Statement by Arrigo Sadun, Executive Director for Albania and Francesco Spadafora, Senior Advisor to Executive Director

This 2008 Article IV Consultation highlights that over the last decade, Albania’s macroeconomic performance has generally been strong and per capita GDP in U.S. dollar terms more than doubled. Strong fiscal policy, largely based on major improvements in tax administration, lowered public debt from 66 percent of GDP in 2001 to 53 percent in 2007. Risks to domestic and external stability have receded somewhat. Domestic credit growth, though still elevated, has decelerated from past highs. The authorities have adapted regulatory and supervisory regimes to keep abreast with the rapidly developing financial system.

Abstract

This 2008 Article IV Consultation highlights that over the last decade, Albania’s macroeconomic performance has generally been strong and per capita GDP in U.S. dollar terms more than doubled. Strong fiscal policy, largely based on major improvements in tax administration, lowered public debt from 66 percent of GDP in 2001 to 53 percent in 2007. Risks to domestic and external stability have receded somewhat. Domestic credit growth, though still elevated, has decelerated from past highs. The authorities have adapted regulatory and supervisory regimes to keep abreast with the rapidly developing financial system.

On behalf of the Albanian authorities, we thank staff for the well-written and informative report, which is testament to the remarkably close and constructive cooperation with the authorities.

Overview

Sound macroeconomic and structural policies, underpinned by Fund programs, have laid the ground for the impressive progress made by the Albanian economy over the last decade. Per capita GDP growth in U.S. dollar terms has more than doubled and graduation from IDA is forthcoming. Inflation has declined toward the European average and is currently among the lowest in the region. Timely monetary policy tightening, complemented by appropriate regulatory measures, was crucial to reach this positive outcome. While implementing supply-side tax reforms, major improvements in tax administration have contributed to strengthen public finances, boosting the revenue-to-GDP ratio and lowering the public debt.

Growth is projected to remain at a solid 6.0 percent in the current year and, equally importantly, is broader-based, with a pick up in the relative weight of such sectors as construction and manufacturing and upbeat trade following export diversification in both markets and products. Credit growth, identified as a major risk in past reviews, has been somewhat contained, but remains relatively robust.

The real exchange rate does not appear to be misaligned and there are no major concerns about competitiveness and external stability. Most of the widening of the current account deficit in 2007 reflected temporary factors and the gap is expected to decline to below 5 percent of GDP in the medium term as a result of stronger exports, buoyant remittances, and a reduction in electricity and road-related imports.

The authorities are now focusing on the medium-term policies and reforms necessary to sustain growth and ensure financial stability. The persistently strong performance under the PRGF-EFF-supported program confirms their commitment. For the fifth review, all quantitative performance criteria have been met and structural conditionality appears on track.

Against such a positive background, in a context of persistent security-related regional risks, some long-standing problems remain, mainly related to the electricity sector, governance and the business environment.

Fiscal Policy

The authorities’ medium-term fiscal framework envisages a small but more efficient government. Fiscal policy has provided a key contribution in maintaining macroeconomic stability and, going forward, should take on a greater role in demand management. In the longer term, further fiscal consolidation will be pursued with a view to fund development projects.

The 2008 budget sets a deficit ceiling of 5.2 percent of GDP that does not generate a fiscal impulse; this gap should decline to 3.0 percent as early as 2009 (as opposed to the projected 3.7 percent at the time of the fourth review).

Following the introduction of a 10 percent flat tax rate for both personal and corporate incomes (respectively in August 2007 and January 2008), personal income tax collections more than doubled in the first quarter of 2008, while the revenues from corporate taxation remained stable due to the broadening of the tax base. Buoyant revenues have allowed the budget to absorb the costs (0.2-0.3 percent of GDP) of compensation for the Gerdec ammunitions explosion. Against such major reforms, the authorities will now concentrate their efforts on bringing actual collections in line with potential yields. In this regard, the objective of increasing the number of social security contributors to 410,000 by end-July 2008 appears on track.

A large wage increase for public sector workers has been scaled back sharply by the mid-year budget review in order to prevent a potential wage-price spiral. Significant contingency reserves of about 1.5 percent of GDP are in place to protect the 2008 budget outcome against the risks arising from quasi-fiscal losses incurred by the electricity company KESH and cost overruns associated with the Rreshen-Kalimas road project.

The authorities stand ready, in consultation with the Fund, to take further actions, including offsetting reductions in other expenditures, should the fiscal deficit target be in jeopardy,

Public debt has been reduced from 58 percent of GDP in 2005 to 53 percent in 2007 and its maturity extended to reduce rollover risk. The authorities aim at reducing the debt-to-GDP ratio to below 50 percent by 2011, in order to mitigate the risks, in terms of costs and volatility, associated with the prospective greater integration with global capital markets. The annual implementation of this target will be carried out either through a cap on the overall fiscal deficit or expenditure consistent with such an objective. In light of the forthcoming expiration of the Fund-supported program in January 2009, the authorities have been discussing with staff how best to replace the current fiscal anchor in order to preserve macroeconomic stability and have expressed a preference for an expenditure-based rule.

Improving the implementation of capital projects remains a priority of public expenditure management. Following the introduction of new public investment management procedures and a new procurement law, the authorities are focusing on strengthening Ministries’ capacity to implement such measures.

