## _cr13223

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---

### Growth and Kosovo’s External Environment
- Kosovo’s economy remained resilient through the global financial crisis; annual average growth since 2007 has been among the highest in the Western Balkans.
- Correlations (2001–2011): Kosovo’s nominal GDP growth (expressed in euro) is correlated with Germany and Switzerland but uncorrelated with the rest of the euro area.
- VECM framework (endogenous variables: imports, private sector credit, bank deposits); Germany’s GDP used as proxy for Diaspora host-country conditions. All variables are I(1) and at least one cointegrating relationship is detected.
- Key econometric findings:
  - Long-run elasticity of imports to German GDP is positive and significant (Johansen VECM and Engle-Granger).
  - Bank deposits have a significant and positive long-run coefficient for imports.
  - Granger-causality tests: strongly reject that German GDP does not Granger-cause Kosovo’s imports; imports Granger-cause deposits.
  - Impulse-response: a one percent shock to quarterly German GDP growth affects Kosovo’s imports by a factor of about three over two years.
    - Contribution breakdown to next quarter’s import growth: error-correction term (αβ) contributes by a factor of 0.6.
    - Short-term dynamics (Γ coefficients) contribute factors of 1.35 in Q2 and 1.78 in Q5.
  - ECM estimation results cover quarterly 2002Q4–2012Q4 (seasonally adjusted, logarithms); significance levels reported as *, **, *** (10%, 5%, 1%).
- Remittances and FDI:
  - Remittances and FDI from the Diaspora (hosted mainly in Germany and Switzerland) account for much of Kosovo’s external resilience.
  - Germany, Switzerland and UK accounted for over half of remittance transfers to Kosovo in 2011 and contributed to about 40 percent of yearly FDI inflows since 2007.

### Determinants of Remittances (Western Balkans, 1999–2011)
- Panel regression (remittances per capita on home and host GDP per capita, log terms; controls include interest rates):
  - Home Country GDP per capita (t-1): coefficient -0.49* (significant at 10% in column 1).
  - Host Country GDP per capita: coefficient 2.67** (significant at 5% in column 2).
  - Host-Home GDP per capita diff (t-1): coefficient 1.75** (significant at 5% in column 2).
  - Observations: 6868.
  - R-squared: 0.22 (column 1) and 0.29 (column 2).
- Interpretation:
  - Host country per capita income is a key driver of remittances.
  - Evidence of altruistic motives: negative coefficient on home country GDP per capita.
  - Complementarity between emigration and FDI is supported by literature and empirical patterns.

### Tax Revenue Structure and Trade Liberalization
- Aggregate metrics and structure:
  - Kosovo’s tax-to-GDP ratio (2006–11 average) was about 22 percent of GDP (excluding social security contributions).
  - More than 80 percent of tax revenue originates from indirect taxes (VAT, excises, customs duties).
  - Import duties account for about 2.5 percent of GDP and 11.5 percent of tax revenue.
  - Contribution of direct taxes (income tax and property taxes) is about half the regional average.
- Economy and revenue alignment:
  - Imports-to-GDP: about 60 percent.
  - Trade deficit: roughly 40 percent of GDP.
  - Recorded remittances: about 14 percent of GDP.
  - Large portion of indirect taxes is collected at the border: customs collection contributes to 80 percent of total tax revenue—specifically all excises and ¾ of VAT.
  - VAT productivity (c-efficiency) in Kosovo is above average for the region and for a sample of small open economies.
- Risks from further trade liberalization:
  - Kosovo participates in FTAs (Albania, Macedonia, Bosnia and Herzegovina, Croatia), CEFTA membership, and is negotiating with Turkey.
  - Literature and the regional econometric analysis do not provide robust evidence that trade tax losses are consistently replaced by increased domestic taxes in the short run.
- Empirical analysis (selected econometric results, regional sample of 17 countries, 1992–2010):
  - Estimating equation: ΔD_it = α_i + β_0 ΔD_it-1 + β_1 T_it + β_2 X_it + μ_t + ε_it, where D = domestic tax revenue, T = trade tax revenue (percent of GDP), X = vector of controls.
  - Estimators: fixed-effects, difference-GMM, and system-GMM; all regressions include country- and year-dummies.
  - Selected reported coefficients (preserved exactly as in source):
    - System GMM:
      - Lagged domestic tax 0.698*** (0.051)
      - Trade taxes -0.213 (0.163)
      - Ln(PCGDP) 0.0005** (0.0003)
      - OPEN 0.0001 (0.000)
      - Ln(INF) 0.0002** (0.0001)
      - AGR -0.0004* (0.0002)
      - D(GDP) -0.007 (0.023)
    - Difference GMM:
      - Lagged domestic tax 0.073* (0.051)
      - Trade taxes -0.262 (0.383)
      - Ln(PCGDP) -0.0000 (0.063)
      - OPEN -0.0007** (0.0003)
      - Ln(INF) 0.039** (0.020)
      - AGR -0.0005** (0.0002)
      - D(GDP) 0.0370 (0.141)
    - Fixed effects:
      - Lagged domestic tax 0.849*** (0.067)
      - Trade taxes 0.067 (0.153)
      - Ln(PCGDP) 0.002*** (0.000)
      - OPEN -0.0002** (0.0001)
      - Ln(INF) 0.0143* (0.0095)
      - AGR -0.0004** (0.0002)
      - D(GDP) 0.004 (0.064)
  - Sample counts and diagnostics:
    - No. of observations: 24 / 12 / 24 (as per columns).
    - No. of countries: 17 in each specification.
    - Diagnostic statistics (selected): Serial correlation 0.478 (p value); M1 (p value) 0.541 / 0.024; M2 (p value) 0.186 / 0.181; Over-identification Hansen: 1.0 (p value) / Sargan: 0.87 / 0.06.
  - Interpretation: No robust short-run evidence that trade taxes are automatically replaced by domestically raised taxes; substitution challenges identified.
- Policy implications (summarized):
  - Short-term: strengthen VAT and excise taxes to replace losses from customs duties phased out by FTAs; consider reducing VAT registration threshold only after tax administration capacity is strengthened.
  - Medium-to long-term: gradual shift to direct taxation as domestic production increases; review corporate and personal income tax rates (current rates low by regional standards); increase progressivity in personal income tax; broaden tax bases by avoiding unnecessary exemptions; improve recurrent property tax system and municipal compliance capacity.

