Mission Concluding Statement 

Albania- Preliminary Conclusions of the Staff Mission for the 2011 Article IV Discussions

June 22, 2011

1. The Albanian economy has shown admirable strength in the recent past. Albania weathered the 2009 global financial crisis well and, in contrast to most other European economies, avoided an output contraction and has again led growth in the region. Moreover, and notwithstanding a substantial deterioration in asset quality, the financial sector proved resilient and did not require public support. Throughout, inflation remained well anchored. Last, but not least, the needed rebalancing of the economy has begun as exports picked up and the high current account deficit began to narrow.

2. As in many other countries, growth has slowed from pre-crisis levels, though. Economic growth in 2010 is estimated at 3½ percent, and we project it to decelerate further to 2⅔ percent in 2011, due to lackluster domestic demand and moderating exports. Over the medium term, given catch-up potential remains and past investment in infrastructure is coming on line, growth could recover to some 4 percent, with some improvements in external sustainability. These levels, though respectable, are considerably below the previous decade’s average of 6 percent, and also subject to downside risks, including those stemming from the high level of public debt.

3. Policy action is called for to raise growth sustainably and more quickly close the still large gap in livings standards. The simultaneous achievement of more vigorous and broader-based growth, heightened resilience against risks, and external sustainability is possible. The paragraphs below set out the relevant policy requirements in greater detail.

Fiscal consolidation based on a sustainable policy framework

4. Fiscal consolidation is the near- and medium-term policy priority for boosting economic performance and lowering risk. It would reduce the risks associated with the high level of public debt and advance external sustainability by helping to narrow the current account deficit. Moreover, lower deficits would boost sustainable private-sector led growth by raising the flow of credit to the economy and securing lower interest rates.

5. As in 2010, the budget finds itself again under pressure. On current trends and policies, the deficit is projected to rise to 4⅔ percent of GDP in 2011 and above 5 percent in the medium term. This would push public debt up very close to the legal ceiling. As was the case last year, another mid-year budget review is thus imperative. It should target cuts of some 1½ percent of GDP (20 billion lek). Moreover, further consolidation efforts will be required in the following years.

6. The repeated budget slippages underscore the need for more realistic macroeconomic framework. Weaker economic activity has pressured revenue, but the shortfall compared to the initial budget mainly reflects its overoptimistic forecasts. More realistic projections could be achieved by assigning them to an independent and apolitical fiscal council, or by aligning them with those of independent professional forecasters. Any positive revenue surprises should be allocated to debt reduction.

7. An expenditure-based fiscal rule could form the centerpiece of sustainable fiscal policy. The recent need for large ad-hoc spending adjustments in mid-year risks completing critical infrastructure projects, triggering arrears and delayed payments, and crowding line agency spending into the early part of a year. Basing budgets on tight limits for expenditure growth avoids these risks, lowers incentives for revenue overoptimism, helps dispel any investor doubts about the government’s commitment to a small government, and offers an anchor for medium-term debt reduction. For example, the government’s pre-crisis target to lower public debt to 50 percent of GDP over the medium term can be achieved by limiting growth in annual real primary expenditure to 1¾ percent.

8. The needed fiscal consolidation will require credible measures and sustained effort. Already interest, wage, and entitlement spending claim more than two thirds of every lek the government collects in taxes and fees. If capital spending is to be sustained at its current share in GDP, the wage and entitlement bill would have to be indexed to inflation only.

9. If the required spending cuts are viewed as unrealistic, direct taxes or contributions will need to be raised. One measure could be to rescind the earlier cuts in social contributions, especially since they have not resulted in the hoped-for increased compliance. Doing so would also help lower the pension deficit—which, at 1 percent of GDP, stands at a rather large level, when put into perspective with Albania’s young and growing population—and facilitate the delayed pension reform. In addition, the very low flat income tax rates could be raised without imperiling Albania’s competitive position. There is also scope for improvements in tax administration, but they are not for free. For example, the stock of unclaimed VAT credits and unprocessed refund applications has reached very high levels and will need to be cleared quickly and current refunds be paid on time. This will be critical for raising future collections.

10. Efforts to improve debt management must be maintained. Albania’s successful debut in international capital markets with the placement of a Eurobond has lowered near-term rollover risks. Further progress is needed on lengthening the maturity of domestic debt, also with a view to develop lek markets. Fiscal consolidation will help achieve this at reasonable costs.

Safeguarding monetary and financial stability

11. The monetary policy framework of an inflation target and flexible exchange rate is a fundamental strength of the Albanian economy. In spite of higher imported prices and increases in administered prices and excises, inflation is projected to quickly return within the Bank of Albania’s target band, thanks to its credibility and a policy of timely and determined adjustment of monetary conditions.

12. A better macroeconomic policy mix is nevertheless called for. Improved fiscal performance will be critical in ascertaining external sustainability as well as the achievement of the inflation target at lower real interest rates. This would hold even more, if capital inflows were to accelerate.

13. Financial sector supervision and regulation will need to stay ahead of evolving challenges. The limited fallout of the global financial crisis owes much to earlier proactive and forceful supervision and regulation. Still, balance sheet repairs have some way to go, financial innovation is progressing, and new international and domestic challenges are on the horizon; hence, continued vigilance is critical. Priority areas for action include fostering the independence of supervisory institutions, expediting the execution of collateral, safeguarding liquidity, enhancing the stress testing framework, and keeping contingency planning up to date.

Upgrading the investment and business climate and safeguarding past achievements

14. Boosting productivity by attracting foreign investment is key for higher sustainable growth. The last decade witnessed the arrival of large-scale international investors in Albania, a critical factor in the transfer of technology and innovation, which in turn are essential for raising productivity and providing higher-wage employment in Albania.

15. A favorable investment environment is a vital condition for success. Albania’s EU perspective is one critical element in its attractiveness to investors. Other key requirements include the maintenance of a level playing field, the adoption of international best-practice regulations and their predictable enforcement by professional institutions. It is also important to persevere with the remaining structural reform agenda, where a relative deceleration of momentum in recent years; further action is especially important in securing property rights, land titling and improving contract enforcement.

16. High-quality economic statistics are essential to improve policy making and business environment. The authorities’ efforts aimed at improving economic statistics are welcome; and further progress on improving the statistical base is essential. Priority areas for improvement include external sector statistics and national accounts. INSTAT needs to be provided with adequate resources to make effective use of the substantial technical assistance delivered by the international community.

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The mission would also like to take this opportunity to thank the authorities for the warm hospitality, excellent cooperation, and fruitful discussions.