Fiscal Sustainability—Undermined by Ad Hoc Expenditure and Financing Policies
4. Fiscal policies are adrift—policy priorities lack clarity and expenditure management is loose. This year’s budget was predicated on the unrealistic assumption of budget neutrality of a substantial loan from the budget to KEK (3¾ percent of GDP), the publicly-owned energy company. Privatization of KEK and repayment of this loan by the new owner was supposed to offset in this year’s budget the capital expenditure associated with the extension of this loan. However, continued privatization delays in all likelihood will result in a pronounced increase in capital expenditures, even though the budgeted amount of the loan may still be reduced. The mission appreciates the importance of energy policy and its implications for the economy and national security. Nevertheless, given the high priority the government assigns to energy policy, it should stand ready to match energy-related expenditure increases with expenditure cuts to safeguard fiscal sustainability. Instead, there are additional unfunded mandates that are inflating this year’s budget expenditures by at least 1½ percent of GDP. As a result, the mission projects government expenditures to grow 39 percent this year, and fiscal risks may cause additional pressures.
• Mid-year budget review (MYBR). Contrary to the instructions by the Ministry of Finance and Economy (MoFE), spending ministries requested additional allocations under the MYBR and the government is now considering a further increase in expenditures over 1½ percent of GDP this year. No increases should be granted—they would call into question the government’s overall expenditure policy and set a dangerous precedent for the 2010 budget preparations.
• Fiscal risks. The dilapidated state of KEK may result in costly, additional energy imports; the costs and financing of the highway project to Albania considered as part of the MYBR have not been properly assessed and risks committing the government to substantial future outlays; the fiber-optics projects for schools (2 percent of GDP) currently under consideration by PTK, the publicly-owned post and telecom company, if undertaken, provides a public service and, in principle, should be accounted for as public investment; finally, calls for renewed wage hikes ahead of the November local elections should be resisted.
5. Recent legal initiatives may create additional expenditure pressures. Several laws and policy documents are being adopted without due consideration of their combined fiscal costs and consistency with the policy priorities set out in the government’s medium-term expenditure framework. These include the Law on the Rights and Responsibilities of Deputies (members of the Assembly), the Law on Civil Service, and the Law on Salaries of Civil Servants, and the White Paper on Social Policies. While the implementation of these policies is likely to be delayed to next year, these unfunded mandates will add at least about 1 percent of GDP to future expenditures.
6. Without substantial expenditure cuts, ad hoc deficit financing poses considerable risks to macro stability. If all expenditures are executed in full the fiscal deficit is likely to reach nearly 11 percent of GDP this year. While the mission understands that the execution rate of investment projects and some current expenditures may reach about 80 percent, the budget deficit would still reach approximately 8 percent of GDP. There are three major options for deficit financing: (i) drawing down the government’s bank balance at the CBK; (ii) spending a prospective dividend payment from PTK; and (iii) borrowing from financial institutions upon passage of the Law on Public Debt. All three options risk undermining macro stability, and this risk needs to be taken into account when determining expenditure priorities and the level of the deficit.
• Bank balance. A reduction in bank balance further limits the scope for the authorities to intervene in the financial sector, in case of need. While the sector has remained stable, prudent policy making requires preparing for the possibility of a liquidity shortage. Left unaddressed, the consequences of such a shortage are undoubtedly serious for macro stability and national security.
• PTK dividend. PTK deposits are an important source of funding for the banking sector (17 percent of total deposits at end-May 2009). If a dividend payment is received from PTK, the government intends to deposit these funds with the same commercial banks that are currently reliant on PTK deposits as funding. While a dividend payment on its own would not upset banks’ funding, its possible use as budget financing would.
• Public borrowing. The main risk is crowding out of private sector investment given that the growth of private sector credit continues to closely follow that of deposits.
Policy Recommendations—Expenditure Prioritization, Credible Fiscal Policy Anchor, and Improvements in Tax Administration
7. First, expenditures priorities need to be reassessed and substantial expenditure cuts are needed to restore fiscal sustainability. Based on year-to-date budget execution, capital expenditure allocations should be reprioritized to identify scope for further expenditure reduction. The extent of these cuts should be determined in order to safeguard an adequate level of the government’s bank balance held at the Central Bank of the Republic of Kosovo (CBK) and, more generally, put deficit financing on a solid footing.