### VAT and Tax Structure: Key Findings
- VAT:
  - Consistent with EU standards.
  - Single-rated—with the lowest rate in the region.
  - Very limited number of exemptions.
  - Threshold for compulsory registration: EUR 50,000—the highest in the region; importers and exporters are required to register.
- Direct taxation:
  - Revenue from taxes on income: about 3.5 percent of GDP.
  - Property tax (municipal): less than ½ percent of GDP.
  - Corporate Income Tax (CIT) current rate: 10 percent.
  - Direct tax performance is weak due to low rates, lack of progressivity in personal income tax, narrow tax bases, and a large informal sector.
  - Property tax revenue productivity low due to low rates and insufficient compliance despite improvements in property registration.

### Euroization, Liquidity Needs, and Foreign Currency Reserves
- Context and constraints:
  - Kosovo uses the euro as legal tender (one of 13 IMF members with foreign legal tender).
  - Foreign tender provides a monetary anchor and lowers administrative costs but forfeits seignorage; places premium on disciplined fiscal policies, competitive wages, and flexibility to adjust to external shocks.
  - All liquidity needs are in FX; traditional central bank lender-of-last-resort via base money creation is not available.
- Definition and composition of readily available FX reserves:
  - Readily available if no non-government institution has a claim to them.
  - Not readily available: assets administered on behalf of the Kosovo privatization fund; assets in which commercial banks’ reserves (mandatory and excess) are invested.
  - In Kosovo, reserves limited to:
    - (i) central bank’s capital,
    - (ii) Kosovo’s SDR allocation (2009 quota increase),
    - (iii) government’s deposits with the central bank.
  - As capital and SDR allocation are fixed (short term), government’s deposits with the CBK are the main instrument to ensure reserves adequacy.
- Reserves adequacy yardstick adaptation and result:
  - Starting point recommended for fixed exchange rate countries: STD% + OPL% + M2% + X% = 30% (formula components and target preserved).
  - Modifications for Kosovo:
    - Replace M2 with deposits.
    - Replace short-term external debt (STD) with short-term public debt (Kosovo’s traded debt = t-bills).
    - Omit OPL and X terms.
    - Add fiscal buffer: one month of government expenditure.
    - Subtract central bank’s other freely available resources (SDR allocation and capital).
  - Resulting operational formula yields a government bank balance (BB) target of about 7 percent of GDP; under the Stand-By Arrangement this yardstick serves as an orientation point.
- Breakdown (Bank Balance Target, 2013, in percent of GDP; IMF staff calculations):
  - Potential sources of liquidity needs: 8.2
  - Government debt market: 1.1
  - Bank deposits: 4.5
    - Banks with ECB access: 3.0
    - Banks w/o ECB access: 1.5
  - Government expenditures: 2.6
  - Minus: central bank own funds: 1.2
  - Target: 7.0
- Range and rationale:
  - Factoring in that about two-thirds of banking system deposits are held by subsidiaries of euro-area banking groups (parents with ECB access) gives a range for bank balance adequacy of 4½ to 7 percent of GDP.
  - 4½ percent of GDP is the minimum bank balance inscribed into Kosovo’s rules-based fiscal framework.
- Operational and political challenges:
  - High government deposits with the CBK as the main funding mechanism can be politically difficult to maintain (competing spending needs) and create operational dependence of the CBK on government willingness to hold deposits.
- Alternative instruments (excerpt notes):
  - Some reserves should be provided by the government (fiscal shock insulation), but collecting reserves from other sources would be beneficial (alternatives are noted in the source).

