Mission Concluding Statement 

IMF Staff Visit to Kosovo, Concluding Statement

June 16, 2003

1. Since last January, IMF staff has engaged the authorities in a dialogue on the design of a macroeconomic policy program that staff could monitor subsequently. This document outlines the staff's assessment of the current economic situation and the outlook; and its recommendations for policies in the near-term.

2. Following a strong rebound in 1999-2000, under the impetus of a massive infusion of donor assistance and remittances, the economy is likely to have slowed down significantly in the past two years due to a decline in inflows and an unintended tightening of the fiscal stance. The major brake on the economy in 2001 was the large swing in the budget deficit (from a deficit of 6½ percent to a surplus of 5½ percent of GDP) resulting from a remarkable increase in taxes. In 2002, the main drag on growth came from a major decline in foreign assistance, whose first round effect may have depressed aggregate demand by some 13 percent. In the absence of proper national income accounts, time-consistent indicators of economic activity, and balance of payments statistics, this assessment is tentative, and subject to further revision.

3. Growth is expected to pick up to 5 percent in 2003. In the context of continued decline in foreign assistance and workers' remittances, the pick up of growth will reflect trends in private consumption and investment and the stance of fiscal policy: ¹

• Growth in private consumption is likely to be subdued owing to a drag on incomes from declining remittances and employment generated by the donor sector. Business confidence and the prospects for private investment are hard to gauge at the moment, even though the continued fast expansion of bank credit may be an indication of an underlying robust trend.



• Under the recommended fiscal policy (see below) the budget would be balanced, compared with the 6½ percent surplus registered in 2002. With most of the increase in public expenditures reflecting a rapid expansion of public investment, the current budgetary balance would continue to show a robust surplus equivalent to some 10 percent of GDP.



• Given the expected decline in foreign assistance, such growth is likely to lead to a widening of the external after-grants current account deficit, which is expected to be financed by a rundown on banks' foreign assets and a continuation of some capital inflows, as in the past two years, associated with investment by the Kosovar Diaspora.

4. In 2004, growth could be sustained at 4 percent if supported by further expansion in the government investment program, provided the existing commitments of foreign assistance are maintained and assuming a moderate impact from the scaling down of UNMIK's operations. The envisaged expansion in government spending could be financed in its entirety by the past accumulated surpluses. Private sector consumption and investment trends described above are likely to persist in 2004 with prospects for private investment to be, hopefully, boosted by privatization and the improvement in infrastructure.

5. Economic prospects are clouded by major uncertainties. These are related to the prospects of remittances and donor support; fiscal policy stance; supply response to structural policies; external environment; and timing and modalities of the resolution of Kosovo's final status. These uncertainties are further aggravated by large data-related deficiencies which hamper a proper assessment of the state of the economy and of the underlying trends.

II. Recommendations

6. The mission considers that in the foreseeable future the authorities should: (i) pursue a gradual and prudent expansion of government spending during this formative stage in the development of the Kosovo budget, given the attending uncertainties; (ii) improve tax administration, including by improving the VAT rebate system and establishing an efficient duty drawback system; (iv) restructure the state enterprise sector; (v) strengthen the implementation capacity to enforce the newly established legal framework; (vi) enhance regional integration to promote exports and attract foreign direct investment, and (vii) tackle data deficiencies.

A. Fiscal Issues

7. The long-term guiding principle in the conduct of fiscal policy should be the establishment of an efficient and effective structure of public spending to support private sector development through the provision of an adequate level of public services and public infrastructure. This requires long-term strategic policy planning and the elaboration of comprehensive and coordinated strategies (especially for the key sectors of education, health, and basic infrastructure) in order to set the priorities in public spending—given limited resources.

