Republic of Kosovo: Second and Third Reviews Under the Stand–by Arrangement, and Request for Program Extension

Economic performance remains positive, with growth estimated at 31/2 percent in 2016 and projected at similar levels this year. Fiscal deficits remain contained, with strong tax revenues limiting the impact from rising war veteran pensions. The banking system is healthy and credit growth robust. Political tensions related to opposition protests earlier in the year have subsided, but some disagreements have emerged inside the governing coalition.

Abstract

Economic performance remains positive, with growth estimated at 31/2 percent in 2016 and projected at similar levels this year. Fiscal deficits remain contained, with strong tax revenues limiting the impact from rising war veteran pensions. The banking system is healthy and credit growth robust. Political tensions related to opposition protests earlier in the year have subsided, but some disagreements have emerged inside the governing coalition.

Political Context

1. Earlier political tensions with the opposition have eased but disagreements have emerged within the ruling coalition. Opposition disruption of parliamentary activity related to the Brussels agreement on normalization of relations with Serbia has largely faded since the spring. However, some disagreements have arisen between the two key coalition partners, compromising the ability of the coalition to pass key legislation (such as the border demarcation agreement with Montenegro, a precondition for EU visa liberalization). This is now compounded by the fact that a minority coalition partner has suspended its participation in parliament, leaving the coalition with a simple rather than a two-thirds majority. Municipal and general elections are scheduled for October 2017 and mid-2018, respectively, although early elections cannot be ruled out.

Recent Developments, Outlook and Risks

2. The economic recovery continues (Figure 1). GDP grew by about 3½ percent in 2016, with robust domestic demand expanding by some 6 percent on the back of healthy remittance inflows, stronger credit growth, and an acceleration of the pace of construction of large projects such as Route 6. This was moderated by a higher than expected import drag, as well as weaker than expected exports due to the extended stoppage of work at a major nickel plant. High-frequency indicators suggest that this overall picture continues into 2017. The growth outlook for 2017 remains largely unchanged at 3.5 percent, still led by domestic demand.

Figure 1.
Figure 1.

Kosovo: Recent Economic Developments

Citation: IMF Staff Country Reports 2017, 068; 10.5089/9781475587500.002.A001

Sources: Kosovo Agency of Statistics; Central Bank of Kosovo; and IMF staff estimates.

3. Prices are slowly recovering. After averaging -0.5 percent over 2015 and remaining negative through most of 2016, inflation has started to recover (1.3 percent y/y in December 2016). The drivers of this turnaround have been external food and energy prices. Under the baseline, base effects should imply a modest but positive inflation for 2017 as a whole.

4. External deficits remain high, but also safely financed. Kosovo’s trade deficits have been historically high, on account of the country’s narrow export base and high import dependence. Data up to 2016Q3 suggest that the trade deficit did not increase relative to 2015’s level (28.5 percent), as favorable terms of trade mitigated the impact of strong domestic demand and associated imports. The current account deficit was close to 10 percent. Following historical patterns, financing of external deficits remains steady and largely non-debt creating, mostly in the form of remittances, official transfers, and FDI (the latter often associated with the Kosovar Diaspora). Going forward, staff project some deterioration in external deficits in 2017–18, as the construction of large projects gathers steam. Gross international reserves remain above prudent levels.

5. The medium-term growth outlook remains positive but still not sufficient for Kosovo’s needs. The acceleration of key infrastructure projects should boost investment and expand the production base. This, together with the ongoing removal of obstacles to bank lending and progress in realigning labor costs via public sector wage moderation, should help support medium-term growth in the range of 3.5 to 4 percent. Such a level is in line with the baseline outlined at the time of the approval of the SBA-supported program. It is ahead of regional averages but still not enough to rapidly reduce Kosovo’s high unemployment and close the income gap with the rest of Europe. Notably, staff have revised down GDP growth over 2017–19 relative to the first review because of failure to secure financing for the Brezovica ski resort (see below for detail), which is no longer in the baseline.

6. Risks to the baseline are tilted to the downside. Political tensions, both domestic and regional, could intensify in the coming months, weighing on confidence. In addition, the run up to local and general elections could see the return of populist measures that could compromise medium term stability. On the upside, medium-term growth could be higher than in the current baseline if the large Brezovica tourism resort and a planned new power plant materialize.