### Alternatives to Finance the Central Bank’s Special Reserves Fund (SRF) and Liquidity Management
- 2012 FSAP proposal:
  - Finance future increases in the CBK’s special reserves fund (SRF) for ELA by collecting a contribution from banks.
  - SRF funds would not carry claims of individual banks and therefore satisfy characteristics of FX reserves.
  - Option to convert a portion of mandatory bank reserves into pooled SRF funds to enlarge SRF rapidly.
- Current SRF status:
  - SRF was set up and funded in 2012 through a government transfer of €46 million.
  - SRF counts toward the government’s usable bank balance; its resources can be drawn down only with CBK consent.
  - Comparable arrangements exist in Ecuador and Panama.
- Liquidity management and macroprudential tools:
  - CBK can vary banks’ mandatory reserves in line with macroeconomic environment and systemic risks.
  - FSAP recommended developing a macro-prudential policy framework.

### Banking Sector Growth, Benchmarking, and Macroprudential Considerations
- System expansion and structure:
  - Since 1999, banking system grew from four banks to nine banks (seven foreign).
  - Banking assets as share of GDP increased more than six-fold over the last decade.
  - Non-bank financial institutions and securities markets remain small or non-existent.
- Indicators and assessment dimensions:
  - Depth: bank credit to the private sector and broad money deposits relative to GDP.
  - Reach/access: number of bank deposit accounts and share of firms with credit.
  - Efficiency: bank lending-deposit interest rate spread.
  - Stability/soundness: NPL ratio to total loans.
- Depth, credit growth, and overshooting potential:
  - Private credit and deposits grew quickly from a low base; private sector credit-to-GDP by 2008 was close to its expected 75th percentile.
  - Private credit-to-GDP gap is still lower than gaps in most other neighboring SEE countries.
  - Kosovo’s banking sector is largely domestic deposit funded despite foreign bank presence.
- Non-performing loans and stability:
  - NPL ratio has trended up since 2006 alongside increasing credit depth gap.
  - NPLs have mostly remained below the benchmark for NPLs; the gap still compares favorably with other SEE countries.
- Reach, access, and efficiency:
  - Number of bank accounts has been improving, closing the gap with the structural benchmark.
  - Percent of firms with credit has not improved since 2007; the gap has widened.
  - Interest rate spread is higher than the statistical benchmark, indicating lower efficiency.
  - Contributing factors: weak creditor rights, bank concentration, limited competition; elevated cost of enforcing claims.
- Enabling environment:
  - CBK credit registry coverage improved; public credit registry contains borrower data back to 2003 and has expanded information content.
  - Kosovo lags most SEE5 and ECA countries in enforcing contracts and resolving insolvencies.
- Policy implications and recommendations:
  - Develop a macroprudential policy framework, monitor credit-to-GDP growth closely.
  - Improve enabling environment to support reach and efficiency (credit information, insolvency enforcement).
  - Central Bank of Kosovo is developing a macroprudential framework in line with the 2012 FSSA recommendation.

*Source: IMF staff report content (June 28 2013) contained in the provided PDF excerpt.*

