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

Albania’s macroeconomic performance over the past year has been good, with strong growth and a significant reduction in poverty under the Poverty Reduction and Growth Facility Arrangement. Executive Directors commended the new strategy for maintaining the macroeconomic stability, enhancement of the budget, and the credibility of the monetary framework. They emphasized the need to accelerate structural reforms, and appreciated the revised strategy for the electricity sector. They stressed the need to improve official statistics to serve as a reliable basis for policymaking and program design.

Abstract

Albania’s macroeconomic performance over the past year has been good, with strong growth and a significant reduction in poverty under the Poverty Reduction and Growth Facility Arrangement. Executive Directors commended the new strategy for maintaining the macroeconomic stability, enhancement of the budget, and the credibility of the monetary framework. They emphasized the need to accelerate structural reforms, and appreciated the revised strategy for the electricity sector. They stressed the need to improve official statistics to serve as a reliable basis for policymaking and program design.

On the behalf of the Albanian authorities, we wish to express our appreciation to the staff for a well-written report and a comprehensive set of selected issues papers, which reflect the frank and constructive discussion held in Tirana for the first review under the three-year arrangement under the PRGF and the review of the Extended Arrangement. The implementation of the PRGF/EFF-supported program has been broadly satisfactory. The request for waiver of nonobservance of a performance criterion reflects the still difficult situation in the electricity sector. The authorities recognize that the restructuring of the public-owned company KESH, along the lines established by the Power Sector Action Plan proved more difficult than expected. The new strategy for the electricity sector, already in place, establishes a tariff structure that would remove currently-existing cross-subsidies from business users to households and increase the average tariff to reflect higher import costs.

1. Albanian’s macroeconomic performance remains solid

With the exception of the supply-induced disruptions related to the difficulties in the electricity sector, the county has enjoyed a prolonged period of sustained growth. The estimated GDP growth in 2006 remains robust, at 5 percent (against 5.5 percent in 2005), slightly below the average of the last few years. Growth is projected at 6 percent in 2007. The electricity crises in October-November of last year, due to climatic circumstances, a poor distribution network, and mismanagement of the electricity company, created serious power problems and economic costs. In 2005, the slowdown was also affected by the modest export performance (only 5.6 percent in volume in 2005, against more than 11 percent, on average, in the three previous years).

Despite the increase in oil prices, inflation remained subdued. Retail prices increased, on average, by 2.4 percent in 2005. However, year-on-year inflation up to May 2006 was 3.1 percent: a sustained increase in non-traded good prices was balanced by lower tradable prices. The authorities remain vigilant in monitoring the phenomenon. Confidence in the monetary framework has been maintained by a credible monetary policy based on a “soft” inflation targeting.

The external current account deficit remains high and is expected to reach 8 percent of GDP this year (excluding official transfers), despite the strong and consistent inflow of remittances (which are about 15 percent of GDP).

2. The Government is committed to maintaining 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

The fiscal stance was restrictive in 2005. The overall deficit was 3.6 percent against 5.1 in 2004, as a result of the policies aimed at improving revenues administration (tax revenue increased by 11 percent) and more stringent criteria for capital expenditure and anticorruption policies. Such policies create a temporary stagnation of government expenditure for public investment (only 38 billion leks, well below the 50.5 billion projected in the budget). However, the “contingent expenditure” embedded in the Memorandum on Economic and Financial Policies (MEFP) should prevent, in the medium term, undesirable under-expenditure of the capital account. The supplementary budget, to be approved this month, will allocate the relevant “contingent expenditure” in high-quality capital spending, tax relief, and debt reduction. The public debt-to-GDP ratio is steadily declining, although now at a relatively less rapid stance: this year, as in 2005, it should remain at about 55 percent of GDP (it was 61.8 percent only three years ago). The external public debt is steady at about 17 percent of GDP.

Limited technical capacities impeded, so far, the initiation of a comprehensive debt management reform. The authorities recognize that improving budget debt management is crucial, given the very short maturity of the debt (on average about 6.5 months) and the number of participant is limited. By the end-October 2006 the authorities will formulate a debt management strategy and, by end-September, they will present to Parliament a public management law, followed by an action plan, along the lines suggested by staff and with the valuable support of donors.