Program Performance

7. Performance against 2nd and 3rd review quantitative performance criteria has been satisfactory (text table). The 2015 budget deficit was contained at 1.8 percent of GDP, 0.7 percentage points of GDP below the 2nd review target.1 Budget over-performance, coupled with stronger-than-expected financing,2 helped bank balances finish 0.5 percentage points of GDP above the program target, despite the fact that the purchases accompanying the first review of the program were disbursed in January 2016 and not December 2015 as originally expected. All end- June 2016 (3rd review) quantitative targets were also met by a comfortable margin. The end-June fiscal balance and government bank balance both outperformed performance criteria by 1.0 percent of GDP, while current expenditures were 1.6 percent of GDP below the indicative ceiling.3

Program Performance: Quantitative Performance Criteria and Indicative Targets for end–December 2015 and end-June 2016

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Adjusted according to the TMU

Continuous ceiling throughout the SBA period

8. The positive fiscal performance continued through the end of 2016, although there is still room to improve the execution of the capital budget (Tables 2 and 3). According to provisional data, the deficit reached €73 million (1.2 percent of GDP) in 2016, substantially below the indicative program target of €93 million.4 This performance was supported by various factors:

  • Strong revenue performance. Tax revenues grew by more than 12 percent, on account of buoyant domestic demand coupled with tax measures taken as part of the program. Tax revenues ended almost a full percent of GDP higher than the targets in the original 2016 budget.5 This tax performance was partly offset by weak non-tax revenues, notably dividends and municipal own- source revenues (OSR), yet overall revenues exceeded original budget targets by 0.2 percent of GDP.

  • Containment of current spending. As the number of certified war veterans surpassed expectations (see below), spending on their pensions exceeded original budget allocations by €25 million (0.4 percent of GDP). However, discipline in public sector hiring coupled with tighter (but, in the views of the authorities, fair) criteria to qualify for the basic pension limited total current spending to only €9 million (less than 0.2 percent of GDP) above the end-December indicative target agreed as part of the Fund program.

  • Under-execution of the capital budget, which ended 0.3 percent of GDP below original budget targets but still above 2015 levels. Under-execution was in part driven by weak municipal own-source revenues (OSR); by law, some municipal capital projects can only proceed if the attached funding sources materialize. But it is also the case that absorption of IFI-financed projects has not scaled up as staff and the authorities had hoped, highlighting important absorption constraints (see below).

  • Given the low deficit, the bank balance ended the year at 3.5 percent of GDP, below the 4.5 percent targeted in the program. But this was only because of delays in completing the 2nd and 3rd reviews. With Fund disbursements associated to these reviews (worth 1.6 percent of GDP), the bank balance would have been above the 4.5 percent target.

Table 1.

Kosovo: Select Economic Indicators, 2013–22

(Percent, unless otherwise indicated)

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

Includes capital spending by publicly-owned enterprises via onlending from the general government.

Total foreign assistance excluding capital transfers.

Kosovo neither recognizes nor services nor tracks this debt.

Table 2.

Kosovo: Consolidated Government Budget, 2013–22 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.

Does not yet reflect the GFSM 2001 methodology.

Including capital transfers to public enterprises.

Based on information on new donor projects up to this point. New projects may be identified in the future.

Includes capital spending by publicly-owned enterprises via onlending from the general government

Including financing for projects for publicly-owned enterprises via onlending from the general government.

Kosovo neither recognizes nor services nor tracks this debt.

Table 3.

Kosovo: Consolidated Government Budget, 2013–22 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.

Nominal values per current GDP projections.

Based on information on new donor projects up to this point. New projects may be identified in the future.

Includes capital spending by publicly-owned enterprises via onlending from the general government

Including financing for projects for publicly-owned enterprises via onlending from the general government.

Kosovo neither recognizes nor services nor tracks this debt.

9. All structural benchmarks for the second and third reviews have been met, several ahead of schedule and one with some delay (Table 2, MEFP).

Second review:

  • A rules-based mechanism to govern the public sector wage bill was adopted by Parliament on December 14, 2015, well ahead of program schedule (March 15, 2016). The new rule will prevent the public sector wage bill from growing faster than nominal GDP, a sharp slowdown relative to historical practice (the public sector wage bill has grown three times faster than nominal GDP since independence).

  • The sale of telecommunication licenses, which generated 0.25 percent of GDP in proceeds, was completed on December 28, 2015.

  • Amendments to the law on public procurement were approved by Parliament on December 28, 2015, and again in February 2016. Separately, on March 15, 2016 the government issued a decision making e-procurement mandatory for the Centralized Procurement Agency (CPA), other central government procurement agencies, and all municipalities.

  • Parliament appointed the vacant seats of the Procurement Review Board (PRB) on March 28, 2016, with some delay relative to the program schedule (February 28, 2016).

