Republic of Kosovo
Request for Stand-By Arrangement: Staff Report; Press Release on the Executive Board Discussion.

This staff report discusses the Republic of Kosovo’s request for a Stand-By Arrangement. Kosovo is in the final stages of transition to full self-governance in economic and financial affairs. Kosovo’s economy has remained largely shielded from turbulence in the euro area, owing to limited integration into cross-border financial markets and a small export base. Real GDP growth in 2011 is estimated at 5 percent, driven principally by domestic demand, in particular investment. Inflation has been moderated to 3.5 percent, after a spike to double-digit figures in early 2011 triggered by higher prices for imported foodstuffs.

Abstract

This staff report discusses the Republic of Kosovo’s request for a Stand-By Arrangement. Kosovo is in the final stages of transition to full self-governance in economic and financial affairs. Kosovo’s economy has remained largely shielded from turbulence in the euro area, owing to limited integration into cross-border financial markets and a small export base. Real GDP growth in 2011 is estimated at 5 percent, driven principally by domestic demand, in particular investment. Inflation has been moderated to 3.5 percent, after a spike to double-digit figures in early 2011 triggered by higher prices for imported foodstuffs.

I. Background and Macroeconomic Challenges

1. Kosovo is in the final stages of transition to full self-governance in economic and financial affairs. Until February 2008, Kosovo was under the administration of the United Nations (UNMIK). Multilateral institutions continued to play a key role also thereafter, notably the International Civilian Office (ICO) charged with overseeing Kosovo’s “supervised independence,”1 while donors like the World Bank, the European Commission, the US Treasury, USAID, and KfW of Germany assisted in building economic and social institutions and promoting economic governance. In the fifth year after Kosovo’s declaration independence, however, the ICO is gradually reducing its involvement, and donor support is receding.

2. Macroeconomic challenges are severe.2

  • External competitiveness is weak. Reasons include a deficient public infrastructure—notably in energy supply and transportation—modest skill levels of large parts of the working force, and a challenging business environment (Kosovo ranks #117 in the World Bank’s “Doing Business” survey). Large remittances and FDI from the Kosovar diaspora fund domestic absorption but also drive up wages, impeding the development of a tradable sector (Box 1, Figure 1). As a result, the bulk of Kosovo’s growth in the past decade has come from domestic demand. Registered unemployment stands at more than 40 percent, but informal employment is widespread.

  • Kosovo’s fiscal position was strong at declaration of independence, but has since deteriorated. Kosovo started off with almost no public debt, sustainable social security systems, primary surpluses, and sizeable cash buffers. From 2008, however,

  • the government adopted an expansionary fiscal stance, reflecting inter alia an ambitious highway construction program and higher social spending. The resulting deficits were financed with donor support and by drawing down cash buffers. Structural fiscal challenges include: (i) a revenue structure that is tilted toward border taxes and provides a limited revenue base to address social and capital spending needs; (ii) inadequate design and costing of spending initiatives; (iii) a system of fiscal decentralization that—while granting municipalities adequate resources—provides insufficient incentives to raise own-source revenues; and (iv) difficulties in monitoring payment obligations and overdue bills.

  • The central bank’s (CBK’s) toolkit to safeguard financial stability requires strengthening. Kosovo’s banks have grown rapidly: at end-2011 they held assets of almost 60 percent of GDP, compared to 5 percent of GDP in 2000. Banks are mostly foreign-owned, but funded with domestic retail deposits. While the banking system has remained stable, the legal framework for supervision and regulation as well as the CBK’s capacity to provide emergency liquidity assistance to banks are in need of an upgrade.

