## 1. Western Balkans—Various Regional Initiatives

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### Public infrastructure: regional context and objectives
- Accelerating economic convergence with the EU is a key objective; the Stabilization and Association Agreement (SAA) came into force in April 2016 and requires progress on the ground to support income convergence.
- Lack of public capital is identified as one of the key reasons behind slow economic progress and recent stagnation in narrowing income convergence.
- Upgrading and expanding public capital stock are essential to achieve higher and sustainable economic growth.

### International/regional initiatives and financing frameworks
- Stability Pact for South-Eastern Europe (launched 1999) provided an internationally-led conflict prevention and reconstruction strategy; later deemed obsolete due to insufficient recipient-country ownership.
- Cooperation Council (established 2008) succeeded the Stability Pact with increased recipient-country role.
- Instrument for the Pre-accession Assistance (IPA) replaced multiple pre-accession instruments to support candidate and potential candidate countries.
- Western Balkans Investment Framework (WBIF), established 2009, coordinates EU Commission, IFIs and bilateral donors to accelerate priority investments through a blending financial mechanism (grant facility and lending facility).
  - Financial institutions participating in WBIF could leverage up to a 1.5 percent of the regional GDP per year of financing in the next 5 years (including the EU EPA II), assuming disbursements in line with the past.
  - Even assuming speedy improvements in project cycles, these resources would be just enough to fund up to 50 percent of the estimated financing needs to close estimated infrastructure gaps.
- Berlin Process (post-2014) focuses on regional infrastructure and connectivity:
  - In the Trieste summit (July 2017), the EU committed an additional €190 million for connectivity projects and adopted an action plan for establishing the regional economic area.

### Key analytical findings on regional infrastructure
- Low stock and poor quality of public infrastructure across the Western Balkans largely reflect the region’s troubled history, political fragmentation, and conflicts, which caused lumpy capital accumulation and capital stock depletion through the 1990s.
- Multiplicity and fragmentation of donors’ instruments, lack of coordination, and limited capacity/ownership in recipient countries have constrained implementation despite substantial international efforts over the last 15 years.

### Kosovo: infrastructure gaps and sectoral bottlenecks
- Quantitative indicators relative to the EU show inadequate coverage of motorways and railways; airport capacity and power generation are very low and insufficient to meet current and prospective demands.
- Infrastructure index gap metrics:
  - Kosovo gap is close to 60 percent lower than the EU average.
  - The Western Balkans regional average gap is slightly above 40 percent lower than the EU average.
  - Large variance among Western Balkan countries: Albania and Bosnia and Herzegovina close to 60 percent lower than the EU; Serbia about 25 percent lower.
- Specific constraints in Kosovo:
  - Railway and motorway density: both weak and well below peers; railway network very obsolete.
  - Power capacity: particularly poor.
    - Kosovo power sector dominated by Kosova A (551 MW) and Kosova B (620 MW), sourced with domestic lignite reserves.
    - The three operating units of Kosova A were operating at about 65 percent of installed capacity; commissioned in the early 1970s; were expected to be decommissioned by end-2017 but now cannot be decommissioned before 2023 when the new plant is expected to be fully operational.
    - Government selected a preferred bidder in November 2015 to construct a 500 Mw power plant and entered negotiations with a private foreign company with the IFC as transaction advisor. Actual operation of the new plant is not expected to commence until 2023.
    - The 400 Kw interconnection between Albania and Kosovo was completed but has not been activated; operationalization is delayed by legal and political obstacles preventing KOSTT from becoming a member of ENTSO-E.
    - Generating capacity in Albania and Kosovo does not exceed 0.8 Kw per habitant, less than half of that in Slovenia and about one-fourth of that in Austria.
    - Energy intensity is very high (six times higher than in the EU), indicating poor energy efficiency.
  - Air transportation/utilization: inadequate but aligned with regional peers.
  - Telecommunications: cell phone connectivity and broadband broadly adequate; phone land lines well behind EU average.
- Quality of existing infrastructure is poor (survey-based indicators from the World Economic Forum suggest quality much lower than measured by quantitative indicators).

### Kosovo: public investment, capital spending, and capital stock
- Since independence in 2008:
  - Annual capital budget has accounted for 9 percent of GDP on average.
  - Infrastructure capital spending has accounted for roughly 35 percent of total public spending, with a rate of implementation close to 90 percent.
- Expenditures dominated by motorways:
  - Route 7 (Pristina–Albanian border) cost close to 20 percent of GDP and absorbed the largest share of the capital budget.
  - Route 6 (Pristina–Macedonian border) completion expected by early 2019 with estimated total cost in the range of 10-12 percent of GDP; completion will occupy much of available fiscal space until 2019.
- Despite relatively high capital spending, public capital stock remains low:
  - Public capital stock is currently 20 percent below the average of Western Balkans countries.
  - Public capital stock is 60 percent below the EU average.
  - New infrastructure projects have been dominated by Route 6 and Route 7 construction.
- National Development Strategy (NDS) 2016-2021:
  - Authorities adopted for the first time a priority project list in March 2016 with total estimated costs in the range of €850 million-€1 billion (15-20 percent of GDP).
  - A revised investment clause of the fiscal rule allows new donor/IFI-financed capital projects not to count against the 2-percent fiscal rule deficit limit if (a) the government bank balance is at least 4.5 percent of GDP and (b) the underlying fiscal deficit is within the fiscal rule. This exemption is subject to a 10-year sunset clause and a debt limit (30 percent of GDP).

### Policy implications and recommendations (infrastructure)
- Strengthen Kosovo’s investment framework to leverage resources from international development partners (EU, EIB, EBRD) and accelerate implementation of priority projects.
- Improve the overall project cycle—preparation, selection, monitoring, execution, auditing and ex-post assessment—to increase actual disbursements and effectiveness of donor/IFI financing.
- Enhance recipient-country ownership and coordination among donors to overcome fragmentation of financial instruments and limited implementation capacity.
- Prioritize resolving legal and political obstacles preventing KOSTT’s ENTSO-E membership to operationalize the Albania–Kosovo interconnection and facilitate regional energy market participation.
- Use the March 2016 priority project list as a basis for mobilizing donor and development partner financing, recognizing the total estimated project costs of €850 million-€1 billion (15-20 percent of GDP).

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### Public investment management: assessment and weaknesses
- Public investment can be an important catalyst for economic growth, but the benefit of additional investment depends crucially on its efficiency.
- The Public Investment Management Assessment (PIMA) reports point to significant institutional weaknesses in public investment management practices, especially in:
  - project appraisal, selection and management;
  - national planning and central-local coordination;
  - multi-year budgets and their comprehensiveness;
  - ex-post independent auditing and assessment of large-scale projects.
- Some progress acknowledged: publication of the National Development Strategy and the single project pipeline, which serve as cornerstones for project prioritization and donor/IFI discussions.
- Kosovo established a National Investment Committee (NIC) to adopt, update, and monitor the priority project list in line with the WBIF process.

### National priority projects (Estimated Total Cost, Millions of euro; Execution Period)
- 1 Rehabilitation of Railway 10 — 195.32 — 2016-2021
- 2 Rehabilitation of regional roads — 29 — 2017-2018
- 3 Modernisation of the railway Pristina-Fushe-Pristina Airport — 40.2 — 1/TBD
- 4 Water Security and Canal Protection Project — 22 — 2017-2022
- 5 Construction of Road 9 Pristina-Peje — 60.82 — 2018-2024
- 6 Rehabilitation of the Eastern-Sourthern Railway — 158.5 — 1/TBD
- 7 Extending irrigation system of Radoniqi - Stage II — 31.5 — 1/2019-2022
- 8 Construction of the new Highway Pristina-Gjilan-Dheu I Bardhe — 250 — 1/TBD
- 9 Pristina Waste Treatment — N/A — N/A
- Note: 1/ Preliminary estimation of total project costs.
- Two new loan agreements signed with the EBRD and EIB for Rehabilitation of Railway 10, complemented by EU grants, and one IDA loan for the water supply project; implementation has been slow and total disbursement until end of June 2017 has been disappointing.
- Preliminary estimates suggest completion of the rail and road projects alone would close a quarter of the current infrastructure gap.
- Implementation of priority projects implies an overall increase in capital spending by 12-15 percentage points of GDP over the next 6-7 years (Section F).
- This higher capital spending could reduce Kosovo’s overall public infrastructure gap vis-à-vis EU countries from 60 to 40 percent.