  • In March and September 2016, the Government submitted to Parliament the first and second semi-annual reports (for information purposes only) on the implementation of donor-financed projects falling under the revised investment clause (see below).

  • The on-site examinations of the three remaining banks using the new risk-based supervision manual prepared with IMF technical assistance were completed ahead of schedule and reports shared with staff.

Third review:

  • Contracts for the centralized procurement of fuel, office supplies, and plane tickets, covering 43 central government administrations and agencies, were awarded in June 2016.

  • The government adopted an expanded list of goods and services that are eligible for centralized procurement in the next round of tenders.

Program and Policy Discussions

A. Fiscal Policy

Discussions centered on a 2017 budget in line with program objectives, and a long-term reform of war-related social and pension schemes. Beyond the program timeframe, efforts will need to be maintained to contain underlying pressures on current spending.

10. The authorities remain committed to fiscal prudence. Parliament has adopted a 2017 budget which is in line with program objectives of keeping deficits within the fiscal rule’s limits so as to preserve low debt, while creating space for priority spending. It targets a 1.5 percent of GDP deficit (ex. PAK and donor-financed new projects) on the basis of:

  • A modest increase in revenues relative to 2016 (0.2 percent of GDP) as tobacco excises will be raised to comply with regional agreements on the harmonization of excise rates. Based on 2016 outturns, staff expect lower non-tax revenues than the authorities, but this should have little implication on the deficit as shortfalls in municipal OSR are mostly budget-neutral.

  • Holding current expenditures constant as a share of GDP. This includes a modest wage increase of 0.5 percent as part of the collective agreement signed in 2014; no new growth in social schemes beyond the (delayed) introduction of two small schemes which are part of the 2014 Law on Pensions; ongoing savings (about 0.3 percent of GDP on an annual basis) from tightening documentation requirements to receive the basic pension6; and allocations for all war-related schemes combined in the amount of €75 million (1¼ percent of GDP), a level that staff judge sustainable and is supported by the recently launched reform of these schemes (see below). These efforts will make room for needed hiring in the justice and penal systems, new contributions owed by the State to its employees as part of the Health Insurance law, and higher goods and services spending tied to scaled up capital investment.

  • Maintaining budget-financed capital spending at some 8 percent of GDP, similar to this year’s budget. In addition, the authorities envisage a significant increase in donor-financed capital spending, as well as in capital spending financed by transfers from the privatization agency (PAK) equivalent to a combined 3 percent of GDP. These donor and PAK targets appear to be optimistic: (i) absorption capacity constraints make 1¾ percent of GDP in new donor projects unlikely; and (ii) given the needed due process to assess creditor claims on old SOEs, staff do not expect that PAK will release 1½ percent of GDP in privatization funds this year.7

  • The expected low deficit, coupled with Fund disbursements, should bring the bank balance above the minimum prudent level of 4.5 percent of GDP targeted in the program.

11. Efforts under the program are helping deflate high labor costs, which have undermined the country’s competitiveness. In the three budgets passed as part of the Fund-supported program, nominal public sector wages have increased by about 1 percent cumulatively. This in sharp contrast with historical experience, with nominal wages increasing by 13 percent per year on average since 2008. Since the State is the main employer in the country, public sector wage restraint is expected to help moderate labor costs in the private sector, aiding competitiveness.8 Going forward, the new public sector wage rule due to take effect in 2018 should help entrench these gains.

A01ufig1

Trends in Average Public Sector Quarterly Wages

(Euros)

Citation: IMF Staff Country Reports 2017, 068; 10.5089/9781475587500.002.A001

Source: Kosovo Pension Savings Trust.1/ Based on allocations in the 2017 budget.

12. Beyond 2017, pressures from war-related social schemes could threaten future budgets while impairing labor market incentives. In 2016, the commission in charge of certifying war veterans awarded upwards of 46,000 certificates, more than double what had been expected. As a result, there are at present close to 30,000 certified veterans receiving a pension, versus 13,000 allocated for in the original 2016 budget. Even assuming the pension level does not rise faster than GDP9, the scheme could end up costing 1.3 percent of GDP/year for close to three decades, compared with 0.4 percent originally anticipated. Spending on war disability pensions10 is also set to rise following the certification of an additional 3,000 war disabled (see below). In the absence of reform, spending on all war-related social schemes11 combined could exceed 2 percent of GDP per year for decades. This would crowd out priority spending in other areas, and put the credibility of the fiscal rule at risk. In addition, because the war veteran pensions are relatively generous, have no minimum age requirement, and can only be earned by veterans with no income, they are incentivizing people to move into the sizeable informal sector, hide business income, or simply not work.

