Mission Concluding Statement 

4. The mission sees the following steps for the elaboration of a coherent macroeconomic policy program to address these risks. In February/March agreement could be reached on the final 2004 budget and possibly on severance packages to POEs' workers. During the remainder of 2004 the focus could be on monitoring implementation of the 2004 budget and on fleshing out: (i) a medium-term fiscal strategy (including the 2005 budget), (ii) structural reform measures, including KEK restructuring, and (iii) policies to promote domestic production and exports.

5. The remainder of this document outlines the mission's assessment of the current fiscal position and the medium-term outlook, main recommendations for the 2004 budget, and structural reforms.

A. Current Fiscal Position and Medium-Term Outlook

6. Barring major acceleration of current spending in the remainder of the year, the current budget out-turn for 2003 will be remarkably strong, with a surplus estimated at 12 percent of GDP (Tables 1 and 2). Revenues are projected to increase by some 18 percent compared to their 2002 level. About half of the increase is due to higher excises¹and the phasing in of income taxes. The remaining buoyancy is likely to be due to further improvement in tax compliance and, possibly, some underlying growth.² Current expenditures have been managed prudently to date and if the same stance were maintained, the outcome for the year would be in line with the staff recommendation in June. However, there is a risk of an acceleration of spending during the remainder of the year, given the room allowed by outstanding appropriations (Table 3).

7. Despite a significant increase in capital spending, its level will remain well below the budgeted amount and is likely to fall short of the generated current budget surplus, leading to an overall budget surplus of 4 percent of GDP.³ The authorities are encouraged to review the reasons for the slow pace of implementation of the capital budget, which, unlike in previous years, cannot be attributed to the late approval of the appropriations as most had been granted at the beginning of the fiscal year. The authorities may want to review the procurement law with a view to its streamlining.

8. The strength of the current budget balance is enviable. According to staff projections, by end-2003, the government will have accumulated cash balances in an amount of almost €330 million, equivalent to over 25 percent of GDP. If prudence in current spending is maintained, the budget would continue to generate substantial current surpluses in the future.

9. Such a strong fiscal position offers unique opportunities, but poses significant risks. The opportunities stem from the ability to finance an ambitious public investment program (PIP) to build the human and physical capital required for a strong private sector-led growth. The main risk is that politically-induced increases in unproductive current spending will erode the existing current budgetary surplus. Given Kosovo's limited capacity to borrow and modest prospects for foreign grants, this would deprive the budget of precious resources to finance public investment. The slow progress in elaborating a PIP adds the risk that budgetary resources are also wasted on low-yield projects.

10. To guard against these risks, the fiscal strategy in the coming 2-3 years should:

(i) Contain the expansion of recurrent current expenditures to moderate levels to prevent waste and policy reversals;⁴ this would preserve a comfortable current budget surplus as a main source of financing the PIP;

(ii) Step up work on strategic planning and the elaboration of a well-prioritized PIP with the aim of increasing spending on growth-enhancing investment projects to levels as high as the current surplus. A higher level of capital expenditure would be encouraged as long as it is consistent with a sustainable financing strategy—combining the use of accumulated government assets, prudent borrowing, and foreign grants—and as long as it would not lead to large swings in the overall public finance balance (i.e., the budget balance plus donor financed spending outside the consolidated Kosovo budget).

11. The mission would advise against any change in taxes that would lead to a significant loss of revenue. Before significant progress is achieved in costing public investment needs and before some of the uncertainty about the main parameters of fiscal solvency is removed, the government should refrain from measures that may jeopardize the revenue base and long-term fiscal solvency. In light of such progress and of unfolding developments, it would be opportune to re-assess the trade-offs in lowering taxes and scaling down government expenditures.

12. An illustrative medium-term fiscal scenario in line with this strategy is shown in Table 4. At this stage, the scenario is only illustrative as its development would require the elaboration of a bottom-up approach to costing public investment based on development strategies for the key sectors of education, health, and infrastructure.⁵ In this illustrative scenario, a prudent and gradual expansion of current spending together with a stable revenue base would continue to generate significant current surpluses. Combined with some draw down of government assets, this would allow financing large annual investment programs of some €200 million over the next 3 years. Once the peak of public investment is over, more modest levels of public investment could be financed, relying mostly on still comfortable levels of current budget surpluses. By end-2007 government assets would have declined to about €90 million (equivalent to about 15 percent of current expenditures), a cushion which is needed for liquidity and risk management.