### References _________________________________________________________________________________ 6

### _cr13223 - References _________________________________________________________________________________ 6

### Growth and Kosovo’s External Environment
- Kosovo’s economy remained resilient through the global financial crisis; annual average growth since 2007 has been among the highest in the Western Balkans.
- Correlations (2001–2011) show Kosovo’s nominal GDP growth (expressed in euro) is correlated with Germany and Switzerland but uncorrelated with the rest of the euro area.
- VECM framework used: endogenous variables include imports, private sector credit, bank deposits; Germany’s GDP used as proxy for Diaspora host-country conditions. All variables are integrated of order one and at least one cointegrating relationship is detected.
- Key econometric findings:
  - Long-run elasticity of imports to German GDP is positive and significant under both Johansen VECM and Engle-Granger two-step methodologies.
  - Bank deposits have a significant and positive long-run coefficient for imports.
  - Granger-causality tests strongly reject that German GDP does not Granger-cause Kosovo’s imports; imports Granger-cause deposits.
  - Impulse-response: a one percent shock to quarterly German GDP growth affects Kosovo’s imports by a factor of about three over two years.
    - Contribution breakdown to next quarter’s import growth: error-correction term (αβ) contributes by a factor of 0.6.
    - Short-term dynamics (Γ coefficients) contribute factors of 1.35 in Q2 and 1.78 in Q5.
  - ECM estimation results (quarterly 2002Q4–2012Q4, seasonally adjusted, logarithms): reported significance levels indicated by *, **, *** (10%, 5%, 1%).
- Remittances and FDI:
  - Remittances and FDI from the Diaspora (hosted mainly in Germany and Switzerland) account for much of Kosovo’s external resilience.
  - Germany, Switzerland and UK accounted for over half of remittance transfers to Kosovo in 2011 and contributed to about 40 percent of yearly FDI inflows since 2007.

### Determinants of Remittances (Western Balkans, 1999–2011)
- Panel regression of remittances per capita on home and host GDP per capita (log terms), controlling for interest rates:
  - Home Country GDP per capita (t-1): coefficient -0.49* (significant at 10% in column 1).
  - Host Country GDP per capita: coefficient 2.67** (significant at 5% in column 2).
  - Host-Home GDP per capita diff (t-1): coefficient 1.75** (significant at 5% in column 2).
  - Observations: 6868.
  - R-squared: 0.22 (column 1) and 0.29 (column 2).
- Interpretation:
  - Host country per capita income is a key driver of remittances.
  - Evidence of altruistic motives: negative coefficient on home country GDP per capita; remittances are stronger when home incomes are lower.
  - Complementarity between emigration and FDI is supported by literature and empirical patterns.

### Tax Revenue Structure and Trade Liberalization
- Overall assessment:
  - Kosovo’s tax-to-GDP ratio (2006–11 average) was about 22 percent of GDP (excluding social security contributions).
  - Kosovo’s tax system relies significantly more on indirect taxation than regional peers: more than 80 percent of tax revenue from indirect taxes (VAT, excises, customs duties).
  - Import duties account for about 2.5 percent of GDP and 11.5 percent of tax revenue.
  - Contribution of direct taxes (income tax and property taxes) is about half the regional average.
- Economy and revenue alignment:
  - Kosovo’s structure—imports-to-GDP of about 60 percent, trade deficit roughly 40 percent of GDP, and recorded remittances of about 14 percent of GDP—makes reliance on indirect taxes consistent with economic fundamentals.
  - A large portion of indirect taxes is collected at the border: customs collection contributes to 80 percent of total tax revenue—specifically all excises and ¾ of VAT—enhancing revenue productivity and lowering evasion risk.
  - VAT productivity (measured by c-efficiency) in Kosovo is above average for both the region and a sample of small open economies.
- Risks from further trade liberalization:
  - Kosovo has implemented liberal trade policies (FTAs with Albania, Macedonia, Bosnia and Herzegovina, Croatia; CEFTA membership; negotiations with Turkey).
  - Literature suggests further trade liberalization can reduce trade tax revenues, potentially more so in advanced stages of liberalization.
  - Econometric analysis in the region does not provide robust evidence that trade taxes are consistently replaced by domestic revenue, implying potential budgetary pressures unless alternative revenue sources are developed.
- Policy implications (summary provided in source):
  - Mid-to long-term development of alternative revenue sources is needed to mitigate fiscal risks from trade liberalization.
  - The paper outlines a summary of alternative tax policy options and recommendations (details in source sections not reproduced here).

*Source: IMF staff report content (June 28 2013) contained in the provided PDF excerpt.*

### 6.      While the structure of the economy matters, a well designed VAT system has

### 6.      While the structure of the economy matters, a well designed VAT system has

### VAT and Tax Structure: Key Findings
- Kosovo’s VAT system:
  - Is consistent with EU standards.
  - Is single-rated—with the lowest rate in the region.
  - Has a very limited number of exemptions.
  - Has a threshold for compulsory registration of EUR 50,000—the highest in the region—which excludes importers and exporters who are required to register for VAT and thus appears justified to avoid high collection costs for small taxpayers.
- Direct taxation in Kosovo:
  - Revenue from taxes on income is about 3.5 percent of GDP.
  - Property tax—collected at municipal level—is less than ½ percent of GDP.
  - Altogether direct taxes make up about half the revenue collected in the region from this source.
  - Corporate Income Tax (CIT) current rate is 10 percent.
  - Low income-tax revenue performance is attributed to:
    - Low tax rates.
    - Lack of sufficient progressivity in the structure of the personal income tax.
    - Narrow tax bases, in part due to a large informal sector.
  - Property tax revenue productivity is low due to both low rates and insufficient compliance efforts, despite important steps in improving property registration.

