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.
Kosovo is a young country. It declared independence on 17 February 2008. In June of the same year, the Constitution entered into force. Towards and since Kosovo’s independence, the authorities have taken great efforts to build the country’s institutions and to secure the basis for sustained growth of the economy, for the welfare of the Kosovan people. Kosovo has also strived for a place in the international community. Becoming a member of the IMF on 29 June 2009 was an important step towards both objectives.
In building the institutions, the authorities are not alone and did not have to start from scratch. Ever since its presence in Kosovo in the aftermath of the conflict, the United Nations Mission in Kosovo (UNMIK) has helped the population to develop public functions such as police and justice, and civil administration. The EU’s EULEX mission, the International Civilian Office, the World Bank, USAID and others provide much-needed support in the build-up of the country. The European Union is expected to provide budget support in 2010, 2011 and 2012. The IMF has played a crucial role ever since 1999 in providing technical assistance in areas such as fiscal policy, banking and payment systems and macroeconomic statistics.
The Kosovans are proud of what they have achieved in the short time of their independence: political stability in a democratic system, a high degree of security, sound public services, economic growth and price-stability, and a stable financial sector and private initiative as preconditions for economic growth. However, great challenges remain ahead and to offer its young and ambitious population a brighter future, Kosovo must enhance its legal infrastructure for the growth potential of the economy. In this regard, Government strategic priorities have been designed to create preconditions for sustainable economic growth. Within this context, the Government is keen to improve the market environment by tackling the informal economy in order to enable private sector development in a way that would bring the Kosovan economy in line with the economies in the region. There is no doubt that reaching the above-mentioned objectives contributes to improvement of the citizens’ welfare, which is one of the preconditions for integration into the European Union. Therefore, for these objectives to be met, further reforms and hard work are needed towards elimination of barriers and factors that may hinder economic development.
In this regard, the authorities are also strongly committed to investing in the country’s physical infrastructure, as shown by the high capital to current expenditure ratio in the budget. The fact that Kosovo is a landlocked country in a precarious international environment adds to the infrastructural challenges. At the same time, there is a need to maintain the minimum level of social benefits which are currently offered to protect the vulnerable groups within the population.
The authorities realize that sound public financial management is a precondition for the development of the economy, as it will ensure that scarce public resources are deployed effectively and efficiently. They also feel that they should take precautionary measures and set aside resources to ensure that financial stability can be maintained if the need arises. The financial and developmental needs mentioned above, and the wish to make full use of the advice which the Fund can offer, have led the government to request a Fund-supported program.
Kosovo’s economic starting position at the beginning of the Fund-supported program is one of moderate real GDP growth (4.6 percent), low inflation (1.7 percent) and a high external deficit (18.5 percent including official transfers).
Monetary policy
Kosovo is a fully euroized economy. This policy has provided an anchor for inflation and thereby strongly contributed to macroeconomic stability. At the same time, it puts the bar high for the quality of fiscal policies, as monetary instruments are lacking. In particular, the lender of last resort function of the central bank is limited to its reserves and the fiscal resources at its disposal for this purpose. Although the financial sector is stable, the authorities do believe that they must make available a prudent level of resources to the Central Bank to be able to provide temporary liquidity, in case the need might arise. Therefore, the program foresees the establishment of an Emergency Liquidity Assistance (ELA) Fund. Setting aside a considerable amount of resources in terms of GDP for a tail risk was not an easy decision in view of the limited budget and large development needs. The Stand-By Arrangement temporarily provides resources for this purpose and thus is essential in making this necessary arrangement.
Fiscal policy
The core medium-term strategy for the fiscal policy is to make room for Kosovo’s immediate investment needs, while safeguarding fiscal sustainability. Kosovo’s top priority in physical infrastructure is the construction of the Route 7 highway. Route 7 will be the country’s main link to the regional transport network in South-Eastern Europe, including to Albania’s port of Durres on the Adriatic Sea.
The capital expenditures for Route 7 in the years 2010–2013 of on average 5.2 percent of GDP (6.1 percent in 2011) are mainly financed as follows:
by limiting other capital expenditures (a reduction of about 2.6 percent of GDP in 2011 and maintained through 2013 as compared to 2009, before the start of the project);
by reserving privatization proceeds for this purpose (a one-off 6.7 percent in 2011); and
by raising specific excise taxes (yielding 1.0 percent of GDP per year).