### Financing options: strengths, constraints, and instruments
- Kosovo’s debt position is currently low, at around 20 percent of GDP, characterized by no foreign commercial loans; foreign debt consists of loans by IFIs and bilateral donors.
- The impact of a capital spending surge on the debt-to-GDP ratio depends on economic activity and tax revenue responses to the investment stimulus, and on government capacity to prioritize productive investments and strengthen absorption capacity.
- Constraints:
  - Limited domestic savings and a shallow financial system; single large projects might exhaust fiscal space for years (example: Routes 6 and 7).
  - Potential crowding out of private sector investment if domestic financing is used.
- Options and assessments:
  - Revenue mobilization and expenditure rationalization could help but only at the margin: since 2015 tax revenues increased by more than 2 percentage points, and current expenditures were frozen at around 20 percent of GDP.
  - External commercial borrowing can finance large projects and free domestic resources, but introduces refinancing, interest, and exchange rate risks.
  - IFI financing remains the most suitable source: favorable interest costs, longer maturity and grace periods, less crowding out; IFIs can provide technical assistance for project selection, preparation, and catalyzing private capital.
  - Diaspora bonds could tap remittance wealth; success higher if proceeds directly finance key infrastructure or benefit diaspora/family; designing such programs is challenging and many attempts have failed.
  - Private financing via PPPs could mobilize private savings and increase efficiency, but requires a sound PPP framework to limit fiscal risks; PPPs can generate explicit and implicit contingent liabilities and encourage off-balance operations while reducing transparency. PPP experiences in the region have been marginal and almost absent in Kosovo.

---

### Macroeconomic impact of scaling-up public capital spending (model and scenarios)
- Model features:
  - Model-based approach simulates dynamic interactions of public investment, growth and fiscal stance; public capital is the model’s “engine”.
  - Public finances subject to budget constraints to ensure debt sustainability; in short/medium run model allows fiscal gap between taxes and capital spending to be financed with borrowing.
  - Key assumption across scenarios: an exogenous increase in public investment by about 12.5 percentage points of GDP, over seven years.
- Scenario outcomes:
  - a. Domestic scenario (capital surge entirely financed by domestic borrowing, largely absorbed by banks):
    - Growth dividend is marginal: less than a 0.1 percentage points increase in the annual growth rate compared to baseline.
    - Aggregate demand impact is largely offset by lower private investment (crowding out) and compressed consumption due to increased tax burden (e.g. VAT) needed for debt service.
    - Debt burden increases more rapidly (above and beyond the 30-percent ceiling), with higher debt vulnerabilities throughout the foreseeable future.
  - b. “Improved” policy scenario (higher efficiency of public spending and greater focus on regional connectivity projects):
    - Growth dividend somewhat higher.
    - Debt-related vulnerabilities remain high despite an expected decline in the debt ratio.
  - c. Concessional financing scenario (increased public investment financed by an equal mix of donor grants and IFI financing):
    - Most favorable scenario due to low interest rates and longer maturity of IFI financing.
    - Could generate a long-term improvement in the level of real GDP per capita in the range of 3-3.5 percentage points above the current baseline.
- Model calibration notes (as used in simulations):
  - A real GDP growth of 4 percent is assumed under the 2015 SBA arrangement.
  - Public debt to GDP ratio of 20 percent (includes former Yugoslavia debt).
  - VAT is 18 percent.
  - Public investment to GDP ratio set at 9 percent to match the average observed in 2008-2016.
  - Real average domestic and external interest rates assumed at 7 and 5 percent, respectively.
  - Productivity of capital assumed at around 20 percent.

### Conclusions and policy implications (multi-pronged approach)
- Scaling up public investment can raise GDP growth potential and accelerate income convergence toward the EU average, but implementation has been modest despite the new investment clause of the fiscal rule exempting IFI-financed projects from the deficit ceiling.
- Recently regained fiscal sustainability should be preserved.
- Scaling up infrastructure is better funded through donor and IFI financing to reduce crowding out and ensure better project selection and vetting, but a weak public investment management framework complicates mobilizing such financing.
- Recommended multi-pronged approach to mobilize external financing, increase absorption capacity, accelerate project implementation, and improve investment efficiency:
  - Introduce a requirement for cost-benefit analysis; strengthen selection, planning, execution of priority projects, and ex-post auditing to prevent addition of politically motivated projects with unclear economic impact.
  - Maximize regional coordination, particularly in the WBIF context, to increase expected returns, improve investment attractiveness and European integration, and secure concessional financing and grants from the EU and IFIs.
  - Prepare multi-year budgets for investment spending to cover construction and maintenance costs, based on conservative assumptions; the medium-term expenditure framework should better reflect fiscal pressures from large scale capital projects.
  - Modernize public procurement processes, including adoption of e-procurement to ensure transparency and a level playing field among suppliers, which is essential to ensure adequate returns from spending and to tackle corruption.

---

### Appendix I — An Index for Infrastructure Gaps (methodology summary)
- Six key quantity indicators used (benchmarked to the EU average; positive gap = above EU average):
  - Telephone/cell phone lines per capita
  - Broadband subscriptions per capita
  - Installed capacity to generate electricity per capita
  - Air passengers carried per capita
  - Highways per km² after controlling for population density
  - Railroad per km² after controlling for population density
- Infrastructure gap formula (per indicator j, country i, time t):
  - Infrastructure gap_i,j,t = [(Indicator_i,t / average(Indicator)_EU,t) − 1] * 100
- Aggregate infrastructure gap constructed using weights inversely related to the volatility (standard deviation) of each indicator gap across time:
  - Aggregate infrastructure gap_i,t = Σ_j w_j * infrastructure gap_i,j,t
  - w_j = 1 / (Σ Std_i(Infrastructure gap_i,j) / # of countries)
- Robustness check using equal weights yields similar results:
  - Aggregate infrastructure gap_i,t = Σ_j Infrastructure gap_i,j,t / 6
- Data sources: World Bank WDI, International Energy Agency, International Road Federation, country authorities’ data.

*Source: IMF staff paper prepared by Giuseppe Cipollone based on the International Monetary Fund European Department Paper “Public Infrastructure in the Western Balkans: Opportunities and Challenges” (January 22, 2018).*

### 12. The public investment management framework, however, needs to be

### Public investment management: assessment and priority actions
- PIMA reports point to significant institutional weaknesses in:
  - project appraisal, selection and management;
  - national planning and central-local coordination;
  - multi-year budgets and their comprehensiveness;
  - ex-post independent auditing and assessment of large-scale projects.
- Progress: National Development Strategy and the single project pipeline published; National Investment Committee (NIC) established to adopt, update, and monitor priority project list.

### Implementation status and financing
- Two new loan agreements signed with the EBRD and EIB for Rehabilitation of Railway 10, complemented by EU grants, and one IDA loan for water supply; implementation slow and total disbursement until end of June 2017 disappointing.
- Preliminary estimates: completion of rail and road projects alone would close a quarter of the current infrastructure gap.
- Implementation of priority projects implies an overall increase in capital spending by 12-15 percentage points of GDP over the next 6-7 years.
- Higher capital spending could reduce Kosovo’s overall public infrastructure gap vis-à-vis EU countries from 60 to 40 percent.

---

### Appendix II. General Equilibrium Model

### Model purpose and key feature
- A general equilibrium model—developed by Berg et al (2012)—was used to simulate a public investment surge.
- The model allows analysis of the interactions between GDP growth, public investment, and public debt.
- The key feature is the public investment-growth nexus.

### Model structure, agents and financing alternatives
- Small open economy with tradable and non-tradable sectors; inputs: private capital, public infrastructure, labor.
- Includes public and private capital; public investment can either increase output by stimulating private investment or crowd it out depending on public capital productivity.
- Agents can import goods for consumption or capital production.
- Two types of consumers: saver and hand-to-mouth consumer.
- Government functions: collects taxes on consumption and fees on public capital; finances via:
  - Increasing tax revenues.
  - Collecting fees on the use of public capital.
  - Borrowing domestically.
  - Borrowing externally.
  - Borrowing externally at concessional rates (e.g. a mix of EU grants and IFI financing).
- Model ensures debt sustainability by allowing tax rates to respond to public debt increases.

### Public investment efficiency and calibration
- Public investment expenditures do not always increase the stock of public capital; model accounts for non-productive share of expenditure.
- Simulations calibrated to Western Balkans average with parameters:
  - real GDP per capita of 3 percent (based on growth observed in 2006-16)
  - public debt to GDP ratio of 51 percent (average public debt for the region in 2016)
  - average tax rate of 18 percent
  - public investment to GDP ratio at 5.2 percent (to match the average observed in the region in 2016)
  - real average domestic interest rate of 7 percent
  - real average external interest rate of 5 percent
  - productivity of capital is assumed to be 20 percent
- Efficiency of the public investment framework calibrated based on Dabla-Norris et al (2011).

