Republic of Kosovo: Staff Report for the 2015 Article IV Consultation

KEY ISSUES Context: Following a six-month political stalemate, the largest two parties reached an agreement in December to form a grand coalition, which enjoys a comfortable majority in parliament. The remittances-fueled growth is set to continue in the near term, but deep challenges remain in view of Kosovo’s narrow export and productive base, low employment ratios, and incomes that are among the lowest in Europe. Fiscal Policy: Following very generous pre-electoral promises, gradual fiscal adjustment is required to preserve the credibility of the fiscal rule and safeguard low public debt levels. Measures should focus on arresting the rapid growth in unproductive current spending, so as to reduce the deficit while creating space for priority areas such as infrastructure, education, and health. Financial Sector: The banking sector has remained well-capitalized, liquid, and profitable. Good progress has been made in enhancing banking supervision as well as the Emergency Liquidity Assistance (ELA) framework. Given low credit penetration, the main challenge is to harness available liquidity so that banks can further support investment and growth: this will require improvements in the weak judiciary, as well as tackling the sizable informal economy. Structural Issues: The key structural challenge is to address the large wage and non- wage competitiveness gap. Gradually deflating high public sector wages will help with the former. As for the latter, the focus should be on tackling the large skills gap by enhancing educational quality—particularly vocational training—and complementing de jure improvements in the business environment with de facto progress. Upgrading energy infrastructure, including a new power plant, is important to avert a future energy crisis. Previous IMF advice: Implementation of Fund advice remained strong throughout the Stand-By Arrangement, which expired in December 2013. However, measures contrary to the spirit of the arrangement were taken immediately after the program’s expiry. This is the first Article IV consultation since July 2013.

Abstract

KEY ISSUES Context: Following a six-month political stalemate, the largest two parties reached an agreement in December to form a grand coalition, which enjoys a comfortable majority in parliament. The remittances-fueled growth is set to continue in the near term, but deep challenges remain in view of Kosovo’s narrow export and productive base, low employment ratios, and incomes that are among the lowest in Europe. Fiscal Policy: Following very generous pre-electoral promises, gradual fiscal adjustment is required to preserve the credibility of the fiscal rule and safeguard low public debt levels. Measures should focus on arresting the rapid growth in unproductive current spending, so as to reduce the deficit while creating space for priority areas such as infrastructure, education, and health. Financial Sector: The banking sector has remained well-capitalized, liquid, and profitable. Good progress has been made in enhancing banking supervision as well as the Emergency Liquidity Assistance (ELA) framework. Given low credit penetration, the main challenge is to harness available liquidity so that banks can further support investment and growth: this will require improvements in the weak judiciary, as well as tackling the sizable informal economy. Structural Issues: The key structural challenge is to address the large wage and non- wage competitiveness gap. Gradually deflating high public sector wages will help with the former. As for the latter, the focus should be on tackling the large skills gap by enhancing educational quality—particularly vocational training—and complementing de jure improvements in the business environment with de facto progress. Upgrading energy infrastructure, including a new power plant, is important to avert a future energy crisis. Previous IMF advice: Implementation of Fund advice remained strong throughout the Stand-By Arrangement, which expired in December 2013. However, measures contrary to the spirit of the arrangement were taken immediately after the program’s expiry. This is the first Article IV consultation since July 2013.

Context, Outlook, and Risks

1. Kosovo enters 2015 with a stable government. A six-month political stalemate following the inconclusive June 2014 elections ended with the formation of a grand coalition. The government holds a comfortable majority in parliament, and past experience has shown that such coalitions can be stable and conducive to effective policy-making.

2. Since the 2013 Article IV consultation, some progress has been made in normalizing international relations. At present, the Republic of Kosovo has been recognized by 108 UN member states and 23 EU member states. Under the EU-sponsored dialogue, there has been progress in normalizing relations with Serbia. However, lack of full international recognition remains an obstacle to greater political integration and economic development. Kosovo is a potential EU candidate and a Stabilization Association Agreement (SAA)—the first step toward official candidature—could be signed this year or next.