13. The mission recommends that the authorities develop a Medium-Term Expenditure Framework (MTEF), which is firmly integrated in the annual budget process. An MTEF is a transparent planning and budget formulation process within which the Cabinet and central agencies establish credible contracts for allocating public resources. The process has two main components: fiscal targets set to maintain fiscal solvency and allocation of resources to strategic priorities within these targets. This allocation requires determination of government-wide priorities by the Cabinet collectively and portfolio-wide priorities by ministries individually. Technical work to prepare an MTEF should be the responsibility of the Ministry of Finance and Economy (MoFE), under the leading role of the Prime Minister's Office in managing core decision processes that involve the Cabinet.

14. Most donors are involved to varying degrees in supporting policy design and strategic planning. Based on a co-ordination meeting held during the mission, it seems that there is some overlap between various initiatives in certain areas, while there are still gaps in certain key sectors (e.g. education). Going forward, it will be important to ensure that donors' assistance responds as closely as possibly to well identified needs. The note attached in Appendix I, contributed by the Pristina DFID office, summarizes the involvement of the various donors. It was compiled during a donor coordination meeting with participation from the Prime Minister's Office, the Ministry of Finance and the Banking and Payments Authority of Kosovo.

B. The 2004 Budget

15. The 2004 proposed budget will be augmented by a supplemental budget early next year, which could be potentially as large as half of the original budget, i.e., 25 percent of GDP. The supplemental budget would re-appropriate some of the outstanding appropriations, which have not been used yet, plus some of the accumulated resources, which have not been appropriated. The existence of such a large stock of unused appropriations is the legacy of: (i) three years of appropriations far in excess of the administration's capacity to spend, and (ii) three years of budgeting rules by which multi-year commitments (such as for long-term capital projects) are appropriated in their entirety in the fiscal year in which the project is started. Box 1 explains the historical rationale behind these budgetary procedures and why the new circumstances necessitate a change.

16. There is official recognition of the need to free the budget process from this legacy as soon as feasible and move toward regular annual budgeting. To that effect, the authorities intend to perform a stock-taking exercise of all outstanding unused appropriations shortly after the turn of the year to determine the exact nature of each commitment in order to asses whether it should be re-appropriated or cancelled.

17. The mission recommends that a final budget for 2004 be adopted by early March, which should be based on: (i) this stock-taking exercise, (ii) the original 2004 budget, and (iii) the outcome of the ongoing work of evaluating and prioritizing all pending requests for additional appropriations for new investment projects. Such a budget should reflect roughly the amount of cash spending projected during the fiscal year. Unlike in the past, the whole amount of multi-year commitments should not be re-appropriated, only the spending need during 2004.⁶ The mission recommends that, for the sake of transparency and forward-looking planning, the full information on approved capital projects be disclosed to the Assembly for approval in a separate document.

18. Once a final 2004 budget is adopted in March, the mission would recommend that the MoFE's efforts be concentrated during the remainder of the year to elaborating a MTEF and the 2005 budget. Additional appropriations may be decided in the context of a mid-year review only if it is deemed that a delay would have serious negative effects.⁷ Barring such exceptional circumstances, budget arbitrage is better kept as an annual exercise and not as an ongoing process. Of course, a mid-year review is a good practice and should be used to inform the MTEF and the 2005 budget preparations. However, to limit the risk that spending agencies will see the mid-year review as another opportunity to "bid" for more funds, specific guidelines to steer this process could be sent to agencies in advance. The process should also be limited in time.

19. Below are specific recommendations regarding the main policies underlying the 2004 budget.

Public employment and wage policy

20. Budgeted appropriations for wages and salaries are excessive. The size of the civil service is projected to grow by 12 percent from the expected level at end-2003 (an additional 8,200 civil servants) while wages are projected to increase by 5 percent across the board. All in all, the wage bill is budgeted to increase by 3 percentage points of GDP to 14 percent.

21. We recommend, pending completion of the pay scale and job description review: (i) to impose a temporary hiring freeze in all units except police and the judiciary where the PISG has to assume new responsibilities transferred from UNMIK, and for tax administration (a total of about 2,800), and exploit to the fullest the possibility to redeploy existing over-employment in some sectors, (ii) not to grant the 5 percent across the board increase in wages, but to use the additional €8 million that this policy will cost to allow the much needed increase in wage dispersion, which will be an important element in the civil service reform being designed at the moment. Both measures will leave more options for the design of the civil service reform, including an appropriate wage structure and an appropriate size and skill profile of the civil service.