*Source: Appendix II. General Equilibrium Model (cr1831).*

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### 18. Social benefit spending in Kosovo has increased substantially since 2010 though

### Overview and main assessment
- Social benefit spending in Kosovo has increased substantially since 2010 though the performance for the expenditure level remains weak by regional standards.
- Weaknesses identified: low coverage, weak targeting and insufficient adequacy of many benefits.
- Composition shift: spending has shifted towards war-related rather than a poverty, inequality and employment enhancing focus.
- Macro-critical objective: Social benefit reform is macro-critical to ameliorate future increases in inequality, while addressing current widespread unemployment and low income of individuals, which should increase aggregate growth.

### Key statistics and program features (selected)
- Social assistance scheme (2017 estimate): 28.5 Euros, millions; Number of beneficiaries (December 2017): 26,117; Average benefit amount, € per month (spending/beneficiaries): 91.
- Basic pension (2017 spending estimate): 113.1 Euros, millions; Number of beneficiaries (December 2017): 122,716; Average benefit amount, € per month: Flat (78); Target group: All 65+; pension tested.
- “Contributory pension”: 90.7 Euros, millions; Number of beneficiaries: 43,300; Average benefit amount, € per month: 179 (range)1/; Beneficiaries based on law from before 1999*.
- Disability pension (civilian): 18.9 Euros, millions; Number of beneficiaries: 19,481; Average benefit amount, € per month: Flat (82); Target: 100 percent disabled.
- Trepca early pension: 4.2 Euros, millions; Number of beneficiaries: 3,232; Average benefit amount, € per month: Flat (105); Target: Involuntary unemployed ;> 50% disabled threshold.
- Kosovo Pension Savings Trusts (KPST): Funded defined contributory scheme; 2017 spending estimate: 5,207 Euros, millions; Number of beneficiaries: Phased withdrawal (at least 150) or annuity; Target: All, payout starting at the age of 65.
- War veterans pension: 78.05 Euros, millions; Number of beneficiaries: 38,263; Average benefit amount, € per month: 170; Target: Certified veteran of war and unemployed.
- Families of martyrs: 10.6 Euros, millions; Number of beneficiaries: 1,934; Average benefit amount, € per month: 455; Target: Families of KLA fighters who died during the armed struggle or later, as a direct result of injuries sustained.
- War invalids of KLA: 12.1 Euros, millions; Number of beneficiaries: 3,405; Average benefit amount, € per month: 295; Target: Disability of 20 percent or higher.
- Note: 1/ Indicative amount.

### Policy recommendations (schemes and cross-cutting)
- All schemes:
  - Set overarching goals and parameters for social benefits, including increasing coverage and benefit levels for bottom of distribution.
  - Introduce an enforceable residency eligibility requirement, such as requiring individuals to pick-up benefits in person every month.
  - Remove disincentives to work by removing requirement of being unemployed to receive a benefit, the exception being for employment benefits.
  - Subject all benefits to personal income tax.
- Age, disability and family benefits:
  - Apply uniform disability criteria across schemes and equalize benefit amounts downwards towards civilian scheme.
  - Revise occupational scheme from general government financing to defined contribution and base benefit amounts on career average earnings.
  - Prevent any reforms that would allow for early retirement, unless actuarily and budget neutral.
- Poverty focused benefits:
  - Index benefits to inflation to avoid the erosion of value over time.
  - Reform the current social assistance scheme to improve the poverty-reduction goal by increasing the benefit amount and improving targeting criteria - to increase the share of beneficiaries and benefits allocated to the bottom of the distribution - by removing categorical requirements for age, unemployment, and that recipients are a family.
- War-related benefits:
  - Enforce the 0.7 percent of GDP budget cap on the veteran’s pensions, and credibly complete reclassification and verification of beneficiaries.
  - Restrict benefits to the current generation.
  - Consider one-off payments in lieu of permanent benefits.

### Targeting and methodology (appendices summary)
- Data: HBS household survey (~12,000 individuals), welfare measured by household expenditure per adult equivalent; poverty line set at 17.6 percent.
- Targeting recommendation: Use layered methods (e.g., geographic targeting + PMT + community-based final verification); PMT effective where income is difficult to verify.
- Trade-offs: Administrative costs, private opportunity costs, perverse incentives, stigma, and political challenges should be managed; pool functions across programs to reduce costs.

*Italic: International Monetary Fund staff summary of content from the chapter.*

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### Kosovo’s banking sector started largely from scratch in the early 2000s

### Historical evolution and credit cycles
- Post-1998-99 war starting point:
  - Banking system assets equivalent to 4.3 percent of GDP.
  - Banks’ outstanding loans at end-2000 totaled €3.3 million.
  - Loans did not comprise a majority of banks’ balance sheets until 2005.
- Boom over 2005-09 driven by foreign funding inflows and independence:
  - By 2005, loans comprised roughly half of bank balance sheets.
  - Credit growth settled into a 20-40 percent y/y range through 2009.
  - Financial depth nearly doubled from 17 to 32 percent.
- No post-boom bust experienced:
  - Credit growth eased significantly in mid-2008 but still averaged 14.5 percent y/y over 2009-11.

### Stagnation (2012–2014) and renewed growth (2015 onward)
- Financial deepening stalled beginning in 2012:
  - Credit growth to the private sector averaged 3.7 percent y/y from October 2012 to October 2014; credit-to-GDP was correspondingly flat.
- Lending growth returned since mid-2015:
  - Credit growth averaged 8.4 percent y/y since June 2015.
  - Kosovo’s credit-to-GDP rose by 2 percentage points of GDP to 36.8 percent in 2016.

### Composition of lending and structural implications
- Loan portfolio composition:
  - Roughly two-thirds corporate loans and one-third household lending.
- Recent upcycle composition concerns:
  - Strong growth in household lending concentrated in consumer goods; new mortgage loans are growing strongly but the market is nascent.
  - Corporate loan growth dominated by wholesale/retail trade and services; limited lending to manufacturing and mining.

### Drivers and constraints on credit growth
- Demand-side drivers:
  - Macroeconomic environment: GDP growth averaged 4.5 percent per year during 2005-11; dropped to 2.5 percent per year while credit stagnated over 2010s; growth since 2015 has been slightly below the boom period but well above stagnation years.
  - Lending rates:
    - Average lending rates hovered around 15 percent until mid-2011.
    - Gradual decline of about 200 basis points over three years after mid-2011.
    - Since early 2014, average lending rate has fallen by roughly 500 basis points.
    - The sharpest drop, of 390 basis points, occurred between October 2014 and April 2015.
- Supply-side developments:
  - NPL ratio doubled to a peak of 8.8 percent in early 2014, then halved since due to increased provisioning, targeted writeoffs, and strong credit growth.
  - Banks generally well-capitalized, liquid, and profitable in aggregate.
  - EU-based banks account for 64 percent of system assets and have returned to lending after pulling back post-euro area crisis.
  - Financial sector reforms: judicial reforms, introduction of Private Enforcement Agents (PEAs), centralized registry of bank account holders at the Central Bank of Kosovo (CBK), risk-based supervision, emergency liquidity assistance framework, deposit insurance fund, macroprudential policy framework.

### Enforcement outcomes (Box 1 summary)
- As of July 2014, courts had an outstanding backlog of over 145,000 open cases (population noted as 1.8 million).
- PEAs introduced in 2014; between May 2014 and December 2015 PEAs resolved 4,809 cases and recovered €51.5 million (equivalent to 0.9 percent of GDP); unofficial estimates suggest recoveries have doubled since then.
- Over 91,000 court-based enforcement cases closed since May 2013 under USAID-supported efforts.

### Empirical disequilibrium analysis of credit supply and demand
- Disequilibrium model based on Everaert et al (2015); monthly data December 2006–April 2017.
- Findings:
  - All variables statistically significant with expected signs except interest rate margin on the demand side (positive sign observed).
  - From mid-2009 onward, supply and demand contributed fairly evenly to credit growth; supply factors were moderately more important during 2011-13 slowdown and the recovery after 2014.
  - Slowdown 2011-13 mostly supply-driven; recovery 2014-present saw both supply and demand recover, with supply improving earlier.