3. Despite political uncertainty last year, economic performance has remained resilient. In 2014, GDP growth is estimated at about 2¾ percent, somewhat lower than in 2013 but still near Kosovo’s five-year average of 3.5 percent (the highest in the Western Balkans). Steady remittances helped, as witnessed by consumption growing at close to 4 percent. This year, growth in Germany—the main Diaspora country—the full-year impact of large wage increases granted before last year’s elections (see below), and a ramp up in highway construction should again support growth of circa 3 percent, despite a gradual, multi-year pullback from the donor sector as Kosovo graduates from acute nation-building needs. As in other countries in the region, low energy prices and ties to developments in the euro area have pushed inflation into negative territory (-0.3 percent y/y in March). Modest inflation is expected for the year as a whole, at best.

A01ufig01

Real GDP Growth

(2009-14 average)

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

Source: World Economic Outlook.
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Price Indices (end of period)

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

4. The trade and current accounts remain in large deficit, but financing is stable and reserves are ample. Given the narrow productive base, most consumption and investment goods are imported, fueling a very high trade deficit (about 30 percent of GDP). Financing sources are relatively stable and generally non-debt creating, with the main contribution coming from remittances, official transfers, and FDI—the last is also largely associated with the Diaspora. Gross international reserves of some 18 percent of GDP are ample relative to a conservative variant of the Fund’s adequacy metric, which suggests reserve buffers equivalent to 12 percent of GDP (Annex II).

5. Medium-term growth prospects appear insufficient to significantly lift incomes and improve labor outcomes. Barring reforms, medium-term economic growth will remain dependent on the same remittance-based model and would not be expected to exceed the recent 3.5 percent average. With income per capita of €3,000, one of the lowest in Europe, higher growth is needed to accelerate convergence towards the Western Balkans average. Higher growth would also be needed to generate jobs in the context of very high unemployment (30 percent), very low employment (40 percent), and fast population growth.

6. Risks to the short-term outlook remain evenly balanced (Annex III).

  • Upside risk in the next 12 months: stronger impact on consumption from last year’s public wage increase. The impact on consumption of the large wage increase last year, which has been modest so far, could surprise positively now that uncertainty related to the political stalemate is resolved.

  • Downside risks in the next 12 months: renewed emigration and possible disruptions to electricity supply. A recent emigration wave, facilitated by easier border entry into Serbia and reflective of a lack of hope among segments of the population, has now calmed down but could begin anew, as it unpredictably did six months ago. Separately, further breakdowns in the two old power plants would result in new electricity cuts and possibly higher tariffs to pay for imports.

  • In the medium term, the risk of a “new mediocre” in Europe would affect Kosovo via lower remittances from Diaspora countries as well as lower exports. On the upside, implementation of the government’s ambitious structural reform agenda could lift potential growth above the baseline.

  • Exposure to regional risks. Intensification of Russia/Ukraine tensions will not have any direct impact, but may affect Kosovo indirectly via the Diaspora residing in high-income European countries. Similar indirect channels would apply with regards to developments in Greece.

Authorities’ views

7. The authorities broadly shared this assessment. In their view, growth could reach 4 percent this year, although they view any differences with staff’s forecast at this stage as within the range of uncertainty. They also agreed with the risks presented, although they are more sanguine about positive confidence effects in the short term coming from implementation of their reform agenda. They also see upside risks in the near term from the euro area, given euro depreciation, lower oil prices, and the impact from ECB’s quantitative easing. Looking towards the medium term, they remain concerned by modest growth prospects, agreeing that higher medium-term growth is needed to meaningfully lift incomes and provide jobs for many in society. In fact, they see addressing infrastructure impediments and boosting the productive and export capacity of the economy as the number one economic challenge and priority facing the country.

Report on the Discussions

A. Public Finances

8. The budget situation has deteriorated. Before the June elections, the government awarded a 25 percent increase in public sector wages and social pensions, promised new benefits for war veterans and prisoners of war, and signed a generous collective agreement on labor relations. Combined, these measures have triggered a sharp increase in current spending, and the authorities managed to contain last year’s fiscal deficit excluding PAK spending at 2.4 percent of GDP1 only thanks to a 2 percent of GDP under-spending of the capital budget.

9. Staff warned that this year’s deficit will be significantly higher than budgeted. Given the long time needed to form the new government, parliament decided to approve a “technical” budget that had been prepared by the caretaking administration several months prior. The problem is that this budget relies on overly optimistic revenue assumptions. Assuming more realistic revenue outcomes, and given the full year effect of the pre-electoral promises together with the expected ramp up in spending on the new route to Macedonia,2 the deficit could reach 3.5 percent of GDP this year. In fact, the deficit would have been higher were it not for recent decisions to increase excise rates on a number of goods and to hold off on filling some open vacancies in the public sector, both of which staff support.