Spending on goods and services

22. We welcome the attempt to curb growth in spending on goods and services. However, the budget appropriation seems overly restrictive as it may imply a 15 percent decline from the projected out-turn for 2003 (€144 million compared to €168 million). We would, therefore, recommend a closer scrutiny of this item to ensure that essential spending on maintenance and repairs will be secured.

Social protection and other subsidies

23. With the introduction of a disability pension scheme in 2004, Kosovo has put in place a social safety net that is already providing minimum adequate protection to its most vulnerable citizens. At close to €100 million, the cost of this safety net would absorb about 20 percent of a prudent envelope for current expenditures (Table 6). We recommend, therefore, that the coverage of the social safety net be stabilized for the time being, and that any new policy initiative be fully costed before it is announced and subjected to the normal legislative procedures. Consequently, pressures to grant early retirement pension schemes under the basic pension system to former workers of public enterprises must be resisted. If no clear stop to this policy is set now, the spiraling costs of various special pensions schemes could endanger the fiscal sustainability of the social programs, as has been the experience in many countries.

24. As a general rule, the authorities should refrain from implementing any new policy retroactively, as potential claims to correct the wrongs of the past could be unlimited. We understand that the authorities intend to apply the new disability pension scheme retroactively from the beginning of 2004 while the scheme could become operational only in mid-year. The authorities are encouraged to examine the possible trade-offs in the use of the extra €6 million. For example, such resources could be used to defray some of the costs of funding severance packages to POEs' workers or other priorities.

25. The authorities are encouraged to examine the feasibility of offering severance packages to workers in POEs receiving subsides from the Budget. As long as the cost of these severance packages in a net present value term is less or equal to the net present value of future subsidies, the impact on the budget would be neutral to positive, while potential efficiency gains could derive from freeing these labor resources to more productive activities, and helping POEs to restructure their activities. Even if the impact on the budget is negative, some trade-offs may be worth examining if: (i) the extra cost would increase only marginally the overall size of the social safety net, (ii) it would ease social and/or ethnic tensions substantially, and (iii) it improves significantly the chances of success of POEs' restructuring.

26. It is the mission's view that the budget cannot afford to provide extra compensation to all SOEs' workers that might be laid off. Workers laid-off in the process of SOEs' privatization are already being partially covered by the severance package they will receive as a share of the privatization proceeds even if, in some cases, these severance packages will turn out to be relatively small. An unemployment insurance policy could be introduced, but it would have to target only short-term unemployment linked to cyclical fluctuations and should not lead to an excessive increase in the cost of labor. The authorities are encouraged to seek the help of the World Bank to design an appropriate policy.

27. Reduction of budgeted appropriations in subsidies to loss-making POEs should be coupled with concrete policy measures to stem the losses. The Kosovo Trust Agency (KTA) and the PISG should step up work to strengthen supervision of these POEs and develop concrete restructuring plans. Only then would real budgetary savings be likely to be forthcoming.

C. Structural Reforms

28. Discussion on structural reforms focused on the two key areas of privatization of SOEs and the restructuring of KEK. In addition, the mission held various meetings to follow up on the ongoing efforts to strengthen the statistical infrastructure.

Privatization of SOEs

29. The mission urges the authorities to work together to ensure a speedy resumption of SOEs' privatization. Further delays would deter potential bidders, postpone Kosovo's transition to a market-based economy, and damage long-term growth prospects. While providing immunity to the internationals working for KTA is beyond the authorities' control, UNMIK and the PISG should work together to ensure that differences in views regarding KTA's operating procedures will not cause further undue delays.

30. Looking forward, we would like to emphasize the need to structure the special spin-offs in a way that ensures the long-term fiscal interests of Kosovo. In particular we would draw your attention to the ferro-nickel complex, one of the largest SOE to be privatized and a potential source of economic growth in the region. Since the Mining Law is still in drafting, it is particularly important to ensure the long-term interests of Kosovo in the negotiation process, notably with regards to fiscal requirements such as royalties, surface fees, and other tax revenues that may be generated in the future.

KEK restructuring⁸

31. Building UNMIK-PISG joint ownership of a sound and credible strategy to restructuring KEK is critical. Given the previous failed initiatives at revamping KEK management, another failure will not only be financially costly, but, more importantly, it will damage the authorities' credibility and lessen the likelihood of success of future initiatives. Joint implementation mechanisms, such as a Steering Committee with political representation from the PISG and senior officials from UNMIK and a task force for implementation of the revenue improvement and theft control campaign, need to be set up.