A01ufig01

Labor Costs

(Ratio of average wage to per-capita GDP)

Citation: IMF Staff Country Reports 2012, 100; 10.5089/9781475503371.002.A001

Sources: World Bank; national statistics offices and tax administration.
A01ufig02

Exports of Goods and Services

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 100; 10.5089/9781475503371.002.A001

Sources: IMF WEO World Economic Outlook
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Primary Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 100; 10.5089/9781475503371.002.A001

Source: Country authorities; and IMF staff calculations.
A01ufig04

Bank Balances

(Millions of euros)

Citation: IMF Staff Country Reports 2012, 100; 10.5089/9781475503371.002.A001

3. Kosovo has been closely involved with the Fund since becoming its 186th member in 2009.3

  • In July 2010, the Executive Board approved an 18-month Stand-By Arrangement (SBA), to support policy credibility and arrest the decline in bank balances. The SBA went off track without completing a review, however, reflecting inter alia outsized public sector wage increases (by 30-50 percent) as part of the 2011 budget.

  • In June 2011, the authorities requested a Staff-Monitored Program (SMP) until end-2011 to establish a track record of disciplined policy implementation that could lead to a new SBA in 2012. The SMP targeted inter alia: (i) structural fiscal adjustment of 1½ percentage points of GDP in the context of the 2011 and 2012 budgets to gradually move toward a sustainable fiscal stance; (ii) improved budgetary planning and execution; and (iii) steps to strengthen the financial system’s resilience, such as completing the legal and administrative framework for the provision of emergency liquidity assistance (ELA).

  • Implementation of the SMP has been broadly satisfactory (Appendix I). Most quantitative and structural benchmarks for end-September and end-December 2011 were met. Significant overperformance was achieved relative to fiscal targets, with an overall fiscal deficit in 2011 of 1.9 percent of GDP, compared to a program target of 2.9 percent and a deficit of 5.0 percent originally inscribed into the 2011 budget (Figure 2). Most structural conditionality was also met, with important progress especially on financial sector reforms.

Figure 1.
Figure 1.

Kosovo: Cross-Country Comparison of Selected Economic Indicators, 2003-11

Citation: IMF Staff Country Reports 2012, 100; 10.5089/9781475503371.002.A001

Sources: IFS; WEO; World Bank; and IMF staff estimates.
Figure 2.
Figure 2.

Kosovo: Recent Fiscal Developments

Citation: IMF Staff Country Reports 2012, 100; 10.5089/9781475503371.002.A001

Source: Country authorities; and IMF staff calculations.1/ Primary balance excluding highway (R7) expenditures, grants, and dividends.2/ Total revenues excluding grants and dividends.
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Primary Balance

(Millions of euros, cum. from the beginning of the year, excl. highway spending, grants, and dividends)

Citation: IMF Staff Country Reports 2012, 100; 10.5089/9781475503371.002.A001

4. Notwithstanding these efforts, the government’s financial position has deteriorated further. The principal reason is the failure to privatize the telecommunications company (PTK) in 2011 as planned, owing to the withdrawal of one out of two prequalified bidders. The process had to be restarted and is now unlikely to be completed before 2013. Privatization had been expected to generate receipts of at least €300 million (6 percent of GDP). As a result, the treasury’s useable balances with the CBK stood at €160 million at end-2011—about half the level needed to insure adequately against fiscal and financial risks (Box 2)—and would fall further in 2012 in the absence of external support. In a unilaterally euroized economy, useable bank balances serve not only as a buffer against fiscal shocks, they also enable the central bank to act as a lender of last resort. Kosovo’s balance of payments need results from this anticipated shortfall in useable bank balances, which is equivalent to a shortage in foreign currency reserves in an economy with an own currency.

5. At the same time, Kosovo’s economy has remained largely shielded from turbulence in the euro area, owing to limited integration into cross-border financial markets and a small export base (Figure 3). Real GDP growth in 2011 is estimated at 5 percent, driven principally by domestic demand, in particular investment. Inflation moderated to 3.5 percent (y-o-y), after a spike to double-digit figures in early 2011 triggered by higher prices for imported food stuffs. The current account deficit is estimated to have widened to about 20 percent of GDP in 2011, from 17½ percent of GDP in 2010, reflecting mostly higher imports. Strong capital inflows, including FDI from the Kosovo diaspora, have continued to fund the deficit. The Kosovar economy has continued to display resilience also in early 2012, although there are some indications of a modest weakening in domestic demand, such as weaker tax revenues and deposit inflows into banks.