10. Fiscal deficits are expected to remain elevated in the medium term. Under the baseline scenario, the deficit is projected to steadily increase and reach 4.7 percent of GDP in 2020. This is because there are a number of one-off revenues that are expected to taper off after 2016, while net interest payments may increase as debt is accumulated. Under this baseline, public debt would steadily creep up to over 30 percent of GDP by 2020 (Annex IV). Moreover, this baseline scenario includes a number of risks (possibly up to 1-1½ percent of GDP), including potentially higher-than-budgeted costs of implementing the collective agreement, uncertainty over the final bill of the war veterans package, erosion in tax bases from trade agreements and, last but not least, the possibility that the transformation of Kosovo’s Security Forces into Armed Forces would trigger additional spending.

11. Beyond deficits, staff drew attention to the worsened composition of the budget. Given large pre-electoral packages before the 2011 and 2014 elections, current spending is expected to increase by 4.3 percentage points of GDP in 2010–15, mostly due to the wage bill (2.7 percentage point of GDP) and pensions (1.7 percentage points of GDP). Since independence, public sector wages have more than doubled, vastly outpacing productivity, private sector wages, or public wages in other Western Balkan countries. To accommodate this sharp increase in current spending, capital spending has been substantially cut over the same period (4 percentage point of GDP), despite Kosovo’s urgent development needs. Moreover, education spending has remained low compared to peers and is in fact on a declining path.

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Trends in Average Public and Private Sector quarterly wages1/

(Euros)

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

1/ 2014 data on private sector wages is preliminary
A01ufig04

Capital Spending

(percent of GDP)

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

12. Staff recommended a gradual consolidation path to preserve the credibility of the fiscal rule and safeguard low public debt. Should the deficit this year exceed the 2 percent limit (see above), the fiscal rule would require that deficits over 2015–18 average 2 percent.3 Staff thus urged the authorities to consolidate gradually so as to preserve the credibility of the rule. At the same time, staff emphasized that the quality of adjustment is equally important: consolidation should focus on arresting unsustainable trends in current expenditure (including via a continued freeze of public wages and benefits in 2015–164) while preserving the budget for priority areas such as infrastructure, education, and health. Given Kosovo’s generally low tax rates, staff also saw merit in a uniform increase in the VAT rate. Instead, the government is planning to introduce differentiated VAT rates as well as zero rate exemptions on some goods: these are not only distortionary, they also mean a missed opportunity to raise needed tax revenue.

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13. More broadly, staff recommended the introduction of a rules-based framework to guide public wage decisions. A rule that caps growth in the public wage bill relative to some well-defined macro-indicator(s) could be a useful complement to the fiscal rule, helping to prevent the large discretionary jumps in wages seen in recent years. Staff analysis (Box 1 and Annex III) shows that such a rule would have delivered significantly more modest and sustainable increases than those actually observed. While such rules have disadvantages, notably their rigidity and potential pro-cyclicality, staff argued that these are outweighed by the positives in a country like Kosovo. At the same time, staff argued that a public wage rule should not be seen as a substitute for the long delayed reform of the civil service.

14. Sources of funding should be diversified by tapping international markets. The shallow domestic market could be stretched if it were to finance a deficit of 3.5 percent of GDP this year. In this context, staff recommended that, in addition to gradual fiscal adjustment, Kosovo seek external market financing. While Kosovo has never borrowed from external markets, and would thus need to go through the process of obtaining a credit rating, the country’s still low public debt should serve it in good stead, notably given significant global liquidity. External funding could in fact help not only to finance the deficit, but to rebuild fiscal buffers to bring them back to prudent levels.5

Authorities’ views

15. The authorities broadly concurred with staff’s assessment. They agreed that, on current policies, the 2015 deficit is likely to be around 3½ percent of GDP, and that there are risks that could drive the deficit even higher. In addition, they shared the view that the composition of the budget has worsened significantly. To redress unsustainable trends in public wages, the authorities are considering a reform of public wage determination processes along the lines recommended by staff. On VAT, the authorities felt that lower rates and exemptions on some products are needed to stimulate investment in growth sectors. Should the need for additional revenue arise, they would consider raising the main rate to 19 percent.

