Republic of Kosovo: 2020 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Republic of Kosovo
Author: International Monetary Fund. European Dept.
Publication Date:
17 Feb 2021
ISBN:
9781513569536
Language:
English
Keywords:
ISCR; CR; targeted cash support; Kosovar authorities; bank asset quality; Kosovo authorities; deficit rule; IMF staff estimate; capital investment; General government cashflow; government intervention; Kosovar government securities
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2020 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of Kosovo

Abstract

2020 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of Kosovo

Context: The Pandemic’s High Socio-Economic Toll

1. Kosovo has been hit hard by the COVID-19 pandemic. Strict containment measures and international travel restrictions limited the impact on health of the first virus wave in March-June 2020. The easing of restrictions in June led to a strong second wave, though the reimposition of movement restrictions in July was effective in reducing the number of cases. Since late October, a third wave is ongoing, which is the strongest so far both in terms of cases and mortality rates. While the response of the health system has been broadly adequate, its capacity has been stretched. Kosovo’s health infrastructure compares unfavorably with that of the region (Appendix I).

COVID-19 Death Rate

(7-day average of daily new deaths per million people)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Sources: WHO and staff calculations. Data as of 01/12/2021

2. Despite policy support, GDP is estimated to have contracted by about 6 percent in 2020. Mobility restrictions led to plummeting economic activity in Q2:2020 (-10 percent y/y). The easing of restrictions in June led to a rebound in activity in Q3:2020, with GDP increasing about 3 percent on a sequential seasonally adjusted basis, cutting about 1/3rd of the second quarter losses. The timid recovery occurred on the back of a subdued summer tourism season, which saw diaspora-related travel contract by about 60 percent. Inflation declined to about -0.3 percent (y/y) in November, as the effect of weak economic activity was compounded by lower energy prices and the elimination of import tariffs from Serbia and Bosnia and Herzegovina in April 2020. The decline in activity is expected to be similar to the average of the Western Balkans’ economies.

Formal Sector Business Turnover and Fiscal Revenues

(Annual change, percent)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Real GDP in 2020

(Percentage change, y-o-y)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Sources: WEO October 2020 and IMF staff calculations.Note: Real GDP of Kosovo is based on the latest staff estimation.

3. Kosovo’s external position was severely affected. International travel restrictions and plummeting growth in countries where the diaspora resides (estimated at -6 percent for 2020) caused diaspora flows (tourism receipts, remittances and real estate purchases) to decline from around 38 percent of GDP in 2019 to less than 30 percent of GDP in 2020 (Box 1). The collapse was felt more intensely in net travel flows, where inter-annual receipts through Q3:2020 decreased by 11 percent of GDP, among the highest in Europe. Despite a decrease in imports and increases in remittances through formal channels (about 10 percent y/y through October), the current account deficit is estimated to have widened to 7.5 percent of GDP. The higher deficit was financed by increased foreign debt (including a purchase under the IMF’s Rapid Financing Instrument -RFI-for €51 million, 0.8 percent of GDP), and decreases in international reserves. Staff calculations suggest that Central Bank’s (CBK) international reserves will end 2020 at just about the level considered appropriate by IMF reserve adequacy (RA) metrics. Moreover, the results of the EBA-lite methodology suggest that the external position remained weaker than implied by medium-term fundamentals and desirable policy settings (Annex III).

Net Travel: Annual change through 2020:Q3

(percent of GDP)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

4. The authorities allowed a relaxation of the fiscal rule over 2020–21 to accommodate the implementation of support measures and that of the recession-induced loss of tax revenues. While fiscal revenues in 2020 declined by about 9 percent, primary spending increased by more than 6 percent, because of mitigation and recovery measures that led to a rise in subsidies and transfers of about 40 percent. As a result, the fiscal deficit soared to 7.7 percent of GDP (8.2 percent of GDP excluding grants). The “fiscal rule” deficit (that excludes capital investment financed by IFIs and bilateral sources contracted after 2015) posted 5.8 percent of GDP, significantly above the 2 percent of GDP deficit ceiling. The deficit was covered by net external financing of around 2.5 percent of GDP (budget-support grants and loans from the EU, lending from the Council of Europe, and financing from the IMF and the World Bank), net domestic debt placements of 2.5 percent of GDP, and decreases in government deposits of about €200 million (3 percent of GDP). Public debt increased to 24.5 percent of GDP at end-2020 (17.6 percent of GDP in 2019), given the large budgetary deficit, but also due to extra-budgetary transfers through the Kosovo Pension Savings Trust (KPST) of about 1.8 percent of GDP.

Kosovo: Summary of Fiscal Accounts

(% change with respect equal period last year)

article image

Data is preliminary

5. Despite fears at the onset of the pandemic, bank deposits and lending have continued to grow, albeit at a lower rate than previous years. Strong pre-COVID-19 capital and liquidity buffers and low non-performing loans (NPLs, of less than 2 percent) contributed to continuing stability in the banking sector. While deposits are estimated to have grown by around 11 percent in 2020, about 40 percent of such increase is due to KPST pension account withdrawals that were authorized as part of the COVID-19 relief package. In turn, lending is expected to have grown by around 6 percent. NPLs through November 2020 remained low (at 2.5 percent) given forbearance on the classification of restructured loans through end-September. Although the large market share of foreign-owned banks, the high liquidity levels and ample capital buffers bode well for the system’s stability, pockets of vulnerabilities may show as forbearance is lift up.

Contributions to 2020 Budget Deficit

(excluding grants, in percent of GDP)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

6. The pandemic has exacerbated many pre-existing structural challenges. Social distancing measures together with the need to refocus spending pushed public investment down by close to 30 percent in 2020. This compounded structural weaknesses in public investment management and will aggravate infrastructure gaps. The need to rely on remote learning combined with weaker infrastructure and lack of adequate equipment in many households will likely increase the education gap. As the health system worked at capacity for most of 2020, the quality of services further suffered. The disproportionate impact of the pandemic in high contact sectors where informality is prevalent (such as hospitality and tourism), fragmented and untargeted social and pension schemes, and government interventions that mainly focused on the formal sector, will lead to increased inequality. Low labor participation rates and high unemployment rates, and emigration, reflect both insufficient economic dynamism and failure to account for the large informal sector (of about 30 percent of GDP). These structural constraints have so far prevented faster per-capita income convergence, which stands at about 30 percent of the EU average (PPP terms).