32. Co-ownership of a credible strategy should find expression in a concerted campaign to send a clear message to the public. Such a strategy would require enactment of a satisfactory law to curb theft and creation of specific enforcement mechanisms. At the same time, there would be a need to design and implement a targeted social assistance system to provide lifeline support for the most vulnerable, and to review the taxation of petroleum products to encourage a shift to alternative fuels for space heating to ensure that the use of energy is affordable for the majority of the people.

33. A sound strategy also requires careful preparatory technical work to design the terms and conditions for handing over management to a private firm. Extra time and resources spent preparing the terms of a good contract can save much time down the road dealing with unforeseen complications. The authorities should secure assistance of legal, commercial and technical consultants to negotiate the proposed management contract. In addition, a financing strategy to cover KEK's investment needs, relying mainly on budgetary resources and on the mobilization of donors grants, should be put together. Commitment of this financing package upfront is needed to ensure orderly investment spending and halt the wastage involved in stopgap measures.

34. The mission would recommend that both KTA and the PISG be signatories to the management contract to be eventually signed, as the PISG will become a main stakeholder in the company given the budgetary resources needed to cover part of KEK's investment needs. If a tripartite contract were not to be legally possibly, then the MoFE should enter into a Memorandum of Understanding with the new private management firm containing similar provisions as those in the management contract. Consideration should be given to having the PISG appoint a professional financial management specialist as a Finance Director to supervise the implementation of the restructuring plan and budgetary investment of the government. In addition, the PISG would need to participate in KEK's annual budget approval process.

APPENDIX I

Donor Support for Policy Design and Strategic Planning

1. As part of the IMF mission to Kosovo, a donor meeting was held on November 11, 2003, to `map out' ongoing and planned donor assistance to the PISG in the areas of government policy, planning, and expenditure management. The results of this mapping exercise are shown in Table 1. The exercise proved useful in helping provide a more comprehensive picture of current donor support in this crucial area. It also stimulated debate within the donor group on the coordination and effectiveness of this support, and on how it could be strengthened.

2. DFID noted that there appeared to be a need for greater analysis of the needs of beneficiary institutions and for closer strategic-level coordination between donors in order to improve the coherence and effectiveness of donor-funded technical assistance. The IMF supported this view, adding that new activities in this area, including the proposed EAR assistance for public investment planning and economic strategy and project development, need to be preceded by thorough analysis and design work.

3. CIDA drew attention to the severe lack of reliable statistical data and the low capacity of the PISG institutions to generate and make use of such data. Without such data it is impossible for the PISG to develop coherent public policies. Statistical capacity needs to be addressed alongside capacity for policymaking and planning.

² However, in the absence of activity indicators, there is no hard evidence on recent trends. Banks and the business community report that activity in most sectors is stagnating, given flat or even declining incomes and the lack of progress in addressing impediments to export competitiveness and access to foreign markets. The continuing rapid growth in credit to the corporate sector is believed to reflect mainly the need of companies to turn to banks to finance their working capital given the squeeze on their profit margins. Core inflation seems to have turned slightly negative.

³ However, the overall stance of fiscal policy is unlikely to have exerted a contractionary impact on the economy as the overall budget surplus in 2002 was higher (at some 7½ percent of GDP).

⁴ At the moment, the main parameters of fiscal solvency are still fluid owing to uncertainty about the growth potential of the economy, the level of future foreign assistance, and the debt that might be inherited from the former Yugoslavia.

⁵ The development of such scenario would also need further elaboration of the underlying macroeconomic framework, one which should be based on a credible financing strategy for high growth to meet Kosovo's long-term employment challenge. For the moment, the scenario assumes an average annual nominal growth rate of 3 ½ percent. Much higher growth is needed to address the large and growing stock of unemployment.

⁶ The shift to true annual budgeting would require more systematic forecasting of cash and commitment flows.

⁷ Revenues are projected to increase by about 5 percent in nominal terms in 2004, an appropriately prudent estimate as further improvement in tax compliance becomes harder to achieve and as growth prospects for 2004 remain uncertain. In the event of higher than expected revenues, the decisions on the use of the additional resources should be taken in the context of the 2005 annual budget. In the event of a revenue shortfall, the existing stocks of government assets would allow room for maneuver thus preventing the need to resort to budget sequestrations.

⁸ This section has benefited from input from World Bank energy sector experts.