Wage and Indexation Mechanism6

In Kosovo, increases in public sector wages have been excessively large for political reasons, resulting in adverse economic consequences. In this context, a rule that caps growth of the public sector wage bill relative to some transparent macroeconomic indicator could have significant advantages. In Kosovo’s case, there are at least four possibilities for rules-based mechanisms: (i) wages could be tied to inflation to account for changes in cost of living; (ii) wages could be tied to real GDP as an imperfect proxy of labor productivity; (iii) wages could be tied to nominal GDP growth as a proxy for changes in the cost of living and labor productivity; and (iv) wages could be changed based on the current formula used for the adjustment of the minimum salary.7

Simulations of the proposed rule-based mechanisms show that, had such a rule been in place in 2009–2014, growth in the public sector wage bill would have been much lower than actually observed. Despite the drawbacks of such rules, such as their pro-cyclicality, the benefits from restraining public wage growth as observed in Kosovo would have more than compensated.

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Actual vs. simulated increases of the public wage bill under alternative rules-based mechanisms

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

Source: Kosovo authorities; and IMF staff estimates.

16. At the same time, they felt the fiscal rule does not give enough recognition to Kosovo’s development needs. The authorities expressed their strong commitment to macro-fiscal stability, pointing to the freeze in wages at 2014 levels and the recent increase in excise taxes. More generally, they committed to finding additional savings, so as to bring deficits back in line with the fiscal rule. However, they feel the fiscal rule’s 2 percent deficit ceiling is too tight for a country like Kosovo with high development needs and very low public debt. In addition, they see provisions in the fiscal rule that allow for privatization proceeds to finance capital spending above the 2 percent deficit ceiling provided cash buffers are prudent as being of limited use. This is because they inherited a deficit above 2 percent as well as low cash buffers, so the clause cannot be activated. More generally, usable privatization receipts are now slightly above 1 percent of GDP, not enough to finance needed development projects. In this context, they expressed interest in working together with the Fund to expand the investment clause in the fiscal rule, so as to allow for IFI-financed growth-enhancing projects alongside those financed with (limited) privatization receipts.

17. The authorities welcomed advice to broaden financing sources. They concurred that Kosovo’s low public debt levels should help it obtain market financing on reasonable terms, and will seek advice on how to proceed along these lines. However, they saw significant untapped potential from IFI financing, and are initiating discussions with the various IFIs to deepen cooperation.

B. Financial Sector

18. The banking sector remains healthy. Kosovo banks are generally well-capitalized, liquid, and profitable. The system’s capital adequacy ratio (18.2 percent) is among the highest in the region, with all banks, both domestic and foreign, above the regulatory minimum. Banks’ aggregate liquid assets cover roughly 41 percent of short-term liabilities, a key consideration in a euroized economy. Profitability has improved and is adequate despite only moderate economic growth. In 2014, all banks were profitable, with overall return on equity of about 20 percent. NPLs are somewhat elevated at 8.4 percent of total loans but stable and fully provisioned.

19. Staff welcomed progress made on strengthening banking supervision. In particular, the CBK has moved steadily toward risk-based supervision, a key recommendation of the 2012 FSAP (Annex VI).8 With help from Fund technical assistance, the CBK has strengthened the depth of its off-site monitoring and analysis, developed an on-site examination model, and tested the new framework at two systemic banks, with plans to roll the new framework out to all banks by the end of 2015. Still, staff recommended that the CBK continue to train its supervisors and deepen its analytic and supervisory capacity, including by further refining supervision manuals and procedures, extending supervision to cover risks on a consolidated basis as applicable, and assessing prudential ratios. Separately, bank supervision will also benefit from memoranda of understanding for the exchange of information signed with home supervisors, a key step given that Kosovo’s banking sector is 90 percent foreign-owned by assets.

20. The authorities have also made efforts to strengthen the emergency liquidity assistance (ELA) framework. With the CBK lacking the ability to issue its own currency, its ELA reserves are critical. Staff estimates that current levels of ELA reserves are more than ample; together with the banks’ own resources, the system could withstand a very severe run on deposits (Annex II). Still, staff welcomed the central bank’s proactive efforts to seek letters of comfort from parent banks stating that parents would work with their subsidiaries in the event of a crisis. In addition, the draft ELA regulation that would govern conditions, processes, and modalities of any emergency assistance provided to banks is generally in line with best practice.

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Banks’ Liquidity1/

(Percent of deposits, as of Dec. 2014)

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

1/ Only foreign subsidiaries and domestically-owned banks.Source: staff calculations.

