Statement by Arrigo Sadun, Executive Director for Albania and Carlo Gola, Senior Advisor to Executive Director

This paper discusses a Request from Albania for a Three-Year Arrangement under the Poverty Reduction and Growth Facility (PRGF). This arrangement aims to prepare Albania for graduation from IMF-supported programs. If properly implemented, the policies it embodies will reduce vulnerabilities, enhance growth potential, strengthen government solvency, and protect priority spending. These policies will also contribute to improved governance—a precondition for attracting the high-quality investment needed to address the structural imbalances in the external accounts and to ensure the continuation of strong growth. Remaining vulnerabilities in the financial system are also addressed.

Abstract

This paper discusses a Request from Albania for a Three-Year Arrangement under the Poverty Reduction and Growth Facility (PRGF). This arrangement aims to prepare Albania for graduation from IMF-supported programs. If properly implemented, the policies it embodies will reduce vulnerabilities, enhance growth potential, strengthen government solvency, and protect priority spending. These policies will also contribute to improved governance—a precondition for attracting the high-quality investment needed to address the structural imbalances in the external accounts and to ensure the continuation of strong growth. Remaining vulnerabilities in the financial system are also addressed.

On the behalf of the Albanian authorities, we would like to express our appreciation to the staff for the comprehensive report, which reflects the very frank and constructive discussions held in Tirana in preparation of this new program. Our authorities are convinced that a three-year program supported by a PRGF-EFF arrangement will provide a good base for a timely and successful exit strategy.

The authorities intend to maintain the current, positive, track record with the Fund and are committed to implement key structural reforms aimed at enhanced growth, proceed with the fiscal consolidation, continue in the institution building process, and eradicate poverty.

1. Despite the recent slowdown, the macroeconomic performance remains strong

From the macroeconomic standpoint the country has maintained a strong and consistent performance. The estimated GDP growth in 2005 (5.5 percent) is only slightly below the average of the last few years. In the last quarter of 2005 the economy experienced serious power shortages due to the exceptional drought season and problems related to the distribution network. The power shortages could also affect this year's growth performance, which is expected to be about 5 percent.

In 2005 the inflation remained below 2.5 percent. The effects of oil price increases on the CPI were modest, due in part to the structure of the economy, characterized by low-energy activities, such as agriculture and services (24 and 58 percent of GDP, respectively). However, should the electricity crisis persist, a potential second-round effect cannot be ruled out, given the necessity for many shopkeepers and small firms to use alternative, and more expensive, sources of energy.

The current account deficit remains high (7 percent of GDP in 2005), despite strong remittance inflows (about 950 million euros, 14 percent of the GDP in 2005), but the net inflow of FDI is consistent (3.7 percent of GDP on average in the last five years), although not particularly high if compared to similar countries in the region.

The debt-to-GDP ratio is steadily declining: between 1997 and 2005 it was reduced from 75.6 to 54.9 percent. In 2005 the deficit was 3.8 percent, well below the 5.1 percent of 2004. The current balance (revenues excluding grants minus current expenditure) was 0.4 percent. Thanks to the restructuring with its main creditors, the external debt shrank substantially and is estimated to be 16.8 percent of GDP in 2005. At the end of September 2005 the stock of external public debt was 1.274 billion euros; the arrears, all accumulated before the transition period, are only 82 million (as compared to 519 million in 2000).

2. The new Government is committed to maintain sound macroeconomic policies

The authorities are determined to preserve the current, prudent macroeconomic policies and further enhance the quality of the budget and the credibility of the monetary framework.

Fiscal policy

With a solid parliamentary majority, the new Government is committed to pursue prudent and growth-supportive, financial policies. To this aim, the authorities concur with staff on implementing a medium-term fiscal framework to gradually reduce the public debt-to-GDP ratio, through a mix of policies that increase the tax base and preserve the level of public investment so as to enhance the countries' physical infrastructures.

One of the key targets of the program is to reduce recourse to net domestic borrowing from the current 2.8 percent of GDP to 2.3 percent by 2009. The budget should be based on realistic assumptions in order to avoid, as occasionally occurred in the past, undesirable under-expenditure of the capital account, due to revenue performances below expectations. As described in the Memorandum on Economic and Financial Policies (MEFP, par. 13, p. 82), the program has a “contingent expenditures” mechanism: should by mid year the revenues be in line with the revenue target set in the budget (see table 1, p. 88), the authorities—after consultation with the Fund - can start releasing the “contingent expenditure” which, for the 2006 budget, equals about 7 billions leks (0.75 percent of GDP). Moreover, as in the past, half of the privatization receipts will be used to reduce domestic debt and half will be spent on well-designed infrastructure projects.

