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

The staff report for Albania’s Sixth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility is presented. The economy has achieved robust noninflationary growth, albeit with increasing external imbalances, and has begun to tackle longstanding problems in the business environment. The upcoming elections risk diverting policymakers’ attention from stability-oriented policies. Despite significant buffers and inbuilt strengths of the financial sector, continued diligent supervision, high-frequency monitoring, and enhanced cooperation with foreign supervisors of resident banks will be needed to underpin prompt, proactive responses to changing circumstances.

Abstract

The staff report for Albania’s Sixth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility is presented. The economy has achieved robust noninflationary growth, albeit with increasing external imbalances, and has begun to tackle longstanding problems in the business environment. The upcoming elections risk diverting policymakers’ attention from stability-oriented policies. Despite significant buffers and inbuilt strengths of the financial sector, continued diligent supervision, high-frequency monitoring, and enhanced cooperation with foreign supervisors of resident banks will be needed to underpin prompt, proactive responses to changing circumstances.

January 28, 2009

On behalf of the Albanian authorities, we thank staff for the well-written and informative report and for the remarkably close and constructive cooperation with the authorities maintained throughout the program.

Overview

In the context of favorable external conditions, the 2006-08 PRGF-EFF arrangement has underpinned Albania’s strong non-inflationary growth, which has allowed the country to join the rank of the middle-income countries.

Growth remained above 6 percent through the first half of 2008, while inflation returned within the Bank of Albania’s 3±1 target band and inflation expectations are well anchored.

Public finances have improved markedly. Significant progress was made in strengthening the revenue administration, as the tax revenues-to-GDP ratio increased by over 2 percentage points despite a reduction in corporate and personal income taxes. Improvements in public debt management have led to a reduction in the debt-to-GDP ratio from 56 percent in 2006 to 52.6 percent in 2008, and to the doubling of the average maturity of public debt.

The deterioration in the current account balance (excluding official transfers) over the program years (from -7.3 percent in 2006 to -11.8 in 2008) partly reflected temporary factors, namely the spike in food and fuel import prices that occurred in the first half of 2008 and the scaling up of a major import-intensive road project. As underscored by staff, the temporary increase in the current account deficit has been fully financed, and the underlying trends remain sound. The reversal of those temporary factors should lower the current account deficit to 7.7 percent in 2010.

Policy implementation in 2008 has been broadly in line with the program, as the authorities have maintained tight macroeconomic policies. All quantitative performance criteria and structural benchmarks set under the program for the sixth review have been met, with the only exception of the end-October effective electricity collection rate for the electricity company KESH. However, the target of 62 percent was missed by only 2 percentage points, and the company is expected to achieve the end-year target.

Albania is now facing the adverse consequences associated with the severe downturn of the global economy. While the medium-term outlook appears relatively favorable, sustained by prudent macroeconomic policies and improved business environment, the global financial crisis has increased external, fiscal and financial sector vulnerabilities.

The authorities expect a decline in exports and remittances, as well as less favorable external and domestic financial conditions. However, their current outlook for growth is somewhat more optimistic than staff’s. Against this background, the authorities’ policies for 2009 aim at preserving macroeconomic stability and further reducing vulnerabilities, while sustaining growth and advancing structural reforms.

Policy commitments for 2009

The authorities remain committed to a prudent fiscal policy. In the face of less favorable financing conditions and heightened rollover risk, they have tightened the 2008 budget by allowing new spending requirements to be met through reallocations. This should preserve the 2008 deficit target of 5.2 percent of GDP.

The 2009 budget envisages a deficit of below 4 percent of GDP. This target strikes a balance between the need to finance key public investment and a tighter fiscal stance made necessary by the increase in borrowing requirement (2.5 percent of GDP, up from essentially zero in 2008). Against a background of intensified financing pressures and uncertainty in early 2009, the authorities agreed to further strengthen the budget by increasing wholesale electricity tariffs, as well as by postponing the planned reductions in the employer social security contribution rate from January to May. Moreover, the 2009 budget includes contingency reserves of about 2 percent of GDP.

In the longer term, fiscal discipline will be further pursued by the adoption of a credible fiscal rule, possibly an expenditure-based one, which would be instrumental in containing the size of the public sector while allowing automatic stabilizers to play a greater role.

On the monetary front, the authorities are committed to the current policy framework, which combines an inflation target range with a flexible exchange rate regime, and has proved to work well as a shock-absorber in the face of the recent commodity price shock.

Impact of the global financial turmoil on the financial system

Supervisory and regulatory regimes were considerably enhanced during the program. Facing the sharp deterioration in the external environment and less favorable financial conditions, the authorities have reacted swiftly to preserve financial stability. They remain vigilant and ready to tackle any potential problems.

In October 2008 the banking system started experiencing some withdrawals of bank deposits, triggered by concerns about the soundness of the banking systems in the whole region, which in turn led to increases in deposit insurance levels outside Albania. Besides, less favorable financing conditions were evidenced by several subsequent government debt auctions that were significantly undersubscribed.

Large liquidity buffers, built up through pro-active regulatory and supervisory measures adopted in the past, have allowed banks to meet withdrawals without experiencing systemic strains. Furthermore, bank deposits are gradually returning. In any event, the Bank of Albania is ready to act as a lender of last resort in domestic currency. Regulatory provisions are also is in place to ensure that banks properly hedge foreign currency liabilities.

As noted in the staff report, Albania’s financial system compares favorably within the region. September 2008 core indicators depict a well capitalized, solvent, liquid and profitable banking system; banks have reportedly little or no direct exposure to international troubled assets or counterparts. While the banking system is predominantly foreign owned, contagion risks are mitigated by a large domestic deposit base, which is the main funding source.

Despite those strengths, the authorities have intensified efforts to improve crisis management in case of a further worsening of financial conditions. Given the preponderance of foreign-owned banks, the Bank of Albania (BoA) has stepped up cross-border coordination efforts with regional supervisors and moved forward to sign MoUs with parent-bank supervisors. To underpin prompt proactive responses to changing circumstances, the BoA has significantly improved its ability to gather high frequency data on developments in the banking sector, and has increased the maturity and volumes of liquidity it provides to banks through the repurchase market. Broadening eligible collateral for liquidity provision is under consideration.

Structural reforms

Further progress has been made in structural reform. Since the last review, assessments carried out by the World Bank, EBRD and Transparency International have acknowledged improvements in Albania’s business environment. The privatization program has approached the end with the sale of the oil company ARMO and the insurance company INSIG. The proceeds from privatizations will be evenly allocated between public debt reduction and capital expenditure on priority road projects. Power sector reform is at a critical juncture. Following the unbundling from the electricity company KESH in June 2007, a 76 percent stake in the power distribution system operator OSSH was successfully tendered, and final negotiations with the winning bidder started in November 2008. It is expected that efficiency gains on the part of the new private owner will raise the electricity effective collection rate to 82 percent by 2014. The authorities remain committed to ensure complete cost recovery tariffs for KESH.

Relationship with the Fund

Fund-supported programs have served as a policy anchor since the early 1990s. The current arrangement expires under challenging external circumstances. While the authorities see potential merit in a precautionary Stand-by Arrangement, they considered that current expectations for growth do not call for a successor arrangement at this time.

Albania: Sixth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility, Review Under the Extended Arrangement, and Financing Assurances Review: Staff Report; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Albania
Author: International Monetary Fund