Republic of Kosovo: Staff Report for the 2013 Article IV Consultation
Author: International Monetary Fund. European Dept.
Publication Date:
23 Jul 2013
eISBN:
9781484377987
Language:
English
Keywords:
ISCR; CR; government; Kosovar authorities; government bank balance; banking authority; agreement; banking sector; country authorities; government T-bill market; central bank; GDP deflator; Global
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This staff report on the Republic of Kosovo’s 2013 Article IV Consultation focuses on economic and financial developments. Kosovo’s economy is excessively dependent on inflows from the diaspora. It is found that while these inflows support incomes, they finance primarily consumption and investments in nontradables, such as real estate or services, and contribute little to the build-up of productive capacity. Goods exports are less than 10 percent of GDP and concentrated in sectors with a low-value added component, notably metals. A coherent strategy is needed to improve competitiveness, foster the development of a tradable sector, and lay the basis for self-sustained growth.

Abstract

This staff report on the Republic of Kosovo’s 2013 Article IV Consultation focuses on economic and financial developments. Kosovo’s economy is excessively dependent on inflows from the diaspora. It is found that while these inflows support incomes, they finance primarily consumption and investments in nontradables, such as real estate or services, and contribute little to the build-up of productive capacity. Goods exports are less than 10 percent of GDP and concentrated in sectors with a low-value added component, notably metals. A coherent strategy is needed to improve competitiveness, foster the development of a tradable sector, and lay the basis for self-sustained growth.

Background

A. The Setting

1. Since the 2011 Article IV consultations, Kosovo has taken important steps toward normalizing international relations. The International Civilian Office overseeing Kosovo’s supervised independence ended operations in 2012. In December 2012, the EBRD offered membership to Kosovo, the third large multilateral organization to do so after the World Bank and the IMF. In April 2013, Kosovo and Serbia signed a normalization agreement that includes a mutual commitment not to block one another’s efforts to join the EU. Around 100 states have recognized Kosovo, up from about 70 in 2011. The domestic political environment has remained stable, albeit at times tense.

2. Limited export and financial linkages to crisis countries have contained the impact of the euro area crisis.

  • Growth performance. Annual real GDP growth averaged 4½ percent between 2007 and 2012, despite the headwinds from the global financial crisis and euro area turbulence. With this, real growth was among the highest in the region, although real incomes were affected negatively by secular price increases for imported food stuffs and energy (Box 1).1 At around 35 percent, unemployment remains very high, although much of it reflects arguably informal employment.

  • Resilience. Kosovo’s solid performance owes mostly to the near-absence of financial or export linkages to crisis countries, and its exposure instead to Germany and Switzerland, countries in which two-thirds of the Diaspora reside (Boxes 2, 3). Remittances and FDI from the Diaspora have held up well, and have therefore continued to support domestic demand.2 By contrast, a robust tradable sector that could support self-sustained growth has yet to emerge.

uA01fig01

Western Balkans: Growth, 2007-12

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Source: World Economic Outlook (WEO).

3. In the past two years, macroeconomic policies have been conducted in the context of a Staff-Monitored Program (in 2011) and a Stand-By Arrangement (from 2012). Major advances have been made in this period to restore a sustainable fiscal stance, anchor fiscal policy, improve the preparation and costing of spending initiatives, and strengthen the financial safety net (Box 4). Further, the government is on-track to restore its cash buffers, provided the sale of the telecommunications company PTK proceeds as planned. The authorities have also taken worthy initiatives to strengthen competitiveness and enhance public infrastructure. Progress is fragile, however, and could be undone by adverse political developments. The Stand-By Arrangement—that the authorities are treating as precautionary in 2013—expires toward the end of the year.

B. Recent Economic and Financial Developments

4. Following buoyant growth in 2011, the economy slowed in 2012 and developed unevenly in the early months of 2013.

  • Real growth exceeded 5 percent of GDP in 2011, driven by strong investment and private consumption (Tables 1, 2). The economy slowed in 2012, however, especially during the year’s second half, with FDI and, correspondingly, private investment contracting. The slowdown was accompanied by a deceleration in credit growth from almost 15 percent in 2011 to 4½ percent (Table 3). Nonetheless, at almost 2½ percent, estimated real growth remained the strongest in the region. Growth appears to have been uneven in the early months of 2013: credit, tax collection and imports all point to stronger demand in the first quarter, but more muted activity in April and May.

