Abstract
This Selected Issues paper on the Republic of Kosovo’s 2013 Article IV Consultation highlights growth and Kosovo’s external environment. In the wake of the global financial crisis, Kosovo’s economic growth slowed but remained positive, while most other Western Balkans slipped into recession. Moreover, the annual average growth rate has been among the highest in the Western Balkans since the onset of the financial crisis in 2007. Kosovo’s tax-to-GDP ratio is comparable to the average of Southeastern Europe, although its tax system relies significantly more on indirect taxation—including a high share of trade taxes. Kosovo’s reliance on trade taxes may create budgetary pressures in the event of further trade liberalization.
Euroization, Liquidity Needs, and Foreign Currency Reserves1
In Kosovo’s unilaterally euroized economy, the government’s deposits with the central bank are the principal instrument to safeguard an adequate level of reserves, and therefore to insure both the public sector and the financial system against liquidity shocks. This chapter discusses operational and analytical challenges in managing reserves in economies with a foreign legal tender, develops a yardstick for bank balance adequacy, and finally explores alternatives to government deposits as the main funding mechanism for reserves.
A. Foreign Currency Reserves in a Unilaterally Euroized Economy
1. Kosovo is one of 13 IMF members that have adopted a foreign currency as legal tender. Using another country’s currency provides for a strong monetary anchor and reduces administrative costs associated with running an own currency. At the same time, the country foregoes seignorage, and the arrangement puts a premium on disciplined fiscal policies, competitive wage levels, and flexibility of the economy to adjust to external shocks.
2. Use of a foreign tender comes with unique operational and analytical challenges for the management of foreign currency (FX) reserves.
First, every liquidity need in the economy is in FX. i.e., cannot be satisfied through domestic liquidity generation (such as traditional lender-of-last resort operations of the central bank).
Second, the standard mechanism to accumulate reserves—issuance of base money to purchase FX assets—is not available.
Third, the definition of FX reserves is somewhat unusual. The IMF BOP manual defines reserve assets as “external assets that are readily available to and controlled by monetary authorities for meeting balance of payments financing needs … Reserve assets must be foreign currency assets” (IMF, 2011a, p. 111). With use of a foreign tender, all central bank assets are in FX—hence ready availability is the main identifying criterion.
IMF Members with a Foreign Legal Tender
Market exchange rates
IMF Members with a Foreign Legal Tender
| Population (millions) | GDP 1/ (billions of USD) | ||
|---|---|---|---|
| U.S. Dollar (8) | |||
| Ecuador | 15.4 | 80.9 | |
| Zimbabwe | 13.2 | 9.8 | |
| El Salvador | 6.1 | 23.8 | |
| Panama | 3.6 | 36.3 | |
| Timor-Leste | 1.2 | 4.2 | |
| Micronesia | 0.1 | 0.3 | |
| Marshall Islands | 0.1 | 0.2 | |
| Palau | 0.02 | 0.2 | |
| Euro (3) | |||
| Kosovo | 1.8 | 6.2 | |
| Montenegro | 0.7 | 4.3 | |
| San Marino | 0.03 | 1.9 | |
| Australian Dollar (2) | |||
| Kiribati | 0.1 | 0.6 | |
| Tuvalu | 0.01 | 0.04 | |
Market exchange rates
IMF Members with a Foreign Legal Tender
| Population (millions) | GDP 1/ (billions of USD) | ||
|---|---|---|---|
| U.S. Dollar (8) | |||
| Ecuador | 15.4 | 80.9 | |
| Zimbabwe | 13.2 | 9.8 | |
| El Salvador | 6.1 | 23.8 | |
| Panama | 3.6 | 36.3 | |
| Timor-Leste | 1.2 | 4.2 | |
| Micronesia | 0.1 | 0.3 | |
| Marshall Islands | 0.1 | 0.2 | |
| Palau | 0.02 | 0.2 | |
| Euro (3) | |||
| Kosovo | 1.8 | 6.2 | |
| Montenegro | 0.7 | 4.3 | |
| San Marino | 0.03 | 1.9 | |
| Australian Dollar (2) | |||
| Kiribati | 0.1 | 0.6 | |
| Tuvalu | 0.01 | 0.04 | |
Market exchange rates
3. The central bank of Kosovo (CBK) considers assets readily available if no nongovernment institution has a claim to them. Not readily available are, e.g., assets administrated on behalf of the Kosovo privatization fund, or the assets in which commercial banks’ reserves (both mandatory and excess) are invested. This criterion renders FX reserves easier to identify from the liability than from the asset side of the central bank balance sheet. In Kosovo, reserves are limited to (i) the central bank’s capital, (ii) Kosovo’s SDR allocation received in the context of the 2009 quota increase, and (iii) the government’s deposits with the central bank.
4. As capital and the SDR allocation are fixed (at least in the short term), the government’s deposits with the CBK are the main instrument to ensure reserves adequacy. A reserves adequacy target therefore translates into a target for the government’s bank balance. This correspondence is not inevitable, however, but the result of Kosovo’s institutional setting (see section C below).
Stylized Central Bank Balance Sheet
Citation: IMF Staff Country Reports 2013, 223; 10.5089/9781484307854.002.A003
Stylized Central Bank Balance Sheet
Citation: IMF Staff Country Reports 2013, 223; 10.5089/9781484307854.002.A003
Stylized Central Bank Balance Sheet
Citation: IMF Staff Country Reports 2013, 223; 10.5089/9781484307854.002.A003
B. How Large Should Kosovo’s Reserves Be?
5. Traditional reserves metrics—such as coverage of a certain number of months of imports, or of a percentage of short-term external debt—do not fit the Kosovo case well. Imports tend to adjust endogenously to remittances and FDI inflows, and do therefore not give rise to a FX financing need. There is also no traded external debt. At the same time, there are other sources of potential FX liquidity needs that are captured by neither metric.