21. Despite these gains, more is needed to bolster Kosovo’ crisis management framework. A Crisis Prevention Council (CPC) comprised of the CBK Governor, Finance Minister, and the Chair of the Parliament Budget Committee has been recently established to discuss financial stability issues in Kosovo and to ensure better coordination in the event of crisis. These are important steps, but staff called for full operationalization of the CPC. In particular, the council should have formal meetings at regular intervals, rather than meet informally and on an ad-hoc basis as is the case now. In addition, the council should include the Deposit Insurance Fund of Kosovo (DIFK).

22. The main challenge facing the financial system is better access to credit to support growth. Despite banks’ healthy liquidity ratios, Kosovo has the lowest level of credit penetration (33 percent credit-to-GDP) in the Western Balkans. This is partly a function of demand—many potential borrowers do not see investment opportunities or an attractive investment environment in Kosovo—but structural factors are also holding back lending. Difficult debt collection procedures, uncertain court processes, and high informality have influenced conservative lending stances and led to both high interest rate spreads (currently about 850 bps) and high collateral requirements. In this context, banks are overly focused on short-term trade financing and personal loans to government employees rather than loans to private enterprises than could help to grow a more dynamic economy.

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Western Balkans Credit Depth

(credit/GDP, Q314; MNE 2013, HRV 2012)

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

23. Tackling this challenge will require a multi-pronged effort. Recent improvements to collateral recovery enforcement through the introduction of private bailiffs should help and are welcome, as are plans to develop more effective NPL recovery and write-off procedures. However, with the current backlog of bank cases stretching up to five years, more work is needed to make court proceedings more efficient, specialized, and timely. Efforts are ongoing, but they are at their early stages and will take time to bear fruit. In addition, legal system improvements are needed to provide more confidence in the rule of law in Kosovo (discussed below). A still-developing microfinance sector could also more efficiently support credit to households and SMEs.

Authorities’ Views

24. The authorities shared the staff assessment on the health of the banks, and appreciated Fund advice and technical assistance in improving CBK supervision and the ELA framework. They expect the draft regulation on the latter to be passed soon. The CBK considers its transition to risk-based supervision a success and that its new staffing level is sufficient. The authorities agree on the need to further develop their macroprudential oversight capacity and have plans to do so, but see the CPC’s current informal setup as sufficient to exchange views and, if necessary, coordinate between Kosovo’s financial authorities.

25. The CBK agreed that bank lending needs to deepen to support Kosovo’s development. In this vein, they saw the constraints squarely on the side of high informality levels and a slow judiciary, rather than on the banks’ side. They expect the introduction of private bailiffs to have a positive effect in the clearing of bad loans, and hence in giving banks confidence to lend more freely. In their view, private bailiffs were needed because the process of reforming the judiciary from within, to which they are committed, will naturally take time to bear fruit.

C. External Sustainability, Competitiveness, and Structural Reform

26. The limited progress in raising incomes and improving labor market outcomes is disappointing. With GDP per capita currently at €3,000, the income gap with the EU remains very large and is closing slowly, while that with EU candidate countries has widened. In addition, labor market outcomes are among the most disappointing in Europe, with unemployment at 30 percent despite extremely low labor participation, particularly among women and the young. In these conditions, it is perhaps unsurprising that so many have emigrated to EU countries in recent months.

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Kosovo GDP per capita as ratio of EU countries and EU Candidate Countries average

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

Sources: World Economic Outlook; national authorities
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Labor Market Indicators

(percent)

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

Source: National authorities.

27. Staff argued that domestic costs are too high given current productivity levels. Strong remittance inflows, close to 20 percent of GDP, have pushed reservation wages beyond levels that domestic productivity can sustain. In fact, Kosovo wages adjusted for productivity are among the highest in the region, not helped by large, ad hoc wage increases in the public sector. In addition, remittances (as well as widespread donor presence) have tended to stimulate consumption and investment biased towards non-tradables. This bias can be clearly seen in the data (Figure 4): in Kosovo, more than 80 percent of FDI is directed towards non-tradables, manufacturing accounts for less than 12 percent of GDP, and the trade deficit last year exceeded 30 percent of GDP. All in all, staff believes Kosovo suffers from a significant real exchange rate overvaluation, on the order of 15–20 percent (text box). In this context, wage restraint in the public sector is important: with the general government providing one in four jobs in the formal sector, containing wage costs will have a direct positive impact on overall competitiveness. The fact that the public sector now offers both greater job security and higher wages than the private sector makes it very hard for firms to attract talent.