Kosovo: Infrastructure Gap

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Source: Eurostat

2018 Pisa Scores

(Average of Competencies)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Source: OECD.

7. A complex political situation creates additional uncertainty. A succession of short-lived governments and caretaker administrations (which operate without Parliament) over 2019–20 have delayed or outright impeded the approval of key legislation. Following a complaint that the election of the government in mid-2020 had proceeded among legal irregularities, a ruling by the Constitutional Court in December 2020 led to the fall of the government, and a call for anticipated elections for mid-February 2021. Both the government and Parliament emerging from that election will have the difficult task to secure a special quorum of 80 MPs (out of 120 in Parliament) needed to elect a new President, a position that is vacant since last November. If the new Parliament is unable to elect a President, a repeat of the elections will be needed, adding to already high uncertainty.

Outlook: Growth to Resume in 2021 Amid High Uncertainty

8. Against the backdrop of continued policy support, staff project economic activity to rebound by 4.5 percent in 2021. The rebound in growth will contribute to partially close the output gap, which will nonetheless remain large. This forecast is predicated on a few assumptions, including: (i) fiscal support proceeds as envisaged in the 2021 budget; this requires the contracting of additional debt of around €160 million (2.3 percent of GDP) if fiscal buffers are to be preserved at prudent levels;1 (ii) the rolling of the vaccine in the first half of 2021 allows for diaspora-related travel to begin recovering in the second half of the year; and (iii) the political situation stabilizes after the February elections. News about the vaccine have improved the growth prospects of Kosovo’s international partners with respect to expectations in October 2020. Some recovery in diaspora-related tourism plus strong remittances should see the current account deficit decrease to 6.4 percent of GDP in 2021. Although the baseline assumes that the decline in international reserves stops, they are nonetheless projected to fall to about 95 percent of the IMF RA metric. Consumer inflation is projected to tick up but remain subdued, in line with expected developments in the Euro area.

9. The pandemic will leave long-lasting scars. While nominal GDP is forecast to return to pre-crisis levels by 2022, it will remain below the pre-crisis trend. Staff project that potential GDP growth will average about 2 percent per year over 2020–22 (compared to 4 percent before the crisis). This reflects the destruction of firm-specific organizational capital associated with bankruptcies (especially in the hospitality sector, as diaspora-related travel is not expected to fully recover until 2024–25); slower capital accumulation; hysteresis effects for laid off workers; and a slower implementation of structural reforms due to political stalemate. Staff expect potential growth to slowly return to 4 percent per year in the medium term, as mobility fully recovers and the pace of structural reforms accelerate. Accordingly, the negative output gap is expected to significantly shrink in 2022 and to fully close in the medium-term. The recovery in diaspora-related travel will gradually reduce the current account deficit, which is expected to converge to about 5 percent of GDP by 2025, in line with the current account norm.

Headline and Potential GDP

(million of chained 2019 Euros)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Output Gap

(percent of potential GDP)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

10. The uncertainty surrounding the baseline is large and the risk of worse than projected outcomes remains sizable. The still-large number of new COVID-19 cases and political uncertainty may exert significant pressures, especially in the near term. Key risks revolve around the speed of the vaccine rollout. The shock will prove more persistent if external growth disappoints and international travel restrictions are extended. The uncertainty surrounding the course of the pandemic is compounded by domestic political risks: confidence could be further dented if the Parliament emerging from the upcoming elections is unable to swiftly elect a new President. In such a scenario, the absence of government may compromise Kosovo’s ability to secure the financing required to implement the economic and recovery measures in the 2021 budget (Annex I).

11. In case downside risks materialize, the policy response will need to consider the persistence of the new adverse scenario. Staff discussed two scenarios, both characterized by a more protracted pandemic. In one of the scenarios GDP growth recovers quickly beginning in 2022, while in the other it remains persistently below the baseline over 2021–23 (Box 2). In absence of a policy response, the lower GDP growth leads to lower fiscal revenues and a larger budget deficit in 2021; however, if the shock is temporary, the budget deficit returns to its baseline level in 2022, while it stays above baseline if the shock is persistent. Staff recommended to accommodate the larger fiscal deficit through additional financing if the shock is temporary; the relaxed fiscal stance would support the economy while the extra financing would help preserve international reserves. If the shock is persistent, staff recommended to only partially accommodate the larger fiscal deficit over 2021–22 through additional financing, and to converge to the baseline fiscal deficit by 2023. This would preserve some fiscal accommodation in the short-term, protect international reserves, and contain the growth of the public debt ratio in the medium term. In case an adverse scenario materializes in 2021, staff advised the authorities to resort to independent analysis on the duration and nature of the shock.

GDP Growth

(Deviation from Baseline, %)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Budget Deficit

(Deviation from Baseline, % of GDP)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Authorities’ Views

12. The authorities broadly concurred with staff on the outlook and on the uncertainty that surrounds it. They explained that while they were initially more optimistic than staff regarding the impact of the pandemic on GDP growth for 2020, the stronger-than-expected reduction in diaspora-related travel persuaded them to revise down their projections. For 2021, they fully concurred with staff views as reflected in the budget’s macroeconomic framework. The authorities further agreed on the need for policy to react cautiously should GDP growth in 2021 disappoints but pointed out that assessing the temporary or persistent nature of a new shock may be complicated by the high uncertainty characterizing the COVID-19 environment.

Policy Discussions: Mitigating the Effects of the Pandemic and Supporting Economic Recovery

Discussions focused on policies for 2020–21 to combat the health crisis and limit economic damage, and on reforms to strengthen economic governance and foster higher and inclusive growth.

