Republic of Kosovo
Request for Stand-By Arrangement
Author: International Monetary Fund
Publication Date:
29 Jul 2010
eISBN:
9781455202638
Language:
English
Keywords:
ISCR; CR; staff appraisal; spending initiative; bank balance; preliminary understanding; law of the central bank of the Republic of Kosovo; central bank; debt service; fiscal policy; IMF staff estimate; broad money; Budget planning and preparation
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Kosovo’s economic performance has strengthened considerably, but structural deficiencies undermine export sector development and prospects for sustainable growth. The program seeks to restore fiscal sustainability and safeguard financial sector stability. Restoring fiscal sustainability requires strengthening the credibility of the budget process and improving tax administration. Decisive action is necessary to improve energy sector finances and halt the drain of fiscal resources. Good governance of the Pension and Savings Trust is essential. Financial strength of the banking sector is adequate, but crisis preparedness needs to be enhanced.

Abstract

Kosovo’s economic performance has strengthened considerably, but structural deficiencies undermine export sector development and prospects for sustainable growth. The program seeks to restore fiscal sustainability and safeguard financial sector stability. Restoring fiscal sustainability requires strengthening the credibility of the budget process and improving tax administration. Decisive action is necessary to improve energy sector finances and halt the drain of fiscal resources. Good governance of the Pension and Savings Trust is essential. Financial strength of the banking sector is adequate, but crisis preparedness needs to be enhanced.

I. Background

1. Kosovo became the 186th member country of the IMF on June 29, 2009. However, since 1999, the Fund has provided technical assistance and policy advice to the United Nations Mission in Kosovo, and since September 2008, to the Republic of Kosovo (Annex I). Fund policy advice was helpful in underpinning macroeconomic stability, and staff’s Letter of Assessment to the European Commission in November 2009 was instrumental in facilitating donor support for the government’s policy program.

2. Structural deficiencies undermine export sector development and prospects for sustainable growth. A decade after the end of the conflict that led to Kosovo’s unilateral declaration of independence in February 2008, growth prospects continue to be hampered by profound structural impediments. These include poor public and private infrastructure, unreliable electricity supply, and inadequate regional connectivity of transportation routes. The economy remains undiversified and dominated by the trade and services sectors that are boosted by the large foreign presence and remittances. The export base is narrow and dominated by low-value added products, and a sector that could drive sustainable growth has yet to emerge.

A. Recent Economic and Policy Developments

3. Nevertheless, economic activity appears to be strengthening and last year’s recession in Europe had only a modest impact on the economy. Following a contraction last year, exports have been rebounding this year (Table 1). Remittances, an essential source of funding of private sector activity, have also been recovering (Figure 1). However, private sector credit growth continues to decelerate. Public spending, especially for capital investments, supported economic activity. Real growth therefore declined last year only moderately to 4 percent from 5.4 in 2008 (Table 2). Public investment spending is expected to increase in 2010, mainly due to the beginning of the construction of the Route 7 corridor, Kosovo’s first highway. The World Bank estimates the project costs at about 24 percent of 2010 GDP over a four-year period, and cost overruns cannot be ruled out.

Table 1.

Kosovo: Main Indicators, 2007–15

(Percent, unless otherwise indicated)

article image
Sources: Kosovo authorities; and IMF staff estimates and projections.

Assumes budget grants of €75 million per year in 2010–12.

World Bank estimates.

Starting in 2010, minimum bank balance recommended by staff.

Savings-investment balance of entire economy, including donor sector.

Total foreign assistance excluding capital transfers.

Figure 1.
Figure 1.

Kosovo: Cross-Country Comparison of Selected Economic Indicators, 2003–09

Citation: IMF Staff Country Reports 2010, 245; 10.5089/9781455202638.002.A001

Sources: IFS; WEO; World Bank; and IMF staff estimates.1/ ALB, BGR, HRV, MKD, ROM, SRB calculated as of 2008.
Table 2.

Kosovo: Real Growth, 2007–15

(Percent, unless otherwise indicated)

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Sources: Kosovo authorities; and IMF staff estimates and projections.

Donor sector includes UNMIK, EULEX, KFOR, and other donor spending.