  • The current account deficit (excluding official transfers) narrowed from more than 20 percent in 2011 to 15 percent in 2012, reflecting primarily weaker imports (Table 4). The trade deficit remained large at about 35 percent of GDP in 2012.3

  • Consumer price inflation moved in line with import prices, notably for food. Core inflation remained contained at around 2 percent, consistent with Kosovo’s use of the euro.

Table 1.

Kosovo: Main Indicators, 2010–18

(Percent, unless otherwise indicated)

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

Data for the first half of 2012.

Total foreign assistance excluding capital transfers.

April 2013.

Series updated according to Kosovo Agency of Statistics (2013), Estimation of Kosovo population, 2012, Pristina, Kosovo.

Table 2.

Kosovo: Real Growth, 2010–18

(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.

Table 3.

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.
Table 4.

Kosovo: Balance of Payments, 2009-18

(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.

uA01fig02

Nominal GDPgrewtra, 2009-2012 (In percent)

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Sojrcs WEO.1/ Swiss norrinal GO3 converted irto Euros.
uA01fig03

Non-performing Loans to Total Gross Loans

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Source: IMF Financial Soundness Indicators (FSI)

5. The banking sector has remained liquid, profitable, and well capitalized, although financial strength differs across banks(Table 5).

Table 5.

Kosovo: Selected Financial Soundness Indicators, 2007–13

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Source: Central Bank of the Republic of Kosovo.

As of Dec. 2012, new capital adequacy rules include an additional capital requirement for operational risk, higher risk-weights for assets rated B-or less, and a deduction for related party loans.

Loans classified as doubtful or loss.

Liquid Assets are cash and balances with the CBK, as well as balances with commercial banks and securities.

Short-term liabilities are deposits, and short-term borrowing and other liabilities (i.e., up to 1 year maturity).

Profits are before taxes and extraordinary items.

Non-interest expenditure from fees, commissions, provisions, and depreciation (i.e., excluding general and administrative expenses).

Non-interest expense including general and administrative costs.

  • Non-performing loans increased from 5.7 percent at end-2011 to around 7½ percent in late 2012 and early 2013. The increase has been concentrated in the corporate sector, arguably reflecting weaker economic activity. NPLs are low compared to the region, however, and are almost fully provisioned.

  • Profitability, as measured by return on assets, halved between end-2011 and early 2013, but remained solid compared to peers. The decline reflects higher loan-loss provisions and lower credit growth.

  • System-wide capital adequacy fluctuated around 18 percent for most of 2011 and 2012. It dropped to around 15 percent in late 2012, as tighter capital rules under the new banking law—which requires deduction of related lending from capital and additional capital buffers for operational risk—took effect.

uA01fig04

Return on Assets, 2012

(percent)

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Sources: Financial Soundness Indicators (FSI); National authorities and IMF staff estimates.

Outlook and Risks

6. The baseline outlook is for a gradual strengthening in activity, in line with expected developments in Diaspora host countries.

  • Staff projects real GDP growth of about 2½ percent in 2013, still significantly below the long-term average. Domestic demand is projected to strengthen somewhat, supported by stronger Diaspora inflows. Exports are also expected to recover, reflecting higher global demand for metals, although their contribution to growth remains small. CPI inflation is projected to decline gradually to below 2 percent, reflecting lower prices for imported food stuffs. The authorities saw upward risk to the growth projections, pointing to anecdotal evidence of import substitution for consumption goods suggesting higher domestic production.

  • In the medium-term, staff projects real growth of about 4½ percent, in line with Kosovo’s average performance of recent years. Although growth would remain driven primarily by domestic demand, staff projects the very gradual build-up of an export sector, as efforts to enhance competitiveness bear some fruit. This would yield a modest improvement in the external balance.

7. Risks to the outlook relate mostly to the external environment in the short-term, and to domestic politics in the longer term(Box 5).

  • Contagion from Diaspora host countries. The key short-term risk is a deterioration in economic conditions in Diaspora host countries that would curtail remittances and FDI, with negative repercussions for growth—by dampening domestic demand—the public finances—through lower border tax receipts—and financial stability—as remittances both fund deposits and are used to repay loans.