A. Fiscal Policy: Combatting the Health Crisis and Cushioning Income Losses

13. Fiscal policy in 2020 aimed at addressing the urgent needs triggered by the pandemic. A “Mitigation and Recovery Package” (MRP), of about 4.3 percent of GDP, included allocations for the health system (0.4 percent of GDP); wage bonuses for health and security workers for overtime and the increased risk faced in discharging their duties (0.5 percent of GDP), social transfers and subsidies to vulnerable households (1.6 percent of GDP), as well as support to firms in the form of salary subsidies and easier access to borrowing (including for POEs and farms, of around 1.7 percent of GDP), and capital spending (less than 0.1 percent of GDP). To stimulate aggregate demand, the MRP also allowed early withdrawals of up to 10 percent from KPST pension accounts (2.6 percent of GDP), a majority of which (1.8 percent of GDP) will be gradually reimbursed by the budget beginning in 2023 (Appendix II). Despite delays caused by political strife, the MRP was almost fully implemented. KPST withdrawals occurred late in 2020, and so should only have an impact on demand in 2021.

14. The 2021 budget intends to preserve health spending and accommodate further MRP measures. The MRP for 2021 (3.1 percent of GDP) includes allocations for goods and services in the health sector (0.7 percent of GDP, out of which €40 million – or 0.6 percent of GDP – for the procurement of COVID-19 vaccines), for transfers to households and firms (1.7 percent of GDP), and for capital spending in the health and education sectors (0.4 percent of GDP). Given the highly uncertain course of the pandemic, the budget also includes an allocation to address contingencies (0.3 percent of GDP). The overall deficit is projected at 5.9 percent of GDP (4.9 percent of GDP according to the fiscal rule definition).

15. Staff emphasized that mitigation and recovery measures should be well-designed, transparent, and targeted to those most in need. Staff highlighted that some of the transfers to private firms in 2020 (€60 million, 1 percent of GDP) were not sufficiently targeted, and advised the authorities to monitor their use for a survey of representative firms. Staff further advised that the design of large subsidies to agriculture (of about 1 percent of GDP in 2020, including planned recovery measures) needs to be strengthened to increase their transparency and effectiveness. Staff argued that the early withdrawal of pension savings from KPST undermines “Pillar 2”, reduces future pensions, and limits the size of the domestic capital market, which has been an essential source for budgetary financing. Staff underscored the importance for the Auditor General to conduct a special audit of all MRP-related spending, to ensure that legislation preventing conflicts of interest in procurement is respected. More generally, staff highlighted that while Kosovo has made encouraging progress in centrally publishing all awarded procurement contracts, stronger action is needed to publish online their associated beneficial ownership information.

Kosovo Mitigation and Recovery Measures Against COVID-19

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16. Firming up the financing program for 2021 is essential for budget implementation and to preserve government deposits at reasonable levels. The financing program includes ambitious net domestic debt placements for 2.4 percent of GDP, confirmed external financing from the EU (budget support lending of €50 million, and grants for €11 million), and the Council of Europe (lending of €17 million); however, it also includes still uncommitted IFI lending for €160 million (2.3 percent of GDP). Securing the financing program is not only essential to allow for MRP implementation but also to preserve fiscal buffers, a key underpinning for Kosovo’s gross international reserves (GIRs).

Gross International Reserves

(Percent of IMF RA metric)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Government Deposits

(Months of primary budget spending)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

17. Staff urged the authorities to formulate contingent plans in case still-uncommitted financing does not materialize. Staff recommended the Ministry of Finance (MOF) to issue instructions requiring the pre-approval of spending on large ticket items at the commitment stage, as well as to strengthen cash management in order to mitigate the risk of accumulating arrears. If uncommitted financing is not forthcoming, staff recommended to reduce the fiscal deficit by decreasing tax expenditures and reprioritizing spending, with a view to reaching those most affected by the pandemic, while minimizing the use of government deposits. Preserving deposits at appropriate levels could prove instrumental if downside risks materialize.

18. The large increase of public debt over 2020–21 will require policy action to preserve the “investment clause” through 2025 as originally envisaged. While the computation of the fiscal rule allows to exclude “investment clause” spending (i.e., capital investment financed by IFIs and bilateral sources contracted after 2015), this exception is applicable provided public debt remains below 30 percent of GDP. However, staff projections suggest that public debt will hit this ceiling already in 2022, much earlier than originally planned. To preserve the “investment clause” through 2025 and keep room for Kosovo to close the infrastructure gap, staff suggested to raise the “investment clause” debt ceiling to the general debt ceiling of 40 percent of GDP. At the same time, staff strongly advised against increasing the general debt ceiling to 50 percent of GDP, as proposed by the government. Prematurely increasing the debt ceiling could lead to risky behavior, including in the negotiation of PPAs or PPPs, which can carry significant contingent liabilities.

19. While the suspension of the fiscal rule over 2020–21 is warranted, it needs to be combined with a commitment to a gradual consolidation path after the crisis abates. Allowing fiscal stabilizers to work and creating room for the implementation of the MRP required a temporary suspension of the fiscal rule over 2020–21. Staff advised that beyond 2021, returning to the fiscal rule as the anchor for policy remains key. Enlarging the revenue base and gradually removing targeted support and refocusing social spending to protect the most vulnerable will be essential to that end. Staff highlighted the need to explore ways to offset the loss of fiscal revenues arising from the implementation of trade integration agreements (of around 0.6 percent of GDP by 2025; Box 3), including by reducing tax expenditures and improving the progressivity of income taxes. Increasing the capacity to absorb externally financed public investment is essential to limit the negative change in the fiscal stance.