13. Recognizing these risks, parliament has recently reformed war veteran pensions. The key elements of the amendments are as follows:

  • The amendments introduce explicit criteria tied to length of service during the war to divide veterans into three distinct categories. Pensions will be differentiated accordingly (€120, 170, and 250/month), compared with a uniform €170/month pre-reform.

  • The amendments create the legal basis for the establishment of a reclassification commission and define which institutions should be represented in the commission.

  • The amendments set an explicit cap on total spending on war veteran pensions, equal to 0.7 percent of GDP per year.12 The amendments also mandate explicitly that all pensions be cut proportionately if needed to comply with this cap.

  • The amendments remove the minimum wage floor on the pension that existed in the original law, thus removing a key obstacle to any needed cut.

14. Some elements of the reform have been challenged in the constitutional court. Opposition members claim that it is unconstitutional to (i) separate veterans into different categories and different pension levels, and (ii) to grant access to the pension to veterans living abroad but in neighboring countries while denying it to veterans living in non-neighboring countries. The Court has sixty days to rule starting from January 10, but could extend this deadline further. Without prejudging how the constitutional court will rule, the authorities have committed to taking any needed measures to preserve the intended savings and the aggregate spending cap. Assuming the court’s ruling upholds the amended law, the authorities are determined to complete the reclassification of war veterans per the criteria set in the law by May 15, 2017, including all administrative appeals.

15. In addition, the authorities are also determined to reform the war disability pension scheme. War disability pensions (€300/month on average) are significantly more generous than their civilian disability counterparts, and the disability threshold to qualify for the former is significantly lower as well. With 3,000–4,000 newly certified war disabled, spending on war disability pensions could go from 0.2-0.3 percent per year to 0.6-0.7 percent, pushing spending on all war-related schemes combined above 2 percent of GDP/year.13 Thus, bringing this spending under a sustainable envelope of 1¼ percent of GDP per year would require reform of war disability pensions in addition to war veteran pensions. To this end, the authorities plan to revise legislation to increase the threshold to qualify for a war disability pension, bringing it in line with civilian disability. This should help reduce spending on war disability pensions by about half; in addition, the authorities see it as socially fair. Parliamentary approval by May 1, 2017 of these amendments to war disability is a structural benchmark for the fourth review.

Potential savings from reform of war-related schemes

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This is assuming nominal benefits grow in line with nominal GDP. Historically benefits have outpaced GDP, in which case both spending and the gains from reform would be higher than shown.

16. Continued vigilance will be needed to keep current spending contained and reasonably well targeted. This has been an overarching goal of the program. Staff estimate that the measures taken so far under the SBA have put current spending some 2 percent of GDP below what it would have otherwise been, while improving some of the targeting (as in the increase in funding of the properly designed social assistance scheme). Still, government and parliament remain under pressure from various constituencies, and continued vigilance will be needed to lock in the gains made under the program.

  • The government is seeking to institute early retirement in the police force in order to lower the average age among active officers–currently, officers cannot retire before the age of sixty-five, the standard retirement age. There may be valid reasons to contemplate early retirement in some professions like the police. At the same time, an overly generous, non-contributory scheme as had been initially proposed would create a permanent gap in the budget and entice other professions to seek similar benefits, undermining the retirement system. The authorities are now working with staff to ensure any early retirement scheme is in line with best practice.

  • Despite the ongoing reform of war schemes, additional efforts will be needed to put social assistance on a more equitable and better-targeted footing. Excluding the basic pension for the elderly, social schemes under the Ministry of Labor and Social Welfare amount to some €240 million (4 percent of GDP). Of this, only €30 million are comprised of reasonably well targeted social assistance for poor families. Much of the remaining €210 million go toward non means-tested schemes that provide generous transfers to occupational groups, some of whose members are poor but many of whom are not. Refocusing social assistance towards those truly in need on the basis of recommendations from recent Fund technical assistance will be a key priority in the coming years.

B. Financial Sector Policy

With the financial sector in good health, policy discussions focused on the development of the new macro-prudential framework, ongoing work to remove structural impediments to lending, and the need to address weaknesses in the insurance sector.