8. In the pursuit of this long-term objective, government spending should be expanded gradually and prudently. Gradualism will allow the budgetary process to benefit from experience, prevent waste, and avoid policy reversals. Prudence is needed to insure that the expansion in public spending will, ex-post, be consistent with medium-term fiscal solvency, once the parameters of fiscal solvency become clearer. At the moment, these parameters are still fluid owing to uncertainty about the growth potential of the economy and of the level of future foreign assistance. In any case, the assessment of fiscal solvency should be kept under constant review.

Fiscal policy for the remainder of 2003

9. Current fiscal plans are a cause of concern: (i) the wage bill is projected to increase by 14 percent, with an underlying increase in employment of 17 percent, (ii) spending on goods and services is projected to increase by 82 percent, and (iii) social programs are under-funded by €10 million². Factoring-in the under-funding of social programs, current expenditures are projected to increase by close to 45 percent. With capital expenditure planned to triple, this would lead to a consolidated budget deficit of 7 percent of GDP, compared to the surplus of 6½ percent in 2002.

10. Such plans carry two risks. First, the surge in spending will test the administrative capacity to spend the resources well and weaken the overall efficiency of public spending. The ability to train the new employees is limited. The hiring procedures are still weak and can not insure the selection of the best candidates. Internal audit mechanisms are still being developed and could handle a fast expansion in procurements only at the risk of compromising on quality. The opportunity of learning by doing and the benefits from prioritization, which could happen under a gradual expansion, will be missed.

11. The second risk is that the fiscal expansion may turn out to be unsustainable in the medium-term, calling for painful retrenchment in the future. For example, the tax base and hence tax revenues, especially customs proceeds, are uncertain owing to uncertainty about the growth potential of the economy and about workers remittances—which is an important income source sustaining consumption. Moreover, some capital expenditures both by the budget and those financed by donors may give rise to recurrent expenditures that might not have been properly factored-in. Finally, the actual fiscal expansion may not leave enough room for further prospective expansion that is required as more powers are transferred to the self-government.

12. To allay these risks, the mission recommends that the authorities contain current expenditure growth to about 15 percent in 2003; capital expenditure could proceed as planned as long as efficiency is ensured. This level of total expenditure together with revised projections of tax revenues will involve a weakening of the fiscal balance by some 7 percentage points of GDP. The budget would be balanced and the current budget balance will preserve a healthy surplus of 10 percent of GDP.

13. Additional appropriations in the context of the 2003 mid-year review should be limited to urgent and high priority investment projects. All other capital expenditures should be reconsidered in the context of the 2004 budget and the medium-term fiscal plan.

14. To ensure fiscal discipline and efficiency it would be imperative to:

• Strengthen the capacity at the Ministry of Finance to develop a fiscal strategy in the form of a rolling medium-term fiscal framework that would take into account future claims on budget resources, in particular the implications of the planned transfer of responsibilities from UNMIK to PISG;



• Use the medium-term fiscal framework as the vehicle for deciding the extent and the pace at which past and future current budgetary surpluses should be used to finance public investment in coordination with donor financed investment spending;



• Support work on the fiscal strategy by setting up a planning unit engaged in overall strategic policy design and in particular the assessment and prioritization of public investment. Promote an open public dialog on these issues.



• Additional resources to cover electricity bills of the government entities and additional social spending to make electricity affordable to the most vulnerable have to be factored into expenditure projections to support KEK's restructuring. In general, the cost of all government policies should be financed directly from the budget in a transparent way, which would allow a better weighing of trade-offs .



• Based on the pay scale review, design a civil service reform aimed at achieving a professional, merit-based and career-oriented civil service, with wage levels linked to appropriate private sector comparators and enhanced incentives for senior-staff performance. At the moment, compressed and, in some sectors, low wages are making it difficult to attract and retain qualified staff, multiple and often opaque allowances make it difficult to control pay policies in the various spending agencies. It would be advisable to explore the possibility of offering graduate level training in public administration.



• The authorities should also address the issue of the optimal size of the civil service, and the sectors in which additional employment or existing employment be deployed/redeployed. This should derive from a clear definition of the role of government, steering clear from any notion of government becoming employer of last resort.