---

### 16. Private credit is also below the level predicted by fundamentals

### Findings on private credit relative to fundamentals
- Per capita private credit is estimated as a reduced form function of supply and demand components; fundamentals include per capita GDP and the interest rate on private debt.
- Results show private credit is some 5-6 percentage points of GDP below the level predicted by fundamentals.
- Caveat: Kosovo data do not span a full credit cycle; using a more balanced sample (2002-2016) the credit gap for Kosovo widens somewhat.

### Pace of credit growth required to close the gap
- Closing the credit gap in the medium-term would require credit growth to significantly outpace nominal GDP growth:
  - Baseline projections for nominal GDP imply that credit growth would have to average 9 percent per year to close the gap in the next five years.
- Kosovo’s private credit depth:
  - Domestic bank credit to private sector about 37 percent of GDP.
  - This is 8 percentage points below the Western Balkan countries’ average.
  - Broader measure including cross-border lending and non-bank credit equals 56 percent of GDP, still 10 percentage points below the regional average.
- If the rapid pace of credit growth seen since early 2016 continues:
  - Kosovo would experience an increase of its credit-to-GDP ratio by 16 percentage points, to 52 percent, by 2026.
  - Recent average credit growth since January 2016 is 9.5 percent y/y.
  - Projected medium-term nominal GDP growth is 6.0 percent y/y.
- Conservative scenarios:
  - If credit grows at same rate as deposits, credit-to-GDP would increase by only 1 to 3 percentage points by 2026.
  - If recent deposit growth parallels recent credit growth, loan-to-deposit ratio would reach 100 percent by 2024, raising financial stability concerns.
  - If deposits continue and all deposits allocated to lending (loan-to-deposit ratio rises to 100 percent by 2026): Credit/GDP would rise by 12 to 15 percentage points, to 49 to 52 percent, by 2026.

### Policy recommendations (financial deepening)
- Demand-side:
  - Maintain macroeconomic stability; contain unproductive current spending and create space for growth- and productivity-friendly capital investments.
  - Improve the business environment: reduce administrative burden, reduce informality, further improve infrastructure.
- Supply-side:
  - Central bank to continue strong supervisory oversight and further develop macroprudential policy framework.
  - Reduce structural bottlenecks: inefficiencies in court and collection system; fully establish best-practice cadastre system to identify and protect property rights.
- Long-term funding diversification:
  - Explore ways to diversify banking funding sources (e.g., a local capital market where banks could issue bonds), recognizing capital markets are nascent and this is a longer-term policy goal.

### Appendix II — Estimating fundamentals-consistent levels of credit (methodology)
- Sample: 34 European countries during 1995–2016.
- Stylized reduced-form model: private sector credit driven by per capita income and nominal interest rate on private debt; includes country-specific constants and time effects.
- Preferred estimator: Arellano-Bond dynamic-panel system GMM (GMM-SYS).
- Long-run relationship from GMM-SYS:
  - d* = 1.62 y* – 2.58 int, where variables are natural logarithms of per capita quantities in thousands of 2005 PPP U.S. dollars.

*Source: CBK, IFS, staff estimates; IMF staff analysis in cr1831.*

### 1. Western Balkans—Various Regional Initiatives _________________________________________4

### 1. Western Balkans—Various Regional Initiatives

### Public infrastructure: regional context and objectives
- Accelerating economic convergence with the EU is a key objective; the Stabilization and Association Agreement (SAA) came into force in April 2016 and requires progress on the ground to support income convergence.
- Lack of public capital is identified as one of the key reasons behind slow economic progress and recent stagnation in narrowing income convergence.
- Upgrading and expanding public capital stock are essential to achieve higher and sustainable economic growth.

### International/regional initiatives and financing frameworks
- Stability Pact for South-Eastern Europe (launched 1999) provided an internationally-led conflict prevention and reconstruction strategy; later deemed obsolete due to insufficient recipient-country ownership.
- Cooperation Council (established 2008) succeeded the Stability Pact with increased recipient-country role.
- Instrument for the Pre-accession Assistance (IPA) replaced multiple pre-accession instruments to support candidate and potential candidate countries.
- Western Balkans Investment Framework (WBIF), established 2009, coordinates EU Commission, IFIs and bilateral donors to accelerate priority investments through a blending financial mechanism (grant facility and lending facility).
  - Financial institutions participating in WBIF could leverage up to a 1.5 percent of the regional GDP per year of financing in the next 5 years (including the EU EPA II), assuming disbursements in line with the past.
  - Even assuming speedy improvements in project cycles, these resources would be just enough to fund up to 50 percent of the estimated financing needs to close estimated infrastructure gaps.
- Berlin Process (post-2014) focuses on regional infrastructure and connectivity:
  - In the Trieste summit (July 2017), the EU committed an additional €190 million for connectivity projects and adopted an action plan for establishing the regional economic area.

### Key analytical findings on regional infrastructure
- Low stock and poor quality of public infrastructure across the Western Balkans largely reflect the region’s troubled history, political fragmentation, and conflicts, which caused lumpy capital accumulation and capital stock depletion through the 1990s.
- Multiplicity and fragmentation of donors’ instruments, lack of coordination, and limited capacity/ownership in recipient countries have constrained implementation despite substantial international efforts over the last 15 years.

### Kosovo: infrastructure gaps and sectoral bottlenecks
- Quantitative indicators relative to the EU show inadequate coverage of motorways and railways; airport capacity and power generation are very low and insufficient to meet current and prospective demands.
- Infrastructure index gap metrics:
  - Kosovo gap is close to 60 percent lower than the EU average.
  - The Western Balkans regional average gap is slightly above 40 percent lower than the EU average.
  - Large variance among Western Balkan countries: Albania and Bosnia and Herzegovina close to 60 percent lower than the EU; Serbia about 25 percent lower.
- Specific constraints in Kosovo:
  - Railway and motorway density: both weak and well below peers; railway network very obsolete.
  - Power capacity: particularly poor.
    - Kosovo power sector dominated by Kosova A (551 MW) and Kosova B (620 MW), sourced with domestic lignite reserves.
    - The three operating units of Kosova A were operating at about 65 percent of installed capacity; commissioned in the early 1970s; were expected to be decommissioned by end-2017 but now cannot be decommissioned before 2023 when the new plant is expected to be fully operational.
    - Government selected a preferred bidder in November 2015 to construct a 500 Mw power plant and entered negotiations with a private foreign company with the IFC as transaction advisor. Actual operation of the new plant is not expected to commence until 2023.
    - The 400 Kw interconnection between Albania and Kosovo was completed but has not been activated; operationalization is delayed by legal and political obstacles preventing KOSTT from becoming a member of ENTSO-E.
    - Generating capacity in Albania and Kosovo does not exceed 0.8 Kw per habitant, less than half of that in Slovenia and about one-fourth of that in Austria.
    - Energy intensity is very high (six times higher than in the EU), indicating poor energy efficiency.
  - Air transportation/utilization: inadequate but aligned with regional peers.
  - Telecommunications: cell phone connectivity and broadband broadly adequate; phone land lines well behind EU average.
- Quality of existing infrastructure is poor (survey-based indicators from the World Economic Forum suggest quality much lower than measured by quantitative indicators).

### Kosovo: public investment, capital spending, and capital stock
- Since independence in 2008:
  - Annual capital budget has accounted for 9 percent of GDP on average.
  - Infrastructure capital spending has accounted for roughly 35 percent of total public spending, with a rate of implementation close to 90 percent.
- Expenditures dominated by motorways:
  - Route 7 (Pristina–Albanian border) cost close to 20 percent of GDP and absorbed the largest share of the capital budget.
  - Route 6 (Pristina–Macedonian border) completion expected by early 2019 with estimated total cost in the range of 10-12 percent of GDP; completion will occupy much of available fiscal space until 2019.
- Despite relatively high capital spending, public capital stock remains low:
  - Public capital stock is currently 20 percent below the average of Western Balkans countries.
  - Public capital stock is 60 percent below the EU average.
  - New infrastructure projects have been dominated by Route 6 and Route 7 construction.
- National Development Strategy (NDS) 2016-2021:
  - Authorities adopted for the first time a priority project list in March 2016 with total estimated costs in the range of €850 million-€1 billion (15-20 percent of GDP).
  - A revised investment clause of the fiscal rule allows new donor/IFI-financed capital projects not to count against the 2-percent fiscal rule deficit limit if (a) the government bank balance is at least 4.5 percent of GDP and (b) the underlying fiscal deficit is within the fiscal rule. This exemption is subject to a 10-year sunset clause and a debt limit (30 percent of GDP).