Budget Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

20. Public debt is projected to drift slowly upwards over 2022–25 but stabilize thereafter. Debt increases in the baseline scenario will be driven by the use of the “investment clause” before its expiration in 2025.2 Staff project that public debt should stabilize around its legal ceiling of 40 percent of GDP after 2025, when the 2 percent of GDP deficit ceiling becomes fully binding. Staff highlighted that though public debt remains sustainable, financing needs are relatively large. While resorting to the implementation of the fiscal rule beyond 2021 will keep public debt sustainable, staff urged to strengthen public debt management to limit the vulnerabilities arising from the absence of external market access. In this regard, staff welcomed recent progress to increase the average maturity of domestic debt and stressed the need to further diversify the investor base to include individuals (including the diaspora), private businesses, and insurance companies, which currently hold less than 5 percent of total domestic debt (Annex II). 3

Authorities’ Views

21. The authorities agreed with most of staff’s messages but highlighted the many challenges they faced in policy design during the pandemic. While they agreed on the need for well-targeted, well-designed, and transparent policy interventions, they noted that in some cases they had to prioritize that the support arrived on time. With regards to staff’s argument that KPST early withdrawals may set a wrong precedent, they pointed out that this was a one-off action justified on the need to swiftly inject liquidity to support aggregate demand. The authorities fully concurred with the need to conduct an ex-post audit of all resources spent in response to the COVID-19 crisis and will publish the results in the audit reports of the 2020 and 2021 budgets. Related to this, they requested IMF staff to assist them in the analysis of the legal procurement framework to allow for collection and publication of beneficial ownership information in public procurement. The authorities agreed with the importance of maintaining healthy fiscal buffers and noted that they expect to firm up still-uncommitted financing for 2021. Finally, they agreed that beyond 2021 and after the recovery is well entrenched, a reversal to the fiscal rule deficit should take place, in order to anchor the path for the public debt ratio.

Short-term Domestic Debt

(by original maturity, percent of total domestic debt)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

B. Financial Policies: Mitigating the Shock without Endangering Banking Stability

22. Financial sector policies provided further support to cushion income losses and ensure a steady flow of credit. In March 2020, the CBK established a 3-month loan payment moratorium that reached about 50 percent of bank loans. A further decision in June allowed applications for up to 1-year loan extensions and restructuring, which at the closing of this window in September, reached around 20 percent of loans. These measures helped bank credit to grow by around 6 percent (y/y) through November 2020.

23. Moreover, the CBK allowed for regulatory forbearance on the classification of reprogrammed and restructured loans to alleviate the impact of the crisis on banks’ balance sheets. To safeguard banks’ capital position, dividend payments were suspended. While staff recognized that forbearance was warranted at the beginning of the crisis, they also encouraged the authorities to lift forbearance before end-2020 so that provisions transparently reflect developments in the loan portfolio.

24. Staff advised against weakening capital standards, while encouraging flexibility in supervisory action towards banks whose capital ratios fall below legal requirements. Staff argued that in such cases, the supervisor should work closely with bank shareholders to ensure that sound time-bound action plans are put in place for capital buffers to be replenished gradually. In that context, staff emphasized that the CBK also needs to engage with parent banks of foreign subsidiaries in case the need for capital injections emerges. Staff further underscored the need to strengthen the operational procedures for the use of the Emergency Liquidity Assistance (ELA).4

25. The transition to IFRS9 (at the beginning of 2020) as the standard to compute NPLs and guide provisioning has created some challenges. Staff emphasized the need for the CBK to continue developing its capacity to analyze banks’ risk models. To that end, staff argued that credit quality should be assessed both according to IFRS9 and the five-bucket credit quality classification used until 2019. This should help the CBK analyze how banks’ models (entailing subjective evaluations) compare with the simpler, and more objective, five-bucket classification; and, help flag any large deviations that may point at differences between needed and effective provisions.5

Authorities’ Views

26. The authorities broadly concurred with staff assessments and policy recommendations. They noted that the CBK communicated to banks the need to classify loans according to their quality beginning at end-2020. They however noted that most foreign banks (which account for a large share of both deposits and lending in Kosovo) were provisioning prudently, following parent bank guidelines. They pointed out that they expect NPLs to rise during 2021, but that they anticipate that existing capital buffers will be enough to absorb the expected increase in credit write-offs, so there will be no need of extra capital injections. Authorities agreed with staff on the need to continue to refine their understanding of banks’ models and expressed appreciation for IMF assistance in building their capacity in this area. Authorities pointed to the lack of operational procedures for an optimal policy response during the pandemic, particularly with respect to the use of the ELA and agreed for the need to have such procedures in place in a near future.

Reforms to Strengthen Economic Governance and Foster Higher Growth

Fiscal Governance

27. Kosovo’s revenue base is weakened by numerous exemptions and special tax regimes. Staff recommended to produce a tax expenditure review quantifying the size of the revenue forgone from exemptions and reduced rates as well as other tax incentives granted to businesses and households. Staff further argued that mobilizing revenue requires continued action to strengthen tax administration and stressed that efforts to collect tax debt should be intensified, including by consolidating all collection processes into one office and writing off uncollectible debt.

28. Finalizing the implementation of e-procurement and expanding the coverage of centralized procurement will increase the efficiency and transparency of public spending. Staff acknowledged that most e-procurement modules have been rolled out in full and that information on suppliers selected for all public tenders is available on-line, but noted the need to finalize the rolling out of pending modules to further strengthen transparency and to improve “value-for-money”. Staff urged to continue advancing on centralized procurement, so at least 20 percent of all goods and services are purchased following this modality by end-2021.

29. Promoting sustainable public employment and transparent and fair compensation remain key reforms that are still pending. Kosovo’s public employment and compensation policies remain lax and uncoordinated and have caused the wage bill to increase steadily over the years. Reform efforts to foster a more predictable and fair wage grid resulted in a law (approved in 2019) that was repealed by the Constitutional Court. Staff urged the authorities to revise the repealed law with a view of salvaging the elements that improved transparency and compensation fairness, while discarding those that would have resulted in an unsustainably large wage bill, most notably an artificially high base wage coefficient. Staff advised for the MOF to have veto power on the filling of new vacancies and on the approval of new collective agreements.6

30. Social protection spending needs to be better targeted and expanded to foster inclusion and equal opportunity. Social protection spending is composed of transfers to people with disabilities (0.3 percent of GDP), as well as a general transfer for low income households under the social assistance scheme (SAS, 0.5 percent of GDP). Conducting a poverty-test will ensure that existing beneficiaries comply with eligibility criteria. As part of the poverty alleviation efforts, staff also recommended relaxing the qualifying child age limit in low-income, low-opportunity households covered by the SAS at an annual cost of 0.2 percent of GDP, starting in 2022. Finally, staff argued that finding the right balance between investment in early education and paid maternity leave will foster equal opportunity for women in the labor force.