  • Bank lending. A related risk are restrictive lending policies of subsidiaries of euro area parent banks—Kosovo’s three largest banks are headquartered in the euro area. Such policies could be triggered by pressures to preserve capital for the consolidated banking group. However, a possible decline in their lending activity could be compensated in part by Turkish and Albanian banks that have gained market share recently.4

  • Political risk. The biggest threat to medium-term prospects are policies that would undermine macroeconomic stability and competitiveness. While policy implementation has been remarkably disciplined in the past two years, the risk of policies that react to short-term political pressures but can do harm in the longer term is considerable, especially in the context of electoral campaigns. A case in point are the public sector wage increases of 30-50 percent in the wake of the 2010 campaign that forced Kosovo’s previous SBA irrecoverably off-track.

uA01fig05

Share of Loans to Industry, 2012

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Sources: Central Bank of Kosovo; and IMF staff calculations.

Policy Discussions

A. Kosovo’s Growth Model and Competitiveness

8. The authorities and staff agreed that Kosovo’s economy is excessively dependent on inflows from the Diaspora(Figure 1). While these inflows support incomes, they finance mostly consumption and investments in non-tradables, such as real estate or services, and contribute little to the build-up of productive capacity. Goods exports are less than 10 percent of GDP and concentrated in sectors with a low-value added component, notably metals. This lopsided structure exposes the economy not only to developments in Diaspora’s host countries, it also casts doubt on the growth model’s long-term sustainability should the Diaspora become less attached to Kosovo.

Figure 1.
Figure 1.

Kosovo: Real and External Sector Developments, 2007-12

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Sources: World Economic Outlook; and Kosovo Statistics Office.1/ Average for 2009 - 2012 data.2/ Data for the first half of 2012.

9. While data limitations complicate the assessment of external competitiveness, staff argued that the available indicators paint an unfavorable picture(Box 6, Figure 2).5 The CPI-based real effective exchange rate (REER) has changed little since the 2011 Article IV consultation, but its evolution reflects mostly import prices and is therefore of little relevance for competitiveness.6 Wages are modest in nominal terms but elevated once scaled with a measure of productivity, suggesting REER overvaluation.7 Lack of wage competitiveness is reinforced by structural impediments, such as a deficient public infrastructure, weak governance, and a difficult business environment. Unsettled relations with Serbia and incomplete international recognition also deter investors.

uA01fig06

Effective Exchange Rates

(2005=100)

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Figure 2.
Figure 2.

Kosovo: Labor Markets, Governance, Business Environment, and SMEs

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

10. There was agreement that a coherent strategy is needed to improve competitiveness, foster the development of a tradable sector, and lay the basis for self-sustained growth. Key pillars of such a strategy should include (i) investments in infrastructure and education, (ii) reforms to strengthen the business climate, (iii) initiatives to support the development of small- and medium-sized enterprises (SMEs), and (iv) wage restraint and the maintenance of flexible labor markets—which are especially critical in view of Kosovo’s unilateral euroization that limits the authorities’ means to react to shocks.

uA01fig07

Average wage to GDP per Capita

(2010, ratio)

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Source: IMF staff calculations.

11. The strategy could build on steps the authorities are already taking, notably:

  • Almost 40 percent of the government budget is spent on capital expenditures, including the authorities’ ambitious highway construction program. The government is also working with the World Bank on upgrading energy supply.

  • Initiatives to streamline business registration and protect investors that helped Kosovo gain about 30 ranks in the World Bank’s 2013 ‘Doing Business’ survey. The government has also initiated a development strategy for SMEs aimed at improving access to finance and enhancing their competitiveness, in cooperation with donors.

  • Improvements in the regional political climate and closer integration with the European Union (EU). In particular, the authorities expect to enter into negotiations for an association and stability agreement with the EU in the second half of 2013 or early 2014.

Staff noted that the success of these initiatives could be undermined by inconsistent, countervailing measures, such as outsized public sector wage increases.

B. Fiscal Sustainability

12. In the past two years, Kosovo has restored a sustainable fiscal stance(Table 6).

Table 6.

Kosovo: Consolidated Government Budget, 2011–18 1/

(Excluding donor designated grants; percent of GDP)

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

Does not yet reflect the GFSM 2001 methodology to ensure consistency within a program context.

Including capital transfers to public enterprises.