### Revenue Composition (selected metrics from the text)
- Import duties account for about 2.5 percent of GDP and 11.5 percent of tax revenue in Kosovo.
- Kosovo’s share of trade taxes is the largest in the region, creating budgetary pressures with further trade liberalization.

### Empirical Analysis: Replacement of Trade Tax Revenue
- Data and sample:
  - Selected 17 countries in the region over the period 1992-2010.
  - Estimating equation: ΔD_it = α_i + β_0 ΔD_it-1 + β_1 T_it + β_2 X_it + μ_t + ε_it, where D is domestic tax revenue, T is trade tax revenue (percent of GDP), and X is a vector of controls.
  - Estimators: fixed-effects, difference-GMM, and system-GMM. All regressions include country- and year-dummies.
- Control variables and expectations:
  - GDP per capita (Ln(PCGDP)) expected to show positive correlation with revenue.
  - Higher share of agriculture (AGR) expected to be negatively associated with revenue.
  - Trade openness (OPEN) can present either sign; in transition economies a negative association is likely.
  - Inflation (Ln(INF)) can have positive revenue effects.
- Econometric results summary:
  - No robust evidence that trade taxes would have been replaced with domestically raised taxes; contemporaneous replacement emerges as non-significant across model specifications.
  - Table excerpts (coefficients and significance markers preserved from source):
    - System GMM: Lagged domestic tax 0.698*** (0.051); Trade taxes -0.213 (0.163); Ln(PCGDP) 0.0005** (0.0003); OPEN 0.0001 (0.000); Ln(INF) 0.0002** (0.0001); AGR -0.0004* (0.0002); D(GDP) -0.007 (0.023).
    - Difference GMM: Lagged domestic tax 0.073* (0.051); Trade taxes -0.262 (0.383); Ln(PCGDP) -0.0000 (0.063); OPEN -0.0007** (0.0003); Ln(INF) 0.039** (0.020); AGR -0.0005** (0.0002); D(GDP) 0.0370 (0.141).
    - Fixed effects: Lagged domestic tax 0.849*** (0.067); Trade taxes 0.067 (0.153); Ln(PCGDP) 0.002*** (0.000); OPEN -0.0002** (0.0001); Ln(INF) 0.0143* (0.0095); AGR -0.0004** (0.0002); D(GDP) 0.004 (0.064).
  - No. of observations: 24 / 12 / 24 (as per columns); No. of countries: 17 in each specification.
  - Diagnostic statistics (selected): Serial correlation 0.478 (p value); M1 (p value) 0.541 / 0.024; M2 (p value) 0.186 / 0.181; Over-identification Hansen: 1.0 (p value) / Sargan: 0.87 / 0.06.
- Interpretation:
  - Time frame may be too short to capture long-run replacement potential, but results point to challenges in substitution of trade taxes in the short run.

### Policy Options and Concluding Remarks (Recommendations)
- Short-term:
  - Strengthen VAT and excise taxes to replace losses from customs duties phased out by upcoming free trade agreements.
  - Consider reductions in VAT registration threshold only after tax administration builds needed capacity to avoid unnecessary burden without clear gains in revenue.
- Medium-to long-term:
  - Gradual shift to direct taxation as domestic production increases.
  - Review tax-rate structure: corporate and personal income tax rates are low by regional standards.
  - Increase progressivity in personal income tax structure.
  - Broaden tax bases by avoiding unnecessary tax exemptions.
  - Further improve recurrent property tax system, especially in context of increased fiscal decentralization; strengthen local government administration and compliance capacity.