31. The lack of a coherent social security strategy has led to a multiplicity of disparate and untargeted pension benefits that threaten fiscal sustainability. Several schemes that are fully financed by the budget (“Pillar 0”) coexist with a mandatory defined-contribution scheme (“Pillar 2”) managed by KPST (Appendix III). Benefits under “Pillar 0” have multiplied in recent years to reward actions during the war of independence. Many of these benefits are overly generous, poorly targeted, and have resulted in duplicate budgetary payments; for instance, pensions to war veterans of 1.1 percent of GDP have largely exceeded their legal spending ceiling of 0.7 percent of GDP. Staff strongly urged the authorities to undertake a holistic analysis of social security in Kosovo, with the aim to: (i) assess the long-term budgetary cost of existing pension benefits; (ii) assess the fairness of eligibility criteria for different pension benefits and identify double payments from different pension schemes or budgetary lines; (iii) analyze ways to streamline and integrate the system to strengthen its fairness and sustainability and minimize economic distortions; and (iv) preserve the integrity and independence of “Pillar 2”.

32. The public investment strategy remains unfocused and the impact of public investment on growth is low. In line with the Public Investment Management Assessment’s (PIMA) recommendations, staff urged to improve the planning, execution and ex-post audits of the Public investment Program (PIP), by formalizing project appraisal, selection, and monitoring procedures during and after the completion of projects. Staff further advised to consolidate sector strategies in the government’s Integrated Planning System; create the obligation to report PPPs and POEs’ investment through an annex in the budget; record assets, liabilities and fiscal risks related to PPPs, and the contingent liabilities arising from POEs’ investments in the government’s annual financial statements; include a schedule of multiannual commitments in the budget and financial statements; plan capital projects’ costs comprehensively, by including a specific item for maintenance costs in the budget; and, establish quality control checks by the Budget Department for data entered by Budget Organizations in the PIP system. Staff further recommended to create a centralized executing unit for externally financed projects at the MOF to coordinate multiple units at the level of line ministries to speed up investment implementation.

Financial Governance

33. The authorities are taking steps to fill existing vacancies at the CBK’s Board and review the CBK’s organizational structure. Filling the vacancies is essential to ensure oversight on CBK’s Executive Board, and for its policies to have adequate institutional backing, as highlighted by the recently concluded IMF’s safeguards assessment. While the CBK’s Executive Board has identified suitable candidates to fill the existing Board vacancies, the appointment of new members must await the constitution of a new Parliament. A review and update of the CBK’s organizational structure is needed to assess the effectiveness of decision-making bodies and refresh their roles and responsibilities. Staff recommended that once the CBK Board resumes operations, it should ensure that the financial stability and macroprudential policy functions are adequately represented at the CBK’s Executive Board. More generally, staff urged to move ahead with the implementation of other FSAP recommendations (Annex IV).

34. The legal basis for CBK’s macroprudential policy powers needs to be strengthened. Staff highlighted that amendments to the law on banks and associated regulations are needed to strengthen CBK’s macroprudential policy powers. Staff urged for stress test exercises to be integrated within the financial stability area, and for their results to be communicated to banks. Staff further recommended developing tools to assess credit risk based on granular data from the Credit Registry.

Improving the Performance of Public Sector Enterprises and Containing Fiscal Risks

35. Public Sector Enterprises (POEs) are inefficient and loss-making, and their oversight and fiscal risk reporting remain weak. Staff strongly urged to establish and develop performance agreements and quarterly risk assessments for high risk POEs; and to strengthen the institutional arrangement for POE oversight, through a functional review, led by the MOF, that assesses the most effective set up for managing POEs’ fiscal risks. Staff argued that all POEs need to design restructuring plans aimed at ensuring cost competitiveness and financial viability, including the capacity to cover their investment needs.

36. An energy sector strategy that jointly assesses economic and environmental issues is needed. While revised renewable energy (RE) targets for 2030 aiming to promote RE investments were established, it is unclear how they align with the current pipeline of generation projects. Staff recommended the creation of a working group involving the regulator, and the ministries of finance and of economy to assess: (i) the expected impact on electricity tariffs of existing PPAs; (ii) plans to reduce, still large non-commercial losses; (iii) the scope to increase the share of RE supplied through the wholesale (competitive) market; and (iv) potential contingent fiscal costs embedded in current and planned PPAs.

Deepening International Integration

37. International integration will promote competition and pave the way to stronger institutions. The implementation of the Stabilization and Association Agreement (SAA) should allow for a gradual alignment of Kosovo’s institutional framework with that of the EU, paving the way for better resolution of commercial disputes, a stronger cadaster system, lower informality, and less cumbersome administrative procedures and inspections (Boxes 3 and 4).

Strengthening Governance and Fighting Corruption

38. Efforts aiming at enhancing governance and reducing corruption should continue. In addition to improving fiscal governance and institutions (transparency, public investment and procurement, revenue administration, POE oversight), and in line with previous Article IV and SAA recommendations, staff urged the authorities to strengthen the rule of law, the anti-corruption apparatus, financial sector oversight, and address remaining deficiencies in the AML/CFT framework (Annex V).7

Authorities’ Views

39. The authorities agreed on the need to rekindle the reform process and expressed confidence that the pace of reforms will accelerate in the coming months. They agreed that before introducing any new major tax initiatives, a diagnostic of the tax system is needed, for which they requested IMF assistance. They noted that the Tax agency (TAK) is committed to advance to “compliance risk management” as well as to set strategic performance targets. The authorities emphasized that they plan to roll out remaining e-procurement modules to cover the full procurement process; this should allow to transparently track the fulfillment of orders; and the receipt of goods and services in the conditions agreed on the tenders. The authorities concurred that holistic approaches to wage and compensation policies as well as to social security are needed and they requested IMF assistance in both areas. They concurred with staff on the need for the wage bill to operate within the existing legal ceiling, although they highlighted the challenges arising from wage pressures. Similarly, they noted the challenges to keep social security spending at bay in light of numerous social demands. The authorities agreed that establishing and developing performance agreements and quarterly risk assessments for high risk POEs is important to improve their efficiency and sustainability.

