Republic of Kosovo: Concluding Statement of the 2011 Article IV Consultation Mission
IMF News, June 1, 2011
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- Published: June 1, 2011
Background
- Kosovo made significant progress with building key social and economic institutions in the past decade, supported by considerable external assistance.
- Growth in the 2000s was robust and tilted toward domestic demand, with remittances boosting consumption and FDI fueling construction; the export sector remained small.
- GDP per capita remains among the lowest in Europe; unemployment is estimated at about 40 percent of the workforce.
- Kosovo unilaterally adopted the euro as legal tender, importing a strong monetary anchor but placing a premium on disciplined macro-policies, competitive wage levels, and internal adjustment.
- The financial system expanded rapidly; banks are mostly foreign-owned and deposit funded. The central bank (CBK) has assumed financial supervision responsibilities and is building capacity for emergency liquidity assistance.
- Low public debt and sizeable government cash buffers reflect conservative fiscal policy in the 2000s; public expenditure as a share of GDP is modest in part due to low spending on transfers.
Recent developments
- The global financial crisis had only a modest impact due to limited integration into global financial and goods markets.
- Inflation tracked imported food and gasoline prices, triggering deflation in 2009 and double-digit inflation in early 2011.
- Credit growth moderated; banks’ portfolio quality deteriorated only modestly and profits remained solid. Large capital buffers suggest ample shock-absorbing capacity.
- Since 2008 the government adopted an increasingly expansionary fiscal stance, financing deficits from cash buffers, asset sales, and donor support.
- General government balance: surplus of more than 7 percent of GDP in 2007 → deficit of 2.6 percent in 2010.
- Capital spending has been the expansion’s main driver.
- In 2010, construction started on a highway linking Pristina with the Albanian border; costs are estimated at more than 20 percent of annual GDP.
- In 2011 spending pressures spread to current expenditures, with large increases in public sector wages and war related benefits.
- An 18-month Stand-By Arrangement (SBA) approved in July 2010 was interrupted in 2011 after program deviations (notably a large wage bill increase); a Staff Monitored Program was agreed at staff-level.
Short-term macroeconomic outlook and risks
- Outlook:
- Economy projected to grow by about 5 percent in both 2011 and 2012.
- High import prices expected to push inflation to more than 8 percent (annual average) in 2011; core inflation remains benign.
- IMF staff projects the current account deficit to increase to 25 percent of GDP, financed by FDI and other non-debt creating inflows.
- Risks:
- Large downside risks from domestic sources (economic policy missteps, political disturbances) and external sources (weaker growth in Europe).
- Weaker growth in Europe could reduce remittances and capital inflows, forcing contraction in domestic demand and affecting bank deposits and debtors’ capacity to service debts.
Enhancing competitiveness and promoting sustainable growth
- Growth model issues:
- Current growth model relies on exceptionally high remittances and FDI from the diaspora, which is likely unsustainable as diaspora Kosovars integrate into host countries.
- Key challenge: fostering emergence of a tradable sector to drive development and growth.
- Constraints to a tradable sector:
- Lack of infrastructure, notably in transport and energy supply.
- Limited administrative and judicial capacity impeding the business climate.
- Modest skill levels for large parts of the workforce.
- Wages, while low in nominal terms, are not particularly competitive when scaled with productivity measures.
- Government strategy and risks:
- The competitiveness strategy includes administrative and legal reforms, privatization of energy production and distribution, and an ambitious highway construction program; related fiscal burdens require careful management.
- Negative implications of government policies for labor costs should be avoided—sharp public sector salary increases may spill over to private sector wages.
- Minimum wages should be set at levels that avoid excluding employees from formal employment, especially younger workers.
Restoring fiscal sustainability
- Policy anchors:
- Maintain adequate liquidity buffers and sustainability of public debt.
- Liquidity buffers:
- Primarily government balances with the CBK; a useful yardstick is one month of public expenditures plus one-tenth of banks’ non-equity liabilities, adding up to about €300 million.
- Debt sustainability:
- IMF staff recommends targeting a medium-term primary deficit of about 0.5 percent of GDP.
- This would allow a very gradual increase of public debt, stabilizing at about 30 percent of GDP in the long term.
- Kosovo’s public debt law prescribes a maximum public debt ratio of 40 percent of GDP.
- Current stance and adjustment need:
- Fiscal stance conflicts with liquidity and debt objectives. Highway outlays give rise to temporary deficits of around 5 percent of GDP with limited financing options through debt issuance.
- IMF staff estimates the primary deficit underlying the 2011 budget at 3½ percent of GDP, implying a fiscal adjustment need of close to 3 percent of GDP.
- Civil service wage hike raises current expenditures permanently by about one percent of GDP; in 2011 this is partly compensated by lower capital spending.
- Receipts from privatization of the post and telecom operator expected to be the main source of deficit financing; possible delay is a risk—IMF staff recommends building a contingency reserve.
- Under unchanged policies, bank balances are projected to be depleted in the second half of 2012.
- Recommended adjustment:
- Fiscal adjustment of ¾ of a percent of GDP annually over a period of four years, with a mix of revenue measures and restraint on current spending, to safeguard liquidity buffers and fiscal sustainability, provided international assistance resumes in 2012.
- Spending and revenue guidance:
- New spending initiatives need thorough costing and require higher revenues or expenditure cuts elsewhere.
- The planned highway from Pristina to Skopje/Macedonia requires a sound financing plan as an indispensable prerequisite.
- Social priorities (pension for war veterans, benefits for former political prisoners) require a comprehensive assessment of eligible beneficiaries prior to benefit design.
- Funding higher permanent expenditures with one-off revenues is unsustainable; more permanent revenues are required.
- One option: raise the low yield from direct taxes; an upcoming IMF technical assistance mission will develop recommendations.
- Measures to avoid:
- Do not tap the assets of the pillar II pension fund (though a modest part of new inflows could be invested in government paper within legal limits).
- Avoid large-scale non-concessional borrowing.
Safeguarding financial stability
- Institutional constraints:
- Progress impeded by limited judicial capacity and incompletely defined property rights; World Bank-assisted cadastre improvements and judicial contract enforcement reforms are underway/needed.
- CBK independence and capacity:
- Full institutional and operational independence of the CBK is critical; the appointment of a new central bank governor earlier in the year followed the central bank law’s nomination rules.
- A priority is enabling the CBK to provide emergency liquidity assistance (ELA); ELA was introduced conceptually in 2010 and a memorandum of understanding between the government and the CBK needs completion to define duties and identify resources for ELA.
- Supervision and legal framework:
- Financial supervision has progressed using a based-risk supervision model under Basel I; at least one comprehensive on-site inspection per bank each year; advances in stress-testing.
- Passage of the new banking law will strengthen governance standards, tighten restrictions for lending to bank-related parties, allow consolidated supervision, and grant better tools for bank resolution.
- Deposit insurance law needs amendment to allow funds to be used for purchase and assumption transactions.
- Microfinance institutions should have clearly defined ownership structures and the CBK should be responsible for licensing.
We wish to thank the authorities for their hospitality and for the open and constructive discussions.