  • Structural adjustment. The government implemented adjustment of about 2½ percent of GDP in 2011-13 through a mix of revenue measures and expenditure-saving structural reforms, notably in the energy sector. The resulting fiscal stance is sustainable, provided capital spending—which has fluctuated considerably in recent years, reflecting in part ambitious infrastructure projects—converges to around 10 percent of GDP.

  • Fiscal rule. To lock in the adjustment achieved under the SBA, fiscal policy will from 2014 be anchored by a fiscal rule that is expected to be enacted in early July. The fiscal rule sets a ceiling for the general government deficit of 2 percent of GDP, consistent with keeping gross public debt at or below 30 percent of GDP. Capital projects are exempt from the ceiling provided (i) they are financed from privatization receipts and (ii) the government bank balance exceeds a minimum threshold of 4½ percent of GDP.8

  • Financing. In the medium-term, the fiscal deficit is expected to be financed primarily through the issuance of securities. The government T-bill market—set up only in 2012—has been off to a good start, with net issuance of 1½ percent of GDP in 2012, maturities of up to one year, and nominal yields between ½ and 3½ percent. T-bills have been purchased mostly by domestic banks. However, it may take a few years until the market will be sufficiently deep to cover the government’s financing needs in a sustainable manner.

uA01fig08

Public Debt Sustainability

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

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

13. The authorities and staff discussed challenges to revenue policy. Staff argued that the government revenue structure was efficient, but would require reform as Kosovo integrates more closely with the EU and shifts toward self-sustained growth.

  • Structure. Government revenue is heavily tilted toward indirect taxes, with more than 80 percent of receipts stemming from VAT, excises, and customs duties. This structure is well aligned with the import-heavy, transfer-dependent nature of Kosovo’s economy and has proven revenue effective, owing in large measure to Kosovo’s well-designed VAT system (Box 7).

  • Challenges. Staff suggested that challenges ahead include (i) replacing customs duties as integration with the EU advances, and (ii) shifting gradually to direct taxation as domestic production increases. The revenue loss from trade taxes could be replaced, at least in the short term, with VAT, as Kosovo’s VAT rate is among the lowest in the region. Strengthening direct taxation, while desirable, is politically and administratively more difficult. Options include broadening the income tax base, reviewing relatively low direct tax rates, and strengthening the local governments’ use of property taxes.

  • Authorities response. The authorities largely concurred with staff’s analysis, but emphasized the importance of phasing gradually in tax losses from upcoming free trade agreements—notably with Turkey and the EU. They also pointed to lowering the VAT threshold as an alternative to rate hikes, arguing that capacity in tax administration had increased to a point where this was feasible.

uA01fig09

Kosovo: Tax structure, 2006-2011

(Percent of tax revenue)

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Source: World Economics Outlook (WEO); and country authorities.
uA01fig10

Revenue Structure and Structure of the Economy

(annual average, 2006-11)

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

14. There was agreement that the public sector’s expenditure structure is conducive to growth, but may be difficult to sustain in view of pressing social needs. Government spending is modest compared to peers, and heavily tilted toward public investment. While this structure is supportive of economic development, it may be unavoidable that the current spending envelope would, over time, become gradually more similar to that of neighboring countries.9 Staff emphasized the need to manage this process in an orderly manner, rather than reacting ad hoc to spending pressures.

uA01fig11

Goverment Spending

(Share of GDP, 2006-11 average))

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Sources: World Economics Outlook (WEO); and country authorities.

15. More generally, staff urged to continue the practice of careful budgetary planning and costing to prevent unfunded spending initiatives. While under the SBA, spending initiatives proceed only after thorough costing—examples include health reform and increases in the basic pension—there have repeatedly been proposals for benefits with unknown budgetary impacts. Staff pointed to examples of neighboring countries where poorly designed benefits had created budgetary burdens exceeding the financial capacity of the sovereign.

16. The authorities and staff discussed the adequate level of the government’s bank balance with the central bank. In Kosovo’s unilaterally euroized economy, the bank balance is the main tool to safeguard an adequate level of reserves, and therefore to insure both the public sector and the financial system against liquidity shocks.

  • SBA yardstick. The yardstick for bank balance adequacy under the SBA—derived from a rule-of-thumb for reserves in countries with a fixed exchange rate—is purposely ambitious, and results in a recommended balance of about 7 percent of GDP. The authorities noted that the bank balance had to be approved with each budget, and that a high level was difficult to defend politically, given urgent capital and social spending needs. They argued that the minimum inscribed into the fiscal rule legislation—4½ percent of GDP—was more feasible.