Staff Appraisal

40. Kosovo’s people and its economy have been hit hard by the pandemic. Being heavily dependent on services and on diaspora-related inflows to generate foreign exchange, Kosovo’s economy suffered greatly from the pandemic’s induced international mobility restrictions. While the health system coped reasonably well, its capacity is stretched, suggesting the need for further investment in the sector.

41. Fiscal and financial policies have mitigated the impact of the shock on households and firms. Kosovo rightly used the available fiscal space to accommodate the workings of fiscal stabilizers and the implementation of mitigation and recovery measures. These measures supported the health sector’s response to the pandemic, aimed to target those most affected by the crisis, and reduced the risk of costly avoidable bankruptcies.

42. Though the design and targeting of most interventions was broadly appropriate, efforts need to be intensified to ensure that scarce fiscal resources are used most effectively. Transfers to firms need to be well-targeted, transparent, and their use strongly regulated to avoid abuses and maximize their impact in sustaining employment, preventing bankruptcies, and ensuring that the payment chain is preserved. The Auditor General should conduct a special audit of all MRP-related spending, to ensure that legislation preventing conflicts of interest in procurement is respected.

43. Policy support should not be withdrawn prematurely. The budget for 2021 strikes an appropriate balance between continuing to support the economy while preserving fiscal buffers, which is essential to maintain confidence given the absence of external market access and Kosovo’s unilaterally euroized economy. To achieve both objectives, the authorities still need to firm up uncommitted borrowing in the financing program for 2021. If uncommitted borrowing is not forthcoming, the authorities will need to reduce the fiscal deficit by reprioritizing spending, with a view to reaching those most affected by the pandemic, while minimizing the use of fiscal buffers. Preserving fiscal buffers is essential in case downside risks materialize.

44. Social security reforms should be actuarially sound and changes to public wage and employment policies should respect the legal wage bill ceiling. Creating additional pension benefits without an actuarial analysis of existing benefits or reforming public sector wage policies without proper budgetary impact analysis should be avoided. Any changes in wage or employment policies should respect the legal wage bill ceiling. Moreover, reforms to refocus social spending to protect the most vulnerable should start in earnest. Additional early withdrawals from KPST must be avoided. Importantly, the implementation of any reforms with significant medium-term budgetary costs should wait until the recovery is well entrenched.

45. Fiscal policy needs to be anchored by a credible consolidation path as the economic recovery is entrenched. A clear communication strategy that highlights the temporary nature of current bonuses and transfers is needed. Unifying the “investment clause” and general debt ceilings at 40 percent of GDP is essential to create room to close the infrastructure gap. Increasing the debt ceiling to 50 percent of GDP should be avoided, as it can create risky behavior.

46. The CBK has maintained broadly adequate operational controls. The recently concluded safeguards assessment found that while the CBK has a sound legal framework, governance arrangements have been disrupted by Board vacancies that result in a lack of a quorum. The absence of a functioning Board poses significant risks for the CBK and requires proactive engagement to expedite filling the vacancies. The external audit arrangements and financial reporting practices otherwise continue to be aligned with international standards.

47. The banking system remains strong but close supervision is needed. Banks have been generally conservative and forward-looking in increasing provisions, and thus, the lifting of forbearance should not result in risks to financial stability. As forbearance is lifted, supervisory efforts should be made to ensure losses are transparently reflected. Without diluting prudential standards or accounting requirements, flexibility should be introduced for banks to use capital buffers so that they can continue to lend to viable firms.

48. While Kosovo’s external position remained weaker than implied by fundamentals and desirable policy settings, GIRs decreased in 2020 and are just at the level considered appropriate by IMF RA metrics. The use of government deposits to finance the 2021 fiscal deficit would result in a further weakening of GIRs, increasing Kosovo’s vulnerability to shocks. The results of the EBA-lite methodology suggest that the external position was weaker than warranted by fundamentals in 2020, though a large part of the current account gap was explained by the cost of policy actions to address the pandemic, and thus, should be gradually reversed in the next few years.

49. Kosovo faces several structural constraints that have prevented faster income convergence, and the pandemic exacerbated many of these pre-existing challenges. The impact of public investment remains low, and the quality of health and education spending lags regional standards. While combating the near-term recession is the priority, strengthening budget effectiveness, reducing human capital and infrastructure gaps, improving governance, and further enhancing international integration would create a more enabling growth environment.

50. The next Article IV consultation with Kosovo is expected to be conducted on the standard 12-month cycle.

The Pandemic’s Impact on Diaspora Flows

Travel restrictions and the global economic contraction will cost Kosovo about 8 percent of GDP in diaspora flows in 2020. Strong emigration since the 1990s (especially to advanced Europe and the U.S.) is reflected in a migrant-resident ratio within the 30 – 40 percent range, one of the world’s highest.1, 2 Over 2018–19, staff assess that the deficit in residents’ transactions in the balance of payments (37 percent of GDP) was financed by an equivalent inflow from the diaspora in the form of tourism receipts, remittances, real estate purchases (recorded as FDI), and compensation of employees by repeated migrants. Kosovo’s tourism receipts accounted for close to 70 percent of its exports of goods and services in 2019, the highest such share in Europe. With data through Q3:2020, staff project that diaspora flows will contract to 29 percent of GDP in 2020. Travel restrictions negatively weighed on tourism and informal remittances (reflected in errors and omissions) but pushed official remittances upwards. Lower diaspora flows will also result in decreased real estate market transactions.

Diaspora-related flows in the Balance of Payments

(Percent of GDP) 1/

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

Staff used available data, and expert CBK judgement to identify diaspora-related flows. In particular, the diaspora is assumed to explain 92 percent of travel services receipts (diaspora-related tourism), and 100 percent of workers’ remittances. Compensation of employees (which is driven by seasonal migrants and thus not properly diaspora) is included as diaspora. Staff assumed that equity liabilities under foreign direct investment fully comprise real estate purchases by the diaspora. Finally, 50 percent of errors and omissions are assumed to be unrecorded remittances or equity investments not captured in other lines.

