Abstract
This staff report on the Republic of Kosovo’s Fourth Review under the Stand-By Arrangement discusses macroeconomic and financial policies. Banking-sector soundness indicators have remained largely unchanged. The revenue shortfall owed to a mix of lower than programmed customs receipts, and delays in receiving transfers from the sales of telecommunication licenses, and lignite royalties. The shortfall was only partially compensated by higher domestic tax collection, and the earlier than expected receipt in dividends from Post and Telecom of Kosovo. Passage of the rules-based fiscal framework would be a key step toward ensuring fiscal sustainability in the longer term.
On behalf of our Kosovar authorities, we thank staff and Management for the fruitful policy discussions and support during the 2013 Article IV consultations and the fourth review under the Stand-by Arrangement. These exchanges of views are very helpful for the authorities when designing their policies.
Since the last review in April, there have been very positive developments in terms of relations with the European Union (EU). On April 19, 2013, the governments of Kosovo and Serbia completed an agreement that would allow both countries to apply for EU membership, a significant improvement towards normalizing relations. Following this major step, there were rounds of talks between delegations from both countries. On June 28, 2013, the European Council announced the decision to begin negotiations for a Stabilization and Association Agreement (SAA) between the Republic of Kosovo and the EU. The SAA is the first contractual agreement between the Republic of Kosovo and the EU which provides a perspective for Kosovo’s full membership. The start of negotiations for an SAA with the EU bodes well for the country’s economic prospect.
The Article IV report’s findings illustrate that the economy has performed strongly, despite headwinds from the global financial crisis and turbulence in the euro area. Growth has continued to stay over 2 percent since 2007 and average growth has been the highest among peer countries. Macroeconomic fundamentals have been strengthened with the support of the Stand-by Arrangement. Very limited financial and export linkages to countries most affected by the euro area crisis and strong remittances from Germany and Switzerland have positively contributed to Kosovo’s growth prospects.
Growth Outlook
The economy is expected to gradually accelerate throughout 2013 and continue along the path to 4.5 percent growth over the next few years. In the coming period, favorable demographics, the strong banking sector, remittances, and foreign direct investment will be important pillars for strong growth performance. There are encouraging signs in terms of an increase in domestic production, which substitutes imports for domestic consumption. Improvements in competitiveness and continued support from the Diaspora are expected to boost the economy’s medium-term growth prospects.
The authorities are mindful of the need to increase the economy’s productive capacity for sustainable growth. To this end, the authorities have committed to strengthening infrastructure, improving the business climate, and increasing regional integration. In order to improve infrastructure, budget spending has focused mainly on capital expenditures. With regard to the business climate, the authorities continue to develop the business environment beyond achieving a significant improvement in the World Bank’s 2013 Doing Business survey. As an important step, the Kosovar authorities have initiated a development strategy for small and medium enterprises (SMEs) which could improve their access to finance and enhance competitiveness. For more regional integration, the authorities are gearing their efforts towards entering into negotiations for a Stabilization and Association Agreement with the EU.
Fiscal Policy
The authorities have been cognizant of the importance of strong fiscal balances in a highly uncertain global environment. Fiscal adjustment was implemented through a mix of revenue and expenditure measures. The authorities are keen on maintaining the sustainable fiscal stance with the help of prudent policies in capital spending. To this end, a rules-based fiscal rule will be in place starting from July 2014. The rule has been designed to keep the general government deficit as well as gross public debt under control. In order to support the economy’s growth potential, capital projects are exempt from the ceiling; depending on the privatization receipts and the level of the government bank balance. The authorities attach utmost importance to the level of the government bank balance, which is critical to safeguarding an adequate level of reserves that would insure both the public and financial system against liquidity shocks. Taking Kosovo’s development needs and prudent fiscal policies into consideration, 4.5 percent of GDP seems to be feasible for the adequate level of government bank balance. Nevertheless, the authorities are aware of the need for targeting higher levels due to multi-year investment projects or debt servicing obligations.
Financial Sector
The 2012 FSAP findings revealed that the banking sector has remained liquid, profitable, and well-capitalized. Although there is an increase in non-performing loans (NPLs), they are comparably low and almost fully provisioned. The banking authority is monitoring the risks stemming from weaker economic activity. The return on assets is one of the highest in the region. The capital adequacy ratio of the system is around 15 percent, the effect of tighter capital rules under the new banking law. The banking subsidiaries of euro area banks are largely deposit-funded and there is limited risk of deleveraging. Lending activity is also expected to be supported by new banks in the system.
The authorities are closely following the 2012 FSAP recommendations to strengthen the oversight of the financial sector. In this regard, the authorities have started numerous initiatives in supervision and in the legal and institutional framework. Recently, they began a study on an emergency liquidity assistance facility for banks through a bank premium. They are also working with other international organizations and donors on improving the property registry and NPL resolution, the court process for contract enforcement, and establishing a mortgage market. Once completed, these initiatives will positively contribute to the growth performance and the banking sector.
Structural Reforms
The authorities are keen on strengthening the competitiveness of the economy. Despite improvements in many areas, public infrastructure – notably energy and transport – are the main challenges to a better investment environment. The high level of capital spending is expected to close the gap and improve public infrastructure. Additionally, the authorities have learned the lesson of the huge public sector wage increases related to the 2010 election campaign and therefore pay due regard to the importance of cautious public sector wage policies and a rules-based framework for setting wage levels to improving competitiveness.
Program Performance and Next Steps
The authorities have shown strong commitment to the program targets. All end-April quantitative performance criteria were met. All continuous performance criteria and most applicable structural benchmarks were also met. Although indicative targets on the nonaccumulation of domestic payments arrears by the central and general governments were not met, they were missed only by small margins and corrective actions were taken. The authorities are ready to take further measures, as needed, to safeguard compliance with the program targets.
The authorities are keen on maintaining sound fiscal policies. The 2013 budget execution has been in line with program targets. In order to keep up with the targets, the authorities have submitted the mid-year budget to the assembly, in line with prior actions and supporting measures. The fiscal rule, which is a critical pillar for the program, is planned to be finalized by parliament in early July 2013 to be in place for the 2014 budget. Under the guidance of the rules-based fiscal framework, the 2014 budget will be submitted to the assembly in line with program targets.
The authorities continue to further strengthen financial sector surveillance in parallel with FSAP recommendations. The authorities will improve the crisis management framework and institutional capacity. The establishment of the National Council on Financial Stability and Crisis Management will be instrumental in following up and working on key FSAP recommendations.
The authorities are attaching utmost importance to competitiveness and structural reforms. With regard to improving infrastructure, they are committed to the preparation of the planned highway R6 to Macedonia by limiting risks to public finances and safeguarding economic viability. In order to limit risks stemming from wages, the authorities will issue an administrative instruction in coordination with the Fund and World Bank staff. The Kosovar authorities will continue projects with international organizations and donor institutions to improve access to finance for SMEs.