---

### Euroization, Liquidity Needs, and Foreign Currency Reserves: Key Points
- Context:
  - Kosovo is one of 13 IMF members that have adopted a foreign currency as legal tender; Kosovo uses the euro.
  - Using a foreign legal tender provides a strong monetary anchor and reduces administrative costs but forfeits seignorage and places a premium on disciplined fiscal policies, competitive wage levels, and economic flexibility to adjust to external shocks.
- Operational and analytical challenges in FX reserve management in a unilaterally euroized economy:
  - Every liquidity need in the economy is in FX; domestic liquidity generation (traditional central bank lender-of-last-resort) cannot satisfy FX needs.
  - Standard mechanism to accumulate reserves—issuance of base money to purchase FX assets—is not available.
  - Definition of FX reserves focuses on ready availability and control by monetary authorities; with foreign tender, all central bank assets are in FX, so ready availability is the main identifying criterion.
- Central Bank of Kosovo (CBK) criteria for readily available assets:
  - Readily available if no non-government institution has a claim to them.
  - Not readily available: assets administrated on behalf of the Kosovo privatization fund, assets in which commercial banks’ reserves (mandatory and excess) are invested.
  - In Kosovo, reserves are limited to:
    - (i) the central bank’s capital,
    - (ii) Kosovo’s SDR allocation received in the context of the 2009 quota increase,
    - (iii) the government’s deposits with the central bank.
  - As capital and the SDR allocation are fixed (short term), government’s deposits with the CBK are the main instrument to ensure reserves adequacy; reserves adequacy target translates into a target for the government’s bank balance.
- Reserves adequacy yardstick adaptation:
  - Starting point (for fixed exchange rate countries) recommended: STD% + OPL% + M2% + X% = 30% (formula components and target preserved as in source).
  - Modifications for Kosovo:
    - Replace M2 with deposits (no base money).
    - Replace short-term external debt (STD) with short-term public debt (Kosovo’s traded debt = t-bills).
    - Omit OPL and X terms (no other portfolio liabilities; imports adjust endogenously to remittances and FDI).
    - Add fiscal buffer: one month of government expenditure.
    - Subtract central bank’s other freely available resources (SDR allocation and capital).
  - Resulting operational formula yields a government bank balance (BB) target of about 7 percent of GDP; under the Stand-By Arrangement, this yardstick serves as a rough orientation point.
- Breakdown and alternative range:
  - Bank Balance Target (2013, in percent of GDP) components from IMF staff calculations:
    - Potential sources of liquidity needs: 8.2
    - Government debt market: 1.1
    - Bank deposits: 4.5
      - Banks with ECB access: 3.0
      - Banks w/o ECB access: 1.5
    - Government expenditures: 2.6
    - Minus: central bank own funds: 1.2
    - Target: 7.0
  - Rationale for reduced buffer:
    - About two-thirds of the banking system’s deposits are held by subsidiaries of banking groups located in the euro area; parents have access to ECB facilities and would likely provide liquidity in case of strains.
    - Factoring this in gives a range for bank balance adequacy of 4½ to 7 percent of GDP.
    - Note: 4½ percent of GDP is also the minimum bank balance inscribed into Kosovo’s rules-based fiscal framework.

### Alternative Mechanisms for Funding Reserves: Considerations
- Current mechanism:
  - High government deposits with the CBK are the main funding mechanism for FX reserves.
- Problems with current mechanism:
  - Political difficulty: national assembly approval needed with every annual budget; 4½-7 percent of GDP in deposits are difficult to defend amid pressing social and infrastructure spending needs.
  - Operational dependence: CBK’s ability to inject liquidity is dependent on government’s preparedness to hold deposits, limiting operational independence of the central bank.
- Suggested approach:
  - While some reserves should be provided by the government (e.g., funds insulating against fiscal shocks), it would be beneficial to collect reserves also from other sources (text notes alternatives without specifying additional mechanisms in this excerpt).

*Source: IMF staff report excerpts provided in the supplied content unit.*

### 11.      There are alternatives. The 2012 IMF/World Bank mission under the Financial Sector

### 11.      There are alternatives. The 2012 IMF/World Bank mission under the Financial Sector

### Alternatives to finance the central bank’s special reserves fund (SRF)
- The 2012 IMF/World Bank mission under the Financial Sector Assessment Program (FSAP) proposed financing future increases in the central bank’s special reserves fund (SRF) for emergency liquidity assistance (ELA) by collecting a contribution from banks.
- These funds would—in contrast to the banks’ mandatory and excess reserves—not have claims of individual banks set against them, and therefore satisfy the characteristics of FX reserves.
- One option to enlarge the size of the SRF rapidly would be to convert a portion of mandatory bank reserves into pooled SRF funds.
- The SRF was set up and funded in 2012 through a government transfer of €46 million. The SRF counts toward the government’s usable bank balance, although—in contrast to normal government deposits—its resources can be drawn down only with the consent of the CBK.
- Comparable arrangements exist in Ecuador and Panama—both unilaterally dollarized economies.

### Liquidity management and macroprudential tools
- Besides managing reserves, the CBK has—and could make greater use of—other options to manage liquidity conditions, in particular by varying banks’ mandatory reserves in line with changes in the macroeconomic environment and systemic risks.
- This relates to an FSAP recommendation to develop a macro-prudential policy framework.