Monetary and financial sector policies

Following three increases of the policy rate in 2007, the monetary authorities stand ready to further tighten monetary policy in order to avoid second-round effects potentially arising from looming domestic and external inflationary pressures. The former are related to the recent increase in electricity tariffs and, over the medium run, to increased food exports; the latter to the expected pass-through to domestic prices from global inflation trends.

Despite the progress, there remain some upside risks to the rate of credit growth from the potential expansion of available collateral, as a result of the ongoing land legalization. Further regulatory and supervisory measures would complement monetary policy in the event that re-acceleration of credit growth materializes. On the other hand, downside risk to the rate of credit growth may arise from a retrenchment of parent banks in funding their Albanian subsidiaries, in a largely foreign-owned banking system (about 90 percent of total assets in 2007, up from 47 percent in 2003).

The banking system is well-capitalized, liquid and profitable. The authorities intend to safeguard its stability through proactive supervision. However, on account of the system’s rapid expansion, they are aware of the need to enhance the regulatory and supervisory regimes in tandem and are benefiting from TA recommendations provided by MCM and LEG.

In particular, the Bank of Albania aims at signing formal Memoranda of Understanding to increase cooperation with the home country supervisors of resident foreign banks. Improvements in the legal and operational framework for executing collateral are also planned, including through changes in the Civil Code.

To improve the effectiveness of monetary policy, as well as to further stimulate the growth of the financial sector, the authorities aim to develop efficient interbank and secondary markets. To this end, a delivery versus payment system for government securities is due for completion by end-October. The development of pensions and insurance markets, supported by the World Bank, would also address the still high rollover risk of domestic debt, although progress has already been made on lengthening its maturity. Moreover, the new IT system for conducting primary auctions of government securities has reduced operational risks.

To prepare the country for the forthcoming graduation from concessional finance, the authorities have been taking steps towards the objective of tapping international capital markets. In order to meet the requirements for a successful first-time market access, a General Debt Department has been created to strengthen debt management capacity. Technical assistance will be sought from donors and the IMF to prepare for Albania’s first sovereign issuance of Eurobonds within a coherent medium-term debt strategy.

The electricity sector

In the authorities’ view, a privately-dominated and diversified electricity sector is critical to ensure a stable supply of electricity at low cost. Unfortunately, previous attempts to place the electricity sector on a sound footing have not been sufficient to obtain a lasting solution and address the ensuing macroeconomic risks. In fact, chronic power disruptions have taken a toll on inflation, the budget deficit and current account (because of the ensuing need to import more costly energy).

With regard to the fourth review’s structural benchmark aimed at reducing the quasi-fiscal losses of KESH to below 1.2 percent of GDP in 2008, a new action plan was adopted as a prior action for the fifth review. This includes such measures as containing KESH’s personnel costs, limiting the electricity imports as well as reprioritizing local investments. The authorities stand ready to take further actions to meet the above target, if necessary

Aware of the importance of strengthening KESH’s cash flow, in addition to last March’s tariff increase, the action plan also aims at raising the effective collection rate from the current 47 percent to 60 percent, consistent with the new structural benchmark of bringing this rate up to 62 percent by end-October. Efforts are under way to ensure that budgetary and non-budgetary institutions, whose arrears have been recently cleared, henceforth pay electric bills on time.

In order to achieve a lasting solution and ensure a stable supply of electricity over the medium term, the authorities, under the advice of the IFC, have set up a program to privatize the distribution arm of KESH by end-2008. To this end, they have finalized the methodology for tariff adjustment and identified qualified bidders in June 2008. Furthermore, with assistance from USAID, they have established the required market structure and regulations for full vertical unbundling of KESH.

The authorities are also involved in a number of projects to diversify electricity supply and further integrate the national grid into the regional network. Construction of a thermal power plant, financed jointly by the World Bank, EIB and EBRD, has already started and should be completed by mid-2009. Additionally, to increase private sector involvement in power generation, they are in the process of concessioning two new large hydro power plants.

Structural issues

The objective of the authorities’ medium-term economic strategy is to foster continued strong private sector-led growth.

In a context of successful macroeconomic stabilization, market-oriented reforms have paved the way to rising investment and Albania now sets itself apart in terms of the contribution of capital accumulation to growth. However, total factor productivity, which has provided the largest push to the expansion, shows signs of deceleration. The authorities are aware of the need to avoid complacency and recognize that failure to advance improvements in governance and business climate will negatively affect growth and debt sustainability. A better business environment is also instrumental in addressing quasi-monopolistic price setting in the distribution and retail sectors.

The authorities intend to address the business climate, governance and institutional weaknesses thorough a wide range of reforms. Steps are being taken to improve the legal system and pursue land registration and titling, in order to enhance contract enforcement and property rights. The National Registration Center, a one stop-shop for business registration that cuts time and cost, has proved effective in prompting the registration of more firms. A new anti-corruption strategy is being implemented with donor support. Privatization of the remaining strategic public assets will continue in 2008. While expecting further benefits from prior reforms, the authorities look forward to the adoption of a second round of structural reforms to improve the business climate.

Relationship with the Fund

The authorities look forward to exploring possible options for future Fund engagement in the context of the sixth review.

Albania: 2008 Article IV Consultation, Fifth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility, Review Under Extended Arrangement, Financing Assurances Review, and Request for Modification of Performance Criteria: Staff Report; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Albania
Author: International Monetary Fund