Figure 3.
Figure 3.

Kosovo: Recent Economic Developments

Citation: IMF Staff Country Reports 2012, 100; 10.5089/9781475503371.002.A001

Source: National authorities; and IMF staff estimates and projections

II. The Fund Supported Program

A. Overall Program Objectives

6. The program’s key policy objective is to make further decisive steps toward restoring fiscal sustainability and to anchor fiscal policy, complemented by appropriate structural fiscal and financial sector reforms. With no monetary policy, fiscal policy is the main tool to safeguard macroeconomic stability. Policies to strengthen competitiveness are primarily being addressed by the World Bank in the context of its Sustainable Employment Development Policy Operation (SEDPO) (Box 3). In terms of financing, the purchases under the SBA allow maintaining an acceptable level of bank balances in 2012 and 2013, and therefore adequate resources to insure against fiscal and financial shocks. Bank balances are expected to recover during the course of 2013, when PTK privatization is expected to be finalized. The program is also expected to facilitate donor assistance.

B. Macroeconomic Framework

7. The macroeconomic framework is based on the following assumptions (LOI¶6):

  • Real GDP growth in 2012 is projected at 3.8 percent (Tables 1 and 2). The deceleration relative to 2011 reflects primarily weaker growth prospects for Germany and Switzerland and knock-on effects on domestic demand. In subsequent years, growth is expected to gradually recover, in line with developments in the euro area. The anticipated completion of highway R7 in 2013 would trigger a temporary deceleration in growth in 2014, however.

  • Consumer price inflation is projected at 0.6 percent (y-o-y) for 2012, in line with expected developments for imported goods, even though possible tariff increases in the context of a revamped electricity regulation may partially offset cheaper imports. Deflationary pressures from import prices are projected to keep inflation low also in subsequent years.

  • The current account deficit is expected to narrow somewhat in 2012/13, reflecting weaker domestic demand and higher metals exports (Table 3). FDI and other non debt-creating flows will remain major financing items. Over the medium term, the external balance is expected to gradually improve due to import substitution.

Table 1.

Kosovo: Main Indicators, 2008–17

(Percent, unless otherwise indicated)

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

Projections assume a grant from IDA in 2012.

Based on World Bank estimates.

Temporary deviations from the recommendation may be warranted in case of (i) large anticipated payments, for example on infrastructure, or (ii) large receipts, for example from privatizations.

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

Total foreign assistance excluding capital transfers.

March 2011.

December 2011.

Series updated with the 2011 census.

Table 2.

Kosovo: Real Growth, 2007–17

(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.

Table 3.

Kosovo: Balance of Payments, 2009-17

(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 at historical value.

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

8. The main risk to the outlook is a sharper-than-expected downturn with higher unemployment in Germany and Switzerland, countries where most of the Kosovar diaspora resides. In such a scenario, remittances and FDI inflows would likely slow, with negative repercussions for growth (by curtailing domestic demand), the fiscal position (by reducing consumption taxes) and the financial system (as remittances both fund deposits and are used to service loans). The example of El Salvador during the 2009 financial crisis shows how deteriorating labor market conditions in the emigrants’ host country can undermine growth prospects and budgetary outcomes (Box 4). By contrast, risks from direct financial contagion appear limited: Kosovo’s banking system does not depend on foreign funding, including from parent institutions, while CBK regulations limit asset-side exposure of Kosovar banking subsidiaries to their parents to a small fraction of their capital.

C. Fiscal Policy

9. The authorities and staff agreed that anchoring fiscal policy would be an overarching program objective, with key components as follows (LOI ¶¶7, 8, Tables 4 and 5):

  • Structural fiscal adjustment. The SBA would continue the process of restoring a sustainable fiscal stance that started with the SMP, when 1½ percent of GDP in structural tightening was achieved in the context of the 2011 and 2012 budgets. The objective is to achieve a primary deficit of 0.9 percent of GDP by 2014, which would stabilize public debt in the long term at less than 30 percent of GDP—a level at the lower end of public debt ratios considered sustainable for emerging economies (Appendix II).4 To this end, adjustment of another 1½ percent of GDP is needed relative to the 2012 budget.5 About 0.4 percentage points in adjustment will be achieved through environmental taxes and fees that will be introduced during the second and third quarters of 2012 and that are in addition to the 2012 budget. The remainder would be achieved in the context of the 2013 and 2014 budgets.