17. The banking sector remains in good health and has increased lending. Capital ratios are well above regulatory minima, with the system-wide capital adequacy ratio above 18 percent. Profitability remains high, as improvements in asset quality (the system’s aggregate NPL ratio is 4.8 percent, from 6.2 percent at end 2015), together with cost-cutting among banks, have more than compensated for lower interest rate spreads. In turn, these lower spreads and stronger domestic demand are helping to spur credit growth, which has accelerated from 3 to 10 percent over the last two years, led by lending to the household sector. Liquid assets still cover some 40 percent of short-term liabilities, comfortably above prudential requirements. Ongoing inspections under the new risk-based model have uncovered no major weaknesses in the banks.

18. The authorities are making strong progress in establishing and implementing a macro-prudential policy framework. In a euroized economy with no independent monetary policy such as Kosovo, a well-established macro-prudential policy framework is of critical importance to identify and mitigate systemic financial risks as they arise. The CBK, with support from Fund technical assistance, crafted a new framework (none existed before) in line with best practice, which the CBK adopted in August 2016. The framework establishes roles and responsibilities, available tools, and communication policies to monitor and mitigate any systemic risk in the financial system. The CBK is now engaged in operationalizing this new framework, including refining the range of indicators to be monitored by the Monetary Policy Advisory Committee, as well as improving synergies with other already-existing lines of work at the CBK, such as the semiannual stress tests.

19. Staff also welcome progress to address structural impediments to banking lending. Despite stronger credit growth, credit penetration remains low in Kosovo, at 36 percent of GDP. A key problem has been weak contract enforcement, which pushes banks to lend at higher interest rates and to demand more collateral. The authorities have taken some key measures to improve contract enforcement:

  • The CBK has put in place a unique account registry. This unique account registry now allows private enforcement agents (PEAs) to garnish debtor accounts automatically via this registry, increasing the speed and efficiency of asset recovery.

  • The authorities have introduced important amendments to the Law on Enforcement Procedures in line with Fund recommendations. The amendments, which now stand between 1st and 2nd reading in parliament, close loopholes that in the past were abused by debtors to circumvent PEA orders and return their cases back into over-worked courts.

  • The authorities are in the process of increasing the number of PEAs and enhancing their oversight. The government added 10 PEAs in September, bringing the total number of working PEAs to 35 (versus a target of 72.) Oversight of PEAs has until now been weak, hence the authorities plan to formally adopt the Manual on Supervision of the Work of the Private Enforcement Agents developed in coordination with international partners, to ensure proper and consistent inspection processes (structural benchmark for the fourth review, March 31, 2017).

  • Finally, the authorities are improving and publishing court-related statistics to better monitor performance of creditor claims in courts, although progress is slow. Resource constraints are hindering the organization and publication of such data.

20. Steps are needed to shore up Kosovo’s weak insurance sector. Kosovo’s 15 insurance companies, largely focused on non-life motor insurance, had an aggregate loss ratio of 65 percent of total premiums collected over 2012–15, and four companies are undercapitalized. The poor performance has been a result of an excess number of insurance companies in a relatively small and undiversified market; a large number of unlawfully uninsured drivers that increases costs; and an overly burdensome taxation system out of line with EU norms. Kosovo’s insurance sector is small (accounting for only 3 percent of financial assets) and so does not pose a systemic risk to the financial sector or economy. Nonetheless, a stronger sector is needed to foster financial deepening in the country.

21. The first step will be to address under-provisioning and weak capitalization. The authorities approved a new insurance law in December 2015 in line with EU standards, and subsequently adopted secondary regulations in line with FSAP recommendations. With this, the European Solvency I framework effective from January 1, 2017 gives the central bank the right framework to assess provisioning levels and any related capital gaps. The CBK is committed to demanding credible and time bound recovery plans for any undercapitalized firms, together with more stringent fit and proper rules for insurance auditors, managers, and board directors. In this environment, the authorities and staff agreed that it is appropriate to delay the liberalization of insurance premiums until the industry is on a more stable footing.

22. The authorities should also reform the insurance sector’s skewed tax regime. Kosovo insurance companies are currently taxed at 5 percent of gross revenues in addition to an 18 percent VAT. This is an overly burdensome tax regime and out of line with EU directives, which exempt insurance companies from paying VAT. In this context, the authorities should consider replacing VAT for insurance companies with an indirect tax on premia paid by consumers as in other EU countries, and replacing the 5 percent tax on gross revenues with the standard corporate income tax (ie. tax on profits) paid by most businesses in Kosovo.