Staff project that diaspora flows will recover only gradually. The speed of recovery will be closely related with the course of the pandemic and mobility restrictions. While the recovery in 2021 will only be partial, it should be more forceful in 2022 provided the vaccine rollout allows international mobility to increase to more normal levels.

While diaspora flows have been essential to support domestic consumption and investment, they also create structural challenges. Large diaspora flows led to an economic structure heavily biased to services, and where goods exports have remained low and concentrated in commodities. The Household Budget Survey suggest that 10 – 15 percent of the typical household’s income is originated in remittances, increasing the reservation wage and resulting in both lower labor force participation and higher unemployment rates. Real estate investment by the diaspora has fueled a construction boom in the capital over 2018 – 19 and increased the banking sector exposure to the sector.

Travel Exports

(Percent of Exports of Goods and Services)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

1/ World Migration Report, 2020; International Organization for Migration, Geneva.2/Migrimi Kosovar; Kosovo Agency of Statistics, 2014; and, Republic of Kosovo, Migration Profile 2019.

Adverse Scenarios: Characterization and Policy Response

The uncertainty surrounding the baseline is large and the risk of worse outcomes, sizable. This Box discusses two adverse scenarios predicated on a worse than expected pandemic. The “no policy response” impact of these shocks on selected macroeconomic variables assumes that the increased fiscal deficit is accommodated using fiscal buffers in 2021, and through increased debt beyond that.

  • Adverse Scenario – Persistent: In line with the October 2020 World Economic Outlook, it assumes that the virus is more difficult to contain that currently assumed, leading to longer social distancing and partial lockdown measures. This results in a GDP growth that is weaker than the baseline by 2 pp/year in 2021–23.

  • Adverse Scenario – Temporary: It assumes that GDP growth in 2021 disappoints as the pandemic takes more time to control, but that the situation normalizes thereafter. This results in a strong rebound in growth in 2022, and GDP converging to the baseline level in the medium term.

The policy response should be calibrated considering the expected duration of the shock In case of no policy response, the lower GDP growth leads to lower fiscal revenues and a higher budget deficit in 2021. If the shock is temporary, the budget deficit returns to its baseline level in 2022, while it would stay above baseline over the medium term if the shock is persistent, causing the public debt ratio to drift upwards (Box 2 – Figure 1). Accordingly:

  • Policy Response – Temporary Shock: The increased fiscal deficit can be accommodated through increased financing. The relaxed fiscal stance would support the economy, the extra financing would help preserving international reserve buffers, and the increase of public debt would be contained.

  • Policy Response – Persistent Shock: The increased fiscal deficit over 2021 – 22 should be only partially accommodated through increased debt contracting, with a view to converge to the baseline fiscal deficit by 2023. This would preserve some fiscal accommodation in the short-term, protect international reserve buffers and contain the growth of the public debt ratio in the medium term.

Figure 1.
Figure 1.

Scenario Analysis: Transitory and Persistent Shocks

(With and without proposed policy response)

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Kosovo’s Efforts at International Integration

Though not a WTO member, Kosovo’s participation in several free trade agreements (FTAs) reflect its decade-long efforts at trade liberalization. Kosovo’s tariff code (based on the 2017 Harmonized Commodity Description and Coding System (HS) and the EU Combined Nomenclature), comprises 10,191 tariff lines at the 10-digit level. FTAs (whose rules apply to about 80 percent of Kosovo’s trade) provide the overall framework for regional cooperation and integration into European economic and political processes. For all other countries, Kosovo’s applies a 10 percent uniform import tariff on 79 percent of tariff lines, and no tariff on the remaining lines. Kosovo is beneficiary of the generalized systems of preferences applied by Belarus, Japan, Kazakhstan, Norway, the Russian Federation, Switzerland, and the U.S.

The EU-Kosovo Stabilization and Association Agreement (SAA) sets to eliminate most tariffs by 2026. The SAA (which became effective in April 2016) provides for the harmonization of Kosovo’s legal and regulatory framework with EU law to prepare for accession negotiations. In 2020, 87 percent of Kosovo’s tariff lines on imports from the EU are duty-free. The SAA was preceded (since 2000) by the Autonomous Trade Measures (ATM), which granted duty-free access to 90 percent of goods exported to the EU. Following Brexit, Kosovo signed (in December 2019) an FTA with the U.K., which is expected to enter into force in 2021.

Trade within the Central European Free Trade Agreement (CEFTA) was fully liberalized in 2015, though Kosovo’s imposition (in 2018) of a 100 percent import tariff on Serbia and Bosnia and Herzegovina represented a setback. CEFTA members comprise Albania, Bosnia and Herzegovina, North Macedonia, Moldova, Montenegro, Serbia, and Kosovo (a member since 2007). The 100 percent tariff virtually stopped imports from Serbia and Bosnia and Herzegovina, and undermined trade cooperation efforts within the FTA. In a welcomed move, the tariff was eliminated in April 2020.

Kosovo’s Imports and Exports by Origin, 2018–2019

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An FTA with Turkey (signed in 2013) became effective in 2019 after Kosovo’s ratification. While Turkey immediately removed import tariffs on Kosovo for all industrial and most agricultural goods, Kosovo will eliminate tariffs over a 10-year period. Negotiations are ongoing to set the start date of tariff phase-out; Turkey’s position is to set the start date in 2016, in par with the SAA.

The implementation of the EU-SSA and Turkey FTA will reduce fiscal revenues by 0.6 percent of GDP by 2025. Imports of goods into Kosovo are subject to customs duties, excise duties, and VAT. Custom duties amounted to €130 million in 2019. VAT and excise duties are calculated on the import values included custom duties.