  • Alternatives. While staff saw indeed room for lowering the yardstick relative to the level recommended under the SBA (Box 8), it encouraged exploring options to fund a higher portion of reserves from other sources than government deposits, with a view to “depoliticizing” cash buffers. The proposal of the 2012 FSAP to fund increases in the emergency liquidity assistance (ELA) facility for banks through a bank premium is a step in this direction. The authorities agreed, and have started preparatory work on an ELA bank premium (¶18).

C. Financial Sector Development

17. While Kosovo’s banking sector has grown rapidly in the last decade, weaknesses in contract enforcement pose an obstacle to future financial development(Box 9, Figure 3). Kosovo emerged from Yugoslavia’s civil war without a functioning banking sector. In the 2000s, Kosovo caught up rapidly: credit and deposit growth was among the highest in the region, intermediated primarily by subsidiaries of euro area based parent banks, and aided by Kosovo’s unilateral adoption of the euro. The process has slowed recently, however, suggesting that a saturation point may have been reached. Moreover, other segments of the financial system—in particular insurance and securities markets—remain underdeveloped. Progress on efficiency—as measured by the loan-deposit interest rate spread—has been slow. Banks reported that weak contract enforcement contributed to intermediation spreads and inhibited the development of new banking products, such as longer-term mortgage lending.10

uA01fig12

Real Credit Growth (2003-12)

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Source: International Financial System; and IMF staff c alculations.
Figure 3.
Figure 3.

Kosovo: Financial Sector Depth, Reach, and Efficiency

Citation: IMF Staff Country Reports 2013, 222; 10.5089/9781484377987.002.A001

Sources: IMF IFS and FAS; World Banks Finstat Database; and IMF staff calculations.

18. The authorities and staff followed up on the analysis and policy recommendations of the 2012 FSAP mission.

  • Resilience to shocks. The FSAP results suggest resilience of the banking system to a wide range of shocks, including turbulence in the euro area (Box 10). Pockets of vulnerability remain, however, primarily from loan and deposit concentrations in some banks, maturity-mismatches, and external assets exposures.

  • Supervision. While the FSAP commended the central bank for a high degree of professionalism in banking supervision, it noted a relatively narrow focus on credit risk. Staff argued—and the authorities agreed—that this focus was adequate for now, but that a gradual move to comprehensive risk-based supervision was desirable. Staff also argued in favor of the development of a macro-prudential policy framework, given Kosovo’s unilateral euroization and the absence of an independent monetary policy.

  • Legal and institutional framework. The FSAP noted significant progress since the 2011 Article IV consultation, notably passage of the Banking Law in 2012 that enhances bank governance standards and resolution powers, and the establishment of a special reserves fund (SRF) for ELA under the exclusive control of the central bank. The FSAP recommended steps to further strengthen the crisis management framework, in particular funding future increases of the ELA facility through a bank premium.

Most recommendations have since been taken up in the context of the SBA. For technically more challenging proposals—including risk-based supervision, the macro-prudential policy framework, and the ELA bank premium—technical assistance is required and is expected to be delivered in the next 12 months.

Staff Appraisal

19. Kosovo’s economy has performed remarkably in the face of headwinds from the global financial crisis and euro area turbulence. Since the onset of the financial crisis in 2007, annual real GDP growth has never been less than two percent, and average growth has been among the highest in the Western Balkans. The resilience owes to a confluence of circumstances, however, that is unlikely to be sustained. Kosovo’s economy depends heavily on FDI and remittances from the Diaspora that lives mostly in Germany and Switzerland. As these economies have held up well, Diaspora inflows have been stable, and have therefore continued to support household incomes and domestic demand. Kosovo’s concentrated external exposure would turn into a risk, however, should the prospects for the Diaspora host countries change, or in case the Diaspora would become less attached to Kosovo. Insuring against such risks requires the development of a robust tradable sector that could support self-sustained growth.

20. Since the 2011 Article IV consultation, Kosovo has taken important steps toward building a more competitive economy. The strengthening of the investor climate, investments in public infrastructure, cautious public sector wage policies since 2011, SME development, and a rules-based framework for setting minimum wage levels11 all point in the right direction, as do recent steps to normalize cross-country relations within the region and integrate Kosovo closer with the EU. While there are some indications that these efforts are already bearing fruit—notably anecdotal evidence about import substitution for consumption goods—enhancing competitiveness and building a tradable sector is a long-term process that requires patience and stamina from policymakers. Kosovo’s competitiveness strategy could usefully be reinforced by efforts to strengthen education and training.