23. The authorities have taken steps to strengthen their AML/CFT regime. Earlier this year, parliament passed a new AML/CFT law that more clearly criminalizes money laundering and terrorist financing and brings the requirements (and related penalties) for banks to report money laundering and terrorist financing activities closer to international standard. The CBK, in turn, is now preparing to adopt secondary legislation to support the new law that covers, among other things, policies and procedures for customer due diligence and politically exposed persons. Further efforts to address remaining gaps in the AML/CFT legal framework and ensure an effective implementation of the regime will be key in addressing ML/TF risks, including underlying offences such as corruption and organized crime. This will also contribute to alleviate potential pressures on Kosovo banks’ correspondent banking relationships.

24. Staff welcomes the deposit insurance fund’s (DIFK’s) efforts to bolster its contribution to Kosovo’s financial safety net. DIFK recently concluded an agreement with the EBRD to increase and expand the duration of its existing credit line, which will help DIFK cover its target of 9 percent of insured deposits while it continues to build up its own funds.

C. Large Infrastructure Projects: Investing in Long-Term Growth

25. The capital budget in Kosovo is large, but so are the country’s infrastructure needs. Since independence in 2008, the annual capital budget has accounted for 9 percent of GDP on average. In addition, infrastructure spending has accounted for roughly 35 percent of total public spending, with a rate of implementation close to 90 percent. Yet these numbers may exaggerate the extent to which public infrastructure has been upgraded, because in small economies like Kosovo single projects can absorb a large share of GDP. For instance, construction of Route 7, linking Pristina with the Albanian border (at a total cost of about 20 percent of GDP), absorbed much of the capital budget between 2010 and 2013 while Route 6 (linking Pristina to the Macedonian border, at an expected cost of 11 percent of GDP) will take up much of the available space until 2018.14

26. In this context, the authorities are intensifying efforts to mobilize donor financing for key capital projects under the revised investment clause. The revised clause lays the groundwork for scaling up donor-funded capital spending while safeguarding debt sustainability. The authorities have created a priority project list and are proactively negotiating with donors, recently signing some important agreements such as the rehabilitation of a major railway.

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Preliminary estimation of total project costs.

27. Despite progress, more is needed to accelerate implementation. Total donor disbursements for new projects was less than €15 million in 2016, and they are expected to accelerate to about €50 million in 2017. This is substantially less than the €90 million/year ceiling allocated under the program. Underperformance owes to clear bottlenecks:

  • Limited capacity to formulate, evaluate, prioritize and plan projects, including the strict due diligence required by many donors to move forward with a project.

  • Unrealistic costing and budgeting regarding both construction and recurrent costs, including maintenance costs. In this context, the Medium Term Expenditure Framework should better reflect future pressures from large scale capital projects.

  • Limited scope for the auditor general to audit projects, which would provide timely and unbiased assessment of key investment projects.

The authorities recognize these issues, and have requested technical assistance from both the Fund and other donors to address them.

28. On the private investment side, the anticipated large foreign investment in the Brezovica ski resort project has not materialized. This project was expected to amount to 3 percent of GDP in the first three-year phase, and 8 percent of GDP over 15-20 years. However, foreign investors that had been in discussions on the project decided against the investment shortly before the May 2016 deadline. The authorities are hopeful that the recently-passed Law on Strategic Investments may help the project to go forward by enabling direct negotiations with new potential investors, although this is not likely to take place in the near term.

29. The authorities continue to work towards a new, badly-needed power plant. Kosovo’s energy supply is currently reliant on outdated power plants that require replacement. Key stakeholders, notably government, donors, and the private consortium selected to build and operate the plant, are slowly converging towards an agreed size in terms of generation capacity. However, the plans being for a coal powered plant, donor financing is also contingent on a strict assessment of the social and environmental impact of the project. In a best-case scenario, work on the new plant would begin in early 2018, with the plant coming online in 2022–23.

D. Governance - Improving Public Procurement

Discussions focused on accelerating the roll-out of centralized procurement and e-procurement, aimed at improving transparency and reducing rent seeking in the large public procurement market.

30. The authorities have made important progress in strengthening the legal framework underpinning public procurement, which will make the overall process more transparent and public spending more efficient. On December 21, 2015, the new law on procurement was adopted by parliament with subsequent amendments in February 2016. The new law represents a significant improvement on many levels. In particular, it eliminates the preferential treatment for Kosovar companies, and strengthens fit and proper rules for members of the Procurement Review Board (PRB).

31. As part of the ongoing reform of public procurement, the authorities need to continue efforts to expand centralized procurement. Under the program, the authorities introduced a designated list of standardized goods and services that can only be procured centrally including for municipalities. Replacing multiple small procurement tenders with one larger central tender makes oversight of the system easier, reducing the scope for rent seeking. This list now incorporates nine goods and services, including key common goods such as vehicle fuel. The authorities are committed to further expanding this list, adding three to five goods and services whose estimated annual procured amounts exceed €1 million for each item (structural benchmark for the fourth review, February 28, 2017).