• Pending completion of the pay scale and job description review, (i) impose a temporary quasi hiring freeze until the future public sector employment needs are fully assessed taking into consideration the projected assumption of some responsibilities from UNMIK, the capacity of the public administration to productively expand employment, and the need to have a small but well paid civil service; the original budget plan to increase the size of the civil service by close to 11,000 staff in 2003, needs to be scaled down; and (ii) limit wage increases to only those that are disproportionately low and are in key sectors such as education and health, while tackling the problem of overstaffing of administrative and support staff in these sectors. Wage increases should be modest to allow room for possible further increases in light of the findings of the pay scale review.



• Examine the possibility of offering severance packages to public sector workers as part of an effort to address the problem of overstaffing in POEs and eliminate the associated drain on the budget.



• Keep up maintenance expenditure but achieve savings in spending on goods and services by strengthening auditing and, in particular, by supplementing financial auditing with physical inspections. Improving procurement procedures would be equally important.

Structural fiscal reforms

15. As the municipalities assume greater financial management responsibilities, mechanisms will be put in place to insure that fiscal decentralization yields its expected benefits, including by setting appropriate systems for a proper evaluation of the quality of municipalities' spending. Some municipalities are reported to be imposing excessively high local taxes and fees. The central authorities should undertake an active campaign explaining the adverse effect that this could have on the business environment and the growth prospects of the municipalities.

16. By and large, the existing simple but well designed tax system has served well the need of the economy to raise taxes in the least distortionary fashion to finance the high quality public services that are needed to support the development strategy. The policy in the near-term should focus on improving tax administration and nurturing a culture of tax compliance, while keeping the tax system broadly unchanged. Frequent changes in the tax environment are difficult to handle both for the tax administration and for the taxpayers. In this respect, the introduction of the comprehensive personal income tax should be postponed until the tax administration has developed enough capacity. In addition, the mission considers that currently the best way to address the problem of the high costs to exporters—from delays in rebating the VAT and the absence of refund of customs duties—is to improve the VAT rebate system, establish an efficient duty drawback system, and improve exporters access to credit for working capital.

17. The remarkable increase in tax revenues since 2000 has been facilitated by the heavy reliance of the tax system on taxing consumption, by the high share of imports in total consumption, and by the presence of international peace keeping forces, which have helped enforce tax compliance at the boarders. As the presence of these international forces is being phased out, and as the structure of consumption shifts toward local goods, the challenge will be to keep up the level of revenue mobilization by strengthening the local tax administration and continuing to preserve the good performance of customs. The law on Customs Services procedures to replace Serbia and Montenegro's customs law, which expires at end-June of this year, should be adopted urgently. Also the Tax Administration has so far been operating on the basis of streamlined regulations. A more comprehensive law has been prepared and should be adopted soon to re-enforce the procedures of the Tax Administration and give it greater enforcement powers.

18. We foresee that the accumulated surpluses plus the prospective current budgetary surpluses in the next two years will be adequate to cover even sizeable capital expenditures. Moreover, the budget should not consider any on-lending to publicly owned enterprises (POE) before a proper restructuring plan has been designed and initial steps taken to implement it.

B. Structural Reforms

19. In the area of structural reforms, the focus should be on: (i) improving the statistical infrastructure; (ii) privatizing/liquidating socially owned enterprises (SOEs); (iii) restructuring KEK and other POEs; (iv) strengthening the implementation capacity to enforce the existing and the newly-established legal system; (v) develop further the financial sector; and (vi) achieving a better regional integration of Kosovo's economy.

20. Data deficiencies need to be addressed urgently as the absence of reliable data hampers economic analysis and policy advice. To this effect, the mission encourages the authorities to adopt quickly the law to launch a population census and publish the results within the following 18 months. With the latest reliable population census dating back to 1981, survey sampling frameworks are not reliable. The official statistical infrastructure needs to be strengthened to compile national income accounts, the balance of payments statistics, and a few high frequency short-term indicators of economic activity.