### Policy implications and recommendations highlighted in the text
- Strengthen Kosovo’s investment framework to leverage resources from international development partners (EU, EIB, EBRD) and accelerate implementation of priority projects.
- Improve the overall project cycle—preparation, selection, monitoring, execution, auditing and ex-post assessment—to increase actual disbursements and effectiveness of donor/IFI financing.
- Enhance recipient-country ownership and coordination among donors to overcome fragmentation of financial instruments and limited implementation capacity.
- Prioritize resolving legal and political obstacles preventing KOSTT’s ENTSO-E membership to operationalize the Albania–Kosovo interconnection and facilitate regional energy market participation.
- Use the March 2016 priority project list as a basis for mobilizing donor and development partner financing, recognizing the total estimated project costs of €850 million-€1 billion (15-20 percent of GDP).

*Source: IMF staff paper prepared by Giuseppe Cipollone based on the International Monetary Fund European Department Paper “Public Infrastructure in the Western Balkans: Opportunities and Challenges” (January 22, 2018).*

### 12.      The public investment management framework, however, needs to be

### 12.      The public investment management framework, however, needs to be

### Public investment management: assessment and weaknesses
- Public investment can be an important catalyst for economic growth, but the benefit of additional investment depends crucially on its efficiency.
- The Public Investment Management Assessment (PIMA) reports point to significant institutional weaknesses in public investment management practices, especially in:
  - project appraisal, selection and management;
  - national planning and central-local coordination;
  - multi-year budgets and their comprehensiveness;
  - ex-post independent auditing and assessment of large-scale projects.
- Some progress acknowledged: publication of the National Development Strategy and the single project pipeline, which serve as cornerstones for project prioritization and donor/IFI discussions.

### National investment frameworks and priority projects
- Kosovo established a National Investment Committee (NIC) to adopt, update, and monitor the priority project list in line with the WBIF process.
- Focus of national pipelines (Western Balkans): largely on transport infrastructure (roads and railways) and energy generation capacity.
- Priority Projects (Estimated Total Cost, Millions of euro; Execution Period):
  - 1 Rehabilitation of Railway 10 — 195.32 — 2016-2021
  - 2 Rehabilitation of regional roads — 29 — 2017-2018
  - 3 Modernisation of the railway Pristina-Fushe-Pristina Airport — 40.2 — 1/TBD
  - 4 Water Security and Canal Protection Project — 22 — 2017-2022
  - 5 Construction of Road 9 Pristina-Peje — 60.82 — 2018-2024
  - 6 Rehabilitation of the Eastern-Sourthern Railway — 158.5 — 1/TBD
  - 7 Extending irrigation system of Radoniqi - Stage II — 31.5 — 1/2019-2022
  - 8 Construction of the new Highway Pristina-Gjilan-Dheu I Bardhe — 250 — 1/TBD
  - 9 Pristina Waste Treatment — N/A — N/A
  - Note: 1/ Preliminary estimation of total project costs.
- Two new loan agreements signed with the EBRD and EIB for Rehabilitation of Railway 10, complemented by EU grants, and one IDA loan for the water supply project; implementation has been slow and total disbursement until end of June 2017 has been disappointing.
- Preliminary estimates suggest completion of the rail and road projects alone would close a quarter of the current infrastructure gap.
- Implementation of priority projects implies an overall increase in capital spending by 12-15 percentage points of GDP over the next 6-7 years (Section F).
- This higher capital spending could reduce Kosovo’s overall public infrastructure gap vis-à-vis EU countries from 60 to 40 percent.

### Financing options: strengths, constraints, and instruments
- Kosovo’s debt position is currently low, at around 20 percent of GDP, characterized by no foreign commercial loans; foreign debt consists of loans by IFIs and bilateral donors.
- The impact of a capital spending surge on the debt-to-GDP ratio depends on economic activity and tax revenue responses to the investment stimulus, and on government capacity to prioritize productive investments and strengthen absorption capacity.
- Constraints:
  - Limited domestic savings and a shallow financial system; single large projects might exhaust fiscal space for years (example: Routes 6 and 7).
  - Potential crowding out of private sector investment if domestic financing is used.
- Options and assessments:
  - Revenue mobilization and expenditure rationalization could help but only at the margin: since 2015 tax revenues increased by more than 2 percentage points, and current expenditures were frozen at around 20 percent of GDP.
  - External commercial borrowing can finance large projects and free domestic resources, but introduces refinancing, interest, and exchange rate risks.
  - IFI financing remains the most suitable source: favorable interest costs, longer maturity and grace periods, less crowding out; IFIs can provide technical assistance for project selection, preparation, and catalyzing private capital.
  - Diaspora bonds could tap remittance wealth; success higher if proceeds directly finance key infrastructure or benefit diaspora/family; designing such programs is challenging and many attempts have failed.
  - Private financing via PPPs could mobilize private savings and increase efficiency, but requires a sound PPP framework to limit fiscal risks; PPPs can generate explicit and implicit contingent liabilities and encourage off-balance operations while reducing transparency. PPP experiences in the region have been marginal and almost absent in Kosovo.

### Macroeconomic impact of scaling-up public capital spending (model and scenarios)
- Model features:
  - Model-based approach simulates dynamic interactions of public investment, growth and fiscal stance; public capital is the model’s “engine”.
  - Public finances subject to budget constraints to ensure debt sustainability; in short/medium run model allows fiscal gap between taxes and capital spending to be financed with borrowing.
  - Key assumption across scenarios: an exogenous increase in public investment by about 12.5 percentage points of GDP, over seven years.
- Scenario outcomes:
  - a. Domestic scenario (capital surge entirely financed by domestic borrowing, largely absorbed by banks):
    - Growth dividend is marginal: less than a 0.1 percentage points increase in the annual growth rate compared to baseline.
    - Aggregate demand impact is largely offset by lower private investment (crowding out) and compressed consumption due to increased tax burden (e.g. VAT) needed for debt service.
    - Debt burden increases more rapidly (above and beyond the 30-percent ceiling), with higher debt vulnerabilities throughout the foreseeable future.
  - b. “Improved” policy scenario (higher efficiency of public spending and greater focus on regional connectivity projects):
    - Growth dividend somewhat higher.
    - Debt-related vulnerabilities remain high despite an expected decline in the debt ratio.
  - c. Concessional financing scenario (increased public investment financed by an equal mix of donor grants and IFI financing):
    - Most favorable scenario due to low interest rates and longer maturity of IFI financing.
    - Could generate a long-term improvement in the level of real GDP per capita in the range of 3-3.5 percentage points above the current baseline.
- Model calibration notes (as used in simulations):
  - A real GDP growth of 4 percent is assumed under the 2015 SBA arrangement.
  - Public debt to GDP ratio of 20 percent (includes former Yugoslavia debt).
  - VAT is 18 percent.
  - Public investment to GDP ratio set at 9 percent to match the average observed in 2008-2016.
  - Real average domestic and external interest rates assumed at 7 and 5 percent, respectively.
  - Productivity of capital assumed at around 20 percent.

### Conclusions and policy implications (multi-pronged approach)
- Scaling up public investment can raise GDP growth potential and accelerate income convergence toward the EU average, but implementation has been modest despite the new investment clause of the fiscal rule exempting IFI-financed projects from the deficit ceiling.
- Recently regained fiscal sustainability should be preserved.
- Scaling up infrastructure is better funded through donor and IFI financing to reduce crowding out and ensure better project selection and vetting, but a weak public investment management framework complicates mobilizing such financing.
- Recommended multi-pronged approach to mobilize external financing, increase absorption capacity, accelerate project implementation, and improve investment efficiency:
  - Introduce a requirement for cost-benefit analysis; strengthen selection, planning, execution of priority projects, and ex-post auditing to prevent addition of politically motivated projects with unclear economic impact.
  - Maximize regional coordination, particularly in the WBIF context, to increase expected returns, improve investment attractiveness and European integration, and secure concessional financing and grants from the EU and IFIs.
  - Prepare multi-year budgets for investment spending to cover construction and maintenance costs, based on conservative assumptions; the medium-term expenditure framework should better reflect fiscal pressures from large scale capital projects.
  - Modernize public procurement processes, including adoption of e-procurement to ensure transparency and a level playing field among suppliers, which is essential to ensure adequate returns from spending and to tackle corruption.