32. Similarly, ongoing progress in rolling out e-procurement needs to be deepened so as to further increase transparency in the system. Since September 1, e-procurement is mandatory for the central procurement agency (CPA) and all other central government procurement agencies. For municipalities, e-procurement is mandatory since January 1, 2017. Crucially, e-procurement will apply to essential medical supplies procured by the Ministry of Health, by far the single largest non-defense procurement item. For all this progress, implementation of e-procurement has lagged not least because of capacity constraints to set up and handle complex electronic systems. Continued technical support from donors, and renewed ownership on the authorities’ side, will be crucial to translate de jure changes into tangible gains.

E. Other Issues

33. The authorities have moved closer to implementing the recommendations of the 2015 safeguards assessment. After significant delay, legal amendments to the CBK law to (a) remove the current requirement for parliamentary approval of the CBK external auditor; and (b) establish a due process for the removal of the CBK governor and board members have been approved in government and submitted to parliament. Parliamentary approval is expected in late February.

34. Following the EU Council’s adoption of the Stabilization and Association Agreement (SAA), the phased adoption of the EU common external tariff has begun. The gradual adoption of the common external tariff started on April 1, 2016. The SAA will facilitate the economic integration with the EU by expanding trade opportunities. Expected revenue losses have already been factored in in budget and medium-term projections.

Program Design and Risks

35. Staff supports the authorities’ request for the following additions to program conditionality (Tables 1 and 2 of the MEFP). New performance criteria have been set for end- March 2017 on the deficit ex PAK, the deficit ex PAK and ex new donor financed projects, and the bank balance. An end-March 2017 indicative target has been set on current spending. In addition, structural benchmarks have been set for the fourth review, including adoption by parliament of legal amendments to align disability criteria for war and civilian disability pensions; the formal adoption by the Ministry of Justice of the manual on oversight of private enforcement agents; and the government addition of three to five additional goods and services under centralized procurement whose estimated annual procured amounts exceed €1 million each. Finally, staff support the authorities’ request to extend the program from May 28 to August 4, 2017, as the time needed to pass the war veteran reform has delayed implementation of other structural reforms.

36. Kosovo’s capacity to repay the Fund remains sound, with public debt is expected to remain quite low throughout the forecast period (DSA Tables). Kosovo’s outstanding debt to the Fund will peak at 185.8 percent of the quota in 2017, and is expected to be almost fully repaid by 2022. Moreover, overall exposure to the Fund remains modest compared to key macroeconomic indicators such as GDP, exports plus remittances, and government revenues. More broadly, staff expect Kosovo’s low public debt to increase to about 24.5 percent in 2018, and to stabilize thereafter. The debt sustainability analysis shows the importance of reforming war-related schemes: should reform (which is still in its initial phase) fail, debt would continue to increase and exceed 30 percent of GDP by the end of the projection period.

37. The constitutional challenge to the war veteran reform is an important risk to the program, although this risk is mitigated by the authorities’ commitment to take contingent measures should parts of the new law be invalidated. In the current political climate, early elections and associated pressures that would compromise program objectives cannot be excluded. Confidence effects from domestic and regional political uncertainty could derail growth, although the risks on fiscal sustainability are contained on account of low deficits and low debt.

Staff Appraisal

38. Staff welcomes progress on the implementation of the program. The economy continues to expand faster than others in the region, although still at a slower pace than needed for incomes to converge to regional standards and to create enough jobs for Europe’s youngest population. Fiscal performance has been strong and government bank balances are moving back towards prudent levels. Credit growth is accelerating and the CBK continues to make progress in shoring up the safety and soundness of the banking sector. Important structural reforms are underway.

39. Staff recognizes the authorities’ continued efforts to maintain fiscal stability. The fiscal outturn in 2016 outperformed targets thanks to strong tax revenue performance. However, current spending was modestly higher than originally expected because of unanticipated pressures from war veteran pensions, while the scaling up of capital spending was somewhat below expectations. The 2017 budget envisions a deficit well within the authorities’ fiscal rule and is based on realistic tax revenue assumptions, together with continued containment of unproductive current spending provided reform of war schemes is followed through. This creates space for a significant ramp up in capital spending.