### Banking sector growth and structural benchmarking (overview)
- Over the last decade, Kosovo’s banking system has been one of the fastest growing in the Western Balkans, although it still remains the least developed.
- Since the end of the war in 1999, the banking system has grown from four banks (half of which were new foreign banks) to nine banks (of which seven are foreign).
- Assets of the banking sector as a share of GDP have increased more than six-fold over the last decade, whereas that of other Western Balkan countries have increased less than three-fold.
- Non-bank financial institutions and in particular securities markets have not seen much growth and remain relatively small or non-existent.
- This paper focuses on indicators of depth, access, efficiency, and soundness:
  - Depth: bank credit to the private sector and broad money deposits relative to GDP.
  - Reach/access: number of bank deposit accounts and share of firms with credit.
  - Efficiency: bank lending-deposit interest rate spread.
  - Stability/soundness: ratio of non-performing loans (NPL) to total loans.

### Depth, credit growth, and potential overshooting
- Kosovo’s fast growth rate of private credit and deposits over the last decade appears in line with its lower starting level of depth.
- Despite fast growth, Kosovo’s banking sector depth, in particular for private sector credit, is still lower than that of its neighbors—largely reflecting its lower level of economic development (i.e., GDP per capita).
- By 2008 Kosovo’s private sector credit-to-GDP ratio was close to its expected 75th percentile. This could be approaching the zone for an excessive credit boom (i.e., assuming this is not a result of a better enabling environment or more macro stability).
- The private credit-to-GDP gap in Kosovo still is lower than gaps in most other neighboring SEE countries, suggesting that high credit depth is a regional characteristic.
- Foreign funding financed credit booms up until the global financial crisis of 2008-2009 in several Western Balkan countries; in contrast, Kosovo’s banking sector, although dominated by foreign banks, is largely domestic deposit funded.

### Non-performing loans and stability
- Since 2006, the NPL ratio in Kosovo has been on an increasing trend, coinciding with the increasing credit depth gap.
- Nonetheless, NPLs in Kosovo have remained mostly below its benchmark for NPLs, suggesting that banks in Kosovo may have been relatively more cautious and that credit quality compares favorably to that in other comparable countries with similar structural characteristics.
- The gap between the actual NPL ratio and the NPL benchmark, while narrowing in recent years, still compares very favorably with the situation in other SEE countries, which have consistently been above their threshold, in particular following the global financial crisis of 2008.

### Reach, access to credit, and efficiency
- Reach as measured by the number of bank accounts has been improving, closing the gap with the structural benchmark.
- Reach as measured by percent of firms with credit has not improved since 2007, when it was close to its benchmark; the gap has since widened.
- Kosovo’s banking efficiency, as measured by the interest rate spread, is below its statistical benchmark (i.e., the spread is higher than expected). This may reflect:
  - Lack of sufficient progress on creditor rights.
  - Financial structure characteristics (e.g., bank concentration or extent of competition).
- World Bank Doing Business indicators show Kosovo’s cost of enforcing a claim has remained elevated, while it has been mostly declining in the SEE5.

### Enabling environment: credit information and insolvency enforcement
- Kosovo has made some progress on credit information: the coverage of the CBK credit registry has improved, and Kosovo has a similar ranking to that of the SEE5 median and a higher ranking than the ECA median.
- Kosovo’s public credit registry has information on borrowers going back to 2003; its information content was recently expanded, and banks cite it as a very useful tool to mitigate credit risk.
- However, Kosovo still lags most SEE5 and ECA countries in enforcing contracts and resolving insolvencies, which would tend to reduce credit expansion (as they add to interest rate spreads and thus the quantity of credit demanded).

### Policy implications and recommendations
- Developing a macroprudential policy framework that includes monitoring closely and assessing credit-to-GDP growth would be an important task going forward.
- The authorities are working on improving the enabling environment, which should allow for further reach and efficiency of the Kosovo banking sector.
- Sustainable financial development also requires financial stability; monitoring the evolution of the credit-to-GDP ratio is highlighted as an important macroprudential task.
- The Central Bank of Kosovo is currently developing a macroprudential framework, in line with one of the key recommendations of the 2012 Financial Sector Stability Assessment (FSSA).