8. Second, a credible anchor is needed to underpin fiscal policies and regain control—once and for all—over expenditures and the deficit. Besides lacking expenditure priorities and the risks from the energy sector, budget policies are subject to major uncertainties over the long term from (i) the forthcoming assumption of Kosovo’s share in the debt of the former Yugoslavia and its impact on Kosovo’s level of external debt; (ii) the level and duration of donor support and its degree of concessionality; and (iii) impending major structural changes affecting the composition of fiscal revenues and expenditures. Given these uncertainties, it is important that budget policies are derived from a consistent medium-term macro framework that ensures fiscal and external sustainability, while also paying due attention to Kosovo’s extensive development needs. The authorities should consider embedding policy targets resulting from such a framework into a simple and transparent fiscal rule; this would prove beneficial in setting and communicating policy. However, the effectiveness of any fiscal rule hinges on its political backing, and backing from the highest political level is necessary for success. The mission stands ready to develop with the cooperation of the authorities a simple fiscal rule consistent with a long-term macro framework during its forthcoming visits.
9. Third, efforts in tax administration need to be stepped up to broaden the tax base. Gains in tax administration may reduce the need for expenditure adjustment, while enhancing fiscal sustainability. The mission is encouraged by the planned introduction of taxpayer identification numbers for new businesses and the intended rollout to existing businesses by year-end. The long-awaited introduction of electronic cash registers is a useful further step. However, the government should only set standards for these registers and leave their provision to the private sector. Moreover, the mission is looking forward to the appointment of a new director of tax administration whose qualifications need to be commensurate with the challenges ahead.
Structural Policies—Vital For Fiscal Sustainability
10. The draft of the Law on Public Debt requires further modification to underpin fiscal sustainability. Much progress has been made in revising this important draft text. However, a number of key concerns remain to be addressed. The terms of municipal borrowing, as specified in the draft, should be tightened. In particular, an effective mechanism certifying municipalities’ financial management capacity is needed, as well as a more prudent ceiling on their stock of debt. The role of the CBK as the sole fiscal agent of the government should also be clarified. In addition, the draft’s consistency with other laws needs to be assessed. The IMF staff is ready to continue to work with the MoFE and the CBK to ensure that Kosovo’s public debt law will support financial stability and fiscal sustainability.
11. Last but not least, the single most important and urgent task is moving decidedly forward with reforming the energy sector, as discussed extensively during earlier missions. The annual costs to the budget of the energy sector is at least 3½ percent of GDP and rising. Adopting either one of the two competing energy sector strategies, as proposed by the World Bank and USAID, thus appears superior to inaction. However, the mission urges the authorities to assess carefully the fiscal implications of either strategy and ascertain their feasibility, including by considering the feedback from market tests. Given long implementation lags, substantial further efforts to improve the collection and billing of KEK are needed to curtail quasi-fiscal risks in the interim. Moreover, audits of financial operations, including for energy imports, should be considered to strengthen KEK finances.
Financial Sector Stability—Closer Policy Coordination and Tighter Regulation Needed
12. Close coordination between financial sector and fiscal policies is vital to underpin macroeconomic stability. So far the international financial crisis has had only a limited impact on Kosovo’s financial sector. However, the banking sector remains exposed to the risk of potential financial difficulties at foreign parent banks. These may exert pressure in Kosovo and possibly result in a liquidity shortage. Therefore, improved collaboration and close policy coordination between the CBK and the MoFE is needed to mitigate such risks.
• Central bank law and policy coordination. Under current legislation, the CBK does not have the authority to provide liquidity to the banking sector. The draft law, drawn up with IMF assistance, provides for limited discretionary authority to the CBK in this regard. The mission, therefore, urges the speedy adoption of this draft. In the interim, the CBK and MoFE should enhance their coordination to address potential difficulties in the banking sector.
• Lender of last resort function. While the use of the euro has conferred welcome stability, euroization leaves fiscal policy as the only major macroeconomic instrument. Fiscal policy objectives should be broadened to recognize the responsibility of the fiscal authorities for financial sector stability. In particular, the government’s bank balance needs to be maintained at an adequate level. Moreover, decisions that may weaken the stability of the banking sector—including the possible reliance on PTK dividend payments as budget financing—also need to be avoided.
• Tightening of exposure limits. In order to safeguard subsidiaries’ liquidity the CBK should consider placing limits on subsidiaries’ gross exposure to their parent banks, in addition to the existing limits on net exposure.
13. A sharper-than-anticipated economic slowdown raises the possibility of pronounced increases in non-performing loans (NPLs). System-wide NPLs are broadly in line with regional comparator countries, and the CBK should continue to ensure their proper classification. Moreover, the regulator should remain vigilant and maintain its intensified on-and off-site supervisory activities. In the current global financial environment, risks need to be managed proactively in the insurance and banking sectors.
We would like to thank our interlocutors for their hospitality and insightful discussions.