40. If left unattended, the rapid expansion of war-related social schemes would have represented a serious threat to the credibility of the fiscal rule and to fiscal sustainability. Reforming war veteran pensions proved politically sensitive; the need to garner social support explains the delay in completing the 2nd and 3rd reviews. Now that parliament has approved these reforms, steadfast and transparent implementation will be critical. Should the constitutional court invalidate some components of the law, the authorities are committed to taking corrective measures to preserve the sustainability of the system. Separately, aligning the war and civilian disability threshold will be needed for budgetary reasons, and staff concur with the authorities that it would be socially fair as well.

41. Reform of war-related schemes should be followed with a broader reform of social assistance. The current system needs to be refocused away from non means-tested transfers to specific occupational groups, and towards well targeted transfers that support those truly in need. This points to underlying pressures from various constituencies that will need to be kept in check beyond the program, so as to lock in and deepen recent gains.

42. Accelerating the implementation of infrastructure projects is an important priority. The recent pace of public-financed infrastructure development has not matched the need for raising growth potential. Despite some progress such as the establishment of the National Investment Council, the authorities’ preparedness for a desired scale-up of public investment spending is not complete. Improved implementation capacity, including a concerted effort within the government, is required to bring to fruition all the key priority projects.

43. The banking sector remains sound and the CBK is advancing its reform agenda. Staff welcome the roll out of risk-based supervision to all banks in Kosovo, which strengthens the supervisory oversight of the CBK. The CBK’s recent adoption and ongoing operationalization of a macro-prudential policy framework will also help to identify and mitigate financial sector risks, which appear contained at present.

44. Staff welcomes the authorities’ efforts to address structural impediments to bank lending. Rapid adoption by parliament of amendments to the Law on Enforcement Procedures would address current loopholes, which have been abused by debtors to delay enforcement of commercial claims. This, along with a new, fully-automated account registry and a steadily increasing number of PEAs to enforce claims, should give banks more confidence in their ability to collect on due debts and thus encourage an expanded provision of credit. The authorities’ plans to further develop their capacity to supervise PEAs is important to ensuring the effective and fair functioning of this system.

45. Developing the weak insurance sector is another financial sector priority. Now that the authorities have better regulatory tools at hand, they need to demand credible, time-bound recovery plans from weak firms and, failing those, force consolidation in the sector. Tighter fit and proper rules should be part of this effort. Reform of the current tax system, which is too punitive of insurance companies, should be the carrot to the abovementioned sticks.

46. The modernization of the public procurement system needs to continue. In particular, continued expansion of the list of centrally procured goods, and widespread implementation of e-procurement, should be the next goals, all the while bringing in municipalities and publicly owned enterprises to these higher standards.

47. Staff welcome the recent progress made in improving Kosovo’s AML/CFT regime and encourage the authorities to ensure its effective implementation. The AML/CFT law passed earlier this year and the subsequent regulations being prepared by the CBK are welcomed steps, which would contribute to mitigate risks of laundering of proceeds of crime, including corruption, and potential pressures on correspondent banking relationships.

48. Staff urges the authorities to finalize plans to implement recommendations of the safeguards assessment. Implementation of the recommendations has been significantly delayed, and parliament should approve these relatively uncontroversial amendments to the CBK law expeditiously.

49. Staff supports the authorities’ request for the completion of the second and third program review, taking into account the authorities’ record of good progress in economic management in a volatile domestic political environment alongside significant efforts to compress unproductive spending, reform the social benefit schemes, and implement important financial sector and public procurement reforms. Staff also support the request for an extension to the Fund-supported program from May 28 to August 4, 2017 to give the authorities the needed time to complete the remaining reforms.

Figure 2.
Figure 2.

Kosovo: Kosovo: Recent Fiscal Developments

Citation: IMF Staff Country Reports 2017, 068; 10.5089/9781475587500.002.A001

Sources: Kosovo Ministry of Finance; and IMF staff estimates.1/ Overall balance excludes PAK spending.
Figure 3.
Figure 3.

Kosovo: Banking Sector Overview

Citation: IMF Staff Country Reports 2017, 068; 10.5089/9781475587500.002.A001

Sources: Central Bank of Kosovo; and IMF staff estimates..
Table 4.

Kosovo: Consolidated Government Budget, 2013–22

(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 only program financing under the 2015-17 SBA.

Includes SDR allocations and IMF account at historical value.

Errors and omissions are thought to be mostly comprised of unidentified private remittances and unidentified DI.

Kosovo neither recognizes nor services nor tracks this debt.

Includes only 25 percent of Kosovo’s position at the Fund, rather than 100 percent assumed at the time of program approval.