*Source: _cr13223 - 11.      There are alternatives. The 2012 IMF/World Bank mission under the Financial Sector (PDF chapter/section).*

### References

### _cr13223 - References

### References cited
- Barajas, A., T. Beck, E. Dabla-Norris, and R. Yousefi (2013): Too Cold, Too Hot, Or Just Right? Assessing Financial Sector Development Across the Globe, IMF WP/13/81.
- Čihák M., A. Demirgüç-Kunt, E. Feyen, and R. Levine (2012): Benchmarking Financial Systems around the World, World Bank Policy Research Working Paper 6175.
- De la Torre, A., E. Feyen and A. Ize (2011): Financial Development: Structure and Dynamics, World Bank Policy Research Paper 5854, 2011).
- Feyen, E. and K. Kibuuka (2013): FinStats 2013: A ready-to-use tool to benchmark financial sectors across countries—User Guide and Benchmarking Methodology, October 2012 (Version 3.0).
- IMF (2012): Republic of Kosovo: Financial System Stability Assessment, IMF Country Report No. 13/99, April.
- IMF (2013): The Boom-Bust of Foreign Bank Flows into CESEE, Central, Eastern and Southeastern Europe Regional Economic Issues, April.
- Source: World Bank Doing Business Surveys.

### Measuring Financial Development
- Definition:
  - Financial development occurs when agents mitigate the effects of imperfect information, limited enforcement, and transactions costs through the use of financial instruments, intermediaries, or markets in order to efficiently allocate financial resources and diversify risks.
- Measurement approach:
  - Direct measures of financial functioning are mostly lacking; literature uses intermediate indicators of the size, efficiency, reach, and soundness of financial institutions and markets.
  - For banks common indicators include private credit by deposit money banks to GDP, bank deposits to GDP, bank domestic assets to GDP, net interest margin, lending minus deposit rate, overhead costs to total assets, deposits per 1,000 people, ATMs per 1,000 people, and branches per 100,000 people.
- Evaluation criteria used by the World Bank (Beck et al. (2008)):
  - (i) empirical evidence of direct link with final welfare (e.g., indicators that perform best in predicting economic growth, such as private credit-to-GDP);
  - (ii) goodness of fit (i.e., R2) in structural regression estimates;
  - (iii) factor loading along the principal component that measures the specific dimension of intermediation;
  - (iv) broadest coverage of countries and over time; and
  - (v) stability (i.e., the ratio of within sample variance to between sample variance).
- Soundness measures:
  - Banking sector soundness indicators include capital adequacy, liquidity, non-performing loans, and the z-score (a proxy for the distance to default).

### Indicator properties (as listed)
- Dimension: Size
  - Private credit by deposit money banks to GDP — Empirical link with growth: Direct; Goodness of fit: High; Factor loading: Excellent; Coverage: High; Within to between variation: (not separately given)
  - Bank deposits to GDP — Empirical link with growth: Direct; Goodness of fit: High; Factor loading: Excellent; Coverage: High
  - Bank domestic assets to GDP — Empirical link with growth: Indirect; Goodness of fit: High; Factor loading: Good; Coverage: High
- Dimension: Efficiency
  - Net interest margin — Empirical link with growth: Indirect; Goodness of fit: Medium; Factor loading: High; Coverage: High
  - Lending minus deposit rate — Empirical link with growth: Indirect; Goodness of fit: Medium; Factor loading: Good; Coverage: Low
  - Overhead costs to total assets — Empirical link with growth: Indirect; Goodness of fit: Low; Factor loading: High; Coverage: High
- Dimension: Reach
  - Deposits per 1,000 people — Empirical link with growth: Indirect; Goodness of fit: High; Factor loading: High; Coverage: Low; Within to between variation: NA
  - ATMs per 1,000 people — Empirical link with growth: Indirect; Goodness of fit: High; Factor loading: Medium; Coverage: Low; Within to between variation: NA
  - Branches per 100,000 people — Empirical link with growth: Indirect; Goodness of fit: High; Factor loading: Low; Coverage: Low; Within to between variation: NA

### Benchmarking Financial Development
- Purpose:
  - When comparing countries, control for policy-invariant structural characteristics (population size, density, age composition, income per capita, transition economy status, fuel-exporter status, offshore financial center status) that statistically impact financial development indicators.
- Method:
  - Use regression controls to estimate a country’s structural “benchmark” (expected average if using least-squares regressions or median/percentile if using quantile regressions).
  - The residual (gap) between actual performance and the expected benchmark can indicate underperformance (negative gap) or overperformance (positive gap). Overperformance combined with weak regulatory/governance frameworks may signal overshooting or boom-bust risk.
- Empirical findings summarized:
  - Depth indicators: positive relationship with income per capita (which tends to level off at higher income levels) and with size of the market (population size).
  - Negative associations: age dependency (more young people below 15) and being a transition economy tend to reduce depth.
  - Population density: tends to increase deposit depth but reduce credit depth.
- Data availability:
  - Benchmarked financial development indicators available from the World Bank’s Finstat database, which covers 183 countries and estimates benchmarks based on data from 2002-2011.
  - The panel regression includes year-fixed effects, but not country fixed-effects.

*Source: _cr13223 - References*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr13223.pdf_