21. Delay in the planned privatization/liquidation of socially owned enterprises (SOEs) has been one of the main drag on economic development and transition to a market economy. The adoption of KTA's operational policies along with the recent passage of a land use regulation, allowing the sale of transferable unencumbered 99-year land use rights, will hopefully clear the way toward fast progress in privatization. To insure success, KTA should insure maximum transparency and provide as much advanced information as possible on prospective tenders to allow time for investors to assess potential interest. To allow liquidation of those SOEs which would not have attracted market interest, and all other SOEs, which can not be sold as an ongoing concern, consensus should be reached on extending the land use regulation to all SOEs.

22. Agreement for restructuring KEK is long overdue. Proposals for establishing a management with clear line of command, free of interference, and running KEK on purely commercial principles are being examined. Staff considers that building consensus around these principles should be reached without delay. As part of the consensus, the authorities would commit to provide budget financing for investment in KEK subject to strict conditionality and quantitative benchmarks, in the context of much greater transparency. Staff recommends that in the context of KEK's restructuring, it would be imperative for PISG and UNMIK to:

• Unconditionally support KEK management in its efforts to collect electricity bills, strengthen enforcement, expedite court proceeding in case of non-payment or theft, and combat corruption at all levels.



• Require all entities (be it PISG institutions, UNMIK, KFOR, SOEs and POEs, and other donor agencies) to pay their bills and disconnect those who do not pay.



• Establish a targeted social assistance system to provide lifeline support for the most vulnerable.



• Encourage and review favorably bids of local subcontractors.

Given the urgency of completing some restoration work, staff calls on the authorities to act expeditiously and responsibly to ensure a reliable supply of electricity and minimize landslide-related risks.

23. Steady progress has been made in putting in place the main building blocks of the legal framework. The main challenge in the coming years is to build the implementation capacity to enforce it. Extremely long-delays in the handling of commercial court cases are hampering the imposition of market discipline. This is affecting particularly the collections of utility bills and the recovery of past due loans. The reasons behind the long delays in the handling of commercial court cases should be investigated, starting with a review of the civil procedural law. The program to train judges should also be accelerated.

24. The rapid surge of credit to the private sector while a possible sign of a welcome vigor in economic activity calls on BPK for vigilance in enforcing prudential regulations and on banks to strengthen their risk assessment analysis. BPK should strive to bring all banks operating in Kosovo under its control. We support BPK's call on all banks to participate in the credit reporting agency as this would enable individual banks to cope better with the lack of data on potential debtors' credit history and would reduce risk to the entire banking system. Faster progress in better defined and enforceable property rights and in more reliable company accounting information are needed to bring about a quick reduction in perceived risk and lower interest rates to more reasonable levels. The adoption of an effective anti-money laundering law is long overdue. Its adoption and setting the institution to enforce it should proceed without delays.

25. Both Kosovo and its neighbors should strive to restore the links that used to connect their economies. The international community has a major role to play to help Kosovo achieve a better integration into the regional economy—tariff and non-tariff barriers Kosovo faces in some neighboring markets are reported to be very high. The boost to employment and growth that could be achieved if Kosovo could resume its exports to what used to be its natural markets in the neighboring states might be significant.

¹ A large component of remittances from abroad during 2000-01 appear to have been associated with one-off repatriation of wealth after the end of the conflict. In the future, remittances would simply consist of the permanent flow of regular workers remittances.

² Current fiscal plans reflect: (i) the appropriations approved at end-December 2002 (€517 million), (ii) unexpended commitment from 2002 plus a small amount of unallocated and uncommitted appropriations from 2002 and 2001 (€159 million), and (iii) new appropriations of €17 million for clearing the coal mines of KEK granted in March of this year. All in all, budget appropriations amount to €693 million.