Figure 1.
Figure 1.

Kosovo: Recent Economic Developments, 2009–14

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

Source: Central Bank of the Republic of Kosovo; and IMF staff estimates and projections.1/ 2014 annual data is an estimate.
Figure 2.
Figure 2.

Kosovo: Recent Fiscal Developments, 2010–14

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

Source: Country authorities; and IMF staff calculations.1/ Overall balance excluding PAK spending.
Figure 3.
Figure 3.

Kosovo: Selected Banking Sector Indicators, 2012–14

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

Sources: Cental Bank of Kosovo; and IMF staff estimates.1/ Liquid assets are cash, balances with CBK and commercial banks, and securities.
Figure 4.
Figure 4.

Selected Labor Market Outcomes in Kosovo

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

Sources: Country authorities; OECD; Haver; World Economic Outlook; World Development Indicators World Bank; Eurostat; CEA; and IMF staff calculations.1/ 2013 data is used.2/ 2014Q2 data is used.3/ Construction, Wholesale, retail trade, repair of motor vehicles etc., Hotels and restaurants, Transport, storage and communication, Financial intermediation, Realestate, renting and business activities, Public administration, defence, compuls.soc.security, Education, Health and social work, Other.4/ Agriculture, hunting and forestry, Fishing, Mining and quarrying, Manufacturing, Electricity and water supply.5/ Data as of 2010.6/ Data as of 2007.7/ Industry excluding construction.
A01ufig10

Labor Force Participation Ratesvs. Remittance Inflows, 2013

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

28. A credible energy pricing policy can help address energy constraints that have become a growing impediment on development. Kosovo currently relies on two old and unreliable electricity power plants, and the system is operating with no redundancy. Electricity imports can help fill temporary gaps, which is why the planned transmission line to/from Albania is important. However, imports are not a long-term fix given their higher cost and constraints in the country-to-country transmission lines. Hence, the country is faced with the urgent need to build a new power plant. With no space in the budget to accommodate its construction (estimated cost: 20 percent of GDP), credible commitments that future tariffs will be set at high enough levels to satisfy the return on investment are critical to attract foreign private investment.

29. To raise medium-term prospects, the weak business environment and rule of law will need to be bolstered. The World Bank’s overall Doing Business Indicator, which is now close to the Western Balkans average, has improved in several areas, e.g., construction permits, but deteriorated in others. But de jure improvements need to be matched by progress on the ground that economic actors can feel. It is particularly worrisome that perceptions of corruption remain widespread. In this context, staff was encouraged by the adoption of the new public sector procurement law, which follows international best practice, as well as the soon to follow e-procurement. Still, the challenge will be in the implementation of the law, and the ability to prosecute those who break it. Improvements in the AML/CFT framework, notably by further strengthening the Financial Intelligence Unit, which has increased its activity, will also help combat corruption. The anti-corruption and AML/CFT assessments conducted as part of the Project against Economic Crime in Kosovo (PECK) are welcome and the authorities are encouraged to undergo a comprehensive AML/CFT assessment against the revised 2012 FATF standard.

A01ufig11

Kosovo: 2010–2015 Doing Business Indicators

(Distance to fron tierscore)

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

External Sector Assessment

Given lack of competitiveness, a narrow export base, and concomitant dependence on imports, the trade and current account deficits are expected to remain at a high level. The narrow export base and large imports, including energy and machineries, are key drivers of the large trade imbalances (a deficit exceeding 30 percent of GDP). Over the medium term, the current account deficit is expected to narrow slightly on account of lower import growth and growing remittance inflows, but will remain high at 10.5 percent of GDP in 2020.

The assessment of the real exchange rate points to significant overvaluation. The two CGER methodologies used in Kosovo’s case, the macroeconomic balance the external sustainability, find very similar results, even if these should be interpreted with caution given limited data availability.1 In the medium term, the results of the above-mentioned methodologies can be summarized as follows:

  • The macroeconomic balance approach points to an overvalued real exchange rate of 15 percent.

  • The external stability approach also indicates an overvaluation of about 18 percent, assuming a stabilizing medium-term positive net foreign liabilities position in the range of 3 percent of GDP.

  • Of note, the current account norm estimated for Albania, the closest comparator, is very close to that found here for Kosovo.