### Appendix I — An Index for Infrastructure Gaps (methodology summary)
- Measuring infrastructure gaps: complexity arises from measuring quality and aggregating different infrastructure types that can complement or substitute each other.
- Six key quantity indicators used (benchmarked to the EU average; positive gap = above EU average):
  - Telephone/cell phone lines per capita
  - Broadband subscriptions per capita
  - Installed capacity to generate electricity per capita
  - Air passengers carried per capita
  - Highways per km² after controlling for population density
  - Railroad per km² after controlling for population density
- Infrastructure gap formula (per indicator j, country i, time t):
  - Infrastructure gap_i,j,t = [(Indicator_i,t / average(Indicator)_EU,t) − 1] * 100
- Highways and railroads gaps are adjusted for population density by projecting a theoretical EU-equivalent density for the country.
- Aggregate infrastructure gap constructed using weights inversely related to the volatility (standard deviation) of each indicator gap across time:
  - Aggregate infrastructure gap_i,t = Σ_j w_j * infrastructure gap_i,j,t
  - w_j = 1 / (Σ Std_i(Infrastructure gap_i,j) / # of countries)
- Robustness check using equal weights yields similar results:
  - Aggregate infrastructure gap_i,t = Σ_j Infrastructure gap_i,j,t / 6
- Data sources for indicators:
  - Telephone/cell phone lines per capita — World Bank, World Development Indicators (WDI); completed with national statistics offices.
  - Broadband subscriptions per capita — World Bank, WDI; completed with national statistics offices.
  - Installed capacity to generate electricity per capita — International Energy Agency.
  - Air passengers carried per capita — World Bank, WDI; completed with national statistics offices.
  - Highways per km² after controlling for population density — International Road Federation; and country authorities’ data.
  - Railroad per km² after controlling for population density — World Bank, WDI; completed with national statistics offices.

*Source: IMF staff estimates and PIMA reports as presented in the chapter.*

### Appendix II. General Equilibrium Model

### Appendix II. General Equilibrium Model

### Model purpose and key feature
- A general equilibrium model—developed by Berg et al (2012)—was used to simulate a public investment surge.
- The model allows analysis of the interactions between GDP growth, public investment, and public debt.
- The key feature is the public investment-growth nexus.

### Model structure and agents
- Small open economy with two sectors producing tradable and non-tradable goods.
- Production inputs: private capital, public infrastructure, and labor for both tradable and non-tradable goods.
- Includes public and private capital; public investment can either increase output by stimulating private investment or crowd it out depending on public capital productivity.
- Agents can import goods for consumption or capital production.
- Private and public capital are produced using imported inputs and nontraded goods.
- Two types of consumers: saver and hand-to-mouth consumer.
- Government functions: collects taxes on consumption and fees on public capital; allocates funds to transfers or to build public capital.

### Financing alternatives and debt sustainability
- Government financing options include:
  - Increasing tax revenues.
  - Collecting fees on the use of public capital.
  - Borrowing domestically.
  - Borrowing externally.
  - Borrowing externally at concessional rates (e.g. a mix of EU grants and IFI financing).
- The model ensures debt sustainability by allowing tax rates to respond to public debt increases.

### Public investment efficiency and productivity
- Public investment expenditures do not always increase the stock of public capital; part of expenditures can be wasted.
- The model accounts for a fraction of public investment being non-productive and allows analysis across different levels of public capital productivity.
- This feature enables assessment of how varying public capital productivity affects growth outcomes.

### Calibration and simulations for the Western Balkans
- Simulations are calibrated to reflect structural features of an average Western Balkan country.
- Main calibration parameters and values:
  - real GDP per capita of 3 percent (based on growth observed in 2006-16)
  - public debt to GDP ratio of 51 percent (average public debt for the region in 2016)
  - average tax rate of 18 percent
  - public investment to GDP ratio at 5.2 percent (to match the average observed in the region in 2016)
  - real average domestic interest rate of 7 percent
  - real average external interest rate of 5 percent
  - productivity of capital is assumed to be 20 percent (in the medium range of estimates by Dalgaard and Hansen (2005) and Foster and Briceno-Garmedia (2010))
- The efficiency of the public investment framework is calibrated based on Dabla-Norris et al (2011).

*Source: Appendix II. General Equilibrium Model (cr1831).*

### 18.      Social benefit spending in Kosovo has increased substantially since 2010 though

### 18.      Social benefit spending in Kosovo has increased substantially since 2010 though

### Overview and main assessment
- Social benefit spending in Kosovo has increased substantially since 2010 though the performance for the expenditure level remains weak by regional standards.
- Weaknesses identified: low coverage, weak targeting and insufficient adequacy of many benefits.
- Composition shift: spending has shifted towards war-related rather than a poverty, inequality and employment enhancing focus.
- Macro-critical objective: Social benefit reform is macro-critical to ameliorate future increases in inequality, while addressing current widespread unemployment and low income of individuals, which should increase aggregate growth.

### Key statistics and program features
- Social assistance spending (2017 estimate): Social assistance scheme: 28.5 Euros, millions; Number of beneficiaries (December 2017): 26,117; Average benefit amount, € per month (spending/beneficiaries): 91.
- Basic pension (2017 spending estimate): 113.1 Euros, millions; Number of beneficiaries (December 2017): 122,716; Average benefit amount, € per month: Flat (78); Target group: All 65+; pension tested.
- “Contributory pension”: 90.7 Euros, millions; Number of beneficiaries: 43,300; Average benefit amount, € per month: 179 (range)1/; Beneficiaries based on law from before 1999*.
- Disability pension (civilian): 18.9 Euros, millions; Number of beneficiaries: 19,481; Average benefit amount, € per month: Flat (82); Target: 100 percent disabled.
- Trepca early pension: 4.2 Euros, millions; Number of beneficiaries: 3,232; Average benefit amount, € per month: Flat (105); Target: Involuntary unemployed ;> 50% disabled threshold.
- Kosovo Pension Savings Trusts (KPST): Funded defined contributory scheme; 2017 spending estimate: 5,207 Euros, millions; Number of beneficiaries: Phased withdrawal (at least 150) or annuity; Target: All, payout starting at the age of 65.
- Pensions for the Blind: 5.5 Euros, millions; Number of beneficiaries: 2,001; Average benefit amount, € per month: 231; Target: Certified as blind.
- Services / Social-School 0-18 years: 3.4 Euros, millions; Number of beneficiaries: 2,777; Average benefit amount, € per month: 102.
- Services / Social-Family Housing within the Relationship: 0.5 Euros, millions; Number of beneficiaries: 383; Average benefit amount, € per month: 108.
- Services / Social-Family Housing outside the Relationship: 0.1 Euros, millions; Number of beneficiaries: 28; Average benefit amount, € per month: 317.
- Woman after childbirth: 1.3 Euros, millions; Number of beneficiaries: 450; Average benefit amount, € per month: 268.
- War veterans pension: 78.05 Euros, millions; Number of beneficiaries: 38,263; Average benefit amount, € per month: 170; Target: Certified veteran of war and unemployed.
- Families of martyrs: 10.6 Euros, millions; Number of beneficiaries: 1,934; Average benefit amount, € per month: 455; Target: Families of KLA fighters who died during the armed struggle or later, as a direct result of injuries sustained.
- War invalids of KLA: 12.1 Euros, millions; Number of beneficiaries: 3,405; Average benefit amount, € per month: 295; Target: Disability of 20 percent or higher.
- Civilian invalids as result of war: 2.9 Euros, millions; Number of beneficiaries: 1,901; Average benefit amount, € per month: 128; Target: Disability of 40 percent or higher.
- War civilian victims: 9.4 Euros, millions; Number of beneficiaries: 4,469; Average benefit amount, € per month: 177.
- Caretaker/Families for those in war (6 schemes) for War Invalids: 1.6 Euros, millions; Number of beneficiaries: 20-358; Average benefit amount, € per month: 50-453; Target: Families of war invalids; after death of war invalid, missing in war, civilian invalid; civilian disappeared; civilian after death.
- Previously KPC Pensions: 2.7 Euros, millions; Number of beneficiaries: 1,001; Average benefit amount, € per month: 228; Target: Served at least for 5 years in KPC (during its 10 years of existence) and reaching age 45.
- KSF pensions: 1.2 Euros, millions; Number of beneficiaries: 288; Average benefit amount, € per month: 364; Target: At least 20 years of service.
- Note in table: 1/ Indicative amount.

