emphasis on support to the social sectors, especially health and education, and on emergency interventions in infrastructure like transport, water supply and sanitation. The Bank’s activities in response to the crisis aimed mainly at long-term development objectives rather than short-term relief, and included cooperation with other donors, especially nongovernmental organizations, in areas of relief and humanitarian assistance. The Public Expenditure Support Credit of US$30 million, approved in May 1999, is an example of efforts to support Albania’s budget and the government’s ability to coordinate and direct international aid. Furthermore, in June 1999, the Irrigation II Project, a Structural Adjustment Credit, a Microcredit Project and supplementary financing for the ongoing Community Works Project, which supports Albanian communities most affected by the influx of refugees, were approved by the Board. The Emergency Road Repair Project (December 1999) is providing assistance in rehabilitating roads damaged by heavy traffic during the crisis. The Water Supply Urgent Rehabilitation Project (February 2000) will rehabilitate components of the water supply systems which are in a state of disrepair in the cities of Durres, Fier, Lezhe and Saranda. The Legal and Judicial Reform Project and the Public Administration Reform Project, both approved in March 2000, will help to strengthen Albania’s weak institutional and governance capacity, including its ability to enforce laws and regulations. The Education Reform Project, approved in May 2000, will assist the Ministry of Education in planning and managing the delivery of education services. Further, the Financial Sector Institutional Building Technical Assistance, approved in June 2000, will assist Government in furthering the implementation of key areas of its financial sector strategy, including completion of its bank privatization program, improving financial infrastructure, and privatization of the insurance sector. In FY01, the Bank has approved a Trade and Transport Facilitation in South East Europe project, which is part of a regional program aimed at strengthening and modernizing the customs administrations.

STATUS OF BANK GROUP OPERATIONS IN ALBANIA

Statement of IDA Credits

(As of November 30, 2000)

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