21. Kosovo has also made large strides toward fiscal sustainability. In the past two years, a sustainable budgetary stance has been restored through a mix of revenue measures and expenditure-saving structural reforms. Future budgets would be guided by the rules-based fiscal framework. However, the framework needs to be complemented by sound fiscal practices, notably the careful costing and planning of spending initiatives, with respect to both social spending—where policymakers need to resist temptations to react ad-hoc to spending pressures—and investment projects, such as the government’s ambitious highway construction program. Otherwise, unfunded expenditure obligations could rapidly put fiscal achievements at risk. Avoiding such an outcome is a common responsibility of all stakeholders.

22. Upcoming challenges to revenue policy require careful preparation. The public sector relies heavily on indirect taxation, which is appropriate for now given the transfer-dependent, import-heavy structure of the economy. Looking ahead, however, customs duties will need to be replaced as Kosovo integrates more closely with its neighbors, including the EU; and the government will need to strengthen its ability to tax the domestic economy as Kosovo’s growth model shifts from dependence on transfers to domestic production. The recommendations of an IMF technical assistance mission from 2011 on tax policy—increasing environmental taxes and tobacco excises, broadening the tax base and increasing progressivity, and gradually raising income and property taxes from current low levels—remain topical.12

23. The government’s bank balance is a critical prudential buffer that needs to be guarded carefully. The floor on the bank balance inscribed in the rules-based fiscal framework of 4½ percent of GDP is at the lower range of levels that can be considered adequate. The government should aim at exceeding this floor when anticipating large payment obligations, such as multi-year investment projects or debt servicing obligations. The government and the central bank should also continue to explore options to fund a portion of reserves from non-government sources, notably a premium on banks to fund future increases of the special reserves fund for emergency liquidity assistance.

24. Kosovo’s financial sector has grown rapidly in the past decade, but appears to have reached a saturation point where further progress requires strengthening institutions. Banking sector depth is now at or even above levels of countries with similar characteristics. At the same time, credit intermediation spreads remain high, reflecting high credit risk and slow and incomplete contract enforcement by the judicial system.

25. Persistent supervisory vigilance, exercised by a strong and independent central bank, is critical to preserve banking sector stability. Banks display generally adequate capital buffers and profitability, a modest level of non-performing loans, and high liquid reserves. They have also avoided funding imbalances typical for many other countries in Emerging Europe. Looking ahead, a gradual move to comprehensive risk-based supervision and the development of a macro-prudential policy framework are called for to contain financial risks. Commendable steps have been taken to strengthen the financial safety net; priorities ahead include the establishment of a permanent funding mechanism for the SRF.

26. It is recommended that the next Article IV consultation with Kosovo to take place in accordance with the provision of Decisions No. 14747-(10/96)

Kosovo’s Growth Record in Perspective

Kosovo’s economy grew on average by 4.3 percent per year in the past decade (2003-2012), which places Kosovo at the top of the region. The comparison looks even more favorable when slightly different base periods are chosen.

Nonetheless, there is a widespread perception that growth has been insufficient to generate satisfactory improvements in living standards. Several factors may contribute to this perception.

  • Population growth. At 1.5 percent, Kosovo’s annual population growth was the highest in the region. Per-capita real GDP grew by 2.8 percent in 2003-12, which does not stand out.

  • Adverse import price developments. The consumer price index grew faster than the GDP deflator (2.3 percent vs. 1.2 percent annual average), as import price inflation reduced the population’s purchasing power. Kosovo was affected worse by this relative price change than neighboring countries. A rough indicator for the improvement in average living standards is real per-capita GDP growth adjusted for the differential between the increases in the CPI and the GDP deflator.1 This indicator places Kosovo at the bottom of the region.

  • Higher prices for food and energy. Food and energy prices increased by even more than the average CPI, especially from 2007. These items tend to be consumed disproportionately by lower-income households, suggesting that poorer Kosovars fared worse than the average population.

Growth and Living Standards, 2003-2012

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Source: IFS; and IMF Staff Computations