  • Bank balances. The program aims at restoring an adequate level of bank balances in 2013 (i.e., of at least €325 million), when PTK is expected to be privatized. For end-2012, an interim level of €187 million is targeted. Achieving this requires—besides the additional revenue measures mentioned above—one-off spending cuts of €20 million (0.4 percent of GDP) and higher dividend payments from PTK as a result of cuts in labor cost of 10-20 percent enacted in early 2012 (LOI ¶¶10, 11).

  • Fiscal rule. A legally binding fiscal rule would provide an operational framework for safeguarding fiscal sustainability even after the program has expired. The rule should take into account transient factors, such as large one-off privatization receipts, and Kosovo’s fiscal decentralization framework. The authorities have requested technical assistance from the IMF to help develop a rule, aiming at incorporating the rule into legislation before the end of the program. With a framework in place that would permanently safeguard confidence in the sustainability of fiscal policy, the government should be able to cover its financing needs in a self-sustained manner—including to maintain an adequate level of cash balances—thus facilitating the graduation from official support.

Table 4.

Kosovo: Consolidated Government Budget, 2011-14

(Excluding donor designated grants; millions of euros; cumulative from the beginning of the year)

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

Including capital transfers to public enterprises.

Based on the WB estimates.

Table 5.

Kosovo: Consolidated Government Budget, 2011-17

(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.

Based on World Bank estimates.

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Kosovo: Public Debt Sustainability1/

Citation: IMF Staff Country Reports 2012, 100; 10.5089/9781475503371.002.A001

1/ This DSA exercise assumes that a notional debt of 7.2 percent of GDP (in present value) inherited from before the conflict will start being serviced in 2017.

10. There was agreement that restraint on current spending and growth friendly revenue measures would remain key components of fiscal adjustment. In particular, public sector wage restraint is vital, to partly compensate for the excessive wage increases in the context of the 2011 budget. Revenue measures would be oriented on the recommendations of an IMF tax policy technical assistance mission of October 2011 (Box 5). Moreover, no measures would be taken that undermine the integrity of the current tax system, especially as regards corporate income tax and Kosovo’s highly effective VAT regime (LOI ¶13).

11. Careful costing of spending initiatives will be at the core of the SBA (LOI ¶15). Several ambitious projects are ongoing or in preparation whose integration into a sustainable budgetary framework requires meticulous design and preparation, and often implementation in a phased manner. These include:

  • the highway R7 to Albania that is scheduled to be completed in 2013. Vigilant cost control will be needed as the project nears finalization, especially with respect to variation costs.

  • another planned highway R6 to Macedonia, for which the government is currently evaluating financing options. Staff and the authorities agreed that preconditions for moving forward with R6 include a transparent financing plan consistent with a sustainable medium-term budgetary framework, and a positive assessment by the World Bank of the project’s economic viability.

  • war veteran benefits, a reform of the health care system, a possible extension of pensioner benefits, and civil service reform, all of which require thorough preparation and costing, in cooperation with the World Bank.

Further, to contain fiscal risks the program specifies several requirements for laws that create or amend benefits (LOI ¶9). These include: (i) only cash benefits will be granted, with no link of benefit levels to the minimum wage; (ii) consideration of new benefits by the cabinet is preceded by fiscal impact assessments that cover a period of at least five years (continuous structural benchmark); and (iii) an article is to be included into any such law that explicitly allows cutting benefits in case of insufficient budgetary funds (continuous structural benchmark).

12. The government has made a promising start in issuing debt to private investors, but further progress is needed before financing needs can be covered in a self-sustained manner (LOI ¶12).