Including service receipts comprising donor sector consumption.

uA01fig01

Remittances

Citation: IMF Staff Country Reports 2010, 245; 10.5089/9781455202638.002.A001

uA01fig02

Contribution to GDP Growth

(Percentage points)

Citation: IMF Staff Country Reports 2010, 245; 10.5089/9781455202638.002.A001

4. Inflation in the euroized economy closely mirrors import price developments. Import dependence is high—the import share in GDP is estimated to have reached 54 percent in 2009—and the euro area is Kosovo’s largest trading partner. As a result, inflation closely mirrors international developments and tends to be volatile. Amidst the ongoing global recovery, a short-lived period of deflation has come to an end, and consumer price inflation (CPI) rose to 2.2 percent year-on–year in May.

uA01fig03

Price Indices

(Annual percentage change)

Citation: IMF Staff Country Reports 2010, 245; 10.5089/9781455202638.002.A001

5. Rapid expenditure growth has undermined fiscal sustainability. Real expenditures surged during 2008–09, albeit from low levels (Tables 3 and 4). These increases were in large part due to capital expenditures, as the authorities began to address extensive infrastructure needs, amid weaknesses in project preparation and execution. However, rising subsidies and net lending to KEK, the publicly-owned and loss-making electricity company, also contributed significantly to expenditures, in addition to appreciable public sector wage hikes. Revenues were boosted in 2009 by a large one-off dividend payment from PTK (5.2 percent of GDP), the publicly-owned telecom company. Excluding this one-off revenue, the underlying 2009 deficit reached 6 percent of GDP, following a balanced budget in 2008 and a substantial surplus in 2007.

Table 3.

Kosovo: Consolidated Government Budget, 2009–15

(Excluding donor designated grants; millions of euros)

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Sources: Kosovo authorities; and IMF staff estimates and projections.

Including capital transfers to public enterprises.

Includes balances at the CBK and in commercial banks.

Assumes that financing gap is covered with external debt.

Table 4.

Kosovo: Consolidated Government Budget, 2009–15

(Excluding donor designated grants; percent of GDP)

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Sources: Kosovo authorities; and IMF staff estimates and projections.

Including capital transfers to public enterprises.

Includes balances at the CBK and in commercial banks.

Assumes that financing gap is covered with external debt.

uA01fig04

Primary Expenditure

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 245; 10.5089/9781455202638.002.A001

6. The energy sector remains mired in financial difficulties and continues to absorb significant fiscal resources. KEK remains under severe financial strain, given widespread difficulties with billings and collections, and a tariff structure that does not ensure cost recovery. Supply shortages persist and tend to result in expensive electricity imports. Budget subsidies and lending reached 3.8 percent of GDP last year. A long-awaited privatization and reform strategy—devised with the assistance of the World Bank and USAID—did not trigger sufficient private sector interest. A revised strategy appears to be attracting investor interest.

7. Significant external imbalances persist, given deep-rooted structural deficiencies and the recent fiscal loosening. Amid the surge in public capital expenditures, the current account deficit is estimated to have reached 25 percent of GDP in 2009, excluding official transfers. Official transfers, although on a declining trend, remained high at the equivalent of 6.4 percent of GDP in 2009 (Table 5).

Table 5.

Kosovo: Balance of Payments, 2007–15

(Millions of euros, unless otherwise indicated)

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Sources: Kosovo authorities; and IMF staff estimates and projections.

Including trading companies, insurance companies, and pension funds.

Includes SDR allocations and IMF account.

Projections of errors include unidentified private remittances and other capital based on average historical levels.

8. The largely foreign-owned financial sector thus far has been comparatively unscathed by the global financial crisis. Foreign subsidiaries dominate the banking sector, holding about 90 percent of deposits (March 2010). Not unlike other countries in the region, Kosovo experienced rapid private sector credit growth prior to the financial crisis. However, loan growth was funded by means of a steady expansion in the deposit base rather than foreign borrowing (Table 6). To shield against the risk of a sudden liquidity shortage, the CBK exercised moral suasion for banks to lower the ratio of loan to deposits to a prudent level, enhanced its daily monitoring of the banking sector, and stepped up its stress testing.

Table 6.

Kosovo: Monetary Survey, 2007–11

(Millions of euros, unless otherwise indicated)

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Sources: Central Bank of the Republic of Kosovo; and IMF staff estimates and projections.

2009 SDR allocation and liability relative to the IMF quota.

Includes government balances and other official deposits.

uA01fig05

Loan-to–Deposit Ratio, 2009

(Percent)

Citation: IMF Staff Country Reports 2010, 245; 10.5089/9781455202638.002.A001

9. Intrinsic weaknesses in the financial architecture nevertheless pose risks to financial stability. While overall banking sector liquidity appears to be adequate (Table 7), euroization limits the scope for emergency liquidity assistance (ELA), if needed. The funds available for ELA are mostly confined to the counterpart of the government’s balances held with the CBK. Moreover, the existing legal framework does not explicitly authorize the CBK to provide ELA, although the program addresses this issue. Departures of the banking law from best international practice pose additional risks to financial stability.

Table 7.

Kosovo: Selected Financial Soundness Indicators, 2006–10

(Percent)

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Source: Central Bank of the Republic of Kosovo.

NPL ratio includes the loans which are classified as doubtful loans and bad loans.

Liquid assets are cash, balances with CBK and commercial banks, and securities.

Not annualized.

Interest income minus interest expenditures. Gross income taken from income statement.

Includes fees, commissions, provisions for loan and other asset losses, and depreciation of fixed assets.