### Policy recommendations (schemes and cross-cutting)
- All schemes:
  - Set overarching goals and parameters for social benefits, including increasing coverage and benefit levels for bottom of distribution.
  - Introduce an enforceable residency eligibility requirement, such as requiring individuals to pick-up benefits in person every month.
  - Remove disincentives to work by removing requirement of being unemployed to receive a benefit, the exception being for employment benefits.
  - Subject all benefits to personal income tax.
- Age, disability and family benefits:
  - Apply uniform disability criteria across schemes and equalize benefit amounts downwards towards civilian scheme.
  - Revise occupational scheme from general government financing to defined contribution and base benefit amounts on career average earnings.
  - Prevent any reforms that would allow for early retirement, unless actuarily and budget neutral.
- Poverty focused benefits:
  - Index benefits to inflation to avoid the erosion of value over time.
  - Reform the current social assistance scheme to improve the poverty-reduction goal by increasing the benefit amount and improving targeting criteria - to increase the share of beneficiaries and benefits allocated to the bottom of the distribution - by removing categorical requirements for age, unemployment, and that recipients are a family.
- War-related benefits:
  - Enforce the 0.7 percent of GDP budget cap on the veteran’s pensions, and credibly complete reclassification and verification of beneficiaries.
  - Restrict benefits to the current generation.
  - Consider one-off payments in lieu of permanent benefits.

### Appendix I — Assessing social benefit performance (methodological issues)
- Data source: Most recently publicly available HBS household survey; approximately 12,000 individuals are included; updated on a quarterly basis and released each year.
- Unit of observation: household and individuals in each household; servants and temporary members are excluded.
- Welfare measure: For the analysis expenditure is used as a proxy for income; household expenditure is divided by the number of per adult household members to obtain expenditure per adult equivalents. Quintiles and deciles derived from per capita household expenditure. For poverty analysis, the poverty line is set at 17.6 percent.
- Sampling: Two-stage random sampling design used by the Statistical Office — random selection of Primary Sampling Units (PSUs) and then randomly selecting households within the PSUs.
- Limitations: Risk of systematic errors reducing representativeness and precision; low response rates for certain questions; intentional mis-statements by respondents (more common at the top of distribution); accurate income measurement in informal sector is challenging due to barter trading, less accurate bookkeeping, misreporting.
- Social assistance performance indicators:
  - Coverage: share households that receive a benefit.
  - Adequacy (Generosity): benefits as a share of expenditure (example: expenditure 1,000 Euros and transfer 100 Euros → generosity 10 percent (100/1,000)).
  - Benefit incidence: how benefits are distributed across deciles and quintiles.
  - Beneficiary incidence: how benefit recipients are distributed across deciles and quintiles.
  - Estimated poverty and inequality impact: percentage change in measures (poverty headcount, poverty gap, severity, and Gini coefficient) if one or all social transfers are removed.
  - Benefit-cost ratio (BCR): share of benefits that reduce the poverty gap (0.0 indicates none reduce the poverty gap; 1.0 means all benefits reduce poverty).

### Appendix II — Improving targeting performance (summary)
- Rationale: Targeting improves distributional outcomes by allocating resources to those most in need; top performing programs allocate up to 60-80 percent of benefits to the bottom income quintile and can increase benefit size by up to four times compared to random allocation.
- Recommendation: Use more than one targeting method; layering methods tends to be most effective (e.g., geographic targeting + PMT + community-based final verification).
- Proxy-means testing (PMT): Effective where income is difficult to verify; uses proxies (housing quality, family composition, location, education).
- Trade-offs and implementation issues:
  - Balance accuracy and efficiency; administrative costs can be high if program is complicated.
  - Minimize private costs such as opportunity costs.
  - Targeting can lead to perverse incentives (changes in savings or labor supply), stigma, and political challenges.
  - Administrative costs are highest in initial years; efforts should be made to pool functions across programs.
  - High opportunity costs may be desirable for self-selection but should not disproportionately affect sub-groups living far from enrollment offices.
  - Social costs can be lowered by awareness campaigns; political support can be bolstered by including some middle-income households in addition to low income households.

### Appendix II — Targeting methods, characteristics and effectiveness (table highlights)
- Categorical: Low cost, administratively simple; low income correlation; Effectiveness: Low.
- Geographical: Low cost, administratively simple; high exclusion errors for those not in region; Effectiveness: Low.
- Self-selection: Low cost, administratively simple, politically popular; stigmatization, some inclusion errors; Effectiveness: Moderate.
- Community-based: Local ownership, can improve accuracy; prone to elite capture; Effectiveness: Moderate.
- Proxy-means testing: Effective in areas when income difficult to verify; Moderate technical ability needed; Effectiveness: Moderate/High.
- Means testing: Good precision when data robust; High administrative and private cost; Effectiveness: Moderate/High.

*Italic: International Monetary Fund staff summary of content from the chapter.*

### 2.      Kosovo’s banking sector started largely from scratch in the early 2000s. Following the

### Kosovo’s banking sector started largely from scratch in the early 2000s

### Historical evolution and credit cycles
- Post-1998-99 war starting point:
  - Banking system assets equivalent to 4.3 percent of GDP.
  - Banks’ outstanding loans at end-2000 totaled €3.3 million.
  - Loans did not comprise a majority of banks’ balance sheets until 2005.
- Boom over 2005-09 driven by foreign funding inflows and independence:
  - By 2005, loans comprised roughly half of bank balance sheets.
  - Credit growth settled into a 20-40 percent y/y range through 2009.
  - Financial depth nearly doubled from 17 to 32 percent.
  - Boom drivers: postwar reconstruction, pent-up demand, exuberance around 2008 independence, and aggressive targeting by European banking subsidiaries.
- No post-boom bust experienced:
  - Credit growth eased significantly in mid-2008 but still averaged 14.5 percent y/y over 2009-11.
  - Kosovo avoided the severe deleveraging seen in much of CESEE due to less pre-crisis leveraging, strong donor inflows, and limited international trade and financial linkages.

### Stagnation (2012–2014) and renewed growth (2015 onward)
- Financial deepening stalled beginning in 2012 due to:
  - Slowing economic growth.
  - More conservative stance by foreign subsidiaries (which control 80-90 percent of banking system assets post-independence).
  - Declining asset quality as boom-era loans seasoned.
  - Structural lending bottlenecks: inefficient courts and collections, very large collateral requirements, prolonged asset recovery procedures, and high interest rates.
  - Result: Credit growth to the private sector averaged 3.7 percent y/y from October 2012 to October 2014; credit-to-GDP was correspondingly flat.
- Lending growth returned since mid-2015:
  - Credit growth averaged 8.4 percent y/y since June 2015.
  - Kosovo’s credit-to-GDP rose by 2 percentage points of GDP to 36.8 percent in 2016.

### Composition of lending and structural implications
- Loan portfolio composition:
  - Roughly two-thirds corporate loans and one-third household lending.
- Recent upcycle composition concerns:
  - Strong growth in household lending concentrated in consumer goods; new mortgage loans are growing strongly but the market is nascent.
  - Corporate loan growth dominated by wholesale/retail trade and services; limited lending to manufacturing and mining.
  - Policy implication: More lending toward productive, export-oriented industries is needed to support structural development.

### Drivers and constraints on credit growth
- Demand-side drivers:
  - Macroeconomic environment: GDP growth averaged 4.5 percent per year during 2005-11; dropped to 2.5 percent per year while credit stagnated over 2010s; growth since 2015 has been slightly below the boom period but well above stagnation years.
  - Sharp drop in lending rates:
    - Average lending rates hovered around 15 percent until mid-2011.
    - Gradual decline of about 200 basis points over three years after mid-2011.
    - Since early 2014, average lending rate has fallen by roughly 500 basis points.
    - The sharpest drop, of 390 basis points, occurred between October 2014 and April 2015.
- Supply-side developments:
  - Improved bank balance sheets:
    - NPL ratio doubled to a peak of 8.8 percent in early 2014, then halved since due to increased provisioning, targeted writeoffs, and strong credit growth.
    - Banks have generally been well-capitalized, liquid, and profitable in aggregate.
  - Lower risk aversion and search for yield:
    - EU-based banks account for 64 percent of system assets and have returned to lending after pulling back post-euro area crisis.
  - Financial sector reforms enhancing lending capacity:
    - Judicial reforms reducing court backlog.
    - Introduction of Private Enforcement Agents (PEAs).
    - Centralized registry of bank account holders at the Central Bank of Kosovo (CBK) to enable garnishment.
    - Adoption and refinement of risk-based supervision at the CBK.
    - Best-practice emergency liquidity assistance framework.
    - Establishment of a deposit insurance fund.
    - Adoption of a macroprudential policy framework.