  • T-bill issuance program. Earlier this year, the government conducted three auctions for three-month government T-bills—the first in Kosovo’s history—and raised a total amount of €30 million, mostly from private banks, at effective interest rates of 3.5–4 percent (annualized). Looking ahead, the next step is to increase the maturity of government paper and establish a yield curve. To facilitate this step, the government aims at obtaining a rating from an international credit rating agency later this year.

  • Pillar II pension fund. Part of the planned issuance of government paper in 2012 of €74 million (1.7 percent of GDP) is expected to be purchased by Kosovo’s pillar II pension fund (KPST). To enable such purchases, the assembly passed in early April a revised pension fund law that loosens KPST’s exposure limit to the government from 5 to 30 percent of total assets. At the same time, the law sets a ceiling on annual investments into government paper of 50 percent of previous-year premium inflows into KPST, to protect the integrity of KPST’s investment strategy (prior action).

13. While the authorities agreed with staff that Kosovo’s system of fiscal decentralization requires an overhaul, they argued reforms should advance in a gradual manner (LOI ¶16). The current system is based on a general grant from the central government to municipalities that equips municipalities with adequate resources, but provides little incentives to raise municipal own-source revenues. Further, rigid, centrally set ceilings on current spending provoke an inefficient allocation of resources, characterized by municipal over-investment and insufficient maintenance of the capital stock. An IMF technical assistance mission that visited Kosovo in December 2011 recommended lifting spending ceilings for all categories except wages, and modifying the formula for the general grant in various ways so as to warrant a more equitable allocation of resources across municipalities and provide better incentives to raise own-source revenues (Box 6). The authorities agreed to allow municipalities to allocate own-source revenues freely across spending categories except wages, starting with the 2012 budget (structural benchmark for end-May). They argued, however, that more consultation was needed with municipalities before further steps could be taken. Staff and the authorities agreed to return to this issue during future program reviews.

14. Capacity building is needed to improve the government’s ability to monitor payment obligations (LOI ¶17). Under the SMP, both the central government and decentralized entities repeatedly accumulated small amounts of domestic arrears, reflecting insufficient capacity to record and monitor bills payable. Further, there are deficiencies regarding the timely recording and reporting of payment obligations. The authorities have requested IMF technical assistance to assess capacity constraints. The recommendations of the technical assistance mission may translate into structural conditionality later in the program. By the end of the SBA, the Treasury should be able to monitor all invoices in real time.

D. Financial Sector Policies

15. Kosovo’s banking system has remained profitable, liquid, and well-capitalized, although financial strength varies across banks (Tables 6, 7, Figure 4). Aggregate capital adequacy for the banking system stood at 17.5 percent at end-January 2012, well above regulatory requirements. 5.9 percent of loans were non-performing, down from 6.3 percent a year earlier. Banks also have conservative credit-to-deposit ratios of about 80 percent, and substantial excess liquidity. However, the capital adequacy ratio of a small domestic bank, accounting for 6 percent of the banking system’s assets, dropped temporarily below the regulatory minimum of 12 percent at end-2011, reflecting additional provisions after an on- site audit identified misclassified loans. Since then, the bank’s owners have injected additional capital, and an action plan is being implemented to address the causes underlying the misclassification. The central bank has also requested technical assistance from the IMF to analyze loan documentation and classification practices, as on-site audits have repeatedly encountered irregularities in this area. Further priorities may be identified by an IMF/World Bank mission under the Financial Sector Assessment Program (FSAP), scheduled for the fall of this year (LOI ¶22).

Figure 4.
Figure 4.

Kosovo: Selected Banking Sector Indicators

Citation: IMF Staff Country Reports 2012, 100; 10.5089/9781475503371.002.A001

Sources: Cental Bank of Kosovo; IMF staff estimates.1/ Liquid assets are cash, balances with CBK and commercial banks, and securities.
Table 6.

Kosovo: Central Bank and Commercial Bank Survey, 2008-14

(Millions of euros, unless otherwise indicated)

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