The authorities reiterate their commitment to preserve the current, sound fiscal policy, reducing gradually but consistently the end-September public debt-to-GDP ratio. They agree with staff that further simplification of the tax system to reduce compliance costs and further broaden the tax base is needed. However, they are convinced that, in the future, there will be room to design a tax regime to stimulate growth and help formalize the economy. In this regard, while sharing the gradualist approach suggested by staff, the authorities see merit in a flat-tax system (with a significantly reduced uniform rate) adopted with success in other countries in the region.

Monetary policy

The authorities are committed to keeping inflation at 3 percent, with a tolerance range of deviation of plus and minus one percent. The current monetary policy framework is based on a reserve money program with quantitative targets and with changes to the repurchase rate as main policy instruments. The flexible exchange rate regime is complemented by limited foreign exchange interventions aimed at maintaining an adequate reserve level and smoothing-out seasonality and short-term shocks. Since the country does not yet have full access to the international capital markets, the phenomenon is mainly related to stock adjustment on the relevant amount of remittances held in foreign currencies. The medium-term goal is to build up (also with the technical help of donors) a monetary framework for a formal inflation target.

In the short term, the main problem is the strong private sector credit growth. Like other countries in the region, this trend is partially related to a convergence problem and to a “catching-up” effect, given the still very low credit-to-GDP ratio (about 17 percent, to be compared with only 9 percent in 2005 and the average of 37 percent of transition countries). More that 73 percent total credit is denominated in foreign currency. The foreign-owned banks (which account for more than 90 percent of the system) seem not to be exposed to exchange rate mismatching since their funding is though domestic deposit denominated in foreign currencies (from remittances). In addition, the banking system is liquid, profitable, and well capitalized, while the non-performing loans are, up to now, very low.

That said, the rapid acceleration of the credit-to GDP ratio is a source of concern. The authorities remain vigilant and will not hesitate to tighten monetary conditions should the economy exhibit preliminary signs of inflationary pressure. However, they also recognize that the effect of monetary policy is limited, since most of the credit is denominated in foreign currencies.

Should the traditional transmission channels fail to succeed (creating incentive to shift from foreign to domestic denominated deposits) the authorities will consider supervisory measures. A few of them would be: increasing reserve requirements on foreign currency deposits above 10 percent; amendments in capital adequacy to allow risk weights up to 150 percent to apply to high risk loans; impose higher that 12 percent minimum capital adequacy requirements. For the moment, the Bank of Albania is encouraging banks, through moral suasion, to adopt stricter debt service-to-disposable income ratios and prudent loan-to-value ratios.

3. Structural reforms

The Albanian economy experienced significantly higher growth than other transition countries, only partially explained by the initial disadvantage. However, in the last few years this differential has been shrinking. As noted by staff, total factor productivity (TFP), which captures the enhancement of organizational and institutional factors, is now growing at a slower pace. To some extent this is a natural phenomenon, as the country is converging toward the peer group. However, it is true that a new wave of reforms is needed to consolidate current results and to boost growth. The attractiveness of foreign direct investment is still low and, in general, the rate of growth of both private and public investments is subdued. It is a source of concern that the investment-to-GDP ratio has steadily declined in the last few years (from 27.6 percent in 2001 to 23.6 percent in 2005). The underperformance of the external sector, and the widening current account deficit, reflects the slowdown in the accumulation of physical capital. It is revealing that, among the interesting comparative indicators produced by staff in table 3 (EBS/06/91, p. 39), one of the most "misaligned" with respect to other Western Balkan countries is the trade openness index (exports plus imports of goods and services as a share of GDP).

The authorities are cognizant that in order to reach the group of middle-income countries a series of challenges still lies ahead. In particular, they need 1) to improve the country’s infrastructure by channeling the available resources into productive investments, according to a strict cost/benefit criteria, and prioritizing the allocation of these resources; 2) to enhance institutional reforms and implementation, particularly in the areas of revenue mobilization, contract rights, governance, informal economy, and, in general, business climate; 3) to promote the external sector, not only by developing a more robust manufacturing sector, but also enhancing agriculture and tourism, where the country has considerable potential; and 4) to continue with privatization policies, particularly in the area of public utilities. They are confident that the current three-year arrangement under the PRGF/EFF-supported program will provide not only a valid strategy to re-address the aforementioned problems, but also a successful exit strategy from a Fund-supported program.

Albania: Staff Report for the 2006 Article IV Consultation, First Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility, Review Under Extended Arrangement, Request for Waiver of Nonobservance of Performance Criterion, and Financing Assurances Review
Author: International Monetary Fund