6. A recent IMF paper developed richer metrics for reserves adequacy (IMF, 2011b). The metrics consider several complementary sources of BOP needs, and are oriented on observed reserves holding patterns across countries. While there is no explicit treatment of countries with a foreign legal tender, for countries with a fixed exchange rate—that share many characteristics—the paper recommends the following yardstick:
where STD is short-term external debt at remaining maturity, OPL are other external portfolio liabilities, M2 is broad money, and X is exports. The reserve buffer related to STD insures against disruptions in debt markets, OPL against equity outflows, M2 against a possible depositor run, and X against trade disruptions.
7. Several modifications are needed to transform this yardstick into an operational government bank balance (BB) target.
With unilateral euroization there is no base money, hence M2 is replaced with deposits.
Kosovo’s traded debt consists exclusively of t-bills. While these bills are held mostly by domestically incorporated banks, they are denominated in FX; hence, a FX liquidity buffer is needed to insure against debt market disruptions. The term for short-term external debt is therefore replaced by one for short-term public debt.
There are no other portfolio liabilities, hence this term is omitted—as is the trade term (X), for the reasons sketched above.
At the same time, the government needs a fiscal buffer to insure against shocks to revenues or expenditures. This term needs to be added to the bank balance target. A standard yardstick is one month of government expenditure.
Finally, the central bank’s other freely available resources—the SDR allocation and its capital—are subtracted from the bank balance target.
8. Overall, this results in the following formula:
The equation puts Kosovo’s required government bank balance at about 7 percent of GDP. Under the Stand-By Arrangement, this yardstick serves as a rough orientation point for bank balance adequacy.
Bank Balance Target
(2013, in percent of GDP)
Bank Balance Target
(2013, in percent of GDP)
| Potential sources of liquidity needs | 8.2 | ||
| Government debt market | 1.1 | ||
| Bank deposits | 4.5 | ||
| Banks with ECB access | 3.0 | ||
| Banks w/o ECB access | 1.5 | ||
| Government expenditures | 2.6 | ||
| Minus: central bank own funds | 1.2 | ||
| Target | 7.0 | ||
Bank Balance Target
(2013, in percent of GDP)
| Potential sources of liquidity needs | 8.2 | ||
| Government debt market | 1.1 | ||
| Bank deposits | 4.5 | ||
| Banks with ECB access | 3.0 | ||
| Banks w/o ECB access | 1.5 | ||
| Government expenditures | 2.6 | ||
| Minus: central bank own funds | 1.2 | ||
| Target | 7.0 | ||
9. By far the largest component is the liquidity buffer against possible banking system strains. There are arguments, however, that this buffer may not need to be quite as ample. About two-thirds of the banking system’s deposits are held by subsidiaries of banking groups located in the euro area. The parents of these banks have access to ECB facilities. In case of liquidity strains, the banks probably would and arguably should turn to their parents rather than the CBK. As a result, the CBK may not need to hold the same reserves buffer against deposits of ECB-based banks than against deposits of other banks. Factoring this in results in a range for bank balance adequacy of 4½ to 7 percent of GDP.2
C. Alternative Mechanisms for Funding Reserves
10. Kosovo’s main funding mechanism for FX reserves—the maintenance of high government deposits with the CBK—is problematic in several ways. First, it is difficult politically, as the national assembly needs to approve the government’s bank balance with every annual budget. 4½-7 percent of GDP in deposits are difficult to defend in the face of pressing social and infrastructure spending needs. Second, the arrangement renders the CBK’s ability to inject liquidity dependent on the government’s preparedness to hold deposits, and therefore limits the operational independence of the central bank. While some reserves should arguably always be provided by the government—notably the funds that insure against fiscal shocks—it would seem beneficial to collect reserves also from other sources.
11. There are alternatives. The 2012 IMF/World Bank mission under the Financial Sector Assessment Program (FSAP) proposed financing future increases in the central bank’s special reserves fund (SRF) for emergency liquidity assistance (ELA) by collecting a contribution from banks.3 These funds would—in contrast to the banks’ mandatory and excess reserves—not have claims of individual banks set against them, and therefore satisfy the characteristics of FX reserves.4 While the specifics of such a mechanism remain to be worked out, one option to enlarge the size of the SRF rapidly would be to convert a portion of mandatory bank reserves into pooled SRF funds.
12. Besides managing reserves, the CBK has—and could make greater use of—other options to manage liquidity conditions, in particular by varying banks’ mandatory reserves in line with changes in the macroeconomic environment and systemic risks. This relates to another FSAP recommendation, i.e., to develop a macro-prudential policy framework.
References
IMF (2011a): Balance of Payments and International Investment Position Manual (6th Edition)
IMF (2011b): Assessing Reserves Adequacy, IMF Policy Paper SM/11/31
Prepared by Johannes Wiegand. The chapter builds on earlier work joint with Pablo Druck and Eduardo Castro.
4½ percent of GDP is also the minimum bank balance inscribed into Kosovo’s rules-based fiscal framework.
The SRF was set up and funded in 2012 through a government transfer of €46 million. The SRF counts toward the government’s usable bank balance, although—in contrast to normal government deposits—its resources can be drawn down only with the consent of the CBK.
Ecuador and Panama—both unilaterally dollarized economies—have similar arrangements in place.
