Workers at a potato factory in Pestova, Kosovo. To regain cost competitiveness in an economy like Kosovo, it is critical to reduce real labor costs, says IMF (photo: Hazir Reka/Reuters/Corbis)
IMF LENDING
Speaking to IMF Survey, the IMF Mission Chief for Kosovo, Jacques Miniane, and the Resident Representative in Kosovo, Ruud Vermeulen, said that significant progress has been made, but the economy still faces significant challenges, including on improving its competitiveness. The IMF is supporting the authorities’ economic program through a Stand-By Arrangement.
IMF Survey: Tell us a little bit about Kosovo’s economy, its main features as well as its main challenges.
Miniane: Kosovo is a young nation, having formally declared independence in 2008. Mirroring this, Kosovo has Europe’s youngest population, with half of Kosovars under the age of 25. This is both the economy’s main asset but also its main challenge.
Why a challenge? Well, while the economy has been steadily growing at an average rate of about 3 percent, which is not bad compared with its Western Balkan neighbors, it needs to grow quite faster than this for incomes to converge to Eastern European standards, and to provide jobs to new entrants into the labor force. At present, income per capita is about €3,000, while unemployment is very high at 30 percent. Neither the authorities nor we can be satisfied with such outcomes, and we are all too aware of the significant competitive challenges facing the country.
IMF Survey: In July 2015, the IMF approved a Stand-By Arrangement for Kosovo. What prompted the authorities to request a program, and what principles guided the design of the program?
Vermeulen: In the months leading to the 2014 elections, there was a significant expansion in public spending, with, for instance, large increases in public sector wages and social pensions as well as benefit packages for war veterans. This was not sustainable. The authorities turned to the IMF both to restore credibility, and to lend support for politically difficult reforms.
The philosophy behind the design of this program is simple: do only a few critical things, but try to do them well. What does it mean? For example, on the fiscal side, no consolidation for the sake of consolidation. In fact, deficits may go up under the program, but the key is that the space will be used for critical infrastructure investment, or for well-targeted social spending that truly reaches the most vulnerable. Similarly, the financial and structural reform legs of the program are pretty parsimonious. We are trying to target a limited set of issues which we consider crucial, such as uncompetitive labor costs, corruption and rule of law, and obstacles to financial intermediation.
IMF Survey: Could you describe the progress made since the program was approved?
Miniane: Kosovo has made progress. All fiscal and structural reform targets set so far have been met, some ahead of schedule. This is a testimony to the authorities’ strong commitment and ownership of the program. The fiscal situation is improving thanks to the efforts to mobilize revenues and restrain unproductive expenditures. Preliminary data for 2015 suggest that the fiscal deficit is well below the targets of the program and well within the fiscal rule’s limits.
Financial sector reforms are also proceeding at a solid pace. The central bank has introduced a new framework for emergency liquidity assistance in line with international best practices, which is key for a euroized economy. At the same time, the Central Bank is taking steps to further strengthen its ability to monitor and assess risks in the banking system.
Finally, we are seeing progress on the structural side. Access to credit is expected to improve thanks to the removal of obstacles to bank lending such as weaknesses in contract enforcement. In addition, the gradual replacement of decentralized procurement in favor of centralized procurement, and later e-procurement, is already resulting in measurable savings. This is testament to the fact that public procurement is becoming more level and transparent, and a concrete example of how one can make progress against economic corruption. This being said, we are not naïve, and we know that a lot remains to be done.
IMF Survey: What are the main risks to the program?
Vermeulen: The main risk is clearly on the political side. The current political gridlock weighs on consumer and investor confidence, and could deter investors from key projects, such as the building of a new power plant and a world-class ski resort. This would negatively affect growth, job creation, and revenue collection, and as such jeopardize the objectives of the program. Parliamentary paralysis could also delay important legislation. Finally, the risk that the parties fail to find a solution cannot be discounted, which would in turn risk undoing many of the achievements under the program.
IMF Survey: Can you tell us about the reform of the public wage bill? Why is it needed?
Miniane: Since independence in 2008, election cycles have coincided with very large increases in public sector wages, the government being by far the main souce of employment in Kosovo. As a result, public sector wages have almost tripled in nominal terms; they have grown three times faster than nominal GDP; and they have significantly outpaced public wages in neighboring countries, private sector wages in Kosovo, as well as productivity growth. This is not sustainable. The widening gap between public and private sector wages has made it difficult for the private sector to attract and retain talent, while rising labor costs have eroded Kosovo’s competitiveness.
For an economy like Kosovo to regain its competitiveness and create jobs, it is critical to reduce real labor costs. The program aims to achieve that objective through nominal public sector wage freezes over a few years, and the introduction of a public wage bill rule that will cap growth in the wage bill at nominal GDP growth going forward. The Assembly has adopted this rule, and it will come into effect in 2018. We are encouraged by the strong ownership of these measures by the authorities and we expect that they will stabilize the wage bill at about 9 percent of GDP, which is a reasonable level.
IMF Survey: How do you assess the competitiveness of the economy?
Vermeulen: Overall competitiveness is low. As hinted previously, labor costs are too high given current productivity levels. This is in large part due to remittances that have driven up reservation wages, together with the unrestrained growth in public sector wages. All in all, we estimate that the real effective exchange rate is overvalued by some 15-20 percent, perhaps even more.
In addition, non-price competitiveness is hurt by infrastructure and skills gaps, obstacles to bank lending, and weaknesses in the business environment and rule of law. However, we are confident that Kosovo’s competitiveness and external position will be improved by some of the measures included in the program that lower labor costs, create space for infrastructure investments, and strengthen contract enforcement and the public procurement process. This being said, it will take time to fix the deep-seated competitiveness issues.
IMF Survey: What can you tell us about the economic impact of the current refugee crisis?
Miniane: The refugee crisis has had a limited impact on Kosovo so far. Most refugees have bypassed Kosovo on their way to Western Europe. However, Kosovo has a sizable Diaspora in countries such as Germany and Switzerland and has seen a significant number of people emigrating in the recent past, reaching record post- 1990 conflict levels in early 2015.
The refugee crisis may mean that recipient countries will accept fewer Kosovo migrants. Germany has already declared Kosovo a safe country of origin and is now returning asylum seekers back home. The social safety valve of emigration that cushioned the impact of high unemployment could thus be under threat. While this and related risks cannot be ignored, we do not expect that this will materially impact remittances flows from the Diaspora already established in Western Europe.
IMF Survey: Going forward, what are the most pressing economic priorities for Kosovo?
Vermeulen: Let me put things in perspective: one in every three working-age Kosovar is unemployed, and one in two young people. In this context, raising medium-term growth prospects and generating jobs remains the number one priority for the country. To this end, Kosovo should move away from its current remittances-driven growth model towards one led by production and exports. In addition, Kosovo needs to close its competitiveness gap to unlock investments in its export sectors, funded domestically and externally.
As part of this, it will be critical to more forcefully fight endemic corruption and strengthen the rule of law. While policies under the program try to address these problems, it will take many years to get to the root of these issues. The current program is set to expire in May next year, hence it will be important to sustain fiscal, financial, and structural reform efforts beyond the time horizon of the program.