Other indicators support the view of a significant competitiveness gap. In particular, wages in the public sector now exceed those in the private sector, making it very hard for the latter to attract the talent it needs to compete. Similarly, the fact that some much FDI is driven not by foreign investors but by the Kosovar Diaspora gives it a clear non-tradable bias: more than 80 percent of FDI is currently going to low-productivity non-tradables such as construction and domestic services, rather than to potentially higher-productivity tradables. The fact that exports have been falling as a share of GDP (despite their low absolute level) is, in itself, a clear and direct indication that Kosovo has a competitiveness problem.

Real Exchange Rate Assessment

(percent of GDP, unless otherwise indicated)

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Lack of data also precludes estimation of the equilibrium exchange rate method.

1 Lack of data also precludes estimation of the equilibrium exchange rate method.
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Firm Survey

Citation: IMF Staff Country Reports 2015, 131; 10.5089/9781513507880.002.A001

Source: World Bank.

30. Raising access and quality of education is another urgent priority, particularly in light of low employment. Currently, Kosovo spends less on education than its peers, and a disproportionately large share of the spending goes to wages. While there is a quality deficit at all educational levels, consensus among experts puts the focus on improving access to and quality in pre-primary and primary education. Similarly, curricula in vocational programs are seen as un-aligned to market needs, and the programs disconnected from the business world.

Authorities views

31. The authorities broadly agreed with the staff assessment. They currently lack estimates of real exchange rate overvaluation, and felt these were very useful to benchmark the competitiveness gap. In this light, they concurred that public sector wage restraint is needed not just for fiscal sustainability but for competitiveness purposes.

32. The authorities are confident of progress in the energy sector. In their view, the transmission line to Albania will bring significant benefits, as Kosovo and Albania are not synchronized in terms of peak energy needs and hence are natural “partners” for an electricity market. At the same time, they acknowledged that electricity imports are not a full substitute for the new power plant, and that the bidding for this plant is facing some hurdles. Nonetheless, they are working very closely with the World Bank and are confident of a breakthrough in negotiations.

33. Tackling corruption is one of their key priorities. They see the new procurement law as a major step forward, as the government is the number one purchaser and economic actor in the country. Current work to improve the debarment process for those who break procurement laws will aid in the implementation, and work is ongoing to implement e-procurement. Finally, they admitted to gaps in their judiciary, but felt that tremendous progress had been achieved in the seven years since independence in close cooperation with the EU’s rule of law mission.

Other Issues

34. Data is adequate for supervision purposes, but the national accounts and activity indicators should be improved. Fiscal and financial sector data is timely and of good quality. Real sector data needs to be improved in terms of coverage, quality, and timeliness, though it remains adequate for surveillance issues. A recent STA diagnostic mission has provided recommendations in this regard.

35. There are no restrictions on payments and transfers for current international transactions, or measures that would give rise to multiple currency practices. The authorities are considering whether to accept the obligations under Article VIII, but have yet to reach a decision.

Staff Appraisal

36. While steady remittances have kept growth going despite external and domestic headwinds, addressing Kosovo’s competitiveness gap within a strong policy framework remains critically important for robust future growth. Recent growth performance has been better than some of Kosovo’s neighbors, helped by steady remittances from the Kosovo Diaspora which has supported both consumption as well as domestic investment. However, without strong reform efforts, medium-term growth prospects are likely to remain below what the economy needs to generate enough jobs and raise the income standards of the population.

37. A gradual fiscal adjustment focused on deflating current spending is needed to contain the growing deficit and preserve the credibility of the fiscal rule. Policies went off-track following expiration of the successful Stand-By Arrangement in December 2013. In the run-up to the June 2014 elections, the authorities significantly increased public wages and benefits and met the fiscal rule only with deep cuts in much-needed capital spending. This year, the full year effect of these large commitments, together with higher spending on road infrastructure, are expected to push the budget deficit to about 3½ percent of GDP. While recognizing Kosovo’s development needs, gradual fiscal adjustment is needed to preserve the credibility of the fiscal rule and safeguard low public debt. But just as fiscal adjustment is important, so is the quality of this adjustment. Any consolidation should target unproductive current spending and leave space open for spending on things that Kosovo urgently needs, such as development projects, education, and health services. As such, the decision in the 2015 budget to keep public sector wages at 2014 levels was appropriate and should be carried forward. Recently approved increases in excise taxes are also welcome, as they bolster the state’s resources to face higher obligations in a relatively non-distortionary manner. Additional measures may be needed this year and next; a proper VAT reform and other tax measures that yield a meaningful increase in revenues could be an important option.