Further fiscal measures included in the program are the reform of the revenue administration, so as to increase the tax base and improve its composition (personal income and social securities contributions amount to only 5.2 percent of GDP, while the total revenues is 24.6 percent of GDP). The implementation of the recently established Large Taxpayer Unit should reduce the under-reporting of employees by large companies. The General Department of Taxation will be reorganized with the aim to create a modern tax administration. In the area of consumer administration, the implementation of the ASYCUDA computer system is almost completed. The authorities are also increasing their efforts to reduce the informal economy, which is estimated at about 30 percent of GDP and is particularly high in the services sector and small companies. A reduction of the tax wedge should facilitate the process.

The authorities are also aware that the increase in government revenues cannot simply be met with administrative measures, but also require a cultural change, as noted in the Poverty Reduction Strategy report. The strategy to raise government revenues should hinge on broadly based support and compliance.

Finally, the authorities recognize that improving the budget debt management is crucial, given the current very short maturity of the debt (on average about 6.5 months). Beside the technical aspects of enhancing debt management, the authorities intend to proceed in an expeditious manner to obtain a country rating with the aim of gaining direct access to international capital.

The banking sector and the monetary policy

Despite significant progress over the last few years, including the privatization of the large Saving Bank in 2004, the Albanian banking system remains relatively underdeveloped. The intermediation rate remains low (of about 52 percent of GDP held by banks as deposits, only 13 percent of GDP is extended as credit to the private sector). The sector is, however, changing rapidly, and the demand for credit is expanding at a strong pace. While the use of cash in transactions remains significant, the situation is rapidly improving: in the public sector almost all wages are now paid though current accounts; 70 percent of companies use banks; in general, the payment system is shifting from a cash-based economy to a system in which electronic payments play a prominent role. Establishing a “credit information bureau,” under the lead of the Bank of Albania, aimed at improving the monitoring of the credit risk by commercial banks is another priority.

Although the degree of dollarization in Albania is below the average of other transition countries (foreign currency deposits are about 36 percent of total deposits), it can partially impair the efficiency of the monetary transmission mechanism, already restricted by the above-mentioned low level of intermediation. The Bank of Albania (BoA) has successfully coped with the structural weakness through a very rigorous and transparent policy. The credibility of the monetary policy allowed the BoA to contain inflation expectations relatively well as soon as prices started to accelerate. The authorities are determined to preserve the independence of the Bank and to enhance its technical capabilities. They are aware that it is imperative to conduct macroeconomic policy in a transparent and credible manner and to maintain a relatively high level of reserve cover.

The foreign exchange market interventions -- kept at a minimum so as not to interfere with the informal inflation target -- are finalized to smooth-out excessive exchange rate volatility and to preserve an adequate level of foreign reserves. The authorities, with the assistance of the Fund, intend to move gradually toward a formal inflation target. However, they are fully aware that this delicate passage needs several pre-conditions and should be carefully designed. They are also conscious that the strong inflows of remittances can be a potential source of real appreciation of the currency. It is therefore important to increase the productivity and contain labor costs to preserve competitiveness.

3. Structural reforms

To improve the infrastructure, enhance the institution building process, and substantially reduce poverty are the three economic priorities.

The recent power shortage showed that the Power Sector Action Plan must be a top priority. The authorities have already introduced new procurement rules that facilitate electricity imports and transmission from neighboring countries. They are also taking further action to improve the performance of the state owned electricity company KESH and are working with the World Bank and other donors to restructure the water supply company. Albania's transportation infrastructure needs substantial improvements. The authorities intend to proceed according to a well-planned and prioritized investment strategy. In this perspective, new large projects should be considered only within this framework. The privatization of the main telephone company (Albetelekom) remains a priority.

Strengthening the rule of law is a key factor for achieving stability and economic growth. The mid-term priorities of the government are: improving the implementation and monitoring of policies and laws, strengthening institutional interaction, enhancing accountability, adopting instruments to motivate public functionaries, and improving available means of technology. It is also important to fight corruption at all levels of administration and complete the reform of government decentralization. The institution building process also includes the necessity to improve substantially the quality, extent, and timeliness of the statistics.

As far as the poverty reduction policies are concerned, we want to underscore the remarkable improvement obtained in just a few years: the percentage of population with per capita income below two dollars a day is now only 10.8 percent (it was 46.6 percent in 1998); the infant mortality rate (per 1000 live births) is 18 (it was 27.6 in 1998). However, as reported in the Poverty Reduction Strategy Report, in order to reach the MDG by 2015, substantial improvement needs to be obtained in the absolute poverty headcount rate, the rule of law, and control of corruption.

3. Future Fund engagement

Given Albania's protracted external financing needs, the proposed access is SDR 17.045 million (35 percent of quota) equally distributed between the PRGF and EFF. The request for a blend of these two facilities reflects Albania's rapid income growth over the last decade. As noted above, the key reforms are in the areas of the revenue administration, public debt management, financial market development, expenditure management and civil service.