### Improvements in enforcement and measurable outcomes (Box 1 summary)
- Court backlog and enforcement:
  - As of July 2014, courts had an outstanding backlog of over 145,000 open cases (population noted as 1.8 million).
- Reforms and results:
  - PEAs introduced in 2014; between May 2014 and December 2015 PEAs resolved 4,809 cases and recovered €51.5 million (equivalent to 0.9 percent of GDP); unofficial estimates suggest recoveries have doubled since then.
  - Over 91,000 court-based enforcement cases closed since May 2013 under USAID-supported efforts.
  - Banking community attributes part of the sharp recent decline in lending rates to progress in contract enforcement.

### Empirical disequilibrium analysis of credit supply and demand
- Model approach:
  - Disequilibrium model based on Everaert et al (2015); credit demand and supply estimated separately; actual credit growth is the minimum of the two.
  - Monthly data from December 2006 through April 2017.
  - Dependent variable: year-on-year growth of bank credit to the private sector.
  - Credit demand explanatory variables: goods import growth (proxy for GDP growth), NPLs as share of total loans (lagged), interest rate margin (lending rate less deposit rate).
  - Credit supply explanatory variables: NPL ratio (lagged), bank equity per assets (lagged), return on assets (lagged), interest rate margin.
- Key empirical findings:
  - All variables statistically significant with expected signs except interest rate margin on the demand side (positive sign observed), possibly reflecting a supply effect dominating that variable.
  - Model fits historical trend fairly well except for outlying variability during 2007-10 boom; captures direction but not magnitude of the boom.
  - Robustness check: regressions from June 2009 onward fit as good or better though some variables lose significance.
  - From mid-2009 onward, supply and demand contributed fairly evenly to credit growth; supply factors were moderately more important during 2011-13 slowdown and the recovery after 2014.
  - After the boom:
    - Slowdown 2011-13: supply slowdown beginning in 2011 driven by declining asset quality and margins and falling profitability; model suggests supply was dominant constraint.
    - Recovery 2014-present: both supply and demand recovered; supply improved earlier due to balance sheet cleanup, allowing banks to meet rising demand.

### Is more lending/financial deepening needed for convergence?
- Financial intermediation and growth:
  - At low levels of financial development, financial deepening can yield substantial growth dividends; beyond a threshold, further deepening can harm growth.
- Kosovo’s private credit depth:
  - Domestic bank credit to private sector about 37 percent of GDP.
  - This is 8 percentage points below the Western Balkan countries’ average.
  - Broader measure including cross-border lending and non-bank credit equals 56 percent of GDP, still 10 percentage points below the regional average.
  - Kosovo’s credit depth is low compared to countries with similar per capita income.

*Source: CBK, IFS, staff estimates.*

### 16.      Private credit is also below the level predicted by fundamentals. Following IMF (2015),

### 16.      Private credit is also below the level predicted by fundamentals. Following IMF (2015),

### Findings on private credit relative to fundamentals
- Per capita private credit is estimated as a reduced form function of supply and demand components; fundamentals include per capita GDP and the interest rate on private debt, with country-specific effects controlling for cross-country differences (see Appendix II).
- The results show that private credit is some 5-6 percentage points of GDP below the level predicted by fundamentals.
- This finding is robust for different specifications and sample sizes.
- Caveat: The data for Kosovo do not span a full credit cycle, implying that the estimated “equilibrium” level of private credit may be overestimated. When using a more balanced sample (2002-2016) the credit gap for Kosovo widens somewhat (while narrowing for other countries plotted).

### Implications and required pace of credit growth to close the gap
- Closing the credit gap in the medium-term would require credit growth to significantly outpace nominal GDP growth for a sustained period:
  - Baseline projections for nominal GDP imply that credit growth would have to average 9 percent per year to close the gap in the next five years.
- Kosovo’s low level of private credit relative to fundamentals, coupled with ample liquidity in the banking sector, provides room for an expansion in lending that can unlock higher output growth and accelerate convergence to Western Europe income levels.

### Banks’ capacity to provide additional funding
- From the supply perspective:
  - Balance sheets are healthy and improving.
  - Funding liquidity is ample.
  - Deposit growth remains healthy.
  - Authorities have made progress in minimizing structural bottlenecks and bolstering the financial safety net.
- From the demand perspective:
  - Kosovo enjoys macroeconomic stability.
  - Economic growth is stronger than Western Balkan peers, with similar medium-term growth projected.
- If the rapid pace of credit growth seen since early 2016 continues into the long term:
  - Kosovo would experience an increase of its credit-to-GDP ratio by 16 percentage points, to 52 percent, by 2026.
  - Recent average credit growth since January 2016 is 9.5 percent y/y.
  - Projected medium-term nominal GDP growth is 6.0 percent y/y.
- If credit growth eases to a pace roughly in line with projected medium-term nominal GDP growth (for instance, the 2012-16 average annual growth rate of 5.6 percent y/y), there would not be any financial deepening at all.

### Funding and liquidity constraints under scenarios
- Assuming recent rates of deposit growth in parallel with recent rates of credit growth:
  - The banking sector’s loan-to-deposit ratio would reach 100 percent by 2024, a level that may raise financial stability concerns.
- If recent rates of deposit growth continue and all deposits are allocated to lending (loan-to-deposit ratio rises to 100 percent by 2026):
  - Credit/GDP would rise by 12 to 15 percentage points, to 49 to 52 percent, by 2026.
  - Reaching this level of credit depth would require credit growth of about 9 percent per year over the next 10 years.
  - Realistically, the final credit-to-GDP ratio would likely be lower because some funding raised by banks would be allocated to investing in government securities rather than loans.
- Under a conservative assumption where credit grows at the same rate as deposits (rather than faster):
  - Financial deepening would be much more limited, with credit-to-GDP increasing by only 1 to 3 percentage points by 2026.

### Conclusions
- Recent return of bank lending is encouraging, but Kosovo requires further financial deepening to support growth.
- Credit growth since 2015 has been far more robust than most Western Balkans peers, supported by improved bank balance sheets.
- Financial depth remains relatively shallow—too shallow to support the level of economic growth needed to meaningfully raise incomes toward the rest of Europe.
- Lending patterns appear to be fairly evenly driven by both demand and supply factors; supply has been able to respond to meet rising demand.

### Policy recommendations
- Demand-side policies:
  - Maintain macroeconomic stability, including by continuing to manage sustainable budgets that contain unproductive current spending and create space for growth- and productivity-friendly capital investments.
  - Continue measures to improve Kosovo’s business environment, including:
    - Reducing administrative burden for businesses by simplifying the legislative and regulatory system.
    - Reducing informality by simplifying and improving revenue collection.
    - Further improving infrastructure to create more productive lending opportunities and improve the quality and composition of bank loans.
- Supply-side policies:
  - The central bank should continue strong supervisory oversight to ensure healthy bank balance sheets and further improve supervisory and regulatory framework, for instance by continuing to develop its macroprudential policy framework.
  - Authorities should seek to reduce remaining structural bottlenecks to bank lending, including inefficiencies in the court and collection system and in fully establishing a best-practice cadastre system to effectively identify and protect property rights.
- Long-term funding diversification:
  - Authorities should explore ways to help diversify banking funding sources (e.g., a local capital market where banks could issue bonds), recognizing that capital markets are nascent and this is a longer-term policy goal.

### Appendix II — Estimating fundamentals-consistent levels of credit (methodology and key coefficients)
- Sample: 34 European countries during 1995–2016.
- Stylized reduced-form model: private sector credit driven by:
  - Per capita income (positive effect on credit demand and supply).
  - Nominal interest rate on private debt (negative effect on demand, positive effect on supply).
  - Includes country-specific constants and common time effects.
- Definition: Private sector debt = domestic bank credit to the non-financial private sector (IFS) + private external debt liabilities (WEO).
- Series are time demeaned by subtracting the mean across all countries in a given period from individual country values.
- Preferred estimator: Arellano-Bond dynamic-panel system GMM (GMM-SYS).
- Long-run relationship (based on GMM-SYS regression results):
  - d* = 1.62 y* – 2.58 int, where lowercase variables are natural logarithms of per capita quantities in thousands of 2005 PPP U.S. dollars; asterisk indicates long-run value.
- Credit gaps: Calculated as the deviation of actual private sector credit from its fundamentals-consistent level.

*Source: IMF staff analysis in cr1831 - 16.      Private credit is also below the level predicted by fundamentals. Following IMF (2015), cr1831.pdf*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr1831.pdf_