During this period, current expenditures are broadly kept the same at a level of 18.5 percent of GDP or 56 percent of primary expenditures in 2011 (was 18.6 percent of GDP in 2009). Wages and salaries will be slightly reduced next year by 0.2 percent of GDP and will make up a modest 23 percent of primary expenditures and 40 percent of total current expenditures in 2011. While the fiscal balance excluding highway-related spending will improve steadily, the budget will see a temporary increase in the overall deficit topping at 5.5 percent in 2011 and gradually receding in the years thereafter to 2 percent in 2015.
Financial contingencies and safeguards are in place to cover possible risks related to the highway project. The total budgeted costs for Route 7 include a significant contingency estimate in line with international standards. Nevertheless, the authorities acknowledge that large infrastructure investments are internationally associated with risks of cost overruns. Therefore, even though they have made great efforts to address such risks in the contract with the consortium of road-builders, the authorities have agreed to raise the bank balance by 2 percent of GDP in 2011 as compared to 2010 as a special contingency. On the revenue side, the authorities feel that risks to the budget are balanced. Direct and indirect taxes provide a steady source of revenues. Moreover, growth projections are cautious. However, the exact revenue to be generated by the privatization of PTK, the profit-making public Telecom firm, is uncertain. Based on valuation of the company, the authorities believe that the budgeted amount for PTK’s privatization is cautious. The authorities are committed to taking extra measures on the (capital) expenditure side and on the revenue side if necessary to reach their fiscal targets. The responsible budgeting and precautionary measures mentioned above will ensure that Kosovo can avoid commercial borrowing during the period of the Fund-supported program.
Public financial management
Strengthening budget processes and public financial management are key pillars of Kosovo’s Fund-supported program. While the institutional base is generally adequate, capacities need strengthening and processes and practices need further development. Main elements of the strategy are to strengthen the medium-term budget cycle including through enhanced transparency and ensuring budget-neutral midyear budget reviews. The authorities’ commitment to results is demonstrated by the fulfillment of the prior actions in this field.
Other objectives during the program period are improving tax administration and rationalizing public expenditure. Regarding the latter, unfortunately, due to capacity constraints the IMF could not grant requested TA assistance before the preparation of the 2011 budget. Nevertheless, the authorities remain committed to elaborating a medium-term rationalization strategy.
Energy sector
The poor quality of the energy sector remains one of the biggest constraints to doing business in Kosovo. The unreliable supply of electricity continues to have major consequences for Kosovo’s economy. The energy sector in Kosovo is dominated by the electricity sector and associated lignite mines. The Kosovo Energy Corporation (KEK) is the sole producer of electric power in Kosovo. KEK’s two large power plants, Kosovo A and B, are about 40 and 25 years old and poorly maintained. While nominal capacities are 800 MW and 680 MW respectively, only about 60 percent or about 900 MW of the aggregate capacities are available, well below the peak demand during the cold season. The current state of the publicly-owned energy company, both technically and financially, poses risks to Kosovo’s economic development and presents too high costs to the budget. The main causes for KEK’s negative fiscal impact are technical and commercial losses, difficulties in billing and collection, and power import subsidies–a subsidy that will increase in the future as demand for energy and power import prices increase. As a result the fiscal burden of the energy sector on the Kosovo’s budget has been running about €70 million per year or about 11 percent of the budget expenditures over the previous years, representing a continuous drain on the budget. Therefore, as a structural benchmark under the program, the authorities have committed to developing a comprehensive strategy to address KEK’s financial challenges.
Financial sector supervision
The financial sector in Kosovo is licensed, supervised and regulated by the Central Bank of the Republic of Kosovo. During 2009, the financial sector in Kosovo continued to grow and remained stable despite the unfavorable conditions that characterized global financial markets in the past 2 years. Regarding the structure of the financial sector, the banking sector continues to represent the majority of assets (78.6 percent), followed by pension funds (13.6 percent) and the remaining part is constituted by micro-financial institution and insurance companies.
Currently in Kosovo eight commercial banks continue to develop their activities from which two are domestically owned and the remaining six are owned by foreign institutions. Moreover, the banking sector continues to be dominated by foreign owners that manage 91.5 percent of total assets. Deposits in the banking sector continue to increase, amounting to € 1.7 billion by the end of 2009, while loans amounted to around € 1.3 billion.
The Parliament has approved a revised Law on the Central Bank of the Republic of Kosovo. While the strength of the financial sector is adequate, the Banking Law is being revised with IMF TA in order to bring it in line with international best practice. The revised law will strengthen governance standards for banks, provide for tighter restrictions on lending to bank-related parties, and enhance supervision of banking groups and branches of foreign financial institutions. It will also include an improved bank resolution regime. The authorities are furthermore working on improvements of insurance sector supervision.