38. In this context, a clear rule that limits public sector wage growth relative to specific macroeconomic indicators would be a useful complement to the fiscal rule. Such a rule would help to prevent repeated discretionary jumps in public sector wages that have exceeded productivity gains and diverted funds from priority items. Moreover, growth in Kosovo should ultimately come from the private sector. Limiting public sector wages would enable private companies to compete on more equal terms when it comes to attracting skilled workers.

39. Kosovo’s banks are well-capitalized, liquid, and profitable, reducing financial risks. Non-performing loans are stable at just above 8 percent and well provisioned. The authorities have recently taken appropriate measures to improve bank supervision, strengthen the emergency liquidity assistance framework (including by seeking letters of comfort from parents of foreign subsidiaries), and coordinate with foreign supervisors. Incipient efforts to oversee macroprudential policy are steps in the right direction and should be deepened.

40. Further efforts are needed to remove impediments to bank lending. Due to the economy’s high levels of informality and an inefficient legal system, interest rate spreads are high (although they have been declining) and banks apply high collateral requirements. The authorities are taking steps to address some of these problems: establishing timelines for writing off bad loans, planning a bankruptcy law, and initiating a strategy to lower informality. But these initiatives are in their early stages and will take time. The authorities should also improve the capacity of the court system to deal with financial cases and clearing court backlogs. The introduction of private bailiffs is a move in the right direction.

41. Raising the productive and export capacity of the economy requires decisive implementation of structural reforms. This is key if the country is to gradually narrow the income gap and provide jobs for one of the youngest populations in Europe. Specifically, the country needs to tackle its significant wage and non-wage competitiveness gap. For the former, wage restraint in the public sector will help. For the latter, a multi-pronged effort will be required:

  • Attend to Kosovo’s aging energy infrastructure. In the years ahead, the old power plants may not be able to provide a reliable and predictable supply of electricity to the private sector, presenting a key obstacle to development. For the project to have any chance of success, the authorities will need to credibly commit to setting tariffs at cost-recovery levels once the new plant is completed.

  • Reducing skills mismatches. The authorities should expand access to pre-primary education and improve the quality of education across all levels, with a particular focus on vocational training.

  • Continue to improve governance and the business environment. This means strengthening the rule of law and applying the same standards to everyone. Much of Kosovo’s de jure legal institutional framework has improved in recent years, but implementation has lagged and perceptions of corruption remain. The new public procurement law is a solid step in the right direction, but the test will be in its implementation and the prosecution of those who break it. Strengthening and mobilizing the AML/CFT framework can complement efforts to investigate and prosecute corruption.

42. It is recommended that the next Article IV consultation with the Republic of Kosovo take place on a 12-month cycle.

Table 1.

Kosovo: Main Indicators, 2010–20

(Percent, unless otherwise indicated)

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Sources: Kosovo authorities; and IMF staff estimates and projections.Note: Forecasts are based on staff’s understanding of current policies, not on a reform scenario.

Data for H1 2013, as published in Kosovo Labor Force Survey, July 2014.

Projected balance does not conform with the fiscal rule.

Total foreign assistance excluding capital transfers.

Includes former Yugoslav debt, not recognized by Kosovo.

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

Table 2.

Kosovo: Real Growth, 2010–20

(Percent, unless otherwise indicated)

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Sources: Kosovo authorities; and IMF staff estimates and projections.Note: Forecasts are based on staff’s understanding of current policies, not on a reform scenario.

Donor sector includes UNMIK, EULEX, KFOR, and other donor spending.

Table 3.

Kosovo: Consolidated Government Budget, 2010–20 1/

(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.Note: Forecasts are based on staff’s understanding of current policies, not on a reform scenario.

Does not yet reflect the GFSM 2001 methodology.

Including capital transfers to public enterprises.

Projected balance does not conform with the fiscal rule.

Table 4.

Kosovo: Consolidated Government Budget, 2010–20

(Excluding donor designated grants; percent of GDP)

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Sources: Kosovo authorities; and IMF staff estimates and projections.Note: Forecasts are based on staff’s understanding of current policies, not on a reform scenario.1/ Including capital transfers to public enterprises.

Projected balance does not conform with the fiscal rule.

Indicative target only.

Includes former Yugoslav debt, not recognized by Kosovo.