European Union Accession Process

The European Union-Kosovo Stabilization and Association Agreement (SAA) entered into force in April 2016. The SAA is the first contractual relationship between the European Union (EU) and Kosovo. It provides a framework for dialogue and cooperation on good governance and the rule of law, competitiveness and investment climate, and employment and education, among others, consistent with the EU’s acquis. The SAA is expected to be progressively realized in 10 years. Annual reviews of implementation result in recommendations. The fifth-year review (in 2021) may modify the ensuing process of association based on a thorough progress evaluation. The 10th-year review (in 2026) may extend the process up to five years, through 2031. The SAA also establishes that the EU and Kosovo should gradually establish a free trade area over a maximum of 10 years (i.e., by 2026). To guide SAA implementation, the European Commission (EC) and Kosovo adopted the European Reform Agenda (ERA) in November 2016.

The 2020 SAA progress report recognizes advancement in reform implementation but highlights that Kosovo is still in an early stage in several areas. The report recognizes the impact of COVID-19 in the Western Balkans and the EU and highlights EU’s efforts to support Kosovo and the region. Despite progress, the report concludes that Kosovo is at an early stage in developing a functioning market economy and in its capacity to cope with competitive pressure and market forces in the EU; that the excessive size of the government hampers its effectiveness and credibility; that the judicial system is still at an early stage; that the Assembly continues to operate in a polarized context resulting in frequent lack of quorum and delays in legislative activity; and that efforts in the fight against corruption, organized crime and money laundering need to be more effective.

The SAA commits Kosovo to continue engaging towards a sustainable improvement in relations with Serbia. The SAA states that policies should ensure that both countries continue their respective European paths and a gradual normalization of relations, while avoiding that either can block the other in these efforts. Kosovo’s decision in early 2020 to lift the 100 percent tariff on imports from Serbia and Bosnia and Herzegovina was welcomed by the EC, as it allowed a resumption of the EU-facilitated Belgrade-Pristina dialogue. Kosovo and Serbia signed several economic agreements under the auspices of the U.S. in September 2020, which are expected to unlock bilateral infrastructure financing.

Kosovo remains the only Western Balkan Country with no visa-free access to the Schengen Area despite having met all benchmarks of the Visa Liberalization Roadmap. The EC started the process of visa liberalization for Kosovo in 2012. In July 2018, the EC confirmed that Kosovo had met the two outstanding visa liberalization requirements (the ratification of the border demarcation agreement with Montenegro, and a strengthened track-record in the fight against crime and corruption), thus fulfilling all benchmarks set out in the Visa Liberalization Roadmap. In March 2019, the European Parliament voted in support of the Commission’s proposal in its first reading. However, the proposal is still pending for final approval at the European Council, where a few countries continue to express reservations.

Figure 1.
Figure 1.

Kosovo: Recent Economic Developments, 2012–2020

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Sources: Haver Analytics; Kosovo Agency of Statistics; Central Bank of Kosovo; Haver; WEO; IMF staff estimates.
Figure 2.
Figure 2.

Kosovo: Fiscal Developments, 2014–2021

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Sources: Country authorities; IMF staff estimates.
Figure 3.
Figure 3.

Kosovo: Labor Market, 2020

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Sources: KAS; OECD; ILO; Eurostat; SEE Jobs Gateway Database; WEO and IMF staff estimates.1/ Data refers to Kosovo Labor Force Survey 2017.
Figure 4.
Figure 4.

Kosovo: Banking Sector Overview, 2014–2020

Citation: IMF Staff Country Reports 2021, 041; 10.5089/9781513569536.002.A002

Sources: Central Bank of Kosovo, IMF staff estimates.
Table 1.

Kosovo: Select Economic Indicators, 2017–2025

(Percent, unless otherwise indicated)

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

2020 as of Q3 2020.

The Fiscal rule exdudes capital investment financed by multilateral/bilateral projects contracted after 2015.

Includes guarantees and beginning in 2020, Euro 120 million of debt with KPST. It does not include contigent debt of former Yugoslavia.

Total foreign assistance excluding capital transfers.

2020 is as of November 2020.

Projections assume that the increase in deposits due to early withdrawals from KPST accounts in 2020 is gradually withdrawn out of the banking sector in 2021.

Table 2.

Kosovo: Consolidated Government Budget, 2017–2025 1/

(Including donor designated grants and PAK operational expenditure, millions of euros)

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

Does not yet reflect the GFSM 2014 methodology.

For staff projections, recovery program measures are directly incorporated in the expenditure lines. These add up to Euro 288 million in 2020 and Euro 220 million in 2021.

For fiscal rule purposes, IFI and PAK-financed projects post-July 2015, as well as PAK-related current expenditure, are excluded from the fiscal deficit; in the IMF presentation, expenditures from carried-forward own-source revenue (OSR) are calculated as the annual difference between the municipal OSR stocks in consecutive years.

Excludes DDGs, revenues held in trust, and additional net PAK expenditure.

The stock of public debt no longer includes the former Yugoslavia debt, which has been reclassified as a contingent liability. Beginning in 2020, it includes Euro 120 million of debt with KPST.

Based on preliminary revenue and expenditure data as of end-December 2020 and the 2020 Budget.

Table 3.

Kosovo: Consolidated Government Budget, 2017–2025 1/

(Including donor designated grants and PAK operational expenditure, percent of GDP)

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

Does not yet reflect the GFSM 2014 methodology.

For staff projections, recovery program measures are directly incorporated in the expenditure lines. These add up to 4.2 percent of GDP in 2020 and 3.1 percent of GDP in 2021.

For fiscal rule purposes, IFI and PAK-financed projects post-July 2015, as well as PAK-related current expenditure, are excluded from the fiscal deficit; in the IMF presentation, expenditures from carried-forward own-source revenue (OSR) are calculated as the annual difference between the municipal OSR stocks in consecutive years.

Excludes DDGs, revenues held in trust, and additional net PAK expenditure.

The stock of public debt no longer includes the former Yugoslavia debt, which has been reclassified as a contingent liability. Beginning in 2020, it includes Euro 120 million of debt with KPST.

Based on preliminary revenue and expenditure data as of end-December 2020 and the 2020 Budget.